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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

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Fri, 25 Nov 2005

Private Sector Watchdogs: Reputational Capital and Financial Capital

In my earlier posting on private sector watchdogs, I argued that these watchdogs can be sued for negligence while government regulators cannot. Commenting on my post, Dr. Ajay Shah asked whether there are many private sector watchdogs who can pay serious money in the event of a lawsuit.

My initial response was that audit firms and investment banks have often paid large amounts of money to settle lawsuits against them. But this exchange set me thinking about the capitalization of private sector watch dogs. Information about the capital and financial position of audit firms is rather scanty. But some information is available from the July 2003 report of the US General Accounting Office ( “Public Accounting Firms: Mandated Study on Consolidation and Competition”) and the July 2004 report of the UK Office of Fair Trading (“An assessment of the implications for competition of a cap on auditors’ liability”).

The US data indicates that audit fees are about 0.15% of the revenues of the firms being audited while the UK data suggests that the audit firms have capital of about 4-5 times their annual audit fee income. Combining the two suggests that capital is less than 0.75% of the revenues of the companies being audited. To my mind, this is a very low amount of capital in relation to the potential liability. The low capital might be an important reason why the audit firms have lobbied hard for a cap on auditor liability.

The low capital might also explain the extremely high degree of concentration in the audit business with the Big Four accounting for practically the entire audit business of large companies. When audit firms rely on reputational capital rather than monetary capital, this becomes a very strong barrier to entry. A different approach to auditing would involve audit firms with large amounts of financial capital. Regulatory changes would be needed to allow audit to be done by public companies rather than private firms. Regulatory changes would also be required to allow audit firms to solicit business and advertise aggressively. This would dramatically ease entry into the audit business and make it highly competitive. For example, one could imagine a Warren Buffet starting a new audit company with say $10 billion of capital and gaining business by aggressively advertising more stringent auditing standards than the existing audit firms. Many institutional investors may then put pressure on companies to use the new audit firm even if it is significantly more expensive.

There is no reason why the same strategy of relying on financial rather than reputational capital cannot be applied to credit rating agencies and other private sector watchdogs.

Posted at 18:30 on Fri, 25 Nov 2005     1 comments     permanent link


Ajay Shah wrote on Sun, 27 Nov 2005 13:54

Re: Private Sector Watchdogs: Reputational Capital and Financial Capital

I am, of course, most supportive of any and every way in which the private sector can be brought to perform what are traditionally considered `regulatory' or `oversight' functions.

In the case of auditing, I think the case is clear and strong. If auditors have strong financial liability, then they have an incentive to do a good job. This ties in tightly with performance because an auditor can be clearly held responsible for a specific piece of checking informationi that he did or did not do. The work of an auditor is relatively black and white.

In contrast, the work of a credit rating agency is necessarily gray. The Agency merely gives you it's opinion that the Pr(default) is (say) 10%. After that, it cannot be held accountable whether default takes place or not, because these outcomes do not serve as a performance evaluation upon the probability statement.

I feel that a credit rating should have the status of an `analyst report' on the stock market. It's the view of an individual. You may want to chat about it in a cocktail party, but for the rest, it should have no special status.

Given the lack of accountability of credit ratings or (worse) corporate governance ratings, I am a big skeptic on their role in public policy. When credit ratings go into pension fund regulation or (worse) Basle II, I think we are merely setting up an expensive diversion of resources with no clear accountability.

In short, I am all for private watchdogs when there is clarity in the principal-agent structure, and when the agent is able to pay big financial liabilities for being wrong. If the financial liability is lacking, or if the performance of the agent cannot be measured, then the slow processes of governance and building a SEBI seem like the better (and a lot cheaper) path.