PAGE 280 APPLYING THE CONCEPT TRUTH OR CONSEQUENCES: PONZI SCHEMES AND OTHER FRAUDS In the financial world, you always have to be on the lookout for crooks. Fraud is the most extreme version of moral hazard, and it is remarkably common. The term Ponzi scheme has its origins in a 1920 scam run by serial con artist Charles Ponzi. Promising a 50 percent profit within 45 days, he swindled unsuspecting investors out of something like $250 million in 2014 dollars. Ponzi never invested their money. Instead, he paid off early investors handsomely with the money he obtained from subsequent investors. Financial laws are now far more elaborate than in Ponzi’s day, and governments spend much more to enforce them, but frauds persist. Bernie Madoff is the leading recent example. For decades, Madoff was a respected member of the investment community and able to escape detection. In the same manner as Ponzi, Madoff was redeeming requests for funds with the money he collected from more recent investors. Madoff’s con, which may have begun as early as the 1970s, failed only when the financial crisis of 2007–2009 depleted his funds, making it impossible for him to pay off the final cohort of wealthy, sophisticated—yet apparently quite gullible—investors and financial firms. The Madoff scandal dwarfed Ponzi’s racket: at the time the scheme blew up, the losses were estimated at $17.5 billion, and extensive efforts at recovery have put final losses in the neighborhood of $7 billion. Unfortunately, in a complex financial system, the possibilities for fraud are widespread. Most cases are smaller and more mundane than those of Madoff or Ponzi, but their cumulative size is significant. One source devoted to tracking just Ponzi-type frauds in the United States listed 70 schemes worth an estimated $2.2 billion in 2014 alone.* We aren’t going to get rid of Ponzi schemes and other frauds (see In the Blog: Conflicts of Interest in Finance). But the mission of ferreting them out and prosecuting those responsible is essential. A well-functioning financial system is based on trust. That is, when we make a bank deposit or purchase a share of stock or a bond, we need to believe that the terms of the agreement are being accurately represented and will be carried out. Economies where property rights are weak and enforcement is unreliable also usually supply less credit to worthy endeavors. That means lower production, lower income, and lower welfare. imagesIN THE BLOG Conflicts of Interest in Finance Financial corruption exposed in the years since the financial crisis is breathtaking in its scale, scope, and resistance to remedy. Traders colluded to rig the foreign exchange (FX) market, where daily transactions exceed $5 trillion, and to manipulate LIBOR, the world’s leading interest rate benchmark (see Chapter 13, Applying the Concept: Reforming LIBOR). Firms have facilitated tax evasion and money laundering. And Bernie Madoff engineered what was arguably the largest Ponzi.

1. PAGE 280
APPLYING THE CONCEPT
TRUTH OR CONSEQUENCES: PONZI SCHEMES AND
OTHER FRAUDS
In the financial world, you always have to be on the lookout for
crooks. Fraud is the most extreme version of moral hazard, and
it is remarkably common.
The term Ponzi scheme has its origins in a 1920 scam run by
serial con artist Charles Ponzi. Promising a 50 percent profit
within 45 days, he swindled unsuspecting investors out of
something like $250 million in 2014 dollars. Ponzi never
invested their money. Instead, he paid off early investors
handsomely with the money he obtained from subsequent
investors.
Financial laws are now far more elaborate than in Ponzi’s day,
and governments spend much more to enforce them, but frauds
persist.
Bernie Madoff is the leading recent example. For decades,
Madoff was a respected member of the investment community
and able to escape detection. In the same manner as Ponzi,
Madoff was redeeming requests for funds with the money he
collected from more recent investors. Madoff’s con, which may
have begun as early as the 1970s, failed only when the financial
crisis of 2007–2009 depleted his funds, making it impossible for
him to pay off the final cohort of wealthy, sophisticated—yet
apparently quite gullible—investors and financial firms. The
Madoff scandal dwarfed Ponzi’s racket: at the time the scheme
blew up, the losses were estimated at $17.5 billion, and
extensive efforts at recovery have put final losses in the
neighborhood of $7 billion.

2. Unfortunately, in a complex financial system, the possibilities
for fraud are widespread. Most cases are smaller and more
mundane than those of Madoff or Ponzi, but their cumulative
size is significant. One source devoted to tracking just Ponzi-
type frauds in the United States listed 70 schemes worth an
estimated $2.2 billion in 2014 alone.*
We aren’t going to get rid of Ponzi schemes and other frauds
(see In the Blog: Conflicts of Interest in Finance). But the
mission of ferreting them out and prosecuting those responsible
is essential. A well-functioning financial system is based on
trust. That is, when we make a bank deposit or purchase a share
of stock or a bond, we need to believe that the terms of the
agreement are being accurately represented and will be carried
out. Economies where property rights are weak and enforcement
is unreliable also usually supply less credit to worthy
endeavors. That means lower production, lower income, and
lower welfare.
imagesIN THE BLOG
Conflicts of Interest in Finance
Financial corruption exposed in the years since the financial
crisis is breathtaking in its scale, scope, and resistance to
remedy. Traders colluded to rig the foreign exchange (FX)
market, where daily transactions exceed $5 trillion, and to
manipulate LIBOR, the world’s leading interest rate benchmark
(see Chapter 13, Applying the Concept: Reforming LIBOR).
Firms have facilitated tax evasion and money laundering. And
Bernie Madoff engineered what was arguably the largest Ponzi
scheme in history (see Applying the Concept: Truth or
Consequences: Ponzi Schemes and Other Frauds).
In response, Congress enacted the Dodd-Frank Act, the most
far-reaching financial reform since the 1930s. Authorities have
leaned on financial firms to diminish risk-taking incentives in

