As finance is about using other people’s money, opportunities to steal are strong (lots of money to be made), easy (people are gullible, think they understand finance, but most do not) and cannot all be eliminated by law (morals cannot be legislated). Professor Utpal Bhattacharya of Hong Kong University of Science and Technology provides a whirlwind tour of 25 years of his research on some of these dark corners of finance.
I grew up in India, one of the world’s most corrupt countries. In 1975, I received a letter from the Central Government informing me that I was entitled to a scholarship for outstanding high school grades, but because my family income was above poverty threshold, I would get a cash award instead. Very fair, I thought. Today it is 2015, 40 years later and I am still waiting for my cash award. Not fair.
I am a Bengali. Financial scams in Bengal are an art form. In 2015, it is the scandal of Saradha. In my youth, in the 1980s, it was Sanchayita.
Being a Bengali from India, it was thus inevitable that my research obsession would become the dark side of finance, beginning with Ponzi schemes.
Ponzi Schemes
I convince my friend Newton that if he invests 100 rupees with me, I will double his money in a month. Newton gives me 100 rupees. Next month I convince my friends Darwin and Einstein. They each give me 100 rupees, and I use these 200 rupees to pay off Newton. Newton is impressed. He tells all his friends. His friends come running to me. I take 100 rupees each from only four of them – Pythagoras, Socrates, Plato and Aristotle – and use the 400 rupees to give back 200 rupees each to Darwin and Einstein. My fame spreads like wildfire. They all want to invest with me. I take money from 8 of them, then 16, then 32 and so on. When a lot of people are involved, I disappear with their money.
The scheme that I have just illustrated is illegal. It is called a Ponzi scheme. It is named after Charles Ponzi, who raked in 15 million dollars in 8 months in Boston in 1920. At the height of his success, Mr. Ponzi was hailed by those he was cheating as the greatest Italian who ever lived. “You’re wrong,” he said modestly, “there’s Columbus, who discovered America, and Marconi, who discovered radio.” “But, Charlie, you discovered money,” they used to tell him.
Versions of such scams had existed before Ponzi and continue to exist after him. Saradha and Sanchayita in Bengal were Ponzi schemes. When I Googled this morning, I found that many such scams were under investigation. Why has the number of Ponzi schemes dramatically shot up? The answer is one word: Internet. News travels faster. Publicity by word-of-mouth has been replaced by publicity by click-of-mouse or swipe-by-finger.
The most fascinating Ponzi scheme, I studied in real time, was the one run by Sergei Mavrodi in Russia in the early 1990s. I was teaching in Stavropol, Russia that year (I teach in a new country every year), and nearly all my students were taking part. I told them to get out before the scheme collapsed. The geometric series – 1, 2, 4, 8, 16, 32, – would explode and soon Mr. Mavrodi would run out of Russian people to sell his certificates to. So there will be a last round. Investors in the last round will know that they will lose their money when the organiser disappears with their funds. No one would want to play the last round, making the second-to-last round actually the last. Those people will refuse to participate as well. Using this logic again and again, no one should take part. Ponzi schemes, I explained to my students, would work only if investors are irrational or there are an infinite number of people and rounds.
Saradha and Sanchayita in Bengal were Ponzi schemes. When I googled this morning, I found that many such scams were under investigation. Why has the number of Ponzi schemes dramatically shot up? The answer is one word: Internet. News travels faster. Publicity by word-of-mouth has been replaced by publicity by click-of-mouse or swipe-by-finger.
My students in Russia did not believe my logic. They said that everyone, including the politicians, were taking part. If the scheme collapsed, as it was “too big to fail,” they believed that they would be bailed out. They were wrong. In the summer of 1993, the scheme collapsed. They lost all their money. I then learnt that these schemes had erupted in most of the Soviet-bloc countries. When such a scheme collapsed in Albania, it led to a civil war.
I wrote a paper, rather whimsically, that it may be rational to take part in the last round in these countries. You will lose, but you may recoup some of the money from the bailout. Your net loss maybe less than the net loss you incur if you did not take part, because it is your taxpayer’s money that would be used for the bailout. But why did these schemes erupt in most Soviet-bloc countries? Why in Bengal? My hypothesis was that the participation of politicians made investors believe that the possibility of bailouts was very high.
