Ubs Newsletter - What Makes A Bank A Bank?

UBS Newsletter for Banks and Financial Institutions

I / 2005

News for Banks 2 Research The transformation of the banking landscape

6 Focus Business The Reference Bank Model

9 Focus Business Clear, informed decision-making

10 Round Table Multi-dimensional decision-making

14 In Brief SWIFTNet: a critical assessment

Point of view

What makes a bank a “bank” ? UBS got to the bottom of this question while analyzing an important client bank. What came out of the study is the Reference Bank Model described on page 6. This model provides a general overview of the functions, products and services that a bank must have and offer to clients in order to be perceived as competent and to be legally classified as a bank.

Marten Sybren Hoekstra Member of the Group Managing Board Head Market Strategy & Development UBS Wealth Management & Business Banking

Ab

ners are speaking the same language by clearly defining every term. The model cannot, of course, judge whether it makes sense to sell a specific business area, or whether doing so will be a huge success. The four participants in the round table (page 10) addressed this question in their final thesis for their Executive Master of Business Engineering programme. They developed a model The Reference Bank Model might also that highlights the critical points and help any bank gain a clearer picture renders the decision-making processes of its business model and strategy. As involved in a potential outsourcing projHenner Schierenbeck, Professor for Bank ect more transparent. Management & Controlling at the University of Basel points out in his article From a shareholder value point of view, on page 2, banks worldwide sometimes a bank has two critical long-term assets feel pressure to consolidate. To succeed, which drive profits: client relationships banks have to concentrate on strengths and a brand which can help generate and core competencies and keep costs new client relationships. These two asunder strict control. Consequently, they sets cannot be outsourced. Depending have to consider which areas of their on a bank’s strategy, most other funcoperations they need and want to cover tions can be partially or completely outand which areas they can outsource or sourced. sell. The model serves to help banks structure and document their functions The Reference Bank Model to outsourcand processes as well. ing is usually not one of strategy or function. It is usually internal debate. We Lastly, the Reference Bank Model demon- believe that the Reference Bank Model strates where and how activities can is an outstanding tool to help any bank’s be outsourced. It also ensures that both management team tackle these issues. a bank, and potential outsourcing part- We hope you, too, find it valuable.

Research

The transformation of the banking landscape A wave of consolidations is sweeping across the banking industry, leaving a verydifferent landscape in its wake. Cross-border mergers are a likely prospect in Europe. In asset and wealth management and in retail banking, too, the pressure looks set to continue.

For some years now, the banking sector worldwide has been undergoing consolidation on a major scale, leading to massive structural change. Consolidation is generally understood to mean a process of increasing market concentration as a result of mergers and takeovers, whereby the historical fragmentation in many sectors of the banking market is reduced or eliminated altogether. As a result of this process, the number of banks in the six leading industrialized nations – the USA, Japan, Germany, the UK, France and Italy – nearly halved, on average, between 1990 and 2002. And in terms of their total assets the 50 biggest banks worldwide also saw their share increase from 45% in 1995 to 55% in 2002 (see Figure 1). Likewise, the group of small and medium-sized banks in Europe has also undergone consolidation. This segment is dominated by public-sector (savings) banks and co-operative banking organizations. Given the nature of the publicsector and co-operative structures in question, takeovers or mergers between this segment and the private sector are a virtual impossibility. As such, crosssector mergers can only take place if both legislators and the associations concerned are ready to abandon these

Figure 1: The global concentration process Top 1000 banks’ assets in USD billion 45

45%

40 35 55%

30 25

25%

20 15 10 5

21%

12%

10%

18%

14%

0

Top 10 Next 10 Next 30 Remaining 950

1995

2002

Source: The Banker

The top 50 banks have increased their total market share by ten percent over the past seven years through mergers.

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legal structures. How far advanced this process is, differs from one part of Europe to another. Where things have yet to open up, mergers have taken place within sectors. As such, the number of independent financial institutions fell significantly between 1998 and June 2004 and the process is still ongoing (see Figure 2).

Given the limited number of potential merger candidates and active players in Europe, the first movers with the best strategy will be at a distinct advantage. The driving forces behind consolidation When searching for the causes of consolidation, one factor that stands out is the growing trend towards industrialization in the banking industry. There are various reasons for this: the impact of modern information technology, without which many activities would simply not be possible, the growing pressure on margins in almost every segment of the banking business, the deluge of banking regulations with their negative implications, the relentless pressure for innovation and the ever-higher levels of expertise required to stay competitive in today’s banking industry, to name but a few. Then there is the sharper focus by modern bank managements on value and the capital markets, which is undoubtedly one of the key elements driving the consolidation process. As a result of this, a bank’s rating becomes a more important measure of success as reflected in its funding costs as well as market standing and customer business in general. Another reason is the increasing pressure for banks to live up to investor expectations. In particular, this means that market capitalization and the structural return on shareholders’ equity

Research

become vital criteria for success, that banks must earn the cost of their capital and that they must consistently apply the principles of return-based capital allocation when deciding which businesses to operate in. These two trends are the primary forces determining the direction and momentum of the restructuring process in the banking sector (see Figure 3).

