Business Expectations and the Business Model of the Employers - Essay Example

The Banking Crisis in the UK and the US - Should Auditors have done better ID 19714 Order No. 285815 [Name] [University Name] [Course Name] [Supervisor] [Any other details] 21 April 2009 Table of Contents: Table of Figures Figure No. Description and Word Hyperlink Figure 1 Rise of interest rates in US, UK and Europe (Source: http://www.marketoracle.co.uk/images/interest_rates_29_7_07.jpg) Figure 2 RBS Assets and Liabilities - comparison of 2007 & 2008 (Source: RBS Annual Review 2008) Introduction: The Year 2007 saw a booming financial services market in the UK and the US and the year 2008 saw a complete crash of the same. What went wrong suddenly in just one year Let us take a close look at the results of Royal Bank of Scotland: 2007: Group operating profit after tax - 7.712 Billion 2008: Group operation loss after tax - (34.373 Billion) Out of the total losses in 2008, the loss from credit markets alone is 7.8 Billion (RBS Annual Review. 2008). Obviously a sudden crash of this nature will compel the experts to question the fundamentals of the business framework whereby auditing forms the critical part of it. The primary task of external public auditors is to carry out fair value assessments of the accounting statements and assess the risks of the banks by getting deep into their credit & liquidity risk management framework and raise alerts as applicable. ISA (UK & Ireland) 300 gives the right of independence to public auditors with respect to compliance with ethical requirements. ISA 300 also allows auditors to consider acceptance of the audit engagement before starting the audit. ISA 315 (UK & Ireland) gives the auditors to understand the internal governance system pertaining to risks of material misstatements and ISA 330 (UK & Ireland) even gives the auditors the right to extend the audit scope to carry out sufficient tests of controls. Given the level of empowerment to Public Auditors by the ISA, they would definitely be expected to stand and answer the reasons of this sudden turmoil in banking & financial services industry as if a time bomb was planted to be exploded and they couldn't detect the same. In this paper, the author critically evaluates if the auditors have been directly responsible for the current financial crisis. Financial Crisis in the UK and the United States The financial crisis in the UK and the United States has occurred due to the same primary factor - uncontrolled Sub-Prime lending and sale of packaged "Collateralized Debt Obligations (CDOs)". Sub-Prime lending initially started with loan products for customers that do not possess a clean credit history or regular source of income. The risks against such lending were managed by acquiring collaterals of better valuation. This is the reason that the home mortgage market in both UK and the US was selected as the most suitable area for productizing sub-prime lending packages given that the property markets in both countries were booming. Banks perceived clear advantages in acquiring the homes as collaterals under mortgage deals. But the rising prices of homes were of no benefit to banks. Hence, they found a method of gaining out of the increasing valuations of the home prices - the "Collateralized Debt Obligations (CDOs)". The banks in UK & US modified their loan management life cycle whereby the loans backed by collaterals (home mortgages) that were originally withheld by the banks internally were pooled into what is known as "Special Purpose Vehicles" or "Special Investment Vehicles" To determine the valuation of the CDOs, a new role called "Pooling Underwriter" was created in every bank in these two countries. The CDOs were sold to external investors thus developing the notion of money flowing through "conduits" from investors to borrowers that de-risked the banks. As a result, these loans went out of the balance sheet of the banks and a new asset called "derivatives" was added in the accounting statements, which (probably) was hardly understood by any risk assessor of the world. This entire process was termed as "securitization" that finally resulted in a booming Credit Derivative market in both the countries resulting in every Bank going after them by stretching their limits. The benefit per CDO was limited because they were sold as retail products in the market and hence the risk assessment per CDO reduced drastically amidst growing number of transactions. To make the situation worse, the role of pooling underwriters was so much in demand that many banks in the US and UK outsourced this process to India amidst insufficient knowledge transfer mechanisms. One key consideration should be kept in mind that this process was not formed overnight but was gradually built in many years and the banks & investors in CDOs made huge profits from this process prior to the crisis. Two critical factors (that probably no one had imagined) contributed to crash of this system - rise of interest rates and the crash of housing markets. Figure 1 shows the rise of interest rates in US, UK and Europe which increased the investments in sub-prime markets by all the banks in the UK and the US. Figure 1: Rise of interest rates