Part 1
400 words
Read the text in the box on page 280 in your textbook titled: APPLYING THE CONCEPT – TRUTH OR CONSEQUENCES: PONZI SCHEMES AND OTHER FRAUDS.
Then, scan the article entitled “Financial Statement Fraud: Motives, Methods, Cases and Detection” by Khanh Nguyen found at:
http://www.bookpump.com/dps/pdf-b/9423197b
NOTE: You only need to scan this article to gather a general knowledge of some of the major issues concerning financial statement fraud. As you will see in this article, financial statement fraud is a major concern for the financial markets as well as for the overall economy. Note the list on page of this article summarizing some of the harmful consequences of financial statement fraud:
- Undermines the reliability, quality, transparency, and integrity of the financial reporting process
- Jeopardizes the integrity and objectivity of the auditing profession, especially auditors and auditing firms
- Diminishes the confidence of the capital markets, as well as market participants, in the reliability of financial information
- Makes the capital markets less efficient
- Adversely affects the nation’s economic growth and prosperity
- Results in huge litigation costs
- Destroys careers of individuals involved in financial statement fraud
- Causes bankruptcy or substantial economic losses by the company engaged in financial statement fraud
- Encourages regulatory intervention
- Causes devastation in the normal operations and performance of alleged companies
- Raises serious doubts of the efficacy of financial statement audits
- Erodes public confidence and trust in the accounting and auditing profession
After you scan the article, find a company that was convicted for committing financial statement fraud between 2005 and 2018. Then find and read a couple of good articles to learn as much as you can about the company’s actions.
For your DB post, tell us about the company, the fraud they committed, and what happened. Specifically, describe what the company did, how they were caught, and what where the consequences of their actions. Your post should be 3-4 paragraphs in length. Be sure to properly cite all articles that you read about the company so that any who read your post can find the article as well.
Part 2
400 words
Pick one of the twenty (20) questions or “explain/discussion” items in the Conceptual and Analytical Problems section of Chapter 14 in your textbook (pages 392-393). Write a 4-5 paragraph response to the question or “explain/discussion” item that you chose.
I would like for everyone to post about a different question or “explain/discussion” item so that as many of the 20 are discussed in the class as possible. Please indicate the question that you wrote about in the title of your DB post (e.g., Question 1, Question 2, Question 3, and so on). Also, copy and paste the question or “explain/discussion” item at the beginning of your post. For example, if you choose to do number 1, begin your post with: “Explain how a bank run can turn into a bank panic.”
Part 3
Company chosen Sherwin-Williamss/ 1000 Words
Research Paper: Chosen Company’s Annual Report Summary
Obtain a copy of the most recent 3 annual reports for your chosen company. You can usually find these on the company website under the heading: Investor Relations. Read the letter to shareholders in all three annual reports. Then, read the entire most recent annual report (this should be a 2017 or 2018 report, depending on the company’s fiscal year end). Read this report as per guidance from Module/Week 1.
Write a paper of at least 1000 words using current APA formatting summarizing the most recent annual report, noting any specific changes, improvement, deteriorations, or similar that have occurred over the past 3 years. Note that you should not do a ratio analysis of your company. Instead, your paper should be based on the text in the shareholder letters and in the management discussion and analysis section of the most recent annual report. The summary must include 3 references.
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 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 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, 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.
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 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 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 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 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)
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)