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Not international jurisidctions; secrecy jurisdictions.
I know nothing about either, other than their names.
I apologise to our second panel for the delay—we took a little longer than expected to hear from our first panel, whose evidence was interesting. In that session, the issue of whether Scottish public sector funds are giving Scotland-based companies a fair opportunity to manage them was raised. It might be worth while for us to write to the pension funds to ask them how they go about selecting their investment managers and what consideration they give to using Scotland-based companies. Is that agreed?
I am pleased to welcome to the meeting representatives of the Association of Chartered Certified Accountants, the Institute of Chartered Accountants of Scotland and the Institute of Chartered Accountants in England and Wales, which has a Scottish branch. I ask them to introduce themselves and to make some brief opening remarks, before we move to questions.
I am the executive director of technical policy at the Institute of Chartered Accountants of Scotland. I am in charge of all the representation work that we do on behalf of our members and in the public interest.
In my day job, I am a partner at PricewaterhouseCoopers in the business recovery services department, which deals with troubled businesses—there are lot of them at the moment. I also chair the technical committee of ICAS alongside David Wood. That is my other hat.
I am head of the financial services faculty at the Institute of Chartered Accountants in England and Wales. I am a Scot, but I am based in London. The ICAEW is pleased to come here to give evidence. We have more than 1,400 members in Scotland who work in senior positions in the public and private sectors, so we are well placed to give evidence.
Did I? I apologise. I will correct that—it is quarter 4 of 2009. It was a slip of the tongue. You already have me on the run.
You have avoided confusing us too much—it is easy to confuse us.
I want to pursue the question of credit availability. On the one hand, the banks tell us that they are open for business and that they are approving roughly the same percentage of business loan applications as they ever did but that the problem is that demand is down and that businesses are not asking for the money. On the other hand, businesses are telling us that they cannot get credit, that their overdrafts are being cut or converted into hard loans that they have to secure against personal properties, and that their fees, such as arrangement fees, are increasing significantly compared with what they were in the past. The result is probably that they are not even asking for loans because they do not think that they will get them. From your experience as accountants, which side is right—the banks or the businesses?
The convener’s point resonates with me. When I meet companies for the first time, they often say that their bank manager or bank does not understand them. We often hear people say that they need money for growth. If we get behind the facts, we will get to the real question. Once we get the financiers and companies on the same factual page, we can move forward. Things often start from a misunderstanding. Some smaller companies do not even understand where they are. When someone says to a bank that they need more money, the bank will want to understand what it is for. People often say that it is for growth, but it is often found that it is for funding losses. People will say that they need more money, but if it is for funding losses that will simply go bad, what is the point? One must reverse slightly with companies, get them on the right platform, and ask them why they need the money. If it is for losses, we should tell them to cut out the losses and then look at what they need. Sometimes there are genuine misunderstandings.
It would be helpful if you could provide the committee with a copy of your report. We have seen the Scottish Government report, but it is relatively dated and we want to see what the trends are. Yours sounds as if it might be slightly more up to date, and it would be helpful to have it.
There is an irony there because some of the time it comes down to pricing. At the lower end of the scale—personal and individual banking—the lower the sum involved, the less there is to move around, and the more it is like a credit application. An individual applying for a £5,000 loan will probably fill in a form as they would do when applying for a credit card. The irony is that the more sophisticated and heavy—”heavy” is the wrong word—or large the lending gets, the more sophisticated the bank’s response will be.
We have been talking about competition. In its submission of last September, ICAS said:
No, I do not think that they can. They are people who can advise customers. As has been said, surveys in many countries indicate that accountants are among the most trusted business advisers. The fact that that helps to give the banks confidence in them means that, to an extent, they are trusted by both sides, partly because, as a profession, accountancy has a dedication to integrity, ethics and so on. That is accountants’ role; they cannot replace the banks’ relationship managers.
Accountants may be akin to translators, in that they help to bridge the information and knowledge gap between small businesses and the banks.
The role of auditors has come under greater scrutiny as a result of the financial crisis. Do you have any comments on that?
Following on from that, have any changes been observed in the demand for auditing and accounting services by headquarters of financial institutions in Scotland?
It would be helpful if your comments relate to Scotland, as we are trying to focus on what is happening here.
I do not expect that there would be any difference between the UK position and the Scottish position.
I endorse that. Audit is a statutory requirement anyway—certainly at the top level. Lower down, there is auditing exemption for the lowest companies, so demand for audits at that level is slipping away slightly.
There has been quite a bit of change between different parts of the business, and we have seen that in previous recessions. The audit is clearly an on-going requirement, so the demand for it remains fairly steady, but demand for other services, such as tax advice, tends to diminish in a recession, while business recovery services tend to increase. The picture is one of different professional service firms growing at different rates.
From observation of our businesses, I would say that there is a demand for the services. Is it higher than before? The transactional work has changed, perhaps temporarily. There is less corporate finance work, and more transaction work of a different nature in my area. Within that, tax services seem to be more focused on transactional corporate finance. If any part of the industry is finding things slightly more difficult, it is the tax advisors within the profession because there is less transactional work and less merger and acquisition activity.
I will give you a brief introduction and perhaps others will supplement it. The most important thing for an auditor is to understand the business. In planning an audit, that understanding is vital when the auditor is looking at the riskiest areas. The auditor normally approaches their work on the basis of risk and, because the concept of materiality features highly, the auditor focuses on the largest and riskiest figures.
I would emphasise the importance of shareholders. The financial reports of the companies are designed to inform shareholders, the market and investors such as the people you heard from earlier, and the audit follows the financial reporting because it is an audit on the financial reports. The auditor must always remember that he is responsible to the shareholders of the company, not to the company.
Auditors are not there to second-guess management and they do not have a particular duty to look for risk problems, other than those that relate to risk of misstatement in financial statements. However, the auditor might become aware of things in the course of the audit report: if so, there is a duty to report that to those who are charged with governance. The typical route is through an audit committee. Auditors are not necessarily required to look for everything, but if they become aware of problems there are obligations to report them.
Often, it would happen in both ways. The auditor would only not tell the CFO something that he was going to tell the audit committee if there were particular concerns about the actions of the CFO. It would be unusual not to inform the executive management. Typically, it would happen in cases of fraud with which the executive management is associated.
We need, however, to be realistic about how far auditors might be able to go. They have financial skills that they use in looking at and reviewing internal control processes, but they are not economists, nor are they better able to predict the future than anyone else. There is therefore a risk that if we oversell their role, we might create an expectation gap with regard to what can realistically be achieved.
I have a point to add on corporate governance. The auditors also have a role in ensuring that disclosures that relate to corporate governance in a company are fairly stated and not misleading. That would not extend to comments about the non-executive directors not being challenging enough; it relates more to structural matters. That is another important role of the auditors.
Would it be true to say, as I think John McFall said, that the number of firms that would have the range of skills and knowledge to audit effectively the large financial institutions would be quite small? Is that a fair comment?
Yes. I can state categorically that such expertise exists in my organisation.
Auditors are meant to check that the value that the banks have put on something is a true and fair value. That is for the benefit not of the bank but of the shareholders. If the value is completely wrong because the underlying risk related to the asset has not been properly assessed, surely the auditors have a responsibility to highlight that. If the auditors do not understand the underlying risks and therefore do not understand the value, surely they have a responsibility to highlight the fact that the assets are such that it is impossible to assess whether a true and fair value has been given to them because the auditors do not understand the meaning of them. That is what I am trying to get at. Did auditors understand the assets that they were valuing as part of the audit process?
Perhaps a linked issue is that the market for some of these instruments was fairly thin. In that respect, it is actually quite difficult to say that price is a realistic value, but there is nothing else to go on. Value obviously exists in the eye of the beholder, so the market price is the most reliable. The other side of the issue is that financial statement users need to understand and be aware of the limitations of the accounts in that respect.
I accept that the data are historical, that there cannot be 100 per cent guarantees, and that events moved extremely quickly. However, things such as the loan to deposit ratios of certain banks did not happen overnight.
A lot of information was known. The accounts provided a lot of information if people went through them. The accounting did its job to the extent that it provided information to the market, which was aware of many things and made its own judgments. It is quite difficult to hold auditors accountable for judgments that are made in the market.
It was mentioned previously that the accounting standards are being improved in specific areas and there are extra disclosures of things such as risks and financial instruments. In essence, risks are flagged up to the outside world for regulators or shareholders to inquire about and act upon. The auditor’s role is to ensure that there is transparency and that what the company says is true and fair.
Your concern is correct. If we were to say that there were no lessons to be learned from the past three years, that simply could not be true—it would mean that we all had sacks over our heads. What is needed is an understanding of the auditor’s role and perhaps a redefining of part of it. However, that cannot be done in isolation; the regulator’s role also needs to be looked at, as well as the question of what is the right loan debt capital. Your concern is genuine, but the body of regulation also needs to be considered.
Such cases have been happening on a large scale. You mentioned Globespan and what emerged in that case. Perhaps there should be some public involvement—a state notariat or something like that—to deal with such large-scale failures. One has the notion that very large concerns have a replica of the state in their structure and are fully alive to the long-term consequences of their actions, but that is not always the case. Firms can enter into the dangerous position of moral hazard—a phrase of John Kay comes to mind, “Too big to fail; too dumb to live.”
I think that David Wood said that there have been changes in the regulation of accountancy and auditing since the financial crisis—is that correct?