in US, UK and Europe (Source: http://www.marketoracle.co.uk/images/interest_rates_29_7_07.jpg) But no one realised that the rise of interest rates is going to have a serious implication - falling of real estate prices. The valuation of all CDOs sold was very complex but fundamentally based on the valuation of the collaterals which in this case were the mortgaged homes. The risk assessment system of banks never realised this dependency because fundamentally they are dependent upon their internal credit & liquidity risk management procedures which is based on historical asset & liability valuation. The Derivatives (CDOs) that have already taken prominent position in the asset master of banks were actually linked with market risks, which is not the expertise of internal risk assessment teams of banks. Moreover, all banks seriously lacked historical data about the CDOs and hence the risk management experts of banks were dependent upon external information about valuations of the CDOs without having confidence upon their accuracy. Now the billion dollar question - why did banks suffer in the CDO crash when they had already transferred the risks to investors in CDOs In fact the banks had insured their CDO investors through backup lines of credits or piggyback loans. Hence, the banks were the ones that had to suffer - this way or that way!! The only things they are left with now are loads of devalued real estate properties with no buyers around. [Clerc, Laurent. 2008. pp1-4] The speculative "Securitization" process that resulted in the booming Credit Derivative Market is now viewed as breach of fair valuation norms like the SFAS 157. The SFAS 157 possesses three levels of asset analysis whereby the valuation of assets cannot completely be based on "unobservable" analytics that might be developed internally by the entities but should be adjusted in accordance with "observable" analytics by market participants where the assets are traded along with similar assets. The CDOs seriously lacked "observable" analytics whether in the markets or in-house by banks due to their sheer complexity and hence their valuations were based on mere speculations only [Statement of Financial Accounting Standards No. 157. pp101; Young and Miller et al. 2008. pp34-36]. With the crash of home prices in the UK and the US, the world realised where the observable valuation data was actually lying - the cost of homes that had escalated as if they were bubbles that finally burst [Schmitz, Michael. C and Forray, Susan J. pp28-30]. This fundamental risk was completely covered under speculative valuations & hyped data about CDOs [Kneuer. 2008. pp11-12]. No expert (includes public auditors as well) ever understood the valuation techniques of the CDOs properly [Clerc, Laurent. 2008. pp1-4] and specifically when majority of these valuations didn't carry much incentives for scrutiny making the buyers mainly dependent upon the credit rating agencies, the baselines of risk assessment were completely missing [Clerc, Laurent. 2008. pp1-4]. Whether auditors have been a direct contributory factor in the current financial crisis Let us take a close look at the asset & liability statement of Royal Bank of Scotland. Figure 1: RBS Assets and Liabilities - comparison of 2007 & 2008 (Source: RBS Annual Review 2008) The derivatives increased from 277.4 billion in 2007 to 992.5 billion in 2008. Even if the auditors did not understand the actual valuation of derivatives, they should have questioned this sudden three fold increase. ISA 330 anyway gives the right to the auditors to test the stress on the assets and extend the audit scope amidst such observations. The gaps in collaborative analytics of credit & liquidity risks and the (never before) market risks of banks was quite complex and not easy for the auditors to assess. However, the auditors could have widened their focus auditing (author's own analysis): 1. Detailed assessment of the credit & liquidity risk management documents & records of the banks especially in the context of the increase in investments in the derivatives. 2. Collaborative assessment of collaterals, assets & liabilities held by the bank and comparing them with loans disbursed to the customers, the non-performing assets, and such other area that might have given the clues to the auditors at checkpoints where the sample size and audit scope could have been increased. 3. The liquidity crunch wouldn't have happened just due to the sub-prime crisis. It was sure that the banks were stretching themselves beyond the "liquidity risk tolerance limits" or may be in some cases were even burning the contingency funds in aggression of selling CDO products in the market. Such high risk taking attitudes cannot escape the eyes of the public auditors by any chance and hence the critics are highly surprised why they were not reported to the central banks. The central banks rather started pushing good money into bad debts in order to protect the reputation of these banks (and the country as a whole) in front of the world encouraging the banks to take even more risks. The auditors could have easily stopped these blunders to happen. 