Yves here. This article falls in the “mirabile dictu” category: an economist arguing that putting bankers in jail is necessary to combat the deterioration in behavior.
By Giancarlo Spagnolo, Professor of Economics at University of Rome “Tor Vergata” and CEPR Research Affiliate. Cross posted from VoxEU
How to save the banks but not the bankers? This column argues that fines for criminal behaviour in banks are not enough – it may be time to start locking people up.
Recent revelations on traders’ behaviour in the Libor rigging case is worrisome not only as a sign of the rotten culture of financial operators, but also for the sense of total impunity prevailing among them.1 They suggest that bank CEOs and complacent supervisors have tolerated and encouraged rate rigging – or negligently lost control of banks’ operations, for years. But they also indicate that law enforcement has been extremely weak in the realm of banking and finance.
In the light of these revelations, on 25 July the European Commission amended its proposal for a regulation and a directive on insider dealing and market manipulation to include criminal sanctions against that type of price fixing.2 Meanwhile, following a report by the FSA on the failure of the Royal Bank of Scotland, the UK Treasury started a consultation on how to introduce criminal sanctions against failed banks’ directors, ranging from automatic debarment to full fledged prison for extreme reckless behaviour (like RSB’s last acquisitions).3 The Libor and HSBC money-laundering scandals make this move even more likely.
The need for tougher sanctions is self-evident, as is the need to hold accountable negligent regulators. But are criminal sanctions a good remedy for financial misbehaviour? Wouldn’t it be better to substantially increase monetary fines? The question is warranted given that, with few exceptions, modern economists from Becker (1968) onwards regard monetary fines as a more efficient law enforcement instrument than non-monetary criminal sanctions.4
The problem with monetary fines is that not always wrongdoers can be fined at a sufficient level to achieve deterrence, given the evidently low probability of detection. Wrongdoers may:
• Not have sufficient wealth (not the least because they can conceal it);
• Transfer gains to other parties (uninformed shareholders, directors’ insurance funds, etc.); or
• Be protected by limited liability (for corporate fines).5
If there is a high risk that the individuals that took or covered the illegal acts cannot be reached by sufficiently high fines paid out of their personal wealth, complementing fines with non-monetary criminal sanctions becomes the only way left to enforce the law.
In the remainder of this piece, I will try to clarify why this argument applies in particular to bankers, intended as those individuals with inside information and control on the banks’ business (traders, directors, CEOs…). As we will see, the same reasons that for a long time have made banks ‘special’ for competition policy also ensure that to deter bankers’ wrongdoing, non-monetary criminal sanctions are necessary.6
First allow me to note that I cannot be suspected of favouring criminal sanctions in general. Some years ago, when the European Commission considered the introduction of criminal sanctions in antitrust,7 I argued against that. The main reason was that the potential of high corporate fines combined with leniency programmes (that give amnesty to the first conspirator that collaborates, introduced in the last decades in Antitrust) was far from being fully exploited in the EU. Antitrust fines were – and many think still are8 – too low to achieve cartel deterrence. We therefore suggested trying first to substantially increase antitrust fines, even at levels that could lead wrongdoing firms into financial distress. Selling a failing wrongdoing firm to new independent owners may be the best way to ensure it will change its course of action.9
For banks, however, this would not work. Banks are considered special, in particular from the antitrust perspective, because governments associate large, profitable banks to financial stability. For this reason, corporate fines on banks cannot be increased enough to discipline bankers.
Corporate fines of a sufficient size would weaken banks’ balance sheet, which is something nobody wants. The threat of destabilising banks through a fine will either induce governments to keep fines low (something courts already do with non-financial firms in weak financial situations10); or, it will increase the likelihood that part of the fine will be paid by taxpayers (through a higher risk of bailout, or subsidised liquidity and deposit insurance).
Individual fines on wrongdoing bankers may help, but they are also unlikely to suffice.
• First, they can (at least partly) be hedged in the market and through directors’ insurance.
• Second, the less honest bankers, the individuals we want to deter more, are also often specialists in transferring and hiding money; they will likely react to large individual fines by transferring or hiding their wealth.
• Third, companies typically indemnify executives (reimburse their fines, explicitly or indirectly) as long as they can argue that they did what they did for the company. Banks are no exception, and individual monetary fines are likely to be at least partly transferred on uninformed shareholders and taxpayers.
For all this reason fines must be accompanied by individual non-monetary criminal sanctions on wrongdoing bankers. But also by well-run leniency programmes and whistle blower reward/protection schemes.
Indeed, most evidence on financial and corporate misbehaviour comes from whistle blowers, or from settlements in which lenient treatment is traded against important information.11 Recent research shows that leniency in exchange for cooperation works well (has collusion-deterrence effects) if it is limited to the first cooperating wrongdoer and either: a) large rewards are paid out to whistleblowers12, or b) sanctions are sufficiently tough to make people afraid to be betrayed by fellow wrongdoers.13
To wrap up, our discussion suggests that:
a) Non-monetary criminal sanctions for individual misbehaving bankers are necessary as well as well structured leniency and whistle blowers programmes;
b) Settlements such as the recent ones, involving only monetary payments from the banks, but no fines nor other criminal sanctions from the wrongdoing bankers, should be avoided;
c) Such settlements should only be admitted if the information obtained in exchange are crucial to charge criminal sanctions against other wrongdoers, as in antitrust leniency programmes.
In the US criminal sanctions are already present, also in antitrust, and will likely be used to send to jail some of the Libor rigging traders, and hopefully their negligent (or accomplice?) bosses. The US also introduced in 2011 an amendment of the Dodd-Frank Act that allows regulators to reward whistle blowers that denounce financial misbehaviour at the cost of their career. This is promising – let’s see how it will be administered.
In the EU there seems to be no intention to introduce effective whistle blower reward schemes. There is therefore only one option open: steeply increasing sanctions. But as argued above, monetary sanctions will not suffice given that governments don’t want to damage banks with sufficiently high fines and that individual fines can be hedged or transferred on minority shareholders and taxpayers. Non-monetary criminal sanctions (debarment from the industry, and jail in worse cases) are harder to hedge or transfer. They are therefore more likely be born by the wrongdoing bankers.
Criminal sanctions might even help with the Eurozone crisis. Suppose CEOs and directors of the Spanish banks in need of rescue could be fined individually and debarred from working again in the financial sector as a condition to access to the EU rescue plan. Isn’t it likely that the open complaint by 180 German economists against Ms Merkel’s willingness to save the Spanish reckless bankers would be withdrawn? After all, it is not Spanish banks that need to be held accountable, but the Spanish bankers that continued to cash bonuses betting other people’s money on an obvious housing bubble that only bank-sponsored ‘experts’ had the ‘courage’ to deny.
See here for references