Examination of Witnesses (Questions 380-399)|
DAVIES, KCB, AND
TUESDAY 2 JULY 2002
380. Sir Howard, welcome this morning. Apologies
for our session running over, but we were receiving very good
information. Could you introduce yourself and your colleague?
(Sir Howard Davies) Howard Davies. Chairman of the
Financial Services Authority. On my right is Michael Foot, one
of my Managing Directors whom you have met before. He has responsibility
for the Markets and Exchanges Division and the listing authority
part of the FSA among other things and is also our representative
on the Financial Reporting Council.
381. One consequence of the Enron collapse has
been that the Big Four accounting firms have now become the Big
Three. Are you concerned about the impact of this on choice amongst
the largest accounting firms? Will it restrict the FSA when it
is seeking to place work? What would be the impact of a further
(Sir Howard Davies) I hope it has not gone down to
three. If there is some news which I have missed, perhaps somebody
would let me know. It is most unfortunate that there has been
this further consolidation in the industry. We went on record
in fact at the time of the last range of mergers taking things
down to five, saying we thought this was unfortunate and it did
restrict choice for firms. It also has an adverse effect on us
in that there are circumstances in which it is quite difficult
for us to find a firm which can act independently. If you have
a disputed takeover or a circumstance in which an auditor has
to leave a company and you need an independent review, sometimes
our choices are highly restricted. Indeed there have been one
or two circumstances in which we have not been able to find an
independent firm to act for us. We are very concerned about the
impact of further consolidation in the accounting industry. I
find it difficult to think that the current position is in fact
stable because whereas you might just about argue four was a possible
number, although in some sectors there are effectively not four
competitors because in some sectors, for example the insurance
sector, there are not really four competitors. It is now a position
where it is impossible for any one of these four to fail because
anybody would agree you could not go down to three or two. This
is a very unfortunate consequence and side effect of the Enron
case and something which the competition authorities need to think
about. As international security regulators in IOSCO, of which
we are the United Kingdom member, we are concerned about this
and have been considering whether there are any steps we can take.
We have said that we should like to encourage some of the second
tier firms to develop, but it is not something which is directly
within our gift as regulators unfortunately.
382. Is the FSA planning any measures, for instance
through the placing of work, to seek to encourage other accountancy
firms to develop the capability to compete more effectively with
the Big Four?
(Sir Howard Davies) We shall certainly take that into
account. The impact of our own purchasing behaviour is likely
to be extremely modest because we are buying services in a fairly
restricted part of the market. We are not buying audit services,
we are buying primarily regulatory analysis or actuarial services.
I fear that the impact of our own purchasing behaviour would really
be very modest. The likely impact on us is more that we will have
to do more work in house than we would otherwise have done because
we cannot always find people with the right degree of independence.
I suspect we may end up doing more accounting reviews or more
actuarial reviews with our own in-house people if we cannot find
people who are prepared to act with the right degree of independence.
383. Just following up your hint that the competition
authority ought to address this issue of the Big Four, are you
suggesting that they ought to break the stranglehold of the Big
Four on the FTSE 100 or are you suggesting that there is a case
for the competition authority to break up the Big Four themselves?
(Sir Howard Davies) I think that a competition analysis
of the overall state of the market would be useful. The question
is: who has the jurisdiction to do it? I would not say I was expert
on that but the candidates are the Department of Justice in the
US and the European Commission, I would say, because this is an
international issue, not purely a domestic one.
Mr Mudie: Is it not worth pursuing? Is the FSA
thinking of writing to the competition authorities to ask them
to have a look at this? Are you thinking of writing to the Chancellor
suggesting that he asked the competition authorities? We have
had experience. There must be something magic about the number
four. We have the Big Four banks operating like four Mafia families
and we do not have much luck with them. It seems to be the same
in accountancy. Have you attempted to trigger anything?
Chairman: That view is not shared by
the whole Committee.
384. I think that is a complimentary reference
(Sir Howard Davies) And why is there only one Treasury
Select Committee? We have not made a formal approach. I am not
entirely sure of our locus in this. The question the Chairman
perfectly reasonably asked me was whether this was inconvenient
for us and I have answered that it is.
385. You referred to the competition authority.
You are in a very important position and you could decide to refer
(Sir Howard Davies) On the last occasion there was
a merger we were asked by the competition authorities for our
view and we gave our view that this was undesirable.
386. A number of witnesses have mentioned this
theme to us throughout this inquiry. What percentage of your out-servicing
goes to the Big Four?
(Sir Howard Davies) Most.
387. Over 90 per cent?
(Sir Howard Davies) Yes, I would say it broadly was.
