Why the World Economic Forum and Goldman Sachs are Capitalism’s Worst Enemies

By William K. Black

It is fitting that Goldman Sachs is the recipient of this year’s “Public Eye” designation, but it is even more fitting that it is being announced during the World Economic Forum (WEF) at Davos.  Goldman Sachs exemplifies the travesty that WEF has created.  It is not the worst of the worst.  It is representative of the financial world of systemically dangerous institutions (SDIs) that are spreading crony capitalism through the West.  The SDIs are the so-called “too big to fail (or prosecute)” banks.

The ability of the SDIs to commit fraud with impunity from the criminal laws is a defining element of crony capitalism.  The impunity and implicit national subsidies to SDIs combine to make “free markets” an oxymoron.  The SDIs’ economic power translates easily into dominant political power.  Crony capitalism cripples markets and democracy.

The ability of the SDIs’ senior officers to commit massive frauds with impunity from the criminal laws makes “control fraud” a “sure thing.”  Control fraud will make the largest banks’ senior officers exceptionally wealthy very quickly – but it will also cause severe harm to the public (and often the bank).  Control fraud occurs when the persons who control a seemingly legitimate entity use it as a “weapon” to defraud.  In finance, accounting is the “weapon of choice.”  It is important to remember, however, that other forms of control fraud maim and kill hundreds of thousands and cause grave environmental damage.  We must always remember the infant formula scandal in China where 300,000 infants were hospitalized with kidney stones due to consumer frauds that drove every honest manufacturer out of business.

Large, individual accounting control frauds cause greater financial losses than all other forms of property crime – combined.  Accounting control frauds are weapons of mass financial destruction.  Epidemics of accounting control fraud drove the national crises that produced the Great Recession.  We have reliable information on this in the United States, the United Kingdom, Ireland, and Iceland.  Spain has kept the facts about lending too opaque to determine reliably what caused their bubble to hyper-inflate, but the lending pattern is consistent with accounting control fraud.  These accounting control fraud epidemics drove crises that caused a loss of over $20 trillion in wealth and cost roughly 20 million workers their jobs.

These epidemics of accounting control fraud were not random “black swan” events.  Criminogenic environments produce such intense and perverse incentives that they generate epidemics of control fraud.  Our financial policies have been so criminogenic for decades that we are suffering recurrent, intensifying financial crises.  WEF is one of the important architects and engineers that have made our financial system so criminogenic.  WEF’s dogmas and policies are so perverse that they drive financial crises, create crony capitalism, and make WEF’s leading products (the Global Competitiveness Index (GCI) and Global Risk Reports (GRR) epic embarrassments.  The WEF is degrading the state of the world.

Criminogenic environments for accounting control fraud

  1. The dogma that control fraud cannot be material
  2. The three “de’s” – deregulation, desupervision, and de facto decriminalization
  3. Modern executive and professional compensation
  4. The ability to grow quickly
  5. Extreme leverage
  6. Ease of entry
  7. Assets that lack readily verifiable market values
  8. Weak accounting requirements, particularly on allowances for loan and lease losses (ALLL)
  9. Distressed banks

Each of these factors need not be present.  I discuss here only the first three environmental characteristics, which are the most important.

Fraud Deniers

In 2012, in response to endemic, elite financial frauds, the WEF declared the following without citation or reasoning in its 2012 report on “Rethinking Financial Innovation.”

6.1.1 Consumer Disservice

Malfeasance and outright fraud [in finance] are extraordinarily damaging but also, fortunately, extremely rare.

This is a convenient dogma for a group of CEOs to hold.  It is an empirical claim that is falsified by reality, but it is a vital belief if one is a philosophical opponent of regulation.  Alan Greenspan was the high priest of this dogma, claiming that there was no such thing as an unregulated market because private creditors always regulated markets to prevent misconduct.  Greenspan’s most infamous statement of this dogma was to Brooksley Born, then Chair of the Commodities Futures Trading Commission in connection with her proposal to investigate whether to regulate credit default swaps (CDS).  Here is her account of the discussion.

“Well, Brooksley, I guess you and I will never agree about fraud” [Greenspan]

“What is there not to agree on?” [Born]

“Well, you probably will always believe there should be laws against fraud, and I don’t think there is any need for a law against fraud,” she recalls. Greenspan, Born says, believed the market would take care of itself.

