Financial Services (Banking Reform) Bill

Lord McFall of Alcluith 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.

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[Baroness Noakes (Con)]

My Lords, I agree with much of what my noble friend Lord Blackwell said—in fact, I probably agree with all that my noble friend Lord Blackwell said—but I would like to pick up something that my noble friend Lord Lawson said when he intervened on my noble friend Lord Blackwell, that the issue was who was to decide on the leverage ratio.

The amendment before us says that the direction, which is the Treasury’s direction,

“may specify the leverage ratio to be used”.

The key issue with this amendment is not who potentially decides on the amount of the leverage ratio but the timing of the leverage ratio. People have been clear, and it is going to be a requirement of CRD IV, that there will be a leverage ratio, and the current international timing is to be 1 January 2018. As I understood it, that timing was going to drive the Government’s decision on what leverage ratio to introduce, given that they have the power to include it within the macroprudential toolkit under the legislation that has already been passed. We should not rush into a leverage ratio because there is still much work to be done on understanding how these leverage ratios, which have not been used much recently, actually work in practice.

My noble friend Lord Lawson also pooh-poohed the idea that the difference in practice between the US and the UK was significant. Some analysis done by the British Bankers’ Association has identified that on any given balance sheet the difference can be 3% under CRD IV and 5.3% under the current US rules. So we potentially have quite a significant difference, and the BBA talks about different leverage ratios as well. We also need to understand the impact of any given level of leverage ratio once the definitions are sorted out.

Mark Carney, who is chairman of the Financial Stability Board as well as Governor of our own Bank of England, has been clear that this is to be a backstop measure and that it is important to calibrate it so that the risk-weighted asset calculation of capital bites before the backstop method. Unless we are very clear when we introduce the leverage ratio about what the impacts will be, we potentially lay ourselves open to the unintended consequences of positively driving the capital requirements of the banks or, more likely, their lending capacity.

It is important that we let the current timetable for the development of the leverage ratio proceed and let the calculations be done properly. Banks are already disclosing leverage ratios to the regulators and will be disclosing considerably more information as time goes on, so there can be much more of a public debate about the impact of different leverage ratios on banks and other financial institutions.

[Lord McFall of Alcluith]

I support the amendment moved by the noble Lord, Lawson, which stands in my name as well. As the noble Lord said, the amendment is, quite simply, about who is doing it. Whatever they do at some future stage, we will let them get on with it, because it is about authority. There are two issues here: learning the lesson, and the authority.

On learning the lesson, I noted the comments of Adair Turner, former chairman of the FSA, when he said:

“We allowed the banking system to run with much too high levels of leverage, inadequate levels of capital, and we ignored the development of leverage in the financial system … That was a huge mistake”.

I had never gone back to basics and asked, “Why do we allow banks to run with 30, 40, 50 times leverage?” Neither had anyone else, funnily enough; so it is about time that somebody asks that question and keeps it in their mind on a daily basis. My point is that politicians—Chancellors, Prime Ministers or whoever—will not keep that in their mind on a daily basis. We learnt that from the financial crisis before. If we set up a new organisation we should give it the authority. I noted the comments made by Lawrence Tomlinson, who was brought in to BIS recently as an “entrepreneur in residence”. He questioned why the British Bankers’ Association needed,

“60 people working full-time lobbying”,

when the Government owned majority stakes in two of the banks, Lloyds and the Royal Bank of Scotland. As he said:

“We already own the banks. Why are Lloyds and RBS paying the BBA to lobby us? They can just get lost! … It’s amazing we let RBS spend tens of millions advertising its services with 80% of our money”.

I mention that because the banking sector is the best sector in the country for lobbying. The banking sector, unlike any others, gets direct access to No. 10 and No. 11 Downing Street. That happened with the previous Government and it is happening with this one. If you do not allow the proper authority—the FPC—to have this leverage ratio, you are weakening its authority in an instant. I suggest that the institutional memory of a Chancellor or a Prime Minister is much less than the institutional memory of the Financial Policy Committee.

In terms of the leverage requirements, we have had the Vickers commission, the Parliamentary Commission on Banking Standards, and the interim Financial Policy Committee asking for that leverage to be handed over. The Government have refused. If the Government do not want to be accused of playing politics, it is important that that is put to the Financial Policy Committee.

Let us look at leverage even today. I looked at Barclays, which has been,

“the poster child for excess leverage. Its balance sheet is roughly the size of the UK’s GDP. It funds 1.5 trillion pounds of risk-taking with 97.5 per cent debt and 2.5 per cent loss-absorbing equity … The average hedge fund trades with less than 3 times leverage … Barclays has chosen to operate with 45 times leverage … So Barclays deploys gearing 15 times that of most hedge funds. If the bank’s assets eroded in value by a mere 1.5 per cent, it would be 100 times leveraged. How confidence inspiring is that?”.

If we do not allow the FPC to look at these issues on a daily basis, when No. 10 and No. 11 Downing Street will not be looking at them, we will find ourselves in trouble in the future. As mentioned by the noble Baroness, Lady Noakes, Dr Carney said that it is,

“essential to have a leverage ratio as a backstop to a risk-based capital regime”.

