Ten years after Lehman: how accountants can make finance safer

Speaker: Charles Randell, Chair, Financial Conduct Authority and Payment Systems Regulator
Location: ICAEW Canary Wharf Members’ Club
Delivered on: 6 September 2018

Highlights:

• The financial crisis raised a fundamental question for the accounting profession and for others: what are financial statements for?
• Ten years on from the height of the financial storm is a good moment to reflect on whether we have answered that fundamental question.
• Good quality financial statements are a key building block of effective prudential regulation of these firms.
• The accounting profession can help to guide firms to put business model analysis and consideration of long-term viability at the heart of their corporate reporting. 

Note: this is the speech as drafted and may differ from the delivered version.

On this day 10 years ago, Fannie Mae and Freddie Mac, 2 enormous engines driving real estate loan markets in the United States, were put into conservatorship and effectively taken over by the Federal Government. Nine days later, Lehman Brothers filed for bankruptcy. Numerous other firms then failed and either entered insolvency processes or were bailed out by governments. It’s often been said that the financial crisis caused lasting damage to our economy and that in the austerity which followed, the living standards of millions of people fell. But behind the economic statistics lie tragedies of individual loss: loss of employment, loss of savings, loss of mental or physical health and, in some cases, loss of life.

Most if not all of the firms which failed had been reporting relatively robust financial positions right up to the point when they did fail, with financial statements signed off by their boards and large audit firms. 

So the financial crisis raised a fundamental question for the accounting profession and for others: what are financial statements for? 

Ten years on from the height of the financial storm is a good moment to reflect on whether we have answered that fundamental question, and to think about how accountants can make finance safer.

Accounting and the FCA

Why is accounting relevant to the mission of the FCA? There are at least 4 reasons.

1. The FCA is a prudential regulator: first, the FCA is a prudential regulator.  Although the capital requirements of some 1,500 banks, insurance companies and large investment firms are set by the Prudential Regulation Authority, there are over 18,000 solo-regulated firms whose capital requirements are set by the FCA, including the country’s biggest asset managers and investment platforms. Good quality financial statements are a key building block of effective prudential regulation of these firms.
2. Accounting metrics drive incentives of management and shareholders: secondly, metrics from financial statements, such as return on capital or earnings per share, drive the incentives, and therefore conduct, of management and shareholders. Both management and shareholders have reasons to want firms to take on more risk, because they have limited exposure to the downside. The financial statements may be accompanied by disclosures about risks that have not yet crystallised but, generally speaking, they do not try to adjust reported results for risk. Both management and shareholders are sometimes long gone by the time that the potential risks to a firm’s business model become actual threats to its survival. We see clearly now that in the years leading up to the financial crisis these lopsided incentives drove risky business models. Customers suffered, as firms mis-sold products in their search for growth and returns; the crisis was a crisis of misconduct and not just a prudential crisis. By 2017, the global banking industry alone had paid out over $320bn in fines worldwide for misconduct, and the amount continues to grow.
3. Poor accounting records can cause consumer harm: thirdly, firm failure can leave customers high and dry. They may lose their savings and, even if they do not, they may face delays in getting their money back. Firms should be financially resilient. But in a competitive market some firms will still fail, and when they do, the loss and disruption caused by their failure must be minimised. This means having good quality records which support rapid valuations and payouts, reducing not just losses to individual customers but also the risk of contagion throughout the financial system.
4. Financial disclosure is a necessary condition of markets that work well: finally, the FCA has a strategic objective of ensuring that markets work well. To work well, markets need good quality disclosure, including financial disclosure. As the UK Listing Authority, the FCA also has specific functions in respect of the continuing disclosure obligations of listed firms. We saw during the crisis that when the market lost confidence in firms’ financial statements, the result was illiquid and volatile markets, with market participants relying more than usual on their own guesstimates.

I would like to talk about the role of accountants in supporting the FCA’s objectives, and making finance safer, under four headings:

• what are financial statements for?
• the importance of business model analysis
• client asset record-keeping
• the relationship between accountants and regulators

What are financial statements for?

The financial crisis posed the fundamental question: what are financial statements for?

The International Financial Reporting Standards (IFRS) Conceptual Framework for Financial Reporting[1] states that the objective of general purpose financial reporting is to provide financial information that helps users take decisions about providing resources to the reporting entity. It adopts the principle of neutrality and measures assets at either their historical cost or their value at the reporting date. 

There’s been much debate about whether financial reporting standards added to financial instability through their procyclical effects, as current values followed the cycle up and then fell when it turned. Without entering that debate, it seems clear to me that the financial cycle has a significant effect on most financial firms, and that many users of a financial firm’s statements are more interested in what is likely to happen to the firm in the future than what happened in the past.  Neither historical cost nor current value, the two measurement principles of IFRS, will fully meet their needs. 

