Supplementary letter from Mr John Griffith-Jones,
KPMG (ADT 35)
I am now writing in relation to the remaining
points in Mr Sinton's letter and my responses, on behalf of KPMG,
are set out in the Attachment to this letter. I am very much conscious
that there is much material in here that I had brought with me
to the oral hearing but which it was impossible to get over in
the time allocated, particularly given the way the questioning
developed. If the Committee would like to discuss these issues
in more detail with my banking expert colleagues we would be pleased
to do so.
17 December 2010
ATTACHED MEMORANDUM
BY KPMG
SECTION 1—AUDIT
OPINIONS ON
THE FINANCIAL
STATEMENTS OF
BANKS FOR
2007 AND 2008
How going concern judgements as part of audits
of banks were reached before and during the financial crisis of
2007-09. The Committee is particularly interested in how auditors
reached unqualified going concern judgements on banks for the
year ending December 2007 only for some of them to collapse in
2008. The Committee would also like to know what was the basis
for going concern judgments on banks' financial statements in
December 2008 when some banks were already in trouble.
In order to address this question we have referenced
the timeline of the key events as the financial crisis unfolded
so that the dates that audit reports were signed can be put into
context. We have also provided some general information on the
auditor's consideration of going concern and how that relates
to banks in particular.
Timeline of key events
At the outset it is important to understand
that events relevant to the financial statements for a particular
year are those occurring up until the date that they and the audit
opinions thereon are approved: in the normal course of events,
for most banks this approval occurs in the months of February
and March following the previous 31 December year end date.
We attach as Appendices 1(a)[40]
& 1(b),[41]
the timeline published by the Bank of England in an Annex to the
Financial Stability Report in June 2009 and a summary of developments
in the financial crisis contained in The Turner Review published
by the Financial Services Authority (FSA) in March 2009.
As the Turner Review makes clear one of the
main sources of the crisis was the development and subsequent
bursting of a property asset bubble initially in the US and subsequently
in the UK. The impact of the former was felt by UK banks mainly
through securitised assets held whilst the latter obviously impacted
their loan portfolios directly. In this context US residential
property prices peaked in the first quarter of 2006 and fell only
slightly during the period to June 2007. The rate of decline accelerated
rapidly to about 10% in the second half of 2007 and this continued
throughout 2008 by which time prices had declined by over 30%
from their peak. UK residential property prices in contrast had
continued to rise and did not peak until late autumn 2007. They
then fell less sharply, by less than 5% through to February 2008
and only by about 20% in total by the first quarter of 2009 (and
this was only about 5% less than prices in the first quarter of
2006) at which point the decline looked as if it was easing. UK
commercial property prices were more badly affected and fell by
about 10% in the 6 months to December 2007, a further 20% by December
2008 and again by 10% in 2009.
Consideration of "going concern"
The requirements to assess "going concern"
are set out in International Standard on Auditing (UK and Ireland)
570 Going Concern. This sets out the respective responsibilities
of management and the auditors and in particular notes various
aspects that both should have regard to in considering whether
it is appropriate to prepare the accounts on a going concern basis.
These include, inter alia, the business' projected net
cash generation and its ability to obtain funding (regardless
of the source—ie debt or equity—or the circumstances
in which the funding is required) for the next 12 months. Importantly
regard will also be had to management's plans in the event of
deviations from the projections that might reasonably be expected.
Following such a review management will conclude that either:
— The financial statements should not be
prepared on a going concern basis—this would only be the
case if they have no alternative but to liquidate the company
or cease trading; or
— The financial statements should be prepared
on a going concern basis, but there exists a material uncertainty
giving rise to significant doubt that the entity will be able
to continue as such; or
— The financial statements should be on
prepared on a going concern basis and there is not a material
uncertainty giving rise to significant doubt. In this event it
might still however be appropriate to make disclosures on the
basis of the conclusions and such (non-material) uncertainties
that do exist.
