The Banking Industry Problems and Competition

The Porter "Five Forces" analysis is only approximately applicable to the banking industry.  Certainly, banks do compete with each other, but they also must cooperate with one another in many respects.  There is an underlying problem in that the major banks of the world are so similar that there is essentially nothing one of them can do that the others cannot easily duplicate.  Because, contrary to some beliefs, bankers are perfectly normal human beings they do have individual abilities and interests that may have a perceptible influence on their institutions, but in the final analysis, all are essentially the same.

Retail customers, ordinary individuals, have no bargaining power whatever as a negotiator.   A classic bit of banking wisdom is, "If you owe the bank $10,000, you have a problem.  If you owe the bank $10,000,000, the bank has a problem.  The disparity in size and power of the bank and the client is so great in most cases that the client has essentially no bargaining power.  Even in the case of large corporate clients, the bargaining power of the client is limited.  Any negotiation of terms and conditions of a banking deal will take the form of a win/win negotiation where both sides are attempting to develop a "deal" that is optimum for both participants.  The client wants the money a loan represents, and the bank wants interest on the loan.  The price of credit and the credit standing of the client are pretty much givens.  The structure of the loan such as the term and the repayment must be structured in such a way that the client can meet the requirements in term of cash flows and the bank is assured of repayment.  The price of the credit may be negotiated a few basis points in one direction or the other, but both parties know going into the negotiation approximately what the outcome will be.

A bank has three suppliers of its product, money:

1.      Its depositors

2.      The credit market

3.      The central bank

The first source, depositors, has no bargaining power whatever in reality.  If they make time deposits the bank will set the price or interest rate it will pay.  If they have a demand deposit the bank pays nothing or effectively nothing for the deposit.  It is possible that there may be some v variation in services as a form of competition, but a demand account (DDA) is not subject to great variation and most customers simply want an account and don't even know the exact terms of their account.

Larger clients, corporations, government agencies, and wealthy individuals are offered packages of services in what is actually a form of "market orientation" in current management terminology.  The bank is still the dominant party, even with very large clients, but the client can make the threat of going to another bank, and if he/she/it is large enough, the threat may have some significance.  There is a distinct element of competition for the business of large accounts, but even here it would be very difficult for any entity to offer anything significant that its competitors could not duplicate almost instantly.  This part of the business becomes very much one of personalities and individuals as opposed to "marketing initiatives."  The bank advertisements on CNN all focus on the quality of the individuals and services.  They say in effect, "Our people are the best." 

The credit market as a source of supply of the raw material, money, is open to all at all times if they are qualified participants.   The source of supply can be argued to be infinite.

The Central bank is effectively the resource of last resort.  Apparently, at least for the moment, it will continue to supply liquidity to the banking system in virtually unlimited quantities at very reasonable cost.

For the most part there is no real threat of substitute products in the banking industry.  It could be argued that a personal loan is a substitute for a mortgage, but in reality both are loans and the loan is taken out because the customer wants money.  The same can be said of other bank products, and even institutions.  A mortgage company is a substitute for a bank, but it is the same product offered by an alternative vendor.  There is a good chance the mortgage company is owned by a bank holding company in any case.  The only question is the origination of the loan.  Bank transfers are more common in Europe than in United States banking practice.  They serve approximately the same function as checks and some of the new Internet banking services are actually transfers, even in the states.  There probably will be a continued evolution of products from paper to electronic in coming years.  This is an area of potential competition, and probably innovation, but the final services, moving money from account A to account B will not change.

There is no real problem in the formation of a new bank, and it is not even an unusual occurrence.  It is also not unusual for an entity such as Merrill Lynch to offer very bank like services to clients.  The market is so large and so fragmented, that the significance of a new entrant or even entrants is minute.  If the concept of the combination of existing participants into what amount to "new entities" the importance of the concept changes, but only slightly.  The ""new entity" is nothing more than a combination of formerly existing entities, and its immediate effect on the market will probably me minimal.  Longer term, its increased size and financial strength may alter the market situation slightly.

Specific Assignment Questions

1. What is the primary company's current competitive strategy (be specific)?   If the primary company is considered Citigroup, or any of the other ten largest banks, the question becomes meaningless.  No single bank is significant in the overall banking industry even it that is defined only as commercial banks worldwide.   The industry is so wide and consists of so many moving parts that the question cannot be answered meaningfully.  Does it refer to gaining deposits, producing loans, underwriting new security issues or other banking services?

