The Universities Superannuation Scheme submission to the Parliamentary Commission on Banking Standards

Transcription

1 The Universities Superannuation Scheme submission to the Parliamentary Commission on Banking Standards 4 th Sept 2012 Summary Urgent action is required to address perverse incentives hard-wired into our accounting and audit system that encourage excessive risk-taking by bank executives. On accounting standards, we propose that: Prudence should be restored as an overarching accounting principle in the UK, to ensure consistency with UK Company Law. The EU s approval process for adopting IFRS is strengthened to ensure the standards are consistent with existing legal requirements for prudence, true and fair view and capital maintenance. Amendments are made to the proposed EU Accounting Directive to strengthen the emphasis on prudence, clarify the link between accounts and requirements for capital maintenance, and emphasise the concept of substance over form. On the audit system, we propose that: Audit Committees are made more transparent. Specifically, the critical areas of debate between the auditor and company, how these were resolved, and what steps are being taken to protect auditor independence should be disclosed to investors. Audit Committees ensure audit firm rotation at regular intervals, with an upper tenure of 15 years. Audit Committees limit non-audit fees to less than 50% of audit fees. 1. Introduction 1.1 The Universities Superannuation Scheme (USS) is the second largest pension fund in the UK. As at August 2012, the value of the Fund was circa 34 billion. We have a large exposure to UK banks, and given the long term nature of our liabilities- a strong interest in ensuring long term sustainable returns from the sector. We also believe that achieving a fundamental shift in the investment horizons and risk-taking culture at banks is vital to broader macro-economic stability, which drives returns throughout our portfolio. 1.2 The Parliamentary Commission is touching on numerous issues that have played a role in the financial crisis. Whilst we believe many different factors are important (from faulty executive remuneration schemes to inadequate regulatory oversight), we focus in this submission on two topics that we feel have received inadequate attention: the accounting and auditing systems. 1.3 We believe the current accounting and audit systems in the UK are contributing to shorttermism and excessive risk-taking in the banking sector (as well as other sectors). We believe, in particular, that: The adoption of IFRS in the EU in 2005 has fuelled incentives to take on excessive risks in the banking sector, leaving shareholders and taxpayers to pick up the tab when boom turned to bust; and 1

2 The audit system in the UK fails to provide the necessary check on banking executives behaviour, in large part due to the lack of transparency and accountability to shareholders. 1.4 Our submission is relevant to your questions 4 to Banking culture is driven by improper incentives 2.1 We believe improper incentives in the banking sector have contributed to excessive risk-taking. Company executives performance is measured to a large extent by reference to banks audited accounting numbers. Remuneration, moreover, is often directly tied to these numbers. Accounting and auditing standards, thus, play a vital role in determining how executives behave. 2.2 Accounts, consequently, also have a direct impact on how shareholder capital is used, and whether it is protected. In short, accounts and the external audits that provide a key stamp of approval - are a vital input to our corporate governance system. 2.3 It is our view that failures in both the accounting standards and audit system have played an important role in the excessive build up of risk in the banking sector prior to the financial crisis. Below we set out our concerns, and reference related submissions and Position Papers on these topics. 3. IFRS has encouraged risk-taking 1 Legal context 3.1 Accounting standards in the UK (and EU) have been seriously weakened with the adoption of IFRS in 2005, and - specifically with the move by the International Accounting Standards Board (IASB) to replace prudence with neutrality as the guiding principle underpinning accounting. This shift in accounting was a key part of the IASB s convergence project with the US accounting standards, i.e. US GAAP. 3.2 Prudence has been at the heart of the UK system of accounts for generations. It is hard-wired into our Company Law and underpins our system of corporate governance, which relies on financial reports as a basis for holding management to account for their use of capital. In Company Law accounts must provide a true and fair view and be prudent. Accounts provide the basis for company directors to determine whether a company is a going concern and ensure they do not make distributions out of capital 2. These are fundamental protections offered to providers of capital, and underpin confidence in the equity markets. 1 Please also refer to the investor group s Position Paper (7 th August) on this topic, which is attached. 2 The Companies Act 2006 requires accounts provide a true and fair view (Part 15, Ch 4), and ensure capital maintenance (solvency) to protect creditors (Part 23, Section ). A prudent accounting framework is required under The Large and Medium Sized Companies and Groups (Accounts & Reports) Regulations 2008 (Part 2). The same requirement exists in European Company Law (2nd, 4th and 7th EC Directives). 2

