Drawing Back the Curtain on Vendor Pricing for Core Processing by Ryan Foster

Cornerstone Advisors

Drawing Back the Curtain on Vendor Pricing for Core Quarter 4 2016 Processing

TABLE OF CONTENTS 3

Key Takeaways

Banking: A Technology Business

Confronting an Opaque Market

Getting Smart About Negotiations

A Winning Negotiation Strategy

A Winning Partnership

11 Conclusion 11

About the Data

About Cornerstone Advisors

WHO SHOULD READ THIS Senior bank and credit union managers who want to better understand the dynamics of vendor contracts for core-processing, debit-processing and eBanking services, and negotiate the best deal for their institutions.

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KEY TAKEAWAYS A vendor oligopoly Four vendors control 95% of the market for core and debit processing and eBanking services. It’s an oligopoly that processes billions of commodity-like transactions per day.

Buyer beware Unlike other commodity-based oligopolies, vendors keep pricing opaque. A market rate that is fair to both financial institutions and vendors exists, but most institutions don’t know what it is because the vendors won’t say. That leads many financial institutions to overpay. Some institutions pay up to three times more than others for essentially the same services.

Smart negotiations, positive results Bundling together negotiations for core, debit processing and eBanking services, aligning contract termination dates, involving senior management in negotiations, and getting assistance and market pricing data from a trusted advisor can lead to better contract terms, allowing an FI to reduce expenses and add new capabilities.

BANKING: A TECHNOLOGY BUSINESS There’s no avoiding it: banking today is as much a technological endeavor as it is a financial one. There really isn’t any part of the business that lacks an information technology component; increasingly, it’s not possible to perform even basic tasks without technology.

A bank at the median spending level devoted $11,448 per full time equivalent (FTE) employee, or 0.24% of assets, to IT spending in 2015, according to Cornerstone Performance Report data.

This emphasis shows in the numbers. A bank at the median spending level devoted $11,448 per full time equivalent (FTE) employee, or 0.24% of assets, to IT spending in 2015, according to Cornerstone Performance Report data. The median credit union’s spending is even higher, at a projected $15,968 per FTE in 2016, or 0.37% of assets. In total, annual IT spending for the median bank is 8.5% of noninterest expenses, second only to personnel expenditures. For the median credit union, annual technology spending amounts to 10.55% of noninterest expenses.

Roughly 20% of the median bank’s technology spending is for the core systems that perform the mundane, day to day business of updating accounts and processing transactions.

And there’s always something new to invest in. Today, the list includes self-service features that automate the loan process or allow card customers to place vacation notifications or temporarily shut a card down online, as well as behind the scenes fraud mitigation tools that detect stolen card numbers and other potential cyber breaches. Even so, much of the spending remains devoted to the basics of managing the flow of customer information. Roughly 20% of the median bank’s technology spending is for the core systems that perform the mundane, day to day business of updating accounts and processing transactions. Another 25% of IT spending goes to remote delivery, including Internet and mobile banking solutions and automated teller machines.

All but the very largest institutions rely on technology vendors to supply these critical functions, and over the past decade, that vendor market has consolidated dramatically. Today, it is the very definition of an oligopoly: nearly 95% of all core, debit card and eBanking solutions are controlled and sold by one of four vendors: FIS, Fiserv, Jack Henry & Associates and D+H. Consolidation brings some potent benefits. Larger vendors can offer fuller suites of integrated products, from teller stations to anti-money-laundering systems, providing seamless experiences for customers and turnkey solutions for the bank. It’s also easier to deal with one company, as opposed to managing multiple vendor relationships. Even so, the vendor market for banks is missing a key feature common to most commodity-based oligopolies: pricing transparency. And that’s a big deal. Even the sharpest management team is vulnerable to overpaying if they don’t have good information on market pricing. It’s difficult for management to feel confident in a contract—and to justify the expense to the board—when they can’t make fair comparisons with the terms and pricing that peers are receiving.

Even the sharpest management team is vulnerable to overpaying if they don’t have good information on market pricing.

Oligopolies typically form when a product or service becomes a commodity. Revenue growth slows and controlling costs becomes a priority, creating waves of consolidation that leave few competitors standing. That has happened in the bank IT vendor market, where a landscape that once featured hundreds of maverick firms now boasts only a handful. Fiserv, for example, has acquired more than 140 companies over its 32-year history, in areas such as electronic billing and payments, mobile banking and real-time account processing. In 2015, Fiserv had $712 million in profits on revenues of $5.3 billion.

