Unlocking value from banking technology investment #IndustryFinance

Over the past few years, global technology spending in banking has been increasing 9 percent a year, on average, outpacing revenue growth of 4 percent. In 2023, this spending totaled $650 billion, which is roughly the GDP of Belgium or Sweden. Despite this significant spending, it hasn’t been easy to quantify the net benefits. Moreover, the banking sector has experienced the following challenges:

• Declining productivity. Labor statistics suggest that since 2010, productivity at US banks has been falling 0.3 percent a year, on average, even as most other sectors have experienced productivity gains. Furthermore, the correlation between banks’ revenues and their number of full-time employees is very high, regardless of the institution’s size, suggesting that the industry hasn’t been able to deliver scale economies on technology spending (Exhibit 1).
• Unclear competitive differentiation. If a bank spends more on technology than its peers do, it doesn’t necessarily lead to a competitive advantage. For example, a large bank and a small bank can both have a mobile app with a 4.9 app store rating, even if the small bank’s technology spending is a tiny fraction of the big bank’s. Banks of all sizes spend around 10 percent of their revenues on technology, and a robust ecosystem of vendors ensures that new developments in technology are quickly commoditized, copied, and distributed, minimizing first-mover advantages.
• Increasing cost of complexity. Growing demands on technology due to regulatory compliance, adoption of AI, and a wave of legacy-system renewals will likely require the industry to continue increasing technology spending. But standard ROI calculations often fail to acknowledge the full costs associated with a tech business case, such as maintenance of the newly built application, increased technical debt from the complexity created, and future infrastructure expenses. This total cost of ownership for a new application can often outstrip the benefits of building one.

While technology has led to major changes in banking, as evidenced by innovations such as mobile apps, algorithmic trading, and automation, quantifying the value from these developments has been difficult for many banks, particularly when it comes to specifying what they are doing better than their peers.

The growth in technology spending is naturally drawing increased scrutiny from management teams, board members, and CEOs, as they expressed in interviews we conducted for this research. This perception was also reflected in our interviews with several leading equity analysts, where we asked for views on value creation and the role of technology in banking. A general sentiment emerged that technology spending is often seen as opaque and that the value enabled is unclear to stakeholders (see sidebar, “Banking equity analysts weigh in”).

In this article, we outline how banks can extract greater value from their technology spending—and demonstrate that value to stakeholders—by shifting the way investments are allocated and driving outcome-based execution.

Currently, some financial institutions are in a negative loop: they have limited discretionary capacity for tech spending but determine they need to build certain solutions themselves, often because vendors’ offerings don’t meet their needs. In the interests of organizational harmony, these institutions typically decide which projects to prioritize from the bottom up, with limited top-down direction, which results in a large number of small technology initiatives whose returns are often unclear. These initiatives typically don’t have the critical mass of funding needed to show results. And because they aren’t expected to show immediate outcomes, these initiatives are executed using a time-and-materials approach that prioritizes minimizing cost rather than maximizing value enabled. This in turn complicates the articulation of that value to investors.

Some other institutions have created a virtuous cycle. They use a value-focused approach and ensure cross-functional collaboration among the C-suite (CEO, CFO, CIO, business unit heads) to ensure value realization beyond the CIO’s office. The approach entails unlocking more technology capacity through productivity improvements, concentrating technology investments in a small number of business domains where the executive team has determined outsize value can be enabled, adopting an outcome-based execution approach to ensure value realization, and developing a stronger articulation of value to investors that is directly linked to financial commitments (Exhibit 2).

The technology investment conundrum

Banks tend to face the following challenges when it comes to technology investment governance:

• Limited discretionary technology capacity. Many banks don’t disclose specifics about their technology spending. At large banks that do disclose this data, “run the bank” and “mandatory change” spending often represents up to 70 percent of technology budgets. These categories include infrastructure hardware and software, IT operations, regulatory compliance, and other types of unavoidable spending, leaving only limited capacity for investments that can drive competitive differentiation (Exhibit 3). Technology productivity is also often perceived to be low. For example, developers may spend less than half their time coding, and implementation of new features can take as long as a year.

