Centre for Economic Policy Research

Avinash Persaud 
State Street Bank and Trust Company
Avinash Persaud agreed with most of the Report and focused his comments on the
areas with which he was in slight disagreement. When discussing regulation, it is
always wise to determine what the market failure that we are trying to address is,
since there is often a large gap between the market failure and the regulatory 
solution. Indeed, there are two key market failures with auditing companies and
rating agencies. 
The first market failure is the principal-agent problem of shareholder capital-
ism. In many places, although not all, the board is neither independent from the
managers, nor acting in the sole interest of their shareholders, nor appointing
auditors who will dig deep to find if there is any disinformation. Often the 
management is key to the appointment and reappointment of the board, to 
determining whether they are on the sub-committees of their choice, knowing
that the sub-committees may give remuneration. Persaud’s favourite solution to
this problem is directors’ liabilities. In almost every occasion the company pays
for the insurance liability of the directors removing the cost that they face of
being sued for their liabilities if the company fails. Persaud said that this is the
wrong approach. The correct way to deal with corporate governance issues and
the correct appointment of auditors who dig deep is to ban companies from pay-
ing the insurance liabilities of their directors. The director should pay and the 
company should pay a good enough, non-exact remuneration that would meet
90 Conflicts of Interest in the Financial Services Industry

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the average director’s liabilities. This is a very good way of enabling the market to
function, since directors with a bad insurance rating will be priced out of the 
market. 
Even when independence is achieved, another issue to bear in mind is the
interest of future shareholders. Even if there is an independent board concerned
with existing shareholders, it might not be good enough to ensure that there is
correct auditing. Who then can make sure that the interests of both current and
future potential shareholders are best served? In trying to break the link between
management and auditing, other people than the board could appoint these 
auditors. There are two possibilities to do so. One is related to the listing agencies;
when a public company is listed there are various commitments to comply with
and one of these could be that the listing agent will appoint an auditor. There are
many issues and problems with this approach and a danger of added 
bureaucracy, added costs of listings when listing should to be made easy to
encourage companies to come to the market.
Persaud was biased to a second solution, which is the rotation of auditors,
despite being aware that it also raises some concerns. The rotation should be of a
long enough period, maybe three to four years, so that the auditors will be 
concerned about an explosion happening on their watch. A counter argument is
that with rotation the auditors do not have enough time to understand the 
company. Persaud dismissed this argument since good management is transpar-
ent and clear and thus making it is easy for someone coming from outside to take
over and understand what is going on. 
The second market failure is the reputation capital, which is the last refuge of
the anti-regulators. It is true that it is a powerful tool, but less so in an environ-
ment of uncertainty and oligopoly, as is the case for rating agencies. Persaud was
very concerned, however, with rating agencies advising on the creation of a debt
structure, which is then sold with their rating on it. Persaud acknowledged some
sympathy with rating agencies and said that one should be careful in the 
finger-wagging exercise. There will always be problems uncovered at the end of
booms, but rating agencies have not been any better or any worse than other 
market participants. The reputation capital should have made sure that they had
behaved better than other market participants, but the problem is that reputation
capital is not plentiful in a duopoly. In an uncertain environment two rating
agencies basically move their ratings in line with each other. Where can the 
reputation loss come from? When one agency gets it wrong, so does the other.
The reputation capital is very slim in such an environment and indeed it is 
slimmer than the reputation required for the industry as a whole. Thus, 
more competition is needed in the ratings industry. There is a danger that 
the regulation is reinforcing the existing establishment, creating higher barriers 
to entry. There are often requirements (from the investors’ side, rather than 
the regulators’ side), saying that a particular instrument has to be rated by 
more than one agent. This has created a market where there are two to three 
players. What would happen if the requirement said that you had to be rated by
more than three? Regulation should be used to encourage competition in that
industry. 
To conclude, there is a risk of creating more regulatory approvals 
for auditing companies and rating agencies, reinforcing their oligopoly 
status and raising the barriers to entry. Regulation should be used to support 
competition, to create reputation capital and break the link between the manage-
ment and the auditors.