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1. Introduction
This paper reviews of the literature
on information technology investments and their impact on value creation
for the firm. From the research literature and the authors’ experience
it appears that IT investments purely aimed at improving productivity
and reducing costs, do not usually lead to value creation for the firm ;
the benefits are frequently passed on to their customers in the form of
consumer surplus.
The study proposes that in order to
convert IT investments into shareholder value, financial services
organisations should focus their effort on revenue enhancement
initiatives. In particular, a model based on making IT investments for
improving performance through obtaining Market Power (or Monopoly
Power), is proposed. The model needs to be made operational and be
empirically tested, for which a discussion on the risks and rewards of
this process is developed.
2. Background: Financial services
organisations under siege!
Financial services is an
interesting industry in which to analyse the impact of information
technology because it is going through intense change (in particular the
retail side of the business). Banks, confronted with declining customer
bases due to the increased competition in the industry, have become
locked into uneconomic cost structures. In addition, increased
competition generates excess capacity, depresses margins and forces many
banks to the “marginal edge of risk taking” and may “tempt some towards
failure by reducing margins and building riskier portfolios” (Llewellyn,
cited be McConnell, 1997). To make things worse, the cost of banking
technology, once prohibitive, is no longer a barrier to entry into the
industry. As a consequence of this, “competition is working
asymmetrically in the banking industry: because of developments in
technology and the general erosion of entry barriers into banking, it is
easier for non-bank financial institutions to move into banking than for
banks to diversify out of financial services”(Llewellyn cited by
McConnell, 1997; Harris, 2001). Tesco and Sainsbury are among the major
supermarkets offering banking services to synergise their strong brands,
their massive customer base, and their ability to offer better financial
terms to their customers. Even in emerging markets like Chile,
traditional retailers are setting up their own banks (e.g.: Falabella,
Almacenes Paris, Ripley).
According to the IBM Institute for
Business Value (IBV, 2003a), banks’ three primary value creation
strategies of the 1990s were revenue diversification, consolidation, and
risk securitisation. In terms of revenue diversification, fee-based
services and the emphasis on non-bank financial offerings grew
annuity-type revenue sources, reducing banks’ reliance on the more
volatile interest-based income. With respect to consolidation, major
regulatory changes spurred strong industry consolidation and afforded
survivors significant scale and scope economies. Finally, banks’
increased use of asset securitisation to improve their risk profile
allowed them to lower their net charge-off rates. However, these
strategies, although successful during the last decade, have now
stalled. In the first place, revenue diversification is failing because
retail banking fees are beginning to plateau, so the mix between
interest income and non-interest income has settled into a constant
range. This is partly due to clients reacting negatively to further
paying fees for services that were traditionally free of charge.
Secondly, efficiency gains achieved through post-merger integration have
dropped significantly, as acquisitions have become less synergistic,
resulting in consolidation loosing momentum . Finally, with respect to
risk securitisation, the portion of loans outstanding that banks are
securitising and selling off their balance sheets have, similarly to
fee-based revenue, leveled-off to settle into a stable range.
Similar trends can be found in the
insurance sector. According to Watkins (1998), in the life assurance
sector there is a shift from low value to higher value products: from
life assurance to investment; from annual products to single premium
products; from simple products like whole life, to complex products such
as utilised products; from rigid products to flexible products; from
mass marketing to individualised marketing; from low advice to high
advice levels; from obtaining new customers to retaining and extending
services to existing customers.
In other words, to achieve higher
retention rates and to overcome price sensitivity, insurance companies
are moving away from a product culture to a service culture. Examples
are: (a) the introduction of the all-embracing protection policy,
instead of individual products; and (b) a major emphasis on improving
quality of service by such measures as “documentation-while-you-wait”,
speedy reply to queries, better claims handling and telephone advice.
From a technology point of view,
the main problem faced by the sector is the need to change from systems
that deliver mass-produced, standardised products to highly specialised
systems that provide customised insurance products for specific groups.
