Make, buy, or cooperate: Right-sourcing the value chain in banking

For banks, the reduced costs from outsourcing have run their course. Given regulatory changes and the threat from new market entrants, they will likely need a new approach: right-sourcing. A five-step process can help them strategically identify and pursue the right solution.

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Make, buy, or cooperate Right-sourcing the value chain in banking

Contacts

About the authors

Beirut Tony Raphael Partner +961-1-985-655 tony.raphael @strategyand.pwc.com Boston John Plansky Senior Partner +1-617-521-8801 john.plansky @strategyand.pwc.com Chicago Carl Hugener Partner +1-312-578-4897 carl.hugener @strategyand.pwc.com Kelley Mavros Partner +1-312-578-4715 kelley.mavros @strategyand.pwc.com

London Alan Gemes Senior Partner +44-20-7393-3290 alan.gemes @strategyand.pwc.com Gagan Bhatnagar Partner +44-20-7393-3747 gagan.bhatnagar @strategyand.pwc.com Munich Johannes Bussmann Partner +49-89-54525-535 johannes.bussmann @strategyand.pwc.com 

São Paulo Roberto Marchi Partner +55-11-5501-6262 roberto.marchi @strategyand.pwc.com Shanghai Sarah Butler Partner +86-21-2327-9800 sarah.butler @strategyand.pwc.com Zurich Andreas Lenzhofer Partner +41-43-268-2156 andreas.lenzhofer @strategyand.pwc.com

Andreas Lenzhofer is a partner with Strategy& in the Zurich office and a member of the firm’s financial-services practice. He leads the firm’s Fit for Growth* practice in Europe, and he has extensive experience implementing major transformations in the financial-services industry. Alexandra Wartenberg is a senior associate with Strategy& in the firm’s Berlin office and a member of the firm’s financial-services practice. She focuses on the European banking sector, especially on regulatory and transformation projects.

* Fit for Growth is a registered service mark of PwC Strategy& LLC in the United States.

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Executive summary

Banks are all too familiar with the cost and income challenges that have persisted since the financial crisis of 2008–2009. Revenues have stabilized at a 40 percent lower level, but banks’ cost base has been reduced only marginally, mostly through tactical measures.1 In this context, outsourcing has been used mainly as a lever to reduce basic back-office and IT costs, and the savings from these efforts have run their course. Given continued regulatory pressure, a matured sourcing market, and the threat from new technology players entering the field, we believe a new approach — “right-sourcing” — is required to ensure long-term profitability. Right-sourcing requires careful analysis and identification of sourcing opportunities across the entire value chain to define how to most efficiently and effectively provide each value chain step, including front- and middle-office functions. By doing so, banks can sustainably lower their cost base and focus their attention and resources on those functions that are truly differentiating. This approach may mean outsourcing what were once considered core bank functions, such as research and product development, and could lead to even less conventional sourcing strategies, such as creating joint ventures with competitors. Several banks in Europe have already leveraged such techniques to increase their effectiveness and efficiency. For banks considering this route, we recommend a fivestep process: define the strategic framework; establish the baseline; identify and evaluate sourcing opportunities along the value chain; prioritize opportunities with a clear business case; and draw the road map for a portfolio of strategic and tactical initiatives.

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Welcome to “right-sourcing”

Given today’s unfavorable environment — characterized by tightening regulatory requirements, intense competition from traditional and nontraditional rivals, and the need to invest heavily in IT initiatives — banks face enormous pressure on both the cost and the income side. Revenues among European banks have stabilized at levels approximately 40 percent lower than before the financial crisis of 2008–2009, while costs have remained stubbornly high. As a result, cost-income ratios have risen from about 60 percent to 70 percent on average. To this point, banks have successfully managed to lower their cost base by using mostly tactical measures, and they have used outsourcing mainly as a lever to reduce basic back-office and IT costs. However, the benefits from these tactical measures have been largely realized. If European banks are to manage the increasingly challenging environment and preserve profitability, they will need to take more strategic action. A new “right-sourcing” approach, involving a systematic assessment of the entire value chain, is a strategic method to unlock value. This approach may mean outsourcing what were once considered core bank functions, such as research and product development, and could lead to even more unconventional sourcing strategies, such as creating joint ventures with competitors. For each link in the value chain, bank executives should ask themselves, “Does this function create additional value for the customer that only we can provide?” If the answer is yes, then the bank should focus resources — and even invest further — to develop this core capability in-house. But if the answer is no, banks should evaluate alternative solutions for sourcing the function, with the goal of reducing long-term costs and accessing skills and innovation at lower risk and with shorter development times. This approach to sourcing is possible today — unlike in the recent past — because offerings from established third-party providers have matured, now including high-quality services, scale, and flexible
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This approach may mean outsourcing what were once considered core bank functions.

