Banking Issues in the 21st Century - Modern Banking

A recent, popular opinion is that the contribution of banks to the economy will diminish significantly or that banks will even disappear, as the traditional intermediary and liquidity functions of the bank decline in the face of new financial instruments and technology.

Rybczynski (1997) argued that financial systems evolve through time, passing through three phases. Phase one is bank oriented, where most external finance is raised through bank loans, which in turn is funded through savings. Banks are the most important financial intermediaries in the financial system, and interest income is the main source of revenue. Phase two is market oriented. Households and institutional investors begin to hold more securities and equity, and non-bank financial institutions may offer near-bank products, such as money market accounts. Banks themselves reduce their dependence on the traditional intermediary function, increasing their off-balance sheet activities, including proprietary trading, underwriting and asset management. The market or securitized phase is established when the financial markets are the source of external finance for both the financial and non-financial sectors. Corporate bank loans are largely replaced by corporate bonds and commercial paper; mortgages and consumer credit originate in banks but are securitised. In this third phase, trading, underwriting, advising and asset management activities become more important for banks than the traditional core banking functions.

Bill Gates, the IT guru, is well known for an alleged remark he made in 1994 that banks were ‘‘dinosaurs’’, which could be bypassed. In 1995, after much consternation among the banking sector about his intentions, Mr Gates subsequently claimed he meant that banking systems were dinosaurs.

Before doing so, the performance of the banking sector is reviewed, together with a discussion of how banks might (and have) turned potential threats into opportunities.

Most studies show that the banking sector underperforms compared to other sectors; and a few argue banks are in an irreversible decline. Some go further, claiming that governments’ (or central banks’) control over interest rates, and therefore price stability, is under threat.

It is useful to begin by looking at some general figures to establish the position of the banking/financial sector at the beginning of the new century. Begin with the performance of banks measured by bank profitability. Figures below show, respectively, the ratio of pre-tax and post-tax profits to gross income for all banks over the period 1989–99.

In the 1980s, Japanese banks, already very profitable, became even more so. But banks’ profits elsewhere were either trendless or slipping. The late 1980s were marked by sharp swings in the profits of Anglo-American banks. After 1990, the situation in Japan changed substantially. There were steady falls in profits from 1990, with a dramatic decline in 1996–98. The recovery to average levels in 1999 was short-lived. Banks in France underwent steady declines in profitability in the early period, but profits have gradually improved since 1996. Like the previous decade, banks in the other major OECD countries show slight rises in the late 1990s, after some declines in the early 1990s.

Turning to the growth of bank assets, in the 1970s, bank assets grew rapidly in nominal terms across the 14 countries, but with wide dispersion, as shown in Table below and Figure below.

Luxembourg exhibited the fastest growth rate, which was more than three times faster than the slowest, the USA. More restrictive monetary policies and lower inflation contributed to the sharply lower growth almost everywhere in the 1980s and 1990s. The lower growth rate of assets also reflected a move away from the strategy of asset expansion to create large banks, or growth for growth’s sake, to an emphasis on maximising profits and shareholder value-added. Belgium was the only country where bank assets grew more quickly in the 1990s than the 1980s; and in Portugal, bank asset growth was faster in the 1990s than in the 1970s. Japan’s financial difficulties in the 1990s underline the collapse in bank asset growth – Japan saw the largest rise in the 1980s of the 14 countries, dropping to the lowest in the 1990s.

Figure below refers to banks’ foreign assets. Though there were some exceptions, foreign asset growth rates tended to outpace domestic assets in all three decades, as a comparison of Figures below reveals.

(a)Ratio of pre-tax profit to gross income.

Ratio of pre-tax profit to gross income.

(b) Ratio of post-tax profits to gross income.

Ratio of post-tax profits to gross income.

Average annual growth rate of domestic bank assets.

Average annual growth rate of domestic bank assets

Average annual growth rate of foreign assets.

Average annual growth rate of foreign assets.

Ratio of total domestic bank assets to nominal GDP.

Ratio of total domestic bank assets to nominal GDP.

Ratio of total bank assets (including foreign assets) to nominal GDP.

Ratio of total bank assets (including foreign assets) to nominal GDP.

Ratio of operating expenses to gross income.

Ratio of operating expenses to gross income.

A typical ratio of staff costs to income (Figure below) is about 0.35. The exceptions are the USA and Luxembourg, which averaged 0.27 and 0.21, respectively. The figures moved slightly downward over the period, except for Spain and Luxembourg. Figure below shows that average staff costs per employee rose over the decade in all countries except for Italy, where they fell slightly. The rise is consistent with the idea that more skilled staff are required as banks move into off-balance sheet activities. The differences between countries are notable. They were lowest in Portugal, the UK and the USA (averaging $33 000 to $43 000) but highest in Switzerland (about $89 000), the Netherlands ($83 000) and Japan ($78 000). The average for Germany was just under $50 000.

