Chapter 8

Findings

—.

Contents

PageConclusion 1: Applications of Technology and the Changed Nature of

Financial Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192

Conclusion 2: Restructuring the Financial Service Industry. . . . . . . . . . . . 194

Conclusion 3: Interaction Between Technology and the LegalRegulatory Structure Governing Banking . . . . . . . . . . . . . . . . . . . . . . . . . 198

Conclusion 4: Financial Options for the Consumer. . . . . . . . . . . . . . . . . . . . 201The Equity of Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203Marketing to the Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203Changes in Pricing Structure. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204The Implications of Technology-Based Products. . . . . . . . . . . . . . . . . . . . 205

Conclusion 5: Security and Integrity of the Financial Service System . . . 205Theft of Funds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205System Integrity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207Specific Consumer concerns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208

Conclusion 6: Integration of Capital Markets . . . . . . . . . . . . . . . . . . . . . . . . 210The Effect of a National Capital Market on Financial Services . . . . . . . 211Future Impacts of Technology on Capital Markets . . . . . . . . . . . . . . . . . 212

Conclusion 7: Entrants Into the Financial Service Industry. . . . . . . . . . . . 213The Role of Information Technology in Competitiveness . . . . . . . . . . . . . 213Availability of Services to Small Financial Service Providers . . . . . . . . . 214Entrance beholders of Communication and Distribution Systems . . . . 214The Effect of New Entrants on Services Provided . . . . . . . . . . . . . . . . . . 214The Effect of Telecommunication Regulations on Financial Services . . . 215Antitrust Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215

Conclusion 8: Competition in the Markets for Financial Services . . . . . . . 216

Chapter 8

Findings

The financial service industry is experienc-ing a period of tremendous change. Economicfactors, specifically those that drove interestrates to record levels during the last decade,have caused the users of financial services toseek new services. In turn, innovative provid-ers of services have responded to consumers’new financial needs and sophistication.

At the same time, a number of technologiesthat have been just over the horizon for sometime have begun to mature. For example, com-puters, still in infancy during the 1950’s, arenow used to deliver services directly to theconsumer without human intervention, andthe tendency to use systems based on infor-mation and telecommunication technologiesfor delivering financial services is increasing.The general public’s level of familiarity withcomputers has increased, providing a fertileclimate wherein significant numbers of usersnow accept the new services. Falling prices forelectronic equipment and the increasing per-vasiveness of such equipment throughout theeconomy have further reinforced this trend.

In many cases, the basic services offered bythe financial service industry are not chang-ing in any fundamental way. A deposit takenthrough an automated teller machine (ATM)is not substantively different from one takenby a human teller. However, the availabilityof technologies that can quickly process andmove vast amounts of data has made it pos-sible for financial service providers to offerproducts beyond those that would have beenpossible otherwise. For example, the moneymarket mutual fund could have been offereda century ago if there had been some meansof processing the transactions necessary tomake such a fund work economically.

Further, there is a definite trend in the econ-omy away from the older “smoke-stack” in-dustries to the production of information andthe development of those technologies that

make possible and facilitate this transition. Aconsiderable number of entrepreneurs see po-tentially profitable opportunities for provid-ing information services directly to consumers,but, in general, they have yet to find thepackage of services that will be successful inthe marketplace. Virtually all agree, however,that financial services will be an important ele-ment of that package. Thus, the forces thatare changing the basic character of the Ameri-can economy are directly affecting the struc-ture and character of the financial service in-dustry.

The foregoing changes have affected the re-lationships between and among the variousparticipants in the marketplace. Some perceivethemselves to be relatively better off, whileothers feel they have been put at a disadvan-tage. Some argue in favor of policies that di-rect the evolution of the industry along pre-determined paths, while others, somewhatfearful of foreclosing opportunities from whichthere could be widespread benefit in the future,argue that policy should remain neutral in or-der to permit the market to work its will inshaping the industry.

The present rate of change is a transitoryphenomenon, and the structure and characterof the financial service industry will stabilizeduring the coming decade. However, unlesssome explicit action is taken to preserve thepresent structure of the financial service in-dustry, it will look much different at the turnof the century than it does now. And yet, thereis no assurance that policy parameters can beadjusted with a high degree of confidence tobring about a specific, desired industry struc-ture. Available and emerging technologieshave created many opportunities for innova-tive people to engineer their way around reg-ulatory barriers to achieve their goals and ob-jectives.

191

192 ● Effects of /formation Technology on Financial Services Systems

In light of the accelerating rate of change try. However, a number of conclusions thatin the financial service industry and in the bound the range of possibilities have beeneconomy in general, it is not reasonable to developed, and these are presented in thismake any firm predictions about the structure chapter.and character of the financial service indus-

Conclusion 1: Applications of Technology and theChanged Nature of Financial Services

The applications of advanced information andtelecommunication technologies in systems fordelivering financial services change the waythose services are created, delivered, priced, re-ceived, accepted, and used.

Years ago, depository institutions creditedinterest to savings accounts only quarterly,or even less frequently. Today, most pay in-terest from the date of deposit to the date ofwithdrawal and compound interest at inter-vals so short that they are nearly continuous.This change was encouraged by deposit-rateceilings and made possible because the insti-tutions installed computers that enabled themto handle the computational workload re-quired to provide the enhanced service.

Rapid advances in telecommunication andinformation processing technologies have beenfollowed by applications to the delivery of fi-nancial services. In some cases, the changesaccompanying the introduction of technologyhave been imperceptible to customers. For ex-ample, one month a statement may be pre-pared on an accounting machine and the next,on a computer. In others, the changes have re-quired users to change the way they use finan-cial services and the way they interact withservice providers and systems for deliveringservices (e.g., ATMs rather than human tell-ers). In addition, as users became more com-petent with the technology, they forced pro-viders of financial services to change the wayin which they interacted with their customers.J. C. Penney, for example, agreed to accept theVISA credit card only after VISA agreed topermit a direct connection to the network bythe retailer.

In some ways, the rate of change in thefinancial service industry is accelerating in re-sponse to the assimilation of rapidly advanc-ing technologies. On the other hand, the reluc-tance of a significant number of users to adaptto the changes is limiting the rate of changein the industry. Only a little over 30 percentof the recipients of Social Security paymentshave agreed to accept payment by direct de-posit, thus limiting the ability of the Departmentof the Treasury to realize the full benefits ofapplying the available technologies. Public re-action to a requirement by one bank that onlycustomers who held deposit balances of $5,000or more could receive service by a human tellercaused cancellation of the program.

Sometimes technology can indirectly affectthe availability of financial services. Technol-ogy that facilitated the development of thebank credit card is particularly important inthe programs of card issuers to limit fraud andlosses to bad debt. One of the key features ofthe cards is that the merchant accepting themis guaranteed the funds as long as the rulesfor acceptance set down by the card issuer arefollowed. As a result, many merchants are re-luctant to accept a paper check at the pointof sale, preferring instead to avoid the risk ofloss the check entails. Thus, indirectly, appli-cations of technology have reduced the abilityof consumers to pay for purchases by check.(Ironically, the same technologies that havemade the credit card attractive to the mer-chant are being applied to rejuvenate thecheck. Although they have not fulfilled the ex-pectations of a few years ago, check guaran-tee and authorization services provide the

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Ch. 8—Findings . 193. — —

same kind of protection from risk for the mer-chant that is offered with the credit card.)

Technologies have also lessened the signifi-cance of distance and time of day as factorsin the delivery of financial services. Telecom-munication makes immediate interaction be-tween service providers and their customerspossible, regardless of the location of either.The terminal device used by either can be onethat can be programed to operate unattended,at hours that are suitable to the schedules ofboth users and providers and in ways thatmake minimization of communication costspossible. International networks of ATMs nowbeing established will allow the consumer toaccess depository accounts in other countriesand will negate existing restrictions on thetaking of deposits across State lines. Wiretransfers, for example, can be used to depositfunds to an account without regard to thebank’s location.

Furthermore, technologies have also changedthe nature of the depository account. Whileonly chartered depository institutions can takedeposits, others have been able to take advan-tage of the ability of the technologies to proc-ess and transfer large amounts of informationquickly to offer various investment productsthat have liquidity approaching that of a de-posit. In addition, the importance of banks andother institutions as depositories for funds isdiminishing. The application of technology hasmade it possible for customers to use deposi-tory accounts only to collect funds for a shortperiod, disburse them rapidly as needed, andplace any remaining funds in short-term in-vestments. In this situation, the depository in-stitution must receive the bulk of its incomefrom fees charged for service because the avail-ability of funds on deposit that can be investedfor its own account is limited. Also, a numberof factors have reduced the spread between thefees paid for deposits and those earned whenthe funds are lent out. One way of replacingthis income, selling services for fee, is thecourse that financial institutions are following.

Major capital investments are necessary toimplement new systems for delivering finan-cial services. However, once the systems have

become operational, the institutions that de-veloped them can market them to other finan-cial service providers. Purchasers of the pack-ages are then able to offer significantlyenhanced services without expending largeamounts of capital.

Historically, only depository institutionshave processed payments transactions andhave had exclusive access to the paymentssystems. Now, the development of informationtechnology has created the opportunity forothers to enter this market. A substantial in-dustry of wholesale service providers not usu-ally seen as financial service providers nowsupports retail financial institutions. In fact,the existence of this industry has made it pos-sible for many smaller retailers to exist. Yetmany wholesale nonbank processors are denieddirect access to the payments mechanism,which, some of them argue, puts them at acompetitive disadvantage as providers ofwholesale services and limits their ability toserve the needs of clients who are not part ofthe financial service industry. These whole-salers see financial institutions competingwith them as providers of information proc-essing services while retaining the advantagesthat come with exclusive access to the pay-ments mechanism.

On the other hand, financial institutions at-tempt to provide the full package of informa-tion processing services needed to support allof the activities of their clients that are relatedto financial operations and payments. As thedependence on technology for providing finan-cial services continues to increase in thefuture, this conflict between competing classesof institutions will become more intense. De-pository institutions, pressured by decreasingearnings from deposits, will seek to expandtheir base of customers that pays fees for serv-ices at the same time that their competitorsseek to provide alternative sources of finan-cial services to those same markets.

The financial service industry is dependenton reliable and effective telecommunication fa-cilities for its existence. If financial data, bothpayments and collateral information, cannotbe moved rapidly and reliably worldwide, the

194 • Effects of Information Technology on Financial Services Systems

financial service industry could not functionas it presently does. Further, systems for de-livering financial services have been designedto take into account the present configurationand cost structure of available telecommunica-tion facilities. Any significant departure fromhistorical patterns could have a direct and ma-jor impact on the costs of delivering financialservices, the structure of the industry, and thedistribution of costs among the various par-ticipants.

For example, home banking systems havegenerally been designed so that the user needmake only a minimal investment in terminalequipment and can rely on the computer oper-ated by the service provider for the process-ing required. Implicitly, this type of designassumes that low-cost telecommunication fa-cilities are available and that the cost to theuser of a lengthy, interactive session with ahost computer will be minimal. On the otherhand, if local telecommunication costs rise sig-nificantly, such systems may have to be rede-signed to minimize the connection time be-tween the user and the provider’s computer;this could result in excessive cost to the userof a terminal. Similarly, the large amounts ofcapital used to establish telecommunicationnetworks operated by providers of financialservices under present pricing structures couldeffectively be lost if changes in telecommunica-tion result in prohibitive costs of operation.

