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This paper shows that the reregulation of the savings & loan (S&L) industry was successful because the regulators correctly identified the primary cause of the second phase of the debacle as an epidemic of “accounting control fraud” and took effective measures to contain such frauds. Control frauds occur when the persons controlling a seemingly legitimate organization use it as a “weapon” to defraud. In the financial sector, accounting control fraud is the “weapon of choice.” The regulators’ primary insights were (1) that lenders optimize accounting fraud by engaging in a distinctive operational pattern that would be irrational for any honest firm and (2) that such frauds’ “Achilles’ heel” is the need to grow rapidly, and (3) the deregulation of the industry produced a “criminogenic environment” that led to an epidemic of control fraud that caused a regional bubble in commercial real estate. The regulators used the distinctive pattern to identify and prioritize the frauds for closure while they were still reporting record profits and minimal losses and to adopt a rule restricting growth. They deliberately burst the financial bubble. The regulators also worked with law enforcement to obtain over 1000 “priority” convictions of senior insiders.

A similar criminogenic environment produced the housing bubble and the current crisis. The regulators and prosecutors appear to have forgotten all of the regulatory and prosecutorial successes of the S&L debacle. This essay argues that there is no substitute for effective regulation. Deregulation and desupervision, which rely on private market discipline do not prevent or contain such epidemics. On the contrary, they foster a climate that encourages them.

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Economic & Political Weekly