Building the modular bank

Building the modular bank: Sourcing strategies in the age of digitization

Executive summary

Almost a decade has passed since the financial crisis, yet European banks continue to struggle to return to economic health. Greater efficiency and profitability remain a challenge, while at the same time banks are under pressure to invest in new digital technologies. Those looking to rationalize their value chains and “modularize” their operations should use an approach we call Fit for Growth*, which involves reducing or eliminating the less strategic aspects of their operations and investing the savings in capabilities that directly promote growth.

Outsourcing remains key to this effort — but the outsourcing options now available go far beyond simply sending IT operations to India. Activities as complex as procurement, analytics, trading, marketing, and several finance functions can now be outsourced profitably and with confidence, often to “nearshore” locations in Central and Eastern Europe. The larger banks are also actively setting up subsidiary technology, trading, and other operations throughout Western Europe to take advantage of proximity and local talent.

Any decision to outsource, however, must be subjected to a careful analysis, including a detailed business case. The financial implications of any outsourcing strategy are complex: Maintaining dual activities while the project is set up, funding a governance function to manage operations, and paying taxes and covering other expenses — all while maintaining mandatory profit levels — can add up, offsetting any gains.

If the process is done right, however, the rewards should outweigh the risks. And every bank should take advantage of outsourcing’s potential for creating a more focused, streamlined organization and for reinvesting the money saved in new, growth-promoting digital capabilities.

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

The sourcing solution

Although the crisis stage of the 2008–09 financial meltdown may be over for European financial-services companies, the region’s banks and insurance firms are by no means out of the woods. The sectors’ market valuations have yet to reach pre-crisis levels, and the need to improve earnings is still pressing. For the 46 banks in the Stoxx 600, the median economic spread — the difference between their return on equity and their cost of equity — was a negative 6.1 percent in 2016; just 12 had earned a positive economic spread (Exhibit 1). The 34 banks with negative economic spreads would have had to earn an additional €129 billion (US$152 billion) in 2016 to close the profitability gap.

Economic spread of Stoxx 600 banks

The pressure on banks is not likely to abate. Interest rates will probably remain low, rendering traditional business models unprofitable. Regulations such as Basel IV are likely to increase required capital buffers and the cost of doing business generally. At the same time, the banks need to prepare for the digital transformation of their industry. New digital technologies and sales channels, while offering greater flexibility and responsiveness to the banking environment, are disrupting long-standing client relationships.

For many financial-services institutions, an approach we call Fit for Growth would provide a path back to financial health. The strategy requires that they rethink their basic operating models, reducing or eliminating certain aspects of their operations and investing the savings in capabilities that directly promote growth. The overall effect will be to disaggregate their value chains, much the way companies in the auto and semiconductor industries — the OEMs, or original equipment manufacturers — work to optimize their supply chains.

The result can be described as a “modular” bank, as distinct from other potential new business models such as platform and digital banks. (See “Strategy& European Banking Outlook 2016.”) The modular bank would outsource to specialist service providers many more activities than the IT, data processing, and call center operations that many banks currently send offshore, primarily to India. Indeed, some banks are already relocating more complex knowledge-based processes such as procurement, analytics, trading, marketing, and audit (see “Sourcing and shoring — a glossary”).

Sourcing and shoring — a glossary

The many different flavors of sourcing and shoring alternatives can be classified along two dimensions, with several options available within each.

“Sourcing” generally describes who provides the service.

  • In-house tasks are carried out within the company.
  • Outsourced activities, whether onshore, nearshore, or offshore, are provided by another company, which may be an independent subsidiary of the company, a joint venture or partnership with a separate firm, or an external service provider.

“Shoring” describes the physical location where a particular sourced service is carried out.

  • Onshoring refers to contracting services outside the company but within the same country.
  • Nearshoring refers to lower-cost locations within the same country or region, such as Central and Eastern Europe for Western European banks.
  • Offshoring involves sending functions farther afield — to India, for instance.

Key to the effort are new technologies that fall under the rubric of digitization. Digital technologies such as cloud computing and artificial intelligence are making it easier and more efficient for banks to operate as modular institutions, and to outsource more and more critical functions. And the most advanced outsourcing service providers can become valued partners as banks look to further digitize their own operations.

Such partners can enable the banks to cut costs while improving the flexibility they need to respond to rapid market changes. That ability is particularly critical because as banking and insurance clients demand easier, more enticing ways of interacting with their financial institutions, future customer relationships will depend more and more on banks’ ability to provide digital experiences across all channels.

In short, the European banking sector has much to gain by exploring the new outsourcing. But how should it proceed?

Strategic drivers

Banks need to identify their strategic objectives for moving to the modular model. Their goals might include cutting costs further while improving control over their current outsourcing providers, gaining access to critical digital capabilities, fulfilling regulatory requirements, improving service quality, or reducing risk.

A further strategic driver is the increasing need to build flexible, highly scalable business models that can adapt quickly to changing market conditions. The U.K.’s decision to exit the European Union, for example, has put pressure on the country’s international banks to rethink their operations and potentially relocate outside their home country.

