12 technology questions investors should be asking banks

When I spoke at the Goldman Sachs financial services conference last Wednesday, we got into a good discussion about how little insight investors are given into bank IT spending (one audience member described it as a “black box”).

Given that IT today represents around 15% of costs at a typical universal bank and given the growing importance of technology to building and maintaining competitive advantage in an increasingly digitized industry, this situation must change. Investors and other bank stakeholders should be demanding more disclosure on where the money goes as well as banks’ strategy and roadmap for the future.

Until that happens, however, investors will have to build for themselves a picture of banks’ IT capabilities and their readiness to take advantage (or withstand) exponential technology change, rapidly changing customer behaviour and a new competitive environment.

To help with this information gathering exercise, another audience member asked me what key questions he should ask bank executives about IT. I gave a few ideas then, but here is a list of 12 good questions and a short explanation of why each is relevant to an investor in banking stocks:

1. How much does the bank spend on IT annually?
A bit of an obvious one, but it’s not disclosed today and is an essential starting point.

2. What is the bank’s ratio of maintenance spend to enhancements?
(Celent estimates that 76.3% of banks’ IT budgets go on maintaining existing systems which is self-evidently too high if banks are keep up with the speed of change)

3. What is the ratio of IT and back office staff to total employees?
This will give a measure of how efficient the bank’s back office processing is and, by extension, an idea of the split between spend on transaction processing and other back office capabilities vs. everything else (which is more likely to result in better customer experiences)?

4. What percentage of transactions are straight through (i.e. don’t involve any human intervention)?
This clearly is a measure of process automation, but it has wider import. One of the fundamental characteristics of a good online experience is speed of response and fulfilment. To keep up with the tech giants, bank would need Straight Through Processing (‘STP’) levels of 99%+

5. How many services are not only straight through but also real time?
STP just eliminates human intervention, it does not stop services being provided through bulk/batch – i.e. collated throughout the day and processed in one go, typically overnight. Since in most countries, clearing and processing is not real-time, not all services can be real-time. But banks will need real-time capabilities to deliver the rich online experience we envisage they’ll have to offer to stay relevant (see below). Banks should simultaneously be building real-time capabilities across all services and lobbying for single immediate payments in their domestic markets.

6. What is the bank’s strategy for leveraging its data to better service, cross-sell and retain its customers?
Data is banks’ most valuable competitive asset and yet so few either capitalise on it today or have a clear strategy for capitalising on it in the future. As I have written before, leveraging data will require a strategy that encompasses a range of factors, such as personnel, technology and mindset

7. What is the strategy for open banking (creating an online marketplace offering both the bank’s and third party products)?
The banking value chain is splitting: new players are offering discrete services (e.g. TransferWise for FX, Lending Club for unsecured credit) and non-banks are trying to offer front-end capabilities that threaten to disintermediate the banks. To successfully compete, banks will need to become more open. They’ll need to offer third-party banking services (e.g FX, remittances) where these are cheaper or offer better convenience as well as third-party non-banking services like legal services if they are to ensure that they remain customers’ principal gateway into banking.

8. How agile is the bank in terms of speed to launch new products and apps?
This will give an indication of how responsive a bank can be to fast-changing competition. How quickly can it launch a new product? How quickly can it launch an app?

9. How is the bank fostering innovation? (e.g. involvement with start-ups)?
Developing an innovative culture will be key for banks to generate new ideas and accelerate the pace at which they are able to bring these to fruition. The most innovative companies are those that cast the widest net for ideas. Is the bank involved with the start-up community? Does it run hackathons? Does it crowdsource innovation? Does it open up its platform to third-party developers? When it is incubating innovative ideas, can the teams involved operate with different conditions (e.g. more autonomy, fewer KPIs)?

10. How is the bank preparing for the explosion of interactions with increasing digitization and the internet of things?
Barclays, since it introduced its highly successful mobile banking app Pingit, has seen the number of interactions rise from roughly 2 per month to more than 30 per month. This phenomenon has been observed in other industries such as travel and book retailing, but is likely to grow exponentially as more and more devices connect to the internet (e.g a smart printer will order its own ink, querying your bank account). Are banks ready for this explosion in look-to-book (i.e. number of times customers access their accounts in a given time period without necessarily executing any transaction), which requires bank to operate at a different scale and also to drive down costs (since the extra interactions likely come with no commensurate increase in income)?

11. Are there any services that can’t be delivered through all channels?
That is not to say that all services have to be available on all channels, but that any service can be delivered on all channels and all channels can distribute any service. GAFA (Google, Apple, Facebook, Amazon) have this capacity today.

12. What is the strategy for managing online security, mitigating risk and potential associated reputational damage?
Our banking relationships are moving online and banks are gathering and analysing more information about us, which needs to kept secure.

The end game

Our view is that the only way banks prevent themselves from disintermediated over the medium term is by offering what we term experience-driven banking (and which we have tried to depict in the graphic below). To deliver this will require positive responses to all of the questions above.



Is software eating the banking industry?

This morning, I took part in a fireside chat at the Goldman Sachs European Financials Conference. We discussed the potential for technology to lower costs and raise productivity.

How can technology help drive down bank IT costs?

