Outsourcing feature: Weighing the risks

Some larger financial institutions are taking the opportunity to radically restructure outsourcing deals in the wake of the recession to release cash and shift the balance of financial risk towards the outsourcing provider. Philip Hunter looks at the state of the market, how it's been affected by the downturn and the coming trends, such as performance-based shared risk models

Despite the economic downturn creating a gloomy picture for many, in the outsourcing market, particularly with Business Process Outsourcing (BPO), it is thought that it may actually be good news and the sector may grow as hard pressed managers at financial institutions look to cut costs quickly and improve the bottom line in the immediate future. Even for those financial firms undertaking software or infrastructure development projects delivering these with less staff, following cuts caused by last year's crunch, may be impossible without some outside assistance. Long-term it is best to view outsourcing as a strategic reengineering tool but in the current climate immediate cost reduction may predominate. Financial institutions must be careful not to get locked into expensive long deals with outsourcers however, as has happened in the past, and ensure strong Service Level Agreements (SLAs) and actionable get out clauses in the event of poor service or delivery, an all too familiar bug bear in the past. If customers leave a bank or insurer due to a deterioration in service, or a new product doesn't come on stream and deliver new revenues as intended, then it's a false economy. Buyer beware is definitely the attitude to have for those financial institutions looking to supplement their in-house efforts.

"The credit crunch has led financial services companies to focus on financial re-engineering, as well as IT re-engineering, and look to release value from their balance sheet," says Jim Scurlock, vice president, global financial services, at EDS, which was acquired by HP for $13.9 billion in 2008, creating a serious large rival for IBM Global Services and other leading players. "There is a desire on the part of financial institutions to significantly reduce capital expenditures and operating expenditures, both of which create, as well as release, value tied to the balance sheet."

For the best results though institutions should not simply squeeze their outsourcer, since history has shown that providers of any kind of service will extract revenue in other ways if the terms of the contract are too draconian, so says Douglas Hayward, an analyst at research outlet, IDC, who specialises in outsourcing. He believes the best approach is to share both risk and reward equitably, combining stick and carrot to give providers the greatest incentive to deliver maximum value, as well as minimum cost. "There has to be a contractual and governance mechanism to align the interests of both parties," he says. "This can include risk-sharing and gain-sharing, or sophisticated ways of rewarding cost-cutting and flexibility by the vendor."

Hayward cites an outsourcing contract that he knows of where the provider was allowed to keep a proportion of the savings made whenever a billable item was eliminated. Normally such items, which could be the fee charged by external consultants hired by the provider for services not covered by the contract itself, would be passed straight on to the customer, but such an arrangement gives providers greater incentive to seek savings beyond their immediate remit. More generally, improved working relationships will lead to savings. "In some cases, joint ventures between customers and suppliers can be a good way of aligning interests," says Hayward.

Recessionary effect
The credit crunch and subsequent recession has placed the management of risk associated with outsourcing contracts higher up the agenda. This has had the effect of steering larger banks, including the super institutions born out of the crisis, such as Lloyds Banking Group, away from the mega contracts of the past, believes Mike Dodd, a senior outsourcing specialist at the PA Consulting Group. "If nothing else, the events of the last 18 months should be reminding banks that one of their key areas of competence is (or should be!) risk management and that putting all their eggs in one basket [i.e. relying on a single outsourcer] does not look like a good risk management strategy," he says.

"In any case there is no real track record of successful mega outsourcing in banking," he adds, citing the case in 2004 when JP Morgan, then the second largest US bank, cancelled a $5 billion contract with IBM. This particular case also indirectly highlighted a contemporary source of risk that ironically might actually have been amplified by the credit crunch
- the loss of in-house IT expertise. One reason cited by JP Morgan for cancelling that IBM contract back in 2004 was a strategic decision to bring some IT functions and expertise back in-house. Yet today the motivation to save money and release capital is leading some institutions to continue making the mistake of running down their in-house IT so they are unable to manage outsourcing contracts properly.

"Many buyers still have an asymmetric approach to outsourcing deals, that is they focus on the transaction and supplier side of the arrangement without paying anything like enough attention to the requirements for changed internal processes, redesign and re-skilling of the retained organisation," says Dodd. "This inevitably leads to problems, sometimes with the supplier getting blamed for lack of preparedness on the customer side."

