Technology is playing an increasingly vital role in the competitiveness of financial institutions. Many are beginning to look to IT groups not only to support their current activities, but also to open up and develop new business. Such a mission calls for a new kind of IT organization. Shifting its focus away from the low-value task of actually writing software, the IT group of the future will be able rapidly to develop, design, and integrate new products and systems.

Outsourcing has long been used by companies that cannot achieve scale in their data center operations or telecommunications. However, the outsourcing of applications development is becoming more and more important for even the largest financial institutions. While outsourcing is not a panacea, IT groups do need to develop explicit strategies distinguishing the functions that will be performed internally from those that are better sourced outside. CIOs need to understand the specific objectives and rationale behind any outsourcing activities, and how these fit in with the group’s overall technology strategy.

The IT units that emerge are likely to be much smaller than today’s organizations, and much more flexible. They will act as systems integrators, drawing heavily on third-party vendors. In this capacity, groups will have to master business skills that lie outside the traditional IT arena, such as supplier management and contract negotiation. Even within that arena—in transaction processing, for instance—most of the value added will derive from managing design and integration.

High-quality third-party system developers are, of course, central to such a strategy. These independent operators are getting better at handling applications development, and they are building a large clientele. External providers now command a substantial share of total spending on applications: 19 percent worldwide and 30 percent in the United States, excluding PC applications. Their share is expected to continue growing steadily, particularly in the banking and finance sector.

Offshore providers hold out opportunities to cut costs on commodity-type coding provided they are properly trained and managed

The majors, such as IBM, Andersen, EDS, and Cap Gemini, offer broad technical capabilities and deep capacity. Niche players like Computer Horizons and Applied Communications can supply specialist skills and access to industry best practices (in merchant clearing, for example). Offshore providers like Tata hold out opportunities to cut costs on commodity-type coding provided they are properly trained and managed.

While few companies have completed this transformation to the new model, there are clear signs that a number of them are moving in this direction, while the external market for services continues to mature. Most recently, one of the major Swiss banks entered into an agreement with Perot Systems. This transaction included giving Perot a 40 percent interest in the bank’s applications development unit as well as a contract to run the data processing operations.

Similarly, a US money center bank has outsourced about 25 percent of its total applications coding, primarily in utility applications like forex where internal development confers no competitive advantage. It set up an outsourcing center to build and institutionalize market knowledge, screen all systems for suitability, and negotiate vendor contracts. Outsourcing has enabled the bank to cut its IT costs and make them variable, shift talented staff to more important tasks, and impose discipline on its business units.

Why outsource?

The near-term benefits of this strategy are many. However, as with all structural changes, there are tradeoffs and risks, and outsourcing decisions need to be made in the broader context of an overall technology strategy. The focus on outsourcing can help guide IT investments by improving tradeoffs of time and money. While "soft" costs are often concealed in in-house development, all costs are real and visible in an arm’s-length arrangement. This transparency supports value-based decision making and encourages the use of standardized software provided by vendors.

Outsourcing coding also allows a smaller internal group to concentrate on business development, design, and integration—the areas where most value is added. Traditional applications development is often dominated by major infrastructure projects. However, business demands on IT organizations are changing, and development efforts will probably shift away from infrastructure toward new products. Such a role calls for more sophisticated business and design skills and heightens the urgency of freeing the best staff from commodity-like coding activities.

Finally, outsourcing can also enhance cost-efficiency if systems and projects are segmented and the pieces matched to appropriate vendor capabilities. IT organizations can save money on lower-end utility coding and maintenance by managing offshore developers astutely. A checklist of factors to consider in deciding to outsource or stay integrated is presented in Exhibit 1.

For most financial institutions, the challenge lies in moving to the new model without disrupting ongoing business, ceding too much bargaining power to vendors, or sacrificing truly distinctive capabilities. The first step in the transformation is to choose an outsourcing strategy linked to your business situation (Exhibit 2). Once the strategy is in place, what determines success is the day-to-day effectiveness of managing vendors, managing schedules and investments, and managing human resource risks.

Bargaining power

Managing vendors is a complex activity, demanding a deep understanding of vendor capabilities and economics, good relationships with a shortlist of vendors, and expertise in contract negotiation. Perhaps most difficult of all, it entails managing vendors actively at all stages of a project. Having only just started down this road, most IT organizations need to build substantial vendor management capabilities virtually from scratch.

Taking steps to build a deep understanding of vendor capabilities and economics is a vital prerequisite to large-scale outsourcing. The outsourcing market is getting crowded, and knowledge of services offered, capabilities, and implementation track records helps to narrow the field. A sophisticated approach might involve screening prospective vendors in terms of project type, size, and complexity, and pairing specialist boutiques with the capacity of larger firms. Equally, a strong grasp of vendor economics is valuable in contract negotiation, allowing projected vendor productivity gains to be built into pricing.

Organizations must strike a balance between maintaining competitive pressure and building strong relationships with selected vendors (Exhibit 3). Both halves of the equation are important; outsourcing can deliver no benefit if the vendors walk away with the value created. The balance depends on a credible—even if rarely exercised—threat of switching. Having a viable second source, which can be achieved by rotating projects among several vendors and promoting competition, is the most effective approach.

