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11 September 2017 Financial Analysts Journal Book Review

Financial Gatekeepers: Can They Protect Investors? (a review)

  1. Martin S. Fridson, CFA
This conference volume deals with the regulatory reactions to the financial traumas of 2001–2002 by examining features of present regulation that have not played out as intended and by offering useful solutions to the problems.

This conference volume deals with international regulatory reactions to the traumatic bankruptcies of Enron Corporation and WorldCom in 2001–2002. The gatekeepers referred to in the title are watchdogs for corporate managers, such as auditors, boards of directors, and equity analysts. Government and quasi-official bodies, in turn, monitor the gatekeepers.

Editors Yasuyuki Fuchita (Nomura Institute of Capital Markets Research) and Robert E. Litan (Brookings Institution) pose the question of how well all this surveillance is working. The answer is, “Not all that well”—when one considers the litany of complaints about the gatekeepers, which persist even after the latest reforms.

In the case of brokerage house (sell-side) equity research, conflicts of interest were a central focus of the post–“Tech Wreck” reforms. Regulators viewed analysts as issuing excessively optimistic opinions in deference to their employers’ underwriting relationships. As contributor John Coffee (Columbia Law School) notes, that unfavorable impression was supported by an increase in the ratio of buy to sell recommendations from 6:1 to 100:1 between 1991 and 2000. Dismayingly, Leslie Boni (University of New Mexico) finds that following 10 major investment banks’ 2003 Global Settlement agreement, sell recommendations declined as a percentage of all recommendations whereas buy recommendations remained at approximately their previous level.

The Enron and WorldCom debacles spurred auditing reform not only in the United States but also in Japan. Editor Fuchita contributes a chapter in which he points out that major accounting scandals involving Seibu Railway and cosmetics manufacturer Kanebo occurred after the establishment of the Certified Public Accountants and Auditing Oversight Board in 2003. And Fuchita notes further problems in Japan, including a shortage of accountants, insufficient time devoted to audits, and low auditing fees.

Financial Gatekeepers: Can They Protect Investors? proposes solutions as well as offering criticism. For example, Zoe-Vonna Palmrose (University of Southern California) argues that the new U.S. accounting oversight body, the Public Company Accounting Oversight Board (PCAOB), has transferred reputational risk to auditors. Palmrose’s notion is that if accounting irregularities come to light, the PCAOB understandably wants to avoid blame. The risk transfer occurs through promulgation of output standards, which make the auditor responsible for detecting misstatements, as opposed to auditing standards, which specify procedures for auditors to follow. Palmrose calls for sharing the risk of new accounting scandals by establishing an auditing master. In cases of alleged audit failure, this office would assess both auditor compliance with accounting standards and PCAOB auditing procedures. The inquiry would determine the relative responsibility of the regulators’ design of the standards and of the auditors’ application of those standards.

In a similarly constructive vein, Boni offers a solution to a problem confronting retail investors. They are unable, for want of the necessary data, to determine whether and to what extent equity analysts’ recommendations add value. Boni finds that stocks rated sell outperform those that the analysts recommend for purchase. With no apparent irony, she comments, “Given the empirical findings reported here, it is unlikely that aggregate comparative reports will be provided voluntarily by the firms.” Accordingly, Boni proposes that regulators compile the statistics and disseminate them via the internet.

Frank Partnoy (University of San Diego Law School) rails against another class of gatekeepers, the credit-rating agencies. Their opinions, he contends, have little informational value but are increasingly “prominent, important, and valuable.” It sticks in his craw that Moody’s Investors Service and Standard & Poor’s have been so financially successful even though they have performed “poorly” in ways that he does not specify.

A presumption runs through Financial Gatekeepers that regulation is necessary and beneficial. The only question is which gatekeepers must be kept on the shortest rein. Readers will find little questioning of the notion that the remedy for failed regulation is more regulation. Neither do the contributors give much consideration to the possibility that after making objectively bad decisions, investors may try to shift the blame with the assistance of opportunistic politicians.

However, more fundamental examination of the government’s role in financial markets is a topic for another book. Financial Gatekeepers carries out its intended mission effectively by shedding useful light on features of present regulation that have not played out as intended. Especially helpful are after-chapter responses by practitioners and think tank fellows and a concluding discussion by Coffee.


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