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18/08/2013 Time: 14:38

Counter the hidden risks of outsourcing

Financial institutions are increasingly outsourcing operations currently performed in-house. They will likely encounter a slew of risks, some of which become clear only when something goes badly wrong. Managers will have to mitigate these risks in order to reap the substantial benefits that outsourcing provides.


Well planned outsourcing gives companies the ability to leverage suppliers' scale, expertise, and systems; access suppliers' lower labor and even capital costs; provide higher quality and more stable processes; and to focus on their core business and competencies. Despite this advantages a recent Gartner Research survey found that 80% of outsourcing deals did not meet the targeted return on investment (ROI). What goes wrong before, during and after accomplishing the outsourcing process ?

Before starting any outsourcing process the financial service company need to rigourously analyze and plan the project. Outsourcing risks can be grouped into the following 4 main categories:

- Operational risks:
- Financial risks;
- Strategic risks;
- Hazards risks.

Research into both successes and failures has identified best practices that can help managers avoid pitfalls in planning and managing major outsourced activities and advance to strategic partner management. The key findings of outsourcing researches can be summarized as following: Successful outsourcing starts by asking the right questions, entails a substantial partner selection process, and continues with sophisticated governance arrangements. Successful outsourcers evidence a level of attention throughout the relationship that goes well beyond the usual procurement approach. An effective approach to outsourcing consists of 3 major phases:

The first phase involves deciding whether, what, and how to outsource. A full range of options, including in-house shared service solutions, should be assessed in light of economic costs and benefits, potential service levels, quantified risks, market capabilities, and competitive realities. We term this broad consideration "right-sourcing", since outsourcing is but one possible outcome. Companies sometimes ignore this phase when they are intent on rapid cost shedding and have been blinded by articles about miraculous offshore solutions. Yet their objectives may be unclear and even conflicting. Marketing and Finance functions, for example, have different views on which capabilities must be kept in-house to maintain control. The understanding of current costs, processes, and the potential for improvement may be so limited that the company cannot accurately estimate potential gains from outsourcing. Thus, an objective assessment of the starting position, major objectives, and possible solutions is an essential first step.

The second phase entails selecting the best partner, reaching a formal agreement, and planning for the transition. One funds manager we interviewed who outsourced back-office transaction processing told us this is the most important part of the whole approach. We recommend a structured process progressing from a Request for Information to a Request for Proposals and ultimately the crafting of a Service Level Agreement (SLA). The process works best when conducted by a cross-functional team. Projected outcomes should be modeled and compared across proposals and with the current situation. This should include value (defined as sales increases, customer satisfaction, up-time of critical activities, or key quality aspects) as well as costs. You should review processes with potential providers, jointly revise them, and establish performance indicators and incentives, linked to exceeding service goals (such as percentage of questions answered on the first call) or savings targets (for example, 50-50 sharing of the first year's gains) in order to align the interests of both parties. Penalties tend not to be useful here. One manager at a financial services company told us, "If it ever came to the fine print, we knew the relationship was over." Review the insurable risks and expand coverage as needed. Finally, negotiate the deal and prepare specific transition plans. The transition from in-house to outsourced services, or from one provider to another, may be the toughest part of the relationship and deserves extensive planning and preparation.

The third phase involves deepening the relationship structure and measurements to ensure strong performance over time. Many companies don't anticipate the complexities of managing large outsourced relationships. If services are outsourced on an ad hoc basis, responsibility diffuses throughout the organization. The solution is formal partner management that includes monthly or quarterly customer/supplier meetings to ensure prompt resolution of problems and ongoing check-ups on business objectives. Senior executives from client and provider organizations must meet regularly to build trust and ensure prompt issue resolution. Partner management teams should include multifunctional and cross-business unit members to properly govern complex outsourced relationships. Annual check-ups serve to evaluate major service suppliers from a strategic perspective. As part of the check-up, ask: How are needs changing? What is the trend in vendor performance? Are there new opportunities available in the marketplace? The answer may be a move to renegotiate or seek a new partner, or to change strategy by outsourcing more activities or bringing back certain functions in-house.

