Before delving into the factors that motivate banks to upgrade their core banking systems and the steps involved in initiating such a major project, it is crucial to grasp the concept of core banking and its definition. The precise definition of a core banking system may vary depending on who you inquire. Nevertheless, understanding what constitutes a core banking system is vital for comprehending the extent of a core banking modernization effort and meeting the expectations of all stakeholders. So, what exactly is core banking? Core banking refers to the operations carried out by a financial institution when dealing with its retail and small business clientele.
The concept of core banking encompasses the essential operations of a bank. The modern banking industry has evolved from its simple roots of accepting deposits and providing loans. Today, banks provide an extensive array of products and services that extend beyond these fundamental functions. This necessitates a combination of a bank’s core banking operations with other elements of its business. Consequently, the definition and understanding of core banking can vary among individuals. At its core, though, it refers to the administration of customers’ financial transactions and their effects on their accounts. So, what exactly is a core banking system?
The core banking systems are essential IT systems and applications that manage fundamental activities in a bank’s infrastructure. In the past, these systems had basic features for account management and customer information. However, modern core banking systems have evolved to become back-end systems that enable banks to efficiently develop, process, and manage various financial products and services. This includes data on clients, deposit accounts, loans, mortgages, payment transactions, and credit cards.The text explains that in addition to complementary products and services, securities, and workflow and business enablement systems, core banking systems also have the essential function of maintaining a bank’s own books. These books contain information about normal business activities, customer account balances, interest, charges, assets, liabilities, income, and expenses. Figure 1 illustrates that core banking systems are the central component of a bank’s IT infrastructure and interact with surrounding applications, networks, and systems. Over the past decade, the importance and functionality of core banking systems have changed. Previously, customers only needed to deposit or withdraw cash during business hours at a branch. However, now core banking is focused on understanding customer needs and providing them with the appropriate products through the right channel 24/7.
Core Banking Systems have become more than just an IT concern and now require increased involvement from business. A well-established bank needs a strong system that offers a deep understanding of the customer’s connection with the bank, specifically for those providing services to them. In the future, Core banking systems will play a crucial role not only in managing costs but also in overall competitiveness and profitability. Several external factors compel banks to take action and update their core banking systems.
The reasons why banks are replacing their core banking systems can be explained by four main factors: three external forces and one internal force. The first external force is regulatory demand, which refers to the tighter regulatory controls that financial institutions are facing in the transformed banking sector. These controls include requirements such as Basel II and III, SEPA, PSD, and EU Settlement and Clearing. Basel II, issued in 2004 by the Basel Committee on Banking Supervision, became effective for all EU members in 2007. The second external force is increased competition, which also contributes to the decision to modernize a bank’s core banking systems. The third external force is the impact of legacy applications that need to be overhauled, as they directly affect a bank’s flexibility in reacting to the other three forces. Finally, the internal force driving core banking modernization can be attributed to mergers and acquisitions.
Figure 2 illustrates these driving forces for core banking modernization.
The text states that Basel III, which was introduced to revise Basel I, includes new regulations for determining capital requirements, implementing banking supervisory control procedures, and disclosing information. The recommendations in Basel III were developed based on experiences with Basel II and address the credit crunch by requiring banks to increase their capital even more to secure risks that were taken on with the introduction of the capital buffer. Implementation of Basel III is planned to occur gradually from 2013 onwards.
The Single Euro Payments Area, or SEPA, started in January 2008 and aims to standardize euro payments so that they are treated as domestic transactions. These examples of regulatory requirements affect all banks and show what they need to respond to. With ongoing market developments, more regulations are expected, forcing banks to react accordingly. Meeting compliance requirements pushes banks towards more agile platforms.
A recent study conducted by Ovum, an independent analyst and consultancy firm, revealed that achieving or maintaining regulatory compliance is a top priority for banks worldwide. This research included banks from Europe, North America, Australia, and Asia. According to Fig. 3, the most important business driver for investments in core banking systems in 2010 was compliance with new regulatory requirements. It is crucial for banks to integrate their systems properly in order to ensure the integrity of their regulatory reporting and avoid potential penalties. This may require an overhaul of the existing core system. Banks must be able to generate reports on short notice regarding their capital positions and risk exposures. To achieve this, data collection must be efficient, reports need to be generated accurately and on time, and challenges posed by heavily customized and inflexible legacy systems must be overcome. The banking industry is experiencing increased competition.
Financial service providers and customers in the banking market are both undergoing significant changes. Banks are looking to stand out and appeal to customers by offering innovative products and services. As a result, decision makers are considering core banking renewal as a way to gain an edge over competitors. To stay competitive, many banks recognize the need to prioritize their customers when making strategic and tactical decisions.
Internet banking has resulted in customers being better informed about the products and services they purchase, leading to an increased demand for personalized solutions. Additionally, banks have lost trust due to the financial crisis and current market events, causing customers to seek more control in their banking relationships. Customers now expect personalized services and products, as well as the ability to access their accounts at any time and from anywhere with consistent and up-to-date information. For banks to successfully meet these expectations, they must be able to identify customer needs. However, a global core banking survey by Accenture and SAP found that branch staff worldwide are facing difficulties in identifying potential business opportunities using their systems. Despite this challenge, recognizing the power clients hold both as threats and opportunities allows banks to quickly introduce new functionality, products, and services to optimize each customer relationship.
