Strategy and Organization of Corporate Banking Giacomo De Laurentis (Editor) Strategy and Organization of Corporate Banking With 12 Figures and 49 Tables 4y Springer Professor Giacomo De Laurentis Institute of Financial Markets and Institutions Bocconi University Via Sarfatti, 25 20136 Milan Italy giacomo.delaurentis@unibocconi.it This book is based on a research developed in the Center for Financial Innovation of Bocconi University (Newfin-Bocconi) and sponsored by Banksiel spa Research and experience made by the authors at SDA Bocconi School of Management have also strongly contributed Cataloging-in-Publication Data Library of Congress Control Number: 2004112290 ISBN 3-540-22797-0 Springer Berlin Heidelberg New York This work is subject to copyright All rights are reserved, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilm or in any other way, and storage in data banks Duplication of this publication or parts thereof is permitted only under the provisions of the German Copyright Law of September 9, 1965, in its current version, and permission for use must always be obtained from Springer-Verlag Violations are liable for prosecution under the German Copyright Law Springer is a part of Springer Science+Business Media springeronline.com © Springer Berlin • Heidelberg 2005 Printed in Germany The use of general descriptive names, registered names, trademarks, etc in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use Hardcover-Design: Erich Kirchner, Heidelberg SPIN 11310839 42/3130-5 - Printed on acid-free paper Foreword Reinhard H Schmidt The impressive development of the finance literature with its emphasis on asset pricing and the formal modeling of incentive systems during the past three decades, has largely relegated the business and operational aspects of banking as an industry from the agenda of academic research Though this is understandable, it is especially regrettable in view of the dynamic developments in the banking industry which have started about a decade ago and are currently in full swing Fortunately, there are now signs of a change to the effect that banking is back on the research agenda The present book by Professor De Laurentis and his co-authors is a highly innovative and interesting manifestation of this reorientation Banking is an important part of any financial system, and it is especially important in the financial systems of the countries of Continental Europe, such as Italy, France, and Germany, which have been bank-based for decades and which are, in my view, likely to remain bank-based for the foreseeable future There are many reasons, based on empirical and theoretical considerations, to believe that strong banks are not only important for the banking industry itself, but also for the respective national economies This situation makes it highly important to deal with the question of how banks of a given country can and face the competitive pressures which come from the banks of other countries, from truly global banks, from "non-bank banks" and, last but not least, from the capital markets, and adapt to the new structures in the corporate world In particular in a subfield of banking which one can call corporate banking there is a need for banks to find new and appropriate ways of meeting the demands of their clients If they fail in this respect, they will lose these clients to their competitors But banking is more than a part of the respective country's financial system It is also an industry, and industries under pressure are forced to adapt to changing circumstances It is the common ground between the fields of industrial organization, strategic management and organization which holds considerable promise to help banks in this situation Fortunately, industrial organization and strategic management are currently developing in a way which seems to lead to a fruitful synergy Moreover, there is now a closer relationship than there has ever been between the thinking on strategy and on organization An established doctrine in the three overlapping VI Reinhard H Schmidt areas, which goes back to the seminal writings of Raymond Chandler, is that "structure follows strategy" This view suggests a linear or hierarchical relationship of what determines what It sees strategy in the leading position and suggests an adaptation of the organizational design to strategy, and it assumes that strategy is determined by factors which are beyond the influence of individual organization and that, moreover, it is largely clear what the optimal strategies are With due respect to Chandler and those like Oliver Williamson who have built on his foundations, one can take issue with this view Banking is an industry in which the strategic imperatives are anything but clear, and this holds all the more with respect to banking services for business or corporate clients Therefore, it would be a delicate matter to take bank strategy as the conceptual starting point As an alternative and more modest view one can argue that, in order to be successful, a number of strategic options are available to large and important banks But what ever the option may be which is finally selected with strategy selection being a difficult issue in itself, and one which has also not received the attention which it deserves - one thing is imperative to understand: strategy and organizational design are complementary elements of a business system: there is a