Outsourcing in Financial Services: Hit or Miss?

Transcription

1 Research Brief Outsourcing in Financial Services: Hit or Miss? Abstract: Financial services providers in Europe are outsourcing to survive but this solution has its risks. However, following the right steps can minimize the hazards for these complex deals. By Peter Redshaw and Roger A. Cox Recommendations Financial service providers (FSPs) need to get the right skills for the job by using dedicated resources, and by making the management of strategic outsourcing deals a core business competency. IT and business process service providers need to recognize that the opportunities for growth presented by the financial services market will require extensive industry expertise, as well as proven success, partnerships and financial stability. Publication Date:16 January 2003

2 2 Outsourcing in Financial Services: Hit or Miss? The Changing World of FSPs The structure of FSPs, and the way they operate, is changing. In the past, financial services companies did everything themselves from controlling costs and growing revenue to developing new markets. Too often this was a recipe for bureaucracy, inefficiency and inertia that is unsustainable in today's business environment. As FSPs have sought to deal with these mounting pressures, they have turned to establishing shared services centers, strategic alliances, joint ventures and long-term outsourcing deals. In 2003 and through to 2006, the financial services sector will continue to see strong compound annual growth rates in IT and business process outsourcing (BPO) of between 6.7 percent and 10.1 percent. However, this is still far from being a fully mature market in terms of both service providers' ability to deliver complex deals (the industry expertise needed may be highly specialized for a particular subsector) and customers' ability to manage them. Financial Services Market Dynamics The advent of deregulation and globalization has increased the level of competition in banking and led to much thinner profit margins. Now FSPs are reeling from the blows of a falling equity market (to which they are heavily exposed) and a swathe of corporate collapses (such as Enron and WorldCom). As margins fall and assets plummet, FSPs must urgently address their cost base as the pressures multiply: Increased competition is forcing FSPs to change their business-to-business and business-to-consumer models to retain appeal. The full impact of true international competition has yet to be realized. Cost-to-income ratios are unsustainably high in many countries, such as Germany where, in 2002, costs are on average more than 70 percent of income (for example, Deutsche Bank has an adjusted cost-to-income ratio of 74 percent). This is substantially higher than in France or the United Kingdom (the Royal Bank of Scotland has a cost-to-income ratio of 46 percent and Credit Agricole's ratio for 2000 was 64 percent). An overcrowded market and mounting bad debts held by German banks can only exacerbate this situation. Consolidation and polarization will continue, with successful FSPs becoming either services aggregators or niche service providers. Mergers and acquisitions were rife in the past decade. However, although the number of banks in Italy has fallen by a third, there is as yet no Italian bank among the top 20 European banks when ranked by assets. The Italian leader, IntesaBci, would need to capture another 15 percent in funds and deposits or $40 billion to break into this bracket. So there is still some way to go in the mergers and acquisitions race. A focus on core competencies is resulting in a "compete in the front office, cooperate in the back office" strategy among the banks. Ageing legacy systems will need replacing at banks (or modifying at insurers) to remain competitive, but many smaller banks will struggle to find the funding and skills to implement, for example, a new core banking engine on their own. Private pension provision and long-term savings products will be a significant growth area as state pension burdens become unsustainable. Europe's ageing population means that, on current trends, workers in countries such as Italy, France and Germany could pay up to half their salaries to meet the generous state benefits being paid to pensioners. Or the benefits would have to be cut to such a low level that it would condemn retired people to poverty.

