   
-
Lehman Brothers Holdings Inc. Chapter 11 Proceedings Examiner’s
Report
- The Auditing Standard No 7, and the new PCAOB
staff questions and answers about the Auditing Standard No 7.
- The news
about the auditors/whistleblowers in Boeing
- Significant Enforcement
Actions: SEC v. General Electric
- Systemic risk: how to deal with it?
Paper by Mr Jaime Caruana, General Manager of
the BIS, 12 February 2010.
Welcome to the March 2010 edition of the
International
Association of Potential, New and Sitting Members of the Board of
Directors (IAMBD)
newsletter
Lehman Brothers Holdings Inc. Chapter 11 Proceedings Examiner’s
Report
REPORT OF ANTON R. VALUKAS, EXAMINER
March 11, 2010
Jenner & Block LLP
The Order appointing the Examiner (the “Examiner
Order”) assigns ten specific bulleted topics for the Examiner
to investigate; in addition, the Examiner Order directs the
Examiner to perform the duties specified in Section 1106(a)(3)
and (4) of the
Bankruptcy Code, that is, to
“file a statement
of . . . any fact ascertained pertaining to fraud,
dishonesty, incompetence, misconduct, mismanagement, or
irregularity in the management of the affairs of the debtor, or
to a cause of action available to the estate.”
INTRODUCTION
On January 29, 2008, Lehman Brothers Holdings Inc. (“LBHI”)
reported record revenues
of nearly $60 billion
and record
earnings in excess of $4 billion
for its fiscal year ending November 30, 2007.
During January 2008, Lehman’s stock traded as high as $65.73 per
share and averaged in the high to mid-fifties, implying a market
capitalization of over $30 billion.
Less than eight months later, on September 12, 2008, Lehman’s
stock closed under $4, a decline of nearly 95% from its January
2008 value.
On September 15, 2008, LBHI sought Chapter 11 protection, in
the largest bankruptcy proceeding ever filed.
There are
many reasons Lehman failed,
and the responsibility
is shared. Lehman was more the consequence than the cause of a
deteriorating economic climate.
Lehman’s financial
plight, and the consequences to Lehman’s creditors and
shareholders, was exacerbated by Lehman executives, whose
conduct ranged from serious but non-culpable errors of business
judgment to actionable balance sheet
manipulation;
by the
investment bank business model, which rewarded excessive risk
taking and leverage; and by Government agencies, who by their
own admission might better have anticipated or mitigated the
outcome.
Lehman’s business model was not unique; all of the major
investment banks that existed at the time followed some
variation of a high-risk, high-leverage model that required the
confidence of counterparties to sustain.
Lehman
maintained approximately $700 billion of assets, and
corresponding liabilities, on capital of approximately $25
billion.
But the
assets were predominantly long-term, while the liabilities were
largely short-term.
Lehman funded itself through the short-term repo markets and
had to borrow tens or hundreds of billions of dollars in those
markets each day from counterparties to be able to open for
business.
Confidence was critical. The moment that repo counterparties
were to lose confidence in Lehman and decline to roll
over
its daily funding, Lehman would be unable to fund itself and
continue to operate.
So too with the other investment
banks, had they continued business as usual. It is no
coincidence that no major investment bank still exists with that
model.
In 2006, Lehman made the
deliberate decision to embark upon an aggressive growth
strategy, to take on significantly greater risk, and to
substantially increase leverage on its capital.
In 2007, as the sub-prime residential mortgage business
progressed from problem to crisis, Lehman was slow to recognize
the developing storm and its spillover effect upon commercial
real estate and other business lines.
Rather than pull back, Lehman made the conscious decision to
“double down,”
hoping to profit from a counter-cyclical strategy.
As it did so,
Lehman significantly and repeatedly exceeded its own internal
risk limits and controls.
With the implosion and near collapse of Bear Stearns in
March 2008, it became clear that Lehman’s growth strategy had
been flawed, so much so that its very survival was in jeopardy.
The markets were shaken by Bear’s demise, and Lehman was widely
considered to be the next bank that might fail.
Confidence was eroding. Lehman pursued a number of strategies to
avoid demise.
But to buy itself more time, to maintain that critical
confidence,
Lehman painted a misleading picture of its financial condition.
Lehman
required favorable ratings
from the principal rating
agencies to maintain investor and counterparty confidence; and
while the rating agencies looked at many things in arriving at
their conclusions, it was clear – and clear to Lehman – that its
net
leverage and liquidity numbers were of critical
importance.
Indeed, Lehman’s CEO Richard S. Fuld, Jr., told the Examiner
that the rating agencies were particularly focused on net
leverage; Lehman knew it had to report favorable net leverage
numbers to maintain its ratings and confidence.
So at the end of the second quarter of 2008, as
Lehman was
forced to announce a quarterly loss of $2.8 billion
– resulting
from a
combination of write-downs on assets, sales of assets
at losses, decreasing revenues, and losses on hedges – it sought
to cushion the bad news by trumpeting that it had significantly
reduced its net leverage ratio to less than 12.5,
that it had
reduced the net
assets on its balance sheet by $60 billion,
and that it had a strong and robust liquidity pool.
Lehman did not disclose, however, that it had been using an
accounting device (known within Lehman as “Repo 105”) to manage
its balance sheet – by temporarily removing approximately $50
billion of assets from the balance sheet at the end of the first
and second quarters of 2008.
In an ordinary repo, Lehman raised cash by selling assets with a
simultaneous obligation to repurchase them the next day or
several days later; such transactions were accounted for as
financings, and the assets remained on Lehman’s balance sheet.
In a Repo 105 transaction, Lehman did exactly the same thing,
but because the assets were 105% or more of the cash received,
accounting rules permitted the transactions to be treated as
sales rather than financings, so that the assets could be
removed from the balance sheet.
With Repo 105 transactions, Lehman’s reported net leverage was
12.1 at the end of the second quarter of 2008; but if Lehman
had used ordinary repos, net leverage would have to have been
reported at 13.9
Contemporaneous
Lehman e-mails describe the “function called repo 105 whereby
you can repo a position for a week and it is regarded as a true
sale to get rid of net balance sheet.”
Lehman used Repo 105 for no articulated business purpose except
“to reduce balance sheet at the quarter-end.”
Rather than sell assets at a loss, “[a] Repo 105 increase
would help avoid this without negatively impacting our leverage
ratios.”
Lehman’s Global Financial Controller confirmed that
“the only purpose or motive for [Repo 105] transactions was
reduction in the balance sheet” and that “there was
no substance to the transactions.”
Lehman did not disclose its
use – or the significant magnitude of its use – of Repo 105
to the Government, to the rating agencies, to its investors, or
to its own Board of Directors.
Lehman’s auditors, Ernst
& Young, were aware of but did not question Lehman’s use and
nondisclosure of the Repo 105 accounting transactions.
In
mid-March 2008, after the Bear Stearns near collapse, teams of
Government monitors from the Securities and Exchange
Commission (“SEC”) and the Federal Reserve Bank of New York
(“FRBNY”) were dispatched to and took up residence at
Lehman, to monitor Lehman’s financial condition with particular
focus on liquidity.
Lehman publicly asserted
throughout 2008 that it had a liquidity pool sufficient to
weather any foreseeable economic downturn.
But
Lehman did
not publicly disclose that by June 2008 significant components
of its reported liquidity pool had become difficult to
monetize.
As late as September 10, 2008, Lehman publicly
announced that its liquidity pool was approximately $40
billion; but a substantial portion of that total was in fact
encumbered or otherwise illiquid.