Figure below illustrates the average number of employees per branch in the 1990s.38 Again, there is quite a variation from country to country. Luxembourg has the highest, which corresponds to the relatively high staff costs shown in Figure below. They are relatively high for the UK, largely because Britain has fewer branches in relation to population than elsewhere in Europe. Employee numbers are quite high for Japan and Switzerland, in line with their high staff costs.

Figure below gives the financial sector share of total employment through the 1990s. The share has been quite steady throughout the decade in most countries – in the UK it has not changed over the period. Switzerland has by far the highest, averaging 3.11% over the period compared to figures between 1.5 and 2% for most other countries. In Japan, the share

Ratio of staff costs to gross income.

Ratio of staff costs to gross income.

Average staff costs per employee.

Average staff costs per employee.

Number of employees per branch.

Number of employees per branch.

Financial sector share of total employment.

Financial sector share of total employment.

is exceptionally low, averaging just 0.60% for the decade. It should be stressed that these figures relate to the financial sector as a whole, and not just banking.

A final exercise is to review the relative share price performance of banks, which gives an idea of what the markets think about the future prospects of banks compared to other sectors. Figures below show the performance of a bank share price index against the general market index for the USA, UK and Europe, based on the share price at the beginning of each month. The longest series is for the USA, for 1976–2001. With the exception of the mid-1980s, the US share prices were below the general share price index from the 1970s until about 1992, when they began to track the index in most years, rising above it in 2002. The performance of US investment banks was more volatile, but with the exception of 1999–2000 they outperformed the general price index from 1998 onwards.

UK banks consistently underperformed against the FTSE 100 until January 1994. From the beginning of 1996, banks do better than the blue chip firms, suggesting investors have a more favourable view of the prospects for British banks.

The European bank index is available from 1987 onwards (see Figure below). Bank share prices closely track the index, until January 1994. The bank share price index is below the general index through most of the period 1994–2001, then more or less tracks the index through to 2003.

A special index for Japanese banks (Figure below) begins in 1989; it was in December 1989 that the stock market began a steady decline which lasted over a decade and began to show signs of recovery in 2003, the time this book was written. It is unclear whether or not this is the beginning of a sustained recovery. From the information on the Japanese

US bank indices compared to the S&P500 index.

US bank indices compared to the S&P500 index.

UK bank index compared to the FTSE100 index.

UK bank index compared to the FTSE100 index.

European bank index compared to the Eurostoxx index.

European bank index compared to the Eurostoxx index.

Japanese Nikkei 500 banking index compared to the Nikkei 225 index.

Japanese Nikkei 500 banking index compared to the Nikkei 225 index

bank index in Figure above, it is clear that investors take a dim view of the prospects for the Japanese banking sector – the index consistently underperforms the Nikkei 225 throughout the period. This result is exactly what would be expected, given the severity of the problems experienced by Japanese banks over the last decade.

Turning Threats into Opportunities

The figures on the performance of banks are mixed. While profitability was fairly static, it appears banks are looking for other sources of income by expanding into non-interest income areas. However, the ratio of cost to income remained largely unchanged, and average costs per employee rose through the 1990s. During the 1970s, 1980s and early 1990s, the share price performance of banks was relatively poor when compared against general price indices in the USA, UK, Japan and Europe. From the mid to late 1990s, British commercial and US investment bank share price performance improved, though the latter was somewhat volatile. By the new century, US, EU and UK banks were either tracking or outperforming the relevant index, suggesting investors have a more positive outlook with respect to banks’ future prospects. Japanese banks are the notable exception to this trend. There are several major changes which the existing highly capitalised banks can (and must) turn into opportunities if they are to survive. They are by no means independent, and include electronic and financial innovations including the introduction of ‘‘e-cash’’, the growth of ‘‘non-banks’’ and the trend towards consolidation within national banking sectors.

New technology and innovation

Begin with the emergence of electronic (e-cash) or digital cash and assume, for the moment, that it has replaced currency in circulation – a cashless society. Based on the development of technology to date, e-cash can consist of stored value cards, network money and e-wallets. Stored value cards store prepaid funds electronically on a chip in the card. Mondex39 and Visa Cash are good examples. The ‘‘smart card’’ is another example of a stored value card, used widely in some parts of Continental Europe. Customers can download cash from their accounts into the card, so they can be used like cash, but are more secure than cash because personal information is stored in the chip, so only the owner can use the card. The reduced chance of fraud (compared to a debit or credit card) makes them attractive to customers and shop owners alike.

Network money is also prepaid but stored on a computer hard disc and transferred between agents via some network such as the internet. Also, assume agents use the e-cash to purchase goods and services by post, the internet or at physical shops. The e-wallet is an electronic version of a credit or debit card. Money is transferred from an individual’s account to the e-wallet, which can be used for internet purchases. All transactions can be traced back to the owner because the e-wallet contains the information.

Some experts have questioned whether the bank intermediary function will be challenged by the growth of e-cash. In this hypothetical world, could the presence of e-cash make banks redundant in the provision of core banking functions? To answer this question, consider each of these functions in turn. First, take payments facilities.

