sou · GOB311d5 · 2001-01-01 00:00:00 — The last potential source of scale and scope economies is the benefit of diversification. From a corporate finance perspective, this benefit is controversial. After all, investors (shareholders) could diversify and why 19 In Section 2.4, I have discussed the effect of increasing competition on the reusability of information. The conclusion there was that bank-borrower relations may have shortened in duration and hence reduced the reusability of information, but that simultaneously investing in information acquisition may have gained in importance for competitive reasons. Volym D:238 Supplement 27 would a financial institution itself need to do this? But, nevertheless, low variability of returns is considered very important in banking. My assessment is that scale and scope economies are present. However, the complexity of running the larger organizations needed to exploit these are far from trivial. I would expect, therefore, that the empirical evidence in a cross-section of financial institutions will continue to be mixed. In terms of observed bank strategies this will translate into the co-existence of specialized and more financial institutions. Consolidation and Strategic Positioning 4 Scope as a Strategic Advantage The explanation developed in this section is that strategic uncertainty about future exploitable core competencies may dictate broadening of scope. The basic idea is as follows. Suppose a bank knows that – perhaps due to deregulation – it can participate in a non-banking market at some time in the future. The problem is that this is a new market for the bank, so the bank is highly uncertain about whether it has the skills to compete effectively in that market. It has two choices. It can wait until that future time to find out whether it has the capabilities and "core competencies" (as defined by Hamel and Prahalad [1990]) for this new market. Or it can enter the market "early" and discover what its skills are prior to making costly resource allocation decisions. The advantage of the second approach is that it permits the bank to "experiment" with a new business and learn whether it has the skills to compete in that business. This learning permits better decisions when competition commences. In particular, having better knowledge about its own skills allows the bank to be more aggressive in its output decisions and gain market share when it knows that its skills are superior to those of its competitors, and to exit the market when its skills are inferior. One can explain scope expansion as the bank reserving the right to play in a variety of "new" activities. By making incremental investment today, the bank puts itself in a privileged position through the acquisition of superior information by learning. This allows the bank to wait until the environment becomes less uncertain before determining whether to compete in the new market and if so, how aggressively; see also et al. [1997] for the link between strategy and uncertainty. In a recent paper (see Boot, Milbourn and Thakor [1999]) a formal model of banking has been developed that formalizes these ideas and incorporates scope as a potential competitive advantage. The framework in that paper is as follows. It starts out with a banking sector with narrowly defined existing activities and asks whether banks should expand into a "new" activity. A key feature of the analysis is that there is strategic future uncertainty about the demand for this new activity, i.e. the activity has only in the long run and demand may not Volym D:240 Supplement 27 The bank must decide whether or not to expand in this activity, and if so, whether to enter early or late. entry is costly because the activity becomes important only later. Demand may not materialize, and entering early requires investments to be made prior to the resolution of demand uncertainty. Moreover, the scope expansion associated with investing in strategic options could reduce the competitiveness of existing operations (say due to dilution of focus). However, early entry offers potential strategic advantages. In particular, early entry could lead to the discovery of skills that would allow for a more efficient delivery of the new activity and hence make the commercial bank a more credible competitor once the of this activity become clear. The question is: when will the benefits of early entry outweigh the costs? The uncertainty about skills plays a key role here. If this uncertainty is substantial, early entry may be beneficial. The other key factor is the competitive environment of the banking sector, and the anticipated competition for the new activity. Suppose that the new activity can also be offered by a specialized provider (a "boutique" specializing in this activity). If the commercial bank enters (early or late), we could consider the market for this activity as a Cournot duopoly game. entry is beneficial because the bank would then learn its skills in the new activity. This allows the bank to compete more aggressively when it has favorable information about its skills and more cautiously when it has poor information about its skills. The benefits of early entry also depend on how likely it is that a specialized provider will come along. Whether early entry is optimal will thus crucially depend on the competitive environment. 