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Suggested Citation:"10 Financial Services." National Research Council. 2008. Innovation in Global Industries: U.S. Firms Competing in a New World (Collected Studies). Washington, DC: The National Academies Press. doi: 10.17226/12112.
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Suggested Citation:"10 Financial Services." National Research Council. 2008. Innovation in Global Industries: U.S. Firms Competing in a New World (Collected Studies). Washington, DC: The National Academies Press. doi: 10.17226/12112.
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Suggested Citation:"10 Financial Services." National Research Council. 2008. Innovation in Global Industries: U.S. Firms Competing in a New World (Collected Studies). Washington, DC: The National Academies Press. doi: 10.17226/12112.
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Below is the uncorrected machine-read text of this chapter, intended to provide our own search engines and external engines with highly rich, chapter-representative searchable text of each book. Because it is UNCORRECTED material, please consider the following text as a useful but insufficient proxy for the authoritative book pages.

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- 341

342 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, “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).   As the case makes clear, ING’s business model is a clear success in that it enjoys supranormal profits.

FINANCIAL SERVICES 343 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.  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   Citibank’s e-Business Strategy for Global Corporate Banking, HBS Case Study, HKU197, 2002, Center for Asian Business Cases, University of Hong Kong.

344 INNOVATION IN GLOBAL INDUSTRIES receivable and payables, and offer advanced treasury services to clients ranging from SMEs and MNCs. 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. 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, 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. 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   Citibank’s e-Business Strategy for Global Corporate Banking, HBS Case Study, HKU197, 2002, Center for Asian Business Cases, University of Hong Kong.   The 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.   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.   We refer the reader to the Harvard Business Review article “Getting Offshoring Right” in Decem- ber 2005; see issue of the journal for further details.

FINANCIAL SERVICES 345 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. 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. 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 FTE 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   When 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.   From a joint research project between The Wharton School and Gartner in 2003-2006.   Full-time equivalent, a measure of the number of employees involved in executing a process. 10 There 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.

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

FINANCIAL SERVICES 347 100% = $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% EMEA 22.7% 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 0.4% Customer Care 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% Facility Human Operations & Resources Management 4.6% 6.6% Engineering Customer Care R&D 10.0% Finance & 6.2% Sales & Logistics Accounting Marketing 22.8% 10% 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

348 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.

FINANCIAL SERVICES 349 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.

350 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 15  As mentioned earlier, this is often referred to as BPO. 16  “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.

FINANCIAL SERVICES 351 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.

352 INNOVATION IN GLOBAL INDUSTRIES (sometimes), and continuous improvements in efficiency over a period of time. These services produce modest gains in cost and quality ranging anywhere from 1 to 10 percent over a period of 3 to 4 years. In contrast to these incremental improvements, the execution of processes can be characterized by order-of-magnitude gains in both costs and quality over the same period of time. Usually, such gains result not from incremental improve- ments but from radical redesign of elements of work. Such redesign can include some of the following: process redesign, radical changes in the workflows and information flows associated with process production, automation in production leading to less human intervention, new information and knowledge transfer mechanisms that make it possible to offshore processes that were hitherto thought of as being too risky to decouple from where they are consumed (e.g., United States, United Kingdom), and the deployment of managerial practices that allow managers to monitor and influence work remotely. Some features of such innova- tions include the following: order-of-magnitude gains (as opposed to steady and incremental gains in costs and quality), gains realized over a compressed time pe- riod (as opposed to small incremental gains), use of new techniques (as opposed to improvements to existing methods), and simultaneous improvements to aspects of production that are thought to be substitutes (such as cost of production and quality of output; in the absence of innovation, lowering the cost of production substantially would result in lowering the output quality). Certain financial services such as bond pricing research, equity research, as- set pricing research in general, cash flow analysis, financial statement analysis, tax management, and modeling are now executed offshore. While the production of these financial services has been characterized by highly innovative practices, some so-called low-end services have proven to be difficult to migrate offshore and have been characterized at best by gains from wage arbitrage and small incre- mental improvements in efficiency. To understand why some complex services have been successfully migrated to offshore entities and have, within a short pe- riod of migration, resulted in innovations in the production and delivery of these services while other seemingly simple services could not be migrated offshore due to a high degree of operational errors, it is necessary to understand the subjec- tive nature of process complexity that underlies the production of services. The lay person might well think that the work involved in tasks such as asset pricing, tax analysis, financial analytics, and modeling is complex whereas the work involved in tasks such as customer service and selling credit card products is relatively simple. In fact, our research into the nature of complexity points to the contrary. There is considerable divergence between managers in different countries in their ratings of what is complex and what is not and as a result there are resulting differences between countries on the locus of innovation in the pro- duction and delivery of financial services. Executives in India and Singapore tend to rate the complexity of different kinds of work very differently from executives

