An analysis of the turnaround strategy in commercial banking (1)

Journal of Management Studies 23:2 March 19860022-2380 S3.50

AN ANALYSIS OF THE TURNAROUND STRATEGYIN COMMERCIAL BANKING

HUGH M . O'NEILL

University of Connecticut

ABSTRACT

An analysis of the content of turnaround strategies in the commercial bankingindustry is presented. Most prior work on turnaround strategies examineddurable product industries rather than service industries. Theory developedin this past work is used to predict the content of turnaround strategies in thisservice industry. Discriminant anailysis is used to test the predictions. Theturnaround prescriptions developed in the durable goods industries are foundto be valid predictors in the commercial banking industry. Suggestions are madeto encourage further study of applications of the strategic paradigm in serviceindustries.

INTRODUCTION

MANY of the prescriptions of the strategic paradigm were developed in maturemanufacturing based industries (Hofer and Schendel, 1978). As recent yearshave brought a reduction in the proportion of G.N.P. expended in manufac-turing industries (indeed service-based firms currently form the majority ofthe G.N.P.), these prescriptions may be obsolete. To date, there has been scantattention to the problem of the fit of a manufacturing based paradigm forapplications in service industries. The study reported herein represents anattempt to apply a set of strategic prescriptions in a service industry. Inparticular, the strategic prescriptions associated with the generic strategy ofturnaround are an2ilyzed in the commercial banking industry (Hofer andSchendel, 1978; Porter, 1980).

There have been relatively few studies, theoretical or empirical, of strategicmanagement techniques in service industries. The few studies which have beendone are not consistent in their findings, especially with respect to strategiesin commercial banking. In a classic study, for example, Fulmer and Rue (1974)

Address for reprints: Professor H. M. O'Neill, Business Environment and Policy, University ofConnecticut, Storrs, Connecticut 06268, U.S.A.

166 HUGH M. O'NEILL

discovered that strategic planning did not improve performance in serviceindustries. This might imply that strategic planning does not pay in commer-cial banking yet Wood and LaForge (1979) assert formal strategic planningin banking does pay {i.e. increases profitability), at least in the case when formalplanners are compared to non-planners. Carmen and Langeard (1980) suggestthat some portions of the strategic paradigm will not transfer to serviceindustries. In the case of commercial banking, they assert that such conceptsas the experience curve and share advantage will not directly transfer tobanking.

This paper presents the results of one application of the strategic paradigmin commercial banking. The study attempts to identify the content of successfulstrategies under one condition: that is the condition of relative decline. Previousturnaround studies, which were based primarily in manufacturing industries,are used to develop hypotheses about the content of turnaround strategies incommercial banking. The essential purpose of this analysis is to confirm whetheror not the prescriptions of earlier studies fit in this type of industry. Followingthis, the impact of certain contextual factors in the turnaround process isanalyzed. Finally, the resource allocations necessary to promote turnaroundin this industry are identified.

The Concept of Generic Strategy and Turnaround

Scholars and practitioners both endorse the idea of'generic' strategies. Genericstrategies are distinct types of strategies that can be applied in certain situations.The situations are differentiated by such factors as organization type, industrytype, competitive position, etc. Hofer and Schendel (1978) identify six generictypes; Porter (1980) identifies three types. Each strategy type can serve as aguideline for choosing goals or resource deployments within the firm. This latteruse (as a guide for resource deployments) is similar to the notion of primaryor grand strategy (Bourgeois, 1980; Hitt et al., 1982) wherein the grand strategyis used to identify the correct balance that should exist among functional alloca-tions in the firm. For example, once growth is adopted as the grand strategy,then certain events should take place in the marketing department, the R. & D.area, the production department, etc. Fox's (1973) matrix of resource cilloca-tion may be the most common model of the relationship between genericstrategy and resource deployment. Well-defined and well-tested genericstrategies serve as an effective tool for the strategic manager in both the designand control of strategies for an individual firm. The use of generic or grandstrategies leads to more effective performance (Hatten et al., 1978; Rumelt,1974) and helps to prevent the suboptimization of firm goals to functional goals.The generic strategies cein be used to define the key characteristics of managers,incentive systems, and the like (Gluck et al., 1982).

Hofer and Schendel (1978) identify the turnaround strategy as a genericstrategy. While other scholairs do not designate turnaround as a generic strategicsituation, none the less the concept has received attention in the management

TURNAROUND STRATEGY IN COMMERCIAL BANKING 167

field (Bibeault, 1982; Hambrick and Schecter, 1983; Hofer, 1980; Schendeland Patton, 1976; Schendel et al., 1976).

This attention is warranted because decline represents a particular strategicdilemma for managers. Such factors as competition, technological change andincreased capital costs cause more and more businesses to face difficult andtrying times. Most managers and stakeholders find decline an unpleasant cir-cumstance. Yet despite the attention devoted to turnaround, there have beenfew systematic studies on turnaround. While it is useful to identify turnaroundas a worthy goal, it is even more useful to identify the distinct means by whicha firm might turn around.

A vast majority of turnaround studies are drawn from manufacturingindustries and/or capital intensive industries. For example, Hofer's (1980)sample includes such firms as an automobile producer and a tractor manufac-turer while Bibeault's (1982) sample includes such firms as a recording tapemanufacturer and a business machine producer. Hambrick and Schecter (1983)identify their sample as mature industrial firms. Few of these studies are drawnfrom a sample which presents an in-depth view of a particular industry or typeof industry (other than the concentrated industry often found at matureindustrial stages).

Previous Studies in TurnaroundInconsistencies across the set of previous turnaround studies complicates anyeffort to compare these studies. There are major inconsistencies in theapproaches used to study the concept. In one group of studies, (Altman, 1968;Argenti, 1976; Ross and Kami, 1973) failed firms are compared to non-failedfirms. Some attempt is then made to identify those factors which separate thesuccessful from the failed firm. These researchers infer that failing firms canreverse their deterioration by managing those factors which are identified asunique in the successful firms. Argenti, for example, notes that successful firmsare less resistant to change; they plan more; they avoid major projects whichbecome corporate albatrosses (Argenti, 1976).

Other researchers study turnaround more directly. They compare turnaroundcompanies to companies that have continually declined (Hofer, 1980; Schendeland Patton, 1976; Schendel et al., 1976). Some comparison is made of thedifferences that can be observed before and after the event; these, then, arethe key turnaround factors. Still other studies concentrate more on the timeduring the turnaround event and attempt to identify the various factors whichaccompany the turnaround effort (Bibeault, 1982).

