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FRM Part II · FRM Exam Part II · Madoff: A Riot of Red Flags

A risk manager reviews why regulators failed to detect the Madoff fraud even though an outside analyst submitted detailed, specific evidence several times. Which factor most directly explains the failure, as discussed in the reading?

The failure stemmed mainly from examiners lacking the expertise and persistence to independently verify trading activity with third parties such as the clearing agency. The evidence was provided repeatedly, but regulators did not test the claims against external records, so the fraud continued undetected.

  1. AThe fraud was too small relative to the market to attract regulatory interest
  2. BExaminers lacked the skills, follow-through and willingness to verify trading with independent third parties such as the clearing agencyCorrect
  3. CNo regulation required Madoff to register as an investment adviser
  4. DMadoff's returns were volatile enough to trigger automatic regulatory alerts

Explanation

Examiners had the red flags but did not verify trades independently, for example with the clearing agency or counterparties. The fraud was huge, returns were unusually smooth rather than volatile, and the issue was enforcement and competence, not absence of a rule.

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