European Electronic Banking Review
Foreword
Discussion
Paper v. 2
by Charles Goldfinger*
Both financial services and information technology have undergone rapid and massive changes. The pace and reach of change are unlikely to slowdown in the foreseeable future. If anything, they may actually accelerate. In particular, European banking and financial markets are on the verge of large-scale upheaval under a combined impact of euro, Internet and Y2000 challenges
Information technology plays an increasing role in financial services, whether in product/services offering, delivery channels or market structure. Its impact is not limited to business strategies but also profoundly influences public policy, in particular the nature of money and monetary systems.
In the new landscape, the roles of financial institutions, technology providers and regulatory authorities need to be redefined. New rules of co-opetition will have to be determined and implemented.
In the past twenty years, financial services have undergone deep and extensive changes in all aspects of their business: product and services, sectoral structure, market segmentation, competitive environment. There are nevertheless significant differences in the rate and scope of change between various segments of financial services:
- Wholesale banking has changed more than retail banking
- Markets have changed more than banking.
Globalisation has been particularly pronounced in wholesale banking and over-the counter financial markets such as foreign exchange. Corporate lending and investment banking are dominated by few global players, active in all markets, established or emergent.
On the other hand, globalisation appears to have affected relatively less the retail banking, which, particularly in Europe, remains very fragmented and localised.
Information Technology has changed the nature of financial markets and financial transactions.
The initial impetus was to reduce the transaction cost by immobilising or eliminating the paper support. This led to dematerialisation of both payments and financial transactions. In turn, this had two consequences:
- An explosive growth of transactions
- A proliferation and greater complexity of new instruments.
The changing nature of financial transactions and financial markets triggered significant new risks and new risk combinations, created by interactions between globalisation and intensive use of technology. As the traditional risks, such as credit risks, have not disappeared, the overall risk level of financial system has increased. At the same time, the ability to manage risks was significantly enhanced. This created a somewhat paradoxical situation: a greater fragility, as evidenced by a succession of crashes and crises (sovereign debt crisis in the 1980s, October 97 global equities crash, US savings and loans crisis, Japanese banks crisis, etc.), and a greater resilience: so far, despite those crashes, the global financial system continues not just to function but to grow and prosper.
All aspects of financial services have undergone substantive changes.
·
Products: In all segments, financial
products have become more varied and more complex. The product cycle has been
considerably accelerated: products are developed, deployed and made obsolete
more quickly. They have become more
liquid and tradable, as financial institutions seek to reduce the size of their
balance sheet by externalising a sizeable size of their through securitisation
technology.
·
Delivery channels: Delivery channels
have proliferated in order to enable customers remote and permanent access to
financial services: ATMs, telephone banking, on-line banking, Internet banking,
etc. Contrary to early expectations, new channels have reinforced rather than
cannibalised existing channels. In Europe, for instance, new delivery channels
have not fundamentally changed the market shares allocation and major financial
institutions were quick to adopt a multi-channel strategy.
·
Market structure: Existing financial
institutions have been subject to strong consolidation and concentration
pressures. With few exceptions, mergers and acquisitions have been taken place
on a local and regional basis. In Europe, there have been very few large-scale
cross-border mergers of financial institutions.
Boundaries between different categories of financial services become blurred to
the point of confusion. Banking, insurance and capital markets firms are
invading each other’s turf and competing aggressively. Market structure is
becoming more fluid and more unstable. Established hierarchies can no longer be
taken for granted. Deregulation has attracted many new comers: retailers,
industrial companies, telecom operators, who adopted different approaches to
entry, some focusing on specific products such as cards, others on customer
segments, still others on specialised financing niches. New entrants achieved significant inroads in
a number of segments, particularly in the US. Yet, banks have
demonstrated a remarkable resilience. In continental Europe, they successfully
invaded life insurance and securities brokerage.
· Regulatory oversight: Boundaries between various financial services activities are no longer rigid. Geographical restrictions to entry have been considerably reduced.
The increased level of risks have led regulators to closely monitor banking activities. In particular, banks are required to report their international activities on consolidated basis. Specific steps have been taken to better track positions in derivatives instruments.
Two trends which will affect financial services in Europe in the coming years are:
· Eurofinance: movement to a common currency, which for all practical purposed will start in mid-1998, once the list of countries admitted to the first round is published. This movement is likely to significantly accelerate consolidation and concentration of the sector. This in turn may entail the surge of cross-border retail banking.
·
Cyberfinance: large-scale deployment of
Internet technologies in financial services. Internet banking is developing
rapidly and Internet technologies are penetrating all aspects of business
operations in various sectors. Internet banking associates more closely than
traditional on-line banking financial institutions and technology providers.
The latter are in position to either marginalise or disintermediate financial
institutions.
