By Anand Swaminathan and Andrew Kappy, Accenture

Medium-sized banks find themselves in an increasingly desperate situation. They are losing significant market share to their larger competitors without the scale or funds to weather the weak economy, diversify their business or acquire others as a competitive strategy.

In this difficult environment, they must become more innovative, as did one midsize U.S. bank which needed to improve its procurement capability. It sought to significantly cut costs associated with third party vendors, improve compliance with their own spending policies, and use technology to streamline the entire process of buying and paying for goods and service.

The bank signed a seven-year agreement to outsource its strategic sourcing, vendor management, accounts payable and help-desk support functions across 45 products and services used by the bank. By enlisting an execution partner, the bank succeeded in realizing both savings and capability improvements.

This is an example of next generation sourcing initiatives that leading midsize financial institutions are embracing. Traditional outsourcing focuses on cost reduction, leveraging cheaper labor and utilizing some third-party technology. Leading midsize banks, however, are taking the next step by making outsourcing part of their core strategy to generate urgently needed efficiencies and access current technology without major capital investment. This strategy combines cost savings through labor arbitrage, improved technology capabilities, process reengineering, and a shift to a cost approach that is directly tied to revenue fluctuations. An example is a transaction-based model where the bank is charged each time it uses the outsourced service, perhaps to run a credit check on a loan application, rather than paying an "all-you-can-eat" fee that continues even when you don't use the service.

Another financial services company entered a multi-year sourcing arrangement that not only reduced human resources costs by up to 30 percent, but provided several long-term benefits. These included the establishment of one core human resources system using advanced technology, a reduction in additional investments in human resources operations, and the ability to support multiple acquisitions that more than doubled the employee population in less than two years.

Yet another bank engaged an execution partner to cut costs in its lending operation, including mortgage post-close, lien release, and tax and escrow services. After re-sequencing process steps and implementing imaging and automation, the lender outsourced these lending functions and, in less than a year, began realizing considerable cost savings. It is now exploring opportunities in marketing and other back-office lending operations.

This sourcing strategy also focuses on revenue growth by equipping both the back- and front-offices with the products, tools and processes necessary to drive shareholder value, while lowering costs. In many cases, third-party providers can deliver significant cost savings compared with current operating expense. Ultimately, the strategy can help financial institutions go beyond relieving short-term problems to address long-term sustainability.

Losing efficiency advantage

Why focus on medium-sized banks – those 30 North American institutions with assets ranging from $20 to $60 billion? When compared to larger banks, our analysis indicates that midsize banks are losing their efficiency advantage, faltering in revenue growth, and relying more heavily on a non-diversified product and revenue mix. Unfortunately, the current deteriorating economic environment is exacerbating the impact of these negative trends.

Absent quick action, these banks will find it increasingly difficult to compete effectively against their larger and more diversified brethren – resulting in continued loss of market share as they struggle to generate superior returns.

Large banks were less efficient in the 1980's and 1990's when an increase in assets and technology led to back-office complexity. Since then, Bank of America, JP Morgan Chase and other big banks have heavily invested in simplifying and streamlining their back office functions, including technology, human resources and procurement.

Such actions have dramatically decreased large banks' non-interest expense in the areas of technology, occupancy, and communications – dropping their average spend per dollar of revenue from $0.23 to $0.16 over the five-year period from 2002 to 2006. In contrast, medium-sized banks have increased non-interest expense relative to revenue (from $0.15 to $0.16) in that same period. This has left them at an efficiency disadvantage relative to large banks.

Slower growth

In addition to losing their cost advantage, midsize banks grew at a much slower pace than the four largest banks in North America by asset size (53 percent for midsize banks vs. 89 percent for the four largest), revenue (62 percent vs. 86 percent), and net income before tax (38 percent vs.128 percent) between 2002 and 2006.

Even more alarming, mid-sized banks' revenue is increasingly concentrated in fewer products, leaving them more susceptible to market shifts and changes in customer needs. In recent years, they have relied on consumer and commercial loans for over 80 percent of their interest revenue—products facing diminishing returns due to a 15-year decline in Treasury yields. In contrast, the largest banks are diversifying across additional sources of revenue such as asset trading and Treasury investments.

Moving ahead

In working with midsize banks, we have learned how they prepare to undertake a major outsourcing initiative. The bank typically first considers its market position and the essence of its differentiation. Understanding what the bank must and can do well in the marketplace is at the very heart of strategy and success. Having determined the core of its competitive strategy, the bank then reviews the functions, processes and technologies that provide its differentiation to determine which could be improved. Human resources, finance and accounting, procurement, mortgage fulfillment and lockbox operations are just a few examples.

The final step is to determine how a third-party partner can help reduce operating costs, free up capital and resources to invest in critical capabilities, and minimize the risk associated with such activities. The end result will be that the midsize banks can refocus their attention on regaining market share through improved customer focus, and product and channel innovation, with the added flexibility provided by a lower expense base.

Midsize banks must take immediate action to remain relevant and competitive. For some, the sourcing strategy described here may provide the difference between future high performance and continued mediocrity.

Anand Swaminathan (anand.swaminathan@accenture.com), a Senior Executive in Accenture's Banking Group, is based in San Francisco; Andrew Kappy (andrew.b.kappy@accenture.com), a Consultant in Accenture's Banking Group, is based in Toronto.

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