3 New regulation such as the Basel II Capital Accord and the European Union (EU) directive that will outlaw state debt guarantees, will drive demand for new services as FSPs have to manage risk more stringently and adapt their pricing accordingly. Put simply, the financial services market is in transition. The days of owning and controlling everything are over. Table 1 Top 10 European Banks, Ranked by Assets User Demand Gartner Dataquest forecasts that business process and transaction management will be the fastest-growing IT services line for financial services in Western Europe. Growth rates will slow through to 2005 as the economic slowdown and poor IT services sales take their toll. However, the latest vertical forecasts issued in early 2003 show that this is the only service line that stands a chance of reaching double figures for the 2001 to 2006 CAGR. Outsourcing will continue to outperform other IT services lines, such as consulting or development and integration, which will struggle to beat the 5 percent CAGR for 2001 to This reflects the pressures that are increasingly driving banks to outsource areas that were previously kept inhouse. Tables 1 and 2 show how the drive for size one of the defining characteristics of the last 10 years has not been linked to any corresponding increase in efficiency. Table 1 ranks the banks by assets (that is, deposits and funds under management) Rank Bank Country Assets ($M) 1 Deutsche Bank Germany 809,220 2 UBS Switzerland 747,211 3 BNP Paribas France 727,325 4 HSBC Holdings United Kingdom 696,381 5 HypoVereinsbank Germany 641,729 6 Credit Suisse Group Switzerland 609,618 7 ABN AMRO Bank Netherlands 526,450 8 Royal Bank of Scotland United Kingdom 519,991 9 Barclays Bank United Kingdom 505, Credit Agricole Groupe France 496,421 Source: Gartner Dataquest (October 2002) 3 Table 2 uses the return on assets as the criterion, that is, the profitability or income as a percentage of the assets from which they are largely derived. That income, in turn, is critically dependent on the costs of the bank. As competition increases, the performance of a bank, rather than its size, becomes the critical success factor. That performance is closely linked to the efficiency of its operations not its size whether it is measured by return on assets or the costto-income ratio. That is why the user demand will be to find ways to reduce costs and optimize processes, which can be achieved through IT initiatives and through outsourcing.

4 4 Outsourcing in Financial Services: Hit or Miss? Table 2 Top 10 European Banks, Ranked by Return on Assets 2001 Rank Bank Country Assets ($M) Profits ($M) Return on Assets (%) 1 Sberbank Russia 25, Banco Popular Espanol Spain 32, Lloyds TSB Group United Kingdom 275,780 5, OKO Bank Group Finland 26, UniCredito Italiano Italy 183,650 3, Banco Sabadell Spain 23, Bank of Ireland Ireland 71, B.Pop.di Verona-B.S. Gem e S. Prosp Italy 26, National Bank of Greece Greece 46, DnB Group Norway 39, Note that the banks shown here have been selected from the 100 largest banks in Europe Source: Gartner Dataquest (October 2002) Just as size is no guarantee of success, neither is geography. Table 3 presents those at the bottom of the rankings when judged by return on assets. Note that nine out of the 10 banks are German, reflecting the crisis that has resulted from oversupply, high costs, bad debt and the economic slowdown. Table 3 Poor Performers European Banks, Ranked by Return on Assets 2001 Rank Bank Country Assets ($M) Profits ($M) Return on Assets (%) 91 Allg. Hypothekenb. Rheinboden Germany 79, Bayerische Landesbank Germany 287, Norddeutsche Landesbank Giro. Germany 170, Landwirtschaftliche Rentenbank Germany 51, Dresdner Bank Germany 446, Wustenrot & Wurttembergische Germany 46, Commerzbank Germany 441, DZ Bank Germany 321, Bankgesellschaft Berlin Germany 166, Fineco Italy 23, Source: Gartner Dataquest (October 2002) Possible Outsourcing Opportunities The opportunities for IT and business process service providers will continue to increase as FSPs struggle to improve their efficiency and competitiveness. These opportunities will arise in several ways. FSPs outsource more of their operations, as they focus on their core capabilities in today's changing market. For example, BPO spending is forecast to increase to $16.9 billion by 2005 for the financial services sector in Western Europe. This market goes well beyond the confines of the IT department and hence of traditional IT outsourcing. Outsourcing will expand beyond the noncore, noncritical (such as human resources) to the critical but noncore (such as check and payment processing). Even functions that have been seen as critical-and-core, such as risk management and claims processing will be considered. The opportunity for external service providers is in converting fixed to variable costs, providing cost reduction and delivering good-quality services. Establishing shared services centers that can serve multiple clients has been a popular model (for example, the ipsl service formed by Unisys, Barclays and Lloyds TSB). Many banks will also need IT service providers to

5 5 help plan their IT strategy, improve customer service levels, migrate to new technical platforms and plan flexible resourcing for software development. FSPs strive for further consolidation and rationalization of their IT systems. For example, enabling central control of more systems, reducing the number of servers by hosting multiple applications on the same hardware and simplifying the architecture by having fewer applications. Harnessing the technical and management expertise of external IT service providers will often be vital in achieving these complex changes rapidly, securing a competitive advantage. We expect to see an increasing number of these transformation programs delivered through outsourcing deals. Mergers and acquisitions among FSPs will create integration opportunities. FSPs will turn to external IT service providers to cope with the huge challenge of realizing the synergies present in the merger, consolidating and integrating systems, and creating a customer-focused "single view" of their operations. How Well Is Outsourcing Working? For the more traditional IT outsourcing services, short-term deals with offshore partners may be considered where the immediate requirement is, for example, code remediation or staff augmentation. Financial services companies are increasingly putting their faith in long-term alliances with business partners and IT service providers, especially for BPO deals. The problem these alliances have is managing the complex and dynamic network of suppliers and partners that makes up this new business architecture. The press statements in Table 4 show that success has been patchy.