From June on, Lehman
continued to include in its reported liquidity substantial
amounts of cash and securities it had placed as “comfort”
deposits with various clearing banks; Lehman had a technical
right to recall those deposits, but its ability to continue
its usual clearing business with those banks had it done so was
far from clear.
By August, substantial amounts of “comfort”
deposits had become actual pledges.
By September 12,
two days after it publicly reported a $41 billion liquidity
pool, the pool actually contained less than $2 billion of
readily monetizable assets.
Months earlier, on June 9,
2008, Lehman pre-announced its second quarter results and
reported a loss of $2.8 billion, its first ever loss since going
public in 1994.
Despite that announcement, Lehman was able
to raise $6 billion of new capital in a public offering on
June 12, 2008.
But Lehman knew that new capital was not
enough.
Treasury Secretary Henry M. Paulson, Jr., privately
told Fuld that if Lehman was forced to report further losses
in the third quarter without having a buyer or a definitive
survival plan in place, Lehman’s existence would be in jeopardy.
On September 10, 2008, Lehman announced that it
was projecting a $3.9 billion loss for the third quarter of
2008.
Although Lehman had explored options over the summer,
it had no buyer in place; its only announced survival plan was
to spin off troubled assets into a separate entity.
Secretary Paulson’s prediction turned out to be right – it
was not enough.
By the
close of trading on September 12, 2008, Lehman’s stock price had
declined to $3.65 per share, a 94% drop from the $62.19 January
2, 2008 price.
Over the weekend of September 12-14, an intensive series of
meetings was conducted by and among Treasury Secretary
Paulson, FRBNY President Timothy F. Geithner, SEC Chairman
Christopher Cox, and the chief executives of leading financial
institutions.
Secretary Paulson began the meetings by stating
the Government was there to do all it could – but
that it could not fund a solution.
The Government’s analysis was that it did not have the legal authority to
make a direct capital investment in Lehman, and Lehman’s
assets were insufficient to support a loan large enough to avoid
Lehman’s collapse.
It appeared by early September 14
that a deal had been reached with
Barclays
which would save
Lehman from collapse.
But later that day, the deal fell apart
when the parties learned that the Financial Services
Authority (“FSA”), the United Kingdom’s
bank regulator, refused to waive U.K. shareholder-approval
requirements.
Lehman no longer had sufficient liquidity to fund its daily
operations.
On the evening of September 14, SEC Chairman
Cox phoned the Lehman Board and conveyed the Government’s
strong suggestion that Lehman act before the markets opened in Asia.
On
September 15, 2008, at 1:45 a.m., LBHI filed for Chapter 11
bankruptcy protection.
Sorting out whether
and the extent to which the financial upheaval that followed
was the direct result of the Lehman bankruptcy filing is beyond
the scope of the Examiner’s investigation. But those events
help put into context the significance of the
Lehman filing.
The Dow Jones index plunged 504 points on September 15. On
September 16, AIG was on the verge of collapse; the Government
intervened with a financial bailout package that ultimately
cost about $182 billion.
On September 16, 2008, the Primary
Fund, a $62 billion money market fund, announced that – because
of the loss it suffered on its exposure to Lehman – it had
“broken the buck,” i.e., its share price had fallen to
less than $1 per share.
On October 3, 2008, Congress passed a
$700 billion Troubled Asset Relief Program (“TARP”) rescue
package.
In his recent reconfirmation hearings, Federal
Reserve Chairman Ben Bernanke, speaking of the overall
economic crisis, candidly conceded that “there were mistakes
made all around” and “we should have done more.”
Lehman should
have done more, done better. Some of these failings were
simply errors of judgment which do not give
rise to colorable
causes of action; some go beyond and are indeed colorable.
Why Did Lehman Fail? Are There Colorable
Causes of Action That Arise From Its Financial Condition and
Failure?
Although Repo 105 transactions may not have been
inherently improper, there is a colorable claim that their
sole function as employed by Lehman was balance sheet
manipulation.
Lehman’s own accounting personnel described Repo
105 transactions as an “accounting gimmick” and a “lazy way
of managing the balance sheet as opposed to legitimately
meeting balance sheet targets at quarter end.”
Lehman used
Repo 105 “to reduce balance sheet at the quarter-end.”
In 2007-08, Lehman knew that net leverage numbers were critical
to the rating agencies and to counterparty confidence.
Its
ability to deleverage by selling assets was severely limited
by the illiquidity and depressed prices of the assets it had
accumulated.
Against this backdrop, Lehman turned to Repo 105
transactions to temporarily remove $50 billion of
assets from its balance sheet at first and second quarter
ends in 2008 so that it could report significantly lower net
leverage numbers than reality.
Lehman did so despite its
understanding that none of its peers used similar accounting
at that time to arrive at their leverage numbers, to which
Lehman would be compared.
Lehman defined materiality,
for purposes of reopening a closed balance sheet, as “any
item individually, or in the aggregate, that moves net leverage
by 0.1 or more (typically $1.8 billion).”
Lehman’s
failure to disclose the use of an accounting device to
significantly and temporarily lower leverage, at the same
time that it affirmatively represented those “low” leverage
numbers to investors as positive news, created a misleading
portrayal of
Lehman’s true financial health.
Colorable
claims exist against the senior officers who were responsible
for balance sheet management and financial disclosure, who
signed and certified Lehman’s financial statements and who
failed to disclose Lehman’s use and extent of Repo 105
transactions to manage its balance sheet.
In May
2008, a Lehman Senior Vice President, Matthew Lee, wrote a
letter to management alleging accounting improprieties; in
the course of investigating the allegations, Ernst & Young
was advised by Lee on June 12, 2008 that Lehman used $50
billion of Repo 105 transactions to temporarily move assets off
balance sheet and quarter end.
The next day - on June 13,
2008 - Ernst & Young met with the Lehman Board Audit
Committee but did not advise it about Lee’s assertions, despite
an express direction from the Committee to advise on all
allegations raised by Lee.
Ernst &Young took virtually no
action to investigate the Repo 105 allegations.
Ernst & Young
took no steps to question or challenge the non-disclosure by
Lehman of its use of $50 billion of temporary, off-balance
sheet transactions. Colorable claims exist that Ernst &Young
did not meet professional standards, both in investigating Lee’s
allegations and in connection with its audit and review of
Lehman’s financial statements.
1. Business and Risk Management
The Examiner has explored this subject because it is
central to the question of how and why Lehman amassed the
assets that ultimately it could not monetize in time to maintain
liquidity, acceptable leverage and confidence.
The Examiner
explored Lehman’s reaction to the subprime lending crisis and
other economic events to analyze whether Lehman’s officers
and directors fulfilled their fiduciary duties.
The Examiner
concludes that some of Lehman’s management’s decisions can be
questioned in retrospect, but none fall outside the business
judgment rule; the Examiner finds no colorable claims.
2. Valuation
The Examiner has explored this subject because it
is central to the question of Lehman’s solvency and to
whether Lehman’s financial statements were accurately stated.
The Examiner concludes that Lehman’s valuation procedures may
have been wanting and that certain valuations may have been
unreasonable for purposes of a bankruptcy solvency analysis.
The Examiner’s conclusion that valuations were unreasonable for
solvency analysis does not necessarily mean that individuals
acted with sufficient scienter to support claims for breach
of fiduciary duty, and the Examiner does not find sufficient
credible evidence to support colorable claims.
3. Survival
The Examiner has explored this subject because it is central
to the question whether the officers and directors discharged
their fiduciary duties.
