Communications of the ACM

Communications of the ACM

Product-Market and Technology Strategies in Banking

By Christopher P. Holland, John B. Westwood
Communications of the ACM, June 2001, Vol. 44 No. 6, Pages 53-57
10.1145/376134.376160
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From the 1950s to the 1980s, bank markets were heavily regulated, which protected incumbent banks from any form of external competition. This period of stability has come to an end, and new entrants such as GE Capital, Ford finance, and, in the U.K., supermarkets such as TESCO and Sainsburys, have blurred the boundaries between banking and other industries. The main sources of change are globalization and customization, information technology, and increased customer sophistication, all of which have wrought massive changes in the competitive environment of banks.

Banks have tended to lag behind other industries regarding globalization and customization, but there are instances where banks are actually more sophisticated in these areas. For example, First Chicago integrated its U.S. and U.K. operations through the effective use of a common Lotus Notes database [5]. Similarly, Coopers & Lybrand has successfully used IT to create a "virtual" global entity composed of its multiple national partnerships [8].

Because of their retail focus, the globalization process has affected commercial banks differently than investment banks. Retail financial services are organized predominantly on a national basis, and even those organizations that have an international presence do so on a multi-domestic basis with little integration of strategies and systems [2]. The classic example of a multi-domestic strategy is HSBC, which operated its global retail banking under national brands until 1999. The exception to the national focus in retail banking is Citigroup, a leader in personal banking for high net-worth individuals, which also has a tradition of global card and telephone-based delivery systems.

Information technology is the most important single factor in changing the banking industry. Most innovations in financial services have been enabled by the creative use of IT, and the speed and scale of change are increasing as the pervasiveness of the technology and the propensity of customers to use it increase. In the late 1980s, Midland Bank (now a subsidiary of HSBC), introduced an innovative telephone-based banking service but did not give it sufficient marketing resources. In the second phase of its operation under HSBC, it has now attracted almost a million customers after more than 10 years in operation. Prudential, the largest U.K. insurer, launched a savings account through a combination of telephone and Web marketing and has attracted a million customers in its first year of operation.

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The competitive forces outlined here are powerful agents of change in their own right, but when they act in concert their effect is to destabilize the banking industry.

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Although U.S. companies generally tend to be further advanced in e-commerce strategies than European companies, there are several European innovations in financial services, particularly in Scandinavian countries where Internet penetration is at least as high as in the U.S., and the use of mobile communications is more advanced. The most advanced Scandinavian bank is MeritaNordbanken, which offers a full range of retail financial services products through the Internet. Growth figures published recently in The Economist illustrate online customers increased from 200,000 in 1996 to 1.2 million in 2000 [4]. This places MeritaNordbanken in a similar position in terms of product range and scale to WellsFargo, which is widely recognized as one of the leading Internet banks in the U.S.

It is clear the Web will have the biggest initial impact on distribution channels. Although only a small proportion of total customers are currently banking online, the potential is enormous. At the end of March 1999, Timewell and Young estimated that BankAmerica had only 1.2 million customers online, and Wells Fargo under a million customers [9]. In this context, it is clear why ISPs such as AOL and Dixon's "freeserve" in the U.K., with 20 million and five million customers, respectively, may prove a threat to banks in the electronic domain. Although the number of online bank customers is small relative to the total number of customers, the growth rate is estimated to be 118% per annum.

From a technologist perspective, the evolution of technology standards and the ensuing battle for domination between different vendors is the primary focus of interest [3, 10]. From a business perspective, technology standards are also of importance, but only as a component of the much broader problem of how to adopt and implement systems for competitive advantage. The integration of Deutsche Bank and Bankers Trust systems illustrates how a global bank employs many different technology standards and platforms that evolved to support applications meeting customer and market requirements. The main IT issues concern project management and implementation rather than technology standards evaluation [6]. Similarly DLJ, a leading investment bank, allows each business to have its own Internet strategy, and limits company-wide technology standards to core infrastructure projects. These examples represent a pragmatic approach to technology standards in banking, where speed of implementation, a willingness to adapt and switch to better technologies as they become available, and an ability to integrate multiple standards and platforms are significantly more important than choosing perfect technology platforms.

A combination of better education and information provision means customers, particularly high net-worth individuals, are much keener to assess the market and switch their assets to follow the best deals. Increased customer sophistication is an indirect consequence of IT, and has a significant effect on the banks' ability to add value. Inexpensive or free information is now readily available through multiple devices connected to the Web. For example, J.P. Morgan is now publishing its market research reports on its public Web site.

The competitive forces outlined here are powerful agents of change in their own right, but when they act in concert their effect is to destabilize the banking industry. Such destabilization affects the profitability of the banking industry in two ways: it widens the gap between winners and losers, reflecting the concept of diverging returns first noted in the Profit Impact of Market Strategy (PIMS) study [1], and it reduces the average profitability of the banking sector as a whole. The Banker data confirms these trends. In 1999, the average return on capital for the top 1,000 banks worldwide was less than 1%, compared to approximately 1.3% a decade earlier. The range of performance over the past five years has increased from 20 to 78 (in 1999 the lower boundary was -35% and the upper boundary 42%) [8].

