Introduction

This study is part of a Benchmarking Pilot Project on the diffusion and utilisation Of Information and Communication Technologies and New Organisational Arrangements (ICT-0), undertaken on the behalf of the European Commission, with the view to assess the feasibility of benchmarking as a policy tool by applying the benchmarking approach to the utilisation and performance impacts of  ICT-O and their relationships to framework conditions. The study analyses the use of ICT-O in the financial services in Europe and seek to draw preliminary conclusions concerning potential actions facilitating the uptake of ICT-O and in particular the framework conditions.

 

The study covers two broad areas:

-     Retail Banking

-     Equity markets and investment banking

within the European Union countries. For the purpose of comparison, data from the United States financial sector have been used.

Given the strict time limitations, the study relies on the existing data and documentation and literature review. No specific data were generated and no formal interview programme was carried out. The study focuses on the use of Information and Communication Technology, particularly on the externally-oriented applications, which support the relationships with other  financial institutions and with customers.

The study is organised in five parts:

-     A conceptual framework of ICT in Financial Services

-     An overview of European Financial Services :

-     A preliminary analysis of ICT use in European Financial Services

-     Benchmarking challenges and framework conditions

Conceptual framework of ICT in Financial Services 

The basis of the proposed framework is a strong mutual dependence:

-     Financial services represent a critical application area of ICT expenditures

-     ICT is a strategic development vector for financial services

Importance of financial services for ICT

Financial services constitute the largest segment of ICT spending. In Europe, financial services in 1996, financial services amounted to 48.8 billion ECU or  27% of the total spending (see diagram 1 below). However, the importance of financial services goes beyond their quantitative weight. Banking has been the fastest growing ICT sector in Europe in 1997 and 1998. Financial services institutions are among the most sophisticated ICT users and play a key role in deployment of key technologies. For instance, while client/server architecture has been deployed in 50.2% of European enterprises sites, within financial sector the deployment level is 64.5% (in 1997). Financial sector is seen as critical to the large-scale take-up of electronic commerce, with Internet banking and Internet securities trading seen as "killer applications."

Diagram 1.

ICT Spending in Europe 1996

source: EITO

Five financial institutions are among top European ICT spenders. Five out of ten largest ICT spenders are financial institutions. Moreover, financial institutions ICT spending

is growing more rapidly than overall IT spending and represents a higher share of overall revenues. However, as we will see below, the level of sophistication in ICT use varies considerably among banks.

Diagram 2

ICT Spending

                            Growth rate 1996-1997       Share of revenues

Source: EITO, Information Strategy

Importance of ICT for financial services

ICT has become an integral part of financial services, whether in product/services offering, delivery channels or internal management. IT spending represents between 2% and 8% of European banks’ revenue and constitutes the fastest growing cost category.

IT employment in European banks represents an average of 8% of their total employment and its relative importance is increasing, with IT specialists often acceding into senior management ranks.

ICT penetration in financial services is a dynamic and on-going process. ICT has started as an administrative back-office function support. It has then moved to the front office to facilitate contacts with customers and to support financial transactions. For Mitchell Madison Group, the process, can be divided into four stages, starting in the 1970s:

-     Back Office Automation, when the key motivation is to reduce transaction costs and administrative overhead

-     Front Office Automation, when personnel dealing with external parties (customers or other financial institutions) were able to access centrally-held information

-     Bringing Customers On-line, when customer gain direct access to their accounts in the core processing and accounting function.

-     An Integrated System, where various elements of ICT are brought together to provide a complete picture of customers' relationships and bank's position.

The three core requirements for ICT in financial services are:

-     Transaction processing

-     Customer interaction

ž      Delivery channels

ž      Product development

ž      Advice

-     Risk management

 

ICT impact is pervasive. It is both tactical and strategic. It provides the essential set of tools that every financial institution need to carry out its business. It also enables some institutions to develop competitive advantage in terms of product/service offerings, delivery channels and risk management. The relationship between tactical and strategic use are dynamic: strategic can become tactical, once a technology is widely adopted. This was the case of ATM networks. On the other hand, tactical can become strategic: this is the case when the bank card was transformed into a vector for loyalty-building services.

 

ICT impact goes beyond competitive positioning. It has changed the nature of  financial markets and financial transactions. These have been dematerialised: what is being exchanged between financial institutions are digital representations of underlying instruments and positions. The dematerialisation has been relatively greater in the wholesale banking and financial markets, where it had two major consequences:

-     an explosive growth of transactions, requiring greater processing power

-     a proliferation and greater complexity of new instruments, requiring sophisticated analytical tools and approaches to develop and manage new instruments.

 

Last but not the least, ICT in financial services profoundly influences public policy, in particular the nature of money and monetary systems. By blurring distinctions between various category of money and financial accounts (checking, saving, investment), ICT has made more difficult the conduct of monetary policy and the supervision of financial institutions.