Other best practices include dividing projects into discrete phases with clear and usable interim deliverables, and selecting vendors with an interest in future deals. Similarly, contract provisions such as short terms (say, five years, with two-yearly renewals), frequent delivery of documentation, and termination clauses providing for the return of key staff help to minimize switching costs and maximize credibility. The best companies go even further to limit vendor bargaining power—for example, by demanding "open books" and requiring occasional rebidding. The final lever is retaining internal development capacity, supported by specific system knowledge and up-to-date documentation.

Vendors need extensive acclimatization to understand the style, standards, and culture of the customer

Using such techniques to establish a stable vendor pool has proven vital to outsourcing success. Experience suggests that vendors need extensive acclimatization to understand the style, standards, and culture of their customer. Any outsourcing arrangement will bring considerable learning curve costs to amortize. Finally, while strict rules-governed relationships can and should be used to deliver certain basic services, real collaboration and value creation are more likely to arise from a trust-based relationship.

It is crucial that IT organizations build expertise in structuring and negotiating contracts. As well as determining future bargaining power, contract negotiation fixes prices, performance expectations, and risk-sharing. While best purchasing practice calls for simple, manageable contracts, there is much to include: business-oriented performance measures, such as availability and customer satisfaction; fixed and/or variable pricing, and links to productivity gains; delivery milestones; anticipated changes in the terms of the relationship; and more (Exhibit 4).

Time and money

The outsourcing process must clearly link all projects to business objectives to prevent "scope creep"

Outsourcing requires IT managers to become far more sensitive to investment priorities and project management. One of its major benefits is the clarity it brings to cost/benefit analysis. But vendors cannot clarify costs without clear direction, and businesses are not yet skilled at articulating benefits and making tradeoffs. The outsourcing process must clearly link all projects to business objectives to prevent what might be termed "scope creep." It should also break large projects down into components or distinct phases in order to facilitate project negotiation and vendor management.

Vendors should provide rigorous time and cost estimates. In many companies, the IT group scopes projects quickly to provide benchmarks for evaluating vendors, and then works in a close, iterative process with the business users to make cost/benefit tradeoffs within each project. Helpful approaches include working with business units to determine which cost/benefit model to apply, and developing rules of thumb to verify vendors’ cost estimates in the absence of a full costing system.

The outsourcing process requires a tightly managed timetable to counter the risks of delay and error arising from the handoff, and to provide sufficient notice for vendors to react to project shifts. Some outsourcing organizations use a quarterly or even monthly internal system to assist with allocating resources to vendors. Companies new to outsourcing will need to streamline their internal timetable to avoid bogging down the whole process.

Effective outsourcing also means that IT organizations must strengthen their design and integration practices and close any skill gaps. Many companies make extensive use of prototyping, which is driven by the business users and carried out with simple tools such as Visual Basic (or even pencil and paper). While particularly valuable for desktop applications, prototyping is also useful for mainframe transaction processing systems. This approach addresses a problem common with outsourcing: requirements that constantly change as the understanding of needs shifts.

In addition, IT organizations should take firm control of vendor communication throughout the development process. This means adopting a disciplined approach and identifying a regular point of contact within the organization for all decisions. But the business area will also need to talk directly to the vendor, so it is important to determine—perhaps by means of a sample project—how the three parties should interact. Performance metrics and documentation standards should also be defined early in the process.

Human risks

The high mobility of talented programming staff makes human resource risk management critical during changeover

Increased outsourcing may mean a large flow of staff into vendor organizations. Moreover, the IT organization will need to modify the skills mix of its staff to boost design and integration capabilities. The high mobility of talented programming staff makes human resource risk management critical during the changeover process.

There are several ways of making this transition:

• Announce the timetable early. Ater completing initial preparations, announce the overall objectives and the timetable for displacing systems and staf. This approach is consistent with good people management and reduces technical risk, but carries higher business risk because of the likely duration of the transition and the number of staf who must be retained over this period.
• Announce as you go along. As each system or area is prepared for outsourcing, announce the staf changes on a rolling basis. This approach may reduce human resource risk, but it may also destroy staf morale and trust.
• Announce when you are ready to go fast. Finish all preparations for large-scale outsourcing and make a single announcement of objectives, staf impact, and timing, leaving only a modest (say, 30- to 60-day) period to complete the transition. Though it carries the lowest human resource risk, this option is more risky technically, as it allows little margin for error or time for learning.

The option an institution chooses will depend on its style of people management and on such issues as the systems to be outsourced, the number of people affected, the lead times, the degree of trust in vendors, the availability of multiple providers, likely switching costs, and vendors’ staffing needs. It often helps to divide the staff affected into three broad categories: retain long term, transfer immediately to vendor (or separate), and retain as critical to the transition. Where this latter group is concerned, helpful approaches include offering appropriate incentives, ensuring systems are thoroughly documented early in the transition, and defining back-up teams.

It is just as important to tell top-performing staff that they have an attractive future in the new IT organization. Since contractors usually represent a high proportion of staff, their employers should be brought into the planning process to secure their support.

Financial institutions are becoming increasingly information-intensive, and technology is accordingly becoming more central to new product development, profitability, and competitiveness. In their new incarnation, IT groups will be smaller, but far more powerful, and far more involved in creating real business value.