European banks have to upgrade their core tech. Are U.S. banks next?

The European Commission has been making rules for the past decade that have pressed banks in the region to adopt modern core systems. Now, the regulators are nudging them even further ahead with proposals that would require them to handle instant transactions and be better equipped to recover from disruptions to digital operations.

U.S. banks — already late to the real-time-payments party — are playing catch up as they attempt to integrate with The Clearing House's RTP network and the Federal Reserve's real-time-payment processing system FedNow. But many still rely on core payment processing systems built for the days of paper checks.

Just how unprepared U.S. banks are for the changing payments landscape is already starting to become apparent, with some calling a string of major bank outages that affected Zelle payments a sign of the friction between banks' grandfathered core systems and modern payment networks.

"On average, the U.S. banks are 10 to 20 years behind most other countries in terms of payments technology," said Gareth Lodge, a payments analyst at Celent. "At some point, you need to go: How do I serve customers of today, let alone tomorrow, with technology from yesterday?"

Roughly 94% of U.S. banks rely on legacy core systems that conduct transactions in overnight batches, with the largest lenders leaning on mainframe systems built more than 40 years ago, according to an estimate from Brad Smith, a partner at Cornerstone Advisors. 

Meanwhile, European banks have been sprinting ahead of their U.S. counterparts. 

That's been since about a decade ago, when almost all European banks — and many others working with them — had to update core systems to comply with rules that require them to offer cashless euro transactions. More technology advances have followed with the push for open banking and more updates to payment service directive rules. 

Europe has since become fertile ground for core banking software vendors — including U.K.-based firms Thought Machine and Mambu and the Geneva-based Temenos — to grow. 

"Virtually all the modernization that's taking place in the U.S. and Canada is using European tech," noted Lodge. 

Even so, real-time payment pick-up in the EU has been too slow for regulators' liking. Instant transfers account for only 14% of all conventional euro transfers, with India the undisputed leader in real-time payments globally, followed by Brazil, China, Thailand and South Korea. 

EU rulemakers are now asking that banks offer instant payment settlement at all times to keep the continent competitive. Along with other rules — like one that would raise the bar for payment systems' operational resiliency standards — those proposals are pushing even more banks to use newer technology, including cloud-based applications.

"With new rules coming, many banks are investing further because they recognize the benefits of doing so," Lodge said. "The banks don't like it because they have to spend money. But it means they've got some of the most modern systems in the world."

Major banks like Zürich-based UBS and Paris-based Société Générale are now investing hundreds of millions into payment system overhauls. And, in what its members call a direct response to the rules, the European Payment Initiative — a coalition of major European financial institutions — has started piloting a digital wallet and instant payments scheme after acquiring two fintechs earlier this year.

The push for better payment processing systems in Europe and elsewhere has spread ripples across countries like Australia and Brazil that are building enhanced payment infrastructures. "There have been some big stones dropped in various ponds," Lodge said. 

But the ripples are yet to reach the U.S., where some banks are still behind where their EU counterparts were a decade ago. 

"U.S. banks haven't needed to change. There's no regulatory pressure," Lodge said, noting that returns on investments into new core systems are minimal in the short term. "If everybody's doing the same thing in the same way, there's no competitive pressure."

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Core replacements are also more difficult in the U.S. because it is hard to get regulators to approve the use of newer, less tested vendors. There have also been some costly fiascos among banks that have tried conversions in the past.

Even while some U.S. banks have developed sidecar cores for digital banking subsidiaries, the biggest of the big still rely on more than 40-year-old mainframe systems — like those built by vendors Systematics and DXC technologies — and join regional and community banks in handling most heavy-duty transactions in nightly batches on mainframes like IBM's Z System, Smith said.

And when U.S. banks have updated their core systems, in some cases it has been with near term Band-aid fixes. But that's just "buying the same car just with a go-faster stripe down the side," Lodge said, adding that core systems have "become the sacred cow which nobody's allowed to touch for fear of breaking them."

Old core systems are often written in clunky programming languages that can be foreign to young programmers. "The people who can write COBOL or DLR are either dead, retired or redundant," Lodge said. 

Antiquated tech is set to become a bigger problem for banks as interruptions to payment services become more disruptive in real-time settings and more customers flock to social media to complain. 

"These growing pains in network availability have no place to hide behind technology veils or vague statements by financial institutions," Jessica Pinkston, a consultant at Cornerstone, said. "As technology integrations become more complex, the implications of an outage in a single system have broad impact and are visible to the end user."

U.S. regulators appear unlikely to force banks to modernize payment systems anytime soon. But banks that are slow to modernize their cores may have trouble competing in the digital payments space.

"Madness is doing the same thing over and over again and expecting a different result," Lodge said in a reference to Albert Einstein, which he followed with a Lewis Carroll quip. "If you don't know where you're going, any path is going to get there. It's the same with payments."