When it comes to financial credibility, the joke is on the ratings agencies!

The extraordinary thing about the loss of our ‘cherished’ AAA credit rating is not that the Chancellor hitched his economic credibility to it in the first place.  Actually, that is fairly incredible but it isn’t the most incredible.

Neither is the most incredible thing the fact that acres and acres of newsprint have been devoted to this ‘disaster’.  Nor is it the fact that almost everybody (including Ed Balls), quietly agrees that it is not going to make a blind bit of difference to our ability to raise money in the capital markets.

No, the most incredible thing is that anybody is even remotely listening to Moody’s in the first place or for that matter their competitors namely Standards & Poors and Fitch’s.

In fact, when I heard that the AAA rating had been removed I laughed!

Why?  Because the main culprits for the financial meltdown in 2008 are as follows.  Firstly the global investment banks who played Russian roulette with the weapons of mass destruction now known as CDOs (credit default obligations).

Secondly, the major accountancy firms who declared the investment banks to be solvent, despite the fact that they had no way of knowing the potential liabilities of banks holding the CDOs.

Thirdly, the politicians who with a combination of either light touch regulation or total disregard for regulatory norms let the banks run amok.

Finally, the credit ratings agencies who gave credibility to the slicing, dicing and securitisation of dodgy mortgages in what became known as the mezzanine CDO market by giving them AAA ratings despite not having a clue what was in them.

In fact, by all accounts the conversations between the ratings agencies and the banks went something like this.

Banker:  “You know that stack of securitised mortgages you gave AAA ratings to a few months ago?”

Ratings agency:  “Yeah”

Banker:  “This one’s exactly the same”

Ratings agency: “OK then, you can have another AAA.”

No research, no questions, just throwing AAA ratings around like confetti.

The fact that these same people now pass judgement on the British economy is risible to say the least.

The ‘Big Four’ must sound the retreat

Good business stories are like buses, nothing for ages and then two come along at once.  Friday was just such a day.  In the morning we had the Competition Commission laying into the Big 4 accountancy firms and by the evening we had lost our AAA credit rating.

I’ll start with the Competition Commission though, before moving onto the downgrade tomorrow.

Certainly the Commission’s report should make for uncomfortable reading on the partner floors of the big firms.  You would think that phrases like “high prices, low quality”, “insufficiently independent” and “cosy relationship between auditors and senior management” would ring alarm bells.

We are talking about the Big Four here though, who promptly declared that there was no conflict of interest in management teams appointing auditors (PWC) and that the market is competitive (Ernst & Young).

In fact, PWC went as far to say that the Commission had grossly under-estimated the role of the Audit Committee in protecting shareholders’ interests.  Perhaps, but the problem is that there is much money to be made from selling other services alongside an audit to the executive management teams.  The danger is that those services, such as tax advice, become so lucrative that auditors potentially become constrained in their criticism which fatally undermines the audit process.

This is not a new concern.  Robert Bruce, who wrote the Audit column in The Times for many years, used to say that an audit should be no more comfortable for a management team than the pulling of teeth.  I know from my own experience that there used to be a client services manager within one of the Big Four here in Birmingham whose job it was to ring up clients post-audit and ask “how was it for you?”

Where do we go from here?  If I was advising the Big Four I would urge them to go along with the Commission’s proposals which seem reasonable.  The Commission is arguing for mandatory tendering and rotation of audit firms.  You could certainly argue it should go much further and insist on no reappointment for at least six years which would allow some of the second tier firms to get a piece of the FTSE 350 action.

The Commission is also recommending the prohibition of ‘Big 4 only’ clauses in loan documentation.  Again, this is not unreasonable and should help introduce further competition.

Personally, I would also introduce a rule that no former auditor should be eligible for appointment to a company’s board for at least five years following his departure from an accountancy practice.  This should ensure that the gravy train comes to a crashing halt.

My advice to the accountancy profession would be to accept that change is required, that major mistakes have been made, such as Ernst & Young declaring Lehman Brothers to be solvent, and that the market is uncompetitive.

The danger for the Big Four if they continue their belligerent approach is that the Commission’s ultimate proposals will be far more draconian.  What’s more it will play into the hands of the European Union which already has them in its sights!