Could SmartSourcing change everything?

Rob Scott, Head of Market Services, Commerzbank

Rob Scott, Head of Market Services argues a new strategic approach based on cooperation could help Tier 2 and Tier 3 banks wrestle market share from global universal banks in asset servicing

It’s well documented that life for banks has become tougher in recent years as the costs of regulatory compliance and the challenging market conditions take their toll. Whichever measure you chose – cost-income ratio, return on investment, return on equity, total costs – it’s clear that the commercial environment is becoming more challenging.

When it comes to addressing the challenge, different types of firms are adopting different approaches, which are summarised in the diagram below.

Outsourcing vs. SmartSourcing chart

The large outsourcers/BPO(Business Outsourcing Providers), represented in quadrant three of the diagram (bottom left) continue to favour a pure cost and efficiency play that has characterised their strategy historically. It entails squeezing every ounce of efficiency and optimisation of process, performed primarily in offshored, low-cost centres. This has worked particularly well in areas as for example Insurance, Airlines bookings and large segments of companies’ supply chain. This offering is now being introduced to banking operations. . Beside them in the bottom row, in quadrant four, are the legion of fast advancing fintech firms. Their ability to be disruptive and their attempts to disintermediate existing participants, and lever technology to produce an alternative low-cost model for customers means that are often presented as an existential threat to large incumbent businesses presented in the top row, quadrants 1 and two. However, as we will see, their killer apps will not threaten both groups in the same way, or to the same extent.

On the top row of the diagram are the traditional banks. On the left in quadrant 2 are the Tier 1 banks, including the major global custodian banks. On the right in quadrant 1 are the Tier 2 and Tier 3 banks, typically with roots in local coverage of a particular country or region and who may also focus on particular segments.

On the top row of the diagram are the traditional banks. On the left in quadrant 2 are the Tier 1 banks, including the major global custodian banks. On the right in quadrant 1 are the Tier 2 and Tier 3 banks, typically with roots in local coverage of a particular country or region and who may also focus on particular segments.

Common to the approach of both of these groups has been to win efficiencies and significantly cut costs by integrating the investment banking divisions with those that support asset servicing. As we will see, the firms in quadrant 2 often face a bigger challenge than those in quadrant 1 due to their sheer scale, balance sheet and global product coverage models. However, firms in quadrant 2 have a distinct advantage to engage in strategic partnerships with other similar sized/regional banks, extending their service offering at the front end while pooling resources in post-trade in order to significantly reduce costs.

Here we will focus on the approach taken by these two groups of the participants illustrated in the top row, starting with the Tier 1 banks in quadrant 2.

A. Quadrant 2 – the Tier 1 banks

Pressure to integrate

Recent years have been marked by attempts by the large global universal banks, whose business models have traditionally been dominated by their by investment banking trading activities, to consolidate these with their investor servicing operations. There are a number of drivers for this. The first is cost. In most cases, firms have squeezed all the cost savings on offer from offshoring to low cost centres and need to look harder for future efficiency savings.

The second reason is the pressure to smooth earnings. The reliable revenues from steady fee-charging businesses have become far more appealing, next to the wild fluctuations in revenues that increasingly characterise the investment banking businesses. Different price to earnings ratio attached to this business reflects the changing emphasis investors place on this.

A third reason is client needs. Here the common approach for clients has shifted from multiple relationships with multiple providers in multiple jurisdictions. Part of this is clients own smoothing of internal processing and the cost savings often attained in reducing the number of counterparties. But it has also become clear that a distributed model is an inefficient and costly way of managing for example collateral, which regulatory reforms have made an increasingly valuable commodity. Both elements increase the appeal of providers where execution and post-trade capabilities are combined and the diffuse elements of cash trading, derivatives, collateral management and clearing is integrated at a single venue.

Obstacles to integration

This trend to consolidate investment banking with asset servicing operations at the Tier 1 banks provides a difficult choice. Either replace the entire bank-wide platform with a single integrated modern technology solution, at a cost of hundreds of millions of Euros at a time when the funds and appetite for this type of project are particularly low. Or work to compress and integrate your business to find cost efficiencies from combining silos.

The second, favoured, path has seen the major global universal banks work to integrate for example wealth management with asset management businesses

and the sales and trading business of the investment bank with its asset servicing operations.