The Examiner finds no colorable claims.
4. Repo 105
The Examiner has explored this
subject after uncovering the issue in the course of his
investigation. The Examiner finds there are colorable claims
against Richard Fuld, Jr., Christopher O’Meara, Erin Callan, and
Ian Lowitt in connection with their failure to disclose the
use of the practice and against Ernst & Young for its
failure to meet professional standards in
connection with
that lack of disclosure.
5. Secured Lenders
The Examiner
has explored this subject because it was specifically
assigned as part of the Examiner Order and because the subject
was addressed in multiple communications with the parties.
The
Examiner finds colorable claims against JPMorgan Chase
(“Chase”) and CitiBank in connection with modifications of
guaranty agreements and demands for collateral in the final
days of Lehman’s existence.
The demands for collateral by
Lehman’s Lenders had direct impact on Lehman’s liquidity
pool; Lehman’s available liquidity is central to the question of
why Lehman failed.
6. Lehman’s Interaction With Government
Agencies
As part of the Examiner’s overall investigation,
it was necessary to consider the interaction between Lehman
and the Government agencies who regulated and monitored
Lehman; for example, Lehman officers suggested to the Examiner
that he should consider, in the course of determining whether
they had breached any fiduciary duties, the completeness of
the disclosures they made to the Government.
Sarbanes Oxley News
Auditing Standard No. 7:
Engagement Quality Review
Applicability of Standard
1.
An engagement quality review and
concurring approval of issuance are required for each audit
engagement and for each engagement to review interim financial
information conducted pursuant to the standards of the Public
Company Accounting Oversight Board ("PCAOB").
Objective
2. The objective of
the engagement quality reviewer is to perform an
evaluation of the significant judgments made by the engagement
team and the related conclusions reached in forming the overall
conclusion on the engagement and in preparing the
engagement report, if a report is to be issued, in order to
determine whether to provide concurring approval of issuance.
Qualifications of an Engagement Quality
Reviewer
3. The engagement quality reviewer must be an
associated person of a registered public accounting firm.
An engagement quality reviewer from the firm that issues the
engagement report (or communicates an engagement conclusion, if no
report is issued) must be a partner or another individual in an
equivalent position.
The engagement quality reviewer may also be an individual from
outside the firm.
4. As described below, an engagement
quality reviewer must have competence,
independence, integrity, and objectivity.
Note: The
firm's quality control policies and procedures should include
provisions to provide the firm with reasonable assurance that the
engagement quality reviewer has sufficient competence,
independence, integrity, and objectivity to perform the engagement
quality review in accordance with the standards of the PCAOB.
Competence
5. The engagement
quality reviewer must possess the level of
knowledge and competence related to accounting, auditing, and
financial reporting required to serve as the engagement partner on
the engagement under review.
Independence , Integrity, and
Objectivity
6. The engagement quality reviewer must be
independent of the company, perform the engagement quality review
with integrity, and maintain objectivity in performing the review.
Note: The reviewer may use assistants in performing the
engagement quality review.
Personnel assisting the engagement quality reviewer also must be
independent, perform the assigned procedures with integrity, and
maintain objectivity in performing the review.
7. To
maintain objectivity, the engagement quality reviewer and others
who assist the reviewer should not make decisions on behalf of the
engagement team or assume any of the responsibilities of the
engagement team.
The engagement partner remains responsible for the engagement and
its performance, notwithstanding the involvement of the engagement
quality reviewer and others who assist the reviewer.
8.
The person who served as the engagement partner during either of
the two audits preceding the audit subject to the engagement
quality review may not be the engagement quality reviewer.
Registered firms that qualify for the exemption under Rule
2-01(c)(6)(ii) of Regulation S-X, 17 C.F.R. § 210.2-01(c)(6)(ii),
are exempt from the requirement in this paragraph.
Engagement Quality Review for an Audit
Engagement Quality Review Process
9. In an
audit engagement, the engagement quality reviewer should
evaluate the significant judgments
made by the engagement team and the related conclusions reached in
forming the overall conclusion on the engagement and in preparing
the engagement report.
To evaluate such judgments and conclusions, the engagement quality
reviewer should, to the extent necessary to satisfy the
requirements of paragraphs 10 and 11:
(1) hold discussions with the engagement
partner and other members of the engagement team, and
(2) review documentation.
10. In an audit, the
engagement quality reviewer should:
Evaluate the significant judgments that relate to engagement
planning, including –
- The consideration of the firm's recent engagement experience
with the company and risks identified in connection with the
firm's client acceptance and retention process,
- The consideration of the company's business, recent
significant activities, and related financial reporting issues and
risks, and
- The judgments made about materiality and the effect of those
judgments on the engagement strategy.
Evaluate the
engagement team's assessment of, and audit responses to –
- Significant risks identified by the engagement team, including
fraud risks, and
- Other significant risks identified by the engagement quality
reviewer through performance of the procedures required by this
standard.
Note: A significant risk is a risk of
material misstatement that is important enough to require special
audit consideration.
Evaluate the significant judgments made about
(1) the materiality and disposition of corrected and uncorrected
identified misstatements and
(2) the severity and disposition of identified control
deficiencies.
Review the engagement team's evaluation of the firm's
independence in relation to the engagement.
Review the engagement completion document 4/ and confirm with
the engagement partner that there are no significant unresolved
matters.
Review the financial statements, management's report on
internal control, and the related engagement report.
Read other information in documents containing the financial
statements to be filed with the Securities and Exchange Commission
("SEC") and evaluate whether the engagement team has taken
appropriate action with respect to any material inconsistencies
with the financial statements or material misstatements of fact of
which the engagement quality reviewer is aware.
Based on the procedures required by this standard, evaluate
whether appropriate consultations have taken place on difficult or
contentious matters. Review the documentation, including
conclusions, of such consultations.
Based on the procedures required by this standard, evaluate
whether appropriate matters have been communicated, or identified
for communication, to the audit committee, management, and other
parties, such as regulatory bodies.
Evaluation of Engagement Documentation
11. In an audit, the engagement quality reviewer should
valuate whether the engagement documentation that he or she
reviewed when performing the procedures required by paragraph 10 -
Indicates that the engagement team responded appropriately to
significant risks, and
Supports the conclusions reached by
the engagement team with respect to the matters reviewed.
Concurring Approval of Issuance
12. In an audit, the engagement quality reviewer may
provide concurring approval of issuance only if, after performing
with due professional care the review required by this standard,
he or she is not aware of a significant engagement deficiency.
Note: A significant engagement
deficiency in an audit exists when
(1) the engagement team failed to obtain sufficient appropriate
evidence in accordance with the standards of the PCAOB,
(2) the engagement team reached an inappropriate overall
conclusion on the subject matter of the engagement,
(3) the engagement report is not appropriate in the circumstances,
or
(4) the firm is not independent of its client.
13. In an
audit, the firm may grant permission to the client to use the
engagement report only after the engagement quality reviewer
provides concurring approval of issuance.
Engagement Quality Review for a Review
of Interim Financial Information
Engagement Quality Review
Process
14. In an
engagement to review interim financial information, the engagement
quality reviewer should evaluate the
significant judgments made by the engagement team and the
related conclusions reached in forming the overall conclusion on
the engagement and in preparing the engagement report, if a report
is to be issued.
To evaluate such judgments and conclusions, the engagement quality
reviewer should, to the extent necessary to satisfy the
requirements of paragraphs 15 and 16:
(1) hold discussions with the engagement partner and other members
of the engagement team, and
(2) review documentation.
