Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 380-399)

SIR HOWARD DAVIES, KCB, AND MR MICHAEL FOOT

TUESDAY 2 JULY 2002

Chairman

  380. Sir Howard, welcome this morning. Apologies for our session running over, but we were receiving very good information. Could you introduce yourself and your colleague?
  (Sir Howard Davies) Howard Davies. Chairman of the Financial Services Authority. On my right is Michael Foot, one of my Managing Directors whom you have met before. He has responsibility for the Markets and Exchanges Division and the listing authority part of the FSA among other things and is also our representative on the Financial Reporting Council.

  381. One consequence of the Enron collapse has been that the Big Four accounting firms have now become the Big Three. Are you concerned about the impact of this on choice amongst the largest accounting firms? Will it restrict the FSA when it is seeking to place work? What would be the impact of a further reduction.
  (Sir Howard Davies) I hope it has not gone down to three. If there is some news which I have missed, perhaps somebody would let me know. It is most unfortunate that there has been this further consolidation in the industry. We went on record in fact at the time of the last range of mergers taking things down to five, saying we thought this was unfortunate and it did restrict choice for firms. It also has an adverse effect on us in that there are circumstances in which it is quite difficult for us to find a firm which can act independently. If you have a disputed takeover or a circumstance in which an auditor has to leave a company and you need an independent review, sometimes our choices are highly restricted. Indeed there have been one or two circumstances in which we have not been able to find an independent firm to act for us. We are very concerned about the impact of further consolidation in the accounting industry. I find it difficult to think that the current position is in fact stable because whereas you might just about argue four was a possible number, although in some sectors there are effectively not four competitors because in some sectors, for example the insurance sector, there are not really four competitors. It is now a position where it is impossible for any one of these four to fail because anybody would agree you could not go down to three or two. This is a very unfortunate consequence and side effect of the Enron case and something which the competition authorities need to think about. As international security regulators in IOSCO, of which we are the United Kingdom member, we are concerned about this and have been considering whether there are any steps we can take. We have said that we should like to encourage some of the second tier firms to develop, but it is not something which is directly within our gift as regulators unfortunately.

  382. Is the FSA planning any measures, for instance through the placing of work, to seek to encourage other accountancy firms to develop the capability to compete more effectively with the Big Four?
  (Sir Howard Davies) We shall certainly take that into account. The impact of our own purchasing behaviour is likely to be extremely modest because we are buying services in a fairly restricted part of the market. We are not buying audit services, we are buying primarily regulatory analysis or actuarial services. I fear that the impact of our own purchasing behaviour would really be very modest. The likely impact on us is more that we will have to do more work in house than we would otherwise have done because we cannot always find people with the right degree of independence. I suspect we may end up doing more accounting reviews or more actuarial reviews with our own in-house people if we cannot find people who are prepared to act with the right degree of independence.

Mr Fallon

  383. Just following up your hint that the competition authority ought to address this issue of the Big Four, are you suggesting that they ought to break the stranglehold of the Big Four on the FTSE 100 or are you suggesting that there is a case for the competition authority to break up the Big Four themselves?
  (Sir Howard Davies) I think that a competition analysis of the overall state of the market would be useful. The question is: who has the jurisdiction to do it? I would not say I was expert on that but the candidates are the Department of Justice in the US and the European Commission, I would say, because this is an international issue, not purely a domestic one.

  Mr Mudie: Is it not worth pursuing? Is the FSA thinking of writing to the competition authorities to ask them to have a look at this? Are you thinking of writing to the Chancellor suggesting that he asked the competition authorities? We have had experience. There must be something magic about the number four. We have the Big Four banks operating like four Mafia families and we do not have much luck with them. It seems to be the same in accountancy. Have you attempted to trigger anything?

  Chairman: That view is not shared by the whole Committee.

Mr Mudie

  384. I think that is a complimentary reference to them.
  (Sir Howard Davies) And why is there only one Treasury Select Committee? We have not made a formal approach. I am not entirely sure of our locus in this. The question the Chairman perfectly reasonably asked me was whether this was inconvenient for us and I have answered that it is.

  385. You referred to the competition authority. You are in a very important position and you could decide to refer it.
  (Sir Howard Davies) On the last occasion there was a merger we were asked by the competition authorities for our view and we gave our view that this was undesirable.

Chairman

  386. A number of witnesses have mentioned this theme to us throughout this inquiry. What percentage of your out-servicing goes to the Big Four?
  (Sir Howard Davies) Most.

