An analysis of the turnaround strategy in commercial banking (1)


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An analysis of the turnaround strategy in commercial banking (1)

  1. 1. Journal of Management Studies 23:2 March 1986 0022-2380 S3.50 AN ANALYSIS OF THE TURNAROUND STRATEGY IN COMMERCIAL BANKING HUGH M . O'NEILL University of Connecticut ABSTRACT An analysis of the content of turnaround strategies in the commercial banking industry is presented. Most prior work on turnaround strategies examined durable product industries rather than service industries. Theory developed in this past work is used to predict the content of turnaround strategies in this service industry. Discriminant anailysis is used to test the predictions. The turnaround prescriptions developed in the durable goods industries are found to be valid predictors in the commercial banking industry. Suggestions are made to encourage further study of applications of the strategic paradigm in service industries. INTRODUCTION of the prescriptions of the strategic paradigm were developed in mature manufacturing based industries (Hofer and Schendel, 1978). As recent years have brought a reduction in the proportion of G.N.P. expended in manufacturing industries (indeed service-based firms currently form the majority of the G.N.P.), these prescriptions may be obsolete. To date, there has been scant attention to the problem of the fit of a manufacturing based paradigm for applications in service industries. The study reported herein represents an attempt to apply a set of strategic prescriptions in a service industry. In particular, the strategic prescriptions associated with the generic strategy of turnaround are an2ilyzed in the commercial banking industry (Hofer and Schendel, 1978; Porter, 1980). There have been relatively few studies, theoretical or empirical, of strategic management techniques in service industries. The few studies which have been done are not consistent in their findings, especially with respect to strategies in commercial banking. In a classic study, for example, Fulmer and Rue (1974) MANY Address for reprints: Professor H. M. O'Neill, Business Environment and Policy, University of Connecticut, Storrs, Connecticut 06268, U.S.A.
  2. 2. 166 HUGH M. O'NEILL discovered that strategic planning did not improve performance in service industries. This might imply that strategic planning does not pay in commercial banking yet Wood and LaForge (1979) assert formal strategic planning in banking does pay {i.e. increases profitability), at least in the case when formal planners are compared to non-planners. Carmen and Langeard (1980) suggest that some portions of the strategic paradigm will not transfer to service industries. In the case of commercial banking, they assert that such concepts as the experience curve and share advantage will not directly transfer to banking. This paper presents the results of one application of the strategic paradigm in commercial banking. The study attempts to identify the content of successful strategies under one condition: that is the condition of relative decline. Previous turnaround studies, which were based primarily in manufacturing industries, are used to develop hypotheses about the content of turnaround strategies in commercial banking. The essential purpose of this analysis is to confirm whether or not the prescriptions of earlier studies fit in this type of industry. Following this, the impact of certain contextual factors in the turnaround process is analyzed. Finally, the resource allocations necessary to promote turnaround in this industry are identified. The Concept of Generic Strategy and Turnaround Scholars and practitioners both endorse the idea of'generic' strategies. Generic strategies are distinct types of strategies that can be applied in certain situations. The situations are differentiated by such factors as organization type, industry type, competitive position, etc. Hofer and Schendel (1978) identify six generic types; Porter (1980) identifies three types. Each strategy type can serve as a guideline for choosing goals or resource deployments within the firm. This latter use (as a guide for resource deployments) is similar to the notion of primary or grand strategy (Bourgeois, 1980; Hitt et al., 1982) wherein the grand strategy is used to identify the correct balance that should exist among functional allocations in the firm. For example, once growth is adopted as the grand strategy, then certain events should take place in the marketing department, the R. & D. area, the production department, etc. Fox's (1973) matrix of resource cillocation may be the most common model of the relationship between generic strategy and resource deployment. Well-defined and well-tested generic strategies serve as an effective tool for the strategic manager in both the design and control of strategies for an individual firm. The use of generic or grand strategies leads to more effective performance (Hatten et al., 1978; Rumelt, 1974) and helps to prevent the suboptimization of firm goals to functional goals. The generic strategies cein be used to define the key characteristics of managers, incentive systems, and the like (Gluck et al., 1982). Hofer and Schendel (1978) identify the turnaround strategy as a generic strategy. While other scholairs do not designate turnaround as a generic strategic situation, none the less the concept has received attention in the management
  3. 3. TURNAROUND STRATEGY IN COMMERCIAL BANKING 167 field (Bibeault, 1982; Hambrick and Schecter, 1983; Hofer, 1980; Schendel and Patton, 1976; Schendel et al., 1976). This attention is warranted because decline represents a particular strategic dilemma for managers. Such factors as competition, technological change and increased capital costs cause more and more businesses to face difficult and trying times. Most managers and stakeholders find decline an unpleasant circumstance. Yet despite the attention devoted to turnaround, there have been few systematic studies on turnaround. While it is useful to identify turnaround as a worthy goal, it is even more useful to identify the distinct means by which a firm might turn around. A vast majority of turnaround studies are drawn from manufacturing industries and/or capital intensive industries. For example, Hofer's (1980) sample includes such firms as an automobile producer and a tractor manufacturer while Bibeault's (1982) sample includes such firms as a recording tape manufacturer and a business machine producer. Hambrick and Schecter (1983) identify their sample as mature industrial firms. Few of these studies are drawn from a sample which presents an in-depth view of a particular industry or type of industry (other than the concentrated industry often found at mature industrial stages). Previous Studies in Turnaround Inconsistencies across the set of previous turnaround studies complicates any effort to compare these studies. There are major inconsistencies in the approaches used to study the concept. In one group of studies, (Altman, 1968; Argenti, 1976; Ross and Kami, 1973) failed firms are compared to non-failed firms. Some attempt is then made to identify those factors which separate the successful from the failed firm. These researchers infer that failing firms can reverse their deterioration by managing those factors which are identified as unique in the successful firms. Argenti, for example, notes that successful firms are less resistant to change; they plan more; they avoid major projects which become corporate albatrosses (Argenti, 1976). Other researchers study turnaround more directly. They compare turnaround companies to companies that have continually declined (Hofer, 1980; Schendel and Patton, 1976; Schendel et al., 1976). Some comparison is made of the differences that can be observed before and after the event; these, then, are the key turnaround factors. Still other studies concentrate more on the time during the turnaround event and attempt to identify the various factors which accompany the turnaround effort (Bibeault, 1982). Another factor makes the comparison of past turnaround studies difficult. Turnaround is often measured in a unique manner. Researchers can differ with respect to the way they define performance; the way they measure performance, and the time span that they adopt for observing performance. The performance variables include stock market price (Bibeault, 1982) net income (Schendel et al., 1976) and survival (Altman, 1968).