Another factor makes the comparison of past turnaround studies difficult.Turnaround is often measured in a unique manner. Researchers can differwith respect to the way they define performance; the way they measure per-formance, and the time span that they adopt for observing performance. Theperformance variables include stock market price (Bibeault, 1982) net income(Schendel et al., 1976) and survival (Altman, 1968).

168 HUGH M. O'NEILL

In some cases, a firm's performance is measured based upon a comparisonto its own historical record (Bibeault, 1982), while in other instances (Schendeland Patton, 1976; Schendel et al., 1976) a firm's performance is measured incomparison with a wider {e.g. national) standard. Some studies use inflationcorrected measures (Schendel and Patton, 1976), while others rely on historicalmeasures (Hofer, 1980). In terms of time span, studies range from those inwhich there is little discussion of the time span to those in which a specific timespan is identified (Hambrick and Schecter, 1983).

In the study reported herein, a cross-sectional approach is used to comparecommercial banks which have enacted a turnaround to commercial banks whichhave declined. Following Schendel and his colleagues (1976), performance isbased on net income which is normalized to reflect industry trends. Thus, bothdecline and gain are relative to industry standards. A turnaround bank hasgained ground in comparison to its strategic group after a period of continuedloss of ground, while a decline bank has exhibited a continued period of declinerelative to its strategic group.

Development of HypothesesPrevious studies support two general propositions:

1) There are different types of turnaround efforts.2) The success of a type of turnaround effort is related to contextual factors.

Bibeault (1982), Hambrick and Schecter (1983), Hofer (1980) and Hoferand Schendel (1978) are just a few of the researchers who discuss different typesof turnarounds. Bibeault, as shown in table I, identifies five types of turn-arounds. He finds that the management process turnaround is used in 68 percent of the successful turnarounds. In Bibeault's study, management processincludes both management's choice of resource deployments (here calledstrategic choice) and the processes or behaviours which managers used toimplement these choices (here called implementation). The study reported hereis an analysis of the choices which are adopted by successful turnaround banksin their efforts to reverse performance declines. The study does not deal withthe processes of implementation.

Hofer and Schendel (1978) and Hambrick and Schecter (1983) present similarturnaround models. The design of this research is based on their work. Hoferand Schendel provide the general guideline for the development of hypothesis 1,while the work of Hambrick and Schecter serves to guide the selection ofvariables to test the hypothesis.

Hofer and Schendel separate turnarounds into two broad types: strategicand operating. Strategic turnarounds represent attempts to enter new businessesor to gain substantive position share in a firm's current business (Hambrickand Schecter's option of product market refocusing is an example of a strategicturnaround choice). Operating turnarounds are those which are based onactions to increase revenues, actions to decrease assets, actions to decrease costs.


Table I. Classification of turnaround strategies by various authors

Bibeault

Management process turnaroundEconomic turnaroundCompetitive environment turnaroundProduct breakthrough turnaroundGovernment related turnaround

Hambrick and Schechter

Asset reductionCost cuttingRevenue generationProduct/Market refocus

Hojer

Strategic turnarounds

Operating turnarounds:

Asset reductionCost cuttingRevenue increasingCombination

Table II. Comparison of turnaround models and bank performance variables

Hambrick and Schecter'sstudy

Hofer and Schendel's model Bank performance

Price

Receivables

Inventories

Capacity utilization

Employee productivity

Product quality

Relative direct costs

Revenue enhancement

Revenue enhancement

Cost control

Revenue enhancement

Cost control

Revenue enhancement

Cost control

Loan income/gross loanssecurities income/securitiesmunicipal income/municipals

Gross charge-offs/loans

Cash and treasuries/demand deposits

Gross loans/deposits

Payroll expense/employees

Loan loss provision/Earning assets

Interest/all depositsInterest/time and savingsOverhead expense/earning assetsOperating expense/earning assets

or some combination thereof. These later studies share similar conclusions:

1) Most successful turnarounds are those that could be called operatingturnarounds.

2) The choice of turnaround method is contingent on severail factors. Thesecontingent factors include the operating characteristics of the businessand structural characteristics of the market.

The operating characteristics of the business include such factors as the relativeamount of direct labour costs and the distance of the firm from its break-evenpoint. Hofer and Schendel (1978, pp. 173-4) offer the following prescriptions:

170 HUGH M. O'NEILL

- if a company is near break-even, has high direct labour costs or highfixed expenses, then cost cutting methods should be used to turnaround;

- if a company is far from break-even, has low direct labour expenses orlow fixed costs, then revenue generating methods should be used toturnaround;

- if a company is very far from break-even (at 30 per cent or less), thenasset reduction methods should be used;

- if a company is in some intermediate position with respect to theaforementioned prescriptions, then a combination of the tactics shouldbe used to turnaround.

There are constraints which limit the strategic options that a turnaroundbank might adopt. For example. Federal and State authorities dictate someconstraints. Federal law requires that banks limit their activities to bank-relatedproducts. These same laws also limit the number of products that banks cansell across state borders (these latter limitations were eased somewhat after theperiod of this study). State laws limit the extent and type of branches thatcommercial banks can use within state borders.

Banks which hope to reverse a decline are also subject to further constraintswhich evolve from the decline itself. Hambrick and Schecter in their study ofmature industrial units show that such strategic options as major share gainsand/or the development of new entrepreneurial thrusts are not likely underconditions of shrinking or negative profit margins.

The Hofer and Schendel model provides no specific guidance in selectingthe variables which might be used to measure the combined turnaround effortin the banking industry. Fortunately, Hambrick and Schecter (1983) are helpfulin this regard. They identify three gestalts which represent patterns of successfulturnarounds. Two of those gestalts (selective product/market pruning andpiecemeal productivity) are relevant to the study presented here. These gestaltsrepresent the combined efforts of revenue generation (selective product marketpruning) and cost reduction (piecemeal productivity). Hambrick and Schectershow that the following variables are significant in turnarounds based on productmarket pruning:

pricemarketingreceivablesinventories

capacity utilizationemployee productivityproduct qualityrelative direct cost

They identify the following variables as significant in turnarounds based onpiecemeal productivity: capacity utilization and employee productivity.

