US central banker urges pillar 3 action now in light of scandals

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NEW YORK -- Recent accounting scandals mean international banks should start improving their disclosure of risks and capital adequacy now and not wait for the pillar 3 disclosure provisions of the Basel II bank accord to take effect in late 2006, a senior US central banker urged in early June.

The breakdowns in accounting, auditing and corporate governance exemplified by the collapse of the energy-trading group Enron and other scandals, should serve as ‘a wake up call’ to corporate boards, management and auditors to enforce ethical standards and effective controls, US Federal Reserve Board governor Susan Bies said.

Banks must strengthen corporate governance to prevent such abuses occurring in their institutions, Bies told the Institute of International Bankers in New York. She made her comments before the late-June news of the apparent accounting fraud at telecommunications group WorldCom in which $3.8 billion of costs that should have been recorded as expenses were instead treated as capital spending.

Bies said the case of Enron auditors Andersen and other corporate events currently under investigation, also provide lessons for bankers trying to increase earnings by cross selling more products.

A US federal jury found Andersen guilty in June of obstructing justice by destroying documents relating to Enron that were needed in a US Securities and Exchange Commission inquiry. Critics argue that leading accounting firms undermine their integrity by their alleged readiness to offer relatively cheap auditing services to a corporate client in return for getting the client’s more lucrative consulting contracts.

Bies said a strong, independent quality-assurance or risk review becomes even more essential for banks when bank line officers are rewarded for sales and cross selling. In banks, where credit is still the dominant risk exposure, the chief credit officers should make sure that unacceptable credit risks are not taken to win fee income business whose net revenue may not cover credit exposures.

Bies said that with accounting firms, strong quality assurance is needed to protect the core integrity of auditing services when the firm is trying to win consulting contracts.

"My intent today is to remind everyone of the importance of maintaining sound ethical practices to help protect the reputation of your bank. As recent events have demonstrated, if we fail to do so, the market will eventually enforce the discipline. And that discipline can be harsh and sometimes indiscriminate. Investors and customers act decisively, once confidence is lost.

"The issues (raised by the scandals) are not new, but the scope and frequency of breakdowns are of concern," Bies said.

Disclosure

"I particularly want to emphasise that disclosure need not be in a standard accounting framework or exactly the same for all -- otherwise we would be certain to create statistical artifacts and implications of safe harbours. Rather, we should insist that each entity disclose what it believes its stakeholders need to evaluate its risk profile.

"The uniqueness of risks and business lines in complex organisations means that disclosures -- to be effective -- should be different for each bank, Bies added.

She noted that’s the approach adopted in the risk-based Basel II bank capital adequacy accord that global banking regulators want to apply to large international banks from late 2006. The pillar 3 provisions of the three-pillar accord will require banks to disclose more information about their risk management policies to reinforce market discipline. Pillar 1 of the accord determines the amount protective capital banks must set aside to guard against banking risks. Pillar 2 provides for close supervision of banks by regulators.

Bies said disclosure rules that are too rigid would be less effective in capturing the risk profile of a bank as risk management practice evolves. "But if bankers do not voluntarily improve disclosures, rules will be written," she added.

Basel II would improve risk disclosure by many banks worldwide, Bies said. "The incentives in Basel II should greatly diminish the opacity that cloaks many international financial institutions and help to bring about a convergence of international norms on banking disclosure." I believe counterparties will expect, indeed force, greater disclosure, she said.

Recent events reaffirm that understanding what drives a counterparty’s financial performance and its risk appetite is necessary for accurately pricing any deal, or even for deciding whether get involved in the deal, Bies said.

In terms of corporate governance, bankers and their directors have specific responsibility to manage risks and effectively oversee the system of internal controls, she said.

Bank directors are not expected to understand every nuance of banking or to oversee each transaction. They can look to management for that, Bies said.

But they do have a responsibility "to set the tone regarding their institution’s risk-taking and to implement sufficient controls so that they can reasonably expect that their directives will be followed", added Bies. And they are also responsible for hiring individuals who they believe have integrity and can exercise a high level of judgement and competence.

Internal controls are the responsibility of a bank’s line management, Bies noted. She said line management must determine the level of risk they need to accept to run their business and assure themselves that the combination of earnings and capital controls is sufficient to compensate for the risk exposures.

Independent review

Staff areas, such as accounting, internal audit, risk management, credit review, compliance and legal affairs, must independently review, test and monitor controls to ensure they are effective and risks measured properly. The results of these reviews should be routinely reported to executive management and directors.

Both executive management and a bank’s directors should be engaged enough to decide whether the reviews are in fact independent of the reporting areas they are designed to review and whether senior officers in those roles can speak freely on issues that need to be addressed.

"Audit committee members should have regular time in meetings to talk with outside auditors without managers present," Bies said.

Best practices for audit committees have been set down many times, she noted. Beyond that, a bank’s directors and managers should periodically test where they stand on ethical business practices. They should ask themselves: ‘Are we squeaking by on technicalities, adhering to the letter but not the spirit of the law? Are we compensating others and ourselves based on our contributions to the organisation, or are we taking advantage of opportunities and abusing our positions?’

In separate remarks later in June, to the World Bank Group’s Finance Forum 2002 in Chantilly, Virginia, Bies said another key issue facing global banking supervisors is that of ensuring banks have controls over their foreign affiliates that are sound and independent of local management’s influence.

The failure of UK investment bank Barings in 1995 as a result of rogue trading in its Singapore office, the losses suffered in the early 1990s by Japan’s Daiwa Bank through rogue trading in its New York office and this year’s near $700 million loss inflicted on Allied Irish Banks by an errant trader at its US-based Allfirst unit, were directly related to a failure to control foreign affiliates properly, Bies noted.