From spaghetti code to the cloud

Jeroen van Herwijnen, Reinier Van Hessen, Merel Vrolijk

November 2018

The first thoughts that come to mind when FinTech is mentioned, are often the visible mobile applications. These applications disintermediate banks and drive the digitalization of financial services. Banks are forced to improve the user experiences and work closely together with FinTech companies to achieve this. In addition, FinTechs can also play an important role in renewing the core banking system, the heart of the bank. The core banking system is amongst other things responsible for payments, processing deposits and loans and functions as a client register.[12] Despite these responsibilities, it often runs on decades-old and complicated software.

Instead of moving to a modern core banking system such as cloud-based banking, banks typically spend 80% of their IT budgets on legacy technology maintenance.[3] Not only will it be less costly and more stable to get rid of their legacy technology, it will also be a requirement to stay competitive as the new PSD2 regulations facilitate market entry for regulated non-bank players. Therefore, transition to cloud-based banking is needed.

The problem of the legacy systems

FinTech companies are using the overall technological advances in IT and their access to the best technicians to develop unique applications and offer services.[4] As more and more FinTech companies are entering the financial sector, incumbent banks stand to lose up to 60% of their retail profits to these start-ups by 2025.[6]

Traditional banks are already trying to keep up with the fast moving changes in the market by developing their own new applications or by investing in and cooperating with these FinTech start-ups.[4] At the same time traditional banks are investing a lot of money to maintain their existing systems which are plagued by system failures. Recently, customers of Barclays, HSBC and TSB were locked out of their accounts and were unable to make crucial transactions due to an outage of the banks’ digital system.[16] This is just one of the many examples of the system failures that large banks experience nowadays. This raises the question whether the core IT systems of these large financial institutions should be replaced as they are unstable and expensive to maintain.

A concept that is often mentioned in this discussion is ‘legacy systems’. It refers to the decades-old systems that traditional banks still use. The so-called legacy code that underpins these systems is the Common Business-Oriented Language (COBOL).[5] COBOL is a computer programming language that was designed in 1959 and still drives the mainframe computers of traditional banks. The use of COBOL is often critiqued for its lack of structure and issues with compatibility. Already in 1975, in a letter to the Association for Computing Machinery, the preeminent software engineer Edsger Dijkstra stated that “the use of COBOL cripples the mind”.[7] The problem is not the age of COBOL itself, but the complexity and lack of structure it created in the legacy systems. Trying to update or add new features to these systems is a painstaking process, with ‘spaghetti code’ as a result. The term ‘spaghetti code’ is used for systems where everything is connected to everything else. “Pull on one thread and everything comes with it”.[3]

The costs of maintaining these ‘spaghetti systems’ are high and banks typically spend 80% of their IT budget on this.[3] In this way, only 20% is left to spend on innovations to keep up with the growing threat of FinTech companies. In 2015, banks spent about $188 billion on IT and this figure was expected to grow close to five percent a year.[2] As the pool of programmers that know COBOL is shrinking, labour is becoming more expensive.[13] These increasing costs of maintenance account for part of the growth on IT expenditure.

One might reason that given the above arguments, FinTech start-ups are easily taking market share from the incumbent banks. Due to PSD2, banks are required to open up their data to third parties.[18] This opens a door for FinTech companies to compete in the market of payment systems. Take for example Monzo and Starling Bank, two small challenger banks that operate using only mobile applications. Consequently, they do not have to cope with complex legacy core systems and can focus on incremental improvements to their applications.[5] On the other hand, FinTech start-ups have their own problems as they are struggling with regulatory requirements in the financial sector, have difficulty winning the trust of customers and often have insufficient access to capital.[4] For those reasons, the future of banks is not cast in stone, provided that they solve the problems regarding their core systems.