relationship of mutual determination In order to be successful, any large economic institution needs to create and maintain consistency between strategy and organization as two core elements of its value-creating system In simple words, consistency is given if the elements of a system are such that they fit together well in the sense that they mutually reinforce their respective positive effects and mitigate their negative effects Complementarity is a relationship which has in recent years been "discovered" in a number of fields, including some which are of primary importance to the topic of the present book These fields include strategy, as emphasized recently by Michael Porter; business systems, as elaborated extensively by Milgrom and Roberts; organizational design, as argued convincingly by Brickley, Smith and Zimmerman; and finally financial systems, as Hackethal, Tyre 11 and myself have tried to show In all of these areas, complementarity is very important, and consistency seems to be an indispensable requirement for success To me the present book offers ample support for this "systemic" approach and its main lesson: It may be more important whether strategy and organizational design of a bank are consistent than the choice of strategy itself In their book, Professor De Laurentis and his co-authors take only a cautious look at the banks' choice of strategy Though they use strategy as a point of reference, they not regard it as the overarching determinant of Foreword VII organization, and they take the declared strategic choices of the large Italian and European banks in their sample as given instead of arguing which strategy would seem best to them Not surprisingly, they find a wide variety of strategic orientations in large Italian banks Instead of on strategy, their focus is on the macro- and micro-level organization of the banks and the way in which, and the extent to which, strategies and organizational designs are consistent As the individual chapters demonstrate in great detail and supported by their extensive empirical research, the authors come away with rather sobering results: The banks in their sample seem to agree that in general divisionalization is the right approach to accommodate corporate banking better than in the past, but disagree widely on the specific form and the extent to which lines of business are in fact separated Even on the normative level, the optimal form and degree of divisionalization is an open issue After all, there are certainly merits in not going too far in splitting up different functions and business areas and instead maintaining elements of a universal bank not only for the large banking groups as a whole but also on the operational level Even for various forms and degrees of divisionalization, the authors find again and again that the individual banks which they have investigated at great length not fully appreciate the importance of properly aligning or creating consistency between - strategies and the way in which the bank as a whole and its subunits and its processes are organized It is very good to have this documented in a sober academic study, even though I not think that this critical assessment should be all that surprising After all, the need to adjust organizations to - possibly new - strategies is a very recent challenge and the strategy-adjusted organization of banks is an area in which neither banking practice nor academic research have yet come up with convincing and general rules and recommendations In view of this situation, one should not take it as a criticism of the banks that one can observe a great deal of experimentation in the way in which large banks in Italy and many other parts of the world reorganize their structures and processes It is indeed a highly worthwhile academic undertaking to observe and critically but cautiously comment on these experiments We can learn a lot from the kind of clinical studies which Professor De Laurentis has summarized in this book, and hopefully this learning will eventually make a contribution to improved business policies Reinhard H Schmidt Professor of International Banking Goethe-Universitat, Frankfurt, Germany Frankfurt, July 2004 Table of Contents Introduction Giacomo De Laurentis 1 Theoretical Drivers of Divisionalisation Ozlem Yildirim Corporate Banking Strategies: Products, Markets and Channels 37 Stefano Caselli Organizational Structures Paola Schwizer 63 Corporate Banker's Role and Credit Risk Management Giacomo De Laurentis 107 Operating Mechanisms Paola Schwizer 139 Information Systems Severino Meregalli 155 Conclusions 167 Giacomo De Laurentis References 183 List of Contributors 191 Introduction Giacomo De Laurentis The needs for better "customer orientation" and for distinguishing retail banking from corporate banking activities were already clear to bank managers during the Eighties However, only in the second half of the Nineties it became apparent, on one side, that in the bank industry real customer orientation could be achieved only by changing the macro and micro, hard and soft profiles of the organization and, on the other side, that corporate banking should not be confined to the small number of very large corporations but should be extended to medium-size customers On April 2nd 1998 Deutsche Bank announced a new "restructuring to rise revenues substantially" according to the principle of "gear business to