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4 Bridging the micro/macro divide in European economic integration

4 Bridging the micro/macro divide in European economic integration

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234 British and German Banking Strategies



range of groups affected by the actions of a firm, including its owners, that

is the shareholders (Freeman, 1983). It follows that the stakeholder concept

is indeed an extension of the narrower shareholder value concept and does

not stand in contradiction to it. The large number of state-owned banks and

mutual cooperative banks along with the strong representation of employees on the supervisory boards nourished the argument that the German

banking system is essentially a stakeholder value oriented system, whereas

the United Kingdom’s is predominantly a shareholder value oriented system, and that this difference largely explains the different levels of profitability (Llewellyn, 2005).

Such observations may hold true if one considers how rigorously Lloyds’

CEO Brian Pitman applied the ROE criteria when shutting down businesses.

The frequent rights issues and the ease with which Commerzbank, among

others, high-handedly tapped the capital markets, thereby ignoring any dilutive effects for existing shareholders, supports the view that German banks

did not adhere to a shareholder value concept. Yet the general assumption

that British bank managers followed a rational shareholder value approach

can also be easily shattered, for example, by the statement by Barclays’

long-standing chairman, Andrew Buxton, that he would not have cared if

Barclays’ share price went down a very long way (interview Barclays senior

management). Furthermore, it should be remembered that all four German

banks analysed here had announced ROE targets by 1994 at the latest.

The three reasons identified by Llewellyn – the shareholder value approach,

structure and a benign British business cycle from the early 1990s – were

important factors supporting profitability in the United Kingdom. Certainly,

Britain’s capital-market based financial system, with its strong fund management industry, encouraged senior managers at publicly listed banks to give

ROE criteria priority in assessing strategic options. However, strictly applying a shareholder value concept implies constraints for corporate strategy.

An orthodox shareholder value approach is likely to run counter to business diversification, ruling out exposure to different business cycles and risk

structures. Moreover, setting a return on equity target for the whole bank

ultimately has implications for each segment. First, internal rivalry about

capital allocation arises. Second, a comparison of segmental ROEs may create tension among the different business segments if their profitability varies significantly, regardless of the actual level of profitability.

The implications of applying a strict ROE approach to managing a bank’s

strategy became evident in the case of Lloyds TSB. Given the high levels of

profitability achieved in its home market, it became increasingly difficult

for the bank to expand internationally without diluting its existing business. Thus, the strict application of ROE criteria confined Lloyds TSB to its

home market, making it difficult for it to escape from its profitable isolation. The development of Lloyds TSB illustrates how rigorous application

of the shareholder value concept may not always be in the best interest of



Conclusions 235



shareholders. What matters to shareholders is stable profit growth, which

appears to benefit from a sustainable business model. Shareholders are also

proxy entrepreneurs who are willing to accept unknown risks if they could

lead to profitable growth.

For example, under stringent ROE criteria RBS would not have provided

the seed money for Direct Line, its hugely successful insurance arm. A

consistent shareholder value approach at HSBC would have deprived it of

becoming a case study for this book, as an investment in the ailing Midland

Bank would have been unthinkable for such a highly profitable Hong Kong

bank. Further evidence of the limited and inappropriate use of the shareholder value concept is the acquisition of the very profitable investment

bank Wasserstein Perella by Dresdner Bank. This move was right insofar as

it enhanced ROE, yet Wasserstein Perella disintegrated within a short period

after it had been taken over and profits declined.

Notwithstanding the importance of return on equity as the principal criterion for the shareholder value concept, the importance of structure finds

insufficient weight in the studies that merely contrast shareholder value and

stakeholder value concepts (e.g., Llewellyn, 2005). The distinctive structure of

the British banking sector results from the fact that bank managements recognised in the early 1990s that they could change the banking landscape to their

advantage through their decisions. For management to recognise this and to

act accordingly takes analytical, pragmatic and power-driven bank managers.

Consequently, the management of British banks focused on domestic consolidation, expanding scale and streamlining processes. If British banks had



in %

10

9

8

7

6

5

4

3

2

1

0

RBS

Figure 5.10



Deutsche

Bank



HSBC



Commerz- Barclays HVB

bank

Group



Tier 1 ratio (average 1993–2003)



Lloyds TSB Dresdner

Bank



236



British and German Banking Strategies



slavishly followed the shareholder value concept, they would not have been

able to grow their revenues by a CAGR of 14 per cent p.a. over a decade.

