Of Creative Destruction, Auditors and Ratings Agencies

Among the lessons to be learned from the financial crisis, so far we've rightly heard a lot about self-restraint and more effective financial regulation. But we've not heard much about how the market for external audit services and credit ratings will change to help protect taxpayers from footing the bill for future bail-outs.

There have been many significant accounting scandals in the decade since the the Dot-com bubble burst on 10 March 2000. Enron died in 2001, eventually taking accounting giant Arthur Anderson with it. WorldCom filed for Chapter 11 in 2002, the same year the Tyco scandal broke - among many others. In 2003, the Ahold and the Parmalat scandals broke. In 2004, it was AIG under investigation, which duly restated its net worth as being 3.3% lower. Madoff's activities went on unchecked until 2008. Meanwhile investment banks packaged the riskiest types of mortgages into allegedly low-risk bonds as due diligence methodologies became outpaced by the sheer scale of debt issuance, seriously undermining confidence in the standards set by ratings agencies.

More scandals and surprise losses are on the way. Only yesterday, internal auditors at 75 major UK corporations recently confessed in a survey conducted by a major accounting firm that they are failing to stem the rising tide of fraud, and are increasingly vulnerable to it:

"The three most common types of fraud were misappropriation of assets, suffered by 31 per cent of companies, improper expenditures (22 per cent) and procurement fraud at 16 per cent. Poor financial controls and collusion between employees and third parties were seen as important drivers of fraud."

In these cases one might conclude that accounting, financial controllership, auditing and the assessment of credit risk all succumbed to the same illness. In fact, there are more similarities than differences between the activities of ratings agencies and audit firms, so they ought to share the criticism of the state of the market for those activities.

There have always been arguments about where the scope of external audit responsibility begins and ends, and whether firms who offer audit services should continue to be free to also offer accounting, regulatory and risk management advice - or, indeed, credit ratings - where they make most of their money. But the fundamental reality is that auditors and ratings agencies purport to offer to external stakeholders some verification of a corporations' activities, yet their fees are paid by the corporations they audit or rate. So there are inherent conflicts of interest to be managed right from the start. We've also now reached the awkward stage where only four firms audit most of our major corporations, including banks. And only three ratings agencies assess the risk of default on most of planet Earth's 'investment grade' securities. Worse still, in May 2010, two of the 'Big Four' major global audit firms said they were planning to launching ratings businesses.

Little wonder that the Financial Reporting Council's Professional Oversight Board believes that the Big Four accounting firms outweigh their regulatory constraints (hand-wringing we've seen before). And that the G20 leaders wish to reduce their reliance on ratings (see the October Basel Committee report), while global regulators are calling for an alternative to single-grade ratings by rating agencies (note the particular frustration of the SEC and the FSA on this front).

Worryingly, however, we are only seeing expressions of frustration from the bodies we rely upon to control the situation. Certainly, the European Commission's dithering over the stranglehold of the Big Four suggests we won't see a more robust approach in the EU any time soon.

Experience suggests that these sorts of issues are only resolved after a crisis has occurred - the process of creative destruction traced in The Ascent of Money. It is also said that industries naturally concentrate and fragment, although customer dissatisfaction and the competitive activities of players normally considered to be in other markets play a role - e.g. social finance models involve parceling loan amounts into tiny loans at inception, rather than introducing layers of securitisation.

So, eventually, life will get pretty rough for the auditors and the ratings agencies. And for the taxpayer. Again.

Slim comfort.

Image from Critter's Crap.