Tag: Corruption

From Russia with Love?

Posted on December 20, 2021 | Policy Brief

Russia Moscow City representing money laundering

Some recently discovered money laundering schemes have funnelled large amounts of illegal money from former soviet states through European banks. This note briefly describes the evolution of the Anti-Money Laundering (AML) regime for financial institutions, the introduction of which was concurrent with the post-soviet transition and the connected illegal flows of funds. It discusses the effectiveness of the current AML regime – and its ability to detect and seize illegal funds. The brief also highlights some of its deficiencies as well as lack of compliance with its prescriptions. It proceeds to stress that after judging the current framework insufficient, the US recently introduced whistleblower rewards for AML-infringements. Europe might want to follow their lead if it really aims at limiting money laundering.

Introduction

In recent years significant deficiencies in Anti-Money Laundering (AML) compliance have been discovered in some European banks (Spagnolo and Nyreröd, 2021). A notable example is the Danske Bank case that emerged in 2018.   Some have called it the largest money-laundering scandal in history: it is estimated that about $230 billion in suspicious funds went through its Estonian branch between 2007 and 2015.

In several of these cases, the sources of a large fraction of the illicit assets were Russia or other former Soviet states (Shaffer and Cassella, 2020).

Prior to the Danske revelations, several schemes have been uncovered that were aimed at laundering illicit money from former soviet states into the western financial system.

In a classic example going back to 2006, about $230 million were stolen in fraudulent tax refunds perpetrated by officials in Russia and then laundered through Moldova, Latvia and then UK shell companies and banks (Browder, 2009). Famously, the tax lawyer Sergei Magnitsky investigated the theft and testified against the fraudsters and was later put in detention for the same tax theft he was investigating. About a year after he was arrested, Magnitsky passed away after allegedly being tortured and denied medical care. This tragic episode gave rise to the Magnitsky Act, which prohibits persons believed to be involved in the theft to enter the US and access its financial system.

Another famous (and partly related) case is the so-called Russian Laundromat (then Global Laundromat), a scheme estimated to have funneled over $70 billion of illegal money out of Russia, through Latvia, Moldova, and then the UK (Tofilat and Negruta, 2019).

Indeed, Russia is widely considered the country with the largest estimated amount of ‘dark’ money hidden abroad, both as a percentage of GDP and in absolute terms (estimated around $1 trillion by Novokmet et al., 2017).

However, the origin of money laundered in the transition region is not limited to Russia. For example, it is estimated that between 2012 and 2014, about $2.9 billion from Azerbaijan were illegally laundered through UK shell companies and then European banks.

Funds from all these schemes appear to have been transacted through Danske bank (Bruun and Hjejle 2018: 33), Swedbank (Clifford Chance 2020: 123), and other European banks.

This evidence warrants some reflection on the effectiveness of the AML framework, particularly in Europe.

The Current AML Regime

The development of the global AML framework has been largely concurrent with the transition from communism and the connected illegal flows of funds.

The Financial Action Taskforce (FATF) was formed in 1989, after an initiative by the G7. FATF’s mission is to develop policies to combat money laundering and blacklist countries that do not comply. The FATF issued its first recommendations in 1999 and continually updates them, most recently in FATF (2021).

These recommendations set out essential measures that countries should have in place to identify money laundering risks, including regulation on preventive measures for the financial and other sectors, powers and responsibilities for competent authorities, coordination of their actions, and the facilitation of international cooperation (FATF 2021: 7).

AML regulation requires financial institutions to know their customers and engage in due diligence to reduce the risk that they onboard criminals seeking to launder money. Information about suspicious transactions and activities should be forwarded to a national financial intelligence unit, usually the financial police. National Financial Services Authorities (FSAs) are usually responsible for enforcing compliance with AML rules – the “preventive” side of money laundering regulation. The “repressive” criminal law or “enforcement” side of the fight against money laundering is usually enforced by the national financial police (Reuter and Truman 2004, Svedberg Helgesson and Mörth 2018).

There are certainly valid questions to be raised regarding the effectiveness of the current AML framework. While the World Bank estimates that between 2 and 5% of global GDP is laundered annually, it is also estimated that less than 1% of the proceeds of crime laundered via the financial system are currently seized by regulators and law enforcement agencies (UNODC 2011: 7).

At the same time, the framework is quite costly to comply with. There have been six EU Directives related to AML. All require legal implementation and impose new demands on banks and other covered institutions. FATF also requires that its members frequently carry out National Risk Assessments, and countries are also subject to Membership Evaluation Reports which imposes additional costs. Compliance costs for banks are estimated in the billions of dollars (Spagnolo and Nyreröd, 2021), and a whole industry surrounding “AML Compliance” has emerged. Part of these costs, not only monetary ones, end up transferred to bank customers.

From a more rigorous policy evaluation point of view, the AML regime is also problematic. There is a remarkable lack of data for assessing the effectiveness of the framework relative to its objectives (see e.g., Halliday et al. 2014, Levi 2018, Levi et al. 2018, Pol 2018, 2020).

Bank’s Failures

A lack of compliance with this preventative framework has been widespread.  In Sweden, for example, most large banks have been fined for various degrees of AML deficiencies. Similarly, many banks in other European countries received fines from local and US regulators (in the order of billions of dollars) for failing to comply with this framework, including HSBC, Credit Suisse, Deutsche Bank (multiple times), BNP Paribas, MagNet Bank, and Barclays Bank. Since 2016, the US has issued AML-related fines on eight occasions to banks with headquarters in European countries for an aggregate amount of $1.7 billion (mean $217 million fine; data from violationtracker.org).

In the case studies we discuss in Spagnolo and Nyreröd (2021), most forms of internal controls failed to some extent. Whereas external whistleblowing was rare or non-existent, internal whistleblowers did not manage to rectify the problems either.

Simultaneously, there were often clear red flags that should have alerted board members and executives. At Danske Bank group, for example, returns on allocated capital in the non-resident portfolio at their Estonian branch, where a substantial part of the money laundering occurred, hit 402% in 2013, compared with the 6.9% average for the whole group, a clear red flag (Schwartzkopff, 2018).

Supervisor’s Failures

The extensiveness of AML non-compliance cannot only be traced to negligent banks – it also has to do with the ineffectiveness of the enforcement of AML rules by supervising authorities.

In the cases reviewed in Spagnolo and Nyreröd (2021), supervisors appeared by and large aware of at least part of the AML deficiencies. Oftentimes, banks were given warnings by regulators, yet continued to violate the same rules.

For example, both the Danish FSA and the Estonian FSA seem to have had some knowledge of the AML deficiencies at Danske Bank’s subsidiary already in 2007, with little consequences.

Coordination between regulators has also been poor. The Danish FSA argues that the primary AML oversight responsibility for the Estonian branch should be the local FSA (Finanstilsynet, 2019), while the Estonian FSA retorts that European rules are not as clear and that the Danish FSA at least has some responsibility to oversee the branches of Danske Group (Finantsinspektsioon, 2019).

On September 24, 2018, the European Banking Authority (EBA) opened an investigation to assess whether the Danish and Estonian FSAs have violated any European laws. On April 16, 2019, it voted to reject an internal draft into supervisory failings that allegedly identified several shortcomings in how Danish and Estonian authorities supervised Danske bank. (Brunsden 2019). The EBA supervisory board’s decision to close the investigation without adopting any findings drew criticism from a range of senior policymakers and spurred calls for its reform. The EBA has also been criticized for its reluctance to pass judgment on its members (Bjerregaard and Kirchmaier 2019: 38).

Conclusion

The limited regulatory enforcement and compliance with the current AML system are likely to only marginally increase the cost of money laundering for criminals. Policymakers should thus wonder whether the current system is delivering value for money. There could be different ways to improve it. Increased fines for non-compliance may for example induce covered entities to comply with the AML framework to a greater extent.

Moving forward, the inconsistent enforcement of AML rules has led experts and policymakers to suggest centralizing some supervision and enforcement of AML regulation at the EU level (Kirschenbaum and Véron 2018, 2020; Unger 2020; JPP 2019; EC 2020, p.8), and improving information sharing between supervisors.

We believe these measures may not be sufficient for facilitating compliance with AML, while imposing substantial enforcing costs.

One way to increase AML compliance at a relatively low cost could be introducing whistleblower reward programs, as done in the US early this year (Nyreröd and Spagnolo, 2021). These programs offer substantial monetary rewards, often in the order millions of dollars, for information on non-compliance, and have proven extremely effective in combating fraud against the government, tax evasion, and securities fraud. While national EU supervisors may not have sufficient resources or competence to manage such programs, centralized actors such as the European Commission appear able to do so. If we see more centralized supervision, together with increased resources and competence, a well-designed and properly implemented whistleblower reward program may become a highly effective way to fight money laundering in the EU.

References

  • Bjerregaard, E., and T. Kirchmaier (2019). “The Danske Bank Money Laundering Scandal: A Case Study.” Copenhagen Business School.
  • Browder, W (2009). “Hermitage Capital, the Russian State and the Case of Sergei Magnitsky.” REP Edited Transcript, Chatham House.
  • Bruun and Hjejle (2018). “Report on the Non-Resident Portfolio at Danske Bank’s Estonian Branch.” Danske Bank.
  • Brunsden, J. (2019). “EBA faces calls to reform after dropping Danske Bank probe.” Financial Times, April.
  • Clifford Chance (2020). “Report of Investigation on Swedbank AB (publ).” Swedbank.
  • EC (2020). “Communication from the Commission on an Action Plan for a Comprehensive Union Policy on Preventing Money Laundering and Terrorist Financing.” 7.5.2020 C(2020) 2800 final.
  • FATF (2021). “International Standards on Combating Money Laundering and the Financing of Terrorism & Proliferation: The FATF Recommendations.”
  • Finanstilsynet (2019). “Report on the Danish FSA’s Supervision of Danske Bank as Regards the Estonia Case.” Danish Financial Services Authority.
  • Finantsinspektsioon (2019). “Response to the Report on the Danish FSA’s Supervision of Danske Bank.” Estonian Financial Services Authority.
  • Halliday, T. C., M. Levi, and P. Reuter (2014). “Global Surveillance of Dirty Money: Assessing Assessments of Regimes to Control Money-Laundering and Combat the Financing of Terrorism.” Center on Law & Globalization. University of Illinois College of Law and American Bar Foundation.
  • JPP (2019). “Joint Position Paper by the Ministers of Finance of France, Germany, Italy, Latvia, the Netherlands, and Spain.”
  • Kirschenbaum, J., and N. Véron (2018). “A Better European Architecture to Fight Money Laundering.” Peterson Institute for International Economics. Policy Brief 18-25.
  • Kirschenbaum, J., and N. Véron (2020). “A European Anti-Money Laundering Supervisor: From Vision to Legislation.” Peterson Institute for International Economics, January.
  • Levi, M. (2018). “Punishing Banks, Their Clients, and Their Clients’ Clients.” In King, C., C. Walker, and J. Gurulé (eds.) The Palgrave Handbook of Criminal and Terrorism Financing Law. Palgrave Macmillan.
  • Levi, M., P. Reuter, and T. Halliday (2018). “Can the AML System Be Evaluated Without Better Data?” Crime, Law and Social Change, 69(2): 307–328.
  • Novokmet, F., Piketty, T., and Zucman, G. (2017). “From Soviets to Oligarchs: Inequality and Property in Russia, 1905-2016”, NBER Working Paper Series, nr23712.
  • Nyreröd, T., and G. Spagnolo (2021). “Myths and Numbers on Whistleblower Rewards.” Regulation and Governance, 15(1): 82–97.
  • Pol, R. (2018). “Uncomfortable Truths? ML=BS and AML=BS².” Journal of Financial Crime, 25(2): 294–308.
  • Pol, R. (2020). “Response to Money Laundering Scandal: Evidence-Informed or Perception Driven?” Journal of Money Laundering Control, 23(1): 103–121.
  • Reuter, P., and E. M. Truman (2004). Chasing Dirty Money: The Fight Against Money Laundering. Peterson Institute for International Economics.
  • Schwartzkopff, F (2018). “Danske’s 402% Return Should Have Raised Red Flag, FSA Says.” Bloomberg, May.
  • Shaffer, Y. and Cassella, S (2020). ” The Causes, Effects, and Manifestations of the Money Laundering Problem in the Former Soviet Union.”, Georgetown Journal of International Affairs, February 21.
  • Spagnolo, G., and T. Nyreröd (2021). “Money Laundering and Whistleblowers.” SNS Report.
  • Svedberg Helgesson, K., and U. Mörth (2018). “Client Privilege, Compliance and the Rule of Law: Swedish Lawyers and Money Laundering Prevention.” Crime, Law and Social Change, 69(2): 227–248.
  • Tofilat, S., and V. Negruta (2019). “The Russian Laundromat – a $70 billion money-laundering scheme facilitated by Moldovan political elites.” Transparency International Moldova.
  • Unger, B. (2020). “Improving Anti-Money Laundering Policy.” Study requested by the ECON Committee, European Parliament.
  • UNODC (2011). “Estimating Illicit Financial Flows Resulting from Drug Trafficking and Other Transnational Organized Crimes.” Research Report, United Nations Office on Drugs and Crime.

