Strategic planning in a competitive market setting

Strategic planning in a competitive market setting

Alan R. Winger

Strategic Planning in a Competitive Market Setting

Strategic planning is a concept that frequently surfaces in discussions of the future of savings and loans. Thrifts must adjust to highly competitive markets with the newly won operaing flexibility resulting from the Depository Institutions Deregulation and Monetary Control Act of 1980 and the Garn-St Germain Depository Institutions Act of 1982. While planning has long been part of the operations of most savings and loans, the magnitude of the task today dwarfs anything that was done in the past. The potential scope of operations for thrifts, both with respect to product lines and geography, has increased substantially. No longer are thrifts confined to accumulating funds from local individuals through limited numbers of savings instruments. No longer are they confined to making mortgage loans to community residents. Thrifts can now literally acquire and dispose of funds on a worldwide basis and can compete more effectively in all markets because they are no longer constrained in the financial instruments they can offer. They also operated in markets that are much more competitive. The concern in this article is with key elements in the strategic planning process of an institution that seeks to survive and prosper in a competitive environment.

Goals and Objectives

The initial element in the strategic planning process is, of course, setting goals and objectives. Traditionally, the savings and loan has been viewed as a community service-oriented institution. Its goals and objectives were the provision of housing finance and savings services to the community in which it was located. A community service orientation made sense because of the need for such services. The growth of the thrift industry early on represented a market response to a need that was not being fulfilled in any other way. Because the need was there, so were the profits. But profits were not a major concern. The emphasis on community was possible in part because of the absence of strong competitive pressure due to the relatively undeveloped state of the Nation’s financial market. The highly regulated financial environment coming out of the Depression also provided a setting in which community service could be emphasized. While most thrifts did not ignore profits in the post-World Woar II era, there was never really much need for concern. Given economic prosperity and the insulated position of depository institutions, profits were relatively

Deregulation has substantially changed this environment. It is now much more competitive. While thrifts have the opportunity to compete in new areas, they are also subject to much more competition in traditional areas of operation. This new environment is much to the liking of consumers because it usually means lower prices. To firms, lower prices are a mixed blesssing. While they stimulate demand, they can also erode profits, which are not automatic in a competitive market setting. Survival is the primary motivating element in competitive markets and profits are the measure of success. While the pursuit of other goals is possible, when profits are at competitive levels, it is perilous to ignore them. Competitive margins are thin. Profits can quickly turn to losses and firms can find themselves out of business.

Obviously, if savings and loans continue to operate in a deregulated setting, the basic goal will be profit maximization. Emphasizing profits will not necessarily mean neglect of traditional concerns. Thrifts could continue to function as community-oriented financial institutions, providing housing finance and savings services to local citizens. An emphasis on profitability simply means that these concerns will no longer be automatic. If it is profitable, the traditional savings and loan operation will be considered. But so will other areas and modes of operation. Those who survive and prosper in a competitive setting will have to look at strategic planning in this way.

Maximizing Profits in a Competitive Environment: What’s Important?

If maximizing profit is the goal, what can a thrift institution do to achieve that objective? Obviously, there is no one answer. Among other things, there are market distinctions that have bearing on the strategies appropriate for maximizing profits. The nature of the competition has bearing on how best to survive and prosper. The distinction economists make between perfectly and imperfectly competitive markets is an important one.

In perfectly competitive markets, firms must be concerned with volume and costs. They have no control over price. When there are many competitors buying and selling the same product, as there are in perfectly competitive markets, the market determines price. Firms can sell as much as they produce at market price. How much they produce, in turn, depends on costs. The product has to be produced at a cost that is less than revenues. Given costs, the firm searches for the volume that maximizes profits. The way to increase volume and, hence, profits is to lower costs. The reverse is also true; that is, the way to lose volume and profits is to be careless about costs. Firms operating in a competitive environment that are not cost-conscious soon do not have much to worry about.

In imperfectly competitive markets, firms have market power which allows them to set prices, as well as control volume and costs. The source of that power can be anything from technology which dictates very large-scaled operations, to the frictions of space that give a firm an advantage over others in dealing with customers nearby, to collusive behavior. What it means is that profit maximizing behavior involves a concern with price as well as volume and cost. Firms operating in these markets cannot sell everything they produce at market price. Prices have to be set. Consumer response to that price determines volume and, hence, revenues. Profits then depend on the costs of producing the volume which generates revenue. The trick is to find the price-volume combination which, given revenues and costs, results in maximum profits. Complications arise if the prices set elicit a price response by competitors. The outcome when there is competitor feedback depends upon the response patterns that develop as firms interact with one another. What these patterns are become an important part of the strategic plan of the profit maximizing firm.

