Strategic Sourcing in Banking - A Framework Markus Lammers, E-Finance Lab University of Frankfurt

1. Strategic Sourcing in Banking- A FrameworkMarkus Lammers, E-Finance Lab University of Frankfurt October 08, 2004

2. Agenda • Problem, Research Questions, Definitions • A Qualitative Framework for Sourcing Decisions • The Banking Value Chain as Sourcing Subject • A Formalized Sourcing Decision Model • Conclusion and Further Research

3. Problem German Banking Industry* Special banks: 68 Institutions Universal banks: 2288 Institutions 28 building and loan associations 14 banks with specific functions 1491 coop. banking associations 524 savings and state banks 271 credit banks (incl. foreign banks) 26 mortgage banks • The German banking market has a polyplolistic market structure consisting of 2354 institutions. • 96,7 % of the German banks are universal banks. Universal banks are highly vertically integrated High Redundancy of Products, Processes, IT Infrastructure and Application Systems *source: monthly report as of May 2003 of the Deutsche Bundesbank http://www.efinancelab.de/

4. Products Products Products Investment Investment Investment Services Services Services Funding Funding Funding Deposits Deposits Deposits Credits Credits Credits Acct. Mgmt. Acct. Mgmt. Acct. Mgmt. Securitization Securitization Securitization Securities Securities Securities Asset Mgmt. Asset Mgmt. Asset Mgmt. Credits Credits Credits Fin. Products Fin. Products Fin. Products Transactions Transactions Transactions Issuance/IPO Issuance/IPO Issuance/IPO Marketing Marketing Marketing Sales Sales Sales Corp. Invest. Corp. Invest. Corp. Invest. M & A M & A M & A Payment Payment Payment Advertising Advertising Advertising Acquisition Acquisition Acquisition Trading Trading Trading Branding Branding Branding Offering Offering Offering Other assets Other assets Other assets Advis. Serv. Advis. Serv. Advis. Serv. Clearing & Settlement Clearing & Settlement Clearing & Settlement Sales Support Sales Support Sales Support Multichannel Management Multichannel Management Multichannel Management Other Serv. Other Serv. Other Serv. Custody Custody Custody Infrastructure Risk Management Risk Management Technology Development Technology Development Technology Development Human Resources Human Resources Human Resources Firm Infrastreucture Procurement Firm Infrastructure Synergy potential Bank 2288 e.g.2288 times redundant credit processes Bank 2 Bank 1 High vertical integration and polypolistic market structure indicates high synergy potentials http://www.efinancelab.de/

5. (4) Payments (national, international) (4) Clearing, Settlement (4) Exchanges (3) M & A (3) Other1 (3) Insurance (3) Asset management (3) Credits (3) Other1 (3) Other1 (1) Purely regional distribution (2) Global wholesale, investment Hamoir et al. expects that 4 banking models may emerge Potential banking models Regional retail distributors (1) Global wholesale and investment bank (2) Pan-European product specialists (3) Pan-European service providers (4) Infra- structure Position along the value chain Products Distribution Mass Affluent Private Small Midsize Multinational Corporations Retail SME2 Type of banking customer 1Such as commercial insucrane and institutional asset management 2Small and midsize enterprises Source: Hamoir et al. (2001), p. 123 http://www.efinancelab.de/

6. Research Questions What is the optimal degree of vertical integration for a bank? • What activities should be made internally? • What activities should be made or produced by a (specialized) supplier? • What are drivers for in- or outsourcing an activity? http://www.efinancelab.de/

7. Definitions Sourcing Analysis: Analysis of the combination of internal and external resources to improve the production mix of a bank by decreasing costs or increasing value generation. Outsourcing: Usage of (superior) resources outside the company. Outsourcer: A company that gives an activity to an external company, which was formerly produced in-house. Insourcer: A company that takes over the activity from the outsourcer. http://www.efinancelab.de/

8. Agenda • Problem, Research Questions, Defintions • A Qualitative Framework for Sourcing Decisions • The Banking Value Chain as Sourcing Subject • A Formalized Sourcing Decision Model • Conclusion and Further Research

9. Theoretic Foundation: An Introduction to Transaction Cost Economics (1/2) • Transaction Costs Economics analyzes the efficiency of different governance forms using transactions as basic analysis unit. (Williamson 1981, p. 548) • Transactions are defined as the transfer of goods or services between technologially separable interface (Williamson, 1981, p. 522) • Governance forms are: • Hierarchy: governance is based on property rights of management, processes and administrative control mechanisms, i.e. companies. • Markets: Are steered by price mechanisms and hierarchical control is replaced by contractual agreements. • Hybrids: include governance elements from both markets and hierarchy, e.g. joint ventures, alliances, shared service organizations. http://www.efinancelab.de/

10. Theoretic Foundation: An Introduction to Transaction Cost Economics (2/2) • Increasing transaction costs are determined by: • Frequency of Transactions: Transaction that are frequently processed will more likely produced internally. • Uncertainty: Increasing uncertainty imply higher transaction costs, e.g. in long-lasting outsourcing deals. • Asset Specificity: Insourcer would have to make specific production investments when taking over highly specific assets. http://www.efinancelab.de/

