Core modernisation: the risks and the rewards

IT issues cost the Co-op Bank dearly

Core banking system replacement projects are notoriously difficult and disaster-prone, but successful legacy migration and systems modernisation can be shown to improve profitability, at least for smaller banks.

Two recent reports show both ends of this spectrum: the Kelly Report into the capital shortfall at the Co-operative Bank details failures in IT projects over several years in enough excruciating detail to give anyone pause for thought about the challenges involved.

On the positive side of the ledger a recent study, Restoring Profitability in the Digital Age, published by systems vendor Temenos and Deloitte shows “clear correlation” between profitability and systems modernisation.

That certainly wasn’t the case at the Co-op, where a six year IT “replatforming” project  was cancelled last year after adding £300 million to the bank’s capital shortfall, according to Kelly.

The independent review led by Sir Christopher Kelly was set up to study the events leading to the £1.5 billion capital shortfall at the Co-op Bank, including the troubled merger with the Britannia Building Society and Project Verde, the failed acquisition of 632 branches from Lloyds Banking Group. But IT issues take up almost as much of the final report’s 150-plus pages as the other problems.

Its conclusion is damning: “IT is at the heart of running an effective bank. Most banks have elderly legacy systems. Few have attempted total replatforming. Only a handful has done so successfully. None had succeeded in the UK at the time the Co-operative Bank attempted it. The Bank’s ambition to leap ahead of its competitors was commendable. But it was always an unlikely candidate for such endeavour. Success would have required strict compliance with best practice. What happened instead provides a case study of how not to go about it.”

Kelly goes as far as to sound a warning to others: “Before launching a significant IT transformation project, any institution is well-advised to test whether more modest alternatives will suffice. If it decides to go ahead, it must strive to keep the programme as simple as possible, phase delivery in a manageable way, deploy the right resources, plan for contingencies, and treat the programme as a business priority. The [Co-operative] failed in all these areas.”

For those that still want to proceed – and particularly for smaller, newer institutions – the Deloitte/Temenos study paints a somewhat happier picture. In particular, it demonstrates that banks that have modernised their core systems are more profitable: “Banks running modern core banking systems have materially better profitability metrics,” it concludes. “Over the past five years, banks using third-party banking applications have enjoyed on average a 19% higher return on assets, a 28% higher return on equity and a 6.5% lower cost-to-income ratio than banks running legacy applications. The correlation exists across a large data series, over time and across regions, the last being particularly important given the significant disparity between the recent performance of banks from emerging and developed economies.”

Even coming from a core systems vendor – and the figures show that this is true for users of rival vendors’ systems including Avaloq, ERI Bancaire, Infosys, Misys, OFSS, Sopra and TCS – this is a strong case, but banks are still reluctant to modernise their core systems, the report says. “There have been very few major IT simplification projects announced and kicked off by banks globally. As a result, the banking industry still has the lowest penetration of third-party software compared to any other industry.”

The researchers say that this largely comes down to cost. Between 1980 and 2007, the average return on equity for banks globally was 16%. Following the 2008 crisis, this has fallen dramatically and has remained at 9% for the past few years. Many analysts expect this to fall even further “One of the major reasons why banks have not launched any major IT simplification programmes is that IT spending (like M&A spending) tends to be pro-cyclical, that is, banks tend to spend much more freely when times are good and profits are high. Therefore it is not surprising that as profitability has remained suppressed, banks have not invested with any significance in third-party core banking software.”

The good news, the study suggests, is that: “There are many reasons to believe that IT renewal will pick up from here. Not only is it essential to grow profits, but the subject is on the radar of all major bank stakeholders including regulators. The perceived risks around IT projects are diminishing as third-party systems become more sophisticated and large system integrators build expertise in this domain. Lastly, other factors such as growing M&A, a need to leverage investments made in digital channels and a shortage of legacy IT skills will add to the pressure to renovate.”

Links:

Failings in management and governance: Report of the independent review into the events leading to the Co-operative Bank’s capital shortfall

Restoring Profitability in the Digital Age, Temenos/Deloitte