Spanish Banks Push for Continued IT Transformation Investments Amid Difficult Local Markets and Industry Consolidation

WHITE PAPER Sponsored by: Finacle from Infosys

Peter Farley David Medeiros

March 2011 fi.com

PREFACE This IDC Financial Insights White Paper, sponsored by Finacle from Infosys, is based on the findings of a survey-based study conducted via both telephone and face-to-face interviews in the last quarter of 2010. A total of 15 senior bankers at 14 different banks and financial institutions in Spain contributed to the research findings.

The banking institutions in Spain surveyed for this primary market research study were Banca March, BBVA, Banco Cetelem, Banco Camino, Banco Cooperativo Español, Banco Popular Español, Banco Sabadell, Banesto, Banco Santander Group, BNP Paribas Spain, Caixa d'Estalvis Laietana, Caja Madrid, Citibank Spain, and Kutxa-Servimática. Information from the survey responses has been complemented with wide-ranging discussions with a variety of key participants in the Spanish banking sector.

EXECUTIVE SUMMARY ● Survey shows appetite for IT transformation but limited budgets

● Industry consolidation and balance sheet rebuilding take priority

● Spanish banks still committed to extend proven IT innovation

● Macroeconomic and sovereign issues cloud market landscape

● Improved customer capabilities still head IT priorities

● Compliance vies with channel improvements for budget

Global Headquarters: 5 Speen Street Framingham, MA 01701 USA P.508.620.5533 F.508.988.6761 www.idc F.508.988.6761 P.508.620.5533 USA 01701 MA Framingham, Street Speen 5 Headquarters: Global ● Core transformation still seen as key to greater flexibility

Just about everyone accepts that banks need to be more efficient. In fact, over the past decade Spanish banks have been among the global industry leaders in driving down the percentage of maintenance and operating costs that absorb such a crippling high percentage of IT budgets. And it is a testimony to most Spanish banks that they are still trying to drive those debilitating ratios even further below the key 50% level that is still a challenge for so many others.

March 2011, IDC Financial Insights #IDCWP13T

However, local circumstances mean even the most ambitious and seemingly sensible plans have had to be compromised. The results of a survey carried out by IDC Financial Insights toward the end of last year show that pragmatism is now the order of the day. But it is a frustrating situation for so many banking technology executives who have been at the cutting edge of so many innovative developments.

However, to be fair, while the Spanish banking sector had one eye so firmly focused on improving areas of business that made a difference with customers, it also allowed the other eye to wander away from the balance sheet risks and problems that crept up on the blind side.

This white paper looks at the backdrop to the current challenges in Spain, analyzes the responses to our survey of industry professionals, and draws some conclusions on the opportunities available. It acknowledges there are those that recognize the need for new investment, while only a minority are yet in a position to execute those plans.

It remains clear that there are difficult times ahead for the Spanish economy in general and banks in particular. In fact there are many imponderables about how that bigger picture will develop. Given that so many of the answers lie outside the ability of local players to influence decisions being taken at EU and ECB level and elsewhere, the opportunity to shape that bigger picture is likely to be limited.

BANKING MERGERS STAR T TO CHANGE THE LANDSCAPE The unfolding events in Spain have already led to mergers last year between 12 of the 45 savings banks, or Cajas, with a 13th requiring support from the Spanish central bank. This process is far from complete and has created an ongoing air of uncertainty in the local banking market. This caution is reflected in the feedback to our survey — despite acknowledgement that more investment in the technology that will drive future efficiency is required, more important issues need to be resolved first.

Leading the way have been Caja Madrid and Barcelona-based La Caixa, the latter the country's third-largest financial institution behind Banco Santander and BBVA. That title has now passed to the new BFA Group.

Indeed, probably the most dramatic development in the Spanish banking landscape was the creation at the end of last year of Banco Financiero y de Ahorros (BFA), formed out of the merger of seven otherwise struggling financial institutions. But it was interesting to note that rating group Fitch, in its assignment of an "A-" initial rating to the new BFA Group, said it will remain under pressure from low interest rates, high funding costs, low business volumes, and high restructuring costs. More importantly, it also said that further benefits and synergies would only become evident through branch rationalization plans and the implementation of a common IT platform.

The banks which merged to form BFA were Caja Madrid, Bancaja, Caixa Laietana, Caja Insular, Caja Avila, Caja Segovia, and Caja Rioja. Like many others, their problems stemmed from the high concentration of risk exposure to the local property and construction sector, the continued depressed state of which means that BFA will take quite some time to both reduce risk concentration and sell distressed assets. But this is not a unique problem.