Greenspan later admitted that this dogma had failed.  The WEF has, recurrently (and implicitly) assumed away control fraud because it shares Greenspan’s dogma.  (The implicit nature of the assumption is particularly dangerous – and symptomatic of dogma.  It is the things we assume out of existence implicitly that are most dangerous because we do not consciously know we have made the assumption and therefore never test its accuracy.)

The leading “law and economics” text on corporate law has taught a generation of American lawyers that “a rule against fraud is not an essential or … an important ingredient of securities markets” (Easterbrook & Fischel 1991).

WEF’s founding ideology is “stakeholder” theory – the philosophical belief that a corporation should serve the interests of its stakeholders.  The stakeholders include stockholders, creditors, and workers.  Variants of control fraud target each of these stakeholders.  Control frauds, therefore, are the kryptonite to stakeholder theory.  Control frauds drive stakes through their stakeholders.  WEF’s solution is to assume away reality.  WEF ignores the findings about control fraud made by modern criminology, effective regulators and prosecutors, and top economists and to embrace Greenspan’s dogma even after Greenspan has abandoned it.

I cite information below on the dominant role of fraud during the savings and loan debacle.  The role of accounting control fraud in the Enron-era is not in dispute.  My FCIC testimony details the extraordinary levels of accounting control fraud driving the U.S. crisis.  (I have other papers discussing the decisive role of accounting control fraud in Ireland and Iceland.)  The briefest version is that by 2006, roughly 40% of mortgage loans made that year were “liar’s” loans.  The incidence of fraud in liar’s loans is 90%.  Lenders put the lies in liar’s loans.

The figure for liar’s loans was even higher in the UK.  On January 25, 2012, Martin Wheatley delivered a speech to the British Bankers’ Association entitled “My Vision for the FCA.”

“And so it must be different from some of the behaviour we saw during the boom years for the housing market.

Here we saw many examples of both poor lending and poor borrowing. It became more common for people to borrow without having their income verified – 45% of people did this at the market’s peak – and, as many have observed, both lenders and consumers were caught up in a misplaced faith in never-ending house price rises.

It is now obvious that the market in the years leading up to the crisis was unsustainable. The crisis and its aftermath changed things temporarily, but we want to change things for the better, for good.

And so here we have to look at the FSA’s mortgage market review proposals, these are currently out for consultation; we hope to be able to finalise rules in the summer.

And what our first-time buyer won’t see in a FCA-regulated world is a queue of lenders waiting to offer them a loan on the basis of what they claim their income is, with no proof required.”

And they won’t find brokers thinking they can get away with persuading them to lie about their income.

This is why, based on our discussions with you, with brokers, and with consumer organisations, we are embedding common sense standards to lending across the board, so that we don’t see a return to the risky mortgage lending and borrowing seen in the boom times.”

Forty-five percent of the home mortgage loans in the UK were liar’s loans – and the new “supervisor” believes that the bank officers made these loans because they all went simultaneously delusional and believed that there was an infinite bubble.

The three “de’s” and the First Virgin Crisis

George Akerlof was made the Nobel Laureate in Economics in 2001.  He co-authored a famous article in 1993 about accounting control fraud (“Looting: the Economic Underworld of Bankruptcy for Profit”).  They concluded the article with this paragraph in order to give it special emphasis.

“Neither the public nor economists foresaw that [S&L deregulation was] bound to produce looting.  Nor, unaware of the concept, could they have known how serious it would be.  Thus the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better.  If we learn from experience, history need not repeat itself” (George Akerlof & Paul Romer.1993: 60).

Akerlof & Romer explained why deregulation encouraged control fraud.

“[M]any economists still seem not to understand that a combination of circumstances in the 1980s made it very easy to loot a financial institution with little risk of prosecution. Once this is clear, it becomes obvious that high-risk strategies that would pay off only in some states of the world were only for the timid. Why abuse the system to pursue a gamble that might pay off when you can exploit a sure thing with little risk of prosecution?” (Akerlof & Romer 1993: 4-5).

N. Gregory Mankiw was a discussant on the Akerlof & Romer paper.  His infamous response to their warning about control fraud was that:  “it would be irrational for savings and loans [CEOs] not to loot.”  Mankiw is arguably the most influential economist because of his textbook and his role as a leading Republican economic adviser.  “Mankiw morality” explains why theoclassical economics fails substantively and ethically.

