Radical Innovations in the Norwegian Banking Industry

Radical Innovations in the Norwegian Banking Industry A historical study through 50 years Martha Gjessing Bakken Astri Agnalt Østmo Industrial Economics and Technology Management Submission date: June 2014 Supervisor: Arild Aspelund, IØT Co-supervisor: Rikke Platou, IØT Norwegian University of Science and Technology Department of Industrial Economics and Technology Management

NTNU Radical innovations in the Norwegian Banking Industry A historical study through 50 years Martha Gjessing Bakken Astri Agnalt Østmo

PREFACE This Master thesis was written during the spring semester 2014 and forms the final work of the five year Master program at Norwegian University of Science and Technology. The master thesis is a part of the program at Industrial Economics and Technology Management within the specialization Strategy and International Business Development. This master thesis studies the effect of radical technological innovations on an industry and builds upon our prediploma thesis written in 2013. The work has been both challenging and rewarding. It has given us the possibility to gain indepth insight into the theoretical perspectives Radical change theory and Population ecology of organizations theory. We have also accumulated knowledge about an industry that we knew little about before the research began. We would like to thank our academic supervisor Arild Aspelund at the Institute of Industrial Economics and Technology Management for his support and feedback in relation to our master thesis. We are also highly grateful for the guidance from PhD student Rikke Stoud Platou. Her open-office policy has been valuable to us. We would also like to thank our three interviewees; Hans Ildstad, Bjørn-Tore Brønlund and Geir Wist, for their expertise and knowledge which gave us an extensive contribution to our empirical findings. Trondheim, June 2014 Astri Agnalt Østmo Martha Gjessing Bakken i

SUMMARY In this thesis we look at radical changes and its effects in the banking sector in Norway. The objective is to study the outcome of radical technological change in a regulated-, compared to a non-regulated, industry which has been the topic of earlier research. The study embraces lies within the technological development from the 1960s up to the present date. The chosen research method in this paper is a combination of a historical study and a case study. An extensive literature search has been done to reveal relevant articles for our theory section. Our empirical findings stem from in-depth interviews with key persons within the banking industry, combined with investigations of documents, archival records and input from Betalingsformidlingskonferansen 2014. This has given us access to information about the technological development, the industry dynamics and the consequences of radical technological changes in the Norwegian banking industry. We have applied two theoretical perspectives; Radical change theory and Population ecology of organizations theory. Radical change theory states that radical change leads to a period of upheaval where incumbents often succumb to new entrants. Population ecology of organizations theory describes the dynamics in an industry and how the environmental factors dictate which firms that survives. These perspectives have been used to illuminate connections between the empirical findings and the theory. This study reveals three interesting contradictions to the well-established theory of Radical change and Population ecology of organizations. First, the effect of radical technological change on the industry density is highly modest compared to previous theoretical studies. This is a cause of elevated entry barriers due to governmental intervention and tight bonds between actors in the industry. Second, incumbent banks are highly capable of conducting radical innovation as well as incremental. This is explained by the clear incentives for the incumbents to adopt the change, namely to improve the service offering to the existing customers and to rationalize their operation. In addition, incumbent banks generally have more organizational slack which gives them more flexibility in conducting explorative research. They also achieve the opportunity to free themselves from the powerful system solution suppliers by conducting technology development in-house. Finally, the degree of innovation is compromised because of limited competition, short eras of ferment, and high pressures for standardization. The pressures are due to an informal agreement between the actors, resource constraints and governmental interaction. Extended to regulated industries in general, these findings suggest that incumbent firms should adopt a more risk prone innovation strategy because they are in a safer position due to its importance for society. Firms without sufficient resources to conduct explorative research should adopt the new technology when the dominant design is evident to reduce risk and cost levels. ii

