Cash & Liquidity ManagementPaymentsSEPA: The Accelerating Shift to Outsourcing

SEPA: The Accelerating Shift to Outsourcing

Outsourcing in payments has been a common practice for years through agency agreements, correspondent banking and shared clearing and settlement (both cards and electronic payments). It may not have been called ‘outsourcing’ but that is what it is – the provision of third party services to complete some or all the steps in a payment transaction from initiation to finality.

Thus any notion that payment transactions are core and fundamental to a bank’s business and therefore cannot be outsourced is groundless. To put to rest any lingering doubt, subscribe to the view that ‘a payment is a payment is a payment’, reflect on the fact that cheque payments and credit card transaction processing have been outsourced successfully for years by banks in many countries, and you can see that it is not a great leap to outsource other payment types and processing.

Closer Look at Outsourcing

The benefits of payments outsourcing include avoiding investment costs in transaction processing capabilities and lower transaction costs for a given level of service, and also greater flexibility to market demand. Payments transaction capability is an enabler of most banking products, e.g. current accounts and loans, and is critical to their provision. Therefore, payments outsourcing can allow a full range of banking products to be offered without prohibitive investments in product development, e.g. e-invoicing, real-time payments, prepaid, mobile, where demand is growing. It can also enable entry into new markets, such as offering consumer loans or credit cards across Europe from a single location and operation using standard SEPA payments into a single collections account.

Despite these benefits, banks can still be cautious about outsourcing, worrying about the loss of control and the impact on the relationship with customers. Provided the right service levels and a well thought through contract are in place, control should not be an issue. Customer relationships should not be affected either, as payments processing occurs in the background, whether it is outsourced or not, and should be invisible to customers.

Modern technology and communications allow operations to be located independently of the point of need for banking services, and enable processing steps in transactions to be disaggregated and passed to operations centres and to third parties best placed to handle them. Within this context, under cost, compliance and revenue pressure, banks are industrializing their operations and IT, including for payments, i.e. they are simplifying internally, differentiating themselves externally through better products and service, and executing their operations efficiently to tight service levels.

Industrialisation requires new operating models – and for these, if a third party can provide a service better, faster and cheaper than in-house, provided the right controls on quality and risk are in place, then there are strong grounds to outsource. This has been occurring across industries and functions, and it is accelerating in banking and payments.

Implications of SEPA

The single euro payments area (SEPA) is a catalyst for change in payments in Europe and it is inevitable it will force change in payments outsourcing. Banks are telling us that they are open to outsourcing more of their payments processing and are exploring the options. In our recent payments survey, the larger banks in Europe estimated that they will spend on average €20-30m each on their migration to SEPA payments, and a similar amount on card payments. With this level of investment, industrialization of payments operations and IT is critical, and banks across Europe are re-examining and changing their operating models.

Figure 1 below shows the typical bank functions supporting payments processing and the associated clearing and settlement and account servicing. It is these functions that can, in whole or selectively, be outsourced, in particular the functions needed for SEPA payments.

Figure 1 – Electronic Payments Processing

Opportunities to avoid heavy investment, achieve SEPA compliance and reduce operating costs are driving banks to consider outsourcing payments in a SEPA world. This includes cross-border payments within the eurozone, international payments outside Europe, and domestic payments within national boundaries (and, in the cards realm, card issuing and acquiring).

Many banks are sub-scale in international payments and unable to offer the full suite of services corporates require – outsourcing these payments is attractive, especially since volumes will decline as cross-border payments within Europe need no longer be processed as international payments.

European cross-border SEPA payments are an obvious candidate for outsourcing, as volumes are low, investment costs to build this capability are high and it is a quick route to SEPA compliance in 2008. However, this decision needs to consider domestic payments – when domestic payments are migrated to SEPA formats, unless these are outsourced as well, a bank will then have two ways of processing the same type of payment.

Banks are often reluctant to outsource domestic payments given the high volumes, and the tight coupling between account management systems and the processes of their local clearing mechanisms. However, local schemes and clearing processes will give way to common SEPA ones, and in changing to these, it is likely we will see banks starting to outsource their domestic payments as they challenge this reluctance and seek practical ways to operate under SEPA.

