The wholesale side of the financial services industry—mergers and acquisitions advice, foreign exchange, and the trading and underwriting of derivatives, bonds, and equities—is among the most global businesses in the world today. But the other side of the industry, personal financial services (PFS), is still largely a local game. This sector, which includes life and accident insurance, retail banking and brokerage, investment management, and payments, is dominated by local operators with local brands that command strong customer relationships and, more often than not, regulatory protection from incursion by outsiders.

All this is changing, however. The rapidly growing PFS industry is subject to the same forces transforming other areas of the world’s economy. Technological innovation is sharply cutting its interaction costs, which make up more than half of the total cost of PFS in developed markets.¹ Global capital markets are integrating. Trade and capital accounts are liberalizing. And despite recent financial crises, the economies of many emerging countries have produced a growing middle class that represents a large new market for PFS products.

So PFS, like the wholesale side of the industry, will become global. The total worldwide profit pool for the sector is already $600 billion, almost all of it (with the possible exception of a few businesses, such as credit cards and mortgages) earned within national borders. Over the next four or five years, this profit pool will expand to $850 billion, and a growing share of it will cross borders.

Such creeping globalization will certainly threaten many conventional PFS companies, especially those with competitive positions based mainly on regulation or traditional consumer preferences. But globalization will also give companies with the right combination of skills and businesses an opportunity to stake out powerful positions over the next five to ten years. For the most skilled companies, this period of transition will also offer a rare chance to shape the landscape to their own advantage.

Global creep

Superficially, the PFS industry seems to be largely confined within national borders. But increasing activity in four areas shows that, beneath the surface, PFS is beginning the transition from a local to a global business.²

1. Customers have greater choice. In saturated markets such as the United States, consumers can already buy investment vehicles through banks, traditional brokers, or discount brokers, directly from mutual funds, over the Internet, from their alumni associations, in department stores, and even at grocery stores. This explosion of sales channels is matched by a similar boom in products, as a glance at the promotional material of any large US retail bank shows. The increase in choice is driven mainly by falling interaction costs, which in turn bring down the cost of tailoring products to ever narrower customer segments. Thanks to electronic networks, many PFS products can be transported for almost nothing, so it makes compelling economic sense to aggregate one of these segments on a global basis.

2. Companies have greater access. Changes in legislation within individual countries and across borders have broadened opportunities for all PFS companies (Exhibit 1 and Exhibit 2). At the same time, the globalization of wholesale markets means that all companies have equal access to capital. When First Bangkok City Bank went deep into the red during last year’s financial crisis, it was able to look across the globe—to Citibank (now Citigroup) in the United States—for the capital it needed to survive. Similarly, some banks have taken advantage of looser regulation to acquire operations abroad; Grupo Santander and Banco Bilbao Vizcaya (BBV), both based in Spain, have done so in Latin America, for instance (Exhibit 3).

3. Specialization is on the way. The first two trends have set the stage for the third: specialization. With the whole world as a market, growing numbers of companies are finding it economically worthwhile to narrow their focus to small segments of the business. The world’s best securitizer of mortgages, for example, is better placed than ever to use its highly specialized skills on the global stage, whether to defeat less-skilled competitors in previously sheltered markets or to acquire foreign competitors it can then fortify with its own skills and superior performance.

Specialized skills provide a platform for large institutions seeking to consolidate or expand globally. To develop a base for growth in foreign markets, Merrill Lynch acquired local investment-oriented nonbanking institutions around the world, including Mercury Asset Management in the United Kingdom, McIntosh in Australia, and Midland Walwyn in Canada. It then transferred specialized skills, products, and capabilities, including its brand name, many of its leading US products, and its "high-touch," advice-based model for high-net-worth customers.³

4. The benefits of scale are becoming polarized. In the most evolved markets, financial giants such as the new BankAmerica and Citigroup coexist with niche specialists, whose minimum efficient scale is falling. Homeshark, a San Francisco-based on-line mortgage broker, began as a one-room operation with three employees. It has since become the provider of choice for cost-sensitive, technology-savvy customers. While Homeshark has not yet gone global, its survival in such a narrow niche certainly demonstrates the ability of new technology to increase access to customers by cutting the cost of transactions (Exhibit 4).

