Changing business models
Turning ‘the art of the possible’ into reality is a challenge for most organisations. Within many, technology departments often espouse a fixed way of doing things and combine this with the millstone of legacy technology which slows the process of change, or limits its reach.
Yet a myriad of demands, from customer expectations of ‘always-on’ business, to regulatory requirements for detailed data, are pushing businesses to work beyond their historical capacities. Maintaining manual processes is no longer just an issue of inefficiency, it is about operational risk.
“Regulators are asking for data,” says Barry Lewis, partner at consultancy Elixirr. “Saying: ‘Trust me I know that things are working properly’ doesn’t work anymore. You need evidence to show that what you are doing is actually working.”
Commercial pressures are also squeezing banks on margins and on costs. Many firms are withdrawing from areas of business that are less economically rewarding.
“Much of that flow firms used to see is not going to be there anymore,” notes Lewis.
The strategy that many banks are adopting to cope with these demands is to cut costs and invest selectively in profitable growth. Few are predicting that actually revenue will go up. Where businesses are not generating sufficient returns to cover their costs, Lewis notes the loss to shareholders will drive a radical transformation.
“Volume isn’t going up in the industry and banks do not have the balance sheets to go and acquire more volume so the only thing that can give in this equation, is cost,” says another industry executive.
The decision whether to invest in or exit a business also carries a third option, notes an additional industry executive, which is to wait. That can be interesting to firms as they are able to pick up the clients of exiting competitors.
Outsourcing is a longstanding solution to these cost pressures, however it has often been set up on a customised basis with providers running different operations for different banks rather than as a true utility model.
The industry has been outsourcing, offshoring and white labelling services for many years, but the question that is emerging now, is about shared services.
Customised offerings lock-in customers to their provider and that reduces the capacity to apply pressure on costs through competition. Industry-run utilities are often hampered for similar reasons, where different players will not agree on priorities.
“Within the last couple of years there has been a syndicate of four banks looking to co-manage their IT platform,” says one industry executive.
The idea was to use an RFP to decide which bank’s platform was the best then the others would get rid of their platforms and all four would share resources.
“Bank A wanted to charge too much for its technology platform,” says this same executive. “Bank B didn’t trust bank A because it knew how to prioritise IT development on its technology platform. Bank C wanted the focus to be on corporate actions not core settlements and bank D realised it couldn’t retire its existing platform because of the peripheral services it offered and the whole thing collapsed. We have got to find a way of making it easier.”
Eric Roussel, Head of Clearing and Custody Solutions at BNP Paribas Securities Services says that the size of institutions that are discussing outsourcing with his team is growing, with major investment banks now considering outsourcing all of their post-trade functionality, with all asset classes now under discussion.
“The value we create is not only what we do ourselves but how we package different things together,” he says. “Most of our custody business has been developed on an internal system, but for example when we decided to enter into US market it was considered to be so big, so complex that it made more sense for us to co-invest with somebody on the platform for the US market and this year we have done that.”
The situation is not being helped by psychological barriers created by regulation, Lewis notes. In the UK the Senior Managers Regime has defined direct individual accountability for all processes, with clear lines of responsibility. While that is a positive step for governance, Lewis notes it makes outsourcing a great concern for many.
“I firmly believe that anything post-trade could be outsourced with the right partner,” Lewis says.
One industry executive says that in theory that is correct, but observes there the continuum of what could be outsourced is dependent on a number of factors, including the risk appetite of an organisation. Fundamental questions need to be asked about what an organisation is doing, its role in a particular post-trade service and what clients buy from it.
“[They need to ask] ‘Do I understand my value chain?’” he asks. “I differentiate that from a cost chain.”
When considering key competencies he cites the airline industry as being more akin to a mobile hotel than a transport or a logistics company, by analysis of the qualities sought by customers.
“In philosophy, the Theseus paradox is that if a man travels away in his boat and returns many years later, having replaced every part of his boat as it became eroded, did he come home in the same boat?,” he explains. “When you outsource your functions, are they still the same when being done by someone else? The culture is different and there are some intangibles that change.”
There is also increased risk where a bank does not have the right amount of control for a function. The middle office is singled out by another, who notes that this is where a firm is expected to exercise oversight and control, yet it is often seen as viable target for outsourcing.
“Don’t forget the regulators are expecting you to be responsible for everything,” he warns. “There are lots of promises from new providers around taking care of known regulatory challenges and mutualising the unknowns, but actually there isn’t a good understanding of what this means.”
The advantage that BNP Paribas Securities Services has had as an outsourcer, is its position within a financial services firm, Roussel notes, which has given it an understanding of the service levels necessary to maintain the wider bank and therefore other banks, even when working across jurisdictions.
Having that experience is useful, as there are no standard definitions of common functions – such as the middle office.
“Where I think BNP Paribas can certainly help is to provide clarity around what are talking about,” he says. “The definitions for everyone are different.”
Lewis recommends that banks’ back offices ‘componentise’ their processes, look at digital technologies and start-ups rather than relying on legacy systems and then be the service provider for their own investment bank operations, before selling that service on to others.
“There is going to be massive increase in outsourcing, whichever definition is used; that’s going to be the game in town for the foreseeable future,” he says.