Float, its cost, and who benefits from it havelong been at issue. The various financial serv-ice participants have developed strategies totake advantage of float that range from con-

sumers issuing checks 2 or 3 days before theydeposit funds to corporate treasurers disburs-ing funds from remote locations. The technol-ogies, on the one hand, provide the opportu-nity essentially to eliminate collection floatfrom the system while, on the other hand,offering the payer the opportunity to controlwith absolute certainty the time at which adisbursing account is debited. Businesses,then, could revise trade discounts to reflect thenew realities by allowing, for example, dis-count if good funds were available after 12 or13 days instead of allowing it if the check ispostmarked on or before the 10th day. Simi-larly, consumers who know that funds will beavailable on a specific day could schedule theirpayments accordingly, rather than playinggames with the system, as they do now.

Finally, technologies make it possible for in-dividuals, businesses, and government to keepminimal idle balances. Because all parties canknow exactly when good funds are availableand when disbursements must be made, theycan move all funds not needed for day-to-daytransactions into investment accounts thatpay market rates of interest. Then, funds canbe moved to transaction accounts that eitherpay no interest or pay below-market interestrates for minimal periods to meet require-ments for disbursements and/or to receivefunds from others. The net effect of thistendency will be a constantly increasing down-ward pressure on the balances of transactionaccounts held by depository institutions andothers.

Conclusion 2: Restructuring theFinancial Service Industry

Some patterns in the ongoing restructuring The structure of the financial service indus-of the financial service industry are discernible: try was, at one time, clearly defined. Mostthe present fluidity and rapid change will con- individuals and businesses conducted their fi-tinue for some time, but many uncertainties can- nancial affairs primarily with depository in-not now be resolved and many alternative pos- stitutions such as banks, savings and loansibilities exist. associations, and credit unions. The financial

Ch. 8—Findings • 195

service industry is now changing: new prod-ucts are being developed and offered and theroles of traditional institutions are shifting.The simplicity of the industry has all butdisappeared.

Today the financial service industry consistsof a variety of organizations, ranging from tra-ditional depository institutions and relatedfinancial organizations that have expandedservices, such as securities firms, to suchnontraditional financial service providers assupermarkets and retail department stores. Avariety of organizations offer investment op-portunities in an increasingly competitive mar-ket. Promotion of products and target market-ing has become increasingly important forfinancial service providers who are looking fornew ways to reach users and retain and gainmarket share; e.g., television and direct mailadvertising has become common.

Depository institutions have begun offeringbrokerage services (INVEST) and insurance(mutual savings bank life insurance in Massa-chusetts and New York). To compete withother financial service providers they placegreater emphasis on serving the customer ona 24-hour basis as well as on making conven-ience a priority (ATM deployment and homebanking).

Depository institutions are governed bystrong regulations, many of which were writ-ten at a time when the competitive characterof the financial service industry was very dif-ferent from what it is today. For example, reg-ulations which set ceilings on deposit interestrates at federally insured commercial banks,savings and loan associations, and mutual sav-ings banks restricted the ability of depositoryinstitutions to compete with money marketfunds, a product development that was not an-ticipated at the time the regulations wereframed. Some regulations, meant to be protec-tive, must be adapted to the changes the in-dustry faces. Some new regulations have beennecessary. For example, the Garn-St GermainDepository Institutions Act of 1982 amendednumerous Federal banking laws and createdfive new ones, allowing depository institutions

to offer the money market demand accountand the Super NOW account.

Major influences for the recent changes inthe industry have been high interest and in-flation rates and, therefore, the high oppor-tunity cost of standard consumer savings in-struments, resulting in a phenomenon knownas “disintermediation.” Funds flowed out ofthe depository institutions into nontraditionalinstruments and institutions as many individ-uals shifted their assets in order to obtain thehigh interest rates. Many of these new instru-ments were created by organizations outsideof the regulated environment of depository in-stitutions. One example is the money marketmutual fund created by the securities indus-try, which works like a combination savingsand checking account. Funds invested inmoney market mutual funds earn a marketrate of return, and the funds are as liquid, forall practical purposes, as a checking account.The customer accesses the account with ashare draft, which works in much the sameway as a check and is considered to be equiv-alent by most users. The only practical dif-ference is that, in many cases, there is a mini-mum amount for which the draft must bewritten, usually $500.

In the new competitive climate, nontradi-tional financial service institutions quicklyrealized the tremendous potential in provid-ing financial services. They also realized theease with which they could enter this indus-try. For example, J. C. Penney, a major na-tional retailer, operates a highly sophisticatedonline communications system that supportsover 35,000 online terminals. J. C. Penney ex-panded the usage of its communication sys-tem and began processing credit card trans-actions for oil companies. Outside of its rolein financial services as an extender of creditto retail customers, J. C. Penney has becomea financial service provider of a different sortby performing functions normally associatedwith a bank.

Supermarkets have become focal points forATM deployment and point-of-sale programs.Safeway, an Oakland, Calif., supermarket

196 ● Effects of Information Technology on Financial Services Systems

chain, has announced plans to develop andmarket a national ATM network. Some super-markets intend to replace banks and others asoperators of switches for financial transactionnetworks and are highly competitive in thisarea. They are also taking a major role in thedecisionmaking surrounding these activities.Petroleum companies, with their vast chainsof retail gas stations, are following the leadof the dry goods and grocery chains.

Unlike most depository institutions, manysecurities firms have a national presence. Theycan conduct business nationally with few re-strictions. In addition to brokerage and invest-ment banking services, many such firms nowoffer a wide variety of consumer financialproducts, such as money market funds, withdebit card and ATM access, as well as assetmanagement accounts (a combination of a de-pository account and a margin account). Thesenew product offerings have gained a signifi-cant market. For example, the Merrill LynchCash Management Account, which works asboth a savings and an investment instrument,serves over 1 million people. Customers canaccess their accounts via telecommunicationnetworks operated by the securities firm fromany office, regardless of location.

Although insurance companies are licensedseparately by each State, many serve a na-tional market through networks of company-operated offices and independent agents.Many insurance companies are augmentingtraditional product lines with new offeringsthat directly compete with those offered byother providers of investment services.

The concept of the “boutique” bank, whichserves a highly specialized market, is becom-ing more widely accepted as the industry re-organizes. National Enterprise Bank, whichopened in Washington, D. C., in August of1983, is one such bank. Enterprise is aimedat professionals—doctors, lawyers, dentists,accountants, and consultants. Its intent is toserve the affluent professional in a specializedfashion far different from that of a commer-cial bank. Palmer National Bank, in Washing-ton, D. C., is another newly opened boutique

bank. It specializes in financing for small,high-technology firms. Many of Palmer Na-tional Bank’s clients have financial service re-quirements that are often too small to be ofinterest to big banks with international ex-perience.

By joining a local, regional, or national net-work, these small institutions can immediatelydeliver services to a large number of locationsin direct competition with major institutions.Despite speculation, there is little doubt thatthese organizations will survive. Unlike the re-gional giants, specialty companies and small-niche companies that cater to a narrow popula-tion segment have positioned themselves todo one thing superbly. It is possible that theindustry may begin to be shaped like a dumb-bell, with a large number of small banks serv-ing local needs at one end, a relatively smallnumber of large banks providing service na-tionwide at the other and, in the middle,virtually no midsize banks serving regionalmarkets.

In sharp contrast to the specialty provideris the financial supermarket. Offered as a one-stop financial center offering banking, insur-ance, brokerage, and investment opportuni-ties, the financial supermarket has been a suc-cessful concept for both Sears FinancialNetwork and Merrill Lynch, among others.Both of these organizations offer brokerageservices in stocks, bonds, options and futurescontracts, insurance, savings instruments,mortgages, consumer loans, retirement sav-ings plans, and even credit cards to their cus-tomers. However, the degree to which theservice packages of each firm are truly inte-grated varies significantly. Financial super-markets seem to have found a niche in theever-growing consumer financial service mar-ket. This concept is attractive because of thelow cost of entering the business as well ashigh potential profits. The financial super-market has not yet matured, nor has its long-term viability been demonstrated.

Legal barriers still hinder the entry of somebusinesses into the financial service marketand the cross-entry of some providers into

other areas of financial services. In mostStates, and at the Federal level, banks arebarred from insurance (except for credit pol-icies), from investment banking, and, to a de-creasing degree, from interstate branching.Present regulatory barriers prevent brokeragehouses from operating as a financial supermar-ket in the true sense of the word. While bro-kerage houses perhaps come closest to achiev-ing true integration, they cannot acceptdeposits or have direct access to the paymentmechanism, and therefore cannot truly offerbanking services. Although no one is surewhat combinations of businesses will prove tobe the winning ones, to the extent that an or-ganization can achieve a greater nationalrecognition in the market, it will enjoy anadvantage over its competitors.

For many types of organizations to build afinancial supermarket, a number of mergersand acquisitions may be necessary. Severalnonbank providers have acquired banks tohave access to the payments mechanism andFederal deposit insurance. These financial con-glomerates have come along much faster thanexpected because of the profound changes ininsurance, banking, and securities broughtabout by the interplay of high interest rates,technology, and regulation.

Aside from economic conditions, whichmany claim are a driving factor behind thechanging structure of the financial serviceindustry, is the major role technology hasplayed. As financial service companies con-tinue to rely heavily on new technologies andautomated processes to provide services, newservices that could not be offered without thesupport of such technologies emerge. Somenew technologies allow a firm to produce twodifferent types of financial services togetherless expensively than for two individual firmsto produce them separately. Online communi-cation systems enable instantaneous debit/credit of financial accounts, and immediateexecution of orders to buy and sell securities.Brokerage sales across the country are facili-tated by immediate real-time access to finan-cial information.

Ch. 8—Findings ● 197

The significant changes in the structure ofthe financial industry bring to light several im-portant points. Technology has been one keyfactor enabling nontraditional financial serv-ice providers to enter the market. The tech-nologies necessary to drive the systems thatsupport financial services are already in thehands of new entrants because such technol-ogies can also be applied to support many dif-ferent industries. As a result, many potentialentrants are able to offer financial servicesusing established computer and communica-tion systems. Some firms have entered themarket for retail financial services, some havebecome wholesale providers, and others haveentered both markets.

Industry restructuring has brought aboutsignificant potential for industry consolidationas the functions that support the industrybegin to overlap. While depository institutionsare technically the only organizations allowedto accept deposits, nondepository organiza-tions have developed products that are near-deposits and thus compete with products ofdepository institutions. Money market mutualfunds, in essence, accept deposits and areviewed by those who own them as savings in-struments. Insurance contracts, particularlythose that allow the owner to control theallocation of funds among alternative invest-ment opportunities and that accumulate cashvalue, can also be viewed as close substitutesfor deposit instruments.

