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1 December 2014 CFA Institute Journal Review

Regulating Fraud in Financial Markets: Can Behavioural Designs Prevent Future Criminal Offences? (Digest Summary)

  1. Marc L. Ross, CFA

Reviewing three high-profile financial scandals, the authors study the favorable circumstances for their occurrence. The authors’ research leads them to consider measures that could mitigate fraud in the financial markets.

What’s Inside?

The social and physical environment can enable or deter financial wrongdoing. The authors investigate three recent events, concluding that realigning performance incentives could help reduce misconduct.

How Is This Research Useful to Practitioners?

Misconduct in the financial markets has a long history, which suggests the limited efficacy of statutes and criminal penalties to deter unlawful behavior. Attesting to this fact is a list of large rogue trading cases in the past 24 years that the authors present in tabular form.

Accordingly, the authors review three recent, well-known cases and consider a better way to prevent financial crime at the source. The misconduct of Bernard Madoff, Kweku Adoboli, and traders colluding to manipulate the LIBOR is telling in its severity. How and why these scandals happened forms the basis for the authors’ research and subsequent recommendations.

The extreme sentence that Madoff incurred included retribution and punishment. How effective a deterrent such a sentence is depends on how effective regulators are at detecting such a Ponzi scheme early in the process. Adoboli breached trading limits, putting his employer at risk and subjecting it to substantial loss. Yet, the authors demonstrate that the mathematics of the cost–benefit analysis suggest that punishment is of limited effectiveness in outweighing the star trader complex. The LIBOR fiasco resulted in more penalties against the institutions involved than against the individual traders. There, too, early deterrence could have been more effective.

Use of behavioral insights could mitigate unlawful behavior. Institutions could subtly appeal to employees’ sense of what the authors call “self-concept maintenance,” or sense of moral obligation. Human resource departments could focus on the difference between individuals focused more on outcome versus those focused more on ethics when making hiring decisions. However, controlled exercises to identify fraudulent conduct have produced mixed results, suggesting that this technique could be flawed. Finally, recognizing how social and physical environments may promote unethical behavior could inform how employers create and maintain a positive workplace.

Students of behavioral finance will find the authors’ prescriptions useful for hiring managers who vet candidates for critical jobs in the financial sector. Finally, policymakers and lawmakers should take heed because statutory law and criminal sanctions have limited efficacy.

How Did the Authors Conduct This Research?

The authors draw on media and legal sources, as well as findings from separate behavioral finance studies, for the three cases in question. They review the facts and circumstances of each case and consider how a cost–benefit analysis would apply. The likelihood that an individual would commit a crime is a function of the probability of conviction, the expected punishment if convicted, and the expected benefit of committing the crime.

They apply this analysis and their insights to the Madoff, Adoboli, and LIBOR trader cases. In all instances, punishment may not have been an ideal deterrent. The threat of early detection, however, could have been. A realignment of incentives may have helped as well.

These cases and their outcomes suggest that behavioral insight is a more effective tool in creating an environment conducive to ethical conduct. Recognizing self-concept maintenance, categorization of cheating types, and the effects of social and physical environments on employee behavior can lead to the creation of a more positive work environment that lends itself to ethical business practices.

Abstractor’s Viewpoint

Ethical lapses and outright misconduct are chronic in the financial marketplace. Punitive retribution has been effective up to a point but does not seem to have addressed the root causes of the misbehavior. The authors apply cost–benefit and behavioral analyses to actual fraud cases to support their argument. An understanding and application of behavioral insight techniques in the workplace could create a more ethical workplace. Such application should extend to the design of proper incentives.

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