4. Every risk management system carries out "stress analysis" to validate if the cut off limits of risk tolerance are in line with the balance between assets & liabilities of the banks. This was a very important area where auditors should have focussed very strongly. ISA 330 empowers the auditors to carry out their own stress tests and validate if the results are acceptable to them from the perspective of acceptable limits for the entity being audited. If the results of stress tests were unsatisfactory, the auditors have all the rights to report to Bank of England in UK. 5. The sampling of Loans & Advances to Customers probably was not adequately done by auditors given that they were getting converted into SPVs & SIVs through an extremely complex process that required in-depth attention of the auditors specifically in the case of sub-prime customers. 6. The sub-prime loans were getting converted into SPVs & SIVs for sale in the credit derivatives markets thus removing the loans from balance sheets and derivatives piling up in the asset masters. Such a major chunk of assets was getting into the asset masters by reducing balance sheet statements and moreover the entire process of this conversion was largely outsourced to India & Philippines. It was very easy for the auditors to assess that this accounts for two major breaches - exaggerated Accounting statements and outsourcing of risk management process. 7. Overall, the auditors should have dived deep into the overall "Securitization Process" and understood every aspect of its transactions and the related risk management procedures. This short analysis hints towards laxity on the part of auditors in following ISA regulations and doing their job as independent public auditors in the interest of the people of United Kingdom. It definitely appears that the auditors have direct contributory factor in the current financial crisis. Are Prof. Prem Sikka's comments valid Before we begin this analysis, the author invites attention towards a very old theory by Denis & Denis (1999. pp1071-1074) pertaining to agency theory acting as controller of risk taking attitudes in corporations. Agency theory states that strategic decisions are taken by people keeping in view their personal interests. Every corporate is comprised of two different stakeholders - the share holders and the managers. The shareholders tend to take higher risks to maximize their wealth whereas the managers tend to take lower risks amidst lower managerial overheads. This is a perfect balance that results in effective corporate governance of corporations. But if the managers are also made shareholders then this balance breaks and taking higher risks becomes the part of life in the corporations. Banks like RBS possess internal policies of providing shares to all employees' right up to the group CEO level. The annual statement of 2008 already reveals the amount of shares owned by Sir Fred Goodwin. This definitely must have resulted in high risk taking attitudes thus resulting in the turmoil that RBS is into. Given that RBS is one of the flagship banks of the UK; their crisis has hit the overall economy of UK as a whole. In this entire process, the only agents that could have made a difference were the external auditors. But in some way, they also became shareholders in the banks. The author does not mean that the banks offered shares or bribes to the auditors. In fact, the author is pointing towards the fundamentals of audit engagements as such whereby the big 4 audit firms - Deloitte, KPMG, Ernst & Young and Pricewaterhouse Coopers operate as commercial "vendors" and the entities to be audited operate as commercial "customers". The big 4 even talk about terms like "audit markets" and "audit customers". Prof. Prem Sikka rightly states that "conventional audit model is broken and cannot be repaired". [Hinks. 2009] He has justified this point by stating - "How can one bunch of commercial entrepreneurs audit another bunch of commercial entrepreneurs That kind of model is broken and cannot work." [Doherty. 2009]. In fact he is right in pointing out that Bank of England should intervene and probably take on direct auditing exercises. [Hinks. 2009] Hence, if we map this scenario with the agency theory, it is apparent that even auditors have become stakeholders in the respective entities that they audit. Prof. Prem Sikka argued that auditors are victims of organizational & regulatory politics. The representatives of ICAEW and ACCA institute are reiterating about the limitations in the power & responsibility of auditors. The author is a student and hence cannot directly counter their standing given that they are deep into this profession. But at least at the academic & theoretical level of understanding, the ISA regulations provide enormous powers to auditors and hence whatever limitations they are talking about appear to be their own creations amidst the money making engagement styles with their clients and also due to getting additional consulting business from the clients outside the auditing framework. I agree with Professor Prem Sikka in expressing that the business model of the big four audit firms appear to be the root of this entire crisis. [Doherty. 