effects of information technology on financial services …effects of information technology on...

Effects of Information Technology onFinancial Services Systems

September 1984

NTIS order #PB85-152619

Recommended Citation:Effects of Information Technology on Financial Services Systems (Washington, D. C.: U.S.Congress, Office of Technology Assessment, OTA-CIT-202, September 1984).

Library of Congress Catalog Card Number 84-601102

For sale by the Superintendent of DocumentsU.S. Government Printing Office, Washington, D.C. 20402

Foreword

In 1982, the House Committee on Banking, Finance, and Urban Affairs; theHouse Committee on Energy and Commerce (expressing the special interest ofits Subcommittee on Telecommunications, Consumer Protection, and Finance);and the Senate Committee on Banking, Housing, and Urban Affairs requestedOTA to assess the impacts of information processing and telecommunication tech-nologies on financial service systems. This report presents the results of that work.

The effects of technology on the internal operations, the structure and thetypes of services offered by the financial service industry have been profound.Technology has been and continues to be both a motivator and facilitator of changein the financial service industry. The structure of the industry has changed sig-nificantly in recent years as firms not traditionally viewed as financial serviceproviders have taken advantage of opportunities created by technology to enterthe market. New technology-based services have emerged. These changes are theresult of the interaction of technology with other forces such as overall economicconditions, societal pressures, and the legal/regulatory environment in which thefinancial service industry operates.

This report describes the technologies now and likely to be available to pro-viders and users of financial services. It analyzes the present structure of the finan-cial service industry, its service offerings, its relationships with users of financialservices, and observable trends. Implications of possible future trends for industrystructure, markets for financial services, and relationships between the industryand the legal/regulatory environment are explored.

For the purposes of this report, the financial service industry has been dividedinto three segments: 1) retail financial services, 2) the securities industry, and 3)wholesale financial services. We focus on the opportunities that may be createdfor consumers and problems they may encounter as the financial service industrycontinues to evolve. Policy questions likely to be of interest to Congress and alter-natives that are available for dealing with them are identified and analyzed. Finally,alternative scenarios for the financial service industry of the future are offered.

In performing this assessment OTA relied heavily on published materials andon other information provided by a variety of persons and organizations. We aregrateful for this support and assistance. Two workshops, one dealing withtechnology and industry trends, and the other with consumer issues, providedmuch valuable information. Members of the advisory panel were particularlyhelpful with their contributions. However, the contents of this report are the soleresponsibility of OTA and do not necessarily represent the views of the membersof the advisory panel or any of the others who have contributed.

JOHN H. GIBBONSDirector

.,.///

Financial Services Advisory Panel Members

Almarin Phillips, ChairmanHoler Professor of Management, University of Pennsylvania

Donald I. Baker, Esq.PartnerSutherland, Asbill & Brennan

Paul BaranChairman of BoardPacketCable, Inc.

Lynne BarrPartnerGaston-Snow & Ely Bartlett

Robert CaponeVice President and DirectorJ. C. Penney Co., Inc.

Kent ColtonExecutive Vice PresidentNational Association of Home Builders

Richard J. DarwinManagerBattelle Memorial Institute

Gerald ElyDivision DirectorMerrill Lynch Capital Market

John FarnsworthSenior Vice PresidentBank of America

Paul HefnerSenior Vice President1st Interstate Bancard

Edward J. KaneThe Everett D. Reese Professor of

Banking in Monetary EconomicsOhio State University

Jerome SvigalsElectronic Banking ConsultantIBM Corp.

Willis H. WareCorporate Research StaffThe Rand Corp.

Steven WeinsteinVice President–Technology StrategyAmerican Express

Milton Wessel, Esq.General CounselADAPSO

Frederick G. WithingtonVice President, Information SystemsArthur D. Little, Inc.

iv

OTA Financial Services Assessment Staff

John Andelin, Assistant Director, OTAScience, Information and Natural Resources Division

Frederick W. Weingarten, Communication and Information Technologies Program Manager

Project Staff

Zalman A. Shaven, Project Director

Phyllis Orenstein Bresler, In-house Contractor

Margaretta McFarland Rothenberg, Research Analyst

Charla M. Rath, In-house Contractor

Administrative Staff

Elizabeth A. Emanuel, Administrative Assistant

Shirley Gayheart, Secretary

Jennifer Nelson, Secretary

Marsha Williams, Secretary

Renee S. Lloyd, Secretary

Jeanette V. Contee, Secretary

Contractors

Maria T. Arminio, ICS Group, Inc.

Vary T. Coates, J. F. Coates, Inc.

Edwin B. Cox, Arthur D. Little, Inc.

Arthur E. LeMay, SEI, Inc.

Kathryn M. White, Editorial Consultant

Financial Services Industry Consumer Workshop Participants

Stanley BessSystems Program ManagerJ. C. Penney Co., Inc.

Ellen BroadmanMinority Chief CounselUnited States Senate

James L. BrownAssociate Professor of LawDirector of Center for Consumer AffairsUniversity of Wisconsin-Extension

Meredith M. FernstromSenior Vice President-Public ResponsibilityAmerican Express Co.

Edward J. KaneEverett D. Reese Professor of Banking

in Monetary EconomicsOhio State University

Mark LeymasterStaff AttorneyNational Consumer Law Center

Barbara QuintMoney Management EditorFamily Circle

Dale ReistadConsultantReistad Corp.

Financial Services Industry Technologyand Scenarios Workshop Participants

Thelma V. RutherfordPrivate Citizen

Michael Van BuskirkAssistant Vice President of

Corporate AffairsBane One Corp.

C. M. BakerDirector of PlanningNavy Federal Credit Union

Edwin B. CoxSenior Management ConsultantArthur D. Little, Inc.

Richard J. DarwinManagerBattelle Memorial Institute

Ronald GliddenSenior Vice PresidentLife Insurance Co. of Virginia

Frederick R. LevyManager of Financial OperationsFMR Corp.

Robert LuckyExecutive Director, ResearchAT&T Bell Laboratories

Deborah SmithVice PresidentBeneficial Corp.

Daniel F. SullivanSenior Vice President, OperationsISFA Corp.

Blake GreenleyVice PresidentCitibank N.A.

vi

Financial Services Reviewers

John B. BentonPresidentThe ICS Group, Inc.

Janice BookerDirector, Federal Treasury DepartmentComptroller of the Currency

John BriggsP. O. S.–Debit Card Project ManagerMobile Corp.

Raymond CocchiVice PresidentNational Association of Securities

Dealers, Inc.

Dan EitingonPresident—Chief Executive OfficerMoneyCare

Jesse FilkinsSenior AttorneyBoard of Governors of the Federal Reserve

John FisherVice PresidentBane One Corp.

Gregory J. FurmanManaging Director of Advertising and

Sales PromotionNew York Stock Exchange, Inc.

Shelley GrossVice President, MarketingComputer Systems & Resources

Arthur LeMayPresidentArthur E. LeMay Co.

Jeffrey A. LebowitzVice President for Strategic PlanningFederal National Mortgage Association

Frederick R. LevyManager of Financial OperationsFMR Corp.

Alan LipisPresidentElectronic Banking Inc.

Lois MartinVice PresidentThe First National Bank of Saint Paul

John T. McGeeVice President, Corporate AffairsSecurities Industry Automation Corp.

Russell MorrisAssistant Commissioner, Federal FinanceDepartment of the Treasury

Michael RadowSenior AssociateCentury-IV Partners

Louise RosemanRegulatory LiaisonVISA, USA

vii

Contents

Chapter Page1.

2.

3.

4.

5.

6.

7.

8.

9.

10,

Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Present and Future Technologies Supporting the FinancialService Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

The Securities Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

Retail Financial Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97

Wholesale Financial Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137

The International Environment for Financial Services . . . 153

The Consumer of Financial Services. . . . . . . . . . . . . . . . . . . . . . . . 167

Findings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191

Policy Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223

Future Scenarios for the Financial Service Industry, 1990-95 . . . . . . . . 251

Appendix: Glossary of Terms . . . . . . . . . . . . 267

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279

ix

Chapter 1

Overview

Major Findings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Industry Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Legal/Regulatory Environment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Financial Service Delivery Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Consumer Interests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Safety and Soundness of the Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Financial Services in the Future.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Influence of Technology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Financial Service Providers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Users of Financial Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Congressional Policy Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .General Policy Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Structural Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Risk Allocation Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

445566

7788

99

1013

Figures

Figure No. Pagel. Organizations Comprising the Financial Service Industry and

Their Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32. Factors Affecting Financial Service Providers . . . . . . . . . . . . . . . . . . . . . . 4

.— —.

Chapter 1

Overview

This report focuses on the relationship be-tween technology and change, both past andfuture, in the financial service industry. Theroles of technology as both a motivator anda facilitator of change are analyzed. Otheragents of change are considered only to the ex-tent that they help define the market for newtechnology or its impact.

The financial service industry (see fig. 1) ismarkedly different from what it was at the endof the 1970’s, and the rate of change will onlyslow slightly during the remainder of the1980’s. Advancing information and communi-cation technologies are key factors that havechanged the nature of financial services: theways in which they are created, delivered,priced, received, and used. Relationships be-tween and among users and providers of finan-cial services are changing.

Figure 1 .—Organizations Comprising the FinancialService Industry and Their Products

Financial service providers:Banks Data processingThrift institutions TelecommunicationsDry goods merchants Insurance companiesCredit card providers Etc.

Financial service Industry products:Credit Debit cardsDeposit-taking Check authorization cardsBrokerage Information servicesInvestment PaymentCredit cards Insurance

SOURCE Office of Technology Assessment

The existing legal/regulatory structure hasroots that extend back 50 years; changes inthe financial service industry have challengedsome of its premises. Since the mid-1970’s,Congress has devoted considerable attentionto the financial service industry and has en-acted several major pieces of legislation. Manyof the regulations governing the industry arebeing relaxed. However, continued congres-sional attention is needed because not all ofthe salient issues have been resolved.

In the last few years, banks legally able tooperate outside traditional banking regulationhave appeared; retailers of food and generalmerchandise have emerged as major suppliersof financial services; changes in law and reg-ulation have enabled banks, savings and loanassociations, and credit unions to broaden themix of services they offer and enter marketspreviously closed to them. At the same time,firms whose financial service offerings are vir-tually unregulated compete directly with tradi-tional, regulated providers.

Information processing and communicationtechnologies are being used to enhance exist-ing services, to implement new ones, and tomake them available in new ways. Money mar-ket mutual funds, operated by investmentcompanies and securities broker/dealers, per-mit shareholders to redeem shares by writingthe equivalent of a check. Banks, dependingheavily on information processing and commu-nication technologies, are beginning to offersecurities through discount brokerage sub-sidiaries. Banks, credit unions, and savingsand loan associations join networks of auto-mated teller machines that enable accountholders to obtain cash 24 hours a day frommachines that are available nationwide. Bothsecurities dealers and banks have developedsystems that allow account holders with per-

3

� 4 • Effects of Iformation Technology on Financial Service Systems

sonal computes to transfer funds between ac- financial service industry. However, other fac-counts, pay bills, and order the purchase and tors such as the legal/regulatory environment,sale of securities. general economic conditions, and the demands

Observers consistently and correctly point of users have also had significant impact onto technology as a key factor responsible for the industry (see fig. 2).the rapidity and magnitude of change in the

Figure 2.— Factors AffectingFinancial Service Providers

Financial service providers

I I

Users of financial service

SOURCE: Office of Technology Assessment.

Major Findings

The changes that have taken place in the fi-nancial service industry affect a number ofareas including industry structure, the legal/regulatory environment, financial service de-livery systems, consumer interests, and thesafety and soundness of the industry. Majorfindings in each of these areas are summarizedbelow.

Industry Structure

● Rapid and dramatic change in the financialservice industry will not persist indefinitely.There will be a period of stabilization, prob-

●

ably over the coming decade, after whichthe financial service industry is likely to re-turn to a more orderly evolutionary pattern.Firms are in the process of broadening thescope of their service offerings, a trend thatwill continue during the coming decade. Thefuture mix of financial services offered byeach class of provider will be much differentfrom what it is now. Some will offer the fullrange of financial service including takingdeposits, extending credit, underwriting in-surance and securities offerings, and secu-rities brokerage. Others will target narrowlydefined markets such as serving the needs

Ch. l—Overview ● 5

of medical and legal professionals. Dataprocessing and communication services arelikely to be increasingly important offeringsby financial service firms.So long as firms can continue to enter thefinancial service industry with ease, thelikelihood of the industry becoming domi-nated by a small number of providers isminimal.Because of the affordability of informationprocessing and telecommunication servicesfor firms of all sizes, access to technologiesdoes not constitute a barrier to entry intofinancial service markets. Technology mayactually facilitate entry. A small firm, byobtaining communication and processingservices from others can enter a market andcompete with firms many times its size. Onthe other hand, if the existing accessibilityof processing services does not continue, en-try into the financial service industry bysmall firms may be foreclosed.The ability to move information quickly, re-liably, and accurately is essential to successfor both providers and users of financialservices. Organizations controlling exten-sive distribution and/or communication sys-tems are entering and will continue to en-ter markets as providers of financialservices.By facilitating the flow of information na-tionwide, information processing and tele-communication technologies have contrib-uted to the development of national marketsfor financial services. Investors and usersof capital benefit to the extent that their of-fers receive broader exposure than theywould in a local or regional market. On theother hand, market conditions are not uni-form nationwide; and opportunities may bemore favorable in some areas than in others.Thus, there is a possibility that the exist-ence of national capital markets will drawfunds from some regions and cause theirneeds to remain unfulfilled.

Legal/Regulatory Environment

The legal/regulatory structure now govern-ing the financial service industry dates from

●

●

●

●

the 1930’s. Technological, social, and eco-nomic factors are causing considerablechange in the types of services offered, thetypes of firms offering them, and the de-mands of the consumer. In light of thechanges that have taken place, this may bethe time to reconsider the overall legal/reg-ulatory structure governing the financialservice industry.Policies that have assumed a specific indus-try structure or service mix seem to be par-ticularly vulnerable to unanticipated effectswhen new technologies are introduced. Forexample, the assumption that only bankswill take deposits was undermined by theapplication of technology by firms otherthan banks to support offerings such as themoney market account.Some recent changes in State banking lawmodify the way in which Federal law affectsfinancial service institutions. In the past,States have generally supported policies forthe financial service industry consistentwith those of the Federal Government. Thisis no longer always true. Some banking or-ganizations have established subsidiaries inStates that have adopted policies favorableto them and use information processing andtelecommunications to distribute servicesnationwide.

Financial Service Delivery Systems

Financial service providers have used infor-mation processing and communication tech-nologies to overcome some of the limita-tions, such as those restricting interstatebanking, imposed on them by law and reg-ulation. This has lessened distinctions be-tween various classes of financial serviceproviders, allowed the entry of firms notpreviously classed as financial service pro-viders into the financial service industry,and allowed banks to enter into new busi-nesses such as the operation of data proc-essing service bureaus.Telecommunication policy is a major factordetermining the price to the user of telecom-munication services. Because telecommuni-cation is a key component of financial serv-

6 ● Effects of /formation Technology on Financial Services Systems

•

●

●

ice delivery systems, telecommunicationpolicy directly affects the design and via-bility of those systems.

Consumer Interests

Because financial service providers are nowable to use price as an instrument for com-petition, more and more financial serviceswill be priced explicitly. “Free” checking ac-counts will disappear; brokers are likely tospecifically charge for advisory services.Customers may be offered an increasedrange of choice and may pay only for serv-ices used. However, the elimination of someof the subsidies once hidden in “free” finan-cial services may not be popular. The truecosts of meeting the financial service needsof society will be more easily recognizable.There is increased flexibility in selecting fi-nancial services and the types of institu-tions from which they are obtained as a re-sult of the trend to explicit pricing and theentry of new providers into the financialservice industry. However, to take advan-tage of these opportunities, consumers mustbe sufficiently familiar with the availableoptions. Many have taken advantage of newoptions they perceive to be in their interests.In spite of broader choices of services andinstitutions, some consumers are findingtheir options constrained. Checks, for exam-ple, often are no longer an acceptable pay-ment medium unless the person can alsopresent one or more credit cards to demon-strate financial responsibility. Some con-sumers are not welcome as clients to somefinancial service providers. Some may pre-fer to avoid financial institutions but findthat increasing use of technology-based fi-nancial service systems propels them to-wards becoming clients of financial serviceproviders. Lack of access to some financialservices may implicitly limit or deny accessto other goods and services (e.g., it is cur-rently very difficult to rent a car if you donot have a major credit card). At somepoint, consumers may require guaranteedaccess to some minimal level of financial

●

●

services if they are to be able to functionas members of society.Survey data show that consumers are con-cerned with the effects of changes in the fi-nancial service industry on their ability topreserve personal privacy. Privacy issues,on the other hand, are not presently promi-nent on the congressional agenda. If in-cidents of compromised privacy are widelyreported in the future, it may again be afocus of public policy debate.In many cases, a financial institution hasno document bearing an authorizing signa-ture that can be reviewed before an elec-tronically issued order is executed. Errorsin electronic financial systems may onlybecome visible on the periodic accountstatement. Therefore, customers of elec-tronically delivered financial services beargreater responsibility for detecting errorsand initiating the procedures for correctingthem than do customers using paper-basedsystems.

Safety and Soundness of the Industry

Increasing use of information processingand communication technologies requiresthat both providers and users take precau-tions to ensure the integrity and securityof financial service delivery systems. Al-though the use of technology may improvesome aspects of the security and integrityof financial services systems, new vulnera-bilities maybe introduced. Computer-basedauthorization systems reduce the oppor-tunity for fraudulent use of stolen creditcards. However, if an account number iscompromised without the knowledge of thelegitimate owner, its fraudulent use may notbe discovered until a statement is received.Thus, the perpetrator may have a signifi-cant period after obtaining an account num-ber to commit fraud with relatively littlechance of detection.The existing regulatory structure promotessafety and soundness of the financial serv-ice industry by providing Federal insurancefor funds deposited in many banks, savings

Ch. 1—Overview ● 7

and loan associations, and credit unions. vestments that offer higher return. Yet,Funds entrusted to other institutions re- based on experience to date, there is noceive little, if any, of this Federal protection. evidence that the fundamental safety andThe changes in the financial service indus- soundness of the industry have been appre-try have led to significant movement of ciably compromised by the movement offunds from accounts in insured, closely funds from federally insured accounts.supervised institutions to alternative in-

Financial Services in the Future

Forecasts of the financial service industryprepared over the last 10 to 15 years have notbeen particularly accurate. Many of the earlierefforts foresaw the virtual elimination of thecheck and significant decrease in requirementsfor currency and coin during the last quarterof this century. Some saw particular promisein specific technology-based services (e.g.,super-check, an instrument that would use oneorder to direct payment to multiple creditors,and telephone bill payment) that has not yetbeen realized.

Experts continue to prepare forecasts forthe financial service industry. Firms continueto develop and bring to market what they be-lieve to be promising services. Some are la-beled experimental while others are designatedas operational systems. Although forecastersappear to have developed more realistic pic-tures of future markets for financial servicesthan were available in the past, much uncer-tainty remains.

Experience to date will not support an at-tempt to develop a detailed picture of the fi-nancial service industry of the future, butsome general trends (e.g., ever-increasing useof advanced technology to deliver financialservices) are clearer now than they have been.For example, there is little doubt among in-dustry observers that customers will elec-tronically order the immediate transfer offunds from their accounts to those of mer-chants at the time purchases are made. How-ever, the specifics of the systems that will beused to implement this service remain open toquestion. OTA’s analysis of general trends be-ing followed by the financial service industry

represents many points of view now held byknowledgeable observers.

Influence of Technology

The financial service industry of the futurewill be quite different. The established trendof increasingly heavy dependence on technol-ogy for delivering services will continue. Serv-ices will be provided by a wide variety of in-stitutions. Barring a major restructuring ofthe wholesale side of the financial service in-dustry, small financial service firms will beable to obtain access to the technologies theywill require to remain viable. Although rela-tively few firms are likely to provide servicenationwide, it is likely that the existence of alarge number of small, specialized financialservice organizations will prevent the few fromdominating the market.

Communication will be key to delivering fi-nancial services in the future. Networks grow-ing out of those used to connect shared sys-tems of automated teller machines are likelyto provide the basis of systems permittingelectronic initiation of fund transfers from themerchant’s counter. Systems providing accessto funds from virtually any place in the Na-tion regardless of where they are deposited arenow being developed and are likely to be in usein the next few years. Advanced communica-tion technologies including satellite relays,video cable, fiber optics and cellular radio willfind wide application in the financial serviceindustry.

Decreasing computer costs will create theopportunity for large numbers of individual

35-505 0 - 84 - 2 : QL 3

8 ● Effects of Information Technology on Financial Services Systems—

consumers and managers of small businesessto take advantage of technology in using fi-nancial services. Large computers will be usedto support the data bases and the communi-cation processing needed to operate the large,interactive financial service delivery systemsof the future. Computers that accept voice in-puts and recognize fingerprints may becomecost effective for financial service delivery sys-tems by the turn of the century. Small, inex-pensive personal computers in both home andoffice will make it possible for customers tointeract with a multiplicity of financial serv-ice offerors. Computer processor and memorychips imbedded in plastic cards may find widespread use in the financial service industry.

Financial Service Providers

Banks, savings and loan associations, andcredit unions probably will concentrate ontransaction processing and place less empha-sis on gathering deposits and providing financ-ing. Emphasis will be placed on computer andtelecommunication-based systems for deliv-ering financial services. Included in the serv-ices offered will be data processing, securitiesbrokerage, and, possibly, insurance. In thefuture, branches will be dominated by a vari-ety of machines the consumer will use to di-rectly interact with financial service systems.Institutional personnel will serve more of anadvisory role and handle customer transac-tions, such as payments and withdrawals, onlyin exceptional cases.

Securities broker/ dealers, long providers oftransaction services, will compete directlywith banks, savings and loan associations, andcredit unions in many areas. Today they al-ready offer a variety of services such as moneymarket funds that are designed to give thecustomer ease of access to financial assets.This trend will continue, and the future islikely to see higher levels of activity by secu-rities broker/dealers in processing an increas-ingly broad variety of transactions. Retailersof food and general merchandise and possiblyother types of organizations will be attractedto the financial service industry. They will seeopportunities to profitably apply technologi-cal resources which are in hand or within reachto offer transaction processing services.

Firms that have established informationprocessing and telecommunication facilitiesare likely to be particularly active in the finan-cial service industry. New entrants into the in-dustry will have roots in such varied areas asretail food and dry goods merchandising, pe-troleum production and distribution, and com-munications. Traditional providers of financialservices are likely to continue the presenttrend toward diversifying their offerings, oftenentering into areas that have been closed tothem in the past.