Throughout this 3 step process, adherence to a handful of best practices will improve the odds of success:

- Make a "right-sourcing" decision based on strategic goals, not just tactical urgency. Use an enterprise-wide assessment of cost- and productivity enhancing options;

- Invest in a robust selection process. It's not easy to switch vendors later, so careful consideration, interviews with other clients, detailed modeling, multi-level contacts, and due diligence investigations are worth the effort;

- Retain domain knowledge. Keep critical strategic know-how inside the organization so that vendors don't become competitors and the company remains in control of strategy;

- In case of regulated FS entities outsourcing arrangements should not impair the regulator's ability to exercise its regulatory responsibilities such as proper supervision of their outsourced activities. The management (BoD) of the FS company remain the ultimate responsible of the outsourced activites;

- Ensure that in case of sensitive client data and/or personal data transfer and treatment, the NON-EU service provider has appropriate security measures in place to comply with the european data protection Directive (95/46/EC);

- Communicate fully with current employees. They must shift from an initial position of fear or anxiety to one of positive collaboration in transferring knowledge to the vendor;

- Build joint company-vendor teams. Joint transition efforts help to fine-tune and introduce new processes. Training and site visits should flow in both directions;

- Define appropriate performance measures. Key performance indicators should address service delivery quality and total costs;

- Provide the right incentives. Baseline and stretch targets for provider payment should directly link to service levels, and supplier staff bonuses at every level should align with contract incentives;

- Assess insurance coverage. Determine possible gaps by thoroughly reviewing all relevant policies, adding needed coverage, and seeking suitable provider liability;

- Design a contingency and exit strategy. Prepare to survive in case of business disruption or contract termination, when operations might need to be transferred to another vendor or brought back in-house.


Conclusion:

Strategic financial services outsourcing can add value through direction setting, intelligent analysis, committed management, measurement, and appropriate risk transfer. To realize the benefits, FS companies must anticipate and address the many risks involved in outsourcing. Developing and following a robust framework for outsourcing decisions, partner selection, and partner management provides the best assurance that outsourcing will be rewarding to both outsourcing companies and their partners/vendors/providers.

Hazard risks:

Natural and man-made risks can rise exponentially when crucial business services are outsourced to far-flung locations. The challenge is to identify the full range of potential issues upfront and approach them through a careful assessment of the levers available to mitigate potential problems. Among the most common hazard risks are these:

Workers' compensation surprises:

Depending on the wording of contracts, the vendor's employees might be considered leased employees of the client company. If so, numerous problems could surface regarding workers' compensation. Countries and states differ in their treatment of which company is the employer, with some conferring that status on both the buyer and the provider. If the buyer is not considered the employer, it may still be vulnerable to a lawsuit by an injured outsourced employee.

Errors and omissions coverage:

Offshore outsourcers may not carry the levels of protection against errors and omissions that major corporations expect of their service providers. In India, for example, Errors & Omission coverage is generally available only up to a $ 5 million limit. Those contemplating externalizing critical functions should insist on proper coverage by their suppliers. This may mean using specialist underwriters such as those in the London insurance markets.

Political instability:

Dealing with distant vendors gives rise to potential risks of expropriation, trade disruption, and exchange rate fluctuations that can have major impacts on a company's costs and supply chain performance. These risks are best handled via a combination of due diligence, splitting the work across several geographies, and insurance.

Natural disaster risk:

Fire, earthquake, and other natural disasters can disrupt activities at a vendor's location and cause the contracting company to lose income. The situation is worse if the vendor does not maintain adequate property insurance. The best response is, first, to maintain adequate amounts of "contingent time element" insurance under the property policy and, second, to have the vendor maintain adequate property insurance on an "all risks" basis, including business interruption coverage.

Strategic risks:

As the scope of outsourced activities has widened, outsourcing providers are more likely to affect companies' core businesses. Among the major risks are these:

Loss of control:

Attention to the outsourced activity may tend to lapse as knowledgeable staff depart for greener pastures or are laid off, leaving fewer people to keep up with advances in the functional area. At some point, the company has little effective control. JPMorgan Chase recently announced it would bring back in-house a major set of IT activities it had outsourced to IBM in a seven-year, $ 5 billion deal. The bank now feels it is critical to manage and control IT directly to gain competitive advantage. Some 4,000 IBM employees will be transferred back to JPMorgan just two years after the contract was announced. The cancellation penalties, missed opportunities, and other transition costs involved in such decisions highlight the value of careful analysis of objectives and options prior to launching any large outsourcing initiative.