2009] Conclusion: How the auditing profession has responded to the current crisis The auditor - auditee engagements driven by the corporate world need to be changed drastically and the Bank of England need to play the role of change agent. The individual auditors should not be blamed for this crisis but they are required to contribute much more than what they are doing today. [Doherty. 2009] John Hitchins, UK Banking Leader of PwC warns that auditors should not get into the role of regulators. The author's perspective hereby is that regulators may have a different role compared to auditors but they do not audit the banks to the depth that auditors do. Hence, they also largely depend upon the auditor's reports. Also, ISA 330 clearly defines the role of the auditor to assess the risks and test the same before giving their approval. Jonathan Hayward states that currently auditors are not liable to comment on the risk position of the banks which itself is conflicting with the ISA guidelines [Hinks. 2009]. The author hereby proposes that auditors should not only test the risks position of banks but should also discuss them with regulators behind the scene. If this conflicts the business & revenue model of Big 4, then let them go out of this business in the interest of the people of UK. If required, it would be better that the banks in UK should be audited by practicing individuals selected by Bank of England. Gwinner and Sanders (2009. pp35-36) blamed the auditors to have acted as catalysts to the mentality of financial boom by financial institutions by understating risks and losses. They blamed that the auditors grossly used improper and imprudent practices in the context of loan originations, accounting & finance, general operations, risk management etc. As is evident from the reports above that the auditor's community have strongly retaliated against such allegations (including the ones that we witnessed from Prof. Prem Sikka) and expressed their limitations in role. The author hereby concludes that this response from the auditors is not compliant with ISA guidelines which allows full authority to the auditors to carry out in-depth checks, especially at the regulatory aspects and risk management level. If the auditors would had warned about the risks and inflated accounting statements to the world on time, this crisis could have been avoided. Auditors do get suppressed by the Fred Goodwin's of the world but this may happen only because of their business expectations and the business model of their employers. If Bank of England takes charge of auditing banks & financial institutions, the auditors would be more independent and empowered. Reference List: Annual Review and Summary Financial Statement 2008. RBS Annual Review 2008-09 09 03 09. The Royal Bank of Scotland Group Plc. 2009. Anonymous Author. Statement of Financial Accounting Standards No. 157. Fair Value Measurements. Journal of Accountancy. Vol. 202. No. 6. ABI/INFORM Global. 2008. pp101. Credit Approval Process and Credit Risk Management. Financial Market Authority (FMA). 2004. pp9-27. Clerc, Laurent. A Primer on the Sub-Prime crisis. Financial Stability Directorate. Occasional Papers - Banque De France. 2008. pp1-4. Denis, David J. and Denis, Diane K. et al. Agency Theory and the influence of Equity Ownership Structure on Corporate Diversification Strategies. Vol. 20. No. 11. pp1071-1073. John Wiley and Sons. 1999. Doherty, Christian. Auditors not to blame for banking crisis - academic tells MPs. Accountancy Age 2009. Retrieved on 05 April 2009. Available at http://www.accountancyage.com/articles/print/2235353. Gwinner, William B. and Sanders, Anthony. The Sub-Prime Crisis: Implications for Emerging Markets. The World Bank and Arizona State University. Retrieved on 22 April 2009. Available at http://umrefjournal.um.edu.my/filebank/articles/138/GwinnerSanders%20for%20IJPS.pdf. 2009. Hinks, Gavin. Bank of England should audit banks. Says Prof. Accountancy Age. 2009. Retrieved on 05 April 2009. Available at http://www.accountancyage.com/articles/print/2235205. ISA (UK & Ireland) 300. Retrieved on 05 April 2009. Available at www.frc.org.uk/APB. ISA (UK & Ireland) 315. Retrieved on 05 April 2009. Available at www.frc.org.uk/APB. ISA (UK & Ireland) 330. Retrieved on 05 April 2009. Available at www.frc.org.uk/APB. Kneuer, Paul. (2008). Bubbles, Cycles and Insurer's ERM - What Just Happened. Risk Management - The Current Financial Crisis, Lessons Learnt and Future Implications. Presented by Society of Actuaries, The Casualty Actuarial Society and The Canadian Institute of Actuaries. pp11-12. Schmitz, Michael. C and Forray, Susan J. (2008). The Democratization of Risk Management. Risk Management - The Current Financial Crisis, Lessons Learnt and Future Implications. Presented by Society of Actuaries, The Casualty Actuarial Society and The Canadian Institute of Actuaries. pp28-30. Young, Michael R. and Miller, Paul B W. et al. The role of fair value accounting in the Sub-Prime Mortgage Meltdown. Journal of Accountancy. Vol. 205. No. 5. ABI/INFORM Global. 2008. pp34-36. Yuliya, Demyanyk. (2008). Did Credit Scores Predict the Sub-Prime Crisis. Federal Reserve Bank of St. Louis. Proquest Information and Learning. Published at The Regional Economist. 2008. pp1-3. End of Document Read More