evolution or extinction: where are banks headed?

Journal of Applied Corporate Finance S U M M E R 1 9 9 6 V O L U M E 9 . 2

Evolution or Extinction: Where are Banks Headed? by Christopher James and Joel Houston,

University of Florida

8JOURNAL OF APPLIED CORPORATE FINANCE

EVOLUTION OREXTINCTION: WHEREARE BANKS HEADED?

by Christopher James andJoel Houston,University of Florida

8BANK OF AMERICA JOURNAL OF APPLIED CORPORATE FINANCE

I

1. “Clueless Bankers,” Fortune, November 27, 1995, Vol. 132, No. 11.

since the early 1990s. Perhaps most telling about theprospects for the industry is the fact that, as shownin Figure 1, bank stocks have recently sold at recordmultiples over book value.

What explains these contradictory signals? Inthis paper, we argue that while traditional banklending and deposit-taking activities have declined(although not nearly as much as popular claimswould suggest), this decline does not imply thatbanks as providers of financial services are losingmarket share or that the banking industry hasbecome less important to the general economy.Financial market innovations and changing technol-ogy have made it possible, and often necessary, forbanks to provide traditional banking services with-out funding loans or acquiring financial assets. And,with the resulting growth of fee-based services,banks’ shrinking “asset-based” market shares pro-vide a misleading picture of the industry’s viability.More generally, while the basic functions of banksand other financial service companies have re-mained relatively constant over time, the specificproducts and services through which these functionsare provided have changed.

t has become almost a commonplaceamong corporate executives, businessjournalists, and academics that commer-cial banking is a declining industry. A

representative, if somewhat extreme, expression ofthis view was a recent article in Fortune magazineclaiming that banks are going the way of the dinosaurand that most bankers are “clueless” when it comesto survival strategies.1

A quick look at the landscape would seem tosupport this view. The number of commercial banksin the United States continues to fall, the share offinancial assets held by banks has declined, anddomestic bank loans represent a shrinking portion ofcorporate financing activity. While deregulation hasallowed banks to expand geographically and toparticipate in a wider range of activities, changes intechnology and competition from outside the indus-try have caused many customers to cut back on theiruse of traditional banking services.

Other signs, however, suggest that the industryis quite healthy. The 1990s have witnessed a sharpdecline in bank failures, and most money-center andregional banks have reported increased earnings

“The banking industry is dead, and we ought to just bury it.”

—Dick Kovacevich, CEO, Norwest

“Far from being threatened by extinction, banks are becoming more, not less,important in the overall economy.”

—James McCormick, President, First Manhattan Consulting Group

9VOLUME 9 NUMBER 2 SUMMER 1996

Thus, while the banking industry may not bedeclining, it is changing—and dramatically so. Inparticular, three major factors over the past ten to 15years have changed the way banking services areperformed. The first is deregulation. Banks are nowallowed to offer a wider set of products, and aresignificantly less restricted in their ability to expandgeographically. The second factor is changing tech-nology. Changes in technology have allowed banksto provide services more efficiently while at the sametime subjecting them to increased competition fromnonbanks. The third factor is the expansion andglobalization of financial markets. In large partbecause of deregulation and changing technology,financial markets have become more competitiveand more global, and they now encompass a muchbroader set of products than in the past. In manyinstances, this expansion of financial markets hasprovided direct links between investors and users ofcapital, thus allowing companies to bypass tradi-tional financial intermediaries such as commercialbanks. Like deregulation and technological ad-vances, the expansion and globalization of financialmarkets enlarge the range of opportunities for bankswhile at the same time presenting them with thechallenge of increased competition.

Not surprisingly, these changes in the businessenvironment are having a pronounced effect onbanks’ competitive strategies. In the past, manybanks thought of themselves as delivering a set ofspecific, largely unrelated products to different setsof customers. But, in response to the changingenvironment, many bank executives today are pur-suing strategies that aim to strengthen their banks’ability to perform various financial functions—say,

general financial planning for retail clients or raisingcapital for middle market companies—that tend tocut across the old product boundaries. The ability toperform such functions increasingly means offeringa range of complementary (or, in some cases, evensubstitute) products and services to the same cus-tomer. In wholesale banking, for example, it maymean including high-yield public debt (junk bonds)along with traditional loans in the menu of financingoptions offered to middle-market clients.

Such major changes in bank strategy are in turnleading to fundamental changes in what might bedescribed as the “organizational architecture” ofbanks. By organizational architecture, we meanessentially three things: (1) how a bank assignsdecision-making authority for various tasks (forexample, whether it chooses to centralize or decen-tralize certain functions); (2) how it evaluates theperformance of managers and employees; and(3) how it rewards its managers and employees (itsincentive compensation system).2 As we argue be-low, some banking activities that once tended to becentralized under the control of a rigid managementhierarchy are now being decentralized. At the sametime, activities that were once largely decentralizedare being consolidated to achieve scale econo-mies—or at least subjected to more central coordi-nation to help realize potential synergies within theirincreasingly diversified product lines.

Along with these changes in decision-makingauthority, banks are also being forced to rethink theirinternal performance evaluation and incentive com-pensation systems. As many banks have discovered,prospering in a more competitive business environ-ment is likely to mean paying talented managers and

2. The concept of “organizational architecture” is presented by James Brickley,Clifford Smith, and Jerold Zimmerman in their book, Organizational Architecture:A Managerial Economics Approach (Irwin, 1996). For a compressed presentationof the concept, see their recent article that appeared in this journal, “The Economics

of Organizational Architecture,” Journal of Applied Corporate Finance, Vol. 8 No.2 (Summer 1992). For an earlier discussion of the concept, see Michael Jensen andWilliam Meckling, “Specific and General Knowledge, and Organizational Struc-ture,” which appears in the same issue of the JACF.

FIGURE 1MARKET TO BOOK RATIOSFOR PUBLICLY TRADEDCOMMERCIAL BANKS1975-1995


employees a larger part of their value added than inthe past. But, the question that bank managementsare wrestling with is this: How do we measure thevalue added by a given activity? In the old world ofdeposit-taking and lending, conventional account-ing measures of bank operating performance such asROA and ROE were reasonably good indicators. But,as an ever larger portion of banks’ activities contin-ues to move off balance sheet, more and more banksare deciding that ROA and ROE are inadequate, andthat economic measures of performance like RAROCand EVA provide a more reliable basis for measuringvalue added for shareholders.

In the pages that follow, we begin with a reviewof the evidence used to support the view that

banking is declining and discuss why this evidencefails to account for much of the growth and changewithin the industry. Then, we discuss the implica-tions of these changes for the competitive strategiesand organizational design of banks.

EVIDENCE OF DECLINE

The trend most often cited to illustrate thedecline of banking is the large drop in banks’ marketshare, as measured by the proportion of bank assetsrelative to the assets of all financial institutions.3 Asshown in Figure 2 and Table 1, commercial banks’share of total financial assets declined steadily fromalmost 40% in 1960 to 26% in 1994. The decline is

3. This section draws heavily on the following two studies: George Kaufmanand Larry Mote, “Is Banking a Declining Industry? A Historical Perspective,” inFederal Reserve Bank of Chicago, Economic Perspectives, May/June 1994; and John

Boyd and Mark Gertler, “Are Banks Dead? Or Are the Reports Greatly Exaggerated?,working paper, Federal Reserve Bank of Minneapolis.