The traditional categories of depository andnondepository institutions are no longer clearlydelineated or functionally separate. Thesechanges create more product choice for theconsumer, but also increase the amount ofconsumer confusion in choosing and usingservices. Since so many of the products andservices from the various financial serviceorganizations are similar, many consumers areunaware of the significant differences.

Regulation, once a guiding force with re-spect to how the industry operated, no longerhas as commanding an influence. Interstate

198 Ž Effects of Information Technology on Financial Services Systems

branching and deposit-taking is now a reality,*influenced considerably by the deployment ofATMs. Many State banking laws now providefor reciprocal interstate branching and may re-sult in the emergence of major regional banksthat maintain offices in several States. Massa-chusetts, for example, passed an act, entitled“An Act Relative to Branch Offices and Ac-quisitions of Financial Institutions, ” thatestablishes new authority for mergers, branch-ing, electronic branching, and mortgage lend-ing by Massachusetts financial institutions.The act is limited in its operation to activitiesinvolving five New England States (Connect-icut, Rhode Island, Maine, New Hampshire,and Massachusetts).

The changes in the structure of the finan-cial service industry now occur at such a rapid

*several states have reciprocity agreements for interstatedeposit-taking by ATM–e.g., Washington, D. C., and Maryland.

pace that it is no longer a question of whencertain changes will occur, but of how to im-plement the changes and how they will be ac-cepted. It is difficult to predict the ultimateconsequences of the restructuring; however,there are indications that the financial serv-ice industry is changing from a traditional toa self-service industry. The overwhelming useof ATMs and the promise of emerging remotebanking/remote information systems provideevidence for this claim. Many of the consumer-oriented systems that deliver services to thehome are being developed by a variety of jointventures that offer a myriad of services, notonly in banking but also in entertainment, edu-cation, and other financially related services.Although the traditional depository institu-tion will remain, its role may well change.There will continue to be new innovations andplayers in the industry, and a market willingto test them.

Conclusion 3: Interaction Between Technology andthe Legal Regulatory Structure Governing Banking

Some of the existing laws and regulations per-taining to the financial service industry are inef-fective or inapplicable to current and potentialchanges in financial service institutions andproducts. Both Federal and State legislativebodies have reacted to changes in the marketand have either ratified events that have takenplace or taken advantage of and encouraged per-ceived trends.

A significant portion of the regulatoryframework governing the financial service in-dustry, written in the 1930’s (Banking Actsof 1933-35), 1940’s, and 1950’s (McFadden/Douglas, Glass/Steagall) is still in force today.A large number of the restrictions imposed onthe banking system were a result of the GreatDepression of the early 1930’s. The restric-tions were an attempt to meet the demandsfor financial services provided by firms thatwere both sound and secure and in an environ-ment conditioned by a significant decline in

the money supply which led to rapid deflation,a large number of financial institution failures,and a very high level of unemployment. Today,the environment is much different, and theneeds of both consumers and businesses havechanged.

The Banking Acts of 1933 and 1935 were de-signed to promote safety and soundness inbanking. While safety and soundness are stillthe main concern, the environment and theconsumer/business needs have changed signif-icantly. Today, only a few of those regulationsadequately meet the needs for which they weredesigned, and some may actually be detrimen-tal to the industry they regulate.

When the financial service industry first be-came regulated, the regulations were writtenaccording to functions performed by the spe-cific institutions, and the legislation becametied to the institution it regulated instead of

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Ch. 8—Findings ● 199

the function. The institutional lines are nowfuzzy.

Existing Federal laws and regulations havemade it increasingly difficult for banks to com-pete against new entrants into the marketswhere they have traditionally had an almostexclusive franchise. Several points must beconsidered, however. Banking is looked uponas a special business that is key to the econ-omy. Consistent with this view, particularsteps were taken to insulate it from other linesof commerce and to limit the risks that bankswere permitted to take. The introduction of de-posit insurance helped limit the exposure ofdepositories to risk. On the other hand, ex-isting regulations are designed to preventbanks from exerting undue influence overother lines of commerce.

Presently, the roles of the various Federalagencies with respect to regulating depositoryinstitutions are complex. National banks arechartered by the Comptroller of the Currency.Federal savings and loan associations andFederal savings banks are chartered and reg-ulated by the Federal Home Loan Bank Board.Federal credit unions are regulated and in-sured by the National Credit Union Adminis-tration. Bank holding companies are regulatedby the Federal Reserve Board.

The United States has maintained a dualsystem (Federal/State) for the regulation andsupervision of banking. This dual banking sys-tem has played a useful and constructive rolein encouraging innovation in the financial reg-ulatory environment and in helping accommo-date local differences in the needs of bankingorganizations and their customers. The sys-tem worked well because, for the most part,the goals of regulation were commonly shared.However, this appears to be breaking down.States are beginning to allow incredible expan-sion of power for banks and thrift institutionsthat go far beyond standards allowed by Fed-eral law and yet still benefit from Federal pro-tection. Banks have demonstrated that theywill establish offices in States that offer a par-ticularly favorable regulatory climate.

One of the concerns depository institutionsface is that a growing number of differentlyregulated financial service organizations areable to offer a broader range of financial serv-ices than the depository itself can offer. Forexample, Merrill Lynch can offer securitiesservices, real estate services, and a packageof additional financial instruments, such asthe money market fund (cash management ac-counts which serve as high interest-earningsavings instruments), and, to a limited extent,transaction accounts. While it is possible fornontraditional providers to compete head-to-head with banks by offering new substitutesfor banking products, depository institutionsdo not have the same leverage.

Many of the nontraditional financial serv-ice providers are improving their positions vis-a-vis banks by establishing or acquiring com-mercial banks or thrift organizations (e.g.,Dreyfus Corp./Lincoln State Bank of EastOrange, N.J.). Travelers Insurance Co. has re-quested regulatory approval to offer FDIC-insured* instruments to its customers througha trust subsidiary. Depository institutions, ex-cept in some States and for some grand-fathered institutions, are not allowed to owninsurance companies nor are they under anycircumstances allowed to provide a full rangeof investment services, although holding com-pany affiliates may engage in discount bro-kerage.

Organizations, however, have found ways tocircumvent the existing financial service reg-ulatory structure. Technology has certainlybeen one of the driving factors. The ATM, forexample, enables interstate access to individ-ual bank accounts, and in some instances localregulatory authorities and legislation havepermitted interstate deposit-taking, as well.(Douglas and McFadden Acts, prohibiting in-terstate banking and deposit-taking, respec-tively, are ineffective.) This same technologyis being applied by nondepository institutions,such as supermarkets and other retailers (e.g.,

* Federal Deposit Insurance Corporation.

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200 ● Effects of Information Technology on Financial Services Systems— . — .

Publix supermarket, Safeway, Sears) to pro-vide services in direct competition with banksand/or their subsidiaries and service corpora-tions. These organizations are not taking de-posits and are not under the same banking reg-ulatory scrutiny as depository institutions,even though the systems being deployed mustmeet all regulatory requirements with respectto Regulation E and other consumer pro-tection.

Notwithstanding Federal and State lawsand regulations, wholesale banking has beendone on a national basis for quite a while.Banks are able to solicit business and estab-lish corporate offices on an interstate basis.Advanced communication systems enable real-time access to financial information so that in-stitutions are able to conduct business, includ-ing movements of funds, regardless of the loca-tions of their customers.

The “nonbank” bank developed as a resultof a loophole to the Bank Holding CompanyAct. Nonbank banks are commercial bankswith either National or State charters thatelect to abstain either from accepting demanddeposits or from making commercial loans–two activities necessary to fall within the def-inition of a bank for Bank Holding CompanyAct purposes. Both the Federal Reserve andthe Comptroller of the Currency have takenactions to slow, if not halt, increases in thenumbers of nonbank banks and branches.

Congressional actions, responding to mar-ket forces and events, have further weakenedthe provisions of existing legislation. TheGarn-St Germain Depository Institutions Actof 1982, for example, permits interstate acqui-sitions of failing depository institutions if theymeet certain criteria. Several savings bankshave acquired savings and loan associationsin other States. A major money center com-mercial bank has been permitted to acquiretwo sizable out-of-State savings and loan asso-ciations.

Many new regulations, primarily those af-fecting electronic funds transfers (EFTs) andwritten with the expectation that the deliverysystems would be fully electronic, do not apply

to the present environment. Debit cards atpoint of sale, for example, are still heavilypaper-based and therefore do not fall under theauspices of Regulation E* (protecting consum-ers using EFT and governing the use of EFT).Actually, the debit card, which in most circum-stances is not processed electronically, falls be-tween the “regulatory cracks” and is notunder any regulatory authority when used tocreate a paper document at the point of sale.Many new payments services and deposit-like instruments have sprung up outside theframework of governmentally protected andsupervised depository institutions.

The administration has reacted to events inthe market that have put banks at a compara-tive disadvantage by suggesting legislationwhich it entitled, “The Bank Holding Com-pany Deregulation Act. ” This act would en-able banks to offer new products and servicesand would address the following four areas:1) the mix of products and services that wouldbe offered by the commercial banks, 2) theprocess for gaining regulatory approval forbanks entering many of the permitted serv-ice areas, 3) the reduction of competitiveadvantage enjoyed by some (because of dis-parities in the regulatory structure) by mov-ing to functional as opposed to institutionalregulation, and 4) the limitation on cross-sub-sidization by requiring banks to establish seg-regated subsidiaries for offering new products.Banks below a certain threshold in size wouldbe treated differently from larger banks insome respects.

Significant changes have occurred to updatesome of the outdated banking legislation andincorporate new measures for the banking in-dustry. One example is the Garn-St GermainAct. This comprehensive statute containseight titles that amended numerous Federalbanking laws and created five new ones.Another is the Depository Institutions Dereg-ulation and Monetary Control Act of 1980,which, in addition to approving a money mar-

*The Federal Reserve Board has put out for comment a pro-

posal to cover paper-based transactions under Regulation E.It has also issued a proposed rule to bring paper-based debitcards under Regulation E [Reg. E; Docket No. R-0502].

Ch. 8—Findings ● 201

ket deposit account for banks, provides for thephase-out and ultimate elimination of all Fed-eral limitations on maximum interest ratespaid on deposits in financial institutions. Bothwere passed in response to compelling changesin the marketplace and are designed to correcta lack of competitive parity among competingproviders of financial services.

In some cases, developments in the provi-sion of diversified financial services have beenspurred by State laws. The most recent exam-ple of this is South Dakota’s allowing Statebanks to own full-line insurance companies.Out-of-State bank holding companies, recog-nizing market trends and pressures, haveshown interest in acquiring or forming SouthDakota banks. Currently, many State legisla-tures have shown interest in liberalizing bankregulations in order to allow forms of inter-state banking.

Functional regulation is being considered asan alternative to the present regulatory struc-ture. Such regulation would subject all firmsperforming the same function to the same reg-ulations imposed by the same regulatory agen-cy. Those who support such a change in regu-lation feel it will provide a level playing fieldfor all institutions providing the same typesof financial services. Additionally, its pro-ponents believe it would provide competitiveequity among the depository institutions andnonbank institutions.

