Monday, January 14, 2008

Competitive Advantage and the Financial Mess

There is a strong drive within a market driven economy to create and sustain competitive advantage. Competitive advantage is a concept that is associated with the work of Michael Porter (Competitive Strategy and Competitive Advantage are his best know books) and refers to the ability of a firm to develop a strategy in which they achieve some kind of market power. This market position will allow the firm to continuously produce a superior performance, meaning that it, the firm, will earn a rate of return on invested capital that exceeds the opportunity cost of this capital over an extended period of time.

In this comment, I would like to examine this drive for competitive advantage and apply it to the recent experience of financial institutions with respect to their move into Subprime Mortgages and other Asst Backed Debt Securities. Over the past fifty years or so, financial innovation has been one of the major driving forces in the financial services industry. Whereas, in many cases this has been beneficial to financial firms, the recent meltdown of the subprime mortgage market has provided us with evidence that this innovation can get out of hand. And, since the drive for competitive advantage applies to all firms, I believe that we can gain some insight from this recent experience that can be used in all industries.

One way to achieve competitive advantage is to create a monopoly or a position of market power (a position of having control over pricing decisions in the market). In their book, Competition Demystified, Bruce Greenwald and Judd Kahn argue that monopoly power can only be achieved “locally.” By “local” they mean either in a geographic region or in a product space. Geographic region is self-explanatory. Commercial banks used to have ‘local’ positions of market power created and maintained through the banking laws of the states and the Federal Government. In terms of product space, it is argued that Microsoft has a strong position of market power in Computer Operating Systems.

Having a monopoly position or a position of market power within a market can mean many things, all of which contribute to a firm’s ability to sustain competitive advantage. For example, banking laws provide a barrier to entry for any other group of people that want to form a new bank within a geographic region. An organization that has a position of market power in a “local” region can achieve economies of scale that allow the firm to produce lower prices than anyone else. The example here is Wal-Mart as it was originally conceived. Having market power in a product space can also create barriers to entry as potential entrants must face such economic hurdles as switching costs, network effects, and positive feedback loops within the product space.

One of the biggest dangers faced by the leaders of firms that have a position of “local” market power or monopoly is the urge to expand beyond the “local” position. The “local” position is achieved by focus and persistence. But, ‘larger’ firms provide executives with benefits over and above what might be gained in ‘smaller’ firms. The argument for growth is easily defended: If firms can create competitive advantage “locally” then it can be assumed that they have the ability to perform on a bigger stage. Growth becomes the mantra of the company, displacing return on capital as the major objective: Achieving a higher rate of return on capital is the longer run goal, but the company needs to expand first so as to grow or maintain market share. What executives got personally (higher salaries or bonuses) was not an issue…of course.

Financial innovation has become increasingly important for the financial services industry in the last half of the twentieth century. Most of the innovation has been to fill niches in financial markets so as to make the financial markets more efficient. Thus, it can be argued that financial innovation comes about to improve risk sharing and bring financial services into areas that were not being effectively served. (A good source book in this area is Financial Innovation and Risk Sharing by Franklin Allen and Douglas Gale.) The subprime market was an attempt to bring mortgage finance to people that had not been able to borrow to purchase a home. This, in itself, is a commendable goal and some success has been achieved. However, other problems have obviously arisen.

Allen and Gale present evidence that supports the conclusion that financial innovation created areas in which financial institutions could achieve some form of monopoly power for their innovations. They state that “Innovating (investment) banks that introduce an innovative product subsequently obtain a larger market share than imitators.” (Page 35) Innovation appears to have created competitive advantage for financial institutions within “local” product spaces and hence provided these organizations with superior performance. There appears to have been ample reason for these organizations to continue innovating.

Note, however, that Allen and Gale do indicate that imitators do arise in an attempt to compete away the superior returns. This is normal market behavior and it is a phenomenon that Greenwald and Kahn emphasize in their book. However, normal competitive pressures will tend to eat away at a position of market power, resulting in lower returns for the innovator. There is always incentive to eliminate competitive advantages. [In financial markets, the Quants have contributed to this competition and have caused returns to diminish even further. For an interesting up-to-date article on the Quants see “The Blow-Up: The quants behind Wall Street’s summer of scary numbers” by Bryant Urstadt in MITs, Technology Review, November/December 2007.] Allen and Gale show that in earlier cases of financial innovation, investment banks were able to maintain their market position.

If competitive advantage cannot be maintained, firms become ‘price takers.’ This results in reduced rates of return on each equity dollar invested where total revenues can only continue to grow with a rise in total dollars invested. Only financial leverage (more and more debt relative to equity capital invested) can keep revenues growing. Thus, financial institutions were driven to pour more and more money into a given ‘product space’ in order to achieve growing revenues to overcome the decline in any competitive advantage that might have existed at one time. Volume (growth) became the game in order to make more fees on underwriting and trading. Corners were cut, as on credit worthiness, on the amount of down payment, and on documentation, and excuses were made to justify the behavior. (In the case of housing, the inflation of housing prices that had existed for decades, was used as a rationale for lowering credit standards and minimizing down payment requirements because it created ‘equity’ for the borrower.) The housing market that at one time had been “local,” became national and then global.

What do Greenwald and Kahn say about a situation like this? Competitive pressures that cannot be offset by barriers to entry, economies of scale, or other means, can only be combated by expense control or cutting costs. Porter also concludes this as well. Unless you can establish and sustain competitive advantage in some way, price competition, or, in the case of financial markets, arbitrage, will eliminate the superior returns. A firm cannot grow itself out of a loss of competitive advantage. Experience has shown that the existence of competitive advantage is the exception rather than the rule and one must intentionally create it, protect it and promote it as diligently as one can. However, one must be willing to change focus when it becomes obvious that competitive advantage cannot be sustained. (Remember the classic response of Dustin Hoffman in The Graduate? Plastics!)

The lessons: first, competitive advantage can come about through the creation of “local” monopoly, either geographically or within a specific product space. Second, competition will arise and, sometimes become quite fierce, to participate in the superior returns that are being earned by the firm with market power. Third, a firm must continuously work to protect the factors that contribute to competitive advantage or create new factors. Fourth, competitive advantage may not be able to be sustained and managements must be realistic about this and change their tactics in such cases. Fifth, growth can destroy competitive advantage and executives must not become blinded by its allure.

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