15. In a review of interim
financial information, the engagement
quality reviewer should:
Evaluate the significant judgments that relate to engagement
planning, including the consideration of - - The firm's recent
engagement experience with the company and risks identified in
connection with the firm's client acceptance and retention
process,
- The company's business, recent significant activities, and
related financial reporting issues and risks, and
- The nature of identified risks of material misstatement due
to fraud.
Evaluate the significant judgments made about
(1) the materiality and disposition of corrected and uncorrected
identified misstatements and
(2) any material modifications that should be made to the
disclosures about changes in internal control over financial
reporting.
Perform the procedures described in paragraphs 10.d
and 10.e.
Review the interim financial information for all periods
presented and for the immediately preceding interim period,
management's disclosure for the period under review, if any, about
changes in internal control over financial reporting, and the
related engagement report, if a report is to be issued.
Read other information in documents containing interim
financial information to be filed with the SEC 8/ and evaluate
whether the engagement team has taken appropriate action with
respect to material inconsistencies with the interim financial
information or material misstatements of fact of which the
engagement quality reviewer is aware.
Perform the procedures in paragraphs 10.h and 10.i
Evaluation of Engagement Documentation
16. In a review of interim financial information, the
engagement quality reviewer should evaluate whether the engagement
documentation that he or she reviewed when performing the
procedures required by paragraph 15 supports the conclusions
reached by the engagement team with respect to the matters
reviewed.
Concurring Approval of Issuance
17. In a review of interim financial information, the
engagement quality reviewer may provide concurring approval of
issuance only if, after performing with due professional care the
review required by this standard, he or she is not aware of a
significant engagement deficiency.
Note:
A significant engagement deficiency
in a review of interim financial information exists when
(1) the engagement team failed to perform interim review
procedures necessary in the circumstances of the engagement,
(2) the engagement team reached an
inappropriate overall conclusion on the subject matter of
the engagement,
(3) the engagement report is not appropriate in the circumstances,
or
(4) the firm is not independent of its client.
18. In a
review of interim financial information, the firm may grant
permission to the client to use the engagement report (or
communicate an engagement conclusion to its client, if no report
is issued) only after the engagement quality reviewer provides
concurring approval of issuance.
Documentation of an Engagement Quality
Review
19. Documentation of an engagement quality
review should contain sufficient information
to enable an experienced auditor, having no previous connection
with the engagement, to understand the procedures performed
by the engagement quality reviewer, and others who assisted the
reviewer, to comply with the provisions of this standard,
including information that identifies:
The engagement quality reviewer, and others who assisted the
reviewer,
The documents reviewed by the engagement quality reviewer, and
others who assisted the reviewer,
The date the engagement quality reviewer provided concurring
approval of issuance or, if no concurring approval of issuance was
provided, the reasons for not providing the approval.
20.
Documentation of an engagement quality review should be
included in the engagement documentation.
21. The requirements related to retention of and
subsequent changes to audit documentation in PCAOB Auditing
Standard No. 3, Audit Documentation, apply with respect to the
documentation of the engagement quality review.
AUDITING STANDARD NO. 7, ENGAGEMENT QUALITY
REVIEW
PCAOB STAFF QUESTION AND ANSWER
February 19, 2010
Staff questions and
answers set forth the staff's opinions on issues related to the
implementation of the standards of the Public Company Accounting
Oversight Board ("PCAOB" or "Board").
The staff publishes questions
and answers to help auditors implement, and
the Board's staff administer, the Board's standards.
The statements contained in
the staff questions and answers are not rules of the Board, nor
have they been approved by the
Board.
The following staff question
and answer related to Auditing Standard No. 7, Engagement Quality
Review was prepared by the Office of the Chief Auditor.
Additional questions should be
directed to Dima Andriyenko, Associate Chief Auditor
(202/207-9130; andriyenkod@pcaobus.org) or Greg Scates, Deputy
Chief Auditor (202/207-9114; scatesg@pcaobus.org).
Auditing
Standard No. 7
On January 15, 2010, the
U.S. Securities and Exchange Commission ("SEC") approved Auditing
Standard No. 7, Engagement Quality Review ("AS No. 7,"), which was
adopted by the PCAOB on July 28, 2009.
AS No. 7 supersedes the
Board's interim standard, applies equally to all registered firms,
and requires an engagement quality review
("EQR") and concurring approval of issuance for each audit
engagement and for each engagement to review interim financial
information conducted pursuant to the standards of the PCAOB.
In its order approving AS
No. 7, the SEC encouraged the PCAOB to provide further
implementation guidance on the documentation requirements of the
standard in light of comments the SEC received during its comment
period.
The following staff question
and answer provides implementation guidance.
Documentation of an EQR
QUESTION
Page 21 of the adopting
release provides the following example of the application of the
standard’s documentation requirements:
If a reviewer identified
a significant engagement deficiency to be addressed by the
engagement team, the engagement team should document its response
to the identified deficiency in accordance with Auditing Standard
No. 3, Audit Documentation.
Because
AS No. 7 does not require duplication of documentation prepared by
the engagement team, the engagement quality reviewer does
not have to separately document the engagement team’s
response.
Rather,
the EQR documentation should contain sufficient information to
enable an experienced auditor, having no previous connection
with the engagement, to understand, e.g., the significant
deficiency identified, how the reviewer communicated the
deficiency to the engagement team, why such matter was important,
and how the reviewer evaluated the engagement team's response.
Does
this example suggest that the standard requires documentation of
all of the interactions between the engagement quality reviewer
and the engagement team, including all of the interactions before
a matter is identified as a significant engagement
deficiency?
ANSWER
No. The example in the adopting release
illustrates how the documentation requirements of AS No. 7 should be applied
once a reviewer concludes that a significant engagement deficiency
exists.
Paragraph 19 of AS No. 7 establishes a
requirement that “documentation of an engagement quality review
should contain sufficient information to enable an experienced
auditor, having no previous connection with the engagement, to
understand the procedures performed by the engagement quality
reviewer, and others who assisted the reviewer, to comply with the
provisions of this standard....”
News
Leaking information to
the media is not protected activity under the Sarbanes-Oxley Act
What happens if auditors find control
deficiencies and disclose their findings to the media?
They lose their job (and Sarbanes Oxley can
not help)
The facts:
Two auditors working for Boeing were
testing information technology controls, in order to audit
compliance with the Sarbanes-Oxley Act’s mandate that publicly
traded companies review their controls over financial reporting.
They made several complaints to supervisors
about perceived auditing deficiencies. After that, the auditors
provided information and documentation regarding the alleged
deficiencies to a reporter.
The auditors were fired soon after that.
The auditors claimed that they were fired in response to their
frequent complaints to their supervisors regarding Boeing’s
Sarbanes-Oxley Act non-compliance - they were whistleblowers.
The decision:
The U.S. District Court for the Western
District of Washington has dismissed the
auditors’ argument on the ground that leaking information to the
media is not protected activity under the Sarbanes-Oxley Act. So
Boeing did not violate Section 806 of the
Sarbanes-Oxley Act, which prohibits publicly traded companies from
discriminating against their employees for disclosing information
regarding certain alleged illegal conduct - and the firm had the
right to terminate the auditors on this ground.
Significant Enforcement
Actions
SECURITIES AND EXCHANGE
COMMISSION, :Plaintiff, : v. : GENERAL ELECTRIC COMPANY,
:Defendant.