TABLE 1 PERCENTAGE SHARE OF ASSETS OF FINANCIAL INSTITUTIONS IN THE UNITED STATES 1860-1994

1860 1880 1900 1912 1929 1939 1948 1960 1970 1980 1990 1991 1992 1993 1994

Commercial Banks 71.4 60.6 62.9 64.5 53.7 51.2 55.9 38.2 37.9 34.8 28.2 26.5 26.3 25.4 26.0

Thrift Institutions 17.8 22.8 18.2 14.8 14.0 13.6 12.3 19.7 20.4 21.4 14.4 11.8 10.6 9.4 8.9

Insurance Companies 10.7 13.9 13.8 16.6 18.6 27.2 24.3 23.8 18.9 16.1 17.3 17.3 17.3 17.4 17.3

Investment Companies 2.4 1.9 1.3 2.9 3.5 3.6 10.5 11.8 13.1 14.9 15.5

Pension Funds 0.0 0.0 0.7 2.1 3.1 9.7 13.0 17.4 21.5 24.2 24.4 24.4 23.9

Finance Companies 0.0 0.0 0.0 2.0 2.2 2.0 4.6 4.8 5.1 5.6 5.3 5.0 4.7 5.0

Securities Brokers and Dealer 0.0 0.0 3.8 3.0 8.1 1.5 1.0 1.1 1.2 1.1 2.4 2.8 2.9 3.3 3.0

Mortgage Companies 0.0 2.7 1.3 1.2 0.6 0.3 0.1 0.0 0.0 0.4 0.1 0.2 0.2 0.2 0.3

Real Estate Investment Trusts 0.0 0.3 0.1 0.1 0.1 0.1 0.1 0.1

Nonbank Total 10.7 16.6 18.9 20.8 32.4 35.2 31.8 42.1 41.7 43.8 57.4 61.7 63.1 65.2 65.1

TOTAL (trillion dollars) 0.001 0.005 0.016 0.034 0.123 0.129 0.281 0.596 1.328 4.02 10.997 12.030 12.747 13.952 14.743

Source: Flow of Funds and Kaufman and Mote (1994).

FIGURE 2SHARE OF ASSETS OFFINANCIAL INSTITUTIONSIN THE UNITED STATES1860-1994


even more dramatic when measured over the pastcentury. The institutions that have realized thebiggest increase in market shares are pension funds(up from about 10% in 1960 to 24% in 1994) andinvestment companies or mutual funds (up from 3%in 1960 to about 16% in 1994). These figures clearlysuggest that depository institutions, including com-mercial banks, have lost significant market share.

It is interesting to note that the market shares ofthe traditional competitors of banks in originatingand servicing consumer and commercial loans havenot increased appreciably—and, in one notablecase, that of insurance companies, market share hasalso declined. In contrast, the institutions that haverealized the largest increase in market shares—mutual funds and to a lesser extent pension funds—focus primarily on activities other than the origina-tion and servicing of loans.

A second trend that suggests the decline ofbanking is the decrease in the number of banks andthe increase in the number of bank failures duringthe 1980s and early 1990s. The number of bankfailures rose dramatically beginning in the mid-1980s(along with the asset size of the average bankfailure), and peaked at over 200 in 1988. While theincrease in failures was driven largely by regionaleconomic problems in the Southwest and NewEngland, such failures nevertheless suggest greaterfragility in the banking system.

Accompanying these failures was a wave ofbank consolidations fueled in part by the removalof regulatory restrictions on interstate banking. Forexample, from 1980 through 1994, the number ofbanks fell by 36% from 12,380 to 7,926. However,the drop in the number of banks through merger orfailure does not necessarily imply a reduction in theavailability of banking services. Over this same

period, the number of bank offices increased 254%from 18,500 to 65,610 offices. In addition the do-mestic assets of U.S. banks grew in real terms duringthis period at an annual rate of about 2%, onlyslightly less than the rate of growth in real GrossDomestic Product.

A third commonly-cited trend is the decline inthe importance of bank loans as a source of corpo-rate debt financing. As shown in Figure 3, loans fromU.S. commercial banks as a percent of totalnonfinancial corporate debt fell from 20.5% in 1980to 14.5% in 1994, with most of that drop occurringfrom 1987 through 1993. U.S. banks lost market shareprimarily to public debt markets and to foreignbanks. But, when foreign bank loans are included inthe market share totals for commercial banks, thereis no discernible trend away from bank financing.Note, in particular, that total bank loans as a percent-age of corporate debt actually increased slightly from26% in 1980 to 28% in 1994. This last piece ofevidence suggests that even at a time when the useof overall debt financing among U.S. corporationswas increasing, the relative demand for bank loanscontinued to be strong.

WHAT’S WRONG WITH THESE PICTURES?

Overall these trends suggest that U.S. commer-cial banks are funding a progressively smaller shareof financial sector assets. But, as several recentacademic studies have pointed out,4 it is unclearwhether these trends tell us anything about thechanging importance of banking within the overallfinancial system. At the heart of the debate iswhether traditional measures of performance suchas the share of assets funded by domestic banksprovide an accurate picture of the value added in

4. See, for examples, Kaufman and Mote (1994), cited earlier.

FIGURE 3SOURCES OF NON-MORTGAGE RELATEDDEBT OF NONFINANCIALCORPORATIONS1979-1994

While the basic functions of banks and other financial service companies haveremained relatively constant over time, the specific products and services through

which these functions are provided have changed.


banking and of the overall importance of banks inthe economy.

The chief problem with the market share num-bers cited above is that they are based primarily onassets funded by the banking sector. Much of thevalue added in banking since 1980 has movedaway from the traditional practice of bundling ser-vices with the funding of loans and has increas-ingly come in the form of fee-based services. Thistrend is evident in the growth of so-called “off-balance-sheet” banking activities, most of whichrepresent the “unbundling” of the traditional inter-mediation process. Common examples of such off-balance-sheet activities are the provision of lines ofcredit, the origination and servicing of loans thatare sold in the secondary market, investment bank-ing services, the provision of financial guarantees,and risk management through derivative transac-tions. In the past, many of these activities werebundled together as part of the bank lending pro-cess (for example, the protection against interestrate risk now provided corporate issuers by interestrate swaps or caps would once likely have beenbuilt into the terms of the loan—whether the loanwas fixed or floating, and how soon the issuer wasable to call the issue). These off-balance-sheetactivities are important sources of fee income forbanks, but they do not require banks to fundspecific assets. Such activities do, however, putbank capital at risk; and thus, as discussed later,they do require a capital charge.

Adjusting Bank Market Shares for Fee Income

While the volume of off-balance-sheet businessis difficult to measure, the crude measures of off-balance-sheet activity that are available all suggest

extraordinary growth. For example, the notionalvalue of counter-party guarantees (that is, loancommitments and standby letters of credit), deriva-tives positions, and loans sold for all U.S. banksincreased from 132% of assets in 1983 to 444% ofassets in 1994. Another measure of the growingimportance of fee-generating business is the growthin non-interest (fee) income. As shown in Figure 4,non-interest income as a percentage of total bankincome increased more than threefold from less than10% of total income in 1980 to over 25% in 1994. Thisincrease occurred for banks of all sizes, suggestinga fundamental change in the way banking servicesare provided.

