Financial Reporting and Economic Development Shyam Sunder, Yale University Second Critical Studies in Accounting and Finance Conference Financing Development and Reshaping Globalization United Arab Emirates University, Abu Dhabi, December 15-17, 2013

Sunder: Financial Reporting and Economic Development An Overview Three elements critical to economic development Public investment Private investment Good governance Financial reporting is an important part of the governance structure Recent attempts to improve financial reporting through grant of globalized monopoly power to a single standard setting body may be well-intended but often misguided Way forward and caution for financial reporting to help promote sustainable development 11/10/2018 Sunder: Financial Reporting and Economic Development

Sunder: Financial Reporting and Economic Development Public Investment Requires generation of sufficient amount of surplus in the society Output in excess of the sum of the opportunity costs of all inputs Political decisions to harvest a part of the surplus in taxes or sovereign ownership of resources Appropriate a sufficient part of harvested surplus for public investment Government must efficiently plan, budget, manage, control, and report on the fruits of public investments In UAE, it is easy to see the importance of public investment for development In many societies, public investment fails when one or more of these conditions are not met (no surplus, no investment, inefficiency, corruption, mismanagement, opaqueness) 11/10/2018 Sunder: Financial Reporting and Economic Development

Sunder: Financial Reporting and Economic Development Private Investment Private investment requires that of the total surplus generated, enough is left in private hands Surplus generated exceeds the living expenses of the population Taxation policy and prospects for the future make it attractive for individuals to save Infrastructure, economic environment, laws and administrative processes render it attractive for entrepreneurs to invest Property rights, Public facilities and services Security and safety Regulation to control externalities, commercial code, Dispute resolution (courts, arbitration, administrative) Banking and capital investment infrastructure, Financial reporting, Financial audit to control fraud, and Operational audits to promote efficiency. 11/10/2018 Sunder: Financial Reporting and Economic Development

Governance--Broadly Defined The abovementioned elements are part of the governance system of each society Organizations and societies can be seen as sets of contracts or alliances among people seeking their respective goals Good governance is an expectations equilibrium; it calls for a match between the expectations people hold of others in the organization, and the incentives of the latter But a static expectations equilibrium is not enough Good governance also calls for generating a positive social, economic, individual and aggregate dynamic to promote and support creativity and innovation This is a challenge for all societies. Why? 11/10/2018 Sunder: Financial Reporting and Economic Development

Sunder: Financial Reporting and Economic Development Imitate to Develop Hardly surprising that the first instinct of most of us, wishing to improve financial reporting and governance to promote development and investment is to imitate Look at developed and high investment societies and reform the reporting and governance system to be like theirs Attempts to imitate tend to fail because governance is a network of expectations and motivations consisting of history, laws, regulations, business and professional practices, social norms and customs Importing a list of check boxes from New York or London and demanding compliance from the locals does not work (even if one assumes that it works in the source country; Enron, WorldCom??) Imitation is at least voluntary, and may include some customization to local conditions A more disturbing tendency is to force the financial reporting and governance practices of the developed economies on others with the assumption that the latter will benefit from them I am going to argue that this “harmonizing” the financial reporting and governance systems by top down rules is not an efficient, even feasible, way of promoting public or private investment in development. 11/10/2018 Sunder: Financial Reporting and Economic Development

Sunder: Financial Reporting and Economic Development Challenges of Improving Financial Reporting and Governance by Writing Standards Eighty-year project in US to write down accounting rules to improve financial reports Rules have grown from a few pages to more than 10,000 pages Yet, no evidence of improvement in financial reports Indeed, many of the failures and misdeeds of the financial services industry in the recent financial crisis attributed by many to wrong-headed written standards Most people think of accounting as rules. Why would written rules, harmonized across the world make things better? 11/10/2018 Sunder: Financial Reporting and Economic Development

Limitations of Written Rules Insufficient knowledge of socio-economic system for rule makers to improve reports What is a good standard is unclear People react to rules and change behavior in ways which are difficult to predict Added detail creates more loopholes (Enron SPEs) Financial engineering easily beats any rules, especially in financial services and instruments; roadmaps for evasion Rules to narrow reporting options also limit the ability of users to signal through choice of reports Reduced discretion in enforcement Specialized standard setting bodies attract endless demands for clarifications 11/10/2018 Sunder: Financial Reporting and Economic Development

What about “Harmonization”? Argument: general standards of financial reporting and regulation applied across time, economies, industries and corporate size and organizational forms best serve the society (e.g., Basel, IFRS, FAS). Standardization does save costs and effort, (electrical plugs, clothing, cars, street grids, commercial codes) Becomes counterproductive beyond certain limits when environments to which they are applied are diverse How do we know the limit of standardization? Rhetoric of universal accounting standards and universal language (Esperanto?) 11/10/2018 Sunder: Financial Reporting and Economic Development