The cloud as solution

In the multiyear and costly process of transforming a core system, it is important to keep the objective of the transformation in mind. The new system should be more agile and have a more flexible infrastructure. This allows banks to adapt more easily and to meet regulatory requirements, client expectations, ever-changing performance improvement goals and demands for efficiency.[9]

One way to transform the core is by doing it within the company. A new core system can be built parallel alongside the legacy core, the core system can be renewed gradually or an entire new core system can be installed. Installing an entire new core system is very complex, risky and time consuming and therefore only suitable for smaller banks.[9] Another solution is to embrace the new players in the market and move the core system of a bank to the cloud.

Moving the core systems of banks to the cloud is beneficial for banks, because it would allow programmers to make continued updates, thus minimizing the necessity of a system overhaul in the future. Additionally, moving to the cloud will save banks money. Some technology experts expect that it could cut IT costs by 75%. Frank Sanchez from Finxact even said to FN London: “Within five years, the banks that are maintaining their legacy [core systems] will be so disadvantaged on the cost, they will either go out of business or be acquired”.[3] According to David Mitchel, president of core banking modernization company Nymbus, the cloud “is a business asset that no modern bank, regardless of size, can afford to bypass”.[10]

Why do banks still use these dated systems?

As all above arguments point in the same direction, you might ask why banks still use these old IT systems. Banks recognize that providing core services in the cloud can be beneficial in delivering agility, innovation and cost reduction. However, change doesn’t happen overnight in the banking sector.[19]

Banks often see legacy-related problems as individual issues instead of addressing it as one big problem.[3] It is therefore hard to get enough funding for a major spend which in the end saves the bank money. They have turned to short-term fixes such as middleware software, which can translate between different programs. With every new feature that they are adding to the existing system, they make migrating off that system harder.[3]

A culture clash between those willing to implement change and the more established staff is also slowing down the banks’ transformations.[11] A solution could be to split the IT staff of the bank into two distinct teams. The old generation is responsible for maintaining the legacy systems. The new generation is responsible for the digital transformation. This approach enables the bank to continue leveraging their historical strengths and at the same time gain agility and innovation.[11]

Another reason why the change is happening slowly is by the banks’ perception of risk involved.[8] CEB research shows that 46% of the banks indicate that core banking system replacement is high, or even very high, risk. System failure, regulatory fines or a system’s inability to enable growth could irreparably damage the bank. It is indeed a highly complex task to change these legacy core systems, but it is not risky if it is done right.[17]

Worldwide movements to the cloud

Banks are starting to recognize the importance of changing their legacy core systems and a cloud-based core system is considered a good solution. Where new risks arise because of FinTechs, FinTechs can also be a bank’s best friend. There are several FinTechs in different regions of the world that respond to the obsolete-core systems problem. Consider for example Mambu in Germany, Ohpen in the Netherlands and Finxact in the United States.[1] These companies are willing and able to help banks change their core systems and move it to a cloud.

Courageous bank executives are increasingly looking for ways to truly adapt their systems to the constantly changing requirements of clients, regulators and the market as a whole. We see this as a rising trend resulting in the growth of FinTechs offering these services. In the Netherlands, Robeco, SNS Bank (de Volksbank since 2017), Nationale Nederlanden Bank and Aegon Bank are examples of this increasing demand for cloud-based core systems.[14] Also worldwide this trend is visible. Name for example Nordea, Scandinavian’s largest bank, that is in the transition phase to a cloud-based platform.[15] Commonwealth Bank of Australia finished their cloud-migration in 2012.[13]

Ohpen, with Robeco, realized the first transition of a core system into the cloud globally in 2013. For Robeco, next to better security and adaptability of their systems, this resulted in a reduction of at least 50% of the total costs of their retail operation. Nationale Nederlanden Bank B.V. also experienced a good reduction in costs and an increase in customer satisfaction. CEO Erik Muetstege concludes: “The use of the core banking platform of Ohpen has enabled us to offer our clients a fully automated and improved discretionary wealth management solution, while decreasing our operations and IT-related expenses significantly”.[14]

We can be clear about one thing: banks have to change the way their core systems are structured and operating, rather sooner than later. Banks are not only struggling to keep their systems in line with changing regulations. They are also facing a big risk in losing touch with their customers, and therefore losing clients to new (FinTech) companies. There is no rationale for banks to keep their legacy systems in place and stay behind in the use of modern software technology. Migrating the core system to the cloud is a good solution. It will save banks a lot of money, make them more stable and make it possible to stay competitive in the changing financial environment.

