Mr. Tim Bush:

Mr. Butler explained the defective accounting standard known as IAS 39 very well. Essentially, the problem started because the standard was drafted to be compatible with EU law, but the detailed guidance notes which everybody follows and which are explicit on points of detail were drafted with the position in the United States in mind. Obviously, that creates scope for confusion and, as a result, banks recorded artificial profits and paid flawed bonuses even on loss-making transactions because their profits and assets were overstated for a considerable period from approximately the beginning of 2005 in the UK and Ireland when the standards were introduced.

I have submitted a PwC document published in 2004, entitled "Joining the Dots", to the committee. It correctly identified that the banking regulation known as the Basel accord relied on banks recognising all losses to comply with company law in the way described by Mr. Butler. These are known as the EU capital maintenance rules, which apply to all companies and ensure that banks and other companies only pay dividends out of genuine profits. Basically, it is a solvency test that applies to every company.

The Basel rules were intended to give an additional layer of protection, beyond what is required of normal companies, to banks. The purpose was to protect the interbank market, in which banks borrow from and lend to each other. If the interbank market is enabled to operate effectively, banks can borrow and lend cheaply with each other. Company law is supposed to protect creditors and shareholders and the Basel system is supposed to protect the interbank market and make it safer than would be the case under company law. That is why, before the crisis, banks could borrow at cheaper rates than companies.

The PwC document refers to the problem with these revised standards, but draws the incorrect conclusion that the Basel accord compensated for it; it did not. At best, it took one year’s losses, rather than lifetime losses, and for some strange reason divided that by two, assuming that half the loss could go to creditors and half to subordinated debt. The technical reason for doing so was a concern over allowing banks to go into run off. Ultimately, banks failed to be going concerns when investors would not touch them as a result of their suspicions eventually that there was no capital there.

Ireland, the UK and the US were the worst-affected regimes. It was not a global crisis. Those three jurisdictions had the worst ordinary lending banks, as opposed to investment banks. Interestingly, some countries, such as Australia, introduced safeguards to counteract the problem. Australia created an additional standard in 2006 - I have provided it to the committee - which would have solved all of the problems we face today and which were present before and during the crisis. There was also a natural correction in much of continental Europe as countries there did not permit the faulty standard in the accounts of banks themselves and it was only compulsory in the consolidated accounts of listed groups. As such, a French bank such as Société Générale would have proper numbers in the accounts of what it considered banking companies, as well as proper public accounts - only consolidated accounts would be slightly wrong.

However, because the UK and Ireland have similar accounting regimes due to the accounting standards board setting the standard for both states, they did not adjust for the defect in IAS 39 and permitted the option of IAS 39 operating in banking companies, rather than using UK and Ireland generally accepted accounting principles, GAAP. Of particular significance is that in a further step it was also permitted to be used for management accounts for the banks. Although the Ireland and the UK merely permitted the use of IAS 39 in banking companies, rather than its use being required, using UK or Irish GAAP was an option which could have corrected it. Unfortunately, the accounting standards board also copied IAS 39 into the UK and Irish GAAP, such that even if one prepared accounts under UK or Irish GAAP rather than international standards, one would have the same error. That is why there was a near systemic banking crisis in ordinary Irish and UK high street banks and building societies. I say it was near systemic because four of the main London-based clearing banks, namely, HSBC, Lloyds, Barclays and NatWest, which is part of the RBS group, had counteracting controls that seemed to make some proper adjustment in spite of the standards.

None of those banks collapsed. The problems with Lloyds when it acquired HBOS - a bank that had collapsed - and the problems with NatWest were not just NatWest itself but with the wider RBS Group. All of the big ones that collapsed were the Alliance and Leicester, Allied Irish Bank, Anglo Irish Bank, Bank of Ireland, Ulster Bank, the Co-operative Bank, HBOS and the parts of RBS that were not based in London. At the time we produced an analysis for the local authority pension funds entitled Banks Post Mortem, which was released in 2012. Interestingly, at the time we produced the report we could not understand why the Co-operative Bank had not collapsed. A year later it did collapse because the Bank of England went in and discovered that its loan books were as bad as all the others but because the Co-operative Bank did not have a quoted share price the market did not pick it up.

My simple conclusion is that accounting standard setting cannot be left to the accountants. It should have legislative standards of scrutiny. Part of the reason we are still talking about this ten years after the crisis is that people who have produced faulty accounts for banks have a vested interest in pretending there was nothing wrong. For basic strict liability reasons the penalties on directors and auditors for producing faulty accounts are quite severe in civil law. Effectively they owe all the losses back. My overall conclusion is that one has to have legislative standards of scrutiny of the standards when they are being set, not after they have caused the problem. I say legislative standards of scrutiny because all of these issues link with other areas of law around misrepresentation on the purchase of shares, misrepresentation when people put new capital into banks and misrepresentation at annual general meetings when directors want to get elected on the numbers. The simplest answer would be to look at what the Australians did in 2006.