Although it seems counterintuitive to predict increasing fraud in a healthy, booming economic market, a new theoretical paper just published in the July issue of The Review of Financial Studies explores that scenario and identifies other key factors that contribute to the probability of fraud in different market and business cycles. The study was conducted by professors Andrew Winton, Paul Povel and Rajdeep Singh at the University of Minnesota Carlson School of Management.
“This work has strong implications for regulators, more than anyone else, because it suggests they should not just look at the accounting numbers to detect fraud, but also at factors like the overall health of the industry and the general state of the market,” said Winton, chair of the finance department at the Carlson School.
According to Winton, intensifying and increasing reporting requirements may have the unintended consequence of actually increasing fraud. “Investors aren’t necessarily motivated to detect fraud. They are only motivated to judge whether investing in a company would be a good return on investment. Requiring more detailed reporting statements or prospectuses can actually increase fraud rather than decrease it, because the accounting tends to get more creative to demonstrate good returns for the investor audience. Our work suggests that a bigger picture view by regulators such as the SEC would be more effective in discouraging fraud.”
There are also strong indications that investor behavior causes fraud, said Winton. “Even if investors are optimistic for good reason … that will encourage fraud. That’s what differentiates our paper from some of the ideas floating around in the business press. We demonstrate that even if investors are doing their best to find good investment opportunities, we should expect to see fraud when times are good.”
Winton and his colleagues wanted to look at these factors because no one had previously studied how market factors related to fraud. The correlation between boom markets and fraud has been a buzz in the industry, but has not really been studied or confirmed, says Winton. One striking finding from the research predicts that in an industry with strong market conditions “… a change that causes investors to loosen standards for low firms [those with weak reported results] reduces fraud because bad firms [those with poor prospects] see less need for it – why commit fraud when you can get funded without it"”
“Internet firms may have fallen into or close to the “fund-everything” regime, in which case there was no need to commit fraud, whereas the telecoms may have fallen into the lower “optimistic” regime, in which case fraud should have been expected.” Winton, Tracy Yu Wang, assistant professor of finance at the Carlson School, and Xiaoyun Yu, assistant professor of finance at the Kelley School of Business at Indiana University, are applying the theoretical model to Initial Public Offerings (IPOs) in the late 1990s and early 2000s.