Sanctions for Financial Misconduct and Other Ways to Stop Malpractice in Banks

Since the 2007-2009 financial crisis, banks have experienced an explosion in so-called behavioral risk, which relates to losses stemming from the incorrect supply of financial services (such as selling unsuitable products, market manipulation, violating tax regulations or anti money-laundering rules). Stricter regulations have made bad behavior easier to spot, and greater awareness on the part of government authorities and private consumers means banks are now more closely watched.

According to the EBA, the European Banking Authority, in an adverse scenario, behavioral risk could end up costing €71 billion to the top 51 European banks in the next three years (with 15 banks suffering hits of more than €1 billion each). A questionnaire sent to 38 major financial intermediaries indicates that 44% of respondents have had to pay more than one half billion euros in damages and fines since 2007. Based on press reports (reclassified by CCCP Research Foundation, a risk management company), in Europe this type of cost has grown strongly in 2011-2015 and the additional reserves put by banks in their balance sheets are a signal that further write-offs are expected. Major banks such as BNP Paribas and Deutsche Bank have already exceeded the threshold of €10 billion to cover themselves against the risk of future losses.

As a consultant on banking supervision for the European Parliament, I have looked at a number of confidential data concerning Italian banks, and these show that while the largest institutions generate the greatest losses, it's the smaller financial companies that are more adversely affected in percentage terms. In addition, banks that face bankruptcy proceedings and are receiving government aid or other kinds of emergency finance are the ones that are most exposed to the risk of misconduct, and this was also the case in the early years of the analysis when extraordinary interventions had yet to take place.

➜ ex post action is not enough
Behavioral risk is often associated with phenomena involving several banks at the same time, such as manipulations of interest rates or sales of questionable financial products to customers. This means that once the phenomenon is discovered, fines and damages can simultaneously hit a large portion of the banking system, giving rise to systemic risk endangering the whole industry. There is also the danger that losses due to financial misconduct will be passed on to consumers by raising fees, employees in terms of layoffs, or shareholders by reducing dividends paid.

Consequently, while it is true that pecuniary and criminal sanctions can play a positive role as they discourage further future violations and recover the unjustly obtained profits to tax-payers, ex post repression of incorrect behavior cannot be the only answer. A wide range of preventative actions must also be pursued.

➜ Clear rules against gray areas
Examples include improving the quality of banking governance, strengthening the requirements for administrators in terms of their technical knowledge and real independence, and preventing variable compensation mechanisms that encourage (or tolerate) inappropriate financial practices by awarding bonuses in proportion to initial placement fees, even in the presence of long-term investment products. It also means to encourage whistle-blowing, a practice whereby employees, suppliers and administrators of a bank may report wrongful behavior to the supervisory authorities, in exchange of anonymity and protection from possible retaliation. Finally, making the rules clearer, so as to prevent the presence of gray areas that led to improper forms of behavior considered acceptable in the past, which were then sanctioned with severity only after they had been adopted by a large portion of the banking system.