Nearly all previous studies on turnaround use mature manufacturingcompanies as their sample. Previous studies on bank management do notspecifically analyze turnaround. Therefore this study must be viewed as an


exploratory study of the content of turnaround in a regulated service industry.The previous literature is used to develop a hypothesis about the content ofturnaround strategies in the banking industry.

The Hofer and Schendel prescriptions indicate that successful turnaroundsin the banking industry will be based on combination efforts because banksare in an intermediate position with respect to labour costs and fixed costs.The Hambrick and Schecter study also prescribes a combined effort, as bothrevenue generation and cost reduction in their model involve multiple resourceallocations. The key unanswered question is the pattern of resource allocation.What specific costs should be cut? What specific revenue generating optionsshould be adopted? In what order? Hypothesis 1 is developed to answer thesequestions.'

Three guidelines are used to predict the major variables in a turnaroundeffort. One guideline is based on sensitivity analysis. As Hofer and Schendelnote, in a combined turnaround effort the alternate actions must be comparedto each other, as the cost/benefit analysis of the second-, third- or fourth-bestcost-cutting alternative may be better than a similarly ranked revenuegenerating option, or vice versa.

The second guideline used to develop hypothesis 1 is an estimate of implemen-tation time. In a turnaround situation, actions that have an immediate impactare usually preferred to long-term actions. As noted earlier, major share gainsor new entrepreneurial thrusts are not highly likely under conditions of shrinkingor negative profit margins.

Previous bank performance studies provide the third guideline for developingthe first hypothesis. Variables which have been shown to contribute to highor low performance are predicted to have a high or low impact on turnaround.The specific performance variables are drawn from the field of finance, wherethere has been some disagreement about the correct set of performance variables(Graddy and Kyle, 1979).

Hypothesis 1 lists the turnaround variables in order of their predictedmagnitude. This is followed by a brief rationale for each variable's order ofentry. This discussion is summarized in table III. Each variable is defined inAppendix A.

Hypothesis 1: Successful turnarounds in commercial banking will be based on com-bination efforts which include aspects of cost reduction and revenuegeneration. The specific variables which contribute to turn-around, in order of their importance, are:

(1) interest on deposits/all deposits(2) gross loans/all deposits(3) cash and treasuries/demand deposits(4) gross charge-offs/loans(5) municipal income/municipals(6) securities income/securities

172 HUGH M. O'NEILL

(7) payroll expense/employees(8) overhead/earning assets(9) operating expense/earning assets

(10) loan loss provision/earning assets(11) loan income/gross loans(12) interest on deposits/time and savings deposits

Table III. Bank performance variables listed in Hofer and Schendel's terms, with rationale andreferences

Variable(in order of hypothesized importance)

Rationale

Interest on deposits/all deposits

Gross loans/all deposits

Cash and treasuries/all deposits

Gross charge-offs/loansMunicipal income/municipals

Security income/securitiesPayroll expenses/employees*

Overhead/earning assets

Operating expense/earning assets

Loan loss provision/earning assetsLoan income/gross loans

Interest on deposits/time and savings

Increase in proportion of demand deposits decreasesinterest cost and ratio; can be enacted more quicklythan interest cost production. Sinkey (1975) and Ford(1978a) use similar variables.Better use of funds. Used by Edwards, 1966; Ford,1978a; Yeats, 1974.Better use of funds used by Ford (1978a). Similarvariable used by Sinkey (1975).Reflects improved quality. Used by Ford (1978a).Better investment experience. Used by Ford (1978a)and Johnson and Meinster (1975).Better investment experience. Used by Ford (1978a).Can be cut by reducing bonuses, overtime, etc. Usedby Ford (1978a) and Johnson and Meinster (1975).Cuts in overhead costs. Identified by Ford (1978a)and Johnson and Meinster (1975)Cuts in total costs of salary and interest. Identifiedby Ford (1978a) and Johnson and Meinster (1975).Reflects improved queility. Used by Ford (1978a).Reflects management's ability to increase price orreceipt of income. Used by Ford (1978a) andJohnson and Meinster (1975)A decrease in the size and/or rate of time accountswill lead to decrease in cost. This can only take placeas contracted obligations expire. Sinkey (1975) andFord (1978a) use similar variables.

* It is possible to have ineffective cost cutting; e.g., by cutting productive employees, net income/employees could decrease; by cutting non-senior employees payroll expense/employees could increase.The argument of importance only applies to effective cost cuts.

Interest on deposits/all deposits is chosen as the first variable because interestcosts represent the highest category of costs for banks and, hence, the mostsensitive variable. This variable is chosen before the other measure of interestcosts (interest on deposits/time and savings) because the total mix of deposits(demand deposits and time and savings deposits) is more flexible than the timeand savings accounts alone. By increasing the proportion of demand deposits,the bank can simultaneously increase the denominator and decrease thenumerator of this performance measure because demand deposits require less


interest. Finally, this variable has been identified as a contributing factor inhigh performance banks by both Ford and Sinkey.

The second and third ranked variables in hypothesis 1 reflect concern forrevenue generation. Loans represent the largest revenue source for banks. Theyrepresent the greatest proportion of the bank's assets, and are typically the mostprofitable of the bank's assets. This variable is listed second rather than firstbecause loan programmes require more time to implement than programmesto lower overall interest costs. Loans/deposits have been identified as a keyperformance variable by Edwards (1976), Ford (1978a) and Yeats (1974). Thisvariable is a crude measure of capacity utilization, which is significant in eachof Hambrick and Schecter's successful turnaround gestalts.

The variable cash and treasuries/demand deposits earns the third rankingfor two reasons. One reason is related to the rationale listed for the previousmeasure. Loans and non-treasury securities are higher profit uses of funds.Banks may fuel turnaround by moving their low yield cash and treasuries tohigher yield applications. A second reason for the relatively high predicted rankfor this variable is that this measure reflects the bank's asset/liability policy.One school of thought suggests that bank managers should 'balance' assets andliabilities. In other words, short-term funds such as demand deposits shouldonly be used for short-term applications such as cash and securities. Conversely,longer-term funds should be used for long-term yields {i.e. loans). An alter-native school of thought suggests that bank managers should, within acceptedlimits of liquidity, maximize yield (Baker, 1978). Decline banks may be ableto reverse decline by apportioning more of their funds to higher yield uses suchas non-treasury securities and loans. This prediction is consistent with thefindings of Ford (1978b) and Sinkey (1975).

