Written by: Karen Augustine, Jerry Silva
Source: IDC, 2021
Digital innovation is disrupting nearly every industry including banking. Customers today expect banks to provide a personalized approach to banking with the same level of customer experience they routinely get from leading-edge retailers, social media, and fintech competitors to traditional institutions. Banks are experiencing customer attrition in areas like lending and payments and will begin losing even core deposit customers unless they can start providing innovative capabilities and services that improve customer experience in this new digital era.
Modernization is also critical to building resiliency, scalability, and efficiency into core systems. Cloud platforms are being adopted by banking institutions worldwide, even for critical workloads like core banking. These modern platforms are scalable, resilient, and cheaper to operate, protecting against disruptions, unexpected surges in demand, and lowering the cost of operation. Most banks' core banking operations have yet to be optimized with new applications and technologies. Rather banks create layers of customization atop legacy systems to add functionality, leaving them subject to risk and liability from aging equipment that cannot support modern capabilities. Updates to legacy systems require experts in outdated programming languages such as COBOL. That talent pool is shrinking, making internal help difficult to find and systems that are costly to maintain.
Even so, many banks are still reluctant to modernize their core platforms and applications because of the risks at stake. Core systems are central to their entire banking architecture, so any snag in the upgrade may cause a shutdown in banking channels or overall operations. Until recently, banks could only conduct a total overhaul replacement to their core using a big bang approach involving setting up a new core side by side with the old core and "cutting over" the bank's database and integration points to the new platform. Today's modern core architectures enable the banks to consider more options to modernize their core banking, including:
Risk is greatest when modernization requires a total replacement in a big bang approach, which is effectively a "bet the bank" approach, no matter how much planning is involved. But for smaller institutions, with simple offerings and systems, the big bang can be a viable approach. For larger and/or more complex environments, banks can opt for a less daunting, incremental approach. A more strategic, incremental plan can take two forms. One way is to establish a digital bank with a new, modern core that runs alongside their legacy core banking systems and progressively move customers from the legacy platform to the modern system. Another is a progressive transformation to core modernization by pulling functionality out of the legacy core, based on business priorities, and moving these functionalities to modern architectures (e.g., microservices in an application programming interface [API]–based environment) over time. While this approach can extend the overall time it takes to completely modernize the core infrastructure, the positive trade-off is a significant reduction of risk.
This IDC PlanScape helps organizations justify investment in core banking modernization, provides insight into different approaches to modernize core banking, and provides process-related advice for these deployments.
"Now is the time for banks to modernize core banking," says Jerry Silva, vice president, IDC Financial Insights' Worldwide Banking Digital Transformation Strategies program. "Between modern technology approaches like microservices and APIs and the use of cloud platforms ensuring scalability and resiliency for the bank's back office, banks would do well to start the journey to core system modernizations without delay."
Most banks around the world rely on aging legacy systems that cannot provide the real-time transactions or personalized services that customers demand more than ever and that they receive from both banking competitors and other industry firms. A modern core is a business enabler using the latest technology to drive better banking experiences with personalized customer engagement and faster response to market changes with new products and services, expanding revenue opportunities for the bank.
Many banks' core systems are based on 30- to 40-year-old technology. As customer demands changed over the years, banks accommodated these changes by adding other legacy platforms and customizing them with work-arounds and point-to-point integration to add products and services. Disparate systems also required disparate data platforms, causing difficulty in cross-platform collaboration to serve customers better and creating complexity when problems arose.
That level of increasing complexity has negative effects on adjacent critical functions like compliance, risk, and security. This historically disjointed architecture is harder to protect against the increasing threats of fraud and cyberattacks like ransomware. The shift toward ecommerce and digital engagement with new marketplace platforms accelerated by the COVID-19 pandemic has caused a sharp uptick in fraud that banks need to address while balancing customers' need for frictionless digital experiences.
All of these legacy core systems, with few exceptions, are batched based, meaning that account settlement is done overnight. In itself, the memo post processing that allowed banks to simulate real time was enough to fulfill the needs of yesterday's customer, but today's focus on a real-time and holistic approach to the customer experience is straining the ability of legacy systems using memo posting to respond to market forces.
