Sunday, 17 February 2019

Understanding the Oligopoly Concept

On a number of occasions here in Financial Regulation Matters we have discussed the credit rating and audit industries. They have taken up a number of posts on account of their negative and impactful behaviour, and in most of the posts we attempt to conclude as to why they a. act in such a manner, b. are allowed to continue acting in such a manner, and c. what may be done to alter that behaviour. Often, we conclude by discussing the oligopolistic features of their industry and implying that those dynamics are the fundamental answer to all three aspects. However, the word oligopoly is sometimes defined within the posts, but often it is not elaborated what the concept is and why it is so impactful within these financial industries that are so crucial. In this post we will dissect the concept of an oligopoly and examine why the two identified industries are absolutely defined by the concept.

The term oligopoly roughly derives from the Greek words oligoi – meaning ‘few’ – and polein – meaning ‘to sell’ – with the essential meaning of a few sellers being helpful. The term itself will usually link one’s thinking to the concept of a Monopoly, meaning one seller, and then a duopoly, meaning two sellers. The actual coining of the term stems from the esteemed French mathematician Augustin Cournot who, in 1838, wrote Researches into the Mathematical Principles of the Theory of Wealth. Friedman discusses how within this noted work, Cournot introduced the theory of an oligopoly, but that ‘its most astounding characteristic is its complete originality. Usually, such a field of study develops through a series of stages, one shading into another, at the hands of a succession of writers’. Friedman notes that, before Cournot, there was no development of the theory. Before this development, Friedman notes how the word ‘monopoly’ was used to describe all variants – monopoly, oligopoly, and duopoly. The theory established by Cournot is particularly technical and is described in detail here. In order to simplify the concept, it is useful to think of the issue of having a number of sellers within a specific marketplace as being constrained by two ‘end-points’: collusion and an oligopoly. For example, in the marketplace the sellers could collude with each other to determine the price of the product(s) sold within that marketplace. However, as collusion is illegal in most economies, the result would be not only the potential of criminal investigation, but also the lack of a bind between the sellers based upon the illegal status of the agreement. So, in opposition to this, it has been noted that in an oligopoly the sellers will adjust their output ‘independently of the other firm’s output to maximise its profit’. Admittedly, the economic theory does become complicated and operates firmly within the comfort zone of Economists, but the essential sentiment is that the companies within the oligopoly have the ability, on account of them all essentially selling the same product, to analyse the strategy of their counterparts and develop their own strategies accordingly – the element binding them all together is the aim to maximise their profits. In that same sense then, undercutting your oligopolistic partner would not serve to maximise your profits, which preserves the status of the oligopoly itself.

However, there are other factors which affect an oligopoly and deviating from Economics for a moment will help us illustrate this better. If we use the financial services sector as a lens, then the audit and credit rating industry provide perfect examples of both oligopolies, but also what variables preserve that oligopolistic structure. In the excellent Corporate Power, Oligopolies, and the Crisis of the State, Professor Luis Suarez-Villa discusses what he labels ‘corporatocracy’ – ‘the overwhelming power of corporate interests over governance and society’ – and that oligopolies are absolutely crucial to the development of that power dynamic. In relation to this dynamic, he states that ‘corporatocracy is as important to oligopolies as water is to marine life – one cannot exist without the other’. Suarez-Villa is not hesitant when it comes to affirming his views on the power dynamic, and his view on the role of the oligopolistic vehicle is never as clear as when he states that in those ‘markets that neoliberal ideologues have fervently advocated for are mostly dominated by corporate oligopolies. Oligopolies that wield immense power over most everything we do, in most sectors of the economy, and that influence most every aspect of public governance’. So, for Suarez-Villa, the influence of corporate oligopolies is abundantly clear if one cares to look. At first glance, the viewpoint expressed above seems almost conspiratorial, belonging within the realm of ‘conspiracy theory’. However, not only is the Professor’s work meticulously researched – as we would expect – but there are examples all around us. Just two examples are the credit rating and audit industries.