Users of Financial Services

Financial services will be delivered to thecustomer at a convenient location with littleneed for clients to visit the offices of a finan-cial service provider. The present tendency ofcorporate financial officers to use terminals intheir offices to manage funds will extend tosmaller businesses. Although the trend is notyet clearly established, individual consumersare likely to use home terminals to interactwith financial service delivery systems.

Consumer financial service packages arelikely to be offered in conjunction with otherinformation-based consumer services such ashome shopping, investment advisories, recrea-tional services such as computer games, travelreservations, and the purchase of tickets tosporting and theatrical events. Financial serv-ice institutions may develop and operate thenetwork used to distribute these services orthey may participate in networks assembledand operated by others.

Consumers may use terminals to orderbanks to pay bills or to purchase securities.They may enjoy more flexibility in servicesused. For example, rather than carrying afixed amount of insurance, a terminal couldbe used to vary it in response to changingneeds (e.g., increasing coverage for theft whilejewelry is kept at home rather than in the bankvault). Orders to buy or sell stocks and bondscould be entered from home and executed onan automated exchange. Consumers may usehome information systems to analyze their fi-nancial positions and to help make decisionson investment opportunities. Using these andother capabilities will give the consumergreater personal control over his assets.

--

Ch. 1—Overview ● 9— — — — —

Consumers may find that they need an ac-count with a financial institution to have ac-cess to a variety of services. Some employersmay require direct deposit of payroll checks.Alternatively, employers may offer employeesthe option of writing checks against salaryheld in a company account in return for beingpaid daily. Consumers may need an accountto be able to use shop at home and travel res-ervation services.

Although technical differences will remain,operational distinctions between services of-fered by various classes of providers willdiminish. It will be more difficult for users todifferentiate between them. For example,though a money market fund offered by asecurities dealer is quite different from a de-mand deposit offered by a bank, both meetsimilar needs for consumers as accounts fromwhich funds can easily be withdrawn.

Congressional Policy Issues

The results of changes already observed inthe financial service industry and those pos-sible in the future are not consistent with someof the key assumptions underlying the pres-ent Federal policy structure. Growing directcompetition between banking and the securi-ties industry, the appearance of new classesof financial service providers, and the changesfollowing from rapid increase in reliance on ad-vanced technologies to deliver financial serv-ices exemplify shifts that have taken place.Therefore, Congress is faced with significantquestions about the relevance and utility ofpresent public policy. In addressing thesequestions, Congress will find it necessary toresolve conflicts between the need to reconcileconflicting interests, on the one hand, and tocreate a climate conducive to the developmentof new financial services and delivery systemsbeneficial to both users and providers on theother.

General Policy Considerations

Restructuring the Policy Framework

● What are the alternative approaches thatcould be used if a review and restructuringof laws and regulations related to financialservices were undertaken?

The financial service industry has changedsince the 1930’s when most of its present pol-icy structure was developed. Rapid change, en-couraged by technology and other marketforces, is expected to abate in the 1980’s or

1990’s. Although Congress has commissionedcomprehensive reviews of the financial serv-ice industry and the legal/regulatory structuregoverning it and has addressed some specificchanges in the industry, legislation revisitingthe fundamental premises of existing policyhas not been enacted.

One alternative is continuation of the pres-ent approach of incrementally adjusting thepolicy framework as the financial service in-dustry continues to evolve. Some of the stepstaken using this approach are in anticipationof future events; others are taken in responseto events in the marketplace. Alternatively,the entire legal and regulatory structure gov-erning the financial service industry could bereviewed and recast in a form deemed suitablein light of expectations for the future.

Implementation of Policy

● What are the mechanisms available to Con-gress for implementing policy pertaining tothe financial service industry?

Historically, Congress has implemented pol-icy for the financial service industry throughone of the most pervasive regulatory struc-tures applied to American industry. Public pol-icy has focused on ensuring the safety andsoundness of financial institutions because oftheir unique role in society. To this end, theassets of the clients of many financial serviceinstitutions, particularly banks, have been pro-

10 . Effects of Information Technology on Financial Services Systems

tected through a combination of insurance andexamination programs. However, new en-trants into the financial service industry,many of whom are subject to neither Federalnor State regulation, now compete with regu-lated traditional financial service firms. Be-cause the nature of competition in the finan-cial service industry has changed, traditionalprotections implemented through existing reg-ulation have lost some of their effectiveness.

Regulations applicable to the financial serv-ice industry have been eased in recent years.Controls on interest rates have been relaxedand bank holding companies have becomefreer to broaden the lines of services (e.g., dataprocessing) they offer.

As Congress continues to develop and refinepolicy for the financial service industry, oneof the tools at its disposal is its ability to varythe degree of regulation applicable to pro-viders of various financial services. Alter-natively, it may modify the outcomes of mar-ket forces to mitigate adverse affects onspecific groups. For example, if the marketwere to compel individuals to have at least oneaccount with a financial service provider, Con-gress might choose to provide a means for en-suring that all are able to obtain a satisfactorypackage of services.

Structural Issues

Consolidation in the Financial Service Industry

● What levels of concentration in the finan-cial service industry are consistent with thegoal of preserving competition among pro-viders of financial service?

There are 40,000 banks, savings and loan as-sociations, and credit unions in the UnitedStates. Thousands of other organizations in-cluding securities broker/dealers, consumer fi-nance companies, merchants, and insurancecompanies also provide financial service. Agoal of Federal financial services policy hasbeen to preserve competition and prevent con-centration in that industry.

Technology-based financial service systemsare changing the nature of competition withinthe industry. Financial institutions are enter-ing new markets and competing both amongthemselves, and with other industries, moredeliberately and directly than ever before. Newentrants are providing services in areas that,in the past, have been reserved to traditionalfinancial service institutions. In the face oftechnological change and competition, merg-ers involving both traditional financial serv-ice providers and new entrants have takenplace. It is possible that these changes will re-sult in a net reduction in the number of pro-viders and will reduce competition in the fi-nancial service industry. Some observers areconcerned that this could lead to excessiveconcentration of economic power.

Congress may find that in light of othertrends affecting the financial service industry,the trend toward greater consolidation in theindustry is acceptable. Alternatively, it mayuse one of several available strategies to limitconsolidation. For example, specific criteria forcontrolling entry to and exit from the indus-try could be established.

Restrictions on Interstate Banking

● What modifications, if any, could be insti-tuted regarding restrictions on interstatebanking?

While Federal law limits interstate branch-ing by institutions allowed to take deposits,it does not prevent interstate activities bythese organizations. Banks have establishedinterstate networks of offices that marketservices other than deposit-taking, such aslending. Some financial institutions have usedtechnology-based delivery systems to circum-vent these restrictions and some States havepassed laws that permit regional interstatebanking. Federal law now permits acquisitionof one financial institution by another in a dif-ferent State under specified circumstances.Unregulated competitors of depository insti-tutions are able to establish offices without re-

Ch. 1—Overview • 11—

gard to geographic boundaries and, hence,may offer services nationwide.

Available options for Congress include re-tention of present policies with respect to in-terstate operations of financial service orga-nizations, reducing or removing restrictionscompletely, or making restrictions more inclu-sive than they are at present. For example, allinstitutions that offer deposit-taking servicescould be made subject to restrictions on inter-state operations. Loopholes in existing lawand regulation could be closed. Restrictionson interstate deposit-taking through auto-mated teller networks could be relaxed.

Limitations on interstate banking stemmed,in part, from concerns that some banks serv-ing regional or national markets could achievean unwarranted degree of economic power andthat local needs for capital would remain un-met as funds were concentrated in major mon-ey centers. An alternative for addressing thelatter would be to strengthen requirementsthat institutions taking deposits meet needsfor credit of the area from which deposits aregathered before funds are made available toregional or national markets.

Market Segmentation

● How might law and regulation be used tofocus the attention of various classes of fi-nancial service providers on specific marketareas?

The existing policy structure more or lesscompartmentalizes the financial service indus-try by function. Banks may take deposits, in-surance companies may underwrite insurance.Insurance companies may not take depositsand banks may not underwrite insurance.Nevertheless, new entrants to financial serv-ice markets have been able to offer servicesin direct competition with those for whom, inthe past, specific market segments had beenreserved. Operators of investment funds, forexample, offer services that share many fea-tures of deposit accounts offered by banks. Insome instances, the traditional providers havebeen unable to respond fully to their new com-

petitors because of the regulatory structurewithin which they must operate.

Congress may choose to resolve this issueby permitting banks and other institutions tooffer financial services that range over a broadspectrum, enabling them to be more respon-sive to competitive offerings of others. Bankpowers could be broadened to include theunderwriting of securities and insurance, forexample. Alternatively, powers to affect merg-ers between financial service providers andfirms from outside the financial service indus-try could be modified. To an extent, this wouldrepresent a continuation of current practice inwhich the Federal Home Loan Bank Board haspermitted mergers across State lines betweensavings and loan associations. Under the pro-visions of the Garn-St Germain Act of 1982,banks have been permitted to acquire dis-tressed, out-of-State savings and loan associ-ations.

A third alternative would see the implemen-tation of policy encouraging financial serviceproviders to engage in activities with clear so-cial benefits. Examples would be incentives en-couraging all providers of financial servicesto finance home ownership and educationalprograms.

Relationship to Telecommunication Policy

● How will further deregulation of telecom-munications affect the financial service in-dustry?

Financial service providers depend heavilyon telecommunications to deliver services totheir clients; and, therefore, they are sensitiveto changes in that industry. Many have builtand operate sophisticated private telecommu-nication networks. Without adequate telecom-munication capabilities, the financial serviceindustry cannot meet the needs of its clients.Changes in telecommunication costs have a di-rect and immediate effect on both providersand users of financial service.

The telecommunications industry is under-going fundamental changes that are alteringthe nature of the services available to its cus-tomers and the prices that will be charged. As

12 . Effects of /formation Technology on Financial Services Systems

financial service delivery systems designed fordirect interaction with customers becomemore commonplace, relationships between theproduct mix, operating characteristics andstructure of the telecommunications industry,and the operations of the financial service in-dustry will become closer.

The formulation of telecommunication pol-icy is extremely complex and beyond the scopeof this report. However, Congress should re-main aware that telecommunication policydirectly influences the economics of financialservice delivery systems and, hence, the mixof financial services that will be offered.

Competition Between Regulated andUnregulated Service Providers

● What steps could be taken to realign thelegal/regulatory structure to make it con-form more closely to the changing structureof the financial service industry?

Many financial services offered by unregu-lated firms are comparable to those marketedby regulated institutions. For example, moneymarket mutual funds marketed by securitiesdealers have attributes in common with someof the various checking accounts offered bybanks. Retailers of food and general merchan-dise are building networks of automated tellermachines and networks to communicate pay-ment data in direct competition with thosebuilt and operated by financial institutions.While the user may not perceive any real dif-ference between the offerings of various finan-cial service providers, in some circumstancesthe existing legal/regulatory structure doesnot cover the activities of non-traditional pro-viders. Users of these unregulated servicesoften do not receive the same protections pro-vided with services offered by regulated insti-tutions.

Congressional options for addressing thisquestion range over a broad spectrum. Thepresent dual system of regulation by both theFederal Government and the States could becontinued. Alternatively, Congress could fol-low the model for the insurance industry and

defer to the States for all regulation of finan-cial services. At the other extreme, Congresscould preempt all State regulation of the finan-cial service industry. Regardless of the levelof the Federal presence, and in contrast withthe present practice of distributing responsi-bility, all Federal regulation of financial serv-ices could be combined and assigned to a sin-gle agency. The focus of regulation could beshifted from the institutions providing serv-ice to the functions performed regardless ofthe nature of the organization performingthem. For example, rather than regulatingbanks as a means of controlling deposit-tak-ing, regulate all organizations that perform thedeposit-taking function regardless of the otherlines of commerce in which they may have in-terests.

Barriers to International Operations● The concerns of foreign governments re-

garding the protection of individual privacycould lead to the erection of barriers forAmerican financial service firms doing busi-ness overseas. What steps could the UnitedStates take to address these concerns or cir-cumvent the barriers?

Foreign government implementation of per-sonal privacy protection programs, some ofwhich are more stringent than those of theUnited States, may restrict the internationaloperations of American financial service pro-viders. Some nations have suggested that theymay limit the movement of personal dataacross their borders to and from others thatdo not meet their standards for privacy pro-tection. The United States may find the oper-ations of its financial service industry limitedby privacy policies of foreign governments.

Congress, in considering this issue, maychoose to continue the present course and tonot expand the privacy protections now inplace. Alternatively, it may adjust privacy lawas it relates to financial services as a meansof reducing potential barriers to American fi-nancial service providers other nations mayraise.

Ch. l—Overview ● 1 3—

Access to the Clearing Systems

● What organizations could be granted accessto the mechanisms for clearing checks, se-curities, and other payment instrumentssuch as credit card drafts?

Banks and savings and loan associations arethe only institutions with direct access to thepayments system. This may give them a com-petitive advantage over other offerors ofchecking account substitutes, credit cards,and debit cards. Some securities brokers of-fer accounts from which funds may be drawnby either a paper draft or debit card and otherorganizations, such as the American Automo-bile Association which offers VISA, issue bankcredit cards. However, offerors of payment in-struments that are neither banks nor savingsand loan associations, almost without excep-tion, must obtain payment-processing servicesfrom an institution that has access to the pay-ments mechanism.

In light of the technologies now available,some argue that other types of institutionsshould also be granted access to the paymentsmechanism. One major merchant is now per-mitted to enter transactions into one of thebank card networks without using the serv-ices of a financial institution. Conceivably, thefuture could see the development and opera-tion of significant systems for transferringfunds without the involvement of banks andother traditional providers of paymentservices.

The Federal Reserve System was estab-lished, in part, to assure smooth operation ofthe check-processing system. Congress maydecide that the operability of the payment sys-tem can only be assured if it remains undercontrol of the banks and savings and loan as-sociations. On the other hand, Congress maychoose to open access to the payment systemto others, such as data processing service or-ganizations, willing to meet specific criteria.Or, it may open the system to all who wouldjoin without establishing specific criteria formembership.

Risk Allocation Issues

Control of Interest Rates

● What alternatives for regulating interestrates are available to Congress?

Federal controls on the interest rates paidby federally insured institutions are beingphased out. States impose limits on the inter-est rates that may be charged on some typesof loans. In recent years, when market rateshave exceeded both Federal and State limits,significant quantities of funds have movedfrom banks, credit unions, and savings andloan associations to alternative investment op-portunities created by new entrants to the fi-nancial service industry. These new entrantshave relied heavily on advanced telecommu-nication and information processing tech-nologies to implement their offerings. Con-strained interest rates effectively limited thesupply of funds to some classes of investments.In many cases, policymakers have reacted tothese movements by changing the legal limitson interest rates paid and charged.

Congress may choose to ensure total decon-trol of interest rates by preempting Stateusury laws. Alternatively, the same mecha-nism could be used to establish uniform, reg-ulated interest rates nationwide. Other al-ternatives include maintaining controls oninterest rates paid on federally insured ac-counts and ceding to the States control of allinterest rates paid within their boundaries.

Allocation of Risk

● What are the alternatives for apportioningrisk between financial institutions and theircustomers and clients?

Deposit insurance protects holders of ac-counts in covered institutions from loss ofassets up to the limits of the insurance. Al-though some noninsured accounts share manyof the attributes of insured accounts, becausethe account holder is not protected from lossof principal, they often carry a higher level of


risk for account holders. However, becauseFederal agencies that insure deposits have preferred to find merger partners for distressedinstitutions instead of closing them, depositinsurance has implicitly provided protectionfor stockholders and holders of large depos-its as well as the owners of accounts withbalances below the limits of insurance cover-age. Some argue that managers of financial in-stitutions take unjustified risks because theyfeel they are implicitly protected by depositinsurance. It has also been suggested thatdepositors and others with whom an institu-tion deals do not review the condition of theinstitutions with which they conduct businessas carefully as they might because of the pres-ence of deposit insurance.

Deposit insurance has been key in the pol-icy framework designed to sustain the safetyand soundness of the financial service indus-try. Congress may choose to continue it in itspresent form where the same insurance ratesapply to all covered institutions. Alterna-tively, the premiums charged insured institu-tions could be modified to reflect the level ofrisk the insurance program is required tounderwrite. Further, deposit insurance couldbe extended to accounts not now covered.

Lifeline Financial Services

● What is necessary to assure an adequatelevel of financial service to all segments ofthe population and to protect other basicconsumer rights and interests?

Individuals who so choose have been ableto avoid dealings with providers of financialservices. However, the ability of consumers toavoid dealings with the financial service indus-try is being limited by such factors as pres-sure from employers and government to ac-cept payments by direct deposit and theincreasing role of the credit card as an itemof identification. In the future, it is likely thataccess to some minimal set of financial serv-ices will be essential for all citizens.

Congress, in approaching this issue, mayfind it necessary to define a minimal set of fi-nancial services needed by virtually the entirepopulace. It may then wish to specify alter-native institutional structures that could beused to deliver such a package of services in-cluding the possibility that all providers oftransaction accounts be required to offer the“lifeline” package. Congress may wish to de-fine the rights of consumers to payment serv-ices and the information regarding them thatneeds be provided to users. Consideration ofa policy that would govern the timing of debitsand credits to an account to ensure equitabletreatment of consumers may be advisable.

Privacy

● Some changes in the delivery of financialservices increase the possibility that the pri-vacy of citizens could be eroded or violated.How can Congress reduce that possibility?

Systems that use information processingand telecommunication technologies for deliv-ering financial services gather data more rap-idly and make it more accessible than dopaper-based systems. Information on the fi-nancial activity of individuals can be ac-cumulated and used without their knowledgeor consent. Existing law provides some pro-tection from intrusion on financial data by theFederal Government, but virtually no protec-tion from the use of this information by Stateand local governments or private parties andorganizations. Increasing use of electronic sys-tems for delivering financial services exacer-bates potential threats to individual privacy.

One alternative open to Congress is to ex-plicitly define the rights of citizens to privacy.Because users of financial services must, bythe nature of the systems used to deliver them,surrender privacy to a degree, Congress maychoose to require they be provided a statementdisclosing the degree to which privacy is likelyto be compromised. A program of monitoringand enforcing rights to privacy might be es-tablished.

Ch. 1—Overview ● 7 5—

Security and Integrity of Delivery Systems

● Are additional actions needed to safeguardthe integrity of national payment and trans-action systems against risk of disruptionsfrom systems failure, hostile attack, andnatural disasters?

System security and integrity have alwaysbeen of paramount concern to the financialservice industry. Both paper-based and elec-tronic systems for delivering financial servicesare vulnerable to attack from the outside andto systemic failure. While electronic systemsovercome some of the vulnerabilities inherentin paper-based systems, new problems are in-troduced. Continued operability of many ma-jor computer-based systems can only beassured through the availability of redundantautomated systems. In these cases, some sys-tem failures can threaten the existence of a fi-nancial institution since manual processing isnot possible in the event that a primary auto-mated system fails. For example, if a bank isunable to perform routine transaction process-ing because of a system failure, it may not beable to settle its accounts with other institu-tions on time and, as a result, may fail.

Although recognition of the problems of sys-tem security and integrity is becoming morewidespread, its true magnitude is not known.Additional information is needed before rea-sonable public policy alternatives can be iden-tified. Therefore, Congress may wish to eitherhold hearings or establish a national commis-sion to assemble additional information priorto undertaking a specific legislative program.Possibly the Federal Emergency ManagementAgency could help meet this need for infor-mation.

Vulnerability of Financial Service Systemsto Theft

• What alternatives are available for control-ling the risk of theft from or associated withfinancial service institutions?

Theft of assets is a constant threat for fi-nancial service providers and their clients.New combinations of telecommunication andcomputer processing for delivering financialservices provide new avenues for theft. Assafeguards are put in place, new methods ofperpetrating crime against financial servicesystems are found. Some of them, theft of dataunder some circumstances for example, are notclearly covered by existing law. Some financialservice providers are hesitant to report inci-dents of theft involving technology-based sys-tems in fear both of lessening the confidenceof their customers and of revealing system vul-nerabilities to potential predators.

In dealing with this issue, Congress maycontinue to rely on existing law and law en-forcement capabilities. Because the issue is notwell understood, Congress may wish to gatheradditional information regarding the problemand alternative solutions either before actingor following initial steps to deal with the mostsalient aspects of the issue. In the short term,it may modify the law to more clearly dealwith the obvious problems (e.g., clarifying thetreatment of those who steal data) that haveaccompanied the inclusion of advanced tech-nologies in systems for delivering financialservices. Additional resources and technologi-cal capabilities could be made available to lawenforcement authorities. Penalties againstboth the perpetrators of crime and those thatconceal it could be increased.

Chapter 2

Present and FutureTechnologies Supporting the

Financial Service Industry

Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Computer Hardware Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Microcomputer Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Large Computer Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Future Computer Hardware . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Software . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Present Applications Software . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Applications Software in the Future.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Telecommunications Technologies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .The Switched Telephone Network . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Private-Line Telecommunications Facilities . . . . . . . . . . . . . . . . . . . . . . . . .Alternatives to Switched Networks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Video-Related Communication Technologies . . . . . . . . . . . . . . . . . . . . . . . .Future Telecommunication Technologies . . . . . . . . . . . . . . . . . . . . . . . . . . .

System Security and Integrity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .System Security. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .System Integrity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Specific Technologies for Delivering Financial Services . . . . . . . . . . . . . . . . .Card Technologies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Document and Currency Readers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Customer Service Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Technology and the Structure of the Financial Service Industry . . . . . . . . .

Appendix 2A: Hardware Components . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Chip Technology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Computer Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Appendix 2B: Systems and Support Software . . . . . . . . . . . . . . . . . . . . . . , .Present Operating and Support Systems . . . . . . . . . . . . . . . . . . . . . . . . . .The Future for Operating and Support Systems. . . . . . . . . . . . . . . . . . . . .

Table

19

20202223

252628

303032323334

363638

38384142

43

444444

454546

Table No. Pagel. General-Purpose Application Processors . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

Chapter 2

Present and Future TechnologiesSupporting the Financial Service Industry

Introduction

Quite simply, the financial service industrycould not provide the level of service it doeswithout the support of advanced informationprocessing and telecommunication technolo-gies. The numbers of checks (over 37 billionannually), credit card drafts (over 3.5 billionannually), and securities trades (over 30 bil-lion shares traded annually) would swamp anymanual system that tried to handle them. Infact, during the 1960’s, trading days for theNew York Stock Exchange were shortened be-cause the broker/dealers were unable to han-dle the workload.

