Chapter 2 documented two historical patterns. The last chapter looked at the first pattern: the regulatory subsidy cycle, in which governments enact regulatory stimulus during market booms and respond with a regulatory backlash after bubbles collapse. This chapter examines the second pattern. It explores the causes and contributing factors to the epidemics of fraud that have historically accompanied asset price bubbles. This exploration, in turn, sheds light on how compliance with financial laws and regulation radically deteriorates during bubble periods. The fecund market of a bubble promotes widespread disobedience of financial rules, or what this book labels “compliance rot.” Charles Kindleberger, the economic historian of bubbles, devotes a significant section of his book Manias, Panics, and Crashes to the “emergence of swindles.”1 Yet he provides a fairly simplistic explanation for this historical trend. He argues that this fraud is “demand determined” and results from the prevalence of foolhardy investors.2 This chapter provides a deeper and more nuanced explanation for epidemics of fraud by analyzing not only the “demand” side of fraud, but the supply side as well. Market booms distort the incentives of market participants to engage in fraud in four broad ways. These four dynamics roughly parallel the models used in the last chapter to explain regulatory changes through bubbles and busts: First, booms or bubbles distort the rational economic calculus of whether to commit fraud by enhancing the immediate benefits to committing fraud, while pushing the legal liability and other costs further into the future. Legal rules thus under-deter fraud. Second, a market boom can exacerbate behavioral biases that cause market participants to underestimate potential liability and other costs of committing fraud. Third, bubbles undermine norms that constrain fraud. Moreover, social norms shift during boom times, as both the financial industry and investor communities undergo rapid change and welcome an influx of new businesspeople and first time investors. Fourth, the crony capitalism and selling of regulatory stimuli that can accompany bubbles (described in the previous chapter) undermines the legitimacy of financial laws. Legitimacy, psychologist Tom Tyler argues, provides a key

determinant of why people obey the law. By comparison, an instrumental framework, in which individuals conduct a rational cost/benefit analysis in deciding whether to comply with the law, offers an incomplete picture, according to Tyler.3 These four dynamics explain more than just how compliance rot afflicts antifraud rules. They also predict lower obedience by financial market participants with a host of other financial laws during bubble times. In particular, this quartet of bubble dynamics generates compliance rot in those financial regulations that curb financial institution leverage, risk-taking, and profit. Systematic noncompliance with prudential regulations that aim to ensure the safety and soundness of banks and other financial institutions poses a deep challenge for the functioning of financial markets and laws. This chapter is organized as follows. It begins with a brief analysis of data that suggest deregulation alone may not explain the rise of antifraud rules, particularly during the 1990s technology stock boom. It then outlines a “demand” side explanation for financial fraud that is more nuanced than Kindleberger’s theory that foolish (or behaviorally biased) investors present attractive targets. The chapter then focuses on the “supply” side of fraud. In modeling the supply side, the chapter proceeds through each of the four dynamics described above. These models explain how bubble conditions can trigger compliance rot with respect to antifraud rules by undermining rational deterrence, exacerbating behavioral biases, altering social norms, and eroding the legitimacy of laws. The chapter concludes by telescoping out to discuss how these four dynamics predict the deterioration of compliance with financial regulations that restrict risk-taking and leverage during bubble times. This final section contrasts how compliance rot during bubble periods may differ with respect to antifraud and prudential regulations.