Strategic problems faced by banks. How to prevent future crises


Term Paper, 2017
9 Pages

Excerpt

Table of contents

1 Introduction

2 Fundamentals of banking strategy

3 Strategic models as contributors to bank failures during the financial crisis

4 Lessons from failing strategies

5 Conclusion

6 References

List of tables and figures

Figure 1: Strategic choices

Figure 2: Deciding how to win

1 Introduction

In this paper, issues of banking strategy as possible contributors to bank failures in the recent financial crisis will be examined. The relevant strategic models which led to the tumbling of banks will be discussed in order to give a clear advice on how to prevent future crises. For a better understanding of this specific area, there will be at first a brief explanation of strategy in banks.

2 Fundamentals of banking strategy

Banking strategy is a widely used term, but it is not the purpose of this essay to present a complete discourse of all its elements. It is rather important to give an overview of the significant drivers that can and should be regarded by bank managers to allocate resources effectively with the aim of long-term company success and - in the light of the devastating financial crisis – adequate risk exposures. “Any strategy should take into account the starting point and the customer, competitive, technological and regulatory trends affecting a bank and its markets. (…) Strategy should define the attractive markets and whether a bank can develop a strong and sustainable position in those markets so that it can build a few distinctive assets and capabilities that set it apart.” (Bain & Company 2015)

A proper start to conduct strategic bank management is to use a three-dimensional matrix with the areas of clients, products and geographies. In the first step, the task is to allocate financial, human and IT resources to the specific cells in the matrix with the highest expected risk-adjusted returns. Then the cells should be linked in order to generate synergies. Examples are operational efficiencies and diversification effects between different client or product groups which generate uncorrelated income streams as well as an improved client service if existing infrastructure in particular locations can be used. It is further suggested to harvest the possible economies of scale (size effects) and scope (synergy effects) for each line of business. Financial firms who understand these linkages exhibit a high grade of strategic integrity by maximizing the value of their business units. In this context, a naïve “overdiversification” is clearly discouraged, because the market would price the bank with a conglomerate discount (Smith et al. 2012).

Another perspective of bank strategy is given by Bain & Company (2015). Figure 1 shows their three-piece pyramid of strategic choices:

illustration not visible in this excerpt

Figure 1: Strategic choices, source: Bain & Company 2015

The first part is ambition, including the vision of the firm which should inspire employees and give specific goals for the future competitive position of the bank. Furthermore, firm fundamentals like risk appetite are defined. The second area contains the portfolio choices from geographical exposure to product choices and business lines to invest in as well as a proper asset-liability management. The above described dimensional linkage and its benefits take place here. Before the tactical implementation starts, the sources of competitive advantage should be evaluated in the third section. Here is for example defined, how customers can be fascinated, which processes are more efficient than those of competitors and which brands can create value (Figure 2). The point is, that is not possible to be the best bank in all segments. Leading institutes know their strengths and invest heavily in those capabilities which makes them more profitable than their peers who try to win in every field of the value chain (Bain & Company 2015).

illustration not visible in this excerpt

Figure 2: Deciding how to win, source: Bain & Company 2015

3 Strategic models as contributors to bank failures during the financial crisis

The basic areas of strategic problems during the financial crisis were asset quality, liquidity and funding structure, capital base and leverage as well as the overall risk management, aligned by some individual issues like failing M&A deals. They will now be discussed successively in order to present a deeper view of the roots of failure.

In a worldwide banking environment full of competition and growth pressure, asset quality issues evolved in many banks who tried to increase profits and market share. Some institutes changed their traditional low-risk regional business models into aggressive global expansion strategies. We have seen the prominent case of the bank Lehman Brothers, who rapidly changed its business model from classic brokerage to highly leveraged real estate and private equity investments, increasing the asset risk significantly in the years prior to the crisis. Another example is that of the German Landesbanken who started operating in international investment banking and funding strategies besides their traditional central banking function for German savings banks. As a result, many of them failed, partly because of lacking expertise and too optimistic views on complex assets classes like securitized debt, whose bubble they unknowingly helped to finance. Their losses were significantly larger than the profits resulting from the expansion, what proves our thesis from chapter 2: Banks should invest heavily in their core capabilities. On the other hand, a too concentrated exposure in the domestic market can also be unhealthy, as the example of the Spanish cajas shows: During the real estate bubble, they aggressively expanded their mortgage portfolio for households and developers. Needless to say, that the deterioration of these loans during the Spanish real estate crash led to the ceasing of operation of many of these banks (Ibid.).