Profit Maximization in a Savings and Loan

Fundamentally, a savings and loan is a financial intermediary that accumulates funds from various sources and makes the funds available to various users. It operates in a number of markets, some of which are perfectly competitive, e.g., the government securities market, and some of which are imperfectly competitive, e.g., the mortgage and deposit market. Recent deregulation has broadened the legal framework within which savings and loans operate. They are now able to do more than they could. In fact, savings and loans can now do much of what commercial banks do. Nobody expects savings and loans to become commercial banks; but most will probably diversify, looking more like a commercial bank on the liability side of their balance sheet, with assets that continue to be dominated by real estate. Such diversification will add complications to the job of managing the institution. If the concern is with maximizing profits, however, there are economic principles that provide insight. The story they tell depends on the characteristics of the markets in which they operate. The results differ according to whether those markets are perfectly or imperfectly competitive.

Perfectly Competitive Markets

To begin with, let us make this very simple. Suppose a savings and loan accumulates funds through savings accounts and loans all these funds to home mortgage borrowers. Assume further that there are no restrictions on what a thrift can do in these markets. It can borrow all that it wants at market rates and make all of the home loans it wants at market rates. These markets are perfectly competitive. Finally, suppose that the mortgage rate is 12.5 percent, the borrowing rate is 9.5 percent, and the administrative cost of operating the association is 0.75 percent per dollar of assets it has on its books. Operating under these assumptions yields the association a spread between revenues and costs of 225 basis points. To maximize profits under these conditions, the savings and loan would simply try to borrow as much as possible so as to be able to make as many home mortgage loans as possible.

If the 225 basis-point profit were attractive, all of the many firms operating in these two markets would be trying to do the same thing. The volume of funds being made available to home borrowers would increase substantially, putting downward pressure on mortgage rates. Savings and loans’ demand for savings to finance these loans would also push up the savings rate. These price adjustments would continue until the profit margin of the savings and loans was reduced to a competitive level. The strategic plan of the individual firms operating in this kind of situation would simply direct the firm to maximize volume (borrowing and lending) and minimize costs.

Of course, the world of the savings and loans is not this simple. Funds are forthcoming from different sources in varying maturities usually at different rates. The savings and loans also have lending and investment opportunities other than the home mortgage loan, which have been increased by deregulation. The maturity dimension of the savings and loan’s liability and asset holdings gives rise to the possibility of interest rate risk exposure, which has turned out to be a serious problem for most thrifts. Risk is an issue that must be addressed. Generally, the greater the risk exposure, the higher the potential profits and vice versa. Decisions have to be made about this risk/return trade-off. Minimizing interest rate risk is likely to bring lower profit; is this what the association wants? This question has to be answered. Given the answer, the strategic plan must provide direction and guidance as to how the stated objective can be best achieved. Thrifts now have many tools that can be used to structure a balance sheet to achieve a specific risk/return objective. The strategic plan must set forth the broad outlines of the process which leads to the desired result.

Another complication arises from the fact that thrifts are multi-product firms. While most are real estate lending specialists, they do more than make real estate loans and will be doing even more as they adjust to a deregulated financial market setting. Multi-product firms have to be concerned with profit prospects for each activity. Profit maximization for the multi-product firms implies choosing the most profitable of the alternatives. Revenue and cost calculations have to be made for each area of potential operation. If the markets within which the savings and loan sells its service are perfectly competitive, revenues can be calculated easily enough–market price times the quantities that are sold. Costs, on the other hand, can present a problem. First, because funds are fungible, money costs are difficult to allocate between alternative uses. Second, there are the problems of disentangling the input costs involved in producing more than one product or service. While these problems are common to all firms, they are particularly troublesome to financial firms. What these problems mean in that if the profit objectives are to be seriously pursued, some kind of functional cost scheme must be developed that enables the thrift to allocate costs between activities. If cost accounting methods of thrifts are inadequate, one key element in the strategic plan should be the provision of direction and guidance in the development of such a cost accounting system.

Imperfectly Competitive Markets

If we assume that the markets in which thrifts operate are not perfectly competitive, a new dimension to the planning problem is introduced. Savings and loans that operate in imperfectly competitive markets are no less concerned with such things as profits, the risk/return trade-off and appropriate cost control measures. However, there is one important difference: the way in which the profit goal is achieved. Firms selling in imperfectly competitive markets are not price takers; they must administer or set prices. The thrift institution that operates in an imperfectly competitive deposit market must set deposit rates. Those that operate in imperfectly competitive mortgage markets must set mortgage rates. This need to set interest rates complicates the job of managing a savings and loan. Revenue calculations are not now simply a matter of multiplying market price times quantity sold. The price set helps determine quantity sold, which means revenues are a function of that price. To be able to set the right price, the firm must have good knowledge of the market. Moreover, if the firm operates in several imperfectly competitive markets simultaneously, it must have some understanding of market price interrelationships.