Three approaches

Financial institutions’ approaches  to ICT can be classified into three broad categories:

·         Tactical approach

-          Technology is seen primarily as a cost reduction tool

-          Preference for cooperative solution

-          Selective ICT investments

·         Strategic approach

-          Fascination with technology

-          Emphasis on proprietary solutions

-          Stop-and-go investment approach

·         Metastrategic approach

-          Intimate understanding of technology

-          Integrating proprietary and co-operative solutions

-          Continuing ICT investment

Most financial institutions adopt tactical approach. Strategic approach is adopted by large-scale institutions, with necessary resources to sustain. Very few financial institutions were able to develop the meta-strategic approach, which seek to weave ICT into the core strategy.

Duality: individual and co-operative systems

ICT in financial services has a dual character. On the one hand, there are systems used by individual financial institutions. On the other hand, there co-operative systems, whose development and operations are shared by several financial institutions. These systems manage functions which ensure the integrity of financial transactions, their correct execution and settlement. They include: 

·         Payment  infrastructure

ž      Clearing and settlement

·         Payment services

ž      Debit and credit cards

ž      Automated Teller Machines

·         Financial markets

ž      Trading

ž      Settlement/clearing

ž      Custody

Co-operative systems are numerous and varied. They differ in their scope, their coverage, their access conditions and their mode of operations. Some systems are highly visible and accessible to all customers, whether retail or wholesale. This is the case of ATMs or credit card terminals. Table 1 below shows the deployment of such systems within 6 major European countries and, for comparative purposes, their deployment in the USA and in Japan. The table shows a very wide dispersion of use pattern, even in neighbouring countries with similar standards of living. It points to considerable differences in the way households approach and consume financial services.

Table 1

ICT Retail Co-operative Systems

source: BIS

Other co-operative systems are more selective and oriented toward large corporate or institutional customers. Still others are restricted to financial institutions only. An example of such restricted system is the TARGET system, designed to process cross-border Euro transactions starting on January 1, 1999. The diagram 3 below shows the overall structure of TARGET.

Diagram 3

TARGET Payment System

Source: EMI

Various co-operative systems are not independent, they are often interconnected and interact intensively with each other.  On the other hand, they are rarely developed as part of an overall and co-ordinated scheme. More often than not, they are created on ad hoc basis in response to specific requirements.   This accounts for their institutional and functional complexity, as demonstrated by Diagram 4 showing the overall architecture of the two main US equity markets, New York Stock Exchange and NASDAQ. This architecture is particularly interesting because it shows how two entities, which on the one hand compete intensely for their main business of listings and transactions, on the other hand, co-operate closely in both front-office (price dissemination) and back-office (clearing and custody). 

Diagram 4

US Equity Markets Architecture

source: GEF

One of the major objectives of co-operative systems is to provide interoperability between various participants and financial services schemes. Interoperability has two aspects:

-     Technical interoperability, to ensure compatibility between applications and networks developed and managed by various institutions and associations of institutions

-     Business interoperability, to define terms and conditions under which institutions can access each others’ applications and networks.

While, in theory, the need for interoperability is widely acknowledged, in practice, interoperability is far from being universal. The progress on the technical side requires the establishment of common norms and standards. This is no longer the domain of official bodies but has been over the financial sector. In the financial ICT, the dominant standards are de facto standards. Organisations, controlled by financial institutions, such SWIFT, which manages the interbank fund transfer network, or Visa and MasterCard, who oversee global bank card networks, play a key role in standards development and implementation.  While this leads to a speedier process than the one managed by official bodies such as ISO or CEN, it also creates fragmentation and turf wars, which are particularly apparent in the areas of standards for financial smart cards and securities transactions.

Business interoperability is hampered by the ambivalence of financial institutions. While they appreciate the benefits of larger markets and lower transaction costs, but at the same time they want to preserve the competitive advantage that comes from the ownership and control of critical infrastructure and transaction processing. Therefore, they seek to obtain economic compensation for access and use of facilities such as ATM and card processing networks. It is the economic discussions rather than technical problems that have hampered the progress of interoperability of such networks.

 

The critical importance of co-operative systems has led to emergence of co-operative organisations to manage those systems. Such organisations, of which SWIFT, VISA and MasterCard, or stock exchanges are good examples, are wholly owned by the financial institutions but have developed considerable operational autonomy and market recognition.

Co-operative systems are usually developed at the initiative of financial institutions, with a limited direct involvement of the public sector, which do not fund such systems to the extent that they financially self-supporting. The public sector institutions most closely involved in the co-operative systems are the central banks. They consider their participation a part of their overall responsability for the integrity of the monetary system. In several countries, such as France, Belgium or United States, the central bank plays a direct operational management in the management of interbank fund transfer and settlement systems. More recently, central banks became also more actively involved in the securities settlement systems.

As co-operative systems become more ubiquitous and spread across borders, their regulatory oversight represents a major challenge to public authorities. Two of the critical issues raised are:

-     What is the status of co-operative organisations ? Should be they treated as financial institutions ?

-     To what extent, co-operative systems are subject to traditional competition rules ?

Three core ICT trends and two themes

What are already apparent trends in ICT, which are likely to significantly affect financial services sector in the coming years ? We believe that three core trends will shape the ICT evolution:

·         Distributed computing. This is the logical extension of client/server computing. It will be marked by ultimate blurring of boundaries between processing and communications. Not only, as Sun affirms, “Network is the computer” but the converse is true is well: “Computer becomes the network.” 

