Auditors to be sent to the front line of financial system defence

The UK's accountancy firms face a radical shake-up of the way they audit banks when the Bank of England takes over banking supervision from the Financial Services Authority.

Audit firms will be required to take a more active "red-light" role in alerting regulators and management to potential problems, according to City sources. One senior official said: "The audit firms have got off scot-free for their role in the financial crash. But the fact is that many of the problems building up in the banks – Royal Bank of Scotland and HBOS – were spotted by the audit firms but these concerns did not get passed on to the regulator. We need the audit firms to focus on what really matters."

Officials at the Bank of England and the FSA, who are working on designing the new rules for the Prudential Regulatory Authority – the FSA's successor – have set up a working party with the audit profession to discuss how the relationship between auditor, client and regulator can be improved following the crash. Chaired by the Bank, the members are now deciding what other changes can be made to improve the way auditors can help management and regulators in spotting potential problems, including the use of 166 reports (prepared by skilled outsiders on identified risks).

The Bank governor, Mervyn King, and his deputy, Paul Tucker, confirmed this intent when they gave evidence recently to the House of Lords Economic Affairs Committee, which is also investigating the role of the accountancy firms in the crash. In his evidence, Mr King said: "It is important for the regulator and supervisor not to try to do everything themselves ... and have a regular dialogue with auditors and to make sure that auditors feel a responsibility for drawing to the attention of the supervisor matters that concern them.

"It does strike me as important not to pretend the regulator can see things if the auditor just hasn't bothered to look at it. We must use the auditors, ask them questions and see whether concerns emerge. This has to be an important part of the way supervision is conducted in future." He added that "it's a dangerous philosophy" to accept a set of numbers, saying that asking "What if? And, What would happen if? would be a key part of future supervision."

Mr Tucker told the committee: "It is completely unacceptable to us that the first line of defence should be management, and the second line of defence the regulators. We want to put in the way the board, the auditors, the equity holders and, perhaps most importantly of all, the bond holder."

The deputy governor also said that a much closer relationship existed between auditor and regulator in the 1980s, but this had been allowed to drift. Many date this change to 1997 when Labour moved banking supervision from the Bank to the FSA.

The Lords committee, which is still taking evidence, is investigating three main issues: the structure of the big four firms – Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers; the role of IFRS; the international accountancy rules; and how the responsibilities of audit firms can be improved. Its report is due in February.

A committee member said: "Do the big four dominate the market too much, and does this give rise to too many conflicts of interest? If the answer is yes, then we need a new investigation into market domination. Some of the banks and building societies which collapsed had three of the big four firms advising them yet there was no alert – the conflicts are enormous."