Of the many challenges confronting banking today, three are of surpassing importance. They are: (1) raising the unsatisfactory revenue growth in many business lines; (2) capitalizing on the scale economies available in many specialty businesses; and (3) reinvigorating the lagging retail franchise.

For many banks, meeting these three challenges necessitates formal mergers with other banks or nonbanks. Clearly, however, formal merger is not the only way to cut costs, raise revenues, and acquire the wherewithal to make investments in new products.

Much can be accomplished along these lines through a variety of activities that fall short of actual merger but can nonetheless achieve many of its objectives. These activities can be grouped under the heading of alliances - associations among banks or between banks and nonbanks to do together what was formerly done separately.

One can envision revenue-enhancing and cost-cutting alliances penetrating several areas of banking life.

For the moment, however, alliance activity is centered on bank transaction processing businesses - those technology- and operations- intensive activities that soak up about 20% of overall bank noninterest expense but would preempt much less if there were a higher degree of interbank cooperation. (In Norway, for example, the entire banking industry uses a common back office.)

Businesses susceptible to alliance activity include check and card processing, data center management, mortgage servicing, securities servicing, and trust recordkeeping.

In the past two years, First Manhattan Consulting Group has assisted in the birth of a number of alliances in these businesses, including that of Bankers Trust and First Fidelity in check processing, Wells Fargo and CES in merchant processing, and Chemical and Mellon in the securities area. As this is written, other deals are in the works.

Spurred by these associations, a growing number of institutions feel that now is the opportune time to conclude agreements that will cut costs and have the potential to raise revenues in processing activity in the short run and preserve control over threatened businesses, including perhaps the entire payments mechanism, in the long run. Alliances are necessary and timely not only because of redundant facilities, but also because of the need to:

1. Replace aging core systems.

2. Introduce new products and services.

3. Bring on stream whole new technologies (e.g., image POD).

At the most elemental level, an alliance is a device with which to flout the seemingly iron laws of arithmetic - to turn one plus one into at least 2#1/2. Stated differently, when, for example, one extracts the check- processing business from two good-sized regionals and rehouses it in a stand-alone entity, one generates more shareholder value than was embodied in the sum of the two preexisting businesses.

Part of the increment to value stems from the elimination of redundant facilities - e.g., processing centers. Another part reflects the impact of larger scale on variable costs. Two banks, each with 10 million prime pass items per month, will process at a unit cost of about 4 cents. A combined 20-million-prime-pass-per-month entity will process at a unit cost of only about 3 cents.

Having lower unit costs, the new entity can reprice its services, thereby stimulating sales to smaller banks and improving cash management effectiveness.

Additionally, not being a bank, the stand-alone check-processing vehicle generally can attract business from other banks that would not have been available to the two sponsoring institutions for competitive reasons. In this case, then, an alliance can increase revenue as well as lower costs.

A final advantage of an alliance is a spillover from the scale effect - namely, with increased volume, it becomes possible for a given entity to introduce technologies that would not be economically justified at a lower level of activity.

An example once again comes from check processing. At volumes below 100 million prime pass items per year, conventional technology yields lower unit costs than image POD. At higher volumes, image gets the nod. Indeed, when volumes exceed 200 million, the unit cost of imaging amounts to about a third lower than that of the conventional technology.

The bigness imperative in check processing is reinforced by the strategic aims of technology vendors like IBM, EDS, Systematics, Fiserv, and Unisys. These are trying to build scale processing facilities in high- volume geographies that will be linked through proprietary communications networks.

The eventual objective is to create a standardized infrastructure with which to do nationwide image net settlement. If sufficient volume can be attracted, the ability to "net settle" across regions will considerably reduce, if not eliminate, the transportation costs and float impacts associated with the physical movement of checks.

Although the technology vendors can try to constrict the role of the banks in the payment system, this is an expensive and time-consuming strategy, given that the banks currently control the bulk of the payments volume. These vendors are instead trying to joint venture with banks, region by region, in order to acquire the volume needed to activate their nationwide image platforms.

