The Maven's circle.

ICT for Little Giants

ICT Technology for "Little Giants

Nowhere is the consolidation of the banking industry more evident than in the cash management sector – more corporates are operating globally so they need global cash management solutions – in terms of the global market, there are four dominant players (JP Morgan, HSBC, Citigroup, and Deutsche Bank). There are also a number of mainly European and US players that still harbour the ambitions of joining this "VIP magic circle" (Abn Amro, Bank of America, and BNP Paribas) – the banks that lie outside of the magic VIP circle:

• Some banks will maintain global ambitions
• The other banks, the Little Giants, will just concentrate on having a regional/niche focus. The sub-contracting play is an increasingly prevalent one that benefits the small regional players  that no longer have the shoulder the expense of either creating or maintaining  the technology to keep up with demand and regulatory compliance. They will also no longer have to battle against these behemoths when competing for business in their local market. These global banks are quite "superficial" thet think in term of "products", in many countries the regional banks think in term of "relationship with the Territory" and to become Little Giants they will probably have to learn to work with the big banks on a distributor basis.

Technology’s little giants

If economies of scale were always available, then IBM would have dominated over Microsoft. However, Bill Gates recognised that integrated circuits had, at any given technology level, some very real diseconomies of scale. Technologies have optimal operating ranges. Up to certain limits they work extremely well and cost effectively. Beyond those limits, it takes ever-increasing amounts of energy and cost to achieve a further unit of output. The success of the minicomputer and desktop PCs followed from this fact.

In reality we have many different technologies and when we combine them we have many different optimal operating ranges where we can achieve effective competitive advantage.

Smaller banks can compete effectively with giants by recognising that their problems being smaller can often be solved more cost effectively using smart technology. The Skipton Building Society moved its banking systems to Microsoft Wintel platforms and achieved technology unit costs much lower than its larger rivals still using IBM mainframes. Similarly some banks are moving onto Unix and Linux and achieving real advantages over traditional technologies. There are limits for effective Unix and Linux deployment. These limits are rising and may soon be able to address even the largest scale problems, but in recent years, smaller banks have been able to do some things at lower price points than their larger competitors because the large dwarves had a large scale, complex problem and extremely narrow margins, while the small giants had problems that were well within the optimal operating ranges of current technology. I believe that the Banca Popolare di Milano is a good example of this, which has innovated with Linux more rapidly than other larger banks, just as the Banca Populare di Bergamo (now part of BPU) did 10 years earlier with Unix and Oracle. It is a pity Rondelli did not mention them.

While I agree that technology will continue to drive economies of scale and outsourcing in general, smart sourcing with smart technology is the way forward: some in house, some outsourcing with different players, and always with the optimal technologies to achieve the best price performance.

Virtual Value Chains

Another important dynamic is the virtualization of the value chain. We are moving here way beyond the simple division of the world into suppliers and distributors into the multi-dimensional world of cyberspace, where commerce travels on the information highway. We can find opportunities for aggregation along the entire value chain. Technology means we can link up these suppliers into a distributed value chain of networked, white label suppliers and still give a coherent, unified brand image at the end of it. Like the Microsoft Windows interface, it is quite easy to understand and use, but quite complex to construct behind the scenes.

Portfolio management, custody, securitization and stock lending can all be split off from asset management and provided by separate entities. Trade routing and order management can be separated from brokerage, as can research and market data. Risk management, collections and even product processing itself can be split off from a mortgage business or credit cards. This has created enormous opportunities for local giants to gain niche market advantage in particular value chain steps.

Moreover the virtual value chain extends to the virtual customer. Instead of selling to private individuals, banks need to think about selling to friends and family or to role categories and affinity groups, with customer incentives to promote cross selling. Banks need to personalize products for children, single parents, pensioners/ grandparents, twinkies (two incomes, no kids), yuppies (young, upwardly mobile professionals), farmers, lawyers, doctors, even peripatetic politicians, etc. In the corporate world, the virtual customer is the whole supply chain or the vertical market sector, and both should be targeted, especially in the SME world.

By reconfiguring the value chain, aggregating key steps, exploiting smart technology sourcing, targeting virtual customer communities and leveraging their community assets, while exploiting their own market knowledge to the full, small, agile players can gain real competitive advantage[1] in the new economy.

Economics of Knowledge

In a world of rapid change, the real challenge is not technology but how to manage knowledge and digital assets, including intellectual property. Building on market insight into old risks and new opportunities, promoting rapid technology transfer and time to market, patenting and exploiting intellectual property, leveraging the knowledge of aggregation and customer access, these are all examples of knowledge management. While technology is often described as the driver, the underlying economics are often really driven by the cost of mobilizing and delivering knowledge. Since knowledge is usually represented as information, technology is the infrastructure for the associated processing and delivery. However, if we focus too much on technology and not enough on knowledge then we will miss a fascinating piece of the action. Building new value chains is really about knowledge engineering.