CIVIL ACTION, COMPLAINT
Plaintiff Securities and Exchange
Commission (the “SEC” or the “Commission”) alleges that:
SUMMARY
1.
Starting in 2002 and continuing through 2003, the General Electric
Company (“GE”), a publicly-traded company headquartered in
Fairfield, Connecticut, acting primarily through senior corporate
accountants, made a number of improper
accounting decisions which resulted in its reporting materially
false or misleading results in its financial statements and
earnings reports in 2002 and 2003 and which required additional
adjustments through 2006.
Beginning in 1995 and continuing through the
filing of the Form 10-K for the period ended December 31, 2004, GE
met or exceeded final consensus analyst earnings per share (“EPS”)
expectations every quarter.
On four separate occasions in 2002 and 2003,
however, high-level GE accounting executives or other finance
personnel approved accounting which was not
in compliance with Generally Accepted Accounting Principles
(“GAAP”) so as to
increase earnings
or revenues or to avoid reporting negative financial results.
In one instance, the improper accounting
allowed GE to avoid missing analysts’ final consensus EPS
expectations.
The
four accounting
violations are as follows:
(a) beginning in January 2003, an improper
application of the accounting standards to GE’s commercial paper
(“CP”) funding program to
avoid unfavorable
disclosures and an estimated approximately $200 million
pre-tax charge to earnings;
(b) a 2003 failure to correct a misapplication
of financial accounting standards to certain GE interest-rate
swaps;
(c) in 2002 and 2003, end-of-year “sales” of
locomotives to financial institutions in order to accelerate over
$370 million in revenue; and
(d) in 2002, an improper change to GE’s
accounting for sales of commercial aircraft engines spare parts
that increased GE’s 2002 net earnings by $585 million.
2. By engaging in the practices and
transactions alleged in this Complaint, GE violated Section 17(a)
of the Securities Act of 1933 (“Securities Act”) [15 U.S.C. §
77q(a)]; Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the
Securities Exchange Act of 1934 (“Exchange Act”) [15 U.S.C. §§
78j(b), 78m(a), 78m(b)(2)(A), 78m(b)(2)(B)] and Rules 10b-5,
12b-20, 13a-1, 13a-11, and 13a-13 under the Exchange Act [17
C.F.R. §§ 240.10b-5, 240.12b-20, 240.13a-1, 240.13a-11 and
240.13a-13].
3. Accordingly, the Commission seeks entry
of a permanent injunction against GE prohibiting further
violations of the federal securities laws as well a civil monetary
penalty.
DEFENDANT
7. GE, a
New York corporation with headquarters in Fairfield, Connecticut,
is a diversified technology, manufacturing, media, and financial
services company.
At all relevant times, GE’s common stock was
registered with the Commission pursuant to Section 12(b) of the
Exchange Act and was traded on the New York Stock Exchange.
GE wholly owns General Electric Capital
Services, Inc. (“GECS”), a holding company which in turn wholly
owns General Electric Capital Corp. (“GECC”). GECC contains the
consumer finance and commercial finance operations of GE and also
provides equipment financing and leasing to a variety of
industries. GE’s fiscal year ends on December 31.
To read more:
www.sec.gov/litigation/complaints/2009/comp21166.pdf
Systemic risk: how to
deal with it?
Paper by Mr Jaime Caruana, General Manager of
the BIS, 12 February 2010.
The paper
analyses
systemic risk and considers appropriate policies to
reduce it.
It examines systemic
risk as a negative externality in
two dimensions: the cross-sectional and the time
dimension.
The paper Discusses:
Policies to reduce externalities in the
cross-sectional dimension seek to limit the damage
that can arise from interlinkages and common
exposures.
Policies to address
procyclicality in the time dimension seek to build up
capital and liquidity margins of safety during the
upswing that can be drawn upon in the downturn.
The paper further argues that financial
regulatory policies are not enough to address systemic
risk. Other policies - especially monetary and fiscal
policy - also have a role to play. It also argues that
policy coordination is essential, nationally among
monetary, fiscal and macro- and microprudential
policies, as well as internationally.
Already, the Basel
Committee on Banking Supervision, working with the
Financial Stability Board, has made great progress in
addressing the regulatory shortcomings highlighted by
the financial crisis.
Systemic risk: how to
deal with it?
Paper by Mr Jaime Caruana, General Manager of
the BIS, 12 February 2010.
The international financial crisis has made us
all think much harder - not only about what systemic
risk means, but also about what it means for policy.
Systemic risk was underestimated
across the board before this crisis.
We were faced with the unthinkable when a
number of very large institutions failed, despite
their previous reputation for balance sheet strength
and leadership in risk management.
Coming to grips with systemic risk is vital
because the aggregate risk facing
the system is much higher than the simple sum of the
individual risks attending financial institutions,
products and markets.
Following the work of the
IMF, FSB and BIS for the G20, systemic risk can
be defined as "a risk of disruption to financial
services that is caused by an impairment of all or
parts of the financial system and has the potential to
have serious negative consequences for the real
economy."
If a bank loses money from a risky investment,
that is not systemic. But institutional failure,
market seizure, infrastructure breakdown or even a
sharp rise in the cost of financial services can have
serious adverse implications for many other market
participants.
In these cases, there is a systemic dimension.
It is such negative externalities and the significant
spillovers to the real economy that are the essence of
systemic risk and which make a case for policy
intervention.
Translating this general insight into
practical policies is of course very difficult.
What I would like to do is to
outline some of the thinking at the BIS and suggest
what this might mean for policy.
First, from a
conceptual point of view, systemic risk has two
dimensions, ie a cross-sectional
dimension and a time dimension.
In the cross-sectional dimension, the
structure of the financial system influences how it
responds to, and possibly amplifies, shocks. Such
spillover effects can arise, for instance, from
common exposures across
institutions or from network interconnections.
The policy problem is how to address such
common exposures and interlinkages among financial
institutions. In the time dimension, the build-up of
risk over time interacts with the macroeconomic cycle;
the associated policy problem is how to address the
procyclicality of the financial system.
Second, and from a
policy point of view, financial regulatory policies
are an essential part of the solution, but they alone
will not suffice to address systemic risk in all its
complexity. Other policies - especially monetary and
fiscal policy - also have a role to play.
Third, policy
coordination is essential - not just nationally among
monetary policy, fiscal policy and macro- and
microprudential policies - but also internationally.
Finally, although this paper does not address
them, there is a fourth group
of very important measures bearing on market
discipline, transparency, governance, incentives,
market integrity, consumer protection, etc, that would
also be very relevant to supporting confidence,
fostering market and institutional resilience, and
curbing excesses in risk-taking.
A key message is that a lot of progress has
already been achieved, but the reform agenda is still
large, and its implementation will speed up this year.
In the first section, the paper briefly discusses the
concept of systemic risk. The second section focuses
on the regulatory policies in the pipeline to address
that risk.
The third and fourth sections deal with
monetary and fiscal policy approaches to the same
risk, while the fifth section outlines the role of
international coordination. The last section concludes
with a few final remarks.
I. Concepts of systemic risk
As already mentioned, systemic risk has two
dimensions, cross-sectional and time. Each has very
different policy implications.
The first dimension of
systemic risk - the common exposures/interlinkages in
the cross section - relates to how a specific
shock to the financial system can propagate itself and
become systemic. The focus is on how risk is
distributed within the financial system at a given
point in time.
A shock may take two main forms:
The financial system is a network of
interconnected balance sheets.
As a result, an
increasingly complex web of daily transactions means
that a shock hitting one institution can spread to the
other institutions that are connected to it and become
systemic.