  4. 4. 168 HUGH M. O'NEILL In some cases, a firm's performance is measured based upon a comparison to its own historical record (Bibeault, 1982), while in other instances (Schendel and Patton, 1976; Schendel et al., 1976) a firm's performance is measured in comparison with a wider {e.g. national) standard. Some studies use inflation corrected measures (Schendel and Patton, 1976), while others rely on historical measures (Hofer, 1980). In terms of time span, studies range from those in which there is little discussion of the time span to those in which a specific time span is identified (Hambrick and Schecter, 1983). In the study reported herein, a cross-sectional approach is used to compare commercial banks which have enacted a turnaround to commercial banks which have declined. Following Schendel and his colleagues (1976), performance is based on net income which is normalized to reflect industry trends. Thus, both decline and gain are relative to industry standards. A turnaround bank has gained ground in comparison to its strategic group after a period of continued loss of ground, while a decline bank has exhibited a continued period of decline relative to its strategic group. Development of Hypotheses Previous studies support two general propositions: 1) There are different types of turnaround efforts. 2) The success of a type of turnaround effort is related to contextual factors. Bibeault (1982), Hambrick and Schecter (1983), Hofer (1980) and Hofer and Schendel (1978) are just a few of the researchers who discuss different types of turnarounds. Bibeault, as shown in table I, identifies five types of turnarounds. He finds that the management process turnaround is used in 68 per cent of the successful turnarounds. In Bibeault's study, management process includes both management's choice of resource deployments (here called strategic choice) and the processes or behaviours which managers used to implement these choices (here called implementation). The study reported here is an analysis of the choices which are adopted by successful turnaround banks in their efforts to reverse performance declines. The study does not deal with the processes of implementation. Hofer and Schendel (1978) and Hambrick and Schecter (1983) present similar turnaround models. The design of this research is based on their work. Hofer and Schendel provide the general guideline for the development of hypothesis 1, while the work of Hambrick and Schecter serves to guide the selection of variables to test the hypothesis. Hofer and Schendel separate turnarounds into two broad types: strategic and operating. Strategic turnarounds represent attempts to enter new businesses or to gain substantive position share in a firm's current business (Hambrick and Schecter's option of product market refocusing is an example of a strategic turnaround choice). Operating turnarounds are those which are based on actions to increase revenues, actions to decrease assets, actions to decrease costs.
  5. 5. TURNAROUND STRATEGY IN COMMERCIAL BANKING 169 Table I. Classification of turnaround strategies by various authors Bibeault Hambrick and Schechter Management process turnaround Economic turnaround Competitive environment turnaround Product breakthrough turnaround Government related turnaround Asset reduction Cost cutting Revenue generation Product/Market refocus Hojer Strategic turnarounds Operating turnarounds: Asset reduction Cost cutting Revenue increasing Combination Table II. Comparison of turnaround models and bank performance variables Hambrick and Schecter's study Price Hofer and Schendel's model Bank performance Revenue enhancement Loan income/gross loans securities income/ securities municipal income/municipals Receivables Revenue enhancement Gross charge-offs/loans Inventories Cost control Cash and treasuries/ demand deposits Capacity utilization Revenue enhancement Gross loans/deposits Employee productivity Cost control Payroll expense/employees Product quality Revenue enhancement Loan loss provision/ Earning assets Relative direct costs Cost control Interest/all deposits Interest/time and savings Overhead expense/ earning assets Operating expense/ earning assets or some combination thereof. These later studies share similar conclusions: 1) Most successful turnarounds are those that could be called operating turnarounds. 2) The choice of turnaround method is contingent on severail factors. These contingent factors include the operating characteristics of the business and structural characteristics of the market. The operating characteristics of the business include such factors as the relative amount of direct labour costs and the distance of the firm from its break-even point. Hofer and Schendel (1978, pp. 173-4) offer the following prescriptions:
  6. 6. 170 HUGH M. O'NEILL - if a company is near break-even, has high direct labour costs or high fixed expenses, then cost cutting methods should be used to turnaround; - if a company is far from break-even, has low direct labour expenses or low fixed costs, then revenue generating methods should be used to turnaround; - if a company is very far from break-even (at 30 per cent or less), then asset reduction methods should be used; - if a company is in some intermediate position with respect to the aforementioned prescriptions, then a combination of the tactics should be used to turnaround. There are constraints which limit the strategic options that a turnaround bank might adopt. For example. Federal and State authorities dictate some constraints. Federal law requires that banks limit their activities to bank-related products. These same laws also limit the number of products that banks can sell across state borders (these latter limitations were eased somewhat after the period of this study). State laws limit the extent and type of branches that commercial banks can use within state borders. Banks which hope to reverse a decline are also subject to further constraints which evolve from the decline itself. Hambrick and Schecter in their study of mature industrial units show that such strategic options as major share gains and/or the development of new entrepreneurial thrusts are not likely under conditions of shrinking or negative profit margins. The Hofer and Schendel model provides no specific guidance in selecting the variables which might be used to measure the combined turnaround effort in the banking industry. Fortunately, Hambrick and Schecter (1983) are helpful in this regard. They identify three gestalts which represent patterns of successful turnarounds. Two of those gestalts (selective product/market pruning and piecemeal productivity) are relevant to the study presented here. These gestalts represent the combined efforts of revenue generation (selective product market pruning) and cost reduction (piecemeal productivity). Hambrick and Schecter show that the following variables are significant in turnarounds based on product market pruning: price marketing receivables inventories capacity utilization employee productivity product quality relative direct cost They identify the following variables as significant in turnarounds based on piecemeal productivity: capacity utilization and employee productivity. Nearly all previous studies on turnaround use mature manufacturing companies as their sample. Previous studies on bank management do not specifically analyze turnaround. Therefore this study must be viewed as an
