David Airey recently joined the Bluerock Management Team - Prior to Bluerock, David was Global CIO for the Wholesale Banking Division at ING and has held senior roles at UBS Investment Banking and Accenture. In last month's Review David provided a brief synopsis on the "green shoots of recovery in the City" which generated significant interest. This month, the Editor of the Bluerock Review, Helga Mepham, interviewed David and asked him to expand on the previous article and also discuss what he sees will be the impact of any market recovery on IT investment and on the role of consultancies and external service providers in the future. Helga In last month's Review you spoke about "green shoots" in the City - are you continuing to see these signs of recovery? David There is definitely an increasing sense of "cautious" optimism in the City as second-quarter results from the major investment banks show a sharp rise compared with the same period last year with some banks, such as Goldman Sachs, reporting their best second quarter ever. Several financial institutions have posted near-20% returns on equity during their second quarters and many have seen their share price rise by almost 50% since February. All this follows on from excellent Q1 results and, whilst the relentless job and bonus cuts undertaken by the banks in 2002 (many reducing costs by over a half) has clearly been one of the main reasons why investment banks have earned such high returns, many bankers believe that the 3 year downturn in the City has finally bottomed out. Helga Is the recovery reliant solely on the current boom in Fixed Income markets? David Undoubtedly the recent half-year results have been primarily driven by the continued buoyant Fixed Income markets. However, whilst the environment still remains difficult, there are positive signs for other business lines as demonstrated by the improvement in equity markets (25% rise since February) and the increase in the number of mergers and acquisitions transactions announced. Investment bankers are seeing confidence returning to the M&A market with many of their clients re-visiting the strategic agendas they had prior to the slowdown of the markets. In spite of this, most bankers expect the overall M&A market to be flat compared to 2002 and, given the long lead times for putting deals together, see the final quarter of 2003 and the first quarter of 2004 as the acid test of any sustained recovery. The major uncertainty at the moment is whether the Equity markets and M&A activity will recover, before the bubble in Fixed Income bursts. Helga If the markets are recovering, why are we still seeing announcements of job cuts in the City? David There is a significant difference between the large-scale redundancies of last year and the recent announcements of job cuts from the likes of UBS, Citigroup and Morgan Stanley. In 2002, the wave after wave of redundancies across the major banks was a result of institutions responding to the continued downturn in markets and falling revenues by almost indiscriminately attacking their fixed cost base. This year the job cuts are much more focused, as banks either trim the size of individual departments to the levels of activity they expect in the future, or target poor performers based on an internal ranking process ("the bottom 10%"). This more focused approach is likely to be a continuing theme over the next few years and, whilst no-one is expecting a return to the job cutting levels of 2002, there is a real sense that a more ruthless, meritocracy-based model will increasingly be adopted across the industry, with regular annual culls based both on projected business activity and on individual performance levels. In IT there will additional pressure on jobs over the next few years, as more firms look to outsource non-core activities (such as design/programming) to cheaper offshore development centres. Helga What do you think the impact of any market recovery will be on the levels of IT investment spending? David IT budgets for 2003 are at best flat compared to 2002 levels and overall global IT spending is down for the second year running after having increased continuously at an industry level since the 1970s. It is likely that 2004 budgets will reverse this trend and spending on IT will once again increase. However this increase will be modest compared to the major step changes experienced in the run-up to the millennium, when many organisations completed major infrastructure projects that future-proofed their investment for the short to medium term. Tier 1 banks are now moving away from cost reduction to cost containment programmes although the Tier 2 banks, struggling with high cost/income ratios, are still focused on initiatives that will drive down their fixed cost base. A marked change over the last 12-18 months has been the shift in focus towards using Return on Investment (ROI) and operational risk as the key measures to prioritise and justify IT expenditure. Gone are the days when information technology projects were given the green light, regardless of their value. The majority of projects that are signed off by management today must demonstrate a return of investment within six to twelve months. This means that organisations are having to introduce a meticulous vetting process, standard measures of ROI and a portfolio management approach to projects. Now only those projects that add real value to the organisation are being approved and the realisation of benefits is rigorously tracked.. In addition firms are increasingly differentiating between "run the bank" and "change the bank" projects. The objective here is to reduce the fixed "run the bank" costs (typically over 70% of all IT spend) and thereby enable the overall cost base to be flexed more effectively as market conditions demand. Helga Where do you see the main areas of IT investment being over the next 12-18 months? David From discussions with senior executives across the City, a consistent theme