Banks must also be prepared to take advantage of new technologies — such as blockchain, artificial intelligence, machine learning, and robotics — that have the potential to disrupt their current business and operating models. Finally, new E.U. Payment Services Directive 2 (PSD2) regulations, designed to promote a more open banking system in Europe, threaten to break up current banking value chains by forcing incumbent banks to provide access to their client accounts to third-party providers of innovative online banking services.

Several trends over the past two decades have made sourcing and shoring activities even more attractive than in the past. Access to low-cost foreign labor markets has improved due to trade agreements and the membership of several Central and Eastern European countries in the European Union. Regulators have forced banks to become more transparent, and laws governing sourcing have been put in place. New digital technologies have improved the ability to work across international boundaries. And various shoring and sourcing models have proven successful.

Defining what the bank does best

The goal of modularity is best attained through a Fit for Growth approach to cost optimization. This approach helps banks minimize the costs involved in maintaining their nonstrategic activities and use the money saved to invest in three to six truly differentiating capabilities they will need to thrive in the future.

These strategic and nonstrategic activities can be divided into four categories:

1. Differentiating capabilities. These are the essential activities that enable companies to distinguish themselves from the competition.

2. Table stakes. These activities, although not differentiating, are required by the very nature of the industry, but should be funded at best-in-class efficiency levels.

3. Lights on. These are the day-to-day operations that any business must maintain to keep the doors open. As with table stakes, they should be run as cost-effectively as possible.

4. Not required. These activities need not be maintained at all, and should simply be dropped.

Exhibit 2 illustrates the kinds of activities that might fall into each category, depending on the institution and its particular goals. Note, too, that a capability that might be differentiating for one bank may be mere table stakes for another.

Fit for Growth category examples

Banks now have the opportunity to outsource more and more activities that were once thought essential to keep in-house but are not truly differentiating. The money saved by running these non-differentiating activities more efficiently can then be invested in capabilities that matter, or sent straight to the bottom line (see “A penny saved…”). But which ones? And where?

A penny saved…

In current banking and insurance operating models, onshore outsourcing typically offers the possibility of reducing annual back-office costs by 20 to 25 percent (Exhibit A). Standardizing processes and platforms alone should yield efficiency gains of 10 to 20 percent, while productivity improvements on the part of the service provider or new center of excellence can generate further savings of between 10 and 20 percent, partly due to automation. On top of these short-term savings, contracts often include agreements to further reduce costs every year going forward. Some of the savings will be offset by the cost of the retained governance organization required to manage the outsourcing process; still, the savings will be substantial.

Typical cost reduction potential for onshore and offshore sourcing

Although offshoring further increases the regulatory complexity of outsourcing deals, it can almost double the potential savings, to as much as 60 percent, due to the significant labor and office cost arbitrage, especially compared with primary banking locations such as Zurich, Frankfurt, and London. While the total savings will be reduced by additional taxes, they will remain large.

Given the potential savings, and considering the investment required to outsource a particular function, the breakeven point for both sourcing and shoring can typically be reached within two to five years.

Location, location, location

Diligently carried out, a capabilities analysis can provide valuable input into what should and should not be outsourced. Commodity-like lights-on capabilities, including many back-office processes, offer the greatest potential for outsourcing. Outsourcing markets are already well developed for these functions, offering a broad range of professional service providers in different locations. Choosing the right service provider for these activities should be based primarily on purely economic factors.

Table stakes activities, however, demand more careful consideration. Many of them will typically be kept in-house for strategic considerations, such as a desire to remain completely independent of any outsourcing provider. Others, however, may be shored differently, through a nearshoring arrangement that increases efficiency but maintains a higher degree of control.

Another promising option for managing table stakes activities such as handling cash, compliance with know your customer (KYC) regulations, and even trade processes and technology would be to create joint-venture “utility companies” among multiple banks. The benefits include greater scale effects, more efficient investment in automation, and greater harmonization of processes across the banking sector. Participants would also benefit from a higher level of control over the joint ventures compared with that available through leading international outsourcing providers.

On the other hand, outsourcing offshore is also maturing, and banks can now outsource more strategic table stakes activities to offshore providers with greater confidence. In addition to the simple processes traditionally outsourced, such as transactional accounting, call centers, IT development, and data processing, more and more complex knowledge-based processes are being relocated, including procurement, analytics, trading, marketing, and audit, to name just a few. In a recent PwC survey regarding business process outsourcing in banking, more than two-thirds of respondents said they expect that banks will further increase the scope of the activities they send offshore.

India is no longer the sole beneficiary of Western European banks’ outsourcing efforts. Particularly over the past five years, many banks have begun to nearshore their mid- and back-office functions to service providers in Central and Eastern Europe. Besides established shoring locations such as Bratislava, Budapest, Prague, Warsaw, and Krakow, more and more alternative shoring locations have emerged, including Tallinn, Riga, Vilnius, Bucharest, Lodz, and Gdansk (Exhibit 3).

