Banking Standards - Minutes of EvidenceHC 27

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Oral Evidence

Taken before the Parliamentary Commission on Banking Standards
Sub-Committee H-Panel on tax, audit and accounting

on Wednesday 16 January 2013

Members present:

Lord Lawson of Blaby (Chair)

Mark Garnier

Mr Pat McFadden

Lord McFall of Alcluith

________________

Examination of Witnesses

Witnesses: Professor Mike Devereux and Dr John Vella, Oxford University Centre for Business Taxation, examined.

HQ1 Chair: Professor Devereux and Dr Vella, thank you very much for coming to see us this afternoon. We are most grateful to you.

You know the subject for this particular session of the Commission’s work, so I would like to come straight to the key issue in the area of taxation as it affects banks and to ask you whether you think the existing system of taxation, which treats debt interest differently from dividend payments, is satisfactory. In particular, we want to ask whether that has any bearing on banks’ policies for how they finance themselves. If that means that they are reluctant to finance themselves through equity rather than through debt, is that not contrary to the wishes of the regulators and supervisors, who would like to see banks safer, with a bigger equity base?

Professor Devereux: Thanks for inviting us.

In answer to the first part of the question, we cannot see any good reason why debt and equity should be treated differently by the tax system as a matter of principle. Indeed, the fact that they are treated differently by the tax system creates a number of distortions-both to the behaviour of banks and for other companies-and a number of problems with the administration of the system in trying to define what debt and equity are. So, as a kind of starting point, I would say that there is no particular reason why we would want to distinguish them within the tax system, and then we can ask the question of the extent to which we think the fact that they are distinguished by the tax system in the way you describe affects the financial position of both financial and non-financial companies.

There has been quite a lot of academic research trying to look at the effects of these differences in tax treatment on the way in which companies finance themselves. Almost all that research has been on non-financial companies-just ordinary companies-and it tends to exclude banks on the grounds that they are different in some way, so researchers have typically focused on non-financial companies. There has been some more recent work, in particular a paper by Michael Keen and Ruud de Mooij, focusing especially on banks, asking the same kind of questions. In our written evidence, we summarise their results. They found that there is a relatively small effect from the tax discrimination, in terms of banks using more debt than they might otherwise have done, and their results are broadly in line with those that people have found for non-financial companies.

Despite that, a final issue in response to your question is: how far has the distinction within the tax system led banks into the position where they have very little equity and a vast amount of debt? A broad answer would be that there are a number of other reasons why we think banks are in that position, and tax is only one of them. Even if that tax discrimination was not there, we suspect that banks would still be using mostly debt rather than equity. I can elaborate on that if you would like me to, but that is the key response.

HQ2 Chair: Thank you. Would Dr Vella like to elaborate on or add to that in any way?

Dr Vella: The only thing I would add is that Mick Keen and Ruud de Mooij say in their study regarding the effect of the preferential treatment of debt from a tax perspective that the reaction by banks is smaller for larger banks than it is for banks of a smaller size. That is something to keep in mind, given the fact that banks in the UK tend to be quite large.

HQ3 Chair: If there were to be a change, it could in principle be done in one of two ways: by removing the tax deductibility of debt interest; or by giving an allowance for dividends. Both have been discussed. Do you see any reason for going for one rather than the other?

Professor Devereux: The key thing would actually be to try to equalise the treatment of debt and equity, so I think one could go in either direction. Indeed, there is an intermediate case. At the moment, we give full relief for the cost of debt and no relief for the cost of equity. We could give full relief for the cost of equity, no relief for the cost of debt, or partial relief for both. Clearly, if we just give relief for the cost of equity and do nothing else, there will be a revenue cost, and there will be a revenue gain if we move in the other direction and disallow interest deductibility. An intermediate position might to try to work out what rate of relief would be possible on both forms of finance while being relatively revenue-neutral. The choice between them then rests on a number of factors, and they may be different whether we are talking about introducing this just for banks or more generally for all companies in the economy.

Very broadly, taking international things into account, giving an extra relief for equity and leaving the tax rate as it is makes the UK more attractive. Disallowing interest will make the UK less attractive for banks locating and doing their business here. There are intermediate positions, and one may change the tax rate as well, but I think that the key issue in terms of which direction to go is whether we are making the UK more or less attractive to international banks to locate their business here.

HQ4 Chair: So you think it has more effect on the location than it does on banks’ behaviour as to how they finance themselves, do you? I do not quite understand that. I would have thought that the effect would be either quite large in both cases, or quite small in both cases.

Professor Devereux: In any of these circumstances, we are going to equalise the treatment of debt and equity. I think that that will have an effect anyway, in the sense that the incentive to use debt finance rather than equity finance will be nullified, so there will not be a distinction within the tax system.

Given that, the question is how generous we are in giving relief for the cost of finance, given that we have the same treatment for both forms of finance. That might have some technical effects on the size of banks within the country, but it seems to me that the biggest effect will be on whether banks choose to locate here, which broadly just depends on how much tax they will pay on their activities once they are here.

HQ5 Mr McFadden: I want to ask about two aspects of this. The first is how international and global this system of the differential treatment of debt and equity is. Is it the norm right across the world? Is there nothing unusual about the UK?

Dr Vella: No. It is the norm around the world.

HQ6 Mr McFadden: You said in your opening answer, Professor Devereux, that this was just one factor at play, and that even if this was not the case, banks would be more attracted to debt than equity as a way of raising money. To what degree do you think this influences bank behaviour? In other forums, witnesses, including the Governor of the Bank of England, have pointed out the huge growth in leverage in the run-up to the crisis. I think the Governor cited Northern Rock as having a leverage ratio of about 60 times its capital-I could be wrong about that, but it was a huge sum. The new supposed prudent international standard is going to be 33 times capital against the whole balance sheet. How much does this tax issue influence banks’ behaviour in terms of increasing leverage?

Professor Devereux: The tax is clearly important, in that there is clearly a tax incentive to use debt rather than equity. The other reasons that people talk about are the limited liability of shareholders and the possible bail-out of creditors. I guess the issue is that given that the limited liability and potential bail-out is so strong, banks want to use a lot of debt anyway. On top of that, there is also another reason, which is tax. If the first reason were not there, I think that tax might be quite important, but the first reason has not gone away.

There are at least two reasons why we might think that tax has not caused a crisis, in the sense that it was not the difference. First, the tax system is the same for banks as for other companies, and we do not see other companies increasing their leverage to the same extent as banks. Secondly, this system has been in place for decades and, again, we did not see banks with the same amount of leverage 20, 30 or 40 years ago-that has increased much more recently. Both reasons would lead me to think that it is certainly not tax on its own that has caused the problem. I think it is certainly there as a factor, but it seems unlikely that it is really the factor that caused the sharp increase in leverage that led to the crisis.

HQ7 Mr McFadden: Do you concur, Dr Vella?

Dr Vella: Yes. The fact that tax was not the primary driver, but one of the factors that was pointing in the wrong direction, seems to be the consensual view among commentators in this area. It is the view of the IMF and the OECD, among others.

HQ8 Mr McFadden: If the UK was to decide to deal with this by adopting one of the two potential cures that Lord Lawson put forward, what do you think that would result in, in terms of bank responses and location? We are quite used to hearing that if we make this or that change, they will all go to Geneva or Singapore. How likely is it that this would have an effect on that kind of decision?

Professor Devereux: The benefit to banks from interest deductibility for tax purposes is quite large-the corporation tax benefit is substantially larger than the bank levy, for example-so just moving to a system where that interest was not deductible would have significant impact on the banks. There is academic research-not particularly for financial institutions, but generally-showing that location decisions are quite sensitive to differences in taxes between countries. In the banking system, we might imagine that, with parts of banks-you know, this shadow banking system-banks will try to put some of their activities in places where they would still get some interest deductibility if they were not getting it in the UK. There would certainly be an incentive to do that. In general, that claim is probably overstated. Every time the income tax rate goes up, bankers say that they are all going to Switzerland, but at least some of them are still here. In general debate, that is overstated, but that incentive would certainly be there.

If we moved in the other direction and gave relief to equity, those problems would not be there because, effectively, we would be giving an additional relief over and above what banks already get. The general problem with trying to introduce a system in which we give a special relief for equity is that, if we apply it to the whole economy, it would be quite expensive. Of course, applying it just to banks-actually, there is very little equity in banks at the moment anyway-would be relatively cheap. So, out of those two options, it might be more sensible to move to what would appear to be the more generous system of giving a relief for equity.

HQ9 Mr McFadden: My final question is on size. Is it possible to put a number on how much this tax differential is worth to banks in a typical year?

Professor Devereux: I do not have a number to hand, I am afraid.

HQ10 Chair: Before I ask Mark Garnier to come in, just to clarify, are you saying that it is perfectly plausible to have a different treatment for banks than for the rest of the corporate sector, and that this might be attractive because, for the reasons that you have outlined, the cost of giving dividend tax relief for banks would be so much less than doing it for the corporate sector as a whole?

Professor Devereux: It is certainly a direction that is worth considering. I would probably fall short of advocating it, on the grounds that we would be introducing yet another somewhat arbitrary distinction into the tax system. One group of companies would be getting the relief, but another group of companies would not, so we would then have to define exactly where the barrier would be between companies that do or do not get relief.

HQ11 Chair: We already have a bank levy on banks in this country, so there is already different treatment for banks from other companies.

Professor Devereux: That is right, and makes it more plausible to do that. Indeed, one might even say we could offset the cost of introducing the new relief on corporation tax by making adjustments to the bank levy to try to compensate for the revenue lost.

HQ12 Mark Garnier: Could we explore the difference between debt and equity? I appreciate that you are suggesting that if you treat them from the point of view of being the same type of animal in terms of taxation or allowance of dividends, that makes some sense, but they are different animals, aren’t they? With the simplest type of debt, which is bonds for banks, there are some differences.

First, when you issue a bond, you know that it will be repaid five or 10 years in the future. You also know exactly what coupon will be paid, so you have a predictable contract. With equity, you have a very different animal. The first point is that you may never be repaid. You are repaid only if you can sell it in the market. The company, broadly speaking, does not pay unless it is wound up.

Secondly, dividend cover-the amount of money that is paid in the dividend-is decided by the company’s board, and there are a number of reasons for that decision, which may be to attract more shareholders, or because the shareholders want a bigger or smaller dividend. Ultimately, a bank may choose not to pay a dividend. Given that there are two different animals, is that ultimately the reason why it is difficult to treat them similarly for tax?

