Bluerock Review : April 2002

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Bluerock Review - April 2002 (229k)
Joint Venture in Business Process Outsourcing. " Managing Operational Risk: Implications of Basel 2.
Keywords: business process outsourcing, joint venture, BPO, operational risk, Basel 2


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THE JOINT VENTURE OPTION IN BUSINESS PROCESS OUTSOURCING Andrew Moyle, Partner, Shaw Pittman Shaw Pittman, a law firm, is a partner company of Bluerock Consulting working within the outsourcing arena. We have invited them to contribute this article on their experiences of setting up joint ventures within business process outsourcing. The joint venture ("JV") is an increasingly popular vehicle in the financial services industry for business process outsourcing ("BPO") transactions. Many processes which financial services institutions ("FSIs") are looking to outsource (e.g. back office settlement, loan application processing) may no longer be 'core' but are still considered fundamental to the FSI's operational integrity. Through an equity stake with the vendor in a purpose-built JV which then supplies it with the outsourced services, the FSI can argue that it retains a greater degree of control. UK-based FSIs using the JV option may also achieve real savings by retaining their VAT-exempt status, a benefit otherwise lost in the typical customer/vendor relationship. In Europe, the JV option may assist employment transfer issues. Joint ventures also make sense for the vendor. Vendors can contribute cost efficiencies and improved service delivery through their technical know-how and service delivery processes, but currently do not have the business processing expertise of their customers necessary to establish credibility and market share. The attraction for both parties is that economies of scale can be generated by leveraging a transformed business process solution to other customers once the JV is operational. Recent success stories include the JV between EDS and Abbey National (EDS Credit Services) to which Abbey National transferred its entire loans and mortgages servicing operations, and the JV between Lloyds TSB, Barclays and Unisys (iPSL) launched in December 2000 to undertake cheque processing for the two banks and existing customers of Unisys. HSBC recently outsourced its cheque clearing operations to iPSL, acquiring a 10% equity stake in the JV. However, the outsourcing world is littered with failed JV outsourcings. What factors are key to ensure the BPO JV has the best chance of success? Unique selling point Is there a market for the BPO service? If so, how many other players are there? What is the unique selling point for the process that the FSI is outsourcing, and can it be replicated for others? Andrew Moyle Shaw Pittman "...the Business Process Outsourcing Joint Venture is one of the most difficult transactions to negotiate and manage..." The FSI must at the outset undertake a detailed analysis of the options, including going to the market to determine whether a JV is viable, or whether a customer/vendor relationship is more appropriate. Managing conflicting objectives Common objectives between the parties are essential if the JV is to have a chance of succeeding. The BPO JV is one of the most difficult transactions to negotiate and manage because it combines the customer's objective in outsourcing (typically to cut costs and improve service) with that of the JV (to compete for customers and increase profits). This conflict must be managed. Before proceeding with the JV, a detailed budget and business plan should be agreed with quantifiable short-term goals (cost savings for the FSI) and realistic long-term goals (revenue growth for the JV). Due diligence Thorough pre-contractual due diligence is vital. The FSI needs to determine whether the vendor is suitable for an enduring relationship, analyse its market position, the quality and price of its offering and its long-term strategic goals. Much of this, together with market comparables, can be assessed through a tender process. Strong services agreement Although the parties are partners in the JV, the services agreement between the JV and the FSI, whereby the FSI receives the outsourced services, remains a customer/vendor relationship. It must be at arms' length and able to stand alone if, for whatever reason, the JV terminates. The rigour and best practice adopted in a standard outsourcing customer/vendor arrangement therefore must apply in the context of a JV. Incentivised management Getting the right people to manage the JV will be key to its success and depends largely on the viability and prospects of the venture. Initial management is often drawn from the parties themselves and must be sufficiently senior, committed and incentivised (through the JV or its parents). Of course, the parties will be reluctant to part with their best managers, so each party must allocate time to negotiate service contracts for key personnel. Managing the JV's success If the JV is too successful, converse problems arise. If its business plan is not sufficiently distinct from the business of either parent, the JV may compete with that party. Alternatively, if the JV pursues and attracts additional customers, its focus may shift from the incumbent FSI to the new customers. Consistent with the conflict of objectives mentioned above, the JV will not want to reduce the incumbent FSI's service charges as these are used by the JV to fund future expansion and competitive service offerings to others - another reason to ensure a strong services agreement is in place. Conclusion Having outsourced a non-core competency, the FSI is generally unlikely to want to remain in the business of delivering the related business process services long-term. Furthermore, the natural dynamic in customer/vendor JVs means the vendor will exert increasing influence over the JV. FSIs therefore need to be pragmatic, treating the JV as a transformation vehicle which provides the FSI with an effective services solution and potential revenue stream in the short- to medium-term, but which, when appropriate, allows the FSI to "cash-out" and rely on a robust services agreement. However, regardless of the legal framework and protections which lawyers can build into the JV structure, the JV will not succeed unless it is based on something far more fundamental: mutual opportunity, a shared vision, realistic goals and a strong, empowered management team. Shaw Pittman's London office focuses on domestic and cross-border technology and corporate finance work. The office provides UK, European and US clients with the unique blend of commercial, technology and legal services upon which Shaw Pittman has built