TUESDAY 4 DECEMBER 2007

MR RICHARD SEXTON AND MR JOHN HITCHINS

  Q1360  Mr Brady: You have been very particular in responding to one or two colleagues to make clear that the proportion of your fee income derived from audit-related activity is higher than has been suggested. Do you think there is an acceptable and unacceptable ratio between those two things?

  Mr Sexton: The purpose of the disclosures of fee ratios is to ensure that users of financial statements are aware of the amount of work we do. We take independence incredibly seriously and look at every piece of work, whether or not it approaches some sort of magical ratio, to see if it can possibly impair our independence. We decline to act where we feel that would be the case. I do not believe that a cap in itself is the right way to look at things. You have to look at each individual piece of work and be comfortable that it has no impact on independence.

  Q1361  Mr Brady: In the past accounting period what has been the ratio of fees as between audit-related services and other services?

  Mr Sexton: In all companies?

  Q1362  Mr Brady: In Northern Rock?

  Mr Sexton: In Northern Rock it is disclosed in the accounts. The ratio in terms of our role as statutory auditor and the work we have to do is less than one to one.

  Q1363  Mr Brady: What ratio would give you cause for concern?

  Mr Sexton: I merely observe what the market analysis as a whole shows. If one looks at the FTSE100 analysis in the 12 months broadly to 31 December—you will appreciate that year ends are different for different companies—the ratio is of the order of 1.1 to one.

  Q1364  Mr Brady: Looking at some of the fee income that you have received for assurance services in relation to securitisation transactions, it appears to me that a significant amount of it was dependent upon the particular business model being pursued by Northern Rock.

  Mr Sexton: It was a fee income reactive to the transactions that they performed.

  Q1365  Mr Brady: So, the more securitisation transactions were performed the more letters of assurance you would expect to provide?

  Mr Sexton: That is correct, but under our ethical standards we cannot provide any kind of management input to a company to encourage it to perform one transaction or another. That is completely forbidden under our ethical standards. We cannot create a transaction flow in order to charge fees; it is purely a reaction to the level of transactions that a company may or may not choose to undertake.

  Q1366  Mr Brady: When Northern Rock decided to pursue a business model which led to a great expansion of certain types of transactions clearly that provided an increased flow of fee income for PwC.

  Mr Sexton: Northern Rock's entry into those transactions has that consequence given market practice that typically requires the audit firm to provide comfort.

  Q1367  Mr Brady: There seem to be some parallels between what happened to Northern Rock and the German bank Sachsen LB which in some ways was pursuing similar business models, particularly through its Irish subsidiary. There was a report in the Financial Times on 23 November which commented that KPMG had undertaken a review of the activities of Sachsen's Dublin-based market business. The FT reported that as early as 2005 KPMG had cautioned, presciently, that the Dublin strategy was based on the premise that markets never malfunctioned and it warned that the bank could be forced to sell assets if investors stopped buying the bonds being used to finance the various funds. Was KPMG able to see something that PwC could not?

  Mr Sexton: I am afraid I do not know on what facts KPMG based that report. Presumably, it would have been a private report commissioned by the bank or other parties. I do not know the information behind it or on what they would have based that conclusion.

  Q1368  Mr Brady: But in your dealings with Northern Rock or your statutory audit function there was no point which would have caused you to raise concerns of a similar nature as to whether or not the model was sustainable.

  Mr Sexton: I think that what you describe is a specific piece of work that KPMG as consultants to the bank were engaged to do on behalf of that institution. We cannot act as consultants to our audit clients.

  Q1369  Mr Brady: I accept that, but during the course of the work that you undertook in terms of your assessment of the bank's practices as statutory auditor there was nothing that led you to have concerns of a similar nature.

  Mr Sexton: For the purposes of looking at the annual accounts, the interim report and preparation of our opinions thereon we would have looked at all pertinent information, including the liquidity in the markets at those points.

  Mr Hitchins: I think it is important to remember how liquid those markets were in the first half of 2007. In May, June and July there was over $30 billion of residential mortgage-backed security issues.