4.2Importance of the competitive environment Also the competitive environment of the existing banking activities enters the analysis because of the investment and risk associated with early entry in the new activity. If banking is sufficiently competitive, banks would be unable to absorb the investment and risk that come with early entry. An immediate implication is that investments in strategic options and thus the adoption of broader, less-focused strategies will be observed in less competitive industries, whereas firms in competitive industries will embrace more focused strategies. This could explain why European banks generally follow broad strategies. Consolidation and Strategic Positioning local market power allows them to afford the "widening of scope" strategy and benefit from its potential future strategic advantages. Moreover, as stated earlier, the anticipated future competitive environment for the new activity matters as well. If the bank anticipates facing or no competition in this activity in the future, early entry – with its accompanying cost of focus dilution – is unnecessary because a competitively unchallenged bank can operate successfully in this market without the benefit of early skills discovery. At the other extreme, when the anticipated competition for the new activity is very intense (perhaps due to many potential future competitors), early entry may once again be sub-optimal. The analysis in Boot, Milbourn and Thakor [1999] thus leads to the prediction that moderate anticipated competition in the new activity facilitates early entry. In Table 3 I have summarized the main insights. Optimal scope as function of the competitive environment Current competitive environment in in the strategic option (new activity) (Narrow - no early investment in new activity, Broad - early investment in new activity) The analysis shows that the competition in the banks current activity, the competition it anticipates in the future in a new activity, and the degree of uncertainty about future skills needed in the new activity combine to lead to predictions about early entry and hence optimal scope. Scope expansion is seen to be optimal when there is high strategic uncertainty, moderate competition expected in the new activity, and low- to-moderate competition in the existing activity. In this context also the benefits of consolidation could be explored. Now assume that there are multiple competing banks at the outset. Consider two of these banks contemplating a merger. The question before them is whether consolidation (merging) today gives them a competitive advantage in undertaking the new activity tomorrow. Boot, Milbourn and Thakor [1999] show that the benefit of such a merger is twofold. First, merging may help create "deep pockets" making investments in strategic options more affordable. Second, merging leads to diversification in skills. The two banks jointly have a higher probability of having the right skills to compete in the new activity than Volym D:242 Supplement 27 each has separately. While both effects may work in concert in many mergers, either effect by itself could rationalize a merger. It should be clear that these effects have significance in an environment without strategic uncertainty. The analysis thus predicts greater consolidation in industries with more strategic uncertainty. 4.3Is strategic uncertainty special to financial services? Why does this model of strategic uncertainty fit banking so well? There are at least three reasons. First, deregulation in financial services is opening doors to new activities for banks at a rate that is unprecedented since the Great Depression. Second, the swirling tides of technological and regulatory changes are generating a level of uncertainty about the skills needed to operate successfully in the future that is perhaps greater in banking than in any other industry. Lastly, banks have traditionally faced limited competition in their home markets. This has created "deep pockets" across the industry, and serves to support the broad strategies observed in banking. In particular, the combined validity of these arguments makes the model especially suited for the banking industry.20 The precise interpretation of the model of strategic uncertainty could also be amended to fit banking even better. In particular, we could interpret the banks problem as the bank not knowing what combination of activities will give it a competitive edge in the future. Now we would not necessarily be talking about a bank entering new activities but possibly about the bank entering "old" activities that it traditionally chose to abstain from. entry, or better, choosing a wider set of activities would let the bank discover what activities optimally fit together. This interpretation would be fully consistent with the analysis in Boot, Milbourn and Thakor [1999]. 20 However, this does not limit the applicability of our model. In fact, any industry with similar characteristics to those given above – such as pharmaceuticals or telecommunications – is amenable to the interpretations and insights provided. Consolidation and Strategic Positioning I will discuss political considerations in the context of differences between the banking industry in Europe and the US In both, government interference has been quite dominant. Consolidation has been observed in Europe already for some time and in the US more recently. But is there really something to be learned from experience, or from the American experience for that matter? And are experiences across continents and countries comparable? In a recent paper on corporate governance, and I describe one of the big fallacies in comparing models of corporate governance. We say "the rhetoric about corporate governance appears to us to be divorced from reality in that two paradigmatic governance systems – the German model and the US model – are not really models at all. [] The German model is not even a model for the rest of Europe" (Boot and Macey [1998]). I feel the same in the context of discussing European or American trends. Of course, some obvious lessons can be learned. For example, the more consolidated financial sector observed in Europe gives a clear hint about what can be expected in US banking when regulatory constraints become less binding (as they have become in recent years). But what can be said more fundamentally about the diverse European experience? And what can be learned from the US experience? Let me first focus on the arguable superficial common European experience as it may relate to