| With outsourcing set to increase financial institutions need to be sure that it is right for them |
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| Outsourcing has played a key role in the development of the Irish financial services sector, with a significant proportion of IFSC companies providing third party services, particularly with respect to the treasury and funds industries. While there are considerable benefits to a financial institution to outsource some of its processes, risks exist also. A report by the Joint Forum of the Bank of International Settlements (BIS), entitled Outsourcing in Financial Services, presents a set of principles, which are designed to assist regulated entities in determining the minimum steps they should take when considering outsourcing activities. The main findings of the report are discussed below. |
TTTTTThe Joint Forum was established in 1996 under the aegis of the BCBS, IOSCO and the IAIS to deal with issues common to the banking, securities and insurance sectors. The aim of the report, which has taken a high-level and cross-sectoral approach, os designed to provide a minimum benchmark against which all financial institutions can gauge their approach to outsourcing.
What is outsourcing?
Outsourcing is defined as a regulated entity’s use of a third party (either an affiliated entity within a corporate group or an entity that is external to the corporate group) to perform activities on a continuing basis that would normally be undertaken by the regulated entity, now or in the future.
Outsourcing can be the initial transfer of an activity (or a part of that activity) from a regulated entity to a third party or the further transfer of an activity (or a part thereof) from one third party service provider to another, sometimes referred to as ‘subcontracting’. In some jurisdictions, the initial outsourcing is also referred to as subcontracting. According to this definition, outsourcing would not cover purchasing contracts, for example, contracts to purchase standardised products such as furniture or software.
Outsourcing today
Financial services businesses throughout the world are increasingly using outsourcing carry out activities that the businesses themselves would normally have undertaken.
Today outsourcing is increasingly used as a means of both reducing costs and achieving strategic aims. Its potential impact can be seen across many business activities, including information technology (eg, applications development, programming, and coding), specific operations (eg, some aspects of finance and accounting, back-office activities & processing, and administration), and contract functions (eg, call centres). Industry reports and regulatory surveys of industry practice indicate that financial firms are entering into arrangements in which other firms related firms within a corporate group and third-party service providers conduct significant parts of the enterprise’s regulated and unregulated activities.
Activities and functions within an organisation are performed and delivered in diverse ways. An institution might split such functions as product manufacturing, marketing, back-office and distribution within the regulated entity. Where a regulated entity keeps such arrangements inhouse, but operates some activities from various locations, this would not be classified as outsourcing. The entity would therefore be expected to provide for any risks posed by this in its regular risk management framework. Increasingly more complex arrangements are developing whereby related entities perform some activities, while unrelated service providers perform others. In each case the service provider may or may not be a regulated entity.
Trends
There has been seen a growth of outsourcing in more strategic areas such as human resources and some have observed the trend of ‘business processing outsourcing’, (BPO) i.e., end-to-end outsourcing of a business line or process in its entirety. BPOs also mean that the relationship between the outsourcer and the third party changes somewhat as the latter becomes more of a strategic partner than a traditional supplier.
Another major trend in outsourcing that appears to have gained momentum is ‘off-shoring’ i.e., effectively outsourcing activities beyond national borders. Many conglomerates are trying to create global efficiencies by basing transaction processing and call centres offshore. Arrangements are sometimes entered into with unrelated parties, while in other cases the outsourcing firm establishes its own off-shore base (i.e., through an affiliate) to provide services.
In India alone a range of organisations have set up outsourcing arrangements as illustrated by the sample of firms in the table 2.
According to a 2004 report by Deloittes, offshoring will continue to grow throughout this decade. The report estimates the percentage of global financial services companies with offshore facilities grew to 67% in 2003 compared with 29% in 2002. It further estimates that by 2005 some $210bn of industry costs will be offshore, rising to $400bn or 20% of the total industry cost base in 2010. The report notes that the percentage for large firms is significantly higher than for small firms and also notes that increasingly firms are setting up their own operations offshore, distinguishing this trend from the growth of outsourcing per se. At a practical level this growth in off-shoring has led to a need for regular monitoring of ‘country risk’ which means that an outsourcing institution needs to monitor foreign government policies and political, social, economic and legal conditions in the country where it has a contractual relationship with a service provider. It should also develop appropriate contingency plans and exit strategies.
Also, the fund management and insurance sectors have for some time outsourced activities which could be potentially considered to be core functions. These include:
• Investment management: Many insurers and fund managers now outsource investment management to external parties and/or related group entities.
• Unit pricing and custody: In many instances the striking of unit prices and custody arrangements are outsourced to third parties in respect of unit linked funds and products.
Underwriting and claims payment: some underwriters allow insurance brokers to accept certain underwriting risks on their behalf and to process claims.
There are genuine reasons for this trend, such as the importance of core expertise when entering a new market, and the benefits of economy of scale, but arrangements can still go wrong as Case study 3 in Annex A demonstrates.
Concerns
Outsourcing has been identified in various industry and regulatory reports as raising issues related to risk transfer and management, frequently on a cross-border basis, and industry, and regulators acknowledge that this increased reliance on the outsourcing of activities may impact on the ability of regulated entities to manage their risks and monitor their compliance with regulatory requirements.
Additionally, there is concern among regulators as to how outsourcing potentially could impede the ability of regulated entities to demonstrate to regulators (e.g. through examinations) that they are taking appropriate steps to manage their risks and comply with applicable regulations. The Joint Forum developed its principles in conjunction with the International Organization of Securities Commissions (IOSCO), which is producing a specific set of principles for the securities industry. The IOSCO principles are complementary and will be more focused and designed specifically for securities firms. The Basel Committee on Banking Supervision (BCBS) and the International Association of Insurance Supervisors (IAIS) will, in time, consider whether additional guidance on outsourcing for the banking and insurance sectors is necessary. |
The full report can be seen on: www.bis.org/publ/joint09.pdf
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| Article appeared in the September 2004 issue.
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