Outsourcing in the Banking Sector: Problems and Prospects
The idea of outsourcing has its roots in the ‘competitive advantage theory’ propagated by Adam Smith in his book ‘The Wealth of Nations’ published in 1776. A hundred years ago, the automotive industry was so vertically integrated that the largest car companies owned vast tracts of fields on which they grazed their own sheep to produce wool for use in car seats! In the 1970s, the industry realised that it simply couldn’t be good at everything. It then began to consolidate, converge and sell off those parts of the business that could be better sourced externally, especially where external suppliers could generate greater economies of scale by supplying multiple manufactures. Subsequently, in the early 1990s, companies began outsourcing strategically significant functions such as manufacturing, logistics and other innovation-related activities. Outsourcing thus became a critical management tool, a management philosophy, a business management style and a restructuring model.
Outsourcing, in layman’s language, can be defined as a process in which a company delegates some of its in-house operations/processes to a third party. While in a contract, ownership or control of the operation/process lies generally with the parent company, with outsourcing the control of the process is with the third party. Outsourcing takes place in two types of services:
1. IT outsourcing (ITO) involving an external service provider who manages specific applications, including server management, network administration and software development/upgrades.
2. Business process outsourcing (BPO) which involves a third party who manages the entire business process, such as accounting, financing, customer support or human resources. BPO is rapidly becoming recognised as a strategy offering a compelling business value proposition for companies as a means to gain operational efficiency, focus on core expertise, save time and potentially reduce costs. BPO is independent of economic cycles and is therefore valid in difficult times when companies want to cut costs as well as times of profit when companies want to focus on growth.
If one doesn’t have the time, money or skill to do the job internally, or if there is a function that is a burden or detrimentally affecting other parts of the business, outsourcing is worth considering. When companies first started thinking about outsourcing non-strategic functions, such as payroll, IT maintenance, facilities management and logistics, their goal was to reduce costs. Today, however, there is a far wider range of reasons why these organisations regularly contemplate outsourcing core operations to third-party specialists, which include the following:
Banks all over the world have developed along a series of vertically integrated ‘silos’ and the result is extensive duplication and redundancy across both businesses and geographies. Duplicated structures and inflexible technology/service solutions not only generate increased costs but also reduce business flexibility and damage service quality through inconsistency.
Since the 1990s, banks have been improving their efficiency ratios by acquiring or upgrading technology, cost cutting and consolidation. But now that further improvements are proving elusive, costs have been trimmed to the minimum and consolidation gains have waned, banks are under pressure to improve earnings. Outsourcing has thus becomes a way of moving banks’ scarce resources away from trivial operations to value-added services, such as business strategy and execution, new opportunity identification and pricing, business results and interpretation, and M&A planning.
Specialisation coupled with greater economy of scale enables an outside provider to provide services at a much lower cost that in turn reduces a bank’s operating costs and increases its competitive advantage. Third-party providers make extensive investments in technology, methodologies and people, which provide banks with a wider range of capabilities. Freed from devoting their energy to areas that are not within their expertise, banks can now focus their resources on meeting customers’ needs.
Markets, government regulations, financial conditions and technologies all change rapidly and outsourcing providers who make investments on behalf of many clients are better equipped to handle the resultant risks.
Outsourcing ensures that banks receive higher quality, better ‘on-time’ delivery access to world-class skills, fast project start-up, industry best practices and even benchmarking information about similar financial institutions.
With investor expectations growing day by day, banks are forced to re-examine their core functions. In effect, the distinction between core and non-core is slowly but surely diminishing, thereby increasing the number of functions that could be outsourced. Jane Linder, senior research fellow and associate director of Accenture’s Institute for Strategic Change in Cambridge, Massachusetts says: “It’s really hard to figure out what’s core and what’s non-core today. When you take another look tomorrow, things may have changed. On September 9, airport security workers were non-core; on September 12 they were core to the federal government’s ability to provide security to the nation. It happens everyday in companies as well.”
With outsourcing in the banking sector moving beyond non-core check processing and IT to high-end functions, banks worldwide are responding to the competitive landscape by outsourcing cash management, research, analytics and other processes once considered core. A recent survey by Accenture on a sample of 30 US retail and commercial banks with more than US$3bn in assets, found that half of the sample outsourced not just functions such as credit card processing, human resources and IT, but also finance and accounting functions, such as general ledger, tax accounting, fixed-asset accounting, accounts payable and receivables, accounts management, reconciliation, treasury and capital management.
Conventionally, investment management functions were managed in-house but many private banks, such as UK-based EFG Private Bank, are outsourcing all or part of their investment management to a range of specialist fund managers to get greater economies of scale, while retaining relationship management with them. ING outsourced its international cash equities clearance and settlements operations in London, New York, Hong Kong and Singapore to The Bank of New York in 2002. The decision was the result of ING’s strategy to provide its businesses with high quality, variable cost clearing and settlement services and the fact that it had uncovered a Yen500m settlement fraud at ING Securities in Tokyo.
When HSBC decided to outsource part of its cash management functions and insource payables at the end of 2004, the decision to outsource was prompted by Basel II and the opportunities rendered by India – the major outsourcing hub. As the emphasis on equity portfolios grow, banks are faced with a shortage of knowledge and expertise and therefore the decision to outsource.
Outsourcing can be a huge success story but there are challenges. Though simple in theory, it is tough to execute especially when companies with high expectations outsource the wrong things for the wrong reasons in the wrong way. Poorly planned deals have grave shortcomings – companies overestimate the economic benefits of the deal, fail to establish the right baseline for price negotiations and performance tracking, or are not fully prepared to manage the transition and post-deal situation. A recent study by Cap Gemini Ernst & Young shows that only 54% of companies are satisfied with outsourcing – down from more than 80% a decade ago.
The following section provides some guidelines in dealing with the various challenges surrounding outsourcing.
Selecting the right partner: Since banking operations are a sensitive area, the primary barrier to outsourcing in banks is security. The risks include disruption to service, defective services and personnel of service providers gaining intimate knowledge of banks’ systems and misusing them. Organisations need to look for a service provider with experience, expertise, integrity and long-term commitment to the industry. It is essential to select a credible outsourcing provider who, besides making a good cultural match, is committed to ongoing technology improvement who can add value to the bank’s operations.
Negotiation: Negotiating teams must negotiate with the business managers, executive team, employees and union representatives. Uncertainty during an outsourcing transition increases the risk of staff turnover so banks should design a retention program that targets and retains key personnel. A dedicated team of change management with top management involvement should be in place to regularly monitor any unforeseen problems.
Timeframe: Outsourcing is not a one-time event with an instant payoff. While rapid execution and implementation enables a bank to get through the most painful part of the change process quickly, and minimises friction created by resisters by forcing them to adapt quickly, speedy implementation certainly deprives the bank and the third-party provider of that all-important ‘courting’ stage before the ‘wedding’. The real benefits of outsourcing take time and before they kick in, things are likely to be painful, ugly and chaotic; and here lies the crucial role of transition management.
Exit policy: Since outsourcing deals have become bigger, complex and strategically important, an exit strategy has to be in place along with contingency planning. The exit strategy may involve bringing outsourced activities back in-house, continuing with the same provider, or choosing a new provider, all of which mean that the bank has to revisit its strategy.
At a time when Basel II, with its artillery of spiky pre-conditions is within striking distance, banks have to keep pace with the global banking environment that is undergoing a colossal metamorphosis. Charles Darwin aptly remarked: “It is not the strongest of the species that survives, or the most intelligent, but the one most responsive to change”. With that in mind, it is no longer a question of ‘why outsource?’ but rather ‘why not?’