Navigating through the core modernization journey

Most traditional banks realize the need to adapt and accelerate their transformation due to competitive threats, rising customer expectations, constantly evolving business models, and stringent regulations. Many banks have expedited their innovation and delivery efforts by acquiring new talent, technologies, and modern working methodologies. However, they remain burdened by legacy back-end core systems, many of which were designed three to four decades ago and are not equipped to meet the demands of today’s dynamic and challenging business landscape.

The legacy core banking systems are generally stable, offering fast and reliable transaction processing. However, the inflexibility and slow adaptability of legacy core banking systems can hinder banks from quickly innovating and launching cutting-edge products and services. Core modernization is inevitable for banks today due to several critical factors, including:

• Customer-centric experience and personalization: Customers expect slick digital journeys and experiences, which are not possible with old, aging legacy systems.
• Growth opportunity: Banks seek additional revenue streams and capture new business through open banking and embedded finance initiatives. These initiatives require API-driven, microservices-based architectures that are not supported by legacy systems.
  
• Operational efficiency and cost saving: Banks need to reduce technical debt and operational overheads typically associated with aging legacy systems, and cloud-enabled systems provide better alternatives.
• Technology resiliency: Though legacy core banking systems are reliable, their technology platforms pose a serious challenge in terms of scalability and continuity.
• Mergers and acquisitions: The banking industry, especially in the Tier three and four segments, is witnessing a surge in mergers and acquisitions among local banks and credit unions. These activities necessitate consolidating and rationalizing multiple core systems, making core modernization essential to streamlining operations, enhancing scalability, and driving efficiency in the post-merger landscape. 
• Regulatory compliance and security: Legacy systems pose a challenge to constantly evolving regulations, and manual workarounds have proven extremely costly and error-prone.

Many banks have prioritized digital front-end enhancements like mobile apps and websites over modernizing core systems. However, this focus must shift as these improvements are often short-lived. Several banks have been hollowing out the core or extracting smaller applications and services to extend the shelf life of their existing core banking system, while a few banks have truly moved to a flexible back end. Even if banks decide to move to a modern core, the core modernization projects are fraught with risk. According to McKinsey, only about 30 percent of CBS transformations succeeded in carrying out a complete migration of ledgers and products to a new system.

The modernization efforts of banks are hindered by challenges like the buy vs. build dilemma, long migration timelines, high costs, complex integrations, risk of failure, ecosystem disruption, and potential customer impact from implementation issues. These challenges must be managed and planned carefully; otherwise, the initiative could be delayed by a few years. Given the critical nature of the transformation, banks have to start in the right manner with the right resources and tools to make it successful. Adopting a game-changing strategy, selecting the right core banking system, aligning the team, and partnering with the right SI provider will put the bank firmly on its transformation journey.

Identifying the right strategy

Banks can consider several strategies to address the challenges of core modernization, each tailored to their size and specific needs:

• Re-platforming: This involves migrating code with minor upgrades to a newer platform, such as through version upgrades, without altering application functionality or requiring new skill sets.
• Re-factoring: Focused on updating the codebase, this strategy enhances readability, maintainability, and extensibility without changing its core behavior, paving the way for future adaptability.
• Co-existence/progressive renewal: This approach establishes a parallel core system to handle advanced requirements not supported by the legacy core. It allows the new core to operate for specific businesses, products, or services while serving as the eventual target for migrating from the legacy system.
• Replacement/Big Bang: This strategy completely overhauls the existing core and replaces it with a modern platform. While it demands a higher initial investment, it enables faster product launches and positions the bank for competitive growth.

The choice of strategy depends on factors such as the bank’s size, geographical presence, customer segments, product offerings, and business vision. It also considers the state of the current legacy system, including access to the codebase, integration complexities, and vendor relationships. Technical readiness, including agility, expertise in cloud and microservices, and program management capabilities, plays a critical role. Furthermore, banks must evaluate regulatory and compliance challenges, risk appetite for operational and technical disruptions, and the financial impacts of transformation efforts.

By carefully assessing these factors, banks can identify the most suitable path to modernization that aligns with their goals and resources.

Stakeholder alignment

Once the implementation strategy is in place, the other key consideration is how the bank is aligned internally for the core banking transformation. While the business and technology teams of the bank may align on the necessity of a new core banking system, they may not often share the same view of why it’s necessary. The CIOs and CTOs may want to modernize the system architecture to enable more capabilities, such as rapid product releases, and decrease technical debt. The business stakeholders may want to increase revenue through shorter time to market and create additional revenue streams, and CFOs may want to reduce overall costs. These competing priorities often result in significant misalignments, frictions, mismatched priorities, and mismanagement. This could derail the entire initiative and must be avoided at all costs.