Page 2 #IDCWP13T ©2011 IDC Financial Insights The Spanish economy generally faces enormous challenges because of these issues, which are likely to continue for several years to come. Spain is also currently in the midst of a potential financial crisis over its level of sovereign debt, and is suffering from high unemployment and falling property values. It is therefore trying to win a mandate for fiscal austerity measures and changes to labor legislation to address wider macroeconomic problems.

The performance of the banking industry in Spain reflects these challenges, in falling profitability levels and industry consolidation. This has also eroded public confidence in banks given contracting and increasingly poorly performing loan portfolios and increased constraints on lending and credit. According to a recent report from Moody's rating agency, the collective Spanish banking sector still needs a further €17 billion in extra capital in 2011 to meet unrealized losses in its domestic banking operations (of which €12 billion is required by the Cajas).

However, despite that bleak environment, the survey shows that there is still a reasonably optimistic mood in local banking circles, combining the sector's historic inventiveness with pragmatism and focus on future opportunities.

ADVANTAGES TO BE GAI NED Although there is considerable caution about the appetite for current large-scale IT investment, the realization that this will eventually become essential at most institutions suggests a significant competitive advantage for those prepared to commit sooner rather than later.

The survey shows most Spanish banks deny that the current financial crisis is having a major impact on plans to upgrade or replace their technology infrastructure. However, there is a clear acknowledgement that it is having at least some impact. But the uncertainty means few banks will offer specific answers to questions regarding when they plan to replace/upgrade key systems, or how much they plan to spend when they do so. These constraints have forced Spanish banks to closely examine their investment priorities for future banking IT development projects, making sure that there is a clear focus on projects with the greatest return on investment and the greatest level of responsiveness to market conditions and demands.

CUSTOMER FOCUS The market conditions with the greatest immediate impact on Spanish banks are those reflecting the fact that customers are demanding more from their banks in terms of meeting their expectations, understanding their banking needs, and providing them with a full range of service delivery channels and touchpoint options. This focus on the customer is also reflected in Spanish banks' top IT strategies and top IT projects in the core banking domain, which focus on customer-centered issues.

At Spanish banks, according to feedback in the survey, the approach toward longer- term core systems upgrades and replacements is driven by evolutionary and not revolutionary factors, and is focused clearly on the capacity to produce bottom-line business results. Top replacement/upgrading priorities focus on using core banking systems' technology for controlling operational and development costs and enabling improvement in the flexibility and efficiency of business processes. Solutions

In working with core banking technology vendors, Spanish banks place a priority on enablement of greater process efficiencies, customization to their own specific needs (in accordance with replicable and industry-standard development methodologies and technologies), and overall dedication to full-service competence and credibility. These factors take current priority over other desired abilities to provide cutting-edge technology or an extensive array of new product features.

GLOBAL LIQUIDITY INF LUENCES Remarkably, despite current problems, the Spanish banking system has endured the recent worldwide liquidity crisis better than those in many other European countries, due to Spain's conservative banking rules and practices. Spanish banks have historically been required to maintain high capital provisions and to demand various guarantees and securities from intending borrowers, due to regulations enacted in response to the banking crisis of 1979 and a later real-estate-precipitated banking crisis in 1993.

This regulatory framework has allowed Spanish banks (particularly those geographically and industrially diversified large banks like BBVA and Santander) to endure the real-estate deflation occurring in Spain better than expected. In fact, many of the larger Spanish banks have been able to capitalize on their strong position to buy up distressed (and healthy) banking assets elsewhere in Europe, Latin America, and in the United States.

FURTHER CONSOLIDATION AHEAD Nevertheless, with the unprecedented deepening of the country's housing crisis, smaller local savings banks (Cajas) are known to have delayed the registering of bad loans (which local rules allowed them to phase in), especially those backed by houses and land, to avoid declaring losses. The Bank of Spain and regulators are therefore now moving to proactively drive mergers of these institutions to strengthen balance sheets and operating efficiencies.

The Spanish banking market therefore faces enormous challenges as it seeks to consolidate, recapitalize, and reestablish growth trajectories. The legacy of dysfunctional balance sheets is being exacerbated by wider macroeconomic malaise as well as international investor skepticism over the country's ability to restructure labor markets, increase productivity, and reduce unemployment in a way that will allow it to reenter sovereign debt refinancing markets on more equitable terms.

