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10
Financial Services

RAVI ARON

University of Southern California

INTRODUCTION

The financial services industry is situated at the intersection of twin forces of disruption: technology and globalization. Financial services, perhaps more than any other industry, is buffeted by the forces of change that technology has unleashed and the intensity of competition that globalization has brought in its wake. The nature of work in financial services is such that the input, work in process, and output are all information. There are no heavy and unwieldy manufactured items that need to be carefully managed in transit, there is no need for the maturing of third-party logistics that will delay the entry of global players, there are no issues of establishing warehouse and distribution centers to handle inventory that will deter offshore competitors, and the traditional advantages of scale and incumbency that established players enjoy can be nullified by an intelligent business model that takes no more than a few weeks—if that—to become a business. While business experience—understanding of a market’s needs and its willingness to pay for services—is an important prerequisite, the role of physical infrastructure as a barrier to competition is greatly lessened.

Consider the example of ING Direct to illustrate how easily incumbency, scale, and local presence can be neutralized by technology. The high-value-added business models of the full-service banks that dominated the retail financial service industry in the United States should have remained inviolate—after all, they had local presence, scale of operations, and a formidable network of branches that straddled the retail markets from coast to coast. These banks were challenged in their backyards by a European bank, ING Inc., that decided to bypass the battle of the branches and reach out to retail market segments directly through nontradi-



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10 Financial Services RAVI ARON University of Southern California INTRODUCTION The financial services industry is situated at the intersection of twin forces of disruption: technology and globalization. Financial services, perhaps more than any other industry, is buffeted by the forces of change that technology has unleashed and the intensity of competition that globalization has brought in its wake. The nature of work in financial services is such that the input, work in process, and output are all information. There are no heavy and unwieldy manu- factured items that need to be carefully managed in transit, there is no need for the maturing of third-party logistics that will delay the entry of global players, there are no issues of establishing warehouse and distribution centers to handle inventory that will deter offshore competitors, and the traditional advantages of scale and incumbency that established players enjoy can be nullified by an intel- ligent business model that takes no more than a few weeks—if that—to become a business. While business experience—understanding of a market’s needs and its willingness to pay for services—is an important prerequisite, the role of physical infrastructure as a barrier to competition is greatly lessened. Consider the example of ING Direct to illustrate how easily incumbency, scale, and local presence can be neutralized by technology. The high-value-added business models of the full-service banks that dominated the retail financial ser- vice industry in the United States should have remained inviolate—after all, they had local presence, scale of operations, and a formidable network of branches that straddled the retail markets from coast to coast. These banks were challenged in their backyards by a European bank, ING Inc., that decided to bypass the battle of the branches and reach out to retail market segments directly through nontradi- 

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2 INNOVATION IN GLOBAL INDUSTRIES tional distribution channels. ING Direct is a straight-to-consumer banking service that has a very focused product line and one that operates at a significantly lower cost structure than competitors (traditional retail banks). ING Direct does not rely on the traditional channels of distribution—physical branches; instead it distrib- utes its products using the Internet and call centers. As a recent Harvard Business School Case showed,1 “ING Direct is able to offer depositors higher interest rates on its savings accounts, dispense with fees and service charges, and still make money by reinvesting depositors’ funds in longer term assets” (Gary, 2004). A research report showed that ING Direct was able to walk away with $17 billion in direct deposits without an extended banking network (Forrester, 2004). In this parable if the large incumbent retail banks were the Goliaths then technology was the sling that ING’s David used to take on the entrenched larger players. Just as technology releases disruptive change in hitherto stable industries, globalization accelerates that speed of change and amplifies the gains and losses that result. Global free trade agreements and the integration of several regions into trading blocks—such as the European Union (EU), ASEAN, and NAFTA— have opened the financial services markets for several countries to foreign players even as the large established banks and insurance companies must face compe- tition from Asian rivals such as HSBC. If necessity is the mother of invention then competition is the mother of innovation. And competition has unleashed in- novations in the financial services industry in mature markets such as the United States and the EU. A recent research report by the management consulting firm of McKinsey & Company attributed the resurgence of European financial services firms to innovation in a variety of sectors when faced with intense competition from lo- cal and foreign players and deregulation (Gary, 2004). The report identifies two different kinds of innovation: the development of new products and services, and the design of innovative ways in which firms produce and deliver these processes. Europe, according to McKinsey & Company, has led innovation in creating derivative products and has also innovated in other product classes such as cash securities. Leading product innovators include BNP Paribas and Société Générale in equity derivatives, and independent advisory houses such as Rothschild. A second kind of innovation—producing and delivering financial services in new ways—including the use of technology in retail financial services and the adoption of global operating models has also resulted in European banks becoming centers of innovation. In other recent research reports, McKinsey & Company identifies that the drivers of success for offshore firms in the Indian and Chinese financial services markets would be the ability to deliver financial services through new and more efficient channels (in India) and to create value- bearing partnerships in China (McKinsey, 2005a,b). 1As the case makes clear, ING’s business model is a clear success in that it enjoys supranormal profits.