King is referring to the settlement of transactions – there is no mention of credit.

As Freedman (2000) stresses, the world of settlement envisaged by King would require a population of 6 billion having accounts, with funds transferred between them via the purchase or sale of assets.

Central banks play an important role in the settlements function. Most of the daily payments made by the household, business and government sectors involve a claim on a bank, and through a given working day, net payments are made to and received from the different banks. Some banks will find their settlement balances at the central bank have increased, others will have declined because they have experienced a net outflow of payments. Banks will use each other or the central bank to ensure their settlement balances at the central bank are kept at some minimum level. The central bank has assumed this role for numerous reasons. It issues the currency, and therefore cannot fail, and it also acts as lender of last resort.40 However, in the event of real time transfers, payments between banks would no longer be necessary (for the reasons given above) and this settlements function could, in theory, disappear.

Turning to the other core functions of the bank, taking deposits and making loans, the chance of banks being replaced is even more remote. With the most advanced technology the chances are slim, because of the time and cost of collecting the information required to locate the optimal place for a deposit, to pool risks with other depositors or to locate the most suitable borrower(s). Any software programme written to undertake these tasks is only as good as its author, and will quickly become dated. Banks are likely to be able to sustain a competitive advantage in an e-cash world because it would be more costly for individuals to replicate the banks’ global risk and information pooling role.

Banks also provide liquidity as a service to their customers. Though technology makes it possible to procure on-line liquidity in the absence of a third party intermediary, changes in liquidity preferences are a different matter. Suppose suitable borrowers are found for depositors, and a term of repayment dates, with interest, is agreed. During the term of agreement, the position of one party is altered: he/she wants the cash earlier or later than agreed. Banks, with a large pool of funds, are able, at a relatively low cost, to satisfy any changes in preferences and to profit from it, either by charging a penalty rate of interest on loan extensions or by reducing the interest paid on deposit, but in cyberspace, in the absence of an intermediary, satisfying changes in consumer preferences becomes far more difficult and costly.

However, the dominance of the payments system by major banks is under threat. Traditionally, the payments system has been a by-product of intermediation, which facilitates the transfer of credits and debits between agents. The growth of electronic delivery of core banking services has already given rise to the emergence of a payments system independent of banks. PayPal is a California-based company that offers business and personal customers a secure means of sending and receiving payments via email. Customers use PayPal if they are reluctant to provide credit card details to unknown internet merchants. Also, for tiny internet firms that cannot afford the cost of offering credit or debit card facilities, PayPal credits them for any purchases made via PayPal. PayPal takes the credit card number and pays for any item on behalf of the customer. Its main source of revenue is fees earned from transactions charges. Its early success was largely due to one major customer – PayPal arranges payments on behalf of e-Bay, an electronic auction site with a large customer base. However, the company is trying to attract a wide customer base. In 2002, just as many banks were prohibiting customers from using their cards for on-line gambling; these casinos have been signing up to accept PayPal. Attempts are being made to pass federal legislation to ban on-line gambling in the USA.

The average fee per transaction is $1.78, and the average PayPal customer has seven to eight transactions per year. By early 2002, PayPal had over 15 million customers, giving it a substantial revenue source which is profitable, given that the cost of processing an email payment is well below $1.41 The firm successfully went public in early 2002, despite the ‘‘tech’’ stock fallout at the time. In April 2002, it reported a first quarter profit of $1.2 million. It competes against payment providers such as credit card firms which charge higher fees, due to the cost of fraud, among other factors.

It is too early to judge whether PayPal will be a success. Payments are made via a credit card, from a bank account or a PayPal account. A website called has anecdotal reports that PayPal pressures customers for access to their bank accounts. It offers a cash payment if customers transfer funds from their bank accounts to a PayPal account – deposits earn the money market rate. However, any attempt to withdraw the funds is costly and difficult. The FDIC42 has made it clear PayPal is not a bank, meaning funds held in PayPal accounts are not covered by deposit insurance. However, PayPal transfers its customers’ deposits into FDIC insured banks, which, according to PayPal, means the deposits are covered by insurance, even though PayPal makes them on behalf of customers.

On the Paypal Warning website, there are unverified reports of accounts being debited by PayPal in the absence of any purchase. Yet another threat comes from Master card. In April 2002, it announced it would not allow credit card payments to go through outlets like PayPal because the credit card firm has far less control over its high risk customers who use PayPal. However, PayPal is confident of gaining an exemption from the exclusion. A number of states are questioning whether PayPal is, de facto, a bank, especially as it expands its services, offering credit and debit cards, money market accounts, international payments and on-line bill payments. Louisiana has asked PayPal to cease offering services to its residents until the firm has obtained a state licence to transmit money. Like any website, it attracts viruses and worms. In the first two months of 2003, several email worms have been part of bogus messages on security changes, purporting to be from PayPal.

