The Impact of Sarbanes-Oxley Act of 2002 on Commercial Banking

Introduction

The Sarbanes-Oxley Act of 2002 (SOX) resulted from numerous accounting scandals before 2002 at Enron and other firms. The SOX focused on corporate disclosure and government practices, emphasizing the independence of the audit committee, financial expertise within the audit committee, and improvements in the timing of corporate disclosures (DeFond et al., 2004). While many investors and corporations expected it would increase the integrity and legibility of financial records, it is unclear whether it is possible to pinpoint these benefits today. Notably, America’s financial markets have seen significant turmoil since the September 2001 attacks, followed by a series of accounting scandals in various corporations. Several top companies in the U.S. witnessed the consequences of these scandals, including Enron, WorldCom, Adelphia Communications, and Tyco (Gao, 2011). The negative news and trends on the market back then were unfavorable to investors who had enjoyed massive gains in the market for several years. There was a substantial failure of internal and external auditing systems, executives and top managers were increasingly involved in the scandals, and most companies’ board of directors could not do their auditing job effectively.

Concerning this historical happening, this paper seeks to analyze the impacts of SOX on commercial banking. It highlights these impacts about the SOX’s consequences on the private corporations, which had fewer obligations in the legislation. The compliance costs of the SOX on financial institutions and other corporations are in a summary form. This paper’s organization is as follows. The following section discusses the literature behind the Sarbanes-Oxley Act of 2002, highlighting overall consequences in various sectors and their implications to the economy. The subsequent section presents the economic analysis of this piece of legislation and its impact on the banking sector from a microeconomic perspective while concluding remarks are in the final section. Various empirical studies indicate that the Sarbanes-Oxley Act of 2002 affected the banking system. It significantly increased auditing costs and fees, leading to high redundancy and burden in auditing practices. The share prices of the corporations expected to incur massive compliance costs were less favorably affected by the Act. The SOX caused sizeable adverse effects on commercial banking. It caused fewer benefits to the public companies relative to private companies.

Literature Review

Historical Perspective

The accounting scandals of the early 2000s were not a new phenomenon. There were common occurrences in the prior period leading to the 20th century, and many companies had already been impacted severely by similar events. During this time, most international corporations and large international Certified Public Accounting (CPA) firms witnessed the highest growth. This growth, however, happened with an immense struggle in many aspects. For instance, many studies record that corporate fraud, unethical management practices, and questionable financial reporting surfaced during this time, with these studies advocating for more ethical behavior. For instance, the 1920s saw exponential industrial growth with a corresponding surge in stock price (Rockness & Rockness, 2005). Rockness and Rockness note that a new type of economy had come up, which got dominated by automobiles, oil, steel, radio communications, and expensive real estate, all of which drove the market prices to extremely high levels. Accounting standards during this period were generally private. As a result, they could get manipulated easily to attract new investors or drive stock prices. The securities market was unregulated, creating an opportunity for corporations to engage in fraudulent trading practices and margin purchases. Investors attempted to influence an increase in the prices even further to get greater returns on investment. The results of such corporate behavior were famous frauds such as the commonly known Ponzi scheme and the crash of 1929.

In the 1930s, the SEC enacted several acts to control these behaviors but did not solve systemic problems. Between this time and 2002, there were numerous unethical practices in America’s corporate financial reporting (Rockness & Rockness, 2005). The 60s got dominated by a series of accounting and reporting scandals. The 70s saw a rise in international frauds and bribery as a result of unethical behaviors. Then came the 1977 Foreign Corrupt Practices Act, imposing several ethical standards on foreign corporations (Pitman & Sanford, 1994). About ten years later, there came the Wall Street corruption, fraudulent reporting, insider trading, and junk-bond schemes, all of which triggered a substantial rise in the FBI annual budget to combat-related crimes. For instance, by the 1991 fiscal year, the FBI had a total budget amounting to more than $125 million to pursue financial fraud (Calavita & Pontell, 1994). A new round of corporate frauds started in the 90s and extended to the 2000s, resulting in several bankruptcies and restatements by a number never seen before (Abdullah et al., 2008). According to Abdullah et al., in 2004, the Government Accountability Office estimated that accounting restatements that occurred between 1997 and 2002 in the United States had caused market capitalization to lose around US$100 billion. Additionally, between 2002 and 2005, another US$36 billion was lost in market capitalization (Nahar Abdullah et al., 2010). These high-profile cases of restatements caused by persistent accounting and financial anomalies led to the enactment of the Sarbanes-Oxley Act in 2002.