Loan income can be easily increased by writing bad loans. Such an actionwould increase the variable gross loans/all deposits, but would neither increasenet income nor reverse decline. Thus, a measure of loan quality is proposedas the fourth ranked variable in the hypothesis. This variable, gross charge-offs/loans, is sensitive to two types of management actions. First, managementcan undertake aggressive actions to recover some payment from past bad loans.Second, management can seize control of new loan volume to assure that itis of requisite quality. In this manner, then, the turnaround bank decreasesthe amount of gross charge-offs/loans relative to decline banks.

The next two variables also reflect the turnaround bank's ability to wrestrevenue from its products. These variables are municipal income/municipalsand securities income/securities. These variable reflect the bank's ability to priceproducts and/or to invest wisely. This source of income comprises a lowerproportion of a bank's assets than the loan portfolio. Therefore, these assetswill be less sensitive to management action than the loan portfolio. This lowersensitivity explains why each of these variables is ranked lower than loans/demcind deposits. Municipal income/municipals is ranked higher than securitiesincome/securities because of the tax effects of the former investments, as

174 HUGH M. O'NEILL

discussed in Ford (1978a; 1978b) and Johnson and Meinster (1975).The next three variables in order of rank are payroll expense/employees,

overhead/earning assets, and operating expense/earning assets. These areranked 7, 9, and 10 respectively. Each of these variables is a measure of costcontrol.

Labour costs represent the second highest cost opportunity for banks, afterinterest costs. Thus, they are ranked after a measure of interest costs yet beforea measure of overhead costs. Overhead costs include all costs other than interestand labour. Such costs may be easier to reduce than personnel costs, butrepresent a smellier ocean of opportunity for the turnaround bank. Operatingexpense/earning assets is a gross measure of efficiency, since operating expenseincludes both interest costs and labour costs. This measure is included in thisstudy because Sinkey (1975) ranks a similar measure as first in importancein defining problem banks (Johnson and Meinster, 1975). This variable isranked relatively low in this model because other measures of expense control(the interest measure and the personnel expense measure) capture the effectsof cost control more directly. These variables are ranked behind variables 2through 6 for two practical reasons. One, the returns to these cost variablesare likely to be lower than returns to efforts to increase the proportion of fundsinvested in higher yield uses. Second, efforts to reduce costs are likely to bemore difficult to enact than efforts to increase returns.

The final three variables in the model include loan loss provisions/earningassets, loan income/gross loeins, and interest on deposits/time and savings. Theyare included in the model because they are either sources of revenue genera-tion (variables 10 and 11) or sources of cost control (variable 12). These variableshave figured prominently in previous studies of bank performance.

The low ranking of these final three variables can be attributed to the factthat they are less sensitive to management action than previously listed variables.The loan loss provision is a sum identified by management to add to reservesfor loans in a given year. A portion of this provision is determined by law,and is a direct extension of past loan experience. As banks improve perfor-mamce over time, the required loss provision will decline. However, the variablewill exhibit a lagged response. The variable ranked fourth (gross charge-offs/loans) is a direct measure of management's quality control in that it respondsmore quickly than the loan loss provision.

Loan income/gross loans earns its low rank because of market conditions.In general, most banks face a competitive environment (this assumption isindirectly tested for this sample in the second hypothesis). Given competitiveconditions, banks cannot extract excess profits from loans. Loan incomeimproves by better selection of clients and quicker response to laggard payers.This selection and control process is more adequately captured by the previouslydiscussed gross charge-offs/loans variable.

Finally, the variable interest costs/time and savings deposits is ranked lastbecause of its relative insensitivity to management action. Management can


refuse to accept increased levels of these time deposits, but it cannot cancelpast contracted arrangements. Thus, this cost element declines only as previouscontracts expire. Over time, the impact of these expiring contracts will varyas the cost of each of the contracts varies. Management cannot control thisvariance as part of any systematic attempt to reverse decline.

In summary, this hypothesis uses turnaround models to predict that bankturnaround will be a combined effort of revenue generation and cost control.More importantly, the hypothesis integrates strategic theory with bank manage-ment literature to predict the relative impact of each of several measures ofbank performance.

Contextual Factors

The previous hypothesis assumes that management's attempts to increaserevenue and decrease costs are the sole factors contributing to turnaround. Amajor factor which could infiuence the outcome of a turnaround strategy isthe extent of market concentration in the bank's competitive region.

Economists working in the field of industrial organization have been the keyinvestigators of the market structure/performance relationship (Porter, 1979;Scherer, 1980). The I/O paradigm suggests that market structure, managementconduct, and performance are inter-related. The study reported here substitutesstrategy for the concept management conduct, and defines performance assuccessful turnaround.

To date, there have been few studies of the relationship between marketstructure and turnaround. There have been several studies of the relationshipbetween market structure and bank performance, where performance is definedas some combination of public and private gain or loss. These studies canprovide some guide in hypothesizing the expected relationship between marketconcentration and turnaround in the banking industry.

Turnaround theorists hint at several possible ties between market structureand turnaround. First, certain market structures might be more likely to causedecline. For example, decline might be more likely in highly competitivemarkets. To the extent that different causes require different turnaroundresponses, then there will be a relationship between market structure and theefficacy of management strategies. Studies by Hofer (1980) and Hambrick andSchecter (1983) are suggestive in this regard.

Hofer argues that competitive position will influence turnaround, whileHambrick and Schecter show that market share will influence turnaround. Tothe extent that competitive position and market share are related to marketstructures, then market structures should infiuence turnaround. Other studieshave highlighted the relationship between market share £ind generic strategies,or between market structure and generic strategies (Porter, 1979; Porter, 1980;Woo and Cooper, 1981). Here our focus is on the latter relationship.

Most of the aforementioned research has taken place across industries, ratherthan within specific industries. This is in direct contrast to a rich tradition of

176 HUGH M. O'NEILL

Studies in banking which analyze the impact of concentration within theindustry. In this tradition, most studies define their market as local or regional(based on Standard Metropolitan Statistical areas) to compare and contrastthe effects of concentration on performance. The results in these latter studieshave been inconsistent (Fraser and Rose, 1976; Heggestad, 1977; Kaufman,1966). The inconsistent results in these studies could be due to differences inthe definition of performance (Heggestad, 1977), or to differences in studydesign (Graddy and Kyle, 1979). In no instance do the banking studies assessthe relationship between market structure and turnaround.

