Cost Efficiency as a Strategic Objective for Banks - Report Example

COST EFFICIENCY AS A STRATEGIC OBJECTIVE FOR BANKS al Affiliation COST-EFFICIENCY AS A STRATEGIC OBJECTIVE FOR BANKS The banking industry is one of the pillars of the world economy and thei stability is paramount for economic sustainability. Since the recent period of global recession, the bank industry has become one of the most regulated markets as the government focus on strategies to ensure bank stability and protection for the general public. However, regulation in the banking industry has different impacts on the operational efficiency of the banking sector especially if evaluated from the situation in different countries. In the harsh economic era, it is indisputable that cost-efficiency is an important factor for the banks, as they strive to optimize their revenue in the long-term. However, regulations impact on the way the banks operate by influencing the competition in the market, economic of scale and the scope of economies. While some countries have injected efficiency within the banking industry by providing regulations, it is clear that regulations can facilitate or hinder cost efficiency within the banking industry. A comparison of the UK and US bank regulations will aid in showing how a country’s regulations impacts cost-efficiency within the banking sector. The priority of any business is to optimize profits both in the short and long run, which is an indicator of business stability. According to economic theories, business organization act to optimize their outputs while minimizing the inputs at any particular level of output. X-efficiency refers to the ability of organization to realise optimal benefits from their investment plans (Mullineux & Murinde, 2003). As the figure below illustrates, organizations expect their output to increase at every level of input. However, there are a number of market factors that hinder organizations from realising optimal profits due, which results to inefficiency. In the banking industry, competition is one of the factors that influence the benefits that investors obtain from the market. The nature of competition within a market may influence the ability of the organization to engage cost-efficiency strategies. In monopolistic competition structures, some banks dominate the market and make exceptionally big profits at the expense of others. This results to x-inefficiency, which is a major concern for many investors. Fair competition within the market is an important factor for the long-term survival of the banks as it provides each organization with an opportunity to win customers, hence providing cost-efficiency incentives. As such, x-efficiency within the banking sector is factor that largely depends on the nature of market competition within the market. Fig. 1. The output increases as the input increases in competitive markets. The role of the government in ensuring fair market competition in the banking industry is crucial for efficient running of the organizations. Government regulations may hinder or encourage fair competition depending on the guidelines they offer. The EU regulations have facilitated a natural and fair market competition within the market (Turner, 2009). After the global recession, the EU deregulated the market to encourage competition and to avoid over-dominance of large banks in the European countries. The laws served to encourage foreign investors to enter the market and act as equal players within the industry. These regulations have promoted fair competition and eliminated the monopolistic structure that existed before the global financial crisis. As a result, the banks have been able to realise optimal profits from their input. Similarly, the US regulations have for long struggled to maintain fair competition within the banking industry. Since the 1970, the US government introduced laws to protect small banks and reduce the over dominance of the large banks. Besides, the US laws encourage inter-state exchanges which allowed new market entrant to venture into the US market. As a result, this reduced the power of monopoly which had threatened small banks and intensified competition within this industry. As a result, cost-efficiency has become an important factor for the banks as all investors strive to increase their market share within a competitive business market. One strategy that the banking organizations have focussed as a cost-efficiency strategy is the economies of scope. The economies of scope point out that the cost of production is inversely proportion to the scope of product that a company develops (Mullineux & Murinde, 2003). The implication, as the graph illustrates, is that the cost of production will decrease when an organization produces more products. Therefore, it is possible for a company to drive down its operation cost by producing more products within the company. For instance, it is possible for a bank to reduce its cost of operation by offering different bank product such as retail banking and investment services within the same platform such as the online service. The cost of production would be higher if a bank opts to offer one service online, while offering the other over the counter. Another good example is when one cashier is trained to serve retail banking customers as well as investment customers. The bank will only incur the wages expenses for one employee, as opposed if the organization had two different employees were used to handle the two different tasks. Therefore, the banking industry focuses on increasing their product ranges to ensure that they can drive cost of production as a strategy to optimize performance. Fig. 2. The cost of production decreases as the number of products increase. However, the range of services that a company can offer to its customers depends largely on the government regulations within the country. While majority of government recognize diversification as an important factor for economic development, it is clear that there are times when service diversification contributes to instability. As economies of scope point out, it is apparent that at some point, increasing the range of services does not contribute to reduction in cost of production (Mullineux & Murinde, 2003). For instance, a banking company that offers too many services online may be forced to incur additional costs of internet and data storage. At this point, increasing the range of products may not result to profit optimization. Public protection laws in EU and US have played an important role in influencing the ability of organizations to diversify their services as they strive down the cost of production. Notably, the European commission has published strict public protection laws that the US, which has discouraged diversification plans. The EU regulations require that bank retain at least 8% of capital as a security against risk investment (Turner, 2009). As a result companies are limited to invest, and hence the incentive to drive down cost through economies of scope. On the other hand, US Congress provides less strict law and this explains why many US organizations have managed to venture in different markets including insurance and lending, which is crucial in driving down cost of production. Besides, regulations over the online business have reduced the diversification strategies that bank investors engage to drive down the cost of production. The internet laws have increased in the era of cybercrime. The government is many countries are concerned with increasing cases of internet fraud, which has resulted to increase in financial losses. In an attempt to protect the public from aggressive investors who ignore the security of their customers, both EU and US have instituted cyber laws to regulate banks that intend to enter the online platform (Bremus & Lambert, 2014). Banks that need to offer financial services to the public through an online presence must secure such transaction by investing in secure networks. Over time, the internet platform has become a favourite trading arena for many banks as they find it cheap and efficient. For instance, international banks can offer a wide range of services to a wide range of customers through the internet, hence driving down the investment cost. However, there is evidence that increase