Will a New Theory Help Firms to Manage in a ‘Flat’ World?

The take-off point for the innovations that we now call the “new economy” is generally traced to 1985, when Michael Porter developed his value chain analysis. But modern economics and the root of the theory of the firm began long before that, in 1776, with the publication of Adam Smith’s treatise, The Wealth of Nations. Since then, of course, technological, cultural and other changes have shaken the theories underpinning economic activity.


Recognizing this, the SEI Center for Advanced Studies in Management at Wharton asked four experts to consider how executives can make sense of the changing environment. As part of a broad research project, the SEI Center is distributing a survey to senior executives worldwide reflecting this theme.


Taking part in the discussion, moderated by Knowledge@Wharton, are Colin Crook, former chief technology officer at Citibank and now a senior fellow at Wharton; Jerry Wind, academic director of the SEI Center; Len Lindegren, former Global Strategy Leader at PricewaterhouseCoopers and now a senior fellow at the SEI Center, and Paul R. Kleindorfer, Wharton professor of operations and information management. Earlier this year, they collaborated on a paper titled, Toward a New Theory of the Firm. Below is an edited transcript of their comments.


Knowledge@Wharton: In looking at all the changes taking place today in the global marketplace, what are key areas that companies should be focusing on?


Crook: I would say that sustained innovation is the most fundamental issue. There is a massive discrimination between those financial companies that are innovating in terms of growth and profitability, and those that are not.


Look at financial services and you will find that technological and other kinds of innovation are the most important drivers. The way financial services are constructed makes the field highly amenable to technology. Everything is done by computers, since money is really information flowing around. Competitors are phenomenal, products and markets are examples of innovation in the widest sense, and a new business model is being developed.


So it’s not just product innovation. It’s really about redefining the business, including expanding into adjacent services, such as health care. Sustained innovation is the most pressing requirement, and once you start to do that, other issues follow.


Knowledge@Wharton: What would you say are some of the key innovations that have recently impacted financial services?


Crook: Financial services has become a customer-driven business, with financial services companies examining all their activities and moving them to a 24/7 basis as consumers demand delivery of what they want, when they want it. They are also quickly merging their delivery, such as payments, into cell phones and other portable devices. So there is massive innovation on the customer side.


As Jerry [Wind] has argued for a long time, the customer is driving innovation and change. We are not talking hundreds of thousands; we are talking about millions of individuals doing this. Another example is the way that adjacent businesses realize that financial transactions are an integral part of their activity, too, and are starting to innovate and encroach upon what has traditionally been defined as financial services.


One clear example is e-Bay working with PayPal to innovate the way the payment system is structured. Rumors are out that Google also plans to do something similar. So financial services companies face threats and opportunities. The opportunity is the chance to redefine themselves by moving into new scenarios. But we are also seeing innovation by other people who want to get into financial services.


Another example is the three billion customers in the world who are not currently being served by financial companies. We are hearing a lot of talk about microfinance. Citibank, for example, just announced plans to go into this area. Other kinds of innovation, in the mortgage business for example, are occurring. It used to take about four weeks to get a mortgage. Now it’s around four days. People are aiming to get a mortgage online in less than five minutes.


Kleindorfer: I’d like to point out some innovations in the operational risk side, following the Basel II directives [overhauling the banking industry’s approach to risk management]. For a while, there was a lack of focus on the issue of how to reduce management mistakes or fraud, operational mistakes, technology failure — all the things that are encapsulated under the heading of operational risk. These are events that occur as a result of a company’s operations, as distinguished from market risk or credit risk.


In the last five years, we have seen a huge growth in the science underlying this — in the systems that are capturing that science and the data that are driving it. It also indicates the global reach of financial institutional innovation. This is something that academics in general and Wharton faculty in particular — including the Financial Institutions Center — can get their arms around.


Crook: Another observation involves the city of London. About eight years ago, there was a real crisis in the United Kingdom regarding financial services and the future of London. The euro was developing and there was widespread worry that everything was going to move on to Frankfurt. Instead, it turns out that the innovative capacity of London is phenomenal.


The city totally changed its approach and opened up the market so that everyone could come in. Now, most of the banks in London and the people running financial operations there are non-British. The majority of the world’s financial currency activity and most of the world’s cross-border financing are done in London. That’s because of its willingness to innovate and do things that other people simply thought were not practical. Now London is really challenging New York to determine where the world’s centers will be.


