The Specialist Challenge

By Steve Klinkerman

Banks traditionally prospered by doing a multiplicity of things well. But Harvard's Clayton Christensen says financial services specialists ultimately will gain the upper hand.

Banks have embraced conglomeration with increasing fervor in recent years, engaging in costly transactions to either buy or merge with brokerage companies, insurance companies, specialty finance companies and asset management companies. "One-stop shopping" is the rallying cry, and some executives now rattle off cross-sell statistics as part of their investor presentations. But will customers buy into this plan for industry rejuvenation?

Clayton Christensen's answer is not encouraging. The Harvard Business School professor and author of The Innovator's Dilemma contends that specialization will inevitably become the dominant business model in banking and financial services, simply because that's what provides the most value to the customer at this mature phase of the industry. Trying to be the best at everything is near-impossible, he says. More to the point, it's tough to compete with specialists who can offer clients better value in specific product lines.

But moving away from the generalist approach poses its own difficulties, according to Christensen. One of the key insights emerging from his book is that established companies face a serious conflict in reinventing themselves. The very organizational patterns that make them so good at serving current customers can interfere with efforts to build new business models and win new generations of clients. Often, Christensen says, mature companies fail to balance the twin dictates of short-term performance maximization and reinvention, and they lose their leadership positions.

In an interview with Banking Strategies, conducted at BAI's Retail Delivery conference in Miami Beach last December, Christensen said banking executives must be clear-eyed about the challenges they face and remain mindful of the powerful forces that transfer market dominance from generalists to specialists as industries mature. He did, however, offer hope that mature companies can foster innovation by establishing independent business units and empowering them to explore new territories unencumbered.

Finally, Christensen counseled humility, saying executives can't approach new ventures with the same certainty they bring to their established operations. "History suggests that the dimensions of a full-blown business model not only are not known, but not knowable, in the formative stages," he says. "You are taking a big risk if you blow a ton of money in pursuit of a strategy at the very early stages of a market, before the business model has coalesced."

Banking Strategies: Counter-intuitively, you have suggested that managers often undercut themselves by focusing on their best customers. Why is that?

Christensen: Let's start by reviewing the motivations for pursuing the most profitable segments of an established market. One impetus is the ferocity of day-to-day competition. If you don't aggressively pursue the most profitable customers, someone else will steal them from you. If you don't anticipate their emerging needs, someone else will preempt your leadership.

The second driving force is that margins tend to collapse at the lower end of the market. Specialists come in with new technologies and lower cost structures, and they invade the mass-market end of the business. For example, Toyota Motor Corp. entered the U.S. sub-compact auto market and made good money for a while, but then Honda Motor Co., Nissan Motor Co. and Mazda Motor Corp. followed suit. Pricing collapsed in that tier. Then all four of the Japanese manufacturers moved up-market, using their efficient business models to attack progressively higher tiers of the American auto market.

We see these patterns repeated in industry after industry, and they underscore the point that companies have to keep moving into the most profitable segments in order to preserve their operating margins and trading multiples.

The danger is that mature companies, in the act of maximizing their current book of business, can miss out on emerging opportunities – both in the simpler tiers of the current market and in brand-new markets. If a business limits its innovation to only those things to which current clients are receptive, it risks divorcing itself from new generations of clients and business models needed to sustain the organization in future years. That's the dilemma. Developing ideas that the best customers do not initially use seems illogical, but it is critical for long-term survival.

Banking Strategies: Are these forces at work in the U.S. banking industry?

Christensen: I believe so. An early disruptive wave was the advent of commercial paper, which enabled Wall Street to supply short-term loans to large corporate clients more efficiently than banks. Then came the credit specialists, such as MBNA Corp., GE Capital Services and GMAC Financial Services. They used focus and efficiency to make major inroads in the simpler tiers of the lending business. On the liability side of the balance sheet, money market mutual funds provided a hugely popular alternative to insured deposits.