The auditor's responsibility is to assess the
basis on which management came to its conclusion and the adequacy
of associated disclosures. In addition if a material uncertainty
exists then the auditor is required to make reference to it in
the audit report—the so called "Emphasis of Matter"
paragraph. Material uncertainties are not defined but, as the
Auditing Practices Board Bulletin Going Concern Issues in the
Current Economic Environment issued in December 2008 makes
clear, include both the likelihood of events occurring as well
as their impact.
Application to banks
The general principles outlined above clearly
apply to banks. However there is one important difference which
relates to the role of the banking system in the economy—namely
to effect a maturity transformation between borrowers (who want
certainty of funding over the medium term) and lenders (who want
ready access to their funds in the short term). A major part of
a bank's financing requirements are therefore met from deposits
which are not committed and rely on continuing confidence from
both the interbank markets and customers. Whilst both prudential
regulators and a bank's management will set liquidity requirements,
these simply cannot be designed to cope with a "run on the
bank". Such "runs" may start as a comparatively
low level of concern amongst a limited number of depositors, but
they can rapidly become self reinforcing and, as was the case
with Northern Rock, once started a public "run" is nearly
impossible to halt.
The question of "going concern" in
a bank is therefore inextricably linked with a question of confidence.
Whilst confidence is maintained the bank is a going concern; when
confidence is lost then it is no longer a going concern. As a
consequence, the normal system of graduated "warnings"
in financial statements (initially management disclosures of concerns,
moving up to an "Emphasis of Matter" in the audit report
if there is a material uncertainty leading to significant concerns)
is not easily operable; once such disclosures are made confidence
is undermined and the prophecy becomes self-fulfilling in a short
period of time. For this reason the Financial Services Authority
(FSA) has made it clear to us on several occasions that issuing
a set of bank accounts with an "Emphasis of Matter"
paragraph in relation to going concern in the audit report is
not an option. In its view the very existence of such an "Emphasis
of Matter" provides sufficient evidence to conclude that
the institution no longer meets the requirements for authorisation
under the Financial Services and Markets Act 2000. The FSA therefore
would be required to intervene to "resolve" the situation
either through providing governmental support or forcing the institution
into administration (or, since February, 2009 the Special Resolution
Regime introduced by the 2009 Banking Act). This is not to say
that auditors will not propose an "Emphasis of Matter"
where it is warranted—just that once proposed those financial
statements will be unlikely to be issued. We believe that this
was precisely the situation facing Dunfermline Building Society
in early 2009.
Audit of bank accounts as at 31 December 2007
At the time of preparing the accounts of the
UK banks at the end of 2007, there were two key issues which had
given cause for concern during the year—firstly in relation
to lack of liquidity, particularly in respect of the securitisation
markets, and secondly in relation to the valuation of securitised
assets, in particular those with a strong US component given the
significant falls in US residential property prices.
On the first, the liquidity issues which had
threatened the interbank market were seemingly being kept under
control by various central bank initiatives by February 2008,
although it was clear that the business models of those banks
which were heavily dependent on the securitisation market for
financing remained difficult as was demonstrated by the nationalisation
of Northern Rock in February 2008.
The market for securitised assets themselves
remained extremely illiquid and as a consequence values were difficult
to establish with any degree of precision. During our audits therefore
particular emphasis was placed on ensuring we obtained adequate
audit evidence as to management's valuations. Although there were
subsequent declines in the prices for such assets, this was demonstrably
a feature of general market conditions which continued to decline
during 2008; indeed there were concerns in the latter part of
2008 and 2009 that the market over compensated for the perceived
credit problems. At the same time there was no indication that
loan losses in the banks' UK domestic portfolios were likely to
increase to the extent that subsequently transpired.
