Determinants of Operational Risk in Global Sourcing of Financial Services

Evidence From Field Research

Abstract

We investigate the factors that lead to operational risk in off-shore outsourcing of business
processes. We base our model of operational risk on field research conducted in multiple
countries over a period of several years. Our research shows that there are two principal factors
that determine the nature and extent of Operational Risk in off-shore outsourcing. The first of
these is the extent to which processes can be codified (or specified exhaustively). The greater the
codifiability of a process the lower the extent of operational risk associated with off-shoring the
process. The second factor is the extent of convergence in understanding of the parameters of
process quality between the buyer and the provider of services. The more objectively defined the
metrics of process quality are the less the operational risk. We formulate the idea of Knowledge
Continuum and show that the factors that determine operational risk originate in the nature of the
information work that is carried out along the Knowledge Continuum. Finally, we contrast the
efficiency and welfare levels associated with the three principal modes of offshore production of
services and show that an emerging hybrid form of governance which we term the Extended
Organizational Form, is the dominant choice for sourcing many kinds of services.

1
1.0 Introduction
The practise of global Business Processes Outsourcing (BPO) has gone beyond call centers
to such expertise-intensive functions such as tax accounting, equity research, cash flow
forecasting, fixed income asset pricing research, transaction processing, supply chain
coordination, and even R&D [BusinessWeek Mar, 21, 2005]. Worldwide BPO1 is projected to
reach $133.7 billion in 2005, an 8% increase from 2004 revenue of $123.8 billion, according to
Gartner. The production of business processes is different from the production of physical goods
in some important ways. The production of business processes involves no movement of
physical goods, raw materials, inventories and shipping and delivery costs. Here, inputs, output
and work-in-process are all information. Secondly, 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 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 varies is in the cost of inspection of the finished output. The
act of inspecting the finished process for errors often involves retracing all the steps involved in
the production of the processes. 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
of the transactions and tally all the debits and credits to make sure that the account total is correct
– which essentially amounts to the original work involved in balancing the account. There are
numerous other examples of business processes including those in corporate banking, insurance,
direct procurement, brokerage services, retail banking etc. where this property holds – i.e. the
cost of inspection is as much as the cost of production. Even where it is possible to inspect the
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 suggest that this aspect of offshored process production is rife
with problems of moral hazard and resulting possibilities of opportunistic behavior on the part of

1
Note that this is the size of the outsourcing market of which off-shore outsourcing forms a smaller segment (of
about 16%).

2
the client or the provider. These factors amplify the likelihood of sub-optimal quality of process
output – which we term as Operational Risk – when processes are sent offshore to a third-party
provider.
Operational Risk: By operational risks, we refer to the possibility of errors in processing
information, delays in completion of work, inadequate documentation of procedures, etc. which
lead to the output (finished processes) being of less than acceptable quality. For instance, when
claims processing in insurance is outsourced to an offshore BPO firm, it is possible that the firm
is unable to understand how to prioritize the client’s (buyer’s) requests and treats all requests
alike and places them all in a process queue. Alternatively, poor understanding of compliance
requirements may lead to the BPO firm keeping insufficient audit trails of its work. Inadequate
grasp of the client’s markets and business context may lead the offshore BPO firm to act in ways
that makes provoke adverse reactions from the client’s customers. Examples of such outcomes –
wherein the output of the outsourced firm is sub-optimal from the standpoint of the buyer (client)
is what we refer to as operational errors and the resulting risk of operational errors as Operational
Risk. The complexity associated with the information work is yet another factor that could
amplify the operational risks associated with offshoring work to a third-party firm. For offshore
outsourcing of information work to release the gains associated with wage arbitrage and
specialization it is essential that operational risks are minimized.
The aim of this paper is to investigate the factors that impact the operational risks of offshore
business process outsourcing. We conduct an empirical analysis using the longitudinal data we
collected containing bi-weekly detailed information on 31 outsourced processes carried out by 5
outsourcing providers for over a year. We found that the nature of the process, the effort and the
experience of the provider, and the characteristic of the contract all have statistically significant
impact on the risk of the outsourced processes. In the next section we review relevant extant
research and in section 3 we introduce the idea of complexity arbitrage and examine its
implications and link it to the discussion of operational risk in section 4 and motivate the
research hypotheses. In section 5 we provide an econometric model of risk and analyze the
survey data. In section 6 we discuss the managerial implications of the research and in section 7
we analyze which forms of governance produce the best results in mitigating the risk associated
with offshore process production and conclude with section 8.

