value insights

Financial Services Globalization Capabilities- Valutrics

 

Defining International Financial Services
Financial services may be defined as the provision of instruments and mechanisms to hold and manage savings, obtain funding, transfer funds between locations and forms, manage risks, and get advice on financial concerns.

A financial services market exists when a firm has found a sustainable (i.e. profitable in the long run) way to satisfy one or more of the above-listed customer needs through selling financial products and services. Product as well as customer properties are frequently used to distinguish between different financial services markets. In their annual reports and conference presentations, executives habitually discriminate between products (banking vs. asset management vs. insurance), geographical segments (local areas vs. nations vs. regions vs. development stage vs. ICT infrastructure availability), client segments (corporate vs. private vs. institutional clients), and distribution channels (branch network vs. agents vs. online vs. telephone). All of these categories, of course, can be sub-segmented and combined. For example, in one of its strategy meetings, AIG management teams may speak about the online car insurance market for Hispanic immigrants in the United States.

In the world of financial services, the business landscape is certainly fragmented: physical presence in financial centres such as London or New York still matters for investment banking and international strategy differs from national strategy in many aspects. If the world were flat, that is, without any cultural, technological, institutional, and geographical barriers, studying international business strategy would be useless. One could just take theories and concepts developed in the field of strategic management and apply them to the one big national market—‘the world’.
In most of its business segments, financial services is still a people business and requires local contacts and face-to-face meetings, which reduces the impact of digital communication channels and opportunities for global or regional service standardization. Product portability even within apparently would-be homogeneous financial services markets such as the Eurozone is very limited.

Digital Financial Service Properties
Most financial services products are experience goods as they are characterized by the fact that quality and price are difficult to observe before consumption. When getting a simple loan or a mortgage, the most important service parameters can be evaluated before contacting a bank. A mortgage can therefore be classified as a search good. Some financial services products are neither search products nor experience goods, but rather credence goods, that is, many clients are not able to evaluate the performance of the bank even after the experience was made. If a customer invests in a leveraged certificate and gets an annual return of 4.8 per cent, is that good or bad? Market conditions, the construction of the product, the service fees, and other parameters would have to be compared to other products and service providers—an effort that customers make intuitively, but most often not based on objective parameters.

In such situations, brands are extremely important. To offer search goods, providers do not necessarily need a strong brand or a large branch network with competent consultants. Getting a loan is as simple as buying a new laptop at the computer hardware discounter Vobis. Consulting activities are hardly necessary. Creating a pension plan is more complex and requires more sophisticated consulting services and the customer has to have an elevated level of trust in the consultant and the service provider in general.

Retail banking services, for example, can be classified under the category of ‘soft’ services, as a significant number of banking operations are produced and consumed at the same time. They do have some ‘hard’ service features, such as back-end information technology (IT) systems and product offerings that can be centralized at one location far from the point of sale or consumption. One example of standardized retail banking services has been successfully implemented by ING Bank online. ING offers standard deposits to its customers in different nations in an uncomplicated manner through the Internet, consequently avoiding customization expenses, branch networks, and client consulting costs.

Retail banking services can also be categorized as knowledge-intensive, where knowledge stored in individuals and units is the key resource, and where capital investments are much lower than for other services. On the macro-level, the retail banking sector is heavily guarded by government controls, which has implications for customer loyalty. In terms of the relative importance of incentives to internationalize, retail banks have witnessed a gradual shift from extrinsic factors (such as ‘follow your client’) to sector-intrinsic factors (such as ‘herding’), and finally to bank-intrinsic factors (such as capitalization, performance) from 1970 to 2000.

