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Evolution, revolution – or business collapse?

Themes: Innovation

Evolution, revolution - or business collapse?Understanding, and reacting to, business model innovation

“To a certain extent, the failure of banks following the credit crunch was the result of business model innovation,” says Cambridge Judge Business School’s Dr Chander Velu, University Lecturer in Marketing and co-author of new research in this field.

CEOs around the world have business model innovation at the top of their innovation priority list. This isn’t surprising when, a recent IBM survey suggests, firms that emphasise business model innovation – innovation that involves not one but several elements of the marketing mix (product/service, price, promotion and distribution) – have grown their operating margins faster than their competitors.

Yet dealing with the opportunities and the challenges that this form of innovation poses is far from easy: the recent collapse of both Northern Rock and Bear Stearns, the fifth biggest investment bank in the US, was the result of business model innovation that did not factor in possible sudden changes in market conditions. So says Dr Chander Velu, co-author of the new research paper Evolution or Revolution? Business Model Innovation in Network Market.

Business model innovation can create huge opportunities for the firms that introduce it – well known examples include, Apple, Dell, and Google – while often simultaneously killing the market positions of others. “But because it involves systemic changes to the revenue- and cost-structure of firms, business model innovation can be hard to detect and even harder to implement,” says Dr Velu, who co-authored the new study with colleagues Professor Jaideep Prabhu and Rajesh K Chandy. “Yet it has profound consequences for businesses.”

For example, he says, “to a certain extent, the failure of banks following the credit crunch was the result of business model innovation. Northern Rock and Bear Stearns both failed because of the way they switched their business models.”

Both banks, he says, had previously seen that it was cheaper for them to borrow money in the money markets on a short-term basis to fund assets than to borrow money long-term, on which they had to pay higher interest rates. “This changed Northern Rock’s whole proposition to customers, because they could pass on the effect of the lower interest rates they were paying by offering customers more attractive mortgages and in the case of Bear Stearns they invested in less liquid assets which earn a better return.” But what the banks did not factor in, adds Dr Velu, “was what would happen when the markets dried up. These incidents are rare, because markets drying up is a rare occurrence. But when lenders’ confidence collapsed because of the collapse in the US housing market, the value of these assets fell. Consequently, lenders didn’t want to lend. It was that which caused the failure.”

So business model innovation can be risky – and not just for the first firm in the market to implement it. Business model innovation can make the fortunes of some firms while threatening those that operate more traditional means of revenue generation. Dr Velu’s paper also looks at how incumbent firms that have not yet implemented such innovations react when their competitors do so.

In their study, the researchers first created a game theory model to develop hypotheses about how established firms in network markets would react when rivals introduced business model innovation. They then tested out their hypotheses with empirical research into the business model innovations developed by investment banks in the US bond market in the early part of this decade. There, after the arrival of a new entrant whose business model harnessed the advent of Internet technology, fellow banks had to decide how and if they might migrate their trading in bonds from phone dealing through brokers to much more open electronic platforms.

“Faced with the prospect of business model innovation, an incumbent firm has to grapple with some important decisions,” the research says. “Should it act right away, while the market for the new business model is still nascent, or should it wait till the market becomes more substantial? In either case, should it introduce a business model that involves substantial changes to the existing revenue and cost structure, or should it simply make marginal changes (if any)?”

To get answers, the researchers interviewed the investment banks. They wanted to test out their theory, for example, that it is the less dominant established firms who are likely to respond first. This did indeed turn out to be the case in the bond market the researchers studied, where the arrival of a new entrant, Trading Edge, which used the Internet to start a direct bond trading model, spurred several of the less dominant banks to join forces and create an electronic corporate bond trading platform called MarketAxess, with marginal changes to the business model.

The bigger banks, shored up by their significant market shares and customer bases, were able to wait a while longer before they made their move. When they did so, however, in line with the researchers’ hypotheses, their move was much more radical. The launch, by Goldman Sachs, Merrill Lynch and Morgan Stanley, of BondBook (which allowed direct trading between market participants in an open platform with live bids and offers) set the stage for a total transformation of the US bond market.

Business model innovation is a fairly new phenomenon, says Dr Velu. “If you search for the term ‘business model’ in articles in The Financial Times, you will find that where there were only 10 articles about this subject in the entire year 1995, by 2007 that numbers has risen to 650-700 articles.” It is also evolving fast, he says, since the advent of new technology is leading to a blurring of lines between formerly separate industries (for example telecoms and entertainment), thus allowing all sorts of new business models to emerge.

But as such change happens, he says, we need to understand it better. Even the biggest and apparently most invincible firms sometimes have to respond to rivals’ business model innovation. Take software giant Microsoft. Companies such as Yahoo and Google have in the last few years threatened Microsoft’s dominance by offering free online and on-demand software tools that make people less dependent on Microsoft applications. “Now this poses a problem for Microsoft,” says Dr Velu. “It has a huge community of customers who already buy its ‘shrink-wrapped’ software, and so it didn’t want to cannibalise that customer-base by offering online software. But when Google started doing this, Microsoft could see that if they didn’t respond, Google could destroy their business.” Microsoft has indeed done so, both with a failed bid to buy up rival Yahoo, and its own move into online software services.

When business model innovation can pose this much threat to firms, no wonder the researchers say that “understanding the foundations of business model innovation is crucial for the long-lived competitiveness of firms.” And by highlighting the systemic nature of business model innovation, they add, “this paper seeks to sensitise managers to the challenges associated with such innovation.”