Symptomatic of the poor situation
of the industry is the creation, last November, of Protektor, Germany’s
life insurance sector-wide safety net. Protektor is sponsored by the
association of insurers to meet a failed insurers commitment for the
duration of any policy. Although everyone agrees that Protektor is an
essential mechanism to keep the confidence of German consumers, foreign
insurers in Germany (who have recently made very little money in that
market) are so convinced that the weakest of the countries life
insurance companies are going to fail, that they are showing signs of
nervousness about supporting it (Financial Times, 2003).
The IBM Institute for Business
Value (IBV, 2003b) says that, although the property & casualty (P&C)
side of the business is going through a positive “fee hardening” period
of the cycle with projected underwriting profits continuing throughout
2003, there are some major concerns when looking to the future. To the
ever increasing seriousness of catastrophic losses deriving from an
increasing number of extreme weather events due to long term climate
change (which manifested themselves in 2002 in major events such as bush
fires in the USA, Australia and New Zealand; floods in Europe; and
tropical storm Allison) the industry is suffering from
difficult-to-predict man-made catastrophes such as asbestos and
environmental risks, fraud risk (e.g.: Enron, Arthur Andersen, Worldcom,
Global Crossing), bankruptcy risks (US Air, Kmart, United Airlines), and
terrorism as in the WTC.
So, in this complex environment,
how can information technology investments create value for financial
services organisations? According to Read et al (2001, page 97) “At its
simplest level, value is created by generating revenues from the
delivery of products and services to customers that exceed the cost of
the delivery process”. In essence, the impact of information technology
on value creation in any organisation can happen either through
increasing revenues at marginal cost, or through reducing costs at
marginal changes in revenue, and thus enhancing operating profits.
3. Cost reduction through the
application of IT: Impact on productivity
If one were to decide on what has
made the decade of the 1990s different from its predecessors in terms of
business and organisation, two things would come to mind: (1) Impressive
growth in labour productivity, and (2) Sharp increase in information
technology investments throughout every industrial sector.
There is a tendency to link these
two phenomena and justify the increase in productivity on the massive
introduction of transactional information systems to support business
processes, and to claim that we are in the presence of a “New Economy”.
However, in their study on influence of IT investments on US labour
productivity, the McKinsey Global Institute (2001) have found
interesting results that seem to challenge this link. “From 1995 to
2000, labour productivity grew at an annual rate of 2.5 percent – nearly
twice the 1972-1995 rate of 1.4 percent. During the same years, US
companies nearly doubled their pace of IT investments”. The McKinsey
report concludes that IT was only one of several factors at work:
Innovation (including but not limited to IT), competition and, to a
lesser extent, cyclical demand factors, explain most of the productivity
growth.
An interesting finding of the
McKinsey report is that “nearly all of the post-1995 productivity jump
can be explained by the performance of just six economic sectors:
retail, wholesale, securities, telecom, semiconductors, and computer
manufacturing (the other 70 percent of the economy contributed a mix of
small productivity gains and losses that offset each other)”. But,
paradoxically, 60 percent of the acceleration in IT investment was
outside of the six productivity growth sectors, and productivity growth
actually declined in some sectors, like hotels and retail banking, that
invested heavily in IT.
Could this be a confirmation of the
famous productivity paradox of IT, depicted by Nobel Laureate Robert
Solow as “we see computers everywhere except in the productivity
statistics?” (Brynjolfsson, 1993; Roach, 1991). This paradox was the
centre of the debate of the late 1980s and 1990s around the benefits of
IT investments (Griffiths, 2003). The most optimistic conclusions were
that value is created but it is difficult to measure because (a) the
present accounting criteria are not adequate for measuring productivity
in the service sector (Brynjolfsson, 1993; Bannister & Remenyi, 1999;
Haynes & Thompson, 2000; OECD, 2003); and (b) IT investments have a
delayed effect on performance, in some cases the lag between investment
and improvement in performance being suggested to be as much as five
years (Brynjolfsson, 1993; Haynes & Thompson, 2000).
