Address by John Moran, Head of Wholesale Banking Supervision, to Chartered Accountants Ireland

02 December 2010 Speech

As EU Internal Market Commission Barnier has said:

“The veracity of financial statements is central to confidence in the marketplace ….. The crisis highlighted failings in the audit sector. These need to be explored and we need to see what improvements can be made.”

As Ireland is a highly open economy, this global backdrop is important and should inform discussions locally. A note of caution, though: we should not delay action in Ireland just because international initiatives are likely to wash ashore at some point. There is much to be done to restore the credibility of the domestic banking system, and taking a firm lead in improving audit practices can only help.

Two questions are frequently asked when considering the role of auditors before and during the banking crisis in Ireland:

  • Could auditors have done more to mitigate the risks associated with the rapid, and in some cases reckless, growth in banks’ balance sheets in the 2000s.
  • Latterly, could auditors have been quicker to bring to light the very rapid decline in asset quality which has occurred?

The answer to both questions is a qualified Yes. In practice, there are probably unrealistic expectations about what auditors could have achieved, at least through the external audit process, to mitigate the build-up, and uncover the subsequent crystallisation of risks in the banking sector. But there is more that can be done; and what I would like to do today is to address these issues, and in particular to explore some realistic and practicable solutions from the perspective of a prudential supervisor.

I suspect there will be some disagreement between what the public in general consider ‘realistic’ and how the audit profession would define this term; but perhaps not as much as we might suppose, and any point of friction will itself perhaps be an indicator that we are focused on the right issue. I know from discussions with the profession to date that there is some impetus for change. I’ll describe later the steps we consider can be taken.

The international context

Before doing so, I’d like to consider what has been, and is, happening internationally as this is relevant to the steps we take as prudential supervisors in Ireland in respect of a dialogue with the audit profession.

Audit, of course, is a global business. Most audits of any size include a major cross-border component because that reflects the international nature of most business today, in Ireland as much as anywhere. And larger businesses tend to be audited by one of the four global audit networks, the quality of whose work is critical.

The shortcomings in audit practice uncovered in the early part of this century in Enron and other cases led to the establishment of public bodies charged with the oversight of audit firms. The Public Company Accounting Oversight Board in the US, the most prominent of such audit oversight bodies, has now been joined by similar regulators all over the world, including IAASA here in Ireland. These bodies have started to engage in the direct inspection of the conduct of audit firms and IFIAR, the International Forum of Independent Audit Regulators, the international committee which brings them together, recently reported on examples of inspection findings. These included concerns with the exercise of professional scepticism, the audit of impairments, the firm’s own internal quality control processes and threats to auditor independence. The lack of scepticism found internationally may identify itself in a number of ways: over-reliance on management representations; failure to investigate conflicting explanations; failure to obtain appropriate third-party confirmation or seeking to obtain evidence that merely corroborates, rather than challenges, judgements made by management.

Such concerns about adherence to higher standards are important in the light of emerging debate about the value of audit. This debate is being pursued within Europe as a whole, where the European Commission has embarked on a consultation on how the European audit market can be improved, looking at the role of statutory audit as well as the wider environment within which audits are conducted. In the UK, the House of Lords has embarked on a major inquiry into market concentration and the role of auditors. The issues being addressed also include how to ensure auditors are truly detached and critical when examining the financial statements of a company where that same company is an existing or potential client for non-audit services, and clarification of the reliance stakeholders, such as investors or regulators can place on audited financial statements.

Audit quality is, of course, difficult to define and there is no internationally agreed definition of audit quality that can be used as a standard against which actual performance can be assessed. Nevertheless, recent events suggest that there is room for improvement. Furthermore, even where accounting and auditing standards have literally been met, it is difficult not to feel that here, and in many jurisdictions, information that could have helped anticipate, or at least mitigate, the crisis was available within the audit firms and could with benefit have been transferred to those in a position to influence the emergence of the risks that have subsequently crystallised.

Power to appoint independent experts

The remainder of my remarks are devoted to exploring ways in which such improvements might be made; and I would mainly like to steer away from external audit of public financial statements and focus on other areas where the audit profession might contribute to a sounder prudential framework in Ireland.

A key role for the profession, and one it undertakes already in Ireland, is to review, outside the external audit process, how financial institutions conduct business, and in particular the adequacy of controls.

In the UK, Section 166 of the Financial Services and Markets Act 2000 gives the FSA the power to require firms to provide reports by skilled persons. This often involves auditors, for example, testing the veracity of financial statements on behalf of regulators. To give you a sense of the importance of this power, the FSA commissioned 88 S166 reports in the period 2009–2010.

We are seeking an equivalent power here in Ireland; and its importance to the completeness of our regulatory regime cannot be overstated. It enables the regulator to access where necessary the important detail of a financial institution’s business without diverting scarce regulatory resources from other critical responsibilities.