FINANCIAL SERVICES 353 in the United States and United Kingdom.20 To understand how the different regions of the world forge very different kinds of innovation it is necessary to investigate the subjective nature of complexity and how offshoring may well set up a mechanism for complexity arbitrage. The Subjective Nature of Complexity We surveyed executives of BPO firms and captive centers and their clients and users21 respectively and sought their views on what kinds of tasks they deemed to be “complex” and which ones not. Executives from BPOs and cap- tive centers were mostly located in India, Singapore, and Mauritius while execu- tives from their clients (and users) were located in the United States and United Kingdom. We showed executives an identical set of processes. As a measure of complexity we asked executives from the four countries to rate an identical set of processes on the level of complexity involved in executing the processes.22 Only those executives that managed the execution and delivery of a process were asked to rate the complexity of the process.23 Each process was rated by four executives (one for each region) and some raters rated more than a single process. 24 They rated processes on a Likert scale of 1 to 7, where the highest level of complexity corresponded with a rating of 7 and the lowest complexity level was rated at 1. The results of the survey are shown in Table 3. It is clear that while the executives of the client firms in the United States and United Kingdom are in broad agreement on process complexity—just as Indian and Singaporean executives are in agreement with each other—they differ to a significant degree from their Indian and Singaporean counterparts. For instance, U.S. and U.K. executives rate process25 P8 as a low-complexity process while their Indian and Singaporean counterparts rate the process as being of relatively 20  Based on a survey of BPOs and captive centers undertaken by the author and his doctoral students. 21 For captive centers the term “client” is less accurate as the users of the service and the providers belong to the same firm. Instead of clients we call them users. 22  As a measure of complexity we asked executives how difficult it was to ensure that a particular process could be executed at an acceptable level of quality, at a required scale, reliably, and predict- ably. It is clear that implicit in this definition of complexity is the difficulty associated with staffing the process and the costs incurred in retaining and training the workforce to reach the adequate levels of quality. 23  all there were 37 processes for which we were able to obtain comparable data for 28 processes. In Each process was rated by an executive from each of four countries: the United States, United King- dom, India, and Singapore. The 28 processes were rated by 112 raters. 24 The same manager often managed two or three different processes and provided a rating for each. 25 The companies that provided us with the data have placed strict restrictions on us whereby we are not allowed to mention the names of processes or firms or reveal any information that may lead to the disclosure of the names of the companies or their clients. We therefore use generic names for processes such as “P1”, “P2”, etc.

354 INNOVATION IN GLOBAL INDUSTRIES TABLE 3  Subjective Perceptions of Process Complexity Processes Indian BPO Firms Singaporean BPO Firms UK Firms US Firms P1 1 2 3 2 P2 3 4 2 3 P3 2 3 5 6 P4 3 4 5 5 P5 3 2 7 7 P6 4 5 4 3 P7 7 6 1 2 P8 6 5 2 2 P9 3 4 5 4 P10 5 4 3 2 P11 3 2 7 7 P12 3 2 5 6 P13 2 3 5 6 P14 5 5 3 4 P15 5 4 3 2 P16 3 4 5 4 P17 1 1 7 7 P18 6 7 2 1 P19 3 4 4 4 P20 6 7 2 1 P21 6 6 2 2 P22 1 3 5 7 P23 5 4 3 3 P24 7 5 1 2 P25 2 2 6 6 P26 6 5 4 7 P27 2 1 7 6 P28 3 3 5 4 higher complexity. Similarly, executives in India and Singapore tend to rate pro- cess P5 as a low-complexity process while executives in the United States and United Kingdom rate it as being of relatively higher complexity. Table 4 provides a summary of the levels of convergence and divergence of opinions, between executives from the buyer and provider countries, on process complexity. The coefficient of correlation in the ratings of process complexity between the four regions is furnished in Table 4. The preceding findings can be explained when we analyze the factors that cause the divergence of opinions between the four regions. We found26 that when a process involved computational work, algorithmic execution, quantitative analysis, numerical analysis, or large dataset handling and analysis, the execu- tives from the United States and United Kingdom tended to rate such processes as being highly complex, while their Indian and Singaporean counterparts rated 26  In interviews with executives that responded to the survey.