  7. 7. TURNAROUND STRATEGY IN COMMERCIAL BANKING 171 exploratory study of the content of turnaround in a regulated service industry. The previous literature is used to develop a hypothesis about the content of turnaround strategies in the banking industry. The Hofer and Schendel prescriptions indicate that successful turnarounds in the banking industry will be based on combination efforts because banks are in an intermediate position with respect to labour costs and fixed costs. The Hambrick and Schecter study also prescribes a combined effort, as both revenue generation and cost reduction in their model involve multiple resource allocations. The key unanswered question is the pattern of resource allocation. What specific costs should be cut? What specific revenue generating options should be adopted? In what order? Hypothesis 1 is developed to answer these questions.' Three guidelines are used to predict the major variables in a turnaround effort. One guideline is based on sensitivity analysis. As Hofer and Schendel note, in a combined turnaround effort the alternate actions must be compared to each other, as the cost/benefit analysis of the second-, third- or fourth-best cost-cutting alternative may be better than a similarly ranked revenue generating option, or vice versa. The second guideline used to develop hypothesis 1 is an estimate of implementation time. In a turnaround situation, actions that have an immediate impact are usually preferred to long-term actions. As noted earlier, major share gains or new entrepreneurial thrusts are not highly likely under conditions of shrinking or negative profit margins. Previous bank performance studies provide the third guideline for developing the first hypothesis. Variables which have been shown to contribute to high or low performance are predicted to have a high or low impact on turnaround. The specific performance variables are drawn from the field of finance, where there has been some disagreement about the correct set of performance variables (Graddy and Kyle, 1979). Hypothesis 1 lists the turnaround variables in order of their predicted magnitude. This is followed by a brief rationale for each variable's order of entry. This discussion is summarized in table III. Each variable is defined in Appendix A. Hypothesis 1: Successful turnarounds in commercial banking will be based on combination efforts which include aspects of cost reduction and revenue generation. The specific variables which contribute to turnaround, in order of their importance, are: (1) (2) (3) (4) (5) (6) interest on deposits/all deposits gross loans/all deposits cash and treasuries/demand deposits gross charge-offs/loans municipal income/municipals securities income/securities
  8. 8. HUGH M. O'NEILL 172 (7) (8) (9) (10) (11) (12) payroll expense/employees overhead/earning assets operating expense/earning assets loan loss provision/earning assets loan income/gross loans interest on deposits/time and savings deposits Table III. Bank performance variables listed in Hofer and Schendel's terms, with rationale and references Variable (in order of hypothesized importance) Interest on deposits/all deposits Gross loans/all deposits Cash and treasuries/all deposits Gross charge-offs/loans Municipal income/municipals Security income/securities Payroll expenses/employees* Overhead/earning assets Operating expense/earning assets Loan loss provision/earning assets Loan income/gross loans Interest on deposits/time and savings Rationale Increase in proportion of demand deposits decreases interest cost and ratio; can be enacted more quickly than interest cost production. Sinkey (1975) and Ford (1978a) use similar variables. Better use of funds. Used by Edwards, 1966; Ford, 1978a; Yeats, 1974. Better use of funds used by Ford (1978a). Similar variable used by Sinkey (1975). Reflects improved quality. Used by Ford (1978a). Better investment experience. Used by Ford (1978a) and Johnson and Meinster (1975). Better investment experience. Used by Ford (1978a). Can be cut by reducing bonuses, overtime, etc. Used by Ford (1978a) and Johnson and Meinster (1975). Cuts in overhead costs. Identified by Ford (1978a) and Johnson and Meinster (1975) Cuts in total costs of salary and interest. Identified by Ford (1978a) and Johnson and Meinster (1975). Reflects improved queility. Used by Ford (1978a). Reflects management's ability to increase price or receipt of income. Used by Ford (1978a) and Johnson and Meinster (1975) A decrease in the size and/or rate of time accounts will lead to decrease in cost. This can only take place as contracted obligations expire. Sinkey (1975) and Ford (1978a) use similar variables. * It is possible to have ineffective cost cutting; e.g., by cutting productive employees, net income/ employees could decrease; by cutting non-senior employees payroll expense/employees could increase. The argument of importance only applies to effective cost cuts. Interest on deposits/all deposits is chosen as the first variable because interest costs represent the highest category of costs for banks and, hence, the most sensitive variable. This variable is chosen before the other measure of interest costs (interest on deposits/time and savings) because the total mix of deposits (demand deposits and time and savings deposits) is more flexible than the time and savings accounts alone. By increasing the proportion of demand deposits, the bank can simultaneously increase the denominator and decrease the numerator of this performance measure because demand deposits require less
  9. 9. TURNAROUND STRATEGY IN COMMERCIAL BANKING 173 interest. Finally, this variable has been identified as a contributing factor in high performance banks by both Ford and Sinkey. The second and third ranked variables in hypothesis 1 reflect concern for revenue generation. Loans represent the largest revenue source for banks. They represent the greatest proportion of the bank's assets, and are typically the most profitable of the bank's assets. This variable is listed second rather than first because loan programmes require more time to implement than programmes to lower overall interest costs. Loans/deposits have been identified as a key performance variable by Edwards (1976), Ford (1978a) and Yeats (1974). This variable is a crude measure of capacity utilization, which is significant in each of Hambrick and Schecter's successful turnaround gestalts. The variable cash and treasuries/demand deposits earns the third ranking for two reasons. One reason is related to the rationale listed for the previous measure. Loans and non-treasury securities are higher profit uses of funds. Banks may fuel turnaround by moving their low yield cash and treasuries to higher yield applications. A second reason for the relatively high predicted rank for this variable is that this measure reflects the bank's asset/liability policy. One school of thought suggests that bank managers should 'balance' assets and liabilities. In other words, short-term funds such as demand deposits should only be used for short-term applications such as cash and securities. Conversely, longer-term funds should be used for long-term yields {i.e. loans). An alternative school of thought suggests that bank managers should, within accepted limits of liquidity, maximize yield (Baker, 1978). Decline banks may be able to reverse decline by apportioning more of their funds to higher yield uses such as non-treasury securities and loans. This prediction is consistent with the findings of Ford (1978b) and Sinkey (1975). Loan income can be easily increased by writing bad loans. Such an action would increase the variable gross loans/all deposits, but would neither increase net income nor reverse decline. Thus, a measure of loan quality is proposed as the fourth ranked variable in the hypothesis. This variable, gross chargeoffs/loans, is sensitive to two types of management actions. First, management can undertake aggressive actions to recover some payment from past bad loans. Second, management can seize control of new loan volume to assure that it is of requisite quality. In this manner, then, the turnaround bank decreases the amount of gross charge-offs/loans relative to decline banks. The next two variables also reflect the turnaround bank's ability to wrest revenue from its products. These variables are municipal income/municipals and securities income/securities. These variable reflect the bank's ability to price products and/or to invest wisely. This source of income comprises a lower proportion of a bank's assets than the loan portfolio. Therefore, these assets will be less sensitive to management action than the loan portfolio. This lower sensitivity explains why each of these variables is ranked lower than loans/ demcind deposits. Municipal income/municipals is ranked higher than securities income/securities because of the tax effects of the former investments, as
