Monday, August 8, 2022

BFS Tech Spending Outlook—Largely Resilient Globally With Some Dose Of Caution

Tech spending continues to be a vital area of focus as BFS firms are in the early stages or in the midst of a tech upgrade journey. Benefits are visible, spurring further investments in new products and services as well as cloud migration and modernization of legacy stack. A weak economic prognosis has led to a re-look on costs, both tech and non-tech related, and can lead to a slowdown in spending, baked in our estimates. Vendor consolidation and push for low-cost outsourcing provide opportunities for the Indian IT.

Tech spending theme stays resilient

Banks and financial services firms continue to maintain spending on cloud and new technologies as a strategic priority even in the face of a deteriorating macro environment and increasing recession possibilities in the US and Europe. Banks are sounding cautious on macro and can cut back on discretionary spending, if necessary. A few segments such as mortgages, capital markets and wealth management have been impacted due to hike in interest rates by central banks, weak IPO activity and market downturn. Technology spending is viewed as an investment for future growth and will not be cut drastically even in case of a recessionary environment. Online penetration continues to be robust and is increasing, providing an impetus to maintain tech spends. A few discretionary areas such as consulting may be impacted. On the other hand, there is considerable scope to cut down on workforce in various operations and use automation and tech-driven solutions to yield cost savings. A few banks are considering vendor consolidation and lower-cost outsourcing, which can provide opportunities for the Indian IT.

Large banks in US largely sound optimistic on tech spending although cautious on costs

Citi is investing across a bucket of technology initiatives with focus on better risk management. Higher digital engagement is aiding cost efficiencies for BofA, ploughed back into technology and marketing. The company will continue to invest heavily in tech. JPM will continue strong tech spending and will not stop investing in technologies such as AI during a recession due to good RoI on such investments. Wells Fargo is lagging behind in technology capabilities and is trying to catch up. Goldman Sachs on the other hand provided a cautious commentary and indicated that it will re-examine spending and investment plans and slow down the pace of a few (not necessarily tech). The bank will also reduce hiring velocity. A similar sentiment was echoed by Morgan Stanley, which indicated careful scrutiny of incremental expenditure.

Tech spends expended in P&L provide mixed outlook

Tech spends expended in P&L of major US banks declined or were flat for Citi, JPM and Wells Fargo but up in mid-single digit for Bank of America and double-digits for Goldman Sachs and Morgan Stanley. Interestingly, spending trajectory is stronger among the banks that sounded more cautious on expenses and future investments (not necessarily tech). Citi’s tech spending trend will be closely watched considering that it is a key account for several Indian IT providers.

Expect higher resiliency of tech spending among BFS clients

Impact of a deteriorating macro, high inflation, rising interest rates and geopolitical tensions will play out differently for various industries. Higher net interest income will be a tailwind for banks although segments such as mortgages, capital markets and wealth management are vulnerable.  BFS is in a better spot compared to verticals such as retail and manufacturing in our view.

Tech spending continues to be an area of strategic focus

Several banks highlighted significant benefit of tech investments in terms of greater online penetration in a variety of banking products and services such as mobile app downloads, digital loan growth, usage of chat bots, etc. Digitalization has simplified internal processes and enabled straight-through processing leading to both cost and process efficiencies. Data analytics and AI are used in a plethora of cases, yet still have a strong pipeline of use cases. Cloud migration continues to be a priority, either towards public or private cloud. 

Focus shifting to cost efficiencies and can provide opportunities

Most BFS firms did not lower expense guidance or near-term/medium-term targets on return ratios but indicated greater scrutiny of expenses. Focus on costs can yield opportunities as well as challenges. Vendor consolidation has occurred or underway in some banks and can continue. For example, Danske Bank indicated re-contracting for some part of IT and potential benefits from lower costs going forward. BNYM indicated focus on better scaling vendor usage to get more buying power and reducing unnecessary consultants among other measures to control expenses. Vendors with efficient execution engines can benefit from push for lower-cost outsourcing. For example, Credit Suisse indicated that there is significant potential in savings in some supplier relationships including managed servicing arrangements.

