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John Holland
Introduction
Traditional finance theory (TFT) provides established ways of developing theoretical models of financial firms, but is necessarily restricted to economic processes. However, in the post 2000 period, many of the economic problems faced by these financial firms have been located in their knowledge and social contexts, and in the (often negative) mutual and reciprocal interactions between knowledge, social, and economic factors. Problems have been encountered in using TFT to explain the phenomena. The aim of this chapter is to rethink models of banks and financial institutions (FIs) using ideas of intellectual capital (IC).
This chapter seeks to extend the explanatory framework for banks and FIs by using empirical (field) research and theoretical ideas about IC-based intangibles and social factors in financial firms and the world of finance. This concerns the role of knowledge-based intangibles and social factors in core economic processes or intermediation in financial firms. It concerns how top management in financial firms have responded to change, created knowledge and social factors, and mobilized these factors in their intermediation processes. It concerns how these interactions can become negative leading to major problems and financial firm failure (Holland, 2010). As a result, new ways of thinking about financial firms are required to analyse interactions between knowledge, and social and economic factors in FIs and their markets.
New developments in financial firm research, such as in IC, have occurred outside of the TFT paradigm and have been much constrained (Gendron and Smith-Lacroix, 2013). This research area has not made the same progress as IC accounting research (Guthrie et al., 2012). Despite this, the progress broadly reflects the three stages of IC research in accounting outlined by Guthrie et al. (2012). The first stage reflects research to improve awareness of the role of IC in banks and FIs. Field work and literature are used in the chapter to explore the use and role of IC in banks and FIs. These sources are used to develop a field-based empirical narrative concerning knowledge (IC) and social and economic interactions in banks and FIs, as well as change processes. The second stage reflects attempts to develop guidelines and theoretical views of IC in banks and FIs. The chapter develops a theoretical narrative to match the empirical results. It reveals work to develop grounded theory and to use alternative, non-finance theory to explain banks and FIs. Alternative theory includes sources such as literature on IC in financial firms and the theory of the firm. The first and second stages reflect attempts to develop and legitimize the field of IC research in financial firms as an area of multi-disciplinary and multi-focused research in a manner similar to IC accounting research (Petty and Guthrie, 2000; Guthrie et al., 2012; Dumay and Garanina, 2013)
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However, given the problems noted by Gendron and Smith-Lacroix (2013) in changing ideas in fields of finance academe and practice after the global financial crisis (GFC), the chapter also focuses on how to stimulate the third stage of more critically focused IC research identified by Guthrie et al. (2012). The chapter therefore identifies a core weakness of TFT arising from its inability to include IC thought in explaining banks and FIs. Such IC factors have been major influences on success and failure in bank and FI intermediation processes (Holland, 2010). The chapter illustrates how the above ideas from field work and empirical narrative and alternative theory narrative can be ‘connected to’ TFT. The combined set of ideas acts as a ‘new theory frame for financial firms’ (NTFF). It reveals new ways for critical thinking about financial firms and developing connections between broader social science and management literature and TFT. This creates new ways to critically evaluate the roles of banks and FI firms in the economy and society, develop a critical examination of IC in financial firm practice, and critically appraise the role of TFT in explaining financial firms.
Golden-Biddle and Locke (2007) distinguish between what they call ‘field-based stories’ and ‘theoretical stories’. In this chapter ‘field-based stories’ or ‘empirical narrative’ refers to the empirical findings about the intermediation processes of banks and FIs in their markets. This includes ‘basic economic models’ of existing types of banks and FIs, as well as ‘advanced models’ that explicitly show the role of knowledge-based (or IC) intangibles and social contexts in economic processes. The empirical narrative also includes change processes and how they have stimulated knowledge creation and played a role in creating new, advanced forms of financial firms. The following section explores problems with existing bank/FI models and with theoretical interpretation using TFT. It highlights the need to include IC and learning ideas in explanation. This is followed by two further sections, which cover the main aspects of the empirical narrative. The first of these uses field-based research to explore the role of knowledge-based intangibles and social context in bank and FI intermediation processes, while the second notes that field-based ideas of change, learning, and knowledge creation are essential to understand the wider dynamics of bank/FI development. Two further sections develop the theoretical narrative, first by developing a theoretical narrative to match these empirical results. The combination of empirical and theoretical narratives form the NTFF conceptual framework to analyse and critically appraise the role of IC in financial firms, as well as the wider economic and social roles of these firms. Next, examples are provided of how this approach can be used to explain specialist financial firms such as retail banks, fund managers, and research analysts. The final section concludes and discusses how the analysis reveals new ways for critical thinking about the role of knowledge and social contexts in financial firms and new ways of developing connections between broader social science and management literature, and established finance theory.