• Lack of top-down portfolio view. Even in this digital age, many executives still feel ill-equipped in the language of technology and often delegate important investments to the tech department. However, many tech departments feel they don’t understand the business strategy and seek out business collaboration. If they don’t receive this partnership at the senior levels, the limited amount of discretionary “change the bank” spending is typically allocated by more junior managers to disparate individual initiatives, and a top-down view is not applied consistently to ensure that spending is aligned with the business strategy. This approach results in investments being spread too thin, as opposed to being concentrated in a few strategic areas of focus. Funding allocation refreshes are also often made with a “last year, plus a bit more” mentality, instead of reallocating based on performance and merit.
• Insufficient focus on outcomes. An initiative’s success is often measured by whether code was released, not by whether the business value expected was realized. As such, operating budgets for areas affected by the technological change are often not adjusted to account for the expected financial impact. This lack of outcome orientation permeates the incentive structure, including how systems integrators are evaluated by procurement groups that frequently value low unit costs over quality or impact generated. This is a logical approach to take if there is no clear articulation of the value to be enabled, so the focus is typically on minimizing costs. Unfortunately, quality often suffers as a result. This led one executive to say, “The only thing I get from paying by ‘time and materials’ is invoices for more time and more materials.”
• Inability to articulate true value. As a result, the CEO, board, and investors may not get the clarity they seek about the value enabled by technology spending, and they, too, may end up treating tech as an expense line item to be reduced. This situation exacerbates the negative loop we described, as compressed spending leads to more fragmentation of investments and reduces the quality of vendor and internal labor, resulting in more incremental progress, slower delivery, and poorer outcomes.

Banks can break this negative loop and move to a virtuous cycle to extract more tangible shareholder value from technology. An executive explained, “If you want to tell investors a powerful value creation narrative, then work backward from that and allocate investments accordingly.”

Investing strategically to drive shareholder value

To assess where to invest in technology, banks can use a combination of approaches.

At the strategic level, executives can consider the fundamental drivers of valuation in the banking industry and for their bank’s stock price. They may then be able to link technology investments to those drivers and to the financial information they provide to their board and investors.

Similarly, at a more micro level, firms can use objectives and key results (OKRs) to link technology spending more tightly to their corporate strategy and specific business outcomes. OKRs spell out the company’s priorities in terms of specific accomplishments and performance improvements. While no single methodology is a panacea, the principle of linking technology work to its eventual impact can transform how incentives work within a company.

Industry-level drivers of value

McKinsey conducted an industry-level analysis to discern which factors drive the most shareholder value in banking. This naturally doesn’t apply to any single bank perfectly, but a bank could use this kind of analysis as a starting point to contextualize its own strategy and determine tech investments accordingly.

Our review of more than 90 US banks’ financial results between 2013 and 2023 indicates that they delivered total shareholder returns (TSR) of 10 percent a year, on average. But banks in the top decile had TSR of 18 percent, outperforming banks in the bottom decile by an impressive 14 percentage points.

To identify what drives some banks to outperform their peers in TSR, we conducted a regression analysis across dozens of financial variables, including total assets, revenues, business mix (retail, wealth, commercial, etcetera), net income per share, loan-to-deposit ratios, loan loss provisions, capital ratios, and others. Our analysis revealed that five operational metrics account for almost 90 percent of the difference in TSR between top-decile and bottom-decile banks (Exhibit 4), with all but the first relating to return on tangible equity (ROTE):

• revenue growth
• earning asset yields (how much income the bank’s assets are generating)
• cost of funds (how much interest the bank needs to pay to depositors and to other banks, institutions, and investors that it borrows from)
• noninterest income (income earned through fees other than interest income on loans, such as monthly maintenance fees on accounts and origination fees on mortgages) as a proportion of tangible assets
• operating expenses as a proportion of tangible assets

A few caveats apply, however. Because we conducted this analysis during a relatively benign credit period, loss-related factors didn’t carry as much weight as they would during a stress cycle. This analysis also doesn’t capture the effects of savvy M&A, especially acquisitions that might deliver disproportionate value based on the price paid for them. Finally, this analysis looks at differential performance, so while some factors may be important to a bank’s TSR, they might not be differentiating if all banks are performing equally well on them.

