Lord MacGregor of Pulham Market
That the Grand Committee takes note of the Report of the Economic Affairs Committee on Auditors: Market concentration and their role (2nd Report, HL Paper 119).
Lord MacGregor of Pulham Market
My Lords, pressures on the parliamentary timetable and the queue of Lords Select Committee reports awaiting debate have meant that it is almost a year since our report was published. There have been some important developments since then, progress on which it will be interesting to discuss today, but many of the issues are still alive and highly topical. As chairman of the committee I am therefore pleased to introduce the report.
When we first decided to look into the oligopoly of the audit profession, some, I think, thought it a somewhat dry and limited if not esoteric topic mainly of interest to the accounting profession. It became rapidly clear to us that this was not so. It was a fascinating inquiry, sometimes taking us in unexpected directions. The serious issues surrounding the current oligopoly I will touch on in a moment. However, as our inquiry progressed, two other important themes emerged on which we have made recommendations: namely the inadequacies of the roles played by auditors and of the dialogue between auditors and regulators leading up to and during the financial and banking crisis—and this became an important issue for us as a result of our probings at the hearing we had with senior partners of the big four auditors themselves—and, secondly, concerns about the effect on audit of the adoption of international financial reporting standards. I shall touch on all three. This widened our inquiry considerably. Our report contains 204 conclusions and recommendations. I hope to cover the main themes but inevitably I shall have to leave a number of issues to others.
Before I do so, I should like to thank most warmly our committee clerk, Bill Sinton, and his staff, Stephen Seawright and Karen Sumner, the committee assistant, for all their invaluable help and hard work. In particular, I thank our special adviser for this report, Professor Andrew Chambers, professor of corporate governance at London South Bank University, whose expertise and advice was invaluable.
First, I turn to the market concentration of auditors. The need for a reliable audit was recognised by this House as early as 1849, when a Select Committee looking into financial scandals in the railway boom was credited with helping to establish the accountancy profession. Certainly by 1872 the Great Western Railway had an audit committee and an external auditor, who was called Mr Deloitte.
Rigorous and trustworthy audit has long been recognised as vital to the proper running of capital markets. Without a clear and reliable system of assurance that accounts show a true and fair picture of a company’s financial state, there is no basis for investment decisions. It has long been a statutory requirement for large firms to be audited every year. The annual audit has become an essential underpinning of financial markets, especially since they have gone global. While offering a statutory service, audit has become a large and prosperous profession. Auditors have built on large firms’ legal obligations to buy their services by selling a range of other financial consultancy services to their semi-captive audit clients.
In recent decades, as financial markets became global, the main audit firms have become very much larger and more dominant as they spread beyond national borders and as they consolidated and concentrated among themselves. By the 1980s we had the big eight international audit firms, mostly international federations of national partnerships. By 2002 mergers and the disappearance of Arthur Andersen had brought the big eight down to the big four: Deloitte, PwC, KPMG and Ernst & Young. No regulatory barriers prevented this concentration in this country or elsewhere. The big four greatly outweighed second-tier audit firms in both size and global reach; and there is always the risk that withdrawal or disappearance of one of the big four could leave us with an even more dominant big three—a point to which I shall return.
So the problem is easy to identify: the big four firms’ oligopoly, especially in the United Kingdom. In the UK, the big four audit 99 of the largest firms listed in the FTSE 100 index. In certain markets, such as banking, there is not even a big four but effectively a big three, since Ernst & Young does not audit banks in the UK. It is questionable whether large banks in the UK have any real choice of auditor, and that may well apply to some other financial institutions as well.
An auditor to a FTSE 100 client remains in place for 48 years on average. Barclays has had the same auditor, PwC or its predecessors, since 1896. The picture is similar in the next ranking FTSE 250 large companies, almost all of which are audited by the big four. A FTSE 250 auditor remains in place for 36 years on average. This does not look like a competitive market.
Witnesses from the big four assured us that the large-firm audit market in the UK is fiercely competitive, but we were not convinced. The market is clearly an oligopoly, with all the attendant concerns about competition, choice, quality and conflict of interest. I must say that I was much struck during our hearings by the fact that almost all of our witnesses without exception agreed that there was a risk that the big four might become a big three, and then there would be a major problem. That included the representatives of the big four. However, finding solutions was not so easy.
The Financial Reporting Council—and I am delighted to see its current chairman, the noble Baroness, Lady Hogg, here today—produced a set of recommendations from its market participants group in 2007. However, in our view—and I think there is general agreement on this—this had little or no effect in lessening the dominance of the big four. The then Minister at the Department of Business, Innovation and Skills, Mr Edward Davey, outlined a number of measures that echoed the approach of the FRC, an approach that we described as having palpably failed. We would expect exactly the same results for the measures which he advocated to our committee as the FRC’s measures have had. As we have said in our report:
“It may be sensible to introduce these measures on their own merits. But they do not add up to a policy of creating greater competition and choice, of altering the current oligopolistic situation, or of addressing the risks of the Big Four coming down to a Big Three”.
We outlined in Appendix 3 of our report 34 individual measures which had been put to our committee in one form or another for dealing with this situation. In our analysis we read carefully through all of them and rejected a considerable number, including the proposal for joint audit committees which the European Commission has now advocated. At a seminar which I addressed in the City attended by senior accountants and regulators, one leading key participant described our report as a,
“road map for future action”.
I turn now to a few of the key recommendations. Although our committee contains members with much experience and expertise, our part-time committee simply did not have the time or the resources, including substantial dedicated staff, to address all the highly complex issues stemming from market concentration. By far our most important recommendation was therefore that the OFT should conduct an investigation into the audit market in the UK, with a view to a possible referral to the Competition Commission to analyse all the issues in depth. Frankly, this has been fudged for some years. We felt that such an investigation was overdue, and I have been delighted to see that the OFT, at our prompting, swiftly took up the matter and the Competition Commission is now carrying out that review.
We recognised the international dimension to the issues, but felt that the UK could give a lead internationally by undertaking such a review. Concurrently we have the European Commission’s inquiry, and our committee was able to have a hearing last month with Jonathan Faull, the Director-General of the Internal Market and Services Department of the European Commission. Like us, the Commission is concerned about competition and choice. It points out that in most member states the big four audit more than 85 per cent of large listed companies. The Commission’s proposals are now before the European Parliament. Some of them are in similar directions to our own recommendations, but the Commission’s remit does not cover pure competition issues, which are the preserve of national authorities such as the Competition Commission.
We had a range of other recommendations, which I have no doubt the Competition Commission will look at more fully, and I touch on them only briefly. We recommended that FTSE 350 companies should carry out a mandatory tender of their audit contract every five years, and that audit committees should be required to include detailed reasons for their choice of auditors in their report to shareholders. We recommended greater involvement of institutional investors in audit matters, although I have to say that I do not overestimate the likely impact of this. We took up the suggestion of the noble Baroness, Lady Hogg, that the abolition of the Audit Commission would provide an opportunity to increase competition and choice in the audit market if it formed the basis of a substantial new competitor to the big four. There have been developments on this, which the noble Baroness will no doubt comment on.
We put particular stress on the need for separate risk committees in banks and major financial institutions, and other large companies where appropriate. We believe that every bank should have a properly constituted and effective risk committee at board level. It should be one of the duties of the external auditors to ensure that this is done. This is relevant to the accountancy marketplace in the sense that such committees will increasingly require specialist skills and external advice. We saw scope for this advice being provided by a firm that is not the company’s auditor, which could open up opportunities for the second-tier accountancy firms.
Next, we were struck during our inquiry by the fragmented and unwieldy regulatory structure that governs accountancy and audit in the United Kingdom, with overlapping organisations and functions. This seemed to us inefficient and unnecessary. It also seems to offer too much scope for regulatory capture, especially since present or former big four partners hold so many positions on the various bodies and committees. Other professions have only one regulator—for example, the General Medical Council. We noted that the Financial Reporting Council has been seeking wider powers that would help promote some rationalisation of the regulatory maze. I look forward to hearing what the noble Baroness, Lady Hogg, has to say about progress on these matters, which our committee strongly supported. If it does not achieve real impetus towards rationalisation, we recommended that the Government should stand ready to impose a remedy. Perhaps the Minister will comment on that.
Finally, because of the concerns about the big four moving to a big three, we recommended that the Government and regulators should promote the introduction of living wills for big four auditors. There are many other recommendations that I have not had time to deal with and which others may wish to mention. As I said earlier, I hope that all of them will be considered by the Competition Commission in its inquiry.
I now turn to the other two areas. First, as our proceedings continued, it became clear that there were shortcomings of auditing during the financial crisis. Banks were audited and certified as going concerns just before they had to be rescued by taxpayers to avoid collapse. We were not particularly impressed by the defences produced by the auditing firms themselves, and there have of course since been highly critical reports on Northern Rock, RBS and HBOS. The value of audit here was at best questionable, even allowing for the issue—which we acknowledged—that panic might have followed if auditors had publicly questioned the accounts of banks. However, confidential dialogue between auditors and bank regulators does not run these risks, and it was on this that we focused. We were shocked to discover that the dialogue on these lines—which was required by statute under the Banking Act 1987, and which I am sure my noble friend Lord Lawson will wish to refer to—was virtually non-existent in the run-up to the crisis. We described the lack of meetings between bank auditors and regulators during that period as a dereliction of duty.
Part of the problem was the separation of powers and duties between the FSA and the Bank of England, which this Government have now rectified. However, we also recommended a statutory change to ensure that confidential dialogue between bank auditors and financial regulators takes place regularly. We welcome the introduction by the FSA and the Bank of England of a code of practice to encourage dialogue. I also note that the Institute of Chartered Accountants in England and Wales has just produced its good practice for bank auditors, audit committees and executive management in this regard. However, in its briefing for this debate, the ICAEW says that it does not see a need to prescribe this dialogue in law. That was not the view of our committee at the time that we did our report, and I for one still do not agree. If we are to avoid the bad habits and mistakes that emerged during the financial crisis, I continue to believe that the statutory requirement for dialogue between auditors and regulators is necessary. I will be interested to hear the Minister’s response.
Finally—and now I get on to the matters that are rather abstruse for many of us—on accounting standards, we heard considerable evidence that the introduction in 2005 of international financial reporting standards, the IFRS, in place of the old British generally accepted accounting principles, GAAP, had led to sharp reductions in the quality and reliability of large-firm audit, especially of banks.
Witnesses told us that under IFRS rules auditors cared more about compliance with rules than with exercising professional scepticism and careful judgment to reach a true and fair view of clients’ accounts as required by company law. In short, so it is said, the auditor’s abiding principle is now box-ticking instead of prudence. The argument runs that superficial conformity with the rules can disguise underlying faults that it was the auditor’s skill and duty to detect under the old system. Banks in the crisis were a case in point. Unlike GAAP, IFRS takes account only of losses already incurred, not of expected losses. In these litigious times it is perhaps understandable if auditors feel safer monitoring compliance with a set of rules and exercising judgment. However, the public interest is not served if, as critics allege, IFRS audits are failing to give a true and fair picture. I note that the new chief executive of the Royal Bank of Scotland has recently referred to the Alice in Wonderland nature of some aspects of the bank’s results.