  10. 10. 174 HUGH M. O'NEILL discussed in Ford (1978a; 1978b) and Johnson and Meinster (1975). The next three variables in order of rank are payroll expense/employees, overhead/earning assets, and operating expense/earning assets. These are ranked 7, 9, and 10 respectively. Each of these variables is a measure of cost control. Labour costs represent the second highest cost opportunity for banks, after interest costs. Thus, they are ranked after a measure of interest costs yet before a measure of overhead costs. Overhead costs include all costs other than interest and labour. Such costs may be easier to reduce than personnel costs, but represent a smellier ocean of opportunity for the turnaround bank. Operating expense/earning assets is a gross measure of efficiency, since operating expense includes both interest costs and labour costs. This measure is included in this study because Sinkey (1975) ranks a similar measure as first in importance in defining problem banks (Johnson and Meinster, 1975). This variable is ranked relatively low in this model because other measures of expense control (the interest measure and the personnel expense measure) capture the effects of cost control more directly. These variables are ranked behind variables 2 through 6 for two practical reasons. One, the returns to these cost variables are likely to be lower than returns to efforts to increase the proportion of funds invested in higher yield uses. Second, efforts to reduce costs are likely to be more difficult to enact than efforts to increase returns. The final three variables in the model include loan loss provisions/earning assets, loan income/gross loeins, and interest on deposits/time and savings. They are included in the model because they are either sources of revenue generation (variables 10 and 11) or sources of cost control (variable 12). These variables have figured prominently in previous studies of bank performance. The low ranking of these final three variables can be attributed to the fact that they are less sensitive to management action than previously listed variables. The loan loss provision is a sum identified by management to add to reserves for loans in a given year. A portion of this provision is determined by law, and is a direct extension of past loan experience. As banks improve performamce over time, the required loss provision will decline. However, the variable will exhibit a lagged response. The variable ranked fourth (gross chargeoffs/loans) is a direct measure of management's quality control in that it responds more quickly than the loan loss provision. Loan income/gross loans earns its low rank because of market conditions. In general, most banks face a competitive environment (this assumption is indirectly tested for this sample in the second hypothesis). Given competitive conditions, banks cannot extract excess profits from loans. Loan income improves by better selection of clients and quicker response to laggard payers. This selection and control process is more adequately captured by the previously discussed gross charge-offs/loans variable. Finally, the variable interest costs/time and savings deposits is ranked last because of its relative insensitivity to management action. Management can
  11. 11. TURNAROUND STRATEGY IN COMMERCIAL BANKING 175 refuse to accept increased levels of these time deposits, but it cannot cancel past contracted arrangements. Thus, this cost element declines only as previous contracts expire. Over time, the impact of these expiring contracts will vary as the cost of each of the contracts varies. Management cannot control this variance as part of any systematic attempt to reverse decline. In summary, this hypothesis uses turnaround models to predict that bank turnaround will be a combined effort of revenue generation and cost control. More importantly, the hypothesis integrates strategic theory with bank management literature to predict the relative impact of each of several measures of bank performance. Contextual Factors The previous hypothesis assumes that management's attempts to increase revenue and decrease costs are the sole factors contributing to turnaround. A major factor which could infiuence the outcome of a turnaround strategy is the extent of market concentration in the bank's competitive region. Economists working in the field of industrial organization have been the key investigators of the market structure/performance relationship (Porter, 1979; Scherer, 1980). The I/O paradigm suggests that market structure, management conduct, and performance are inter-related. The study reported here substitutes strategy for the concept management conduct, and defines performance as successful turnaround. To date, there have been few studies of the relationship between market structure and turnaround. There have been several studies of the relationship between market structure and bank performance, where performance is defined as some combination of public and private gain or loss. These studies can provide some guide in hypothesizing the expected relationship between market concentration and turnaround in the banking industry. Turnaround theorists hint at several possible ties between market structure and turnaround. First, certain market structures might be more likely to cause decline. For example, decline might be more likely in highly competitive markets. To the extent that different causes require different turnaround responses, then there will be a relationship between market structure and the efficacy of management strategies. Studies by Hofer (1980) and Hambrick and Schecter (1983) are suggestive in this regard. Hofer argues that competitive position will influence turnaround, while Hambrick and Schecter show that market share will influence turnaround. To the extent that competitive position and market share are related to market structures, then market structures should infiuence turnaround. Other studies have highlighted the relationship between market share £ind generic strategies, or between market structure and generic strategies (Porter, 1979; Porter, 1980; Woo and Cooper, 1981). Here our focus is on the latter relationship. Most of the aforementioned research has taken place across industries, rather than within specific industries. This is in direct contrast to a rich tradition of
  12. 12. 176 HUGH M. O'NEILL Studies in banking which analyze the impact of concentration within the industry. In this tradition, most studies define their market as local or regional (based on Standard Metropolitan Statistical areas) to compare and contrast the effects of concentration on performance. The results in these latter studies have been inconsistent (Fraser and Rose, 1976; Heggestad, 1977; Kaufman, 1966). The inconsistent results in these studies could be due to differences in the definition of performance (Heggestad, 1977), or to differences in study design (Graddy and Kyle, 1979). In no instance do the banking studies assess the relationship between market structure and turnaround. One of the problems with the industrial structure paradigm is that the measure of concentration requires an objective measure of the entire market. This notion of market measurement becomes difficult when competitors do not compete in a national market (as is the case with the vast majority of competitors in the banking industry) and when there is difficulty in drawing barriers between local markets (as is the case in banking). It may be that the lack of physical inventory in a service industry creates problems in the measurement