3 3.3 Prudence also lies at the heart of EU Company Law and system of corporate governance. In 2005, the EU s IAS Regulation came into force requiring companies listed in EU securities markets to use IFRSs (as adopted by the EU) in their consolidated financial statements 3. The Regulation explicitly reinforces the requirement that all standards adopted by the EU must comply with true and fair view and all relevant EC Directives And yet, fundamental changes to IFRS including the replacement of prudence by neutrality as a guiding accounting principle do not appear to have been picked up as contrary to EU or UK Company Law. This has led to the application of accounting standards that have a high risk of diverging from the true and fair view, and producing profit numbers that are not distributable (see the ICAEW in its 02/2010 Guidance on Distributable Profits which takes 167 pages to try to reconcile the two) Notwithstanding the legal questions, the move away from prudence to neutrality has led to greater incentives for risk-taking in banks. We provide two examples below. Loan loss provisioning encourages risk-taking 3.6 IFRS replaced the UK GAAP s expected loan loss provisioning with incurred loan loss provisioning. 3.7 Under UK GAAP (prior to convergence with IFRS), accounts were expected to hold loans at no more than realisable value, meaning that it was necessary to estimate likely loan losses / defaults on different pools of loans dependent on their level of recovery risk. That was achieved by general provisions for bad debts. The riskier the pool of loans, the higher the provision. Decisions about appropriate provisioning were audited. This approach was considered prudent, and it was aligned with key accounting principle of accruals and matching (i.e. recognising revenue as it is earned, not necessarily paid, and matching it with the associated costs). 3.8 Under IFRS, however, an incurred loan loss provisioning approach was adopted, which required that only actual defaults be recognised as a cost of the loan. No estimations for future losses were permitted. The intention was to tackle management manipulation of provisions to smooth earnings. However, in tackling what was is in effect a problem of implementation and audit (management manipulation of accounts) by changing the standards, we are left with a standard that is not prudent, and does not comply with accruals and matching principles. 3.9 The incurred loan loss provisioning approach feeds through to bank executive incentives for risk-taking. In boom years, where accounts do not provision for future likely loan losses, banks will earn the highest profit on the riskiest (and highest margin) loans. Banks with the riskiest 3 Although the EU Regulation only requires IFRS is used for Group accounts, the UK went further and requires IFRS for banks subsidiaries. Indeed the UK s Accounting Standards Board appears to have been moving away from prudence even earlier than required by EU regulations. 4 See Paragraph 9, Regulation 1606/ Please refer to LAPFF, UK and Irish Banks Capital losses - Post Mortem, Dec 2011 to gain a sense of the scale of the problem for UK banks. 3

4 loan books, and who grow these most quickly, will see profits rise faster than competitors. Executives will also likely see their bonuses rise commensurately As the banks equity increases, moreover, banks are able to extend their lending even further, thereby fuelling the boom. When the economy turns, of course, the process goes into reverse. Banks with few provisions for bad debts then have to recognise large losses. In effect, under IFRS the profits for banks loan books are all front-ended, and the losses come through all at once in a downturn What is particularly damaging is how the accounting standard feeds through to incentives for risk-taking, which accentuates the boom and bust, with enormous costs for macro-economic stability 6. Excessive use of mark to market (MTM) encourages risk-taking 3.12 Under IFRS, the use of MTM (and mark to model) for valuing trading and available for sale assets has been significantly expanded. This is particularly evident with respect to accounting for financial instruments (IAS39 until 2009/2010, and now IFRS 9 and 13). Market prices are viewed to be neutral, and the best way to value banks assets. However, the approach faces two critical flaws First, markets are rarely perfect, and the prices at any one time may be biased for a number of reasons. This is particularly true in illiquid and volatile markets. Indeed, in such markets the sale of the assets held by banks to realise the value quoted on the balance sheet may itself lead to a price drop. In other words, the prices quoted on the balance sheet would not be realisable in practice. Balance sheet valuations are then, as the CEO of RBS remarked during the crisis, Alice in Wonderland numbers (Preliminary Announcement, February 2012). Depending on the day that you value the assets, you might come up with very different numbers. Where there is no acceptable market price according to IFRS rules, then companies can mark to model, which introduces enormous scope for subjectivity and manipulation Moreover, using MTM so extensively (under UK GAAP a more restricted and considered use of MTM was permitted for the most liquid assets see the British Bankers Association SORP) fails to meet the prudence test. The profits which flow through the Profit and Loss account as a result of revaluation of assets (which are not in fact sold) are viewed as real profits and may be used as a basis for determining distributions. However, if these profits turn out not to have been real (e.g. are reversed when markets turn) and were never realised (i.e. never actually converted into cash), the distributions (which were made in cash) may have been made out of capital. This is, of course, not permitted under Company Law. Furthermore, the unrealised profits then feed into the company s equity, which is in turn used as a basis to ascertain a company s going concern status. 6 While the problem with incurred loan loss provisioning has been recognised by the IASB, and is currently being reviewed, early indications of a replacement model do not address the core weakness: the failure to adequately and prudently provision for expected future loan losses. 4