Within this context, as a major economy of the European Union, Spain is also subject to the larger challenges facing the euro region, including slow growth and systemic issues that are even casting doubt on the very future of the euro as a pan-European currency.

Not surprisingly, there is little evidence of much immediate appetite for substantial investment in new projects while the industry still faces so much uncertainty. There is little doubt that there will be further industry consolidation, and there could well be future surprises that require as yet unforeseen bank rescues.

Page 4 #IDCWP13T ©2011 IDC Financial Insights However, wherever there is turmoil there is opportunity. It is therefore clear to most banking industry leaders in Spain that the banks which emerge from this period will not only have to be stronger, but leaner and more efficient.

KEY SURVEY FINDINGS

Market Conditions and Their Impact The majority of banks that responded to our survey indicated that the current financial crisis has had only a moderate or small impact on their plans to either replace or upgrade their core banking systems, or no impact at all (see Figure 1). However, it is also the case that a majority of the banks surveyed indicated that the current financial crisis is having at least some impact on their plans to replace or upgrade their core banking systems.

F I G U R E 1

T o What Extent Has t h e Economic Crisis o f Recent Years , a n d i t s I m p a c t o n t h e Banking Industry , A f f e c t e d t h e P l a n s Y o u May Have Had t o R e p l a c e o r Upgrade Your Core Systems ( C h o o s e O n e )?

Not at all 2

To a small extent 4

To a moderate extent 5

To a great extent 1

Accelerated plans 2

Deferred or delayed plans indefinitely 1

0 1 2 3 4 5 6

(Number of respondents)

Source: IDC Financial Insights, 2011

Because of the uncertainty in the market, the majority of Spanish banks seem to be adopting a "wait and see" attitude toward upgrading or replacing their core banking systems. A majority of the banks interviewed indicated that they have set no specific timescale for when they plan to replace or upgrade their core banking systems. Similarly, the majority of the banks surveyed also indicated that they have no specific answer to the question of how much they plan to spend on their next core banking system upgrade or replacement.

©2011 IDC Financial Insights #IDCWP13T Page 5 However, we know from wider conversations with industry leaders that these formal responses to questions mask an underlying concern that insufficient attention is being given to improving efficiency through upgrading core systems and other legacy infrastructure. Because of this, some believe there could well be a bigger price to pay in years to come.

The market conditions — whether local, national, or regional — with the greatest perceived impact on Spanish banks are customer-centric. These reflect the fact that customers are demanding more from their banks in terms of meeting their expectations, understanding their banking needs, and providing them with a full range of service delivery channels and touchpoint options (see Figure 2).

In an industry as highly regulated as banking, one of the few differentiating factors among banks is the ability to provide a higher degree of customer service. Many of the banks interviewed indicated that in response to customer demand, they would be paying increasing attention in the near future to channel and touchpoint management options, including social networking, collaborative tools, mobile banking, and Internet-based offerings.

F I G U R E 2

W h i c h Conditions Specific t o Your Local Market a r e C u r r e n t l y H a v i n g t h e Largest Impact o n Your Decision t o U p g r a d e o r Replace Your Core Banking System (Choose Three )?

Managing customer expectations and relationships 73

Managing customer touchpoints/delivery channels 53

Need for improved risk control 40

Changes in technology standards 33

Regulatory requirements: European 27

Regulatory requirements: National 27

Industry consolidation 20

0 10 20 30 40 50 60 70 80 (%)

Source: IDC Financial Insights, 2011

Current Business and IT Priorities

This "focus on the customer" is also reflected in Spanish banks' top applications of IT to business strategy and top IT project investments.

In the area of IT business strategy, the focus is clearly directed externally, on the customer (acquisition, satisfaction, and product choice), rather than on internal factors such as cost reduction or profitability improvement (see Figure 3).

Spanish banks' top IT project investments also reflect strategic priorities oriented externally, toward customer demands for banking services through online and mobile channels, and toward mobile-channel platform integration.

F I G U R E 3

What are the Top 3 Focus Areas o f Your Application o f Information Technology t o Your Business Strategy (Choose T h r e e ) ?

Improve customer service/satisfaction 73

Acquire new customers 60

Introduce innovative new customers 53

Reduce costs 47

Improve profitability 33

Cross-sell to customer base 20

0 10 20 30 40 50 60 70 80

(%)

Source: IDC Financial Insights, 2011

Also among the top IT project investment priorities at Spanish banks are the always- necessary categories of compliance/risk management, and also fraud/security initiatives. Compliance and security concerns are mounting under increasing regulatory pressures, driven by global initiatives such as Basel III and Solvency II as well as national-level initiatives, with many banks aiming toward implementing integrated risk control approaches (see Figure 4).