Starting with the credit rating industry, this author discusses in meticulous detail the development of the industry from its non-commercial beginnings (with the Baring Brothers banking empire’s move into the antebellum [pre-war] United States), to the commercialised beginnings with the social reformers Lewis Tappan in the 1840s (via a failed venture in the 1830s). After enjoying a monopolistic situation in the first few years, Tappan would be joined in the marketplace by John Bradstreet, and his entrance was predicated upon methodological advances that served to quantify the process of credit rating. Henry Poor would develop his company based upon extensive knowledge and research of the rail roads, and John Moody would develop his company on the basis of a clearly defined Manual in the early 1900s. Once the split between credit reporting and credit rating – the former being concerned with a qualitative analysis of debt, and the latter concerned with presenting alphanumerical ratings – occurred at the turn of the turn of the 20th century, very little has changed. The merging of Standard Statistics with Poor’s company in the early 1940s gave birth to the modern-day Standard & Poor’s, and alongside Moody’s the duopoly was developed and has maintained ever since. The development of Fitch Ratings from 1914 has done little to dent the dominance of the Big Two, but is substantial enough to declare the modern industry as representing a pure oligopoly – the Big Three control more than 90% of the market between them. There are two elements which allow the oligopoly to continue irrespective of external pressure, and those elements are also witnessed in the auditing industry. The first is that all of the rating agencies, essentially, sell the same product. There are slight differences in the underlying methodologies behind the credit ratings, but essentially it is exactly the same offering (particularly with the Big Two). This serves limit competition because there is little use on 15 companies all doing the same thing. This leads us to the second and by far the most important issue, and that is the purpose and usage of the products being sold. It is often found within corporate oligopolies that it is the consumer that maintains the oligopoly, not regulation or legislation which is often criticised as protecting the oligopoly. For instance, the modern economy is defined by dispersed investors – say, institutional investors like a pension provider – and those investors have a number of competing pressures affecting them at any one time. Their managers must take certain investment decisions, but their principals, the pension holder, will want to a. know what the manager is doing and how they are performing, and b. constrain that management if there is a need to. Now, the pension holder would find it massively inefficient to review every financial decision the management take in detail, and if that were the process it would be so laden with inefficiency it would make the act of investing counter-productive in terms of profiteering. So, it is in this gap – what is called ‘informational asymmetry’ – that the credit rating agencies exist. They provide easy-to-understand and easy-to-assimilate information on what are often extraordinarily complex financial actions. That asymmetry is resolved, theoretically, by the rating agencies. If we return to the dynamic mentioned above then, the consumer of the ratings would therefore be disadvantaged if there were 10 leading rating agencies, because which one is best to follow? Which one is most accurate? Which one can be trusted? With Moody’s and S&P demonstrating reputations spanning more than a century, that reputation breeds trust. Yet, this is all very theoretical and we shall see shortly why.

The audit industry is remarkably similar to the credit rating industry. It is led by the ‘Big Four’ – PricewaterhouseCoopers, Deloitte, Ernst & Young, and KPMG, and their histories go back longer still. However, whilst the rating agencies’ function is central to the capital markets and their development, auditors are arguably central to the economy as a whole. In any interaction within the business sphere, trust is a central component. Even with reputation, how can one really trust in another? What happens if a traditionally trustworthy entity suddenly changes course? It is within this truly-foundational asymmetry that auditors sit. The modern day auditors fulfil a number of crucial roles within the marketplace, but acting as the primary ‘check-and-balance’ within business and within a host of transactions makes the existence of auditors crucial. So, even more so with auditors, what would the effect be of increased competition? The auditors are constantly facing ‘competition probes’ and suggestions that competition needs to be increased, but the reality is ‘increased competition in audit markets impact audit quality negatively’ – calling for increased competition within a perfect oligopoly displays a fundamental misunderstanding of an oligopoly. The consumers of audit ‘products’ would be fundamentally disadvantaged by an increase in competition, as the ability to trust in the auditor’s decisions would be compromised, thus making the whole process inefficient. We can see here that these two examples demonstrate the core constituents of oligopolistic characteristics – a market that competes on price but one which contains actors which can easily match their strategies to their competition’s based upon the selling of the same product, and a consumer base that would be actively disadvantaged by an increase in competition, thus preserving the oligopoly and preserving the cycle.

Any regular reader of the blog will know that this story cannot finish here. We have covered almost every negative action taken by the credit rating agencies since before the Financial Crisis, and we are kept abreast of negative developments within the audit industry. We will not go back over them here, but what can be easily seen just by keeping up to date with the business media is that these two industries consistently transgress (misbehave), even despite record penalties and massive regulatory action. We see the rating agencies receive over $2 billion in fines between Moody’s and S&P, a record figure, and then continue to transgress via methodological failings that favour the issuer over the investor. As for auditors, their misbehaving has shown absolutely no restraint, with almost every member of the Big Four taking up column inches in the business media on an almost daily basis (this is no exaggeration). A statement from Suarez-Villa seems absolutely relevant here and can, in terms of providing a juxtaposition, give us the answer why these industries continue to misbehave. Very early in the book Suarez-Villa declares that ‘the relations of power that oligopolies represent are largely ignored by the public today – lost in an avalanche of reports that are largely pro-corporate, and that view corporate interests as beneficial to most everyone’. So, according to this viewpoint, the public are not aware of the power of the oligopoly. However, and much more importantly, the oligopolists are aware of their position and subsequent power, and that is the primary reason why we see repeated transgressive behaviour. It does, admittedly, sound like a severe over-simplification, but the reality is that these industries transgress merely because they can, and it is extraordinarily lucrative to do so. Yes there are a number of criminological, philosophical, biological, anthropological, and many other perspectives that we could apply to why actors within these industries transgress, but what is for sure is that the oligopolistic vehicle is what fundamentally allows them to do so.

