Newton’s third law of motion states that for every action there is an equal and opposite reaction. We all learned that in high school physics. But, what does physics have to do with technology, more precisely, the business of financial technology? Literally, not much. I’m citing it, however, to show there is a correlation between market forces in the banking industry and the reaction to those forces by technology vendors.
The force I am referring to is the reduction in charters due to consolidation. Quietly and consistently community banks are consolidating year after year. From the beginning of 2010 through the first half of 2017, the total number of banking charters has been reduced by 1,891! That market force, I believe, is beginning to have an impact on all technology vendors. A near 25% reduction in charters in 6.5 years has to have had an effect, and I believe we are seeing that today.
A few months ago, I was called by a senior level account executive asking if I knew of any openings as he was recently laid off due to cost cutting. Last month, there was a well-publicized layoff of 350 employees by another major tech vendor. A few weeks ago, I was called by a currently-employed account executive expecting his job to be eliminated along with others at that tech vendor by year end. I had a senior level account executive at a major EFT service provider contact me earlier in the year looking for employment due to a reduction in clients. I have heard rumors of other layoffs yet to come at other vendors. These examples are all anecdotal and unsubstantiated as I have not contacted any vendor to verify what I have been told. I am not naive enough to think that such a significant reduction in charters is not having an impact on tech vendors, and neither should you be.
I am not an expert in bank mergers and acquisitions, but our firm, ProBank Austin, has a very active Investment Banking Division. In fact, ProBank Austin is ranked fifth in whole bank deals since 2005 by S&P Global Market Intelligence. Rick Maroney, Managing Director of ProBank Austin’s Investment Banking Division, shared his thoughts on what he is anticipating for bank M&A in the future.
“I expect the industry to continue to consolidate at its current pace of approximately 250 charter eliminations per year (4-5% of the total bank charters). Community banks especially have not seen the expected benefits of economic expansion, loan growth, and improved profitability. All of this puts pressure on valuation levels and eventually leads to merger/sale discussions,” Rick stated.
“Compounding the impact of M&A activity is the lack of de novo bank formations since the recession. Only eight banks have been formed since 2011, compared to 1,362 new charters between 2000 and 2008. The FDIC has indicated a greater willingness to grant charters, but the required capital and current profitability levels of the banking industry make it a challenging investment proposition. I would expect only a handful of new banks to be chartered in future years primarily in larger metro areas.”
As you can see in the graph below, the number of charters has been steadily decreasing year after year. As Rick indicates, de novo activity has all but ceased. If the trend continues, consolidation is bound to have an impact, not only on technology vendors, but on all business dependent on providing services and products to financial institutions.
Obviously the processing of the acquired bank does not disappear; it gets folded into the acquiring bank. But due to economies of scale, the cost will be at a lesser rate than what was being paid at the acquired institution. Larger banks pay less on a per account basis than smaller banks do for essentially the same services. As acquisitions occur, there is an overall reduction in processing fees paid to vendors. It is unavoidable.
I am not suggesting that any technology firm is, or will be, in an unprofitable state, however, they all must take steps to manage their expenses if they are facing a shortfall in revenue. I suspect we are seeing some of that now.
What can your bank do to help insulate your bank from increased risk? Actually, there is a lot that you should be doing.
1. Increase your vendor management due diligence. Review your vendor’s financials carefully and compare each quarter’s results to previous quarters’ revenues. If you can determine recurring revenue as well as fees paid due to contract termination, keep track of each. Both contribute to the bottom line, but excessive termination fees will indicate less recurring revenue in the future and that ultimately is what the vendor operates on. If you notice revenues (not profitability) are falling, expect your vendor to react accordingly.
2. Keep track of the number of clients under contract for the solution you are using. Ask your vendor now for that number and update it annually. If your vendor offers multiple core solutions, especially track the number under contract for the solution your bank is using, not just the total number serviced by your vendor. At some point, it may no longer be cost effective for a vendor to support a solution. Then what? A forced migration may occur most likely. You will never know that it is being considered until it is announced. But you should know, well in advance, that the numbers serviced are receding and will have considered your options.
3. Keep an eye on research and development. This will be difficult to do, for many it will be a gut feeling. Unless your bank is evaluating other solutions you may not realize deficiencies. A vendor may reduce their investment in development and that may only be realized once it is too late. Be aware.
4. Take a more active role in managing your relationship with your vendor. Become more self-reliant. Insure that your staff is taking advantage of all training opportunities available to minimize errors and support concerns. Vendor staff may shrink as consolidation continues. Take control now and do not let a change in vendor staffing impact your bank adversely.
5. Consider the risk versus reward in longer-term contracts. Time is money – all vendors offer discounts for longer-term agreements. Consider the potential impact if consolidation does continue at the present rate for the next decade. What impact will that have on your vendor? While a long-term agreement may look financially attractive today, will your vendor continue to be viable in seven years? Long-term contracts have to be considered carefully. I discussed many factors to consider regarding contract length in a previous blog, “How Long is Too Long?” (July 26, 2017), now there is one more consideration.
Again, I am not suggesting that any vendor is in financial peril. However, all vendors must react to changing market forces. Your bank must recognize that it might not be “business as usual”, if consolidations continue as they have been.