Such running down of in-house IT leaves organisations over-exposed to the fortunes of the outsourcing provider, and over-reliant on its ability to keep pace with changing technology. "This could leave banks or insurers in a very vulnerable position - suppliers could essentially charge what they wanted for applications and systems and they would lose their competitive edge because they would have to rely upon the same 'off the shelf' package as their competitors," says Martyn Hart, chairman of the UK trade body, the National Outsourcing Association (NOA). "There needs to be a proper balance between onshore and offshore work and all organisations
should look to maintain ample expertise in-house."

Indian scandals
Some financial institutions will have been alerted to the potential risks of outsourcing by two major recent scandals involving Indian providers. Firstly it emerged in January 2009 that outsourcing and computer services group Satyam had been inflating its accounts by just over $1 billion to protect itself from hostile takeover. Then remarkably, in the same week, India's third largest outsourcer Wipro was banned from competing for contracts financed by the World Bank, in light of the revelation that it had provided improper benefits to the staff of some of its clients back in 2000. The Satyam scandal was more recent and serious, but the two combined to dent confidence in Indian outsourcing, claims Yuri Elkin, managing director of the financial services practice at rival Russian-based outsourcing provider, Luxoft. "Satyam's scandal cast a shadow on the entire industry's image," he says. "Companies realised that, even though India still remains a prime outsourcing location, it is not safe from geopolitical risks and corporate frauds, and so they started to look more at alternatives, such as central and Eastern Europe and Southeast Asia."

Indian outsourcers themselves have responded by setting up or acquiring operations in these other territories, in part to meet growing demand for a balance between in-house, near-sourcing and far-sourcing. They continue to diversify and expand, and the impact of the scandals earlier this year already appears to be receding according to some other commentators. "One of the best indicators of India's success is to look at the performance of its large IT services companies," says the NOA's Hart. "Companies like TCS and Infosys have taken the IT world stage by storm and have been going from strength to strength increasing their client portfolio and offering innovative outsourcing solutions. It is unlikely that their client base will reduce dramatically as a result of a loss of confidence caused by the scandals. The price and the service they are offering are just too good."

Not all trends in financial outsourcing have been driven by the recession. And while payments, finance, administration and human resources continue to be the principal activities to be outsourced, there have been some ongoing changes in the balance between onshore and offshore locations for some activities. According to Mark Ingleby, business development director, financial services, at BPO firm, Vertex Data Science: "We are seeing a swap out as voice service moves onshore to be replaced by back office functions. It's important to stress that customer service and loyalty remain central to these deals and therefore we see organisations measuring the perceptions among their customers of any service development." Ingleby's point here is that organisations are finding customer facing operations such as call centres may be best provided onshore by people with greater geographical knowledge and closer linguistic affinity with the service area, while commodity and some technical functions can be offloaded to the lowest cost provider.

In fact there has been a strengthening trend towards outsourcing technical functions requiring specific financial expertise but that are not deemed core to the business, driven by the growing complexity of trading environments and increasing number of regulations with IT implications. In this case the recession has added impetus by virtue of the regulatory and governance changes it has brought about, believes Luxoft's Elkin. "We have acquired a number of new projects including ones that would never have been outsourced before the credit crunch," he says. "Recent changes in capital markets have also led to more business. For example, the growing number of electronic trading exchange venues, wide usage of dark pools of liquidity (i.e. non-displayed trades), increased volatility affecting trading algorithms on the sell side, new government regulations post-crunch and more strict risk control procedures all require related changes on the technology front. Given the pressure to reduce IT spend a lot of these complex technology projects get outsourced to IT vendors like Luxoft."

Strong SLAs
Whatever the functions involved, one component of outsourcing contracts has become almost universal, the Service Level Agreement (SLA). This is essential in some form in order to monitor the performance of the outsourcer and the quality of the services provided. "Tom DeMarco wrote 'you can't control what you can't measure', and Peter Drucker famously made similar observations," notes PA's Dodd, referring to two great philosophers of IT. "Neither of them though said that it was easy to pick the right measurements!"

This observation partly explains why SLAs are often ill-conceived and only measure what is easy or obvious, and monitor the wrong aspects of a contract. They can also, as Elkin emphasised, be to the detriment of both parties, unless it is kept in its place as a tool for communicating between parties, rather than a rule of engagement. "It is best for the SLA, like the project itself, to begin on a trial basis and evolve through mutual consent and experience," he says. Some bankers or insurers who've been burned in the past might not agree, perhaps demanding a watertight contract instead, but deep down we all know that good results come from good teamwork. Both viewpoints are valid, which is why the risk-based model, where both parties share in the dangers and the rewards, is perhaps a mutually beneficial development.

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