US banking failures: the role of big auditors in another financial crisis

LONDON — Three recent and very serious US bank failures — Silicon Valley Bank (SVB), Signature and First Republic — have one common denominator: all three businesses were audited by one of the world’s major professional services firms, KPMG. 

The company has stood by its audits of the first two banks, which collapsed soon after publishing financial reports certified by KPMG. The FT reported in March that KPMG chief Paul Knopp said:

As we take into account everything we know today  . . .  we stand behind the reports we issued and we think we followed all professional standards. 

Now lawsuits have been filed against KPMG over its audit of First Republic, as well as over SVB’s collapse. And the issues are not confined to one audit company. In fact, a series of scandals have engulfed members of the “big four” accounting firms of KPMG, Deloitte, Ernst & Young (EY) and PriceWaterhouse Coopers (PWC), which dominate the industry. 

In recent years, EY has been criticised over its audits of failed financial firm Wirecard, as has Deloitte over its audit of transport company Go Ahead. More recently, PWC’s Australia CEO resigned this position after reports of conflict of interest in terms of tax advice given to private clients. 

I have researched similar issues to those being discussed today — in particular, whether auditors should have reported warning signs to regulators before the 2008 global financial crisis. Even with new regulations having been imposed since then, the industry needs a radical overhaul to become more transparent, competitive and accountable. 

Audits provide an independent, professional endorsement of an organisation’s own financial reports. As such, auditors get special access to a company’s board and detailed information on its finances, risks and activities. 

They have the opportunity to ask challenging questions and interview influential people within the audited company about their actions, strategies and forecasts for the future of the business. They are trained to undertake forensic analysis and question management on their risks and performance. 

Large auditing firms often work with a significant proportion of an industry. KPMG is believed to audit more US banks than any of the other big four accounting firms, for example. This gives an auditor a unique view of the risks and opportunities in an industry, as well as the stresses and strains in various parts of a market. 

So, in theory, auditors should be able to issue warnings — to regulators for example — about hidden or as-yet unidentified risks, as well as endemic false accounting. This would not only protect shareholders, employees and investors, but also society in general, from the collapse of a large company or an industry crisis. 

After the 2008 global financial crisis, I researched the role of KPMG in the largest ever corporate failure in British history: the near-collapse of HBOS bank in 2008. As the fifth-largest bank in the UK at the time, HBOS had assets of £690 billion. 

My research indicated several strong signals of management hubris inside HBOS before its collapse: fast-paced growth, increasing inter-bank borrowing, and high-risk commercial property lending during a market bubble. 

The bank’s ex-head of group regulatory risk, Paul Moore, said he had raised concerns about “excessive risk-taking and mis-selling” internally, but was ignored and then sacked in 2004. An investigation by KPMG dismissed Moore’s claims in 2005, three years before the bank’s collapse. 

In 2017, the Financial Reporting Council (FRC), the audit sector watchdog, cleared KPMG of misconduct in relation to its work on HBOS’s financial reports, before the bank’s failure. In a statement reported at the time, KPMG said it was pleased with this conclusion, adding: 

We have always maintained that our audit was robust and undertaken in accordance with the regulations and practice of the time. 

But a separate House of Lords select committee investigation into bank audit failures after the 2008 financial crash concluded that the audit market is highly concentrated and uncompetitive. And the big four accountancy firms still dominate the audit industry for large, powerful multinational corporations to this day – despite lots of smaller firms providing the same services. This may in part be because the Big Four offer a vast range of commercial services and expertise on laws and regulations. 

But my research has indicated instances of “regulatory arbitrage”. This is when an audit firm uses its knowledge of the rules — on taxation, for example — built up in other parts of its business to help clients avoid certain costs and restraints. 

This is legal, but can undermine business regulations by giving some firms an unfair advantage due to unequal access to professional advice. (KPMG did not provide a comment when asked about this issue.) 

This is why I believe large, private, commercially minded firms with a range of advisory services cannot be relied upon to police other multinational corporations. Audits of systemically important institutions such as banks — the failure of which can trigger the collapse of an entire economic and financial system — should instead be undertaken by state auditors. 

In the UK, investigations and several reviews of the audit profession since the financial crisis have indicated the need for change, but this is happening slowly. 

The most recent set of government proposals has resulted in a package of reforms, but no date yet for an expected draft audit reform bill. Changes include plans to transition the FRC, which currently oversees the audit profession, into a new body called the Audit, Reporting and Governance Authority (Arga) in 2024. This will keep auditing in the private sector, while giving more power to the regulator to act against poor audit quality. 