customers' expectations"; this led to the creation of market divisions: retail and private clients (with two different business areas), corporate banking and real estate (designed for small/medium-size companies, for which the bank intended to become a sort of 'financial family doctor'), global corporations and institutions (for the specifically aimed control of individual product lines and special important customers which might enable them to reach a top-five position within three years), asset management, transaction banking (for technologically assisted services) The creation of a dedicated organization division nowadays represents the most relevant evolution being carried out by big and medium-size banks in corporate banking This phenomenon marks a clear shift in organization structures, i.e from a functional configuration (with a geographically extended distribution network) to a divisional configuration, which is characterized by the presence of more product and/or customer segment specialized divisions Such evolutionary trend in the organization structures has been long observed in the sector of non-financial firms (mainly in the Sixties), but for the banking sector the phenomenon is far more recent In the past five years, a relevant number of banks have been pursuing this course of change under the strong pressure of top management and consulting firms Despite the large number of banks involved in this process, it is not yet clear whether they have embraced a rationalistic approach requiring the analysis and formulation of the strategy and the planning of the organiza- Giacomo De Laurentis tion in accordance with their "declared strategy" or simply acknowledged the presence of an "emerging strategy" in the diversification of client requirements and product/process solutions due to technological and financial innovation Undoubtedly the wide range and the frequently renewed formulation of strategies and organization models that are actually implemented in corporate banking by almost all banks highlight four facts: a) the persistent attempt to understand the real nature of the business and to optimize production units and distribution channels, b) the absence of both an established theoretical framework and a dominant model (even within specific territorial contexts), c) the huge risk of misalignment of strategy, market policies, macro/micro and hard/soft organizational profiles, for not a short period of time, d) the increasing pressure that such changes impose on banks' managers and clerks who have to reshape their skills and competencies as well as to accept career patterns that are less clear and less consolidated than in the past Consequently a lot of questions arise Causes of the organizational structure evolution Are bank divisionalization drivers to be identified in the diversification and correlation degree of the different businesses as well as in the implementation of performance valuation and control systems, as is the case for non-financial firms (Williamson 1975)? What are the determinants of divisionalization by geographical area, product, and client segment? Is bank divisionalization driven by verified different customer needs? Take note that when divisions are specialized according to identifiable groups of customers we'll say that they are built around client or market segments Vision, mission and strategy of corporate banking Is this business area centered on customization or commoditization philosophies? In terms of the basic competitive strategies (Porter 1980), should banks pursue costleadership or differentiation based on the ability to establish broad, privileged and long-term customer relationships? Will the relationship-oriented offer model prevail on the commoditization trend of the lending business? If the community bank business model that emphasizes personalized service and relationships based on soft information is likely to be viable in the long run (De Young et al 2003), is bank divisionalization a way for larger banks to penetrate the community banks traditional markets? Conclusions 175 b) the coincidence or the separation of the portfolio manager's role and that of the branch manager; c) the presence or absence of branch product specialists; d) the presence or absence of credit specialists in the bank branch, and their belonging to the corporate division or hierarchically reporting to a credit function outside the division; e) the range of tasks for the corporate banker; f) the presence of assistants to the corporate banker, their relationship (one to one, more to one, one to more) with their chief and their credit/commercial specialization The corporate banker's role shows some tasks which are common to almost all the banks of the panel and which can be defined as "characterizing" the role itself (client portfolio assignment, client need diagnosis); some tasks are present in the majority of banks and can be defined as "common" (credit management, risk analysis, product specialist triggering, client scouting); some tasks are present just in a few banks and can be defined as "distinctive" (pricing, product specialist coordination, direct interface with the area manager or corporate division manager, loan underwriting) The Italian banks show a more varied range of configurations compared with the other European banks; once again, as observed for other micro-organization aspects, there is no correlation with