SAMMENDRAG Denne masteroppgaven fokuserer på effekten radikale teknologiske innovasjoner har på dynamikken i den norske bankbransjen. Målet er å studere utfallet av disse forandringene i en regulert bransje, sammenlignet med tidligere studier av ikke-regulerte bransjer. Vi har studert den teknologiske utviklingen fra 1960 tallet og frem til nåtiden. Forskningsmetoden brukt i denne oppgaven er en kombinasjon av en historisk studie og en casestudie. Vi har foretatt et omfangsrikt litteratursøk for å finne relevante artikler til teorikapittelet. De empiriske funnene stammer fra dybdeintervjuer med nøkkelpersoner innen bankindustrien, kombinert med studier av dokumenter, arkivdokumenter og innspill fra Betalingsformidlingskonferansen 2014. Disse kildene har gitt oss tilgang på informasjon om den teknologiske utviklingen, bransjedynamikken og konsekvensene av radikale teknologiske forandringer i den norske bankindustrien. Vi har anvendt to teoretiske perspektiver i denne oppgaven; radikal forandringsteori og teori om populasjonsøkologi for organisasjoner. Radikal forandringsteori sier at radikal teknologisk forandring fører til en periode med kreativ destruksjon der markedsledere ofte går under som et resultat av inntrengere i markedet. Teorien om populasjonsøkologi for organisasjoner beskriver dynamikken i en industri og hvordan miljømessige faktorer dikterer hvilke firmaer som overlever. Disse to perspektivene blir brukt til å finne sammenhenger mellom empiriske funn og teori. Studien avdekker tre interessante motsetninger til den veletablerte teorien om radikal forandring og populasjonsøkologi for organisasjoner. Den første motsetningen er at radikal teknologisk forandring har en beskjeden effekt på dynamikken i bankbransjen. Dette er et resultat av hevede barrierer for å entre industrien på grunn av statlig inngrep i markedskreftene og tette bånd mellom aktører i bransjen. Den andre motsetningen er at markedsledende banker mestrer radikal innovasjon på i tillegg til inkrementell innovasjon. Dette kan forklares med de klare insentivene markedsledende banker har til å gjennomføre de radikale forandringene, nemlig å forbedre tjenestene til sine eksisterende kunder og å rasjonalisere driften. I tillegg har markedsledende banker generelt en større ressursbuffer som gir dem mer frihet til å utforske nye teknologier samt muligheten til å gjøre seg uavhengig av mektige systemleverandører ved å etablere en intern utviklingsenhet. Den tredje og siste motsetningen er at innovasjonsgraden er svekket på grunn av begrenset konkurranse, korte perioder med utvikling av alternative teknologiløsninger og sterkt standardiseringspress på grunn av uformell forståelse aktørene i mellom, ressursbegrensninger og statlige inngrep. Dersom man trekker sammenligninger til andre regulerte industrier, vil disse funnene insinuere at markedsledere burde tillegge seg en risikovillig innovasjonsstrategi fordi de er i en tryggere posisjon grunnet deres betydning for samfunnet. For å redusere risiko og kostnader burde banker uten tilstrekkelig ressurser til forskning og utvikling være mer risikoaverse og implementere den radikale teknologien først når standarden er satt. iii

TABLE OF CONTENTS Preface... i Summary...ii Sammendrag... iii List of abbreviations... vi 1 Introduction... 1 2 Theory... 2 2.1 Population ecology of organizations theory... 2 2.2 Radical change theory... 5 2.3 The two perspectives compared... 8 3 Method... 10 3.1 Plan & design... 10 3.2 Literature search... 13 3.3 Data collection... 14 3.4 Analysis... 17 3.5 Evaluation... 17 4 Empirical research... 20 4.1 Technological history... 20 4.2 Industry dynamics... 28 4.3 A presentation of the four innovations... 37 4.4 Summary... 46 5 Preliminary discussion... 47 Are the changes radical?... 47 6 Discussion... 49 6.1 Industry density... 49 6.2 Industry composition... 52 6.3 Degree of innovation... 59 6.4 Summary of findings... 64 7 Implications... 65 7.1 Insights extended to other industries... 65 7.2 Managerial implications... 65 7.3 Implications for policy makers... 67 iv

7.4 Implications for theory... 67 8 Conclusion... 68 9 Limitations and further research... 69 10 References... 70 11 Appendix... 74 Appendix 1: Complete overview of commercial banks... 74 Appendix 2: overview of system solution suppliers... 78 Appendix 3: Transcript of interviews... 79 v

