654m. Unleashing the benefits of microfinance. Temenos White Paper

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1 Unleashing the benefits of microfinance Estimated microfinance cooperative and other non bank institution (MFIs) accounts that serve this market 654m Core banking in the cloud has the capacity to completely change the financial services landscape. We stand at the door of a world changing opportunity for the 3 billion underbanked. Temenos White Paper

2 2 Contents 03 Executive summary 03 Background 04 The unmet demand for microfinance where s the challenge? 04 The technology conundrum 05 How can it work for microfinance? 06 Strengthening the frameworks technology and compliance 06 Can cloud banking usher in a new era? 07 The partner role 07 In conclusion

3 3 Executive summary Background This paper is written for the management and investors of and in microfinance institutions; niche banks; non-profits; financial cooperatives; community banks; and various non-bank financial institutions concerned with banking the poor as well as the broader community of stakeholders in the discussion of financial inclusion. This paper makes the case for cloud computing in the microfinance sector as an imperative driven by cost and efficient resource utilization. In less concentrated markets where there are many small financial institutions serving local communities, on-premise software in local data centres imply a build in overhead and require hard to find people resources to be tied to the business of managing information systems. Tending of transactional information systems is a mundane duty and not a high value use of information technology (IT) talent. Cloud computing has evolved from the older application service provider (ASP) business model. Cloud computing makes vastly more efficient use of resources and represents the industrialization of the value chain in banking through specialization. Microfinance institutions have an opportunity to be early adopters of this new wave of technology and not only gain a competitive advantage by containing costs but they can dramatically increase choice and quality of their services. This also removes the burden of the extraordinary capital costs and demands of managing on-premise enterprise technology. While progress has been made toward the goals of financial inclusion in many countries, meaningful scale has not yet been achieved. As financial services providers look toward providing and financing innovative products and services that help curb the growth of burgeoning poverty, microfinance can offer some hope but only if providers understand the services that the under-banked demand and if they can learn from the positive experiences that have allowed the particular finance needs of the poor to take centre stage. An estimated 2.5 billion working-age adults globally have no access to the types of formal financial services delivered by regulated financial institutions. 1 Now, there s an opportunity to expand financial inclusion by combining the use of current financial technologies with better and secure infrastructures, particularly through two defining areas mobile technology and core banking in the cloud. With over 215 microfinance customers across 36 countries, Temenos has been able to build a practice in microfinance with industry knowledge and a commitment to the broad objectives of financial markets, deepening and improving access to finance for the poor. Working with microfinance network partners such as Opportunity International, Vision Fund, ACCION, as well as numerous individual microfinance banks, NGOs, cooperatives and other non-bank financial institutions, Temenos was able to build out a T24 core banking model bank configuration to meet the general requirements of microfinance across multiple jurisdictions and business contexts. Temenos plays an important role in the provision of technology to address the challenges of financial inclusion and the economic empowerment of the 3 billion people living in poverty. The Microcredit Summit Campaign applauds the innovative steps Temenos are taking in moving this important initiative forward. Larry Reed, Director of the Microcredit Summit Campaign Reference 1 Wikipedia

