It wasn’t long ago — you don’t have to go back further than the 1950s — that U.S. financial institutions could be neatly pigeonholed by function.
Banks and thrifts took deposits and made loans to businesses and consumers. Insurance companies sold health, property and life insurance policies. Securities firms underwrote and issued marketable securities and offered brokerage services. Pension funds saw to it that workers could count on retirement income. And mutual funds — which offered unsophisticated products at a time when money market and cash management accounts did not exist — were sold to a relatively small number of people.
Government regulation kept these institutions separate and distinct, and firms and customers alike had little reason to complain. Institutions turned profits, and individuals and businesses were able to secure financing at stable interest rates. International competition was non-existent and information technology was in its infancy.
It was a largely comfortable, predictable system within which financial institutions fulfilled their roles well. But U.S. finance has undergone an upheaval in the last 40 years, and the tidy certainties that the industry once enjoyed have gone the way of hula-hoops, 10-cent hamburgers and Father Knows Best.
Driven by deregulation, changing market demand and technological advances that lowered costs and allowed firms to achieve economies of scale, financial institutions have moved far beyond their traditional lines of business. Competition is greater today, and so are the risks of instability and insolvency.
Banks now make securities products available to customers. Retail brokerage firms like Charles Schwab Corp. compete with banks by offering asset-management accounts that allow customers to write checks. Companies whose core businesses were never financial services — such as AT&T and General Motors — have made forays into the credit-card business. Mutual funds are as well-known to Americans as passbook savings accounts used to be. And foreign firms are key providers of financial services in the United States.
A New Approach
As researchers at the Wharton School and elsewhere analyzed these changes over the years, their work — like the institutions they studied — tended to be compartmentalized. Research typically focused on issues confronting particular types of institutions. But the Wharton Financial Institutions Center, recognizing that the most critical research issues today cut across traditional categories, is taking a new approach: it is studying financial services collectively — as an industry. To carry out its ambitious crossdisciplinary research effort, the Center has brought together not only specialists in finance, but experts in such areas as management, statistics, human resources and engineering.
“The Financial Institutions Center has embarked upon a research program to address the key drivers of the fortunes of the financial sector,” says Anthony M. Santomero, the Center’s director and Richard K. Mellon Professor of Finance. “What we have done is try to address those issues central to the evolution of the industry — efficiency issues, risk-management issues and structural evolution issues.”
Kathleen Holmes, the Center’s managing director and senior partner of Furash & Company, a financial services consulting firm, notes: “There isn’t a common database or language or metrics of performance across all types of financial institutions. While institutions feel they compete with one another … there’s no way to evaluate how institutions are doing against their competitors.”
A “Center of Influence”
At the Center, she adds, “We’re trying to create a research community that puts Wharton on the map in financial services research on a much broader and deeper basis than ever before …. We’re trying to create a center of influence here.”
The Center began operations in 1992 when it received $3.4 million from the Alfred P. Sloan Foundation — the largest grant ever awarded to study the financial services industry. In June 1995 the foundation awarded the Center an additional $2.5 million for further research.
Pivotal to the Financial Institutions Center’s purpose is its emphasis on working closely with executives of financial institutions to ensure that its research not only serves the needs of academics, but also addresses real-world problems faced by financial services companies. Wharton researchers engage in field work — visiting companies to conduct interviews and collect data — and invite industry representatives to campus to elicit their insight on issues that concern their companies. Over the past three years, the Center has sponsored 11 conferences.
The Center also has established links with industry through its board of directors, which is chaired by George J. Vojta, vice chairman of Global Merchant Banking at Bankers Trust Co. Other Center board members include Stephen L. Brown, chairman and chief executive officer of John Hancock Financial Services; Robert H. Mundheim, managing director, Salomon Brothers Inc., and Thomas C. Wanjert, chairman and CEO of AT&T Capital Corp.
“We assembled a first-rate board of industry leaders that reflects the broad array of financial institutions,” says Richard J. Herring, professor of finance, who served as the Center’s director from 1992 to the summer of 1995 and continues to conduct research for the Center. “We’ve used [these individuals] pretty intensively as a sounding board, to react to research proposals and to gain access to leading financial institutions.”