Service delivery is another issue. The financial service sector’s move to become customer focused has placed a massive strain on the ability to deliver on promises to business and non-business customers. Executing this successfully requires innovation and attention to operational performance. If you want to run a global 24/7 operation, with customers in the hundreds of millions, you must have a fabulous service delivery. That’s because people now are transacting online in real time, and they want things done right away. That’s why as part of service delivery, mortgages are moving to web-time, essentially right away.


This leads to another set of issues that are associated with credit risk. How are you going to extend credit — for example, in the mortgage area — in a matter of a few minutes? So this whole area of risk management — which, in its wider sense, includes credit risk and operational risk — means that the way of running a business has got to change. If you throw in issues like hedging strategies, then this area of risk explodes.


Consider mortgages, where you have to originate a loan, service it, assess it and do an interest rate assessment in a very short time. This demands new thinking and new levels of excellence in the way things are done.


The financial services area is also concentrating on cost reduction. This is important, since financial services is a phenomenally competitive industry, especially in the retail area. In fact, one of the serious criticisms that has been leveled at Citibank CEO Chuck Prince is his inability to keep costs under control.


The whole area of cost reduction is a major stress factor. You have to drive costs out while, at the same time, innovating to produce fabulous service delivery and unprecedented levels of customer satisfaction. This leads to a serious need for innovation in a wide sense.


Finally, that brings us to the broad issue of security and confidentiality. Consider this: In the past, customer credit card theft was taken as a cost of doing business. The companies used to whack in a certain percentage and write it off. But as you become customer-centric, you realize that customers are concerned about issues like identity theft, and they are no longer satisfied being told that they don’t have to worry about the charges. The integrity of personal identity has become an obsession among customers, so the entire approach to risk has changed. It’s no longer simply a compliance issue to keep the bank examiner off your back. It’s now become a business issue, a brand issue.


Wind: I’d like to add to something that Colin mentioned about the power of the consumer. There’s an increased concern about a customer’s ability to trust a financial advisor. This lack of trust is reflected in groups like TIGER 21 [a network of peer-to-peer learning groups for high net worth investors] that facilitate the transfer of advice among themselves, instead of using traditional advisors.


This is important because these people are basically saying they can’t trust traditional financial institutions. In response, some companies, such as SEI Investments, are coming up with interesting alternatives like life-driven wealth creation programs that try to offer an integrated solution that focuses on the customer — covering estate planning, traditional investments and other related services. It’s similar to what the Mayo Clinic has done in the health care area.


Kleindorfer: I would like to add an observation about the financial services side, specifically in the area of public-private partnerships. I see this as a further extension of the increased complexity of the interplay between political and public decisions, and private decisions.


I noticed this when I was appointed to an advisory group to the Secretary-General of the OECD [Organization for Economic Cooperation and Development]. We are analyzing the significant catastrophic risks that are on the screen, from pandemics to terrorism. There’s recognition that some of these imply financial consequences that cannot be dealt with by current risk-bearing instruments in the private sector.


Once you start engaging the public sector in these matters — for example, the government taking the upper end of the reinsurance contract for terrorism risk — some very complicated issues begin to arise, such as the efficiency of the markets and the problems of moral hazard. All of this is really because of the interconnections across the planet, the nested relationships, and the network-enabled characteristics of companies’ operations.


All of these things become complicated: If you talk about public-sector involvement in the upper end of risk, it turns the matter into an amazingly complex set of discussions. The principles for delineating that — for example, determining the boundaries between public and private risk-bearing — are yet to be worked out.


Lindegren: My background was with PricewaterhouseCoopers, and I think the professional services industry is instructional in at least two ways. One, it is a fairly sizable business, and some of this applies equally well to accountants, lawyers and other firms that are global. Some of the accounting industry’s struggles with global versus national issues might be instructive on a broad basis.


Perhaps we can start by considering the impact of regulation and the scope of services. People speak of global accounting firms, but they are really more complicated than that. They are more like federations of national firms. Historically, that federation was very weak; it was really an alliance. You had no profit-sharing, legal, or other relationship beyond your common interest in serving clients across borders. Over time that changed, with varying degrees of success, to the point where some firms tried to become single, global entities.