Professor Devereux: I would start from the opposite perspective. Pure debt and pure equity are different in the ways you described. We know that financial institutions have invented many hybrid instruments that are a bit of one and a bit of another.

HQ13 Mark Garnier: Convertible debt.

Professor Devereux: For example, yes. At some point there is a grey area where it is hard to tell whether something is debt or equity. I would turn it round and say that although to some extent a company or bank has a choice in what dividend to pay, we should think of the return on equity as being not only the dividend, but an increase in the share price. If a company chooses not to pay a dividend, that money is still within the company. The company is that much more valuable and its share price is higher. There are two ways in which shareholders may get a return: through the dividend and through the capital gain on the share. That is one point.

The second point is that some investments give a fixed rate of return, and some give a variable rate of return. Normally, when we think about the design of the tax system or of fair tax, there is no reason for saying that a fixed rate of return should be taxed at a different rate from a variable rate of return. Normally, you say that this is income received and we will tax it. There are differences, but it is not clear to me why those differences should lead us to think we should tax them in a different way.

HQ14 Mark Garnier: Perhaps I could suggest one reason. When deciding what dividend you will pay on your equity, if it comes below the line you will pay quite a big dividend, but if it comes above the line-sorry, it is the other way round. If it is tax deductible you might pay a bigger dividend than if it was not tax deductible.

Professor Devereux: When I talk about relief for equity to make it comparable with debt, I am not talking about dividends as such, so I would not advocate that dividends are tax deductible. What I have I in mind is something more like relief for the opportunity cost of finance. If the bank raises 100 units of new equity, the shareholders are giving up the opportunity of doing something else with the investment. We can give relief for some rate of return times 100. I would advocate relief based on the amount of equity invested and a reasonable rate of return, rather than relief that is based on dividends.

HQ15 Chair: That is what is known as the ACE system?

Professor Devereux: Yes, exactly. Allowance for corporate equity is based on that notion, rather than on dividends, which are very much a variable choice of the company.

HQ16 Mark Garnier: Would you mind expanding slightly on what you are proposing?

Professor Devereux: Allowance for corporate equity is precisely that, so if the bank borrows 100 units and has to repay it with an interest rate of 5%, it will get relief of five units. That essentially represents a relief for the rate of return of 5%. If we ignore risk and all the complications, the idea would be that the alternative for the bank is to raise new equity of five instead of borrowing five.1 Those shareholders are giving up the possibility of earning interest of five if they put their money into a bank account, so the opportunity cost of finance is also, say, 5%.

The idea of the allowance for corporate equity is that you take that 100 that has been raised in new equity, multiply it by something like 5%, representing the required rate of return on equity, and give relief against the tax system for that five. That is what the allowance for corporate equity would be. There are issues about exactly whether that should be 5% or some other rate of return, depending on the risk surrounding that allowance.

HQ17 Mark Garnier: With these comparisons you could use a five-year gilt yield or something.

Professor Devereux: Something like that. There is also the issue of what the base would then be. New equity is clearly within what you would give relief on, but retained earnings would be as well.

HQ18 Mark Garnier: So this is relief to the equity holder?

Professor Devereux: It is relief at the level of the company or the level of the bank. This is a relief against corporation tax.

HQ19 Mr McFadden: But it is effectively a tax giveaway to shareholders. Is that the right way to understand it?

Professor Devereux: Yes, I think that is right. At one level with taxing, to the extent to which any company borrows and pays interest back, corporation tax is taxing its profits less that cost of finance. For equity it is taxing the entire profit. That is why there is a discrimination between them.

HQ20 Mark Garnier: It is the difference between being paid above the line and below the line, isn’t it?

Professor Devereux: Effectively, yes. That is one way of thinking about it. If you gave relief for the cost of equity as well, you would be saying that the corporation tax charge is only going to be on profits over and above the required rate of return on all types of finance. That is clearly a narrowing of the tax base.

HQ21 Mark Garnier: We come back to my point about the decision. You are saying that the Government would say that a fair return on equity is, let us say, 5%. I know you cannot treat it like this, because obviously you can only treat it as at the share price at the time you pay the debit, but let us say you are taking 10%-you only get the tax break on the 5%.

Professor Devereux: Do you mean as a dividend?

HQ22 Mark Garnier: As a dividend on equity, yes. So you are paying a much more generous dividend than what you are saying is the commercial ideal, but then you do not get the tax rate on the difference.

Professor Devereux: That’s right. The dividend that you pay is going to be irrelevant for the purposes of this allowance. The allowance is really saying-

HQ23 Mark Garnier: So it is a pre-determined allowance.

Professor Devereux: It is a pre-determined allowance. It says, "This is supposed to represent the opportunity cost of funds-what you could earn somewhere else." It may be that the bank is phenomenally profitable and earns way more than that, and that is why there is a tax base.

HQ24 Mark Garnier: Are you basing this allowance on the valuation of the equity at that time?

Professor Devereux: It would be based on the value as it went into the company or into the bank, so you would accumulate it year by year.

HQ25 Mark Garnier: I am slightly testing your model. You assume things go well, although obviously it has not gone very well for banks recently. Let us say that you issue equity, when you come to the market, at £1. The bank does very well and the share price goes up to £5. What was a 5% allowance is actually now only a 1% allowance, if you bought the equity when it was £5.

Professor Devereux: That would be true, yes, but it would still reflect the fact that what you have actually given up is £1. If, in the following year, the bank makes a large profit, which it retains within the company and does not pay out as a dividend, the retained earnings would go into the tax base for the following year, because the size of the equity base has effectively been increased. It is the new equity plus the retained earnings, so the following year it would actually get a higher allowance.

HQ26 Mark Garnier: Okay, I am with you. It is quite a complex model. Having been an investment banker for 20 years, I know that the average investor tends to take a relatively simplistic view of the world. I can see the merits of it, but it becomes quite complex to administer, doesn’t it?

Professor Devereux: I suppose, but relative to the existing corporation tax system, I am not sure that it is that much more complicated.

HQ27 Mark Garnier: No, probably not actually.

Another question I wanted to ask you was similar to that. This may be slightly drifting away from tax, but it is none the less sort of relevant to compare the two. The reality of it is that with equity, of course, you have a vote, and with debt you do not. Would you change the voting rights at all, because suddenly you’re getting a tax break of one description or another for owning equity, and you’re now getting a lot more? The other thing you’re getting is capital gains, which you don’t necessarily get with debt.

Professor Devereux: I think there are two things there. One is that you might want to take into account the personal taxes that you pay on the receipt of interest, or the receipt of dividends or indeed capital gains. I think that is quite complicated, in the sense that the people who are providing money to banks in terms of finance can be all kinds of different institutions and are all taxed in different ways. If it were the case that all equity, all capital gains and dividends were taxed a higher rate than the interest received, that might offset things to some extent, but I think that in practice that is not very likely. The fact that one type of finance gives you the right to a vote and another does not doesn’t strike me as a reason for taxing them differently.

Dr Vella: And you could have shares without voting rights.

Professor Devereux: Indeed.

HQ28 Mark Garnier: But you get them cheaper for that. Typically, you would discount them.

Professor Devereux: Yes, but the prices of all these financial instruments would adjust, depending on what their characteristics were; whether they had a vote, whether they had limited liability and so on. We would expect prices to adjust because of all of those things, and that doesn’t necessarily give us a reason for saying "Well, we ought to change the tax system because of that".

HQ29 Lord McFall of Alcluith: What are your views on whether tax arbitrage can affect leverage in banks? We have had a paper from the OECD on this, talking about it leading to lost Government revenues, wasted resources and so on.

Professor Devereux: I’ll start, but I’m sure John will want to add something. There are several different kinds of tax arbitrage, of banks using different instruments and tax systems in different countries which, among other things, may reduce their tax bills. That clearly happens. I think this relates partly to one of the answers I gave earlier, in the sense that we have two things going on. We have the tax system, which is discriminating in favour of debt, and we have the regulatory system, which is trying to limit the amount of debt. We have hybrid financial instrument which are introduced specifically with the aim of capturing the tax deduction while still being tier 1 capital for the purposes of the regulation.

That is great for banks, because they satisfy the regulator and they get the tax relief. It is probably not what the system intended, but in a sense if we then ask the question, "What was the effect of the tax relief on the leverage of the banks?" that would be another reason for thinking it wasn’t that strong. In effect, they are getting tax relief on what the regulator regards as equity anyway-the tier 1 capital. Banks are going to continue to create hybrid instruments in order to do these kinds of things, so my view-if anything-is that simplifying the system and equalising the treatment of different types of financial instruments would just make it easier to administer that system.

HQ30 Lord McFall of Alcluith: Do you have any comments on the Government’s strategy to combat tax avoidance, and tax avoidance facilitation by banks? They did come out with their code of practice for taxation for banks, which says that the principles introduced by the code include the principle that "banks should…not undertake tax planning that aims to achieve a tax result that is contrary to the intentions of Parliament." There’s a motherhood and apple pie element to that.

Professor Devereux: John will answer this one.

Dr Vella: The Government’s strategy to deal with avoidance by banks must be seen in the context of its broader strategy to deal with avoidance generally. At the moment there are loads of measures being taken. Apart from the traditional ones of challenging, litigation, and introducing detailed legislation to close loopholes, we also have newer measures such as disclosure rules, and we will soon have a general anti-avoidance rule in the UK. For banks, as you mentioned, we also have a code of practice, which is said to be voluntary, it but wasn’t really voluntary for the top 15 banks. It states that banks are required or expected to refrain from transactions even if they might be permissible under the law. So this code of practice essentially has some tests-quite vague tests-to determine which transactions the Government expect banks to refrain from, even if they are perfectly legitimate under the law. My personal view is that I do not think that having a system whereby the Executive branch of Government leans on a particular group of taxpayers to refrain from undertaking certain transactions is a good system.

There are a number of reasons for that. First, this structure will work only with some banks but not with others. So this will not help to change the behaviour of banks that are determined to be very aggressive. Secondly, if there are transactions which we find objectionable and which we want to stop banks from undertaking, we should do that through the law. That is my view.

HQ31 Lord McFall of Alcluith: Do you think banks’ approach to tax avoidance has an effect on their standards and culture, including their attitude to other forms of regulation? Within the banking world, the banks have to comply with the regulator. I do not know any other industry that uses the term "comply". It indicates a negotiation, where others have to obey. Should we look at areas like that to toughen up?

Professor Devereux: I am not quite sure what that question means.