·         Object technology. This trend has two dimensions:

-          Component architecture

-          Object oriented programming

       Object technology will fundamentally alter the nature of software application development. It will also change the nature of database management, which no longer be limited to quantitative data but will also cover multidimensional and heterogeneous (multimedia) objects.

·         Internet. 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. Its impact is not only technical but also economic. There is no Internet hype: various forecasts on the speed and the extent of adoption of Internet-related technologies (Java) and applications (electronic commerce), as widely 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. Ubiquity, which means widespread availability and low cost, has three dimensions:

-          Ubiquitous computing. In addition to personal computers, whose price/performance will continue to improve at least until year 2015 (when Moore’s law may reach its limits), 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, resulting in lower prices.

-          Ubiquitous programming. Object technology and Internet carry the promise of democratisation of software application development process. According to no less an authority than Bill Gates, the process will shift from custom applications to integration of existing components, solutions and business processes

·         Mobility. 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, with rates which are comparable to that of Internet. A process of integration of those technologies within the three core trends has already been initiated. Of particular relevance are the on-going efforts to:

-          bring together Java and the smart card: Javacard

-          use the smart card as a security device for electronic commerce.

       It should also be noted that Europe and European financial institutions are fairly advanced in the deployment of those two technologies.

Key issues

The intertwining of ICT and financial services raises several issues. Among those, three appear of critical importance:

·         The role of ICT in corporate strategy of financial institutions. ICT is both a tactical tool and strategic weapon. Tactical use means heavy reliance on co-operative approaches and systems and cost minimisation. Strategic deployment implies a close integration of ICT within the overall corporate strategy and continuing heavy financial and human investment. To make things more complicated, tactical and strategic use are not necessarily exclusive but can be complementary. Their relationship is dynamic and changes continuously. Financial institutions experience difficulties coming to grips with the various aspects of ICT. These difficulties are exacerbated by the problems of measurement of business impact of ICT (see below).

·         Management of complexity and heterogeneity. ICT is changing at an extremely rapid pace and changes are major. It is not always easy to keep track of those changes and identify their implications for major systems decisions. More importantly, financial institutions need to ensure absolute business continuity which means organising the coexistence of old and new architecture, which are far from peaceful, and an orderly transition. A related issue is that of ICT management, both in the development and operational stages. This issue has two dimensions:

-          To what extent, ICT should be managed internally and to what extent it should be externalised either to co-operative organisation or to independent suppliers such as EDS, IBM or Andersen Consulting

-          What should be the respective role of ICT specialists and ICT users ? How should the conflicts be resolved ?

·         Co-opetition. More than any other aspect of financial activity, ICT raises the question of co-opetition, a delicate and unstable mix of co-operation and competition:  What to share, what to keep ? Whom to trust and whom not to ?

       Co-opetition has several dimensions:

-          among financial institutions

-          among financial institutions and co-operative organisations

-          among financial institutions and ICT suppliers

New rules of co-opetition are still in the process of being defined. They represent a challenge not only to financial institutions but also to the regulatory authorities. Should these encourage or discourage co-opetition ?

European Financial services : an overview

Economic importance

While financial services are often considered as essential to the development of overall economy, their importance as a specific economic sector is often overlooked. And yet, this importance is considerable. According to Eurostat, financial services generate over 5% of GDP of the European Union. In 1992, this amounted to 255 260 million ECU or265% increase over 1980. Financial services employ over 2,6 million employees or

3,1% of the total EU employment. In comparison, financial services in the USA employ 1,4 million people and in Japan, 400 000 people. EU banking system is the largest in the world with more than 40% of global banking assets

 

The overall structure of financial services in Europe is geared primarily toward banking intermediation rather than toward financial markets, as shown in the Diagram 5. This is a pattern similar to that of Japan but quite different from that of the United States. The relative underweighting  of the equity markets relative to GDP (44% in Europe, 95% in the United States), suggests a high growth potential for  the European financial markets.

Diagram 5

Banking intermediation and Equity markets
(in billion ECU)

source: IMF

Main characteristics

The main characteristics of European financial services are

·         Fragmentation

·         Strong national variations

·         Gradual pace of consolidation

 

According to Eurostat, in 1996 within the European Union, there were some 8 400 credit institutions, controlling around 234 000 local units (branches or subsidiaries). However, it should be noted that such fragmentation is not specific to Europe. In the United States for instance, there were close to 10 000 banks (with 57 600 local units) in 1995. Nevertheless, there is a general sense that Europe is “overbanked, ” with too many financial institutions and too many local units.

 

Financial systems differ considerably from a country to country. Banking industry is highly concentrated in some countries and relatively fragmented in the others (see Diagram 6 below). The relative importance of financial institutions controlled by public sector also varies considerably within the European Union.

