Often, I get complaints that focusing on criminal penalties for financial fraud is for some reason unrealistic, and that settlements can themselves be meaningful if they cause the offending party some economic pain. This overlooks several points. First, no executive ever pays out these settlements; they basically come out of reserves, and the most that can be said is that shareholders pay the cost if a publicly traded company pays the fine. So the individual fraudster experiences no real pain, and therefore has no deterrent against the same behavior in the future.

But the Washington Post recently identified another issue. The way in which the government has structured their settlements, particularly settlements with the financial industry, allow the offending party to take a tax write-off for the penalty.

When Bank of America agreed in December to pay $335 million to resolve federal charges that its mortgage-lending arm discriminated against black and Hispanic borrowers, government officials hailed it as the largest fair-lending settlement in history.

But, in fact, the banking giant has the right to a massive discount on the payout. Thirty-five percent of the settlement is deductible. That means Bank of America could wind up saving $117 million on its tax bill [...]

Corporations can write off any portion of a settlement that is not paid directly to the government as a penalty or fine for violation of the law. A majority of the settlements that federal regulators announced in the past year include some form of restitution that is eligible for a tax deduction.

For example, the great majority of the $25 billion settlement over foreclosure fraud can be written off by the five major banks as a business expense. Only $2.5 billion of that, about 10%, resulted in direct payments to the states and the federal government. And this runs the gamut of virtually all settlements the government has forced upon financial entities over the past few years.

There’s a simple fix here, and that’s for Congress to change the law and make these kinds of penalties not tax-deductible. The problem, say a couple tax experts in the article, is that this would make litigation more likely, and a verdict resulting from such an outcome would also be deductible. Of course, Congress could change THAT outcome as well.

Penalties for defrauding customers shouldn’t come with a sweetener of a tax break; that much is simple. Once that becomes the goal, you reverse engineer back to the policies that would make it a reality. Of course, this only works if you assume that a Congress captured by banking interests WANTS to fix this. Max Baucus and Chuck Grassley had legislation to take care of this in the past, but they haven’t submitted it since 2005.

The other possibility is for the regulators to stipulate in the language of the settlement that the company in question cannot take a tax break. The SEC did that with the Goldman Sachs settlement on the Abacus deal. Goldman did not protest (they made about four times as much on the deal than they paid in fines, after all). So there are ways to get this done, it just takes a little will.

Of course, the idea that these settlements are merely the cost of doing business is magnified when they get written off as business expenses.