Restructuring costs rationally for long-term competitiveness in financial markets

IBM Institute for Business Value

By Daniel Latimore, Ian Watson and Greg Robinson

Restructuring costs rationally for long-term

competitiveness in financial markets

In 2001, securities industry revenues dipped dramatically

—

the largest decline

in 20 years

—

and spurred a similar drop in profit margins. In the near term,

securities firms have tried to prop up margins by reducing capacity. However,

long-term competitiveness depends on altering a company’s cost structure

permanently. Three strategic initiatives promise the type of far-reaching change

that is required to rein in costs today …and position firms favorably for the

next market upturn.

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Contents

1 Introduction

1 Eliminating excess capacity will not

be enough

3 Establishing an efficient cost

structure: A competitive advantage

4 Straight-through processing:

Start small; start now

6 IT delivery optimization:

Decrease duplication

9 IT outsourcing: Preserve

financial flexibility

11 Implementing a type II strategy

12 Assessing your efficiency

12 It’s time

Introduction

For the securities industr y, 2001 was the worst year in a generation. At New York Stock

Exchange (NYSE) member firms, revenues fell by 20 percent, the largest drop in the last

two decades.

1, 2

Even during the last major revenue dip in 1990, revenues declined only

10 percent.

But even before the recent revenue freefall, there were signs of trouble. Between 1996 and

2000, expense increases outpaced revenue growth by 10 basis points.

Pretax profit margins

at top-tier firms declined even more severely than the rest of the industr y— contracting

by 50 percent between 2000 and 2001.

When revenue was growing 10 percent annually, rising

costs seemed less ominous. However, with revenues deteriorating, the growing imbalance can

no longer be ignored.

With top-line growth stalled, financial markets firms have only one avenue for increasing

shareholder value in the near term: reducing costs. Scrutinizing budgets and trimming surplus

capacity — although necessary — will not be enough to produce margins that satisfy anxious

stockholders. In fact, research at the IBM Institute for Business Value indicates that top-tier

fir ms may need to cut overall costs by as much as 16 percent simply to regain previous

profit levels.

Eliminating excess capacity will not be enough

As they have done during past market downturns, securities firms initially responded

to margin pressure by reducing headcount and cutting compensation. Between Februar y

20 01 and February 2002, Wall Street cut 43 000 jobs — the largest reduction in 25 years.

In 2001, investment-banking bonuses were slashed to half of their 2000 levels.

These

reactions are not surprising because, on average, compensation comprises almost 60 percent

of a securities firm’s noninterest expense.

Yet, not all cost-cutting measures carry equal weight. Cost-reduction strategies generally fall

into one of two categories: type I strategies, which reduce costs by reducing capacity, or type II

strategies, which drive savings by improving efficiency.

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Besides the typical first-wave cost-cutting measures already mentioned (pay cuts and layoffs),

type I strategies also include initiat ives s uch a s consolidating locations, exiting geographic

markets and reducing the number of services or products offered. In contrast, type II

cost-reduction strategies enable long-term efficiency gains by lowering the price of inputs

(switching data providers, adopting open-source software or relocating specific operations

offshore), streamlining operations (perfor ming processes electronically or centralizing support

functions) or reducing infrastructure costs (optimizing or outsourcing IT support). These two

types of strategies can be further differentiated by their business impact (see Figure 1).

Figure 1. Cost-reduction strategies: type I versus type II.

Source: IBM Institute for Business Value.

But, the most important distinction between the two types of strategies is the difference in

their impact once business picks up again. Although the payoff for reductions in capacity may

be quick, it will not — in and of itself — return margins to their historical levels. Compounding

the problem, type I initiatives can actually hamper a fir m’s ability to grow as the economy

revives. In contrast, type II strategies require more upfront investment and take some time

to implement, but they allow a company to make permanent changes to its cost structure —

helping improve its financial position now and, perhaps more importantly, offering a source

of competitive advantage as the market rebounds (see Figure 2).

