Regulatory Implications of Outsourcing by Financial Firms

1
Regulatory Implications of Outsourcing by
Financial Firms

• Mark M. Spiegel
• Senior Research Advisor
• Federal Reserve Bank of San Francisco
• NICSA Conference, November 20, 2003
• Views expressed are those of the speaker and not
  necessarily those of the Federal Reserve Bank of
  San Francisco or the Board of Governors of the
  Federal Reserve

2
Foreign Outsourcing by Financial Firms is Growing
at a Rapid Pace

• 58 percent of banking and financial services
  firms currently do some outsourcing
• Compared to only 51 percent in manufacturing
• Information-intensity of financial industry
  leaves it particularly conducive to outsourcing
  some activities
• J.P. Morgan, Morgan Stanley, Deutsche Bank all
  sending stock research services to India
• 40 J.P. Morgan junior equity analysts in Mumbai
• Over next five years 500,000850,000 financial
  sector jobs projected to be exported

3
Primary Advantage of Outsourcing is Reduction in
Labor Costs

• Can be one-fifth of those in United States
• Software engineer starting salary in India around
  5,000
• Top IT professional 20,000
• Wall Street firm back office research job in
  Bangalore starts at 13,000
• Another advantage can be time difference
• Can issue order at 5 pm and have it ready next day

4
Disadvantages Associated with Operating Over Long
Distances

• Management issues
• Recent survey Widespread difficulties with
  communications and deadlines
• Control over intellectual capital
• Security issues
• Terrorism
• Exposure to computer hackers
• Liabilities concerning activities of foreign
  workers

5
Despite Challenges, U.S. Bank Presence Abroad
Growing Rapidly

• HSBC moving 4,000 jobs from England to India,
  Malaysia, and China in next 3 years
• Abbey Mortgage Bank moving back-office activities
  to Bangalore, India
• B of A laid off 900 workers last year in
  connection with Indian outsourcing
• Bank of NY setting up back-office in Philippines
• Chase moving 1,000 credit card jobs to Vancouver,
  Canada from Hicksville, NY

6
Outright outsourcing also growing rapidly

• Office Tiger (headquartered in New York) has 150
  securities professionals currently in India
• up from 30 last year
• Activities are primarily back end (dont face
  clients), but growing in sophistication
• industry coverage
• revising equity valuation models
• preparing research reports

7
Regulatory Concerns

• Not jobs
• SR 00-4 Reduced operational control may expose
  institution to additional risk
• Heightened complexity of activity exacerbates
  this potential
• When foreign outsourcing implied primarily
  programming and limited back-office activity,
  there was little regulatory concern
• Regulators maintained a relatively hands-off
  approach

8
Regulatory Response

• Response is still in its infancy
• Current Federal Reserve rules are summarized by
  supervisory letter SR 00-4
• Rules were primarily designed to address issues
  that arise in domestic outsourcing
• Expanded to accommodate problems particular to
  international arena
• New regulation likely to be forthcoming

9
Relevant operations

• Origination, processing, and settlement of
  payments and financial transactions
• Processing of information related to customer
  accounts
• Activities related to critical bank functions,
  including lending, deposit-taking, fiduciary, or
  trading

10
Concerns surrounding Outsourcing Information
Processing

• Risks faced are similar to those faced when
  functions are performed internally
• System availability
• Integrity and security of customer account
  information
• Integrity of risk management systems
• However, under outsourcing, internal controls
  usually under operational control of service
  provider
• Bank bears risk of financial loss or liability

11
General Guidelines

• Banks must ensure that controls over outsourced
  activities are equivalent to those that would be
  implemented if the activity were conducted
  internally
• Board of Directors and senior management should
  ensure that an appropriate oversight program is
  in place
• In practice, bank is liable for activities of
  service provider

