Why Regulators Must Fight 'Control Fraud' Like Public Health Specialists .

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“Control fraud” is the leading cause of bank failures and financial crises. In “control fraud” the persons controlling a seemingly legitimate entity use it as a weapon to defraud. This essay analyzes the role of regulators in two epidemics of control fraud: the savings & loan debacle of the 1980s and the ongoing financial crises that first became acute in the nonprime mortgage sector.

Effective regulation is essential to prevent and contain such epidemics. An epidemic is the natural outcome of a “pathogenic environment” which requires a reservoir of hosts for the pathogens to infect, and “vectors” to spread the pathogen. The anopheles mosquito is a vector for malaria.

The financial world incurs epidemics of fraud when there is a “criminogenic environment.” Factors that make an environment criminogenic include non-regulation, assets that lack verifiable values, and compensation systems that create perverse incentives. The vectors of such epidemics include rating agencies, accounting firms, and appraisers. The symptoms include financial bubbles. They aid accounting fraud by creating fictional income to hide real losses. This feature of bubbles is analogous to infectious disease. Symptoms (coughing, sneezing) both spread disease and weaken the host, making him more susceptible to other infections.

Effective regulation is essential to prevent epidemics of accounting fraud. Economists who determine regulatory policy have operated like faith healers instead of public health specialists. Their policies create, rather than prevent, criminogenic environments. They did so in the S&L debacle, the Enron/WorldCom scandals, Russian privatization, and “The Washington Consensus.”

Economists’ failures are particularly tragic because there was a brief period (1983-1987) when regulators did act like public health officials. Those actions are largely unknown, as are the regulatory and Justice Department actions in 1990-92 that produced the largest number of convictions of white-collar criminals in U.S. history and prevented a subprime lending crisis.

The Clinton and Bush administrations seemed unaware of these regulatory successes. Their deregulatory policies produced a criminogenic environment. Ending effective financial regulation was a key step in producing that environment and delaying the diagnosis of the resulting epidemic of mortgage fraud and other forms of accounting control fraud.