Prime Thrusts: Productivity and Risk Management
To date, the lion’s share of the Center’s research has focused on two topics — improving productivity, efficiency and performance in financial services organizations, and risk management.
The first phase of the work on productivity has involved a major study of retail banking by three researchers — Patrick T. Harker, UPS Transportation Professor for the Private Sector and professor of systems engineering and operations and information management; Larry W. Hunter, Paul Yeakel Term Assistant Professor of Management, and Frances Frei, a former Wharton doctoral student in Decision Sciences now teaching at the University of Rochester. Initial findings from the retail banking study, which involved a survey of more than 300 large commercial banks, were presented in June 1995 at a conference of industry representatives titled “Creating Comparative Advantage in Retail Delivery Systems” (see research sidebar).
Among other things, Holmes notes, the productivity research is probing several questions: “Why is it that the banking industry hasn’t adopted high-involvement workplace practices to create efficiency and value? Why aren’t financial services companies more worried about understanding poor quality? Nobody tracks how much inaccurate checking account statements to customers cost banks to fix. They don’t look at customer risk. This is exactly the situation the auto industry was in until the Japanese set new standards of quality.”
With the retail banking study well underway, Harker, along with J. David Cummins, Harry J. Loman Professor of Insurance and Risk Management, and Peter Cappelli, professor of management, have begun to analyze the efficiency of the insurance industry.
The Center’s study of risk management deals with one of the most critical issues facing financial companies. Traditionally, each kind of financial institution specialized in managing a particular type of risk. Commercial banks for example, managed credit risk in lending, investment banks managed market risk in trading and underwriting, and insurers managed event risks in property/casualty and life products.
But since institutions today are less specialized and offer products that spill over the boundaries that once divided them, most firms must manage a broad array of risks, including default risk, interest-rate risk, market risk and liquidity risk.
The research on risk is being conducted by Santomero, Herring and David F. Babbel, associate professor of insurance and finance. The researchers want to know: How does each sector of the industry measure and control the risks at the heart of their businesses? How can systems be established to determine if the industry and its various sectors are taking on the proper amount of risk?
One concern involves determining the appropriate limits that an institution should impose to reduce risk. “There are examples of institutions that went bankrupt because of overconcentration,” says Santomero. “Look at Texas banks, the mortgage industry and commercial real estate lending in the Northeast.”
Risk Management: More Art Than Science
According to a report summarizing their research on risk, the Wharton scholars said they found “unevenness in the industry’s understanding of the process and science of risk management within the individual sectors of the financial services industry and … wide variation in emphasis on specific elements of risk management across sectors. Evaluations of risk-management practices at the firm level showed even more striking differences in practices. It is clear that firm-level risk management today, regardless of the sector being analyzed, is more of an art than a science.”
Santomero says researchers have “gone into the field doing analyses of the risk systems in place in major commercial banks, investment banks and insurance companies. We go with a team of five or six people — faculty and PhD students — and work with the top executives of each firm. We’re doing an audit of the practices of risk management in the industry and contrasting that with best practices and highest knowledge. The hope is that this audit will prevent firms from taking on risks that are excessive.”
Alternative Financial Systems
In addition to the two core projects on productivity and risk management, the Center also has sponsored research on a third topic — the implications that financial systems of other countries hold for the modernization of the U.S. financial system. In a study commissioned by the Swedish Productivity Commission, Herring and Santomero have analyzed the role of the financial sector in economic performance in Sweden. The study showed how the financial sector can improve the quantity and quality of real investment and thus increase per-capita income.
In a series of papers, Franklin Allen, Nippon Life Professor of Finance and Economics, has explored the consequences for economic performance of alternative financial systems. Specifically, he contrasted the German system — with its heavy reliance on universal banks that have both investment and commercial banking powers — with the U.S. system, where greater emphasis is placed on financial markets.
In addition, in a 1995 book titled Financial Regulation in the Global Economy, Herring and Robert E. Litan, deputy assistant attorney general in the Justice Department’s Antitrust Division, analyzed the regulatory and supervisory problems that arise among differing national financial systems.
As part of its goal to become a “center of influence,” the Center wants to be a leader in research that has an impact on public policy. Already, researchers affiliated with the Center have been asked to contribute to policy discussions.