Has the growth in non-interest income and off-balance-sheet activities been sufficient to maintainthe market share of banks within the financial sector?An ideal measure of the importance of bankingwould capture the value added of the banking sectorrelative to the value added of all financial servicesfirms. Unfortunately, detailed information on thevalue added of financial services firms is not avail-able. One measure, admittedly imperfect, is grossrevenues. In the early 1990s, banks’ share of thegross revenues of all financial institutions was about40%, approximately the same as it was in the 1960s.

An alternative way of measuring bank marketshares, which was proposed by John Boyd and MarkGertler,5 is to calculate the capitalized value of fee-generating activities. The capitalized value of fee-generating businesses provides an estimate of thequantity of on-balance-sheet assets that would berequired to generate the observed level of non-interest income in banking.

Following Boyd and Gertler’s suggestion, wecalculated the capitalized value of fee-generatingbusiness by assuming that the capitalization rate for

5. Boyd and Gertler (1994), cited earlier.

FIGURE 4NON INTEREST INCOMERATIOS1980-1994


fee-generating businesses is equal to the rate ofreturn on funded assets. Using this procedure, wewere then able to calculate a market share forbanking that includes off-balance-sheet activities. Asshown in Figure 5, such “fee-income-adjusted” bankmarket shares have fallen only modestly since 1980.

Another problem associated with using marketshares to measure the importance of banking maycome from the rapid growth of the total financialsector during the 1980s. Assets at all financial insti-tutions grew at an annual real rate of over 5% duringthis period while real GDP grew at about 2%. Theassets of the banking sector may well have beengrowing relative to the overall economy even as themarket share of commercial banks relative to allfinancial institutions was falling. Having a smallerpiece of a larger pie does not necessarily mean thatbanking is shrinking.

Some New Evidence on the Importanceof Bank Loans

While the role of banks in the overall economydoes not appear to be shrinking, does the fallingproportion of bank loans to total corporate debtmean that banks are becoming a less important partof the corporate capital acquisition process? Here,too, the simple trends can be deceiving. First, asshown earlier in Figure 3, if off-shore loans and loansmade by foreign banks (designated “other loans”)are included as part of bank lending, the share ofcorporate debt funded by commercial banks hasincreased slightly since 1980. Keep in mind that thesemarket shares are again based on assets funded bythe banking sector, which means that loans origi-nated and sold by commercial banks as well as loancommitments and standby letters of credit are notincluded in the total.

A more detailed picture of the changing impor-tance of bank lending as a source of funding comesfrom our own recent study of changes in the use ofbank financing by 250 publicly traded corporationsover the period 1980 through 1993. (Because 133 ofour 250 sample firms were no longer independentcompanies by 1993, we also compared the bank debtfinancing of the 250 firms in 1980 with that of the 117firms that were still independent in 1993 plus 133companies matched by size and industry to thosefirms that disappeared. Besides addressing concernsabout “survivor bias,” our use of an “industry-matched” sample was also intended to adjust for thenatural tendency of companies to reduce theirreliance on bank debt as they mature.)

The results of our study are summarized inTable 2. First notice that the companies in our sampleare fairly large, with median assets in 1980 dollars ofover $80 million—which is equivalent to over $140million in current dollars. Companies of this size arelikely to have the opportunity to substitute othersources of credit for bank loans. Second, note that forour sample of 250 industry-matched firms, both theaverage ratio of bank debt to total debt and bank debtas a percentage of total assets increased over the 14-year period. Moreover, for those 117 companies thatwere still in our sample in 1993, the average ratio ofbank debt to total debt fell only slightly whileaverage bank debt to total assets actually increased.(As suggested above, we expected to see somedecline in the percentage of bank debt for thissample if only because mature firms naturally tendto rely less on bank financing.)

Perhaps the most remarkable statistics reportedin Table 2, however, are the percentages of bankdebt to total debt—68% in 1980 and at least 66%(and as high as 75%) in 1993. These numbershardly suggest that bank loans (and other forms of

FIGURE 5SHARE OF ASSETS OFFINANCIAL INSTITUTIONS*

*Commercial bank assets include non interest income capitalization credit.

Non-interest income as a percentage of total bank income increased more thanthreefold from less than 10% of total income in 1980 to over 25% in 1994. This

increase occurred for banks of all sizes, suggesting a fundamental change in the waybanking services are provided.


private debt)6 have lost their place in corporatecapital structures.7

Overall, then, our results contrast sharply withthe popular view that bank loans are declining as asource of corporate financing. Our results also differfrom the findings of other studies that use a differentsource of data—namely, the Federal Reserves Flowof Funds data. One reason for the difference infindings is that Flow of Funds data measure onlyonshore loans funded by U.S. banks and not totalbank lending (that is, foreign bank loans and off-shore loans by domestic banks are excluded). Incontrast, we measure all loans originated by com-mercial banks. Another source of the difference isthat we define bank debt broadly to include allprivate debt that is not specifically referred to in thefirm’s annual report as being originated by a nonbankfinancial institution. But, even if our measure of bankborrowing thus includes some nonbank forms ofprivate debt, our results nevertheless seem to offerfairly conclusive evidence that there has not been a

dramatic shift away from intermediated debt by U.S.corporations.

In sum, the data clearly suggest that bank-funded assets are a shrinking proportion of totalindustry assets, which in turn reflects the decliningrole of banks in funding loans. At the same time,however, the growth of fee-based businesses andthe continued importance of banks in the corporatecapital acquisition process suggests that the impor-tance of banks in the financial sector has notdeclined.

WHAT DOES IT ALL MEAN?

While the demise of banking appears to begreatly exaggerated, there is little doubt that thebusiness environment in which banks must competehas changed dramatically. As we noted earlier,deregulation, advances in information technology,and the expansion and globalization of financialmarkets have all worked together to afford banks the

TABLE 2DEBT STRUCTURE OF 250PUBLICLY TRADEDCORPORATIONS 1980-1993*

6. The measure of total debt excludes mortgages and capitalized leases. Onepotential problem with the statistic on total bank borrowing is that it may includedebt from other private lenders. The annual reports of corporations often do notindicate whether private debt is from bank lenders or from nonbank financialinstitutions. Since the majority of private lending is from commercial banks, weclassified these cases as bank debt. This definition is likely to provide an upwardbiased estimate of the importance of bank debt. To address this concern we alsocollected information on the type of bank loan (i.e. revolving credit, term debt andnotes payable). Since bank loans are frequently made under revolving credit

agreements, tracking changes in loans made under revolving lines is least likelyto overstate the importance of bank lending. Our results concerning the trends inbank lending are similar when we employ the narrow definition.

7. One could also argue that our results exaggerate the importance of bankloans by taking an equally-weighted as opposed to a value-weighted average ofindividual company ratios, which places greater weight on small firms. But, evenwhen using value-weighted measures, the bank debt ratios are only slightlylower—55% in 1980 and 60% in 1993.

