On Financial Fraud

There are some good lessons in this article on financial fraud:

That's how we got it so wrong. We were looking for incidental breaches of technical regulations, not systematic crime. And the thing is, that's normal. The nature of fraud is that it works outside your field of vision, subverting the normal checks and balances so that the world changes while the picture stays the same. People in financial markets have been missing the wood for the trees for as long as there have been markets.

[..]

Trust -- particularly between complete strangers, with no interactions beside relatively anonymous market transactions -- is the basis of the modern industrial economy. And the story of the development of the modern economy is in large part the story of the invention and improvement of technologies and institutions for managing that trust.

And as industrial society develops, it becomes easier to be a victim. In The Wealth of Nations, Adam Smith described how prosperity derived from the division of labour -- the 18 distinct operations that went into the manufacture of a pin, for example. While this was going on, the modern world also saw a growing division of trust. The more a society benefits from the division of labour in checking up on things, the further you can go into a con game before you realise that you're in one.

[...]

Libor teaches us a valuable lesson about commercial fraud -- that unlike other crimes, it has a problem of denial as well as one of detection. There are very few other criminal acts where the victim not only consents to the criminal act, but voluntarily transfers the money or valuable goods to the criminal. And the hierarchies, status distinctions and networks that make up a modern economy also create powerful psychological barriers against seeing fraud when it is happening. White-collar crime is partly defined by the kind of person who commits it: a person of high status in the community, the kind of person who is always given the benefit of the doubt.

[...]

Fraudsters don't play on moral weaknesses, greed or fear; they play on weaknesses in the system of checks and balances -- the audit processes that are meant to supplement an overall environment of trust. One point that comes up again and again when looking at famous and large-scale frauds is that, in many cases, everything could have been brought to a halt at a very early stage if anyone had taken care to confirm all the facts. But nobody does confirm all the facts. There are just too bloody many of them. Even after the financial rubble has settled and the arrests been made, this is a huge problem.

Posted on July 25, 2018 at 6:29 AM • 28 Comments

Comments

echoJuly 25, 2018 7:09 AM

Heck, oh, mighty! Judging by the quotes the article looks good. I certainly agree there are issues with authority and division of labour and certainly too many facts to consider.

From the other side of the fence trying to get a lawful tranaction cleared where the processors are over-zealous and discriminatory? I have given as much information as I can without writing a book and a list of statutory bodies and have included the police if they wish to verify the transaction. I even said I would give them names and numbers of individual police officers and am available if they wish to make an appointment. Everything is open book at my end. Cue complaints in 5...4...3...2...1... I have spent three days so far collating and drafting a core document to approach another finance processor and also serve as a submission to the regulator and ombudsman. It's long enough as it is and I haven't listed detailed citations covering the exactline of statute or other relevant material. As much as I want to push this out the door I'm letting it rest so I can review and rewrite if need be and decide how much granularity I want to provide at this stage. I would rather not have to dig deeper because this kind of material can blow up to the size of a mountain very fast.

I also have additional complaints in hand about lawyers on a security related issue and am referring them to the ombudsman. Basically, they wouldn't accept a one page document in electronic form in any format or via media while other lawyers do. Oddly, they are happy processing messages via their website or email. Investigating how lawyers manage the whole area reveals very low quality guidance and expertise.

Impossibly StupidJuly 25, 2018 9:11 AM

They might be "good lessons", but they're not exactly new lessons. It's downright laughable that nobody was looking for "systematic crime" given the vast history of the financial industries doing exactly that. It is equally laughable to say "moral weaknesses, greed or fear" aren't at the root of the motivated reasoning that gets people to follow non-scientific methods for evaluating the available facts.

It's all just another case of convenience undermining security.

marcJuly 25, 2018 9:21 AM

There are many consensual crimes, drug crimes being the primary example. More and "better" enforcement won't fix that problem, and it won't fix this. Did they ever think to question why they are tying all these things to LIBOR rates? A fragile system, indeed.

HJohnJuly 25, 2018 9:48 AM

Any fraudulent act requires three components, some call them the three C's:
* Commit the Fraud Act
* Convert
* Conceal

If any of these components fail, the fraud act itself fails. Fraud is useless if it cannot be converted into useful form, and if it cannot be concealed.

(The three C's are based on the Fraud Element Triangle, which is Theft Act, Conversion, Concealment. This is somewhat different than the standard Fraud Triangle of Pressure, Opportunity, Rationalization.)

AlanSJuly 25, 2018 9:55 AM

as industrial society develops, it becomes easier to be a victim. In The Wealth of Nations, Adam Smith described how prosperity derived from the division of labour....While this was going on, the modern world also saw a growing division of trust. The more a society benefits from the division of labour in checking up on things, the further you can go into a con game before you realise that you’re in one.

