Banking Standards

iv. The government proposals for a Banking Bill focus on ring fencing the retail / commercial banks from investment banks based on the Vickers Report. Given past regulatory captures by the industry and glaring failures, it is naïve to believe that anything short of complete separation between investment and commercial / retail banking will work.

v. Rules, however well-crafted, can be, and always have been, bypassed when rewards from doing so are sufficiently tempting. Ethics, risk management, governance and control systems cultures of investment and commercial / retail banks are, and have to be, so different that allowing them to operate under a single roof, no matter how well they are said to be "ring fenced" will not work. Giving one part of the "ring fenced" organisation access to taxpayer support, while the other is free to take unsupervised risks is simply an invitation to creative financial engineering, and well-financed political lobbying to regulators to either bend the rules or to look the other way. Moreover, the aftermath of the demise of Lehman Brothers furnished ample evidence that the consequences of even "private" risk taking by large financial institution have systemic effects paid for by taxpayers.

vi. It is misleading to attribute major scandals in the investment banking sector to weak internal controls because, in spite of built-in "deniability" protections, it is evident that approval and consent of most such activities came from the top echelons of management. Attribution of such failures to poor internal controls must be supported by evidence of intent and serious efforts to control such activity. The problem is absence of ethical standards in the industry, or reckless and widespread disregard for them at all levels. The case of Goldman Sachs being fined $550m by the SEC in 2010 [8] for misleading investors was the deliberate result of corporate policy which might be called moral turpitude in individual contexts; it is not a mere failure of internal controls in the organisation.

vii. The Commission should be mindful that investment banks also indirectly are responsible for the public’s money via various investment institutions. We suggest that the ethical codes in all financial institutions should be based on social norms which have stood the test of time. An ideal model would be the cardinal virtues of Plato [9] : prudence; restraint; fortitude and justice. The behaviour observed in the recent decade appears to have more in common with three of the deadly sins of greed, envy and pride.

The ethical code for banks should be based on the cardinal virtues deriving from Plato (prudence, restraint, fortitude and justice) rather than three deadly sins (greed, envy and pride).

We support the proposal to separate completely, not merely "ring fence" retail /commercial banking from investment, banking, because there is no practical and implementable way of isolating them from each other within a single organization. Investment banks, excluded from any actual or potential taxpayer support, should be required to establish, observe and enforce ethical codes, and maintain effective control and governance systems because they also are entrusted with other people’s money.

5. Globalisation

i. While globalisation brings the benefits of cross-border trading in financial assets, multiple listings, and financing; it also lowers the barriers to transfers of economic, legal, regulatory and cultural weaknesses. For example, both the Enron as well as subprime mortgage crisis originated in U.S. but had major impact outside its economy. The Euro debacle is another example of the failure to recognise and manage intra-Eurozone cultural and economic disparities. Few global mechanisms that exist for regulated globalised phenomena remain weak and ineffectual, since the bulk of regulatory and disciplinary powers reside in domestic government for historic reasons. Absent effective global regulation, unintended consequences of cross-border activities continue to leapfrog piecemeal national efforts, and need more comprehensive solutions.

ii. The financial services industry has often used staying competitive as the excuse for adopting the highest risk financial schemes independent of where they originate. Regulators of financial service industry must decide if they wish to encourage in a race to the top or to the bottom.

We recommend that UK regulators and government should be particularly mindful of the risks associated with cross border activity in the financial sector. The UK economy needs to be protected against the financial consequences of importing high risk financial developments or activities originating in other countries on the grounds of maintaining competitiveness. Before allowing unbridled expansion in financial products, regulators and government should ask if they are promoting a race to the top or to the bottom.

6. The introduction of IFRS in the EU in 2005 and convergence with US GAAP

i. The IFRS accounting model was introduced into the EU for group accounts of listed companies for December 2005 year ends by an EU Regulation issued in 2002. Shortly after the Regulation was issued the International Accounting Standards Board (IASB) the body responsible for setting the standards, announced that it was planning to converge its standards with US accounting standards, known as US GAAP [10] . The US standards are set by Financial Accounting Standards Board (FASB) [11] . There was no public consultation on this decision which is quite extraordinary, given the significance of the consequences of this decision. Perhaps the IASB hoped that, in the long term, the US Securities and Exchange Commission would approve the converged standards in the form of IFRS for use by US companies. Neither the source of this decision, nor the identity of the parties involved in making it is known.

