SPEECH
BY GOVERNOR LARS ROHDE AT THE ANNUAL
MEETING OF DANISH AUDITORS
CHECK AGAINST DELIVERY
10 September 2019
Thank you for inviting me to speak here today.
My topic is trust and transparency in the financial system.
This topic is always current, but it became particularly relevant in
connection with the financial crisis. It was a substantial breach of trust when
central governments in large parts of the western world had to use taxpayer
funds to save the financial sector.
In recent years, the topic has surfaced again following a number of unfor-
tunate issues that have accumulated since the financial crisis. For a long
time we may have thought that this was primarily a problem that existed
outside Denmark's borders. But then cases emerged in Denmark too.
There have been money laundering cases, there have been deliveries of
very large banknotes to bureaux de change, and incorrect advice has
been provided in connection with investment products. The financial sec-
tor has been involved in transactions that have drained the government
coffers of many billions of kroner in dividend tax. And I am sure we could
find more examples.
What these examples have in common is that they contributed to
undermining trust in the financial system. Trust is low at the global level. That
has been documented by the Edelman Trust Barometer. In fact, one of
the key messages in the Edelman analysis is that the financial sector is the
sector that people trust the least. Danish surveys also point to low trust
in the financial sector.
*** *** ***
How can we learn more about the present and about how to shape the
future? One way is to look back and learn from history. So I would like to
start with two examples from the past.
I will begin in the 18th century. More specifically with the Rothschild
family dynasty. It was founded by Mayer Amschel Rothschild. He was the head
of a poor family comprising his wife and 10 children. The family lived in
Frankfurt in the late 18th century. Good ideas combined with unusual
willpower gave Mayer Rothschild a point of departure for forging
business relationships with powerful men in the area. He also dispersed his
sons across Europe. The sons established their separate trading firms
and were successful. Especially the son in London was doing well. He
soon became so rich that he could lend money to the Duke of Wellington.
In 1814, this son became the British government's secret banker for
funding the Napoleonic wars.
The family established a close network throughout Europe, with links to
ship owners, transport companies and financers, among others. News
spread very fast through this network. After Napoleon's defeat at
Waterloo, the Rothschild family received the news - before the British
government! They purchased British government bonds, and when news of the
victory arrived, prices rose, making the Rothschild family even wealthier.
At the core of the family's success was the foresight of Mayer Rothschild,
which led him to conclude a partnership agreement with his sons at an
early date. This agreement was aimed at ensuring a strong family-owned
business based on the father's solid reputation as a businessman. The
family was to benefit from the reputation that Mayer Rothschild had built
up.
Furthermore, Mayer and his sons were to share the profits from the
business empire, which meant that they took an interest in each other's
affairs and the partnership as such. In other words, the business empire
was based on the principle of everyone having something at stake.
*** *** ***
My other retrospective example relates to a period of around 30 years in
mid-19th century USA. Before this period, every single bank in the USA
had to have a charter through special legislation for that specific bank.
However, this changed when many states began to introduce state
charters describing the general requirements to be met by banks that wanted
a licence to operate. This period has been called the "free banking" era
because anyone meeting the relevant state's banking requirements could
establish a bank.
A bank was typically established by selling shares - "subscriptions" - and
by using the funds received to purchase government bonds. If you
wanted to operate a bank, you had to deposit government bonds to back the
banknotes issued by the bank. The banknotes were used by traders, and
there were "banknote reporters" who prepared lists of counterfeits and
listed the prices of the various banknotes.
Later generations have interpreted this period in different ways. A num-
ber of banks failed, so initially it was investigated whether they misused
their special position, e.g. by having insufficient backing for the
banknotes issued. In the literature, these banks were referred to as "wildcat
banks". Later, the view of the period changed, and focus is now on
market discipline during this period. This was reflected in the market's ability
to price the risk on the banknotes from the individual banks, which was of
paramount importance to the bank's reputation. There were banks that
failed, but they did so because the market was able to price the risk.
People voted with their feet. So there was a high degree of market
discipline.
*** *** ***
What can we learn from these two historical examples? Firstly, I note that
the people involved also took on the risk - they all had something at
stake. It was their own money - or their close business partners' money -
that was lent. That gave them an incentive for sound risk management.