Unlike their British counterparts, the management of several German

banks found it difficult to accept their path dependency and wanted to

switch to a business model that was not compatible with the country’s prevailing bank-based financial structure. This was the case at Deutsche Bank,

Dresdner Bank and Commerzbank. Deutsche Bank was in the privileged

position that it could at least partially overcome the structural forces of

the German banking landscape by building up international investment

banking expertise, financed by billions of euros of disposal gains from its

industrial holdings.

Despite having the same ambitions as Deutsche Bank, Dresdner Bank did

not have the same financial cushion. It also had inferior risk management

and less stable management. Commerzbank wanted to go down the capital

market and investment banking road as well but was simply too slow, which

eventually made it easier for management to reverse its strategy. HVB pursued a consolidation strategy that aimed at gaining regional strength. It was

therefore the only bank of the four analysed that accepted the structures of

the bank-based German financial system. Yet, this high-sounding strategy

did not entail good risk management.

The case studies of HVB and Dresdner Bank, the two banks with the lowest

average returns on equity and the weakest capital positions, also brought to

light the shortcomings of supervisory boards. The role of a supervisory board

is to monitor the work of the management board and to appoint and if necessary dismiss the bank’s executives. There seemed very little reaction by the

supervisory boards to the fact that both banks consistently missed their targets. Overall, the German corporate governance system showed a great degree

of phlegm and indifference towards the activities of the management board.

There appeared little awareness by the supervisory board members that

their essential task is to oversee the management board and to make the

right personnel decisions. In the United Kingdom, the greater professional

experience of non-executive directors seems to have nourished an environment in which personnel issues were addressed more openly. For example,

Barclays’ board showed excellence in appointing the right CEO for each

phase in the bank’s development. The different corporate governance systems and their impact on the important task of finding the best-suited

executive directors would be worth a detailed analysis, but that goes beyond

the scope of this book.

Finding the leader who is best suited for a particular phase is a soft, but

important, factor that set German and British banks apart. A less legalistic and quantitative and more sales and client-oriented understanding of

banking contributed to the quality of leadership among British bankers.

Thoroughly comprehending the clients’ situation and needs also serves as

the best initial risk management tool. RBS’ US expansion, which followed



Conclusions 237



the maxim “if you cannot drive to it, don’t lend to it” is a case in point, illustrating the importance of client proximity as a means of risk management.

Another important reason why British banks fared better in the 1990s

is that they had already undergone a tremendous crisis in the 1980s. The

learning curve, that is collective memory, seemed to have worked to their

favour. The 1980s included such incidents as NatWest’s Blue Arrow scandal,

the crisis at Midland Bank and overly ambitious international expansion by

Barclays and Lloyds that eventually depleted their profitability. The senior

managers of the 1990s had lived through the 1980s and seemed to remember and have learnt from that experience.

In addition, Big Bang in 1986 paved the way for greater flexibility. More

importantly, Big Bang raised the question of what the British clearing

houses should do with regard to disintermediation and transaction services.

Overall, the numerous small British merchant banks were too proud to join

up with the clearers and did not merge with each other. So the more salesgifted US investment bankers with their greater experience of the capital

markets swiftly moved in. The old clearing houses quickly abandoned any

attempts to make inroads into this investment banking business. Instead

they focused on the retail client base which they had been familiar with for

decades and knew how to serve. The decision to opt for “scale” over “scope”

was made and led the way for consolidation of the domestic market.

The presence of US American investment banks in London and the

aggressive Japanese banks on the British corporate lending market in the

early 1990s helped British banks to focus on retail clients, the last business area which appeared difficult for foreign banks to reach. The strong

UK economy provided additional backwind and British consumers and

house-owners further accelerated revenue growth. Moreover, the presence

of US investment banks on the London market attracted more and more

well-qualified bankers to the City. Although most of them stayed within

the investment banking world, this still provided an intellectual spill-over

effect and enabled, for example, Barclays to develop Barclays Capital under

Bob Diamond, an American investment banker and one of the key figures

in Barclays Capital’s success.