A state auditor would be better. Many governments already have experience of auditing via institutions such as the US General Accounting Office and the UK National Audit Office. Staffed by experts, they have institutional separation and state-backed independence and powers, alongside a commitment to public service. 

This would be more effective at safeguarding society and the financial system than a private company. Open and transparent rules, systems and processes, as well as close monitoring of risk both between and within industries and organisations, will limit the damage of future failures — in banking and beyond. 

Atul K. Shah is a professor of accounting and finance at City, University of London. Read the original article with full hyperlinks on The Conversation. Author photo: The Conversation.

Hill-favored projects called defense budget’s ‘black hole’

Congress directed the Pentagon to spend $12.2 billion in the current fiscal year on nearly 1,000 different “program increases” in the Defense spending bill’s research account alone, projects pushed by lawmakers that the Defense Department did not publicly request, according to a previously unpublicized database.

As spending on the overall defense budget grew in the last several years, the number of these lawmaker-inserted projects has ballooned from 600 in fiscal 2021 to 996 today, a 66 percent hike, according to the database, compiled by Taxpayers for Common Sense, a nonpartisan group that monitors government spending. 

The initiatives, which average $12 million apiece, are each tiny when considered separately, at least in the massive Pentagon budget, which is more than $800 billion. For that reason, the individual projects, like the larger phenomenon of surging congressional additions to the defense research budget, have received virtually no attention in the press. 

“It’s grown to more than $12 billion crammed into the services research accounts out of public view and without oversight,” Steve Ellis, president of Taxpayers for Common Sense, said in an interview.

To be sure, Congress has a duty to write defense spending bills as it sees fit. What's more, on many occasions these congressional “plus-ups” or “adds” — which are often supported by Defense Department officials at military research labs or executives at start-up companies, even if not by senior Pentagon leadership — have led to what are widely considered useful outcomes. These include Predator drones that transformed military operations, and the Maui Space Surveillance Complex, where Air Force personnel track space objects and conduct laser research.

But the recent uptick in congressionally initiated spending on hundreds of defense research projects has gone on with little transparency or independent oversight. It is not clear how much the U.S. military has gotten out of it all. And there are unresolved questions about how often the contracts that follow from these appropriations are competitively awarded, as advertised.

That is the upshot from interviews with a dozen current and former congressional aides, lobbyists, Defense Department officials, auditors and nongovernmental experts on military budgets, most of whom requested anonymity because they are, with a few exceptions, still participants in the defense budget process and are concerned about professional consequences.

A former senior Pentagon financial official said the department has a lot of measures for gauging the effectiveness of weapons but “less often do we ask: ‘Did we get our money’s worth?’”

As Congress gears up to begin writing defense authorization and appropriations bills for fiscal 2024 in the coming weeks, any newly proposed defense research program increases may draw more scrutiny than usual, especially if the budget deal that emerges from debt limit talks puts downward pressure on Pentagon spending. 

The defense research projects are not the only additions to the Pentagon budget that are not requested. Congress adds billions each year for everything from weapons to medical research, much of which is not publicly endorsed or is even, in some cases, opposed by Defense Department leaders. 

But the research additions stand out because of their growing number and several key unaddressed questions about how they come to be and who benefits.

The defense research projects, listed in unclassified tables in the appropriations reports, have names that are sometimes inscrutable even to most defense experts, and many sound as if they might be patented processes of a particular company, such as “chromate-free corrosion inhibitor coatings for marine applications” and “ENDOR spectrum superiority technology.”

The spending insertions are not generally considered earmarks — a term that refers to congressional additions to funding bills that are aimed at particular recipients and that were wracked with abuses in the early 2000s, leading to several criminal convictions.

The defense research program increases are not categorized as earmarks because the contract awards they lead to are — technically at least — put out for competition.

But numerous defense contracting experts say the funding lines are often written in such a way that only one company can do the work. As a result, critics charge, these are de facto earmarks in many cases, and their numbers and costs are growing.

A few legislators have even issued press releases touting their work in “delivering” defense research appropriations for named companies in their states — even before any ostensible competition has taken place. 

Ellis of Taxpayers for Common Sense described the spending lines as “earmark-esque.”

Moreover, these projects and the process of funding them is almost completely opaque.

The unanswered questions go beyond how often more than one bidder vies for these contracts. 

Other lingering questions include: Which lawmaker pushed for a given funding line and how many of those advocates are influential appropriators? Which contractor or military organization would benefit? What is the purpose of any particular technology, as the funding tables offer only a few cryptic words of description per project? How often do useful military breakthroughs emerge from the process, as programs tend to appear only for a year or two in the spending bills before they are replaced by others? 