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Examples of Innovative Strategies

The first and most striking example of a successful new entrant was Merrill Lynch's Cash Management Account (CMA) in the 1980s, which has been credited with the demise and subsequent government rescue of the U.S. Savings and Loans sector. The CMA combined elements of a brokerage account with those of traditional checking and credit accounts and heralded the onslaught of IT-based change in retail banking. For the operational details of how the account worked, see [2]. Two main results merit particular mention because they apply more generally. The first is that IT enabled Merrill Lynch to offer innovative financial service products by combining its skills with those of Banc One of Ohio, which operated the banking side of the operation. The second is that over a relatively short period of time from 1978 to the mid-1980s the CMA brought about the demise of the Savings and Loans sector of the bank market, and the incumbents were unaware of what was happening until it was too late.

Although several banks attempted to copy the CMA, none was able to achieve the same market impact as Merrill Lynch. It appears to be much more difficult to catch leaders than originally believed, a pattern since replicated by other leaders, including Charles Schwab, Citibank, and Prudential's Egg, in the retail brokerage, global cash management, and retail bank markets, respectively. Discount broker Schwab has repositioned itself as the dominant Web-based broker in the U.S. and is now establishing a similar strategy in Europe. It has over 40% of the U.S. discount brokerage market, and has grown in less than three years to have almost three million customers, who now account for 40% of its deals. In the process, it has become a global financial brand that is arguably better known than most banks on an international basis. Once the customer base is established, it will be relatively straightforward for Schwab to diversify into online insurance and banking, and become a global, integrated financial services provider.

The first movers such as Schwab and Amazon are extremely difficult to emulate because their competitive advantage is multidimensional, consisting of several components: technology, product breadth, scale, customer relationships, knowledge, and implementation capabilities. Not all of these dimensions are visible to the market and are therefore not obvious to competitors. If a competitor was able to see the whole situation, it is feasible that individual dimensions could be copied, but it is extremely difficult and costly to replicate them all. Leaders also tend to engage in continuous innovation and growth, making them fast-moving targets. This analysis is particularly relevant when a broad range of services and expertise is required to manage and deliver the final product. Even Merrill Lynch with all of its internal resources needed to enter into an alliance with Banc One of Ohio to help it manage the banking side of the CMA account.

Egg was launched into the U.K. retail bank market by Prudential, one of Europe's largest insurance companies. It was originally a combined telephone- and Web-based banking operation but is now totally Web-based. Egg has attracted over 500,000 customers and $8 billion in deposits in less than nine months. The financial performance of Egg is still unproven, and is widely considered by banks to be a loss leader. However, traditional banks such as Halifax plc and the Cooperative Bank are emulating Egg with their Internet brands "Intelligent Finance" and "Smile." Why these established banks have chosen to develop totally new brands for the Internet is unclear, but they may be trying to distance these offerings from their traditional branch offerings.

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Bank Size and Strategy

As only a handful of banks worldwide could attempt to offer an integrated cash management account in the 1980s, few banks today can offer truly global services in investment and commercial banking. The wave of mergers and acquisitions is testament to the perceived view from Chief Executives in major banks that comparative size is extremely important to achieving their market ambitions. But certain niche operators also appear very successful in their own defined markets from both a financial and market perspective. Based on data from a detailed survey of the top 1,000 banks in the world [8] the size distribution will be used as the basis for developing a model relating bank size to product-market strategy. The distribution of total assets for the top 1,000 banks in the world is shown in Figure 1.

As illustrated in Figure 1, the assets of the surveyed banks range from $313 million (Asaka Bank) to $732 billion (Deutsche Bank), with bank size distribution heavily skewed toward the smaller banks. The modal point, indicated by the peak in the figure, is $11.1 billion and the long tail of larger banks makes the mean size much higher at $35 billion. For the purposes of this analysis, a stylized version of the current situation is shown in Figure 2.

Two vertical lines shown in Figure 2 split the banks into three broad groupings: focus, juggernaut, and death valley. The current wave of consolidation and mergers is clearly moving the right vertical line further to the right, and it seems likely banking will soon resemble other global markets, such as the automotive, aerospace, and airline industries, which are dominated by a handful of large companies, and it appears that there is likely to be room for only a handful of juggernaut banks (probably 4–6). In the automotive industry this has already happened, and there are two major companies in each region: Volkswagen and Daimler-Chrysler in Europe, Ford and GM in the U.S., and Toyota and Honda in Asia. The right vertical line is currently placed at $350 billion and there are currently 25 juggernaut banks. The left vertical line is currently at $40 billion and most banks are in the focus segment (approximately 80%).