Diagram 6

European retail banking market structure 1996

source: Datamonitor

The European financial services is consolidating but the consolidation is very gradual (see Diagram 7). In some countries such as Greece, Ireland or Sweden, the number of credit institutions has actually increased in the recent number. Interestingly, the reduction in the overall number of credit institutions has not led to a decrease of the number of local units. This tends to suggest that the local units continue to play a key role as distribution outlets for financial products and services.

Diagram 7

Evolution of credit institutions in the EEA and Switzerland

source: Eurostat

The speed of consolidation has accelerated in 1998 and is likely to accelerate further in the run up in the aftermath to euro. In the retail financial services, the consolidation process is primarily national. Most banks and national authorities follow the model of a “national champion” and give priorities to the strengthening of their home base. Cross-borders mergers are only beginning (see Diagram 8) and they primarily affect neighbouring countries (Netherlands-Belgium, Sweden-Finland). The “national champion model” is evolving toward the regional one.

Diagram 8

Mergers and acquisitions in European financial services
(in BECU)

source: Acquisitions Monthly

European regulatory framework

The bulk of banking activities is regulated at the national level, with resulting considerable differences between countries. The European Commission has been a driving force in an effort toward harmonisation of regulatory approaches and, more importantly, toward liberalisation of financial services. The two key levers in this efforts are

·         The Second Banking Directive, adopted in 1989 for implementation on January 1, 1993

·         The Investment Services Directive, adopted in 1993

These directives established the principle of a single EU passport for banks and investment services companies, based on mutual recognition among EU supervisory authorities. Thus an authorised financial intermediary from any EU country  can offer its services across Europe without establishing physical local presence in countries in which it markets its offerings. Furthermore, under home regulator rule, it is not subject to dual or multiple regulations. This approach thus aimed at lowering barriers to entry by lowering initial establishment costs. ICT development was expected to facilitate this trend by enabling remote selling and delivery of financial services. It was particularly hoped that the Investment Services Directives would spur the development of remote membership in national exchanges and thus stimulate cross-border equity trading. Yet, the impact of both directives appear so far to have been limited, particularly at the retail level.  Numerous obstacles remain to the creation of level playing field which would allow a free flow of financial transactions across Europe. For instance, institutional investors, pension funds and insurance companies in most European countries (with the exception of Netherlands and United Kingdom), are constrained in a way they can invest their funds. Obstacles are even higher in retail banking due to a combination of legal hindrances, discriminatory taxation regimes and above all high entry costs. Extensive local branch networks constitute serious obstacle to direct entry. State-controlled financial institutions benefit from many forms of official regulatory and fiscal protection and thus distort the competitive situation. Furthermore, there are numerous restrictions on product offerings such as interest-bearing checking accounts or innovative life insurance.  Social legislation and protectionnist attitudes of national regulators may also discourage entry by acquisition.

Restrictions on competition and on new product/services deployment meant that the rationalisation of financial sector has not been progressed as far and as speedily as expected by promoters of the single market. While the net lending margin has declined, it was not sufficiently compensated by cost reduction or increase in commissions and other non-lending revenue sources. As a result, in many countries, banking profitability has substantially declined (Diagram 9). Interestingly, it was in the countries, United Kingdom, Ireland and Luxembourg, which adopted most open attitude to the new entrants that the profitability has actually increased.  Furthermore, those countries also demonstrate higher level of profitability.

 Diagram 9

Profitability of financial institutions
1990-1994 average

source: IMF

Restriction on competition affected not only financial institutions but also potential entrants from non-financial sector. Not surprisingly, the new entrants were most numerous and aggressive in countries with an open competitive environment. This was particularly the case in the United Kingdom, where retailers such as Marks and Spencer or Tesco were able to develop sizeable financial services business. However, retailers were also able make strong, if selective, inroads in countries such as France, where the market climate is more restrictive. Industrial companies, with very few exceptions such as General Electric Capital Corporation which pursues an aggressive Europe-wide acquisition strategy, have not sought to enter the financial services on a large scale. Thus, the European financial services remain dominated by banks. On the European continent in particular, universal banking, where a single institution offers a wide range of financial services, basic banking, brokerage, life insurance and fund management, remains a dominant model.

Many European banks have proved remarkably adept in cross-selling financial services. This is demonstrated by a rapid growth of bancassurance. Bancassurance has been the key for the strong performance of Lloyds TSB, which has become one of the most profitable large banks not only in Europe but in the world. In France, the largest French bank, Crédit Agricole, has developed a highly successful life insurance subsidiary, Predica, which within two years was able to claim 30% of all new life insurance subscribers.

Diagram 10 shows the development of bancassurance in selected European countries.

Diagram 10

Estimated share of new annualised life and pensions business, 1996

Source: Datamonitor

Retail banking continuity and investment banking upheaval

The evolution of the European retail banking has been marked by continuity. National fortress model still remains dominant. Each national market is dominated by large domestic banks, none of which has really succeeded in significantly penetrating other national markets. Banks which sought to achieve penetration by building their delivery network from the ground have been notably unsuccessful. The only way to enter another market is through a merger, such as Merita and Nordbanken in Scandinavia or acquisition, such as ING acquiring BBL in Belgium.