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

On Corporate Wrongdoing in Europe and Its Enablers

Posted on April 13, 2021 | Policy Brief

20210413 On Corporate Wrongdoing in Europe FREE Network Image 01

In the last two decades, several instances of prolonged and severe corporate wrongdoing by European companies have come to light: from Dieselgate to corruption, money laundering through large European banks, recidivist bid and price rigging, and most recently Wirecard. What allowed European firms to engage in so much wrongdoing? In this brief, we consider some important institutional drivers behind corporate wrongdoing, focusing on the European countries with the largest share of corporate infringers.

The Harm from and Extent of Corporate Wrongdoing in the EU

In June 2020, the German firm Wirecard AG’s stock price fell from €104 to below €2 in the span of nine days after the firm admitted it could not locate $2 billion missing from its accounts. The firm has since then been accused of a wide range of infringements including money laundering, corruption, and fraudulent inflation of profits and sales, with some allegations going back over a decade. The Germany financial supervisor BaFin has been criticized as allegations about fraud had been made several times in prior years. Yet, BaFin failed to identify the problem and even banned short-selling of the stock, as well as accused journalists who were critical of the firm of market manipulation.

This scandal occurred against a backdrop of several other prolonged corporate scandals and has led many to wonder how extensive corporate wrongdoing is and how to combat it more effectively.

Corporate wrongdoing has a range of negative effects in competitive markets that are frequently overlooked in the public debate. Beyond the immediate damages of corporate wrongdoing, such as the draining of public resources in the case of tax evasion, money laundering, corruption, air pollution and associated health harm in the case of environmental law violations, there are also more general negative effects of corporate wrongdoing.

It attracts investors to the worst part of the industry, as firms that engage in profitable wrongdoing often do better than their competitors. Also, it forces out honest competitors and increases market entry thresholds for new competitors. These effects become more pronounced when the wrongdoing is prolonged, so, in an ideal world, regulators need to act fast.

Instead, several recent cases of European corporate wrongdoing lasted for many years before being detected and sanctioned, and there is a worrying degree of recidivism in several regulatory areas, including financial regulation with several banks being recidivists, but also in antitrust (Marvão, 2016).

What are the drivers and enablers behind these many prolonged cases of wrongdoing, and why do firms feel emboldened to engage in recidivism?

One way to gain some insight is to identify European countries whose firms are most frequently fined for wrongdoing and review the legal, cultural, and political contexts of those countries.

We tackle this issue by using data from Violationtracker, a database with over 400 000 actions by US enforcement agencies and prosecutors (such as the Securities and Exchange Commission and the Department of Justice). Many of these sanctions are against firms with headquarters in EU countries. In Nyreröd and Spagnolo (2021a), we added the fines for firms with headquarters in all respective EU countries for the period 2000-2020. After excluding countries like Switzerland, well known as homes of extensive financial crime linked to their status of international tax havens and off-shore centers, we find that the United Kingdom is the gold medalist in corporate wrongdoing, with Germany coming in second place.

Table 1. Fines across the top six EU countries (2000-2020).

Note: Author’s calculation based on data retrieved from Violationtracker.org. Number of fines in parentheses.

Interestingly, the top of the ranking is preserved no matter which metrics we use. In Nyreröd and Spagnolo (2021a) we weigh the fines by population, GDP, and exports to the US, and the UK and Germany remain stable at the top, with the UK’s first position becoming more pronounced. Therefore, we focus on these two countries, although many of the problems we identify apply to a varying degree to most other EU countries.

Because of the recent headlines made by the Wirecard case we start with the runner-up, Germany.

Germany

The Wirecard case follows a long tradition of large “household” names such as Siemens, Deutsche bank, Thyssenkrupp, and Volkswagen that have engaged in systemic wrongdoing over extended periods of time and are responsible for most of the fines shown in Table 1.

In one of the largest corruption scandals in history, Siemens was fined $1.6 billion by the Department of Justice in 2008 for systematically paying bribes to government officials around the world, amounting to more than $1.4 billion since the mid-1990s. According to the Securities and Exchange Commission’s investigation, bribery at Siemens was “standard operating procedure” for decades, and the SEC concluded that “the company’s tone at the top […] created a corporate culture in which bribery was tolerated and even rewarded at the highest levels of the company”(SEC, 2008).

In 2015 the Dieselgate scandal unraveled, where it was discovered that several car manufacturers had installed “defeat devices” to cheat emissions tests. Volkswagen had installed the device in 11 million vehicles, some of which emitted up to 40 times more than emissions standards allowed (Gates et al, 2017).

Germany’s largest lender Deutsche Bank has since 2000 paid a whopping $18 billion in fines in the US for alleged infringements ranging from facilitating money laundering and tax evasion, to concealing bribe payments and misleading investors (DoJ, 2021). This is by far the greatest amount paid by any EU bank in the period 2000 – 2020 (Violationtracker.org, 2021)..

Finally, there is the steel conglomerate ThyssenKrupp, which was handed a €479 million fine for bid-rigging by the European Commission in 2007, the highest EU bid-rigging fine ever at the time. The size of the fine was motivated by the fact that, in 2007, Thyssenkrupp was already a repeat offender. In 2019, Thyssenkrupp and three other steel manufacturers were fined $719 million for price-rigging between 2002 to 2016. The firm has also been accused of bribe payments on several occasions (see Nyreröd and Spagnolo 2021a for details).

In reviewing local factors that have enabled these incidents, we find that Germany appears to have a particularly lenient stance toward corporate wrongdoing and a notably hard one against whistleblowers disclosing it. With respect to corruption, for example, bribe payments could be deducted from tax in Germany up until 1999 if paid to foreign officials, and up until 2002 if paid to recipients in the business world (Berghoff, 2017). In October of 2003, the United Nations adopted the Convention Against Corruption. On average, European countries had ratified this treaty halfway through 2007, but Germany was one of the last to ratify the treaty, it did it only in 2014 (UNODC, 2020).

Perhaps more importantly, Germany’s institutional environment seems focused on punishing and deterring whistleblowers, rather than listening to their reports in order to fight corporate wrongdoing. This is likely a crucial enabler of the prolonged wrongdoing we discuss in more depth in Nyreröd and Spagnolo (2021a). It is well known that whistleblowers are essential to detecting corporate wrongdoing (ACFE, 2020). Yet, Germany has some of the worst whistleblower protection laws in the EU (Transparency International 2013, Wolfe et al 2014), and one of the worst records in Europe in terms of mistreating the (obviously few) whistleblowers that dared to denounce corporate wrongdoing (Worth 2020a).

The German opposition to the protection of(truth-telling) whistleblowers from employers’ retaliation was on full display when a public consultation was held on the new EU Directive on whistleblower protection (2019/1937). German industry representatives were particularly active in arguing against it, suggesting that whistleblower protection is not necessary and that the new regulations are a clear signal of mistrust towards companies (BDI, 2019). The German parliament discussed improving the poor whistleblower protections in 2013 but did not enact any improvement of whistleblower protection laws. There are several instances of retaliation against truth-telling whistleblowers where they had very little legal recourse (Worth 2020a; Nyreröd and Spagnolo, 2021a).

The hostile regulatory and political environment to whistleblowers is likely a main factor that has enabled so many German corporations to engage in such prolonged wrongdoing with no records of employees reporting it.

The United Kingdom

We now turn to the winner of our contest, the UK. Over $26 billion of the total fines paid by UK firms in Table 1 is accounted for by the British Petroleum’s (BP) Deep Horizon oil spill in 2010 in the Mexican Gulf. It is estimated that 5 million barrels of oil were released into the ocean, a spill regarded as one of the largest environmental disasters in history.

Internal investigations at BP during the decade preceding this spill had warned senior BP managers that the company repeatedly disregarded safety and environmental rules and risked a serious accident if it did not change its ways. A 2004 inquiry found a pattern of intimidating workers who raised safety or environmental concerns (Lustgarten and Knutson, 2010). The company allegedly flouted safety standards by neglecting aging equipment, delayed inspections to cut production costs, and falsified inspection records. Even before the 2010 spill, officials at the US Environmental Protection Agency had considered debarring BP from receiving government contracts (Lustgarten, 2012). Since 2000, BP has been fined 158 times for environment-related offenses in the US, and again over 60 times since the oil spill in 2010.

Then there is the UK banking sector, with many large banks continuously engaging in wrongdoing, and seemingly more so than elsewhere. CASS (2020: 6) shows how, since 2011, the conduct costs of UK banks have far exceeded that of banks based in the US and Euro area when compared to GDP. In 2017, conduct costs for UK banks represented 0.88% of the UK’s annual GDP, while conduct costs for US and Euro area banks represented around 0.10% or less. In 2018, the conduct costs for UK banks shrank and constituted around 0.55% of the UK’s annual GDP.

In 2010, it was discovered that HSBC had systematically laundered money for some of the bloodiest drug cartels in history through its Mexican subsidiary. Despite numerous internal warnings, complaints from regulators, and internal flags, HSBC Mexico continued laundering money for organizations like the Sinaloa cartel, who not only flood the US with illegal drugs but is considered responsible for the gruesome killings of tens of thousands of people, often innocent civilian casualties at home. The UK’s then-chief financial minister, George Osborne, pleaded with the US Treasury Secretary and others that they do not impose criminal sanctions on HSBC (US Congress 2016).

Another major scandal involving UK banks that have cost regular people billions of pounds was the misselling of “payment protection insurance”. This aggressively marketed insurance had profitability of approximately 90% (Laris, 2020). Several barriers were created to inhibit people from claiming the insurance, such as contract exclusions or administrative barriers, and many people who bought these insurances either did not need them or were unsuitable. As of January 2011, UK banks and financial institutions had paid out £37.5 billion in compensation to customers who were wrongly sold the insurance (Coppola, 2019).

One of the main drivers of corporate wrongdoing in the UK appears to have been the lack of effective corporate sanctions. The “identification principle” requires the identification of a directing mind and will of the company (typically a director), and then proving criminal liability through this person’s conduct and state of mind. This principle has been singled out by several experts as making it “impossibly difficulty” for prosecutors to find companies guilty of serious crimes, especially crimes in large companies with devolved business structures (The Law Commission, 2015: 15). Several UK institutions, such as the UK’s Serious Fraud Office and the Crown Prosecution Service, have also pointed to the identification principle as a central hurdle to their ability to bring corporate prosecutions (Corruption Watch, 2019).

Moreover, effective business lobbying and close connection between politicians, regulators and the financial sector have been prevalent in the UK for a long time and may have exacerbated the already accommodating regulatory environment. Several well-known high-level politicians that affected financial regulation and its implementation for years ended up being hired with handsome pay by financial institutions afterwards (see Nyreröd and Spagnolo 2021a for details).

Regarding regulators, Miller & Dinan (2009: 29) notes that of the 36 people that served on the board of the Financial Services Authority (FSA) between 2000 and 2009, 26 of the members had connections at board or senior level with the banking and finance industry either before or after their term of office, whilst nine continued to hold appointments in financial corporations while they were at the FSA”.

The UK also has an outdated and ineffective whistleblower protection law, the “public interest disclosure act” of 1988 (see e.g., Lewis 2008, Thomas Reuter Foundation and Blueprint for Free Speech 2016, All Parliamentary Committee 2020). At the same time, important UK regulatory agencies have been proactive in neglecting the mounting independent academic research highlighting the effectiveness of the US whistleblowers rewards programs (see Nyreröd and Spagnolo 2021b).

Conclusion

Corporate wrongdoing appears widespread in Europe, and recent cases have been prolonged, severe, and sometimes industry-wide.

The UK and Germany stand out, but other EU countries are no angels. In the case of Germany, an acute aversion to whistleblowers by government institutions appears as a central driver that has enabled corporate wrongdoing. With respect to the UK, ineffective corporate sanctions laws, regulatory/political capture, and a lack of whistleblowers, appear to have driven or enabled firms to engage in prolonged corporate wrongdoing. Similar enablers and drivers are likely present in other EU countries to varying degrees.

There is now an EU Directive on whistleblowing, requiring all member states to put in place retaliation protections for those reporting on corporate wrongdoing. But protections have proven insufficient in a variety of ways and are unlikely to be a game-changer in terms of combating corporate wrongdoing (see e.g., GAP and IBA, 2021).

In the light of the strong independent evidence on the effectiveness of whistleblower reward programs at increasing detection and deterring wrongdoing (see, e.g., Nyreröd and Spagnolo 2021b for a survey), EU Member States seriously concerned about corporate wrongdoing should consider introducing them in a wide variety of regulatory areas.