4 4 The unmet demand for microfinance where s the challenge? Community banks, microfinance institutions (MFIs) or large commercial banks that create businesses targeting microfinance aim to serve a market typified by a high volume of relatively low value accounts. All have unique challenges with regard to technology and there is a catch-22 problem associated with technology in this environment. Small financial institutions need sophisticated enterprise level banking technology in order to cater for the ever-changing requirements of the retail client and to provide the transparency required by regulators. This enterprise level technology is needed to better understand profitability and financial risk through the provision of timely data and management information. Here s the catch: small financial institutions have difficulty funding and managing large bank technology environments on a small bank asset base. Enterprise level core banking needs to be managed in a highly disciplined environment; a pre-requisite to enter the payments business and to be able to achieve scale. This is hard to achieve on a small bank budget. Niche payments players such as mobile operators are competing for the payments business of the microfinance client and are now expanding their footprint by introducing loan products to compete with the core business of banking. Typically small financial institutions will only afford less robust technology solutions which are available from small regional companies that cater for very localised requirements. With local or regional technology providers, capacity problems are endemic, leading to delays in time-to-market for new product delivery and chronic problems associated with security and interoperability with other financial systems and payments networks. The challenge: how does a small niche player in the microfinance sector afford and manage the kind of technology that it needs to be able to achieve scale while also taking advantage of the intimate relations they typically enjoy with their customer and their community? According to Gartner, the SaaS market is expected to grow 22.2% in 2013 to $19.8 billion. The emerging Asia Pacific and Greater China regions are the fastestgrowing regions with five year CAGRs of 32.1% and 30.0%, respectively. Gartner Forecast Overview Public Cloud Services, Worldwide, , 4Q12 Update February 2013 The technology conundrum There is nothing particularly valuable and nothing particularly important about a bank managing its own core banking information system. This is all cost and overhead. Small financial institutions need to be light on their feet and be able to adapt to changing market conditions and customer expectations. Their strategic advantage is their client member relationship. Information technology staff, in particular need to be employed in a high-value information technology role, supporting management decision-making and customer service. Not just running a core-banking back office. Why run a generator in the basement if you have a reliable electricity grid? Running a data centre and core banking application management may seem like alchemy to a non-technical manager but the 24/7 tending of transactional information systems is a mundane duty and not a high value use of IT talent. Community banks and MFIs are beginning to see that this IT talent would be better invested in exploiting the capabilities of the core banking software, pushing its limits, exploiting electronic delivery channels and remote devices. This is not only more interesting work for the IT staff; it is a far more important and forward thinking use of their time than just maintaining a transaction processing engine. IT should not be tied down to maintaining large onpremise enterprise level technology installations and data centres. In the quest for lower transaction costs, the catch-22 technology conundrum is realised. Total cost of ownership on on-premise software is high. Enterprise systems with the requirement for local data centres as well as on-going application management and maintenance all drive up costs. Cloud-based services can solve this problem for smaller financial institutions, and in particular for networks of small financial institutions such as with financial cooperatives. A shared services strategy allows even a very small intermediary to use enterprise software without owning the overhead and risk associated with large systems, and the MFI can focus all of its management s technical skills on the customer, leveraging the investments made by larger industry players. This strategy provides a pathway to achieve scale on a pay-per-use basis that the smaller institutions so keenly need. The business case for cloud is so compelling and the urgency so great that microfinance is leading the way through early adoption of outsourced core banking. With full understanding of the general direction that the industry is moving this strategy, Temenos is proving the viability of cloud-based core banking in the microfinance sector for the mainstream commercial banking market. In less concentrated markets competitive forces will convert the majority of the community banking sector to cloud-based Software-as-a-Service (SaaS) core banking, while large scale retail moves in the direction of Infrastructure-as-a-Service (IaaS). Cloud computing represents a fundamental technology shift and early adopters of this new wave will be the winners in the longer term.

5 5 How can it work for microfinance? Temenos has implemented microfinance core banking projects where MFIs can use the Temenos T24 Software-as-a-Service from Microsoft Azure data centres via the internet. The user does not have to manage an on-premise installation of the software. The bank subscribes to a service and uses the T24 core banking software on their local area network via the internet as if T24 were running on premise on a local server. The user knows no difference. It is simply available. But with cloud, at the end of the business day, the IT department goes home and overnight Temenos engineers take control of the application and execute end-of-day processes and maintain the application as may be required. In the morning, the customer comes back to work, turns on their PC, logs in and uses the system. Management reports are sitting in the printer queue ready to be printed. This simple concept allows any user anywhere the ability to use all or part of T24 as a service without having to own the hardware, physical environment, application software or database. Nor does the user have to have waste valuable skills in managing a large enterprise core banking installation. In the early days of computing Thomas Watson, Chairman of IBM, is often alleged to have said I think there is a world market for maybe five computers. The growth of mainframes and the subsequent explosive adoption of personal computers proved Watson wrong. We now have millions of enterprise data repositories and millions of copies of application software everywhere. The PC culture has created a perception that owning a computer, buying software and managing one s own data on site is normal and central to running a bank; it is not. This massive dispersion of computing capacity in an enterprise environment has empowered business and fuelled the information industry for decades. But this dispersed system of computing capacity and data storage has built in costs relative to their scale of operations associated with the requirement of maintaining independent physical and people infrastructure to manage all these independent systems. Every instance of software needs to be managed. Every instance of software needs to be kept up-to-date and upgraded. Each database has to be managed and its data interpreted. In order to have any kind of view of scale of operation, somehow this data has to be collected in a central repository and interpreted for use by networks of organisations. The costs associated with this are extraordinary when considered in aggregate. Maybe in the long run Thomas Watson will be proved right. The replication of effort associated with enterprise systems builds in overhead that contribute to higher transaction costs. This is nowhere more apparent than in microfinance where the cost per transaction is so critical. For large banks in mature financial markets with affluent consumers with average balances in the thousands of dollars, a one dollar debit fee is not a lot of money relative to the value of the account. If the account balance average is $100, one dollar is 1% of the value of the account. When a high value account customer withdraws on average $200 from an ATM, a one-dollar fee has become acceptable. When the customer withdraws $10, a one-dollar fee is 10% of the value of the transaction. Beating these costs will provide a compelling advantage to any financial institution that aims to serve large volumes of low value accounts.

