Electronics and the Dim Future of Banks
January 1996
Presented at conference on Electronic Banking of the Fujitsu Research Institute
Eli M. Noam
Professor of Finance and Economics
Director, Columbia Institute for Tele-Information
Columbia Business School
809 Uris Hall
New York, NY 10027
E-mail: enoam@research.gsb.columbia.edu
I. Introduction 1
It has often been observed that railroad companies lost their dominating role in the American economy because they saw themselves in the railroad business rather than in transportation. Today, does something similar happen to banks? A recent study commissioned by the Bankers' Roundtable concluded, "Banking is essential to a modern economy; banks are not."2  Are banks as we know them threatened to become second-rate institutions because they cannot keep up with technology and institutional progress? This is the question addressed in this article.
Banks are not strictly about money. Banks are about information. They are information processing and control centers that adjust, coordinate and channel the shifting claims on society's pool of resources. In fulfilling these functions, banks, like all institutions, are based on a particular set of information technology and economics. If the technology and the economics change, the institutions must adjust, too.
In the beginning, the information gathering technology of banking was based on what might otherwise be called gossip-- personal knowledge based on proximity. To reduce risk, depositors and lenders alike had to know each other's personal and business reputation. Given the physical nature of money, they needed to be close to each other for transactions. These reasons led to localized banks, networked with each other
Today, vastly more powerful information technologies than word-of-mouth have become available to the world of finance: high-capacity telecommunications links, powerful and interconnected computers, cheap storage, value-added data networks, unbreakable encryption, and much, much more. These technologies led to numerous changes:
II. The Future of Banks reasons led to
One could imagine that all these changes strengthened banks by making them faster, smarter, broader, and more global. But this is not so. To the contrary. Even though banks have become bigger, they have been weakened. One of the major reasons is that the new technologies have accelerated the entry of rival institutions that were more adept in utilizing them. Today, American banks' share in borrowing dropped from 36% in 1974 to 22%. For thrift institutions, it dropped from 21% in 1976 to 8% in 1994. Commercial banks' share of total financial intermediary assets dropped from a steady 40% in the 60s through 80s to below 30% in 1994, the first time that deposits in non-banks were greater than in banks.6
One major reason for the decline was the growth of alternative sources of funds. Information technology enabled investors to evaluate securities and to be reached directly by borrowers. Thus, commercial paper outstanding as a percentage of business loans rose from 5% in 1970 to above 20% in 1994. Computers could be used to evaluate credit risk by using various quantitative methods, and this made it possible for non-banks to transform loans into marketable securities. This technique of securitization by non-banks is now also moving to small business loans.
In response, banks increased non-lending activities. The share of their non-interest income rose from 17% in 1977 to 34% in 1994. Their commercial real estate loans, as a percentage of assets, doubled from 4% in 1970 to 9% in 1994. And they began to be heavily active in financial derivatives. Widespread derivatives markets were not possible without information technology; their complexity makes controls difficult, and this increased riskiness. It helped bring down the Baring and Daiwa banks, demonstrating the global nature of the problem. In non-lending activities, too, banks fell behind institutions without banking charters but with superior operational or technological ability. In credit card processing, banks lost all but 20% of the market to non-banks such as First Data Resources. Banks were slow in offering Electronic Data Interchange (EDI) services that standardized invoicing and payments for transactions. When EDI emerged outside of banks it reduced the need for bank intermediaries.
ATMs, too, proved a mixed blessing. The linkage of ATMs to banks declined: physically, over 41% of American ATMs are not located at banks anymore. As this reduction in physical presence continued, the banks' advantage of proximity declined. Customers deal with machines that are now interlinked by vast ATM networks, and care little about who is behind them -- a bank, a near-bank, a non-bank, or a distant bank. Institutionally, over 13,000 ATMs are operated by non-banks, and their share is increasing. ATMs led to a reduction in branches. Between 1990 and 1992, 4,000 bank branches were closed; by 1997, another 15,000 are projected to be eliminated.