Technology development, economic condi-tions, and other market forces have changedthe structure of the industry to such a degreethat the boundaries in the existing legal reg-ulatory framework have less and less of an im-pact. ATM systems permit access to accountson a national basis; they even permit accessto money fund accounts held outside of depos-itory institutions (First Boston/Fidelity). Onlythe limitations on interstate deposit-taking bybanks seem to be holding up, and these areweakening, as evidenced by interstate ATMaccess reciprocity agreements between States(D. C./Maryland).

A major goal of financial service regulationis to assure the safety and soundness of thefinancial system. Technology and marketforces have introduced significant changes inthe industry. Based on available evidence,technology has brought about no apparent re-duction in the safety and soundness of the in-dustry. The changes have encouraged Con-gress to begin reexamining existing legislation,but for the most part Congress has directedits most recent efforts toward catching upwith the events that have been occurring inspite of the legal regulatory barriers. In lightof the realities of the technology, regulatoryconsideration and emphasis may be betterplaced on the impacts of new services on pro-viders and users rather than on the technologi-cal developments that ultimately drive them.

Conclusion 4: Financial Options for the Consumer

A primary consequence of the changes in fi-nancial services has been the proliferation ofoptions available to users. While many sharecommon characteristics, there are technical dif-ferences between them that could catch the userwho is unaware of their true implications.

Today, there are more payments and invest-ment options and a greater variety of insti-tutions providing financial services to theconsumer than ever before. Choices have ex-

panded in all areas of financial decision-making.

Since the introduction of the bank creditcard in the late 1960’s, the consumer has ben-efited from the convenience of a readily accept-able payment mechanism, which provides ameans of payment much more negotiable thana check but safer than cash. In the mid-1970’smoney market mutual funds were introduced,allowing the consumer to invest relatively

202 Ž Effects of Information Technology on Financial Services Systems

small amounts of money at substantially high-er interest rates than with bank savings andtime deposits— without sacrificing liquidityand at apparently minimal risk. By the 1970’s,deregulation legislation recognized both theinability of banks to compete explicitly forsmall-denomination consumer funds under thecurrent interest rate restrictions, as well as theimportance to some consumers of insured al-ternatives to money market mutual funds.Also inherent in the legislation was therecognition of the importance of consumer sav-ings to the health of the economy.

Banks can now offer federally insuredmoney market accounts and interest-bearingaccounts that are the functional equivalent ofchecking accounts (NOW and Super NOW ac-counts). In addition, penalties for early with-drawal of funds from certificates of deposithave been lessened. Through changes in theregulations affecting Individual RetirementAccounts (IRAs), all consumers can enjoysome tax-postponed income. The systematicdismantling of Regulation Q will eventuallycompletely deregulate interest rates on timeand savings deposits.

The individual also has a greater number ofoptions with respect to the financial institu-tions with which he can do business. The lift-ing of regulatory restrictions and the devel-opment of innovative products inside andoutside the banking industry have allowed fi-nancial institutions to become full-service pro-viders, differentiating their products and ap-proaching different market segments. Savingsassociations are allowed to extend consumercredit, which puts them in direct competitionwith commercial banks and consumer financecorporations and, to a lesser extent, retailorganizations. They are also able to offer NOWand Super NOW accounts. Asset managementaccounts available through securities brokersare accessible through debit and credit cards,which have the same characteristics as theplastic counterparts issued by the banks.Owing to the broad acceptability of the creditcards issued by some companies, primarilyVISA and MasterCard, the debit card hasbecome a “paperless check” that is more

readily accepted than the traditional paperinstrument.

Another option for the consumer of finan-cial services is “one-stop shopping” throughthe financial supermarket, where all banking,*investment, insurance, and real estate needscan be served in one place. The most visibleexamples are the Sears Financial Centers,which are under the umbrella of a retailingorganization rather than a traditional finan-cial institution. Other national and regionalretailers as well as bankers and brokers areconsidering the same concept. Also, niche mar-keting–the offering of services tailored to thespecific needs of small groups-is availablethrough financial service boutiques. The up-scale consumer and specific occupational groups(e.g., farmers) benefit.

Technology provides the competitive edge,making a particular product possible or allow-ing an institution to take advantage of eco-nomic conditions. The most widely availabletechnology-based services are the ATM andautomated deposit services (ADS). At-homebanking, which began with simple telephonebillpayer services, is now being introducedthrough videotex services and the computer.Point-of-sale (POS) electronic payments sys-tems, which were attempted in the 1970’s, arebeing attempted again in specific trials.

The distinction between those options avail-able to the consumer through technologicalmeans and those which seem to be the resultof the condition of the economy, product in-novation, and legislative changes is not asclear. Many of the options which seem to bethe result of economic conditions such as in-terest rates—e.g., the money market fund–are facilitated to a great extent by the tech-nology. These funds have been automatedsince their introduction and, considering thesize and number of participants in the in-dividual funds, might not have been possiblewith manual systems.

*Physical deposit-taking services cannot be offered at alllocations.

—

Ch. 8—Findings ● 203— — . — .- ——

The Equity of Choice

Choice, in an economic sense, is good, andas such, the assumption underlying the in-crease in financial management options is thatit must benefit the consumer. However, twobasic issues must be examined in this context:

1. Do all consumers actually benefit from thecurrent expansion of choice in instrumentsand institutions?

2. Are there countervailing trends in the fi-nancial service industry that may even-tually limit options for the consumer or forparticular groups of consumers?

There is some evidence that certain classesof consumers are becoming more sophisticatedand are demanding new financial services.These consumers are becoming asset manag-ers. However, although most consumers areaware of the choices available to them, manyare still confused by the options. Certainsegments of society will prosper under a sys-tem of greater choice: they will have the nec-essary information and know-how to make useof the information to their financial advantage.However, other segments may be less fortu-nate. According to the available trade press,it appears that most financial institutions wishto attract the upscale market, not the lowerincome and lower balance consumers.

Only a small number of consumers fall with-in the definition of upscale, yet nearly all con-sumers require financial services of some sort.Those consumers who are not upscale arelikely to experience a decrease in available op-tions. A particularly obvious example of thismovement occurred in 1983, when Citibank in-stituted a policy that barred customers witha balance under $5,000 from dealing with ahuman teller, Citibank’s action met withstrong opposition and was eventually re-versed. It is difficult to say whether other in-stitutions would have instituted the same orsimilar policies.

There are more subtle means of reaching thesame end, i.e., moving an institution’s lessprofitable customers out of the bank lobby.One way is to price the services of a human

teller higher than those of an ATM. Others in-clude having fully automated branches in con-venient locations and full-service branches inlimited locations, or creating branches whereall teller operations take place at the ATM, butpersonnel on location can assist if there areproblems or can carry out functions not pos-sible through an ATM.

In order for the consumer to take advantageof the increased number of alternatives avail-able for financial management, he must under-stand their function and benefits. Commercialbanks and savings institutions may not beequipped to provide consumers with the in-formed assistance necessary for helping themmake increasingly sophisticated decisions. Inmany cases the bank employee knows as lit-tle about the new products and services as thecustomer he is trying to help. Although theconsumer may prefer to deal with a local in-stitution, he will tend to do business withthose institutions that not only offer him thebest return, but also provide good information.In some cases, that will be the local institu-tion; in others, it will be an institution witha regional or national presence and a more so-phisticated marketing approach. This, in turn,may mean a flow of funds out of the community.

Within a single organization, those profitingfrom the system and those providing informa-tion may be the same, creating a potential con-flict of interest. In the past, one bank’s prod-ucts were the equivalent of the next bank’s,the products offered were straightforward, andcompetition was based not on the relativemerits of each but on the “extras’ ’-i.e., theservice offered. Although Truth in LendingAct regulations require that the terms and in-terest of various credit instruments be clearlystated for purposes of comparison by the con-sumer, there is no comparable requirement forinformation about investments.

Marketing to the Consumer

It is no longer clear what the purpose androle of depository institutions is. No longer dosuch institutions have a unique niche in themarketplace. Under these circumstances, in-

204 ● Effects of Information Technology on Financial Services Systems— —

formation available to the consumer maysometimes be biased. In the highly chargedcompetitive atmosphere that now prevails inthe financial service industry, informationmay either obscure the real situation or inflateits advantages. A particularly vivid exampleoccurred the first year that IRAs were madeavailable. Advertisements stated that theholder of an IRA could be a millionaire byretirement; however, the ads misled the pub-lic by failing to put the notion in economicperspective. Although the consumer shouldapply the principle of “caveat emptor” to themanagement of his financial affairs, he hascome to perceive banks as noncompetitive, andhe conducts his business with banks based onthis perception.

In addition to the issue of consumer confu-sion about available options, which in someways can be solved by making informationavailable, there is also the question of con-sumer awareness and education. Consumer research shows that beyond a certain numberof variables, the consumer tends to be unableto process information. Often, increasing theamount of information available does not help.Educational differences or the predispositionof the consumer may preclude him from proc-essing the information in a way that would fa-cilitate decisionmaking. Also, the consumerneeds more time to make intelligent decisionsabout the management of his assets, whichcould force changes in the industry in a num-ber of ways. First, it seems to support the needfor a class of personal financial advisors. Thistrend is likely to continue as the number andcomplexity of options available to the con-sumer increases. Unfortunately, there is nocertifying process or standard form of educa-tion required for these advisors.

Second, it could also eventually affect thenumber of options offered by the industry. Ifinstitutions find that their clientele are con-fused and unwilling to spend the time to makea decision among a wide variety of choices, theinstitutions may decrease the number of op-tions available. For example, as of October 1,1983, banks were allowed to offer certificatesof deposit in any denomination for any time

period, with fewer withdrawal penalties. Theymay, however, benefit more from offering onlyspecific products to avoid the confusion at-tached to infinite choice, in much the sameway that a manufacturer will package hisproducts in prespecified amounts. A situationmay evolve where the industry is allowed tooffer many alternatives but chooses to offera limited selection based on the preference ofa particular market segment or, -perhaps,mass market.

Changes in Pricing Structure

the

The one trend that is likely to have the mostsignificant effect in the near term on the avail-ability of options to the consumer is the ex-plicit pricing of services.

Competition has forced the industry–in par-ticular, banks-to reduce the “spread,” or thedifferential, between interest earned on assetsand paid out on liabilities. In the past, this dif-ferential has been the major source of incomefor financial service providers; however, newsources of income are needed to replace incomelost from the reduction of spread. In addition,higher balance, static accounts subsidized ac-tive accounts having a low-to-zero balance. Asa result of the change in the industry’s com-petitive structure, customers are beginning tobe charged for the cost of their services. In ahighly competitive, deregulatory atmosphere,cross-subsidization is infeasible because thelarger, more profitable account holders willtend to move to those institutions where theycan earn the highest interest rate.

Fee-for-service pricing, in most cases, willencourage the consumer to use those servicesthat are the least expensive and may thereforelimit his use of particular products and serv-ices. However, in certain cases he may nothave a choice; for example, most householdsneed checking accounts to manage their ac-counts. This trend toward explicit pricingseems to affect payment mechanisms the mostand therefore will have the greatest impact onthose consumers whose financial transactionsare heavily payment-oriented.