1980 1993 1993

Same firms Industry Matched

Mean Median Mean Median Mean Median

Assets (millions)(1980 dollars) 906 82.2 1,904 153 693 89

Age 38 34 48 44 35.6 25.0

Leverage .36 .35 .41 .37 .39 .39

Market/Book 1.20 1.00 1.63 1.27 1.58 1.17

Bank Debt/Total Debt .68 .83 .66 .74 .75 .95

Bank Debt/Assets .13 .10 .14 .11 .17 .14

Public Debt/Total Debt .14 .00 .17 .00 .13 .00

Commercial Paper/Total Debt .01 .00 .04 .00 .02 .00

Other Private/Total Debt .17 .01 .13 .01 .10 .01

All Private/Total Debt .85 1.00 .77 .96 .85 1.00

Unused Lines of Credit/ Assets .13 .05 .16 .12 .16 .11

Percent with Public Debt 35% 47% 25%

Percent with Commercial Paper 5% 21% 7%

N 250 117 250

*Total debt equals short plus long term debt less industrial revenue bonds, mortgages and capitalized leases. Other privatedebt is privately placed bonds and loans specified in the financial statements as being from non-bank sources.


opportunity to offer an expanded range of productsand services. At the same time, these developmentshave stepped up the intensity of competition in allthose markets.

Such changes in the business environment arelikely to produce major changes in banks’ strategicbusiness approaches. As we discuss next, manybanks are shifting from a product-based strategicfocus to a more function-based approach. And sucha major change in bank strategies is in turn leadingto changes in what we earlier described as banks’organizational architecture.8 (For a graphic illustra-tion of the interaction between the business envi-ronment, strategy, and organizational architecture,see Figure 6.) Decision rights inside many banks are

effectively being reassigned, with many bank man-agers and employees being given greater au-tonomy—while at the same time many bank activi-ties are being consolidated, or least subjected tomore centralized oversight or coordination. More-over, in response to these changes in strategy anddecision-making authority, many banks are nowrethinking a vital piece of their organizational de-sign—namely, their internal performance evalua-tion and incentive compensation systems. We arguebelow that while these measurement and incentiveissues are likely to be important for any enterprisewith more than a handful of employees, they be-come critical when a company or an industry isundergoing fundamental change.

*This graphic is taken from James Brickley, Clifford Smith, and Jerold Zimmerman, “The Economics of OrganizationalStructure,” Journal of Applied Corporate Finance Vol. 8 No. 2, Summer 1995, pp. 19-31.

8. For the intellectual background behind the concept of organizationalarchitecture, see footnote 2.

FIGURE 6DETERMINANTS OFORGANIZATIONALARCHITECTURE*

In response to these changes in strategy and decision-making authority, many banksare now rethinking a vital piece of their organizational design—namely, their

internal performance evaluation and incentive compensation systems.


SHIFT IN STRATEGIC FOCUS—FROMPRODUCTS TO FUNCTIONS

In the past, most banks viewed their organiza-tions as providing a set of distinct products. A list ofthese products might include commercial and con-sumer loans, demand and savings deposits, trust andprivate banking services, and risk managementservices. Within this product-based strategic frame-work, decisions were made and tasks were assignedaccording to product groups and/or strategic busi-ness units. Often times, these business units were runas separate profit centers.

A product-based strategy has many potentialbenefits. In particular, product-based strategies pro-mote specialization and allow managers to focus ona specific set of problems. This makes sense whenone or more of the following conditions hold:

1. The bank is operating in a highly regulatedand/or stable environment. When technology andthe economic and regulatory environments are allfairly stable, it may make sense to allow managerswithin a particular product group to operate as if therest of the bank is “held constant.” In addition, in astable, highly-regulated environment, the potentialfor new product development is generally limited,which means that managers’ primary responsibilitywill be to concentrate on improving operationswithin their product group or business unit.

2. There are significant economies of scalewithin product groups. In such circumstances it maybe highly profitable to develop systems and pro-cesses to exploit economies of scale. Thus, for thisreason, too, the appropriate focus is likely to be onimproving productivity and/or minimizing costswithin each product group.

3. It is difficult to transfer information acrossproduct groups. Information within a product groupmay be highly specific and hard to transfer acrossbusiness units. Expertise in functions such as themechanics of check processing, the valuation ofcomplicated derivative products, and the portfoliostrategies used in trust services and private bankingmay be hard to develop and difficult to communicateto managers in other business units.

4. The cross-product synergies are limited. Ifthere are limited synergies across products, it is lessnecessary to develop an “integrated” approach thataims to coordinate decision-making and tasks acrossproduct groups. In this scenario the downside to aproduct-based strategy is likely to be minimal.

5. There is limited substitutability among differ-ent products. Limited substitutability suggests thatthe various products within the firm are distinct fromone another, and do not compete within one an-other. In such circumstances, strategies designed tomaximize profit on individual product lines will leadto overall firm profit maximization.

In the past, many of the above conditions heldtrue for the banking industry. Prior to the last ten to15 years, the industry was highly regulated, and theproducts and technologies that were employed werefairly stable. While there have always been someimportant linkages between the various bankingproducts, regulation and technology have tended tolimit bank managers’ ability to exploit these linkages.In such an environment it is not hard to understandwhy so many banks adopted a product-based stra-tegic focus.

Toward a Functional Approach

While a product-based strategy may have beenappropriate in the past, many of the above condi-tions no longer hold. The evidence cited earlierconfirms that, although customers still rely on banksfor a variety of services, the ways in which theseservices are provided have clearly changed. In thecurrent dynamic environment of continuous prod-uct innovation, the traditional product-based ap-proach to strategic management will often proveshort-sighted and otherwise ineffective. By contrast,the basic functions that banks and other financialservices firms provide their customers are likely toremain relatively constant over time. The challengeis to continue to develop new, more efficient waysof providing these basic services.

What functions do banks provide their custom-ers? A partial list would include:

ConveniencePayment servicesCredit risk evaluation and monitoringAdvisory servicesRisk management services

As financial markets evolve, there will continueto be a demand for all of these services, but the waysthey are provided and the role of banks in providingthem will change.

To illustrate this point further, consider threeexamples:

Example 1. One way that banks provide conve-nience to their customers is by allowing them to


convert deposits to cash. In recent years, theseservices have increasingly been provided at remotesites by ATMs instead of by tellers in branch offices.In the years ahead, it would not be at all surprisingif the vast majority of these transactions take placeoutside of the bank’s facilities.

Example 2. Corporate customers looking forcredit risk evaluation and monitoring often receivethese services through products other than tradi-tional commercial loans. These customers increas-ingly rely on stand-by letters of credit, loan commit-ments, and, in some cases, even direct underwritingof public securities. Each of these “products” servesan important function, yet unlike commercial lend-ing they are not funding-based activities that requirethe bank to hold an asset on its balance sheet.

Example 3. In the past, banking customerslooking for investment advisory services were auto-matically steered to the trust department. While trustservices still remain an important banking product,banks may also indirectly or directly provide mutualfund services to their customers as an alternativeproduct.