The National Commission on Financial Institution Reform, Recovery and Enforcement (NCFIRRE) investigated the causes of the savings and loan debacle that Akerlof and Romer referenced.

“The typical large failure [grew] at an extremely rapid rate, achieving high concentrations of assets in risky ventures…. [E]very accounting trick available was used…. Evidence of fraud was invariably present as was the ability of the operators to “milk” the organization” (NCFIRRE 1993).

Investigations, and successful actions and prosecutions, by regulators, the FBI, prosecutors, and white-collar criminologists confirmed the key role that accounting control fraud played in causing the second phase of the S&L debacle.

The Financial Crisis Inquiry Commission (FCIC) investigated the causes of the current U.S. crisis.  It reported:

“We conclude widespread failures in financial regulation and supervision proved devastating to the stability of the nation’s financial markets. The sentries were not at their posts …due to the widely accepted faith in the self-correcting nature of the markets and the ability of financial institutions to effectively police themselves.

More than 30 years of deregulation and reliance on self-regulation … championed by …Greenspan and others, supported by successive administrations and Congresses, and actively pushed by the powerful financial industry … stripped away key safeguards, which could have helped avoid catastrophe.”

“This approach had opened up gaps in oversight of critical areas with trillions of dollars at risk….

In addition, the government permitted financial firms to pick their preferred regulators in what became a race to the weakest supervisor.” [FCIC Report:xviii]

The Office of Thrift Supervision (OTS) “won” the U.S. race to the bottom.  The photograph of OTS head “Chainsaw” Gilleran (see Exhibit A at the end of this text) is the iconic image of this crisis.  It was intended to symbolize that the regulator (sic) and the industry would work together to destroy any regulations or supervision the industry felt was onerous.  The OTS and the FDIC were so proud of the image that they placed it in the annual report of the FDIC.

The “race to the weakest supervisor” did not occur only within the U.S.  Brooksley Born and a former senior SEC official have confirmed to me that UK regulators directly pitched U.S. financial firms to relocate operations to the City of London in order to obtain weaker supervision.  “Fed lite” supervision was a competitive response to the FSA’s “reg lite” system of deliberately weak supervision.  The City of London became the most criminogenic environment in the world for financial fraud, which is why so many UK banks and units of foreign banks located in the City have caused the major scandals in the UK and globally.

The investigations into the Irish crisis described their deliberately weak supervision as an EU policy.

“there was a socio-political context in which it would have taken some courage to seem to prick the Irish property bubble.”

“generic weaknesses in [EU] regulation and supervision.”

“Four main failings of supervision: (i) Supervisory culture was insufficiently intrusive, and staff resources were seriously inadequate ….”

“On-site inspections were infrequent.  Supervisors … imposed no penalties on banks at all.”

“Ireland’s mounting financial vulnerabilities meant that strong action was called for to over-ride the prevalent light-touch and market-driven fashions of supervision: to call a spade a spade….”

“failure to identify, recognise the gravity of, and take tough remedial action to correct such serious governance breaches was a cardinal error of supervision….” Report on the Irish Crisis (2010).

The FCIC dissent claimed that deregulation and desupervision could not be a major cause of the U.S. crisis because the crisis also occurred in Europe.  The dissent incorrectly (and implicitly) assumed that the three de’s did not occur in the EU.

Only regulators and prosecutors can break a Gresham’s dynamic and save markets

In its 2011-2012 Global Competiveness Report, the WEF conceded that effective financial regulation is essential to a safe and sound financial system.

“In order to fulfill all those functions, the banking sector needs to be trustworthy and transparent, and—as has been made so clear recently—financial markets need appropriate regulation to protect investors and other actors in the economy at large” [p. 7].

Its GCI, however, has no index category for effective financial regulation – only securities law regulation.  The WEF has several more general indices that refer to regulation.  Each of them assumes that regulation is inherently harmful – rather than essential.  The WEF encourages Nations to use its indices to engage in a competition in regulatory laxity.  It makes the financial environment deeply criminogenic.