either the commoditization or customization oriented vision of corporate banking The basic and almost universal feature of the role is that the corporate banker carries out his/her activity prevailingly outside the bank premises in order to constantly interact with clients and fulfill the primary sales function and the secondary function of collecting "confidential" information for credit risk analysis A client portfolio is nearly always formally assigned and, in Italy, consists of 80-100 companies which are not selected by business sector but by geographical proximity The great number and the business diversity of companies condition the specialization of corporate bankers The fact that a certain number of companies belong to groups can alleviate the problem, at least partially Choices concerning portfolio size are determined by the need to cover the corporate banker's costs with the margins of managed clients It is true, however, that the chances of growth in such margins depend on the quality of the service provided by the corporate banker, and that such quality depends on the number and the diversification of the portfolio he/she has been assigned Due to the lack of a definite decision model, banks have to proceed by trials and errors 176 Giacomo De Laurentis At present a critical aspect is the gap between expected and perceived competencies and independence of the corporate banker from the point of view of his/her customers On one side there is the figure of the "facilitator", the corporate banker who promotes customer needs in front of other bank structures (specialized on products or risk evaluations and operation approvals) by promptly and purposefully triggering product and credit specialists On the opposite side there is the figure of the "banker", the corporate banker who interacts with the company much more deeply, professionally and continuously by covering a far wider range of financial or non-financial solutions with great competence and who is able to promptly provide the majority of services by operating in the corporate (specialized) branch Customer proximity in credit underwriting is being raised not so much by increasing corporate bankers' lending authorities compared with those traditionally assigned to branch managers in non-divisionalized banks, but by placing in corporate branches, and more often in regional structures, operators with significant lending authorities, often supported by semiautomatic evaluation processes Credit risk management evolves, on the one hand, by increasing the differentiation of the methodologies applied to the various market segments and, on the other, by introducing internal ratings In the typical target market segment of corporate banking in Italian banks, such ratings are not interpreted as an ordinal expression of the level of the risk being perceived, but as judgments founded on largely structured and mechanical analysis processes (statistical scoring, expert systems and other similar procedures) The consequences of the mechanization of credit evaluation processes are multiple and may involve either the system (macro) or the company (micro) In the first group, along with a favorable discipline-effect among debtor companies, there may be a number of adverse phenomena: bankcompany relationships tend to become less flexible, credit tends to be considered a commodity, pro-cyclic bank behaviors grow intensified, credit decisions are characterized by possible "short termism" In the second group, along with the favorable effects of the squeeze in operating costs and process standardization, there may be weaker pressure on the development of corporate analysis skills in the bank and a lack of consistency with the customized approach of the corporate division This is due to the poor sharing of information among such activities as customer advisory, sales and risk assessment, which is considered by all the banks of great importance Mechanical credit risk assessment applies to the banks viewing corporate banking as a customization-oriented business as well as to those viewing the same as a commoditization-oriented business Conclusions 177 In the banks surveyed no particular consistency can be observed between corporate banking vision/mission on the one hand and credit-risk evaluation approaches on the other (Table 7.3) In particular, no empirical confirmation has been found for the assumption that the customizedrelationship approach is associated with a growing exploitation of medium-term credit risk analyses primarily based on analysts' skills; the same applies to the assumption that the commoditization-oriented approach is associated with analyses aimed at shorter-term objectives and substantially relying on mechanical systems Table 7.3 Corporate banking vision and credit risk analyses approach Credit risk analysis Orientation Judgmental Mechanical Commoditization BCH Y Z E Customization DV XW AF Corporate banking vision The use of mechanical evaluation models is often attributed to Basel's new proposal on capital regulation On the contrary the reform aims at stimulating the competitive development of internal management methodologies (i.e independently established by individual banks,) which should be utilized also to regulatory purposes, and the specific provisions regarding rating assignment procedures - as per paragraphs 372-407 of The New Basel Capital Accord Consultative Document dated April 