The Legislative Time-line

The need to reform corporate business practices and improve accounting and governance systems for publicly traded companies became paramount in 2001 after the collapse of Enron. Further events leading to 2002 aggravated this concern, to the point that many Americans saw a looming collapse of the entire stocks market. The Sarbanes-Oxley Act resulted from the merging of reforms proposed by Senator Paul Sarbanes in the Senate, Democrat of Maryland, and Representative Michael Oxley in the House, Republican of Ohio (Hochberg et al., 2007). The latter introduced his bill firm in the House on February 13th, 2002, passed in the House on April 24th, 2002. The former introduced his bill to the Senate Banking Committee in May 2002 and was passed overwhelmingly by the Senate on July 15th, 2002 (Spedding, 2009). In the same month, the House and the Senate formed a committee intending to combine the two bills, renaming them into the Sarbanes-Oxley Act of 2002. This bill was later passed by congress on July 25th, 2002, and signed by the President into law on July 30th. It directed the Securities Exchange Commission (SEC) to develop rules to aid the legislation’s implementation process. This process started in August of 2002 and ended in mid-2004.

A Summary of the Legislation Content

The primary focus of the Sarbanes-Oxley Act is on regulating corporate conduct to minimize unethical behavior and reduce fraudulent financial reporting failures witnessed in the past decade. SOX applies to various groups; the Board of Directors, the Audit Committee, the CEO, the CFO, and all other staff that influence the accuracy of financial statements in one way or another (Rezaee, 2005). Each section of the legislation targets a particular concept of reporting and dealing with financial records. For instance, Section 301 of the Act addresses the responsibilities of the Board of Directors’ Audit Committee that have been the focus in the modern corporate world. In the recorded ethical failures of the past, there was the direct involvement of the ethical committee, especially those oblivious to the financial reporting situations. Under this piece of legislation, this committee is required to oversee the appointment and compensation of the external auditor and must approve all services these external auditors engage in, provide a communication mechanism for reporting unethical behavior by employees and facilitate the communication through proper procedures. Provisions 303, 304, and 306 of the SOX promote the ethical conduct of the board of directors, key employees within the corporation, and corporate executives (Rockness & Rockness, 2005). It advocates for severe punishment for those that engage in fraudulent behavior and prescribes guidelines that corporations can use to establish an ethical culture and maintain high integrity levels.

A Summary of the Act’s Implications to Commercial Banking

While the media focus on the credit, loan, and mortgage crises, the banking sector is increasingly under the pressure of evolving regulations. This sector is one of the most heavily regulated industries in the world. Most banking executives consider SOX and other legislations burdensome to the banking sector, some terming the SOX as the draconian measure (Garneau & Shahid, 2009). The numerous regulators acting in the banking sector each provide a different code or set of regulations that commercial banks must comply with to continue their business operations. For example, the Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991 requires depository institutions to improve their supervision and examinations and provide resources to the Bank Insurance Fund, among other obligations (Eisenbeis & Wall, 2003). There are some similarities between these regulations with those stated out in the SOX Act. Even though legislation, such as the SOX, FDICIA, were made in isolation, the relevant bodies did not take adequate time to assess whether their provisions correspond to the current regulatory environment. Because much of these regulations fall into more than one category, commercial banks are subject to what many researchers call a regulatory overlap.

