Financial earthquakes have a way of revealing weaknesses in regulatory systems and uncovering wrongdoing.
So it is with the current financial crisis, which revealed many flaws in the operations not only of the Securities and Exchange Commission, but also of the Federal Reserve and other agencies.
The latest is the huge Bernard L. Madoff scam.
Without the market collapse brought about by the mortgage crisis, Mr. Madoff might well have been able to continue his alleged $50 billion Ponzi scheme uninterrupted for months or years more.
The scandal stunned Wall Street and the entire investment community, an awesome achievement given the shocks the massive financial collapse this year already has inflicted.
The Madoff scandal revealed by the crisis has significant lessons for the investment community.
It showed that investors — often very successful, very smart, very sophisticated people — still can be easily deceived, despite many lessons this decade of other major corporate, accounting and money management scandals.
Second, the Madoff case showed the due-diligence failures of consultants that recommended Madoff, and of hedge funds of funds that invested with Madoff. The hedge fund-of-funds' business model purports to offer access to the best funds, as well as diversification and, most importantly, due diligence.
Proper due diligence would have detected troubling signs of the Madoff investment management operations, especially in the unremarkable, tiny firm that audited its financial statements and the outlying consistent investment returns.
Third, the Madoff scandal revealed major flaws in the SEC and other agencies that serve as a catalyst for an overhaul of the supervision of the markets and investors.
The Madoff scandal didn't have to reach its massive scale. It could and should have been detected and stopped years ago. Fraud will always exist, but it is possible to detect it early, if regulators are looking for the right signs.
In recent months, many investment analysts, academics and practitioners have discussed the limitations of risk management models that have had a tough time protecting against the hurricane of the credit crisis that swept away much of everything in its path, from equities to fixed income.
But the Madoff scandal was no storm of systematic risk. It was an unsystematic risk that investors could have detected and avoided by due diligence.
The scandal should reinforce with pension funds, endowments and foundations the importance of due diligence, written procedures and documentation, as well as understanding an investment strategy.
Fund sponsors should place under new scrutiny any investment manager or other financial institution that had assets with the Madoff firm, or conducted other business with it. They should examine any failure of diligence. The financial management firms themselves should re-examine their own controls, reporting on their findings.
Investors cannot rely on the protection of the SEC. After the scandal broke, Christopher Cox, SEC chairman, said in a statement that agency officials learned of “credible and specific allegations regarding Mr. Madoff's financial wrongdoing, going back to at least 1999” that “were repeatedly brought to the attention of SEC staff, but were never recommended to the commission for action.”
The SEC properly is undertaking a review of its failure to detect the fraud. Congress should examine how the SEC should be overhauled to improve its oversight. The Madoff scandal is only the latest evidence of the SEC's lax oversight in examination and enforcement.
The Madoff failure is another setback to the restoration of investors' confidence in markets.
Yet institutional investors, in particular, must keep perspective. They are the market. They have the resources and the capabilities to do their own due diligence in the evaluation of money management firms, their leadership and their investment operations.
