At American Banker: Banks, Auditors, Market Concentration And More Audit Failures

My latest column at American Banker was published online on Monday and discussed some of the reasons, I think, why bank auditors are missing or consciously ignoring increased risk and poor to no controls at the big banks.

Auditors Are Asleep at the Switch on Banks’ Risk Controls

The Big Four auditors may not be catching errors and frauds at financial companies because they’d like to keep the business.

Those firms – Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers – are too busy trying to maintain longstanding relationships and selling consulting services to raise their hands about accounting manipulation and illegal activities.

Even a retired Ernst & Young Global Vice Chairman is worried the auditors are losing focus.

“I am personally worried about audit firms trying to get you to spend money with them on consulting,” Roger Dunbar, now chairman of Silicon Valley Bank, told the audit profession regulator, the Public Company Accounting Oversight Board, at a recent forum on auditor rotation. “It’s a risk.”

There’s more, but, in trying to get this column approved I had a spirited discussion with my editor. He was not quite convinced at first that I was being logical. In trying to convince him, I had some other thoughts on the subject.

He kept asking me, in several different ways, “How does the lack of choice for the bankers CAUSE auditors to look the other way?”

My responses are below:

There are at most four choices for auditors for the largest banks. It is an oligopoly not monopoly.

From Wikipedia: An oligopoly is a market form in which a market or industry is dominated by a small number of sellers (oligopolists). Because there are few sellers, each oligopolist is likely to be aware of the actions of the others. The decisions of one firm influence, and are influenced by, the decisions of other firms. Strategic planning by oligopolists needs to take into account the likely responses of the other market participants.

Although an auditor has some leverage over the client, since they control the opinion, auditors are tightly competitive within the financial services market for market share. When they threaten a material weakness or internal controls or push too hard on a correction to the client’s accounting that would cause a profit hit, they often get fired. If they get fired from an audit, they are likely not getting the consulting business for the bank either. Consulting is the growth business they all want more of, even more lucrative than audits and less likely to result in damaging litigation – except for Deloitte which has lots of  lawsuits for SAP and Oracle implementations especially in state and local governments. Consulting is a nice consolation prize for firms like Deloitte who lost Bear, Merrill, and WaMU, for example and were sued for their negligence in auditing them.

Auditors should be able to do the right thing but it is not in their economic interests to press issues or do more work or to force clients to pay more for work because of risky or questionable practices. We’ve returned to highly competitive pricing for audits, after the bonanza of the immediate years after Sarbanes-Oxley was passed. Audit have to hit their profit margin goals. Any large firm that is more strict or charges more for higher risk is easily replaced by one of the other four, but not so easily replaced that everyone would not rather cooperate and collaborate rather than be contentious and confrontational.

The Center for Audit Quality, an arm of industry trade organization AICPA, is the vehicle for communication between firms and keeps firms in line who make the rest look bad or who sell audit at a loss or otherwise upset the delicate balance. Even auditor changes have to be discussed, I would imagine, amongst the four large firms – whether the change is voluntary or involuntary. We heard at the PCAOB Forum in DC from P&G, PNC, and Goodyear that not all firms want to do audits for all companies, and some companies do not want to use some firms for audits because they prefer them to be consultants or because of previous experience or bias. So, in many cases, there are fewer than four firms who are willing and able to be an auditor for any Fortune 500 company, especially a systemically important bank or financial serves firm that requires specific expertise.

SOx was supposed to embolden auditors to speak the truth because it introduced increased independence by prohibiting most non-audit services. However, with only four firms,the oligopoly market situation frustrates this goal. Although banks may think they have upper hand because they can fire a firm, there are truly few to choose from and a new one may not be more pliable in the end than the incumbent. Banks don’t change firms because, after a while, they get one trained to their management philosophy and POV and do not like to train a new one with the risks and costs that entails. But banks use the threat of firing to keep firms in line. The oligopolistic market, however, does not mean auditors have upper hand on pricing because when they quit over principle, there is always another firm willing to take the business. It is just too lucrative.

The largest four audit firms also have additional limits as to which banks they audit because they have to bank with someone and they can’t audit that one. I’ve explained this challenge in a previous American Banker column. Independence requirements frustrate the possibility of implementing mandated auditor rotation for the systemically important financial institutions that the audit firms depend on to conduct their money-intensive business.

If we had ten audit firms of comparable depth, breadth, and experience in auditing publicly listed multinationals and banks, auditors would compete on quality. The audit firms are justifiably afraid of auditor rotation or dual audit schemes that may support development of viable alternatives for major portions of big audits or some significant other audits since this will affect pricing. The next tier firms all naturally would come from a lower cost structure position at first and be able to price more competitively. Eventually, given the consistent requirements of systems, quality and risk management infrastructure as well as having a legitimate global network not a marketing alliance, firms that want to play in the big leagues will develop cost structures that fall within a tighter range. But the entry of smaller, hungrier and, perhaps, more nimble next-tier firms into the mix for really big public company audits would wreck the big firms oligopolistically-priced, still highly profitable business model if given the chance to.

Should we care?

The largest four firms now only compete on how well they can please the client within a range of pricing that they may be, in effect, agreeing to amongst themselves. The four biggest global audit firms are self-insured using an offshore captive and so any loss by one or any willingness of one firm to tolerate significantly more risky activity and, therefore, accept a higher litigation risk has an impact on them all. Conversely, any significantly higher quality and or significantly stricter attitude by any one firm, especially in the tight financial services market, makes the rest look bad.

With only four large audit firms, there’s also the personal to consider. Leadership of the audit firms identifies more closely with bank executives  – see Davos appearances – than with shareholders. Audit firm leadership is increasingly dependent on the banks not only for audit business and the more lucrative consulting business but also for jobs. They have taken major board roles after retirement from the firms. It’s another example of watchdog capture.

Sir Michael Rake, retired Global Chairman of KPMG, is Audit Committee Chairman at Barclays. Former PwC Chairman Sam Di Piazza is a Vice Chairman at Citigroup, KPMG’s most recent Global Chairman Tim Flynn recently joined the board – the audit committee (and probably a reconstituted risk committee) – at JP Morgan. Deloitte’s former Chairman Parrett is on the board at Blackstone. Another PwC former global Chairman, Schiro, is Board Chairman and Audit Committee Chairman at Goldman Sachs. KPMG’s UK Chairman Griffith-Jones is heading over to that country’s financial services regulator. These are just a few examples at the highest, most visible levels.