Type I

Type II

Effect on revenue potential

Neutral to negative

Neutral to positive

Investment required

Minimal

Minimal to substantial

Time until impact

Short-term

Short- to long-term

Supports long-term, strategic goals No

Yes

Execution risk

Low

Moderate

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Figure 2. Type I strategies move a company down the cost curve; type II strategies shift the

company’s cost curve down.

Source: IBM Institute for Business Value.

Establishing an efficient cost structure: A competitive advantage

As financial markets firms contemplate more substantive cost-reduction measures that funda-

mentally alter their current cost structures, they will likely encounter a wide variety of type II

improvement possibilities. The IBM Institute for Business Value recommends a closer look at

three specific areas that show significant potential for long-term efficiency gains:

• Straight-through processing (STP) — By optimizing and automating processes related to the

performance and confirmation of securities trades and other financial transactions, the IBM

Institute for Business Value estimates that a company can eliminate 10 to 20 percent of

its back-office expense.

• Information technology (IT) delivery optimization — Inventorying IT infrastructure,

identifying redundancies and redesigning the IT organization, processes and technology can

lead to a 20- to 30-percent reduction in IT delivery costs without sacrificing flexibility or

functionality.

• IT outsourcing — Through the use of third-party vendors for development, management and

maintenance of technology systems and personnel, firms can lower IT costs by as much as

five percent and, more importantly, make a sizable portion of their fixed IT costs variable.

Although initiatives in any one of these three areas would likely provide worthwhile gains,

firms often uncover additional synergies by combining elements from multiple efforts into a

comprehensive cost-optimization portfolio.

Type II: Shift the cost curve down

Capacity

Type I: Move down cost curve

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Straight-through processing: Start small; start now

The Securities Industry Association’s (SIA) push to move the entire industry to a one-day

settlement period (T+1) relies heavily on a comprehensive, inter-enterprise STP implementation.

In fact, the T+1 initiative has made STP a standard part of the industry’s vernacular and

tightly linked STP and T+1 in most execut ive’s minds. However, the urgency behind T+1 has

waned. Succumbing to industry debate questioning the validity of the business case that it

commissioned, the SIA is reevaluating the costs and benefits of moving to T+1.

Without reg-

ulatory backing, the SIA mandate — with its deadline already postponed to 2005 — has

limited influence.

As the momentum behind T+1 slows, STP is dropping off the priority list at many firms. STP

has become so intertwined with the now controversial T+1 initiative that businesses tend to

ignore them both, overlooking the possibility of selectiv e STP implementations — in individual

processes versus end-to-end and with other financial products beyond equities.

Despite T+1’s reliance on STP, they are not synonymous; STP pursued in individual opera-

tional areas by individual securities fir ms can yield significant returns, with or without the

industry moving to T+1. Besides the cost-savings potential, STP can increase the overall

transactional capacity of securities firms, helping handle periodic spikes in trading volume.

Particularly attractive amidst today’s highly volatile market, selective implementation of STP

has the potential to reduce operational and settlement risk. By enabling STP in key areas,

companies can reduce costs now, and at the same time, position themselves for a future

end-to-end implementation. To identify the specific processes that would benefit the most

from STP, firms should examine their back-office operations both vertically and horizontally

(see Figure 3).

Figure 3. STP can take costs out of the back offices of securities firms in two ways.

Source: IBM Institute for Business Value.

Equities Fixed

income

Derivatives Foreign

exchange

Vertical process improvements:

Improving processes within specific product silos

Horizontal process improvements:

Improving processes across product silos

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33%

11%

Vertical process improvement

At many securities firms, cross-border equity trading is a prime opportunity for vertical

process improvement through selective STP implementation. By its very nature, cross-border

trading is significantly more complicated than domestic trading, with differences in currencies,

transaction calculations, regulations and settlement periods.

With complexity come consequences. The Global Straight Through Processing Association

(GSTPA) estimates that 15 percent of all cross-border trades currently fail to settle on time.

Estimates from SWIFT are even higher; they suggest that on-time settlement failure affects

15 to 20 percent of all cross-border trades.

In addition, the one-day settlement lag between

the foreign exchange and the equity transaction makes hedging risk difficult, particularly when

one considers the significant amounts involved.