  387. Over 90 per cent?
  (Sir Howard Davies) Yes, I would say it broadly was. There are two sorts of use we make of the accounting firms. The first is usage made under what we called our skilled persons report. That is part of the normal process of regulation. We would not ask for a skilled persons report on every firm every year by any means, but in the case of larger banks or larger insurance companies we would quite frequently say, this year, as part of our regulatory review, we want a review by your auditors of your risk management systems for example, or your claims reconciliation procedures, or whatever. The people we would typically use for that would be the auditors of the firm. In a sense that would not be our purchasing decision because we would use their reporting accountants. The report would then come to us and to the firm so that we would see it in its unvarnished state. For that, the profile of our purchaser, our outsourcing, is determined by who the auditors of those firms actually are. That is not our decision. There is another set of work which we would do, which would mainly be on developing regulatory policy where we would outsource. That is not a huge amount of money and it would typically go to the major accounting firms. It might also go to companies like economic consultancies from time to time.

  388. Could you provide us with a note about that?
  (Sir Howard Davies) We certainly could, but I do think it would be 80 per cent. [17]

Mr Plaskitt

  389. Is it appropriate in your view that accountancy firms themselves should be significant funders of the accountancy boards in this country?
  (Sir Howard Davies) I am in a slightly difficult position to answer that because of course all my funding comes entirely from the industry I regulate and I do not regard that as compromising the FSA's independence. I do not think that the source of the funding is necessarily the problem. I think there is a question about whether that funding is discretionary. If you have to go along every year and say you would like a few more pounds for this and a few more pounds for that, that is not a satisfactory position. It is perfectly all right for a regulator to be funded by the industry it regulates as long as the funding basis is clear, straightforward, repeatable, etcetera. I favour things like broad industry levies, where you account on an annual basis for your economy and efficiency, but you do not have to justify individual bits of work and you are not vulnerable to people withdrawing funding because they do not happen to like what you did last year. It is not the fact of being funded by the industry. It may be the structure of that funding which perhaps needs looking at.

  390. That is right. Is it not clear from the evidence we are hearing that the structure inside accountancy is much cosier than the structure which funds the FSA? There is a big difference between the two set-ups, is there not?
  (Sir Howard Davies) There is and the accounting set-up has more of a self-regulatory feel to it and was clearly a halfway house between statutory and self-regulation.

  391. Do you think it should move closer to the way your agency is funded in structural terms?
  (Sir Howard Davies) It is interesting to look at what is happening internationally and particularly in the United States. As it stands, our system is more independent and more objective than the United States system, indeed the Americans have looked favourably on our arrangements and the SEC have frequently said that they want to move to something more like that. As a result of Enron and Global Crossing and WorldCom etcetera, it is now clear that the likely outcome in the US is going to be something which goes around our system on the right—or left, depending on which way you look at it—in that they will end up with something which is actually more rigorous and more independent and less connected with the industry than our system is. It is hard to say precisely what that is because there are currently a couple of competing congressional proposals and an SEC proposal. All three of them actually go beyond what we have in terms of having the Public Oversight Board appointed by the SEC rather than with the profession involved in it. The question we have to ask ourselves here and which is being asked by the Government's review, is whether our system will internationally look robust enough if the Americans have gone for something else. This is a different question from saying that there is anything wrong with our system at the present time or that our system is not performing well.

  392. You are not suggesting that there is anything wrong with the funding system here.
  (Sir Howard Davies) It is difficult to say that there is because it has not really been in place for long enough. The system has really only been in place for the last year or so and the Government had put in place a five-year review. If you look forward to a world in which there are international accounting standards in 2005 and where there will therefore be a lot more international pressure on individual countries to demonstrate that they have a system of enforcing those international standards, in order to guarantee mutual recognition and equivalence, the US will be saying, "Can we be satisfied that there is an adequate enforcement regime which matches the robustness of ours, that UK companies are preparing their accounts under international accounting standards and therefore we can allow them without further qualification to list in New York?". That is really going to be the crunch issue. Indeed it will be for us too. We shall want to look at other countries whose standards may be slightly doubtful and decide whether we are prepared to accept these or whether we would want to review their accounts as well. If you look at it in that context, there may well be a need to make our system more rigorous by 2005, which might point to putting the funding on a more automatic basis, an industry levy basis and there is also the question of proactivity versus reactivity in reviewing accounts. At the moment, our system does not do that on a sampling active basis in the way that the US system and the French and Italians and Canadians and Australians do. It may be that in order to satisfy the rest of the world that we are achieving standards which can be recognised internationally, we may need to do some more of that.