Oligopolistic markets are criticized for their high barriers to entry and lack of choice. One thing they usually have going for them is a somewhat intense and transparent price competition between participants. Consumers know up front how much they’ll pay for a gallon of gas, an airline flight to Phoenix on Tuesday, or monthly cell phone service. Similarly, manufacturers know the market rate for inputs such as a ton of steel or a kilowatt of electricity. Since one company’s offerings are pretty much the same as the next, price often becomes the primary factor in purchasing decisions. Transparency gives purchasers confidence that they’re paying a fair market price for the commodity in question. Really, no one would tolerate things being any other way. Except when it comes to the market for outsourced core technologies, where vendors work to keep pricing information hidden from their bank and credit union customers. While vendors will emphasize the differences in their products and services, the reality is that few things are as commodity-like as processing a banking transaction or updating an account. These are things that are done literally billions of times every day. None of the four major vendors has a published price sheet laying out the per-unit costs of core, debit processing or eBanking solutions. Worse, asking for comparative pricing data elicits stonewalling and chuckles. Not only are vendors unwilling to share how much a similar size institution is paying for its solution suite, they often contractually prohibit a bank or credit union from disclosing pricing information to other institutions.

None of the four major vendors has a published price sheet laying out the per-unit costs of core, debit processing or eBanking solutions.

This lack of transparency puts individual banks and credit unions at a significant disadvantage when it comes to negotiating vendor contracts. Bankers might demand to see a vendor’s best price, but even if the vendor reveals a number, there’s no real assurance that someone else isn’t paying less. It also creates wild variations in what different banks pay for essentially the same services. Cornerstone Advisors is aware of banks that pay triple what some other institutions pay for the exact same services, even after allowing for differences in size and volumes. Banks at the high end of this curve are overpaying—and they may not even be aware of it. According to the Cornerstone Performance Report, a bank at the 75th percentile of per-account spending on core systems presently pays 61% more as a percentage of assets than does a bank at the 25th percentile. For remote delivery services, including mobile and Internet banking, the difference between the 75th percentile and 25th percentile is a whopping 126%. Likewise, a credit union at the 75th percentile pays 52% more as a percentage of assets for core systems than one at the 25th percentile. The price gap between the two levels for Internet and mobile banking services is 97% (Figure 1).

Figure 1 | Core Spending as a % of Total Assets

Core Spending as a % of Total Assets

The delta between the lowest and highest performer is 5 bps for banks and 7 bps for credit unions

25th

75th

In either case, the difference can amount to millions of dollars a year—money that could be redirected into investments in new technologies or returned to the bank’s or credit union’s stakeholders. Table 1 illustrates in real-life terms just how damaging the lack of pricing transparency can be for an ill-informed financial institution. Recently, two banks of roughly the same size and product capabilities entered into contracts with the same vendor for similar core, debit and eBanking services. Yet Bank A paid the vendor 83% more per customer—and 93% more as a percentage of assets—per year than Bank B, which had better market-pricing knowledge during contract negotiations.

Table 1 | Pricing Transparency – A Real Life Example

Bank

Assets

All-in Cost per Customer per Year

Vendor Spending as a Percentage of Assets

Noninterest Expense/Average Assets (%)

Operating Expense/ Operating Revenue (%)

$3,881,833,000

$86

0.001551951%

2.60%

57.62%

$2,279,399,000

$47

0.000804235%

2.72%

62.36%

For a typical $3 billion-asset institution, such a gap has the effect of cutting 7 basis points off of return on assets. That typical bank would need the revenues from an additional $70 million in loans with a 3% net interest margin (roughly the going rate today) to make up for the bottom-line impact of the spending difference.

CONFRONTING AN OPAQUE MARKET Why isn’t there greater transparency and uniformity in vendor pricing? What can a bank or credit union do to ensure it gets a fair price in its vendor negotiations? (Hint: It has everything to do with knowledge and leverage.) Cornerstone estimates that more than 90% of all banks have the potential to improve the terms of their core, debit processing and eBanking contracts. Doing so requires the involvement of senior management in negotiations, a strategic plan that ensures investment in the right technologies, and insightful information on the market’s pricing dynamics.

Cornerstone estimates that more than 90% of all banks have the potential to improve the terms of their core, debit processing and eBanking contracts.