This is a complex area, and I do not pretend that we will get to the bottom of it all—although there are members of my committee who are better equipped to do so than I am. The Government gave a lengthy but somewhat holding reply in their official response to our report on this, and we have since had correspondence with Norman Lamb, the new Minister for Employment Relations, Consumer and Postal Affairs in BIS, in which he states:
“I consider that the changes in IFRS introduced since the financial crisis and the further changes proposed to be implemented should help to achieve accounting rules for banks which are crisis-neutral, provided they are endorsed by the EU, and provided they are properly applied the next time that valuations come under pressure”.
That is pretty guarded. On the issue raised by Mr Andrew Haldane of the Bank of England that new standards are needed for bank audits, he referred to the preliminary report of the Sharman committee—under one of our colleagues, the noble Lord, Lord Sharman—and said:
“The Sharman panel are considering the responses to this Report at present. We await their conclusions with interest”.
It would be helpful to hear from the Minister when we can expect definitive government decisions on this matter.
To conclude, it has been a fascinating and rewarding inquiry that has led to action. I am most grateful to all my colleagues for their substantial contributions to it.
Lord Hollick
My Lords, I thank the noble Lord, Lord MacGregor, for his excellent chairmanship of our committee and for the very clear review of our report that he has just given. I apologise to the Minister and noble Lords for my early departure from today’s debate to catch a flight to Berlin this evening.
I shall focus my remarks on the committee’s work on how banks were audited before and during the financial crisis and on the impact of IFRS rules on the audit. Banks rely on the confidence of depositors, bond holders and investors to survive. That confidence is founded on the belief that the bank is a going concern. In his report Going Concern and Liquidity Risks, to which the noble Lord, Lord MacGregor, referred, the noble Lord, Lord Sharman, and his colleagues identify two elements to the going-concern test: solvency, which is the ability to meet liabilities in full; and liquidity, which is the ability to liquidate assets at the velocity needed to meet liabilities as they fall due.
If confidence is shaken, the flow of funds to the banks dries up and the fragile business model, which in essence is to borrow short and to lend long, is imperilled and a funding crisis ensues. That is what happened in 2007-08 and, to a considerable degree, the problem persists to this day. Indeed, eurozone banks, in particular, are wary of lending to one another and therefore place their funds with the ECB, which recycles the funds to other banks. That recycling was augmented at the end of 2011 by the ECB’s three-year LTRO—long-term refinancing operation—which is a programme to ease liquidity and introduce quantitative easing into the eurozone. However, that programme does not address solvency. Indeed, it could exacerbate solvency if the banks use the LTRO funds to add to their holdings of risky sovereign debt.
The annual audit, particularly the going-concern test, is crucial to building and maintaining confidence in banks. Without it, banks become uninvestable and unable to fund their day-to-day activities. Our report highlighted several areas of concern. We noted that, in recent years, as the noble Lord, Lord MacGregor, has said, the traditional principles-based approach of auditors has been replaced by a more rules-based approach. “Prudence”, “true and fair view” and “going concern”, all viewed through a sceptical set of spectacles, have given way to a close adherence to rules, which to some observers looks, as the noble Lord, Lord MacGregor, has said, like box-ticking supplanting mature judgment.
For the auditors, this approach makes life a little easier. There is less likelihood of litigation, which of course is a major issue in the United States, whose voice is probably the loudest at the global debate on audit rules, and there is less pressure to use judgment. Yet informed, experienced judgment by a professional sceptic is precisely what is needed. The recognition of losses on loans and other assets held by the banks is just such an issue, where judgment really matters. Instead, IFRS rules are now paramount and IAS 39 requires that provisions against these assets can be made only for incurred, and not expected, losses. This led to a procyclical reporting of bank profits, which Mr Timothy Bush of the Investment Management Association said was in conflict with the Companies Act 2006 requirement to prepare accounts prudently without crediting any unrealised profits. Professor Fearnley saw IAS 39 as far less prudent than its equivalent under UK GAAP because it substituted neutrality for prudence. As a result, the profits of banks were artificially boosted during the period leading up to the banking crisis—including, in some cases, unrealised profits, leading to unjustifiably higher bonuses and dividend payments, a practice colourfully named in the City as “skimming”. That “skimming” led, when the true state of affairs became apparent, to an even larger hole in the balance sheets of our banks, which of course had to be filled with taxpayers’ money.
IFRS rules require assets to be mark to market, which is fine if there is a liquid market, but all too often the assets held by banks—some devilishly complex and frankly beyond the ken of most bank directors—are either not traded or so infrequently traded that a market valuation is meaningless. Quite perversely, such practices could actually lead the banks to write up the value of certain assets, thereby recording unrealised profits which were deemed available for distribution but which turned out to be wholly fictitious when the asset matured or came to be realised.
Before the advent of IAS 39, banks and their auditors were able to apply prudence to loan asset provision and to provide against anticipated but not incurred losses. IAS 39 forbids that. It even has the absurd example in its practice note that a loan to a dead person who died before the accounting date can be provided against, but no such provision can be made if the death occurred after the accounting date. In the world of absurd things, this probably trumps Donald Rumsfeld’s “known unknowns”.
A judgment about the liquidity of the bank is critical to its going-concern status. In retrospect, it is clear that many of our banks were dangerously reliant on short-term money market funds. This risk of illiquidity was not spelt out by the directors or auditors in their report, yet it goes to the heart of the viability of the bank’s business model and its going-concern status, so essential to creditor and depositor confidence. The senior partner of PwC told us:
“It’s not the job of the auditor … to look at the business model of a business”.
This, as we conclude in our report, appears disconcertingly complacent. The noble Lord, Lord Sharman, in his report, says:
“The going concern assessment should focus on the risks the entity takes and faces that are critical to its success or which could cause its business model to fail”.
It is simply not good enough for the auditors to stand aside. It is their job to look at and analyse the business model, and to satisfy themselves that the bank is indeed a going concern. They cannot hide behind the director’s judgment. Indeed, they should recall that when, in 1879, banks were allowed to become limited liability companies, Parliament made it abundantly clear that it intended the auditor to be the last honest man standing, to protect the interests of depositors and investors.
Reliable and transparent bank accounts are essential to rebuilding confidence in our banks. Andy Haldane, the executive director for financial stability at the Bank of England, has called for a different accounting regime, which allows for judgment and prudence to be exercised. His colleague Andrew Bailey, the chief cashier, wrote:
“Current financial statement disclosures … despite being compliant with accounting standards are … not sufficiently granular or transparent … to support users’ understanding”.
The credit rating agencies offer no help. Leaving aside their calamitous record over the past few years, they too have to rely largely on published accounts.
What is the Government’s response to this urgent problem? They agree with the committee’s conclusion that financial institutions should build appropriate capital buffers to provide against downturn. They welcome signs that accounting standards boards are proposing to move to an expected-loss model that provides for a more forward-looking approach to how credit losses are accounted for. Then timidity creeps in. They say:
“Financial reporting however, is designed to convey a true and fair view at a point in time”.
That lets the auditors off the hook on the going-concern test and puts the auditors’ interests ahead of the users’ interests. I would like the Minister to tell us when the Government expect the new forward-looking approach to accounting for credit losses to be introduced. In their response they mention that it would be June 2011. It clearly has not been. As I understand it, there is a three-year backlog among the accounting standards setters, so the earliest that one could expect this would be the middle of this decade, by which time we will probably have another financial crisis.
I ask the Government how they respond to the Sharman report’s call for the going-concern test to be more qualitative and longer-term in outlook rather than, as they say in their response to our report,
“at a point in time”.
Also, what steps do they plan to take to put prudence and judgment back at the heart of accounting, as called for by the Bank of England, which echoes the principles in the Companies Act 2006 setting the requirements for audited accounts to give a true and fair view above all other standards?
Lord Shipley
My Lords, I, too, thank my noble friend Lord MacGregor of Pulham Market for chairing such a detailed and important inquiry, and for leading the committee to a set of very powerful recommendations.
When I draw back the curtains at home in Newcastle, I can see over the rooftops the new HQ building of Northern Rock that was under construction in 2007 when the bank failed and had to be nationalised. It is now owned by the city council, purchased under prudential borrowing powers, and earning a rental stream for the council. Here I should declare my interest as a member of Newcastle City Council still, and also as an account holder at Northern Rock in 2007 and now.
That view of that building each morning serves as a salutary reminder to me of what can go wrong; how trust in large, familiar institutions can be lost overnight; and how vital and essential it is that effective checks and balances are delivered through high-quality audit and risk management processes. We should never forget that a lot of people lost their shares in Northern Rock in 2007, nor that many employees lost their jobs.
Shareholders had a right to expect better than they got. They received annual reports and were entitled to think that the report was an accurate reflection of the health of the bank as a going concern. They still ask what went wrong. Was it a culture of box-ticking and telephone audit interviews rather than a detailed examination by the auditors of the Northern Rock business model? Did the auditors know or suspect? Was everyone too complacent? Had corporate memory of previous banking failures simply faded away?
We know now that, for many months before its collapse, Northern Rock was following a risky business model in its reliance on wholesale markets to sustain its very high lending levels. Yet auditors appear not to have been aware of, nor to have understood, the dangers—or, if they were, to have acted upon them. Today I still find myself astonished that, in 2006, not a single meeting between the FSA and the external auditors of Northern Rock or HBOS took place, and that only one meeting between the auditors of RBS and the FSA took place. In 2007, only one FSA/auditors meeting took place with each bank auditor.
In their response to the committee’s findings, the Government said that they had three clear policy objectives: high-quality audits which are independent of the body being audited; a competitive market in the supply of audits; and an audit market that is resilient and could withstand the withdrawal of one of the major firms. We can agree on that. However, there is a specific problem in the banking sector, because only three of the big four are active in it. In addition, choice of auditor can be limited by the need to avoid using a firm engaged by another bank. There is also a risk that, with only three audit firms active, the essential challenge theoretically provided by the audit system can end up being blunted. Familiarity, complacency and a lack of an alternative can dominate thinking. That is why the recommendations of the committee on the issue of risk are so very important, because we must separate risk from audit.
Risk and audit, however closely related, are actually about different things. Combining the two can lead to risk being seen as secondary to audit, and when an audit report gives no indication that a company is in trouble when it is, it suggests that the risk function has not been properly carried out. So, separation is vital.