Insider Trading
A classic paper in finance showed that markets will collapse if information was the only motive for trade. The intuition is that if someone wants to buy (sell) a share from you, you believe he has good (bad) news, and so you will not accept the low (high) price he is offering you right now. My dissertation in 1990, titled “Insiders, Outsiders, and Market Breakdowns,” introduced another motive for trading: risk-sharing. Trading will now take place. With Matthew Spiegel, I showed in a theoretical model that even here markets will collapse if there is too much insider trading.
I have been fixated with insider trading since then.
Using a sample of Mexican corporate news announcements from the period July 1994 through June 1996, Hazem Daouk, Brian Jorgenson, Carl-Heinrich Kehr and I found that there was nothing unusual about returns, volatility of returns, volume of trade or bid-ask spreads on the day of the announcement. This suggested one of the five possibilities:
- our sample size was small
- or markets were inefficient;
- or markets were efficient but the corporate news announcements were not value-relevant;
- or markets were efficient and corporate news announcements were value-relevant, but they had leaked out;
- or markets were efficient and corporate news announcements were value-relevant, but unrestricted insider trading had caused prices to fully incorporate the information.
Our evidence supported the last hypothesis.
The paper caused quite a stir in Mexico. I was invited to Cancun to present the paper. My mother feared for my life, and told me not to go. I went. The presentation was a big hit. Today, the methodology introduced in our paper is a potent tool used by regulators to detect insider trading. The idea is simple. It was already there in a famous Sherlock Holmes story. “Become suspicious when a dog that should have barked did not bark.”
Not being Mexican, I felt guilty embarrassing the country. So I decided to embarrass the whole world. For the next three years of my life, with the help of Hazem Daouk, we hand-collected insider trading data from all the 103 countries that had stock markets. What did we find? We found that most countries ban insider trading but few (only one-third) enforce the laws. We then documented that share prices did not respond to the introduction of insider trading laws but did increase at the enforcement of those laws. Thus it is not enough to legislate; they must be enforced. Common sense! The thing is that no one seemed to have it before we used formal evidence to prove.
Finally, Hazem and I completed the trilogy with a rather radical paper. We showed that the price of shares decrease when emerging market countries pass laws against insider trading but do not enforce them. In these cases, it may be preferable to have no laws rather than having laws that are not enforced. This last finding has profound implications for legislators: it is dangerous to introduce financial laws if you do not mean to enforce them.
Hazem and I had much fun writing these papers. The regulator of one country, which shall be left unnamed, asked what we meant by insider trading. The insider trading law of one country was an exact “copy and paste” of the insider trading law of another country.
Who does illegal insider trading? Classical economics (Nobel Laureate Gary Becker, for example) says that crimes should be committed by the poor rather than the rich. This is because the extra rupee means a lot to the poor and the cost of being caught is lower for them (little reputation to lose, less lost income). Using a sample of all illegal insider trading cases in the United States, Cassandra Marshall and I found that it is actually the richer CEOs who do illegal insider trading.
Earnings Manipulation
Hazem Daouk, Michael Welker and I analysed financial statements from 34 countries for the period 1985-1998 to construct a panel data set measuring three dimensions of reported accounting earnings for each country – earnings aggressiveness, loss avoidance, and earnings smoothing. We hypothesized that these three dimensions are associated with uninformative or opaque earnings, and so we combined these three measures to obtain an overall earnings opacity time-series measure per country. We then explored whether our three measures of earnings opacity affect two characteristics of an equity market in a country – the return the shareholders demand and how much they trade. While not all results were consistent for our three individual earnings opacity measures, our panel data tests documented that, after controlling for other influences, an increase in overall earnings opacity in a country is linked to an economically significant increase in the cost of equity and an economically significant decrease in trading in the stock market of that country.