2. What are the two competitors doing to improve their current competitive position?  Again, the question as posed is not meaningful.  All of the banks on the list compete in a number of individual markets.  If the question for example applies to the generation of large corporate loans or credit lines these are ordinarily syndicated among a number of banks with one or two acting as the lead bank and the other banks participating.  The banks become collaborators rather than competitors.  If the question refers to retail deposits it is much the same as any other consumer product marketing and there are constantly shifting initiatives, strategies and counter strategies.

3. What likely moves or strategy shifts will the two competitors make?  There are no real basic strategic shifts available in the banking industry.  A bank can change the emphasis from retail to corporate banking or increase its emphasis on wealth management, but these are internal shifts.  A wise bank would have made the strategic decision not to participate in the sub-prime mortgage market, but would hardly make public or announce such a strategic decision.  The relevant strategic decisions are not marketing related, but relate to shifts in asset liability composition of the institution.  Again, shifts by Citi in its A/L structure is not important to other banks or its industry situation, it is internal. 

4. Where is the primary company most vulnerable? The vulnerability of Citi is in its asset quality.  It has two obviously questionable asset classifications, sub-prime mortgages and its international loans to developing nations.  In terms of currency, the sub-prime mortgage exposure is paramount at the moment.  It has already engendered billions of dollars of losses and caused the replacement of the CEO.  Problems do not get a lot more critical than that in banking.  The international exposure is not a new problem, but one that is of long standing.  With the increasing importance of the terrorist groups in the world, the potential for serious problems is growing, but has not yet reached the level of popular press coverage and public concern.

5. Where are the two competitors most vulnerable? For most of the banks on the list, the primary vulnerabilities are probably similar.  If BNP Paribus and Credit Agricole are considered the situation of the French economy is a serious problem.  For the Japanese, the competitive element is the growing strength of the Korean economy.  These are not marketing related problems, but are strategic concerns that the banks must address.  Who gains or looses market share in the New York DDA account market are insignificant, but in terms of marketing are the level at which major banks are forced to operate.

6. What competitive moves by the two competitors will provoke the greatest and most effective retaliation by the primary company?  For the management of Citigroup, the potential problem of capital impairment which would force it to limit its activities in some market segments or even withdraw are the most serious problem from a strategic viewpoint.  If this comes to pass the competitors will have the opportunity to increase their participation in capital-intensive market segments at Citigroup's expense.  There would be little that Citi could do about the problem. 

7. Would you recommend the continuation or modification of the primary company's current strategy (support your rationale with specifics)?  Citigroup has a long history of aggressive risk acceptance, usually with positive results.  Its growth and pre*eminent position in the industry are a direct result of its acceptance of a somewhat higher risk coefficient in its overall operations than its competitors.  It has had setbacks before and the current problems in terms of asset quality are the direct result of its historic risk strategies.  It is easy to point out the problems and say that its risk strategy is too aggressive, but based on the long-term record this position is harder to support. 

Porter competitor analysis criteria

Estimated overall business strength

·    Market share (percent, rank)   As an organization there is no meaningful manner in which the concept of market share can be discussed.  Which product, loans, deposits, investment.  Which market, New York City, United States, industrialized world. Global?

·    Market share trend (five years) The growth of the organization over the long term is indisputable.   The trend of a non-definable measure such as market share is not determinable. 

·    Financial strengths Citigroup is the largest bank in the world by most measures, total asset, total capital, and earnings.  The potential impact of the current asset quality problems are potentially great, and would make in and of themselves a challenging project

·    Profitability Historically, the profitability of Citigroup has been strong.  It is a participant in a cyclical industry and has had internal problems from time to time related to its growth and specific strategic moves.  This does not compromise its overall good profit record. 

·    Management Citigroup did not become the largest bank in the world through poor management.  Clearly, its management can be faulted, and it has made errors over the years in terms of areas of concentration and emphasis on particular lines of business.  Its aggressive risk stance is currently coming home to roost, but this does not alter the overall long-term quality of its management.

·    Technology position An example of the technical position of the company is discussed later in the paper.  It is one of the largest IT users in the world, likely second only to the US Government. 

·    Other key strengths/limitations (e.g., production cost advantages) Citigroup probably does enjoy some advantages of scale, but can hardly be considered a low cost producer.  Its sheer size and global span offers numerous advantages, but also introduces problems in term of span of control in various areas. 

