Tuesday, 10 July 2018

Another Transgression in the Automobile Industry Highlights the Need for ESG Consideration – Nissan’s Emissions Scandal

As part of this author’s research on the Principles for Responsible Investment, the concept of ESG consideration has been analysed in relation to its importance to development of more forward-looking and sustainable investment practices. In this post, we will look at whether Environmental, Social, and Governance’ (ESG) principles are followed in full, or whether there is still some resistance to incorporating all of the concept. There is a suggestion that only certain elements are ‘material’, but recent news suggests that it is sometimes, or even often, unwise to separate the three components.

In reviewing the two particular reports generated by the PRI concerning the impact of ESG on credit analysis (the first one is available here, and the second here), it quickly becomes apparent that, for the Credit rating agencies (CRAs), the concept of ‘G’overnance is the most material aspect. Yet, the CRAs make a point of the Volkswagen emissions scandal to demonstrate where the different elements of ESG converge, with that case in particular covering aspects of Governance (via poor management practices), Environment (via environmentally-concerned regulations), and the wider impact upon Society. This focus is valid, but within the reports this situation is held up as a somewhat solitary event. Just a couple of weeks since the last report was published, the automobile industry is facing another scandal with the news that Nissan, Japan’s second largest automobile company, has been falsifying its emissions-related data.   

The first point to note is that the business media are almost unanimous in suggesting that this case is not exactly the same as the VW case. The suggestion is that Nissan have fallen foul of poor practices across their manufacturing operations, with certain tests falling short of the prescribed requirements imposed by Japanese regulators – as opposed to VW, who were found to be including emission-altering recording software in their vehicles. This narrative falls in line with previous issues at Nissan relating to safety concerns and practices which resulted in a recall of 1.2 million cars last year. However, Nissan has confirmed that emissions data was ‘deliberately altered’, and that news has had an immediate and significant effect upon the company’s position. In response, Nissan has initiated internal investigations which it says will consist of ‘a full and comprehensive investigation of the facts… including the causes and background of the misconduct’. There has been little to suggest, so far, that the company will find itself embroiled in a scandal the size of VW’s, but these news does signal that focusing upon the entirety of ESG as a concept is important, as many investors have been calling for.

The CRAs, who exist to provide an opinion on the creditworthiness of a given entity, are in complete agreement that governance is the key factor. There are a number of reasons for this, but the main reasons are that the management of a company will often have direct impact upon the company’s creditworthiness, and that the governance of a company can be made much more quantifiable than the other elements within ESG. This, of course, is not invalid, and it is not a surprise to hear that the CRAs want to focus upon what can be quantified. However, whilst Governance is obviously a massive factor in the Nissan case, the other elements of ESG are all present, meaning that this story (in addition to the VW scandal), is a shining example of the interlinking properties of the concept of ESG. Furthermore, there is perhaps a fear that these stories represent a trend, which makes ESG analysis even more valuable. In the Nissan case, the ‘E’ is represented by the regulations designed to enforce environmentally-concerned standards, and the ‘S’ essentially informs the ‘E’ policies – the standard-setting in this industry is not just in relation to environmental concerns, but also is in relation to consumer habits, the impact of a degrading environment, and the direction of society towards a more renewable sentiment.

The implications of the Nissan story will be felt for some time, and it is likely that Nissan will not be the last automobile company to fall foul of emissions regulations. The issue is that these factors are only slowly coming to be recognised by the financial sector, with traditionalist viewpoints maintaining in the face of mounting evidence that a dynamic and more forward-looking focus is required. The story represents a clear demonstration that finance needs to respond to the changing, and more ‘ethically’ concerned society. However, this term is problematic in that it describes processes which are moralistic in nature. It is mostly for this reason that the PRI has decided to attempt to take the world of ‘ethical’ finance, or more accurately ‘sustainable’ finance, more mainstream so that the impact of changes in the field will be more widespread; news like that from Nissan will only help to demonstrate why that is a worthwhile endeavour.

Keywords – Nissan, emissions, ESG, PRI, CRAs, environment, @finregmatters

Tuesday, 3 July 2018

PricewaterhouseCoopers: A US Court Takes A Stand

Today’s post reacts to the news that PricewaterhouseCoopers (PwC) has been fined a record amount by a US Court in Alabama over its role in the collapse of Colonial Bank. The reaction to the news, and what it may mean for other regulators (who are currently in the limelight for their soft-touch approach) will be discussed in this post, with the sentiment being that this action is just a step in the right direction, but nothing more (for a number of reasons).