There was, I think, a misunderstanding in the Government’s response to the committee’s report, regarding which audit company could give specialist advice to a risk committee. It is obviously important that the main auditor should explain any concerns it has directly to the committee. However, it would be inappropriate for a risk committee to be given continuing specialist advice on its work by the main auditor. I think that that was the committee’s overall intention. There is a related issue here in that there is a clear conflict of interest if an audit company provides other services to the company it audits. It surely must be better for other firms to provide such advice, and it would, of course, give companies not in the big four an opportunity to undertake such work.
I welcome the Government’s response that audit committees should meet formally with principal shareholders regularly, and I agree with the committee’s recommendation that published reports of audit committees should explain significant reporting issues raised during the course of an audit.
Shareholders bear responsibility too. It became all too obvious in our inquiry that shareholders did not question the choice of auditor as much as they should and that they tended, to their own potential detriment, to be insufficiently assertive in a company’s business.
We have at least learnt that, when concerns become apparent, there has to be a clear framework for bank auditors to talk directly and privately with the Bank of England. Too many people took their eye off the ball, forgot the examples of the past and made assumptions about viability that were deeply damaging to the reputations of many people. Supervisors, shareholders, board members, audit committees, risk committees—all need clarity about what is expected of them and a constant restatement of their role so that audit is not just left to somebody else.
Crucially, we have learnt that auditors have the clearest responsibility to advise on a company’s state of health. It is not enough to see annual audits as a snapshot in time. Auditors have a wider set of responsibilities, to shareholders, supervisors, customers and the taxpayer, to ensure that they fulfil the responsibilities placed upon them by others.
In conclusion, the committee’s report has been a major help in identifying how communication and the regulatory framework can be improved, and how we should learn from the lessons of the banking crisis. However, it requires continued vigilance, particularly in the years ahead, as corporate memory starts to fade yet again.
Lord Lawson of Blaby
My Lords, like my fellow members of the committee I should like to start by paying tribute to the outstanding chairmanship of my noble friend Lord MacGregor. I should also like to associate myself with his thanks to our small but hardworking corps of staff and advisers during this inquiry.
One thing came out loud and clear in the evidence we had: the change from GAAP to IFRS was a change from prudence to box-ticking. That is disastrous and it has to be changed—it has to be reversed. However, like my colleagues, I shall devote my remarks overwhelmingly to the issue of the banks. Not only are the banks of overwhelming importance to the health of our economy—we have seen what has happened as a result of the banking meltdown of 2007-08—but a move away from prudence in accounting is far more serious in banking than in other areas of business and industry. I shall make a number of points; it is a complicated subject. I do not expect my noble friend the Minister to reply to my points. I hope, however, that she will take them back to her department, that they will be properly considered there and that she will write to me in answer to the various points that I shall make.
Banks are particularly important, as I said, because prudence is more important in the case of banking than it is anywhere else—it is absolutely essential in the case of banking. However, there is another reason why banks are particularly important. In the normal course of events there is a sanction which auditors can impose in relation to a company’s accounts—they can qualify the accounts if they have concerns. However, no auditor will ever qualify a bank’s accounts when the bank is likely to be in difficulty, when the qualification is required, because it would lead to a run on the bank, which would be absolutely disastrous and clearly not in the public interest. Something needs to be done to rectify this, and I shall come on to that.
At the heart of it all, however, there is a cultural problem and a moral decline, both of which are very difficult to address by legislation. Some noble Lords here today may have read today’s New York Times, which contains a devastating article headed “Why I am leaving Goldman Sachs”, in which a senior Goldman Sachs executive who has decided to leave itemises in detail what he describes as the moral bankruptcy of Goldman Sachs. We should not be complacent and think that that moral decline was only in Goldman Sachs, or indeed only in the United States. Last week the FSA produced a report on HBOS—Halifax Bank of Scotland—which did not receive the attention that it merited. The report states that this bank was “guilty of serious misconduct” and ascribes this to a culture,
“of optimism at the expense of prudence”.
“Culture of optimism” is quite a nice euphemism—we all know what was going on. This included, incidentally, and I will come on to it, grossly inadequate provisioning, which is highly culpable in the case of a bank. What were the auditors—in this case KPMG, but I do not think that KPMG was any worse than any of the others—doing? To all intents and purposes it was doing nothing.
It is more than 50 years since I was the senior writer of the Lex column in the Financial Times, and I have watched with concern the decline in moral standards in the City of London and in finance. It might be part of a decline in the whole community, which we are not here to discuss now. However, the matter is particularly serious in the case of banking.
The Deputy Chairman of Committees
My Lords, I am sorry to cut the noble Lord off midflight but there is a Division in the Chamber. I suggest that we adjourn for 10 minutes, until 4.35 pm.
The Deputy Chairman of Committees
My Lords, I think everyone has returned. If that is the case—nobody is obviously missing—I invite the noble Lord to continue his remarks.
Lord Lawson of Blaby
As I was saying when I was so politely interrupted, we have a problem. Now I turn to what we are going to do about it. Andy Haldane, the executive director for financial stability at the Bank of England, has been mentioned once or twice already, and I have had the benefit not merely of reading what he has to say but of a number of private discussions with him over the months and, indeed, years. That has been a great assistance to me in clearing my own mind, but he is not necessarily responsible for any of the points that I am going to make. He may agree with some but not others.
I have seven practical proposals to make. First, however, I shall give a bit of background. My noble friend Lord MacGregor, our chairman, mentioned the Banking Act 1987, which I introduced with the enormous assistance of the Economic Secretary to the Treasury at the time, my noble friend Lord Stewartby. I could not have done it without him, and I am delighted that he is taking part in this debate. We produced an Act which was partly intended to deal with the problems of the banking sector, both the supervision and the auditing dimensions. Perhaps I may add in parenthesis that I had authorised the Bank of England, as the owner of Johnson Matthey Bankers—when Johnson Matthey Bankers went belly up it had to be rescued by the authorities, and I did that through the Bank of England—to sue the auditors, Arthur Young. The Bank sued Arthur Young and received a very substantial out-of-court settlement. This time, when the situation has been far worse, not a single firm of auditors has been sued. I find that baffling.
My first specific proposal is to recreate the Board of Banking Supervision, which was an important innovation in the Banking Act 1987. It was swept away by Mr Gordon Brown when he very mistakenly tore up the improved system of banking supervision and regulation that I had put in place and replaced it with his dysfunctional system involving the FSA. The present Government are doing something a bit like recreating the Board of Banking Supervision, but in not nearly as effective a way. I would like to see it recreated in the way in which my noble friend Lord Stewartby and I put it into the 1987 Act.
Secondly, before that Act it was illegal for there to be a dialogue between the auditors and the supervisors because the auditors would be breaking their confidentiality towards their client. The Act not only made that legal but stated that there must be that dialogue. It was there for a few years but with the Brown changes in the regulatory system it fell into desuetude. The Bank of England and, I think, the coalition Government are now proposing that there should be a code of practice in order to reinstate the idea of dialogue. As auditors are unable to qualify accounts in particular, it is particularly important that if they discover anything amiss with a bank’s account, they can tip off the supervisory authority, which is now the Bank of England.
Equally, if the Bank of England has some concerns, it can say privately to the auditors, “We would like you to look at this particular bank and see what it is up to in this regard”. The dialogue is crucial, and I do not believe—nor did our committee believe—that a code of practice is enough. Our committee concluded that this should be mandatory: there should be a legal requirement for the dialogue to take place, which is absolutely right. So, that is my second proposal.
The third proposal comes back to the problem of the qualification of accounts. As I indicated, in practice it is impossible—it does not happen, and it did not happen before the banking meltdown of 2008—for an auditing company to qualify a bank’s accounts. Under the present system the accounts are either qualified or they are not. Qualifying them is almost like using a nuclear weapon. It may well be worth considering using a gradation, rather in the way that the rating agencies grade financial instruments, starting with AAA and going down to wherever they eventually go. It would be possible for the auditors to grade the accounts, and there could be a requirement for them to do so. It is quite possible that the auditors would be less corrupt and more reliable than the rating agencies are. That is my third proposal.
The fourth proposal is that in order to recreate the culture of prudence in core banking, there should be a complete separation between retail banking and investment banking. I am delighted that, thanks to the Vickers commission, the Government are going half way towards that by creating the ring-fence. However, I do not believe that a ring-fence will be impermeable or wholly effective. Bankers are very clever, or most of them are, and they will find ways round it. We are also talking about culture, and the prudent culture of retail banking and the adventurous culture of investment banking are two diametrically opposed cultures. With the best will in the world it is difficult to see how we can have two quite different and opposed cultures within the same corporate entity. There should be a complete separation, not just the ring-fence.
My fifth proposal concerns the issue raised particularly by the noble Lord, Lord Hollick, about the problems of mark-to-market accounting and valuations of assets. Mark to market, as he indicated, can be pretty fictitious when the market is so thin. Of course, there is often no market at all, so they mark to model, which is a complete fiction. Is that a reliable form of valuation for establishing the profits of the bank and also its capital? At present, these paper profits add to the bank’s capital. If we are concerned that banks should have adequate capital, the idea that we are satisfied with paper capital—which of course disappears just when you really need it—is both absurd and deeply worrying. The paper profits are also used to pay out bonuses that are anything but paper; they are real. That has to be stopped. Unrealised gains should neither count as capital nor be payable as bonuses. There is an analogy with dividends in the latter point. It is not permitted to pay dividends out of purely paper gains, but it is permitted to pay bonuses out of them.
My sixth proposal concerns the question of provisioning. One of the many defects of IFRS is the way that the old idea of general provisions—which was certainly very important when I was a non-executive director of Barclays Bank, some 20 years ago—is no longer permitted; you can only have specific provisions. A moment of reflection makes quite clear that this is unacceptable, because specific provisions come about only when it seems as if the loan, or whatever it is, has been impaired. You need provisions when times are good. You do not need them when you are already in great difficulty because you have all these impaired loans on your book. You need to be able to make a general provision because you know as a prudent banker that although there are things that you do not know about specifically, you do know, because of the nature of things and the way that the world works, that something like it will happen. We have to get back to the general provisions that IFRS prohibits.
My seventh and last proposal concerns taxation. That may not be a matter for your Lordships’ House, but we can talk about it. It is particularly timely now, with a Budget coming up very shortly. The proposal addresses the problem of the treatment of loan capital compared with equity capital. If we are going to have a strong and stable banking system, it is essential that it has adequate equity capital. That is what makes it secure. However, we have a tax system in which the interest payable on loans is tax deductible but the dividends paid on equity capital are not. So there is always a perverse incentive for the banks to capitalise themselves as much as possible on a tiny little sliver of equity. The tax system tells them that that is what they should be doing. It should not do so, and the tax system in this regard has to be changed.
I commend these seven modest proposals to my noble friend. As I say, I am not expecting her to reply to them this afternoon.
