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Trust and Delegation

Stephen Brown, Stern School of Business, NYU

11th Jun 2010  10:30 am - Room 215, H69 - Economics and Business Building

Due to imperfect transparency and costly auditing, trust is an essential component offinancial intermediation. In this paper we study a sample of 444 due diligence (DD)reports from a major hedge fund DD firm, many of which indicate a lack of transparencyabout past legal and regulatory problems, failure to use a major auditing firm and the useof internal pricing. Previous studies have examined the empirical correlates of the limitedinformation revealed in the mandated hedge fund disclosures of 2006. This study usesevidence of inadequate or failed internal processes to derive a simple and direct measureof operational risk that is consistent with the Basel definition. Exposure to this riskincreases the likelihood of subsequent poor performance. Since these DD reports areperformed after positive performance it is important to control for potential bias due tothis and other conditioning factors. Although our sample is not sufficiently large todetermine whether this is a priced source of risk, it does not appear that exposure tooperational risk influences in any way the tendency of hedge fund investors to invest onthe basis of past high returns. Our study emphasizes the importance of informationverification in the context of financial intermediation.