References

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

Political Implications of the Rise of Mobile Broadband Internet

Posted on February 8, 2021 | Policy Brief

Image of 5g broadband tower representing implications mobile internet

In the last ten years, the world has experienced the dramatic rise of mobile broadband internet brought by third-generation (3G) and fourth-generation (4G) mobile networks. This has resulted in major political changes – reduced confidence in governments around the world, lower voting shares of incumbent political parties, and the rise of populists. The empirical evidence is consistent with both the optimistic view of 3G internet (the “Liberation Technology”) and the pessimistic one (the “Disinformation Technology”). 3G internet helps to expose actual corruption; however, it also contributes to electoral successes of populist opposition.

The Spectacular Rise of 3G

Communication technologies have undergone a dramatic change in the last 10-15 years. According to the International Telecommunications Union (ITU), there were only 4 active mobile broadband subscriptions per hundred people in the world in 2007, while this number reached 75 per hundred in 2020. The growth of mobile broadband internet – provided by the third and fourth generation of mobile networks (3G and 4G, respectively) – was the main driver of growth in broadband access. The number of fixed broadband subscriptions per hundred people has only increased from 5 to 15 percent in the same period of time.

Relative to the previous generations of mobile technology, 3G provides a qualitatively different way of using the internet. First, it is broadband access on the go, available wherever the user is rather than at a fixed point at home or in the office. Second, it allows for downloading and uploading photos and videos. Before 3G, mobile technology only allowed exchanging text messages along with limited and slow access to the web. Third, it is the technology that is best suited for social media. While social networks started before 3G and were initially accessed on fixed broadband, today most Facebook, Twitter and YouTube users are mobile.

Liberation Technology or Disinformation Technology?

What are the political implications of the spread of this new technology around the world? Initially, political scientists were excited about the internet as a “Liberation Technology”, especially after it played an important role in the Arab Spring. Internet – and in particular mobile internet –helped pro-democracy activists in autocratic states to disseminate critical information about the government, expose corruption, and coordinate protests.

Later on, however, it became clear that social media also provided a platform for the dissemination of false news and hate speech – thus supporting the rise of populists. This led to a rethinking of the role of mobile internet – and rechristening it into a “Disinformation Technology.”

Which view, the optimistic or the pessimistic one, is correct? In Guriev et al. (2021), we study the impact of the expansion of 3G around the world on attitudes to government and electoral outcomes.

Exposing Actual Corruption

In order to explore the effects on confidence in government, we use data from Gallup World Poll surveys of 840,537 individuals from 2,232 subnational regions in 116 countries from 2008 to 2017. In each region and year we calculate the population-weighted average access to mobile broadband relying on the network coverage data from Collins Bartholomew’s Mobile Coverage Explorer.

First, we find that increased access to 3G internet causes lower confidence in government, judiciary, honesty of elections, and a lower belief that the government is not corrupt. As shown in Figure 1, the magnitudes are substantial. In our paper, we show that a decade-long 3G expansion has the same effect on government approval as a 2.2 percentage-point rise in the national unemployment rate.

Figure 1. Mobile Broadband Access and Government Approval.

Source: Guriev et al. (2021), Table 1, authors’ calculations.

This effect is only present when there is no online censorship and stronger when traditional media are not free. Furthermore, the spread of 3G makes people think that the government is corrupt when the actual corruption is high. In the cleanest countries of the world, the effect is actually positive – better access to information may help citizens to understand that other countries are much more corrupt relative to their own. 

This positive impact is, however, limited to about 10% of the world’s countries. On average, the effect of 3G on the perception that government is clean is negative (see Figure 1). There are two potential explanations. First, as suggested by Gurriv (2018), before the arrival of the fast internet, the elites controlled the media and, as a result, the public was not fully aware of the elites’ corruption. 3G helped to expose this corruption and corrected the pre-3G positive bias. The second explanation is related to the negative bias of social media where critical messages spread faster and deeper (see the references in Guriev et al. 2021).

Another potential explanation is that social media promote overall negative and pessimistic attitudes. We show that this conjecture is not consistent with the evidence: the spread of 3G does not reduce life satisfaction or expected future life satisfaction.

Helping European Populists

The evidence above is consistent with the view that mobile broadband internet and social media help to expose misgovernance and corruption. These findings are in line with the optimistic view of mobile broadband internet as a “Liberation Technology.” However, it turns out that the pessimistic view of “Disinformation Technology” may also be correct.

We examine the impact of 3G expansion on the outcomes of 102 parliamentary elections in 33 European democracies between 2007 and 2018. Using subnational data, we show that the spread of 3G, not surprisingly, decreases the vote share of incumbents substantially (see Figure 2).

 Figure 2. The impact of 3G expansion on incumbent vote share in Europe.

Source: Guriev et al. (2021), Figure VIII.

Figure 3. The impact of 3G expansion on opposition vote share in Europe.

Source: Guriev et al. (2021), Figure IX.

If incumbents lose votes, who picks them up? We show that the main beneficiaries of 3G expansion are the populist opposition parties, both on the left and right (Figure 3). The non-populist opposition does not gain.

Why do populists benefit from the spread of mobile broadband and social media? One explanation is that social media is decentralized and has no entry barriers. It is not the first time in history that populist politicians have relied on new communication technology to circumvent mainstream media controlled by the elites (e.g. the US late 19thcentury populists used telegraph and railroads, the Nazis in Germany used radio). It may also be the case that populist messages may be simpler, and thus, better suited for a short and catchy communication on social media. For example, another pan-European family of anti-system parties, the Greens, do not benefit from the spread of the 3G internet at all (see Figure 3): their narrative is more complex, asking voters to take responsibility for the planet.

Fact-Checking Alternative Facts

Many populist politicians point to actual corruption of the incumbent elites, but some also spread false narratives or “alternative facts.” (It was Donald Trump’s Counselor Kellyanne who, in January 2017, when asked to comment on false statements by Trump’s Press-Secretary about his inauguration, famously said that these were not falsehoods but “alternative facts.”) What can be done to stop the dissemination of these falsehoods on social media? Can fact-checking by mainstream media and independent organizations help?

In two studies, Barrera et al. (2020) and Henry et al. (2021), we carry out two randomized online experiments to identify the causal effects of alternative facts spread by populist politicians and their fact-checking. The findings are as follows: (i) alternative facts are highly persuasive; (ii) fact-checking helps to correct factual beliefs – but do not change voting intentions; even though the voters understand that the populists misrepresent the facts, they still support their agenda; (iii) fact-checking, however, substantially reduces sharing of alternative facts on social media; (iv) the impact of fact-checking on sharing is equally strong regardless of whether the users are forced to view the fact-checking information or are simply given an option to click on a fact-checking link; (v) asking users to re-confirm their intention to share alternative facts with an additional click greatly reduces sharing.

Our results suggest that fact-checking may not be as effective as fact-checkers themselves hope, but can help slow down the dissemination of falsehoods on social media. Furthermore, our analysis delivers clear policy implications – both providing fact-checking (even in the form of accompanying alternative facts with fact-checking links) and requiring additional clicks before sharing can be very effective.

Conclusion

The findings from our analysis of the worldwide spread of mobile broadband internet in the last decade are consistent with both optimistic and pessimistic views. On the one hand, 3G internet does help expose actual corruption. On the other hand, it helps populist opposition to gain votes. Likely, the latter result is eventually due to the populists’ abuse of online platforms for spreading disinformation. We show that the propagation of falsehoods on social media can be at least partially slowed down by fact-checking.

References

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

Combating Misuse of Public Funds in COVID-19 Emergency Procurement

Posted on September 28, 2020 | Policy Brief

Image of two medical workers with face shields representing COVID-19 procurement

The Covid-19 pandemic has revealed substantial shortcomings in central governments’ and municipalities’ ability to procure items needed in the fight against Covid-19, and corruption has been rampant partially due to the increased discretion of procurement staff to award contracts. We argue that suspension of ex ante rules safeguarding accountability is essential for disaster relief, but must be compensated for by better ex post monitoring. Such monitoring can be greatly strengthened by increasing transparency of all awarded contracts and providing incentives to whistleblowers to come forward to report fraud and corruption.

Corruption in Covid-19 Procurement

The disastrous Covid-19 pandemic has revealed weaknesses in global supply chains and in national public procurement systems’ ability to secure essential Personal Protective Equipment (PPE), ICU material, and Covid tests. Several countries have been and are experiencing issues like poor quality of procured goods, extremely high prices, scams, and a general inability to source.

Examples of quality under-provision abound. The Spanish government discovered that out of 340,000 tests purchased from a Chinese manufacturer, 60,000 of them did not test accurately for Covid-19 [1], and the Dutch ministry of health issued a recall of 600,000 face masks from a Chinese supplier due to poor quality [2]. Analogous problems were common in the UK [3, 4]. Several countries have also had difficulties to procure at all, for example in terms of their desired number of tests [5, 6], or the reagents used to analyze the tests [7], as well as swabs [8].

Reports on price gouging – selling at extremely high prices – are also widespread. Examples of price gouging and investigations by competition authorities can be found throughout Europe and the US, but also in developing countries like Indonesia, Brazil, Thailand, Kenya, and South Africa (OECD 2020a), and in Ecuador and Paraguay, with corruption as the alleged cause [9].

While many reasons lie behind these procurement failures, several of them are directly traceable to the abuse of the increased discretion granted by emergency procurement rules to urgently source material and bypass time-consuming public procurement processes and legal frameworks. This important and necessary increase in discretion can easily be abused to hand out contracts to friends and/or political allies or to cash bribes.

Again, examples in the press abound. In the UK, a clearly non-urgent contract was awarded without competition to a firm owned by two long term associates of Michael Gove and Dominic Cummings [10]. In Slovenia, a gambling mogul with no public record of healthcare experience appears to have received millions in an emergency contract related to Covid-19 [11]. In Bosnia, a raspberry farm was apparently granted a contract to import 100 ventilators,paying $55,000 for each ventilator, while their price was around $7,000 to $30,000 on the international market in the relevant period [12]. In India, a Mumbai Realtor with no previous healthcare experience got a contract to supply things such as oxygen cylinder and medical beds [13]. The health minister in Bolivia was arrested in May after the country bought 179 ventilators at $27,683 each while it later was revealed that the manufacturers were offering ventilators at approximately half that price [14]. In Bangladesh, Transparency International issued a study suggesting widespread corruption in the country during Covid-19, including the purchase of substandard medical supplies at five to ten times the market price [15].

The Covid-19 crisis has exacerbated an already significant problem: according to Transparency International (2020), up to 25% of all global healthcare procurement spending is lost to corruption.

Historically, Fraud Increases During Emergencies

Disaster related fraud is frequently a problem in the western world as well. In September of 2005, in the aftermath of Hurricane Katrina in the US, the Hurricane Katrina Fraud Task Force was set up to go after frauds related to recovery funds. By August 30th, 2007, the task force had prosecuted 768 individuals for Katrina-related fraud, and additional state and local prosecutions for disaster-related fraud had been brought (DoJ 2007). The National Center for Disaster Fraud was also created within the justice department in the aftermath of several devastating hurricanes in the US, and currently houses over 80 employees.

Organizations and academics warned the public early about the risk of increased corruption in public procurement during the Covid-19 pandemic (Khasiani et al 2020, OECD 2020b). Indeed, emergency procurement and disaster relief has historically been linked to increases in corruption (Leeson and Sobel, 2008), especially where institutions are weaker (Barone and Mocetti 2014). The problems often highlighted in this context, such as using emergency authority when it is not required/warranted or using it beyond the time it is required, abuse of discretionary authority, drawing up specifications to suit the firm desired to win the contract, restricting the number of bids, and caving in to political influences (Schultz and Søreide 2008: 523), have also been on display during the Covid-19 crisis.

There are of course compelling reasons to relax stringent procurement rules in emergencies to allow for a fast response proportional to the population´s needs. But such a lessening of oversight and ex ante checks must be compensated for by much more extensive ex post checks, that should be advertised widely to deter public officials from abusing discretion. Broadly, there are two main ways of strengthening ex post checks/monitoring.

Two Ways of Ex-post Monitoring

The first is to have complete and transparent documentation of all the contracts awarded and the related documents, a “keep the receipt” mentality and practice, and making these records publicly available as soon as possible. Several countries have been moving in this direction as a response to the crisis, often with the help of NGOs like the Open Contracting Partnership (The Economist 2020). Examples include Ukraine, that require the submission of a report for each contract within a day of its conclusion, which is then made publicly available on an internet platform; and as of 2016 a third of government contracts in Colombia were published on an e-procurement platform where they can then be scrutinized by the public. In the US, the user-friendly website USAspending.govprovide data on federal contracts, with advanced search functions including tags specific to Covid-19 contracting.

The organization Open Contracting Partnerships provide a list of suggestions for any government that is looking to increase transparency in procurement; it includes the timely publication of contracts, licenses, concessions, permits, grants, as well as related pre-studies and bid documents. A full list of best practices, which can be implemented at a low cost, can be found on their website (Open Contracting Partnerships 2020).

The second is to protect and incentivize whistleblowers. Adequate protection of whistleblowers is a first step, but protection is always partial and imperfect, and may therefore be insufficient to induce those close to frauds to come forward, given the terrible consequences they typically face (see e.g. Rothschild and Miethe 1999, Nyreröd and Spagnolo 2020c).