1. Reducing hardware and software maintenance costs. Modern systems are better architected, with broader capabilities, than the legacy systems they replace, helping to consolidate the number of software applications banks run whilst reducing infrastructure overheads.

2. Extracting IT economies of scale. As banks grow, IT costs should fall relative to income. But banks have struggled to realize IT economies of scale, as legacy systems are too complex to integrate (in the case of M&A) or scale to support organic growth. Modern systems provide a scalable platform for improving productivity as demonstrated by the experiences of Temenos customers like Bank of Shanghai and EFG

3. Greater straight through processing. Automation of processes helps to reduce the number of back office and IT staff needed, but also helps to reduce errors. Automation also leads to faster fulfilment of customer interactions, critical to satisfying customer expectations in an increasingly digital world (technology giants like Amazon and Google run at 99%+ STP, a level banks will need to reach as well)

4. Lowering the cost of compliance. It is relatively easy for banks to quickly and simply implement most new rules and regulations on integrated and highly parametrised modern systems. Where a third-party packaged system is used, the provider can leverage the economics of packaged software to develop new modules for compliance which can be made available to all customers at zero marginal cost

5. Better risk management and operational control. Modern systems have very robust workflows, to ensure segregation of duties for example, or to keep detailed audit records. They also provide comprehensive and real time information about the business to help management to make better informed and faster decisions.In terms of risk management, modern technology helps by giving better data, a greater insight into customers’ circumstances that goes way beyond standard credit checks.

Can banks continue to defer technology renewal?

Time is definitely running out. In another blog, I suggested that many banks were underestimating the pace of exponential change and needed to act quicker.

The challenge is two-fold.

The first is opportunity cost. Maintaining legacy systems takes up 76% of banks’ budgets, leaving little to invest in meaningful enhancements that consumers demand and that market leaders deliver.

Secondly, if banks don’t modernize legacy systems, they won’t have a platform to deliver seamless and rich customer experiences. Customers – of all types – want their financial services providers to become trusted advisors, helping them to make better financial and commercial decisions, giving them advice, finding ways for them to save money, introducing them to trusted partners and so on. For banks to be able to successfully play this role as ‘infomediaries’, they will need real-time capabilities (offers, publishing, etc ) that simply aren’t possible with legacy infrastructure

How much more efficient can banks become with IT renewal?

Temenos produces a report every year with Deloitte that compares KPIs of banks running modern core banking systems vs. those running legacy systems. It shows a significant and sustained differential in performance (a 6.5pp lower cost to income on average over a 5 year period).

Obviously, the report can’t establish causation, but the correlation is extremely strong (it holds across every year, every region, every type of bank, etc) and certainly this kind of differential in performance is representative of the cases where we can prove causation.

Is IT cost/total cost still a meaningful efficiency metric?

In future, people will focus much less on IT costs relative to total costs. As the industry digitizes, IT costs will necessarily rise relative to other costs. Technology will become an even more important source of competitive advantage and a higher ratio of IT costs to total costs might even come to be seen as a good thing.

Instead, people will focus more on where  IT costs are invested. Investors, management and other stakeholders will concentrate on KPIs like how much of a bank’s IT budget is spent maintaining systems vs. developing or acquiring new capabilities.

Will banks be able to realize significant savings themselves or will they rely more on third parties?

Banks can realise massive savings by adopting modern third-party systems, irrespective of how the software is deployed. However, much bigger savings can be made if banks use shared infrastructure. A recent report by IDC looking at Microsoft SQL found that it was over 50% less expensive to run the database in the Azure cloud.

Therefore, more and more banks will turn to the cloud. Not necessarily the public cloud but private and community clouds in order to take advantage of  lower costs; they’ll be obliged to as significant parts of the banking value chain commoditise, forcing transactions to be processed at the lowest unit costs.

Nonetheless, we don’t predict a more significant move to bureaus and business process outsourcers because this would entail banks giving up too much of their capability to differentiate in the front office; to launch new products quickly, to differentiate their channel experience, etc.

Is technology modernization becoming less risky?

Today, things have moved on quite a lot. Most systems are open i.e. they can run on most technologies, so banks can continue to leverage their existing platforms if they choose to. In addition, a lot of the big SIs like Accenture and Capgemini have built practices, so there is more expertise around mission critical banking technology. Lastly, the systems have been more and more componentized, meaning progressive renovation is now possible – replacing a bank’s IT estate bit by bit, reducing risk and time to value.

Will technology displace the labour force?

Some jobs in banking will inevitably be replaced by technology over time. There are many studies looking at the kinds of jobs most susceptible to automation and, unsurprisingly, many of these are in banking (tellers, for instance).

But ultimately technology is an enabler. It will enable bankers to do their jobs better, with better information, fewer mistakes and better customer outcomes. For example, while there is a valuable place for roboanalyzers, they won’t replace, but empower, the best wealth managers.

Do banks give adequate disclosure of IT spending?

If you look through a typical bank annual report, you’ll see some information about how the bank accounts for IT costs, some information about what IT costs the bank has recognised as assets on the balance sheet, but that’s about it. Given IT costs are typically around 15% of total costs and given the growing importance of technology in establishing competitive advantage, this level of disclosure is completely inadequate. Investors and other stakeholders should be demanding much more disclosure about where the money is going, banks’ IT strategy and roadmap.