ii. The US GAAP convergence project changed the IASB working plans, and considerable resources were redirected towards joint projects and meetings on various standards. In spite of many warnings to the contrary, the convergence project was based on, and promoted, the astonishingly naive proposition that it was possible to bring about the development and acceptance of a single set of "high quality" accounting standards for hundreds of countries of the world with their diverse economic, legal, business, political and social systems. This vision was actively supported by global accounting firms who stood to benefit greatly from common global standards by driving out competition from smaller local firms. Not only the meaning and substance of "high quality" standards remained unspecified, for reasons discussed in point (v) onwards, the resultant standards were everything but of high quality.

iii. The naive proposition was also supported by regulatory groups such as IOSCO [12] as well as politicians of G-20 who understood little of what they recommended. Very large international companies and investors in international markets who also stood to gain from not having to deal with different accounting regimes in the countries where they had interests. It was assumed that the FASB and the IASB were competent to produce "high quality" standards which were fit for use around the world. It was also assumed that culture, context and widely differing legal and regulatory framework in countries could be ignored or overruled by the converged standards. Scores of developing countries, hoping for inflows of investment capital from conformity with IFRS, promptly declared their adoption in name, and IASB loudly trumpeted these swollen number of "adoptions" to those who saw through the game and were reluctant to follow suit.

iv. Professors Fearnley and Sunder repeatedly warned about the obstacles to achieving global standards in August 2005 [13] and May 2006 [14] , [15] i.e. at an early stage of IFRS adoption.

We believe that the concept of a common set of "high quality" accounting standards for use around the world has been seriously flawed from the outset and the IASB has misused its resources in a convergence project which was bound to fail. It let down its users, particularly in the EU, by concentrating on convergence with US GAAP instead of ensuring that the standards were of "high quality" for existing users. The UK government should not blindly support the principle of common global standards because of the self-interested lobbying by a relatively small number of large organisations. Also, as argued below, the IASB is not capable of producing "high quality" standards. Neither is it possible to achieve uniformity of results from a single set of rules in a world of economic, social, legal, and political diversity.

7. The accounting model, auditing and the banking crisis

i. There has been much criticism of the IFRS accounting model in the UK and in other countries since it was introduced in 2005. The complexity of the standards, (note ) [16] and the counter-intuitive outcomes of some of the standards are best examined in the context of the banking crisis, the mark-to-market regime (under the comforting but misleading label of "fair value" accounting) for financial assets and liabilities and the incurred-loss regime for loan losses.

ii. These criticisms are not new. Extensive academic and practice debates have existed over the past century over the appropriateness of marking assets to their market prices for accounting purposes (note [17] ). More recently, Fearnley and Sunder criticised mark-to-market in the US context in 2007 before the depth of the crisis manifested itself and reinforced their views on the impossibility of global convergence (note [18] ) demonstrating how a mark-to-market change in the rising market in the US had enabled US banks to report significantly higher profits.

iii. As the banking crisis developed, the House of Commons Treasury Committee set up an Inquiry in 2008 to which Fearnley, Beattie and Hines responded. They expressed concern about the complexity of IFRS and the mark to market accounting regime, which allowed unrealised gains on financial assets marked to a rising market to be treated as profits (note [19] ). Other academics, e.g., Page and Rayman also criticised the accounting regime for the same reasons in their submissions (see below note 16). Rayman blamed bad financial theory and bad economic theory for the accounting failures.

iv. The IASB’s own submission to the Inquiry (see also note 14) was subsequently reinforced by evidence given by its Chairman, Sir David Tweedie. The submission makes the statement, subsequently repeated by Sir David: Fair value accounting did not cause the banking and credit crisis-it has simply helped to reveal it (note19). It is factually correct that accounting was not the cause of the crisis as there were other factors involved. However, this statement does not acknowledge that fair value played a role in causing the crisis by blowing up asset prices in a bubble market and allowing banks to book unrealised gains before the market for the overblown assets collapsed and prices marked to market fell dramatically. The IASB sought to glorify itself without admitting the problem its standards helped to create.

v. It is disturbing that a body holding itself out as fit to set accounting standards for the world could make such a statement to a parliamentary committee. If the IASB was not aware of the problems its standards were causing, it is unfit for its self-proclaimed role as the world’s leading expert in accounting. If the IASB did know of the problems its standards were causing, it is incompetent in its duty to serve the public interest. The denial of accounting’s role in the crisis was repeated by the current IASB chairman Hans Hoogervoorst (note 20) in 2012.

vi. Unsurprisingly, the accounting establishments gave such broad support to IASB in submissions to the Treasury Committee that the latter shied away from seriously addressing the role of IASB’s standards in the financial crisis. The Committee also accepted the IASB’s contention that bank regulators are not a targeted user of financial statements produced under IFRS, and therefore these standards should not be evaluated on the basis of their consequences for prudential regulation, such as determining bank capital. It was suggested that bank regulators should establish separate accounting standards of their own to attain their prudential goals (which are often incompatible with the mark-to-market regime). The Committee also questioned the value of audit.

