Since the financial crisis, the banking industry has been subjected to high financial penalties and increased scrutiny by regulatory agencies. On the one hand, several banking professionals assume that the number and the amount of penalties have lowered bank profitability to an extent that it has created uncertainty concerning the solvency and the business model of banks. On the other hand, several commentators have described the litigation costs as another cost of doing business. Banks with high litigation costs tend to conduct business in areas that are not clearly regulated, which allows them to generate abnormal gains. These abnormal gains may exceed the financial penalties. In addition, many national tax laws allow banks to deduct specific financial penalties from the taxable income, reducing the impact of initially imposed penalties. As a result, shareholders might not be too concerned about the imposed financial penalties.

However, the penalties have reached a dimension that caused the European Systemic Risk Board to issue warnings that the current and forecasted levels of financial penalties might pose systemic risks (European Systemic Risk Board, 2015). The Board’s report argued that the growing number and amount of financial penalties could increase public concerns with the regard to the business model and solvency of banks. In addition, banks may be encouraged to withdraw from specific financial markets, which could lead to adverse effects on the functioning of these markets (European Systemic Risk Board, 2015). Thus, regulators might prevent future misconduct by imposing financial penalties, though by doing so, they might also increase systemic fragility. If that were the case, imposing penalties would undermine their mission to protect the stability of the financial system.

Based on these observations, our research seeks to study the effect of financial penalties on the banking sector. Since only little is known about this matter, our findings help financial authorities, governments, bank managers, and investors to gain a better understanding of the implications of financial penalties on the banking sector.

To answer our research questions, we accumulate a unique dataset that contains hand-collected information on the amounts and the dates of individual bank fines and settlements between 2007 and 2014. The annual reports of banks have been criticized because they disclose the cost of financial penalties in a non-transparent manner, and there is no common internationally accepted standard for listing these items in reports. To obtain an estimate of financial penalties paid by each bank in a given year, we use different databases of regulatory authorities as well as business information providers and newspaper archives. To measure the banks’ systemic risk, we use the dynamic Marginal Expected Shortfall of Acharya et al. (2010) and Brownlees and Engle (2012) and the ΔCoVaR of Adrian and Brunnermeier (2016).

We find a negative relation between financial penalties and pre-tax profitability but no relation with after-tax profitability. This result is explained by tax savings, as banks are allowed to deduct specific financial penalties from their taxable income. Moreover, our empirical analysis of the stock performance shows a positive relation between financial penalties and buy-and-hold returns, indicating that investors are pleased that cases are closed, that the banks successfully manage the consequences of misconduct, and that the financial penalties imposed are smaller than the accrued economic gains from the banks’ misconduct. This argument is supported by the positive abnormal returns, which we detected on the announcement of a financial penalty. Finally, we obtain evidence for a significant negative relation between financial penalties and banks’ systemic risk exposure but not between financial penalties and banks’ systemic risk contribution. We also demonstrate that the characteristics of the regulatory and supervisory system of a given country affect the relation between financial penalties and banks’ systemic risk exposure. Our results contribute to the ongoing debate on the appropriateness of financial penalties and address the question whether bank regulators limit or contribute to banks’ systemic risk.