Colonial Bank collapsed in 2009, after buying over $1 billion’s worth of fraudulent mortgages from Taylor, Bean & Whitaker, the former Mortgage-originator which also collapsed in 2009 and saw a number of its executives jailed for fraud. The collapse of Colonial, which is one of the largest in the state of Alabama, has been the subject of a number of trials and investigations, with the most recent concerning the performance of auditors who were tasked with assessing the workings of the bank. Yet, in the overarching story, this is not the first time that the auditors have come under fire, with PwC settling for $5.5 billion in a civil law suit in 2016 for failing to recognise the fraud via Colonial, and with Deloitte agreeing to pay the US DoJ $149.5 million earlier this year for its failings regarding Taylor, Bean & Whitaker directly. However, the US Court yesterday ordered PwC to pay $625 million to the Federal Deposit Insurance Corporation (FDIC) for ‘failing to do enough to uncover a fraud involving non-existent mortgages that triggered the failure of Colonial Bank’ – the FDIC had initiated this current action.

Originally, the Judge presiding over the case had accepted that PwC were ‘duped by a determined gang of fraudsters’, but ultimately declared that, irrespective of this, PwC still fell short of its professional responsibilities. Specifically, the Court ruled that the auditor had demonstrated ‘negligence’ when it failed to perform the adequate checks, and as such the FDIC were entitled to be compensated for being on the hook for the collapse of Colonial. Although this author, as many of the regular readers of Financial Regulation Matters will know, is no fan of the financial penalty system (over custodial sentences), this does appear to be a positive step in the fight against the oligopolistic dominance of the Big Four auditors; after all, this fine represents the largest fine on record for an auditor (taking into account the differences between a fine and a settlement, of course). Yet, here in Financial Regulation Matters we are constantly proposing that we need to assess these situations in reality, and not as one may want them to appear, and in this instance that viewpoint is particularly useful. Initially, and rather predictably, PwC have announced they will appeal. This of no great surprise, but what will be more impactful is their oligopolistic response, which was confirmed by a Lawyer who represents the firm when he stated that the judgment will ‘greatly increase’ audit costs, and that ‘auditors have to charge enough of a fee to account for claims like this’. The inference in this statement is abundantly clear: “if you come for us, we make everybody pay”. This is the typical response from an oligopolistic member, as they fully internalise the influence that comes with being a member of an oligopoly. Furthermore, it is likely that PwC will use this instance as a deterrent to other regulators not to be so zealous, and with that in mind we have a tremendously apt example.

Across the Atlantic, British regulators have more than heeded that warning (if they were ever capable of doing so in the first place). The besieged Financial Reporting Council (FRC) is currently undertaking a number of investigations into audit firms, including Deloitte and KPMG. In attempting to respond to parliamentary pressure for its ‘passive and reactive’ approach to regulation, the FRC is investigated KPMG for its auditing of the failed drinks supplier Conviviality. This comes after a string of actions, including PwC’s audit of failed retailer BHS (which resulted in a record £6.5 million fine), although the underlying inference is that the FRC is still reactionary, just now it is reacting to Parliamentary pressure and the looming Kingman Report. Unfortunately, the recent decision in the US provides for an uncomfortable comparator for British regulators.

The difference between record fines of $625 million and £6.5 million are stark, irrespective of the different scales. Whilst the US is obviously a larger entity than the UK, the damage caused by the auditors and their ‘negligence’ is just as severe and widespread, so why the difference? Professor Prem Sikka, who will be leading the Labour Party’s review of the industry, commented via his Twitter account that ‘fines [in the Conviviality case], if any are levied, will be passed to the ICAEW. What a circus’. The FRC, in its March 2018 Budget and Levies strategy report, state that ‘If the FRC’s audit investigation and sanctions work results in a statutory fine under the Statutory Auditors and Third Country Auditors Regulations 2016 (SATCAR), that fine would be required by those regulations to be paid to the Secretary of State’ – presumably the Conviviality fine would be established under those regulations, but only time will tell if this ends up being the case. Yet, the real issue is this one ‘toothlessness’ described by Parliamentary Committees, and these reactions by the FRC only support these claims, despite what they may think. In reality, if the FRC was confident that their regulatory approach was the correct one, they would not bow to the external pressure. It is also telling that their response to that pressure has been to raise their fines to ‘record’ levels, all of which constitute the smallest of fractions of the auditors’ operations. Ultimately, the UK is in real danger of being regarded as a particularly light-touch jurisdiction when it comes to financial regulation, and in the post-Brexit arena this will have disastrous consequences; the race-to-the-bottom will have many losers.

