Banks outsourcing: new route to bottom line
This is a reproduction of an article by Bob Gach, Financial News
The financial crisis, the euro crisis, recessions, fiscal consolidation by governments and the biggest regulatory upheavals since the 1930s have combined to hammer profitability of the investment banking industry.
Ambitious return-on-equity targets of 20% have had to be lowered and even the new 12% to 14% targets now appear to be a stretch.
Much of the industry is currently struggling to generate returns of more than 5% or 6% despite cost reduction programmes over the past four-and-a-half years, which have resulted in business closures and job cuts in London and New York estimated at more than 130,000.
These actions have cut costs by 15%, but the knife needs to go deeper.
Fixed costs are still too high and inflexible given the current levels of business. The average cost-to-income ratio among the top 20 banks is 71%, although much of this is due to a few particularly poorly-performing banks.
That said, the problem for the industry is that profitability in many of the investment banks’ main business lines is down by between 50% and 80% since the financial crisis and nobody is anticipating dramatic growth soon.
This has forced banks to re-evaluate their business models and make significant, creative structural changes in IT and operations.
The banks have three options: to simply exit business lines – a route recently followed by UBS, which pulled out of the least capital-efficient elements of its fixed-income sales and trading business; to invest to scale up current businesses to compete as a top player; or turn to more fundamental structural reforms that involve sharing costs through pooled services provided either by a consortium of banks or run as market utilities created by external providers.
Through this outsourcing option, banks are aiming to save a further 15% to 30%.
We have seen this model work extremely efficiently in the mortgage industry, a complex and heavily regulated sector in its own right.
Twenty-five years ago, the outsourcing of mortgage processing was virtually unheard of. But the industry’s booms and busts and the wave of regulation over the past decade have made a strong case for structural change.
Since 2007, the outsourcing of mortgage processing worldwide has increased by 30% and is now a $13bn world-wide industry. This rise reflects the sector’s need for scalability and, more recently, for steep cost reduction, tighter controls and better service.
Very few banks now believe they can differentiate in the market place with their back-office processing, particularly as regulatory compliance has dictated much more standardised processes. The banks make money from trading activity but, in the current environment, the spread on most transactions may no longer cover the cost of the back-office processing and asset servicing.
Some of the big investment banks will continue to maintain full-service front and back-office functions but, for most of the industry, this no longer makes any more sense than paving their own roads, running their own electricity plants or bottling their own water. Some good examples include post-trade processing, reconciliations and research.
Clients tend to care little about the actual provider or functions of back-office processing, providing their bank is able to offer a reliable and cost-effective service.
By purchasing this kind of commoditised service more cheaply from an external provider – post-trade processing, reconciliations and research are all good candidates for outsourcing – it allows banks to invest more easily in the customer-facing products that clients do care about: innovation and service levels. These are the differentiators that set one bank apart from another and provide competitive advantage.
The key question is whether a multibillion third-party industry will emerge offering back-office processing services or would the need to save costs push banks into accepting such a service from a rival, despite the highly confidential nature of the information involved?
— Bob Gach is global managing director of Accenture capital markets and Owen Jelf is global managing director of Accenture trading services.
Key Takeaways for small and mid-sized financial firms:
Cost cutting should continue for years: Our key takeaway is that off-shoring activities should continue to be a focused strategy for the entire financial services segment, not just banking. Particularly, mid and small size financial firms will need to focus on where specifically they can compete effectively on costs, without increased risk of running an offshore captive unit.
How we can help: Indeed, high end research and banking support is our niche focus at ValAn Global. We believe our business model should actively help the mid and small size firms compete effectively with their larger well-capitalized brethren.
Also, please see our interesting weekly blog on high end investment research outsourcing.