Is Outsourcing Part of Your Bank's Payment Strategy?
Money transfer, like credit provision, is a service that defines a bank. It is a core competence that all banks must have. Every transaction, from an interest rate swap to the issuance of commercial paper, involves the transfer of funds between counterparties. But, like credit, payments is a business in which it is increasingly hard for the bank to add value for the client or raise revenue for itself. Just as few large corporate clients differentiate between banks purely on credit provision, it is only customers with specific needs (i.e. diverse geographic coverage, in-country branch network and cash handling facilities) for whom payments capabilities is a critical selection criteria.
As such payments is often seen by banks and corporates as a commodity service; a low-margin business (with increasingly high costs) where competitive advantage is hard to establish or sustain. This view can draw banks into a vicious circle in which reluctance to invest in a low margin business leads to lower service levels and higher unit costs; the under-performing payments business then inevitably spirals further down the bank’s list of strategic priorities. Yet this particular circle can be squared if banks are prepared to undertake a full examination of payments strategy.
A bank that decides to invest in payments systems and processes has the opportunity to make the service a core strategic strength. By processing payments more efficiently and cost-effectively than the rest of the market, ‘transaction’ banks can capture corporate and – perhaps more importantly – FI business. But this is only a path for the few. Given the choice between upgrading systems to keep up with the market and outsourcing ‘non-core’ payments processing to a third party, many banks can save money by choosing the latter path. The question of what constitutes core and non-core activities varies from bank to bank, but it is fundamental to the outsourcing debate.
This article argues that banks need to review all payments activities across the organisation and develop a strategy based on a clear understanding of their market position across all product lines. It examines the internal difficulties banks face in assessing total payment costs, the factors informing payment strategy, the role of outsourcing and priorities of corporate clients. It also reviews the regulatory and competitive pressures that are gradually reducing payment revenues.
Lack of Visibility = Lack of Strategy
For any bank that serves a range of product or customer sectors, maintaining and managing payment channels can be complex. Domestic payments on behalf of retail customers might require internet-based interfaces with the local clearing house, while international payment flows might demand links to any number of non-domestic clearing houses, settlement systems or correspondent banks. The costs of external clearing are not a high proportion of overall payments costs but are highly visible and frequently not optimised. Banks regularly use correspondent relationships to process particular payments flows but this is not called outsourcing and is conducted on a bilateral basis. In addition, asset management, foreign exchange, equity trading and M&A advisory services within the bank all require payment transactions with a specific set of counterparties according to well-established practices and protocols.
Because they are managed by specific business lines within the bank with limited levels of interaction, payment revenues and costs are rarely considered collectively. As a result, the direct cost of making a payment is very visible to an individual business line, but not to the bank as a whole. Payments either stem directly from a customer instruction to move money or are the bi-product of another service, such as FX or equity dealing. This can make it hard to first separate out then aggregate total payment costs. Only when all payments functions are regarded as a single activity – for instance when a bank creates a shared service centre to supply common services across business lines – are the full costs exposed. And only in such a structure can processes and service levels be measured, managed and optimised across business lines. This internal approach can only have beneficial effects on clients, internal and external, and establishes a first step towards the identification of end-to-end process costs and revenues that is a precursor to decisions on the strategic role of elements of the payments processing business.
Current practice means that payments strategy and cost are very often unclear. Very few banks have looked at their entire payment activities across institutional, corporate and retail services in a strategic context, asking themselves ‘Where do I want to be in five years time?’ or ‘Am I making any money out of this?’ Without a more all-encompassing approach, supported by activity-based cost analysis and an understanding of the impact of process change on end-to-end costs – banks will find it hard to decide which payments processes are strategically important to the business and which are better performed externally.
Payments outsourcing is already alive and well and growing. The recent announcement of Barclays Bank’s deal with Deutsche Bank to serve the European cash and payments needs of the UK institution’s international corporate clients may be an exception at present, but there are many less public examples. In the UK, cheque processing is handled by a very small number of banks on behalf of the majority of retail institutions. Elsewhere, high value and international payments are regularly outsourced to international banks by domestic mortgage institutions whose core business does not generate large enough volumes to justify the costs of direct links to clearing systems.
The more business lines a bank offers, the more strategic considerations there are and the more complicated the outsourcing options become. A bank with retail, corporate and institutional business across the UK, Belgium and the Netherlands, for example, may face prohibitive costs of expansion unless it can reduce overheads by consolidating or outsourcing elements of the payments process. First and foremost, a bank’s payments strategy is a function of the desired place in the market; global, regional, national and smaller domestic players will have differing views on the strategic importance of specific payment processes and the cost effectiveness of the people, systems and infrastructure required to process payments in-house. But, with the exception of a handful of global players that have made a strategic decision to focus on and grow their payments business, all banks are likely to find at least some payment processes that cannot be justified by their contribution to the bottom line. For those banks, each business must be examined case by case.
For each payment process, current and projected volumes, strategic fit, and client response will all play a part. A request from a customer in one country to purchase shares listed in another can trigger a number of transaction flows depending on whether the bank can buy direct or needs the services of a third-party broker. Transaction costs to the bank may be passed on fully or in part. If the transaction is repeated frequently, the bank will recoup the costs of maintaining the necessary systems and linkages, but if a payment channel is used only a handful of times a year, it is likely to be more cost effective to let another party handle payment flows that are simply a consequence of the underlying fee-earning transaction. However, payments processing capabilities can be seen as a strategic as well as a volume issue within individual lines of business. A retail bank may only process a small number of FX transactions per week, but still wish to bear the costs required to settle FX payments in-house if there are plans to provide more extensive FX services to customers in the medium term. Or if the service is believed to form a critical part of the client relationship where an inability to provide FX could result in erosion of the client relationship and revenues.