We need more thoughtful regulation. These days, there is a danger of making things overly scientific, putting numbers to risks and then relaxing because we think that the issue is sorted. What we need is better behaviour and more thoughtful challenge by non-executive directors. More thoughtful analysis of the risks is required.
The challenge for regulators is that we are not likely to see the same crisis happening again. There will be another crisis—we do not know what it will be—and whatever we do now will not prevent it. We will never know how many other potential problems and crises have been prevented by the effect of regulation.
As a Scot who lives in London, I tend to agree that such feelings may be felt more in Scotland and by Scots, but the problems were global.
My second question is for Mr Coke and it relates to paragraph 24 of his organisation’s submission, which mentions
Paragraph 11 of Mr Martin’s submission talks about the Scottish Government influencing how regulation can be applied in the sector. The Scottish Government cannot introduce any regulation, as that comes from London, although it can certainly discuss matters with stakeholders and interested bodies. However, if it wanted to feed something back to London, but London did not want to accept that—regardless of which parties were in power—that would leave the Scottish Government with little influence in terms of trying to improve the situation or to liaise with the industry in Scotland.
I have a question on the independence of the audit process, which Iain Coke mentioned in his earlier responses. It is known that the auditors of large companies and institutions in particular often carry out significant work for those companies in addition to the formal audit process. The value of the additional work is often significantly more than the value of the formal audit. Does that relationship undermine the independence of the audit process?
I will take that question—I referred earlier to the project that ICAS undertook on non-audit services. In 2001-02, the non-audit services fees for the FTSE-100 companies came to around 300 or 400 per cent of—three or four times—the audit fee. A lot of changes have been made since Enron; there was a lot of scrutiny around the issue at that time. Non-audit fees now comprise roughly between 30 and 70 per cent of the audit fee, depending on how that is analysed. The issue has reduced significantly in size, but there are still potential issues around non-audit services influencing the auditor.
I think that that gives you one of the answers, David. The term “non-audit services” can be quite broad, but if you get the disclosure right in relation to what those services are, the audit committees and the shareholders can make an informed decision. It is wrong to lump everything under one heading and say that the fees come to a certain amount. People have to understand what is being done, and then everyone can take an informed view on how appropriate it is.
One important aspect is that since Enron, audit committees in companies have taken on the role of deciding whether auditors should take on non-audit services, and they oversee any independence issues that arise.
To guarantee the independence of the audit process in a large institution, would it not be better if the auditors were appointed by a third party such as the FSA rather than by the board of the company?
I am sorry that it has been another lengthy session, but we had a lot of ground to cover. I thank David Wood, Bruce Cartwright, Richard Martin and Iain Coke for their evidence.
Thank you very much for those opening remarks.
Essentially, the business model of a rating agency is that we are typically paid from two sources: the people who subscribe to the ratings and the people who are rated. For the large rating agencies, the bulk of the rating revenues comes from the people we rate. Similar to auditors, we have in effect an issuer-pays model. The fee that we get paid depends very much on the size of a bond issuance, but there is a cap. Typically, the highest amount of money that we can receive from a single issuer is limited by a cap on fees for any individual issuer or, indeed, individual issuance.
Could you, for the benefit of a layperson, elaborate on the rating models, methodologies, assumptions, criteria and protocols that you employ?
You mentioned that, unsurprisingly, the process has been tightened up this year. How do the procedures and methodologies for credit risk characteristics for structured finance products differ from those for other securities?
You said that you rate literally tens of thousands of products, some of which are hundreds of pages long. Given the number and length of these products and the number of analysts involved, how accurate can you be in rating something AAA, AA or whatever?
That is a good topic, which is more for Europe than for the United States where, if someone invests in a securitised bond, the underlying data are reasonably easily available. There are varying schools of thought on how easily available that stuff is in Europe, but my conclusion is that it is not as easily available as it is in the United States. In Europe, the ability of investors to access directly the information in forming a view on the underlyings is improving. The banking industry has realised that it will not get this product off the ground again until it re-establishes confidence in it.
Are rating agencies subject to any requirement to report the number of rating actions that they take in each class of rating?
We are now, as a result of forthcoming regulations. I think that you would find that, in the past, the three global agencies did that, but it was perhaps not as evident as it is now. Over the past year and a half, work has been done to synthesise all of that.
I will go back to what Richard Hunter said about credit ratings and residential property values. One of the big criticisms of credit rating agencies has been that they have failed to take into account macroeconomic factors such as residential property values. Do you accept that that is a fair criticism?
The Treasury Committee commented in its ninth report of 2009 that
That is a very good question. Perhaps we could also discuss alternative business models.
I would not want to speak for my colleagues in other agencies. It would be very unusual to draw a direct line between a rating agency’s decision and the actions of a corporation’s executive.
I believe that the rating that we upgraded in December was the bank’s individual rating. That immediately sounds somewhat archaic, but it is an important hook to move on to discuss how we look at banks. In effect, we have two rating scales for banks. Everyone is familiar with the AAA scale, but we also have what we call the individual scale, which is A, B, C, D, E and F. That marks the bank against our expectations or our view of its vulnerability on a standalone basis. It is possible—it was the case for Germany for many years—for banks to be rated towards the foot of that scale, at the D or E level, which is low and would certainly be a sub-investment grade on a standalone basis, but to have quite high debt ratings on the AAA scale because our belief was that the Government or lender of last resort would step in.
In other words, barring a dramatic change in Government policy towards such banks, there are no circumstances that would remove that AA- standing.
Over what period is it possible that the D/E rating will improve and move somewhat closer to where it was before the current situation began?
Typically, it would take a while. For example, to leave RBS to one side, if a bank was rated very low and we simply said, “There’s one factor; let’s give it an awful lot more capital”, but there were still question marks over the profitability, the quality of the loan book, the asset profile and investment strategy or whatever, that would need to be factored into whether there should be an upgrade in the individual rating. We have many banks that have optically high capital ratios but which are low rated because they have other challenges.
Convergence in the sense of?
I am afraid that I am not aware of UKFI’s exact mandate for relinquishing, whether it is profit maximisation for the Government or a desire to get the bank back into the private sector as quickly as possible. It would depend on that. If it were a desire to get it back into the private sector as quickly as possible, there might be a reasonable level of convergence.
Lloyds Banking Group has some state ownership too. Would the kind of rating that it might attract be influenced by, for example, its decision not to enter into the asset protection scheme in the same way that the Royal Bank did?
I will conclude by asking a question that ties in with our previous evidence session on the auditing of banks with the auditors and representatives of the accounting profession. To what extent do you take account of companies’ audit certificates when you rate them?
My pleasure.
Thank you for those opening remarks. Could you consider the other side of the coin and highlight some of Scotland’s strengths in the investment management market?
First, our international brand and educational and business reputation are still regarded as very strong. Part of that comes down to weight of money. Some very sizeable pools of assets are still being managed here, primarily through the life companies, and that source of capital acts as a commercial imperative for companies.
It is relatively complex in terms of the underlying client base, but I will try to summarise it. We have public offer funds, so it is possible for private individuals here and elsewhere to invest in the pool vehicles that we run. On the institutional side of our business, there is typically a gatekeeper between us and the client. The gatekeeper is often a global consulting firm, which conducts due diligence visits and basic research visits. That involves the firm getting comfortable with our investment approach, and—increasingly, given the turmoil in the broader financial industry—gaining a clear understanding of the commercial and ownership dynamics within businesses.
Thank you.
Fund management in Edinburgh is probably in a stronger position now than it was before the financial crisis. I say that because there are a number of strongly independent ownership structures here. Those independent firms will have prospered with the removal of the worry about parental ownership and what that might mean. Given the type of investment that takes place here—this is a generalisation—it is fair to say that, although nobody thanks us for losing their money, we are measured on a relative basis. In 2008, on average, Scots firms probably did relatively well. We could give a number of anecdotes about companies that performed relatively well through the downturn. In the short term, there will have been a commercial impact, because if assets under management fall, revenues generally also fall. However, in the longer run, we are probably reasonably well positioned.
I am interested in seeing the paper that you summarised. Committee members have many questions, so we will move on, but the whole committee welcomes those comments.
The answer to your first question is an emphatic yes. A trade-off—probably the best way to describe it is as a potential conflict—often exists between the commercial imperative and the investment decision.
Is your bonus structure a hindrance to the recruitment of good staff, in that people think that they can get more money more quickly somewhere else, or does the longer-term approach mean that you retain staff longer, because they know that the rewards are on the way?
Has the crisis affected your ability to recruit in Scotland the qualified staff that you need?
We have been able to recruit. I will put that in the context of our overall team size. About 25 people are directly involved with the investment team. As I said, roughly half of us are based here and half are based in Asia. We have taken on three people since September—one chap joined us just a couple of weeks ago.
In common with other firms, I have a number of points to make. We are not convinced that standards of arithmetic and literacy have improved—indeed, in some cases, they may have declined. The comment on bureaucracy was in relation to the need for mobility between our offices, so that people can train with us for a couple of months and then return to their home office. That is important.
We experience a lot of difficulty in moving people around the world. I am sure that that is driven not by anything that is done in Scotland, but tighter immigration policies. For example, it is very difficult to try to bring someone into the country on a two-month secondment. That is the case even if they are part of our team in Hong Kong or Singapore. Anything that Scotland can do to facilitate a two-way flow that broadens the experience of people in this country will serve the industry well in the longer term.
You talked about financial education in Scotland and said that it may be the role of the FSA and the Scottish Government to do that. We have been told that various bodies are working in partnership to look into financial education in Scotland. Has anyone from the FSA asked for your opinion on that?
