Enabling Usage-Based IT Costing in the Banking Sector Alea M. Fairchild Tilburg University, The Netherlands
[email protected] Abstract: As economic conditions result in increased exposure to market volatility and margin erosion, banks are looking to exchange fixed IT cost for variable IT cost structures. This has driven a change of internal mindset towards an increased acceptance of outsourcing to achieve IT cost optimisation. This paper examines findings from two industry case studies in outsourcing on cost, risk and technology costing, both from the viewpoints of the bank and the technology provider. Keywords: transaction cost economics, risk, outsourcing, financial services, innovation
1. Introduction Traditionally, financial service organizations have approached technology as a supporting element in the corporate infrastructure that permits operational activities to occur. Keen (1991) states that IT rarely reduces costs, as IT’s main value is more often in changing the cost structure of the firm so that it can increase throughput without increasing personnel. Historically, investment in core IT displaces variable cost labour in favour of fixed cost capital. So IT costs have been scrutinized in terms of fixed costs and investment lifecycle, and allocated to business units or specific activities by usage with difficulty. This has been due to an organizational lack of ability to meter internal IT usage and attribute technology resources based on operational and support activity. But key IT topics now on the agendas of most financial institution boardrooms are business process outsourcing and a concept of shared processing utilities. This has been prompted by a change of internal mindset towards an increased acceptance of outsourcing to focus on the goals of IT cost optimisation. This has been particularly prominent in industry media of late in the form of IT outsourcing (ITO) and business process outsourcing (BPO) deals involving major banks. Financial services organisations are increasingly choosing outsourcing solutions, driven by business need to create usagebased costing, increase flexibility and release working capital as margins decline. Outsourcing could be considered an inevitable development of the financial services industry; a trend based on the labour market and the economic conditions. But these outsourcing activities are not for a quick fix, but are focused on strategic partnerships that may take their businesses in a new direction.
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Banks, like other financial service institutions (FSIs), are focusing on their core competencies of relationship management and providing innovative services to their customers. Given the recent trend of banks to outsourcing certain segments of their IT infrastructure, this led to our research on the role technology plays in innovation. The findings of this paper are based from this case study research. This paper examines the economics that led to the change of mindset, and discusses findings from two bank case studies in IT cost optimisation and outsourcing. The paper provides initial findings for the future of IT cost optimisation in financial services, both in banking and in other financial activities such as insurance.
2. Economics of IT cost optimisation 2.1
Measuring IT investment
Financial services organizations are looking to IT to build strategic and competitive advantages. These types of investments yield results over time, but seldom in the short-run. This is problematic among shareholders and investors who demand more immediate results. Moreover, it is difficult to quantify and calculate the tangible benefits of technology when it is used for strategic purposes. Purchasing and maintaining IT is a capitalintensive activity, with a predetermined lifecycle and a required payback in terms of the investment. Financial theory suggests measuring financial returns on a risk and timeadjusted basis (Hamel and Prahalad, 1991), and in most cases, firms rely on financial measures such as return on investment (ROI), net present value (NPV), and internal rate of return (IRR). But the financial rationalization fails to capture the complete picture in terms of
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Electronic Journal of Information Systems Evaluation Volume 6 Issue 2 (2003) 87-94 issues such as customer satisfaction, service, quality, employee satisfaction, productivity, or strategic positioning (Williamson, 1997; Bharadwaj and Konsynski, 1997). Traditionally, banks have viewed IT cost allocation on a fixed cost basis, one with a high degree of complexity, in terms of cost/usage analysis. In banking, the transaction is the basic unit of analysis for IT usage, and since transactions are not equal across business units and banking applications, it is difficult to create mechanisms for tracking usage. By pursuing perceived economies of scope to achieve greater cost efficiency, some banks discovered competitive advantage is more clearly defined in terms of capabilities than range of products and markets (Teece, 1980). This has led to the interest in outsourcing for IT cost optimization, allowing banks to focus more on their core competencies.