3. their compensation schemes. Governments and private litigants
obtained ever-larger pecuniary settlements—between 2009 and
2015, the total was in excess of $200 billion—at the same time
that prosecutors convicted both firms and individuals involved
in the big trading scandals. And leading regulators have warned
the largest U.S. institutions that a failure to improve their
ethical culture could lead policymakers to downsize their firms.
So far, the most obvious reaction from the financial sector has
been to hire thousands of compliance officers and risk managers
to police the behavior of their own employees.
Yet, corruption persists.
The source of this continuing behavior is poor incentives arising
from a principal-agent (or agency) problem. If employees and
firms (the agents) can hide their conduct, then they can benefit
greatly by acting in ways that run counter to the interests of
their employers or their clients (the principals). Unless the
principals (or the government) can prevent such concealment at
a reasonable cost, it comes as no surprise that agents behave
unethically, if not illegally.
Agency problems are particularly rampant in finance because
both the rewards to exploitation and the cost of detection are so
high. The incentive problems appear worst in the largest, most
complex intermediaries that engage in multiple activities.
The reason is that the presence of diverse business lines both
breeds conflicts of interest and makes them more difficult to
contain.* To be sure, many financial activities are pursued at
the same time by the same firm and rarely trigger serious
conflicts of interest. For example, without harm, most banks
and brokers simultaneously provide (1) safekeeping services for
assets, (2) access to the payments system, and (3) accounting
services to track transactions and balances. Even here, however,

4. major frauds occasionally arise. Bernie Madoff’s clients may
have thought that the lack of an independent asset custodian
was safe and reduced their costs. Instead, allowing Madoff to
serve both as broker and custodian helped him to conceal his
fraud.
But, when pursued together, a variety of other activities are
prone to widespread and costly conflicts. Perhaps the most
notorious is the mix of equity underwriting, equity research, and
equity sales. The incentive problem here is simple: With large
underwriting fees at stake, analysts are motivated to produce
optimistic company research reports to attract issuers, even if
the result is that brokers sell overvalued stocks to unwitting
clients. Yet, more than a decade after the legal settlement that
compelled brokerage firms to erect or fortify costly “Chinese
walls” between their investment banking and research staffs,
reports indicate significant violations.
Overall, the most serious issues arise in the context of large,
complex intermediaries, whose failure threatens the financial
system as a whole. Unfortunately, the combination of increased
transparency, improved market discipline, enhanced regulation,
massive financial penalties, and criminal prosecution has thus
far failed to halt repeated, large-scale misbehavior arising from
conflicts of interest.
What to do?
The main options are to (1) break up large institutions into
smaller ones with restricted scope, (2) hold individuals more
accountable, and (3) some mix of the two. Regulators may wish
to consider the first option if the cost of losing economies of
scope is small relative to the social costs of conflicts of
interest. The case of equity research and underwriting may be a
useful example.

5. The second remedy requires that managers face greater personal
financial liability for their firms’ excesses. Large fines that
punish stockholders who have minimal corporate control may
simply increase the cost of capital for big firms. In contrast,
partnerships, where owners face unlimited liability for their
own and their partners’ actions, foster strong incentives to
police bad behavior. Hence, compensation arrangements that
create partnership-like downside risks for years into the
future—even for middle-level managers with risk-taking
authority—ought to be a common feature in large, systemic
intermediaries. For similar reasons, more frequent criminal
prosecutions (such as those for LIBOR and FX manipulation)
promote individual accountability and eventually may increase
deterrence.
Unfortunately, there is no panacea. Regulators and prosecutors
must continue to experiment with new remedies, acknowledging
that past efforts have proven remarkably ineffective. And they
must remain vigilant because the financial system constantly
evolves and adjusts.
Chapter 14 in your textbook (pages 392-393).
Chapter Lessons
The collapse of banks and the banking system disrupts both
the payments system and the screening and monitoring of
borrowers.
Intermediaries are insolvent when their liabilities exceed
their assets.
Because banks guarantee their depositors cash on demand
on a first-come, first-served basis, they are subject to runs.
Shadow banks like MMMFs and securities brokers also face
runs because some of their liabilities can be withdrawn at face

