Keynote Address at the Public Company Accounting Oversight Board´s Center for Economic Analysis 2015 Conference on Auditing and Capital Markets
Washington, D.C.
Oct. 22, 2015
Good afternoon. Thank you, Luigi [Zingales], for that introduction. It is a pleasure to be here and speak with you today about a topic of great mutual interest: how economic analysis can — and should — inform the SEC and the PCAOB as we fulfill our missions. I plan to comment on areas of similarity and difference in the economic questions we confront and how we can transparently analyze them in our rulemaking and standard-setting efforts.
Before I deliver the substance of my remarks, I must remind you that the views expressed today are my own and not necessarily those of the Commission, individual Commissioners, or my colleagues on the Commission staff.[1]
The PCAOB is publicly committed to performing economic analysis in support of its standard setting. Likewise, the SEC is committed to economic analysis of new rules. Both Commission and Board staff have issued guidelines that articulate the building blocks of a robust and transparent analysis.[2] The SEC´s Current Guidance on Economic Analysis in SEC Rulemaking lays out four elements of any SEC economic analysis: (1) justification for the rule; (2) the baseline against which the effects of the regulation should be measured; (3) the economic effects, including the benefits, costs, and effects on efficiency, competition, and capital formation; and (4) alternative regulatory approaches. The PCAOB´s guidance follows this same basic approach. The overarching goal, of course, is to ensure that the public, PCAOB and SEC staffs, Board Members, and Commissioners can fully understand the motivations and potential economic consequences of regulatory actions.
Why is this relevant to the 2015 Conference on Auditing and Capital Markets? This avowed commitment to economic analysis by both the PCAOB and the SEC means that original research is vital to our ability to understand the markets and activities we oversee. The economic analysis of a rule´s impact is a specific type of research question — a question to which we should apply the most current tools available. This is why my Division at the SEC -- the Division of Economic and Risk Analysis (DERA) — employs nearly 80 Ph.D. financial economists, accountants, and statisticians. These experts are fully engaged with the academic community, authoring papers and presenting at conferences. Our staff´s connection to current research — both as contributors to and consumers of the latest developments — is crucial to incorporating the most current work on the financial markets into the SEC´s work. We routinely draw on the academic literature to provide us with deeper understanding of market issues. Moreover, SEC staff engages in original research for publication in peer-reviewed journals, for release as Commission white papers, or for inclusion in Commission rulemakings. All of this "research" activity enhances our ability to determine how the research of others can provide insights about how to further the SEC´s mission.
So what are the missions of the SEC and the PCAOB? The SEC has a very broad mission — to protect investors, to maintain fair, orderly, and efficient markets, and to facilitate capital formation. The PCAOB´s mission is to oversee the audits of public companies in order to protect investors and the public interest by promoting informative, accurate, and independent audit reports. Of course, these stated goals share a common basis: the desire to protect and inform investors. Although the SEC and the PCAOB operate under somewhat different legal arrangements, they share a similar economic basis for many of their actions.
Today, I´d like to speak on what I — and I suspect many of you in this room — know best: identifying some of the most salient market failures or inefficiencies related to our missions, and how our mutual commitment to economic analysis can aid in their identification, evaluation and, perhaps, resolution. I hope that I am able to spark some conversations — and even inspire new research questions — as I touch on some of the fundamental issues that I believe economic analysis can help us address.
In a theoretically perfect ("textbook") market, investors and traders would know everything there is to know about a company, and the markets would efficiently price the company accordingly — perfect information, and perfect pricing efficiency. Companies would make optimal operating and investment decisions based on accurate market valuations of available alternative strategies.
But we do not live in such an ideal world. Rather, there exist impediments to the smooth functioning of financial markets. Information is costly to gather and costly to evaluate. Even though some investors (and other market participants) have less than complete information, the market will process and price the available information "efficiently" in the sense of rational expectations. But the price signals in a real-world market are less than perfect and hence real sector allocations of resources are also less than perfect. Moreover, value-relevant information is not equally available to all participants in a real-world financial market. Heterogeneous information costs may leave some investors with less information than others. Similarly, managers likely have relatively complete information regarding a particular issuer. Less informed investors will likely be aware of their handicap, leading them to require a higher return on invested capital, which renders some investment projects uneconomic. Some such investors will withdraw entirely from the market, further limiting capital formation.