6 6 Strengthening the frameworks technology and compliance In 2020, global financial services won t look like the western world s 20th century model. The number and variety of financial intermediaries will increase enormously as the cost of entry decreases due to cloud adoption. Any financial services business that wishes to offer any financial product will be able to purchase a service to provide and manage their product(s) and resell these in the market as part of their own services, without having to invest in owning the infrastructure and technology to manage those products. This is similar to financial institutions that purchase card services from third party card and pin suppliers. Shared services consumed in this way put the small financial services provider on the same technology level as the large banks, which hitherto were able to subordinate smaller providers because of the cost barrier to entry of large technology environments. Now small banks and MFIs can enjoy improved operating margins and compete with banks that own their own largescale IT infrastructure. This industrialization of the value chain through specialization will create a very competitive market for financial services, empowering the consumer through more competition and choice than is currently available. This should prove to be good news for early adopters and expose a survival risk to a late adopter. Additionally, legislators want to open markets to promote financial inclusion. In order for microfinance institutions to thrive, financial authorities must promote a policy and regulatory framework that makes serving the underbanked an attractive and sustainable business. Cloud computing offers legislators the chance to set the bar of disclosure higher for small services providers without threatening their viability or dampening down financial inclusion. There will be no reason to fear impeding small intermediaries by raising expectations for transparency if cloud computing holds promise for small MFIs to have access to the same business intelligence reporting systems as large financial institutions have. Recent changes in policy are already introducing non-traditional financial services providers, such as mobile operators, to traditional financial services markets. Competition from non-traditional players will increase as a result. These reforms ought to be seen as a positive effect and there is good reason to believe we will see increased competition for the business of the poor. But this regulatory reform will likely favour larger institutions that have the capital and infrastructure to support large payments systems and electronic delivery channels, leading to consolidation and greater concentration. That is unless small institutions take advantage of cloud computing to give them the means to compete. Cloud computing also has the potential to obviate the usual cost and risk of regulating a large number of small institutions for public sector regulators and selfregulating financial networks. Indeed, cloud services can have the effect of providing the best of both where networks of small locally relevant microfinance institutions can afford the efficiencies of scale and provide regulators comfort through greater transparency. Cloud computing providers offer a compelling solution but additionally these cloud services providers themselves must also be compliant with various multi-lateral and regional standards related to data handling and data security such as SSAE 16/ISAE 3402 Attestation and ISO/IEC 27001:2005 Audit and Certification. Vendors who have potential sight of data also have to comply with ISO standards and international audit compliance. Temenos internal procedures and data handling processes are ISO/IEC 27001:2005 audit and certification compliant. All processes are documented; employees are trained and aware of the procedures and these are audited by internal audit, monitored by a risk department and externally audited by independent risk auditors. Vendors must be able to report to risk managers that their systems and procedures comply with international standards in order to provide the confidence regulators will expect from systems and operations. The demands of standards and auditability will eventually drive smaller financial institutions towards large enterprise level cloud providers who are compliant with international standards and who can provide reporting and business intelligence tools to meet the dynamic risk and regulatory compliance and reporting requirements of a modern industry. Small virtual internet-based companies offering low cost cloud-based services cannot easily provide their clients with the compliance certifications that regulators will require of them as these institutions move towards a more regulated environment. Can cloud banking usher in a new era? Gross operating margins in microfinance are significantly wider because of cost to transaction value of the relatively high number of low value transactions. A significant proportion of the cost of operation is information technology systems. If the IT cost can be reduced, there is an opportunity for community banks and MFIs to either reduce costs to their customers, increase profit, or both. Presumably market forces will make these choices apparent. But opaque markets with poor consumer information and awareness can create an impression of seemingly unlimited effective demand for financial products, particularly loan products, amongst the poor. Community banks and microfinance institutions that aim to provide responsible credit and affordable savings instruments bear considerable cost. Technology can reduce these costs. MFIs must pass these costs on to the customer and this is expressed in APRs from 40% to 120% or (much) more depending on term and loan size. New entrants that are able use technology to reduce their transactions costs can either reduce the cost to the consumer to gain market share or increase the return to their shareholder so long as markets are sustaining these high rates. The more MFIs that are able to adopt mobile payments technology and business intelligence tools - available now through the cloud - the faster competitive forces will drive this benefit in the direction of the consumer. Through competition, greater pricing transparency, and a growing awareness amongst microfinance investors, legislators and consumers, we expect that pricing and profit fairness will become more of a discussion point in the microfinance community. Cloud technology can fast track this process by giving even small remote MFIs access to technology that can reduce their operating costs and provide consumers with more choice. A low cost cloud-based service for core banking and payments is made possible by Temenos delivering its T24 core banking product through SaaS. Temenos is enabling MFIs to mitigate the high costs associated with local data centres by moving these operations to a consumption-based pricing model. As a result, these MFIs can benefit from increased productivity, lower total cost of ownership and offer modern electronic payments without having to deal with the cost and complexity of managing such an environment.

