Fixing the Bank Factory
A century ago, industrialists Werner Siemens and Henry Ford invested in vertical integration. Today, Apple has in-house design and marketing, and outsourced operations. Banks are similar: They started out like Ford and Siemens but are now positioned like Apple.
About 50 years ago, mass-market banking took off in a big way in Western Europe, offering traditional payment, savings, and mortgage services. Because banks were early adopters of information technology (IT), they developed in-house systems to give their customers what they needed, when they needed it. Meanwhile, the financial services industry grew exponentially through a combination of innovation, deregulation, and technology evolution.
Innovation brought products and services such as debit cards, credit cards, and mutual funds to the retail market. The financial markets started working with derivatives and securitized all sorts of obligations, making virtually every financial asset or source of risk tradable to some degree.
Deregulation widened the markets, enabling a broader service portfolio that included bank insurance products, new investment products such as exchange-traded funds (ETFs), and other structured investment funds; privatization allowed ordinary people to become shareholders of significant telecommunication and energy companies. Deregulation tried to foster competition, starting in 1986 with London's Big Bang, a groundbreaking set of banking reforms, and likely culminating with the repeal of the Glass-Steagall Act in 1999 in the United States.1 Encouraged by fierce competition, banks started a process of domestic consolidation in the 1990s followed by cross-border consolidation a decade or so later. At the same time, the international Basel Committee on Banking Supervision (BCBS), recognizing a growing need for risk management, issued a set of banking guidelines called Basel II and, more recently, Basel III.
Technology led to more new products and services, from ATMs to call centers to online banking and, more recently, mobile banking. Retail customers now have a variety of channels to choose from and expect seamless service across all of them. Financial markets benefited enormously from the fast-growing capabilities of IT processing and global networking with the development of Automated Clearing Houses (ACHs), virtual stock exchanges, international centralized securities depositories, and specialized market infrastructures such as Continuous Linked Settlement (CLS).
The Heart Attack in Operations and IT
The rapid development of the banking industry had a downside: It created an unprecedented burden on banks' operations and in-house IT staff. As innovation continued apace, regulators wanted constant maintenance and enhancements, and applications that first saw the light of day 30 years ago had to be broadened and adapted. The banks, desperately trying to keep up, poured vast amounts of money into the IT budget, primarily to enable the existing infrastructure to cope with market and competitive requirements. (At one time, they spent more than 90 percent of the budget on routine maintenance and changes that were often technical or regulatory in nature—the most notable being the Y2K bug, which cost the industry about 2 to 4 percent in return on equity for about three to four years.)
In the current economic climate, such a modus operandi is not sustainable. As regulators scrutinize leverage and demand higher amounts of capital for a given business volume, profitability must be sustained by increased productivity. This requires lean processes and rebuilding IT architecture to allow for more throughput to improve quality and reduce costs. Additionally, regulators are requiring tighter business controls and disallowing a number of business practices.
Creating Advantage from Strategic Partnerships
Why have banks not worked their usual value chain magic? Primarily because they failed to understand the need for strategic transformation. While banking changed around them, some banks stayed with their existing business process and IT outsourcing strategies. But business process outsourcing (BPO) and information technology outsourcing (ITO) have their specialties—BPO specialists rely on a proprietary stack of IT solutions, and a partial ITO decision may cut laterally through the process infrastructure. The usual result is a patchwork of services that is difficult to manage.
Leading banks, in contrast to ordinary banks, develop smart bank-factory transformation strategies for operations and IT to help them remain competitive (see sidebar: Strategic Partnerships Keep Banks Competitive). They pursue long-term strategic initiatives, rather than short-term, cost-centric, incremental tactics. They partner with vendors that have the volumes to deliver a superior customer experience while remaining cost competitive. Among the advantages of partnering with strategic vendors, five stand out:
Cost efficiency. Operations, and especially IT, have positive economies of scale for any specific process or system. In short, the larger the volume, the lower the unit cost. Banks cannot generate the volume-to-cost base that external vendors can to drive cost advantages.
Shared investments. New products, processes, and systems are encouraging more investments. As products become global and standardized, banks can benefit from sharing such investments, especially when it comes to developing new standard products or meeting regulatory requirements.
Flexibility. Volume-peak management is easier for an external vendor, which can level out peaks among its customers. This is a key driver in cloud computing, for example, where there is access to on-demand capacity.
Innovation. Innovation is a scarce resource in banks. "Vanilla" innovations in the IT infrastructure and application domains or in standard-product processing are better shared with other banks through vendors than undertaken alone at each bank's expense.