3
2.0 Literature Review
Operational risks play an important role in the Transaction Cost Economics (TCE) literature
in determining the boundaries of the firm. The prevailing view that the natural boundaries of the
firm were determined by technology, technological non-separabilities and economies of scale
was first challenged by Coase (1937), who held that the firm and the market were alternatives for
organizing the very same set of transactions and the costs associated with arranging to have work
done, rather than the cost of doing the work itself — offered the best explanation for the
existence of separate firms rather than the universal reliance upon market transactions. TCE was
developed to justify the firm as economizing on transaction cost, i.e., to identify the most
economically efficient governance structure and to show the conditions under which the firm and
not the market provided the ideal governance structure. Central to TCE transaction frequency,
investment idiosyncrasy and uncertainty as the critical dimensions of contractual relations that
yield transaction cost. The essential role of risk as a large component of transactions cost created
by leaving the internal hierarchy of the firm was first explained by Klein, Crawford, and Alchian
(1978) and Williamson (1979). Agency theory (Grossman & Hart 1983, Grossman 1986)
explained the role of principal agent problems, mainly deliberate underperformance of
contractual tasks under conditions of imperfect observability and misalignment of incentives
between client and vendor. Incomplete Contract Theory (Hart & Moore 1988, 1990) brought up
the opportunity renegotiation and hold-up problem as another contract risk between client and
vendor. TCE has been readily used by researchers in the field of Information Systems to explain
the impact of information technology (IT) on the boundaries of the firm. Bakos and Brynjolfsson
(1993) show that while having too many suppliers can result in significant coordination costs and
greater risk of operational errors, relying on too few suppliers amplifies the threat of
opportunistic behavior.
To further understand the nature and extent of operational risk associated with a process
knowing what components really drive the transaction cost and risk is important to both
practitioners and researchers alike. The earlier empirical works of TCE confirm the positive
relationship between investment specificity and contract cost, and thus contract duration [Palay
1984, Joskow 1987, Crocker and Masten 1988] or vertical integration [Monteverde and Teece
1982, Masten 1984]. Anderson and Schmittlein [Anderson 1984] find that the most important

4
variables that drive the contract risk are the difficulty of evaluating performance and the
importance of non-contract activities in the sales department context.
3.0 Process Complexity
Our interest in operational risk associated with processes, led us quite naturally to studying the
nature of complexity associated with processes. We surveyed several senior executives and
sought their views on the nature of complexity associated with several kinds of processes. We
spoke to executives both in the “buyer economies” (US, UK etc.,) and in the ‘provider
economies’ (India, Mauritius, Thailand and Singapore). We found to our surprise that there was
no consensus around the extent of complexity associated with a process and views of complexity
were quite subjective. However, what was equally interesting was that there was some agreement
between the executives of US and UK even as there was agreement between executives of India,
Singapore, Mauritius and Thailand. However, while assessments of process complexity was
positively correlated within the same shore2, they were negatively correlated across the
offshoring divide. Which meant that not only did executives in the US and UK shared an
assessment of complexity they disagreed with their counterparts in India, Singapore and
Mauritius. This led us to analyze the components of complexity and what led to the divergence
in views of complexity. We selected some processes mostly from the financial services industry3
that were being executed in the US and UK as well as in India and Singapore and described the
work involved in executing these processes in exact detail. We captured data about the nature of
work in extensive detail. Some of the elements of data we captured are shown in Table 1 below.

Table 1: Survey of Process Complexity: Elements of Data Collected

Dimension of Complexity Elements of Data Collected

Agents in involved in process Training, education, experience, compensation

execution

Firm-Level Inputs Extent of managerial supervision, investment in IT

monitoring systems, extent of quality inspection by client

2
US and UK on the one hand and India, Singapore, Mauritius on the other.
3
As a result of the non-disclosure agreements that we entered into, we are unable to provide any description of
processes or firms that could in any way lead to the identity of the firms that provided these services in India and
Singapore or their clients in US and UK being revealed.

5
 etc.

Process Characteristics Cost of inspecting finished process for errors, extent of

Errors in process execution, Number agents required to
process a single process cycle, extent to which the work
involved in the process could be codified, number of sub-
tasks associated with the process, extent of algorithmic
computation and quantitative analysis required to execute
the processes, etc.

Composite Complexity Attribute Managers were asked to rate the process complexity on a
Likert Scale [1 to 7] where 1 would be not at all complex
and 7 highly complex.

Our survey included a comprehensive collection of attributes associate with process complexity4:
we captured details of process execution ranging from aspects of the information workers (IWs)
that executed these processes – i.e. training, educational level, compensation etc. to firm-level
inputs such as the extent of managerial supervision, use of real-time systems to monitor quality
etc., and process attributes such as, the extent to which the work involved in the process could be
codified, number of sub-tasks associated with the process, extent of algorithmic computation and
quantitative analysis required to execute the processes etc. Finally we also asked managers from
the four countries to provide a single composite rating of process complexity – i.e. rate the
complexity of the process on a Likert Scale (1 to 7) . The analysis of the data collected provided
further evidence of the phenomenon that we had first noticed: there was indeed considerable
divergence in managerial assessment of complexity across the regions. Table 2 below shows the
complexity rankings assigned by clients in the US and vendors in India and Singapore to the
same 10 processes in the survey instrument. A quick examination of the table shows that as we
suspected, tasks that were viewed as complex by the American executives were generally viewed
as much simpler by their vendors. There is a very high level of agreement on complexity, as
perceived by vendors both in India and in Singapore. Indeed, the correlation between the

4
In selecting these attributes we were guided by extensive interviews that we conducted with executives from all
four countries.

6
observations from these two markets is close to 0.85. We then note that there is a strong
negative correlation between complexity, as predicted by American and British clients, and
complexity, as observed by Indian and Singapore vendors.

Table 2 – Complexity rankings assigned to the same 10 processes by client managers in the
US and UK and vendor managers in India and Singapore.

Processes US Firms UK Firms Indian BPOSingaporean BPO

P1 2 3 1 2
P2 3 2 3 4
P3 6 5 2 3
P4 5 5 3 4
P5 7 7 3 2
P6 3 4 4 5
P7 2 1 7 6
P8 2 2 6 5
P9 4 5 3 4
P10 2 3 5 4

In particular, we found that multi-stage, computationally intensive analytical tasks can be

executed by engineers and technical personnel in India and in Singapore at adequate levels of
quality. Often their performance levels relative to their counterparts in the US and the UK is
actually superior; that is, in addition to the wage arbitrage gains that this labor pool offers, these
IWs, when provided with comparable training and comparable support technology, deliver levels
of quality that is adequate or superior to the levels of quality of the clients’ in-house operations.