Yet, even with all of its sophistication in theapplication of technology, the financial serv-ice industry has not yet exhausted the poten-tial of the technologies now available. Eventhough large computers support check reader/sorters handling thousands of items a minute,all other aspects of check processing are man-ual, and telecommunications is not used in thecheck-processing cycle. Checks are still man-ually encoded with the amount by proof oper-ators at the bank of first deposit or, in returnfor a reduced processing fee, at the retailerlocation. Return item processing remains amanual operation. Similarly, credit card draftsare manually encoded before processing, andthe securities industry still processes millionsof stock certificates manually.

As the economics of the technologies con-tinue to improve, market pressures to applythem more extensively increase. They help andencourage further migration from paper- andlabor-intensive implementations to electronic,self-service, and remote-based banking.

Operational considerations limit more wide-spread realization of the potential of the tech-nologies. For example, only in recent years has

the annual rate of growth in the number ofchecks slowed, from about 7 percent to about5 percent. The fact that many are unwillingto forgo return of the physical check to retainas proof of payment limits the possibility ofimplementing meaningful check truncationprograms. Similarly, many still take deliveryof physical stock certificates, even thoughbook-entry systems for recording the stockownership provide an alternative.

In the future, the costs of hardware used toimplement advanced systems for delivering fi-nancial services will continue their long-termdecline. New technologies such as the proc-essor in a card and new systems to establishthe authenticity of the order to execute a fi-nancial transaction will become available. Ingeneral, the ability of the financial service in-dustry to take advantage of the technology isnot likely to approach the rate at which itbecomes available. There is little chance thattechnology will limit the industry any time inthe foreseeable future.

Historically, the initial applications of tech-nology “automated’ existing processes. Forexample, the application of computers to ac-count maintenance simply translated existingmanual processes into automated ones. Theadoption of MICR* encoding on checks hasdone little to change the way checks are used.Thus, early application of automation in thefinancial service industry had little, if any, di-rect effect on the users of financial services.On the other hand, systems now being de-ployed are changing the fundamental charac-ter of the financial services consumed by users.Automated teller machine (ATM) networks,

*MICR—magnetic ink character recognition.

19

20 ● Effects of Information Technology on Financial Services Systems

for example, enable users to obtain cash atlocations that cannot be served directly by thefinancial institution holding the account.Moreover, funds are accessible around theclock.

Technologies waiting in the wings have thepotential for changing the basic character ofthe systems used to deliver financial servicesand, as a result, the structure of the financialservice industry. Remote banking via such di-verse technologies as teletex, home computers,and multifunction transaction work stationsinstalled in the offices of financial institutionscould be implemented with technologies nowavailable.

The so-called smart card, lingering just overthe horizon, has the potential for changing thebasic character of currency from paper to elec-tronic. Market viability remains to be demon-strated and sufficient developmental capitalallocated. In addition, an infrastructure of ter-

minals capable of supporting the smart card,either supplementing or replacing the existinginfrastructure for handling magnetic stripetechnology, must be put in place before thistechnology can become a significant factor.

In order to understand present and futuretrends in the financial service industry, it isessential to have a grasp of present and emerg-ing information processing and telecommuni-cation technologies and of their relationshipto present and future products and services.This chapter describes the basic technologiesthat are and could be applied for delivering fi-nancial services. The purpose is to create anappreciation for the potential and the limita-tions of the technologies for facilitating changein the financial service industry. Yet, one mustunderstand that the technologies constitutebut one of a number of forces operating toshape the financial service industry and thattheir potential may not be realizable becauseof other constraints that are operating.

Computer Hardware Systems

The providers of financial services have beenamong the leading users of medium- to large-scale processors, and only the very largestscientific computers have not yet been widelyapplied for the delivery of financial services.These large computer systems generally re-quire dedicated facilities and support from anonsite team of information processing profes-sionals. For all practical purposes, providersof financial services can buy computing powerappropriate to their needs from a number ofwell-established manufacturers. Further, be-cause of the way computer manufacturersdesign and enhance their product lines, orga-nizations are able to have reasonable expec-tations that they will be able to make the tran-sition, as needed, to machines of greatercapacity with a minimum of operational dis-ruption. However, even with the decreasesthat have occurred in the costs of medium- tolarge-scale computer systems, they are stillpriced beyond the means of many of the

smaller financial service organizations thatcould benefit from having access to them.

Microcomputer Systems

Changes in the technology of computer proc-essors at the low end of the capacity spectrum(i.e., those with the most limited capacity) arehaving the greatest impact on the operationsof the financial service industry. Both usersand providers are using them heavily. Micro-computers range in price from less than $100to almost $10,000 (for some of the more elabo-rate systems now on the market). However,a $100 unit has only limited capacity to par-ticipate in a financial service system becauseit has neither communication nor significantdata storage capacity. Additional capabilitiesmust be added if the user wants to use the var-ious financial application packages being mar-keted for personal computers. These include,for example, such diverse applications as home

Ch. 2—Present and Future Technologies Supporting the Financial Service Industry . 21

Phofo credtf Mfcro Genera/ Corp

Two widely used microcomputer systems

Photo credit. L/S/ Computer Products

Printed circuit card of the type used in microcomputers.Each of the rectangular cases contains a circuit thatconsists of the equivalent of several thousand transistors

budgeting and accounting systems, checkbookbalancing programs, securities price trendanalysis, portfolio analysis, and income taxpreparation.

A cassette recorder costing about $50 wouldpermit the user to load prerecorded programsand save intermediate results so that theywould not have to be reentered into the com-puter manually every time they are to be used.

A disc drive offering faster and more reliableaccess to data and programs can be purchasedfor some units for about $250. A printer thatcan be used to make paper records for userswould cost another $250. Applications theuser may wish to run may require the addi-tion of memory expansion modules that costmore than the original $100 price of the com-puter. The user will, in some cases, have tospend $200 or more on an accessory requiredfor making the connections between the per-ipherals and the computer. Yet even with allthese additions, the user would still have a sys-tem limited to local use and applicable prin-cipally only to recordkeeping and analysis ofdata entered into the computer by the user.

To take advantage of home banking andstock market transaction services, informationutilities, and home shopping services that en-tail interaction of a personal computer witha computer operated by the financial serviceprovider a personal computer must be

equipped with suitable data communicationequipment. These include a feature that doesthe processing required to establish and main-


tain a telecommunication connection (RS-232interface) and a unit (modem) connected to thetelephone line for converting digital pulsesused internally by the computer to analogsignals that can be transmitted over the con-ventional telephone lines of a switched tele-phone network. In addition, programs to sup-port the communication function or to handlethe financial application would have to be pro-cured, at a cost ranging from under $100 to$250 or more, depending on the complexity ofthe application. Although a disc drive and ex-pansion interface might be required for sucha function, a printer would most likely be adiscretionary purchase.

Thus, while computers can be acquired for$100 or less, the person who would like to usethem either to receive financial services and/orto perform financial analysis is more realis-tically looking at an investment that is closerto $700 or $800. However, this situation is notlikely to persist in the long run. The prices ofall computing equipment are falling. Somevendors are selling modems for under $100,and the price of disc drives continues to fall.Computer modules that work with widely dis-tributed video games are on the market, andthey are expected to offer the user significantimprovement in the performance-to-cost ratiofor equipment that could be used in conjunc-tion with various future financial service of-ferings. In addition, small, battery-powered,portable computers that can be carried in abriefcase and have a built-in modem and RS-232 interface are now available for under$1,000, a price that will undoubtedly be lowerin the future. Therefore, computers that canbe used by individuals to receive financial serv-ices both at home and work are likely to be wellwithin reach of a large portion of the popula-tion within the 1988 to 1993 time frame.

Another alternative would be developmentof very inexpensive specialized devices ori-ented to users of financial services. Thesecould use cartridges similar to those used withtelevision game machines, very simple controlmechanisms, and a television to display thedata. Some providers may even develop appli-cations that use a TV game machine as the key

processing element. In this environment, usersmay actually have several terminal devices tointeract with financial service systems, eachof which is dedicated to the offerings of a par-ticular provider. Simple, inexpensive, dedi-cated devices may find extensive applicationin point-of-sale (POS) systems as well as thosedesigned to deliver services to consumers. Theavailability of terminals for users at little orno cost could be a strong impetus to increas-ing significantly the rate of adoption of ad-vanced systems for delivering financialservices.

People have demonstrated repeatedly thatthey will spend substantial sums if they per-ceive utility in a product. Historically, this hasbeen true with television; more recently, withvideo recorders. However, it remains to beseen whether a large number of individuals willbe willing to invest in information processingand telecommunication equipment capable ofinteracting with systems for delivering finan-cial services to the home. Success of financialservice offerings may depend on minimizingthe investment of potential customers and,perhaps, what other services may be availablethrough the same systems.

Large Computer Systems

While there will be significant changes in thecapabilities of computers at the low end of thespectrum that will enable a larger number ofpeople to access the technology, changes at thehigh end of the scale will also occur. Speedsof computation and the basic architecture ofcomputers will change so that there will be amarked increase in the performance-to-costratios over those now available. The raw com-puter power for applications such as imageand voice processing will become available.Both applications have potential for the finan-cial service industry. Voice recognition ap-plications could be used as an alternative tokey input particularly in telephone-orientedsystems in which the user would use voice toissue payment and other directives to finan-cial service systems. Applications of imageprocessing systems, some of which are now be-

Ch. 2—Present and Future Technologies Supporting the Financial Service Industry ● 2 3— . . . —-- — .———..—— - ——.

ing tested, could range from processing finger-prints for identifying the user of a remote serv-ice device to reading information on checks aspart of check processing. As the cost of equip-ment continues to fall, more providers of fi-nancial services will find the equipment afford-able. In addition, customers will become betterequipped to take advantage of the variousservices offered (see table 1).

Future Computer Hardware

During the coming 10 years, changes in com-puter hardware that are generally invisible butbeneficial to users will occur. Functions such

Table 1 .—General-Purpose Application Processors

1982 1987 1992Small:

Cost (dollars in thousands) . . . . 12 8 5Storage (megabytes) . . . . . . . . . . 0.5 1 2Speed (millions of instructions

per minute) . . . . . . . . . . ... . 0.05 0.1 0.4Medium:

Cost . . . . . . . . . . . . . . . . . . . . 100 60 40Storage. . . . . . . . . . . . . . . . . . . . . . 1 2 8Speed . . . . . . . . . . . . . . . . . . . . 0.2 1.0 4

Large:cost . . . . . . . . . . . . . . . . . . . . .. ..1,400 600 400Storage. . . . . . . . . . . . . . . . . . . . . . 8 16 48Speed . . . . . . . . . . . . . . . . . . . . . . . 4 8 24

SOURCE Arthur D Little, Inc “Application of Technology for Providing FinancialServices, ” April 1983

as those needed for system control and theprocessing of some programing languages nowimplemented in software will be moved to thehardware. Special-purpose machines featuringapplications built into hardware will be as-sembled from a variety of general-purposebuilding blocks at minimal cost to meet theneeds of specific applications. As a result, notonly will the computers used to deliver finan-cial services be less expensive, they will alsobe more reliable.

From the users’ point of view, this will re-duce the complexity of computer systems,while at the same time enabling him to selecta computer that is more or less tailored to theapplications it must support. For example,suites of special-purpose machines in facilitiesoperated by financial institutions, mixed tomeet the needs of the customers using them,will be possible. Some devices could be usedonly for balance inquiry and the kinds of trans-actions now performed through an ATM.Others could be used to submit loan applica-tions and/or initiate securities transactions. Asingle cash dispenser/deposit acceptor* couldserve multiple user stations, thus keepingoverall system costs down. Financial institu-tions may find it in their interest to providecustomers with terminal devices specificallyoriented to the package of products and serv-ices being provided, thus overcoming anyhesitancy to acquire and use general-purposecomputer hardware that requires some specificknowledge of the technologies.

Computer architecture will be increasinglymodular, with functions divided between andamong various system components. On theone hand, this will make it possible for usersto configure systems to meet their specific re-quirements, while on the other, it will tend toincrease system reliability and integrity. If onecomponent fails, the probability that systemoperation will continue at some degraded levelof performance is high. Providers and usersof systems for delivering financial services willbenefit from an increase in the availability of

*A d~PoS~acceptor would have the capability to count cashand read the amounts of checks as they are deposited.

35-505 0 - 84 - 3 : QL 3


fault-tolerant systems to support online ap-plications. The mean time between failure forsuch systems is measured in years, since theyare designed to continue operating withoutdegradation in performance in all but the mostcatastrophic circumstances.

Alternatives to keyboard entry will increasethe flexibility and attractiveness to users ofself-service financial systems that are access-ible from remote locations. For example, theuser will be able to communicate instructionsto a computer by touching one of a few con-trol buttons or an image on a screen. Already,touch screens are available on devices thatrange from wristwatches to computers, andgreater application of these in the future canbe expected. Limited voice input capabilitieswill be available, but continuous speech lan-guage processing will not be possible beforethe turn of the century, if then. Optical char-acter recognition technologies will continue tobecome more cost effective, and there will besome capabilities to process handwritten in-put. Systems that use the signature to iden-tify the user rather than a personal identificat-ion number coupled with a machine readablecard could come into use by the middle of thecoming decade. On net balance, these alterna-tives will reduce the use of multiple keystrokesneeded to respond to requests for information,and hence will reduce barriers to use and in-crease efficiency of the new systems for deliv-ering financial services.

Greater use will be made of color and graph-ics in computer output. The ability to transmitpictures easily will mean that the user willhave less need to read. Video disc technologycould be coupled with computers, especiallyin such applications as home shopping andothers that require catalog-type data. Video“catalogs” could show the shopper multipleviews of an item and could be updated fre-quently to show newly arrived merchandiseand to reflect price changes. Voice synthe-sizers have become very affordable, and theywill be used both to support graphics displaysand to provide computer output through thestandard voice telephone. Displays will be-come more compact and will blend more com-

pletely into the background than is now thecase, thus making them more acceptable inboth the home and office. The telephone willbecome a multipurpose instrument capable ofreceiving alphanumeric as well as graphicdata, in addition to its conventional use forvoice transmission. Such devices are alreadyon the market for applications in the businessenvironment.

The key to the future will be ease of use. Asnew terminals become available and are capa-ble of presenting and transmitting informationin a multiplicity of formats, user anxiety re-lating to the technology used to interact withsystems for delivering financial servicesshould approach the level now experiencedwith the telephone or the handheld calculator.

Future providers and users of financial serv-ices will have the choice of using networks ofsmall processors or the minicomputers andmainframes that will soon become affordablefor them. To some extent, they, like everyoneelse who acquires information-processing ca-pabilities, will be able to choose the equipmentthat best meets their requirements for proc-essing and their philosophies of product designand management. Factors such as systemsecurity, reliability, and integrity will be takeninto account. Other factors will be the avail-ability of appropriate software packages andthe costs of telecommunication services.

In some specialized applications, however,the large computer system will continue todominate. For example, significant computerpower is required to support the check reader/sorters used widely throughout the financialservice community. While electronic bankingwill lessen the growth in check volumes, theywill remain high. Therefore, requirements forsupporting check-processing equipment willcontinue into the foreseeable future. New ap-plications implementing processing of voiceand/or handwriting will also require the powerof mainframe computer systems. In addition,microcomputers may not be capable of man-@g future telecommunication functions thatwill become even more significant to the finan-cial service industry.

Ch. 2—Present and Future Technologies Supporting the Financial Service Industry ● 2 5

Online POS systems will consume substan-tial processing and communication resources.Interchange networks that serve ATM sys-tems are designed to handle 4 to 10 transac-tions per second and provide a response timethat ranges from 30 to 90 seconds. PaulHefner of First Interstate Bancorp of Califor-nia, points out that POS networks will haveto handle hundreds of transactions per secondand provide a response on the order of 6seconds. Thus, the processing capacity re-quired to support these networks may beginto approach the limits of the technology, ifthey begin to handle the transaction volumesforeseen by some.

Already, both users and providers of finan-cial services have put in place a considerableportion of the hardware infrastructure thatwill be key to delivering financial services.Banks and other financial service providershave been long-time users of computers, ashave the major dry goods retailers. However,an increasing number of small stores are in-stalling electronic cash registers and com-puters from which they will be able to buildin the future. Some grocery chains have madeheavy use of computers to automate the check-out process and inventory systems for in-dividual stores. Major firms regularly useautomated systems to generate payrolls andpay suppliers. Smaller firms are increasinglyturning to data service bureaus or installingsmall computers to obtain comparable serv-ices. Also, considerable numbers of consumersare acquiring computers that could be con-figured to perform the processing required tointeract with financial service deliverysystems.

One of the factors that has limited the de-gree to which advanced systems for deliver-ing financial services have been accepted hasbeen the lack of processing capabilities in thehands of many potential users and suppliers.The fact that many potential participants inthe financial service industry are installingcomputers for a variety of reasons is creatinga latent capability for either using or deliver-ing financial products because the marginalcost of such a move could be minimal.

The long-term impact of changes in the ca-pabilities of computers on the users and pro-viders of financial services is not so much thatthe raw computational capability of the equip-ment will increase. Rather, an increasing num-ber of individuals and organizations are buy-ing equipment because its cost is dropping.The result is a decreasing marginal cost of en-try for potential users and providers of ad-vanced financial services systems. Higher po-tential levels of participation will encouragethe deployment of advanced systems and, inthe absence of other barriers to their accept-ance, will result in their achieving a greaterlevel of economic viability than would be possi-ble with the present level of equipage.

Generally, the financial service industry hasnot demanded access to the largest computersto handle its applications. Advances in com-puter technology will most likely continue tooutpace the demands of the financial serviceindustry, and therefore, lack of sufficient com-puter power will not be one of the factors thatwill limit the development of new systems fordelivering financial services.

SoftwareA computer is useless without software: the ing a program to be operational, and an ongo-

programs that instruct a computer to perform ing program of maintenance to ensure that theoperations. The development of software software remains responsive to user needs anddepends on the careful and precise definition to remove errors that are almost invariablyof requirements by those for whom a system identified after a program is declared opera-is being built, thorough testing before declar- tional. All of these operations are labor-


intensive, and therefore very expensive. Thecost of software is determined by its complex-ity rather than the size of the machine onwhich it is to operate or the volumes of datathat are to be processed. Generally, however,larger machines are needed to use the morecomplex software packages that support thelarger data bases.

Although the cost of computer hardwarewill continue to decrease, the cost of computersoftware may not, or may not decrease asmuch. Software development remains a labor-intensive activity and is likely to remain sointo the 1988 to 1993 time frame. However,more widespread use of software packages willlower costs for individual users.

Until now, resources for software develop-ment have fallen short of demand. The adventof new tools for software development, how-ever, should increase the productivity of soft-ware professionals somewhat. Furthermore, agreater tendency to purchase and modify ap-plication packages to meet specific needs asa substitute for the development of applica-tion packages by each end-user organizationwill reduce the apparent shortfall of softwaredevelopment resources in the future.

There are three basic classes of software—systems software, support software, and ap-plications software. Systems software controlsthe minute-to-minute operations of the com-puter by allocating resources and schedulingtasks. Support software is typically used forsuch functions as controlling a communica-tions network, monitoring transaction proc-essing, managing the data base environment,or furnishing tools intended to improve theproductivity of programmers and, in some cases,end-users. Applications software directly in-terfaces with the end-user and is designed tocarry out functions unique to the particularsituation.

Systems and support software, includingdata base management systems, are discussedin appendix 2B to this chapter. Applicationssoftware and its use for delivering financialservices is described in the sections thatfollow.

Present Applications Software

The acquisition of applications software hasalways been the responsibility of the user orga-nization. Today the computer user has threeoptions for acquiring software. First, the usercan retain either in-house staff or a consult-ant/contractor to build application packagesuniquely tailored to his needs. Because pro-gram development remains labor-intensive,this can be a costly process, a significant por-tion of which is the cost incurred-after thesystem becomes operational-for maintainingthe programs, correcting errors as they are dis-covered, and making changes as the needs ofthe organization evolve. For operators of largescale computer systems, such as those usedby many providers of financial services, thishas been the only option considered. Largestaffs of highly trained professionals havebeen assembled and supported to handle thetasks of system development and mainte-nance. Experienced organizations have foundthat over 70 percent of the resources spent onthese staffs is for maintaining existing sys-tems, leaving only 30 percent for developingnew applications programs.

Financial service organizations have devel-oped a huge body of proprietary software overthe years. Included are applications that rangefrom internal accounting systems to thosethat support home banking products. Whena new product such as a money market mutualfund is offered, its introduction must often bepreceded by a significant software develop-ment effort. Regulatory changes such as theimposition of Regulation E* can also result inmajor software development efforts or theneed to make significant changes to existingsoftware systems.

However, just as the advent of small com-puters has brought the power of the technol-ogy within reach for the individual user, it hasalso had an impact on the costs of system de-velopment and maintenance. Consumers nowidentify applications in which the small com-

*Re~lation E is the Federal Reserve Board Regulation im-plementing the consumer protection provisions of the EFT Actof 1978.


puter can provide significant benefit and eitherwrite the programs themselves or with helpat minimal cost. Generally, the small packagesfor personal computers which result are usedfor analytical applications that are often tai-lored to the specific working habits of the in-dividuals using them. To some extent, the per-sonal computer has replaced the worksheetand personal file system that have alwaysbeen the tools of the professional analyst anddecisionmaker. This software is not suitablefor account maintenance and other adminis-trative tasks that require the manipulation oflarge data bases and the processing of a largenumber of transactions. On the other hand, aportion of these applications depend on beingable to access the major corporate data basesthat are maintained by the large, central com-puter facility.

In one example, a microcomputer is used tohelp farmers generate the information requiredto support applications for loans. Another ap-plication using a voice response unit and in-put from a 12-key telephone has been devel-oped by a financial analyst to process marketdata and generate information used for port-folio management. Automated spread-sheetprograms running on microcomputers havealso become popular tools among users andproviders of financial services. Users havefound that for some purposes the informationgenerated by a microcomputer running allnight can be just as satisfactory as the samedata produced in a few minutes on a large, cen-tralized computer. Further, the user of themicrocomputer may be able to avoid hasslesoften encountered when a data processing de-partment is asked to implement an appli-cation.

Over the years, the usefulness of applica-tions packages has been recognized across anindustry, and significant numbers of packagesare now developed and offered for sale or leaseto a variety of users. In some cases, thepackages were developed by organizations fortheir own use and later offered to others. Inother cases, the package was developed to bemarketed commercially. In this environment,all benefit because the costs of development

and maintenance are potentially spread overmultiple users.