FINANCIAL SERVICES 355 TABLE 4  Correlation Coefficients of Process Complexity Ratings Correlations India Singapore United United States Kingdom India 1.000 Singapore 0.831 1.000   t-stat 7.61099815   P-value 4.4461E-08 United –0.760 –0.813 1.000 Kingdom –5.9608215 –7.112491   t-stat 2.7238E-06 1.4903E-07   P-value United States –0.644 –0.720 0.861 1.000   t-stat –4.2870909 –5.2887715 8.61462229   P-value 0.0002204 1.5708E-05 4.2947E-09 such work as being of low complexity. Similarly, when the work involved in executing these processes required interpretation, judgment, understanding of the market context, understanding the client’s business context, communication, persuasion, or disambiguation,27 the executives in India and Singapore rated the processes as being highly complex while their Western counterparts rated such work as being of low complexity. Why do executives in India and Singapore find the latter kind of work complex? The answer to this question also has to with difference between domain expertise and domain experience and the difference in turn explains the very different kinds of innovation in financial services that we see in Western and Asian economies. Domain Expertise and Domain Experience Domain expertise refers to an expert’s understanding of a body of knowledge and ability to use a set of rules to execute some tasks in a given domain. For in- stance, an employee in a captive center in India may have acquired the expertise needed to do equity research and forecast a stock price window for a basket of stocks. The techniques needed to do this can be learned from a doctoral course in asset pricing and require no experience on the part of the agent actually work- ing in an investment bank. Similarly an agent working for a BPO in China could well forecast cash flows and create scenario models for a client firm without ever having worked for a corporate bank. The mastery of a set of techniques and un- 27  Sometimes it is necessary for an agent that is executing the process to use personal understand- ing of the business context of the process to remove ambiguities that may arise in executing the process.

356 INNOVATION IN GLOBAL INDUSTRIES derstanding of rules needed to perform such work is termed domain expertise in this context. On the other hand, in order to design a new financial product or offer an asset of a specific risk category to an investor it is necessary that the manager have an understanding of the nuances of the market that cannot be codified or captured in algorithms or cannot be easily transmitted to offshore providers via documentation. A private equity investor needs to understand the business of the client as well as be able to judge the quality of the management of the company in which he plans to invest. Similarly a wealth management specialist needs to have a clear understanding of the social and financial context of a high-net-worth individual as well as her personal goals in order to offer her a wealth management solution. These skills cannot be acquired without actually working in the business environment in which they are required. Employees of financial service firms in developed economies have the domain experience needed to execute these tasks. The tasks that require interpretation, communication, persuasion, understand- ing of the business context, and so forth very often need domain experience to execute. Those tasks that require computation, quantitative analysis, algorithmic execution, statistical analysis, and so forth can often be captured in terms of rules and expressed as techniques that can be learned. To execute such tasks it is enough for the agent to have domain expertise—there is no need for domain experience. It is indeed this difference in the nature of the two sets of tasks that drives the divergence in perceptions of complexity. This difference is one of the principal reasons28 for the divergence in the approach to innovation adopted by managers in different parts of the world. The locus of innovation is different for the different regions in the world. The Locus of Innovation To launch new innovative features in financial products or entirely new cat- egories of financial products it is necessary for the designers of these features (or products) to have considerable domain experience. It is not possible to launch new features or services for a segment of the market without knowing the busi- ness context of the market segment. On the other hand, it is possible to improve how some back-office support processes work without having the same level of domain experience. As an example, consider a credit card-based financial service that a company may offer to the merchants that accept its credit card. It is neces- sary for the company to know the needs of the merchants and have an estimate for their willingness to pay for the service, their preferred channel of service delivery, and the compliance procedures that they must follow. However, this company’s offshore captive center or BPO provider need not have the same level 28  Other factors too are important. Factors such as compliance regime in different countries, the economic systems, the extent of participation in the economy permitted by national governments, and the sociocultural beliefs of the consumers are also important. These factors can be thought of as exogenous or can be seen as parameters set by nature and constitute systemic variables.