of market; it may also be that services naturally exhibit only one type of market structure. The inconsistencies found in previous studies, and the contrasts between service industry and manufacturing industries, lead to the following hypothesis: Hypothesis 2: There will be no relationship between local market concentration (as reported in government records) and turnaround performance. SAMPLE IDENTIFICATION AND METHODOLOGY The sample is provided by the Compustat tapes. Market concentration data is provided by FDIC records. The first research task is the idenfication of banks which have turned around, and banks which have declined. These banks are identified by inspecting the net income of all banks reporting on Compustat tapes for the period 1959 through 1978, inclusive. Following Schendel et al. (1976) the net income figure is 'normalized' to reflect industry growth; a particular bank's net income performance is compared to the net income performance of the bank industry (this procedure departs somewhat from the procedure of Schendel et al., who used a GNP measure to normcJize the data). If in a particular year a bank's performance exceeds the industry's performance, then that year is labelled a growth year. If a bank's performance lags industry performance, then that year is labelled a decline year. This classification system is based on the assumption that the proper referent group for the banks in this Scimple is the industry, rather than some subset of the industry or some referent group beyond the industry. This classification system uses a strategic referent group rather than a bank's individual history as a comparative reference for performance analysis. This
  13. 13. TURNAROUND STRATEGY IN COMMERCIAL BANKING 177 is consistent with past turnaround studies, and helps to counteract the delusionary impact of inflation. The focus of the study is not a single year of performance, but rather a pattern through several years of performance. The question of how many years constitutes a pattern is answered in a pragmatic manner. Previous studies of turnaround suggest that the process takes place in a period of three to eight years (Hambrick and Schecter (1983) provide a discussion of this question). In this study, seven years (counting a base year) is adopted as a reasonable time span of turnaround. An increase in the time span would drastically reduce the size of the sample. Given the length of the search (20 years) this may be evidence that patterns beyond seven years are unusual in this industry. The existence of bank regulation authorities who will intervene when decline becomes habitual may provide an artificial barrier to longer-term declines. If a shorter period of time is used, the sample size increases but it is more likely that the sample would then include random short-term declines and turnarounds which are not related to patterns of strategy or strategic management, or would not capture the dynamics of a strategic era (Mintzberg, 1978). A bank enters the sample if it exhibits three consecutive years of decline up until the three-year period before the end of the study. There are 51 banks which underwent such a three-year decline period. The three-year period after the three-year decline is used to label the banks as turnaround or decline. If a bank improves performance in two of these three years, the bank is then labelled a turnaround bank. If the bank declines in two of these three years, the bank is then labelled a decline bank. Thirty-one of the banks in this sample reversed their decline (i. e. became turnaround banks) while 20 of the banks continued their decline. Once a bank joins the sample, a complete performance profile is gathered for that bank. Following a search of the financial literature (Baker, 1978; Edwards, 1966; Ford, 1978a; Johnson and Meinster, 1975; Mayne, 1976; Sinkey, 1975; Yeats, 1974) a set of variables is chosen that have management relevance and can be used to test the turnaround models developed elsewhere. The variables are listed in tables II and III, which classify the variables in terms of the turnaround models. Hambrick and Schecter identified eight variables as significant in two types of turnaround. Surrogate for seven of those variables are used for this test of the turnaround model in banking. The data base did not provide a direct measure of the eighth variable, marketing expenditures. The relative amount of loan income, security income, and municipal income are used to assess the impact of pricing. Given the same level of loans (or securities or bonds), then one bank's ability to get greater loan income (or security or municipal income) reflects that bank's ability to get better prices for its products. While it might be argued that the increased level of income is due to riskier (and therefore more profitable loans), such an outcome would violate the prescription of product quality which is also required for turnaround.
  14. 14. 178 HUGH M. O'NEILL The relative amount of gross charge-offs is used as a measure of the level of receivables that a bank has. Gross charge-offs represent a bank's bad debts. The relative amount of cash and treasury bonds in the bank's portfolio is used as a measure of inventories. In a mature manufacturing industry, inventories reflect idle assets. Similarly, cash or treasury bills represent idle assets for banks. The variable gross loans (as a percentage of toted deposits) is used to assess the bank's capacity utilization. Since loans usually represent a bank's highest source of income, and deposits represent the bank's ability to loan, this is a direct measure of capacity utilization. Employee productivity is assessed by the level of payroll expense per employee. This variable was chosen because it is a direct cost measure. The level of product quality is measured by assessing the loss experience of each bank in the sample (gross charge-offs/loans and loan loss provision/earning assets). Here, the assumption is that higher quality loans are those that maintain their ability to pay over the life of the loan. Relative direct costs are measured through the use of interest costs, overhead expenses, and operating expenses. A discriminant analysis model is then used to verify the success of the classification criterion and to test the ability of the models to predict turnaround. Standardized coefficients are used to rank the variables. The discriminant analysis is supplemented by use of univariate t-tests. Data on market concentration is gathered from the F.D.I.C. statistics for the year 1978. This year is chosen because it represents the year that most of the banks completed their patterns. Market concentration is measured as the share of the top three competitors in a regional market, the top five competitors in a regional market, and the absolute number of competitors (that is, the number of other commercial banks) in a regional market. The impact of concentration is tested in two ways: through a discriminant analysis model and through a t-test. RESULTS The discriminant analysis. The results are summarized in tables IV to VI. Some of the twelve performance variables exhibit collinearity. Nine of the 66 pairs show correlation at a level of 0.6 or better (the full correlation matrix is available on request). Most of this collinearity can be traced to two sources. First, the operating expense/earning assets variable is correlated with three variables (overhead/earning assets, loan income/loans, loan loss provision/ earning assets). Second, the loan loss provision/earning assets measure is correlated with overhead expense/earning assets and gross charge-offs/loans. Since there were no a priori reasons for deleting one or the other of the variables in each correlated pair, the variables were retained. The loan loss provision/ earning assets variable was predicted to rank in the lower half of the discriminant variables. This prediction was based, in part, on the level of correlation.