Systems for processing checks and servic-ing deposit accounts and outstanding loanshave been developed by both financial insti-tutions and data-processing service organiza-tions and are widely used throughout the in-dustry. Organizations that have developed thesoftware for home banking applications are ac-tively marketing it to providers.

Thus, as a second option, the user can ac-quire an application package that comes asclose as possible to meeting his needs and theneither modify it with internal resources or re-tain the original developer or another party tomake the required changes. This approach hasthe disadvantage for both the vendor and theuser that multiple versions of a basic packagemust be supported. Costs and difficulty ofmaintenance are both increased as, almost in-variably, the modifications made periodicallyto the basic package and the changes made tomeet specific user needs generate conflictsthat require basic changes in the software toresolve. Some marketers of software systemsmitigate this problem by including featuresthat permit the user to customize the packageat specific points in the processing cycle with-out actually modifying the basic program.

The third option for the user is to acquireand use an application package as is. This op-tion is more often used by users with smallcomputers than with large. However, opera-tors of large installations are turning with in-creasing frequency to generalized softwarepackages. Prepackaged software for micro-computers has enabled significant numbers ofusers in the financial service industry to applyinformation processing and telecommunica-tion resources to the operation of their busi-nesses without needing to become proficienttechnically in the operation and use of thetechnology.

To use these various packages, the user neednot purchase or lease the computers on whichthe applications run. Time on systems oper-ated by others can be purchased, an optionthat has enabled many smaller providers of fi-


nancial services to take advantage of availabletechnologies. In many cases, banks and serv-ice bureaus that develop application packagesalso sell the machine time required to runthem. In others, those with excess processingresources available sell them. For example, thelargest processors of bank card transactionsare service organizations, not banks. Checkprocessing and account maintenance is oftenperformed by other than the institution offer-ing the service.

Conventionally, the medium for distributingsoftware is either floppy disc or magnetic tape.Telecommunication links between computersare also used for transferring software. Thistechnique is used to distribute programs forlarge computer systems and for providing pro-grams stored on large central computers tosmall peripheral ones in distributed process-ing environments.

Experience has shown that safeguardsagainst copying or modifying software caneasily be circumvented by individuals whohave a moderate degree of technical sophisti-cation. This presents a problem to operatorsof systems for delivering financial serviceselectronically to a large number of people. Ifthe software used to access a service from thecustomer’s premises can be altered, a compro-mise of system integrity or security could re-sult, causing damages for both the systemoperator and other users.

One way to avoid this problem is to distrib-ute software in cartridge form, in the form ofhardware, a technique that is being tried byat least one marketer of home banking serv-ices. Although this minimizes the chances ofmodifying the software, users whose comput-ers do not accept cartridges are eliminatedfrom the market. Moreover, it does nothing tostop the potential intruder who obtains thefunctional specifications of the cartridge or isable to copy the program from the cartridgeto another medium. In these cases, the intru-der could modify the program to perform un-authorized functions, just as it is possible tomodify software distributed using other, moreconventional media. On the other hand, a ma-

jor computer manufacturer has announced amicrocomputer that accepts program car-tridges; this is likely to provide the impetusneeded to make this medium of software dis-tribution more widely accepted for financialservices.

Applications Software in the Future

The evolution of applications software in thefuture is likely to be relatively slow becauseof the huge base of operational programs, rep-resenting an investment of billions of dollars,that is now installed.’ Language developmentwill be constrained because in many areas newlanguages will have to be compatible withthose used to implement the installed base.

Even though there is considerable inertia inthe form of installed application systems, ap-plication programs will continue to evolve. Inthe near term, the emphasis will be on modi-fying batch applications* to operate interac-tively where it is reasonable to do so. Specificattention is being given to providing the mostup-to-date information possible to both usersand providers of services in order to improveoverall management of financial resources.Even where batch processing is most desira-ble, transaction data will be entered interac-tively and accumulated until a batch process-ing program designed to handle the accumu-lated data is run. Eventually, however, interac-tive processing will dominate and up-to-the-minute data will be available to all who need it.

Most programs today have been developedto meet the needs of classes of individuals onthe assumption that the requirements of mem-bers of a group for computer support are ap-proximately the same. This assumption holdsfor people engaged in routine activities, butit tends to break down at the upper levels oforganizations. In the future, generalized sys-

IThe material in this section draws heavily on the report,“Future Information Processing Technology -1983° preparedfor the Institute of Computer Science and Technology and theDefense Intelligence Agency.

*Batch applications me those when data are assembled overa period of time and are processed periodically, frequently ona fixed cycle.

Ch. 2–Present and Future Technologies Supporting the Financial Service Industry ● 2 9

terns and capabilities will be more easily tai-lored to the specific needs of individuals. Userswill be provided the facility to set applicationparameters to meet their individual needs. Ob-vious examples that already exist are the abil-ity to request the detail to be used in prompt-ing the computer user online and the formatto be used for displaying data. The user unfa-miliar with an application can be led throughit step by step, while those who have masteredthe operations required can be freed of the bur-den of detailed instructions.

Applications will be self-teaching to a greatdegree. Many, as already illustrated by thesystems that support ATMs, will be menu-driven; users will not be required to learn anduse commands. Today, a growing number in-clude tutorial features; but in the future theuser will have greater facility in selecting thespecific points where instruction is needed andw-ill be able to obtain help without interruptingthe ongoing flow of processing. Audio-visualdisplay technology, heavily dependent on vid-eo discs, may figure greatly in implementingthis capability.

Users will have a larger variety of optionsin selecting the format in which data is pre-sented. Color graphics will come into morewidespread use and users will have greatercapabilities to manipulate graphic images inaddition to already existing facilities for ma-nipulating and analyzing combinations of nu-meric and alphabetic data. For example, thecapability of manipulating a trend line for onevariable and seeing its effects on other trendswill be possible. Mice, * light-pens, and voiceinput/output will greatly facilitate interactionbetween the user and information system.

*A mou9e i9 a small device attached to a computer that isused instead of keys to control the movement of the cursor, theindicator on a video display that indicates where the next char-acter will be formed.

“Windowing” technologies that permit theuser to display the results of multiple proc-esses simultaneously on the screen will im-prove the utility of the technology to the users.They will allow the users to concurrently viewdata from multiple sources and select thoseitems most useful to the task at hand. For ex-ample, the user may use one window to reviewthe status of a transaction account, a secondto project cash flow, and a third to enter anorder with a broker/dealer to buy or sell a secu-rity using a telecommunication line that con-nects directly to the broker/dealer’s computer.

More of the processing capability will be res-ident at the user site and will therefore bemuch more of a personal tool. Large systemsmay be limited to being repositories of datato which the user is provided access on a “needto know” basis. At the start of a problem-solving session, a microcomputer will be usedto access a data base on a large computer sys-tem, retrieve the data needed to address theproblem, and store it locally on a small disc.Applications running on the microcomputerwill perform the required analysis, and afterthis has been completed, the central data basewill be modified as required. In fact, in someorganizations, this mode of problem-solvingis already quite commonplace.

Knowledge-based systems, one of the areasin the general field of research known as arti-ficial intelligence, will become more generallyavailable. For the financial service industry,this could mean that financial advisors andcounselors will be augmented, or possibly re-placed, by automated systems. Research inartificial intelligence and expert systems hasshown some valuable results. However, thereis considerable uncertainty about when suchsystems will be sophisticated enough to havean operational impact on the financial serviceindustry.


Telecommunications Technologies

Telecommunication technology provides anindispensable lifeline to users and providersof financial services. Of the number of alter-native telecommunication technologies fromwhich suppliers and users of financial servicesare able to choose, the most common is theswitched telephone network. But, both provid-ers and users of financial services also con-struct and use a variety of alternatives, whichinclude such diverse technologies as privatemicrowave links, satellite transponders, videocable, public packet switched networks, leasedlines, and local area networks.

The divestiture of the operating telephonecompanies by American Telephone & Tele-graph (AT&T) in 1984 substantially changesthe communication environment in which pro-viders and users of financial services operate.Both local and long-distance telephone ratesare likely to change. Competition from non-Bell suppliers of telecommunication servicesand equipment is already significant and islikely to increase in magnitude and kind inlight of the divestiture. Those who enter mar-kets as providers of equipment and servicesare likely to intensify competition further.

Both suppliers and users of financial serv-ices are heavily dependent on telecommunica-tion services, and as systems to deliver finan-cial services directly to customer premisesbecome more widely deployed, this depend-

Photo credit Raca/.M//go Corp

Network control console like those used to managemajor financial service telecommunication networks

ency will increase. Securities markets, cardand check authorization systems, and cashmanagement services are now totally depend-ent on telecommunication. Products such asremote banking and shopping and off-marketsecurities trading have a dependency equallygreat. The premium placed on timely financialinformation is increasing, and the only way tomeet this requirement is through the applica-tion of communication technologies. Changesin the technologies, policies, and economics ofcommunication will directly affect the designof systems for delivering financial services, thecost schedules facing both users and providersof financial services, and, hence, the structureof the financial service industry.

The Switched Telephone Network

The most widely available communicationfacility is the switched telephone network thatserves virtually every place of work and resi-dence in the United States. Only a limitednumber of locations can send and receive tel-ecommunication traffic without using this net-work for a portion of the route. Subscribersto non-AT&T long-distance networks gener-ally access them through the facilities of localoperating companies. In fact, some of the al-ternative services actually use long-distancecircuits provided by AT&T.

The switched telephone network is basicallydesigned to handle analog voice traffic. Gen-erally, digital data sent between computersand between computers and terminals mustbe converted from digital to analog format fortransmission through the network. Networkfacilities capable of carrying the digital signalsand thus eliminating the need for this conver-sion/reconversion process are now coming intouse and will eventually replace the analog linksin the system. In this environment, voice aswell as data will be transmitted through thenetwork using a digital format.

The switched telephone network was de-signed to handle a relatively large number of


calls of short duration in which the parties arespeaking a high percentage of the time the con-nection is maintained. A circuit is establishedbetween the parties for the duration of the call.Whether or not there is traffic on the connec-ting circuit, the facilities used to maintain theconnection are denied to others. A POS ter-minal connected continuously through theswitched telephone network may be used onlyintermittently. Although this constitutes aninefficient use of network resources, a mer-chant may desire to maintain such a connec-tion in order to minimize the time required toprocess a transaction at the point of sale.

The common telephone is by far the primaryterminal used with the switched telephone sys-tem. Although it functions well for voice com-munication, its capabilities as an instrumentfor data entry are limited, and those for receiv-ing other than voice response are almost non-existent. The 12-key tone pad is a moderatelyeffective data entry device that can be usedto transmit numeric data to a computer withrelative ease, but it transmits alphabetic dataawkwardly. It has been used for applicationssuch as telephone bill paying and balance in-quiry. In those locations where tone serviceis not available, an easily acquired attachmentto the traditional dial telephone or widelyavailable dual-mode instruments allows theuser to transmit the tone codes required forcertain services. This operation requires useof either a tone generator placed over themicrophone of the handset or a type of tele-phone now available that can switch betweendial pulse and push-button tone operation.With either, the customer can make a connec-tion using conventional dialing and thenswitch to tone output to communicate with anelectronic device. If financial service providers’applications can conform with the capabilitiesof the voice telephone as a data communica-tion device, a significant portion of the Nationcould have immediate access to computer-based financial services. Marketers of suchservices have been limited in the past by thelack of capabilities of the stand-alone tele-

phone as an input/output device. If successfulmarket penetration occurs, home computersmay offer a more viable alternative for deliv-ering service.

Presently, commercial users in some areashave specialized, switched digital service. Inthe future, virtually all customers will havedigital network service available, primarilythrough the digital termination servicesplanned by operators of the switched tele-phone network. As outlined in greater detailin the next section, each digital line will havesubstantially more capacity than is now avail-able in the conventional voice circuit and willbe considerably more versatile.

Wide Area Telephone Service (WATS) is aspecialized service offered through theswitched telephone network. This serviceallows a fixed number of hours per month ofcalling for a specific geographic area. IN-WATS permits incoming calls at no charge tothe caller, and WATS, or OUT-WATS, per-mits the subscriber to originate calls using theservice. IN/OUT-WATS permits both. Finan-cial institutions and others use this service toexpand their markets geographically withoutestablishing physical presence in the targetedareas. The availability of toll-free calling en-courages the remote customer, who might beunwilling to incur a toll call charge, to contactthe institution. The service is particularly val-uable to depository institutions that face re-strictions on the geographic areas in whichthey can establish facilities.

In addition to the common voice telephone,many other types of communication devicescan be attached to the switched telephone net-work. Included are computers, simple termi-nals, and facsimile terminals. These can pro-vide for interaction with humans and/orunattended operation. However, all currentlycost more than the voice telephone. Serviceproviders must recognize this cost differentialwhen planning the deployment of a systemthat depends on the user acquiring the re-quired terminal equipment.


Private-Line TelecommunicationsFacilities

Many commercial organizations and govern-ment agencies use leased circuits for their in-ternal communication needs. Providers of fi-nancial services are among the heaviest usersof such facilities, and some operate largeglobal networks for moving funds and infor-mation.

A leased circuit guarantees access to a cir-cuit between the points that meets specifiedelectrical characteristics. This eliminates theproblems of uncertain quality and relativelyslow access* when dial-up lines are used. Whilethere is no assurance that the same physicalcircuit will be made available at all times, orthat the signals will not be multiplexed withothers between various points along the route,the quality of the line becomes invariant fromthe user’s point of view. This minimizes thevariability of one of the elements critical tooverall reliability and integrity of financialservice systems.

Institutions with sufficient need and fundscan install their own circuits; in some cases,private microwave networks have been estab-lished. Fiber optics and coaxial cables are usedfor networks confined to a limited area, suchas an office building or factory complex. Somehave leased transponders on communicationsatellites, and others have leased circuits onvideo cable systems. Financial service orga-nizations are among the heaviest users of thevideo cable that runs from midtown Manhat-tan to the Wall Street area in New York City.Aetna Insurance Co. is one of the three pri-mary partners in Satellite Business Systems,a major communication venture. New technol-ogies will increase such options. For example,the installation of teleport facilities will makesatellite communication available to a largercommunity of users and offers the opportunityto bypass local telephone facilities completely.Merrill Lynch is one of the major backers ofthe teleport installation planned for New York.

*The time required to dial a number ~d go through the log-on procedures that must be used in a dial-up environment.

Fiber optics offers greater capacity and secu-rity of transmission than do copper conduc-tors of comparable size, properties that areparticularly attractive in areas like the finan-cial district in New York, where the availablespace in conduits for wires has been almost ex-hausted.

A communication technology of growing im-portance is local area networks, which are in-stalled within an organization’s facilities toprovide a variety of communication services,including the transmission of both voice anddata. Digital, private, automated branch ex-changes are being installed to manage someof these networks. Others have been developedby manufacturers of office computer equip-ment and emphasize such features as sharingof data resources and electronic mail. * Char-acteristically, all of these networks providegateways to the switched telephone network,including the private, value-added carriers andany private networks to which the user mayhave access. The user of a local area networkwith gateways to the switched telephone net-work has access to all of the data and proc-essing resources that comprise the local net-work and, using the same terminal equipment,to other facilities that are external to it.

All of the classes of equipment that willoperate with the switched public network willalso operate with private networks.

Alternatives to Switched Networks

Because the switched telephone network,where “hard” connections are established andmaintained for the duration of a conversationbetween the parties, is not particularly wellsuited to traffic that is characterized by rela-tively short bursts of activity separated bylong periods of silence, alternative technolo-gies more suited to data traffic are used byproviders and users of financial services. POS,ATM, and home banking systems, as well asothers that use interactive computer facilities

*EIWtronic m~ is the technology Of Sending mess%es e~ec-tronically between computers. Messages are stored on the ad-dressee’s computer system to be retrieved, read, and disposedof at his/her convenience.


to deliver financial services, are characterizedby this kind of bursty traffic pattern.

One of these is packet switching, in whichmessages are broken down into small packets,each of which is routed separately through thenetwork. One property of this technology isthat the cost of communication becomes morea function of the volume of traffic handledthan the distances involved. Also, there is min-imal penalty for having a network that in-cludes a large number of points between whichonly limited traffic volumes pass. Because itis oriented to handling messages that are fairlyshort in length and are spread over consider-able periods of time, packet switching is par-ticularly suited to the type of traffic likely tobe generated by providers and users of finan-cial services. POS systems and systems fortrading securities are candidates for this tech-nology.

Multiplexing, a well-established and widelyused group of technologies that permit a com-munication circuit to be shared more or lesssimultaneously by multiple users, is also ofinterest to providers and users of financialservices. These technologies permit a single,high-capacity circuit to be used for various ap-plications, none of which could alone justifythe expense of a dedicated line. For example,if local communication costs rise, as some pre-dict, the operator of a shopping center couldestablish a connection to a financial networkor a specific financial institution that wouldpermit the merchants access to POS servicesat lower costs than if communication serviceswere paid for independently. This could bedone by connecting to a specific institution,thus eliminating choice of a financial serviceprovider for individual tenants of the shoppingcenter. On the other hand, the shopping cen-ter owner could conceivably provide access toa gateway that would permit individual mer-chants almost unconstrained freedom in se-lecting financial service providers.

Video-Related CommunicationTechnologies

Considerable attention has been given in re-cent years to using technologies built aroundsome modification of the common televisionset for distributing information, including fi-nancial services. The services offered are gen-erally built around alphanumeric displays ofinformation that fill one television screen. Thequality of graphic capabilities varies from sys-tem to system, but none presently offers anysignificant degree of animation. However, withsome systems, computer programs will betransmitted to the user’s terminal at relativelylow speed and then executed in the customer’sterminal to produce animated graphics. Oneapplication for this technique is the distribu-tion of video games; other applications arelikely to follow.

While video-based systems have been some-what accepted in Europe, they are still in theexperimental stage in the United States,where only a limited number of systems is inoperation. One of the principal drawbacks en-countered is the price of a modified televisionset or specialized terminal capable of partici-pating in the system. Three general types ex-ist: teletex, videotex, and cable television.

In teletex, frames are transmitted over theair during the blanking pulse in the televisionsignal, the period when the raster on the televi-sion returns from the lower right comer of thescreen to the upper left. Because the techniquerepeatedly transmits a limited number offrames that can be selectively captured by theterminal equipment, the capacity per channelfor offering adequate response to users is lim-ited to about 25 to 100 frames. This is essen-tially a one-way system because there is nei-ther a path over which the user can respondto the system nor a means for sending a signalto a specific receiver. Users can, however, usea telephone connection to transmit to the sys-


tern. Conceptually, an address routing mes-sage to a specific receiver could be added tothe transmitted frame, but the limited capac-ity of the channel would effectively limit suchan application. Full-frame teletex, an alterna-tive to transmitting the textual informationduring the blanking pulse, is the dedication ofa channel to a telex application. Capacity couldthen increase to about 1,500 frames per chan-nel. Application of this technique is generallylimited to dissemination of advertising andbulletin board type of information. Includedcould be price quotations, but it would not bepossible to tailor the information to the needsof a specific subscriber. Transaction initiation,except through the use of an auxiliary chan-nel such as telephone, is not possible becausethere is no direct path from the user to thesource of the information.

Videotex generally uses the telephone net-work to transmit the required information tousers, who are able to interact with the infor-mation source, selecting material from a largelibrary that is directed only to the user’s televi-sion set or personal computer display. A verylarge number of frames is available, and it ispossible to charge for each frame viewed (theuser requests specific frames). Some applica-tions, such as those related to financial serv-ices, permit the user to enter data that is thenprocessed (e.g., a mortgage amortizationschedule is produced when the user entersprincipal, term, and interest rate). Becausedata is directed only to a specific terminal, per-sonal information such as account balancescan be delivered using this technology. The ca-pacity of the telephone channel limits the de-gree of animation that can be offered, and thedata transmitted is generally confined to text,numeric tables, or fixed graphics.

The third technique, cable television, usesvideo cable, with all of the transmissioncapacity inherent in that medium. The War-ner-Amex QUBE system that has been oper-ating in Columbus, Ohio, for some time offersconsiderable capabilities for delivering text tospecific users and a low data rate return chan-nel for reacting to specific user input. It there-fore has considerable potential for delivering

financial services. This system includes pro-vision for interactive response from users toquestions posed by the program being trans-mitted. Applications include all of those possi-ble with videotex and others that can makeuse of the capacity of the television cable.Large amounts of data, such as historicalstock market information, can be transferredrapidly and loaded into a user’s computer forprocessing at a convenient time.

Future Telecommunication Technologies

Generally, telecommunication technologieswill continue to provide the means by whichfinancial and payment information is trans-mitted rapidly from point to point. In manyways, the specifics of telecommunication tech-nology are of minor interest to users and pro-viders of financial services. As long as suffi-cient capacity is available at an affordableprice, the needs of the financial service indus-try will be met.

While voice communication will continueindefinitely to dominate the traffic handled bythe common switched telephone network,transmission technology is changing. Digitaltransmission will replace the analog signalsnow used most commonly. Voice will be digi-tally encoded and will share circuits with data,video, and facsimile transmissions. This willmean that users of telecommunication serv-ices will be able to interweave voice and vari-ous forms of data on the same circuit. Systemsthat offer these capabilities to commerical cus-tomers are being marketed. For example, a fi-nancial service consultant is able to send atable of data showing the expected results ofalternative investment opportunities for dis-play on a client’s terminal in the midst of anormal conversation. Even now, terminal de-vices capable of supporting such usage pat-terns are coming on the market.

The concept of a telephone industry ISDN(Integrated Services Data Network) is emerg-ing and will reach fruition sometime before theend of the century. An ISDN is a network inwhich all traffic is represented digitally, andvarious types are freely mixed as traffic passes


from origin to destination. However, becauseof the magnitude of converting the installedplant, ISDN capabilities may not be availableto significant portions of the subscribers toswitched telephone services for some time be-yond the turn of the century. Further, whilethere is now no compelling reason for makingISDN generally available to consumers, thereis a distinct possibility that a force driving inthat direction will emerge and will hasten thedeployment of ISDN. For example, if consum-ers become heavy users of information utili-ties, their needs for transmitting and receiv-ing significant volumes of data could stimulatedevelopment and deployment of ISDN fa-cilities.

Users of telecommunication systems builtin accordance with the ISDN concept, or a lessgeneral one called “Digital Termination Serv-ice, ” that shares many concepts with it, maybe provided with a single high-capacity com-munication line. The capacity of this linewould then be allocated among various appli-cations at the user’s discretion. Some maychoose to use it for multiple voice lines, whileothers may allocate a portion to data and an-other to voice. Allocations could be changeddynamically in response to user needs. At onepoint, several people could be using the facil-ity for a number of simultaneous conversa-tions, which could include conference calls. Atanother point, a single user could use part ofthe capacity to carry on a conversation, whilethe remainder is used to access information re-sources. Using advanced software technolo-gies, the user could also interact simultane-ously with multiple information providers. Forexample, an individual may review accountbalances, along with economic statistics andhistorical data provided by independent ven-dors of information services, in formulating in-vestment decisions.

