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Booms, Busts, and Fraud

  • Paul Povel

    (University of Minnesota)

  • Rajdeep Singh

    (University of Minnesota)

  • Andrew Winton

    (University of Minnesota)

We examine firm managers' incentives to commit fraud in a model where firms seek funding from investors and investors can monitor firms at a cost in order to get more precise information about firm prospects. We show that fraud incentives are highest when business conditions are good, but not too good: in exceptionally good times, even weaker firms can get funded without committing fraud, whereas in bad times investors are more vigilant and it is harder to commit fraud successfully. As investors' monitoring costs decrease, the region in which fraud occurs shifts towards better business conditions. It follows that if business conditions are sufficiently strong, a decrease in monitoring costs actually increases the prevalence of fraud. If investors can only observe current business conditions with noise, then the incidence of fraud will be highest when investors begin with positive expectations that are disappointed ex post. Finally, increased disclosure requirements can exacerbate fraud. Our results shed light on the incidence of fraud across the business cycle and across different sectors.

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File URL: http://econwpa.repec.org/eps/fin/papers/0312/0312007.pdf
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Paper provided by EconWPA in its series Finance with number 0312007.

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Date of creation: 11 Dec 2003
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Handle: RePEc:wpa:wuwpfi:0312007
Note: Type of Document - pdf; prepared on WinXP; to print on any;
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  1. Persons, John C & Warther, Vincent A, 1997. "Boom and Bust Patterns in the Adoption of Financial Innovations," Review of Financial Studies, Society for Financial Studies, vol. 10(4), pages 939-67.
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