FINANCIAL SERVICES 357 of understanding of the market in order to make some of the supporting back- office processes work well. The offshore provider may be able to intelligently automate some segments of the process, may reengineer some information flows, and may bring experts to resolve transactions that are otherwise difficult to rec- oncile. Thus, he can innovate with processes to be able to better support the new innovative features that the product carries. Product innovation requires domain experience while process innovation requires only domain expertise. Executives in Asia often focus on process in- novation, leaving product innovation to their Western counterparts. Product and process innovations often have very different implications and market dynamics associated with them. We explore these two kinds of innovation in the section that follows. Product and Process Innovations The principal difference between Asian and Western executives in the kinds of innovation that they bring to the market has to do with process and product innovations. While Asian executives29—especially in the financial services in- dustry—are far more likely to bring to market process innovation, their Western counterparts focus almost exclusively on product innovations as a means of creating competitive advantage. This difference in focus of managerial priorities is because of the lack of domain experience on the part of the providers and is not due to any other factor. As we mentioned earlier, product innovation requires considerable domain experience, making it a daunting challenge for providers of offshore services to release innovations for the Western markets.30 In addition to this, there are crucial differences between product and process innovation that ex- plain why the offshore providers and their Western clients specialize in different chunks of the value chain. Our studies of the offshore financial services industry since 2000 indicate that there is what amounts to a rough division of innovation labor—Western corporations increasingly look to product innovations to boost growth while their service providers (and captive centers) in Asia support them with process innovations. Product Innovation Product innovation in financial services is about adding new features to exist- ing products or offering new products to the market. It is almost always customer 29  does not matter whether these Asian executives are employed by Western or Asian firms. Their It lack of domain experience does not go away irrespective of who employs them. 30  Of course for non-Western markets this is less of a problem. In Bangladesh, for instance, Mo- hammed Yunus was able to formulate a microcredit mechanism via the Grameen Bank and serve an underserved segment of the market.

358 INNOVATION IN GLOBAL INDUSTRIES facing.31 Product innovation usually takes several months of R&D effort (includ- ing market research, research into product feature mix, pricing schemes, and the kinds of delivery channel to be deployed). It is usually piloted first to a few market segments; once it reaches a stable state, it is rolled out in scale. Examples of such innovation include the introduction of web-based banking and web-based insurance delivery. However, once product innovation is introduced into the mar- ket, the extent to which the innovation has succeeded takes a far shorter time to measure and it can be measured through relatively well-understood and unam- biguous measures of product performance such as extent of consumer adoption, market share, profitability indices (including measures of gross and net margins), and customer satisfaction scores. Product innovation nevertheless has an interesting “dark side”—it often adds to the complexity of operations. Each new suite of features or product of- ferings brings greater complexity in operations and more intense demands on the company’s service infrastructure. As an example consider the following: a bank adds a new feature—the ability to apply online for a loan and consolidate all asset balances into a single-view account at the level of each customer. This feature places considerable strain both on the back-office operations and on the technology infrastructure needed to support the feature. The underlying informa- tion systems have to be modified to be able to store information in customer- centric accounts as opposed to the legacy product-based storage of transactions. It will not suffice if the information is aggregated in real time based on customer requests from multiple accounts. As the number of customer requests increase, this real-time aggregation is bound to break down under the load of processing requests. The entire database has to be redesigned and applications have to be rewritten. If the technology were substantial, the human operations challenges tend to be even more daunting. The bank would have historically supported cus- tomer requests based on product type (banking related, credit card-related, etc.), while now it has to transition to a system where the customer’s requests have to be processed with a minimal set of interactions, both with the customer and between the bank’s back-office processors. The bank’s back-office staff are usu- ally product-level experts that specialize by product type. Thus, a mortgage loan service staff will have little understanding on how to service a question related to credit card interest rate and the bank’s new feature of relationship banking may flounder due to a sharp and significant increase in operational complexity. Adding new features and products often results in placing a strain on the organization’s service operations amplifying the levels of complexity. This is where process in- 31  Customer-facing activities are those that involve direct interaction with end customers, have a direct impact on the end customer experience, or both. Thus, a new product or service that is offered to the market is a customer-facing initiative, as opposed to sourcing a process from an overseas pro- vider that will be subsumed into a service by a corporation. In the second case a corporation builds the process (sourced offshore) into its service but the offshore provider does not directly interact with the end customers.

