vk.com/id446425943
70	Citi GPS: Global Perspectives & Solutions	March 2018
	Figure 66. Payback Period For Core Banking Transformation

Note: The plot comprises 29 banks belonging to Tier 1 (>US$500m), Tier 2 (US$100-500mn, Tier 3 (US$5-100m), and Tier 4 (<US$5m) category, with a majority of banks belonging to Tier 3 and Tier 4 category.

Source: Capgemini Analysis, 2013; Core Banking Systems Cost Benchmark, IBS Intelligence, 2012

So systems upgrades are complex, costly and take time. But on the positive side, new systems enhance the customer experience, via reduced on-boarding and approval times, better straight-through-processing, and more agile capabilities to launch new customer offerings, thus helping to potentially drive superior revenues or lower cost to serve per customer. And crucially, they help secure incumbents’ competitive moats beyond just inertia and client laziness.

IT Change: Incumbents, Neobanks and Vendors’ Views

We find many incumbent banks are still reluctant to overhaul core banking systems, due to high initial investment, high execution risk, and long payback periods. To be sure, there is an argument to be made for banks not transforming their core banking systems but rather building new front-end and middleware solutions on top of their legacy core systems. (We do not think there is a credible argument for banks not adopting a digital strategy nor do we know of any major banks making that argument.) The argument against core transformation is that not only is it expensive and time-consuming, but that there is considerable execution risk.

[A] The Incumbent Banks’ View

The Australian banks were among the first to upgrade their core systems and have had a mixed experience as these projects often exceeded initial cost and timeline estimates and the actual benefits fell short of forecasts. We would note that these banks were among the first large banks to launch core transformation programs – announced in 2008, a decade ago – and since then both software vendors and third-party implementers have built a reservoir of experience which should reduce execution risk today.

© 2018 Citigroup

vk.com/id446425943		71
March 2018	Citi GPS: Global Perspectives & Solutions

We look at the experience of two of the first-movers below.

Commonwealth Bank of Australia (CBA) announced a replacement of its core IT system in 2008, and initially estimated the cost of the replacement would only be A$580 million (~$450m) over four years. The end result was A$1.3 billion ($1bn) over five years. By adopting the new SAP system, CBA did create a scalable platform, with some competitive advantages, such as real time processing, a superior customer experience, reductions in branch staff errors, and better speed to market with new products.

On the flip-side these benefits do not appear to have translated into significant market share gains. Furthermore, there are some areas that haven’t been as successful. The mortgage loan book has not been migrated over to the new system due to cost and complexity; Australian mortgages are customized products that don’t naturally fit. Annual IT costs have also failed to meaningfully decline following the completion of the project, albeit this is complicated by extra regulatory spend.

National Australia Bank (NAB) attempted a similar core IT system replacement with Oracle, rather than SAP. This project was hampered by serious issues with both the vendor system and the NAB IT infrastructure supporting the system. NAB ended up delaying the migration of existing customer files to the new system due to cost and complexity. New customers are entered into the new Oracle system, while existing customers remain on the existing 40-year old system and will need to be run off. The costs of this IT project are also expected to be multiples of the original estimates and the timeframe has moved from a 5 year project to a 15 year project.

NAB now targets an additional A$1.5 billion of investment spend over 2018-20. This is focused on: (1) customer journeys at scale; (2) enhanced technology resilience (e.g., cyber security, AML, regulatory requirements); (3) product & tech simplification; (4) digital capabilities, ecosystems; (5) automation, straight through processing; (6) SME digital investments; and (7) pricing analytics.

Figure 67. Australian Banks – Tech & Communications Operating Expenditure Per Year Continues To Rise As % Of Total Expense

11.4%

11.0%

10.3% 10.5%

9.4% 9.1% 9.2% 8.9% 9.5% 9.4%

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Source: SNL, Citi Research. Note: Different banks allocate tech spend differently, hence why we show an aggregate measure of operating expenditure. This measure excludes depreciation & amortization (see second chart for capex spend) and also excludes internal IT employee compensation (but will capture third-party contracts).