Lord Currie of Marylebone
My Lords, in rising to speak in this debate on the Economic Affairs Committee’s report on concentration in the auditing market, I should start by declaring an interest as one of two non-executive directors at BDO. I will touch on that role and the experience that it has given me in some of my remarks. Because of that interest, although I am a member of the Economic Affairs Committee, I had to recuse myself from this inquiry. The loss was very much mine—my colleagues have clearly enjoyed a most interesting, wide-ranging and very rich inquiry and have produced an excellent report. I congratulate them, particularly our chairman, the noble Lord, Lord MacGregor. The report has been deservedly influential, with the very rapid adoption of its first key recommendation, of an OFT investigation of the auditing market, leading to a Competition Commission inquiry. We await the results of that inquiry later this year.
The appointment of independent non-executives to audit firms became mandatory in 2010 under the FRC governance code for audit firms. Under the code, the non-execs have a rather broad remit to look after the public interest in the activities of audit firms. Some of the points that have been made about the audit of banks bears very strongly on that role. Different firms have chosen different ways to incorporate their non-execs into the decision-making of their partnership governance arrangements. BDO saw advantage in non-execs rather earlier than its rivals. In 2008, it appointed me and my colleague Lesley MacDonagh, the former managing partner of the law firm Lovells. In contrast to the non-execs at other firms, we have been placed at the heart of BDO’s decision-making, sitting as part of the leadership team meetings. Lesley chairs those meetings, while I chair the firm’s risk committee. As such, we are involved in all the key strategic and operational decisions that drive the business forward. One could question whether such a central role in decision-making is not in conflict with the public interest remit given to us under the FRC code. I would strongly argue that that is not the case: public reputation is key to the success or otherwise of audit firms, as the unfortunate demise of Arthur Andersen demonstrated, so I see no conflict between the public interest and the successful development of the business.
In December, the FRC called a meeting of the independent non-execs across all the audit firms to monitor how the new arrangements code was working. It was welcome to hear that the non-execs of the big four saw as possibly the key public interest ensuring that four do not become three. As the report makes clear, the collapse, like Arthur Andersen, of one of the big four would turn an undesirably concentrated audit market into one where major companies faced no effective choice. It is therefore vital that none of the big four gets into difficulties that threaten its reputation and market standing. Were the worst to happen, regulatory intervention to prevent further market consolidation in those circumstances would be essential, however difficult.
My role as a non-exec of one of the leading mid-tier audit firms is rather different. The public interest imperative on us is to turn the four into five by enhancing the capacity and range of BDO, whether through organic growth or by mergers. BDO itself has grown to the size it has largely as a result of organic growth but also as a result of mergers, some large and many small. Small-scale mergers continue as small audit partnerships decide to join a stronger brand, and they are regular features of our leadership team meetings. They will undoubtedly continue as the flat-lining of the audit market induces further rationalisation.
My experience is that the directors of most FTSE 100 companies, and indeed many of those of FTSE 250 companies, underestimate the capacity and quality of what the leading mid-tier firms, such as BDO and Grant Thornton, can and do offer. It is a little-known fact that BDO is a $5 billion dollar business worldwide, operating in more than 120 countries but, as the report states, too few of the top companies look beyond the big four for audit services. The big four often claim to be the guardians of audit quality and to be the only ones who can undertake the audit of sophisticated businesses. Yet the AIU assessments of audit quality do not highlight any bright line between the quality of the big four and that of the larger mid-tier firms. What they show is that all audit firms experience occasional lapses of quality, but that quality is generally high and that there is little difference in standard between the big four and the mid-tier.
The large mid-tier firms would probably acknowledge that they do not have the capacity to audit all of the biggest, very complex and highly internationally diversified businesses—the global banks and the oil majors come to mind. That may be true, but I would make two points about it. First, as the report demonstrates very clearly—others have already alluded to this, particularly the noble Lord, Lord Lawson—the big four did not cover themselves with glory in their audits of the major banks. The FSA report of only last week pointed out that HBOS was able to conceal problem loans from its auditors, KPMG, in the run-up to its financial collapse, and KPMG raised no red flag over HBOS’s excessive risk taking. Secondly, if the major banks are exceedingly complex to audit, it is almost certainly the case that they are exceedingly complex to manage. Too big to fail goes hand in hand with too big to audit. The source of the problem is less the incapacity of auditors, big four or others, effectively to audit these complex businesses, but rather the incapacity of the human mind to grasp the complex interrelationships between these businesses. The answer is not bigger, more concentrated auditors, but rather less complex businesses that the human mind can understand and manage rather than delegating that to mathematical computer-based algorithms.
I would argue that the capacity and quality of the leading mid-tier audit firms, such as BDO and Grant Thornton, are not limiting their ability to acquire FTSE 100 and FTSE 250 companies, but rather it is market perceptions about them that constrain things. These perceptions should shift over time, were it not for the undoubted barriers to effective competition that the OFT investigation has highlighted and the Competition Commission is investigating, but there is no doubt that the quickest way to resolve such barriers is likely to be consolidation in the mid-tier part of the market. As I have already noted, the flat-lining of the audit market is providing a strong impetus to consolidation. I hope very much that the competition and regulatory authorities would not allow one of the big four to take over one of the mid-tier firms, since that would mean still more entrenched concentration. What could and should be allowed are mergers among the mid-tier businesses. That would help to create a still more viable alternative to the big four and should also help to overcome the perception that the mid-tier lacks capacity and capability.
However, we should not underestimate the difficulties that need to be overcome for such mid-tier consolidation to happen and to be effective. First, combining mid-tier firms will not automatically lead to a change in market perceptions. Secondly, most audit companies are partnerships, and there is no effective take-over mechanism for partnerships. Rather like universities, mergers happen only with the consent of both sides and, as for universities, this happy constellation does not often come around. Matters are made still more complex and difficult because we are talking about the merger not just of partnerships, but also, at some levels, of complex international networks of partnerships. Winning agreement for any merger of this kind is far from straightforward, even if the commercial logic is compelling. That is not to say that consolidation of the kind that I have been discussing will not happen, but it is to say that it is not assured. Without it, we are left with the current market position in which choice and competition are insufficient for FTSE 100 and FTSE 250 companies. Over time, continued investment and organic growth by the mid-tier companies could change the market structure, but that is a long-term outcome while market sentiments require something more urgent.
That leads me to the one area of this admirable report with which I take issue: its analysis of the case for changing the ownership rules for audit companies. Currently non-auditors are precluded from owning more than 49 per cent of the voting rights in an audit firm, as was the case for law firms until last autumn when the provisions of the Legal Services Act 2007, allowing alternative ownership structures—the so-called Tesco clause—came into effect. The Economic Affairs Committee did not see any immediate grounds for changing the law in respect of ownership, despite the strong advocacy of the FRC. It took this position in the light of evidence from BDO and Grant Thornton that they do not feel the need for greater access to capital to expand. I think the committee’s position on this is mistaken.
I would interpret the evidence from BDO and Grant Thornton somewhat differently. Within their preferred partnership model, they do not feel constrained by the availability of capital, but the partnership model undoubtedly places constraints on the strategic moves that these businesses can contemplate, as I can attest having sat through many strategic discussions. This is not in any way a criticism of their way of doing business, but it is to recognise that partnerships are only one way of organising audit business, or indeed any business. Given that, I think that there is considerable merit in allowing greater variety in governance: this would allow new entrants to come into the market with a corporate genetic structure different from the partnership model. That can only be good for greater choice and competition in this market. Indeed, not to do so could be seen as a form of professional restrictive practice, and that has fallen out of favour in almost every other area of business life. After all, we do not expect airlines to be owned by pilots or technology companies to be owned by nerds, although in the latter case some of them are, with great success. So I would argue strongly for the change in ownership rules that the committee turned its back on, but which are part of the European reform package proposed by Monsieur Barnier, and I would also note that BDO favours this change.
There is much else in this rich report that I have not commented on, and there is insufficient time for me to do so. They include: the very important weaknesses in IFRS; marking to market and marking to model which contributed to the financial boom and subsequent crisis; the need for risk committees; the much needed simplification of the regulatory landscape, which the noble Lord, Lord MacGregor, referred to; and the necessary enhancement of the powers and authority of the FRC that would come with that; the relationship between auditors and regulators; and much besides, but I have spoken long enough. I conclude by congratulating the noble Lord, Lord MacGregor, and my colleagues on the Economic Affairs Committee on producing such an excellent report. It has already achieved its key objective the form of the Competition Commission inquiry. This debate is merely a staging post. We must await what the competition gurus come up with. Let no one underestimate what is at stake. We cannot allow this critical market for corporate information to lack the choice and competition that we take for granted in all other walks of business life.
Lord Stewartby
My Lords, retrospectively, I declare some interest in this field, having been chairman of the audit committees of banks and building societies and having been involved in or with banks in some form or other during most of my working life. I would like to offer a few comments in light of that.
We have an admirable report here, but I kept asking myself, “Well, what would we do about that?”, and “Would this be an effective answer to the problem that we are looking at?”. It is very difficult to match it up. I am not in any sense criticising the committee for not having found some punchy answers to some of these difficult questions, but there are still a lot of unresolved issues that are going to need continuous attention.
It was helpful of my noble friend Lord Lawson to give us his seven recommendations and I thank him for his kind words about me. It was an interesting task, constructing the Banking Act in the 1980s. I was glad that my noble friend drew attention to the BoBS—Board of Banking Supervision—because we came to the conclusion that the best judges of whether things were all right or not would be those who had practical experience, rather than our relying on the detached co-operation that we would otherwise get. I am sure, as sure as my noble friend, that doing away with the BoBS represented a practical weakening of the system because, thereafter, it lacked this accumulated experience of practitioners in the area, and that had been extremely valuable.
This leads on to a question that I ask myself frequently: “Is there any obvious way around the dominance of the big four, and how on earth can competition operate effectively when you have so few players and the things they are competing in are not measurable by ordinary standards?”. If you are a big international company looking to change your auditors, what will you be looking for? The answer is reputation, high-calibre staff and probably, among the many other considerations, the right geographical coverage. It seems to me that that is what has driven the consolidation of the big auditors. After all, their major clients need a thorough service from experts.
For that reason, I think that it is likely that there is a limit to the number of well qualified big audit firms that there can possibly be. There is just no impetus to create another one. I have seen people suggesting that we should encourage the setting up of new firms, but I do not think that is realistic. I am much more interested in what the noble Lord, Lord Currie, said about whether there is an opportunity for upping the game for the medium players. It is not satisfactory that, when an audit company is looking for business, it cannot sell itself very easily on price or service because they are so difficult to compare, and that is an argument against moving too often. The most astonishing figure in this document is that to which my noble friend drew attention: on average, major companies change their auditors every 48 years. That is generations. It has come about because of a historical process that got huge stimulus from globalisation. Service companies had to adapt to dealing with much larger and more complex businesses than they had been used to. Although I very much welcome the discussion and thinking of ways of dealing with this, we are not all that far away from a situation where there are only three, or possibly fewer, companies that can do something on that scale.
