Is there a first-mover advantage? (June 24, 2008)

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Is there a first-mover advantage? (June 24, 2008)

Being the first to branch in a developing market has advantages, but research shows that followers are often better off

By Brian Diepold, Ph.D., senior manager, client services, Pitney Bowes MapInfo—Financial Services Practice

Bankers often are faced with uncertainty when making decisions about branching into newly developing markets. High growth projections and lucrative development plans can be hard to ignore, and in most markets new developments are the only opportunities left for a bank to be first to market. A further consideration is that the concept of a first-mover advantage has been prominent in theory and practice for decades. The reasons are fairly intuitive and simple—the first mover can quickly gain and hold share, potentially grow faster and retain a lasting advantage. But do data support that belief?

Branch expansion is a risky endeavor. While the recent boom in the number of branches appears rational based on deposit and population growth, there are risks involved with the high capital expense required. As a result, banks are rewarded for placing a high value on the performance of their branches as the central hub for customer service and product delivery. In turn, banks consistently seek to gain a competitive advantage through branch decisions.

It often feels like a good strategy to be the first bank to open a branch in a newly developing part of the market. Intuitively, one might reason that the first branch could benefit from early brand awareness, capturing sticky customers, and by having the first option of location. But, not everything is clear on the first pass.

In the case of branch banking, many other factors are important to understanding whether there is a benefit to entering a new market first. For example, the costs to customers to switch banks are decreasing, resulting in less loyalty, more price-chasing behavior, and ultimately more opportunity for follower banks in the market to capture customers.

Additionally, there may be more information available to later entrants in a new or previously underserved market area. The first mover may locate its branch in a new development that is expected to provide them entry to new growth in the marketplace. Over time, however, that market may develop differently than they expected and a later entrant could open a branch in a better location based on those market developments.

Another possibility is that the market-level first-mover advantages typically seen in banking may not apply at the micro level, where each branch’s performance is dependent upon its competitiveness with other nearby offerings.

What does the research say?
What bankers want to know, of course, is whether there really is a first-mover advantage to be gained in branch banking. Pitney Bowes MapInfo produced a statistical analysis of whether this advantage exists. Using the Branch Source Dataset from Highline Data, we identified a sample of first-mover and follower branches that opened from 1993 to 2000. From this, we analyzed the growth history of the branches opened in the same markets.

The findings indicate that there are some short-term advantages available for the first movers, but over time the followers are able to attract a greater level of deposits compared to their incumbent peers, and the latter effect appears sustainable over the long term. The first chart depicts the change in the first-mover advantage ratio based on the age of the branch. Each first mover and follower is compared at the same ages rather than at the same point in time to allow for equal maturation of the follower compared to the first mover. The results show that first-mover branches achieve relatively higher deposits than followers in the early years after opening, but are soon outpaced by follower branches. First movers outperform their followers where the bars in the graph are below the line representing equal performance, while the followers are performing better beginning in the fourth year where the bars are above the equal performance line.

These results suggest a long-term advantage to follower branches. We also performed a simple net present value analysis based on these findings. Assuming constant revenue-to-deposit ratios for all branches, 12% discount rate and common expenses, first movers generate a lower net present value.

Lone entrants under perform
Earlier we mentioned that decreasing customer switching costs and a high degree of information availability could limit potential first-mover advantages. In addition to those, banking products are infrequent purchases, such that it may not be a significant advantage for a bank to open their branch a year or two earlier than a competitor because that may not yield them access to superior sales opportunities. If the typical customer makes a banking decision once every 3.5 years, then there should be sales opportunities available to the branch whether it is the first to a local market or not.

Most importantly, the first-mover branches assume greater risk than the followers. The first clue that significant risk exists in acting first is that our study identified 214 first movers with followers compared to 1,072 lone entrants. The five-to-one ratio of lone entrants to first movers suggests that most of the markets entered were not as fruitful as those banks initially believed. In one sense, the followers have the opportunity to observe which markets have been entered and potentially which markets have been entered successfully.

This is further supported by the lackluster performance of the lone entrants. For example, after operating in the market for five years (see second chart), the average first mover has deposits equal to approximately 39% of the average U.S. branch, while the typical follower branch deposits has equal to 43%, and the lone entrants a meager 24% of the average U.S. branch. This data combined with the net present value advantage to follower branches is strong support of acting patiently when entering new or developing markets. Lone entrants—or first movers without followers—are not only a common occurrence, but their performance is far inferior to other new branches.

It is certainly possible that followers are able to gain knowledge of the market potential by observing the performance of the first-mover branch. Evidence of this learning potential for followers was found in the research.

The results suggest that the order of followers is positively related to the advantage ratio, meaning that the second follower to the market gains a greater advantage relative to the first mover than the first follower in a market. This is interpreted as evidence of opportunities for followers to gain knowledge from the actions of the first movers and from the development of the market.

This knowledge allows the follower branch to avoid much of the downside risk of entering less profitable markets. Once this additional knowledge is coupled with the commodity-like nature of retail banking, the result is that follower branches have at least equal opportunity as their first-mover peers, with less risk involved.

Patience and planning

In many markets today, the most likely option for being the first branch to market is to be part of a new development. This can be a particularly risky approach given the dependence on developer’s plans and new households being occupied early enough in the life of the branch to make it profitable. To the extent that development and retail use patterns shift over time, the follower branch could benefit by having more information before entering the market and be able to gain an advantage over the first-mover branch that has assumed the initial risk of the market.

The issue cannot be simplified to a set of rules that suggests always or never open the first branch in a new market. But, the findings suggest there is no evidence of long-term first-mover advantages in branch banking, and that should be enough to remind banks that they need to put location-intelligent research behind branch planning decisions. BJ

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