Problems with existing bank/FI models and theoretical interpretations
The work of Revell (1973) and Lewis and Davies (1987) demonstrates how field-based research can be used to develop descriptions of new forms of banks and banking institutions (such as wholesale banks and commercial banks) in new kinds of financial markets (such as interbank markets for deposits and derivatives). These explanations focus on the basic economic processes in banks and FIs such as ‘on balance’ sheet and ‘off balance’ sheet financial intermediation as well as information intermediation. Bank/FIs financially intermediate and alter financial assets and their risks (both on and off balance sheet), and at the same time intermediate information about these transactions. All forms of intermediation can exist in a symbiotic relationship in the one financial firm or can operate at ‘arm’s length’ through specialist financial firms and market mechanisms. The conventional literature has a strong emphasis on the economic processes of such intermediaries as they produce new information and transform financial assets (size, maturity, liquidity, function) and risks. This literature focuses primarily on the ‘financial’ and ‘information’ contexts of financial firms and their agents. These include contexts such as financial markets for the supply and demand of funds and financial services (Lewis and Davies, 1987), and markets for supply and demand for information (Barker, 1998). Conventional financial intermediation theory and finance theory are used as the sole means of interpretation (Buckle and Beccali, 2011) of empirical insights concerning economic processes in these contexts. However, many problems have been identified concerning the use of this theory. For example, it underplays the role of knowledge and social contexts, and change and knowledge creation (Holland, 2010).
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Context also includes the social context in which agents of financial firms operate. The agents consisted of teams and individuals in bank/FI top management, their specialist research and information teams and individuals, specialist financial transaction teams, specialist asset portfolio and liability portfolio teams, and specialist teams for joint asset and liability management. Specialist ‘front office’ agents included financial actors such as bank lenders, fund manager investors, traders in markets, research analysts, and others. Context includes agents’ ‘relations’ and network context with suppliers and users of funds, and financial and information services in financial markets. They include each agent’s parent firm context and team context and individual agent’s skill and behavioural contexts. These contextual areas function as a connected economic and social system.
Events immediately before and during the GFC, and analysis by many authors, have highlighted the importance of combined social, knowledge, and ‘financial and information’ contexts in the economic functions of financial firms and their agents (Holland, 2010; Holland et al., 2012). They are the connected contexts in which agents in financial firms play an active role in intermediation processes. The GFC illustrated how knowledge of contexts and of economic processes in financial firms in these contexts is central to the work of agents in the firms. Knowledge-based intangibles (e.g. understanding of social or hierarchical positions, power, reputation, brands) in social contexts such as firm organization and external social networks (in markets) are major influences on success and failure in intermediation processes. Conventional theory and literature underplays or ignores the role of knowledge and social contexts in the decisions of financial firms and their agents (e.g. top management, middle management, front office staff).
In addition, before the GFC of 2007 to 2008, many authors identified problems in using finance theory alone in the world of finance (e.g. Holland 1998, 2005, 2006; Scholtens and Van Wensveen, 2003). After the GFC, authors such as, e.g. Holland, 2010 and Gendron and Smith-Lacroix, 2013, discussed how the crisis had exacerbated these problems and stimulated the need for a new approach. They included problems of change and limited learning and knowledge creation during change (Holland, 2010), and a lack of direct research on finance in action (Gendron and Smith-Lacroix, 2013).
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Empirical narrative: central role of knowledge-based intangibles and social context in intermediation
In response to the above problems, this section uses field-based research to explore the role of knowledge-based intangibles in bank and FI intermediation processes. This research makes explicit the central role of knowledge in economic processes in new ‘advanced models’ of banks and FIs. It makes explicit the way in which management of financial firms mobilize knowledge and other resources to maximize their impact on wealth creation in economic processes such as intermediation.
These studies include Holland’s (2005, 2016a) research into fund manager firms, Chen et al.,’s (2014) study of banking firms, Holland et al.’s (2012) research into venture capital firms, Chen et al.’s (2016) study of financial analysts in investment research firms, and Holland’s (2016b) model of the ‘market for information’. The GFC also revealed the central role of (failing) knowledge-based intangibles in wholesale banks and investment banks, as they developed risky and poorly understood new universal banks (Holland, 2010).
The field studies show the central role of unique combinations of many connected IC-based intangible resources in financial and information intermediation processes in banks and FIs. These included intangible resources such as knowledge or IC about financial firms (organization, hierarchy, process, culture, routines, teams) and the capabilities of bank/FI teams and individuals. They included knowledge of the financial needs of customers or clients, financial transactions, and of banking and financial markets. They also included knowledge about the external social networks and relations and the power and processes that banks and FIs have in relationships with customers and market participants. They included knowledge of pricing mechanisms in financial markets and the role of intangibles such as brand, reputation, and customer relations in supporting transactions in these markets. The tangible resources included financial resources, technology, and offices.
Each financial firm had a unique combination of resources, financial and intangible, integrated in a business model and driven by strategy. The special combination constituted a unique and sustainable competitive advantage (SCA) (Barney, 1991) for each financial firm. The intangibles and SCA were the basis for the bank/FI to construct specialized economies of scope and scale (Merton, 1995). Management mobilized the combined and special resources to enhance information production and support asset, liability, and risk management decisions by ‘front office’ teams and individuals. This enhanced ongoing intermediation processes, leading to success in transacting and in financial performance relative to competitors. Most banks and FIs operated as combined information and financial intermediaries, but specialist information intermediaries (investment banks, research firms), financial media, and database companies also existed.
More specifically, each bank/FI as an information intermediary involved economic, knowledge, and social processes in the search for production, exchange, and use of information. These processes occurred within the bank/FI firm as well as its specialist financial markets. For example, retail banks sought special insights (knowledge) into savings, spending, and borrowing behaviour by customers and by others in the retail banking market. This knowledge was the means to create special and private information about customers and close economic ‘relationships’, which together formed part of the competitive advantage for the retail bank. Bank learning over time created special knowledge about customer behaviour in markets and social settings. Similar processes occurred in other FIs such as pension funds, insurance companies, and fund managers.
