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 […]

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April 30, 2007 Categories

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:

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
Payments insourcing considerations

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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