FINANCIAL SERVICES 359 novation—especially by offshore providers—plays a significant role as a comple- ment to product innovation. Process Innovation Unlike product innovation, process innovation is not market-facing in its direct impact. Process innovation is about making significant changes to how tasks are executed, changing information flows and workflows to achieve radical simplification of process execution in order to achieve greater process efficiency and more effective support of the company’s market objectives. Process innova- tion supports product innovation by reducing complexity in operations, making information work and its output more predictable, and improving the alignment between a company’s service and operations and its market objectives. In the preceding example of the financial services corporation that introduced innovative features into the market, the offshore provider of back-office processes to whom the firm outsourced these processes was able to radically reengineer processes by changing both the process architecture—consisting of informa- tion flows and workflow—and the skill sets of the agents that did the work. The company reengineered the entire back-office process from end to end to dispense with product-based specialists and instead moved to a model of deploying agents that had a 360-degree view of customer accounts and could process all kinds of products. To be able to support this process architecture the company needed back-office workers of a higher skill level than before. Under the changed scheme the agents had to be able to understand standard loans, split-coupon rate loans, mortgages, and credit lines. They hired agents with the necessary skill sets and trained them additionally as needed.32 In another example of process innovation supporting product innovation, a large financial services MNC launched a new financial loan product to its corpo- rate customers whereby the company would offer a series of small tranche loans to corporations for funding working capital requirements. The loan amounts would be priced, negotiated, and delivered to the corporation within 24 hours notwithstanding the complexity of the deal. Furthermore, the company offered to price each tranche based on the risk level associated with the tranche as op- posed to a fixed-rate coupon for the whole loan. This was especially attractive to corporate customers who believed that there would be a reduction in risk as the business moved forward. To make this possible, the company had to radically re- design its operations. It offshored the loan-processing tasks, including application management, credit risk assessment, and structuring the loan, first to a captive center that broke up the operations into modules. Thus, each set of related tasks 32  “‘Smart Growth’: Innovating to Meet the Needs of the Market without Feeding the Beast of Complexity,” Knowledge @ Wharton, see http://knowledge.wharton.upenn.edu/article.cfm?articleid= 1585&CFID=2650244&CFTOKEN=97771378#.

360 INNOVATION IN GLOBAL INDUSTRIES would be carried by a modular operations unit team. Whenever a new customer entered the market a new operational silo could be assembled in real time to service that customer. The corporate loan-processing division was radically re- organized into modular units that specialized in a particular task.33 For each new customer an assembly line of services would be created in real time by plugging in the modularized components. The offshore firm was able to do this in very short time as it could recruit employees with the specialized skills needed to achieve this within a much shorter period than was possible in the United States.34 Second, in order to get this design correct, the company had to carry some slack labor in the early months before it could reach a stable state of operations. This was not a problem in the offshore location because of the far lower wage costs. The firm’s redesigned, modularized business processes are shown in Figure 3. Product and process innovations differ in many aspects (as seen in Table 5), which we highlight in this section. Process innovation often complements product innovation and the two kinds of innovations have a lock-and-key structure35 of complementarily. They also differ in some important ways; process innovation invariably takes far less time to deploy than product innovation. However, the metrics that measure the effectiveness of process innovation are rarely (if ever) direct—they tend to measure the impact of product innovation such as process output quality and customer satisfaction with service. However, these measures are compounded by a number of internal factors and are at best proxies for mea- suring process innovation effectiveness. Second, it takes much more time to judge the effectiveness of process innovations. Unlike the case of product innovation, where critical success factors such as market share and gross and net margins often provide an accurate picture of the success of the innovation, in the case of process innovation not only are there few (if any) direct metrics, there is also con- siderable lag between introducing the innovation and measuring its effectiveness. The absence of direct measures means that it is necessary to capture measures of a variety of indirect proxies and to compare their change over a period of time to get some idea of how successful the innovation has been. Thus, while process and product innovations are complementary in the financial services industry, 33  The reader should note the direct contrast with the preceding example, where such specialized units were broken down into more versatile operational divisions. What should be clear is that there is no canonical way of engineering process innovation and very different solutions would work in slightly different situations. 34  Mainly because it was located in a country with a very large labor pool with the necessary skills. 35  The idea of a lock-and-key structure is used to illustrate how one kind of innovation holds the key to the success of another kind. New product introduction tends to snarl up the operational processes of a firm. Process innovation opens up operational silos, eases information flow, and reengineers workflow, thereby reducing complexity and allowing the benefits of product innovation to be deliv- ered to end customers.

