‘Rip and replace’ is outdated: Progressive modernization is key to transforming the banking core

The financial services sector continues to dominate globally in operating profits, with a 2023 value of $2.86 trillion, surpassing other industries like basic materials, consumer goods and healthcare. The sector is also the largest spender on IT, with a substantial investment of $564 billion, according to a recent Zafin study in partnership with McKinsey.

Financial institutions are aware they must prioritize transformation to allocate resources toward innovation and stay ahead of consumer and market demands.

Despite this level of spending, when banking executives think about significant technology upgrades, the first thing that often comes to mind are lengthy, resource-heavy projects that drain time, effort and management attention. Even when there’s a clear need to replace outdated core systems, past experiences with large-scale projects that failed to deliver the expected results often cause hesitation.

This skepticism is understandable. Banks are now overburdened with the technology they do not need in the name of core transformation and modernization. Some are hesitant to adopt a “rip and replace” strategy due to the associated risks, including possible downtimes, data migration challenges and potential disruptions to customer service.

But today’s modular architectures and cloud-based platforms significantly reduce the risks associated with modernization. Instead of requiring years-long implementations, modern solutions position banks to adopt changes incrementally, delivering value faster and consistently as part of an ongoing transformation process.

The misconception of ‘rip and replace’

There is a widespread thinking that legacy core systems must be entirely removed and replaced to derive value, regardless of the significant time and financial costs involved.

This “rip and replace” strategy is often likened to a heart transplant — inherently risky, fraught with challenges, and carrying a high probability of failure. Yet, perhaps considered to have no alternative?

A major risk of this approach is the potential revenue loss from business disruptions, as all new business initiatives are paused during the transition to new core technology.

According to Mckinsey, over the past decade, only about 30% of core banking system transformations successfully migrated ledgers and products to a new system, suggesting that banks have not yet cracked the code on full implementation.

The prevailing assumption has long been that replacing a core system would solve banks’ legacy infrastructure challenges. However, this approach does little to change business outcomes or drive the product and relationship innovation banks desperately need to remain competitive in today’s market.

A proven and more efficient approach to core transformation is “progressive modernization,” where banks continue operating and introducing initiatives without shutting down their core business. This method follows three key steps.

Step one: Aligning technology transformation with business strategy

The first stage involves developing a comprehensive strategy that aligns business objectives with technology transformation. Banks cannot anticipate how technical challenges will impact their business strategy without a clear target state architecture for their technology ecosystem.

Cloud-based and microservices-enabled modern technology stacks with best-of-breed technology providers are important in this phase, as they enable banks to maintain flexibility while gradually transitioning from legacy systems. According to Capgemini’s report on cloud adoption, 91% of banks and insurance companies have initiated their cloud journeys, a significant rise from 2020, when only 37% of firms had embarked on this path.

Step two: Externalize products and pricing from the core

With the strategy defined, the next step involves transitioning away from the traditional core banking system, which has been hardcoded with layers of logic and functionality over time.

Instead, you are deliberately hollowing out your core banking system by taking out capabilities like products and pricing into a common cross-product layer where they can offer more flexibility and efficiency. This gradual transition is an important step in the progressive modernization journey.

Externalizing products and pricing enable banks to continue innovating with new business strategies, such as relationship pricing and cross-product bundling, while the underlying technology stack is simplified behind the scenes. At this point, business innovation can proceed without disrupting the core technological infrastructure.

Step three: Transition to a fourth-generation core without risk

Over time, as products and pricing are externalized, the core system reverts to its original role as a ledger. At this point, the bank can consider replacing its legacy mainframe-based core with a modern, fourth-generation core. By doing so, the bank can minimize risk, as the most important business functions are no longer embedded in the core and the product and pricing layer can act as the orchestrator between the old and new cores. This approach creates a system where the new and legacy cores can coexist, enabling the ledger’s gradual and seamless transition.

A 2023 study by research firm IDC and payment software company Episode Six projects that using outdated technology cost banks more than $36 billion in 2022 and could cost banks more than $57 billion by 2028.  And as EY emphasizes, banks that undertake modernization efforts stand to gain significant economic benefits.

With the right plan in place, this gradual process of progressive modernization ultimately only takes two to three years and positions banks to innovate and remain competitive without the disruption of a “rip and replace” approach.

Dinesh Krishnan is Cofounder and Chief Commercial Officer at Zafin.