Japanese Bank IT: Strategic Investment in an Uncertain Market

These are tough times for Japan's banks.

Many banks have posted heavy losses over the past several years as a result of Japan's long economic downturn coupled with a crushing bad debt problem, the fallout from the bursting of the speculative bubble of the 1980s. Unfortunately, no recovery is in sight. Banks are also facing intense competition both from other domestic banks and from major international banks operating in the Japanese market, particularly on the corporate side. Moreover, Japan's banks are seeing their traditional business being encroached upon by new competitors, including consumer finance companies and financial advisory firms.

On top of all this, long-standing structural problems continue to limit the upside potential for banking in Japan. For one thing, banks operate under continued regulatory limitations with regard to the products and services they are allowed to offer. At the same time, banks face subsidized competition from the government's Postal Savings and Postal Insurance programs, which dominate their respective markets.

Despite, or perhaps because of, these competitive pressures, Japanese banks are increasingly relying on technology to improve their cost efficiency, the services they provide, and their competitiveness. Technology spending at Japanese banks will reach an estimated US$11.8 billion for FYE March 2004. The five biggest banks (Mizuho, SMBC, Tokyo-Mitsubishi, UFJ and Resona, known as "city banks") dominate technology spending, accounting for US$5.6 billion, or 53 percent of the total. The 115 regional banks account for 22 percent, and the 24,000-branch postal savings system, along with thrifts and other institutions, spend 25 percent.

As a result of their large share of spending, the recent wave of mergers among the city banks has had a significant effect on overall bank technology investment in Japan. These mergers increased bank IT budgets by as much as 50 percent for FYE March 2002, as banks spent massively to consolidate the disparate systems of the pre-merged entities. One result was that, as merger-related IT work wound down, spending the following year showed an 11.7 percent decline.

We expect IT spending to continue to decline, albeit gradually, through the fiscal year ending in March 2004, as the major banks continue to realize operational and cost efficiencies from this wave of consolidation. At the same time, strategic spending on technology by banks is on the rise, and this will lead to a gradual recovery in IT spending from the year ending in March 2005.

Both domestic and international competition is compelling the big five banks, as well as the more forward-looking regional banks, to develop enhanced products and services. This strategic trend is driving spending on new technologies, which in turn is increasing the proportional spend on external IT development. Celent estimates that external investment will rise to 51.6 percent of the total by the fiscal year ending in March 2004, a 3.7 percent increase over 2001.

Like their counterparts in the U.S. and Europe, Japan's major banks are active investors in information technology. According to an oft-repeated bromide, Japanese banks are two years behind the U.S. in terms of technology. While there is some truth to this, the big five banks, and the more forward-looking of the regional banks, see technology as a vital strategic imperative. Despite the constraints of the current economic environment, they are continuing to dedicate substantial resources to IT in order to lower costs, enhance operational efficiencies, and improve customer service and competitiveness.

Some of the major technology trends at Japan's banks include the adoption of new internal accounting and auditing systems, enhancing online corporate and retail banking functionality, retooling loan processing, and implementing certain aspects of branch automation and multi-channel integration. Faced with intense pressure to contain costs and improve profitability, Japan's banks are increasingly turning to outsourcing. Among the largest banks, SMBC and UFJ are outsourcing significant portions of their technical operations. UFJ, in fact, is planning to outsource the development and operation of its next-generation core system to a joint venture with Hitachi.

Japan's regional banks are also turning to outsourcing in greater numbers. Over the past year, a number of these institutions, including Bank of Yokohama--Japan's largest regional bank, with US$75 billion in assets--have recently announced plans to outsource core system development and/or operation to firms such as NEC, NTT Data and IBM.

Although Japan's banks are preoccupied with grave issues such as a poisonous economic environment and overwhelming bad debt portfolios, this has not distracted them from maintaining a serious focus on technology. Although current market conditions will limit growth in IT budgets (with the exception of merger-related systems consolidation) for the foreseeable future, banks are mustering what resources they can to improve their competitiveness and, some day, their profitability.

Neil Katkov is an analyst at Celent Communications, a financial services research and consulting company headquartered in Boston, Massachusetts.

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