One of the problems with the industrial structure paradigm is that themeasure of concentration requires an objective measure of the entire market.This notion of market measurement becomes difficult when competitors donot compete in a national market (as is the case with the vast majority ofcompetitors in the banking industry) and when there is difficulty in drawingbarriers between local markets (as is the case in banking). It may be that thelack of physical inventory in a service industry creates problems in the measure-ment of market; it may also be that services naturally exhibit only one typeof market structure.

The inconsistencies found in previous studies, and the contrasts betweenservice industry and manufacturing industries, lead to the following hypothesis:

Hypothesis 2: There will be no relationship between local market concentration(as reported in government records) and turnaround performance.

SAMPLE IDENTIFICATION AND METHODOLOGY

The sample is provided by the Compustat tapes. Market concentration datais provided by FDIC records.

The first research task is the idenfication of banks which have turned around,and banks which have declined. These banks are identified by inspecting thenet income of all banks reporting on Compustat tapes for the period 1959through 1978, inclusive. Following Schendel et al. (1976) the net income figureis 'normalized' to reflect industry growth; a particular bank's net incomeperformance is compared to the net income performance of the bank industry(this procedure departs somewhat from the procedure of Schendel et al., whoused a GNP measure to normcJize the data). If in a particular year a bank'sperformance exceeds the industry's performance, then that year is labelled agrowth year. If a bank's performance lags industry performance, then that yearis labelled a decline year. This classification system is based on the assumptionthat the proper referent group for the banks in this Scimple is the industry, ratherthan some subset of the industry or some referent group beyond the industry.This classification system uses a strategic referent group rather than a bank'sindividual history as a comparative reference for performance analysis. This


is consistent with past turnaround studies, and helps to counteract thedelusionary impact of inflation.

The focus of the study is not a single year of performance, but rather a patternthrough several years of performance. The question of how many years con-stitutes a pattern is answered in a pragmatic manner. Previous studies ofturnaround suggest that the process takes place in a period of three to eightyears (Hambrick and Schecter (1983) provide a discussion of this question).In this study, seven years (counting a base year) is adopted as a reasonabletime span of turnaround. An increase in the time span would drastically reducethe size of the sample. Given the length of the search (20 years) this may beevidence that patterns beyond seven years are unusual in this industry. Theexistence of bank regulation authorities who will intervene when decline becomeshabitual may provide an artificial barrier to longer-term declines. If a shorterperiod of time is used, the sample size increases but it is more likely that thesample would then include random short-term declines and turnarounds whichare not related to patterns of strategy or strategic management, or would notcapture the dynamics of a strategic era (Mintzberg, 1978).

A bank enters the sample if it exhibits three consecutive years of decline upuntil the three-year period before the end of the study. There are 51 bankswhich underwent such a three-year decline period. The three-year period afterthe three-year decline is used to label the banks as turnaround or decline. Ifa bank improves performance in two of these three years, the bank is thenlabelled a turnaround bank. If the bank declines in two of these three years,the bank is then labelled a decline bank. Thirty-one of the banks in this samplereversed their decline (i. e. became turnaround banks) while 20 of the bankscontinued their decline.

Once a bank joins the sample, a complete performance profile is gatheredfor that bank. Following a search of the financial literature (Baker, 1978;Edwards, 1966; Ford, 1978a; Johnson and Meinster, 1975; Mayne, 1976;Sinkey, 1975; Yeats, 1974) a set of variables is chosen that have managementrelevance and can be used to test the turnaround models developed elsewhere.The variables are listed in tables II and III, which classify the variables in termsof the turnaround models.

Hambrick and Schecter identified eight variables as significant in two typesof turnaround. Surrogate for seven of those variables are used for this test ofthe turnaround model in banking. The data base did not provide a directmeasure of the eighth variable, marketing expenditures.

The relative amount of loan income, security income, and municipal incomeare used to assess the impact of pricing. Given the same level of loans (orsecurities or bonds), then one bank's ability to get greater loan income (orsecurity or municipal income) reflects that bank's ability to get better pricesfor its products. While it might be argued that the increased level of incomeis due to riskier (and therefore more profitable loans), such an outcome wouldviolate the prescription of product quality which is also required for turnaround.

178 HUGH M. O'NEILL

The relative amount of gross charge-offs is used as a measure of the levelof receivables that a bank has. Gross charge-offs represent a bank's bad debts.The relative amount of cash and treasury bonds in the bank's portfolio is usedas a measure of inventories. In a mature manufacturing industry, inventoriesreflect idle assets. Similarly, cash or treasury bills represent idle assets for banks.

The variable gross loans (as a percentage of toted deposits) is used to assessthe bank's capacity utilization. Since loans usually represent a bank's highestsource of income, and deposits represent the bank's ability to loan, this is adirect measure of capacity utilization.

Employee productivity is assessed by the level of payroll expense peremployee. This variable was chosen because it is a direct cost measure. Thelevel of product quality is measured by assessing the loss experience of eachbank in the sample (gross charge-offs/loans and loan loss provision/earningassets). Here, the assumption is that higher quality loans are those that maintaintheir ability to pay over the life of the loan.

Relative direct costs are measured through the use of interest costs, overheadexpenses, and operating expenses.

A discriminant analysis model is then used to verify the success of theclassification criterion and to test the ability of the models to predict turnaround.Standardized coefficients are used to rank the variables. The discriminantanalysis is supplemented by use of univariate t-tests.

Data on market concentration is gathered from the F.D.I.C. statistics for theyear 1978. This year is chosen because it represents the year that most of thebanks completed their patterns. Market concentration is measured as the shareof the top three competitors in a regional market, the top five competitors in aregional market, and the absolute number of competitors (that is, the number ofother commercial banks) in a regional market. The impact of concentration istested in two ways: through a discriminant analysis model and through a t-test.

RESULTS

The discriminant analysis. The results are summarized in tables IV to VI.Some of the twelve performance variables exhibit collinearity. Nine of the

66 pairs show correlation at a level of 0.6 or better (the full correlation matrixis available on request). Most of this collinearity can be traced to two sources.First, the operating expense/earning assets variable is correlated with threevariables (overhead/earning assets, loan income/loans, loan loss provision/earning assets). Second, the loan loss provision/earning assets measure iscorrelated with overhead expense/earning assets and gross charge-offs/loans.Since there were no a priori reasons for deleting one or the other of the variablesin each correlated pair, the variables were retained. The loan loss provision/earning assets variable was predicted to rank in the lower half of the discrimi-nant variables. This prediction was based, in part, on the level of correlation.