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 FINANCIAL SERVICES Recent reports in the business press have dwelt at length on the idea of “high-end” and “low-end” work. Some of these reports seem to suggest that some work, such as call center work, is routine and can be seen as “low-end,” whereas other work, such as financial analytics and investment banking research, is “high-end.” The lay reader may well take away the impression that in the global sourcing and delivery of financial services there is a clear understanding of what constitutes low- and high-end work and that corporations in the United States and Europe innovate while their service providers in Asia and other low-wage regimes provide routine low-end services at low cost. There is a widespread as- sumption in media coverage of these trends that the so-called high-end work is complex whereas the low-end work—as typified by a tech support call center—is essentially low-complexity work. As we show later in this chapter, this assump- tion both is wrong and reflects a poor understanding of the subjective nature of complexity. To understand how global sourcing of services drives innovation and how the nature and extent of the innovation is itself determined by the subjective perception of complexity, it is necessary to first understand the globalization of the financial services industry. The Scope and Growth of Offshore Activities in Financial Services The phenomenon of globalization of financial services has both supply and market (demand) side implications. Large multinational financial services corpo- rations such as American Express, Citigroup, and HSBC Inc. have established a significant sourcing and market presence in Asia and Europe. These companies have a retail, corporate, and investment banking presence in Indian and Chinese markets. In addition to these traditional financial services, investment and risk- based financial services are also offered by multinational VCs and private equity firms. To compete against local companies, the aforementioned firms have to constantly innovate and deliver services to niche segments such as urban retail customers in India. Citibank launched its web-based corporate banking products in 2001 to cap- ture a significant chunk of the market for cash management and trade services. The bank then rolled out this product widely in the Asia-Pacific region (Malaysia, Australia, Singapore, and Hong Kong) and later into India and parts of Europe. 2 The bank found a new way of distributing corporate banking services via the web based on a flexible electronic product that linked the bank’s front office to the clients’ back offices. The web-based banking services that the bank launched in Asia and the United States were based on creating a flexible suite of corporate banking products that would connect their clients to the bank’s service delivery portals, provide a set of tools to the clients to automate and manage their accounts 2 Citibank’se-Business Strategy for Global Corporate Banking, HBS Case Study, HKU197, 2002, Center for Asian Business Cases, University of Hong Kong.

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 INNOVATION IN GLOBAL INDUSTRIES receivable and payables, and offer advanced treasury services to clients ranging from SMEs and MNCs.3 The idea of creating an electronic channel that would of- fer a flexible suite of financial services that would—to quote the bank—connect, extend, and transform the operations of the clients was an idea that was tried in the highly competitive Asian markets of the Far East (Singapore, Malaysia) and then rolled out with variants in other parts of the world. As the technological ca- pabilities offered by the Internet matured, the diffusion of the innovation in other markets such as Europe, India, and China was also accompanied by accommoda- tions of local banking customs, market contexts, and numerous custom features that tailored the innovation to local market conditions.4 Thus, the expansion of multinational financial services firms into global markets has resulted in the globalization of innovation. Our definition of the globalization of innovation is one where the innovation that takes place is global in nature—not that the output (e.g., the applications) of an innovation process (perhaps done in a single home country) is used globally. On the sourcing side too there have been numerous innovations in the use of technology as well in new managerial initiatives. OfficeTiger,5 an American business process outsourcing (BPO) firm with offices in India, Sri Lanka, and the Philippines, has been able to serve offshore clients in projects that often re- quire near-real-time collaboration on highly judgment-intensive processes (i.e., processes require experts such as accountants and financial analysts to intervene and exercise judgment) executed by financial service professionals (Aron and Singh, 2005). A third of OfficeTiger’s deadlines are an hour or shorter. The firm has been able to deploy a combination of technology and a collaborative inter- organizational managerial structure called the Program Office in order to deliver highly strategic and value-added services to its clients.6 Thus, global sourcing of financial services too has left an “innovation foot- print” in various parts of the world. There is considerable divergence in the definition of what constitutes offshore production of services and how these are categorized (by work type [i.e., call center] as opposed to vertical industry [i.e., financial services]). There is also considerable variance in the sources of data and the sampling methods used by various firms. Rather than go by any single 3 Citibank’s e-Business Strategy for Global Corporate Banking, HBS Case Study, HKU197, 2002, Center for Asian Business Cases, University of Hong Kong. 4The details of customization and localization of the innovation require a detailed exposition beyond the scope of this chapter. We refer the interested reader to a business case developed by the Center for Asian Business Cases, University of Hong Kong, entitled “Citibank’s e-Business Strategy for Global Corporate Banking” HKU197, 2002. 5 For an insightful discussion of the business challenges faced by the firm OfficeTiger, we refer the reader to an article in The New Yorker, July 5, 2004, titled “The Best Job in Town” by Katherine Foo. 6We refer the reader to the Harvard Business Review article “Getting Offshoring Right” in Decem- ber 2005; see issue of the journal for further details.

