Published : 7 years ago, on 13/03/2018

By Alberto Corvo, Founding Partner, Motive Partners

Alberto Corvo

According to Gartner, global IT spending in 2018 is expected to grow by 4.3% to reach$3.5Tr, and Financial Services will be one of the main industries driving this growth.In recent years, financial institutions have spent substantial amounts of money bringing their core legacy infrastructure up-to-date to fit with modern day requirements brought about by regulations such as MiFIDII, PSD2, and the impending GDPR in the EU, as well as24-hour servicing demand by consumers.

The modern reality is that financial institutions are coming under increasing pressure from regulators to make changes, and fast. At the same time, clients are demanding more and more services, and challengers are entering what used to be a protected space.Executive teams are under pressure to increase capital risk ratios, increase investment in innovation and efficiencies, cut costs and increase top line growth, however more and more money is being spent by financial institutions to keep compliant for the same levels of output. This puts executives in a difficult position where by EBITDA margins are at risk as they are forced to spend money as a preventative measure rather than to focus on growth and productivity. With margins at risk, cost-cutting is rife throughout the Financial Services industry and the mounting service pressures caused by old technology infrastructure is only going to get worse until significant changes are made.

As financial institutions strive to become more efficient to keep up, I believe the next logical step for the industry is to identify non-differentiating or non-competitive functions and cost centers to pursue one of three courses of action: dismiss, outsource, or utilitize.

In certain cases, dismissing may require fully exiting. Whilst this can be effective, broadly speaking an institution generally has business lines using shared infrastructure meaning that in many circumstances, giving up certain functions would mean exiting multiple business lines. Outsourcing would deliver some short-term cost controls, however, in the long run would create challenges around achieving true cost reduction given that work gets transferred from inside the bank to an outside profit-driven operator.

In my opinion, creating utilities is the logical next step for financial institutions.Huge savings can be made in the immediate and long-term, increasing with the more participants that join, and exiting support businesses that provide no differentiation reduces overheads whilst providing income should the utility be partially owned. Look no further than Worldpay as an example of a successful utility carve out from RBS in 2010. As a standalone payments business, Worldpay has gone from strength to strength and after having successfully completed an IPO on the London Stock Exchange in 2015, it was most recently acquired by Vantiv for over$10.4Bn in January this year. Although I can think of many examples of cross-functional operations that exist in banks today, areas ripe for utility creation that instantly spring to mind include: trade surveillance, post-trade settlements, data and AI focused utilities, the list goes on…

An obvious question when evaluating the case for creating more inter-company utilities in Financial Services is: why are there not more, and why have many previous attempts to create utilities not come to fruition?

I believe this comes down to three main drivers: institutions being used to owning all the components of the value chain, irrespective of the differentiating features of each; industry publicly traded investors that are constrained by the need for short-term returns; and attempts carried out by vendors with a potential biased interest in performing services or specific technologies, hindering the pursuit of optimal technology solutions.

Financial institutions would do well to remember the golden rule of ecosystem economics: 10% of a big number is better than 100% of nothing. Taking the banking industry as an example, when players have previously tried to create utilities they have tried to contribute their infrastructure in return for offloading technology debt and associated costs, with a requirement for other banks to work painfully to integrate into the utility. With this approach, the conflicting economics are often unworkable for anyone other than the proposing institution. From an investment perspective, the scale and size of the products being created have meant that many of the companies that have attempted to create a utility have been public and requirereturn-on-investment in short timeframes. In this scenario there is significant pressure on the economics of the utility and the attractiveness to the final solution is limited as, often the solution becomes subject to shortcuts once the risk is factored in.

So, is there hope? I strongly believe the answer is yes, and I think that the solution comes from third party institutions providing patient capital with no technology biases. Patient capital allows the sponsor to carry out the work that is needed in the right way, without the pressure of quarterly announcements, market volatility and the scrutiny of public perception. The absence of a technology service provider’s interest means that the private sponsors act as the truly‘honest broker’ tofreely pick the correct technology solution, without having to satisfy different internal constituents and maintaining control ofthe costs. And finally, no biases mean the end goal is not distorted by predispositions or other goals than maximizing the efficiency of the utility while maintaining the SLAs.

In summary, the primary aim of a utility is to be as proficient as possible to maximize cost savings ahead of rewarding risk. The upshot isthat more capital is freed-up in the immediate-term for necessary spending, with the potential for additional capital gain in the long-term. As I see it, the Financial Services industry is in desperate need of finding ways to increase efficiencies and reduce costs in order to spend money on critical innovation and staying ahead of compliance.