This retreat from brick-and-mortar has long-term effects on banks as organizations. In the past, the work process was organized such that the employees would come to the place where the information relevant to the business was present, physically or in the knowledge of their co-workers, and the customers would come to the employees. But this flow is being reversed as it is becoming much cheaper to move information than people. Therefore, data will move to the employees, wherever they are; customers, too, will be everywhere. In the process, banks will gradually become virtual organizations -- networks of specialists sharing information, decentralized boutique operations interacting, and customers distributed around the globe, often equally virtual as the banks. Many employees will work at home or at far-away locations. Indeed, the concept of stable employment itself will change to ad-hoc arrangements and to independent contractors working for multiple employers. For many tasks, these employees will, be located at the lowest cost locations -- perhaps not Tokyo and New York but Manila and Bombay.
By focusing on ATMs as teller-less branches, banks lost sight that these were merely one electronic form of customer interface, and a fairly inconvenient one at that. Thus, banks were unprepared for the emergence of terminals and network relations outside their control, as the Internet emerged as a locus of commercial activity in which vast numbers of customers are connected to a vast number of businesses, transacting with each other in increasingly secure and authenticated ways. Financial institutions are only feebly using the Internet as a business tool. In late 1993, when data for user activity on the Internet was still being broken down, J.P. Morgan and Citibank topped the list of bank users, with respectively 7 billion and 80 million bytes out of Internet NSFNet backbone and 600 million bytes into the Internet by Morgan.7  But this traffic was trivial relative to what some non-financial users were logging, less than 1/100 of 1 percent of the of the biggest Internet users among technology firms. In America, the penetration of micro-computers will reach 40% in 1996. By the year 2000, estimates US News and World Report , there will be 13 million American households banking by computer. As this happens, customers can out-migrate electronically to distant banks or other types of institutions. Yet banking's strength is based on proximity to customers, and its core competency is relations. How could that be preserved when a bank becomes a branchless virtual organization?
III. The Next Generation of Money
Even more radical will be the change in the nature of money, the banks' life-blood. Technology will lead to new types of money -- e-money, digital cash, cyber-dollars. Money has metamorphosed from store of value like a gold coin, to a physical token like a bank note, to a variety of payment vehicles, to a string of digital signals that are recognized as valid claims. Now, "smart" stored-value cards can receive, contain, and dispense these signals easily and securely, using one of several systems for encryption and authentification. These cards would be replenishable electronically from distance, even by wireless communication. They would create, in effect, a mobile, shirt pocket ATM. Old-fashioned money will still be around. But soon, "digital wallets" will become prevalent that permit electronic money, as well as specialized money -- cash that earns interest, cash that is conditional, i.e., usable only on certain items or in certain locations, or "closed cash" that functions only within certain institutions. Who would dispense e-cash, and in what currencies? Various financial institutions are likely to issue their own money or near-money. Some of these currencies would be pegged to real resources such as oil, while others might be fixed to some official currency, and still others would be based on the issuers' reputation.8  In such a fashion, parallel private currencies would emerge.
Private e-money raises many questions.
Perhaps the main question for banks is: Who will supply electronic money and authenticate it to its recipients? Will it be banks or non-banks? Would they be licensed and regulated? So far, a variety entrants into electronic money have emerged proposing various techniques. They bear names such as First Virtual, CyberCash, Digicash, Security First Network Bank, 1st Bank of the Internet, and Mondex. One first observation is that many of the companies involved are not banks. Banks taking an initiative are less than a handful of big banks, from among the thousands of American banks, or they are the banking industry's credit-card organizations, whose interests may well not be to make cash transactions convenient relative to the profitable credit-card operations.
Still more critical for banks' long term role is an important fact: with e-cash one can bypass banks. Individuals and firms can pay directly into each others' e-money wallets or stored-value smart cards. Such transactions would be like handing over cash among individuals. Why then have a middleman, the bank, for such transactions? And, why have transfer intermediaries among banks, such as correspondent banks, and clearing networks such as SWIFT, or central banks?