In Germany, banks had not gone through the same traumatic experience

as their British counterparts during the 1980s. 1989 brought about the fall of

the Berlin Wall, the end of communism and the first signs of globalisation

with a sense that a new era was beginning. This created an enthusiasm that

quickly turned into euphoria and from there into megalomania and hubris.

Against the background of the difficult retail banking market this internationalisation, along with Europeanisation and globalisation, was taken

as a reason or excuse to embark on an internationalisation spree. Moreover,

technical innovations added to the range of new opportunities.

From the early 1990s German banks slowly but steadily moved into an

opportunity dilemma. Management perceived incessant opportunities that



238 British and German Banking Strategies



appeared attractive but forgot to prioritise. The banks saw the opportunities

but not the opportunity costs that came with them. While a more capitalmarket or shareholder value oriented approach might not have stopped

such projects, it might at least have raised additional questions before some

projects were launched.

The findings from the case studies clearly demonstrate that, on the whole,

the British banks analysed pursued defensive strategies, in other words they

remained focused on the domestic market. For a defensive strategy of this

type to be successful, a bank needs assets and capabilities that are specific to

the domestic market (Adamides et al., 2003). For example, a well-established

distribution network may help to deter rivals even in industries like banking

which have strong globalisation characteristics.

By contrast, German banks, showed a strategic pattern which fully

embraced all new opportunities that led to an international multi-business

strategy. Yet, the attempt to capture many of the new opportunities that

arose in the early 1990s deprived the German banks analysed of their

strategic focus and provoked erratic strategy changes. Even in the case of

Deutsche Bank, which with hindsight had a coherent strategic reorientation towards international investment banking, there were many “trials and

tribulations” as a former board member conceded in the interview for this

book (interview Deutsche Bank senior management).

Consequently, these German institutions could not develop sufficient

power to make inroads into other European countries. Effectively, neither

the corporate strategies pursued by British banks, nor those followed by their

German counterparts did much to promote European banking integration

and thus European financial integration, other than on some wholesale markets. Moreover, none of the banks, with the exception of the hapless HVB,

pursued with great rigour a corporate strategy that was tailored towards the

enlarged opportunities that opened up after the Single Market had, de jure,

been completed in 1993.

Indeed, HVB can be identified as the only bank of the eight studied for

this book with a clearly formulated pan-European strategy targeted at seizing the opportunities of a liberalised market. Ironically, its takeover by the

Italian bank Unicredit meant it did actually become one of the few banks

to be involved in a large pan-European banking deal – but only as prey.

Deutsche Bank’s pan-European retail banking endeavours were described

as mere trials and tribulations, as its focus was on international investment

banking. Besides some rudimentary European cooperations in the 1970s,

any substantial European strategy seemed out of reach for Commerzbank

as it was too entangled in its local retail and SME business. Dresdner Bank’s

talk about being a European, or even a global player could never materialise

due to its poor risk and cost management and frequent changes of CEO.

At HSBC, Europe and the liberalised European banking market appear to

have played only a subordinate role in the group’s overall global multi-local



Conclusions 239



corporate strategy. The acquisition of CCF in France was certainly driven

less by a pan-European approach than by the chance of acquiring an established local player with promising prospects on attractive conditions. Lloyds

TSB did not “go European” as the expenses for internationalisation would

have diluted the high profitability generated by its domestic operations. For

similar reasons, and because of the absence of potential scale efficiencies

from branching out into other European countries, Barclays remained coy

about European banking strategies. In the case of The RBS, the period analysed was used to gain size on the British market and to grow beyond its

peripheral position, which it primarily achieved through the acquisition of

NatWest. Thereafter, The RBS promoted its pan-European interests slightly

more intensively, but largely via a cautious organic approach focused on

commercial and wholesale banking.

Overall, it can be concluded that for economic integration to become

effective, market liberalisation on a grand scale is certainly a necessary,

but by no means a sufficient condition. Managing economic integration

requires a thorough understanding of the interests and capabilities of those

players that act on a micro-level, thereby ultimately altering the macrostructures. Opening up new opportunities does not necessarily mean that

the newly available opportunities are also seized (as evidenced by British

banks) and if they are exploited, then it is still not certain that the new situation can be successfully managed with the existing set of capabilities (as

shown by German banks).

