International Accounting Standards

• Fraud suspected as National Australia Bank totters
• Pension deficits: don�t relax yet
• Premiums have further to rise

Fraud suspected as National Australia Bank totters

Australia�s largest bank, the National Australia Bank, has been rocked by a scandal which has cost it at least A$360m (US$286), its chief executive, Frank Cicutto, and its chairman, Charles Allen. Some analysts now doubt whether NAB has the financial strength to continue as an independent bank.

The problems at NAB stem from unauthorised foreign exchange trades that are reminiscent of those caused by Nick Leeson at Barings, which lost the historic British investment bank £800m (US$1.5bn) and brought it to its knees. Cicutto has agreed to leave the bank, taking a A$3m (US$2.4m) severance payment. Four currency option traders in Melbourne and London have been suspended while the causes of the foreign exchange losses are investigated.

Cicutto is replaced by John Stewart, previously head of UK operations in charge of Yorkshire Bank and Clydesdale Bank. Stewart said of the bank�s problems: �What I suspect - so this is now conjecture, let me make that clear - is that we�ll probably find fraud and we�ll probably find people who were asleep on watch.� Allen�s position is now taken by Graham Kraehe, who chaired the bank�s recently established risk management committee.

The damage to NAB is as much reputational as financial and is the latest in a sequence of crises that hit the bank under Cicutto�s leadership, dubbed by a team of Australian analysts as the �14 Evil Sins�. The bank�s purchase of US mortgage provider HomeSide led to a A$4bn (US$3.2bn) writedown three years ago. It lost another A$100m (US$79m) in bad debts on the bankruptcy of bus company King Bros.

NAB�s ambitious plans were knocked back in a series of deals under Cicutto�s leadership. It failed in its attempt to purchase both the UK�s Abbey National bank (which now trades as Abbey) and AMP, where it bought 5% of stocks in a failed attempt at taking over the company to merge the businesses into a giant bancassurer.

There are allegations that fraudulent and unauthorised foreign exchange dealings may have also been conducted through client accounts. Claims have been lodged by an NAB customer, fruit exporter Erimus International, that the bank permitted A$1.6m (US$1.3m) in unauthorised trades to be conducted on Erimus� account. The company has since gone into liquidation, at the instigation of creditors including NAB. Another NAB customer has claimed that debts of A$2.7m (US$2.1m) he owes to the bank were generated by unauthorised currency dealings undertaken by the bank.

The foreign exchange losses have led to five investigations into the management of NAB. The Australian Securities and Investments Commission is inquiring into possible breaches of the Corporations Act, including whether the bank kept the markets properly informed. The Australian Prudential Regulation Authority is determining whether the bank needs to improve its risk management policies and practices. There is a criminal investigation taking place, while PricewaterhouseCoopers is conducting a review on behalf of the bank, with an internal bank inquiry supported by NAB�s auditor, KPMG, also taking place.

Investigations are likely to focus on much more than the causes of the losses, which the bank has said related to �fictitious trades�. They will also examine why the bank�s management and financial records failed to pick up the problem, whether risk management practices at the bank were adequate and whether any bank of this size and global reach requires derivatives experts on its board. Part of the internal and PwC investigations will probably have to consider, too, why the scale of the losses initially appeared to be much smaller than the eventually disclosed figure.

Pension deficits: don�t relax yet

Conflicting research findings have created fresh doubt over the capacity of company pension schemes to meet their potential liabilities. Whilst the recent bull market in shares has seen investment funds rise in value sharply, some analysts claim that the impact of FRS 17 means that, for many companies, their book position continues to worsen.

A study by pension advisers, Watson Wyatt, found that institutional pension fund assets in the world�s 11 major markets grew by 12% last year, the strongest performance since 1999. Global pension assets returned to pre-2000 levels. On average, funds have grown by 7% per annum for 10 years. But more than three-quarters of that growth occurred between 1993 and 1998. The state of pension funds now differs in various countries. Funds with heavy exposure to US, UK and Canadian equities grew by an average of 16% last year. But funds in Japan, France and Germany - which are more weighted to bonds than shares - increased in value by less than 10%.

This analysis was broadly backed by a study conducted by Hewitt Bacon & Woodrow, which examined pension scheme deficits in the UK at the end of last year. Hewitt reported that deficits had halved in 2003 because of the strong growth in equity markets. It estimates that total deficits in the FTSE 100 now stand at about £50bn ($95bn), under FRS 17, compared with the £100bn ($190bn) discussed a year ago.

�At last there is a sliver of good news for pension schemes,� said Raj Mody, principal consultant at Hewitt Bacon & Woodrow. Investment market changes over 2003 will mean that balance sheet pension deficits for leading companies will have halved overall since the worst point of the year. Although 2003 was a good year for the financial health of most pension schemes, it�s important to note that they are not out of the woods yet. While assets are invested mainly in equities, schemes could still see a dramatic reversal of fortunes. The trustees of any scheme and the company which sponsors it need to get together to think about whether to lock into their current position, by investing in bonds, or whether to continue to take the risk with equities in the hope of further gains.

�Improvements in life expectancy mean that it will take longer for companies to pull their schemes out of the remaining funding difficulties. Employers will also have to adopt radical solutions in future to solve the demographic challenge of longer living pensioners but with fewer people of working age. Companies will need to offer much more flexible approaches around retirement to their employees, and allow older employees, in their 60s and maybe even 70s, to continue to work part-time, say, to make up for future skills shortages.�

But Watson Wyatt takes a more negative view of the situation in the UK. It suggests that the recovery in equities over the past year has been largely cancelled out by increases in liabilities, as calculated by FRS 17. In effect, it says, the pension deficit has remained stable over the last year at £60bn ($114bn) despite the bull market.