There are two sorts of use we make of the accounting firms. The
first is usage made under what we called our skilled persons report.
That is part of the normal process of regulation. We would not
ask for a skilled persons report on every firm every year by any
means, but in the case of larger banks or larger insurance companies
we would quite frequently say, this year, as part of our regulatory
review, we want a review by your auditors of your risk management
systems for example, or your claims reconciliation procedures,
or whatever. The people we would typically use for that would
be the auditors of the firm. In a sense that would not be our
purchasing decision because we would use their reporting accountants.
The report would then come to us and to the firm so that we would
see it in its unvarnished state. For that, the profile of our
purchaser, our outsourcing, is determined by who the auditors
of those firms actually are. That is not our decision. There is
another set of work which we would do, which would mainly be on
developing regulatory policy where we would outsource. That is
not a huge amount of money and it would typically go to the major
accounting firms. It might also go to companies like economic
consultancies from time to time.
388. Could you provide us with a note about
(Sir Howard Davies) We certainly could, but I do think
it would be 80 per cent. 
389. Is it appropriate in your view that accountancy
firms themselves should be significant funders of the accountancy
boards in this country?
(Sir Howard Davies) I am in a slightly difficult position
to answer that because of course all my funding comes entirely
from the industry I regulate and I do not regard that as compromising
the FSA's independence. I do not think that the source of the
funding is necessarily the problem. I think there is a question
about whether that funding is discretionary. If you have to go
along every year and say you would like a few more pounds for
this and a few more pounds for that, that is not a satisfactory
position. It is perfectly all right for a regulator to be funded
by the industry it regulates as long as the funding basis is clear,
straightforward, repeatable, etcetera. I favour things like broad
industry levies, where you account on an annual basis for your
economy and efficiency, but you do not have to justify individual
bits of work and you are not vulnerable to people withdrawing
funding because they do not happen to like what you did last year.
It is not the fact of being funded by the industry. It may be
the structure of that funding which perhaps needs looking at.
390. That is right. Is it not clear from the
evidence we are hearing that the structure inside accountancy
is much cosier than the structure which funds the FSA? There is
a big difference between the two set-ups, is there not?
(Sir Howard Davies) There is and the accounting set-up
has more of a self-regulatory feel to it and was clearly a halfway
house between statutory and self-regulation.
391. Do you think it should move closer to the
way your agency is funded in structural terms?
(Sir Howard Davies) It is interesting to look at what
is happening internationally and particularly in the United States.
As it stands, our system is more independent and more objective
than the United States system, indeed the Americans have looked
favourably on our arrangements and the SEC have frequently said
that they want to move to something more like that. As a result
of Enron and Global Crossing and WorldCom etcetera, it is now
clear that the likely outcome in the US is going to be something
which goes around our system on the rightor left, depending
on which way you look at itin that they will end up with
something which is actually more rigorous and more independent
and less connected with the industry than our system is. It is
hard to say precisely what that is because there are currently
a couple of competing congressional proposals and an SEC proposal.
All three of them actually go beyond what we have in terms of
having the Public Oversight Board appointed by the SEC rather
than with the profession involved in it. The question we have
to ask ourselves here and which is being asked by the Government's
review, is whether our system will internationally look robust
enough if the Americans have gone for something else. This is
a different question from saying that there is anything wrong
with our system at the present time or that our system is not
392. You are not suggesting that there is anything
wrong with the funding system here.
(Sir Howard Davies) It is difficult to say that there
is because it has not really been in place for long enough. The
system has really only been in place for the last year or so and
the Government had put in place a five-year review. If you look
forward to a world in which there are international accounting
standards in 2005 and where there will therefore be a lot more
international pressure on individual countries to demonstrate
that they have a system of enforcing those international standards,
in order to guarantee mutual recognition and equivalence, the
US will be saying, "Can we be satisfied that there is an
adequate enforcement regime which matches the robustness of ours,
that UK companies are preparing their accounts under international
accounting standards and therefore we can allow them without further
qualification to list in New York?". That is really going
to be the crunch issue. Indeed it will be for us too. We shall
want to look at other countries whose standards may be slightly
doubtful and decide whether we are prepared to accept these or
whether we would want to review their accounts as well. If you
look at it in that context, there may well be a need to make our
system more rigorous by 2005, which might point to putting the
funding on a more automatic basis, an industry levy basis and
there is also the question of proactivity versus reactivity in
reviewing accounts. At the moment, our system does not do that
on a sampling active basis in the way that the US system and the
French and Italians and Canadians and Australians do. It may be
that in order to satisfy the rest of the world that we are achieving
standards which can be recognised internationally, we may need
to do some more of that.
