Banking: it’ll make you go blind, you know


In my quest to bring the Paintbrush reading public their favourite type of non-Lily Allen related post (srsly, guys, she really isn’t here), I’ve been considering Banking reform.

The beeb is reporting that Mervyn King and Alistair Darling are clashing over what needs to be done. The Governor’s view is that there needs to be more done to allow intervention in banks that are “seen to be behaving riskily”; The Chancellor, on the other hand, favours leaving the tripartite system as is.

So far so predictable. I have some sympathy for King’s view, in honesty: but the important question is, how do you tell when banks are behaving riskily?

So here’s my two penn’orth for banking reform: Nationalize banking audit.

At present, banks (like other large businesses and financial institutions) must have their accounts audited, and spend large sums of money on getting the large auditors like PwC, Accenture and KPMG to come in, sift through everyone’s desk, and sign off on the accounts.

However, there have clearly been problems. There’s not a suggestion that any of the banks or mortgage lenders that have run into difficulties in the last two years came close to failing an audit; surely that’s a damning indictment of the present audit system?

There’s clearly a peverse incentive operating here. If a bank is paying an auditor hundreds of thousands of pounds to perform a service, there’s little incentive for the auditor to give their client bad news.

They are, after all, keen to get the contract again next year. In fact, the sort of personal relationships that can build up at a management level between banks and auditors that work with one another for a long period of time could work to make this worse.

That’s why, I think, the state should get involved. I think that a new consensus emerging from the financial crisis is that the public interest stake in the stability of the banking sector should be acknowledged more, and that there is a legitimate role for the state.

So, once the state relinquishes the stakes it has bought in the banks which required bailing out, we need to look at how that role is to be maintained.

Having a nationalized Office of Banking Audit – financed by an Audit Tax on banks, which would more or less replace the fees banks currently pay to their private auditors – would ensure that a stringent watch could be taken on risk taking, and that banking balance sheets can be kept in check.

Nationalizing bank audit is a neat “third way”, if you like, between returning to the light and limited touch of the past, and all-out state intervention in banking through ownership of stakes in large banks.

Can it happen? I’m not sure the government is feeling bold enough. But it should do. The time for being squeamish about nationalization is past: I think we’re all past the days when it meant going for the “commanding heights” of the economy.


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4 Responses to “Banking: it’ll make you go blind, you know”

  1. duncanseconomicblog Says:

    Totally agree.

    According to the Turner Report – several banks were holding the same assets at different valuations last year, due to using different auditors.


  2. Paul Says:

    That’s surely an argument for nationalising all audits?

    You are right that there is a vested interest in audit firms being gentle with clients, because clients pay their fees and negative audit reports might lead to a competitor stealing a client. There is an additional potential conflict of interest in audit firms not wanting clients to suffer by forcing them to disclose/adjust their accounts for things that the market might dislike, for example asset impairments, because financial distress could threaten future fees.

    However, there are also counter-pressures that do help create good-quality audit reports.

    Most importantly, there is the reputation risk that comes with auditing a dodgy bank and not issuing an adverse decision. The Big 4 are very, very concerned with quality for two main reasons:-

    1) Their brands are very important (see what happened to Arthur Andersen when their brand got hammered after Enron). A poor reputation can very adversely affect the business, and that is why they are so concerned to make the right calls.

    2) Partners issue audit opinions: the people making the calls are personally liable for any bad decisions, since they are also the owners of the firm.

    As someone who works in one of the Big 4, I can assure you that audit decisions are taken extremely serious. In my firm there are double-checks on all audits by default, but in high profile banks there will be multiple signoffs by multiple partners. They are absolutely terrified of losing the firm’s reputation, or of losing their shirt.

    This is not to say that auditors don’t fuck up. They clearly do. However, by using a public body you will get worse audits, not better audits.

    1) Less concern for firm reputation. Whatever body is used won’t have its survival on the line, in the way that audit partners have their houses on the line.

    2) Lack of shared knowledge. Audit firms have enormous expertise because they look at companies across the board, across the world. There is an amazing depth of talent, which would be missing in a small department such as that you propose.

    3) Lack of quality staff. Audit firms renumerate their senior staff very highly, attracting a very high quality of staff. A public body couldn’t do this to the same extent.

    4) Poor methodology and poor technology. What people from the outside don’t realise is that audit firms spend a lot of time training their people and developing processes to catch common problems. This links into point 2.

    OK, I think I’ve wrote enough.

    To address Duncan’s point: auditors don’t decide on asset valuations, management do. It is only up to auditors to check that valuations are not materially wrong. Any discrepancies between firms are unfortunately inevitable – especially when the fair value of illiquid, highly complex assets aren’t discoverable via the conventional market-price method, but instead rely on models.

    If you are looking for causes of the financial problems, I suggest the following would be more fruitful avenues:-

    1) High leverage of financial institutions
    2) A failure to assess risk
    3) A failure to understand complex financial instruments and the correlations between them
    4) The natural economic cycle, whereby low interest rates lead to unsustainable speculation, particularly on real estate. See
    5) Poor regulation, particularly in regards to creating a robust, counter-cyclical, capital requirement regime for banks.
    6) Bad incentive structures, whereby renumeration was not vested over a number of years and dependent upon long-term profitability.

  3. LookLeft Says:

    Have to agree with Paul.
    Its fundamentally not the job of auditors to assess for themselves the risks that inistitutions are taking – only to check that the accounts are correct and the methods and models used by management are reasonable. Since the Financial Crisis and its scale was largely unforeseen the optimism of management models seemed more plausible then than they may do now. You can’t audit on the basis of facts that don’t exist yet.
    The Commons Treasury Committee sessions with Auditors are quite illuminating on this point.
    So Auditors were by and large doing their job – its just not the job we would have wanted them to be doing.
    I think any solution to prevent repeats of this form of crisis has got to look at the incentive structures facing bankers and broader questions of wealth concentration. Better and tighter regulation wouldn’t hurt though.

  4. euandus2 Says:

    I don’t think the reform being considered by Congress goes far enough because I don’t think they (and we) know the extent to which bankers will go to get their way. BTW, I recommend the following:

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