The chief drawback of a static, product-basedapproach in the new environment for financialservices is that it is more likely to retard rather thanencourage innovation. Just as a company like IBMthat produces mainframe computers was slow todevelop personal computers, bank executives re-sponsible for particular products may devote insuf-ficient time to developing new products that providethe same function. If bank managers’ compensationis tied directly to the number of loans their unitsoriginates, they have little incentive to sell the bank’sother products, particularly if the growth in theseother products—say, the underwriting of public debtissues—comes at the expense of the manager’s ownproduct. A broader function-based approach is lesstied to particular products and thus more likely toencourage use of all of the bank’s various productsto provide the most service to the customer and themost value to the bank.

Within the past decade, there has been signifi-cant deregulation, important advances in technol-ogy, and major innovations in corporate and per-sonal finance. Banks are now free to expand geo-graphically and to offer customers a wider range offinancial services. Today the subsidiaries of manybank holding companies offer mutual funds andinsurance products, underwrite securities, assist incorporate restructurings and mergers, and serve as

dealers in the market for derivative products such asinterest rate and currency swaps. In sum, deregula-tion combined with the rapid pace of financialinnovation has enabled banks to provide many ofthe same functions they have in the past, but usingdifferent sets of products.

At the same time, technological advances havemade it easier to collect and exchange information.These advances have changed the way in whichmany banking functions are performed and havealso allowed information to be transferred withinand across organizations. In so doing, these im-provements in technology have enabled banks totake fuller advantage of potential synergies amongtheir various products. As just one example, informa-tion about deposit and credit histories can now beefficiently linked to improve the marketing andservicing of other products such as lending andinvestment services. At the same time, this kind ofinformation can be readily shared across institutions,which may explain the rapid development of loansales and securitization.

CHANGES IN ORGANIZATIONALARCHITECTURE

As bank competitive strategies change in re-sponse to deregulation and innovation in the finan-cial marketplace, so too will their optimal “organiza-tional architecture.” Following the authors of theconcept—James Brickley, Clifford Smith, and JeroldZimmerman—we earlier defined organizational ar-chitecture as consisting of three major components:(1) how a company assigns decision-making author-ity for various tasks (for example, whether it choosesto centralize or decentralize certain functions); (2) theinternal performance measurement system it uses toevaluate the performance of managers and employ-ees; and (3) the compensation plan.

Significant changes in the organizational de-sign of banks are already under way. For example,BancOne, after years of building and running itshighly decentralized network of business units onthe principle of the “uncommon partnership,” hasrecently announced its plan to consolidate at theholding company level many of the information-processing and product-pricing functions that oncewere the sole responsibility of the units. Banks likeFirst Union, First Chicago (now a part of NBD),and Bank of America, among others, have createdcorporate banking groups to expand the range of

The chief drawback of a static, product-based approach in the new environment forfinancial services is that it is more likely to retard rather than encourage innovation.Just as IBM was slow to develop personal computers, bank executives responsible for

particular products may devote insufficient time to developing new products thatprovide the same function.


the products they provide to their middle marketand large corporate clients. The creation of suchgroups has required these banks to redesign theirperformance and reward systems. For example, inthe past promotion-based reward systems resultedin the elevation of successful relationship manag-ers to management positions and away from directcustomer contact. In today’s “relationship” banks,promotion-based reward systems are giving way tocompensation systems designed to encourage thedevelopment and preservation of relationships withcorporate clients. Reinforcing this change in com-pensation, the prestige of the relationship manager’sposition in these banks has been elevated to alevel comparable to that of a senior managementposition.

Centralization vs. Decentralization

As banks seek to adjust their organizationaldesign in response to the changing environment,they are often forced to revisit the issue of whichactivities should be centralized and which shouldbe decentralized. Michael Jensen and WilliamMeckling have a provided a useful framework foraddressing this issue—one that centers on the dis-tinction between “specific knowledge” and “gen-eral knowledge.”9 Defined as briefly as possible,specific knowledge is the kind of information thatis difficult and costly to transfer (and verify); gen-eral knowledge is easy and inexpensive to transfer.Details of complicated financial products or tradingand hedging strategies may be difficult to convey toothers within and outside the organization, and inthis sense they constitute a form of specific knowl-edge. Another example of specific knowledge isthe information an effective middle market or com-munity lending officer accumulates over time abouthis or her customers—the kind of information thatmight serve as the basis for “character” lending.(Although it is easy enough to convey such subjec-tive judgments to a credit committee, it is virtuallyimpossible for the committee to verify such infor-mation.) By contrast, information about prices, ac-counting data, and credit histories is easy to trans-fer among agents, and thus is an example of gen-eral knowledge.

Decentralization has the virtue of transferringdecision rights to those with specific knowledge.The main drawback of decentralization, however, isthat it increases the costs arising from any substantialdifferences between the objectives of the decision-maker and those of the organization. To cite theclassic example in banking, paying a loan officerprimarily to generate new loans while also givinghim the power to approve those loans is a prescrip-tion for disaster.

Put another way, centralization within the or-ganization (say, subjecting loan proposals to acredit committee and bank-wide credit standards)can play an important coordinating role in ensuringthat managers and employees are pursuing consis-tent organizational objectives. The big problemwith centralization, though, is that decisions maynot be made by those with specific knowledgeabout the firm’s opportunities (profitable loan op-portunities may be lost because of a too rigidapproval process). Organizations trade off theseconflicting elements when determining the optimallevel of centralization.

The changing business environment in bank-ing has caused many banks to re-evaluate theneed for centralization. Changing technology hasin some instances expanded the set of specificknowledge. In those cases where changes intechnology have created new and more compli-cated products and systems, the set of specificknowledge has expanded, thereby acceleratingthe push towards decentralization. (See “TheCase of Morgan.”)

In other circumstances, however, new technol-ogy has encouraged the centralization of activitiesby making it increasingly possible to collect andtransfer vast amounts of new information. (See“Wells Fargo’s Approach to Small Business Lending:Centralized Decentralization.”)

Deregulation has had a similarly complicatedeffect on banks’ move toward greater decentraliza-tion. As Brickley, Smith, and Zimmerman point out,in most industries deregulation causes companies todecentralize decision-making and to change theirperformance evaluation and reward systems in waysthat give workers stronger incentives to maximizeshareholder value. But, although these same pres-

9. See Michael Jensen and William Meckling, “Specific and General Knowl-edge, and Organizational Structure,” Journal of Applied Corporate Finance, Vol. 8No. 2 (Summer, 1995).


cated financial services throughout the world.These developments have vastly increased theamount of specific knowledge within the bank.The increase in specific knowledge has made acentralized organizational structure increasinglyunwieldy. Warner’s push to “flatten” and “decen-tralize” is a move to transfer decision rights tothose that are best informed.

But the move to decentralize is not without peril.Lines of authority are less clear, making it moredifficult to coordinate the firm’s various activities. Asdescribed in a recent profile of the bank in Institu-tional Investor, “For a flat organization to work, andfor Morgan to survive at its center without being runragged, more decisions, more conflicts have to beresolved horizontally, not vertically.”

decision rights in banks is less clear because of thenature of past banking regulations.10

10. There is considerable evidence that regulation influences compensationstructure as well. In particular, the evidence suggests that regulated industries havea weaker relationship between pay and performance.