Some would argue the growth of firms outside the banking system offering payments is a healthy development. Recall the concerns expressed by Cruickshank (2000) over the monopoly power of the ‘‘big four’’ banks in the United Kingdom. Firms such as PayPal will undermine this monopoly and improve prices for consumers, though it is worth remembering that PayPal’s services are confined to e-commerce. If payments are offered by non-banks, it does not follow that the core intermediary functions are under threat. Furthermore, if organisations such as PayPal expand to the point that they are effectively banks, the regulators will almost certainly demand they be registered as banks, subject to all bank regulations.

The above discussion indicates that the traditional intermediary and liquidity functions of banks appear reasonably secure. However, some off-balance sheet subsectors are potentially more vulnerable. Large non-banking corporations engaging in the direct trade of financial instruments, such as swaps, just as corporate bonds or commercial paper are used to raise finance instead of loans – both challenge this intermediary role. Likewise, medium sized and large corporates could use the internet to successfully bypass banks when searching for loans and trade finance. However, for banks to lose their competitive advantage, these firms need a more cost-effective way of dealing with credit, settlement, liquidity and other financial risks arising from these transactions: to date, it is the banks which have excelled in financial risk management. Also, established banks are anticipating these new threats and finding new ways to keep this business. For example, Barclays Bank is experimenting with a new service which offers their risk management expertise and, in addition, a business-to-business exchange whereby corporate customers can get information on a large range of products and services, from cheap sources of office equipment to recruitment.

A number of small, specialised on-line investment banks have been established in the USA, though their focus on the technology sector meant they were hit badly by the burst of the technology bubble. On a more positive note, some of the traditional investment banks are taking advantage of the opportunities offered by the internet. An established investment bank has developed a system to put initial public offerings (IPOs) on-line. The prospectus is posted on the internet, and videos replace traditional visits to investors to sell the new issue. Traditionally, an IPO was underwritten by a well-known investment bank. In some cases, a very small percentage of the IPO is released on the market, thus creating excess demand and raising the price. The underwriter (investment bank) profits from the sale of their shares before official trading begins. Most retail investors have to wait until the official markets open. Access to the internet means a much larger pool of investors has access to the IPO information, which could erode the dominance of the institutional investor in this market. For example, one American investment bank reports institutional investors have dropped from holding 80% of the issues to just 27% in one year. The more direct access will benefit the retail or smaller wholesale investors. Thus, the presence of IT will challenge the current favourable position of institutional investors, but banks will continue in their intermediary role. However, there are fewer barriers preventing firms from arranging their share issues independently. Again, the question is whether the bank can remain competitive, arranging the IPO at a lower cost than the issuing firm could. For example, if a firm declines the services of an investment bank, it runs the risk of being unable to place the shares at the expected price; an investment bank would normally underwrite the share issue. Large corporations may have the expertise to arrange an in-house IPO, which is unlikely to be the case for smaller firms.

The rapid growth of the internet is also likely to change the way the bond market functions. In 2000, the World Bank employed two investment banks to issue new bonds direct to investors via the internet – e-bonds. Other key borrowers have announced their intention to do the same. An e-bond creates greater transparency in the market because the borrower knows the end investors, and the size of their commitments. Like the internet IPOs, it also opens the market to new investors, so reducing the dominance of institutional investors in these markets. For example, the e-bonds issued by the World Bank attracted investments ranging from $1000 to $250 million worth of bonds.

The influence of institutional investors is also being challenged as the secondary markets go on-line, with well-established investment banks leading the way. Goldman Sachs, together with some other well-known investment banks, set up Trade Web in 1998, which trades US Treasury bonds. A European equivalent was established in 2000, called Bond click. There are also on-line services providing information on the prices of bonds issued from all over the world. However, to date, only frequently traded highly liquid bonds have been targeted for electronic issue and trading.

The impact of the above trends should be a reduction in the fees charged for the issue of new shares and bonds, and a narrowing of the bid–offer spread in the secondary markets, which could undermine the profitability of these activities. At the same time, however, related costs should be lower once the IT investment has been made. For example, the use of interactive TV to market new issues could replace expensive sales teams. It is also important to stress that it is the well-known investment banks leading the way with respect to on-line investment banking.

The development of e-cash also has macro/monetary implications. In separate papers, Good hart (2000) and Freedman (2000) considered the issue of e-cash from the standpoint of the central bank. Both authors argue there is still a role for the central bank in setting monetary policy via short-term interest rates, even if it is accepted that a cashless society will emerge. The central bank only need raise/lower the rate by offering to borrow money at a rate higher/lower than the going market interest rate. These operations (and possible losses arising from its intermediary role) would be backed by government. Alternatively, Good hart noted, a government could require all taxes be settled in a currency issued by the central bank if it wanted to keep a monopoly over the currency. Freedman makes a similar point: the central bank, especially if it continued to act as banker for the government, could refuse any alternative settlement mechanism and insist on settlements in the currency or a government digital currency. These points demonstrate that sovereign states, should they choose, can undertake very simple measures to have a currency alternative to e-cash and will have sovereignty over monetary policy even in a digital cash world.

