Should the state ever enter a market that can be served by the private sector?

Economics, and the law of a finite checkbook teach us that that the state should not undertake work that the private sector could do better

Strategy Study W0 4

Why now?

We continue the off-site planning for the study, thinking through the broad strategy issues/considerations that box in the bank’s options. We are about 2 weeks to go until the team goes on-site to begin this landmark study.

We will keep these issues at the back of our mind as we go out and structure the analyses, particularly the focus interviews.

The 3rd issue relates to the timing. Why does the bank want to do this right now?

(1) Is there an unsaid reason that is compelling the bank to go after one of the world’s most competitive financial services markets? Most likely

(2) Does the bank have weaknesses in their core business forcing them to make this shift? Maybe but unlikely

(3) Are they in danger of running out of cash and want to reinvent themselves? Unlikely

We will only know more once we start, but this area is outside our scope. We just need to consider the implications by showing the bank how much the US banking venture will cost before it creates positive free-cash-flow or how much it will consistently lose.

Given the bank’s cost structure and additional compliance costs in the US, it is hard to see how this can make money.

In other words, every market is profitable to a market entrant with the right cost structure but we do not think it is this bank.

What is the role of a state-owned bank?

The 4th issue and 2nd issue are somewhat related.

The 2nd issue asked what is the role of this particular bank, and will be determined by the act of government which incorporated them, or shareholder agreements, whichever may be the case.

The 4th issue sits above that and looks at the role of a state-owned bank, any state owned bank for that matter. What should its role be? This could apply to any state-owned entity.

State banks typically exist to invest in areas of the country which need investment, but generate such a low return, that private banks would never go near those areas. There is just no meaningful return.

What is the role of government?

In other word’s the role of a state bank – or any state entity – is to make an investment that the public needs/wants, as determined by the government, but which the private sector cannot or is unwilling to make.

(1) Should the bank invest in sectors/regions, which are attractive financially, since those attractive sectors/regions would likely receive private sector funding?

(2) In essence, should the banking client compete with the private sector, or should they pursue different return ranges?

The 2nd issue provides part of the answer – possibly.

Balance sheet impact

If the bank is going after the US market to secure higher returns to invest in parts of Latin America with low to negative returns, then it could make sense.

Yet, how sustainable is this cross-subsidization model?

Does it mean LAB is a bank with good and bad assets? How does it manage those assets? Does it ring-fence them? Against which balance sheet does it raise capital?

Again, outside our scope, but our work will inform the bank of the implications.

The good assets can probably raise money at better interest rates than the bad assets. This, in turn, matters because the rate at which the bank raises its capital is the base rate at which it can lend money.

On top of this base rate, it attaches an interest rate to compensate for risk, it’s costs and the profit it wants to generate.

If the base rate rises and it cannot pass costs to borrowers, its margin will fall. If it can pass costs to borrowers than it may price itself out of the market. And there are rules on how high-interest rates can go so it is not within the bank’s control on how much costs it can pass long.

So, it is a big deal. The study will get a little hairy later as we will almost certainly have to model the behavior of claims and defaults on the balance sheet.

Financial strategy

Notice how we are discussing finance and accounting from a strategy perspective.

Do you see how we link the concepts back to the primary issue we are trying to solve?

CAs and CPAs would make astonishingly good strategy consultants if they could naturally use their skills to focus on these broad issues versus getting bogged down in the minutiae of the calculations. That comes later.

QUESTION(S) OF THE DAY: Do you agree with the economics view that the state should not compete with the private sector? What are the implications for LAB if you accept this view?

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.