Keywords – Audit, US, Fraud, Colonial Bank, Banking, Business, Regulation, @finregmatters

Thursday, 21 June 2018

A Massive Reprieve for Credit Rating Agencies: China Opens its Doors

Regular readers of Financial Regulation Matters will know that, in 2015, Standard & Poor’s was fined a record $1.375 billion for its role in the Financial Crisis, and in early 2017 Moody’s was fined $864 million for the same offences. Although the two leading agencies of the rating agency oligopoly were never in any great danger because of these financial penalties, they did cause damage to their financial position. Recently, however, a massive development has taken place which may see their fortunes irrevocably increased. As part of China’s attempts to open up its marketplace to the world, long-held restrictions on foreign businesses within the Chinese jurisdiction have been relaxed so that now the agencies can set up independent entities within the country, as opposed to the previous regime whereby they could only hold minority stakes in joint ventures with Chinese companies. This has a massive potential for the agencies, who can now establish a massive foothold in such a lucrative marketplace. The question is, what may be the effect of this development, both for the agencies but also for China?

The rating agencies have been keen to add to the narrative that new rules developed by the National Association of Financial Market Institutional Investors (NAFMII) ‘will facilitate bond market development’. One of the clearest reasons for the permitting of foreign rating agencies on Chinese soil is that, as suggested in the Financial Times, ‘ratings from local agencies are widely viewed with suspicion’, which is an element that would be completely removed from the equation with the establishing of a foothold in the country by the leading rating agencies. It has been noted that although China’s bond market is the third-largest ($9.7-11 trillion), foreign investment pales in comparison. This is a fantastic development for the agencies, as the need to coax foreign investment into the country fundamentally emboldens their position and importance to the Chinese. So it is no surprise that the leading rating agencies have been drafted in to help increase that foreign investment, but there are potential issues with this arrangement.

The first issue is that China’s attempts to counter the influence of foreign rating agencies, in establishing its own ‘credit rating architecture’, have potentially been obliterated on account of the greater need of foreign investment. It is likely that the ‘One Belt One Road’ initiative is a key factor in taking this decision, but the effect still stands that the dominant Chinese rating agencies, such as Dagong, will now be put in a precarious position having to jostle with these oligopolistic leaders in their own jurisdiction. The second issue is the danger in allowing the rating agencies, who lest we forget have just received record fines for their performance and organisational behaviour, into their oft-protected jurisdiction. China has, primarily since the era of Deng Xiaoping, been open to the limited inclusion of foreign business, and different administrations since have been keen to maintain that same stance. Now, however, President Xi Jinping appears to be confident that he can loosen those restrictions in order to provide the financial basis for his generation-defining initiative – the question is whether this risk is worth it. It is without doubt that Xi Jinping’s authority has been greatly strengthened by the recent consolidation of his position, but there is perhaps a need to suggest that Deng Xiaoping’s cautionary advancement into the globalised world should not be abandoned just yet. Yes the One Belt One Road initiative is important, but is the country ready to risk being overly exposed to the iniquities of the Western financial realm? Perhaps there are many answers to that question, but one thing is for sure: China has just increased its risk profile considerably for the attainment of its cherished initiative.

Keywords – Credit Rating Agencies, China, Financial Services, Business, Politics, @finregmatters

Monday, 18 June 2018

Does the Audit Industry Represent “Too Few To Fail”? A Flawed Diagnosis

In today’s post, the focus will be on an industry that has been covered a lot here in Financial Regulation Matters. Recently, two auditors, in particular, having been making the headlines for all the wrong reasons, and as a result there have been calls for the industry to be ‘broken up’. However, how realistic is that call? There is a potential issue within society whereby calls are made that have no substance nor any understanding of the dynamics at play, so in this post we will look at the industry in closer detail to see just how realistic that large-scale call actually is.

In the wake of the Enron Scandal and the collapse of Arthur Andersen, in addition to a massive reputational breakdown of the wider audit industry, the term ‘too few to fail’ was put forward as a suggestion for why the industry could simply carry on with their business once the news cycle has turned elsewhere. In the last year, these suggestions have been repeated, with there being an increased focus on the ever-reducing level of competition within the audit industry. These claims have only intensified on the back of recent public failures, with PwC recently being fined a ‘record’ amount by the Financial Reporting Council (£6.5 million) for its role in the collapse of BHS, and with KPMG being singled out today in an FRC report. Though the FRC is clear that all of the ‘Big Four’ audit companies ‘feasted’ on Carillion as it delved ever more into crisis, the report singled out KPMG, noting that there had been an ‘unacceptable deterioration’ in the quality of KPMG’s work in particular. This comes just a week after KPMG was fined £3 million for its ‘misconduct’ when auditing the insurance software company Quindell. Predictably, this has led to a number of calls to act against the auditors, with MPs calling for PricewaterhouseCoopers to be investigated further over its role in the auditing of Sir Philip Green’s business empire. Some MPs have gone further, arguing that the ‘Big Four’ should be ‘broken up’. The MPs report on the collapse of Carillion assessed the situation with the ‘Big Four’ and found that, despite a number of initiatives to reduce the competition-related issues, there has been little to no development in that area. The report suggests that there some potential resolutions to this issue, including breaking the industry up, regular rotation of auditors and contract tendering, and also the division of audit and non-audit services. The report ends with the statement that ‘it is time for a radically different approach’, but what does that mean?

