Are banks’ accounts too complex to oversee? An external auditor talks to Joris Luyendijk about understanding true risks
• This monologue is part of a series in which people across the financial sector speak about their working lives
We are meeting for lunch in a restaurant near Canary Wharf. He is well dressed in a non-flashy kind of way and delivers his verdicts and observations in a staccato and confident voice, as if the world’s absurdist aspects are actually quite amusing.
“The hardest thing to explain about this job to outsiders? I wouldn’t know. As soon as I mention to people that I’m an accountant, the conversation ends.
“The biggest shock if readers saw what I see? I suppose the numbers, the sheer size of the data streams. You lose perspective. I lose perspective. Sometimes when all the figures on a page are in millions, I catch myself assuming that another figure on that page is also in millions, when it’s actually in billions …
“Think of when an exam is graded, and a random sample gets passed on for inspection? Accountants, or external auditors, are those inspectors. Except here it’s the annual financial statements of a bank or financial firm.
“We come in for anywhere between two weeks for smaller companies to all year for a large multinational, and we talk to people who are busy, or pretend to be busy. They don’t want us to find anything, as this will mean more work, and will make them look incompetent to their boss. Some get stressful but most are co-operative.
“We need to find stuff that we can take into the meeting with the client, so we can say, look, this is what we found, can you explain that? How do we justify our fee if we dig up absolutely nothing? At the other end of the spectrum there is the opposite dynamic. The more we find, the more extra work we need to do. That pushes up our cost to the client, or eats into our revenues. You could argue that on an individual basis accountants are incentivised not to find something.
“We check by sampling. This is worth emphasising. Operations of large firms have become so huge and complex, and none more so than those in this sector. A client may process transactions worth a trillion pounds a day. There’s no way you are going to check everything. When we find an error we extrapolate it; suppose this level of irregularity was found across the company, how much would that affect the numbers quoted in annual report? If it is below our levels of ‘materiality’ then we don’t worry about it.
“Materiality is a key concept. In essence it means how big does a number have to be to become important to the users of the financial statements? Say a bank turns over £10bn per annum. We might go in and say that 2% of that is our materiality so if the errors we find add up to less than that (£200m) the accounts can pass as accurate. There is another number we come up with which is for amounts below which we’re just not interested. This can be as high as £10m.
“Nobody at a major bank can have a complete overview any more. It’s simply become too large. A lot of the people I talk to don’t really understand where they fit into the bigger picture. By the way, a lot of non-financial companies are like this, too. People in an office context have this security zone, they know where the boundaries are, and they stay within them, do what they have to do and that’s it.
“Some are self-deluded, telling themselves they understand it all when they don’t. Others will hide their confusion. Basically I have never met anyone so far who owned up to any worries about the operations, everything is fine until you find a problem.
“But when I ask questions, often they don’t have answers. Or rather, they have answers for the area they are responsible for. Then there’s a manager who is supposed to oversee all this. But the manager doesn’t have an on-the-ground view, he works with abstractions. That manager reports to a higher manager who is even further away from it all, and so on.
“Generally I find that the simpler the question you ask people in banks and financial firms, the more lost they are. For instance, why did you make less profit than last year? Accountants need to come up with a narrative, a storyline why profits went up in one department, down in another. On that level of analysis, investment bankers have simply no clue, most of the time. They can give me the numbers I need, they can answer my question about differences between one figure in a report and another. But where the economy is going and why they won or lost money … It’s always a similar answer: profits went down due to something external in the market, profits went up due to their competence, this trade, that trade etc.
“There’s a reason this is important for us. Accountants look at the value of the company. But there’s also something called ‘going concern’; do we believe that a year from now this company will still exist? For that, we look at the reliability of projections for cash flow, at how much risk the bank is currently running. That’s very hard to do, to say the least, a negative report would kill a company off.
“When something has gone wrong, for instance with RBS, people say: where are the auditors? The thing is, on a macro level there are so many ‘unknown unknowns’. I find sometimes the people in financial firms and banks themselves can’t really determine the risk they’re taking. Every day they look at what they own, their positions on the market and how much loss these might cause, and they calculate the risks of that. But it’s very hard to work out these risks. Sure, you can model for a whole number of risks, foreign exchange fluctuations, credit risk – someone defaulting etc. But at the macro level, when the whole economy goes down, or banks can’t get funding – you can’t really protect yourself against that. And everything has become so interconnected.
“Compare understanding a bank’s true risks to understanding a person’s true nature. You can run all sorts of psychological tests and these will throw up patterns; if this situation happens, then they will do this. If that situation happens then … But it’s like the real world, it’s impossible to get to the bottom of it all, there are just too many factors. Say every day I have a chicken sandwich for lunch and the next day bacon and continue this for a year. You may be able to model this, form expectations and get it right a large proportion of the time, but what happens when I turn vegan, or develop a gluten intolerance? That’s a game changer, all of a sudden I’m eating couscous salad and your old models which worked perfectly for several years are obsolete.
