Competitive Advantage: Does LAB compete on risk or price?

A bank can only build its competitive advantage on one of these levers.

Strategy Study W0 5

Competitive Advantage

The age of the client, and particularly the age of its debt book is crucial.

When LAB was first conceived it would have been capitalized with billions of dollars from the government and/or any outside partner investors. Remember, the client is a state bank.

At first, the banking client has all this capital on its balance sheet which it borrowed at relatively low rates since there is a belief in the market that the bank is backed by the government. True or not, this is what the market thinks, even in the US where Fannie and Freddie are assumed to have government backing and will not be allowed to go bankrupt.

Initially, those low rates are the banking clients’ key competitive advantage. It can compete against private banks by offering clients lower loan interest rates because its cost of capital was lower due to the implied government guarantee.

So the loan book ages more like blue cheese left out in the sun and not like fine wine in a climate controlled cellar.

Changing competitive advantage

Over time, as the bank made more loans to the market, two things happened.

(1) First, if the bank is keeping with its mandate of banking those with very low incomes and with a higher risk profile, its bad loan book increases. It is hard to avoid this if your intended goal is to serve a part of the market that is so risky, no one even wants to go there.

(2) Second, as the bad loan book increases, while the market will continue lending money to LAB at lower rates, the difference between LAB rates and that of private banks become smaller and smaller, since LAB’s risk increases with its bad loan book size.

Even if the government will bail out LAB, if LAB becomes too big of a problem, there will be a concern that LAB could hurt the government and the countries own rating takes a hit.

Why do we care about this?

LAB, like any other state bank, will compete on financing terms as a younger bank.

It can offer better rates. In theory anyway. We say in theory since its credit rating is somewhat linked to the credit rating of Mexico. If that falls, LAB is also impacted.

As it gets older its ability to do this diminishes, for the reasons listed above, and it needs to find new ways to compete.

So, we need to carefully analyze its loan book and bad loan book to see if it can continue competing on pricing, and if so, by how much, and for how long. And if not, how else can it compete?

Logic would dictate that if LAB honored its mandate of helping those with poor credit scores and access to the market, its bad loan book would increase.

The question is, how bad is the bad loan book?

Why the USA?

The US is a massive market. Everyone wants to be there and everyone wants to have a dominant market share. Issue 6 considers why LAB wants to enter the US market, specifically.

In essence, they will build a retail-banking network and those networks need scale to pay-off the high fixed cost investment.

Yet, the issue is more nuanced than this.

LAB wants to generate a certain return from financing small businesses in the US, primarily among immigrants. So it needs to deploy capital in the form of loans, equity investments, credit guarantees etc.

From the profit, it needs to pay off its retail structure investment and then move the remaining profits back to the head office.

Absorptive capacity

If LAB is going after such a large market like the US, it must have a lot of capital to both fund the infrastructure investment and create a loan book. It needs to apply for a banking license, lease branches, remodel them, hire and train staff and advertise. It needs to do this while competing who the DFIs.

It is tricky since LAB needs to steal customers from the DFIs while needing the DFIs to keep servicing its clients until LAB no longer needs the DFIs.

Why does it have so much under-deployed capital that needs to find such a large parking lot for it?

It implies that LAB’s current markets suffer from a lack of absorptive capacity. That means the markets it now operates within cannot absorb the cash LAB wants to lend. In basic terms, there are not enough viable opportunities to fund.

So, what is it about the US market that makes LAB think there is a greater absorptive capacity?

A larger market does not correlate with a larger absorptive capacity. Many barriers like legislation can reduce the absorptive capacity.

What answer does the client want?

The 7th issue relates to the clients’ bias and not its mandate.

The client is already preparing for implementation.

The internal strategy unit (ISU) contains several alums: a roster of ex-McKinsey, ex-BCG and ex-Bain principals, managers, associates and analysts. Several of the EVPs running key divisions are also ex-partners.

I know some of these guys. Can’t say I like them all too much. Although, they would probably say the same about me. That said, my reasons have more to do with the quality of the work when they were consultants and their general attitude towards clients.

To me they acted like being a consultant was their right since they attended prestigious schools. I did not believe they tried as much as they could and should have.

ISU believes entering the US is a good idea and they have done some studies to support this. We have not seen these studies and will not need to see them.

In fact, the CEO initially discussed focusing the study on a plan to make the implementation work. This was the initial scope of work, an implementation plan. Our view was that we needed to make sure the economics made sense before proceeding. We have seen numerous such ventures fail and simply relying on detailed studies done by outside parties was not an appetizing idea.

Aggregating the detailed studies from external parties does not lead to a better study. It leads to a summary of errors.

Asking the right question

The only reason we were successful in being awarded the role of serving the client, is because of this focus on testing the idea more rigorously. The board would want to see that it makes sense, and I have not yet seen a board use the findings of an ISU for these big decisions.

That just not happen for major decisions. If boards routinely used ISUs, McKinsey and the like would be out of business.

There are just too many conflicts of interest, and other issues with using ISUs, which we will discuss later.

These are all the things we are thinking before we even start the study. And our hypotheses and assumptions can be refined to such precision, that the actual analyses will rarely change the findings much. The challenge for most consultants, even clients we have at McKinsey and BCG, is that they have never been taught this technique and jump straight to the analyses.

You will see here that just refining our hypotheses from focus interviews generates significant insights before the analyses is even started, let alone completed.

QUESTION(S) OF THE DAY: Why is the client so intent on entering the US market?

We answer this question, additional reader questions and discuss more issues raised in this article on the accompanying episode on the Strategy Skillspodcast channel on iTunes, Spotify, Acast and Google Android Podcasts. This is the world’s #1 ranked business strategy podcast channel.

If you have a question, please post it as a comment on iTunes and we will respond in a podcast.

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