ow After Enron (and the 2007/08 Financial Crisis)?

Reform

Future Outlook: What N Proposals For

First Proposal:

As is the case with bank regulation and supervision in Germany, there should be a greater role for and greater involvement of the Bank of England in the bank supervisory process than is the case at present. The Northern Rock crisis highlighted the following problems inherent in the tripartite arrangement between the Treasury, the Financial Services Authority and the Bank of England for dealing with financial stability:⁶⁷⁵As soon as Northern Rock encountered problems, it was virtually impossible for the Bank of England to perform its traditional role as lender of last resort as such role was required to be made public – even though the risk of destroying confidence in the mortgage lender existed.⁶⁷⁶The Treasury has proposed to restore to the central bank its ability to lend to a troubled bank for a limited period whereby the public would not be aware of such – hence avoiding a situation of panic

See <

670 http://www.bundesbank.de/bankenaufsicht/bankenaufsicht_basel.en.php> (last visited 30 April Basel II’s incorporation in Germany, into national law was not only facilitated through changes to the Act, but also by means of additional regulations, particularly the

2008)

671

Banking Solvency Regulation

(Solvabilitätsverordnung) which was published in mid-December 2006 and the Regulation governing large exposures of €1.5 million or more (Groß- u Millionenkreditverordnung);ibid

In accordance with the EU’s Capital Adequacy Directives 2006/48 and 2006/49 on the taking up and f the business of credit institutions and the capital adequacy of investment firms and credit institutions ely, the so-called Basle II capital-adequacy principles will take effect as from January 1^st 2007. The exception or financial institutions adopting more sophisticated methods of risk calculation, who will be allowed to adopt iples on January 1^st 2008.

e new risk based capital regime ( as introduced by the Capital Requirements Directive, RD), were formally finalised in October 2006. 2007 however, is intended to be a transitional year with firms having n to continue with Basel based rules for all or part of 2007. All firms subject to the CRD must have adopted the

673In the UK, rules relating to th C

the optio

regime by the 1^st of January 2008: (see http://www.fsa.gov.uk/pubs/iro/iro_2006.pdf), International Regulatory Outlook,

lso ‘Avoiding the Next Northern Rock: The Treasury has Learned Some Expensive Lessons’ The Economist 31^st 2008

December 2006, FSA, page 12)

674 ibid

675 See W Buiter ‘The Lessons from Northern Rock’ The Financial Times Nov 13 2007

676 See a January

and a “run” on the bank.⁶⁷⁷ The second problem comprised of an ineffective scheme of deposit insurance.⁶⁷⁸ A run might still have been avoided (after it had been revealed that the Bank of England had provided emergency loan to Northern Rock) if an effective deposit insurance scheme had been in place.⁶⁷⁹ The Treasury proposes an element of pre-funding which should provide some relief to a banking industry concerned about having to provide an entirely funded scheme.⁶⁸⁰ Perhaps the most important of the proposed reforms relates to the problem whereby during the Northern Rock crisis, the government lacked powers to withdraw control from Northern Rock’s board and shareholders even though the bank was being funded with tax payer’s money. As a response to this problem, the establishment of a

The special resolution regime constitutes the focal point of the Banking Act 2009 in respect of measures aimed at dealing with failing banks. It is the new statutory and permanent regime which consolidates temporary measures introduced by the Banking

“special resolution regime” which should enable the seizure of a failing bank and facilitate all or part of its business to be transferred to a “bridge bank” which would manage services for customers, has been proposed.⁶⁸¹ The FSA is most likely to be in charge of the oversight of these new powers.⁶⁸² The Bank’s role in ensuring financial stability is also to be strengthened. The tenure of the present Governor of the Bank, Mervyn King, has been extended to provide some degree of certainty at a time when the markets are unsteady. In addition to strengthening the Bank’s role in ensuring financial stability, plans are being made over the next months to grant to the FSA, the US style of plea bargaining powers.⁶⁸³ This is aimed at encouraging wrong doers to admitting their faults in return for leniency.

(Following the original publication of this thesis in September 2008, the Banking Act 2009 was introduced.