2.2
Opportunism related to trust and risk
In outsourcing relationships, specific investments have to be made by both parties that tie them together and specific arrangements are needed to safeguard the long-term perspective of the relationship because the transaction parties, given a chance, are naturally prone to opportunistic behavior (Van der Meer-Kooistra and Vosselman, 2000). If hierarchy is not an option, then transaction cost theory would recommend that special (contractual) arrangements are needed to make outsourcing relationships “save” despite the asset specificity. In transaction cost theory, the characteristics of the transaction itself (degree and type of asset specificity, transaction frequency, and length of transaction period), the transaction environment (uncertainty about future contingencies, extent of risks and nature of institutional environment) and the characteristics of the transaction parties (risk attitude, experience, reputation, bargaining power) need to be considered when choosing between alternative governance options, as described in Table 1. Joskow (1987) analysed asset specific contracts and tested whether the importance of relationship-specific investments are associated with long-term contractual agreements. He used measures of site specificity, physical asset specificity, and dedicated assets as types of transactionspecific investments. He found that increases in the specificity of investments increase the
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duration of the formal contract. In the case of IT outsourcing for financial institutions, the site is specific, the assets are unique to the contract and both capital and labor are contractually dedicated resources to one or more business units. Therefore, the long duration of IT outsourcing contracts (years, not months) is logical and governance mechanisms to manage both the contract and the relationship are important. Table 1: Characteristics of the contingency factors (Van der Meer-Kooistra and Vosselman, 2000). Characteristics of the transaction Degree and type of asset specificity Frequency and repetition Length of the transaction period Measurability of activities and output
Characteristics of the transaction environment Uncertainty about future contingencies Degree of market risks: institutional, environmental (rules, systems and organizations)
Characteristics of the transaction parties Information asymmetry Reputation Experience with cooperation in networks or with specific parties Risk attitude Bargaining power
Transaction cost theory, however, does not consider the possibility of using trust as a means to reduce the risk of opportunistic behavior. Williamson (1993) acknowledges that the “social embeddedness” (Granovetter, 1985) of transactions has an influence on the contracting parties’ behavior and can reduce their propensity towards opportunism, but he treats social embeddedness largely as an institutional-environmental factor and thereby denies trust the status of a means to reduce the risk of opportunistic behavior in inter-firm relationships its own right. Van der Meer-Kooistra & Vosselman (2000) combine transaction cost theory and trust in their conceptual model and distinguish between market-based, bureaucracy-based and trust-based patterns as three ideal types of management control patterns in inter-firm relationships. Either a bureaucracy-based or a trust-based pattern of inter-firm governance can govern outsourcing relationships. In either ITO or BPO, the outsourcing relationship goes further than just substituting for an internal IT service and a contractual relationship is sought where the service provider assumes responsibility for one or more of the organization’s IT or even business functions (Hoecht, 2002). In this case, the relationship includes the transfer of resources
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Business Process Importance
of the outsourcing organization to the external service provider and involves a long-term commitment with a detailed legally binding contract. Significant organizational changes are needed as the role of the internal IT department changes form being a supplier of
Strategic
Tactical
its own services to assuming the function of a controller and broker of IT and/or business services. A very high level of trust is required for such relationships as the risks involved are substantial.
BPO activities: e.g. Complex or core applications, software development ITO activities: e.g. Help desk, asset mgmt, data center Volume Activity
Value Activity
Revenue Generation Figure 1: ITO vs. BPO: trade-off between process control and revenue generation (Saxton, 2003) Because of the long-term timeframe, the level of resources committed and the emphasis on cost efficiency, a bureaucracy-based approach to relationship management and management control is often pursued. This is not the best fit to the task, and leads to disappointment on both sides and further enforces the desire to impose a high level of management control.
particularly on IT spending. Optimization of IT cost, using various methods of cost allocation, is one way that banks believe they can be more innovative and flexible in their portfolio of market offerings. Part of the optimization process is creating a cost mechanism that allows charge-back and service level agreement (SLA) relationships to IT usage.
2.3
Therefore the clarity of definition of tactical, straightforward costs of volume activities lends them to an outsourcing action, as shown in Figure 2.
