Strategies in Financial Services, the Shareholders, and the System: Is Bigger and Broader Better?

THE CLASSIC STRUCTURE-CONDUCT-PERFORMANCE approach to industrial organization centers on three questions. First, why does an industry look the way it does, in terms of numbers of competitors, market share distribution, and various other metrics? Second, how do firms actually compete, in terms of the formation of prices, quality of products and services, rivalry and collaboration within and across strategic groups, and other attributes of economic behavior? And third, how does the industry perform for its shareholders, employees, clients, and suppliers, and how does it perform within the context of the system as a whole, in terms of its impact on income and growth, stability, and possibly less clearly defined ideas about such issues as social equity? In the financial services industry, these same questions have attracted more than the normal degree of attention. The industry is "special" in a variety of ways, including the fiduciary nature of the business, its role at the center of the payments and capital allocation process with all the static and dynamic implications for economic performance, and the systemic nature of problems that can arise in the industry. So the structure, conduct, and performance of the financial services industry have unusually important public interest dimensions.

One facet of the discussion has focused on the size of financial firms, however measured, and the range of activities conducted by them. Figure 1 depicts a taxonomy of broad-gauge financial services businesses. What are the strategic opportunities and competitive consequences of deepening and broadening a firm's business within and between the four sectors and eight subsectors? Is size positively related to total returns to shareholders? If so, does this involve gains in efficiency or transfers of wealth to shareholders from other constituencies, or maybe both? Does greater breadth generate sufficient information-cost and transaction-cost economies to be beneficial to shareholders and customers, or can it work against their interests in ways that may ultimately impede shareholder value as well? And what about the "specialness," notably the industry's fiduciary character and systemic risk? Is bigger and broader also safer?

This paper begins with a simple strategic framework for thinking about these issues from the perspective of the management of financial firms. What should they be trying to do, and how does this relate to the issues of size and breadth? It then reviews the available evidence and reaches a set of tentative conclusions from what we know so far, both from the perspective of a shareholder and from that of the financial system as a whole.

A Simple Strategic Schematic

Financial firms want to allocate available financial, human, and technological resources to market segments that promise to throw off the highest risk-adjusted returns. ¹ In order to do this, they have to appropriately attribute costs, returns, and risks to specific cells in a client-product-geography matrix. And the cells themselves have to be linked together in a way that maximizes what practitioners and analysts commonly call "synergies":

• Client-driven linkages exist when a financial institution serving a particular client or group of clients can, as a result, supply financial services either to the same client or to another client in the same group more efficiently in the same or different geographies. Risk mitigation results from spreading exposures across clients, and achieving more stable earnings, to the extent that income streams from different clients or segments of clients are not perfectly correlated.
• Product-driven linkages exist when an institution can supply a particular financial service in a more competitive manner because it is already producing the same or a similar financial service in different client or arena dimensions. Here again, there is risk mitigation to the extent that net revenue streams from different products are not perfectly correlated.
• Geographic linkages are important when an institution can serve a particular client...