Financial Services (Banking Reform) Bill

Lord Flight Excerpts

Wednesday 23rd October 2013 Lords Chamber

[Lord McFall of Alcluith (Lab)]

My Lords, I support the noble Lord’s amendment enthusiastically because the auditors were the weak link in the financial crisis. In terms of profits, the banks booked expected profits and then found out they were not there. So the question is: where were the auditors in that situation?

I was chair in 2007 when the Treasury Committee looked at Northern Rock. There were no meetings between the regulators and the auditors. The auditors of Northern Rock received more income from consultancy for Northern Rock than they did from audits. If I remember correctly, the auditors wrote 10 letters on behalf of Northern Rock, from which they gained £800,000. That is £80,000 a letter: not bad for a day’s work. Again, if I remember correctly, there were about seven meetings between the regulators and Northern Rock. At the time the mentality in the Financial Services Authority was the bigger the bank, the bigger the risk; the smaller the bank, the smaller the risk. Of these seven meetings, four were conducted by phone. Three were face-to-face, with no minutes taken. If you were the secretary of your local community council or your golf club and came up with such practice, you probably would not be the secretary at the end of the year. The regulator, however, kept on swanning along. That practice was a terrible practice—the voice of the auditor was missing.

The Treasury Committee report was clear. We said that within the limits of what they are required to do, perhaps the auditors did an adequate job. However, if they did an adequate job in terms of what they were required to do, the question remains: what is the point of an audit? That question continues to haunt the audit profession and it has not started to answer it.

The Government say there is talk about a code of practice, but in 2011 in a letter to the Economic Affairs Committee, Andrew Bailey of the Bank of England was very clear that,

“the working relationship between external auditor and the prudential supervisors had broken down in the period prior to the financial crises”.

So the code of practice does not work. The aim of this amendment is to ensure that there is a statutory basis so that no one can come along in future and say “That aspect was overlooked”. There has to be a serious duty on individuals to look at that.

From an accounting and disclosure perspective, RBS, Halifax and Northern Rock went down because of factors such as huge wholesale funding and property exposures. It was clear from the accounts two to three years previously exactly what the risks were, but nobody took heed. That is why the voice of the auditors has to be that much stronger. At the time, RBS shareholders approved the ABN AMRO deal by 95% to 5%, but that was just months before it collapsed.

When he was on the Economic Affairs Committee the noble Lord, Lord Lawson, asked John Connolly of Deloitte a pertinent question about auditing. The answer was that perhaps Deloitte would have had a different interpretation of “going concern” if it had realised that the Government were not standing behind the banks at the time. How flexible and flimsy is this focus on auditing from the auditors themselves?

There is a long way to go on audit, not just with regard to a statutory basis. There has to be a look at what auditing uncovers and what information it gives. I suggest that the Government look at three key features of an early warning system, having said that the auditors knew what the risks were before. First, there has to be a duty on auditors to raise these issues early with the supervisor. They knew what lay ahead if the reckless approach continued. Secondly, and very importantly, the auditors need to become more professional and sift large numbers of high-impact, low-probability events so that the regulator can understand what the risks are. Remember that the regulator was operating on the basis of business models—the profit and loss accounts of companies—which had nothing to do with the regulator, so they never looked at that. That is why we ended up with such huge scandals as PPI, interest rate swaps and whatever else. Business models are crucial to the regulator, as they should be to the auditors, so it is crucial to sift that large number of high-impact, low-probability events.

Given the point I made earlier about nobody taking heed, there needs to be an increase in credibility to ensure that all stakeholders pay attention to what auditors are saying. In terms of auditors and auditing and the link between auditors and the regulator, there has to be a less compliance-driven and more comprehensive approach. There has to be an enhanced role for the auditor as an independent expert to check and challenge all the trivial and complex issues that banks present. There has to be clear and unequivocal communication from the auditor to the company, and it is important that the regulator is aware of that information. From the auditors there has to be an insight into the company’s risk management system. More than anything, there has to be a universally consistent interpretation and application of standards. Given that we have to increase the confidence of the stakeholders by auditors, financial reporting needs to ensure that investors understand what is happening in a company.