·    Marketing strategy (assessment of key strengths and limitations)     Competitive strategy (Porter's), Market strategy Distribution strategy  Recent offensive or defensive competitive moves .   These elements are discussed below in some detail

The industry and competitive environment

There is a fundamental problem facing all the participants in the banking industry.  The product they sell, money, is totally fungible.  In the world of modern communications it is possible to deposit funds in currency A and instantly convert it to currency B.  It makes no real difference what the customer or the bank does the nature of money does not change.  The client cannot tell a dollar from bank A from a dollar from bank B.  Indeed he has little real interest in if he receives dollars, Sterling, Euros, or Swiss Francs or virtually any other currency in the world.  For a very modest cost they can be converted into any other form of money the client desires.  There is absolutely no way in which a bank can differentiate its basic product, money.

If the product cannot be differentiated then it must be possible to differentiate the service provided to the client in the handling, storage and investment of this most precious of commodities.  If fact, in a given national market there is virtually nothing any major bank can do that its competitors cannot match very quickly.  There is also very little point in beginning a price war because again, the major banks are so nearly matched that any pricing initiative can be met by competition.  The cost of trying to "buy business" in this manner is simply too high.

There is still another problem to defining competition in the banking industry.  Major banks such as Citigroup, Bank of America, Wachovia, HSBC and even relatively smaller banks such as Bank of New York Mellon are all in a variety of businesses, not a single one.  If the definition of competition is expanded to include the other major international banks the situation changes only slightly.  The international competition includes the German, Swiss, and Japanese banks. Again, they may not all compete head to head in every market segment, but they do in most of them. In fact, it is difficult to determine who are the largest banks and indeed, how large they really are.  There are more than 10 banks in the world that have total assets in excess of US$1 trillion. 

Worlds Largest Banks
	Bank	Country	Assets US$ Mil	Equity US$ Mil
1	Citigroup	USA	$1884	$119.2
2	JP Morgan Chase	USA	$1351	$115.8
3	Bank of America	USA	$1460.0	$135.3*
4	HSBC	UK	$1860.8	$114.9
5	Mitsubishi	Japan	Not comparable	Not  comparable
6	Credit Agricole	France	Not comparable	Not comparable
7	BNP Paribus	France	€1440.3	€49.5
8	Mizuho (est. $)	Japan	1270.2	41.6
9	Royal bank Of Scotland	UK	$1706.9	$78.5
10	Deutsche Bank	Germany	€1126.3	€32.8
11	UBS	Switzerland	CHF2060.3	CHF51.9
12	Credit Suisse	Switzerland	$1006.5	$34.9
13	Industrial and Commercial Bank of China	China	$900+?	$62+?
*  Includes goodwill of $66 billion

Bank clients fall into four groups, individuals, business, government and institutions.  For individuals banks provide banking services such as checking, bill payment, loans and mortgages, credit card and international services.  For business, institutions and governments they also provide loans and banking services, plus cash management, investment banking, and benefit services.  While all of these go under slightly different names at various institutions and may vary somewhat between national operations, they are really very comparable.  There is only a negligible difference in the packages of services offered by various major banks.  In the corporate area, and with substantial individual depositors, there is what is generally referred to as relationship banking.  Banks assemble packages of services such as loans and credit lines combined with cash management and even investment banking services.  This can be considered a special case of the market-oriented company.  Banks were doing this long before the marketing people invented the term "market orientation."

There are cases of one or a few banks developing a particular service of class of services ahead of rivals.  Internet banking in the early days was such a service, and the first banks to develop it had a competitive advantage briefly, but after a few years virtually all banks offered Internet application packages to customers and the ability to bank on line.  The futility of trying to build sustainable competitive advantage in retail banking is demonstrated by a classic banking joke.  One bank, frustrated by its competitors offers of gifts in exchange for deposits offers, "Bring us your toaster and we will give you a $1,000 deposit."  The other classic ploy in retail banking is the addition of branches.  The concept is that the additional branches attract additional clients.  The result is a bank on each of the four corners of an intersection complete with bricks and mortar investment and personnel costs.  (Carlson & Mitchener, Marc)

