Outsourcing by Banks: The Right Approach

Although India is a favored Information Technology (IT) outsourcing destination for global financial services firms, ironically, the domestic banking industry does not have a long history of such partnerships. As a rule, the Indian banks chose to build in-house IT capability, and limited outsourcing if any, to low-impact functions where they could cut costs. These sub-contracting engagements were mostly tactical in nature. That is beginning to change with the dawn of a new perspective of outsourcing as something that is not merely a cost-saving measure, but rather a strategic partnership capable of delivering significant value to banking institutions.

As banks consider these new possibilities and partnerships, what are the key factors they must take into account before arriving at a decision? Is there an outsourcing paradigm that goes beyond cost? Here are some thoughts.

For most Indian banks, the decision to outsource technology is primarily driven by multiple dimensions listed below

• A Need to Optimize Cost: Both public and private sector banks are striving hard to build share in a highly competitive Indian market. In these conditions, even a slender advantage in cost pricing structure can make a big difference to a banks performance. Therefore cost optimization is the baseline expectation of most outsourcing partnerships.
• A Search for New Revenue Streams: Indian banks generate a significant part of their revenue from Net Interest Margin (NIM). With the cost of funding and NIM of most banks being comparable, there isnt much scope for differentiation here. Today, banks in Indialike other global institutionsrecognize that both competitive advantage and revenue realization opportunities lie in the delivery of customer experience through new value added services, channels and innovations, and accordingly seek technology partners to help them implement these.



• A Quest for New Capabilities Such as Technology-led Innovation: As intensive users of IT, the Indian banks have developed reasonable technical skills over the years; however they lack the business-will to invest in new/niche IT capability for innovation. For that, they need the support of a specialist technology provider, who can equip them with next-generation technology solutions, such as cloud, mobility, etc.
• An Alternative Business Model or Business Such as Financial Inclusion: The Indian government is strongly pursuing its financial inclusion agenda by mandating that banks open a certain number of branches in underserved locations and attaching similar stipulations to the issue of fresh licenses to new entrants in the retail banking space. The economics of rural unbanked markets are very different from that of urban centers, which can absorb the high costs of the normal branch banking model. In order to succeed in their financial inclusion initiatives, banks need alternative business model and technology solutions, which can replace expensive branch infrastructure by bringing in low cost channels of delivery. Most banks dont have the necessary reach or resources to undertake such an initiative on their own. Therefore it makes business sense to ally with a partner and with a solution that has proved its ability to operate in remote areas, many of which lack adequate electrical or telecom connectivity.

Technology companies with ready-to-deploy mobility solutionswith their advantages of a low-cost delivery platform and large scale implementation and operational capabilitiesare, therefore a natural choice for being a strategic partner.

Where to Start?

One of the first and most important question that banks need to resolve is where to start the outsourcing journey from. There is no single answer to this, and therefore each institution may approach it differently, depending upon which of the above mentioned drivers is the most important to the business.

• Start with Core, Enabling, or Tertiary Functions: From an operational perspective, a strategic technology partnership can be structured around a banks core, enabling, or tertiary functions, or a combination of the above. Outsourcing of tertiary activitiessuch as the maintenance of remote branch operations, ATM networks, and desktop infrastructureseems an intuitive and logical choice. However cost saving, which is the singular benefit of such an arrangement, plateaus in a few years, after which the partnership begins to lose appeal. It is mostly the small banks, which are yet to optimize operations or are new to outsourcing, which seek partnerships in this area. Established players have more complex needs, which can only be fulfilled by outsourcing other, more critical functions.

Understandably, banks find it hard to divest core activities to an external agency at the start of an outsourcing relationship, for a number of reasons. For one, these functions are at the heart of their business and any slip-up in execution could inflict a serious damage. Two, banks know best how to run core operations, which means that they may not reap any material benefit by outsourcing the same. Finally, there could be regulatory, implementation, or security implications to outsourcing critical core functions.

Experience shows that technology partnerships focused on a banks enabling functions work well. Enabling functions have a wide scope, which in the context of large retail banks could range from the management of a data center to creation of an online channel to implementation of a business intelligence/data warehousing solution. They are closer to the core of banking than tertiary functions. The reason why these operations make good outsourcing candidates is because they enable the realization of multiple benefits or key drivers of outsourcing, such as lower Total Cost of Ownership (TCO) and revenue generation potential. For instance, when a bank vests the responsibility for their data center with an external partner, they are assured of quick scalability, which is so vital to business growth. Similarly, when they enter into a partnership with a business intelligence provider, they can enhance their analytical and reporting capability almost immediately. These benefits are so significant as to even compensate a slight increase in the banks TCO in the initial years of certain outsourcing arrangements. That being said, the bank needs to give the partnership at least a few years to realize the full extent of its benefits.

• Take a Big Leap or Incremental Steps: The jury is still out on the age-old debate about the relative merits of big bang and phased implementation. Most often, this decision is driven by factors such as the size or duration of a window of opportunity or the length of a regulatory timeline.