The costs of the SOX are more pronounced than the benefits. The cost of compliance remains a grievance in most banking institutions. Years ago, the American Bankers Association testified before congress that submission to these numerous overlapping regulations cost banks a tune of $26 billion and $40 billion annually (Garneau & Shahid, 2009). For the commercial banking sector in the U.S., the added cost of SOX compliance contributes to the already immense compliance bills. SOX compliance is costly for all banks. However, small banks face the likelihood of incurring compliance costs that are larger than the total revenues. Smaller banks incur audit fees and are sometimes needed to hire or train staff for compliance purposes. According to Garneau and Shahid, these institutions often employed a consultant, incurring over $3000, which could go up to $1.4 million. The additional redundancy created by this Act is time-consuming and costly. Most banking institutions in the country do have to weigh the costs and benefits of SOX to determine the right amount to invest in compliance or an alternative measure of interest. The next section of this paper looks at the benefits and costs of this Act to the commercial banking sector more closely.

This Paper’s Contributions

This paper seeks to provide a deeper understanding of the impacts of the SOX Act on consumer banking by basing on the argument that there were only minor benefits relative to the costs. It will consider the progress of the corporate market in the country, how these regulations have affected demand and supply in the stock markets and what could be the future of publicly-traded companies in the U.S. Compliance cost becomes part of the fixed costs for most banking institutions. These could also affect variable costs marginally and significantly in some aspects. Since their effective date several years ago, corporations have sought ways to increase their profitability and attract investment legally, including product differentiation strategies intended to increase brand equity and market structures leveraging to gain a competitive advantage over the rivals. A better overview of these effects is provided in the next section of the paper, laying the basis of the hypothesis that the SOX has caused remarkable changes in commercial banking, and most of these changes have been negative.

The Economic Analysis

SOX imposes relatively extended costs for smaller firms, with many effects on the fixed costs. Most firms prefer to go private because of the SOX compliance costs (Engel et al., 2007). The net benefits of being public are miniature for relatively small firms because most firms go public as smaller enterprises and remain public as they expand. Other than high fixed costs due to SOX compliance, several cost types increase with firm size. The presence of huge fixed costs suggests that SOX could make going private attractive for small corporations. “The fixed compliance costs (for example, additional fees to auditors, spending on information technology, costs of recruiting and educating new outside directors on business processes) may fall disproportionately on smaller firms” (Wintoki, 2007, p. 246). These impacts are evident in large firms. According to Zhang (2007), the cost savings of delaying compliance for one more year is approximately 1.26% of the firm’s market value. The publicly traded commercial banks often have a percentage of their potential revenue to cover these compliance costs.

The implementation of SOX increased the costs of corporate audits for commercial banks. Research indicates that before the implementation of SOX, price competition between auditors in the industry remained unimpaired. The price difference corresponds to the quality differences between these auditors. The Big 4 auditors in the U.S include Deloitte & Touche, Ernst & Young, KPMG, and Pricewaterhouse Coopers (Cosgrove & Niederjohn, 2008). Cosgrove and Niederjohn note that while these auditees have a highly inelastic demand for a Big 4 audit, most small firms may also choose the middle-tier auditors. Most of these popular auditors serve their clients by investing heavily in technology, training, and facilities than smaller auditors. These investments translate to higher fixed costs which small banks or corporations may find too costly for the marginal benefit of a Big 4 audit. As Cosgrove and Niederjohn record, these differences affect choices made by publicly traded banks in the market because while regulations on government financial statements are intense, it is always the priority to grow and attract investors. It has been a challenge for most financial institutions because they have to make choices that do not impact revenue. There are differences in elasticities regarding the cost of auditing by these top or middle-tier auditors. It influences the pricing power of the auditors by charging according to the available supply and demand. Even if SOX results in higher audit fees, most commercial banks are unlikely to change their demand for a Big 4 audit. As a result, the Big 4 firms can pass on any additional cost to their established clients in the form of higher prices. Nevertheless, today most banks requiring these auditing services have highly inelastic demand and a few substitute providers.