Although one could assume that the vehi-cle for implementing ISDN will be the frame-work provided by the switched telephone net-work, there is no technical reason why thisneed be the case. Most private locations, suchas homes and places of business, will be ableto have telecommunications delivered over at

least two types of networks, switched tele-phone and video cable. Either could be usedto implement ISDN-like concepts. The cabletelevision systems may enjoy some cost andbandwidth advantage over the telephone net-work. The transmission capacity of a cable ismuch greater than that of most ordinary tel-ephone circuits, and the cost of serving a sub-scriber is less.

Designers and users of financial service sys-tems will be able to choose from a variety oftelecommunication technologies in designingand accessing services. Some new telecommu-nication technologies will have greater capac-ity than the switched telephone network of to-day, but development of new techniques toextend the capacity of the present telephoneplant are evolving. For example, dial telephonelines are now routinely used to transmit at2,400 bits per second, a rate that could not berealized with acceptable error rates severalyears ago, and rates as high as 9,600 bits persecond are becoming possible. Switched tele-phone networks are expected to evolve slowlyfrom conventional copper wires to fiber opticcircuits. Fiber optics have transmission capac-ities far greater than those of the present cop-per conductors. However, as is now the case,some network segments will always be carriedby radio transmission, as exemplified by theuse of microwave and satellite facilities.

Technologies such as cellular radio and dig-ital termination services are now being offeredcommercially for the first time. These are ex-pected to come into widespread use by themid-1990’s. In addition, direct broadcast sat-ellite systems will soon become operationaland may be used in some systems for deliv-ering financial services.

There will be a diversity of telecommunica-tion networks in the coming years. Variousvendors of telecommunication services andtechnologies will try to offer systems thatmost effectively serve certain classes of users.While there is a proliferation of systems, ven-dors recognize that they will have to providefor the interoperability of communication fa-cilities. Gateways between private networks


and public transmission facilities are nowalmost mandatory. Thus, users and providersof financial services will be able to communi-cate between and among themselves with min-imal concern for the particular technologiesused in implementing financial service sys-tems. The emergence of other alternatives toconventional switched telephone servicesshould be expected over the coming 10-yearperiod. These new services will almost cer-tainly offer opportunities of value to bothusers and providers of financial services.

Now, and probably more so in the future,numbers of telecommunication options avail-able to all users, including individuals, will beavailable. Users will be able to closely alignservices procured with needs. But the full ben-

efits of the ability to choose from a range ofoptions will be realized only if the customerexpends the effort needed to evaluate the alter-natives. In all likelihood, independent devel-opment of system designs and seeking thevendor best able to meet the need will be re-quired. Not all potential users who could ben-efit from this approach will be prepared to takeit, with the result that they will probably set-tle for something much less than the bestavailable communication facility at the mostadvantageous price. To the degree that com-munication costs become relatively more sig-nificant for providers and users of financialservices, this shortfall could affect their basicability to compete in the market with othersnot carrying a similar burden.

System Security and Integrity

Security has long been an area of concernto providers and users of financial services.Traditionally, banks have been characterizedby large metal doors and imposing vaults withmassive and complex locking mechanisms. Fi-nancial service providers stress the safety ofassets in attracting customers, and customertrust is a keystone of the financial service in-dustry.

Increasing use of telecommunication and in-formation-processing technologies in conjunc-tion with financial services raises two areasof concern that relate to the basic soundnessof the financial service industry: system secu-rity and system integrity. System securitydeals with the problem of those who would at-tack the system from the outside, includingthose who work with the system but wouldattempt to invoke operations they are notauthorized to perform. System integrity ad-dresses the problems that arise with recover-ing a system without loss of data in the eventof a failure.

System Security

As demonstrated by the young people inMilwaukee in 1983, it is not difficult for in-dividuals with minimal equipment and train-ing to penetrate some computer systemswhich contain sensitive information. In theMilwaukee caper, one of the computers com-promised, using a common home computerand telephone line, belongs to a major westcoast bank. Other instances of penetration ofcomputers used by providers of financial serv-ices are on record; and some experts believethat only a relatively small portion of the secu-rity breaches that occur are detected, andfewer are reported outside of the victim orga-nization.

Historically, embezzlers from within andcheck forgers and confidence artists from with-out have threatened the financial service in-dustry. Computers, particularly those acces-sible through telecommunication networks,add new dimensions to the vulnerabilities of

Ch. 2—Present and Future Technologies Supporting the Financial Service Industry ● 37—

financial service providers. In a high-technol-ogy environment, the assets of an organiza-tion and the proprietary information on whichit bases its business operations are subject toremote-access thefts.

Attacks on financial institutions throughtheir own processing systems can directly vic-timize those institutions’ clients. A thief whorobs a bank at gunpoint steals from the insti-tution; the electronic thief can reach directlyinto the accounts of individuals. The burdenof detecting the crime, reporting it to the orga-nization holding the account, and recoveringthe lost assets could shift from the institutionto the account holder. When the thief’s bootyis information rather than financial assets, nei-ther the specific individual nor the institutionaffected may ever become aware of the factthat the system has been penetrated.

Threats to a system can materialize bothfrom within and outside the target organiza-tion. Employees throughout an organizationcan individually or in concert attempt to com-promise a system. Technical personnel canmodify operational programs or write newones to perform improper operations. Similar-ly, nontechnical personnel can seek to performoperations not authorized to them or misusepowers with which they are entrusted.

Programmers have written codes that creditthe fractional cent from an interest computa-tion to their personal accounts and fail to re-port properly the overdraft conditions in thoseaccounts. Some programs to perform unau-thorized operations destroy themselves aftercompleting their task, leaving no trace of theirexistence. A few people used computers tocreate and maintain millions of dollars worthof bogus insurance policies in the EquityFunding case, a task that would not have beenpossible without the technology.

Conceptually, it is possible for anyone to useinternational telecommunication facilities toattack financial institutions without ever com-ing within the jurisdiction of American law en-forcement officials, much less being in closephysical proximity to the institutions they areattacking. With relative impunity, individuals

or organizations could launch their attacksfrom any telephone, including those in motelrooms and pay stations, from which they couldoperate undisturbed for brief periods. At leastone computer now on the market fits nicelyinto a large purse and can be used to initiatean attack on a financial institution from anylocation where a standard modular telephoneconnector can be found. Some devices can beset up to operate unattended, and then re-trieved.

Not all attacks on financial service systemsmust be so sophisticated. Individual consum-ers of financial services and various user or-ganizations have demonstrated a marked yetunwitting ability to aid the thieves who wouldvictimize them. Personal identification num-bers (PINs), given to account holders to usein depositing and withdrawing money fromATMs, are written on access cards. Telephonenumbers and key access codes are written oncommunication terminals and bulletin boardsin clear view of those unauthorized to havethem. In one instance, an enthusiastic user ofan ATM demonstrated the use of the machineto a complete stranger and, in the process, re-vealed his PIN to all within 20 feet. A vari-ety of comparatively simple scams, that rangefrom asking individuals for PINs and the useof their cards to retrieving used carbons show-ing account numbers from the trash cans oforganizations that accept cards in payment ofaccounts, have been used to compromise finan-cial service systems.

Computer-to-computer communication isnow used to initiate and execute a substantialnumber of financial transactions, a practicethat will become more widespread in the fu-ture. Therefore, the problem of authenticatingthe “signature” of a computer that partici-pates in financial transactions in order to au-thenticate the transactions will become as crit-ical as that of establishing the identity ofhuman users. Although under study, no suchtechnique has emerged that shows promise forwide adoption by the financial service indus-try. Finding a solution that will be acceptablefor use by individual consumers and others notsophisticated in the design and operation of

38 ● Effects of /formation Technology on Financial Services Systems—

advanced technological systems constitutesthe most difficult subset of problems in thisarea.

Providers of financial services, aware of thethreats to their systems, are taking steps totighten security. Various devices and tech-niques exist for minimizing the vulnerabilityof computers and communication networksused to deliver financial services. The use ofdata encryption techniques is growing, and asystem in which the PIN is never accessiblein clear text to any human is available and inuse by many financial institutions. Physicalsecurity around computer facilities is the focusof considerable attention, and research de-signed to overcome the known weaknesses ofthe PIN as an access code is continuing.Nevertheless, human ingenuity and fallibilitywill probably counteract attempts to providefoolproof security for computer systems.

System Integrity

All systems, whether manual or automated,will at some time fail in the sense that opera-

tions will be interrupted for a period of time.Such interruptions may be the result of attackby an outsider, natural calamity such as anearthquake, or the inadvertent error of an au-thorized user of the system. Thus, systemsmust be built so that they can be restored tofull operation without loss of data or transac-tions in process at the time of failure. This isa particularly important factor in deliveringfinancial services because lack of system in-tegrity could result in a situation where thelevel of confidence so essential to the viabilityof such systems is degraded.

The problem of providing for system integ-rity is largely a technical one. Increasing useof telecommunications adds new dimensionsto the problem, but a number of well-acceptedpractices aimed at ensuring system integrityexist. It remains for the operators of financialservice systems to ensure that those practicesare followed during the design, implementa-tion, and operational phases of the systemlifecycle.

Specific Technologies for Delivering Financial Services

Applications of general-purpose informationprocessing and telecommunication technolo-gies specific to the needs of the financial serv-ice industry have been developed. Included aretechnologies for accessing systems and han-dling items such as cash and checks that areunique to the financial service industry.

Card Technologies

Embossed/Magnetic Stripe Card

The embossed plastic card with a strip ofmagnetic tape embedded in the back has be-come almost ubiquitous. This device providesthe primary means for accessing credit anddebit services that are delivered through bothpaper-based and electronic systems. Common-ly, the card is presented at the point of sale,and an impression is taken on a paper docu-

ment that is then processed. Most often, theconsumer is making use of a credit service andis billed by the credit provider. Today, em-bossed plastic cards are also used to originatedebit transactions that are processed over thesame network as credit transactions.

Generally, the data are recorded on the mag-netic stripe on the card by the card issuerbefore it is sent to the account holder and theyare not changed during the life of the card.This striped card has room for about 1,000 bitsof data. Allowing for the information thatmust originally be recorded on the card, thereis just not enough room to record transactiondata. Technologically, however, there is no rea-son why data on the stripe could not be alteredafter issuance. On the other hand, the limitedcapacity of the stripe and the cost of deploy-ing sufficient terminals with the capability of


recording data on the stripe makes this devicegenerally unsuitable for applications thatwould require changing the data repeatedly.Also, the stripe is easily readable, eliminatingthe possibility of building security into thecard.

However, the same basic technology is usedin the Washington, D. C., subway farecard sys-tem. When a farecard is purchased, theamount is recorded by the machine dispens-ing the card. Each time it is used, the startingpoint of the trip is recorded, and when thepassenger exits the subway system, theamount of the fare is computed and deductedfrom the balance on the card. In this system,the magnetic stripe is mounted on a paperbacking, and the card is generally disposed ofafter only a few cycles, a lifetime that wouldnot be suitable for a card that is to be usedrepeatedly over an extended period.

Data on magnetic stripes are read by ATMsand special terminals used by some merchantsat the point of sale. Merchant terminals pri-marily facilitate the process of obtaining atransaction authorization from the card issuerby eliminating the requirement for either theclerk in the store or an authorization clerk atthe issuer’s facility to key in the account num-ber. Some merchant terminals also print thenecessary information on the paper document,further reducing clerical workload.

Among the problems with the embossed/magnetic stripe card is that it is relatively easyto copy or counterfeit. Several technologieshave been developed to overcome this prob-lem. Data can be recorded in the laser card byburning pits in a reflective material that canbe sensed by an appropriate reader. Once re-corded, the data can be neither altered norerased. Holography is being used on some cardblanks to create a background image that isvery difficult to reproduce.

Laser Card

The laser card, or memory card, is just mak-ing its debut. At this date the laser card is notused by the financial service industry; how-

ever, its potential use is likely. As describedby S. Berton Latamore:

The card can store digital data signifyingthe bearer’s fingerprint, voiceprint, or eventhe pattern made by capillaries in theretina. A stand-alone card-reading machine,equipped with a microprocessor, would checkwhether this biological data on the cardmatched that of the card-holder. The card isbeing developed by Drexler Technology ofMountain View, Calif. The company’s Drex-on card stores 1.2 megabits, or roughly30,000 words–nearly 1,000 times more thana magnetic stripe card.

The Drexler cards are coated with a two-layer plastic film. The top layer is embeddedwith microscopic pieces of silver, giving thematerial a highly reflective, metallic look. Towrite data, a low-power laser melts pits in thetop layer to expose the unsilvered—and un-reflective-bottom layer. To read the card, alaser scans the surface, and a photodetectorsenses the presence and absence of pits ashighs and lows in the intensity of the re-flected light.2

Unlike the magnetic stripe, the laser mate-rial cannot be erased and rewritten; pits arephysical holes that cannot be refilled.

Electron Card*

Electron cards, first distributed in early fallof 1983 by VISA, U. S. A., combine three en-coding technologies on the back of the plasticcard-the banking industry’s magnetic stripe,the retail industry’s optical character recogni-tion, and the universal product code barcode.** The card, which is not embossed andcannot imprint paper forms, is an attempt toembrace both the banking and retail environ-ment with a move toward a more secure elec-tronic environment than presently exists. Thecard will feature a direct debit option but will

‘J. Berton Latamore, “Putting Intelligence in Your Market, ”Iljgh l“eclmology, published by High Technology PublishingCorp., June 1983, p. 16.

*“Electron f’ card is a trade name for a VISA card.**Optic~ ch~ac~r recognition (OCR): the process of reading .

a stylized type face with an optical sensor. Universal productcode (UPC): a bar code now imprinted on many items that isread by a suitably equipped terminal.

35-595 0 - 84 - 4 : QL 3


also have the capabilities of a credit card. Itpresently replaces proprietary ATM accesscards. A full-scale POS project is expected toget under way in mid-1984. The card will mi-grate to full-service use at points of sale.

Use of the electron card is intended to re-duce the number of paper checks, resulting inlower processing costs, less fraud, and fasterservice at the point of sale. Cardholders willhave electronic access to cash through a globalnetwork of ATMs and to goods, services, andcash at many locations. Authorization will beprovided electronically at the time and pointof each transaction and will be fully controlledby the card issuer.

The processor card, or “smart card, ” devel-oped in France, contains a tiny embedded com-puter chip with about 1,000 times the storageof the conventional magnetic stripe. However,once data are recorded in the memory, theycannot be simply altered, and their memorycells cannot be directly reused. The smart cardcontains processing capabilities that enhanceits security and flexibility. A standard for itsformat has recently been adopted, eliminatingsome of the uncertainty that may have beenlimiting its adoption. The user plugs the cardinto a terminal that then queries the cardmemory as part of the processing to validatethe transaction. Once authorized, the transac-tion data can be recorded in the card’s mem-ory for later retrieval. With present technol-ogy, the card costs in the range of $5 to $10and is good for approximately 200 transac-tions before its memory is full.

Even though Carte Bleu, a group memberof VISA International, France, has begun

Photo credit: High Technology, June 1983

The French smart card contains a microprocessorcapable of interchanging information with another

computer

placing chips in all its VISA cards, the futureof the smart card is uncertain. Some suggestthat it represents the wave of the future, whileothers see it as a technology in search of anapplication. If it is to come into widespreaduse, merchant terminals will have to be gen-erally available. Development of a card withreusable memory could also enhance the util-ity of the concept.

In its current form, the smart card is a mod-ification of the conventional plastic card it isintended to replace. It contains a microproc-essor chip, but because it includes neither akeyboard nor display, it can be used only witha terminal device that provides power and theappropriate input/output capabilities.

However, there is no reason why a smartcard that includes a keyboard and displaycould not be built. Calculators that are nolarger than the card are available with suchfeatures; and an interface to a merchant or fi-nancial institution termina1 could be provided.Such a card could include in its functions theability to determine the balance remaining andto review the transactions for which it hasbeen used. Multifunction cards that containmore than one processor could also be built.

The smart card could evolve as an alterna-tive to cash following the general model of thefare card used by some subway systems, in-cluding that in Washington, D.C. The usercould “charge’ the card with funds from a de-pository account and the funds would be dec-remented for the amount due each time it isused. Terminals for recording value in the cardcould even be located at home, giving the con-sumer the ability to obtain the equivalent ofcash. Card readers could be provided at eachcash register or POS terminal to allow a con-sumer to verify the card’s balance. Hard cur-rency dispensers, rather like the commonchange machine, could allow the smart cardto serve as the equivalent of a large-denomi-nation bill.

In the future, applications of card technol-ogy will become more widespread. Already,there are telephones which accept magneticstripe cards and other vending machines may


A newly designed pay telephone produced by Flonic-Schlumberger in Paris accepts smart cards. It is being

deployed by the French Government’sTelecommunications Administration

be designed to accept them also. As the facil-ites for online transaction authorization anddirect debit of accounts from point of sale aredeployed more widely, the utility of card tech-nology will increase. In the long run, however,the plastic card could be displaced if a secure,practical means of user identification that de-pends on the physical characteristics of the in-dividual could be developed as an alternative.Signature dynamics, fingerprint readers, andsensors that process the pattern of blood ves-sels in the retina of the eye are technologiesthat show some promise. It remains to be seenwhich, if any, will ever be operational.

However, all of the security features thatcould be implemented have flaws. For exam-ple, if an intruder can capture the digitalrepresentation of a fingerprint before it isencoded and inject it into a system being at-tacked, the user’s “key” will have been com-promised. When this happens with a conven-tional PIN, a replacement code is issued and

the old one invalidated. The question that fol-lows the compromise of a fingerprint or a ret-inal pattern is: “What replacement code is tobe issued?” On the other hand, if the datastream associated with a system that uses thesignature dynamic is compromised, a possiblereplacement could be some alternative phrasewith which the user identifies himself.

Document and Currency Readers

The cost of processing billions of paperitems is becoming prohibitive for an industrylosing some of its principal sources of revenue,and the pressure to find lower cost process-ing alternatives is intense. Reading of checksencoded with magnetic ink has been common-place for over a decade, and credit card vouch-ers are generally transferred to magnetic tapefor processing. However, aside from some lim-ited applications such as making change, fi-nancial document readers are in very limiteduse in the United States.

One of the major suppliers of ATMs has an-nounced a model that will accept and time-stamp individual checks. It will also be ableto dispense currency and coin in any amount.Models that accept and count Japanese cur-rency are already in use. Thus, the technologyto provide deposit verification by the ATM is

Photo credit Burroughs Corp

Reader/sorter processes checks and other documentsat the rate of 1,625 per minute

42 • Effects of Information Technology on Financial Services Systems

just over the horizon and is likely to increasethe utility of these machines substantially.

Systems that process credit and debit cardtransactions already truncate the paper flowat the earliest practical time. Instead of mov-ing paper, the data are recorded on magneticmedia and transferred electronically for proc-essing by the card issuer. Documents arecoded so that they can be retrieved if neces-sary. Moreover, credit unions and savings andloan associations generally do not returndrafts on NOW accounts to the account hold-er, also truncating paper flow. However, withrelatively few exceptions, commercial banksstill return canceled checks with monthlystatements; and attempts to stop this prac-tice at least for individual accounts have metwith considerable resistance.

In the long term, however, banks and otherdepository institutions will develop and deploysystems in which checks are truncated or ter-minated at the bank of first deposit. Issuerswill be provided the means for retrieving eitherthe original or an acceptable photocopy ifneeded. The issues standing in the way of sucha change are related more to legal and mar-ket problems than to lack of suitable technol-ogies. For example, who in such a system

Photo credit Burroughs Corp

Document encoder used to record data on checks in amachine-readable format

would be responsible if a forged check wereprocessed against an account? Consumers useand hold canceled checks in lieu of receipts,especially for tax purposes. What alternativeswould be acceptable to the Internal RevenueService?

Customer Service Equipment

Cash dispensers were the first terminalsmade available for customer use by financialinstitutions. These were followed by the mul-tifunction ATMs now in widespread use thatare capable of initiating bill payments, trans-fers between accounts, and other types oftransactions, in addition to accepting depos-

Photo credit: Diebold Corp

Inner workings of an automated teller machine

Ch. 2—Present and Future Technologies Supporting the Financial Service industry ● 4 3

its and dispensing cash. The functional capa-bilities of these machines are continuing to in-crease and they are becoming capable ofhandling increasingly diverse kinds of transac-tions. Counter to this trend, however, some in-stitutions are making available specializedmachines to perform balance inquiries and aresupplementing full-service ATMs with cashdispensers so that customers requiring onlycash will not have to wait behind those withmore complex transactions.

There may be a movement to customer serv-ice machines that have a wide range of capa-bilities. Some may be of limited purpose, forsuch applications as cash dispensing and bal-ance inquiry. Others may have the capabilitiesof the ATMs of today: accepting deposits,moving money between accounts, paying bills,and dispensing cash. Still others may be usedfor time-consuming but infrequent transac-tions, such as the filing of a loan applicationor ordering securities transactions.

In the future, a number of “customer workstations” could be available in a lobby area.These could be configured so that the custom-er could sit at a desk and accomplish a num-ber of tasks, including making a deposit orwithdrawing funds. Then, when the bulk of thework is finished, the customer could go to adevice supporting many terminals that ac-cepts the deposit or another that would dis-pense cash. Express terminals for customerswith limited needs could also be provided.

Bank branches without human tellers areoperating, and some institutions are shrink-ing their networks of full-service branches.Some of these automated branches provideonly telephone communication for the cus-tomer in need of assistance. Others aremanned by a customer representative who isavailable to answer questions and marketservices, but who performs none of the tellerfunctions, such as accepting deposits or pay-ing withdrawals.

Technology and the Structure of theFinancial Services Industry

One of the impacts of present and futuretechnologies on systems for delivering finan-cial services is that there is a real possibilityof redistribution of function between andamong traditional suppliers and potential newentrants. Whereas the payment system hasbeen reserved largely by the banks, becauseonly they have access to facilities for clearingand settlement, movement of funds electron-ically makes it possible to avoid the traditionalpayment system and to effect net settlementdirectly between members of a communitythat have agreed to the necessary implement-ing conventions. Alternative means of distrib-uting information could diminish the role ofbrokers for such varied products as securities,real estate, and insurance. Telecommunicationsystems that are capable of message switch-ing are implicitly capable of performing the in-terchange function for payment networks.Retailers and other cash-oriented businesses,

such as gas stations, are motivated by lossesfrom bad checks and card fraud to take stepsthat minimize their exposure. For example, anATM in a supermarket has the potential forrelieving the requirement to cash checks whileminimizing the amount of currency and cointhat is held at each store location and subjectto theft.

