Basel II Audit and Supervision – Supervisors Rely More on External Auditors (And it Can Be Risky)

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Basel ii is very different from Basel i. The new risk sensitive framework is linking capital allocation to risks, and risks are quantified by banks with the use of internal models and advanced mathematics. To make things worse, there are new complex accounting standards, innovative and confusing financial instruments, and the need to mark-to-market and to work for fair value estimates.

Supervisors around the world have serious problems, as they are more accountable but less capable to understand the internal models. Today banking supervisors rely much more on internal and (mainly) external auditors.

Auditors have to express an opinion on the internal control framework and the financial statements. They have to follow principles-based accounting standards, to challenge the assumptions related to estimates and to exercise professional judgment.

Principles-based standards (in a society without principles) and not detailed rules lead to difficult and subjective interpretations, and create the need for expert auditors, qualified to investigate and understand complex legal, accounting and scientific issues.

In the European Union they went one step further. A person may be approved to carry out audits only after having attained university entrance, then completed the theoretical instruction, undergone a tough practical training and passed an examination organized or recognized by the Member State.

According to the 8th Company Law Directive of the European Union (called also the European Sarbanes Oxley), the test of theoretical knowledge covers in particular:

Accounting theory;
Accounting and principles;
Legal requirements and standards;
International accounting standards;
International auditing standards;
Risk management;
Internal controls;
Professional skills;
Professional ethics and independence standards;

It shall also cover to some extend:

Company law;
Corporate governance;
Law of insolvency;
Tax law;
Civil law;
Commercial law;
Social security law
Employment law;
Information technology;
Financial management of undertakings;

There is a minimum of three years’ practical training as well in the auditing of annual and consolidated accounts. More than two thirds of the practical training shall be completed with an audit firm approved in a Member State.

Yes, auditors with the above theoretical and practical training have the ability (and hopefully the willingness) to exercise professional judgment. But supervisors outsource their assessment to qualified professionals, and this can be a risk.

The external auditors (whatever knowledge and experience they have) are not supervisors, and should not become supervisors.

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