  15. 15. TURNAROUND STRATEGY IN COMMERCIAL BANKING 179 Table IV. Discriminant analysis Wilks Lambda Sig. Classification* Hofer and Schendel, w/Mthree 0.4472819 0.0162 82.35 Hofer and Schendel Model 0.4480026 0.0165 82.35 0.4460799 0.0158 82.35 w/Mfive Hofer and Schendel Model w/Ncomp • In an unbiased classification model (a hold-out sample was used) successful classification was achieved for 73% of the cases with Ncomp used as the measure of market concentration. As table IV indicates, the discriminant analysis was successful. The variables suggested by the models as key determinants for turnaround in this industry do successfully discriminate the banks. Another test of the model is its ability to classify banks, which it does successfully in 82 per cent of the cases in this sample. This analysis is performed at the sixth year after the initial decline, so that the differences between the groups are at their greatest level. When a hold-out sample is used for classification, the unbiased classification rate is 73 per cent (Ncomp serves as measure of market structure for this analysis). Three different measures of concentration are each used in a discriminant analysis to assess the impact of market concentration. Mthree, which is the total regioned share of the three top competitors (share is measured as share of total bank deposits for the region), is first used with the performance variables in a discriminant analysis. Following this, Mfive and then Ncomp are used in separate discriminant analysis. Mfive is the total regional share of the top five competitors in the region, while Ncomp is the number of commercial bank competitors in the region. As table IV indicates, the concentration variables are consistent in their impact: classification is significant regardless of the choice of variable. Hence, further analysis uses only a single measure of market concentration (Mfive). The key question here is the importance of the concentration variables in the task of discrimination. The task of identifying the most important variables in a discriminant ancdysis is an ambiguous one, in that there is no accepted single standard for choice (Eisenbeis, 1977; Perreault et al., 1979). Here, the stEuidardized discriminant function coefficients are used to assess the importance of the concentration variables. In a group of 13 variables, the concentration measures rank 12, 12, and 11. The conclusion, then, is that these variables are not important factors in the turnaround strategy. One of the important contributions this study makes is the identification of the content of a turnaround strategy in banking. Two types of analysis are used to identify the strategy. First, standardized coefficients in the discriminant analysis model are used to rank order each of the performance variables. As Tatsuoka (1971) suggests, the standardized coefficient is similar to a beta weight. The absolute value of the standardized coefficient is a measure of the variable's contribution. The discriminant analysis is supplemented by a t-test
  16. 16. 180 HUGH M. O'NEILL analysis. The discriminant ranking is presented in table V, while the t-test analysis is presented in table VI. The results show that turnarounds in banks are indeed fuelled by both revenue generation and cost control, as Hofer and Schendel suggested. The results confirm that the successful turnaround bank exhibits elements of both selective product market pruning and piecemeal productivity, as Hambrick and Schecter found. Table V. Standardized coefficients of performance variables in rank order* Variabtes Interest on deposits/all deposits Gross charge-offs/loans Gross loans/all deposits Gash and treasuries/demand deposits Municipal income/municipals Securities income/securities Overhead/earning assets Operating expense/earning assets Loan loss provision/earning assets Loan income/gross loans Payroll expenses/employees Interest on deposits/time and savings ( 1)* ( *) ( 2) ( 3) ( 5) ( 6) ( 8) (9) (10) (11) ( 7) (12) (Gost control) (Receivables) (Gapacity utilization) (Use of inventory) (Pricing) (Pricing) (Gost control) (Gost control) (Quality) (Pricing) (Gost control) (Gost control) -0.91322 0.77486 0.79769 0.56055 0.55130 0.53055 -0.48367 -0.47916 -0.45616 0.26821 0.16959 0.06640 * Predicted rank given in brackets. Table V lists the standardized coefficients in rank order, and gives the hypothesized rank. An inspection of the table will show that the actual and predicted ranks are quite similar. Except for the case of one variable (payroll expense/employees), none of the predictions were off more than two steps in the ranking scheme. Four of the variables ranked as predicted, while six of the predicted ranks were off by one step. Overall, this performance documents the utility of turnaround models in identifying the patterns of resource deployment necessary to reverse decline. Univariate t-tests were used to supplement the discriminant analysis. For the most part, the univariate analysis supports the results of the discriminant analysis. On the basis of the t-tests alone, one might conclude that several of the key discriminators are not important in the turnaround. However, this conclusion would ignore the fact that the t-tests are not sensitive either to the correlation among the variables or the variance within the variables. Thus, both the multivariate and the univariate analysis are necessary to reach the conclusions in this study. For eight of the variables in the model, the mean differences between the groups are in the expected direction. The decline banks have higher interest costs, exhibit higher loan loss experience, have less loans per deposit dollar, and have higher costs in general. While these differences may not be significant in the univariate sense in each case, overall performance (i.e. turnaround) is sensitive to each of these variables.
