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November 23, 2011

Moral Hazard, Ultimate: Prosecution of Financial Fraud at 20-Year Low

The United States must be blessed with the most ethical and fraud-free financial system in years.  Prosecutions for financial fraud have been declining for a decade and have reached a 20-year low.  If you are surprised after all the financial system turmoil of the past few years you need to read on.  The reduced prosecution may have no relationship to the amount of fraud perpetrated. 

First, lets look at the prosecution history data from Syracuse University (TRAC Reports):

U also has data for which agencies are filing prosecutions: 


From TRAC Reports:
As shown in Figure 2, additional agencies with substantial numbers of referrals for financial institution fraud were: Homeland Security - Secret Service (32.5%), "Postal Service" (12.9%), "Homeland Security - Immigration and Customs Enforcement" and the Internal Revenue Service (3.9%). 
Of course, the lower prosecutions must be a reflection of the trustworthiness of banks – NOT.  The following Gallup data reported in the Huffington Post shows how trust and confidence in banks have eroded over the past five years:
In July The New York Times had an article that discussed a little known policy guideline that could be a partial explanation of the decrease in prosecutions since the middle of 2008:  deferred prosecutions.  From the NYT:
Though little noticed outside legal circles, the guidelines were welcomed by firms representing banks. The Justice Department’s directive, involving a process known as deferred prosecutions, signaled “an important step away from the more aggressive prosecutorial practices seen in some cases under their predecessors,” Sullivan & Cromwell, a prominent Wall Street law firm, told clients in a memo that September. 
Read the Times article for discussion by a number of criticisms from legal scholars, who feel the practice lets perpetrators, especially high executives, off too easily.  The term applied to such forbearance is moral hazard.  That expresses the idea that failure to punish wrongdoing can encourage repetition.
Before deferred prosecutions became operative in 2008 it has been suggested that shift of Justice Department attention to Homeland Security issues produced a reduction in financial crimes prosecutions.  Of course, even without Homeland Security the prosecutions might have declined anyway as the 21st century became the playground for deregulation.
The situation was recently summed up by GEI guest author Mike Norman at Mike Norman Economics:
French economist, Frederic Bastiat, perfectly summed up the concept of fraud and how it is perpetuated with this quote:
"When plunder becomes a way of life for a group of men living together in society, they create for themselves in the course of time a legal system that authorizes it and a moral code that glorifies it" - Fredric Bastiat.  (h/t Roger Erickson)
Hat tip to RH.

About The Author - Global Economic Intersection focuses on the economic effects on finance, investing, social interactions, and politics / public policy. It features original economic, financial and investing commentary, debate, news and analysis of economic data and indicators. This article was originally posted on the GEI News Blog. GEI is operated by Econintersect LLC, a Nevada corporation. (EconMatters author archive here)

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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