The need to partner is also apparent in other processing activities. Big mortgage companies can service loans at an appreciably lower cost than smaller ones, enabling them to bid more for servicing rights than the smaller entities.

Big trust record-keepers are far more economic than small ones, enabling them to underbid the latter for 401(k) plans. In other words, in these businesses, bigness has already begotten, and will increasingly beget, more bigness.

To gain the advantages of scale, a typical regional bank must choose among essentially three options:

1. Get out of processing businesses by outsourcing to larger banks, alliances of banks, or technology vendors and their allies.

2. Stay in these businesses by merging or forming alliances with banks.

3. Stay in these businesses by allying with a technology vendor.

As a general rule, admitting of exceptions, the optimal choice depends on current and projected volumes. At low volumes - e.g., in mortgages, fewer than 80,000 loans serviced - outsourcing the business to an efficient processor makes sense.

At intermediate volumes - e.g., between 80,000 and 200,000 mortgage loans serviced - searching for alliance partners with whom one can associate on more or less equal terms becomes feasible. Finally, at higher volumes, the institution can itself contemplate becoming a servicer for other institutions' mortgage loan volumes.

Assuming that a given bank resides in the intermediate-volume zone, with whom does it ally, a technology vendor or another bank? As already noted, there can be advantages to hooking up with a technology vendor in check processing.

A bank-to-bank alliance, however, can produce more immediate benefits. Since another bank will add check-processing volume, while a technology vendor currently has little or no volume to contribute, an all-bank tie-up will yield greater initial unit cost savings.

These gains must be weighed against the possibility that an alliance with a technology vendor will spare a regionally dominant bank the need to invest in image POD and will facilitate eventual entry into the projected national image exchange network - circumstances that could convey both greater float and unit-cost advantages than were possible through a bank alliance.

Conceivably the optimal strategy in check processing may be a two-staged one. First, do an all-bank alliance. This adds to volume and raises the bargaining leverage of the bank-formed entity, which is then better able to negotiate a second deal with the technology vendor.

At the moment, there are no alliances between banks and technology vendors in check processing, although there is a significant amount of outsourcing. But there are a number of deals under consideration.

Should one eventuate, others - and perhaps a flurry - will follow. Many banks that have been slow to consider alliances with technology vendors could then find themselves quickly outflanked and thus competitively disadvantaged.

In many businesses, the choice of a partner will depend on the trade off between the revenue and cost-savings potential of a given deal and its ownership options. If a bank finds it necessary to throw in its lot with a larger bank in its region, its equity stake in the venture will generally be less than half. By contrast, it may be easier to negotiate a more favorable split with a technology vendor.

And a big piece of a smaller operation with a strong growth potential can be worth more than a small piece of a bigger operation with a more limited growth outlook.

In determining whether to seek alliances, a bank must answer four big questions. The first is: Is sole ownership of a particular activity critical to its success?

An affirmative answer self-evidently ends the inquiry. A negative answer elicits the second question, which is: Does the bank have a technology advantage in the business that is sustainable?

Again, affirmative answer, no point in continuing; negative answer, push on to the third question, which is: Is the bank operating in this business at a maximum scale advantage? If the bank answers "no" to this query, it then must pose the final question: Do we have something to contribute to a prospective alliance? This time it is a negative answer that shuts off further discussion, while an affirmative one suggests the strong need to explore alliance possibilities.

Finally, it is important to emphasize that alliances are risky ventures which may not live up to their advertised potential. Hence, it is vital to pay attention to the following five prerequisites for success:

1. Make sure that all potential partners have been considered.

2. Make sure that the economics of the deal take into account the value added by each party.

3. Ensure compatibility of participant strategies and culture.

4. Guarantee that all scenarios result in gains for each party.

5. Ensure that there is an agreed-on approach on how to deal with new services or changes in services that are likely to occur.

If a bank does the appropriate soul-searching and then structures any prospective deal with an eye to satisfying the above prerequisites, it stands more than a fair chance of emerging as a winner in this brave new world of processing alliances.

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