Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

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.

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