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Financial Crisis, Fraud, and Corruption

Introduction

Fraud, corruption, and corporate crime serve as examples of white-collar crime. Alone or in combination, they can contribute to the collapse of corporations or even be instrumental in a national or global financial crisis as happened in 2007—2008. Fraud and corruption raise ethical issues and indicate dishonest behavior. Legislation addressing fraud should also include corruption as a criminal offense. The recent crisis in the Eurozone has focused attention on corruption. In the case of Greece, for example, corruption is endemic and has stifled development of the country’s economy and the modernization of its public service for decades. Corruption of this nature on such a large scale is a malignant cancer that sinks a country ever deeper into national debt. Before focusing on fraud and corruption, let us first consider the 2007—2008 financial crisis.

A Brief Consideration of the 2007-2008 Financial Crisis

Focusing on the financial crises that have occurred since 1980 (discussed in depth in the next chapter), Dempster (2013) of the Centre for Financial Research at Cambridge reported the underlying causes to be inflation, currency crashes, currency debasement, and finally asset price bubbles. Inflation in this context is illustrated by the Russian default in August 1998, the currency crash of the Mexican peso in 1995, and currency debasement due to the Argentine default in 2001. Prominent examples of an asset price bubble are the Asian crisis of 1997 and the US subprime crisis of 2007—2008.

According to The Economist,' the 2008 crisis had multiple causes, including years of irresponsible “subprime” mortgage lending in America and financiers who lost control of the risks involved in using pooled mortgages to back securities known as collaterized debt obligations during a time of prosperity. In addition, central bankers and other regulators tolerated such irresponsible lending practices for years and failed to exercise proper oversight of financial institutions. Finally, ever-optimistic consumers believed their prosperity would continue because property prices would continue to grow indefinitely, and thus their “subprime” borrowing would not sink them. The 2008 financial crisis in the United States can be considered a failure of corporate governance.

Concerning the 2007—2008 crisis, Tomasic (2011) asserted that “the global financial crisis has revealed massive financial frauds and misconduct that have long been part of our markets but have been submerged by the euphoria that has dominated these markets” (p. 7). Anabtawi and Schwarcz (2013) noted that the financial system is a high-risk complex network of financial firms interacting against a background oflegal rules. They also drew attention to two significant precursors of the 2007—2008 financial crisis2 :

  • 1. The process of transforming loans into credit shifted from commercial banks to shadow banks during 1990—2007 due to regulatory arbitrage and substantial intermediation.3 The shadow banks that mediated between the borrowers and the lenders were not regulated like traditional banks, and they contributed to increasing the volume of risky loans in the financial system.
  • 2. The interconnecting contracts that existed among parties in the financial system triggered a domino effect when one party defaulted on its obligations.

In support of Anabtawi and Schwarcz (2013), Aron (2015) cited empirical evidence that (a) a firm’s complexity can contribute as much to its own collapse as its size, (b) even a small firm can be complex in a way that could threaten financial stability if it failed, and (c) banks tend to be less complex than insurance firms.

Kaufmann (2009) claimed that the 2007—2008 financial crisis in the United States was caused by (a) influential members of a community or regulators lobbying for legislation that benefited them, such as lax capital reserve requirements or a relaxed regulatory stance allowing larger amounts of debt; (b) lax regulatory oversight and excessive risks bringing down multinational corporations; (c) giant mortgage lenders taking advantage of lax oversight switch regulators; and (d) authorities and regulators knowing of fraud, corruption, and capture, but ignoring the signs and failing to investigate potential wrongdoing.

Considering further the etiology of financial crises, Gorton argued in his 2012 book Misunderstanding Financial Crises: Why We Don’t See Them Coming that there is no convincing evidence linking capital to bank failures; in fact, he maintained that all systemic financial crises arise from a broad loss of confidence in bank debt. He further argued that the panic created by the Lehman Brothers collapse in 2008 was the result of the American government’s failure to apply the Livingstone doctrine,4 which meant it did not relax debt contracts and did not expand support for the banking system to prevent or significantly reduce the public’s panic. Consequently, he contended that the Federal Reserve’s failure to ensure public trust in banks’ liabilities caused the financial crisis. Taking a holistic approach regarding the responsibilities of an organization to all its stakeholders (and not just the shareholders), Simpson and Taylor (2013) have argued that corporate financial scandals (e.g., Lehman Brothers) occur because the prevailing corporate culture focuses only on profits; transparency and accountability, trust, and business ethics are lacking. The explanations provided by Gorton (2012) and Simpson and Taylor (2013) are not mutually exclusive but rather complement one another. While there are differing accounts of the etiology of the 2008 global financial and economic crisis, this crisis and previous ones “are rewriting the relationship between business and society” (Kemper and Martin 2010, 229) and have led Richard Posner (2009) to write about the failure of capitalism.

 
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