The anatomy of scandals

The anatomy of scandals
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First Published: Sun, Jan 11 2009. 08 56 PM IST
Updated: Sun, Jan 11 2009. 08 56 PM IST
B. Ramalinga Raju invented $1 billion in cash, which never existed. Satyam, his firm, has lost close to $4 billion in market value, wealth that never had a firm foundation, it turns out. The Satyam scandal has shaken corporate India, and damaged its reputation with investors, domestic and foreign. Meanwhile, of course, Bernard Madoff had evaporated tens of billions of investors’ dollars in the US. And the subprime crisis of fraudulent and misrepresented mortgage-backed assets triggered perhaps $30 trillion in losses of wealth worldwide. It is tempting to see all these scandals as symptoms of the same disease—unchecked capitalist greed— and look for a fix through greater government control. We seem to have come full circle since the heady days following the collapse of the communist model across eastern Europe. But capitalism is a complex beast, and the scandals that have been piling up have multiple causes and require multiple cures.
Private negligence: Financial capitalism needs monitoring and disclosure. The basis of modern limited liability corporations is high standards of accounting and disclosure, which allow markets in ownership shares to function well by increasing certainty and trust. Auditing of accounts to verify disclosure is a basic check in the system. Several years ago, Enron perpetrated a massive accounting fraud. It failed, and so did its auditor. Satyam’s accounting fraud appears to be much less complex, and the auditing failure all the more shocking. Madoff used a tiny auditing firm to help hide his Ponzi scheme; Satyam’s auditor is one of the big four global accounting firms. Unlike Madoff, Satyam also had a high-profile board of directors, whose job it was to monitor and guide. What were they doing? Numerous officers of the firm should also have had some inkling of what was going on, even if they were not involved in the fraud. Enron did have a whistle-blower, whereas Satyam relied on a Madoff-like ending when hiding the fraud finally became impossible and the perpetrator confessed. Negligence can be punished, but raising standards won’t help if the problem is failure to detect violation of standards.
Public negligence: Financial markets or financial systems rarely thrive with self-regulation alone. It is too tempting to gang up on the outsiders and cheat them. Corporate outsiders can be insiders through public action, helping create government regulation. The Satyam scandal is being seen as indicating weaknesses in India’s corporate governance, which is based on government regulation, but structural weakness was less important in this case than sheer negligence. On the other hand, the Madoff scandal seems to have involved public negligence on the part of the Securities and Exchange Commission (SEC), which failed to pay attention to numerous warning signs. And the subprime scandal was allowed to develop and spread because of the SEC’s apparent negligence in supervising investment banks, as well as the Federal Reserve’s seeming failure to do its duty with respect to monitoring the soundness of the banking sector.
Private institutional failure: In the case of Satyam, the surrounding institutional structures were sound—the actions taken were not. Even in the Madoff scandal, the requirements for due diligence by institutional investors existed, but were just not followed. On the other hand, the subprime scandal was magnified and spread because the institutional structure itself was unsound. Numerous financial innovations of great complexity had taken place, including derivatives built on top of securities carved out of asset pools containing toxic mortgages. Yet the trading system for these complex derivatives was poorly developed: bilateral deals, no transparency, and no clearing mechanism for large gross positions on different sides of the market. Modern institutions used for trading more basic financial assets (shares of firms) were not adopted for trading a wide array of complex derivative assets. The investment banks operated in a 19th century manner.
Public institutional failure: This is the most talked-about cause of the scandals we have been seeing, usually in the form of criticizing deregulation. But the old regulations were obsolete long before they were repealed. The public institutional failure was in not forcing the market participants to design and implement new institutions for trading new financial instruments: Public action could have substituted for the lack of private institutional innovation. There are numerous public institutional failures in India (e.g., regulations for corporate governance, bankruptcy, and maintenance of competition), but they did not cause the Satyam scandal. The much bigger subprime mess, however, was compounded by public failure to update key institutions.
The lesson of the scandals is that there are multiple things that can go wrong in modern economies built on complex financial systems. Negligence needs to be distinguished from structural failure. And it needs to be recognized that these problems can arise in the private and the public sectors. Solutions have to be matched to the nature of the cause and its institutional location. Bleeding the patient cannot be the treatment for every disease.
Nirvikar Singh is professor of economics at the University of California, Santa Cruz. Your comments are welcome at eyeonindia@livemint.com
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First Published: Sun, Jan 11 2009. 08 56 PM IST