implementation models, thereby reducing the risks inherent in outsourcing. Further, additional providers have entered the market, extending the offering that was formerly focused on the back office to include front- and middle-office services. What’s happening in the banking industry today is similar to what happened in the automotive industry several decades ago: Each part of the value chain is becoming more and more standardized, with a focus on who can deliver components at the best price. In other words, the banking value chain is industrializing, just as the automobile value chain did. In addition to sourcing through third parties, some banks have recently started to explore “cooperation” as an alternative sourcing strategy, particularly for functions where no adequate provider exists or where the banks want to exert some level of control. Several such ventures involving competitors are in the works today, suggesting this may become an increasingly popular option if inherent governance challenges can be resolved. The bottom line is this: To ensure long-term profitability and establish a basis for growth, it’s critical to examine one’s own value chain very diligently.

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What to outsource?

As noted, the traditional outsourcing of IT and back-office functions is well established. Among Swiss banks, for instance, 69 percent outsource application management and 70 percent outsource data center management.2 Over time, the providers of these services have become quite specialized, giving them scale and allowing them to offer attractive pricing. Many have also expanded to supplement their core offerings. For example, IT outsourcers routinely offer business process outsourcing along with their solutions. Now, however, the sourcing opportunities for higher-value functions in the front and middle office are gaining momentum. In the front office, new offerings include the analysis of customer data and behavior across media; credit administration; equity/bond research and analysis; know-your-customer (KYC) and onboarding processes; and white-label solutions for online banking and personal financial management. In the middle office, new offerings include services for easy, secure worldwide online and mobile payments; risk management and compliance processes; and platforms for issuing structured products (see Exhibit 1, next page). The extension into the middle and front office by third-party outsourcing providers has clear benefits for banks. Providers, with their intense focus on one area of the market, offer banks access to innovation. For example, by integrating data from different sources such as social media and customer movement profiles, providers can offer more relevant customer information that banks can leverage for more accurate credit-risk scoring or more targeted client offerings. What’s more, innovations such as application programming interface (API) enable providers to connect their tools with the bank’s IT platform in a flexible way with low risk and costs for the bank. In other words, banks that have historically been constrained by slow IT platforms with limited ability to analyze client data can now buy innovative solutions, connect them relatively quickly, and offer instant personalization of banking services.

Now the sourcing opportunities for highervalue functions are gaining momentum.

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Exhibit 1 The outsourcing service maturity curve
Relative service depth

Developing
Examples: – Research (shares, bonds, funds) – Data analysis and evaluation – Market/reference data – Selection/evaluation/ documentation of products – Valuation of shares/ derivatives – Collateral management – Loan administration – Risk management Examples: – Finance

Rapidly growing

Matured
Examples: – Payroll accounting and social security bene ts – Legal services – Applications development and maintenance – Server hosting – Mainframe hosting – Network (voice and data) – IT support

– HR (recruiting, workforce planning, and training) – Procurement (indirectly) – Collection of receivables – Payment/settlement handling – Billing and collection – Sales/customer support

Relative service provider experience and capabilities

– Niche providers – Less than five years’ experience – Expanding customer base – Small projects

– Several established providers, numerous newcomers – 5-8 years’ experience – Expanding customer base – Strong skills, approaching world-class – Innovative pricing

– Numerous established providers – 10-plus years of global experience – Broad service offerings and clients in the Fortune 200 – First-class skills and established reputation – Standardized pricing

