Large application outsourcing transactions in the banking sector hit a record five-year high last year, according to a recent report by outsourcing consultancy Everest Group. There were 54 new big application outsourcing projects in the sector with a total contract value of $5.9 billion in 2015—an increase in volume of 45 percent and in value of 25 percent over the previous year.
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Financial institutions tend to outsource applications around three different dimensions, says Jimit Arora, partner at Everest Group There are systems to run the business which are outsourced for cost reduction and efficiency reasons. There are systems to manage the business, which may involve issues of regulatory compliance or cybersecurity and are driven by cost or penalty avoidance. And there are systems to change the business, which are efforts to drive revenue growth by introducing new products and services more quickly.
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Typically, those “run” and “manage” categories drive the outsourced IT application projects, Arora says. But digital transformation efforts are clearly driving an increase in application outsourcing. “Half of analyzed application outsourcing deals in banking in 2015 had elements of digital transformation in their scope,” says Arora. “These could be engagements that had elements of mobility, big data, cloud, social media, artificial intelligence, or block chain for example.” Banks are looking to third parties for these large transformational projects in order to more easily and quickly access the talent required to deliver them.
Outsourcing is clearly not just a simple cost cutting measure for banks. It’s “also about getting access to the right talent in the right location to enable transformation initiatives,” says Arora. “More specifically, there are clients (especially in the mid-market) who have traditionally preferred a DIY approach to run, but changing market dynamics are forcing them to partner on digital transformation initiatives. This is also shifting the nature of the marketplace from longer-term annuity based contracts to shorter, project-based engagements.”
At the same time, financial institutions are seeing increased cost savings from outsourcing systems for running the bank more efficiently, which can further fuel investment in other areas. And they’re doing it by switching IT service providers. “The nature of the game in the financial services space is that incumbency is proving to be not such a great thing,” says Arora. “Clients have option value in the market today, and there are challengers who are guaranteeing 30 to 50 percent cost reduction on the run spend through aggressive automation. This is requiring the incumbent service providers to cannibalize their own book of business or face elimination in their existing accounts. So the savings are very real.”
Simplification via digital means will help banks reduce costs
Looking ahead, IT budgets in the banking industry are expected to remain flat or inch up slightly from 2015. The spending emphasis will be on simplification, says Arora. In order to compete in a market that is becoming more crowded and disruptive, banks must simplify business operations, regulatory compliance, and user experience to reduce costs and remain successful.
“Banks are progressing in the right direction,” says Arora “On the retail deposits side, we believe banks invested in time to offer the digital-only options in the marketplace and are adequately secure from challengers. However, in the areas of payments and mortgages we believe the traditional banks are vulnerable.” A majority of digital transformation dollars to date have been invested in customer-facing systems, leaving back-office systems largely paper based.
“This disjointed approach to creating digital workflows—a function of how banks are organized—causes friction and value leakage,” Arora says. “Take, for example, a mortgage, where a client may start by using digital systems of engagement but quickly runs into a paper environment in the middle or back office where the process breaks down and [takes] weeks.” A digitally native competitor can easily win over that customer.
Another issue is that many financial institutions also lack a well-designed enterprise digital transformation strategy. “Ad-hoc adoption of digital technologies such as mobile and data analytics do not allow banks to own the entire customer experience journey,” Arora says. “The true benefit of these investments is realized at the convergence of these technologies.” The average bank is running more than 1,000 different applications, often in a siloed way, limiting their ability to generate actionable insight from those systems the way a new company might be able to.
Outsourcing could help banks overcome these issues. It depends on how the banks approach their IT application outsourcing, Arora says. “Outsourcing done the traditional way—think of the functional siloes —will continue to emphasize the challenges outlined above. The new demand profile is different, and therefore the supply model needs to evolve as well,” he says. “However, in some situations outsourcing can also act as the bridge that helps a large bank collapse functional siloes and think of vertically integrated, front-to-back solutions.” Expect more as-a-service deals that involve business process, application, and infrastructure: enrollment-as-a-service, for example, or claims-as-a-service.
“Also, service providers have matured to become business partners, with a willingness to engage in an outcome-based engagement model,” says Arora. “Most of the service providers have a dedicated strategy where they partner, build, and buy these startups and can bring to the table capabilities that an individual bank may not be able to bring on its own.”