Now the pendulum has swung back to something far stronger than it was historically, but not as a global organization. While it’s all within one firm, it becomes an interesting study in how to motivate people at the global level versus regulating them at a national level. I think all the firms would probably claim that it’s impossible to create a single global entity in a business that is so highly regulated on a national level. Enron and Sarbanes-Oxley dramatically affected the accounting and other professions. Initially, it was a boon to the accounting profession, but now it’s causing a backlash that I think extends beyond the profession. Sarbanes-Oxley, for example, is complex; the compliance cost is high, and, along with other factors, may be contributing to a concern that the U.S. capital markets are not as desirable as they used to be. I think there’s a lot of emphasis on helping clients deal with regulation and compliance in a cost-effective way.


The other point I would make is the way in which this profession has had to formally struggle with the global versus national issue. This may be informative and could be useful in thinking through issues like supply chains that cross legal entities, or consumer and other questions.


Wind: On the global issue, it’s interesting that law firms realize they need a presence around the world, especially in places like China and India. This leads to a lot of acquisitions and strategic alliances.


Kleindorfer: It’s also interesting that the accounting profession still has very strong ties to the federation culture of national firms. What you often see are handoffs from one country to the next that should occur seamlessly. But they remind one of banking in the pre-euro age, when additional transaction costs were incurred because the players maintained different cultures. I would be curious about Len’s thoughts on whether part of the tension is due, not to a reluctance to let go of the federation aspect, but to a desire to maintain the boundaries of liability and also [a desire by] individual partners and others to maintain the good looks of their own garden. So there are tensions associated with moving to a global brand.


Lindegren: I see that. Initially, the response was one of kicking and screaming, but the drive to be more global is clearly there. As they move to being more global, the firms also have to struggle with the issue of liability. It is not black and white. The lawyers will tell you, on the one hand, that you must remain separate and not share profits or take other steps. But then another set of lawyers will tell you it doesn’t make a difference, that ultimately plaintiffs will go after the deep pockets regardless of where they are. And they will cite whatever they can to prove you pierced the veil of liability. It’s not clear. I think that initially, the firms were set up like watertight compartments. There was no profit sharing; then there was a little bit of cost sharing; then it was almost as if the profession couldn’t exist without responding by essentially being a global firm. At Pricewaterhouse, we devised clever schemes to limit the impact of liability transfer, but the fact of the matter was that the firm was willing to take a bit more risk in that area than they had in the past, because the pressure to be global was greater.


Then, that began to dip into your other subject pool, which is that people felt they needed to be part of national firms. They were regulated as national businesses, and most of the profits were shared nationally. So the idea of doing things for the greater good began to give way to concerns about the national practice. If business in the U.S. was growing faster than the global practice — but profits were shared across borders — then that year the Americans felt like they were subsidizing the whole world. And it might be reversed the next year. What you’re really trying to do is create an equilibrium between how global you want to be, and what are proper incentives for individual performance.


Kleindorfer: I’d like to say that a person could ask what’s new about what we’re discussing. What, after all, has changed in 2006 from 2000? For example, [when discussing how to view the firm], we use the terms “node” vs. “nexus”. In the flat-earth economy, node implies looking at the company or individual partner as an entity that has its own existential existence, with such issues as decision rights and capital structure. There’s also a nexus view that recognizes this node is actually networked out — sometimes across the planet — but certainly to a number of partners, customers and suppliers. And they in turn are networked out.


There are some very interesting questions about the dynamics, how the connections are formed and how well they water a particular node. So there’s a node vs. nexus view that’s captured in one of the survey questions and it’s safe to say that a lot of people had a network-enabled view of companies going back to 1990. We can also characterize it as a view that suggests thinking globally and acting locally. The strategic issues we talk about have, in some cases, been around for decades or longer. You can see the roots and even track them from feudalism to the Industrial Revolution, to the corporate revolution, the information revolution, and finally to the flat-world revolution in which we’re currently involved.


The fundamental difference is the challenge that arises from the increased speed and interconnectivity, and the scope of power, that national regulators now have. The global economy moves much faster.


So we are now getting to the fundamental difference: how managers and senior executives view these changes. Right now, I really don’t think we have our arms around questions raised about the sources of the new complexity and how it impinges upon the kinds of business models and strategic planning that senior executives should be considering.


Knowledge@Wharton: Perhaps we could also look at the organizational implications of these changes, and what kinds of challenges they create for companies.