There was a time when the managerial and financial elite was represented by the Republican Party, with the Democratic Party often refraining from this dominant group. Today, however, both major political parties have close ties to the members in finance, such as investment bankers and hedge fund managers. The call to roll back the SOX is from vocal supporters of both parties. The rapid rise in the intensity of claims against this Act has several implications. The social norms that triggered the reaction to the scandals and passing of SOX have disintegrated over the last 30 years (Fanto, 2007). Fanto says that this erosion resulted from the growing acceptance of the self-interest ideology among financiers and members of American society. Fanto explains the implications of this change. He says the dominant model of acceptable human behavior in the financial industry is the individual who pursues profit maximization in a self-serving way. To many financiers, the SOX seems to be just an inappropriate government interference with the private markets, which may indicate the efforts by regulators and politicians to advance their self-interests. It might explain why the Act is precarious – a weak social foundation for endurance – and incomplete legislation.

The Sarbanes-Oxley Act of 2002 is crucial legislation. It promotes accurate reporting to help investors to make informed decisions on where to invest. Section 501 of the Act lessens conflicts of interest among research analysts (Cherry, 2004). Previously, there were claims that research analysts would assign positive “buy” ratings to the stock of corporations that used their employer’s investment banking services. According to Cherry, this hidden conflict of interest reduced the credibility of much research released to the public. The SOX remedies these conflicts of interest by preventing investment banks from having control over the research analysts. The Act’s Section 501 prohibits investment banks from approving research reports or compensating analysts tied to their underwriting. If the analysts produce a negative or neutral report, this section prohibits and prevents any potential retaliation.

Summary and Conclusion

The previous sections of this paper have discussed several consequences of the Sarbanes-Oxley Act of 2002 on the corporate world. It is crucial to note SOX effects that many studies identified as specific to the corporate market could extend to commercial banking, such as the high compliance costs for publicly traded financial institutions. Most small firms could not cover these costs, so most either went dark or converted to private ownership. These financial institutions give firms huge loans for investment needs. Whenever they do so without analyzing the likelihood of the firm making sufficient revenue and utilizing the investment efficiently, it causes massive losses to potential investors. An investor looks at many factors in determining the best choice of firms to focus their investment. They make an informed decision based on the financial records produced by external auditors or even commercial banks. If these reports are misleading, the entire market could incur immense costs. The purpose of SOX was to reduce these occurrences. To an extent, it has done so at the expense of overregulation and redundancy.

Most of the codes and acts intended to ensure accurate reporting of finances by corporations are redundant. As the paper highlighted, the FDICIA and SOX Act resemble each other to some degree. This similarity causes financial institutions and other corporations to incur unnecessary costs by investing more in auditing than would be without this overregulation. As a result, almost all large firms incur these costs (categorized as fixed costs). To some extent, this reduces competition and raises the unattractiveness of the market to investors and entrants. The mandatory requirements for such auditing also make the demand for auditors relatively inelastic. Notably, most corporations go for the popularly known auditors. If these auditors provide their services at a high cost, the auditee transfers these charges to the public and government. Yet, the benefits of adhering to these regulations in commercial banking could be essential in our modern financial market.

This paper concludes that commercial banks must comply fully with the Sarbanes-Oxley Act to improve brand image by showing the public and other firms that it intends to obey the regulations and practice good business ethics. The Act adequately covers the aspects of unethical practices, enabling real-time disclosure of issues, disclosure of periodic reports, management’s assessment of internal controls, and penalties for forging financial documents. From an economic perspective, the unfavorable effects of the Act outweigh the potential benefits, and these impacts become increasingly evident in smaller corporations. Finally, it is a fact that there has been a significant improvement in the governance of corporations over the past three decades. Yet, a new set of requirements targeting all forms of high-profile scandals in the country and more stringent auditing standards under the SOX are needed. These could encourage managers and boards to pay greater attention to accuracy in the reported financial information.

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