Figure 3: Consolidation pressure on two fronts

An overview of the European banking landscape In order to ascertain the strength of the pressure to consolidate within a given banking system, we can study both market structure data and profitability indicators based on data for the period 1992 to 2001. In this instance, the structural data include bank concentration figures, the G5 coefficient (i.e. the aggregate market share of the five biggest institutions), the bank density ratio per million inhabitants, the density of the branch network (number of branches for every 10,000 inhabitants) and the average number of branches per bank. It is important to note that – for systemic reasons – the G5 coefficient will be higher for smaller countries although the absolute figures for the banks in question will tend to be lower. There will also be country-specific anomalies.

and

At the bottom of the league table when it comes to concentration in the bank-

Growing pressure on margins Growing pressure to rationalize Deluge of banking regulations High investment requirement Ever-greater expertise required/pressure for innovation Decline in state guarantees and subsidies Banks’ increasing dependence on capital markets

Banks increasingly focused on investor expectations

2,500

ing industry is Germany. Here, the five biggest banks have a combined market share (in terms of total assets) of just 20%. Top of the table are the Scandinavian countries, with G5 values in excess of 77%. The main reason for this high level of consolidation is the serious banking crisis of the early 1990s. The bank density ratio also varies from country to country. Front-runner here is the clearly “overbanked” Austrian mar-

● Credit co-operative in Germany ●

●

2,100

n Regional banks and savings banks in Switzerland

2,035 1,792

●

1,700

1,619

●

1,300 594 600

◆

550

578

◆

562

◆

110 100 90 80 70 60

108

n

1998

106

n

1999

1,489

●

1,393

1,378

●

● –39%

537

◆

500 450

520

◆

491

486

◆

◆ –18%

103

n

200

Bank strategies geared to value and capital markets ...

Industrialization, together with the banks’ sharper strategic focus on value and capital markets, is driving consolidation.

◆ Savings banks in Germany

2,256

... as the driving force for consolidation

Increasing importance of bank ratings

Figure 2: Consolidation among small and medium-sized banks Number

Industrialization of the banking industry...

94

n

2001

88

n

2002

83

–36%

n

69

2003

June 2004

n

Source: zeb/rolfes.schierenbeck.associates

Due to current legal strictures, mergers among small and medium-sized banks have tended to occur within the same sector.

ket, with 103 banks per million inhabitants. At the other end of the spectrum is the UK (8), which has managed to slash the number of banks drastically.

Industrialization and the sharper focus by modern bank managements on value and the capital markets are the primary forces determining the direction and momentum of the restructuring process in the banking industry. As far as the density of the branch network is concerned, the mid-range values are much closer together. Extremes are shown with the UK, Sweden and Finland with between 2.1 and 2.4 branches per 10,000 inhabitants and Spain with 9.5. These major disparities can be attributed to strategic differences in the distribution systems of the various countries, but – in this case – have no real impact on efficiency. Finally, the average number of branches per bank is a further key structural indicator. Here, Finland (3) and Austria (5) UBS News for Banks

I / 2005

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Research

have extremely low values indeed. This is due to the prevalence of savings banks and co-operative banks in particular. At the other end of the spectrum is Spain, with almost ten times more branches per bank than Germany (15), for instance. If one compares the country-specific structural data, certain clusters emerge. With the exception of certain ambiguities, we can identify three distinct groups. In the first group we find Switzerland, Denmark and Sweden. The second group is made up of the UK, Belgium and the Netherlands, Finland and France. The third and final group comprises Spain, Italy, Germany and Austria.

assets and the cost/income ratio, and market capitalization, as expressed by the price-to-book ratio. As in the case of the structural data, distinct clusters can be identified, which can again be divided into three groups. In group 1 we find Switzerland, Spain and the UK. Group 2 is made up of Denmark, Sweden, Belgium, the Netherlands, Germany and Italy. Group 3 comprises France, Finland and Austria.

On this basis, we can state that successful banking systems are characterized by above-average profitability, as measured in terms of return on assets, a high cost/income ratio and high market capitalization in terms of price-to-book ratio. When it comes to attempting to link the performance indicators with the market structure data, it is important to be aware that there can be no simple, monocausal explanations. There is simply too much divergence in the strategies pursued by the various European banks in their respective business segments and the “perceived psychological stress” in the event of poor performance. There are examples of extremely successful specialist and full-service banks in Europe, as well as highly profIn addition to structural data, banks’ per- itable bancassurance companies. Spain, in particular, is convincing proof that a formance indicators are also analyzed on a country-by-country basis. The crite- relatively high market concentration and intense competition need not be muturia used for comparison purposes are ally incompatible. Here, oligopolistic profitability, measured by return on

Successful banking systems tend to exhibit a relatively low bank density, a high number of branches per bank and a relatively high degree of concentration (G5). And vice versa.

Group 1

low

FR FI AT

Structural indicators: UK BE/NL FI FR

Group 2

DK SE BE/NL DE IT

CH DK SE

ES DE IT AT

Group 3

Group 3

• Ø Return on assets • Ø Cost / income ratio • Ø Price-to-book ratio

Group 2

Performance indicators:

Consolidation pressure

ES CH UK

high

Group 1

Figure 4: Regional differences in consolidation pressure

• G5 coefficient • Bank density • No. of branches per institution • Density of the branch network

Linking the performance indicators for banks in individual countries with the corresponding structural indicators reveals which regions will be exposed to the greatest cost pressure.

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UBS News for Banks

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structures actually encourage competition and, at the same time, have a positive impact on banks’ performance. With this proviso, the following rule applies: successful banking systems tend to exhibit a relatively low bank density, a high number of branches per bank and a relatively high degree of concentration (G5). And vice versa. On the other hand, the density of the branch network per se is apparently only of minor importance. In other words, it gives more of an indication of how well the population is provided with financial services than the degree of consolidation of the banking market (see Figure 4). Cross-border mergers Outside of the “bulge bracket” segment, too, the consolidation of the big banks looks set to continue apace. In other words, in the European big bank sector – now that the opportunities for consolidation at the national level have been exhausted in many places – we are likely to see a growing trend towards cross-border mergers and thus the emergence of pan-European banks. Such a development looks probable for a number of reasons. Firstly, this is the only way to achieve any kind of a counterbalance to the might of the big American banks such as Citigroup in particular. The EU – with its regulatory framework geared to integration, particularly in relation to the financial services market, its common currency in the form of the euro and its standardized banking regulations (Basel II Accord) – looks set to dismantle the barriers to cross-border mergers. Running counter to this is the strong desire in certain European countries – such as Germany or France – to build up or preserve their own “national champions” in the banking sector, but this can be neutralized through European holding structures. Last but not least, there is no doubt that the European banking industry still lags a long way behind other sectors in terms of the degree of market concentration. Given the limited number of potential takeover/merger candidates and active players in Europe – no more than about 30 institutions in total – the first movers will be at a distinct strategic advantage.