6 6 Outsourcing in Financial Services: Hit or Miss? Table 4 Financial Services Contracts in Europe Client Provider Price of Contract Length of Contract Press Comment ABN Amro EDS $1.5 billion Five years Global banking group ABN Amro is in final contract discussions with EDS to outsource its IT function. EDS claims the largest-ever outsourcing contract in the financial sector. "We're convinced we can reduce costs on our IT function, which is also important for clients of ABN Amro, and we want to have a more flexible cost base," said a spokesman for the bank, adding, "we think we can achieve that through outsourcing a part of our IT department." Barclays and Lloyds TSB Barclays Bank Unisys IBM Global Services Joint Venture to form ipsl Approx. 100 million per year Barclays and Lloyds TSB outsource check processing to Unisys. Unisys has a 51 percent stake in subsidiary company, Intelligent Processing Solutions Limited (ipsl). Barclays Bank is embarking on a program to update IT in its network of branches as part of a company-wide drive to improve the efficiency of its computer systems and reduce overheads. The bank is spending an estimated 200 million to replace outdated branch hardware and software, networks systems, storage systems and its automatic teller machine (ATM) infrastructure with state-of-the-art equipment through a mixture of outsourcing and in-house development. News of the plan comes as Barclays is in negotiations with IBM to outsource the management of its entire IT infrastructure in a deal estimated to be worth more than 100 million a year. Cazenove IBM Cazenove, a U.K. stockbroker, is to bring its IT operations back in-house, ending a 10-year outsourcing contract with IBM after only three years. Cazenove outsourced its entire IT operations to IBM in October 1999 in the U.K.'s largest IT agreement of its kind. The contract was believed to be worth more than 100 million. Deutsche Bank IBM $2.5 billion 10 years IBM signed a $2.5 billion outsourcing agreement with Deutsche Bank to manage its computing centers in continental Europe. IBM will take responsibility for data centers and smaller server sites in Belgium, Germany, Italy, Poland, Portugal, Switzerland, Spain and Luxembourg. It will also set up a new data center in Germany's Rhine-Main region and will take more than 900 Deutsche Bank staff, who will move to IBM in the first quarter of IBM said that Deutsche Bank will also gain access to its hardware, software and services on an "on-demand" basis. Halifax Bank of Scotland Halifax Bank of Scotland IBM 700 million 10 years The Bank of Scotland, which merged with Halifax bank last year to form HBOS, is to terminate its outsourcing contract with IBM after less than two years and bring its IT back in-house. The move is likely to cost the bank a substantial amount in one-off transition costs. It will also be forced to pay penalties to IBM for terminating the contract early without sufficient cause. Xansa Joint Venture to form First Banking Services (FBS) Xansa is to be compensated for early termination of its IT contract with the Bank of Scotland after it merged with Halifax to become HBOS last year and decided to rewrite its IT partner relationships. FBS, the joint services venture established between the premerged Bank of Scotland and Xansa in 1998, will lose 91 million in sales after HBOS cut the contract by 18 months. Schroders CSC $240 million Seven years CSC has entered into an IT outsourcing contract with the U.K. arm of Schroders. The agreement calls for CSC to manage infrastructure and application services, including desktop computing, help desk, midrange and voice services, and certain applications development and support. Schroders IFDS Schroders has signed an agreement with International Financial Data Services (IFDS) to outsource its U.K.-based authorized unit trust administration. IFDS is a joint venture between Boston-based State Street Corporation and DST Systems. Source: Gartner Dataquest (November 2002) What Are the Pitfalls to Avoid? Gartner Dataquest has identified the key reasons why many of these outsourcing deals fail at some stage in their life cycle and the primary pitfalls to avoid. Few companies have the necessary people, processes and resources. Specialist skills and a professional approach are needed to structure and manage complex long-term outsourcing relationships that can flex to accommodate today's