In the U.S., the False Claims Act (FCA), first enacted by President Lincoln to curb fraud on military supplies during the civil war, and strengthened in 1986, has gone one step further by providing whistleblowers with substantial monetary rewards when they report on procurement fraud. Building on the success of the FCA, the US has introduced similar programs in several areas, most prominently with respect to tax evasion (in 2006) and securities fraud (in 2011).

Providing meaningful monetary incentives to whistleblowers who report on particularly egregious frauds and corruption can have a substantial deterrent effect on potential fraudsters as several studies show (see e.g.  Wilde 2017, Johannesen and Stolper 2017, Wiedman and Zhu 2018, Amir et al. 2018, Leder-Lewis 2020; see Nyreröd and Spagnolo 2020a for a review of the earlier literature). Simple cost-benefit analysis shows that a well-designed and implemented whistleblower incentives scheme can be a highly cost-effective continuous monitoring tool for enforcement agencies and public prosecutors (see e.g. Nyreröd and Spagnolo 2020b).

As for the EU, it is conspicuously lagging behind. Even prior to the Covid-19 crisis there was a need for increased monitoring evidenced by a 2019 European Court of Auditors (ECA) report entitled “Fighting fraud in EU spending: action needed.” A central emphasis of this report is that the Commission lacks insight into the scale, nature, causes, and level of fraud, as well as the level of undetected fraud. In 2018 the EU adopted a Directive that would harmonize and strengthen whistleblower protection in the EU. While the new EU Directive on whistleblowing is a step in the right direction, it failed to provide a framework for whistleblower rewards.

This may have been a mistake, as standard detection methods, including whistleblower protections, have often proven inadequate. The recent Wirecard scandal is a testament to the failure of standard fraud detection methods. In June of 2020, the stock price of Wirecard dropped from €100 to sub €2 in less than nine days after it was revealed to be an Enron-level accounting fraud. The firm has also allegedly laundered money for mobsters and was involved in a range of shady practices. Since 2008, fraud accusations have been leveled several times against the firm and Wirecard´s response was to label their critics “market manipulators”. The German financial supervisors, instead of investigating Wirecard, went after those who correctly claimed that the firm was a fraud, including reporters at the Financial Times. This fraud went undetected for at least 12 years, costing investors millions and undermining trust in financial markets. Moreover, those correctly accusing Wirecard of fraud allege they were subject to harassment campaigns, including phishing attacks by hackers and intimidating surveillance outside their homes and offices [16]. This is perhaps not surprising given that Germany is a country with some of the worst protections for whistleblower [17].

The shortcomings of traditional methods of fraud detection may turn out to be especially costly and ineffective during the Covid-19 pandemic.

Conclusions

With increased public spending being a cornerstone of the response to this crisis, adequate monitoring of abuse of public funds will become more urgent. Some EU institution, such as the European Public Prosecutor’s Office, or the European Anti-Fraud Office, could be suitable for a whistleblower reward program, as investigators are likely stuck looking for needles in haystacks, or lack the necessary information to bring/recommend actions to recover funds. Irrespective of the lost opportunity of the Directive, evidence shows it is time to introduce serious (high stakes) whistleblower rewards programs in Europe, unless of course Europeans are not able to manage them, or are more interested in hiding rather than airing their dirty laundry.

References

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

The Shadow Economy in Russia: New Estimates and Comparisons with Nearby Countries

Posted on March 16, 2020 | Policy Brief

Image of a metro elevator going upwards representing shadow economy of Russia

We apply a new method to measure the shadow economy in Russia during the period 2017-2018 and provide evidence on the main factors that influence involvement in the shadow economy. Drawing on a methodology developed by Putnins and Sauka (2015), we estimate that the size of the shadow economy in Russia is 44.7% of GDP in 2018. This is similar to the size of the shadow economy in countries such as Kyrgyzstan, Kosovo, Ukraine, and Romania, but higher than the level of the Baltic countries. Our findings are largely consistent with other less direct approaches for estimating the shadow economy. An advantage of our approach is that it can provide more detailed information on the components of the shadow economy.

Introduction and Approach to Measuring the Shadow Economy

The aim of the Shadow Economy Index, which has now been estimated in a number of countries, is to measure the size of shadow economies and explore the main factors that influence participation in the shadow economy. We use the term “shadow economy” to refer to all legal production of goods and services produced by registered firms that is deliberately concealed from public authorities (OECD, 2002; Schneider, Buehn and Montenegro, 2010).

The Shadow Economy Index draws on a survey-based methodology developed by Putnins and Sauka (2015). It combines estimates of business income that has been concealed from authorities, unregistered employees, and ‘envelope’ wages. The approach exploits the fact that entrepreneurs and business leaders are in a unique position in that they have knowledge about the amount of business income that is concealed from authorities, the number of employees that work for them unofficially, and the extent to which they pay wages informally to avoid taxes.

The challenge for such methods is to elicit maximally truthful responses about these sensitive issues, otherwise, the size of the shadow economy will be underestimated. To address this challenge, we use a number of survey and data collection techniques shown in previous studies to be effective in eliciting more truthful responses (e.g. Gerxhani, 2007; Kazemier and van Eck, 1992; Hanousek and Palda, 2004). While the full details can be found in Putnins and Sauka (2015), they include confidentiality with respect to the identities of respondents, framing the survey as a study of satisfaction with government policy, phrasing misreporting questions indirectly about “similar firms in the industry” rather than the respondent’s actual firm, gradually introducing the most sensitive questions after less sensitive questions, excluding inconsistent responses, and controlling for factors that correlate with a potential untruthful response such as tolerance towards misreporting.

The Index measures the size of the shadow economy as a percentage of GDP. Computing the Index involves three steps:

  • (i) estimate the degree of underreporting of employee remuneration and underreporting of firms’ operating income using the survey responses;
  • (ii) estimate each firm’s shadow production as a weighted average of its underreported employee remuneration and underreported operating income, with weights reflecting the proportions of employee remuneration and firms’ operating income in the composition of GDP; and
  • (iii) calculate a production-weighted average of shadow production across firms.

The survey about shadow activity in Russia from 2017 to 2018 was conducted between February and March 2019. We use random stratified sampling to construct samples that are representative of the population of firms in Russia drawing on the official company register and covering all regions in Russia. In total, 500 phone interviews were conducted with owners, directors, and managers of companies in Russia. We use the same methodology to collect data in other countries, which we compare with Russia, conducting a minimum of 500 interviews in each country.

Size of the Shadow Economy in Russia and Nearby Countries

The estimated size of the shadow economy in Russia is 44.7% of GDP in 2018. Our estimates suggest that the year before, in 2017, the shadow economy was slightly larger with 45.8% of GDP, although the annual change is not statistically significant. For comparison with nearby countries, using the same approach, high levels of shadow economy are also found in Kyrgyzstan (44.5% of GDP in 2018), Kosovo (39.5% of GDP in 2018), Ukraine (38.2% of GDP in 2018), and Romania (33.35% of GDP in 2016), but considerably lower levels are found in the Baltic countries, especially Estonia (16.7% of GDP in 2018). See Table 1 for the full set of estimates.

The estimates using our direct micro-level approach to measuring the shadow economy are largely consistent with other less direct approaches for estimating the size of the shadow economies, such as Schneider (2019). An advantage of the direct micro-level approach is that it is able to provide more detailed information on the components of the shadow economy, which we turn to next.

Components and Determinants of the Shadow Economy in Russia

We find that envelope wages and underreporting of business profits stand out as the two largest components of the Russian shadow economy. Underreporting of salaries or so-called ‘envelope wages’ in Russia are approximately 38.7% of the true wage on average in 2018, whereas approximately 33.8% of business income (actual profits) are underreported. Unofficial employees in Russia as a percentage of the actual number of employees are estimated 28.2% in 2018.

Some companies in Russia, rather than simply concealing part of the income or employees, are completely unregistered and therefore also contribute to the shadow economy. We estimate that such companies make up 6.1% of all enterprises in Russia.

Our findings also suggest that there is a very high level of bribery in Russia: the magnitude of bribery (percentage of revenue spent on ‘getting things done’) is estimated to be 26.4%, whereas the percentage of the contract value that firms typically offer as a bribe to secure a contract with the government in Russia is 20.6% in 2018. We also find that more than one-third of companies in Russia pay more than 25% of the revenue or contract value in bribes.

We find that the size of the shadow economy in all sectors of the Russian economy is close to 40% with somewhat higher levels in the construction and wholesale sectors, controlling for other factors. Using regression analysis, we find that entrepreneurs that view tax evasion as a tolerated behaviour tend to engage in more informal activity, as do entrepreneurs that are more dissatisfied with the tax system and the government. This result offers some insights into why the size of the shadow economy in Russia is so large – it is at least in part due to relatively high dissatisfaction of entrepreneurs with the business legislation and the government’s tax policy. We also find some evidence that higher perceived detection probabilities and, in particular, more severe penalties for tax evasion reduce the level of tax evasion, suggesting increased penalties and better detection methods as possible policy tools for reducing the size of the shadow economy.

Finally, while firms of all sizes participate in the shadow economy, we find that younger firms tend to do so to a greater extent than older firms. The results support the notion that young firms use tax evasion as a means of being competitive against larger and more established competitors.

Acknowledgments

This research was supported by a Marie Curie Research and Innovation Staff Exchange scheme within the H2020 Programme (grant acronym: SHADOW, no: 778118).

References

  • Gerxhani, K. (2007). “Did you pay your taxes?” How (not) to conduct tax evasion surveys in transition countries. Social Indicators Research 80, pp. 555-581.
  • Hanousek, J. and Palda, F. (2004). Quality of government services and the civic duty to pay taxes in the Czech and Slovak Republics, and other transition countries. Kyklos 57, pp. 237-252.
  • Kazemier, B. & van Eck, R. (1992). Survey investigations of the hidden economy. Journal of Economic Psychology 13, pp. 569-587.
  • Lechmann, E. and D. Nikulin (2017). Shadow Economy Index in Poland. Gdansk University of Technology, Poland: Gdansk.
  • Lysa, O. et al. (2019) Shadow Economy Index in Ukraine. SHADOW: an exploration of the nature of informal economies and shadow practices in the former USSR region. Kyiv International Institute of Sociology, Ukraine: Kyiv.
  • Mustafa, I., Pula J.S., Krasniqi, B., Sauka, A., Berisha, G., Pula, L., Lajqui, S. and Jahja, S. (2019) Analysis of the Shadow Economy in Kosova. Kosova Academy of Sciences and Arts, Kosova: Pristina.
  • OECD, 2002. Measuring the Non-Observed Economy: A Handbook. OECD, Paris, France.
  • Putnins, T.J. and Sauka, A. (2019). Shadow Economy Index for the ‘Baltic Countries 2019-2018. SSE Riga: Riga, Latvia.
  • Putnins, T.J., A. Sauka and A. Davidescu (2020, forthcoming). Shadow Economy Index for Moldova and Romania, 2015-2018. SSE Riga, National Scientific Research Institute for Labour and Social Protection.
  • Putnins, T.J. and Sauka, A. (2015). Measuring the shadow economy using company managers. Journal of Comparative Economics 43, pp. 471-490.
  • SIAR (2019). Shadow Economy Index for Kyrgyzstan. SHADOW: an exploration of the nature of informal economies and shadow practices in the former USSR region. SIAR research and consulting, Kyrgyzstan: Bishkek.
  • Schneider, F. (2019) Calculation of the Size and Development of the Shadow Economy of 35 Mostly OECD Countries up to 2018. Unpublished manuscript.
  • Schneider, F., Buehn, A. and Montenegro, C. (2010). New estimates for the shadow economies all over the world. International Economic Journal 24, pp. 443-461.

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

Buyer Competence and Procurement Renegotiations

Posted on December 2, 2019 | Policy Brief

20191201 Buyer Competence and Procurement Renegotiations FREE Network Policy Brief Image 01

This brief deals with the extent to which a more competent public bureaucracy can contribute to better economic outcomes. It addresses this question in the context of public procurement, governments’ purchase of goods and services from private contractors, which accounts for about 15% of GDP in most economies and is on the rise. The efficiency of the procurement process directly influences the prices and quality of many government-provided goods and services that are crucial to social welfare objectives and sustained economic growth. Several issues challenge this efficiency. Media attention is typically on episodes of corruption, which can of course be a major source of waste. Here, we focus on a less glamorous, often overlooked, but potentially even more important source of waste, the lack of procurement competence.

Public procurement is a complex task. Contracting authorities must know market characteristics, design and implement efficient award mechanisms, balance risks and incentives in drafting contracts, effectively manage the contracts in the execution phase, etc. Effective procurement, in particular for complex services or works, requires teams endowed with legal, marketing, engineering, and economic/strategic expertise. The World Bank‘s Benchmarking Public Procurement 2017 compares the quality of the legal and regulatory environments of 180 countries and reveals the existence of great heterogeneity in the quality of the procurement processes across countries. Saussier and Tirole (2015) focus on the case of France, documenting that 63% of the staff of French contracting authorities do not have a legal profile, and only 39% have qualifications specific for managing public purchases.