On the other hand, what is technologicallyfeasible may be neither possible nor desirable.Consumers may balk at accepting new serv-ice delivery mechanisms. Legal/regulatory con-straints may limit options, and the potentialproviders of the services may opt not to im-plement them for any of a variety of reasons.Further, changes in the technologies modifythe parameters that bound system design al-ternatives. Those that are attractive now maybecome undesirable in the future, while newalternatives not now feasible may emerge.


Appendix 2A: Hardware Components

Chip Technology

The fundamental building block for informationprocessing and telecommunication is the siliconchip. Many thousands of electronic components,constituting an infinite variety of electronic cir-cuits, can be fabricated with these chips. The new-est computers have memory chips capable of stor-ing 64,000 bits of information; chips capable ofstoring 256,000 bits of data are now emerging.Chips with 1 million electronic components are inthe laboratory stage of development.

Processor chips used in today’s large microcom-puters tend to include only the functions neededfor performing the required logical and arithmeticoperations. Memory for data storage and circuitryto facilitate the movement of data between theprocessor and various peripheral devices such asdisc drives and telephone communication linksusually require additional chips mounted on thesame printed circuit board as the processor. Asingle chip which includes the processor, memory,and other supporting circuits, is in widespread usefor many appliances and devices. But most of thehome computers and larger units separate thisfunctionality into several separate chips.

Silicon chips in use today tend to be less thanone-quarter inch on each side. Dr. Gene Amdahlhas suggested that it maybe possible to fabricateeconomically chips that are several inches on aside. If so, performance-to-cost ratios for electronicequipment could rise significantly because thelarger size would limit the need for physical inter-connection between chips which is one of the ma-jor costs of fabrication. One of the major factorsreducing the cost of consumer products, such ashome computers and video games, has been thedecrease in the number of chips required in thesedevices as it has become possible to pack more andmore onto a single chip. Also, because the speedof an electronic circuit is limited by the distancebetween its components, the ability to manufac-ture very large chips could translate into signifi-cant increases in processing speeds for the devicesthat use them.

Computer Systems

A computer system consists of a number of sub-assemblies that are collected in much the samemanner as a component high fidelity system. It

includes a central processor, high-speed randomaccess memory to which data and programs aremoved when they are active on the system, andperipheral storage devices, such as disc and tapedrives that store data and programs not immedi-ately needed by ongoing processing operations.Additional components, depending on the systemconfiguration, might be printers, card readers, anddevices specifically designed to handle the telecom-munication function.

The heart of any computer system is its centralprocessor. It is the subsystem that performs theinstructional program written to support a specificapplication. Processors can be fabricated on asingle chip or may require several cabinets of com-ponents. For any type, the key to increasing speedand minimizing costs of fabrication and operationis to minimize the physical dimensions of the proc-essor and the number of discrete components re-quired.

Most modern systems use more than one proc-essor. In a small desktop computer, for example,one processor on a chip may perform the primarywork of a machine while other processors performsupporting roles, such as generating the charac-ters on the screen of the terminal through whichthe user communicates with the system. Largesystems may use networks of processors to per-form the variety of functions required of a ma-chine. Small systems are capable of tens of thou-sands of operations per second, and some largercommercial systems can perform millions of oper-ations per second. Computer systems capable ofbillions of operations per second are just over thehorizon.

The central memory of a computer contains theprogram instructions and data that comprise theelements of an application system when it is ac-tive. A small desktop computer may have storagefor as few as 1,000 characters of information, whilelarge systems used by providers of financial serv-ices may have main memory capacity measuredin tens of millions of characters. More commonly,desktop computers with main memory capacitiesranging from 48,000 to 256,000 characters areused for financial service applications both by in-dividual users and providers of financial services.Even though some financial service applicationscan run on computers with as little as 16,000 char-acters of main memory, computers with memoriesmuch smaller than 48,000 characters tend to be

Ch. 2—Present and Future

too small to conveniently hold the programs anddata required for serious financial services applica-tions. Larger systems used by providers of finan-cial services include main memories that com-monly range in capacity from 1 million to 8 millioncharacters.

Disc drives, another system component, havelarge capacities relative to the main, random ac-cess memory of a computer and permit processorsto access individual records in a fraction of a sec-

Appendix 2B: Systems

Present Operating andSupport Systems

The sophistication of systems and support soft-ware generally varies directly with the capabilitiesof the computer on which it is to be used. Largemainframe computers are supported by compre-hensive software packages that provide extensivecapabilities to those capable of using them. Thisis to be expected because the larger computer canbe utilized effectively only if most of its operationsare controlled automatically. At the other extreme,software for microcomputers is much more rudi-mentary in its scope of functions. The user of amicrocomputer is in direct control of virtually alloperations, and the services of a complex operat-ing system would be of only limited benefit. How-ever, operating systems even for the smallest com-puters are expanding in terms of the capabilitiesoffered.

Twenty years ago, systems software and somesupport software were furnished free to users bythe manufacturers of computer equipment. How-ever, unbundling of software and hardware hasbeen common industry practice for a number ofyears, and today’s user pays for each of the sys-tem and software support modules used. Operat-ing system and support software is expensive bothin terms of the direct cost and overhead imposed.These software packages can soak up a consider-able portion of available computer resources. Thus,a small system with support facilities limited toa single application may, in some cases, be moreeffective than a large machine burdened with largeamounts of overhead. One manufacturer, in fact,had to expand significantly the available memoryon one of its larger models to accommodate theburden of operating system and support software.

Technologies Supporting the Financial Service Industry ● 4 5

end. For example, the interchangeable floppy discsused with a computer having 48,000 or so char-acters of main memory will have a capacity of100,000 to over 1 million characters. Hard, nonin-terchangeable discs used with such systems canhave a capacity of 5 million to 40 million charac-ters. Discs used with large-scale computers havecapacities of hundreds of millions of characters,and many can be attached to each system.

and

Data

Support Software

Base Management Software

Data base management systems constitute aspecialized software technology of particular im-portance to providers and users of financial serv-ices. This software facilitates the tasks of organiz-ing and accessing large quantities of data whererelationships between the various elements com-prising a data base are complex and where diversecommunities of users access various subsets ofthe data base. By permitting the sharing of datathroughout an organization, the costs of data col-lection, maintenance, and dissemination are con-trolled, and all users are able to base their deci-sions on a common body of information.

Data base technology insulates data bases fromthe application programs that access them and cansignificantly improve system integrity and secu-rity. Depending on the data base system, users canbe limited to accessing only specific data elements,and further, the operations permitted them can becontrolled by the data base administrator. Audittrails that record the identity of all who accessdata and the operations performed can be gener-ated. For example, some users may be permittedonly to retrieve data, while others may both re-trieve and change a specific set of data elements.Permission to add new elements to a data base canbe denied both of these groups and given, instead,to other units within the organization.

On the other hand, data base management sys-tems “put all of the eggs in one basket” in thatmuch of the data critical to an organization is con-centrated in only a few data bases. Compromiseof a data base management system can lead to sig-nificant damage to the organization that is af-fected. In such an environment, the organizationcan become vulnerable if management does not

46 . Effects of /formation Technology on Financ ia l Serv ices Systems

fully use those data base management system fea-tures which are designed to ensure system secu-rity and integrity. Although there is no such thingas perfect security for any system, data base man-agement technology can allow a higher degree ofsystem security and integrity than possible whencollections of individual files are used by each ap-plication system.

Software Development Tools

The rate of productivity increase for applicationprogrammers in the past has been small relativeto the rate of increase in the performance-to-costratios of computer hardware. However, a newgroup of tools is becoming available to help alle-viate this problem. Data base management tech-nology discussed in the previous section is onesuch tool. In addition, there are interactive, ter-minal-oriented systems that support applicationprogrammers by minimizing the steps they haveto execute to write and test new programs andmodify existing ones. Management techniquesthat emphasize modularity in design and make ex-tensive use of procedures for controlling systemsconfiguration have also proved beneficial.

In addition, advanced languages have made iteasier for programmers to develop the requiredcomputer codes. Procedure-oriented languagespermit the end-user to interact directly with gen-eralized systems and minimize the need for ap-plication programmers to develop applications cus-tomized to the needs of each user.

Perhaps the major breakthrough has been inprogrammerless application generators. For exam-ple, general-purpose spreadsheets, such as Lotus1, 2, 3 and VisiOn, allow nonprogrammers to de-velop complex models and display their resultsgraphically.

The Future for Operating andSupport Systemsl

Support functions such as telecommunication,data management, allocation of hardware re-sources, and job scheduling will be performed byhighly modular support software. More functionsnow performed by the operating system will beperformed in hardware. New emphasis will be plac-ed on the security features and the user will com-

I Most of the concepts relating to the future of system and supportsoftware are drawn from, Future Information Processing Technology,1983, prepared jointly for the Institute for Computer Sciences and Tech-nology and the Defense Intelligence Agency.

municate with the operating system throughhigher level commands.

Users will be able to select capabilities that aretailored to their needs and pay only for those. Gen-erally, ease of use will increase and users will notbe required to learn separate ways for dealing withvarious classes of applications. For example, allterminals will be able to communicate will all ap-plications because the required protocol conver-sions will be performed automatically. It will bepossible for major systems to operate in multiplesites as a single entity because access to and allo-cation of resources will be controlled by the sys-tem and support software. Worldwide distributednetworks will be feasible by the mid-1990’s. Theability to distribute functions among multiple co-operating processors will serve to increase systemreliability and integrity. In addition, the varioussupport packages will develop so that they havegreat facility to recognize and recover from errorsand will be able to notify the appropriate user oftransactions that could not be successfully proc-essed because of either a hardware or software er-ror. A key feature of operating system and sup-port software will be its ability to diagnose systemproblems and dynamically reallocate system com-ponents. User installations will have to expendminimal effort to support software packages.

One manufacturer of microcomputers is alreadymarketing an operating system that provides theuser with the facility of moving easily from oneapplication to another without the need of expli-citly terminating one and initiating a second. Asadditional applications are added to the repertoire,they can be integrated with operating system sothat the user is faced with a single, integrated en-tity rather than a number of disjoint applications.Integrated, multifunction software packages formicrocomputers are well established in the mar-ket; and although they do not constitute operat-ing systems, they offer some of the features onewould expect to find in an operating system.

This trend toward easing the burden of detail onthe end-user of computer systems is expected tobe a major theme in the development of systemand supporting software into the indefinite future.At some point, the user will no longer have to rec-ognize the existence of a discrete operating sys-tem and will be able to focus all attention on theapplications that are being used.

Many of the features of the operating systemsfor large computers are already becoming availablefor microcomputers. Some of the software devel-opment tools that are now available on large com-

Ch. 2—Present and Future Technologies Supporting the Financial Service Industry • 47—

puters are being implemented on small ones. Onemanufacturer has added to its product line a mi-crocomputer that will run a variant of the virtualmemory operating system used on its large sys-tems. Networks of small computers will becomethe functional equivalents of large central systemsin many operating environments. The emergenceof such capabilities is foreshadowed by some of theoffice systems that are already being deployed bysome manufacturers.

By the mid-1990’s, large computers may func-tion largely as repositories of data and supportonly the largest processing systems. Small com-puters directly controlled by end-users will per-form most of the processing functions and reportgeneration that will be required. Some installa-tions are already approaching this state.

Tools for system development and maintenancewill be of growing importance over the coming dec-

ade. As more generalized functions are moved intothe hardware, the operating system and supportsoftware, the tasks required of applications pro-grammers will be simplified and, hence, less costlyto accomplish. A key element in realizing the ben-efit of this technology will be the ability of man-agement and technicians to understand its capa-bilities and apply it intelligently in supportingapplications systems.

The same system development and maintenancetools that will benefit professional technicians willalso help end-users interact directly with computerand communication systems without the need forintermediation by members of technical staffs. Thesupport functions will complement the generalized,user-oriented application systems that will beavailable; and, together, they will provide the end-user with a powerful package of tools for apply-ing the technologies that will be at his disposal.

Chapter 3

The Securities Industry

Contents

PageStructure of the Securities Industry . . . . . . . . . . . . . . . . . . . . ... , . . . . . . . . 51

The Development of the Securities Industry in the United States . . . . . . 51Organizations Composing the Securities Industry . . . . . . . . . . . . . . . . . . . 52Industry Users.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57The Regulatory Structure of the Securities Industry . . . . . . . . . . . . . . . . . 59Characteristics of the Securities Industry . . . . . . . . . . . . . . . . . . . . . . . . . . 62New Entrants to the Securities Industry. . . . . . . . . . . . . . . . . . . . . . . . . . . 63The Securities Industry and the International Market . . . . . . . . . . . . . . . 64The Effects of Information Technology on the Structure of the

Securities Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64

The Functions of the Securities Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64The Securities Industry as an Advisor.. . . . . . . . . . . . . . . . . . . . . . . . . . . . 65Acceptance of Risk by the Securities Industry . . . . . . . . . . . . . . . . . . . . . . 67Marketing by the Securities Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69Technology and the Functions of the Securities Industry . . . . . . . . . . . . 75

The Effects of Information Technology insecurities Instruments . . . . . . . 75

Appendix 3A: Securities Instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76Corporate Capital Structure: Debt and Equity Issues . . . . . . . . . . . . . . . . 76Short-Term Debt–Money Market Securities.. . . . . . . . . . . . . . . . . . . . . . . 83Options and Futures Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84

Appendix 3B: Capital Formation and the Functions of theSecurities Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91

Private Sources of Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92Venture Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92Public Offerings of Securities of a Corporation . . . . . . . . . . . . . . . . . . . . . . 93

Tables

Table No. Page2. Contracts Traded-Futures Exchanges: A Comparison of

1983 and 1982 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 563A-1. Meet Active Venture Capitalists, 1982 . . . . . . . . . . . . . . . . . . . . . . . . . 93

Figures

Figure No. Page3. Average Daily Share Volume New York Stock Exchange

1963 to 1983 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 544. Volume of Futures Trading, 1958-83 (millions of contracts traded) . . . . . 585. Overview of SIAC Facility Management for NSCC Services . . . . . . . . . . 74

Chapter 3

The Securities Industry

The securities industry in the United States,which developed to help young American busi-ness gain financing from European investors,continues to bring together those who needcapital and those wishing to invest. The indus-try directs its concentrated expertise on finan-cial markets toward its intermediary role offacilitating the development of capital. It pro-vides advice, accepts risk, and offers market-ing services to ensure that an orderly marketfor the issuing and trading of securities* ismaintained.

XFO~ PUW{)=S of this study, securities include debt and equityissues used to develop capital (stocks and bonds, money-marketsecurities, and instruments which have been developed to allowhedging and speculation in securities and commoditymarket s—i. e., options and futures contracts). These instru-ments, as well as investment tools which developed from thepackaging of securities instruments, such as mutual funds andcentral asset accounts, are described in app. 3A.

Since the introduction of the telegraph 140years ago, communications technologies havebeen used by the industry to convey informa-tion on which the operations of securities in-dustry depend. However, while the securitiesindustry has always applied state-of-the-arttechnology to its operations, the level of tech-nology used today and likely to be availabletomorrow is beyond what could have beendreamed of when the telegraph was applied in1844.

In this chapter, the structure, functions, andinstruments of the securities industry are de-scribed. The impact that the application ofcomputer and communications technologieshas had in these areas is reviewedble future effects are discussed.

Structure of the Securities Industry

The structure of the securities industry hasbeen shaped by the demands of users, nationalpolicy objectives regarding the financial serv-ice industry, practical operational concerns,and competitive market forces. In this section,a brief overview of the development of the cur-rent structure of the securities industry anda description of the organizations and compet-itive forces comprising the industry will beprovided. Present and future effects of infor-mation technology on the structure of the in-dustry will be discussed.

The Development of the SecuritiesIndustry in the United States

The securities industry in the United Statesdeveloped to meet the capital demands of thenew Nation. One side effect of the independ-ence won in the Revolutionary War was wardebt. This was funded by the issuance of in-terest-paying bonds, for which a secondary

market shortly developed.1 At the

and possi-

same timethe need to finance development in the newNation was recognized. The burgeoning secu-rities industry provided a vital link to Euro-pean capital markets and also a means oftransferring capital within the United States.The basic role filled by the securities indus-try in the late 1700’s is still a driving forcebehind its operations today: to provide a meansof interaction for those seeking capital andthose wishing to invest.

Two factors which quickly emerged as essen-tial to the operation of the securities industrywere the maintenance of an orderly marketand the availability of trading information.Twenty-four brokers, conducting trading undera buttonwood tree, subscribed to a brokers’agreement that formed the first stock market

IMarketpIace-A Brief History of the New York Stock Ex-change (New York: New York Stock Exchange, Inc., 1982).

51


in New York on May 17, 1792.2 This marketbecame the New York Stock Exchange. Inwhat is now known as the “ButtonwoodAgreement, ” the brokers focused on workingtogether to assure they would be able to tradesecurities smoothly and fairly.

Information on trading and prices has al-ways been essential to trading decisions. Se-curities firms and exchanges clustered (as onWall Street) to facilitate the communicationsneeded for the operation of the market. Anewspaper first published stock prices in 1815.Prior to the introduction of the industry’s firsttechnology-based information system, theelectric stock ticker (in 1867), messengersliterally ran from the trading floor to brokers’offices with information.

Early refinement and expansion of securitiestrading can be related to three communica-tions technologies: the telegraph, the trans-atlantic cable, and the telephone.3 These tech-nologies improved information flows on whichthe markets are dependent. The telegraphlinked exchanges, brokers, and investorsthroughout the country and made decision-making on investments by someone not onWall Street practical for the first time. Thistechnology offered the first hope of a national,noncentralized market. The transatlanticcable, completed in 1866, made an interna-tional market feasible at a time when Ameri-can industry was still very much dependenton financing from European investors. Tele-phones were first used to convey orders frombrokers to the floor of the New York Stock Ex-change in 1878, 2 years after the first suc-cessful test of that technology.

The adoption of these communications tech-nologies and the stock ticker were based onthe recognition that the faster and more ac-curately information flows, the better securi-ties markets function. The introduction of newtechnologies today is largely based on thisassumption.

Organizations Composing theSecurities Industry

Three types of organizations traditionallycompose the securities industry: investmentbanks perform the services surrounding a pub-lic offering of the stocks and bonds of a cor-poration; brokers manage the buying and sell-ing of securities; and exchanges provide avehicle for setting prices and actually conduct-ing transactions.

Investment Banks

The activities of investment banks are cen-tered on the development of capital. The Bank-ing Act of 1933, commonly called “Glass-Stea-gall, ” required that investment banking beseparated from commercial banking becauseof the sometimes incongruent objectives andthe different levels of risk associated withthese kinds of organizations. Investmentbanks fall into two categories: originatingfirms and distribution firms. Originating firmsdeveloped largely as intermediaries betweenEuropean financiers and young American in-dustry, and they remain major players in thedevelopment of securities offerings. Distribu-tion firms come together in syndication, underthe guidance of an originating firm, to guar-antee and sell the securities of an issuer.4

The four leading investment banks in bothdomestic and foreign financing are SalomonBrothers, Inc.; Morgan Stanley Inc.; FirstBoston Inc.; and Goldman Sachs & Co. Mer-rill Lynch, Pierce, Fenner, & Smith Inc. (Mer-rill Lynch) and Paine, Webber, Jackson, &Curtis (Paine Webber) have a significant shareof the domestic market. Three levels of pur-chasers and sellers are reached through invest-ment bank activities: first, the issuers of secu-rities, those corporations and governmentsthat purchase investment bank services; sec-ond, the investors in new issues; and third, theintermediaries who bring these two partiestogether—other investment bankers, distri-

‘New York Stock Exchange 1983 Fact Book (New York: NewYork Stock Exchange, June 1983), p. 66.

‘Marketplace-A Bn”ef History of the New York Stock Ex-change, op. cit.

4Sarnuel L. Hayes III, “The Transformation of InvestmentBanking, ” Harvard Busines 12ew”ew, January-February 1979,pp. 153-170.

—

Ch. 3—The Securities Industry ● 5 3

buting underwriters, and commercial banks.Investment banks assume the risk of a pub-lic offering of investments by guaranteeingtheir purchase—i.e., underwriting them.

The nature of competition within invest-ment banking is changing. Price competitionis cutting fees for underwriting to new lows.In addition, simplification of securities regis-tration requirements could make underwritersunnecessary. Nevertheless, the need to trans-fer risk continues to provide a strong incen-tive for utilizing the services of investmentbanks.

Brokerage Houses

Full-service brokerage houses perform tradesin securities and commodities and provide fi-nancial counseling services supported by in-depth research and analysis of markets andindustries. This segment of the industry isdominated by firms which are subsidiaries ofcompanies that offer a range of financial man-agement services. Six national brokeragehouses lead the industry. They are: MerrillLynch; E. F. Hutton & Co.; Shearson/Ameri-can Express; Prudential Bache; Dean WitterReynolds; and Paine Webber. There are alsomany regional firms, such as Alex Brown &Sons, which play major roles in trading eithernationwide or regionally.

This portion of the industry has been af-fected by the abolition of fixed commissionrates in 1975. While brokerage houses in thepast competed on the reputation of their re-search and the quality of their service, pricecompetition has also become a factor. Dis-counters, who concentrate on the transactionside of the business, have entered the marketand have attracted a significant portion ofboth institutional and individual trading. Inresponse to this market entrance, many full-service brokerage houses are taking steps todistinguish their services and to increase cli-ent loyalty. Increased efforts are being di-rected toward product development and pro-motion.

Exchanges

The fundamental role of all exchanges in thesecurities industry is to provide an orderlymarketplace for trading. Exchanges providea central location and a structure in whichbuyers and sellers can conduct trades. Ex-changes are operated on a membership basis.“Seats,” memberships that carry the right totrade on an exchange, are purchased by firmsor individuals desiring access to its market.Members agree to direct all trades on listedsecurities through the exchange floor. Thisallows the exchanges to manage the marketsbetter–for example, to halt trading on a se-curity, if necessary, with the assurance thatmember firms will not trade off-market.Stocks and bonds, options, and futures con-tracts are usually traded on separate ex-changes. This specialization is a carry-overfrom the separate formation of capital andcommodity markets.