They were focused on behaving in such a way that their good names and
reputations and their wealth were not jeopardised. That is no longer the
case. Today's banks are so large that no individual or small group of
people can own and operate a big bank. This means that there is no
longer a close link between those bearing the risk, the owners, and the
day-to-day management. When shares are as widely dispersed as they
are in most Danish banks, everyone is responsible, which ultimately
means that no-one takes on the responsibility. Being owned by everyone
is the same as being owned by no-one.
Secondly, I note that the market plays an important role. It is good if
clients vote with their feet.
You might ask whether things had been different today if we had learnt
more from history.
*** *** ***
Now I will turn my attention to something more recent - the financial
crisis. It is already more than 10 years since the financial crisis erupted.
The financial crisis made it very clear that we had created a system in
which the banks reaped the gains in good times, while society and the
taxpayers had to foot the bill when things went wrong. Distressed
western banks were saved by means of government funds. That was also the
case in Denmark. There was simply no other option. It was necessary to
intervene to support financial stability. That was important in order to be
able to continue the functions within the financial system that are critical
to the real economy. Households, firms and authorities all depend on
services provided by the institutions. Default within the financial system
would interrupt these critical functions, which would have considerable
negative consequences for the financial system and the real economy.
*** *** ***
After the crisis, crisis management regimes were introduced for banks
worldwide. In the USA, Dodd-Frank was passed. And at the EU level the
Bank Recovery and Resolution Directive, BRRD, was adopted to prevent a
similar situation in the future.
The BRRD requires all banks and mortgage banks to prepare and update
recovery plans and also requires the authorities to prepare resolution
plans. These plans are the point of departure for the crisis management
in the institutions and authorities.
Besides these two requirements, the BRRD includes another key element:
it lays down a framework for the authorities' management of a failing
institution or an institution that is likely to fail. There are rules stating who
is to bear the losses. Institutions must observe a minimum requirement
for own funds and eligible liabilities. This requirement is referred to as
the MREL. The purpose of the MREL is to ensure that it is possible to
resolve the individual firm in a crisis. The bail-in tool is of particular
significance in this respect. I will get back to that.
The MREL has two components: a loss-absorption amount and a
recapitalisation amount. The loss-absorption amount corresponds to the losses
the institution can be expected to have to absorb. The recapitalisation
amount is to ensure that the chosen resolution strategy can be
implemented. If the group is to continue as a viable business after having been
distressed, it must be possible to recapitalise it at a level whereby it
meets the capital requirements and enjoys sufficient trust in the market.
By the way, that is the resolution strategy for the systemically important
financial institutions in Denmark. So we are no longer in a situation where
we either save them all or do not save any.
The BRRD has introduced a new layer in the creditor hierarchy. This is
non-preferred senior debt, which can be used for loss absorption and
covers losses before senior unsecured creditors are affected. The price of
this new type of debt is a sensitive indicator of the soundness of a bank.
In that way, there is no risk that taxpayers, rather than investors and
creditors, will bear the costs of handling a failing institution. The idea is
that losses should be borne by those who incurred the risks and those
who get the prospect of profit. That is known as bail-in. Bail-in helps to
ensure that the institutions have an incentive to run their businesses
prudently and that investors and creditors monitor the activities of the
institutions in order to prevent excessive risk-taking.
The BRRD is the most significant regulatory initiative in the financial area
in Europe in recent times. We now have a set of rules that reduces the
risk that institutions will suffer serious financial problems, while also
ensuring that the authorities have the tools required to handle the situa-
tion, should the institutions nevertheless become distressed. Like other
firms, banks can fail without passing the bill to society and its citizens.
But the BRRD cannot stand alone. There is a need for regulation of
financial companies. For example, capital and liquidity requirements must
apply. The requirements as to how much capital banks and mortgage banks
must hold have evolved considerably over the last 30-40 years. Seen from
today's perspective, starting with Basel I, it included very simple rules
regarding the capital required if a bank was to lend money. There was a
fairly rough breakdown by loan risk, which meant that loans were
weighted according to their riskiness.
The belief that it was possible to estimate the loss profiles of various
customer and loan types, and hence to calculate the capital requirements for
unexpected losses on loans, led to Basel II.
As we all know, it did not stop there. We now have Basel III, and complex-
ity has increased. Fortunately, the capital requirements have also
increased.
