ICBI Operational Excellence

1. ICBI Operational Excellence • What do Banks Really Need to do to Address the Issues of Business and Operational Excellence? • How will the Long Arm of Regulation Continue to Impact Banking Operations? • September 2010 • BOB LYDDON – IBOS ASSOCIATION

2. The Payments business is not on a convergence trend • Harmonisation within the EU / EEA has hit the buffers Politicians’ stated aim Status • Only 4% migration to SEPA instead of the critical mass that should, by end of 2010, have made migration irreversible (SEPA Roadmap 2004) • XML no longer integral to ISO20022 or SEPA • More room for national flavours • Cut 2% GDP off cost of payments • Direct Payments • Fewer Interbank events • Layered Market • Maxi-SEPA, universal usage of XML are not “just around the corner”….

3. Impact of latest regulations • Reg 924/2009 - partial abolition of CBR • - reachability for SEPA Core Direct Debit • - no MBPs after 2012 • PSD - float income reduction • - increased responsibilities and risk • - new entrants with passports • SMED - mandatory adoption of SEPA schemes • - but with many safety valves • - national variations/”niche” schemes • More complexity • Lower price

4. Latest “Industry” developments • SWIFT - standards co-existence • - no retirements dates for MT • - E&I and n92, 95, 96 co-exist beyond 2012 • SEPA - SEPA does not mean XML any longer • - “essential requirements” discussion • - permits national variations/data formats • - Credeuro (XCT) is SEPA-compliant • - “niche” schemes formally excluded (RIBA) • Standards convergence no longer on the agenda • Proliferation and complexity • Very low migration to SEPA instruments so far (see Appendix with STEP2 statistics including for Credeuro)

5. EU Vision for future market structure: away from Vertical to Horizontal Integration VERTICAL = BANK HORIZONTAL Direct SWIFT Access Bank-owned Channels Customer Access Systems Mobile Social Networks Acquisition Activities requiring Banking Licence or Payment Institution Licence Processing Operations and data centres Processors of non-licensed activities Communications SWIFT ISPs BT Radianz Own backbone PEACHes ACHs Net Settlement Systems Banks Shareholdings Clearing & Direct memberships • Final Settlement activities: • Direct RTGS membership • Banks Settlement Sub-memberships Correspondents • Only two areas of activity are the unalterable preserve of Banks: • Activities requiring a full Banking License (as opposed to a PI or eMI) • RTGS clearing membership

6. EPC Design Model for Card Schemes (Source EPC) • Cards market model is already layered • EPC design encapsulates this

7. EPC Design Model for Payments (Source EPC) • Layered – big change from status quo • More layers and more complex than for Cards • In principle a lot of space for non-bank “horizontal” players

8. Cards vs Payments

9. SWIFT Standards Co-Existence IR 535 • IR 535 approved at SWIFT’s June Board Meeting is a major change of position: • Migration to XML is non-mandatory: no end dates for MT • ISO20022 does not automatically imply XML as the physical layer • The UML level (actors, data, process) is the fulcrum • By extension any Scheme that fulfils the EPC Rulebooks and the UML models can be SEPA-compliant – it does not have to use XML

10. Industry Utilities • Layered market should create many opportunities for industry utilities • For activities not needing a banking licence • Should banks lead this? What is the track record in collaborative, self-regulatory ventures? • What activities and tasks could be delegated to industry utilities? • What would be the hand-offs to them as Inputs to their Processes, and how would their Process Outputs be re-integrated into the banks’ processing flow?

11. Simple Outsourcing Model (Source PW) So which actions in the payment processing flow can be outsourced and who to? Complicated in banking by the banking licence issue + VAT + no proof that the service itself is becoming harmonised.

12. Linear & Sequential Process - Amazon • Payment and Logistics are Non-Core but Critical. • What about Fedex? • Is there room here for a cheap volume processor?

13. Payment Process • Sporadic “Core and Critical” actions all the way along • PSP must retain decisions on credit, routing and liquidity. • Outsource does the legwork that does not require a banking licence. • Multiple hand-offs during the flow • Outsourced work is VAT-able towards the PSP: can the PSP reclaim it?