None from which it is not possible to recover. It is unfortunate that two banks with Scottish names were significantly involved in what went wrong, but they are regarded as international banks and many of the activities that went wrong were managed from outside Scotland anyway.
Do you anticipate many—or any—regulatory changes to your industry in the near future? If so, what concerns do you have about any proposals?
The problem with regulation is particular to the retail sector. Because we do not interface directly with the retail customer, we are not so affected by it, but anyone in the retail sector will tell you that the amount of box ticking that goes on is incredible. It is becoming very expensive and the consumer pays for it in the end.
In your first answer, you talked about remuneration and risk, which you think might be regulated. You have talked about how your organisation is no worse off—indeed, it is possibly better off—in relative terms than it was prior to the financial crisis. Has its approach to risk management changed at all? Have your risk-management procedures been considered and reviewed, or are they broadly the same as they were before?
Risk should be defined, and losing money in real terms should be adjusted to inflation. That is where people should start from when they consider risk.
Basically, the investment banks took risks using Government money. At the end of the day, they were going to be bailed out, so the situation was completely skewed. That is a different problem. One issue with investment banking that I feel strongly about and which is one reason for excessive incentivisation is that there is perhaps not enough competition in the business. There are certain oligopolistic practices that need to be considered. For instance, for an initial public offering in the States, there is a standard fee of 7.5 per cent, which is considerably more than the fee in this country. No one has ever explained to me why that cannot be competed down, which is what normally happens when people make huge margins.
The regulatory function lies elsewhere—with the FSA, the Bank of England and so on, and in carrying out their regulatory reforms they need to learn from other sectors of the financial industry. Should they be learning lessons in rolling forward the Turner recommendations regarding the approach to risk and fund management that you follow—lessons that would be applicable to the wider financial services sector?
I should be familiar with that scheme but I am not. It is difficult to know what a demand for something is until the supply is created. Anything that would help for the first year or two years, so that a service can be established, would be very beneficial.
A route development fund was suspended two and a half years ago because of concerns about European regulation and so on. Those concerns could be addressed. We are concerned with what enables you to do business effectively. Missing out Heathrow is a critical part of that.
A fair point.
I cannot really comment on their cost effectiveness. There is no doubt that they would improve connectivity, but the Edinburgh tram system shows that one can spend a huge amount on something where there might have been a simpler, lower-cost solution.
One will always overlook people, however hard one tries. When we recruit, we try to ensure that we advertise internationally. We hope to attract people from Scotland as well as elsewhere. On the operational side, quite a lot of the people we recruit went to university here—about 20 to 25 per cent of the investment team were at Scottish universities. However, any team must be diverse. We need language skills, for example, so we have to be diverse. If we had a recruit Scotland policy, we would cease to be able to compete internationally.
Students forget that there are lots of ways of getting into a business. If we have someone on our operational side who has any interest in investment matters, they are always welcome to attend any of our meetings. It is remarkable how seldom people take advantage of that. Our hours fit in with Hong Kong’s and Singapore’s so we are in at 7.30 in the morning and it is easy for people to come in an hour early and sit in on the meeting. If they occasionally ask a good question, there is no reason why they cannot move into the investment side if we are looking and feel that they are bright enough.
I return to the future of the investment management sector as a whole. You spoke persuasively about the desirability of culture change and not relying on a tick-box mentality as well as about your institution’s commitment to looking at the fundamentals of the companies in which you seek to invest, although you conceded that that might not be typical of the entire sector. In that context, next week the committee has the chance to meet Lord Myners, the City minister, who reflected that without significant change, ownerless corporations will sleepwalk into further catastrophe. When looking at institutional ownership, the Treasury Committee described institutional investors as “supine and ineffective”. Perhaps such colourful language is less typical of this institution, but the comment raises the issue of what is the right way to address the phenomenon of ownerless corporations and strengthen the hand of institutional investors in the future. I am interested in your views.
You have made helpful suggestions on capital gains tax and holding shares.
I feel strongly that a local banking sector is important. The sector in Scotland that will be most hit by the loss of headquarters is the charities sector. I am thinking about sponsorship of events and a myriad of activity that we do not see. It is tragic. We are experiencing an age in which big is beautiful, but big is not beautiful at all. People overestimate the economies of scale and completely underestimate the diseconomies of scale. In any disposal of the stakes, it is terribly important for Scotland that there should be local participation—I very much hope that there will be.
For state-aid reasons, the EU has forced various disposals in Lloyds Banking Group and RBS. RBS’s balance sheet is envisaged to shrink by about 40 per cent. Is there a case for a future Government—after the forthcoming general election—to consider further shrinkage of RBS’s balance sheet or further disposal of activities, or should that stop there because the EU went far enough?
That is healthy.
The original proposition was for regulation light compared with the FSA in the UK. I am not sure whether that idea prevails.
The issue is not whether regulation is light or heavy but whether it is properly focused. One should try to identify, focus on and hit hard people who are clearly misleading the public. Regulation should be light until people show evidence of being irresponsible, when they should be hit hard, rather than having hundreds of people ticking boxes and not considering the spirit of the law.
Would it have been easier for a Scottish FSA to confront RBS—whose total balance sheet was 20 times in excess of the national gross domestic product—and to regulate it effectively? We face such challenges. The issue is scale. We celebrate the financial services in Scotland, but the dilemma is that if a country is home to retail banking institutions whose assets are 20 times in excess of the national GDP, that creates a perplexing power balance for the regulatory community.
Does that not suggest that regulation must be international rather than national? The question is not whether it should be Scottish or British. Whatever happens, we must move together internationally much more when we talk about such institutions. Who was responsible for regulating the Icelandic bank system, for example? The issue is difficult.
The information is publicly available from the prospectuses that are published. Investors are told what they are investing in. However, whether the average investor understands the nature of what they are investing in is a different matter.
One last point, if I may, convener.
Please be quick.
The Chinese family could be equated with Hawick, in terms of rugby. It would like to benefit humanity in general, but Hawick first. That is important, and the thing that worries me is the secrecy jurisdictions, which have not been mentioned so far. There are a large number of tax havens into which activities disappear. One knows that something is going on, but it appears that the matter can be settled only by international regulation.
All that I can say is that I know nothing about international jurisdictions.
I thank Stuart and Angus for a fascinating evidence-taking session. We could have gone on for considerably longer. In particular, we would have liked to explore in more detail the papers to which you referred. It would be useful if you could submit them formally as evidence to the committee, and we will certainly take them into account in our report.
You just said something about 2004.
We have 10,000 members in Scotland and a good mix of members in practice and in business. We have not done an up-to-date survey as the ICAEW has, but we did a survey in March 2009 and will repeat that next month. The 2009 survey was of interest. Firms found that their clients were struggling. Many had working capital problems and blamed the banks for the withdrawal of finance.
In many ways, the current recession and downturn emphasise the importance of finance functions and properly managed finances—we have seen the same in previous recessions. On the whole, the role of finance in organisations large and small tends to be more important in recessionary times, so to some extent the importance of accountancy has increased.
We undertook research into that in the middle of last year and found that, to an extent, both sets of views are correct. We spoke to our members. Some SMEs are finding it harder to find finance, but there are regional variations, variations among banks and even variations within banks. There may have been some movement of foreign banks out of the UK, so there may be less capacity, but I think that a real element of fear exists. Some people have not wanted to raise issues with their banks because of their fear that terms would be reduced or taken away, or would be less favourable. There was a divergence of views. Some people commented on whether repricing was fair and whether banks were overcharging in difficult circumstances. The alternative view was expressed that the banks were moving the charges to more realistic levels.
From what you have just said, is there a gap in the business advisory services that are available to small and medium-sized enterprises? If there is, who should be filling it? Should it be the accountancy profession, the business gateway, Scottish Enterprise, or someone else?
Our experience is that, for many SME businesses, the accountant is often the trusted business adviser. Such a business will probably have a lawyer and an accountant, even if they do not produce or audit the accounts. Most businesses of a reasonable size—I am talking about the £2 million-plus level—will have an accountant as an adviser. Perhaps they could talk more to their accountants to get help through a period of crisis.
The role of auditors is extremely important, as it is about giving confidence to capital markets in relation to financial reporting. There have been some challenges.
Obviously, whenever there are major financial losses, questions are asked about audit and the role of auditors. We have seen that in previous crises with Enron and so on. Our view is that the auditing and accounting profession of course needs to look at what has happened to see whether any lessons can be learned. We are certainly doing that—not just in the UK but in other countries around the world—and we are considering whether the audit should look at wider issues. However, we come back to the position that the audit is on the financial statements, which are historical records. That is an inherent limitation in financial reports and in the audit of those reports that we cannot get away from.
Further to Richard Martin’s allusion to the post-Enron reforms, we have gone through a significant strengthening of the accounting and audit regulatory system over the past few years, so we perhaps arrived in the current crisis in relatively good condition. I think that those reforms have held up quite well. Press reports in early 2008 about the performance of auditors indicated that auditors were being quite strongly challenging of management—which is what one would want them to be—and that auditors were doing their job under quite difficult circumstances.
At the start of 2008, there was a challenge in valuing assets and liabilities in stressed markets. Responsibility for doing that lies with management; the auditors review the judgments that management have made in putting together the year-end accounts. That was quite challenging for the auditors, whose job is not to decide on or report on the business model that the management use but to report on whether the accounts present a true and fair view of that.
