Opening Gambit

Major financial institutions now see the wisdom, and savings, in outsourcing significant portions of their IT infrastructure.

Determined to rein in IT costs and get the most value for their dollar, banks have concluded that less is more.

In December, JP Morgan Chase, Bank of America, ABN AMRO and Deutsche Bank announced outsourcing deals totaling $13 billion with IBM and EDS. The deals, along with those announced earlier last year by American Express and CIBC, made 2002 a banner year for strategic outsourcing in the banking industry.

A medley of forces, including the sagging economy, regulatory pressure, industry consolidation, and excess IT capacity, have created a climate favorable to outsourcing, observers say.

"A lot of thing have converged to create an environment where these institutions feel comfortable doing this," said Coley Clark, senior vice president of the financial industry group at Plano, Texas-based EDS.

"This trend started 25 years ago with small banks, and over time larger institutions have grown more comfortable with outsourcing," he added.

The trend has become more pronounced as banks struggle to eke out profits.

"The deals reflect the volatility in financial services and the search for more flexibility in IT spending, particularly capital spending," said Susan Cournoyer, senior analyst at GartnerGroup. "The cost pressures in financial services are a major driver for this."

To some extent, the flurry of deals reflects the natural ebb and flow of business. "We had the run up in the bull market in the late '90s and a lot of things need to be rationalized now that the market's not what it was," said Clark. "Banks are trying to consolidate some of the gains that were made when they were in the acquisition mode."

Industry consolidation and the completion of internal IT projects have made the timing of major outsourcing deals propitious.

"We're behind a lot of compliance and IT issues around Y2K, the Internet and CRM," said Jim Eckenrode, research director at TowerGroup. "We're also on the back end of a lot of merger and acquisition activity."

Banks are depending on outsourcing companies to tackle the thorny technical issues that have cropped up with the advent of the Internet. "The exuberant spending on the Internet in the late 1990s has led to IT environments that are heterogeneous," said Cournoyer. In the case of JP Morgan Chase, she noted, "IBM will be replacing three dozen networks with one network."

Regulations, particularly the Basel II accord, have also played a role in banks' outsourcing decisions. By requiring banks to set aside a portion of their capital reserves to cover operational risk, Basel II invites them to seek outside expertise.

"It reflects some of the fears big banks have about outsourcing and that regulators have about business continuity," said Cournoyer. "For example, IBM has agreed to invest in fiber optic technology that will meet proposed guidelines by regulators."

A central feature of the $5 billion, seven-year deal between IBM and JP Morgan Chase is the creation of a virtual pool of computing resources-peopled by 4,000 JP Morgan employees that are being transferred to IBM-that will be accessed and deployed as needed. The intent is to allow the bank to move from a traditional fixed-cost approach to a utility on-demand approach, paving the way for smoother growth and innovation.

"The significance is the variability component," said Mike Sztejnberg, managing director at JP Morgan Chase. "We're going to be buying what we need and use, not incurring expense for things we don't use."

JP Morgan Chase will outsource a significant portion of its IT infrastructure, including data centers, help desks, distributed computing, data and voice networks. Core competencies like application delivery and development and desktop support will be retained in-house.

The deal, which covers operations in 50 countries, is unprecedented in size and scope.

"It represents a different kind of outsourcing than what we've seen traditionally," said Eckenrode.

VOLUME DISCOUNTS
Traditionally, large banks have shunned outsourcing of their infrastructure in favor of a more selective approach involving a particular application or line of business.

"If large institutions like Citibank, Chase, Bank of America and Wells Fargo are going to outsource anything at all," said Eckenrode, "it's been in high-scale concentrated businesses like credit card issuing and mortgage servicing, where you see the dominance of players like Total Systems Services TSYS and First Data in credit cards and Alltel, and to a lesser extent Fiserv, in mortgage servicing."

"But this is sourcing for a particular line of business and a particular application functionality," he said. "Whereas what you're seeing with JP Morgan Chase, American Express and CIBC is the outsourcing of the entire IT infrastructure. The data centers, mainframes, networks."

The contracts are structured in a way that allows banks to outsource commodity services in order to lower costs. "IBM's view is that computing power is a utility, much like electricity and water," he said. "The banks are buying on volume."