The key potential of regulators and prosecutors is that we are not employees or agents of the banks we regulate.  Control frauds use their powers to hire, fire, promote, and compensate to suborn the supposed internal and external “controls” (such as auditors).  As Akerlof and Romer noted, accounting control fraud is a “sure thing” that will promptly produce record (albeit fictional) profits.  Creditors love to lend to highly profitable borrowers.  Private markets do not “discipline” accounting control frauds – they fund their rapid expansion.

Control frauds have shown strong abilities to suborn even elite financial players, such as audit partners at top tier firms.  George Akerlof was the first economist to apply the concept of Gresham’s law as a metaphor to explain how control fraud can create a competitive advantage that drives honest firms out of the markets.  In his famous article on markets for “lemons” he explained.

“[D]ishonest dealings tend to drive honest dealings out of the market. The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.”  George Akerlof (1970).

While economists have had no excuse for not understanding this dynamic for over 40 years, economists were not the first to explain a Gresham’s dynamic.  An acute observer of human nature wrote centuries earlier than Akerlof:

“The Lilliputians look upon fraud as a greater crime than theft.  For, they allege, care and vigilance, with a very common understanding, can protect a man’s goods from thieves, but honesty hath no fence against superior cunning. . . where fraud is permitted or connived at, or hath no law to punish it, the honest dealer is always undone, and the knave gets the advantage.”   Swift, J.  Gulliver’s Travels.

The WEF, through its many indices that purport to measure internal and external controls and quality of governance spreads the false belief that these actions prevent accounting control fraud.  A recent OECD report confirms that the EU suffered from the complete failure of audit and governance to prevent the crisis.

Effective financial regulation is not the enemy of markets or competition – it is essential to the preservation of well-functioning markets and the ability of honest business people to compete.  Control fraud begets fraud in the industry and other professions that are supposed to serve as controls.  NCFIRRE found that:

“abusive operators of S&L[s] sought out compliant and cooperative accountants.  The result was a sort of “Gresham’s Law” in which the bad professionals forced out the good” (NCFIRRE 1993).

FCIC found a similar Gresham’s dynamic among appraisers.

“From 2000 to 2007, a coalition of appraisal organizations … delivered to Washington officials a public petition; signed by 11,000 appraisers…. [I]t charged that lenders were pressuring appraisers to place artificially high prices on properties [and] “blacklisting honest appraisers” and instead assigning business only to appraisers who would hit the desired price targets.”( FCIC: 18)

Note that loan origination fraud originated with the loan originators rather than the borrowers.

Modern Executive Compensation is Criminogenic

In a delicious irony, Business Week asked Franklin Raines, Fannie Mae’s CEO why there was such widespread securities fraud during the Enron-era.  Raines replied:

“Don’t just say: ‘If you hit this revenue number, your bonus is going to be this.” It sets up an incentive that’s overwhelming. You wave enough money in front of people, and good people will do bad things.’”

Raines knew that bonuses had corrupted the unit at Fannie that should have been most resistant – internal audit.  We know that Raines read Rajappa’s speech because he made handwritten comments on it suggesting how to strengthen the message, which he returned to Rajappa.

“By now every one of you must have 6.46 [EPS] branded in your brains.  You must be able to say it in your sleep, you must be able to recite it forwards and backwards, you must have a raging fire in your belly that burns away all doubts, you must live, breath and dream 6.46, you must be obsessed on 6.46….  After all, thanks to Frank, we all have a lot of money riding on it….  We must do this with a fiery determination, not on some days, not on most days but day in and day out, give it your best, not 50%, not 75%, not 100%, but 150%.

Remember, Frank has given us an opportunity to earn not just our salaries, benefits, raises, ESPP, but substantially over and above if we make 6.46.  So it is our moral obligation to give well above our 100% and if we do this, we would have made tangible contributions to Frank’s goals.”  (Mr. Rajappa, head of Fannie’s internal audit, emphasis in original.)

The investigation into the Irish crisis by Mr. Nyberg displays poor analytics, but the facts he found demonstrate the perverse effects of compensation in encouraging accounting control fraud and enlisting the support of subordinates.