Ch. 8—Findings ● 205.— — —

The Implications ofTechnology-Based Products

Recent work published by the Federal Re-serve Bank of Atlanta projects the rate atwhich checks will be displaced by other, elec-tronic, methods of payment. Although it stillrepresents a small percentage of total accountactivity, the steady growth in the deploymentand use of ATMs shows some willingness bythe consumer to accept technology-based serv-ices when they meet specific needs. In theAtlanta analysis, the first stage of checkdisplacement will be in the cash-dispensingfunction. As long as the infrastructure for theacceptance of electronic payment remains un-derdeveloped, there will still be a need forpaper-based instruments.

Eventually, the entire population may haveto participate in the system. This becomes par-ticularly obvious on examination of direct de-posit services. Since the U.S. Treasury beganencouraging direct deposit of Social Securitypayments, the penetration of direct deposithas gone from 11 percent of total paymentsto 33 percent. ] A Social Security system where100 percent of all transfer payments aredirectly deposited would require that all recip-ients hold accounts with a financial institutionor be provided some alternative means of re-ceiving payments electronically.

Currently, 17 percent of all households donot have any relationship with financial in-

— ———‘Economic Review, Federal Reserve Board of Atlanta, August

1983, p. 33.

termediaries, either because the consumerchooses not to establish this relationship orbecause he is an undesirable customer andtherefore cannot find a financial institutionwilling to do business with him. With directdeposit there is pressure on both the individualand the institution to form a relationship. Thispressure for institutions is in direct oppositionto the competitive pressures they feel from therest of the industry to rid themselves of un-profitable accounts. Yet, these accounts neednot be unprofitable for the bank if it chargesappropriately for its service. However, the po-tential exists of charging an individual, whois in essence forced into the system, a dis-proportionately high portion of his income. *There is some argument for the subsidizationof these accounts, but with the current com-petitive state of the industry, it is doubtfulthat a financial institution would be willing tobear those costs. It is not unreasonable to ex-pect the organization that benefits from directdeposit, in this case the U.S. Treasury, to paythese costs.

As direct deposit of government transferpayments becomes more common, other reg-ular income payments may also be paid direct-ly. The issue on a larger scale is not only whopays for the service, but also whether the con-sumer can be forced to establish a relationshipwith a financial service intermediary in orderto receive his salary.

*sOme ~ndil~idu~s LISP Ser},ices for a Jrariet?r of nOrlllati\’e rea-

sons that may actuall}’ be more expensi~’e than would becharged by a financial institution.

Conclusion 5: Security and Integrity of theFinancial Service System

The application of advanced information tech- Theft of Fundsnologies to financial services significantlychanges the ways in which, and the extent to There are two kinds of threats to financialwhich, payment and transaction systems and service systems: 1) those threats inherent inthe users of these systems are vulnerable to sys- the system, that usually require technical solu-tem failure, disruption, theft, error, and invasion tions; and 2) those that are perpetrated by in-of user privacy. dividuals who wish to compromise the system

206 ● Effects of Information Technology on Financial Services Systems

and that require more complex solutions, in-cluding technology. Some types of crime arepossible because of the nature of the paper-based system–e.g., theft of funds sent throughthe mail, check forgery, and even, to a certainextent, credit card counterfeiting. Technology-based systems can provide solutions; however,by providing new points of entry into the sys-tem, they offer potential for new kinds offraud. Future crimes involving financial trans-action and payment systems will primarily in-volve a computer simply because one is inevi-tably part of a large-scale, modern-day financialsystem. The question of computer securitytouches every aspect of the financial serviceindustry. As the volume of EFT transactionsrises, it becomes increasingly important thatfinancial information be secured against un-lawful entry and that a system of law be de-veloped under which computer criminals canbe prosecuted.

Some perceive technology as a solution toproblems that plague the consumer of finan-cial services. Credit card fraud, which is fre-quently cited as a growing problem in the in-dustry, can be made more difficult by the useof sophisticated technologies. Because of con-sumer protection legislation, fraud is primar-ily a provider problem. The consumer is pro-tected from illicit use of his credit cards, andif sufficiently informed, he can prevent all buta minimal financial loss from the fraudulentuse of his card. Both VISA and MasterCardhave introduced or are planning the introduc-tion of cards that are expensive and difficultto counterfeit. It is difficult to say whetherthese cards will in the long run reduce fraud,since it will be some time before the effect oftheir introduction and use will be felt. The costto produce these cards will be much greaterthan that for current credit cards. Althoughthe consumer will explicitly or implicitly paythe cost of the card, it may not mean addi-tional financial burden for the consumer in thelong run because of the reduced costs of fraudto the card user.

Recent concern in the area of consumer fi-nancial services has revolved around the rela-tive security of access devices and the need

-.

to identify positively the EFT user. As sys-tems become more complex and a greater per-centage of the population begins to use homebanking and POS systems, problems with thecurrent means of identification will becomemore obvious. With ATM the consumer’s lossis limited by the amount of cash he is allowedto withdraw from the system. Although hisliability for unauthorized transactions islimited, under the Electronic Funds TransferAct (EFTA), his financial loss could be greaterwhen more sophisticated financial trans-actions are involved and if those transactionsare not reported within the time required bylaw. This risk could affect the willingness ofthe consumer to use these systems, and there-fore the rate of acceptance of these services.In that event, the market could force the pro-viders of services to secure systems better. Itshould also be noted that to the extent thatthe law places responsibility for losses on theprovider, it provides additional impetus forproviders to secure their financial systems.

Solving the identification problem is evenmore difficult when placed in the context ofthe home or workplace. The volume of busi-ness at an ATM may allow the use of expen-sive identification technologies that would notbe feasible at a place of business, and certainlynot at home. Now the major means of iden-tification in these systems is some form ofalphanumeric code or personal identificationnumber (PIN), again not identifiable with aspecific individual. Although banking termi-nals in these locations do not yet dispense cashor a cash equivalent, they certainly provide theopportunity to transfer funds among accountsor to embezzle electronically. These problemswill become immense if all personal computersare equipped to access videotex services andelectronic financial services and if a larger per-centage of the population has access to theseterminals.

EFT also generates new kinds of personalsecurity problems—an individual using anATM to receive cash maybe particularly vul-nerable to robbery. During normal businesshours, a traditional brick and mortar facilityprovides the individual with security during

. .

—

and after a transaction. An ATM located awayfrom this structure may place the user in avulnerable position. Even those ATMs locatedat bank branches can be unsafe when used innonbanking hours. It is difficult to assess theseriousness of the problem because most insti-tutions are unwilling to divulge informationon security issues for fear of discouraging useof the systems. Often, the robberies that oc-cur at ATMs are not reported as such.

The smart card is another new technologyclaimed to be more secure than existing cardtechnologies. The microchip-implanted cardhas different levels of security, but the futurerole of the smart card in the financial serviceindustry remains unclear.

In the commercial environment, the securityof payment systems is also an issue of signifi-cance. The increasing use of computers to ini-tiate payments automatically raises the needto establish the identity of the computer ini-tiating a financial transaction, just as, in thepast, it has been necessary to establish posi-tively that a payment order issued by a humanis authentic. Financial systems that performaccounting as well as payment functions mustbe auditable, lest an unauthorized feature behidden in the computer programs that consti-tute them. Care must be taken to limit accessto financial information that may be of valueto an intruder, even if there is no unauthorizedtransfer of funds. Finally, superimposed onthese requirements are all of the concerns thatpertain to individual users of financial serv-ices, particular services that entail remote ac-cess to financial service systems.

System Integrity

Systems for delivering financial services canalso be compromised by a number of factorsthat are inherent in the operating environmentbut are, nonetheless, capable of interruptingservice.

In the more traditional systems for deliver-ing financial services, breakdown of system in-tegrity is possible. Records can be lost, alongwith the audit trails necessary to reconstructthem. Checks and balances built into proce-

Ch. 8—Findings ● 207— — . .

dures for processing transactions can be cir-cumvented for expediency or can fail tooperate under an unanticipated set of circum-stances. However, human involvement in thedelivery systems can be instrumental in de-tecting breakdowns of system integrity whenthey occur and in implementing the steps to

repair or minimize the resulting damage.

On the other hand, financial service deliv-ery systems that rely heavily on advancedtechnologies are subject to more breakdownfactors than those that can damage or destroysimpler technologies. At the same time, theymay be built to include protections that can-not be incorporated into simpler systems.

Computer programs, for example, are de-signed and built to handle a predetermined setof conditions. Any data values not falling intoone of the defined categories should be re-jected by the program and examples of suchoccurrences should be included in the testsconducted before a program is put into oper-ation. However, even though computer pro-grams are “validated,” exhaustive testing isnot physically possible, and there is always thechance that some combination of data can beentered that will produce totally unanticipatedresults. If the system operator is lucky, theimpact will be large enough that it will benoticed immediately and corrective action canbe taken. On the other hand, if the error is sub-tle, its effects, though significant, can go un-noticed for years. In the aggregate, the im-pacts could be significant, although no oneincident may be great enough to instigatesteps to correct the error.

Computers rely on magnetic media for stor-ing data, and these media are generally quitereliable. However, since they are not as reliableas paper, particular pains have to be taken tomake sure usable copies of the data are avail-able when needed. For example, data on mag-netic tape will deteriorate with the passage oftime. Also, mechanical failure of a disk drivecan cause data to be destroyed. Although so-phisticated techniques exist for detecting er-rors in data recorded on magnetic media, someerrors remain undetected. These problems are

208 ● Effects of Information Technology on Financial Services Systems. — .

reasonably well understood, and the tech-niques for neutralizing them are straightfor-ward and relatively inexpensive if operatingmanagement is willing to pay sufficient atten-tion to them and the system design incor-porates them.

Similarly, the use of telecommunications insystems for delivering financial services intro-duces threats to system integrity. Quitesimply, if a path between a user and a serviceprovider is not available and verifiable, serv-ice cannot be delivered. However, several or-ganizations may be involved in operating thetelecommunication facilities that are used,and the problem arises of identifying the onesthat are responsible for detecting and correct-ing any errors that may occur. The divestitureof the Bell System complicates this problemsomewhat, but, again, resolution is not beyondthe means of competent technical management,

To a very significant degree, a financial serv-ice industry operates on the trust and confi-dence of its customers. Thus, the systems usedto deliver financial services must be reliableand verifiable; if not, the basic viability of theindustry could come into question. In the fu-ture, virtually all providers of financial serv-ices will rely heavily on information process-ing and communication technologies, and itwill be virtually impossible for them to revertto manual systems, even for short periods. Theapplication of advanced technologies in sys-tems for delivering financial services intro-duces new vulnerabilities to system integrity.1f these are not taken into account by thedesigners and operators of these systems, thebasic trust that customers place in the finan-cial service industry could be threatened.

Since the class of problems discussed hereare purely operational and can be resolvedpartly with technical solutions and partly withoperational procedures and management con-trols, the key question is whether operatingmanagement will devote the resources re-quired for the solution of these problems andwhether those who regulate financial institu-tions will include in their reviews of operationsthose factors that affect the integrity of sys-

tems for delivering financial services depend-ent on advanced technologies.