Source: Strategy& and PwC analysis

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Yet the very proficiency of these providers raises an important consideration for banks. At what point do providers become competitors? Providers partly operate at the customer interface, threatening key customer contact points and information. It is a risk, and one that banks must consider when they enter into a relationship with providers. For this reason a bank needs to think through its outsourcing strategy carefully and coordinate across the enterprise to make sure it does not enter into any agreement that undercuts its competitive strengths and long-term market positioning. That said, when done correctly these sourcing agreements can greatly improve both effectiveness and efficiency. For example, a global private bank recently decided to outsource parts of its equity/bond research function to a knowledge process outsourcing (KPO) partner in India. The company segmented its research value chain into six functions and decided to outsource labor-intensive monitoring and reporting services (such as reformatting company data, writing reports, and ensuring the audit trail) from the KPO partner while keeping higher-value activities such as rating and distribution in-house. This arrangement allowed the bank to lower its cost base significantly, expand its coverage of the equity/bond universe by a factor of four, and comply with constantly changing consumer protection requirements.

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When to cooperate

Besides classic outsourcing to third-party providers, another emerging option for banks is to cooperate with each other. When viable third-party options are not available or banks want to continue to exert a certain level of control, banks are starting to team up and create joint ventures — or “industry utilities” — dedicated to handling certain steps in the value chain. Like traditional outsourcing arrangements, the cooperative agreements can reduce costs both to run the bank on a day-to-day basis and to change the bank, giving the organization greater flexibility to innovate. There are four basic cooperation models for banks. Network cooperation between partner banks: Banks feed work orders into a central platform, which then distributes these orders to the appropriate bank for execution. When completed, the executing bank feeds the results back through the central platform. For this model to work, each bank needs an area of specialization where it has superior capabilities compared to other banks in the group (e.g., one bank has the capability to process payments significantly more efficiently and effectively). Outsourcing/insourcing between partner banks: Within a group of banks, one has a competitive advantage in handling a certain bank function and its associated services (i.e., a “service bundle”). This bank acts as insourcer, processing all such services for the entire banking group. Outsourcing to an existing third-party service company: A group of banks decides to transfer a service bundle completely to an existing service company. This service company acts as outsourcing provider for all banks in the group. Typically, the service company is an existing joint venture of the participating banks. Establishing a joint venture/service company: A group of banks sets up a dedicated service company in which all partner banks have shares (see Exhibit 2, next page). The partner banks might transfer some staff to the joint venture, which handles the service bundle for each bank.

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Exhibit 2 A joint venture in which banks set up a shared utility to manage customer reference data
Starting point
Bank 1

Target model
Bank 1

Bank 2 Customer reference data utility
Customer

Bank 2

Bank 3

Bank 3

Customer

Bank 4

Bank 4

Bank 5

Bank 5

– Multiple data deliveries – Multiple relations – No standard format – No standard processes for maintenance – Greater effort by banks – Regulatory changes lead to major costs

– One “utility,” jointly owned by the banks, serves as a specialty provider – Consistent, secure data repository – Customer “owns” his data and can assign access rights – Consistent format and one-time initial recording of data

Source: Strategy& and PwC analysis

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A perfect example of how joint ventures can benefit banks and their customers is the recent effort by 12 global investment banks to create a central utility to handle customer reference data. The collection, storage, and maintenance of this basic customer data is the very definition of nondifferentiating — it’s a commodity that all banks can share. Before the creation of the utility, customers had to reenter their information whenever interacting with one of the banks. There was no standard format for this information, increasing customer frustration as well as the processing and maintenance costs for the banks. What’s more, any regulatory changes had an expensive, complex ripple effect across all the banks’ systems. Today the single reference data utility owned by the 12 banks provides a secure data repository with a consistent format. Customers have to record their information only once and can simply assign access rights to any bank they choose among the partner institutions. Besides easing the frustration of customers, this arrangement means the banks no longer need to track down this data on their own, reducing complexity, processing, and maintenance efforts. Another joint venture in the works today involves two major European banks that combined their IT and operations units — which neither bank considers a competitive differentiator — to improve economies of scale and reduce run-rate costs. The plan is to ultimately transfer IT and operations functions to a newly formed joint venture covering transaction processing, core banking application, and IT infrastructure services. At a later point, the entity can potentially add other banks — as either partners or customers — to reap even larger scale benefits (see Exhibit 3, next page). These examples prove that right-sourcing can provide significant benefits for banks. Still, banks need to make their sourcing decisions consciously and carefully weigh the benefits and risks of a new sourcing model. While the entire value chain could be outsourced in theory, the ultimate risk-management responsibility remains with the bank. Therefore, management teams need to carefully evaluate any new sourcing strategy.