That leads me on to the question of how much the competition among them does for the good of the business. If competition was operating effectively, you would expect it to have a significant impact on how audit firms, among many others, go about their business. Everything we have seen in the past few years makes us ask another question: why did auditors not recognise the risks? Of course, the setting up of risk committees is a useful development. Two of the committees that I was on had to make a change because of extraneous factors and other changes have been out of their desire to rotate activities, but on risks and losses they all seemed set in the same mould. There was not a readily identifiable characteristic of one type of audit work or another. I keep remembering the remark made by the Queen when she visited the Stock Exchange. She asked how come no one saw this coming if it was all so big. You could say that of the business community. If you had six firms instead of three that could do international banks, would you really get much alternative or would they all have made the same mistakes?
The thing that I find most extraordinary is that, across the board, there was a unification of attitude and outlook. I do not know how you could define that, but certainly the end product with the massive extra provisioning and losses that have come through in the past three years shows that something was seriously wrong with the process that was meant to identify risks and what they would do. You do not get the impression that this is how it was looked at. You could almost say that there was a suspension of critical faculties across the whole area. You have the managers and executives in the businesses, the internal audit departments, the audit committees and external auditors, so it is not all the fault of any one of those. Curiously enough, however, they are all involved in relatively the same process.
When I was dealing with investment managements a few years back, the absurd phrase “slicing and dicing” was often used. The idea was that you had a whole lot of loans and you put a little bit of each one in a package and walked around the corner to see the rating agencies. As it happens, they seem to have fallen over very badly on this. The point is that there were several different layers, so if you deconstructed the slicing and dicing you would find small parts of some very unsatisfactory businesses. Yet nobody in these operating roles managed to permeate this wall of almost wilful ignorance about what was going on in those sorts of businesses. It was not just the auditors or the banks, but a collective failing. It is appalling that we have not had any explanation as to how auditors, or anybody else, failed to test out on a sampling basis the decisions before them.
In particular, I welcome the recommendation about the Office of Fair Trading investigation. That is absolutely essential. I strongly support the elevation of prudence to a more prominent role, which was the second of the committee’s main recommendations, particularly because I thought that the introduction of Basel II and the IFRS was bound to lead to trouble as it would exaggerate rather than offset economic swings, and that is exactly what happened. The trouble is—and I must apologise if it seems like I am being overly critical here—the accounting profession is not always best placed to provide the sort of rules that we are all going to have to live by. Undoubtedly, the IFRS and Basel II made life more difficult and meant that a lot of provisioning was not as strong as it should have been.
Finally, I come to the point that my noble friend Lord Lawson spoke of: the dialogue between auditors and supervisors. A small point of definition is important here, because at the bottom of the first page of the abstract it says,
“the fact that, as our evidence revealed, confidential dialogue between auditors and bank regulators had fallen away before the financial crisis”.
That dialogue is immensely important. However, while on that page it talks about dialogue between auditors and regulators, at the end of the next page it says,
“dialogue between auditors and supervisors”.
It may seem to be a small point, but I draw attention to this because it is very important to remember that the functions of regulators are different from the functions of supervisors. They overlap, but the regulator makes the rules and sets the framework in which the whole business has to operate. The supervisors are meant to go institution by institution and satisfy themselves as to the soundness of individual businesses. Because these two words are often used interchangeably, I suspect that sometimes people have been doing what they thought was regulating but in fact should have been supervising, and vice versa. I do not want to overstate it because I do not think that it is the cause of too much mischief, but it is thrown up by the fact that, until the legislation, there was no statutory provision for auditors to talk to supervisors or regulators. The need for that has been revealed enormously by what has actually happened.
Finally, the move to a more judgmental approach rather than too many rules is essential, but you also need people who have the background and experience to cope with these things. It will be very important that audit committees have among their members people who have come across some of the real business questions of recent time and will more than take into account the fact there has been a lot of discussion on these things but there are still very many unanswered questions.
Lord Hodgson of Astley Abbotts
My Lords, I was not a member of my noble friend’s committee, but I add my congratulations to him and his fellow committee members on a really interesting—indeed, fascinating—report that raises many important issues, both within and without the banking system. I have a number of relevant interests declared on the register of your Lordships’ House, but I draw the committee’s specific attention to the fact that I am the senior independent director—the SID, as it is known in the trade—of one of the FTSE 250 companies. I am a member of its audit committee and chair of its remuneration committee.
I will focus my remarks not on the banking issues, which have been ably and decisively covered by my noble friends Lord Stewartby and Lord Lawson. I will focus my remarks on the first two issues that the committee looked at: the dominance of the big four and its effect on competition and choice and whether the traditional audit still meets today’s needs.
The committee hit the nail on the head when it mentioned in paragraphs 18.vi and 18.vii,
“the perception that big is best”,
and,
“the reputational assurance of using Big Four auditors”.
These things are at the heart of the difficulty that we face. I do not wish to press the noble Lord, Lord Currie of Marylebone, but I think it unlikely that my co-directors would be prepared to take on a firm outside the big four, even if it were demonstrably cheaper and probably even if the service was the same. We are reaching the tipping point, but we are not there yet. There is more to be done along the lines that I shall refer to in a minute and which he was hinting at in his remarks. The noble Lord, Lord Shipley, asked how we deal with conflicts of interest. Well, we have a fairly clear way of doing that, in the sense that we make sure that we measure the amount of non-audit work that we are giving to the firm, we measure the amount that we give to the firm in relation to the total in the office—in other words, how big we are in relation to that particular firm’s regional office—and we disclose in the annual report. Where we have areas where conflicts of interest are clearly irreconcilable, such as international law, we use another firm. We go outside for things where we cannot satisfy ourselves that we can have a proper divide-and-rule situation.
I was not at all surprised that the committee reached the conclusion that the Financial Reporting Council’s market participants group had not really achieved very much. The suggestion in paragraph 49 that the way in which to encourage more participation by firms outside the big four is by involving institutional shareholders is, I fear, doomed, as my noble friend Lord MacGregor said in his opening remarks. I am not hopeful because it is pretty difficult to get institutions or shareholders to engage at any level. It is very depressing, with a few honourable exceptions. Apathy and worse is the only description of their interest.
Why is that? In the company I am talking about, three of our top 10 shareholders are tracker funds, so they have no particular interest in what we are doing. In fact, they would rather not see us as it might bias them in a sense. They want us to follow the index exactly or they do not want to see us at all. For others, best governance practice suggests that the SID—senior independent director—should meet the major institutional shareholders once a year. Trying to get a meeting is extremely difficult. Most of the time they say that they are perfectly happy and do not want to meet you. Meetings are cancelled at the last moment. You turn up and find that the man with whom you had a relationship is too busy and you end up with a junior person who may have been in the investment business for only two or three years. There is nothing wrong with that; I am not trying to sound pompous and say that I will not talk to him. The nature of the relationship that you have with your institutional shareholders is transitory in that sense. We are talking here about the operations of a company itself, not the appointment of auditors, which by its nature is of another degree of importance.
A counsel of despair surrounds one, but things can be done. First, I share the committee’s conclusion that examination by the Competition Commission is a worthwhile exercise, so that we get examination in detail of the warp and weft of this difficult issue. As to the advantage of a big bang conclusion with the recommended break-up of one or more of the big four, I am more doubtful about that. I am far from convinced. To use the famous phrase, “You don’t strengthen the weak by weakening the strong”. The halo effect will continue and may well survive and you may have damaged the firm’s international reach in the mean time.
Clearly the Government have the reach and the scale to offset some of this halo effect, so I very much support the committee’s proposal about work previously undertaken by the Audit Commission being a possible way to build a new firm. The Government should go further than the committee suggests. There are a number of areas where the Government could help to create a situation where the smaller firms reach a tipping point. For example, within the Financial Services Authority— I know that it is unfashionable to say anything good about the FSA—a Section 166 report, or expert person’s report, is increasingly being used. There is a tendency to go for the big four firms there, but reports could easily be carried out by other firms. These and other reports carried out by the FSA, and no doubt by other government bodies that I do not know about, could usefully suggest that a wider range of firms should get involved with this. There are things such as encouraging banks and private equity houses to use firms outside the big four for due diligence purposes, and there are the trade bodies—the Investment Management Association and the British Insurance Association—that could also lend their weight to ensure that over time this situation could be improved. There is no silver bullet, but with a concentrated effort from within the profession, in whose interests this sort of development must be, something will be achieved.
In my remaining remarks, I will deal with whether the traditional statutory audit still meets today’s needs. Clearly many people feel that it does not. Many people feel that it lacks focus and priorities and emphasises process at the expense of judgment. At our annual general meeting, one of our more experienced private investors said that reading the annual report was like having a bucket of warm blancmange poured over your head. Perhaps I can illustrate that in a very simple way. The company of which I am the senior independent director is a simple company. We are entirely in the UK; we have no overseas operations. Our final salary pension scheme is closed. The only complication in our business is that we have some hedging and some derivatives for our longer-term borrowings. In 1995, our annual report was 25 pages long; in 2000, it was 41 pages; in 2005, it was 76 pages; in 2010, it was 104 pages; and it will be a bigger number in 2011. I cannot see that this—
The Deputy Chairman of Committees (Lord Geddes)
It is now 5.35 pm. The noble Lord, Lord Hodgson of Astley Abbotts, who was so abruptly cut off in mid-flow, may resume his speech.
Lord Hodgson of Astley Abbotts
I was winding up, talking about the value of the traditional statutory audit and whether it now needs some serious revision. I said that my company is a simple company, with market capitalisation of £660 million, all in the UK, no foreign exchange, none of those complications, no open final salary pension scheme and, apart from some hedging for our long-term debt, not a great deal of complexity. I pointed out that in 15 years our annual report has gone from 35 pages to 104 pages. I questioned whether that is a useful exercise and how many people read it. In the Companies Act 2006, we thought we were being extremely clever in introducing the e-mail opportunity for companies. In a strange way, that has taken the pressure off auditors to think about the thing because they can e-mail people. Many fewer copies of the report can be printed. Increasingly the default option is to send it by e-mail anyway, so some of the self-restraint has been removed.
I think the auditing profession needs to follow this report with some serious intellectual heavy lifting to provide a greater degree of focus going forward. I turn to another context: the City at the moment. Noble Lords will have received papers from banks recommending shares. On the back page there is half a page of tiny type containing disclaimers. An investment bank put halfway down that, “If you have read this far, call this number and we will send you a bottle of champagne”. In three months, it never had a call. That is how much all this stuff is being read. It has become boiler plate. Similarly, too much of annual reports has become box-ticking and verbiage read by almost nobody. I think the profession could do a really valuable service by introducing a degree of rigour and focus. I hope that above the desk of each of the members of that working party, there will be a banner reading: “Less is More”.