How outsourcing allows innovation
The current focus of financial services is to increase innovation via decreasing costs,
Strategic
Cost Avoidance Cost Containment Cost Reduction Tactical
Cost Clarity
Figure 2: Tactical to strategic view of IT cost approach in banking (Saxton, 2003)
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According to analysts Datamonitor (2003), outsourcing IT by banks is more likely to be sought for a mix of cost reduction, service improvement and control of contextual determinants of transaction costs. Motivations and management decision basis for the banks to arrange IT outsourcing are mainly categorized into: operating cost reduction predictable cost forecasting efficient capital allocation flexible business expansion professional resource assurance availability of large-scale outsourcers. As the market has been down for quite some time, reducing cost to increase flexibility is a particularly pressing issue in the securities and investments space. In the post-dot-com world, financial services institutions (FSIs) increasingly use ROI models to increase the likelihood that projects achieve targeted returns. FSIs also base outsourcing decisions on qualitative factors, including information security requirements, operational risk considerations and process control. This latest trend towards large, multiyear outsourcing arrangements has the ability to transform the institutions' IT infrastructure and, in some cases, the applications and related business processes. Evidence presented in Lacity-Hirschheim (1993) and Lacity et al. (1996) among others, supports Williamson's market transaction cost arguments (1975) for outsourcing and suggests several reasons for firms to outsource IT intensive processes (see Table 2). Table 2: Reasons for Expansion of Outsourcing Incentives to Outsource Coping with Market Volatility
Characteristics
-Companies abandon diversification to focus on core capabilities. -Reduce cost structures by turning fixed into variable costs. Lack of Skills -Improve access to more skilled staff. Improve Budget -Exposure of otherwise difficult to Allocation control functions to market discipline. Source: Wood and Batiz-Lazo, 1997; LacityHirschheim (1993); and Lacity et al.(1996)
An important driver of IT outsourcing is opportunity cost. This is based on a reflection
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of what the core competency of a bank is, and a determination of whether the bank of an IT service provider operates the technology infrastructure more effectively. In a service, the product is the process. Innovation in banking lies more in process and organizational changes than in new product development in a traditional sense. Given the mix of content and infrastructure for providing a banking service, marketing, business units, IT, and a complex web of IT suppliers and consultants drive the innovation processes in banking (Frei, Harker and Hunter, 1998). Metrics for measuring a service can include market share, customer satisfaction and increased revenue growth. Financial services performance improvements that drive innovation will arise in the integration of front- and back-office functions; i.e., in integrating business processes. Roach (1993) points out that the consolidation of back-office operations is due in large part to scale economies due to IT investments, but that these investments are becoming increasingly difficult to find.
3. Research objectives and methodology This paper is based on case study research conducted in early 2003 focused on major outsourcing deals in banking. The research methodology used for this case study research was a combination of literature review and structured interviews, enhanced with secondary research. The research objective for this research was: In terms of both tangible cost and intangible cost/benefit analysis, how does the bank view innovation in terms of IT infrastructure? How was IT cost optimization part of the outsourcing decision making process? The questionnaires for the case studies were guided questions, targeted to senior executives familiar with the outsourcing deal under discussion. Each case study had at least two sides to the story: interviews both with the bank and with the IT outsourcing provider. The interviews, given the different geographies, were conducted by telephone with the most senior person available in regards to this outsourcing deal (e.g. EDS Managing Director for The Netherlands, Exec. VP of ABN AMRO, VP for Financial Markets for IBM, etc). Each participant was given the questionnaire in
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advance, and each interview lasted 30 – 45 minutes in length.
employees through joining a global, wellrespected IT-company.
4. Case studies
From IBM’s point of view, there were a number of reasons why IBM felt, together with subcontractor CSC, was a good match for Deutsche Bank’s objectives in this activity. These include the fact that IBM culture is close to current Deutsche Bank culture and that IBM’s European coverage minimizes risk for Deutsche Bank.