Research

will be greatest in the two key strategic areas of retail & commercial banking and wealth & asset management (private banking). Of late, there has been a growing consensus of opinion that retail banking is in a position to generate respectable, stable margins provided that the business is run properly and with a sizeable customer base. Combining private clients and (medium-sized) corporate clients in an integrated business model can also be an additional contributor to success. But above all, if a retail bank is to succeed, it must have an outstanding sales culture, a strong distribution model, rigorous cost control – with intense exploitation of economies of scale in processing and transactionbased operations, in particular – and Strong pressure to consolidate There may be immense pressure to con- highly sophisticated risk management procedures. Moreover, the greater its solidate, but not all banks or business market clout and the larger its customer areas will be affected in the same way. Looking at the various banks and the re- base, the better placed a bank is to spective core businesses individually, one boost its earning potential still further. can say that the pressure to consolidate Thus, to the extent that mergers serve At the same time, those first movers will increase the consolidation pressure on other banks (see Figure 5).

If a retail bank is to succeed, it must have an outstanding sales culture, a strong distribution model, rigorous cost control and highly sophisticated risk management procedures.

Figure 5: Prospective merger candidates Market capitalization in EUR billion, as of July 31, 2004 Commerzbank Hypo-Vereinsbank

8.490 9.842

to increase a company’s market share and the number of potential customers in its particular businesses, they can also optimize the earning potential of these businesses. In asset management – which is often an integral part of wealth management – many banks and insurance companies massively increased their capacity during the boom period in order to benefit from the expected growth in the industry. In the meantime, they have had to lower their expectations considerably. According to a study by Oliver, Wyman & Co. the volume of assets under management in Europe will only grow by 7.4% per annum up to 2006 compared with 20% in the 1990s. At the same time, annual earnings growth is set to halve to just 7%. Much like traditional on-balance-sheet business, the asset management and private banking markets are highly fragmented. With more than a thousand rival players in the field, the five biggest asset managers in the European banking scene have a total market share of just 16.5%. In private banking, the top five global players account for a mere 6.5% of the assets of high net worth individuals. As such, we can also expect to see a massive process of consolidation in both these businesses in the future.

Svenska Handelsbank

10.059

Banco Popular Español

10.173

Abbey National

12.632

Danske Bank

12.681

Henner Schierenbeck

San Paolo IMI

13.764

Professor at the Department of Bank Management

KBC Group

14.575

& Controlling, Institute of Economics,

Dexia

15.768

University of Basel

Standard Chartered

15.888

[email protected]

Nordea

16.491

Gruppo Intesa

18.220

Fortis

23.264

Unicredito Italiano

25.053

ABN Amro

28.638

Crédit Agricole

28.881

Société Générale

30.257

Deutsche Bank

31.282

Credit Suisse

31.864

Lloyds TSB

34.842

BBVA

37.503

Grupo Santander

37.670

HBOS

41.839

BNP Paribas

42.802

Barclays

44.751

UBS

65.785

Royal Bank of Scotland HSBC

Bibliography KPMG: “Hungry for more? Acquisition appetite and strategy in the global private banking and wealth management industry”, Zurich, 2004. Krabichler, T. / Krauss, I.: Konsolidierung im europäischen Bankenmarkt, Regensburg, 2003. Lahusen, R.: “Bankenerfolg in Europa: Grosse Fortschritte durch Konsolidierung – mit Ausnahme Deutschlands”, in: EU-Monitor, Frankfurt am Main, 2004. Oliver, Wyman & Co./ UBS: “The Future of Asset Management in Europe”, September 2002. The 2004 Global 500 annual ranking of the world’s largest corporations, in: Fortune, Vol. 150, pp. F16 – F22.

73.261 135.107 Source: Datastream

Paul, S.: “Zwingt das Internet-Zeitalter Banken zu internationalen Fusionen?”, in: Internationalisierungsstrategien von Kreditinstituten, Stuttgart, 2002.

There are 28 banks which are candidates for a pan-European merger. UBS News for Banks

I / 2005

5

Focus Business

The Reference Bank Model As an aid in the optimization process, UBS has developed a generic model that replicates the value chains of a range of different banks. The Reference Bank Model is a useful tool for the managements of partner banks when faced with decisions on the outsourcing of sub-processes.