7 changeable business environment. Processes put in place to manage long-term agreements often monitor the wrong things and serve little practical purpose, other than justifying the existence of the in-house team. Users need to assign dedicated staff to act as the interface between the business and the outsourcer. A lack of compatibility. Although many service providers can provide experienced engagement executives and consultants with strong financial services credibility, this does not mean that the service provider's delivery model is necessarily compatible with the dynamics of the business. For example, few IT outsourcing companies would have a standard delivery model compatible with a trading floor. Expectations are not aligned with real needs. The details of a long-term agreement, spelt out at the beginning of the deal, may not be what each business unit involved actually needs in the long term. Managers then complain about the service they receive, and the in-house team that's left in place to manage the deal is naturally unwilling to take the blame. Service providers, although they may be fully meeting their contractual obligations, are used as convenient scapegoats. Deals are wrongly structured. Short-term pressures can lead companies to sign unsuitable long-term agreements sometimes in the full knowledge that they are not doing the right thing. Many long-term outsourcing relationships are negotiated on the assumption that the company and its business will not change significantly, when the reality is an environment of continuous development and uncertainty. Communication is poor. Those responsible for the relationship (business unit heads, CFOs and executives from the service provider) typically receive overdetailed monthly performance reports that track irrelevant or inappropriate measures. As a result, they fail to see the value of the deal. Leadership is lacking. Senior managers, who were closely involved up to the time contracts were signed, are no longer focused on the outsourcing deal. The skeleton staff left in place to manage the complexities of the continuing relationship is often overworked, under-resourced, ill equipped and under-valued. To solve these problems throughout the life of an outsourcing deal, organizations have to make major changes to the way they work. Those that do can establish and maintain long-term deals that add value to their business. There is often more noise about high-profile "failures" and far less about the quiet achievers. 7 Case Study Getting it Right There are many success stories and Accenture's deal with the London Stock Exchange (LSE) is a case in point. First struck in 1992, the deal has been renewed twice, in 1996 and 1997 and in 2002 for a further five years. Clearly, both parties must be doing something right. One of the features of this deal is that it has included elements of all the typical outsourcing styles, as follows: "Utility" where Accenture took over IT operations and provided stability, streamlining and quick wins. "Enhancement" replacing the IT infrastructure, re-engineering the processes and improving operational excellence). "Frontier" relationship jointly looking for opportunities to exploit new technologies for the benefit of the business. Gartner Dataquest research shows that deals with higher proportions of "enhancement" and "frontier" components offer far more opportunity for the service provider to add value; tend to be better aligned to business needs; are managed

8 8 Outsourcing in Financial Services: Hit or Miss? better and consequently have a higher proportion of satisfied customers. This deal has embodied what Accenture calls "business transformation outsourcing," simultaneously driving down the operational costs while creating a new technical platform and providing new capabilities. The deal has avoided many of the pitfalls described in the previous section. Compatibility The scope and coverage of this deal has been wide-ranging: as well as managing and supporting the hardware and software operations, Accenture has also been responsible for consulting and software development, principally the SETS electronic trading platform that was initiated in 1992 and went live in Since then, it has suffered only two outages (in November 1997 and April 2000) but has twice been scaled up so that it can support nine times greater trading volumes. This scalability has been needed to deal with the boom driven by institutional and programmed trading, plus the cheaper trading that SETS supports through central counterparties and netting. Accenture was involved in brokering the arrangement with the Johannesburg Stock Exchange (JSE) whereby SETS is used on an application service provider-style basis, generating an extra income stream worth 11 million ($17.7 million). There may be more such deals in the future, which is why the openness of the new IT architecture that is evolving is so important. Deal Structure The increasing commercialization of the LSE, as it competes or collaborates with rival exchanges throughout the world, is another aspect of the relationship within which Accenture has had to thrive. Accenture has been a "thought leader" in supporting this new role, looking for ways in which the LSE can differentiate itself and offer new sources of value to the marketplace. Whereas the emphasis in the phase from 1997 to 2002 was on cutting cost, in the next phase from 2002 to 2007, it will be on providing additional services and continuous improvement in quality. In addition to SETS, Accenture has also delivered the Regulatory News Service, the Retail Service Provider system, and, in April 2003, the first phase of the new MIDAS system will go live. MIDAS will offer a real-time data warehouse of open price information to financial services institutions, to be followed in July by a full historic service. This scale of innovation is one reason why Accenture has always striven to keep software development separate from (but aligned with) the LSE's daily operations. Expectations Reducing cost has been achieved in both operational and development areas. When the outsourcing deal commenced, IT costs were escalating rapidly and accounted for a growing proportion of the LSE's total operations cost. Its forecast IT operations costs over the next 10 years (including third-party costs and depreciation) have been reduced by about 55 percent and total IT costs (operations plus development) have been reduced by more than 18 percent since transfer. IT efficiency has contributed significantly to the LSE's recent financial performance; while the LSE's total costs have only increased by 11.5 percent in the last four years, revenue has risen by 47 percent and operating profit by 238 percent. It is important to appreciate how IT is not simply about driving down costs, but also about delivering real business value. In 2001 and 2002, Information generated 94.9 million or 47 percent of the total revenue, compared with 40 percent for Brokerage and 13 percent for Issuer Services.