The different outcomes of the strategic reactions of British and German

banks identified in this work corroborate the theory that a financial system is a configuration of its subsystems with a coherent structure (Schmidt,

2001). As banks are an integral part of their respective national financial

systems, this coherence, which in fact contributes to the stability of a financial system, also poses a challenge for new corporate strategies that are not

compatible with the prevailing structure.

Therefore, a stable and coherent financial system with banks forming

important institutional pillars is relatively resistant to structural change

(Hackethal & Tyrell, 1998; Hackethal & Schmidt, 2000; Schmidt, 2001). The

case studies showed that banks which pursued a defensive strategy, accepting the premises of a coherent financial system, fared better than those that

attempted to break out of a coherent structure to pursue strategies not compatible with the overall financial system in their home market.

Studying the corporate strategies of eight large European banks offers an

unprecedented understanding about the interdependence of agents and

structure of Europe’s financial system. In the tradition of Giddens’ ontological concept of structuration, this work demonstrates that social action

requires structure and that structure is the result of social action. According

to structuration, there is an intrinsic interdependence between the micro

and macro levels. This interdependence could be shown in the function



240



British and German Banking Strategies



of banks (representing micro structures) as institutions that determine the

macro structure of a financial system.

Applied to the realm of corporate strategy, Giddens’ concept of structuration strengthens the argument that strategy cannot be separated from its

environment and that the formulation and implementation of strategy are

closely intertwined, as a natural consequence of the view of strategy as process (Clausewitz, 1997; Mintzberg et al., 1998). In economic theory, Giddens’

concept of structuration finds its parallels in the Structure-ConductPerformance Paradigm (SCP), as previously discussed (Mason, 1939, 1949;

Bain, 1951, 1956, 1959). The SCP paradigm recognises the link between

industry structure and the conduct of the firms that comprise an industry.

This analysis made use of the SCP paradigm through Porter’s more specific

five forces framework modified for the banking industry.

The importance of power in Giddens’ concept of structuration also complements the understanding of strategy as a process. The relative power of

actors becomes pivotal for the interdependence between agent and structure. An actor’s ability to alter the prevailing structure depends upon its

resources and positioning, and thus its power within the structure. This reasoning appears consistent with Schmidt’s previously elaborated argument

that a financial system is a configuration of its subsystems, which complement each other, and that the coherence of such a system renders it resistant

to structural change (Hackethal & Schmidt, 2000; Schmidt, 2001).

In order to overcome systemic rigidity, a few actors need to become sufficiently powerful to change the structure to meet their interests. The findings from the case studies brought to light that this is precisely what did

not happen in Germany, whereas as it drove the consolidation process in

British banking between 1993 and 2003. As the analysed four British banks

gained more power relative to the other actors that made up the structure, they attained an even more favourable position that enabled them to

achieve further changes. It can be concluded that the more consolidated a

banking market, the easier it is for the players to change the structure.

Moreover, applying Giddens’ concept of structuration as a methodological

framework also pays adequate attention to the unintended implications

that one level has on the other. The slow progress of banking integration

in Europe between 1993 and 2003, which fell short of the expectations

at the beginning of the Common Market, strengthens the argument that

the interdependence between actors and structure should be given greater

prominence in international relations and socio-economic research projects.

Merely liberalising markets and harmonising the laws of European nations

is evidently not enough to stimulate European integration. From this analysis it may be concluded that European policy-makers do not sufficiently

take into account the interdependence of agents and structure. Their focus

appears either too narrow – on the micro level (agent) – or too general – on

the macro level (structure), ultimately fostering structural inertia.



Conclusions 241



5.5



Epilogue – daring an outlook



This book focuses on the period stretching from 1993 to 2003. There are

three reasons why it appeared pertinent to analyse this decade. First, in 1993

the Single Market Programme (SMP) was completed. This triggered wideranging changes in the financial services industry in the following years.

Second, it takes several years for strategic adjustments to be implemented

at large financial institutions and to show results. Third, the time between

1993 and 2003 spans one full business cycle in Britain and Germany.

Moreover, for pragmatic reasons there had to be a cut-off date for the case

studies, as otherwise this would have become a perpetual task. Between the

cut-off date at the end of 2003 and summer 2008, when this book project

was completed, the European banking landscape continued to evolve.

