The next challenges for global securities firms 2Hedge funds, financial sponsors, weak credit markets, new advisory business—a lot of opportunity, but not for the fainthearted.

The right fix for fixed income 10Today’s warnings about credit risk give firms enough time to protect the earnings they derive from fixed income.

Rethinking wholesale-banking operations 15By restructuring operations and aligning front and back offices, wholesale banks can cut costs dramatically and find new sources of revenue.

Trendspotter 19How fee pools are shifting

January 2006

McKinsey on Corporate & Investment Banking

15

Rethinking wholesale-banking operations

Adam H. Bremner and Anthony E. Simone

For many years, high margins allowed wholesale banks to operate in product-aligned “silos,” with traders and sales desks in the front office receiving customized—and often manual—support. But this environment had a high price: duplication in trade processing, account maintenance, and support functions across products. When the economy headed south in 2000, all banks began cutting their management and support staffs, automating manual processes, and streamlining IT budgets, thus reducing costs by 8 to 12 percent in many cases.

Tactical improvements have their limits, however. A handful of leading banks are thus starting to take a more strategic approach to improving the performance of the back office—an approach that makes it possible to achieve further savings of 10 to 20 percent while improving service, driving innovation, and generating new revenues. To accomplish all this, banks must rethink both the fundamental configuration of the back office and the way it works with the front office.

Reconfiguring operationsTo reconfigure operations effectively, banks must take a much harder look at their options for creating shared services, utilizing lower-cost locations, and

outsourcing selected functions. Players that apply all three levers will achieve the greatest gains.

Create more shared services

Our experience indicates that no more than 10 to 15 percent of all back-office activities may be needed to support specific product areas. The rest can be rolled up into shared-service groups or centers of excellence.

Banks can explore three basic models for sharing. First, they can look for back-office functions that are common across products and can be fully shared. A number of banks we know have taken this approach for trade reconciliations, data management, and account maintenance.

Second, when only part of a function can be shared, banks can create partially shared functions. Bonds, equities, and derivatives could share tracking announce- ments about corporate actions (such as stock splits or board votes), for instance, even if these product groups used the information in unique ways for accounting purposes. It is equally possible to share functions across different subsets of products. One bank, for example, set up two confirmation groups: one for simple products such as equities and bonds, the other for more complex, structured products like derivatives, which require a legal contract specific to each trade as part of the confirmation process.

Third, banks can create centers of excellence to provide common support for processes that demand both functional excellence and specific product knowledge. These include product-aligned middle-office functions (such as analytical support, profit and loss accounting, and risk analysis) that can benefit from shared “best of breed”

By restructuring operations and aligning front and back offices, wholesale banks can cut costs dramatically and find new sources of revenue.

McKinsey on Corporate & Investment Banking January 200616

approaches. For this model to work, banks must standardize their processes, tools, and procedures; establish service-level agreements; and actively monitor the delivery of services.

Relocate support groups

Many banks still maintain much of their support staff in high-cost metropolitan locations such as New York and London. Yet the risks of relocation have declined significantly in recent years as companies gain more experience in moving their

increasingly complex operational functions to offshore and near-shore locations. Our experience indicates that wholesale banks could move 35 percent or more of their

back-office functions to offshore regions (such as China, India, and the Philippines, where costs can be cut by as much as 40 to 50 percent) and an additional 45 percent to near-shore locations (such as Canada, the southwestern United States, and Ireland, for savings of 15 to 25 percent). One bank we know has already set up two offshore service centers—one for trade and data management, the other for account reconciliation, data management, cash management, and financial messages—with a total of 650 people.

Outsource selectively

Wholesale banks have traditionally embraced a “build, don’t buy” mind-set and resisted outsourcing, shared sourcing, and cross-industry collaboration. But by selectively outsourcing or shared-sourcing less strategic activities, such as infrastructure, reconciliation, and data management, they can gain economies of scale, reduce excess capacity, and cut redundancies throughout the industry.

The options include not only established outsourcing providers such as Automatic Data Processing (ADP) and Pershing (for processing services and correspondent clearing) but also hundreds of developing niche players. The shared-sourcing options include joint ventures or industry consortia to optimize capacity and take advantage of best practices across institutions.