9 9 Communication While there are well-understood rules for keeping operational costs down (such as consolidation and rationalization of hardware, simplification of the applications architecture and utilizing buying power for software licenses), software development costs have always been a tougher problem to crack. Jeremy Oates, Accenture client partner for the LSE, attributes the success to: Always having a business case for change Delivering through demand-based resources A streamlined development process Zero-based costing (there is no "standing charge" for software development built into the contract) Lessons Learned ThekeylessonfromthisdealaccordingtoJeremyOatesisto"revalidatethe agreement between both parties every day why we are there and what value we add." The success factors are more about management and attitude, than technology. Jeremy Oates identified the following lessons that have contributed to the success of the Accenture-LSE relationship: The LSE was committed to change: it was prepared to make the changes that were needed (such as formal fault reporting and escalation procedures). Keep development and operations separate, but ensure that they are co-ordinated and that they support each other. Continuously improving quality, especially around processes, is vital to making cost savings. Fewer faults mean fewer calls to the contact center and prevention is always cheaper than the cure. Make sure that the software works from day one. This entails making sure that operations have input to development right from the start so they can, for example, define acceptance test criteria as early as possible. It also requires extensive market testing with clients using high-quality specification, interfaces and test services. When things are going well, do not become complacent. Maintain the same level of effort into reviewing development and operations with the client. Ironically, it has been repeated changes of CEO in the LSE that has driven this sort of revalidation on a regular basis. Changes in the senior management often usher in a new strategy and undermine such outsourcing agreements. In this case, it has forced Accenture to engage the business at every stage and served to keep the deal relevant.

10 10 Outsourcing in Financial Services: Hit or Miss? Gartner Dataquest Perspective There is much noise about the minority of high-profile failures in outsourcing but relatively little about the majority of quiet achievers. Inevitably, there will be some more failures to come, but, other deals will succeed as this market matures and as FSPs strive to remain competitive. Overall, outsourcing in financial services will continue to grow, especially the BPO service line. Gartner Dataquest recommends the following: FSPs need the right skills for the job, and make the management of strategic outsourcing deals a core business competency, as follows: Do not assume the current management can cope with a complex network of business partners and suppliers. Appoint a senior executive to take direct responsibility for your outsourcing activities. Move from ad-hoc project teams to dedicated and skilled people operating strategic sourcing as a core business process. Those that get "strategic outsourcing" right will gain an advantage over their competition. IT service providers need to recognize that the opportunities for growth presented by the financial services market, outside the technical aspects of IT infrastructure, will require extensive industry expertise. This is more than having the right salespeople or a small number of domain experts available "on call." It may require partnering with FSPs to gain expertise, radically changing delivery models and recognizing that FSPs may emerge as competitors for some types of IT services. Success is more about new attitudes than new applications. This will become increasingly important as the balance of outsourcing gradually shifts away from IT outsourcing toward BPO. Key Issue Whatistheroleofoutsourcingintheindustry? This document has been published to the following Marketplace codes: ITSV-WW-DP-0447 For More Information... In North America and Latin America: In Europe, the Middle East and Africa: In Asia/Pacific: In Japan: Worldwide via gartner.com: Gartner, Inc. and/or its Affiliates. All Rights Reserved. Reproduction of this publication in any form without prior written permission is forbidden. The information contained herein has been obtained from sources believed to be reliable. Gartner disclaims all warranties as to the accuracy, completeness or adequacy of such information. Gartner shall have no liability for errors, omissions or inadequacies in the information contained herein or for interpretations thereof. The reader assumes sole responsibility for the selection of these materials to achieve its intended results. The opinions expressed herein are subject to change without notice