‘Our system is so flawed that fraud is mathematically guaranteed’

Former bank regulator Bill Black:

Fraud is both a civil wrong and a crime and it’s when I get you to trust me and then I betray your trust in order to steal from you. As a result, there’s no more effective acid against trust than fraud and, in particular, elite fraud, which causes people to no longer trust folks, economies break down, families break down, political systems break down and such if you don’t have that kind of trust. So that’s what fraud is.

But what my work focuses on is: what kind of frauds are the most devastating? And it turns out that the most kind of problems that we’re seeing, systemic problems and such, arise when we have, what we call in criminology, control fraud. And control fraud simply means when you have a seemingly legitimate entity and the person who controls it uses it as a weapon to defraud others. And so in the financial sphere the weapon of choice is accounting and the losses from these kinds of control frauds exceed the financial losses from all other forms of property crime combined.

So for example, in the current crisis, as with the prior ones, if you’re a lender there’s an easy recipe for maximizing fake accounting income. And it goes like this. You need four ingredients:
* grow like crazy
* by making really, really crappy loans but at a premium yield (yield just means ‘interest rate’)
* while employing extreme leverage, and
* while setting aside only the most trivial reserves or allowances for the inevitable losses this kind of behavior produces.

George Akerlof and Paul Romer wrote the classic article in economics about this in 1993. And their title really says it all in terms of the dynamic: Looting the Economic Underworld of Bankruptcy for Profit. The idea is you have a seemingly legitimate entity, the person at the top is looting it. They loot it by destroying it but they walk away wealthy. Of course, in the modern era we don’t necessarily, we may bail out the entity. So it may not even fail in that sense.

But here’s what Akerlof and Romer also said that was so critical as an understanding. They said these four steps, these four ingredients: it’s just math. It is – and I’m quoting them now “a sure thing.” So you’re mathematically guaranteed if you do these four things to report, not just substantial income, but record levels of income.

The big thing about the seemingly legitimate entity when the CEO is the crook is, first, everybody reports to the CEO ultimately, right? So the CEO is the point failure mechanism where if he or she goes bad, almost everything may go bad as well. So all those things that we call internal and external controls, all report to the CEO and the CEO therefore can, as I’ll describe, use compensation, hiring, firing, praise, and such to produce the environment that will commit, create allies for his fraud. Now, note that what I’m saying. The CEO, the art of this is not to defeat your controls. The elegant solution as in mathematics is to suborn the controls and turn them into your most valuable allies. And therefore, for example, when you’re running accounting control fraud where your weapon of fraud is accounting and that weapon of choice in finance is accounting. You’re going to want to hire the most prestigious accountants as your outside auditors because it is precisely their reputation that is most valuable when you can suborn them. And, they give you that clean opinion that you just described that will help you deceive other shareholders. So one enormous advantage is internal and external controls come to the CEO level.

A second incredible advantage is the CEO can optimize the firm as a weapon of fraud. And the< CEO can do that. Basically, this falls into two big categories. One, you can put it in assets that have no readily verifiable market value because then it’s a lot easier to inflate asset valuations and to hide real losses. And the second thing you do is grow like crazy. And, of course, that is the essence of something your listeners have all heard about, and that is a Ponzi scheme. And so these accounting control frauds have strong Ponzi-scheme like elements, which is why they tend to cause such catastrophic losses.