Baroness Hogg
My Lords, I, too, should like warmly to congratulate the noble Lord, Lord MacGregor, and his committee. First, however, I must declare my interests—which are in the register—principally, today, as chairman of the Financial Reporting Council.
The report was, as one would expect from this distinguished committee, rigorous in its analysis, but equally important, and much more unusual, have been the results. As a former member of this committee, I cannot think of another inquiry conducted by it in recent years that has had such a powerful effect. I am sure that the Minister will provide an excellent summary of the actions taken by government and regulators following this report, so I shall concentrate on those taken by the FRC.
As many noble Lords have said in this debate, these issues go to the heart of the effective functioning of capital markets. The FRC’s mission is to,
“promote high-quality corporate governance and reporting to foster investment”.
This reflects our recognition that the willingness of investors to provide risk capital—a vital link in the chain of economic growth—depends on their confidence in how companies are run and how their accounts are prepared and audited. So, after the financial crisis, this report was timely and influential.
I would diffidently say to the noble Lord, Lord MacGregor, that the committee did not have to tell us at the FRC that the efforts we were making within our remit to reduce concentration in the market had made very little difference. We have been shouting that loudly, hoping someone would take notice. We are delighted that the committee did and that the alarm it sounded penetrated more ears and led to the Office of Fair Trading asking the Competition Commission to take another look. This is a very important step which we hope will also lead to thinking, at national and international level, about what the government response would be if there were to be another crisis and a threat that the big four would come down to three.
We are also very pleased that a new point of alarm on domestic concentration that we raised with the committee has been taken up by it and then picked up by the Government. Like the noble Lord, Lord Hodgson, we welcome the action that the Government have taken to ensure that work flowing from the abolition of the Audit Commission is well spread among firms of a certain size and not concentrated among the big four.
The European Commission is right to see concentration as an international issue. However, the reason why we want a competitive audit market is to safeguard audit quality, not to endanger it. We have therefore made clear that we are opposed to certain EC proposals, such as the break-up of the audit firms, which we think would damage quality.
Equally, we want to encourage competition in order to empower choice of auditors, not simply to disrupt it. We believe that clearer guidance on non-audit services will both deal with conflicts of interest and stimulate market development. We will also shortly be publishing proposals that do not enforce a merry-go-round of compulsory auditor rotation but request companies to retender their audits after eight to 10 years. This should be introduced on a “comply or explain” basis and with transition arrangements to prevent market turmoil. We must not disempower the audit committee from choosing the best firm for the job.
Whatever improvements are needed, we must not shoot ourselves in the foot. Despite all its strictures, the committee noted much evidence to support the view that British auditing is among the strongest in Europe and indeed is arguably the world leader. Moreover, our approach to corporate governance, of which audit is a key component, has helped give us the deepest capital market in Europe. We must continue to strive for improvement. The audit inspection unit continues to highlight weaknesses—as the profession will tell you, sometimes through gritted teeth. However, in considering EU reforms, we must avoid a surfeit of prescription designed to raise standards elsewhere. Rules that are too detailed damage the willingness to exercise judgment; and judgment is what we most need in times of crisis, as the committee has rightly said.
Many of the key recommendations of this report chime with the proposals that we at the FRC have set out in our paper on effective company stewardship. I hope that all Members of the Committee have had the opportunity to read this report. I would be happy to send copies to those who would like it. They may have noted particularly the points on auditor scepticism in this report.
We are very mindful of the questions that members of the committee raised about the role of accounting standard-setters, preparers of accounts and auditors in the financial crisis. Put simply, the challenges were: did they do their job; if they did not, what is being done about them; and if they did, what does that say about the value of accounting, reporting and auditing?
The most far-sighted members of the accounting profession do not seek to answer these challenges simply by reminding us of the limitations of accounting and audit or by asserting that these are mysteries others cannot challenge. They are willing to engage in a more ambitious debate on how the value of audit can be enhanced and how accounting standards can be improved. The committee has challenged the monopoly of wisdom of the technical standard-setters. Our reforms at the FRC are designed to help us engage with the wider debate. Many of the weaknesses in IAS 39 that have been referred to have been addressed, in fairness to the technicians, but we are still concerned about the speed of implementation. Brussels seems to take the view that all changes should be saved up to do together. We believe this to be unnecessary delay.
Meanwhile, as the Minister will no doubt confirm, at the FRC we have taken the lead on a key issue by asking the noble Lord, Lord Sharman, to head an inquiry into the role and value of going-concern statements. His draft report has been published and we expect the final report shortly.
For this report raised a deeper challenge for the FRC. The committee criticised our structure, finding it confusing and overcomplicated. Indeed, we have at present some seven operating bodies to fulfil one objective. The result is that too much of our work is done in silos, and there are overlaps and underlaps between them. This is no criticism of the excellent people involved. Some of these barriers are statutory, others derived from the way in which the FRC was cobbled together. However, the committee was right to call for change, and we are glad that the Government have responded.
We need to share knowledge across the organisation in order to operate more effectively, both in our conduct role in the UK and in the international debate on codes and standards. Our international task has become a much more complex exercise, requiring us to mobilise all the expertise in different operating bodies for maximum effect, and for cross-silo challenge within the organisation.
We also need to ensure that the work of the audit inspection unit is useful to chairmen of audit committees and maximise the combined value of the work of the audit inspection unit and the financial reporting review panel. We also need to clarify the dividing lines between ourselves and the professions so that we can truly claim to be an independent regulator. Clarifying that status will also help us to work more effectively with other regulators. The noble Lord, Lord Lawson, rightly highlighted the breakdown in the arrangements that he put in place to ensure the Bank of England's assessment of macroprudential risk was informed by what the major audit firms were seeing. He also used this inquiry to probe at the gaps and overlaps between regulators.
Legislation is not for us, but with these challenges in mind we have with the Bank's help put in place a forum for information flow and discussion of risks and appropriate responses between ourselves at the FRC, the Prudential Regulation Authority, the Financial Conduct Authority and the Financial Policy Committee. The reform proposals that we put forward jointly with government would streamline our work on codes and standards on the one hand, and conduct—review, inspection and disciplinary action—on the other.
I welcome the prompt that the committee's report gave to fresh thinking about this in government and at the FRC. We have had a lively consultation on our proposals and done our best to respond to the points made without compromising our independence or losing the opportunity to match our organisation to today's challenges. I hope that we will receive a statement from the department on this soon, and look forward to hearing what the Minister has to say. I hope that the resulting reforms will lead the committee to conclude that we have responded to its challenge.
Lord Northbrook
My Lords, we are all grateful to the noble Lord, Lord MacGregor, and his committee for a thorough, detailed and important report. Like him, I am very sorry for the delay of nearly a year before we have come to discuss it.
As other speakers have said, the report covers four major issues: the dominance of the big four accountancy firms; whether the traditional audit still meets today’s needs; the effect on audit of the adoption of international reporting requirements; and how banks were audited before and during the banking crisis and what changes there should be. Having carefully read the report, I find that the second and third issues are well covered but, though very reluctant to disagree with such an eminent team on the committee, I find the conclusions on the first and fourth issues slightly unsatisfactory. I will go on to cover each issue in more detail.
There is no doubt about the dominance of the big four accountancy firms in auditing large quoted companies. As the noble Lord, Lord MacGregor, has already said, in 2010 the big four audited 99 out of the FTSE 100 leading firms, and around 240 of the next biggest FTSE 250 firms. They also had about 80 per cent of the FTSE smaller capitalisation firm audits.
I first make one comment based on my experience as an investment manager. I always had a comfort factor in seeing the name of a big four auditor, particularly when looking at a small and growing company's accounts. Several companies with smaller-sized auditors came to grief through, as it subsequently proved, being allowed to adopt overoptimistic accounting policies, which I am sure would not have been tolerated by the big four auditors. I am not sure that that is fully appreciated by the committee’s report.
The report also states that the chairman of the Hundred Group of finance directors of FTSE 100 companies said they were, in general, content with the service provided and the competition they noticed in the market today. I know it may be heresy to say so, but I do not know what is going to be usefully achieved by a Competition Commission investigation, even though the noble Lord, Lord Currie, has made an interesting argument for the merits of BDO and Grant Thornton, and I know it is supported by the Economic Affairs Committee and the noble Baroness, Lady Hogg, of the Financial Reporting Council.
What will it conclude? Are major companies going to be forced to change auditors? I cannot see the advantage of mandatory joint audits either, and nor can the Government in their response to the committee’s report. I also cannot really agree with the idea of compulsory tender for audits every five years. The reply from the Government—and that of the noble Baroness, Lady Hogg—suggesting a more flexible approach is better. I agree with paragraph 53, which refers to the noble Baroness’s view that,
“the expected abolition of the Audit Commission would provide an opportunity to increase competition and choice in the audit market if it formed the basis of a substantial new competitor to the Big Four”.
Paragraph 60 of the report also raises an important question about whether the limited liability partnership status of the medium and smaller-sized audit companies will be sufficient to protect them from unlimited liability. According to the noble Baroness, Lady Hogg, the situation is not entirely clear on this matter.
The third issue is the major impact of international financial reporting standards. Although I am far from being an expert on these matters, I note—as have many other speakers—with interest the sentence in paragraph 113 that states:
“In short, a box-ticking approach is replacing the exercise of professional judgment which allowed the auditor’s view of what was true and fair to override form”.
The report then moves on to the application of IFRS standards to UK banks. The letter by the noble Lord, Lord Flight, in Appendix 7 of the report is very interesting on this subject. He makes three interesting, if rather technical, points: first, that the accounting treatment of the granting of options to be booked through the profit and loss account both obscures the real trading position of the business and fails to advise shareholders of actual or potential dilution. It is significant that Adam Applegarth, then CEO of Northern Rock, told the Daily Telegraph in 2005 that moving to IFRS had introduced more volatility and led to “faintly insane” profits growth.
Secondly, as the noble Lord, Lord Hollick, discussed earlier, the IFRS mark-to-market standards served to overstate capital resources in buoyant times; subsequently they served to understate them in difficult times. Thirdly, he considered that the requirement to discount pension fund liabilities at a rate of interest measured by prime bond yields overstates effective liabilities and has been a major contributor to the demise of final salary pension schemes.
The committee overall concludes that IFRS standards are not fit for purpose. However, in their response, the Government disagree and do not accept that they have led to this loss of prudence. The results of the panel convened by the FRC and chaired by the noble Lord, Lord Sharman, which were published in November, identified lessons on going-concern and liquidity risk for companies and auditors. Again, as the noble Lord, Lord Hollick, reiterated earlier, the key sentence of its preliminary report, as far as I am concerned, is:
“Require the going concern assessment process to focus on solvency risks”—
to the entity’s business—
“as well as liquidity risk”.