Roach (1991) concludes that as a
result of heavy ongoing investments in technology, the service sector’s
cost structure has been ominously transformed and service companies are
now strapped with a steadily climbing stream of expenses on IT, but
employ just as many workers as before. The bottom line, Roach adds, is
that service companies have moved from a variable-cost (i.e. people) to
a fixed-cost regime. Keen (1991) says that one reason to stop looking
for IT productivity benefits under the “financial reporting lamppost” is
that IT rarely reduces costs. Its main value is more often in changing
the cost structure of the firm so that it can increase throughput
without increasing personnel: IT displaces variable cost labour in
favour of fixed cost capital
An interesting finding of the MIT
1990s research (Scott Morton, 1991), supported by Hitt & Brynjolfsson
(1996) and by Hayward et al (2002), is that benefits from IT do in fact
exist, but are not captured by the organisation. They are transferred to
the end customer in the form of consumer surplus. Another is that the
external world is demanding more (e.g. consumers want higher quality or
more features, the government wants more detailed reporting,..); in some
cases the only way to comply with customer expectations is to use IT,
but such an investment does not show up in economic returns. On the
negative side, the MIT90s research concludes that benefits of IT
investments do not materialise for one or more of several reasons: (a)
Many firms have applied IT to areas of low payoff; (b) Too often IT is
laid on top of existing practices so there are no cost reductions, just
cost displacement; and (c) The change was managed superficially and was
not absorbed by the organisation.
Summarising, IT investments do not
in themselves create benefits through cost reductions but they can,
however, transform the organisation’s cost structure. In order to
materialise the benefits, the organisation must increase transaction
volumes. The other important finding is that reductions in unit costs
are passed on to the final consumer through price reductions (consumer
surplus).
4. Industrial mutation: IT as an
enabler to balance efficiency and innovation
Organisations are in a permanent
state of change under the effects of two opposing forces: those of
convergence or consistency (such as the intrinsic need to take advantage
of established skills and knowledge), and those of divergence or variety
(prime among those is the obsession with innovation). Although Mintzberg
& McHugh (1985) were referring to adhocracies and one could hardly
depict banks and insurance companies, as they are known today, as such,
it is clear that all organisations are subject to the
efficiency-innovation dilemma.
What demands does this place on
information technology? “A rigid information technology infrastructure
will stymie even the best strategic initiatives, making it difficult to
introduce change in cost- and time-efficient ways”, were some of the
conclusions arrived at by Prahalad & Krishnan (2002) working with more
than 500 business leaders in large companies over a period of four
years. The objective of the study was to determine the capacity of these
managers to lead change within their companies.
The authors apply the portfolio
concept to the applications that support the business processes. The key
for success here is to get the right balance between support for
innovation and experimentation (flexibility), and support for efficiency
(standardisation). Getting this balance right means understanding the
competitive reality of the firm and how it affects its internal business
processes that lie on a continuum between a Stable Domain (low variance
in user expectation) and an Evolving Domain (high variance in user
expectation). Prahalad & Krishnan (2002) conclude that generating a
dialogue between business and technology managers is necessary to solve
these dilemmas. Some authors (Sauer & Willcocks, 2002) go further to
propose that organisations should have an “organisational architect” to
help close the gap between corporate strategy and technology by enabling
this dialogue.
In an application of these concepts
to the Financial services industry, Watkins (1998) says that in retail
banking the majority of information systems investments are made to
support products or services that are commodities throughout the
industry. The author goes further to say that as information technology
is applied to more sophisticated tasks, mass service becomes
increasingly a commodity and incumbent financial services organisations
are forced to move into higher level service. As a result a range of
changes occur: (a) focus of activity becomes more people- than
equipment-oriented; (b) customer contact time lengthens; (c) the degree
of customisation is greater; (d) employees use more discretion in their
work; (e) value-added is moved from back to front office; (f) focus
moves from product- to process-orientation as described in Figure 1.. Of
course, to be able to do this banks need to have highly qualified staff
(their only other strategic resource in this information intensive
industry) but the reward is differentiation and revenue enhancement.
Watkins’ conclusions allude to the
necessity of accompanying information technology investments, with other
changes. Firm-level studies performed by the OECD (2003) support “that
ICT is part of a broader range of changes that help enhance performance.
The impacts of ICT depend on complementary investments, e.g. in
appropriate skills, and on organisational changes, such as new
strategies, new business processes and new organisational structures.