Aligning the front and back officesPerhaps the biggest challenge, given the traditional culture of wholesale banking, is to get the front and back office to work together more closely. Even when located in the same place, they tend to operate independently and to display counterproductive attitudes and behavior born of a “revenue generator versus cost center” mentality. A closer alignment can help to cut the number of trade exceptions, reduce costs, develop more innovative products, and generate higher revenues. Wholesale banks can meet these goals in four primary ways.

1. Promote joint front-to-back accountability

for process excellence

Many downstream process errors—more than 60 percent at some banks—start with incomplete or incorrect data from the sales and trading desks or directly from institutional clients. In addition back-office clerks may, for example, misinterpret faxes and phone calls or make errors while rekeying data into back-office systems. These errors require manual intervention and time-consuming investigations by back-office staff members, thus driving up processing and operational costs.

Although such problems may seem easy to fix, the solutions involve changing the behavior of both front-office personnel and clients, and banks have wrestled with

The front and back office tend to operate independently and to display counterproductive attitudes and behavior.

17Rethinking wholesale-banking operations

that challenge for many years. The answer is to make both groups jointly responsible for finding and fixing the root cause of problems—for example, by holding periodic quality review meetings and, potentially, by creating a feedback loop that hits trader P&Ls with the cost of poor quality.

2. Use the cost transparency of products to

drive profitability

As a result of individualized treatment and uncontrolled allowances for many institutional clients, few wholesale banks fully understand the true cost—and thus, profitability—of their products and services. Special services (such as customized reporting, the handling of expired futures contracts, and the acceptance of manual or incomplete trade data) drive up uncompensated costs, which are allocated to traders and clients equally. Lower-cost-to-serve clients and traders thus end up subsidizing higher-cost ones. In addition, without knowing the “true” profitability of clients and traders, relationship managers can’t make effective trade-offs between costs and service.

To address this issue, banks must upgrade their ability to measure the costs of specific services and to track those costs back to specific clients, client segments, or trading desks. With this information in hand, the back office can align the revenue from a client or desk with the true cost of service. Service decisions then become fact based, and the front and back offices can work together to design different service packages with different levels of service at different prices to meet varying needs. This approach, while novel in wholesale sales and trading, has been very effective in other corporate- and institutional-banking areas, such as custody and cash management, where many players have defined different service tiers

and product bundles targeted at specific client segments.

3. Manage product development as a cross-

enterprise activity

Product development at wholesale banks is traditionally a front-office domain, and products originate and evolve within different groups without being integrated into core operations. The result can be either small, fragmented “island” units that support specialized products or disruptive work-around processes developed to overcome the system’s deficiencies.

Much of the problem can be avoided if the front and back offices work together earlier in the product-development cycle—even during the initial design phase. A more proactive, coordinated approach to development would allow banks to design products that better fit the existing infrastructure and to tackle system and control issues earlier and more effectively. The result: a shorter time to market, lower investments over the life of a product, and less operational risk.

4. Foster operations-driven product

innovation

Sales and trading institutions traditionally focus their product innovation efforts on new structured trades and new asset types. But other wholesale institutions, such as custodians and cash managers, have effectively developed new operations-driven services, particularly outsourcing services such as portfolio and payables-and-receivables management. Bear Stearns and Pershing have leveraged their expertise in clearing by offering it as a service to other institutions. Likewise, wholesale banks should see their back-office expertise as a source of new, revenue-generating service offerings—which might include integrated

McKinsey on Corporate & Investment Banking January 200618

service bundles targeting specific customer segments (an integrated market-maker service, for example), value chain “sliver” offerings (such as execution-only services at certain exchanges), and extensions into nontraditional but complementary services (say, a full-service hedge fund incubator). Working together, the front and back offices can identify the unmet needs of clients and explore additional services they might find valuable.

Most wholesale banks are experimenting with some or all of these strategic levers, with promising results. Few banks, however, are taking the holistic approach needed to improve performance more drama- tically by reducing support costs while satisfying clients and the front office and creating new sources of revenue.

Adam Bremner is a principal in McKinsey’s New

York office, and Tony Simone is an associate

principal in the Miami office. This article was adapted

from the original version, published in McKinsey

on IT, Number 2, Spring 2004. Copyright © 2004,

2006 McKinsey & Company. All rights reserved.

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Copyright © 2006 McKinsey & Company