Law enforcement spillover effects in the financial sector

• Published date: 01 November 2022
• Author: Shivam Agarwal,Cal Muckley
• Date: 01 November 2022
• DOI: http://doi.org/10.1111/eufm.12356

DOI: 10.1111/eufm.12356

ORIGINAL ARTICLE

Law enforcement spillover effects in the

financial sector

Shivam Agarwal

1,2

|Cal B. Muckley

3

1

UCD College of Business, University

College Dublin, Belfield, Dublin, Ireland

2

Rennes School of Business, Rennes,

France

3

Banking & Finance, Smurfit Graduate

School of Business and Geary Institute,

University College Dublin, Ireland

Correspondence

Prof. Cal B. Muckley, Ph.D, Chair in

Operational Risk, Banking & Finance,

University College Dublin (UCD),

Republic of Ireland.

Email: cal.muckley@ucd.ie

Abstract

Recipient firms but also comparable peer firms exhibit a

sizeable negative capital market reaction to United

Kingdom's regulatory enforcement actions. This result is

invariant to the identification of peer firms as belonging

to the same industry classification or as having com-

parable propensity scores to attract a sanction. Indis-

criminate regulatory contagion, however, is ruled out.

As per expectation, enforcement actions which pierce

the ‘corporate veil’, that is, target an individual within a

firm, are related to no significant firm‐level market re-

actions. These findings, in the financial sector, indicate

that sanctions are associated with a material spillover

effect consistent with informed regulatory contagion.

KEYWORDS

abnormal stock returns, enforcement actions, peer firm effects,

regulatory risk

Eur Financ Manag. 2022;28:1477–1504. wileyonlinelibrary.com/journal/eufm

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This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution and

reproduction in any medium, provided the original work is properly cited.

© 2022 The Authors. European Financial Management published by John Wiley & Sons Ltd.

The authors would like to thank Phelim Boyle, Michael Brennan, Emmanuel Eyiah‐Donkor, Mohamad Faour, Ron Giam-

marino,BruceGrundy,JamesNaughton,KarlyeDiltsStedmanand the Centre for Financial Markets at University College

Dublin. We are also thankful to an anonymous referee and John Doukas (the Editor) for their helpful comments and

suggestions. Shivam Agarwal and Cal B. Muckley are grateful for the support provided by the VAR consortium, Science

Foundation Ireland and an Operational Risk industry consortium comprising: Bank of Ireland, Citibank Europe Plc, Deloitte

Ireland and Institute of Banking. Shivam Agarwal also gratefully acknowledges the support of a generous UCD Business

School Doctoral Scholarship. Cal B. Muckley would like to acknowledge the financial support of Science Foundation Ireland

under Grant Number 16/SPP/3347 and 17/SP/5447. This study has also received funding from the ADAPT Centre for Digital

Content Technology, funded under the Science Foundation Ireland Research Centres Programme (Grant 13/RC/2106_P2),

co‐funded by the European Regional Development Fund.

JEL CLASSIFICATION

G21, K42

1|INTRODUCTION

We investigate the spillover effects of regulatory sanctions on financial firms. The global financial

crisis was pivotally related to deficient banking oversight and the nonenforcement of legally binding

requirements (Barth et al., 2013;Caprioetal.,2010). Since then, major regulatory reforms have been

undertaken, which have resulted in increased regulation and supervision with fines running inter-

nationally to 400 billion USD, 2008–2020.

1

A growing body of research has analyzed the impact of

regulatory sanctions,

2

such as on the market price (Armour et al., 2017;Floreetal.,2021;Nguyen

et al., 2016), the bond and credit default swaps (Flore et al., 2021) and the financial safety and

soundness (Delis et al., 2017) of penalized firms. We know less, however, about the effects of

regulatory sanctions on peer firms, and whether the announcement of misconduct can introduce

indiscriminate contagion. Alternatively, informed regulatory contagion can prevail. An announce-

ment of misconduct can generate negative reputational contagion effects, in comparable firms, with

respect to the likelihood of receiving a sanction or it can provide new information reducing the

uncertainty associated with such settlements, and improving the competitive position of the peer

firms. This is the first paper to investigate the spillover effect of financial regulatory sanctions on peer

firms and hence the wider systemic impact of sanctions in the United Kingdom's financial system.

Financial sector misconduct has risen to a level that has the potential to create systemic risks, that

is, the risk that banks may fail together, and undermine trust in financial institutions and the market

(Mark Carney, former governor of the Bank of England; Financial Stability Board, 2018). The extent

of an equity market spillover effect in the financial sector, due to the disclosure of misconduct, is of

critical importance due to the central role of the financial sector in the transmission of shocks to the

real economy (e.g., Cornett et al., 2011;Vinas,2021).InaEuropeanSystemicRiskBoardreport

in 2015,itisindicated:‘Confidence is fundamental to the stability of the banking sector and financial

markets. Issues undermining it can thus have a systemic impact. A misconduct case in one bank can

quickly undermine the confidence of the public in the entire banking sector, because it is difficult for

outsiders to differentiate between banks which behave well and those which behave badly’.Asa

result of the possibility of systemic risk associated with the information content of sanctions, we

investigate the extent of the stock market spillover effects due to regulatory sanctions in respect to

misconduct. We aim to discern whether equity market spillover effects exist and whether they are

well informed, that is, whether they pertain to comparable firms only or are indiscriminate and

whether they can discern between individual‐specific and financial institution level sanctions.

The study of spillover effects in the United Kingdom's financial system has merit over other

countries. The UK regulators use a watertight communication system. As highlighted in

Armour et al. (2017) and Flore et al. (2021), the UK regulators only make their investigation

and decisions public once the misconduct has been established.

3

In contrast, a process of

1

See https://www.spglobal.com/marketintelligence/en/news-insights/trending/cg9b4mhc6revpg5jnhqgxa2 and author

calculations which are available on request.

2

Throughout the paper we have interchangeably used ‘regulatory sanction’and ‘enforcement action’.

3

The UK regulators' announcements are generally unique events. They can pertain to the information content of three

or four separate announcements (e.g., investigation, conclusion, penalty and civil actions announcements) in a typical

US Securities and Exchange Commission case (Flore et al., 2021).

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