Given the huge levels of investment in information technology in recent years, it is hardly surprising that many chief executive officers and business managers have asked whether IT spending has actually made the institution more profitable, or whether additional IT expenses simply erode the firm's net profit. Some have suggested that there is a direct correlation between the level of IT spending that a financial institution engages in and its overall profitability. The argument is as seductive as it is flawed: since IT is becoming so crucial for banks to survive, those firms that invest the most will be the best positioned to reap the benefits that technology offers and will see a direct impact on their bottom line. This is simply not true. Spending more on IT does not guarantee greater profitability. In fact, blindly spending more on information technology is a certain way to decrease profitability. There is nothing magical about IT spending; it is not guaranteed to increase profits.
ROA: spending is not enough
The correlation between the level of IT spending (measured as a percentage of overall expenses) and return on assets (ROA) is extremely tenuous at best. Rather, it appears that there is no direct dependence of ROA on the level of IT investments at all. This may come as a surprise, especially to those who have been professing how important large IT investments are and how crucial they are to a financial institution's future viability. IT undoubtedly has an important part to play, and the importance of its role will continue to increase. However, simply increasing spending on IT does not bring about higher profits; this would be too simple. Some institutions spend their IT budgets well, bet on the right technologies, and are able to thereby positively impact the firm's overall financial performance. Other firms spend their IT dollars less wisely.
While there is no direct correlation between IT spending and profitability, there is a frontier that can be seen when comparing IT spending to ROA (see chart). This frontier shows the range of outcomes that are possible with IT; individual firms are scattered throughout the bounds of this frontier. This implies that IT can have an impact on profitability, albeit not a simple and direct one. What is important is not how much a firm spends on IT, but rather how that money is spent, which technologies are invested in, how well the firm executes its technology plans and how well those IT plans are coordinated with the institution's business strategy. It is interesting to note that firms do not fall directly on the frontier, but are scattered throughout the area enveloped by it. This can be tied back to the fact that individual banks do not execute uniformly well in their technology groups. The same brokerage firm that might have been able to create a new electronic delivery platform that helps the institution gain large numbers of new clients might also have enormous amounts of spending on IT projects in its custody operations that refuse to make progress and simply squander resources. Every institution has its share of those technology projects that do well, and have a positive impact on the firm's profitability, as well as those that seem simply to consume time, effort and money without any tangible benefits.
spending can hurt, not help
A large number of firms lie in the "middle of the pack". They have moderate IT budgets, when measured as a percentage of their total expenses, and their ROA are about average for the industry. These firms might try to increase their technology spending in an attempt to boost their profitability. A word of warning would be in order for firms tempted to do this. Increased IT spending can just as easily move a bank down the profitability frontier as up. An institution that starts in group B may find that increased investments in technology have made the firm less profitable and have moved the institution from group B to group C. In group C, the firm will find itself in the company of financial service providers who have spent lavishly on IT but have been unable to turn those investments into profits. Simplistically, one might regard these firms as having placed large bets on IT and having lost. Frequently, a dollar spent on IT at these institutions is simply a dollar less in net profit.
Moving up the profitability frontier from group B to group A, on the other hand, is considerably more difficult. This requires careful selection of technology investments and ever vigilant monitoring of projects to make sure that they do not go awry. Those firms in group A are the ones that have technology budgets that are considerably larger than the average, and which have been able to reap considerable rewards from their IT investments.
Any institution attempting to boost its profitability with greater technology spending should move cautiously. Once a firm lands at the bottom of the profitability frontier in group C (see chart), it becomes exceedingly difficult to get back out. The IT group starts to take on a life of its own and suck in ever greater amounts of money without showing hard results. As more and more IT projects appear, effective oversight becomes harder and harder, and eliminating or canceling large IT projects that have gone awry exacts a heavy political toll on any CIO.
As we have already seen, strategic IT investments are making up an ever increasing percentage of IT budgets and receiving more and more attention, not just from technologists, but also from business executives. The sheer size of IT spending alone means that technology has become a critical area for banks. While it is possible to identify certain application areas, such as customer management, electronic delivery or risk management that are currently key technologies, it is almost impossible to predict which applications will become strategic in more than three or four years. Consider the Internet; before 1995, few people in the industry were even aware that the Internet existed. Today, this technology commands a considerable share of banking IT executives' attention. Predicting which technologies will become important is extraordinarily difficult and frequently is not even worth the effort since technology moves so rapidly, so fluidly and so unexpectedly.
What is sure to happen in the coming years is that the pace at which new technologies emerge and present either business opportunities or threats will accelerate. How then, should a bank prepare itself for the future, which is sure to become more and more dominated by information technology? Some banks will undoubtedly continue to react passively to new technologies and will launch ad hoc projects when it appears that they have fallen behind the competition, or seem to be under threat. However, this is not an approach that will allow the institution to stand above its competition.
Banks will have to be able to react more quickly, not only in identifying promising technologies, but also in integrating them into the institutions' existing infrastructures. This will place considerable burdens on many banks' legacy systems, which are already heavily taxed by the plethora of new applications that extract data from and write it to the host systems. Those banks that will be the best positioned to take advantage of new technologies rapidly will be the institutions that create the necessary infrastructure to allow the rapid addition of new applications and new technologies. Increasingly, architectural concerns will become important, and those firms that are able to create IT architectures that allow the firm's portfolio of applications to grow modularly and coherently will be the best positioned to implement new technologies as they appear.
While the issues that we have described so far are mainly technical, there are also considerable organizational hurdles that must be surmounted in the years to come. Most importantly, frequently strained dialogue between IT and business units must work more effectively. Business executives, many of whom have traditionally shunned technology and have had a poor understanding of IT, must make efforts to better understand how their businesses and technology relate to each other. At the same time, the often torturous decision making processes needed to both initiate and terminate IT projects must be streamlined. The quickening pace of technical innovation means that many banks will miss the boat with their plodding and awkward approach to technology decisions.
The technical and organizational ability to rapidly add new applications, new hardware and new systems will become crucial. This will require a clarity of thinking and planning in technology endeavors that banks are unaccustomed to. The complexity of large banks' IT systems has risen dramatically since the 1980's when client/server technologies started to become popular. Those banks, and there are many, that have built haphazardly on top of their legacy systems, find that they have an IT infrastructure that is held together with rubber bands, glue and sticky tape. Adding new applications becomes not only difficult to do, but also risky. One is never sure when the overall system's limits of complexity will be reached. What is certain: The more layers of technology built on top of each other haphazardly, the more difficult, costly and risky it becomes to add new systems.
Those firms that will be the best placed for the future will be the ones that are able to implement firmwide architecture that facilitate the necessary modularity and flexibility. Those institutions that do not will eventually find themselves in a technological tangle that will act as a straight jacket and paralyze future innovation.
Creating an IT architecture that will hold a financial institution in good stead into the next century presents a significant technical challenge. Such an architecture must assimilate and exploit not only the business support systems built during the last ten years of the client/server era, but also the legacy operational systems whose development goes back ten or more years before that. But it is not the technical aspect of the challenge that will be its greatest hurdle. More difficult will be the organizational issues that confront the development of this architecture, including more effective planning of IT projects, better coordination within IT and business departments and development of the skills necessary to manage projects that include multiple vendors and outside consultants. The truly intractable part of the challenge may well be the redefinition of roles of business units and IT professionals. MS