also helps to facilitate understanding between a bank considering outsourcing and its prospective solution providers. A corresponding glossary Rather than succumbing to the pressure ensures that both parties to any outsourcing arrangement are speaking the to consolidate and going down the merger route, many banks are opting to same language when it comes to the functions and processes concerned. The outsource parts of their value chain to professional, experienced partner organi- Reference Bank Model is the result of a zations – the rationale behind this being collaborative venture with a Swiss private bank that contacted UBS to disthat another bank can carry out the cuss the possibility of outsourcing eleprocesses in question more cost-effecments of its value chain. tively than would be possible in-house. But before deciding which activities and processes to entrust to a partner organi- Focusing on the client zation, a bank must first identify its own For a private bank, the ever more sophisticated nature of financial products, core competencies. for example, raises the issue of whether it can – or indeed should – continue to Speaking the same language develop and put together the full range With that in mind, the UBS Reference Bank Model can be a very useful tool in- of products in-house, or whether it might not, perhaps, be better to buy in deed. The model replicates every single The intense competitive and consolidathe requisite know-how from an extervalue creation, management and suption pressure in the banking industry is nal source, given the increasingly comforcing non-global banks in particular to port process. The accompanying quesplex regulatory and fiscal environment. consider their future strategy. The main tionnaire is designed to help the manBy teaming up with a professional partquestion facing management is whether agement team identify the applicable ner organization that will develop the the bank can continue to cover all areas core competencies and determine the bank’s future strategic orientation. Only financial products and deal with all the of the business to optimum effect and legal issues, a bank can concentrate its then can the issue of outsourcing nonhow best to utilize the available reefforts on front-line activities such as the sources. Whilst the ever-changing regu- strategic sub-processes be addressed. acquisition of new clients and the care By depicting all the different areas of latory environment and the increasing of existing clients, or devising tailorthe business, the generic bank model complexity of customer products and solutions are absorbing more and more resources, competition and falling margins demand efficiency and cost control.

Industry trends in private banking Major industry trends

Business implications

• Changing client needs

• Advice required on all financial needs: assets, liabilities, insurance, tax, pensions, real estate

• A more demanding regulatory environment • Continued in-market and cross-border consolidation • Ongoing cost control paramount as margins are continually squeezed • Outsourcing of back-office functions as a means to address the cost issue

• Risk systems need to be enhanced (or outsourced) • Size increasingly important as a means to extract cost (synergies) and remain competitive • Weak performers will come under further pressure and will have to either rationalize or exit • Intense competition for outsourcing mandates could help to further reduce cost

The private banking industry has undergone fundamental changes over the last few years. Both strategic and structural changes have been accelerated by the recent bear market.

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Focus Business

made investment solutions. In this way, the bank will be able to devote far more time to its clients and dramatically improve the quality of the contact it has with them.

The Reference Bank Model replicates every single value creating, management and support process. Identifying risks and defining the interfaces The potential risks of outsourcing particular activities can be identified at an early stage with the aid of the Reference Bank Model. Thus it is possible to ascertain early on whether selling third-

Last but not least, by clearly illustrating the processes involved, the generic bank model allows the costs of carrying out specific sub-processes within the bank to be identified. Only when these precise costs are known is it possible to Once the areas to be outsourced have been decided, the next step is to clearly make any meaningful comparison with what a prospective outsourcer is offerdefine the interfaces with the partner organization. Here, the challenge lies in ing. In some cases, the outsourcer will not only be more cost-effective, but also the detail. Take the decision to outsource the processing of securities trans- more flexible and more responsive. actions, for example. It might sound straightforward. But in practice the entire process – from submission of the Markus Bühler order through to confirmation of execu- UBS Investment Bank, tion – has to be broken down into its Regional Distribution Channel Management constituent parts so that the relevant [email protected] activities can be outsourced without causing disruptions in the process as a whole (see diagram on page 8). As a rule, this will also involve seamlessly integrating different IT platforms at the various interfaces. party products or using external trading platforms, for instance, would involve any risk to a bank’s reputation and, if so, how that risk can be limited.

The Reference Bank Model for a private bank

Corporate Functions

Products and Services

Business Strategy

Financial Planning

ALM & Finance Investment Solutions Risk & Compliance

Legal

Banking Products

Communication

HR & Education

Transaction Products

IT

Research

Central Logistics

Investment Banking

Client Advisory

Financial Planning Estate Planning Tax Planning Foundations and Trusts Insurance Fund Advisory Portfolio Advisory Portfolio Management Alternative Investments Fund Administration Accounts Cards Payments Mortgages Other Loans Trade and Export Finance Equities FX FI Proprietary Funds Third-Party Funds Macro-Economic Investment Strategy Asset Allocation Capital Structure Advisory Restructuring/Privatization/IPO M&A and Divestitures Corporate Finance Advisory + Outsourcing to be ruled out

Client

Outsourcing to be considered

The Reference Bank Model shows all the products, functions and processes of a bank at the generic level. With the aid of this model, a bank can identify its core competencies and business strategy. At the same time, the model also illustrates which activities a bank could theoretically outsource. UBS News for Banks

I / 2005

7

Focus Business

Breaking down processes to the last detail BVC Flow Diagram: Equity trade is requested

Offer Basic Product Service Equity Trade Order (requested) Enter Equity Order

Equity Trade Order (captured) Enrich Equity Trade Equity Trade Order (validated) Execute Equity Trade Equity Trade Order (captured) Market

Equity Trade (filled) Execute Equity Trade Equity Trade (executed) Allocate Execution to Equity Order Equity Trade Order (executed) Allocate Equity Order Execution to Client Equity Trade Order (executed) Generate Equity Order Trade Confirmation Equity Trade Order (confirmed)

Equity Trade Order (confirmed)

Equity Trade Order (executed) Client

Process Security Delivery

Archive Documents

Equity Trader Order (executed) Custodian Network

Sub-process / activity

Outsourcing to be ruled out

External agent / party

Outsourcing possible

Infrastructure

Outsourcing potential identified

The Reference Bank Model can be used to break down a process into its component parts. The flowchart for a sub-process of securities trading shows which aspects are suitable for outsourcing and which should definitely remain in-house. It shows all supporting elements, as there are systems, human skills and tools required for each individual activity. In addition the model enables the calculation of production /service creation costs. The entire model can also be seen as a glossary explaining and defining terminology being used in the financial industry. It therefore makes communication across different companies much easier.