Stock Exchanges.– Stock exchanges are in-dependent players in the securities industryand have two functions: performing transac-tions and accepting risk. Stock exchanges actas a secondary securities market for both debtand equity issues, providing flexibility andchoice for investors. Potential investors in newissues can evaluate the desirability of the in-strument in light of their ability to sell it, andtherefore may recognize a lower opportunitycost. The existence of secondary markets alsoincreases the available investment choicessince securities other than new issues are madeavailable.

There are seven major stock exchanges:New York, American, Boston, Cincinnati, Mid-west, Pacific, and Philadelphia. In 1982, 80.8percent of the total share volume of registeredexchanges was traded on the New York StockExchange (NYSE). The National Associationof Securities Dealers, Inc. (NASD) operates aquotation system and clearing facility for theover-the-counter market. The automated quo-tation system, NASDAQ,5 has been responsi-

5National Association of %curities Dealers Automatic Quota-tion System.


Figure 3.—Average Daily Share VolumeNew York Stock Exchange 1963 to 1983

85,334 85,000

[ 1 ! !

82500

80,000

7 7 5 0 0

75,00072,50070,000

SOURCE Futures Industry Assoclatlon, Inc

ble for a dramatic increase in trading volumein over-the-counter stocks, an indication of theimportance of information flows to trading.

Options Exchanges.–The goal of optionsexchanges is to provide a continuously com-petitive and orderly market environment forthe purchase and sale of options.6 Each ex-change determines standards regarding whichoptions may be traded on that exchange. Theyselect the underlying securities on which op-tions may be traded based on factors such as

‘American Stock Exchange, Inc., et al., Understanding theRisks and U=s of Listed Options, 1982.

Photo credit. New York Stock Exchange

The trading floor of the New York Stock Exchange: 1984

the number of shares held by the public andtrading volume.

The principal established marketplaces forthe trading of options are: the American StockExchange; the Chicago Board Options Ex-change; the Pacific Stock Exchange; andthe Philadelphia Stock Exchange. These ex-changes compose the Options Price ReportingAuthority (OPRA). Trading information fromall of the options exchanges is coordinated inOPRA’s automated last-sale reporting sys-tem. This system, developed and operated bythe Securities Industry Automation Corp.,provides a consolidated tape of last sale andquote information. The exchanges also formedthe Options Clearing Corp. (OCC), which ac-

Ch. 3—The Securities Industry • 55

;red/t New York Stock Exchange

The trading floor of the New York Stock Exchange: 1930

tually issues the exchange-traded options and futures contracts.7 Futures trading is con-assigns exercises. ducted in price auctions on the trading floor.

Options exchanges aid in industry self-reg-ulation by developing and enforcing rules con-cerning the handling of accounts by brokers,trading hours, and position and exercise limits.Options exchanges and the OCC are regulatedby the Securities and Exchange Commission(SEC).

Futures Exchanges.—The principal respon-sibility of a commodity futures exchange is toensure the existence of competitive marketsfree of price manipulation for the trading of

The exchanges are operated on a membershipbasis, and exchange regulations and policiesare set by their boards of directors and sub-ject to approval of the Commodity FuturesTrading Commission (CFTC). There are manyfutures exchanges in the United States. Thelargest is the Chicago Board of Trade, whichin 1983 handled 44.89 percent of total tradingvolume (see table 2.)

‘Futures Industry Associates, Inc., “Roles Played by EachParticipant, ” Futures Trading Course and Handbook, Wash-ington, D. C., 1983, p. I I-4.

35-505 0 - 84 - 5 : QL 3


Exchange

1. Chicago Board of Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2. Chicago Mercantile Exchange. . . . . . . . . . . . . . . . . . . . . . . .3. Commodity Exchange, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . .4. Coffee, Sugar & Cocoa Exchange5. New York Mercantile Exchange . . . . . . . . . . . . . . . . . . . .6. New York Futures Exchange . . . . . . . . . . . . . . . . . . . . . . . . .7. MidAmerica Commodity Exchange . . . . . . . . . . . . . . . . . . .8. New York Cotton Exchange. . . . . . . . . . . . . . . . . . . . . . . . . .9. Kansas City Board of Trade. . . . . . . . . . . . . . . . . . . . . . . . . .

10. Minneapolis Grain Exchange. . . . . . . . . . . . . . . . . . . . . . . . .11. New Orleans Commodity Exchange . . . . . . . . . . . . . . . . . . .

1983

Contracts

62,811,52337,830,04420,014,5974,876,0693,926,5893,510,2853,166,5371,703,1051,693,042

379,60713,542

139,924,940

Percent

44.8927.0414.303.482.812.512.261.221.210.270.01

100.00

1982

Contracts Percent Rank

48,206,790 42,89 (1)33,574,286 29.87 (2)17,520,712 15.59 (3)3,252,512 2.89 (4)2,649,941 2.36 (5)1,451,442 1.29 (9)2,397,721 2.13 (6)1,479,781 1.32 (8)

1,493,558 1,33 (7)346,264 0.31 (lo)

27,872 0.02 (11)

112.400.879 100.00, .SOURCE: Futures Industry Association.

, ,

Ch. 3—The Securities Industry ● 57— — — — —

The exchanges play a major role in self-reg-ulation of the futures industry. In this rolethey are required to perform four activities:surveillance of market activity to detect andprevent situations conducive to price distor-tion; surveillance of trading practices to detectand prevent trading abuses; investigation ofrule violations and customer complaints; andexamination of members’ books and records.8

The introduction of new investment products,such as stock futures, indicates that activityon futures exchanges may be expected to growover the next several years. The regulatoryand operational role of the exchanges will be-come more complex. Information technologyis being applied to facilitate the operations ofthe exchanges and will play an increasinglyimportant role in their activities.

Industry Users

The demands and characteristics of users ofthe industry are major determinants of indus-try structure. The organizations of the secu-rities industry serve as intermediaries betweentwo sets of users: capital seekers and in-vestors.

Organizations Seeking Capital

While the focus of much of the activity ofsecurities industry is on secondary markets,the underlying demand for capital is the rea-son the industry exists. In 1982, the value ofnew issues of common stock publicly offeredwas $23.4 billion; new, publicly offered debtobligations totaled $45.2 billion. Private place-ments of debt and equity totaled $22.3 billion.As the U.S. economy completes its evolutionto an information economy, it may be expectedthat a great number of both new firms and ex-isting corporations with growing operationswill be seeking capital through both privateand public sources.

Corporations will demand more rapid accessto their capital than ever before because of theeffect of information technology on the over-

8U. S. General Accounting Office, Survey of Investor Protec-tion and the Regulation of Financial Intermediaries, 1983, pp.28-29.

all economy. Business decisions are beingmade more quickly, and delays in financingwill not be tolerated.

Institutional Investors

Institutional investors include special-in-terest funds and companies such as pensionfunds, mutual funds, insurance companies,and private foundations that have a goal ofproducing income for a specific organizationaluse and deal in large blocks of securities. Theydemand prompt, efficient transactions and ex-tensive information.

Since the passage of the Employee Retire-ment Income Security Act (ERISA), the im-pact of these investors on the total market hasincreased substantially. Trades in 10,000 -share blocks, a measure of institutional in-volvement, have increased to over 44 percentof total share volume. g The broker must alsobe willing to assume risk by buying from theinstitutional investor because he demands ahigh level of liquidity. At the same time, theimportance of this segment of the market hasled to price competition following the deregula-tion of commission rates in 1975.

The demands of institutional investors havebeen, in large part, responsible for much of theautomation of trading and clearing by the se-curities industry. Exchanges need to attractinstitutional capital to maintain the market-place, yet information technology, combinedwith institutional traders’ level of market ex-pertise, makes off-market trading a viable al-ternative for these traders. The volume oftrading conducted by institutional investorsmakes those investors valuable clients forboth brokers and exchanges.

Pension funds are the most significant insti-tutional investors in capital markets. In 1980,these funds held 13.4 percent of the total mar-ket value of NYSE listed stocks.10 Two factorsthat have contributed to the growing impor-tance of pension funds, both as savings vehi-cles and institutional investors, are the aging

‘Securities Industry Association data.IONew York Stock Exchange 1983 Fact Book, op. cit., P. 52.


Figure 4.—Volume of Futures Trading, 1958-83 (millions of contracts traded)

1958 ’59’60 ’61 ‘62’63 ’64 ’65 ’66 ’67‘68’69’70 ’71 ’72 ’73 ’74 ‘75’76’77 ’78 ’79 ’80 ’81 ’82 ’83SOURCE New York Stock Exchange data

of the population and ERISA. Since there has for the benefit of shareholders. Shares are soldbeen great interest in individual retirement to investors for the net asset value plus anyplanning, pension funds may be expected to applicable sales charges. The return for the in-be a major player in securities markets. vestor in a mutual fund is similar to that for

any corporate shareholder: the investor prof-A mutual fund is a company whose principal its from the assumed expertise of the company

line of commerce is investment in securities management in investment decisions. Mutual


funds are significant as institutional investorsbecause they usually trade in large volumes.

Funds are classified by investment strategyand fall into three categories: income funds,which strive to provide a current income forinvestors; growth funds, which focus on long-term appreciation; and income and growthfunds, which try to be all things to all people.Generally, funds that seek a higher return forinvestors are more risky. For example, somefunds, such as the Phoenix Fund of MerrillLynch, are composed of securities of failingcompanies that are believed to have the po-tential to rebound. While the risk level ishigher than average, shareholders in this typeof fund have less exposure to risk than if theywere to invest in individual securities, andthey benefit from high yield.

Mutual funds frequently specialize in spe-cific types of securities, such as governmentbonds, or in securities from a particular typeof industry. Money market mutual funds in-vest only in money market securities, whichare by definition short term. For this reason,money market mutual funds are consideredless risky and are more liquid than the tradi-tional mutual funds. Money market fundshave three basic objectives: to preserve share-holder capital; to maintain liquidity; and, inlight of these two objectives, to achieve thehighest possible current income.” Money mar-ket instruments are generally written in highdenominations and are only accessible to manyinvestors because they are able to pool theirinvestment dollars in the funds. The moneymarket benefits from the funds because a largequantity of capital not otherwise available isattracted.

Individual Investors

The typical individual investor in securitiesis an affluent consumer who demands infor-mation and advice geared toward his require-ments. The sales of mutual funds, a proxy in-dicator of the level of individual involvementin the securities market, are rebounding aftera period of decline. This upswing, plus recog-

“U.S. General Accounting Office, op. cit., p. 60.

nized opportunity to market new investmentproducts, has generated renewed interest inindividual investors by the securities industry.

There has been tremendous growth in thenumber of stockholders. NYSE reports that42.36 million Americans own shares of U.S.corporations or stock mutual funds, an in-crease of 10.1 million since 1981. ]2 Of particu-lar significance to the securities industry is thetremendous growth in the number of first-timeinvestors, 7.3 million since 1981. This growthma-y be attributable to several factors, includ-ing the strength of the stock market duringthe early 1980’s, corporate employee stockpurchase plans, and most notably, changingdemographics.

The “aging” baby-boom generation, now ap-proaching peak investment years, may causean increase in the number of people investing.People are waiting longer to get married forthe first time and have families and thereforeare likely to be able to invest at a younger age.While securities firms once targeted their serv-ices towards a small portion of the population,their market has become more diverse in termsof both age and income.

Securities firms have been expanding theirproduct lines and the scope of financial serv-ices they provide to meet the demands of theindividual investor. Movement by firms intoother areas, such as insurance and real estate,is an attempt to draw clients at an earlierstage in their financial lifecycle and to fill allof their financial needs.

The Regulatory Structure of theSecurities Industry

Federal regulations enacted in the 1930’sdisallowed involvement by depository institu-tions in securities activities because of con-cerns about the effects of risk associated withthese transactions on the stability and sound-ness of banks. Such restrictions separated cap-ital creation from the banking activities of cor-porations, such as the extension of operating

‘zJon Friedman and Tom Petruno, “Record 42M of Us AreWall Street Investors, ” USA Today, Dec. 1, 1983, sec. A, p. 1.

60 • Effects of /formation Technology on Financial Services Systems—

credit and transaction accounts. These restric-tions were intended to assure that depositoryinstitutions acted in the best interests ofdepositors.

The regulatory structure of the securities in-dustry recognizes that capital and money mar-kets are essential to the health of all sectorsof the national economy. Legislation concern-ing the securities industry has focused onthree areas: providing for disclosure to in-vestors, promoting self-regulation by the in-dustry, and facilitating the development of anational market for securities. Federal regu-lation that is focused directly on the commodi-ties futures segment of the industry is simi-larly designed and seeks to protect marketsand individual traders.

Securities and commodities trading is over-seen by a two-tier regulatory system: Federaland State government and industry. Federalregulation is focused on the oversight of mar-kets and investor protection. State regulationof securities, commonly called “blue skylaws,” since they were designed to prevent thesale of securities with the investment poten-tial of the blue sky, preceded Federal regula-tion, and the right of States to regulate waspreserved when the first major legislation con-cerning the operation of the securities indus-try, the Securities Act of 1933, was passed.

While Federal regulation focuses on dis-closure without value judgment on the worthof the securities, State laws may actually in-volve licensing. Registration of an issue maybe refused by a State authority, which wouldprohibit sale in that State.13 State laws differ,but efforts to develop uniform laws are beingled by the North American Securities Admin-istrators Association.

Self-regulation is imposed and enforced bythe exchanges and by industry associations.While the industry began formally supervis-ing its own operations with the developmentof the Buttonwood Agreement, the self-regu-latory system was first recognized by Con-gress and subject to Federal Government

13U.S. General Accounting Office, op. cit., p. 22.

supervision with the passage of the SecuritiesExchange Act of 1934.

Federal Regulatory Agencies

Several Federal agencies play roles in theactivities of the securities industry. The SmallBusiness Administration licenses and regu-lates Small Business Investment Corpora-tions, a type of venture capital firm. TheBoard of Governors of the Federal Reserveregulates the extension of credit by brokers,as mandated in the Securities Exchange Actof 1934, and has a major impact on the in-dustry by regulating the activities of banks.However, responsibility for regulating thesecurities industry is held by SEC, and respon-sibility for the futures industry, by CFTC.

SEC was established by the Securities Ex-change Act of 1934. Its regulatory activitiesare based on the belief that disclosure is thepreferable means of assuring the smooth oper-ation of securities markets; it is not invasiveto the operations of industry players, and itretains investor choice. SEC also acts to pre-vent price manipulation of securities and reg-ulates the the practices of exchanges, brokers,and dealers. It acts in conjunction with the in-dustry self-regulatory agencies and overseestheir activities.

While not a regulatory agency, the Securi-ties Investor Protection Corp. (SIPC), a quasi-governmental organization, has brought a uni-form investor protection policy to the securi-ties industry. SIPC operates as a private non-profit membership corporation whose primaryfunction is to provide financial protection forthe clients of failed securities firms. The cor-poration was mandated by the Securities In-vestor Protection Act of 1970 in response toproblems that occurred in the late 1960’sthroughout the brokerage industry as stockprices fluctuated widely and volume on the ex-changes increased dramatically.

The only function of SIPC is to insure ac-counts. It covers shortages in accounts of upto $500,000, including coverage for as muchas $100,000 in cash, for each account. Sinceit began operation in December 1970, it has

Ch. 3—The Securities Industry . 61

paid out more than $133 million in claims. ’4SIPC assesses an annual fee on each of the7,000 brokerage houses in the United States,which are required to be members of the cor-poration, to maintain the $150 million level itis required by law to keep available to satisfyclaims. At times, SIPC has acted as trusteein cases of brokerage house liquidations andas such has distributed payments to custom-ers as accounts were settled.

The corporation relies on SEC and the se-curities industry’s self-regulating organiza-tions for notification that a member firm is indanger of collapse. If SIPC determines thatthe customers of the brokerage house are inneed of its protection, it begins what is termeda “customer protection proceeding, ” which isa liquidation procedure. SEC is the only orga-nization that can sue SIPC to force it to beginliquidation proceedings.

CFTC is responsible for regulating com-modity futures trading on organized ex-changes. It acts to prevent price manipulation,attempts to corner market dissemination offalse or misleading information, and mishan-dling of traders’ margin money and equity.15

It reviews and approves the instrumentstraded on the futures exchanges-i. e., futurescontracts. CFTC oversees the activities of ex-changes and other self-regulatory associations.

Disclosure for the futures industry involvesnot only the characteristics of specific con-tracts, but also the level of risk involved in thistype of investment. All potential investors infutures markets are informed that they mayexperience large losses as well as gains andthat it maybe difficult to liquidate a position.

Industry Self-Regulatory Agencies

Industry associations and exchanges estab-lish and enforce rules concerning the opera-tions of the securities industry, rules that areoften more stringent than Federal regulations.An implicit objective of self-regulatory agen-cies is to maintain the autonomy of the indus-

14 Christine Davies, “Brokerage Failures Bring Agency toLife, ” USA Today, Mar. 9, 1983.


try. To meet this goal, these organizations tryto ensure that the behavior of the industry isabove reproach. They play a major role in over-seeing the markets, market systems, and theindividuals active in the industry. Self-regu-latory agencies also have an educational rolein dealing with both members of the industryand the public.

The two most significant securities indus-try self-regulatory organizations are NASDand NYSE. Their roles may be expected togrow as they continue to carry a great portionof all securities trading. The National FuturesAssociation (NFA) is the self-regulatory orga-nization of the futures industry.

NASD is a self-regulatory agency responsi-ble for regulating the over-the-counter secu-rities market and for promoting high stand-ards of operation throughout the industry. Italso establishes standards of professional com-petence. NASD was empowered through theMaloney Act of 1938 amendments to the Se-curities Exchange Act of 1934. Its central pur-pose—to promote high standards of commer-cial honor and just and equitable principles oftrade throughout the industry—has becomeeven more important to the industry as tech-nology is applied.

NYSE oversees the operation of the ex-change marketplace and administers rules andregulations related to the maintenance of or-derly markets and the standards of profession-al competence. ” NYSE is also a major sourceof information concerning the industry as awhole.

In 1981 NFA was designated a “registeredfutures association” by CFTC, which overseesits activities, with congressional endorsement.It began operating on October 1, 1982. NFAwas formed in recognition of the continuinggrowth of futures trading to bring a uniformsystem of self-regulation to its activities.

NFA works toward four fundamental pur-poses: strengthening industry self-regulationby regulating those segments of the futures



industry that were previously outside thescope of self-regulatory organizations; elim-inating duplication in self-regulation, therebycontrolling expenses; eliminating overlap andconflicts in self-regulation of the industry byproviding uniform standards; and aiding ef-fective regulation by removing unnecessaryregulatory constraints.17

Trends in Industry Regulation

Trading volume and the number of types ofsecurities instruments have been increasing.The securities industry is being entered byplayers from other sectors of the financialservices industry and by outside industries.It is likely that more demands will be placedon the oversight functions of the regulatorysystem. However, while the importance of thisrole is increasing, technology will facilitate thisfunction by improving information flows onthe operations of the industry.

While the oversight role may be stream-lined, standards and education will requiremore attention. Changes in industry functionsand the introduction of new products (facili-tated by the application of information tech-nology) will require an expansion of the educa-tional role of the regulatory agencies. Thecontinuing development of technology-basedsystems necessitates coordination of stand-ards to ensure that different markets, both do-mestically and internationally, can interact.

Characteristics of the Securities Industry

Concentration

The securities industry is heavily concen-trated. In 1982, the 25 largest firms, out ofnearly 550 Securities Industry Associationmember firms, controlled nearly 75 percent ofthe total capital of the industry. The 10 largestinvestment banks controlled two-thirds of theprofits for that segment. This high level of con-centration results, in part, from the large num-ber of mergers, reorganizations, and liquida-tions that occurred during the 1970’s. The

l~NatiOn~ FUtUreS Association, A %rtnership Between thePublic and the Industry, Chicago, 1983, p. 11.

consolidation activity was spawned by risingbusiness costs for the industry and the weightof transaction processing, as the volume oftrade had increased throughout the 1960’s.

Throughout the 1970’s several verticalmergers between brokers and investmentbanks occurred-most notably the acquisitionof Reynolds Securities by broker Dean Wit-ter & Co. and the purchase of White Weld byMerrill Lynch. These mergers integrated newissue management with the distribution of se-curities and may be considered an early movetoward consolidation throughout the financialservices industry.

Recent acquisitions and mergers seen in thesecurities industry have frequently involvedplayers from other financial services indus-tries. The product lines of firms are becomingboth horizontally and vertically integratedwith lines previously only offered outside ofthe securities industry.

Movement Toward a NationalSecurities Market

The Securities Acts Amendments of 1975directed SEC and the securities industry tocreate a national market system for bothtransacting and clearance. Movement in thisdirection is having a profound effect on thestructure of the securities industry. Ex-changes have been linked to a degree not pre-viously seen, through development of technol-ogy-based information systems such as theIntermarket Trading System. Clearing sys-tems involving the National Securities Clear-ing Corp. have made same-day settlement apossibility.

The driving force in developing systems thatmake a national market possible is the Securi-ties Industry Automation Corp. (SIAC). Thegreat increase in the volume of trading on themajor exchanges in the late 1960’s made it evi-dent that the securities market needs the ca-pability to deal with extensive volume. SIACwas organized both to operate and to developmore efficient and effective ways of dealingwith the transaction process. SIAC systemssupport order processing, trading, and report-

3333333333. —

Ch. 3—The Securities Industry ● 6 3— — —— ———- — — . ——— . —

ing functions, as well as clearance and settle-ment for stocks, bonds, options, and financialfutures. The corporation is owned by the NewYork and American Stock Exchanges,

One of the major impacts of SIAC on thesecurities industry is that it makes the devel-opment and refinement of technological sys-tems a continual process. This should preventor at least limit the lag between the identifica-tion of a need that could be best addressedwith a technology-based system and the appli-cation of a solution.

New Entrants to the Securities Industry

Entrance by Depository Institutions

An amendment, effective September 9,1983, to Regulation Y of the Federal ReserveBoard has added securities brokerage andrelated margin lending to the list of activitiespermissible for bank holding companies. Thisaction, which extends from previous approvalby the Government for the acquisition of retaildiscount brokers by bank holding companies(notably the BankAmerica Corp. acquisitionof Charles Schwab), may increase the interestamong bank holding companies in entering thesecurities industry. ]8

The motivation of banks for providing dis-count brokerage services may be seen as eithera reaction to market conditions or an attemptto protect market shares. Since many broker-age houses are offering investment opportu-nities that serve functions similiar to depos-itory accounts, often with more flexibility andhigher rates of return, the consumer’s per-ceived need for a bank may be decreased. Onemotivation for providing brokerage servicesmay be to prevent the potential luring awayof other portions of a depositor’s business.