As well as volume and strategic importance, client perception may also be a factor. Clients may consider the outsourcing of payments processing negatively, perhaps as a sign of lack of commitment to the service. Could outsourcing lose a bank business in a particularly volatile or competitive market? A bank typically has four broad client types for its payment services: internal; institutional; corporate; and retail. Of these it’s the corporate sector that has the most varied needs. This makes it hard to generalise, but recent survey and anecdotal evidence suggests that a key priority for corporates is for banking partners to help them reduce transaction costs (through increased levels of straight-through processing) and improve liquidity management (through more comprehensive and timely balance and transaction information). A bank that outsources elements of its payments operations, e.g. paper processing, is in no way inhibited from helping corporate clients achieve these aims. Indeed, the opposite is true. Providing service levels can be guaranteed contractually, outsourcing paper processing to a specialist should reduce the banks’ costs and free internal resource to focus on customer delivery. Far from signalling lack of commitment, outsourcing may actually indicate the bank’s intention to concentrate on the issues that matter most to corporate clients.
Indeed, there are already parallels in corporate use of banks’ FX services. Many corporates have shifted the majority of their commodity foreign exchange dealing from voice trading to single or multi-bank platforms. Multi-bank platforms represent a form of outsourcing for banks and their corporate clients have had no qualms over using a third-party provided solution – due to the evident benefits on pricing, convenience, transaction costs and ‘auditability’. Nevertheless, corporates have not shifted their higher ticket FX business away from banks that offer value-added relationship support. Keen pricing and high service levels – regardless of the medium through which they are delivered – remain the cornerstone of the treasurer’s selection criteria.
As yet, clients have not penalised banks’ inefficiencies in payments processing, but this is beginning to change. First, regulatory pressures on pricing, particularly in Europe, are forcing banks to re-examine the costs of payments, revenues are reducing faster than costs. Second, global banks are beginning to compete in local markets at prices and service levels that local institutions struggle to match. Third, Basel II’s guidelines on operational risk could result in an increase in the regulatory capital required to support operations, thus adding cost to the overall process.
In the absence of a coherent payments strategy, banks have tended to react to market events in an ad hoc manner. For instance when a new clearing infrastructure is announced, banks have decided whether to participate directly, indirectly or not at all. But recent developments are forcing the pace of change. Both CLS and the forthcoming Target2 system for euro payments have a limited number of settlement members. CLS’s 56 settlement members already offer a form of outsourcing through third-party services to banks, financial institutions and even corporates. And not all current members of national RTGS systems in the EU will be allowed to link directly to Target2. For many large national banks for whom the economics are unattractive or for whom strategic issues do not support membership, Target2 may prove a painful trigger. If you are not a domestic – particularly euro – clearer, what is your role in the payments market? What impact could that have on clients in the corporate sector? And how can banks that cannot support inhouse payments ensure minimum erosion of their market position?
Although global banks are entering new territories around the world, competition is particularly fierce in the European payments market. Not only is there pressure from the European Commission to level domestic and cross-border pricing, but the euro has thrown open national borders. Whereas previously only Dutch banks could clear local payment instruments, now international banks are using the Dutch clearing system directly to process euro payments for clients anywhere. National players often do not have the volumes or the resources to compete with international banks on price. In addition, a convergence in the technological infrastructures used to support payment processing is tending to favour large volume players even more than at present.
For some banks, apocryphal stories about tellers jotting down payment instructions on a post-it, sending a fax form to another branch where the details are finally keyed into a system incompletely and the payment clears days later following several calls exaggerate reality only slightly. The inefficiencies persist because banks have never weighed up the cost of payments processing across all business lines. Increasing regulatory pressure is forcing high costs and inefficient practices into the open and the technology is available to improve straight-through processing benefiting banks and their clients. In Europe, the pressure is stronger than elsewhere. Banks that previously benefited from huge margins on cross-border payments have been told by the European Commission that domestic payments must be priced the same as cross-border transfers. This revenue stream is in the process of being eliminated. The choice is stark: lose money, reduce in-house inefficiency or outsource.
Strategy will of course be strongly influenced by perceptions of future revenues and this means listening to their clients. Which elements of a bank’s payments services offering can only be delivered in-house from the corporate or institutional clients’ perspective? The answer may prove a green light to radical shift in the payments environment.
The question of how to outsource, and to whom, lies outside the scope of this article but there is no doubt that payments outsourcing presents a significant revenue opportunity to successful providers and considerable potential benefit to banks whose strategy enables outsourcing. Some banks may use cost-efficient payment processing as a competitive weapon in the corporate market. Others may offer white label services to other banks. But this is not exclusively an opportunity for large banks. A sound business can be built on processing domestic paper transactions if the appropriate investment is made in technology and can yield a 30 per cent margin per transaction against a market average of 10 per cent. Alternatively, smaller banks are winning cheque processing business from customers by competing on enhanced service against commoditised, volume-driven processors with limited flexibility. Whether the aim is to reduce costs or increase revenues, a bank’s payment strategy can play a crucial role in the success of the business.