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HOW CAN BANKS PREPARE FOR THE CLIMATE-RELATED INVESTMENT STORM AHEAD?

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By Amer Khan, Managing Director Europe, Entelligent

 

The Covid-19 crash in March 2020 provided a stark illustration of the degree to which natural disasters can affect the global financial system. Stock markets plunged around the world, with London’s FTSE 100 enduring its lifetime second biggest fall, and the Dow Jones its worst quarter ever. Crude oil prices dropped into negative territory for the first time in history.

As we approach the end of 2020 stock markets have largely recovered, driven by the expectation of vaccines that will effectively combat Covid-19. We cannot however protect ourselves from the effects of unabated climate change with a vaccine. So, what can the financial services industry do to protect itself, and its stakeholders against the impending climate-related investment storm?

Interestingly, as Covid-19 caused stock markets to suffer record investor withdrawals during the first half of 2020, investment banks saw one area of the investment markets flourish: ESG funds experienced record inflows throughout the crisis.

It quickly became clear that the Covid-19 pandemic had amongst other things, caused a shift in attitudes towards investing for a more sustainable future, and an environmentally one.

Amer Khan

Alongside increased investor appetite for climate resilient investments, banks have increasingly recognised that whilst climate-related risks may only materialise over the following decades, the actions they take today will determine the extent and impact of those future risks.

The risks from climate change that banks are analysing and integrating into their operations today, can broadly be split into two types: physical and transition risk.

 

Physical risk covers issues which the world may face in the future as a result of climate change causing melting glaciers, sea level rises and increasingly frequent extreme weather events, which in turn might cause catastrophic knock on events on the operations of various businesses.

In order to protect and mitigate against the future physical risks of climate change, governments around the world have been increasingly introducing new policies that are designed to encourage the move to an economy that will less severely impact global climates – a green economy. The application of these green policies represents transition risk.

 

Enhanced Disclosure

To protect against the future physical and current transition risks of climate change, banks must perform detailed analyses of their existing investment portfolios, to ascertain the degree to which each individual investee company is exposed to each of these risk types.

The critical first step in this process is better disclosure. Banks can only make well-informed decisions if the companies in which they invest are disclosing adequately.

The Task Force on Climate-related Financial Disclosures (TCFD) was launched almost immediately upon the signing of the global Paris Agreement in 2015. Its recommendations were published in 2017 and supported by global financial institutions, including the Bank of England.

Whilst the recommendations were extensive and applicable to all companies, a key issue was that they were only voluntary. Over the past five years the TCFD’s recommendations have been adopted by an increasing number of large businesses, albeit to a varying degree.

Fast forward to 2020 and the lessons learned from Covid appear to have rapidly intensified the urgency of ensuring financial systems are resilient to natural disasters.

In November 2020, we saw the UK Government announce that climate-related disclosures would become mandatory by 2025 for large companies and financial institutions, with some companies having to disclose from as early as 2021.

Other governments are expected to follow suit.

 

Climate Scenario Analysis

Even with increased disclosure from their investee companies, banks are faced with the problem of continuing uncertainty. The extent to which climate change will affect the economy depends on the temperature pathway, on a global scale as well as local.

Leaders around the world agreed in 2015 that to avert catastrophic events in the future, climate change must be restricted to no more than 2˚C above pre-industrial levels by 2100, and ideally kept below a 1.5˚C increase. Governments collectively agreed to commit to achieving these targets.

The problem is we are currently on a failure path ([2.6]˚C)1 and nobody quite knows which temperature pathway we will be on in the future.

One way in which banks can manage these uncertainties is to use climate scenario analysis and stress testing.

By incorporating multiple scenarios that cover a range of temperature pathways from a best case 1.5˚C to a worst case of >4˚C, banks can assess the resilience of their own operations, and that of their investment companies, across a wide range of possible future climate outcomes.

By analysing the sensitivity that companies are exhibiting across the whole range of likely futures, banks can determine today which companies are best prepared for the climate related storm that lies ahead, both physical and transition.

 

[1] https://climateactiontracker.org/global/temperatures/

 

Banking

COMBINED RISE OF M&A AND CYBER RISK CREATES STORMY SEAS FOR INVESTORS

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UK organisations carrying out merger and acquisition (M&A) activities must improve pre-acquisition due diligence of software vulnerabilities

By Philippe Thomas, CEO at Vaultinum

At present, the UK is seeing a sharp rise in M&As. Indeed, in the first quarter of 2021, the UK saw a £1.1 billion increase in domestic M&As when compared with the same period in 2020 (Office for National Statistics). This trend is set to continue, with 57% of UK executives reporting that their companies intend to pursue M&As in the next 12 months, and 65% of these respondents focusing on cross-border acquisitions (EY). As such, UK businesses have given a clear vote of confidence in moving forward with M&As, making them a focal point for accelerated organisational growth and development.