the US Europe and the US share some similar dynamics. In particular, the relaxation of constraints on interstate banking in the US is reminiscent of Union banking directives liberating cross-border banking. However, immediately, a fundamental difference between US and Europe surfaces. The domestic banks in Europe were – and are – protected as domestic flagships. A fundamental belief that financial institutions should not be controlled by foreigners has (so far) almost prevented any cross-border merger. The political dimension is at the root of this. Even in countries that do not have any direct interference by governments in banking operations and where banks are considered truly commercial enterprises (and have generally been successful, e.g. ABN and in The ), the political dimension is important. Central banks, ministries of finance and the banks operate in close concert. This is not very surprising: a very homogeneous group of executives is in charge of the financial sector, central bank and government ministries guaranteeing Volym D:244 Supplement 27 a clear national identity of domestic institutions. In countries with explicit government involvement (e.g. and ), foreign control over domestic institutions is even more unlikely unless banks become so inefficient and weak that involvement of foreigners becomes almost inevitable. To some extent this is happening. For example, in the recent bidding war for the French , ABN was favored by some because of its excellent track record vis-à-vis competing French bidders. The primary response to the liberating E.U. directives has so far been defensive: domestic mergers are generally encouraged to protect national interests. A case in point is . Many have observed that banking in that country is surprisingly dispersed despite the powerful images of , and . Public policy definitely aims at protecting the interests of these powerful institutions, but the consolidation is played out mainly on the Länder-level (the separate states). Indeed, precisely at the level where the political dimension is at work. This is an important explanation for the regional consolidation in German banking. So, wherever we look in Europe, I dare to conclude that the national flagship dimension has been of primary importance. Cross border expansion is rare and consolidation is primarily observed within national borders. For the US this gives direction. Interstate expansion has been a driving force behind the consolidation in US banking. Politics does now seem to interfere with interstate expansion. The political dimension in the US seems focused on the demarcations between commercial banking, investment banking and insurance. Powerful lobbies are successful in mobilizing (local) politicians and in this way have been able to obstruct major banking reform in . In other words, in both the US and Europe vested interests are at work. In Europe there are national authorities preserving their national flagships, in the US, powerful lobbies that seek to preserve traditional demarcations between financial institutions. These observations do not yet answer the question whether national (European) authorities are serving the interests of their constituencies when advocating national flagships. This is a different issue, and may have to be looked at in a game-theoretic context. If other countries are following these policies, an individual country may be well advised to follow the same policy. However, all would possibly be better off if none would follow a "national flagship policy". The ultimate success of such policy depends crucially on the efficiency of the financial institutions involved. Consolidation and Strategic Positioning 6The Future and Implications for 6.1Relevance of strategic options Let me highlight a broader interpretation of the strategic option explanation in Boot, Milbourn and Thakor [1999] in the context of the restructuring of financial services industry. Bankers strongly belief that a strong position in the home market is crucial for a successful expansion in foreign markets. Generally, this seems to be the case. I will give a few examples. Belgian banks have weak foreign operations: the Belgian political situation (the split between the French and Dutch speaking regions) did not allow for strong domestic powerhouses. Swedish and other Scandinavian banks suffered from a financial crisis in the late eighties, early nineties inhibiting their foreign aspirations. Spanish banks started to consolidate "late". Their foreign aspirations seem limited, but some (e.g. ) choose to expand in the South American market (with some success). The Dutch, Swiss and – to a lesser extent – German powerhouses have strong franchises in their home markets and may well be the only European banks with credible foreign aspirations.21 In the interpretation of the Boot, Milbourn and Thakor [1999] paper, strength in the home markets allows banks to invest in strategic options. An important one is investment banking (IB). While European banks traditionally dominated the domestic activity in investment banking, they have had a more marginal role in IB in foreign markets and now also face severe competition in their domestic IB activity. Many of them feel that a presence in IB might be important for their existence as powerful banks in the future. They are willing to accept – for the moment at least – relatively low returns on those activities. The potential but uncertain vital role of these activities in the future defines them as a strategic option. 