  17. 17. TURNAROUND STRATEGY IN GOMMERGIAL BANKING 181 Table VI. T-Tests/means/standard deviations: differences at year six''' Decline 1) Interest/all deposits 2) Gross charge-offs/loans 3) Loans/deposits 4) Gash and treasuries/deposits 5) Municipal income/municipals 6) Securities income/securities 7) Overhead/earning assets 8) Operating expense/ earning assets 9) Loan loss provision/ earning assets 10) Loan income/loans 11) Payroll expense/employees 12) Interest/time and savings 0.0439 (0.008)!^' -0.0068 (0.003) 0.7051 (0.082) 0.8085 (0.204) 0.0465 (0.003) 0.0669 (0.009) 0.0243 (0.006) 0.0925 (0.011) 0.0066 (0.004) 0.0856 (0.008) 12.7138 (1.704) 0.0800 (0.015) Turnaround T-Staiistic 0.0416 (0.012) - 0.0040 (0.002) 0.7063 (0.101) 0.8335 (0.278) 0.0497 (0.005) 0.0661 (0.009) 0.0173 (0.005) 0.0766 (0.014) 0.0035 (0.002) 0.0775 (0.012) 13.4703 (2.452) 0.0727 (0.015) 0.75 -3.24" -0.04 -0.35 -2.92" 0.30 4.25"* 4.19"* 3.14" 2.58' -1.13 1.61 ''' Listed in order identified by discriminant analysis model '^' Figure in brackets is standard deviation * = 0 . 0 5 Level of significance •• = 0.01 Level " • = 0.001 Level Four of the variables exhibit unanticipated results. Contrary to the initial hypothesis, decline banks show a lower level of cash and treasuries/deposits. This might imply that decline banks are making better use of their inventory. However, they are using inventory in unprofitable ways as their net income continues to decline. The decline banks earn a slightly better return on securities (0.0669 to 0.0661). There is no readily apparent reason for this minuscule advantage. Decline banks earn more income from their loans. This unanticipated result must be interpreted in light of other results. First, the decline banks are using fewer of their deposit dollars for loans. Secondly, the decline banks are charging off more of their loans. Apparendy, the decline banks are sacrificing quality to obtain these higher loan incomes. Finally, in spite of the higher loan income per dollar of loan, the decline banks are not able to control costs. It may be that the decline banks are focusing on a single variable (loan income/loans) rather than making the combination effort required for turnaround. The final unanticipated difference in the univariate analysis is the fact that decline banks pay less for their employees. The turnaround banks pay their
  18. 18. 182 HUGH M. O'NEILL employees more; the return to the banks is higher productivity. This confirms Hambrick and Schecter's empirical finding that employee productivity is an important variable in turnaround. In summary, the discriminant analysis leads to acceptance of the first hypothesis and a failure to reject the second hypothesis. In a t-test of the difference between concentration ratios for the groups, no significant difference is found (T = 0.39; sig. = 0.699). The mean concentration ratio for the turnaround groups is 72 per cent while the mean concentration ratio for the decline groups is 73 per cent. Again, this leads to a rejection of the second hypothesis. DISCUSSION The results paint a vivid picture of the turnaround process in commercial banking. The findings confirm the prescriptions of Hofer and Schendel, and of Hambrick and Schecter. In commercial bank turnarounds, revenues are increased by such methods as the increased use of loan capacity, better use of inventory, better pricing and better quality. Costs are minimized through methods such as the control of interest costs, the minimization of loan losses, and the minimization of operating and overhead costs. A cost control variable (interest on deposits/all deposits) ranks first in discriminatory power. This is followed by five variables which reflect revenue generation. The primary position of interest costs is undoubtedly due to the fact that interest costs represent the greatest proportion of banking costs. Interest costs can be controlled in two ways: by offering lower rates on deposits, and by adopting a lower cost mix of demand deposits and time deposits (demand deposits carry lower interest rates). In a competitive market, it is difficult to attract deposits by offering lower rates. Therefore, successful turnaround banks control their interest costs by achieving a lower cost mix of deposits. This statement is confirmed by the ranking of the second measure of interest cost, interest on deposits/time and savings. This latter measure of interest costs ranks last in discriminatory power in the discriminant analysis model, suggesting that turnaround and decline banks pay similar rates for these expensive deposits. Turnaround banks manage to attract a higher portion of the cheaper demand deposits. The variables which rank second through sixth in discriminatory power reflect a turnaround bank's success in increasing revenues. The increased revenue can be attributed to better management of the loan portfolio (fewer loans are written off), better management of capacity (more loans per dollar of deposits), and better pricing (more dollar volume from municipal bonds). These revenue increasing options have a higher marginal impact on net income than further cost reduction options. Since other components of cost in banking (overhead/ earning assets, operating expense/earning assets) represent a small proportion
  19. 19. TURNAROUND STRATEGY IN GOMMERGIAL BANKING 183 of costs, cost reductions in these areas are likely to have a lower marginal impact than revenue increasing options. As Hofer and Schendel suggest, turnaround efforts which are based on a combination of cost cutting and revenue increases require a careful comparison of the marginal returns to each option. Turnaround banks find an optimal combination. The variables which rank seventh through eleventh in the turnaround model lend further support to the notion that the turnaround is based on a combined effort. Two of these variables represent the control of costs (overhead/earning assets and operating/earning assets) while two of these variables represent revenue increases through quality control and pricing. As noted, one cost variable which does not hold a prominent position in the turnaround process is the cost of employees. Since payroll costs do represent a major opportunity for cost reduction (payroll costs rank second to interest costs), this ranking is somewhat surprising. However, Hambrick and Schecter note that personnel productivity (not cost) contributes to turnaround. Apparendy, human resource productivity is more important than human resource cost in bank turnarounds. One key question not answered by the discriminant analysis is how the turnaround banks managed to reduce interest costs, reduce the level of loan charge-offs, increase capacity utilization, and the like. To answer this question, each bank in the sample was asked to provide archival data for the period of decline or turnaround. Responding banks provided such information as annuaJ reports, 10-K reports, and investment reports. This core of information was supplemented by a review of industry materials in the public domain (Moody's industrial reports, banking periodicals, etc.). Table VII summarizes this review. Since this material was gathered after the decline-turnaround event, any interpretations are subject to the cautions which accompany all ex post research designs. Nonetheless, this material describes the universe of methods used to achieve the cost reductions and revenue increases which combine to cause turnaround. This description should be of value to both researchers and practitioners. Table VII shows that the turnaround process required attention in each of several functional areas. Marketing, general management, the loan department and operations each contribute to the turnaround process. Marketing and general management contribute both to cost control and revenue generation. The principal contribution made by marketing is to attract more demand deposits and attract more loan customers. This is accomplished through such programmes as advertising, promotion, and the identification of new markets. New markets include new geographical locations (that is, new branches), new serivces (such as more consumer or commercial loans,) and changes in market definition. General management decisions involve the careful co-ordination of resource deployments through the use of targets, plans, and cost controls. General management makes key decisions about the balance between cost decreasing
