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The dark side of finance

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The dark side of financeWhite collar and corporate crimes have long been part of markets and are among the most difficult crimes for the legal system to deal with, let alone control. This is especially so where these crimes are of enormous proportions or involve some of the most powerful individuals or corporations in a society.

Their seeming invulnerability to regulation is enhanced in boom times and this is further buttressed by powerful political forces supporting corporate risk taking. These political forces have served to muzzle or curtail the activities of enforcement agencies either directly, through the lack of adequate resources, or indirectly, by promoting ideologies which legitimize the minimal role of government in markets and a preference for industry self-regulation.

In so far as corporate conduct is concerned, it has proved to be very difficult to criminalize catastrophic failures, such as those that have lead to the nationalization of a number of British banks. The savings and loans crisis of the 1980s in the USA saw much unlawful risk taking and looting by bank executives, but few criminal actions; although many banks were closed down. The 1990s actually saw a contraction in the use of criminal law for white-collar crimes. The occasional “rogue” trader, such as Nick Leeson in the collapse of Barings, was successfully prosecuted. This poor history of enforcement is not surprising given the limited effectiveness of criminal sanctions in this area.

In the USA, the collapse of investment bank Bear Stearns, shortly after the collapse of Northern Rock plc in the UK, immediately saw US prosecutors bring charges against former officers of Bear Stearns. Likewise, after the collapse of Enron and WorldCom, US prosecutors moved quickly to convict their senior corporate officers.

More recently, after pleading guilty, Bernard Madoff was very quickly given a 150-year sentence for his role in a massive fraud involving a massive Ponzi scheme. Such actions have been almost unheard of in recent times in the UK, with former chief executives and company chairmen, instead being, are allowed to retire gracefully, often with very comfortable pensions.

Ponzimania and the Madoff affair

One of the many frauds to come to the surface following the collapse of the financial bubble of the last decade has been a number of pyramid-like Ponzi schemes that seem to have been proliferated during the boom years without much interest or concern from regulators and investors. The most dramatic of these involved New York securities identity, Bernard Madoff. At first sight, the conviction of Bernard Madoff in July 2009 for financial fraud and his sentencing to a term of 150 years seems like a signal achievement for the legal system in dealing with financial misconduct. However, the fact that it took almost two decades for authorities to act in this case, after the SEC had had many opportunities to intervene earlier and to limit the massive US$65 billion loss that investors suffered as a result of this fraud.

Madoff's conviction was not the end of the matter as efforts were made to convict others who may have been involved in this scandal and to recover lost funds. Frauds such as that perpetrated by Madoff only really became apparent as anxious investors sought a return of their funds due to the liquidity crisis; most investors found that no funds were left and that they had been duped, usually by someone who seemingly had impeccable credentials and was widely trusted in the business community and by regulators.

Madoff claimed that he alone had been responsible for the Ponzi scheme which misappropriated the massive sum of $65 billion. He probably had a small number of direct accomplices, such as some immediate members of his family, but this was not a massive corporate failure, such as the unwise expenditure of almost £50 billion by the Royal Bank of Scotland in 2007 in the takeover of Dutch bank ABN-Amro and which triggered the failure of RBS itself.

Whilst the damage suffered as a result of these two episodes was roughly similar, their legal framework was of course vastly different. There was no suggestion of fraud on the part of RBS in its actions to acquire ABN-Amro, although it was blighted by what is sometimes called “the winner's curse” in that it imposed a debt burden on the company which made it unsustainable. The liquidity crisis simply made funding such as transaction unsustainable for RBS. Many of those who invested in RBS and those who left their money with Madoff suffered a similar fate with a significant decline in the value of their investments or assets. From a consumer protection perspective, those who placed their faith in a reckless RBS and in Madoff were both to suffer considerably. But the law treats these two episodes quite differently given the different definitions of corporate misconduct that applied in each instance.

"The Madoff affair was so enormous that it will not come to an end merely with the conviction of its principal actor; there will be years of litigation by victims to seek to recover some of their lost investments."