However, the focus on the customer is key for future investments as well, with the most frequently mentioned top IT investment project being a refresh or upgrade of online channels. In a similar vein mobile-channel platform integration was also among the most frequently mentioned top IT project priorities.

W h a t a r e Y o u r T o p 3 I T P r o j e c t s ( i n T e r m s o f I n v e s t m e n t ) f o r This Financial Year (Choose Three )?

Online channels upgrade/refresh 60

Compliance/risk management 53

Fraud/security initiatives 40

Mobile-channel platform integration 40

Back-office consolidation 33

BPM/process intelligence 27

Core systems replacement 27

Branch systems transformation 7

0 10 20 30 40 50 60 70 (%)

Source: IDC Financial Insights, 2011

The technology factors driving the need for core systems replacement at Spanish banks are evolutionary, not revolutionary, and clearly focused on their ability to produce bottom-line results. Wholesale changes in service or computing models (moving to real-time systems, or moving from an application services provider or ASP model) are seen as less important than basic bottom-line business factors such as controlling operational and development costs, enabling improvement in the flexibility and efficiency of business processes, and staying ahead of general technology obsolescence (see Figure 5).

Many of the banks interviewed indicated that a number of the key limitations to their existing core banking systems were in the areas of constraints on data governance structures and barriers to cross-functional, cross-line-of-business data availability. The ability to provide solutions with sophisticated yet easy-to-use data analytics, easy business process design and incorporation of business intelligence, and tools for managing unstructured data will be critical for any core banking systems vendor in the Spanish market.

Which are the Most Important Technology Factors That a r e C a u s i n g t h e N e e d f o r Core Systems Replacement a t Y o u r B a n k ( C h o o s e T h r e e )?

Need for more flexible business process/work 73

Reducing platform costs 67

Lower IT/development costs 53

Technology obsolescence 40

Application rationalization 33

Move to real-time systems 27

Move from ASP model 7

0 10 20 30 40 50 60 70 80

(%)

Source: IDC Financial Insights, 2011

This emphasis on business practicality is also reflected in Spanish banks' perceptions of the primary technology barriers to core systems upgrading and replacement. Spanish bankers told us that the top technology barriers to core systems replacement are mainly practical, bottom-line business factors (such as the necessary time, expense, and complexity of defining business solutions and implementing solutions to automate them), rather than operational limitations, such as the lack of available solutions, problems with documentation, or the need for customization (see Figure 6).

Furthermore, Spanish banks' strategies for core systems modifications largely avoid large-scale changes (extensively reengineering systems, or replacing them entirely); rather, the focus is on "wrapping" core systems for greater openness and integration (see Figure 7).

What are the Most Important Technology Barriers t o C o r e Systems Replacement (Choose Three )?

Time and expense of implementing existing solutions 93

Complexity of technology implementation 80

Difficulty of defining business processes 47

Need for extensive customization of new system 40

Lack of documentation for current system 27

Lack of solutions available from vendors 13

0 10 20 30 40 50 60 70 80 90 100

(%)

Source: IDC Financial Insights, 2011

F I G U R E 7

Which of the Following Best Describes Your Approach t o C o r e Systems Strategy (Choose One )?

Wrapping core systems for greater openness/integration 40

Other/no response 27

Reengineering core systems for greater "componentization" 20

Replacing some core legacy systems where required 13

0 5 10 15 20 25 30 35 40 45

(%)

Source: IDC Financial Insights, 2011

Page 10 #IDCWP13T ©2011 IDC Financial Insights In considering how core banking information technology can be transformative, Spanish banks focus on process efficiency (streamlining end-to-end processes through straight-through processing, bringing new products to market more quickly, and making cross-selling of products easier). Other application areas (product standardization, regulatory compliance, post-M&A consolidation) are also seen as important, but not ones where technology is "transformative" (see Figure 8).

F I G U R E 8

W h a t , i n Your Opinion , a r e t h e Most Important Ways That Technology Can Enable Banking Transformation (Choose T h r e e )?

