The inflection curve is a concept that I became familiar with by reading Andy Grove’s biography, Only the Paranoid Survive. In his words, “A strategic inflection point is a time in the life of business when its fundamentals are about to change. The change can mean an opportunity to rise to new heights [for newcomers or incumbents]. But it may just as likely signal the beginning of the end.”

Three Points on the Inflection Curve
During 2007-2008, the financial services industry hit a strategic inflection point during which the banking business changed rapidly and virtually all players (perhaps with the exception of collections and risk management experts) started to decline in performance. The industry performance curve has continued to decline. However, in recent months the position of banks and the business units within them is showing increased divergence.

 

Most businesses rest on one of three positions on the inflection curve:

 

* Continued decline. These are the banks whose loan losses are still not under control. Management remains highly concerned about the extent of losses, such as in commercial real estate, while expecting another shoe to drop. We recently listened to about ten quarterly report calls. In several of them it was apparent that management did not know when they would hit bottom; you could “smell the fear” as one banker commented about his bank. (Interestingly, one of those banks had a huge stock price rise last week due to the surge in industry prices; the fundamentals would suggest prices should head in the other direction.) A bank on the decline needs to be very concerned that as the industry picks up his bank will continue to go the other direction and spiral downward, ultimately disappearing or becoming an irrelevant institution.

 

Most recently, the entire industry suffered from the downward inflection point, but those that continue downward during the next inflection point will likely disappear.

 

* Beginning to stabilize. These banks have already increased provisions to a sufficient degree, taken losses, and see the light at the end of the downward sliding tunnel. In many cases we find that management of these banks is so gun shy that they will not act to exploit possible growth opportunities. Ironically, they are approaching stability but still operating as if they are heading downwards. Their excess of caution is resulting in missed opportunities. But as a columnist in the New Yorker wrote recently, companies are more afraid of sinking the boat than missing the boat, meaning they are more concerned about leading their company into a downward spiral than missing an opportunity for growth. This represents a belt and suspenders approach that, to mix metaphors, is happening after the horse has escaped the barn.

 

* Stabilized. These fortunate few have their problems under control (although remaining vigilant on risk). They may have paid back TARP funds or are about to do so. They may be one of the banks that passed their Stress Test with no need for additional capital or may have recently issued capital. Based upon press reports only, a bank such as U.S. Bancorp may be in this group. Many community and regional banks also fit into this category.

 

Degrees of Freedom Differ
Depending upon the category a bank falls into, they operate with different degrees of freedom and different upside opportunities. Banks in continued decline operate with close to zero degrees of freedom, scrambling to survive while focusing on regulatory and investor concerns. They have little opportunity to think about growth strategies or market positioning over the next three-five years. They are very much next month- and maybe next quarter-oriented.

 

Those that have reached stability are on the other extreme of the curve from the declining banks. These few are in the envious position of developing and executing on growth strategies that can result in taking increased share from the laggard banks.

 

For us, the group that is approaching stabilization is the most interesting. In our view they represent the majority of banks today. Understandably, however, as noted above they remain frozen, unwilling to commit to expansion opportunities despite their inherent attractiveness. It is easy for an outsider to say that a bank should consider growth. We have not undergone the stress of worrying about performance and capital and investors, and regulators, etc. The good news is that sticking one’s toe onto a growth path will unleash pent up energy and frustration within the bank. We know many bankers who are anxious to return to growth and believe their institutions are ready to do so.

 

In particular, individual lines of business within banks are frustrated. We find business units often are on different positions of the inflection/growth curve from their parents. Groups such as commercial finance, wealth management, small business, and other areas present attractive risk-adjusted growth opportunities to their banks. The market opportunity is there, the competitive dynamics are in the bank’s favor, and the potential returns are attractive. Nonetheless, the parent companies continue to “keep their powder” dry in case an unexpected crisis arises and, hence, refuse to commit to growth.

 

While this type of caution is totally understandable, it is also unfortunate. Executives need to fight against the tendency to circle the wagons even when they fear the stray arrow might show up. Why take this risk? Because over the next quarter, or two quarters or year, the risk of doing nothing will be greater than taking measured steps toward growth.

 

Concluding Thought
In thinking about the inflection curve, senior management needs to begin by assessing the position of the overall bank and its major business lines on the curve. Those banks that believe they are reaching stabilization and have attractive business lines to exploit should make certain that the plans exist to do so. Whether implemented now or next year, the economic crisis will shift to a growth opportunity; banks should prepare for growth now.