Each bank/FI as a financial intermediary involved financial transformation processes using the knowledge resources (intangibles) and information sources (from information intermediation above) in balancing financial asset and liability risks to achieve a profit. Prior expert knowledge based on ‘best practice’ and many years of bank/FI management experience of success and failure in various connected areas of risk management (and often embodied in regulation and professional exams) was the means for effective management of the financial intermediation process. For example, in a ‘basic’ model of financial intermediation, financial risks were ‘juggled’ or managed in combination, in pursuit of profit, through well-tested and well-understood mechanisms and principles. The latter included contracting and diversification for both asset and liability transactions, asset/liability matching and mismatching for asset transformation, controlling asset and liabilities’ interest rates or returns for positive margins, and the use of ‘adequate’ cash (liquidity) and equity capital as ‘risk buffers’ (Lewis and Davies, 1987). These were the combined basis for the transformation of the full set of assets and liabilities by size, maturity, and risk in financial firms such as banks, pension funds, insurance companies, fund managers, and venture capitalists (Buckle and Beccali, 2011). The ongoing ‘front office’ decisions about individual specialist financial assets and liabilities were conducted (in this controlled firm risk management context) in associated financial markets for savings, investment, and security exchanges.
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Mobilizing resources: intangible and tangible
Knowledge-based intangibles were not static, passive dimensions of bank/FI economic activity. They had to be mobilized in a purposeful way by management to maximize their impact on intermediation and economic processes in banks/FIs. Top management used a combination of human and structural capital within the firm and relational capital in external networks as part of this mobilization. The human capital included the skills and capabilities of top management, middle management, and front office teams. Structural capital included knowledge of how to use bank/FI hierarchy, power, and organizational processes to mobilize resources. Relational capital involved knowledge of how to use social relationships and power to mobilize and exploit external financial resources.
In more specific terms, field studies revealed that each bank/FI firm was an organization made up of connected teams (e.g. Chen et al., 2016; Holland, 2016a). They had a board and top management team with their own strategy and philosophy. They had a bank/FI firm hierarchy made up of top and middle management teams, which directed operational teams and individuals, both front and back office.
Each bank/FI firm had combinations of resources that were integrated in the bank/FI firm business model. For example, each bank/FI had expert knowledge for different kinds of specialist top management and for front and back office teams. These were key resources mobilized within the firm. Expert knowledge was the core of competitive advantage in ongoing bank/FI intermediation processes. In specific terms, bank/FI top management mobilized these knowledge-based intangibles via exercise of their power in the hierarchy and via their direction of organizational processes. These were used to support information production by front office staff dealing with new asset and liability decisions in financial intermediation.
We should also note that bank/FI intangibles such as quality of top management and front line and back office staff, of risk management methods and skills, and of board governance and accountability systems were increasingly the focus of regulation. Thus their coherent integration in the business model and effective mobilization relative to best practice became a compliance necessity for bank/FI management as much as a competitive and value creating issue. Poor compliance with regulatory requirements led to regulatory sanctions and subsequent negative impact on bank/FI reputation and value.
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During this resource mobilization process, many bank/FI intangibles interacted in a purposeful way in bank and FI value creation processes. For example, Holland (2005) discusses how each case company (including banks and insurance firms) created value through careful management of its hierarchical, operational, and network value creation processes (Holland, 2004). In the case of banks and FIs, a specific group of intangible assets (or qualitative value creation factors such as top management quality, board governance capability, and quality of oversight of risk management), were critical hierarchical or top down drivers of the value creation process. Each case company also articulated a concept or idea of its ‘operational’ value creation process consisting of financial sourcing decisions and processes, financial asset and liability transformation decisions and processes, and financial outcomes (as in bank/FI financial and information intermediation). Within this intermediation process the top management of case financial firms exploited middle management and ‘front office’ employee human capital and other external intangibles such as customer and supplier relations and brands. They also exploited network value creation processes based on sharing of both tangible and intangible value drivers via customers, alliances, suppliers, and distributors. These were mainly employed at the boundary of the bank/FI firm. The nature of these value creation processes is discussed in detail in Holland (2004). The bank/FI cases discussed here were part of more general processes of intangibles in value creation in many different types of companies.
Bank/FI organizational processes for firm wide control (behaviour, risk, and so on) and information production were critical to resources mobilization (Cyert and March, 1963). They were driven by bank/FI aims and philosophy, based on bank/FI specialist financial roles and products. The organizational processes when combined with hierarchical power were the primary means for top management to mobilize resources within the bank/FI structure or hierarchy to support ‘front office’ team conditions, information production, and their financial asset, liability, and risk management decisions.
New value relevant information for these decisions was primarily created in organization processes and established decision routines from a variety of sources. These included combinations of soft and hard information sources (Stein, 2002), subjective judgements, and information from analysis of perceived regularities in markets for assets and liabilities. This information was the basis for active decision making by front office teams in financial asset, liability, and risk management areas. These included single financing and investment transactions (such as loans in banks or stock selection in fund managers). They included decisions about portfolios of large numbers of financial assets and liabilities, and they included joint asset liability risk management decisions (on and off balance sheet).
