In the sports world, there’s a saying that goes: “If you’re not cheating, you’re not trying.” Unfortunately, the same is probably true in business — a fact regulators should keep in mind when they are making policy and meting out discipline.

This attitude is highlighted in a recent paper by professors Leemore Dafny and David Dranove at the Kellogg School of Management at Northwestern University in Evanston, Ill. (They conducted the study for the U.S. National Bureau of Economic Research.)

The study found that managers who fail to exploit regulatory loopholes are vulnerable to being replaced. In an industry rife with cheating, those who don’t cheat are perceived as not trying and often end up getting fired.

The proof for this hypothesis is the U.S. hospital industry. The paper notes that a change to Medicare rules in 1988 opened a loophole in the Medicare payment system. That gave hospitals the ability to fatten their margins by fiddling with the way patients’ medical conditions were coded to maximize reimbursement. The study notes that the fiddling was so egregious in some cases that it rose to the level of fraud.

The change, the paper suggests, provided hospitals “with an opportunity to increase operating margins by five or more percentage points by ‘upcoding’ patients to more lucrative codes.” Hospitals that did so obviously made more money by cheating the system (particularly in an industry in which margins were running at less than two percentage points at the time).

The question for front-line managers was whether they should exploit the loophole to boost margins — even though, from a moral perspective, such a move was clearly wrong. However, managers who wanted to keep their jobs were wise to cheat the system. The professors found “that ‘room to upcode’ is a statistically and economically significant predictor of whether a hospital replaces its management with a new team of for-profit managers.”

So, managers who didn’t take advantage of the system often lost their jobs. And, if there was any doubt about why they were replaced, the study found that hospitals that replaced their managers went on to exploit the loophole more than hospitals that didn’t replace them.

“Firms in regulated industries often face opportunities to enhance profits by taking advantage of regulatory loopholes. Managers who overlook these opportunities risk replacement by executive teams who are willing and able to seek these rents,” the paper finds.

These conclusions have troubling implications for regulators trying to craft rules in any regulated industry: any loophole must be exploited by anyone who hopes to keep his or her job.

This is problematic, for a few reasons. Firing people for failing to exploit regulatory gaps is substantively different than firing them for incompetence. The paper notes that dispatching incompetent management can lead to more efficient use of resources by better managers, but punishing lack of avarice doesn’t necessarily have similar results.

The paper also points out that when firms operate in a public market — in which underperforming firms are vulnerable to takeover and having management turfed out — “agency problems” bet-ween firms and regulators are intensified. Regulators can’t trust firms to do the right thing in an environment in which they’ll fall into rivals’ hands unless managers exploit every opportunity for profit.

Dafny suggests the study results imply that regulations must be tougher in industries in which firms that play nice are liable to be taken over and their management terminated. “The paper suggests that regulatory oversight must be tighter in industries with active markets for corporate control,” she says. “If executives will be ousted for not exploiting regulations in the short term, it is difficult to rely on a long-term ‘implicit contract,’ whereby regulators and the regulated agree to be bound by mutually beneficial but unenforceable rules.”

In the securities industry, a mitigating factor may be market discipline — at least, on the institutional side, in which sophisticated players are typically on the other side of transactions. Cheaters risk being punished by peers, which may keep firms playing by the rules.

The retail market is not as equipped to discipline firms. Most investors don’t know the rules or the loopholes, so won’t know when rules have been broken or loopholes have been exploited. Whereas Medicare was too big and bureaucratic to know it was being fleeced, the average retail investor is too small and ill-informed to detect when he or she is being abused. That’s why regulators are needed to look out for investors’ interests.

@page_break@Regulators should remember the plight of hospital managers when they’re deciding how far to trust their charges. IE