Examining the way that western executives estimate the complexity of tasks to be outsourced
does provide an explanation for why their estimates are consistently different from those of their
vendors, and why there are opportunities for outsourcing tasks that they consider to be complex.
Table 3 below provides correlation co-efficients in process complexity ratings between the four
regions. There is strong agreement between the managers of the buyer economies – US and UK
– and equally strong agreement between the managers of the provider economies – India and
Singapore. However it is clear that between the two regions there is a clear divergence of views
on what constitutes a complex process.

Table 3: Divergence in perceptions of complexity: Correlations in process complexity ratings

between regions.

7
 US Firms UK Firms Indian BPO Singaporean BPO
US Firms 1
UK Firms 0.89 1
Indian BPO -0.47 -0.56 1
Singaporean BPO -0.54 -0.63 0.84 1

What factors contribute to complexity as seen by managers in the buyer countries? Our survey
shows that:

• The buyer country managers surveyed consistently assigned higher over-all complexity
measures to tasks that were more algorithmically described, and more analytically and/or
computationally demanding.

• As tasks went from subjective, context-dependent and implicitly understood and verbally
described to explicitly codified, dependent only upon analysis of data using formal
techniques which could be specified in advance, these tasks received higher scores of
complexity from managers in the buyer countries.

On the other hand, tasks that were seen as complex by managers in the provider economies, often
involved a high degree of contextual interpretation, implicitly understood rules embedded in the
business context of the client. For instance, Indian managers rated work that went into sell-side
equity analysis that involved understanding of mathematical models and analytical modeling
skills as low complexity while writing a report on the prospects of a basket of stocks was seen as
significantly more complex. The opposite was the case with the managers of firms in US and
UK. They rated the actual analysis that went into the report as high complexity work while
writing a report around analytical estimates (that have been made available) as work involving
lower complexity.

This raises a question, could there be a market for ‘Complexity Arbitrage’ between the two sets
of regions? To answer this question we need to address a related issue: could the more complex
processes (as seen by the western managers) get offshored while the less complex ones were
executed in the western economies? For such an arbitrage to be feasible, it is necessary that the
extent of operational risk associated with offshoring processes has to be manageable and low

8
enough to not negate the gains from wage arbitrage. In other words, we need to determine the
extent of operational risk associated with complexity arbitrage. This observation leads us to the
analysis of operational risk in the section that follows.

4.0 Operational Risk

BPO involves the outsourcing of information-rich processes. The reason that offshoring of
processes is prone to errors in execution is because the transformation of data into knowledge
that can support decision making is achieved through the combination of human intervention by
IWs and computer processing (automated routines that sort and classify large data sets).
Intervention by IWs is needed at various levels to convert, translate, transform and validate the
data that is fed into corporate information systems, and the risk of outsourcing a business process
is determined by the extent of IW intervention required and the nature of the IW intervention that
is required. This leads us to the idea of a spectrum of work that calls for different degrees of
judgment and expertise.
3.1 The Knowledge Continuum:
We introduce the idea of “The Knowledge Continuum” here which describes the spectrum
of information work that goes into the production of business processes. The Knowledge
Continuum spans work that is routine data creation (transfer from one medium to another,
transcription etc.) through information analysis which calls for some expertise and analytical
skills on the part of the IWs to highly judgment driven, expert works such as generating equity
research and bond pricing research reports5, and litigation research support. For those processes
located at the left end of the Knowledge Continuum, such as inbound Tech-support calls,
transaction processing, document management, direct mailing, e-mail query resolution etc. most
of information that the IWs need and most of work that needs to be done is easy to specify via
business rules and calls for very little judgment and expertise. These processes feature a higher
degree of what is described as ‘rules-based work” by Levy and Murnane [Levy 2004]. As
opposed to these processes, there are processes that stretch from the middle of the knowledge
continuum to the right end which involve discretionary decision making, such as yield analysis,
direct procurement, critical event simulation, SEC filing verification, contract research for M&A
and remote research support to the Investment Banking industry. These processes call for the

5
While doing the mathematical analysis that goes into the report is less judgment-driven, the construction of the
report involves substantial amount of judgment-driven and often context sensitive work.

9
exercise of judgment, inference, and the ability to call upon tacit knowledge (or expertise) to
map a course of action to a desired set of outcomes. Thus we can see that the Knowledge
Continuum has three kinds of information generation activities – the set of activities leading to
data creation, collation, correction and transformation which we term the Data Phase; the set of
activities leading to information extraction and creation which we term the Information Phase;
and the set of activities leading to the production of knowledge which can be used to support
decision making which we term the Knowledge Phase. Based on our field research we have
mapped a set of off-shored outsourced process to the Knowledge Continuum as seen below in
Figure 1.
[Insert Figure 1 About Here]
The nature of the Information Work that is performed along the Knowledge Continuum
impacts the extent of operational risk. In particular, two aspects of the knowledge work stand
out. The first is that work that is performed in the data phase can be easily described in terms of
business rules which specify the set of actions that agents must take when they meet specific
situations. The second aspect that has an impact on operational risk is the set of metrics that are
used to measure the quality of process output; it is intuitively clear6 that the quality of data
transcription, correction etc. can be measured fairly easily through error rates and related metrics
while the quality of output of work that is carried out in the Knowledge Phase such as a research
report for Investment Banking or litigation support cannot be easily measured. These
observations in turn lead us to our next section on the analysis f operational risk.