The above resource mobilization can also be interpreted from a risk management perspective. In the advanced model of financial intermediation (set in the bank/FI business model), top management ‘juggled’ tangibles risks (financial, technology) and intangibles risks to both balance and offset these combined risks in the search for profit. The intangibles risk concerned human capital as competence and skills, and with relational capital as reputation and brand power, and their impact on financial risks. This combined dynamic risk management created opportunities to mobilize bank/FI resources to ensure that the bank/FI could conduct financial and information intermediation in a highly competitive manner and thus add more value and make more profit than the competition. From a ‘good practice’ perspective, banks/FIs did this combined risk management first, and then sought profits. In the period before the GFC this was conducted the other way round by those banks that eventually failed.
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Social contexts and bank/FI intermediation
The field studies reveal how various social contexts in the bank/FI and its external world were central to bank/FI economic processes. Knowledge of these contexts formed structural and relational types of IC (Meritum, 2002) which were developed by bank/FI top management during experiential learning during response to change. Within the firm, social context involved areas such as organization hierarchy and power (Stein, 2002), organizational culture (Schein, 1989), and organizational process (Cyert and March, 1963). For example, banks/FIs sought a balance between ‘steep’ and ‘flat’ organizational hierarchy to control decision costs or the costs of making decisions based on poor quality information. Stein (2002) argued that the steep hierarchy in established commercial banks maximized the use of hard numerical information (such as accounting information) but lost the benefits of ‘soft’ impressionistic or subjective information (such as information about people running firms). The ‘flat’ hierarchy used by financial firms such as investment banks and fund managers was intended to have the opposite decision costs and benefits, and to quickly exploit new impressionistic information. Banks/FIs used various types of hierarchy (steep, flat) and organization control process (centralize, high autonomy) to control decision costs and reduce behavioural biases in front office teams (Holland, 2016a). Banks/FIs also operated in external networks of social and economic relations (Stones, 2005). These networks supported information search and exchange. They were important in the control of behaviour and risky transacting and in further reducing decision costs for bank/FI agents. High power, reputation, and quality brands relative to external clients, customers, and suppliers in joint social and economic networks were expected to increase financial transaction success.
Management knowledge of, and power in, financial firm social contexts (internal and external), was the key to creating and using new information – both soft and hard – in specialist information intermediation processes. They were integrated means to cope with and reduce the uncertainty associated with financial asset, liability, and risk management decisions (Hellman, 2000, p. 236). When combined and mobilized they were important organizational means for uncertainty avoidance and conflict resolution in the manner suggested by Cyert and March (1963). Thus organizational and social contexts, agent knowledge of these, and power within contexts, were central to the bank/FI economic processes and decisions by their agents in financial markets.
Empirical narrative: change and bank/financial institution learning and knowledge creation
The previous section has discussed how knowledge-based intangibles and social contexts can be mobilized to play a role in bank/FI economic processes. It did not explain the origin and changing nature of knowledge and social factors. It did not explain changing bank/FI economic processes. Change has been a source of major problems and opportunities in banks/FIs. This section explores field research concerning how banks and other FIs respond to change and create knowledge. It argues that field-based ideas of change, learning, and knowledge creation are essential to understand the wider dynamics of bank/FI development.
Bank and financial institution learning: new knowledge and management and economic processes
Research by authors such as Harris (2002), Antonacopoulou (2006), Shih et al. (2010), Holland (2010), Holland et al. (2012), and Chahal and Bakshi (2015) illustrate how banks and other financial institutions respond to change, learn, and create knowledge-based intangibles of relevance to the effective functioning of the banking or FI firm. Top management and front office staff in financial intermediaries (banks and FIs) learnt over time to create knowledge to overcome, and at times create, market imperfections. They learnt how to develop IC (Meritum, 2002) to exploit the imperfections. This explanation is at odds with the TFT position whereby efficient markets and competition will erode imperfections and reduce the need for banks and FIs (Scholtens and Van Wensveen, 2003).
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The above studies reveal how agents such as top management and front office staff learnt how to develop bank or FI organization and hierarchy (structural capital); the skills and capabilities of their teams and individuals (human capital); and their relationships, brands, and reputation with customers and other external agents (relational capital). The knowledge-intensive intangibles provided the means to create information for financial intermediaries to overcome market imperfections and to create financial products and services not available through markets. For example, agents learnt how to overcome imperfections associated with consumer preferences for funds (size, maturity, liquidity, risk), and consumer liquidity needs and shocks. They learnt how to reduce transaction costs and control adverse behaviour (before, after transactions) (Buckle and Thompson, 2005). They learnt how to use such knowledge to develop economies of scale and scope in financial transacting. In this frame, financial intermediaries existed because their agents learnt and created knowledge. However, banks and FIs did more than overcome market imperfections. In their search for value and profit, they used their knowledge to create competitive advantage in new products and services. These created new market imperfections which were best exploited by the bank/FI firm that created them.
For example, a study of Japanese FIs (fund managers and venture capital firms) by Holland et al. (2012) provides examples of how agent learning and knowledge creation were central to their response to change processes and hence to the way they formed new, valuable, and innovative economic processes in banks/FIs and financial markets. More generally, Shih et al. (2010, p. 74) comment:
The ability to create knowledge is highly relevant to IC in the banking industry. Companies should define their own robust mechanisms for knowledge creation to improve their ability in knowledge creation. Knowledge creation in banks should focus on the exchange and sharing of information.
