Progressive Renovation for Core Banking System Modernization Temenos White Paper
02 Executive summary The global banking industry is at a crossroads. It is faced with a wave of market changes, such as new regulation, which will weigh on profitability. The industry is subject to technology disruption, especially in the form of mobile technology, which is dramatically changing how it interacts with its customers at the same time as empowering them by giving more choice and better information. Further, the competitive landscape is changing: banks now face competition from new banking entrants, such as Metro Bank in the UK, as well as competition from outside the industry in the form of supermarkets, online retailers like Amazon and technology providers like Google, none of whom is burdened by legacy technology. Banks now need to rethink their approach to IT or they risk being rendered uncompetitive and unprofitable. Many retail banks are running on old, costly, product orientated and increasingly complex batch technology which is hindering their competitiveness and allowing new entrants with customer and service models to edge in on retail banking customers. In the 1990s capital markets built middle offices to achieve straight-through processing and manage real time risk with accounting at the end of the workflow. In 2000, Amazon reconfigured retail systems into front office (sales), middle office (payment processing) and back office (distribution). This architectural change provided the flexibility to meet customer (i.e. market) needs. The large retail banks remain stuck in a preonline age of batch processing if they are on branch accounting and therefore need to embrace this new architectural paradigm. The collective experience of large retail banks worldwide suggests that they can t just swap out an old core banking system (referred to as a Big Bang approach). The building of systems to surround the core has provided capabilities to meet some of the new market demands. However, some capabilities are best addressed by moderization of the core systems themselves. Banks really just want to simplify their IT architectures to reduce cost and risk. Banks can achieve these aims of simplicity, self-assisted transactions and straight-through processing by adopting a Build and Migrate approach as part of a Componentized Renovation strategy. Although they are all at different stages in their core systems modernization, large retail banks are showing an appetite to finally move forward such as Nationwide Building Society who has a new product Flex Direct which is running on modern standard software. Others include National Australia Bank has a 2016 target for their core banking migration and Commonwealth Bank of Australia who have a core banking project underway. Accelerated activity is anticipated in other markets such as the Americas in the near term.
03 Where is the industry with core banking renovation? Doing nothing is not an option The retail banking competitive landscape is changing. Regulators are more minded to grant banking licences and are taking steps to make it easier for new banks to set up operations, including applying lower capital requirements. Retailers, notably supermarkets, see an opportunity to leverage their brands, their customer service ethos and their analytical capabilities to move into the provision of financial services. Technology companies, such as Google and PayPal, believe that technological know-how in an increasingly digital age can see them capture a share of the market. Unburdened by legacy systems, it is much easier for new banks and non-banks to move quickly in response to changing market conditions: to open up new channels and target particular groups with personal service and real-time information. If retail banks don t make a structural change, some of the leading established ones may fade. Inevitably a competitor will emerge to do an Amazon in retail banking. It could be Tesco, PayPal, Metro Bank or a business not yet on our radar. This may not be before they have lost a share of their customers to competitors, an increasingly realistic threat as the percentage of customers who are looking to change principal banking providers in the next 12 months stands at 12%, up from 7% in 2011 1. When they built their core systems four or five decades ago, the large retail banks created an IT architecture which has endured but doesn t match their requirements for the future. This legacy slows them down and has created an unsustainable situation which leaves channel managers in some circumstances barely able to meet the demands of the marketplace. Risk factors Some large retail banks have performed renovation in their branch networks but it s probably fair to state that very few, if any, large retail banks have been able to successfully execute a Big Bang replacement programme. On the contrary, there is a list of highprofile failures that have cost a lot of money to achieve little business benefit. While the risks of undertaking change may look daunting, the risks of not changing include the mounting costs of managing core banking system complexity and a lack of competitiveness when unable to meet the expectations of customers to keep them loyal. During the mergers and takeovers prior to the 2008 financial crisis, IT departments were unable to do anything more than import customer data into the same architecture, leaving banks on the knife edge of batch processing failure. The existing architecture s reliance on overnight batch processing concentrates unacceptable risk into a two or three hour window, often in locations that provide no time for recovery before the beginning of business on the next day. The added pressure is that banks need to run a 24 hour 7 days a week service with growing expectations from customers and significant technological advances. The size of the batch process (amounting to millions of transactions) commits considerable IT resources just to keep the business going day to day. Ageing core banking systems can t necessarily be maintained successfully. The recent failure of core banking functions at a large UK retail bank left most customers without access to their accounts for 48 hours and some without access for up to two weeks. The compensation for corporate and individual customers, who incurred unnecessary and unplannedfor debts, will be considerable. The fallout in terms of consumers trust in the bank has yet to be determined with the loss to the bank estimated at 150m. The way forward Since a swap-out of core banking is too risky, banks have begun to investigate the strategy of progressive renovation. In this way, banks have been able to resolve business issues, such as the need for relationship pricing. They deploy modern technologies and extract data out of the legacy code. These new capabilities surround the core systems that handle loans and deposits. Although this strategy solves immediate business challenges, it retains the outdated core banking code, which, in addition to the issues highlighted above, is becoming increasingly difficult to maintain as the number of staff with the requisite knowledge declines. Note 1 The customer takes control, Global Consumer Banking Survey 2012, Ernst & Young, November 2012