12
Management Responsibilities

• Risk assessment Assess key risks that may arise,
  and options for controlling risks
• Must have contingency plan if service is
  interrupted
• Conduct due diligence in selection of service
  provider to ensure service providers competence
  and stability
• Contract must explicitly specify terms and
  liabilities of both parties
• Ensure that terms are appropriate for service and
  result in acceptable risk
• Should be reviewed by legal counsel

13
Required Operational Controls

• Internal control procedures
• Provider should follow procedures analogous to
  those that the institution would pursue if the
  service were performed internally
• Client banks should review these procedures
• Client bank must monitor procedures
• Ensure that service provider is meeting terms
• Bank must have skills necessary to engage in
  monitoring
• Bank must have access to information necessary to
  conduct such monitoring

14
Regulatory Issues

• Bank must keep sufficient records on site to
  allow examiners to fully and effectively assess
  outsourced functions
• Service provider must conduct effective internal
  audits (could be outsourced)
• Banks should review these audits
• Audit results must be available to examiners upon
  request

15
Foreign provider must comply with U.S. laws and
regulations

• Example Bank Secrecy Act
• Cannot release information to third party
• Foreign regulations may not be sufficient to
  ensure compliance
• Bank is responsible for maintaining oversight to
  ensure compliance with U.S. laws
• Transparency
• Examiner must be able to reconstruct activities
  related to U.S. bank in a timely manner
• Copies of records must be maintained at U.S.
  office
• Copies of audits must be maintained at U.S. office

16
Potential for Geopolitical Risk

• Bank must have contingency plan to ensure timely
  access to critical information and service
  resumption in event of geopolitical disruptions
• Can hinder ability of provider to provide
  services
• Bank may need to possess back-up arrangement
  with other U.S. providers or service providers in
  other geographic areas

17
Summary of Regulations

• General guideline Foreign outsourcing cannot
  diminish compliance relative to level that would
  prevail if activity were not outsourced
• Reality of Regulatory competition
• U.S. banks competing with both foreign banks and
  U.S. non-banks
• Goal is to ensure foreign outsourcing conducted
  safely, not to preclude it

18
Conclusion

• Fast growth of foreign outsourcing by U.S. banks
  provides new challenges to bank regulators
• As always, challenge is to ensure adequate
  compliance without stifling activity
• General guideline is that banks are responsible
  for activities of foreign providers
• Level of compliance must equal that which would
  prevail in absence of outsourcing
• Activities must be sufficiently transparent to
  allow oversight
• In practice, challenges are likely to limit scope
  of activities moved offshore
• Current rapid pace may not be sustainable

19
Business Process Outsourcing

• An Offshore Providers Perspective
• Kenneth Nelson
• November 20, 2003

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BPO--What is it?

• Fundamental building block of business
• A way to accomplish more than you could by doing
  everything yourself
• An approach to doing things better, more
  efficiently or cheaper
• Traditional business processes that are
  outsourced
• Manufacturing
• Payroll
• Internal auditing
• Tax Preparation
• Legal
• Reprographics
• Building and landscape maintenance
• Communications networks
• Conventional wisdom (Peter Drucker)
• Do what you do best and outsource the rest!

21
BPO Drivers

• Manufacturing has led the way
• Lower labor costs
• Materials availability
• Fewer regulatory hurdles
• Global markets
• Non-manufacturing Offshore BPO
• Lower labor costs
• Communications skills
• Cultural considerations
• Technology enablers
• Global markets
• Always seeking greater labor arbitrage
• Labor cost
• Labor skills
• Labor supply

22
Product Life Cycle Look at Outsourcing
BPO
Software Services
23
Evolution of Outsourcing

• Place and form
• Domestic to offshore
• International locations shift with labor
  arbitrage
• Outsourcing - Assign part/whole functions to 3rd
  party with SLAs
• Insourcing - Establish your own captive center
  offshore
• Extrasourcing Intelligent outsourcing of
  specific tasks in tightly coupled,
  collaborative, manner

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Next Steps in Evolution of BP Outsourcing

