Why institutions trade their reputations for profit

It is a key assumption that financial institutions such as auditing firms and credit ratings agencies will act in an ethical way to protect their reputation because it is, ultimately, the source of their profitability. But groundbreaking work by Harvard University postdoctoral fellow Abigail Brown posits that institutions may actually be incentivised to cyclically “trade down” their reputation in an effort to maximise profit.

Brown, who presented research at a recent conference at The Paul Woolley Centre for the Study of Capital Market Dysfunctionality, is part of a cohort of Harvard academics looking at the question of institutional corruption.

The attempt to identify, define, classify and ultimately find solutions to the question of institutional corruption in a free-market economy is a focus of Brown and other scholars at The Edmond J Safra Center For Ethics at Harvard.

Brown’s work utilises an unusual blend of historical research and economic theory, which she says is an “attempt to develop the intellectual infrastructure to actually be able to measure this [institutional corruption] in a more empirical context”.

The research she presented at the conference is still in the developmental stages but examines the structure of the market and the role of reputational-dependent industries, such as ratings agencies.

Brown argues that ratings agencies – or what she calls “certifiers” – have a unique role in the market because a number of institutional investors are required to hold triple A-rated assets.

In addition, the reputation of ratings agencies is reinforced by the quality of clients they attract on the back of their ratings being crucial to access capital markets.

“Reputation is important to these entities, but it is not as responsive to behaviour as we anticipated it being, and there are several things that contribute to a firm’s reputation,” Brown says.

“Some of these are internally directed, such as their competence and their honesty, and some of these are an artefact of their clients. If they have a lot of great clients, then they have a lot of great results, even if the clients they are supposed to be constraining they don’t actually constrain.”

Brown looks at the role of certifiers, such as credit ratings agencies, and argues that their signalling role has little informational value to clients.

Sophisticated investors rarely depend on credit ratings as an accurate analysis of risk, Brown says, the real value that these ratings provide is vital access to capital markets.

“The value of going to the capital markets is so high that clients are willing to pay a fee for a certificate that doesn’t actually provide any additional information, because it gives them access to credit markets,” she says.

“Because these good clients are willing to stick around, you [certifiers or credit ratings agencies] can afford to collude with low-quality clients because the overall rate of failure is still going to look pretty good.”

Because there is little informational value in the signal, poor-quality projects are not discouraged from attempting to gain certification – further strengthening the role of certifiers, says Brown.

In fact, the value of access to capital markets is so high, Brown argues, that both poor and good quality projects will seek the certification, leaving the certifier in the powerful position of being the sole filter of projects.

Brown says it is often the case that a misstep does not result in a reputational disaster for an audit firm or ratings agency.

She cites recent examples, such as Bear Sterns and Lehman Brothers, where firms that were responsible for overseeing financial checks escaped disastrous damage to their reputation, despite the high-profile failures.

In the case of Arthur Andersen – whose demise was linked to scandals at Enron and WorldCom – Brown argues that the indictment the firm faced was more damaging than any direct reputational damage, because it eroded its quality client base.

Many clients in the US were not authorised to use the services of a firm that was facing an indictment.

The lack of a quality client base is a major barrier to entry for any possible new entrant, further strengthening the position of existing certifiers, Brown says.

Even if a new certifier was better at identifying good projects from bad projects, their lower quality client base would result in a higher failure rate of firms, ultimately undermining their reputation.

This limited reputation would, therefore, diminish the real value of the certifier as a provider of access to capital markets.

There is also evidence that certifiers who hold a powerful position will act as a cartel and collude to maintain their oligopoly position, says Brown.

She attempts to provide a mathematical model by using a basic profit function to demonstrate that there is a point where a firm will seek to maximise profit by cyclically trading down their reputation.

“When your reputation is damaged it is relatively cheap to be honest, because the value of the bribes you can collect is lower,” she says.

“Once your reputation is high, the value of those bribes is very valuable and you can spend down that capital.”

Brown says this research is still a work in progress, with questions around whether the market can predict this reputational cycling and react accordingly; and whether this oscillation in reputation is a result of assumptions in the modelling or actually present in the inherent workings of the market.

Along with her current work, Brown has also utilised the archives of PricewaterhouseCoopers – covering more than a century of accounting – which the firm donated to Columbia University in 2000.

Brown has used the historical archives and basic game theory concepts to look at when an auditor and a client may be likely to collude.

The Harvard’s Center for Ethics has an ambitious plan to move from research to advocacy of potential solutions to the problem of institutional corruption in the next five years, Brown says.