We are saying that, if we have appointed Dr Carney with all the thrills and frills of a Chancellor’s appointment, we should give him that authority so that he can get on with the job straightaway and we can keep it away from the hands of the politicians.

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[Lord Phillips of Sudbury]

My Lords, I commend the mover of the amendment, the noble Lord, Lord Turnbull. If, as I assume, this matter is brought back at Report, I should like to raise two questions. The first concerns the fact that the code is to be solely the responsibility of the FCA and the PRA. I wonder whether it should have a broader base than that. The City is a real bubble. The two authorities are part of that bubble, as are most of the people working in them. Everybody—particularly the noble Lord, Lord Turnbull, in moving the amendment—has said that we have to break out of this small enclave to understand the wider national, social and cultural impact of what is going on in the square mile. I just throw that idea out.

My second question concerns proposed new subsection (3)(a) in the amendment, which requires that those subject to the code shall,

“receive a proportion of their remuneration in the form of variable remuneration”,

although it does allow specific exceptions. For the life of me, I do not see why that is being insisted upon. Twenty-five years ago, most of the senior bank executives and those on the boards of banks did not receive a variable element in their remuneration at all. The problem that the amendment seeks to address was not present then, or at least not remotely to the degree that it now is. Therefore, again, if this matter is to be brought back at Report, I should be grateful if more thought could be given to the need for subsection (3)(a).

[Lord McFall of Alcluith]

My Lords, I support the amendment. The most important and admired banker of the 20th century—the late Sir Brian Pitman, the former chairman and CEO of Lloyds—came to the Future of Banking Commission, which I established, and on which David Davis MP, Vince Cable, Roger Bootle and others served. He gave us a lesson that day: he said very clearly that he understood that banks should be run for the long-term benefit of shareholders, and that that was what customers wanted most.

Sir Brian’s synopsis of what mattered to him as a banker was very clear, when he said in evidence to us:

“Nobody is a greater believer in shareholder value than me ... It’s long term shareholder value and everything has to be structured around the long term, particularly the remuneration structure … The minute you move to a huge emphasis on short term big bonuses you're going to change the behaviour. It is perfectly possible, in our case for 17 years when I was there”—

at Lloyds, that is—

“we were doubling the value of the company every three years for 17 years. Nearly everybody had shares in the company; messengers were worth a quarter of a million pounds when I left because we’d been successful as an organisation. But we believed it all had to start with the customer”.

He was very clear that if you had the customer in mind in terms of remuneration, you had to measure it on a 10-year basis. Only that way do you find out about the business cycle, and about whether the money paid in bonuses is money that has really been earned at all. As was said earlier, that money was not really earned in the past, because remuneration was based on expected profits, which did not materialise.

For the senior executives in banks it was upwards all the way: whether the bank went down or up, they had their bonuses. Sir Brian distinguished banks from other organisations as follows: “Banks and insurance companies have the unique ability to engineer increases in profits by pulling a lever that forces their banks to take more risks to lend and invest more relative to their capital resources, unlike other institutions”. That is why, in our report, we wanted a statutory basis, and we wanted the regulator to look at this issue.

When the noble Lord, Lord Lawson, and I were on the Parliamentary Commission on Banking Standards we considered the same issue on our sub-committee. We examined Barclays and its culture, and looked in particular at the structured capital management division —which, incidentally, the noble Lord, Lord Lawson, referred to as tax avoidance on an industrial scale.

We wanted to find out about the business model for that, and we spoke to insiders. When Sir David Walker and Antony Jenkins came to the committee, we had prepared questions, and my question for Sir David was along these lines:

“I would like copies of all management reporting and management performance information provided to Roger Jenkins”—

who established BarCap, along with Bob Diamond—

“and Iain Abrahams to support the bonus pool”—

in other words, to provide the numbers for us. I continued:

“The second one is the information used for the purposes of calculating the bonus pool of the structured capital management division, and the information used for determining the bonuses in particular for”,

three senior executives for the past decade.

The reason why we asked for that information is that the noble Lord, Lord Lawson, said in the evidence session that Roger Jenkins, who established the division, had had more than £40 million in one year. Bob Diamond had £100 million over a 10-year period. We wanted to find out exactly how they had earned that. The insiders told us that in 2008 BarCap was responsible for 110% of the profits of the whole entity. Here we had a tax avoidance unit on a massive scale masquerading as a bank, and responsible for 110% of the profits—and we did not have a clue how they made their money. I said that we wanted the information,

“in sufficient detail in order to identify each of the subcategories of the structured capital management business. In that respect, it will be the year-end management accounts information and quarterly reports information”,

which we received. We went on to ask for more—and we received absolutely zilch information. So, as we take this banking reform Bill through the House, we still do not know exactly what BarCap was up to.

What I—and the noble Lord, Lord Lawson, and others—want to know is that the regulator has the authority, so that it can see exactly how a business is performing and getting its money, and what business model and culture it has, so that the remuneration structure does indeed have a long-term basis and serves the long-term interests of society and of customers. That is not happening to date. That is why the amendment is before the House.