On the other hand, the investment banking within Europe has gone through a major upheaval. On the Continent, the securities brokers have practically disappeared as independent entities, their clients and/or their business being taken over by commercial banks. In the City of London, practically all merchants bankers, which have ruled the City for over hundred years have been acquired by European or US banks. The most significant development however has been the triumphant progress of the large US investment banks, which have moved from cross-border to domestic transactions, from financial advice to financing, and from private sector to privatisations operations, to achieve dominant positions in both primary (IPOs) and secondary (trading) financial markets and related operations such as mergers and acquisitions.

 

Their success came at expense of large universal banks, particularly from Germany and Switzerland. Remarkably successful in the retail segment, the European universal banking model proved less resilient in the corporate segment. Difficulties and relative lack of international success experienced by European universal banks in investment banking area may appear somewhat paradoxical to the extent that they combine strong corporate relationships with massive distribution capability, which are generally believed to be the key factors of success in international investment banking.  Moreover, universal banks appear well-placed to offer the full range of various financial services and to integrate advice and financing.  However, the emerging universal banking model is very different from the traditional one, which has been often characterised by opacity of bank-client relationships, low concern for the effective use of capital and conservative approach to financial innovation. The new universal banking, which can be called global universal banking  is based on transparency of relationships, gives absolute priority to the return on capital and aggressively promotes financial innovation. Recent merger of Travellers and Citicorp appears as an attempt to implement this vision of universal banking. It remains to be seen whether Citigroup example will stimulate similar attempts in Europe.

ICT in Financial Services

Spending patterns

Overall spending on ICT in financial services in Europe is estimated by Datamonitor at 19,1 ECU billion in 1997, of which retail banks spend 15,5 ECU billion and investment banks,  3,6 BECU. The overall spending pattern is shown on Table 2

Table 2

1997 IT Expenditures by European Financial Institutions
(in ECU billion)

 

Retail banks

Investment banks

Hardware

4,6

0,9

Packaged software

1,2

0,4

Outsourcing

1,4

0,3

System Integration

0,8

0,2

Professional Services

0,8

0,2

Internal spending

6,6

1,6

TOTAL

15,5

3,6

Source: Data Monitor

Not surprisingly, retail banks represent over 80% of the total spending.

Datamonitor forecasts that that the IT spending will continue to grow at a 5% annual rate until the year 2001, reflecting the Year 2000 and Euro project expenditures. This is confirmed by a more detailed analysis which shows a surge of spending in 1998 and 1999. After 2001 and until 2005, Datamonitor anticipates a slowdown, fairly significant for the retail banking, which is expected to fall to an annual rate of 1.6%, and more gradual for the investment banking, with an annual growth rate of 4.6%.

At the aggregate level, there are no significant differences in resource allocation between various categories of spending. The two largest categories are Internal Spending and Hardware, which together represent over 72% of the total spending for retail banks and 70% for investment banks. This reflect the traditional approach of financial institutions, which tend to control IT infrastructure and applications. As we will see below, this attitude is evolving and outsourcing is increasing rapidly.

There is one significant difference in spending pattern that need to be highlighted: while in retail banking, geographical distribution is fairly evenly spread, with the largest country, UK accounting for 23% of the total European spending, in investment banking, the spending is heavily concentrated in the UK, which accounts for 60& of the total IT investment banking spending.

IT Retail banking expenditures

Diagram 10 shows the 1997 IT spending in retail banking by nature of business processes. Combined expenditure on distribution channels for banking services accounted for 6.16 BECU or 39% of total expenditures. At 18%, branch systems represent the largest investment in this area. Alternative delivery channels, such as PC banking, still represent a small, albeit growing, share of expenditures. The second largest category is the expenditure on processing functions, at 29% of IT budget, with cheques especially high at 18% (2.7 BECU). Core systems, and the customer information systems supporting them, account for 3.7 BECU or 24%, of the total retail banking IT expenditures.

Diagram 10

European retail IT spending by business processes

source: Datamonitor

 

 

 

European retail banks share three common priorities:

-     Euro

-     Year 2000

-     Multi-channel distribution

The first two priorities are mission-critical, to the extent that the financial institution which would fail to complete the Euro conversion and/or Y2K projects on schedule will be threatened in its very existence. At the same time, they are extremely time-specific and their completion will therefore lead to a slowdown of the rate of grown of IT spending.

 

Multi-channel distribution is a more permanent priority. All leading banks pursue a multi-channel strategy. They view various channels, both traditional and new, as complementary rather than exclusive. As a result, new delivery channels do not fundamentally modify market positions. In other terms, banks with strongest traditional channels (branch and ATM networks) are also likely to capture the largest share of new channels customers.

Nevertheless, the range of delivery channels will continue to expand and become more virtual. Today, the new delivery channels, particularly telephone and PC banking, have still relatively low customer penetration. However, they are growing rapidly (see Tables 3 &4 below). Their penetration varies considerably among countries. According to Datamonitor, both telephone banking and PC banking have achieved the highest penetration in Scandinavian countries. This reflects the open telecommunications environment, which led to lower telecommunications costs and cultural openness toward IT.