Marketing futility

Two examples will serve to demonstrate the underlying futility of bank marketing programs.  First Tennessee Bank developed a novel marketing approach using its Automated Teller Machines (ATMs) to deliver marketing messages to users of the machines.  Because any ATM can deliver cash to any client or potential client that has a credit card, it was assumed that non-clients using the machines are a valuable potential source of new clients.  When the user asked the machine for money the machine delivered a message touting the products and services of FTB.  The problem is that if the program is successful, any other operator of cash machines can easily duplicate the message and try to take customers using FTB services.  It is clearly a clever idea, but simply a different advertising venue and nothing that will deliver a sustainable competitive advantage.   (Sheffield, 2007)

In another instance, mighty Citigroup, an industry leader in the credit card servicing business, was already positioned as the largest and most profitable insurer of credit cards in the world.  Credit card issuance and servicing is basically Information Technology (IT) driven operation.  Simply put, the biggest computer wins!  The people at Citi developed a market and product strategy based on responsive service and continuous quality enhancement.  To implement this approach, Citi concentrated on an ongoing process of enhancing its I/T capabilities.  Citigroup is assumed to be one of the world's largest non-government information technology investors. The company acquired very large-scale image processing capabilities and even its own satellite communications network. The satellite network allowed Citigroup to avoid reliance on third-party networks, thus enhancing both security and reliability. The use of this very advanced IT technology improved the company's control and service opportunities at the point of sale. According to IBM's Systems Journal, "By pursuing this innovative strategy, CPG put itself in a position to transform processes almost continuously without sacrificing efficiency, service quality, or service innovation."  This would appear to be a situation where a sustainable competitive advantage was developed, but any of the other banks on the list above had the resources to develop a comparable capability within a year or two if it chose to do so.  Because Citigroup's activities are well known within the banking community, if the profit potential was sufficient to make the investment of resources worthwhile, any other bank in the group could have done so.  In fact several other have very strong credit card operations. (Boynton, Victor, & Pine, 1993)

How do banks compete if not through marketing?    

Banks do compete for desirable customers through relationship banking.  If competition is measured by the attempted maximization of profit potential, the most important area of competition is through the structure of the institution.  They compete based on the mix of assets and liabilities in the institution and their ability through relationship banking to develop and maintain desirable mixes of assets and liabilities.  Operating a bank is a sort of balancing act of asset and liability maturities combined with interest rates and liquidity.  As taught in finance courses short term assets have low returns while longer term investment have higher returns, conversely short term liabilities are inexpensive while longer term liabilities are more expensive for a bank.  Typically, a demand deposit account (DDA) will carry no interest expense, but the bank must obviously be prepared to liquidate the account on demand.  Most people and businesses carry at least some balance in their checking or DDA account at all times and the average balance will be considerably greater than the minimum balance.  There is also a transactional delay, technically called float, in clearing checks and payments so there is additional "no cost" funding on the banks balance sheet.  Beyond these, as maturities of both assets and liabilities rise, returns or cost also rises.  

Liquidity is the measure of the financial strength of a bank.  From a liquidity standpoint, perfect safety would lie in having a maturing asset to offset each maturing liability.   The problem with this approach is that the "spread" is not satisfactory.  Spread is bank speak for the difference between the banks cost of fund, comparable to cost of goods sold in a conventional income statement, and "interest income," comparable to revenues are too close.  The margin that can be generated, if the perfect balance between maturities in order to maximize liquidly is maintained, is simply too small to allow satisfactory profitability.  The alternative is "mismatching" of funds.  In the ultimate mismatch, a bank would be entirely funded by its DDA accounts and would invest only in long-term, ergo high interest rate, assets.    The problem is the risk coefficient of such an operation would be excessive to say the least.  The solution is risk management as practiced by the "Asset Liability Committee (ALCO)," that sets the banks investment policy and determines which sources of funding it will utilize, and how the funds will be invested.  This is a competitive tool, but obviously not one that will gain clients.  What then is the "real competitive arena?"

