Is the writing on the wall for Wall Street? It could be, according to a gloomy warning from US Senator Charles Schumer and New York City Mayor Michael Bloomberg. The two published a worrying report in January saying that New York could lose its status as a global financial market without a major shift in public policy. The report, commissioned from consultant McKinsey, says New York’s financial markets have been stifled by stringent regulations and high litigation risks and are in danger of losing businesses and high-skilled workers to overseas competitors. New York could sink to the lowly status of a ‘regional market,’ which would have wide-reaching implications, both for the city and the US economy, it said. “If New York goes from being the financial capital of the world to becoming only a regional market, as this report predicts will happen within the next 10 years, every aspect of New York life will suffer, not just financial services,” Mr Schumer said at a press conference to release the report; Sustaining New York’s and the US’s Global Financial Services Leadership. Speaking with typical New Yorker bravado, Mr Bloomberg told the same audience that excellence in financial services had made the city “the world’s capital,” but that title could soon be up for grabs.
Economic dominance
“The 20th century was the American century in no small part because of our economic dominance in the financial services industry, which has always been centred in New York,” he writes in the introduction to the report. “Today, Wall Street is booming, and our nation’s short term economic outlook is strong. But to maintain our success over the long run, we must address a real and growing concern: in today’s ultra-competitive global marketplace, more and more nations are challenging our position as the world’s financial capital.” While London has traditionally been the city’s chief competitor, “Today, in addition to London, we’re increasingly competing with cities like Dubai, Hong Kong, and Tokyo.” And this isn’t just an issue for New York. Financial services drive eight percent of US gross domestic product, and create more than five percent of all jobs nationwide. Seven states, including New York, have more than 10 percent of their state’s GDP derived from financial services. McKinsey argued that, left unchecked, certain key trends could knock a big dent in the US economy. The country could miss out on between $15bn and $30bn in financial services revenues annually by 2011. Those revenues, if retained, could translate into as many as 30,000 to 60,000 jobs in the US, said the consultants.
Financial markets
So what are these trends that are doing so much damage? Much of the pressure on New York is due to improved financial markets abroad, and the fact that sophisticated technology has virtually eliminated barriers to the flow of capital. Physical location is simply less important than it used to be. But a significant number of the causes for the city’s declining competitiveness are self-imposed. For instance, US-based financial services firms are now unable to attract and retain many of the highly skilled professionals they need because of caps on the number of visas available under US immigration rules, the report said. And a greater perceived litigation risk has reduced the appeal of the US market to many foreign firms. Ironically, at the press launch of the report Mr Bloomberg and Mr Schumer shared a platform with state Governor Eliot Spitzer who, in his previous role of State Attorney General, vigorously prosecuted Wall Street wrongdoing and probably did more than anyone to create a climate of fear. On top of all that, a complex and sometimes unresponsive regulatory framework has not only prompted many foreign firms to stay out of the US markets, but also is forcing more business overseas because of the complexity and cost of doing business in US financial markets, regardless of where they are located.
The findings of the report break down into three main areas. First, the US regulatory framework is a thicket of complicated rules, rather than a streamlined set of commonly understood principles, as is the case in the UK and elsewhere. The flawed implementation of the 2002 Sarbanes-Oxley Act (Sox), which produced far heavier costs than expected, has only aggravated the situation, as has the continued requirement that foreign companies conform to US accounting standards rather than the widely accepted – many would say superior – international standards. “The time has come not only to reexamine implementation of Sox, but also to undertake broader reforms, using a principles based approach to eliminate duplication and inefficiencies in our regulatory system,” Mr Bloomberg writes. Second, the legal environments in other nations, including the UK, far more effectively discourage frivolous litigation. “While nobody should attempt to discourage suits with merit, the prevalence of meritless securities lawsuits and settlements in the US has driven up the apparent and actual cost of business – and driven away potential investors,” says Mr Bloomberg.
Overblown reputation
“In addition, the highly complex and fragmented nature of our legal system has led to a perception that penalties are arbitrary and unfair, a reputation that may be overblown, but nonetheless diminishes our attractiveness to international companies.” The proposed answer is legal reforms to reduce spurious and meritless litigation and eliminate the perception of arbitrary justice, without eliminating meritorious actions. Third, and finally, a highly skilled workforce is essential for the US to remain dominant in financial services. “Although New York is superior in terms of availability of talent, we are at risk of falling behind in attracting qualified American and foreign workers,” says Mr Bloomberg. “While we undertake education reforms to address the fact that fewer American students are graduating with the deep quantitative skills necessary to drive innovation in financial services, we must also address US immigration restrictions, which are shutting out highly-skilled workers who are ready to work but increasingly find other markets more inviting. The European Union’s free movement of people, for instance, is attracting more and more talented people to their financial centres, particularly London.”