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Focus Business

Clear, informed decision-making With the help of the outsourcing decisionmaking model, management can make more informed decisions about outsourcing based on a clear understanding of the inherent risks and benefits.

1. Business strategy Questionnaire: corporate strategy, core competencies, management’s outsourcing capabilities, possibility of partnerships and cultural change 2. Complexity of the process, function or subject Questionnaire: documentation, interfaces, proximity to core business and type of activities to be outsourced 3. Costs Questionnaire: economies of scale, reduction of fixed costs as a result of outsourcing

7. Risks Questionnaire: dependencies, arrangements for dealing with temporary quality-related problems, preparation of management for changes on the personnel front 8. Management of the outsourcing Questionnaire: experience with outsourcing decisions, project culture, control mechanisms In a second phase, the answers to the questions on each of the eight dimensions are weighted again by the respondent. Finally, the computed and weighted values are displayed visually in a network diagram (see below). This shows at a glance whether outsourcing is an option in a particular case and pinpoints possible trouble spots. As such, any potential problems in connection with outsourcing can be addressed at an early stage.

The Reference Bank Model can help banks to define their processes and functions and identify those areas where 4. Staff Questionnaire: communication with it might make sense to outsource prodstaff, future employer, staff training ucts or services to a third-party provider. But what the model does not indicate is where problems might arise in the event 5. Outsourcing partner Questionnaire: core competencies, of outsourcing or what prospective outtrack record and experience, financial sourcing partners need to consider strength; as well as “soft” factors when evaluating a particular solution or such as negotiating language, vision, The Outsourcing Decision-Making discussing plans with potential partner etc. of the prospective outsourcing Model is the subject of the round table organizations. service provider discussion that follows. Further information is also available from the architects With this in mind, four members of the of the model. Executive Master of Business Engineering 6. Legal aspects Questionnaire: length of negotiations, program at the University of St. Gallen’s transparency, termination options, Institute of Information Management Monika Baumgartner liability for damages have developed an extensively generic, UBS Wealth Management & Business Banking non-industry specific procedure for [email protected] uating different outsourcing projects and making the corresponding decisions clear, comprehensible and transparent. The eight dimensions of the Outsourcing Decision-Making Model For, as their thesis on the Outsourcing Business strategy Decision-Making Model points out, out10 sourcing decisions are often based on a 9 Management limited number of factors – mostly cost8 of the Complexity 7 related – and, as such, tend to be emooutsourcing 6 tional rather than objective. 5 Although the Outsourcing DecisionMaking Model is universally applicable, it nevertheless takes account of the specific circumstances of a given outsourcing project. Drawing on the relevant specialist literature, the architects came up with eight dimensions that they believe have a major impact on outsourcing decisions and the evaluation of outsourcing options. A detailed questionnaire has been drawn up for each of the eight dimensions, and touches on the following topics:

4 3 2 1 0

Risks

Legal aspects

Costs

Personnel Outsourcing Strike Point OSP Results of the evaluation Outsourcing partner

The network diagram shows the subjectively weighted values from the eight questionnaires. The result indicates that, due to the complexity of the system, outsourcing could present difficulties. Being aware of these problems can be tackled at an early stage. UBS News for Banks

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9

Round Table

Multi-dimensional decision-making

Andreas Urwyler

Participants Claudius Sutter Chief Operating Officer, UBS Investment Bank, Opfikon (Switzerland) [email protected] Marcel Müller Chief Risk Officer, Member of the Executive Board, Baloise Bank SoBa, Solothurn (Switzerland) [email protected] Herbert Portmann Head of Controlling, UBS Card Center AG, Glattbrugg (Switzerland) [email protected] Andreas Urwyler Head of Consulting, Partner, Stepwise AG, Jegenstorf (Switzerland) [email protected]

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Outsourcing a process, system or function is often exclusively a matter of costs. In the opinion of the participants in this discussion such an approach is too shortsighted. They have developed a model in which decisions on outsourcing can be taken more consciously and with greater transparency.

Marcel Müller: It’s certainly a balancing act. If you are not talking about a core competency, then a company wants to benefit from the capability of a partner in this sector so as not to have to deal with this problem.

The coordination and control of costs as well as other aspects are often underestimated in outsourcing. Herbert Portmann

When does a bank make the decision to outsource ?

Herbert Portmann: In my experience costs usually dictate the outsourcing decision. The idea is to try and achieve economies of scale by outsourcing, which in fact is often the case. What is often underestimated are the coordination and control costs of outsourcing as well as all other aspects.

Claudius Sutter: When you realize that the bank has no core competence in a particular area and does not want to build up such a capability; when you realize that the services to be provided require critical mass and there is no possibility of achieving economies of scale. In reality, companies often try to improve a problem situation by outsourcing. I have also observed that management often does not have enough time to effectively deal with the sector that is a potential candidate for outsourcing.

Andreas Urwyler: For the small and medium-sized enterprises for which I act as an advisor the point of outsourcing is not to save money. These companies are looking to boost their quality, for example in the Human Resources area. Companies notice that their systems and processes are no longer up to the latest standards. Their core competence is not in this area, so not much time and effort is invested. Nevertheless, the companies want to benefit from the most efficient technologies and methods.

Round Table

Claudius Sutter

Sutter: For small and medium-sized companies outsourcing means primarily IT outsourcing. In this respect they are not that different from large banks. If the infrastructure is not state-of-the-art, then you have to go outside the firm to get it. But the picture is different for business processes. I would draw a line between client-facing and back-office processes. Basically, a bank should outsource those processes that do not give it differentiation in the market. There are of course services that a bank must provide due to regulatory requirements.