The ultimate areas of bank competition

There are two "real" areas in which banks can compete, price or interest rate and credit quality.  As the market becomes stronger, more lucrative, all the participants will become more aggressive.  They will offer more and more attractive rates to clients and pursue clients more aggressively.  There is obviously a finite number of really prime credit risk clients in the market at any point, so to increase market potential it is necessary to increase market size.  The only way to do this at any give time is to accept less credit worthy clients.  In an expanding market environment which implies an economic upturn, the perceived risk of lending to less credit worthy borrowers is lower because of the strength of the economy where everyone is employed and earns increasing amounts of money.  (Ruckes, 2004)

The validity of this analysis of the approach to competition by banks is being demonstrated in the newspapers every day.  As the American economy faltered the US Federal Reserve first under Chairman Alan Greenspan and now under Ben Bernanke persistently inflated the money supply to maintain a high level of economic activity.   This is almost pure Milton Friedman monetarism, distorted for political convenience.  Mr. Greenspan inflated his way out of the softness in the economy in the early 1990s and created the housing bubble of the end of the last century and the early years of this one.  The ultimate result was the sub-prime mortgage which loaned money to people on houses that they could not afford to pay for at "teaser rates" that escalated after a few years and adjusted further after that based on market interest rates.  This is, among other things, a classic example of aggressive bank marketing and the development of a "financial product" that was based on unrealistic assumptions.  Mr. Bernanke is now trying to inflate the economies way out of the problem by pushing additional liquidity into the system to reduce the actual value of money and thereby the burden on the overstretched consumer.  (Bonner, 2007)

Citigroup is known widely for its aggressive risk acceptance, typically with profitable results.  Its growth and upper position in the industry is partially the result of their acceptance of higher risk coefficient in its overall operations, compared to its competitors.  While business in general and Citibank in particular, have had setbacks, Citibank's current problems, in terms of asset quality, are the direct result of its historic risk strategies.

          "The collective strength of these five competitive forces determines the ability of firms in an industry to earn, on average, rates of return on investment in excess of the cost of capital." (Porter, 1980: 3).  

          A bank has three suppliers of its product, money.  Each of these three supplies, depositors, credit market, and central bank, have varying levels of bargaining power. The Central bank is effectively the resource of last resort.  Apparently, at least for the moment, it will continue to supply liquidity to the banking system in virtually unlimited quantities at very reasonable cost.  In contrast, the price of the credit may be negotiated a few basis points in one direction or the other, but both parties know going into the negotiation approximately what the outcome will be.

          Large banks such as Citigroup, Bank of America, Wachovia, HSBC and even comparatively smaller banks such as Bank of New York Mellon are all in a variety of businesses, not a single one.  If the definition of competition is extended to include the other major international banks the situation changes only slightly.  The international competition includes the German, Swiss, and Japanese banks.  It should be noted that they may not all compete head to head in every market segment, but they do in most of them. In fact, it is difficult to determine who the largest banks are and how large they really operate. There are over 10 banks in the world that have total assets in excess of US$1 trillion. 

          Because Citigroup's activities are well known and publicized within the banking community there is greater chance of accountability.  If the profit potential was sufficient to make the investment of resources worthwhile, then other banks would have been better able to compete.  Citibanks current position is a testament to its dominance.  

          If competition is measured by the attempted maximization of profit potential, the most important area of competition is through the structure of the institution.  They compete based on the mix of assets and liabilities in the institution and their ability through relationship banking to develop and maintain desirable mixes of assets and liabilities.  Operating a bank is a sort of balancing act of asset and liability maturities combined with interest rates and liquidity.  Porter's 5 forces is among the best ways in which businesses can calculate and manage risk in constantly changing local and international economies and markets.

References

Bonner, W. (2007, November 9). The Daily Reckoning.

Boynton, A., Victor, B., & Pine, B. J. (1993). New competitive strategies: challenges to organizations and information technology - Technical. IBM Systems Journal, (March 1993), . Retrieved November 12, 2007, from Find Articles Web Site: http://findarticles.com/p/articles/mi_m0ISJ/is_n1_v32/ai_13667571/pg_2

Carlson, M., & Mitchener, K. J. (March 2005). Branch Banking, Bank Competition, and  Financial Stability (). Retrieved November 12, 2007 from http://www.federalreserve.gov/pubs/FEDS/2005/200520/200520pap.pdf

Ruckes, M. (2004). Bank Competition and  Credit Standards. In University of Wisconsin (Ed.), The Review of Financial Studies (1102 ed., p. 1073). Madison Wisconsin: University of Wisconsin. Retrieved November 12, 2007, from http://research.bus.wisc.edu/mruckes/Papers/StandardsRFS.pdf

Sheffield, C. (2007, November 2). First Tennesse turning ATMs into automated bank marketing tools. Memphis Business Journal. Retrieved November 12, 2007 from http://www.bizjournals.com/memphis/stories/2007/11/05/story9.html