In fact, to reduce risk, one potential migration strategy for outsourcing SEPA payments is first to outsource low volume cross-border eurozone SEPA payments, then migrate high volume domestic payments to the new service as the legacy domestic payments in-house service runs down.

SEPA will drive competition among banks with additional implications for their use of outsourcing. For example, standardization of payments formats will increase competition among banks for corporate mass payments (e.g. salary payments for credit transfers or telecom bills for direct debits or e-invoicing), and there will be a need to differentiate in the market through providing additional optional services (AOS). The capabilities required to support AOS could be provided by third parties instead of through investing in in-house capabilities.

Payments Outsourcers/Insourcers and Payments Service Providers

So who are the suppliers who can process payments transactions for banks? In addition to banks, the recently agreed Payments Service Directive (PSD) allows non-banks to process payments transactions (provided they do not introduce ‘undue operational risk’). Possible types of outsourcers include:

  • Card processors such as FDR and Atos expanding into ACH payment processing.
  • Automated clearing houses (ACHs), such as Voca becoming payment service providers (PSPs) and increasing their service offering in bank-to-bank processing and providing services in bank-to-customer processing (e.g. e-invoicing and information exchange).
  • Established outsourcers taking over bank payment operations.
  • New entrants – possibly new companies, but also established companies with major billing operations, such as telcos setting up their own shared payment operations (although these are more likely to be competitive alternatives to banking infrastructures rather than service providers to banks).

Then of course, there are the banks themselves who may want to insource payments operations for other banks, e.g. Deutsche Postbank (which already processes payments for Deutsche Bank, Dresdner Bank and HVB). This is where much of the outsourcing activity is likely to be over the next three years, with many of the larger banks with transaction banking businesses considering using the capacity and capabilities in their payments operations to insource SEPA payments from other banks – partly as a way to get a return on their SEPA investments through scale of economies, and partly as a way to establish their presence across Europe outside their domestic base.

The Decision to Outsource

To respond to SEPA, banks face strategic choices – operational, IT and commercial. Decisions to outsource are derived from the choice of operating model for payments operations under SEPA, while the decision to insource is a commercial choice core to a transaction banking strategy.

Banks are in different starting positions and different situations and prescriptive approaches to outsourcing and insourcing are not practical, but here are some considerations:

