The Forge of the Marketplace

Freedom to innovate is one of the liberties that truly make America great. Our American passion for innovation continually pushes us to do better and rewards those who succeed. Bankers support innovation by providing access to borrowed capital, which enables people of modest means to try out new ideas. But we are also entrepreneurs ourselves: over the last 30 years bankers have spawned many new processing systems: core processing systems such as ITI, SilverLake, Open Solutions and Ultradata; check imaging systems such as AFS and DSI; Fair Isaac credit scoring; Hyland OnBase and LQAS document imaging and exception tracking, to name just a few. The list goes on and on, including scads of “ancillary” systems in addition to the marquee examples just named.

Working in their garage or basement, creative bankers combined experience and “a better idea” with very little money (and a liberal dose of guts) to create systems that challenged the conventional wisdom that bank processing required mainframe computers. Banks and credit unions large and small now do much of their work using them.

Enabled by the shift toward inexpensive client-server and PC-based distributed architectures, the hallmark of most of these systems was that they were easy to use, could be run “in house” without a large technical staff, and delivered cost savings and better control of priorities. With few exceptions the marketplace rewarded these pioneers for challenging the conventional wisdom.

However, time moves on and things change. Once-little Jack Henry and Associates’ Silverlake system and Fiserv’s Signature system now process tens of billions of bank assets every night. The Hyland OnBase system, literally designed in pencil on the back of a brown paper grocery bag, is now the repository for trillions of document and check images. Fidelity’s premier check processing system, formerly known as AFS ImageVision, processes checks and images for some of the largest U.S. banks and thousands of community institutions.

I call this relentless pursuit of improvement “the forge of the marketplace,” and it sooner or later forces other changes. Clearly, there are functions that banks will always prefer to keep in house, but the number and scope of outsourcing options grow larger daily. Core processing, item processing, credit card accounting, cash vaults, ATM servicing, physical security, lockbox, statement/notice printing and rendering, auditing, loan review, compliance and network administration are just a few examples. The list is endless!

How does a bank evaluate when to quit doing something for itself and turn it over to an outside provider? Here are some of the considerations to think about when evaluating outsourcing:

1. Do we need to be leading-edge in this particular area of our operations?
   Most organizations know that they can’t be all things to all people. If the bank’s corporate strategy requires it to be leading-edge versus merely competitive, it should assess whether that goal is being achieved.
2. Can professionals who do this time and again do it better?  
   When an organization only does something infrequently or on a limited basis, it never has the opportunity to develop mastery. For example, if a bank only makes a major system change once every decade or so, it understandably will not develop the expertise to do it well. Consider that there are experts out there with the proven ability to deliver excellence right from the git-go.
3. Do we want to dedicate scarce personnel resources to this function?
   Devoting in house personnel may not be the optimal use of a bank’s resources. Outsourcing can enable a bank to “level the playing field” and then rapidly adopt best practices with vendor assistance.
4. Can we do it internally at less cost than if we turn it over to an outside organization?
   It is usually not good enough to be able to perform a function as inexpensively as an outside party. If the bank is doing it at the same cost, it is probably not adding value. Sharing of overhead and leveraging of expertise leads to reduced costs.
5. Will our volumes change rapidly, up or down, in the near future?
   Outsourcing shifts some of the burden of capacity planning to the other party. If rapid increases are expected, the other party must obtain the necessary resources. If rapid declines are expected, shedding people and equipment becomes the vendor’s problem.
6. Is this function burdensome from a regulatory perspective?
   Outsourcing allows sharing of some regulatory burdens with vendors and other clients of that vendor, but not all risk can be outsourced; in most cases the bank will ultimately still be responsible for regulatory compliance.
7. What will happen if we outsource this function and it doesn’t work?
   The bank will want to evaluate whether the function can be brought back in house or turned over to competing vendors if the outsourcing effort does not go as planned.
8. Would we lose technical skills that are required for our future success?
   This is an argument both for and against outsourcing. If the bank has access to the best and brightest in its labor pool, it may be better to keep a function in house. On the other hand, those who outsource may have access to the best and the brightest on a national scale.
9. Does doing it in house maximize shareholder wealth over the long term?
   Take a look at whether outsourcing would provide short-term gains at the expense of long-term profitability. Is the bank leveraging the future by outsourcing?
10. Does outsourcing mean management loses control?
    A couple of common myths about outsourcing are that management will lose control and that less management is required. Different management skills may be required to manage an outsourced function, but when it is done well, outsourcing neither requires less management nor does it reduce management control.

Consider the example of item processing. Driven by changing consumer preferences (popularity of electronic transactions – PIN and signature debit, ACH and online bill pay), technological change (rapid decline in the cost of imaging hardware, growing availability of high-speed networks and wireless communications) and regulatory change (Check 21), the world of item processing is very different today than it was a three short years ago. Distributed capture (branch, merchant and in some cases teller) is no longer optional. As a result, community banks and credit unions have adopted this technology by the thousands. Simultaneously, though, this is complex technology. Critical competencies include preventing presentment of duplicate images or IRDs, maintaining satisfactory image quality, maintaining precise controls over significant numbers of low-dollar transactions, and managing hundreds or thousands of remote capture devices. All of this must be done while managing fixed costs in a declining transaction volume environment.

For many organizations, item processing is no longer a function that must be done in house, absent uniquely compelling circumstances. Item processing has become a commodity, and doing it in house doesn’t pass 9 of the 10 criteria listed above. There are many other functions banks would be well-served to NOT do for themselves in a tough economic climate. The 10 criteria listed above provide a useful framework for evaluating almost any outsourcing decision.

The banking marketplace is a fiery furnace, continually refining products, services and best practices. This persistent refinement can be a banker’s ally or enemy. Where a bank has a better strategy and the ability to execute that strategy it is usually vital to keep and enhance those competitive differentiators by sourcing those products or services in house. Where a product or service has become humdrum, available from any financial institution, bankers owe it to their investors and customers to consider outsourcing those functions to specialized providers who have economies of scale and who can compete nationally or globally in those commodities.

Our American passion for innovation is always pushing us to do better. The Forge of the Marketplace, characterized more brutally as the Survival of the Fittest, forces a re-thinking of “conventional wisdom” again and again. Excellence in strategic execution is a core management competency that cannot be outsourced, but just about anything else can be.
-bm

 

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