It is not necessarily a good time for auditors. They might be busy, but that does not mean that the market is not competitive. I would like to think that any profession has a revenue stream to support it, but it is not as simple as saying that this is a profitable time. It is a case of having a business that will be sustainable for the next 50 to 100 years. It not about making hay in one year, but about how a firm stays in the business over a lifetime, as with any business.
That is a relevant point. Numerous witnesses from various sectors have stated that a critical feature of the crises that hit HBOS and the Royal Bank of Scotland was the failure of non-executive directors in particular, and of the board in general, to pick up on the risks that had got out of control, and to rein in the executives who were clearly taking outrageous risks with other people’s money. What is the role of the auditor in that situation? If non-executive directors and shareholders fail to recognise overly complex financial instruments, risk that is out of control and acquisitions that are not in the best interest of the acquirer, is the auditor responsible for alerting non-executive directors and shareholders to those issues before they arise?
The auditor has no role in communicating with shareholders beyond the question of the truth and fairness of the financial statements that are issued. We have to remember that that was in train before the financial crisis. Those financial statements now try to communicate much more the sort of messages that you are talking about, such as taking on risk and the strategies and sorts of business models that banks and other companies are pursuing. That information is increasingly in the financial statements. There is a responsibility for the auditors in that regard.
Would reporting to the audit committee be on a separate channel from the ordinary conversations with the chief financial officers that you would, I presume, have on a daily basis during an audit?
What is interesting is that the auditor is better qualified to understand the financial processes within a company than almost any other independent external person. Have auditors’ professional judgment and understanding been fully utilised in respect of financial sector organisations that have got into difficulties such as we have seen?
Such expertise would be available in Scotland—if a Scotland-based institution were being audited, a Scotland-based auditor would be available to do that.
I want to press you a bit further on the true and fair nature of financial reports, because it seems to me that that is the crucial issue here. I presume that in producing such reports, you must be satisfied that you understand the nature of the risks that the banking industry has undertaken. It appears, from the crisis, that some banks were not clear about the nature of the risk that was involved in the cut-and-sliced instruments that they were dealing in. Are you satisfied that the auditors understood the nature of the assets that were held by the banks—in particular, the toxic assets that are now costing the taxpayer a fortune?
We have accounting standards to help to describe the type of risk disclosures that are needed. Recently, the level of disclosures on financial instruments has increased and been strengthened. “International Financial Reporting Standards 7—Financial Instruments: Disclosures”; which deals with disclosures on financial instruments and covers risk disclosures among other things, came in for the first time for 31 December 2007 year-ends, which was probably slightly too late for the current crisis. The accounting profession has been looking to strengthen risk disclosures over the past few years.
Much of this morning’s discussion has been about looking back at what went wrong and why certain things were not spotted. You have responded to those questions, but I have a big concern. You have explained what auditors do and what they ought to be expected to do, but based on that it does not seem to me that they would spot the next Northern Rock, Dunfermline Building Society, HBOS or RBS now or in five or 10 years’ time. Is that a fair assessment?
I agree. I return to what I said earlier. An inherent limitation of financial reports, and therefore of audits, is that they are historical. It is a matter of trying to get a true and fair record of what has happened in order that investors can make their own judgments about how companies will perform in the future. Financial reports and audits are historical information that allows investors to make future estimations and predictions. Truth and fairness are needed on the balance sheet date, and that should be informed by events right up to the date on which the accounts are agreed by the directors and signed off by the auditors. Balance sheets should try to be records of conditions on the balance sheet date, and true and fair records of the period that led up to that date. To some extent, the business is not predictive; rather, it is a matter of providing historical information from which others will make predictions.
You have lost me.
That is interesting, because they were the little guys in a downtown office in New York who were the auditors of Bernie Madoff. Two of them were there, one had retired and gone to Florida and there was a secretary, which means that there was a staff of three. Those guys audited the books of what was probably the biggest scam in world history—they were auditors.
On the point about the small firm that audited the Madoff firms—again, my comments are based on reports rather than on detailed information—I understand that the people involved may not have been members of the American Institute of Certified Public Accountants and that they may not have had audit licences, so there are wider problems. It is difficult for us, as a professional body, to comment on action taken by someone who is not one of our members and who should not be doing the job anyway.
But surely PricewaterhouseCoopers, KPMG and such firms would make such judgments.
And they are subject to the US audit regulation, which was strengthened significantly after the Enron problems. I was referring to the specific small firm that was mentioned.
You have to distinguish between the roles, because the failure was of the auditor to the small firm. Until about two weeks ago, I was involved with the Globespan airlines. I was being told categorically, “We hold £35 million of your money.” We proved it only by going to the High Court. It is difficult, but to this day a certain individual would probably tell me that he still holds that money. You have to distinguish between the entity that is being audited where the fraud is being committed and the auditors of other entities that interact with it through normal business.
About five months ago, I was at a conference on the crash that was organised by the Commonwealth Parliamentary Association in—where else?—Guernsey. One interesting speaker was Dr Tom Burns, who is a lecturer in finance law at the University of Aberdeen. He spoke about shadow banking, and said that he intended to offer a course on the law of securitisation—that whole area of collateralised debt obligations. From his talk, I discovered that everything was carried on computer; no one had ever researched the law on securitisation. Given that something like audit is very closely interlinked with the existence of legal codes, does it not seem that what Burns found is very worrying indeed?
A couple of weeks ago, we had a conference that was attended by Lord Turner. Among the other speakers was Josef Ackermann, who is the Deutsche Bank chief executive officer. One of his opening comments—it may have been a throwaway comment—was that one of the results of the Wall Street crash was the invention of securities regulation. It was thought that one of the results of the recent crisis might be the introduction of securitisation regulation. You make an interesting point.
What changes have been made and have they gone far enough? On transparency, I ask basically the same question. You have talked a bit about transparency, and the committee has had questions about the transparency of the auditing process. I would like your views on any changes that have been made in regulation and on the transparency of the auditing process.
That would be helpful.
I have three very brief questions, one of which is for Mr Wood. It relates to his organisation’s submission of September, paragraph 22 of which states:
I agree.
We support the idea of more co-operation. The markets operate on a cross-border basis. Starting to regulate on a national basis would present challenges. Differences in regulation can create problems and undermine the effectiveness of regulation in all jurisdictions. We think that there needs to be cross-border regulation, but we are not in favour of the move towards the creation of European regulators because that would lead to a loss of political accountability and would mean that we might have problems with knowledge of local markets, products and cultures. We think that co-operation is needed, but we are not looking to single European regulation.
If there was some element of European regulation, that would provide a standard, high level of regulation across the whole of the EU, and the member states within the EU could add to that. Would that not be a worthwhile thing to consider?
We have that already, through the director process and regulation. The EU has its financial services action plan, which has worked over a number of years. We have regulation at that level, and we have co-ordinating bodies that are being strengthened. We support those moves. At an international level, the board of the Basel committee on financial stability is looking to co-operate internationally and develop common rules. However, we think that there still needs to be accountability at a national level as well.
Iain Coke made the point that something will arise in the future that we cannot predict at the moment. We should think about what lessons we can learn from what has happened. A serious recommendation is that big financial services organisations should have living wills; I know that that issue is being pursued. In the case of Lehman Brothers, operational control was transferred over the course of a weekend—on a Sunday night, basically. In such a situation, there will inevitably be a lot of collateral damage. If an institution fails in some manner—we might not see anything on the scale of the Lehman Brothers collapse, but smaller institutions will still fail—living wills would help to limit the resultant collateral damage.
We were talking about a lot of background matters that the Scottish Government should address in trying to help the development of the financial services sector in Scotland. Some of those matters, such as education and encouraging businesses to locate here, were alluded to earlier. It would surely be worth while for the Scottish Government to express its views to Westminster and at the European level, and to make it known that it is closely examining the regulatory solutions. We have not by any means come through that process yet; I do not believe that we have responded properly to the crisis in terms of bank regulation, nor in terms of corporate governance. There is plenty to play for: Scotland needs to communicate to the Parliament the importance of those issues, and you need to communicate that you are seeking the right type of solutions through that process.
That makes sense. We heard about the auditors of the Madoff company that should not have been allowed to do that work. The regulator in the States has a list of approved firms that it allows to carry out audits.
I will start with just a few words on credit ratings and Fitch, but I shall move as quickly as possible to questions as I sense that there are quite a few questions today.
That is quite a big question, because we are talking about criteria and protocols, so I will separate it into the way in which we get to a rating decision, and the analytical judgments that go into that and how we view things.
We have concerns because the complexity of financial products almost mirrors the development of the rating agencies. They have developed and become a major issue in the past 10 to 15 years. I suppose that this is the biggest crisis for CDOs, and the way in which they develop in future must affect how you can assess them. You have given two excellent examples, but the underlying problem seems to be that the management and directors of banks could not understand the products. How do rating agencies issue a rating on a structured finance product that reflects the characteristics of the assets that underlie it?
How many people work for your organisation?
Two thousand.
I accept that our estimates on residential mortgage foreclosures, particularly in the US, were off. To give some hope to the situation, we have understood where they were off. We did—in the stress cases for our AAA ratings, for example—assume very substantial fall-offs in residential values. There is perhaps a misperception that we assumed that house prices would keep climbing, and that we were blithely unaware that there was a cycle in the housing market.
Do you believe that lessons have been learned?
Lessons have been learned. As one of the previous witnesses from the accounting profession said, none of the lessons that we learn will bullet proof our ratings against future defaults or future negative rating migration. However, we think that the lessons that we can learn in this instance have been learned.