3.2 Factors That Impact Operational Risk: Research Hypotheses

Operational Risk manifests itself in the form of operational errors. These errors may be in
the form of inaccurate (mistake-ridden) process delivery, delays in completing the work,
incomplete or inaccurate audit trails, etc. In general a deviation from a predetermined form of
output7 is an operational error. The magnitude of Operational Risk is therefore the extent to
which the output of a process is error-ridden. There are two advantages to proceeding with this
definition; (1) the firm that buys the services specifies what an error is in the SLA, thereby

6
As we will see from the analysis of data collected in our field research
7
Note that it is possible to specify what the end result of a process should be – even when it is not possible to
specify exhaustively how agents should behave when they encounter different situations (or states of the world).
Here we make a careful distinction between what is to be done – i.e. the output of a group of workers - and how the
actual work is to be performed.

10
restricting the ambit of analysis to what really matters and (2) Parsimony – this model of
operational risk is a parsimonious construction of risk that will span to include different kinds of
operational errors – errors of execution, delay in delivery, sub-optimal customer satisfaction8
outcomes in different process types – financial services, direct procurement, legal research, Bio-
informatics and the all too familiar call center work.
It is clear from the discussion above that when provider of services (the firm that executes
these business processes) is provided with a fully specified charter of work – a document that
exhaustively specifies exactly and how an agent should respond to each situation that she
encounters while working on a business process – the provider is likely to make fewer errors in
producing the process. We term this ability to specify the set of agent responses to states of the
world that can be encountered in working as Codifiability of a process. The idea of codifiability
two constructs developed by Levy and Murnane [Levy 2004]: codifiability of work enables a
combination of computer substitution and pattern recognition by human agents leading to
specific actions that need to be taken. Processes that involve routine work are far more codifiable
than processes that involve subjective judgment calls. We would expect to find therefore that
greater the extent of Codifiability of a process, fewer the operational errors associated with the
process. This leads us to our first hypothesis:

H1: The higher the codifiability, the lower the extent of operational risk.

A second factor that we were able to identify from our field research that has a significant
impact on the extent of operational risk is the convergence of understanding the buyer of services
(firm) and the provider on precisely how quality of output is be measured. Again, it is clear that
this too is driven by the nature of work. For processes that fall on the left of the Knowledge
Continuum – routine data creation and simple forms of information extraction - the measures of
process quality are clear and unambiguously understood by both the buyer and the provider of
services. On the other hand, for processes that involve the use of judgment and expertise that
result in the creation of knowledge that supports decision making, buyer and seller may not have
complete convergence in their understanding of process quality. In several countries and across
many firms we encountered this phenomenon. For processes such as litigation research support,

8
Very often buyers specify that customer satisfaction surveys

11
financial research in Investment Banking, Financial statement analysis and presentation, the
quality of the finished process and indeed the measures used to estimate quality were not always
well understood. We define an important measure here – The Objectivity Quotient Of Process
Metrics (Objectivity Quotient – or OQ - from hereon) as follows: this is the ratio of the number
of parameters of process quality on which there is complete convergence between buyer and
seller to the total number of parameters of process quality. This ratio will equal to unity when
there is complete convergence and will fall to a number less than unity when there are one or
more parameters on which the buyer and seller do not share an unambiguous understanding of
process quality. Smaller the value of the OQ greater is the extent of operational risk resulting
more operational errors. There is theoretical support behind this intuition - according to
multitask theory (Holmstrom & Milgrom, 1991), assigning tasks in which performance is
imprecisely measured will increase the propensity of agents to shirk work. This leads us to our
next hypothesis.
H2: The lower the objectivity quotient, the higher the operational risks.

A process often consists of more than one task and is often executed by more than one IW.
Often IWs pass on information between them and one IW’s output (within the same process)
serves as the input for another IW. When there are such intra-process linkages, we call these as
Information Dependencies (ID). It is intuitively clear that the complexity of coordination
increases in the number of IWs that work on the same process thereby resulting in greater
operational risk. In general, more agents involved in executing a process increase the complexity
of the coordination task and therefore the likelihood of operational errors. These observations
lead us to our next two hypotheses.

H3: Operational risk increases with the number of Information Dependencies (within a
process).

H3A: Operational risk increases with the number of IWs (per process cycle).

A final set of factors that we will investigate have to do with the profile of agents. There is a
body of extant research in the field of labor economics that points to the fact that training given
to IWs improves the quality of their work as well as the fact that more experienced IWs make
fewer errors. This leads us to final set of hypotheses:
H4: The extent of operational risk decreases with higher training imparted to IWs.

12
 H4A: Greater the experience of the IW the lower the extent of operational risk.

5.0 Model And Analysis Of Results:

The above research hypotheses provide clear clues into the nature of the econometric model that
we will employ.