(Special Provisions) Act 2008 (BSPA) which was implemented as a means of exercising control and bringing Northern Rock into temporary public ownership in February 2008.

According to Part 1, section 1 (1) of the Act, the purpose of the special resolution regime for banks is to address the situation where all or part of the business of a bank has encountered,

es 675 and 676

0 bonuses for the FSA watchdogs who watched Northern Rock collapse’ Daily Mail March

677 Supra not

678 See W Buiter ‘The Lessons from Northern Rock’ The Financial Times Nov 13 2007

679 ibid

680 ibid

681 ibid

682 ibid

683 See B Barrow ‚£300,00 28 2008

or is likely to encounter financial difficulties. The special resolution regime consists of ⁶⁸⁴ three stabilisation options,⁶⁸⁵ the bank insolvency procedures⁶⁸⁶ and the bank administration procedures).⁶⁸⁷

(The Banking Act 2009 not only consolidates the tripartite arrangement as established under the 2006 Memorandum of Understanding, but is also evidential of the extension of the Bank of England’s role in the supervisory process. This is reflected in sections such as those of 7 and 8 of the Act, which clarify responsibilities in relation to the exercise of powers. In respect of bank insolvency procedures, an insolvency order may be made only on the application of the FSA with the consent of the Bank of England, or on the application of the

Bank of England (See section 117(2) of the Act). Further, before exercising insolvency powers in respect of a residual bank, the FSA is required to give notice to the Bank of England. In Germany, the perception that the allocation of responsibilities between the Bundesbank and BaFin had lacked clarity and transparency and had the potential to result in inconsistency and duplication of work, lead to the issue of a new Memorandum of Understanding in February 2008.⁶⁸⁸ This followed a series of government bailouts of state owned banks in 2008 – which in part, was attributed to the systemic importance assumed by such banks and the potential disastrous consequences which could occur if they had been allowed to fail).⁶⁸⁹

As well as assuming a greater role within the supervisory process and collaborating with the FSA, the Bank of England would greatly contribute to the supervisory process as a result of its use of external auditors - in a way similar to that employed by the Bundesbank. In addition to the employment of auditors to conduct trading activities on behalf of the Federal Financial Supervisory Office and audits to determine the adequacy of institutions' market

n 2 of the Act

684 Sectio

685 See section 1 (3a-c) : These are a) transfer to a private sector purchaser b) transfer to a bridge bank, and c) transfer to

ee W isis’ IMF Working

ttp:/ el.de/international/business/0,1518,536635,00.html temporary public ownership

686 As stated under Part 2

687 As provided under Part 3

688 S Nier, ‘Financial Stability Frameworks and the Role of Central Banks: Lessons from the Cr Paper WP/09/70 April 2009 at pages 21 and 22

689 h /www.spieg

risk models,⁶⁹⁰ the Bundesbank has its own banking supervisory auditors (approximately 70 as of September 2000). As a result, the system of bank regulation and supervision in

ermany could be said to involve a degree of on-site supervision and pro active monitoring.

As illustrated by the Legal & General case, regulators in employing the expertise of external

lear division between e conduct of the investigation on the one hand and the need to maintain the supervisory the firm on the other.⁶⁹² At the same time this division of responsibility

focus more on investor protection, in comparison to aly, there is greater need for the use of external auditors. This is not to say that Germany and Italy are not encouraged to make greater use of auditors. The Basel

G

auditors, should also be more pro-actively involved in the supervisory process. As regards the involvement of supervisors during the investigation phase, supervisors of a firm are not as a general rule, directly involved in an investigation which is being pursued by Enforcement.⁶⁹¹ This approach has its advantages in maintaining a c

th

relationship with

may mean that the investigation does not benefit as much as it might otherwise do from the knowledge of the firm or individuals that the supervisor will have built up, nor from the general understanding of the firm’s business or sector that the supervisor may be able to contribute.⁶⁹³

Financial crises such as those of Northern Rock, IKB and Hypo Real Estates in Europe, have lead to a review of arrangements involving the central banks in the jurisdictions concerned.

The occurrence of these crises also highlighted the need for a special resolution regime and a

“bridge bank” whose aims are to address the needs of failing banks.