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 FINANCIAL SERVICES estimate of this phenomenon, we find that the meta-research done by the firm Pipal Research summarizes the different estimates best. Figures 1 and 2 provide summaries of the estimates. There is wide variance in the estimates of outsourc- ing because the term is defined differently by different researchers. Some conflate outsourcing with offshoring (i.e., production of services and goods in a different country than the one in which the final output is consumed) while others group all offshoring under outsourcing.7 BPO is the practice of sourcing services (pro- cesses) from a third-party provider of these services. BPO could be an offshore or onshore phenomenon; indeed there is nothing in the nature of BPO that restricts it to a particular location. In popular usage, the term BPO is frequently used to mean offshoring. Many of these reports include both offshoring and outsourcing activities, whereas some of these reports exclude offshoring of business processes to a sub- sidiary of the parent corporation (offshoring but on outsourcing). For instance, the Gartner estimate of USD 173 billion includes all the processes in Tables 1 and 2 only to the extent that they are outsourced to a third-party provider, whereas the estimates by IDC (2005) in Figure 1 include processes that are offshored even if they are not outsourced. Political sensitivity and tensions with labor advocacy groups and organized labor surround the phenomenon of offshore outsourcing. As a result it is not possible to collect data exhaustively from offshore firms on what processes have been offshored and how many agents are employed in executing these processes. We have—as part of our larger research agenda—identified the different kinds of services (and subprocesses) that are offshored in the domain of financial ser- vices. Table 1 provides a list of major financial services offshored while Table 2 provides a breakdown of these major financial services to the level of subpro- cesses.8 There exist no rigorous estimates that can quantify the extent of offshore outsourcing (or even just outsourcing for that matter) by process type (work type) in financial services in terms of either dollar volumes or of the FTE9 involved in producing the services.10 What Tables 1 and 2 provide, however, is a fine-grained analysis of what kinds of financial service-related tasks are offshored. As we discussed earlier, the advent of BPO also led to the globalization of innovation in financial services. Other examples of such innovation include the 7When a corporation, say, in the United Kingdom locates its back office in India and sources back office processes through a fully owned subsidiary, it is offshoring but not outsourcing. 8 From a joint research project between The Wharton School and Gartner in 2003-2006. 9 Full-time equivalent, a measure of the number of employees involved in executing a process. 10There are two reasons why this is not possible: As mentioned earlier, there is intense political sen- sitivity that surrounds offshore outsourcing and, therefore, senior executives are reluctant to provide any estimates that will result in media attention being focused on their firms. Second, measuring the economic significance of activities at the subprocess level requires the deployment of resources that represents a prohibitively high level of cost and effort, especially given the rapid growth of offshoring, which in turn creates a rapidly changing market that is not easily surveyed.

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 bitmap image financial-1.eps FIGURE 1 The size of the offshore outsourcing market.

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 FINANCIAL SERVICES 100% = $375.0 $405.1 $447.7 $497.8 $554.8 $614.9 $682.5 $ billion Asia/Pacific 12.1% 12.5% 13.0% 13.6% 14.5% 15.3% 16.2% 22.7% EMEA 22.3% 22.0% 21.8% 21.6% 21.4% 21.3% Americas 65.2% 65.2% 65.0% 64.6% 63.9% 63.3% 62.5% 2002 2003 2004 2005 2006 2007 2008 Procurement Logistics Customer Care 0.4% Procurement Facility 40.7% 29.8% 0.2% Operations & Training Human Management 0.8% Resources 0.5% 2.4% Engineering R&D Training 2.8% Sales & 15% Finance & Marketing Accounting 24.4% 3.4% Human Facility Resources Operations & 4.6% Management 6.6% Engineering R&D Customer Care 6.2% Finance & 10.0% Sales & Accounting Logistics Marketing 10% 22.8% 32.9% Total BPO Market, $447.7 bn, 2004 Offshoreable BPO Potential, $120.4 bn, 2004 FIGURE 2 Growth of total BPO market and offshoreable BPO size. financial-2.eps TABLE 1 Finance and Accounting Processes Account management (transaction reconciliation, other asset and liability account administration) Accounts payable Accounts receivable Actuarial analysis Asset pricing research: equity research and fixed income asset research Billing Cash flow analysis (including forecasting and related services) Cost accounting and analysis Electronic payments (in retail and institutional financial services) Financial statement analysis General ledger Management accounting Preparing asset schedules Risk analytics Tax accounting and analysis (individual and corporate) Tax management Treasury and cash management Underwriting Yield analysis

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 INNOVATION IN GLOBAL INDUSTRIES TABLE 2 Financial Services Subprocesses Actuarial (insurance) All data processing (banking and insurance) Automated clearing house and/or electronic funds transfer Business and corporate credit card issuing and processing Cash management Check processing and imaging Claims processing Core banking Credit card issuing: retail financial services Credit card merchant processing: retail financial services Data warehousing (retail and corporate banking, insurance) Liability and asset account management (deposits, savings accounts, certificates of deposits, loans, etc.) Electronic checks Electronic invoice presentment and payment Exception processing and automation Internet banking Internet lending and asset creation Investment and portfolio management (insurance) Investments and trading Mortgage banking (both loan origination and subsequent account services) Pension administration (insurance) Policy servicing and administration (insurance) Policy underwriting (insurance) Primary business applications (insurance) Trade services (as necessary: cargo and business insurance) Trust (as necessary: retirement and custodial plan trust and administration Vehicle financing (vehicle leasing and lending) use of LEAN techniques by Wipro Technologies in India for the production of processes such as financial accounting, management of accounts receivable, and payables. Wipro Technologies was able to cut the time required to execute these processes by between 12 and 47 percent while increasing the quality of output by between 7 and 29 percent.11 We studied other firms such as Pipal Research Inc. and i-Flex Inc. that provide innovative services similar to those provided by OfficeTiger.12 Many of the drivers of offshore production of processes are also the drivers of innovation at those locations where these processes were sourced. To understand the globalization of innovation, it is necessary to understand the offshoring of business processes. The advent of GE’s BPO initiative in India in 11 From a paper titled “The Use of LEAN Techniques in Offshore Outsourcing,” forthcoming (2007). 12 Pipal Research’s Manoj Jain: “We Have Created a Spot Market for Research,” Knowledge @ Wharton, see http://knowledge.wharton.upenn.edu/india/article.cfm?articleid=4155; “How Some BPO Providers Seek to Build and Protect Their Turf,” Knowledge @ Wharton, see http://knowledge. wharton.upenn.edu/article.cfm?articleid=1101.

