shyam sunder yale school of management krakow university of economics krakow, poland may 21, 2009

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  • Shyam SunderYale School of Management

    Krakow University of EconomicsKrakow, PolandMay 21, 2009

  • Protecting Consumers and InvestorsProtection of consumers and investors from unfair or misleading practices is the common goal of regulationThe question worth discussing: How do we achieve this goal?We do not wish to fail to protect the interests of consumers and investorsOr promote unwise regulation that may bring more harm than goodI would like to concentrate these remarks on regulation of corporate financial reporting which has gained in urgency in light of the recent events

  • Regulatory Cooperation and CoordinationRegulatory cooperation yields many advantagesSimplifying the environmentClear communication of the regulatory regimeBetter and cooperative enforcement among jurisdictionsAdoption and use of best practicesAvoidance of race to the bottomAn appearance and sense of control (until things go wrong)Closing the cracks between the adjacent regulatory domains, etc.The recent decades have seen gradual expansion of regulatory cooperation which has yielded many of these benefits (and revealed some weaknesses)However, as in most matters of social policy, there always the other side of the coin to be considered: regulatory competition

  • Regulatory CompetitionIn pursuit of the obvious advantages of regulatory cooperation, it is easy to overlook its limits and the advantages of alternativesRegulatory uniformity and cooperation works fine in a world were regulatory alternatives and their respective properties are already known and well-understoodSuch extensive knowledgea Cartesian universeis highly desirable, but often unachievable by any oneAs recently as 18 months ago, US regulators sincerely defended their hands-off approach to the derivatives marketThey were neither incompetent nor MachiavellianFew people knew the consequences of those regulatory policies until much damage had been doneIn fact, most of the time, we live in a world where properties of regulatory policies, and indeed the alternatives themselves, must be discovered through trial-and-error through experience

  • Regulatory HumilityThere is a case to be made for regulatory humilityoften we do not know the consequences of policy alternatives until we try them outIn contrast to the Cartesian mindset of regulatory uniformity through top-down design with complete knowledge of the system, regulatory competition suggests a Darwinian mindsetThe consequences of changes in social policy involve reactions of millions of people adjusting to the policy in their own diverse and ingenious waysWe cannot be sure of the consequences of a policy until we try it out and see what happensWe could try to find a balance between the cooperative and the competitive approaches

  • Extraction and Generation of Benefits of InnovationEUs single market initiative is an example of an effort to make sure the benefits of innovation are enjoyed to the maximum extent by lowering barriers to free movementMaking the markets more perfect by removing frictions clearly helps this goalBut there is the other side of the innovation coingeneration of innovationEntrepreneurs innovate to make private profits by differentiating their products and thus creating local imperfections which tend to be eliminated only over time through competitionBlocking innovation to prevent profit making through differentiation would kill the golden goose of prosperityPatent law as an example of the struggle for this balance

  • Financial Reporting: Some Commonly-held Beliefs

  • 1. Universal StandardsUniversal standards of financial reporting applied across time, economies, industries and corporate size and organizational forms best serve the constituent interestsStandardization does save costs and effort, (electrical plugs, clothing, cars, street grids, commercial codes)Becomes counterproductive beyond certain limitsHow do we know where to stop?Few industries have universal standards, and no professions have themRhetoric of universal accounting standards and universal language

    *(c) 2005 Sunder, Nanny Knows Best*

    (c) 2005 Sunder, Nanny Knows Best

  • 2. The Static IdealThere exists a set of financial reporting standards that, once discovered and implemented, will induce corporations and their auditors to prepare the best attainable financial reportsDynamics of the game between managers and standard setters makes any such static ideal all but impossibleStandards is only a (small) part of the problem

    *(c) 2005 Sunder, Nanny Knows Best*

    (c) 2005 Sunder, Nanny Knows Best

  • 3. People or StructureIf we select knowledgeable, experienced, self-less, public-spirited, and wise individuals to constitute bodies that devise accounting standards through deliberation and due process, we can improve financial reportingIndividuals stand where they sitMuch emphasis on the quality of individuals, too little attention to the structure of game they are asked to play*(c) 2005 Sunder, Nanny Knows Best*

    (c) 2005 Sunder, Nanny Knows Best

  • 4. Engineering Standards through DeliberationIt is possible to construct or discover better financial reporting standards through deliberation in properly organized corporate entities (such as the IASB, the FASB, etc.).Assumes that such bodies can know the consequences of their actionsHistory does not support the proposition