Philippe Thomas

Traditionally, organisations and investors have conducted due diligence covering financial, legal, operations, and human resources. Comprehensive software due diligence is not always carried out systematically, which has significant adverse consequences given that a company’s technology is increasingly its primary asset. As non-tech organisations use more and more tech for their day-to-day operations, and as the number of tech-forward companies grow, new issues have arisen which are overlooked in traditional due diligence.

 

A crucial time for tech security

Data breaches during M&As have become infamous during the last few years, with more than 1 in 3 executives surveyed by IBM reporting data breaches associated with M&A activity during the period of integration. This figure could be set to increase, as statistics highlight that cyber-attacks are rising sharply in the UK. According to Sophos data, 51% of UK organisations were affected by ransomware attacks in 2020, with criminals successfully encrypting data in 73% of these attacks. Cybercriminals are increasingly targeting organisations in ransomware attacks with the eventual goal of large-scale business interruption. Carrying out comprehensive due diligence that assesses both software and source code during the pre-acquisition phase enables the early identification of data breach risks, providing the acquirer with a full view of the financial and legal consequences at this stage of negotiations.

Acquiring or merging with a secondary company that has hidden data vulnerabilities can impact the primary company’s business operations, investor relations and reputation. The most well-publicised example of this occurred in 2017, when Verizon revealed a pre-merger data breach at Yahoo!. During negotiations of the merger, it was revealed that Yahoo! had experienced a data breach during which a hacker stole the personal data of at least 500 million users, followed by a second data breach in which 1 billion accounts were compromised and users’ personal information and login credentials stolen. In this instance, Verizon had done their due diligence, and were able to make an informed decision about going ahead with the deal. If Verizon had not carried out any tech due diligence, and this data breach had not been revealed during the negotiations, Verizon could have overpaid for Yahoo!, as well as experiencing long-term legal and reputational damage. Instead, both companies understood the liabilities before entering into an agreement.

Other companies have not been so lucky. In 2016, Marriott International purchased Starwood Hotels & Resorts for $13.3 billion. Two years following the merger, Marriot revealed a huge data breach in Starwood’s reservation system that occurred pre-merger in 2014, in which 400 million guest records were exposed through a security flaw. This resulted in a $123 million GDPR fine by Britain’s Information Commissioner’s Office, as well as reputational damage for both Marriott and Starwood. This is an example of an instance in which insufficient software due diligence prior to the merger has catastrophic consequences for both the acquirer and the target company later down the line.

Software due diligence highlights risks and weaknesses in digital assets. This can bring to light data security issues, as well as other vulnerabilities such as intellectual property risks linked to the use of open-source software (OSS) licences and maintainability complications. All of these risks can affect the overall quality of the asset, and thus its value for the acquirer and so uncovering them through comprehensive due diligence at the pre-acquisition stage is essential.

 

Understanding open-source software (OSS)

For any M&A activity in which the target company’s software is a significant asset of the deal, which is now the case in most start-ups which have AI or algorithms at the heart of their offer, the issues do not end with hidden data vulnerabilities. Today, software developers often rely on public code repositories available on websites like GitHub or Stack Exchange, as OSS has a number of significant benefits, most notably that it appears to be free at the point of use. However, many OSS licences are often offered subject to conditional restrictions. When using OSS to create derivative products or linking source code to OSS, the integrated product becomes subject to these conditional restrictions, which can include making all or part of the code public or paying a fee for its use. In other words, a company may not have full rights to their product or software.

This is problematic for any tech-enabled company in general, but can be uniquely catastrophic during M&As. If acquirers carry out comprehensive due diligence in the pre-acquisition phase and discover any such OSS embedded in the target’s software, they may walk away from the deal entirely, or at the very least adjust its value and/or terms. If acquirers do not implement comprehensive due diligence, they become liable for the target’s previous use of OSS, and any terms relating to its licencing.

 

Algorithms add robustness to tech audits

Carrying out comprehensive software due diligence is essential during the pre-acquisition phase, to avoid the aforementioned issues associated with data breaches and software licencing. Today’s advances in AI technology enable these audits to be thorough, analysing every line of code to identify possible cyber vulnerabilities, intellectual property issues (usually linked with the use of open-source code) and maintainability risks.  These methods enrich traditional tech due diligence, by making audits more objective and less susceptible to human error.

Ultimately, this approach protects the acquirer’s reputation, ensures business continuity, and helps avoid possible legal liability for the target’s previous vulnerabilities.

 

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Banking

THE GROWTH OF DIGITAL BANKING: WHY COLLABORATING WITH FINTECHS IS CRUCIAL TO ADAPT TO CUSTOMER DEMANDS IN LIGHT OF THE PANDEMIC

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The growing customer demand for a seamless digital banking experience looks set to transform how the entire banking industry operates. Traditional banks have been left playing catch up with the emergence of new fintech players and challenger banks. The demand for slick digitally finance solutions is led by the digital native generations, the millennials and Gen Z. However, the coronavirus pandemic accelerated the uptake of online shopping and remote working for whole swathes of the population. Even the older generations have been left wondering why accessing banking services online remains so cumbersome.