The Herstatt and
Continental Illinois crises both started with problems
in one specific financial institution.
Because of settlement and interbank linkages,
the failure of each of these specific firms threatened
wider problems for connected institutions that were
otherwise sound.
Alternatively, a shock
can have wide ramifications and become systemic
because of direct common exposures.
By its nature, a nationwide downturn in
commercial real estate or housing markets tends to
have this character. As the recent crisis has shown,
such common exposure can
have a profound international sweep.
A negative exogenous shock, or, metaphorically
speaking, a meteor strike or perfect storm, is indeed
how many practitioners viewed this crisis, at least
initially.
The procyclicality dimension of systemic risk
relates to the progressive build-up of financial
fragility and how aggregate risk evolves over time.
Over the economic cycle, the
dynamics of the financial system and of the real
economy reinforce each other, increasing the amplitude
of booms and busts and undermining financial and
macroeconomic stability.
Typically, booms are periods of financial
innovation.
When things are going well, firms and
individuals feel (over)confident in experimenting with
and taking on risk. They create new, untested
instruments that are difficult to understand and
value.
Credit grows rapidly, based on, and
contributing to, higher asset prices. In this way, the
common exposures/interlinkages dimension concerns the
various interconnections among the network of
financial institutions.
By contrast, the
procyclicality dimension of systemic risk highlights
the underlying build-up over time of risks that are
hidden and underpriced.
As strains develop, previously unseen risks
materialise, deepening the retrenchment that is
already under way.
In this procyclicality dimension,
the financial sector endogenously generates systemic
risk and this risk can be highest precisely when it
looks lowest. It is precisely then that credit is
extended most freely and that low volatility
encourages the greatest leverage. Complacency
regarding risk itself turns into a source of risk.
Normal margins of safety, whether down
payments in real estate lending, haircuts in
securities financing or covenants in corporate loans,
are seen as unnecessary hindrances to profit.
Policies to deal with systemic risk must
operate in both dimensions.
II. Policies to deal with
system-wide interlinkages and with too-big-to-fail and
moral hazard issues
Turning first to the cross-sectional dimension
of systemic risk, the policy task is to capture
system-wide risk and to adjust prudential tools based
on individual institutions' contribution to that risk
. It is a continuous approach, which does not require
one to draw up a list of systemic institutions.
Let me highlight six key
building blocks in setting policies to mitigate
this common exposures/interlinkages aspect of systemic
risk:
1. More and better capital/liquidity:
Firms that contribute to systemic risk must
internalise the externalities that they create. Higher
prudential standards would be one way to do this.
Capital and liquidity buffers need to be
higher across the board. The Basel Committee's recent
reform package is aimed at improving the banking
sector's ability to absorb shocks arising from
financial and economic stress - whatever the source -
thus reducing the risk of spillover from the financial
sector into the real economy.
The Committee's proposals include a series of
measures to raise the quality, consistency and
transparency of the regulatory capital base. In
particular, they aim to strengthen the component of
the Tier 1 capital base that is fully available to
absorb losses on a going concern basis.
This will contribute to a reduction of
systemic risk from the banking sector.
The Committee's proposals also seek to
strengthen the capital framework's risk coverage.
Failure to capture major on- and off-balance sheet
risks, as well as derivatives-related exposures, was a
key destabilising factor over the past two and a half
years. Therefore, in addition to the trading book and
securitisation reforms announced in July 2009, the
Committee is proposing to strengthen capital
requirements for counterparty credit risk exposures
arising from derivatives, repos and securities
financing activities.
More importantly, the reforms also have the
necessary macroprudential focus, addressing both
system-wide risks and their procyclical amplification
over time. One way to get systemically important
institutions to internalise the risks that they pose
is to require them to hold more capital and more
liquidity than other firms. Such additional charges
should be calibrated to a given institution's
contribution to systemic risk on a continuous basis,
with a view to reducing its probability of default and
related knock-on effects. In addition, a
straightforward leverage ratio will serve as a
backstop to risk-weighted capital measures.
2. Resolution regime:
The failure of a systemically important
institution should be managed in an orderly manner.
Adequate resolution regimes should be put in
place to hold down the system-wide loss that arises
when such an institution fails. One important aspect
is to ensure that the counterparties of an important
institution are not sheltered from loss in the event
of failure, so that market discipline is strengthened
ex ante.
This can further help to limit the probability
of default.
However, setting up adequate resolution
regimes is no easy matter.
Progress has been limited, and work by the FSB
and the Basel Committee continues.
One reason is that the
legal problems are complex, as the ongoing
Lehman Brothers liquidation reminds us.
Another difficulty highlighted by the recent
crisis in Iceland relates
to the problem of cost-sharing across countries.
Nevertheless, new standards for cross-border
resolution frameworks have already been developed.
Concrete proposals to facilitate the orderly
resolution of a failing firm are actively being worked
on, and progress can be expected this year.
3. Structure of the
financial industry:
The recent financial crisis was a sign of
market failures within the financial industry.
Measures must be adopted to avoid perverse
incentives that spur leverage and the pursuit of
short-term profit.
Bank supervisors are working on proposals to
strengthen governance within firms and to encourage
sound compensation practices. In addition, a number of
countries are considering steps to limit the
size/structure of financial groups, or to place curbs
on some of their business activities.
We have to accept that there will never be
total agreement across borders on what banks should
and should not be allowed to do. There have always
been differences in the business lines permitted to
banks in different countries and there probably always
will be.
Hence, there can be a wide range of
approaches, depending on the particular circumstances.
But all measures should be consistent with
internationally agreed standards to ensure that the
playing field is level and that systemic risk is
reduced.
4. More robust market infrastructure:
A key way to lessen the systemic risks created
by large, interconnected firms is to put in place more
resilient market structures. Trading of financial
derivatives on organised exchanges is one way.
Another is to replace the web of bilateral
exposures with robust central
counterparties (CCPs).
This can reduce the risk of common exposures
in several ways. A CCP is an entity that interposes
itself between the two sides of a transaction,
becoming the buyer to every seller and the seller to
every buyer; this contributes to greater liquidity in
the market and reduces contagion effects.
A CCP also addresses default risk by requiring
each participant to hold a margin account in which the
balance is determined by the value of the
participant's outstanding contracts: the more volatile
the market, the larger the required margin balance and
the more expensive it becomes to hold large positions.
Furthermore, channelling transactions through a single
platform enhances the collection and dissemination of
information.
This in turn allows market participants and
the authorities to monitor the concentration of
individual exposures and the linkages that they
create.
5. Taxation:
Another building block added recently to the
debate is the idea of taxing bigness or
interconnectedness.
While this deserves study as a classic means
of dealing with an externality, many questions arise.
Would the tax end up being paid by customers,
or even by shareholders if their control over
management is weak?
Wouldn't higher capital and liquidity
requirements for systemic institutions, or prudential
incentives for simpler structures, be preferable?
6. Supervision:
Finally, more proactive supervision of
systemic institutions is necessary to ensure that the
perimeter of financial regulation is wide enough for
supervisors to be able to see right through a
financial institution, no matter what the legal
configuration may be.
An interesting question posed by the recent
crisis is why the same regulation produced different
results in different countries. Banking systems in
Australia and Canada, for instance, remained
relatively resilient during the recent crisis.
There were obviously many reasons for the
differences seen across various jurisdictions
including differences in the structure and the
business models of the financial system. Still,
another relevant factor was that regulation was not
implemented across countries with the same rigour.