Taken together, the current state of legacy core platforms, particularly if the bank continues to build on top of this shaky foundation, will quickly add to the enterprise risk to the organization, ultimately forcing a reactive need to modernize.
For these reasons and more, core banking modernization is critical to overcoming the complexity the industry has built over the years that has led to high costs, fragile infrastructures, slow product innovation, and increasing difficulty in finding skills to maintain legacy platforms. The benefits of core banking modernization are clear:
It should be said that core banking modernization should not be viewed strictly as an IT project to transform its digital infrastructure for the future on the 3rd Platform. Banks should consider modernization as a new foundation to improve their products and services, innovate "outside the box," find new customers and markets, and create operational efficiencies for the bank and its customers. This makes modernization significantly more valuable from a business perspective.
Banks that delay core banking modernization risk customer attrition to more convenient and ubiquitous "digital first" and embedded banking services, whether from a modernized traditional competitor, a fintech competitor, or a challenger bank that can provide the personalized experience customers now expect. Resiliency will be tested more often, costs will rise as skills become more expensive to find and retain, and overall risk and compliance will be challenged.
Core banking refers to back-office processing of the customer's financial needs such as deposit accounts, payments, loan origination and servicing, product pricing, interest calculations, and general ledger. Customer, account, and product data typically resides in the core data architecture as well. Many core systems go back 30 years or so from their original design, many of those being heavily customized in the intervening years. This is a simple definition of what is a complex collection of functionality and technologies that vary from bank to bank.
IDC defines core modernization to mean the creation of a modern, digital architecture in which business functionalities are supported by modern development and deployment paradigms. To be sure, this does not imply that, at the end of the day, all components of the legacy platform are replaced or removed. The overall architecture could, and perhaps should, allow for some aspects of legacy platforms to participate (again, using modern interfaces like open API) in the overall digital infrastructure.
The next generation of core banking systems requires cloud-native, open banking platforms to achieve the agility and scalability needed to respond to changing market demands. Workloads like digital lending origination, for example, can be split up into discrete microservices, running in a container environment, that are scalable in the cloud. Each discrete service communicates through application programming interfaces. If a problem or change is needed in one microservice, it is isolated for a quicker fix while the rest of the system keeps running. Independent and scalable use of microservices enables more frequent deployment.
While making the case for modernizing the core platform becomes easier every year, executing on a modernization initiative is not trivial or without risk. In times past, the only approach to modernization was a "big bang" strategy that had the bank standing up a modern platform next to the old one and picking a weekend over which the data, including customer data, would be transferred to the new system. The bank would flip the switch to turn the new system on and hoped it worked without problems. This approach would fail often enough to create a stigma on core modernization that persuaded many banks to keep applying patches to the legacy platform instead.
So, how can banks modernize core banking without risking a critical operational disruption? Today, banks have more options than to simply cut over their entire operations at once in a big bang approach. IDC identifies three major options for core banking modernization: progressive transformation, building a greenfield digital bank, or the big bang approach — and hybrid models consisting of more than one of these approaches. The best approach for each bank will depend upon the size of the bank, complexity of existing environment, cost, and the risk appetite of the specific bank.
Progressive transformation is the movement of specific business functionality from legacy platforms to modern platforms slowly over time. This approach allows banks to identify key business functions that are the highest priority to modernize. A bank can take an application and reinvent the customer journey by breaking it down into designated tasks to rebuild iteratively as microservices that can share resources, deploy those in a modern infrastructure (mainframe, server cloud, etc.), and decommission the workloads in the legacy platform.
This incremental approach requires an ongoing commitment and investment and may take 5 to 10 years or longer to complete, allowing the banks to build their architecture around the most important customer journeys while reducing the overall risk of core modernization. This approach works only as long as the legacy system remains viable. In this approach, core banking modernization is an ongoing activity, progressively "hollowing out" the core by adding modern, microservices-based architecture around the legacy systems to continually refresh core capabilities. This approach represents a distributed cost model and minimizes risk exposure while modernizing a bank's core business capabilities over time.
Interestingly, this approach lends itself to a hybrid modernization strategy wherein there may come a point in time when some workloads, general ledger perhaps, remains on the legacy platform due to performance, risk, or resiliency characteristics, for an extended period after most other functionality has been modernized.