Furthermore, numerous efforts are being carried out to design and implement
Internet-based payment systems. Some of those systems, according to their
proponents, have a truly revolutionary potential and can trigger the emergence
of alternative monetary systems, which would be outside the reach of the
existing banking structure and its regulators.
Thus, while eurofinance appears a vector of continuity with the existing financial trends,
cyberfinance contains a significant potential for discontinuity. We need to probe deeper the implications of those two trends.
While technology constitute a key vector of geofinance, not all the technologies played an equally important role in its development. Among those which did, two appear as core levers.
·
Transaction processing. Banking automation process has been largely
triggered by the need to lower transaction costs and increase transaction throughput.
As transaction volume increased, system requirements became more stringent,
either in terms of performance or reliability. The key nodes of financial
systems: settlement systems, payment networks and market trading systems, all
rely on state-of-the-art transaction processing technologies
·
Financial instrument technology. This
technology, which combines software development and pure economic theory, is
based on the option theory developed in the early 1970s by US academics Fisher,
Black and Merton. The theory, which allows the quantification of the value of future
and uncertain cashflows, has played a critical role in the development and
explosive growth of organised and informal markets for financial derivatives.
More fundamentally, the financial instrument technology contributed to the
dematerialisation of financial transactions and financial markets. The main
purpose of financial markets is no longer to support trading of physical goods
but to exchange of information and to manage risks.
Financial institutions are heavy users of
Information Technology. Banking sector absorbs between 20 to 25% of IT
expenditures world-wide, with major financial institutions spending several
billions dollars a year each. By and large, banks are conservative users,
putting heavy emphasis on proven reliability and robustness of IT applications.
Major applications decisions and development processes are often ponderous and
time-consuming. While banks accept the significance of information technology
in their business, they remain ambivalent in their attitude toward it: is at a
tactical tool or strategic lever ? Is it a core banking business ? Does
technology offer sustainable competitive advantage ? Is it a means of
differentiation among banks or between banks as a group and non-banks ?
The ambivalence entails a frequent shift between go-alone or co-operate attitudes, particularly among major players. These often feel that they have the resources to impose their own proprietary approaches and to create exclusive links with their clients.
On the other hand, financial services is a network business, whose value increases with the number of users and wider reach, which implies at least some degree of interoperability. Hence the need for co-operative systems and networks: financial institutions have been remarkably successful in developing and managing such systems and networks. SWIFT, VISA and MASTERCARD, CHIPS and CHAPS, Banksys or Carte bancaire are just a few examples of thriving value-added facilities controlled by financial institutions. They dominate their markets, are often highly profitable and have the ability to impose standards. These facilities constitute a major competitive asset in the continuing battle with non-banks for control of financial transaction systems. At the same time, their very success bred tension between the shareholders and the management of the facilities. Their relationship constitutes a good example of co-opetition, a delicate and unstable mix of co-operation and competition.
Common facilities have taken a life of their own. VISA or MasterCard, for instance, have been promoting their brand and gained high consumer visibility. They have acquired a considerable degree of operational autonomy from their shareholders. How far this autonomy is likely go ? Could it lead to full-fledged independence and public flotation ? Could VISA and Mastercard achieve a market position in electronic banking similar to that attained by Reuters, a newspaper co-operative, in electronic financial markets ? The outlook for common facilities is an important discussion topic.
Internet is considerably more than a networking protocol and set of
communications standards. It is a broad environment, which encompasses both
technical and business architectures. It implies an ultimate blurring of boundaries between processing and
communications. Its impact is not only technical but also economic. Not only,
as Sun affirms, “Network is the computer” but the converse is true is well:
“Computer becomes the network.” There
is no Internet hype: forecasts on the speed and the extent of adoption
of Internet-related technologies (Java) and applications (electronic commerce),
as wildly optimistic they might have seemed at the time of their publication,
are lagging behind the actual market development. Internet will have a broader, deeper and more destabilising impact
on both Information Technology domain and user businesses than the personal
computer (of which Internet is a logical extension). In a nutshell, Internet
means:
·
Warp speed of development and, above all, diffusion of applications, products
and services
· Low costs: even if Internet development and operational costs are not as low as asserted by its most enthusiastic proponents, they are considerably lower than that of traditional networks and application distribution. Similarly, Internet lowers significantly business transaction costs
·
New approaches to collaborative
work and transaction management.
The three trends strongly interact with each other and are mutually reinforcing. Their impact can be summarised around two major themes: ubiquity and mobility.
Ubiquity, which means widespread availability and low cost, has three dimensions:
· Ubiquitous computing. In addition to personal computers, the range of intelligent information access and processing devices will continue to expand: PDA, telephone, NC and other forms of information appliances.
· Ubiquitous networking. Internet is likely to accelerate the trend to lower communication costs and, more importantly, force network operators to pass cost savings to consumers..