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 FINANCIAL SERVICES 1996 started a spurt of offshore outsourcing activity in the region that has since grown rapidly.13 There are two reasons for the growth of offshore production of financial services: competitive pressures of a maturing industry and technologi- cal enabling factors. Indeed, these are also the factors that drive the globalization of innovation in financial services. Let us begin by analyzing the competitive pressures. COMPETITION AND PRODUCT MATURITy The evolution of any product or service is characterized by three phases. In the first phase, when the product or service is initiated, the challenge is to simply make it work and deliver the core benefits associated with the product. We term this the product creation phase. There are numerous examples of products in financial services that went through the product creation phase when they were introduced. In retail financial services, the now ubiquitous ATM provides a good example. The ATM was introduced for the first time in 1939 in New York City by the City Bank of New York and was withdrawn soon after for lack of adoption by consumers.14 It was reintroduced in 1967 in London and has since become a standard feature of all retail financial service products. When the ATM was first introduced it lacked ease of use and was not connected to the savings accounts of the consumers. For one thing there were no mainframe computers then and it was not possible to store account information and support transactions. And for another, without computer networks that could support multiple machines in dif- ferent locations, the ATM could be used only at the physical location where the bank was situated. The advent of mainframes as the enablers of retail financial services meant that the ATM could be deployed remotely and connected to the accounts. This in turn allowed banks to deliver several financial services through the ATM and consumer adoption followed. The second phase in the evolution of products and services is the integration phase, where the objective is to integrate the product to work seamlessly with the firm’s existing products. As the ATM evolved into the integration phase it was extended to offer a suite of services that went beyond dispensing cash to include deposits, balance enquiry, money transfer, and so on. As the industry matures and all other firms offer similar products and differentiation becomes increas- ingly more costly, the firm in the final phase outsources several components associated with the product. We term this the orchestration phase, where firms outsource (often to offshore entities) several aspects of production, delivery, and postpurchase service. Most banks now are connected to ATM networks run by 13 “The Little Start-Up That Could: A Conversation with Raman Roy, Father of Indian BPO,” Knowledge @ Wharton, see http://knowledge.wharton.upenn.edu/article.cfm?articleid=794. 14 MIT Series on Inventor of the Week: Luther George Simjian, see http://web.mit.edu/invent/iow/ simjian.html.

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0 INNOVATION IN GLOBAL INDUSTRIES third parties. In the orchestration phase, ownership of ATM networks is no longer a source of competitive advantage because ATM services are bought by banks from third-party firms that provide connectivity to ATM networks. Indeed, major ATM networks are now managed by third-party firms that are not in the bank- ing business, thus turning the ATM network into a “banking utility” comparable to electric power and other commoditized services. Many wealth management and personal financial services (PFS) firms often offer portfolios of services that include offerings of other firms. Financial services are natural candidates for outsourcing, in the production and delivery of financial services, input, output, work in process—are all infor- mation. Most products and services in the financial services industry are mature and as a consequence there is considerable competition among firms that offer all of these services. Almost all retail banks offer the spectrum of services rang- ing from savings and checking accounts through money market accounts and PFS including wealth management services. As a result there is considerable pressure on firms both to differentiate themselves by providing a higher quality of service—more accurate resolution of transactions, quicker balancing of asset accounts, better customer service, faster turnaround on loan and credit card ap- plications—and to lower the costs of production of services. As a result firms have been forced to relocate the production of several services to wage regimes where skilled (white collar) labor can be sourced more cost-effectively. Finan- cial service firms have offshored processes both to third-party providers 15 and to their own subsidiaries offshore—known as captive centers (or simply “cap- tives”)—that execute these processes offshore. The phenomenon of offshoring that we witness is an evolution of financial service products where firms have entered the orchestration phase. As we can see, the business case for offshore production of financial services was chiefly due to the maturation of products and the fact that differentiation of products had become costly. This alone was not enough to result in firms moving offshore. The technological platforms and business infrastructure that would en- able such a move were not in place before the advent of the Internet and its wide and ubiquitous adoption in countries like India and China. In 1996 Raman Roy set up a captive center for General Electric (GE) to process transactions and de- liver support services.16 Roy first demonstrated his ability to deliver high-quality financial services out of India as a part of American Express’s back-office team and then demonstrated it again with GE. After his success with GE he set up Spectramind Inc. as a third-party offshore financial service provider for MNCs. As the success of Roy’s Spectramind received attention from the business and trade press, several Western companies started sourcing services from India 15As mentioned earlier, this is often referred to as BPO. 16 “TheLittle Start-Up That Could: A Conversation with Raman Roy, Father of Indian BPO, Part 2,” Knowledge @ Wharton, see http://knowledge.wharton.upenn.edu/article.cfm?articleid=798.