HQ32 Lord McFall of Alcluith: On tax avoidance, for example take Goldman Sachs and the 50 pence rate. It was suggested that they were not going to pay until after April. There is a tax avoidance element that has influenced the broader standards and culture within the organisation. As a parliamentary Commission, we have been set up to look at the issue of culture and standards in banks, and tax is obviously an element in that. Let me take you away from your narrow field. I am just asking a question.

Dr Vella: There certainly is anecdotal evidence that banks were particularly aggressive in the way in which they structured their tax affairs, but I do not have empirical evidence showing that. Whether the banks’ attitude towards tax planning actually influences their attitude towards other regulation is impossible to show. To say that because they have a certain attitude towards tax, that influences the way they deal with other forms of regulation, I do not think you could ever show causality between the two.

Professor Devereux: I would say it is part of the culture rather than influencing the rest of the culture, probably. I am not sure whether that’s an important distinction.

HQ33 Chair: Before we conclude, may I ask one question for information? Going back to the question of the different treatment of equity finance and loan finance, this is something that, as you mentioned, the IMF has looked at. The IMF came to the conclusion that it was somewhat perverse that, particularly in the case of banks, there should be an incentive to be more highly leveraged in the tax system. This was an IMF thing. Are there any countries to your knowledge where this issue is being looked at, with a view possibly to making a change?

Professor Devereux: Some countries have introduced the allowance for corporate equity that we have been talking about-or something along those lines. Belgium has one, but that is not just for banks; it is generally for the corporate sector.

HQ34 Chair: That is not for banking. It was also some time ago, wasn’t it?

Professor Devereux: That is right. It has been there for a while.

HQ35 Chair: Following the great banking meltdown and the IMF study on this issue, do you know whether any country is looking at this?

Professor Devereux: Not within corporation tax, as far as I know. However, you might think of the bank levy as being essentially the same kind of idea, because the bank levy is a tax on liabilities on the loan side, effectively. There are several other countries that, like the UK, have introduced a bank levy.

Dr Vella: About 12 European member states have introduced a bank levy. Although not all of them are taxes on liabilities, most of them are. The bank levies at least try to reduce the tax preference for debt.

Chair: Thank you very much indeed. That was most helpful and I am most grateful to you both.

Examination of Witnesses

Witnesses: Professor David Cairns OBE, visiting professor, University of Edinburgh Business School, Professor Stella Fearnley, Bournemouth University Business School, and Professor Prem Sikka, Centre for Global Accountability, University of Essex, examined.

HQ36 Chair: Thank you all very much indeed for coming to see us this afternoon. You know precisely what we are looking into, and you know what we are interested in. There are a lot of accountancy issues which do not primarily affect banks, but are of general significance. This afternoon we are focusing exclusively on how the IFRS affect the banks and banks’ behaviour. I would like to start by asking you all a very general question: are there any ways in which it might affect bank behaviour that you think are concerning, or not in the public interest? If so, what would you like to see done about this? Professor Fearnley, would you like to go first?

Professor Fearnley: What has happened in the accounting environment is that banks were provided with an opportunity to book profits, which was brought in by the accounting environment in 2005. There were lots of other circumstances around that as well. What we have to do is to look at the accounting. The IASB is looking at some of it-whether we agree with what it is doing is, of course, another matter-but we need to make it more difficult for the banks to under-provide for their loans and to make profits out of financial instruments that are not marked to deep and liquid markets. That is the key to it. When you get surpluses on these financial instruments, they should not be able to use them for either any form of distribution or bonus payment, or to ramp up their solvency. As Lord Turner said, these things are socially useless; well, let’s make them economically useless, and then we might see a little less of them.

HQ37 Chair: What specific changes would you like to see?

Professor Fearnley: I would like to see the unrealised profits clearly disclosed and ring fenced in the accounts so that we all know what is there, because at the moment what is realised and what is unrealised is not clear. I would like to see them not able to be used for any benefit to the organisation, because I think that it would be in our interest to try to curb some of the excesses. Our previous colleagues talked about creating financial instruments to ramp up the solvency and dodge tax at the same time. I think that they have told us all we need to know on that subject, and I was very interested to hear that.

HQ38 Chair: On this particular point, you are talking about disclosure.

Professor Fearnley: I am talking about accounting as well.

HQ39 Chair: So on mark to market or fair value accounting, or whatever term you like to use-of course mark to market is often a crazy term, because there frequently is not a market-are you suggesting change in that? If so, what?

Professor Fearnley: If you restricted the use of them, that would bring about change in itself, because no self-respecting banker-if they are self-respecting, in some parts of the banks-would engage in an activity that did not create a lot of benefit for them.

HQ40 Chair: Would either of you like to add anything to what Professor Fearnley said?

Professor Sikka: I agree with what Professor Fearnley said, but one of the problems is that we have delegated public policy-making decisions to a private limited company. Okay, it has some kind of oversight from the European Union, but it has not really adopted any kind of a social perspective. If somebody is marketing medicines, they have to demonstrate that there is some social benefit.

The economics of banks are complex, and we heard that they continue to make it complex with a whole variety of financial instruments. Then along comes the IASB, which is willing to provide some kind of a measurement rule, but without ever testing what the consequences and the harmful effects might be. That should be a key requirement, because now we can see that one of the outcomes of the IASB’s recommendations is that not only national accounts but household accounts are infected-people’s pensions and savings. Everything is infected as a result, because this has a knock-on effect. A key requirement should be that the rule makers should test any measurement method that they are recommending to see what the outcomes would be.

The second thing is that they have to be accountable to national Governments. We have not got federal Europe at the moment-it may happen in the not-too-distant future; I don’t know-but there are whole issues about who they are accountable to for what they recommend. In this country, we have also eroded our standards setting capacity. The Financial Reporting Council has hitched its horses to the IASB and, indeed, some years ago, there was even a recommendation that we should think about doing away with the income statement and concentrate solely on the balance sheet. The IASB is mainly concerned with getting what it says is the balance sheet right as its main focus-I am not saying it gets it right-whereas people are often looking at the income statement as a mechanism for telling us something about the well-offness and possibilities of paying dividends, and these things have got disconnected. We have to look at the institutional structures. I do not think that they are appropriate at the moment.

HQ41 Chair: Some people might have reached the conclusion that the whole purpose of the IASB is to create a decision-making body that cannot be accountable to the wider public interest in the sense of Governments, because, as you say, there is not an international Government. It escapes from national Governments into the wide blue yonder, which may or may not be a good thing.

Professor Sikka: I would not agree with that. It is only because Governments have allowed it to function in that way. Governments are sovereign, at least within their defined jurisdiction. The United States has not fully bought into the international accounting standards-and for good reason. The idea that somehow Britain, Bolivia, America and Afghanistan need the same accounting rules, regardless of history, institutional structures and the development of markets, does not really hold.

HQ42 Chair: So you are saying that we in this country should do what we think is right and not be concerned about whether there is international agreement.

Professor Sikka: I think that is the line to pursue. I believe parliamentary Committees-we can talk about which Committees-should ultimately scrutinise accounting and auditing standards, too. When we look at the IASB, which is primarily funded by $1.5 million a year from the big four accounting firms and about 200 other corporations, many of which are financial, we can see which way the levers have been pulled and what the outcomes have been. We need a counter force for that, which cannot be provided by the private sector itself, because it has different interests. I would argue that we need national standards setting. It has a great role to play. It can talk at an international level to see what we can agree, but I did not see much sign of that. Indeed, many of the international accounting standards have often been hoisted upon people.

We have to remember that the IASB has its own political objectives. If I may give an example, the IASB has been very keen for China to adopt international accounting standards. The Chinese have not been very keen on related party disclosures, so when a new related party accounting standard came into operation, one of the exemptions was that Government-linked organisations did not provide any related party information. In other words, it is a race to the bottom-the lowest common denominator. I say that because one of the questions that the Committee was thinking about was whether the IFRS add enhanced transparency. The answer in that example is no. The main concern was to get China on board. I am afraid that it has opted for the lowest common denominator.

Also, lots of NGOs have been pushing for information about banks, which would be extremely helpful. It is called country-by-country reporting, which is persuading multinationals, including banks, to publish their tables to show what their sales, profits, employees, taxes, assets and liabilities are in each country. The IASB has indicated opposition to that, though it has been chastised for doing so to varying degrees by the European Parliament. The European Commissioner also looked into the issues relating to that. That kind of information would enable us to see at a glance exactly where the banks are, which country may well have a responsibility for rescuing them, and where the profits are being booked or otherwise. There are many things that can be done, but because the IASB’s funders do not approve of such projects, it has generally not been keen on those kinds of ideas, so we have to look at institutional structures, because many of the problems that we have in accounting flow from that particular structure and the lack of counterweights within the structure.

HQ43 Chair: Professor Cairns, do you agree or disagree with what your two colleagues have been saying?

Professor Cairns: I agree with them in so far as they are concerned about some of the excesses and some of the things that have gone wrong. I disagree with them quite strongly in a number of other respects. If we look first of all at the transition from the UK GAAP to IFRS for banks, then the model they used under UK GAAP is the same that they now use under IFRS. In substance there was no change in the loan loss provisions that UK banks made under UK GAAP and under IFRS. The evidence for that comes from comparing requirements that are articulated slightly differently but are remarkably similar in what they are seeking to achieve. Under both UK GAAP and under IFRS, there was-and is-an incurred loss model, which requires banks to work out the expected future cash flows from loans which are impaired.

The same applies with respect to financial instruments which are held for trading. Under both UK GAAP and under IFRS, there is a requirement for a mark to market model. If one looks at the disclosures that UK banks made on their transition from UK GAAP to IFRS at the end of 2004, one would not see any significant changes. Either they got it wrong, but there is no evidence for that, or the suggestion that there was a substantive change is not correct. That would be one of the points where I would start.

HQ44 Chair: So you are saying that there has been absolutely no change in banks’ provisioning policies as a result of the change from UK GAAP to IFRS?

Professor Cairns: I would not go so far, perhaps, to say absolutely no change. There were small changes. I have included in my written evidence a table which shows the changes for eight2 UK banks, and the changes in each case were really very small relative to the large numbers in the banks’ financial statements. In several cases, the loan-loss provisions increased in moving from the UK GAAP to IFRS rather than decreased.

The Financial Reporting Review Panel of which I am a member-but I was not involved in any of its work on banks’ financial statements-looked at the transition from UK GAAP to IFRS by UK banks. It acknowledged that there was no change in the methodology. In fact, if anything, there would be a small increase in the loan-loss provisions. That is what happened and what the evidence shows if one compares the requirements and if one looks at the financial statements and the leading textbooks on bank accounting at that time.