In assessing the going concern question prior
to approving the 2007 financial statements in February 2008 therefore
management and auditors would have considered carefully the relevant
forecasts and budgets for the next year, the continuing ability
of the institutions to secure funding through deposits and their
ability as necessary to raise capital in the debt and equity markets.
For the UK banking industry in general there was insufficient
evidence to believe at that time that a material uncertainty in
relation to going concern existed in this regard. Although further
systemic shocks could not be ruled out it would have been premature
to anticipate them at that stage.
As the Bank of England reported in its Financial
Stability Report in October 2007:
"UK banks are profitable and have high
capital ratios. But confidence in the robustness of the financial
system, in the United Kingdom and internationally, has been dented
by recent events. And as risk is repriced and balance sheets are
repaired, the financial system in the United Kingdom and elsewhere
is vulnerable to further shocks, whether in the credit markets
that have been affected most to date or in new areas—for
example, in equity or currency markets. "
Similarly in its Inflation Report in February
2008, around the time when the 2007 financial statements of banks
were being finalised, the Bank of England continued to predict
growth in GDP over the coming year(s) as shown in the following
chart.
Figure 1
BANK OF ENGLAND GDP PROJECTION
Source: Bank of England Inflation Report—February
2008.[42]
It is also worth noting that even in the Financial
Stability Report in May 2008—some three months after the
banks' 2007 financial statements were signed—the Bank of
England continued to maintain a positive, albeit cautious, outlook:
"Looking ahead, the most likely outcome
for the financial system is that conditions improve gradually
as measures—such as those described in Section 4—are
taken to restore market functioning and to bolster confidence
in the resilience of financial institutions. Low prices should
induce investors to return to markets, leading to a recovery in
asset values and a strengthening of balance sheets. But this is
likely to take some time as the disruption in markets reflects,
in part, structural factors such as information and incentive
problems. While this adjustment takes place, risks to financial
stability remain high. "
In addition, as late as August 2008, the Bank
of England predicted an annualised range of GDP growth for the
UK of +1.5% to—1.5% in Q1 09 (the lowest point of its projection
for the economy). This contrasted with—0.25% to—3.75%
for the same period in the November report only three months later.
Finally we note that although not directly in
relation to the audit, we also had discussions in late 2007 and
early 2008 on some of our key UK bank clients with the FSA as
part of their regular supervisory regime. It was evident from
those discussions that whilst they were aware of the extent of
clients' exposures to the UK property market in particular they
did not at that stage express any significant concerns in this
regard.
As demonstrated above, we were clearly conscious
of the general stresses in the financial systems that existed
at the end of 2007. As a consequence we had taken specific steps
to ensure that our partners and staff were alert to the issues.
The AIU, in its individual report on KPMG issued on 8 December
2008 in commenting on our actions in the autumn of 2007 noted
that:
"In our view the firm [that is, KPMG]
responded in an appropriate and timely manner to the audit risks
arising from the global liquidity problems"
In summary therefore, and in so far as KPMG's
major UK banking audit clients were concerned, we believed that
there was no substantive evidence to require the general use of
the Emphasis of Matter paragraphs in our audit reports and therefore
that the issuance of unqualified opinions in respect of the banks'
2007 financial statements was appropriate. In particular, events
which were to trigger a fundamental change in market sentiment—the
troubles of Fannie Mae and Freddie Mac and the bankruptcy of Lehman—were
still many months away.
Audit of bank accounts as at 31 December 2008
When Lehman Brothers entered into bankruptcy
proceedings in mid-September 2008 it created unprecedented turmoil
in the main global financial markets due to the uncertainty of
the impact on other financial institutions—both direct and
indirect. In response the UK Government announced a series of
measures on 8 October 2008 to provide both liquidity and temporary
capital support to the UK banking system. During the course of
the oral evidence given to the Committee on 23 November this year,
mention was made of the meeting that the senior partners of the
largest four firms had with Lord Myners in December 2008. The
background to this meeting was a letter written to the Chancellor
on 11 November 2008, a copy of which is attached as Appendix 1(c)[43].