Table IV. Discriminant analysis

Hofer and Schendel, w/Mthree

Hofer and Schendel Model w/Mfive

Hofer and Schendel Model w/Ncomp

Wilks Lambda

0.4472819

0.4480026

0.4460799

Sig.

0.0162

0.0165

0.0158

Classification*

82.35

82.35

82.35

• In an unbiased classification model (a hold-out sample was used) successful classification wasachieved for 73% of the cases with Ncomp used as the measure of market concentration.

As table IV indicates, the discriminant analysis was successful. The variablessuggested by the models as key determinants for turnaround in this industrydo successfully discriminate the banks. Another test of the model is its abilityto classify banks, which it does successfully in 82 per cent of the cases in thissample. This analysis is performed at the sixth year after the initial decline,so that the differences between the groups are at their greatest level. Whena hold-out sample is used for classification, the unbiased classification rate is73 per cent (Ncomp serves as measure of market structure for this analysis).

Three different measures of concentration are each used in a discriminantanalysis to assess the impact of market concentration. Mthree, which is thetotal regioned share of the three top competitors (share is measured as shareof total bank deposits for the region), is first used with the performance variablesin a discriminant analysis. Following this, Mfive and then Ncomp are usedin separate discriminant analysis. Mfive is the total regional share of the topfive competitors in the region, while Ncomp is the number of commercial bankcompetitors in the region.

As table IV indicates, the concentration variables are consistent in theirimpact: classification is significant regardless of the choice of variable. Hence,further analysis uses only a single measure of market concentration (Mfive).The key question here is the importance of the concentration variables in thetask of discrimination. The task of identifying the most important variablesin a discriminant ancdysis is an ambiguous one, in that there is no acceptedsingle standard for choice (Eisenbeis, 1977; Perreault et al., 1979). Here, thestEuidardized discriminant function coefficients are used to assess the importanceof the concentration variables. In a group of 13 variables, the concentrationmeasures rank 12, 12, and 11. The conclusion, then, is that these variablesare not important factors in the turnaround strategy.

One of the important contributions this study makes is the identification ofthe content of a turnaround strategy in banking. Two types of analysis areused to identify the strategy. First, standardized coefficients in the discrimi-nant analysis model are used to rank order each of the performance variables.As Tatsuoka (1971) suggests, the standardized coefficient is similar to a betaweight. The absolute value of the standardized coefficient is a measure of thevariable's contribution. The discriminant analysis is supplemented by a t-test

180 HUGH M. O'NEILL

analysis. The discriminant ranking is presented in table V, while the t-testanalysis is presented in table VI.

The results show that turnarounds in banks are indeed fuelled by both revenuegeneration and cost control, as Hofer and Schendel suggested. The results confirmthat the successful turnaround bank exhibits elements of both selective productmarket pruning and piecemeal productivity, as Hambrick and Schecter found.

Table V. Standardized coefficients of performance variables in rank order*

Variabtes

Interest on deposits/all depositsGross charge-offs/loansGross loans/all depositsGash and treasuries/demand depositsMunicipal income/municipalsSecurities income/securitiesOverhead/earning assetsOperating expense/earning assetsLoan loss provision/earning assetsLoan income/gross loansPayroll expenses/employeesInterest on deposits/time and savings

( 1)*( *)( 2)( 3)( 5)( 6)( 8)( 9 )(10)(11)( 7)(12)

(Gost control)(Receivables)(Gapacity utilization)(Use of inventory)(Pricing)(Pricing)(Gost control)(Gost control)(Quality)(Pricing)(Gost control)(Gost control)

-0.913220.774860.797690.560550.551300.53055

-0.48367-0.47916-0.45616

0.268210.169590.06640

* Predicted rank given in brackets.

Table V lists the standardized coefficients in rank order, and gives thehypothesized rank. An inspection of the table will show that the actual andpredicted ranks are quite similar. Except for the case of one variable (payrollexpense/employees), none of the predictions were off more than two steps inthe ranking scheme. Four of the variables ranked as predicted, while six ofthe predicted ranks were off by one step. Overall, this performance documentsthe utility of turnaround models in identifying the patterns of resourcedeployment necessary to reverse decline.

Univariate t-tests were used to supplement the discriminant analysis. Forthe most part, the univariate analysis supports the results of the discriminantanalysis. On the basis of the t-tests alone, one might conclude that several ofthe key discriminators are not important in the turnaround. However, this con-clusion would ignore the fact that the t-tests are not sensitive either to thecorrelation among the variables or the variance within the variables. Thus,both the multivariate and the univariate analysis are necessary to reach theconclusions in this study.

For eight of the variables in the model, the mean differences between thegroups are in the expected direction. The decline banks have higher interestcosts, exhibit higher loan loss experience, have less loans per deposit dollar,and have higher costs in general. While these differences may not be signifi-cant in the univariate sense in each case, overall performance (i.e. turnaround)is sensitive to each of these variables.

TURNAROUND STRATEGY IN GOMMERGIAL BANKING 181

Table VI. T-Tests/means/standard deviations: differences at year six'''

1) Interest/all deposits

2) Gross charge-offs/loans

3) Loans/deposits

4) Gash and treasuries/deposits

5) Municipal income/municipals

6) Securities income/securities

7) Overhead/earning assets

8) Operating expense/earning assets

9) Loan loss provision/earning assets

10) Loan income/loans

11) Payroll expense/employees

12) Interest/time and savings

Decline

0.0439(0.008)!^'-0.0068(0.003)0.7051

(0.082)0.8085

(0.204)0.0465

(0.003)0.0669

(0.009)0.0243

(0.006)0.0925

(0.011)0.0066

(0.004)0.0856

(0.008)12.7138(1.704)0.0800

(0.015)

Turnaround

0.0416(0.012)

- 0.0040(0.002)0.7063

(0.101)0.8335

(0.278)0.0497

(0.005)0.0661

(0.009)0.0173

(0.005)0.0766

(0.014)0.0035

(0.002)0.0775

(0.012)13.4703(2.452)0.0727

(0.015)

T-Staiistic

0.75

- 3 . 2 4 "

-0.04

-0.35

- 2 . 9 2 "

0.30

4 .25"*

4.19"*

3 .14"

2.58'

-1.13

1.61

''' Listed in order identified by discriminant analysis model'̂ ' Figure in brackets is standard deviation

* = 0 . 0 5 Level of significance•• = 0.01 Level

" • = 0.001 Level

Four of the variables exhibit unanticipated results. Contrary to the initialhypothesis, decline banks show a lower level of cash and treasuries/deposits.This might imply that decline banks are making better use of their inventory.However, they are using inventory in unprofitable ways as their net incomecontinues to decline. The decline banks earn a slightly better return on securities(0.0669 to 0.0661). There is no readily apparent reason for this minusculeadvantage.