To illustrate what might be involved in running a savings and loan in an imperfectly competitive market setting, consider a thrift that accumulates funds through savings deposits and uses these funds primarily to make mortgage loans and to buy some investment securities for liquidity purposes. (Forget about advances, capital, consumer lending, etc., in this exercise.) Suppose now that the deposit and mortgage markets are imperfectly competitive and the market for investment securities is perfectly competitive. The “decision’ variables in this situation are the deposit and mortgage rates and the proportion of funds allocated between mortgages and investments.

What should this savings and loan do? It could set deposit rates at levels designed to achieve a maximum rate of savings growth. If it did, profits might not be maximized. Profits depend on revenues from the association’s portfolio of mortgage loans and investment securities in relation to money costs. Paying higher deposit rates to achieve a growth target increases money costs. If the revenues generated by the additional funds do not increase correspondingly, profits will decline.

If its primary concern is with profits, a savings and loan operating in imperfectly competitive markets would be well advised to look at its asset markets first. Presumably, profits are to be made from making mortgage loans; but there are limits to the number of loans that can be made in an imperfectly competitive market. Beyond some point, the thrift can only make more loans if it lowers the interest rate, and lowering the rate can affect profitability. What happens to profits when mortgage rates are lowered depends on how borrowers respond to lower rates. It also depends on what happens to money costs as firms seek more deposits to finance the additional loans, costs that are the outcome of the deposits that are set when operating in imperfectly competitive markets.

Profit maximizing behavior in imperfectly competitive markets should initially involve the savings and loan in analyzing the mortgage market to set a mortgage rate. There should also be an investigation of the securities market to determine the expected rate of return on investments. Knowing rates of return on assets allows the association to calculate revenues from the assets it can hold. Maximizing revenues is accomplished by allocating funds between mortgages and investment securities in a way that equates the revenues received from the last dollar invested in each alternative, that is, it equates marginal revenues. To maximize profits, given potential revenues, attention must be paid to deposit costs. The association has to set the deposit dollar acquired so that it is equal to the revenues generated from using that dollar. If it is less, more profits can be made by going after more deposits. If it is higher, more profits can be made by going after fewer deposits.

The activity levels generated when the thrift tries to maximize profits in this way is largely determined by mortgage market conditions. If market conditions are strong and, hence, mortgage rates can be set at relatively high levels, the thrift will be able to set deposit levels at rates that bring about a relatively large inflow of funds into the institution through its deposits. On the other hand, if mortgage market conditions are weak, these deposit inflows will be less; hence, so will activity levels.

Of course, if the savings and loan is allowed to operate in other markets, the growth of the institution need not be restricted by the condition of the mortgage market. The opportunities provided by the mortgage market will also be influenced by the risk exposure created by operating simultaneously in the mortgage and deposit markets and the savings and loans’ views about risk. But, irrespective of the complications, the fundamentals of operating a savings and loan in imperfectly competitive markets are the same. As in perfectly competitive markets, profit maximizing behavior requires a concern with volume and costs. In imperfectly competitive markets, it also means a concern with price which, to do effectively, requires a much more detailed knowledge of the markets within which the thrift operates. A successful strategic plan of a profit maximizing savings and loan provides the direction and guidance necessary to achieve the pricing, cost, and volume elements requisite to a profitable operation in this kind of market setting.

Strategic Planning and Thrifts in the Contemporary Setting

Through deregulation, thrifts have moved quickly from operating in a highly imperfect market setting to one in which there are intense competitive pressures. They have gone from concern with expanding market share through nonprice means, e.g., branching, premiums, etc., to a concern with measures that ensure survival in a highly competitive market setting. It is not that today’s successful savings and loan is no longer concerned with expanding its share of the market. It is just that most thrifts realize the key to success in today’s financial markets is a profitable operation. The successful pursuit of profits in competitive markets, of course, means generating volume in asset acquisitions and controlling costs. For financial institutions, it also means dealing with the issue of risk. And since the major areas of operation of thrift institutions are in imperfectly competitive markets (deposit and mortgage markets), thrifts must be concerned with pricing and other nonprice means of competition.

While strategic planning in this kind o setting means doing many things, it means, most importantly, doing what is necessary to ensure that profitability can be properly evaluated in the different areas of thrift operations. To do this implies some ability to segregate costs and price properly. It also means having a good handle on the meaning of risk exposure and a firm viewpoint about the risk/return tradeoff. Functional cost analysis, pricing financial services, and measuring and dealing with risk exposure are thus important areas of consideration in the development of a strategic plan.


COPYRIGHT 1984 U.S. Government Printing Office

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