Table 3

Telephone banking penetration among retail customers

 

1994

1996

2001

Scandinavia

13,00%

16,90%

26,90%

UK

7,00%

10,00%

32,00%

Netherlands

8,00%

9,10%

19,30%

France

6,00%

8,70%

19,10%

Germany

3,00%

5,40%

14,10%

Belgium

3,80%

4,90%

18,20%

Austria

2,00%

3,40%

21,00%

Spain

2,00%

3,10%

17,10%

Portugal

0,10%

1,10%

15,00%

Italy

0,00%

0,20%

7,30%

Source: Datamonitor

Table 4

PC banking penetration among retail customers

 

1994

1996

2001

Scandinavia

0,20%

0,40%

6,90%

Netherlands

0,10%

0,30%

5,40%

UK

0,10%

0,30%

2,40%

Germany

0,16%

0,29%

5,00%

Austria

0,10%

0,20%

4,00%

France

0,06%

0,13%

3,33%

Belgium

0,05%

0,12%

2,90%

Spain

0,03%

0,08%

1,90%

Italy

0,01%

0,03%

0,90%

Portugal

0,00%

0,01%

0,90%

Source: Datamonitor

Datamonitor forecasts that telephone banking, already more prevalent is likely to continue to be more widespread than the PC banking. However this estimate should be treated with caution. PC banking penetration data are misleading to the extent that they do not take into account the very high penetration of videotext banking, which in France is used by 15% of retail banking customer and a considerably higher percentage of corporate business.  Furthermore, the combined development of Internet and GSM mobile telephony is likely to lead to the emergence of new forms of remote banking which will combine voice and data as well as PC and telephone terminal. There are no reliable data on Internet banking penetration in Europe but, based on the speed of the adoption of Internet technologies both by businesses and by  customers, it is unreasonable to foresee, within a five years, a 20% Internet-based banking penetration of retail customers.

 

Besides common priorities, there are considerable variations among retail banks in their IT approaches. One of the key differences concerns the external suppliers of IT and outsourcing, and the country of origin appears as determining variable. Thus, as group, German banks are the least likely to use package software and to outsource their IT than the French, who are the champions of outsourcing, or the British banks who rely most heavily on packaged software. Differences are very significant. In 1997, French banks spent 4.7 times on outsourcing than the German ones, and the UK banks.

 

Banks also differ considerably in their approach toward Internet. In countries such as Sweden or Spain, large retail banks have embraced Internet and offer a wide-range of financial services. In Germany, some large banks, such as Deutsche Bank or Bayerische Vereinbank have set specialised subsidiaries to offer Internet banking and other forms of remote banking. In France, banks have hesitated to offer Internet because of the concern that it may cannibalise Minitel banking revenues. Since early 1998, however, they adopted a more open attitude. In particular, they seek to integrate smart card technology in order to increase the security of Internet banking, which remains a major concern.

Investment banking

Diagram 10 shows the split of IT investment banking spending between front office, back office and middle-office functions.

Diagram 11

1997 European investment banking IT spending by office

 

 

 

 

 

 

 

 

 

 


Source: Datamonitor

The key priority for investment banks is the risk management, which is seen not only a critical management tool but also, though use of sophisticated financial engineering techniques as a source of new products and revenue generator. Current spending is driven largely by the need to prepare for the euro-denominated trading in bonds, money instruments and equity markets. This requires investment in settlement systems and networking. In the longer run, IT spending will be driven by the convergence of technology at the desktop: flat screens, TV, Internet and newsline integration. Investment in networks will be the fastest growing area of IT spend until 2005. Developing and implementing ATM backbones, and subsequent intranet infrastructures, will consume the majority of new (non-maintenance) networking spend between 2001 - 2005.

Eurofinance and cyberfinance

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 started in mid-1998, once the list of countries admitted to the first round has been 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.

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 ?

 

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

Global comparison : ICT strategies of European and American financial institutions

It is interesting to compare approaches to ICT by European and US financial institutions. Information Strategy, a UK monthly, has carried out a survey on the topic. The survey showed that the US financial institutions are much more willing to use outside ICT resources. They outsource considerably more than the European financial institutions. They also use more frequently the packaged software (see Table 5 ).

Table 5

Financial Institutions: use of packaged software

 

Europe

US                                                                                Europe                                                                           US

Commercially available package/
extensive customisation    

7%

29%

                                                                                29%

Commercially available package/
minimum customisation

21%

 

29%

Custom-built systems

57%

17%

Source: Information Strategy

 

The survey also demonstrated some significant differences in overall approach to ICT investment. US banks are much likely to use ICT to achieve competitive breakthroughs and to capitalise on advances in Information Technology, both in hardware and software.

Table 6

Top Information Systems Issues for Financial Institutions

Europe

 

US

 

1.      Aligning information systems with corporate goals

 

1.      Aligning information strategy with corporate goals

 

2.      Implementing business re-engineering

 

2.      Organising and utilising data

 

3.      Organising and utilising data

 

3.      Instituting cross-functional information systems

 

4.      Cutting information systems costs

4.      Using information technology for competitive breakthroughs

 

5.      Instituting cross-functional information systems

 

5.      Capitalising on advances in information technology

 

Source : Information Strategy

Imaginary gap

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 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.

