How US mid-cap banks can solve the conundrum of scale in technology

Scale in tech spending is projected by many to become a major differentiator in US banking over the next decade. But thus far investors have not unequivocally signaled their agreement with this notion. So, smaller banks face a conundrum about when and how much to invest in building their own technology. If they outsource, they will be relying heavily on vendors who by definition will not offer differentiating solutions—which defeats the original purpose. M&A is another option, but getting to a perceived threshold size may be out of reach for many small banks, and mergers alone cannot cover for poor technology, and may even create more tech issues.

Given this challenge, mid-cap banks need to make strategic choices about where and how to play, and use new talent, operating models, and tools to overcome their lack of scale in technology. This is no easy task, but many Asian banks, and some US and UK fintechs, are showing that it is possible. It will take urgent action for US mid-caps to follow these examples, however.

For US mid-cap banks ($10 billion to $100 billion in assets, or $500 million to $5 billion in revenue), the new age of banking technology is a clear strategic threat. Like larger banks, mid-caps spend 6 to 8 percent of revenue on technology. But given their size, that’s at most a few hundreds of millions of dollars, compared to billions for the larger banks. Meanwhile, the scale of tech spending is being widely commented on as a future differentiator. This is creating a sense that outsized investment will confer unassailable competitive advantage and market value gains, and leave behind banks that do not or cannot invest at comparable scale.

Already, for some mid-cap banks, entire areas of banking—such as consumer payments (e.g., credit cards, peer to peer, instant pay), mortgage origination and servicing, and online deposit gathering—are becoming inaccessible. The advanced capabilities that power these services (e.g., the latest mobile-first capabilities, cloud-based services, or cutting-edge marketing analytics tools) are beyond their reach. As a result, these banks are increasingly reliant on commoditized vendors (often of variable quality) or are late joiners to industry consortiums like Zelle. And as the best engineers, analysts, and product owners are being recruited by larger institutions that can offer rich career paths, exciting technology, and high salaries, mid-cap banks struggle to build the talent bench that might prevent a strategic spiral downward.

The wrinkle, however, is that the market has not yet actually signaled unequivocally that bigger is better. For example, many mergers over the past decade have not moved returns to shareholders significantly. Pure financial performance has not demonstrated bigger is better—21 of the top 25 highest price-to-book value US banks were mid-caps as of June 2019. Between 2013 and 2018, mid-caps had the highest return on assets and revenue growth, and the best efficiency ratio across all size categories. The cost of technology will continue to fall, potentially becoming more accessible. Many segments are more sensitive to relationship than to technology (e.g., commercial lending, advisory wealth management, or new mortgages originated via realtors). Even in treasury management, which is often highly tech-enabled, relationships are a crucial part of the sales approach. And there is more evidence against the primacy of scale: many smaller fintechs are growing rapidly, demonstrating that success in certain verticals is not scale dependent (e.g., unsecured or point-of-sale lending). Finally, some Wall Street analysts complain that returns on digital investment have been low and opaque (while risks have been high).

So, thus far, many smaller banks are not being penalized by the stock market or by customers, creating a real conundrum around when and how much to invest.

But anxiety is growing in the mid-cap space, along with a sense that scale could make a real difference to smaller institutions in at least three areas.

First, retail deposits could become a key battleground. While generally among the more “sticky” banking businesses—US banking consumers keep a vast majority of deposits at far lower rates than they might receive by switching—the “glue” that keeps customers loyal to their deposit bank shows early signs of weakening. For examples: more than half of US deposit consumers now use their mobile phones to access their deposit accounts at least every three months; experience-based attackers like BankMobile and Chime have reportedly gathered millions of customers; and transactions and traffic in branches are dropping at 5 to 10 percent per year, in line with broader retail trends in the US. For small banks that rely heavily on retail deposits to fund commercial lending activity, a movement by customers toward more digitally sophisticated players could be a major disruption they will struggle to counter.

The second area where scale could begin to create real separation between banks is the broader payments space, which is witnessing tremendous technology-enabled change (e.g., peer-to-peer payments, faster payments, merchant acquiring for mobile players, point-of-sale terminal sophistication). It is true that smaller banks do not really play a big role in this space; but if payments are used to disintermediate the deposit relationship (or even treasury management relationships), it could lead to serious disruption.

Third, across the board, the use of data and analytics is a key battleground, though its reliance on pure technology is lower than some might expect. Still, the skills to host and analyze the massive amounts of data created by consumers interacting digitally in every aspect of their lives are aggregating to the largest financial institutions. As well, the largest technology companies are demonstrating they prefer to partner with large financial institutions for products that plug into their ecosystem.

What should mid-cap banks do?

We suggest there are four interrelated moves that mid-caps can make to lessen the increasingly disruptive impact of scale:

  1. Clarify what is truly strategically important and focus investments on those areas only. Use this clarity to build a compelling vision for new talent.
  2. Modernize the “delivery infrastructure” in a targeted way; for example, by leveraging new cloud- based cores for select parts of the business that will need to move rapidly, and by building other modern tools to enable rapid speed to market.
  3. Dramatically upgrade the technology group’s talent and skills, practices, and counseling ability, with the aim of reducing costs by as much as 30 percent.
  4. Build an operating model that is far more technology enabled and collaborative.