emerges, with IT investment being targeted at cost reduction, operational risk and regulatory initiatives. Discretionary spend is low and the main focus of attention is still on mandatory projects and those that will drive down or contain the cost base. These key areas are: Outsourcing & Offshore Development Basel II & IAS39 Disaster Recovery (Business Continuity) & IT Security Outsourcing and Offshore Development In a continued aim to drive down fixed costs and move away from non-core competencies, outsourcing and offshore development (often called "smart sourcing") are high on the IT agendas of investment banks. Whilst IT/business process outsourcing has become the fastest growing IT services market in the financial sector, the history of outsourcing is littered with unkept promises and scepticism remains widespread among financial services firms as to the hidden costs in such arrangements. However several outsourcing mega-deals have been struck recently (e.g. ABN Amro and EDS, JP Morgan Chase and IBM) and new, more flexible, business models such as on-demand (or utility) computing, promise relief from the pitfalls of previous fixed price contracts. IT development is increasingly being outsourced to cheaper development centres such as India, and investment banks intend to significantly expand their investment in offshore development over the next few years. Initial projects have been completed in most firms and lessons are being learnt that will shape the composition of IT departments in the future. Concerns over the rights to intellectual property when using offshore development partners, together with cultural fit and the loss of in-house knowledge, mean that banks are likely to re-balance the type of IT resources they need to employ directly. Programme/project managers and business analysts will increasingly be seen as a core resource to be retained internally, whilst systems analysts/developers will be sourced via cheaper offshore development partners. Basel II and IAS39 Regulatory requirements will again dominate the IT agenda over the next couple of years as the requirements to meet new operational risk requirements (the Basel II Accord) and new accounting standards (IAS 39) are implemented. This year the majority of financial institutions are focused on understanding/confirming requirements - the new regulations come into effect in 2005 (for IAS 39) and 2006 (for Basel II) and banks are planning to have major programmes up and running during 2004 to ensure that these regulatory requirements are met on time. Disaster Recovery and IT Security The September 11 attacks and the subsequent increased threat of terrorism has resulted in the financial services industry taking disaster recovery (or business continuity) and IT security far more seriously. Whilst the major City institutions have back-up facilities, many are still sited close to their main buildings, not regularly tested and particularly vulnerable to an attack that knocks out an entire area. In addition, the need to comply with regulatory/operational risk requirements such as the Basel II accord, means that business continuity is increasingly being seen as a necessary cost of doing business. As a result, many financial institutions plan to increase significantly their spending on disaster recovery and IT security products over the next two years, with several institutions already in the process of moving their disaster recovery sites outside of the City. Helga How do you see the role of consultancies and other external service providers changing in the future? David It seems unlikely that, even in the event of a significant upturn in market conditions, investment banks will re-hire within their IT departments to anything like the staff levels of three years ago. This will provide opportunities for consultancies and external providers to assist in balancing supply and demand. Increasingly CIOs are looking for a more flexible resource model and turning to trusted external parties. There is a clear move away from buying the traditional Big 5 consultancy model and a move towards the use of niche, flexible, "experience led" consulting firms. Rates have clearly had a major impact here and the severe downward pressure on rates, coupled with a high cost base, has hit the mainstream consultancies hard. However, even where resources have been offered "free" there is an increasing resistance to the "land and expand" approach, with CIOs turning to smaller consulting firms to provide the experienced business/IT project resources as and when required. Whilst there will clearly always be a market for the major consultancies, especially for the large-scale high profile/high risk initiatives, it is likely that the niche consultancies will gain market share, with financial institutions developing a select number of long-term, "trusted" relationships with such companies. For these smaller consultancies, many formed as a result of the market downturn over the past three years, a critical success factor will be their ability to partner with other service providers. The key here is to ensure that any partnerships are both complementary (not competitive) and result in a true win-win situation for both parties. The use of associates to manage the cost base within these start-up consultancies is currently in-vogue (especially given that many who have set up these companies come from medium size consultancies whose demise was caused during the market down turn by their high fixed cost base). However quality and commitment ("the extra mile") are key issues to be addressed within such a business model, and some clients are now stipulating that they will only accept resources permanently employed by a consultancy. This is likely to be an increasing trend and, where quality of client service is key to the brand, there will be a pendulum swing back to a more permanent recruit based approach, with the fixed cost base being managed by diversification across sectors and service lines.