Figure 68. Australian Banks – Additional Capitalized Software Balances As % Of Total Expense (And Capex Net of Amortization)

12%	Amount capitalized per year as % of costs
10%	Amount capitalized per year net of amortization as % of costs
8%
6%
4%
2%

0%

2003 2005 2007 2009 2011 2013 2015	2004 2006 2008 2010 2012 2014 2016 2003 2005 2007 2009 2011 2013 2015		2004 2006 2008 2010 2012 2014 2016
ANZ	CBA	NAB	WBC

Source: Company Reports. Note: ANZ 2016 number was impacted by an accelerated amortization charge of $556m, relating to previously capitalized software balances

© 2018 Citigroup

vk.com/id446425943
72	Citi GPS: Global Perspectives & Solutions	March 2018

Transforming without a core system replacement. DBS, the largest bank in Singapore, has successfully transformed itself without replacing its legacy core system but rather by reducing its dependence on it. DBS launched its technology transformation back in 2009 and in 2014 accelerated that transformation in the face of growing digital competition.

While DBS called its transformation “digital to the core” – it would not simply apply “digital lipstick” to the front-end systems – the bank decided not to replace its legacy core banking system. Instead, DBS decided to reduce its dependence on it by moving functions to microservers and designing systems and processes which would migrate to the cloud.

Following this transformation, DBS says that its digital customers have a cost-to-income ratio of 34% versus traditional customers at 55%, and that digital customers generate a return on equity (ROE) of 27% versus an ROE of 19% for traditional customers.

Our take on DBS is that (1) it demonstrates the benefits for a bank that fundamentally transforms itself into a digital bank, (2) a bank that does so must reduce its dependence on its legacy core banking system even if it does not replace it but (3) that this approach is likely only an option for the very largest banks with scale and substantial resources whereas (4) banks lacking that size are likely better off using a third-party vendor to re-platform.

European Banks and Legacy Systems. In contrast to their Australian peers, the European banks are only now starting to review their legacy core banking systems. Two of the most prominent examples are Nordea and Bank of Ireland, which have announced agreements with Temenos to develop and deploy new systems over 2015-21 and 2016-21 respectively.

Nordea’s program is expected to cost €1.1 billion ($1.35bn) in total (split 70% capex, 30% opex), a 30-35% average annual increase in the banks’ IT budget. This would be equivalent to ~4-5% of annual Group costs. Nordea expects development spend and capitalization to peak in 2017, while IT-related intangible assets are expected to peak in 2020 (at ~€2.5bn) and depreciation & amortization in 2021.

Figure 69. The Nordea Program - Plan and Milestone Delivery

Source: Nordea Company Presentation

© 2018 Citigroup

vk.com/id446425943		73
March 2018	Citi GPS: Global Perspectives & Solutions

Bank of Ireland expects to invest €0.9 billion ($1.1bn) in total (mainly capex), or ~€0.2 billion per year, equivalent to a 50% increase in the annual IT budget, or ~10% of Group costs. The capex will hit CET1 capital ratios on day one (even though it will only be amortized via the P&L over time), so this will be a 35-45 basis point impact per year.

Figure 70. Bank of Ireland – Core Banking Platforms Investment Program

Key Activities

2016	2017	2018	2019		2020
	Implementing new systems		Launch to new
	and data cleansing		customers

Phased migration of existing accounts

Decommissioning of legacy systems and activities

Source: Bank of Ireland Company Presentation

These two banks are however still in the minority. Many European banks that we speak to still stress that it does not make commercial sense to overhaul existing core banking systems.

While most banks are talking about “digital transformation”, we’ve found banks are often only focused on the front-end. While this may enhance the functionality for the customer, many of the changes are just cosmetic. This does not necessarily address back-end infrastructure issues that matter in the long-run.

The common push-back we received from the incumbent banks was as follows:

Execution risk. These projects can be multi-year projects, with sizeable risk of cost and time over-run, and long payback periods. This high execution risk means that the immediate cost & revenue benefits need to be more tangible.

Rationalization required before replacement is even considered. Many European banks still operate with multiple core banking systems, especially if they operate on a cross-border basis and/or across multiple products. From a cost perspective the ‘low hanging fruit’ is first and foremost from rationalizing the number of systems that the bank operates with. This can then also significantly reduce the execution risk of migrating to a new system at a later date.

Existing core banking systems can be highly bespoke. Systems may be old, but they are still functional and have been adapted over time to suit a bank’s needs and product offering. It would be extremely difficult to replicate this with an ‘off-the-shelf’ vendor offering. The risk is then that ongoing running costs would actually rise, rather than fall, due to an inability to migrate legacy products. This tends to be particularly true for checking accounts, due to their long duration, and mortgages, where each country tends to have its own product nuances.

Big banks are complicated. Other large banks argue that their existing core banking systems are highly bespoke and difficult to replicate. Our view is that while this may be true, it applies much more so to the very largest global banks. As such, we think these banks are unlikely to rely on outside vendors for core banking transformations but may use them for smaller projects.

© 2018 Citigroup