Outsourcing in Financial Services: Cost Savings or Competitive Advantage?

Financial institutions are turning to business process outsourcing to save money. But if properly managed, these arrangements can produce long-term strategic benefits.

Due to the economic climate that has prevailed over the past 18 months, outsourcing, in its different shapes and forms, has once again been gaining strategic significance in the financial services industry.

Institutions are finding real business opportunities in outsourcing various parts of their extensive IT capabilities. Outsourcing arrangements for large institutions have made the headlines, as they usually amount to a few billion dollars in spending distributed over a seven to 10 year period. Do these and other smaller outsourcing arrangements entail real benefits, or is it all just another technology hype?

The current composition of IT spending reveals the already important portion that institutions trust to external parties. Globally, financial institutions will be investing an estimated $340 billion in IT hardware, software, specialized resources, and external services in 2003. An estimated $120 billion, or nearly one-third of total spending, is being entrusted to third parties. This amount includes three significant IT components:

- Software, including external developments and packages;

- Professional services, such as IT consulting, systems integration and training;

- Outsourcing services, covering a wide range of traditional service bureaus, Application Service Providers (ASPs), facilities management and Web hosting arrangements.

BPO ON THE RISE

Adding to the respectable size of IT spending that is placed with external providers, there is a trend toward including business processes in the outsourcing bundle. Operational expenses in financial institutions are typically seven times larger than IT spending. This brings up another area of opportunity to employ third parties to carve out and transform parts of the IT and process capabilities. Such transformation includes an end-to-end recombination of business functions encompassing the supporting people, processes, hardware, software and network resources.

Business Process Outsourcing (BPO)-together with a more holistic transformational outsourcing approach-constitutes a strategic field for competitive business edge and operational efficiency that could add another $100 billion in external FSI spending over the next five years. Institutions are finding that an alignment of business strategies, operational processes and IT investments is a key driver for operational efficiency and resilience. Many institutions have been embracing outsourcing as a catalyst for such alignment, either because the outsourced pieces already reflect a strategic business transformation or they reduce and bring flexibility to various fixed IT and operational expenses.

BPO may be thought of as end-to-end outsourcing of a particular business line or process, which is a natural evolution from traditional service bureau processing. Outsourcing of specific application functionalities-such as core banking, credit card processing or mortgage servicing-is well-established in many markets, but recent deals have emphasized the outsourcing of horizontal technology management functions, allowing financial institutions to more effectively manage scale issues through "services on demand."

To illustrate the continuing momentum on outsourcing, let us mention that American Express, Deutsche Bank, Bank of America, and JP Morgan Chase have announced outsourcing arrangements totaling approximately $15 billion in contract value to their service providers over the next seven years. Given the pressure for business performance and strategic cost management in operations and IT organizations, this trend towards outsourcing is likely to continue in 2003.

REBUILDING THE INFRASTRUCTURE

Besides the dollar amount, this new wave of outsourcing arrangements is transforming the institutions' IT infrastructure and, in some cases, the applications and related business processes. From the perspective of traditional IT cost, the expectation is a reduction of expenses. As the market has been down for quite some time, reducing cost is a particularly pressing issue in the securities and investments space.

To achieve that reduction however, institutions need to invest in strategic transformation projects. The cost of this transformation naturally precedes the savings and compounds the challenge. A classic target for cost reductions is the large expense portion in IT maintenance capabilities that support day-to-day operations and regulatory mandates. And many institutions are now looking at outsourcing as a vehicle to advance their IT functionality faster and cheaper.

These investments go to strategic developments for business transformation and competitive purposes. Thus, outsourcing is a strategic vehicle to pull savings from efficiencies in the fixed cost layers, and to invest smartly in strategic transformations that deconstruct and recombine discrete financial functions into more efficient business solutions.

OPEN ADVANTAGE

Recent advances in information technology enable such strategic transformations. These advances include the development of a more standards-based, open IT environment that provides technological flexibility, and is cheaper and more flexible to manage.

Open IT environments complement financial firms' recent penchant for the open software movement as signified by growing popularity of Linux among financial firms (especially on Wall Street). Such an approach is based on the deployment of Web services to both enhance the efficiency of internal operations and to gain access to product and process features outside the firewall of an individual financial services institution. Essentially, this is really about putting together the horizontal financial functions, including:

- Common business functions within the institution;

- Best-in-class industry utilities that add a new dimension of value.

The resulting environment provides industry connectivity, standardized processes, and advanced software development capabilities for improved flexibility and scalability.

And while Web services deployment will impact the traditional service bureau model we see today, the development and maintenance of applications, including those developed on Web services standards, will encourage still another form of outsourcing: the offshore services approach. Several offshore and larger vendors have perfected their software development methods and have attained higher levels of maturity along the widely established Capability Maturity Model (CMM) from the Software Engineering Institute at Carnegie Mellon University. Here, institutions find yet another interesting area of outsourcing to evolve their more basic, and oftentimes antiquated software development methods.

THIRD PARTY CONCERNS

To reap the benefits of outsourcing, institutions face several challenges. Third parties must comply with financial services regulations, and institutions must keep control over a new breed of risks stemming from the involvement of third parties in the service chain.

Probably the most significant challenge is that institutions must develop a completely new set of skills to manage the outsourced capabilities and vendor performance at arms length. New forms of business interdependence emerge, as institutions transfer vital IT and business knowledge to third parties. As there are more parties to the service equation, outsourcing increases complexity and introduces new risks. If deficiencies in technology governance are left unchecked, outsourcing can only complicate the interactions with the business areas and exacerbate any looming issues.

When the opportunities for improvement are well understood, outsourcing arrangements may bring mutual benefits. For example, vendors may lock in multi-year contracts and entice institutions with short-term gains that discount the intended long-term efficiencies. A robust case for long-term benefits may also lead to business alliances and partnerships that build on the respective core competencies.

As there is no magic formula for success, institutions should thoroughly understand their business case for outsourcing. In addition to the tactical and strategic cost reduction opportunities, access to the latest and greatest functionality and sophisticated IT development capabilities are powerful drivers that help institutions reduce the time to market of new products and maintain a competitive edge.

Jim Eckenrode is group director, Consumer Banking and Guillermo Kopp is director, Financial Services Strategies & IT Investments for TowerGroup, a Needham, Mass.- based financial services analyst firm. Both can be reached at www.towergroup.com