The final major issue of the report is how banks were audited before and during the financial crisis and what changes there should be, including to auditors’ relationships with financial regulators. I think overall the committee is unfair in criticising the auditors so strongly in paragraph 142. I support the comments of the heads of KPMG, Deloitte and PwC: the role of auditors, in my view, is to count the score at the end of an accounting period. They are not trying to forecast next year’s profits. It is not the job of the auditor to look at the business model of a business; that is the job of management. Surely the job of monitoring the day-to-day activities of the banks should be for the regulators. Auditors look at the company at a set time, not throughout the year, as regulators should be doing. Otherwise, what can be the limits of the auditor’s responsibilities?
For instance, the FSA, in its report on Northern Rock, tells us that its insurance team was in charge of regulating the company. No wonder it totally failed to understand the dangers of the company’s business model. How could auditors influence the disastrous tie-up between HBOS and Lloyds TSB which was personally engineered by the Prime Minister? How could they have influenced the RBS takeover of ABN AMRO which Barclays was also interested in? It was a management decision and seemed justifiable at the time. Let us remember that neither the regulators nor the rating agencies foresaw the major problems which began in the USA with the abandonment of the Glass-Steagall Act and the US Government’s decision to allow cheap loans to NINJAs—those with no income, job or assets.
Finally, I would just like to requote paragraph 151 of the Economic Affairs Committee report which states that,
“very few in senior management positions in the major banks had more than a ‘cloudy’ grasp themselves of the mathematical models used to value the banks’ complex financial instruments”.
From my knowledge, I fear that that is true. Universities, such as Reading, offer highly detailed courses in financial instruments. This is a relatively recent development, so I am not surprised that senior management is not up to date. Surely they should do courses as well. Auditors should also go on courses to familiarise themselves more with these products. Overall I welcome this most interesting report despite my disagreement with parts of it. It has been an excellent undertaking, but the important dialogue in my view is not between auditors and regulators; it should be between regulators and companies.
Lord McFall of Alcluith
My Lords, I am delighted to contribute to this debate and congratulate the noble Lord, Lord MacGregor, and his colleagues on a very cogent report. When the auditors came before the Treasury Committee after the financial crisis in 2007 we concluded that they had done their job adequately in auditing, but that if these are the limits, what is the point of an audit? That question still haunts the audit profession to this day.
Progress has been made with accounting standards setters by the noble Baroness, Lady Hogg, and her colleagues and with the Sharman committee. However, the factors that led to the demise of RBS, HBOS and Northern Rock, such as the dependency on home sale markets funding in the case of Northern Rock, the high exposure to property in the case of HBOS and the very significant exposure to markets and businesses in the case of RBS, were all clear to accountants and auditors two or three years before the collapse. The problem was that no one paid any attention. The Bank of England and the FSA came before the Treasury Committee and said that they sent out warnings but nobody listened. There was no influence there and people were not talking to one another. That is the biggest issue in this financial crisis. The regulators were not talking to one another and there were black holes in between—that is the issue.
For the future, the question posed by McChesney Martin, the chairman of the Federal Reserve, is relevant: who will take the punch bowl away? We have to support the regulators and others to ensure that that is taken away. RBS was mentioned, where there was a 95 per cent shareholder endorsement. Where were the auditors? Where were the non-executives? How was corporate governance and risk organised? Abysmally—that is how. Auditors need to engage on a statutory basis with the FSA. It told us that it had six engagements with Northern Rock in the previous two years—four by telephone and two meetings with no minutes. If you had been secretary of your local community club or golf club, you would be thrown out at the AGM as a result of that.
That is the state we are in. We have to ensure an early warning system for the banks involved, which should involve a very measured risk profile. The problems were seen late. The issue with accounting is that it looks backwards and largely aims to reflect the transactions that have been committed to and not to affect future events. An audit will be effective only if it is underpinned by a thorough understanding of the business model. Auditors are close to the management, and they, above all, should have that understanding of the business model. That is why engagement is very important.
Simplicity of language is very important. One of the things that I regret not doing when I was in the other place was putting forward a 10-minute rule Bill to say that annual reports should be a maximum of 80 pages in length. When I was on the Treasury Committee, the HSBC report came to 500 pages. I challenged the main auditor to sit by a fire on a winter night with a nice good malt whisky and look at that report. I guaranteed that he would be asleep before he read it. Simplicity of language is hugely important. Given that we now have the Financial Policy Committee, that wider constituency should be used by auditors to report. I suggest an annual report from the FPC to Parliament to take these concerns into consideration.
I suggest the curriculum for auditors and accountants should be looked at. A result of the financial crisis was that the economics profession’s efficient-markets model was thrown out of the window. They have to look at that again. I think a wider constituency is important. I shall give my experience as an educationalist. I undertook a MBA part-time—three nights a week—at Strathclyde University. It was the best degree I undertook. Why? It was because everything was black and white and then went to grey as a result.
I shall give a six-point plan. Unlike the noble Lord, Lord Lawson, I know my place in this House. My six-point plan is: early warning; business model; wider engagement; education; corporate governance and risk; and culture and ethics.
Lord Young of Norwood Green
My Lords, I enter this debate with great trepidation, not being a financial expert by any means. I do not envy the Minister her task in trying to sum up. I am only going to touch on a few points. I did not read all of the report and did not have a single malt, but I certainly had a good look at it and at the government response. I think we should congratulate the committee on doing a good job. I am indebted to the noble Lord, Lord MacGregor, for the history. I was fascinated by Deloitte’s involvement as the first auditor of the Great Western Railway. Knowing Brunel’s propensity for raising cash from investors and very rarely giving them any return, I can see that it is a historic problem.
Some key points have arisen during this debate, which focused on the banking crisis. Time and time again, although not everybody seems to agree, the question of whether there should be a dialogue between auditors and regulators was raised. The noble Lord, Lord Stewartby, drew to our attention the subtle distinction between regulators and supervisors. I am sure the Minister will deal with that. It seems to me that that is part of solving this difficult problem.
Then we got to the nature of the audit and the IFRS and GAAP approaches. We had a debate between box ticking and prudence, and it seemed that most noble Lords erred on the side of prudence. I think it was the noble Lord, Lord MacGregor, who talked about professional scepticism and the feeling that it is important that auditors exercise their judgment.
I was also interested in what the noble Lord, Lord Lawson, said when he asserted that there has been a decline in moral standards in the City of London. In fact, he talked about moral bankruptcy. What we saw in 2007 and 2008 was quite clearly the product of a catastrophic failure of governance and the failure of regulators to understand the nature of the systemic risk in the financial system. It may be that we should be taking the opportunity to reassert the existence of the fiduciary duty on those who are responsible for managing the assets of savers and investors to act in their interests, exercise good judgment and be accountable for that judgment.
There has been a lot of discussion about the dominance of the big four, but no one has come up with a solution to that particular problem yet. I was exercised again by the noble Lord, Lord Stewartby, reminding us first of all of this 48-year relationship in what I would describe, in a variation on the word oligopoly, as a “quadropoly” and secondly that there seemed to be a “unification of outlook”—I hope I have not paraphrased him—and a “suspension of critical faculties”. None of the people involved seemed to have recognised the risk. He talked about the Queen’s comment that no one saw this train crash coming. Then he referred to the slicing and dicing of products, these financial derivatives that were so complicated yet nevertheless managed to achieve an AAA rating when we knew they were rotten at their core.
Clearly there is a need, as I think both the noble Lord, Lord Northbrook, and my noble friend Lord McFall of Alcluith said, for auditors and indeed management to be trained to recognise risk. That is something else I hope the Minister will address. On the question of risk and risk committees, that seemed to be one of the important recommendations, although the report seemed to refer just to banking and finance companies. I was thinking about that and reflecting that there were other companies that took substantial risks, which resulted in the Government footing some of the bill. The one that came to mind was Southern Cross, which became so leveraged that it could not sustain itself, and I recalled the impact the foundering of those care homes had on society as a whole. When it comes to big companies and risk committees, it seems to me that it is not just the banking and finance sectors that should be required to submit to them.
I am also indebted to, I think, the noble Lord, Lord Shipley, for reminding us of the human consequences of the Northern Rock crisis, which he saw every time he looked out of his window in Newcastle; and not just for shareholders, but for the employees who suffered as a result. It seems to me that a risk committee and auditors being involved in that is fundamental.
I am not sure how we are to resolve the dominance of the big four. I hope that the noble Lord, Lord Northbrook, is wrong that the Competition Commission will not be able to shed any light on that. We had the noble Baroness, Lady Hogg, suggesting—and she was not the only one—that now the Audit Commission is going this should present an opportunity for other auditing companies to emerge. Somebody else suggested that the FSA reports would be a good vehicle to assist in this process. I do not feel competent to comment on that but no doubt the Minister will, although she was given a get-out clause there when the noble Lord, Lord Lawson, said that she could deal with his seven recommendations by letter. I felt the Minister should be eternally grateful for that because they got more and more complex towards the end.
I think it was the noble Lord, Lord Lawson, who made the point that no auditors have been sued as a result of the banking crisis. Amazingly, nobody seemed to take any responsibility. There must be something wrong if everybody apparently was exercising their responsibilities and yet we had this financial crisis. As the noble Lord said, nobody at this point in time is willing to accept responsibility. We know that there is plenty of work to be done. When I look through the government response, I do not think that they have got it right in all cases. I gave the example of the question of risk. It is important that all companies should have that. The relationship between the auditors and the risk committee will be important. I look forward to the Minister’s response and once again thank the committee for its work.
The Parliamentary Under-Secretary of State, Department for Business, Innovation and Skills (Baroness Wilcox)
My Lords, I thank my noble friend Lord MacGregor of Pulham Market for calling this debate. We have heard some well informed and constructive contributions from the House. It has been a particular master class for me, and certainly for my civil servants behind us because they have had evidence today of what a Lords Select Committee can do with a subject all by itself. At the moment, every time we can show how well a Lords committee does, we should do so.
Of course, I will not be responding to the noble Lord, Lord Hollick, who asked my permission to be able to speak and to leave. He therefore knows that I will be writing to him rather than answering his questions while I am on my feet. As we have already heard, my noble friend Lord Lawson decided to let me off the hook today and gave us those seven biblical recommendations that he left us to reflect upon. We will, of course, write to him. As for the rest of the questions from your Lordships, I hope that I will be able to answer a goodly few of them along the way. Of course, I will write to anybody to whom I have not been able to immediately respond.
I start by paying tribute to the Economic Affairs Committee’s chairman, and to the report and recommendations, some of which have already resulted in action. One of the recommendations in the report was that the audit market should be investigated by the competition authorities. As my noble friends Lord MacGregor and Lord Stewartby, and the noble Lord, Lord Currie, noted, within two months the Office of Fair Trading had announced its provisional decision to refer the market for the audit of large companies to the Competition Commission, which plans to publish its provisional findings by the end of November. I emphasise what an important development the Government consider this investigation by the competition authorities to be.