Drehmann et al. (2002) ask whether an e-cash society is imminent. They cite qualitative evidence showing a strong demand for currency. In the UK, cash holdings per capita rose from $470 in 1990 to $695 in 1995. In the USA, the respective figures were $998 and $1908; in Japan, $2003 and $4594. Similar trends were found for the major OECD countries. The authors identify several reasons for the sustained demand for cash. Cash is easier for certain small transactions, and is sometimes needed for the occasional one-off large payment. ‘‘Hoarders’’ hold certain foreign currencies (the dollar or Swiss franc) to hedge against inflation in their home countries or political uncertainty. The desire for anonymity, for legitimate reasons or otherwise (black markets, money laundering), also preserves the demand for non-digital cash. Some people, on a point of principle, will not succumb to the lure of e-cash because all transactions are traceable. Even if it became possible to eliminate the trail, there is no guarantee the other party will keep the transaction secret.

The authors also show (where data are available) that the cost of cash as a payment method for retailers is considerably lower. In the Netherlands, the cost per transaction (in euros) of cash is 0.095, compared to 0.22 for on-line debit, 0.25 for an e-purse and 2.5 for a credit card. In the USA (in dollars), the figures are 0.12 for cash, 0.34 for an on-line direct debit, 0.36 for a cheque and 0.72 for a credit card. E-purse costs are not available for the USA.

Drehmann et al. (2002) produce figures showing the demand for products giving electronic access to bank accounts (credit/debit cards) has been much greater than the demand for e-money. The number of debit card transactions per capita in the UK was 0 in 1988, rising to 35 by 1999. Canada’s and Denmark’s per capita card use rose to 54 and 68, respectively. Credit card transactions underwent similar increases, though their growth rates have been overtaken by debit cards. For the few countries reporting figures, e-cash transactions per capita, at its highest, was 4.45. However, the figures should be treated with caution because e-cash, like the debit card in 1988, is relatively new.

Drehmann et al. claim the threat of counterfeiting is a serious security issue for e-cash issuers. While counterfeit currency is a relatively minor problem,44 the costs incurred to protect e-cash from counterfeit are considerably greater. Providers must bear the cost of frequent technical updates, limiting the amount stored on cards and the duration of e-money balances. Such costly security precautions will limit demand; for example, hoarders or those seeking anonymity would not want to use e-cash.

Using econometric analysis, Drehmann et al. provide convincing evidence that the replacement of currency by digital cash is some way off. The authors identify two separate markets for currency; the illegal group who demand cash for large value payments, and another group wanting small bills to pay for incidentals such as newspapers, sandwiches or bus tickets. The sample consisted of panel data for 16 OECD countries over the period 1980–98. Two separate equations were tested, one with log(cash[large]/GDP per capita) as the dependent variable and the second using log(cash[small]/GDP per capita). Each equation was regressed against a number of independent variables. The main findings were as follows. First, both the demand for large and small bills was found to be interest sensitive, with a significantly negative coefficient. As interest rates rise, the demand for large/small bills falls. The demand for currency was found to be positively related to increases in real expenditure, though the degree of significance varied from country to country. An increase in taxes (taxes: GDP) increases the demand for large bills in the pooled sample, and in some of the individual country equations. Card payments should be easier with EFTPOS, meaning the demand for currency would fall. The sign is negative but insignificant. The ATM coefficient was positive but not significant for small cash holdings; negative and insignificant for large cash holdings. The authors conclude that EFTPOS reduces the demand for currency, but this has been somewhat offset by ATM usage, which eases payment by cash. However, the overall impact of card technology is relatively minor. The main factors which discourage the growth of a cashless society, the authors argue, are the need for anonymity, the hoarding of certain foreign currencies, the cost of keeping digital cash secure and inconvenience, for example, the need to remember PIN numbers.

E-banking and other remote delivery channels

It is important to draw a distinction between the question of whether digital cash will replace banks and the presence of electronic products which change the way intermediary banking services are delivered. They are two quite separate issues. The main attraction of IT-based remote delivery/distribution of banking services is lower costs. There have been a number of estimates.

  • A survey undertaken by Booz, Allen and Hamilton47 (US accounting firm) reported comparative costs per transaction
    • branch banking: $1.07
    • telephone: 54 cents
    • ATM: 27 cents
    • internet: 1.5 cents
  • Wood (2002) cites similar figures
    • branch transaction: $1 per transaction
    • on-line transactions: 1 cent per transaction
  • Bainbridge et al. (2001) report that including the IT systems required, internet transaction costs are 10% of those incurred by a traditional branch.

