Slow on the uptake

Roxane McMeeken finds out why so many institutions are refusing to jump onto the back-office outsourcing bandwagon, despite the advantages on offer. “The back office adds no value for investment houses and should be outsourced. It’s time to focus on the front end.” This is the view of Ruwan Weerasekera, partner for wealth management at Accenture. But if outsourcing the back office is so desirable, why have so few institutions taken the plunge? A good deal of scepticism surrounds the concept. The first question for a private bank or retail fund manager considering outsourcing their back office is which model to adopt. Should they opt for the “lift out” model, where the custodian effectively buys their back office and runs it as it is, or the alternative model, where the custodian goes into the back office and reconfigures it to fit with its own systems? The benefit of the lift out is that it is immediate. The problem is that its success relies heavily on the strength of the fund manager or bank’s existing back-office systems. While the outsourcing service provider is taking over these systems and will be likely to work on improving them, the provider is not offering the chance to switch to pre-existing proprietary systems. Barclays Global Investors (BGI) commissioned Investors Bank & Trust to lift out its back office in the US in the summer of 2001. While BGI has not complained about the arrangement, a recent internal review of business operations in Europe concluded the back office here should remain in-house. A spokesman in London said BGI thought this arrangement would best serve customers. Another way The alternative route to back-office outsourcing has the disadvantage of taking several years to complete. Only now are the first projects, such as that signed between custody giant State Street and Scottish Widows Investment Partnership in the UK, coming to a close. Roger Fishwick, director of ratings at custody consultants Thomas Murray, says this means the outsourcing idea is “still unproven”. He says another cause of scepticism among potential outsourcers is the loss of momentum in the drive towards trade settlement in one day – a capacity that would require up-to-the-minute back-office systems. At the peak of the bull market there was a sense of pressing urgency to reach T+1. But without the anticipated jump in transaction volumes and with the collapse of the Global Straight Through Processing Association, whose mandate was to urge the market towards T+1, the goal of shorter trade cycles has slipped to the bottom of the agenda. Cost control A further problem, says Mr Fishwick, is that contrary to what some had thought, “you don’t save any money by outsourcing”. It is rather “a case of avoiding future capital expenditure” and “in this economic climate people are interested in cutting costs now.” “It won’t be until the big deals are established that fund managers will be able to control costs,” he says. “The third, fourth and fifth deals done by a service provider will probably be priced more competitively as it becomes cheaper to offer the service.” The other side of the coin, Mr Fishwick says, is that while smaller fund managers might be interested in outsourcing, they are having trouble finding any service providers willing to take them on. Again, the reasons are economic. Yet despite all this, Mr Fishwick stresses that eventually, “everyone wants to be there”. He says that the benefits of outsourcing are difficult to deny. Research from outsourcing pioneer Bank of New York (BNY) suggests that “back-office type costs” account for 30 per cent of fund managers’ overall expenses. In addition, technology costs typically account for a further 20 per cent. This means 50 per cent of fund manager costs are as a result of operations. With this in mind, Jeff Tessler, executive vice-president and head of Europe for BNY, outlines three key benefits of outsourcing:

• it converts cost from a fixed to variable basis, removing the fixed overhead of running the middle and back offices means that costs are volume based;
• it aligns revenues with expenses, the core business activity of the fund manager actually drives the cost base, rather than the other way round;
• it protects the managers from non-core infrastructure costs, managers have been asked to pay for a whole series of events – the euro, Y2K, etc – that adversely affect the bottom line, but that probably add no real value to their operations. Delegating outsourcing responsibility to the outsourcing partner means a significant reduction in expenditure for non-business-related projects. Increasing impetus BNY’s head of European fund services, Nick Parkes, adds that a number of European fund industry trends are increasing the impetus towards outsourcing. These include the growth of third-party fund distribution, especially through web channels, consolidation among product providers and the dominance of bancassurers in the pan-European distribution arena. These factors will put particular emphasis on transfer agency and should therefore encourage the back office to be outsourced in order to ensure this function is carried out optimally. So why are institutions holding back? Thomas Murray’s Mr Fishwick says one problem could be that they would rather outsource components of the back office instead of the whole thing and custodians – especially the large ones – are not responding flexibly enough. “Many institutions are not keen to hand everything over to the one provider. Take for example securities lending. Many fund managers are battling their custodians for the freedom to use third party stock lenders.” Component outsourcing Mr Fishwick predicts custodians will begin to respond to such demands and increasingly offer component outsourcing, where they only take over a particular back- or middle-office service, such as record keeping. BNY, claims Mr Tessler, is happy to offer component outsourcing. He notes that it is particularly desirable for retail players because of their focus on distribution to the end investor, and consequently the importance to their business of transfer agency and administration. These two functions can be neatly outsourced as separate services. Another issue discouraging institutions from full scale outsourcing is the difficulty of undoing the move once it has taken place, according to Tom Abraham, global head of strategic solutions group at Citibank Global Securities Services. Outsourcing the back office is such a major and expensive undertaking that it is safe to say once it has happened there is almost no going back. Again, component outsourcing looks like a good solution. Citibank is convinced that outsourcing “needs to be founded on smaller scale projects with an easier ability for the respective parties to exit or stop, if the anticipated benefits are not achieved,” says Mr Abraham. “Our own strategy is predicated on leveraging capabilities within Citigroup and focusing on specific functions, such as funds administration or specific problem areas, such as corporate actions.” So it seems that outsourcing could benefit private banks and retail fund managers. But while they are aware of this fact, they are holding back until it becomes a more economical move and one they can undertake on their own terms.