Cloud shift, modernization drive higher IT spending

BFS firms continue to progress to cloud at a good pace. Interestingly, while no firm indicated any delays to timeline of projects or pullback in tech spends, commentary of acceleration in tech spending and becoming a digital-first or cloud-first bank was far muted compared to earlier periods. Spending is increasing in data analytics and AI. Several banks highlighted higher IT costs due to cloud migration of key workloads and modernization initiatives. For example, Blackrock indicated higher tech costs due to various strategic investments in technology, including the migration of its Aladdin platform to the cloud.

European firms are more cost focused but retain willingness to invest in tech

BFS firms in Europe are watchful for stress in key markets such as the UK, France and Germany considering higher possibility of recession compared to the US. Financial stress on European banks in higher in the US. Willingness to invest in technology is prevalent but ability to spend is constrained. Even so banks have not highlighted any significant cut in tech spends. NatWest Group indicated that it will maintain investment spend despite an adverse macro given clear benefits of the investments. In the case of HSBC, focus on costs has resulted in an automation journey with reduction in operations headcount. The bank indicated that it is only partway through the journey with an ambition to achieve even greater savings. UBS provided similar commentary and is using automation to increase productivity and manage rising wage costs. Intesa Sanpaolo indicated significant investments in digital banking and highlighted partnership with Thought Machine. ING aims to increase straight-through processing by 15% in the next 2 years from 60% to 75% and will increase private cloud penetration to 70% by 2025 from 34% currently. A few banks highlighted higher near-term costs to manage investment spending. For example, Deutsche Bank lowered CY2022 cost-income ratio guidance to provide room to invest. The bank will nevertheless focus on additional measures to ease cost pressures.

Tough environment will pose a dilemma—change spends are easier to cut but are crucial investments

BFS firms have increased mix of tech spending towards change from 30-40% in the past to 50-60% as they implement new tech stack at scale. Change spending usually comes under discretionary category, but is more crucial now considering the view among companies that digital investments are necessary to compete and survive and not just a nice-to-have. Digitalization provides cost efficiencies and superior customer experience. Shift to cloud enables greater agility, flexibility, resilience and helps leverage big data. However, a deteriorating macro and uncertain revenue environment demand cut in expenses. Change spends are easier to cut. This puts firms in a tough position.

Change spends can be moderated to achieve desired cost outcomes quickly but can impact long-term growth and competitive positioning if cut for too long. Run spends can be squeezed via automation, higher outsourcing, rationalization of legacy stack and vendor consolidation but takes time. We believe BFS firms will take a balanced view and delay/pullback change spends for a limited duration. Optimization of run spends will provide opportunities for the Indian IT to gain share.

Growth deceleration for Indian IT due to high base; underlying drivers strong

Growth rates of the BFSI vertical decelerated for TCS, Infosys and Wipro on a high base due to lack of mega deal momentum in TCS and Infosys and normalization post Capco acquisition in the case of Wipro. Underlying drivers of growth are strong except in the mortgages segment. BFSI vertical of mid-tier companies showed strong growth except Mphasis (high exposure to mortgage segment) driven by strong spending in key clients and large deal wins. Large acquisitions in the space such as Capco for Wipro and SLK Global for Coforge have performed well till now. Cognizant continues to lag behind on growth. 

Tech spends can moderate due to slowdown but baked in our estimates

We note that companies which provided strong commentary on tech spending were also to an extent more bullish on economic prospects. Citi and JPM are a couple of examples. Citi CEO indicated less possibility of a US recession while JPM CEO indicated no pullback in end consumer spending. A weakening macro can spur caution even in these cases. We believe there can be ‘excesses’ and ‘non-essentials’ which can be pruned in case of a tough environment. Change spending can be delayed or pulled back. We do not expect abandoning of transformation journey. Cost-focused outsourcing opportunities will increase and to the advantage of companies strong in core services such as TCS and Infosys in Tier 1 and Mphasis in mid-tier. Captive carve-out opportunities, especially offshore, might be limited. There are instances of pick-up in insourcing such as in State Street. BFS firms might increase hiring in low-cost geographies such as India due to (1) lower cost of talent, (2) high talent shortage in developed countries and (3) higher acceptance of offshoring post Covid.  Slowdown in tech spending is already baked in our estimates through 6-7% growth deceleration in FY2024.

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