11. Theroretic Foundation: An Introduction to the Resource Based-View (1/2) The Resource Based-View (RBV) explains how companies can gain and sustain a competitive advantage having superior resources. Barney (1991) derives that a sustainable competitive advantage results from resources that are: • Valuable: Resources increase revenues or decrease costs • Rare: Resources are not freely availabe • Imperfectly imitable: it is not clear for a competitor how to build identical resources • Non-substitutable: no alternative resources providing identical value http://www.efinancelab.de/

12. competitive advantage sustainable Non-substitutable Imperfectly imitable rare valuable • Analyze cost, revenue or value contriubtion • Benchmark against competitors, e.g. using DEA • Determine competitve advantage • The resource or the resource bundle is not freely available. • Competitors can not buy the resources immediately • Direct competitors do not deploy identical resources/resource bundle • The resource bundle is heterogene from other resource bundles • Heterogenity cannot be rebuild in the short to medium time frame • The resources or resource bundle can not be substituted by other resources Theroretic Foundation: An Introduction to the Resource Based-View (2/2) http://www.efinancelab.de/

13. Institutional design of sourcing alternatives Making Sharing Buying hybrid forms: Joint Ventures / Shared Services / Alliances Degree of market coordination Degree of hierarchical coordination TCE based recommendation for sourcing decisions high Asset specificity of activity low high Frequency of activity low high Uncertainty low Resources and capabilities pro-vide a sustainable competitive advantage RBV based recommendation for sourcing decisions Resources and capabilities are a source of competitive advantage, but may be easily to imitate or substitute Resources and capabilities provide a competitive disadvantage Company Objective realize efficiency improvements / scale economies by bundling activities increase own market share realize efficiency improve- ments from specialists Qualtitative Sourcing Framework http://www.efinancelab.de/

14. Agenda • Problem, Research Questions, Defintions • A Qualitative Framework for Sourcing Decisions • The Banking Value Chain as Sourcing Subject • A Formalized Sourcing Decision Model • Conclusion and Further Research

15. Products Marketing Trans-actions Sales Investment Services Funding Deposits Payments Advertising Credits Acquisition Acct. Mgmt. Securitization Securities Asset Mgmt. Trading Branding Offering Credits Fin. Products Issuance/IPO Clearing & Settlement Sales Support Multichannel Management Corp. Invest. M & A Custody Other assets Advis. Serv. Other Serv. Risk Management Technology Development Human Resources Firm Infrastructure Detailed Generic Value Chain of the Banking Industry In opposite to the industrial value chain from Porter (1985, p. 86), the developed banking value chain starts from the customer side. • Fist the product will be offered to the market, sold, provided to the customer and finally corresponding transactions will be executed. • Additionally, Risk Management is introduced as supporting activity. http://www.efinancelab.de/

16. Transaction Marketing Sales Product Branding of a Product Sales Support Multi Channel Mgmt. Acquisition and Offering Credit Funding Payments Clearing and Settlement • Introducing a brand e.g. „easycredit“ in the credit market • Advertising • e.g. general offers to customers via letters • Management of Sales via Internet, branches and sales banks • Determine financial requirement • Identification of potential collaterals • Pricing • Collateral evaluation • Rating of borrower • Final pricing • Credit Approval • Credit Account opening • Payout of credit • Credit data to Treasury • Refinancing of Credit • Payment of Interest • Payment of amortisement • Booking of Payments • Governance of in-time payments • Bad Loan Mgmt./ Realisation of collaterals Risk Management: Management of Credit Portfolio and Credit Risk Identify the resources allocated to the consumer credit process Calculate costs and revenues for each process step Evaluate cost efficiency respectively value added for each process step A generic value chain for consumer credits Consumer Credit Process derived from the generic value chain Evaluation of in-house efficiency of value activities http://www.efinancelab.de/

17. Mini Case Study: Norisbank • Marketing: • Branding of product “easycredit®” • Independently from corporate identity of Norisbank • Registered trademark: valuable and rare • Sales: • Effectively leveraging product via different sales channels • Norisbank is able to invest 87% of all funds easycredit • Products/Transactions: • Fully automated processing of consumer credit • Average processing-time reduced from 128 to 35 minutes http://www.efinancelab.de/

18. Agenda • Problem, Research Questions, Defintions • A Qualitative Framework for Sourcing Decisions • The Banking Value Chain as Sourcing Subject • A Formalized Sourcing Decision Model • Conclusion and Further Research

19. Production Cost Economics • „Squeeze Out Potential “ – Reality Check Financial Services http://www.efinancelab.de/

20. Scale and Skill economies of Insourcer Production Cost Economics C/y CO Insourcer „Skill Potential“ CI‘ C/y Outsourcer CI‘‘ C/y Insourcer Insourcer „Scale Potential“ y http://www.efinancelab.de/