Decline banks earn more income from their loans. This unanticipated resultmust be interpreted in light of other results. First, the decline banks are usingfewer of their deposit dollars for loans. Secondly, the decline banks are chargingoff more of their loans. Apparendy, the decline banks are sacrificing qualityto obtain these higher loan incomes. Finally, in spite of the higher loan incomeper dollar of loan, the decline banks are not able to control costs. It may bethat the decline banks are focusing on a single variable (loan income/loans)rather than making the combination effort required for turnaround.

The final unanticipated difference in the univariate analysis is the fact thatdecline banks pay less for their employees. The turnaround banks pay their

182 HUGH M. O'NEILL

employees more; the return to the banks is higher productivity. This confirmsHambrick and Schecter's empirical finding that employee productivity is animportant variable in turnaround.

In summary, the discriminant analysis leads to acceptance of the firsthypothesis and a failure to reject the second hypothesis. In a t-test of thedifference between concentration ratios for the groups, no significant differenceis found (T = 0.39; sig. = 0.699). The mean concentration ratio for theturnaround groups is 72 per cent while the mean concentration ratio for thedecline groups is 73 per cent. Again, this leads to a rejection of the secondhypothesis.

DISCUSSION

The results paint a vivid picture of the turnaround process in commercialbanking. The findings confirm the prescriptions of Hofer and Schendel, andof Hambrick and Schecter. In commercial bank turnarounds, revenues areincreased by such methods as the increased use of loan capacity, better useof inventory, better pricing and better quality. Costs are minimized throughmethods such as the control of interest costs, the minimization of loan losses,and the minimization of operating and overhead costs.

A cost control variable (interest on deposits/all deposits) ranks first indiscriminatory power. This is followed by five variables which reflect revenuegeneration. The primary position of interest costs is undoubtedly due to thefact that interest costs represent the greatest proportion of banking costs. Interestcosts can be controlled in two ways: by offering lower rates on deposits, andby adopting a lower cost mix of demand deposits and time deposits (demanddeposits carry lower interest rates). In a competitive market, it is difficult toattract deposits by offering lower rates. Therefore, successful turnaround bankscontrol their interest costs by achieving a lower cost mix of deposits. This state-ment is confirmed by the ranking of the second measure of interest cost, intereston deposits/time and savings. This latter measure of interest costs ranks lastin discriminatory power in the discriminant analysis model, suggesting thatturnaround and decline banks pay similar rates for these expensive deposits.Turnaround banks manage to attract a higher portion of the cheaper demanddeposits.

The variables which rank second through sixth in discriminatory power reflecta turnaround bank's success in increasing revenues. The increased revenue canbe attributed to better management of the loan portfolio (fewer loans are writtenoff), better management of capacity (more loans per dollar of deposits), andbetter pricing (more dollar volume from municipal bonds). These revenueincreasing options have a higher marginal impact on net income than furthercost reduction options. Since other components of cost in banking (overhead/earning assets, operating expense/earning assets) represent a small proportion

TURNAROUND STRATEGY IN GOMMERGIAL BANKING 183

of costs, cost reductions in these areas are likely to have a lower marginal impactthan revenue increasing options. As Hofer and Schendel suggest, turnaroundefforts which are based on a combination of cost cutting and revenue increasesrequire a careful comparison of the marginal returns to each option.Turnaround banks find an optimal combination.

The variables which rank seventh through eleventh in the turnaround modellend further support to the notion that the turnaround is based on a combinedeffort. Two of these variables represent the control of costs (overhead/earningassets and operating/earning assets) while two of these variables representrevenue increases through quality control and pricing.

As noted, one cost variable which does not hold a prominent position in theturnaround process is the cost of employees. Since payroll costs do representa major opportunity for cost reduction (payroll costs rank second to interestcosts), this ranking is somewhat surprising. However, Hambrick and Schecternote that personnel productivity (not cost) contributes to turnaround. Apparendy,human resource productivity is more important than human resource cost inbank turnarounds.

One key question not answered by the discriminant analysis is how theturnaround banks managed to reduce interest costs, reduce the level of loancharge-offs, increase capacity utilization, and the like. To answer this question,each bank in the sample was asked to provide archival data for the period ofdecline or turnaround. Responding banks provided such information as annuaJreports, 10-K reports, and investment reports. This core of information wassupplemented by a review of industry materials in the public domain (Moody'sindustrial reports, banking periodicals, etc.). Table VII summarizes this review.Since this material was gathered after the decline-turnaround event, anyinterpretations are subject to the cautions which accompany all ex post researchdesigns. Nonetheless, this material describes the universe of methods used toachieve the cost reductions and revenue increases which combine to causeturnaround. This description should be of value to both researchers andpractitioners.

Table VII shows that the turnaround process required attention in each ofseveral functional areas. Marketing, general management, the loan depart-ment and operations each contribute to the turnaround process. Marketingand general management contribute both to cost control and revenuegeneration. The principal contribution made by marketing is to attract moredemand deposits and attract more loan customers. This is accomplished throughsuch programmes as advertising, promotion, and the identification of newmarkets. New markets include new geographical locations (that is, newbranches), new serivces (such as more consumer or commercial loans,) andchanges in market definition.