2003 - establish that banks should have absolute freedom in selecting the evaluation procedures they retain most appropriate in the various business segments controlled by the individual banks The choice, therefore, is up to the bank As for credit lending authority regarding most corporate clients' credit operations, the prevailing trend sees customization-oriented banks place such authorities in less customer-proximate structures (Table 7.4) This might be an attempt to balance the expected high customer-proximity of commercial functions with a more detached evaluation of credit risk In the case of banks A and F, whose analysis process has a higher mechanical content, the choice seems particularly defensive 178 Giacomo De Laurentis Table 7.4 Corporate banking vision and delegation of lending authority Corporate banking vision U U U U U U C C C C C C Lending authority for most operations is given to: - credit officers in corpoX X rate branches - corporate branch manX agement - credit officers in reXX gional offices - regional offices X X X X X X - credit function of corporate division - bank credit function XX XX C stands for commoditization-oriented business, U stands for customizationoriented business The benefits of relationship banking for both financial institutions and customers as well as the determinants of transactional/relationship orientation of bank lending in different market segments and in different countries are still controversial (Petersen and Rajan 1994; Angelini et al 1997; Foglia et al 1998; Emmons and Schmid 1998; D'Auria et al 1999; Boot and Thakor 2000; Farinha and Santos 2000; Schmidt 2004) Also the way relationship banking adds value to banks and customers needs much more research (Boot 2000; Elsas and Krahnen 2004) However, a common assumption in the banking literature is that relationship lending is associated with a credit risk assessment based on the use of soft information, bottom-up methodologies, customer proximity of those having lending authority (Berger and Udell 2001) Large banks, traditionally less inclined to interrelate with small, informationally opaque and risky businesses with a relationship-oriented approach (Berger et al 2002), may see divisionalization by market segment as the way to attack the attractive markets of local banks These, in fact, are attractive but also highly exposed to the competitive choices of large banks if characterized by service customization,: "a community bank business model that emphasizes personalized service and relationships based on soft information is likely to be viable in the long run the survival of community banks in the future depends on the ability of large banks to increase personalization and Conclusions 179 customization of their services, while still maintaining their low unit cost advantage" (De Young et al 2003) Instead, our research has not confirmed the expected consistency between the declared vision of corporate banking (as a customization or commoditization oriented business) and rating assignment procedures On the contrary, the pursuit of a customization-oriented supply model seems to be attributed to the configuration of commercial functions and processes, whereas the task to balance the commoditization-oriented approach of corporate branches and corporate bankers is assigned to the mechanization of rating assignment processes In other words, while Udell (1989) empirically verified that banks who delegated greater lending authority to loan officers were actually investing more on their control through the loan review function, in the new context characterized by organizational divisionalization and by the introduction of rating procedures, banks seem to exploit the standardization of the loan approval process as a tool for simplifying the credit supply by means of the new contact roles This choice may strengthen the bank's capacity of daily monitoring (as the use of highly automated systems allow banks to start up evaluation processes on a continual basis) but it also suffers from short termism and, as such, it may affect the optimal allocation of financial resources intermediated by banks and it is little consistent with banks' competitive strategies in the market segments where they intend to consolidate customer relationships Considering the other operating mechanisms of the corporate division, the current level of differentiation is on the whole quite limited The areas which, above all but not only in the Italian banks, require more substantial interventions are: the definition of corporate bankers' career profiles, the definition of incentive criteria (the variable remuneration rate is still limited to 10% of the total), client and staff customer satisfaction analysis, planning and control instruments explicitly designed for the mission of the corporate division and its organization, integration mechanisms for units operating outside the corporate division but strictly necessary to its functioning (product units, retail branches), "corporate culture" development, training processes specifically designed for corporate bankers (about budgeting, management and control, behavioral and cultural aspects, negotiation, time management and, last but not least, corporate finance) The reason lying behind the limited evolution of the operating mechanisms is to be attributed to the relatively recent times in which divisionalization has been introduced and