The Government’s response to the commission’s report is totally inadequate. They said that they are,

“not convinced of the need to define the frequency of this dialogue in statute”.

The Bank of England has also said:

“The PRA has published a code of practice on the relationship between an external auditor and the supervisor”.

That code of practice, by the way, was ignored and jettisoned in the past. The FSA, given its culpability in Northern Rock, Halifax and the Royal Bank of Scotland, has the cheek to say that it supports an open dialogue with external auditors.

Andrew Bailey’s letter states quite clearly that the code of practice does not work. The empirical evidence states quite clearly that the auditors and regulators did not do their job in the past. If all we have is an exhortation to the financial community, auditors and regulators, to do things better, we will be back here in a few years. I therefore ask the Minister and the Government to look at this issue very seriously, and if they cannot give us a full answer today, to ensure that when we come back on Report and have had adequate time to look and present our amendments on that, at least we can have a positive way forward.

[Lord Flight (Con)]

My Lords, I strongly support these two amendments and the points made by the noble Lords, Lord Lawson and Lord McFall. I will add only the point that IFRS renders accounts virtually impenetrable, and fund managers have to convert them into a more understandable form of accounting to understand what on earth is going on within the organisation. I have been critical of IFRS for more than 10 years. The point was made to me initially that this was not a matter for Parliament but for the profession. It is of crucial importance to Parliament, because if it leads to things such as the banking mess, the nation at large is responsible. Secondly, as the noble Lord, Lord Lawson, pointed out, not only did it exaggerate profits in good times and create fictitious profits on the back of which excessive bonuses were paid, but it also exaggerates the other way in bad times, and therefore arguably can lead to an underappreciation of a bank’s strength. I had thought that France and Germany had some sympathy with this view and, notwithstanding other criticisms, I had been hopeful that the EU was looking to address this issue. I am disappointed that, to date, nothing seems to have happened.

I also make the point that, going back 20 years, Switzerland actually put a legal obligation on the auditors to do the compliance regulatory checking. The auditors were then liable if they had not done their job properly. I think it is a pity that Switzerland changed from that practice because I thought that it worked extremely well. I am not necessarily recommending it for this country but it was a novel idea, and the auditors ought to know what is going on within a bank if they have done their duty in auditing that bank properly. Switzerland has since changed its approach. Indeed, it was after it did so that Switzerland, too, encountered problems.

When the crisis broke in 2007-08, I asked myself: where were the auditors? Since then, candidly, there has been justified criticism of the regulators, but the issue of what the auditors were doing and why, and why bank accounts were so unsatisfactory, has not been adequately examined. I believe that the Treasury Select Committee has looked at this, but I am not sure whether it has done so in any detail. It is still quite an important issue and I believe that this Government should exercise pressure to effect reform of IFRS. In addition to the havoc it caused in the banking industry, it has also been significantly responsible for massive damage to our pension systems by overestimating the liabilities, especially when bond interest rates are artificially low. That has led to massive closure of justifiable defined benefit schemes. It really is a problem and it needs addressing.

[Lord Barnett (Lab)]

My Lords, I strongly support the amendment moved by the noble Lord, Lord Lawson. I declare what I suppose is a former interest, as many years ago I was a senior partner in an accountancy firm of modest size—I say “modest size” by comparison with the three or four firms that audit banks or, indeed, any of the FTSE 100 companies. That firm became bigger since I retired, because it merged with a fairly large international group, but at the moment it is not one of the likely auditors of any bank, whether small or large.

The noble Lord who just spoke asked where the auditors were. That question arose constantly, and understandably. If a bank gets into that kind of trouble, what were the auditors doing over the years? Never mind dialogue with the regulators; what about a dialogue with themselves or with the banks? Something serious will have to be done by the Government or by the profession about there being only three or four firms which audit all banks or, as I said, any FTSE 100 company. It is a serious matter and will obviously have to be addressed. It has been broadly spoken about for years, but nothing has ever been done about it.