More information might expand capital formation, but more information is costly to produce. What is this optimal level of information? When is the public value of better information insufficient to cover its cost? And is that level of information the same as where an investor´s cost of gathering more information equals her private benefit? Not all information improvements are worth having. Put another way, the SEC´s mission of maintaining "fair, orderly, and efficient markets" requires a balance between the costs and benefits of more and better information.
The SEC´s and PCAOB´s commitments to protecting investors must balance the costs and benefits of their potential rules and regulatory alternatives. Some costs are obvious, such as the expense of enhanced reporting requirements. But other costs, and many benefits, are more subtle and here is where a clear economic analysis of market functioning is crucial to defining the full range of a policy´s effects. For example, consider credit ratings agencies and audit firms. They both seek to confirm information produced by corporations, using their expertise to supplement that of ultimate investors. More and better information of this sort should lower investors´ required returns and enhance the real sector´s capital formation.
However, the raison d´etre for credit rating and auditing firms has embedded within it a potential information problem of the sort they are intended to correct. Both types of agents are selected and paid by the affected firm, for the purpose of conveying information to third parties, i.e., investors. To whom do auditors and rating agencies ultimately owe their allegiance? Are their economic incentives consistent with this allegiance? Relevant policies in this area can seek to improve incentives without compromising the value of the services being provided. Unfortunately, it is difficult to fashion policies that ameliorate information costs without some sort of costly side-effect.
As I stated before, the first element of both an SEC and a PCAOB economic analysis is to identify the need for a rule. Often, this will involve a market failure. [3] And often the market failure itself derives in some way from the fact that value-relevant information is costly to obtain and costly to evaluate. The existence of asymmetric information can enable market participants to engage in deleterious strategic behaviors that would be impossible in a world of complete information. For example, an auditor´s knowledge of audit processes and efforts is superior to that of management and boards, or third parties like investors, which can lead the auditor to act strategically in his or her own self-interest. Regulatory interventions such as audit performance standards or audit committee reporting standards may be appropriate to address this potential market failure. Similarly, in the SEC´s space, the lack of symmetric information between a buyer and a seller can lead to adverse selection, or even to complete market failure.[4] Hidden information or hidden actions may also permit a firm to substitute more risky assets without bondholders´ knowledge, or permit executives to collect unwarranted rents for themselves, at the expense of shareholders.
Obviously, we cannot assure that each and every market participant actually possesses and acts upon the same, optimal, information set. In designing required disclosures about investment risks or audit quality, regulators can only focus on facilitating access to information that (we hope) reduces perceived imbalances. In the public company space, the SEC typically addresses asymmetric information issues through mandatory, periodic financial disclosures that are received concurrently by all investors. Such disclosures are intended to permit comparability across issuers in a timely manner. The lingua franca of these disclosures is Generally Accepted Accounting Procedures (GAAP). However, precisely because GAAP applies to many disparate types of companies, it may not describe each and every one perfectly. Within limits, GAAP permits managerial judgments to determine how information is reported, and managers may have an incentive to report in the most favorable possible light.
The PCAOB´s oversight of public company audits is an important complement to these mandated disclosures, but can present distinct challenges. Let´s start by focusing on auditor reporting standards — not because they are the most important aspect of what the PCAOB does, but because they represent the slice of issues on which the PCAOB and the SEC address similar market failures with a toolkit of similar potential regulatory responses.[5] Audit reporting standards can, in the first instance, increase the amount of information that investors receive regarding an issuer´s financials. [6] In an asymmetric information environment, a better understanding of the disclosed information in a company´s financials can enable an investor to predict future earnings with more confidence, which can, in turn, lower the discount rate applied to those future earnings.
Let me turn now to the PCAOB´s projects on audit performance standards. Although the performance standards do not directly affect the content of an audit report, an efficient and rigorous audit process should enhance the confidence an investor can have in reported financial information. Even if no additional information is revealed by the audit report itself, procedures mandated by the PCAOB can affect how investors perceive the assurance obtained by auditors. While these effects on the market are indirect, they are potentially quite important.