14. ACH models – direct + indirect submission • Vocalink acts as an effective outsource for UK banks • It prepares files of accounting entries • There is no “choice of routing” for UK Credit Transfers and Direct Debits as Vocalink is the sole system • Banking controls are done upfront by the posting of credit limits by system members for corporates + other FIs (who are not direct members) • Those other FIs in turn post limits for their customers • Three rings: not equal access for all, as required by PSD Title 2

15. ACH Payments – Credits and Debits: Submission direct to clearing DR/CR ACCOUNT Client Accounting system File upload into EB Account-holding bank Clearing System OTHER BANKS OTHER BANKS OTHER BANKS BENEFICIARIES/DEBIT PARTIES’ ACCOUNTS

16. ACH Payments – Credits and Debits: Submission model through the bank DR/CR ACCOUNT Client Accounting system File upload into EB Account-holding bank Clearing System OTHER BANKS OTHER BANKS OTHER BANKS BENEFICIARIES/DEBIT PARTIES’ ACCOUNTS

17. Cloud computing is internet-based computing, whereby shared resources, software and information are provided to computers and other devices Is Cloud Computing the answer? Is this the way the hand-off to Outsourcers is effected? What is the certainty that the computing resources at the Outsource remain superior to in-house ones? How nimble is this set-up when requirements change and what are the costs of change?

18. A blade server: houses multiple server modules ("blades") in a single chassis (rectangular, usually steel frame). • Used in datacenters to save space and improve system management. • Massive increase in power and flexibility. • Enables datacentre consolidation and shrinkage. • Game-changer – allows processes to be run in much smaller scale without normal penalty of poor scale economics. What about Blade Computing?

19. What’s the environment we are going into? • Proliferation of processes defying achievement of scale economics • Variations in data and service level • Learning from other industries: • Banking processes are not linear and can be hard to fully automate • Activity has to be strictly standardised with rigorous data and banking checks applied upfront • The Cards business and a utility model like Vocalink for UK BACS follow this line • That is not the SEPA environment as it appears to be unfolding

20. SEPA environment unlikely to be 6σ compliant • Too many players • Too many routing choices • Expandable data requirements (VAS, AOS..) • May work in small volumes to begin with • As more players come on and more volumes, standard deviation moves away from the mean over time • Many instances then fall outside Upper/Lower Specification Limits which are only 2σ away from the mean • Not 3.4 Defects Per Million Opportunities (6σ) but 000s of DPMO • non-STP rate in 15-20% range Bank A SCT SEPA Compliant ACH R-message SCT STEP 2 SCT R-message SEPA Compliant ACH SCT R-message PEACH Bank B Account Blocked R-message

21. What happens when more volume is brought onto SCT and the normal assumed movement of 1.5 occurs in or over time? • But huge numbers – 45% - fall outside USL • Non-compliance / not STP • Proliferation of official Schemes (Core, B2B..) • Annual Scheme upgrades • AOS LSL USL μ • Curve is same shape but μ moves by 1.5σ • Hardly any instances below LSL μ +1σ +2σ +3σ -3σ -2σ -1σ • μ moves by 1.5σ because • μ itself moves or • σ widens

22. Conclusions The emerging environment is one of divergence, not convergence Detailed management of inputs and outputs becomes a Core and Critical function of a Transaction Bank That means “do it in-house” Whether the IT configuration can include Cloud will depend on line capacity and contention with public internet usage Blade seems to be a better bet: higher power in one place and more flexibility >> lower costs and a change of scale economies

23. Appendix • EBA STEP2 Volumes as a proxy for SEPA migration: • STEP2 frequently used a bridge between other CSMs • Credeuro (XCT) statistics are steady • SEPA Credit Transfer (SCT) statistics show steady increase: • Higher average value than XCT • Higher average value than national payments • Volumes are therefore: • Cross-border payments • Corporate payments • Virtually no Direct Debit volumes migrated to the SDD yet – key date is 30th November when all Euro-in banks must be reachable

24. APPENDIX: STEP2 SCT

25. APPENDIX: STEP2 XCT

26. APPENDIX: COMBINED STEP2 SCT & XCT