The first thing to note is that the audit industry is very much similar to the credit rating industry, which is this author’s specialism (as many regular readers will know). The reason that they are similar is not because of the services they provide, but because they are oligopolies, and that must be the starting point for any discussion. Unfortunately, the word ‘oligopoly’ was only mentioned six times in this extensive report, with the very concept of an oligopoly not being addressed. To understand this further, it is worth looking at the calls of the report and assessing them against the study of oligopolies.

I would urge anyone interested in this topic to read Corporate Power, Oligopolies, and the Crisis of the State by Professor Luis Suarez-Villa; within the literature today, it is perhaps the closest account of the realities of the oligopolistic structure in relation to finance and its effect upon society (many others look at oligopolies, but from an economic perspective). So, with regards to the calls of the MPs report, let us start with the regular rotation of auditors and the tendering of contracts.


The suggestion is that fee-paying companies – let us not forget, companies pay for their audits, not the investors who need them – should not be able to persist with any one auditor for a period of time, for the purpose of reducing the bind that can be created by this which may lead to inefficiencies and malpractice. However, in the UK in 2014, rules were established so that FTSE 350 companies must put their contracts out to tender (i.e. rotate auditors) at least every ten years. This sounds like a positive endeavour. Yet, the report confirms that in 2016, the ‘Big Four’ ‘audited 99% of the FTSE 100 and 97% of the FTSE 250’. So, the rules have enforced change, but have in no way affected the oligopoly.

Breaking up the Oligopoly

The second suggestion of the report is to break up the ‘big four’. This would be done by simply breaking the large audit firms up into more audit firms, which would theoretically break the stranglehold of the oligopoly and simultaneously promote competition. However, the question then who says that is required or desired by the market participants? Here in Financial Regulation Matters it is often stated that the public should be perhaps the dominant consideration in financial matters, as they are the ones who pick up the pieces when things inevitably explode, but in reality the public are not considered. The consideration is for the companies who need to be audited to attract investment, and for investors who must have their capital flows undisturbed as much as possible. Even a cursory glance at the interests of these two parties confirms that neither wants more auditors (more on this shortly).


Interestingly, this author’s new book on the credit rating agencies makes exactly this same argument for the CRAs, but there are a number of caveats. The suggestion is that because the ‘big four’ have two particular streams to their business – audit and ‘non-audit’ services i.e. consultancy/advisory/ancillary – then it is the case that the conflict of interests that arise from that dual offering should be removed. This is not invalid, because as the report rightly states, in 2016 the ‘big four’ recorded £2 billion in fees from audit services combined, but a staggering £7.9 billion in non-audit fees combined. This has the effect of the audit services, essentially, becoming ‘loss-leaders’ so that the firm has access to a company in order to sell it the more lucrative non-audit services – this is the very problem that engulfed Arthur Andersen and the Enron-era audit firms, so much so that they were forced to divest these arms, albeit temporarily. However, after researching this issue for a Doctoral Thesis and a Monograph, this author found that there is little appetite for this approach from the State, for a number of reasons.

The reason for all of these issues is the very concept of an oligopoly. Also, in conjunction with that concept, is the concept promoted by this author in the aforementioned book, which is the divergence between the actual and the desired. In the second chapter of that book, the focus is solely on this concept, and for good reason. The concept is based upon the notion that certain parties hold certain positions, with the noted parties being companies (issuers), investors, and the state. All of these parties have a stake in the process, and it is proposed that those stakes are intrinsically tied to the economic cycles. For example, in a boom period, the state must be seen to be encouraging business, which means encouraging investors to move their capital and for issuing companies to grow and develop, for which they need to borrow (predominantly). In this sphere, the issuing companies want to keep their operating costs as low as possible, as do the investors, in order to increase profits. Sounds simple, but if we look at the bust cycles, then there is a different sentiment put forward. The focus is on both recovery and attaining the heights of a boom period, so what is stated is often different to what is actually taking place. With respect to the audit industry, this can be seen with the competitions authority declaring that issuing companies must switch auditors at least every ten years – in terms of optics, this is very much a positive. But, if the aim were truly to protect the public and system moving forward, then the state would take aim at the oligopoly, which by its very definition does not allow for increased competition – the word itself is a derivative of a Greek word meaning ‘few sellers’. If the aim was long-term in its focus, the auditors would be forced to irreversibly divest from their conflict-laden consultancy businesses, which would serve to realign their focus on their audits and not treat them as loss-leaders. We know, however, that this has not happened. We do know that the illusionary approach of promoting competition was the approach taken, and in that sense we can clearly see the aim of the state. This is because it is imagined that the state acts for its citizens and their protections, so the calls to dismantle the auditors are based upon the notion that the auditors are causing harm, so the state must take significant action against them. However, is that version of the state a reality?

