5 forces analysis

5 Factors Analysis: The Financial Industry 1

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5 Forces Analysis: The Financial Industry

Kristina Kivi

University of Maryland University College

IMAN 601 9040

According to Michael Porter, an industry’s innate structure will drive competition and de-

termine its overall profitability (Porter, 2008). He postulates that there are five major categories

by which an industry’s structure is analyzed: threat of new entrants, rivalry among existing com-

petitors, threat of substitute products or services, bargaining power of suppliers, and bargaining

power of buyers (Porter, 2008). As the topic in question is whether credit unions should keep

their tax-exempt status, it is important to analyze not only credit unions, but the entire financial

industry.

A long and arduous road lies ahead for those persons who wish to start a bank or credit

union. Each entity takes from a year or more to gain approval from the necessary governing bod-

ies. For national banks, the overseeing bodies are the Office of the Comptroller of the Currency

and the Federal Deposit Insurance Corporation (Federal Reserve, 2013). Credit unions must un-

dergo steps determined by the National Credit Union Administration. Each potential financial in-

stitution must submit application packages that detail its current assets, business and marketing

plans, and board of directors or leaders (National Credit Union Administration, 2014).

Because of the time and effort it takes to form a new financial institutions, the threat of

new entrants is very low. Assuming that one makes if through the application process, most new


entrants in finance start as small regional firms and are quickly bought up by large commercial

banks. In a report issued in 2004 by the Board of Governors of the Federal Reserve System, over

3,500 mergers between various commercial banks occurred between 1994 and 2003 (Pilloff,

2004). Credit Unions are a more viable option due to their charter requirement. As commercial

banks can serve any consumer, credit unions are limited to those consumers who fit within their

field of membership. Therefore, a credit union that serves military members cannot merge with

another credit union that serves the employees of an insurance company. While mergers do hap-

pen between credit unions, they are much more rare when compared to national banks. Consider-

ing the restrictions placed on membership, credit unions will always maintain a smaller share of

those consumers using financial institutions.

Despite the fact that commercial banks and credit unions are considered two different

types of financial institutions, the rivalry amongst them is very strong. This also applies to those

individual entities that make up the entire financial industry. Success in finances is dictated not

only in the amount of customers or members an organization has, but on the total number of as-

sets. Without a high deposit base, financial institutions cannot be strong competitors, especially

considering how deposits affect the ability to lend.

In order for financial institutions to remain solvent, their total number of assets must ex-

ceed their total number of liabilities (Federal Reserve, 2014). After the market crash in 2008, the

Federal Reserve began implementing measures to ensure that consumers never again faced such

financial hardships in the wake of poor comptroller decisions. As a result, it enacted the Basel III

Liquidity Coverage Ratio in 2013, setting a new precedent for asset requirements (Federal Re-

serve, 2014). This applies to all financial institutions that provide lending products. If


an organization does not have a large customer base, their deposits are likely to be small as well.

Most institutions pay dividends for deposits. If the lending portfolio is small, the organization

cannot offset dividend payouts with lending fees, such as late payment fees and mortgage origi-

nation fees. Therefore, it is of utmost importance for financial institutions to compete for the

largest amount of customers and the largest amount of deposits.

Most customers have their funds in multiple financial institutions. This makes threat of

substitutes generally high. The majority of their deposits may be at a commercial bank whereas

their lending products may be at a credit union due to more favorable interest rates. Financial in-

stitutions may also have programs created in conjunction with certain large employers to offer

more favorable products, such as early deposit access. Customers and members are free to shop

between financial institutions to find the best rates. However, the switching costs focus more on

a customer’s time and convenience as opposed to monetary costs. It takes time for direct deposits

to change to another institution and certain firms may not have as many local branches to con-

duct business. Consumers must weigh their options before considering whether the time and en-

ergy associated with changing their direct deposit institution is worth the additional .05% in in-

terest.

While the latter information focused on customers keeping their funds in financial institu-

tions, there are other important substitutes to consider. Depending how risk-adverse a customer

may be, he or she may also place her funds into the stock market. Other investments include

helping to fund a new business or donating money to charity in hopes of offsetting federal taxes.

