Everlasting Fraud

Abstract

This paper models the interdependent mechanisms of corporate fraud and regulation. Our analyses yield two key insights. First, fraud is a never-ending game of cat and mouse because the strength of detection optimally matches the severity of fraud in equilibrium. Second, anti-fraud regulations can tamp down fraud pro tem by sharply decreasing the most fraudulent firms' net benefits from continuing fraud. However, concentration of regulatory resources on these firms allows other firms to be more aggressive. As such, regulations do not eradicate fraud but synchronize firms' otherwise idiosyncratic fraud decisions and lead to fraud waves. Empirical examinations of these insights provide supporting evidence. These results carry strong policy implications, offering a realistic understanding of fraud as a permanent risk in the financial markets and the limited efficacy of anti fraud regulations.

Keywords: Regulation, Financial Reporting, Accounting Fraud, Crime