On Wednesday 27 June 2012, Barclays announced details of a settlement with regulators under which it agreed to pay record fines of £290m (AU$440m). This had been imposed by the UK’s Financial Services Authority and the US Commodity Futures Trading Commission and Department of Justice following an investigation into Barclays’ role in manipulation of the setting of LIBOR (the London interbank offered rate), used as a baseline for lending decisions in the UK and beyond.

The following day, Barclays’ stock price declined over 15%, wiping approximately £3.5bn (AU$5.4bn) off Barclays’ market capitalization. The following Monday, 2 July, Barclays CEO Bob Diamond bowed to shareholder and political pressure and announced his resignation. Two features of this story are particularly interesting. The first is that the decline in Barclays’ market capitalization was over eleven times the size of the financial penalty. The second is that Barclays’ stock price actually rose by 1.9% on the day of the announcement, but then fell so dramatically on the following day. 

The loss of Barclays’ market capitalization over and above the amount of the penalties represents in part the markets’ expectations of likely payouts Barclays will have to make in lawsuits by disgruntled counterparties who entered into derivatives and other transactions with it based on the (false) Libor rate. However, a big chunk of it surely represents the damage to Barclays’ reputation from having been involved in this kind of misfeasance. A firm’s reputation reflects the expectations that its trading partners have of the quality of its expected performance of its promises. In general this is difficult to assess, as an particular counterparty may have their own reasons for decrying ‘poor’ performance. Regulatory or judicial investigations provide an opportunity for the release of unbiased information about a firm’s behaviour which may be relevant to expectations about its future contractual performance. Where the firm is assessed by regulators to be engaged in misfeasance, potential trading partners revise their expectations downwards, which makes the terms of likely trade move against the firm, and its expected profits will decline. Stock price declines following regulatory announcements can be interpreted as reflecting this.

Although the numbers involved in this case are very large, the phenomenon of reputational harm following the announcement of regulatory sanctions is not new. In a recent paper Regulatory Sanctions and Reputational Damage in Financial Markets, available on SSRN here, my co-authors (Colin Mayer and Andrea Polo, both at the Saïd Business School in Oxford) and I study the impact of the announcement of enforcement of financial and securities regulation by the UK’s Financial Services Authority and London Stock Exchange on the market price of penalized firms. A primary function of regulation of financial markets is to uncover and discipline misconduct. In the absence of effective monitoring and enforcement of rules of conduct, financial markets are particularly prone to abuse. The imposition of penalties on firms is an important part of the armoury available to regulators and, following the financial crisis, regulatory authorities have shown a greater willingness to employ them. We find that, similarly to the case of Barclays’ LIBOR settlement, reputational sanctions are, for some categories of misconduct, far more significant than direct financial penalties.

We present findings from a uniquely clean dataset of enforcement actions drawn from the UK: those taken by the UK’s Financial Services Authority (‘FSA’) and the London Stock Exchange (‘LSE’). The FSA and LSE investigate firms respectively for possible violations of financial regulation and listing rules, but until recently, only made the investigation (and its result) public if and when the firm was found to have breached the rules and incurs a fine and/or an order to pay compensation. This meant that the announcement of a breach was an exceptionally clean signal to the market about the extent to which the firm in question abides by its legal obligations.

We conduct an event study of the impact of the announcement of such enforcement notices of breach on the stock price of the disciplined firm. We find that reputational sanctions are very real: their stock price impact is on average nine times larger than the financial penalties imposed by the FSA. In view of their scale, this paper points to the need for regulators to have a greater awareness of the reputational consequences of their actions than they have demonstrated to date.

Still more strikingly, we find that reputational losses are confined to misconduct that directly affects parties who trade with the firm (such as customers and investors). The announcement of a fine for wrongdoing that harms third parties has, if anything, a weakly positive effect on stock price. Hence, in the first type of case (harm to trading partners), reputation massively reinforces the penalties imposed by regulators; in the other (third parties) it negates or reverses them. Regulatory penalties that do not recognize these differences will be seriously excessive in the first case and deficient in the second.

These findings help to shed light on the second interesting feature of the Barclays case—that the stock price first rose in response to the announcement before falling so hard. Since January 2011—after the period we study—the FSA has begun to announce the opening of its investigations; the investigation of Barclays in this matter had been public knowledge since 27 April. So the initial stock price rise quite possibly represented relief on the part of investors that the fine was not even larger. However, as the matter was reported in newspapers the following day, it became clear that anyone who had borrowed money on a floating rate contract during the period when rate-fixing was going on might have overpaid. The full extent of the reputational loss then began to sink in, with disastrous consequences for Barclays. Whilst the contracts concerned were not with Barclays, many of the people concerned would also be Barclays actual or potential retail customers through current accounts and credit cards. Consequently this was a case of the bank suffering for having caused indirect harm to its own customers.