Exploring the Global Financial Information Superhighway

Vol. 2: Initial Period of Offshoring and Outsourcing in the Investment Banking Industry

Consulting Fellow, RIETI

In the process of developing information system strategies, offshoring and outsourcing of cost centers has now become an issue that cannot be ignored in the investment banking industry. With this in mind, this paper will analyze through what kind of processes the structure of offshoring and outsourcing has developed in the investment banking industry from three perspectives: the evolution of international political economy, changes in the investment banking business, and the advancement of computers.

Development process of offshoring and outsourcing

Offshoring means the transfer of a business process within a certain country to another country. Outsourcing means the contracting out of an internal business process to an external organization. These structures of offshoring and outsourcing appear to be well accepted by the investment banking industry. In this series, the development of the above structures will be analyzed by classifying the period from 1970 to the present into five periods:

1) Pre-dawn: 1970-1989
2) Dawn: 1990-1994
3) Construction: 1995-1999
4) Expansion: 2000-2004
5) Establishment: 2005-present

This report will principally examine the evolution of international political economy, changes in the investment banking industry, and the innovation of information systems during the initial period of offshoring and outsourcing between 1970 and 1989.

International politics and economy: Changes in the structure of the Cold War between East and West, the Plaza Accord, and Black Monday

In March 1985, Mikhail Gorbachev became the General Secretary of the Communist party of the Soviet Union, and began reform based on the concepts of perestroika and glasnost. With this, the framework of international politics, namely the division between the communist camp and the capitalist camp that had been formed after World War II, changed dramatically. The Cold War between East and West ended in 1989. During the Cold War period, the markets in which investment banking businesses could be carried out had naturally been limited to developed countries that belonged to the capitalist camp.

In September 1985, the five leading capitalist nations - the United States, United Kingdom, former West Germany, France, and Japan - adopted the Plaza Accord at the Group of Five meeting of finance ministers and central bankers, primarily for the purpose of reducing the U.S. trade deficit by jointly intervening in currency markets to depreciate the U.S. dollar. With this Accord, the exchange rate of the U.S. dollar against other currencies began to decline. For instance, the U.S. dollar/yen exchange rates dropped from a level of \250 per U.S. dollar in 1985 to less than \150 in 1989.  During this period, the largest spontaneous worldwide decline in stock values in stock market history, Black Monday, occurred in October 1987.

Investment banking business: Depreciation of the U.S. dollar and establishment in Japan

Even before the Plaza Accord, Western investment banks had already begun cross-border businesses. For example, one U.S. investment bank opened a branch in London in the early 1970s. By the mid-1980s, London branch operations had expanded to the point where it was one of the largest banks by trading volume in London. As another example, a Swiss commercial bank forged a capital alliance with another U.S. investment bank in the mid-1970s. These types of international capital alliances evolved into international mergers after Black Monday, making way for the development of multinational investment banks.

In addition to the developments described above, starting in the 1980s U.S. and European investment banks began focusing on the Japanese financial markets, which offered the potential for future growth. Perhaps this was because there were no other choices in Asia during those Cold War days. As described above, in line with the Plaza Accord, the U.S. dollar experienced a sustained fall against the yen. In an effort to deal with concerns over a high yen recession, the Japanese government adopted a low-interest rate policy. As a result, by as early as April 1988, just six months after Black Monday, the Nikkei Stock Average had recaptured all the ground it had lost in the global stock market collapse. Surplus funds brought by this low-interest rate policy continued to be invested in land and stocks, creating the bubble economy. On December 29, 1989 the Nikkei Stock Average finished just short of 38,900. Most Western investment banks operating in Tokyo today entered the Tokyo market and obtained their securities business licenses during the bubble era between the early and late 1980s.

In response to the internationalization of financial businesses and the depreciation of the U.S. dollar described above, U.S. investment banks changed their business structures from a framework in which New York offices handled investments in U.S. dollar-based stocks and bonds and London offices handled investments in pound-based stocks and bonds, to a structure in which New York also invested in stocks and bonds in currencies other than U.S. dollars. Back offices of U.S. investment banks resultantly faced an increasing volume of operational processing associated with international settlements of funds and securities related to, for instance, investments in European bonds and Japanese stocks, in addition to operations associated with transactions in U.S. dollar-based stocks and bonds also executed in New York. Moreover, from this time, arbitrage trading between products on intrinsic securities markets and those on futures markets began to pick up, making the operational processing associated with international settlements of funds and securities more complex. These developments made it necessary for operations divisions in Tokyo, London, and New York to develop close cooperation.

