The Payments Crossroad – April 2023 recap – The evolution of core banking systems
Just like any other software area, the technologies powering banks are evolving. But unlike many other software areas, their adoption happens in decades rather than years. Will composable banking change that?
Also in this month’s newsletter, Revolut joins the SEPA big league, BaaS is feeling the pressure, and why successful fintechs go multi-bank.
Heard about composable banking?
The core banking tech stack is undergoing the same transformation the e-commerce tech stack did 15 years ago: it’s being unbundled, moving to the cloud, and starting to have APIs everywhere. It’s becoming composable. For the best.
I know, big words, big claims, big concepts. We’ll cover them, but first, we need to understand what core banking is and how it evolved until today.
A quick history of banking tools
Banking tools are tools that enable banks to do their jobs. No surprise here. But what jobs are we talking about? What?is a bank? We can summarise banks’ role in 3 main tasks: keeping money, moving money, and lending money.
Banking tools are, therefore, tools that enable banks to keep money, move money and lend money.
They were no computers at that time, but banks still worked. Every day, branches’ physical general ledgers were manually updated and consolidated across the entire bank weekly in the bank’s physical general ledger.
Banking before computers
The first time the concept of banking as we know it appeared was around 2000 BCE. The first “modern” bank did so in the late 17th century. Yes, I got that from?Wikipedia.
They were no computers at that time, but banks still worked. Every day, branches’ physical general ledgers were manually updated and consolidated across the entire bank weekly in the bank’s physical general ledger.
Bank transfers within the same bank were done via coded messages, and interbank transfers were done through messages sent to the Central Bank that would transfer money between the relevant commercial banks’ accounts it held and update its general ledger accordingly.
Similarly, lending was also done via paper processes.
These processes worked. They have worked for hundreds of years and improved over time. But they faced obvious speed and scalability limitations.
The time of mainframes
In the late 1950s, banks started to adopt mainframes. Mainframes are super-powered (relative to the time) central computers used for bulk data processing. Perfect for updating ledgers, calculating balances, and, more generally, accomplishing the core tasks banks need to complete.
But as powerful, secure, reliable and proven as they were, mainframes had their own limitations. Mainframes were designed as single, central computers and not meant to be interconnected with other systems. As powerful as they are, a single mainframe can only process that many daily operations, meaning scaling implied upgrading to a bigger mainframe. This was costly, especially as banks needed to transfer data and business logic from one mainframe to the other. All that using the 60s’ COBOL programming language.
The monoliths
The core banking systems as we know them today first appeared in the 90s. They introduced bank employees and sometime customer-facing applications and interfaces on top of the back-office ledgers. They run on classic servers instead of mainframes, allowing more flexibility in their deployment, especially in terms of horizontal scalability.
As new providers launched their monolithic core banking systems and existing ones updated theirs, new capabilities were introduced, more connectivity was added on top of the still rather closed core, and a cloud version appeared. Core banking systems can now manage all banking needs, from card payment and issuing to complex regulatory reporting.
These core banking systems defined the banking world we know today: scalable, connected, available via multiple channels, and enabling relatively fast banking.
What’s wrong with traditional core banking?
Core banking systems are incredible systems. They support banks across the world, from local credit unions to the world’s largest tier 1 banks. They are the core of their operations, managing billions of accounts, transactions per day, and loans. They are part of what makes our economy run.
But the core banking needs are evolving.
Being at least a decade old, traditional core banking systems are based on technologies of these times, including architecture, coding language, and coding principles.
All or nothing
Monolithic core banking was designed for traditional banks and their complex needs. But new, smaller players now have to hold accounts, extend loans and enable payments. Or just one of the above. Traditional core banking systems are usually made to be used as a whole or require costly customisation to scale down. They are not adapted for smaller institutions that require only some critical functionalities of these platforms.
Hard to evolve
Being at least a decade old, traditional core banking systems are based on technologies of these times, including architecture, coding language, and coding principles.
This legacy they carry makes them hard to adapt to, hard to connect to, and hard to improve with additional modules. It makes it complex for their customers to add modern interfaces on top of their core banking systems, connect them to new payment methods or comply with new regulations.
For example, in their impact assessment on the instant payments initiative, the European Commission estimates costs for larger entities, such as banks, using traditional core banking systems to support instant payments to as much as EUR 1.3 million.
Enters composable banking
To overcome these limitations as well as address the needs of new market segments, a new generation of core banking systems appeared in the late 2010s. More open, more modular, hosted and managed in the cloud, and delivered via APIs, they enable a new way of thinking about the banking stack: composable banking.
Gartner defines a composable enterprise as “an organisation that delivers business outcomes and adapts to the pace of business change. It does this through the assembly and combination of packaged business capabilities (PBCs). PBCs are application building blocks that have been purchased or developed.”
Apply it to banking, and you get composable banking: the assembly of independent building blocks to build the exact banking capabilities you need, whether you are a global, tier 1 bank or a launching fintech.
