What is the price of broken trust? In a study of investor behavior in the wake of the massive Bernard Madoff Ponzi scheme, Dyson assistant professor Scott Yonker and two co-authors found a way to estimate for the first time the cost of the scandal to the financial intermediation industry. Their study, “Trust Busting: The Effect of Fraud on Investor Behavior,” was recognized with the Wharton-WRDS (Wharton Research Data Services) Best Paper Award in Empirical Finance at the Western Finance Association Conference in June.
Yonker, who is the Lynn A. Calpeter Sesquicentennial Faculty Fellow in Finance, collaborated on the study with Umit Gurun of the University of Texas at Dallas and Noah Stoffman of Indiana University.
Focusing on the behavior of investors relative to their geographic and social proximity to Madoff’s victims, Yonker and his co-authors established a correlation between degree of exposure to the 2008 scandal, whether through news or social channels, and the movement of funds out of accounts managed by registered investment advisors and into banks. They estimate that the loss of trust in financial advisors that resulted from the shock of the Madoff fraud cost the intermediation industry $430 billion in investments—about 25 times the $17 billion in restitution that Madoff was ordered to pay his victims—with the greatest losses concentrated in areas with the greatest numbers of defrauded investors.
The study found that investment advisors who, like Madoff, had custody of investors’ assets suffered the largest loss of business from the trust shock, and those with clients in geographic areas with a higher concentration of direct victims were about 30% more likely to go out of business as a result. Those firms that offered trust-building advisory services, such as financial planning, were better able to maintain the trust of their clients and suffered fewer withdrawals than the others. Data from four years after the shock showed no reversal of the flight away from money managers, suggesting that the damage done to investors’ trust may have long-lasting consequences.