Operations Management | By Christina P. O’Neill
Banks and credit unions between $100 million and $5 billion in asset size could save an average of $1.2 million over fair market value during a five-year contract life if they sought to renegotiate outsourced core processing and IT services contracts during a critical time window.
That’s according to “The Core Way Forward,” a report issued last week by the Business Performance Innovation Network. The ideal window turns out to be between 24 and 18 months before the expiration of the contract, the report finds.
Small to midsized financial institutions are increasingly squeezed by low margins and regulatory pressure, as well as increased difficulties in making sound new loans, says David Murray, director of thought leadership at BPI Network. At a time when they’re spending more per staffer on compliance than their larger counterparts, they’re also seeking to add new services to stay competitive. They must trim non-interest expenses without compromising their internal operations.
The study findings are partly based on national data on contract pricing, terms and conditions supplied by research and consulting firm Paladin fs, which tracks pricing data for core and IT services for community financial institutions. In addition, it incorporates a national survey of community financial executives conducted in the first half of 2014, and interviews with leading executives and advisors.
Paladin conducted a blinded survey of 54 banks and credit unions across the nation that renegotiated their core IT contracts. The report details how some achieved significant fair market value reductions.
The analysis demonstrates that institutions in every part of the country can significantly reduce the cost of vendor services by negotiating based on fair market pricing.
Seventy-seven percent of study respondents said they expect to add services in the areas of Internet and mobile banking and fraud protection, but only 30 percent said they believed they are paying what they should for their core processing and IT services; 37 percent believe they’re overpaying and 33 percent said they feel they lack sufficient information to know whether or not they are overpaying.
That “don’t know” figure results from a combination of factors. First, there has already been significant consolidation in the third-party core business/IT processing market, with three providers controlling 85 percent of the market, compared to dozens of competitors 20 years ago.
Secondly, the IT personnel at most banks and credit unions only negotiate contracts a few times in their entire careers, while vendors do so day in and day out. Finally, there’s a lack of overall information on processing industry pricing – equivalent to the auto industry’s Kelly Blue Book. (Paladin has dubbed its metadata information on contracts, invoices and terms and conditions that went into the report a “Blue Book.”)
“IT people lack negotiating skills because they have no reference point,” Murray said, adding that the dearth of core-processing vendors takes the teeth out of the RFP process. “The alternative: to confer with one’s existing vendor and restructure the contract to bring it more in line with what national pricing says you can get.”
The downstream consequences of not renegotiating spill over into the domain of mergers and acquisitions, Murray said. Contracts that are not cost-efficient, and/or those with materially-significant termination fees, could compromise or even kill M&A deals. The study found that 69 percent of executives responding expect increased M&A activity over the next two years, with 36 percent saying they expect to enter that arena as a buyer; 21 percent said they’d be a buyer or seller depending on the opportunity, while only four percent identified themselves as probable sellers.
A Starting Point
Murray cited a $320 million institution that signed a letter of intent, but because their core services had been auto-renewed, the deal was called off due to the exposure to a termination penalty.
“More often, the deal has much less accretive value early on,” he said, particularly if the cost of services is not tiered to reflect growth. “Some of these contracts just don’t stipulate that the cost per transaction comes down after a certain point.”
Community banks and credit unions in the $100 million to $5 billion asset size are paying between 10.2 and 41.4 percent above what the study determined could be fair market value for outsourced core processing and IT services. In order to recover $1.2 million on the interest income side, they’d have to make $6.4 million in new loans on day one of the contract, based on the average net interest margin of 3.7 percent earned by community banks at the end of 2013, according to the report.
“Savings are all over the map,” Murray said, citing an institution under $500 million in assets that saved more than $2 million over five years in the Northeast. The bad news: institutions often overpay. The good news: They can address that.
Having the insight into what a bank or credit union across the country, of the same size, and with the same set of services and sales volume is paying for core processing services “is a really important starting point, instead of negotiating blindly based on just asking for a deal,” Murray said. The report is not meant to be vendor-adverse, he emphasized. “But having some transparency as to what pricing looks like, nationally, is important.”■