Overview:
BB&T Bank had encountered a catastrophic outage in their online application system over several days in 2018. Because of this outage, Millions of its customers were unable to access bank’s online website, their Mobile App, their ATM services and their Wire transfer services for 15 hours over several days in 2018. BB&T’s customers were unable to perform any transaction during these 15 hours. This outage cost the bank about $15 million in lower deposit service charges and about $5 million in higher operating expenses. BB&T is holding computer hardware vendor Hitachi Vantara responsible for this catastrophic outage.
Abstract:
Vendor Searching and Selection is cumbersome and big task specially for big enterprises. Decision to select a right vendor faces Adverse Selection Problem. Computer Hardware Vendor’s know their core-competency, Area of Expertise and level of maturity/experience but this information is hidden from the hiring firm. It is hard to differentiate between cherry and lemons. In addition to thisproblem, Vendor are more likely to Shirk after a contract is executed leading to Moral Hazard Problem. In this case, If BB&T had this information known somehow, they could have performed alternate activities to prevent/minimize this. In addition to this, they could have analyzed the problems adequately before hand thus making sound decisions despite these problems.
Decision Process
This case particularly refers and evaluates thedecision-making process that happens when a firm like BB&T tries to nominate a hardware and software solutions vendor for their online platform. However, the problem statement and solutions discussed in this case can be generically applied to any decision-making process that happens during vendor/supplier selection. Below are the steps involved in selecting a vendor.
A Firm submits RFP to different vendors listing out their high-level requirements. Vendors after reviewing the RFP, submit their proposal to the firm along with their solution and their bid price. After submitting the proposal, Vendors schedule proposal meeting with the firm to answer any question a firm would have. Firm after reviewing all the proposals from different vendors, at last decides/grants the contract to one of the vendors. Contracts are presented from vendors side as well as Firm side, Once both parties sign the contract, the deal is executed.
Problem Statements
Adverse Selection occurs when there is a lack of symmetric information prior to a deal between a firm and a vendor.
In our case, Vendors have information that the firm do not have. Normally, it is well expected that All vendors who come to the proposal meeting are more likely to exaggerate their core-competency, maturity and experience. In addition to this, they would try every effort to be/act exactly like the company the firm desires. Vendors are aware of their sets of Core Competencies and their level of experiences and also know the quality of hardware and software they will be able to deliver however firms do not have this information. It is hard for the firm to distinguish between cherry and lemons. This leads to adverse Selection Problem.
Moral Hazard Occurs when there is asymmetric information between firm and vendor and there is a change in behavior of vendor after an agreement is made.
Our Vendor would agree to everything until the agreement is made and placed into contract, but they might not abide to the agreement after the agreement is reached. They would only be obligated to follow exactly what is listed out in contract. In our case, our hardware vendor could agree to provide highly trained technical staff, but later could decide to create a group of less qualified staff, cutting costs/ increasing profits. They can even agree to provide higher quality hardware before the agreement but might later decide to change it to lower quality hardware to increase their profits. This leads to Moral Hazard Problem.
Solutions
We have 2 problems at play here for which we will present solutions and share the tradeoffs.
1) Adverse Selection problem while selecting a Vendor
2) Moral Hazard problem.
Adverse Selection problem while selecting a Vendor
Let us try to solve this problem using our Economics Decision Solving Strategy.
1) Who made the decision? Hiring Team of the firm
2) Did the decision-making person/team have enoughinformation? No
3) Did the decision-making person/team have enoughincentives? Yes
We can see that we have problem in #2. Our decision makers although with enough incentive do not have the information to make the right decision.
To solve this problem, we must differentiate between cherry and lemons. We could ask various set of questions that can help us elicit more information about the vendor.
1) Is your company ok with a third-party auditing/ reviewing the application/hardware?
2) Will you be able to provide us with free maintenance once the product is completed?
3) Will you be ok with us reviewing the staff’s profile that are dedicated to our product/ application?
4) Will you be ok with having shorter contract that would be renewed every 6 months?
Any vendors agreeing to these conditions know that they are competent. They are aware of the application support/maintenance costs associated with the product they build. And at last, if they were guaranteed to have highly technical staffs, they would be ok with sharing the information as well.
Moral Hazard problem
Let us Try to solve this problem using our Economics Decision Solving Strategy.
1) Who made the decision? Hiring Team
2) Did the decision-making person/team have enough information? No
3) Did the decision-making person/team have enough incentives? Yes
We can see that we have problem in #2. Similar to earlier problem, our decision makers do not have the information to make the right decision. Firms are at risk to moral hazard problem once they abide to agreement with firm.
To solve this problem, we should draft a strategy that would give enough incentive to vendors to complete the product diligently. Binding Contract is the only truth.
Below are couple of terms that can be added to the Agreement. Each solutions/ term has tradeoffs. We will discuss benefits/ tradeoffs for each of these solutions.
1. Audit Obligations
We Can add Audit/Review terms to our agreement. We can have a third party review the quality/benchmark of an application produced on a timely basis. This is one of the best option to ensure the quality progress however Hiring a Quality auditor is expensive and would incur heavy costs.
2. Looking for Warranty/ Maintenance
We can add free Maintenance or fixed costs warranty that requires a vendor to provide free/fixed cost maintenance after the product is delivered.This would provide enough incentive for the Vendorto build higher grade product. One of the trade-offs for this solution is that we will be stuck with the original vendor even though we might find a cheaper/better alternative.
3. Vendor Staff Review
This is another feature that we can add to contract and rip the benefits. This would solve the problem that could arise when a vendor would hire less qualified individuals to build the product. Having this as a legally binding contract, vendor will be diligent while allocating staff for the project. One of the trade-off for this contract feature is that the vendors are more likely to increase their bid after this.
4. Share of Loss or Profit as a result of developed solution
This contract feature will define the incentive a vendor would receive if the product developed does show very less issues over predefined time. With this incentive, Vendors are more likely to build a quality product since they have a share on it. Payoff to the vendor is the trade-off here, but again we do not have to pay if we see more than pre-agreedissues in our system.
5. Monitoring Progress
Our Contract can add Monitoring terms that requires vendor to timely demonstrate the progress they are making while building the application. This would ensure that the product is developed in a stable and mature fashion rather than hastily built. Tradeoff for this contract feature is that it would require firm’s time and would incur additional management overhead expenses.
Conclusion
We have discussed the decision process, problems/challenges while making those decisions, solutions to those problems and their tradeoffs. Vendor Selection is a crucial decision-making process for any company size and requires any firm to address different sets of challenges. Adverse Selection and Moral Hazard were the bigger challenges in BB&T case. With the Solutions implemented efficiently, they would have selected the right vendor to start with and would have been able to create enough incentives for the selected vendor to deliver a mature product and finally BB&T would not have faced this issue or at least would havesignificantly minimized the damage.
References:
1. Author, Luke M. Froeb, Managerial Economics, A Problem solving Approach 5th Edition (2019), ISBN-10: 1337106666
2. EconomicsHelp.ORG, https://www.economicshelp.org/blog/glossary/adverse-selection/