I´m sorry to say that I cannot provide the answer to the question of how the PCAOB — or the SEC for that matter — should solve these knotty regulatory problems. But I believe I can offer an approach to finding the answer. Much like Anton Chekhov´s gun, I did not mention the SEC and PCAOB´s economic analysis guidance in the first act, just to forget it now.
Both the SEC´s and the PCAOB´s Guidances underscore the importance of identifying a baseline against which to measure the possible effects of regulatory action. A baseline is thus the starting point for any analysis of a potential market failure or inefficiency. It is vital to understand how a market is functioning before we can identify what might be wrong within it. This goes beyond a simple recitation of current regulatory requirements or an overview of general market statistics. It is incumbent upon regulators to understand fully the complexities of the markets we regulate. Only then that can we make a theoretical market failure concrete and specific.
So how do we do this? At the SEC, we are very focused on data-driven baselines. As much as possible, we seek to use available data — even data that is difficult to work with — to allow us to characterize the markets we regulate. An example that is somewhat far afield from the topics today, but illustrative nonetheless, is of a recent white paper released by SEC staff economists regarding the liquidity of mutual funds.[7] The Commission´s recently-proposed liquidity rules — intended to protect investors in those funds and the overall market — relied in part upon the white paper´s analysis. The paper revealed new information about mutual funds´ liquidity practices, including the fact that funds´ redemption patterns vary widely by fund size and investment objectives. Importantly, this variation seems to be as great within size or investment classes as it is between such classes, which in turn informed the discussion of how to structure a minimum liquidity requirement for open-end funds.
I note that the PCAOB is fortunate to have a host of inspections data regarding audits and audit firms that it can use in establishing the regulatory baselines for its rules. This kind of data can be used to help create a more complete picture of how changes to auditing standards and other PCAOB rules may improve audit quality, and thereby investor confidence and valuations. By making use of this rich source of data, the PCAOB can identify the potential market frictions or failures, as well as identifying a baseline against which regulatory options should be assessed. Through the rulemaking baselines, the public portions of individual inspections reports, and so-called "4010 reports," the PCAOB can provide the public with valuable information, which can be used to comment on PCAOB standard-setting projects, or to conduct academic research — so we can have further informative conferences such as this one!
So, finally, I return to my introductory argument that academic work has a crucial role in helping us think about whether and how to regulate. Indeed, I hope this afternoon and tomorrow we will be hearing about papers that may address some of the very issues I have just raised. I will not take the liberty of suggesting particular topics for future research. Rather, I will simply encourage each of you who perform research in this field — and I include SEC and PCAOB staff in this! — to think critically about how our work can provide data-driven insights into the need for regulatory intervention and what that intervention should look like.
Again, I thank the Conference organizers for the opportunity to speak with you today and I look forward to the papers and discussions.
[1] The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the author´s colleagues upon the staff of the Commission.
[2] See Current Guidance on Economic Analysis in SEC Rulemaking (available at http://www.sec.gov/dera/current-guidance); Staff Guidance on Economic Analysis in PCAOB Standard Setting (available at http://pcaobus.org/Standards/pages/05152014_guidance.aspx).
[3] See PCAOB Guidance: ""Usually, the Board's professional practice standards address information-based market failures (i.e., asymmetric, imperfect, or incomplete information) that cannot be effectively corrected without regulatory intervention.
[4] George A. Akerlof, "The Market for ‘Lemons´: Quality Uncertainty and the Market Mechanism," The Quarterly Journal of Economics (1970).
[5] See PCAOB Guidance "Broadly understood, the audit serves to enhance the reliability of certain information companies disclose, thus addressing the asymmetry of information that exists between a public company's management and its investors."
[6] For example, through a going concern or other explanatory paragraph added to the auditor´s report.
[7] Paul Hanouna, Jon Novak, Tim Riley, Christof Stahel, "Liquidity and Flows of U.S. Mutual Funds" (September 2015) (available at http://www.sec.gov/dera/staff-papers/white-papers/liquidity-white-paper-09-2015.pdf).