Financial Fraud in the Financial Services Industry and Regulation 2022-2021: The US Experience

Financial fraud involves deception, intent, and violation of trust (Ramamoorti and Olsen 2007). Fligsten and Roehrkasse (2013) suggest that criminality in financial markets occurs on such a grand scale that it can no longer be regarded as exceptional. Yet trust lies at the heart of financial services and the financial markets. In large measure that accounts for the preponderance of regulation in financial markets beginning in the UK with the establishment of a private company, The Bank of England, in the 17th century (Gilligan 1997). Trust is enforced in financial markets in three ways: related party enforcement through market forces as well as reputational capital (Bratton and Sepe 2020 suggest such an approach is ineffective); first party enforcement facilitated through ethics, culture, internal regulatory processes, and internal controls (Sapienza and Zingales 2011); and third-party enforcement through agencies and institutions who enforce regulations and laws (Dupont and Karpoff (2020). Trust in financial institutions was significantly strained due to the sub-prime mortgage meltdown and the resulting Global Financial Crisis 2007/2009. In the US, efforts to restore trust by Congress resulted in the Dodd-Frank Act, together with actions taken by the Bank of International Settlements setting new limits on risk and equity requirements, along with a more proactive and interventionist stance adopted by regulators. Financial service providers placed more emphasis internally on regulatory and compliance activities. Nonetheless, financial fraud and malfeasance in the financial services industry remains problematic due in large part to: perceived and real conflicts of interest; incentive systems that frequently reward perverse behavior; rapid technological changes that are incrementally innovative and often times disruptive innovations; complexity of financial instruments and products; use of off-Balance Sheet devices; and the need for dual objectives—transparency and client confidentiality, (Amiram et al. 2018, Reurink 2016, Schwarcz 2008, 2011, van Driel 2019). The result of the preceding factors has been an enhancement and extension of various regulatory institutions with various degrees of efficiency and efficacy. (The concerns of the public, market participants with respect to wrongdoing in financial institutions is confirmed in 3 other jurisdictions, e.g., The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, the Hayne reports of 2018/2019 in Australia for example). The regulatory institutions no longer rely on market forces and self-correction as indicated by the change in the approach taken by the SEC with respect to “neither admit nor deny”, perhaps driven by the actions taken by Judge Rakoff in the Southern District of New York. Coupled with a new attitude and action driven agenda that companies who self-report must identify all those involved in an instance of wrongdoing not just the most culpable, increased willingness to criminally prosecute wrongdoers (a work in progress), increased penalties enacted for instances of malfeasance, and strong encouragement by firms to not only self-report but fully disclose— early. The US financial services industry operates with a complex framework of institutions, with sometimes conflicting mandates. They include: the Department of Justice (DoJ); the US Treasury; the Office of the Controller of the Currency; the Federal Reserve (specifically FINCEN—the recipient of suspicious activity reports by federally regulated financial institutions); the Federal Deposit Insurance Corporation, the Financial Institute Regulatory Authority; the Securities and Exchange Commission (SEC); the Commodities Futures Trading Commission (CFTC) and the Consumer Protection Bureau. Notable that under the Republican administration (2016-2000) some of these agencies were bypassed in terms of effectiveness. The paper examines the settlements and fact situations of the industry as outlined by the SEC/DoJ, and the CFTC for the period 2011-2021. The beginning date was chosen to avoid overhang from the GFC of 2008/2009. The ending date ensures current material was included but excludes the most recent, 2022, of the failure of two cryptocurrency exchanges—FTX and Block Fi. The analysis of the settlements, highlights—failures of processes, wrongdoing by individuals (often in smaller financial institutions), proactive actions of the regulators to ensure market transparency and protection of market participants, as well as the financial settlements involved. Given the time between the investigations and settlements we are unable to pinpoint in every instance the exact time-period involved. In general, the number of cases is in a declining trend but that may well be due to the period 2016-2020, that is part of our sample period, (Garret 2020, suggests that criminal prosecutions are rare), but the settlement data does not totally confirm that wrongdoing is on the decline