5 June 2020

The Covid reset is a vital chance to restore faith in Britain’s corporate regulators

By

As the country slowly awakens from an induced economic coma, it faces harsh new realities of gargantuan corporate bailouts and a profoundly bloated public debt. Now more than ever we need corporate accounting to faithfully represent underlying business performance – or the public will find its bailouts are squandered and the current low trust in capitalism will plunge further still.

Accounting is like the plumbing of modern capitalism. When it works, we don’t think much of it. But when it fails, the stench can drive us mad.

Following several years of outrageous corporate conduct on accounting matters, three government reviews over 2018-19 all pushed for major regulatory reform. A key conclusion was that the current accounting regulator – the Financial Reporting Council – had failed at its job and must be reimagined. Coronavirus bumped that off the agenda, but now the time is right to restore Britain’s once-storied reputation for sound corporate accounting.

The priority is to design the FRC’s successor, the prospectively named Audit, Reporting, and Governance Authority [ARGA]. In doing so, Whitehall can look at other accounting regulatory models that have both worked and failed. At least then we can let ARGA make its own mistakes.

In the United States, the work of the would-be ARGA is performed in varying measures across an alphabet soup of three regulatory bodies – the FASB, PCAOB, and the SEC. Each, in its operation, has something to teach us.

The Financial Accounting Standards Board sets corporate accounting rules. When it was established in the 1970s, the structure was designed to create an agency insulated from special-interest lobbying. The regulators were paid handsomely, they were given generous research support, and they were expected to resign all prior commitments.

Nearly 50 years on, the record does not impress. The FASB has a reputation for insularity, but not for independence – its ranks are peppered with alumni and future employees of the very industries for which it sets standards. It so happens that generous salaries and the nominal severance of professional ties do not in themselves buy autonomy.

What the FASB consequently lacks is a culture of scepticism – the healthy ability to doubt corporate managers who might seek to twist accounts and lead investors down a primrose path of hypothetical profits. Its standards, for instance, enabled several banks to accumulate unrealised gains, giving us the bubble that led to 2008 global financial meltdown.

The Public Company Accounting Oversight Board is a relatively more recent creation – dating to the mid 2000s – and charged with regulating the audit industry. Early in its history, fresh in the wake of corporate scandals like Enron, the PCAOB was able to draw to its cadre shark-like attorneys, seeking the glory of doing battle against conflicted auditors.

But it has not been able to sustain that momentum, and with time, the regulator has become a little too familiar with the tribe it was conceived to regulate. So much so that two years ago some PCAOB employees were charged with tipping off auditors before their formal inspections.

The Securities and Exchange Commission is the oldest of the three – founded in the 1930s after the Great Crash of 1929. It has had a varied history – with ups and downs, driven substantially by the personalities and integrity of its chairmen and chairwomen.

Where the SEC has gone astray in recent years is in its very deep politicisation. Partly this is inevitable – the commission oversees the nation’s powerful financial economy and sits just blocks away from the hyper-toxic US Congress. To insulate themselves from the vagaries of this noxious politics, staff bureaucrats at the SEC have created a mountain of rules behind which they can take cover when their judgment is questioned.

The result is an agency that can suffocate creativity and initiative – ambitious young public servants rarely seek to make their name at the SEC.

But it is not all doom and gloom – there are instances of public watchdogs that have largely gotten it right. One case in point is the office of the federal prosecutor in Manhattan, known colloquially as SDNY. This group, which employs over 200 attorneys, is responsible for policing bad behaviour on Wall Street, among other torts.

From a recent study, I have highlighted three SDNY practices that are particularly worth considering as Whitehall contemplates ARGA’s design. First, recruiting is highly selective – the prosecutor’s office would rather have a handful of very capable but overworked employees who stay for a short time, than hordes of lifers who have been around long enough to do their jobs asleep.

Second, those who are selected, even if they are early in their careers, are given major cases, with the enviable discretion to make important judgment calls. There isn’t time for rookies to be bedded into the bad habits of Wall Street – fresh from law school in New Haven and elsewhere, they bring drive, intellect, and a youthful pursuit of purity, to sniff out malpractice where they see it.

And third, there’s tremendous pride amongst current and former employees in the office’s independence, from Washington or anywhere else – a pride almost bordering on arrogance, as the office often refers to itself as a “sovereign district”. Successive SDNY leaders, over at least five decades, have worked hard to sustain this independence – when a new leader is named, all living former leaders are said to take time to socialise the incumbent in this all-important tradition. “One must be prepared to resign to defend it,” one former head said to me.

Notably, it’s not simply about the pay. Federal prosecutors in Manhattan earn less, on average, than the government lawyers at the SEC and certainly heaps less than their opposing counsels from private practice. It turns out that organisational culture, not pay, is what really drives integrity and independence in public service.

Designing ARGA gives Britain a chance to show the world that it can lead on corporate accounting again. Accounting regulators the world over face crises of confidence – indeed, the public’s lack of faith in their oversight contributes to low approval ratings for capitalism as a whole.

But few other countries came as far as the UK in 2019 in forcing a full reckoning with its compromised accounting. Now, as Britain presses the reset button on its economy, let’s get it right.

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Karthik Ramanna is Professor of Business and Public Policy at the University of Oxford’s Blavatnik School of Government.

Columns are the author's own opinion and do not necessarily reflect the views of CapX.