KHAYA SITHOLE: KPMG auditing scandal illustrates the dangers of concentration

In 2007, the US Federal Reserve Bank in New York released a paper reflecting on market concentration and market stability.

The paper referred to a market structure characterised by a few dominant firms and many smaller players. The question was whether the exit of one major player in such a concentrated market would lead to market instability.

The South African market system — in particular for the banking and auditing services — replicates this market structure as a few prominent firms dominate, with the rest making up a minor market share.

This week, in an Association of Black Securities and Investment Professionals discussion with Reserve Bank deputy governor Kuben Naidoo, we looked at how the Bank dealt with the African Bank curatorship versus the VBS Mutual Bank scenario.

In essence, African Bank was regarded as systematically important to the banking system, given its wide range of depositors, who would have been affected had the bank been liquidated. To mitigate this, the Bank, Public Investment Corporation and a consortium of commercial banks stepped in to recapitalise African Bank and keep it operational, albeit in a more "co-ordinated" form.

In the VBS scenario, while the curatorship is still under way, it does not appear that the same appetite for a co-ordinated rescue effort exists.

First the issues that led to the curatorship itself that relate to the operations of the bank — underproviding for bad loans, for example — are to be expected in any bank. Consequently, the impact of such failures can be remedied, as in the African Bank case.

VBS’s secondary problems — failures of governance and poor work by the auditors, which led to the financial statements being withdrawn — are less easy for a regulator to work around. Consequently, the approach taken to African Bank is unlikely to work out for VBS.

Between the two banks, African Bank was bigger and its footprint more pervasive. Its failure was therefore undesirable and required extraordinary interventions. VBS, being relatively small, poses a lower risk to the system at large. This all seems to support the idea that in highly concentrated markets the failure by one major player that leads to its exit is a recipe for larger market instability.

The KPMG case reflects this. As one of the big four players in the audit field, an exit of KPMG would create unprecedented disruption in the market as the rest of the players outside the big four have historically never operated on the scale and depth of KPMG. In SA, scale and international reach are regarded as proxies for capability. That excludes smaller and indigenous firms from consideration for bigger audits with transnational operations such as banks and insurance companies.

Based on this historical exclusion, there is going to be an unquantifiable cost of transition associated with the process.

Given the fact that shareholders would prefer not to carry the burden of this cost, the tendency will simply be to migrate to firms that have operated on a scale and footprint that mirrors that of KPMG — in other words, the other three big firms. The tragedy of this state of affairs is that the original source of the problem — market concentration — is actually amplified rather than resolved.

The hard reality is that had the auditing profession been subjected to mandatory rotation much earlier, such market dynamics would have been mitigated, as the other market players would by now have exposure and experience in managing large audits.

As it stands, 2023 seems too far away for a profession that is rapidly being sucked into the vortex of its own structural limitations.

• Sithole (@coruscakhaya) is a chartered accountant, academic and activist and chaired the Lesedi Education Endowment Fund as part of the #FeesMustFall campaign. He writes in his personal capacity.