Operational processing system: Comparison between investment banks and commercial banks

The back-office systems of investment banking operations, which perform operational processing for the settlements of cash money and physical securities, are complicated compared with those of commercial banking operations. This is because the back-office systems of investment banking operations require not only functions to settle cash money and foreign exchanges, but also physical securities, while the main function of the computer systems of commercial banks is the management of cash money and foreign exchanges.

Securities have been historically settled through physical paper (called certificates). Because of this, the back-office systems of investment banking operations need to link a function that manages this physical paper and a function that manages the cash money. For example, in corporate activities, owners of shares and bonds have the right to receive dividends or interest. Therefore, if an investment bank holds shares and bonds on its own account, it needs to process the receipt of dividends or interest from issuers of shares and bonds. If an investment bank provides custody services, it needs to process the receipt of dividends or interest from the issuers of shares and bonds, and the payments of the relevant dividends or interest to the actual holders of the shares and bonds.

To perform this operational processing efficiently, a system known as the stock record was developed by the U.S. investment banking industry during the 1980s. This system could efficiently perform the international settlements of cash money and physical securities in each securities transaction by centrally coordinating the management of names of securities, the names of owners, and the number of securities and management of custodians, with whom the actual securities are held, and linking it all to the accounting processes of each office.

Progress in operational processing: Improving efficiency and dealing with globalization

Based on the experience of Black Monday, U.S. investment banks clearly divided their profit centers and cost centers to improve their revenue structures. Consequently, they successfully established clearly defined missions within the organization: the profit center aims to improve profitability and the cost center aims to achieve cost savings. Under three pressures - the clear definition of the missions of each division described above, the increase in operational processing of international settlements of funds and securities described in the previous section, and innovation in computers - U.S. investment banks vigorously analyzed operational processing in terms of who, how, and at which operational bases, to achieve the most efficient processing in the most cost-effective manner. They also established a structure of cost-benefit analysis and clarification of internal sponsorship of computer investments.

One U.S. investment bank was finding that it could not generate profits from the U.S. stock markets following Black Monday. Consequently a back-office manager in New York developed a global back-office system, in a project sponsored not by the front office in New York, but by the front office of the Tokyo branch, which was doing well at that time. By 1989, several U.S. investment banks had developed and managed global back-office systems that could process cross-border settlements of funds and securities by linking the operations of offices in Tokyo, Hong Kong, London, and New York. One even adopted a system that enabled all officers to communicate using e-mail well before the Internet explosion made it popular among the general public.

Information technologies: The foundations in place and versatility improved

Forward-looking investment banks began using computers for financial analysis as early as the mid-1960s. They developed computer programs that analyzed market trends based on a database in which market fluctuations were memorized, and gave instructions for the trading of financial products based on projections of near-future financial market trends. The development of this program trading can potentially cause a negative spiral in which a small initial fall in share prices in the markets prompts the computer programs to give a series of sell orders, resulting in further sell orders, thus it is considered a factor behind Black Monday, the largest collapse in share prices in history.

The 1970s were when the foundations of modern information technologies were being laid in the computer industry. A number of primitive models of the hardware and software we know today were launched during this period, among them were Intel's microprocessor, Microsoft's MS-DOS, Cray Research's supercomputer, and Apple's PC. The 1980s were when the computer industry began taking steps to improve the versatility of modern information technologies, to expand the user base. During this period, Microsoft launched Windows and Sun Microsystems developed workstations, while personal computer manufacturers, such as IBM, Toshiba, and NEC competed to develop personal computers. Meanwhile, software for business purposes, such as spreadsheets, word processing, and relational databases, were being developed and marketed.

Information society: The future outlook is set, but political decisions have yet to be made

Taking a somewhat different perspective, in 1980 Alvin Toffler released his book, The Third Wave. In 1993, the Clinton administration was inaugurated and began pursuing its information superhighway program. In other words, although it was widely accepted that the future would bring a highly sophisticated information society, no political decisions had yet been made. This was a particular characteristic of the initial period of offshoring and outsourcing up till 1989, the focus of this report.

In this environment, the challenges the investment banking industry faced during this period related to who would handle the processing of settlements of funds and securities associated with increasingly international financial transactions, how they would handle it, and at which operations bases. These questions were like magma beneath the earth's surface, which eventually formed a volcano of offshoring and outsourcing from the 1990s. Before this magma could erupt to form a volcano, the international society witnessed three major events: the adoption of the market economy by the countries of the former Eastern Bloc, the explosion in international financial transactions, and the growing use of the Internet. Also during this period, offices that had developed the international financial information superhighway were facing the need to deal with the European monetary union and computer concerns associated with the year 2000 (Y2K).

The next report will examine the status of offshoring and outsourcing in the investment banking industry during the dawn period.

October 31, 2007

October 31, 2007

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