Large Dwarves and Small Giants

The Future of the Popular Banks in Italy:

A universal battle of large dwarves and small giants

In October 2004 Lucio Rondelli, the former head of Unicredit, gave a talk to a study group of Italian Popular Banks on the future of their industry given the momentous changes taking place. He spoke amusingly of the national banking leaders, whom he characterized as “large dwarves”, and the much smaller Popular Banks, whom he described as  “small giants”. His memorable characterization deserves a wider audience. It is equally applicable across Europe and opens up an interesting debate on how different types of banks should respond to their fast changing environment.

The explosion of merges and takeovers is relatively new to world banking, with a strong increase in the level of concentration. Various factors lie beneath the phenomenon: the process of updating the banking sector rulebook; the integration of markets; as well as a new range of services with advanced computerized technology. Even Italy is going the same way. However, major Italian banking groups remain too small in the European panorama: this “dwarfism” reflects the characteristics of the economic structure of the country, based upon relatively small enterprises. In order to command an adequate level of international competitiveness, we need a “cultural revolution”; to rethink the credit system which has until now financed family capitalism.

My commentary:

Introduction

The Rondelli thesis is first presented in summary and then further analysed and extended as a contribution to the debate.

The Rondelli Thesis

Rondelli’s thesis involves several interesting ideas; each is described and then followed by my own comment:

• The concentration process at European or global level still has a long way to run, both in terms of the concentration of assets and liabilities and the physical size of the players: this is a fairly obvious observation
• The large Italian banks are still dwarves at European level and need to look at cross border consolidation and place greater emphasis on investment banking and corporate finance in order to compete in this broader context: hence the Unicredit – HVB deal in 2005
• The Italian banking sector is the product of the Italian corporate institutional environment based on SME success: this is an important point
• However, the Italian SME world itself is having to adapt to globalization and so the banks too will have to adapt with them. The old arrangements will no longer work: this is Rondelli’s “challenge”
• The Popular Banks too have seen consolidation, and a few have become relatively “little giants” in their own territories by virtue of the granularity of their local distribution networks: the concept of the “little giant” as an ideal type is perhaps Rondelli’s key contribution
• Notwithstanding their absolute size, as a group, the Popular Banks have been quite successful in terms of market share. Rondelli attributes this mainly to their local roots and customer knowledge especially of their SME clients: of course, here he is just repeating the standard explanation; however understanding what “local roots” really means is the hard bit.

The historical trends underlying this process Rondelli sees as being:

• Deregulation and reregulation
• European integration and globalization
• Technology

He sees technology as being particularly important, and the economies of scale as being crucial to deploying technology successfully in the banking context. However, he warns that size alone does not determine success, and even suggests that size could undermine the traditional success factors of the Popular Banks by distancing them from their roots and bureaucratizing their flexible customer relationships.

Thus, for the future of the Popular Banks, Rondelli recommends 3 strategic initiatives:

• To achieve economies of scale against the large players: joint ventures and outsourcing of IT and services including product factories
• To give them strength in negotiation with commodity product and services suppliers, banks should focus on supermarket style distribution, leveraging their customer assets. In other words they should deliberately broaden the product base by buying in, and thereby broaden their customer relationships to achieve economies of scope and share of wallet
• To build barriers to entry in their market, the Popular Banks need to become a Hausbank to their SME clients, helping the latter to adapt strategically to the forces of globalization. He says that this will take a “cultural revolution” but will deepen their customer relationships

Comment

I would not disagree with any of this analysis. The need for economies of scale and scope that I describe as part of the “industrialization” of banking. They are the essence of the current transformation of the industry and many useful ideas can flow from this insight. It should be noted however that industrialization is much more than just selective sourcing. It includes for example the notions of end-to-end automation of processes (STP), the construction of regional or global, multi-entity, enterprise hubs, the close coupling of rules-based business process and content management, the development of database driven exception based banking, quantitative quality management and achieving a true “factory mentality”. These will all have a huge impact on small banks, and Rondelli could usefully have described the tensions between some of these concepts and the historically personalized approach of the Popular Banks.