Credit rating agencies are beginning to fall away from public view a decade on since the Financial Crisis, mainly because their transgressions are now ‘limited’ in their scope. For auditors, the situation is very much different and they beginning to experience scrutiny like they did at the turn of the 21st century with their conduct surrounding Enron. This is leading auditors to defend their oligopolistic position, with some putting in measures like the clear separation of auditing and consulting service provision, and some even claiming that the perceptive role of auditors is wrong and should be altered. Yet, the reality is, there is no cure. There is an abundance of reform proposals, and an abundance of commentary that supplements criticism with calls for disbandment of the industries etc. However, this does not take into account the reality of the oligopoly and it is suggested here that any reform proposal that does not take that fully into account is bound to fail. Criticism and critical reform proposals are to be encouraged, but it is vital they are directed to the most realistic and therefore potentially most efficient route to altering the transgressive nature of these industries – and that route is by fundamentally considering the dynamics of oligopolies and then taking the appropriate action.

Keywords – business, audit, accounting, credit rating, regulation, oligopolies, @finregmatters

Saturday, 2 February 2019

Auditors and the ‘Expectation Gap’

We have only looked fleetingly at the story of Grant Thornton – The British-founded ‘professional services’ company that is now regarded as one of the largest firms outside of the traditional ‘Big Four’ audit firms – and its connection to Patisserie Valarie. As the chain sits currently in administration and is ‘set to be sold off piecemeal’, the role of Grant Thornton in auditing the chain just before it collapsed has brought the auditor firmly into the spotlight. Grant Thornton’s CEO is currently facing questions from MPs and, as part of his response, he has told the House of Commons Committee that there was an ‘expectation gap’ between what is expected of audit firms and what they do in practice. In this post, we will review the story and analyse the developments, but focus more on this concept of an ‘expectation gap’ existing in relation to the auditing industry, which is particularly centralised within the financialised society we live in.

Patisserie Valerie entered into administration last week, with the chain saying that 70 of its stores would immediately close. The Financial Times is reporting that, due to its ‘unreliable accounts’, even businesspeople who specialise in purchasing collapsed companies are avoiding the wholesale purchase and are instead looking to purchase only ‘chunks’ of the failed business. KPMG, the auditor undertaking administration responsibilities has provided very limited information so far and it has been suggested that the chain’s financial figures, dating back almost six years, may not be reliable; the newspaper continues by including a quote from an unnamed source that states: ‘it’s been a very long time since I’ve seen a fraud like that. I couldn’t bid on it’. As a result, there are a number of investigations currently underway. The FRC are investigating the associated auditors under the ‘Audit Enforcement Procedure’, the SFO has opened an investigation into an unnamed individual, although it is also conducting a wider investigation into the collapsed chain. However, it is currently David Dunckley who is facing the questions. Dunckley stated that ‘we are not doing what the market thinks. We are not looking for fraud and we are not looking at the future and we are not giving a statement that the accounts are correct. We are saying they are reasonable, we are looking at the past, and we are not set up to look for fraud’. MPs responded angrily, with Peter Kyle MP responding ‘if an audit is not picking up on [fraudulent] behaviour, what is the point of audit in the first place?’. It is worth mentioning that representatives of other firms did not agree with Dunckley’s assessment, with BDO saying ‘you look for material frauds’ and Mazars saying ‘what the public expect is to be able to rely on a set of accounts’. A rival auditor was quoted by The Financial Times attacking Dunckley’s testimony, stating that ‘our worry is that he has damaged the audit profession as a whole’. The question is, is the public perception of the audit industry inherently damaged anyway?