4.1 The Econometric Model: Operational Risk (R) is modeled as a linear combination of the
factors discussed above: Codifiability (C), Number of Agents per Process (A), Number of
Process Dependencies(PD), Objectivity Quotient(OQ), Number of Measures of Quality(Q),
Agent Training (T) and Agent Experience (EX). We write the econometric model as follows9:
Rit = β1 + β 2Cit − β3 Ait − β 4 PDit + β5Qit + β 6OQit + β 7Tit + β8 EX it + ε i

4.2 Data Profile: We collected data from several firms in several countries starting from
December 2004 until current date. The providers were principally drawn from including
Singapore, India, Mauritius, Thailand and the buyers were drawn from India and UK. We used
the data from five firms and 33 processes for this project. For each process we took two
observations 6 months apart – of all the variables (dependent and independent) resulting in 66
observations in all. Variables were operationalized as shown below 1:
Table 4: Operationalization of Variables:

Variable Operationalization
Likert Scale 1 to 7 – Collected from Process
Owners (manager in charge of process
Codifiability (C) production).
Number of IWs that work per process cycle
Number of Agents Per Process (A) – computed from billing records.
Number of Process Dependencies
(PD) From the process flow specified in the SLA.
Number of Measures of Quality (Q) Captured from the SLA.
Ratio computed by dividing provider’s
number by the number captured from the
Objectivity Quotient (OQ) SLA.
Agent Training (T) Number of weeks of training (average)

9
Where the subscripts, i and t stand for the i th process at the t th instant.

13

Agent_Experience (EX)
received by agents working on a process -
computed by the provider from work log
records..
Number of months of experience (average)
of agents working on a process - computed
by the provider from personnel data.

4.3 Analyses of Results: Our analysis shows that in general there is robust empirical support for
our principal hypotheses. We find that Codifiability and Objectivity Quotient indeed are the
major drivers of operational risk associated with process quality.
Table 2 below shows the results of the regression analysis.

Table 5: Model of Operational Risk: Regression Analyses

Huber-
Pooled 1st 2nd White
Variable GLS
OLS Period Period Robust
OLS OLS Error
-0.109*** -0.110*** -0.110*** -0.109*** -0.110***
Codifiability (C) (0.002) (0.002) (0.002) (0.001) (0.000)
Number of
Agents Per 0.015*** 0.014** 0.015** 0.015*** 0.010***
Process (A) (0.003) (0.005) (0.005) (0.003) (0.001)
Number of
Process
Dependencies 0.008** 0.009 0.008 0.008* 0.015**
(PD) (0.003) (0.006) (0.006) (0.004) (0.001)
Number of
Measures of -0.014*** -0.015*** -0.015*** -0.014*** -0.016***
Quality (Q) (0.002) (0.002) (0.002) (0.002) (0.000)
*** *** ***
Objectivity -0.259 -0.260 -0.261 -0.259*** -0.264***
Quotient (OQ) (0.01) (0.01) (0.01) (0.008) (0.002)
*** *** ***
Agent Training -0.008 -0.009 -0.009 -0.008*** -0.010***
(T) (0.001) (0.002) (0.002) (0.001) (0.000)
*** *** ***
Agent_Experience -0.003 -0.004 -0.003 -0.003*** -0.003***
(EX) (0.000) (0.001) (0.001) (0.000) (0.000)
*** *** ***
0.985 0.991 0.994 0.985*** 0.999***
Intercept (0.021) (0.015) (0.017) (0.013) (0.003)
N 66 33 33 66 66
804.13 2332.56 2304.03 4437.33
F (Prob>F) p<0.0001 p<0.0001 p<0.0001 p<0.0001
296643.8
Wald (Prob> χ 2 ) p<0.0001
R2 98.9% 98.9% 99% 98.9%

14
 Standard error in parenthesis; *** -p<.001, ** - p<.01, * - p<.05

We find that it is clear that greater Codifiability is strongly correlated with lower operational
risk. A unit increase in Codifiability, results in a decrease of 10.9% in the operational error
associated with the process. Similarly, we find that convergence in process quality- metrics -
i.e., OQ - has a marginal impact of a decrease of 25.9% in the operational error rate. It is clear
that there is considerable value to creating an exhaustive set of rules to describe the nature of
work and to investing in creating better shared definitions of process quality between provider
and seller. The impact of complexity of coordination on the extent of process risk was also
significant though of considerably lower magnitude. It can be seen from Table 2, as the number
of agents per process increases, the rate of errors in process output increases. Each additional
agent per process cycle causes a 1.5% increase in process quality.
The number of process dependencies did increase the extent of operational risk but to a less
significant extent. We were surprised to note that Process Dependencies did not have a strong
impact on the extent of operational error. We will discuss these in the next section. Finally, we
found that while greater training and experience (of IWs) did decrease the extent of operational
risk neither had a strong impact and of the two, training had the stronger impact on operational
risk. We furnish the results of the regression analysis in the table below. Note that the pooled
OLS regression below produces the same outcomes as the Huber-White Robust Error procedure.
The results of the regression are also consistent across cross sections of time periods. We can see
the regression co-efficients have more or less the same values across time periods. Finally, the
GLS regression with the forced zero intercept constraint produces results very similar to the OLS
and the H-W procedure. The convergence of regression tests assure us that our results are robust
and without significant operationalization bias.

6.0 Managerial Implications

There are a number of interesting managerial implications of the insights uncovered by this
research. We discuss the principal implications for managers and policy makers below.

15
5.1 Process Specification and Codification: It is clear from the analysis above that one of the
principal drivers of operational risk is the extent to which a process and the work that goes into
executing the process can be codified and explained analytically to the agents of the provider.
Table 3 below shows how operational risk increases as processes become less and less
codifiable. Note too that for a given level of codification operational risk increases as the
objectivity quotient declines10.

