Financial complexity: Accounting for fraud

The following letter was published in Science on 15 April 2015.  It discusses the role of fraud in the 2008 financial crisis, and the importance of taking fraud into account when attempting to explain what happened.

The Policy Forum “Complexity theory and financial regulation” (S. Battiston et al., 19 February, p. 818) offers some interesting suggestions regarding the complex dynamics of markets, but it does not address fraud.

How does “traditional economic theory” account for fraud? The role of fraud seems to be rampant at all levels in the case of the 2008 financial crisis in the United States: There was fraud in real estate appraisals (1), fraud among accounting firms (2), fraud in how the risks associated with novel financial instruments were presented to investors (3), and fraud in interbank lending (4).

Economist James Galbraith has argued that the existence of a bubble in a stable, regulated market like housing is prima facie evidence of fraud (5). William Black, another economist, has asked why neither the U.S. Securities and Exchange Commission nor the Federal Reserve employs a criminologist (6).

Explaining the 2008 market failure, and market failures in general, is not a scientific problem so much as a regulatory and enforcement problem. Rather than develop more elaborate models to analyze markets, one simple place to start may be to reinstate regulation like the Glass-Steagall Act (7) and to investigate fraud more aggressively.

REFERENCES
1. J. Eaton, The appraisal bubble, The Center for Public Integrity (2009)
2. R. Wolff, Lehman Brothers: Financially and morally bankrupt, The Guardian (2011)
3. U.S. Securities and Exchange Commission, “SEC enforcement actions: Addressing misconduct that led to or arose from the financial crisis”
4. “Tracking the libor scandal,” New York Times
5. A. Sherter, One word explains what caused the financial crisis: Fraud, CBS MoneyWatch (2010)
6. W. K. Black, Levy Institute’s Annual Minsky Conference (2009)
7. N. Irwin, What is Glass-Steagall? The 82-year-old banking law that stirred the debate, New York Times (2015)