Several insights emerged from our analysis. While the drivers of ROTE proved to be the most important value creation driver, accounting for about 55 percent of the difference in TSR between top-decile and bottom-decile banks, revenue growth was the single most important variable, accounting for 34 percent. Various balance sheet drivers such as the loan-to-deposit ratio accounted for 11 percent.

Within ROTE, earning-asset yields, cost of funds, and fee income as a share of total revenue accounted for more than 90 percent of the difference in TSR, while controlling operating expenses represented less than 10 percent. In other words, reducing operating expenses was one of the smallest drivers in our analysis. Expense efficiency, though it can deliver relatively predictable and rapid results, is not sufficient to make a bank outperform its peers, possibly because most peers can easily pull the same lever, thereby making it less differentiating. This is an important insight, especially given that business cases for technology initiatives are often predicated solely on efficiency savings.

Stability over time is rewarded by investors, too. Banks with consistent revenue growth and less volatile ROTEs tend to outperform their peers.

Some metrics that we thought might be important to banks’ strong TSR performance turned out not to be. For example, asset size wasn’t a statistically significant factor, indicating that scale doesn’t necessarily lead to higher TSR. Both small and large banks can achieve similar margins, and while some segments do witness scale effects (such as in payments and capital markets), the banking industry as a whole doesn’t seem to exhibit a scale curve. Although the biggest banks have scale on their side, they can be impeded by organizational complexity, a fragmented technology landscape, and more stringent regulatory requirements.

Among other variables that didn’t rise to the top was business mix, possibly because many of the banks we examined have similar profiles, or because its effect shows more strongly in other variables like the share of fee income.

Bank-specific prioritization of value drivers and outcomes

Banks can consider prioritizing various value drivers depending on their relative performance against industry peers. For example, banks with a high ROTE and robust record of enabling growth could focus on improving expense efficiency in a way that doesn’t hamstring growth. Banks with relatively lower revenue performance may consider putting capital behind longer-term strategies to increase revenue and improve their net interest margin versus short-term expense cuts.

Different types of institutions could vary in terms of relative emphasis. For example, regional and midcap banks may want to focus on increasing fee income, which typically represents a lower share of total revenue than it would at larger banks. Consumer finance specialists typically have high asset yields and may want to strive to gather low-cost deposits to further improve their net interest margins. The biggest banks have a relatively high share of fee income, so they may want to focus on driving efficiencies in an effort to benefit from their scale.

This kind of thesis concerning business priorities should ground the institution’s overall strategy and inform tech investments, setting the stage for aligning outcomes.

At the micro level, for instance, when choosing whether to invest in a mobile app or in a platform for branch employees, linking the work to OKRs is often helpful. Investing in the mobile app could boost digital sales and self-service, while reducing branch footfall and contact-center volumes. Investing in a branch platform might improve in-branch sales and employee satisfaction. Business leaders should determine where the greater opportunity lies, based on the corporate strategy and expected financial outcomes. By tracking OKRs over time and hardwiring them into the objectives of integrated technology and business teams, the CFO could ensure that the expected financial impact of technology investments is achieved and can eventually be communicated to the CEO, board, and investors.

It is critical for OKRs to form a system that aligns the objectives of individual teams and groups of teams to enterprise-level priorities.

Five examples of strategic themes for technology investment

To identify examples of how a financial institution can align its technology investments with drivers of strong TSR performance, we analyzed initiatives that banks in our database have undertaken over the past few years and mapped those to the drivers of differential value identified above. Our analysis revealed five examples of strategic themes for banks to consider:

Each of these five strategic themes maps to the value drivers revealed in our analysis. Specific outcome metrics aligned with each theme could be used to track value realization.