As noted in that letter and accompanying background note (also
attached as Appendix 1(c))[44],
the firms were concerned to understand better the extent and nature
of the Government's support measures, in particular whether more
support might be forthcoming (both in amount and duration) if
that were necessary. Whilst Lord Myners repeated certain of the
general statements of support both in the meeting and in his subsequent
letter of 17 December 2008 (attached as Appendix 1(d))[45],
no assurances were sought or given on individual banks. Rather,
this meeting was requested and held simply to gather appropriate
audit evidence on the functioning of the banking system as a whole;
this was clearly fundamental to the going concern assessment of
all the UK banks and many other corporates. In this respect out
of all the tripartite authorities the position of the Government
was key because, as had already been demonstrated, only the Government
could provide the necessary systemic support. It was neither the
intention nor the result of that meeting that the audit work undertaken
by KPMG on any specific bank was in any way reduced as a consequence.
Lord Myners offered a subsequent meeting in
late January if that proved necessary. In the event the situation
was more stable by that time and KPMG did not consider it necessary
to ask for such a meeting. Specifically in concluding in February
and March 2009 on "going concern" in relation to the
banks' accounts as at 31 December 2008, the following factors
are particularly relevant:
— The various recapitalisation share issues
undertaken by the UK banks at the end of 2008 and early 2009 were
completed (or well underway) and had been undertaken against the
background of severe stress tests imposed by the Financial Services
Authority;
— Similar measures had been taken by other
governments to recapitalise key financial institutions such as
Citigroup, AIG and ING;
— Several smaller UK financial institutions
(mainly building societies) had merged with stronger societies;
— The Government announced further stabilisation
measures on 19 January 2009, including the formation of what has
become known as the Asset Protection Scheme and extension of the
credit guarantee scheme;
— The Special Liquidity Scheme seemed to
be operating successfully and had brought some stability to the
interbank markets. As is now public that had also been supplemented
by Emergency Liquidity Assistance to HBOS and RBS;
— US Government support for the Commercial
Paper market.
It was against this background that, whilst
there was continuing uncertainty in respect of the future macroeconomic
outlook and hence potential future loan losses, auditors in the
main agreed with the management of the relevant UK financial institutions
that they had sufficient capital resources and access to funding
to continue as going concerns. The one significant exception to
this was Dunfermline Building Society.
17 December 2010
40 Not published here. To view attachments please go
to http://www.parliament.uk/documents/lords-committees/economic-affairs/auditors/KPMG171210.pdf Back
41
Not published here. To view attachments please go to http://www.parliament.uk/documents/lords-committees/economic-affairs/auditors/KPMG171210.pdf Back
42
"The fan chart depicts the probability of various outcomes
for GDP growth. To the left of the first vertical dashed line,
the distribution reflects the likelihood of revisions to the data
over the past; to the right, it reflects uncertainty over the
evolution of GDP growth in the future. If economic circumstances
identical to today's were to prevail on 100 occasions, the MPC's
best collective judgement is that the mature estimate of GDP would
lie within the darkest central band on only 10 of those occasions.
The fan chart is constructed so that outturns are also expected
to lie within each pair of the lighter green areas on ten occasions.
Consequently, GDP growth is expected to lie somewhere within the
entire fan on 90 out of 100 occasions. The bands widen as the
time horizon is extended, indicating the increasing uncertainty
about outcomes." Back
43
Not published here. To view attachments please go to http://www.parliament.uk/documents/lords-committees/economic-affairs/auditors/KPMG171210.pdf Back
44
Not published here. To view attachments please go to http://www.parliament.uk/documents/lords-committees/economic-affairs/auditors/KPMG171210.pdf Back
45
Not published here. To view attachments please go to http://www.parliament.uk/documents/lords-committees/economic-affairs/auditors/KPMG171210.pdf Back
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