So a key lesson is that good regulation will
not work without adequate supervision that looks
through both the business cycle and the structures of
financial institutions.
But this is easier said than done.
The recent crisis has highlighted
the difficulties of setting a consistent perimeter of
regulation over time and across jurisdictions.
Moreover, the problem of the shadow banking system
remains a challenge. 8 Ongoing work to ensure greater
consistency across sectors and jurisdictions in the
key respects of capital, liquidity and resolution
regimes will be essential to address these issues.
III. Policies to deal
with procyclicality
Let me now turn to
policies that deal with systemic risk in the time
dimension, the so-called procyclicality aspect.
The first, and
obvious, lesson is that capital
and liquidity buffers need to be higher on
average over time, as was outlined in the previous
section.
A second element
of the macroprudential response to procyclicality
consists in building up and
running down buffers over the cycle.
The guiding policy principle must be to
build up safety margins of
capital in good times, when it is easier and cheaper
to do so. These can restrain risk-taking. In bad
times, the margins can be run down, allowing the
system to absorb emerging strains more easily and
dampening the feedback mechanisms.
At the level of individual banks, the
maintenance of appropriate buffers can be achieved
through capital conservation measures when the buffers
are inadequately replenished, including actions to
limit excessive dividend payments, share buybacks and
compensation; these buffers can then be used when
periods of stress arise.
At the macroprudential level, an operational
framework has to be set up that relies on adequate
indicators signalling the build-up of risks in the
financial system.
A third element is
to encourage banks to use
forward-looking provisioning based on expected
losses instead of more backward-looking provisions
based on realised losses.
This will promote early identification and
recognition of credit losses in a more robust manner.
It will better reflect the reality of the financial
performance and risk of financial institutions, by
incorporating a broader range of credit information,
both quantitative and qualitative.
This should be done in a transparent way and
be subject to appropriate internal and external
validation by auditors.
Finally, it should
be acknowledged that other macroprudential policy
tools can be used to limit or prevent the emergence of
macroeconomic and financial imbalances.
Indeed, they have long been part of the
arsenal, particularly - but not only - in Asia. For
example, tighter provisioning norms against rapid
credit expansion have been used in China to counter
potential vulnerabilities from excessive credit growth
or asset price bubbles.
Other prudential tools have been used as
automatic stabilisers, that is, to forestall the
emergence of such imbalances.
In India, for instance, a
long-standing prudential requirement is that banks
must hold a relatively large part of their assets in
risk-free liquid securities.
Several other
Asian economies place limits on credit exposures or
otherwise restrict concentration risks towards banks.
Korea, for instance, has
announced loan-to-deposit requirements that aim to
limit the exposure of its banks to wholesale funding
markets.
Because it can be difficult to set general
rules that cut across all sectors, some countries have
also used sectoral policies to regulate credit terms,
as well as capital or provisioning requirements for
loans to specific borrowers or sectors.
For instance,
loan-to-value (LTV) ratios and
restrictions on mortgage lending have often been used
by Asian authorities to address concerns about real
estate bubbles.
In India, the central bank has actively used
differential risk weighting in capital regulation and
countercyclical provisioning norms to slow the pace of
growth of bank credit to specific sectors.
One must, however, recognise that some of
these measures can be intrusive and can have
unexpected distortive effects. In addition,
significant uncertainty remains about how and under
what circumstances these measures are likely to be
effective.
While discretionary sector-based prudential
measures taken by Asian policymakers have proved quite
successful in containing financial system damage as
asset prices fall, generally they have been less
effective in preventing or constraining asset price
booms.
It remains to be seen whether and how
rule-based measures might counter the effect of
distorted incentives and so prevent boom-bust cycles.
Effective rules need to take into account the
endogenous behaviour of financial institutions and
their impact on credit extension, as well as the
relationship between the financial and real sectors of
the economy.
IV. Regulation is not enough: monetary policy
This brings me to my next point, that is:
better regulation is essential,
but even with the new macroprudential focus it may not
be enough to prevent the build-up of systemic risks.
Other policies, particularly monetary policy,
must play a supporting role.
The question is not whether monetary policy
should target asset prices. It is rather what role
monetary policy should play in leaning against the
build-up of imbalances that contribute to systemic
risk which can derail the economy.
It is tempting to make a neat Tinbergian
assignment in which we would assign a single policy
instrument to each policy objective. In such a world,
interest rate policy is assigned to stabilise prices,
while prudential policies, be they capital
requirements or credit restrictions, are assigned to
maintain financial stability.
In reality, however,
prudential policies will not suffice to maintain
financial stability and should be supported by
monetary policy.
A key element is that monetary policy should
take into account its effect on financial stability,
for instance on financial innovation and the quest for
yield.
The current crisis has highlighted the hitherto
neglected channel of monetary transmission, the
"risk-taking" channel: the link between monetary
policy and the perception and pricing of risk by
economic agents.
Such self-reinforcing dynamics were detected
empirically in Spain, where lower short-term interest
rates led Spanish banks to loosen their lending
standards and to grant riskier loans.
This and other research at the ECB suggests
that this effect is related to the impact on the
banks' appetite for credit risk when interest rates
are low.
As a result, the interest rate can affect the
supply of credit through the bank lending channel and
risk-taking through the search for yield, thereby
influencing the pace of financial innovation.
Asset
price and credit cycles cannot be treated as exogenous
when they are, in fact, inherently influenced by the
monetary policy stance.
A more symmetrical approach is
needed: monetary policy should not act only when the
bubble bursts, leading to a macroeconomic downturn; it
should also act pre-emptively to limit the preceding
phase of expansion.
This suggests that the reaction function of
the monetary authorities should not be narrowly
understood as aiming at controlling inflation over the
short run.
Rather,
it must also take account of credit
growth and asset information with the goal of
promoting financial and macroeconomic stability over
the medium term. In some circumstances, central banks
may need to respond directly to this additional
information, even if inflation deviates from its
objective in the short run.
This is because the trade-off between
financial stability and monetary stability may be more
apparent than real when the appropriate time horizon
is considered.
In the long run, the two goals are indeed
likely to be complementary. For example, some
restraint on the build-up of financial imbalances
today may mitigate the severity of a subsequent
financial crisis, preventing a future economic
contraction and the undershooting of inflation
targets.
Several recent experiences suggest that
central banks are becoming more alert to developments
in asset markets.
In 2003, for instance, the
Reserve
Bank of Australia's interest rate policy quite
appropriately erred on the side of tightness in the
face of strong credit growth and housing price
increases, even though consumer price inflation
remained muted. The RBA also made public statements
highlighting the risks in the rise in housing prices.
There is little doubt that this subsequently
contributed to the levelling-out of house prices. In
the euro area, the monetary pillar - that is, broad
money and credit growth - also helped the ECB to take
difficult interest rate decisions in 2004 and 2005.
V. Regulation is not enough: fiscal buffers
and tax policy
Fiscal policy can also be called upon to
promote financial stability, not least because of the
sheer scale of the financial resources that the public
sector can call upon in times of stress.
One obvious mechanism is to let fiscal
automatic stabilisers play their part in difficult
times, alleviating the impact of economic weakness on
business activity and employment.
Moreover, government can play the role of a
kind of insurer by building fiscal room for manoeuvre
in good times.
When bad times come, these "reserves"
can be used for financial stability purposes.
Governments have mobilised massive resources in the
financial rescue programmes set up in response to the
recent financial crisis.
This implies that government debt should be
maintained at reasonably low levels in good times so
that additional debt can be taken on in times of
stress without unsettling financial market conditions.