What the next decade will bring

Although all of these developments are most apparent in highly deregulated markets such as the United States and the United Kingdom, truly global operators are emerging everywhere. In many less developed nations, in fact, the requirements of the World Bank and the International Monetary Fund (IMF) are prodding companies to leapfrog ahead both in regulation and technology. In Thailand, for example, IMF-related reforms introduced since the financial crisis allow foreigners to own 100 percent of a particular local bank, up from 25 percent, and the new arrangements have been guaranteed for at least ten years. Furthermore, the number of branches foreign banks may own has been raised to three, from one. Similarly, the government of South Korea has removed its 4 percent cap on foreign ownership of banks and, for the first time, is opening the market to foreign subsidiaries and brokerage houses. In Malaysia, the government has so far refused IMF assistance but quietly increased foreign ownership limits for financial institutions to 51 percent on a case-by-case basis.

As the national model gives way to the international one, the factors needed for success in PFS will change. Over the next five to ten years, three emerging kinds of companies are likely to dominate the industry at the expense of more traditional players.

1. Geographic incumbents. Occupying the lower left quadrant of Exhibit 5, geographic incumbents represent three-quarters of the global market. They have relatively small market capitalizations, show little growth in their book value, and earn more or less constant or declining returns. Yet they typically have a thorough understanding of the customers, competitors, other businesses, macroeconomic rhythms, regulations, and idiosyncrasies of the regions where they operate, and they often control many parts of the value chain there. In addition, they tend to have long-standing relationships with key customers, partners, government entities, and other influential parties, and this gives them preferential access to opportunities. Finally, the superior knowledge of the incumbents permits them to mitigate risk—through more savvy underwriting, for example.

The value of the geographic incumbents’ local expertise is by definition declining in an increasingly global, transparent market. The protection previously afforded by government regulation and privileged access to local markets is gradually, and sometimes rapidly, being stripped away. Since many incumbents are losing market share and reporting falling returns, they must find ways to use their local presence to gain access to the skills they need to compete globally—and quickly, before their advantage evaporates. Indonesia’s leading financial institutions exemplify this type of operator, and their free fall in the wake of the country’s recent financial crisis shows the problems they face. Many of them have been forced to close, while the rest are engaged in a frenzied quest for security through mergers or foreign capital. At the root of their difficulties is a lack of skills, technology, and—now—capital. In the words of Indra Widjaja, president director of Bank Internasional Indonesia, "The most important things we need are technology and human resources. If other countries already have nuclear weapons at their disposal and we still fight with sharpened bamboo sticks, how can we compete?"

But some geographic incumbents still flourish. One of them is Banco Itaú, Brazil’s third-largest retail bank, which had more than $900 million in net income in 1998, a market capitalization of $5.6 billion, 1,800 branches, 9,400 automatic-teller machines, and 40,000 employees. In the face of heightened competitive pressure related to deregulation, Banco Itaú decided to expand its client base by purchasing three local banks: BEMGE, BFB, and Banerj. It has also established overseas joint ventures—with Bankers Trust, for example—in asset management and investment banking. In addition, the bank has been approached to form further alliances in insurance, credit card processing, mortgages, and custody.

Because Brazil has few distribution channels other than national banks, Banco Itaú’s branch network and overseas alliances earn it good returns. Foreign companies, attracted by the large Brazilian market and Banco Itaú’s knowledge of it, are willing to trade skills (and often cash) for access. This bargaining power is likely to give Banco Itaú a solid foothold as the industry globalizes. The bank enjoys a window of opportunity to carve a role for itself integrating the multiple "slivers" of the value chain pursued by foreign specialists, because its local expertise, which foreign competitors find difficult to match, remains critical to success in the Brazilian market.