Santomero has appeared before the House Banking Committee to discuss competitive pressures on the financial services industry. Herring has explored regulatory issues at the Governors Meeting of the World Financial Services Forum in Davos, Switzerland, and Allen has led discussions about universal banking at the Center for Economic Policy Research in London and the National Bureau of Economic Research in the United States. This fall, Center researchers are scheduled to appear in Washington before the Federal Trade Commission on antitrust issues.
Students in the field
The Center also has made contributions to Wharton’s educational mission. Through the spring of 1995, 24 doctoral students worked on Center research projects, 30 MBA students took part in a field-study course sponsored by the Center, and 13 undergraduate students supported Center-sponsored research in research assistant positions.
“In the first year we offered a field-based research course,” Holmes says. “We took [MBA] students to three sites and helped them look at problems that management was trying to address and that bring some reality to the theory taught in finance courses.”
Over the next few years, the Center will continue analyzing topics related to productivity, risk management and comparative financial systems. Two academic conferences organized by Santomero and Gary B. Gorton, professor of finance — on risk management in insurance companies and risk management in commercial banks — are scheduled for 1996. Harker also plans to hold five industry conferences in 1996 on issues related to productivity in financial services.
In its next major research project, led by Donald B. Keim, professor of finance, the Center will conduct a comprehensive analysis of the mutual funds industry. Researchers will examine the major functions performed by mutual funds — back office operations, distribution and investment management. They will analyze the implications of the phenomenal growth of the mutual fund industry — whose assets grew from $293 billion in 1983 to $2.6 trillion in 1995 — for the competitive structure of the financial services industry and the nation’s economic performance.
Looking back on the research conducted so far, Santomero says, “We’re most proud of the fact that we have defined the agenda to be consistent with what appears to be the major issues facing the industry.”
The financial industry “ought to see the Center as a source of industry knowledge and up-to-date research on industry practice and innovation … In terms of dollars and faculty participation and in scope of years, it is clearly the most ambitious research effort that Wharton has ever seen.”
Retail Delivery Systems in the Financial Services Industry
The Wharton Financial Institutions Center surveyed more than 300 of the nation’s largest banks to determine how they are faring in their attempts to create advantage through information technology, customer service and human resource management.
Summaries of three of their findings are presented here.
Many banks have been looking for high-tech solutions to solve problems of productivity and service quality. In 1990, financial institutions spent $61 billion on hardware, $18 billion on software, and $75 billion on computer services. These costs have climbed
But the Wharton Financial Institutions Center study found that although banks are pumping massive amounts of funding into information technology (IT), they are not taking care of the “nuts and bolts” of the process.
Many of the banks seem to be managing IT inefficiently, the researchers argue, and 75 percent of the 300 surveyed have no formal structure to improve IT. As a result, only the largest projects receive the management committee’s attention, are approved, and have some formal structure. Smaller decisions requiring less capital are not dealt with firm-wide, and changes are made with little or no coordination.
System integration is not achieved in many banks either, because decisions relating to that process are often made without taking into account the business processes that the technology is supposed to support. For instance, a bank might implement a $100 million system to allow it to sell investment products more efficiently. But it may have no electronic means of automatically changing a customer’s address at his or her request, as is the case with half of the surveyed firms.
Human Resource Management
Research in the manufacturing sector has found that high performance workplace practices improve quality, improve productivity, and are necessary to leverage new technology. But the Wharton researchers found that retail banks lag behind other industries in this area.
Banks experiment with a number of different high performance workplace practices, such as increased employee involvement, investments in training, and compensation based on performance incentives, but the impact tends to be small, short-lived and hard to predict — if the initiatives have any impact at all.
Part of the problem is that banks are implementing individual high performance initiatives without a coherent, systematic approach to the management of human resources. For example, some banks spend a lot of money to train and empower employees, but still do not redesign jobs to give employees the authority to waive a $5 fee.
Similarly, many banks have tried to implement sales-based cultures, with commission-based pay and sales-supportive technology. But they have not trained employees in selling, nor have they adapted their hiring or promotion practices to ensure effective sellers are in the right positions.
