As Bernie Madoff goes to his reward today, we should be asking how this could have happened. Not only Madoff and Allen Stanford, but also dozens of “mini-Madoffs” have been unearthed since the market collapse in September and October, which seems to have reminded the SEC that it has an law enforcement function. Not surprisingly, regulators are ramping up their enforcement divisions, and Congressmen are planning legislation to increase enforcement budgets.
A little late to close the barn door.
While Christopher Cox, SEC chairman from 2005 until this January, makes an obvious target, there is a deeper phenomenon at work than just the Bush administration’s hands-off attitude toward corporate fraud (an attitude largely shared by the Clinton administration). That is the general tendency of people – investors and officials alike – to underestimate the risk of fraud during a boom and overestimate the risk of fraud during a bust.
This issue is discussed in a paper by Amitai Aviram published in my own school’s Yale Journal on Regulation (but since you can’t get it from their website, get it from SSRN).
Aviram’s first point is that people tend to ignore fraud risk in good times and worry about it in bad times. There are many reasons for this. Falling asset values and credit crunches make it harder to perpetuate certain types of fraud, such as Ponzi schemes, but there are other factors. In one form of cognitive bias, people ascribe good outcomes to their own investing “skill,” and bad outcomes to exogenous factors they cannot be blamed for, such as fraud. The discovery of a few well-publicized instances of fraud creates an availability bias, where people miscalculate the incidence of fraud.
Typical enforcement patterns only exacerbate this cycle. According to Aviram, the traditional academic model of enforcement is that you set a budget such that, at the margin, the marginal cost of enforcement equals the marginal benefit of enforcement. In practice, however, this model is affected by political pressures. In a boom, when the public underestimates the risk of fraud, there is no percentage in presenting yourself as a crusader against big corporations or Wall Street – especially when they are being portrayed in the media as heroes, as Enron was prior to 2001. But in a bust, the way to score political points is to go after the “crooks and robbers,” which is especially convenient after they have been pointed out to you by the markets (Enron, Madoff). This leads to underenforcement during the boom and overenforcement during the bust. (Or, I might say, severe underenforcement during the boom and maybe sufficient enforcement during the bust.)
Here’s what this looks like:
That’s the annual percent change in the S&P 500 plotted against the annual percent change in the number of SEC enforcement actions. I would have liked to see a regression, or at least a correlation, but this is a law paper, after all.
So, yes, it’s the fault of regulators who are too soft on industry, but they also share the misperceptions of the public at large, which wants to believe that everything is just fine when the market is going up. Of course, regulators are supposed to know more than the public at large.
Aviram has a discussion of the role of conspicuous law enforcement itself in reinforcing or counteracting these misperceptions. This discussion is wishy-washy, because he leaves open the question of whether conspicuous law enforcement increases or decreases risk perceptions. (Again, this is a law paper – no equations and few numbers, just concepts.) But I think it’s pretty clear that it decreases risk perceptions. Let’s put it this way: On the day that you learned about Bernie Madoff, did you feel more secure because you felt like the SEC was doing a good job protecting you? Or did you feel less secure because if Madoff could get away with it for so long, who else could? Let’s assume I’m right and then follow Aviram’s reasoning. In that case, this cyclical enforcement pattern makes things even worse, because the lack of enforcement during good times makes people feel even more secure, and the “over” enforcement in bad times makes them even more paranoid. Therefore, he concludes, enforcement should be expressly counter-cyclical, which requires insulating the regulators from public pressure to be lax during a boom.
Thus, when conspicuous law enforcement increases risk perception [my assumption], implementing the correct long-term policy will cause fear and anger among the public in the short term. Nonetheless, if the goal of anti-fraud laws is to maximize long term efficiency, the public’s immediate sentiments should not be a consideration for abandoning the optimal (long-term) policy. In fact, the law enforcer should be shielded from precisely these short-term pressures.
Aviram cites central banks as an example of an institution that is appropriately counter-cyclical. But let’s not fault him for that. The paper was first written in early 2007, and few people could have foreseen what happened since. Indeed, the implicit prediction that we would see a blossoming of enforcement energy in a market bust – after most of the damage has been done – turns out to have been dead-on.