To make matters even more challenging, cross-border equity trading volumes are rising

significantly. Dollar volumes in and out of the U.S. tripled between 1990 and 1995, from

US$615 billion to US$1.7 trillion. Traveling a continually steeper growth curve, cross-border

trades in 2000 totaled US$10.6 trillion, over six times the amount traded in 1995.

As companies chart their response to these trends, they should consider the pivotal role that

STP can play. By automating key processes and reducing the number of failed trades, STP can

help companies lower the overall cost of cross-border trading and mitigate risk.

Equity trading — both domestic and international — represents only a portion of the overall STP

opportunity; STP-enabled trading processes for other financial products can generate savings

as well. Companies should look beyond the STP avenues popularized by T+1 and examine

each line of business for potential STP efficiency gains.

The average cross-border

transaction weighs in at

US$210 000.

15,1 6,17

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Horizontal process improvement

Looking horizontally across a typical financial markets organization, collateral (securities and

cash) and liquidity management stands out as a significant opportunity for gaining efficiency.

The growth in the number of products offered and geographies served has led to a complex

and inefficient collateral and liquidity management process. Firms often interact with a

large number of correspondent banks, as well as numerous clearing and settlement providers.

This complexity has made it increasingly difficult for organizations to have a transparent,

near realtime view of collateral on a global basis.

Lacking this view, financial markets firms are unable to optimize their asset utilization, and

the cost of managing exceptions is high. The IBM Institute for Business Value estimates that

the typical large investment bank could generate savings of US$1 to 2 million per day given

a transparent and efficient approach to collateral and liquidity management. Connecting and

automating collateral and liquidity management processes through an STP implementation can

help firms achieve these significant cost savings.

IT delivery optimization: Decrease duplication

Throughout the last decade, several factors have reshaped I T deliver y at financial markets

firms. Industry consolidation and global expan sion created a g roundswell of industry mergers

and acquisitions (M&A)— with the number of M&A transactions increasing 316 percent

between 1990 and 1999.

With other synergy opportunities garnering corporate attention, IT

integration often received short shrift. Newly formed organizations were frequently left with

overlapping systems, excess computing capacity and inconsistent IT service levels.

During this same time period, many securities firms abandoned centralized IT functions in

favor of business unit or geographic-based IT organizations, in hopes of gaining speed and

flexibility. Unfortunately, decentralization also introduced significant overlap and unde-

rutilized capacity. As with prior decades, the 1990s brought advances in technology,

pressuring firms to experiment with unproven technology simply to remain competitive.

Caught up in the unprecedented growth of the late 1990s, firms spent more

freely on IT, making investments that— in hindsight — seem risky and, in some cases, unnec-

essary. With unrelenting emphasis on top-line growth, controlling IT costs was not

a priority.

1999 saw a record number of

securities firm consolidations

with 82 in the Pacific Rim,

113 in North America and 101

in Europe.

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Taken individually, each IT decision made in response to these industry pressures was

undoubtedly sound … at the time. But, collectively, over the past ten years, these actions have

led to bloated, inefficient IT delivery infrastructures, which now cost the securities industry 3

to 4 percent of its annual revenue.

21, 2 2

At most securities firms, IT infrastructure needs a major overhaul, not only to reduce costs but

also to improve service levels and increase operational flexibility. The payback on improved

efficiency can be substantial. The IBM Institute for Business Value estimates that a compre-

hensive IT delivery optimization strategy — implemented at a top-tier financial markets firm

with an IT budget of US$1.5 billion — has the potential to reduce annual IT expense in the

range of US$122 to 250 million.

Taking a holistic look at IT infrastructure involves careful consideration of three types of

consolidation initiatives — sha red serv ices, hardware consolidation and application ration alization

(see Figure 4).

* Estimates based on IBM Business Innovation Services consultants’ experience working with financial markets firms.

Figure 4. Three key infrastructure consolidation initiatives.

Source: IBM Institute for Business Value.