Reputational damage:

Retailers such as Nike have been tarred with the “bad practices” brush because of their choice of product suppliers in China and Central America, while Wal-Mart’s brand has been tarnished by allegations of improper hiring by a subcontractor. Banks and other service businesses are just as vulnerable to perceived misdeeds by providers in distant geographies. These potential costs must be considered early to avoid costly surprises later.

Arrested evolution:

Business requirements inevitably change, and an outsourcing solution defined from a short-term, static perspective likely cannot respond adequately to rapid growth or new challenges. Companies thus may face a costly reassessment and complex transition of providers. This can materialize as an inability to serve new needs, to scale up, or to innovate.

Financial risks:

Through lower wage rates, economies of scale, and a specialist's expertise, outsourcing can deliver savings of 25% to 50%, after adjusting for incremental management and communications costs. But just as enterprise resource planning rarely lived up to the promised return on investment, outsourcing also holds numerous financial risks:

Unforeseen costs:

In the first moment of enthusiasm, managers rarely reckon the costs of evaluating vendors, managing major contracts, traveling to offshore sites, enhancing security, and paying severance for laid-off workers. In addition, standardized services rarely meet the needs of the business, and customized solutions by the vendor will likely add between 15% and 30% to the cost. Finally, exit costs can be substantial, as ending an arrangement prematurely exposes both buyer and provider to litigation. Managers should plan realistically for the full range of costs, creating detailed financial models and testing scenarios to make sure the decision will still look good if various factors go wrong.

Regulatory risks:

Restrictions on outsourcing motivated by protectionist instincts are appearing on state and local governments. Even without dramatic change, companies remain responsible for regulatory compliance in areas such as corporate accountability and privacy, and this clearly extends to their vendors as well. Sarbanes-Oxley, Basel II-III, and numerous other statutes and regulations in the U.S. and Europe require compliance by financial service and other firms, as well as by their providers. Yet not all outsourcers can assure customers that they are fully compliant. This is another reason for a comprehensive due diligence process.

Operational risks:

Most risks that arise in outsourcing are operational risks. All of the operational challenges related to in-house activities persist when outsourced, but they may be less visible and harder to correct. Operations can go awry in numerous ways:

Poor service performance:

This problem can defeat the most attractive cost advantage. An example in the past has been a well known multinational credit card company who cancelled a contract with one of India's largest call center provider, after instances of workers tempting credit card customers with unauthorized free gifts. Poorly integrated processes, language difficulties, or contextual unfamiliarity also can threaten customer service. To minimize service risks, one major retailer maintains a small team to integrate new service providers into its ongoing operations, viewing the skills for ramping up new vendors as replicable across functions.

Weak governance and poor internal communication by the outsourcing company:

At a leading high-tech company, a major operating function had been outsourced to the same provider independently by four different divisions via seven contracts worth a total of $ 250 million annually. Only when one of the divisions expressed dissatisfaction with the supplier's responsiveness did managers connect the dots. Not surprisingly, the provider then resisted attempts to centralize control over its activities. Success in complex outsourcing relationships demands cross-functional teams, senior management leadership, and metric-driven processes.

Staff resistance and motivational issues:

Outsourcing can profoundly disrupt staff and cause lower morale, lower productivity, higher turnover, and reduced service delivery. Employees should be actively involved in the project, with retention plans, role changes, reassignments, job shadowing, severance programs, and interviews with the provider all part of the plan.

Process fragmentation:

How will the outsourced processes link to other key internal activities? As one bank manager we interviewed put it, "Moving IT across the street was a disaster. How could we ever contemplate offshoring?" The CEO of a software firm that sends development offshore to its India office notes that much of the important knowledge is not committed to paper: "There's so much knowledge sitting in people's heads that even if you sit down to document things, you miss out on quite a few items that you only remember when a problem happens." Joint process analysis prior to launch and continuing close interaction with the provider are critical to ensuring that various processes function well together.
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