It is an essential, core power, not one that is merely nice to have...

A better dialogue with auditors

This legal power would lead to a very defined, and issue specific, sharing of information. As supervisors, we think there is also a case for re-invigorating the frequency and quality of the three-way dialogue between the Central Bank, regulated firm and its auditor. We also think there needs to be a more fulsome bilateral dialogue between the Central Bank and auditors...

What do I mean by this?

The Central Bank and the auditor profession are, to a greater or lesser degree, in privileged positions in that we both see different information which, by its nature, is relevant to our respective statutory duties. From time to time this information is automatically exchanged – for example, when an audit report is qualified. What we are less good at doing is sharing our interpretations of this information. In other words, we do not spend enough time discussing what we know of risks within financial institutions, either within individual firms or across the financial markets generally.

This, we think, can easily be resolved.

To this end we will be meeting representatives of the major audit firms next week to discuss how we promote an enhanced, regular dialogue between auditors and supervisors. We do not want to invent new rules or processes to make this a reality, but we do think there is a good case for defining, in writing, what this dialogue should encompass and how it can be organised. In essence, such a document would establish the basis on which the Central Bank can engage in substantive discussions with auditors on areas of interest to prudential and conduct of business supervision.

We hope the profession will respond positively to this initiative.

Auditor appointment and rotation

But is this sufficient?

In addition to promoting a better dialogue between auditors and supervisors, there could be further own-initiative measures.

For example, should there be more frequent rotation of audit firms or partners for financial institutions than for corporations generally?

Should there be a pre-approval regime for the audit partners of those financial institutions classified as major under our new corporate governance regime?

Should IAASA and the Central Bank work more closely together on issues of audit quality as they arise in the financial sector?

I do not propose to answer these questions today; but we do think it is entirely legitimate that, as a prudential supervisor, we should consider whether further safeguards need to be built into the prudential regime for major financial institutions.

Quicker Identification of Asset Quality Deterioration

At the start of my speech I asked whether auditors have been slow to recognise the rapid deterioration in asset quality which has occurred on the balance sheets of Irish banks.

I ask this question because a material gap emerged earlier this year between banks’ own estimates of losses in their financial statements, and thus their capital requirements, and those estimates of losses and capital resulting from our Prudential Capital Assessment Review – the PCAR.

The PCAR, of course, has a different objective in being forward-looking, and makes use of different measures of loss to those which determine the construction of financial statements. As such, a simple like-for-like comparison is not possible. However, it is far from clear that banks would have commenced a re-capitalisation process on anywhere near the scale required to cover losses, if at all, had the Central Bank not initiated a process to assess expected future losses.

This is not a moot point: the Irish banking system has had, as this week’s announcements remind us, to be re-capitalised to absorb quite staggering losses. Against this backdrop, the incomprehension which has been expressed at the production of unqualified audit reports so close to major re-capitalisation is understandable.

The audit profession is not, of course, deaf to these issues. We noted with interest the recent IASB-FASB exchange on the estimation of expected losses. Our position on these issues is clear: only last week - in this auditorium, in fact - the Governor criticised the backward-looking loan-loss provisioning methods linked to current International Financial Reporting Standards. The limitations of this approach are well understood, so I won’t repeat them here. Suffice to say that changes in accounting standards which might follow the IASB-FASB discussions would be welcome.

But experience in Ireland suggests that, even if there were to be changes in accounting standards, a close look at audit practice is required.

I mentioned earlier the international concern about the degree of scepticism exercised by auditors. In that connection doubts are expressed as to whether firms employ auditors of sufficient experience adequately to challenge the views of management.

The profession also needs to overcome a significant (and self-imposed) assumption: it is simply not sufficient to have a view on a control that is silent on the context within which that control operates, especially the organisational culture at work and the behaviour of key individuals. The statement “culture eats strategy” can fairly be re-worked to make “controls” its object. I have no doubt that some auditors in Ireland failed either to realise this, or, worse perhaps, recognise it in their dealings with clients and the regulator.

There are solutions, though. The Management Letter gives auditors a vehicle to make these wider points. Similarly, the Audit Committee is a forum in which auditors can raise issues they consider material to the soundness of a financial institution’s operations. The construction of financial statements should not, in other words, be considered a sealed channel in which auditors must operate; and I suspect most auditors would agree with this statement.

But what am I really talking about here? Well, the central issue is undoubtedly the exercise of professional scepticism - in the same way that supervisors at the Central Bank need to operate with an independent and sceptical disposition, so I think the same is true of auditors. For all of us here today, institutionalising such a mindset is work in progress. I hope my remarks today provide a foundation for us to make progress.

Thank you.