Table: 6 Codifiability And Risk

Objectivity
Codifiability Quotient Operational Risk
7 1.00 0.009
7 0.75 0.046
7 0.67 0.042
7 0.50 0.097
6 1.00 0.075
6 0.75 0.116
6 0.67 0.168
6 0.50 0.148
5 1.00 0.163
5 0.67 0.180
4 1.00 0.230
3 1.00 0.346
3 0.50 0.448
2 1.00 0.433

The value of codification becomes even greater in the case of off-shore outsourcing where the
employees of the provider (IWs) and the buyer are often located in different countries. These
(IWs) are unaware of the context of the work although they may have a high degree of domain
skill (such as in financial analysis, molecular biology or accounting and actuarial services). Thus
investments made in transferring process knowledge pay back considerable dividends in terms of
lower operational risk (and therefore, higher process quality). Indeed, our survey found that firms
(both buyers and suppliers) that invested most in process specification and knowledge transfer
were the ones that reaped the benefits of consistently high quality of process productions. Firms

10
Refer to table 4 for a similar comparison.

16
such as Wipro and HCL in India and Beredium International in Mauritius are excellent examples
of firms that invest in fine grained process specification (codification).
5.2 Convergence in Process Metrics: A second insight from this stream of research is the
importance of buyer and provider having as accurate an understanding of the parameters process
quality as possible. If the provider does not fully understand the nature of the one or more
parameters of process quality he will fail to monitor his employees sufficiently to ensure that the
parameter of quality is met. This is more so in the case for processes which call for a high degree
of expert judgment. Table 4 below shows the operational risk increases with decline in
Objectivity Quotient.

Table: 7 Process Metrics Convergence (Objectivity Quotient) And Risk

Objectivity Operational
Quotient Codifiability Risk
1.00 7.00 0.01
1.00 6.00 0.08
1.00 5.00 0.16
1.00 4.00 0.23
1.00 3.00 0.35
1.00 2.00 0.43
0.75 7.00 0.05
0.75 6.00 0.12
0.67 7.00 0.04
0.67 6.00 0.17
0.67 5.00 0.18
0.50 7.00 0.10
0.50 6.00 0.15
0.50 3.00 0.45

Firms such as OfficeTiger Inc. and HCL Ltd. in India and IT-One Ltd. in Thailand have
explicitly recognized this factor and have set up procedures to make the measures of quality as
transparent as possible. OfficeTiger has established a mechanism called the ‘Program Office’
where managers of the buyer and the supplier work together to jointly define the parameters of
process quality and make sure that there is complete convergence of understanding between the
client and OfficeTiger in establishing process quality measures.

17
 Finally, we found it somewhat surprising that Information Dependencies had only a weak
impact on the magnitude of operational risk. One of the explanations that we have for this
phenomenon – is that Information Dependencies is a weak proxy for the complexity of
coordination and a stronger proxy for this phenomenon is the number of IWs per process.
Indeed, it is clear that this factor has a stronger impact on the extent of operational risk than the
factor of Information Dependency. This would strongly point towards automation as the means
of ensuring process quality. Clearly, operational risk falls with lowering the number of IWs that
work on a process. This indicates that when firms off-shore processes, they should also re-design
them and introduce higher automation where possible to lower the complexity of coordination
between agents. We find that firms such as Allsectech Ltd. and I-OneSource have been able to
do this to a significant extent in process that span such diverse functions as financial services and
supply chain coordination. Some processes can be automated over time reducing the number of
agents needed to execute the process, while other processes resist automation as the nature of
work involves a high degree of human judgment and interpretation (what Levy and Murnane
refer to as ‘pattern recognition’). This raises the question of what else could firms do in order to
lower the operational risk associated with off-shore outsourcing? This brings us to the question
of what economists call as the ‘governance form’ or the nature of the contract between the buyer
and seller of services. When a buyer of services can be reasonably confident that inspecting the
finished output of the provider is effective – i.e. the cost of inspection is low and the accuracy of
inspection is high – it can indulge in what economists often refer to as arm’s length outsourcing.
However, when inspection is costly (or is not an accurate measure of process quality) the buyer
would want to combine the control that in-house production11 of processes offers with the
efficiencies of an offshore outsourcer. This observation leads us to our analysis of an emerging
governance structure that combines the benefits of an organization with the market.

7.0 The Extended Organizational Form

The advent of the Internet and the relatively cheap availability of bandwidth have enabled
firms in the US and Europe to link themselves reliably to firms in countries such as China, India,

11
The two governance forms are referred to as ‘Hierarchies’ and ‘Markets’ in the extant research in ‘Theory of The
Firm’.

18
Mauritius, the Philippines and Singapore. Advances made in software platforms and connectivity
have also made it possible for firms to monitor projects, people and the execution of processes
across the globe in real-time and in fine-grained detail. An example of deep linkages between
firms can be found in the case of AllSec Tech Ltd., a Chennai-based firm that has placed its
process execution specialists inside the Ford Trusted Zone, across the city on it client’s premises.
Allsec Tech’s agents resolve supply chain coordination problems by tracking invoice clearance,
payment and accounts receivables and payables (by querying data repositories that are located in
Detroit and Chennai), and provide expert intervention where it is called for. The agents of the
provider work under the direct supervision of the provider’s mangers and virtual supervision of
the buyer’s (client’s) managers. It is important to note that this arrangement is offered for such
of those tasks where cost of inspecting the provider’s (AllsecTech Ltd.) quality of output is
expensive. For several routine processes where the quality of output is easy to inspect this form
of governance is not featured in the outsourcing contract.
Such arrangements are not uncommon in the financial services industry either. Lehman
Brothers has set up such arrangements with its service providers in India, where agents of the
provider work closely with the managers of the buyer under joint monitoring and supervision for
such of those tasks where inspecting the quality of the provider’s output is costly. Two large
British banks have set up similar arrangements with their off-shore service providers in India for
execution of (only) such of those processes where the provider’s output quality is not
transparent. OfficeTiger’s (OT) operations in India provider further evidence of the phenomenon
that we investigate. The firm is in the business of providing expert judgment and analysis to its
clients. OT has established a mechanism - called ‘The Program Office’ – consisting of managers
of both the client and OT’s managers. Senior managers of the client and those of OT jointly
review and manage the strategic, long term goals as well as day-to-day operational details.
Further, OfficeTiger has developed real-time performance tracking and quality control systems
which allows its clients to track the productivity and quality levels of teams of agents and where
required, even the output of individual agents (employees of OT). It is possible for OT’s clients -
some of the leading Investment Banks in the US and UK - to use theses systems to monitor their
projects in fine grained detail and ask for modifications to operational procedure, agent
assignment, QC mechanisms and project prioritization. About 40% of the firm’s deadline are
under an hour long and often include work that involving research support, real-time scenario