Alliances would enable Banco Itaú and its partners to generate higher returns together than they could independently. Perhaps more important, these relationships could form the basis of a significant effort to transfer skills. Since the bank is too small to grow by international acquisitions, such intangible capital will be crucial for expansion. Banco Itaú has already embarked on this course by using its world-class technology-based processing skills to expand into Argentina, where the market is less productive than Brazil’s and the bank can offer better service than local competitors do for 30 to 50 percent of their fee. Today, Banco Itaú has nearly 60 branches in Argentina and is well placed to grow further. Alliances should permit it to develop strong skills in other areas and thus to survive in a global market.

2. Geographic integrators. Occupying the lower right quadrant of Exhibit 5, geographic integrators—such as BankAmerica, UBS-Swiss Bank Corporation, HSBC, and Citigroup—pursue capital-intensive strategies and generally own or control all parts of the value chain. These companies have large market capitalizations and enjoy rapid growth in their book equity, with relatively constant returns on capital. They are often the leading operators in several regions.

Integrators, representing about 12 percent of the global market as reckoned by the global pretax profit pool⁴, take advantage of falling geographic barriers and technology to operate across wide geographies, typically by acquiring or merging with similar companies in adjacent regions. These integrators "roll up" other players, gaining access and scale advantages at the expense of competitors that lose both their positions and the opportunity to do the rolling up themselves. The strategy increases the integrators’ absolute earnings and expands their geographic base while eliminating potential rivals. As the more successful integrators grow, they exploit their fixed-cost advantages: the ability to spread production, overhead, and physical distribution costs over a widening geographic base.

NationsBank, for example, has used integrator acquisition strategies to improve its position over the past 20 years. Starting out as NCNB, the bank embarked on an aggressive program of domestic expansion by acquiring First National Bank of Lake City, Florida, in 1982. NationsBank then had earnings of $95 million and a market capitalization of $325 million. Over the next 20 years, it acquired and integrated banks in many other states, developing world-class skills in running systems and cross-geographic customer and product organizations. When it merged with Bank of America to become the new BankAmerica, it became the biggest, most profitable bank in the United States, with pro forma earnings approaching $18 billion and a pro forma market capitalization of $130 billion—400 times the market capitalization of NationsBank in the early 1980s. NationsBank achieved this transformation without moving outside the United States.

Citigroup, by contrast, has focused on international operations. Throughout the late 1980s, Citibank essentially replicated its full credit card business system (card manufacturing, printing, mailing, processing, marketing, customer service, and collections) in each country where it operated. In the early 1990s, it set about turning its collection of mainly local operations into a truly global institution that exploited its international presence and worldwide scale, as well as its local expertise. It centralized many functions, including card manufacturing, branding, processing, printing, mailing, and data management, and ran them from a single global location or on a continent-by-continent basis. At the same time, marketing, customer service, and collections were kept almost entirely under local control. This global-local approach made it possible to harness the benefits of global reach by realizing economies of scale in low-cost and high-productivity locations.

Citigroup is part of a small group of financial institutions—also including the new BankAmerica, Norwest, Deutsche Bank, Axa, and HSBC—that seem likely to enjoy special advantages in the coming decade. These financial institutions have the deep pockets to acquire geographic incumbents around the world, as well as the approach and resources to develop critical skills. Yet even these large integrators face a significant challenge as the global economy evolves, because the vast scope of their businesses may make them easy prey for companies adopting another potent competitive model: specialization.

3. Specialists. Occupying the upper left quadrant of Exhibit 5, specialists are light on capital and physical assets but heavy on intangible assets, such as skills, proprietary technologies, and brands. They are notable for the high returns to capital they achieve with little growth in their book value. Driven by high market-to-book ratios, their market capitalizations are large, though not as large as those of geographic integrators. They focus on areas in which they have a clear skill advantage and leave less profitable activities to others. Fidelity, for example, concentrates on private investment (such as mutual funds and investment management) in the United States, Canada, the United Kingdom, Germany, France, Japan, and, through Hong Kong, the Asia-Pacific region.