Yes. In fact, I can give you an example of that, although my understanding of it could at best be described as a layman’s understanding, as it is on the structured side of the house. A single-tranche synthetic CDO, which does not really exist in the marketplace anymore, is an insurance policy against a particular event. Because the event’s chances of occurring are very remote, the CDO could be rated AAA. All the same, it is by no means a liquid instrument; no one will buy it off you, because it is basically a bilateral swap contract drawn up between two counterparties.
So organisations that are rated pay 80 per cent of your organisation’s revenue. What measures do you take to minimise or prevent any conflicts of interest and ensure that those who get paid are not those who do the rating?
Some were things that we did prior to the crisis, although efforts have been intensified in that region. We have significantly increased our investment on the compliance front, for example. We have created a new operational risk team that ensures that we can respond with procedural changes as soon as we identify any issues that need to be addressed.
I had a sort of forewarning of this because one of my economics students in Tübingen pointed out that an American financier called Paul Erdman, who was jailed in Basel, produced what was called a finance thriller in 1994 called “Zero Coupon”. It argued that for the financial hood the thing to do was to move out of stocks and into rating agencies because they were much less supervised than under the SEC. It was curious to see that looming up in the Tett article.
A lot of SIVs were based on this side of the Atlantic. Again, it is difficult for us to comment because we did not rate very many SIVs.
So you would absolve Moody’s of responsibility for, let us say, the irrational exuberance of Sir Fred Goodwin.
I would not necessarily use the word “dramatic”. We have a certain number of notches that we can play with. If there was a significant change in policy towards supporting the banks, there are bank support floors that are below AA- and it would be possible to use them. We do not anticipate that right now, and certainly from the modest improvement in the individual rating, it seems that things are getting marginally better for RBS. It is possible that the country floor on which the senior rating is resting could move without a dramatic change, but it would have to be fairly significant.
Sure, but to achieve profound and significant improvements in capital availability and profitability—
Do you expect there to be any convergence between your rating of the Royal Bank of Scotland and the divestment by the UK Government of its majority shareholding?
Would the factors that might lead UKFI to dispose of its shareholding on behalf of the Government be the same factors that would persuade you to upgrade the rating of the institution?
That is getting into the details of individual bank ratings. I could ask a colleague to give you more information on that.
That would be helpful.
I agree with the witness from the auditing profession who said that we should not make a distinction between price and value. Ultimately the value will be the price at which it can be sold; there is no point in saying that a thing has a value of X if the only person prepared to buy it will do so for one tenth of X. That is clearly the case for the auditors because they are looking at statements that have been prepared for them to review. From the rating perspective, however, if somebody came to us with a balance sheet that had an enormous amount of goodwill on it because they had made a large acquisition, although that would have a significant impact on the company’s balance sheet, we would not look at it particularly. Instead, we look at the fact that the company has made a big acquisition and ask how much cash it will pay off. Then we ask whether it will make enough cash out of the acquisition to pay off the debt that it raised to finance the acquisition, make a reasonable return to the shareholders and be able to do all that with the level of credit risk in its current rating.
It is just a pity that the mountain has to go to Mohammed.
Good morning, everybody. It is a pleasure to be here—thank you very much for having us. I will start with a few comments to give you a feel for what Angus Tulloch and I do and where we are coming from.
Pension funds and charities make up the institutional side, which accounts for probably around half of our business.
Yes, it does.
We do not do much direct advertising in relation to the retail side, which is probably why you have not heard of us. We manage money for institutions such as Barclays and their clients, all the clearing banks and Fidelity. They have platforms that retailers can go through to put their money into our funds. More than three quarters of our money comes from overseas: the Ohio state teachers fund was our first emerging markets client. We also manage money for three county councils in England, although none in Scotland. We get a lot of money from Australia and a growing amount from the far east, and middle east Governments account for around 15 per cent. We have a very broad base.
In the business insight section of yesterday’s edition of The Times, Ben Thomson made much about transparency for investment firms. Can local councils and charities in Scotland access that information easily?
The impact has been nil. Fortunately, we have not been associated with what has gone on in the banking sector. We are a very different industry. There has been no impact at all.
Yes. When I spoke to a colleague from another firm here over lunch earlier this week, he told me that his firm has definitely benefited from being perceived as making absolutely no changes to its head count or its systems. His firm has done no restructuring, which has been taken as a reassuring sign.
We have prepared a short paper—we did not submit it before the meeting, but I will leave it for anyone who wants to see it—that gives personal views on what caused the financial crisis, what its impact will be on Scotland and what can be done. Most of us think that we should focus on narrow banking and that many functions that are in big banks should be taken out of them to be run and capitalised separately, so that the amount of capital against businesses varies according to the amount of risk that people take. For some very risky activities, that might mean returning to a partnership-type structure, under which those involved would personally suffer and lose their houses if they took ridiculous risks.
I will follow up on Stuart Paul’s answer to Rob Gibson’s earlier question on whether fund managers should be judged on long-term returns. Would there be a problem with that, in that fund managers obtain their business on the basis of short-term rather than long-term results? That produces in the sector a tendency to chase returns rather than long-term value. Does anything in your company’s bonus structure result in people chasing short-term returns or is the structure such that that does not happen?
Education is one aspect. We have spent a huge amount of time explaining to clients that we report over three years rather than three months. Clients know that they are in for the long run. In relative terms, we have had significant underperformance this year—up 35 or 40 per cent against an index of 55 or 60 per cent—but we have had remarkably few complaints, because clients understand that we define risk as losing money rather than underperforming against a very flawed notional benchmark index.
It is very much the latter case. Our approach prevents us from recruiting a certain type of investor, but we argue that they are not the type of investor whom we want to recruit in the first place.
We have been recruiting on the operational, support side, which is mainly locally recruited. Recruitment has continued apace and we are employing more people in both the investment and operational sides than we were employing a year ago.
You talked about the importance of having headquarters in Edinburgh. We have heard from witnesses that Scotland’s highly skilled staff are a key reason why people locate in Edinburgh or elsewhere in Scotland. However, you said that bureaucracy has increased and you talked about Scotland’s declining reputation. Will you amplify those comments?
That is correct.
Does your company have good links with the Scottish universities?
The answer is no. We do not do a formal training scheme. We are not big enough to do that. We tend not to employ graduates. If people are going to be internationally aware, we quite like them to go away from Scotland, find out about the rest of the world and get London out of their system. We can put people into Hong Kong and Singapore for a couple of years. We have done that quite a lot. As I said, we do not have a formal scheme. Although we have taken on a couple of people at graduate level that is not something that we focus on.
Not from the FSA. We have spoken to the Scottish Government education directorate—we have had quite a lot of discussion with it—and the Scottish centre for financial education. However, they are interested only if it is home-grown—if it is produced by them. They are really not interested in outside services.
We have heard from other witnesses that sector-specific qualifications are required. You made that point in your opening remarks.
We have had evidence from some witnesses on regulation. One specific piece of regulation—nicknamed the hedge fund directive but, I think, officially titled the alternative investment fund managers directive—has been debated in the Parliament, even though it is a European Union proposal. Do you have any comments on that? Will it negatively affect your industry?
I will talk more generally. The directive’s direct impact on our business would be limited, but it would have a significant impact on the investment trust sector in Scotland. I am sure that members have already heard about that. I understand that the proposals threaten self-managed investment companies in particular and that they would be very damaging. Several very large self-managed companies employ a number of people in Scotland, and they would certainly be affected. I know that they are lobbying hard on the directive.
We have a potential problem with capacity because of the markets with which we are involved, so we have closed quite a lot of our products. The problem is that, if you simply do everything with flat fees, some of the better fund managers will be excluded, because there is a limited amount that can be managed in particular markets. Obviously, the best way to ration that is through prizes.
I have a couple of questions. First, I want to follow up on that interesting set of questions and answers on risk. You talked about having a commercial environment that allows a common-sense approach to risk and said that, in simple terms, the approach should fundamentally be about whether money is lost. Would that approach to risk have made a difference to the financial services sector over the past three or four years and, if so, how?
The broad issue is of great interest to us. We have had evidence from two or three witnesses that different parts of the financial services sector have almost profoundly different approaches to risk. Could the investment banking sector—which led us into some of the difficulties that we are talking about—learn from the approach that you describe, or is there such a profound difference in what you do that your approach to risk could never be the same as the approach in the investment banking sector?
There are areas of overlap and areas of divergence. The areas that overlap revolve around incentivisation, time horizons and reputational risk. Our clients would not expect us to lose money in a falling market—that would be an unexpected result for them. For investment banking businesses, if there were a clearer definition of types of business that they wanted to be associated with, or did not want to be associated with, a different approach could be taken. There is a vast area of business that is very different from the one that we are involved in.
The key thing is to focus people on responsibilities to the client, rather than on the short-term transaction. It is debatable whether it is possible to change people’s behaviour in that way, but one can have a go, by trying to make people in the industry feel that they have a responsibility.
Yes, absolutely. If you make more regulations, it just encourages very bright people to work out ways to get round them—and they will, as has been shown over the past year. I do not think that they provide the answer.
That is helpful.
Yes—and I am sure that the French could teach us a few ways of getting round such things.
When we travel to Hong Kong and Singapore we are struck by how easy it is to get there, and then to get into the city. Anything that we can do to mirror their success would be helpful. As Angus Tulloch mentioned, Singapore, which is within our sphere of operation, has been very successful in getting businesses to relocate and in encouraging investment in the core business that it sees as being part of its economy for the next 10 years or so.