Recent research focusing on prices of standardized goods showed that (lack of) buyer competence among public buyers could make an even bigger impact on the waste of public funds than corruption. For example, Bandiera, Prat and Valletti (2009) estimate that Italian public buyers would save 21 percent of their expenditures if they all paid the same as the buyers at the 10th percentile of the estimated procurement price distribution. Savings could reach 1.6-2.1 percent of the Italian GDP per year. They then estimate that bureaucratic inefficiency also linked to incompetence is the main cause of waste, accounting for 83 percent of total estimated waste, compared to only 17 percent due to corruption. In a similar vein, Best, Hjort and Szakonyi (2017) report that over 40 percent of within-product price variation on standardized goods in Russia in 2011-2015 can be ascribed to the bureaucrats and organizations in charge of procurement. They estimate that if the least effective quartile of bureaucrats and organizations had the effectiveness of the 75th percentile, the Russian government would save around $13 billion per year – roughly one fifth of the total amount spent on health care by the Russian government at federal, regional, and municipal level combined.[1]

The role of competence in complex procurement

This problem is becoming even more serious now that, being under fiscal pressure after the crises, many governments are promoting the use of public procurement not only as a tool to save budgets – sometimes at the expense of quality – but also to achieve more complex objectives like fostering innovation, protecting the environment, and promoting social objectives, a multiplicity of goals that per se makes the procurement mission even more complex.

Little is known about the importance of procurement competence in more complex procurements, not least because it is very difficult to measure performance in these environments. In our paper (Decarolis et al. (2019)) we try to make a step in this direction by focusing on works and services, typically more complex than goods. We use data from the US, probably the country with the most well-developed system of production and certification of procurement competences. Thus, our estimates of the effect of lack of competences should provide a lower bound of most other countries.

We combine, for the first time, three large databases: contract-level data on procurement performance in the Federal Procurement Data System (FPDS); bureau-level data from a survey conducted by the Office of Personnel Management since 2002 on federal employees, the Federal Employee Viewpoint Survey (FEVS); and Federal Workforce Data (FedScope) containing information on characteristics of the public workforce at the employee level.

To quantify the extent to which the government-bureau-level competencies determine procurement outcomes, we use the first database to construct procurement performance measures and the second dataset to build measures of procurement offices’ competence. We then use the third database to construct instruments that help us addressing important endogeneity issues. Our identification strategy exploits the exogeneity of death events involving public officials to allow for a causal interpretation of bureau competence on procurement performance.

Measurement Challenges

Indeed, there are three main challenges that our analysis needs to overcome. The first is how to measure procurement performance. Unit price comparisons have been used for standardized goods, but they are not suitable for the more complex procurements we focus on as they are heterogeneous in many non-recorded dimensions and their contracts are often incomplete. We use FPDS instead to construct three proxies of performance based on time delays, cost overruns, and the number of renegotiations. Although the first two measures are widely used in the literature, we are careful to take into account that cost overruns and delays may be due to new or additional work requested by the public buyer, in which case they should not be viewed as indicative of a poor outcome. We, therefore, consider only those which have occurred to deliver the work or service that was originally tendered. The third performance measure, the overall number of renegotiation episodes, is new and aims at capturing Williamson’s “haggling costs,” which are a pure deadweight loss present whatever the reason behind the renegotiation and have been shown to be economically sizeable for complex contracts. Our data reveals a surprising and persistent heterogeneity along these three dimensions across US federal bureaus.

The second challenge is the measurement of bureaucratic competence. Other papers in the field have measured it using buyer fixed effects. We use a novel approach based on the mentioned survey of employees’ subjective evaluations (FEVS). The survey is extremely rich, and we chose the most general question as an overall measure for competence (How would you rate the overall quality of work done by your work unit?). Responses to this question should be seen as measures of the overall efficacy of the workflow and processes within the bureau, hence proxying for the ideal measure of competence on the many different aspects relevant to procurement. An extensive set of robustness checks support our idea of measuring competence through the FEVS data.

The third measurement problem is the association between more complex contracts and more competent buyers: the most competent buyers may consistently produce poor performance because they are allocated the most complicated procurements. This point is well illustrated in a case study showing that the performance of the agencies that are worst in terms of competence (the Department of Veterans Affairs and the Department of Justice) is superior to that of the two most competent agencies (the NASA and the Nuclear Regulatory Commission) in terms of both delays and cost overruns. This striking inversion indicates that any straightforward regression of performance on competence would grossly underestimate the impact of competence.

We, therefore, develop an instrumental variable strategy exploiting exogenous changes in competence. We use FedScope to build instruments for bureaus’ competence based on the deaths of specific types of employees: bureau managers and white-collar employees who are relatively young and earn a relatively high wage. The idea is that more competent offices adopt better managerial practices, routines and processes that are more resilient to risks, such that of an unexpected loss of a key employee, and less dependent on specific individuals. This is precisely what the first stage of our IV strategy documents. Our instruments perform well in terms of their statistical properties and they allow us to estimate a causal effect of bureau competence on procurement outcomes that is an order of magnitude larger than the corresponding OLS estimate.

Results

We find that one standard deviation increase in competence reduces the number of days of delay by 23 percent, cost overruns by 29 percent and the number of renegotiations by half. This implies that if all federal bureaus were to obtain NASA’s high level of competence – corresponding to the top 10th percentile of the competence distribution – delays in contract execution would decline by 4.8 million days, and cost overrun would drop by $6.7 billions over the entire sample analyzed. We also find a consistently negative effect of greater competence on the number of renegotiations: one standard deviation increase in competence causes 0.5 (39%) and 0.8 (71%) fewer cost renegotiations and time renegotiations, respectively.

Finally, we try to understand what exactly makes a bureau ‘competent’ using the FEVS data to identify three different components: cooperation among employees, incentives and skills. Separately estimating their causal effects is unfeasible with instruments like the two described above as the validity of the exclusion restriction, which can be argued to be satisfied when measuring a broadly defined notion of bureau competence, is unlikely to hold for more specific components. However, we provide multiple pieces of evidence suggestive that cooperation is the key driver behind the positive effects of bureau competence. This finding conforms with the view that successful procurement requires appropriate coordination of a multiplicity of tasks involving different individuals. We also consider the extent to which the role of cooperation is due to the presence of capable managers, able to lead a group to effective cooperation, exploiting the heterogenous effects obtained through instruments considering the deaths of different subgroups of employees. We find that the deaths that matter the most are those of relatively young and best paid white-collar employees.

These results point at the large potential improvement in the performance of public contracts that could be achieved by investing more resources in increasing the competence of contracting authorities, even in a country with long-established procurement training and certification institutions such as the US. In Europe, recent policy initiatives see the introduction of qualification systems for public procurers as a necessary response to the generally lower procurement competence coupled with the greater discretion granted by the 2014 Procurement Directives. Our results on the role of cooperation suggest that certification programs would be also useful at the level of the procuring office, and should include features such as the organisation of the acquisition process and the prevailing management practices, as is often done for private firms.

References

[1] See also, Bucciol et al (2017) who study procurement of standardized medical devices purchased by local Italian purchasing bodies, finding that the price for the same medical devices paid by Italian public buyers differ substantially, and that the differences are explained by ‘buyers fixed effects’ capturing all specific buyers characteristics, including their competence levels.

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

Gender and the Agency Problem

Posted on May 20, 2019 | Policy Brief

20190520 Gender and the Agency Problem Image 02

Is it good for a firm to have a female CEO? Are countries with more female politicians less corrupt? An increasing attention to female representation in key roles in society has called for research exploring the outcomes and implications of such representation. A useful approach to investigate the impact of gender in such contexts is the so-called principal-agent framework which studies situations in which one party acts on behalf of another party. The idea is that the gender of participating parties is likely to affect motives, behavior and outcomes, predicted by the principal-agent framework. This brief reviews the use of the principal-agent framework for analyzing the effect of gender in two important areas of research: corporate finance and corruption. It outlines postulated theoretical channels for gender to matter, summarizes empirical findings and points to some of the policy challenges.

Increasingly, arguments in favor of more women in key positions are being put forth in society. Many European countries have by now introduced gender quotas for corporate board participation, with Norway being the first one to mandate a quota of 40% female board membership in late 2003. The United States joined the trend in 2018, with California being the first state to require women on corporate boards. The 2019 share of female CEOs in Fortune 500 companies is 5 %; while this number sounds very low, it is twice as high as a decade ago. Women’s presence in politics and bureaucracy is also increasing in many countries worldwide.

This tendency is clearly positive news in the fight for more gender equality, and it is likely to improve the position of women in the society. However, its implications for other economic and societal outcomes are not immediately clear. For example, is a more gender-balanced board or a female CEO good news for company performance? How would female politicians affect policy and societal outcomes?

One useful approach for answering such questions is based on the so-called principal-agent framework (developed to study what is known as “agency problems”). This framework, widely used in economics, political science and other related disciplines in the last half century, addresses the problem of incentivizing one person (referred to as an “agent”) to act on behalf of another person or entity (referred to as a “principal”). Many situations in real life are well described by this basic framework and it has been used in a wide range of different contexts, from relationships within a firm, or between a lawyer and her client, to insurance, real estate, policy choices by elected officials or appointed bureaucrats, and even situations involving corruption.

The relevant question is then whether, and if so, how, the gender of the agents can affect motives, behavior and outcomes, predicted by the principal-agent framework. This brief will focus on two main areas of studies within gender economics that use agency theory to motivate their findings: the role of gender in corporate governance, and in corruption. The brief will outline the theoretical channels through which the gender of the actors may act in these contexts, summarize the empirical findings of this literature, and shortly comment on policy implications. While the focus on two areas only may seem to be relatively narrow, it will allow identifying a number of common gender effects across the contexts, which may suggest implications for the other potential applications of the approach.

The basic principal-agent framework

Effectively any situation in which one party acts on behalf of another party for monetary or non-monetary compensation can be analyzed within an agency framework. A typical feature of such situations is that the parties have different objectives: for example, the board of the firm (the principal in this case) would be interested in maximizing the firm value, while the CEO (the agent) would probably be more concerned about her personal compensation. This difference is not necessarily problematic per se as long as the principal can get the agent to act as the principal wants. However, if parties do not have the same information – which is typically the case in the reality – the misalignment of their objectives becomes an issue.

Two main problems may arise in such situations. The first one is referred to as the problem of hidden action (moral hazard) – that the agent is likely to act in line with her own objectives, rather than in the principal’s ones. This is likely to occur as long as her effort cannot be perfectly monitored by the principal. For example, shareholders typically cannot directly attribute the evolution of the firm’s value to the actions of the CEO, which may result in the CEO making decisions that are, for instance, too risky from the firm’s value maximization perspective. The second one is the problem of hidden information – when the agent is better informed about the issues at stake than the principal, which again may result in the agent not acting in the best interest of the principal. For example, shareholders may have a poorer knowledge of the market than CEO, which may result in the CEO making decisions maximizing her own compensation rather than the firm’s value.

To lessen the extent of these problems, one needs to think of the spectrum of tools/decisions under the agent’s control, as well as of the design of her compensation schemes so as to align her private objectives with those of the principal. For example, to motivate a CEO to behave in the interests of shareholders, his/her compensation package typically includes company stock options. In some cases, the way to provide better incentives for the agent is to delegate more decisions, allow her more discretion and link her compensation closely to the outcome of her actions. One possible example of such a mechanism is franchising: on average franchisees retain about 94% of franchise profits, which would make them very motivated to achieve good franchise performance. However, the cost of high incentivization is the potential misuse of decision power, especially if the set of the decisions for an agent to have control over is not chosen wisely and if sufficient alignment (or intrinsic motivation) is not achieved. Another obstacle when implementing the principal’s preferred outcome is the trade-off between agent’s incentivization and risk aversion. The agent is typically seen as more risk-averse than the principal (for example, firms’ shareholders would typically diversify their risks by investing in a number of companies, while the CEO’s main source of income would be associated with the company she manages). As a result, the agent may avoid undertaking the principal’s value-maximizing actions because of the risks associated with them.

The bottom line of this discussion is that the task of incentivizing the agent may be difficult, and the principal’s best-preferred outcome may not be achievable.

Gender and the agency problem

There are many twists and modifications of the basic framework described above aimed at better modelling the specific problem at hand. One particular feature of the principal-agent relationship that has received increasing attention in the literature is the gender of the participating parties. The main strands of this literature have studied the relevance of gender for corporate governance and corruption.

Gender and corporate governance

The corporate governance part of the literature focuses on the impact of the gender composition of the board of directors or of the gender of the CEO on firms’ (or banks’) performance, risk-taking, capital allocation decisions, firm reputation etc. One standard approach to this set of questions is to consider the principal-agent relationship between the agent – the CEO – and the principal(s) – the board of directors (and sometimes other firm stakeholders) – and ask how, and why, the gender of either party may affect the relationship between them and the outcomes of this relationship.

