Offshoring-enabled VALUE CREATION in the financial services industry by Chris Disher, Arie Y. Lewin, and Carine Peeters, Booz Allen Hamilton/Duke University Most financial services companies believe they are leading the way in innovative offshoring. The fact is that other industries are pursuing more sophisticated initiatives, having already recognised that offshoring is about more than taking out costs: it s about value creation over the long term and financial services firms who understand and exploit this strategic opportunity will be successful over the long term and those who don t, won t. So far, most financial services firms have focused on realising the immediate benefits of labour arbitrage in low cost countries, but these benefits are being eroded by rapid wage inflation up 26% in Bangalore over the past 12 months high employee turnover rates and the associated costs, and declining service levels. Only a few companies have recognised that they must begin creating longer term competitive advantages through greater efficiencies and fundamentally transformed business processes on a global scale. As financial services firms learn to transact business globally with greater sophistication, they will reap the competitive rewards: scale, lower costs, and quantum increases in efficiencies through re-engineered and redesigned processes particularly in the delivery of transactions. Financial services firms should also pursue residual revenues by working with outsource partners to develop best-in-classs utilities to which other companies can bolt their applications. To realise these benefits, financial services companies will need to adapt their vendor selection criteria to identify vendors who can function as critical business partners in strategic relationships. Unlike other firms, we do not expect financial services firms to create value in the near term by offshoring product development. For now, we expect financial services firms to maintain this work in-house in cities such as London and New York City, where finance rocket scientists, behavioural economists, finance modellers, game theorists, and other finance techies tend to congregate. BEYOND LABOUR ARBITRAGE Although process re-engineering can be a significant source of cost reduction and greater efficiency, the financial services industry lags behind other industries in pursuing process redesign opportunities. In fact, financial services firms are accomplishing less in this 11
Is your firm on track to benefit from offshoring-enabled value creation? Has your firm: Implemented process re-engineering? Developed selection criteria that will identify vendors capable of partnering in value creation? Identified criteria for safeguarding core process knowledge? Developed and disseminated a corporate-wide strategy for guiding offshoring? Implemented a global sourcing strategy? area than is commonly believed, so potential opportunities for growth and value creation are significant (Exhibit 1). To extract value from this untapped business frontier, financial services firms will need to: Re-engineer and redesign entire business processes in ways other firms cannot easily imitate to generate longer term competitive advantages beyond labour arbitrage. Devise new criteria for choosing third party providers which emphasise specific financial services domain expertise, and process redesign and re-engineering capabilities. Although most vendors talk business transformation, it s mostly just talk: their focus is on taking out cost but focusing on cost reduction alone is a losing proposition; such cost savings evaporate quickly in the face of wage inflation and rising turnover, and this inflation is likely to continue its steady climb, especially in hotspot offshore locations. Work in partnership with the third party providers to develop optimal business processes, or industry best practices, for which the co-developing firms can earn residual revenue in the form of royalties. In fact, the race is on within the financial services industry to see who will be first to develop such best practices standards. Strategic drivers of offshoring Exhibit 1 Taking out cost Competitive pressure Growth strategy Access qualified personnel Industry practice 51% 76% 71% 76% 74% 69% 69% 66% 93% 97% Improved service levels 45% 49% System redundancy Business process redesign Increased speed to market Change rules of game Access to new markets 0% 24% 43% 33% 36% 48% 31% 34% 31% 36% All Financial services 12
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Forward-looking financial services companies that understand the evolution in offshoring from opportunistic to strategic will establish their competitive advantage and increase their odds of staying in the game. OFFSHORING TRENDS IN THE FINANCIAL SERVICES INDUSTRY Focus on taking out costs We expect that financial services companies will continue offshoring low skill jobs to reduce costs and increase efficiencies, mainly through labour cost arbitrage; so far, they report average cost savings of 35% off baseline costs. In 2001-2002, financial services firms responded to continuing pressure to reduce costs and maintain margins by offshoring administrative functions, IT, and call centres, which continue to account for 94% of all applications (Exhibit 2). On the basis of responses to the ORN survey, we expect such offshoring initiatives to accelerate over the next two years, with 