Competitiveness
The report sets out an action programme to rescue New York’s future. The measures it calls for include short-term administrative actions that can signal renewed focus on competitiveness, actions to level the playing field for both domestic and foreign companies doing business in the US, and longer-term initiatives to address more complex policy, legal, regulatory and other structural issues affecting the US position as the world’s leading financial centre. Action number one on the list (see sidebar on next page) is a move to make compliance with Sarbanes-Oxley easier. No doubt the New York burghers were cheered by the fact that they got much of what they wanted on this score before the ink had even dried on their report. Just before Christmas US regulators proposed to alter the basis on which the notoriously onerous provisions of Sox operate. The Securities and Exchange Commission (SEC), the US financial regulator, and the US audit standard setter the Public Company Accounting Oversight Board (PCAOB) each published proposals aimed at making life easier for those companies that have to comply with the act, which affects US listed companies and their affiliates. The SEC said its proposals would encourage more of a risk-based approach to compliance with section 404 of the Act, by setting out the principles it expects companies to follow, rather than strict rules.
Section 404 requires companies to evaluate the company’s internal controls over financial reporting. It has been a major bugbear for companies, and has massively increased their compliance workload. SEC chairman Christopher Cox suggested companies had turned to PCAOB’s guidance on interpreting the requirements about internal control in the act in the absence of any clear guidance from the SEC, which, he said, “was not what was intended.” With the proposed new guidance and the new auditing standard from PCAOB “management will be able to scale and tailor their evaluation procedures to fit their facts and circumstances,” he said. The SEC says the guidance will address the main concerns companies have raised about section 404. These include excessive testing of controls and excessive documentation of processes, controls, and testing. The new guidance – still only in a proposed form – is organised around two principles. First, management should evaluate the design of the controls that it has implemented to determine whether there is a reasonable possibility that a material misstatement in the financial statements would not be prevented or detected in a timely manner. This change will allow management to focus on controls needed to prevent or detect material misstatements, rather than all the financial reporting controls.
Associated risk
Second, management should gather and analyse evidence about the operation of the controls being evaluated based on its assessment of the risk associated with those controls. This will allow management to align the nature and extent of its evaluation procedures with those areas of financial reporting that pose the greatest risks to reliable financial reporting. The guidance goes on to address four specific areas: how to identify the risks to reliable financial reporting and the related controls that management has implemented to address those risks; how to evaluate the operating effectiveness of controls; how to report the overall results of management’s evaluation; and how to document controls.
Assessment procedures
“The proposed interpretive guidance should reduce uncertainty about what constitutes a reasonable approach to management’s evaluation while maintaining flexibility for companies that have already developed their own assessment procedures,” said John White, director of the SEC’s division of corporation finance. “Companies will be able to continue using their existing procedures if they choose, provided of course that those meet the standards of Section 404 and our rules.” In a coordinated move, the PCAOB published several proposals including a new principles-based standard to replace Auditing Standard Number Two.
The standard-setter said the proposed new standard on internal control is a principles based standard designed to focus the auditor on the most important matters, increasing the likelihood that material weaknesses will be found before they cause material misstatement of the financial statements. The proposed standard also eliminates audit requirements that are unnecessary to achieve the intended benefits, provides direction on how to scale the audit for a smaller and less complex company, and simplifies and significantly shortens the text of the standard. Another proposed standard focuses on the grounds on which external auditors can use the work performed by internal auditors, management and others in an integrated audit of financial statements and internal control, or in an audit of financial statements only. This proposed standard is intended to further clarify how and to what extent the external auditor can use such work to reduce the amount of work they have to do.
Those changes, if they are introduced, will be a big help in the short term. But Mr Bloomberg emphasised policymakers must avoid complacency about New York’s long-term future. “Our capital markets and financial services firms will only enjoy continuing growth – growth that our city expects, needs and demands – if we take seriously the challenges from rapidly-expanding competitors in Europe and Asia,” he said. If the first step it to acknowledge the extent of the problem, Mr Bloomberg has certainly achieved that.
