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As Banks Go Digital, It’s What's Inside That Counts

While consumer-facing tech like real-time payments and mobile banking hold great promise for banks, updates to behind-the-scenes infrastructure could be the key to cost savings and competitive advantage.

This year, European retail banking could be on the cusp of what our team at Morgan Stanley Research is calling “an operational revolution.”

With improved regulatory clarity and the prospect of normalized interest rates, technology will be the future battleground of differentiation for both consumers and investors. As an example, most bank consumers in developed markets are expected to have access to real-time payments by the end of 2018 allowing banking transactions to be completed with a swipe of the smartphone.

Regardless of how banks screen against each other, a focus on technology and constant IT investment across the sector will be paramount.

But customer-facing applications aren’t the only differentiators that investors should be watching. Indeed as mobile banking increases customer traffic, having efficient scalable back-end systems becomes critical. Behind the scenes, digitization in banking has the potential to boost back-office efficiencies, reduce operational risk and ultimately improve profitability. 

Transforming Banks into Tech Companies

Over the long term, tech advances such as artificial intelligence (AI) and blockchain will clearly play a role in the evolution of banking. However, modernizing the infrastructure backbone—that is, the core banking systems which handle the backbone of a bank’s activities, such as deposits and credits—is arguably the most important step banks will need to take.

In order to remain competitive, banks will need to update technology on the back end in order to deliver a seamless experience on the front end since customers will have little tolerance for glitchy apps no matter how sleek the user interface.

Meanwhile, investments in cloud computing and robotic process automation (RPA) should also take priority. Both of these investments offer an immediate opportunity for cost savings in the back office, while at the same time putting banks in a better position to compete with FinTechs. 

Finding the Leaders

The question for investors, then, is how to identify which banks are truly ahead of the curve. Every bank in our coverage has a digitalization plan. Yet, understanding and comparing how firms are spending their IT dollars is difficult; disclosure of IT spend in financial statements is not consistent. 

To better gauge infrastructure spending, our team recently analyzed IT expenses over the last five years—and earnings call transcripts over the last two years—to better understand how banks are spending their IT budgets, gauge their progress against their competitors, and identify banks with the highest potential for improvement.

Here are a few highlights:

Core banking systems: With many banks still operating off a patchwork of legacy systems, most banks will need to make some improvements to their backbone. Migrating to a state-of-the art core banking system could reduce cost/income by 9%.

However, because a full-scale move to a single system brings its own challenges, we expect that most banks will opt for “wrappering” existing systems; this reduces back-end functions to basic processing but centralizes data so banks can have a single view of their customers and add new technology to modern systems.

Cloud computing: Most of the banks we cover are moving to the cloud, which offers the potential to shrink relevant infrastructure costs by 30% or more. Leaders have already moved 10% to 40% of their servers and operating systems to the cloud, and many are targeting up to 80% by 2020.

The case for cloud computing, however, varies based on whether banks are already outsourcing IT functions, whether they plan to use a public, private or hybrid cloud, and what applications they migrate. Moving horizontal applications to the cloud, for example, is relatively easy but has limited cost impact, while moving vertical applications could be more material but is more complex to achieve.

Robotic process automation: Among all of the technologies on the table, RPA may have the greatest potential in the near term. Put simply, these applications (robots) transfer information from one system to another, automating processes previously handled by humans; this can include everything from customer onboarding and payment reconciliations, to fraud prevention and compliance reporting.

Based on our analysis, some leading banks are already deploying up to 200 robots and targeting as many as 1,000 in the future. While the obvious benefit of RPA is reducing headcounts, such automation reduces human error and reduces transaction times.

All this said, regardless of how banks screen against each other in these areas, we think that a focus on technology and constant IT investment across the sector is paramount to avoid the risk of being disrupted by new entrants and FinTech players. 

Note: Much thanks to Giulia Miotto for her research on digitization in banking referenced throughout this piece.

For more Morgan Stanley Research on European financials and digitalization, ask your Morgan Stanley representative or Financial Advisor for the full report “Digitalization in Banking: On the Cusp of Operational Revolution?” (Mar 13, 2018). Plus, more Ideas.