19
analysis or model building with very little margin for error or time to correct errors post
execution. The firm and its clients work off the same files, spreadsheets and data feeds and
where necessary they work iteratively. Again our survey of OT showed that only for such of
those processes and tasks where the provider’s quality of output is not transparent or where
inspection is costly (involves costly delay in the delivery of service to the client’s customers), are
such fine-grained joint monitoring and control mechanisms created. For more routine tasks
where quality of output is transparent or where inspection is not costly, the governance of the
contract resembles the traditional outsourcing contract with pre-specified price and post-
inspection penalties [Wharton 2004].
While OT was perhaps one of the earliest and most successful proponents of this hybrid
governance structure (EOF), it is not the only one now practicing this form of governance.
GECIS in India too has evolved its own flavor of the EOF (quite similar to OfficeTiger in many
ways). When GECIS’s employees are working a client’s processes – such as tasks surrounding
Commercial Real Estate Finance – the two teams, the client’s managers and GECIS’s agents
work as though they are a part of the same team. GECIS has configured the project teams so that
the off-shore employees are monitored and controlled through fine grained performance
tracking systems in real-time. The process owners (buyer’s managers) set task priorities, track
progress, help define quality standards and operational measures to ensure adequate output
quality. Other large offshore service providers too are beginning to deploy this mechanism.
Wipro Technologies, a large Indian offshore provider with office in India and China, too has
evolved its own version of the EOF. For companies such as Wipro and HCL their IT service
delivery capacity allows them to set up sophisticated performance tracking and process
monitoring systems. Because of the rich and deep linkages between the client and Wipro the IT
major has found ways of linking its managerial structures seamlessly with its clients. Wipro has
developed an in-house system called Veloci-Q to track the key success parameters of each team
(cost, quality, productivity), down to each employee. Wipro’s clients are given access to this
tracking system via extranets which allow them drill deep into Wipro and monitor the progress
of their projects.
Other firms such as HCL Ltd. (based in India) permitted their buyers to use real-time
monitoring mechanisms to track how specific functions were being executed. I-OneSource a
BPO service provider firm based in India, is deploying similar mechanisms to track the progress

20
of work that it does for offshore clients. Two Asian firms, Beredium International, based out of
Mauritius that executes outsourced processes for European firms as well as ITOne a firm based
in Bangkok, Thailand, that executes several outsourced services for its Thai clients have both
deployed mechanisms that allow them to track the key performance indicators in fine-grained
detail and jointly monitor these with their clients. A clear factor that emerges from all of the
above examples – where the nature of the service (a set of processes) executed by the provider is
such that inspecting the quality of output is expensive or where the quality of output is not
transparent, buyers have resorted to setting up real-time monitoring and managerial controls. For
more routine tasks or where the cost of inspection is minimal, we find that more conventional
contracts with post-inspection penalties are the case.
The study of hybrid mechanisms is particularly interesting in the case of services. Unlike in
the case of manufacturing where raw material and physical products change form, in the case of
information work it is possible to redo a task or start a process again ab inito without incurring
any costs other than labor related. This in turn allows buyers to graft a layer of managerial
control via inter-organizational information systems and exert control across the boundaries of
the firm without waiting for a process cycle to be completed. These controls have created a form
of governance that we call the Extended Organizational Form (EOF). This hybrid organizational
form – EOF - has the following features:
ƒ The buyer contracts the production of process to the provider,
ƒ The buyer can inspect the provider’s output quality after production and
ƒ The buyer’s managers can also exercise partial managerial control over the provider’s
agents by monitoring the quality of process execution during the production.
The objective of managerial control is to ensure that the operational risk in the production of
services by an offshore provider is diminished. The buyer’s managers exert an additional layer
of control which amplifies the returns to the provider’s effort. The natural question here is if the
EOF is an efficient governance structure? Does it improve the overall efficiency and therefore,
lead to welfare gains?
We compared the efficiency of the three principal modes of governance in the production of
financial services off-shore (i) in-house production of services off-shore also called a Captive
Center (ii) off-shore outsourcing of services to a BPO firm and (iii) The EOF in which an off-
shore provider is monitored and managed by the buyer’s managers. We selected two kinds of