Banking fraud and failure was an issue in the 18th C. as now. Smith has a whole section in Wealth of Nations on banks. Here's what he has to say about banking practices, trust and financial risk:

To restrain private people, it may be said, from receiving in payment the promissory notes of a banker, for any sum whether great or small, when they themselves are willing to receive them; or, to restrain a banker from issuing such notes, when all his neighbours are willing to accept of them, is a manifest violation of that natural liberty which it is the proper business of law, not to infringe, but to support. Such regulations may, no doubt, be considered as in some respect a violation of natural liberty. But those exertions of the natural liberty of a few individuals, which might endanger the security of the whole society, are, and ought to be, restrained by the laws of all governments; of the most free, as well as of the most despotical. The obligation of building party walls, in order to prevent the communication of fire, is a violation of natural liberty, exactly of the same kind with the regulations of the banking trade which are here proposed.

This might be a little surprising to anyone who has been brought up on the "invisible hand of the market" nonsense, a 'theory' created by modern economists and projected back onto Smith.  A 'free' market in the Smithian sense only works within a system of laws and regulations (a system of justice) that restrains "the natural liberty of a few" acting to their own advantage against the interest of the "whole society". It's an ideal. Smith wasn't very hopeful that anything approaching the ideal would be established: "as absurd as to expect that an Oceana or Utopia should ever be established". The system of mercantilism that existed in his time (and which is not too dissimliar to modern economies in many ways), and which is a primary target of criticsim in Wealth of Nations, functioned through the conning of the public and corruption of the legislature by private interests. Good regulation is the solution but that's not what government delivers.

HumdeeJuly 25, 2018 10:28 AM

There is another aspect to fraud in the modern context that makes it so difficult to deal with and that is the fact that most fraud is committed by large groups, not individuals. This makes it difficult to assign blame because the Western legal systems are all set up on the basis of individualized rather than collective guilt. The modern market economy does a great job of risk distribution but there is no concomitant way to deal with guilt distribution. I like to make this point by asking the following question: How does a culture have a guilty mind? It is this form of systemic risk that creates the most long-term problems and is directly responsible for the financial crisis of the last decade,

de la BoetieJuly 25, 2018 10:53 AM

I'd say there's a more invisible and bigger level of crime - except ostensibly not a crime because executed by those in power. Namely, institutionalised insider dealing and market manipulation, based on nation state mass surveillance. Think the NSA feeds and analysis tools flowing into the Federal Reserve and their corporate buddies.

To quote Terry Pratchett

'.. there's big crimes and little crimes.Sometimes the little crimes look big and the big crimes you can hardly see, but the crucial thing is to decide which is which.'

WinterJuly 25, 2018 12:48 PM

The article explains why people do not invest time in looking for frauds:

It’s the Canadian paradox. Although in the short term, you save your money by checking everything out, in the long term, success goes to those who trust.

Alyer Babtu July 25, 2018 1:35 PM

Adam Smith never seems to directly discuss the underlying problem, which is justice, i.e. the good of the other, but instead seems to talk about a war of “liberties” and “security” without saying what these would be. They could be read as supporting anything from anarchy to totalitarian regimes. Why should your security trump my liberty or vice-versa ? “Regulation” is not really a helpful term here as it puts the focus in the wrong place, on the making of a rule. Liberties are consequent on responsibilities. If justice is ensured, there is no infringement of liberty. Smith’s party wall is not an infringement of liberty, since there is a shared resource with attached natural considerations of justice.

de la BoetieJuly 25, 2018 2:26 PM

May I recommend the book Deceit and self-deception by Robert Trivers in this connection.

His key thesis is that while deceit is very widespread and in an arms race with detection (which lags behind), we also practice self-deception in part to reduce the cognitive load of lying.

In this context, it means that the cheaters & frauds have insulated themselves from the notion they are doing wrong, and this particularly applies to the rich and powerful. I'd also recommend listening to Nick Leeson's account of how he progressively fell into fraud, backed by the obvious blind eyes of management and regulators.

Trivers is also of the view that economics is not a science because its view of utility (what you're supposed to maximise) is not grounded in meaning to evolved beings who also practice fraud and deceit.

Right now, we have a system that rewards the cheats (increasing inequality, diversion of power and resources to rent-seekers, very rare punishment of wrong-doers and at a medium-low level of responsibility). At worst, the leaders responsible get stripped of their knighthoods.

While the weak suffer what they must.

Jesse ThompsonJuly 25, 2018 2:41 PM

@Alyer Babtu - these are all really valuable ways to look at the matter. Thank you. :)

When perspectives like "one person's liberty is another's insecurity" come up, my favorite tool to tackle the matter is "law exists for no reason beyond settling disputes". Where there are no disputes to settle, law has no application and cannot even be enforced.