• Challenge conventional wisdom
• A new look at what you do best/outsource the
  rest in BPO
• Understand importance of domain expertise in
  BPO?
• Knowledge acquisition and transfer
• What knowledge in the BP is most difficult to
  transfer
• Who is the repository of that knowledge?
• Who is the go to person, the domain expert

25
Next Steps in Evolution of BP Outsourcing

• Focus on Maintain and Gain
• Maintain Control
• Maintain Accountability
• Maintain domain expertise
• Maintain Compliance
• Gain benefits of labor arbitrage
• Prepare by pruning and simplifying
• Identify that portion of the BP that leads to the
  action or decision (i.e. pay or not pay)
• 80/20 rule says that 80 of work in BP is
  performed to enable/inform the most important 20
  of work
• Achieve Portability
• Overcome difficulties in knowledge transfer
• Retain Domain Expertise
• Ensure flexibility to adapt to change
• Basis for Risk Mitigation in outsourcing strategy

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A BPO Example
Typical Accounts Payable Process
Cost 3 to 10 per invoice
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BPO Prune and Simplify

• Overcome
• We have always done it that way
• We wont pass an audit if we move it
• The regulations cause us to do it that way
• Our customers require it to be done that way
• Our vendors expect it
• Key to Portability Prune the paper!
• Weve been truncating paper for years
• Weve accomplished a lot
• Check Processing
• Pass-through-processing in Clearing Trades
• Some we just cant seem to get rid of
• Notarized documents
• Original signatures
• External entities
• Document repositories
• Portability in BPO gained by
• Severing the tie to paper

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A Portable BP
Pruned and simplified
Exception Handling
From your outsource provider

• Searchable Image Database
• Matched Transactions
• Pending Receipts
• Pending Invoices

Payment Schedules
Cost 35 to 1 per invoice
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Whats Different?

• Whats not new
• Concept
• Technology
• Drive for process simplification
• What is new Greatly reduced costs
• Software tools
• Open source
• Elimination of per-seat pricing
• Communications
• Bandwidth
• Network Monitoring
• Portable business processes
• Maintain control
• Maintain accountability
• Maintain domain knowledge for value adding 20
• Achieve efficiencies and cost savings

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Common BPO Issues

• Where?
• Depends on
• Outsourcing Strategy
• Tier
• Risk
• Buy, build, lease, etc.
• Market strategy
• Facilitate entering new market
• Corporate policies
• Above/below public radar
• International
• Financial condition
• Survival
• Start-up
• Available capital
• Size?
• Solution for everyone depending on.
• Shared services model for lower volume
  applications
• Scalability

31
Common BPO Issues

• Control?
• How do you control remote locations now?
• Adapt controls for 24-hour day
• The management day is much longer
• Dedicated oversight in your U.S. office
• Expatriate presence offshore is important
• Implement
• Clear metrics and real-time scoreboard
• Real time monitoring
• Communications and more communications
• Cultural differences are important
• Holidays are different
• Language is important
• Complement multi-media contact with visits
• Build a collaborative team
• Systems?
• Extending systems offshore
• Licensing
• Asset management

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Summary

• Focus on Maintain and Gain
• Maintain Control
• Maintain Accountability
• Maintain domain expertise
• Maintain Compliance
• Gain benefits of labor arbitrage
• Prepare by pruning and simplifying
• Identify that portion of the BP that leads to the
  action or decision (i.e. pay or not pay)
• 80/20 rule says that 80 of work in BP is
  performed to enable/inform the most important 20
  of work
• Achieve Portability
• Overcome difficulties in knowledge transfer
• Retain Domain Expertise
• Ensure flexibility to adapt to change
• Basis for Risk Mitigation in outsourcing strategy

