Six ways to reduce financial fraud – lessons from history

Financial fraud is a major and costly problem that’s difficult to solve. A recent report has estimated the annual cost of fraud in the UK as being as high as £219bn, representing almost ten per cent of the country’s total economic output (Gross Domestic Product ((GDP)). Tackling the systematic determinants of fraud would therefore seem to be worthwhile, and yet despite frequent updates to regulations aimed at tackling the root causes of fraud, financial scandals still regularly feature in newspaper columns along with alarming stories of an explosion in financial scams.

Is fraud, therefore, an increasingly unavoidable problem and a necessary cost of doing business? To answer this question, in my book - Systems of Deceit: Financial Fraud and Scandal in the United Kingdom, 1700–2010 - I have quantified financial crime in the UK using three centuries of data, revealing long-run patterns that contain important lessons for present-day policymakers.

Figure 1 shows the trend in the number of financial scandals (indicated in grey bars) and an index of the incidence of financial fraud (indicated by the solid red line) over the last hundred years. Financial scandals are acts of economic deception resulting in losses to third parties whose consequences are widely known, usually through newspaper headlines. Fraud refers to financial crimes which individually may be insignificant but are collectively recognised as a problem.

Both data series indicate a post-1900 decline, a mid-century hiatus, followed by a resurgence in the final decades of the twentieth century, up to and including the global financial crisis of 2007-2008.

Figure 1

 

The striking feature of Figure 1 is that the incidence of fraud and scandal demonstrates substantial variation over time, with three distinct phases. The u-shaped pattern over the twentieth century is uncorrelated with crime generally but is correlated with changes in the configuration and scope of economic institutions and economic policy.

The decline and hiatus periods (1900-1970) illustrate how certain economic structures and policies are likely to reduce fraud. In the first half of the twentieth century restrictions on capital mobility across national borders increased, following the upheaval of the First World War and the 1929 stock market crash, with international transfers of capital limited to trade in goods under the Bretton Woods arrangements in the post-World War Two period. Fraudsters were thus denied the opportunity to escape scrutiny by moving financial activities offshore.

In an economy increasingly dominated by large firms, corporate hierarchies helped establish better internal controls and empowered the managerial and professional accounting classes. Product innovation, as measured by patent data, peaked during the hiatus period. At the same time, banking functions became more standardised, which meant relatively lower pay for banking and finance staff. Within the banking sector, risky lending was constrained by credit and capital controls.

Since the 1970s, there has been a notable increase in scandals and fraud, contrasting with previous trends. This rise was associated with greater financial deregulation and greater economic freedom, manifested in credit expansion in the early 1970s and the removal of controls on international transfers of capital in 1979. Deregulation in the 1980s resulted in the further expansion of the banking and finance sectors, financial product innovation, decreasing banking stability and the growth of international secrecy jurisdictions.

As a consequence, financial scandals were increasingly centred on the banking and finance sector and involved financial transfers through offshore tax havens. The development of accounting and auditing standards and corporate governance codes have been inadequate defences against fraud and scandal in face of financial deregulation.

Much of the post-1970 resurgence was history repeating itself. During the nineteenth century, in the period of economic liberalisation and globalisation, financial fraud and scandal reached similar peaks. Across the last three centuries, the variation of outcomes reflects the balance of power between the state, industrial and financial sectors, the provision of credit through risky lending, and the effectiveness of audits. "Rogue traders" and other flawed individuals have throughout this time been the focus of blame narratives constructed with the intention of deflecting comprehensive systematic reforms.

These long-run trends contain important lessons for present-day policy. A return to the economic management of the 1950s and 1960s is unlikely, although the benefit of reduced fraud may increase the appeal of moves in that direction. If the objective is purely to reduce fraud, notwithstanding wider benefits or costs, there are several policy directions likely to achieve this objective:

1. Have a ‘right-sized’ financial sector that serves the rest of the economy. The expansion of banking and financial services leads to financial innovations of risky products that are difficult to value and difficult to audit.
2. Promote banking stability. Financial repression, in the form of quantitative tightening, constrains the provision of risky credit. Where more risky projects are funded, more will get into difficulty in a subsequent downturn creating pressures to manipulate financial reports to disguise poor performance. 
3. Restrict movements of capital (while promoting trade in goods and services), thus preventing fraud operations from escaping scrutiny through the use of offshore secrecy jurisdictions.
4. Encourage productive entrepreneurship and associated product and service innovation and discourage financial innovation.   
5. Empower the audit profession. Throughout the twentieth century, auditors have been increasingly implicated in financial scandals. An explicit obligation on auditors to detect fraud would disincentivise unproductive collaborations with management by auditors and meet public expectations of their responsibilities.
6. When investigating fraud, examine the context and systemic causes, rather than limiting the blame narrative to ‘rogue traders’.

The combined effects of such policies would be a substantial reduction in fraud. They would require significant changes in economic policy, which is of course driven by wider goals. Even so, the substantial costs of fraud in relation to GDP suggest it should be taken into consideration. By doing so, we can learn from the lessons of history and create a fairer and more productive business environment.

In the absence of systemic reform, the present high levels of fraud and financial scandal are set to continue.