Firms adopting these practices tend to gain market share and enjoy
higher productivity gains than other firms.” At another point the report
asserts that “the use of ICT may help firms expand their product range,
customise the services offered, or respond better to demand, i.e.,
innovate.” However, it must be pointed out that, although the OECD’s
statements are intuitive, the report does not show the reader how they
were arrived at.
Figure 1: Evolution in Service
Characteristics (Watkins, 1998)
As a closing remark of this
section, it is illuminating to cite Drucker (1988) when he says: “IS is
an instrument of economic and social change and a specific case of what
Schumpeter calls industrial mutation; it is one aspect of the phenomenon
of creative destruction. It changes the way businesses do business and
the ways that they are organised. Arguably IT is currently the most
influential force leading to the restructuring of business, politics and
economics. In the process of this change, a new bureaucratic form is
being created called the “information based organisation” (Drucker,
1988).
5. Construction of a model of IT
investments for value creation.
Another aspect that is critical for
value creation through IT investments, which will not be tackled in this
paper, is the question of strategic intent. Defining the value
discipline of the organisation, and having a clear mission understood by
its members, are well-known pre-requisites for any major organisational
transformation, but more so when it is a transformation enabled by
technology (Scott Morton, 1991; Griffiths & Remenyi, 2003).
As already discussed above,
information technology investments for cost reduction are not always
effective. It has also been suggested that if organisations are to
convert information technology investments into shareholder value,
defining a value discipline is a pre-requisite to deciding and making
the investment. If, therefore, it is assumed that a cost-leadership or
an operational-excellence value-discipline is not a real option,
incumbent banks and insurance companies should orient themselves towards
Customer Intimacy or Product Leadership as their value disciplines (Treacy
& Wiersema, 1995). In this context, their information technology
investments should be aligned with their value discipline and aimed at
creating value more through revenue enhancement than by cost reduction (Griffiths
& Remenyi, 2003).
According to Crowston & Treacy
(1986), the industrial economics theory of market power, or
monopolisation theory, provides a basis for understanding the effects of
IT on firm performance measured by prices, market share and/or revenues.
Edward Chamberlin (1933) defined monopoly or market power as the ability
of a firm to control price through altering supply, and he defined
‘pure’ competition as competition in which monopoly elements were
absent. He argued that the reason why real-world competition diverged
from pure competition was that firms in practice experienced some degree
of monopoly power. Markets are both competitive (firms compete against
each other) and monopolistic (firms have control over the price of the
goods they sell). In this context, Chamberlin analyses market structure
in terms of two dimensions: the number of firms in an industry and the
degree to which each one produced a differentiated product. Product
differentiation means that each firm has a degree of monopoly power in
that it can raise its prices without losing all its customers
(Backhouse, 2002, p.205-6).
Information technology investments
operate on prices, market share and revenues through attractive product
differentiation and/or by reducing the amount of searching by customers
(Crowston & Treacy, 1986). This can be represented graphically as shown
in Figure 2.
Figure 2: Effect of Market Power
(based on Crowston & Treacy, 1986)
It is our contention that, in order
to convert their IT investments into shareholder value, incumbent
financial services organisations should aim their IT investments at
supporting Product Differentiation, and at producing Ease of Search for
their Customers and prospects.
How far should they go on Product
Differentiation? Being the financial services industry highly
competitive, if the firm conforms to the strategies of others it will
find itself approaching perfect competition where economic rents
approach zero. Therefore it needs to differentiate as much as possible.
On the other hand, being this industry very sensitive to public trust
and highly regulated, institutional forces put pressure on the
individual firms to conform mainstream strategies under the argument
that a firm that is similar to others avoids legitimacy challenges. It
should be noted that legitimacy challenges lead to diminishing the
ability of an individual firm to acquire resources from customers and
suppliers (Deephouse, 1999).
By analysing the tension between
forces to differentiate and forces to conform, Deephouse (1999) has
found evidence to support his strategic balance proposition: “Moderate
amounts of strategic similarity increase performance”. From the results
of Deephouse’s tests, it appears that the relationship between
performance (dependent variable) and strategic deviation (independent
variable) is quadratic and has the shape of an inverted “U”. Performance
will maximise at a strategic balance point where the increased benefits
of more differentiation equals the cost of increased non-conformity as
demonstrated in Figure3.
