The Failure Of Private Auditing

On this blog I often discuss market failures and the need for government action to correct them. It is necessary for regulation to keep the free market from getting too wild. But is government the right answer? Can the market not control itself? Could companies not bind together to create industry standards without government bureaucracy? Can private regulators not ensure proper standards are met without the need for state intervention?

The logic behind it is simple. A private business, say an accounting firm offers to exam the books of a major corporation. The accounting firm is dependent on its reputation for business and hence has an incentive to do a good job. Word will spread about the reliable firms and they will be the industrial standard. If one is lax with its standards, it will be replaced by one of its competitors. Thus once again the day is saved thanks to the magical workings of the free market, all without any need for the government.

As anyone who reads the newspapers knows, the real world is different. The notion of private regulators keeping corporations in check is a manifestation unfortunately missing from the markets. Rather than being watchdogs holding the market in check and guiding investors towards the safest options, rating agencies were cheerleaders for the riskiest banks and inflated the bubble. Supposedly independent auditors Arthur Anderson went bankrupt after being caught colluding in the deceit of Enron. Not only did they fail to blow the whistle on the fraud, they joined in. Just how little changed was revealed five years later during the Financial Crisis when panic spread when bonds that had high ratings turned out to be complete junk. The same auditors emerged unscratched and are still receiving large contracts ensuring that history will repeat itself.

The reason for this is due to incentives. As accountancy firms and other nominally independent firms get paid by the companies they are supposed to regulate, they have little incentive to criticise them. After all, if their report is too negative, they risk losing their client who can find a new and more agreeable monitor. Companies only spend money if they expect to make a return on it. Hence hiring an “independent” auditing firm is just paying for a service they expect will boost their image. No one pays good money for negative publicity; rather they only hire an audit as a PR exercise. As a friend who works for an auditing company told me, the companies who pay for an audit decide what the report says. Why bite the hand that feeds you?

In 1957 Edmund Vogelius, the Vice President of Moody’s (before it became the leading rating agency) hit the nail on the head when he said: “We obviously cannot ask payment for rating a bond. To do so would attach a price to the process, and we could not escape the charge, that would undoubtedly come, that our ratings were for sale.”

This has been confirmed by a former senior President of Moody’s who acknowledged there was a conflict of interest from being paid by those they are supposed to monitor. He also told how Moody’s has a long standing culture of “intimidation and harassment” to ensure the ratings match what the clients want. Staff who compiled reports that didn’t please their clients were seen as losing Moody’s business and disciplined or even fired. If you pay the piper you get to pick the tune.

Private audits also suffer from the problem of diversity. Unlike the government, there is no one standard to compare all companies with. Each company uses its own measurements, its own calculations to compile its reports, which makes it very difficult to cross compare two separate reports. The whole point of an audit is to inform investors of the state of the firm, something which is greatly obscured by the lack of central standard.

Private industry standards also fail to work. The reason is also obvious. Why would you set a test unless you knew you were going to pass? If you had the option of deciding which questions would be asked in an exam you would sit, isn’t obvious that you would choose questions that suited you? No company is going to voluntarily be a member of a group that criticises it, therefore voluntary bodies are toothless talking shops that avoid criticising anyone for fear of losing membership. Hence the rules suit the people who make them, the businesses themselves. Private auditing isn’t good for the consumer; it’s only good for businesses. They are also largely ineffective as each member wants everyone else to change to suit themselves, without them having to change. With no overall body to force the issue agreement and co-operation is rare.

So what should we do? The financial crisis showed that regulation is absolutely essential and also that it cannot be left to private rating agencies. There is simply too great a conflict of interest and incentive to report what the client wants. Therefore I believe we should have a government auditing company. It would provide standardised ratings allowing accurate comparisons between firms. As compliance would be mandatory, there would be no conflict of interest or perverse incentives. With the power of the law behind them regulators could enforce compliance better than private auditors afraid of losing clients and dependent on the firms for all their information. There is a risk of regulatory capture but it can’t be any worse than the current situation where the supposed private regulators are completely captured by their clients.

We have tried leaving regulation and auditing to the private sector. It failed. It is time for the government to step in. We cannot afford another failure.

