Finance: Research, Policy and Anecdotes

Supervising auditors: need for reform

Last week, the Lisbon-based CIRSF (Research Center on Regulation and Supervision of the Financial Sector), joint with CMVM (the Portuguese Securities Regulator) and the Florence School of Banking and Finance, organised a very timely and interesting panel discussion on the Supervision of Auditors: Lessons Learned from Landmark Cases, with a number of legal scholars and economists. In the centre of the discussion were recent accounting/auditing scandals, including Wirecard, and how the regulatory supervisory frameworks have to be adjusted. I was asked to provide some concluding remarks, which I used both to summarise the discussion and to provide some additional perspectives.

 

As economist, my first concern is: why do we care about these scandals? Well, we need functioning capital markets for resource allocation, which is especially important coming out of the pandemic.  This requires sufficient information for investors and investors’ trust in the accuracy of such information. Scandals like Wirecard come at the end of a long misallocation process and undermine investors’ trust.  It is clear that criminal activity such as in the Wirecard case can never be completely prevented; what a functioning regulatory and supervisory framework can do is to detect such fraud earlier and thus minimise losses.

 

Auditors are supposed to provide a third-party independent assessment of whether financial statements are free of material misstatements and fraud, so have the function of monitors. But who monitors the monitors? And where does the buck stop? It is clear that German authorities have failed, but what are the necessary reforms? One suggestion has been to move from national to supranational supervision within the European Union - similar as in banking, with the additional motivation that a functioning and effective capital market union can benefit substantially from common regulation and supervision.  And as in the case of banking, it is not necessarily about centralisation (which carries not only benefits but also shortcomings) but about diversity of approaches and building a joint European culture.

 

On a more conceptual level –what is the role of public vs. private enforcement.  Andrei Shleifer and co-authors find in a seminal paper “little evidence that public enforcement benefits stock markets, but strong evidence that laws mandating disclosure and facilitating private enforcement through liability rules benefit stock markets.” This would suggest not necessarily a stronger oversight, but stricter liability rules. In terms of liability, there is a clear trade-off, however,– on the one hand, this might provide auditors with more discipline, on the other hand, it might also raise prohibitive entry barriers into the auditing profession.

 

The world is always more complicated than in our regression models.  I believe we need both, more supervisory and more market discipline.  Industry self-regulation (as is the case for the first level of auditor oversight in Germany) can work in certain circumstances (closed and concentrated market with high stakes for market participants, as in the case of the German private banking market before 2000), but it is less likely to work in open and competitive markets as we have them now. European markets simply do not work with national regulation and supervision.

 

Often the argument has been made for more competition in the auditing market, actually an argument that regularly comes up after every scandal. I am not convinced that more competition (in the form of more auditing companies) helps. It might actually drive down standards as long as companies can choose their auditor. More competition can drive down franchise values of incumbent auditing firms and thus lead to auditors being less careful rather than more. What seems urgent is to force firms to change their auditors on a regular basis.

 

As so often, what stands in the way of meaningful reforms is politics. On the upside, crises are often good moments to trigger change. Unlike in banking, however, the pressure in this case might weaken rapidly, so events such as this one are critical to maintain the pressure.