Nobel Laureate Gary Becker, says that crimes should be committed by the poor rather than the rich. This is because the extra rupee means a lot to the poor and the cost of being caught is lower for them (little reputation to lose, less lost income). Using a sample of all illegal insider trading cases in the United States, Cassandra Marshall and I found that it is actually the richer CEOs who do illegal insider trading.
Honest balance sheets and profit and loss statements, our research showed, were rewarded in the marketplace.
An interesting sidelight of this paper was that it came out around the same time that the spectacular accounting scandals of Enron and WorldCom – the Satyams of the United States – broke. I remember the media coverage of our paper. One newsmagazine said that solace should be taken from the conclusions of our paper: ‘though accounting manipulation in the United States is bad, the accounting manipulations in the other countries are worse’. In our sample, China showed the most earnings opacity.
Illegal Cross-Subsidy in Mutual Funds
A major reason for the existence of conglomerates or business groups is to create internal capital markets to promote the efficiency of the group. One of many efficiency measures that internal capital markets can offer is an insurance pool, which provides temporary liquidity to the members of the group in the event of adverse shocks. It is for this reason that an Indian business group like the Tatas or a U.S. conglomerate like G.E. cross-subsidize their various segments. Such corporate behaviour is legal.
If mutual fund families, which are a collection of independent mutual funds tied together by the sponsoring management company, are regarded as groups, it seems reasonable to assume that there would be a group interest. If so, it seems natural to ask whether insurance pools would exist in these families, where cash-rich mutual funds direct capital to their cash-poor cousins. The law, however, does not allow this. This is because a mutual fund owes a fiduciary responsibility only to its own shareholders, and not to its family. Nevertheless, several papers suggest that group interest comes before fiduciary responsibilities in many fund families.
Jung Hoon Lee, Veronika Pool and I analysed the investment behaviour of AFoMFs. AFoMFs are mutual funds that can only invest in other funds in the family, and are offered by most large families. Though never mentioned in any prospectus, we discovered that AFoMFs provide an insurance pool against temporary liquidity shocks to other funds in the family. We showed that though the family benefits because cash-poor funds can avoid fire-sales, the cost of this insurance is borne by the investors in the AFoMFs. Is this illegal? Yes, if our findings are true.
Can Some Securities Remove the Dark Side of Finance?
No.
Andreas Hackethal, Benjamin Loos, Steffen Myers and I recorded what happens when ETFs, a kind of security whose payoff is tied to a market rather than a company, is offered to retail investors. We found that retail investors, since they now cannot get ripped off by investors who have private information about firms, benefit. This is good news. The bad news is that retail investors are now tempted to time the market, and they time it wrong.
Can Honest Expert Advice Remove the Dark Side of Finance?
No.
Working with one of the largest brokerages in Germany, Andreas Hackethal, Simon Kaesler, Benjamin Loos, Steffen Myers and I recorded what happens when investment advice was offered to a random set of approximately 8,000 active retail customers out of the brokerage’s several hundred thousand active retail customers. The customers knew that the advice was unbiased (it was generated by us academics from a classical algorithm) and for the first six months it was free. We found that only 5% wanted our advice. Who were they? They were the ones whose portfolios were doing better than the portfolios of investors who did not want our advice. So, like medical advice, those who most needed the advice were least likely to obtain it.
What happened to these 5% after they got the advice? Their portfolio performance did not improve. Why? We dug deeper. We found that they hardly followed the advice and that is why they did not improve their portfolio efficiency by much.
Moral of the story: Hwa is thet mei thet hors wettrien the him self nule drinken [Who can give water to the horse that will not drink of its own accord?]. This is the oldest English proverb, first recorded in 1175.
Overall, our results imply that the mere availability of unbiased financial advice is a necessary but not sufficient condition for benefiting retail investors. In other words, what is the point of the regulators wasting so much energy to get rid of conflicts of interest in the financial services industry when, at the end of the day, investors ignore even honest expert advice?
So What Is To Be Done?
My research is about what is, not about what ought to be done. But if I am forced to give some advice, here it is:
- Few, simple, obvious, regulations
- Tough enforcement of these regulations
- Short-sellers and governments acting as party spoilers
- Financial literacy
- A discarding of the naïve belief that the problem can be solved; it can only be contained.