Remarkable and striking changes have happened to banking assets over the past two decades: we have shifted to a knowledge economy where intangible assets now make up the bulk of bank assets. How does a retail bank adjust its strategy and culture to account for a world where most of its assets can’t be put in a vault?
It's an issue that's at the heart of our top level of retail banking training. Governance drives ethics, behaviour and values in an organisation, but it also rules over the management of assets – and over the last two decades, nothing has changed in banking as much as assets. We all got the memo that Facebook was a publisher with no content, and Uber was a taxi business with no taxis. Data localisation is now a massive controversy that most people aren't even aware of.
Writing from Davos last week, the FT's editor at large Martin Wolf noted that global flows of people, money and information had changed completely. "A report on Global flows by McKinsey Global Institute provides needed illumination," he wrote. "A signal concludes that global flows are now being led by intangibles, services, and human skills. Thus, trade in goods has stabilised relative to world output since the global financial crisis, after an enormous rise over the decades before it. Flows of services, international students, and intellectual property grew about twice as fast as trade in goods in 2010-19. Data flows grew at nearly 50 per cent annually. Crucially, most flows have proved robust during recent disruptions: flows of goods recovered quite strongly after the pandemic."
Retail Banking Institute's Governance programme tackles precisely this issue and its relevance to retail banking. It's easiest to understand Governance when put in the perspective of the global financial crisis of 2007-2008, which is still playing out. Here is a key piece of the Governance text:
"Three key global phenomena happened in the 2007-2008 moment in history, each of which individually would have accelerated the transition but would not have caused a step change – it was that they happened simultaneously that made us change gear from evolution to revolution, particularly so in the financial services sector. The three phenomena are, first, the advent of the Great Recession with the devastating effect it had on the reputation of the financial sector that spilled over to the rest of business. The second is the technological revolution that came with the coming of age of cloud computing and the advent of the first iPhone and the other smartphones that followed. This led to the creation of social networks and their unplanned side-effect of uncontrolled growth in data that we understatedly called Big Data. Finally, at approximately the same time we had the Millennium generation or Generation-Y with the cultural changes they bring, having reached adulthood and making their footprint felt in the workspace and consumer markets.
The conjunction of these three phenomena revealed the preeminence of intangible assets over physical ones, for which our accounting and reporting systems are not prepared. In 1975 83 percent of assets in the Standard & Poor 500 companies were tangible, and only 17 percent were intangible. By 2015 the relationship at the S&P 500 flipped to only 13 percent tangible assets and 87 percent intangible ones, the majority of which are in the form of intellectual capital. How can we govern organisations with reporting systems that give us granular visibility of only 13 percent of assets? Even more important than this from a governance perspective is the fact that intangible assets being shareable radically changed the competitive landscape. While in the industrial era success depended to a great extent on taking control of physical raw materials and other resources and thus confrontational competition, in the knowledge economy no organisation creates value on its own but requires collaboration with multiple other organisations. This requires a radical change in the approach to governance."
Retail Banking Institute offers an intensive Governance in Retail Banking seminar led by Professor Paul Griffiths, author of Governance: Corporate Governance in the Knowledge Economy, on 20 April 2023. Enrolment is now open. Contact firstname.lastname@example.org for details.
As Michael Lafferty notes, "accounting practices and standards are largely designed for the industrial age of tangible assets. While intangible assets resulting from mergers and acquisitions can be treated as assets and depreciated, the same does not go for intangibles created from investment within the business. This means that substantial amounts of intangible assets are not reflected in bank balance sheets. One way around the problem would be for intangibles to be valued independently and for this value to be shown as a note in the accounts."
Governance also extends to auditors, who play a vital role in bank governance – and questionable accounting and auditing practices often play a role in bank fraud, money laundering and mis-selling scandals. Indeed, under UK company law the auditor is an officer of the company – though not a director. The auditor's role is to express an opinion on the truth and fairness of the bank's accounts. If this opinion were to be qualified in some way it is generally thought that it would be highly damaging if not terminal for a bank.
In some countries auditors are themselves subject to supervision. In the US this function is performed by the Public Company Audit Oversight Board (PCAOB).
In a long-running controversy stemming from scandals surrounding Chinese companies listed in the US, the American regulators threatened to ban Chinese listings in the US if the PCAOB was not allowed to inspect the activities of the Chinese companies' auditors – themselves member firms of the international accounting networks. The Chinese authorities eventually relented – and the PCAOB said it exercised sole discretion to select firms for audit and selected two, KPMG Huazhen LLP in China and Pricewaterhouse Coopers in Hong Kong.
In truth, auditors are increasingly criticised for the quality of their audit work and for conflicts of interest when they provide other services to audit clients. Across the world it has long been understood that some companies have operated under weak accounting professions and corporate reporting practices. The position has improved considerably since the advent of international accounting standards – but these matters take many decades to change.
While they may be world leaders in industrial terms, many of the world's largest economies are also accounting laggards, including Germany – where the Wirecard saga exposed the country's weak accounting standards not to mention the weak-willed regulators. In January 2023 in the midst of the Wirecard trial the presiding judge criticised EY for allegedly failing to act on clear evidence of fraud at the payments company.
The more advanced accounting countries have long been understood to include the UK and Nordic countries, though it should also be mentioned that recent accounting scandals have also done great damage to the reputation of the most sophisticated accounting countries.
It is arguable that auditors should have played a more powerful role in unearthing at least some of the many banking scandals that have come to light in recent years – whether these relate to money-laundering, large-scale mis-selling or other fraudulent activities.
Our news pages over these last few years have been chock full of Hollywood-worthy money laundering stories including Danske Bank's world-beating channeling of money out of Russia, and HSBC's tailored dollar deposit scheme.
Make sure not to join them on our news pages.