Adam Smith Was Right About Corporate CEO's Incentives Absent Effective Regulation

Abstract

Adam Smith warned that the officers of corporations were likely to be unfaithful agents that would harm shareholders. Modern anti-regulatory economists sought to remedy this flaw at capitalism’s core by supercharging executive compensation. However, modern compensation systems further misaligned the CEO’s interests, and intensified the perverse incentives to engage in accounting "control fraud," where the CEO uses an apparently legitimate firm as a "weapon" to defraud creditors and shareholders. No regulation forced any lender to make a bad loan. "The greedy" do not "aim at profits, not losses" when compensation schemes are perverse. They maximize short-term accounting "profits" in order to increase their wealth. Making bad loans, growing rapidly, and extreme leverage maximize "profits." Bad borrowers agree to pay more and it is impossible to grow rapidly via high quality lending. Lending to the uncreditworthy requires the CEO to suborn controls, maximizing "adverse selection." This produced an "epidemic" of mortgage fraud, particularly in the unregulated nonprime sector. The FBI began warning in September 2004 about the mortgage fraud "epidemic." Fraudulent loans cause huge direct losses, but the epidemic also hyper-inflated and extended the housing bubble, and eviscerated trust, causing catastrophic indirect losses. When we do not regulate or supervise financial markets we, de facto, decriminalize control fraud. The regulators are the cops on the beat against control fraud – and control fraud causes greater financial losses than all other forms of property crime combined.

Keywords: Corporate law, Financial crisis, Financial regulation, Banking, Banking regulation, Securities, Securities regulation, Control fraud, Fraud

JEL Classification: K14, K22, K23, K42, G18, G28, G38