14 thoughts on “The Failure Of Private Auditing”

  1. In addition to all the things you mentioned, the incentives for “the firm” are different from the incentives for the individuals within the firm. A reputation for dishonesty, not to mention lawsuits, will be disastrous for the firm in the long run, but by this time the individuals responsible for the bad reputatin and the lawsuits will have disappeared, and, even if they’re still around, won’t suffer much.

    1. Exactly. There interests of the individual and that of the firm can often grow apart. For example during the financial crisis, people working in the sales division of a bank followed their self-interest by making as many loans as possible. When many of these people could not pay their loans, this was not the sales staffs problem but got shifted to another division.

      I noticed this recently in my summer job. It was in the interests of the firm that we be as polite to customers as possible, but it was in the interests of the staff to get the job done as fast as possible to avoid reprimand from their supervisors. The result? Staff was fast to the point of being rude with customers, but were able to avoid criticism from their supervisors.

  2. Did you know that people were obliged, **by the government**, to deal with their approved credit rating agencies? Did you mention that?

    “It all started back in 1975, when the Securities and Exchange Commission began to use such ratings to calculate how much capital broker-dealers should be required to hold. To prevent the proliferation of fly-by-night raters, the SEC designated a handful of firms as “nationally recognized statistical rating organizations,” or NRSROs. By the time the financial crisis hit, NRSRO ratings were embedded in thousands of regulations and private contracts, if not more, determining what securities money-market funds would be permitted to own, how much collateral counterparties would have to put up in trades, and countless other arcane matters. At the hearing, Mark Van Der Weide of the Federal Reserve testified that Fed regulations contained no fewer than 46 references or requirements regarding credit ratings.”

    1. Yeah I knew that. But the problem isn’t with any specific firm but rather with the process in general. Ireland does not have any such government support for agencies and the problem is just as bad.

  3. Besides anything else, it’s completely unrealistic to expect to be told, for free, the probability of a bond defaulting. This is another one of those “the market’s not perfect, therefore we need the government” games.

    1. Well the old way used to be to charge everyone who wanted to know the details of the company for the report. However, this has problems of its own, such as difficulty of leaks and informational advantage to some over others.

      “This is another one of those “the market’s not perfect, therefore we need the government” games.”

      The post in general is a response to your frequent claims that market failures can be solved by the market itself and that private regulation can do the job of the government. This post is about why they cannot.

      1. Can we please make a distinction between auditors and accountants on the one hand, and credit rating agencies on the other? Auditors and accounts prepare financial statements, while credit rating agencies study the company and provide a report on its ability and willingness to meet its financial obligations. You want to nationalise one or both of these functions?

        Did you ever hear of Arthur Andersen? They failed to audit Enron and other companies properly, and that’s how the “Big 5” accounting firms became the “Big 4”. Nobody wanted to hire them anymore because investors wouldn’t trust the financial statements they produced. You propose to replace a system whereby companies seek accountants who will produce financial statements which investors trust, i.e. a competitive environment in which accountants are permanently seeking to get reputational advantages over each other, with an environment in which none of these pressures exist? And this is on behalf of investors?

        As for the credit rating agencies, you didn’t really answer my point. I still maintain that you are in a fantasy land if you think (a) that precise probabilities exist with respect to default likelihoods, and (b) that such likelihoods would be given out for free.

        The credit rating agencies are actually quite successful in the sense that their ratings are correlated very strongly with default likelihoods. They can’t predict the future (anybody who can do that can immediately become a millionaire); they can only give their appraisals of a situation. However, market participants often figure things out first and sell off the bonds in advance of the credit rating downgrade. Market participants are incentivised to do the research faster and better because their own money is at stake. So the credit ratings are not too useful if you want to “beat the market”, but they are still very useful if you want to avoid holding a bond that defaults. It’s not a perfect system, but nationalising them and replacing them with a single agency would be another completely pointless exercise that would remove all elements of competition between them.

        I hope you can escape from this “the market’s not perfect, therefore the government” meme. The only difference between a government and a very large corporation is an army, a police force, and a bunch of prisons, right?

        1. GM, you seem to suffer from 2008-amnesia causing you to have absolutely no recollection of the Financial Crash and requiring me to remind you repeatedly. I’ll be brief. There were many rating agencies who examined the books of major banks and investment firms and declared that there were no problems. Imagine everyone’s surprise when these banks turned out to have major problems and some were even insolvent. However, the agencies received no punishment and they remain auditors of banks and the government. The market has failed to discipline them.

