The True Cost of Outsourcing in Financial Services

Chief financial officers (CFOs) are increasingly viewing IT outsourcing as a means of improving accuracy and timeliness of their current transaction processing, as well as reducing cost. In theory, corporate governance and compliance can be improved and control over the processes can be increased. The economic benefits in terms of lower costs are so substantial that firms often cannot afford not to tap into the potential of India, China and other developing countries.

However, achieving economies of scale is the most over-cited reason for IT outsourcing. Let’s face it, you don’t have to be Alan Greenspan to understand that IT outsourcing brings some clear economic advantages, such as a reduction in overhead expenses and the elimination of soaring costs associated with hardware and software maintenance.

While cost saving is quoted by many major financial institutions as the most important driver for outsourcing, contractual flexibility and professional services integration are also becoming appealing to the financial services (FS) industry.

Over the past few years, an increasing number of banks have been moving towards outsourcing. For example, London-based Barclays Bank, one of the world’s top 25 banks, has expressed a commitment to offshoring. In 2009, it announced that it would cut almost 2,000 technology jobs in the UK, including high-level positions, and move them to Singapore, India and Hungary.

It is my view that many banks, brokerages and insurance companies outsource to enable them to focus on their core business. In such an information-intensive industry, IT is treated as a core competitive resource with potential use in the development of new products, markets and organisational capabilities.

Three years on from the biggest financial meltdown in living memory, there is increasing pressure for banks to deliver high quality services that can satisfy customers whenever, wherever and however they need. This requires banks to use a set of complex and diversified technology to run their business. To put it simply, it has become far too difficult for financial institutions to manage these complicated IT skills entirely in-house.

In light of this, companies are looking to IT outsourcing to provide them with early and cost-effective access to emerging technologies that have the potential to fundamentally change the firm’s business processes.

According to recent research, FS organisations most commonly outsource back office processes, followed by call centres and then human resources (HR). Other industry specific processes commonly outsourced include claims, transactions (e.g. credit card, equity trading, etc) and cheque processing activities.

Today, more and more standardised open IT environments, such as Linux, increase the flexibility and the security of technology for financial firms. Take the surge throughout the recession in mergers and acquisitions (M&As) as a prime case in point. M&As are frequently used in the banking industry as a part of a strategy to develop new business and cut costs. However, system incompatibility often makes the system integration process difficult and can cause delays in operational consolidation. Therefore, by outsourcing IT, banks use common service providers and shared technology, which makes merging more easily and efficiently.

Risk Management and Regulations

However, it is not just about the M&A process. Being able to react quickly to the regulation requirement of risk management is another crucial reason for why banks are now outsourcing IT. Regulators such as the Financial Services Authority (FSA) and Independent Commission on Banking (ICB) are continuously increasing tightening banking regulation, which brings increased demand for detailed and timely financial data. For example, the Basel II Accord requires banks to set aside a minimum of 7% of their capital reserves to cover operational risk such as bad housing debts. This has played a role in banks’ outsourcing decisions because Basel II invites banks to seek outside expertise.

In addition, operational activities such as cheque processing can make up a larger percentage of banks’ expense base. Therefore, outsourcing this process ensures that a bank receives higher quality and better on-time delivery at a lower price.

For too long now, the FS industry has been dominated by obscene bonuses, regulation, the London Interbank Offered Rate (LIBOR) rate and capital reserve requirement. One could be forgiven for forgetting that it has also been focussed on restructuring operations that have nothing to do with pay scales or nationalisation. A quiet outsourcing revolution has been taking place behind the scenes, driven by a need for cost saving and a desire to take advantage of the changing market.

Conclusion

Success in the FS industry lies in the ability to improve business agility and to alter working practices. Even though FS is still facing uncertain times, one thing is very likely: important partnerships with outsourcers will soon become standard practice across the industry.

Changing Tack – The Skandia Case Study

Halfway through a £105m outsourcing contract, investment firm Skandia UK’s operating model changed radically. Rob Hornby, chief information officer (CIO) of Old Mutual Wealth Management Group, explains how he managed to steer the contract through the upheaval.

For investment firm Skandia UK, everything changed in 2006.

First, after a six-month battle for ownership, South African savings group Old Mutual acquired its Swedish parent for £3.6bn. That meant Skandia UK was merged with another Old Mutual subsidiary, Selestia, whose operations differed in a number of ways.