7 7 The partner role Temenos has a strong partner ecosystem to enable the smooth running of its cloud-based solution. The partnership with Microsoft has enabled T24 core banking to run on the Microsoft Windows Azure platform and have this available over the internet in the cloud. Other deployment options are available. Temenos provides access to its T24 software and other associated software as a service via the internet while Microsoft provides Temenos the platform. The user accesses the software over the internet and the vendor manages everything to make sure the system is up and ready for the day s operations. No datacentre is needed nor is there need for a license commitment. The services are provided for a small fee per account per month. The user needs only an internet connection and user training. A single monthly fee is charged on an incremental monthly basis as a one rolled-up cost for all T24 and Microsoft software licenses and all maintenance, Temenos close-of-business operations, all application support services, on-going software management and upgrades, database management, interfaces, payments and the Microsoft hosted platform. The fee structure is built into the business model. The Temenos client pays one monthly fee based on a metric that is geared to the business and makes sense for the customer. This approach turns the business of managing core banking systems on its head. The PC culture has created a general belief that owning and managing software is necessary and a valuable use of resources. But this is a perception created out of necessity of the way enterprise systems required us to work. It is not necessarily the most efficient use of resources. With cloud computing the vendor takes responsibility for the management and quality of the software and owns any problems associated with it. A local business partner provides the services and post-live support. This powerful combination of remote and local can serve thousands of potential customers and millions of accounts and grow to provide many more people with the financial services they need. Our work in Africa is designed to help accelerate economic development by bringing technology solutions and world-class skills to Africans, in a way which can bring about social change and improve their lives. Meeting this challenge in an emerging market like Africa requires making financial services and other relevant services available, at an affordable price point, for those who need them. With the Windows Azure cloud infrastructure, Microsoft and Temenos are engaged in providing these services to microfinance institutions and, together, we are helping to lead the transformation of financial services for the underbanked. Fernando de Sousa, General Manager, Africa Initiatives at Microsoft Corp In conclusion Where this will lead we are not sure. But we do know that as financial institutions gain comfort with cloud-based services, Temenos will be there with a mature product offering, a trusted mobile payment platform and a track record of experience and innovation. Cloud computing has the capacity to completely transform the financial services landscape, particularly as this pertains to financial inclusion. By making enterprise-level banking systems and associated technologies available in the cloud on a pay-per use basis anyone, anywhere, can have access to modern core banking systems without the cost and other barriers usually associated with this technology. The small bank market has always been an incubator of innovation and once again leads us on a path of discovery to a new way of thinking core banking in the cloud. Author Murray Gardiner is Director of Microfinance and Community Banking at Temenos. He is based in Toronto and can be contacted at mgardiner@temenos.com For further information on Temenos and our work in the microfinance and cloud sector please visit temenos.com or marketing@ temenos.com

8 About Temenos Founded in 1993 and listed on the Swiss Stock Exchange (SIX: TEMN), Temenos Group AG is the market leading provider of mission-critical software systems to retail, corporate, universal, private, Islamic, microfinance and community banks, wealth managers, and other financial institutions. Headquartered in Geneva with 59 offices worldwide, Temenos software is proven in over 1,500 customer deployments in more than 140 countries across the world. Temenos products provide advanced technology and rich functionality, incorporating best practice processes that leverage Temenos expertise around the globe. Temenos customers are proven to be more profitable than their peers: in the period , Temenos customers enjoyed on average a 30% higher return on assets, a 46% higher return on capital and an 8.5 percentage point lower cost/income ratio than banks running legacy applications. The information contained on this report relates to Temenos information, products and services. It also includes information contributed by other parties. While all reasonable attempts have been made to ensure accuracy, currency and reliability of the content in this report, all information in this report is provided as is. There is no guarantee as to the completeness, accuracy, timeliness or the results obtained from the use of this information. No warranty of any kind is given, express or implied, including, but not limited to warranties of performance, merchantability and fitness for a particular purpose. In no event will Temenos be liable to you or anyone else for any decision made or action taken in reliance on the information in this report or for any consequential, special or similar damages, even if advised of the possibility of such damages. Temenos does not accept any responsibility for any errors or omissions, or for the results obtained from the use of information contained in this report. Information obtained from this report should not be used as a substitute for consultation with Temenos. TEMENOS, TEMENOS, TEMENOS T24 and are registered trademarks of Temenos Headquarters SA 2013 Temenos Headquarters SA - all rights reserved. Warning: This document is protected by copyright law and international treaties. Unauthorised reproduction of this document, or any portion of it, may result in severe and criminal penalties, and will be prosecuted to the maximum extent possible under law