1 Myth About Competition -- Busted!

We like simple rules of thumb that apply to every situation. "The early bird gets the worm," or "If you don't have something nice to say..."

Rules like these just make life easier. 

Unfortunately, they don't always work. And that can make a huge difference in how you invest your money.

Competition is often accepted as a good thing. But recent research shows how competition can sometimes actually make things worse -- for example, with banks and the financial crisis.

What you need to know
A European Central Bank analysis issued earlier this year looks at the market pressures facing the banking industry over time, and how they gave rise to an unsustainable competitive environment.

For much of the 20th century, banking was heavily regulated. There were very strict limits on what banks could and couldn't do, and the U.S. even instituted heavy restrictions on bank expansions between states. This limited the number of ways in which banks could one-up their competitors, and it kept the sheer number of banks fairly large.

Deregulation changed these dynamics. Once banks could partake in investment activities, cross state lines to expand, and compete against each other with new products and services, competition heated up.

According to the ECB study authors, access to securitized products took things over the edge. Being big and widespread is one thing; taking on increasingly larger risks in order to get bigger, faster, and stronger is quite another.

Why did competition heat up so much? 
Consider the incentives. Pretend you're a bank, which traditionally are pretty boring. You take deposits, you make loans, you hold those loans, and you make money from interest payments. Are you falling asleep? Of course you are. It's not supposed to be exciting.  

This might have been a boring business model, but it was a stable business model. One you could stick with (and invest in) for the long haul. But then deregulation happened.

Let's try an easy example. Imagine a friend asks to borrow a sizable amount of money from you. As much as you like your friend, you're probably going to think about whether he or she will pay you back -- after all, it's a lot of money. If you aren't 100% convinced, you might decline to loan the money.  

Now pretend you know a guy who is willing to buy the debt from you. The terms are pretty good, because he really wants to own this loan for some reason, so maybe you lend the money even if it's a big risk. After all, you're getting paid either way, right?  

Now put this in a context in which everyone else is doing essentially the same thing. Your friends are all making lots of money by lending money to their buddies and selling the loans to someone else. It seems like everyone wants loans, so the money is just pouring in. 

You want to look good in front of your friends, right? So maybe you start lending more money, too. 

Oh, and banks have investors who want to see success -- so the pressure comes from outside as well.

What does it mean?
In the end, the banks that weathered the crisis the best were those that underperformed beforehand -- those that didn't seem to know how to keep up with the times and remain competitive in a changing world.

That's because they remained, well, boring.

What does that mean for you? Competition is an ambiguous thing, and it's useful to think about how competitive pressures impact a particular industry or business. Are businesses getting involved in unsustainable practices? Are they taking on too much risk? Are they making their product worse in order to boost margins? 

When answering these questions, remember that competitiveness can also be misleading -- what looks like an ability to compete today could be masking a great deal of weakness tomorrow. Slow and steady can win the race -- if you let it.

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