LIST OF ABBREVIATIONS Abbreviation ATM BBS BSK CBK DNB DnC EDP EFTPOS FNO ICT ID IDA KID LO MICR NAF NBO NCR NCSA NTNU OCR PEOT RCT SMB SMS SWIFT UCLA WAP Full form Automated Teller Machine Bankenes Betalingssentral Bankenes Standardiseringskontor Christiania Bank og Kreditkasse Den Norske Bank Den norske Creditbank Electronic Data Processing Electronic Funds Transfer at Point of Sale Finans Norge Information and Communications Technology Identification Integrert Databehandling AS Kunde-ID Landsorganisasjonen i Norge Magnetic Ink Character Recognition Norsk Arbeidsgiverforening Norges Banks Oppgjørssystem National Cash Register National Centre for Supercomputing Applications Norsk Teknisk-Naturvitenskapelige Universitet Optical Character Recognition Population Ecology of Organizations Theory Radical Change Theory Small & Medium Banks Short Message Service Society for Worldwide Interbank Financial Telecommunications University of California, Los Angeles Wireless Application Protocol vi

1 INTRODUCTION This study concerns how industries are affected to various degrees by new technologies. As technology infiltrates all aspects of society, no sector is exempt from the effects of the technological changes. These technological changes will hit the relevant sectors periodically (Simons, 2009). When they do, it holds huge consequences for the existing firms in the banking sector. Firms that are not able to transform and adopt the new technology will succumb due to industry alterations. Population ecology of organizations theory is a perspective extensively applied to explain the dynamics on industry level. Another perspective, Radical change theory, has thoroughly documented the failure of incumbents in a various range of industries (Abernathy and Utterback, 1978, Christensen, 1997, Cooper and Schendel, 1976, Foster, 1988, Henderson and Clark, 1990, Christensen and Rosenbloom, 1993). As regulations interfere with the market powers in an industry, we have reason to believe that these might affect the outcome of the radical technological change. In order to shed light on this topic, we will use Population ecology of organizations theory and Radical change theory to analyze the effect of radical technological change in a regulated industry. This may hold strategic implications for companies in industries operating under similar conditions in other industries. For this purpose we have chosen the Norwegian banking industry as our subject of research. This is an industry with a long history, giving the possibility to look at changes over the past decades. There are plenty of actors in the industry which gives us the opportunity to investigate the industry dynamics. The industry is regulated by the government, and has been so for the decades we are researching. It has also been through an extensive technological development over the last fifty years. Since this development has brought radical innovations through several decades, we have the chance to extract knowledge from several radical innovations in the same industry at different decades and under different conditions. The emphasis in this paper has therefore been to collect the most relevant information from written sources and supplement it with expertise gotten from interviews with employees in the banking sector. By assembling this information about the conditions in the Norwegian banking industry and the effects of radical technological innovations on the market and the different actors, we lay the foundation for extracting knowledge about strategic decisions in the banking industry and other regulated industries in the future. Following, our research question is twofold, the first part concerns learning in the Norwegian banking industry in particular, while part two concerns the generalizability of the findings. 1. How does radical technological change affect the industry dynamics in the Norwegian banking sector? 2. What insights might be extended to other regulated industries? To help us shed light on this dual research question, a combination of a historical study and case study is used. NTNU 1 Introduction 1