For a key transformative initiative like core modernization, the bank needs to be aligned internally on common goals and objectives in a top-down manner across business, technology, operations, finance, program or delivery management, resourcing, and cultural standpoints. All stakeholders must be in sync and aligned to the common objectives. The figure below illustrates the key areas an organization must align to ensure a successful core modernization.

Insights from experience

Through our extensive experience in core banking modernization programs globally, we have observed that Tier 1 banks often opt for the co-existence strategy. This strategy is chosen because the bank is extensive and spans multiple products, services, and customers across various geographies and regulatory jurisdictions. Most of these banks have homegrown core banking systems, which are legacy, monoliths, and extremely complex systems heavily customized over a period of time. With the co-existence strategy the bank can retain its existing core and implement the new core to launch new and innovative products/services with a faster time to market. The bank gets enhanced product features or capabilities and significant time to market with the new core at a low risk, which they would have never achieved with their existing core system.

Over time, the bank can gradually migrate products from the old core to the new core as they embark on the journey of hollowing out the old core. This journey could take a few years, depending on the bank’s size and the legacy platform’s complexity. Though the co-existence strategy is a low-risk strategy of core transformation for large banks, there are significant overheads due to managing multiple core systems simultaneously. Hence, they need to be addressed and managed carefully to achieve success. The organization needs to be aligned internally on the goals, business priorities, timelines, cost, decision-making, delivery process, culture etc., across the business, technology, operations, and delivery to succeed. On the external front, aligning common goals and objectives with the product and SI vendors is critical.

Tier 2 banks opt for re-factoring or replacement strategy for core modernization. Most of these banks have out-of-the-box solutions from third-party product vendors, which can be replaced with an enhanced version of the same product or replaced with another vendor. In the replacement strategy, there will be an element of progressive replacement due to the complexity and the risk involved in replacement. The approach is less risky and cost-effective compared to the co-existence scenario. However, the alignment of stakeholders and the clear segregation of duties and responsibilities involving the product and SI vendors is crucial to achieving success. 

Tier 3 banks opt for the replacement strategy. Since these banks are mainly local/regional, the complexity and risk are much less than Tier 1 and Tier 2 banks. The banks are highly risk-averse due to their size and limited budgets. However, the risks can be managed with effective processes, methodologies, and governance. It may not be a Big Bang replacement of the legacy core, and there will be an element of progressive replacement of products and services. Still, the intention is to replace the existing core with the new one within a fixed timeframe and reduce the cost of running two cores simultaneously. There are many benefits of a progressive replacement, such as it helps reduce business, technology, people, and regulatory risks.

Role of a SI partner

To achieve solid stakeholder alignment across the organization, an organization should find an implementation partner with a similar level of vested interest in the transformation. Choosing the right partner with significant past expertise and experience in core banking modernization is crucial. An experienced partner can guide the entire transformation journey, align various internal stakeholders, and leverage industry best practices to avoid common pitfalls. They can identify critical risks early, develop effective mitigation strategies, and define clear modernization goals. Additionally, the proper implementation partner can help banks streamline and accelerate their transformation process by utilizing proprietary tools and accelerators.

Buy vs build dilemma

The other key consideration in core banking modernization strategy is to decide what kind of core banking system the bank wants to choose. Does it want to opt for a build, buy, or hybrid solution? Each type of solution has advantages and disadvantages, and the bank must decide on the best option based on its business objectives, time to market, risk appetite and technology capability/maturity.

Many banks opt for a hybrid approach, implementing a "headless" core banking system. These cloud-native, API-driven systems offer an out-of-the-box core ledger functionality and building blocks in terms of vendor-provided libraries and workflows for configuring additional products and services. They provide the best of both worlds for time to market, flexibility, and control. Additionally, these systems integrate seamlessly with the existing ecosystem, ensuring continuity, interoperability, and scalability.

Successfully modernizing core banking systems requires a well-thought-out strategy, emphasizing thorough assessments during the planning phase and choosing the right technology and implementation partners. Transitioning from legacy systems is essential for innovation and competitiveness, but the process comes with challenges, such as integration complexities and risks of operational disruption​.

To achieve their goals, banks must adopt flexible, agile, next-generation core banking systems built on modern architectures—cloud-native, API-based, and microservices-driven. Banks must adopt incremental approaches, like sidecar strategies or phased deployments, to reduce risk while enabling innovation. A dedicated focus on evaluating system needs, aligning with business objectives, and collaborating with reliable partners can ensure a smoother transition and long-term success in modernization efforts.

Notes: Raphael Friese, Harald Kube, Sebastian Schöbl, and Henning Soller, How to get a core banking transformation right: Eight mistakes to avoid, McKinsey Digital, February 17, 2022, How to get a core banking transformation right: Eight mistakes to avoid