Select Committee on Treasury Appendices to the Minutes of Evidence


Memorandum submitted by Sir Bryan Carsberg

  Thank your for your letter of 20 May. I am pleased to try to help the Committee. I am sorry I could not reply sooner—my computer has been out of order.

  I think I should first explain one reason why the measurement of accounting profits is subject to uncertainty. When a business makes an expenditure, it expects to receive some benefit. That benefit may arise over a number of future years, over a short future period or may have already expired when the payment is made. When the benefit is expected to arise over a significant future period, accounting does not deduct the cost from profits immediately but rather spreads it over the estimated life of the benefits. Where the expenditure is to acquire a tangible asset, the estimation of the life is not too difficult (although subject to some uncertainty) because similar assets have probably been in use previously and it will have been possible to observe their lives. Where the expenditure is to acquire an intangible asset, for example to develop a brand or train employees, it is impossible or impracticable to conduct observations to establish the period over which a benefit is received. So the lives of the assets are uncertain and so are the profit calculations.

  When one is dealing with uncertainty, it can sometime be helpful to express the results by saying something along the lines "I am 95 per cent confident that the `true' number lies between x and y". This would indicate that, if one carried out similar investigations 100 times, one would expect to find that the true number was in the range on 95 occasions. And you might think that I could say something like this with regard to the banks' profits. One can indeed validly make such statements for certain kinds of studies, for example estimation by statistical sampling. Unfortunately, one cannot do so for the measurement of accounting profit in the circumstances I have dealt with because the bounds are not defined. One can examine the effect of different assumptions on profits and one can take a view about the reasonableness of the assumptions. But the process is subjective.

  It is important for the Committee to understand that my brief from the DTI in carrying out my analysis was to "provide advice on whether the accounting methodology and analysis carried out by the Competition Commission in the Report is a fair and reasonable basis on which to base possible remedies"; also to "provide expert advice on the methodology used by the Competition Commission in the Report to measure profitability and the application of this methodology in the Report." I was not asked to provide an alternative estimate of profitability and it would not have been practical for me to do so without at least interviewing the banks and examining for myself much of the evidence studied by the Commission. This was not what was wanted, nor do I think it would have been a good use of effort. With the above background, the conclusion that you quoted in your letter was based on my opinion that the Commission's analysis was appropriate in principle and meant that, in my view, reasonable people applying the Commission's methodology, but perhaps differing in subjective judgements about the length of time over which expenditures gave their benefits and other uncertain measurements, would nevertheless be very likely to share the conclusion that significant excess profits over the cost of capital had been made.

  Perhaps I might comment on three other points that arose during the hearing. First Mr Goodwin said, in paragraph 132, that "quite a number of people would similarly take issue with the methodology". I doubt that and I note that few such people have come forward to tell us their views (although one or two consultants did challenge the fundamentals in evidence noted in the Commission's Report). The fact is that capital markets, regulators and many others use calculations based on the same methodology as that used by the Commission every day, and modern economic life would come to a halt if this were not so.

  Secondly, in paragraph 137, Mr Barrett said, in effect, that many businesses earned returns at a similar rate to the banks on SME business. No doubt that is true but that is a beneficial part of the ordinary workings of economic markets. The key point for the banks was that they first were found to have a (simple or complex) monopoly position and only then did the question of excess profits arise.

  Thirdly, Mr Ellwood says, in paragraph 134, that the main area of disagreement concerned the treatment of bad debts. Here, the issue is rather different from the one involved in the treatment of intangible assets and so forth: it is about averaging over the economic cycle. The Commission made an allowance for this and what they did seems reasonable. However, it is clear that bad debts were relatively low over the last few years. The banks seem to be saying that bad debts may well be high over the next few years and excess profits low or non-existent. The Commission doubted this but none of us can know what the future holds. In this context, the remedies recommended by the Commission (and applied) seem helpful. (This is a personal comment outside the terms of reference for my work for DTI.) Paying interest on current accounts is paying an economic price for a resource used by the banks. Charges are not to be formally controlled and, if the banks were to experience economic difficulty because of heavy bad debts, they presumably could recover the position through their charges.

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