To get a feel for the structural obstacles that make this difficult, consider the difference between investment banking and asset servicing business lines. These are typically enormous global organisations in their own right. Each follow different cultural and logistical priorities: the servicing division based around a model of long-term relationship management; the investment banking operation based around short-term transaction flow.

These cultural differences have shaped different approaches to delivering services depending on which part of the business a given bank has its roots in. The investment banking model is characterised by an industrialised, process-driven approach; banks that have their roots in asset servicing have traditionally started with client requirements and modelling specific solutions based upon their existing capabilities and constraints.

Finally the business cycles in the two types of business work in tension. In particular, the focus on the immediate deal-based business environment of the front office business is at odds with the longer lead cycles associated with deals an procurement that characterises asset servicing. It is hard to fit the incremental gains of new technology, for example, into the shot-term P&L based transaction models that dominate investment banks.

B. Quadrant 1 – Tier 2 and Tier 3 banks

Strategic partnership

The Tier 2 and Tier 3 banks that inhabit quadrant 1 are starting to consider a different approach.

Typically these firms enjoy strong but increasingly challenged profitability but have been prevented from growing by the high current cost of capital. What investment dollars that are available at these firms are mopped up largely by the costly business of regulatory compliance; the remainder goes on squeezing out smaller efficiencies.

Firms in this quadrant, such as Commerzbank, are addressing this through the exploration of strategic bank partnerships and cooperation type agreements. Typically this means a number of banks collaborating in front end services to help fill the gaps in each other’s services. It also means pooling resources in the post-trade environment to defray costs. Careful selection of the right strategic partners entails leveraging complimentary competencies to take market share away from their larger Tier 1 competitors and to increasingly service its clients in a cost effective and innovative way

For Tier 2 and Tier 3 firms a complimentary approach holds a special appeal. Bank A may lack for example an ETF trading platform or sophisticated fx capability in a market or have sufficient investment budget to build its own capability. Bank B may have this product but may for example lack the resources to service pension funds or asset managers effectively, which may me an area of specialism for Bank A. Strategic partnerships or collaboration agreements between them will potentially enable them both to fill their respective gaps with the functionality and experience provided by the other, benefit both parties with new business growth opportunities without putting existing business at risk.

The strategic partnership model is available to Tier 2 and 3 firms because the regional or specialist nature of their business means they tend not to be in direct competition with each other in their respective markets. By contrast, tier 1 global universal banks are organisations active in usually every sector, often in direct competition with each other regardless of the type of service they are offering, often trading with the same counterparties in the same products and same markets and are therefore suspicious of cooperation with similar type organisations. Achieving consensus in strategic partnerships is therefore hard and such co-operative efforts are bound to move slowly at best and may not materialise at all.

C. Fintechs: threat as opportunity

The strategic partnership model also puts quadrant one firms at an advantage over quadrant two firms in dealing with the fintech threat.

Fintech are long on innovation and short on customers and capital. The right fintech solution acquired by a quadrant one firm can be an essential part of the strategic partnership. Firms in this quadrant are also nimble enough to absorb and integrate a fintech firm quickly and apply it directly in pursuit of the strategy.

Because they do not have the internal complexities and are “not trying to turn an oil tanker”, a problem that Tier 1 banks experience, they can realise the gains of such acquisitions/partnerships in a more agile manner. With a high degree of specialisation in their regional market or sector they will also have a keener eye for precisely what fintech solution can apply to customers, making the business of choosing which to buy more straightforward. Spotting which killer app is just right for example with asset managers in Germany, , is a much easier task than finding one that improves your offering to insurers, pension funds, sovereign funds, broker dealers and retail banks across 150 countries.

These benefits are much harder to harvest for the behemoth inhabiting quadrant 2. Evidence is provided by the number of initiatives launched by the major Tier 1 firms aimed at working together to deal with the threat posed by fintech start-ups. Achieving consensus from a large group of firms that are used to working in competition is very hard. With members pre-occupied with protecting their existing business models and client franchise; it’s hard to see these collaborative efforts yielding working quickly.

*Commerzbank is a Tier 2 bank in quadrum 1: historically we’ve built our business around corporate services and deep rooted relationship driven business activities and services, which means we have developed a different culture and approach to purely investment bank-centered firms