  393. In your memorandum to us, you say that ". . . possible initiatives in the UK will need to be considered in the light of likely changes being made in the US". Should we really wait to be directed by the biggest sinner? Should we not be more proactive?
  (Sir Howard Davies) It is entirely right, and the Government are doing this, to look at our own system and decide what is good about it and what we want to do. However, the real reason I made that point was the explanation I have just given you that in reality when you get international accounting standards it will be necessary for you to demonstrate that your standards are as rigorous as those in the markets in which your own companies wish to list. Therefore one of the blunt realities of this is that you need to satisfy the American authorities that you have a set of procedures which are equivalent to theirs. That is why I make that point.

  394. What if those markets are not rigorous enough?
  (Sir Howard Davies) The present position is that in the US they have not been, but as a result of Enron and Global Crossing and WorldCom, etcetera, etcetera, they are going to leap over us into a system which exhibits more obvious independence and rigour and proactivity than the system we have currently got. Then you may say that it is jolly unfair that the Americans, having done that, then insist that everybody else does it; but there is a lot of unfairness in the world.

Dr Palmer

  395. In the submission of the FSA to the Committee you said that it is apparent that not all major banks fully understood the total size of their exposure to Enron. Can you elaborate a little on that? What was the nature of the problem?
  (Mr Foot) The problems arose really for the most part in the biggest and most complex groups where typically they would have had exposures in a number of different areas. The question then was the speed with which they could bring back to their central group risk management an accurate figure of the total exposure, of all the different forms of exposure they could have had. I have to say that as it happens British based banks were not that significantly exposed. That was a comment made in respect of some quite well-known publicly discussed problems in the United States rather than here. The issue in something like this where you have a market risk, you have a credit risk, you may have a wide range of instruments being held and sold around the group, is always the speed with which the group's central risk management can take those numbers and be reasonably confident that it has an accurate total for the whole group's exposure.

  396. So we were just lucky, it was not that the British banks were wiser, they just happened not to be heavily into Enron.
  (Mr Foot) We have put a lot of effort in recent years, and so have the major banks and securities houses in the UK into improving their risk management positions. One should never be complacent and the larger and more complex the borrower who fails or the company who fails, the more the pressure is on the systems.
  (Sir Howard Davies) In response to the point you make, particularly about British banks, it would be fair to say that a number of British banks have said—and I think rightly—that they did not have any exposure to Enron because they did not understand the company and they did not understand the balance sheet. I think they should be given credit for that.

  397. The FSA had some success in handling problems presented by the hydra-like Enron legal entities without loss to counter parties. Can we say this is actually a success for the UK regulatory system?
  (Sir Howard Davies) Regulatory success is always something you are extremely nervous about claiming. The fact was that the three major financial entities which were subsidiaries of Enron and operated in our market, which were regulated by us, were regulated effectively and they either closed down with little market disruption or in one case were sold on, also with little market disruption. In that sense we felt we understood those parts of the group, we had insulated them adequately and they were able either to disappear or be sold on. We would regard that as a satisfactory piece of cleaning up.

  398. One sometimes hears that we have to struggle with too much red tape. Could this be an example of where red tape can sometimes be useful?
  (Sir Howard Davies) In one respect it would offer a lesson because there are certain elements of derivatives activity which we regard as requiring regulation in this country and as therefore coming in under our regulatory regime, which would not necessarily come under a regulatory regime in the US. Enron in the US had a waiver from CFTC, which is the US futures and derivatives regulator, which in the UK we would not have granted. We are more keen to grab hold of the derivatives activities even of some non-financial corporates. For example, we have an energy participants regime so that the part of BP which trades financial derivatives related to energy would be regulated by us. We think that is a good approach and we think that the Enron experience has shown that is a valuable thing to do, which was agreed in the Financial Services and Markets Act.
  (Mr Foot) We are very keen in this country on ring-fencing authorised firms from their parents. If you go back a long way and the collapse of Drexel Burnham for example, then the British part of that was wound down satisfactorily and after the collapse of Yamaguchi in 1997 the British part was wound down satisfactorily. One does not want to be complacent but it is an important aspect of our regulatory reach that having got it inside the authorised frame we do look pretty carefully at the exposures between it and its parent.

Mr Ruffley

  399. One way of improving the operation of public limited companies in terms of transparency and accountability is statutory intervention. The other one of course is changes to the listing rules. I wonder whether you could outline to us what changes to listing rules you are recommending and why?
  (Sir Howard Davies) I am glad you asked that question and I mean that; it is one of those rare occasions when I do mean it.


17   Ev. 194 Back


 
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