1. Clarify what is truly strategically important

Some bank CEOs have asked their teams a very powerful question: “Does our IT project portfolio reflect the focus of our strategy?” The answer is quite consistently “no.” IT project portfolios can be visualized by duration, strategic business focus, impact, budget commitment, and resourcing/skill level. These visualizations often show that while mid-cap banks may say that “commercial lending and retail deposits are where we make money,” their IT projects are geared toward retail lending and payments; that while the CEO wants to focus on high-impact strategic work, the projects are actually geared toward “keeping the lights on”—maintenance-level work. Or while the CEO wants to build analytics and digital marketing and cloud skills, most of the projects involve coding languages from the 1980s or commoditized skills. Or while the CIO wants to build a talent bench for the future, the most sophisticated work is outsourced, and the bank’s employees focus on commoditized work.

Clarifying the business strategy and ensuring the IT project portfolio and workforce reflects this prioritization is an indispensable first step.

2. Modernizing the delivery infrastructure in a targeted way

Mid-cap banks’ IT groups often focus their development work on customizing vendor platforms (creating more maintenance work for themselves over time). With what capacity they have left, they build new features that try to catch up with what larger banks can achieve by deploying their large workforces. And typically, mid-caps don’t leverage their smaller size to become more nimble—their IT projects move no faster than those at more complex institutions.

In technology as in nature, being large and fast is best . . . large and slow can work . . .  small and slow is a pathway to extinction. To be competitive, mid-cap banks need to be nimble. But even the best intentions cannot overcome Jurassic tools and infrastructure. Legacy core banking systems slow down time to market for new products, the lack of microservices and APIs, the missing DevOps tools, the reliance on non-cloud-enabled data and analytical packages, and the lack of “agile-scrum” ways of working—all conspire to hamstring efforts to be nimble. And all need to be modernized.

The technology is now available to help scale-constrained mid-cap banks to compete. For example, our analysis suggests that new (albeit less proven) cloud-based core banking systems could lead to significant improvements in efficiency over legacy core systems (Exhibit 1).


However, given budget constraints as well as safety concerns (legacy systems are often very stable), mid-cap banks need to be careful about what parts of their delivery infrastructure they modernize, and how they do it. There have been several cautionary tales globally of banks investing hundreds of millions of dollars in the move to new core systems, and the resulting customer disruption. Smarter ways of leveraging new cores are emerging that may bring down costs and risks significantly, and the first proofs of concept are now underway in Europe and the US. In a similar way, new approaches in other parts of the delivery chain (e.g., web services in the existing core to speed up predictable and frequently demanded services; automated testing) can make the development environment far faster.

3. Dramatically upgrade the technology group’s talent, practices, and counseling ability

Moves 2 and 3 are interdependent. It is impossible to upgrade a delivery infrastructure without the right engineers and tech leaders to manage that modernization. But those engineers are unlikely to join the bank unless there is a compelling value proposition and development environment to attract them.

Breaking this chicken-and-egg cycle requires small but meaningful steps. Some banks are setting up new business capabilities (e.g., digital deposit attacker, new treasury management lab) using new technologies, in cities with talent bases, to attract talent to the bank and build a sophisticated and more modern culture. They are rotating current employees with potential into these new groups to build the expertise. In parallel, they are leveraging the deep expertise and knowledge of current employees to modernize legacy systems as well.

Other banks are experimenting with the new technologies while modernizing their legacy systems. Importantly, experiments all have ROI targets attached to them.

Finally, nearly all the banks we have seen embark on this journey are setting an aspirational technology vision, articulating how it will support their strategy, and developing a fit-for-purpose employee strategy.

And most importantly, they are breaking down the walls between business and technology, and the C-suite is role-modeling the change in mindsets and behaviors.

4. Build a new operating model with the business

According to our analysis, some engineers can be as much as eight times more productive than the lowest performers in their group. But highly productive individuals do not always make for productive teams. A talent reset has to be accompanied by an operating model redesign in which silos and individuals come together to work on their teams’ mission. Many larger banks are already seeing success with this “mission-based” operating model—with some calling the resulting model a digital factory with very different way of working and interacting with the rest of the company.

What success could look like

At least one Asian bank built on a digital-native stack has a technology cost per customer of $1 compared to the average of $30 to $50 for US banks. On its own, this efficiency is not game-changing, as total IT expense is only 6 to 8 percent on average of a bank’s revenue. But the capabilities it confers can be disruptive in capturing market share; for example, by facilitating value-creating M&A by enabling rapid onboarding of new customers (one Asian player that owns a payments company was able to onboard 25 million customers in one quarter, a population the size of Texas’); or by increasing flexibility and innovation. For example, a digital bank in the UK can provide a replacement debit card in 45 seconds directly to a customer’s mobile app—exactly the kind of “delightful” moment that will foster loyalty and generate share gains in a competitive market. It is not overstating the case to say that for some mid-cap banks, offering these kinds of experiences to retail deposit or treasury management customers could mean the difference between extinction and success in the next decade. And if they are going to begin the transformation, the time is now.