2 THEORY In the following chapter we will present theory that describes the development of industries. We have chosen two streams of research that serve our purpose. The first is Population ecology of organizations theory (PEOT) which views organizations as unable to adapt to changes and environmental factors as decisive of variation within a population. The second stream of research, Radical change theory (RCT), is based on Kuhn s (1962) theory on paradigm shifts and Schumpeter s (1942) theory on creative destruction. Subsequent research has attempted to explain how technological progress affects industries and why some organizations survive technological shifts while others do not. We conclude the chapter with a comparison of the two streams of theory. 2.1 POPULATION ECOLOGY OF ORGANIZATIONS THEORY Population ecology relative to organization s theory became well established through Hannan and Freeman s work in 1977 and 1989. A major conclusion in their work was that a similar phenomenon to Darwin's natural selection occurs when organizations compete in an environment. Analysis of organizational founding and mortality, firm growth, and change constitute the foundation of PEOT (Hannan and Freeman, 1977). Hannan and Freeman (1977) stated that adaption and isomorphism are not enough to explain the dynamics of organizations in an environment. In contrast to adaption theories, PEOT considers organizations as unable to adapt to change. Therefore environmental factors are decisive of which organizations that survives. The organization survives or disperses depending on the environment s ability to select certain types of organizations and disregard others (Garcilazo, 2011). Because of the limited ability to adapt, change on industry level comes from new entrants in the industry or the dispersion of existing organizations (Hannan and Freeman, 1977). The following sections are divided into the central aspects of PEOT; variation, selection and retention. VARIATION The central question in PEOT is Why are there so many different types of organizations? (p.956, Hannan and Freeman, 1977). According to PEOT, organizations will transform slower than the environment, which imply that the variability in industries is mainly a result of creation of new organizations and organizational forms and the replacement of old ones (Hannan and Freeman, 1988). As the environment changes with time, the organizations match with the environment will be altered as well. Niche theory provides an explanation of how organizations may choose between two structures that will give them various starting points under different circumstances. According to Hannan and Freeman (1977), an organization can either be generalist or specialist. Specialist organizations exploit one single configuration within their current environment, while accepting the risk of a change in that environment. Generalist organizations, on the other hand, are more risk averse at the price of a lower profit. Instead of specializing in one narrow environmental niche, they will occupy a broader niche to 2

increase the chance of keeping some of its territory when the environment changes (Hannan and Freeman, 1977). Figure 1 shows the fitness graph of two different organizations. Organization A occupies a broad niche in the environment, while organization B has a narrow environmental span, but a concentrated fitness. FIGURE 1 FITNESS FUNCTIONS FOR SPECIALISTS AND GENERALISTS. VERTICAL AXIS REPRESENTS FITNESS. (HANNAN AND FREEMAN, 1977) Variations in the environment are often characterized as fine-grained or coarse-grained. Finegrained refers to the variations of short durations relative to the lifetime of the organization, such as demand for products and services. Course-grained refers to the variations of long duration relative to the lifetime, such as changes in regulations. This definition states that the environmental conditions decide if the organization should develop specialized isomorphic structural relations with one possible environmental state or generalized structural features (Hannan and Freeman, 1977). Theory suggests that specialism is always the best option in stable environments. However, generalist structures are not always optimal in uncertain environments. During fine-grained variations, organizations that attempt to adjust to every change will spend most of its time on changing instead of acting and will therefore be disfavored. SELECTION To each variety of environmental conditions, one organizational form will be optimally matched to the demands of the environment. Competition theory explains how the environment chooses the optimal combination of organizations. When the organization s and the environment's rationalities do not coincide, or when two organizations stay in the same niche, the weakest organizations from the environment's perspective are selected out. The deposed competitor needs to either vary its territory or its functionality to survive, which increase the diversity (Hannan and Freeman, 1977). 3