Recently we looked at the work of Karl Marx, and it is perhaps apparent that his work may be of relevance here. We saw in the wake of the Financial Crisis, or at least those who care to look saw, that the state does not prioritise the care of its citizens, but instead prioritises the care of the system. Now, some will surely respond to that by stating that to care for the system is to care for the citizen, but this author disagrees. To care for the citizen and the system would have resulted in quantitative easing, yes, but that would have been followed by extensive prison sentences to those who offended. As we know, that did not happen. What did happen was a period, that continues, of massive economic hardship for those at the bottom of society and political unrest that serves to shape the future for generations to come. Yet, amongst all of the sick dying in hospital corridors because there are no hospital beds, a surge in serious crimes like knife crimes, state-based attacks on the disabled, significant increases in those using foodbanks and many more social ills that are intensifying all the time, business is still prioritised, promoted, encouraged, and supported even when there is clear evidence that the business elite are plundering the marketplace – just think of RBS, Lloyds, Carillion, the ‘Big Four’, and many others. Many may argue, and that is of course their right, but the reality is that the state works for the system, not the public, and the fallacy that if you embolden the system you embolden the citizen is exactly that, a fallacy. So, in short, yes the audit industry is ‘too few to fail’, but in reality the number of auditors is irrelevant – their place within the system means they are immune to failure, and this is why the auditors behave in the manner that they do; they realise their position. Furthermore, the leading members of these firms and others like them are protected by their company-status, i.e. limited liability and pro-business Directors Duties. The result is that they remain protected even when proven to have transgressed, which is not a right afforded to any other lowly citizen, and soon, when the news cycles turn and the economy picks up, the focus will be on how to ensure that these very same firms grow – which, when you really take a moment to stand still and consider that dynamic, is truly remarkable.

Keywords – audit, oligopoly, KPMG, state, Marxism, business, politics, @finregmatters

Friday, 15 June 2018

Karl Marx: 200 Years On

Karl Marx would have celebrated his 200th birthday this year, and a recent article in the Financial Times has caused this author to muse ‘What would Marx think of today’s society?’ In this very brief post, we look at this article and discuss just what Marx may have thought of how society has developed, and whether the common perceptions of Marx even do the great philosopher justice in today’s consciousness.

This post is not meant to be a philosophical essay (far from it), nor is it meant to be some political statement. It is a simply a brief musing after reading a very interesting article here in the Financial Times. It is acknowledged that the FT is a subscription service, so whilst excerpts will not be repeated here, the general essence of the article will provide us with enough to look at the answer the question posed above (one cannot answer it, of course). The article is concerned with a project in Berlin set up to create a complete collection of Karl Marx and Friedrich Engels’ work, which when complete will span over a staggering 110 volumes of work. Such a staggering body of work will include letters and excerpts (which will be published in a digital format only), and the project’s leaders predict that it will be complete in 15 years’ time. The appropriately termed ‘Mega’ collection has had, as the article explains, a remarkable history in that others who have attempted such a feat have come in for political and, sometimes, actual execution. Gerald Hubmann, who is leading the project, is keen to project the ‘real’ image of Marx and Engels, an image he suggests should be characterised as one of academic and scientific debate rather than political discourse. Hubmann argues that earlier attempts to document the scholars’ work have constructed an image of the two as political animals attempting to meet political ends, but he suggests it is more the case that ‘Marx saw himself as a researcher and a scientist’. To supplement this point, Hubmann suggests that if Marx was a the political ideologue he has been painted to have been, then he would have completed the famous Das Kapital – that he did not proves, argues Hubmann, that he was an academic at heart and that he would have acknowledged that he did not finish this incredible work because, simply put, he could not… the research was not completed enough to allow him to do so. There is sense in this argument because, as Hubmann argues, if he was an ideologue, he would have completed the work and disseminated it to meet a certain goal.

It is likely the case that Das Kapital is one of Marx’s most famous works, perhaps behind the The Communist Manifesto, but that he did not conclude the work and others have done in his name is problematic. Hubmann discusses how this important element to Marx’s career and life, which as a scenario is replicated in another famous work – The German Ideology – has caused great consternation amongst followers of the Marxist ideal, with Hubmann noting how the Chinese Communist Party were displeased with the release of a new version of The German Ideology that proclaimed that ‘social existence determines consciousness’. The Chinese Communist Party apparently were unhappy as this notion affects one of the ‘pillars’ of Marxism.

