Compliance systems are key to reputational risk, says Sullivan & Cromwell’s Cohen

Regulators, he said, ask: “Did this violation occur despite a strong compliance function or because of the absence of a strong compliance function?” If the latter, they are likely to be more severe in their approach, he said.

Cohen, speaking in Philadelphia yesterday at the sixth annual Wharton Financial Institutions Center Risk Roundtable, sponsored by the Wharton Financial Institutions Center and consulting firm Mercer Oliver Wyman, said reputational risk is the “nearly dominant” threat to financial institutions today.

The spate of scandals in the last two years, from the Enron and Worldcom meltdowns to the more recent Wall Street stock research imbroglio, has caused regulators and prosecutors to move much more quickly and aggressively to investigate and prosecute financial institutions. Regulators are also holding financial institutions to higher standards than ever before, leading to situations where “widespread industry practice is suddenly illegal”, Cohen said.

Even so, Cohen said he does not believe any firm is in mortal danger. “There is a well-reasoned, conscious concern among regulators not to create a problem that would drive a company out of business,” he said. Although he believes there is an “insidious” relationship among financial institution regulators, prosecutors and trial lawyers, who share information and leverage off of one another’s investigations, he says this will not last. “This zeal tends to burn itself out.”

But the cost to a firm of being subject to an inquiry or indictment can be large – witness the recent $1.4 billion industry settlement over allegedly tainted stock research. “Most investigations do not lead to serious repercussions unless they involve the CEO or senior staff, or are repeat infractions,” Cohen said. Even so, he said firms must respond to regulatory criticism “with alacrity” and always seek to establish and maintain credibility in the eyes of their regulators.