“It’s become a black hole of the defense budget,” Ellis said.

Neither Congress nor the Office of the Secretary of Defense nor the Pentagon inspector general’s office nor the Government Accountability Office, in replies to queries, could point to any exams aimed at answering or even addressing these specific questions. The Pentagon does an annual report on competition for its contracts, but the review does not focus on any one appropriations area. 

The Defense Department did not answer a series of specific questions about the research funding additions and the department’s monitoring of their effectiveness. 

Instead, an official said via email that while the department is focused on certain technology areas, “we understand that priorities change based on a number of factors. We will continue to work with Congress and other stakeholders on these priorities as we set technology development on the right path to provide key capabilities to the warfighter.” 

Appropriations that are allocated for these projects go to the military services’ and defense agencies’ labs or other facilities to either perform the work themselves or contract it out to companies or nonprofit institutions. 

Congress added $12.2 billion to the research budget but cut more than $2 billion from other programs to at least help pay for lawmakers' additions elsewhere in the bill.

Consequently, the net increase in the research section of the fiscal 2023 Defense funding bill was $9.9 billion above President Joe Biden’s request, part of a $43 billion boost in total to the Defense spending bill above the request.

The defense research funding inserts are aimed at exploring important defense technologies that are generally not large-scale enough to be on the radar of senior military leaders and so do not make the annual “unfunded priorities lists” of top projects that senior Defense leaders say should be funded even though they are not in the budget request, advocates of the additions say. Only a handful of the 996 lawmaker-added projects in fiscal 2023 were on those unfunded priorities lists.

One current Defense Department official and one former one said the armed services’ senior leaders typically only learn about the projects when the spending bill and report are made public.

But the program increases are typically supported, though not publicly, by someone in the far-flung Defense Department bureaucracy, experts said. 

“Yes, many of these projects have Member constituent connections, so they support the requests for multiple reasons including valid user requirements and district employment,” a defense industry lobbyist said by email. “While they may not be officially requested, they are unofficially supported.”

The Pentagon is not a monolith, Mark Cancian, a former Office of Management and Budget official and now an analyst with the Center for Strategic and International Studies, said by email.

“Each of the subordinate baronies looks out after its own interests and maintains its own lines of communication,” said Cancian. “So it’s not surprising that laboratories or programs connect with congressional staff or their local members of Congress to suggest increases.”

The proponents also say the unrequested research projects are often aimed at developing technologies whose significance is not anticipated when each year’s budget is written more than a year before it is voted on. And they contend that the Appropriations Committees rigorously review the projects. 

A Senate Republican appropriations aide called the funding additions a pathway for small businesses and researchers to bring innovation and entrepreneurship to the Defense Department. 

“Input from a wide variety of innovative small businesses, defense experts, stakeholders, military leaders, research facilities, and universities throughout the country are taken into consideration during the appropriations process as part of the long-standing practice,” the aide said by email.

Most appropriators publicly celebrate when they net Defense appropriations increases for large weapons like aircraft or ships. Less often do they tout securing relatively small defense research projects for their districts or states.

But some have done so on their websites, and a few have even mentioned companies that are going to win contracts long before the supposed competitions have even begun. 

For example, Sen. Jon Tester, D-Mont., the chairman of the Defense Appropriations Subcommittee, issued a press release in December when the omnibus spending package was unveiled. Tester touted how the bill “delivers” for Montana, because the senator was “making targeted investments” in Montana and the Department of Defense. 

Under “funding for Montana businesses,” Tester listed a half-dozen military research projects not requested by the Pentagon — and the names of the Montana companies that would secure the deals in competitions that have yet to take place.

An aide who is familiar with the appropriations process said the companies are just potential recipients. 

For example, Tester took credit in the statement for garnering $12 million in the Navy research budget for “universal achemetal titanium process.” It turns out there is a proprietary process by that name — a way to extract titanium from raw ore — that belongs to a Butte, Mont., company whose name is, in fact, “Universal Achemetal Titanium LLC.” 

The press release and the appropriations law itself contain a sentence noting that competition is required for each program except when it has happened in an earlier year.

The aide said the titanium project had been competed the year before, and UAT won, hence the fiscal 2023 funding was a follow-on that did not have to be competed.

Marc Snyderman, UAT’s general counsel and director of strategy, said via email it is “unknown at this time” if the company will face competition for the $12 million in fiscal 2023 funds.