The model brings a certain level of objectivity into the assessment of outsourcing projects. Claudius Sutter Müller: Small and medium-sized businesses, compared with banks, have clearly defined core competencies. Thus for these companies it often makes sense to outsource their non-core areas. The core competencies for banks are less clearly defined. Regional banks are not best in class in any area. They may be able to stand out in the market by advertising that they provide more personal service; but as long as the global players put pressure on prices, this advantage does not bring much. Clients want more than personal service; they want low prices above all.

Herbert Portmann

You developed an Outsourcing Decision- smoothly. It should help in recognizing Making Model for your final thesis and managing the potential risks; thus at the University of St. Gallen. Why ? the model can also be used as a controlling instrument. It is also a good tool Sutter: In the period following the for an outsourcing service provider to merger, we at UBS were confronted assess potential clients. Outsourcing with the topic of outsourcing for certain means making a contractual commitsectors. I noticed that the discussions ment over a long period. The model can with management concentrated on help the outsourcing service providers those aspects that were at that time estimate whether they are dealing with perceived as costs. But there was not a short-term opportunity or a long-term enough clarity about how new costs relationship and thus manage risks could arise during the outsourcing. At accordingly. the same time I was also scouring the relevant literature for a model that dealt with the various aspects of outsourcing. There was no model out there, however. So I took the initiative and found some capable and competent colleagues to help me develop it. Portmann: I had a similar experience in my job as controller. Attention is completely focused on costs. There was no pragmatic model that one could use to find out whether the outsourcing of an activity was even practicable. The thesis gave me the opportunity to work together on developing such a model. The model not only takes into account the many aspects of outsourcing, it also shows where potential trouble spots and opportunities could arise if the decision to outsource is made. Urwyler: The model makes it possible to find out where you stand. But it can also show a company what it can and must do to ensure the outsourcing goes

It is crucial that everyone involved agrees to the decision-making process itself, before the results of that process are on the table. Andreas Urwyler The model covers eight dimensions. The purpose is to make the outsourcing decision-making process more transparent. How important is that ? Müller: A big problem in making decisions – and not only with outsourcing – is the one-dimensional focus on numbers. It’s as though the numbers primarily serve later as the (only) justification for the decision taken. Marketability, implications for processes and the environment – in other words soft factors – UBS News for Banks

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Round Table

Marcel Müller

are sometimes also considered, but often not analyzed and documented in a structured way. Sutter: In the evaluation phase the potential success of outsourcing an activity is measured using net present value. At this point in time it does not matter whether the project will be successful or not. Often there is one lead person promoting outsourcing for specific and sometimes very personal reasons. Thus the model can help bring some objectivity to the assessment of outsourcing projects, despite all the subjectivity that the model also allows for. The model can help management make a conscious decision about how subjective the final decision should be.

The model could help me determine, for example, that the resources that I could save with outsourcing cannot even be reduced, whether due to regulatory factors or possible damage to the company’s reputation. This would be a potential cost factor. The management is open to these types of arguments, as it understands that there are risk factors that only later start to impact the numbers.

Urwyler: It is crucial that everyone involved agrees to the decision-making process itself, before the results of that process are on the table. This means that the persons responsible for the process that leads to the decision must approve the process, regardless of the resulting final decision. Otherwise, the reCosts are just one of eight dimensions in sult could be questioned by stating that your model. Is it not expecting a bit too the process leading up to it was deficient. much for something other than costs to come up in discussions with the management ? Portmann: The model makes it possible to weigh individual aspects subjectively. If management sees costs as the most important element, the model can give a stronger weighting to costs over other aspects. The weighting of the factors makes the model dynamic and takes into consideration the various points of departure a company may find itself in. Sutter: It is possible to argue versus management that all dimensions are expressed in terms of costs sooner or later. 12

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A frequent problem in the decision-making process is the onedimensional focus on numbers. Marcel Müller

Müller: There is no doubt that costs drive outsourcing. But when discussing outsourcing with company management personnel issues are also a key element.

It is relevant both for the outsourcer and for the provider to know how many employees and which employees will be taken over. This is not only a question of people’s lives and livelihood, but also one of ensuring know-how and quality in the company after the outsourcing takes place. Have you been able to use the model ? Sutter: We have used it several times. We have learned that the model helps you to focus on details that you may not have paid much attention to otherwise. With the model you can also demand proof, as sometime in the marketing effort solutions are proffered that look rosier on paper than they are in reality. We have not entered into certain partnerships because either we have discovered details that we were not happy about or because after applying the model we discovered that the risks associated with the outsourcing were greater than the benefits. Portmann: I have used the model to look into the sale of a business unit. I had to leave out certain aspects such as the outsourcing partner or substitute some aspects such as the size of the buyer. Using the model helped me to include all the key points in the decisionmaking process and not focus merely on costs. Interview Monika Baumgartner

In Brief

Due diligence made easier… Take 2 The avid reader of News for Banks will recall the publication, in the January 2004 issue, of an article entitled “Due diligence made easier” which described in some detail the concept of an international registry for financial institutions, emanating initially from the Wolfsberg AntiMoney Laundering Principles for Correspondent Banking of November 2002.

clients, and would also be notified of any relevant information updates regarding those clients. The estimated economic benefits of such a system are expected to be significant.