Initiative

Goal

Target

Potential savings as a

percent of IT spend*

Shared services

Consolidate similar IT functions • Hardware

4 to 6 percent

across multiple business • Software

units to reduce costs and • Staff

improve service

• Processes

• Sites

Hardware consolidation Review and redistribute a firm’s • Networks

4 to 10 percent

technology components to • Storage

optimize operational capability • Servers

and flexibility at the lowest • Sites

possible cost

Application rationalization Review and reduce a firm’s • Applications 4 to 7 percent

application portfolio to better

align applications with business

objectives and lower costs

while maintaining necessary

functionality and flexibility

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Revenue and Fiscal Management

IBM Institute for Business Value

Shared services

When shifting IT toward shared services, firms should evaluate each function carefully to

deter mine whether it is best delivered centrally or through individual business units. A shared

services model is not an “all or nothing” proposition; finding the right balance between

centralization and business unit autonomy is key. An important output of this evaluation is

a business case that clearly delineates the expected returns and helps garner management

approval and commitment.

Naturally, business units may be apprehensive about losing influence and control as IT becomes

more centralized. To gain their confidence , a shared services strategy should include provisions

for governance to establish unambiguous decision-making processes, flexibility to meet the

needs of a larger constituency and incentives to maintain responsiveness to the customer

(business units).

Properly implemented, shared services encourage collaboration, reuse of intellectual capital

and implementation of best practices across the company, which, in turn, can help increase

innovation, raise quality levels and reduce cycle time. But, most importantly, shared services

help businesses control costs. IT expenses — which were previously scattered and hidden in

pockets throughout the organization — become more visible and easier to manage, allowing the

business to allocate increasingly scarce resources to the enterprise’s highest priorities.

Hardware consolidation

Besides eliminating hardware costs through consolidation, businesses can lower support costs

as well. By shrinking the overall architectural base, IT departments have fewer systems to

monitor on a daily basis, change becomes more manageable and the IT department’s ability to

introduce new business capabilities may improve.

Although hardware con solidation offers tremendous opportunity for cost savings, businesses

should perform an in-depth analysis of user needs and expectations alongside the potential

impact of any hardware restructuring, to avoid negatively affecting the company’s long-term

business strategy. When planning a hardware-consolidation initiative, it is also an opportune

time to revisit business-continuity plans. Consolidation can make contingency plans less

complex and reduce continuity-related risk.

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Application rationalization

Rationalizing application investments involves careful scrutiny of a fir m’s entire application

portfolio. To remain part of the optimal application portfolio, an application must pass

through multiple filters — strategic, functional, technical and financial. Based on this analysis,

applications are retired, replaced by or combined with other applications, restructured to

reduce repair frequency or retained “as is.” Reconciling the application portfolio can also

help position the business for additional changes — such as implementing shared services or

outsourcing application management.

Changes to the portfolio are likely to face organizational resistance. The line between

preferences and needs blurs quickly when business units face losing applications that they

designed and built. The company must be prepared to address organizational challenges

throughout the valuation and implementation stages. The magnitude of financial benefits from

applicat ion rationalization varies widely based on a number of factors, such as size of portfolio,

age of applications and degree of overlap. However, the greatest returns usually come from

retiring applications or transferring application management to a third party.

IT outsourcing: Preserve financial flexibility

At financial services firms, IT budgets command a higher percentage of company revenue

than at firms in almost any other sector. And, with the latest market downturn reminding

securities firms just how cyclical the industry is, the idea of converting fixed IT costs into

variable ones is particularly alluring. However, securities firms have been extremely reluctant

to venture into outsourcing arrangements.

Securities firms have the same concerns as other companies that are considering outsourcing:

deteriorating service levels, lower IT morale and loss of control. They are also nervous about

prospective vendors’ industry knowledge, track record and solvency. But, above all else, securi-

ties companies worry about risk. In the financial markets, penalties for operational failure are

much higher than in other industries. Technology problems can escalate quickly in a realtime

trading environment. With high transaction volumes and huge monetary amounts involved,

one glitch can cost a securities firm tens— or even hundreds— of millions of dollars.

Yet, business pressures are intensifying, compelling the security industry to reconsider its

views on IT outsourcing. Industry cycles continue to drive large swings in IT demand.