Globalization and Offshoring of Financial Services
Ongoing domestic merger activities cause substantial data collection difficulties. BBVA, for example, emerged out of nine Spanish banks. Understanding how the degree of internationalization (DOI) changed over time would mean trying to reconstruct the internationalization history of the observed banks. Changing accounting standards also complicates the definition of a DOI: in 2006, Banca Intesa did not separately account for retail banking activities (reported figures include corporate banking) and their annual reports list retail activities for foreign clients (but managed out of Italy) as foreign sales. Furthermore, some firms move their headquarters to a different country as HSBC did in 1993, or refer to neighbouring countries as part of the ‘extended home market’ or as the ‘second home market’. In addition, countries change their boundaries and thus alter DOI measures.

In other words, measuring the DOI of a financial services firm is always arbitrary and subject to discussion. The construction of an index including several dimensions nevertheless gives an approximate sense of the degree of international exposure of a financial services firm. To construct such an index, several dimensions of multinationality can be used:
• Foreign sales to total sales
• Foreign assets to total assets
• Number of foreign countries with direct presence
• Number of foreign employees to total employees
• Cultural distance index of foreign subsidiaries
• Number of international strategic alliances
• Number of foreign top managers to local top managers
• Number of international competence centres to total competence centres
• Percentage of foreign ownership
• Number of foreign clients to total clients

Most of these measures, however, assess merely the level of international presence but reveal little about the level of cross-border integration. Especially in retail banking, most international subsidiaries today may share a common ICT backbone but are fairly autonomous entities in terms of strategic decision- making and resource allocation. They are often close to being completely independent banks with a foreign financial services firm as shareholder. In a truly transnational or globally integrated bank, however, the subsidiaries are incomplete economic entities and their value derives largely from relationships with others. Increasing cross-border integration implies an increased coordination control of business activities and resources.

Currently used DOI measures by international business (IB) literature capture the international exposure but do not reveal much about the evolutionary state of the network of subsidiaries. Many studies in IB literature draw on the concept of integration of international operations as a key element of international strategy4and some even suggest that the international integration of value-added activities is the essence of global competition. Few contributions actually measure the concept of ‘geographical integration’ on a firm level.

Multinational financial services firms exist because they are able to successfully transfer their superior resources and capabilities to other markets. For those firms, international presence has the potential to increase their performance substantially. Citigroup boosted its international presence when it started to develop dedicated products that could be standardized to some extent and valued by global corporate clients. To increase product homogeneity across markets, Citigroup changed its organizational structure from a purely geography-based organization with autonomous local banks to a matrix structure, at least in corporate banking, with the formation of a ‘global relationship bank’ serving OECD countries where geography is no longer the primary concern.

Given the nature of emerging market countries, Citigroup decided to stick with geography as its main segmentation criterion but assigned the global relationship bank with the coordination task for product development.
International consolidation is more complex to plan and execute because financial services firms need to follow strict national regulations to which they are subject, and customer behaviour in relation to savings, investment, and transactions is nationally differentiated by culture and tradition.

For these two reasons, internationalization in banking and insurance firms is strategically and operationally more complex and interesting than internationalization in computer software, semiconductors, or soft drinks, and even compared to other service types such as business consulting, hotel services, legal services, restaurant services, and the like.

International presence can create economic value by reaping economies of scale, scope, location advantages, and global learning. Unlocking such sources of returns to an international presence requires close managerial attention to trade-offs in deciding when to go international, which markets to enter, how to enter a particular market, how to compete locally, and how to organize the enlarged firm.

The specific characteristics of financial services typically alter the costs and benefits of international expansion, and, as a consequence, the direction, path, and mode of foreign market entry. The challenge for financial services firms was and still is to find opportunities to apply superior and transferable (IT) systems, brands, products, marketing, and general management skills to potential new markets. As banks and insurance firms increasingly seek profitable growth through geographical diversification, we can observe that individual banks apply distinct strategies and organizational designs leading to significant performance differences. There is no ‘one size fits all’ approach to banking internationalization, and the ‘herding’ approach that many banks applied in strategy making in the past is no longer sufficient.