Yes.
I will start with that point about rail links. Your organisation is affiliated to the Commonwealth Bank of Australia. I am not sure whether you have been to Melbourne, but it is a major city and industry hub, and the transport from the airport into the city is quite excellent without a rail link. I just wanted to get that on the record.
How do we incentivise that behaviour to typify the industry more generally and not just individual players within it?
To want to do that in a commercial sense you have to believe that, in the long run, understanding a business’s strategy and ultimately where it is going will lead you to make better investment decisions. The problem is that if you are being assessed on whether your decisions have worked on a rolling 12-month basis, there is almost no point in having such a conversation because there is no requisite timeframe over which you can be rewarded. That disconnect has definitely led to some of the ownerless corporation-type approach.
I ask Stuart Paul to go first. Our answers might differ; I am not sure.
The authority would have to be original and different and would depend on the people who ran it—they would have to focus on the spirit rather than the letter.
You stress the relatively long-term policies that you pursue in allocating investment, which seems to contrast dramatically with what I have read in the sensationalist press—the Financial Times, in other words—about operations in London hedge funds, for example, where a portfolio might change rapidly over a couple of days. When we interviewed David Nish, from Standard Life, he stressed that a lot of Standard Life’s investments were going into private equity, which was not known for unadventurous activity when it comes to changing portfolios. What was your attitude to investment in private equity organisations during the two or three years of the boom that came before the spectacular slump?
My thought on that is that it can be difficult to prove a direct link. Forgive me for using a sporting analogy, but the situation strikes me as being similar to developing youth talent within a football or rugby club. The talent might not immediately flow through to the first team and make that team more successful; it might make its way elsewhere. However, the idea is that, ultimately, the positive flow and knock-on benefits that are produced are a good thing. There are two or three examples in Edinburgh of companies that have spawned quite successful business as people have left one business and set up another one. Ultimately, the investment in those individuals was not necessarily directly to the benefit of the organisation that trained those individuals, but it was of indirect benefit, as it helped to create a more vibrant industry. Certainly, it was of benefit to Scotland.
I am head of financial reporting at the Association of Chartered Certified Accountants. The ACCA is a global body for professional accountants with 500,000 members and students around the world. We are well established in Scotland, as more than 7,000 of our members are here. They work in a variety of fields—such as the public sector, and corporate and public practice—as professional accountants. Our global administrative headquarters are in Glasgow. We have a separately constituted branch—ACCA Scotland—which looks after our members in Scotland.
Stuart McMillan talked about graduate recruitment earlier. It is very clear that the accountancy profession is not here for the short term: there is a blip, but we are in a transitional period. In the larger firms, mine included, there has been no change in graduate recruitment in the past two years. We are probably recruiting as many people, if not more—I believe that my firm recruits about 80 graduates in Scotland.
We are increasing the number of banks that are training with us. RBS is one example—it has trained with my colleagues’ bodies for some time and has recently started training ICAEW students. As a profession, we are working to increase the availability of training contracts and working with the financial sector as well as within professional practice.
I agree with that; it is all true. All our surveys are done through the Open University business school and are funded by us and Barclays Bank. The overall survey view tends to reflect the business position in a simpler way than the banks’ position. There was a distinct drop of around 10 per cent in the facilities that were available in the early part of 2009. We are seeing some recovery from that position, but the drop was noticeable.
The banks have business branches and managers, so there is someone to talk to. However, I completely agree with Bruce Cartwright that banks set thresholds below and above which applications are dealt with differently, and different information is demanded at different thresholds. It is not surprising that banks do things differently with applications and on-going monitoring according to how much money they have out there.
It is funny that you should ask that. I am sitting here as a member of ICAS and thinking that there are ICAS members in local communities all over Scotland. For example, in the farming community, it is obvious that people talk to their accountant. Sometimes we have to be fair and say that people like getting free advice; they do not like to pay for it. There is a natural network, but it is a two-way thing. A small business with a £2 million loan might not do its accounts regularly and might not be able to give facts and information. People are sometimes reluctant to turn to a lawyer, an accountant or professional adviser because the clock is running, but there are probably ICAS members in every location in Scotland. I do not want to brag about ICAS, but the professionals are out there, and perhaps they are underused.
David Wood referred to the non-anticipation of the sub-prime mortgage crisis. Given their understanding of collateralised debt obligations and the like, surely sub-prime mortgages should have flagged up dangers in the minds of auditors ahead of time. Were challenges being made to management about such financial investment structures, which were proliferating in the market at the time?
I emphasise that the audit is a true and fair view at the balance sheet date. During the crisis, we know that events moved extremely quickly. Although some investments were difficult to value—there were many problems with that—investments that were being traded at a particular value subsequently saw their value diminish significantly over a matter of a few months. Therefore, very big losses were incurred by some institutions. However, on the whole, the picture that we now see is that those losses were recorded in the right period. I do not think that we have seen lots of cases in which the values that were attached at the balance sheet date were necessarily widely out or wrong. The values were right at that date, but events changed subsequently. In those few months, major losses of value were incurred that had to be recognised.
I can probably offer comments on the UK more generally, rather than on Scotland—
So, it is a good time for auditors and their profits.
The headquarters of financial institutions in Scotland, the asset managers, insurance firms and so on, as well as the banks, are all seeking your services. Is there any noticeable difference in that demand just now? That was the root of my question.
I go back to the audit issue, and ask for a little bit more clarification of the audit process in a major bank, for example. What will the auditor do, and to whom will it give account at the end of the examination of the accounts?
It is important to remember that the auditors of a bank have exactly the same job as the auditors of any other institution. They have only limited responsibilities in relation to the FSA and on the regulatory side. Therefore, if a bank auditor or an insurance auditor becomes aware during the course of their normal audit work of anything that the regulator ought to know about, they have a statutory obligation to report that to the regulator.
You are right that auditors must have an overall view of often large and complicated institutions and that there is something in that position that could be useful. As I said, the financial statements have to talk about how the company manages its various risk exposures and about the nature of its investments. All that has to be covered as part of the audit because it is in the financial statements and, sometimes, in associated documents that the auditors are responsible for examining.
Yes, that is right. We are talking about very big financial conglomerates with global operations. The number of firms of similar size with expertise to match is fairly small.
I knew that you would say that.
There is a so-called big four of accounting firms. Other organisations are looking to get into that market, but the focus is on the big four.
With many such instruments, it is a question of what the value of those instruments was. That is what I was trying to say. Such instruments have a value on a particular date, which is a true and fair value on that date but not at a subsequent date, so a great deal is caught up in the valuation that is put on them. The valuation that was put on the instruments in question was put on them by the management and was based on transactions that might have been taking place on similar instruments. There are specialist firms that value such instruments. It is accepted that the market priced some of those instruments incorrectly: it did not understand the risks, so it got the valuation wrong.
Richard Martin is right about valuation, but even if we move away from considering instruments—in order to make the issue more tangible for people here—and look at the property market, which people can see and feel more readily, we see that the values that were put on property were correct at that point in time. An irony is that the financial crisis was a liquidity crisis but, because that made people lose confidence, there was an almost self-fulfilling expectation that property prices would begin to move downwards due to lack of liquidity. For example, values in the commercial property market are probably 50 per cent of what they were two years ago. I do not think that people would have predicted that sort of correction. I find it easier to consider the issue in the context of the property market because I can see and feel it. Property prices were not previously wrongly valued—people were willing to pay those prices for property, although they would certainly not pay the same price today. Values will come back, but it might take seven or eight years.
I want to press you on that because, to my mind, you are mixing up price and value. The price of something is what someone is willing to pay for it, but that is not its value. For example, if I was foolish enough to buy a fake painting, I could pay a large price for it but it would not actually be worth anything. Did the people in the accounting industry who were auditing the banks understand the underlying value—as opposed to the price, which we all know was wrong—of the assets? Did they understand the risks that were contained within those assets in a way that enabled them to say that they had been given a true and fair value, as opposed to a true and fair price?
Before answering that question, I need to be clear that, if someone is willing to pay the price, that is the value that they attribute to the asset. I am sorry to disagree on this—
Price is probably the best and most objective indication of value at any point in time. Yes, price and value are different, but price is an objective measure whereas value is a bit of a theoretical concept.
Clearly, auditors look at the balance sheets of companies and organisations. To what degree do auditors have discussions with institutions—financial or otherwise—about what is not on the balance sheet?
The International Accounting Standards Board has been looking closely at off-balance-sheet issues over a number of years and has tightened up what goes on to the balance sheet. The IASB chairman, Sir David Tweedie, is on record as saying that he will feel that his job is done when British Airways has its aeroplanes on its balance sheet. There has been an on-going process at looking at what is on and off balance sheet.
I agree. Obviously, the UK and the other European banks have been using the international financial reporting standards, and the generally accepted accounting principles apply to the US banks. The off-balance-sheet issue is always difficult and significant, but I agree that it was more of an issue for the US than for the IFRS. When Deutsche Bank moved from using US GAAP to using IFRS in 2007, its balance sheet expanded by 40 per cent as a result. It is right to say that the issue of what was off balance sheet was much bigger for the US.
There are probably a lot of lessons to be learned about how banks are regulated. The FSA has been considering those lessons. There may be questions about how accounting interacts with regulatory standards and about how some regulatory numbers fed into the capital rules, made them pro-cyclical, and therefore helped to inflate performance in the good times and caused it to become more severe in the downturns. The capital rules need to be looked at.