HQ45 Chair: On this specific point of provisioning, do your colleagues agree with what you have just said?

Professor Fearnley: Not entirely, because I think I look on the IFRS IAS 39 model as having failed its first test. What we had going on at that time was an explosion in bank behaviour, because there were many other factors allowing them to increase their lending and ramp up their solvency and so on. I think what we got was that, as the banks’ business models were moving very fast, the accounting was not addressing it, because you cannot get a incurred loss unless you have a default.3 If their portfolio of lending is shooting up, things do not default on day one. You wait, and as it was growing and as the portfolios were changing and the behaviour was changing, the provisioning was not really following it in quite the same way.

I am aware of what Professor Cairns has said, because this has been said to me before. That does not solve the problem. UK GAAP had "true and fair"; it had other safeguards within it to prevent what has just happened.4 Arguments have been put to me that the banking SORP that was being observed was very similar. It was, but it was not absolutely similar. This is the core issue, because the IFRS had no mechanisms to control what happened. I am quite happy to believe the Bank of England, who say that loans are under-provided now. We can go back to 2005, but what I am more worried about is where we are now. This is the key issue: that model was simply not able to cope with what was going on in the banks’ business models.

Professor Sikka: I agree with that. I think IFRS not only encouraged under-provision for toxic assets but enabled banks to inflate profits. The realisation principle has been the cornerstone of accounting, together with prudence, for a long time, but the realisation principle itself was diluted. It is a paradox that as banks become more risky their discount rate rises, so the debt number is reduced on the balance sheet, but the accommodating adjustment actually ends up increasing the reported profit. They call it debt valuation adjustment.

Under the old UK GAAP, there is no way you would have been able to show that as part of your income statement or total gains; it would be somewhere in the reserves away from it all. In a sense, the realisation principle has also been diluted. A lot of these things have been diluted, as I indicated earlier, without considering the consequences. It is just that under the influence of certain kinds of economic theories, the IASB thought that somehow the balance sheet could mimic market prices, which is an impossible task and can never ever be accomplished, but along the way they jettisoned certain principles that worked. The previous panel talked about taxation, which is essentially based on a realisation principle; if you have not realised your gains, you cannot pay tax. That would be highly inequitable. In many ways, IFRSs have eroded that kind of issue as well-we might come to that later on. So, yes, I support what was said earlier.

HQ46 Chair: Before we come to that, so that we are absolutely clear, what specific changes would you propose?

Professor Sikka: In relation to UK accounting or banks generally?

HQ47 Chair: You said in your opinion that, although it is very good to get international co-operation if we can, essentially we should do what we think is right. That is why I am asking, in that context, what would you do?

Professor Sikka: There are a whole range of issues, so perhaps I will talk about simple things first and a bit more complicated things in a moment. I think we should restore the prudence principle that enabled companies to build up buffers, as it were, and deal with that.

HQ48 Chair: Including general provisions?

Professor Sikka: Yes. Realisation principles should be a keystone to the financial statements. That said, I think there are inevitable tensions between whether you are looking for financial stability, or you are trying to inform investors. There are two entirely different issues, which may well mean that the regulators have to think about what measures they want to focus on. We are already seeing some of that in Basel III, talking about different categories of leverage, for example, different categories of risk asset. That is very different from giving somebody information to say "Well, okay, you can now go and trade in the market". I don’t think that should be the main purpose of financial statements. That much was said by the Law Lords in the Caparo judgment; that is not the purpose of financial statements, to enable investors to invest. They are saying it is primarily a stewardship purpose. If you are going to move away from that you need to design something entirely different.

There are tensions between those kinds of issues and it may well be that the regulators may have to specify different things. That is not unusual. When we look at the energy sector, people regulating utilities want a particular kind of information. They may require that. We also see from covenants on debenture trust deeds that debt providers impose covenants wanting certain kinds of information to regulate that kind of debt. Otherwise the danger is that we would expect one set of accounts to provide a whole lot of different things that cannot actually be done. We possibly need to go down a different route.

We also need to think about who we are aiming these accounts at. The IASB says investors. I don’t know. When you look at banks’-say, Barclays’-balance sheet, the gross leverage ratio is 24 times. It means that only 4.5% of capital is provided by shareholders. Is that who we should be aiming the whole financial reporting apparatus at? It doesn’t seem very sensible to ignore the other 95.5% of risk takers and providers of finance.

We have a narrow approach by the IASB. It does not seem to fit any of the recent developments. Investors do not appear to have a long-term interest. The average shareholding at banks is probably close to three months, so they are not even the owners. Maybe we need to redesign the accounts altogether, to think about meeting the needs of society. That means a variety of different stakeholders, but regulators will have a different kind of need. We can debate that if you wish, but that is how I see it.

HQ49 Mr McFadden: I would like to ask you all what effect, if any, you thought these accounting standards had in the run-up to the crisis and in today’s circumstances, to go back to what you were saying a second ago, Professor Fearnley.

Let me begin with the run-up to the crisis. One of the criticisms made of the IFRS is about this area of provisioning; you will be familiar with this. The accusation is that under the predecessor regime, banks could make provisions against expected losses, whereas under this regime, it is incurred losses. Could I begin with this? I will begin with you, Professor Fearnley, because you raised this. To what extent do you think, in the run-up to the crisis, that resulted in optimism by us and over-rosy or inflated results in terms of profits booked and balance sheets?

Professor Fearnley: I think you have to look at it in the context of changes in the business models. I have already mentioned that there was a change, which I think was almost running up to the IFRS change, with this banking regulation. They were moving towards an incurred loss.

One of the issues that has always concerned me is that a lot of the changes that have been taking place have only been known about by the accountants. How many people knew that we were gradually moving to an incurred loss? How many people knew that the IASB was busy taking prudence out of its conceptual framework? There were all these things that were happening that stakeholders knew nothing about.

That is a very important point that we need to be aware of. The accounting establishment has been doing all sorts of things that we did not know about, and when we challenged them about it, they told us something different: "Prudence is written into our standards….except where it isn’t". The last bit is what they missed out. We also heard: "Accounting did not cause the crisis, but helped to bring it out."

We have to think about the way the banks were behaving, which is why I said that the model failed at its first point. Obviously, if you under-provide for your loan losses, you inflate your profits; that is the obvious point. You can do what you like with those profits, but you finish up with assets on the balance sheet that are not represented by cash. As that grows-the whole issue is that it starts off maybe small and then it grows-the cash does not represent it. In the end, as can happen with a misrepresentation and overvaluation in any company, the whole thing implodes, because you cannot convert these assets into cash. What was happening was that it kept on growing. The incurred loss did not care that the banks were taking on more and more risky business.

HQ50 Mr McFadden: Is this not like driving only with a rear-view mirror?

Professor Fearnley: I think it is driving with a blindfold.

HQ51 Mr McFadden: If the assets have not gone bad, and that is all you are looking at, this does not teach you anything about whether they might go bad, and therefore blinds you to something like the explosion in growth of sub-prime mortgages, because the defaults, in the end, came quickly and suddenly. A few people saw this, went short against these assets and made a lot of money out of it, but the people who were only looking in the rear-view mirror did not see this coming-I include the rating agencies in this, as well as the accountants. To what degree were these accounting standards responsible for this rear-view mirror method of calculating risk, profit and balance sheets? Professor Cairns, what is your view?

Professor Cairns: I would take issue with the suggestion that it is a rear-view mirror approach. Under the incurred loss model-under UK GAAP and under IFRS-one predicts the future cash flows from those loans. One makes those predictions of expected future cash flows, based on the conditions which existed at the balance sheet date. It is incurred loss model in the sense of looking at the conditions at the balance sheet date and, based on those conditions, predicting what the future cash flow was going to be.

Under an expected loss model, we are still going to have to predict expected future cash flows, but to do it based on something else-not the conditions at the balance sheet date, but some prediction of events or circumstances which might arise in future. That would be a change for banks, whether we are looking at IFRS or UK GAAP. It will be a change in respect of accounting for everything else. One solution to that problem would be to require banks to give some sort of sensitivity analysis of their loan-loss provisions as to future events. We already have, in IFRS financial statements, various sensitivity analyses, particularly where estimates of numbers are uncertain. We could do that with respect to loan-loss provisions, saying, "Well, the incurred loss provision is based on the circumstances at the balance sheet date. Can we look at what might happen if there were changes in economic circumstances?" Where I have some trouble is thinking about whether banks would, in 2006 or 2007, have looked at the possibility of there being the sort of financial crisis which there was in those later years, in doing that sensitivity analysis.

Another solution is the one which Professor Sikka put forward, which is to go back to the idea of building up buffers, having general provisions, which somehow or other attempt to smooth out the ups and downs of the economic cycle. We used to do that in this country 40 years ago. Banks were able to do it because they were exempt from giving a true and fair view of financial statements. The banks stopped doing it voluntarily and subsequently the law was changed, so they now do have to present a true and fair view. We could go back to that, but I would not advocate it. The UK led the opposition to that sort of smoothing in Europe and, indeed, international standard setting. It may well not simply smooth out the bad and the good, but may often, in some cases, hide losses as much as profits.

There is an assumption that if you are smoothing, you are hiding profits, but it actually could mean you are hiding losses. It also produces an absurd situation in the bad year, because it would have meant that in 2008 and 2007-that UK banks would have shown substantial profits, because that would have been the year in which their underlying business had lost money, but they were suddenly releasing some of these buffers into the income statement.

HQ52 Chair: The problem, Professor Cairns, is that, while I agree that the old system that I recall very well did not give a true and fair view, neither does the new system. Anything but.

Professor Cairns: With respect, Sir, I disagree. It does show a true and fair view of what financial statements can portray.

HQ53 Chair: It portrayed the banks to be in a much stronger position than in reality they were. Surely that must be agreed by everybody now.

Professor Cairns: I think that that has been agreed by everybody and, therefore, that is why the IASB, among others, is looking at a different sort of model. It is looking at an expected loss model, which means somewhow or other making predictions about what will happen other than changes in the cash flows.

HQ54 Mr McFadden: I have to say in parenthesis that, from the taxpayers’ point of view, the release of held capital to cover 2007-08 would have been a pretty good outcome relative to the one that we had. I am really trying to probe what effect the assumptions and the rules built into these accounting standards had in the run-up to the crisis. Professor Sikka, what is your view?

Professor Sikka: What you are referring to is an inherent tension between what is needed for financial stability and integrity off the system versus what you think the markets might need. Those tensions cannot really be resolved by one general set of accounts or documents. There are different kinds of concerns.