Pricing opacity works strongly in the vendor’s favor. Once a bank has all of its systems on a given vendor’s platform, it’s difficult to change. Sure, an FI can switch. Each year, roughly 4% of financial institutions jump ship to new vendors. (The #1 reason for switching is a lack of faith in the vendor’s management team, according to a Cornerstone survey.) But converting systems from one vendor to another is a time consuming, technical challenge, fraught with distractions and risks. Recently, a Cornerstone client moved all of its business to a new vendor. The in-house description of the transition period, “the lost year,” says it all. The task demanded so much attention from management that other strategic priorities, such as mergers, market expansions, and new product launches, were put on hold. Unless the vendor relationship is toxic, it usually doesn’t seem worth the effort to make a change. And the vendors know it. So why would they tip their hand on pricing when it might eat into their margins?

GETTING SMART ABOUT NEGOTIATIONS We’re not saying that vendors are inherently evil. We are saying that all four major vendors are publicly traded companies with shareholder mandates to maximize profits. As such, there’s no real incentive for them to proactively reduce fees for their clients, or to share pricing information. Vendor contracts typically come up for renewal once every five years. For banks and credit unions, the negotiations offer a rare opportunity to put a meaningful dent in IT spending or to redirect the savings they can get from lower prices on core systems to new innovations.

Shockingly, many banks pass on the chance. Cornerstone estimates that as many as 15% of all banks auto-renew contracts with their existing vendors. The reasons include satisfaction with the present vendor solution, which is good, or bank management’s discomfort with technology negotiations or a lack of market knowledge, which is bad. Regardless of the reason, when a bank auto-renews, champagne starts flowing in the vendor’s office. Prices on an auto-renewal are essentially the same as the ending prices in the old contract, which are almost always higher than what a bank can get in a negotiation.

Regardless of the reason, when a bank auto-renews, champagne starts flowing in the vendor’s office.

Another common mistake is for a bank to open the door to negotiations, only to jump at the first price break offered. The reality is that a 20% discount off the last contract price might still be 15% to 20% above what other banks are paying the same vendor for the same services today. When a bank or credit union negotiates smartly on a new contract, the savings to the institution can be substantial. Data from a representative sample of seven recently inked contracts where Cornerstone represented a bank or credit union in its negotiations with the same vendor illustrate the point (Figure 2). Figure 2 | Processing Cost per Unit

Processing Cost per Unit

Starting Ending

Core

eBanking

Debit

Combined

All of the institutions bundled together their core, eBanking and debit card processing in one contract, which can provide more negotiating leverage. The agreed-upon contracts for all three services combined provided the institutions with an average per-unit savings of 17% from the old all-in pricing. Average savings on core processing per account and debit card processing per card were the greatest, at 23% per account. eBanking processing—including Internet and mobile banking and bill pay—which is now the biggest piece of the three, declined 14%.

Some banks, of course, beat the average. One $20 billion+ asset institution reduced its per-account spending on core processing by 40%. A small regional bank cut its per-card costs on debit processing by 33%. But even those that scored the smallest relative gains (because their starting point was more favorable) saw significant benefits from negotiating with the vendor. In each case, Cornerstone worked with the financial institutions and vendors to create a “win-win” situation for all concerned. As an advisor on the bank or credit union side of the negotiations, Cornerstone brought to bear the experience, vendor relationships and market know-how that comes from having represented thousands of other institutions in similar negotiations.

A WINNING NEGOTIATION STRATEGY The banks in our sample had several things in common that helped them win concessions from their previous vendor contracts and strike deals that worked for both sides. • They didn’t auto-renew. A best practice bank opens negotiations 18-24 months ahead of its current contract’s expiration, which allows the bank time to entertain both the incumbent’s and nonincumbents’ bids—and time to convert, if necessary. Even if a bank intends to stay with its current vendor, it doesn’t hurt to let the vendor think the bank might leave. Waiting too long diminishes the bank’s negotiating leverage. • Their top executives got involved in the negotiations. Because many CEOs and CFOs grew up on the lending or retail side of banking, they can be uncomfortable dealing with technology. That’s OK. Interest and involvement in the decision-making from the highest levels of the organization sends a message to the vendor that the bank is committed to striking a competitive deal. • They bundled core, debit processing and eBanking into one contract. Offering the opportunity for a larger contract gives the vendor greater incentive to strike a favorable deal. As a marketer of commodity products, the vendor is usually more interested in the total dollar value of a deal than any one component. • They created additional leverage, either by soliciting competitive bids or by bringing in an advisor. Vendor contracts are complicated, and putting together the right package can be tricky. While bankers negotiate a new vendor contract once every five years, vendors employ professionals who do nothing but negotiate contracts. Vendors know the right pressure points and will sometimes play hardball to take advantage of a bank’s lack of experience or knowledge. Having someone familiar with the process can balance things out. • They had an overall technology strategy. The banks in our sample all entered into negotiations with a plan for re-directing some of the savings from their core contract negotiations into new technologies and products. Many also let some of the savings flow to the bottom line.

