Financial Fraud: Lacking Morality versus Lacking Ability
The hidden alpha, presented at the 2023 ASSA conference, shows that hidden connections (connections between hidden profiles) between fund managers and firm officers on Facebook predicted abnormal returns of the fund. They implicitly hint at insider trading, showing that the fund managers not just blindly buy their hidden friends’ stocks, but also seem to time (and thus, sell) the stocks of their hidden friends optimally. This paper is a clever example of how combining data mining with behavioral finance research can uncover hidden human behavior. What this paper will likely not do, is improve the public’s negative view of financial experts' morals. From huge bonuses when the firm is in turmoil to Madoff’s Ponzi scheme: financial experts appear to have a stronger predisposition to be immoral than the rest of the world. How can this be? Are most financial fraudsters born into immortality, and raised to make a career in finance? Financial fraudsters are violating moral codes that many ‘normal’ people would never consider doing. Or would they?
Milgram's seminal experiment teaches us how assuming to be morally superior to others can be deceiving. In an attempt to explain the atrocities of Nazi Germany in the Second World War, Milgram set out to prove that Germans were inherently predisposed to blindly follow orders without question. Subjects were told to give (increasingly severe) electric shocks as punishment to a (fake) test subject, under the watchful eye of an authority (called the experimenter). Milgram needed a baseline measurement of good moral behavior and thus used ‘normally moral’ US citizens. The results puzzled him. The presuming morally superior US subjects also repeatedly punished peers beyond unconsciousness, even when told that those peers were suffering from severe heart disease. It was later concluded that Germans were indeed not morally inferior. In retrospect, German's behavior was more a result of the situation they were in, than their inherent nature.
Figure 1. The Milgram experiment setup (left), and a subject during administering shocks (right).
Ray Chetty’s big data analysis on tax fraud also showed how morality and behavior conflicted in a financial setting. Chetty investigated why 30% of the single children’s parents in Miami reported the exact amount of income needed for a maximum tax rebate, whereas only 3% reported this income in Detroit. Many of these 30% reports were found fraudulent. Chetty continued to look at who committed fraud. He found that it was not age, education, ethnicity, nor gender, but closeness to financial advisors that increased the likelihood to commit fraud. Learning about the loophole, either from an advisor, family, or friendly neighbor gave people from Miami the tools needed to commit fraud. And once those tools were available, they were used. Detroit was not more moral, but simply less aware. Luckily for them, Chetty also showed that people who learned how to cheat the system passed the knowledge along after moving, spreading the tax fraud through the US like wildfire. Once people who formerly denounced fraud learned how to do it, most of them did.
Granted, it is a big leap from tax fraud to insider trading or a Ponzi scheme a la Madoff. Nevertheless, this research suggests that sometimes we adhere to the rules due to constrained abilities, not due to superior morality. We should realize that we are not very good at predicting how we would act under those unknown circumstances. Stating that you "are not likely to commit fraud” does not always coincides with actual behavior (a phenomenon known as cold-to-hot intertemporal empathy gap). Acknowledging these cold-to-hot empathy gaps is useful for understanding and anticipating the behavior of ourselves and the people around us, instead of blindly assuming you would and others should ‘do the right thing’.