 

An area where national fragmentation has been  highly detrimental are the European equity markets, where both trading and clearing/settlement infrastructure remain confined to national borders. Large institutional investors and investment banks were able to overcome this fragmentation and trade across borders (see diagram). For retail investors, fragmentation result in high trading commissions (anywhere between 1.5% and 5% of the value of the trade) and prohibitively expensive settlement and custody costs. This discourages cross-border trading, resulting in higher capital costs to the issuers, lower revenues to the financial institutions and relative underdevelopment of European equity markets. With European equity markets moving to euro-based pricing in early January 1999, the shortcomings of this situation will become even more apparent, hopefully accelerating the so far ponderous pace of market infrastructure integration.

Diagram 12

Greatest European trading volumes, 1996

source: Datamonitor

 

IT and Competitive Advantage

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 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. Table 7 shows the largest ICT spenders among the European financial institutions. Financial institutions, which are the heaviest relative spenders are not necessarily the most profitable ones.

Table 7

IT Spending and Profitability
(1996 data)

 

Country

Revenue

Profit

IT spend

IT % of revs

Profitability

HSBC Holdings plc

UK

27497

8144

1500

5,46%

29,62%

Union Bank of Switzerland

CH

14392

-54

1233

8,57%

-0,37%

ABN Amro Bank NV

NL

21962

2262

944

4,30%

10,30%

Barclays plc

UK

18632

3505

1338

7,18%

18,81%

ING Group NV

NL

21976

2152

1187

5,40%

9,79%

Deutsche Bank

D

27432

2595

740

2,70%

9,46%

National Westminster Bank plc

UK

21707

1669

545

2,51%

7,69%

Lloyds TSB

UK

20962

4099

481

2,29%

19,55%

Dresdner Banks AG

D

16809

1409

390

2,32%

8,38%

Paribas SA

F

16023

1201

350

2,18%

7,50%

Commerzbank AG

D

15382

898

322

2,09%

5,84%

Bayerische Vereinsbank AG

D

13668

795

318

2,33%

5,81%

Société Générale

F

20658

1081

293

1,42%

5,23%

Abbey National

UK

10480

1735

273

2,60%

16,56%

Swiss Bank Corporation

CH

12003

-1003

219

1,83%

-8,35%

Standard Chartered Ltd

UK

5563

1294

191

3,43%

23,26%

Banco Centrale Hispanoamericano SA

E

7195

320

174

2,41%

4,45%

Source: Information Strategy

The relationship is complex. For one thing, it 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.

Benchmarking implications

Before discussing framework conditions, let discuss the problems of benchmarking the ICT use in financial services. These problems are serious.

First of all there are measurement difficulties. Although ICT generates plentiful data, meaningful data are scarce. Traditional accounting data (income statement and balance sheet) provide either no information at all or only aggregate data. There are no clearly established standards for measurement, which makes comparison arduous even in a single country let alone on a cross-border basis.

The lack of external reporting data is mirrored by the dearth of internal performance indicators. For instance, total costs of the use of ICT are not fully apprehended. The Total Cost of Ownership approach pioneered by Gartner Group should be extended to systems, applications and networks. Within European financial institutions, ICT is monitored on a purely technical basis of throughput, performance and availability. Only in few exceptional cases is the use of ICT related to business processes. Senior management may have information about ICT efficiency but has practically no data about its effectiveness.

The problem is not purely methodological but also conceptual. The impact of ICT on productivity remains highly controversial, with partisans of IT productivity paradox, first formulated by Robert Solow, very active and vocal. The measurement of ICT impact in financial services is particularly delicate due to the problem of output definition. IT has clearly contributed to the explosion of the number of financial transactions. Are those transactions final or intermediate products. Should they be considered as a net contribution or a cost to the economy. Is the increased liquidity of financial assets a social “good” or a social “bad”? Beyond the transaction cost there is a need to better understand transaction economics.

 

Another benchmarking approach, the Best practices, is also plagued by measurement and comparison difficulties. In a context of national fragmentation, leading to country-specific payment systems, how transferable are the best approaches.

What should the basis of comparison: financial or service indicators. For instance, UK banks are very profitable but there are some indications that their level of customer service leaves a lot to be desired.

Framework conditions

These difficulties in benchmarking financial services are likely to affect the benchmarking of framework conditions. This means that we can only formulate very broad and preliminary remarks. We will focus on two categories of framework conditions: regulatory environment and research and development programmes.

Regulatory environment

Regulatory environment should be seen in a broader sense as comprising all public sector policies and bodies which have direct and indirect impact on financial services.

 

All major payment and financial market infrastructures are subject to regulation in terms of :

-     Their institutional set-up and membership

-     Pricing, particularly as it affects non-banking consumers

-     Consumer protection

ICT use and deployment in financial sector is also impacted by broader policies, which govern competition in the financial services. Data presented above tend to suggest that a more open policy toward competition lead to a more effective use of ICT. This hypothesis however needs to be corroborated in a greater detail.