General management decisions involve the careful co-ordination of resourcedeployments through the use of targets, plans, and cost controls. Generalmanagement makes key decisions about the balance between cost decreasing

184 HUGH M. O'NEILL

Table VII. Reported methods for enacting turnaround

Variable Methods

Interest on deposits/all deposits

Gross charge-offs/loans

Gross loans/all deposits

Cash and treasuries/demand depositsMunicipal income/municipalsSecurities income/securitiesOverhead/earning assets

Operating expense/earning assets

Loan loss provision/earning assets

Loan income/gross loans

Payroll expense/employees

marketing, targets and plans, new consumerservices, new markets, increase demand depositsrelative to time and savings, increased deposit base,new branches.new business, reduction in problem loans, controlof loan risk, credit rationing, restricting growth,increased diversity in loan portfolio.marketing, targets and plans, new banks, newconsumer services, new markets, internationalexpansion, change in market defmition.targets and plans, new technology in operations.marketing, targets and plans.marketing, targets and plans.cost controls, targets and plans, merge branches,liquidate subsidiaries, increased centralization, sellor close branches.cost controls, targets and plans, new technology inoperations, increased centralization, increasedtraining, work simplification, new business.reduction in problem loans, control of loan risk,credit rationing, restricting growth.marketing, targets and plans, new branches, newconsumer services, new markets, internationalexpansion, change in market defmition, increasedservice charges.reduction in personnel, merge branches, increasedcentralization, change staff composition.

options and revenue increasing options. The turnaround bank mustsimultaneously increase the amount of demand deposits, while decreasing therelative amount of time deposits. Similarly, the turnaround bank must increaseits volume while controlling for quality. The selection of specific targets, plansand controls apparently helps management achieve this balance.

The contribution of the loan department impacts on the effort to increaserevenues. This occurs through improved pricing, performance, quantity andquality in the bank's portfolio. Often, the review process for problem loansis changed as banks react more quickly to non-performing loans (i.e.delinquent). Often, the review process for new loans is changed so that thebank anticipates potential loan risks. In step with marketing efforts, the loandepartment promotes business in new areas.

The operations areas of the bank (personnel, administrative services, M.I.S.,etc.) contribute to the turnaround through work rationalization. Newtechnologies (primarily computer-based) foster turnaround by improving speedand accuracy in funds management. Training, work simplification, andincreased centralization improve productivity.

This archival review suggests a menu of options which banks can use bothto decrease costs and improve revenues. No single bank in the sample adopted


all the options. Rather, each bank adopted that set of options which fit itscircumstances. One turnaround bank, for example, focused its cost reductioneffort on interest costs exclusively. Since this represents the most sensitive costarea for the bank, such attention (combined with efforts to increase revenues)led to a turnaround. This archival review further suggests that the decline bankstypically made one of two mistakes. They either chose the incorrect strategy,or they failed to implement the correct strategy. Those decline banks whichchose the incorrect strategy focused their attention solely on growth or solelyon the control of costs; they did not choose a combined strategy. While someof the decline banks did recognize the need to enact a combined strategy, forsome reason they were not able to implement the desired strategy. Unfortunately,the archival data offers no clues about the causes of these implementationfailures. The phenomenon of implementation failure represents an importantopportunity for further research.

SUMMARY

This study presents a test of the prescriptions of the strategic paradigm in anindustry which is not similar to the industries in which the paradigm wasdeveloped. The application presented here is successful in the sense that theprescriptions suggested by the paradigm do fit the situation; the efficacy of theturnaround model is confirmed. If this application of one generic strategy inone service industry can be taken as evidence of a more general fit, then wecan suspect that the concept of generic strategy or grand strategy will havewide application in the service industries. At the very least, this study confirmsthat turnaround in the banking industry is dependent upon a combinationstrategy, which will require specific attention in the areas of cost control andrevenue enhancement. The key areas for cost control include the control ofoperating expense, overhead and interest costs. The key areas for revenueenhancement lie in the control of loan pricing and quality: turnaround banksextract better returns for their loans in that losses are controlled moreadequately. These findings imply that the functional areas of the bank thatmust manage their resource deployment decisions in the turnaround processinclude the sales area, the credit control area, the operations area and theadministrative area.

While these results verify the applicability of strategic paradigms in industriesother than mature manufacturing industries, the study cannot support a firmconclusion about the potential transference of other aspects of strategicparadigms to other services. In the case of turnaround, it is necessary to applythe paradigm to a wider sample of banks, and/or to study individual turnaroundbanks more intensively to describe the processes which accompany turnaroundmore fully. Further, we cannot be sure without more study if banks are typicsilservice industries; it may be that the banking industry is more exposed to mature

186 HUGH M. O'NEILL

manufacturing industries and therefore adopts similar management practices.Finally, we need to expand our understanding of the application of other genericstrategies in service industries. For example, share increasing or decreasingstrategies may be different in various service industries. Here, a study similarto the work of Hitt et al. (1982) might identify the relationship between strategyand resource deployment in the service sector. Given predictions that the growthof the service sector will exceed the growth of other sectors of most moderneconomies, this knowledge should be of interest to both researchers andpractitioners.

Appendix I. Performance variable definitions

Interest on Deposits/All DepositsInterest is the total interest and expense paid on all deposit accounts andborrowed money. All deposits is the total of all deposits. This figure includesboth demand deposits and time deposits.

Gross Charge-offs/LoansGross charge-offs are the net credit or charge to reserves for debt recovery.Loans include all loans written by the bank and federal funds sold and/orsecurities purchased with agreement to resell. These latter funds (federal fundsand securities purchased to sell) represent loans made to other banks or loansto customers.

Loans/DepositsThis is the total amount of loans divided by the total amount of deposits. Itis a measure of loan per dollar of deposit.

Cash and Treasuries/DepositsThis is the sum of cash and treasury securities held by the bank, measuredas a proportion of total deposits.

Municipal Income/MunicipalsThis is the amount of interest the bank earned on its investment in municipalsecurities.

Securities Income/SecuritiesThis is the income the bank earns on its investments in securities other thanthe municipal securities.

Overhead/Earning AssetsOverhead represents the totsil current operating expenses for the bank, otherthan interest and salary. Earning assets are the total holdings of the banks (loans,securities, accounts in other banks).


Operating Expense/Earning Assets

Operating expense is the total of all operating expenses, including interest andsalary cost. Earning assets are the total holdings of the bank.

Loan Loss Provision/Earning Assets

The loan loss provision is the amount identified by management to add to loansin any given year. Earning assets are the total holdings of the bank.

Loan Income/Gross Loans

Loan income is the revenue received from interest and fees on loans. Grossloans is the total amount loaned by the bank.

Payroll Expense/Employees

Payroll expense is the sum expended for employee wages and benefits.

Interest/Time and Savings

This is the total interest divided by the amount of deposit dollars held in timeand savings accounts.

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Economy & Finance

An analysis of the turnaround strategy in commercial banking (1)