6. value without notice.
A bank run can occur simply because depositors have
become worried about a bank’s soundness. Shadow banks also
may face runs due to a loss of confidence.
Page 392The inability of depositors to tell a sound from an
unsound bank can turn a single bank’s failure into a bank panic,
causing even sound banks to fail through a process called
contagion. Shadow banks face similar risks.
A financial crisis in which the entire system of banks and
shadow banks ceases to function can be caused by:
False rumors.
The actual deterioration of balance sheets for economic
reasons.
The government is involved in every part of the financial
system.
Government officials may intervene in the financial
system in order to:
Protect small depositors.
Protect bank customers from exploitation.
Safeguard the stability of the financial system.
Most financial regulations apply to depository institutions,
while shadow banks usually face less regulation.
Intermediaries that are less prone to runs, such as pension
funds and most insurers, face less intrusive government

7. oversight than the banking industry.
The U.S. government has established a two-part safety net
to protect the nation’s financial system.
The Federal Reserve acts as the lender of last resort,
providing liquidity to solvent institutions in order to prevent the
failure of a single intermediary from becoming a systemwide
panic.
The Federal Deposit Insurance Corporation (FDIC)
insures individual depositors, helping to prevent bank runs by
reducing depositors’ incentive to flee at the first whiff of
trouble.
The government’s safety net encourages bank managers to
take more risk than they would otherwise, increasing the
problem of moral hazard.
Through regulation and supervision, government officials
reduce the amount of risk banks can take, lowering their
chances of failure. Regulators and supervisors:
Restrict competition.
Restrict the types of assets banks can hold.
Require banks to hold minimum levels of capital.
Require banks to disclose their fees to customers and their
financial indicators to investors.
Monitor banks’ compliance with government regulations.
Regulators use macro-prudential tools to limit systemic
threats to the financial system. Such risks usually arise from

8. externalities—costly spillovers from the behavior of
intermediaries. These externalities have two sources: (1)
common exposure of intermediaries to frail institutions or to
underlying risks and (2) pro-cyclicality of the links between
financial and economic activity, which amplifies boom and bust
cycles.
Conceptual and Analytical Problems image
Explain how a bank run can turn into a bank panic. (LO1)
Current technology allows large bank depositors to withdraw
their funds electronically at a moment’s notice. They can do so
all at the same time, without anyone’s knowledge, in what is
called a silent run. When might a silent run happen, and why?
(LO1)
Page 393Explain why financial institutions such as pension
funds and insurance companies are not as vulnerable to runs as
money-market mutual funds and securities dealers. (LO1)
Explain the link between falling house prices and bank
failures during the financial crisis of 2007–2009. (LO1)
Discuss the regulations that are designed to reduce the moral
hazard created by deposit insurance. (LO3)
During the financial crisis of 2007–2009, the Federal Reserve
used its emergency authority to lend to nonbank intermediaries.
Explain how this extension of the lender-of-last-resort function
added to moral hazard. (LO2)
* Why is the banking system much more heavily regulated
than other areas of the economy? (LO3)
* Explain why, in seeking to avoid financial crises, the
government’s role as regulator of the financial system does not

9. imply it should protect individual institutions from failure.
(LO2)
Explain how macro-prudential regulations work to limit
systemic risk in the financial system. (LO3)
Why were runs during the financial crisis of 2007–2009 not
limited to institutions with large exposures to subprime
mortgage lending? (LO1)
Suppose you have two deposits totaling $280,000 with a bank
that has just been declared insolvent. Would you prefer that the
FDIC resolve the insolvency under the payoff method or the
purchase-and-assumption method? Explain your choice. (LO2)
* How might the existence of the government safety net lead
to increased concentration in the banking industry? (LO2)
One goal of the Dodd-Frank Wall Street reform is to end the
too-big-to-fail problem. How does it propose to do so? Why
might it fail? (LO3)
A government can overcome the challenge of time
consistency only if it is both able and willing to make credible
commitments. With this in mind, how might the U.S. laws and
procedures for bankruptcy affect the too-big-to-fail problem?
(LO2)
If banks’ fragility arises from the fact that they provide
liquidity to depositors, as a bank manager, how might you
reduce the fragility of your institution? (LO1)
* Why do you think bank managers are not always willing to
pursue strategies to reduce the fragility of their institutions?
(LO1)

10. Regulators have traditionally required banks to maintain
capital-asset ratios of a certain level to ensure adequate net
worth based on the size and composition of the bank’s assets on
its balance sheet. Why might such capital adequacy
requirements not be effective? (LO3)
You are the lender of last resort and an institution approaches
you for a loan. You assess that the institution has $800 million
in assets, mostly in long-term loans, and $600 million in
liabilities. The institution is experiencing unusually high
withdrawal rates on its demand deposits and is requesting a loan
to tide it over. Would you grant the loan? (LO2)
Page 394You are a bank examiner and have concerns that the
bank you are examining may have a solvency problem. On
examining the bank’s assets, you notice that the loan sizes of a
significant portion of the bank’s loans are increasing in
relatively small increments each month. What do you think
might be going on and what should you do about it? (LO3)
In the period since the financial crisis of 2007–2009,
inflation has been low in many countries, while a few
experienced outright deflation. Why might unexpected deflation
be of particular concern to someone managing a bank? (LO1)