Banks have no obvious advantages in the e-money business over other providers, such as network operators like AT&T (with its communications network, nationwide customer billing relationship, established credit card operations, and proximity to prepaid phone cards), or over computer network platforms such as Microsoft's MSN. It was for related reasons that Citicorp furiously dropped AT&T as a telephone service provider when it entered the credit card business, and that many banks strongly opposed the planned acquisition by Microsoft, of Intuit, whose Quicken software could have helped divert transactions to Microsoft's new MSN network.
The latter example shows that banks are beginning to appeal to government to protect them by evoking various public interest, consumer protection, and competitive equity rationales to exclude non-bank competition in electronic money, or to control it tightly.11  But in a dynamic global economy with distance-insensitive communications, protective regulation is not sustainable in the long-run.
IV. Banks as Financial Systems Integrators
In 1815, the Rothschild bank in London used a carrier pigeon to obtain the critical news of Napoleon's defeat at Waterloo. Even for the time, this was a backward communications technology: the French already had a "semaphore" signaling telegraph that could transmit coded messages at a speed of over 500 miles per hour.12
Birds worked for Rothschild. But luck and pluck cannot be the business strategy for today's banking industry. Their self-image notwithstanding, banks are not near the leading edge of information technology applications. Their information technology investments are lagging. According to one study13, the cost of systems and hardware of American banks will have to double, from 10 to 20% of total non-interest costs. And there is very little R&D by banks. [Need more data on those points.] Yet, information technology and the pace of change will accelerate, if anything. In the past, a gradual change was acceptable because banks competed largely with other banks, which acted at a similar pace. Those banks that were faster adaptors of technology, like Citicorp or State Street Bank, could forge ahead. By now, many non-bank institutions are active on banks' turf. They are often more innovative, usually less regulated, and, with cheap electronic communications, more global.
How then can banks attract and retain business and how can they differentiate themselves from each other? There is a way for banks to create an opportunity out of a problem. Electronics is a two-way street. A bank can use information technology to create a full service customer relationship . They must create an integrated financial value-added platform that combines convenient transaction, information, and communications. Through these platforms, banks can become financial shopping malls, perhaps with several anchor services of their own, but mostly occupied by many financial service boutiques provided by other specialized companies. The bank's function is to link them up, provide a brand identity, control risk, and assure quality. This is a systems' integrator function, and it must be clearly distinguished from the provision of the service modules themselves. A successful systems' integrator must use the best and most efficient modules, without favoring its own operations, if it wants to prevail against competitors.
The specialized functions would be a wide potpourri: credit cards, e-money, commercial credit, payments, tax returns, insurance, health care claims, invoicing and collection, retirement accounts, data bases, record and book keeping, liquidity and asset management, investment navigator, point-of-sale services, card authorization, encryption, clearing and settlements, custody services, mortgages, portfolio accounting, budgeting, investment management, trustee services, mortgages, securitization, etc., etc.
One example: customers would be offered access to expert systems  and artificial intelligence applications such as intelligent agents and neutral networks -- autonomous and adaptive computer programs that could seek out the best investment opportunities, discern patterns and trends, and correlate hundreds of variables. This is useful for securities analysis or for credit card fraud spotting by merchants. Another example: flexible credit card terms, in which a consumer's credit cards might not be tied anymore to a single bank, but instead seek, at each use, "bids" by various institutions for the best terms.
Thus, banks could be at the center of electronic commerce for their customers, and benefit from the transformation of what today are cash transactions into electronic ones.
