As market challenges multiply, future banking success will depend on making the right strategic decisions now. Outsourcing and partnership are key elements of emerging new business models.

Globalisation drives commoditisation, as customers with clout demand service consistency across their global organisations. This in turn favours the global financial institutions, which have the geographic reach and network to meet such demands, as well as the resources to develop more sophisticated product ranges and services. In this environment smaller players – however skilled – struggle to grow or to survive. Consolidation is the inevitable outcome, particularly in over-banked markets such as Europe.

Consolidation accelerates

The industry consolidation that has been happening for some time is accelerating – according to research by Deloitte, the top 20 banks now own 18% of the banking market defined by asset size compared with 12% a decade ago. And a further slowdown in asset growth by smaller banks could lead to a more aggressive capture of market share by the global players.

There is also pressure on pricing with margins eroding in a number of products/services – payments, securities, foreign exchange (FX), money markets and, to a certain extent, currency options. These products used to pay their way and cover a relatively expensive back office but are much less profitable today. And, while the big players can invest in running their businesses more efficiently, allowing them to attract more volume and keep costs down, smaller players are further disadvantaged.

Technology costs represent a huge and ongoing burden. According to market estimates, on average they are around 20% of the total cost base of payments organisations. The global IT investments (that is, not just payments) of financial institutions are an estimated $347bn a year, according to Tower Group (2004). Few banks can sustain these levels of investments, further differentiating the ‘haves’ and ‘have nots’.

All these pressures have been building for some time but, more recently, a wave of new regulatory challenges has brought matters to a head. Know Your Customer/USA Patriot Act, Basel II and Sarbanes Oxley together represent significant and unavoidable costs for financial institutions. HSBC, for example, has calculated that the cost of meeting regulatory requirements is 3.125% of its Ebitda (earnings before interest, tax, depreciation and amortisation) according to Computer Weekly (July 13, 2004 ).

“There are a number of global cost pressures at work, not least, those associated with increased regulatory requirements,” says Leonard Stolk, head of alliance solutions origination, EMEA, at ABN AMRO. “Banks need to ensure that their processes are solid in straight-through processing (STP) to avoid taking charges on Basel II for operational risk.”

If a bank is operating a financial markets platform that consists of 15 different applications, 12 of which need to be processed with manual work, this constitutes a potential operational risk and will incur a cost determined by central bank regulations based on Basel II. “To upgrade a financial markets back-office system will cost €40m-€50m, simply in order to comply with Basel II requirements. These pressures are of course felt most strongly by medium sized and smaller banks,” says Mr Stolk.

The struggle to compete

With so many pressures, it may look like “game over” for any bank not in the so-called top tier of global players. But, of course, that is much too simplistic a view. “While fewer, larger banks will dominate, there will always be markets, niches and opportunities for smaller players. And the global players will always need to look out for institutions that may prove nimbler and more innovative. But increasingly, success – and survival – will depend on making the right strategic decisions and will necessitate radical change. More and more, all banks are going to have to make difficult choices,” says Sam Zavatti, vice chairman, global financial institutions at ABN AMRO.

One of the more fundamental choices for local banks may well be whether – and how – to provide cross-border solutions and capabilities. “Much of the discussion we have with clients centres around lost revenue opportunities because they don’t have the product breadth or the feature functionality their clients are starting to demand,” says Ken Alverson, head of alliance solutions origination, Americas at ABN AMRO.

“As an example, local banks tend to attract a lot of entrepreneurial clients that start their business on a small scale. In this growth stage, the bank obviously bears all the upfront risk of supporting a relatively small corporate client. At some point, that client will require more complex products or larger loans that a smaller bank is unable to provide. So these attractive growth clients will tend to gravitate towards the larger banks,” he adds.

Best route to success

Increasingly, local banks are finding that outsourcing operational processing of this kind to regional or global players can be the best route to obtaining the spectrum of services, operating efficiency and geographic reach that their clients require. Electronic delivery, together with carefully specified service level agreements, can make such arrangements transparent to the customer via so-called white-labelling (where services are branded by a bank but actually delivered by a partner institution). “Many banks today are looking to avoid investing a large amount of money in expensive and highly sophisticated platforms,” confirms Mr Alverson. “White labelling can help them to do that without impacting revenue opportunity.”

Cross-border capabilities are an obvious candidate for local banks to outsource. But outsourcing a business area such as loan processing may represent a more radical rethinking of an organisation’s business model.

“A global partner can provide standardised processing of loan transactions, including risk assessment – basically, all the work necessary to prepare the application for a yes or no decision,” says Mr Alverson. “Of course, in such arrangements, the business decision would always remain with the institution owning the asset base and the customer relationship. But outsourcing the processing to a provider able to offer scale and efficiency might provide very valuable cost savings and significantly increase profitability.”

Changing business models

It has been said that only by “thinking the unthinkable” will the problems besetting the current pensions crisis be resolved. Arguably, the banking industry requires a similarly radical rethink, in which everything is open for consideration and new business models can be shaped and developed.

New business models

These business models already include:

  • A new service sector as large financial institutions move in to offer the third-party operational expertise and regulatory discipline that traditional suppliers cannot provide. This market is relatively small at the moment, but research from Deloitte suggests it could be worth up to $100bn for equities, FX, cash and trade services alone
  • A spectrum of operational outsourcing models, for a single or multiple business line, from full business process outsourcing to white-labelling solutions delivered online
  • Outsourcing and advisory services for treasury activities, such as collateral and asset and liability management
  • Partnerships and joint ventures between institutions

These are not theoretical models, but a structural transformation that is already under way. The shift from outsourcing non-core functions (such as finance, human resources and IT) to outsourcing activities some would consider close to, or at, the core of the business (such as securities, international payments and trade) has already begun. This supplement examines the issues and suggests some responses.

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