Wind: It could be argued that all of these forces apply to the professional services area. You could think about the way it’s redefining the business of some of them, such as Li & Fung, which has redefined just what a trading company is, and has, in a sense, become a professional services firm. [Founded in China in 1906 as a trading company, the $8.5 billionmultinational group is today engaged in export trading, retailing and distribution.]


Crook: In the sense of redefining professional services, it might be noted that the military is today considering engaging private armies to deliver certain professional services, like intelligence gathering, that conventional militaries can’t do as well. Thinking like this may lead us to redefine the public and private boundaries of professional services.


Lindegren: Paul’s point about node and nexus raises the question about the shift of relative importance between the issues. Doesn’t something very substantial happen in an organization when the nexus view becomes much more significant?


There may even be a tipping point. If you go back 20 years, the node view would be much more dominant. That may vary by sector and occur at different rates, but there’s also an inexorable shift because of a multitude of factors, including global competition. It’s important to get at the issues that are out in front of people, and not the ones they have been struggling with for the past 20 years. I think the questionnaire does that; it asks people where they’re going.


Crook: I would also note that in general there’s a trend toward commoditization. From the standpoint of a new product or a new service, the challenge is how to structure it in a way to create sustainable, enhanced value. It’s an alternative to producing something that has only a nine-month or one-year life before the competition gets the same thing. This issue has never before been as urgent, especially because there’s evidence to suggest that any innovation taking place today is only good for about a year, unless the innovators are very careful.


Kleindorfer: It not only must be unique, but it must be profitable as well.


Crook: I think that the speed of cycle times and development processes, and the ubiquity of competing information flows, bring about a lot of stress. Look at Sony, which appears to have lost its creativity.


Lindegren: From the professional services side, the ability to innovate is less a matter of designing a new service or product, and more a matter of being able to react to what’s happening around you. Hence, the greatly increased value of scenario planning. Because it’s less a matter of deciding and implementing a brilliant strategy than a matter of saying: “If this is what happens to X or Y, how can you react quicker than your competitor?” That’s more important than creating a new audit format.


Kleindorfer: In the past six months, there has been an upsurge in the number of companies coming through INSEAD [the European institute for management education] looking for assistance in scenario planning and scanning, or determining the signposts that suggest which scenario or scenarios should be the focus. Some companies — like Nestle, Unilever and Procter & Gamble — have been doing some scenario planning, but it’s been directed toward competition and technology. So these and other companies were completely blindsided by the recent increase in mineral oils — which was spurred by a law in Germany requiring power plants there to burn 10% bio-fuel by 2010 –and its impact on the vegetable oils and other ingredients they purchase for their products.


These sorts of commodity risks have escaped the scrutiny of many companies. Now they see a single government make a decision and it throws the profitability of an important ingredient out the window. So scenario planning and scanning, together with strategic modeling, intelligence and other issues, are really beginning to take on a much larger significance than before. It used to be about markets, technology and competitors, but now there’s a much richer texture.


Crook: I think the supply chain concept is also having a significant impact on corporate structure. It originally brought together a whole bunch of previously disparate organizational elements of the business and integrated them into one service delivery capability that’s fundamental to many businesses. Now I think you will see, organizationally, searches for the equivalent impact of a supply chain. Business organizations will be moving toward a capability approach rather than the classical functional approach.


Knowledge@Wharton: On another topic, do you see any tax issues arising as companies become closer, even as they are more disparate in terms of geography?


Kleindorfer: As competition increases between countries and even between regions within countries, tax breaks of one sort or another are a central element of the extended market complexity of the flat world. For companies, this is different than just shopping around for the best supplier price, because the rules by which some of these governments operate are not always based on profit-seeking motives. Some are driven by pressure groups, or growth and other concerns. It adds another order of complexity to global planning issues.


Knowledge@Wharton: What effects on individual managers do you see?


Crook: One implication is that there will be enormous tension between focusing narrowly on your professional skill versus being drawn away to a broader stream of activities.


Lindegren: Going back to the node versus nexus issue, the individual manager will be wondering if his or her future will be a function of events in the nexus world or the node world. Companies that do well in human resource management will be able to communicate to individuals so they will understand what’s important. This impacts the decision about which individual professional skills should be developed and which perspective should be emphasized.


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