Indian IT firms may face modest impact from Moody’s downgrade of US banks

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The panic surrounding banking contagion in the US affecting IT companies in the recent past may have subsided but a souring environment is adding to the latter’s woes.

On August 8, Moody’s lowered its ratings for 10 small and midsize lenders, and said it may downgrade six other major banks. This comes at a time when banks are continuing to focus on efficiency gains, and discretionary spending has been reduced significantly.

According to Peter Bendor-Samuel, founder and CEO of global research firm Everest Group, this bad news for the US banks will only add to the headwinds that the IT sector has been facing amid significantly reduced discretionary spending in the sector. He added that Moody’s downgrade is indicative of the pressure that banks are under, smaller banks in particular.
But it may not be all bad news.

“We believe that this souring environment will only modestly reduce the level of discretionary spend,” he told Moneycontrol.

This is because spends are already below industry norms, and Everest believes it's either at or close to the bottom. Additionally, smaller US banks have been impacted more, which do not contribute to the Indian IT sector significantly.

“The small banks which this most affects or is indicative of, do not contribute significantly to the marketplace for the large Indian tech services firms. On the bright side we believe that this will add more impetus to the banking consolidation that the US Federal Reserve is attempting to drive, and as this plays out the larger banks will reach out to the Indian tech services firms for post-merger integration which will provide attractive opportunities in the sector,” Bendor-Samuel said.

IT companies’ BFSI challenge

The softness in the banking, financial services and insurance (BFSI) vertical was a common theme across Indian IT companies in the recently concluded earnings season, despite some deal wins coming in from this vertical. While Wipro had said that BFSI was impacted due to softer discretionary spends, Infosys said clients were typically not choosing to spend at this time.

“Large and super regional banking clients in the US have been resilient during this quarter. Large banking clients are focusing on vendor consolidation, cost takeout and self-funding transformation programmes,” Chief Financial Officer Nilanjan Roy told analysts. Infosys said it was seeing different patterns with different clients in the sector. Pressure was visible in asset management, investment banking, payments, and mortgages.

But IT companies have also maintained that the overall BFSI impact has been sporadic depending on the sub-segments like lending, insurance, capital markets, etc.

Tata Consultancy Services (TCS), the country’s largest IT services firm, generates over 31 percent of its revenue from the BFSI vertical but has seen some moderation in growth in Q1FY24.

In a recent interview with Moneycontrol, K Krithivasan, CEO and MD of TCS, said, “When we say banking, financial services and insurance, large banks are a component of it. We have capital markets, we have insurance firms, we have mortgage firms – not every sector of the industry is doing well, right like we are doing quite well in banking. But all of them must fire for us to show you growth. If only one segment grows, you don't get that benefit.”

Also Read: Global banking crisis adds to woes of IT firms, slowdown expected in near term

Large US banks reducing tech spends

According to a note from ICICI Securities, some of the largest US banks have started to reduce technology spending on a quarter-on-quarter basis, with the exception of Citi Bank. Banks are also increasingly highlighting efficiency targets from tech spends.

For instance, JP Morgan mentioned on its investor day that it has delivered $0.5 billion in productivity-led savings versus its 3-year productivity target of $1.5 billion set in May 2022, the note said.

In terms of tech spend reduction, major US banks including Bank of America, Goldman Sachs and Morgan Stanley lowered spending in Q2CY23 versus Q1CY23, “yet grew at a rate in line with, or better than, their respective revenue growth”, ICICI Securities said.

While Bank of America and JP Morgan have retained their full-year tech spending outlook, across banks there will be a higher focus on realising efficiency gains through past and ongoing technology investments.
Commentary from banks has largely shown that there is a higher focus on realising efficiency gains through investments they have made previously as well as those that are ongoing.

However, according to ICICI Securities, mid-sized banks are continuing with their transformation programs, going by their commentary.

While it has slowed down on a QoQ basis, a note by Kotak Institutional Equities said that US regional banks have not yet announced any significant cuts to tech expenses or budgets, and some have even indicated a continuous pace of investment into technology. Key drivers, the note said, are the necessity to invest in tech to improve operations, keep pace with competitors and also for compliance. In addition, it's also laggards catching up.

“Fifth Third Bancorp, for example, indicated low double-digit growth in tech spends in CY2023. Keycorp is cutting costs in operations and investing in tech. First Horizon is ramping up tech spends to catch up after a period of underinvestment due to a merger plan with TD, which failed. Regions Financial indicated the possibility of tech spends as a percentage of revenue to go up from the current 9-11 percent,” the note read.

Analysts, however, do not expect an immediate revival in the BFS sector for Indian IT. Bendor-Samuel from Everest said that he believes things are either near or at the bottom of the current negative cycle.

“However, we don’t foresee significant improvement this year. Provided the economy does not turn bad next year, we expect growth to return next year and perhaps as early as the fourth quarter of this year,” he said.

ICICI Securities also said that a revival in BFSI is contingent on a revival in discretionary demand, something that is currently weak.

“Weak performance by Indian IT in the banking vertical is a paradox, partly explained by likely resilient spending on insourcing and cloud/SaaS consumption. Focus on expense reduction and tech modernisation at the same time can lead to large cost take-outs while discretionary spends can return post near-term headwinds,” the note read.

Insourcing in vogue

In some cases, even the resilient tech spending by the BFSI sector is not showing up in the IT companies’ revenues. This is largely because the banks are choosing to build out their own talent through captive centre investments and insourcing technology requirements from them.

According to Bendor-Samuel, as BFSI firms move into a mature digital run phase, there is a growing trend where they are looking to control the tech stack.

Kotak said in its note that in a weak environment, it is natural for companies to prioritise their own workforce and reduce consumption of third-party services.

“Demand for outsourced services can normalise once the demand environment brightens. The greater threat is a permanent shift towards insourcing, which banks such as DB have embarked on,” Kotak said.

But this isn’t expected to have a significant long-term impact on Indian IT.

“Although the GICs (global in-house centres) take work that otherwise could go to the tech services firms we do not see this trend as materially affecting the growth prospects for the Indian tech services firms. Simply put, the demand for services is too great and the need from tech services partners is accelerating as more and more of the economy is powered by digital IT,” Bendor-Samuel said.