Cash & Liquidity ManagementPaymentsRole of Outsourcing in Protecting Profits Post-SEPA

Role of Outsourcing in Protecting Profits Post-SEPA

“Plus ça change, plus c’est la même chose,” they say – and quite right too. Even before the single euro payments area (SEPA), payments margins were under competitive pressure. Client demands and regulatory pressures were ever higher. IT needed large investments with uncertain returns. Attracting or retaining talent was a challenge.

SEPA elevates pressures to a higher level. It will lead to a substantial reduction in per-payment revenue; lower barriers to entry in domestic payments and demand major investment in updating business models and IT. So, how might a bank react?

To answer this, let us recall that, less than a decade ago, the euro eliminated possibly the largest element of revenue from cross-border payments in Europe – the foreign exchange spreads. A few years later, EC Regulation 2560/2001 dealt another body blow to these revenues. What’s worse, these past years have enjoyed historically high liquidity leading to sub-normal float earnings. They have also coincided with the need for large investments, for example in electronic banking, in upgrades to market infrastructure as well as for regulatory compliance and operational resilience. At the same time, competition and client sophistication have ratcheted down prices.

Despite these factors, strong transaction banks have improved profitability. Let us look at two examples, from Europe and the US. Deutsche Bank has increased its underlying return on average active equity in this business to 80% in Q1 2007 from 20% earlier this decade, with approximately 15% annual revenue growth after adjusting for spin-offs. Citi’s 2006 return on risk capital was 96%, up from about 50% a few years back and with 15-20% annual revenue growth.

So let this be our first insight. Good transaction banks have performed well in a tough environment. How they did this may offer some tips on how to achieve success in the future.

What Have Successful Transaction Banks Been Doing?

Few benchmark studies offer real answers, most vendors do not understand the business well enough to delve deep, and successful banks themselves never publish the secrets of their success. Therefore, the factors driving success in the tough payments market in the recent past remain shrouded.

Even while making no claims to omniscience, a few salient observations from recent work with a variety of transaction banks may be helpful.

First, building scale has moved from being merely a slogan to a necessity. Scale has helped successful banks in building an internal clearing network, especially in individual payments, where book transfers replace the need for external execution. Typically, the unit cost of a book transfer is under one-tenth of an externally executed individual payment. Thus for every 1% increase in the proportion of book transfers, a bank could save 0.9% in corresponding costs. Through this effect, and by further leveraging fixed infrastructural costs for higher volumes, strong banks could grow volumes at 10-20% annually at flat operational costs.

Second, driving harmonisation of services, systems and processes across client segments and geographies was another major lever. It helped them achieve greater profits on IT investments while reducing operating costs, offering better client service and improving management control.

Harmonisation has also been a key stepping stone to outsourcing and offshoring in IT and operations. Successful banks have used smarter sourcing to reduce IT costs by 30-50% and operational costs by up to 30%.

To date, most sourcing initiatives have been cost-driven and narrowly focused on the so-called ‘non-core’ activities, for example application maintenance, operational data entry, data centre management or call centres. IT or operations departments have usually managed them with little participation from the business lines.

Maturity in Payments Outsourcing: Based on Comparative Advantage

Strangely enough, the payments business line has used outsourcing for far longer than the banking IT sector. This was traditionally in the form of correspondent banking networks, agency agreements, multi-bank electronic banking systems, etc. These arrangements were for business-driven services, though in niche markets and on a small scale. From these, the sourcing market in payments has jumped to the larger scale but business-agnostic services in IT or operations described above.

While both these models were, and continue to be, helpful in securing profitability, competition is likely to drive another sourcing model in future. This is shown in the graphic and explained below.

Figure 1: Future Sourcing Models

Banks already realise that they cannot afford to be all things to all people, and they will be pushed ever more to find their comparative advantage. Rising client sophistication and margin pressure will force them to focus on producing the services they excel in. They could then buy other services and orchestrate them all to deliver a unique and valuable client experience. For example, a bank strong in payment processing but weak in electronic banking could use a white-labelled customer access tool to offer a top-class, complete solution. Or, a bank strong in euro treasury payments can tie up with a strong bulk-processing bank, organise a SWIFT member-administered closed user group (MA-CUG) using SwiftNet FileAct for access, thereby offering a complete client solution.

