Deutsche Bank analysts expect acceleration of change in banking leads a big increase in bank IT spend. At heart of bank’ strategies, the replacement of core IT systems.

« With the press full of reports on innovation in money matters – think progress by Square, volumes in mobile payments at M-PESA, doubled revenue at Monetise, new bank launches like Metro, big data, digital wallets, mobile banking, crowdfunding, P2P lending – we think most investors see mostly downside risk from change. We look at each topic and conclude that a big increase in bank IT spend is coming which isn’t captured in market expectations. But we also think this spend will deliver an ability to process higher volumes at lower unit costs, reduce branch costs and generate new revenue streams. We do not expect material bank disintermediation by tech », reveals a research conducted by Deutsche Bank.

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The Rotten Core

« We expect many developed market banks to replace core IT in the next decade at significant expense in projects lasting five years or more. Near term this sees costs rise unless expensed under restructuring charges. This should leave firms more nimble, better able to meet rising regulatory requirements, and delivering broadly stable costs despite further increases in transaction volumes. With revenue growth therefore we expect cost/income ratios to fall.

• Banks are technology companies that move and keep track of money, with linked service and selling arms. Most banks run mainframes installed decades ago and subsequently patched to deal with M&A, product proliferation and innovation, geographic expansion and new regulatory requirements.

• The Standard Bank case study shows why Core System replacements are fairly rare. The project, begun in 2005, is taking longer and costing more than initially planned: 2012 IT costs were 72% higher than 2008’s despite a significant increase in capitalised costs on balance sheet. Temenos, a bank software company estimates that the average bank devotes 15% of costs to IT: SBK is now at 24%.

We expect retail and commercial banks to recoup the 5-10% initial increase in costs from full IT renewal (SBK 70% increase in 15% of group IT = 10%) via cheaper branches and lower unit costs. Phasing is unlikely to match, however, with IT costs up before efficiencies come through. IT is not, in our view, the route to a material decline in big bank costs.

• We expect regulators to play a pivotal role in some markets in IT renewal, especially given high profile outages at RBS for example. This isn’t to say regulators don’t already impose material operational risk requirements: the 32 Eurobanks we survey have E815bn in op risk RWAs costing 0.7% off the sector ROE to support. Op risk RWAs avg ~14% of credit risk RWAs, with banks such as Credit Suisse (36%) and UBS (56%) carrying higher proportional burdens. We think systems outages, a focus on cyber risk and growing regulator capacity to return to issues other than capital and liquidity will result in more regulatory emphasis on IT.

• It’s worth examining parallel banks (new digital ventures set up by existing banks like BNP Paribas (Hello Bank!) and NAB (UBank)) as a potential new IT platform (for NAB at least) and as a learning ground for digital and multibrand banking. For NAB at least, the on-line venture will form the basis for the broader group in 3-4 years.

We think it is poorly understood that Bank-in-a-Box solutions can get a new bank running for $15-20m. Though market share gains and NIM remain key challenges, the surprisingly modest upfront investment and scaleable cost base means breakeven is mostly about “when” rather than “if” with timing driven by management calibration of growth (paying for customers, opening branches) against profits. We expect owners of these businesses to ultimately do well, but we don’t expect a massive change in market shares for the large banks. »