There are several channels suggested by the literature. First, women and men may have different personal characteristics – such as risk aversion, level of confidence or ethical values (though there is not necessarily agreement on the direction of the difference: while most studies argue that, on average, men are typically more overconfident than women (e.g., Barber and Odean, 2001; Lundeberg et al., 1994), there is no consensus about risk attitudes – e.g., Jianakoplos and Bernasek (1998) or Croson and Gneezy (2009) show that women are more risk-averse than men, while Adams and Funk (2012) document the opposite). These differences in personal traits may affect the decision-making of a board/CEO in an incomplete-information environment and ultimately the firm’s performance.

Second, women and men may face different employment opportunities in case they lose their job, which, again, is likely to affect their decision-making and risk-taking (e.g., Faccio, Marchica and Mura, 2016).

Third, more gender-diverse boards may better reflect the preferences of (gender-mixed) firm stakeholders; in terms of the agency theory this would imply more aligned interests between the principal and the agent. It may matter because mixed-gender groups (and, by implication, boards) may exhibit different decision-making processes than same-gender groups, which, again, may introduce frictions into the agency relationship (e.g., Amini et al., 2017 or Van Knippenberg and Schippers, 2007).

Finally, the gender composition of the board may matter because female board members may improve monitoring over the actions of the CEO, since they are more independent not being part of the same “old boys’” social networks as the male members of the board and the (male) CEOs (Adams and Ferreira, 2009).

Empirically, this literature is largely inconclusive: while the majority of studies does find that the gender of the firm’s decision-maker(s) matters, the sign of the effect differs between studies, datasets and specifications. For example, based on a US sample of firms, Bernile, Bhagwat and Yonker (2018) find that more gender-diverse boards lead to lower firm risk, and better performance. In turn, Adams and Ferreira (2009) document negative effects of more diverse boards on performance. Sila et al. (2016) find no relation between board gender diversity and risk. Similarly ambiguous are the findings on the effect of CEO’s gender on firms’ performance, as measured by risk exposure, capital allocation, propensity to acquire, business strategies etc.

One possible reason for this variability of findings is the endogeneity of the presence of female CEOs/board members and firms’ outcomes, which is difficult to account for empirically (Hermalin and Weisbach, 1998; Adams et al., 2010). For example, female CEOs may self-select into firms with lower risks due to their own risk-aversion. Alternatively, corporate culture may affect the relationship between the gender of the CEO/board members and firm performance, etc. (see Adams, 2016 for an overview of this problem). There has been a number of attempts to address the causality/endogeneity issues in this context. For example, Bernile, Bhagwat and Yonker (2018) and Alam et al. (2018) exploit variation in the gender composition of boards created by the diversity of potential directors residing a non-stop flight away from the firm headquarters. Their motivation is that the personal travel costs of directors decrease with the availability of non-stop flights. Faccio et al. (2016) attempt to resolve the endogeneity issue by proxying the likelihood of hiring a female CEO by a measure of how many other firms that share board members with the firm in question have female CEOs. The idea there is that working with female CEOs in other firms may make board members more familiar with working with female executives, and more willing to hire a female CEO in the firm in question. A subset of the literature exploits reforms introducing gender quotas in corporate boards. These studies argue that the reforms are introducing an exogenous variation in the proportion of mandated changes in board gender composition – firms with more women in the board prior to the reform would need less adjustments to comply with the reform (see, e.g., Bertrand et al., 2018 for a state-of-the-art example of such an approach). Still, the endogeneity concern remains very valid for this literature. A recent literature overview by Kirsch (2018) or somewhat more dated, but still be relevant one by Terjesen et al. (2009) can be a good starting point for more detailed information on this field.

Gender and corruption

Similarly, there is a sizeable literature of gender aspects of corruption. This literature addresses a variety of topics, including the impact of corruption on women and gender inequality, gender-associated forms of corruption, and most importantly for us in the current context, gender attitudes and behavior towards corruption. One of the predominant theoretical mechanisms in this literature, again, uses agency theory. The main difference to the version of agency theory applied in the corporate governance case above is, perhaps, that in the case of corruption there is not always a clear pattern of subordination between the principal and the agent. More specifically, the principal for a (potentially corrupt) agent official may be either a higher-level official, or the direct recipient of her services or the electorate in general (of the agent official is elected). However, just as in the corporate governance literature, the gender vs. corruption literature asks the question how the outcome of an interaction between the principal and the agent would be altered by the gender of either party. It argues that women may behave differently from men in a corrupt environment through a number of channels, most of which resemble the ones in the corporate governance literature outlined above.

For example, gender differences in behavior and attitudes to corruption may be due to of personal traits, such as risk aversion or gender-specific conformity with social norms (e.g., Esarey and Chirillo, 2013 suggest that women are more likely to conform to the local social norms, so they are less likely to engage in corruption in an institutional environment where corruption is condemned, than in the societies when it is more accepted).

These differences may be due to differences in outside options of the corrupt official in case corruption gets detected (such as alternative employment opportunities). They may also be due to women not being part of business/political network(s), or having less experience in how things are done in decision-making positions. This could make them better monitors when they are in a principal role, or less able (or willing) to engage in corruption when in the role of agent. Thereby, it may result in a negative link between women in government and corruption, but only a short-term one (e.g., Pande and Ford, 2011). However, Afridi et al. (2017) argues for an opposite view, that a newly appointed female bureaucrat’s lack of experience may increase corruption due to inability to handle matters efficiently. Their empirical results indeed support it: in India newly appointed female council heads are less efficient than male ones due to lack of experience; this efficiency gap also includes higher corruption levels in female-led villages. With time, as the female council heads gain experience, the difference disappears.

As can be expected, empirically this field is again not entirely conclusive. The early empirical research suggested a negative link between gender and corruption, or, more specifically, found that a higher presence of women in government is associated with lower levels of corruption (e.g., Dollar, Fisman, and Gatti, 2001 or Swamy et al., 2001). However, there has since been a wide discussion about the causal mechanisms of this relationship. One of the arguments has been that this correlation is due to institutional mechanisms: greater representation of women in power is observed in a more developed institutional environment, which is also providing more effective checks on corruption (e.g., Sung, 2003). Still, the discussion is ongoing, as other scholars argue that the relationship is still in place even after controlling for the institutional factors, though not in all power positions (e.g., Jha and Sarangi (2018) show that female presence in parliament decreases corruption while other measures of female participation in economic activities have no effect). There is certain evidence of female bureaucrats being less aggressive in extracting bribes (Dabalen and Wane, 2008) or female business owners paying less bribes (Breen et al., 2017), but the determinants and the causal relationship of these findings are again, unclear.

There has been a number of attempts to resolve the causality issue of the gender-corruption link. Similarly to the corporate governance literature, researchers have used an instrumental variable approach (e.g., Jha and Sarangi (2018) use number of genders in a country’s language to instrument for female labor force participation, as it has been shown that gender discrimination is higher in countries where the dominant language has two genders as opposed to countries where it has no gender or three or more genders. The same authors use the year of universal suffrage to instrument the female participation in parliament). Unlike in corporate governance literature, a large part of this literature uses experimental approach, relying both on lab experiments to study gender attitudes to corruption (e.g., Rivas, 2013), and natural experiments (Afridi et al., 2017 study the reform in India that randomly allocated a third of council headship positions to women) and quasi-experiments (Brollo and Troiano (2016) look into close elections in Brazil and use a regression discontinuity design to show that female mayors are less likely to be corrupt). A useful overview of the literature is offered in Rheinbay and Chêne (2016).

Summing up and policy implications

There is an active public and academic debate about the greater involvement of women in key positions in society, its implications and outcomes, and potential policies to achieve it. A natural way of analyzing the implications of having more women in strategic positions utilizes the principal-agent modelling approach, with the presumption that the gender of the parties is likely to affect the model’s predictions and outcomes. A substantial attention in this literature has been devoted to the impact of gender in corporate governance and corruption. Importantly, these two strands of literature outline several common channels through which gender is likely to have an impact, such as risk aversion, outside opportunities in case of losing employment, etc. This similarity suggests that the same channels are likely to play a role in other gender-relevant agency contexts.

Another similarity between these two areas of research is the ambiguity of the results in terms of both theoretical predictions and empirical findings. One possible source of this ambiguity is, likely, suboptimality of the empirical methods used, which might not allow to adequately establish the causal relationship between the characteristics and outcomes of the agency relation and gender of its participants. Differences of the contexts of the empirical studies are another probable contributor to the variation in predictions and results.

However, this ambiguity obviously does not mean that policies to empower women should not be undertaken at all. First, even if the results of a particular narrowly-targeted policy are so far found to be ambiguous, it may still be highly useful in changing social norms, with all the benefits attached to it. For example, there is no sufficient evidence that establishing gender quotes in corporate boards would improve firms’ performance. For example, Ahern and Dittmar (2012) find that introduction of quota in Norway had a negative effect on Tobin’s Q. However, a quota reform in Norway resulted in the appointment of better qualified female board members and raised the career expectations of younger women post-reform (Bertrand et al., 2018). Second, this ambiguity stresses that there is no universal “silver bullet” policy applicable to all countries and contexts: the design of policies that address gender inequalities, as any other policy, needs to carefully account for the local institutional and cultural context. Further, recent contributions to this literature has become much more informative for the policy makers. An active development of this field and its methods suggests that we are about to learn much about the role of gender and other compounding factors in the above contexts. In other words, modern informed gender policy is just around the corner.

References

  • Adams, R. B., (2016). Women on boards: The superheroes of tomorrow? Leadership Quarterly, 27 (3). pp. 371-386.
  • Adams, R. B., Hermalin, B. E., & Weisbach, M. S. (2010). The role of boards of directors in corporate governance: A conceptual framework and survey. Journal of economic literature, 48(1), 58-107.
  • Adams, R. B., & Ferreira, D. (2009). Women in the boardroom and their impact on governance and performance. Journal of financial economics, 94(2), 291-309.
  • Adams, R. B., & Funk, P. (2012). Beyond the glass ceiling: Does gender matter?. Management science, 58(2), 219-235.
  • Afridi, F., Iversen, V. & Sharan, M.R. (2017), Women political leaders, corruption, and learning: evidence from a large public program in India. Econ. Dev. Cult. Change, 66 (1) pp. 1-30.
  • Ahern, K. R., & Dittmar, A. K. (2012). The changing of the boards: The impact on firm valuation of mandated female board representation. The Quarterly Journal of Economics, 127(1), 137-197.
  • Alam, Z. S., Chen, M. A., Ciccotello, C. S. & Ryan, H. E., (2018). Gender and Geography in the Boardroom: What Really Matters for Board Decisions? Mimeo. Available at SSRN: https://ssrn.com/abstract=3336445
  • Amini, M., Ekström, M., Ellingsen, T., Johannesson, M., & Strömsten, F. (2016). Does gender diversity promote nonconformity?. Management Science, 63(4), 1085-1096.
  • Barber, B. M., and Odean T.  (2001). “Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment.” The Quarterly Journal of Economics 116, no. 1: 261-92.
  • Bernile, G., Bhagwat, V., & Yonker, S. (2018). Board diversity, firm risk, and corporate policies. Journal of Financial Economics, 127(3), 588-612.
  • Breen, M., Gillanders, R., McNulty, G., & Suzuki, A. (2017). Gender and corruption in business. The Journal of Development Studies, 53(9), 1486-1501.
  • Brollo, F., & Troiano, U. (2016). What happens when a woman wins an election? Evidence from close races in Brazil. Journal of Development Economics, 122, 28-45.
  • Croson, R., & Gneezy, U. (2009). Gender differences in preferences. Journal of Economic literature, 47(2), 448-74.
  • Dabalen, A., & Wane, W. (2008). Informal payments and moonlighting in Tajikistan’s health sector. The World Bank Policy Research working paper 4555, https://elibrary.worldbank.org/doi/pdf/10.1596/1813-9450-4555
  • Dollar, D., Fisman, R., & Gatti, R. (2001). Are women really the “fairer” sex? Corruption and women in government. Journal of Economic Behavior & Organization, 46(4), 423-429.
  • Esarey, J., & Chirillo, G. (2013). “Fairer sex” or purity myth? Corruption, gender, and institutional context. Politics & Gender, 9(4), 361-389.
  • Faccio, M., Marchica, M. T., & Mura, R. (2016). CEO gender, corporate risk-taking, and the efficiency of capital allocation. Journal of Corporate Finance, 39, 193-209.
  • Hermalin, B. E., & Weisbach, M. S. (1998). Endogenously chosen boards of directors and their monitoring of the CEO. American Economic Review, 96-118.
  • Jha, C. K., & Sarangi, S. (2018). Women and corruption: What positions must they hold to make a difference?. Journal of Economic Behavior & Organization, 151, 219-233.
  • Jianakoplos, N. A., & Bernasek, A. (1998). Are women more risk averse?. Economic inquiry, 36(4), 620-630.
  • Kirsch, A. (2018). The gender composition of corporate boards: A review and research agenda. The Leadership Quarterly, 29(2), 346-364.
  • Lundeberg, M. A., Fox, P. W., and Punccohar, J. (1994). Highly confident but wrong: Gender differences and similarities in confidence judgments. Journal of Educational Psychology, 86( 1), 114
  • Pande, R., & Ford, D. (2011). Gender Quotas and Female Leadership. Background Paper for World Development Report, World Bank.
  • Rheinbay J. & Chêne, M. (2016). Gender and corruption topic guide, Transparency International, https://www.transparency.org/files/content/corruptionqas/Topic_guide_gender_corruption_Final_2016.pdf
  • Rivas, M. F. (2013). An experiment on corruption and gender. Bulletin of Economic Research, 65(1), 10-42.
  • Sila, V., Gonzalez, A., & Hagendorff, J. (2016). Women on board: Does boardroom gender diversity affect firm risk?. Journal of Corporate Finance, 36, 26-53.
  • Sung, H. E. (2003). Fairer sex or fairer system? Gender and corruption revisited. Social Forces, 82(2), 703-723.
  • Swamy, A., Knack, S., Lee, Y., & Azfar, O. (2001). Gender and corruption. Journal of development economics, 64(1), 25-55.
  • Terjesen, S., Sealy, R. & Singh, V. (2009). Women Directors on Corporate Boards: A Review and Research Agenda. Corporate Governance: An International Review, 17(3), pp.320–337.
  • Van Knippenberg, D., & Schippers, M. C. (2007). Work group diversity. Annu. Rev. Psychol., 58, 515-541.