21 I deliberately leave out the U.K. banks whose are mixed, but definitely have a strong potential. One of my more favorable consolidation scenarios would involve cross-border mergers of Dutch and British institutions. Volym D:246 Supplement 27 From a shareholder value maximization point of view, investing in strategic options might be desirable (if at least potentially sufficiently lucrative). However, how can we distinguish the "strategic option" explanation from a simple managerial entrenchment explanation? That is, managers (and governments!) may just want powerful institutions for their own sake. Distinguishing between those explanations is difficult. As the experiences of the French teach us, banks that are not accountable, and even worse, operate as playground for government-appointed crownies are unlikely to follow value maximizing strategies. Growth then becomes a managerial entrenchment strategy. Banks themselves are ambivalent too. The struggle of European banks in investment banking is a perfect example: while some see it as a strategic option, others (NatWest and Barclays) have retreated, albeit not really voluntarily! We see a similar ambivalence vis-à-vis insurance activities. Some think that it is perfectly complementary to commercial banking activities (e.g. to economize on the distribution network) and have embraced it – see and – others choose to stay out of it (e.g. AEGON). Nevertheless, as attested to in Section 3, I do believe that scale and scope economies are present in banking. I am tempted to subscribe to Calomiris and Karceskis [1998] notion of "client based banking strategies" where a bank seeks to optimally service its client base by choosing the appropriate products, services and geographical presence. Simultaneously, however, I observe that much of the consolidation in European banking is defensive. Consolidation has increased scale and scope mainly in domestic markets and facilitated local market power. Size has reached proportions that seriously questions whether anymore benefits of scale are present. And is the wider scope truly sustainable? it not cause dilution and loss of focus? If so, it will clearly limit the desirability of investing in strategic options. Instructive in this respect is that the operations of European banks in foreign markets (where they face more competition) are generally well-focused. 6.2Is national identity important? I would not dare to say that the national identity or ownership of financial institutions does not matter, albeit as free-market economist, I would choose to leave it open to market forces. As I have stated in Section 5, individual countries may sometimes be well advised to preserve national flagships. However, I am not suggesting in any way that the state should subsidize its financial institutions. Consolidation and Strategic Positioning facilitate their healthy growth and development. But favoritism should not always be excluded. I list five categories of issues: i. important considerations for the Swedish financial sector, ii. main strengths of financial institutions, iii. weaknesses and concerns, iv. options for the future, and v. the value of alliances. An important distinction needs to be made between the viability of existing financial institutions in the Swedish or Scandinavian market and the likelihood that existing institutions will preserve their independence (and remain or become national flagships) in the future. Swedish banks seem ahead in the Nordic market. An noteworthy exception is the challenge by , the largest bank in that bought the Swedish regional ; Swedish banks have followed very diverse repositioning strategies, e.g. (main focus: retail (mainly in ) and some corporate and investment banking in Nordic market; recent merger with local mortgage lender ), FöreningsSparbanken (main focus: retail in local Swedish market; result of merger between ), (main focus: pan-Nordic bank; result of a merger between the Swedish Nordbanken and ), and SE-Banken (main focus: heavier in investment banking, trading and asset management; recent merger with insurer Trygg- ); Investment banking in Nordic market is truly international with a sizable market share by foreign (non-Nordic) institutions; Strong Nordification of financial institutions. non-Nordic competition in traditional commercial banking activities. Similarly, Nordic players only focus on Nordic market; "Fortress " is to some extent being created, see also that has chosen not to participate in the pan- European cooperation of major stock exchanges. Strengths of Swedish financial institutions The Swedish financial institutions have recovered remarkably from the banking crisis of the early 1990s. In terms of efficiency numbers, Volym D:248 Supplement 27 profitability and capitalization, they belong to the top of European financial institutions. Their strengths could be summarized as follows. high return on equity; leading in Nordic countries; culturally adapt, strong relationships with . These strengths should not lead to complacency by Swedish financial institutions. Major challenges lie ahead. Weaknesses and main concerns small home market. The scale of operations that can be obtained within the Nordic market is relatively small; limited geographical diversification (Nordic market at best); (risk of) lack of true international perspective; main profitability comes from traditional commercial banking activities;22 potential mismatch between regional orientation of banks and international orientation of the major industrial Nordic corporations; risk of new distribution channels. specifically, direct banking by new entrants (possibly linked to asset management firms) could pose a threat;23 A general concern is that the regional orientation of Nordic banks potentially insulates them from new innovations. What I mean with this is that the lack of international presence reduces the possibility of "importing" innovations and/or practices from other markets. This is a serious concern. The experience is that head-to-head competition in some (foreign) markets has a very healthy impact on a banks performance in its more protected domestic market. Geographic segmentation of financial services will not adhere to Nordic borders. If autonomy of Nordic financial institutions is an 22This actually is partially a strength too, because it also points at capitalizing on strong relationships.