33
NICSA West Coast Regional Meeting SEI
Investments An Offshoring Case Study
34
SEI InvestmentsCorporate Overview

• Deliver financial wellness solutions by focusing
  on innovative, complete business solutions
  strongly enabled by technology and offered via an
  operational model that is both scalable and
  leverageable across all SEI businesses worldwide
• Wealth Solutions offered to Individuals,
  Intermediaries and Institutions in both ASP and
  BSP models
• 2002 Revenues of 621 million (5 Year CAGR 14)
• 1700 Employees (800 in Operations)
• Operating in 14 countries

35
SEI Investments2002 Revenues by Market
Investments in New Business 45.0 million 7
Private Banking Trust 324.5 million 52
Money Managers 46.2 million 8
Enterprise/Retirement 55.8 million 9
Investment Advisors 149.2 million 24
36
SEI Investments Operations Overview

• Client Services
• Client Support
• Product Support
• Knowledge Mgmt
• Administration

• Transaction Services
• Transaction Processing
• Securities Processing
• Cash Processing
• Custody

The Operations Units design, develop, and
operate global, leverageable and scalable
service platforms that enable the creation of
new solutions, facilitate entry into new markets
and continually increase operational
efficiency. Our goal is to be a strategic
builder and operator of SEIs business processes.
Advise
Design
Build Integrate
Operate Maintain

• Accounting Services
• Pooled Accounting
• Fund Accounting
• Custodial Recon
• Financial Admin

• Reporting Services
• Performance Rpting
• Tax Reporting
• Financial Reporting
• Regulatory Reporting

37
SEI InvestmentsCurrent Condition

• Strategic shifts in all markets to a total
  solution offering built upon straight through
  business processes
• Increasing diversity and complexity in business
  functions
• Shift from ASP to BSP in all businesses
• Demand to accelerate the globalization of
  revenues
• Continued emphasis on leverage and scalability
• Investment in future technology platforms to
  enable straight through business solutions and
  globalization
• Imperative to transform and globalize operations

38
SEI InvestmentsFuture Operational Model
Client Experience
Leveragability
Flexibility
Scalability
Speed to Market
Global
39
SEI InvestmentsPath to Global Sourcing

• Need to commit to an offshore operations center
  in support of global business
• New technology platforms enable greater
  distribution of functions
• Desire to focus on transformational activities,
  optimize non-core legacy processes, and
  maintaining or enhancing service quality
• Need for lower overall cost of operations to help
  fund the investment in new platforms

40
SEI InvestmentsPath to Global Sourcing

• Established a core team to research BPO market,
  in India and elsewhere
• Mapped out an evaluation process and objectives
• Interviewed providers and consultants on-shore to
  deepen our understanding and prepare for site
  visit
• Began a preliminary assessment of processes that
  were candidates for offshoring
• Began educating senior management about the
  potential for BPO
• Completed a two week visit to India to understand
  the landscape

41
SEI InvestmentsObservations from Site Visits

• BPO industry is nascent, with early success in
  migration and stabilization of processes
• Much experimentation underway
• Tremendous investment in infrastructure to
  support rapid growth
• No clear trends in services offered, but early
  trials focused on low risk processes
• Market is beginning to segment, but few providers
  can articulate a clear strategy beyond labor cost
  arbitrage
• Technology is being applied tactically, not to
  transform strategically

42
SEI InvestmentsObservations from Site Visits
ITS ABOUT THE RELATIONSHIP
43
SEI InvestmentsOur Process

• Refine target processes
• Engage candidate firms to conduct an assessment
  of our operations in order to
• Validate our target processes
• Identify other opportunities
• Begin to quantify the potential benefits
• Experience working with the partner firm
• Identify two pilot processes for offshoring
• Pick a partner, structure the relationship,
  negotiate critical terms and SLAs
• Begin transition and pilot

44
SEI InvestmentsCritical Areas of Focus

• Structure of the relationship
• Cultural fit
• Structure of oversight
• Quality standards and monitoring
• Process effectiveness review
• Financial oversight
• Effective knowledge transfer and technology
  migration
• Compliance and data security
• Employee and community issues