in internet regulation has imposed high cost on internet investment. The high costs associated with the provision security and the high risk of financial loss within the market has reduced the incentive for online investment in both US and EU. As a result, cost-efficiency has become a challenge for bank investors as many banks use internet platform as a marketing tool rather than a business tool. Additionally, banks have an option to capitalize on economies of scale in an effort to drive down the cost of production. According to the theories of economics of scale, the cost of productions in inversely proportion to the quantity of production. Since the cost of production is equal to the value of fixed cost plus the variable cost, the cost of production is bound to decrease as production quantity increases (Mullineux & Murinde, 2003). This is due to the fact that companies’ fixed cost remains constant at to some point for production of either lower or more products. From the graphical illustration (fig. 3), as long as the economies of scale hold, organizations can drive down the cost of production. Therefore, economies of scale is one of the bank operators have considered in the push to lower the cost of production. As cost-efficiency becomes a basic essence in a competitive market, banks seek to increase production of services to ensure that they operational cost remains as low as possible. Increasing the number of customers for every product is one way that such organizations have used. For instance, the loan section within a bank seeks to target as many customers as possible in effort to reduce the expenses of offering loans. Just like any other organization, the cost of serving few customers within the industry is very high and may result to company failure. Fig. 3. The cost of production decreases as the level of output increases. However, using economies of scale to increase production within the banking industry has been a tough decision for managers to make. While the economies of scope requires product diversification to bring down cost, the economies of scale require increase in quantity of services as the sole mean to cutting cost of production within the banking industry (Santillán-Salgado, 2005). Therefore, economies of scope require specialization rather than diversification if companies have to realize optimal profits. The use of this strategy has sent mixed reactions within the public domain as the perception of product specialization seeks to introduce small monopolistic organizations where the demand and supply forces are restricting. If all banking organizations focus on economies of scale, there is evidence that each will concentrate on one service, be it loans, retail banking or insurance, which will result to a monopolistic structure. If all organization opts to specialize in one market, there will be oversupply of services, which will reduce demand and push the prices down. As a result, companies will experience intensive of competition as the demand fluctuates for each service. Therefore, companies are always in a dilemma to engage the economies of scale as move to drive down cost and optimize performance. In the US, the economies of scale have been curbed through strict market regulations. Shortly after the great financial crisis in the banking industry, the US congress came up with laws to reduce small firms that initially focussed on provision of one service. Previously, such firms worked on the economies of scale by providing one service at the lowest costs possible. However, the risk of providing one service is high and puts companies at a vulnerable position. For instance, small banks that offered agricultural loans in the US were harshly affected by the financial crisis as many debtors defaulted their loans. In response, the US government provided exit strategies to ensure that such companies can pull enough resources to provide diverse services within the market. For instance, the Federal deposit insurance corporation (FDIC) provides companies with an incentive for small banks to merge to avoid the risk of running into financial distress (Ait-Sahalia, Andritzky, Jobst, Nowak and Tamirisa, 2012). FDIC takes small banks that are in danger of failing and merges with another to reduce the possibility of each bank collapsing. Therefore, these federal policies have reduced the incentive for banks to specialize as an economy of scale strategic objective, which may place companies at a vulnerable position. Therefore, the US congress has put regulations to limit the extent to which companies can engaged in economies of scale in an effort to bring down the cost of production. On the other hand, the European commission has been far much more liberal in terms of promoting diversification rather than specialization within the industry. While banks are competing to produce as much as possible, it is clear that the laws discourage extreme specialization of the banking services. Deregulation of the European Union region banking industry has given managers an opportunity to invest in any market that they intend (Allen & Rai, 2012). As economic theory points out, competitive markets discourage extreme specialization due to the risky nature of such ventures. Companies that specialize in one product are at higher risks that those with a wider range of products. Therefore, banks that intend to specialize with production of one service as economies of scale measure cannot do so since other bank managers may swing to the same direction, which may result to market saturation. As a result, managers are more focussed in maintaining a balance between specialization and diversification to ensure that they perform optimally. A close analysis of the changes in market structure indicates that the banking industry is the most regulated market. Government regulations both in the EU and US have focussed on providing competitive market. As economic theories point of out, competitive markets are manifested by existence of equal power competitors, free entry and exit from market and reduced externalities. Since market regulations have fostered competition within the banking industry, bank managers are facing hard decisions while trading on the various available options of cost reduction strategies. In a competitive, neither economies of scale nor economies of scope can be used solely to bring down the cost of production. In a deregulated market, companies face the challenge of balancing the two to ensure that they achieve x-efficiency within the market (Berger, Hanweck & Humphrey, 2012). The x-efficiency is realised when the banking companies strike a balance between specialization and diversification of services to increase profits as they minimize the cost input. Therefore, cost-efficiency is factor of production that banks must target to ensure that they survive within a strongly regulated market. In conclusion, during the era of intensive competition in the banking industry, cost-efficiency is an important factor for managers within these organizations. Bank managers are seeking different approach to minimize the input cost at any particular level of output. After the global crisis, government regulations within both the EU and US regions have become more strict than before, in an effort to prevent recurrence of same ordeal. Both regulators have focussed on measures to deregulate the market to increase competition, which they believe is crucial in eliminating dominant market partisans. Therefore, x-efficiency has become an important concept as organizations intend to increase their level of output and drive down the cost of production. Besides, the economies of scale and economies of scope has become a point of focus for organizations intending to drive down cost of production. Unlike in the US, the EU regulators have allowed banks to diversify their products and services to bring down costs. However, the two regulators have used different mechanisms to prevent extreme product specialization, which was a tradition economy of scale approach to cost reduction. While cost remains an important aspect of business performance, bank managers are left with the option of trading between various cost-efficiency strategies to optimize production within their organizations. 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