The selection process is a result of structural inertia. Inertia can come from both internal and external factors. Examples of internal factors are investment in plant and equipment, sunk cost or reduced information received by the managers. External factors can be legal or financial barriers, or external constraints on information (Hannan and Freeman, 1977). PEOT states that organizations have difficulties with change because of structural inertia, not because of a lack of reaction, but because they react slower than the environment (Hannan and Freeman, 1977). Therefore, structural inertia prevents organizations from undergoing radical strategic changes when faced with threats from the environment (Hannan and Freeman, 1977). The higher the inertial pressure, the less flexibility and the more likely the environment will discard the organizations. In addition to this, the process of change itself is so disruptive for organizations that the mortality rate increases (Hannan and Freeman, 1977). However, structural inertia does not have the same impact on all types of organizations. Larger companies often have a greater chance of altering the environment conditions because they have access to resources and expertise that smaller organizations do not (Daft, 2000). This may give them more freedom to choose which products and customer segments to focus on, thus which environment they participate in (Daft, 2000). Another way to modify the environment can be to gain control critical resources which reduces the dependencies on other organizations (Pfeffer and Salancik, 2003). In addition to the match between the organization and the environment, there are some phenomena often observed regarding selection of organizations. Regulations and the age and size of the organizations all affect the founding and the mortality rates. Regulations will add or remove constraints to the accepted scope of opportunities in the environment. This will select out the organizations that no longer meet the criteria of the environment or potentially open a new opportunity for organizations that now are within the borders of the environment. This will affect the diversity of organizations in the industry (Hannan and Freeman, 1977). Most often, regulations will pose tighter restrictions on the industry and select out the smaller organizations (Hannan and Freeman, 1977). The age of the organization also affects its risk of mortality. According to PEOT there are three liabilities that are related to age. The increased risk of mortality among newly founded firms is called liability of newness. New firms have a lower rate of reproducibility than older firms. When first founded, they have to co-operate, develop trust, and a working relationship with other parties, which takes time. Routines and processes also have to be developed from scratch and tested, instead of continuing existing ones. Newer firms also struggle with reliability and accountability because of their employees lack of dedication to gain organization-specific experience. According to Hannan and Freeman (1977), employees often delay investing in the development of organizational skills not easily transferred to others, until a firm has survived the initial period of testing. This valuable experience increases with the firm s age, which in turn increases the reliability and accountability and reduces the risk of mortality (Hannan and Freeman, 1977). In addition to liability of newness, we can find liability of adolescence which regards the increase in the mortality rate once a firm has survived its founding stage, after the resources and support from external sources have depleted. Liability of aging includes the risk an organization faces when it gets older for example due to an increasing mismatch with its environment. Older firms may have accumulated accountability 4

and reliability, but this again leads to higher levels of inertia and lower ability to adapt to changes in the environment (Hannan and Freeman, 1977). Finally, the size of the organization has implications for the organization s chances of failure. Common liabilities of smallness include resource restrictions, problems to recruit, train and retain the workforce, paying higher interest rates and handling costs of regulatory compliance (Aldrich and Auster, 1986). RETENTION When the weakest organizations are selected out, the organizations that have some beneficial features favored by the environment are retained. Retention is a term that in the PEOT literature regards the reproducibility of advantageous traits of organizations that have adopted a successful variation (Baum and Amburgey, 2000). Beneficial variations will be tried imitated by other organizations in the industry. However, how obvious these advantageous traits are, vary extensively. If environmental trends are clearly identifiable or when the variations clearly can be separated from other factors, it is easier to adopt the right successful variation across the industry. However, sometimes there might be ambiguity about the causes, or trends may be hard to identify due to uncertainties regarding customers, suppliers or competition (Baum and Amburgey, 2000). Regardless of the clearness of the variation, it will be retained because successful organizations that continue to exist will bear this characteristic (Baum and Amburgey, 2000). 2.2 RADICAL CHANGE THEORY RCT is roughly twofold. One part of the theory discusses the patterns of development in industries. The second part is of more practical and strategic nature and concerns the advantages and disadvantages of different types of organizations when faced with a radical technological change. Following, we will present a description of how technological paradigm shifts alter industry dynamics according to Kuhn and Schumpeter, and how the competition, as a result of a radical technological change, develops in technology cycles. Thereafter we will elaborate on the most prominent distinctions deciding what organizations which prosper when faced with a radical technological change. Finally we will present some well-established definitions of radical innovation. PARADIGM SHIFTS, CREATIVE DESTRUCTION AND TECHNOLOGY CYCLES Kuhn s (1962) highly influential article Structure of Scientific Revolutions explores the accumulation of knowledge and is closely connected to the phenomenon of radical change. He redesigned the foundation earlier scientists based their work on by stating that science does not advance linearly, but undergoes periodic revolutions, also called paradigm shifts. The older paradigm is replaced in whole or in part by an incompatible new one which means that one must choose between these two (Kuhn, 1962). Kuhn s contribution to the literature made it clear that technological innovation does not just happen incrementally, or by a linear accumulation of new knowledge, but revolutionary via paradigm shifts. 5

