important decisions about how their firm's information processing assets are designed, deployed, and utilized. Antiquated and patchwork data systems, along with obsolete and feature-starved process applications, can seriously undermine the competitive position of a financial institution. In many cases in which bold, long-range planning decisions are desperately needed, institutions fail to prioritize major improvements to their information processing capabilities, and this failure to prioritize can be the primary constraint on progress toward a more holistic and capable information processing infrastructure. Evidently, as we will argue, in this industry so dependent on superior information processing, institutions seem to be weak in assessing where the current investment trade-offs are, where they are headed, and how fast they are changing. One symptom of this state of affairs is the enormous difficulty and expense that firms have experienced in trying to meet post-crisis regulatory requirements, such as Comprehensive Capital Analysis and Review (CCAR). Replacing antiquated legacy capabilities and taking a more deliberate and holistic approach to information processing means not only restructuring or replacing physical data processing and analytic resources, it also means creating an organizational structure to match that modernized business model. This means that the overall strategic direction must be identified, that the underlying physical infrastructure must be aligned with that vision, and that a plan to match personnel with that model must be developed and communicated throughout the organization.
This book seeks to provide context, as well as analytic and anecdotal support, for the simple characterization described above – that to be more successful and more competitive, financial institutions need to focus on information processing as the core competency. It seeks to provide some organization and definitions of terms and ideas embedded in the concept of management of information assets, primarily surrounding data and information processing and statistical modeling. The goal of this exercise is to make the relationship between firm organization around these functions and overall firm strategy and performance more stark. Finally, the book provides practical observations about how information assets can be actively and effectively managed to create competitive advantage and improved financial results. Toward the end of the book we survey some case studies that highlight some of the positive and less positive results that have stemmed from institutions either recognizing or failing to recognize the strategic importance of information processing capabilities.
Acknowledgments
Those who deserve special thanks include Brian Peters, Karen Schneck, Andrew Clyne, Mark Almeida, Hsiu-Mei Chang, and Gordon Cooper for various contributions, edits, and moral support; Jorge Sobehart for teaching me about information entropy and many other things; and to all my wonderful and brilliant colleagues at AIG. And to Sarah Kate Venison who provided encouragement all along the way. The multitude of remaining errors and defects are of course my own.
Chapter 1
Financial Institutions as Information Processors
Financial Institutions' RAISON D'ÊTRE
Economic literature includes a rich debate on why firms exist as they do – the main question being why firm boundaries are defined in the ways that we observe. Certain types of activities that could remain in-house are routinely outsourced, while many activities with the potential to be outsourced remain internal to the firm. Mergers, acquisitions, and divestitures do exhibit certain patterns with respect to how firms believe their own boundaries ought to be defined, but these patterns are by no means exhaustive nor are their outcomes obviously probative. Some corporate restructurings are metamorphic and highlight the question of what makes a financial institution a financial institution. For example, in 1987 Greyhound Corp., a bus line company since 1929, spun off its bus line operating units so that it could “focus on its core business of financial services.” To even think about which firms should be defined as belonging to the financial services sector we need to have some practical mechanism or criteria for inclusion. Theoretically we could simply enumerate a comprehensive list of financial services and products, and include firms that engage in this set of activities. With a boundary so constructed, we would have an identified set of institutions to analyze. But does that boundary really exist or is it helpful even as an abstraction? Retail sales finance is one of the largest and most obvious types of boundary blurring, often occurring at the direct expense of banks and retail credit suppliers. Captive finance subsidiaries for manufacturing firms are also common and the obvious complementarity between manufacturing goods and financing their sale seems to suggest that the latter function can be effectively internalized. But while the economic incentive to encroach on the boundaries of financial services seems to be predominantly one way – that is, we have not heard of things like mortgage institutions directly engaging in home construction – no hard and fast rule seems to apply.
There are well-known cases of captive finance companies whose financial services activities grew beyond financing the parent's manufactured products – in one case so much so that the entity became a systemically significant financial institution in its own right with only remnant relationships between their financing activities and the financing of the parent's products. Are there economic principles that would allow us to explain why, and the extent to which (for example) auto sales and lease financing are or are not more thoroughly internalized within auto manufacturers? While to economists the answer is surely yes (what area of human endeavor do economists feel cannot be explained by economics?), it seems clear that management teams at financial institutions themselves do not recognize or embrace such principles. For if they believed they understood the principles that define why the financial institution exists, they would surely leverage those same principles to establish firms that function better overall.
Rather than try to tackle this broader problem head on, in this book we simply focus on the kinds of firms that dominate the financial services industry landscape: banks and insurance companies. We leave it to the reader to consider whether or not the observations made also apply to any specific firm or subset of firms with financial sector exposure or activities. A number of factors characterize the financial services industry in a way that might help us better understand why financial institutions exist in the way they do, and how they can improve their economic strength and competitive positions.
Low Barriers to Entry
Over the bulk of the financial industry's long history, practical barriers to entry in banking and insurance were quite high. In the modern era this was primarily due to regulatory and licensing requirements, but also due to consumer preferences for brand stability and stature. Over the past 100 years or so great banking and insurance industry firms were founded on brand strength, and their ability to attract depositors and policy holders was their primary determinant of growth. However, those barriers began to erode during the twentieth century as cultural changes and an increasing dependence on technology changed both the supply and demand sides of financial services markets. Changing regulatory requirements produced periods that alternated between stimulating and dampening bank and insurance company formation as well as merger activity, which is beyond the scope of this book to either document or survey. What is important is that evidence can be presented to support the claim of low barriers to entry.
Interestingly, the aggregate data does not show an upward trend in the number of operating financial institutions. For banks, the total number of operating institutions in the United States hovered around 14,000 for the nearly 20 years between the early 1960s and the early 1980s. Then, after the savings and loan crisis began to unfold, the total number of banks began to drop – a trend that continues to this day, with the number of banks dropping by more than 50 percent from its 1980s total to fewer than 6,000 in 2013 (see Figure 1.1). However, looking only at the total number of institutions does not tell the whole story. In particular, the stability of the total number of institutions during that 20-year period between the 1960s and the 1980s reflected an offset between periods of great consolidation through mergers and acquisitions that reduced the total and periods of rapid entry of new institutions – particularly savings and loans associations, prior to the S&L crisis. Overall, entry into the banking sector has remained brisk and steady,