Later that year, Skandia UK decided to outsource its application development and management functions to Indian IT services provider HCL Technologies. The five-year deal, worth around £105m, saw 250 jobs move to the Indian company.

To begin with, HCL was contracted to support Skandia UK’s legacy applications, which were based on IBM’s iSeries platform (formerly AS/400, now Series i) and which supported the mainly paper-based processes through which the company had traditionally sold investments to customers.

In early 2009, it was decided that Selestia’s online portal, which at the time brought in only a small proportion of the group’s revenue, would become Skandia UK’s primary sales channel. The company predicted that the industry would soon be moving online and wanted to get a head start. “It was a risky bet, but a potentially lucrative move,” recalls Hornby.

Hornby drew up a two-year plan to recalibrate the IT department’s staffing resources and operating model for the online world. “For this online business context you need an entirely different skill set, and in some cases a different mentality,” he says.

However, it soon became clear that this plan drastically underestimated the pace of change that was already under way. “The transition accelerated like a Formula 1 racing car,” Hornby explains. “Skandia’s sales team had embraced the new model, resulting in a sharp decline in sales of its traditional products; all new business was coming in online. The comfort of a two-year transition period was no longer a possibility.”

This meant that Skandia UK was midway through a £105m outsourcing contract to provide skills it needed less of by the day. Clearly, the outsourcing engagement needed to change fast.

The Long Game

At this point, Skandia UK considered its options. One of these was to exit the HCL contract altogether and find a new partner to provide the Java programming skills it now required.

Two factors prevented it from doing this. “Exiting the contract and negotiating a new deal from scratch would have cost a huge sum of money,” explains Hornby. “Also, our priority is execution – we are trying to serve the business and enable it to compete. Creating a hiatus by transitioning to a different supplier is probably the biggest risk to execution we could have come up with.” However, staying with HCL put Skandia UK in a difficult position. “If they had been so minded, they could have held us to the original contract,” Hornby says.

HCL effectively scrapping the original contract, and developed a ‘cross-over plan’ that described what Skandia wanted and how HCL would change its offering to deliver that. “The cross-over plan laid out how we would move from where we were to where we needed to be,” explains Hornby.

The plan asserted three new goals for the engagement:

  1. To build a high-availability platform for online business.
  2. To extend that platform into global markets.
  3. To maintain the legacy systems for as long as they were needed.

“Achieving these involved establishing some new delivery models, such as working with our internal IT service provider, which had some internet development capability already, and some new skill requirements,” explains Hornby. “For example, the Siebel CRM [customer relationship management] application is one of the key components of [the ecommerce platform], but we hadn’t looked to HCL for any Siebel skills before.”

HCL was prepared to renegotiate its engagement with Skandia UK so comprehensively because it was at risk of becoming a legacy supplier, Hornby says. “HCL knew that if the old world they had contracted into was becoming our legacy business and that all our investment was going to be in something they were not engaged in, then eventually they would have become marginalised,” he says. “They took a long-game view.” Indeed, he credits HCL with being a ‘strategic’ partner to Skandia UK, in that it is prepared to take a longer-term view of their shared best interests.

Many Indian IT providers aspire to become ‘innovation partners’ to their customers, and Hornby reports that HCL does suggest modifications to Skandia’s IT systems that are valuable, but this has not always been the case. “Earlier in the relationship, HCL brought things that were innovative but not necessarily strategic,” he explains. “It’s only as the relationship has matured that HCL has genuinely understood our business and brought things that are strategically valuable.”

Hornby adds, though, that he is happy with the level at which HCL attempts to innovate. “We definitely expect them to come up with new ideas on the fine line between IT and business, but we’re not looking for HCL to tell us what sorts of products to sell,” he says. “From my own previous experience, some of the other global IT services providers might have had a lot to say about our business itself, and we overtly do not want that from our partner.”

Time for Change

While Hornby broadly praises HCL for its flexibility, he believes that Skandia UK’s experience has shown the shortcomings of traditional outsourcing contracts.

The company’s contract with HCL is up for renewal in 2012, and Hornby says the new engagement must make allowances for a greater degree of change than would previously have been considered. “We need to anticipate dimensions that might change and pre-negotiate how that change will occur,” he says. “Rather than relying on each other’s goodwill and creativity when that change happens, we need to have already rehearsed some of the shifts that might happen.

“Of course, we need to have a sensible and tangible start point,” he adds, “but we have to spend more time working out how that will change during the life of the deal.”

 

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