Brookings Trade Forum 2005 (2005) 373-398
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Determinants of Operational Risk in Global Sourcing of Financial Services:
Evidence from Field Research
The practice of global business process outsourcing (BPO) has gone beyond call centers to expertise-intensive functions such as tax accounting, equity research, cash flow forecasting, fixed income asset pricing research, transaction processing, supply chain coordination, and even research and development (R&D).1 Worldwide BPO is projected to reach $133.7 billion in 2005, an 8 percent increase from 2004 revenue of $123.8 billion, according to the Wharton Gartner Research Forecast (2003).2
The production of business processes is different from the production of physical goods in some important ways. First, the production of business processes involves no movement of physical goods, raw materials, inventories, or shipping and delivery costs. Here, inputs, output, and work-in-process are all information. Second, there is often minimal latency between the production of a process by a service center and its being bundled into a service for the end customer. An offshore service provider (a BPO firm) may process all the savings and checking account–related transactions of customers, and these customers may well make decisions based on their account balances a few minutes after the [End Page 373] transactions have been processed and the account has been balanced. This makes operational excellence—the accurate and timely production of information-intensive processes—of paramount importance. A third aspect in which the production of information-intensive processes varies is in the cost of inspecting the finished output. The act of inspecting the finished process for errors often involves retracing all the steps involved in its production. For instance, if a customer's account balance (processed by an offshore BPO firm) is to be inspected for accuracy, then it is necessary to actually process each transaction and tally all the debits and credits to make sure that the account total is correct, all of which amounts to redoing the original work involved in balancing the account.
There are numerous other business processes where the cost of inspection is as much as the cost of production, including those in corporate banking, insurance, direct procurement, brokerage services, and retail banking. Even where it is possible to inspect a service for quality, there are only a few unambiguous metrics of quality that both the buyer of services and the provider can agree on, such as what level of research is adequate for forecasting a stock's price. Agency theory suggests that this aspect of offshored process production is rife with problems of moral hazard and resulting possibilities for opportunistic behavior on the part of the client or the provider. These factors amplify the likelihood that the process output will be of suboptimal quality—which we call operational risk—when processes are sent offshore to a third-party provider.
By operational risk we mean the possibility that errors in processing information, delays in completion of work, inadequate documentation of procedures, or other unforeseen circumstances will lead to an output (finished process) that is of less than acceptable quality. For instance, when claims processing in insurance is outsourced to an offshore BPO firm, the offshore firm may not understand how to prioritize the client's (buyer's) requests and treat all requests alike by, for example, placing them all in a process queue. Alternatively, a BPO firm with a poor understanding of compliance requirements may keep insufficient audit trails of its work. An inadequate grasp of the client's markets and business context may lead the offshore BPO firm to act in ways that provoke adverse reactions from the client's customers. Examples of such outcomes, wherein the output of the outsourced firm is suboptimal from the standpoint of the buyer (client), are what we refer to as operational errors; the resulting risk of operational errors is operational risk. The complexity associated with information work is yet another factor that could amplify the operational risks associated with offshoring work to...