Yet, the collected works bring forward new discussions regarding the work of these two scholars. Interestingly, Hubmann notes how even the remarkable level of output from the two is something of interest, mostly because they used to write side-by-side on occasion, page-by-page, so it is difficult to determine what ‘order’ the scholars wanted their narrative to be interpreted by the reader (as endeavours such as Hubmann’s piece them together after the event). However, it is noted at the end of the article that such endeavours are in-keeping with the times, as since the Financial Crisis there has been a marked increase on the work of the scholars from around the world. What then would they make of today’s world, particularly in this post-Crisis era?

It is, of course, an academic endeavour to ask such a question. The obvious response would be that Marx may feel vindicated in his approach because capitalism continues to lurch from crisis to crisis, enveloping all in its path just as he predicted in The Communist Manifesto (in fact, one need only read a few pages from the beginning to find such prophetic proclamations). However, rather than ask if he would feel vindicated, there may be other questions that would be better to ask. One of those may be to ask his thoughts on the scale of capitalism, as the capitalism he experienced has since morphed into something completely different. Now capitalism reaches into life (particularly first-world life) in such an intrusive manner – via the incorporation of modern technology in modern life – one wonders whether he could even comprehend that such an expansion was possible of such a system. He was, of course, effusive in his argument that capitalism is an organism that ‘spreads’, but its spread is so remarkable one wonders if he would even recognise this system as capitalism, or perhaps something else? There are of course a number of aspects of current life that he would realise, with aspects such as wealth-extraction, severe divisions within society (on many aspects, not just financial), and the presence of substantial globalisation (despite the best efforts of a certain political leaders) being clear examples of what he warned against. Yet, on that basis, one wonders whether he would change his views in light of what he would see today. This author studied Marxism during his first degree, and it was always apparent that certain elements of nature were, for want of a better term, overlooked. Perhaps ‘overlooked’ is too strong a term because Marx did acknowledge such elements a number of occasions, but his suggestion that the world would/should go back to a developed form of ‘early communism’ would be something to debate with him today. For example, what would his thoughts be on an argument that suggests with the ever-increasing human population, the inherent iniquities of human beings would be a natural prevention to the realisation of his idea? That is a common question that is asked of Marxism – how does this model actually apply to human beings – but the added element of an increased population may add a different dimension to this imagined conversation with the great philosopher. Perhaps the model only works when populations are at a certain size like that experienced by early humans? Perhaps that is not true, and that it is the presence of the ideal of capitalism as a counter-measure which is the foundation of any prevention. This author suggests that Marx would be tremendously staggered by what he would see today, but similarly not in the least surprised.

Marx has a permanent place in human history for his work, and rightly so. It is right that he has this place not because of one’s views, but because of the philosophical endeavour of the man and his work. But, one element stands out above all others when we consider his works on capitalism, and that is the concept of its ‘spreading’, or better still ‘contagion’. Despite what we may see on the news channels and on our phones whilst browsing Twitter feeds that suggest to us that globalisation is in recession, and that nationalism and individualism are marking irreversible marches to domination, it is not true. A system as complex and strong as capitalism does not simply die away as many have suggested in the past and continue to do so. It is, by its very nature, parasitic in composition – as the world grows, so does it. That last comment was not a comment on the worth of capitalism, but only on its composition, and in this imagined conversation with Marx one feels that it would be this element that would be most intriguing to him. On the 5th of May he would have celebrated his 200th Birthday, and now 135 years since his passing the composition of the system of capitalism has morphed into something much greater, something much more advanced – perhaps he would not even recognise it? If that was the case, one wonders what the philosophical implications of that are for us who inhabit the current system.

Keywords – Karl Marx, Politics, financial crisis, capitalism, @finregmatters

Article Preview: “Can Credit Rating Agencies Play a Greater Role in Corporate Governance Disclosure?” – Corporate Governance: The International Journal of Business in Society

In the first of a few brief posts today, we shall be looking at a forthcoming article by this author on the credit rating agencies and their potential involvement with a push to increase corporate governance disclosure rates in the EU. The article was invited as part of a special edition for the Corporate Governance: The International Journal of Business in Society Journal, and will be published very shortly.

The article is concerned with the European Commission’s (EC) efforts to increase the effectiveness of corporate governance disclosures, which is a system they have established which aims to construct a ‘comply or explain’ system of corporate governance reporting. The system was set up by the EC in 2014, and would take the form of what are called ‘corporate governance statements’. Since this system has been established, it has only witnessed limited success because, as was mentioned in a commissioned report for the EC, there has been a lack of ‘informative disclosure’ from companies caught by the regulatory endeavour. The EC acknowledged this in 2011 and since then have been formulating measures to help alleviate the problem, but there are a number of issues at play. The commissioned report noted that, as far as investors were concerned, only a quarter of reporting companies were producing information regarding their compliance with stated corporate governance regulations as ‘sufficiently good’.