In the case of RBS, which also failed during the crisis, non-performing loans were an issue, but they were not the original cause. Rather problematic was the publicly known competition strategy containing aggressive growth targets, leading to market concerns regarding the scale of necessary impairments and the stability of the bank. In fact, this confidence effect was at the beginning of the crisis higher than the real loan losses. Beyond that, RBS exhibited tremendous losses in its credit trading books, alone £12.2bn in 2008. Like many other banks, they bought complex exposure in the US housing credit market, tempted by attractive returns of mortgage-backed securities (MBS) and safe-looking senior tranches of collateralized debt obligations (CDOs). Here the strategic problem of a non-functioning risk management capability comes to the light: Management as well as the board of directors should have been informed on the one hand about the toxic subprime mortgage exposure inside these structured credit instruments and on the other hand about the limited extent of tranching in CDOs (Financial Services Authority 2011).

That devastating situation was further worsened by the following aspects: The pre-crisis acquisition of ABN AMRO, which was conducted with inadequate portfolio due diligence and can be called a strategic failure for itself, led to a doubling in the credit trading book of the new entity. Additionally, hedging and distribution of non-performing credit derivatives to less informed investors was not a strength of RBS traders. Such toxic offloading behavior is not a proper way to deal with clients if we look back to chapter 2, where we defined customer relationships as a proprietary asset and as a source of competitive advantage. Thus, distribution should only occur to informed investors (Ibid.).

RBS management saw its share price declining in 2006 and made the wrong conclusion, that they were undervalued by the market while in reality the immense asset risk exposure was deducted. One of the biggest strategic mistakes was then the further expanding of trading activities with the aim of recovering market capitalization (Ibid.). Looking back at the model of the strategic cube, this management decision to invest heavily in the “credit trading cell” was only short-term return-driven, but not risk-adjusted as proposed in the model.

Staying at the RBS example, the next strategic area is liquidity and the funding structure. Both aspects are interrelated, because a sufficient part of liquid assets is needed to cover for a possible short-term funding gap on the liability side. The previously mentioned concerns about the real impacts on the loan portfolio of RBS and the aligned potential insolvency led to a liquidity run, mostly by wholesale lenders (i.e. banks and corporate investors, money-market) who lost confidence. The reliance on short-term wholesale funding is thus a strategic problem, which led primarily to the failure of this specific bank and many other institutes. RBS had an extremely high share of these volatile funding sources and 70% of them had an overnight maturity. This fact was enforced by the ABN acquisition which was nearly completely funded by short-term market debt. In general, UK banks growing loan books were funded less by deposits which led to a rising “customer funding gap”, making the industry vulnerable as a whole, because retail deposits are a more healthy, wide-spread and long-term funding base. In the given case, the “depositors bank run impact” was of low extent and occurred much later, compared with the wholesale funding sources (Ibid.). The ratio of depository funding over total assets is called “exposure to rollover risk” in regard to risk that the wholesale market refuses to roll over short-term funding (Ratnovski/Huang 2009). This risk was apparently not proper managed. “The key problem was that banks stopped trusting each other and the interbank market, one of the most liquid markets in the world, became completely illiquid.” (High Level Expert Group 2012, p. 59)

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Excerpt out of 9 pages

Details

Title
Strategic problems faced by banks. How to prevent future crises
College
School of Oriental and African Studies, University of London  (CeFIMS)
Author
Year
2017
Pages
9
Catalog Number
V379757
ISBN (eBook)
9783668572607
ISBN (Book)
9783668572614
File size
552 KB
Language
English
Tags
strategic
Quote paper
Arno Hetzel (Author), 2017, Strategic problems faced by banks. How to prevent future crises, Munich, GRIN Verlag, https://www.grin.com/document/379757

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