My starting point would have been to say, "What did we learn from previous banking and financial crises?" Long-term capital management was effectively run by Nobel prize winners in economics. It could not really build the kind of models to, as it were, anticipate market uncertainty crises and get good accounting numbers at the same time. Then we had the east Asian crisis, the Scandinavian crisis and the savings and loan crisis.

I am not aware of how any of the lessons of those crises were weighted into the development of accounting standards. I have seen the various documents; I have not seen any of that. One thing is that we should have learned, if we are making the rules. I haven’t seen any evidence of that. That is why I was saying earlier-

HQ55 Chair: Sorry, what should we have learned?

Professor Sikka: We should have learned how difficult or easy it is to cope with uncertainty, where the risks come from, where the impact is, what happens when the markets are illiquid, which was one of the big issues in the collapse of LTCM, and then considered what kind of accounting, or any other measurement or disclosure rules, would be appropriate.

One approach would be simply to say to the markets, "Look, we are at the limits of accounting knowledge. We actually do not really know a great deal about how the risks are manufactured or what their consequences are. What we would require the banks to do is give you as much information as possible. If you really want to invest in these banks, you work out the figures. We are giving you as much information as possible. We are being honest and saying that we cannot work out these things. They are too complicated.

Typically, when we are building a mark-to-model, some of the models have about 150 different variables. We should say, "We cannot really figure this out. As accountants, we do not really have the expertise to check that those variables or the assumptions are reasonable. If you want to take the risks, go ahead. That is your choice."

That is one option open to us. We keep coming back in various debates to the feeling that somehow accountants can produce a magic number. We have to say, "No. We are at the limits of our knowledge. We have shifted from the world of industrial capitalism to the world of finance capitalism. We do not fully understand how all this works yet."

HQ56 Mr McFadden: What about today? The accusation levelled against IFRS today is that it can act as a barrier to banks seeing and being honest about the true state of their balance sheets. This relates to a discussion about zombie households and companies, which can pay the interest on the loans but none of the principal. There has been some publicity about this in the last 24 hours with the Bank of England making statements about the amount of extra capital that banks may need. I will go along this way this time.

On the question of how the rules affect today’s situation, Professor Sikka, do you think there is validity in the argument that the accounting rules might be playing a role in stopping the banks from facing up to the true state of their balance sheets and therefore from being able to truly move on and regain the confidence of investors?

Professor Sikka: Accounting obviously portrays a picture. It is inevitably abstract; it can never ever be a full picture. Whatever gets put into a balance sheet or income statement depends on the political flavour of the times. That is why we put things like intellectual properties in a balance sheet today, when a few years ago we did not.

We talk about fair value accounting today. A few years ago, that was not the case. Certainly, accounting can portray a particular picture. At the end of the issue, as I said earlier, the question is which way do you want accounting to go? Is it helping the market and investors or is it with stability? I don’t think we can have both. Markets are inherently volatile and that volatility would be imported into any financial statements as long as your numbers are related to any market activity.

HQ57 Mr McFadden: I am not sure whether you are agreeing with the critique I put forward or not.

Professor Sikka: As I said earlier, I am saying that we should be fully conservative, with a small "c" perhaps, to say that we should go back to ideas like prudence, ideas of making general provisioning. It is not in the taxpayer’s interest to have instability in the financial system; it is not even in the investor’s interest. But it may well be in the interests of some people who regularly transact in the market to have financial statements that reflect market values. But is that what we want to serve? So I would say, "Let’s go back to some basic principles" and then the rest would follow from that.

Professor Fearnley: What has been a concern to me, as I mentioned earlier in relation to the financial instruments and the low losses, is that we need to be thinking about bringing some of these transactions back to the realisation and the cash. If you see these things on your balance sheet, okay, are they represented by cash? If you think of a normal trading company, your inventories and your debtors you can turn into cash. These things cannot be turned into cash. We need to move away from that.

I do not entirely agree with Prem about the two sets of accounts. I think the underlying numbers have to be what they are. We cannot have one set of numbers for the regulators and another set for the markets. We have to have a set of numbers that we can believe.

If we go back to what company law says, not what accounting standards said, company law and directors’ duties and responsibilities are about solvency-they are about going concerns and the ability to make distributions. If we take ourselves away from the accounting standards and go back to what the Companies Act says about true and fair-not true and fair in accordance with accounting standards and woe betide you if you shift-we actually want to go back to company law.

We really want to be thinking about where we are in the UK. If I can just remind you, gentlemen, we have the second largest capital market in the world with a very strong financial sector in it and we are the largest capital market using IFRS by far. Therefore we should have a lot more welly than we appear to have about what we want from these standards. We really have to start shouting.

One of the things that I have been horrified about through all of this is the deathly silence from the accounting establishment about some of the dysfunctional outcomes from these standards. This is extremely worrying. I know, Lord Lawson, that the House of Lords Committee commented on the dogs that didn’t bark. Well, I think what we had was the whole accounting establishment morphing into a bunch of Newfoundlands who were swimming away from the maelstrom that they all knew about and they weren’t rescuing anybody. They were rescuing themselves. This is a worrying situation.

All these people-the standard setters, the IASB, the UK Financial Services Authority, the auditors, the professional bodies, everybody-should have been standing up there and shouting, "Hey, this is important to us in the UK", and they did not. I think what they were trying to do was to protect the idea of global standards. You can look at the various self-interested issues that are sitting in there.

HQ58 Mr McFadden: Did it result in an optimism bias? That is what I am trying to find out.

Professor Fearnley: Sorry; I have digressed a little. I audited some simple financial institutions many years ago. You look at different parts of the portfolio. Some parts are much higher risk than others and you charge more interest. Effectively, what you have to do is to accept at the time that you set it up that there is a risk.

If you do not have to take account of that risk, because it has not defaulted, of course it is optimistic. In fact, one of the witnesses from HBOS talked about optimistic accounting and optimistic provisioning. What you are actually talking about, if we are perfectly honest about it, is aggressive accounting. I would substitute "aggressive" for "optimistic".

Professor Cairns: There are a lot of issues. To link back to the previous session-

HQ59 Mr McFadden: I want to focus on the question of how the standards are affecting the judgments today.

Professor Cairns: That is what I am on the look-out for. You prefaced your question with some references to transactions that are currently taking place. One of the problems that we face, whether we are looking at this session or the previous session on taxation, is the efforts by some companies, aided by bankers, lawyers and accountants, to structure transactions in a particular way to achieve a particular end, whether it is for financial reporting purposes or for taxation purposes-or, indeed, for some other purpose in order to pay bonuses.

In my experience, and I have not looked at all possibilities, the structuring tends to be towards deferring the recognition of losses, accelerating the recognition of profits and removing liabilities from the balance sheet. Therefore the standard setters are for ever having to do a catch-up to keep up with these sorts of efforts. I would like to think that by some general principles the efforts to structure would be thwarted, but that simply does not seem to work.

HQ60 Mr McFadden: So you are saying that if there is an optimism bias, it is not the fault of the accounting standards.

Professor Cairns: I am saying it is the preparers of those financial statements, with the aid of their advisers, structuring things to achieve a particular aim. One can say that the accounting standards are out of date-that they were written three, four, five, 10 years ago and need to catch up with these things, which is why the IASB is now looking at its loss model for loans and advances.

HQ61 Lord McFall of Alcluith: I want to look at the role of auditors. Auditors came before the Treasury Committee during the financial crisis and they explained what their role was. I asked them, "What is the point of an auditor? What is the role of an auditor?" I remember the answer to Lord Lawson’s question in the House of Lords Committee when John Connolly of Deloitte said that they would maybe have had a different interpretation of the going concern of the bank had they not had the Government standing behind it. There seems to be variability here. So what is the point of an audit?

Professor Sikka: There is a whole range of issues. Auditors have been the real weak link in the banking crisis. Let me start at the beginning. The FSA or its successor is given the responsibility for regulating banks, but it does not have the power to set accounting rules or to appoint auditors, and it does not have the power of statutory access to the auditors’ working papers. Auditors do not owe it a duty of care, yet there was talk that the auditors and the regulators would meet and discuss. My written submission cites the example of Barings Bank and how the Bank of England was unable to get access to the people who actually did that bank’s audits, on the basis that UK-based firms had delegated that part of the work to an office in Singapore, and it had no jurisdiction in Singapore. There was a whole range of problems. On top of that, auditors should have qualified the bank account, and there are historical examples of when they have. Many banks-

HQ62 Lord McFall of Alcluith: Professor Sikka, what is the point of an audit?

Professor Sikka: Auditors would say that it is to give an opinion on whether the financial statements show a true and fair view. We then have to decode what that means. My argument is that auditors should have been telling us that there were financial difficulties with some entities. I believe it is their duty.

Nowhere in the Companies Act does it say that auditors are not required to provide any warning about a company not being a going concern. It does not say that they are not required to do that, but the auditors deny this. So I say that auditors should have been telling us. They should have been aware that banks such as Bear Stearns had a leverage of about 33 to one, and that for about five years before its demise, almost all its income came from speculative activity. Sooner or later the financial horses were not going to come home-and they did not. But the auditors should have been aware that this was how the bank was generating its revenue. It was the same at Lehman Brothers; there was very high leverage, so the auditors should have alerted us to going concern problems.

HQ63 Lord McFall of Alcluith What you are saying is that auditing is a backward-looking process, rather than having both backward-looking and present elements to it-that is what you are saying if you are talking about leverage and whatever else-and also that the audit report may be a bit narrow. I am trying to get this into a few words, rather than the few thousand words that you have given me.

Professor Sikka: I think the auditors also have to look forward. There are lots of forward-looking assumptions in accounting, whether about depreciation or assets or prepayments. Certainly when it comes to whether something is a going concern, they should be considering the immediate future, at least, if not the next 12 months. But in the case of banks, it was evident that they had been having very, very high leverage for a long time. That was listed as one of the going concern problems in the auditing standards.

Professor Fearnley: The legal responsibility of auditors is very simple: just to say that the accounts comply with accounting standards in the short view. Although I am not saying it would have made a lot of difference, one thing to consider is whether after the IFRS came in we had a proper, true and fair view. There has been a lot of discussion about this, and I think it is something the panel needs to bottom out. The purpose of the true and fair view is to make sure that the accounts meet the requirements of the Companies Act.

