Exploring the Global Financial Information Superhighway

Vol. 7: Dawn Period of Offshoring and Outsourcing in the Investment Banking Industry (part five)

Consulting Fellow, RIETI

What is the essence of the changes that contemporary society confronts? British historian Dr. Arnold Toynbee offered a straightforward answer: the "disappearance of distance." The emergence of the information society dates back to 1990. U.S. futurologist Alvin Toffler called the information revolution the third wave, after the first wave, the agricultural revolution, and the second wave, the industrial revolution. Offshoring and outsourcing of cost centers are seen as one of the most important management strategies in the investment banking industry today. This phenomenon can be interpreted as an event that symbolizes the disappearance of distance in a flow of business processes that resulted from the information revolution.

A summary of the dawn period from 1990-1994

The Global Financial Centres Index (Note 1) is published annually. In the report for the last fiscal year published in September 2007, the Tokyo market just made it into the top 10 markets, coming in at 10th. The top markets for the year were, in descending order, London, New York, Hong Kong, Singapore, Zurich, Frankfurt, Geneva, Chicago, Sydney, and Tokyo. The Tokyo market has already fallen far behind Hong Kong and Singapore in international status. At the first session of the year on January 4, 2008, Atsushi Saito, president of the Tokyo Stock Exchange, expressed his concern at the flagging state of Japanese equity markets with the remark, "The Tokyo market may be losing its appeal." Offshoring to neighboring Asian countries has now become common practice among Japanese manufacturers. I believe there is a significant possibility of the same thing, a shift to other Asian countries, taking place in the financial industry.

This sense of urgency impelled me to make suggestions in response to the question, "How can we stimulate financial services in the Tokyo market and regional cities?" in my column "Japanese Financial Market's Strategy in the Globalization Era" published on September 25, 2007. In addition, I started this series in October 2007 to find an answer to the question, "How can we recover the Tokyo market's position in the Asia Pacific region?"

In Volume 1 (Note 2) titled "Investment Banks as a Global Financial Information Superhighway," I explained the situation at investment banks at the point of 2007 from the two perspectives of organizational structure and information systems. Later, I began a historical analysis focusing on the offshoring and outsourcing of cost centers, one of the distinct characteristics of multi-national investment banks. In Volume 2 (Note 3), I described how European and U.S. investment banks entered the Japanese market, how their back-office processing systems were structured, and what they did on-site to streamline and globalize their back-office processing in the initial period (from 1970-1989). In Volume 3 (Note 4), I explained changes in Japanese financial markets, the presence of a wide variety of back-office processing systems, and the market entry barriers European and U.S. investment banks faced in Japan in the dawn period (from 1990-1994).

In Volume 4 (Note 5), I touched on information systems back-office processing departments used in the dawn period after offering explanations on the history of the Japanese securities industry, the Financial Instruments and Exchange Act and other relevant regulations, legal documents, and regulatory reports. In Volume 5 (Note 6), I explained the struggles in the back office, the expansion of end-user computing, the characteristics of IT project management, the active use of prototypes, and the training of hybrid managers.

In Volume 6 (Note 7), I explained federal-type information system departments suited for global businesses after describing the characteristics of hybrid managers and the organizational structure of information system departments. In this volume, I will report how outsourcing and offshoring decisions were made and how people were relocated in accordance with such decisions in the final phase of the dawn period from 1990-1994, as a summary for this period.

Back-office processing departments at investment banks

Let's began by considering briefly back-office processing departments at investment banks, explored in this series from the two perspectives of information system structure and organizational structure.

Information systems at back-office processing departments consist of three layers. There are three functions in the first layer. They are a product master that manages the attributes of financial products, a customer master that manages the attributes of counterparties, and a module that generates and records financial transaction data. The second layer contains the function of historically storing financial transaction data, produced in the first layer. Based on this data, it manages the position of the investment bank's proprietary accounts, at levels ranging from the company, through to the department, group, and trader, and it provides the function of cash remittance or the settlement of physical securities. The third layer has corporate management and accounting functions, and the function of producing regulatory reports and legal documents.

Investment banks operating in Japanese markets must naturally observe Japanese legal requirements. These legal requirements are characterized by legal documents peculiar to Japan, represented by several account ledgers produced at the end of each month, and the presence of regulatory reports that must be submitted on a daily weekly, monthly, quarterly, and yearly basis. The quantity of regulatory requirements in Japan is much greater than in other countries. To meet the Japanese market's regulatory requirements, many European and U.S. investment banks implemented bureau-type systems compliant with Japanese requirements.

