William Black, professor of economics and law at the University of Missouri – Kansas City (UMKC) and author of THE BEST WAY TO ROB A BANK IS TO OWN ONE gave an interesting speech in Iceland recently on his concept of ‘control fraud’.
My notes from the speech, which is available in two parts online here and
here.
Control fraud & Fraud epidemics
Control fraud – organizational leaders use the organization to game results to their own benefit and protect them from prosecution.
ECONOMETRICS & ENCOURAGEMENT OF ADVERSE SELECTION
Econometric practices tend to focus on benefits of high profitability as measured by share prices, net profits.
The problem is fraud is done to maximize these benchmarks in the most egregious way, thus, econometrics can often end up tacitly creating an environment that fosters fraudulent practice
Optimization mechanisms become highly perverse and instead encourage adverse selection.
In China, producers of Melamine-tainted milk saw massive competitive advantages in the baby milk market as their product was cheaper to make – and it killed and maimed tens of thousands of childrens.
Another great example of this were liar loans in U.S. as the very worst borrowers and data were encouraged to make incorrect applications.
Pareto optimality – this did not occur in U.S. subprime loans as both parties were made worse-off (the company extending the loan was worse off as was the borrower), the agents of the transaction however were a lot better off.
Long before fraud becomes widespread it can shut down markets – think about if 1 in a water 100 bottles were poisoned: no-one will drink bottled water.
CORPORATE GOVERNANCE & CONTROL FRAUD
Most of the supposed fixes don’t work – corporate governance etc.
Corp goverance is useful for many things but it won’t prevent control fraud.
The reason being you can’t ‘govern’ control frauds as the organization is controlled and governed already often by the very top and often with the backing of the entire organization.
You can short-circuit controls by bonuses, stocks etc. This can turn majority of people into supporters of the system. Any ‘softly, softly framework’ will be taken apart by this
It’s still possible to create the appearance of regular order by hiring prestigious institution to sign off on fraud – be this auditor or external directors.
Agency-cost is essentially a variant of control fraud but it says this can be paid away. You can’t pay away corruption.
Back-dating options – destroys all notion of performance-related pay, unless cheating is the performance you are benchmarking
How to Commit Control Fraud
Assets with no readily verifiable market values means you can inflate the assets very easily. (Options, securitized products).
These assets also inflate capital.
Creating phony assets allows you to grow very rapidly as you can leverage your assets.
Ultimately you will also create enormous losses
Firm assets must be convertible to personal assets for control fraud to occur – you can use accounting fraud to do this.
If many lenders or a handful of large lenders do this you create a hyper-inflated bubble.
Using corporate mechanisms to transfer wealth from stakeholders to insiders.
