Reporting on Banks’ Regulatory Capital: A Role for Auditors?

Michael D Izza, FCA, Chief Executive, ICAEW | October 6, 2015 |

Some of the most fundamental indicators of the strength and resilience of banks are reported outside of their financial statements. The Institute of Chartered Accountants in England and Wales (ICAEW) believes that external assurance by professional accountants could increase confidence in these key market indicators and information—and that this is of interest to us all as users of and investors in the banking system.

ICAEW’s Financial Services Faculty published a discussion paper, Reporting on Regulatory Capital: Choices for Assurance, which is open for public comment until October 16, 2015. The aim is to develop guidance for assurance on capital ratios. This is part of a series of projects under the Faculty’s Inspiring Confidence in Financial Services initiative, which includes hosting debates on the future of financial services, developing a framework for assurance reports on benchmarks and indices, and providing recommendations for restoring trust in banking, assessing financial regulators, and strengthening bank auditing.

Since the financial crises began, banks have been under increasing pressure to be accountable to society and demonstrate that they are safe, both for investors and depositors. Questions have been asked of banks, their regulators, preparers, financial reporting, and auditors. As a profession, we must work with stakeholders to ensure that the quality of bank reporting and auditing is high and meets society’s needs.

Regulators are demanding that banks hold more capital in case of unexpected losses. Banks have also created contingent convertible debt (co-cos) as a built-in way to increase their equity capital in a crisis. These offer investors higher returns, but come with the risk of converting into equity should a bank’s capital levels drop below a prescribed percentage. These demands mean banks must increase capital while also becoming more efficient businesses in order to continue to be profitable and pay a return to their shareholders. This creates tensions and promotes capital measures as vital indicators of strength and resilience for banks.

Every announcement of a bank’s results shows that capital ratios not only remain central to investors but are also used by management to drive business decisions. Return on risk-weighted assets has become a prominent measure of success for banks, which are under increasing pressure to make money while protecting depositors.

Capital ratios, as well as other capital indicators like liquidity and leverage, are produced alongside banks’ financial information but are not audited in the same way. This risks creating an expectation gap for society: what may be a bank’s most looked-at indicator is not audited. ICAEW is keen to explore what society expects from auditors in relation to this information, and where there is a potential role for assurance. The Financial Services Faculty’s discussion paper considers capital ratios and risk-weighted assets, but asks if other areas should be explored, such as leverage or liquidity ratios.

Requirements for independent scrutiny of capital information have evolved piecemeal across the world; some countries have publicly-available assurance reports, some only inform regulators, and some have none whatsoever. Given the size and importance of the banking sector—and the systemic risk posed to global markets—credibility and reliability are crucial.

And so in 2014, Andrew Bailey, the Chief Executive of the UK Prudential Regulation Authority, asked ICAEW to consider how independent assurance might be applied to bank capital information. While ICAEW has been asked to do this by the UK regulator, the framework is being designed to be applicable internationally, wherever demand exists.

The discussion paper is part of the process of designing an assurance framework for capital information, a framework founded in the International Framework for Assurance Engagements, issued by the International Auditing and Assurance Standards Board®. The proposed framework aims to show how independent scrutiny could add credibility to banks’ capital ratios and risk-weighted assets calculations.

Not everyone will welcome assurance on capital ratios. Banks face more cost pressures and the cost of assurance is likely to be significant—particularly for complex banks using thousands of internal models. The first step is to discuss the nature and extent of the assurance to be provided. We are asking stakeholders—from bank audit committee chairs to anyone who owns a bank account—how far should assurance go and what sort of assurance do you need? Once established, we need a consistent way to deliver this that meets different users’ various needs.

This is not the first project of its type that the Faculty has undertaken. In 2014, they released Assurance Reports on Benchmarks and Indices in response to the demand for assurance from stakeholders and regulators following the LIBOR scandal.

Benchmarks are vital for the smooth running of the markets and market confidence. They allow parties to form contracts with each other on a transparent, arms-length basis using standard terms, but take into account the changing economic reality of their particular market or sector. Though they do not form part of financial reporting—and the processes used to produce benchmarks or benchmark submissions are well outside of processes normally considered by the auditor—the role of independent assurance has been found to be crucial.

We worked with a range of stakeholders to provide guidance for assurance practitioners that meets their different expectations and is practical. This was a pragmatic step to a wider mission of restoring trust and inspiring confidence in financial services and we will be updating this guidance next year.

The profession has made significant improvements since the crisis. ICAEW’s 2010 report, Audit of Banks: Lessons from the Crisis, recommended better risk reporting from banks, better auditor and audit committee reports, better dialogue with bank supervisors, and more involvement from auditors on key regulatory information, such as capital.

The international, private sector initiative Enhanced Disclosure Task Force has worked with stakeholders to recommend improved disclosures, including on risks. The UK has led the way in new-style auditor and audit committee reports that highlight not just processes but they key risks that have been assessed. ICAEW has worked with the audit firms and bank regulators to establish genuine dialogue.

Less progress has been made on assurance of capital, with the UK behind many parts of the world in terms of auditor reviews of regulatory information. While there has been significant international convergence and cooperation on bank regulation, audit and assurance requirements on capital is an exception. We think the debate is internationally relevant and welcome comments from IFAC member organizations and key stakeholders.

As a profession, we must rise to the challenge of meeting new user expectations. Developing new assurance models is one way we can do this. We cannot stand still.

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