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Service Level Agreements (SLAs)
Service level agreements are formal documents that outline the institution’s predetermined requirements for the service and establish incentives to meet, or penalties for failure to meet, the requirements. Financial institutions should link SLAs to provisions in the contract regarding incentives, penalties, and contract cancellation in order to protect themselves against service provider performance failures.
Management should develop SLAs by first identifying the significant elements of the service. The elements can be related to tasks (i.e., processing error rates, system up-time, etc.) or they can be organizational (i.e., employee turnover). Once it has identified the elements, management should devise ways to measure the performance of those elements objectively. Finally, institutions should determine the frequency of the measurements and an acceptable range of results to determine when a service provider violates the SLA benchmarks.
Although the specific performance standards may vary with the nature of the service delivered, management should consider SLAs to address the following issues:
■ Availability and timeliness of services;
■ Confidentiality and integrity of data;
■ Change control;
■ Security standards compliance, including vulnerability and penetration management;
■ Business continuity compliance; and
■ Help desk support.
SLAs addressing business continuity should measure the service provider’s or vendor’s contractual responsibility for backup, record retention, data protection, and the maintenance of disaster recovery and contingency plans. The SLAs can also test the contingency plan’s provisions for business recovery timeframes or conducting periodic tests of the plan. Neither contracts nor SLAs should contain any extraordinary provisions that would excuse the vendor or service provider from implementing its contingency plans (outsourcing contracts should include clauses that discuss unforeseen events for which the institution would not be able to adequately prepare).
Financial institutions should have several choices when it comes to pricing an outsourcing venture. Management should consider all available pricing options and choose the most appropriate for the specific contract. Examples of different pricing methods include:
■ Cost plus—The service provider receives payment for its actual costs, plus a predetermined profit margin or markup (usually percentage of actual costs).
For example, the service provider builds a website at a cost of $5,000 plus a 10% markup; the institution pays $5,500.
■ Fixed price—Tire service provider price is the same for each billing cycle for the entire contract period. Hie advantage of this approach is that institutions know exactly what the provider will bill each month. Problems may arise if the institution does not adequately define the scope or the process. Often, with the fixed price method, the service provider labels services beyond the defined scope as additional or premium services. For example, if a service provider bills an institution $500 per month for maintaining a website, and the institution decides it wants to add another link, the service provider may charge more for that service if it is not clearly defined in the original contract.
■ Unit pricing—The service provider sets a rate for a particular level of service, and the institution pays based on usage. For example, if an institution pays $.10 per hit on a website, and the site has 5,000 hits for the month, the institution pays $500 for the month.
■ Variable pricing—The service provider establishes the price of the service based on a variable such as system availability. For example, the provider bills the institution $500, $600, or $800 per month for service levels of 99-00, 99-50, or 99-75 percent system availability, respectively. If a website was available 99-80 percent of the time in a billing period, the institution would pay $800.
■ Incentive-based pricing—Incentives encourage the service provider to perform at peak level by offering a bonus if the provider performs well. This plan can also require the provider to pay a penalty for not performing at an acceptable level. For example, the institution wants a service provider to build a website. Tire service provider agrees to do so within 90 days for $5,000. Hie institution offers the provider $6,500 if the website is ready within 45 days, but states that it will only pay $3,500 if the provider fails to meet its 90 day deadline.
■ Future price changes—Service providers typically include a provision that will increase costs in the future either by a specified percentage or per unit. Some institutions may also identify circumstances under which price reductions might be warranted (i.e., reduction in equipment costs).
Hie provider may entice the institution to purchase more than one system, process, or service for a single price - referred to as “bundling.” This practice may result in the institution getting a single consolidated bill that may not provide information relating to pricing for each specific system, process, or service. Although the bundled services may appear to be cheaper, the institution cannot analyze the costs of the individual services. Bundles may include processes and services that the institution does not want or need. It also may not allow the institution to discontinue a specific system, process, or service without having to renegotiate the contract for all remaining services.
Contract Inducement Concerns
Financial institutions should not sign servicing contracts that contain provisions or inducements that may adversely affect the institution. Such contract provisions may include extended terms (up to 10 years), significant increases in costs after the first few years, and/or substantial cancellation penalties. In addition, some service contracts improperly offer inducements that allow an institution to retain or increase capital by deferring losses on the disposition of assets or avoiding expense recognition. These inducements may attract institutions wanting to mask capital problems.
Inducements can take several forms including the following examples:
■ Tire service provider purchases certain assets (e.g., computer equipment or foreclosed real estate) at book value (which exceeds market value) or purchases capital stock from the institution.
■ Tire service provider offers cash bonuses to the institution upon completion of the conversion.
■ Tire service provider offers up-front cash to the institution. The provider states that the institution acquires the right to future cost savings or profit enhancements that will accrue to the institution because of greater operational efficiencies. These improvements are usually without measurable benchmarks.
■ Tire institution defers expenses for conversion costs or processing fees under the terms of the contract.
■ Low installation and conversion costs in exchange for higher future systems support and maintenance costs.
These inducements may offer a short-term benefit to the institution. However, the provider usually recoups the costs by charging a premium for the processing services. These excessive fees may adversely affect an institution’s financial condition over the long-term. Furthermore, institutions should account for such inducements in accordance with generally accepted accounting principles (GAAP) and regulatory reporting requirements.
Accordingly, when negotiating contracts, an institution should ensure the provider furnishes a level of service that meets the needs of the institution over the life of the contract. The institution must ensure it accounts for contracts in accordance with GAAP. Contracting for excessive servicing fees and/or failing to account properly for such transactions is an unsafe and unsound practice. In entering into service agreements, institutions must ensure accounting under such agreements reflects the substance of the transaction and not merely the form.