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 FINANCIAL SERVICES and other third-party services providers and IT majors started offering these services.17 Since then the BPO industry in India has grown rapidly. Corporations in the United States and United Kingdom could transfer raw data across the Internet and Indian companies would process the data according to prespecified rules and transmit information back to the clients. The service could range from simple transaction processing to finance and accounting and as the industry matured it would grow to include financial analytics and research. For all of this to happen two factors were necessary: (1) the availability of the Internet as the physical medium of connection and (2) the availability of firms that would provide these services, because not all corporations could run their own captive centers and the presence of third-party firms—such as Spectramind—was necessary to scale up the offshoring trend.18 In the period from 1999 to 2002 several third-party provid- ers of BPO services came into being (principally) in India but also in countries such as China and the Philippines. By the end of 2004 there were several third- party providers of these services as well as captive centers in several regions of the world including Sri Lanka, Jamaica, and the Philippines.19 The combination of competitive pressures in a maturing industry and the presence of technological factors of enablement made it possible for corporations to migrate the production of some financial services to offshore providers. Offshore production of financial services is often seen as being analogous to the production of goods offshore. The production of physical goods offshore was facilitated by the emergence of large and cost-effective labor pools in Asia and parts of Latin America. Specialized supply chains emerged in industries such as apparel, auto components, consumer electronics, and toys, which enabled firms to set up offshore operations to service markets in the advanced industrialized countries, thereby leveraging wage differentials for factory labor. While there are similarities between the two forms of production, it would be wrong to assume that the production of services is chiefly about white collar unskilled labor, such as seen in call centers, which offers attractive wage arbitrage possibilities. It is useful here to make a distinction between the production of financial services at a lower cost made possible by an attractive wage arbitrage to be found in migrating to low-labor-cost countries and the sourcing of innovative solutions, processes, and management techniques from providers offshore. The produc- tion of financial services can be characterized by lower costs, productivity gains 17 “The Little Start-Up That Could: A Conversation with Raman Roy, Father of Indian BPO, Part 2,” Knowledge @ Wharton, see http://knowledge.wharton.upenn.edu/article.cfm?articleid=798; “In a Global Economy, Competition Among BPO Rivals Heats Up,” Knowledge @ Wharton, see http:// knowledge.wharton.upenn.edu/article.cfm?articleid=642. 18 “The Little Start-Up That Could: A Conversation with Raman Roy, Father of Indian BPO, Part 2,” Knowledge @ Wharton, see http://knowledge.wharton.upenn.edu/article.cfm?articleid=798. 19 “Move Over, India: The Shifting Geography of Offshore Outsourcing Creates New Challengers,” Knowledge @ Wharton, see http://knowledge.wharton.upenn.edu/article.cfm?articleid=1100.

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2 INNOVATION IN GLOBAL INDUSTRIES it is clear that they are very dissimilar. Table 5 contrasts process and product innovations. Given the aforementioned nature of product and process innovation, are corporations willing to source from offshore providers? If so, what is the degree of acceptance of such sourcing mechanisms? SOURCING INNOvATIONS OFFSHORE We surveyed the views of senior executives of Fortune 1000 corporations on their willingness to source innovations from offshore providers (see Tables 6 and 7).36 While the survey was not restricted to corporations in the financial services industry alone, we captured data about the industry to which respondents be- longed and were able to extract the responses from the executives of the financial services industry.37 We found that senior executives in corporations are prepared to source innovations from offshore providers as long as they have a means of dealing with the risk inherent in such a relationship. In response to the question, “Can you partner with an offshore provider of innovation?” most executives (68 percent surveyed38) expressed their willingness to source innovations from offshore outsourcing firms. Only a small minority (13 percent) expressed the view that it was strategically risky to source innovations from offshore firms. It is particularly interesting to note that there is little or no concern expressed about the ownership of the offshore provider. Of those manag- ers that were open to sourcing from offshore providers only a minority wanted to have full ownership control of the offshore provider. About 56 percent of these managers were open to sourcing from a firm that could become a strategic partner and another 15 percent or so were satisfied with additional control over outcomes offered by a joint venture with the offshore firm. Product innovation often results in the creation of IP assets that corpora- tions try to protect. Large investment banks have proprietary program trading algorithms that they go to great lengths to safeguard. Similarly corporate banks have developed risk assessment and management systems for different kinds of businesses that are protected as valuable IP assets. As opposed to this, process innovation rarely results in the creation of sensitive IP assets. The gains of process innovation in financial services can be shared in a non-zero-sum fashion between the offshore provider and its Western clients. A final contrast between product and process innovation that we wish to comment on is that product innovation usually involves tight control via contract 36The survey was conducted by Knowledge@Wharton in 2006. About 75 percent of respondents worked either in financial services firms or were executing processes that belonged to the finance and accounting category. 37This is a subset of a larger set of responses. 38 Sum of the first three rows, which represent the willngness to source innovations from offshore providers under different conditions.