So, banks: what are you still waiting for?


Footnotes

[1] Andreasyan, T. Banking technology-The definitive source of the global fin-tech sector. Oct. 2018.
[2] Arnold, M., and T. Braithwaite. Banks' ageing IT systems buckle under strain. 18 Jun. 2015: https://www.ft.com/content/90360dbe-15cb-11e5-a58d-00144feabdc0.
[3] Bobeldijk, Y. Banks face spiraling costs from 50-year-old IT. 12 Sep. 2017: https://www.fnlondon.com/articles/banks-face-spiraling-costs-from-archaic-it-20170912.
[4] Broekhuizen, K. and R. Betlem. Banken en verzekeraars ontfermen zich over financiële start-ups. 25 Jan. 2018: https://fd.nl/achtergrond/1270747/banken-en-verzekeraars-ontfermen-zich-over-financiele-start-ups.
[5] Chowdhury, H. Banks face continued IT woes as legacy infrastructure holds them down. 8 Oct. 2018: https://www.telegraph.com.uk/ technology/2018/10/08/banks-face-continued-woes-legacy- infrastructure-holds/.
[6] Dietz, M. et al. The Fight for the Customer. McKinsey & Company, Sept. 2015.
[7] Dijkstra, E. How do we tell truths that might hurt? 18 Jun. 1975: https://www.cs.utexas.edu/users/EWD/transcriptions/EWD04xx/ EWD498.html.
[8] Focardi, C. Banks too slow to modernize core systems. 17 Nov. 2015: https://www.bloomberg.com/professional/blog/banks-too-slow-to-modernize-core-systems.
[9] Geurden, W. et al. Surgically replacing core banking platforms. EY, 2016.
[10] Hansen, D. What are the benefits of a cloud-based core banking solution? 17 Aug. 2018.: https://biztechmagazine.com/article/2018/08/ what-are-benefits-cloud-based-core-banking-solution.
[11] Hemon-Laurens, A. Banks don't have to kill legacy systems to be more agile. 23 Jan. 2018: https://www.quadient.com/news-events/banks-dont-have-kill-legacy-systems-be-more-agile.
[12] Hickson, J. The death of core banking systems or a world of opportunity. 13 Oct. 2017: https://www.mash.com/en/blogs/core-banking-systems.
[13] Irrera, A. Banks scramble to fix old systems as IT 'cowboys' ride into sunset. 10 Apr. 2017: https://www.reuters.com/article/us-usa- banks-cobol/banks-scramble-to-fix-old-systems-as-it-cowboys-ride-into-sunset-idUSKBN17C0D8
[14] Ohpen. 2018: https://www.ohpen.com/.
[15] Quaresma, J. and A. Boudali. How do you fit a Core Banking System into a few containers? Accenture, Nordea, 2017.
[16] Sillars, J.. HSBC, Barclays and TSB customers hit by latest digital banking problems. 28 Sep. 2018: https://news.sky.com/story/hsbcs-uk-customers-latest-to-feel-app-misery-11510881.
[17] Skinner, C. The 10-year ticking time bomb – the timeframe for banks’ death. 9 Nov. 2017: https://banknxt.com/62073/legacy-core-systems.
[18] Tesselaar, H. How Open Banking will blow core systems out of the water. 26 Feb. 2018: https://www.finextra.com/newsarticle/31697/how-open-banking-will-blow-core-systems-out-of-the-water.
[19] Trossel, D. Why do banking institutions no longer fear the cloud? 22 May. 2018: https://www.4bridgeworks.com/why- do- banking-institutions-no-longer-fear-the-cloud.

References


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