Financial fraud and investor awareness

Abstract

In a retail financial market, firms strategically choose whether to commit financial fraud to exploit naive investors who are unaware of such practices. In a leader-follower setting, we identify a segmented equilibrium in which an honest firm offers a normal product to sophisticated investors, while a dishonest firm offers a fraudulent product that targets naive investors. Competition may not benefit investors because the presence of a rival firm reduces the profitability of offering a normal product and thus discourages honest behavior. If there is a positive cost of entry, the incumbent firm may strategically switch to offering a fraudulent product to deter entry. As a result, policies that alter the entry barriers to the market may have unintended negative effects on welfare. In the segmented equilibrium with free entry, the honest firm has an incentive to disclose information about financial fraud and steal market share from the dishonest firm. However, this incentive is limited because such disclosure may prompt the dishonest firm to deviate and compete for the normal product market.