The Wolfsberg Group had already identified the information that its members wished to see in the registry, which would also ensure a standardization of due diliThe yet more assiduous reader may even gence information globally, in itself prorecall that the purpose of such a registry viding a potential cost-saving in that less was to centralize useful and necessary time would be spent collating required information which would assist financial information from a diverse set of sources. institutions in carrying out appropriate due diligence investigations on their cor- The Group began collaborating with respondent banking clients, while genBanker’s Almanac in early summer, and erating cost-savings, though not diswe are delighted to inform you that the charging financial institutions from their Due Diligence Model, which the Wolfsresponsibility to conduct their own risk berg Group has contributed to developassessments based on the information ing, is now available for “inspection” on held in the registry. the internet. It was argued that, in the context of ever increasing regulatory requirements, the registry as recommended by the Wolfsberg Group, and fully supported by UBS, provided an indispensable tool for banks to ease the financial burden of conducting proper due diligence on their correspondent banking clients. Recent enforcement actions by US Regulators prove that insufficient due diligence on these clients will not in any way pass muster on inspection. Indeed, the fines recently levied for failings in due diligence exercises in respect of correspondent clients have been on the high side, and the historical tendency for fines to increase rather than decrease should give us some pause for thought. The basic premise of the registry remains simple: rather than requesting the relevant information from each individual institution, and, similarly, rather than provide this information to each correspondent, the necessary due diligence information would be centralized in a global registry. Financial institutions would be responsible for providing and maintaining accurate, complete and upto-date information in the registry; they would be able to retrieve information about their correspondent banking

While we are still assisting Banker’s Almanac in the finalization of various elements of the module, the coming months will clearly be spent encouraging our correspondents to populate the registry, so that it is as useful, complete and cost-effective as possible for everyone. We therefore wholeheartedly recommend that you visit the site, inspect the module and suggested requirements and submit your documents as soon as possible, so that the benefits of a fully functioning registry can be achieved sooner rather than later. In the current regulatory environment, such a facility can only be seen as a boon to the appropriate and risk-based conduct of correspondent banking business, if not a panacea for all ills.

Contact / further information [email protected] www.bankersalmanac.com

Growing UBS UBS has grown significantly in all three divisions Investment Bank, Wealth Management and Global Asset Management over the past few months. The first in a series of acquisitions, mergers and joint ventures was the purchase of the Capital Markets division of Charles Schwab in New York. The transaction was completed at the end of October 2004. Already a top-three firm in the trading of NYSE-listed securities, the integration of SCM results in a significant expansion of UBS’s US capabilities. By increasing its equity sales and trading offering, including the addition of a state-of-the-art technology platform and NASDAQ trading system, UBS also becomes one of the top volume traders in NASDAQ securities in the US. In Wealth Management UBS is supplementing its organic growth with a series of acquisitions in Europe and the Americas. In Germany, UBS and Sauerborn Trust will merge their advisory services for ultra-high net worth clients. Managing more than 6 billion euros in client assets for some 100 families and family-owned companies, Sauerborn Trust is Germany’s biggest provider in this market. In Italy, UBS is to acquire Etra SIM S.p.A. of Milan which manages 500 million euros in assets for wealthy private and institutional clients. UBS will acquire the private banking activities of American Express Bank in Luxembourg with assets of around 385 million US dollars, and also take over the wealth management business of Dresdner Bank Lateinamerika. DBLA, with a head office in Hamburg, is active in all Latin American markets, managing assets for affluent and high net worth clients of around 4.8 billion euros. In Canada and the US UBS will acquire the North American wealth management operations of Julius Baer with a main location in New York and offices in Los Angeles, Palm Beach and Montreal. They manage more than 4 billion US dollars in client assets. The new acquisitions are all subject to receiving the necessary regulatory approvals. In January 2005, UBS Global Asset Management announced the formation of a joint venture fund management company in partnership with the Chinese State Development Investment Corporation (SDIC). The joint venture will come about through UBS’s purchase of a 49% stake in the Shenzhen-based China Dragon Fund Management Co Ltd (China Dragon). This joint venture will be one of the first to allow the new maximum 49% foreign partner holding in a Chinese fund management company, and continues the growing interest UBS has in the Chinese financial services industry. In the same month, Global Asset Management signed an agreement with Siemens in which UBS will acquire a majority stake (51%) in the real estate funds business of Siemens Kapitalanlagegesellschaft mbH (SKAG), currently a 100% subsidiary of Siemens AG and part of the Siemens Financial Services Group. Both transactions are subject to regulatory approvals.

