Many banks are facing structural loss in international payments processing: losing money on every transaction. Received wisdom is that competitive unit costs can only be achieved by a premier league of banks with very high technology investments processing very high volumes. For the rest, says the argument, the logical route to cost control is outsourcing to one of these banks.
Yet John Rushton of PA Consulting Group argues that for many medium-sized banks outsourcing is unlikely to deliver the required cost reduction. It may well add unwelcome complexities to the payments process. And, because the market is immature, outsourcing entails considerable risk. Rather than be paralysed by the received wisdom, banks should get a grip on their cost base themselves; the systems investment required is well within their reach.
Continued market evolution, across the inter-bank, commercial and retail segments, places strong pressure on the pricing of international payments, especially in Europe. Already the market price for an international payment in competitive corporate RFP situations in Europe is €3, and banks should be targeting an end to end unit cost of €2 or less from next year. Yet many banks in Europe today have unit costs ranging as high as €20. These banks either are, or soon will be, losing money on every transaction. Clearly something needs to be done, and quickly.
Evaluating the case for outsourcing
It's understandable that many banks respond to intensifying cost pressures by thinking of outsourcing their payments processing. They're buying into the widespread belief that it's only the largest banks that can achieve competitive unit costs internally. These giants alone, according to this view, have the investment dollars to win a technology "arms race". They alone have the transaction volumes to achieve the necessary economies of scale. This view is one that's perpetuated both by consultants and by the large banks themselves.
Influenced by these arguments, senior bankers from smaller organisations are reluctant to invest in payments processing, particularly as they see payments as a 'non core' business, and one that inevitably delivers declining revenues (both questionable assumptions, incidentally). For these decision-makers, an outsourcing deal with one of the major players may appear to be the only available means of achieving the essential cost reductions.
But just how effective a cost-reduction strategy is outsourcing; and more concretely, can it deliver a unit cost of €2? Any medium-sized bank with annual international payments volumes in excess of 2 million should look to an internal cost reduction programme, rather than outsourcing, as the route to achieving a radically lower processing cost base. Moreover, the received wisdom about the inevitability of outsourcing is paralysing bank management; it is preventing them from making moderate investments in high payback projects which will deliver competitive unit costs.
Let's review some possible scenarios.
Comparing the options
The diagram shows the end to end process chain for an outbound international payment. An outsourcing decision could draw the boundary between what should continue to be done in-house and what should be passed to the insourcer in any of several places. The three main possibilities are discussed below.
Option 1: Outsource routing and delivery only. Just outsourcing the routing and delivery would be relatively simple, and could be regarded as little more than an extension of the arrangements which many banks have today for dollar or euro clearing. However, as this piece of the process accounts for no more than 10% of the end to end cost, outsourcing it would have little impact on the unit cost problem.
Option 2: Outsource the bulk of back office processing. Outsourcing the bulk of back office processing, which accounts for perhaps 50% of end to end costs, appears to have the potential to deliver significant economies of scale.
The main problem with this option is that, because the outsourced process needs access to many functions that will be retained in-house, there will be a large number of new interfaces to develop - perhaps as many as three or four dozen by the time front end channel systems, reference files, core accounting systems, and treasury and liquidity systems are taken into account. The substantial interface development and testing costs which the insourcing company incurs during the take-on period will inevitably be reflected in the eventual unit pricing.
Any potential cost savings are likely to be further offset by the expenses incurred by the bank itself in policing the new boundaries between the insourcer's processes and its own. In particular, the outsourcing bank will need to ensure that control of liquidity management is not diluted.
At the same time, customer servicing - including front line query handling and message tracking as well as more complex investigations and billing activities - could in theory be outsourced, but the customer relationship issues would be significant and it is doubtful that savings would accrue.
Option 3: Outsource the entire process including customer interface. 70% of the end to end cost is directly driven by the mix of front end channels: processing paper payments, for instance, is equally labour-intensive whoever does it. Reductions in this cost can be achieved only through changes in the channel mix, such as substituting electronic channels for paper, or switching to a more effective electronic banking front end.
Changes to channels amount to changes in the customer offer and product features. Although making these changes can be an effective component of the overall cost reduction approach, few banks would want to jeopardise their customer relationships by allowing an outsourcer to make such choices on their behalf.
The maturity of the outsourcing market
There are substantial disappointments, then, if outsourcing is adopted as the route to cost reduction for medium-sized banks in international payments. There are several further disadvantages to outsourcing:
- There is almost no commercial offering for the outsourcing of international payments; the outsourcer would be a guinea pig and both parties would be entering uncharted waters
- The most obvious potential suppliers, the large payments banks, do not want to insource low margin, potentially high risk, commodity business. They may be happy to insource 100% STP transactions, but these can already be processed at acceptable cost
- External suppliers make a margin and charge (unrecoverable) VAT. An insourcer would have to be delivering efficiency savings of nearly 50% simply to avoid putting up the unit cost to the customer bank
- Large payment banks will want to add more value to the deal, by expanding its scope into other product areas and thereby threatening the outsourcing bank's customer relationships.
Getting to grips with costs: the alternative
Fortunately there is an alternative to outsourcing, and one which can deliver the requisite cost savings without outsourcing's complexity and risk. For banks to take it requires them to stop believing the urban myth that competitive technology is unaffordable
We have seen a number of medium-sized banks work through a 'back to basics' programme to deliver a €2 unit cost in international payments processing in three ways:
- Leveraging internal economies of scale by setting up a centralised Group payments operations centre
- Introducing modern package-based payment engines - often the very same ones used by the big banks - and re-engineering the new Centre's processes around these systems
- Aggressively changing the channel mix to raise STP rates, including changes to the customer offer and product design
Any bank processing more than a couple of million international payments a year can afford to follow this route. What's more, such a programme can typically be expected to pay back within 12 months of going live.
It's not just that outsourcing is fraught with hazard; there really is no reason to consider it when pioneering banks are already achieving quantum improvements by taking control themselves. Banks should avoid the paralysing received wisdom about the inevitability of outsourcing, and get a grip on their cost base themselves.
