January 27, 2004

Economies of scale say that unit costs diminish with larger size. When it comes to sourcing IT personnel, software, and equipment, however, smarter seems better than larger. Of course, cost efficiency stands out as a key driver amid a renewed wave of bank mergers, since these transactions entail a substantial consolidation of IT resources. Financial services institutions (FSIs) globally are getting higher productivity gains by increasing their investments in IT offshore outsourcing. TowerGroup estimates that investments in various models of IT offshore are growing at an annual rate of 11.2%, and that this spending will reach $38.2 billion in 2006.

These outsourcing models challenge conventional wisdom about the role of technology and demand a new breed of IT governance competencies. A sensitive point is the public debate about large shifts of technology jobs from the US to offshore locations. While FSIs can free up capital by transferring selected IT and business process functions offshore, if they hope to add sustainable business and economic value they must reinvest part that capital smartly in more innovative services and advanced technologies. The goal is to articulate a federated network of distributed services that operate more productively, while creating new value added for competitive differentiation. Otherwise, absent a continuing flow of innovation, intellectual capital might become an offshore commodity. Leading FSIs had better keep building productivity and value, or would sooner or later they will lose their edge in the industry.

A strategic feature of all variations of outsourcing is that they provide a more professional focus on selected IT activities. In a "captive" model, FSIs operate their own IT support centers offshore to increase their in-house productivity. Similarly, an institution may operate directly with specialized offshore vendors to benefit from their labor arbitrage advantage and advanced IT capabilities. Alternatively, vendors end up transforming local IT functions by sending some work "indirectly" to their own offshore facilities. In many cases, the right solution involves a combination of these models. Outsourced staff that interact actively with mainstream FSI businesses may also be deployed "on-shore" and at strategic "near-shore" locations. While each model has a different balance of risk and benefits, TowerGroup finds that FSIs benefit the most if they fully understand the possible gains from offshore outsourcing and reap the "low hanging fruit" first.

Over the past few years, the global economic downturn has made it hard for FSIs to invest in IT developments. Institutions have been searching for ways to upgrade their application functionality and systems infrastructure in a manner that is cost efficient and consistent with budgetary constraints. First, FSIs identify those internal best-in-class applications that have an edge over their direct competitors. The remaining internal IT spending in "commodity" functions consumes a large and mostly fixed portion of the expense base and therefore constitutes an attractive avenue to free up capital through offshore outsourcing. A comprehensive scan of the business processes and application functions reveals opportunities to reorganize logically interrelated IT components that may also be an integral part of a business process outsourcing (BPO) service. By choosing the right systems and processes, it is possible to find alternative solutions externally that fulfill equivalent functions at a lower cost and with improved performance.

Strategic cost management builds heavily on outsourcing to bring much needed flexibility to the technology function and align IT initiatives with the business strategies. Rather than adopting either a completely "in-house" or a completely "outsourced" approach, institutions can derive strategic benefits by managing IT assets in a manner that maximizes the functional value of the application systems while still reducing overall end-to-end expense in business operations. An emerging trend is the deconstruction and recombination of technology functions in support of streamlined business processes. TowerGroup associates a "multiplier effect" to this transformation, whereby each dollar saved in legacy technology brings up to seven dollars in savings. These additional savings stem from the operational efficiencies gained when the functional constraints of legacy systems disappear. Thus, a smart sourcing approach can optimize the relationship between value and cost by combining different options for an application portfolio composed of diversified functional groups.

Strategically, 20% can be more than 80%

To illustrate the 80/20 paradox, let us take the case of elementary application functionality that occurs repeatedly across different business units"for example, capturing customer information to open a new account. Since most of the features in this elementary function are common to all applications and offer little differentiation value, they can be characterized as a "commodity." Typically, this is the case of midsize and large institutions, where 80% of features may be similar across different application systems. Aiming at reducing maintenance cost, smarter application architectures then combine the common features into standard enterprise solutions. Even if 80% of the enterprise solution streamlines common functions into a single service, however, the 20% balance of unique features may end up requiring a much larger maintenance effort! The explanation of this paradox is that 80% of the features had occurred in many duplicative applications and were consolidated into a single solution, whereas the remaining 20% are unique custom features that will still require individual maintenance. If left unchecked, the cumulative cost of maintaining, let us say, some 30 residual features could add up to around four times more than implementing and operating a common service. This paradox highlights the creation of new value: The higher cost efficiency of streamlined applications.

Sourcing alternatives

TowerGroup estimates that FSIs are already spending 35% of their global investments in technology on external IT software and services. These include fees paid to outsourcing service providers like service bureaus, and fees for professional services like consulting, systems integration, and training engagements. They are also spending on external application and system software (custom development or packaged solutions). Offshore outsourcing is a common strategic opportunity that leverages the low cost of offshore labor for highly qualified technology resources. As an example, many outsourcing arrangements count with vast resource capabilities based in India and offer sophisticated technology services at a fraction of the equivalent cost in the US and Europe. The high levels in the Capability Maturity Model (CMM) ratings established by the Software Engineering Institute (SEI) provide a practical gauge of the level of sophistication attained by many offshore shops.

Specialization and economies of scale may grow commodity IT vendors into strategic partners. Externally sourced value is then created in the form of advanced features or is enabled by means of cost efficiencies and improved service. An emerging trend is to put together disaggregated entities to assemble a collection of specialized processes. This approach entails a fundamental shift from vertical integration within an institution. Continuing developments in supply chain automation and business-to-business Web Services are likely to fuel this outsourcing trend by adding new dimensions of strategic value.

Among other benefits, outsourcing arrangements make additional resources available to meet peak business demands. IT assets lose value as technology evolves and end up obsolete. By placing these assets under external outsourcing arrangements, institutions may find it easier to keep their IT current and avoid steep depreciation charges or write-offs due to accelerated obsolescence.

Outsourcing has an impact on operational risk. Upgrading to a more robust and resilient IT infrastructure along with a formal engagement framework helps to mitigate this risk. Resourceful outsourcing vendors can also lower the risk involved in large IT applications development projects compared to in-house implementations. To be effective, such transfer of risk must offset the added dependency on the vendor, which can be substantial in the case of full-scale outsourcing.

As the outsourced functions operate at "arm's-length," they require additional interaction and management coordination in processes such as planning, approval, change, security, and control. To balance the interactions between institutions and outsourcing vendors, governance processes must address issues stemming from the shift of power and authority in other related sourcing decisions. The additional process burden may eventually bring strategic benefits like tighter discipline in IT spending. A more careful analysis of the return on investment for each sourcing decision helps curtail low-value IT projects or activities.

Institutions should take control of their strategic applications for competitive differentiation purposes. Synergistic strategies of connecting core competencies within and outside an institution will represent a fundamental shift from the monolithic, vertically integrated model.

Mr. Guillermo Kopp is the director of the Emerging Technology Solutions and Financial Services Strategies & IT Investments practices at TowerGroup, a leading research and consulting firm focused exclusively on the global financial services industry. He can be reached at gkopp@towergroup.com.