The Select Committee report made several other recommendations. I recognise that the committee expressed disappointment with some of the elements of the Government’s response to its report. It might help if I start by covering two issues where I know that the committee continues to have concerns. The first is the issue of international financial reporting standards—IFRS. Under EU law, listed companies in the European Union are obliged to prepare their consolidated accounts in accordance with IFRS. My ministerial colleague, Norman Lamb, replied to a letter from my noble friend Lord MacGregor on this issue last week; I think that he is coming out with a Statement fairly soon. In line with the conclusions of the G20 last November, we continue to support the aim of a single international system of standards. These will develop with time and aim to address issues, on an international basis, as they arise. The Financial Reporting Council—FRC—is engaged in that process, as are the Government when revised standards come to be adopted in the European Union.
The other area where the committee expressed concern was the need for discussions between auditors of financial institutions and the prudential regulator. The Government continue to support the code of practice that now requires discussions twice a year, with one discussion including the relevant bank. The code of practice appears to be working. For this reason, and in accordance with better regulation, we will not be introducing a statutory requirement. The Government, the Bank of England, the FSA and the FRC all support this. However, we will be watching the issue closely.
My noble friend Lord MacGregor asked what the FSA code of practice requires. The code of practice now requires discussion about each of the banks between the relevant auditor and the prudential regulator twice a year, with one of those meetings including the bank itself. These discussions are happening and the code, as I say, appears to be working. My noble friend Lord Stewartby asked why auditors did not recognise the risks. The banking crisis had a range of causes. More or better assurance alone would not have stopped it, but we have certainly learnt lessons.
The systemic problems that caused the banking crisis have been well rehearsed and include a failure of credit judgment, a failure on the part of central banks to recognise asset bubbles, weaknesses in regulation and deficiencies on the part of credit rating agencies. Audit has never had a financial stability role, and is only one element of the regulatory framework that ensures that we have working capital markets. The issue of systemic risk falls to the regulator, as well as to the boards of companies, rather than to the auditors. In terms of the audit of banks, the Government are committed to the objective of improving bank corporate governance, and will continue to work closely with the European Union and internationally to increase transparency and accountability in a proportionate manner.
I now turn to some other recommendations of the committee, where the Government and the FRC have taken action. On the long tenures of some auditors of large companies, BIS and the FRC consulted separately last year as to how discussions between auditors and audit committees about the appointment of auditors might be improved. Amendments to the FRC’s corporate governance code and audit committee guidance will follow this year. This will include a new requirement for auditor retendering by FTSE 350 companies, on a “comply or explain” basis, every 10 years. My department will publish a summary of responses to the consultation on narrative reporting shortly and we will set out the Government’s position as regards wider assurances of corporate reporting beyond the audit of accounts.
My noble friend Lord MacGregor asked whether the Government are proposing to encourage company boards to form risk committees. Well, the Government are reviewing the structure of the corporate reporting framework. We propose splitting the current single corporate report into two documents: a strategic report and the annual directors’ statement. The strategic report, as its name implies, is strategic. It will allow companies to tell their story, describing their business model, the strategy to deliver this and the risks to this strategy through the directors’ remuneration. It is not the Government’s intention to create legislation to mandate that companies have specific risk commitments.
My noble friend Lord Hodgson asked why we need to change the current narrative framework. The results from the August 2010 BIS consultations, “The future of narrative reporting” and “A long-term focus for corporate Britain”, demonstrated a consensus among respondents that change to the current narrative reporting framework was required. They struggled to glean the key messages from the mass of data presented. We propose to divide the current annual report into two documents. The first is called strategic, as I have already mentioned, and the second—the annual directors’ statement—will contain information that is used by some, but not everyone. Our proposals will, I hope, help companies and investors concentrate on strategic issues for the business, and encourage more integrated reporting, giving a clear line of sight from the company’s results through to its business model, strategies and risks.
On the abolition of the Audit Commission, the Audit Commission announced the award of contracts to outsource its audit work to private-sector providers last week. This was very good news in terms of concentration in the audit market. Grant Thornton, from outside the big four, has been awarded the largest share of new work of any of the recipients. These contracts were awarded on the basis of cost and quality criteria, and demonstrate the confidence we can have in auditors outside the big four.
The noble Lord, Lord Currie, spoke of the need to promote the use of middle-tier audit firms by large companies. At present, under the EU directive, statutory auditors have to be majority-owned by qualified auditors. We are continuing to support an exploration of the likely demand for and consequences of alternative structures, and this might help smaller firms grow. It might also help recapitalise an audit firm in the event of its failure. We recognise that other member states have differing views on this and are continuing to discuss this issue with the presidency and the Commission.
My noble friend Lord Hodgson asked whether the Government are enabling non-big four firms to win public sector work. The answer is yes. The Government are committed to improving value for money from public procurement. We are centralising within Whitehall the procurement of common goods and services, including for audit and assurance. Central government purchases from small and medium-sized companies doubled to £6 billion in the past year as the coalition has pursued its pledge to realign its spending away from multinationals. The shift will see almost 14 per cent of Whitehall’s £44 billion budget secured by SMEs this year, up from 6.5 per cent in 2010.
The noble Lord, Lord Northbrook, asked whether proportionate liability or a statutory cap on auditor liability could serve to encourage more audit firms to bid for large company audits. The Government have no plans to do that. The Companies Act 2006 already allows for contractual limitation of liability, and some auditors’ liability agreements have been signed. The committee supported the exemption of more SMEs from audit. My department’s consultation closed in December, and we will be setting out our response to the findings in the spring. In Europe, we are making the case for raising the exemption thresholds. The committee expressed concern about fragmentation between regulators of audit, accounting and corporate reporting. In October, BIS and the FRC consulted on changes to streamline the internal structure of the FRC and improve its regulatory efficiency and effectiveness. My colleague Norman Lamb intends to make a Statement on this in the other place shortly. On non-audit services, my department has now amended regulations on disclosure of auditor remuneration to bring them into line with the revised ethical standards.
The noble Lord, Lord Shipley, talked of the conflict of interest if one company provides audit and other services and my noble friend Lord Hodgson said that he did not see a problem with it—I thought I would put both those pieces in. In answer to the noble Lord, Lord Shipley, as the committee heard during its inquiry, the standards were revised following the financial crisis. The disclosure framework is now in line with the categorisation of non-audit services in the standards. It also reflects the concerns the committee raised about internal audit services and tax advisory services, in particular, where the regulations ensure separate disclosure will be made. Shareholders can then question the audit committee on the discussions it had with the auditor on those services and the safeguards to the auditor’s independence.
On accounting standards for SMEs, the FRC is continuing to consult on how UK GAAP should be developed, including how it should apply to medium-sized companies. I recognise that I have not covered all of the committee’s recommendations. There were a number of others which the committee suggested should be taken forward as part of the Competition Commission’s investigation and there are others that the commission has voluntarily included within the scope of its investigation.
My noble friend Lord MacGregor spoke about living wills. The FRC has begun work with the six largest audit firms to develop a framework. It will be a sort of “how to” guide by a firm for regulators who might have to dismantle or separate various parts in an orderly fashion.
I would like to answer one of the questions from the noble Lord, Lord Young, because questions from the speaker for the Opposition always come at the very end and rarely get answers. The noble Lord asked about conversations between auditors, banks and regulators. That has been well received in the UK and by banking regulators overseas, which are looking at—or already are—implementing similar approaches in their jurisdiction. I will write answers to the rest of the questions that he asked.
The committee made some proposals that are now reflected in the European Commission’s proposals and which we welcome. These include removing the audit firm ownership rules from the directive, making big four-only clauses ineffective and making audit reports more informative.
As far as the Government are concerned, this has been a very useful debate and I am sure everyone else in this Room has enjoyed every single moment of the two and a half or three hours that we have been doing this. It has been a useful debate on an important subject and I thank noble Lords very much.
Lord Young of Norwood Green
Before the noble Baroness sits down, there was just one area I wanted her to elaborate on. Paragraph 184 is very emphatic. It says:
“We believe that every bank should have a properly constituted and effective Risk Committee of the Board”.
I do not want to go on to quote the rest of the paragraph but that is very firm. Despite the banking crisis and the concern expressed—almost unanimously, or at least by almost every contributor—the Government’s response was that it is “desirable” for banks and other institutions but not absolutely mandatory. It then goes on to say:
“There is a strong presumption that banks and insurers that are included in the FTSE 100 are examples of types of firm that should have separate risk committees”.
In the light of what has happened and the strength of that recommendation, I would like to understand exactly why the Government felt they should not go further than they have done in their response.
Lord MacGregor of Pulham Market
My Lords, I thank my noble friend Lady Wilcox for that very helpful and comprehensive reply. We have had a high-quality debate, rich in contributions, and I am particularly grateful to the noble Baroness, Lady Hogg, for her kind words about our committee’s report. I cannot begin to sum up the debate properly as it would take much longer than this reply is conventionally allowed. However, I will quickly make five points.
First, it is unfortunate that such a high-quality debate has taken place in the Moses Room because of the pressure of legislation in the main Chamber. However, I hope that this report will be widely read and followed up. Secondly, we are probably going to face a House of Lords reform Bill, but if anyone had followed this debate they would have seen the high quality of debates that take place in this House and would not always necessarily occur in the other place. I say that fully aware that at least half of the colleagues who have taken part in this debate have, for a long time, been in the other place. I am not criticising the other place, but the contribution from those who would probably not have stood for election to Parliament has been very valuable in this debate and it shows the quality of the House of Lords on topics such as this.
Thirdly, I say to my noble friend Lord Stewartby, who was sceptical about whether we had found answers on the first part of our report, where the main thrust is about the oligopoly of our auditors, that we never expected to have a magic wand and find a magic solution. As I said at the beginning, finding solutions is not so easy. I hope that a number of issues that we have put forward and that have been pursued further will help to deal with a number of aspects of this. However, of course, the problem we face of finding a way of extending the major auditing firms beyond the big four is a very difficult one.
Fourthly, as I said at the beginning, some thought that this study would be rather dry and esoteric. I think that is largely because of the title we gave it, which probably put a lot of people off. However, it has been clear from this debate that the issues we have raised go to the heart of many aspects of our financial, economic and business life; not to mention, as my noble friend Lord Lawson pointed out, behavioural and cultural attitudes. It is a much more widely based debate than one just dealing with audit matters.
That leads me to my final point. The noble Lord, Lord Currie, very kindly said that this debate was merely a staging post, and I entirely agree with him. Clearly, this issue will be debated further and I hope that at some stage our committee will be able to come back to it again. This will not be immediate, because we have just agreed that our next topic will be the economic implications for the United Kingdom of Scottish independence, so that will obviously take up much of the next year. However, I hope that we can come back to address these issues in one way or another because there is clearly still so much to be followed through.
I thank all those who have contributed and particularly all my colleagues on the committee for all that they have done and all the hard work that they have put into it. I think it has been well worth it.