The same article discusses how the audit industry, or at least three of its biggest players (PwC, EY, and KPMG) would be ceasing providing ‘consulting services’ to FTSE 350 audit clients by the end of 2020. We have discussed this issue of ‘consulting services’ before, primarily in relation to the conflict-of-interest issue that similarly occurs within the credit rating industry when they provide ‘ancillary services’ for those who they rate (the sole focus of the author’s first book), but it is worth asking whether this is enough to rebuild the public’s trust in this particular sector. Though there are clear historical cases of auditors’ failures, including Enron and WorldCom, the auditors will be quick to label these as ‘legacy issues’. However, if we focus more recently, we can see that the auditors, and this spread between them and not just one particular auditor, have consistently failed in their remit. Recently there has been a number of scandals involving auditing failures, including: Patisserie Valerie; Carillion; Conviviality; Rolls-Royce; BT; Mitie Group; BHS; Sports Direct; Ted Baker; and Quindell. It is bordering on the remarkable that there is even a question over the competency of these massive global firms; it is clear there is something inherently wrong with the operations of these companies.

It is difficult to pinpoint where that problem lies however, and that is assuming there is just one problem. Reviews of the associated regulators have found that, in the case of the FRC, the regulator is ‘built on weak foundations’, whilst it has been suggested by a number of observers (chief amongst which is Professor Prem Sikka) that the auditing and consulting arms of the auditors should be fundamentally split. In this author’s first book cited above, there was a discussion on the auditing industry and that fed into the calls to enforce the splitting of these two arms within the credit rating industry, and make the splitting of the arms irreversible. This suggestion was based on the fact that, after the Enron and WorldCom scandals, the US-led Sarbanes Oxley-era provided an environment where, essentially, the largest auditing firms were pushed to divest from their consultancy arms. Although the credit rating agencies (S&P in particular) went on to acquire a number of components from this divestment, there was a fundamental issue in that the Sarbanes Oxley-led divestment was done with the sentiment of encouragement, rather than enforcement. The auditors did divest, but they did so on their terms, with short periods being declared as to when they would not conduct consultancy services from that point. Inevitably, in the run-up to the Crisis, the auditors had rebuilt these consultancy arms that were directly identified as being crucial to the Enron-era degeneration in standards, and since the Crisis these consultancy arms have continued to grow. Now, with PwC, EY, and KPMG telling regulators that they will divest, it appears the same thing will happen again; the auditors will respond to public demand, but wait for the news cycles to oscillate away from the industry and then rebuild. This tremendously cyclical arrangement is continuing unabated, and many seem happy for this to be the case because it resolves an issue now, and not fundamentally.

Another aspect is that the so-called ‘Big Four’ are an oligopoly, and that is a vital understanding. The theory of the marketplace is that the firms will compete on quality and price, and what will result is an efficient sector that is affordable to the customer. However, in an oligopolistic marketplace, those elements do not exist. When one firm takes a certain action, the other members of the oligopoly will usually, and it is argued here that they must, take the very same action – this is represented clearly with the firms stating that they will stop providing consultancy services to FTSE 350 companies who they provide audit services to as well (KPMG started this sentiment and the others followed). So, if we accept this oligopoly-based theory is the truth, and it surely is, then the options available to regulators are extraordinarily limited. They cannot seek to encourage competition to disturb the hegemony within the oligopoly because an oligopoly is defined by a lack of competition. Also, increasing competition has the potential of perceptively reducing quality within the sector, and even though it may sound paradoxical, many customers would not want a potential reduction in quality even though the sector is clearly fraught with inefficiency – customers know what they are getting with the Big Four and, crucially, the validation received from the Big Four still carries value with external elements, such as investors. Whilst the value exists, the oligopoly will also exist, as is the theory of oligopolies (a great book on Oligopolies can be found here by Luis Suarez-Villa). With that in mind, the current situation is unlikely to change. What will probably happen, and it is strongly suggested here that the following is almost guaranteed to happen, is that the auditors will respond to external pressure in a manner that placates that external pressure, after which they will perform, for a while, in a manner that removes scrutiny from the sector. Once that scrutiny passes and moves onto another sector, the audit sector will re-develop the very same practices and the cycle will simply continue. If one is uncertain about the direction of a certain sector, it is usually wise to look backwards. The cyclicity within the marketplace is abundantly clear to see, if one cares to examine it within that set of parameters. If one is looking for a political victory, in the here and now, then it will be easy to overlook such a trend. It will be worth noting the current stage where it has been identified that the mix of auditing and consulting arms are one of the fundamental keys to auditor failings, and see how long the industry-led impediments on that combination actually last; it will likely be not very long at all.

Keywords – audit, regulators, business, patisserie Valerie, law, economics, @finregmatters