Twenty-five years ago, Bill Gates, then-CEO of Microsoft, declared "Banks are dinosaurs, they can be bypassed." Most banks have survived, but some believe that Gates wasn't wrong, just very early in his prediction that the digital age would destroy banks. For example, this year Francisco González, Chairman and CEO of BBVA, predicted, "Up to half of the world's banks will disappear through the cracks opened up by digital disruption." Now that the digital age is disrupting the marketplace, are banks like dinosaurs whose extinction is imminent, or are they more like sharks, which grow new teeth to survive, adapt and continue to dominate?
Core banking systems are the oldest banking technology. Many core banking systems used by banks in North America and Europe are considered prehistoric in technological age. Maintenance costs and manual workarounds consume precious resources that could be invested in further digital channel improvements or other uses. In addition, flat file mainframe databases and overnight batch processing impede the real-time transaction processing and information updates that consumers demand and financial institutions want to improve service, lower processing costs, manage financial assets, and compete. In essence, legacy core systems make banks slow and vulnerable to new competitors, new business models, and operational, IT and compliance risks.
Are banks (and credit unions) sitting idly by ignoring the threat and moving slowly on core banking system replacement? The answer is no. In fact, core banking system replacement is happening, and additional core transformations are well underway throughout North America and Europe. A survey by CEB found that 16% of financial institutions around the world are replacing core banking systems, and an additional 12% — primarily smaller or newer institutions — did not have a core banking system, and are adopting one for the first time. The primary value drivers for adoption are to improve regulatory compliance, improve processes and customer experience, and to reduce risks.
In addition to core replacement, there are additional core modernization projects underway and other IT projects making banks more digital, efficient and profitable. The question is not whether to transform, but rather how and when. Many banks are making significant strides toward eventual core system replacement by adding digital channel technologies, data warehouses, and customer relationship management systems and integrating them with legacy core systems through a web-based integration layer that makes the banks more digital and near-real-time, and improves process workflows. This approach is not optimal, but it is an effective, lower-risk approach than big-bang, rip-and-replace projects. Another strategy is to "export out" data, product management, and customer data management functionality from the core into modern, web-based systems. This reduces the inefficiencies of flat file, batch-processing systems that don't scale, and will reduce the risk of system conversion when banks do decide to replace the core. A third strategy is to prepare for eventual core replacement by first reducing the multiple, redundant payment processing, mortgage and other lending systems that still exist many years after mergers were long completed. Yet another strategy is to create a separate digital bank with a modern core banking system, then migrate customers from the legacy system after the new one has matured.
CEB research shows that banks remain constrained from doing all they should by their perception of the risk involved. Forty-six percent indicate that core banking system replacement is high risk or very high risk. For virtually all large banks in the survey, it is very high risk. So the strategies mentioned above are rational and appropriate. Yet the risks of extinction, not from a meteor, but from market factors, remain. System failure, a system's inability to scale and enable growth, lost customers, and regulatory fines could irreparably damage an institution.
Are fintech companies a threat? Yes. Is their success guaranteed? Not necessarily. Can anyone name one Unicorn that emerged from Silicon Valley during the first dot-com boom to replace banks? However, this time it is different, especially in the payments arena, where commercial and retail bank transaction data and revenues are at risk. The biggest threat is a bank's unwillingness or inability to consistently fund a high cost project over many years while facing the pressure to meet quarterly earnings targets. However, inefficient legacy systems hold back the very thing that shareholders value most: a lower cost-to-income ratio, organic growth and higher return on equity. It is these areas that U.S. and European banks lag other countries that are further along with modernizing their core systems, such as Australia, Canada, China, India and South Africa.
The second biggest risk is a newer, or better, bank competitor with a better digital platform, operations, people and capital that leads to superior product offers, service, pricing, and customer loyalty. Core replacement planning, selection, and full implementation can take five to 10 years. Kicking the can forward on the core replacement decision can mean that the internal labor and capital resources — and external project implementation resources — may be in short supply when you absolutely need to replace the system. It will be too late to catch up, and financial and operational inefficiency will force some poorly performing banks to sell and others to scramble to adapt or die.
Most banks are moving forward with various types of core modernization activities, and will still be in existence five years from now. I doubt that half the world's banks will disappear within the next five to 10 years, as Gonzalez predicted. Since 2007, the number of U.S. community banks has declined at a compound annual rate of 3.5% — almost the same as that for credit unions (3.4%). At that rate, it will take 20 years for the number of U.S. financial institutions to be halved, and there are many forces in addition to technology driving that trend. Many are not moving fast enough and their core banking systems will not outrun father time or the competition, and they will disappear. Banks need to accelerate their core modernization IT investments, because the risk of waiting too long is that it will take too long to catch up.
Craig Focardi is a principal executive adviser at CEB TowerGroup.