Is it Time for Banks to Abandon Their Fear of Outsourcing?
It is time for banks to abandon their fear of outsourcing. Despite the potential short-term discomfort, there are many long-term benefits to be gained. Many corporates worry that, after a long and deliberate decision-making process, supported by many analyses and reports, their expectations might not be fulfilled. They realise that each subsequent change requested of the service provider will incur an additional cost, while there is always the possibility of changes not receiving enough attention where a service provider has merged with another company and needs to focus on its own harmonisation – or simply where the service level does not meet expectations.
The feeling of a lack of control can be avoided, however, by having a clear picture of what your value proposition is, if the customer values your product, how the value proposition is supported by your staff and infrastructure and, finally, the delta of your revenues and costs. Insourcing and outsourcing normal business processes like production or buying.
Certain external trends mitigate in favour of outsourcing in the payments business: increased regulatory pressure, increased customer demand, increased competition and standardisation. These put margins under pressure. Banks need to differentiate and have economies of scale. The result is a consolidating market.
In the US, the abolition of interstate banking in 1990 was a catalyst for consolidation, leading to a payments market concentrated on some money centre banks and a few clearing houses, while smaller regional banks outsourced their payments activity or even their core bank processing to large-scale processors. In the US, the standardised environment made economies of scale for outsourcing possible, while US insourcers were not successful in the European market because they could not realise the necessary economies of scale.
According to Capgemini Research, the single euro payments area (SEPA) will do the same for Europe. The research says that, with SEPA, the regulator aims to foster more competition, but will in fact fuel consolidation, leading to fewer competitors and a substantial number of banks removing payments from their core business activities. I disagree with this point – payments is even more core than savings and loans for banks. Most people open their first bank account in order to make payments and, for banks, the payments business is the anchor point of the relationship. One thing is certain – outsourcing is about reducing the cost of activities that could be labeled as non-core, but still have to be continued as part of your business as a whole. The cost savings are realised through economies of scale – stopping the activity is apparently not an option, at least for the moment.
Outsourcing is, above all, a logical consequence of industrial specialisation and the division of labour. In the same way as the water and electricity industries were outsourced, we will outsource standardised or even commoditised parts of the payments value chain to those who do it more cheaply. Outsourcing is thus unavoidable.
The key asset of a bank is trust and the relationship with the customer. Therefore it is understandable that non-customer-related processes are often the first that are eligible for outsourcing. But does the customer really care? After all, the customer has outsourced their payments to the bank, and the bank is responsible for processing it quickly, securely and at a low cost by fully controlling the value chain end-to-end.
It should be remembered that a bank is the director of the value chain, not the star. If you can outsource parts of the value chain in a way that improves the service level, at a lower cost, you should always consider it. And that is what outsourcing is all about: cost reduction.
But how can banks achieve this for their customers? As an example, let’s look at Bank Mendes Gans (BMG), a member of ING Group. A niche bank for liquidity and information management services, it provides integrated customised solutions for corporates around the globe. BMG is, on one hand, the in-house bank for corporate companies and its subsidiaries – the ongoing consolidation within corporate treasuries increases the need for out-sourced services. On the other hand, BMG is highly dependent on outsourced operations and services aimed at setting up global overlay solutions on top of existing local bank infrastructure.
For example, some years ago, a payment services provider (PSP) questioned why ING was still doing its own transaction processing, and that they could do it cheaper. ING analysed its total payments value chain and the transaction processing value chain in detail. We found that the cost of the transaction processing was only a small part of the total payments value chain, and that a large percentage of these costs were fixed and that the variable part was mainly the local clearing cost. ING’s cost price was competitive compared with the insourcers’ offering.
In its report, ‘Weathering the Storm’, Boston Consulting stated: “Look carefully at the viability of insourcing and outsourcing strategies; benefits are not easily achieved.” We agree with the use of the word ‘easily’. We concluded that there were cost benefits that could be achieved in the area of further internal rationalisation of the transaction value chain and in the area of lower clearing costs before considering outsourcing.
Therefore ING has continued focus on streamlining its payments value chain, looking at:
The theme for system improvements – ‘from many to fewer’ – is applicable for engines, channels and order managers. This applies not only to short-term cost savings, but also to long-term synergies with a strategic sourcing partner.
ING compared its payment mechanisms with the PSP’s. In short, the high-level design principles for the target models are: a component-based model for organisation design and for IT; a service-oriented approach towards architecture, resulting in loosely-connected components. In other words: the goal is a value chain made up of standardised or even commoditised parts. Ideally, you outsource to a provider with a more mature infrastructure, to avoid financial consequences further down the line. Regarding the services, we learned that the value chain of a bank is, in most cases, longer than that of ‘full’ PSPs. Another problem is that a partial overlap of domains means that you cannot shut systems down to save on fixed costs.
Some parts of the payments transaction chain, including cash handling, clearing and settlement services and document scanning, were already commoditised with clear interfaces. These could be outsourced. Initially, ING outsourced document scanning of paper-initiated payments to a PSP, who turned out to be in difficulty. The PSP’s business model, and the maturity of their market, are important. It should be profitable for both and the insource supplier’s market needs to be mature.
The same is true for cash: ING outsourced cash-in-transit and ATM servicing, while conducting the processing and operational management in-house because we were able to achieve economies of scale. ING also does this for another bank in the Netherlands. The taboo on outsourcing to a competitor is counter-productive – where you cannot differentiate, it is better to collaborate with your competitors. If you can outsource most parts of your value chain to those competitors with the lowest cost price for that part, you will be cheapest overall.
Another example is in the area of documentary trade, where ING outsourced the labour-intensive document checking. The bank has a follower strategy in this market, which shows overall decline globally. It gave us more flexibility and the bank can cope better with peak loads at lower fixed costs. ING believes that now is not the time for further outsourcing in the area of documentary trade because of the lack of a mature supplier market. This applies in areas such as payments, and in the documentary trade market.
Clearing services are a good example of a loosely-connected commoditised service with a standardised interface. For smaller banks, a logical first step in outsourcing is often to use another bank’s clearing connection. It is applicable for domestic payments as well as for international payments. There are high investments and fixed yearly costs involved for connectivity to an automated clearing house (ACH), a real-time gross settlement (RTGS) and nostro network. Connecting indirectly via another bank is therefore a key way of keeping costs down.
Processing card transactions is rapidly becoming standardised via EMV and Mastercard and Visa’s industry processing standards. This will increase competition and give banks a better negotiating position with their processors.
Outsourcing requires special attention to procurement and service level management. The Dutch Normalisation Institute (NEN) adopted an initiative to standardise outsourcing contracts – possibly against ISO standards – there is also a growing need outside the banking community for expectations to be better managed.
The ultimate goal of outsourcing is to move the focus from inessential to essential business areas, but this should not be seen as a panacea. If you outsource back office functions, remember that the rule of ‘garbage in – garbage out’ is still valid. As long as your customers outsource their payments to a bank, the bank has end-to-end responsibility for the value chain. Maintaining your value chain and migrating to a target model with standardised (or even commoditised) building blocks is necessary to prepare for outsourcing. In Europe, SEPA will be a catalyst for this process.
The business case for outsourcing legacy domestic schemes is hampered by a limited payback period. However, the current slow pace of migration to SEPA has extended this period. Co-sourcing for bigger domestic players, which currently happens in Germany, could be an option to share costs during period of overlap.
There is no reason to fear insourcing and outsourcing – it is not about winning and losing. Like any other sector, the payments industry has to evolve. Sourcing decisions should continue as usual, and as long as there is no mature insource suppliers market, I would recommend taking care of, and cherishing, your own processes.
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