Strategic Sourcing in Banking A Framework Markus Lammers, EFinance Lab University of Frankfurt

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Strategic Sourcing in Banking- A
FrameworkMarkus Lammers, E-Finance Lab
University of Frankfurt

• October 08, 2004

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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

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Problem
German Banking Industry
Special banks 68 Institutions
Universal banks 2288 Institutions
28 building and loan associations
14 banks with specific functions
26 mortgage banks
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
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Synergy potential
Bank 2288
e.g.2288 times redundant credit processes
Bank 2
Bank 1
High vertical integration and polypolistic market
structure indicates high synergy potentials
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Hamoir et al. expects that 4 banking models may
emerge
Potential banking models Regional retail
distributors (1) Global wholesale and investment
bank (2) Pan-European product specialists
(3) Pan-European service providers (4)
Infra- structure
Position along the value chain
Products
Distribution
Mass Affluent Private
Small Midsize
Multinational Corporations
Retail
SME2
Type of banking customer
1Such as commercial insucrane and institutional
asset management 2Small and midsize
enterprises Source Hamoir et al. (2001), p. 123
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Research Questions
What is the optimal degree of vertical
integration for a bank?

• 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?

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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.

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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

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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.

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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.

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Theroretic Foundation An Introduction to the
Resource Based-View (1/2)
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

• 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

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Theroretic Foundation An Introduction to the
Resource Based-View (2/2)
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Qualtitative Sourcing Framework
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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

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Detailed Generic Value Chain of the Banking
Industry
In opposite to the industrial value chain from
Porter (1985, p. 86), the developed banking value
chain starts from the customer side.

• 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.

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A generic value chain for consumer credits
Consumer Credit Process derived from the generic
value chain
Evaluation of in-house efficiency of value
activities
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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

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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

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Production Cost Economics

• Squeeze Out Potential Reality Check
  Financial Services

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Production Cost Economics

• Scale and Skill economies of Insourcer

C/y
CO
Insourcer Skill Potential
CI
C/y Outsourcer
CI
C/y Insourcer
Insourcer Scale Potential
y
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Economies of Scope vs. Economies of Scale
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.

• 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

• vs.

Set of products under study Quantities of
products Multiproduct Cost Function Vector of
factor prices
Source Panzar and Willig, 1981
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.
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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

• Joint Venture
• Banks jointly produce specific bank products or
  processes to generate scale economies.
• Example Eurohypo

• vs.

vs.
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Make vs. Buy Decision
Make

-
Cost Function
Scope economies
Transaction costs
vs.
Buy


One-time costs for outsourcing
Price
Transaction costs
C(y,w) Cost function output and factor prices
G(f,u,s) Governance cost function N1,2,...,
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 Yi Yearly output from
diversified company of activity i YN Yearly
output from diversified company of activities 1
to n YM Yearly output from diversified company
of all activities M
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Make vs. Share Decision
C(y,w) Cost function of dependent output and
factor prices G(f,u,s) Governance cost
function N1,2,...,n Set of activities under
study K1,2,...,k Firms participating in
joint venture 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 Yi
Yearly output om diversified company of activity
I YN Yearly output of activities 1 to n YM
Yearly output of all activities M
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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

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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

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Backup
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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.

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Model of three banks

• 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).

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Steffens (2002) expects special distribution,
transaction and product banks

• 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

• 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.