The aide did not say whether the other awards listed as going to Montana companies in the press release were going to actually be competitive. The other five companies did not respond to requests for comment.

Similarly, Sen. Christopher S. Murphy, D-Conn., another appropriator, said in a December statement about the fiscal 2023 spending bill that he “supported federal funding that will benefit Connecticut’s defense and manufacturing industries.” 

Included on Murphy’s published list of programs that “will” benefit Connecticut were not just billions of dollars for submarines and fighter jets but also 13 defense-related research projects worth roughly $145 million altogether, though Murphy did not name companies. 

“Part of my job on the Appropriations Committee is making sure the budget we write funds Connecticut priorities,” Murphy said in the December press release.

In a statement this month to CQ Roll Call about the issue, Murphy said: “I have never shied away from promoting Connecticut’s manufacturers. I’m proud that last year’s defense bill will give many highly skilled manufacturers the opportunity to further develop new technologies, demonstrate them to the government, and compete for competitive contracts.”

Competition vs. effective competition

It is not clear how often the defense research funding additions are subject to effective competition — the official Pentagon term for situations where more than one bid is considered.

Washington insiders report that it seems, anecdotally at least, a substantial portion of the defense increases are handed to one favored company or institution — the one that Congress intended to get it. 

In some cases, experts say, the purported competitions are waived for legally allowable reasons, such as if only one company is technically able to do the work. 

More likely, a competition is in fact held, but the outcome is all but preordained, they say, because the names of projects are carefully written in the appropriations report’s funding tables so that only one company is likely to be qualified to do the work and so only one company answers the contract solicitation. 

Jack Deschauer, a partner at the Squire Patton Boggs law firm, has over 30 years experience in Washington, including as a Defense Department legislative liaison and a lobbyist. He said in an interview that the legal requirement for competition is satisfied if the service or agency holds a competition and abides by all the rules — even if ultimately only one company bids. 

But Deschauer suspects, based on his experience, that appropriators write their additions to the research budget so as to reduce the number of potential competitors.

“The specificity involved in many of these line item ‘program increases’ leads me to conclude that they are for a particular company,” Deschauer said.

What’s more, Defense Department officials, congressional staff and lobbyists typically communicate with one another to understand the congressional intent behind a funding line, Deschauer and others said.

Winslow Wheeler, a former Senate and GAO staff member for three decades, had a similar exam.

“Either the committee staff or member staff will contact the appropriate office in DoD and say, ‘That $2.7 million for nanometer electronics — that’s my baby, and here’s who we expect to receive the money and, if you don’t do this, you’re going to get holy hell,’” Wheeler said in an interview. 

Moreover, if it appears to competitors that one company will win it, they sometimes do not bother competing, according to veteran observers of the process.

“These contractors aren’t dumb,” said Ellis of Taxpayers for Common Sense. “If there’s a funding line clearly tailored to one company, then a rival company isn’t going to spend the resources to compete.”

To be sure, on occasion a company that was not “supposed” to compete for the work vies for it, former congressional aides said, but more often than not, they said, the companies that lawmakers want to win the awards get them.

After earmarks — directed spending for projects of interest to lawmakers — earned a bad name in the early 2000s, Congress banned them from 2011 until 2021. 

When Congress permitted earmarks to resume, it was under rules that barred directing them to private corporations. The rules narrowly defined earmarks as funding that is uncompetitively awarded to government agencies or nonprofit institutions — such as the Army Corps of Engineers and university labs — when the funds have not been requested and are inserted at the request of a member of Congress. 

These earmarks for entities that are not companies are called community project funding in the House and congressionally directed spending in the Senate. 

The Defense research section of the fiscal 2023 spending law includes 16 of these projects, worth just $54 million, all added by the House — a minuscule portion of the defense budget.

This year, House Appropriations Chairwoman Kay Granger, R-Texas, has barred this small set of earmarks from the Defense bill and limited them in other bills. 

Spending on the rebranded earmarks has been transparent, with requirements for tables to be published in the appropriations reports listing which lawmaker sought the project, the amount of money, the purpose and the recipient. 

By sharp contrast, no such reporting is required for the “program increases.” The only public record of each of these is the dollar amount and a few words in the appropriations report funding tables.

Likewise, Congress asked the GAO to track and report on the community projects spending in great detail, and the GAO issued a report on fiscal 2022 earmarks spending. 

The auditors have done no such monitoring of the much larger sums of defense dollars dedicated to defense research “program increases.”

The program increases are not necessarily de facto earmarks, but the extent to which they are vied for by more than one company remains an open question — one that has not, it seems, even been addressed.