The first three strategic themes involve harnessing technology to help boost revenue growth, fee income as a share of total revenue, and asset yields, while lowering cost of funds and operating expenses. With these strategies, it is important to note that technology is an enabler of a broader business transformation, and that nontech levers need to be pulled as well, including, for example, the hiring of bankers, business process changes, adoption of technology by frontline employees, and marketing. M&A can also play a critical role, particularly in increasing fee income.

The fourth strategic theme is focused on ensuring that the bank’s technology is resilient enough to withstand cyberattacks, system failures, and other shocks; that it enables risk management more broadly (including preventing financial crime and optimizing credit risk); that it reduces technical debt that has accumulated over the years; and that it complies with regulations. Making sufficient investments in this area is critical to preventing value compression.

The fifth strategic theme entails transforming the technology function itself, with the objective of improving engineering productivity, accelerating time to market for new solutions, ensuring a stronger delivery orientation toward business outcomes, and creating more capacity to invest in the other four themes. Moreover, many organizations are finding that the product development life cycle, including software development, is one of the areas that can benefit most from generative AI.

Based on our analysis, we estimate that a typical bank could enable ROTE improvements of three to four percentage points by pursuing one or two of the tech-enabled business strategies as well as the tech-enabled risk management and technology transformation themes. It is unlikely that a bank would choose to pursue all five themes at once, due to the investment, talent, and time needed.

Implications for bank executives

Our research indicates an opportunity to elevate banks’ approach to technology, turning it from a budget line item into an uncontested enabler of value creation. Bank executives can consider following this approach in a continuous cycle:

• Free up discretionary-technology capacity. Accelerate the transformation of the technology function to increase capacity available for discretionary investment by 50 percent or more (such as by increasing engineering productivity and optimizing run-the-bank spending).
• Allocate investments strategically. Add a top-down approach to supplement the usual bottom-up generation of technology initiatives based on ROI as part of the yearly strategic-planning process. Accomplish this by conducting an analysis of the bank’s market valuation to prioritize enduring value creation drivers and define strategic investment themes. Ensure that capital is mostly allocated to a focused set of business domains that align to those themes, decide on whether to build or buy specific tech solutions, and translate each investment into OKRs that are hardwired into budget expectations and integrated team incentives. Consider the full burden of new tech, not just the initial costs. This strategic process is a critical foundation on which to build a narrative for investors about the value enabled by technology, and it can enable a dynamic reallocation of capital.
• Execute with an outcome orientation. Be purposeful about the operating model the organization uses. For instance, a platform operating model could ensure that execution is conducted through cross-functional teams focused on delivering business outcomes at an accelerated pace. Establish a quarterly outcome-based review using the relevant OKRs to ensure that technology solutions are adopted and the financial impact is realized.
• Provide transparency on tech-enabled value creation. Some banks link their technology investments to their investor guidance on revenue growth and ROTE targets. They incorporate this into their investor communications and shine a light on the metrics that matter (for example, their “run” versus “change” ratio, the magnitude of investments made across different business units, or the specific business outcomes those investments are enabling).

As an example, a financial-technology company recently conducted a review of its technology investments across 20 business domains, with a focus on boosting revenue growth and ROE. Following the review, the company reallocated about $100 million of technology investments a year over three years, representing more than 10 percent of its “change” spending and targeting growth expected to generate several billion dollars in market capitalization.

Management and investor expectations concerning technology spending may continue to grow in the coming years. Bank executives can address this proactively by transforming the technology function to unlock more capacity, reshaping the way technology investments are allocated, ensuring value realization, and providing more transparency to stakeholders. Establishing this virtuous cycle could earn executives the right to make the investments that will likely be necessitated by technology and AI’s growing importance to doing business.

A deep dive into strategic themes for tech-enabled value creation in banking

Earlier in this article, we gave five examples of strategic themes banks can use to focus their investments and create a virtuous cycle for technology spending. Below, we explore those themes in greater detail.