Bankers like JP Morgan Chase's John Schmidlin, CTO of enterprise services, are increasingly looking to outsourcing firms to help them slash inefficiencies in commodity services and gain the upper hand in more strategic business partnerships.
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Outsourcing is in. The competitive pressures of a global marketplace and the rapidly evolving technologies that help keep banks in the hunt has forced executives to look creatively across the enterprise for ways to reduce costs while at the same time leveraging their strategic advantages. Perhaps nowhere has this thinking manifested itself more obviously than in the trend toward multi-year, multi-billion dollar outsourcing deals.
Once almost exclusively the province of small banks, big banks are taking a hard look at their operations-parsing those functions that are core but not strategic, from those functions that truly differentiate them in the marketplace. The endgame is to outsource as many commodity-like functions as possible so that valuable personnel can focus on customer service and more innovative, revenue-producing endeavors that set an institution apart.
"There are certain business processes that are necessary, but not strategic," says Pam Brewster, senior analyst at Celent. "In this time of increasing competition and decreasing margins, financial institutions are looking at what is tactical and what is strategic. They want to focus internal resources on strategic decisions."
The upshot, says John Smith, vp of global financial services at Unisys, is "every institution is looking at what adds value to the customer and what is strategic to that relationship, and anything that doesn't add value is a candidate for outsourcing."
The consensus is banks will back up this due diligence by opening up their wallets in the years ahead. TowerGroup estimates that of the $340 billion in IT spending in 2003, $120 billion will go toward outsourcing, and over the next five years $100 billion will be spent specifically on business process outsourcing-the most strategic kind of relationship between bank and outsourcer, a relationship that aims to do more than cut costs, but to transform the bank's way of doing business. "I anticipate a good number of these deals and arrangements to be announced over the next six to nine months," says Guillermo Kopp, a director in TowerGroup's financial services group, who estimates that for mid to large sized institutions the "minimum cost reduction" is 30 percent "because inefficiencies are everywhere."
In the past, larger institutions resisted such outsourcing, generally arguing that controlling all technology and operations was in itself a strategic function and that they had the scale to do it efficiently on their own. But the stresses of the marketplace have been unrelenting and the cost pressures have continued to mount: a declining stock market, upset investors, fickle consumers, increased global competition, reduced growth, scarcer human resources, technology upgrades, and research and development.
Eric Ray, a vp of financial services for IBM Global Services, says "the number one reason behind the outsourcing trend is curving out costs-and creating an 'on-demand strategy,' or a consumption-based pricing model where they pay for the things they need when they need them. They want to move to a variable cost structure from a fixed cost structure. ... The larger institutions believed they had the scale to be productive and enhance services. But now they see that we have the greater scale, and they can leverage our investment." Tops on the list of outsourcing these days, Ray says, are: procurement, human resources, CRM, and call center operations.
"There are immediate, significant economic benefits" to the outsourcing agreement, says John Schmidlin, CTO of JP Morgan Chase's enterprise technology services group and lead negotiator in the $5 billion outsourcing deal the company struck with IBM in December. Maintaining an independent function creates a high cost base that is not competitive, he says. "Whether the market increases or decreases that volatility needs to be managed in a way that will help our lines of business and our shareholders. ...For us it's a very compelling model, and I'd suggest it will be for others as well. You get to pay for what you use and when you use it, rather than pay for a build up of fixed costs."
James Harris, managing partner of financial services outsourcing at Accenture, explains that outsourcing helps drive out costs on a number of fronts: the consolidation or rationalization of systems perhaps acquired through multiple acquisitions; leveraging up-to-date technology of the outsourcer; exploiting lower cost locations since many outsourcing firms have operations in places like India; an opportunity to introduce greater financial transparency to operations to identify efficiencies and inefficiencies in operations; and better allocation of personnel. "A lot of talent gets tied up with transaction processing, and CFOs can't just hire more, they have to 'untrench' them, and outsourcing can be a cost neutral way to do so," Harris says.
Financial transparency was critical to JP Morgan Chase as it negotiated with potential outsourcers. Schmidlin says the bank wanted the ability to clearly see the financial implications of different business processes to learn what works best and what's creating inefficiencies. "Historically, it's very difficult to get that information. Internal infrastructure groups don't provide that kind of commercial information. And, besides, it's a big investment."
