Efforts to mitigate the impact of systemically important nonbanks on the global economy have largely omitted a sector deeply entangled with financial institutions across the capital markets: the big accounting firms.
The Financial Stability Oversight Council, mandated by the Dodd-Frank Act to designate "systemically important financial institutions" for bank-like regulation, has to date applied the label to four firms: three insurance giants — American International Group, Prudential and MetLife — and GE Capital. (A court overturned MetLife's designation, and steps by GE Capital led the council to rescind its designation.)
While FSOC's future authority is somewhat in doubt as President-elect Trump sets to take office and the GOP has maintained control of both chambers of Congress, the work of regulators to contain systemic risks is no less important. And they should turn their attention to the "Big Four" auditors that, despite being nothing like a bank or a broker-dealer, provide the audit opinions legally-mandated for all of the SIFI-designated institutions.
Market regulators have often declared auditors as important components of the capital markets. But some media attention has highlighted obvious concerns about "too big to fail" for a sector largely concentrated into four big firms: Deloitte, EY, KPMG and PwC.
Some have also raised concerns about the quality of audits performed by the Big Four. In conjunction with a critical report released in 2015 by the International Forum of Independent Audit Regulators, IFIAR Chair Lewis Ferguson, a member of the Public Company Accounting Oversight Board, said, "We continue to see high levels of inspection deficiencies in vital areas of public company audits."
These are valid starting points, but there are further reasons for concern.
The first is the precarious state of the Big Four model itself. Although it was the most tightly organized and profitable of the then-Big Five, Arthur Andersen collapsed in 2002 under the crushing weight of the liability and law enforcement burdens of Enron's collapse. Nearly 15 years later, nothing has made the surviving Big Four any more robust against a shock of similar magnitude.
This issue was put in sharp focus in August, when PwC's U.S. firm was put under the microscope in a state court trial in Florida over its audits of the failed Colonial Bank and the bank's relationship with mortgage underwriter Taylor Bean & Whitaker, which was linked to criminal activities. Claims against PwC totaled $5.5 billion, which would threaten the financial resources of most any company. The firm settled for an undisclosed amount.
But systemic-risk concerns with the Big Four extend to how they audit already-designated SIFIs. Should just one of the Big Four collapse, the whole audit model for the SIFIs would collapse too, due to conflicts of interest and scope-of-practice limitations.
A SIFI is required be audited by a firm that does not already provide ancillary services to the company, such as tax advocacy, valuation, M&A advice or systems consulting. Because of consolidation in the accounting industry, a SIFI likely has connections to all of the Big Four. Should one of the big accountants fail, a SIFI would have no auditor replacement options among the resulting Big Three.
Middle-tier accounting firms would be unable to fill the void left by the collapse of one of the Big Four, because of the demands of scale, geographic coverage and depth of sector expertise required of a realistic alternative; also, those smaller firms would be unwilling to inherit the risk of legacy lawsuit liability, and so would have no incentive to fill such a void. Suddenly, the entire auditor role filled by accounting industry giants could be called into question.
Complicating matters, the Big Four accounting companies are structurally unresponsive to the tools typically deployed by bank regulators, e.g. capital injections, reorganization or "living wills", or "bail-in" equity. In light of their partnership structures, they have neither the need nor the use for additional capital.
In light of all this, the FSOC should be asking: What would happen if audit opinions for the SIFIs became unavailable due to the collapse of the Big Audit model? Is an audit opinion on a SIFI's financial stability — that is, that it is a "going concern" — so vital that the system would be questioned if another Big Four firm suffered an "Andersen-like" exit?
Dodd-Frank provides FSOC with the authority "to monitor domestic and international financial regulatory proposals and developments, including … accounting issues, and to advise Congress and make recommendations in such areas that will enhance the integrity, efficiency, competitiveness, and stability of U.S. financial markets." Accordingly, the onus should be on FSOC to monitor and scrutinize the stability of the Big Four.
The FSOC should also craft a roadmap for the reconstruction of financial statement assurance in the event of the collapse of the current model. Planning today for the unappealing but real possibility of the need to pick up the pieces of a broken Big Audit model would be in the interests not only of effective auditing, but of the entire financial system writ large.
Presuming that these issues resonate with the banking regulators, we propose that FSOC take a hard look at the extent to which the auditors and their function are "systemically important," and consider what actions should follow.
Jim Peterson is a lawyer whose practice concentrates on financial information and securities. His book, Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms, was published in December 2015 by Emerald Books. William Kring is a senior academic researcher at the Boston University Center for Finance, Law & Policy.