Ponzi Scheme in China: $7.6 Billion Lost

A recent article in The Economist elaborates on a massive Ponzi scheme that recently collapsed in China and caused 900,000 investors to lose about $7.6 billion.

Ponzi schemes are not new in China. In fact, China’s current lack of regulation in the peer-to-peer lending industry has created an environment ripe for fraud. This article points out how the lack of government regulation can lead to an economic environment where investors find it nearly impossible to distinguish between fraud schemes and legitimate businesses. We can also learn a few additional things from this Ponzi scheme that might help investors identify when something really is too good to be true.

Regulation and Fraud

A few days ago I had an interesting discussion with a friend about regulation. He argued that regulation tends to make individuals more likely to fall prey to scams. One of his arguments in particular made me pause to think a little more deeply about regulation and fraud:

Shrink the SEC?

Bloomberg reports that the Obama administration may attempt to reduce the regulatory power of the SEC, although the article acknowledges that the administration may have difficult time gaining the required support in congress. I am interested to see whether the proposed changes would affect either financial accounting standard setting or public company audit standard setting (both fall under SEC jurisdiction via the FASB and PCAOB). I would also like to know why the administration believes that we have a need for such a regulatory overhaul. While the SEC has had some rather public blunders lately, I believe that the agency plays an important and valuable role in helping to ensure a safe and fair marketplace. I have a hard time believing that diminishing or dissolving the agency is in the best interests of the country as a whole.

Audit Quality and the PCAOB

The PCAOB, charged with oversight of public company audits, has received a great deal of criticism as of late. Clive Lennox and Jeffrey Pittman add to the debate with their paper, Auditing the auditors: Evidence on the recent reforms to the external monitoring of audit firms, which was recently accepted for publication in the Journal of Accounting and Economics (HT Harvard Law School Corporate Governance Blog).

The paper focuses on the value of PCAOB inspection reports, which have replaced peer review reports as the primary source of information about audit firm quality. The authors find that:

• PCAOB inspection reports are not a meaningful signal of audit quality to audit clients
• Peer review reports are less informative than they were prior to the initation of PCAOB inspections

These findings imply that we know less about audit quality under the current regulatory structure. This reduction in knowledge causes concern, as a strong, independent audit is a significant deterrant to fraud.

The full text of the paper can be found here.