Rondelli’s concept of the “Hausbank” is also an interesting application of another well known concept, namely, that of customer assets in the information economy. In a networked world the concept of community is important, and “stickiness”, the preference of community members to return to a web site or other cyberspace meeting place, helps us to understand community dynamics. In this characterization the physical branch should be seen as just one dimension of cyberspace, alongside the cyber cafes, call centres, and other virtual meeting places. In this multi-dimensional world, there is real value in building a coherent, i.e. sticky, community with some shared values and preferences, and then to become its customer advocate: you aggregate your customer knowledge and access in order to acquire tradable customer “assets” that can be exchanged in the global virtual markets. Of course, Rondelli does not resort to the cyberspace vocabulary, but the logic of what he says is very similar.

However, while there is nothing wrong with the analysis, there is also nothing really new in it either. All of these concepts were discussed and debated in the late 1990s, when we all started travelling down the “information highway”, a sadly forgotten piece of jargon, which got at the nub of many important issues. In the intervening years of course, banks have now started to put these concepts into practice and success stories are starting to circulate. That is real progress of course. Nevertheless, I felt that Rondelli should have gone further and offered some new insights.

For example, he might have pointed out that in the new economy there are 4 key value propositions for banks:

• Customer intimacy
• Product leadership
• Price leadership
• Market knowledge and insight

The first three propositions are also well known and have been much debated. I think, however, it is useful to distinguish between product leadership and market knowledge and insight. The asset manager with the best performing funds may have a standard “product”, but he gains excellence by knowing the market better in order to generate higher returns. Similarly the ace brokers and corporate finance teams often have a better product only insofar as they have a better reputation for market intelligence and contacts, that allow them to deliver the results that create real added value, rather than for offering a different “product” per se, which is more about delivery issues: i.e. packaging, pricing and servicing.

Now with this value framework Rondelli might have pointed out that for product leadership and operational efficiency you need technology and, other things being equal, economies of scale and scope. These value propositions in the end have become the natural preserve of the larger players. However, the Popular Banks can still flourish by focusing more on customer intimacy with their traditional SME and family relationships, and better local market knowledge and insight. They know their customer in order both to personalize their service to his needs as well as to sell that knowledge in the market. In this sense they become small, local giants.

Of course they can also compete on price and innovation by using smart sourcing or smart technology as we describe below. However, they differentiate themselves by their customer focus and relevant knowledge.

In any case, I repeat: Rondelli’s analysis is very robust and I would not disagree with any of it. However, he does not really go far enough and has missed out many key points, which are extremely important for practical decision-making.

• Technology too has its own “little giants”, local optima, which can be leveraged by the Popular Banks in their contest with the larger players.
• Virtualization of the value chain and the customer too will be key to success: this goes way beyond the split between production and distribution and gives many new opportunities for niche markets, which smaller, more agile banks can often capture
• The economics of knowledge management is the real driver of change
• Globalization and multi-channel mobility are now becoming crucially important in the multi-dimensional world of cyberspace.

Rondelli notes that size alone does not determine success, but he never really explains why not. He admits that his argument would tend to suggest that everyone should try to grow, but warns of diminishing returns and hidden barriers.

If the universe were a pure continuum, and if we had reached the eventual steady end state, then economies of scale might become the dominant driver. However, the universe is quite a chaotic, dynamic set of galaxies, in constant motion and evolution. Energy may never be created out of nothing, but power is certainly generated by a constant churning of the energy-matter balance. Old stars die and new worlds are created in this constant universe of change. This astrophysical metaphor also applies to economics and finance

Conclusion

Rondelli addressed many interesting issues in his talk. However, he also raised a number of questions. Adaptation to one’s environment is key. Enormous change is taking place. Banks will need to have a rich and deep understanding of their place in the world in order to compete successfully. In this post I have tried to illustrate a few more factors that they should take into account, in order to build a strategic framework that can meet the rapidly changing needs of banks large and small in the 21^st century.

Since the concept of Large Dwarfes and Small Giants is of European interest I would appreciate your ideas and comment on this important topic.

Lucio Vollaro

Comments

[pb]

It is difficult, at least for me, to state if the model of business of the Popular Banks in Italy is winning or not. For sure, it could be interesting to know if it was analysed, in order to a potential customisation, suitable and useful abroad, for those banks to become big giants.
But the questions are three.
Who has the knowledge and the experience to do it?
Who should have to do it, had the need to do it or they could however “survive”?
How to stimulate the change of people, could be the primary goal?
May be that people coming from more competitive fields, could be the strongest support for helping Italian Groups, Banks and so on, to become “big giants” in the world context.