Streamline end-to-end processes (improve STP) 93

Enable more rapid time to market for new products 80

Enable cross-selling opportunities 67

Enable more standardized products 33

Enable more compliance with changing regulatory requirements 20

Improve post merger and acquisition consolidation 7

0 10 20 30 40 50 60 70 80 90 100 (%)

Source: IDC Financial Insights, 2011

Partner Selection Criteria

Spanish banks have historically preferred to develop their own solutions rather than relying on packaged options from vendors. By an overwhelming margin, core banking systems in Spain are either entirely custom built, or a mix of a packaged and in-house-developed systems (see Figure 9).

And, while there is no immediate sign that that pattern is to be reversed, conversations with senior banks reveal an increasing awareness of both the improvement of packaged vendor solutions and the cost effectiveness that these can offer. This suggests that vendors are likely to receive a more sympathetic hearing than in the past, particularly as internal IT resources are going to be under more intense scrutiny as the mergers force management to look for widespread areas of savings and greater efficiency.

So, for the time being at least, the patterns of the past might not be the best indication of future activity.

F I G U R E 9

Which of the Following Best Describes Your Current Core Systems Environment ? ( S e l e c t O n e O n l y )

Custom system developed entirely in-house 47

Mix of packaged and in-house developed system 33

Packaged core system from external vendor 7

Outsourced/ASP-based vendor solution 7

Shared processing center 7

0 5 10 15 20 25 30 35 40 45 50

(%)

Source: IDC Financial Insights, 2011

Spanish banks clearly perceive that the capability to customize and tailor solutions to each bank's specific needs is a critical vendor skill, but at the same time, solutions must be created according to widely adopted industry and technology standards (see Figure 10).

Solutions must be created according to existing and accepted development methodologies, and be sufficiently industry-standard that the solution could be used by the vendor for resale or reuse by another banking unit or institution.

At the heart of this has been a historic concern about the ability of vendors to fulfill implementation commitments. That said, there were certainly signs from some of our interview conversations that this is not only less of a worry, but that some vendors have been able to demonstrate a sharp improvement in core competencies.

W h a t W o u l d b e Your Ideal Method o f Working With a n E x t e r n a l V e n d o r ? Select One O n l y

Custom development based on existing dev't methodology 47

Partner with vendor to develop new system for resale/reuse 33

Fully custom-built development 13

Implementation of packaged solution 7

0 5 10 15 20 25 30 35 40 45 50

(%)

Source: IDC Financial Insights, 2011

Vendors are also expected to be credible, competent, and dedicated to providing full- service offerings. These factors are considered by Spanish banks to be more important than product or technology factors such as ability to provide state-of-the-art technology or best-of-breed product functionality (see Figure 11).

F I G U R E 1 1

What are the Most Important Factors i n C h o o s i n g a C o r e Systems Vendor? (Select Three )

Ability of vendor to offer end-to-end service 60

Existing reference sites 60

Vendor viability (financial stability) 47

Ability to implement successfully 33

Best-of-breed product functionality 33

Future proof of technology roadmap of vendor 27

0 10 20 30 40 50 60 70

(%)

Source: IDC Financial Insights, 2011

©2011 IDC Financial Insights #IDCWP13T Page 13 CONCLUSION The Spanish banking market has certainly established many innovative products, services, and working practices in the last decade or more. We are confident that it will therefore emerge stronger from a difficult period of significant and wide-ranging challenges at all levels — global, regional, national, and industry-specific. But, for now at least, these challenges have driven Spanish banks to take a "wait and see" approach to making major changes to their core banking systems.

Despite this hesitancy to make large-scale changes, within Spanish banks, a slow return to positive growth in technology spending is expected in 2011. This will be driven by demand for improved customer service externally and the desire for better use of business intelligence and the obligation to comply with regulatory demands internally. Spanish banks are seeking cost-effective, customizable solutions, based on industry-standard development technologies that improve efficiencies, enable innovation and incorporation of business intelligence into business processes, and improve customer service deployment without the need for wholesale core banking platform replacement.

Survey highlights:

● Current uncertainties in the economy and the banking industry, both worldwide and within Spain, are making Spanish banks hesitant to undertake large-scale changes in their banking technology platforms.

● New technology investments at Spanish banks are predominantly targeted at initiatives that strengthen customer relationships and customer service options.

● The predominant technology strategy at Spanish banks is to "wrap" an existing core banking system with new applications that enable acquisition of new customers, improve systems for providing service to existing customers, and enable the introduction of new products.

● Most Spanish banks use a core system either developed entirely in-house or developed as a tailored or customized solution in cooperation with a vendor. Partnerships with vendors are based on vendors' ability to offer complete, end-to- end solutions based on replicable, industry-standard technologies and methods.

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