“How this job works, in very practical terms. We come in and decide what areas we are going to focus on. Then I get a lot of numbers on my screen, which I try to connect to something physical. I need to see the contracts that those numbers derive from. Many contracts are about transactions the bank is going to do in the future. We need to know what is in those contracts, no nasty exception clauses or anything. Basically we put a number to all obligations the bank has, determine the value of everything it owns, and say: on 31 December this company was worth …
“Now by the time the report comes out we will be in a completely different situation because months have passed. Say the bank holds many futures on currency swaps. Then tomorrow the euro goes up or down and the value of anything in euros has changed enormously.
“I’d have a number in one system and another number in another system; and these two should be the same. But they’re not. So I go to the person responsible and we work out the reason. He may say, you didn’t add this up, or: this is in dollars, that is in pounds. One system may work with one data set for, say, interest rates over the past 360 days, and another system with interest rates over the past 365 days – I am giving simplified examples.
“The truth is that banks don’t have one system designed to deal with all their activities. They have lots of different systems on top of one another. Often when a new financial product is designed, they add a patch. Then front-, mid- and back-office may have different systems. Different branches of the bank in different countries may have different systems. What happens is that those operating the systems will have ‘get-arounds’, solutions for when one system cannot process a particular product or activity. You will not be surprised to hear that there are systems running those systems, and so on.
“I don’t understand many of these products myself; we have a special team of financial products specialists, who actually understand these instruments. We have a special team of IT specialists, who actually understand the systems and how they interact … If you are a boots factory, you have different products but they’re all the same in a fundamental way, they’re boots. Banks have such diverse revenue streams, and they work with products that behave in markets in completely different ways, that are fundamentally different from one another. As a CEO you cannot understand every single algorithm your bank uses, every product they trade. CEOs get someone telling them: don’t worry, it’s under control.
“What many people fail to realise: not only do banks have these products on their books. Other companies have bought them, too. Now is some power company in, say, South America really going to understand the complex derivative it bought, and with it the risks they have taken on? That’s not their expertise.
“Initially derivatives are taken on by companies to lower their risk, which derivatives are perfectly able to do. However, derivatives bring their own risks, if a company gets a decimal place in the wrong place on calculations, or their systems valuation isn’t entirely accurate on a certain set of derivatives then they could have lost billions without even knowing it.
“I am still training to be a chartered accountant and I knew very little about finance before this. One thing that surprised me was just how many controls there are around the banks’ systems. There is always someone checking if everything adds up. They have internal auditors, they have a control department … And still there are errors and fraud. Some instances of ‘rogue trading’ [traders hiding losses in the system] reach the press, but there’s more that doesn’t get out.
“I have been in retail banks, clearing houses, brokers, hedge funds, commodity traders … There is no real difference between the people, I find. Compared with other industries people in finance look a bit smarter, ha ha, because they get paid a bit more. The stereotypes of white-collar shirts and pin-striped suits … I presumed there to be much more like that. I don’t believe people actually work such long hours as they claim on your blog. They like to show off how important they are and working long hours must be a part of that. There’s no busier time around Canary Wharf, or Bank station [both home to a number of major banks] than around 6pm. People are going home! Stay on till 9pm and there’s no one there, relatively speaking. We have had to stay late a few times in one of those big banks. At 10.30 I wouldn’t see anybody else in the building. I am sure people make long hours. But it’s not the majority of the people, nor the majority of the time.
“As external auditors we get to see the payroll reports. That’s one of the best parts, seeing what everyone in that company is getting. Of course we are quite careful not to reveal anything to outsiders. It’s striking how people seem to make quite a lot more in jobs that are generic in nature. If you are in HR you are doing the same work as in any other industry, yet you make 20, 30% more, plus a 10k bonus. Not every year but often enough.
“I would go over these reports and think, wow, that guy makes 80k. Well, he is not that smart, I can easily do what he does … The money is a pull factor, to go into finance, why wouldn’t it be? If you are offered two identical jobs and one pays 20% extra, which are you going to choose? There are firms that I wouldn’t want to work for in the financial industry, but that would be the same in any industry; advertising, manufacturing, energy, pharmaceuticals …
“Still, I think I’d prefer to work in an industry that produces something more tangible. I would want to be in a small, relaxed company where you can get out in time. Some time ago I was in this company that had only a dozen people working there. They would have lunch together every day. That was great.
“In a way bankers are Marx’s dream, it’s the workers getting the fruits of their labours. It’s funny that the left is usually angry at shareholders, for taking money out of companies and thereby bringing down workers’ salaries. Yet with the banks they want shareholders to press the banks to do exactly that, and curb pay.
“I don’t know. They say that with day-to-day contact you take on the world view of those you surround yourself with, their norms, fashions, the way they talk … Maybe this is why I am beginning to sound like an apologist. I think of myself as quite leftist, though.
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