Specific Consumer Concerns

Transition From Paper-Based toTechnology-Based Systems

Competitive pressures within the financialservice industry have fostered the use of tech-nology, augmenting and replacing paper-basedsystems. On the consumer side of the business,however, this force must be reconciled with thedemands of the marketplace, which maybe infavor of paper-based systems. As a result, theimplementation of technology has not alwaysbeen as easy in this market as in others.However, as technology-based services andproducts are introduced and accepted in themarketplace, certain issues arise that are spe-cifically related to the transition from onesystem to another, and to the reliability ofsystems.

Although technological systems may havea lower error rate than those using manualprocessing, those errors may be more difficultto detect and resolve. In contrast, a human er-ror can often be resolved immediately. A sig-nificant problem regarding some advancedsystems for delivering financial services is thatthere is no guarantee that a paper record ofa transaction is ever created. While Regula-tion E requires that a customer be issued a re-ceipt at an ATM, remote financial services ac-cessed through a terminal located on customerpremises are not covered. Thus, an individualcan initiate a transaction without any tangi-ble proof of the fact. Also, while a stop-pay-ment order can be put on a check that is be-lieved to be lost in the mail, it is not clear thatan analogous step is possible in cases wherea payee denies having received an electronicpayment. Guidelines are written that enablea consumer to stop a pay order via the auto-mated clearing house (ACH).

Regulations Relating to Consumer Finance

The consumer facing choices between simi-lar financial instruments is probably unaware

. . . .

Ch. 8—Findings ● 209. . — —- —— — . ———

of their differing regulatory requirements, orof his protection under the law. It is now pos-sible for an individual who possesses what ap-pears to be a traditional bank credit card tobe protected from misuse of the card under avariety of legislation or not at all, dependingon the type of transaction.

If a bank issues an individual a debit cardthat is associated with an account with a lineof credit and is also an ATM debit card, theindividual can perform a number of differenttypes of transactions with the same card. Ifhis line of credit is accessed fraudulently, theowner has recourse under consumer credit leg-islation and under Regulation E if the fraudinvolves EFT. When ATMs or electronic POSterminals are used, his liability is limited underEFTA. If, however, the fraudulent use of thecard directly debits his bank account in apaper-based transaction, the consumer has norecourse under current legislation. This is anexample where the same card represents threedifferent instruments, each of which, in thecase of fraud, would require different actionsby the consumer.

The consumer is likely to be aware of the dif-ference between accessing a line of credit anddirectly debiting his bank account with thecard, but it is doubtful whether he would rec-ognize a distinction between a debit that isprocessed electronically and one that is proc-essed in the paper system. It is also reason-able to assume that the consumer perceivesno differences between the transactions in aregulatory sense. Of particular importance,regardless of consumer perception, is the factthat debit card transactions in the paper-basedsystem offer no protection to the consumer.

Privacy

Much controversy surrounds the issue ofEFT and privacy —i.e., whether the systemsthat enable EFT make the individual morevulnerable to violations of privacy. The diffi-culty of such a discussion is that since privacyhas a different meaning to every individual,violation of privacy is not easily defined. Inthe final report of the National Commission

on Electronic Fund Transfers, privacy wasdefined as “the individual’s expectation of con-trol over what information about himself iscommunicated to or used by others. ” Further,“the object of the consumer’s concern regard-ing privacy under EFT is the potential use ofhis financial transaction information to de-velop a personal profile.”2 This use could beas seemingly harmless as an individual receiv-ing product solicitations, based on his incomeand profession, from the financial institutionwhere he does business and could range to thecapability of the system to provide sensitiveinformation about behavioral patterns of theindividual.

Consumers, for the most part, do not appearto perceive privacy as a major concern in theirchoice of EFT systems; other, more market-oriented, questions seem to determine theiruse of these systems. A Bank Marketing As-sociation (BMA) survey questionnaire showeda low level of concern about privacy with re-spect to electronic banking systems. There isadditional evidence that transactions per-formed by ATMs are considered more privatethan are transactions using a human teller.’]

The paradox is that other studies show thepublic to be very concerned with privacy, inparticular, the use by government of personalinformation. 4 However, correlations have yetto be made between this use and individualuses of financial systems. The BMA surveydoes not question overall the individual’s feel-ings about financial privacy; it only questionsthe consumer on how secure he perceives spe-cific financial services technologies to be andindicates that users of the technology seem tobe less concerned than nonusers with privacy.

However, the issue extends further, to thecapability of these systems to track financialactivity, which was impossible on a large scaleunder a paper-based system. Individual be-

2National Commission on Electronic Funds Transfer, final re-port, October 1977, p. 19.

‘Ilank .$! arketing ,Lf ssocjation, Pa.}’ men t .+1 t t) tudes (’f?angf’l;~aluation, {Chica~o, 111.: BNIA, 1982), p. 2.1 H.

‘I,ouis 1 I arris & Associates, Inc., and Alan F. \$’estin, ‘‘TheDimensions of Pri\rac}’, ” 19’79.

210 . Effects of Information Technology on Financial Services Systems— — —

havioral profiles can be compiled in the tradi-tional system using account records, but onlywith great effort and expense. The same tasksbecome fairly easy using technology. The com-petitive atmosphere in the financial service in-dustry today encourages the accumulation ofpersonal information to help minimize the costof bad accounts and to segment a market ofpotential customers to approach with newproducts. The accumulation of this informa-tion for marketing purposes allows a readydata base for other purposes. Not all com-panies have and enforce a strict privacy pol-icy, nor do they guarantee that the informa-tion is inaccessible through other means, legalor otherwise.

Privacy is not entirely a domestic issue.Countries outside the United States, notablyin Europe, express considerable concern forprotecting the privacy of individuals and, insome instance, businesses. Some have limitedor prohibited the movement of data relatingto their citizens to nations that do not meettheir standards for privacy protection. Hence,pressure for privacy legislation may material-ize from sources outside the United States,regardless of the level of concern of Americancitizens with the issue.

Conclusion 6: Integration of Capital Markets

Advanced financial information systems haveforced the creation of a highly integrated, na-tionwide capital market and increased the ve-locity of money.

A highly integrated, nationwide capital mar-ket is being created, driven by the demandsof users and facilitated by the application ofinformation and communication technologies.Financial institutions began moving capital ona national scale when it was recognized thatcapital supply and capital demand within re-gions do not necessarily meet. These insti-tutions have produced a national marketthrough which needed and available fundswithin and between regions of the country arebalanced. Local financial institutions are ableto serve as intermediaries between their cus-tomers and national markets because of theiraccess to the financial systems and becauseof their expertise. The ability of an organiza-tion or individual to participate in a capitalmarket is restricted by the quality and quan-tity of information available on the market,and financial service providers have tradi-tionally had superior access to that infor-mation.

Traditionally, secondary markets for bothdebt and equity securities facilitate the proc-ess of intermediation between regions. Under-writers buy securities from the primary issuersand make them available on local, regional,and national markets. Modern informationprocessing and telecommunication technol-ogies have provided increased exposure tosecurities and therefore have increased oppor-tunities for issuers to increase net proceedsfrom the paper issued.

Congress mandated the development of anational market system for securities in 1975.National markets are advantageous for capi-tal seekers and investors. The truer and moreequitable pricing of funds that results from ex-posure to larger markets is demanded by mar-ket participants. This impact is demonstratedby the success of the National Association ofSecurities Dealers Automatic Quotation Sys-tem (NASDAQ), which provides nationalmarket exposure to what in the past wereover-the-counter stocks. Trading volume onNASDAQ has reached the levels of the NewYork Stock Exchange as investors are at-

Ch. 8—Findings ● 211— . —

tracted to issues to which they suddenly haveaccess.

The Effect of a National CapitalMarket on Financial Services

A national capital market results in competi-tion between diverse local and regional require-ments for capital. The fundamental problemassociated with the national market is whetherthere is equal access to all potential players.While information technology facilitates thecommunication of information used as thebasis of financial decisionmaking, and there-fore has made it easier and cheaper to partici-pate in the national market, in some cases theadvantages of a regional market may be lost.For example, regional markets may be moreappropriate for the development of capital fornew or growing firms that may not be able tocompete in a national environment yet makea unique and valuable contribution to the econ-omy of the region. Cost and income character-istics for businesses tend to differ between re-gions, and it may be beneficial for a firm tohave its potential level of return evaluatedregionally rather than nationally. While the ac-tual cost of money may be equal in a nationalmarket, its cost relative to return may differbetween regions.

The exposure of securities and loans to na-tional market circumstances has led to anequilibration of securities prices and interestrates. This trend initially developed on an in-stitutional level and has now encompassedconsumer markets. Consumers and small busi-ness customers were at one time dependent onlocal financial institutions because they didnot have the knowledge required to operate ina financial market beyond their area. Theavailability of information on a national levelresults in more equitable choice and qualityin services offered.

The nationalization of capital formation maybe a leading cause in the shift in placement ofan increasing portion of consumer funds intoinvestment instruments, such as money mar-ket mutual funds. This movement is an indica-tion of the importance of information flows in

financial decisions. Technology that allows fora rapid transfer of information diminishes theimportance of location of both service pro-viders and customers. Return potential hasenabled the funds to draw a market share froma broad-based population.

Investment funds may draw capital awayfrom depository institutions and therefore themortgage market. The individual developmentof equity represented by home ownership isan important cultural and economic value inU.S. society. Historically, the home mortgagewas placed by a depository institution in thesame community as the financed property;however, information technology has facili-tated the nationalization of mortgage capitalmarkets and changed the ways in which thiscapital is developed. The movement away fromlocal mortgages may be harmful for consumersin some areas and may remove some incen-tives for forming ties with local financial in-stitutions.

The development of secondary markets forboth long- and short-term debt instrumentshas been a great benefit for smaller financialinstitutions. Financial institutions, particular-ly banks, are able to redistribute and balancecapital by buying and selling debt contractsamong themselves. Information technology fa-cilitates this process by making it easier forfinancial institutions to identify potentialtrading partners and to analyze market oppor-tunities.

While access to the national capital marketthrough the use of information technologymay greatly benefit sophisticated investors,some worry that less sophisticated investors,who need help to interact in a national mar-ket, may realize lower returns. The nationalcapital market has caused a proliferation of in-vestment choices that entail a higher level ofanalysis of personal investment goals and op-portunities.

At the same time that a national capitalmarket has been developing, the velocity ofmoney—a measure of the number of times perperiod an average dollar is spent to purchasenewly produced goods and services—has been

212 • Effects of Information Technology on Financial Services Systems

increasing. While the incredible growth in thetrading of securities and in asset transactions,as seen in bank deposits, may be driven bymarket forces, it would be physically impos-sible to complete the actions required for theseactivities without communications and com-puter technologies. While information technol-ogy is not directly the cause of an increase inthe velocity of money, without its applicationthe velocity could not have increased to thelevel demanded by the market. This type ofconstraint could have a severe impact on theeconomy.

