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Banking has changed radically in the last 10 years. Remember when ATMs were new? The bank of the future--especially it's back office--will look even more different in 2010.

Here's why. Back in 1990, a bank's competitors were generally local. The bank performed 90-95 percent of the work in house. Information technology was moderately important; banks outsourced some business processes, primarily check and credit card processing. The bank's organization chart represented a very straightforward and traditional operating model, and offshore service delivery wasn't even on the horizon.

Since 1990, there has been tremendous consolidation among banks in the U.S, which started with deposit deregulation in the 1980's. (For example, Capital One just announced its purchase of North Fork Bancorp last month.) Since then, banking in the U.S. has increasingly moved toward becoming a national business with highly efficient back offices, putting greater and greater pressure on banks of every kind. To meet these increased competitive pressures, banks are outsourcing a substantial number of information technology services. This outsourcing trend will continue to accelerate as banks strive to improve their operating ratios.

Offshoring is one lever banks are using to deal with the new market forces. In 2004 banks spent over $16 billion in offshore outsourcing contracts, according to the Everest Research Institute, about half of that went to firms in India (approximately $7 billion) and the Philippines (almost $1 billion).

Figure 1:

By 2005, the number of employees in offshore captives had become a substantial part of the banking industry's total workforce. (A captive is simply a facility owned by a company that operates in another country and provides services on an exclusive basis to its parent. In other words, it is a domestic service center moved offshore.)

We believe that the percentage of offshore employees will swell quickly as banks now take real advantage of labor arbitrage. The trial period is ending and the period of aggressive exploitation is now underway. Figure 2, which covers just India, shows the number of offshore workers as a percentage of the various bank's total 2005 workforce.

Figure 2:

Banking in 2010

Fast forward to 2010. By then, between 20-30 percent of the bank's staff will be either in an offshore captive or employed by a third-party outsourcer.

Another big change coming is information technology will be even more critical than it is today. Much of banking will be, in a real sense, a technology business. The dilemma facing banks is that they may not be able to afford to make the investments needed to stay competitive; this will force them to rely even more on outside providers.

Bank operations in 2010 will also become more global than they are in today - driven by globalization of capital and labor markets. Although this will not be new for the current mega banks, such as Citi and JPMorgan Chase, regional and even some local banks will be dealing with multiple outsourcing suppliers located around the world.

Suppliers will have facilities in a broad group of countries to reduce risk by taking advantage of a broader group of skilled resources and labor arbitrage. They will have to provide additional capacity and disaster recovery capabilities. In addition, some regional banks will create their own offshore captives to take advantage of the offshore labor rate differential, and these captives will create substantial new management challenges of their own.

Figure 3:

To manage multiple far-flung suppliers and captives, banks in 2010 will need to develop a more sophisticated approach to supplier governance. They will face very different challenges managing people, processes, and technology as Figure 4 indicates.

Figure 4:

To meet the growing demand for offshore services, suppliers are investing in new capabilities. By 2010, they will have to handle both traditional transaction processing (for which they have become well known) as well as the emerging sophisticated knowledge processes, such as equity research, market modeling, trading floor analyses, etc. Service delivery will be structured in more sophisticated transaction vehicles that include captives, joint ventures, build-operate-transfers (BOTs), traditional outsourcing relationships, and hybrids that mix one or more models.

Captives Add a New Dimension

Among larger banks, captives have grown in importance because they permit a firm to move core processes that it would not want to send to a third-party supplier. Although captives have their own challenges (recruiting and training qualified local management are among the most important), they permit a bank to take broader advantage of labor arbitrage than it could by using a third-party supplier alone.

Location of the captive is critical because it must be situated in a locale with the maturity to support service delivery over the long term. At the very least, the locale must have:

• the ability to support infrastructure growth
• a labor pool being large enough with the needed skills
• a cost structure that enables the captive to provide cost savings over the long term

Risk Profiles Change

Competitive pressures will continue to force banks to expand the migration of work offshore, which will change their risk profile. Several factors have the potential to increase risk over the next five-to-ten years.