27% of existing applications expected to expand and new implementations expected to grow by 43%. Other industries, however, have already begun to move beyond labour arbitrage because of the looming shortage of qualified workers in the US and the EU. These firms are looking offshore for the talent they need to foster innovation, increase productivity, create value, and achieve growth. Across all industries and functions, more jobs have been created offshore than have been eliminated in the US (average ratio of 2.5 to 1). But most financial services companies have focused on replacing high cost workers with lower cost workers (average ratio of approximately 1 to 1) and have overlooked the opportunities for growing scale through offshoring. Functions offshored Exhibit 2 Adminstrative 24% 41% IT Contact centres Product development 6% 15% 21% 23% 30% 32% Procurement Other 0% 0% 2% 6% Whole sample Financial services companies 14
KEY OFFSHORING RISKS Regulatory compliance The highly regulated nature of the industry leads financial services firms to be more concerned than other firms about many offshoring risks (Exhibit 3). More specifically, they are more concerned about data security, the quality of offshored services, and the loss of control over business processes. Surprisingly, they are less concerned than firms in other industries about the risks associated with high employee turnover at offshore locations. Infrastructure and political instability Financial services companies are also less sensitive than other firms to the risks associated with inadequate infrastructure and political instability. This lower sensitivity reflects a preference for nearshore locations where these risks are lower. For instance, 21% of implementations are located in Canada compared to 6% for the total sample. In fact, nearshoring allows financial services firms to mitigate the risks of political instability and helps them align their needs with the necessary language skills and available expertise (Exhibit 4). BEYOND NEARSHORING: MITIGATING RISKS However, nearshoring strategies alone cannot address four significant offshoring challenges: 1. Growing turbulence at offshoring hotspots, such as employee turnover, increased training costs, and wage inflation. To address these problems, firms should consider second tier cities, where the competition for talent is less acute. 2. Third shift performance issues. Some firms have addressed persistent performance inconsistencies Perceived risks of offshoring Exhibit 3 Data security Service quality Loss of control Corporate culture buy-in Client acceptance Weakening morale Cultural fit IP loss Disaster recovery Opertional efficiency Employee turnover Infrastructure instability Political backlash Political instability 53% 68% 59% 67% 47% 62% 55% 61% 52% 56% 43% 56% 58% 44% 41% 44% 41% 39% 38% 38% 49% 24% 36% 24% 33% 21% 29% Whole sample 76% Financial services companies 15
Criteria for selecting offshore locations Exhibit 4 Language Expertise Political stability Best provider Infrastructure Collocation Government incentives 6% 11% 31% 19% 25% 26% 21% 29% 17% 38% 51% 73% 67% 71% Whole sample Financial services companies 16 during third shifts by using follow the sun strategies that eliminate grave yard shifts. These strategies allow workers in different locations to work during the day, which improves service and helps companies retain qualified workers. 3. Major catastrophes. Firms must create system and infrastructure redundancies and contingency plans: if one centre shuts down because of a power failure or because a provider fails to meet SLAs, or if one centre experiences peaks in demand the work can be seamlessly shifted elsewhere. 4. Loss of process knowledge. Firms must make strategic decisions about what core process knowledge should be retained in-house regardless of the scope of the outsourced functions, which can range from independent sets of well-defined tasks to entire processes. Field research also suggests that employees responsible for implementation voice their concerns about this risk, but are often marginalised as non-team players. A few firms are devising global sourcing strategies to address these risks, and the risks associated with specific offshoring locations and functions, such as language requirements for customer-facing activities. In the case of language, French financial services firms will probably favour countries like Morocco and Tunisia, while German companies are more likely to go to the Czech Republic and Hungary. The critical point is that for financial services firms to move toward more effective global sourcing models, they must create more nuanced risk mitigation and location strategies that evolve as their needs change. GETTING READY FOR THE FUTURE Only a few financial services firms are actively implementing Generation 3 offshoring strategies; most