There has been a lot of debate about where the true and fair view lies in all this. I think the key to it is that true and fair view is about economic substance, and we need to know whether the true and fair view was used in these circumstances. I think that this is the purpose of audit and how audit is done, and the information auditors provide to consumers. This does not only concern the shareholders, because we have to remember that audited accounts are a public good and they are in the public interest. Although not everyone has a claim on the auditors or the company if things go wrong, if people do not know whether an organisation is solvent and trading well, all sorts of other people can be involved.

We really have to look at whether the audit report has died a death. Should we be looking for other things from the auditors? There has been a lot of ducking and diving in the past, and we also need to be mindful that the accounting is predicated on US accounting standards, which are predicated on litigation defence. That was something that we did not want in this country, because there are all these bright rules and lines and so on. Litigation in the US is part of the creditor protection game, and it is a very different thing. We have to look at what auditors are being required to do and ask ourselves, "Is this what we want?" Maybe I am getting on to the expectations gap here.

HQ64 Lord McFall of Alcluith: No, that’s good. What you are saying is that we are at the second juncture at the moment and it is time for a fundamental reappraisal-fair enough.

Professor Cairns: I agree with that, and you may be pleased to hear that there are a couple of things that Professor Fearnley has said that I also agree with.

Professor Fearnley: Wow!

Professor Cairns: I agree that the Companies Act requirement about the role of auditors is narrow. I also agree that a true and fair view means economic substance. That is how I would define true and fair view, and if financial statements do not report the economic substance, changes should be made to them, and if changes are not made to those financial statements, the auditors should issue a qualified opinion. Where I do disagree is whether or not true and fair still exists. I think it still does exist, and I can certainly speak from my experience as a member of the Financial Review Panel that we look as much at true and fair as at compliance with standards.

HQ65 Lord McFall of Alcluith: Okay, we don’t want a fight. Professor Sikka, on you go.

Professor Sikka: One of the problems is that this idea of true and fair is very appealing, but in reality it has become a box-ticking exercise. Accounting firms will use checklists, comply with accounting standards, and make this disclosure and that disclosure, but the Companies Act says that in pursuit of true and fair, the accounting standards and other things can be overridden. The question then is whether there is any evidence that the auditors look beyond this tick-box mentality. There is very little evidence to that effect.

HQ66 Lord McFall of Alcluith: That leads on to my second question. It is a common criticism that IFRS are too complex and lead to box-ticking. To what extent should box-ticking allegations be levelled at auditors, rather than at accounting standards themselves? Do you think it is the auditors?

Professor Sikka: The auditors are appointed, as it were, as watchdogs, as some people say, so it is their responsibility. Obviously there is some management responsibility as well, but if management could be entirely trusted. One might say you don’t really want an independent opinion, so we invite auditors to give an independent opinion, but the auditors have entirely different kinds of considerations. Legal issues are mentioned-I might come back to that later. They are concerned about the time they might have to spend on the job. They want to get the audit work done within a particular time, so this kind of tick-box approach applied long before the auditors appeared.

HQ67 Lord McFall of Alcluith: Professor Fearnley, is it auditors rather than accounting standards themselves?

Professor Fearnley: The tick-box complaints came in after 2005-no, we had a big reform after the Enron collapse. In 2005, the international standards on auditing came in as well and the audit inspection unit also started to function. Therefore there was a lot of pressure on auditors to comply. This was where the tick-box stuff came from. We have to look to see whether the auditing standards, the accounting standards and the AIU have changed the nature of how audits are done detrimentally. Certainly the research I did with Vivien Beattie and Tony Hines showed that although this had improved the audits where people hadn’t been doing them properly before, it had actually created a lot of box-ticking. It is certainly something that I am concerned about anyway. We have to look, as Prem has already referred to, at the way audit and accounting are regulated. Auditing and accounting sit with the FRC and BIS and, in my view, they were all part of the Newfoundland dog bit. So we have to look at the links between that and the FSA, and where the accountability actually lies.

HQ68 Lord McFall of Alcluith: I am getting stopped by my kind and considerate Chairman, so I will try to get out quickly. When we examine Northern Rock in the financial crisis, the relationship between the auditor and the regulator did not exist. I think the Committee suggested at the time that there had to be a more formal relationship between the auditor and the regulator. Should we turn that into a duty of care on the auditors’ part to the regulator?

Professor Fearnley: I believe so.

HQ69 Lord McFall of Alcluith: Professor Sikka, give me a quick answer.

Professor Sikka: I think you need an entirely different structure, and I have put that in my written submission. I believe a state body should be auditing all financial enterprises, because think of the hurdles. You have got to get access to the auditors’ files. You need to act on a real-time basis-

HQ70 Lord McFall of Alcluith: Let me stop you there. Professor Cairns.

Professor Cairns: It is not really my field, but my answer would be yes, there should be a duty of care to regulators.

Lord McFall of Alcluith: Two to one. I am going to stop at that.

HQ71 Chair: I shall exercise the Chairman’s prerogative of asking the last questions as well as the first.

I have just one last question on auditing, but before I get to that, just for clarification, Professor Fearnley, did I understand you to say that unrealised paper profits-notional profits or whatever you like-should somehow be corralled and unavailable for distribution in dividends, bonuses or in any other way? Were you proposing that?

Professor Fearnley: Yes.

HQ72 Chair: And this would be a change from the present state of affairs.

Professor Fearnley: I think that in the UK, if we do have a true and fair view, we should start thinking very seriously of suggesting to the Bank of England that we should use an override in the UK and say rats to the IASB, to be honest. I think it is such a serious matter that if our banks are undercapitalised, let’s get it out on the table. Once we know that, we can deal with it. If we gave ourselves the authority to override the accounting-I cannot see why we should not; we need to explore this-a lot of things would fall into place. I suspect that other countries might be equally unhappy, but as we have the biggest capital market involved in it, we will be more unhappy if we have to carry on with it. Part of the problem is that it takes ages to change. You cannot trust the organisation and you cannot change the structure around it, so let’s just get on with it.

HQ73 Chair: Finally, following on from what Lord McFall was asking about, we have heard Professor Sikka’s proposal that the big four should be told to go away and that we should have a state auditor who audits all the banks. We may not go down that route and stick with having auditing firms audit the banks. If I may correct Professor Sikka on one thing, he cited Barings as an example of when the Bank of England had no access to what the auditors had discovered. That was absolutely true, but it has changed. In the Banking Act 1987, for which I was responsible, I broke down that iron curtain of confidentiality, and indeed encouraged dialogue between the auditors and the supervisors. This worked for a short time, and then it fell into desuetude. Do you think it would help if it were recreated and made to work? Do you think that would be desirable rather than a code of practice? I understand that the Government and Bank of England say there should be a code of practice by which the auditors and the supervisory or regulatory authority talk confidentially to each other about bank accounts, so that even if the accountancy system does not give a completely true and fair view for all purposes, any concerns that the auditors have will be relayed to the bank. Do you think that if this dialogue were made a statutory duty, that would be an improvement?

Professor Sikka: I think the way of putting it is very persuasive, but I am looking at historical evidence. In the case of BCCI, the Bank of England and PricewaterhouseCoopers, according to the US Senate report, effectively engaged in a cover-up. The proposal we are making is ostensibly for protecting the public for the benefit of the public, but the question is: what exactly are the public going to be told about these meetings? Are we going to see the minutes?

HQ74 Chair: No, of course not.

Professor Sikka: Why not? I think that is an issue, because the tendency in this country is for elites to do deals in the name of public interest name and then not tell the people. We can see the Bank of England Monetary Policy Committee’s minutes. Should we not see other kinds of minutes? I would be more interested in knowing how the public are going to be informed, because going back to the time of BCCI, it is to this day one of the few banks where inspectors never got appointed, and the Sandstorm report is still a state secret in the UK. I had to fight five and a half years’ litigation under freedom of information law to get the names of the wrongdoers who are covered up.

I think we should be privileging the public interest-the public’s right to know. If the regulators, auditors and others are reaching some deal behind closed doors, I believe that the depositors and taxpayers deserve to know that. I do not believe there should be complete secrecy about it.

Chair: The sounding of the Division bell means that this is an appropriate time to end the session. I think that most people accept that the difficult task of bank supervision cannot be done in public, but that is another issue. Thank you very much to all of you.

Sitting suspended for a Division in the House of Commons.

<?oasys [pg6,cwe1] ?>Examination of Witnesses

Witnesses: Hans Hoogervorst, Chair, IASB, and Sue Lloyd, Senior Director of Technical Activities, IASB, examined.

HQ75 Chair: Mr Hoogervorst and Ms Lloyd, thank you very much for coming along. We are extremely grateful. I am sorry for our discourtesy in keeping you waiting a little bit because of the Division in the House of Commons. It is a busy time generally, in parliamentary terms, so we are slightly depleted now, which we hope that you understand.

Before we ask questions, is there anything you would like to say to us, Mr Hoogervorst? You know the subject of our inquiry.

Hans Hoogervorst: Thank you, Lord Lawson, for inviting me over here. It is good to be back in a Parliament. I used to spend a lot a time in Parliament, albeit not this one. It is an honour to be here and to be able to give some information to you. I would like to make a couple of general comments on where I think our IFRS held up well during and leading up to the crisis, and where they were clearly in need of improvement, because both were the case.

I have been triggered a little by what Professor Sikka said when he was talking about what had gone wrong and what went well. He said that the auditors should have warned us that Bear Stearns was leveraged 33 times. The fact is that the financial statements, as produced under IFRS, showed very clearly in the period leading up to the crisis that banks were excessively leveraged. RBS was leveraged 42 times at the end of 2007, and one glance at the balance sheet could have taught you that that was the case. Our numbers very clearly showed that there was excessive leverage in the system and that the banking system was in a perilous state.

What we also showed very well was that there was an explosion of the balance sheets-of the assets of banks. In that respect, IFRS were more successful than US GAAP, because our standards are stricter. Our consolidation requirements are much stricter, which meant that, in Europe, there were fewer problems with special purpose vehicles, where all these poisonous instruments were hidden-that was the case to a much lesser extent in Europe than in the United States. IFRS also require banks to show all derivatives-or almost all derivatives-on their balance sheets, whereas in the United States, under US GAAP, they can be relegated to the notes. That is why, under IFRS, a banking company such as JP Morgan would have a balance sheet that would be about 30% higher than under US GAAP. In terms of showing how vulnerable the balance sheets of banks were, I think IFRS did a good job. The main question is why nobody paid attention to it-I can tell you more about that later, perhaps.

