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06 Nov 2008
Peter Wyman, head of professional affairs at PricewaterhouseCoopers, has called for a review of the audit profession in response to the banking crisis.
Wyman told Accountancy Age that although the audit profession had been reviewed by the government in 2004 and was doing a good job, the shockwaves caused by the banking crisis underline the need for a fresh review of the industry. ‘We are in the worst financial crisis in living memory. It would be ridiculous to just go on as before,’ he said.
He said a review of the audit profession could take place in the summer as part of a wider review into global regulatory structures, banking supervision, fair value accounting and complex Basel II Capital adequacy rules.
Wyman is the first big hitter in the profession to call for a review of the audit industry amid growing pressure from politicians and experts for a shakeup of auditing.
Last month, Chris Dickson, executive counsel of accounting regulator JDS, called for a review into whether auditors can rely on debt ratings given by credit rating agencies such as Fitch, Moody’s and S&P, when valuing company assets and signing off company accounts.
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Briefings
By looking at the reasons supplier statements became unfashionable, and the reasons why it is different today, this paper delves into the many benefits that can be obtained by automating the process.
Having a real and true view of your organisation’s current financial position, and having the right systems and processes in place, will ensure that you can make strong choices and are ready to capitalise on opportunities
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Reliance on Rating Agencies
Inappropriate ratings of Collateralised Debt Obligations (CDOs) in particular have contributed to the general loss of confidence on financial markets. But inappropriate ratings may have been issued on CDOs, even if there had been no conflict of interest now legislated about. The underlying assumptions of ratings of CDOs need discussion, as part of the regulatory reform anticipated on ratings agency practices in 2009.
CDO ratings are based on the risk of defaults by corporations called reference entities in a portfolio (?reference portfolio?) of corporations that owe debt to the Special Purpose Entity issuing the CDOs. Now it has been commonly assumed that default in the debts of these reference entity corporations are generally independent of each other. This enabled a conclusion that although there may be a few defaults by individual reference entities, these defaults were unlikely to coincide to have any significant effect on the CDO as a whole. I have noted an assumption of fixed correlations of 5% between corporations in the same industry sector, and 15% between corporations in different industry sectors.
The assumptions of near independence of defaults are probably realistic in times of ordinary economic trading conditions. But this does not mean the same assumptions are probably realistic in times of a general and severe downturn in the economic system. If there is general economic downturn, the same collapse in consumer confidence affects all entities in the economy, and it is likely that many entities in the reference portfolio experience cash flow problems together.
I have seen no indication that the assumptions for the ratings of CDOs allowed for recession in the depth now experienced, nor for a depression, in the thousands of computer simulations previously made by the rating agencies in generating ratings. I have seen no indication that rating agencies considered how robust their ratings were to economic conditions of recession and depression. Their AAA and AA ratings appeared to be based on the continuation of past general economic trading conditions. It is true the source data (the last 25 years) included some recession periods, but the period of economic shocks of the early 1970s was omitted in data that I have seen. Much lower ratings of CDOs by rating agencies would probably have resulted if simulations had been run with higher correlations of defaults encountered in severe recessions and depressions. It is not good enough to assume that the general upward trend in the past 25 years will be repeated.
We now have a confluence of serious economic issues: rising global food prices, significant costs of climate change that do not generate new wealth, relatively high energy costs, high and underestimated burden of war in Afghanistan and Iraq (see economists Stiglitz and Bilmes), unfinancial borrowings for housing, growing debt burden by government, and multiplier effects on defined benefit superannuation schemes.
This confluence of serious economic issues may differentiate current economic conditions from previous experience. We do not know that previous growth trends in the western economies will be resumed within anything like the same time frame as previous trade cycle patterns.
It seems appropriate to overhaul and regularise rating agency procedures.
The interpretation of the ratings may need closer attention. Ratings that indicate how robust the financial products and corporations are for severe fluctuations in the business cycle may be more useful than current definitions. Maybe AAAA and AAAAA could be additional classifications for financial products and corporations assessed as able to withstand a recession and depression without default, respectively, for the next twelve months.
The method of arriving at ratings needs closer attention. Maybe ratings agencies need access to better sources information, without opening the sources to threat of legal action. Maybe uniform periods for source data on ratings need agreement, and uniform assumptions on correlation of defaults by different rating agencies need agreement, to facilitate comparability of ratings.
The rating agency themselves may be best able to clarify how to generate ratings that are robust and reliable for severe economic downturns. Government leadership appears needed on the regulatory reform anticipated on ratings agency practices in 2009.
Posted by: Geoff Williams, 14 Dec 2008 | 00:00