Table 3: Summary of Case Studies discussed in this paper Bank / Technology Provider
Type of Outsourcing
Deutsche Bank / IBM
Horizontal, across functional lines of business
Computing data centers
ABN AMRO / EDS
Vertical, specific to one line of business
Wholesale Client Services (WCS)
4.1
Outsourced
Size and length of deal Euro 2.5 billion, 10 year deal US$ 1.3 billion, 5 year deal
Deutsche Bank with outsourcing partner IBM
Deutsche Bank has given IBM the outsourcing contract to manage its computer centers in continental Europe. The impact to the IT organization of Deutsche Bank is a transition of Deutsche Bank resources, systems and approximately 900 employees to IBM during the first quarter of 2003. Deutsche Bank also gains resources in a new computing facility run by IBM in Rhine-Main region of Germany. Deutsche Bank was impressed by IBM's ebusiness on demand technology, which will allow Deutsche Bank a more flexible answer to the changing financial services arena by integrating core business processes and systems. Klaus Thoma, a spokesman for Deutsche Bank, said that key to the deal was IBM's ability to update Deutsche Bank to stateof-the-art technology while offering it a utility model for purchasing IT resources, Thoma said. "This is being driven by our strategy to get rid of fixed costs [and] areas that we feel are not our core competencies," he said. The bank expects to save $1 billion over the next decade through its outsourcing deal with IBM. Deutsche Bank felt comfortable outsourcing its data processing operations because IBM and other IT services vendors have proven that they can provide sufficient uptime and security, according to Thoma. IBM was seen as a strong partner to overall manage technological and operational risks and to ensure long-term technological innovations. And IBM provided a valuable career perspective for Deutsche Bank
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4.2
ABN AMRO with outsourcing partner EDS
ABN AMRO negotiated a contract with EDS to provision technology services and applications development in the major countries in which Wholesale Client Strategic (WCS) business unit operates. WCS provides investmentbanking services to corporate, institutional and public sector clients worldwide. The impact on the IT organization of ABN AMRO is the transition of several hundred employees to EDS, with certain core employees staying on the ABN AMRO side of the IT management. The technology benefit was a more cost-effective method to deliver services more efficiently. An interview with Mike Hampson, Exec. VP for ABN AMRO's Wholesale Client (WCS) Strategic Business Unit, led to a discussion of how strategic IT investment projects have been traditionally a very low percentage of the total portfolio. Once the group realized that many parts of the infrastructure were either discretionary or mandatory for business operations, they focused on how to reduce the total return to shareholders (TRS) by cost transparency and accountability in the service delivery model. Transparency of costs and governance were some of the key drivers for the outsourcing activity. This was due to their performance culture and need to create management for value (MFV) metrics by doing “smart sourcing” to control cost and risk more effectively. EDS believes it provides value in these deals by way of its smart organization and shared services. For example, EDS is the 5th largest mortgage processor in the world. EDS sees drivers for outsourcing in banking as cost reduction, core and supportive functions, Basel II and necessary performance metrics for the bank to measure transactions against service levels. EDS offers its service excellence dashboard to enable companies to examine the benefits from the outsourcing activity. EDS
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for limited bids mainly to the single outsourcing party.
defines cost, risk, leveraging of skills, and the format of reporting all to be concerns of ABN AMRO in this deal.
Zaheer and Venkatraman (1995) propose that the greater level of business process asset specificity creates an increased requirement for the governance to offset the dependence caused by such specific assets. Indeed, a higher degree of dependence due to higher investments made in business processes (e.g. human assets, physical assets and site assets) requires that the relationship include greater safeguards to make sure their transaction specific assets will not be appropriated opportunistically. Therefore, control, risk sharing and value via innovation from modularity and flexibility of infrastructure all require a strict governance structure, based on trust and reputations.
5. Case study analysis What drove the need to outsource were tactical, volume activities that needed to have more cost clarity in their make-up. IBM offers Deutsche Bank utility pricing so that they can use usage-based costing methods, for example, providing longer-term cost reduction as the banks can see where they are having the most variable costing. The pattern of outsourcing relationship for these two case studies shows an evolution from the traditional multi-year outsourcing bureaucracy-based pattern to a more interactive, trust-based pattern with business process asset specificity as the governance driver. In these cases, trust had already been established as all of these parties previously had outsourcing relationships. ABN AMRO asked seven companies to bid, but Deutsche Bank and the other banks in the study asked
As shown in Figure 3, based on a presentation of the outsourcing deal by ABN AMRO, this is how the bank sees cost, control, risk sharing and value via innovation for the change in service delivery paradigm.