The Scandinavian countries, especially Finland and Sweden, have been very successful in attracting customers to e-banking. Suominen (2001) reports that 30% of bank customers in these countries either use the internet or engage in PC banking via a modem. In Sweden, tax incentives mean 65% of households are on the internet. The proportion of internet customers is treble that of the European average. Nordea48 is often cited as the world’s leading internet bank because it customers complete 7.2 million on-line transactions per month, twice that of the Bank of America identified (at the time) as the second most internet active bank. The leading Scandinavian banks have also integrated stock broking and e-shopping (over 900 shops in one case) with their internet banking. Mobile banking, with the use of a smart card, is also on offer. To date, no serious breaches in security have been experienced. These banks have managed to produce a high quality deposit product and to cross-sell a diverse set of services.

Suominen identifies several reasons for the success of e-banking in Finland and Sweden. First is the use of account transfers through a centralised clearing system in place of a cheque-based or direct debt/credit clearing system, which meant the technology was in place for on-line banking. The account transfer system involves the real time transfer of credit/debits from one account holder to another. The person making the payment provides not only his/her account number, but also the account details of the recipient to the bank, and the transaction is settled.

A second reason for the success of Finnish and Swedish internet banking is due, Suominen argues, to a concentrated banking sector. In 1999, the combined market share of household deposits for the five largest banks was 90% in Finland and 83% in Sweden, compared to an EU average of 58%. The high degree of consolidation and lack of competition meant banks could set fee structures and price deposits/loans to attract customers to on-line banking. Once the technology is in place, the marginal cost of e-banking is nearly zero, making for a profitable operation. Though fees were reduced to attract customers to on-line banking, their more frequent use of the system has boosted operating income. Linked to the rapid increase in e-banking was a fall in the cost-to-income ratios for the banks in both countries. In Finland, the cost-to-income ratio in 1999 was just below 60%, compared with a G-5 average of about 65%. The Swedish banks experienced a temporary increase in the C–I ratio towards the end of the century,49 but by 2001 it was also below 60%.

Suominen cites additional factors contributing to the success of e-banking. Opting to offer e-banking by the bank rather than a separate subsidiary gives branch managers an incentive to sell this form of banking to their customers. Major security breaches have been avoided, increasing consumer confidence. At Nordea bank, customers use both a permanent password and a list of passwords that are only used once. A new list of passwords is sent to the customer once the list is exhausted.

Suominen acknowledged the use of e-cash is still quite low but expects demand to grow with electronic identification cards (SIM cards), along with m-banking, banking via the mobile phone.50 However, whether the growth of e-cash will be as successful as the emergence of internet banking is unclear. In both these countries, the per capita value of cash holdings actually rose between 1990 and 1999; from $1224 to $1303 in Sweden and from $472 to $506 in Finland. As in other western countries, per capita debit card and credit card transactions rose during the 1990s – in Finland debit card transactions increased from 11.4 in 1987 to 51 in 1999. By contrast, there were only 0.1 e-money transactions per capita in 1999; the equivalent figure for Sweden was 0.02.

According to Pyun et al. (2002), Scandinaviska Enskilda Banken (SEB) of Sweden introduced (European) cross-border internet banking in 1998 – its first targets were Germany and Denmark. However, penetration of different EU states will remain difficult because of the poor integration of European payment systems. Retail interbank cross-border payments are costly and slow, hampered by problems such as the absence of a single standard for processing direct debits, cheques, etc. Until a single interbank payments system is adopted (the EU has agreed to introduce a common international bank account number and international payments instructions but no date has been set for their implementation), the integration of European retail banking will be difficult, be it via the internet or more traditional methods. Diverse computing systems in the EU will also have to be integrated, requiring a substantial outlay. Cultural differences, labour laws and European directives on the use of the internet put more obstacles in their way.

Internet banking has had some success in the United States. Between 1997 and 1999 the number of US banks offering some form of internet banking increased from 100 to 1100. Just under 40% of US banks (regulated by the Office of the Comptroller of the Currency) offered internet banking services in January 2001.52 Regulators expect about half the US banks will offer this service by 2002. The top 120 banks (with about 75% of the US bank assets) offer some form (e.g. checking balances, paying bills and transferring money between accounts) of interbank access. The number of customers using the service remains small (proportionately, compared to Scandinavia) – about 13 million households banked on-line in 2000. But the figure doubled in one year, and if this growth rate continues, large numbers of Americans will be using it.

Pyun et al. (2002) report that both NetBank and E*Trade have been able to attract relatively low cost deposits and profit by transforming them into high yield assets. NetBank, opened in 1996, is the largest of the branchless internet banks, operating in 50 states and 20 other countries. E*Trade began as an on-line discount broker but opened a subsidiary, E*Trade Bank. Both banks offer a full range of internet retail banking, but other innovative services suggest both have found a formula to be profitable internet banks. For example, NetBank customers can use their website to view accounts held at other banks, brokers orcredit card firms. E*Trade opened a branch in New York City, benefiting from some forms of P2P (person-to-person) relationship banking. Others have fared less well, and interbank subsidiaries have recently been integrated with the parent bank’s internet banking division. These include Wingspan, now a part of its parent, Bank One,53 and Security First Network Bank, part of the Royal Bank of Canada’s on-line (US) bank subsidiary.

