Industry Asks If Outsourcing Really Pays Off

Farming out data processing operations to computer services firms is one of the hottest trends in the industry these days. But there is a growing debate in technology circles over whether the idea is a key strategic development or just a cost-cutting fad.

Over the last five years, the number of U.S. banks signing so-called outsourcing deals has doubled. Major technology corporations, including International Business Machines Corp. and Electronic Data Services Corp., a unit of GM Corp., have lured some of the nation's largest financial institutions with promises that back-office expenses could be slashed by 10% to 50%. Once only community banks and small regionals comprised the prime market for data processing services.

But most of the large customers so far seem to be troubled financial institutions attracted by a quick way to get some computer equipment and labor costs off the books when the regulators come visiting.

If outsourcing is advantageous to banks in the long run, some observers wonder, then why aren't more healthy banks signing on?

Reacting to a Problem

According to consultants and bankers, the majority of outsourcing contracts now on the books are a result of an emotional reaction to a bad business climate. When outsourcing is used as a last-ditch effort to reduce costs, it makes it hard for a bank to effectively evaluate what services it needs and the benefits of its contract.

The result is often an agreement that covers too little too late.

"In my experience, the cost savings from outsourcing - if there are any at all - are small and short-term," said William M. Arnold, a management consultant at Towers Perrin in Atlanta.

Outsourcing's contributions to the bottom line come mainly from "taking some risk out of the earnings stream and from allowing a bank to focus on core businesses," Mr. Arnold said.

Vendors Question Risks

However, while ailing banks look to outsourcing to improve their financial condiion, the recent spate of bank failures is making vendors wonder whether all the risk is falling on them.

With each passing month, regulators have been seizing financial institutions that have outsourcing contracts. Great American Bank, San Diego, is the most recent such example. The $10 billion-asset thrift had a long-term outsourcing deal with Systematics Information Services, Little Rock, Ark.

When the Resolution Trust Corp. or the Federal Deposit Insurance Corp. seizes an institution, it has the power to declare any of a bank's contracts null and void, if doing so will make the institution easier to sell. Voiding an outsourcing deal can be disastrous for a vendor, particularly if it is dropped early in the contract's life, when a provider usually loses money.

Picking Your Customers

As a result, vendors are becoming more careful about choosing the institutions they do business with.

"The present climate has forced us in some instances to consider the creditworthiness of prospective clients," said Stephen R. Bova, a senior vice president at Systematics "From our perspective, it's just not worth converting a bank that might not be there in five years."

Some of the most vivid examples of outsourcing deals at ailing financial institutions are the customers of IBM.

IBM entered the data processing service business in the late 1980s, promptly signing Hibernia National Bank in New Orleans, Bank South in Atlanta, and more recently Southeast Banking Corp., Miami, to large deals. With these deals, the whole notion of outsourcing was instantly legitimized.

But Hibernia and Bank South reported big losses last year, catching the attention of regulators. And Southeast canceled its contract with IBM last May in anticipation of a merger.

In contrast to other banks turning to outsourcing, Republic New York Corp. stands among a handful of institutions that seized upon outsourcing as a profitability tool than as a life jacket. In 1981, the $29 billion-asset bank agreed to hand over its domestic retail operations to Systematics Inc. in what was then called a "facilities management" contract.

Ten years later, Republic - which analysts regard as one of the most consistently profitable institutions in the United States - is still crediting a large portion of its success to its outsourcing deal.

"Outsourcing has gone through several evolutionary changes over the years, and now perhaps it's time that bankers catch up with those changes," said Towers Perrin's Mr. Arnold.

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