· Ubiquitous programming. Object technology and Internet carry the promise of democratisation of software application development process.
Computing and networking are increasingly mobile and this trend is likely to continue. It will be further stimulated by two technologies:
· Wireless communications
· Smart Cards
Both those technologies experience explosive growth, which is comparable to that of Internet.
It should also be noted that Europe is fairly advanced in the deployment of those two technologies.
The trend toward dematerialisation and virtualisation of financial services will be amplified.
In particular, we are likely to see a continuing shift in distribution channels from physical to virtual. The range of virtual channels will continue to expand: in addition to Internet banking, mobile (wireless) banking is being tested and is likely to be deployed on a large-scale in Europe.
Channels virtualisation dematerialises customer relationship. In corporate banking, this lead to a shift from a relationship banking to transaction banking. Will the retail banking experience a similar shift ?
Dematerialisation will also affect the transaction and payment infrastructure. Internet model
dissociates the network from the physical infrastructure. It allows interconnection between heterogeneous networks and provides common standards. Furthermore, with encryption technology, digital certificates and smart cards, it is now possible to use security in a modular and flexible fashion. A highly secure environment can be created on the public networks. To what extent these development change the prevailing approaches to payment and transaction processing networks, based on dedicated infrastructure and proprietary protocols ? What are the implications for their architecture ? For their access and control policies ?
Does the combination of business and technological trends imply a banalisation of financial services ? Does it reduce barriers to entry to a point where any network can become a market, any computer a clearing system and anybody can issue electronic money ?
In the new environment, what is the meaning of: financial transaction, financial intermediary (bank, broker, broker/dealer) and money ?
In the coming years, the financial systems in Europe will face a double transition challenge
· Business transition: from national to international framework. Common currency environment will trigger major overhaul of the existing national payment and settlement systems, as well as securities market and associated depositories. Interconnection becomes imperative and is likely to lead to full scale institutional integration and merger
· Technical transition: From the existing to a new architecture, which would be based on three core trends, particularly on Internet
It is essential to minimise disruption and to facilitate co-operation and rapid deployment.
The new environment is highly uncertain and unstable. The systemic risk potential is high. It will require new approaches to regulation and oversight. Design of such rules such be based on a thorough understanding of the dynamics of the emerging financial services realm.
The combined impact of eurofinance
and cyberfinance present European financial institutions with three major
transition challenges in the ICT domain:
· From payment infrastructure to trust
infrastructure
· From national to European
infrastructure
· From centralised to distributed
computing/networking
There is a widespread perception that
the European Union is lagging behind the US in the deployment of sophisticated
financial technology. This perception is plainly wrong. European banks do not
lag behind the US banks in the deployment and the use of IT.
As a matter of fact, they have achieved
significant lead in several key areas of electronic finance:
- On-line banking
- Bancassurance and other forms of cross-selling
- EFTPOS deployment
- Smart card deployment.
In those areas, European banks have
deployed products and services on a large-scale.
One of the reasons for the
perception of the gap is the apparent inability of European institutions to
capitalise on their technological advance and to impose their solutions as
global standards. This inability can in turn be explained by two major weaknesses:
- National fragmentation
- Tactical ICT vision
European financial institutions
approach technology deployment within national borders and fail to take into
account its international or global potential. This results in proliferation of
incompatible standards and dead-end solutions. Thus, while there are at present
close to 100 million smart cards issued by financial institutions or their
associations, they are splintered into over 20 incompatible schemes, both from
the technical and the business viewpoints. Attempts to achieve interoperability
have been laborious and, so far, met with limited success. Similarly,
extra-ordinary domestic successes of videotext banking proved impossible to
export across borders. Many analysts came to consider those systems as
impediments to a speedy adoption of Internet banking.
A second weakness of the European
financial institutions is a frequent ambivalence of their senior management
toward the technology. Many of them see ICT as primarily as a tactical tool and
thus fail to leverage its potential.
This ambivalence is understandable
to the extent that the relationship between ICT spending, on the one hand, and
the profitability and the competitive advantage on the other hand, is far from
simple. Financial institutions, which are the heaviest relative spenders are
not necessarily the most profitable ones. The relationship appears to be
asymmetrical: developing profitability and a competitive advantage requires
heavy IT spending (in absolute terms), but a heavy IT spending does not
necessarily lead to a competitive advantage. Spending numbers tell only a part
of the story. To make an impact, ICT spending has to be intimately integrated
into the overall product/distribution strategy. Moreover, market environment seems to play an equally
important role: despite considerable variation in their spending level, UK
financial institutions display consistently high profitability, which exceeds
by wide margin that of other European institutions.
* Managing Director, Global Electronic Finance and Chairman,
Financial Issues Working Group (FIWG). Opinions expressed in this paper do not
constitute an official position of the European Commission or FIWG members.