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Banks must recover confidence and market credibility in order to survive Back  
Professor Ray Kinsella examines the development and strategy of Ireland’s two largest banks in what he calls a ‘watershed’ year for Irish banking - 2002.
2002 will, in retrospect, be seen as a watershed in the development of the Irish banking and financial sector. At the heart of a change process, that is still ongoing, were, firstly, the decision by AIB to sell Allfirst in exchange for a 22 per cent share in MNT bank and, following hard on the heels of this, the failure by Bank of Ireland to acquire Abbey National in the UK.

It is important to emphasise that developments at the two major retail banks were part of a more substantial transformation, in terms of both strategy and, also, organisational structures. The strong showing of First Active and more particularly the evident success of Irish Life and Permanent - through its acquisition of TSB - in creating a major bank assurance force (that may yet prove a springboard to overseas markets) - has substantially reconfigured the domestic banking franchise. Ulster Bank too has restructured itself. The entry of Bank of Scotland some two years ago had a catalytic effect on the market, showing that the Irish banking sector is, in fact, highly contestable and that this new reality must be built into margins and earnings projections.
Another development of landmark proportions was the establishment of the new Single Regulator. This will result in a greatly enhanced burden of compliance on all financial institutions.

But the real story of 2002 revolves around the developments at AIB Group and the Bank of Ireland. If you look at the banks’ performance over the last number of years, some key points are evident:
• There has been, over the longer-term, a progressive rise in the P / E Ratio of the Irish banks.
• This is reflected in the respective share price of the banks. Taking, first, the period since 1986, both of the main groups have progressively strengthened compared to the wider markets.
• Taking a shorter-term perspective (based to 2000 A.D), the Irish banks have continued to outperform the wider markets. Bank of Ireland peaked in mid-2002 and declined subsequently, only to recover lost ground following the termination of its bid for Abbey National.
• AIB’s structural problems to do with ‘Allfirst’ meant that they traded lower than Bank of Ireland, while still outperforming the financial sector as a whole.

Detail, of course, matters. But it’s the big picture that is important here. Essentially, over the last decade or so the two main Irish banks have performed strongly relative to the markets.

More important, however, is that compared with what would, at the start of the 1990s, have been seen as a reasonable benchmark - Royal Bank of Scotland (RBS) - they have been left far behind. It is this strategy-driven ‘performance gap’ compared with RBS, that leaves them both vulnerable to predators. It also provides the focus for an evaluation of where they are at now and what is the key to their future performance.

The starting point for any evaluation is the reality that the 1990s was a period of wholly different - but equally successful - strategic development for both banks. Bank of Ireland, scarred from its experience in the United States in the 1980s - essentially withdrew back to its core domestic franchise. Pat Molloy was enormously successful at retrenching and reducing costs, and establishing a platform on which to build a new strategy. Equally, he steered the ship through what were very choppy waters - it would be easy to forget the courage that was required to commit capital to a subsidiary that continued to haemorrhage over an extended period and then to exit that market on reasonable terms.

This provided the basis for a strategic transformation of the Bank of Ireland into strong local / regional player with a wholly new strategy emerging from Lower Baggot Street with the decision to acquire Cheltenham & Gloucester. This provided a degree of both geographical and earnings diversification and signalled a return of confidence and sense of direction. Given the rapidly evolving nature of the mortgage market, it was hardly the most innovative use of capital. But it did provide a strong pointer to where the bank intended to position itself. And it provided the basis for the abortive bid for Abbey National: the latter was based on the logic of the board strategy, rather than being an individual initiative of its chief executive. In truth, it never looked like succeeding.

The decision by AIB Group to sell Allfirst for a 22 per cent stake in M & T Bank can be seen at a number of levels. To begin with, Berkshire Hattawhay has a 5 per cent stake in M & T: market prescience provides a degree of comfort if you are going to do a deal such as this. At a more serious level, while continuing to provide albeit indirect exposure to the US market (and therefore a degree of income diversification), the sale of Allfirst marks the end of what will be seen by monetary historians as a highly successful strategically driven process of geographical expansion. The case study quality of AIB’s market entry strategy into Poland. Whatever the future earnings capability post-EU enlargement, the execution of the entry into the Polish market was masterful. The building up and consolidation of AIB’s US holdings, which were rebranded in 1998 under the Allfirst banner, was driven by a commitment to compete head on with the emergence of the ‘super-regionals’ by acquiring scale, notably through the acquisition of Dauphin in 1997. The decision in 2002 to effectively exit the US market turns that strategy on its head. In terms of strategy, has the Allfirst debacle, and its subsequent sale, brought the global expansion strategy of AIB to a juddering halt?