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

Capital Flows from Russia — The Bigger Picture

Posted on April 8, 2019 | Policy Brief

A bunch of dollar bills covering table that represents capital flows in Russia

There is an increasing focus on how Russian capital flows are being channelled through Western banks to various destinations, including offshore havens. There are of course legitimate reasons and legal ways of moving capital across borders, but much of the international focus on capital flows in recent decades is linked to the financing of terrorism, tax evasion, and money laundering in connection with criminal activities. This brief provides the macro view of capital flows between Russia and the rest of the world to paint the bigger picture behind the more specific stories we read about in the news that involve individual businessmen, corrupt officials, criminals, and banks.

International capital movements have a clear role in allocating resources efficiently across countries. However, today’s media coverage instead typically focuses on the role of capital flows in financing terrorists and avoiding taxes. Recently, money laundering has been creating headlines around the world in the Panama papers and other similar stories, illuminating complicated schemes in the global financial system in connection with illegal activities such as tax evasion, corruption, drug dealing and human trafficking.

In the international policy making arena, since 1989, the Financial Action Task Force (FATF) has the objective “to set standards and promote effective implementation of legal, regulatory and operational measures for combating money laundering, terrorist financing and other related threats to the integrity of the international financial system”. After the terrorist attacks in 2001, the issues of anti-money laundering (AML) and combatting the financing of terrorism (CFT) also became a central area of the IMF’s work and has since become an increasingly important policy question.

In several of the news stories, money flowing from Russia features prominently. This brief provides the bigger picture of Russian capital flows based on publicly available data as a complement and background to the news stories that are based on inside information, or “leaks”, and that focus on particular individuals and banks.

Composition of capital flows

In the official balance of payments statistics, capital flows are divided into a number of different categories, for example, private vs public or banks vs non-banks. There is also a distinction made between foreign direct investments (FDI) on the one hand and portfolio flows, loans and other types of transactions (PLO) on the other. Since the balance of payments also has to balance (despite the fact that not all international transactions have been recorded) there is also a term called errors and omissions (E&O) that take care of various discrepancies. In environments with poor data collection and a large share of activities that take place “off the books”, this term tends to be large. For Russia, this term has become smaller over time as the economy and data collection has matured.

In terms of volatility and magnitude of flows, the distinction between FDI and PLO is often important and so also in Russia. Figure 1 shows the private sector flows to and from Russia over the last two plus decades.

Figure 1. Capital flows to and from Russia

Source: Central Bank of Russia and author’s calculations

After a rather slow start in the early years of transition, capital flows took off as Russia started to generate growth in 2001, and the flows kept growing until the global financial crisis. As expected, FDI flows have been less volatile than PLO flows but perhaps more surprising, in- and outflows in both categories seem to move closely together (see Becker (2019) on why this is the case). We can also note that there has been a marked downturn in flows at the time of the annexation of Crimea and subsequent sanctions and counter sanctions between the West and Russia.

Cumulative capital flows

By computing net flows from the data in Figure 1 and accumulating this over time, we get a clearer idea in Figure 2 of the massive amounts of capital that have left Russia over the last decades. In the early years, the outflows were in the form of errors and omissions (E&O) and PLO, but the PLO trend was reversed in the early 2000’s and turned total accumulated flows back to zero before the global financial crisis hit. The global financial crisis was a clear turning point for capital flows in general and PLO flows in particular.

Figure 2. Net private capital flows

Source: Central Bank of Russia and author’s calculations

In the year following the global financial crisis, almost USD 300 billion left Russia. Outflows then continued, albeit at a slower pace, only to accelerate again at the time of Russia’s annexation of Crimea. By mid-2018, USD 700 billion had left Russia since 2008, mainly in the form of PLO flows. This is equivalent to twice the amount of fixed capital investments in Russia in 2017.

For a country like Russia that is in need of increased investments both from domestic and foreign sources to generate long-term sustainable growth, these outflows are very costly at the macro level even if they are beneficial to individual entities that are behind the flows.

Destinations of capital flows

Where the money from Russia ultimately ends up should matter less to people in Russia than the fact that they are not invested and generating growth at home. However, it can matter a great deal to people, policy makers and businesses in the destination countries. Not only because it involves business opportunities and employment to some, but also because it generates concerns among regulators, law enforcement and tax authorities regarding the origins and purposes of the investments.

We do not have full coverage of where all the money Russian entities invest or park abroad end up, but official statistics are available for at least part of the investments. First of all, there is data on cross-border assets and liabilities of the banks that report to the Bank of International Settlement (BIS), which shows what foreign residents have deposited in the banks. Russian claims on BIS reporting banks are shown in Figure 3, where we can note that total claims by Russians amount to USD 131 billion. Half of this amount was deposited with French, Swiss, UK, and Belgian banks at the end of September 2018.

Figure 3. Russian claims on BIS reporting banks in different countries (USD bn, Sept. 2018)

Source: BIS and author’s calculations

Given the recent scandal in Danske Bank, we can also note that USD 8 billion was deposited by Russian entities in Danish banks, which may not sound much in this context but amounts to around 2 per cent of Danish GDP.

Again, macro level data does not tell us if the flows behind the numbers are illicit or legitimate, but it provides some sense of the order of magnitude and possible significance for the entities involved in the transactions and their regulators and supervisors.

The next piece of information is due to the IMF’s and others’ efforts to collect and harmonize data on the destination of portfolio and FDI assets, and the data for Russia is presented in Figures 4 and 5.

The prime locations for Russian owned portfolio assets are Ireland and Luxembourg, followed far behind by the Netherlands, UK and US. In total, official portfolio assets are rather modest at USD 69 billion, which is far off the cumulative net PLO flows in Figure 2 of over USD 500 billion even if we add the BIS reporting bank deposits in Figure 3.

Figure 4. Russian portfolio assets by the destination country (USD bn, Sept. 2018)

Source: Central Bank of Russia and author’s calculations

This could have many explanations, including that a significant share of Russian PLO assets is not in BIS reporting banks or in countries that provide transparent reporting of other types of PLO assets. The fact that cumulative flows and stocks reported in international statistics are so different, though, clearly asks the question where the remaining assets are invested.

The last component for which we have data is the location of Russian FDI assets. This turns out to be the most significant asset class available in the official statistics with a total of USD 364 billion invested abroad. Given that the magnitudes of FDI flows in Figures 1 and 2 are much smaller than PLO flows, this is somewhat surprising. Less surprising is the fact that more than half of this is invested in Cyprus, which is a well-known destination for Russian money.

However, it also begs the question on how assets are classified and where; Cyprus annual GDP was USD 24 billion in 2018, or 13 per cent of what is classified as Russian FDI assets in Cyprus. The only reasonable interpretation is that Cyprus is an offshore destination to park Russian money and not the ultimate location of direct investments from Russia. It is not unlikely that similar explanations are also valid for a significant share of the assets recorded as investments in the Netherlands, Austria and Switzerland, not to mention the British Virgin Islands (BVI) or the Bahamas. This problem is not unique for Russian data, but the magnitude of the problem regarding this data is still striking.

Figure 5. Russian FDI assets by the destination country (USD bn, Sept. 2018)

Source: Central Bank of Russia and author’s calculations

Policy conclusions

Capital leaving Russia is mainly a problem for investments and growth in Russia, but, as has become far too clear recently, some of the flows also create problems in other countries. In particular, flows that are associated with money laundering and channelled through financial institutions in the West can create massive problems for banks that do not have sufficient control mechanisms in place or are guided by short-term profit maximization that encourages staff to look the other way when illicit flows are coming in.

Given the massive scale of flows coming from Russia, it can obviously be tempting to be part of this business while at the same time very costly to implement procedures and routines that control all of the flows adequately. However, not understanding the bigger picture of Russian flows can be even costlier.

References

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

Money Laundering: Regulatory or Political Capture?

Posted on December 10, 2018 | Policy Brief

20181210 Money Laundering Image 01

Danske Bank has recently been accused of having laundered more than 200 billion Euros through its Estonian branch. The size of the scandal has reinvigorated the discussion over lax enforcement by regulators and poor bank compliance with anti-money laundering laws. In this brief, we concisely review some recent cases of poor regulatory and political behaviour with respect to these matters, focusing in particular on the UK, whose financial system seems to have become a main hub for this type of financial misconduct.

A widespread phenomenon

The size of the recent money laundering scandal at Danske Bank, involving more than 200 billion Euros, has surprised many. Money laundering is a widespread issue in an increasingly complex world where financial transactions are many and instantaneous, while oversight slow and limited (Radu 2016). According to the United Nations Office on Drugs and Crime, an estimated $800 – $2 trillion is laundered every year (United Nations Office on Drugs and Crime). The source of laundered money is often from corruption, crime and drug cartels (as with the HSBC scandal, see below). Attempts to blow the whistle on these illegal transactions have gotten several people killed, especially in Russia (The Daily Beast, October 2018).

Malta’s Pilatus bank recently had its license revoked by the European Central Bank after its chairman was charged with money laundering (Reuters, October 2018). The investigative reporter Daphne Caruana Galizia was killed in a car bomb in October of 2017 in Malta (The Guardian, October 2017). She was leading the Panama Papers investigation into corruption in the country and had accused Pilatus bank of processing corrupt payments (The Guardian, November 2018). In Sweden, some banks have recently been criticized for insufficient actions against money laundering. Experts at the regulator recommended extensive sanctions, but upper management stopped them (Svenska Dagbladet, December 2018). In November, Deutsche Bank’s headquarters in Frankfurt were raided by prosecutors in a money laundering investigation (BBC, November 2018).

Back to Danske Bank. Its Estonian branch was recently accused of having laundered money, amounting to over 200 billion Euros of suspicious transfers (Financial Times, November 2018). In 2011 the Estonian branch accounted for 0.5% of Danske Bank’s assets, while generating 12% of its total profits before taxes. In 2013, 99% of the profits in the branch came from non-residents. Many of the non-resident customers are believed to be from Russia and other ex-soviet states (Forbes, September 2018). The alleged money laundering came to light due to the whistleblower Howard Wilkinson, who headed Danske Bank’s market trading unit in the Baltics from 2007 to 2014. Surprisingly, his anger over these transactions was not primarily aimed at top management in Copenhagen, or failure of rank and file employees to follow protocol in customer acquisition, but against the UK, who he claimed is “the worst of all” when it comes to combating money laundering (Financial Times, November 2018). In fact, the UK institutions seem to have been at the very heart of the scandal (ibid):

“Mr Wilkinson’s emails to Danske executives in 2013 and 2014 highlighted how UK entities were “the preferred vehicle for non-resident clients” at the heart of the scandal.”

In an address to European Union Lawmakers, he said (Reuters, November 2018):

“The role of the United Kingdom is an absolute disgrace. Limited liability partnerships and Scottish liability partnerships have been abused for absolutely years”.

Regulatory or political capture?

The increasingly central role that the UK appears to be playing as a hub for financial crime is perhaps not new or surprising. The UK has indeed come to be widely recognized as one – though certainly not the only – main hub for these illegal transactions (see e.g. Radu 2016, p.15). The UK’s National Crime Agency estimates 93 billion GBP of tainted money is flowing into Britain annually (Financial Times, September 2018).

And according to the classic theory of regulatory capture (Stigler, 1970), it is to be expected that a large, wealthy and highly concentrated sector such as the UK financial industry, will be able to capture regulatory institutions and lead them to act more in its favour than in that of the (national or international) community. However, besides being a concentrated source of special interests, the financial sector also represents a large share of the UK economy. It could be the case, therefore, that the capture goes all the way up to the political system and the government (as in Becker 1983, and Laffont, 1996). So, is it the alleged crime-friendly environment in the UK financial system linked more to problems of regulatory capture, or to deeper political capture?

