According to expert opinion, of all industries in the globalized market economy the one poised for rapid growth in the next 15 years is financial services. Some estimates suggest that, by 2020, the financial industry will account for almost 10% of global gross domestic product (GDP). Though this may be an exaggerated figure, it is nev- ertheless an indicator of shift taking place in the relative weight of industry sectors.
The growth of the economy, at large, will not be even around the globe. One study done in 2005 expects that the financial industry in China, Russia, India and Brazil will grow more than twice as fast as that in the rest of the world. By contrast, countries in Latin America and in Africa will not see any significant increase in the weight and importance of their financial sector. Overall, in coun- tries where the financial industry progresses rapidly, private banking is expected to be one of the winners.2Other industry segments poised for growth are pension funds, mutual funds, and health insurance. Experts also bet on the growth of retail banking, while wholesale banking will most likely move slower, and lend- ing may achieve growth rates of just 2% per year.
Another of the predictions currently made on the future of banking and of finan- cial services at large is that consumers will become more sophisticated and dis- criminating about where they put their money. Savvy savers and investors will also ask for documentary evidence on risk and return, including comprehensive
reliable accounts. This will increase the importance placed on accounting stan- dards (see section 3). In all likelihood:
● Tomorrow’s financial services industry will not be a scaled-up version of today’s,
● But will rather take on a new pattern characterized by greater competitive- ness, innovation, and accountability.
In the background of the growth projected for the banking industry is the explo- sion of financial assets. Financial assets and financial liabilities are traded in the exchanges or over the counter (OTC). The latter are bilateral agreementsguaran- teeing one party’s contractual right to receive (or obligation to pay), matched by the other party’s corresponding obligation to pay (or right to receive). This dual- ity is at the root of practically all transactions.
Recording transactions and their value is one of accounting’s functions.
However, not all instruments can be unequivocally classified into financial assets and financial liabilities. For instance, contingent rights and contingent obligations meet the definition of assets and financial liabilities even though they are not always recognized in statements. What makes the difference is:
● The accounting standards, and
● Regulatory rules being adopted.
A most precious commodity among all financial assets is cash. Cash is a raw material of the financial industry which acts as medium of exchange. It is, there- fore, the basis on which all transactions are measured and recognized in finan- cial statements. A deposit of cash with a bank, or other institution, represents the contractual right of depositors to obtain cash, or use some other instrument against their credit balance.
Closely associated with the concept of financial assets is the time value of money. Two notions underpin the calculation of actuarial present value (see Chapter 7). Money today is worth more than the same amount time hence; and the difference is made up by the rent of money, or interest. The concept of time value finds its roots in the fact that people:
● Prefer present money to future money, and
● Choose present goods over future goods.
Even if they have no immediate need for money for reasons of consumption or investment, people and companies appreciate that money can be moved into the
future earning an interest. Such interest, however, may not be commensurate with risksbeing assumed. Like the price of any commodity, the price of money varies, with:
● Supply and demand
● Credit rating of the borrower
● Legal restrictions and customs
● Prevailing market factors, and
● Length of time for which money is lent.
The concept of interestis steadily evolving and this evolution must be reflected in accounting standards. What a person, or a company, gains with the capital which it manages must compensate credit risk(s), market risk(s), liquidity risk(s) and other risks being assumed. It should also leave a residual profit that repre- sents the productivity of capital.
The whole theory of capitalism is based on the fact that capital used in business and industry is productive. Capital can (or, at least, should) be employed to earn more capital at a rate higher than the cost of borrowing. This is increasingly achieved by leveragingone’s resources. But leveraging involves a mare’s nest of risks.3
The value of assets and liabilities, as well as risk and return, must be reflected in the books a person or entity keeps, by applying the rules of accounting – which brings up, once more, the need for reliable and universal accounting rules and standards. This is the aim of IFRS by the International Accounting Standards Board and other accounting standards like the United States Generally Accepted Accounting Principles (GAAP) (see section 3).
One of the controversial rules of IFRS concerns its treatment of gains and losses with derivative financial instruments. Derivatives have changed both the size of leveraging and the span of time characterizing commercial banking. Economists used to contrast the span of time inherent in a life insurance policy or an employee retirement plan, with the shorter time period of commercial banking.
But the life cycle of securitized products and other instruments embedded in a retirement plan may be 30 years. This has also revolutionized classical rules of commercial banking.
● In some countries, France and Italy being examples, commercial banks can only lend short term.
● With derivative financial instruments the timeframes in commercial bank- ing have been lengthened de facto.
For example, securitized mortgages, which run over 20 or 30 years, have become fairly popular. This has significantly increased exposure because nobody can foretell what the interest rates will be two or three decades down the line – and accounting standards should be able to track the change in market value.
Unlike cash, and other more classical assets or liabilities, derivative instruments defy actuarial studies because the latter were not made for superleveraging, and trades closely resemble financial gambles. As an article in Business Week had it, returns from gambling through financial instruments supply 30% of all US com- pany profits, up from 21% in the mid-1990s – and such ‘profits’ don’t come only from the financial industry but also from manufacturers and retailers.
For instance, at Deere, the farm-equipment company, financial deals produce nearly 25% of the company’s earnings.4And while General Motors is having trouble sell- ing cars, its ditech.com mortgage business is very profitable. GM’s financing opera- tions earned $2.9 billion in 2004, while the auto-making operations lost money.
There is a major risk that this wholesale substitution of a physical economyby a virtual economycan lead to a casino society. Sound accounting standards should reflect this change. Moreover, a major problem with finance dominating the cor- porate landscape is that any threat to financial earnings has a magnified impact on economic stability, and by 2005 several threats were gathering.