          In my post I explain that this was due to the conflict of interest of agencies who wanted to keep their contracts and hence didn’t report suspicious issues. I also discuss how competition makes the problem worse not better.

          To my disappointment your comment didn’t address any point I made in the post, but instead took off in a tangent. Is it too much to ask that you read the post you are commenting on and respond to it?

          “I hope you can escape from this “the market’s not perfect, therefore the government” meme.”

          You keep throwing out dismissive remarks like this without every explaining them or showing why the government isn’t the answer to market failures. Why not?

          “The only difference between a government and a very large corporation is an army, a police force, and a bunch of prisons, right?”

          Huh? I’m afraid anarchist quotes have little effect on me, though I’m not such what your aim was with this one.

          1. Hi there.

            Firstly, the rating agencies do not remain auditors of the banks – auditing is a separate function.

            Secondly, there might not have been any problems if housing was not in bubble territory. Detecting and preparing for the collapse of a bubble is an extremely difficult task. And the ratings agencies are not economists: they will try their best, but they can’t be expected to predict the economy better than anybody else.

            Most people trusted Greenspan and Bernanke, and looked to them and for guidance on the economy.

            Bernanke, October 2005:” Although speculative activity has increased in some areas, at a national level these [house] price increases largely reflect strong economic fundamentals, including robust growth in jobs and incomes, low mortgage rates, steady rates of household formation, and factors that limit the expansion of housing supply in some areas.”

            Bernanke, March 2007: “the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.”

            Bernanke, July 2008: “The GSEs are adequately capitalized. They are in no danger of failing.”

            No prediction of a housing collapse from the Fed (unsurprising to me, given my belief that the Fed and Congress were largely responsible for the bubble). If the Fed says everything is ok, it would be rude for the credit rating agencies to assume that housing is going to collapse, right? How do you propose that Bernanke and his colleagues be punished?

            1. You do realise that the title of this post is “The Failure Of Private Auditing”? That I specifically discuss auditing of banks in the post?

              Its funny how Austrians praise the market as the best disperser of information and sing of how much better it is than the government. They talk about how the markets know so much more than the government etc. Then when the crash happens suddenly they drop everything and forget all their plaudits. Suddenly, the market is just as flawed as everything else and you really can’t expect it to know something the government doesn’t?

              “it would be rude for the credit rating agencies to assume that housing is going to collapse, right?”

              I don’ think credit agencies are overally concerned with being polite. After all it would be rude to raise the interest rate on government bonds or to shut the government out of the bond market, but that doesn’t stop them.

              Do you realise how silly your argument is and how you are clutching at straws to defend it? Best to cut your losses on this one and try again next time.

              1. So you’ve got nothing to say about Bernanke’s total failure. Instead of blaming the captain of the ship and his deputies at the Federal Reserve and other central banks, you want to crucify other people. I wonder why!

                To be honest, it’s not clear to me that you know much about auditing or about credit analysis. There seems to be a lot of confusion in your mind about which is which, or else you are just making yourself sound uncharacteristically unclear.

                As for the market being flawed, etc., I have told you many times by now that I do consider the market to be flawed. Humans are flawed, and therefore markets are flawed. Seriously flawed, and flawed in many different ways. I am in no sense a utopian.

                But this is why your arguments come across as religious in nature: because you think there is a solution, and the solution is obvious to you: the government. Just like the religious person who thinks that “God made it” or “because God says so” is a good answer to a question. Unfortunately, it’s not. If you don’t know the answer, there might not be an answer, or maybe we’ll never know it.

                Better to admit that there are no easy answers than to choose an obvious answer which is probably wrong.

                1. Why do you keep lumping me together with Bernanke? I don’t agree with him and I never have. Post Keynesians don’t. Criticising him doesn’t affect the debate at all.

                  Whenever you say the market is flawed you always cover by saying that private firms could audit other private businesses and correct the market failure without the need for the government to intervene. Here I directly address this argument and show that private auditors or regulators cannot solve the problem.

                  I notice that you have yet to say where you disagree with the argument but have argued over semantics and side points which is much more reminiscent of religious debates than anything I have said.

                  I never claimed this would be an easy solution and private auditors would certainly oppose the advance of government intervention. However, I spelt out why I think government intervention is the best solution, rather than just assuming so. Only in religious debates re issues dismissed out of hand. In economics, you have to at least consider the other point.

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