It is now generally accepted that there is notechnological constraint to the trading ofassets at whatever speed is demanded by themarket. Almarin Phillips notes that bank de-mand deposits in New York City were turnedover 1,200 times a year in 1981 as comparedto an average of 150 times a year in 1970. Heattributes this acceleration to the appearanceof new markets, the availability of better in-formation, falling transaction costs, increasedliquidity of many assets, and the general risein interest rates. These factors have put apremium on the efficient management of liq-uid assets.5 It would be prohibitively expen-sive to complete transactions at the demandedspeed without the level of technology appliedby the banking and securities industries in thelast several years.

As the banking industry moves toward mul-tiple settlements during a business day, fail-ure to adopt the needed technology could re-sult in a massive movement of funds out ofthe financial service industry by corporatecash managers. An indication of this poten-tial was seen in the movement to trade secu-rities off organized exchanges in the early1970’s, when it appeared that the exchangescould not operate at the level demanded. Trad-ing was only returned to the exchanges as in-formation technology increased their capacityand speed.--——-.-..——_—-

‘Almarin Phillips, “Technology and the Nature of FinancialServices, ’ Strategic Planning for Econom”c and TechnologicalChange in the Financial Services Industry, Proceedings of theEighth Annual Conference, Federal Home Loan Bank of SanFrancisco, Dec. 9-10, 198!2, San Francisco, Calif., pp. 5-6.

The increase in trading volume for securi-ties is another indication of the general quick-ening of the American economy. Share daysof 100 million are not uncommon on the NewYork Stock Exchange, on which a daily aver-age of less than 17 million shares were tradedin 1972. And high volume no longer requiresthe curtailing of trading hours. Long-rangeplanning by the New York Stock Exchangeanticipates average daily trading of between200 million and 250 million shares.’ Given therequirement for quick settlement, it wouldhave been physically and fiscally impossiblefor trading to approach this level without automation.

Information technology has given both do-mestic and multinational firms far greater ca-pability to identify available assets and to di-rect them to those investments that offermaximum return for whatever period thoseassets are available. This ability relates to thetremendous growth of money market mutualfunds and accounts that are based on short-term investment instruments.

Future Impacts of Technology onCapital Markets

In an integrated world economy, a high de-gree of capital mobility is required to offsetmovements in other items of balance of pay-ments. 7 An international capital market hasdeveloped, facilitated by the application of in-formation technology. This market is havinga major impact on the world by intertwiningthe economies of culturally and politically di-verse nations. Also, worldwide financial cen-ters have emerged in countries such as HongKong and Bahrain. Unlike a domestic market,however, there is no overriding internationalsystem through which a global economy couldbe governed. Whereas the United States ofAmerica share a common Federal Governmentand political and cultural rooting, this type ofrelationship does not exist between nations.

61VYSE 1983 Fact Book, p. 4.‘R. M. Pecchioli, The Internationalisation of Banking: The

Policy Issues (Paris: Organization for Economic Cooperationand Development, 1983), p. 115.

Ch. 8—Findings ● 213-. .—.— ———- .- ——

The differences between telecommunicationindustries and regulations in various countriesmust be recognized as a barrier to the devel-opment of global capital markets. Informationtechnology creates new vulnerabilities in in-ternational markets.

Information technology has made it possi-ble for financial service institutions in differentnations to direct excess capital much in thesame way it is directed between regions of theUnited States. In addition to more sophisti-cated asset and liability management tech-niques, improved communication facilities hadvast consequences for the rapid emergence of

the eurocurrency market for redeployment ofinternational capital. 8

Communication technologies have also hada particularly strong impact on internationalwholesale or interbank activities. Interbankactivities provide a large portion of the fundsfor international investment. The use of tech-nology has allowed small banks for the firsttime to become involved in internationalbanking.

‘I bid., p. 20.

Conclusion 7: Entrants Into theFinancial Service Industry

The major new entrants into the financial serv-ice industry are, and will increasingly tend tobe, organizations that already have extensivedistribution and/or communications systems.

A financial service organization that has anestablished technology infrastructure usuallyhas a competitive advantage in three areas:1) facilitating the intermediary functions of thefinancial service industry; 2) providing conven-ience of location to its customers, including theincreased movement to remote banking andother financial services; and 3) in general, im-proving productivity.

The experience of present leaders in the fi-nancial service industry —e.g., Citicorp, Sears,ADP, and Merrill Lynch–indicates that strongdistribution and communication systems aremajor factors in their ability to capture andserve markets. It is expected that the controlof or access to distribution and communica-tion systems will continue to be an importantindication of the potential success of currentindustry players and, therefore, an indicationof who will be the new entrants into the finan-cial service industry. The identification of po-tential entrants is important because they help

determine the competitive character of the in-dustry.

The Role of Information Technologyin Competitiveness

The flow of information is essential to theorderly operation of financial service marketsbecause it is essential to the making and di-recting of decisions. Information may be arepresentation of or collateral to the transferof value. At the same time, cost and accessi-bility considerations have led to a change inpreference for electronic systems from theonce-practical paper-based systems for manytypes of information. The transfer of financialservice records is changing from the physicaltransportation of documents to the electronicexchange of information. The communicationsystems developed to meet this demand arefar more technology-dependent and capital-intensive than their predecessors.

The application of information technologyfrequently decreases the costs of delivering fi-nancial services. The corporation that canautomate delivery systems has a competitive

214 ● Effects of Information Technology on Financial Services Systems

advantage because it faces lower total costs.The importance of technology in communica-tion systems is found in time, as well as dollar,considerations.

Availability of Services to SmallFinancial Service Providers

Lack of access to sophisticated communica-tion and distribution systems could poten-tially be a significant barrier to small serviceproviders both for entering and competing infinancial service markets. A tier of wholesalersof data processing and communications serv-ices has developed to supply services to end-users or to small financial service providersthat cannot afford to invest in large-scale com-munications or computer systems.

Entrance by Holders of Communicationand Distribution Systems

Existing information technology infrastruc-tures have provided market opportunities inthe financial service industries for several cor-porations. For example, a data processingfirm, ADP, is an organization whose entranceinto the financial service industry grew fromholding a sophisticated computer and commu-nication system. J. C. Penney has applied itscommunication network to the processing ofoil company credit card transactions. Penney’sestablished communication system gave it theopportunity to expand into new markets.

Given the great value of sophisticated com-munication systems to operating financialservice systems, new entrants may be foundin established communication firms such asAT&T and MCI, which may find it cost effec-tive to enter the financial service industry aswholesalers of services or, because of theirestablished systems of customer service, as di-rect service providers.

A successful distribution system may bejudged not only by the number of physicallocations in which an outlet is placed, but alsoby the extent to which it provides cohesivecoverage of markets. Distribution systemsshare many of the characteristics of commu-

nication systems and are usually dependenton information technology for operation.

Established distribution systems may easeentry barriers to new markets. When Searsentered the financial service market, it had thebenefit of an established system of retailstores through which it had community pres-ence. The availability of these locations for theoffering of financial services eliminated muchof the startup cost involved in selecting appro-priate locations for retail businesses, since in-formation on customer traffic and other sitecharacteristics was available. The opportunitycost for Sears of extending its line of com-merce to financial services may be assumedto be lower than otherwise might be expectedbecause much of the cost for distribution chan-nels was already paid.

The distribution system of a player in thefinancial service industry involves not only itsphysical presence but also its ability to dis-seminate information. Sears has the most ex-tensive private card base in the Nation, equalin importance to its retail outlets. BecauseSears had this communication system in place,it could develop a direct marketing system.

Future entrants into the financial service in-dustry may include corporations that enjoy astrong distribution system such as gasolineretailers. These corporations have a presencethrough gas stations in urban and rural areasthroughout the Nation, a strong fiscal person-ality, significant card bases, and sophisticatedPOS systems.

The Effect of New Entrants onServices Provided

The new entrants with strong communica-tion and distribution systems have increasedthe number of options available to financialservice consumers by making a wider rangeof product offerings and delivery mechanismsavailable. Communication and computer tech-nology has made it possible to develop farmore diverse and complex investment pack-ages that serve a greater range of investors.In addition, the refinement and increased

Ch. 8—Findings ● 215— — —— ——.———

speed of settlement found through the applica-tion of information technology also improvesthe quality of service received.

It is possible that, in the long run, the needfor communication and distribution systemsmay decrease consumer options if the marketbecomes dominated by national firms with lit-le local presence. However, it does not appearlikely that the market would tolerate this typeof development. Small firms can compete aslong as they are able to access delivery sys-tems built and operated by others.

The possibility of cross-entry into the finan-cial service industry by communication firmsand others may protect consumers from theeffects of monopolization. No matter whathappens to the concentration levels in the fi-nancial service industry, the availability of ad-ditional and diverse organizations to providefinancial services if market circumstances arefavorable should lead to competitive prices.

The Effect of TelecommunicationRegulations on Financial Services

Most segments of the financial service in-dustry are subject to Federal or State regula-tion. With the application of communicationtechnologies, players throughout the financialservice industry may find themselves subjectto regulation both of their products and serv-ices and of the systems they use,

While it maybe expected to be a transitionalproblem, the applicability of two regulatorystructures to the financial service industrymay hinder its operation by increasing admin-istrative costs. In the extreme, the economicviability of existing systems could be de-stroyed. Product development and marketingactivities could be adversely affected by reg-ulatory uncertainty about communication fa-cilities. Regulation of communication servicesmay limit the ability of financial service pro-viders to realize the potential benefits of newtechnologies in internal systems if restraintson their usage are imposed. As a result, newsystems could be stymied.

Antitrust Implications

Vertical integration may result in greatermarket concentration by foreclosing the com-petitive opportunities of those selling or buy-ing in competition with integrated marketparticipants.9 Given that distribution andcommunication systems of an organizationmay be indicative of possible future entranceby an organization, these systems should alsobe considered in cases of proposed mergers.Antitrust enforcers should be aware of thepossibility that if dominant communicationcarriers move into the payment system it ispossible that their market position in com-munications may place banks and other finan-cial intermediaries at a competitive disad-vantage. 10

Antitrust enforcers should also keep the in-creasing competitive overlap in mind whenanalyzing mergers. The Merger Guidelinesissued by the Department of Justice in 1982identify both established players and firmswhose production and distribution facilitiescould reasonably be adapted for entrance intoa market as market participants.11 The mar-ket impact of proposed mergers and acquisi-tions has to be evaluated, among other factors,by the likelihood of one of the players inde-pendently entering the market of the other asa competitor. Therefore, distribution and com-munication organizations outside of the finan-cial service industry that propose a mergerwith a current player should be evaluated interms of their adaptability to financial ap-plications.

‘Donald 1. Baker and W’illiam Blumenthal, 4 ‘The 1982Guidelines and IJreexisting Law, ” California Law Ite}’iewr 71,March 1983, pp. 311-344.

1ODon~d 1. Baker ad 13everl}~ G. Baker, “Antitrust ~d Com-munications Deregulation, 28 Antitrust Bulletin 1, 1983.

