Auditors: EAC Report

Lord Stewartby Excerpts

Wednesday 14th March 2012 Grand Committee

[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.