Keynes famously remarkedwhen asked why he changed his opinions relatively frequently, ‘When circumstances change, I alter my conclusions. What do you do, Sir?’. Circumstances have changed in terms of the fundamentals of both credit and capital markets and, also, in terms of the type of business model that is appropriate in these changed circumstances.We have seen, for example, the Citigroup beginning, perhaps, to unwind. Equally, there is a silent, largely unnoticed, but enormously significant shift happening - particularly at the corporate level which must have a bearing on the future strategies of both banks. The growth of the capital markets, in all of its dimensions, is leading to a process of ‘adverse selection’ with regard to the credit markets and to even medium-sized banking institutions. This is a logical starting point for any bank seeking long-term sustainable competitive advantage. It is where we are at in terms of the continually evolving market paradigm. The proposed Abbey National deal lacked conviction. Equally, the decision by AIB Group to reverse what was clearly a long-term strategy would certainly appear to reflect a view that a relatively painless exit from a prospectively difficult situation was preferable to a strategy requiring both commitment and not a little courage.

In both instances, the fear must be of a possible lack of confidence and how best to define and bring forward a new strategy adapted to the changed circumstances. The domestic franchise of both banks is now more important than ever. The market is more competitive and aggressive: margins notably in the mortgage market which is the main driver of domestic credit expansion are much narrower. Against this background, the recent experience of both AIB Group and Bank of Ireland highlight a number of key features in terms of developing a new strategy adapted to greatly changed circumstances both domestically, across the EU and within global markets.

• Neither bank has yet begun to effectively leverage their internal intellectual capital - their ‘knowledge equity’.
•Two practical examples may help in making this point. Successive cost-cutting retirement packages are in danger of creating an ‘experiential anorexia’ within middle management ranks and, more important, in the crucial personal interface with the customer. It is simply not enough to cut out large tranches of over-50s in the drive to reduce costs. Nor has this process been as effectively handled - in terms of organisational learning - as it might. For example, why are certain people taking the ‘package’ on offer and going? How far does this leave a gap in the banks overall capability - particularly within its crucial domestic franchise? To what extent, for example, have their been ‘exit polls’ carried out in order to generate some insights into how the culture of the banks could be enhanced. It is possible to say, on good authority, that there is an uninformed ‘revolving door’ policy of experience out and lower cost workers in that will run counter to the importance of sustainability.
•A second example of the failure to exploit internal ‘knowledge equity’ can be illustrated from some personal experience. What some initial research strongly points to is that the ‘average’ branch falls far short, in terms of its earnings generating capability of what can be called a ‘composite’ branch: that is, a ‘best case’ branch within the individual group (which makes it very attainable) - a branch which combines responsiveness, sensitivity to, an empowerment of staff as well as productive use of management resources. This gap may be of the order of 30-40 per cent. This represents an enormous loss of earnings opportunities. Addressing this gap beats the hell out of short-term cost cutting.

A final point which must be factored into a new strategic direction for the banks relates to the whole issue of the compliance/ethical challenges. There is, as already noted, a whole new regulatory structure - and also a market discipline - that will impel banks to address the issue of ethics - not just in terms of Codes of Practice, important as these are, but of an objective ethical code and understanding of what this implies in terms of management practice. Banks with strong corporate cultures have always had, not just a culture of ‘compliance’ or even of good ‘citizenship’ but an ethos that resonates with the Central Bank’s ‘fit and proper’ test.

In retrospect, the 1990s will be seen as a golden period, not alone for the Irish economy but for the Irish financial sector which was, in many ways, at the cutting-edge. This has now changed. The indications are that if either or both of the banks are to survive this will require a recovery in terms of confidence and composure as well as market credibility. The banks will have to address existing internal weaknesses - as well as their undoubted strengths, which were highlighted during the 1990s - as a necessary basis for developing forward-looking strategies.

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