Some of the policies which have a substantive impact, which not even intended to deal with financial services. A case in point is the telecommunications policy. The lack of competition in this sector may lead to high prices, which may discourage the use of financial ICT relying on the telecommunications network, which charges high prices. The issue of high telecommunications has for many year hampered the growth of EFT POS cards in Belgium as banks and merchants fought over who was going to assume the cost. Government intervention, following a bitter strike by  cash transport personnel, was required to settle in issue. In France, high telecommunication costs led to the choice of a smart card-based off-line autorisation infrastructure for debit cards (see the Case Study).

These two cases suggest that broad competition policies have a strong impact on ICT deployment in financial services. However this impact is far from unequivocal and warrants further investigation. 

Research and development programmes

Traditionally, financial systems have been conceived, developed an funded by co-operative efforts of the private sector. This is particularly the case for major international payment systems and networks such as VISA and MasterCard, which have been initiated by financial institutions with a limited initial involvement of public sector.

Similarly, standards have been defined by co-operative organisations, representing a broad financial institutions constituency. SWIFT is a good example here.

 

This situation is evolving, as the importance for payment networks and clearing systems for the integrity of financial systems is recognised by public authorities. They now play a major role in the design of new payment systems such TARGET and monitor closely activities of payment networks.

 

Public authorities play also a major role in stimulating risk management efforts. Improvements in risk management methodologies such as RiskMetrics® launched by JP Morgan have been developed in response to risk management guidelines formulated by regulatory agencies. Similarly, settlement risk systems such daylight overdraft system implemented by CHIPS, have been developed through close interaction between the Federal Reserve and CHIPS banks.

Two additional developments are likely to lead to a greater involvement of the public sector: Traditionally Past situation: limited impact of public R&D programmes

-     The need to overcome national fragmentation and to movel to European infrastucture

-     Electronic commerce challenge and developing trust infrastructure.

This involvement will be primarily at the European level, through programs funded by the European Commission

Challenges

Looking forward, framework conditions would need to be adopted in response to three major challenges :

·         Co-opetition

-        To what extent should the competition inprovision of ICT FS infrastructure be encouraged ?

-          What kind of market model should the public authorities encourage

-  A controlled oligopoly such as VISA vs. MasterCard

..or free entry model for all ?

The choice will be affected by consideration of a trade-off between economic benefits of competition and the imperative of  financial system integrity

·         Cross-domain regulation

-        Across various financial services segments

-        Across financial institutions/IT providers divide

·         Changing boundaries

-        Within financial services sector

-          banks and insurance companies

-          between banks and non-banks

-        Within IT domain

-          Who will manage trust infrastructure

Certication process

Transaction integrity

Benchmarking of framework condition would require:

-     A qualitative rather than quantitative approach

-     A multidimensionnal rather than uni-dimensional approach

-     Focusing on attitudes rather than numbers

-     System-wide rather than individual benchmarking.

 

Summary Bibliography

 

1.     Bank for International Settlements, Statistics on Payment Systems in the Group of Ten Countries, BIS, Basel, december 1997

2.     Bradley, S.P., Hausmanm J.A,, Nolan, R. (editors), Globalization, Technology and Competition, Harvard Business School, 1993

3.     Carrington, M., Langguth, Ph., Steiner, T., The Banking Revolution Salvation or Slaughter ? , Pitman Publishing, 1997

4.     Datamonitor, IT in European Financial Services 1997 – 2005, 1997

5.     Dermine J., European Banking in the 1990s, Oxford, Blackwell Publishers, 2nd ed., 1993

6.     Ernst & Young and American Bankers Association, Managing the Virtual Bank, 1995 Special Report Technology in Banking

7.     Ernst & Young, Managing the Value Network, 1997 Special Report Technology in Banking and Financial Services

8.     Euroclear,"Cross-Border Clearance, Settlement and Custody: Beyond the G30 Recommendations", 1993

9.     European Information Technology Observatory 1998

10.  Financial Services Statistics, Eurostat, March 1998

11.  Flokers-Landau D., Mathieson D.J. and Schinasi G.J., International Capital markets: Developments, Prospects, and Key Policy Issues, IMF, Washington, 1997.

12.  International Federation of Stock Exchanges, Annual Report 1997

13.  International Securities Market Association, Towards a Single European Securities Trading Market, 1993

14.  Lewis, A., & Pescetto, G., EU and US Banking in the 1990s, Academic Press, 1996

15.  Molyneux, Ph., Altunbas, Y., Gardener, E., Efficiency in European Banking, John Wiley & Sons, 1997

16.  OECD, Bank Profitability Financial Statements of Banks, 1997

17.  Paulet, E., "Universal Banks and the European Banking System: Problems and Prospects", EUI Working Papers, Florence, October 1996

18.  Steiner, T., Teixera, D. , Technology in Banking, Irving Press, 1990

19.  The Single Market Review, Subseries III: Dismantling of Barriers Volume 5: Capital market liberalization, 1997

20.  The Single Market Review, Subseries V: Impact on Competition and Scale Effects Volume 2: Intangible investments, 1998