We can say that information is data structured to answer a question and that knowledge is information being applied to solve a human problem. Usually that knowledge is in people’s heads when they take decisions. However, it can also be seen to be present in computer systems. The systems know where to go and what to do next. Unfortunately, in the past most of this knowledge was “embedded in the code” and quite fixed. It was implicit in the software programs and not held as data, which is more accessible, and thus can be shared and processed. Now, modern business process management systems are starting to embody all of the process rules in data tables, where they can be used both to drive the software and to help solve other problems, including error diagnosis and recovery, operational risk management, optimal costing, best execution decisions, etc.

When Rondelli talks about the cultural revolution of the Hausbank, he is tackling one set of knowledge management problems. When some banks chose Microsoft for their core-banking platform, they did so because they realised that ease of programming and the wealth of low cost skills, read “knowledge”, in the market place would all impact on time to market, which had real value. When the EU issues directives like Basel II and MiFID, which require banks to know their customers and build risk or best execution models with market data to justify their actions, they are forcing banks to publish and record their corporate knowledge. These are all prime knowledge management issues.

Globalization and Multi-channel Mobility

Finally, while Rondelli mentions globalization in the context of bank consolidation, outsourcing and SME competition, he does not highlight one immediate and significant impact, the need for multi-channel mobility for companies and private clients. Multinational corporations have long had to deal with this, but relied often on fixed line telecommunications to established offices. For SMEs mobility is also becoming important, but the infrastructure is just not there. Portable mobility solutions are now becoming increasingly important in this sector as well.

The Italian SME market place used to depend on local knowledge for their supply chains and regional or global knowledge via marketing intermediaries for their distribution. Physical presence and personal contacts were critical. Now, small companies need a much broader range of knowledge in order to survive: technology knowledge, product knowledge, financial knowledge, supply-chain knowledge, distribution chain knowledge, risk management etc. Moreover, the SME entrepreneurs are having personally to travel more, doing deals and adapting to more complex virtual supply chains.

Banks can intermediate in these value chains in many new ways: electronic billing, micro payments, output factoring, treasury and payment management, financial value chain support etc. They can design once-off derivative or structured finance products to meet the specific risk hedging needs of particular projects. They can even manage the accounting and payments between clusters of SMEs working together in these value chains, reducing SME costs, speeding up the velocity of money and providing intermediation to the rich world of global finance.

However, most importantly banks need to provide their own sales staff and their SME clients with mobility solutions that allow them to build up e-trust and manage their affairs on the hoof.  SMEs have limited connectivity to the outside world because of their size. Nevertheless, they still need to be able to manage the business while travelling and optimize the use of every trip. They also need to leverage their distributed supply chains for the knowledge and global contacts they represent.

Therefore, multi-channel access to their banks and mobility support will be key success factors for the new Hausbanken. While the biggest players will probably want to build their own multi-channel solutions, smaller players with fewer challenges of scale, should be able to maintain cost performance parity through smart sourcing.

Extending the Rondelli Argument

In summary, we can extend the Rondelli thesis for smaller banks as follows:

Small Bank Strategic Focus	Key Driver	Key Differentiator
Production	Industrialization & Virtual Value Chains:  greater emphasis on third party products and outsourcing	Smart Sourcing & Technology
Distribution	Supermarket- One stop shop and Virtual Customers	Knowledge Management and Multi-channel Mobility
Value Proposition	Customer Intimacy and SME Hausbank Relationships with mainly a Retail Focus	Market insight and agility

For larger banks the thesis becomes:

Large Bank Strategic Focus	Key Driver	Key Differentiator
Production	Industrialization & Virtual Value Chains: greater emphasis on insourcing	Smart Sourcing & Technology, Knowledge Management
Distribution	Supermarket- One stop shop, Third party partnerships and Virtual Customers	Knowledge Management and Multi-channel Mobility
Value Proposition	Operational efficiency, Product Leadership/ Innovation with a mixed Retail/ Corporate/ Institutional focus	Market insight with global reach

This gives a much broader view of both the challenges and opportunities facing the various contenders. Naturally there are many more issues than these, but I think it gives a good framework for strategy development.

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 paper 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.

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[1] The virtualization concept also plays an important role in the “on demand” computer utility, which is coming to dominate technology architectures, but this takes us too far away from our main business focus.

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