Another option for a bank to modernize its legacy systems is to establish a greenfield digital bank as a standalone unit that leverages a new modern core with cloud-native technology for real-time transactions, typically under a new brand. The digital bank operates independently from the bank's core business, serving a separate customer base. The new core will offer cloud-native capabilities that legacy systems cannot provide, enabling the bank to test new products and services.
Once proven stable and successful, the bank can slowly migrate more functionality and its traditional customer base over to the new core. (The "new" brand created could be retired at that point or kept.) This greenfield bank strategy is a faster approach to modernization, instantly transforming into a digital bank. Yet it is more costly and riskier than progressive transformation, though certainly less expensive than a full core conversion with less risk of disruption to normal business operations. A notable success story is Goldman Sachs' launch of the company's Marcus digital bank, well positioned as a tech-savvy digital-first brand whose retail deposits reached $97 billion in 2020.
A full core replacement to a modern cloud-native platform in a big bang conversion is a bank's riskiest option. However, for smaller, less complex banks, this is still a viable option to consider. In many of these cases, the core is provided to the bank by a managed services partner that assumes a large part of the responsibility for core modernization. In some cases, "core pre-modernization" could also be applied to a bank running a core banking system that is several versions behind the latest iteration. This pre-modernization could be mandatory to address procedural or systemic requirements as a halfstep before the legacy core is replaced. The benefit of a big bang approach is that the total cost of modernization is more certain than in a longer-term progressive approach. The new core is entirely functional after the cutover, and, if a managed services provider is involved, is being supported by a firm with long tenure and experience in this kind of modernization approach.
Another scenario in which a bank may decide to use a big bang approach is the institution with a homegrown core banking system that acutely suffers from all of the disadvantages and limitations of aforementioned legacy core platforms.
Larger banks rarely opt to conduct a transformation of this magnitude because the risk of disruption is too severe. Occasionally, banks may be forced to implement a big bang cutover within a specific line of business (like lending) to retire their legacy systems and urgently migrate to a new platform for regulatory issues or other reasons. In any case, a big bank conversion requires a good deal of planning beforehand to minimize the risk of disruption and curtail any foreseen snags in the process.
In all of these cases, the resulting core architecture may not, and probably will not, look anything like the outgoing or remaining legacy platform. While simplifying many aspects of core system operations, the transformation to microservices and containers, using APIs to interconnect, often forces institutions to modernizing other nontechnology aspects of their operations to align with the new digital infrastructure. Container management, cloud management, security, development operations, data governance, operational risk, and other skills required by modern infrastructures may not currently exist at the bank.
As core banking forms the heart of a bank's operations, nearly every leadership role at the institution is affected by or has influence over core banking initiatives. Table 1 depicts the most common roles involved in a core banking modernization project and the benefits they expect from it.
Source: IDC, 2021
Banks today must recognize that they can no longer afford to delay core banking modernization if they want to survive in this new digital era. Banks face increasing competition from technology companies and challenger banks offering new digital banking services and embedded financial services to customers more conveniently and intuitively than ever before. Banks' efforts to roll out new digital strategies to meet customer expectations are crippled by an overreliance on monolithic legacy systems that are not designed to process real-time transactions or access enterprisewide data that is left siloed by disparate, incompatible systems. The gap between digital leaders and banks is widening every day. The challenges, costs, and risks of running and maintaining outdated core systems will only become more daunting. Further:
Core system modernization is being driven by a number of customer trends influenced not only by the financial services industry but by retail, government, big tech, and others. In a sense, the need to modernize is as much a way to compete and collaborate with these firms as it is to improve the bank's own products and customer experiences.
It will also be driven by some common technology themes essential to driving digital transformation initiatives throughout the financial services industry:
These technologies and initiatives will form the basis of core banking system modernization designed to support greater innovation and agility to meet changing market expectations for banks to grow and thrive. Whichever approach the bank takes in its modernization journey, whether it be a full-scale big bang cutover, establishment of a greenfield digital bank, or progressive transformation, the financial institution will need to upskill its staff in automation efforts, orchestration of the modernization initiatives, while adding an extra layer of security, compliance, and governance.
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IDC analysts predict major digital innovation for the banking industry to meet customer demands