Does the name Friehling & Horowitz mean anything to you?
It does not mean anything to me.
Clearly, if there are audit failures, the people responsible must be held accountable for what they have done and the accountancy profession as a whole has to examine its role in the monitoring that we do and the disciplinary action that we take over our members.
With respect, you had the Arthur Andersen failure as a result of the Enron fraud three years before this and yet the same thing has happened again—this time, even less of a real firm was involved. The dominance of the big firms went on: they signed off accounts and people believed them. As Lady Bracknell might have said, “To allow this to happen once is an accident, but to allow it to happen twice seems like carelessness.”
Over the past few years, there has been a lot of focus on audit quality. That is important. When Patricia Hewitt was Secretary of State for Trade and Industry, she asked us to set up the audit quality forum to improve dialogue with investors, regulators, auditors and preparers on what people want from auditors and to look at issues including independence and processes around audit.
It may have been Iain Coke, but yes.
On the transparency of the audit process, the FRC is looking at the audit report and whether it can be made more useful. That is one initiative. On increasing the transparency of financial statements, we mentioned the work that is being done to develop accounting standards and improve disclosures on financial instruments and risk et cetera. Changes in the corporate governance code are bringing in disclosures on business models and risk, and there are additional structural changes regarding risk with the recommendation that risk management committees be established at the highest level. A stewardship code has also been issued in relation to investors getting more involved with companies, which links back to the previous evidence session. A number of changes have been made.
A couple of weeks ago, the FRC and the ICAEW launched a code of governance for audit firms. That project started in about 2007, so it is not directly related to the crisis. However, it addresses the competition and choice debate in audit firms and looks for ways to strengthen governance in audit firms and avoid risks, or perceived risks, arising from the withdrawal of another major audit firm from the market.
I agree with all the foregoing comments. A number of people who are responsible for regulation in the area have been going over the lessons that have been learned and the things that need to be put right. The International Accounting Standards Board and the International Auditing and Assurance Standards Board have also been active. A lot of the work has been co-ordinated, ultimately, through the G20 meetings, and a lot of the direction has come from there. Because the International Accounting Standards Board is involved, a lot of the basic regulatory framework rests at a global level. The G20 has been very important in that process.
What recommendations should we make to Government in our inquiry report to ensure that such a crisis does not happen again or, if one is coming down the line, that we know that that is the case? Are the changes that are being made enough, or should they go further?
I think that that is more of a short-term blip and that there are no long-term implications for Scotland’s reputation. We have been concerned about our international reputation, but other countries have had their own problems to deal with. The fact that the two banks whose names are attached to Scotland have had problems was an issue, but I think that we will get over it very quickly.
That must be right. As we sit here in Edinburgh, we feel the denting of our reputation—it is tangible. We are all Scottish and it feels very personal, but we probably feel it worse. In London or in countries abroad, people have their own issues.
The European level is a difficult issue. We have to live with that because the EU exists, and it has produced some legislation at that level. Ultimately, however, one of the things that has been clear in this area over the past few years is the global nature of the crisis. To some extent, global co-ordination for the solution is necessary. Iain Coke mentioned a number of global bodies, and co-ordination must be achieved at that level.
I have a suggestion. We have discussed regulation, but I believe that we need to move towards having better and more effective, rather than just more, regulation. The danger of approaching an issue by saying, “Nothing like this must ever happen again” is that we often end up putting in place huge and burdensome regulation that stifles a lot of economic activity. We need to be careful and guard against that—there is a balance to be struck.
After the Treasury Committee report was published last year, I did some research into the disclosures of auditor fees in the accounts of the 23 largest UK financial institutions. That research supported the analysis that David Wood has given. Overall, an average of 56 or 57 per cent of the total fees charged by the auditor was for audit, but behind that we gave quite a precise meaning to the term “audit”. It covered only the work that was done for the year-end financial statements and did not include work such as reviewing the interim financial statement—that is described as a non-audit service.
Auditors are appointed by the audit committees, so the independent non-executive directors are responsible for that and shareholders have rights of approval. In the case of banks and financial institutions, the FSA has the ability to say that it does not think that the auditors are up to the job. The FSA does not appoint the auditors, but I understand that it has a right of refusal, if you like.
Colleagues, we welcome our third panel this morning. Again, I apologise that we are a little behind schedule, but we have had a very interesting morning so far. I welcome Richard Hunter from Fitch Ratings, which is one of the leading global credit rating agencies. Perhaps he can make some opening remarks before we open things up to questions.
I would hate to start my first answer by larding it with caveats that there are so many limitations to the ratings that people misuse them. Clearly, the performance of a number of ratings, particularly in structured finance, has not met our expectations, and we are working hard on that. Nonetheless, I agree that there has been a problem with people not so much misusing as misunderstanding ratings. There is a limit to the dimensions of risk that ratings represent. For example, a rating does not capture the liquidity risk of a bond. A bond might be very unlikely to default but simply be illiquid because it is denominated only in very large selling amounts for a very small bond from an issuer that nobody has heard of. The rating does not speak to liquidity or to many other things.
I will pass on to Rob Gibson, who will ask the next question.
Slightly more than half.
I will again split that question into two: how we deal with it and whether the risks are different.
The word “complexity” is used a lot, but it is important to go a little beyond the topic of complexity. There are lots of moving parts, and many people cite the fact that the documentation for a structured finance deal might be 2,000 pages long. The figure of 2,000 pages is largely apocryphal—typically, it is a few hundred pages—but the documents are still a lengthy and dense read.
There has been some criticism that ratings are not reviewed often enough. Are there ways in which the surveillance of ratings ought to be made available to the public, in addition to the data that you publish on the web?
How many of them are analysts who decide the ratings?
We would regard that comment as an outlier. The United Kingdom has a AAA rating from us, with a stable outlook. The UK has had to spend a lot of money as a result of the financial crisis. It has had to spend more, as a percentage of GDP, than some other countries—above 20 per cent of GDP has been the immediate cost of the financial crisis, including the loss in revenues through the shrinkage in GDP. However, the UK started the financial crisis with a lower than average level of debt in relation to GDP. Also, the amount of money that has been spent is a gross amount of money—a lot has been spent in buying securities. Ultimately, there will be some return on that, so the net cost will be lower.
That is a very good question. Those tens of thousands of products can be broken down by complexity. A more complex product, for example, will require more analysts. When the US Securities and Exchange Commission carried out an investigation, it discovered that our agency was the only one to keep pace with the growth in the number of these securities and to ensure that more analysts worked on them. I said that, at the moment, we have about 1,000 analysts, but a year ago we had 1,500. A number of analysts left Fitch because the market for those securities does not really exist any more and we do not need people to read those 200-page prospectuses.
A debate that has been raised in public is that about the potential for a conflict of interest. You mentioned that the bulk of your revenue comes from organisations being rated. Can you give a rough percentage for that?
It is more than 80 per cent.
You mentioned a number of things that you have done to minimise or get rid of the conflict of interest, including separating analysts from marketing, appointing compliance auditors, establishing a credit policy group and having a chief credit officer in each of your teams. Have those things happened as a consequence of the financial crisis, or did you do them prior to the financial crisis?
Scotland on Sunday carried a story about the rating of UK Government bonds and used the quote that they were
Let me take you back to the takeover of ABN AMRO in early 2007 by the Royal Bank of Scotland, Fortis and Santander. An article by Sam Jones, Gillian Tett and Paul J Davies in the Financial Times talks of a mispricing of constant proportion debt obligations. ABN AMRO had made a particular market in those and was offering returns that were substantially above those of traditional mortgage-backed securities. However, Moody’s downgraded the rating of CPDOs in mid-2007 on discovering that there was a computer flaw that was overpricing them by up to four notches. In October 2007, the Royal Bank of Scotland found the money to bid what amounted, in the end, to €70 billion for ABN AMRO with the result that we all know—the biggest corporate loss in British financial history in 2008. What role do you think the failure of the credit ratings agency played in that? The FT seemed to be of the opinion that the word of the rating agencies had misled the markets on that.
There are a few topics in there. I will start with constant proportion debt obligations and say at the start that we did not rate them because we did not think that they would get to anything like a rating level of AAA; we thought that the highest they would get would be the middle of investment grade. I am conjecturing with hindsight, but I doubt whether they would have made a significant difference to RBS’s interest in bidding on ABN AMRO. Obviously one of the most attractive things for RBS about ABN AMRO would have been LaSalle, the large regional bank in the US. Again, because I do not know the figures for the exposure of ABN AMRO to CPDOs, it is not clear to me whether it would have made a particularly big difference to RBS’s decision to enter into that merger.
I understand that Fitch upgraded the Royal Bank of Scotland’s rating in December. I believe that it is now AA- for long-term default prospects. It would be helpful if you can confirm that. If not, I would still be interested in hearing your comments on the wider question. When you consider the rating of an institution such as the Royal Bank of Scotland, and given the particular circumstances that apply there, what factors might you take into account? I am thinking of, for example, capital injection by the UK Government, entry into the asset protection scheme, the European divestment requirements that have been published in recent months, and other factors of that sort. Would those factors influence the rating that you provide to such an institution?
Before, it was at A/B, so it was very close to the top of the scale. It would be difficult to tell and it is slightly off my bailiwick to discuss how long that would take.
We take account of them in numerous ways. First, we look at what the audit statement says. Believe it or not, some audit statements do not actually amount to audits. A particular type, which I believe is called a compilation, allows an auditor to put a note on the front of the report that says, “We have compiled this” when they have taken literally no interest in the truth and fairness of the view contained therein. Compilations are relatively infrequent and might be a peculiarity of the United States.
