There is a widespread view that opportunities to cut costs in banking are receding as the big intramarket mergers near completion. Don't believe it. Future progress in industry expense reduction will depend as much on vertical dis-integration as on horizontal integration. Otherwise put, merger mania will soon be supplemented by outsourcing obsession.

The surviving megabanks will be uncovering the existence of, or actually helping to create, a vibrant community of external suppliers of what they are now doing in-house. These suppliers will, in effect, be "hollowing out" banks, denuding them of operations the retention of which is burdensome. The development is not optional for banks, or is so only in the sense that the instructions on a life preserver are optional.

Certainly, there is a lot of room to maneuver. Financial institutions are about 50 years behind such seasoned outsourcers as the auto companies. Indeed, measured by the percentage of purchased or outsourced expenses to total expenses, banking companies are close to being the most vertically integrated in the country. Outsourcing in the last decade has increased the ratio of purchased to total bank expenses by only 1%.

We feel that the bank purchased-expense ratio could rise from around 50% to 75%. Such an increase, buttressed by the aggressive monitoring of all types of external suppliers (not cozy partnership arrangements), could improve the standard bank efficiency ratio by between 5 and 10 percentage points in a very short period of time.

Outsourcing has been slowed by a flawed approach to the evaluation of feasible initiatives. In brief, the core problem is an overestimation of what is "core." The bedrock attributes of a flourishing bank are very few. The two most important core competencies are the ability to capitalize on public trust in order to create and manage a brand and the capacity to mobilize and exploit a vast amount of customer-specific knowledge. Most other skills are in effect commodities-technologies shared with a broad community of providers, many of which enjoy greater scale and thus lower costs than even the largest bank.

These basic truths are often concealed by self-deception reinforced by the extensive use of high-sounding jargon. Thus, consumer credit processing operations are often viewed as part of the core because they embrace customer acquisition, transaction authorization, statementing, payments processing, and customer service, all functions for which few external suppliers appear to exist. However, a different and less pretentious way of characterizing these functions reveals that most are applications of three standard technologies: phone operations, data capture, and printing. Disaggregated in this jargon- free fashion, the component credit processing functions seem far more outsourceable.

After stripping away definitional cobwebs, an institution needs to ask two questions: Does a supplier community for a particular function exist or is one coming into being? And could such suppliers provide at least a 20% improvement in cost performance? If the answers are yes, the indicated course is outsourcing. The burden of proof is on naysayers to show why outsourcing should not occur, rather than the other way around. If the answers are no, it might be concluded that the function should remain in- house. But if that is all the institution concludes, it may be missing a great deal.

For example, in analyzing functions that can be outsourced, an institution may uncover the opportunity to itself become an external supplier. If its analysis indicates that there are no feasible outside providers of a given function, this may mean that the bank is ahead of the market. That is, it may be sitting on an asset which can be fashioned into an independent business. Call it a "latent" bank asset, if you will.

Consider the phone operations area. Most outside providers are limited to "smile-and-dial" telemarketing activities. They have little experience with complicated customer service types of functions. But a few banks are starting to acquire such experience. For some, a logical step might be an equity partnership with an existing phone supplier to upgrade capacities. Thereby, the bank can take advantage of increased revenue and also of the lush P/E ratios (much higher than those of banks) accorded to phone operators by a marketplace apparently convinced they will soon broaden their menu of services.

So while banks clearly need to offload a lot of activities, it is a mistake to view them as inherently disadvantaged participants in the outsourcing arena. For some operations the outside-supplier cost and efficiency advantage relative to banks is large and increasing rapidly (e.g., printing). For others it is large but increasing more slowly (e.g., data processing). But for some activities the advantage is negative. In other words, the nod goes to the banks (e.g., besides phone operations, imaging) if only they can bestir themselves and seize the opportunity.

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