The ins and outs of outsourcing

Product and operating managers are challenged daily to prove and improve the value of providing letter-of-credit processing services for their banks. Gerard Sheridan identifies the primary profit and cost drivers and looks at a typical trade outsourcing model. He also explains how establishing a strategic trade partnership can be a “win-win” situation for both the insourcing and outsourcing bank.

Banking services are critical to the trade cycle, and credit services (such as credit facilities, confirmation, pre- and post-export finance and foreign exchange) can be separated from the processing functions of issuing/advising, document examination and payment. A critical analysis of bank trade revenues and expenses concludes that, while all banking functions generate revenue, it is the credit components that actually drive profitability.

Many managers facing the task of justifying the stand-alone value of commercial LCs are having difficulty doing so because they have not clearly identified the difference between profit drivers and cost drivers. Additionally, some banks include very high credit revenues, such as standby LCs, in their profitability numbers. However, these standby revenues should be considered separate and distinct from commercial trade revenues. Standby LCs, although they do have processing components, are principally financial instruments whose revenue is almost entirely credit-related and can easily mask the overall profitability of the commercial LCs business. The following discussion focuses on commercial LCs – those used for imports and exports. Trade expense is heavily driven by processing activities – issuing and amending LCs, examining documents, resolving discrepancies, answering enquiries, reconciling transactions and effecting payments.

These activities are still very labour intensive and, because they are complex and problematic, they require significant scale, investment and management expertise to be profitable. In addition, the cost of the technology required to deliver trade services competitively is continuously increasing.

Many banks believe that a vendor software package can solve their profitability issues, viewing their purchase simplistically as representing the total cost to the bank. They generally overlook the true costs of a software package, which include the additional costs of telecommunications, systems integration, data-centre expenses, back up and contingency, ongoing software upgrades, annual maintenance fees, staffing help desks and more.

Many banks have an opportunity to increase revenues significantly by providing services to both the importer and exporter of the same transaction. This opportunity is often overlooked because either the importer/issuing bank or the exporter is viewed as the customer and not as both. As long as a high degree of integrity is maintained, the bank can act as the issuing and negotiating bank to create excellent value for both parties. Another key reason why many banks do not fully benefit from the business they have sourced is because they do not have the global reach to act as both the issuing and negotiating bank in multiple locations.

The value of outsourcing

The concept of outsourcing is fairly simple: outsource cost drivers while maintaining and enhancing profit drivers. There are several variations to the outsourcing model, ranging from partial outsourcing for particular service or technology needs to full outsourcing. In general, the best model for a particular bank is one in which the outsourced bank maintains as much of the credit relationship, financing, foreign exchange, sales and consultative functions as possible, while choosing to outsource as many of the operating and technology functions as possible.

Ideally, the bank chooses an insourcer who can perform these operating and technology functions with a higher level of quality than the outsourcer (based on investment), while, at the same time, providing the services at a lower cost than the outsourcer (based on scale). Additionally, the insourcer should be able to provide the outsourcer with opportunities to increase revenue by expanding the outsourcer’s global reach and ability to generate new fees from existing transactions.

Working with an external consulting firm, The Bank of New York developed a model of a typical mid-sized bank with an even split of business between import and export transactions. We found that if you take away the credit fees (standby commission, issuance commission, confirmation commission, acceptance commission, and foreign-exchange commission), the remaining processing fees (flat fees charged for advising, amending, examination, discrepancies, telexes, etc) do not adequately cover the cost of performing those processes. We also found that, although the combined credit and processing revenues could generate very attractive operating margins, the operating margin for commercial trade processing alone could be as low as negative 40%.

In the end, the credit revenue subsidises an expensive operation and the overall profitability is significantly reduced. This is becoming more and more common as the competitive and technological environment quickly changes, affecting trade-profitability dynamics in a negative way. In this environment, a “business-as-usual” approach can easily mask negative operating-margin performance.

Overall profitability margins improve dramatically in an outsourcing model where the outsourced bank keeps all of the profit-generating components, seeks out opportunities to increase both importer and exporter revenue streams, and outsources trade-processing functions. This model, and The Bank of New York’s experience, suggest that a bank can convert unprofitable processing functions into net gain. Add this new net income to old credit revenues and the result is a dramatically improved operating margin for the total business.

Why would a bank be in the insourcing business if processing margins are so low? The answer is that the insourcing bank generally has a very different perspective and cost dynamic. To the insourcing bank, the additional business can be brought on profitably at marginal costs that are below the costs of the outsourcing bank. Additionally, the insourcing bank is not taking on any of the credit exposure. In effect, the outsourcing bank provides the insourcing bank with additional scale and margin without using its balance sheet.

Outsourcing is a “win-win” situation for both the outsourcer and insourcer because it:

Leverages the outsourcer’s operations, technology, product development and experience;
Expands the insourcer’s and outsourcer’s geographic reach – the outsourcer gains new international branches and the insourcer gains a new sales force selling its operating capacity;
Reduces cost and controls the outsourcer’s expense growth, while also improving its operating risk profile and profitability ratios;
Allows the insourcer and outsourcer to concentrate their resources on their core businesses and customer relationships;
Improves the competitive position of both parties within their core business lines.

Insourcing and outsourcing require hard work and commitment by both parties. Finding a long-term partner and setting proper expectations is extremely important. If the outsourcing bank believes it can sit back and ignore the operations altogether, it will be greatly disappointed.

An outsourced operation still needs to be managed to be successful. Likewise, if the insourcing bank treats new customers as captive business that doesn’t need attention, it will quickly find business volumes eroding and a relationship nightmare on its hands. Here are a few steps to achieving outsourcing leverage:

Appoint a senior manager to make an objective assessment of your current business;
Solicit proposals from experienced outsourcers who are committed to the business and that do not pose a competitive threat;
Compare total costs to the price charged by the outsourcer and, if attractive, work with the outsourcer to develop a detailed implementation plan, setting realistic timetables and operating and financial goals;
If you agree that an outsourcing partnership could work for you, establish a multi-disciplinary team to develop and execute the plan. That team should include representation from legal, audit, compliance, trade sales, trade operations, technology and financial functions. The upfront investment needs to be made in order to ensure a long-term benefit.

Clearly, there are no standard solutions for managing the trade-processing business to ensure acceptable and sustainable profit margins. Each situation deserves and requires careful evaluation of viable alternatives, but one of the alternatives certainly worthy of consideration is outsourcing.

Gerard Sheridan is managing director at The Bank of New York in New York.