21. Economies of Scope vs. Economies of Scale Economies of Scope: Def.: Economies where it is less costly to combine two or more product lines in one firm than to produce them separately. • Economies of Scale: Def.: Economies realized by output expansion, i.e. decreasing marginal costs when expanding the output. • C = Kosten • X = Outputmenge • [Source: e.g. Murray/White 1983, Mester 1987] • vs. = Set of products under study = Quantities of products = Multiproduct Cost Function = Vector of factor prices [Source: Panzar and Willig, 1981] Economies of scope can only be realized by Universal banks, and may be a driver not to disaggregate the value chain. Scale economies may be realized by Specialized Banks as well as by Universal Banks. http://www.efinancelab.de/

22. Internal Production vs. Joint Venture vs. Specialist • vs. Universal banks: Highly diversified banks, which have separate business units may generate economies of scope. • Example: Deutsche Bank Joint Venture: Banks jointly produce specific bank products or processes to generate scale economies. Example: Eurohypo Specialized Service Provider Specialists is concentrating on one specific business segment thus being able to generate economies of scale and skill. Examples: IBM, Aareal Hypotheken Management • vs. http://www.efinancelab.de/

23. Make vs. Buy Decision Make - + Cost Function Scope economies Transaction costs vs. Buy + + One-time costs for outsourcing Price Transaction costs C(y,w) = Cost function output and factor prices G(f,u,s) = Governance cost function N={1,2,...,n}= Set of activities under study M = N without i P = Price per output unit of the potential supplier r = Risk-adjusted discount rate in percent S(s,f,u) = One-time sourcing cost function T = Years of contract w = Vector of factor prices Yi = Yearly output from diversified company of activity i YN = Yearly output from diversified company of activities 1 to n YM = Yearly output from diversified company of all activities M http://www.efinancelab.de/

24. Make vs. Share Decision C(y,w) = Cost function of dependent output and factor prices G(f,u,s) = Governance cost function N={1,2,...,n} = Set of activities under study K={1,2,...,k} = Firms participating in joint venture M = N without I P = Price per output unit of the potential supplier r = Risk-adjusted discount rate in percent S(s,f,u) = One-time sourcing cost function T = Years of contract w = Vector of factor prices Yi = Yearly output om diversified company of activity I YN = Yearly output of activities 1 to n YM = Yearly output of all activities M http://www.efinancelab.de/

25. Agenda • Problem, Research Questions, Defintions • A Qualitative Framework for Sourcing Decisions • The Banking Value Chain as Sourcing Subject • A Formalized Sourcing Decision Model • Conclusion and Further Research

26. Conclusion and Further Research • Conclusion: • a qualitative framework using RBV and TCE was introduced to identify: • Superior Skill Sets • Superior Governance Structures consequently supporting a make, buy or share decision. • A top-down approach for identifying and analyzing activities in banking was introduced using the generic banking value chain • Co-opetition/Share is a possible sourcing solution for activities and a way to increase production efficiency • Influencing variables of a sourcing decision were formalized to show interrelation and impact on a sourcing decision • Further Research: • Extending the Model by Uncertainty and Risk • Sensitivity Testing of the Model Variables http://www.efinancelab.de/

27. Backup

28. Literature Barney, J.B. (1991): Firm resources and sustained competitive advantage, in: Journal of Management, 17, 99-120. Barron, T. (1992) “Some new results in testing for Economies of Scale in Computing” Decision Support Systems, 4/8, 405-429 Lacity, M; Willcocks, L. (1996): Editorial; Information Systems Outsourcing in Theory and Practice, in: Journal of Information Technology, 10, 203-207 Lacity, M; Willcocks, L. (1996): The Value of Selective IT Outsourcing, Sloan Manangement Review, 13-25 Porter, Michael, E. (1985): Competitive Advantage: Creating and Sustaining Superior Performance, Free Press, New York. Williamson, O. E. (1981): The Economics of Orgnaization: The Transaction Cost Approach, in: American Journal of Sociology, 87, p.548-577. http://www.efinancelab.de/

29. Model of three banks Production bank • IT- and Transaction Management • „manufacturer“ for clearing, settlement, payments and other transaction related business Salesbank • Marketing management • Multichannel mangement • Distribution of products to private and corporate customers Portfolio bank • Risk Management and term transfor-mation • Issuance and advisory business • Building and allocation of special financial know-how Model of three banks • DG Bank as well as the Norisbank divides the banking business into sales-, portfolio and production activities. They expect using these function banking holding companies and specialized banks will evolve (source: Salmony 2002, Norisbank 2002). http://www.efinancelab.de/

30. Steffens (2002) expects special distribution, transaction and product banks Distribution • Distribution specialists concen-trating on sales channels like Charels Schwab, MLP or American Express. Products • Product specialists like Credit Card, Credit and Asset Management companies provide their products to universal banks resp. global players Transaction • Transaction banks provide clearing and settlement, payment, trading and custody facilities • Steffens (2002) expects a specialization of banks towards distribution, product and transaction banks. Anyway, the author expects still global players and universal banks which use specialized banks as supply or sales channel. http://www.efinancelab.de/