  Q1370  Mr Brady: I accept that. My point however is that albeit KPMG may have been acting in a different capacity for Sachsen LB two years ago when there was significant liquidity in those markets it was cautioning that the strategy was based on the premise that markets never malfunctioned.

  Mr Sexton: As auditors clearly we have been conscious of the fact that for a number of years valuations have been rising in respect of various asset classes. Therefore, part of our work has been to focus carefully on the values based on the information that we have available at the time we do our work. That encompasses a whole load of facts. Our opinions at that moment in time are based on the best information available to us, so we would have been cognisant of that kind of issue for the purpose of looking at annual financial reports.

  Q1371  Mr Brady: You would have been cognisant of that presumably not only for the purposes of the financial report but also in relation to letters of assurance relating to securitisation transactions?

  Mr Sexton: During the first half of 2007, yes. The last securities issue that Northern Rock entered into of which I am aware was in June.

  Q1372  John Thurso: First, is it right that neither of you was involved in the audit of Northern Rock and neither of you is a client partner or anything like that?

  Mr Sexton: We are both client partners but not of Northern Rock.

  Q1373  John Thurso: In other words, you are not in the direct client relationship chain?

  Mr Sexton: That is correct.

  Q1374  John Thurso: Clearly, I understand that an audit is really about establishing the veracity of what has happened in the past rather more than about the sagacity of the actions that have been taken. I want to turn to the questions that my two colleagues have been asking about the relationship between the audit committee and risk committee and the auditors. It seems to me that the core failure of Northern Rock was the fact that the risk committee failed to see the risk of an illiquid market. When they came before us they said that it was unforeseeable. From the conversations that have just been going on it seems that others, including KPMG, foresaw it, so maybe it was foreseeable. Asking you not as this company's auditors but as serious practitioners in this field, what can be done to improve the performance of a risk committee of a financial institution and the way in which it interacts with an audit committee? One of the points which struck me was that the chairman of the risk committee and audit committee was the same person and mostly the same independent executives were involved. Is there anything that you would like to see done in that part of the mix of corporate governance?

  Mr Hitchins: Banks tend to have risk committees at different levels. There is usually a management risk committee that manages the business day to day. Many banks have now established risk oversight committees as committees of the board. The reason for their establishment is that the workload of audit committees has become too great for the committee itself to handle both audit and risk oversight. What one needs is a clear link and common membership, not exactly the same. Having common members is an important way to ensure that the audit committee is aware of what the risk committee is doing.

  Q1375  John Thurso: Would you think it a wise precaution to say that the risk committee chairman should not be the same individual as the audit committee chairman?

  Mr Hitchins: I do not believe that would necessarily be a weakness.

  Mr Sexton: One of the challenges is that there are pros and cons. Obviously, on the positive side they are aware of both aspects of that part of the management of the business, but, frankly, the downside is the amount of work involved to do both jobs. Therefore, one has to balance the two. As with all committees of the board, they are acting on behalf of the board as a whole, so there is a role for it.

  Q1376  John Thurso: My worry is that the audit committee's job is basically for the independent directors to ensure the audit is being done correctly and you as client partners have been given the opportunity to meet with the audit committee without any members of management. All of that is designed to try to make things as robust as possible. But if you have exactly the same chairman and people on the audit committee as are on the risk committee the chances are that the same problems can occur as between the audit committee and the full board.

  Mr Sexton: Having variation in committees and different people looking at different aspects is a good thing, and we see that today in many of our client companies. They will select their independent non-executive directors for specific skills and deploy those in particular ways.

  Mr Hitchins: Today some banks still have combined audit and risk committees.

  Q1377  Chairman: From the questions put by a number of my colleagues it appears they are not particularly satisfied that you have adhered to general principles, for example the issue of regulatory returns raised by Mr Cousins. In light of those comments I shall be writing to you for further details and I hope you can reply as quickly as possible, say, within a couple of weeks.[9]

  Mr Sexton: We will certainly do that. We did come in the spirit of answering questions on financial stability rather than Northern Rock specifically, so I hope we have been able to help you.

  Q1378  Chairman: Northern Rock is the elephant in the room, is it not?

  Mr Sexton: I understand that as well.

  Chairman: Thank you very much.