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CHRISTOPHER W. YOUNG

COMMENTARY

Most would argue that the free-market system, the system of choice for most nations, has been the igniter of technological innovation, economic growth and the tool that has pulled people from poverty throughout the world.

However, the efficiency and viability of this system rests on three pillars: investment transparency, liquidity, and regulation. Such pillars can be compromised, however, when an elite few develop undue influence on the market, creating a risk for market failure and a climate of public anger and uncertainty. This invariably leads to a discussion as to the viability of the free-market, with alternative economic models of egalitarian theory proposed as anodyne to our pains.

Over the past twelve years or so, the free-market has witnessed three unique, yet interconnected, market failures created by lack of competition and exploitation of ill-conceived regulatory frameworks. The first illustration of just such a recent failure came to us just as we were entering the 21st century. Research analysts at many of the large investment banks were investigated by the SEC because of their curious habit of awarding high ratings to companies with a penchant for bankruptcy, cf. Enron and WorldCom. The findings from the investigation showed that many of these research analysts were paid not according to the quality and accuracy of their research, but rather upon their success in securing investment banking business for their employers. The best way to secure IB work, these analysts found, was to trade it for favorable ratings.

The research analysts were not the only ones to come under the regulatory gaze prompted by Enron and WorldCom's failures. An additional culprit, the auditing business model of the large accounting firms, was brought down to the station. The responsibility of these auditing firms was to ensure accuracy of a firm's financial statements, yet Arthur Andersen, like the other firms at that time, was paid directly by the corporation they were auditing. The conflict of interest resulted in Arthur Andersen's audit to be, shall we say, less than thorough.

Eerily similar are the events of the fall of 2007, when many of the mortgage backed securities portfolios, once rated so highly by credit rating agencies, began to underperform. The business lent itself to at least insinuations of impropriety, with security issuers selecting their credit rating agency from a number of open bids. Although not empirically proven, such a practice may have resulted in the selection of a rating rather than an agency, rewarding "A"'s rather than accuracy.

Regulatory changes were implemented due to each of these situations, and while they addressed some of the more pernicious practices, they have not fundamentally changed the misalignments that still persist between investors, corporations, and stakeholders.

1. The research analysts were financially aligned with the company they were researching rather than with the stakeholders who were relying on the research reports.

2. The auditors were financially aligned with the company they were auditing rather than with the stakeholders who rely on the validity of the financial statements.

3. The credit rating agencies were financially aligned with the investment bank underwriting the securities rather than with the stakeholders who rely on the validity of the ratings.

At the core of the problem is a lack of fiduciary responsibility; those who manufacture, analyze or rate corporate information do so for the client and not the stakeholder relying on the information. It seems that in order to reestablish trust in the marketplace and to once again reinforce the free-market system, the government must address this real concern.

First, any financial misalignments between those relying on and those creating or supplying financial or corporate information must be eliminated, requiring the mandated divestiture of investment banks' research departments. To the extent the investment banks need research to support their sales efforts, they may purchase the research from independent research providers. In doing so the independent research marketplace will thrive, competition will increase, as will the overall quality of research, once again re-establishing trust in the marketplace.

Secondly, it must be ensured that auditors and credit rating agencies are not paid by corporations or investment banks. A potential solution may be to create financial statement insurance, as described by Joshua Ronen, Professor of Accounting at NYU. The insurance would protect the policy-holding corporation from misrepresentations or omissions in financial statements. To price the policy correctly, the insurance carrier would manage its own financial review and audit, a practice paid for by the insurance premiums collected. With the inclusion of a legitimate third party, the stakeholder is ensured that their priorities are aligned with the auditor.

A similar case can be made for credit rating insurance, whereby the investment or commercial bank purchases insurance on the credit rating. To mitigate the risk of loss, the insurance carrier would ensure that the underlying review and analysis is of the highest quality. In the process, the stakeholder wins.

Lastly, we must re-establish competition in the market. Today, there are only four major auditing firms, ten credit rating agencies (with the largest three servicing the majority of the marketplace) and only a handful of reputable firms creating independent research. Consideration must be paid to the idea of breaking up the four major auditing practices into a dozen or so companies that will foster competition. Transparent SEC guidelines that enable competent analysts can gain Nationally Recognized Statistical Rating Organization status will also increase competition. By creating more competition in the marketplace, these service providers will continue to seek out new and innovative processes to help create better quality audits, research, and ratings.

When considering the above, it seems obvious that the Dodd-Frank Wall Street Reform and Consumer Protection Act have not addressed the bona fide historical crisis destroying the free-market system in the United States — the crisis of trust. As it stands financial incentive misalignments between investors, corporations, and agencies have usurped the efficiency and viability of the free market.

If the free market is to survive and produce once more a greater standard of living, both our misalignments and our aim must be straightened and our trust restored.

Christopher W. Young, Ph.D. is visiting assistant professor of economics at Seton Hall University.

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