Will the current economic downturn lead to less investment by banks in technology and an end to the double-digit information technology budget increases we’ve seen in recent years?

TowerGroup projects that U.S. banking institutions will spend $31.4 billion, or almost $17,000 per employee, on information technology this year. This estimate is based on a broad definition of spending that includes both internal and external spending across hardware, software, and services. “Internal” spending includes fully loaded employment costs of staff and their managers, including associated facilities. The reality is that investment in technology has become a major necessity on two important fronts.

First, one of the great effects of technology on financial services is to make traditional demarcations increasingly obsolete, as technology makes it easier for institutions to quickly move into each other’s “space.”

Second, financial institutions view technology as a necessity that enables them to respond to elevated consumer and business expectations. Retail customers want products and services that match their increased prosperity and changing lifestyles, and businesses want quick, reliable, and global access to information and finance.

As banks get bigger, technology spending grows as a proportion of both revenue and noninterest expense. Industry technology spending is gradually becoming a larger share of bank operating expenses, partly in response to the emergence of technologies such as the Internet.

Though the number of banks in the United States continues to decline, industry spending on information technology continues to grow. In fact, continuing industry consolidation supports rising investment, since larger institutions spend disproportionately more on technology.

Three institutions alone, Citigroup Inc., Bank of America Corp., and J.P. Morgan Chase & Co., are expected to spend a combined $11.8 billion on information technology this year, or 40% of the industry total.

Further consolidation will help ensure healthy annual increases in technology investments in the longer term. Despite the perception that financial services are already highly concentrated, a comparison with other industries suggests there is a long way to go.

Citigroup, the largest and most global banking institution, has a market share of just 3% or 4%, compared with General Motors’ 30% and Wal-Mart’s 40%. Wal-Mart, a U.S. discount retail chain, is so large that it has more people working for it than are believed to be employed by all the dot-com companies in the United States.

Many have pointed out that in the near term, a slowing U.S. economy and falling profits for banks, combined with an end to a period of large-scale projects such as the year 2000 date change and adoption of the euro, suggest there will be slower growth in bank technology spending.

Crucially, what many overlook is that a big proportion of technology spending is maintenance-related. The result is that much technology spending is relatively insulated, at least in the short term, from cutbacks that may affect the business generally.

This is truer in banking than in the securities industry, where spending has grown at a rapid pace in recent years as firms invested heavily to develop businesses like online trading. Proportionately, far less “discretionary spending” is going on in banking, which consequently has less room for cutbacks.

If a prolonged downturn were to occur, institutions might choose to outsource more as a means of internal cost-cutting. Traditionally a back-office endeavor concerned with extracting scale economies from high-volume processing (such as check processing), outsourcing has evolved to become more acceptable to financial institutions for other parts of their businesses.

In the past, for instance, institutions were reluctant to let third parties (outsourcers) interact directly with their customers, but that has changed. Front-end customer acquisition for consumer credit, for example, is a thriving business among specialist outsourcers catering to large community banks and, in a few cases, large money-center institutions.

During a longer period banks could, of course, choose to accelerate their decisions to outsource or find other ways to cut information technology spending (mergers, third-party solutions, etc.).

Banks will continue spending a bundle on technology -- not because they necessarily want to but because they have to.

Though an economic slowdown has begun, most technology spending is relatively insulated from short-term cutbacks. In the long term, however, changes are occurring -- such as a switch to outsourcers and third-party solutions -- and these shifts will probably accelerate if a decline in bank profitability starts squeezing technology budgets in the period ahead.

Mr. McEvoy is the director of strategic information technology investments research at TowerGroup, a Needham, Mass., research firm.

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