After 2003, streamlining and efficiency programmes remained high

on the agenda at British banks. More widespread use of a wide variety of

technological innovations has led to signs of increasing industrialisation in

banking, especially retail banking. Strong economic growth in the United

Kingdom provided further tailwind for British banks’ profitability. In fact,

without any notable new entrants thwarting the banks’ comfortable market

position, the degree of market concentration has actually increased. Thus,

the dependence on the British economy has become one of the greatest risk

factors for some of the banks analysed in this book.

German banks have now recovered from their experiences in 2002/03,

which nearly wiped out some of the country’s financial institutions. Continued

restructuring has taken the form of stringent cost control, improved risk

management, more client-oriented sales approaches and, most importantly,

a greater awareness of the importance of not wanting to be involved in all

aspects of the value chain. Notwithstanding the progress made by adopting

more focused strategies, the structure of the German banking market has

not changed substantially. The three-pillar structure remains the dominant

characteristic of German banking and still impedes mergers between savings

banks, cooperative banks and the private sector banks. Operating in a highly

fragmented domestic market, none of the German banks has gained such a

position that large scale international expansion seems imminent.

Since summer 2007 British and German banks have faced the challenge of

a financial crisis of unprecedented magnitude and complexity. At the heart

of the crisis is a drastic reduction in liquidity in markets which are necessary for the banks’ refinancing strategy. In conjunction with accounting

standards that increasingly rely upon the functioning of such markets, this

has led to massive write-downs and the collapse of several banks. When the

fundamental premise of the International Financial Reporting Standards

(IFRS), namely that fair values are determined through market transactions,

failed, the interdependence between accounting standards, markets and

regulatory requirements entered a vicious circle.



242 British and German Banking Strategies



The chain of crises that eventually came together to create one major

crisis is rooted in a long period of inadequate risk pricing in various parts

of the financial system. Effectively, the price differences between so-called

risk-free assets and risky assets had narrowed since the late 1990s and –

at least with hindsight – were too low. Following the end of the dotcom

boom excess liquidity was largely channelled into real estate and absorbed

by newly created financial assets so it did not fuel the traditional inflation indices which are based on consumer prices. Against the background

of moderate inflation, interest rates remained at historically low levels.

A strong belief that the rescue mechanisms of the Federal Reserve Bank

would avoid serious financial collapses added to the prevailing risk tolerance (Goodhart, 2008).

Besides these benign macroeconomic and monetary conditions, which

altered risk perception, the banks’ own securitisation policies contributed

to inadequate risk pricing. From the late 1990s they increasingly sold loans

on to the capital markets. Generally, securitisation enables a bank to use the

capital markets to adjust its loan portfolio in order to optimise risk diversification and use capital more efficiently. However, instead of using securitisation merely as a risk management instrument, some banks pursued an

“originate and distribute” approach where securitisation itself became the

dominant strategy.

Some banks, principally US mortgage banks, sold on a significant proportion of the loans originated by them or cooperating mortgage brokers in

this way. Assuming that the associated credits risk would only be on their

balance sheet for a short time, the quality of credit assessment became less

rigorous. A common approach was to use Special Purpose Vehicles (SPVs),

often known as conduits, as intermediaries which then issued short-term

asset-backed commercial paper to fund long-term loans. Such refinancing

structures require liquid money markets on which these quickly maturing

commercial papers can be easily placed and traded.

In case an SPV should run into refinancing difficulties the banks had made

arrangements to act as a “lender of last resort” (Goodhart, 2008). Hence the

pivotal assumption on which this “business model” rested was that the markets for commercial paper would remain liquid. Yet they did not. Without

a high volume of offers and bids, the number of transactions declined and

price fixing became discrete rather than continuous. Thus, liquidity dried

up and the markets for these instruments effectively ceased to exist.

Several years of rampant mortgage lending meant that loans had been

granted on the assumption of rising property values, that is declining LoanTo-Value Ratios (LTVs). Consequently, more and more liquidity was injected

into the real estate market, thereby driving up prices and creating assetprice inflation. As US interest rates began to rise in 2004, housing prices

first started to rise more slowly and then, towards the end of 2006, began

to fall.



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