New competitive landscape: Banks face challenges in maintaining their market share due to important changes in the business environment. Community banks, industry specialists, and non-banks are now competing to increase their customer base by offering specialized services to targeted groups of customers. However, these nimble players have the advantage of not having to deal with legacy systems and processes, allowing them to use their resources for innovation. Consequently, banks risk losing clients to these innovators who are continuously improving collaboration and segment capabilities.
Given that 50% of customers would only give their bank two chances to fail in meeting their requests before considering a new financial provider, banks need to prepare. They are facing limitations due to legacy systems as they try to cope with the demands of today’s banking environment. Financial institutions have encountered major problems with the functionality of their existing core banking systems to support changes due to regulatory requirements or competitive reasons. The term legacy is in this context defined as “of, relating to, or being a previous or outdated computer system”. There is a need for greater flexibility, as highlighted by a survey conducted by Accenture and SAP in 2005 which showed that lack of flexibility, mentioned by 70%, is one of the key problems with current core banking systems. The source of the problem lies in legacy applications that limit the bank in developing and introducing new products and services needed to increase customer satisfaction. As banks desire to expand into new geographies and new product lines, they require a flexible and scalable system.
Legacy systems in the banking sector are often heavily customized and resistant to change, making it difficult for banks to adopt new business models and comply with regulatory changes. Another challenge is that these systems are typically focused on products rather than customers, which is also reflected in their IT architecture. However, banks are increasingly shifting towards a customer-centric approach, where the core banking system holds a single record for each customer and connects it to all of their accounts. Additionally, most legacy systems lack the capability to support multiple channels and currencies. These outdated systems were developed in the 1970s/1980s and were designed to provide basic functionalities. They are mostly proprietary systems running on Assembler or COBOL code, built around products rather than customers. In the past few decades, the banking industry has witnessed the emergence of new delivery channels, products, and market segments, further complicating the use of legacy systems.
Banks have utilized middleware to address the deficiencies of their systems and to add layers of functionality on top of their outdated systems. Until now, banks have allocated a significant amount of their budget, around 70% of their entire IT budget, to maintaining their systems, with less than 30% dedicated to implementing new capabilities. A considerable portion of this expenditure has been devoted to developing new product functionalities or system features for the core system. For some banks, reducing the overall cost of ownership alone may be incentive enough to pursue the replacement of their core system, as highlighted by more than 47% of interviewees in Accenture’s & SAP’s Core Banking survey who identified cost as the top issue. Additionally, the need for enhanced system integration and stability was identified in the same survey. At the branch level, various issues were identified that were either directly related to or stemmed from core system problems. Among these issues were frequent or unnecessary delays, cited by 50% of branch staff interviewees as the primary processing issue, along with inconsistent customer data, limited understanding of customer needs, and inaccurate data.
One major problem arises from the presence of product-centric legacy systems that have separate lines of business. This leads to the repetition of entering information about a customer several times, resulting in redundant and inconsistent customer data. Additionally, the technology of these legacy systems is often poorly documented and known only by employees involved in their development, many of whom are approaching retirement or have already retired.
The challenge lies in finding new employees with the necessary knowledge, especially for banks that have collaborated with vendors. This is because some vendors who installed the system have either gone out of business or no longer support it. It is essential for banks to meet the demands of a mobile and tech-savvy population. However, traditional core banking systems make it difficult to effectively cater to customers. These systems act as obstacles, hindering banks from following their customers’ footsteps. Furthermore, mergers and acquisitions have been a growth strategy for many banks in response to the financial crisis. Although there has been a significant decrease in M&As, information technology plays a crucial role in these activities. The motivation behind bank mergers is the expectation of achieving business benefits such as increased market share, reduced joint operating costs, and a more integrated value chain.
IT integration plays a vital role in maximizing the expected synergy effects. Typically, there are various core banking systems being utilized, and the decision on which target core banking system to choose becomes crucial. The options include selecting either the acquired or acquiring bank’s core banking system, merging the two, or undergoing a complete redevelopment. Given the post-crisis landscape, it is unlikely for an institution to opt for running two core systems concurrently. As a result, most banks opt to migrate the acquired bank to their own core banking system.
In the past, many banks chose not to consolidate their outdated legacy systems, resulting in the need to handle multiple banking platforms. This required them to maintain and support a combination of systems, which often exceeded their planned time and cost savings. Banks that did pursue consolidation often used middleware to address the limitations of their non-scalable legacy infrastructures. The failure of post-merger integration was a major factor in the low success rate of 50 to 70% of all M&A transactions, where banks were unable to fully leverage the expected synergies. Nowadays, banks still face the challenge of managing a highly complex IT environment with aging core banking systems that are difficult to support. They must deal with a diverse range of hardware platforms, operating systems, messaging formats, database standards, and business rules. To prepare for future M&As and maximize their business potential, banks need a core banking system that is standardized, scalable, and flexible.