Typically, a regulatory initiative like financial inclusion is implemented through a big-bang program in which all aspects of outsourcing, such as build-and-operate are activated at the same time.

Large public sector banks such as State Bank of India and Punjab National Bank channelize their financial inclusion initiatives through sponsored co-operative/regional rural banks, which implement the same within their local area through their network of physical branches. In such arrangements, a syndicate of co-operative banks shares the technology solutions and infrastructure. The outsourcing partner designs, builds, and operates the infrastructure, and charges the banks monthly, or for the number of branches or services covered. This type of outsourcing is highly beneficial to banks, which can mitigate both implementation and operational risks, and also gain visibility into the cost-benefit equation at the start of the engagement.

The example of initiatives like m-pesaa highly successful mobile money transfer service that has been adopted by millions of unbanked Kenyansshows how an alternative model of financial inclusion can be built on a platform of information and communication technology. However since Indian banks dont have the technological or innovation ability to develop this on their own, they would do well to outsource the project to an external service provider with the requisite skills and an established track record. The good news is that many domestic and multinational technology companies operating in India have the capability to deliver connectivity as well as implement secure, low-cost technology solutions to spread financial inclusion.

What to Consider?

After they identify the areas of strategic outsourcing, banks need to find a suitable technology partner to implement their plans. Once again, the important thing is to ensure that the vendor selection criteria are aligned with the factors driving the outsourcing decision. The following are some of the key considerations in vendor evaluation:

• Business Scale: Both large and small-sized technology vendors come with certain advantages and limitations. A bank in partnership with a small, upcoming firm can command the attention of its senior management or insist that it dedicate a large part of its resources in their service. On the flipside, the bank may not be able to explore a wide-ranging relationship with the vendor, owing to the latters limited capability.

In India, strategic outsourcing partnerships with large technology organizations have been more successful than those involving small firms. Large-scale partners usually pack a wider range of services and long-term commercial viability. But more importantly, they bring greater flexibility to the relationship. Consider the example of a bank that has outsourced a data centeroccupying prime real estateto a large technology organization. Should they decide to move everything to the cloud in future, they might be able to divest the facility to the partner, a very unlikely possibility when the outsourcing vendor is a small firm. Such options could be very valuable in an environment of rapid technological evolution, innovation, and also obsolescence.

• Relationship Longevity: The business value of an outsourcing partnership becomes tangible only after a few years. Hence banks also need to assess potential technology partnerships from a perspective of longevity. The partners track record, organization structure, market knowledge, and size of the Indian operations are good indicators of their commitment to this market, and consequently, their ability to go the distance.

Again, larger organizations have the upper hand. Long-term contracts are usually more sophisticated, are predicated on certain assumptions, and are frequently open-ended. A small firm may be genuinely interested in entering into such an arrangement, but midway through the contract, might realize that it lacks the requisite staying power. On the other hand, large organizations have proven credentials, and hence, are a much safer bet as a long-term partner.

• Regulatory Compliance: A bank must consider the regulatory implications of outsourcing before plunging ahead. It would be to their advantage to ally with a partner who not only has the capability to deliver a particular service, but also the resources to satisfy any surrounding compliance mandates. For instance, while outsourcing financial inclusion operations, the bank must insist that the partner also maintain paper records of electronic transactions to guarantee non repudiation. Similarly, while outsourcing a multi-factor authentication solution, the bank must preferably choose a partner who can also manage the maintenance, upgrade, and replacement of tokens, dongles etc.
• Financial Consideration: Although cost is a very important factor in choosing an outsourcing partner, it must not be the only one. A bank, which simply awards a contract to the lowest bidder, might eventually derive less benefit than another, which bases its decision on a more balanced evaluation. Therefore while assessing different outsourcing options, banks must not only look at the cost per unit of work, but rather the total projected benefitwhich is the sum of the monetary benefit and a monetary equivalent of non-monetary benefits such as innovation and revenue potentialto arrive at the correct decision.

The structure of the commercial arrangement can also make a considerable difference. Some organizations bring creative options to the table, including non-linear pricing, risk/benefit sharing, or pay per use agreements. This is an attractive proposition for banks, which can reduce risk, convert fixed costs to variable, and pay only for what they consume or is actually delivered by the partner.

Last but not the least, banks must also understand the potential partners motives for entering into the relationship. Ideally, the partner must have strategic vision, clear focus, and the willingness to invest in new technology and innovation, in the interest of the partnership.

A number of factors are driving Indian banks towards more meaningful technology outsourcing. Cost optimization is certainly one of them, but increasingly, other dimensions, such as revenue generation and innovation are coming into play. As a result, the outsourcing arrangement of old is evolving into a strategic partnership that promises much value, well beyond cost saving.

In order to derive maximum benefit, banks must approach outsourcing from this broader, multi-dimensional perspective and ensure that all their decisionsfrom what to outsource and whom to outsource it toare aligned with those drivers that propelled them towards this initiative in the first place.