Now we see another wave driven by credit scoring and securitization. Instead of having lending officers laboriously underwrite credits on a case-by-case basis, new market entrants are using statistical models to make credit decisions in a standardized way. Then they are selling pools of these assets directly to investors, circumventing the need for balance sheet funding. The process has migrated from the simplest credits, like credit card and auto loans, to more sophisticated credits, like mortgages. Now it's creeping into the small business sector, which is a major market for the banking industry.

Banks have responded by emphasizing fee-based services, asset management and consultative selling, all of which could be construed as attempts to move up-market, to go beyond basic intermediation.

Banking Strategies: Based on your studies of industry life cycles, how well can these efforts be expected to work? Can the banking industry break out of its lackluster revenue trend?

Christensen: How did the mainframe computer manufacturers react when the mini-computer and then the personal computer disrupted their markets? They merged, consolidated operations, cut costs and laid people off. They just kept turning down the thumbscrews on their traditional business model. They were simply unable to transform themselves.

When I see the mergers and consolidations and cost-cutting going on among the big commercial banks, the scenario seems exactly the same. That is, as disruptive innovators seize more of the volume in the standardized end of the market, there simply isn't enough room at the high end to support all of the big traditional players. I wouldn't look to this industry for strong core revenue growth.

Banking Strategies: A number of executives at the nation's biggest banks say otherwise. Although they acknowledge the need for consolidation, they also believe that cross-sector mergers will jump-start growth. By blending banking, insurance and brokerage services, the new financial conglomerates hope to increase convenience for customers and capture a greater portion of their overall business. What do you think?

Christensen: That logic swims against a powerful historical current. Rather than integrate and generalize, the evidence suggests the industry inevitably will segregate and specialize. There is a persistent tendency for generalists to lose ground once a market has grown to a level that will sustain specialists. But rather than dividing themselves into focused units that can compete in a specialized world, ironically, generalist firms doggedly stick with their model until they are driven out of business.

The question is, can a merged company, by virtue of managerial coordination, be better and more efficient at a variety of things that could otherwise be done by independent, focused companies? History says no, because specialists always can innovate faster than integrated companies. It's a pipe dream to think that financial services conglomerates can simultaneously maintain the state of the art in online banking, and equities underwriting, and wealth management, and insurance, and so on.

The coordination mechanisms will prove too ponderous, and this already can be seen in the branch systems. It's no coincidence that many monoline providers are using the Internet to invade the banking space. They are circumventing the complicated and expensive branch delivery system and going straight to the customer online. This is a clear example of how a disruptive technology can level the playing field.

There's a compelling customer angle to this as well. Consumers hate complexity and love convenience and simplification. A department store may have what you want, but you have to wade through tons of stuff that you don't want in order to find it. Specialty clothiers step into this situation and simplify things for the customer. Everything stocked by Ann Taylor Stores is consistent with a certain lifestyle and market segment. Talbots Inc. chooses another segment, as does GapKids, and Banana Republic, and so on.

Value is added through simplification. Specialists not only can offer this simplification, but they also can offer deeper product lines and greater expertise. And because of their efficiency, they can offer highly competitive prices and still maintain healthy profit margins.

Banking Strategies: On the other hand, it's not as if all powerful generalist firms vanish. Sears, Roebuck and Co. hasn't gone away. Dell Computer Corp. hasn't toppled IBM Corp. E*Trade Group Inc. hasn't toppled Charles Schwab & Co., and Schwab hasn't toppled Merrill Lynch & Co. U.S. commercial banks still control more than $5 trillion of assets and remain a major force.

Christensen: I don't mean to be pessimistic, but going back to the examples you've cited, IBM is the lone survivor from the shakeout in the mainframe and mini-computer markets. And IBM went through hell before it disaggregrated itself into a set of focused businesses.