In short, banks must become financial systems integrators. They must integrate all the various financial services of the customer. Their orientation would be customer and relationship based, not account oriented. They have awesome amounts of information on their customers' transactions, which they could, with the proper protection of privacy, use to serve customers in an integrated fashion. They could play a vastly increased role in the financial transactionsof large customers, too. These banking customers change, too. They also become decentralized and often virtual organizations, for reasons similar to those of banks. They downsize and remove layers of management, and have fewer in-house specialized staff to handle complex as well as routine financial functions. Their needs to outsource them -- to banks or specialized firms -- therefore is growing, and banks can serve them. To do all this, banks must resort to heavily electronical integration. Ironically, therefore, technological integration can restore the personal link of customers to a bank, which ATM electronics and the closing of branches has undermined. But this role can also be played outside of the traditional banks by non-banks. And among banks, given the economies of scale of the financial shopping malls, puts the future of small banks into question. Their role may be highly personalized service -- the opposite of closing down branches -- and a narrowing of focus into the provision of specialized services for others' super-malls.
The threats to traditional banks may not dominate overnight, but they will surely arrive. People often overestimate the impact of change in the short term, but they also underestimate it in the long term. They recall that earlier promises about home banking and the cashless society failed to materialize, and they now believe that even a vastly more effective interactive medium will meet the same fate, forever. Those who hold these views will pay for them, eventually.
This is the most exciting period the world of finance has ever seen. There are tremendous opportunities for those who succeed in marrying finance with information technology, and technology with relationship management. Yes, banks have more opportunities than ever before, but their customers opportunities have grown even more, and with it, the lattersŐ bargaining strength. Yes, there is a chance for some of those dinosaurs, as Bill Gates has dismissively called banks. There is a chance for some of them to learn to fly and becomes birds soaring in the sky. But for most banks who will not be at the forefront, the future looks dim indeed.
Footnotes
Note 1 : The author wishes to thank John Friedman, Alex Wolfson, and for their help, and Bundo Yamata and Munehiko Ishimi of the Fujitsu Research Institute for raising the question and providing the opportunity to discuss it. Back
Note 2 : Neumann, Edward, Banking's Role in Tomorrow's Payments Systems: Insuring a Role for Banks, prepared for the Bankers' Roundtable. Washington, D.C.: Furash & Co., June 1994, p. 17. Back
Note 3 : Richards, Heidi Willmann, "Daylight Overdraft Fees and the Federal Reserve's Payment System Risk Policy,"Federal Reserve Bulletin, December 1995, p. 1065. Back
Note 4 : Palfreman, Jon, and Doron Swade, The Dream Machine, BBC Books, London, 1992, pg.78. Back
Note 5 : Gregor, William and Jonathon M. Sandler, "Comment: Home Banking May Arrive Via Data Superhighway," American Banker, June 20, 1994, pg.18. Back
Note 6 : This information, and that of the next two paragraphs, are from the article by my colleagues, Edwards, Franklin R., and Frederic S. Mishkin "The Decline of Traditional Banking: Implications for Financial Stability and Regulatory Policy," FRBNY Economic Policy Review, July 1995, pp. 27-45. Back
Note 7 : Levin, Jayne, "Wall Street and the Internet," The Internet Letter, November 1993, p.6. Back
Note 8 : Kurtzman, Joel, The Death of Money, Simon & Schuster, NY, London, 1993. Back
Note 9 : Ludwig, Eugene, Testimony before the Subcommittee on Domestic and International Monetary Policy of the Committee on Banking and Finiancial Services, US House of Representatives, 104th Congress. October 11, 1995. Back
Note 10 : Stanley E. Morris, Testimony before the Subcommittee on Domestic and International Monetary Policy of the Committee on Banking and Finiancial Services, US House of Representatives, 104th Congress. October 11, 1995. Back
Note 11 : Blinder, Alan, Testimony before the Subcommittee on Domestic and International Monetary Policy of the Committee on Banking and Financial services, House of Representatives, 104th Congress. October 11, 1995. Back
Note 12 : Holzmann, Gerard J., and Björn Pehrson, "The Early History of Data Networks," Washington: IEEE Computer Society Press, 1995, p. 89. Back
Note 13 : Harrop, Peter, "The Myth of the Cashless Society," The Future of Payment Media: Plastic Money, Banknotes, Coins, and Cheques. Financial Times Business Information, London, 1989, pg. 141. Back