In the more immediate aftermath of the crisis, the FSA’s Turner Review[2] in 2009 proposed that published accounts should also include buffers which anticipate potential future losses, through, for instance, the creation of an ‘Economic Cycle Reserve’. The Parliamentary Commission on Banking Standards concluded that for banks there should be a separate set of accounts for regulators drawn up on the basis of prudence rather than neutrality, which should be externally audited and might be published alongside the IFRS accounts, together with a reconciliation of the two statements.

Neither of these proposals has been adopted, although to a certain extent, IFRS 9 addresses the limitations of the historical cost and current value approaches. Going forward, firms will need to provide for one year of expected credit losses when financial instruments are acquired or created.  Those provisions will need to be increased to include lifetime expected losses when there is a significant adverse change in circumstances. This is a step towards giving users of financial statements greater confidence in firms’ reported numbers, which many analysts lost after the onset of the financial crisis. It’s now up to the accounting profession to make IFRS 9 work and, critically, to ensure that the standard is applied in such a way that investors can make meaningful comparisons between different firms.

However, the continuing limitations of the historical cost or current value approach of financial reporting standards lead to regulatory requirements for financial firms to keep what amounts to multiple sets of books.  This is, to put it mildly, not ideal: I spent part of my summer break reading Dan Davies’s very entertaining book about fraud, ‘Lying for Money’ in which he describes numerous scams involving the keeping of two sets of books. But for many financial firms, accounting standard setters and regulators effectively require three sets of, I should stress, legitimately prepared books:

• First, the financial statements present the results and financial position of the entity for the reporting period, generally based on current market circumstances, adopting the principle of neutrality.
• Secondly, regulators then require a set of regulatory capital numbers to capitalise the entity on the basis of assumed levels of risk in their assets and operations reflecting, we hope, a more prudent view of the risk of future losses.  
• And thirdly, regulators then require a further set of numbers to be prepared based on severe but plausible stress scenarios. For FCA solo-regulated firms, this is done through the firm’s Internal Capital Adequacy Assessment Process. On the basis of this further set of numbers, the FCA sets individual capital guidance for firms.

How should we feel about this?  I would make three points.

First, and most importantly, the audited financial statements of a financial firm are the cornerstone on which the additional regulatory processes are built. For that reason, we need accountants to deliver high quality audited financial statements for firms. It was, therefore, very disappointing to see that the Financial Reporting Council’s (FRC) announcement of its 2017/18 Audit Quality Review highlighted a decline in the audit quality for the Big Four audit firms and specifically a decline in the quality of bank audits.  Whatever the outcome of the current review of the Financial Reporting Council which is being undertaken by Sir John Kingman, the profession needs to address audit quality as a matter of urgency.

…the profession needs to address audit quality as a matter of urgency.

Secondly, high quality auditing requires robust scepticism and challenge from auditors. Bringing this scepticism and challenge to bear is the core purpose of audit. The accounting profession needs to step up its game here, including ensuring that it benefits from — and matches — the scepticism and challenge inherent in the regulatory capital setting process. Disclosures in the financial statements should properly reflect the risks which are revealed by that process, including the ICAAP or other stress scenarios. It is perhaps an interesting thought experiment to ask whether, if the regulatory capital numbers were subject to external audit, that would increase the focus of auditors on these risks.

And thirdly, it seems to me that the current approach of financial reporting standards — in particular the neutrality principle and the lack of forward looking risk measurement — makes it inevitable that the financial statements of firms will not be sufficient for regulators to do their job in setting capital.  However, it also seems to me desirable that the information asymmetries between firms, their investors and creditors and their regulators should be limited to the minimum necessary. Information asymmetries increase agency problems between a firm’s management and its investors, they reduce the effectiveness of market discipline and they can lead to moral hazard.

Some of the information asymmetries I have referred to have been addressed by the public disclosure of the stress test results of the largest banks and changes in the policy on disclosure of banks’ total capital requirements.

However, this leaves some categories of firms, including FCA solo-regulated firms, where the full amount of capital the regulator deems they should hold, including the additional capital they need to meet stress scenarios, is not transparent to the market. We should continue to debate whether this is satisfactory, and whether financial statements or other disclosures can provide more transparency about the risks an entity may face in a range of plausible future scenarios.

The importance of business model analysis

One of the key lessons of the financial crisis was that good quality corporate reporting and auditing needs to start with the firm’s business model: how the firm generates economic value. In the years leading up to the crisis, we lost sight of what financial firms were for. It’s now clear that to create economic value sustainably, firms need a clear understanding of their purpose and how they ensure they achieve good outcomes for their customers. Since the financial crisis, regulators also start by analysing a firm’s business model when they are deciding their supervisory strategy. 