Second Proposal

Greater use of external auditors should be encouraged not only in the UK but also in the US.

As these jurisdictions' audit objectives Germany and It

Committee also recommends greater use of external auditors within these jurisdictions. The reason for the UK FSA's reduced use of external auditors may be attributed to the dual role

690 Bundesbank's Involvement in Banking Supervision Monthly Report September 2000 p 37

691 <http://www.fsa.gov.uk/pubs/other/enf_process_review_report.pdf> p 30

692 ibid p 30

693 ibid

of the reporting accountant and skilled person which may result in a conflict of interests where the external auditor performs both roles – hence, compromising his independence. To avoid such conflicts of interest, separate persons should perform these roles and greater use of external auditors should be encouraged in the process. The adoption of a risk-based

rvision is one which should be applauded – however it should not provide an excuse for the reduced use of external auditors. Globalisation and conglomeration call for

r

Third Proposal

omponents of the expectations gap makes it difficult to eliminate⁶⁹⁵. Perceived performance of auditors is an element which is difficult to measure and changes

by popular consensus – as realised through the opinions received from

approach to supe

a risk based approach to supervision. A consolidated supervisor is also able to manage mo e efficiently cross-sector services' risks.

Since Article 57(2) of the Treaty of Rome requires unanimity for the adoption of community measures concerning the protection of savings, what applies to banking depositors in Germany, Italy and France should also apply to policy holders in these countries and the UK.⁶⁹⁴ In addition, the FSA should have some form of responsibility for loss caused to depositors as a result of its negligence – as is the case in Germany and Italy.

Fourth Proposal The nature of the c

constantly. It is possible to substantially reduce but not totally eliminate.

Periodical surveys should be carried out in the general public to ascertain what many perceive to be the role of an auditor. These surveys should be carried out only after the public has been sufficiently educated about the role of the audit. After this, draft proposals should be made whereby the public is involved and is invited to submit their ideas or challenge any proposals. The draft proposals on the definition of an audit should be a more acceptable definition

694 See Summary of Submission to the House of Lords Select Committee on the Accountability of the Financial Services Authority in general, and of the Accountability of the Government and of the Parliamentary Ombudsman Regarding the Equitable Debacle.

695 See P Sikka A Puxty H Willmott and C Cooper ' The Impossibility of Eliminating the Expectations Gap:

Some Theory and Evidence” December 2003. Sikka et al argue that due to social conflict the meaning of social practices continually face challenges and the gap between competing meanings of audit cannot be eliminated.

surveys carried out on the public. There should be an objective component within the definition of an audit which would be the public's reasonable expectations. These expectations could be deemed reasonable as public would already have been educated about

component would also be revised from time to time based on periodical surveys. In the absence of a duty to third

rd Performance Component could be reduced by restoring the fraud and

oses of educating users of financial information. It would be more feasible to educate users of financial information as opposed to members of the general public –

ot all members of the public use financial information.

The more stringent regulations which exist in Italy such as not allowing external auditors to nger periods of tenure, rotation the role of auditors, nature of audits before a survey is carried out to find out what the public want from an audit.

The subjective component definition of an audit would be revised from time to time – depending on social, environmental changes. The objective

parties, the fraud and error detection role of an auditor seems to be a role which should become a primary audit objective – as this would help bring about some form of accountability. Of course, the auditor cannot be expected to sniff out every form of fraud – only material ones.

In sum, various ways through which the individual components of the expectations gap could be reduced are as follows:

The Sub Standa

detection role as the main audit objective.

The Deficient Standards Component could be reduced through unambiguous wordings within Statements of Auditing Standards. These should be avoided and clearer definitions provided to give the auditor a better understanding of his duties.