Not only capital has been regulated. There are also rules on liquidity, fit
and proper rules for management and rules on investor protection now.
And many more. All these rules and measures address important issues.
And they have been necessary because there were insufficient incentives
to ensure that the financial sector behaved.
We cannot and should not regulate all aspects of the financial sector in
detail to prevent things from going wrong. It would simply not be possi-
ble to formulate such rules and it would also be virtually impossible to
observe them. The banks' managements must have a certain degree of
freedom to run their businesses.
I am not in favour of further detailed regulation. And perhaps we should
consider whether the fence poles are in the right place or whether we
have fenced in some areas too much. So I am on the side of simplifying
and streamlining rules and regulations if possible. And as I have said, that
is possible now because the BRRD ensures that irrespective of the size of
a bank, we can manage it in a crisis situation. The critical functions will be
continued, and investors and creditors will foot the bill - not the taxpay-
ers. In other words, the BRRD is a prerequisite to do away with some of
the detailed regulation. If we do so, it may give managements and
boards more space to actively consider the business model and ethical
principles on which their business is to be based. It is a task for
management to create a culture based on responsibility and decency and to
ensure that employees contribute actively to that agenda.
In Denmark, we basically trust our institutions and firms and each other.
But when this trust is broken, we cannot simply lean back and wait for it
to be restored. That requires an effort. Trust is something we earn. And in
this respect the financial sector has its task cut out. It is by no means all
banks that misbehave, presumably it is only a few and perhaps only in
certain respects. But a breach of trust rubs off on the whole sector.
*** *** ***
Lenin said, "trust is good, control is better". I prefer to say that trust is
good - in fact it is a precondition - but control is necessary. That is why
the quality of such control matters. And you, the auditors, play a special
role as the trusted representatives of society in general. That role must
be undertaken with credibility and integrity as the whole purpose of
conducting audits is to support trust in the information published. So you
have a very important role.
There is a price to be paid if the quality of an auditor's work is not good
enough. And we all know that that is sometimes the case. We have seen
cases where the Disciplinary Board on Auditors (Revisornaevnet) has im-
posed fines on auditors for having acted contrary to good auditing
practices.
Sometimes there may be a discrepancy between, on the one hand,
general expectations regarding an auditor's work and, on the other hand,
legislative requirements. In a court of law it can be difficult to prove that
an auditor has not observed good auditing practices. It can only be
hoped that the scope and quality of audits in the vast majority of cases
go well beyond the legislative requirements. In this respect self-checks
and quality controls by the authorities are both important tools for
ensuring trust in auditors. It is also important that you, the auditors, stay
focused on your core task - audit - and do not give lower priority to audit
quality in favour of consultancy services - although they may appear to
be more profitable in the short term.
The relationship between a firm and its auditor is a client relationship.
This involves an inherent conflict between the auditor's wish to meet the
customer's expectations and the role as the trusted representative of
society in general. Your task is to take a critical view of what you see in
firms. You must challenge management and point out practices that are
not in accordance with the rules. And you must communicate clearly if
they are not brought in order. That is your task. If you do not do that,
you are doing your clients a disservice in the long term. If you lose clients
on that account, you should see it as a necessary cost of maintaining
integrity and the respect of society - your other clients.
Your organisation, FSR - Danish Auditors, has prepared an action plan to
strengthen the quality of the sector in Denmark. I note that it includes
strengthened public sector control of auditors, new tools for measuring
the quality of the work performed and enhanced self-checks. Might I
suggest that you also consider the role of auditors in relation to the ethical
foundations and culture of a firm? I would like to see auditors play a role
in relation to reviewing whether the targets for ethical behaviour set by
the board are also implemented in practice.
*** *** ***
We must learn from history and consider whether we have the right
incentives. The task is to keep your own houses in order. That applies in
the financial sector and among auditors. I can say for certain: once the
crisis hits, there is no-one you can call! At least I can say; We do not pick
up the phone. The financial institutions - their creditors and investors -
must suffer the consequences. Just as the BRRD envisages. So when you
audit financial enterprises, I hope you keep in mind that it is an honour to
be the trusted representatives of society in general. And I hope that the
trust placed in the employees and managers of the financial enterprises is
rewarded with responsible and decent performance of their tasks.
Thank you.