to the priority obviously given to the hard rather than soft aspects of the organization So far the involvement of the functions responsible for the design of the operating systems in divisionalization projects has been quite limited Generally, they have been in- 180 Giacomo De Laurentis volved ex-post for the realization of some specific aspects of such projects As a result the level of consistency between the operating mechanisms and the vision/mission/strategy trio of corporate banking still appears to be quite limited and strongly conditioning the effective and clear-cut differentiation of the organizational behavior and the quality perceived by customers The scenario does not change when looking at the use of information technology Even in the banks with more independent corporate divisions* the management of information systems is left to substantially nondifferentiated structures aiming at obtaining competitive advantages from scale and scope economies: sometimes managerial figures have been selected to direct the phase of acquisition of bank divisions' specific requirements Corporate division managers are generally little involved in technological decisions The first main initiatives dedicated to corporate banking have been concentrated on the set-up of a data-warehouse and major efforts have been made in order to integrate the new corporate divisions into the operating and executive procedures previously utilized by the nondivisionalized bank No bank may be considered a point of reference As a matter of fact, latent technological requirements are several, deep and innovative The new figure of the corporate banker requires the integration of advanced information systems for the identification of customer needs, the presentation of bank products and services, for the development of the advisory capabilities and the evaluation of credit risk Such systems, along with the corporate banker's independent lending authority and professional competencies, seem to be the most immediate elements of assessment adopted by customers to measure the value added of the bank new organizational structure IT requirements for organizational planning and self management regard all the main operating systems: sales planning, planning and control, staff management, competence and communication development To conclude, researchers have identified the causal factors and the achievable advantages of some general categories of organizational structures and have provided only a few detailed concepts about the configuration of the optimal models specifically designed for some particular business areas The other European banks, which have started the divisionalization process earlier on, and Italian banks, which have more recently introduced first the private and then the corporate divisions, are trying to find strategically-organizationally balanced solutions Such solutions usually present a high degree of diversity and unsteadiness because of the difficulty, above all for the corporate division, to rely on a sufficiently powerful and shared model of value creation Diversified solutions Conclusions 181 can be observed also within specific contexts and, thus, they are not the mere expression of the contingency theory (Lawrence and Lorsh 1967) Without a defined theoretical framework and a dominant model, the use of experimental solutions is a widespread phenomenon On the one hand, banks have focused on the structure profiles of the organization rather than on the soft profiles of the operating mechanisms, competencies, information systems; on the other, customer segmentation still relies on a far too general specification system (above all in the Italian banks, 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Giacomo De Laurentis Institute of Financial Markets and Financial Institutions Bocconi University Via Sarfatti, 25 20136 Milan Italy giacomo.delaurentis@unibocconi.it Stefano Caselli Associate Professor of Banking at Bocconi University, Milan, Italy Professor at Banking and Insurance Department of SDA Bocconi School of Management E-mail: stefano.caselli@unibocconi.it Giacomo De Laurentis Full Professor of Banking at Bocconi University, Milan, Italy Director of Banking and Insurance Department of SDA Bocconi School of Management E-mail: giacomo.delaurentis@sdabocconi.it Severino Meregalli Professor at Information System Department of SDA Bocconi School of Management E-mail: severino.meregalli@sdabocconi.it Paola Schwizer Full Professor of Banking at Parma University, Parma, Italy Professor at Banking and Insurance Department of SDA Bocconi School of Management E-mail: paola.schwizer@sdabocconi.it Ozlem Yildirim Ph.D in Business Administration, Master in International Economics and Management, SDA Bocconi School of Management E-mail: ozlem.yildirim@unibocconi.it .. .Strategy and Organization of Corporate Banking Giacomo De Laurentis (Editor) Strategy and Organization of Corporate Banking With 12 Figures and 49 Tables 4y Springer Professor Giacomo... "soft" data that may be difficult to quantify, verify, and transmit through the layers of management and ownership of a banking organization" (Berger and Udell 2002) Giacomo De Laurentis Organization. .. combination and represents an autonomous profit center (Schwizer 2000) Banking groups and universal banks can be compared in terms of width of diversification and level of control (Fig 2.) Width of diversification