The limits of efficiency maximisation through outsourcing

I have blogged on several occasions about the problems with excessive pursuit of efficiency maximisation. This post will draw attention to the perils of outsourcing in military, banking, and automobile industry. 

Matt Stoller (HT: Ananth) points to the role of management concepts and services contracting in the failure of the US strategy in Afghanistan. This from an Afghan General, 

Contractors maintained our bombers and our attack and transport aircraft throughout the war. By July, most of the 17,000 support contractors had left. A technical issue now meant that aircraft — a Black Hawk helicopter, a C-130 transport, a surveillance drone — would be grounded. The contractors also took proprietary software and weapons systems with them. They physically removed our helicopter missile-defense system. Access to the software that we relied on to track our vehicles, weapons and personnel also disappeared. Real-time intelligence on targets went out the window, too.

The US military like the corporate world appears to be another example of the pursuit of efficiency taken to its extremes - management consultants and their ideas being applied indiscriminately and outsourcing to keep costs down and harvest efficiency gains.

Another area where outsourcing poses great risks is in banking. 

Thanks to the success of fintech startups with customer acquisition and explosive growth in transaction volumes on the payments side, another area where outsourcing is gaining currency is loans origination of banks. The digital trails generated by their current activities and the inherent nature of digital platforms makes these fintechs very attractive intermediaries that banks can rely on to originate loans. Aadhaar completes the list of digital workflow requirements. These intermediaries can significantly lower two major costs faced by banks - customer acquisition and credit-worthiness assessment - and thereby expand the banking market itself. 

This creates a problem. If the banks end up outsourcing their credit origination process, they are left with only the bulk money management activity - raise capital and manage investments. Bankers lose the important personal touch with their borrower clients. An industry which historically was thought to survive on the nature of personal relationships would have become completely impersonal. The perverse incentives are easy to see - the fintech which originates the loan is incentivised to maximise volumes (both numbers of borrowers and the amount they borrow) with little to answer for when the loan runs into trouble, and the banker is incentivised to focus only on money management and gloss over the small details of credit worthiness assessment and client relationships. The result, as with the sub-prime mortgage crisis and all financial engineering which disperses ownership far and wide, is all too obvious. 

In this context, Andy Mukherjee had an oped looking into the future of Indian banking,

Google Pay wants to push time-deposit products of small Indian banks that don’t have much of a retail liability franchise of their own. According to a press release, Equitas Small Finance Bank will offer Google Pay customers up to 6.85% interest on one-year funds as part of a “branded commercial experience” on the platform... The move has global significance. It shows the tenuous nature of the hold financial institutions have on a core operation like deposit-taking, and their vulnerability to an assault from online search, social media and e-commerce behemoths. Alphabet, Facebook Inc. and Amazon.com Inc. may pose a far bigger challenge to brick-and-mortar lenders than fintech startups that don’t have the scale of platform businesses. Just like in India, deposit-strapped challenger banks might throw the keys to tech intermediaries with hundreds of millions of active users. When the giants storm the fortress, even larger banks will lose control of banking..

China’s homegrown tech titans have already shown how easy it is to dislodge traditional lenders from lending... India’s deposit-taking institutions don't have any special advantage left in moving retail money. Yes, they still hold the accounts for sending or receiving funds. But rather than transacting on their bank apps or cards, customers prefer to use Google Pay or Walmart Inc.’s PhonePe to pay one another and merchants... Since it won’t even take two minutes for a platform to book deposits from scratch, if another lender offers a better deal, idle funds might go there next. Customer loyalty, which is often just plain inertia, will no longer ensure stickiness... For a fee, platforms can easily extend their insights into consumer behavior and payment flows to influence deposit mobilization. The higher the commission, the lower the banks’ profit... Regulated institutions may be left holding a license to take deposits--and a thick rule book accompanying that privilege--but platforms will decide if a bank’s promotional offer is to be displayed prominently or buried in an obscure corner. The same slow, painful decline that gutted the print media after readers and advertisers moved online and publishers lost their sway over them may be waiting in the wings for banking, too.

A third example that illustrated the limits of outsourcing is the automobile industry during the ongoing supply chain disruption. One auto manufacturer which managed to escape the problem and keep its production lines running and meet its annual target has been Tesla. A Times article writes, 

When Tesla couldn’t get the chips it had counted on, it took the ones that were available and rewrote the software that operated them to suit its needs. Larger auto companies couldn’t do that because they relied on outside suppliers for much of their software and computing expertise. In many cases, automakers also relied on these suppliers to deal with chip manufacturers. When the crisis hit, the automakers lacked bargaining clout. Just a few years ago, analysts saw Mr. Musk’s insistence on having Tesla do more things on its own as one of the main reasons the company was struggling to increase production. Now, his strategy appears to have been vindicated... “Tesla, born in Silicon Valley, never outsourced their software — they write their own code,” said Morris Cohen, a professor emeritus at the Wharton School of the University of Pennsylvania who specializes in manufacturing and logistics. “They rewrote the software so they could replace chips in short supply with chips not in short supply. The other carmakers were not able to do that.” “Tesla controlled its destiny,” Professor Cohen added... 

Doing more on its own also helps explain why Tesla avoided shortages of batteries, which have limited companies like Ford and G.M. from selling lots of electric cars. In 2014, when most carmakers were still debating whether electric vehicles would ever amount to anything, Tesla broke ground on what it called a gigafactory outside Reno, Nev., to produce batteries with its partner, Panasonic. Now, that factory helps ensure a reliable supply. “It was a big risk,” said Ryan Melsert, a former Tesla executive who was involved in construction of the Nevada plant. “But because they have made decisions early on to bring things in house, they have much more control over their own fate.”... Tesla’s approach is in many ways a throwback to the early days of the automobile, when Ford owned its own steel plants and rubber plantations. In recent decades, the conventional auto wisdom had it that manufacturers should concentrate on design and final assembly and farm out the rest to suppliers. That strategy helped reduce how much money big players tied up in factories, but left them vulnerable to supply chain turmoil.

Tesla's foresight points to the importance of striking a balance in the unconstrained pursuit of efficiency and profits at the cost of all else in any industry.