Consumers’ growing desire to access financial services through digital channels has already led to a surge in various new banking technologies which are reconceptualising the banking industry. Consumers have rapidly moved to adopt payment solutions such as those offered by apps like Revolut.

Manoj Mistry

Retail banks continue to launch platforms in the Banking as a Service (BaaS) space, in an effort to remain competitive. An example of this in the UK is how NeoBank (Starling) used to only offer business to consumer (B2C) retail banking services. However, once it launched its BaaS platform, Starling was able to rapidly diversify to include consumer services.

New technologies like blockchain and artificial intelligence (AI) continue to evolve, and look set to have an enormous impact on banking over the next three to five years. The type of cryptocurrencies that we have seen to date look set to be far more tightly regulated, given significant governmental concerns about their potential for misuse in cybercrime and money laundering.

In the blockchain space, the transformative development which will accelerate the rise of digital finance is the advent of central bank-backed digital currencies. The US Treasury has described the creation of a digital dollar as a high priority project. China is already trialling its digital Yuan. Meanwhile, the ECB is actively pursuing its plans to launch a digital Euro. The launch of stable, highly secure digital currencies, underpinned by major central banks, looks set to ensure that digital finance will permeate every area of our lives in the not too distant future.

How we use digital finance is also set to change radically. We are used to seeing new technology emerge from Silicon Valley. However, an analysis by KPMG Australia suggests that a new breed of apps which prefigures the future of digital finance has already emerged in the East. The report notes that “super apps” are “already encroaching on traditional financial services territory”.

Super apps are defined as apps which “essentially serve as a single portal to a wide range of virtual products and services. The most sophisticated apps – like WeChat and Alipay in China – bundle together online messaging (similar to WhatsApp), social media (similar to Facebook), marketplaces (like eBay) and services (like Uber). One app, one sign-in, one user experience – for virtually any product or service a customer may want or need.

“Due in large part to their versatility, super apps have quickly become ingrained into users’ daily lives. It is not unusual for a WeChat user in China to set up a date with a friend via instant messaging, make dinner reservations, book movie tickets, order a taxi and pay for every transaction along the way, all using one single app.”

We are already beginning to see trends in this direction in the Western world, with Facebook launching a marketplace and even a dating service within its social network. Facebook also attempted to launch its own digital currency, Libra, but this move stalled when it ran into significant governmental opposition. However, Facebook hasn’t given up, and it is determinedly pursuing the launch of a revamped stablecoin, Diem, which has been redesigned to address regulatory concerns.

A group of Citi analysts recently wrote an interesting research paper, which predicts that “the story of digital money in the 2020s will be the growth of tokenised money”. Noting that both Big Tech and Central Banks “are building new payment formats and rails,” they say that “while stablecoins such as Diem await regulatory approval, they could benefit from the huge network effects of their Big Tech sponsors. In fact, Diem could be an effective tokenised payment format inside the Facebook universe.” The paper predicts that “Stablecoins, such as Diem, could benefit from the huge network effects of their Big Tech sponsors”. With 3.3 billion monthly users, Facebook certainly has remarkable global reach.

The idea of an integrated tech platform which enables people to interact and purchase goods and services – including financial services – is now being pursued by many major players.

Amazon has long been rumoured to be planning to launch its own bank. Yet, research by CB Insights concludes that, “from payments and lending to insurance and checking accounts, Amazon is attacking financial services from every angle without even applying to be a conventional bank.” This is perhaps not surprising. After all, tech companies rarely replicate existing models. They usually find disruptive new ways to achieve the outcomes that consumers want. Even the messaging service, WhatsApp, has recently moved into financial services with the launch of WhatsApp Pay.

As money becomes digitised and tokenised and ever more areas of our lives move online, the distinction between an online marketplace, a social network and a financial services provider will continue to blur. How traditional financial services companies react to these developments remains to be seen. Some may partner with tech companies in creating new services. For example, Visa and Mastercard were involved with Facebook’s Libra stablecoin project. Visa also responded to the popularity of peer to peer payment services such as Revolut by launching Visa Direct, which enables users to make payments directly to another account in 30 minutes. Most major banks now support Apple Pay, which enables users to authorise payment by scanning their face or thumb.

Banks can also collaborate with tech companies in terms of data sharing, in order to better understand what their customers want. A company like Amazon knows what books people like, what music they listen to and what they purchase. By combining such data with wider financial data, remarkably predictive Big Data models could be created. Some banks might increasingly pursue opportunities to monetise data, while others might make privacy their unique selling point.

The banking sector fundamentally deals with money. Yet, the very nature of money is set to change, as it becomes digitised. Banks are no longer merely competing with each other, but they are both competing and collaborating with tech companies and social networks. Looking ahead, the only certainty we have is that we are in for a period of remarkable change.

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