Payments outsourcing considerations
  • First define a coherent operating model (operations and IT) for payments across the bank, covering retail, corporate, international, domestic and SEPA, then identify opportunities to outsource. Payments processing is often distributed and duplicated across a bank, and if decisions to outsource parts of it are made in isolation to the rest, then the result will be complexity.
  • Evaluate existing and future customer payments propositions. These drive the payments processes in the operating model and therefore have implications for outsourcing decisions.
  • Confirm the bank’s commercial strategy for SEPA. If the strategy is to expand beyond national boundaries and provide services to customers acquired in new countries, then the outsourcer will obviously need to have the required reach into those countries. If it is to stay within existing boundaries, then the choice to outsource, and of outsourcer, may be different.
  • Align with the bank’s service oriented architecture (SOA) strategy, if there is one. SOA enables the support of multiple products and business units with a single payments IT architecture, making it possible to be selective in outsourcing and to reduce ‘lock-in’ to any particular outsourcer.
  • Systematically evaluate each payment product/transaction type – and triage into ‘retain in-house’, ‘outsource’, ‘discontinue’. It is unlikely that every payment type and every step of a payments process can be outsourced, so those products and process steps where there is a case for outsourcing need to identified.
  • Ensure end-to-end costs of existing payments processes are known in detail to construct business cases and to make valid comparisons, e.g. it is meaningless to compare ACH/bilateral processing costs in isolation without taking into account bank-side processing costs (which will be lower the richer the ACH functionality).
  • Check fixed costs are allocated accurately and logically – will fixed costs be allocated arbitrarily to a payments process disappear if the process is outsourced, or will they need to be re-allocated elsewhere?
  • Define the business case for processing that is to be retained in-house and for processing which could be outsourced. Consider factors such as scale/volumes, investment costs, and service levels when evaluating outsourcers, consider the following:
    1. Regardless of the pricing structure, is it clear that the outsourcer can process transactions at least 20-30% cheaper than in-house? The outsourcer is a business and needs to make a margin – to achieve this, there need to be factors which give it a lower cost base e.g. scale economies or heavy automation, otherwise either its pricing or service levels will be unsustainable.
    2. What other volumes does the outsourcer process, and what percentage of these will be ‘on-us’ transactions, i.e. between banks using the same outsourcer? A high percentage gives the outsourcer a real advantage in reducing exceptions and exceptions processing costs even in high STP environments (which is one reason why ACHs who become PSPs in SEPA are well placed as outsourcers).
    3. Ensure the outsourcer can provide/is willing to invest in services for new schemes in the future, if not, a bank could be stranded, e.g. in the UK, the new Faster Payments scheme is being introduced later this year, but it is not clear how all (mainly) building societies and banks who have agency agreements for payments with the main banks will access the new scheme.
    4. The same goes for the future product support of an outsourcer – if the bank’s strategy is to offer new services such as value-added collection services for wholesale customers, will the outsourcer be able to provide this?
    5. How much of the end-to-end process for payments can the outsourcer handle? Some ACHs such as Voca have a richer set of capabilities e.g. corporate payment submission (so-called ‘thick ACHs’) than others.
    6. What is the pricing structure? The balance between fixed and variable pricing (per transaction price) needs to be right and decided in the context of current and future volumes.
    7. What processing schedules can the outsourcer handle? Under the PSD, SEPA payments need to be completed within D+1, so this should be a minimum requirement. However, real-time payments are likely to be in high demand in the future, so it is a risk to outsource to a provider that does not have, or plan to have, high volume real-time or near real-time capability.
    8. Does the outsourcer have operational and IT capability that can scale with volume growth? SEPA volumes will not reach current domestic levels (e.g. in bank terms, 1m+ payments per day) for some time, so no-one can claim they have processed this level of SEPA payment volume for real (and being XML based, is not comparable to traditional bulk file payments processing). Due diligence on performance test results is a good idea.
Payments insourcing considerations
  • Establish an efficient, industrialised payments operation internally first before opening it up to process external volumes – bringing additional volumes onto an operation which is struggling to meet internal needs could be disastrous.
  • Ensure both payments operations and IT can support multiple banks, and on a re-usable basis (i.e. without customization for each bank). A multi-bank operation is very different to an in-house operation and it is not a simple step to convert from the latter to the former (note, it is also not the same as traditional correspondent banking, and cannot be approached in the same way).
  • Allow for the costs of business acquisition and management overhead for running/growing a one-to-many business (relationship managers, sales and marketing etc). Outsourcers typically budget business development costs of several percentage points of the value of the contracts they bid for, and it should be no different for a bank bidding to insource payments.
  • Work out early if the service to external customers is to be comparative to that for internal customers, and plan governance of payments accordingly.
  • Get regulatory clearance early, e.g. around customer data, VAT, PSD requirements.
  • Be realistic about take-up, volume growth and profitability – these are often significantly over-estimated leading to unrealistic business cases – be prepared for a long payback period.
  • Avoid offering services that rely on adding people to scale them – history (e.g. with call centres) shows economies of scale relying purely on people do not make money.
  • Avoid joint governance or decision-making – the service will require strong leadership to drive progress; this means clear leadership within the bank which does not rely on consensus with other banks.

The Future

To conclude, payments outsourcing is not new, but is likely to increase in Europe. SEPA is causing banks to make significant changes to their payments operating models, and consequently they are reevaluating their operations and their use of outsourcing. PSPs and the larger banks which provide transaction banking services see this as an opportunity to insource payments from those banks that want to outsource, in particular SEPA payments.

Both payments outsourcing and insourcing require strategic choices, which typically banks do not make rapidly. However, as SEPA becomes a reality from next year, the European payments landscape will change irreversibly and payments outsourcing/insourcing will become a major feature within it.

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