The easy option is rarely the right one

No one knows what would actually happen if any of the “too big to fail” banking and investment giants were actually allowed to do just that. The untested perception is that a destructive contagion would spread beyond the immediate circle of investors and depositors to engulf the financial community in a wave of institutional panic that in turn could destabilise the world economy.

Yet when the US authorities allowed Lehman Brothers to lapse into ignominious bankruptcy there was no contagion, mainly because counterparty institutions managed to disentangle themselves from Lehman’s precarious derivative positions. A different judgment was made with Bear Sterns, costing taxpayers billions of dollars – who can say, in hindsight, whether that cost was justifiable?

Who can say, in hindsight, whether that cost was justifiable?

Public trust is central to the question of whether a retinue of taxpayer-funded bailouts is preferable to fall-out from a small number of high-profile bankruptcies – accompanied by suitably retributive punishments for the villains who are never “too big to jail”.

Shortcomings of governance

On the pretext that prevention is preferable to a painful cure, here are some of the lessons. Risk and governance committees, supported by internal auditors, are adept at constructing safety nets, reporting channels and all the structures of accountability, often with approval of external auditors. The resulting control framework may tick all the boxes in the textbook, but what of its substance?

A forensic analysis of every recent banking disaster reveals (i) the presence of that old demon “management override” – the failure of all those chains of control to resist the easy option of succumbing to authority; and (ii) accounting standards that permit – no, encourage – the misreporting of loan book impairments. A third, less obvious, finding is that external auditors are fearful of issuing going concern warnings for the very reason that such a warning might prove to be self-fulfilling.

This highlights the real issue for auditors: either report it like it is, or risk becoming part of the debris. After all, when did you hear of an auditor being sued by management or shareholders for issuing an unwarranted warning in an audit report?

Indictment in the Lords

After the Northern Rock scandal the House of Lords Select Committee expressed the clear view that the auditors, PwC in that instance, should have issued going concern warnings given that Northern Rock’s business model was “dangerously risky”. The Lords’ Committee also noted that it had been “provided with no evidence from the Big Four that they did, in fact, have any concerns over banks’ viability”.

Concerning the profession as a whole, they added: “It may be that the big four carried out their duties properly in the strictly legal sense, but we have to conclude that, in the wider sense, they did not do so.” Before the Enron and WorldCom audits destroyed Arthur Andersen no one contemplated a possible migration from Five to Four.

Yet those audits, and all the surrounding scandals, are a case study in how such a thing could happen.

Paradoxically, it has little to do with financial consequences, as was shown when EY was fined $10 million after the Lehman Brothers collapse and Deloitte was fined almost double that amount in connection with its audit of Bear Sterns. No, the real risk is perception.

Being criminally indicted for document shredding post-Enron destroyed Andersen’s credibility to the point of no return. They were contaminated, and “guilt by association” did the rest. It may just be worth noting that the catalogue of misdeeds listed in HSBC’s latest annual report under the heading of “Exposure to historical failings” includes such delicacies as sanctions-busting in Iraq, money laundering, funding terrorists and drug cartels, product mis-selling, masterminding tax evasion, and Libor and forex rate fixing.

Even auditors may be judged by the company they keep! Who can blame Smith & Williamson for resigning as auditors of Stanley Gibbons, the listed dealer in stamps and coins, “because they consider the risks and uncertainties associated with the audit to exceed the level they are willing to accept.”