Knowledge management in this context is the key to superior value creation and performance relative to competitors. In this respect, Chahal and Bakshi (2015, p. 376) find many supportive relationships between change, learning, new IC formation, and innovation in banks. They note:
The study finds that intellectual capital has direct and positive impact on the competitive advantage. It is also verified that innovation fully mediates the relationship between intellectual capital and competitive advantage. Further, the moderating effect of organizational learning on the relationship between intellectual capital and competitive advantage is also confirmed.
‘Dynamic spirals’ and change in banks and FIs
The major changes, learning, and knowledge creation noted above occurred in bank/FI firms over time as they learnt about new threats and opportunities. These were associated with reciprocal changes in customers, products, and markets in a “financial innovation spiral” (Merton, 1995, p. 26). Despite changes in these elements, there was no fundamental change in the core risk management and intermediation roles of the banks/FIs in the real economy. The history of such change explains bank/FI success/failure as specialist intermediaries and as combinations of intermediaries. Merton’s spiral provides a tentative explanation of how bank/FIs create knowledge and acquire new knowledge-based intangibles essential to SCA in financial intermediation.
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However, major barriers to learning and knowledge creation also existed in banks/FIs and hindered constructive change. Harris (2002) and Antonacopoulou (2006) noted that problems can emerge in bank learning and knowledge creation. Harris (2002) provides evidence that learning from past mistakes, or even building upon past successes, continues to be the exception rather than the rule in major UK banks. Antonacopoulou (2006) argues that care must be taken in managing individual and team learning in bank organizational contexts.
The field studies above revealed a larger bank/FI ‘change spiral’ involving interactions within and between economic, knowledge, and social change processes in banks/FIs and their immediate markets. This involved mutual and reciprocal changes in these elements (Stones, 2005). This showed the central role of changing social context and forces in affecting bank/FI actions, at team and individual levels, and during ongoing decisions and long-term change periods.
Major events such as the GFC highlight how all of the above interactions (learning, knowledge, and role core functions) could go wrong and banks/FIs and markets could fail. In the period before the GFC, major (combinations of) bank/FI problems arose over time in intangibles, such as the quality of top management and their understanding of new risky bank models developed in a period of rapid change from 2000 to 2007. This led to high exposure to risk and excessive risk taking. When these coincided with major negative events (economic, political, and so on) in 2007 to 2008, they led to bank/FI firm failure and market problems (Holland, 2010). Major reasons for failure arose with problems with knowledge-based intangibles in banks/FIs in top management and front office staff. These created further problems with tangibles in intermediation processes. These intangibles’ problems arose, inter alia, from joint social and economic issues such as top management abuse of reputation, knowledge, and power in financial firms and networks. They arose from problems with organization and with knowledge (Holland, 2010). These contributed to intangibles’ problems with front office staff such as limited understanding of risk in new transactions and perverse incentives to sell these transactions. The above highlights the need to use the above ideas to develop ongoing diagnosis of change, ‘innovation’, and emerging problems with knowledge-based intangibles before they adversely affect the core intermediation processes in bank/FIs.
Developing an ‘NTFF’ using IC ideas
This section develops a theoretical narrative to match empirical results or narrative outlined in the previous two sections. This uses alternative, non-finance theory, to explain banks and FIs. Alternative theory includes sources such as literature on IC in financial firms and the theory of the firm. This section also illustrates how the ideas from field work and alternative theory can be ‘connected to’ TFT. The combined set of ideas acts as an NTFF.
Alternative theory to explain banks and FIs
The empirical narrative outlined in previous sections can be interpreted within a wider, non-finance theory literature, hence creating a broader theoretical narrative. This seeks to understand banks and FIs as profit-seeking businesses that organize their resources, tangible and intangible, to create an SCA matched to the needs of their markets, which allows them to conduct their specialist intermediation processes (information, financial) and risk management processes in more effective and valuable ways than similar specialist financial firms and in a superior way to individuals operating in markets. They sustain that advantage over time by the way they learnt and responded to change.
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The empirical insights into ‘real world’ banks and FIs and the way they developed over time has revealed the importance of knowledge-based intangibles, such as bank/FI organization, hierarchy, capabilities (individual and team), social networks, and other factors in bank and FI intermediation processes, set in coherent business models, operating in competitive markets. Problems have been encountered in explaining banks and FIs using conventional theory (financial intermediation theory and finance theory) (Scholtens and Van Wensveen, 2003; Holland, 2010; Gendron and Smith-Lacroix, 2013). These problems become acute when new IC-based insights into banks and FIs are developed (Holland, 2005, 2006). As a result, a range of management theories and sociology of finance theories are combined with conventional theory (financial intermediation theory and finance theory) to interpret banks and FIs in their combined social, knowledge, and economic contexts.
The financial firms can be interpreted as evolutionary (Nelson and Winter, 1982) responses to uncertainty. Their organization structures and processes, external social networks, and shared firm wide knowledge, as knowledge-based intangibles, were developed by their agents learning in a common institutional setting (Scott and Meyer, 1994; Scott, 2001) during shared change processes. Holland et al. (2012) illustrates how these knowledge factors were the result of long-term learning and knowledge creation processes in financial firms during change processes. Knowledge in the firms changed over time via their activity as ‘learning organizations’ (Pedler et al., 1997) hence maintaining, and at times enhancing, the firm’s SCA (Teece, 2007).
