Shakeouts in Businesses

Sometime back in a strategy class, I told my students that several sectors in the economy were growing and expanding for the benefit of the country. However some sectors including banking and insurance had too many players and in the near future, there will be a shakeout. The shakeout would involve failure, closure or a merger of weak institutions. Banking sector in Uganda has over 20 banks and over 25 insurance companies. As the industry matures there will be a shakeout and we shall have less than 10 banks and a similar number of insurance companies.

It was the Austrian economist Schumpeterian who saw that when there are innovations in an industry, a variety of new firms enter the industry. The early entrants make profit and it is this profit that attracts new entrants. The entry depends on entry and exist barriers. For instance, telecommunications require heavy investment therefore you cannot have many new entrants. The cost of entry is a barrier. Neither is it easy to leave because the entrant has put in lots of money. For sectors where  entry costs are low for instance insurance, FM Radio stations, entry does not require heavy investment and consequently  increase entry. Entry into this banking sector in Uganda has not been extremely restrictive. At the moment, you require only about USD 10million to establish a bank. For international investors and most of Uganda’s businesses, this is no big deal. As new firms rush into an industry, competition intensifies. The behavior of firms during intense competition is either to exit, buyin or merges costs of existing firms. Firms will exit if they cannot make profit over several years. They will either close voluntarily or involuntarily. If they feel they can continue to exist but with lower margins, they seek to buy weak existing firms, others simply seek out of existing firms to merge to get advantage of scale.

This is the shakeout that Schumpeter predicted. It is usually entrepreneurial firms that survive. Fools rush in, is a description of these firms that enter the industry just because it looks attractive. Such firms are shaken out of the industry. The Bank of Uganda according to newspaper reports has just closed Global Trust Bank. It is reported that it has accumulated a loss of USD22.5million. Remember the start is USD 10million, if they do not make profit; they eat not in their investment but depositors funds. I hope customer deposits are safe and this loss was covered by the Bank reserves. Luckily where a business closes, customers suffer inconveniences but somebody else, another firm, picks up the product or service and provides. Shakeouts are good for both industry and customers. It eliminates poor players who are loss making, it enables only firms with good products and management to survive.

As the economy grows and attracts businesses, we will see shakeout in different universities, insurance companies, schools, FM radio stations, and of course in small sectors like furniture, metal works where we cannot see the impact.

Business failure is good for the economy since it eliminates inefficient high cost producers and for the customers, worry not for the failure of the business but that of the entrepreneur.