How India's Next Outsourcing Wave Can Help the U.S.

Everyone agrees that the U.S. financial meltdown was the result of several factors, including indiscriminate lending, unprecedented levels of debt, poor assessment of risks, and indifferent oversight by corporate boards. An overlooked factor, however, is the breakdown of systems, especially risk management systems. Large financial institutions have been burdened by several generations of systems that operate in isolated "silos" and rarely talk to each other. These closed systems duplicate functions and make it impossible to get an integrated perspective of the underlying business. The systems kept regulators, investors, clients, and even the executives of the companies themselves from knowing exactly how things worked.

As the U.S. economy revives, it is critical that banks, insurance companies, and other financial institutions do a thorough overhaul of their underlying information technology applications to be able to compete and grow in the future. To do this, they can leverage the next wave of Indian IT outsourcing.

Over the last 30 years, the Indian IT outsourcing industry has gone through two stages. The first wave was characterized by staff augmentation—"body shopping," as it was then called—and established that Indian IT professionals were as good as their Western counterparts. The second wave saw the establishment of offshore development centers. Started during the 1990s to fix the Y2K bug, these centers evolved to deliver software maintenance and incremental developmental services for a fraction of the cost U.S. companies would pay for similar work at home. Second-wave firms now also deliver ERP implementation and maintenance, infrastructure management, and testing services. Today, India exports more than $25 billion of IT outsourcing services and is the mainstream destination for offshore programming. It commands more than a 70% share of the global offshore outsourcing market.

Over the last few years, we have seen a third wave emerge: a growing reliance on outsourcing companies for high-end strategic work. Indian firms have won a significant portion of the work through strategic outsourcing deals like the one announced recently with BP (BP). Large Indian IT services firms are today seen as being on a par with companies like IBM (IBM) and Accenture (ACN) for delivering strategic cost advantages.

Indian firms leading the Third Wave also have been partners in major consortiums delivering large, greenfield government programs. For example, both Tata Consultancy Services and my company, Mastek, have been involved in Connecting for Health, a multibillion-dollar health-care IT program for Britain's National Health Service. Specializing in large and complex applications for government clients, Mastek has delivered solutions for the London Congestion Charging scheme through its British partner, Capita (CPI.L), and is now involved in an air movement logistics application for the British Defense Ministry in partnership with Thales (TCFP.PA).

According to the Standish Group's Chaos report, which tracks project failure rates across a broad range of companies and industries, large IT programs across the globe are fraught with risks and have less than a 30% chance of success. More than two-thirds of large programs encounter significant time and cost overruns and almost a third never see the light of day. In contrast, Third Wave firms from India are leveraging their investments in software quality initiatives to bring higher levels of success in large program delivery.

The Innovation Challenge Large financial institutions suffer from an early-adopter disadvantage, as legacy systems become burdensome. Many of the core back-office applications and systems are several decades old and are written in antiquated languages like Assembler, PL/1, and Cobol. Not many people in the modern workforce are skilled enough on the old systems to keep them running. Furthermore, few managers today are familiar with the organizational knowledge, business rules, and structural logic behind these old systems. Reverse engineering is improbable, if not impossible.

Most IT organizations have kept these systems running by patching them together, using the IT equivalent of Band-Aids. They have been minimizing changes to these core systems and developing front-end applications, first during the client-server era and then using different generations of Web technologies. These front-end applications are only pretty faces for old applications—lipstick on pigs—and sometimes incorporate complicated, expensive workarounds that adversely affect the business.

Users adept at tools like spreadsheets and local databases have created their own personal and departmental applications to get around the IT departments. The percentage of critical decisions that depend on simple spreadsheet-type applications is shockingly high in many large institutions.

Mortgage-backed securities, collateralized debt obligations, and the credit default swaps emerged against the backdrop of this creaky IT infrastructure. A set of mortgage-backed securities could actually be sliced and diced into different tranches of CDOs, creating magical new properties; AAA-rated slices could be carved out of BBB-rated mortgages. The assumption (now proved questionable) was that not all mortgages in a pool will default. These bonds were packaged and sold far and wide, with no connection between the prime borrower and the institution holding the liability.

Most old systems, within the institution as well as across the chain, did not have the capability to track the links between the original mortgage and the tranche of CDOs that they were carrying on their books. Companies could not keep track of risks to their own portfolio. To give a parallel, a mutual fund publishes the investments it has made in stocks, their quantities and their latest prices; these are used to compute the fund's net asset value. If any portfolio company issues a warning, an investor can immediately figure out its impact on the funds that he has invested in. Unfortunately, there was no similar online system for CDOs under the legacy IT systems. No one could calculate the impact on an institution's CDO portfolio if mortgage defaults increased in, say, Stockton, Calif. Corporations were taking multibillion-dollar risks with systems far less sophisticated than the ones most of us use when making a mere $10,000 investment today.

Leveraging Third-Wave Indian IT Companies While the problems of legacy systems have been known for quite some time, corporations have been reluctant to address this issue for two reasons—risks and costs.

The risks associated with legacy modernization are twofold: requirements management and large program execution. Requirements management is a risk because of scant organizational knowledge and documentation about these core legacy systems. Many have tried reverse engineering with little success. In many ways, reverse-engineering software code is like assembling a jigsaw puzzle. Imagine putting together a 1,000-piece puzzle without the picture on the box.

The only viable method for addressing the requirements challenge is a combination of forward engineering, reverse engineering, and pragmatic business support. In brief, this approach entails strong teams of local domain and subject matter experts re-specifying requirements in conjunction with the business users. This effort must be supported by teams of business analysts and technical analysts who reverse-engineer the software code. From time to time, executive support must make pragmatic decisions on inventing new business rules/logic where the old rules are indecipherable or obsolete.

Third Wave Indian firms recognize this need for multiskilled teams. They have strong domain experts and subject matter experts in the countries where they operate, supplementing the technical resources from India. They recognize that the Second Wave approach of working to a customer-given specification will work for application maintenance and minor enhancements, but will fail in large-scale transformation programs. These firms bring in deep domain expertise and are committed to co-creating the application vision in collaboration with their customers. They work side by side, in an iterative fashion, to develop and deliver the ultimate solutions.

In the area of large program expertise, Third Wave firms have the track record of much higher rates of successful delivery, largely due to their mature software engineering processes. The offshore model brings in cost efficiencies which make the legacy transformation programs more affordable. In addition, the collaborative requirements and design processes actually help in increasing the proportion of work that can be performed offshore, making the economics even more attractive.

In summary, it is imperative for large U.S. and European financial institutions to modernize their legacy IT infrastructure in order to survive, innovate, and flourish in the coming years. The costs and risks associated with embarking on such major transformation programs locally may be prohibitive. Third Wave Indian firms offer a more attractive alternative to deliver these programs successfully.