In our recent study of the banking industry, we find that banks have a weakerpay-for-performance relationship than nonbanking firms. We also find, however,

that deregulation has increased the sensitivity of pay to performance in banking,and that banks with significant “nonbank” activities have stronger pay-for-performance links than other banks. See Joel F. Houston and Christopher M. James,“CEO Compensation and Bank Risk: Is Compensation Structured in Banking toPromote Risk-Taking?,” Journal of Monetary Economics, November 1995.

WELLS FARGO’S APPROACH TO SMALL BUSINESS LENDING. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .IN THE PAST, most banks found it difficult togenerate large profits from small business lending.The credit risk was significant, yet margins weresmall because of the costs associated with acquiringand processing information about borrowers.

Wells Fargo, recognized by American Banker asthe “runaway leader in small-business lending,” hastaken great strides to develop an expertise in theapplication of technology to small-business lend-ing. Wells has used technology to centralize largeamounts of information about its customers. Thisinformation has been used to develop models topredict the likelihood of defaults, as well as to helpits sales force identify customers that may be inter-ested in a small-business loan. Their efforts havebeen rewarded—small-business lending now pro-duces about $100 million in profits, roughly 10% ofthe bank’s overall profit.

Creating large data bases to develop credit-scor-ing models is not new. Wells’ distinctive accom-plishment has been to do this on a massive scale, andto centralize this information, thereby expandingthe level of general knowledge throughout thebank. In effect, technology has enabled Wells totransfer decision rights to a centralized authority.

But, in the process of centralizing informationand the credit-approval process, Wells’ credit-scor-ing technology has also effectively allowed for amore decentralized delivery system. Individual lend-ers are now able to go out in the field armed witha laptop computer loaded with information from thefirm’s large data base. This enables the lender to“plug in” the borrower’s information into the com-puter model—and, in many cases, to approve loanson the spot that in the past might have taken a greatdeal of time and a great number of people to process.

sures for decentralization now exist in banking, theoverall effect of deregulation on the assignment of

J.P. MORGAN IS A BANK RICH IN TRADITION, witha well-established corporate culture. Like manybanks, Morgan’s organizational structure was largelyhierarchical. Each of the bank’s business unitsreported to a corporate office that was responsiblefor overseeing the bank’s various activities. Re-cently, however, Sandy Warner, Morgan’s newlyappointed chairman, has undertaken dramatic stepsto transform the bank’s organizational design. More-over, as described by an analyst for Merrill Lynch,“Morgan is now shifting from a product focus to aprofitability focus.”*

Warner’s initiatives have come about in re-sponse to changes in Morgan’s business environ-ment. Deregulation and globalization have en-abled Morgan to offer a wide range of compli-

*Quoted in Institutional Investor, March 1996

THE CASE OF MORGAN. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

In cases where changes in technology have created new and more complicatedproducts, specific knowledge has expanded, thereby accelerating the push towards

decentralization. In other circumstances new technology has encouragedcentralization by making it increasingly possible to collect and transfer vast

amounts of new information.


In the past, banks’ attempts to consolidate andso realize scale economies have been limited byrestrictions on interstate branching. And their ef-forts to achieve economies of scope by diversify-ing their product line have been frustrated bylegislation like Glass Steagall, the Investment Com-pany Acts passed in the 1940s, and the BankHolding Company Acts. While deregulation andadvances in information technology have led toflatter organizations in banking (as evidenced bythe significant decline in employment within bank-ing), deregulation has also driven many regionalbanks to consolidate and centralize other pro-cesses such as check clearing, mortgage servicing,credit cards, and even small business loans. More-over, the move we mentioned earlier by someregional banks to consolidate lending activities—which includes consumer lending as well as thelarge corporate and middle market businesses—can also be seen in part as a response to geo-graphic deregulation.

At the same time banks have consolidatedprocessing actitivities and lines of business, theyhave increased the diversity of products offeredthrough their delivery systems. For example, mostlarge regional banks now provide their middlemarket and corporate customers access to a broad setof investment banking products (through Section 20subsidiaries), asset securitization and risk manage-ment services, and an array of private placementactivities. At the retail level, customers of most largebanks now have access to a broader array ofinvestment products through private banking, bro-kerage, and investment units.

The proliferation of products has expanded theresponsibilities of—and, in many cases, the knowl-edge requirements for—relationship managers andothers in the bank delivery system. Besides placinggreater demands on bank employees, such broadproduct strategies require a relationship focus thatcuts across narrow product lines. And, as we discussbelow, one major challenge confronting bankerstoday is to develop performance evaluation andreward systems that promote teamwork amongproduct specialist and reward relationship managerson the basis of the total value created through therelationship.

Performance Measurement andCompensation

Banks, like all firms, must develop effectivesystems for evaluating and rewarding performance—systems that ensure that their managers and employ-ees have the right incentives to increase shareholdervalue. With this in mind, many corporations haveredesigned their internal performance measures andincentive compensation programs to encourage theiremployees to think and act more like shareholders.

In our own recent study of compensation in thebanking industry, we found that although bankshave a weaker pay-for-performance relationship thannonbanking firms, deregulation in banking has beenaccompanied by a significant increase in the sensi-tivity of pay to performance. We also found that,within the banking industry, the pay-for performancelinks were strongest among those banks with signifi-cant involvement in “non-banking” activities.11

The redesign of bank compensation plans ofteninvolves offering managers and employees (or, insome cases, requiring them to buy) shares of thecompany’s stock, or stock options. But, despite theimmense appeal of stock ownership and optionprograms, even providing all employees with signifi-cant amounts of company stock or options willgenerally not be enough to ensure that the firmmaximizes shareholder value. While everyone withinthe organization should think like a shareholder, andtake actions consistent with maximizing shareholdervalue, the actions of most employees are not likelyby themselves to have a profound effect on thecompany’s stock price. The stock price is determinedby the joint activities of everyone within the firm,creating the potential for large “free-rider” problems.For example, the employees within one division ofa bank may have performed poorly and actuallyreduced shareholder value, yet the value of theirstockholdings may have risen if the rest of the bankperformed well. Likewise, the trust department of abank in a given year may have taken large strides toimprove shareholder value; but the value of theirstockholdings may have fallen if elsewhere in thebank there were large trading losses or bad loans.The key is to measure the marginal impact that eachemployee or division has on shareholder value.

11. See Joel F. Houston and Christopher M. James, “CEO Compensation andBank Risk: Is Compensation Structured in Banking to Promote Risk-Taking?,”Journal of Monetary Economics, November 1995.


Unfortunately, there is only one stock price forthe entire bank holding company. As bank productand service offerings broaden, this single measure islikely to become less effective as a way of rewardingperformance. Bank managers therefore need todevelop effective measures of performance for vari-ous units within the organization—measures thatprovide reliable indicators of whether such opera-tions are really adding value for shareholders.

Many banks use measures such as net interestmargins, expense ratios, ROA, and ROE to measureperformance at various levels of the organization.But each of these traditional accounting measures ofperformance has shortcomings. In principle, a busi-ness is adding value if its return on the capital tiedup in that business is greater than the cost ofcapital—the rate of return investors expect to earnon an investment of comparable risk. Given thisobjective, the use of profit margins and expenseratios alone are unlikely to provide useful guides tovalue.12 Businesses with very low profit margins orhigh expense ratios could add significant value ifthey use small amounts of capital. Conversely,activities with high margins could actually be reduc-ing shareholder value if they required large amountsof capital to support them.

