Outsourcing -- whether a simple service-bureau arrangement, a facilities management contract, or the transfer of an entire back office to an independent processor -- is a logical answer to several major problems of banks and thrifts.
It has, therefore, been a surprise to read recent critiques of the phenomenon, as well as a finding of the American Banker annual technology survey that most users of outsourcing are neutral to negative about the results.
For example, only 5% were "very satisfied" with the savings achieved; 14% were "very dissatisfied." And while 41% expressed some degree of satisfaction, the remaining 59% were neutral or dissatisfied.
One bank officer quoted in the survey said banks should take management information systems back in-house because the profits being earned by service vendors were too high.
Has the Wave Crested?
And Arthur Gillis, president of Computer Based Solutions Inc., a smart and well-respected consultant, concluded from a survey of his own that purchases of outsourcing services may have peaked in the past year, at least among the larger financial institutions that fueled the recent attention to the subject.
But I believe the rise of bank outsourcing has only just begun.
The dissatisfaction of many outsourcing users may be well founded, but numerous compelling arguments establish the logic of applying this approach to bank operations.
First, most small to mid-size depository institutions have too much computing capacity. Moreover, computer technology changes so rapidly that the relative cost of running old machines rises persistently.
Individual banks do not have the resources to keep upgrading their systems to the state of the art. Nor do they have the desire -- they believe too much is invested in computers already.
Complex Choices
Second, it is becoming increasingly apparent, too, that not all software is equal.
For example, the popular Microsoft Windows program is graphically more pleasant and easier to use than that company's DOS. However, most users would also agree that Windows is slower than DOS and has memory problems that in the past could cause a personal computer to shut down in the middle of an application.
When it comes to sophisticated banking software, the differences are even wider, so it is hard to choose the right program for a particular job.
This leads to the next crucial factor: An in-house management information system needs constant care to be kept efficient. Programmers are needed to deal with market developments and to react to regulatory demands - expensive and time-consuming tasks.
Further, if a bank has very few programmers, they will have a hard time meeting the institution's needs while staying current with hardware and software developments.
Thus, the flexibility many banks believe they achieve by keeping systems in-house is an illussion, because they lack the resources to stay current.
Larger Banks' Advantages
Big banks can offset the negatives of retaining control, because they have the volume to run their systems efficiently; large staffs that can analyze software and put it to the best use; and programmers capable of customizing systems better than vendors can. Much big-bank software is competitive enough to be sold to other institutions.
But numerous instances exist of conflict between bank technology managers and general business managers -- namely, presidents or chairmen.
One large western bank seems to turn over its management information systems manager every three years or so. Two big Pennsylvania banks have had major public conflicts leading to dismissal of their information-system managers.
In essence, strong and capable information-system departments can threaten a bank president's control. Beyond that, they drain resources and time that should be used to advance the bank's business purposes.
Sidestepping Problems
In theory, outsourcing should solve all these problems. With an outside provider, a bank would use only the amount of computer capacity it needs. And the vendor should be passing along the economies of scale that result from running many client banks on the same systems.
A high proportion of the proceeds should be invested in research and development, keeping client banks more competitive and at the proverbial state of the art.
The process should be so efficient that the biggest banks using an outsourcing vendor can expect to cut costs of management information systems by 8% to 12%. Smaller entities can cut 20% to 25%. And when selling its information-system operation to an outsourcer, the bank obtains needed capital.
Every three to five years, the bank has the contractual option to fire its outsourcing vendor. And the bank president need not worry about the information-system manager threatening his control of the institution.
The American Banker survey, conducted this year by Ernst & Young, indicated that the benefits envisioned from outsourcing often are not delivered.
The reason is that the structure of many outsourcing arrangements precludes the development of operating efficiencies or significant enhancements.
To demonstrate why this is so, assume that an outsourcer approaches a midsize depository institution that is under pressure to raise capital.
The outsourcer agrees to buy the information-system operation, which puts fresh money into the bank, and, at the same time, effectively guarantees through a fixed-price contract that the bank's information-system costs will be reduced by 20% for three years.
Moreover, the outsourcer agrees not to change any of the bank's operating systems, information-system policies, or reports.
The problem is that the economics work for the vendor only if service to the bank is dramatically limited.
Frustrations Explained
The vendor cannot allow extensive customization, nor can it react quickly, or perhaps at all, to marketplace and regulatory changes. To make the contract work, the vendor must avoid influences that drive up costs.
One might argue that this is an exaggerated description, but it explains the frustrations evident in the technology survey. One-fourth of respondents were negative toward the idea of being locked in to a service provider for a long-term contract.
Basically, these banks view outsourcing as more confining than doing the job internally.
This probably happened because the outsourcing decision was an outgrowth of the bank's need for capital and higher nearterm earnings, rather than of a strategic decision to improve operations while reducing costs - to the customers' benefit.
Taking the Big Plunge
Not all outsourcers operate in the same fashion. It is possible to find a company that will deliver the promised benefits.
The way to succeed that appeals to me most is for the bank to agree to convert all its systems to those of the outsourcer. This horrifies most bankers but guarantees obtaining the maximum available economies of scale.
Further, it is very likely that this outsourcer will allocate a large portion of its excess cash flow to develop customized products rather than using its money to make minimal changes on a number of programs being run on the multiple hardware platforms of other clients.
Bankers unable to stomach the thought of total conversion can seek an outsourcing arrangement based on delivering more products or services at lower cost. Reputable companies in the industry are doing this for clients and have the cash flow to back up their claims.
It is hard to imagine, given the evident diseconomies, that banks will revert to in-house management information systems.
A migration is likely to outsourcing companies that provide more flexibility at lower cost. This will occur not only because individual banks will decide to change but also because inefficient producers will sell out to efficient outsourcers.
This process is well under way.
Mr Bove is a banking consultant with the Bove Group in Chatham, N.J.