21
services those that are highly codifiable and those where the Codifiability score was between 6.0
and 7.0 and processes where the work was characterized by low levels of Codifiability where
Codifiability score was between 3.0 and 4.0 on a scale of 1 to 7. For each of the two process
types we selected firms12 that were executing near identical processes in that category and
collected panel data of production costs and production quality data and compiled their total cost
of process production and quality of output over a period of time. Figures 2 & 3 and 4 &
5below provide trends.
[INSERT FIGURES 2 & 3 ABOUT HERE]

6.1 Highly Codifiable Processes

Figure 2 provides a comparison of the efficiency of the three forms of governance. It is clear that
the Captive Center produces the highest quality of output. If we ignore the total costs of
production, it is clear that the captive center is the best option. However, over a period of time
the quality of process output of the EOF nearly equals that of Captive Center. The BPO provides
just as much as quality as specified in the contract (or slightly greater than the contract-specified
level). Providing higher levels of quality is costly and would come from the BPO’s profits. The
situation changes in Figure 5, when we consider the total costs of production13 – i.e. the welfare
levels of the three forms of governance. While the captive center starts out being the most
effective form of governance, the EOF over a period of time turns out to be the most efficient
governance structure and the captive center the least efficient. The EOF is able to combine the
strengths of the BPO - cost efficiency (due to its profit focus) - and the captive center –
managerial control and focus on quality of production. This results in the EOF producing the
highest levels of welfare.
[INSERT FIGURES 4 & 5 ABOUT HERE]

12
As a precondition to receiving the data we are not allowed to furnish any details of the firm that may lead to the
identification of the firm or any of its clients.
13
Total costs of production = cost of production + managerial oversight + errors detection and correction + costs of
errors that go undetected.

22
6.2 Low Codifiability Process: For these processes, the work done by agents is not easily
Codifiable and call for judgment, interpretation and expertise based on a formal body of
knowledge (such as seen in financial analysts, tax accountants etc.). Again it is clear from
Figures 4 and 5 that the quality of output of the captive center exceeds those of the BPO and the
EOF. Over a period of time the gap diminishes and as before the EOF’s quality of output
improves while the BPO’s output quality flattens out once it reaches the contract-specified level.
When efficiency levels are compared – an interesting picture emerges: The Captive Center starts
out being the most efficient structure while the EOF displays significant variations. There is a
period during which the EOF produces gross inefficiencies. This is the period when the agents of
the provider are adjusting their working style to match the expectations of the managers of the
buyer. Since the work is not easily Codifiable, managers of the buyers are involved in more
hands-on management of the provider’s teams. As a result the buyer’s agents under perform –
they have to meet the expectations of their own managers (employed by the BPO) and those of
the client’s. The client’s managers too learn to calibrate their expectations better over time – they
begin by expecting the same level of quality as provided by their employees and then realize that
this will take time. In the interim as the two sides perfect their terms of engagement through a
process of trial, error and resetting of expectations, the costs increase producing low levels of
efficiency. Over a period of time however, the two sides reach a steady state of performance and
the EOF produces sharp gains in welfare.
6.3 Complexity Arbitrage and The Offshore Outsourcing Of Services: While divergence in
perceptions of complexity offers buyers and sellers the opportunity to maximize their relative
comparative advantage, what really determines the extent of gains from offshoring is the ability
to measure, manage and control operational risk associated with offshore outsourcing. The
results of our analysis show that American and European firms will try to benefit from
complexity arbitrage – where it is possible to codify the work that goes into executing processes
– to third party firms in countries such as China, India, the Philippines, Singapore and Mauritius.
For such processes, the optimal governance structure is an EOF with stable monitoring systems
built into the contract. Where establishing EOFs proves to be expensive, the buyer should look to
third-party provider of services off-shore rather than set up captive centers. Managers of the
buyer’s firm should invest in technology-enabled mechanisms that help them inspect the quality
of process production and enforce contracts more effectively.

23
 For processes that are not highly Codifiable – such as report generation in equity research
and fixed income asset research, corporate finance, contract research support for investment
banks and risk analytics in insurance - firms should either set-up captive centers or transition
their BPO contracts to EOFs. Ideally, firms should establish contractual mechanisms that allow
the buyer’s managers to monitor and manage the provider’s agents. Over a period of time these
structures yield the best results. Managers of these firms should invest in technology-based
monitoring mechanisms and establish control structures that allow them to intervene in real-time
and correct processes that are being executed at less than optimal quality. Systems established by
firms like OT and Wipro to enable fine-grained monitoring of agents represent the kind of
mechanisms that are likely to be very effective in global sourcing of services.
8.0 Conclusion
We investigated the drivers of operational risk in the off-shore execution of business
processes and disaggregated the drivers of risk. Our survey spanned several countries over
several years and we drew upon data from a diverse array of industries and functions. We
formulate the concept of the Knowledge Continuum and show how the two principal drivers of
risk – process Codifiability and Process Quality Metrics – originate in the nature of work along
the Knowledge Continuum. Further, we formulate and econometric model of operational risk
and provide robust evidence in support of out model. We also surveyed the functioning of
different forms of governance and found that a hybrid form of governance that combined the
market and hierarchy – which we term the Extend Organizational Form - produced the best
results.

24
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 Appendix of Figures and Charts

Figure 1: The Knowledge Continuum

Figure 2: Comparison of Quality of Process Output: Three Forms of Governance: Highly

Codifiable Work

27
Figure 3: Comparison of Efficiency: Three Forms of Governance: Highly Codifiable Work

28
Figure 4: Comparison of Quality of Process Output: Three Forms of Governance: Low
Codifiability Work

Figure 5: Comparison of Efficiency: Three Forms of Governance: Low Codifiability Work

29