Quoted companies have had to disclose their business model since 2013. Good business model disclosures are the foundations of a firm’s strategic reporting, and should in turn drive disclosures about performance indicators and risk. Firms should link their remuneration policies to these performance indicators and risks. And the accounting policies should be appropriate to the business model.

Coupled with the long-term viability statement, which quoted companies are now required to include in their corporate reporting, these reforms provide companies with an opportunity to set out how, why and for whom they create value, and the longer-term threats to this model.

I think it is fair to say, firstly, that business model disclosure and the long-term viability statement have not yet reached maturity in all quoted financial firms and, secondly, that firms to which these requirements do not apply have not all recognised the benefits of voluntarily adopting them as best practice.  The accounting profession can help to guide firms to put business model analysis and consideration of long-term viability at the heart of their corporate reporting. 

Client asset record-keeping

The aim of financial statements drawn up on a going concern basis is to reflect the value of assets, liabilities and earnings streams that would continue to be enjoyed if the firm stayed in business. But the regulator tends focus on what happens when all is not well — particularly the point at which the firm is likely to fail and the consequences of the firm’s failure.

As well as recording their own assets and liabilities, the investment businesses we regulate must maintain records of the money and investments they are holding on behalf of their clients. The accuracy of these records is vital to ensure that if they fail, the client money and assets they hold can be returned promptly to clients. We have detailed rules on how to keep and reconcile these records and we also require firms to arrange for an independent audit of compliance with these obligations.

Auditor reporting on client assets has improved significantly over the last five years, particularly after the introduction in January 2016 of the FRC Standard on Providing Assurance on Client Assets to the FCA.

However, the FCA remains concerned that some audit firms have not invested sufficiently in building their knowledge and understanding of the Client Asset Sourcebook (CASS) Rules and the FRC Standard. We continue to see Client Assets reports that are just not good enough.

We continue to see Client Assets reports that are just not good enough.

Our rules require senior management to take reasonable steps to ensure that their CASS auditor has the required skill, resources and experience to perform its functions — and this is a continuing requirement. The obligation we place on firms is additional to the requirements on the auditors themselves, under their own professional standards, to ensure that they are competent to carry out their work.

We continue to monitor this area but be warned: we have a very low tolerance for CASS failings, because of the significant customer detriment these can cause, and we expect auditors to identify CASS failings when they report to us.

The relationship between accountants and regulators

Which brings me on to my final point.The relationship between accountants and regulators since the financial crisis has not always been easy.

Formally, our expectations are set out in the FCA Finalised Guidance 13/3[3] Code of Practice for the relationship between the external auditor and the supervisor’. However, a relationship does not work well just because it is set down in a Code of Practice. It takes hard work on both sides and requires both sides to listen to problems and resolve them. So as the (relatively) new chair of the FCA and Payment Systems Regulator, I would like to assure you that I am happy to get feedback, good or bad, on the functioning of the regulator/auditor relationship and suggestions to improve it.

I would single out firm culture as a particularly important point to discuss in this relationship. It’s clear that it’s one of the most important drivers of conduct outcomes for a firm. The auditors will have a clear view of the culture of the firm they audit, based on the extent to which senior and junior management accept challenge, allow discussion and give straight answers. The effectiveness of the relationship between the executive and the board, and in particular the relationship with the audit committee, is generally a good indicator of culture, as is the extent to which firms empower and take heed of their risk and internal audit functions.

...we need to continue to debate whether financial statements or other disclosures can provide better guidance about future risks and reduce the information asymmetries which still exist between management, investors and creditors and regulators.

Conclusion

Ten years on from the start of the financial crisis, there’s still much more to be done to ensure that accountants in general, and auditors in particular, play their part in supporting markets that function well. This requires high quality audited financial statements, based on well-articulated and sustainable business models.

The accounting profession needs to ensure that firms embed the changes which have been introduced since the financial crisis, including disclosure and analysis of business models and long-term viability and consistent and comparable reporting of credit loss provisions. 

But after that we need to continue to debate whether financial statements or other disclosures can provide better guidance about future risks and reduce the information asymmetries which still exist between management, investors and creditors and regulators. 

However good the financial statement disclosures may become, in a competitive market some firms will still fail. Accountants also have an important role to play in ensuring that firms have good quality records, including records of client assets, so that they can fail safely.

And finally, auditors and regulators share many common objectives and need to ensure that their relationship is open and effective and that auditors share with us their insights into the culture of the firm they audit.

If together we can deliver all of this, then accountants will have helped to make finance safer for everyone.