Sears is still here and probably will be for another 40 years. But if you compare its store count with that of the total retailing industry, and calculate the share of total retailing dollars those stores now command, Sears is a badly weakened institution. So it would be a real overstatement if I said all of the biggest companies in mature markets are going to die. But over time, they will be relegated to smaller and more esoteric tiers of the market unless they completely reconfigure themselves.

Banking Strategies: Some banking executives believe they can achieve this reconfiguration by becoming savvy aggregators of products and services obtained externally through outsourcing agreements, and by focusing on managing customer relationships and distribution systems. Do you agree?

Christensen: This approach also can prove problematic. When a system becomes sufficiently mature that centralized development of all the constituent parts no longer is necessary, margins shift from the firms that assemble end-use products to the component suppliers.

Let's step back and review how this happens. Over time, assemblers learn which specifications are the most important for each major subsystem. In the hard drive industry, for example, it might be the rate at which the storage device transfers data to the computer, or storage capacity, or mean time between failures. For a certain financial instrument, it could be some combination of yield, liquidity and risk.

Then people develop reliable metrics, so they can be assured that each part passes muster on the specifications that matter most. Finally, they learn how to control variability in the way that subsystems interact with each other. Software drivers, for example, enable a printer to reliably interact with a personal computer's hardware, operating system and individual software applications. In underwriting, a credit-scoring model might be developed that satisfactorily screens all applicants, for example homebuyers, whose loans will go into a certain portfolio.

Once these three prerequisites – specifications, quality metrics and interoperability – are met, then the formerly proprietary system becomes a market. Instead of only one entity being able to produce a product, like the personal computer, anybody can build one using off-the-shelf components.

Creating a virtual bank that derives all of its functionality from external providers is a wonderful accomplishment. But that's done in a market setting, which means others can replicate the feat. Long-term, it will be difficult for virtual banks to differentiate themselves, because they are outsourcing everything from a common set of suppliers.

So the prime rewards won't go to the institutions purchasing outsourced services. It will be hard for them to make more than subsistence profits. Instead, the advantage will go to the sellers of outsourced services – the ones providing the best credit scoring models; the best securitization services; the best transaction processing services; and the best software.

Banking Strategies: So how can banks best take advantage of outsourcing?

Christensen: Some institutions have opportunities to purvey outsourced services. Bank of America Corp., let's say, might have an excellent ability to process checks, and can do that at lower cost and with faster speed and greater reliability than anybody in the country. If that's the case, then the little banks can't afford not to outsource check processing services from Bank of America, which earns its money in that capital- and scale-intensive back office game.

My guess is, you'll see consolidation and a strengthening profit model in those critical back-end systems. Virtual banks and small-scale conventional banks will step up the demand for outsourced services. They'll outsource their custodial services from companies that have lots of scale and expertise in that area, such as State Street Corp. or Bank of New York Co., right? And this trend is not unique to banks.

You could make a compelling argument that in the retailing value chain, the big money is made in logistics management. Wal-Mart Stores Inc. makes its money from its integrated back end. The reason the discount chain is still fairly healthy is that it invested so heavily in back-end systems. By contrast, the retailers who simply own the customer interface, and rely on others for the complex back-end integration, are competing in a dog-eat-dog world.

Broadening the discussion, executives should look inside their institutions and try to identify key capabilities that could be marketed to other companies. Advantage can come from a variety of sources, such as proprietary knowledge and expertise, economies of scale, market position, and entry barriers such as capital intensity. But companies should be circumspect about what gets rented and what gets spun off or sold. General Motors Corp., for example, spun off all of its component operations. Arguably, it let go of the wrong piece of the business. Going forward in that industry, you would much prefer to own the components business than the car business.

Banking Strategies: Based on everything you're saying, how should executives and investors frame their expectations about the banking industry? The outlook was dismal in the late '80s and early '90s when the realty and commercial lending problems were at their worst. Then we saw an era of optimism as the economy soared in the mid- to late-'90s. Now clouds are creeping back into the picture as some major banks miss earnings targets and experience difficulties with mergers. What's your take?