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 FINANCIAL SERVICES TABLE 6 Sourcing Innovations from Abroad Number of Can you partner with an offshore provider of innovation? Responses Percentage Yes, if it is our fully owned subsidiary 12 7% Yes, if we can establish a JV with an overseas firm 27 15% Yes, if we can exert some measure of operational control over the 101 56% overseas firm and make it a strategic partner No. We cannot risk sourcing innovative products and processes from 23 13% an overseas firm Other please specify 16 9% Total responses 179 TABLE 7 Product and Process Innovations and IP Assets Product innovation usually results in valuable intellectual property (IP) assets that need to be protected Strongly disagree 3 2% Somewhat disagree 3 2% Neither agree nor disagree 7 6% Somewhat agree 51 40% Strongly agree 62 49% Total 126 Process innovation, rarely, if ever, results in proprietary IP assets Strongly disagree 11 9% Somewhat disagree 17 13% Neither agree nor disagree 19 15% Somewhat agree 48 38% Strongly agree 31 25% Total 126 The company that brings an innovative product to the market often takes ownership of the innovation Strongly disagree 1 1% Somewhat disagree 8 6% Neither agree nor disagree 11 9% Somewhat agree 59 47% Strongly agree 47 37% Total 126 Gains from process innovation are often shared in a zero-sum manner Strongly disagree 31 25% Somewhat disagree 33 26% Neither agree nor disagree 49 39% Somewhat agree 11 9% Strongly agree 2 2% Total 126

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 INNOVATION IN GLOBAL INDUSTRIES by one firm, due in part to the nature of the proprietary IP assets, which takes ownership of the innovation and takes it to the market. As opposed to this, process innovation works through collaboration. Some of the most successful examples of offshore process innovations feature close collaboration between the client in the United States/United Kingdom and the provider located in India/Sri Lanka/ China. The work that occurs on OfficeTiger’s premises involves a high degree of collaboration between the clients in the United States and United Kingdom and OfficeTiger’s Asian offices. Sometimes the same project may be broken up in real time so that one chunk of it is handled in Sri Lanka while another is executed out of the Philippines even as a third piece is executed in Chennai in India. OfficeTiger’s managers work with the client, monitor the progress of work in three countries in real time, and stitch together the output so as to create a seamless delivery vehicle for the client. This kind of collaboration raises the question of governance: what is the optimal governance structure for these offshore innovation centers? Is it neces- sary for corporations to own (via a captive center) the innovations or will they be able to source these innovative solutions from a third-party provider? It turns out that the emergence of a new governance structure made possible by advances in information and communication technologies is particularly well suited to sourc- ing innovations from offshore providers. Before we investigate this governance structure we will first discuss the different governance options open for sourcing services from offshore providers. We term this collection of options the gover- nance spectrum. THE GOvERNANCE SPECTRUM Economists, following in the central tradition of Ronald Coase in 1933 (Coase, 1937) have long posited that the two principal ways of coordinating work are through an organization or the market. These two solutions—organization and market—that straddle opposite ends of the means of governing the production of work, map onto the “make or buy” options that executives face. The make option corresponds to doing the work in-house while the buy option is about outsourcing work to a third party. In offshore outsourcing in particular there are some inter- esting options that have emerged in recent years. Figure 4 provides a schematic representation of the spectrum of governance solutions. Build operate transfer (BOT) and run to outsource (RTO) are temporally separated variants of the make and buy options. In several offshoring deals in the financial services domain we saw both BOT and RTO arrangements. In the BOT model, a third party runs an offshoring center for the client that after a period of time, is bought by the client and made into an in-house offering. Ownership in an RTO moves in the opposite direction: the client sells an in-house facility to a third-party provider after a prespecified period of time. A key point that is worth noting in this context is that offshore sourcing of financial services deals are par-

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 FINANCIAL SERVICES The Extended Organizational Form Hierarchy Market Third Party Captive Build- Joint Service Run-to- Service Operate Provider Outsource Center Venture Transfer (Market (Hierarchy) Solution) FIGURE 4 The governance spectrum. financial-4.eps ticularly well suited for the governance structures—BOT, RTO, and the extended organizational form (EOF)—that we discuss here. Furthermore, we believe that the sourcing of innovations in financial services—as opposed to the sourcing of services that are chiefly about labor arbitrage39—requires some special features of governance, which we term the EOF and which we discuss later in this section. In cases of both BOT and RTO, the transfer of ownership as well as the handover of assets is easier for financial services firms for a variety of reasons. First, the input, output, and work in process are all information. There are no messy transfers of semifinished inventory nor is there transfer of raw materials and commodities that are factors of production (such as oil or coal). As a result there are few if any issues that have to do with valuing tangible assets that enter production. Second, it is possible for buyers to exert considerable operational control over suppliers via technological monitoring mechanisms and to integrate the work of the offshore supplier closely with the buyer’s firm. Investment banks and corporate banks have used fine-grained monitoring mechanisms to keep a close watch on the production process taking place offshore. Due to the continu- ous proximity enabled by technology, the transfer of control from suppliers to buyers (or the other way around) becomes a lot easier than in the case of offshore production of other products and services. Finally, financial services firms have a culture of measurement and use of metrics to track the critical success factors of their major initiatives (whether in their end-customer markets or having to do with offshore suppliers). As a result, both the buyer and the supplier have a reasonably clear idea of the health of the operation at the time of transfer of control. 39 Lower wages for comparable skills in Asia and parts of Eastern Europe.