Offshoring in financial services has historically been focused on low value-added activities and forced to fight with legal constraints and cultural barriers. Only recently have large financial services firms such as Citigroup, JP Morgan Chase, or HSBC offshored more sophisticated processes such as equity research. This shows that even in knowledge-intensive services industries, it is possible to identify value chain activities that can be standardized and offshored. However, this is a recent trend. Lower value- added equity research processes that can be offshored are library functions, structured company and industry reports, and to some extent even the blending and packaging of various data on a given subject, for example an analysis of earnings estimates for a biotech company and, based on that research, the development of a valuation model. The higher value-added activities of investment banking, such as raising money by issuing and selling securities in the primary market, assisting public and private corporations in raising funds in the capital markets, or providing strategic advisory services for mergers and acquisitions, however, are still located in the richer countries.

Similarly, insurance companies have tapped into offshore resources using a variety of different models. AXA and Allianz have set up captive operations. In 2003, Allianz set up an offshore software development operation in Southern India. Others, such as the world’s biggest insurance company AIG, decided to directly contract an Indian supplier. Still others decide to use the offshore arms of Western services firms or a more complex ‘build-operate-transfer’ approach to offshoring: AVIVA first created captive offshoring operations, operated them, and then decided to spin off those operations.

New Competitors Emerge
As the competitive landscape of financial services evolves, we can observe new competitive players entering attractive segments. Among these new entrants are industrial corporations like GE or Siemens, retailers like Metro, Wal-Mart, or Marks & Spencer, and car manufacturers like BMW, Volkswagen, or Ford. Banks and insurance companies have lost their well-protected oligopoly for financial services to the benefit of competitors from a variety of industries. In addition, exchanges or other financial transaction platforms increasingly enter traditional banking markets.

To defend the territory, financial services firms will have to prepare a convincing response to this threat. The competences on which new entrants often base their competitive advantage are technology based and include expert systems, customer relationship management (CRM), and distribution technologies. Financial services companies must invest in these areas to defend successfully. The threats for financial services companies exist in areas where they are unable to match service levels or product variety. Threats also exist in areas where financial services companies have insufficient information to target customers effectively.

Peer-to-peer finance is another phenomenon contributing to the erosion of the oligopoly of banks in lending. The basic business idea of companies like Zopa or Prosper is rather simple—institutional scrutiny of finance demands is replaced by supervision within a network of peers. The mission of Prosper, America’s first peer-to-peer lending marketplace, is to ‘… make consumer lending more financially and socially rewarding for everyone’.13Borrowers and lenders meet in the marketplace, the ‘eBay’ of consumer lending, and Prosper facilitates that process, earning a service fee for the facilitation. A good idea attracts new competitors, and the British competitor Zopa entered the American market in 2006 with its offerings.

Even the highly profitable exchanges are signalling a willingness to move towards the banking businesses. As banks increase their off-exchange business and set up exchange look-alikes of their own, the exchanges promptly threaten with backward integration. The global consolidation process of the exchanges continues, which will most likely lead to the creation of four to six dominating marketplaces. The London Stock Exchange is gaining importance with the increased weight of the Eurozone and an advantageous time zone position. While the New York Stock Exchange drives the cross-Atlantic consolidation process, the LSE is searching for a regional solution with its acquisition of Borsa Italiana.

Increased scale gives the exchanges the power to respond aggressively to the disintermediation attempts of banks and alternative trading markets backed by banks. The response of the duopoly, the New York Stock Exchange and the NASDAQ, has been to buy new entrants.

The longer-term implications will be an increase in the number of entrants into financial services markets by out-of-sector companies with strong brands, better ways of segmenting customers, and well-built service cultures. But not all of those new entrants will succeed in staying ahead of the competition. General Electric, for example, announced that it will sell off parts of its commercial and consumer finance business and focus on its fast growing areas of aerospace, energy, and disposals. However, the result of falling industry boundaries is a further pressure on basic financial product margins.
The sectors most susceptible to new entrants are motor insurance, accident and health insurance, household insurance, mortgages, life insurance and pensions, leasing, and credit cards. Technology will help new entrants match existing financial services company strategies through the implementation of customer relationship management systems and developments in distribution. Existing financial services companies with a strong brand and solid financial performance will be the least susceptible to losing customers to new entrants. However, this trend is not unilateral. Banks have also started to diversify into other non-banking businesses (besides insurance).

