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.