Essentially, the program dictates that companies who are caught by the regulation (it differs by size and status i.e. public companies) must declare in a separate statement alongside their annual reports which national corporate governance regime they are following, and how they are complying with that stated regime. Taking influence from other jurisdictions that have applied a similar philosophy previously (like the UK), the EC wanted to allow for flexibility so companies are allowed to miss their obligations (if it is reasonable for them do so, on account of aspects such as applicability related to size or industry etc.) but they must subsequently explain why then have chosen not to comply. In attempting to increase the effectiveness of the regime, the EC has decided that a regulatory amendment is in order, and not a private one. That regulatory amendment takes the form of the national regulators (the ‘competent authorities’) taking a more active role in the monitoring of responses and the enforcement of the regime. The article discusses how that, according to some in the literature, ‘the market is not particularly concerned about non-compliance’, which adds to a viewpoint that there are very few deterrents within the current regulatory regime. This argument is based on the concept that, for investors, it is likely a ‘comply or perform’ dynamic, rather than a ‘comply or explain’ dynamic on account of investors tending to focus on the financial performance of a given company in respect of its organisational behaviour. For example, the suggestion is that if a firm is performing well, then it must be being governed well. We know that this is not the case, because a company may be performing well for many reasons other than good governance, and indeed it may be the case that the company is performing well because it is not being governed well. We know this dynamic to be short-termism, which is something the EC is trying to reduce on a systemic scale. However, the question for the article is whether the approach is increasing the regulatory framework is optimal or not.

There are issues with the call to increase the regulatory framework. Though it is often the case here in financial Regulation Matters that giving more power to the market is rarely called for, on this occasion the increase in regulation is littered with potential inefficiencies. One inefficiency that the literature has found is that the cost to the national regulators will increase, whilst the perception or the care from investors will not. If that dynamic comes to bear, then it is unlikely that companies will respond by increasing their disclosure rates. It is probably more likely that a ‘box-ticking’ exercise will ensue that will cost regulators but not benefit the marketplace. It is for this reason that the article suggests, but only suggests, that a different approach may be required.

That approach is to work with the credit rating agencies more and push for a slight alteration in their methodologies. Any regular reader of Financial Regulation Matters will know that this author is particularly critical of the credit rating agencies, and this article does not suggest that the rating agencies are the most optimal option as they stand. However, theoretically, they do have a potential role to play. For the agencies, methodologically speaking, ‘governance’ is one of the key factors in developing a credit rating. If a CRA is concerned with whether a borrower can repay a loan on time and in full, then how that borrower is governed will naturally be of importance to the designation of that particular rating. To digress, in a forthcoming book by this author entitled The Role of Credit Rating Agencies in Responsible Finance, the focus will be on examining the incorporation of ‘ESG’ principles into credit ratings – Environmental, Social, and Governance – although, for the rating agencies, they are incredibly clear that, for them (and for investors too), ‘Governance’ is the primary factor. So, if governance is a key factor for the agencies, what does that mean for the EC’s push for an increase in governance disclosure rates?

The article suggests that if the CRAs were to adapt their methodologies slightly so that, now, a credit rating included the quality of a company’s CG Statement disclosure, then there would be a market-based deterrent. Furthermore, this deterrent would be much more powerful than anything the state could provide, mostly because of how it would be received. Leaving aside whether it is positive or not for one moment, the marketplace is intrinsically linked to the CRAs and their ratings, and as such a negative rating carries serious weight for companies. You can often see press releases from companies (and states) and annual reports mentioning the need to improve a credit rating or protect a credit rating, and that is because investors use credit ratings. The reason why they use these ratings is another matter and has been discussed here in the blog, but the fact that they do means that companies would be incredibly attuned to the rating process. If the CRAs were to include the quality of governance disclosure within their rating, and also make that incorporation transparent for investors, there exists a real opportunity to develop a meaningful deterrent. The result would be a system whereby not only would poor disclosure be punished, but good rates of quality CG disclosure would be rewarded, which is a situation the EC covet. However, there are potential issues because of how the CRA industry is set up, and the ‘issuer-pays’ remuneration system is the largest issue of them all. If this system was put in place, then there is a potential that the issuer-pays dynamic would be leveraged so that the CRAs favoured the issuer when deciding the quality of the CG statements. For those who may read this and suggest there are safeguards in place to prevent that, this author would suggest that those safeguards – reputational pressure, competition, transparency – have always been in place and have been proven to have failed on a number of occasions in the past. But, there is a potential if the EC and the CRAs were to consider it.