In relation to the Unreasonable Expectations component, reasonable expectations of the public could be ascertained through education of the public about the role of the auditor and the auditing standards relating to his role. Public education about the auditor's role could be facilitated through annual shareholders' meetings and other events which are organised for the purp

especially since n Fifth Proposal

offer additional (non-audit services), appointing firms for lo

of audit firms, restrictions on staff movement between firms and clients and monitoring audit fees/hours are factors which would facilitate a better environment for auditor independence. It would therefore be worthwhile considering the adoption of these measures

t is needed in the form of a degree of liability which discourages the auditor from acting negligently or intentionally taking risks. However, there is need to

caps as discussed in the next section should help achieve this balance.

t and third options⁶⁹⁷ could also serve as an option. The four options presented for reforming auditors’ liability are as follows:⁶⁹⁸

The introduction by Member States of the principle of proportionate liability, which means that in the UK. As stated previously, corporate governance structures, “thinness”⁶⁹⁶ of the audit market and other relevant factors and jurisdictional differences would need to be considered when deciding whether or not to adopt certain measures.

Sixth Proposal

In relation to audit liability, auditors should be held liable for the negative consequences of their actions. A deterren

ensure that such liability is not so high that it leads to defensive auditing. The introduction of liability

The issue of audit liability in the UK could be addressed by the relatively newly introduced Companies Act 2006. However on a European level, a combination of variants of the European Commission’s firs

The introduction of a fixed monetary cap at European level, which in the Commission’s opinion, might be difficult to achieve.

The introduction of a cap based on the size of the audited company, as measured by its market capitalisation.

The introduction of a cap based on a multiple of the audit fees charged by the auditor to its client.

696 Audit markets wi

697 The European Commission in its consultations relating to whether there is need for a reform of the auditor liability regime, not only presented four options, but also invit

th relatively few large clients are referred to as thin markets.

ed stakeholders to submit their opinions by 15 March 2007. For

&guiLangu more on this, see <

http://europa.eu/rapid/pressReleasesAction.do?reference=IP/07/60&format=HTML&aged=0&language=EN age=en>; also refer to the first chapter of this thesis.

698 ibid; also see < http://ec.europa.eu/internal_market/auditing/liability/index_en.htm > (last visited 2 May 2008)

each party (auditor and audited company) is liable only for the portion of loss that corresponds to the party’s degree of responsibility.

In relation to the European Commission’s options, I would propose a model based on a combination which are variants of the first and third options, namely a combination of a single monetary cap at a European level and a cap based on audit fees⁶⁹⁹. Whilst a cap based on market capitalisation would be rather subjective, adopting a principle of proportionate liability, also involves subjective elements. According to the European Commission, the option relating to proportionate liability would not only consist in courts awarding damages which are in proportion to the auditor’s fault, but also in contractual arrangements being negotiated between the company and its auditors and approved by shareholders.⁷⁰⁰ In relation to the subjective nature of disproportionate liability, where does one draw a distinction between negligent acts and those acts committed intentionally? Whilst some negligent acts may result in greater losses, is this to imply that such unintentional acts should attract more severe punitive sanctions than intentional ones

between the company and its auditors and approved by shareholders. These variants are introduced

re not whose acts incurred fewer losses? Furthermore, how is one to distinguish between grossly negligent and mere negligent (simple negligent) acts, and how is one to apportion liability for those acts which are merely negligent but which have resulted to greater losses than grossly negligent acts?

Do we apportion according to the losses incurred by the company or on the basis of the nature of the act? It seems that a response to these questions would necessitate a consideration and balance of those factors surrounding both the nature of the act, the extent and consequences of the losses incurred. For example, the impact of the loss on third parties and other affected stakeholders. These are issues which would have to be considered in the contractual arrangements being negotiated

as follows:

In relation to the first option, I support a monetary cap at a European level. However, such cap would have to be defined since a fixed figure does not take into consideration the differences which exist in the audit environments of various EU member states. For example, whilst 5 million Euros may be deterrent for audit companies in Italy and Germany (as the market for audit services a

699 In considering a variant based on audit fees, the audit revenue generated by the audit firm is considered.

700 See ‘The European Federation of Accountants_ Federation des Experts Comptables Europeens’ Paper

<http://www.iwp.or.at/veranstaltungen/documents/unterlagen_2007-05-07.pdf>

as great as in the UK and the US)⁷⁰¹, it might not produce such a deterrent effect in the US or the

as great as in the UK and the US)⁷⁰¹, it might not produce such a deterrent effect in the US or the

Im Dokument The role of the external auditor in bank regulation and supervision: A comparative analysis (Seite 108-123)