393. In your memorandum to us, you say that
". . . possible initiatives in the UK will need to be considered
in the light of likely changes being made in the US". Should
we really wait to be directed by the biggest sinner? Should we
not be more proactive?
(Sir Howard Davies) It is entirely right, and the
Government are doing this, to look at our own system and decide
what is good about it and what we want to do. However, the real
reason I made that point was the explanation I have just given
you that in reality when you get international accounting standards
it will be necessary for you to demonstrate that your standards
are as rigorous as those in the markets in which your own companies
wish to list. Therefore one of the blunt realities of this is
that you need to satisfy the American authorities that you have
a set of procedures which are equivalent to theirs. That is why
I make that point.
394. What if those markets are not rigorous
(Sir Howard Davies) The present position is that in
the US they have not been, but as a result of Enron and Global
Crossing and WorldCom, etcetera, etcetera, they are going to leap
over us into a system which exhibits more obvious independence
and rigour and proactivity than the system we have currently got.
Then you may say that it is jolly unfair that the Americans, having
done that, then insist that everybody else does it; but there
is a lot of unfairness in the world.
395. In the submission of the FSA to the Committee
you said that it is apparent that not all major banks fully understood
the total size of their exposure to Enron. Can you elaborate a
little on that? What was the nature of the problem?
(Mr Foot) The problems arose really for the most part
in the biggest and most complex groups where typically they would
have had exposures in a number of different areas. The question
then was the speed with which they could bring back to their central
group risk management an accurate figure of the total exposure,
of all the different forms of exposure they could have had. I
have to say that as it happens British based banks were not that
significantly exposed. That was a comment made in respect of some
quite well-known publicly discussed problems in the United States
rather than here. The issue in something like this where you have
a market risk, you have a credit risk, you may have a wide range
of instruments being held and sold around the group, is always
the speed with which the group's central risk management can take
those numbers and be reasonably confident that it has an accurate
total for the whole group's exposure.
396. So we were just lucky, it was not that
the British banks were wiser, they just happened not to be heavily
(Mr Foot) We have put a lot of effort in recent years,
and so have the major banks and securities houses in the UK into
improving their risk management positions. One should never be
complacent and the larger and more complex the borrower who fails
or the company who fails, the more the pressure is on the systems.
(Sir Howard Davies) In response to the point you make,
particularly about British banks, it would be fair to say that
a number of British banks have saidand I think rightlythat
they did not have any exposure to Enron because they did not understand
the company and they did not understand the balance sheet. I think
they should be given credit for that.
397. The FSA had some success in handling problems
presented by the hydra-like Enron legal entities without loss
to counter parties. Can we say this is actually a success for
the UK regulatory system?
(Sir Howard Davies) Regulatory success is always something
you are extremely nervous about claiming. The fact was that the
three major financial entities which were subsidiaries of Enron
and operated in our market, which were regulated by us, were regulated
effectively and they either closed down with little market disruption
or in one case were sold on, also with little market disruption.
In that sense we felt we understood those parts of the group,
we had insulated them adequately and they were able either to
disappear or be sold on. We would regard that as a satisfactory
piece of cleaning up.
398. One sometimes hears that we have to struggle
with too much red tape. Could this be an example of where red
tape can sometimes be useful?
(Sir Howard Davies) In one respect it would offer
a lesson because there are certain elements of derivatives activity
which we regard as requiring regulation in this country and as
therefore coming in under our regulatory regime, which would not
necessarily come under a regulatory regime in the US. Enron in
the US had a waiver from CFTC, which is the US futures and derivatives
regulator, which in the UK we would not have granted. We are more
keen to grab hold of the derivatives activities even of some non-financial
corporates. For example, we have an energy participants regime
so that the part of BP which trades financial derivatives related
to energy would be regulated by us. We think that is a good approach
and we think that the Enron experience has shown that is a valuable
thing to do, which was agreed in the Financial Services and Markets
(Mr Foot) We are very keen in this country on ring-fencing
authorised firms from their parents. If you go back a long way
and the collapse of Drexel Burnham for example, then the British
part of that was wound down satisfactorily and after the collapse
of Yamaguchi in 1997 the British part was wound down satisfactorily.
One does not want to be complacent but it is an important aspect
of our regulatory reach that having got it inside the authorised
frame we do look pretty carefully at the exposures between it
and its parent.
399. One way of improving the operation of public
limited companies in terms of transparency and accountability
is statutory intervention. The other one of course is changes
to the listing rules. I wonder whether you could outline to us
what changes to listing rules you are recommending and why?
(Sir Howard Davies) I am glad you asked that question
and I mean that; it is one of those rare occasions when I do mean
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