Bernard Madoff stands accused of a colossal investment scam. The scandal threatens severe damage to institutions that deposited money with him. And it raises yet more questions about the adequacy of financial regulation. But its most lasting effect for the financial system, as opposed to the investors who have suffered alleged fraud, should be a change in the way that investment returns are scrutinised. The affair is a disgrace, and a warning. Month after month, regardless of market conditions, Madoff’s funds booked implausibly consistent trading profits. Investors who believed they were benefiting from these paper returns had no incentive to investigate Madoff’s methods or inquire into the firm’s idiosyncrasies. Eventually, provided that distressed assets are written down promptly, the Western financial system will emerge from its contagion of bad debts. When that happens, a more realistic accounting of financial risk needs to be established. Policymakers, regulators and investors should scrutinise the way that abnormal profits are earned.

The scale of Madoff’s alleged fraud — with estimated losses of $50 billion — belies its unsophisticated character. The operation appears to have been a “Ponzi scheme”, named after Charles Ponzi, who in the ’20s swindled tens of thousands of American investors while promising to double their money. It involved paying out supposed investment returns that were not genuine, but were merely the deposits paid in by other investors. The exposure of banks and investment funds to Madoff’s operations threatens huge losses for many already stricken institutions. And the affair has important implications for the future shape of the financial system. Madoff’s operations comprised a hedge fund and advisory business. Hedge funds are unregulated investment vehicles for very wealthy private clients...

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