Centre for Economic Policy Research

General discussion
Richard Portes argued that the picture was even worse than that described by the
Report. Recent work in game theory overturns the conventional views about the
value of reputation. It says that developing reputation can be a bad strategy that
could lead to minimum rather than maximum profits in the long run, therefore
suggesting more arguments for regulation. He also commented on the idea of
directors paying for their liability insurance. There is an example of such a solu-
tion in the United Kingdom with charities that cannot buy the liability insurance
of their trustees. Implementing this more broadly does not seem implausible.
Finally, he discussed the value of rating agencies. In the sovereign debt market,
the market processes risk reasonably well. Historically, after market crashes, the
data on sovereign bonds suggests that during the lending in the 1920s; the bank
lending of the 1970s; and the sovereign bonds issued in the 1990s the real rate of
return ex-post, taking into account the defaults, is almost the same, about 2%. In
fact, the market is pricing the risks of default without any particular help from the
rating agencies. These make things worse ex-post, after issuance, because they con-
tribute to the self-fulfilling nature of financial crises. Therefore, we ought to ques-
tion the value added of rating agencies, at least in that market.
Charles Freedman commented on the role of litigation risk in explaining 
developments and behaviour. The high risk of litigation may be one of the 
Discussion and Roundtables 93

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reasons why the United States has adopted a rules-based approach to accounting
standards, while Europe, with less litigation risk, has tended to use a principles-
based approach. It has also been argued that an enhancement of the ability to sue
accounting firms may give them greater incentives to function better. 
Trevor Harris answered that from an economic efficiency perspective, internal
controls could be more efficient. Performance measurement and the way 
incentives are provided actually create the split, however. From a more 
macroeconomic point of view, the split will globally raise the costs because it will
take away the efficiency that exists. Harris argued that it is true on the analysts’
side as well. 
Avinash Persaud elaborated on the idea that rating agencies encourage selling
when they are downgrading. The problem is that there are covenants in the 
private sector by which private companies are forced to sell bonds with low 
ratings. This can trigger a vicious circle since when the bond price falls, and the
rating agency downgrades it, private companies are in turn forced to sell. Persaud
admitted not knowing how to eliminate these covenants in the private sector,
however.