A WINNING PARTNERSHIP Contract negotiations should be businesslike and mutually beneficial for the bank and the vendor. The bank relies on its vendor for updates and service over the length of the contract, and it doesn’t want its vendor to be unhappy about the terms. But neither does the bank want the vendor to walk away with more than is fair. Cornerstone Advisors has established a reputation in the marketplace for assisting banks and credit unions with their contract negotiation, system selections and vendor performance management needs. We have negotiated nearly 2,500 bank and credit union contracts, and we understand that as a trusted advisor, our job is to: •

Explain that vendors aren’t necessarily out to take advantage of their FI clients, but as rational businesses they will seek to achieve the best deal for themselves.

•

Convey market pricing to our clients based on the 15,000 pricing data points in the Cornerstone Contract VaultTM, putting the FI on more equal footing with vendors and leading to an agreement that is fair to both sides.

•

Convey that a vendor is often focused on an FI’s total spend and understands that it might need to give a bit on core pricing to encourage customers to buy new technologies. (Banks might actually end up paying more for their entire vendor solution but getting more and better capabilities.)

•

Know the peculiarities of vendor contracts, including cost-of-living adjustments that can add up quickly over the course of five years.

•

Use our experience to negotiate a contract that takes into consideration the pricing tiers of a fastgrowing institution—for instance, lowering the per-drink price above 100,000 customers—and the service level agreements that define the penalties a vendor pays if the system is not operational a given amount of time.

•

Engage our knowledge of what other institutions are paying for similar services to help management make fully informed decisions.

•

Employ our technical expertise to aid in a systems conversion, if for no other reason than to raise the threat of moving in the vendor’s eyes.

CONCLUSION Vendors are crucial partners in the success of any modern-day bank or credit union, and it’s important to maintain good relationships with them. When it comes to the contracts for core processing, debit processing and eBanking, creating “win-win” contracts leaves both sides motivated to grow the business. Good relationships are built on many things, including good information. Vendors won’t willingly share market pricing data, but FIs that understand pricing dynamics are able to strike fair, marketrate deals with their vendors and in turn free up money that can be redirected to new products and technologies.

When it comes to the contracts for core processing, debit processing and eBanking, creating “win-win” contracts leaves both sides motivated to grow the business.

ABOUT THE DATA Much of the data in Drawing Back the Curtain on Vendor Pricing for Core Pricing comes from the Cornerstone Performance Report and Cornerstone’s Contract VaultTM, a database of 15,000 pricing points collected from negotiating thousands of vendor contracts. If you have questions about the data included in this report, please contact: Brian Hagan Senior Director Cornerstone Advisors bhagan@crnrstone.com 480.663.2190

ABOUT CORNERSTONE ADVISORS After 14 years in this business, Cornerstone Advisors knows the financial services industry inside and out. We know that when banks and credit unions improve their strategies, technologies and operations, improved financial performance naturally follows. Cornerstone’s multidisciplinary team is backed by the experience that comes from hundreds of thousands of gritty, in-the-trenches client hours. We live by the philosophy that you can’t improve what you don’t measure. With laser-focus measurement, financial institutions can develop more meaningful business strategies, make smarter technology decisions, and strategically reengineer critical processes. Our comprehensive advisory services include: • Performance: Including Benchmarking, Best Practice Assessment, Process Improvement, Enterprise Content Management and Workflow Management • Strategy: Including Strategic Planning and Facilitation, Mergers and Acquisitions Advisory, Enterprise Risk Management, Organizational Assessment, and Board Governance Advisory • Technology: Including Technology Assessment, IT Benchmarking, Strategic Technology Planning, RFP Development, System Selection, and Implementation Services • Contracts: Including Negotiation, Opportunity Assessment, and Renewal Advisory Services • Payments: Including Assessment, Scorecard Development, Strategy Roadmap, Branding Agreements, and Revenue Enhancement • Channels: Including Integrated Delivery Channel Planning, and Remote Delivery Planning • Insights & Knowledge Sharing: Including Research Reports, White Papers, GonzoBanker.com (our blog), GonzoBanker Roundtables, Webinars and Podcasts, and Professional Speakers