Banks’ and FIs’ SCA was based on a unique, difficult to copy, combination of resources, both tangible and intangible. This idea is explained in the ‘resource-based view of the firm’ (Barney, 1991). Special combinations of resources with specific strengths matched to the external environment were the key to bank and FI success. A combination of unique knowledge-intensive intangibles and tangibles (with competitive advantages) were strategically matched to the external environment (customer needs, market conditions, competition, technology change, etc.) and were integrated in bank/FI business models and value creation chains (IIRC, 2013).
Bank and FI firms, and their top managers and ‘front office’ or decision teams, used organization processes and hierarchy to mobilize and exploit organizational resources such as knowledge, hierarchy, brand, and reputation in their financial decisions and financial intermediation processes (Cyert and March, 1963). The knowledge-based intangibles provided top management and ‘front line’ teams with organizational means and resources to focus on and interpret events and to produce new information during decisions (investment in financial assets, financing of financial liabilities, risk management of these). These intangible and tangible resources (and the SCA) were used by bank and FI teams to enhance information production and to support financing, investment, and risk management decisions by teams and individuals. They were the basis for effective and valuable intermediation (information, financial) and risk management by banks and FIs.
Connections to finance theory
Epistemological and ontological differences in the theory assumptions, core tenets, and views of the world create barriers to full integration of TFT and the above theories. However, the above alternative theory narrative can be connected to the TFT view (Buckle and Beccali, 2011) as follows. In TFT theory terms, the mobilization of resources and enhanced decision conditions for front office teams were expected to reduce information asymmetry, adverse selection, and moral hazard problems at single transaction and individual customer level as well as at aggregate portfolio levels. These conditions were intended to support front line staff to generate profitable transactions. The IC elements were seen as a primary means to aid senior management to manage aggregate transaction risk in the form of financial asset and liability portfolio risks and hence risks of intermediation processes in financial firms. The knowledge-intensive intangibles provided the means to manage joint asset liability portfolio risks through diversification, matching, and mismatching. Knowledge-based intangibles were the means to stabilize expected firm income. Enhanced knowledge of customers was the way for banks and FIs to manage and forecast their transaction flow for assets and liabilities. This improved the risk management and intermediation processes, and stabilized supply and demand, and costs and revenues, across market cycles. The size of a firm’s cash reserves and equity levels as ‘risk buffers’, and preferred risk management methods were also determined by expert knowledge at top management level in the firm as well as by regulation (based on established expert knowledge). The combined impact of mobilized resources, improved team conditions, reduced information problems (at transaction, portfolio, firm levels), and improved risk management were the means to create value in the bank/FI through profitable transactions and secure financial intermediation.
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The above theory narrative can also be extended to explain change in financial firms. The new conceptual framework viewed banks and FIs as profit-seeking businesses facing major change over time. Bank and FI learning and knowledge creation over time was the basis for the development of a dynamic version of SCA (Teece et al., 1997) and for the creation of winners and losers between banks and between specialist FIs. The dynamic change in economic processes over time in the banks and FIs was an example of Merton’s “financial innovation spiral” (1995), where key elements such as bank and FI business models, value creation chains, and competitive positions evolved together over time. At the same time, other elements such as the forms of financial and information intermediation, their financial and information products, their risk management services, product users and their needs, and the wider market for these bank and FI products, evolved together over time. Thus in terms of Merton’s functional approach (1995), the financial functions of the financial system remained constant and stable, but the banks, FIs, and markets serving those functions evolved and changed over time.
From a TFT viewpoint, the role of knowledge in banks/FIs was to reduce agency costs and improve risk management. However, the empirical results reveal that banks’ and FIs’ primary aim was to create and use knowledge-based intangibles for value creation. Reduction of agency costs and transaction costs was achieved as a by-product of the main value creation purpose and activity, as suggested by Scholtens and Van Wensveen (2003). Thus, TFT by itself is inappropriate to explain the primary function, purpose, and behaviour of banks. It cannot explain the value creation process, the change process in banks, the creation of new knowledge, and emergence of new products and new transacting means. But these TFT sources (Buckle and Beccali, 2011) are important to explain the economic relationship between financial firms and markets once such change has occurred and the required knowledge has been created. Thus, current research requires the ideas from field work and alternative theory be ‘connected to’ TFT in a coherent way. The combined set of ideas acts as an NTFF.
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Developing a meta theory framework
We should note that Stones’ (2005) ‘strong structuration theory’ has been used in two complementary ways in the chapter. First, to explain observations of mutual, reciprocal, interactions between knowledge, social, and economic factors in banks and FIs. Second as a potential means to develop a meta theory approach.
In the first case, we use Stones’ (2005) four elements of external structure, internal structure, actions, and outcome to structure the analysis of empirical insights into the intermediation role of agents in financial firms. Stones (2005) refers to active agency, in which agents such as top management or front line staff draw, routinely or strategically, on their internal structures (knowledge) to guide action in external contexts. Agents draw on their prior knowledge (general and specific) of external parent firm structures, of external market structures, and their socialization within these structures, to interpret events and circumstances, and to frame and direct their actions within the market and firm structures. The elements of structure, action, and outcomes are always present together in mutual reciprocal interactions. Economic processes in the form of agent experience of the supply of and use of funds, risk management, information exchanges (private, public), and stock market reactions to public information and actions by financial firm agents, provided rapid feedback stimuli during the interactions. The above is an ongoing economic process interacting with existing social and knowledge contexts, and is the means to reproduce social, knowledge, and economic structures on an ongoing basis.
