Another week, another bank scandal. The latest affront: a vast money laundering scheme by HSBC involving illegal drug and possibly terrorist funds. Some say it will take jail time for executives to end the epidemic of financial crime. But is the court system up to the task?

While HSBC has not been charged formally with a crime (it is in settlement negotiations with British and American authorities), the bank is preparing to pay as much as $1 billion in fines and has twice in recent years apologized for money laundering activity. The bank’s chief executive, Stuart Gulliver, was quoted yesterday calling the bank’s failed money-laundering controls “shameful and embarrassing.”

The list of major of bank wrongdoings has been relentless leading up to the HSBC case. The latest, involving JPMorgan Chase & Co.’s derivative losses of nearly $6 billion, along with the LIBOR interest-rate-fixing scams, seem to solidify charges of systemic corruption rather than problems resulting from lone-wolf traders or some other one-off explanation.

In the HSBC case, a multi-year probe found that the bank provided a network for illegal drug money, maintained clients who allegedly had terrorist connections and sterilized information from transactions that would tie them to principals in Iran, which, according to press reports, could place the bank in breach of U.S. sanctions. Senator Carl Levine of Michigan, who led the U.S. investigation, said HSBC’s culture has been “pervasively polluted for a long time.” HSBC is also potentially involved in the LIBOR scandal, which could involve an additional $1 billion in fines.

Those levels of fines and penalties can seem big. Barclays recently paid $453 million to U.S. and British regulators for fixing LIBOR interest rates, and many other big banks look likely to be involved. But given the huge size of the banks, do these fines simply amount to a relatively small cost of doing business?

“I think penalties for these large corporations need to be much higher,” says Wharton finance professor Franklin Allen. “They should perhaps be defined in terms of a percentage of profits over recent years or of market capitalization.” Allen also believes that people should go to jail if the offenses are serious enough. He thinks the recent LIBOR fines for Barclays were “much too low,” although in the LIBOR case more broadly, there is talk of some jail time for “the fraud abuses.” And even in the case of HSBC, where penalties could reach $2 billion once LIBOR offenses are accounted for, “the kinds of figures they are talking about are small given the seriousness of what the bank did.” 

Wharton finance professor Richard J. Herring thinks jail time may be the only thing that has a chance of deterring fraud. Financial penalties don’t seem to work. It is generally “inappropriate to levy penalties on corporations because shareholders seldom have the information or ability to curb such infractions.… Most shareholders simply … sell their shares if they don’t like the firm rather than try to reform it.”

That leaves stiffer sanctions on the “individuals who commit such crimes” as the best route, Herring argues. Yet, “from the evidence of the worst crisis since the Great Depression, it would appear that the chances of being held personally liable are minute, while the potential gains, if you aren’t caught, are huge. It’s not surprising that we seem to be witnessing an epidemic of financial crime.”

What’s more, in the HSBC case and many others, bank bonuses appear to be tied to risk management performance. While perhaps well-intentioned, this incentive model can end up discouraging bank executives from reporting problems to compliance officials. Such misaligned incentives look like “a major flaw in our attempt to establish accountability that undoubtedly contributes to excessive risk taking,” Herring says.

On those rare occasions when officials actually do try to prosecute someone, “it usually ends in an out-of-court settlement….”  And even when a fine is levied, insurance usually covers it, Herring points out. True, insurers could try to throttle such behavior “by demanding more rigorous compliance inspections, but so far they have mainly reacted by raising rates that are passed on to the shareholders.”

Given such incentives, or the lack thereof, Allen agrees that jail sentences would help, along with more bonus clawbacks for senior managers that should go back “many years.”

Mauro Guillen, a Wharton management professor, agrees. “Aiding in money laundering should be punishable by jail time. I think it is dealt with in that way in many countries. I can imagine, though, that targeting specific employees of a bank might be difficult.”

So, even if regulators get more serious about imposing jail time on miscreant bankers, it may not solve the problem. It’s very difficult to prove a case beyond a reasonable doubt, Herring notes. “The standard of proof in a criminal proceeding is very high, and most juries simply can’t understand the complexity of many financial crimes.”

That fact that no bank executives have gone to jail following the global financial crisis supports this view. And the most notable exceptions do not inspire confidence. Before finally being convicted, Bernie Madoff managed to “elude prosecution for decades even when it was evident to sophisticated observers that he was running a Ponzi game,” Herring says. And Martha Stewart, also convicted, had nothing to do with the “the financial crisis that has impoverished many Americans. This was most assuredly not a victimless crime, but the authorities appear to lack the will or the appropriate tools to prosecute the perpetrators. Until this situation is improved, we should not be surprised to witness more of the same.”

It’s not this way in every country. Some show little tolerance for those involved in major bank fraud. For example, yesterday an Iranian court sentenced four people to death by hanging for a billion-dollar bank fraud that tainted the government of President Mahmoud Ahmadinejad, Reuters reported. In addition, two people were sentenced to life imprisonment, others received jail sentences of up to 25 years and some were sentenced to flogging.