The banking industry is at the tail-end of a consolidation period that will cut the number of “brick and mortar” banks by as much as 25 percent by the end of the year, according to the National Association of Economists. This decade-long acquisition and merger binge by banks has created plenty of business opportunities for outsourcers that have the capabilities to help the banks with reorganization and consolidation of their IT infrastructures. By outsourcing the consolidation of its IT functions, the acquiring bank can cut costs and reduce risk according to Mike Littell, president of the U.S. Banking area of EDS’ Diversified Financial Services business unit.
The banking industry has transformed itself over the last decade. Seven of the 10 biggest commercial-banking companies of 1988 as ranked by Fortune have been acquired since that year. Citicorp was acquired by Travelers Group in October 1998, Chase Manhattan by Chemical Banking in March 1996, Security Pacific by BankAmerica in April 1992, BankAmerica by NationsBank in September 1998, Manufacturers Hanover by Chemical Banking in December 1991, First Interstate Bancorp by Wells Fargo in April 1996, and Bankers Trust by Deutsche Bank announced December 1998. The last decade has been one wild ride topped off by 1998, which was the biggest year ever for takeovers, according to dollar-volume estimates.
The Driving Forces Behind the Merger Frenzy
The reasons for the amount of acquisition activity are quite simple. First, federal restrictions were relaxed in 1994. Before deregulation, banks could acquire other banks in more than one state, but they had to operate as separate companies. When the new laws passed in Congress in 1994, acquisitions outside the state of the parent bank could operate as branches of the parent bank. Second, there is a lot of money in the system. And third, there are too many banks. In the age of virtual business, most banking customers don’t need “bricks and mortar” banks once an account has been opened. And the saturation of banks has led to brutal competition. And competition leads to consolidation.
“Shareholders are demanding consolidation because they want to capitalize in a growing economy,” Littell says. “Because we have been riding a bull market for over ten years, there is more money in the hands of institutional buyers. So as a result banks have the ability to gain new market share. Banks can either go out into new markets and fight hand to hand with their competition or they can buy the competitor and increase market share quickly and gain immediate payback on their investment.”
Mitigating the Risks of Merging
Outsourcing can help the merging institution get to the new market a lot safer and a lot quicker, Littell says. One way this is attained is by allowing a vendor like EDS to come in for a brief stint of 24 to 30 months and manage the IT change. Once an acquisition has been finalized, the acquiring bank has to run on two IT infrastructures, which includes two IT data centers, networks, helpdesks, check processing systems and two sets of system engineers and business analysts. The bank’s ultimate goal is to merge these two infrastructures into one integrated unit.
An outsourcer can relieve the bank of the duality of the fixed cost infrastructure that the financial institution has inherited and turn it into a variable rate service, he says. So the vendor, in essence, becomes the change agent for the bank and handles its transformation. The advantage of a vendor coming in short term is that the bank doesn’t have to inherit a huge cost. Instead the outsourcer will take the risk and put the cost on its books. This outsourcing model mitigates the banks’ risk by taking away any responsibility the bank would have of disposing of unneeded assets after the overall conversion is done. The extra assets of hardware, software and people may not be as valuable to the bank as they are to a company like EDS because they can deploy them to satisfy the requirements of other customers, he notes.
“The bank is reinventing itself into a newer, bigger company,” Littell says. “This model allows the acquiring bank to retain their focus on the business of banking. They now have their own customers plus a whole new set of customers they want to keep. So their focus is marketing, selling new products, getting their products to a common set, and handling training for their sales personnel. What they don’t want to do is ramp up fixed costs in IT to handle the overabundance of work that has come their way for a short period of time until they get it converted to one network.”
Deciding Between Two Outsourcers
Sometimes a decision has to be made on what outsourcer to use after an acquisition. Often both merging organizations are using outsourcers and what ends up happening is that there are two outsourcers that are doing the same task. Littell says that the acquiring company usually resolves the issue. The outsourcer that is currently doing the work for the acquiring bank is typically the one that is looked upon more favorably, primarily because it knows the agreement, the cost and the service levels, and it has already been through the process of competitive bidding. Consequently it has already proven to the acquiring bank that it has the core competencies within that particular operation to deliver a cost benefit to the bank.
This scenario played out when the Bank One Texas subsidiary, one of EDS’ customers, of the Bank One Corp acquired a banking franchise in Louisiana last year. Since EDS was the incumbent outsourcer to Bank One and was already doing a large portion of its outsourcing, they selected the outsourcer to help with the transition and provide service for the new banks. “They knew our core competencies in doing conversions and they also were able to prove that there was a cost benefit to going with EDS for that acquisition,” he says.
It was also the case with Washington Mutual (WAMU), which is approximately a $150 billion banking institution on the West Coast and is headquartered in Seattle. Over the last year WAMU has gained about $100 billion in assets by acquiring Great Western Financial Corporation and Home Savings of America, both out of Los Angeles. As a result it put WAMU into three highly profitable markets – Texas, Florida and Southern California.
EDS provides check processing services to WAMU and has a national infrastructure to handle check processing, Littell notes. So EDS was chosen to continue providing these services to the new units. “The requirements came to us because we could offer [the bank] a stable environment, one that did not have to change dramatically,” he says.
“As a result they end up having accountability for their project, they end up having improved time to market and they mitigate the risk factor of the acquisition. These are all important things to consider when putting together an overall business case.”
Littell thinks that the acquisition phase in the banking industry will begin to wind down soon. “Ultimately, the banks will have to prove their business case — that market share really did bring them new profits and increased growth and efficiencies.”
Lessons From the Outsourcing Primer:
- Relaxed federal regulations, a bull market and the saturation of banks has led to a record number of bank acquisitions in the last decade.
- Merging helps a bank gain market share quickly.
- Outsourcing can help the acquiring bank get into the market a lot quicker and a lot safer.
- The incumbent vendor of the acquiring bank is usually chosen to continue the outsourcing services if there are two contractors doing the same task.
- The acquisition and merger frenzy will soon die down, as banks will have to prove their business case.