The above reveals that Stones (2005) can also be potentially used as a ‘meta’ theory framework to guide choice from a ‘menu’ of theory and literature to match the empirical categories or narrative. Stones’ (2005) strong structuration approach, and other relevant literature, can be used to interpret social structures in which agents operate in their parent financial firms (e.g. Chen et al., 2014, 2016), and in social networks and relations in financial markets. The social and knowledge contexts are key areas where more explanation is required of the role of knowledge, social forces, and behaviour in purposeful agent economic processes and actions, and of how they contribute to structure in the agent financial firms and financial markets. This reflects the duality of structure and agency, whereby agents and structures (in financial firms and financial markets) mutually enact (or perform) social systems and social systems become part of that duality.
A new combined ‘theory narrative’: examples from field work
In this section, three examples are presented of how empirical insights, alternative theory, and finance theory can be combined in explaining specialist financial firms. The examples concern banks, research analysts, and fund managers (FMs). The alternative theory and literature view of banks/FIs is connected to (but not integrated with) the established finance theory view of banks/FIs. Together they offer a novel conceptual approach to analysing and interpreting the central role of knowledge-based intangibles in FIs.
A bank example of how to connect (expanded) theory and empirical sources
For example, Chen et al. (2014) outline a new theoretical narrative (Locke, 2001) corresponding to empirical findings on retail banks. Chen et al.’s (2014) views are briefly summarized in what follows.
Banks have business models (IIRC, 2013) that contain tangibles and knowledge-intensive intangibles (or human capital, structural capital, and relational capital as in Meritum, 2002). The core tangibles of bank business models include financial assets, liabilities, and technology, and tangible processes such as risk management, intermediation, and technology-based processes. These tangibles are easily copied. Bank’s intangibles, such as human capabilities or brands, are at the core of SCA in business models, as argued in the resource-based view of the firm (Barney, 1991). Intangibles are characterized as rare, inimitable, and difficult to copy sources of value (Barney, 1991). Combined intangibles and tangibles form bank business models (IIRC, 2013) and value creation chains (Porter, 1985). These are the means for banks to conduct risk management and financial intermediation in a more valuable way than competitors, and create higher financial performance. Use of intangibles in banking is expected to stabilize expected income. Enhanced employees’ knowledge of customers can help banks better manage and forecast their transaction flow for assets and liabilities. This can improve the risk management and intermediation processes, and stabilize supply and demand, and costs and revenues, across market cycles.
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Knowledge-intensive banks can reduce agency costs and problems of information asymmetry, and adverse selection and moral hazard at individual transaction (loan, deposits) levels and at aggregate portfolio levels. Knowledge-intensive intangibles provide the means to manage joint asset liability portfolio risks through diversification, matching, and mismatching and the use of equity capital and cash as risk ‘buffers’. However, empirical studies such as Chen et al. (2014) reveal that the bank’s primary aim was to create and use knowledge-based intangibles for value creation. Reduction of agency costs and transaction costs was achieved as by-products of the main value creation purpose and activity, as suggested by Scholtens and Van Wensveen (2003).
A research analyst example of how to connect (expanded) theory and empirical sources
In another example, Chen et al. (2016) outline a new theoretical narrative (Locke, 2001) corresponding to empirical findings on sell side analysts. This narrative can be constructed based on a combination of new literature and the conventional finance theory narrative. Chen et al.’s (2016) views are briefly summarized in what follows.
Analysts are concerned with knowledge-intensive intangibles that are rare, inimitable, non-substitutable sources of value (Barney, 1991). Analysts are also concerned with general knowledge about the external social and economic contexts of the firm, and with inter alia knowledge about the analyst parent, the company being analysed and valued, the fund manager client being served, and the wider market for information (MFI). At individual analyst level, these knowledge-based intangibles reflect special informal or experience-based capabilities allied with more conventional formal or professional capabilities. At analyst firm level, they reflect firm philosophy (on quantitative and qualitative research methods), and the degree of autonomy allowed for analysts. Analysts also rely on core tangible assets (e.g. technology, offices) and tangible processes (e.g. management, intermediation, technological). Knowledge-intensive intangibles are at the core of SCA for individual analysts, teams, and their parent firms, as noted in the resource-based view of the firm (Barney, 1991). These integrated and combined intangibles and tangibles form analyst value creation chains (Porter, 1985). These are the basis for analysts to conduct information intermediation (concerning information about company intangibles and their business models) more effectively than their competitors. This is expected to result in higher analyst performance in the provision of the combined information package of forecasting, valuation, explanation, and advice. Across many analysts and research teams it is expected to result in higher financial performance of the equity research function in parent investment banks. Such knowledge-intensive individual analysts, teams, and parent firms provide the means to reduce agency costs and associated problems of information asymmetry, adverse selection, and moral hazard between analysts, companies, and MFI actors, such as client FMs and small investors. Analyst intangibles provide the means to overcome imperfections by contributing to economies of information specialization, scale economies in information acquisition, and reduction in information search costs.
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Analysts learn over time while making routine decisions and when responding to change pressures. This new knowledge contributes to changes in their information intermediation model, their outputs, and relations with companies and clients. These changes in information services, structure, and function in the MFI are interpreted through Merton’s (1995) ‘financial innovation spiral’ (economic changes) and Stones’ (2005) ‘strong structuration theory’ of social structure and change.