Christensen: My perspective is that the credit-related troubles of a decade ago were operating problems. The situation facing banks now is quite different. The industry is facing a fundamental strategic problem relating to the obsolescence of the generalist business model and the emergence of disruptive new business models that are placing more of the financial services market into the hands of specialists.

So I don't think we're going to see a renaissance in the banking sector, absent some major structural changes in individual institutions and the industry itself. I do think that individual companies, for example Chase Manhattan Corp., can command attractive valuations for the foreseeable future as they find bona fide ways to improve profitability by slashing excess capacity and reaching a broader set of customers. I would look towards a continued trend of consolidation, but I would not look to the banking industry for significant core revenue growth. Individual companies might grow through acquisition. But I think the strongest organic growth, the kind that comes from healthy sales increases, will come from nonbank financial institutions moving up from the low end of the market.

Banking Strategies: So what should the industry's leaders do?

Christensen: One thing is to remain cognizant of certain market axioms. Don't ignore reality, and don't fight it. Business markets start out under a generalist model. That's the way the world works. But over time, you can expect specialists, by virtue of their ability to offer greater service, expertise and convenience within a category, to supplant the generalists, initially at the low end of the market. In turn, the generalists face a continuing need to move up-market. But the very capabilities, processes and values that enable the generalists to move up-market can actually render them incapable of succeeding in the next realm.

These are like laws of nature, and they can be intimidating for an established company. But once you understand them, then you can start to design structures that either help you gain advantage or at least do a better job of coping.

One of the most obvious principles is that you need to set up separate organizations to compete with the specialists. Why? You're trying to make money with a different business model. You need a lean cost structure to compete with the newcomers. And you're trying to reach a different set of customers.

Another law of nature is that big companies can't get excited about small opportunities. It's not that their managers are bad. It's just that for a $40 billion company, for example, achieving 10% growth requires that it find $4 billion of new business next year. This causes managers of large organizations to either dismiss or overly pressurize innovations, most of which appeal only to small markets at the outset. If a company is committed to renewing itself, it must approach innovation within the proper context. Rather than a cure for short-term earnings problems, innovation is the long-term means of gaining footholds in new markets – and should be nurtured as such.

A third precept is that the very processes that make you good at doing one thing can make you bad at doing another. People are flexible but processes are not – they are designed to do the same thing, well and consistently, over and over again. You shouldn't tangle up new projects in processes designed to support traditional business lines, especially when those business lines are profitable. That's where generalist companies get messed up.

We often hear the phrase "slow and bureaucratic." That's a symptom of a larger problem related to change management. A process can function quite efficiently in supporting one set of activities. But when you ask it to support a whole bunch of new activities, then it looks bureaucratic, because it wasn't designed for those purposes. That's another reason why focus has such value: the problem can be aligned with the new processes needed to solve it.

Banking Strategies: What's the managerial state of mind that allows a company to take advantage of these principles?

Christensen: Humility. Humility in the sense that managers need to understand that the very things that make them good in one type of endeavor can make them virtually incapable of doing something quite different. Operating processes are not to be confused with innovation processes. Burdensome cost structures limit generalist responses in a market besieged by lean specialists. Strengths also define limits.

And when you're jumping into new ventures, humility is important there as well. You can march into something absolutely convinced that you understand the new business model. But you may actually get farther by assuming the opposite, because history suggests that the dimensions of a full-blown business model not only are not known, but not knowable, in the formative stages. You are taking a big risk if you blow a ton of money in pursuit of a strategy at the very early stages of a market, before the business model has coalesced.

I'm not taking a poke at WingspanBank.com; I think it's operated by good people who are bold pioneers. But if I were funding the venture, I would hope that the unit's managers pursue their strategy with both aggressiveness and deep humility. I would want them to be convinced that they don't know how to do it, as opposed to being convinced that they've got the right strategy and just have to execute.

Mr. Klinkerman is managing editor of Banking Strategies.

Copyright © 2003 by Banking Strategies, published by BAI.

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