The underlying assumption is that a bank can buy computing power more cheaply than it can manufacture itself. "Although the bank has huge scale in itself, IBM's scale is an order of magnitude larger, which translates into economic benefits," said Chase's Sztejnberg.

Previously, the largest outsourcing contract negotiated by JP Morgan Chase was the seven-year, $2 billion Pinnacle Alliance, a consortium formed in 1996 by the heritage JP Morgan, AT&T, Bell Atlantic Network Integration, CSC and Andersen Consulting.

"This new contract is several times the size of Pinnacle Alliance," said Gartner's Cournoyer. "It covers 50 countries and over 4,000 employees."

Although the announcements take pains to point out that certain IT functions like application development will be retained in-house, it's clear that in handing their legacy applications over to their outsourcing partners, the banks are entrusting them with the lifeblood of their organizations.

"What runs on the mainframe of JP Morgan Chase and the other top 50 banks is the very definition of mission-critical application," Eckenrode said. "It's the core banking, brokerage applications that run the business, that provide all the account functionality and transaction processing. Although it can be viewed as plain vanilla in terms of the services provided, it's also terribly mission-critical."

For IBM, which competed with EDS and CSC for the JP Morgan Chase business, the willingness of banks to sign big outsourcing contracts signals a change in attitude.

"Financial services have long regarded IT as such an integral part of their operation that there's been substantial diligence done before anyone would enter into a transaction such as this," said John Lutz, managing director of financial services, IBM Global Services.

"The trust we've earned on the part of JP Morgan Chase is testimony to the power and readiness of this model to support financial services," he said.

With the giants of the industry giving their blessing to IBM, others are certain to take note. "IBM's win at American Express, JP Morgan Chase and Deutsche Bank indicates that it's time for other institutions to look around," Eckenrode said. "Increasingly, where they're looking is IBM."

The banks have made clear their desire to shift the risk of changing economic conditions onto the vendors.

"In brokerage, we're seeing a huge uptick in volume in terms of securities trades," said Eckenrode. "JP Morgan Chase can elect to buy additional MIPS millions of instructions per second to handle this additional volume, but if trading volumes go down, then they're stuck with all this excess capacity."

CORE COMPETENCIES
The focus in contract negotiations is not only on price, but on reducing the banks' exposure to variable costs. "It goes beyond cost containment," said IBM's Lutz. "While they will get some cost improvement in the beginning, the longer-term benefits will be on having costs aligned with the business. So they can allow the lines of business to understand how costs scale up and down as the business expands and contracts."

IBM's perceived leadership in technology impressed JP Morgan Chase. "We're transferring 4,000 employees to a company with a very innovative record and a leader in the technology space, with more than 150,000 people in the services business," said Sztejnberg.

For the transferred employees, IBM provides opportunities to refine their knowledge and skills, which will redound to the benefit of JP Morgan Chase. "IBM offers a rich environment where, even more than in a financial service firm, they can find a rewarding IT career," said Lutz. "The infusion of new ideas from our research group will be invaluable."

With Sept. 11th still fresh in people's minds, the need for business continuity in the event of a disaster permeates outsourcing discussions. "We are going to provide a highly available, resilient technical infrastructure to be responsive to failover," said Lutz. "The characteristics are reliability and resilience, coupled with a steady-state high availability."

The deal between EDS and Bank of America, while smaller than IBM-JP Morgan Chase, is still of blockbuster proportions. Under the $4.5 billion, 10-year contract, EDS will take over management of BofA's voice and data networks, and will help the bank transform its network infrastructure through stronger and more flexible operating platforms. Approximately 1,000 employees will be transferred to EDS.

EDS will assume responsibility for carrier services, establishing a one-stop shop for voice and data services. "We'll transition our existing contracts with our multiple carriers to them, as well as our existing maintenance contracts with our equipment providers," said Ralph Ziegler, head of network services at Bank of America.

EDS will also redesign and implement solutions to optimize BofA's optical network and will provide help desk support.

The bank turned to EDS in order to secure end-to-end operations, including flexible, secure telecommunications solutions employing best-in-class technology. "They'll provide network services including carrier services data and voice, and equipment routers, switches, hubs, telephones, mobile phones, calling cards," Ziegler said.

