Over the past few decades, economic theories have become increasingly sophisticated, borrowing analytical tools from theoretical physics and mathematics. Financial tools have become vastly more complex. Regulators have created sophisticated rules to govern the economy, particularly banks.

So why did we not see this coming? And how did last year’s “strong incentives” and “profit-driven behaviour” become today’s “reckless profiteering” and “abuse of the system”?

One reason is that we neglected basic economic facts and failed to appreciate the evolving structure of industries and sectors. In the past decade, what I term the “industry architecture” – the rules and roles that govern how participants do business – in financial services changed the financial world dramatically, but almost nobody noticed. Most economists did not bother – for them, industry structure (in particular, the business models operating in the sector) is of secondary interest – and they stuck to the mantra that “markets regulate themselves”. Regulators ignored the monumental changes in how money was made, concentrating instead on fine-tuning rules that focused on an ever-decreasing part of the business world. Academics busied themselves with models that had less and less to do with reality, helping to create structures so complicated that they were bound to implode. And management gurus did not want to spoil the party by suggesting that there were no solid foundations for this brave new world.

So much for the bad news. The silver lining to the cloud is that a better understanding of the industry architecture (especially in financial services) will help us to understand both the causes and the remedy for our malaise. This crisis could be a wake-up call, showing us how some companies manage industry architectures to their advantage – and how some industries are dangerously unstable. Armed with this insight, we can take advantage of the opportunities presented by this downturn to reshape companies and even sectors.

What is industry architecture and why does it matter?

Industry architectures consist of the roles played by companies in a sector and the rules (standards, regulations and conventions) that connect them. They define the ways in which money is made – companies’ business models. They influence “who does what” (strategic choices, and what each role is in the industry) – which, in turn, determines “who takes what” (revenues, market share, competitive advantage and profit). However, they are not static – they change substantially over time.

Consider financial services. Over the past decade, we have seen new instruments (securitised loans and, later, collateralised debt obligations), new rules (often promoted by the companies and individuals who stood to benefit from them) and new models (varying types of hedge funds). These changes transformed the way money was made and created new winners: securitisers in the beginning of the decade, hedge funds and private equity shortly thereafter and (until the collapse) all their employees.

What is interesting about industry architectures is that they often change without us noticing; indeed, I only helped coined the term “industry architecture” in 2006. Since nobody is meant to monitor them, industry architectures can lead to boom or bust – or both. If you take a step back and get a sense of the entire system, you might see the risks and opportunities. But if you do not, you might get a meltdown. Thus, each successive change in financial services was eminently sensible in isolation – but their cumulative impact was disastrous, and someone should have foreseen it.

What went wrong in financial services?

The first change was the arrival of securitisers: new players who found a novel way of slicing and dicing risk for profit. The problem was that the risk rating agencies, who were supposed to be the gatekeepers, were not up to the task. Their flawed business model, where profits were made from risk rating and costs were associated with the expertise of the executives doing the rating and the time they spent on it, practically guaranteed that supervision would deteriorate.

Then came the collateralised loan obligation/collateralised debt obligation market, which generated more demand for securitised loans and stretched quality guarantees even more thinly. Hedge funds joined the party, supported by leverage from banks that were exposing themselves to more and more risk – encouraged by analysts and regulators. Finally, generous compensation packages, initially from hedge funds and later from banks (who felt they had to compete for talent by matching these short-termist incentive structures) gave everyone a reason to perpetuate this upward spiral of make-believe.

In this new world of securitised and structured finance, the risk was spread in ways that were hard to measure or even understand. Since nobody was charged with “connecting the dots” of evolving industry architecture, nobody foresaw the crash.

Using this big-picture perspective can help us create new industry architectures while avoiding excessive blame – or misplaced forgiveness – for the current downturn. It is important that policymakers take such a systemic view into account as they restructure this critical sector. As they do, they may want to reframe the pointless debate about “too much” or “too little” intervention of the state. States can set or institutionalise the rules of architectures; and markets are integral, but engineered, parts of architectures, shaping individual and collective behaviour. What financial services need now is a robust architecture, not one where the state simply pours in resources or micro-manages everything. To get it right, we must ensure both that the parts of the system make sense, and that the way to put them together is sustainable.