04 Componentized renovation The strategy of componentized renovation allows a large retail bank to get the advantages of enterprise-ready components quickly, with acceptable technical and business risk. This approach allows the banking IT system, regardless of whether it is layered horizontally or vertically, to be renovated in a componentised way by individual vertical silo credit card, mortgage, bulk processing or by horizontal core accounting function accounting, calculation of interest, statement generation - or by a mixture of both. Componentized renovation breaks the problem down to individual component replacement, which contributes to a simpler architecture. The simplicity can be achieved by a centralised infrastructure supporting standalone components that work together through various messaging technologies. This infrastructure provides the freedom to quickly add new channels, products and user interfaces as regulation or market forces demand. The new core banking infrastructure has a flexible architecture: the bank s front office can mix and match its product offerings, some own-brand, some from third parties, some based on geography. The middle office can be organised by line of business and span geographies. The back office handles global clearing and settlement, with high volumes of transactions. The flexibility of this architecture will allow banks to adapt. The core infrastructure of the new system will support open standards, be easily configurable, scalable, offer low cost of ownership and be easy to maintain and configure. The performance of standard software is improving all the time and benchmarking shows that such software is meeting the requirements of even the biggest retail banks with tens of millions of customers and adding many hundreds of thousands of new accounts each year. New technologies promise even faster processing to support the realtime nature of these systems. Conclusion The banking industry faces an almost perfect storm of change which is undermining profitability and will prompt a rethink regarding technology and system modernisation. Regulation is being tightened, customer loyalty is diminished, competition is becoming more intense and multi-form and there is a revolution in mobile technology. Large retail banks stuck on branch accounting are operating at high cost, high complexity and low flexibility. A build and migrate approach as part of a componentized strategy removes the technical risks by starting afresh. Because banks are at different stages of designing a solution for core banking system renovation, each project is technically unique. In the on-going dialogue between banks and technology companies, banks should therefore expect agility not just in the technology offered but also in the attitude of the software solution provider. Componentized renovation removes the roadblock to change, not because it s revolutionary but because it s manageable for a typical IT department. A bank s CIO can be confident in building a new line of business and progressively migrating accounts under controlled conditions. Such a project contains reasonable risk in terms of cost, time to completion and ultimate success. A build and migrate approach With a build and migrate strategy, a bank sets up a new line of business and migrates the accounts. During the first stage, the bank identifies a new line of business that is worth launching on its own merits. It sets up this new branded line of business using the latest core banking system technology. A full- service bank without branches can start up quickly (e.g Juniper Bank in the US in 15 months) and some large banks have already developed a new channel in a matter of months in order to get quickly into a marketplace. Once the brand is up and running, it acquires existing books of business, such as mortage, credit cards and branch current accounts from the host bank. The old banking system will be wound down by natural attrition as accounts expire and customers are encouraged to take up products offered by the new brand.
05 Authors The pressure of market forces The main market forces that have driven down banks return on equity and which banks are unable to respond to without a change to the core banking infrastructure: Tougher regulation, especially in the form of higher capital requirements. Changing customer behaviour, putting pressure on pricing at the same time as raising cost to serve. Increased funding costs, stemming in particular from a relative shrinkage in the wholesale lending market. More intense competition arising chiefly from new market entrants. Technology disruption, coming mainly from the proliferation of multi-access devices which mean offering services over an ever-increasing number of channels and devices Temenos Ben Robinson is Director of Strategy and Marketing at Temenos, based in Switzerland and can be contacted at brobinson@ temenos.com John Schlesinger is Chief Enterprise Architect at Temenos, based in London and can be contacted at jschlesinger@temenos.com IBM Steven Engle is Client Solutions Executive at IBM, based in New York and can be contacted at sengle@us.ibm.com Evolution of large retail bank core systems When retail banks set up their first core banking systems, they were setting up double-entry bookkeeping systems for their physical branches. They were simply the result of automation of the back office functions in a branch. The banks later added systems to record transactions during the banking day. At the end of the day, they send the transaction log to an overnight batch processing run. The batch processing authorizes payments (but has no risk management built in). It calculates cash in and out, interest and tax to produce new balances, which are available for the start of the next day. When ATMs were introduced, customers transactions at the online ATMs were collected separately. The same happened when banks enabled the use of debit and credit cards at point of sale. When UK retail banks were required to provide same-day payments, they built a parallel system, further side-lining the core systems. Every new channel duplicates IT resources. Every change a new regulation, a product revision - has to be applied many times on many different servers.
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