For the true miser, he or she may choose to keep large cash holdings out of the financial industry

altogether and place them underneath the couch.


The suppliers of the financial industry can be seen as three major groups: the Federal Re-

serve, major credit card companies, and employees. Considering these three suppliers, the bar-

gaining power shared amongst them is very high. Beginning with the Federal Reserve, this sup-

plier determines the rate by which financial institutions may purchase money. Once again, we

turn to the events of 2008 to highlight their authority. In the wake of economic collapse, the Fed-

eral Reserve waived the normal charges paid by banks and credit unions to place monetary or-

ders. This continues to this day. Deposit dividends also took a sharp dive, as financial institutions

no longer needed to rely on their customers funds for liquidity. If financial institutions begin to

pay fees again, one will expect the dividend rate of deposits to increase as well. The effects of

the Federal Reserve’s policies on monetary orders trickles down from the comptroller’s offices

of financial institutions to the consumers and is reflected in their earned interest.

Major credit card companies also play a large role in the industry. Those organizations,

such as Visa and Mastercard, set industry standards on fraud procedures and account security. In

order for financial institutions to produce cards with their logos, bank and credit unions must

comply with a number of terms. For instance, in order to have an instant card issue machine that

produces VISA cards at branches, organizations must place those machines in secure areas with

a camera directly facing it. If there are no cameras installed that meet those requirements, one

must be retrofitted to face the machine. Additional requirements may include the number of

cards issued to consumers in a specific period of time, point of sale amount limitations, and re-

serve card stock limitations. If financial institutions do not comply with their requirements, they

cannot issue those company’s cards.


Employees of financial institutions are not to be discounted when considering the bar-

gaining power of suppliers. Those that supply their labor to banks and credit unions do not nec-

essarily have the most bargaining power in the industry when compared to the Federal Reserve

and major credit card companies. When observing the labor market, employers still have the ma-

jority of the power. While unemployment is declining slowly and steadily, the locus of power

has not yet shifted to the employees. Employers may supplement their workforce with applicants

with cash handling skills, not necessarily banking skills. There are still too many people looking

for employment as opposed to employers looking to fill vacancies.

Depending upon the type of financial institution the bargaining power of buyers may be

high or low. With regard to commercial banks, the bargaining power is very low. The most influ-

ential stakeholder for publicly traded entities is the stockholders, not the customers. Profit is the

overriding principle and the ultimate concern when planning marketing strategies and product

development. For credit unions, which are not-for-profit, the power of the buyer is higher. Be-

cause they are not-for-profits, the majority of the income of credit unions is returned back to the

member in the form of higher dividend rates and other services. The rest of the income is used to

cover operating costs. Credit unions have a member-owner structure in which each individual

member gets a vote and owns a portion of the organization. While changes may be slow to take

effect, members have a much greater say in the actions of credit unions as opposed to customers

of commercial banks.

With the proper ration of assets to lending, financial institutions can reap generous re-

wards. However, there are a few caveats. If a financial institutions has a number of assets but a

very small amount of lending, income will be limited as you are paying out more dividends than


receiving in interest. As most small institutions are bought by larger commercial banks, the indi-

vidual identity of the institution does not last long. This also plays a huge role in the restructuring

of the newer institution. Branches may close and individuals, especially mid-level managers,

may lose their jobs as there are too many employees for that leadership level. For those sitting in

the board room of financial institutions, the profitability is high.


Bibliography

Board of Governors of the Federal Reserve (2013, August). How can I start a bank? Retrieved

from http://www.federalreserve.gov/faqs/banking_12779.htm

National Credit Union Administration (2014, September). Federal Credit Union Charter

Application Guide. Retrieved from http://www.ncua.gov/Resources/Documents/

CUDev/ Federal-Credit-Union-Charter-Application-Guide.pdf

Pilloff, S. (2004, May). Bank merger activity in the United States. Federal Reserve Bulletin.

Retrieved from

http://www.federalreserve.gov/pubs/staffstudies/2000-present/ss176.pdf

Porter, M. (2008). The five competitive forces that shape strategy. Harvard Business Review,

86(1), 78-93. Retrieved from http://eds.a.ebscohost.com.ezproxy.umuc.edu