Yet despite the potential cost savings involved with outsourcing, that's not the entire story. Over the long term, banks can't cut costs to success and profitability, so they are increasingly looking to partner with outsourcers who can help them strategically by reengineering business processes to position the bank to compete in the tough global environment for the long term.
Therefore, as counterweight to the immediate cost cutting pressures facing financial institutions, are the long term issues that demand a continued investment in technology: the need to comply with regulatory mandates, such as the Basel II Accord and the USA Patriot Act, the need to permanently improve efficiency ratios, and the need to improve customer acquisition and retention in an era of low consumer loyalty. "Outsourcing needs to be used to position banks for fundamental restructuring for the long term," Harris says. "Banks need to reposition themselves for customer needs and to implement regulatory changes."
Schmidlin says his team realized that through outsourcing "there were opportunities from an efficiency point of view, a service excellence point of view, and a people development point of view." The agreement the bank struck is intended to transform its technology infrastructure through absolute cost saving and increased cost variability, but also transform it through access to the best research and innovation, and improved service levels. The rationale being that by moving from a traditional fixed cost approach to one with increased capacity and cost variability, the institution can respond more quickly to changing market conditions.
In this way, the motivation of the big banks to outsource is very similar to what has driven the smaller banks to do so for years-not as much to cut costs as to stay nimble and competitive in a harsh environment. Thomas Graham, a vp at First Fidelity Bank in Oklahoma City, says his bank has been outsourcing functions since the late 1980s as a way to get new products up and running fast while keeping the bank's focus on the customer. "As a $550 million asset bank, it might not always be feasible to do things on our own, we might be behind the curve. Instead, we can be on the leading edge with some of these technologies." For instance, the bank was the first in the state back in 1994 to have document imaging, and later this year it's rolling out a new CRM system hosted by Jack Henry & Associates.
Similarly, over at Blackhawk State Bank in Beloit, WI, executives also use technology to stay on the leading edge, says Phyllis Oldenburg, evp of operations. Going forward, Oldenburg says that $328 billion asset bank has decided, based on a survey of customers, to outsource a new check imaging service, a contract it plans to award in February ahead of an August roll out. But the bank has learned that not all functions-even those that might seem obvious candidates-should be outsourced. For instance, Blackhawk has decided to keep item processing in-house since to do otherwise would slow the availability down by a day, and same-day availability is important to clients. This kind of careful discrimination between which functions to outsource and which to keep in-house will also be key for large banks. "In our industry a lot of the products are the same," Oldenburg notes. "We'll grow through customer servicing. That's the key."
While the small banks may have been first onto the outsourcing bandwagon, the stampede among big banks to follow suite seems to be gathering force. In the second half of 2002 the market saw a cavalcade of agreements between multi- billion dollar banks and outsourcers: Hewlett-Packard signed a seven-year deal worth C$2 billion with the Canadian Imperial Bank of Commerce to provide comprehensive IT services; Electronic Data Systems signed a five-year, $1.3 billion deal with ABN AMRO to handle the back office activities of its wholesale banking arm; EDS also signed a 10-year, $4.5 billion deal with Bank of America to transform its voice and data systems; Unisys signed a seven-year, $400 million outsourcing deal with Washington Mutual to host and manage a new check management system; meanwhile, IBM inked a $2.5 billion, 10-year deal with Deutsche Bank to take over the European financial systems operations; and capping off 2002 was the $5 billion deal IBM signed with JP Morgan Chase to take over a significant portion of the data processing technology infrastructure.
The first weeks of 2003 showed promise that the pipeline is not exhausted as Sovereign Bancorp signed a six-year deal with Alltel to handle information technology services, including Internet banking and channel integration. "My pipeline is as strong as it's been in two years," says IBM's Ray. "Look to see a lot more of these transactions in the future."
It bears mentioning, however, that not all large institutions are swept up in the outsourcing fury. Bank One actually took many outsourced functions back in-house starting about 15 months ago, and since that time has taken advantage of a weak job market to hire 1,400 people. "We think that technology is a core competency for us and can give us a competitive advantage against other companies and therefore we should control it ourselves," says Thomas Kelly, a spokesman. "There's more accountability and it can be less expensive because if a vendor is doing it, they have to pay the same people you do and make a profit. ...We don't want that institutional knowledge to walk out the door when they do the next consultant gig."