�While a rising stock market has been positive, the liabilities of pension schemes have increased because of higher inflation expectations and lower corporate bond yields,� said Robert Hails, a partner at Watson Wyatt. �The stock market recovery was clearly welcome but rising liabilities mean it has done little to eat into these accounting deficits.�

Watson Wyatt based its pessimistic interpretation on the higher inflation expectations which are implied by the gilt market - rising from 2.25% to 2.75% - which raise liabilities as they increase the expected pay-outs from pension schemes. At the same time, lower corporate bond yields - down by 0.25% - increase the net present value of the payouts.

The firm says that the unchanged figure for total deficits despite the strength of stock market bounce shows an underlying potential volatility induced by the use of FRS 17. �In May 2002 the FTSE 100 had virtually no FRS 17 pension deficit,� said the company. �By the end of that year it was up around £60bn, and will have been even higher than this at the low point of the market last March.� It suggested adopting a different measure of pension fund deficits, based on the shortfall facing employers if they closed down occupational schemes. Using this measure the size of deficit for FTSE 100 companies is currently £150bn ($285bn).

�Pension funds are managed over the long term, and while many companies are increasing contributions, they are doing so gradually, typically over the next five to 15 years,� said Hails. �In order for FRS 17 deficits to be removed through stock market rises alone, we would need to see the very strong recovery in equity markets experienced in 2003 to be repeated for at least another three years. This is above the level expected by many commentators, and so it could well take substantially longer than this.�

Meanwhile, fears of widespread occupational scheme closures have led to forthright action being taken by the UK Government to underpin pension schemes. A Pension Protection Fund will be established which effectively insures occupational plans and has similarities to the US� Pension Benefit Guarantee Corporation (PBGC). Employers will be charged a flat rate fee in the first year, before moving to a risk based assessment of schemes which will determine compulsory premiums.

Secretary of State for Work and Pensions, Andrew Smith, said: �Where companies with under-funded pensions have gone bust, workers have found themselves severely short-changed on the pension they were expecting. With the Pension Protection Fund, people in pension schemes can be much surer that they will get the pension they were promised.� The fund will be backed by a new pensions regulator, who will be expected to take a proactive approach to protecting pension schemes.

But in the US there is growing frustration with the PBGC. This is partly because it uses a flat rate scheme which provides no incentive for proper corporate management of pension funds. But there are other partially related and serious problems, with the size of deficit it is faced by and its need to bail-out failed schemes. Before its bankruptcy, US Airways, for instance, traded from 1999 to 2003 without putting any funds into its pilots� pension scheme. As a result PBGC had to take over a bill of $2.2bn (£1.2bn). This was a significant factor in the total PBGC deficit last year, jumping from $3.6bn (£1.9bn) to $11.2bn (£5.9bn). At some point much of this figure is likely to have to be written off by US federal funds.

Premiums have further to rise

Hikes in premiums for liability insurance for accountants, advisers and directors is threatening to cause severe problems for both practising firms and clients. The problems, it seems, are international.

Tillinghast, part of Towers Perrin, surveyed over 2,000 North American companies and found that liability insurance premiums increased by a third last year. Most claims on policies, the survey found, were filed by staff, with employment discrimination and wrongful dismissal the most common causes for employment related claims. Companies involved in merger and acquisition reorganisation were three times more likely to be subject to an employment related claim.

According to Tillinghast, premiums in most sectors will stabilise this year, but with practitioners in some activities facing further big increases. In the UK, Tillinghast predicts premiums will continue to rise - following what it describes as already �substantial� increases - particularly for large and multi-national companies.

Tillinghast predicts that UK businesses whose operations are subject to the US� Sarbanes Oxley Act are particularly likely to face further rises in premiums for directors� and officers� liability insurance, given their greater exposure to potential litigation arising from the heavier regulatory burdens imposed by the Act. Other companies in the UK could find themselves also facing more legal claims and consequently higher premiums if they fail to comply with the Combined Code. In many cases until now, premium increases have been avoided by insurers instead introducing restrictions on cover.

A spokesman for insurance broker Heath Lambert said that accountants in the UK could also expect to see further premium rises over the next 12 months. �There has been a big reduction in [insurance] capacity in recent years,� he said. �A certain amount [of capacity] has come back in, but not even back to the level at the beginning of the cycle. Small firms of accountants will find it a bit easier to obtain cover if they have a clean record. Larger firms will find difficulty to place their capacity. Across the whole market [of PII cover] there is an increase of 5% to 7% [this year], which is not as sharp as in the last couple of years.�

Patrick Strange, executive director of AON Risk Services Ltd, confirmed the view that premium variations for accountancy firms differed substantially according to size of firm and focus of activities. He said that small firms should be able to reduce premium costs as a result of more insurers moving into the market. But medium sized firms would find premiums stabilising, rather than reducing. Further, he suggested, those firms engaged in what were perceived as high risk activities - the selling of tax avoidance schemes and investment advice - could find cover becoming more expensive, reflecting recent claims experience. Firms would, though, be able to reduce the size of premium increases if they could point to good risk management practices.