are still in Generation 1. However, the rapidly evolving competitive playing field makes it increasingly critical that financial services companies embrace Generation 3 offshoring and fully leverage the potential for growing global scale and creating value (Exhibit 5). To move to Generation 3 offshoring and achieve the greatest transformational business impact, financial services firms must: Formulate and disseminate corporate-wide offshoring strategies which serve to guide, encourage, and reward individual business units for experimenting with more strategic offshoring initiatives Such strategies should: Make fundamental re-engineering a reality. Most financial services firms settle for lift and drop and for refining existing processes, which is like rearranging the deck chairs on the Titanic. According to a survey of alumni of Duke University s Fuqua School of Business, only 1% of the more than 400 respondents say their corporations have a corporate-wide offshoring strategy despite its essential importance. Ensure critical process knowledge is retained. In the rush to offshore, some financial services firms have lost crucial process knowledge and have become dependent on third party service providers. Again, the key is making strategic choices about what core process knowledge must be kept in the retained organisation, even if the function itself is outsourced. Take full advantage of offshoring s benefits from labour arbitrages and scale to process re-engineering and innovation (Exhibit 6): Effective corporate strategies will emphasise different elements at different times given different objectives. Towards offshoring-enabled value creation Exhibit 5 Gen. 1 Opportunistic Gen. 2 Informed Gen. 3 Strategic Relative strategic value to companies Efficiency Value Labour arbitrage Effectiveness Value: Scale Specialisation Optimisation and standardisation of processes Learning from vendors Scope of functions outsourced/offshored Value creation Value: New functionalities New methodologies and techniques New service offerings Global sourcing 17
Elements of corporate offshoring strategy Exhibit 6 Transformational impact Value creation Process reengineering Global sourcing Scale Labour arbitrage 18 Clearly, over the next few years, firms will continue to seek the benefits of labour cost arbitrage; however, as these opportunities decline, firms must experiment with more value-creating offshoring activities that will fundamentally transform their businesses. Build a global labour strategy Financial services firms should: Identify vendors that can deliver more than cost savings and align these vendors with their business objectives. Although most vendors are still best at taking out costs, some leading-edge vendors are beginning to see opportunities to undertake process re-engineering projects. And as financial services companies start creating strategies focused on re-engineering, more vendors can be expected to develop value creation capabilities, which should create more opportunities for firms and vendors to work together to develop new business models. Develop more refined capabilities for managing a global workforce. Firms must begin investing in the creativity and talent needed to take advantage of strategic offshoring. This effort includes creating new managerial positions and providing training in areas such as cross-cultural effectiveness. Develop more nuanced strategies for selecting the right offshoring locations for redesigning and re-engineering processes based on the availability of qualified personnel; the skills needed, such as language skills, process knowledge, and customer orientation; and the expected evolution of the supply and demand for talent. This effort also includes locating in second tier cities to minimise difficulties at offshoring hotspots; developing follow-the-sun strategies to increase performance consistency and provide better in-region support; and mitigating catastrophe risks by creating redundancies.
The Duke University CIBER-Booz Allen Hamilton Survey on Offshoring Summer 2004 Launch Offshoring Research Network Summer 2006 Third Duke CIBER-BAH annual survey. Target Executives and functional managers. Administrative and technical offshore implementations. Demographics Average revenue: US$21bn. Average market cap: US$30bn. Scope Extended to European companies in 2006 (UK, Germany, Netherlands, Spain, Denmark, Belgium). Analyses Within and across countries, industries, functions, offshore locations, service delivery models, and over time. Info http://offshoring.fuqua.duke.edu They must bridge, or even abandon, the traditional vertical silos typical of most financial services organisations. If financial services firms fail to reorganise, they will continue to be hindered by obsolete business models and inadequate internal processes which limit innovation and restrict the horizontal exchange of ideas and knowledge. What remains to be seen is which firms will rise to the challenge of reinvention, and marshal the imagination and vision needed to embrace strategic offshoring and meet the daunting task of managing change. Chris Disher Arie Y. Lewin Carine Peeters In other words, financial services firms must move beyond Generation 1 opportunistic offshoring to more strategic Generation 3 initiatives based on process re-engineering to achieve scale at lower cost. To do that, firms must develop global sourcing strategies, build strategic partnerships with vendors, and learn to source, train, coordinate, and retain talent anywhere in the world. Making this move to Generation 3 offshoring will require that financial services firms reinvent themselves. Chris Disher is Vice President at Booz Allen Hamilton Chicago, IL. Arie Y. Lewin is a Professor and Carine Peeters is a Research Associate at Duke University in Durham, NC. For further information, please telephone +1 (312) 578 4505 (Chris Disher) +1 (919) 660 7654 (Arie Lewin) or e-mail: disher_chris@bah.com ayl3@duke.edu 19