FINANCIAL SERVICES 361 LC Bundle Bundle PFS Set Up An LC and Retail Processing & Treasury Service Financial Management Services Services Custom e r Interface Process Create Set-Up Manage Configure Customize Transaction, Customer Working Working Channels Loan Instruments & Asset Capital Capital and Deliver Products Manage A/c. Account Account Account Service Assessing Verify Customer’s Financial Price the Credit Rating Risk- Assets and Service Revenue Collateral Profile FIGURE 3  The modular operational unit. financial-3.eps TABLE 5  Product Versus Process Innovation Innovation Factor Product Innovation Process Innovation Locus of innovation Market facing Inside the firm, directed at back-office and service operations Principal goal Competitive advantage, higher Operational efficiency, redesign of market share and revenues operations Principal impact Increases operational complexity Lowering of complexity, increases service effectiveness Gestation time Comparatively long, often preceded Short; time lag between design and by elaborate (several months of) deployment is minimal R&D and market research efforts Metrics to measure Direct metrics, including market Only indirect proxies exist for effectiveness share, and gross and net margins measuring the effectiveness of the innovation Time for market Comparatively short; within a Much longer; it takes several validation couple of quarters of introducing periods of observation of indirect the innovation, CSFs can be proxies for success to arrive at measured some estimate of the innovation’s effectiveness Prerequisite for Domain experience and Domain expertise, ability to manage innovation understanding of market and complexity and deal with rapid business context changes in business volume IP assets Proprietary in nature; companies Rarely, if ever, proprietary, companies guard these carefully share these in a nonzero fashion Contract structure Coordination between firms, clearly Collaboration between firms and defined boundaries and control between departments within structures firms; blurring of organizational boundaries

362 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 36  The 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. 37  This 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.

FINANCIAL SERVICES 363 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

364 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-

FINANCIAL SERVICES 365 The Extended Organizational Hierarchy Form Market Captive Third Party Joint Build- Service Service Run-to- Operate Provider Center Venture Outsource 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.

366 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. 40  The 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).

FINANCIAL SERVICES 367 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.

368 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.

FINANCIAL SERVICES 369 100 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-

370 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.

FINANCIAL SERVICES 371 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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The debate over offshoring of production, transfer of technological capabilities, and potential loss of U.S. competitiveness is a long-running one. Prevailing thinking is that "the world is flat"—that is, innovative capacity is spreading uniformly; as new centers of manufacturing emerge, research and development and new product development follow.

Innovation in Global Industries challenges this thinking. The book, a collection of individually authored studies, examines in detail structural changes in the innovation process in 10 service as well as manufacturing industries: personal computers; semiconductors; flat-panel displays; software; lighting; biotechnology; pharmaceuticals; financial services; logistics; and venture capital. There is no doubt that overall there has been an acceleration in global sourcing of innovation and an emergence of new locations of research capacity and advanced technical skills, but the patterns are highly variable. Many industries and some firms in nearly all industries retain leading-edge capacity in the United States. However, the book concludes that is no reason for complacency about the future outlook. Innovation deserves more emphasis in firm performance measures and more sustained support in public policy.

Innovation in Global Industries will be of special interest to business people and government policy makers as well as professors, students, and other researchers of economics, management, international affairs, and political science.

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