Changing industry architecture

Many sectors have changed dramatically during the past few years, reducing leaders to laggards and turning newcomers into giants. Consider the early days of computing, where the industry unbundled, vertically dis-integrating, changing the competitive dynamics and even the identity of the sector. IBM outsourced too much during the 1980s giving up critical business functions. Meanwhile, the Apple of the late 1980s was too integrated and closed, losing the battle for personal computing and allowing previously unknown companies to capture the key parts of its value proposition. Both organisations came close to failure.

Microsoft, by contrast, used shrewd agreements to maintain its position as a “bottleneck”, retaining the key parts of the computing value-added process and guaranteeing a foothold in the critical area of graphical user interface, operating system and pre-installed software. Companies such as Microsoft do not just work in a sector – they work on it, shaping the sector and ensuring that the future of the industry will fit their capabilities.

IBM and Apple’s more recent history suggests that they, too, managed to overcome their previous failures by becoming more savvy managers of their sector’s architecture. IBM’s rebirth in the 1990s was based on an open, flexible model that focused on keeping the critical parts of customer handling and higher value-added sectors, while exiting the commoditised parts of the business.

Apple’s return to dominance through the iPod was the result of a cleverly designed ecosystem: by controlling iTunes, design, the brand and pricing, Apple ensured it ruled the environment without needing to integrate most parts of the value chain. In other words, it turned itself into a bottleneck. Because its supplier relationships are so well designed, Apple does not need to manufacture any of the components of an iPod. It also fosters competition between the different “complementors” – makers of speakers and iPod accessories, who agree to play by Apple’s rules and create an installed base of compatible products. So, the company’s success stems, in large part, from its ability to build a new industry architecture.

Even when no single company dominates a sector, profits migrate as industry architectures change. Consider the increasingly untenable position of large telecommunications operators, which have been challenged by new ways of making money and having to reposition themselves constantly vis-à-vis content providers, handset manufacturers and service providers. Or consider healthcare, where traditional pharmaceutical companies are having to change their value-adding activities as demands for personalised medicine and more advanced care change the landscape. The new winners will be the companies that manage to adapt, changing the way they make money. In every industry, success flows from the ability to adapt to (or reshape) industry architecture and your role within it.

Rethink your role, reshape the architecture – especially in a downturn

As downturn becomes recession and credit evaporates, other industry architectures are up for grabs. Recessions cause transformations in the way we do business. The 1970s downturn gave European and US manufacturers the chance to change their practices and reorganise their supply chains. The early 1990s recession helped spur the growth of outsourcing, and the IT slump at the start of this decade ushered in a new type of networked organisation and flexible workers.

When sectors are growing, everyone is busy making money. They carry on doing what they have always done, even if it is inefficient, and nobody wants to voice any doubts or change the sector. But when the going gets tough, companies are willing to consider entirely new ways of doing business, and established leaders may be unable to prevent changes in the structure of their sector.

Consider the UK construction sector, which was stable for decades and inefficient for a very long time. New ideas such as “design for buildability” and “design for cost minimisation” only took hold when the 1990s recession forced existing players to change their structures and span more parts of the value chain in order to survive.

Crisis means new industry architectures. That means new opportunities for those who can adapt and challenges for those who think that a downturn can only mean lower output, lay-offs and retrenchment. Customer needs are different in a downturn: consumption shifts from an aspirational, image-driven model to an emphasis on thrift and value, as we can see from the spike in sales of low-price retail chains such as Aldi, Lidl or Wal-Mart over the Christmas period in Europe and the US.

Business-to-business relationships are being redrawn, shifting the focus from growth to preserving cash. Capital markets are preoccupied with risk. And regulators are aiming for corporate survival at all costs, where once they sought competition. This is why downturns are associated with rapid changes in a sector’s pecking order – a threat for those at the top and an opportunity for those hungry for success. So what should companies do?