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This approach brings many benefits to financial institutions of all sizes.
Shorter time-to-market
First, small ones can start small, working with, for instance, only the modules they need for essential account keeping, payments and the associated compliance.
Composable banking also enables faster time-to-market, for both new companies launching their first financial products or established ones looking to launch new ones. Once you’ve assembled your core blocks, you just need to connect the additional ones supporting your new offers.
Composable banking provides modularity by design and, therefore, easy upgrades. Whether you need to support a new payment method, adapt to a new regulation, or start offering lending products, you can simply add the corresponding building block to your stack.
Modularity
In addition, this approach means that there is now a market for best-of-breed, point solutions for every block — bank payments, card acquiring, card issuing, KYC, AML, ledgers, and FX. Specialised editors can position themselves on one or a few of these capabilities and provide a depth of functionalities and flexibility that traditional monolithic core banking systems couldn’t provide off the shelf.
Before composable banking, the only way financial institutions could get solutions customised to their needs and dictate their own speed of evolution was by building in-house or working with integrators to customise their systems.
With composable banking, financial institutions can buy the blocks they need off-the-shelf, easily adapt them to their specific needs, and connect them to the rest of their stack to build their perfect core banking system.
A new approach to banking stacks
Composable banking brings many advantages, but of course, it isn’t just magic and raises new points of attention.
First, selecting multiple building blocks from various vendors means interacting with more vendors, which can be challenging.
It also means that when something breaks, you cannot rely on your single vendor but must identify which part of your stack is causing the problem and potentially involve multiple vendors to resolve it. This can be expedited if the responsibilities are well defined and relevant monitoring is set up, but it is something to consider. One advantage of composable banking, on that note, is that a single block failing most likely won’t take your entire stack down.
Finally, while easier to integrate than traditional core banking systems because of their smaller functional scopes, modern APIs and documentation, composable banking blocks need to be assembled. It requires internal engineering resources or buying external services to do so.
Traditional core banking systems, as they are today, are here to stay for decades, at the core of the world’s biggest banks. But they will slowly decommission part of their capabilities to replace them with point solutions and add new capabilities on top of them with new solutions.
How to get there?
Obviously, the technology being available today doesn’t mean every financial institution worldwide can and should switch to composable banking today.
Depending on the complexity of their account-keeping needs, new entities can start with the core modules of a modern, modular CBS and add new capabilities as they need. Or just skip the CBS altogether and work with a standalone ledger, a payment API, and KYC and AML APIs.
Existing financial institutions relying on traditional core banking systems won’t re-platform to composable banking overnight. But they can start from the surface of their stack or offering, such as Intesa Sanpaolo working with Thought Machine to launch their digital bank Isybank. Need to support a new payment scheme? Connect your CBS to the schemes with an API gateway. Need to run KYC in a new market? Choose a point KYC solution that supports this market.
Traditional core banking systems, as they are today, are here to stay for decades, at the core of the world’s biggest banks. But they will slowly decommission part of their capabilities to replace them with point solutions and add new capabilities on top of them with new solutions.
The change won’t happen overnight for the entire industry. But composable banking is a game-changer for new financial institutions and will accelerate the adoption of new payment methods and banking interfaces and improve the customer experience of existing ones.
In this composable banking landscape, Numeral provides the gateway to payment schemes piece. If you’re looking to build or upgrade your stack, contact us ??
The crossroad
Building better banking experiences
Speaking of composable banking, ex-Mambu CTO launched Plumery. Plumery connects to legacy or modern core banking systems to provide modern APIs for easily building modern banking customer UX. A great example of how financial institutions can gradually evolve their stack into a composable banking one.
Revolut connects directly to SEPA financial network
In January 2022, Revolut obtained its Credit Institution licence, making it, at least regulatory-wise, a full-fledged bank. Up until this February, Revolut connected to SEPA as a SEPA indirect participant (learn everything about it in our dedicated guide). As a Credit Institution, Revolut got the possibility to become a direct participant, connecting directly to the clearing and settlement mechanisms. This new direct access gives Revolut independence from sponsor banks, most likely lower costs on payments, but also the ability to become a sponsor bank and offer indirect access to SEPA.
BaaS is the new crypto
It’s obviously an overstatement. Or at least we hope so. But regulators are looking more and more closely at BaaS businesses. BaFin, Germany’s regulator, disclosed a ban on Solaris from onboarding new customers without obtaining regulatory approval. The Bank of Lithuania did the same on PayrNet, the local subsidiary of already in trouble BaaS Railsr. Back in 2021, Bank of Lithuania also restricted European Merchant Bank’s ability to service existing and newly regulated fintechs. Pressure is mounting.
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Head of Operations at Universal Export International
1 年an exciting read, offering insights into the transformational potential of composable banking and how it aligns with broader industry trends and developments.