Amendments 92 and 104D relate to some extent to leverage, which is what Amendment 93 concerns, and to whether banks have adequate capital to do the job of being a normal bank. This clearly is a serious issue, which nobody has properly addressed. How do we get to the situation where other major banks can be called on to have some kind of competition for who does that auditing job? When a firm knows that it will have that job permanently, the likelihood is that it does not do the job as well as it could or should. That has been happening all the time.

I hope that the Government will listen very carefully to what the noble Lord, Lord Lawson, my noble friend Lord McFall and others said, and what previous Select Committees said. This is an all-party issue, as the noble Lord, Lord Deighton, knows. I hope that he will be able to tell us that the Government will seriously consider what has been said today. If they cannot accept the amendment because the drafting is not quite as it should be—which I would understand—I hope that they broadly agree with it and will come back on Report with an amendment that does the job. We cannot just leave this; something will need to be done. I hope that the Government will listen very carefully today.

--- Later in debate ---

[Lord Flight]

My Lords, as the noble Lord, Lord Eatwell, pointed out, this is crucially important territory. However, I am not certain that the amendment gives the right answer.

I recollect that when I was studying economics at Cambridge 40-something years ago, a capital base of 8% and a gearing ratio of 12.5% was viewed as the prudent formula for a bank. Things have changed a great deal since then. Who was it that allowed banking ratios to get to such ludicrously low levels in this country? It was the regulator. Although we have a change of regulator organisation, there are still, to some extent, the same people and I am not sure that I necessarily trust the regulator in its new name as being sound in overseeing such things.

Look what has happened, I repeat, in the past 10 or 15 years. I think it was the noble Lord, Lord Lawson, who made the point that risk-weighted asset formulae are somewhat discredited. Again I agree and, having had some recent experience of it, I have little confidence going forward.

I also note in terms of ratios permitted that the regulator for some extraordinary reason—at least until the recent present—had ridiculous differences between the capital ratios required for large, too-big-to-fail banks and smaller and new banks. The ratio for mortgage lending was something like 20 times as much for a small bank as for a large bank. So, again, how come the regulator allowed crackpot different capital ratio requirements to creep in in a way that was thoroughly anti-competitive?

I am not sure that the Treasury may not be the safer party to ultimately have the power to determine capital ratios. As has been pointed out, the amendment states:

“The direction above may specify the leverage ratio to be used”.

The direction is given by the Treasury and so the amendment ultimately gives the last-call power to the Treasury and not to the PRA.

So where are we? I do not think the issue is resolved. It certainly needs addressing.

[Viscount Trenchard (Con)]

My Lords, I agree with much of what my noble friend Lord Flight has said. I also agree with a great deal or all of what my noble friends Lord Blackwell and Lady Noakes have said. I was also impressed by the way in which the noble Lord, Lord Turnbull, stated that he believed that the straightforward, unweighted leverage ratios should operate in tandem with a risk-weighted ratio.

I noticed that noble Lords opposite smiled when my noble friend Lord Blackwell pointed out that if the absolute ratio bites first and becomes effectively a frontstop rather than a backstop, it will lead banks to concentrate more heavily on risky assets, on lending on assets which they think will give them higher returns. I am convinced that that is correct. It is therefore important that the absolute ratio should be a backstop rather than a frontstop.

I am confused by the difference in responsibility between the FPC and the PRA. The amendment suggests that the Treasury should enable the FPC of the Bank of England to determine what the leverage ratio should be. However, as noble Lords have pointed out, the FSA had already become more involved in interfering with and providing advice, exercising influence over banks’ lending policies and questioning their formula and the basis on which they applied certain leverage to certain categories of asset class.

I am not sure where the writ of the FPC stops and where that of the PRA starts. I know that they are both part of the Bank of England and this is confusing. I would welcome clarification from the Minister.