5 3.15 The extensive use of MTM also feed executives incentives for risk-taking. In an upward moving market, the more assets banks hold in their trading books, the more paper profits they will make, and the higher their bonus payments. As with incurred loan loss provisioning, the higher profits feed the banks equity base (and Tier 1 capital), off which they are able to buy more of these trading assets thereby pushing up the prices. The more risky assets, of course, will tend to generate the highest returns. In a downturn, the process reverses. In short, MTM is pro-cyclical The examples above highlight why we believe the move to IFRS, and specifically the move to neutrality as a guiding principle in accounting, has led to excessive incentives for risk-taking in banks. It is vital that this matter is looked at in greater detail and action taken. Recommendations 3.17 There are important openings right now to address the weaknesses with IFRS. We recommend the actions outlined in the Box below. Recommendations Restore prudence as an overarching accounting principle in the UK. The UK should explore what steps might be taken to restore prudence in UK accounting, to ensure consistency with UK Company Law. This may require a supplementary process of reviewing standards before they are rolled out in the UK. Strengthen the EU s approval process for adopting IFRS to ensure the standards are consistent with existing legal requirements for prudence, true and fair view and capital maintenance. The UK should use its vote and voice in this approval process to achieve this goal. Amendments are made to the proposed EU Accounting Directive to strengthen the emphasis on prudence, clarify the link between accounts and requirements for capital maintenance, and emphasise the concept of substance over form. The proposed Accounting Directive is currently being debated in the European Parliament. City of London MEP Syed Kamal s proposed amendments to clarify the link between prudent accounts and capital maintenance requirements. These were dropped from the most recent compromise version from parliament 7. In addition, the EC s proposed Article 5(h) emphasising substance over form as a General Financial Reporting Principle has also been dropped 8. The UK government should seek to have these reinstated. 4. Audits have failed to provide a robust check on executives 4.1 Audits are undertaken for directors on behalf of shareholders to provide an independent and robust check on accounting numbers. The audit, therefore, reassures providers of capital that the accounts can be trusted. The audit plays a critical role in maintaining investor confidence in equity markets. 7 Proposed amendments are found in Recital 6, Recital 31, Article 4, 7(5), and 7(6) in the attached document Amendments , Draft Report by K. Lehne, 9 th May Please see Article 5(h) in the proposed Accounting Directive, and Parliament s compromise version (6 th July 2012). 5

6 4.2 It is our view, however, that the audit system currently suffers from a number of structural flaws that undermine auditor independence. This problem was highlighted by the House of Lords Economics Affairs Committee inquiry into audit in , and has been taken up by the UK Competition Commission in its ongoing investigation into large audit market. Concerns over the failure of auditors have also resulted in proposed reforms by the European Commission (EC) in 2011, which are currently being debated by the European Parliament. 4.3 USS has contributed to both the UK and EU policy debates, and led a coalition of long term investors in drawing up a Position Paper on audit 9. These papers set out evidence that illustrates the failure of the audit to deliver demonstrably independent verification of accounts; the underlying causes for these failures; and what we feel needs to be done to tackle these problems. We attach the relevant submissions for your information. Recommendations 4.4 Our key proposals for action are summarised below. We hope these will be taken on board also by the UKCC and EU as proposed reforms are explored. Audit Committees should be more transparent. Shareholders need to know, in particular, the critical areas of debate between the auditor and company, how these were resolved, and what steps are being taken to protect auditor independence. Audit Committees should ensure audit firm rotation at regular intervals, with an upper tenure of 15 years. Firm rotation should ensure there is a regular challenge to past assumptions and offer independent due diligence on the previous auditor. Firm rotation should fundamentally shift power back to shareholders as the ultimate client. Audit Committees should limit non-audit services provided by the auditor to 50% of audit fees. Auditors seeking to win non-audit contracts with their audit clients are conflicted. No doubt, there should be flexibility for companies to appoint the best possible service provider, but shareholders also need reassurance that the integrity of the audit is paramount. Where the ratio rises above the 50% threshold, it must be brought back down. 5. Conclusion 5.1 The financial crisis resulted from numerous failures at several levels. Banking executives behaviour, and the culture of risk-taking, is nonetheless a vital piece in the jigsaw. Understanding what has driven executives decision-making and, in particular, their often imprudent risk-taking is of utmost importance. 5.2 We believe that to date regulators have failed to appreciate the integral role of accounting standards and the audit system. Our submission, therefore, focuses on these two topics. 5.3 Importantly, we believe there are important openings right now to address the failures we identify, and have made specific recommendations for what steps should be taken. 9 Please see attached Position Paper Audit a long term investor position paper on proposed EU reforms, 7 th Aug,

7 6. Attachments Concerns with IFRS A long term investor position paper, 30 July Audit a long term investor position paper on proposed EU reforms, 7 th Aug, USS submission to UKCC, 9 th May Amendments , Draft Report by K. Lehne, 9 th May Parliament s compromise version (6 th July 2012). 7