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 INNOVATION IN GLOBAL INDUSTRIES These three factors—monitoring, transfer of control, and metrics—taken together allow offshore financial services centers to work as if they are an exten- sion of a client’s organization and to be able to sense and respond to the client’s context. For the sourcing of process innovations it is essential that the service pro- vider be allowed the leeway to experiment and arrive at innovative solutions to problems. Second, too rigid a controlling structure results in the service provider being reduced to execute against specifications and not try to formulate process innovations that may complement the client’s product innovations and address the problems of complexity. The optimal governance structure that allows both the sourcing of process innovations and delivers on contractual terms is a hybrid governance structure that has some measure of flexibility built into the contract while giving the client sufficient monitoring capabilities. We call this hybrid governance structure, which has features of both market-based governance and a hierarchy, the extended organizational form. This is a governance structure that is seen predominantly in the financial services industry for the aforementioned reasons. EMERGENCE OF THE EXTENDED ORGANIZATIONAL FORM The extended organizational form (EOF) is a hybrid governance structure that brings together some elements of market and hierarchy. The strength of market-based governance (or sourcing processes from a third-party provider) is that it enforces the discipline of cost containment. Third-party firms have to com- pete with each other, and in order to lower costs they specialize or acquire scale economies and contain costs. However, the weakness of this mode of production is that the incentives of the supplier of services and the buyer are not aligned. The supplier would prefer to minimize the effort at any given price while the buyer would like to induce the highest possible effort from the supplier at the lowest possible price, thus setting up the classic problem of moral hazard. 40 The use of contracts to mitigate moral hazard often involves wasteful expenditure involved in monitoring work, inspecting output, enforcing penalties, and so forth, which economists often refer to as transaction costs associated with market-based gov- ernance (Coase, 1937). As opposed to market-based governance the firm could produce these services in-house through a captive center in an offshore location. This would largely eliminate the misalignment of incentives and provide the corporation control over its production facilities offshore through the device of organizational hierarchy. However, the corporation would lose the benefits of scale and specialization and the reduction in costs due to competition that a market solution would offer. 40The situation that arises when the incentives of the supplier and buyer diverge. When buyers cannot fully observe the effort level of the supplier, the supplier’s incentives would be to cut costs (make a suboptimal effort).

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 FINANCIAL SERVICES A solution to this problem of bringing together the strengths of the two forms of governance is the EOF. It affords the clients both more control over the supplier of services and lower costs of production. Some examples of the EOF include Pipal Research, a firm that provides expertise-driven financial analytics and research services to corporations in the United States and the EU. The com- pany is headquartered in Chicago and has offices in India, China, and London. Once the client and provider establish a contractual relationship, the client works directly with researchers in India and China and the client’s managers can direct Pipal Research’s associates as well as collaborate with them in research. An example of the EOF can be seen in the operation of OfficeTiger, a U.S.- based company with operations in several countries including India, Philippines, Sri Lanka, and Switzerland. The firm faces deadlines for work that range from one hour to a month. As a result of facing short deadlines, OfficeTiger does not have the luxury of negotiating arm’s-length contracts each time a client com- missions a project. The corporation has established a managerial control mecha- nisms called the “Program Office” by which its managers work closely with managers of the clients. Furthermore, the company has created one of the most comprehensive management information systems that we have studied, called T-Tracks, which it deploys through extranets at the client’s site. Client managers as well as OfficeTiger’s managers can track the progress of work and slice and dice the work by project, by team, by shift, and even by individual agent in real time. The use of a very fine-grained monitoring system combined with a system of metrics that allows every aspect of work to be tracked and monitored allows both OfficeTiger and clients to execute projects of considerable complexity.41 In fact OfficeTiger’s agents become extensions of the client’s organization—an example of the EOF—which in turn allows the client to migrate the production of strategically significant services such as financial analytics, equity research, and market research to OfficeTiger’s production teams. Another example of this phenomenon is the company EquinoxCorp.42 Equi- noxCorp provides services across the mortgage finance value chain that range from simple loan processing to predictive analytics leading to customer profit- ability gradient and retention. The company has created a network of partnerships along the mortgage processing value chain so that it is able to offer predictive analysis and customer retention services based on the use of a proprietary plat- form that captures data from several stages of the mortgage financing process. 43 Corporations such as EquinoxCorp and OfficeTiger are networks that span sev- eral corporations. Their ability to offer innovative solutions results from process 41 “How Some BPO Providers Seek to Build and Protect Their Turf,” Knowledge @ Wharton, see http://knowledge.wharton.upenn.edu/article.cfm?articleid=1101. 42 Recently acquired by i-Flex Solutions a subsidiary of Oracle Inc. 43 “How Some BPO Providers Seek to Build and Protect Their Turf,” Knowledge @ Wharton, see http://knowledge.wharton.upenn.edu/article.cfm?articleid=1101.

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 INNOVATION IN GLOBAL INDUSTRIES innovations that they forge across the value chain in the production and delivery of several products ranging from mortgage financing in retail financial services through tax analysis and financial analytics in corporate banking to strategic market analysis, forecasts, and research in investment banking. To be able to deliver process innovations and calibrate their needs to the context of the clients and their changing market needs, companies such as Of- ficeTiger and Pipal Research require both considerable flexibility to try and experiment with their solutions as well as the ability to collaborate in real time with their clients. The EOF allows this flexibility as well as establishes deep collaborative links that span joint technology platforms, interorganization infor- mation systems, extranet-based tools, and managerial mechanisms (such as the Program Office) that allow the firms to deliver innovations to clients offshore. In the survey (mentioned earlier) we asked executives what forms of governance might be best suited to source different kinds of services and products. Their re- sponses are shown in Figure 5.44 It is clear in the assessment of these executives that for sourcing innovations the form of governance structure that works best is the “sense and adjust” collaborative networks. The EOF is a recent phenomenon. The strength of this form of governance emerges from the combination of fine-grained monitoring enabled by technology and the flexibility of work enabled by removal of restrictions on experimentation. In our survey of business process offshoring starting in 1999, we found few if any cases of EOF in the first few years. It is only in the past 5 years or so that this organizational structure has become relatively more prevalent. The EOF, as we saw earlier, is a particularly effective tool for mitigating risk and for aligning the interests of the buyer and the provider of services, especially in financial services where the provider’s ability to innovate and create value for the buyer is signifi- cant (Economist, 2006). Indeed our past research also points in this direction: we find the EOF being deployed in domains where close collaboration between the buyer and the provider of financial services is necessary to transform sourcing via contracts into collaborative networks that can deliver innovations. CONCLUSION The diffusion of innovations in financial services across the regions of the world has been propelled by the twin forces of market participation by financial services firms and by the sourcing of process innovations that emerged as a result of global sourcing of financial services. A key factor that drives the division of la- bor in bringing innovations to market is the divergence in perceptions of process complexity. As we showed earlier, process complexity is subjective and the di- vergence in views of complexity often stem from the fact that many executives in Asia and Eastern Europe have domain expertise but domain experience is needed 44 Based on 102 responses.