Nearshoring and sourcing expansion in Central and Eastern Europe

But outsourcing to providers in Central and Eastern Europe isn’t the only nearshore option. Larger institutions are also setting up their own nearshoring facilities in Western Europe. For example, Credit Suisse has moved parts of its trading operations from London to Dublin, J.P. Morgan and Morgan Stanley have opened technology centers in Glasgow, and Deutsche Bank has moved a significant workload to Birmingham and to its tech center in Dublin. Smaller banks, lacking the scale of such large rivals, are more likely to make use of established outsourcing providers, which offer the scale and capabilities needed to maintain operations abroad.

The number of potential outsourcing options is growing quickly.

Clearly, the number of potential outsourcing options is growing quickly. But deciding where to send those table stakes and lights-on activities isn’t simply a matter of choosing the one that is most convenient. There are typically six factors to be considered in any assessment. The two most important are operating costs — wage rates and office costs — and the availability of skilled labor. The other four factors, however, can be equally decisive: business continuity (the reliability of the local political regime, threat of natural disasters); business infrastructure (availability of adequate office space, network bandwidth, travel connections to headquarters and partner locations, even time zone proximity); socioeconomic development (the site’s economic growth and investment in education); and financial and municipal incentives (the treatment of investments, tax incentives). These issues become even more relevant as we enter the digital age, given that the relative degree of technological sophistication and adaptation can differ significantly from country to country.

Risk/reward ratio

There are many financial advantages to shoring and sourcing, but it takes careful planning to realize those advantages (see “Five steps to modular banking”). Although the cost of setting up 100 people in an office in Central or Eastern Europe may be less than half of what it costs to do so in London, Frankfurt, or Zurich, additional costs can quickly offset these financial benefits. For example, VAT and mandatory intercompany charges designed to ensure that the subsidiary earns a taxable profit can quickly generate a 10 to 20 percent markup, and the expense of actively controlling the quality of the work can add still more.

Five steps to modular banking

1. Set a goal for your institution’s sourcing and shoring agenda and match it with your digital agenda. Prioritize your business goals: Is your primary goal reducing costs, improving quality, reducing management attention, or closing capability and digitization gaps?

2. Document your entire value chain and related processes. Scope and evaluate each area for its sourcing and shoring potential based on your defined goals and a careful assessment of your institution’s capabilities. Focus on non-differentiating capabilities for further analysis.

3. Consider the options for improving your current processes internally, through automation and robotic processes, artificial intelligence, and other digital technologies, and evaluate the maturity of these technologies, given your needs.

4. Assess the various sourcing and shoring models and their ability to provide the digitization and automation technologies that may be relevant for your institution. Determine whether you have sufficient scale to manage complex digital technology on your own, perhaps through onshore subsidiaries, or if you would benefit more from an established outsourcing provider. Draw up a business case, including a detailed financial assessment, for each option.

5. Define an outsourcing governance model that balances your business targets with an effective risk management system and an appropriately sized retained organization. Include in the model the means to ensure that all technologies and processes employed will comply with regulatory and data security requirements.

Moreover, during the transition phase, which may last as long as three years, the activity to be outsourced must be maintained in both the old and new locations, requiring further expense, as will the outsourcing project team itself. And the ongoing “war for talent” is also being fought in Central and Eastern Europe, where the growing business centers actively compete for the best employees, wages are steadily increasing, and workforce turnover can be high. In short, the financial benefits and risks need to be carefully assessed in a detailed business case analysis before a final decision is made on the sourcing or shoring model, setup, and location.

Every sourcing and shoring effort requires a strong governance model that allows for a sufficient degree of control over quality of service to satisfy regulators, while maintaining the retained organization at a level that brings the greatest cost benefit. This is particularly relevant for outsourcing — especially offshore, where the potential for loss of control can be greatest. But it also applies when sourcing functions to other legal entities within the same company. Appropriate governance processes need to be put in place to manage and mitigate operational risk, support the business in making informed outsourcing decisions, and be in accordance with regulations such as the Solvency and Basel frameworks. No governance model, however, should be so elaborate or onerous as to keep the institution from achieving the outsourcing effort’s business and financial goals.

For most banks, it may be best to put in place a centralized “data management office” that can maintain a comprehensive overview of all the bank’s sourcing and shoring activities, including their costs, risks, levels of quality, and the security and privacy issues surrounding the end-to-end flow of data. This would enable effective steering, ensure consistency across the company’s outsourcing efforts, and let the company use all available data in its efforts to gather critical customer insights.


Banks throughout Europe are seeking innovative ways to improve earnings and boost growth. High on their list should be a concerted effort to rethink and streamline their business models, focusing on strengthening the capabilities that define their strategic identity. Key to this effort is optimization of the costs involved in carrying out the many activities that don’t directly contribute to generating customer value. That’s where the new outsourcing comes in. New digital technologies, together with more advanced new service centers, offer a real opportunity to redefine which activities need to be kept in-house and which don’t. Is it time for your bank to go modular?