If the relative weight of the
forces of competition is greater than the institutional forces, the
strategic balance point will move to the right. If, on the other hand,
the institutional forces of conformity are greater than the forces of
competition, the curve (and the strategic balance point) will move to
the left.
Figure 3: There is an optimal level
of Strategic Deviation
Returning to the model being
proposed, and assuming that product differentiation is a materialisation
of strategic positioning, it appears that strategic balance acts as a
moderator between product differentiation and performance, as shown in
figure 4.
Although there is no intention to
go into this in depth, for the sake of completion it is important to
mention that security is a growing concern in terms of vulnerability to
criminal theft and fraud and to accidents of leakage of information. The
difficulty to combine access and control is a dilemma financial services
companies have to live with. The very idea of on-line customer service
and product delivery is to make access convenient and easy for more and
more people (ease of access in the proposed model). Control demands the
opposite: restriction and difficulty of access (Keen, 1991). Security is
therefore included in the model as a moderator between ease of search
and performance, as shown in Figure 4.
Figure 4: Effect of Market Power
Moderated by Strategic Balance and Security.
6. Applicability and future research.
What relevance has this to the
business community? If it is considered that information technology
expenditure consumes an ever increasing portion of operating costs, the
impact is significant. And, if this is added to the fact that the
benefits from IT investments are hard to realise (as transpired from the
authors’ interviews with bank and insurance company managers in several
markets), the relevance is more significant still.
In practical terms, what sort of
information technology investments lead to increased market power? As
mentioned in an earlier part of this paper, the OECD (2003) mentions ICT
investments that assist innovation, like those that lead to expanding
the product range, to customise the services offered, and to respond
better to demand. Three examples of market-power building initiatives,
are as follows:
1. Fairchild (2003) gives a
good example of how banks can become part of their corporate Clients’
supply chain. She makes the case for Electronic Invoice Presentment and
Payment (EIPP), which is the process by which companies present invoices
and make payments to one another through the Internet, allowing
businesses to view, dispute, approve and pay their bills. Fairchild adds
that EIPP allows for the electronic delivery of complex business
invoices while accommodating highly variable billing data structures and
wide-ranging global regulations. The opportunity for banks is to “have
referral or reseller relationships with software or service providers,
playing the role of biller service provider (BSP) to their corporate
customers”. Fairchild (2003) says that this BSP role for banks is
important in bringing the EIPP market to maturity and encouraging its
natural relationship with the other corporate-oriented services offered
by banks.
2. In many counties, the
passing of legislation to regulate digital signatures opens a whole new
area for banks, particularly in their electronic business. It enables
the concept of “virtual branch office” which gives a lot of banking
flexibility to corporate Clients, particularly valued by small and
medium enterprises. “Banks will offer new features, such as online
cheque and statement images, account alerts and pre-filled applications,
to achieve their core objectives, but customer expectations will drive
up overall standards” according to TowerGroup (2003).
3. A stable and reliable
digital signature framework should also enable the elimination of
“hard-copy” insurance policies, and therefore streamline the
carrier-broker-Client relationship interactions, and enable a “real”
move towards the paperless office.
As with all theoretical
propositions, the model needs to be refined and must be tested in order
to achieve validity. This is a challenging task because (a) some of the
concepts borrowed from the strategy field (i.e. Strategic Balance) are
still in their early stages of development, and (b) some of the
constructs borrowed from other disciplines (i.e. Product
Differentiation, Ease of Search, Security) are not operationalised in a
generally accepted way.
Although the risks are high, it can
be anticipated that returns for banks and insurance companies will also
be high. There is little doubt that deregulation and globalisation
during the 1990s have both reduced margins in the traditional operations
of the industry, but as Roach’s quote included at the beginning of this
paper warns, the cost cutting route leads to a dead end. As mentioned by
Keen (1991) the opportunity for financial organisations now is to manage
the top line while controlling their cost structures.
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