Compliance. Product, process, and system compliance and related work can be shared among banks through vendors. This enables all banks to benefit from size advantages as the vendor performs each task once for a group of participating banks rather than over and over for individual banks.
From Strategy to Tactics
How does a struggling bank plan the process of strategic transformation? We suggest the following steps:
Develop a multi-vendor partnership strategy. Today, the banking industry has four basic sourcing partnership strategies from which to choose, each with an almost limitless number of variations (see figure 1).
Banks that jumped on the single sourcebandwagon a decade ago and partnered with a global IT service provider are now evaluating whether or not to team up with more vendors before riding the next wave of cost and innovation synergies. Banks that went with smaller scale external solutions just five years ago are looking into how they might take advantage of these existing relationships and move away from a piecemeal strategy. Although most banks are coming from different starting points, almost all are arriving at the same endpoint: a multi-vendor solution based on its ability to deliver on five criteria:
- Improves service quality by offering access to specialist competence—several vendors mean a larger pool of specialists
- Increases flexibility in terms of both solution design and availability, because single-vendor solutions typically leave little room for back-up vendor solutions
- Enables risk management at the appropriate level and makes it possible for resources to be reallocated fairly easily between vendors
- Spurs innovation because joint development initiatives across vendors are more likely to make exciting things happen than silo-based work
- Improves the financials either by creating a level of competition impossible in a single-source situation or by achieving economies of scale that a piecemeal strategy could never accomplish
The good news is that the business process and IT industry has now come of age with many potential vendors to choose from (see sidebar: The Maturing Supply Market). The challenge of a multi-vendor strategy lies in the orchestration. Just as an orchestra requires many different musicians, a bank requires many players with different skills to come together and perform as one. Outsourcing mortgage services to one process specialist and Web servers to another may require managing a complex deployment process every time the bank decides to upgrade its online mortgage offering.
Combine vertical and horizontal sourcing. The classic approach to strategic sourcing has been to separate the initiatives, first between operations and IT and then further into vertical and horizontal sourcing. Vertical sourcing initiatives look at the entire business process: the products, processes, and IT for specific product or service areas. A typical example is payment outsourcing, where payment products, processes, and underlying systems are outsourced to a processor. Horizontal sourcing initiatives focus on a specific service that cuts across business units and product areas. Many traditional IT outsourcing initiatives such as desktop management, hosting, and network management are horizontal by nature.
It is crucial in today's banking environment for banks to develop a comprehensive strategy—to think of vertical and horizontal sourcing as combined dimensions that together offer the optimal mix of sourcing initiatives. Figure 2 illustrates this in a sourcing matrix.
The horizontal axis covers the overall bank process, from customer interaction and relationship management to product, financial, and decision support. Along the vertical axis are technology, processes, products and services, and sales and marketing. To find the right mix of initiatives from both axes, there are three factors to keep in mind: strategic focus, competitive position, and sourcing mix (see figure 3). The bank's strategic focus determines which products, services, and business areas will serve as key design factors. This means that any sourcing strategy should underpin development in these strategic areas. The bank's competitive position includes key market trends, the current market position, and the activities of key competitors. The sourcing mix is the current performance of strategic partners, those partners' current business development and innovation agendas, and any contractual constraints. The competitive position and sourcing mix will determine the starting point for the sourcing optimization exercise.
Developing a solid sourcing strategy is a joint effort between operations and IT. This is a natural consequence of how vertical and horizontal sourcing initiatives, both on the operations and IT sides, impact each other (see figure 4). For example, by outsourcing payments processing, the demand for data processing capacity is reduced and, over time, systems will be decommissioned, reducing the need for application maintenance and development. At the end of the day, horizontal sourcing layers are affected, both in the infrastructure and application domains, which eventually triggers discussions with one or several strategic IT partners on how volumes have changed. Understanding how these dimensions work and impact each other is crucial for building the sourcing strategy.
Understand the economics. Every transformation is different because each bank has its own legacy and future aspirations. Our experience is that savings for a single vertical business platform or a horizontal layer typically range between 10 and 20 percent.