Securities firms have difficulty increasing capacity precisely when needed, and — during

troughs— overcapacity places a heavy burden on the corporate income statement. Competition

is intensifying, requiring fir ms to deliver a solid financial performance quarter after quarter.

All the while, remaining technically current is difficult — and expensive to sustain. In a world

shaken by the events of the September 11 terrorist attacks, fear of catastrophic disasters

is rampant, pushing firms to seek cost-effective methods for safeguarding the business and

reducing risk.

In 2000, outsourcing comprised

only 8 percent of the IT

expense within the securities

industry — compared to 20

percent for insurance and 25

percent for banking.

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In many ways, outsourcing helps insulate securities firms from the pummeling effect of these

market pressures. Acquiring IT support on an incremental basis — paying only for the capacity

needed at any given time — helps financial markets firms cost-effectively address oscillating

levels of demand (see Figure 5). IT costs become variable, rising and falling with demand.

Transferring assets to an outsourcing vendor can help businesses boost return on assets.

Plus, with most outsourcing arrangements, business-continuity protection is built in. Fir ms

can avoid large upfront capital investments to construct their own in-house disaster recovery

capabilities — and the ongoing expense of maintaining them —plus, the outsourcing vendor

assumes a portion of the risk.

Figure 5. Obtaining IT functionality on an as-needed basis allows firms to reduce lead times,

upfront costs and unused capacity.

Source: IBM analysis

Total lost and unused capacity

paid for in this example is

approximately 35 percent

Total lost and unused capacity

paid for in this example

is approximately 15 percent, a

20 percent reduction

Time

Used capacity

Unused capacity

Unmet capacity need

Capacity, which is increased and

paid for in a step-function manner

Lost capacity during set-up

Used capacity

Capacity obtained as needed from

outsourcing vendor

Time

Unused capacity

Lost capacity during set-up

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Implementing a type II strategy

Type I I initiatives are more complex and difficult to implement than type I strategies. As

companies execute these long-term strategies, they face three primary challenges:

• In-depth oversight — Strong leadership is required to successfully shepherd a type II initiative

through approval, planning and implementation. Whether consolidating trading platforms

across multiple lines of business or negotiating an outsourcing agreement, major initiatives

need a champion — someone willing and able to take significant risk to achieve potentially

significant results and someone tenacious enough to see the effort through to completion.

• Funding — Paying for a type II initiative may seem impossible, given the constrained fiscal

environment. Upfront investments can be substantial, and payback periods are often longer

than those of other initiatives. However, with careful planning, firms can create a self-

funding portfolio of initiatives that uses savings from early — usually type I —initiatives to

pay for subsequent efforts. To work around restrictive budgets in this manner, firms must

withstand the short-term earnings pressure to let type I savings flow directly to the bottom

line and, instead, invest some portion of those funds to develop a more competitive long-

term position.

• Organizational impact — Implementation of type II strategies may require extensive organiza-

tional change. Because compromise may be necessary, businesses need to devise methods for

overcoming territorial defensiveness and reducing organizational friction. Carefully outlined

and effectively executed change management plans — which encompass every facet of change

from restructuring the organization, to adjusting incentives, to introducing new systems and

processes — are critical to success.

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Assessing your efficiency

How much opportunity for improvement currently exists within your operations? Take a moment to

reflect on your existing operations and identify areas worthy of a more in-depth investigation:

• What are the major expenses involved in the trading processes of each of your product groups?

• How much are broken trades costing your firm?

• What are the primary causes of trade settlement failures?

• Which areas within your trading process are manually intensive?

• What are the top three cost drivers within your IT delivery infrastructure?

• How complete is your understanding of the total cost of IT?

• Which IT areas have expanded considerably over the last few years due to M&A transactions and

global expansion?

• What are the key similarities and differences in IT needs among your various lines of business?

It’s time

Cost-cutting initiatives that required nominal investment and carried low execution risk have

largely been tapped already, but, for many companies, these initiatives have failed to push

margins back up to desired levels. To improve — or perhaps simply sustain — shareholder value,

financial markets fir ms need to make substantial improvements to their cost structures.