Creating World Monopoly in Accounting Standards Informational disadvantage of a monopoly No opportunity for experimentation No opportunity to learn from the experience of alternatives; arrogance No pressure to do better, or to correct errors Pros and cons of regulatory competition 11/10/2018 Sunder: Financial Reporting and Economic Development

Accounting Regulators No Match for Financial Engineers Regulators, constrained by governments, business and profession, often take years to write the rules and standards. Their labor of love—carefully drafted regulations—rendered ineffective when financial engineers and lawyers design of new instruments, transactions and organizations to bypass the regulations. No amount of wisdom and hard work by regulators, whether located in Basel, Norwalk, or London, has or can overcome this fundamental disadvantage. 11/10/2018 Sunder: Financial Reporting and Economic Development

Why Difficulty Writing Regulatory Standards for Derivatives? Some derivatives are designed to get around the intent (provision of information) of the extant financial reporting standards How does one write standards for these instruments? Is it possible to have an equilibrium between design of such instruments and standards for reporting them? The problem seems to have gone largely unnoticed in the flurry of proposals on financial reforms now on the table The question is: Are the optimization in financial engineering (relative to prevailing reporting standards), and search for standards that provide useful information to investors mutually consistent goals? 11/10/2018 Sunder: Financial Reporting and Economic Development

Standards and Language Standards of financial reporting and regulation must necessarily be specified in language Language, in order to be useful, must necessarily have certain imprecision around the meaning of words Can we specify precisely the meaning of a house, or shirt, or table? Instead reliance on usage—a matter of social norms What happens if we try to do so? Regulators have tried to counter financial engineering by resorting to the fiction that more precise definitions of words, e.g., assets, liabilities, income, regulatory capital, etc. will solve the problem But they have not, and they cannot; bound to fail 11/10/2018 Sunder: Financial Reporting and Economic Development

Returning to Development If it is so difficult to improve financial reporting in UK, EU and US by writing down standards of financial reporting and governance, what is the chance that imitating the standards written for these economies elsewhere will assist development and prudent investment? Each society has its own history, customs, language, social norms, laws, commerical and business practices Chances that a one-size-fits all approach to financial reporting, promoted by the comforting label of “harmonization”, will help is remote in my mind 11/10/2018 Sunder: Financial Reporting and Economic Development

Sunder: Financial Reporting and Economic Development Creativity in Finance These consequences of financial engineering suggest that the social consequences of creativity in finance can be as socially detrimental as creativity in accounting Objects of finance consist of (are defined) entirely by the relevant covenants and the accounting system To the extent financial institutions have significant social externalities, and receive special support in form access to borrowing from the central banks Their transactions have to confined to those conforming to a pre-approved template. 11/10/2018 Sunder: Financial Reporting and Economic Development

Sunder: Financial Reporting and Economic Development A Lesson from History Financial services became exciting and high-paying in the 1920s, and dropped to a low level after the great crash of 1929. After half-a-century of excitement and high paying jobs and finance, we have seen another global crisis. We need to assess the contribution of the new finance to GDP and social welfare, and assess if it is better to return it to a boring trade which is confined to a small set of pre-approved transactions. Remuneration of people working in such an industry will return to low levels, but the rest of society may be safer and prosperous. 11/10/2018 Sunder: Financial Reporting and Economic Development

Sunder: Financial Regulation & Engineering 1/18/2013 Sunder: Financial Regulation & Engineering

Good Accounting/Banking/Finance is Boring Our lives depend on efficient functioning of many systems (e.g., electrical wiring, plumbing, foundations of our buildings, telephones, and computer networks) All such essential and critical systems are made efficient and routine to the point of being boring, low paying jobs, following pre-specified procedures and codes. Innovations are slow, but made only after much experience and regulatory deliberation. Excitement in such essential fields portends disaster (e.g., electrical wiring of Boeing 787 Dreamliner) 11/10/2018 Sunder: Financial Reporting and Economic Development

Sunder: Financial Reporting and Economic Development In Summary What is “sustainable development”? If development is continuing increase in per capita consumption, how can it be sustainable? Sustainable development makes exacting demands on accounting, finance, and the larger system of governance in society and economy Chances that a single system of globalized financial reporting and financial regulation can achieve these ends are low With the development of mathematical finance, financial engineers rapidly redesign transactions, instruments, and business entities to render prudential and reporting regulation in the financial services ineffective. This new reality has been a key element of the celebrated regulatory and reporting crises of the past dozen years. Band-aid solutions for this new fundamental reality (such as Basel III and IFRS fair value accounting) have little prospect of success Development will not be facilitated by dependence on such a top-down system of financial reporting or governance We should explore ways of developing and analyzing solutions to this challenge, beyond imitation of London, Frankfurt or New York This will help bring to academica a sense of social responsibility for the consequences of our own research agendas? 11/10/2018 Sunder: Financial Reporting and Economic Development

Shyam.sunder@yale.edu www.som.yale.edu\faculty\sunder Thank You. Shyam.sunder@yale.edu www.som.yale.edu\faculty\sunder