its reputation. They can be contacted at: Tower 42, Level 23 25 Old Broad Street London, EC2N 1HQ Phone 020 7847 9500 Managing Operational Risk - Implications of Basel 2 Chris Beer Whilst the European banking sector wrestles with over-capacity, declining revenues and margin erosion, senior managers are already looking beyond this current uncertainty to the long term and to formulating a coherent response to the implications of the New Basel Capital Accord. The most contentious area of The Accord or 'Basel 2' relates to a new requirement for banks to allocate regulatory capital against operational risk, in addition to existing credit and market risk provisions. Indeed, criticisms by market participants of these particular proposals have led to a postponement in the implementation of Basel 2 by one year to 2005. So what is all the fuss about? In summary, the Basel Committee proposes three options for calculating a bank's operational risk capital allocation or 'charge'. - Basic Indicator Approach. The charge is calculated as a percentage of a single financial indicator (probably gross income). - Standardised Approach. The charge is calculated by multiplying an operational risk exposure indicator for a standard business line (defined by the regulators) by a beta factor also set by the regulators. - Internal Measurement Approach. The charge is calculated by multiplying the expected losses for each standard business line by a gamma factor set by the regulators. These expected losses are in turn calculated using a bank's internal historical loss data. This means that the more complex and, in theory, accurate the methodology, the less a bank's required capital charge. Basel 2 - A Guide Basel, a charming Swiss city canton (see photo), is home to The Basel Committee, established by the central bank governors of the Group of Ten countries in 1974. The Committee formulates broad supervisory standards for the international community banking and guidelines and recommends statements of best practice in the expectation that individual country authorities will take steps to implement them through detailed arrangements. In 1988, the Committee decided to introduce a banking capital measurement system commonly referred to as the Basel Capital Accord. This system provided for the implementation of a credit risk measurement framework together with provisions for governing the minimum amount of regulatory capital a bank was required to maintain (8% by end of 1992). Since 1988, this framework has been progressively introduced not only by member (Group of Ten) countries but also virtually all other nations with internationally active banks. The New Basel Capital Accord, or 'Basel 2', revises the existing 1988 provisions and is designed to ensure greater transparency in a bank's disclosures to the marketplace and extend the scope of risk definition to better reflect the range of activities international banking groups undertake. Since their publication, the European banking community has raised a number of concerns at these operational risk provisions. The most significant of these have been: - The target proportion of regulatory capital to be allocated against operational risk was too high at 20%, although this has since been revised to a more amenable 12%. - Existing quantitative approaches to identifying and measuring operational risk differ significantly from bank to bank and are typically emergent rather than fully mature. - The internal measurement approach relies on predictive historical loss data, meaning that banks will need to start accurately collecting relevant loss information soon if they are to make use of this method by 2005. - Basel 2 takes no account of any existing qualitative methods for assessing controls used for managing and mitigating operational risk. - Smaller banks that lack the financial resources to implement more complex operational risk calculation methodologies will be penalised by relatively higher capital allocation requirements. Despite the 'fog' that continues to swirl around the operational risk provisions of Basel 2, there is a series of actions senior managers can take now - many are already doing so. As the Basic Indicator Approach will prove to be unacceptable to the majority of market participants (it will probably inflate capital allocation requirements unnecessarily); then European banks need to undertake the following steps: - Conduct a high-level 'impact analysis' to assess the implications of Basel 2's for the organisation. Understanding its impact on a bank's existing operational risk management infrastructure (if any) will be particularly important. - Select the preferred approach to operational risk measurement and calculation from one of the three options available. - Map internal business lines to the standard categories prescribed by the Basel 2. This will have a considerable organisational impact on any bank. - Create an independent operational risk function if one does not already exist. - Implement the relevant loss tracking and reporting systems. - Estimate the bank's probable operational risk capital charge, although this cannot happen until the regulators release the beta and gamma factors they propose using. Banks wishing to adopt the internal measurement approach will also need to develop operational risk loss databases to enable expected loss calculations, back testing and scenario analysis. This will prove to be a significant IT development initiative as this database will need to deliver a level of analytical sophistication for operational risk on a par with existing market risk applications. Senior managers now reaching for the Vallium shouldn't despair, however. Although there is a lot to do and the clock is ticking, there is still time to respond positively to Basel 2 and even get one up on it by using it as a catalyst for improving the allocation of capital over and above its requirements. If you require any further information please contact: Julian Sawyer [email protected] Helga Mepham [email protected] Bluerock Consulting Limited Alderman's House Alderman's walk London EC2M 3XR Tel: 020 7743 6780 About Bluerock Consulting Bluerock Consulting specialises in providing consulting services to the financial services sector. Our senior consultants have typically worked for financial services institutions and for one of the large consulting firms. Consequently, each Bluerock consultant brings to assignments in-depth business knowledge and a proven track record. Bluerock's approach to assignments is to work with our clients and focus on the success that they want to accomplish and not to prolong our assignment. We have many blue-chip financial services institutions that will testify to this success and economy of our approach.