These bureau-type systems, however, had the weakness of delaying the response to new products and new markets. For this reason, European and U.S. investment banks developed their own additional functions for responding to new products and new markets by utilizing their UNIX and Windows environments. Meanwhile, a large and varied array of information systems existed within the three-tier system structure of back-office processing departments. They included online systems linked directly to host computers at external organizations, global network systems connecting overseas entities, and end-user computing (EUC) systems originally developed within their respective PC platforms by users. Consequently, it was common for an overall information system structure to take the form of a "spaghetti structure," in which a wide variety of information systems are intertwined, instead of an organized "makunouchibento structure" (a makunouchibento is a Japanese lunch box with rice and neatly arranged side dishes).

These information system structures resulted in an enormous and diverse volume of paper slips to fly around within back-office processing departments. That in turn meant that data entry and data-reconciliation departments were involved in labor-intensive operations. In response, examples of "prototype EUC application," in which small information systems produced through EUC are used as models for developing large-scale systems, began to emerge. At the same time, investment banks started training hybrid managers to ensure the success of their large information system projects.

Moreover, initiatives to develop federal-type information system departments began to get underway at investment banks looking to link requests from their business departments to information system development directly. These moves involved the establishment of sections dedicated to developing information system applications at front-office, middle-office, and back-office departments, and the creation of a department to globally control the information system base for organizing overall information system architecture.

Cost per ticket analysis

As I explained in Volume 2 (Note 3) of this series, in the wake of Black Monday, investment banks sought to improve their profit structure by clearly distinguishing between the missions of profit centers in that part of their business that generated a profit from the missions of cost centers in the part of their business that involved expenditures. Profit centers are departments that generate profits through financial transactions. Cost centers, meanwhile, are departments that support profit centers. They include risk control departments and back-office processing departments. In response to the increase in back-office processing of international settlements of cash money and physical securities and under new pressure to produce innovative information systems, investment banks began looking for the most efficient back-office processing framework from a global viewpoint.

Profits made by investment banks consist primarily of advisory fees received in connection with M&A and issuing securities in primary markets, trading profits made on their own accounts in secondary markets, and commission income obtained from brokerage operations, including share and futures options traded on customer accounts. The competence of managers and traders who work at profit centers is determined on the basis of profits they earn through these diverse front-office operations.

Meanwhile, the competence of managers who work at cost centers is judged on the basis of the degree to which they can cut costs, in addition to whether or not they have developed an organization for accurate, error-free daily back-office processing. The overall performance of back-office processing departments becomes the criteria for determinations made with respect to cost reductions. For this reason, balanced cost management is essential.

For example, sporadic and local cost reduction achieved with EUC is meaningless if higher costs are generated in other departments. Consequently, investment banks started cost per ticket (CPT) analysis in an effort to understand the level of cost savings achieved by cost centers in quantitative terms. In the cost per ticket analysis, the costs incurred across the organization in processing one trade ticket are calculated. Examples of costs, such as ¥100 for processing one trade ticket for a Japanese share and ¥10,000 for processing one trade ticket for a Japanese government bond, result from this analysis.

Outsourcing, offshoring and offshore outsourcing

As I clarified in Volume 3 (Note 4) and Volume 4 (Note 5) of this series, European and U.S. investment banks struggled under high back-office processing department costs related to the businesses they were operating in Japan after 1990. They consequently began to search for new frameworks centered on the cost per ticket I explained earlier at their cost centers for back-office processing or system development. Outsourcing and offshoring were ideas that surfaced in those days as strategies for cost reduction.

Offshoring refers to the transfer of a business process currently carried out within one country to another country. Outsourcing meanwhile means engaging an outside organization to perform an internal process. Offshore outsourcing combines the two methods. It means engaging an outside organization based in another country to perform an internal process currently carried out in Japan.

During this period, investment banks primarily relied on the following three methods for outsourcing and offshoring:
(1) Domestic outsourcing to other companies in Japan
(2) Intra-group offshoring to overseas entities
(3) Offshore outsourcing to other companies overseas

When it comes to strategic planning, such as outsourcing and offshoring, Professors Mary Lacity, Leslie Willcocks, and David Feeny have pointed out the need to conduct a careful study from the three perspectives of economic environment, business environment, and technical environment (Note 8). Based on this opinion, investment banks first break down the business processes undertaken by their front offices, middle offices, and back offices into small components when they plan global information system strategies.

Investment banks then conduct an analyses from the three perspectives of the mobility of each business process, the costs generated by the business process changes, and the risks created by the business process changes, to determine which company is the appropriate choice for domestic outsourcing, which facility in which country is the appropriate choice for intra-group offshoring to an overseas facility, and which company in which country is the appropriate choice for offshore outsourcing, for each of the business process components. They then produce a simulation matrix based on the analyses.

Simulation matrix analysis

First, whether each business process is restricted to a fixed place or not is analyzed from the perspective of business process mobility. For example, it is generally concluded that processes that require communication with government agencies and domestic customers must be done in Japan because they demand knowledge of the language and customs. On the other hand, processes such as the management of databases for financial products in English, reconciliation of figures related to accounting, and system development on the UNIX platform have generally been seen as work that can be done at overseas entities, using information networks that connect all offices.