Hell, even when your conscience bothers you about technically violating some rule, or what happens if you get caught, even that represents a relatively mild dispute internal to one's own mind. Lacking dispute compliance to law cannot even be measured or perceived.

I find that viewing things through these optics helps to relieve the pressure on what to call "Security" vs "over-controlling abuse of others", and what to call "liberty" vs "violating the rights of others".

No sufficiently large population (such as n>3 or so) will ever find unanimous consensus on where the boundaries to their personal domains of influence really end, so the balance of how to settle such a dispute with least injury to either party (or least squared injury in cases that approximate zero-sum) becomes the best estimate of such. It's just like economic price discovery and finding where the supply and demand curves intersect.

In this framework "Justice" is exactly that: working to discover a best available approximation of where that least squared injury boundary can be found in every dispute.

Thus I agree that application of justice, by way of dispute resolution, represents a more fundamental framework than the details of which or how many rules to draft.

vas pupJuly 25, 2018 2:48 PM

@all: sorry, bitter joke
"Success [e.g. financial, political]in life depends on decency and honesty. Absence of those two guarantees success".

HumdeeJuly 25, 2018 2:50 PM

"It’s the Canadian paradox. Although in the short term, you save your money by checking everything out, in the long term, success goes to those who trust."

Never heard of this before. Think it is nonsense. While I agree that over the long term paranoia is bad and trust is good what is being ignored in the statement that I quoted is the fact that this plays out at the group and not the individual level because of the role of luck. An individual not only has to trust, they have to trust the right people. There are going to be people who trust and who pay for that mistake with their lives but so long as that bad luck is minimal to the /group/ the group can survive.

WinterJuly 25, 2018 3:47 PM

@Humdee
As with all things security, trust and distrust come with costs. The Canadian paradox is that in a safe country, if the (opportunity) cost of distrust is much higher than of trust, you find more con games than in an unsafe country where the situation is reversed.

k15July 25, 2018 4:23 PM

Where are the reporting channels? I see the appearance of fraud everywhere I look and everywhere I go. I also see that everyone is pretending they see nothing - or at least I see the appearance of that.

When did we lose the channels for reporting problems?

65535July 25, 2018 4:51 PM

@ Alyer Babtu and Jesse Thompson

I agree with the thrust of your postings.

Other important factors:

The USA does have a de-facto national ID number for almost every person. It is the Social Security Number or Tax Identification Number.

Those numbers were put in place well before the “internet” was formed. These SSNs and TINs are generally available to a huge number of orgizanations, both governmental and corporate entities like the Social Security Administration, IRS, Banks, credit rating agencies and so on.

The SSNs were used as college ID numbers in days gone by. Quite frankly, the SSN was not properly handled in a secure fashion. I would say USA citizen’s SSNs were handled very carelessly. The SSN of most US citizens is now known to hackers via the internet computer breaches.

Another factor includes the use of early computer systems and the birth of the internet where both the Government and the Private Sector did a poor job at securing SSNs.

Other countries watched with glee as the USA made mistake after mistake. These other countries learned for the USA’s mistakes. Most EU countries are a bit more secure because of this “watch and learn” curve and have done a better job of keeping their citizen’s confidential information private.

Now, the USA is reaping the bitter taste of having poorly secured SSNs and TINs floating around on the internet. Those above problems along with many other mistakes have painted a target on the backs of US citizen and other public and private enterprises. This will take decades to clean up.

k15July 25, 2018 6:09 PM

If you can see a security flaw at an insitution you are doing business with, that's a branch of a national or international business, what is the best thing to do?

HmmJuly 25, 2018 7:45 PM

"Fraudsters don't play on moral weaknesses, greed or fear;"

As far as a writing style thing I think we all should make a mental note to avoid superlatives.

I makes this mistake sometimes myself and it has consequences. Even if correct in the way we mean it.

Arthur DoohanJuly 26, 2018 5:31 AM

Schneier - on fraud - comment
Greetings!

The greatest fraud of the most recent epicycle has been the effort by the authorities to distract from their incompetence by 'gaslighting' the LIBOR issue.

Please bear in mind that NO ONE and NO FIRM has been found guilty of actually manipulating the rate and no court case has been brought, let alone succeeded, re proving loss arising from a manipulated LIBOR fixing.

Fines have been imposed on firms for not having managerial systems robust enough to prevent conspiracy to rate rig. People have been jailed for conspiracy to attempt to rate rig. If you doubt what I'm saying, please read some of the original penalty notices and findings by the regulators.

Paying the fines and sacrificing individuals is seen by the boards of the TBTF banks is merely seen as 'a cost of doing business' and being left alone to manipulate their privileged position in the FIRE economy.

The original article is quite correct to say that, as currently constructed, the system does not reward fact-checking or whistleblowing. This line, "But nobody does confirm all the facts. There are just too bloody many of them", is perhaps the most relevant.

