Make your innovation strategy pay off

If you were to take a quick glance at the returns banks enjoy from innovation, you might say that innovation in banking doesn’t pay off.

But after drawing on a novel database of individual bank holding companies (BHCs) in the US and tracing how their structure and business models change over two decades, Michael G Jacobides, Associate Professor of Strategy and Entrepreneurship at London Business School and his co-authors have found conventional wisdom wanting.

The real picture is far more intricate. The ongoing research, ‘Transformation of Corporate Scope in US Banks: Patterns and Performance Implications’, offers a more nuanced picture. It also provides lessons in corporate strategy for business leaders and in regulation for policymakers.

Why is the US banking industry a good case in point for innovation? Banking has experienced unprecedented change – from regulation to technological innovation – over the last three decades. Disruptors have even called into question what it means to be a bank. The competitor landscape today includes payment platforms, peer-to-peer banking, blockchain technology and more. This evolution has seen banks expand their scope.

“Scope expansion is what banks do,” says Professor Jacobides. “Banks can stick to depository lending, or they can start to broaden out.” To compete, banks have entered new areas such as insurance, underwriting and wholesale banking. Some firms have moved where they think the market is heading – take a bank that buys a real estate developer because it wants to sell mortgage loans and thinks that building a pipeline of leads from these loans will help. Some companies have moved vertically – consider a bank that decides having an in-house management consultancy is better than buying in specialised, albeit pricey, help.

But scope expansion in banking can also mean a change in the business model, allowing companies to sell new products and services. Professor Jacobides says: “The focus of the research is not what economists would call the ‘intensive margin’ – having subsidiaries enter new areas. It's more about the ‘extensive margin’ – looking at banks doing something they didn't do in the past.” So while this research touches on diversification, it’s more about how novel combinations – new unchartered territories – affect a company’s bottom line.

Professor Jacobides analyses the BHCs’ structure and performance, measuring with Return on Equity (ROE), how much profit a company generates from shareholders’ money. Subsidiary by subsidiary, trait by trait, he paints a picture on an industry-wide canvas, revealing which firms expand into new areas, in which sectors and activities, and, at what time. As such, a more nuanced tapestry emerges.

Where innovation pays off

The research first investigates where companies expand. This story is in itself not new. Expanding in an area that is close to the business is more beneficial than expanding into what Professor Jacobides calls “wacky” areas. It makes sense: you don’t want to give your money to a quirky bank; you really want a reliable bank to care for it. “You need to choose an area that is consistent with the business,” he says.

What is deemed “close” or related to the business changes over time, so the research maps the dynamic process of entry and exit across sectors, and explores how different strategies have different implications for performance.

The research also tracks “hot” or modal expansions: the areas competitors choose to enter. Why do companies expand into these areas? Professor Jacobides sets out two potential routes. First, companies do the same things because they are all following the same rules and have the same technological traits. Second, everyone likes to look like everyone else: it’s about being trendy. He says: “Some companies are no better than a fashion show, they value doing what is hot. Just like in conservative society, we value looking like everyone else for fear of reprisal.”

So, which of the two routes compels companies to expand? “We say that if it were to be the isomorphic firms, the firms that want to look like everyone else, then the early movers should get a slap on their wrists because they’re breaking convention.” It should also mean that the late movers, the so-called “Johnny-come-latelys”, enjoy a boost in their performance and ROE.

“We find the opposite,” he says. “It's not that firms are trying to look like everyone else, but rather that successful firms are able to take advantage of shifting technology.”

When innovation pays off

The findings also prove that timing, as the saying goes, is everything. Logic might suggest that the trailblazers taking risks and breaking the mould by entering experimental areas should be penalised. It’s sensible to think that the latecomers should benefit from the road more travelled. But that’s not the case.

The first-movers, on average, reap the best rewards. “It’s a case of strategy, not mimicry,” says Professor Jacobides. Consider the innovation landscape like an airport. The first-movers are the people who arrive early, book their extra leg room and do their duty-free shopping. Then the fast-followers book the next best seats on the plane; they feel good about not having to wait in the airport lounge so long. But then there are the late arrivals, the “Johnny-come-latelys”: these are the people who miss their final announcement, don’t have time to check their bags and, make your plane late.

“The firms that benefit the most move early into new areas and know why they’re doing it. Then the companies that immediately follow capture some value. The late expanders, however, fall flat on their face,” he says.
When expansions become less novel and a little too well known, the late arrivals think it’s a free lunch. In fact, they do so badly that they drag down the entire industry’s performance: they make it seem as if innovation in banking doesn’t pay off.

What lessons can the board members, strategists and leaders trying to step ahead of the market draw from these findings?

Tips for industry leaders

1. Avoid the strategy of growth by delusion

Don’t delude yourself: only expand where it makes sense. It's important to innovate, to be at the leading edge, and to have a strategic overview of where the industry is heading and where synergies exist. Professor Jacobides says: “Innovation pays off for the early players going into hot areas. It may be that the latecomers are deluded in their capabilities. They may be overestimating the synergies their business has with the new areas. They may also feel pressured to change when they actually shouldn’t.”

2. Don’t succumb to industry pressure

Bigger doesn’t mean better. Professor Jacobides says: “Boards must take a more qualified view of scope expansion. It’s valuable when you build the capabilities to expand, and when you’re part of a firm shaping the sector, close to the changes in your industry.” It’s fruitless to enter a new area just because everyone else is. Many latecomers would be better off staying put.

3. Move with the times, move early

As we’ve now established, the early movers enjoy better returns. Combine that with expansion into new – but not weird and wacky – areas consistent with the business, and the outcome is positive enough to overcome the average liability. “Innovation pays off for those who experiment both in the direction that the industry is heading and for those driving the change.”

4. Enter, but don’t forget to exit

“The firms only interested in building empires end up wasting money and reducing their ROE. The firms that engage in corporate renewal, the ones that enter and then exit at the right time, have a better chance of being profitable,” he says. Companies should consider expansion as a set of moving experiments: the people leading the trials need the discipline and focus to enter new territories – and then get out when the time’s right.

The key lesson for regulators? Stop with the blanket policies. When you look at the entire population of US-based BHCs it appears they’re collectively losing when it comes to innovation, which makes it easy for policymakers to say “It’s safer not to innovate”. But when you start digging beneath there’s more.

Professor Jacobides says: “We may want to rethink the way banks are regulated. It's not that expansion and moving into new areas is entirely a bad thing. It requires a better understanding of a company’s position, and where it stands in the life cycle of its peers and competitors.” So rather than thinking about growth and scope as good or bad in absolute terms, policymakers should look at who is doing what and why.

Just as a doctor would diagnose a medical problem, Professor Jacobides offers a treatment effect and suggests an examination at the level of the organisation. “Shrinking the scope will not necessarily fix the underlying issues of the industry in terms of innovation. We have no evidence that this alone would address the root cause.”

His next study will add another stratum to the question “Why do banks expand?” and reveals that expansion is just like taking a trip to the casino. More on that soon.