Norms and Regulation: Accounting beyond the Financial Crisis Shyam Sunder, Yale University Social and Moral Norms: Institutional Perspectives on Accounting, Financial Markets and the Firm Annual Meetings of the American Accounting Association, New York, August 3, 2009

An Outline A polity can be thought of as a set of alliances among individuals based on personal goals Culture is a set of common knowledge expectations of the members of a polity Control in a Polity: balance between self-interest and expectations, better performance for satisfaction of all members of the polity In the financial crisis control broke down, leading to losses and disappointments due to change in environment and excessive reliance on formal regulatory mechanisms (reasons) Social norms play a critical role, need to be valued and preserved (in addition to written rules, standards and laws) Balancing written standards and social norms may help reduce instability but will need new institutions of accounting (regulatory competition, self-restraint, and antitrust relief)

Culture In management, culture often treated as a counterpoint to economics Can think of culture of a group as the common knowledge expectation of behavior of the members of a group –Starting meetings on time –Wearing black on black Expectations lie at the heart of economic models

Controls A viable concept of control in a polity can be built from alliance, expectations, common knowledge and culture A polity is in control when its members find it in their own best interests to behave in a manner that is expected of them by the other members of the group In other words, expectations and self-interest balance each other

Threats to Control Environment and self-interest change An alliance which is in control today, will not be in control tomorrow if conditions change Regulatory structures are supposed to maintain the balance necessary for control But these structures themselves suffer from two major difficulties: –The Information Problem –The Gaming Problem

1. The Information Problem Regulator has to figure which rule is better What is a good rule for determining interference in soccer? What is a good height of the goal posts? Each possible answer changes the behavior and therefore the game itself in ways which are difficult to anticipate The regulator may try to ameliorate this informational disadvantage by soliciting information from the parties potentially affected by its actions. No incentive to report truthfully; strategic responses only muddy the waters

2. The Gaming Problem The information problem compounded by dynamics between rules and the behavior the rules are intended to influence Each regulation alters the decision environments of individuals, and potentially alters their decisions Induces individuals to search for new alternatives, create new opportunities The regulators cannot anticipate all such changes and the new rules often lead to unintended consequences Individuals can adjust faster than the rule makers can The regulated can easily and rapidly change instruments, transactions and their organization Difficult to make sure that this action-reaction sequence converges to a rule and behavior in equilibrium

Role of Social Norms Can polity be run smoothly by markets and alliances alone The information and gaming problems point to the difficulty of relying totally on markets Some self-restraint, whether it comes from social norms or moral code seems necessary No matter how you write the regulations, the regulated parties have innumerable degrees of freedom to redesign the instruments, transactions and organizations to get around the intent of the regulations It is difficult to think of a recourse other than self-restraint Since self-restraint cannot always be expected of all, such crises are likely to be repeated The problem is that exclusive reliance on social norms itself is hardly a perfect solution because societies often get stuck in inefficient norms So the problem of crises is inherent in human nature and society

What Is the Best We Can Hope to Achieve? We know that written standards alone cannot ensure balance or control in an economy We also know that dependence on evolution of social norms alone may not work Perhaps striving for a new kind of balance between standards at a general level, combined with social norms hold better promise Example of revenue recognition What kinds of institutional structures will be needed to support this balanced regime?

Reform of Institutional Structure of Accounting Existing structures (FASB, PCAOB, IASB) must progressively clarify their standards to increase the size of their rule book pushing social norms to extinction Alternative structures: Limited regulatory competition Emphasis on professional responsibility in education and practice combined with self-restraint on business side of practice and antitrust relief from government With its quality essentially unobservable to the customers, the market for audit services cannot survive full competition without turning into a market for lemons

A Summary A polity can be thought of as a set of alliances among individuals based on personal goals Culture is a set of common knowledge expectations of the members of a polity Control in a Polity: balance between self-interest and expectations, better performance for satisfaction of all members of the polity In the financial crisis control broke down, leading to losses and disappointments due to change in environment and excessive reliance on formal regulatory mechanisms (reasons) Social norms play a critical role, need to be valued and preserved (in addition to written rules, standards and laws) Balancing written standards and social norms may help reduce instability but will need new institutions of accounting (regulatory competition, self-restraint, and antitrust relief)

Thank You.

Rethinking the Financial Architecture The financial crisis calls for some basic rethinking of the financial architecture along many dimensions 1.Degree of integration and insulation in the global system (capital convertibility) 2.Control of systemic risk (deposit insurance, size of institutions) 3.Separation of commercial and investment banks and control of leverage 4.Transparency of financial transactions (exchanges, clearinghouses) 5.Opaque regulatory jurisdictions beyond law (Cayman Is.) 6.Dynamics of financial regulation, instruments, transactions, and organizations (degrees of freedom in the system) 7.Regulatory competition (getting ready to fight the last war, creativity) 8.Interaction between politics and regulation (mortgage security, compensation, capture, no ultimate solution) 13