  20. 20. 184 HUGH M. O'NEILL Table VII. Reported methods for enacting turnaround Variable Interest on deposits/all deposits Gross charge-offs/loans Gross loans/all deposits Cash and treasuries/demand deposits Municipal income/municipals Securities income/securities Overhead/earning assets Operating expense/earning assets Loan loss provision/earning assets Loan income/gross loans Payroll expense/employees Methods marketing, targets and plans, new consumer services, new markets, increase demand deposits relative to time and savings, increased deposit base, new branches. new business, reduction in problem loans, control of loan risk, credit rationing, restricting growth, increased diversity in loan portfolio. marketing, targets and plans, new banks, new consumer services, new markets, international expansion, change in market defmition. targets and plans, new technology in operations. marketing, targets and plans. marketing, targets and plans. cost controls, targets and plans, merge branches, liquidate subsidiaries, increased centralization, sell or close branches. cost controls, targets and plans, new technology in operations, increased centralization, increased training, work simplification, new business. reduction in problem loans, control of loan risk, credit rationing, restricting growth. marketing, targets and plans, new branches, new consumer services, new markets, international expansion, change in market defmition, increased service charges. reduction in personnel, merge branches, increased centralization, change staff composition. options and revenue increasing options. The turnaround bank must simultaneously increase the amount of demand deposits, while decreasing the relative amount of time deposits. Similarly, the turnaround bank must increase its volume while controlling for quality. The selection of specific targets, plans and controls apparently helps management achieve this balance. The contribution of the loan department impacts on the effort to increase revenues. This occurs through improved pricing, performance, quantity and quality in the bank's portfolio. Often, the review process for problem loans is changed as banks react more quickly to non-performing loans (i.e. delinquent). Often, the review process for new loans is changed so that the bank anticipates potential loan risks. In step with marketing efforts, the loan department promotes business in new areas. The operations areas of the bank (personnel, administrative services, M.I.S., etc.) contribute to the turnaround through work rationalization. New technologies (primarily computer-based) foster turnaround by improving speed and accuracy in funds management. Training, work simplification, and increased centralization improve productivity. This archival review suggests a menu of options which banks can use both to decrease costs and improve revenues. No single bank in the sample adopted
  21. 21. TURNAROUND STRATEGY IN COMMERCIAL BANKING 185 all the options. Rather, each bank adopted that set of options which fit its circumstances. One turnaround bank, for example, focused its cost reduction effort on interest costs exclusively. Since this represents the most sensitive cost area for the bank, such attention (combined with efforts to increase revenues) led to a turnaround. This archival review further suggests that the decline banks typically made one of two mistakes. They either chose the incorrect strategy, or they failed to implement the correct strategy. Those decline banks which chose the incorrect strategy focused their attention solely on growth or solely on the control of costs; they did not choose a combined strategy. While some of the decline banks did recognize the need to enact a combined strategy, for some reason they were not able to implement the desired strategy. Unfortunately, the archival data offers no clues about the causes of these implementation failures. The phenomenon of implementation failure represents an important opportunity for further research. SUMMARY This study presents a test of the prescriptions of the strategic paradigm in an industry which is not similar to the industries in which the paradigm was developed. The application presented here is successful in the sense that the prescriptions suggested by the paradigm do fit the situation; the efficacy of the turnaround model is confirmed. If this application of one generic strategy in one service industry can be taken as evidence of a more general fit, then we can suspect that the concept of generic strategy or grand strategy will have wide application in the service industries. At the very least, this study confirms that turnaround in the banking industry is dependent upon a combination strategy, which will require specific attention in the areas of cost control and revenue enhancement. The key areas for cost control include the control of operating expense, overhead and interest costs. The key areas for revenue enhancement lie in the control of loan pricing and quality: turnaround banks extract better returns for their loans in that losses are controlled more adequately. These findings imply that the functional areas of the bank that must manage their resource deployment decisions in the turnaround process include the sales area, the credit control area, the operations area and the administrative area. While these results verify the applicability of strategic paradigms in industries other than mature manufacturing industries, the study cannot support a firm conclusion about the potential transference of other aspects of strategic paradigms to other services. In the case of turnaround, it is necessary to apply the paradigm to a wider sample of banks, and/or to study individual turnaround banks more intensively to describe the processes which accompany turnaround more fully. Further, we cannot be sure without more study if banks are typicsil service industries; it may be that the banking industry is more exposed to mature
  22. 22. 186 HUGH M. O'NEILL manufacturing industries and therefore adopts similar management practices. Finally, we need to expand our understanding of the application of other generic strategies in service industries. For example, share increasing or decreasing strategies may be different in various service industries. Here, a study similar to the work of Hitt et al. (1982) might identify the relationship between strategy and resource deployment in the service sector. Given predictions that the growth of the service sector will exceed the growth of other sectors of most modern economies, this knowledge should be of interest to both researchers and practitioners. Appendix I. Performance variable definitions Interest on Deposits/All Deposits Interest is the total interest and expense paid on all deposit accounts and borrowed money. All deposits is the total of all deposits. This figure includes both demand deposits and time deposits. Gross Charge-offs/Loans Gross charge-offs are the net credit or charge to reserves for debt recovery. Loans include all loans written by the bank and federal funds sold and/or securities purchased with agreement to resell. These latter funds (federal funds and securities purchased to sell) represent loans made to other banks or loans to customers. Loans/Deposits This is the total amount of loans divided by the total amount of deposits. It is a measure of loan per dollar of deposit. Cash and Treasuries/Deposits This is the sum of cash and treasury securities held by the bank, measured as a proportion of total deposits. Municipal Income/Municipals This is the amount of interest the bank earned on its investment in municipal securities. Securities Income/Securities This is the income the bank earns on its investments in securities other than the municipal securities. Overhead/Earning Assets Overhead represents the totsil current operating expenses for the bank, other than interest and salary. Earning assets are the total holdings of the banks (loans, securities, accounts in other banks).
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