Engineering Products for Customer Value
Based on preliminary survey findings this year, Patrick Harker, chairman of Penn’s department of systems engineering, and Larry Hunter, assistant professor of management at Wharton, discussed what steps banks should take to achieve convenience, precision, efficient costs, adaptability, and market penetration.
Banks should align practices, policies, procedures, and IT to ensure value creation. Banks must determine their goals in their retail delivery systems and use them as the templates to assess management choices and implement practices the company adopts. This approach ensures that every decision will work towards achieving desired results. For example, banks believing local market adaptability and agility are key to meeting national competition might give their local marketing managers the authority to customize product pricing and delivery to meet the specific needs of their customers.
Banks should build the customer’s perspective into product processes. Some products are more important to certain types of customers than others. Banks committed to serving each of these customer groups individually should extend this approach into their product-process designs. For example, would a customer rather have the sales rep or teller draw up a CD redemption check? Instead of speculating about what the customer wants, banks should ask them.
Banks should align human resources practices with value-creation objectives. As banks create their workplace management policies, they must ensure that job design and incentive programs support the bank’s value-creation goals. If not, re-engineering efforts will be ineffective.
Harker and Hunter found that bank employees have a good feel for customer preferences and the ways in which bank processes can be streamlined to improve customer service. Banks should use these employees as a primary intelligence source.
“There is no panacea to the customer-value puzzle,” the authors note. “Creating customer value, building a high-performing organization, and embracing a commitment to quality take hard work and attention to detail. Managing customer sales-and-service processes effectively is an important element of a comprehensive commitment to creating value for customers and shareholders.”
On Bank Mergers and Mutual Funds
Bank mergers took place at a fevered pitch in 1995 and there is no reason to think the pace will slow any time soon, say Anthony M. Santomero, director, and Kathleen Holmes, managing director, of the Wharton Financial Institutions Center.
Bank mergers are being driven by several factors. For one thing, America is “overbanked,” says Santomero. “There are too many institutions and too many branches. Part of the reason for the recent merger activity is to eliminate redundancies.”
In addition, he said, some mergers represent an “expansion of franchise.” First Union Corp.’s recent purchase of First Fidelity Bancorp, New Jersey’s biggest bank, and PNC Bank Corp.’s purchase of Midlantic Corp. are examples of an expansion of geographic franchise that illustrates the ongoing nationalization of the U.S. banking market.
“The pace of merger activity is extraordinary,” says Holmes. “It’s fueled by the increase in value of market capitalization of financial services companies. They’re using that value to drive for market share and market position and operating efficiency. But the second part is overcapacity. So now you’re getting a window in time where it’s affordable for these banks to consolidate.”
Santomero and Holmes agree that bank mergers will continue. One reason is that the geographical limitations that prevented banks from merging across state lines were artificial and are being phased out because of changing regulations.
What’s more, some product lines have gone national. “When we grew up, there were no credit cards at all and all lending was at your local bank,” Santomero says. “Now credit cards are a national business, not a local business.”
Bank mergers grab plenty of media attention, but Santomero and Holmes say other sectors of the financial services industry are also feeling turbulence.
“Investment banks have undergone substantial change in cross-industry merger activity,” says Santomero. “They are now heavily involved in global capital markets and they have undergone substantial change in key players.”
In addition, “securities firms have been expanding their product array and significantly increasing their services to the household sector.”
Looking ahead, the challenge for investment banks “is to manage trading risk in esoteric products, such as derivatives, swaps and options, and to control their network of global real-time trading,” says Santomero. In the insurance industry, he adds, “insurance companies are looking more like diversified financial firms. A recent property-casualty cycle has been weathered and they’re looking for new markets and expanded opportunities.”
Holmes says the mutual fund industry, like the banking sector, will witness increased consolidation. “A number of banks started their own proprietary funds and found that economies of scale weren’t there,” she notes. “They’ll sell those funds, and you’ll see more fund complexes come together to drive operating efficiencies.”
The industry also will see increased segmentation, as mutual fund companies tailor products to meet specific customer needs. For example, “life cycle” funds provide an asset mix that changes as fund owners grow closer to retirement.
Stephen Morgan is a Philadelphia area freelance journalist and former director of media relations at Wharton.