As the U.S. banking industry shows signs of recovery, technology experts and regulators are looking more critically at institutions that signed long-term technology outsourcing deals.
The regulators want to make sure that bankers signing deals now are not being shortsighted when they commit to such arrangements, often seen as smart ways to cut costs.
Regulators and others are concerned, too, that the duration of outsourcing contracts -- typically 10 years -- will reduce banks' flexibility to respond to financial and marketplace changes.
This attention comes after a wave of popularity that peaked in 1990 and 1991, when several of the largest banking companies, including First Fidelity Bancorp. and Continental Bank Corp., farmed out practically all of their computer operations in long-term contracts for hundreds of millions of dollars.
The Long View
After these high-profile deals, regulators and industry consultants began voicing concerns that the short-term solutions being provided entailed some big long-term costs.
In such deals, a bank receives a quick boost to its balance sheet when the service provider purchases the bank's computer equipment at above-market rates. The outsourcing company is compensated in later years of the contract, when fee schedules assure that its profit margins widen.
The contracts' financial structures, particularly the early-stage purchases of computer equipment at sweetened prices, were scrutinized by the General Accounting Office of Congress.
A survey it published earlier this year found that 8% of financial institutions and nearly 40% of outsourcing companies had at some time agreed to such questionable contractual arrangements, but industry insiders say the practice has virtually ceased.
Scrutiny Having an Effect
"We haven't seen any abuses at all in the last few months, and we firmly believe that it's a direct result of increased guidance and scrutiny by government agencies," said a high ranking official at the Office of Thrift Supervision, who requested anonymity.
And John Steuri, chairman and chief executive of Systematics Information Services Inc., agreed with this assessment. The practice of loading up the front end of contracts "has waned due to pressure from the regulators," he said. "We heartily endorse the work that they are doing."
But regulators are taking a more general interest in outsourcing, not just in potential improprieties.
Earlier this year California Federal Bank was forced by the Office of Thrift Supervision to forgo a 10-year outsourcing contract with Systematics in favor of smaller deals reviewed on a year-to-year deal basis.
Pressure to Be Prudent
The OTS saw nothing improper or illegal. it just deemed the shorter commitments more prudent, given CalFed's capital problems.
Even so, the GAO report seems to be the main reason that regulators are scrutinizing outsourcing deals. And experts say that scrutiny has had a number of effects.
The first and most important of these is that the lengths of contracts appear to be shorter.
According to Computer Based Solutions, a New Orleans firm that tracks bank technology use, outsourcing contracts from 1989 to 1991 tended to be seven to 10 years.
But in recent months, the typical term has come down to five to eight years.
More Leverage for Banks
While it may be too early to call this a genuine trend, some experts attribute the development in large part to regulators' contentions that shorter deals give financial institutions more leverage to demand the services they need from service providers.
"No one has a crystal ball that predicts what the future holds, so a long-term contract that has no provisions for flexibility can turn into a real quagmire," said M. Arthur Gillis, president of Computer Based Solutions. "The regulators are bringing this point home to those banks that don't realize it already."
As Mr. Gillis indicated, regulators' attention to outsourcing has underscored the need for the periodic renegotiation of contracts to meet banks' changing needs.
Renegotiating Contracts
For example, Bank South Corp., Atlanta, wants to rework its deal with a unit of IBM Corp. to acknowledge the effect of changes in its customer base and inflation.
"It's hard to draw a straight line of cause and effect between contract structuring and regulatory scrutiny," said Harry H. Glasspiegel, a partner at the Washington firm of Shaw, Pittman, Potts & Trowbridge.
He added that regulators and bankers are coming to agreements on the potential pitfalls of long-term contracts.