C urrent Structure
Target Structure
•H igh, fixed cost base •N o protection from m argin erosion
C O ST
•U nresponsive to m arket and com petitive pressure •Technology base is inflexible and unreliable
V A LU E
•C annot m easure service delivery •Lack of m anagem ent bandw idth •D elivery is high risk for the bank
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•Low , variable cost base •B etter protection from m argin erosion •B etter utilization of resources •D eliver m ore revenue for low er spend •C apability to grow the business m ore quickly
CONTROL
R ISK
• A gree and im plem ent service levels •Total cost transparency •R etain control of key services •D elivery is low risk for outsourcer
Figure 3: Service Delivery Paradigm Drivers (from ABN AMRO interview materials) Of these four elements, from our research, control of the service and risk sharing are coming after the cost element in prioritization from the bank’s perspective. Value is again considered the innovation, from the ability to be flexible and modular with service growth. These recent deals have mainly emphasized the outsourcing of horizontal technology management functions, allowing financial institutions to more effectively manage scale issues through "services on demand."
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Optimizing IT costs while at the same time preparing for the future can be achieved through a combination of initiatives: saving costs initially, turning fixed into variable costs and investing the freed budget for the future. The impact on service delivery is therefore both short-term for cost savings, and long-term for levels of flexibility. But a higher degree of dependence due to higher investments made in business processes (e.g. human assets, physical assets and site assets) requires that the outsourcing
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93 relationship include greater safeguards to make sure their transaction specific assets will not be appropriated opportunistically. Therefore, control, risk sharing and value via innovation from modularity and flexibility of infrastructure all require a strict governance structure, based on trust and reputations.
6. Conclusion and future direction As shown from the case studies, IT cost optimisation is actually leading to a new service delivery paradigm, allowing banks to provide innovation and value from flexible and modular service. Technology spending appears to be related to creating innovation through value and bringing benefits in cost and efficiency. Banks are focusing on outsourcing for IT cost optimisation to create governance for cost, control, risk and value, allowing the possibilities to be innovative. Governance of quality and service levels is vital to achieve cost reductions and ensure the longevity of the outsourcing alliances. This current outsourcing trend has been stimulated by cost, but also by risk as it allows hedging against technology obsolescence, access to ‘best-of-breed’ technology, freedom from specific IT operational responsibility and rapid IT deployment time-frames. This in turn reduces TCO and provides banks an option to convert from a fixed cost model for IT spending to a variable cost model. The bank only pays for the extent of usage, enabling the bank to focus on its core activity of relationship banking without the continued capital expenditure and maintenance cost required. Drivers for why this outsourcing trend is taking off may also be attributed to the service delivery models of the technology vendors, with examples being EDS and IBM. EDS' Service Excellence Dashboard and IBM’s service virtualisation capability (from IBM Research) both provide integrated mechanisms for banks to see both technology and business process bottlenecks on a usage basis by business activity. This is possible for both the tier one banks and the larger IT outsourcing providers. But what about smaller banks and smaller integrators? In our future research, we question how well BPO will work when the business structural sizes do not match, just like when electronic data interchange (EDI) activities have been tried between a large and a small firm.
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Alea M. Fairchild
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Electronic Journal of Information Systems Evaluation Volume 6 Issue 2 (2003) 87-94 Organizations and Society, vol. 25, pp. 51-77. Williamson, M. (1997). “Weighing the nos and cons”, CIO [On-line]. Available: http://www.cio.com/archive/041597_ne ed_content.html. Williamson, O.E. (1975). Markets and Hierarchies: Analysis and Anitrust Implications, New York: Free Press. Williamson, O.E. (1993). “Opportunism and its critics”, Managerial and Decision Economics, vol.14, pp.97-107
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