Auditors: EAC Report

Lord Colwyn Excerpts

Wednesday 14th March 2012 Grand Committee

[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.

--- Later in debate ---

[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.