Measures like ROA and ROE represent an im-provement over margins, but they too have limitations,particularly their propensity to lead to underinvestment.For example, as discussed in a recent AmericanBanker article (1/24/96), SunTrust Banks remains oneof the few large regionals to maintain a number ofseparately chartered bank subsidiaries. The CEOs ofthese 29 subsidiaries enjoy a high level of autonomy.While the system has generally worked well, achievingROE and net income targets at the local level does notalways serve the interest of the holding company. AsSunTrust president L. Phillip Humann explains, “Oneway to make your profit plan, in a very near-termsense, is to underinvest... we were always making ourplans but in doing so we were sort of squeezing ourselfout of a part of our future.”

In response to these concerns, some bankshave developed alternative approaches to evaluat-ing economic performance. One approach that israpidly gaining acceptance is to calculate the eco-

nomic value added, or EVA, of the organization andeach of its sub-units. A company or one of itsdivisions generates positive EVA, and thereby cre-ates economic value, to the extent that its after-taxoperating cash flows exceed the cost of the capitaltied up in the business.

Besides measuring a company’s efficiency inusing capital, the EVA measure can also be custom-designed to encourage longer-term investment bycapitalizing expenditures with deferred payoffs. Forexample, using an EVA system, a bank intent onbuilding its retail business might want to capitalize (forinternal measurement purposes) part of the expense ofacquiring new technology or running a promotionalcampaign to gain new customers—and then amortizethat expense over a three- to five-year period. In thisfashion, EVA can be used to overcome the shortsight-edness that is effectively built into GAAP accounting.

The principle contribution of EVA, however, isthe emphasis on economic as opposed to account-ing profits. By establishing the weighted average costof capital as the hurdle rate, EVA correctly recognizesthat for projects to add value they must generateenough cash not only to service debt, but to provideshareholders with their required rate of return.

Allocating Capital

Apart from the standard objections to usingtraditional accounting measures to gauge perfor-mance, the use of ROA or ROE seems even moreproblematic given the recent changes in the bankingindustry. As banks move away from traditionalfunding-based activities toward off-balance-sheet,fee-based services, ROA and ROE are even less likelyto provide an indication of whether an activity ordivision is creating value for its shareholders. Thereason lies in the distinction between what RobertMerton and Andre Perold call “cash capital” and “riskcapital.”13 Cash capital is the up-front cash contrib-uted by equity holders to acquire an asset or effecta transaction. Risk capital, on the other hand, refersto the amount of equity capital needed to absorb aloss in a particular position.

In traditional funding-based activities such ascommercial and consumer loans, the amount of cash

12. For evidence of the unreliability of expense ratios as guides to profitabilityin banking, see Jon Osborne, “A Case of Mistaken Identity: The Use of ExpenseRatios to Measure Efficiency in Banking,” Journal of Applied Corporate Finance,Vol. 8 No. 2 (Summer 1995).

13. Robert C. Merton and André F. Perold, “Theory of Risk Capital in FinancialFirms,” Journal of Applied Corporate Finance, Vol 6, No. 3 (Fall 1993).

Besides measuring a company’s efficiency is using capital, the EVA measure can alsobe custom-designed to encourage longer-term investment by capitalizing

expenditures with deferred payoffs.


capital (which is usually determined by regulation)was intended to approximate the amount of riskcapital needed to insure against credit losses. As aresult accounting measures of performance such asROE were reasonably related to the true risk-ad-justed return associated with a funded asset such asa commercial or consumer loan.

By contrast, measuring the ROE of activities suchas issuing standby letters of credit, intermediatinginterest rate and current swap agreements, and provid-ing advisory services is much more challenging. Thesefee-based services generate income without any ap-parent increase in either assets or cash capital. Never-theless, these activities do make use of bank resourcesby exposing the bank to potential losses and shouldtherefore be assessed some capital charge. Put anotherway, without such an adjustment, it would appear thata simple way to increase a bank’s ROE would be to cutits loans in half and then use fee-based services to offsetthe lost income. This action would maintain the samelevel of income with fewer assets and would ostensiblyrequire less equity capital.

Currently there is a tremendous amount ofinterest among bank managements and bank regu-lators in capital allocation models that link theamount of capital to the value the bank has at risk ina particular activity or position. These so-called“value at risk” models base the amount of capitalrequired for a particular position on either thehistorical variability in the market value (or netoperating income) of a position, or on the variabilityderived from an underlying pricing model. Once theappropriate level of capital has been estimated for agiven business or activity, management can then usethat estimate to calculate the activity’s risk-adjustedreturn (RAROC) or its EVA.14

Capturing Synergies

While RAROC and EVA calulations provide abetter benchmark for evaluating performance thantraditional accounting measures, a number of prob-lems remain. Perhaps the most difficult is how to

account for synergies across bank products. Furthercomplicating matters, there are generally two differ-ent kinds of synergies at work in most banks andother financial institutions. We will call them finan-cial synergies and operating synergies.

Accounting for Financial Synergies. The amountof risk capital necessary to support a given activity orposition depends on how the variability in the mar-ket value or earnings of that activity contributes tothe overall variability of the bank’s market value orearnings. But this contribution to overall variabilityin turn depends on the covariability of the activity’sexpected returns with the expected returns of thebank’s other assets. The more highly correlated anactivity’s profit stream with the rest of the bank’s, thelarger the activity’s contribution to overall risk and,hence, the higher its minimum required rate of re-turn. Conversely, the more an activity’s profits serveto offset and dampen the bank’s profit swings, thelower is that activity’s risk contribution and requiredreturn. Without going into more detail here,15 we willsimply note that the covariability of returns amongdifferent business activities can make calculating themarginal impact of any single activity on the overallrisk capital of a bank a complex undertaking.16

Accounting for Operating or Product Syner-gies. In some ways, an even more challengingproblem arises in attempting to determine the valueadded associated with a particular product or groupof products provided as part of an overall relation-ship with a particular customer. For example, towhat extent do securities underwriting opportuni-ties arise from an ongoing credit relationship with aparticular corporate customer? To what extent is thesale of mutual fund services attributable to the salesexpertise of the private banker at the local bankbranch as opposed to, say, the investment expertiseof the fund manager?

The inherent difficulties in separating the con-tribution of particular products offered as part of abundle of services make allocating the value addedextremely difficult. And this problem is likely to getworse as banks centralize many activities while at the

14. Calculation of a business’s RAROC per se does not tell you how much valuea business is adding for shareholders, or, in the absence of a hurdle rate, evenwhether that business is adding or subtracting value. This is what an EVA measureis designed to capture. For a much more detailed discussion of these issues, seelater in this issue, Edward Zaik, John Walter, Gabriela Kelling, and ChristopherJames, “RAROC at Bank of America.” See also the extensive discussion of RAROC-based systems in the Roundtable discussion that follows this article.

15. For a quantitative method for capturing these interrelationships amongbusiness units, see Robert C. Merton and André F. Perold, “Theory of Risk Capital

in Financial Firms,” Journal of Applied Corporate Finance, Vol 6, No. 3 (Fall1993).

