Financial Services Sector Braces for Basel II

Finally, we predict that 10 years from today, no major bank will insource any major component of its IT environment: such components will be completely outsourced.

The little-understood Basel II Accord will radically change the face of the financial services industry by:

Basel II imposes strict and onerous capital requirements upon banks to support operational risk. Banks will have to reduce the size of their businesses or increase their capital (raise equity). They can either go it alone and create demonstrably superior operationsa difficult and expensive undertakingor they can offload both operating efficiency and operating risk onto an outsourcer. By outsourcing, a bank will be able to reduce its operational risk capital, thus increasing the amount of capital available to support its core business and therefore its profits. While at first glance the gains seem modest, unlike most operating changes that greatly improve only a small part of operations, this change affects the entire businessproducing a significant efficiency improvement throughout the bank.

As a result of Basel II, we believe that consolidation in the banking industry will accelerate from the pace it has followed for the past 20 years. From 1980 to 2000, the top 10 firms doubled their market share from 20 percent to 40 percent. We believe that in the next five years, the top 10 firms will again double their market share, this time to 80 percent. Consolidation is driven by the fact that merging an inefficient bank into an efficient bank results in inefficiently deployed capital being deployed more efficiently. In other words, the acquired bank provides capital to the more efficient acquiring bank. Basel II changes the regulatory landscape by explicitly recognizing a capital allocation to operations, for the first time in history. Operations are no longer a back-office/overhead issue; regulators have recognized it as a core business process, and they are ready to regulate and account for it.

We have described the benefits of efficient bank operations under Basel II. How does one achieve these efficiencies in order to secure the financial benefits? We believe that business processes will be outsourced to a few business process outsourcer (BPO) providers that will supply those processes to the entire industry. We already see that trend in mortgage processing and credit card processing. This trend will accelerate under the impetus of Basel II. Since few BPO leaders will emerge for each process, bank CIOs will need to manage relations with the BPO provider, knowing that there will be few alternative vendor options available. Business process outsourcers that can aggressively manage real-time processing risks will be the winners in this space. Financial services initiatives such as Straight Through Processing (STP) aggressively tighten the link between decision and execution, increasing the need for BPOs that can aggressively manage these risks.

We believe there will continue to be traditional outsourcing opportunities for low-value operations that span multiple business processes, such as desktop management and networking/communications. Unlike the BPO marketplace, which will be characterized by a few vendors with high market share, many vendors with low market share will characterize the outsourcing market. Successful vendor management by banks will be characterized by aggressive enforcement of vendor commitments (SLA compliance) and a willingness to quickly switch away from weak performing vendors.

Finally, bank senior management will continue to insource strategic management of the operational environment. The biggest risk here is in the area of productizing new technologies. Unlike the past, when bank management usually brought in new technologies at their own risk, we believe they will seek to conduct trials of new technologies under shared risk agreements with vendors. This is a tectonic change from the traditional outsourcing value proposition (outsource what is not a core function in order to focus on your core business) to a new value proposition (outsource core business function and risk in order to create transparency and reduce risk). Outsourcing mission-critical operations requires more than trusted provider statusit requires trusted partner status.

Conclusions

In 2005, Basel II will be broadly adopted, and leading firms are already starting to plan how they will deal with this rewriting of the game rules. Based on this scenario, we believe the banks that currently have stronger risk-based capital ratios will be better positioned to succeed under Basel II and to become acquirers of other banks. At the end of the first quarter of 2002, according to FDIC information, large banks with very strong risk-based capital (RBC) accounts were Bank of America, Bank One, Bank of New York, State Street Bank, and Fifth Third Bancorp. Thinly capitalized firms that can be expected to struggle under Basel II include Citigroup, Wachovia, Wells Fargo, FleetBoston, and Keycorp. We expect consolidation to occur in this industry over the next two to three years.

We also believe that leading business process outsourcing firms will be able to aggressively sell into this vertical over the next five to seven years. The leaders at this point are EDS, Accenture, KPMG, CSC, and IBM GS. However, we are familiar with a number of smaller firms that are partnering to develop business process utilities (BPUs), and venture-funded initiatives to develop BPUs. No one has fully realized the vision; the leaders have recognized the opportunity and are in hot pursuit of it. Because partnering is required at this stage in order to realize the vision, no one has a lock on success. Winners will develop robust offerings quickly and will aggressively sell them to banks that are likely to be acquirers.