Banking on Robbery: The Role of Fraud in the Financial Crisis

In his book, The Best Way to Rob a Bank is to Own One, William Black describes in detail the complex collusion between bankers, regulators, and legislators that brought about the Savings and Loan crisis of the 1980s and early 1990s. As part of the scheme, leverage was used to purchase bankrupt companies that became the basis for a Ponzi-like speculative bubble that ultimately collapsed. Deceptive accounting rules were used to hide the true state of the banks. Litigation and lobbyists were used to delay and frustrate timely enforcement, adding significantly to the taxpayer’s bill. Since the bursting of the S&L bubble, a number of additional financial bubbles and debacles have occurred, including Enron, the Internet bubble, the subprime bubble, and the Madoff Ponzi scheme. The details of the S&L crisis—civil and criminal trials and federal agency investigations—have been well-documented and will serve as a model for later crises. This paper will describe how fraud and corruption played significant roles in these financial crises, including the current crisis that began in 2007 and is still unfolding.

Motivation: Though “moral hazard” and “the principal agent problem” are frequently cited when discussing the causes of the financial crisis, relatively little research has focused on the role of fraud. This paper highlights the role of fraud and corruption in the financial crisis.

Method: We review the fraud literature with respect to past financial crises, and highlight commonalities between some of the well-documented financial frauds of the past and the current global financial crisis. We also support our arguments with some statistics from the current crisis that predicted the bubble before it burst.

Results: The evidence indicates that a well-established and well-known permissive attitude towards fraud created a global systemic risk of such significance that a financial crisis of major proportions was all but inevitable.

Conclusions: Reinstitution of previously abandoned regulations that protected the banking system from risk (i.e., Glass-Steagall Act) and a new commitment to SEC enforcement of already existing antifraud laws are greatly needed. If fraud is not pursued and prosecuted, future financial crises where fraud is a significant factor are likely to occur.

Keywords: Financial crisis, fraud, systemic risk.