Pyun et al. (2002) identify two major internet banks in Japan. In 2000, Japan Net Bank (JNB) was established by a consortium of financial institutions, including an insurance firm. JNB offers the standard retail banking services (with access to cash via over 100 000 ATMs), mutual funds and insurance. In 2001, Sony Corporation set up Sony Bank, another bank with no branches, offering all the standard transaction banking services. There are also two relatively minor internet banks, eBank and IY, and a number of on-line brokers offering securities trading. At the time of writing no internet bank was reporting profits.

In the UK, virtually all the (11) major banks offer on-line banking; many of them through subsidiaries. For example, Smile, Egg and Cahoot are subsidiaries of, respectively, the Cooperative Bank, Prudential (an insurance firm) and Abbey National. In the early years of operation, most UK e-banks reported losses, though in the second quarter of 2002, Egg reported pre-tax profits, a first for a UK internet bank. Security breaches plagued Egg in the first year of its operation. Customers found they could read the details of other customers’ accounts; later some hackers were able to access their systems. Barclays Online opened in 2000, but suffered serious operational and security problems. Heavy use slowed transactions and at one point, the system crashed. Following work done on the computer software, customers found large amounts missing from or wrongly deposited in their accounts; others entered their passwords only to obtain another client’s account.

Customer concern over the security of the systems may slow the growth in demand for these new forms of delivery. Information technology literate clients are probably the most suspicious of any claim that an internet-based service is secure; and there is also the challenge of convincing new users of PCs and the internet/iTV that a system is secure. Nor is the track record for resolving these problems very good: a common complaint is of ‘‘phantom’’ withdrawals of money from accounts via ATMs. Yet for 20 years, British banks appeared unwilling or unable to deal with the problem and, in the absence of hard evidence, usually blamed the customer for a security lapse. Recently, it became possible to video all transactions, enabling banks to identify the true phantom withdrawals, though the problem itself remains. With the advent of on-line and iTV banking, where a client’s information is available at multiple sites, security breaches have the potential of rising at an exponential rate. These security concerns, together with consumer inertia, may explain why banks world-wide (with the exception of the Scandinavian countries and possibly Japan, where electronic innovation is popular) are taking a measured or ‘‘click and brick’’ approach in the transformation of delivery from branch (brick) to IT (click) banking. However, the success of Sweden and Finland suggests security concerns can be overcome.

Consumer groups have expressed concern about the potential for financial information on individuals to be passed between financial firms without the client’s knowledge. This is not a new problem – just think of the numerous complaints to banking ombudsmen (or equivalent) that a customer has discovered he/she has been given a poor credit score because of a past misunderstanding with a financial firm that turned out to have nothing to do with the client’s creditworthiness. In the absence of adequate data protection laws, the potential for mistakes will rise with the number of electronic transfers of information.

Like internet/on-line banking, digital interactive television banking presents the banking sector with an opportunity for a complete overhaul of the way it delivers or distributes core banking services. The interactive nature of iTV banking makes it attractive; an added bonus is that virtually every household (98% in the UK) owns one, and is television literate. In the UK, there is a government initiative to have all households on digital TV by 2010. The existing banks (with the capital to back the very high start-up costs) have opened up the television banking market. HSBC, the third largest bank in the world (ranked by tier 1 capital – see The Banker, July 2003) launched the first interactive banking service in the UK in October 1999. The Woolwich and Abbey National (Cahoot) have since followed. Barclays should gain immediate expertise in this, after purchasing the Woolwich in 2000. One outcome may be that on-line banking remains a limited service offered to a select group, while television banking appeals to the masses. However, it is worth emphasizing [96 ] that on-line and iTV banking have been offered almost exclusively by existing banks or their subsidiaries, not new entrants.

De Young (2001) is one of the first researchers to study the financial performance of groups of banks, what he calls ‘‘pure play’’ internet banks compared to standard branch banks or thrifts. The study uses quarterly US data for the period 1997Q2 to 2000Q2. Only six banks/thrifts met the strict criteria54 to qualify as pure play, giving an unbalanced sample of 38 observations, against 3225 for the benchmark banks/thrifts. Both groups are de novo (newly chartered) banks that commenced operations in the period 1997–99. Using 17 measures of financial performance in a multiple regression model, De Young found that the internet banks were significantly less profitable than the branch banks of similar age, offering similar bank services. Several factors contributed to the lower profitability. The internet group’s relatively low physical overheads were more than offset by high non-interest expenses – largely in the form of high staff costs. Hence overall, overhead costs were not lower. Furthermore, there is no evidence that these banks pay higher than average deposit rates. He found non-interest income ratios were significantly lower than for the benchmark banks, suggesting the absence of ‘‘P2P’’ contact makes the cross-selling of other services more difficult, which in turn will lower revenues. Finally, the internet group had higher asset growth rates which outstripped the growth of deposits, forcing them to draw on relatively expensive equity capital to fund the growth.

