The Future of Financial Fraud

Jonathan M. Karpoff is Professor of Finance at University of Washington Foster School of Business. This post is based on his recent paper, forthcoming in the Journal of Corporate Finance.

Is financial fraud becoming a bigger or smaller problem over time? This paper applies two theoretical models to gain insight into this question. The first model is the Trust Triangle, which Dupont and Karpoff (2020) use to describe the forces that discipline misconduct and encourage the building of trust that is at the core of most economic transactions. The second model is Klein and Leffler’s (1981) theory of contractual enforcement in the absence of third-party enforcement. These models add content to Becker’s (1968) basic proposition that a person will commit fraud when the expected benefits exceed the expected costs, by partitioning the costs into first-party, related-party, and third-party mechanisms. These models yield comparative statics predictions about the impacts of changing technology and wealth over time.

I use theory to peer into the future because historical data do not yield a clear-cut answer to the question of whether fraud is trending up or down. One problem is that different indicators trend in different directions. For example, Cornerstone Research (2020) reports that the annual number of securities-related class action lawsuit filings that allege financial misconduct reached an all-time high in 2019. In contrast, the number of new SEC enforcement actions targeting publicly traded firms for financial misrepresentation trended up only through 2003 before turning flat or slightly downward in more recent years. Among firms facing enforcement action, the number of firms violating financial reporting rules in any given year has actually decreased since the early 2000s.

Another problem is that, even if the empirical measures of fraud trended in the same direction, they omit frauds that occur but never trigger a regulatory enforcement action or lawsuit. Alternative indicators of financial misconduct, such as restatements, also do not resolve the observability problem, as previous research shows that many restatements have little to do with misconduct, and many actual instances of misconduct do not trigger restatements. To address the problem of unobserved misconduct, some researchers attempt to measure the probability of detection and the prevalence of unobserved fraud. These approaches hold promise, but have not been extended to assess time series trends in fraud.

Using the Klein and Leffler (1981) and Dupont and Karpoff (2020) theoretical constructs, I infer that some technological changes—say, the anonymity afforded by some blockchain applications—will lower the cost and increase the profitability of fraud. Similarly, technological shocks will decrease transaction costs and facilitate the implementation and profitability of some fraud schemes, e.g., by decreasing the cost of raising financial capital. Most technological changes, however, work to increase the use and effectiveness of first-party, related-party, and third-party fraud enforcement and deterrence. Decreases in information costs help to uncover frauds faster and, by bolstering the gains from reputational investments, work to encourage honest reporting. Decreases in transaction costs, possibly including but not limited to the use of blockchain technology, decrease the cost of tracking financial transactions and financial reports, further deterring and decreasing the profitability of fraud. The net effect of such technological changes is therefore likely to be a decrease in the profitability and incidence of financial fraud.

Secular increases in wealth also work to decrease the incidence of fraud, via all three legs of the Trust Triangle. This is because the quality of third-party, related-party, and first-party enforcement all tend to increase with wealth. Thus, both technological and wealth changes point to a long-term decrease in the incidence of financial fraud over time.

To be sure, such a happy conclusion comes with qualifications, as several forces—including increases in informational frictions, behavioral biases, loss of trust in institutions, and income inequality—could disrupt a long-term trend toward less fraud. Most importantly, the COVID-19 pandemic and resulting economic shutdown have disrupted relative demands and devastated organizational capital throughout the world economy—changes that provide fertile ground for frauds of all types, including financial fraud. Despite such dangers, and despite a likely short-term increase in fraud associated with the COVID-19 pandemic and associated economic and political turmoil, I argue that the long-term trend is toward less fraud. Stated differently, honest dealing is an income normal good, and demand for it will increase with technological changes and long-term economic growth.

The complete paper is available for download here.

Both comments and trackbacks are currently closed.