Focus. The main focus strategies are market focus (a particular segment), geographical focus, supply chain focus, and product focus. Republic Bank of New York focuses on global high net-worth individuals and offers a sophisticated personalized banking service. The Cooperative Bank in the U.K. focuses on domestic retail customers and differentiates itself from other domestic banks by being the only "green" bank, which is reflected in its ethical and environmentally informed investment policy and its internal use of energy resources. The Cooperative bank's operational strategy is based on customer relationship management through multiple distribution channels, combined with effective outsourcing of most other functions, including bank processing and IT systems. Another focus strategy is to concentrate exclusively on a particular stage in the bank supply chain, such as transactions processing (Banc One of Ohio, ABN Amro). In Europe this approach is being developed into a separate business-banking brand by Deutsche Bank, which has launched a "European Transactions Bank," essentially a factory for processing back-office transactions for European commercial and investment banks.

Juggernaut. The juggernaut strategy is based on size to control the market. The PIMS studies demonstrated companies controlling large market shares typically outperform the average return in that industry [1]. Mergers and acquisitions within the same country such as Lloyds-TSB, and BankAmerica and NationsBank have been justified on the basis of economies of scale and cross-selling of products, which should lead to greater efficiencies and increased revenues. Although this has seldom been demonstrated in practice. The Deutsche Bank and Bankers Trust merger is the creation of an international universal bank from a traditional commercial bank and an investment bank, and represents the ultimate juggernaut strategy.

It is plausible that to qualify as a juggernaut bank, a minimum asset base of $1 trillion may soon be required. Cross-industry mergers that have already occurred in the media and communications industries such as AOL, Time Warner, and EMI set the example for, say, Barclays and British Telecom to merge to form a banking/telecommunications giant, which could leverage core strengths in financial services, telecommunications, and customer relationship management.

Death Valley. The banks in death valley will struggle because they will be caught between banks focusing on particular segments and market niches, and by the market power of juggernauts. They are too big to be small, and too small to be big. This was Midland's problem before it was acquired by HSBC. However, it is not always straightforward to position banks. Is Lloyds TSB a juggernaut (it is the fourth largest bank in the world measured by market capitalization) or its focus (predominantly domestic customers, strong emphasis on retail). Similarly Bank Austria is a juggernaut in Austria, but can only be classified as a focus bank in Europe. Banks in death valley must recognize their position, and then formulate a strategy to get out, either by becoming more focused (and perhaps more vulnerable to takeover), or by merging/forming alliances to become a juggernaut. The remaining option, and the ultimate challenge, is to try and become both.

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Conclusion

Information technology and other business forces have destabilized bank markets. The overall profitability of banks has declined over the past 20 years, accompanied by diverging returns. New entrants have had a significant effect on competitive strategies of the incumbents, and also changed the expectations of customers placing incumbent banks in a vulnerable position. The immediate threats are the online brokerage firms such as First Fidelity and Charles Schwab, and the launch of simple bank products by nonfinancial services organizations such as retailers, telecommunications companies, and large insurance organizations. The new entrants exploit the fact that bank value chains are being broken up into their constituent parts and the separate activities of relationship management, processing and IT infrastructure, and distribution and risk are likely to be managed across a network of organizations with distinctive skills and competencies. The next wave of competition is likely to come from retail e-commerce companies such as AOL and Amazon.

The nonfinancial companies have strong advantages over banks because their marketing databases and associated management information systems give them more insights into customer behavior and requirements than banks' information systems typically allow. Banks have traditionally been poor at exploiting their customer databases to segment markets, and although they have information on assets, payments, and sometimes investments, they rarely know much about their customers in terms of their buying habits and aspirations.

The size-strategy model is a powerful framework for analyzing bank markets. However, as organizations become more virtual, it may need to be amended. For example, a small bank can achieve scale economies by outsourcing agreements with a large transaction bank such as Banc One of Ohio or ABN Amro. It can then combine this scale economy with superior customer relationship software and sophisticated links to the money markets. A small bank can therefore focus on the gateway with the customer and can deliver products or fee-based services from a portfolio of product offerings actually managed by other financial service organizations. It is then possible for focus banks to achieve the benefits of size without asset ownership. The compound growth rate of new entrants in Internet banking also suggests it may be easier to grow Internet market share rather than acquire it, which makes established brands and high levels of assets of less value than on the high street. The strength of Internet brands such as Egg, Smile, AOL, and Amazon also raises the possibility of Internet brands transferring to the high street. This may be easier to achieve than high-street brands moving to the Internet. Banks have a very short time periods to establish their presence, probably less than two years. If they do not react they are at risk of being overtaken by new entrants, which in terms of market capitalization, if not asset size, will be juggernauts in their own right.

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The Digital Library is published by the Association for Computing Machinery. Copyright © 2001 ACM, Inc.

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