We touched on this earlier with the auditors, but when you do your credit ratings, to what extent do you look at whether the value of the assets stated by the companies is genuine—in other words, the price versus value differentiation that we spoke about earlier? I do not know whether you listened to the earlier evidence.
Thank you. It would be interesting to hear what your valuation of Kraft is after its debt-funded acquisition of Cadbury, but perhaps that is a matter for another day. I thank you for taking part in that lengthy evidence-taking session. It was helpful in giving us a better understanding of the role of credit rating agencies.
Next week will be our penultimate evidence session in this inquiry. Martin Currie Investment Management has agreed to give evidence and we will fit that into our meeting on 24 February. Next week we will hear from the Financial Services Advisory Board and the finance sector jobs task force. We will then hear from the Cabinet Secretary for Finance and Sustainable Growth.
I thank everyone for what has been a long but interesting meeting.
Good morning. I welcome everyone to the fifth meeting of the Economy, Energy and Tourism Committee in 2010. We have one item on today’s agenda: to continue taking evidence for our banking and financial services inquiry. We have three panels to hear from today.
Where do you draw your client base from, and how do you go about attracting new clients? You mentioned the Scottish institutional aspect in particular.
I have prepared a few points on how I think the Scottish Government might be able to help and grow the industry.
With regard to the cultural aspect, Scots as a people quite like to be contrary. They love arguing with each other, and that is an important part of our business. I say this carefully, but I think that the Calvinist dimension is important too. There is a degree of loyalty up here: there is much less mobility between companies than there is in London. People work pretty hard, and they do not like losing money. That is very much part of what we do: we are not making fancy new products; we are genuinely trying to work in the interests of our clients.
I want to ask about how the financial crisis has impacted on the investment management industry in Scotland, but first I have a follow-up question on the suggestion that it would be a good idea for local investors to think about using local fund managers. Is it possible to compare the success of Scotland’s investment management firms with that of others? After all, sentiment is one thing, but the bottom line is another.
Two things immediately come to mind. In some ways, our business is the most transparent in the world, because our performance is clearly visible to anyone who has an interest. The counter-argument is that there are lies, damned lies and statistics. As everyone sitting around this table will probably be aware, the industry has asked itself many questions over the years about how it presents information and advertising. Typically, when people want to buy into a certain investment strategy or area, that means that the investment is popular. However, to take the contrarian view, that means that it is questionable whether it is the right time to make such an investment decision. There is often a somewhat inverse logic to such things.
The information is available and such organisations will have advisers who have access to it. The question, I suppose, is who provides advice and on what basis fund managers are selected. However, we probably do not have a great insight into that.
So basically—this relates to the restructuring that might happen in banking—the strength of the investment management industry lies in its diversity and firms’ independence.
If the committee were to make recommendations to the Government, I take it that you would want us to ask it to look at numeracy and literacy standards in the school system.
The answer is probably no, but we are trying to do something about that. I am involved with a group of people and the University of Edinburgh in looking to set up a centre of financial history, given Scotland’s huge contribution to the world’s financial history. If that happens, the approach will be deliberately pragmatic and not theoretical. Universities tend to be extremely academic in their approach to investment, which is a problem for us. They are very good at producing mathematical models and so forth, but that is not what investment is about. The meeting of minds has been difficult to maintain.
Let us say that a large Chinese pension fund is making its first overseas investment in this country. If we can offer to have someone from the organisation to train with us for six months, we have a huge edge over other people. We are very open to doing that. As much as it is possible to do so, we have people sitting in with us and learning about the business.
I return to your links with universities. Graduate training and employment is very important. Are you involved in any graduate training schemes?
I am sure that there will be regulatory changes; we expect that to happen. I imagine—this is a personal view—that there might be far more focus on remuneration structures.
We are fortunate. Earlier, I mentioned that we have a broad degree of autonomy over running what is effectively a business within a business. Ultimately, Angus Tulloch and I are our business’s risk managers. That places a huge responsibility on us, but it also gives us the ability to not make changes to satisfy people in the short term. I would probably give you a very different answer if we were part of a bigger organisation. I am sure that there is a lot of pressure in big, broad-based financial services companies and that many questions are being asked.
Another issue that is likely to be put under the microscope is fees. That is completely understandable, but the focus on fees often distracts from the focus on what is fundamentally being invested in. Reducing costs for the consumer is a popular cause and, in some cases, it has a lot of merit, but it is even more important to ensure that the structure of the products or the strategy has integrity and that the end investor understands what they are investing in. It can be argued that people would not mind variable fees as long as they were achieving the returns that they set out to achieve. It is quite easy to produce a low-cost solution, but whether that is the right solution may be questionable. That was tried with stakeholder pensions. It is clear that I am talking from a particular perspective; you are hardly likely to hear me say anything else.
If, rather than the absolute performance that a fund manager achieves, they are held to account for their investment performance during periods of relatively short-term underperformance, there tends to be commercial pressure to do something about it. If a certain sector is prominent and is performing well—as the financial industry was two or three years ago—the commercial pressure is great for fund managers to participate in that, even if, on a five or 10-year view, they regard many of the dynamics in the sector as unhealthy. Anything that enables a fund manager to step back and consider whether something is in the clients’ long-term interests is good, as that is a healthy question to ask.
As you say, it is a behavioural, cultural issue, rather than one that is amenable to regulation. Would that be fair comment?
Those models are well connected, with hub airports and rail links directly to the city centre.
I am not for one minute suggesting that you should recruit only Scots. I studied European business and languages. When I came out of university in 1997, there was a lack of understanding of the course that I had taken and it was difficult to get over to people its diverse nature. Folk from my course struggled to gain employment in the international sphere or work that had a European outlook. There must be a two-way street. Universities and graduates need to sell that aspect and businesses need to sign up to it. I wanted to get that on the record and to get a feel for your views.
In our business there are two areas we can talk about—the hiring of investment talent and the hiring of operational talent. My perception is that the industry has done quite a good job in the latter area. Although we have almost the same number of people in the broader business in London as we do in Edinburgh, the vast majority of the operational side of the business is run from Edinburgh. That is testament to the skills pool that has developed here and the ability that exists to build a team.
How long do you have? We both have views on that—I will make one or two comments and I know that Angus Tulloch will too. It goes back to the point about the timeframe for assessing performance and decision making. My personal view is that the industry has got to where it deserves to be in some ways, because as the focus has become more and more short term, there has been less and less interaction between shareholders and executive management teams. As I said at the outset, that is what our business is all about. However, it is a two-way street: if you are a chief executive of a public limited company, you will spend time speaking to investors only if you feel that you have a duty to satisfy and hope to get something back. It should be a two-way street. We should be helping by being a sounding board or providing ideas.
On the corporate governance front, we strongly believe that companies that do not look after all their stakeholders—not just their shareholders—will not be good, long-term, sustainable investments. There are a lot of companies that we will not touch, because they do not look after their employees or customers or the community—I am thinking about pollution incidents in China, for example. During the past year we have been partially responsible for senior management changes in companies in which we have investments. We find that discussing such issues helps our investment process tremendously, as Stuart Paul said.
Private equity funds provide useful operational and financial discipline. We do not have a vested interest in that regard, as we do not run private equity funds, but that is our observation. What I like to see in Asia is a family that controls a business with a private equity shareholder, because that lets you know that they are being watched, so it serves a purpose. A problem arises when the private equity shareholder has excessive leverage, as has been the case in the past, because if it is involved for a three to five-year term, it can squeeze the business of cash towards the end of that period.
I cannot really comment because we focus much more on overseas businesses than on local businesses.
My final question is about the way forward for financial services in Scotland. You will know of the Financial Services Advisory Board. The Scottish Government has mooted the idea that Scotland should have an entirely separate equivalent of the FSA—a separate regulatory authority—which could introduce another regulatory authority for organisations that operate from a Scottish base but are UK-wide and global. Do we want to duplicate the FSA and have a separate regulatory authority? Would such a development be desirable?
I think that I know what Angus Tulloch thinks that I will say, but I might say something different.
Almost all of the investments that we make are in the quoted arena, which means that we do not really invest directly in private equity. We have views on what happened in that sector, however, which I am happy to give you.
Do you, as investors, have a readily accessible map of the exposure to particular types of organisation that you would get within a particular investing community such as Edinburgh? Do you have a notion—whether it is based predominantly on anecdotal evidence or on information on balance sheets and so on—of who is heavily into private equity, hedge funds and so on or is that an area where you would just have to suck it and see in order to work out what is going on?
Scottish Financial Enterprise would be the organisation to ask. If anyone ought to know about that, it would. I know only a couple of organisations that manage hedge funds—Martin Currie and Standard Life—and that is a small part of their business in Edinburgh. The organisation with the biggest involvement in private equity is Standard Life, but that is not a huge part of its business.
The points that you made earlier about financial education and so on have relevance for any Scottish political structure, because it must provide the infrastructural funds that will supply your needs, for example for trained manpower. Therefore, do you see problems in a situation in which the profit can go into secrecy jurisdictions and the like and not make it back to the place of origin, as is the case in the present system? There has to be some sort of loop whereby the money that the Government spends on providing infrastructure that enables enterprise to function—whether in the form of airports, trained workers or whatever—is returned to the community. However, in our investigations, we have repeatedly come across the fact that the other end of that loop seems to disappear, somehow.
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