One is the expanded movement of work offshore - more suppliers entering the market, creation of captives, growth of existing suppliers - that is straining financial, service delivery, and management resources. Experienced, outsourcing-savvy management talent at offshore providers is becoming scarce and expensive.

Another is the bank's ability to efficiently manage the work parsed out to internal or external suppliers who perform it in multiple locations throughout a single country or the world. Problems can quickly get out of hand if the infrastructure has a failure in a critical node. Disaster recovery and business continuity planning take on a new, more important dimension.

A third is that traditional internal control mechanisms may not ensure that the offshore suppliers have the internal processes to manage the work flow and meet regulatory requirements. Even when banks create captives, the chances for lapses in control and security breaches increase. Companies looking at captives, Tier 2 and 3 suppliers, or new suppliers entering the market should look carefully at their controls and their ability to sustain them over time.

Captives have their own, unique set of issues. Experience has shown that captives are not a panacea because the moment a company decides to create a captive it has become an outsourcer. The "owner" must make investments in people, processes, systems, and facilities as an outsourcer in order to build and maintain an infrastructure that can scale, provide services at competitive prices, and meet the bank's security requirements.

Captives often find it hard to compete against the multinational suppliers for top talent. In order to recruit staff, they have to pay above market rates, which adversely affect their business case. Turnover at captives is also traditionally higher than with the multi-national companies, creating staffing and possibly service delivery and security problems.

Regulatory Challenges

The offshoring revolution not only affects the way a bank operates, it also impacts the work of regulatory agencies who are studying how they can accomplish their mission in this new banking world. Understanding a bank's operations in 1990 was relatively simple. In 2010, it will be even more complex than it is in 2006. Many of the controls and processes now being used were put in place before the turn of the century. By 2010, there is a risk that many regulatory approaches may be obsolete or worse, ineffective.

These changes suggest a different slant on traditional questions.

• Financial - What financial risks do offshore operations pose?
• Operational - How effectively is the bank performing work offshore? Does it have the appropriate controls in place for its own operations AND do its suppliers have the needed controls?
• Jurisdictional - What authority does the regulatory agency have in the country where the work is being performed?
• Security - Do the internal controls and standards for staffing and processes as well as the infrastructure meet privacy and data security standards?
• Law enforcement - How are the banks and their captives and offshore suppliers enforcing money laundering and counter-terrorism laws?

To minimize risk and to ensure effective service delivery, governance models will have to evolve for the bank of 2010 to succeed. Their staffs will need different processes and the skill to manage business results delivered by a variety of internal and external service providers located throughout the world. This will require an enterprise view of governance and risk, one which needs to be managed at the enterprise level and measured in terms of operations, finances, regulatory and legal, business strategy, and organizational impact. To do this, bank senior leadership teams should start evaluating offshore outsourcing at a strategic rather than a tactical level.

In other words, banks should create an enterprise strategy for outsourcing rather than the more traditional functional or tactical approach run by functional or business unit leads. The resulting master plan will help the bank evaluate which processes could be outsourced and which ones could or should go offshore in logical groups sequenced to maximize value as well as being prepared for the challenges of managing a bank in 2010 and beyond.

Lessons from the Outsourcing Journal:

• Offshoring will continue to expand in banking as a greater portion of the banks workforce will be offshore.
• Risk profiles of banks are changing due to the offshore movement because offshoring:
  • Stretches the supplier community's and management's resources
  • Requires a different governance model
  • Has more complex process
  • Includes a greater variety of transaction models
• Captives are becoming more popular but have their own set of unique challenges. Buyers typically don't understand them well.
• Regulators are evaluating how offshore service delivery is affecting transparency
• Banks can effectively manage these changes by:
  • Creating an outsourcing master plan that identifies which processes can be outsourced, which ones can be moved offshore, then logically grouping and sequencing the transactions to maximize value
  • Maintaining an enterprise picture that quantifies risk in at least five dimensions - strategic, operational, financial, legal, cultural
  • Upgrading their outsourcing governance models so they are better positioned and able to manage global service delivery and risk

Publish Date: April 2006

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Copyright © 2006 - Everest Partners, L.P.

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