Outsourcing, especially offshore seems to offer significant benefits in terms of cost savings and conversion of fixed costs into variable costs. It seems all the more attractive to financial institutions and banks as significant effort is involved in back-office processing, which by nature is technology-intensive, repeatable and thus a strong case for outsourcing. Despite a lot of press reaction and people opposition, outsourcing is growing stronger day by day. Most of the larger firms around the world have begun outsourcing significant parts of their business to countries such as India which offer significantly better returns for the dollar. Some of the better-known names include CitiBank, World Bank, Bank Of America, Merrill Lynch, Lehman Brothers, Deutsche Bank, etc., and all of them have transferred a bulk of back-office operations and new system development to India and other lower cost markets. Some of them have even outsourced high-value and risk-sensitive work such as trend analysis for both derivatives and equity markets and are reaping the benefits of continued cost advantages and equally - if not superior - qualified technically and functionally competent personnel.
This does not mean that outsourcing does not have its own problems. Many of the banks and financial service organizations who were part of the first outsourcing wave that started without adequate research and preparation have had bad experiences. Even now, when processes are fairly standardized and evolved, firms are finding it difficult to coordinate, monitor and control performance of their vendors effectively. Still the value proposition of offshore vendors is so strong, many operational issues have not distracted people from going ahead.
It has been estimated that 47 percent of losses in capital markets and banking is due to systemic process and systems failures. This article attempts to explain the impact of the outsourcing of business processes, new technology development and existing system maintenance by external vendors and/or by subsidiaries of the firms in a geographically disparate location on the overall operational risk and whether it is possible for an arithmetic correlation between the two.
Why Outsource?
Outsourcing has significant advantages in cost reduction, increases in operational efficiency, decreases in operational costs and better management of quality human resources. PwC's Paul Halpin said, "Many people think that operational risk inevitably increases when processes are outsourced. However the introduction of more effective controls and better management of risk, by an outsource provider, can often reduce operational risk." High-profile accountancy scandals, systemic failures and lack of BCP/DRS systems in conjunction with the proposals contained in Basel II and the EU Credit Directive are increasing the awareness of operational risk. As the financial markets move towards further statutory regulation, operational risk is something that the market makers and executives need to be considering. Outsourcing providers can play a key part in their clients' operational risk strategies.
There have been several instances of significant quality improvement at firms due to better processes at vendor site. Very often software development vendors are world leaders in processes for software development life cycles, and many of them actually enable firms to improve on existing operational and process efficiencies with multiple-way knowledge transfer.
Outsourcing a range of functions to third-party vendors is an attractive risk mitigation option. Outsourcing allows better alignment between cost structure and revenues, greater flexibility to introduce new products, more innovative investment structures, access to new technology, rapid integration of the same into the company's systems and greater ability to keep pace with changing regulations and markets.
Given the complex and global nature of investment management and the varying functions that can be outsourced, identifying and developing the right model is often difficult. A four-step phase for assessment of the efficiency can help recognize the appropriate outsourcing model - in shore, near shore, offshore or combination/mix of the three. First, the divisional managers need to identify why they want to outsource a particular function. Second, they need to isolate potential issues with outsourcing. Third, they should determine what to outsource. Finally, they need to understand their current and projected cost and revenue structures well enough to align those in an outsourced relationship.
As with any business activity, outsourcing has risks. Such risks depend on several factors, but are most clearly measured by the size, nature and criticality of the outsourced activity. If managed appropriately, outsourcing can be an efficient operational risk mitigation tool. Regardless of the EC disposition on operational risk capital charges, it is likely that more investment managers will turn to outsourcing as a source of flexibility in developing their businesses, reducing cost, and aligning their core competencies and risks with their value added.
Operational Risk and Basel II
There are various risks associated with outsourcing and one of the dominant ones is the "fear of the unknown" as many managers feel there is a certain feeling of lack of information in engagements. The only way to mitigate this risk, apart from top-management commitment, is to involve the customer at every stage in the delivery process.
In the January 2001 Basel II consultative package, operational risk was defined as, "The risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events." The January 2001 paper went on to clarify that this definition included legal risk, but that strategic and reputational risks were not included in this definition for the purpose of a minimum regulatory operational risk capital charge. However in this article for the purpose of better understanding, we shall also look at the possible impact of such risk on the overall portfolio of risks and ways to minimize the probability of such occurrences.
