Financial Services Bill

Committee (5th Day)

My Lords, the hybrid Grand Committee will now begin. Some Members are here in person, respecting social distancing, others are participating remotely, but all Members will be treated equally. I must ask Members in the Room to wear a face covering, except when seated at their desk, to speak sitting down, and to wipe down their desk, chair and any other touch points before and after use. If the capacity of the Committee Room is exceeded or other safety requirements are breached, I will immediately adjourn the Committee. If there is a Division in the House, the Committee will adjourn for five minutes.

I will call Members to speak in the order listed. During the debate on each group, I invite Members, including Members in the Grand Committee Room, to email the clerk using the Grand Committee address if they wish to speak after the Minister. I will call Members to speak in order of request.

The groupings are binding. Leave should be given to withdraw amendments. When putting the question, I will collect voices in the Grand Committee Room only. I remind Members that Divisions cannot take place in Grand Committee. It takes unanimity to amend the Bill, so if a single voice says “Not Content”, an amendment is negatived and if a single voice says “Content” a clause stands part. If a Member taking part remotely wants their voice accounted for if the question is put, they must make this clear when speaking on the group.

Amendment 74

74: After Clause 40, insert the following new Clause— “Alignment of accounting to prudential standards Where the prudential capital and profit or losses for a banking company are lower than the accounting numbers for that banking company where International Accounting Standards have been used, then the accounting numbers must have an adjustment to the balance sheet and profit and loss account in order to—(a) align the accounting numbers with the regulatory capital of the banking company which constrains the growth of a banking company and its ability to lend,(b) align the regulatory capital for going concern purposes with the accounting capital for going concern purposes,(c) align the regulatory capital and profits for remuneration purposes with the accounting capital and profits in accordance with the regulations for shareholder approval of director remuneration, and(d) align the regulatory capital and profits for distribution purposes with the accounting capital and profits for distribution purposes.”Member’s explanatory statement This amendment ensures that when there are prudential filters discounting capital these should be carried through to accounting capital figures.

My Lords, I declare my financial services interests as in the register. The two amendments in this group concern the use of international financial reporting standards, particularly with regard to banks. Their aim is to permit a very abbreviated explanation of some of the problems with and lack of transparency of IFRS and to probe the return of a role for the Bank of England concerning the endorsement of accounting standards now that the approval of IFRS is repatriated to the UK and their approval under UK legislation involves an economic interest test. I thank my noble friend Lady Kramer and the noble Lord, Lord Sikka, for signing my amendments.

It is undeniable that IFRS played a part in the financial crisis and, even though they have been amended since in recognition of that role, they are still not fit for purpose for calculating prudential capital. As far as banks are concerned, they have two sets of numbers: statutory accounts for Companies Act going concern, on which there is an auditor’s opinion, and numbers for the prudential regulator which—if I may put it this way—really show the going concern situation, because that is what prudential regulators want to know.

It is worth looking at a couple of points to see the sort of thing that regulators discount for prudential purposes. Good will is taken out, because obviously it is not loss-absorbing and is not much good when a company is running out of money. It is also the case that a bank’s debt can be shown merely at the junk bond debt value in a bank’s IFRS accounts rather than the sum actually owed, which again is not the real money situation. For a bank that is going bust, or just not doing so well, the published accounts can show a rosier picture than the prudential numbers. I do not know any serious analysts who use the IFRS accounts rather than regulators’ numbers.

Regrettably, there are many other anomalies affecting other businesses. IFRS 15, for example, can introduce a smoothing effect, changing some sales into an income spread over future years and therefore providing exactly the kind of disguising of downturns that has caused problems in the past.

My Lords, I am struggling with Amendment 74 because I think that it is aiming at a target that does not really exist, and it confuses capital and profits and losses.

The amendment would require what are quaintly called the “accounting numbers” to be adjusted to align with regulatory capital. Apart from anything else, that would result in accounts that do not comply with the Companies Act 2006, which requires, under Section 393, that accounts show

“a true and fair view of the assets, liabilities, financial position and profit or loss”.

The amendment seems to suggest that adjustments would be made to the accounts other than for the purposes of compliance with international accounting standards or to show a “true and fair view”, and, in that case, I believe that the resulting accounts would not comply with the Companies Act. We have to emphasise that these are international accounting standards, to which all countries that sign up follow, so this would be a major departure for accounting by banks and other institutions in this country.

I also note that, in proposed new paragraph (d), this is to apply to “profits for distribution purposes”, but that seems to misunderstand the fact that distributable profits are determined at the level of the parent entity solo accounts, whereas the adjustments that I believe are being targeted would be found in the accounts of subsidiary regulated entities or in the consolidated accounts, rather than those of the parent itself.

Regulatory capital already operates as a constraint on lending, so I fail to see what real-world impact any adjustments in the statutory accounts would have. While I understand the concept of regulatory capital, I do not understand the concept of “prudential” or “regulatory” profits or losses. I do not believe that “regulatory profits or losses” is a term that really exists, except to the extent that accumulated profits or losses form part of regulatory capital. It is difficult to see how proposed new paragraph (c) in Amendment 74 would work in relation to remuneration.

