Don't throw the baby with the bathwater

The “assurance industry” is in a crisis. For purposes of this column, the term is being used to cover the profession of chartered accountants and auditors, and indeed the activity of credit rating — all of which are now facing a crisis of confidence. It is not surprising, particularly when systemically important financial institutions are under stress; when crude knee-jerk reactions of regulators are dime a dozen; and when investor confidence levels are at a low.

It is a very sensitive and critical juncture for the regulatory system. Everyone with any role in the corporate and business space has firm views on how bad or how good the assurance industry is. Dealing with the situation calls for the skill-sets of a peace-time general (one who works on doing the best to avoid an actual war), as opposed to the skill-sets of a war-time general (one who would thrive and revel in waging war).

Wars are expensive and indeed bring on the feeling that “all is fair in war and love” — the love for protecting society and the hatred of those perceived as adverse to society are a potent mix. When waging a war, one does not worry about collateral damage, innocents being hurt or killed, and even society accepts these costs when the war is a popular one. Regulators and political incumbents are human and not at all immune to the feeling.  

Throwing out the baby with the bathwater is real prospect. When allegations of auditors colluding to cook the books, or of rating agencies being potentially guilty of fraud, are levelled, the consequences are severe and serious — not just for those accused but for the rest of society. Information and integrity of information that is available to the market to take informed decisions is vital — be it investment decisions, or credit decisions, or even basic trade and business decisions, and indeed policy decisions. Therefore, one has to be extra careful and sensitive in ratcheting up allegations about these agencies. If there is not enough to support an allegation and yet it is lightly made, one not only hurts them but also every person whose decision-making is influenced by their services.

If the work done by those in the industry were to be of a shoddy quality, the decision-making would be shoddy and thereby the societal impact would be wider. This is why the assurance industry has a very vital and sensitive role to play — and precisely why licences and registrations to carry out such activity are handed out with a very tight fist. It is easy for the securities market regulator to issue a broking licence but tough for it to issue a credit rating agency licence. Erring on the side of caution is the accepted norm since one does not want riff-raff to be in the business. A corollary to that necessarily is not to be loose-tongued and theatrical when attacking these agencies when suspecting wrong-doing.   

If hatred of government keeps rising, the mob on the street would want to overthrow the government. The overthrow may even seem romantic, or at the least, justifiable. Yet, in the process, one would be saddled with anarchy. Likewise, if distrust of those in the assurance business is high, the path could lead to chaotic conditions.

In such regulatory situations, there can emerge an inherent conflict between the role of the regulator in meeting its “prudential” objectives and its role in enforcing against “misconduct”. The conflict between the two objectives is fine and an important one. For example, if you punish a bank in very harsh terms, you end up eroding public confidence in the bank, resulting in a run on the bank. On the other hand, if you let an errant bank off lightly, you risk placing a premium on violative conduct and the moral hazard of encouraging the belief that the bank is “too big to fail”.

The distinction and conflict between these two objectives is so sharp that by sheer regulatory design, the United Kingdom has broken up its regulatory framework into a “conduct authority” (an organisation that handles misconduct and enforcement action against violations) and a “prudential authority” (an organisation that regulates how a market entity must be organised and must act prudently by stipulating norms such as minimum net worth, risk assessment norms etc.).

The assurance industry is not regulated with such finesse in India. It deserves to be. Absent institutional and organisational involvement in wrong-doing, the rule must be to save the institution without compromising the individual wrong-doers. Putting these players out of business may grab a great headline, but the impact would be as temporary as the headline.

Disclosure: The author represents members of the assurance industry in his professional capacity.
The author is an advocate and independent counsel. Tweets @SomasekharS