Next, temporary project costs that arise at the time of outsourcing or offshoring execution and running costs after project execution are analyzed from the perspective of costs generated by business process changes. Setting labor costs in Tokyo at 100, comparative values came to around 80 for Hong Kong, around 60 for Singapore, and around 40 for Mumbai based on currency exchange rates in 1994. This shows that the number of business processes investment banks can offshore from their Tokyo office to other Asian offices to reduce the long-term running costs of their cost centers is a key issue for their management strategies in the Asia Pacific region.

Meanwhile, factors such as whether or not manpower can be truly secured, whether or not internal management organizations can be appropriately maintained, and whether or not the quality of services provided to external parties can be kept at sufficient levels are analyzed from the perspective of risks created by business process changes when business processes are outsourced or offshored to companies or bases overseas. For example, there were instances in which investment banks elected not to outsource or offshore accounting processes to meet international standards, and continued to do the work in-house, because building solid frameworks that sufficiently protect against information leaks to control information asset risks was not easy, even though it was technically feasible to do the accounting overseas.

The results of analysis for all business processes from the three perspectives are put together, matrix tables are produced for domestic outsourcing, intra-group offshoring, and offshore outsourcing, and the potential for reducing the cost per ticket and the potential increase or decrease in latent business process risks are analyzed. No general or standard strategic design existed for outsourcing and offshoring in the investment banking industry back in 1994, because the matrices contained a wide range of combinations.

Decisions in outsourcing and offshoring, and manpower transfer

As a result, investment banks that adopted cost per ticket reduction as their primary objective selected the pattern of "intra-group offshoring," which sought to reduce costs by relocating not only their system development functions but also their core back-office functions, such as securities management and accounting, in their entirety to other Asian countries and regions, including Hong Kong and Singapore. In another pattern selected, "offshore outsourcing," the focus was on the possibility of reducing IT development costs, with investment banks commissioning only those functions that had previously been performed by their IT development departments to other companies in places like Mumbai.

Investment banks that were interested in cutting costs, but that were unable to clearly grasp the real picture of offshoring and outsourcing, opted for a pattern of "decision postponement," and chose to monitor how other companies in the same business operated. Another group of investment banks elected not to adopt offshoring and outsourcing methods by placing cost reduction outside their emphasis and attaching top priority to bolstering front-office profits.

In this environment, one Western investment bank opted in 1994 to develop a large-scale business process center in Singapore to manage all IT development and back-office processing in Asia Pacific. Once the decision was made to go ahead with this intra-group offshoring project, staff were picked to move from the bank's Tokyo or Hong Kong offices to the Singapore office and were trained to lead the way in the transfer of back-office processing functions. In an early stage of this offshoring project, highly-capable staff members capable of achieving the EUC described above, so-called hybrid managers, were selected as personnel for dispatch to the overseas entities.

Starting with the next volume, this series will look at changes that took place in the construction period for offshoring and outsourcing in the investment banking industry from 1995-1999, with a focus on the experience of the Western investment bank described in the previous paragraph.

March 21, 2008
  1. Yeandle, M., M. Mainelli, and I. Harris. (2007), The Global Financial Centres Index - 2, 78 pages, City of London Corporation, September 2007.
  2. Matsumoto, H. (2007) "Investment Banks as a Global Financial Information Superhighway," Overseas Report Series: Exploring the Global Financial Information Superhighway, vol. 1, October 10, 2007.
  3. Matsumoto, H. (2007) "Initial Period of Offshoring and Outsourcing in the Investment Banking Industry," Overseas Report Series: Exploring the Global Financial Information Superhighway, vol. 2, October 31, 2007.
  4. Matsumoto, H. (2007) "Dawn Period of Offshoring and Outsourcing in the Investment Banking Industry (part one)," Overseas Report Series: Exploring the Global Financial Information Superhighway, vol. 3, November 22, 2007.
  5. Matsumoto, H. (2007) "Dawn Period of Offshoring and Outsourcing in the Investment Banking Industry (part two)," Overseas Report Series: Exploring the Global Financial Information Superhighway, vol. 4, December 18, 2007.
  6. Matsumoto, H. (2007) "Dawn Period of Offshoring and Outsourcing in the Investment Banking Industry (part three)," Overseas Report Series: Exploring the Global Financial Information Superhighway, vol. 5, January 16, 2008.
  7. Matsumoto, H. (2007) "Dawn Period of Offshoring and Outsourcing in the Investment Banking Industry (part four)," Overseas Report Series: Exploring the Global Financial Information Superhighway, vol. 6, February 18, 2008.
  8. Lacity, M. C., L. P. Willcocks, and D. F. Feeny (1996), "Sourcing Information Technology Capability: A Framework for Decision-Making," in Information Management: The Organizational Dimension, M. J. Earl, ed., Oxford. University Press, 1996, pp. 399-425.

March 21, 2008

Article(s) by this author