16. One of the difficulties arises from the fact that the amount of capitalrequired for a position will depend on the other assets in the bank’s portfolio. Andthis means that continuous changes in the bank’s portfolio would, in principle,require continuous changes in capital allocations to business units. In such cases,compromises with theoretical precision would almost surely be made in order togive operating managers a relatively stable benchmark.


same time relying more on incentive compensationin their delivery systems.

The difficulty of devising performance measuresthat succeed in capturing synergies no doubt ex-plains why so many banks in the past have choseninstead to rely on standard accounting measures thatare easy to calculate and understand. Indeed, giventhe stable environment that banks once operated in,such simple systems may have made sense. But,given the rapid change in the economic and regula-tory environment, banks no longer have the luxuryof doing it the “simple way.” With this in mind, moreand more attention is likely to be devoted in the yearsahead to developing improved systems for evaluat-ing performance.

Another solution to the problem of how tomeasure and motivate synergistic behavior is simplyto reorganize by combining once separate businessunits. One advantage of such consolidation is that itreduces the need for developing narrower measuresof value added—although there is an offsetting costin the form of less effective use of specific informa-tion. Yet another approach to capturing synergies—one that is designed to achieve greater coordinationwhile preserving some of the incentive benefits ofdecentralization—is to establish matrix forms of or-ganizations. In matrix organizations, product man-agers are given authority and accountability that cutsacross different operating units, even as operatingheads continue to operate in an otherwise decentral-ized fashion.

CONCLUSION

The banking industry represents an importantand interesting case study in how changes in tech-nology and regulation influence business strategyand organizational architecture. Focusing narrowlyon traditional bank products and performance mea-sure, it is easy to conclude that banking is a decliningindustry. Such a focus, however, ignores much of theinnovation that has occurred in financial markets andthe banking sector over the past several decades. Abroader perspective reveals that banks are evolvingto provide the same basic functions in new, moreefficient ways.

The changes in the environment of bankinghave forced banks to change their strategic focus andto modify their organizational design. Many of thesechanges, such as the centralization and consolida-tion of processes and the broader product offerings,appear to be quite different from changes now takingplace throughout much of the nonfinancial sector.For example, while most industrial companies arespecializing in fewer products—or at least selling orspinning off unrelated lines of business—the prod-uct offerings of many banks are becoming steadilymore diversified. Managing the increased diversifi-cation and innovation that is occurring in the finan-cial services sector represents a major challenge tobank managers. Meeting this challenge will requireconsiderable rethinking of performance evaluationand reward systems.

CHRISTOPHER JAMES

is the William H. Dial/SunBank Professor of Finance at theUniversity of Florida.

JOEL HOUSTON

is Associate Professor of Finance at the University of Florida.

The inherent difficulties in separating the contribution of particular products offeredas part of a bundle of services make allocating the value added extremely difficult.And this problem is likely to get worse as banks centralize many activities while atthe same time relying more on incentive compensation in their delivery systems.

Journal of Applied Corporate Finance (ISSN 1078-1196 [print], ISSN 1745-6622 [online]) is published quarterly on behalf of Morgan Stanley by Blackwell Publishing, with offices at 350 Main Street, Malden, MA 02148, USA, and PO Box 1354, 9600 Garsington Road, Oxford OX4 2XG, UK. Call US: (800) 835-6770, UK: +44 1865 778315; fax US: (781) 388-8232, UK: +44 1865 471775, or e-mail: [email protected].

Information For Subscribers For new orders, renewals, sample copy re-quests, claims, changes of address, and all other subscription correspon-dence, please contact the Customer Service Department at your nearest Blackwell office.

Subscription Rates for Volume 17 (four issues) Institutional Premium Rate* The Americas† $330, Rest of World £201; Commercial Company Pre-mium Rate, The Americas $440, Rest of World £268; Individual Rate, The Americas $95, Rest of World £70, Ð105‡; Students**, The Americas $50, Rest of World £28, Ð42.

*Includes print plus premium online access to the current and all available backfiles. Print and online-only rates are also available (see below).

†Customers in Canada should add 7% GST or provide evidence of entitlement to exemption ‡Customers in the UK should add VAT at 5%; customers in the EU should also add VAT at 5%, or provide a VAT registration number or evidence of entitle-ment to exemption

** Students must present a copy of their student ID card to receive this rate.

For more information about Blackwell Publishing journals, including online ac-cess information, terms and conditions, and other pricing options, please visit www.blackwellpublishing.com or contact our customer service department, tel: (800) 835-6770 or +44 1865 778315 (UK office).

Back Issues Back issues are available from the publisher at the current single- issue rate.

Mailing Journal of Applied Corporate Finance is mailed Standard Rate. Mail-ing to rest of world by DHL Smart & Global Mail. Canadian mail is sent by Canadian publications mail agreement number 40573520. Postmaster Send all address changes to Journal of Applied Corporate Finance, Blackwell Publishing Inc., Journals Subscription Department, 350 Main St., Malden, MA 02148-5020.

Journal of Applied Corporate Finance is available online through Synergy, Blackwell’s online journal service which allows you to:• Browse tables of contents and abstracts from over 290 professional,

science, social science, and medical journals• Create your own Personal Homepage from which you can access your

personal subscriptions, set up e-mail table of contents alerts and run saved searches

• Perform detailed searches across our database of titles and save the search criteria for future use

• Link to and from bibliographic databases such as ISI.Sign up for free today at http://www.blackwell-synergy.com.

Disclaimer The Publisher, Morgan Stanley, its affiliates, and the Editor cannot be held responsible for errors or any consequences arising from the use of information contained in this journal. The views and opinions expressed in this journal do not necessarily represent those of the Publisher, Morgan Stanley, its affiliates, and Editor, neither does the publication of advertisements con-stitute any endorsement by the Publisher, Morgan Stanley, its affiliates, and Editor of the products advertised. No person should purchase or sell any security or asset in reliance on any information in this journal.

Morgan Stanley is a full service financial services company active in the securi-ties, investment management and credit services businesses. Morgan Stanley may have and may seek to have business relationships with any person or company named in this journal.

Copyright © 2004 Morgan Stanley. All rights reserved. No part of this publi-cation may be reproduced, stored or transmitted in whole or part in any form or by any means without the prior permission in writing from the copyright holder. Authorization to photocopy items for internal or personal use or for the internal or personal use of specific clients is granted by the copyright holder for libraries and other users of the Copyright Clearance Center (CCC), 222 Rosewood Drive, Danvers, MA 01923, USA (www.copyright.com), provided the appropriate fee is paid directly to the CCC. This consent does not extend to other kinds of copying, such as copying for general distribution for advertis-ing or promotional purposes, for creating new collective works or for resale. Institutions with a paid subscription to this journal may make photocopies for teaching purposes and academic course-packs free of charge provided such copies are not resold. For all other permissions inquiries, including requests to republish material in another work, please contact the Journals Rights and Permissions Coordinator, Blackwell Publishing, 9600 Garsington Road, Oxford OX4 2DQ. E-mail: [email protected].

evolution or extinction: where are banks headed?

Documents