But then, what did not go so well? That was what the previous people were talking about. It was the incurred loss model-the level of provisioning. Let me begin by saying that I think even the incurred loss model as it still exists now could have been applied much more vigorously. For example, it took banks up to 2011 to start recognising the impairment of Greek debt. Once it happened, it was unevenly applied across Europe. I wrote a letter to ESMA, the European securities regulator, to ask it to do something about that.

Having said that, there were two vulnerabilities or weaknesses in the incurred loss model. First of all, the way it was phrased gave too much leeway for banks to procrastinate recognising their losses and facing reality, which caused too low a level of provision. Secondly, it also led to some degree of front-loading of profits. For loans that have a high risk, you normally ask a high-risk premium-so a higher interest rate-with the expectation that part of that will be destroyed by later losses, so you begin by recognising the profits, and your losses come during the crisis. That was bad timing.

Those were the two reasons why we decided to change the model. We are very busy finalising a new model, which is the expected loss model. It will mean that banks will have to take some provisioning for all assets, even if they are not visibly impaired. The trigger for taking a full lifetime loss will be much lower than in the current incurred loss model. Banks that have looked at our new model and have done calculations assume that their level of provisioning will go up-some say 30%, others say 100%, but we can safely assume that it will be quite substantial.

Having said that, I would warn you that even an improved expected loss model would not have given enough safeguards. It would have helped, but it could not have provided sufficient safeguards for the huge unexpected losses that occurred during the crisis. To give you one example, one European country worked with a sort of expected loss model: Spain. They called it dynamic provisioning. Based on historical analysis, they required banks to take a higher degree of provisioning than was the case in the rest of Europe. It helped a little, but ultimately they were completely overwhelmed by the enormity of the crisis.

To sum up, I don’t think, in general, that our standards led to an overly rosy picture of the banks. It was clear that they were in a very dangerous shape and we all chose not to look at it. There was a weakness in the incurred loss model, and we are very busy improving it.

Chair: Thank you very much. I turn to Pat McFadden, because I don’t think he will be able to stay as long as the rest of us.

HQ76 Mr McFadden: I will ask only one question. I apologise, but I have to go in a few minutes. Given what you have said, I will not go over the run-up to the crisis, but you were listening to the last session and I just want to ask you a question about today. We know that there is still doubt about the balance sheets of banks across Europe, including here in the UK. We know that investors are unsure about what they own, and we know that this doubt about balance sheets is a contributory factor to the fact that most of them are trading at less than their book value. To what degree are your accounting standards contributing to this problem in the sense that they may not be forcing banks to focus on the impaired assets on their balance sheets?

Hans Hoogervorst: First, I am neither an auditor nor a regulator, so I have to be careful here. I cannot look into banks’ balance sheets to see what they are really doing. It is interesting that we require banks not only to state their loans at historic cost, but to give the fair value of the loans, which is more of an expected loss model than historic cost. The Bank of England demonstrated in its financial stability report that the fair value of the banks’ loan portfolios is now lower than what they have on their balance sheets. The Bank of England, and many other market regulators and participants, are afraid that because interest rates are so low, there is huge encouragement to procrastinate on recognising losses and to evergreen loans. I would not be surprised if that is still going on to a great extent. Given the seriousness of the economic situation, under the incurred loss model, you are able to recognise these losses.

HQ77 Mr McFadden: You are?

Hans Hoogervorst: I am certain you are.

HQ78 Mr McFadden: So you reject the criticism that because these losses have not really been incurred, but are likely to be incurred when reality comes back, in terms of higher interest rates, that is not contributing to putting off the inevitable.

Hans Hoogervorst: I heard one of the previous speakers say that under the incurred loss model, a loan has to be in default before you can recognise the loss. That is not the case. If there is a very serious deterioration in the financial condition of a firm, or in its economic environment, even under the incurred loss model you can recognise a loss before a default and before it is written off. It is my conviction that banks have been very hesitant to do so.

HQ79 Chair: You say that is your interpretation, and you say that banks have been hesitant, but have the big four-the big three, really-that audit the banks been slow to realise this?

Hans Hoogervorst: I have to be careful here, because I am not an auditor and I cannot second-guess their work. That is up to the regulator. I used to be a regulator of audit firms and we frequently asked them to improve their work, so that is nothing new. I gave you a concrete example of the Greek situation where it was very clear that even though the country was not officially in default, there were such serious problems that even under the incurred loss model, banks could have taken those losses earlier. When it finally occurred in some countries, they took 22%. In other countries, they took 80%, and it ended up being 80% across the board. It is clear that auditors have to play a part.

Mr McFadden: Thank you. I am sorry that I cannot stay for the rest of the session, but I leave you in very good hands.

HQ80 Lord McFall of Alcluith: This is an aside to the main question. I think I remember being at a conference with you about five or six years ago during the financial crisis when you stated that mis-selling was in the DNA of the financial services industry. Am I correct?

Hans Hoogervorst: Did I say that?

Lord McFall of Alcluith: Yes.

Hans Hoogervorst: I might well have said it. I used to be a conduct of business regulator.

HQ81 Lord McFall of Alcluith: It was quite a long time ago. What advice have you got for us now in 2013? Given your statement, what should we be looking at as a Commission?

Hans Hoogervorst: Mis-selling is, of course, a very different piece of cake. As a regulator, I was very fortunate. I became a regulator in September 2007, which was just after the outbreak of the crisis, so I was not responsible for the crisis itself. The first thing I did was to try to find out what had happened. Then I discovered the numbers that I just gave you-banks that were 30, 40 or 50 times leveraged. A normal company has equity of 30%, 40% or 50%. We know that banks can have a little bit less, but 2% or 1%-who invented this system? It was so clearly completely perilous. The tragedy was that, in regulatory terms, the Basel ratios, which were based on our accounting numbers, came up with very different figures. Basically, the Basel regulations allowed banks to risk-weight their assets, so if you had sovereign bonds, they counted for 0% on your balance sheet, because sovereign bonds were safe-we know differently now. Mortgages accounted for 50%. That was how a bank such as the Royal Bank of Scotland, which had a leverage ratio of 42-so real capital of just over 2%-had a regulatory capital ratio of 11.2%. Miraculously, that is five fold the real number. That is where things have gone wrong. Everyone was focusing on the regulatory numbers instead of the normal accounting numbers, which gave all the signals of what was going wrong. But the fortunate thing is that right now, because of the revision of Basel, the numbers are coming together again. Basel introduced a leverage ratio, which is basically an unweighted ratio of total balance sheet relative to capital.

HQ82 Chair: Do you think it is average?

Hans Hoogervorst: In Basel III, it is 3%, which is extremely low. I completely sympathise with people such as Andy Haldane, who has said that it should be at least 5% to 10%. Thomas Hoenig, who is the chair of the FDIC, has said that it has to be 10%. I completely sympathise with that. Then you have a buffer, which you can get through a crisis with, but 3% is still very low.

HQ83 Lord McFall of Alcluith: Andy Haldane has also spoken about Basel. I think we had Glass-Steagall at 37 pages, Basel I at 150 pages, Basel II at more than 300 pages, Basel III at more than 600 pages, and Dodd-Frank with well over 1,000. By the time we have the appendices, we could end up with 30,000 pages. Is this not just a game? We are adding complexity on complexity, and the people right at the centre do not understand it themselves.

Hans Hoogervorst: I have to show a little humility here. We have 1,328 pages. That is a lot better than US GAAP, which has 7,300 pages.

HQ84 Lord McFall of Alcluith: How is it that we can get by in religion with the 10 commandments, but we get a thousand-odd pages for this, for God’s sake?

Hans Hoogervorst: I completely agree. It is much better to have rough and ready measures than these very complicated standards, and a leverage ratio is one of those.

HQ85 Lord McFall of Alcluith: It seems almost a futile exercise we have set ourselves. Will we ever get out of this? Will we just keep adding complexity and complexity and have a parliamentary Commission in five or 10 years’ time when the historical memory is lost?

Hans Hoogervorst: It is a big problem. I do not think that life, especially in the financial sector, will become simple. The accounting has become complex because reality in the banking sector is extremely complex with all these derivatives. Once you have derivatives, you have a lot of complexity. I think that regulators can do a lot to reduce it, but to eradicate it will be very difficult.

HQ86 Lord McFall of Alcluith: May I ask a technical question before Lord Lawson pulls me up? Can anything be learned from the insurance industry, for example the use of the European embedded value system? One of our contributors has said that insurance companies do not use IFRS because the standards setters had not got to grips with it. There is, therefore, a precedent for industries not to use it when the business model is too complex.

Hans Hoogervorst: Of course, insurance is a very different business from banking, although if we talk about mis-selling being in the DNA, the insurance industry has also shown a lot of problems-PPI for example. With regard to the embedded value approach, we are now developing a standard for insurance, which is really necessary, because we don’t have a proper standard right now. We do use the embedded value; we have sort of incorporated the philosophy of the embedded value approach. I agree that it is relevant.

HQ87 Chair: I was very interested in a speech that you made a little while back in which you said that the old definition of prudence that was written into accounting standards was spot on, but it was removed in the desire to achieve convergence with US GAAP, which does not have prudence. Ironically, it is now clear that there is no need for convergence; the US is going ahead with its own system and the rest of us have to decide what we are going to do. Do you think that makes a conclusive case for writing prudence back into IFRS-the accounting standards?

While I am on that, you mentioned the lessons of the banking meltdown. You said that one lesson was that the provisioning rules needed to be different. Are there any other lessons for accounting standards apart from that?

Hans Hoogervorst: On the concept of prudence, let me state first that it was removed only in 2010, well after the outbreak of the crisis. In the period before the crisis, it was in our standards. It served its purpose at that point, so I don’t think that bringing it back will lead to magical results.

HQ88 Chair: Unfortunately, nothing will lead to magical results. You are setting the bar a little too high.

Hans Hoogervorst: Yes, but I don’t think it will lead to fundamental differences. In that same speech, I said that the definition as we had it was, basically, if you are in doubt about results, please be cautious. That is a very good principle and I think that it is still ingrained in our work. The reason why it was removed was because we felt that it was being abused, or misunderstood, to underestimate artificially the value of assets, and we like accounts to be as neutral as possible.

In itself, it seems very appealing to create hidden reserves in good times so that you can release them in bad times. However, as Professor Cairns has already said, the big problem with it is that if you do what we pejoratively call "cookie jar accounting"-you put cookies in a jar and "release" them when times are bad-is that you then mask hidden losses when times are bad, and investors need to know what is going on.