‘l Baker and Blumenthal, op. cit., p. 337. Baker and 131umen-thal note that the U.S. Department of tlustice, NlergerGuidelines \I, 47 Fed. Reg. 28,493, 28494 (1982) list the fol-lowing classes of firms as market participants: 1) firms thatcurrently produce and sell the relevant product, 2) firms whoseexisting production and distribution facilities could be shiftedto enable the firm to produce and sell the relevant productwithin 6 months of a 5 percent price increase. 3) firms that recy-cle or recondition products that represent good substitutes forthe rele~.ant product, and 4) vertically integrated firms that pro-duce the relevant product for capti~’e consumption.

35-505 0 - 84 - 15 : QL 3

216 ● Effects of Information Technology on Financial Services Systems

Conclusion 8: Competition in the Marketsfor Financial Services

A major uncertainty in the changing structureof the financial service industry is what degreeof consolidation and concentration of serviceswill eventually occur. A second major uncer-tain y is what level and scope of competition infinancial service markets would be appropriateand desirable for a healthy future economy.

The compartmentalized structure of the fi-nancial service industry established over thepast 50 years is in the process of vanishing,and the future structure of the industry re-mains as yet undefined. In the past, geograph-ic limitations were placed on the areas a bankcould serve so that none could position itselfto dominate the banking industry. Becausebanks were limited only to the banking andrelated business, banks were also effectivelykept from using their unique position in theeconomy to dominate other industries. How-ever, banks were given an exclusive franchisefor the taking of deposits and access to thepayments system. Only commercial bankswere permitted to offer a demand depositaccount, and only they had access to theFederal Reserve and the check-clearingmechanism.

Regulations were promulgated for specificclasses of institutions; so long as there was noeffective way for new entrants to encroach onthe franchises that had been granted in legis-lation, the structure remained intact and wasgenerally able to achieve the goals that hadbeen established for it. However, economicconditions, in combination with the latent ca-pabilities of advanced information processingand communication technologies, encouragedthe successful entry of new firms into the fi-nancial service industry from such diverseareas as retailing, communication, and infor-mation processing.

Significant numbers of those concerned withthe long-term effects of the changes now tak-ing place in the financial service industry have

expressed concern that one of the outcomeswill be consolidation. The number of firms inthe industry would be reduced to a point wherea small number could dominate the market.Such concentration would directly contraveneone of the central themes embodied in estab-lished policy. Some also express concern thatusers of financial services provided by nonde-positor institutions may be exposed to un-warranted risk because the firms providing theservices may be prone to accepting a higherdegree of risk than depository institutions arepermitted to take.

Even though firms not traditionally pro-viders of financial services have entered theindustry and operate outside the constraintsimposed on traditional suppliers, they appar-ently have not weakened it. New entrants havegenerally been successful in broadening com-petition in the face of the existing legal/regu-latory structure. In recent years, Congresshas repeatedly been called on to remove con-straints that have limited the ability of theregulated firms in the financial service indus-try to compete with the new entrants; it hasnot been asked to act to protect the groundtaken over from the traditional service pro-viders.

A key parameter for success in the financialservice industry is access to systems based onadvanced information processing and telecom-munication technologies. Large service pro-viders have the resources to develop and de-ploy these systems on their own. However, theexisting infrastructure of wholesale serviceproviders has made it possible for all firms,regardless of size, to have the requisite accessto the advanced technologies. New entrants,taking advantage of the advanced systems,have repeatedly demonstrated their ability tocompete successfully with larger firms in themarketplace. As long as this alternative ex-ists, there are few barriers to entering the fi-nancial service industry.

.—

Ch. 8—Findings ● 217———

Another concern expressed by some is thata financial service industry dominated by afew national organizations would no longer beresponsive to local needs of the communitiesin which they operate. On the one hand, easeof entry will continue to minimize the chancethat an area would not be served by institu-tions responsive to its needs. On the otherhand, continuing to regulate the interstateactivities of the banks will not guarantee thatcapital will be available to meet the needs ofthe areas that generate it. As the pervasive-ness of technology-based systems for manag-ing financial resources increases, intermedia-tion by banks will become a less significantportion of bank activities because depositsfrom which loan portfolios are generated willcontinue to shrink. There is some indicationthat banks will become primarily service pro-viders through which funds flow. Therefore,policies that are intended to assure the avail-ability of capital for socially worthwhile proj-ects are more likely to be successful if theyfocus on nonbank institutions.

Historically, there is some evidence to sug-gest that large financial institutions are notnecessarily successful in their attempts to en-ter and dominate markets held by smallerfirms. In areas where they were able to enter,the larger firms were at least as responsive tolocal needs as were the local banks that hadpreviously provided service. Fears that theNew York City banks would be able to drivethe smaller upstate banks from the marketwere expressed when statewide branching wasfirst permitted.

However, according to a statement by Fred-erick Hammer, Executive Vice President,Chase Manhattan Bank of New York, “Vir-tually all the New York City banks that wentupstate ended up closing most of thosebranches. The only branches from those ef-forts that are profitable are those done by ac-quisition. In the towns where our banks wereable to branch, we were able to provide newservices. Studies done by the FDIC indicatedthat the loan ratios went up in those towns.The banks were doing a better job of servic-

ing their communities. ’12 On the other hand,this statement says nothing about the propen-sity or the ability of an organization to entera market through the process of acquisition,one which Hammer indicates is likely to besuccessful. Nor does it say anything abouttheir propensity to continue to serve localneeds if a dominant position in a market isestablished.

Evidence indicates that the propensity ofcustomers to switch financial institutions isrelatively low and that there must be some sig-nificant event to motivate such a change. Onthe other hand, some believe that packages ofservices could provide the necessary motiva-tion for customers to change financial serviceproviders and that once new, complex relation-ships have been established, the inclination tomove in the future will be lower than in thepast. Securities firms assume that they willbe able to establish a high degree of customerloyalty because they are able to offer serviceregardless of whether the customer is home,on a short trip, or permanently relocating toa new area. * Thus, the firms that can estab-lish a national presence and offer a comprehen-sive package of interrelated services may beable to generate a degree of customer loyaltythat could enable them to dominate the finan-cial service industry.

The States are not waiting for the FederalGovernment to modify its position with regardto the policies that help shape the structureof the financial service industry. Laws thatwould permit regional banking have beenpassed in New England. Some States, SouthDakota and Delaware among them, have en-acted legislation designed to attract financialservice organizations. Thus, even though pro-hibitions of interstate banking based on Fed-eral law may continue in force, regional bank-

‘zFrederick Hammer, Executive Vice President, ChaseManhattan Bank of New York, in testimony in oversight hear-ings before the Committee on Banking, Housing and Urban Af-fairs, U.S. Senate, May 3, 1983.

*The strate~ is also intended to change the loyalty of thecustomer from the account representative to the firm, a prob-lem that has been facing securities broker/dealers for some time.

218 . Effects of Information Technology on Financial Services Systems

ing in significant areas of the country couldemerge. Also, organizations that provide fi-nancial services in nationwide markets oper-ating from States that have passed permissivelegislation may emerge. Federal law permitsinterstate and cross-industry mergers when itcan be demonstrated that they will serve thepublic interest.

No clear picture of the future structure ofthe financial service industry exists. Someforesee considerable consolidation, with manyfewer firms serving the public than at present.Some believe that the industry will consist ofa small number of large firms serving nationalmarkets and a large number of small firmsspecializing in specific market niches. On theother hand, others contend that the financialservice industry is already heavily concen-trated in many respects and that it will notchange significantly in the future. Given thecontravening forces operating, there is nobasis for adopting one of these positions or anyothers that could be suggested.

However, it is clear that future financialservices will be provided by a variety of firms,not just banks and the other traditional par-ticipants in the market. New classes of firmshave already established themselves in the fi-nancial service industry, and there is no rea-son that the trend should not continue. Thus,policies need to be formulated to account forthe influence of the technologies and the op-portunities they create for the entry of firmsthat have not previously been providers of fi-nancial services.

A key element in the present structure ofthe financial service industry is that the cus-tomer has the option of investing funds in anaccount insured by the Federal Government.This type of insurance was one of the elementsin the 1930’s program to restore confidence inthe financial service industry. Because of theexistence of the insurance, depositors with bal-ances below the limit of the insurance are fullyprotected and have not suffered losses as a re-sult of any of the failures that have occurredin recent years. On the other hand, some arguethat the availability of insurance and the read-

iness of the regulators to step in to protect afailing institution have resulted in a false senseof security that has led some institutions totake unwarranted risks in participating indeals put together by others. The secondaryeffects from the failure and closing of the PennSquare Bank illustrate this point. They alsoargue that these policies protect the stock-holders as much as the depositors and, as aresult, the institution will undertake projectsfor its own account that represent an unduedegree of risk.

However, the combination of economic forcesand technological applications has resulted inthe movement of deposits from insured ac-counts in financial institutions. Although theintroduction of insured money market ac-counts by depository institutions at the begin-ning of 1983 was accompanied by some in-crease in deposits, over the long run there isa distinct possibility that the deposits held byfinancial institutions will continue to shrinkrelative to all financial assets. Investors infunctional equivalents of depository accountsthat are not insured would then be exposed toloss of principal in the event of institutionalfailure, with the result that the sensitivity ofthe financial services industry to disturbancesin the economy could increase significantly.

Antitrust actions in the computer and tele-communication industries have demonstratedthat it is not always possible to define clearlythe elements of a market in order to analyzethe competitiveness of the firms participatingin it. Given the changes in the financial serv-ice industry, a situation analogous to thatfound with the computer and telecommunica-tion industries is developing. As new entrantsprovide financial services, the lines that deter-mine market boundaries become much lessclear than they were in the past.

New entrants often compete only in someparts of the financial service market. For ex-ample, a supermarket that operates a networkof ATMs is in direct competition with deposi-tory institutions that offer comparable serv-ices. On the other hand, the supermarket

Ch. 8—Findings ● 219—

would not be a factor in the markets for com-mercial loans or trust services.

Even within the community of depositoryinstitutions, care must be taken in definingmarkets. The small, local bank is not a factorin the market for cash management servicesoffered to the largest corporations in the coun-try. Conversely, a branch operated by a ma-jor money center bank may bean insignificantfactor in a market dominated by a small butvery successful bank.

The changing structure of the financial serv-ice industry will exacerbate this problem in thefuture. Thus, great care must be taken in sug-gesting that one institution will be able todominate the others in a market. Unless thestatement is made in full recognition of theconditions existing in a specific area for a spe-cific package of services, such generalizationsare likely to have little validity.

Conversely, one must recognize that theability to offer a package of complementaryservices may place a firm at a significantadvantage relative to others with product linesthat are less broad. Even though the horizon-tally integrated firm may not dominate anysegment of the market in the context of itscompetition for specific products, when con-sidered in its totality over time, the integratedfirm could dominate a market, possibly over-powering market competition.

Events to date have not endangered the ba-sic soundness and safety of the financial serv-ice industry. However, one cannot assume thatthis stability will remain, and constant moni-toring of the industry would seem in order. Onthe other hand, policies developed in anticipa-tion of events not having a high probabilityof occurrence could foreclose benefits or un-intentionally trigger undesirable impacts.