    *(c) 2005 Sunder, Nanny Knows Best*

    (c) 2005 Sunder, Nanny Knows Best

  • 5. Specialization in Setting StandardsSpecialist standard setting bodies, standing ready to address new problems, inquiries and requests for clarifications help improve financial reportingTheir existence encourages a new clarification game targeted at themThey must keep a full agenda (performance)Revenue and budget pressuresOver time, their output must accumulate to a thick rule book*(c) 2005 Sunder, Nanny Knows Best*

    (c) 2005 Sunder, Nanny Knows Best

  • 6. What is High Quality Standard in Accounting?Standard setters can tell which standards are better and why.Little evidence that they know, or can knowCost-of-capital is the result of complex interactions among many factors (including accounting)These influences cannot be sorted out by ex ante analysisEx post analysis of data to assess the impact on cost of capital may be possible

    *(c) 2005 Sunder, Nanny Knows Best*

    (c) 2005 Sunder, Nanny Knows Best

  • 7. Standards MonopoliesGranting monopoly power in a given jurisdiction to standards written by a given body can help improve corporate financial reportingInformational disadvantage of a monopolyNo opportunity for experimentationNo opportunity to learn from the experience of alternativesNo pressure to do better, or to correct errors*(c) 2005 Sunder, Nanny Knows Best*

    (c) 2005 Sunder, Nanny Knows Best

  • 8. Competition and Race to the BottomA regime that encourages reporting entities to choose among the standards written by competing organizations (and paying them a royalty for the privilege) induces a race to the bottom to devise less demanding standardsCounter examples (Stock exchanges, bond rating services, appliance standards, college accreditation, bank regulation, corporate charters across U.S. states, etc.)

    *(c) 2005 Sunder, Nanny Knows Best*

    (c) 2005 Sunder, Nanny Knows Best

  • 9. Force and EffectivenessIncrease in the power of enforcement behind authoritative standards improves compliance and quality of financial reportingIncreased enforcement also increases resources devoted to evasionDraconian punishments do not necessarily induce better behaviorCrime, alcohol and drug abuse*(c) 2005 Sunder, Nanny Knows Best*

    (c) 2005 Sunder, Nanny Knows Best

  • 10. Statutory Approach Dominates Common LawThe quasi-statutory approach to setting accounting standards dominates a common law approach to financial reportingEvidence?Constitution (U.K., U.S., Europe)

    *(c) 2005 Sunder, Nanny Knows Best*

    (c) 2005 Sunder, Nanny Knows Best

  • 11. Written Standards Dominate Social NormsWritten standards backed by power of enforcement work better than unwritten social norms backed only by internal and external informal sanctionsSocial norms govern great parts of our lives including many aspects of lawInsider tradingGuilty beyond reasonable doubtPrivate commercial codes (cotton, diamond trades)

    *(c) 2005 Sunder, Nanny Knows Best*

    (c) 2005 Sunder, Nanny Knows Best

  • 12. Who defends the middle ground?The ideal accounting regime would consist of all written standards or all social normsEasier to make the extreme cases for standards or norms aloneDifficulty of defending the middle ground where both may co-exist, as they do in many other aspects of life

    *(c) 2005 Sunder, Nanny Knows Best*

    (c) 2005 Sunder, Nanny Knows Best

  • 13. New Problems, New SolutionsFinancial reporting and governance problems originated in the 20th centuryHistory tells us otherwiseGovernance problems of the East India CompanyClive, Hastings, and the Companys Court of Directors*(c) 2005 Sunder, Nanny Knows Best*

    (c) 2005 Sunder, Nanny Knows Best

  • 14. Financial Reporting is Getting BetterSeventy years of standardization of financial reports (in U.S.) has helped improve the quality of financial reportingEvidence?Is a thicker rulebook indication of better financial reporting?Perfect correlation between accounting and stock returns?How do we judge if our financial reports are getting better?*(c) 2005 Sunder, Nanny Knows Best*

    (c) 2005 Sunder, Nanny Knows Best

  • 15. Fewer Alternatives, Better ReportsFewer the alternative treatments the reporting entities are allowed to choose from, the better the quality of financial reportingFewer alternatives also tie the hands of the ma

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