Auditors: Market concentration and their role - Economic Affairs Committee Contents


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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