De Young acknowledged the limitations of his study, such as a very small sample size of pure play banks. Furthermore, critics might argue that these banks (and e-commerce firms in general) simply take longer to become profitable. Finally, it may be that internet banking is more successful if offered with traditional branch banking. Furst et al. (2000) employ a large database of US commercial banks, but use a broader definition, i.e. any bank which offers an internet service. They find the typical internet bank is more profitable than non-internet banks, and generates more non-interest revenue.

The amount of capital required to offer PC, internet or iTV banking will require deep pockets for existing banks and new entrants. Innovations such as on-line banking and iTV banking should reduce the need for banks to have a global presence, because they can offer banking services via the internet without setting up costly branches or subsidiaries in other countries. In Europe, cross-border mergers continue apace, though attempts at cross-border internet banking have not proved successful to date. There are problems to overcome, especially with the payments system.

To summarise, most of the evidence to date suggests the emergence of a cashless society is unlikely. Cash remains attractive because of the considerable costs associated with making e-cash secure, it is convenient, ensures anonymity and provides residents of unstable countries with an opportunity to hoard safe, foreign currencies. Even if digital cash could overcome these considerable hurdles, governments are unlikely to be willing to lose their sovereignty over currency issue, and will establish measures to safeguard their control over monetary policy.

The use of the internet, interactive digital television and other new forms of delivering core banking services should be embraced by the banks because of opportunities related to the substantial change in the way banking services are distributed. The weight of evidence suggests the new delivery methods will substantially reduce the cost of delivering core banking, even after the capital investment required is taken into account. Security issues must be addressed (the Scandinavian experience with internet banking demonstrates they can be) to alleviate consumer concerns. Banks also must be proactive in dealing with consumer inertia, offering the right combination of incentives to persuade consumers to adopt the new technology. Experience in the USA and Scandinavia suggests this can be done without offering high deposit rates that eat into profits. Banks must also be ready to face increased competition in certain off-balance sheet activities, such as their intermediary role in initial public offerings and bond issues. All these remarks point to the need for banks to evolve in the face of new technology, a point which is hardly unique to the banking sector.

The growth of non-banks

There has been much discussion on the threat posed to traditional banks by the growth of non-banks. Non-banks, by definition, are firms which do not offer a complete core banking service but are very similar to banks. For example, personal loan or mortgage corporations specialise in loans or mortgages that are funded through bond issues and/or by turning a bundle of assets into asset backed or mortgage backed securities and selling them to raise liquidity. Though they offer a ‘‘banking’’ product, loans/mortgages, they are not banks because they are not funded by deposits. General Electric Capital (GE Capital) is the financial services subsidiary of General Electric. It issues the largest amount of commercial paper in the USA, supplies credit card facilities to department stores, is the largest insurer of private homes and, for nine years, owned a securities firm, Kidder Peabody. In the UK, Marks & Spencer, well known for its retail clothes, food and home furnishings, began to offer a selection of financial services in the 1980s, starting with an in-house credit card business and expanding into personal loans, unit trusts, personal equity plans and, from 1995, insurance and pensions. Marks & Spencer is able to fund its asset requirements because it is top-rated by key rating agencies. It has since been followed by some well-known shop/brand names such as Virgin, Direct Line Insurance, Tesco and Sainsbury.

However, virtually all of these non-bank firms have chosen to enter niche markets – they do not offer the core activities that define a bank, intermediation and the provision of liquidity. Usually, if one or more of their products includes part of the core functions (e.g. personal loans and/or deposits), these services are supplied to them by existing banks. For example, Tesco, Sainsbury and Virgin have their banking products supplied to them by either the Royal Bank of Scotland or the Halifax Bank of Scotland (HBOS). First Direct, the highly successful telephone bank (now offering on-line services) is a wholly owned subsidiary of HSBC. Also, there are notable examples of failed entry into these markets. In 1999, Marks & Spencer allowed the use of rival credit cards in its shops for the first time, part of an overall strategy to revive profits. In 2003, it abandoned its in-house card for a Master card issue which rewards loyalty. Sears Roebuck was one of the first large retail firms to offer financial services, but it has recently scaled back its activities. Westinghouse wound up its credit arm after it lost nearly $1 billion in property loans. GE Capital purchased Kidder Peabody for $600 million in 1986 but, in 1994, after losses on the mortgage backed securities portfolio and dubious trading activities in government bonds, sold it to Paine Webber (an investment bank) for $90 million plus a 25% stake in Paine Webber. In the UK, the poor performance, to date, of the telephone/on-line bank Egg illustrates the difficulties of setting up a whole new bank, even if the bank offers customers attractive deposit rates.


Another important trend is increased consolidation of the national banking sector through mergers and acquisitions. European bank mergers rose from 49 in 1990 to 184 in 1999; for US banks they rose from 113 to 381 in 1995, but had fallen back to 255 by 1999. Mergers of securities firms followed a similar trend.56 It is unusual for banks to merge because of difficulties related to hidden skeletons in their balance sheets.

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