As with monetary policy, it is also important
to take into account how fiscal policy affects
financial stability.
In good times, procyclical
policies can serve to heighten complacency and
encourage the build-up of financial imbalances. This
is even more the case when rapid credit growth and
high asset prices flatter the fiscal accounts during
the upturn.
All this implies that fiscal policy may
have to err more on the side of tightness, preparing
for the realisation that part of what appears to be
sustainable revenues may be subject to a payback.
Of
course, this strongly reinforces the case for reducing
government debt in relation to GDP in good times.
That
said, we should recognise the political economy
problem that Adam Smith highlighted in his treatment
of the public debt.
Lastly, tax policy could be also used to
address sectoral developments with potential financial
stability implications. We have seen how
macroprudential tools can be used to limit excessive
credit growth in specific areas such as housing; tax
policy could also be of use here.
A key way to ensure that the tax code worked
for rather than against financial stability would be
to reduce or to eliminate its bias towards debt and
against equity.
The recent crisis has shown the unfortunate
results this bias can have on asset prices and
leverage, especially in housing markets. This is not
the place to explore in detail how the tax code might
be made more even-handed. Suffice it to say that
getting rid of the tax incentive to leverage could
make a handsome contribution to financial stability.
VI. The institutional framework of systemic
regulation
To summarise, we need to ensure that
all public policies - especially
monetary, fiscal and macro- and microprudential
policies (complemented by adequate supervision) -
become part of a consistent macrofinancial stability
framework designed to pre-empt financial excesses and
serial boom and bust cycles.
To make this framework effective, careful
thought must be given to the institutional setup and
to international coordination.
It is crucial to align goals, know-how and
control over the various policy instruments, precisely
because the responsibilities for financial stability
are so widely distributed. The institutional setup
should therefore be based on clear mandates and
accountability.
It will need to rely on close cooperation
between central banks and supervisory authorities,
both within and across borders.
All that said, let me recognise that
some important questions remain
open.
A first open question
pertains to the governance structure and flow
of information in systemic risk regulation.
The crisis has shown that central banks play a
decisive role in systemic regulation.
But it is not
entirely clear how central banks need to be equipped
to play this role.
Especially where the central bank is not the
bank supervisor, it is important that the goal be well
defined, the instruments understood and the exchange
of information with other authorities appropriate -
including detailed supervisory information on
individual firms.
Financial supervisors can also benefit from
information collected by central banks in the context
of their liquidity operations.
A second open question
is how to balance rules and discretion.
In principle, we should rely as far as
possible on rules and automatic stabilisers rather
than discretion.
Rules can help avoid errors that can stem from
difficulties in identifying threats to financial
stability contemporaneously - dynamic provisioning is
a good example of a rule that can help in dealing with
procyclicality.
In addition, clear rules can allow the
authorities to commit themselves ex ante to responses,
thereby facilitating international coordination and
enlisting the understanding, and even the
anticipation, of market participants.
For instance,
market participants, including rating agencies, may
not necessarily permit capital and liquidity that is
built up in good times to be used in bad times.
In this case, clear rules communicated by
supervisors will help drawdowns be accepted in the
marketplace. Lastly, and perhaps more importantly,
rules reduce the enormous political pressures on
policymakers to refrain from intervening against
booms.
However, rules may not be enough: discretion
has a role to play as it can help tailor intervention
to varying, and often unpredictable, circumstances.
This is why
we should accept that some degree of
discretion is inevitable.
While these open questions have still to be
dealt with, I would like to emphasise that important
progress has been made in the international
coordination of systemic regulation.
Indeed, we emerge from the global financial
crisis with a brand new structure. The crisis gave
further evidence that financial stability cannot be
assured by each neighbour keeping his own house in
order. This is necessary but not sufficient. Exposures
to a neighbour's losses can bring down one's own
house.
The Financial Stability
Board has taken up a key role in coordinating
the work of national authorities and standard setters
to ensure international consistency.
New mechanisms have been developed to support
the development of the IMF-FSB early warning
exercises, to increase cooperation across borders and
between supervisors, and to conduct peer review
exercises. Comprising both thematic and country by
country approaches, such exercises are a new
instrument that will strengthen adherence to
international standards.
Key input into the coordinating work of the
Financial Stability Board comes from the
expanded
Basel Process, which internationally coordinates
standard-setting.
Whatever the differences at the
national level regarding the scale and scope of
financial firms, international agreements on minimum
capital and liquidity are being refined.
Peer review
exercises have been launched to ensure adherence to
these standards in each jurisdiction.
New institutional arrangements are being
explored to enhance cooperation among supervisors both
at the national level and across borders.
Let me just mention a few examples.
In the case of the biggest firms
operating across borders,
colleges of supervisors are supplementing the Basel
Concordat that sets out the respective roles of home
and host supervisors. Another example, of a different
nature, is the proposed European Systemic Risk Board,
which will help to coordinate micro and macro
approaches and enhance international cooperation.
This body would take charge of macroprudential
supervision at the European level, issuing risk
warnings and making recommendations on policy
measures.
Lastly,
the G20 is playing an increasing
role to
enhance the necessary coordination of
macroeconomic policies and to ensure political support
for financial regulatory reform.
The mutual assessment
process reinforces the commitment of national leaders
to joint and coordinated action. Just as financial
stability needs help from monetary and fiscal policy
at the national level, international financial
stability cannot be achieved in the face of
inconsistent policies at the global level. It is very
important that leaders remain engaged in and committed
to this effort.
No
doubt this international structure will continue to
evolve.
The challenge is to maintain the intimate
cooperation that has characterised the Basel Process
even as it widens the effort in terms of both
participants and issues.
As it approaches the end of
its 80th year, the Bank for International Settlements
pledges to continue its support for this cooperative
project to tame systemic risk.
VII. Final remarks
The issue of systemic risk is probably
the
most important and most difficult that we confront.
Progress will require a combination of better
regulation, a more macro orientation of prudential
tools, better macroeconomic policies, enhanced
international coordination and greater market
discipline. A lot of work has been done and much
progress made.
In some areas, such as capital and
liquidity, the convergence of minds has been already
substantial.
In others, such as the handling of
systemically important institutions, work is well
under way.
Many ideas and proposals are on the table, and
we need to make sure that this work does not lose
sight of the forest for the trees.
The BIS will fully
support the Basel Committee and the Financial
Stability Board in their comprehensive assessment of
the impact of the various proposals to strengthen the
financial system before they are implemented.
This assessment will clarify the new
regulatory framework and will ensure that the
transition to this new and more demanding framework is
achieved with minimal interference to the ongoing
recovery process.
Dear
Potential, New or Sitting Member of the Board of
Director,
You
have the duty to prudently represent the interests of the
shareholders.
You have to understand the needs and desires
of employees, customers and regulators.
You have to do your
best to understand the risks in your organization, and to exercise
oversight.
Year after year, you have to do more, and you
have more responsibilities.
Our Mission: To help you make
informed business decisions in good faith.
Our International
Association provides networking, training, certification, alerts and
updates you can use.
Best Regards,
George
Lekatis
President of the International Association of Potential,
New and Sitting Members of the Board of Directors (IAMBD)
General
Manager, Compliance LLC
1200 G Street NW Suite 800, Washington DC
20005, USA
Tel: (202) 449-9750
Email: lekatis@members-of-the-board-association.com
Web:
www.members-of-the-board-association.com
HQ: 1220 N. Market Street
Suite 804, Wilmington DE 19801, USA
Tel: (302) 342-8828
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