"We wanted to complete our technology evolution at a faster rate," he said. "We were moving at a pretty good clip, but they could help us accelerate that."

EDS also brings to the table purchasing power that BofA, huge as it is, doesn't possess. "By combining our existing purchasing power with theirs, we got better rates for commodity products such as carrier services, long distance rates and equipment," Ziegler said.

"A secondary reason is they took all our associates, approximately 1,000 across the U.S. in 22 states," he added. "Third, they guarantee year-on-year service improvement."

The groundwork for the agreement was laid over several years, beginning with a total cost of ownership (TCO) study that the bank undertook in 1998 and repeated in 2000. It didn't much care for the results.

"We had benchmarking done across all our technology," said Ziegler. "When we looked at that and where we were with our networks, we needed to improve upon and evolve them. At the same time, we seemed to be lagging the marketplace in TCO."

The bank concluded that its core competencies lay outside network services. "This is where we had a huge opportunity," said Ziegler. "The marketplace does it better than us."

The economics of outsourcing proved compelling, he noted. "It's a managed network services agreement. Eighty-five percent of this deal is commodity. Take it over, consolidate it, improve our spend and pass on the savings to us. But we also want to continue our new network evolution."

COMMODITY MARKET
As with the JP Morgan Chase-IBM deal, however, the term "commodity" is subject to interpretation.

"In the case of Bank of America, it's reengineering their domestic voice and data networks," said EDS' Clark. "Some people might say that's commodity. But there's a lot of work that has to be done to add value."

The same applies to EDS' $1.3 billion, five-year deal with ABN AMRO, which covers the provision of technology services and applications development in the bank's wholesale client division.

"In the case of ABN AMRO, it's clearly not commodity," said Clark. "It's application development and maintenance, as well as infrastructure. We're trying to transform processes and networks to take advantage of new technologies."

The services will be rolled out over the next six months, according to Steven Blaney, a spokesperson for Netherlands-based ABN AMRO. "The services will include infrastructure development, operations and management, and applications development."

Outsourcing had been under consideration for about two years, he noted. "The bank has been going through a rationalization process in terms of how it provides services. The decision was driven by the provision of IT support services as well as costs."

For EDS, the Bank of America and ABN AMRO deals help shore up its reputation after it had missed financial projections earlier in the year.

"When you have large global banks doing due diligence on us and feeling comfortable in signing a 10-year relationship, it says a lot about our financial condition and our ability to generate cash," said Clark.

Still, EDS' overall financial performance may have cost it the JP Morgan Chase contract. "JP Morgan got scared by the earnings announcements and the lack of visibility in earnings at EDS," said Eckenrode.

One risk faced by both EDS and IBM is the lengthy negotiating process. "Most of these things take seven or eight months minimum," said Clark. " In some cases, it can be single-sourced but usually there's three or four providers competing. There's a process put in place, sometimes run by a bank, sometimes by a third party. It comes down to who has the best team, the best solution, the best price."

Noted Gartner's Cournoyer, "It's very challenging to get companies to sign consulting and system integration deals. There's a strong pipeline for outsourcing, but there's also a long negotiating period."

Yet another question is whether the deals provide an adequate profit margin. "The vendors are working very hard to promote this concept of utility services," said Cournoyer. "The risk is it becomes just a utility play."

Noting IBM's acquisition last year of PWC Consulting, she said, "IBM gained all those business transformation resources, and yet they're not being tapped. How do you fit those into an on-demand utility model?"

By agreeing to take on IT staff from the banks, the vendors incur yet another fixed cost with little initial return. "They're acquiring large numbers of infrastructure people, that stop short of business process skills or even vertical applications," said Cournoyer. "They're kind of the plumbers in these organizations."

EDS, for its part, is also focused on IT operations. "For a company that wants to focus on business processes, these outsourcing engagements are not offering that opportunity," Cournoyer said.

Yet so long as banks continue to rely on legacy systems, the business case for outsourcing will remain strong.

"If we're afraid of moving off the mainframe to more easily supported and lower-cost platforms, then we have to stay on them," said Eckenrode. "And if we stay on them, we have to make them as cost effective as possible. So we look to someone who can do it better, and maybe we can achieve some cost savings as a result."