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Fomenting Fraud: How Weak Enforcement of Bank Misbehavior Threatens to Bring About the Next Financial Crisis

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Results of a recent Gallup Poll reveal that the American public's trust in banks has hit a record low. Just 21 percent of Americans have faith in the nation's banks, the lowest recorded number since the poll was first taken in 1973. It is lower now than it was in 2009, in the teeth of the financial crisis.

One can speculate that, like distrust in Congress, this lack of faith appears across the political spectrum. From the left, banks are criticized for engaging in risky conduct that helped to bring about the Great Recession. Similarly, many on the populist right vilify government intervention designed to prop up poorly managed financial institutions as threatening capitalism itself. In many ways, this lack of faith is not surprising. Media reports routinely provide the general public with reminders of bank misconduct, whether in the illegal origination of loans, the shoddy packaging of mortgage-backed securities, excessive and ill-advised risk taking or the faulty prosecution of foreclosures. These revelations have had a profound impact on the general public's faith in financial institutions. Making matters worse, law enforcement's most recent attempt at uncovering and prosecuting bank misconduct in the lead up to and fallout from the financial crisis has gotten moving in only fits and starts. These forces -- public disenchantment with the banks, coupled with weak law enforcement -- are a toxic mix. They will fail to prevent future misconduct; what's worse, they may, in fact, encourage it.

Throughout the year, as more information comes out about bank misconduct before and after the financial crisis, public perception of the financial sector remains poor. Whether it's the $25 billion settlement of so-called "Robo-Signing" practices; revelations of the failure of Bank of America to disclose losses at Merrill Lynch when it asked its shareholders to approve purchase of the investment bank; the billions in trading losses at JP Morgan Chase; or the recent settlements of mortgage discrimination suits against Wells Fargo, Countrywide Financial Corporation and SunTrust Mortgage, the public receives constant reminders that our financial institutions have engaged in, and apparently continue to engage in, some very risky, and, at times, illegal, behavior.

At the same time, the law enforcement effort that was initiated as part of the Robo-Sign settlement, which is charged with reviewing bank practices both before and after the crisis, seems to have stalled. It is both underfunded and understaffed. While the S&L Crisis inquiry had a staff of over 1,000 lawyers and investigators, the current team is roughly one tenth the size, and does not seem capable of obtaining information about, let alone reviewing, the countless transactions and documents at the heart of the financial crisis.

What all of this means is that bankers and the general public are left with the distinct impression not only that fraud in the financial industry was widespread, but also that those guilty of it are not likely to face any punishment. Simply put, this is a very dangerous combination of forces, one that will only lead to precisely the type of behavior that led to the most recent financial crisis in the first place.

Perceptions of widespread misconduct, coupled with a belief that punishment of that misconduct is rare, leads to -- no surprise -- more misconduct. The field of behavioral economics teaches us that the extent to which we perceive others as complying with the law will likely influence our willingness to obey or break it ourselves. If we think others are complying, we are likely to behave similarly. If we believe others are breaking it, we will not wish to be seen as the suckers, the ones following rules that everyone else ignores. A now-famous study of the behavior of individuals who frequented a national park reveals how these forces work. In instances where park goers were confronted with signs that led them to think many people engaged in improper conduct in the park, fewer people were willing to forego such conduct for fear they would be missing out on something. By contrast, efforts that communicated the importance of pro-social behavior in the park resulted in more conduct that conformed to the rules. Similarly, and not unexpectedly, whenever the public believes that many people cheat on their taxes, and enforcement of such tax cheats is weak, there is more likely to be more tax evasion, not less.

All signs indicate that the current situation finds just these types of forces at work. First, there is a widespread mistrust of banks, one that is fueled by a perception that in the lead up to the crisis banks were routinely engaged in improper and even illegal conduct (whether such perceptions are justified or not). Second, law enforcement officials seem somewhat limited in their ability to hold financial institutions accountable for the illegal conduct, despite having made some headway recently in the area of punishing mortgage discrimination. Since at the heart of the financial crisis lies a range of bank misconduct, an atmosphere filled with the widespread perception of misconduct, coupled with little fear that lawbreakers will be held accountable, could send us back to a second financial crisis.

In order to rein in unnecessary risk and fraudulent behavior, what is needed now is a robust, serious and sustained effort to root out, expose and prosecute those illegal acts that led to the financial crisis. Once that is done, faith in the financial sector can be restored; the public will know that the misconduct has been addressed, and those responsible brought to justice. Moving forward, bankers will want to uphold their improved reputations, and will fear punishment should they fail to do so.

Until that time, perverse forces will lead to a repeat of the excesses, and illegal behavior, of the past, and widespread mistrust of financial institutions will continue. When such poor esteem is coupled with a lack of accountability, it will only encourage, not inhibit, the misconduct that led to the current crisis, and maybe bring about the next one.