Already in 2004 there were worrying signs of possibly deep political capture.  At the time, Paul Moore, a senior risk manager at Halifax Bank of Scotland (HBOS), raised concerns about the bank’s risk taking and was subsequently fired by the executive James Crosby. Crosby then proceeded to become Deputy Chairman at the Financial Services Authority (FSA). HBOS then collapsed during the financial crisis of 2008 and merged with Lloyds bank, leading to one of the most concentrated banking systems in the world (the top 5 banks have 85% of the UK banking market). Many took this to substantiate Moore’s claim that the bank had been taking excessive risks. During Prime Minister’s question time in the House of Commons, David Cameron commented on then Prime Minister Gordon Brown’s decision to appoint Crosby to the FSA:

“Sir James Crosby, the man who ran HBOS and whom the Prime Minister singled out to regulate our banks and to advise our Government, has resigned over allegations that he sacked the whistleblower who knew that his bank was taking unacceptable risks.” (cited in Dewing and Russell 2016, p.165)

A suggestive episode directly involving politicians and money laundering is the case of HSBC, with headquarters in London. HSBC avoided criminal prosecution in the US and entered into a deferred prosecution agreement with the DOJ in 2012 (Department of Justice, December 2012). HSBC was found to have violated U.S. Anti-Money Laundering and Sanctions Laws by laundering billions of dollars linked to Mexican drug cartels, groups in Iran and Syria, and groups linked to terrorism. While HSBC apparently had systems to flag suspicious transactions, employees were told to disregard red flags (Garrett 2014, p.201). The case led to a 2016 House Committee report entitled “too big to jail” that was extensively used against the Democrats by the Trump presidential campaign (Committee on Financial Services, 2016).

The report states that on the 10th of September 2012 UK Chancellor George Osborne (the UK’s chief financial minister) wrote a letter to Federal Reserve Chairman Ben Bernanke (with a copy transmitted to then Treasury Secretary Timothy Geithner). In the letter, Chancellor Osborne insinuated that the U.S. was unfairly targeting UK banks by seeking settlements that were higher than comparable settlements with U.S. banks. He also worried about what criminal sanctions against HSBC would imply for financial stability. Criminal charges could also lead to a revoked license, making the bank unable to do business in the US (Financial Times, July 2016). HSBC was eventually ordered to pay a 1.9 billion dollar fine, while another whistleblower claims that the money laundering still went on (Huffington Post, August 2013).

The FSA also appeared much more concerned about criminal sanctions against HSBC than with money laundering for the bloodiest drug cartel in history (estimated to be responsible for several tenths of thousands of murders). In fact, the house committee report states that “The FSA’s Involvement in the U.S. Government’s HSBC Investigations and Enforcement Actions Appears to Have Hampered the U.S. Government’s Investigations and Influenced DOJ’s Decision Not to Prosecute HSBC” (p.24).

Things have not improved more recently. In 2013 the FSA was split up into the Financial Conduct Authority and the Prudential Regulation Authority (FCA & PRA). In 2014 the FCA & PRA came out with a note requested by the British parliament on whether financial incentives for whistleblowers should be introduced in the UK. These financial incentives, or reward programs, are used extensively in the US in tax, procurement, and securities. The FCA & PRA came out strongly against rewards in their seven-page note, yet do not cite a single piece of evidence (PRA and FCA, 2014). Most importantly, the note contains important factual misstatements about available evidence on their effectiveness that were easy to check at the time of the report (Nyreröd & Spagnolo 2017, National Whistleblower Center 2018). Nor was the note amended when one of us repeatedly communicated the mistakes to the agencies. This suggests persistent and deep regulatory capture. Consistent with this interpretation is the sanctioning behavior of UK regulators.

A blatant recent example is the ridiculous fine against CEO of Barclays Bank Jes Staley. He ordered his security team to unveil the identity of an uncomfortable whistleblower, going so far as to request video footage of the person who bought the postage for the letter. Yet, the FCA & PRA decided to just fine him £642 000 – a small fraction of his pay package that year (Reuters, May 2018). When Moore was asked about the fine he replied that “it is a very clear sign to whistleblowers not to bother” (Reuters, April 2018).

Conclusion

Is this regulatory capture, or political capture? The impressive list of consistent cases of regulatory slack and of political complacency suggests both, at least in the case of the UK. But the problem of regulatory capture in the case of financial crimes goes way beyond the somewhat extreme case of the UK. In all jurisdictions financial misbehavior has recently only led to settlements between regulators and the infringing financial institution, with settlement payments way too low to generate (financial stability concerns, and) deterrence effects. Banking regulators appear mainly concerned about banks’ health and profitability, so that large financial institutions have not only become too big to fail, but also too big to jail, and now even too big to fine, at least to the appropriate extent (Spagnolo 2015). All this even though the financial crime has been that actively supporting through money laundering criminal organizations that killed tenths of thousands of innocent people.

References

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

Managing Relational Contracts

Posted on November 26, 2018 | Policy Brief

20181126 Managing Relational Contracts Image 01

A wide range of important economic activities depend on self-enforcing informal “relational” contracts. For instance, a firm may buy a good knowing that it cannot sue the other firm if the quality is low – instead high quality is maintained through threat of the firm not making any future purchases. Relational contracts are typically modeled as being between a principal and an agent, such as a firm owner and a supplier. Yet in a variety of organizations, relationships are overseen by an intermediary such as a manager. Such arrangements open the door for collusion between the manager and the agent. We develop a theory of such managed relational contracts. We show that managed relational contracts can be both more and less efficient than the principal agent ones. In particular, kickbacks from the agent can help solve the manager’s commitment problem. When commitment is difficult, this can result in higher quality than the principal could incentivize directly. However, making relationships more valuable enables more collusion and hence can reduce quality.

Introduction

In 2006, the American retailer Aéropostale accused its chief merchandising manager Christopher Finazzo of receiving more than $25 million in kickbacks from a supplier, South Bay. Aéropostale argued that Finazzo had paid inflated prices to South Bay in exchange. Finazzo responded that he had favoured South Bay since they provided higher quality and a willingness to adapt to Aéropostale’s procurement needs. He argued that Aéropostale often remained “loyal” and “committed” to long-time “vendors even when those vendors charged higher prices” (Droney, 2017). In 2013, a jury found Finazzo and South Bay guilty of fraud. They appealed the restitution amount and in 2017 the Court of Appeals for the Second Circuit demanded a recalculation. Judge Droney argued that it was possible that Aéropostale did not lose money as a result of the kickback scheme. He argued that instead Finazzo’s “conduct may have reduced transactions costs for South Bay” and the relationship may have made it profitable for South Bay to pay kickbacks even at non-inflated prices (Droney, 2017).

Relational contracts between organizations are ubiquitous and are crucial for enforcing promises. Indeed, “lack of trust and commitment” is behind most supplier collaboration failures (Webb, 2017). The task of maintaining these relationships is often delegated to a manager like Finazzo. As illustrated by Aéropostale’s case, the firm can never guarantee that the manager will exclusively act in the firm’s best interest. Managers can exploit the (otherwise very valuable) trust relationship with their suppliers to collude with them. Does collusion between the manager and agent crowd out quality? Is collusion always detrimental for the principal?

In a new paper (Troya-Martinez and Wren-Lewis, 2018), we develop a theory of managed self-enforcing relational contracts.

Our model features a manager and an agent who have a bilateral relational contract over time (Levin, 2003). To model that the relationship is managed on behalf of a third party, we assume that profits are shared between the manager and a principal. Every period, the agent privately exerts costly effort to produce a quality which cannot be formally contracted on. To motivate effort, the manager promises to reward high quality with a price premium. This price is paid in part by the principal and in part by the manager. The manager and agent can also make side payments (which represent kickbacks, bribes or other favours) after the quality has been realized. The payment of both the price and side payments needs to be self-enforced.

Kickbacks as an enforcing mechanism

We find that collusion resulting from a managed relational contract can disincentivize quality if the manager pays a discretionary price premium regardless of quality. In particular, she may do so when she trusts that the agent will respond by making a side payment. More surprisingly, side payments can enhance a manager’s ability to commit, and hence allow higher quality. This is because the supplier will renege on paying side payments if the manager reneges on the promised price. This is consistent with evidence that side payments can help contract enforcement. Cole and Tran (2011) analyse informal payments in an Asian country and find that when contract payments are dependent on non-contractible quality, “the kickback is paid only after all contract payments have been made”. In a similar case, Paine (2004) describes how “a purchasing official called about an overdue payment for items already received, [explaining] ‘we can get you a check by next week if you can give us a discount — in cash so we can distribute it to employees’”.

Side payments are thus not necessarily detrimental for the firm when commitment is scarce. This theory thus provides an instance of the “reduced transaction costs” mentioned by Judge Droney.

More trust is not always better

Another interesting implication of a managed relational contract is the non-monotonicity of the relation between trust and efficiency. In the standard principal-agent model of relational contracts, more trustworthy relationships produce higher quality. In managed relational contacts, we show that the opposite may happen.

Figure 1 depicts the effort (and hence quality) exerted by the agent when the manager is in charge (purple) and when the principal is in charge (green). It depicts the effort as a function of the time discount factor delta, which is a measure of how valuable the relationship is (i.e. a larger delta implies a more valuable future). More valuable relationships produce higher effort, and hence higher quality, only up to a point. Once the relationship is sufficiently valuable, extra value facilitates collusion, which reduces effort. In particular, it allows the manager to pay the agent a high price in exchange for a side payment even when quality is low. This non-monotonicity result is consistent with evidence on firms’ use of guanxi, a system of trust-based “informal social relationship” in China which is often used to ensure “that a contract is honored” (Chow, 1997). Vanhonacker (2004) observes that “it would be naive to think—as many Western executives do—that the more guanxi you have on the front lines in China, the better”. Instead, he argues too much guanxi can “divide the loyalties of the sales and procurement people”.

Figure 1. Effort (or quality) with and without delegation to a manage

Source: Troya-Martinez and Wren-Lewis (2018). This figure plots the effort incentivized by the manager (in purple) and by the principal (in green) as a function of the discount factor (delta), which is a measure of how valuable the future is.

This result has important implications for policies designed to reduce fraud or corruption in contexts where relational contracts are valuable. Many such policies involve disrupting relational contracts in order to reduce manager-agent collusion, for instance by encouraging competition or increasing personnel rotation. The results of the analysis suggest that, in some circumstances, weakening manager-agent relations may simultaneously cut corruption and improve output. In other circumstances, however, there will be a trade-off, and reducing corruption may come at the cost of holding back potentially productive relationships.

Conclusion

The paper summarized by this brief is the first paper that studies the impact of collusion on relational contracts. The main take away messages are the following: First, when trust is a scarce resource, managed relational contracts are more credible and can incentivize more quality than direct relational contracts.

Second, collusion can crowd out productive effort when the relationship between manager and agent is too strong. In this case, trust is used to overpay the agent when quality is low.

Before the most recent Aéropostale judgment, it was common to use “the value of the kickbacks” as “a reasonable measure of the pecuniary loss suffered” by the third party (Droney, 2017). Judge Droney, however, argued that this “negative correlation” between kickbacks and loss should not be taken for granted. Indeed, our model has shown when this negative correlation may not exist. Hence, our conclusions may help explain why politicians and firm owners frequently turn a blind eye to employees accepting side payments (Banfield, 1975). On the other hand, our model also identifies when side payments undermine effort. In other words, it emphasizes the complex relationship between kickbacks and productive relational contracts. This complexity needs to be accounted for in policymaking.

References

  • Banfield, Edward C. 1975. “Corruption as a Feature of Governmental Organization.” The Journal of Law & Economics, 18(3): 587-605.
  • Chow, Gregory C. 1997. “Challenges of China’s economic system for economic theory.” The American Economic Review, 87(2): 321-327.
  • Cole, Shawn; and Anh Tran. 2011. “Evidence from the Firm: A New Approach to Understanding Corruption.” In International Handbook on the Economics of Corruption Vol. II. , ed. Susan Rose-Ackerman and Tina Soriede, 408-427. Edward Elgar Publishing.
  • Droney, J. 2017. “United States v. Finazzo.” 14-3213-cr, 14-3330-cr.
  • Levin, Jonathan. 2003. “Relational Incentive Contracts.” American Economic Review, 93(3): 835-857.
  • Paine, Lynn S. 2004. “Becton Dickinson: Ethics and Business Practices (A).” Harvard Business School Case 399-055.
  • Troya-Martinez, Marta; and Liam Wren-Lewis, 2018. “Managing Relational Contracts”, CEPR Discussion Paper Series DP12645 (v. 2).
  • Vanhonacker, Wilfried R. 2004. “When Good Guanxi Turns Bad.” Harvard Business Review, 82(4): 18.
  • Webb, Jonathan, 2017. “Why Do Supplier Collaborations Go Wrong? What Can Be Done About It?”, Forbes, 28 September 2017.

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.