Drive to Total Outsourcing
Byline: Richard Greensted
Is the outsourcing bubble about to burst? When Barclays Global Investors (BGI) quietly decided to shelve its plans for outsourcing middle and back office functions for its UK business, there was some concern that the momentum of the previous two years had stalled. But most of the leading providers remain bullish about the market's long-term prospects, undaunted by the increasing focus of fund managers on immediate cost benefits, said to be the primary reason for BGI's decision not to proceed.Tom McCrossan, global head of State Street's investment manager solutions business, accepts that there has been a shift of emphasis. He says: "The market is buzzing, but sometimes fund managers have unrealistic expectations of what can be achieved. Our challenge is to create an immediate benefit for our clients while delivering the scale we need to reach our long-term goals."
With research suggesting that as many as two-thirds of managers see cost reduction as the primary motivation for outsourcing, the custodians are being asked to walk a very fine line: do they sell on the basis of instant cost savings, or do they argue that there is much more to outsourcing than simple financial considerations?
Daron Pearce, managing director of The Bank of New York's (BNY) European outsourcing business, recognises the dilemma. He says: "When it comes down to it, managers only ask one question. Will outsourcing save us money? Over three to five years, the answer is definitely yes. But over the short term, it's more difficult. What we do is to excel at helping our clients to avoid future costs."
One of those future costs is the huge investment in technology needed purely to stay in business, let alone remain competitive. State Street's McCrossan gives a highly topical example. He says: "There is a heightened interest in transferring technology risk. Contingency planning, disaster recovery and business continuity have all become big drivers for outsourcing." After September 11, and the on-off plans for T+1 in the US, this is not an entirely surprising development.
But how much risk can managers transfer to their outsourcing partners? According to Tom Abraham, head of Citibank's advisory services group, the issue of risk has only recently assumed a high priority. "Outsourcers are being asked to take on more operational risk, but I'm not convinced that current agreements are sufficiently well structured to cover all the obligations of the parties involved. One of the problems is that the implementation date of Basel II is too far away to make people focus on the issue of risk capital, but it has to be done."
Transferring risk is one of main drivers for outsourcing, according to Rob Mancuso, head of marketing and client management for Investors Bank & Trust (IBT). He says: "Risk is one of the key factors, and we probably spend more time documenting risk exposure and responsibilities than on anything else. Outsourcing should minimise and spread risk." BNY's Pearce agrees. He says: "When managers transfer risk to us, they should also benefit from risk reduction.
Outsourcing clarifies operational performance targets, responsibilities and service levels, which are not necessarily imposed when the functions are run internally."
Citibank's Abraham says that risk management is a function for which the providers need to be paid. "We have to price appropriately for the risks we take on, and that has to be properly reflected in our agreements," he says. The question then arises as to what will happen to pricing as the service model is extended and further capital is required. IBT's Mancuso thinks that the past two years of deals have provided helpful information for the custodians. He says: "At first, pricing of these deals was unexplored territory, but now we all have more experience, and prices will probably reflect that experience. …