We have built a system that is beyond the ken of anyone to comprehend and calling time on naked Emperors is now met with the attitude first defined by Upton Sinclair's aphorism “It is difficult to get a man to understand something, when his salary depends on his not understanding it.”

The FIRE economy is clearly a vampire predating on the goods and services economy and it is being propped up by politicians and regulators who cannot bring themselves to admit this. With ZIRP and QE still extant, the GFC is ongoing and when ‘the other shoe drops’ there will be no wiggle room to evade the cascade of debt defaults.

When that happens, we will find that we have been defrauding ourselves by believing that what money, debt and credit represents is not subject to the 2nd Law of Thermodynamics.

Jon (fD)July 26, 2018 6:02 AM

@65535 on using the SSN as "Student ID number".

My school did that. But it's worse...

They would print out lists of students that included both name and number. Then, to put up a list of (e.g.) "Who is in [this class]", they would razor out the student ID numbers and tape up on the department office windows the list of names.

Then, after (say) midterm exams, they would print out the same list, with grades in place, and razor out the names, leaving the student ID numbers. And stick it up also to be seen by anyone, anytime.

But it was the same list. It was always printed with student names in alphabetical order. My number was always in the same place. And sometimes the two lists were taped up at the same time...

Not to mention the office staff, who printed the whole list every time, and could easily have collected the razored out bits from the trash had they cared to.

Foreign students had it better, as they were assigned a number unique to the University, at least.

Anyhow, an aside to an aside about Universal ID numbers. Have fun, Jon (fD)

65535July 26, 2018 8:28 PM

@ Jon (fD)

Your story mirror’s one of my cousins older brother’s problems. I believe my relative had all of his credit cards stolen because of the extremely poor handling of SSNs as student IDs. This got so bad that he was hesitant to enroll in post grad programs if the school used SSNs as student ID numbers.

I am guessing a lot of people in that category would like to sue those schools for compensation. Colleges and Universities can be a good example of a bad example.

Dave SchreiberJuly 27, 2018 9:00 AM

My view on the issue with SSNs is not with how various organizations use them as identifiers - it is with the laws and regulations allowing lenders to issue and collect on debt that was issued without properly identifying the party that was receiving the loan or credit or any sort of a financial service.

There are countries which issue national ID numbers to every resident, and these numbers are just identifiers - they are not used as authorization tokens. Thus they can be published and are even open to being looked up from government sources.

In such countries, the lenders are regulated to require a much higher standard of proof of identify before being allowed to issue a loan or a line of credit. Or, conversely, their ability to collect on said debt depends on strong evidence that the person they claim took out a loan actually authorized them to take out such a loan. Usually, this requires presenting a government issued photo ID, plus taking photocopies of the same.

At any rate, I think the focus with SSNs is on the wrong problem. Force lenders to identify their clients and provide strong evidence on their debt collection claims and the industry will fix itself in a hurry.

AlanSJuly 27, 2018 10:12 AM

@Alyer Babtu

Adam Smith never seems to directly discuss the underlying problem, which is justice, i.e. the good of the other, but instead seems to talk about a war of “liberties” and “security” without saying what these would be. They could be read as supporting anything from anarchy to totalitarian regimes.
Ugh? Are you reading the Smith that wrote that a principle of good citizenship was "an earnest desire to render the condition of our fellow-citizens as safe, respectable, and happy as we can" and when support of the established government ran contrary to such then "even a wise man may be disposed to think some alteration necessary in that constitution or form of government"?

vas pupJuly 27, 2018 12:05 PM

@Dave Schreiber:
"In such countries, the lenders are regulated to require a much higher standard of proof of identify before being allowed to issue a loan or a line of credit. Or, conversely, their ability to collect on said debt depends on strong evidence that the person they claim took out a loan actually authorized them to take out such a loan. Usually, this requires presenting a government issued photo ID, plus taking photocopies of the same."
Yeah, because I guess in those countries legislators/regulators are substantially less depend on those lenders(aka banks and other private financial institutions and their lobbyists)for reelection. They are more reflect on constituents' needs.

@all on psychology of financial risk taking:
https://www.sciencedaily.com/releases/2018/07/180726085745.htm

"The attitude towards riskier or less risky decisions showed a stronger correlation to the actual behavior than the reward outcomes," reports Häusler. Two factors are of essential importance for this attitude: risk optimism and risk tolerance. Individuals with more risk optimism are firmly convinced that investing in stocks leads to high profits. Anyone who enjoys the thrill of risky decisions has a high risk tolerance. Both factors also play an important role in the relationship between the "anterior insular" and the purchase of stocks in real life. Here, they act as a mediator between brain activity and the real-life stock trading behavior."


echoJuly 28, 2018 7:13 AM

Sorry but the missing "." in the first "[...]" (whatever these things are called) of this topic is bugging the heck out of me.

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