vii. After the Report of the House of Commons Treasury Committee Inquiry, the House of Lords Economic Affairs Committee set up an Inquiry into ‘Auditors: Market Concentration and their Role’ in 2010. In the interim, more problems had emerged over the accounting for loan loss provisions. IASB had switched from expected-loss to incurred-loss provisioning on loans. Even in a normal economy, not all borrowers can be expected to pay their creditors in full. The expected-loss model considers this credit risk associated with bank’s a portfolio of debts, and recognises the appropriate amount as a loss at the time credit is extended, and when the estimated creditworthiness of the borrower changes. Under this model, the bank does not wait until a specific loan is in default to recognise the loss. In contrast, the incurred-loss model adopted and enforced by IASB in EU requires a provision for loss to be delayed until there is evidence of default. The definition of default can vary significantly.

viii. In the opening evidence session, Beattie and Fearnley (note [20] ) pointed out many problems of IFRS including (1) the mark-to-market accounting model; (2) incurred-loss model of loan loss provisioning; (3) the complexity of the presumably simpler "principles-based" IFRS; (4) dysfunctional consequences of attempts to converge with US GAAP; (5) the compliance-driven regime undermining the true-and-fair view; (6) the absence of the principle of substance-over-form and its consequences; (7) the identification of distributable profits under the mark-to-market regime and disbursement of dividends and bonuses out of paper gains; and (8) the loss of prudence associated with the IFRS switch from lower-of-cost-or-market to mark-to-market regime. They also pointed out that although the House of Lords Inquiry was focussed on auditing, it was essential for the Committee to appreciate that auditing is a subset of accounting. Therefore, if the accounting model with which auditors are required to comply is defective, under a strong enforcement regime such as the UK has, the defects would leak through to the audited accounts. Other witnesses criticised the mark-to-market regime, the loan loss provisioning and the abandonment of the principle of prudence in financial reporting.

ix. A comment from Steve Cooper of the IASB claimed that: prudence does permeate accounting standards, revenue recognition, and all sorts of areas. We are careful to make sure that profits are only recognised when they really are profits. Since mark-to-market accounting in illiquid markets can hardly be described as prudent, the logical basis of IASB’s position remains mysteriously vague. The IASB used a euphemism "improved" when it furiously back-pedalled from its incurred loan loss disaster in light of experience with financial crisis. Since this ‘improvement’ will have to wait at least till 2016 to be implemented, there is a yawning gap between IASB’s rhetoric and acts. Since serious differences have arisen between IASB and US FASB on which model is of "higher quality" as the single standard for the world, even 2016 may not see the implementation. This is just one more example of the impossibility of attaining a single set of global accounting standards.

x. Unlike most aspects of human endeavour, creativity and innovation are not appreciated in accounting. Indeed, they have an unsavoury connotation in this context, because they imply a deviation from tried and true, and well-understood principles of prudence (conservatism) in order to maintain trust and faith in the credibility of financial reports. Development of mathematical finance and financial engineering has goals which are the diametrical opposite of prudent accounting because the former seeks to design transactions, instruments, and organizations to manipulate what appears in the financial reports. In the pursuit of clear written accounting rules, the IASB and the FASB have fallen prey to financial engineering innovation; the more they clarify the rules, the easier it is for financial engineers to evade them through new designs.

xi. In addition to offering one side of the double-entry to a Parliamentary Committee and providing unhelpful evidence to the Economic Affairs Committee of the House of Lords, the IASB suggested that banks keep two sets of book, one for the shareholders and another for the regulators! The proposition that regulators are not a primary user of audited accounts remains in the IASB’s conceptual framework and was re-iterated by IASB chair Sir David Tweedie in a letter to the Financial Times on 29 March 2012. This letter was followed by a letter from Sir Chips Keswick (note 21) offering a donation of £1,000 to a charity chosen by anyone who could explain the IFRS gobbledegook as set out by Sir David. In response to Sir Chips’ letter a series of highly critical and at times mocking letters followed which ran for several days.

xii. The Economic Affairs Committee itself questioned if the banks who had been bailed out with large doses of taxpayer money shortly after their accounts had been signed off as true and fair were, indeed, going concerns on the date of the report.

xiii. We find it surprising that, following the debate on the Economic Affairs Committee Report, the government accepted IASB’s facile claim about the prudence in IFRS (note 21). Acceptance of IASB’s position on two sets of books, and rejection of bank regulators as legitimate and important users of audited accounts, also implies that accounting valuations are inappropriate for regulatory purposes’ (note [21] refers to note 20 para 192). While regulators are asked to make their own adjustment for capital maintenance, how would they know when accounting valuations are inappropriate? It may be observed that the recent changes made to the IASB conceptual framework such as the removal or prudence, reliability and accountability to regulators have emerged since the mark to market and loan loss provisioning changes began to be recognised as seriously problematic.