Schumpeter (1942) proposed a theory that concerned the industry dynamics surrounding the linear development of science and the periodic revolutions. He introduced two terms that described the alternating industry dynamics, namely creative accumulation and creative destruction. Creative accumulation is a technological regime that is characterized by high cumulativeness and low level of opportunities, which leads to more stable environments (Schumpeter, 1942). This period can be viewed as linear accumulation in Kuhn's model. Large and established firms carry out the bulk of innovation incrementally, which leads to an industry structure with high entry barriers and oligopolistic competition. Creative destruction, on the other hand, is characterized by low cumulativeness and high level of opportunities. This leads to an environment with lower barriers of industry entry and exit, as well as a major role played by entrepreneurs and fierce competition. The entry by innovative entrepreneurs is the driving force of the disruption (Schumpeter, 1942) and will introduce a paradigm shift. This disruption will be the initiation of yet another technology cycle. A technology cycle is a term that describes the evolution of the competitive forces when a new product or service is proposed to the market. Due to lower barriers of market entry when a disruption faces the industry, there are many new products or services that would compete to be the dominant design and need to gain acceptance in the industry. This is often called era of ferment. This follows with the era of ferment being ended when the dominant design is set. If the radical technological innovation builds on existing competences, the era of ferment is short (Tushman and Anderson, 1990). In the era of ferment, competition is mainly centered on product specifications when the dominant design is clear, and the focus shifts to process innovation, cutting costs and adding features, but in line with the standard that is established. This process continues until a new substitution event occurs and the cycle repeat itself (Tushman and Anderson, 1990). The technology cycles are shown in figure 2. FIGURE 2 RATE OF PRODUCT AND PROCESS INNOVATION DURING TECHNOLOGICAL CYCLES (P.16, TUSHMAN AND O'REILLY, 1996) 6

THE ATTACKER S ADVANTAGE Different skill sets are demanded to survive during a period of incremental change, than what are needed to adjust to a whole different environment after a radical change (Tushman and Anderson, 1990). Often, organizations that have been successful during a period of creative accumulation are likely to fail under the new environmental conditions because of the same reason they prospered earlier. The routines, procedures and human drive that made the organization able to maintain leadership under the previous conditions will be transformed into chaos and resistance to change. This lack of flexibility is normally referred to as inertia. Inertia is often divided into structural and cultural inertia. Structural inertia is described as a resistance to change and is a result of the size and complexity of the organization, in addition to the complexity of the organization s structures, procedures and processes (Tushman and Anderson, 1990). The structural inertia often increases as the company grows. Cultural inertia is not directly coupled to size, but rather to age and success. A strong culture will increase the organization's ability to pull in the same direction, by ensuring e.g. a common language, values, understanding of how things are done in the organization and a sense of belonging. However, when this strong culture is institutionalized over time, and strengthened by success, the cultural inertia increases and due to increased contentment and arrogance towards threats in the environment, becomes a danger to the organization's existence (Tushman and O'Reilly, 1996). In addition, the cognition of managers has been found to contribute significantly to determining where to search for new technological opportunities and what technologies to pursue. If these factors are not coherent with the current strategy, it may be a major source of inertia (Tripsas et al., 2000). Strong ties to stakeholders may also obstruct necessary responses to be able to implement the change (Sull, 1997). Due to these causes, the fierce competition in a period of creative destruction tend to favor smaller more agile organizations, rather than large market leading firms (Abernathy and Utterback, 1978, Christensen, 1997, Cooper and Schendel, 1976, Foster, 1988, Henderson and Clark, 1990, Christensen and Rosenbloom, 1993). This phenomenon is sometimes referred to as the standard model (Hill and Rothaermel, 2003). We will continue to refer to this phenomenon as the standard model in this paper. The factors deciding if the incumbent or the attacker is to prosper when faced with a radical technological change, are summarized by three factors printed by Christensen and Rosenbloom (1993). 1. The characteristics or magnitude of the technological change relative to the capabilities of the incumbent and entrant firms 2. The managerial processes and organizational dynamics through which entrant- and incumbent firms respond to such changes (p.234, Christensen and Rosenbloom, 1993). 3. The degree to which the innovation will be valued within the networks already served by the innovator, or whether the performance attributes implicit in the innovation will be valued within networks already served by the innovator, or whether other networks must be addressed or new ones created in order to realize value for the innovation (p.242, Christensen and Rosenbloom, 1993). 7