On October 6, 2014, the Wall Street Journal, only three days ago, published an editorial claiming that regulatory capture was “inevitab[le]” and that we should give up on regulation and rely instead on “simple laws that can’t be gamed” such as an increased capital requirement for banks. I wrote a two piece response to the editorial. What I just discovered (though it bears an October 7, 2014 date on the WSJ website) is that one day after the editorial claimed that asset and liability values (the inputs that define “capital”) “can’t be gamed” they presented data indicating that corporations frequently game asset values and that private auditors frequently fail to follow former audit procedures to detect and prevent the overstatement of asset values. The title of the article is “Audit Deficiencies Surge” and the first two sentences contain the key data.
“Auditors at the largest U.S. accounting firms failed to follow proper procedures in more than four in 10 audits, according to the latest inspections by the U.S. government’s audit watchdog. That was more than double the rate four years earlier.”
The study notes that the percentage of violations involving inflated asset values has fallen since the crisis when such violations represented roughly 30% of the audit violations discovered by a review. The key is that the worst financial crises are driven by epidemics of accounting control fraud and that because the bank CEO can hire and fire the audit partner – while it is much harder to fire regulators. Because fraudulent bank CEOs can hire and fire the audit partner they can – and do – deliberately create a “Gresham’s” dynamic in which bad ethics drives good ethics out of the professions. This is the leading cause of the extraordinary percentage of audit failures we observe as soon as we create competent reviews.