The Role of Networks
To a large extent, fast-paced internationalization depends on an organization’s set of network relationships . Foreign firms seek to obtain a position in an industrial value network. Such networks can be based on strong personal relationships or institutional ties. In Germany, for example, the term ‘Deutschland AG’ (i.e. Germany Ltd.) has been coined to indicate the cross-shareholdings of large companies and the cross-company supervisory board memberships. In Japan, such networks are called ‘keiretsu’ and describe a set of companies with interlocking business relationships and shareholdings. In South Korea, such business groups are called ‘Chaebol’. If such industrial value networks are already developed across borders, they could support a late mover to tap into complementary resources in established industrial networks in the host country. Hence, international expansion may proceed faster, compared to firms that operate in industries where international industry networks have not yet been established. Such networks may well be instrumental for firms during rapid internationalization because networks often allow access to complementary resources to compensate for lacking own capabilities and assets.

Personal international networks may also contribute to manager/ entrepreneurs’ experiences and open attitudes. Individual managers with an international mindset may have international access to social networks. This, in turn, can contribute to early and accelerated internationalization. Network relations may become bridges to foreign markets. If managers have acquired prior foreign market knowledge, the internationally expanding firm may not need to independently acquire knowledge, and one would expect faster internationalization and higher commitment modes.

International Niche Markets
Independent new ventures operating in niche markets may exhibit patterns of accelerated internationalization. If firms operate in niche markets or narrow product lines, growth objectives will be constrained by limited home demand: if international expansion provides the only growth path, internationalization may be required to achieve economies of scale or to leverage differentiation advantages gained at home. Hence, the speed of market entry depends on the need to achieve economies of scale and scope.
Many financial services firms offer a vast product range in their home countries but focus on a few main products in their international markets.

Firms such as UBS, Credit Suisse, or Deutsche Bank offer retail services in their home markets but focus on wealth management and/or investment banking in foreign markets. The Australian Macquarie Group, headquartered in Sydney, is another example of a financial services firm that chose to internationalize with a focused service offering. It seems that with increasing geographical distance, the bank narrows down its service range. More than 55 per cent of bank income is generated from clients and activities outside Australia. Macquarie Group strategy is to ‘expand selectively, seeking only to enter markets where our particular skills and expertise deliver real advantage to the clients. This approach allows the flexibility to enter new sectors and regions as opportunities arise and to respond to the specialist requirements of individual markets’.

The Role of International Governance Mechanisms
Speed of market entry and penetration are also dependent on the modalities of governing international expansion. International expansion in financial services firms has in the past seen many mergers and acquisitions but relatively fewer strategic alliances. This tendency towards higher commitment market entry modes depends on the nature of the financial services business and the difficulties of limiting transaction costs of an alliance agreement.

If a financial services firm judges the risk of imitation by local firms to be high, it may refrain from joint ventures, since these may expose the firm to substantial expropriation risk by incumbents who act as partners. There are obviously also many reasons why mergers and acquisitions may not be the best mode of entry. If a foreign bank has to pay four times book value for targets in Eastern European markets and is forced to buy at the same time a large portion of undesired assets, mergers and acquisitions might not be the ideal option.

Scaling Capabilities
The growth of the firm is limited by the speed with which it can replicate its knowledge-based resources. The design of internal knowledge management systems, however, is a neglected aspect in current theory on the internationalizing firm. If economies of scale and scope are essentially economies of knowledge re-use and the internationally expanding firm acts under constraints of rapid imitation, then bottlenecks in the internationalization process of the firm might depend not only on the speed with which it acquires market knowledge through experience-based learning, but additionally how it develops absorptive capacity55and the ability to replicate proprietary knowledge across international markets through the design of its internal knowledge management system.