Capital ratios are the best indicator we have of a bank’s strength and resilience – and yet they are currently unaudited.
Banks’ half-year results, published last week, showed that these ratios not only remain crucial for 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. The need to get capital ratios right is reinforced by the new Senior Managers Regime, which will make executives and non-executives more personally accountable. The new criminal penalties and “guilty until proven innocent” approach are focusing minds across key functions in banks.
In other countries, requirements for independent scrutiny of capital information have evolved patchily: some have publicly-available assurance reports, some only inform regulators, and some have none whatsoever. However, given the size and importance of the UK banking sector – and the systemic risk posed to global markets – credibility and reliability are crucial for British institutions. In 2014, the Prudential Regulation Authority asked us to consider how independent assurance might be applied to bank capital information.
There are several ways banks can calculate how much capital they need to remain safe. They could use a standardised approach, where risk weightings are set by regulators. Or they can use Internal Ratings Based (IRB) approaches, which use sophisticated models designed by the banks themselves based on how they manage different risks. Both approaches require extensive judgement by management and huge amounts of data. Independent assurance could help ensure that the data used are reliable, appropriate and properly chosen. It would also examine the framework around management decision-making and the governance applied when making key judgements.
The financial crisis bailouts, and the increased use of contingent convertible debt (which converts from debt to equity if capital falls below a set level), mean greater focus on the capital numbers published alongside audited financial statements. This risks creating an expectation gap for society: what may be a bank’s most looked-at indicator is not audited.
ICAEW has issued a paper looking at how we can make audit of these figures a reality. We are asking stakeholders – from bank audit committee chairs to anyone who owns a bank account – what sort of assurance they need. Responses are invited by 16 October; we will then develop guidance on how to do this.
As optimism returns to the City, we must ensure it is built on strong foundations. Assurance would both add credibility to the information banks produce for regulators and investors, and increase public confidence in the regulatory system – at a time when trust in banks remains low.
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. However, that cost is small when set against the price of getting this wrong, both for individual bankers under the new penalty regime and for society if banks had to be bailed out again.