My Lords, it is a great pleasure to follow the noble Baronesses, Lady Bowles of Berkhamsted and Lady Noakes. I will speak to Amendments 74 and 77 because they both raise some real, important and fundamental issues.

As the noble Baroness, Lady Bowles, indicated, vastly different numbers for bank capital and profits are communicated through conventional financial statements and by the regulators—because they are prepared on different assumptions, for different audiences and for different purposes. I hope that the Minister will tell us which of those numbers can considered true and fair. Can he also say whether the regulators are justified in relying on something that does not pass that test?

Amendment 74 raises questions about going concern. The auditor’s assessment of going concern is based on accounting numbers in financial statements and not on the numbers used for regulatory purposes. If anything, the regulatory capital is likely to be smaller than financial reporting capital as the PRA ignores some accounting numbers; good will has already been mentioned and there is ongoing debate about the recoverable value of software assets. So is the PRA relying on the auditor’s assessment of going concern or does it ignore that and make its own assessment? If so, how?

Every year, the regulators are required to have a tripartite meeting—that is, a meeting between regulator, bank directors and bank auditors—to discuss matters of mutual concern. At these meetings, the auditors can surely speak about audited financial statements and capital only from the perspective of IFRS-led financial reports—they cannot speak from any other perspective. How effective is this dialogue now?

The accounting and regulatory capital differ; that means that there are different numbers to consider for distributable reserves as well. Yet banks pay dividends out of distributable profits—distributable reserves as some would call them—as required by company law. Again, there is an issue of how the PRA forms its view about distributable reserves, given that it ignores large chunks of the conventional financial statement.

Accounting profits are a factor in many executive bonus schemes operated by banks. A payment based on accounting numbers can also erode regulatory capital. A reconciliation of accounting and regulatory capital is essential; this is really the essence of Amendment 74. A more efficient and practical approach would be to align the two and thus eliminate the confusion and duplication that exist at the moment.

I will now speak to Amendment 77. The post-Covid economy is likely to throw up a large number of insolvencies. This will have consequences for banks, insurance companies and pension funds. With the downturn in brick-and-mortar retail and the trend of remote working, the value of many city-centre shops, shopping malls and offices may well decline. Many a property company may experience difficulty in servicing debt, which will inevitably have implications for banks. The crucial question is whether financial enterprises have a good capital base and safety buffers to absorb losses.

The Government’s faith in Basel III does not fill me with great confidence. The Basel Committee on Bank Supervision was established in 1974 after serious turbulence in the foreign currency market, most notably the failure of Bankhaus Herstatt in Germany. The committee’s main concern was to protect the interbank market and ensure that, in the event of bank failures, there would be sufficient capital to meet those obligations. The Basel I capital accord was issued in 1988 after the Latin American debt crisis. It called for a minimum ratio of capital to risk-weighted assets of 8% to be implemented by the end of 1992. Basel I did not differentiate the risks very well and, somewhat perversely, encouraged risk-seeking. It promoted the loan securitisation that led to unwinding in the subprime market. So Basel I was not a roaring success.

Basel II measures began to emerge in 2004 and were finally issued in June 2006. Their deficiencies were highlighted by the 2007-08 crash. The banking sector entered the financial crisis with too much leverage and inadequate liquidity buffers. Lehman Brothers had a leverage ratio of 30:1. Bear Stearns had a leverage ratio of 33:1 and almost all its profits came from speculative activities. Basel II underestimated both the risk of losses on assets and their exposure to the failure of others.

Now we have Basel III. The minimum capital adequacy ratio that banks must maintain is 8%; its calculation is risk-weighted and obviously highly technical. The capital buffer is essentially the shareholder funds in a bank’s balance sheet. However, the long-standing problems about such markers in the balance sheets have not really been addressed. I will mention just a few.

First, equity is a key component of regulatory capital, but it has no definition in company law. The PRA relies primarily on bank financial statements for sight of equity. These are based on the international financial reporting standards issued by the International Accounting Standards Board. In financial reporting, equity is simply the arithmetical residue arrived at after deducting liabilities from a bank’s assets. It includes things such as realised and unrealised reserves, the share premium account, and sundry other bookkeeping entries. The equity side of a bank’s balance sheet is the product of a hotchpotch of bookkeeping entries. Equity does not equal cash or liquid assets. It cannot be touched, has no physical existence and therefore cannot really reflect economic value. Yet it is a foundation stone of the PRA’s regulation.

Secondly, the PRA is concerned about capital maintenance, but financial reporting has no recognisable concept of capital maintenance. In accordance with the IFRS, some items in bank balance sheets are shown at historical cost, while others are shown at amortised cost, net realisable value, present value, fair value and numerous other bases. The addition, subtracting or netting off of these numbers gives us a crude arithmetical calculation, but it does not yield any recognisable measure of capital maintenance. Banks are maintaining neither money nor any variety of real capital.

For most of the early 20th century, court cases relating to distributable dividends were concerned that after paying dividends, companies should maintain capital that was adequate to protect creditors; that is, capital was seen as a kind of fund, or buffer, out of which creditors could be paid. Such is the confusion about the IFRS that the Local Authority Pension Fund Forum and Pensions & Investment Research Consultants have reported that many companies have paid or are in danger of paying illegal dividends. It would be helpful to know how the PRA deals with these problems.