Riskmanagement responsibility remains with the bank.

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Exhibit 3 A joint venture in which two banks combined IT and operations
Starting point
Value chain .... Inbound supply chain Operations Outbound supply chain .... Value chain .... Inbound supply chain Operations Outbound supply chain ....

Target model

IT Finance and accounting HR

IT Finance and accounting HR

– Each bank owned individual IT and operations units. – Banks were at different starting points: one needed to upgrade its IT platform, while the other just implemented a new platform. – Neither saw IT or operations as a key competitive differentiator; both focused on client-facing business as their core capability. – Both saw high potential in a globally standardized setup/architecture with economies of scale significantly lowering run-rate costs.

– Transfer of IT and operations functions to a newly formed joint venture (covering transaction processing, core banking application, and IT infrastructure services) – Significant potential to reduce “change the business” cost for one bank and “run the business” cost for both banks – Setup established for onboarding additional banks and reaping even larger scale benefits

Separately operated by each bank     Jointly owned utility

Source: Strategy& and PwC analysis

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How to decide

In our experience, putting a right-sourcing strategy into motion typically takes six to 10 weeks and includes five steps: 1. Define the strategic framework. What is the bank’s long-term strategic intent? What strategic goals does the bank need to achieve? Which conditions (such as regulatory requirements) need to be considered? 2. Establish the baseline. Create an overview of all functions and processes in the value chain, including cost. Describe the current sourcing model per function and process. Which functions are currently in-house or outsourced? If they are outsourced, to whom? What is the “case for change”? 3. Identify and evaluate sourcing opportunities. For each step in the value chain, determine whether a sourcing change might be appropriate: Is the function part of the corporate governance? Is the function key to achieving a competitive advantage? Could someone else deliver this function better or more cost-efficiently? Could cooperating with a partner create synergy potential? Is the function economically necessary? Establish a bank-wide sourcing heat map and, for those functions that someone else could deliver better or less expensively, explore an alternative sourcing model. Evaluate sourcing partners in terms of feasibility and risk; develop a business case for either a traditional sourcing arrangement or a cooperative partnership. Especially the risk assessment should be conducted with diligence, including an assessment of the counterparty risk involved (e.g., solvency, reliability, capability to comply with regulatory requirements) as well as the degree to which relevant regulatory topics such as data privacy and IT security questions are to be considered. 4. Prioritize opportunities. Use clear criteria to assess opportunities (e.g., potential benefits and difficulty of implementation) and determine which opportunities are “quick wins” as well as which will take longer to materialize.

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5. Draw the road map. Identify potential dependencies between sourcing opportunities, sequence the prioritized opportunities, estimate the resources necessary and the time required to see results, and develop the implementation road map with an initial focus on the quick wins.

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Conclusion

Some banks may hesitate to adopt a strategy of right-sourcing, worried that outsourcing functions once considered core to the business and striking partnerships with competitors could undermine their market position. But in today’s hyper-competitive, regulatoryheavy environment, financial institutions must take decisive, strategic action and focus on their competitive strengths in order to secure their basis for future profitability. We believe that firms that can adroitly navigate this landscape and identify when to “make” capabilities, when to buy them, and when to cooperate with others to source them will achieve the greatest success in the years ahead.

Endnotes
Strategy& analysis based on data from European banks [members of the STOXX European banks index]; data from Bloomberg.
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“Handout Swiss Banking 2013,” Active Sourcing.

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