Three factors are of note here. First, in line with classical theory of trade, this mechanism is driven by comparative – and not absolute – advantage. For example, let us say Bank A is better than Bank B at both bulk and treasury payments. Bank A will be comparatively ‘better’ at one of the two, let’s say at bulk payments. In other words, Bank A will use its resources most optimally when it focuses on bulk payments rather than splitting them across both services. Similarly, Bank B may not be as good as Bank A in either service, but is comparatively better (or less bad) at treasury payments, and should ideally focus on these.

Second, both of the banks in our example could trade services with each other. This way, they would both improve their resource efficiency and still offer a complete set of services to their respective clients. Of course, they will have to control such relationships through sourcing procedures, legal contracts, confidentiality arrangements, etc.

Third, in the real-life environment with hundreds of banks and dozens of products, the various practical tasks of implementing such a strategy are going to be complex. This will include identifying services where one has a comparative advantage, shifting capital and management resources to these, offering them to other banks, buying some services from other banks, etc.

Some Practical Bank-to-bank Service Examples

Competitive developments, client needs and business strategy will drive the development of the services that banks can profitably offer in the bank-to-bank market. However, let us look at some existing and emerging examples.

As noted above, correspondent banking and agency clearing are examples that have been in vogue for many decades. Also prevalent is the practice for banks and non-banks to offer white-labelled cards-issuance and processing services to each other. Pooling resources for bulk domestic clearing has long been common in the co-operative and savings sectors, and private sector banks are also increasingly looking at it. Though it is not directly SEPA-related, integrated paper processing centres handling cheques and paper-based payment instructions are also emerging, though often run by a technology or process outsourcer.

A low-value, high-volume service for international automated clearing house (ACH) will be attractive for buying banks from outside Europe, as well as for some regional European banks. A service-offering bank will perform domestic clearing for mass payment and direct debits for the clients of other banks on an agency basis. This will enable a service-buying bank to focus on individual or pan-European payment types, while still being able to offer the complete set of in-country transactions to its clients (including, but not limited to, the complex national variants such as RID, RIBA or LCR). For the service-offering bank, the ‘last man standing’ strategy will offer greater leverage of existing infrastructure and improve returns. Such services will also be attractive for specialist segments such as migrant payments and pensions.

Treasury aggregation services can bundle commercial products around foreign exchange, money market, liquidity management and individual payments. The service-offering bank will be able to get higher flow business to leverage their investments in electronic client access, execution and settlement. Buying banks will typically be those with strong client relationships but with limited stand alone scale to build or maintain such capabilities.

Even in non-processing areas, white-labelled electronic banking, mega-scalable low-cost messaging hubs, AP/AR/electronic invoicing utilities or investigations factories, are all emerging service concepts.

A Word of Caution

We have had the economics theory behind this approach for 200 years, thanks to the political economist David Ricardo. Even in practical terms, hardly a week passes by without a senior bank executive calling for greater industry co-operation in payments. In spite of this, development of such bank-to-bank services has been very cautious.

To move from a scrapping on all fronts to competing on comparative advantage, bank executives have to overcome inhibitions acquired over generations. They will need a keen analysis of their capabilities and market developments. Implementing such ideas will also need careful tuning of systems, operations and governance procedures. While not easy to realise, it is quite possibly an idea whose time has come.

Conclusion

Banks have long used outsourcing in payments to satisfy client needs and improve business performance. This has included:

  • Buying niche services from other banks on a small scale, e.g. from correspondents and agents.
  • Buying operational or technology services from outsourcing companies on a large scale.

The introduction of SEPA will lead to stronger margin pressures. It is already demanding large investments. In this environment, merging the two conventional outsourcing schemes, i.e. buying banking services and on a larger scale, will help the payments industry to maintain, and even improve, return on capital. When well conceptualised and implemented, the impact on client satisfaction will also be resoundingly positive.

Banks will seek their comparative advantage, focus resources on these and buy other services. Some of them will commercialise the services that they are competitive at producing and offer them to other banks.

A thorough analysis of a bank’s specific situation will drive the decision on which bank-to-bank services to buy or sell and with which partners to trade. The design of such services will have to satisfy compliance, risk and confidentiality considerations. The use of service oriented architecture and workflow technologies will be critical to realise this approach in practice.

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