The liquidity crisis also effectively drew attention to Madoff's Ponzi scheme, even though for many years he had managed to pass himself off as an esteemed member of the financial community in New York and internationally. The most extraordinary thing about the Madoff affair is that it was allowed to continue for as long as it did without effective regulatory challenge. Like the failure of the FSA to prevent the collapse of Northern Rock by adequate monitoring, the SEC seems to have had only the most cursory interest in Madoff's real activities. Instead, he was often seen as “an expert” that the SEC would even call upon for advice. As a former Chairman of NASDAQ, Madoff's standing in the market was high. He used his standing as an “insider” to lure people to give him their money to invest upon their behalf.

The Madoff affair was so enormous that it will not come to an end merely with the conviction of its principal actor; there will be years of litigation by victims to seek to recover some of their lost investments. Regulatory agencies will also need to spend some time to create public confidence in their abilities and to show that they are capable of effective action.

Most importantly, the affair has seriously damaged the idea that markets can regulate themselves without stronger external oversight. The fact that many large banks were suspicious of Madoff, yet did not act or speak out against him, also raises questions about the self-regulatory capacity of financial markets and the corrosive power of self-interest.

The costs of the financial crisis

We have yet to see whether the financial crisis will bring about fundamental changes in regard to the problems that led to the current global crisis. As Timothy Geithner has warned, reforms in the wake of financial crises all too often come too late to be effective; one might add that those that do are occur are much weaker than might be necessary. Is it then a prospect of “too little, too late” that we see on the horizon? It is really too early to say, but all the vital signs are not encouraging.

The costs of the recent financial crisis have been massive and widely shared due to the resort to the general taxpayer to fund bank rescues. However, as the tax burden is not equally shared, because many corporations and wealthy individuals have been more effective in being able to limit their payment of taxes through the use of off-shore havens, some have carried a heavier cost burden than others.

Other costs from the financial crisis include the significant down-turn in the economy, insolvencies and massive unemployment that has accompanied the crisis. In contrast to the costs of the financial crisis are the benefits that individual bankers have received both before and after the collapse, such as generous bonuses on the basis of short-term gains and the payment of generous pensions to leaders of failed banks. This is an astonishing, but not surprising, contrast in the calculus of costs and benefits arising from this crisis. Not surprisingly, there has been some political concern about the revival of pre-financial crisis bank bonuses.

Beyond cost-benefit analyses

The financial crisis has directed attention to the internal governance mechanisms and values of modern financial institutions. This has provoked a strong debate which may leave an impact upon the shape of the law and regulatory strategies in this area. However, there is always a danger that following the end of the crisis that many market actors will simply be tempted to return to their old ways. This is a very natural and difficult tendency to change.

One of the darkest episodes in the recent history of stock markets in the form of the Ponzimania has been found to have been so widespread in recent times. Financial crises sometime uncover a large number of illegal and fraudulent practices that flourish undisturbed in “normal” times. This crisis occurred as a result of the liquidity crisis and meant that there was a demand from investors for a return of their capital or investments. We saw a run on British banks with the first of these being the run on Northern Rock plc in September 2007.

We also saw demands by investors for the return of funds that had been invested with securities trader Bernard Madoff in New York. This uncovered a massive fraud and the loss of some $65 billion in investor funds though Madoff's Ponzi scheme. The failure of regulatory agencies over many years to deal with this scandal is extraordinary. Equally troubling has been the failure of some banks and other market actors that suspected Madoff's fraud to act more effectively against him.

The dominance of self-interest and a culture of greed have undermined trust in market institutions such as banks, securities advisers, regulators and the capacities of the legal system. Despite the conviction of Bernard Madoff, it is clear that had there been more effective monitoring of banks transparency in regard to market actors, some of the damage that has been done in recent years might have been avoided. As US Treasury Secretary Timothy Geithner noted recently, there is a need for a smarter approach to business regulation than that which we have previously seen. This is especially so in regard to large banks and financial institutions.

August 2011.


This is a shortened version of “The financial crisis and the haphazard pursuit of financial crime”, which originally appeared in Journal of Financial Crime, Volume 18 Number 1, 2011.

The author is Roman Tomasic.