A fund manager example of how to connect (expanded) theory and empirical sources
Holland (2016a) outlines a new theoretical narrative (Locke, 2001) corresponding to empirical findings on FMs. These findings are summarized in what follows.
FMs have knowledge-intensive intangibles that are rare, inimitable, and non-substitutable sources of value (Barney, 1991). FMs are concerned with general knowledge about the external social and economic contexts and also with, inter alia, knowledge about the company being analysed, valued, and invested in, and about analysts and other information providers in the MFI. At individual FM level these knowledge-based intangibles reflect special informal or experience-based capabilities allied with more conventional formal or professional capabilities. At FM firm level, they reflect firm philosophy (on quantitative and qualitative research methods), and the degree of autonomy allowed for individuals and teams involved in investment decision making. They include organizational resources in the fund management firm such as organizational, hierarchical, team, and individual capabilities and processes. FMs also rely on core tangible assets (e.g. technology, offices) and tangible processes (e.g. management, intermediation, technological). The knowledge-intensive intangibles are at the core of SCA in individual FMs, teams, and their parent firms, as noted in the resource-based view of the firm (Barney, 1991). These integrated and combined intangibles and tangibles form FM value creation chains (Porter, 1985). These are the basis for FMs to conduct information intermediation (concerning information about investee company intangibles and their business models) more effectively than their competitors. These are the basis for FMs to conduct financial intermediation (concerning savers’ funds and portfolio investment) more effectively than their competitors. These are expected to result in higher FM performance in the provision of saving services and investment portfolio services at team and FM firm levels.
For example, the behavioural theory of the fund management firm reveals much about the interaction of organizational intangibles (organizational, hierarchical, and individual/team processes) and tangibles in the FM economic process. FM firms created and mobilized intangible organizational resources to help investment decisions by teams and individuals in the FM firm. These intangibles were central to information production and risk management at firm, team, and individual levels.
The grounded theory was based on a set of relational concepts involving ongoing FM decision action, and broader organizational process and hierarchy. It was also based on a set of FM strategic and contextual resources and their properties. Immediate (investment) decision actions by individuals and teams were a goal-seeking structured task sequence and a process of sense making. These were different but related means to reduce the uncertainty associated with equity investments (Hellman, 2000, p. 236) and to find new information and investments of value.
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The FM organizational processes were identified, first, as an integrated set of hierarchical processes or firm wide processes of control and influence over the allocation of resources, risk, and autonomy. Second, they existed as firm wide and team information production and exchange processes. FM firm wide organizational processes were key means for uncertainty avoidance and conflict resolution in the manner suggested by Cyert and March (1963). They were means to create and control FM hierarchy costs (Stein, 2002). They were also the base from which FM creativity could be stimulated. Both informal ‘conversations’ and formal communications were important in micro and macro processes. They were important in solving problems and making novel associations. The organizational processes mobilized FM resources in a dynamic and purposeful way to produce the desired influence on investment team conditions, ongoing investment decision processes, and investment success or failure.
Resources were interpreted as knowledge-based key properties of FM internal and external contexts. The external context of FMs consisted of various external ‘networks’ and markets. The internal context of FMs consisted of top management context, an organizational context, a team context, a personal context, and an immediate decision or action context. Each FM context had various knowledge-based properties and peer group relative strengths of these properties.
From the resource-based view of the firm (Barney, 1991) the FM contexts and their knowledge-based properties were resources mobilized by FM organizational processes to support investment team processes. The key resources were central to FMs exploiting investment opportunities and creating value, as well as in uncertainty avoidance and conflict resolution processes as outlined by Cyert and March (1963). These dynamic elements to FM firms can be interpreted as tentative organizational means to deal with major problems of behaviour, uncertainty, and information asymmetry at the heart of the valuation, investment, and performance problems facing FMs.
Summary
The aim of this chapter has been to rethink models of banks and FIs using ideas of IC. Problems have been encountered in using TFT to explain these financial firms, especially in the GFC and post GFC period. Many of the economic problems faced by these firms have been located in their misuse of their own expert knowledge and dependence on TFT to direct and explain these firms.
This chapter has extended the explanatory framework for banks and FIs by using empirical research and theoretical ideas about IC-based intangibles and social factors in financial firms and the world of finance. Golden-Biddle and Locke (2007) distinguish between what they call “field based stories” and “theoretical stories”. The chapter has developed a novel empirical narrative to explain the role of knowledge-based intangibles in economic processes or financial intermediation in banks and FIs. The empirical narrative was extended to include issues of change, learning, and knowledge creation. The chapter has also developed a theoretical narrative to match these empirical results. The chapter illustrates how diverse but relevant literatures can be linked together via the analysis of the empirical patterns to form a coherent alternative ‘theoretical narrative’ for financial firms such as banks and FIs. The alternative literature base includes IC literature, ‘management’ theory, and theory of the firm relevant to financial firms. The chapter illustrates how the ideas from field work and alternative theory can be ‘connected to’ TFT. The combined set of ideas acts as an NTFF.
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The analysis therefore reveals new ways to analyse and critically appraise the role of IC in financial firms. It reveals new ways for critical thinking about financial firms. It demonstrates new ways of developing connections between broader social science and management literature, and TFT. This provides a new form of intellectual flexibility designed to help practitioners and academics break out of dogma and “psychic prisons” (Morgan, 1986, p. 215) created by adherence to a single theoretical frame or intellectual viewpoint.
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