Wednesday, October 15, 2008

The Special Case of Financial Institutions

In my last post, “Good Management Never Goes Out of Style”, I discussed what I believe to lie at the foundation of good management. The primary emphasis of this argument is that good management focuses upon what helped to create any competitive advantage it might have and maintains that focus over the longer run. In order to do this, good management must obtain good talent and then give the good talent the room and authority to put that talent to work. Good management facilitates good talent by creating a culture of high performance while keeping the focus of the business on what can sustain the competitive advantage of the firm.

Competitive advantage produces exceptional returns but these returns are difficult to sustain because potential competitors, seeing the exceptional returns, attempt to duplicate the results and aggressive market response reduces the firms’ advantage and drives down returns. In some instances, the firm with the competitive advantage may be able to sustain competitive advantage. However, the company may not be able to sustain the competitive advantage…in many cases, it is just not possible. In such cases the only really effective action management can take is to become very efficient and reduce expense ratios.

One recognizes when these foundational principles are being neglected when firms resort to gimmicks to achieve performance. In the last post I mentioned two such gimmicks: increased leverage and the mismatching of maturities. There are many other gimmicks that can be used such as assuming additional risk, accounting tricks (hello Enron), attempts at diversification, and secrecy. As I argued, these efforts generally represent an attempt to force results and come about either from greed or hubris or both. Because they are forced and are not related to basic underlying market realities they eventually fail, often at great cost. Arguing that the world has changed and that this world-change requires new standards only lasts for so long. Losing or changing focus may produce results in the short run but it never succeeds in the longer run.

Financial institutions represent a special case that needs to be discussed separately. The reason for this is that financial institutions are generally intermediaries and therefore depend upon the two ends of the market that they intermediate. The commercial bank is the prime example of an intermediary for historically a commercial bank took small deposits from relatively small economic units that didn’t have any alternatives to depositing it’s funds in the bank, and made large loans to larger economic units that needed the funds to run their businesses. As a consequence of the nature of the business, a commercial bank was grounded in its local or regional economy. Only a few borrowers had a national presence.

This dependency started to break up in the 1960s. Bank borrowers got larger and larger and demanded larger and larger loans. Financial markets developed so that these larger borrowers found that they had more sources of funds than before. In order to support these borrowers, commercial banks had to create new instruments to raise the funds they needed to meet the changing conditions. Commercial banks began to innovate and the result was the large negotiable Certificate of Deposit and the Eurodollar markets. These markets were large and deep, sufficiently so that commercial banks could buy or sell all the funds they wanted to at the going market interest rate. (In the terms of the economist, the supply curve of funds became perfectly elastic.) “Liability Management” was created! Now banks were only limited in their size by their capital base. And, commercial banks could become truly international!

The large customers of the banks found that their sources of funds became more elastically supplied and hence their demand for funds from their commercial banks became more elastic. Bank spreads declined!

Competition worked! Now the race was on! The rest is history!

The problem with innovation in financial markets is that finance is just about information…and the marginal cost of creating more and more information is very, very low. (For an example of this idea see “Information Markets: What Businesses Can Learn from Financial Innovation” by Wilhelm and Downing, Harvard Business School Press, 2001.) Consequently, information can be cut up in many, many different ways. The primary example of this is the Mortgage Backed Security that allows mortgages to be cut up into tranches, including toxic waste, into interest only securities, principal only securities, or any other way that might be thought of and sold.

Thus, financial innovation in making financial more efficient narrows spreads as the supplies of funds becomes more and more elastic…people can buy and sell as much as they want without affecting the price of the funds they are buying or selling. But, in such markets, leverage can become infinite! And, how do people then make money? Well, they must find mismatches…mismatches in risk, mismatches in maturities, mismatches in information, mismatches in timing. There becomes no limit to gimmicks.

We have seen two types of responses to this. First, there was an increase in secrecy. With spreads narrowing it becomes imperative that others not know what you are doing. Long Term Capital Management was noted for its attempts to keep secret what it was doing. The reason…if others know what you are doing the spreads narrow even more. (Three cheers for competition!) Another way to increase secrecy was to put things “off-balance sheet”. In this way institutions could get away with smaller capital bases and riskier business than if they kept these assets “on” the balance sheet.

The second type of response is to review your business model. This is an appropriate thing to do, but in changing ones business model one must be careful about whether or not the change really builds a different business model or not. Financial institutions responded to declining interest rate spreads by cultivating the “fee-based” business model. It can be argued that this effort really did not change the nature of the business but just shifted business. If I create the mortgage, I can then sell the mortgage for a fee. Another institution can package mortgages and get a fee for that. And, another organization can service the mortgages and get a fee for that. And, another institution can…. And, so on and so on.

In this example, the financial business has not changed…just different pieces of the package have been shifted around…and risk is located somewhere else out in the world, someplace no one knows where.

A business model can be changed in a way that can create value. This is what I think the financial services industry is going to have to do. The financial institutions industry is not the only industry that is facing massive changes in this Information Age. When it becomes nearly costless to create information, the old business loses relevance and must find a new way to create value. The question for management becomes, “What is it about what I do that I can, at least initially, create a competitive advantage?”

The follow up question becomes, “After I create the initial competitive advantage, what do I do next?” We see in the case of Information Goods that time pacing becomes extremely important. I tell the young IT entrepreneurs that I work with, “It is all fine and good that you have captured a niche in the market but you must already be planning the next generation of the product or the new, new product that you will bring to market.” Modern technology produces such an environment.

What does this mean for the management of financial institutions? That is for the future to determine. I have my own ideas. But, another question is…and this is just as important…what does this mean for the regulation of financial institutions? In building new financial regulation in this Information Age we cannot just fight the past wars…especially the wars we are now engaged in. That, of course, is the hardest thing for the Government…both the President and Congress…to do! It is going to be an interesting ride.

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