Increasingly, however, that is a minority viewpoint, especially when it comes to the issue of research and development, a costly but necessary endeavor that more banks want help shouldering. Schmidlin explains that when JP Morgan Chase narrowed the field of potential outsourcers to three-IBM, EDS, and CSC-the bank asked them to consider how a partnership would influence the bank's: efficiency and variability, financial transparency, improved service levels, and-critically-innovation. Leveraging an outsourcing partner's R&D was key to JP Morgan Chase's decision. The lifecycle of innovation is planning, building, deploying and operating ssentially, Schmidlin says, JP Morgan Chase is retaining the planning component and outsourcing most of the rest.
According to Doug Elix, svp and group executive IBM Global Services, "JP Morgan Chase will be receiving a continuous infusion of technology and business process innovation from IBM."
This focus on innovation is by no means limited to JP Morgan Chase. Take, for instance, the deal inked in December between Wamu and Unisys. Unisys will host and manage a new check operation for Wamu involving image capture of checks and transaction tickets in Wamu's financial stores, the first top ten financial institution to do so. Check imaging devices will be installed in each financial center's back office and will be piloted in the first half of 2003 with rollout near year end. Unisys will create and staff regional processing centers across the U.S. to handle item processing for Wamu. "Wamu is ahead of the curve in their thinking," says Smith of Unisys.
Smith says the deal positions Wamu to confront such industry issues as the increasing cost of processing paper checks and the shift to electronic transactions such as electronic bill presentation and presentment. The agreement also puts the bank in an excellent position to take advantage of the Check Clearing for the 21st Century Act (the erstwhile Check Truncation Act), pending legislation intended to enhance the efficiency of the check system by allowing digital images, which can eliminate the need for a paper trail in check processing. Once passed, Smith notes, banks will likely want to take advantage of the efficiencies of digital imaging, giving Wamu and Unisys an opportunity to offer the service.
Innovation was also a linchpin to the Sovereign-Alltel agreement. "We get the economic benefit of processing our core accounts in a leveraged ASP environment and we also receive the benefits of continual technological innovation," says John McCarthy, evp and CTO of Sovereign. "Alltel will maintain an on-site presence and offer continual support and direction to improve our business processes. In this arrangement, everyone is motivated to deliver process improvement that result in cost savings for the institution and better products and services to our customers."
This kind of tightly focused partnership described by McCarthy is all well and good in theory, but analysts say institutions may have difficulties in structuring and maintaining the spirit of agreements years down the line. For starters, says TowerGroup's Kopp, "You need to have a very good understanding of your problems and strengths before even talking to outsourcing partners." Too many institutions think an outsourcer is going to swoop in and solve all their problems.
Celent's Brewster adds: "These kinds of agreements might actually create a greater management issue. ...You need to manage the relationship on a day-to-day basis...and it's a real gray area between expectations and delivery of services. It's truly a partner relationship, not a vendor relationship, and its needs to be actively managed." She points out that like any partnership there also needs to be a sense of dual ownership. "It needs to be very clear and well structured on both sides."
"This outsourcing relationship is not a traditional vendor relationship. It's a partnership," Schmidlin agrees, noting that the senior relationship manager from IBM will sit on The JP Morgan Chase Technology Counsel. "We've been working with IBM for 40 years, but this is taking the relationship to a new level. We don't look at it as separate teams, but a fully integrated team... Like any agreement of this scope there is obviously a contract of terms and conditions to make sure that for each firm there is an alignment of values, objectives, and strategy. ...And the terms and conditions are from a service level point of view, financial point of view, and number of people point of view. "
One popular strategy banks have used to bind the outsourcer closer to them is to transfer a hefty number of employees to the outsourcer: JP Morgan Chase sent 4,000 to IBM, Deutsche Bank sent 900 to Big Blue; meanwhile EDS took 1,000 people from Bank of America and 2,000 from ABN Amro.
How such partnerships might evolve over time remains to be seen, but Smith of Unisys has an idea-or at least an ideal-in which the outsourcer eventually shares directly in the cost savings or revenue generation created by the partnership. "If the goal is to reduce costs or increase revenue, then the partnership should share. That's not happening now, but as a trend we'll see those types of things happening."
