Thoughts, essays, and writings on Liberty. Written by the heirs of Patrick Henry.

June 7, 2008

Do Government Regulators Protect Investors?

by tarran

In a thread at Reason’s hit and Run, during a discussion where Enron was cited as an example of what happens when governments fail to regulate private behavior, frequent commenter fluffy wrote an insightful comment which is well worth reading in full. The second half of her comment read:

It is customary in the US for the Wall Street markets to be seen as the embodiment of unbridled capitalism, and they really aren’t. What they are is a complex system of federal regulation designed to foster “confidence” in publicly-traded companies, to facilitate the growth of those companies via debt and capital aggregation and intermediation. Their existence is a deliberate policy choice of the state, to attempt to use regulation to make it possible for small investors to trust people they have never met and of whom they have no knowledge – in order to allow corporations to grow larger, or to grow more quickly, than they would have in the days when trust was based on the personal or family qualities of the entrepreneur behind the corporation or the bank doing the underwriting for the corporation’s stock. The complex rules regarding accounting, corporate reporting, transparency, etc., are designed to allow corporations and investors to trust each other without actually having to do anything to establish trust beyond participating in the regulated system.

This has two unintended consequences. First, it allows corporations to be much larger and more powerful than they would otherwise be. The social and economic effects of this are open to debate. Second, it creates a situation where the “incentive problem” MNG talks about looms pretty large. As long as a corporation can do the bare minimum necessary to keep the SEC from shutting them down, they are in a position to command broad respect from investors that they may not deserve. The highly technical nature of the regulations in question also creates a milieu where a company like Arthur Andersen can begin to see its task as ensuring technical compliance and nothing else; the exotic techniques their consultants were using to build earnings or smooth earnings in that context begin to look not like “frauds” but simply “innovation”. By trying to facilitate the operation of the market, the state has in a sense corrupted it, or at least created an environment where corruption can hide behind the wall of paper the SEC requires.

But why has this corruption occurred? Why wouldn’t it happen in a private stock market? Well, a thought experiment will explain why the government intervention is corrupting. Imagine two stock markets. One, the Boston Stock Exchange is interested in attracting investors with assurances that their money will be safe. The other, the new York Stock Exchange does not care. The owners of the Boston Stock Exchange publish a set of accounting standards and demand that any company that trades on their stock exchange must follow those rules and publish those reports. The New York Stock exchange does not have that requirement.

Some investors choose only to invest money in companies trading on the Boston Stock exchange. They eschew the New York exchange. In the meantime investors who are less choosy (or more foolish) continue to invest in companies on the NY exchange. As a result, the companies that invest in meeting the requirements of the Boston exchange have access to additional capital that they couldn’t get if they were limited only to getting it from the NY Stock exchange. If the additional capital is worth the expenses involved in meeting the Boston standards, a company will rationally choose to adopt the Boston standards. Companies that find the additional cost not to provide sufficient benefit will not adopt the standards. Those companies will forego being traded on the Boston exchange and will make do with the capital available in New York.

In this scenario, the cost of adopting accounting rules is an investment in the business, much like the cost of marketing or the cost of insurance. Companies that choose to spend the money will attempt to ensure that it is well spent, that they are necessary for investor protection. There will be a negotiation between investors, the Boston Stock exchange, accountants and the companies being audited to arrive at meaningful standards that satisfy everybody. In the commercial insurance industry there instances of fraud tend to be aberrations rather than systematic because this very process is in place.

Now let us assume that for a variety of reasons the U.S. government passes a law mandating that all companies meet the Boston standards. Immediately all the companies trading exclusively on the New York exchange are slapped with an additional cost that they don’t want. The benefit of compliance will be reduced since the capital funds available in Boston will now be spread over many more companies. These companies, having been saddled with an unwanted cost will attempt to reduce the cost. They will seek out corrupt auditors who will rubber stamp their records. In the meantime the auditors who specialized in Boston accounting rules, now assured of a captive market, have to expend less effort pleasing their customers, the stock exchanges. In fact, they merely have to satisfy government regulators to keep their licenses, so they will pay less attention to the officers of the stock exchange. Since the government regulators, unlike the Boston Stock exchange, face no losses should they certify a corrupt regulator, they have a much lower incentive to ensure that the auditors are doing a good job.

At this point the accounting industry will not only become corrupt, it will also stagnate. The process that causes the stagnation is quite straightforward:

Let us assume that a couple of investors think that the Boston system is flawed. So they come up with a new system, and establish a stock exchange in Chicago which insists upon these alternate standards. Let us further assume that they convince a number of investors to agree with them, to the point where a few companies are interested in adopting the new standards. Whereas before the companies would merely have to switch to the Chicago system and to abandon the Boston system, they are not allowed to do this. They must continue to spending the money required to comply with the Boston system. If they want to meet the Chicago rules, they must purchase this as an additional cost. And, if the Chicago sytem contradicts the Boston system they cannot adopt the system at all.

This sets up a nearly insurmountable hurdle for anyone to adopt the Chicago system. And there is little chance of the Chicago system being mandated, because there will be many people with a vested interest in keeping the Boston system in place. Only in a time of crisis will the adoption of the Chicago system be considered by the legislature. And, if they should mandate it, they will be mandating an untested system. Should the system not work out as advertised, they could set back the industry dramatically as is happening as a result of the Sarbanes Oxley law.

If people truly wish to protect investors, they would lobby for the immediate dissolution of the SEC and allow stock markets to compete again on the quality of auditing. We would see a dramatic improvement in investor satisfaction as Stock Exchanges were not limited to competing for customers using price.

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  • http://trumpetbob15.blogspot.com/ trumpetbob15

    Nice post tarran.

    As a student of accounting, there is one more point I would like to add. Because the regulations keep getting more complex, would-be auditors must be regulated as well to “protect” investors from corrupt auditors. This gives the state, the current certifiers, the incentive to make the certification process more and more complex. This leads to higher audit fees, leading more companies to go “private,” and avoid the SEC and auditors, or waste even more money trying to certify their books, even as the quality of the audit suffers as more and more auditors are forced into specialized roles from the complex regulations. So on top of the complex regulations on companies leading some companies to favor the current arrangement, now state certifiers and auditing firms have an incentive to protect the status quo in an ever increasing cycle.

    By the way, Enron is a great case-study in the idea of <a href=regulator capture, although in this case, the opposite form where Enron hired former members of the Financial Accounting Standards Board (FASB) to create the complex financial arrangments.

  • http://trumpetbob15.blogspot.com/ trumpetbob15

    Shoot, that link didn’t work. Try this one.

  • http://djomama.blogspot.com jomama

    But why has this corruption occurred?

    “Why does corruption in government always
    surprise us? Why do we expect anything else from
    it? Government is organized force. It takes our
    wealth and makes war. And we think honest men
    would do that work?” –Joseph Sobran

    …and soon, The End results of this corruption.

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