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 FINANCIAL SERVICES 100 Percentage of Respondents 80 60 40 20 0 Raw Materials Standardized MRO Goods Call center Non-expert Expertise R&D/ Innovations Components services BPO Driven BPO Product Design / Development Type of Service Sourced Command and Control Coordination via Contracts Sense & Adjust Collaborative Networks FIGURE 5 Governance structures, sourcing, and innovations. financial-5.eps axis labels were behind clipping masks and elsewhere to deliver innovative products. Thus, service providers in Asia have often restricted themselves to process innovations while their counterparts in the United States and EU have been able to deliver product innovations. The strength of this model, however, is the complementarity between process and product innovations. Process and product innovations have a lock-and-key structure, where process innovations hold the key to resolving the problem of complexity that is unleashed by the introduction of new products. Finally, the sourcing of innovations in financial services requires forms of governance that are very different from the contractual, command-and-control mechanisms used for the procurement of more routine and highly codifiable forms of work such as call centers and data processing. For sourcing innovations from offshore pro- viders it is necessary to be able establish a collaborative mechanism that allows the Western clients to monitor their offshore service providers in fine-grained fashion, which in turn allows them to give these firms the leeway to experiment and arrive at innovative process-based solutions. Second, this form of governance also establishes deep collaborative linkages between firms, thus enabling the client and the buyer to come up with highly customized solutions in relatively short time frames. Where do we expect to see these trends lead? The cost of bandwidth has been falling over the past decade even as the reach of the Internet has been increas- ing. Interoperability between computing platforms has made it relatively easy to transport vast datasets between firms that are on very different platforms. The emergence of collaborative technological platforms such as Wikis and Web ser-

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0 INNOVATION IN GLOBAL INDUSTRIES vices (that can connect disparate systems over the Internet) as well as structured blogs will deepen the collaborative capabilities of corporations. Increasingly companies are able to monitor the working of the offshore providers at finer and finer levels of detail thanks to technological advances. These forces will result in greater global sourcing of innovations from various regions and will expand the sourcing footprint of corporations to include regions other than China and India. Brazil, Sri Lanka, Philippines, the Republic of South Africa, and Poland could well become important providers of financial services innovations in the near future. International trade trends are also making it easier for corporations to compete in offshore markets. Free-trade agreements between the United States and Singapore and between the United States and Australia, as well as the inte- gration of Eastern European countries into the EU, have all resulted in increased market participation in global markets by financial services firms the world over. Technology has brought instant transparency to business practices and product strategies adopted by firms in different regions and markets. As a firm introduces a new product or new features of an existing product, it will rapidly get copied by all other firms and will become a standard feature of the next generation of products. Firms will thus have to compete constantly for profits and market share. Competition is perhaps the most powerful driving force of innovation. As competition intensifies in world markets, we will surely see greater innovation in these markets. ACkNOWLEDGMENTS We wish to thank the Mack Center for Technological Innovation and the Fishman Davidson Center for Service and Operations Management at the Whar- ton School, University of Pennsylvania, for supporting this research. REFERENCES Aron, R., and J. Singh. (2005). Getting offshoring right. Harvard Business Review December: 135-143. Coase, R. (1937). The nature of the firm. Economica 4:386-405. Economist. (2006). Partners in wealth. January 19. Emloh, David von, and Yi Wang. (2005b). Competing for China’s credit card market. McKinsey. Avail- able at http://www.mckinseyquarterly.com/competing_for_chinas_credit_card_market_1713. Ensor, B. (2004). How ING DIRECT stole $17 billion in bank deposits. Forrester. Available at http:// www.forrester.com/Research/Document/Excerpt/0,7211,41632,00.html. Gary, L. (2004). Taking disruption to the bank, Strategy & Innovation, September-October 2004. Gupta, Rajat K. (2005). Fulfilling India’s promise. McKinsey Quarterly Special Edition. Available at http://www.mckinseyquarterly.com/public_sector/economic_policy_fulfilling_indias_promise _1673.

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 FINANCIAL SERVICES Roxburgh, Charles. (2006). Industry comment: The outlook for European corporate and invest- ment banking. McKinsey Quarterly Web Edition. Available at http://www.mckinseyquarterly. com/industry_comment_the_outlook_for_european_corporate_and_investment_banking_1838. Segupta, J., and Renny Thomas. (2005a).What Indian consumers want from banks. McKinsey. Avail- able at http://www.mckinseyquarterly.com/what _indian_consumers_want_from_banks_1662.

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