Writing your rags-to-riches story

Adapting to a new reality, changing the way you do business or reshaping your industry’s architecture is no mean feat. First, you need to work out how you can add value in the new environment. This requires realigning what the company does to match emerging needs. It means reconsidering how the organisation is structured, and how its financial and capital structure translates success into results.

To do this, you must clearly express why and how a company can add value, and explain how it can continue doing so as the downturn deepens and conditions change. You have to decide how to reposition the company in the sector, distinguishing between temporary lulls and profound cyclical changes, and consider what could be tenable in the future. You need to plan for the worst while plotting your course to emerge stronger from this difficult period.

You must also leverage the needs of other companies to gain a strategic and architectural advantage for tomorrow. As economic conditions change, companies that you deal with will develop new priorities; they will be less concerned about structuring their long-term plans or positions than preserving cash or addressing immediate needs. So, in exchange for accommodating their short-term requirements, you could build a relationship to enhance your long-term prospects. And consider how you can capitalise on cheap resources available today: most of the technology-based companies that were hiring in the wake of the 2001 stock market crash reaped handsome returns from the exceptional talent they could afford to lock in. Strategic recruiting of bright graduates now could lead, a few years down the road, to a formidable strength.

You might also have the opportunity to occupy the niches that other companies are being forced to leave (especially in emerging markets). This is one of the reasons why some companies can grow in leaps and bounds during downturns and why established leaders are particularly vulnerable, even if they appear less prone to going under.

It is like judo as opposed to boxing: using rivals’ weight to your advantage. Most of today’s giants initially positioned themselves as allies of existing players, carving new business models, reshaping industry architectures and gradually improving their positions. They shaped their own long-term future by understanding and meeting the short-term needs of the companies around them.

Consider a company such as Velti, an upstart in the interface between mobile communications and advertising. It re-shapes the nature of the sector around it by updating its business model as the sector evolves, and shifting its compensation model to a results-driven structure, to preserve cash for its clients and reduce their perception of risk in a technology venture. Or consider more established players that capitalise on growth opportunities caused by the downturn, such as the hedge funds and private equity groups with plenty of cash that are starting to replace functions traditionally performed by investment banks. It is essential to redefine yourself as needs change.

But many companies do find themselves in crisis management mode. In order to move forward, they need to address the causes of diminished performance, not the symptoms. This, alas, does not come easy. In a crisis, organisations often resort to fire-fighting or papering over the cracks. They try to cut costs to deal with declining revenues, often spreading the pain equally across lines of business or functional divisions. Worse still, they might eliminate the areas that appear “easy to cut” in the short-term, cashing in every investment regardless of its medium-term prospects. This risks throwing the baby out with the bathwater.

Instead, companies and their leaders need to recognise that changes in customers and markets require a wholesale rethink of their value proposition, business model or financial structure. Focusing on the basic questions of how value is added can help companies save themselves from a spiral of cost-cutting and lay-offs that ends in administration regardless.

Thinking about industry architectures can also help to dispel the gloomy introspection that accompanies downturns. In tough times, everyone looks inwards, obsessing over redundancies, politics and re-organisation – losing touch with customers and the market just when they can least afford to. Finding a way to refocus on value, on what lies behind the financial results, could help to combat this dangerous tendency. It could be just the challenge you need to energise and awaken the talent in your business and restructure your company and your sector.

Companies that have the courage to do so, do much more than manage their operations and costs to return to profitability. They identify which parts of their business are viable and which are not, taking the crisis as an opportunity to take a strategic look at their future and that of their sector.

We know that companies do not change unless they are forced to, and that managers have used “burning platforms” as an opportunity to reorganise from time immemorial. The good news is that no one needs convincing that the platform is burning. The flames are around our ears. What is important now is not to let a good crisis go to waste.

Michael G. Jacobides is associate professor of strategic and international management at London Business School and the Sumantra Ghoshal Fellow at the Advanced Institute of Management
mjacobides@london.edu

Copyright The Financial Times Limited 2009