Seven factors determine the transformation economics (see figure 5). Efficiency improvement includes, for example, volume balancing, reduced complexity and waste, and improved automation. Significant savings will often be gained by economies of scale—the higher the volume, the lower the cost that can be negotiated. Risk premium, or the cost of uncertainty, needs to be taken into account—failing to specify the scope of services to the extent necessary is a common reason for running into problems. The typical partner margin is in the range of 15 to 25 percent; a healthy partnership is when both parties win. The transition cost, or the amount spent getting to where you want to be, is typically 15 to 35 percent of the business-as-usual cost, according to benchmark figures, but can be higher or lower depending on the extent of the IT and staff transformation needed. Retained organization encompasses resources that serve the interfaces to the external partner. The last factor is potential VAT impact. Transferring activities to strategic partners can break the chain of bank activities and thus make partner services liable to, for example, value-added tax (VAT). In such cases, the local VAT rate will hit the business case, bringing savings into the single digits.
False Starts and Failures
Strategic transformation in banking is not a new trend; banks recognized this a while ago as they moved from integrated divisions to consolidated operations and classic outsourcing (see figure 6). Yet only a few have found a satisfactory answer on how to arrive at the truly optimized value chain.
Early attempts at value chain reconfiguration and optimization were hardly encouraging. Remember Hyperion? It was an outsourcing attempt in the early 1990s that sought to have all issues related to IT development handled by the leading provider at the time: IBM. Eight U.S. banks signed on—and the project died quietly and expensively. The banks failed to recognize that complex problems require something other than boilerplate Band-Aids.
Many other banks have also had unfortunate experiences when outsourcing IT operations. Maintaining responsibility for running the processing part, they found the interface difficult to manage, and the fundamental difference between process outsourcing and IT outsourcing became disastrously clear. In some cases, outsourcing offered only a partial answer—mergers and acquisitions activity, for example, required some parts of the portfolio to be processed on legacy systems and others to be outsourced to a provider. Finally, while the advantages of centralized operations are clear, from a top-management perspective, local regulatory and market practices create difficulties in transferring data and adapting processes.
Charting the Transformation
To execute a successful bank transformation, we recommend the following 10 steps:
Define the operating model. Determine the products or services you will outsource or operate in-house, the impact on core business processes, and the underlying IT architecture. This will boil down to a few fundamental choices in terms of which channels are used for business processes and which processes require centralized or decentralized computing.
Articulate the long-term sourcing transformation vision. This can be done in simple terms by comparing outsourcing costs to the benchmarks or, in more vivid terms, by describing how things will work—and what benefits will eventually result—once the transformation is complete and the bank is functioning smoothly with its sourcing partners.
Develop a realistic yet flexible roadmap. Chart key operations and IT initiatives to reach the long-term vision, and position them on a logical roadmap. The roadmap should ensure that the transformation path leads to the desired results and addresses interdependencies between initiatives and other ongoing programs. New ideas and projects trigger a rehearsal of the roadmap.
Create a solid business case. Focus not only on the obvious cost savings in sourcing but also on investment avoidance—that is, the potential reductions in capital expenditures (CAPEX) that can result from sourcing. Additionally, specify the more indirect financial benefits, such as increased flexibility and speed of innovation. To minimize up-front program-related investments, such as project and restructuring costs, use early wins as cash generators to fund other initiatives throughout the program.
Get everyone on board. From the executive level down to staffers, the right mindset is critical for achieving successful, long-term change.
Provide active change management. Communicate the reason for change in the organization, and present the level of aspirations. Mobilize the company to prepare for change, and support the transformation with activities on the organization, team, and individual levels.
Adapt the organization. It may be necessary to strengthen skills associated not only with sourcing, per se, but also with operations and IT, for example in architectural design and specifications requirements.
Govern the program jointly at the level. Executive governance will help ensure sustained success and maximize synergies between operations and IT. A joint effort is absolutely necessary for preparing the bank to face future challenges and keeping it competitive in the long term. In particular, a good framework to manage operational risk is required.
Track benefits. Ensure that the program remains on track, as any executive leadership would do.
Change tactics as necessary. The market is constantly changing, and tactics should be revisited every 12 months to ensure the strategy is on a path to fulfillment.
Living the Transformation
Embarking on a strategic transformation means constantly striving for excellence in everything—customer interaction, product and service innovation, process efficiency, and IT performance and agility. It is about planning how to conduct business going forward and how to stand out from the crowd. Living the transformation will not be easy. It will require a number of tough strategic decisions, including where to place bets on future blockbusters and which business areas to assign to a partner. To be a winner in the highly competitive banking industry, getting these decisions right will prove essential for sustaining a strategic transformation.
1 The Glass-Steagall Act launched bank reforms during the Great Depression. It separated investment and commercial banking to protect depositors from risks related to security transactions. Since the act's repeal, the distinction between commercial banks and brokerage firms is cloudier, with many banks now owning brokerage firms and offering investment services.