As I said, however, in all our standards-I have mentioned consolidation, very strict, and derivatives, very strict-in the use of fair value when there is a mark to model, which, by the way, in the banking sector is only max. 3% to 4% of total assets. But if it is applied, we ask banks to make a risk adjustment. We are trying to get leases on the balance sheet, because there is a lot of hidden leverage through leases on the balance sheets, or outside the balance sheets, of companies, and we want them to bring it on the balance sheets.

Caution is ingrained in our way of work. So sometimes I feel that we got rid of this prudence concept for various reasons, but we have really given our critics a stick to hit us with, and perhaps from a political point of view it was not such a fantastic move. Has it made a difference in our way of working? No.

HQ89 Chair: Are there any lessons at all that you have learned, so far as accounting standards are concerned, from the banking meltdown, other than the one point you raised about provisioning?

Hans Hoogervorst: First, that you should indeed be extremely strict in what you allow to be off balance sheet, and that if things are off balance sheet you should ask for adequate disclosures.

I think that another thing that we redressed as a result of the crisis was the fair valuing of own credit, which led to very counter-intuitive results. When a bank is in trouble, the market value of its bonds goes down and that leads to diminution of its liabilities, which in turn increases profits-totally incomprehensible. For the investor, it is important to know that the fair value of bank bonds is going down, because it is a very important signal that the bank is in trouble. But that we allowed it to go through P&L-profit and loss-was a big mistake because it gave a very counter-intuitive signal, and so we decided to remove it from the profit and loss. This has been redressed in IFRS 9. Unfortunately, that standard has not been endorsed by the European Union yet.

HQ90 Mark Garnier: I want to carry on with that fair-value line of questioning. Let me get this absolutely right-if a bank’s bonds have gone down in price, the liability is valued at the market value of the bonds and not the outstanding principal?

Sue Lloyd: Only in narrow circumstances. In the vast majority of cases, bank debt and everybody’s debt is measured at amortised cost. In some exceptional cases, they are measured at fair value. It is usually either because they manage things on a fair-value basis, so they think it is more representationally faithful, or it is very structured debt products, where amortised cost does not give a very full measure of the value of the instrument. In those narrow cases, then, yes, an entity can measure its liabilities at fair value and it is in those situations that we have made changes to present differently the own-credit effects of that.

HQ91 Mark Garnier: That is very interesting. The whole concept of this marking to market, and you made a very good point that actually when you look into complex derivatives and that kind of stuff it is only a very small part of the balance sheet. None the less, complex derivatives can have a zero value, yet have an extraordinarily high liability, given the fact that something could change and that’s not factored in. I would like to dig deep into your thoughts about fair value and marking to market?

Hans Hoogervorst: Generally, we try to look at it in a pragmatic way. We have never proposed a full fair value approach of the balance sheet of banks, such as our America colleagues did at some time. We have always said that you need both measurement techniques; you need both fair value and amortised cost. Fair value is inescapable for instruments that are actively traded on a market; market prices are very important. It is also unavoidable for derivatives because many derivatives start with zero cost; if you would keep it at zero it doesn’t give any information on what is going on with the derivative. For regular loan portfolios, amortised cost is much more appropriate. We have always been an advocate of a mixed measurement approach, and we will probably remain so in the future.

There has been a lot of academic research into the effects of fair value in the crisis. Most of the research pointed out that most of the problems in the banks were in the traditional assets such as mortgages, which were valued at amortised cost and that fair value played, at most, a very small role.

HQ92 Mark Garnier: On a slightly different subject, as you know, we have had some sessions on the role of auditors. One slightly oblique question is: do you think auditors and accountants have a greater role to play in terms of analysing the corporate governance and the management of an organisation that should be published so that investors and regulators can see it?

Hans Hoogervorst: I am not quite sure about corporate governance. In my previous position as chairman of the Dutch FSA, I did give a speech in which I pointed out that it was remarkable, given the obvious dangers in the banking system, that to my knowledge no auditors had raised issues of going concern. In that same speech I also said that I can very well imagine why they didn’t do that in public; once you do that in public about a bank, the bank is broken.

Mark Garnier: Unless what you’re saying is very welcome.

Hans Hoogervorst: You organise a run on the bank. I said that there should be a very intense dialogue between the auditors and the regulators so that they can give the signals to the regulators. That was a practice that existed in the Netherlands, but I don’t know if it fell into disuse, but it was certainly not very active. I also think that auditors did their work in a world where everybody thought that the situation in the world was hunky-dory. Regulators don’t see anything, despite all this leverage. I think that the auditors were relying on the regulators to take care of going concern, to tell you the truth. That’s a reason why they were not so very critical. I think they need to be more critical. I appreciate that they are in a very difficult position to raise it in public, but I think they should do it with the regulators.

HQ93 Mark Garnier: Do you think there should be a statutory requirement that they do it to the regulator? That they provide an audit of competence to the regulator?

Hans Hoogervorst: That could very well be a legitimate political choice.

HQ94 Chair: I would like to follow that up because it is quite clear that the auditors did leave it for the regulators, and yet they weren’t speaking to the regulator. Equally, the regulator was not speaking to the auditors. It is common sense that they should be, from the point of view of the regulator. You said it, you previously regulated so you know this very well. Do you agree with Mark Garnier that it would be desirable for there to be a statutory duty for the auditors of banks and the bank regulator or supervisor to be in dialogue, so that if the auditor is concerned about a bank, he can express his concerns to the regulator, and if the regulator is concerned about a bank, he can maybe ask the auditor to look more deeply into it? Do you think that that kind of statutory duty would be helpful?

Hans Hoogervorst: It is such common sense to do so. I am trying to find reasons against it, but I cannot seem to find them.

HQ95 Chair: That is a very important point-thank you.

The other thing coming out of your evidence is that you referred to the delay in getting agreement over IFRS 9. That must be of some concern to you, because you obviously think that IFRS 9 is an improvement on what has gone before, and therefore you very much want to see these improvements. I am not asking you to give advice, which would be difficult in your position, but what would you think if this Commission were to say that, because of the huge importance of the financial sector to the British economy, we should go ahead unilaterally with the changes recommended in IFRS 9 rather than wait for there to be a European agreement?

Hans Hoogervorst: First, that would have to be negotiated between your Prime Minister and the European Union, because I do not think that you could possibly do that at this point in time-it is European law.

HQ96 Chair: But there is such a thing as national law as well as European law.

Hans Hoogervorst: Yes, but it cannot override European law.

HQ97 Chair: So if we wanted to have better accounting standards in these areas, and there is something on the table that you have agreed is an improvement, we would be taken to the European Court if we tried to introduce it in this country, is that what you are saying?

Hans Hoogervorst: Yes, but I do not want to get drawn into the British debate on Europe. Of course, I am very sympathetic to this idea-the sooner our standards are adopted, the better, and this is a very good proposal, but other countries in Europe would probably want to change their own little things, and those would not necessarily be improvements. Let me just put it this way: investors around the world invest around the world. British investors need to be able to invest outside the United Kingdom, and they do so. For them, it is of the utmost importance that we have a single set of global standards, or at least a single set of standards that is used very widely in the world and applied in the same way. If every country went its own way, it would become a mess again. We have made tremendous progress in the last decade, and now accounts in Korea, which is a very important economy, are comparable to accounts here in Great Britain. That is tremendous progress. Accounts in Brazil, another important growth economy, are comparable to those of Korea and the United Kingdom.

HQ98 Chair: In theory, yes, but how much of that is there in practice we shall have to see. The United States, which is even more important than Korea or Brazil, is going its own way, isn’t it?

Hans Hoogervorst: For the time being, that seems to be the case, and that is unfortunate. However, there is not much that we can do about it. Obviously, they had to make that decision in a very difficult economic time, during the financial crisis. I do not know whether the European Union would have been able to take such a position in the middle of economic upheaval. In the long term, I am still very optimistic that the United States will come on board, but it will probably take a little longer than is desirable.

HQ99 Chair: One focus of elucidation that I have-I do not know whether my colleagues have any other things that they want to ask-is to be absolutely clear: are you entirely happy with the fair value accounting, marking-to-market model, as exists at the present time, or would it be healthy to see changes? As Mark Garnier, who has just had to leave, said, although it is true, as you say, that the sort of instruments that are mark to model are a small part of the banks’ balance sheets, nevertheless, they can regularly incur a 100% loss, which makes them rather more important than their overall share of the balance sheet.

Hans Hoogervorst: That is true, and given that banks have such a low level of capital, which is often no more than 3%, mark to model, if it is completely faulty, it is very important, so I agree with you. Overall, I am pretty happy with our requirements on fair value and to which categories of instruments they apply. We do not have it across the board, but it is the appropriate measurement method in a certain number of instruments. We have greatly improved the application guidance for fair value, especially for mark to model, where we have required banks to give a clear overview in their notes, not just of the number that they arrive at, but of different scenarios-good scenarios, bad scenarios-so that the investor can really see that it is not an exact number, but an estimation. We have to be very careful, and if things turn out not as well as the bank is predicting at the moment, it could be a terrible loss. All that information is there at this moment. So I think that we did a pretty good job of improving the quality of fair value reporting.

HQ100 Chair: On that happy note, I thank you very much indeed for coming here to give evidence to us today. I wish you the best of luck. I suspect that the most important thing that you have been saying-you have been speaking not only in your present and important capacity, but as a former regulator and a former Finance Minister, which puts you in very good company indeed-is about how, if there were a sensible leverage requirement and a sensible capital requirement for banks, it would not be so troublesome for the accountants and auditors.

Hans Hoogervorst: In the 19th century, which is of course a long time ago, banks had capital of 25%. Okay, that might be overdoing it a little, but whoever invented the idea that banks could get away with 2% or 3% capital-that just does not make sense.

Chair: Thank you very much indeed.

Hans Hoogervorst: Thank you.


[1] Witness Correction: I should have said ‘the alternative for the bank is to raise new equity of 100 instead of borrowing 100’ and not ‘the alternative for the bank is to raise new equity of five instead of borrowing five’

[2] Witness correction: I should have said ‘six UK banks’ and not ‘eight UK banks’.

[3] Note by witness: I did not explain this point well and would like to expand on it. Under IAS 39 no provision can be made when a loan is set up ie against the inherent risk in a portfolio. A provision can be made after an event or events subsequently occur which justify a provision. This could be a default or evidence that a specific exposure or group of loans is seriously at risk. The evidence needs to be objective.

[4] Note by witness: A further point to make here is that some banks had general provisions which are not allowed under IAS 39. For example Barclay had a general provision of £564m at the end of 2004.

Prepared 24th June 2013