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68	Citi GPS: Global Perspectives & Solutions	March 2018

own and use their personal data as they see fit. It potentially imposes severe financial penalties, up to four times global annual turnover on organizations which misuse personal data.

These new regulations are not merely a cost and operational burden on banks: in some cases, they also increase the risk of disintermediation. For example, in Europe, Payment Services Directive 2 (PSD2) requires banks to share customer data, with the customer’s consent, with third parties. And it also allows third parties to initiate payments from a customer’s bank account to a merchant’s bank account.

As such, PSD2 increases the chance that a third party could insert itself between banks and their customers by offering those customers a better user experience and superior product than the banks offer. PSD2 also offer banks with modern architecture the opportunity to exploit PSD2.

In the end, we think the question for banks arises as to whether or not it is more cost efficient to comply with these and future regulations with a more advanced core banking system. It also raises questions as to how these and future regulations change the nature of competition in the banking industry, and whether or not these regulations place banks with legacy systems at a competitive disadvantage.

Do Banks Need To Update Core Systems?

Both the technology and structure of major developed market banks has changed dramatically since core IT systems were put in place in the 1970s/80s. While most of the IT development has been focused on customer interfacing channels, an estimated two-thirds of a major bank’s cost base is not seen or touched by the customer. A myriad of systems have been developed to speed up processes and handle large volumes of accounts, but core IT banking systems remain the same.

A bank’s core banking system is essentially the back-end system used for deposit, loan and credit processing capabilities. This is used for daily banking transactions, such as making and servicing loans, opening deposit accounts, processing cash deposits and withdrawals and interfacing with general ledger systems to reconcile transactions and post updates to customers’ accounts and other financial records.

According to a survey by Temenos to identify where banks’ investment priorities reside, Core Banking systems were cited as the main focus area as it is a key driver of long-term cost efficiencies and is often a pre-requisite to maximizing the benefit of investment in other areas. Investments in Digital Channels were listed as a second priority, before a decline to Analytics, CRM & Regulatory investment. Meanwhile, Service, Payments & Virtualization bring up the rear.

Figure 65. IT Spending Priorities, 2014-2016

28%

	2014		2015		2016

24%

20%

16%

12%

8%

4%

0%

Core	Digital	Analytics	CRM Regulatory Service Payments Virtulisation
Banking	Channels

Source: Capgemini, Temenos

© 2018 Citigroup

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March 2018	Citi GPS: Global Perspectives & Solutions

When these legacy IT systems were created the banking world was a very different place: (1) Customers had a single contact point with the bank at their local branch;

(2) The key processes were “product”, rather than customer focused, with payments dominated by a multi-day check clearing system; (3) Many key functions which are now conducted centrally, like credit assessment, were conducted locally with significant discretion given to officers; (4) IT architecture was mainframe based, complete with processors, memory and operating systems, making business growth and scalability prohibitively expensive. While, the proliferation of servers in the 1980s/90s assisted, it often meant that banks ended up with large inventories of underutilized hardware, with thousands of servers using a fraction of their capacity.

In today’s digital world: (1) The customer demands multiple interfaces with the bank with various levels of human assistance, while many branch operational roles have been centralized and branches closed as part of large cost-cutting drives; (2)

Customer expectation is for a rapid on-boarding process, quick credit decisions, and (close to) real-time payments, else the bank risks being disintermediated by new neo-bank and FinTech start-ups; (3) Many business processes remain the same with large amounts of manual processes which could theoretically be eliminated and re-engineered in this digital world, while cloud adoption has the potential to significantly reduce capex required for the purchase of hardware and software.

Legacy bank IT systems have arguably reached the point of redundancy, as the convoluted integration of outdated systems has become too costly and unwieldy to persist with. Consequently bank managements have started to ‘bite the bullet’ and address IT systems as an enabler to driving sustainable cost savings.

However the path to achieving these productivity initiatives usually requires a costly, multi-year investment. Once underway management is typically committed to the resultant project and investment spend, regardless of any changes in the broader operating environment, or advances in technology that happen in the meantime (albeit upgrades can be negotiated with third-party IT vendors).

Updating core banking systems can result in various upfront charges for new hardware, system integration, new training and new license fees. In addition a new core banking system can lead to recurring maintenance charges, albeit a bank would typically look to more than offset this by retiring legacy systems and by streamlining back-office support and processing functions.

As the initial investment in a new core banking system is high, the payback period can stretch into multiple years. According to Capgemini analysis (see ‘Core Banking Transformation: Measuring The Value’), the payback period for Core Banking projects can range from 2.5-5.5 years with an average period of ~4.5 years.

© 2018 Citigroup