Long-range initiatives, like the type II cost-reduction strategies outlined here, require time

and money to implement— both of which are in short supply during a market downturn.

Yet, during an upturn, operational efficiency initiatives are almost always suffocated by an

overwhelming focus on growth. Simply stated, the optimum time to invest is when companies

can least afford it.

Because the timing rarely seems appropriate, firms can easily ignore operational efficiency

altogether, steadily falling behind competitive benchmarks until some type of crisis forces

change. But, by investing regularly in type I I initiatives, securities companies may be able to

avoid drastic, catch-up attempts.

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Although type I initiatives may provide temporar y relief during financially challenging

periods, they may eventually stifle a firm’s ability to grow. Type II strategies, on the

other hand, offer an important premium: they remain in effect long-term, helping

position a firm for market leadership as the industry rebounds.

To learn more about type II strategies and their potential impact on your business, we

invite you to contact us at

bva@us.ibm.com

. To browse other resources for business

executives, we invite you to go to our Web site at

ibm.com

/services/strategy

About the authors

The Financial Services Sector Team at the IBM Institute for Business Value created

this executive brief based on their study entitled “Pulling the Cost Lever to Optimize

Operations at Financial Markets Firms.” To learn more about this study or discuss the

potential impact of type II strategies on your business, please contact Dan Latimore

dwlat@us.ibm.com

The IBM Institute for Business Value develops fact-based strategic insights for senior

business executives around critical industry-specific and cross-industry issues. Clients

in the Institute’s member programs — the IBM Business Value Alliance and the IBM

Institute for Knowledge-Based Organizations — benefit from access to in-depth con-

sulting studies, a community of peers, and dialogue with IBM strategic advisors.

These programs help executives realize business value in an environment of rapid,

technology-enabled change. You can send an e-mail to

bva@us.ibm.com

for more

information on these programs.

Contributors

• Vikram Lund, Banking Lead, IBM Institute for Business Value, IBM Global Services

• Claire Paisley, Consultant, Financial Markets Industr y Practice, IBM Global Services

• John Raposo, Consultant, IBM Institute for Business Value, IBM Global Services

• Sumit Sood, Consultant, Strategy and Change Practice, IBM Global Services

Daniel Latimore

Financial Markets Lead

Ian Watson

Senior Consultant

Greg Robinson

Associate Consultant

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IBM Corporation

IBM Global Services

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06-02

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References

2001 securities industry data. [Data file]. Securities Industry Association. April, 2002.

“2001 Securities Industry Fact Book.” Securities Industr y Association. 2001.

Ibid.

IBM Institute for Business Value analysis based on company annual reports

1997 - 2001

Wells, David. “Wall Street Job Cuts Highest Since ‘74.” Chicago Sun Times.

April 4, 2002.

Winokur, Cheryl and Cowan, Lynn. “Wall Street Bonus Pool Seen More Like a Puddle

This Year.” Dow Jones News Service. September 10, 2001.

“2001 Securities Industry Fact Book.” Securities Industr y Association. 2001.

IBM Institute for Business Value analysis.

Ibid.

1 1

Ibid.

Kittell, David. “STP/T+1 Program Overview.” SIA Operations Conference.

May 8, 2002.

Serricchio, Miguel A. “Back to the New Basics: Taking Advantage of the Real Value in

the Web Two: Web-based Cash Management.” Citibank. December 21, 2001.

Ibid.

IBM Institute for Business Value analysis.

“Omgeo Intelligent Trade Management.” Sun Microsystems. 2001.

“Federal Reserve Flow of Funds.” www.federalreserve.gov. December 7, 2001.

Ibid.

“Report on Con solidation in the Financial Sector.” Group of Ten. Bank of International

Settlements. January 2001. www.bis.org/publ/gten05.pdf

Ibid.

Securities industry data. [Data file]. Financial Services Technology Group.

Datamonitor. April 2002.

2001 securities industry data. [Data file]. Securities Industry Association. April, 2002.

Securities industry data. [Data file]. Tower Group. 2002.