Ultimately, however, the article suggests a regime that may work, but whether that gets adopted or not is another question entirely. Why would the CRAs increase their workload when they are recording massive revenues anyway? Is there an appetite from the EC to incorporate financial third-parties? To answer the first question, the CRAs may adopt this program as it would increase their shattered reputation in the eyes of investors and the financial arena, but we know here in the blog that they are not subject to reputational pressures. To answer the second question, the EC has shown that they favour the regulatory approach rather than a private approach, and that may be because of the damage the rating agencies caused in the Eurozone Crisis after the Financial Crisis – perhaps those wounds are (understandably) not healed yet. Nevertheless, there are options available to the EC and the marketplace to add a level of effectiveness to the CG Statement regime that is currently missing.

Keywords – Credit Rating Agencies, EU, Corporate Governance, Business, @finregmatters

Monday, 4 June 2018

Deutsche Bank’s Woes Continue

To say that the post-Crisis era has been challenging for Deutsche Bank would be a massive understatement, and recently their woes have worsened considerably. In today’s post we will focus on the Bank and its troubles and look at its chances of surviving such a turbulent time in its history. Ranging from massive fines to shareholder revolts, the Bank is lurching from one crisis to the next, and over the weekend S&P slashed its rating on fears that the bank will be unable to recover from this era of crisis. Therefore, a question that may need to be posed is whether the bank is approaching the end of its crisis, or whether these continuous troubles are merely the red-flags in the demise of this massive bank that had grand ambitions.

Developed in 1870 by the bank’s “true founder” Adelbert Delbrück, the bank’s original ‘statute’ ‘laid great stress on foreign business’. Very quickly the bank opened branches in Japan, China, the UK, and of course throughout Germany, although the bank’s own account of history notes that raising foreign capital with a name like Deutsche Bank proved difficult. To counter that problem, the bank would develop innovative models and products to help its expansion plans come to fruition. This snapshot of their origins has been included here because, if we look at the current problems being faced by the bank, it is this expansionary vision that is proving to be their greatest liability, and no longer their greatest asset. This is perhaps proven in retreat, and earlier this year the new CEO of the bank – Christian Sewing – was abundantly clear that long-held plans to challenge the giants of the global investment banking scene, like Goldman Sachs for example, had proven particularly costly and would not be part of the bank’s plans for the future. Again, to say that those plans had proven costly is an understatement, with their $7.2 billion fine for misleading investors in the US proving to be a critical juncture in this story of crisis at the bank.

Yet, whilst it was a critical juncture, it was perhaps the starting point. Since then, the bank has become inundated with crises, with Sewing stating recently that he is becoming ‘sick and tired’ of the bad news crashing against the shores of the bank. He said this after S&P had just cut the bank’s rating to BBB+ from A-, although that news followed closely behind the news that ‘the US Federal Reserve quietly decided the bank’s US arm was “troubled” up to a year ago’. The bank’s shares fell 7% as a result (this was on the 31st of May), which was arguably a reaction to this news and the news that the bank is planning ‘significant’ job cuts in key sectors of its business. The bad news continued to roll in, with it being suggested that Australian prosecutors are ‘preparing criminal cartel charges against Deutsche Bank, ANZ, and Citigroup, over a A$2.3 billion share issue’. The parties all deny wrongdoing, and Sewing was clear that ‘our financial strength is beyond doubt’, although this did not stop S&P declaring that ‘we see significant execution risks in the delivery of the updated strategy amid a continued unhelpful market backdrop, and we think that, relative to peers, Deutsche Bank will remain a negative outlier for some time’. This is clearly a damning assessment of Sewing’s ability to lead the bank out of crisis, and others in the business media have argued that, if one looks at the trajectory of the company, it is only heading one way; also, that European banks are suffering in relation to their American counterparts is only providing further fuel to the fire.

Ultimately, it is difficult to say that Deutsche Bank will fall. It is difficult to say this not because of Sewing’s declaration of financial strength – this is not to doubt his integrity, but saying anything other than this would be suicide for the bank – but quite simply because the widely-held (and probably amnesic) view that banks have had their ‘too-big-to-fail’ status reduced since the crisis is simply not true. Think of it this way, if the Bank was to show signs of imminent failure tomorrow, would the EU and Germany stand by and let it fall? The bank is far too entrenched for that to happen, but the reality is that this theory may soon be tested, because the sheer ferocity of these crises is perhaps indicative of the inevitable – not many companies faces crises of this magnitude, and this frequency, and live to tell the tale. Fines, job-cuts, criminal investigations, rating downgrades, a failing surrounding marketplace, and regulatory warnings are always negative occurrences, but to experience them all, within the space of a couple of years, has the potential to be terminal. The bank’s strength, and the political institution’s belief in not meddling in private institutions’’ affairs, will no doubt be tested in the near future if current trends continue.