Private investment managers such as Fidelity and Schwab may seem to be broad-based businesses to consumers in the United States. But compared with the universal banks that dominate many markets, they are in fact quite narrowly focused. Furthermore, growing numbers of PFS companies are focusing more narrowly still. Two in insurance are Matrix-Direct, which markets Transamerica life insurance products through radio and television advertising and sells them over the telephone, and Quotesmith, which provides quotes and applications from 375 insurance companies over the World Wide Web. An even better example is "World Mae"—the World Mortgage Association—a company launched in 1996 to securitize mortgages around the world. It is actually a conglomeration of "National Maes" established to leverage a common set of systems and processes that they run collectively to market products to banks in their home countries. Mortgages originated by these banks under the World Mae system are then purchased by the National Maes for World Mae, which can market the mortgages globally.

Such specialists bring their skills to specific slivers of the value chain, often building sliver businesses across many geographies to create "microindustries" around a particular area of expertise and outsourcing ancillary activities. As these institutions do more business in their area of specialization, they learn more, attract more talent, and find other specialists to acquire. In this way, the reputation of the specialist grows and it wins more customers, so it achieves benefits of scale and raises its returns. Specialists now represent only 10 percent of the global PFS market, but the percentage is growing.

MBNA, which offers tailored credit cards to distinct customer segments, is another notable specialist. Spun off from an almost bankrupt bank-holding corporation in 1990, MBNA is now the third-largest credit card company in the United States, with a market capitalization of about $20 billion. Besides codeveloping branded credit cards with such organizations as sports associations, professional associations, and universities that endorse MBNA products, MBNA markets them on its own to attractive customer segments that share common attributes, such as alumni associations or the elderly.

MBNA customers typically carry balances that are 45 percent higher than the industry average, while their credit losses in 1997 hovered at 4 percent, a bit more than half of the level for the industry. By using two fundamental assets, sophisticated technology and highly predictive credit models, MBNA can make sounder credit decisions than its rivals do. Specialization generates the additional intangible assets of customer knowledge and relationships, which MBNA converts into valuable intangible capital: databases and networks. These intangibles can be used to create more tightly targeted marketing strategies. To avoid building a heavy balance sheet around the ownership of credit card debt, the company securitizes its receivables.

In this way, MBNA has created a business system that does not need a large capital base, so the company can generate a consistent return on equity of more than 30 percent. Given this rapid growth in a relatively narrow band of the value chain, MBNA has already exhausted its expansion possibilities in the United States. It is now beginning to expand abroad, building its business into what looks very much like a global sliver. After only a few years, the company has attained a 7 percent share of the market in the United Kingdom.

4. Shapers. Companies that successfully pursue the specialist or integrator approaches over the next five to ten years are sure to be highly rewarded. But there are fundamental business and strategic reasons for believing that the ultimate winners in financial services will be the "shapers."

There are two kinds of shaper, or at least two routes to shaper status. A shaper can be a specialist with a specialty so compelling that it becomes fundamental to a whole industry, which reshapes itself around it. The specialist can then add raw size to the massive market-to-book ratio that initially made it powerful, moving from the top left of the map in Exhibit 5 to the top right. Alternatively, a shaper can be a geographic integrator that develops a special skill in a particular area and then exploits size and scope to institutionalize this expertise quickly across the globe.

Of course, the shapers threaten other contenders in the industry. Integrators are at risk because eventually they will run out of candidates to acquire. If their growth slows or stops altogether, they will be in danger of turning into nothing more than unusually large geographic incumbents. The whole strategic-control map would then shift rightward, and what was once big would look small. Specialists, meanwhile, must deal with the possibility that shapers might redefine the industry in ways that eliminate the need for their expertise.

Shapers, with high market-to-book ratios and high book equity, will occupy the upper right quadrant of Exhibit 5. Although no company yet plays this role, AIG in insurance and GE Capital in many of its finance businesses are beginning to execute shaping strategies. Each company involves others in every part of the business it is mobilizing—except the best, which it keeps for itself. Each has secured rapidly increasing book equity and high returns on invested capital thanks to the growing share of profit it has snatched from geographic incumbents, integrators, and specialists forced to collaborate with it.