xiv. Countries, such as India and China have hesitated to adopt IFRS in their entirety, and have indicated their intent to deviate when it suits their interest. Japan also has not come aboard after several years of intensive deliberations. Despite having absorbed huge resources the IASB and the US FASB could not reach agreement on changes needed to the standards in the wake of the banking crisis. They have substantially weakened their commitment to work towards convergence, and seem intent to go their own respective ways. In June 2012, Fearnley and Sunder published another article in the Financial Times yet again emphasising the impossibility of a single set of global standards and questioning the trustworthiness of the IASB (note 22). In July 2012 the US SEC issued a staff paper making it clear that in the short to medium term the SEC was not going to approve IFRS (note 22) adoption. One reason given was that there was insufficient support for the changeover to IFRS in the US. It is surprising that it has taken them so long to acknowledge this key fact.

xv. Questions were raised in the UK almost immediately after the introduction of IFRS about compatibility between the new EU Regulation and the UK company law. That accounts should show a true-and-fair view as well as comply with accounting standards and other regulations has been a long standing principle in UK company law. Some took the view that IAS 1 (a part of IASB’s IFRS suite of standards) weakened the true-and-fair view and, in spite of IASB rhetoric to the contrary, drove companies towards a rules-based accounting regime closer to US GAAP (note [22] ). After these concerns were raised, the need for accounts to show a true-and-fair view was emphasised in the 2006 Companies Act; yet it remain ambiguous whether the true-and-fair perspective is or is not a part of the current regime in UK (note [23] ). Also concerns have been expressed as to whether accounts prepared under IFRS and the current auditing regime show the economic substance of a business, especially when the business is a bank.

xvi. There are inevitable questions about the role of auditors in the crisis. The concerns about true-and-fair view, going concern and the payment of dividends and bonuses out of unrealised profits of banks as a result of the IFRS’s mark-to-market and incurred-loss provisions have been widespread for some time. Yet, no reference in public to the impact of these changes in inflating profits of the banks has been made by auditors and representatives of the accounting profession. Neither has the widespread unpopularity of IFRS among preparers (see note 15) and audit partners as a results of its complexity and lack of understandability received much acknowledgement.

xvii. In respect of the true-and-fair view and going concern, the auditors have faced a dilemma in that compliance with the IFRS standards was expected under the UK’s strong enforcement regime. Prior to the introduction of IFRS, the true-and-fair view was used by auditors in negotiating with clients when the latter pressed for deviation from law or regulation (note 24) to make the results look better. The threat of a qualified report from an auditor that the accounts did not show a true-and-fair view usually sufficed to persuade clients to abandon such aggressive postures.

xviii. In absence of a standard to account for a particular transaction(note [24] ) the true-and-fair view was used to negotiate an accounting treatment which was acceptable to the auditor. Application of IFRS to banks confronted auditors with the choice between accepting overstatements and deviating from the written standard. IFRS strongly discouraged auditors from deviating for the standard in this new situation. Auditors, as well as the UK Accounting Standards Board, unfortunately chose silence at the time and now face criticism for not challenging the inflated numbers from a true-and-fair view perspective. There can be little doubt that the auditors would have known of the inflated profits. The large firms and the professional accounting bodies pursued their significant economic interest in promoting a global accounting model and supporting the IASB. Whether they pursued their duty to serve the public interest remains unclear.

xix. Going forward, a number of initiatives to improve audit reporting, disclosure and the role of auditors and directors in going concern issues are on the table. Given the seriousness of the past failures to make stakeholders aware of the uncertainty associated with banks’ financial reports, it does not seem prudent to wait for the outcome of these proposals. Instead, urgent steps are needed towards a stronger regime for auditors and companies to report accounts that reflect the economic substance of their business.

We recommend from the evidence shown above that the UK government should no longer trust the IASB standards to produce credible accounting numbers, which are drawn up under the principles of prudence and reliability, show a true-and-fair view and reflect the economic substance of the business. Also it is clear that the true-and-fair view requirement has not been retained in IFRS. Therefore UK company law should be changed so that directors and auditors are required to report that the accounting numbers are prudent, reliable, show a true-and-fair view and reflect the economic substance of the reporting entity. Both directors and auditors should be required to override the IFRS standards and conceptual framework as necessary. In the case of banks the agreement of the banking regulator should be required. In the case of other companies the market regulator should be consulted.

3 September 2012