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In Brief

SWIFTNet: a critical assessment more generally, the financial industry. Hence, when considering the migration of the underpinning technology, the question for UBS and all other financial institutions working with SWIFT was not whether to adopt, but rather when. In the past,financial messaging infrastructure technology was perceived merely as an enabler, not as a potential product in its own right. Thus, the driver for this Today the financial messaging world has change was more than simply to utilize increasingly modern technology. The key almost achieved this ambitious migrapoint was that the financial industry was tion goal. Based on current statistics demanding more services from SWIFT (December 2004), approximately 99% than “just” the old FIN service. SWIFT of all financial institutions, accounting for some 96% of the entire SWIFT-based was compliant and introduced additional new SWIFTNet services which are traffic, have migrated to the new technology. As it stands today, the migration only available and possible with the will be globally complete by the time of much more flexible IP technology. publication. SWIFT expects that it can The new services offered by SWIFT begin dismantling the old X.25 infrastructure commencing the second quar- include: ter of 2005. ❑ SWIFTNet FIN SWIFTNet FIN essentially remains the Within the financial world, the SWIFTsame. The difference between X.25 and Net migration is the second largest IP-based FIN is in the technology, not initiative since Y2K. Due to the signifithe service as such. SWIFTNet FIN is still cance of both its size and success, this the most common and frequently-used migration is a milestone for the entire of all SWIFT services. In 2004 (Jan – Sept) financial industry. for example, FIN carried roughly 1.7 billion messages. Peak days will currently Goals of SWIFTNet It is not always enough to replace (even see above 10 million messages. outdated) technology with newer tech❑ SWIFTNet InterAct nology, just for the sake of updating it. SWIFTNet InterAct is an interactive mesThis raises the question of what stratesaging service supporting the pre-agreed gic or particular objectives the SWIFT community had on its agenda when the exchange of messages between two parties. With InterAct, banks can exSWIFTNet initiative was agreed upon change interactive messages. Contrary and eventually launched. to the FIN Store & Forward service, InterIt is important to note that the technical Act can be used for mission- and timecritical applications such as Continuous SWIFTNet migration was a mandatory Linked Settlement (CLS) or real-time undertaking for all SWIFT participants because SWIFT is a co-operative owned gross settlement systems (RTGS). by banks. Consequently, whatever ❑ SWIFTNet FileAct SWIFT does must be agreed upon and SWIFTNet FileAct allows the secure transapproved by the member banks or, fer of files and can be used to exchange batches of structured or unstructured fi1 X.25 still is a popular international standard for nancial messages. With FileAct it is now possible to send files as large as 250 packet-switching networks. It provides a connection-oriented technology for transmission through megabytes. FileAct is closely linked with InterAct. highly error-prone facilities, which were more Approximately five years ago, SWIFT announced the concept of a new messaging platform, based on the well-known and established Internet Protocol (IP) technology. It was intended to replace the outdated and somewhat inflexible X.25-based messaging environment 1. The official deadline communicated for this migration was 31 December 2004.

common at the time it was first introduced. Errorchecking is performed at each node, which can slow overall throughput and renders X.25 incapable of handling real-time voice and video.

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❑ SWIFTNet Browse SWIFTNet Browse allows users to operate in a secure and reliable environment.

The browse service is based on the “https” internet standard protocol. It is designed to complement SWIFTNet FileAct and SWIFTNet InterAct. New services pose challenges Banks which have made the technical migration to SWIFTNet have the option of using the new services described. Although these services are available for all financial institutions, there is a price to be paid if banks want to fully utilize them for high-volume processing, automation or even straight-through processing (STP). This price involves factors such as investments in infrastructure components or more complex and therefore more costly processes. Not all banks are willing to invest this much without seeing a clear business opportu-

New services: where does UBS stand today? UBS was the first financial institution amongst the top 10 SWIFT users to complete the entire SWIFTNet migration. After successfully finalizing this, UBS went on to use FIN over IP as its first SWIFTNet service by the third quarter of 2003 (FIN is the traditional and broadly used Store & Forward Service of SWIFT). Technically, UBS has been SWIFTNet compliant since the third quarter of 2003. This, however, does not mean that the firm wishes to immediately take the final steps towards a full-scale rollout of the new non-FIN services including the MA-CUG concept without considering the options available. Instead, UBS is looking for a clear business opportunity, to justify investments in this area. This opportunity might come from the market but it is also highly probable that product developments will make it necessary to bundle products with one or another of the new SWIFTNet services. SWIFTNet is very important to UBS. The bank clearly sees the benefits of using the new services if it can justify capital expenditures and operating costs. And since SWIFTNet is – to a certain extent – a fixed-cost-driven infrastructure, it makes sense to go for the highest transaction volume possible in order to reduce unit costs. For instance, using the new SWIFTNet services such as InterAct and FileAct could enable UBS to remove volumes from other proprietary messaging infrastructures and consolidate these transactions in SWIFTNet. With the bulk of migrations having been achieved, the financial industry is now entering a fresh phase of opportunity where the next few years promise to be challenging yet rewarding for UBS as well as the entire SWIFTNet community.

In Brief

nity, including a business case with a reasonable ROI. Unfortunately, the situation can become convoluted and intractable. On the one hand, we have financial institutions which want to see clear demand from the market. On the other hand, the market seems to be waiting for a visible offer from potential service providers. Somehow, the Gordian knot will have to be cut.

Subscription form Would you like to receive the complimentary newsletter News for Banks regularly? To subscribe to the quarterly newsletter for financial institutions, please complete this form and fax it to UBS AG, Switzerland, +41-61-288 56 53. You can also send an e-mail to: [email protected]

Personal details In addition to the market situation and the question of who should take the lead to drive this further, there is an issue involving standards. Whilst the FIN service is very strict on standards, the new services, in principle, allow for significant flexibility. Hence, in an extreme case, two partners could negotiate individual agreements outside any pre-defined defaults. This gain in flexibility implies a loss of standardization, and thus one of SWIFT’s original core values. As a result, the issue of standards convergence must be discussed on a much broader basis. If not, each financial institution could be required to spend large amounts dealing with the implications of any bilateral agreements it might have with potential partners. Additional SWIFTNet features There is a further issue which requires addressing. Based on SWIFT’s 2006 strategy, the intention was – and still is – to significantly increase its customer base. The only way this could be achieved was to allow corporates access to SWIFTNet. However, it was decided to prohibit direct access for corporates as members, and instead allow them access as participants or via a so-called Member Administered Closed User Group (MA-CUG). Every point mentioned in connection with the new services must also be applied to corporate users. In an extreme situation, this can lead to an environment where banks have to monitor bilateral standards agreements not just with other financial institutions, but with corporates as well.

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UBS AG Financial Institutions P.O. Box CH-8098 Zurich +41-1-239 80 08 [email protected] www.ubs.com/newsforbanks

Production: UBS AG, Marketing & Sales Development / Publications; CC Publishing Photos: Andy Müller, ESA Date of publication: February 2005

Disclaimer: While the facts in this publication have been carefully researched, UBS cannot be held responsible for their accuracy. The opinions expressed may differ from official UBS views.

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