1. Strategic Sourcing in Banking - A Framework Markus 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. http://www.efinancelab.de/ Problem German Banking Industry* 26 mortgage banks Special banks: 68 Institutions 28 building and loan associations 14 banks with specific functions Universal banks: 2288 Institutions 271 credit banks (incl. foreign banks) 524 savings and state banks 1491 coop. banking associations  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

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

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

6. http://www.efinancelab.de/ Research Questions  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? What is the optimal degree of vertical integration for a bank?

7. http://www.efinancelab.de/ 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.

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. http://www.efinancelab.de/ 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.

10. http://www.efinancelab.de/ 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.

11. http://www.efinancelab.de/ Theroretic Foundation: An Introduction to the Resource Based-View (1/2)  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 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:

12. http://www.efinancelab.de/ Theroretic Foundation: An Introduction to the Resource Based-View (2/2) sustainable competitive advantage valuable 1.Analyze cost, revenue or value contriubtion 2.Benchmark against competitors, e.g. using DEA 3.Determine competitve advantage Non- substitutable Imperfectly imitable rare 1.The resources or resource bundle can not be substituted by other resources 1.The resource bundle is heterogene from other resource bundles 2.Heterogenity cannot be rebuild in the short to medium time frame 1.The resource or the resource bundle is not freely available. 2.Competitors can not buy the resources immediately 3.Direct competitors do not deploy identical resources/resource bundle

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

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. http://www.efinancelab.de/ Detailed Generic Value Chain of the Banking Industry  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. Firm Infrastructure Human Resources Technology Development Risk Management Products Credits Securities Fin. Products Corp. Invest. Other assets Investment Deposits Securitization Credits Funding Acct. Mgmt. Services Asset Mgmt. Issuance/IPO M & A Advis. Serv. Other Serv. Payments Trading Clearing & Settlement Custody Trans- actions Acquisition Offering Multichannel Management Sales Advertising Branding Sales Support Marketing In opposite to the industrial value chain from Porter (1985, p. 86), the developed banking value chain starts from the customer side.

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

17. http://www.efinancelab.de/ 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

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

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

21. http://www.efinancelab.de/ 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. = Set of products under study = Quantities of products = Multiproduct Cost Function = Vector of factor prices [Source: Panzar and Willig, 1981] Economies of Scope vs. Economies of Scale vs. 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] 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.

22. http://www.efinancelab.de/ Internal Production vs. Joint Venture vs. Specialist Universal banks: Highly diversified banks, which have separate business units may generate economies of scope. Example: Deutsche Bank 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. Joint Venture: Banks jointly produce specific bank products or processes to generate scale economies. Example: Eurohypo vs.

23. http://www.efinancelab.de/ Make vs. Buy Decision 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 Y i = Yearly output from diversified company of activity i Y N = Yearly output from diversified company of activities 1 to n Y M = Yearly output from diversified company of all activities M One-time costs for outsourcing Price Transaction costs Make vs. Buy Cost Function Scope economiesTransaction costs + + - +

24. http://www.efinancelab.de/ 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 studyK={1,2,...,k}= Firms participating in joint venture M= N without IP= Price per output unit of the potential supplier r= Risk-adjusted discount rate in percentS(s,f,u)= One-time sourcing cost function T= Years of contractw= Vector of factor prices Y i = Yearly output om diversified company of activity IY N = Yearly output of activities 1 to n Y M = Yearly output of all activities M Make vs. Share Decision

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. http://www.efinancelab.de/ 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

27. Backup

28. http://www.efinancelab.de/ 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.

29. http://www.efinancelab.de/ Model of three banks Production bank  IT- and Transaction Management  „manufacturer“ for clearing, settlement, payments and other transaction related business Model of three banks 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  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).

30. http://www.efinancelab.de/ Steffens (2002) expects special distribution, transaction and product banks Distribution  Distribution specialists concen- trating on sales channels like Charels Schwab, MLP or American Express. Distribution  Distribution specialists concen- trating on sales channels like Charels Schwab, MLP or American Express. Transaction  Transaction banks provide clearing and settlement, payment, trading and custody facilities Transaction  Transaction banks provide clearing and settlement, payment, trading and custody facilities Products  Product specialists like Credit Card, Credit and Asset Management companies provide their products to universal banks resp. global players Products  Product specialists like Credit Card, Credit and Asset Management companies provide their products to universal banks resp. global players  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.