“Targets that were intended to be demanding through the pursuit of sound policies and prudent spread of risk were easily achieved through volume lending to the property sector.” (Nyberg 2011: 30)

“Bank management and boards in some of the other covered banks feared that, if they did not yield to the pressure to be as profitable as Anglo, in particular, they would face loss of long-standing customers, declining bank value, potential takeover and a loss of professional respect.” (Nyberg 2011: v)

“The [compensation] models, as operated by the covered banks in Ireland, lacked effective modifiers for risk.  Therefore rapid loan asset growth was extensively and significantly rewarded at executive and other senior levels in most banks, and to a lesser extent among staff where profit sharing and/or share ownership schemes existed.” (Nyberg 2011: 30)

“The associated risks appeared relevant to management and boards only to the extent that growth targets were not seriously compromised.” (Nyberg 2011: 49)

“Occasionally, management and boards clearly mandated changes to credit criteria. However, in most banks, changes just steadily evolved to enable earnings growth targets to be met by increased lending.” (Nyberg 2011: 34)

“all of the covered banks regularly and materially deviated from their formal policies in order to facilitate rapid and significant property lending growth. In some banks, credit policies were revised to accommodate exceptions, to be followed by further exceptions to this new policy, thereby continuing the cycle” (Nyberg 2011).

“The demand for Development Finance was so strong over the Period that bank and individual growth targets were easily met from this sector. Both of the bigger banks continued to lend into the more speculative parts of the property market well into 2008, even though demand for residential property (a major end-user) had begun to decline by the end of 2006.” (Nyberg 2011: 35-36)

“The few that admitted to feeling any degree of concern at the change of strategy often added that consistent opposition would probably have meant formal or informal sanctioning” (Nyberg 2011:  v).

The last sentence makes explicit the root ethical issue.  FCIC examined the same question.

“We conclude there was a systemic breakdown in accountability and ethics. The integrity of our financial markets and the public’s trust in those markets are essential to the economic well-being of our nation.”

Modern executive compensation further misaligns executives’ financial interests with the shareholders’.  It is, instead, superb for fraud because it is very large, largely based on short-term reported earnings or share prices (which the CEO can easily manipulate), and lacks a “claw back” provision.  It helps fraudulent CEOs convert firm assets to his personal benefit through seemingly normal corporate mechanisms, which makes it harder to prosecute.

The WEF is, again, a force for harm.  It has an index for performance pay.  CEOs who participate in the WEF survey are instructed that tying pay to performance is a desirable step, but there is no attempt by the WEF to verify that the dominant executive compensation system in their Nation is tied to long-term performance and has claw-back rights.  The index, therefore, tells Nations that they should make their financial environments even more criminogenic.

The WEF gets it so wrong because it ignores accounting control frauds

WEF’s competitiveness index has a series of indices that relate to the financial system and the quality of public and private institutions.  The WEF loved Ireland, Iceland, and the UK’s financial systems while they were massively insolvent – an insolvency hid by accounting fraud and the grotesque failure of EU Nations and audit bodies to interpret international accounting standards as requiring lenders to recognize losses arising from their fraudulent lending.

In its 2006-2007 and 2007-2008 GCI’s, WEF’s executive survey claimed that Irish banks’ “soundness” was, respectively, the 3rd and 5th best in the world.  Today, the same index rates them 144 – the worst in the world.  The truth is that the worst Irish banks were in economic reality insolvent long before 2006 because of their fraudulent lending practices.

The respective ranks WEF gave Iceland’s banks in those years were 26 and 29.  The WEF now ranks them 136.  Spain’s banks are down to 109th from 16 and 19.  The UK’s banks fell from the fiction that they were the best in the world (2006-07) (4th best in 2007-2008) to 97.

The WEF’s Global Risk Reports’ financial warnings are every bit as embarrassing.  They are overwhelmingly odes to the austerity that threw the Eurozone back into a gratuitous recession.

The WEF survey is a mass of business prejudices collated and called science.  If the CEOs, despite their close ties with the banks (indeed, many of them are bankers) cannot even spot the problems of banks in Ireland, Iceland, the UK, and Spain over a year after the bubbles have ceased expanding they are even more useless than scholars feared.  It is time for WEF to get out of the business of being an apologist for and enabler of control fraud and to tell the likes of Goldman Sachs that a banker who sells its clients toxic mortgages the bank describe internally as “shitty” is a bank that is degrading the state of the world and it is unwelcome in Davos.


Exhibit A

The Faces of Desupervision in the U.S.:  “Chainsaw” Gilleran and friends – America’s leading bank lobbyists act together with their faux regulators to destroy effective regulation and supervision.