While acquisition of a discount broker pro-vides one method of expansion into securitiesfor depository institutions, economies in op-erations made possible by the application in-formation technology have made other meansof market entrance possible. Twenty-five sav-—-————

‘“Federal Reserve Press Release, Aug. 11, 1983.

ings and loan associations and savings banksown ISFA Holding Co., Ltd., which operatesINVEST, a brokerage service, through awholly owned subsidiary. Thrift institutions,which would not be able to enter the brokeragebusiness independently, can offer transactionand advice investment services to their cus-tomers by subscribing to INVEST.

Special INVEST centers are placed inbranches where they are accessible and evi-dent to customers, yet remain separate anddistinct, by order of SEC and the FederalHome Loan Bank Board, from the other opera-tions of the thrift. Just as the securities indus-try is developing and offering new productsto retain clients, this is also a basic motiva-tion behind INVEST. Thrifts are thus able toexpand the services they can offer their cus-tomers.

Trades conducted through new alternativebrokerage services are executed through theexchanges, usually by way of a clearing bro-ker. The securities industry finds itself in theposition of servicing competitors, a situationthat is quite common throughout the financialservice industry. As capabilities and econ-omies found in information technology con-tinue to grow, more entrants maybe expectedand the wholesale portion of the securities in-dustry will probably grow.

Possible Entrants to the Securities Industry

Players throughout the financial service in-dustry, including the securities industry, havebeen expanding their product lines to fill asmany of their clients’ needs as possible. Rec-ognized economies of scope usually underliethis expansion of distribution systems, bothfor information and for community presence,and in terms of complementing current prod-uct lines. Providers often feel they can retaintheir customer base by entering other lines offinancial services.

The entrance of other financial service play-ers into the securities industry is already oc-curring. Several insurance companies havepurchased regional brokers, and some depos-itories have acquired discount brokers. Shear-


son/American Express and Prudential Bacheare both results of mergers between playersin different sections of the financial servicesindustry. Consolidation within the financialservice industry is likely to continue.

Others, not traditionally thought of as pro-viders of financial services, have also enteredthe securities industry. The most widely citedexample is Sears’ entrance through the acqui-sition of Dean Witter.

Other players who may recognize significanteconomies of scope in entering the securitiesindustry are firms in the communications andcomputer industries. These firms might be inan especially strong position to enter thewholesale side for the securities industry. Bar-riers to entry, such as exchange membership,may be overcome by technology. Computerand communications technologies allow for thecreation of information and transacting sys-tems not dependent on the current industrystructure.

The Securities Industry and theInternational Market

The securities industry has its roots in theneed for the American economy to interact inthe international capital markets. However,prior to the completion of the transatlanticcable in 1866, a real international market couldnot exist because it was impossible to conveyinformation in any meaningful time frame. In-formation technology has made it possible forthe American securities industry to interactin the international market, while economicforces have made it essential.

Information technology has allowed a globalcapital market to develop, resulting in in-

creased opportunities both for investors andcapital seekers. Foreign individuals and insti-tutions made purchases and sales of $79.8 bil-lion of domestic corporate stock in 1982, andtransactions in all securities resulted in a netinflow of $14.3 billion in capital to the UnitedStates. ’g

Communications technologies are so ad-vanced that a market anywhere in the worldcan be selected for trading. This could havesignificant impacts on the stability of the econ-omies of nations. For example, the halting oftrading on an exchange in one country couldsimply result in new trade in another nation.It is not clear what impact large differencesin the valuation of a security by different coun-tries could have on capital markets. Interna-tional issues in the development of capitalmarkets are being considered by various or-ganizations. One such organization is theFederation Internationale des Bourses de Va-leurs, an association of 30 stock exchanges in20 countries.

The Effects of Information Technology onthe Structure of the Securities Industry

The application of information technologyin the securities industry affects its structureby facilitating the flow of information to suchan extent that it removes geographic con-straints on market participants and allows fordevelopment of international capital markets.It may also place additional barriers to entryto the securities industry. Without adequateaccess to telecommunication services, for ex-ample, a securities firm cannot function.

1’New York Stock Exchange 1983 Fact Book, op. cit., p. 63.

The Functions of the Securities Industry

The most significant role of the securitiesindustry is in the development of capital. Theinstitutions and players of the securities in-dustry facilitate the development of capital

structures of organizations and corporations.While it would be possible for organizationsin search of financing and potential investorsto interact directly, the market structure that

Ch. 3—The Securities industry ● 6 5

has developed provides needed services moreefficiently. Since most corporations and orga-nizations do not approach capital markets fre-quently, financing with the aid of the securi-ties industry is usually more cost effectivethan direct attempts because of the expertisesecurities institutions have in analyzing secu-rities markets and in locating potential inves-tors, and because of the ability of the securi-ties industry to accept risk.

The use of information and communicationtechnologies by the industry is nearly univer-sal, and adjustments may be expected in op-erations as the value of technology is realized.However, while information technology maychange the way in which the securities indus-try performs its activities, and may even fa-cilitate attempts by investors to act on theirown behalf, it is expected that the basic func-tions of the securities industry will remain anessential part of the development of capital.In this section, an overview of the functionsof the industry and the emerging effect of theapplication of information technology on theseroles will be described. The significance of theadvisory, risk-accepting, and marketing func-tions of the securities industry to the processof gathering capital will be outlined, and theeffect of information technology on this proc-ess will be summarized. Specific approachesto capital formation are discussed in appen-dix 3B.

The Securities Industry as an Advisor

In its advisory role, the securities industryprovides information and offers guidance toits clients. It is able to advise organizationsseeking capital on the type of financing mostdesirable, whether through private or publicmeans, and, perhaps most significantly, whatthe timing for entering the capital marketshould be. These decisions are based on the ob-jectives of the firm. Factors to be consideredinclude the risk and return associated withvarious issuing organizations and instru-ments. Timing of buy and sell decisions is alsopart of this advice function.

Information Dissemination

Information technology affects informationdissemination by the securities industry inseveral ways. Information is now less costlyto gather, store, and access than it was inlargely manual systems. Therefore, not onlyis it likely that the quantity and quality ofavailable information will increase, but alsothat more information will be sought. Inves-tors and other parties interacting with thesecurities industry may be expected to makebetter and more satisfying decisions becauseof the increased availability of information.

Technology has already had a major impacton information flows throughout the securitiesindustry, and it appears that the resultantchanges may have major impacts on the oper-ation and, in time, the structure of the securi-ties industry. Information technology en-hances the reporting of securities trades. TheConsolidated Quotation System, which wentonline in 1978, collects and disseminates quo-tation information from exchanges across theNation and calculates and appends the na-tional Best Bid and Offer to the quotation in-formation. 20 Communication technologymakes it possible to transmit this informationin real time to system subscribers nationwide.A similar system is in place on the NYSE fordebt issues. The Automated Bond System pro-vides current quotation and trade informationfor more than 80 percent of the exchange-listedbonds.21 This system has improved the qualityof information available on bond trading.

Information technology may increase theindependent role investors assume as infor-mation monitors, particularly the individualinvestors. Although massive quantities of fi-nancial information are currently availablethrough a variety of media, such as news-papers, radio, and television, and through pub-licly available consolidated tapes, individualinvestors may expect to have even more in-

‘“Securities Industry Automation Corp., Annual Report, NewYork, 1982.

21 New York Stock Exchange, Amual Report 1982, New York.

66 . Effects of Information Technology on financial Services Systems

formation at their disposal. While a “more isbetter” philosophy is usually applied to infor-mation, the result can be confusing, deceptive,and frustrating to users. Moreover, informa-tion gathered by intermediaries within thesecurities industry may require translation toa form that can be used by clients.

The adoption of home information systems,particularly interactive cable and personalcomputer systems, may change the way inwhich this information is gathered and used.E. F. Hutton and Dean Witter provide cus-tomers with securities research that can be ac-cessed via home computers.22 It is not clearhow investors will use this information. Thecontinual availability of new information mayresult in more frequent trading; however,home systems may just be, in the aggregate,a new medium. Investors may evaluate nomore information than they did in the past.

Computer and communication technologieshave increased the speed with which informa-tion is available to the mass market. With thesystems now available, investors may becomeless dependent on a broker or dealer for up-dated information. An example of this type ofsystem is Pocket Quote, produced by TelemetAmerica, Inc. The basis of Pocket Quote is an1 l-ounce programmable receiver, which lookslike a calculator and can be used to monitorthe New York and American Stock Exchangesas well as option exchanges. Information, in-cluding price and trade volume, on up to 20securities specified by the user is transmitted,subject to a 15-minute delay. The data arebroadcast in a scrambled form on FM sidebands, using a digital signal. Not only is theinformation readily available to the investor,but the system can be programed to page theuser automatically at any time there is “news”about any investment instrument in which he/she is interested.

The potential for investors to act immedi-ately on information continually updated andtransmitted via such systems may affect thestability of securities markets. The ability of

“Tim Barrington, “Stock Trading by Computer EntersHomes, ” The Wall Street Journal, Oct. 6, 1983.

the market to correct itself in unusual situa-tions may be destroyed. In the long run, thismay be a severe disadvantage for the investor,particularly the small investor, who may findhimself bearing both transaction and lost op-portunity costs because of action taken because of basically meaningless market fluc-tuations.

Counseling

The nature of counseling may be changedby the amount and type of information andsupporting analytical tools available. Researchis expected to become pivotal rather than pas-sive in the investment advisory function.23

Analysis and recommendations presented bysecurities industry intermediaries to clientsconcerning potential investments may be moredetailed and, to complement this process, anal-ysis of the financial needs of the individualmay also improve.

Increased availability of information tech-nology has changed the nature of counselingby placing more sophisticated analytical toolsin the hands of both advisors and investorswho may not have had access to these toolsin the past. This change may affect the wayin which investment decisions are made andthe quality of these decisions.24

The reliance on information technology foranalysis of personal investment needs, objec-tives, and choices may indicate an initial movein the industry to reemphasize individual hu-man judgment and perhaps a reemphasis ofthe client/broker relationship. It is not clearwhat the impact of this change will be; how-ever, a decline in personalized service, basedon the evaluation by the broker of the client’sfinancial objectives, may occur.

While counseling may be displaced in someareas within the securities industry, its impor-tance as a separate and unique service of theindustry has been highlighted in some cases.

“Thomas Moore, “Ball Takes Bache and Runs With It, ” For-tune, Jan. 24, 1983, pp. 97-98.

24 Lee B. Spencer, “The Electric Library, ” remarks to theAmerican Bar Association, Federal Regulation of SecuritiesCommittee, Nov. 19, 1982.


Advice, particularly counseling, has been un-bundled from the total package of services of-fered in a new service supplied by MerrillLynch, called “Pathfinder.” For a set fee, theclient receives what amounts to a financialcheckup. The evaluation provides guidance tothe investor in a somewhat objective frame-work. The success of this product may be anindication of the future role of advice withinthe securities industry.

Acceptance of Risk by theSecurities Industry

The securities industry accepts risk thatmight otherwise be experienced by individualsor organizations seeking investment. It doesthis in two ways: through underwriting andby the extension of credit through margin.Underwriting refers to the assumption of riskby an investment bank or other third partyat the time of a public offering. The extensionof credit by brokerage houses is referred to asmargin.

Underwriting New Issues

Underwriting involves the purchase of se-curities from the issuing company and thesubsequent resale of the instruments to thepublic. This service, which is usually per-formed by investment bankers, is essential tofirms in need of capital that are not in the busi-ness of marketing securities. It allows themto receive the funds they need while transfer-ring the marketing function to an expert whomay be expected to be more effective in reach-ing prospective investors.

The underwriter accepts some of the riskassociated with a public offering. He preventslag time by assuring that the issuing corpora-tion has access to the funds it is attemptingto raise when needed. By buying the public of-fering from the firm in search of financing, theunderwriter makes it easier for the manage-ment of the firm to plan the use of the fundsgenerated. The issuing organization may beless concerned about the flow of cash the saleproduces because it is usually guaranteed afixed price and can use those funds when the

agreement with the investment bank or otherunderwriter is closed.

In most cases, the underwriter also assumesrisk by assuring that the issue will be sold, andhe accepts the risk that market fluctuationsor initial pricing mistakes may influence thesuccess of the issue. Offerings underwrittenon a “best efforts” basis, where the under-writer does not bear the risk of an unsuccessfuloffering, permit those issuers in a startup ordevelopmental stage, whose issues may beconsidered to be more risky, to have access tothe public capital markets.

Underwriters earn money by buying secu-rities at a lower price than they resell them forto investors. The difference in price, or spread,is a major consideration in the selection of aninvestment bank by a firm. A prospective cli-ent for an underwriter may choose an invest-ment bank through two methods: competitivebidding or negotiation. Both systems have ad-vantages, and experts disagree on which pro-vides the best price for the capital seeker. Theadvantage of the negotiated system is that theissuing firm and the underwriter work to-gether to make decisions about the pricing andtiming of the issue.

The company using a competitive biddingsystem invites offers from investment bank-ers. This process is required for many publicutilities and most municipal offerings. Butwhile some experts believe it results in highernet proceeds for the issuing organization (be-cause of the forces of competition), it has dis-advantages. Much of the benefit of the advi-sory function that the issuing company wouldenjoy in a negotiated situation is lost. A higherprice may be received, but this largely dependson the health of the market at the time of theoffering. In a depressed market, investmentbankers are less likely to compete for a pub-lic offering, and therefore the price receivedmay be lower.

It is also typical for investment banks tominimize their risk by forming syndicates.This spreads risk and benefit because of theirpooled sales force and allows a number ofunderwriting firms to participate together in


large public offerings. Changes in industrystructure, particularly consolidation among in-vestment banks, may affect this operation.

The presence of an underwriter provides avaluable service for the prospective investor.Investment bankers are expected to examinethe corporate records with due diligence andare liable to defrauded investors if they failtheir due-diligence obligations and miss anymisstatement or omission of material fact bythe issuer in the prospectus. Therefore, notonly does an underwriter assure that the issuewill be sold in a “firm commitment” offering,but it also provides an oversight function ofthe issuer on behalf of prospective investors.

The underwriter also frequently accepts riskthrough providing a secondary market for se-curities by maintaining a position in the stock.This activity, called “making a market, ” issimilar to the role played by securities special-ists, which is discussed in a later section. Theunderwriter quotes “bid” and “asked” pricesfor the security based on market supply anddemand and intervenes as a buyer or seller,when necessary. The original offering of a debtor equity issue may be expected to be moresuccessful when the potential investors knowthat the existence of a secondary market isguaranteed.

Information technology may affect theunderwriting function by decreasing the timebetween the initial development of a securitiesissue and its sale, lessening the need of capi-tal seekers to be protected against this lag.Pricing decisions and market evaluations maybe more certain if the time frame in which thesecurity is offered is lessened.

Price competition has been increasing in thearea of underwriting. Since the use of syndi-cates is decreasing, there is a greater need forindividual firms to have substantial capital ifthey are to continue functioning as underwrit-ers.25 Information technology may be a con-tributing factor in the advent of bought dealsthat involve the purchase of an entire issue,

usually by a single underwriter who has notlined up buyers in advance. While informationtechnology may allow underwriters to locatebuyers quickly, more risk is involved in thismethod than with a traditional syndicate.

The emphasis on price competition maybea disadvantage for corporations entering cap-ital markets because the benefits of advice onpricing and timing of an issue is sacrificed.While sophisticated analytical tools, which in-formation technology may enhance, may as-sist corporations seeking financing in evalu-ating various possibilities, this type ofanalysis may not be tailored to the needs andobjectives of corporations to the same extentas the information and counseling services pro-vided by an underwriter.

Margin

“Margin” refers to the amount of moneypaid by an investor to acquire a securitythrough credit instead of cash. At the end of1982, the securities industry held nearly $13billion ($12.98 million) in margin debt securedby nearly $39 billion ($38.88 million) worth ofcollateral. 26

The Securities Exchange Act of 1934 em-powers the Federal Reserve Board to regulatethis extension of credit. Brokers are permittedto extend regulated credit on stocks and con-vertible bonds traded on registered exchangesas well as some select over-the-counter stocks.Initial margin requirements, set by the Fed-eral Reserve Board, currently call for a depositequal to 50 percent of the total value for bothstocks and convertible bonds. Stock ex-changes and other self-regulatory agencies ofthe industry have individual requirements forthe opening and maintenance of margin ac-counts. For example, the NYSE requires aninitial deposit of at least $2,000 and the main-tenance of equity of the customer at 25 per-cent of the value of securities carried.

The advent of home equity access accounts,encouraged by advances in information tech-nology, may increase the amount of margin

25A. F. Ehrbar, “Upheaval in Investment Banking, ” Fortune,Aug. 23, 1982, pp. 90-95, Z6New york Stock Exchange 1963 Fact Book, OP. cit., Il. 46.

-..

Ch. 3—The Securities Industry ● 6 9— —

debt and change the nature of collateral. Whilesome accounts restrict this use of credit drawnfrom home equity for the purchase of securi-ties, in many situations this is acceptable.

Margin takes on a different meaning in op-tion and futures contract trading. In futurestrading, margin refers to the amount of moneyor collateral which a client is required to de-posit with his broker to insure the brokeragainst losses on open futures contracts. Op-tion writers must, similarly, deposit cash orsecurities with their brokers so that the bro-kers are covered in case of an assignment.

Margin plays an important role in specula-tion in securities markets. A frequently usedstrategy in the buying and selling of securi-ties is the “short” position. In this case, aninvestor sells securities he does not own, buthas borrowed, to make delivery in the hopesthat the price will decline before it is neces-sary for him to return the security. This activ-ity can be extremely risky. However, it ac-counts for a significant amount of marketactivity. In 1982, 1.5 billion shares, in roundlots, were sold short, an amount that was 9.3percent of all reported securities sales.27

Information technology may decrease thesignificance of margin as a convenience forbrokerage customers because it eases accessto assets and facilitates funds transfers. Cus-tomers may be able to finance securities pur-chases using other assets whose liquidity hasincreased as a result of increased use of infor-mation technology. It is not clear what the neteffect will be; however, the use of electronicfunds transfers may largely eliminate the useof margin by brokerage houses to providefloat.

Marketing by the Securities Industry

For purposes of discussing the securities in-dustry, “marketing” is defined as those activ-ities designed to identify and meet the needsof clients; i.e., both seekers of capital and in-vestors. It is assumed that these clients do notdemand a specific product or type of service,

but rather, that the clients recognize an un-filled need and seek a way to meet it.

At one time the operations of the securitiesindustry were centered on what was possible,given the regulatory framework and its busi-ness concerns. Now, a new awareness of theimportance of basic marketing to retain anddevelop business is evident, resulting in re-search to support activities in product devel-opment and promotion and the targeting ofspecific segments of the population for special-ized products. Given the competition the in-dustry faces in its traditional and new prod-uct lines, especially from new entrants into thefinancial service industry, the marketing func-tion may be expected to continue to grow inimportance for the foreseeable future.

Information technology may affect thosemarketing functions of the securities industrythat comprise product development, sales orbrokerage, and pricing.

Product Development

In recent years, the regulatory restraints onthe financial service industry have decreased,and the securities industry has found competi-tors in what at one time were strictly separatebusinesses. These developments have occurredwhen the securities industry was observing acontinual demographic and psychographicchange among its potential retail clients, agrowing institutional market, and more com-plex financial needs among organizations seek-ing capital.

Shifts in the area of product developmentare seen mainly in the way products are pack-aged, specifically in the variety of mutualfunds and money market mutual funds thathave been developed. It is not yet clear howpatent and copyright laws will affect the de-velopment of information technology-based fi-nancial services products. If financial serviceproducts become patentable, some securitiesindustry experts believe that competitioncould be stifled.28 Many financial service prod-ucts are similar in both character and features,

“New York Stock Exchange 1983 Fact Book, op. cit., p. 48.“’’Merrill Lynch Wins Cash Account Row With Dean Wit-

ter, ” The Wall Street Journal, Dec. 29, 1983, sec. 1, p. 2.


and therefore, there is an inherent possibilityof patent infringement. Differentiating prod-ucts by attribute has not been of great interestto the financial service industry, which hascompeted by geographic market and compara-tive return and cost.

Information technology has created interestin patenting financial service products becausecommunications and computer technologieshave broadened markets. Products that at onetime may have been offered locally now com-pete nationally. Therefore, protection of prod-uct may become as necessary as the position-ing of the product.

The patentability of financial products isnow being tested in cases involving the cen-tral-asset account. In response to perceivedconsumer demand, most major firms in thesecurities industry, including Dean Witter,Paine Webber, Shearson/American Express,and Prudential Bache, have introduced theseaccounts, which are combination margin ac-counts and investment funds. Merrill Lynchled the development of asset managementaccounts with its introduction of the cashmanagement account in 1977, for which it re-ceived patents in August 1982 and March1983, and, with over 1 million accounts, is themarket leader. Following the receipt of its pat-ent, Merrill Lynch notified competitors thatit was imposing an annual licensing fee of $10on all asset management accounts. Initially,this levy was not taken seriously throughoutthe industry; however, without admitting anypatent infringement, Dean Witter resolved itsdispute with Merrill Lynch about the accountsin late December 1983 for $1 million. The firmsagreed to “grant each other a nonexclusive,royalty-free license to use any improvementsor changes either might make relating to cen-tral-asset accounts. ”29

If financial service accounts are routinelypatented, investors may find that their choicesare limited, since the patent may be a barrierto entry into some product lines for some serv-ice providers. Since players within the securi-

29Ibid.

ties industry may be expected to make effortsto distinguish similar products legally, patent-ing may also increase consumer confusionabout product features and attributes.

Brokerage

Brokerage involves bringing together buy-ers and sellers, facilitating trades through themaintenance of a marketplace, and assuringthat the trade is complete. The significance ofthis activity as part of the operations of thesecurities industry cannot be overestimated.Traditionally, all of the costs of supporting aninvestment bank or brokerage house were re-covered through this portion of the business.The services provided to clients, such as re-search support and advice, were bundled intothe commission rate for purchasers of securi-ties and into the spread on new issues for in-vestment banks.

The heart of brokerage with retail clients hasbeen personal selling. The relationship be-tween the investor and the individual brokerhas been fairly constant, and typically, the ac-counts a registered representative developswhile with a particular brokerage house movewith him if he/she switches firms. Firms withinthe industry have expended great effort in at-tempts to retain clients. The development ofnew products unique to particular houses mayencourage a loyalty to the company ratherthan to the broker. It is not yet clear how thismight change the character of the industry.

Most technology-encouraged competition isoccurring within the selling function of retailand institutional brokerage. The end of stand-ardized commissions on the sale of securities(1975) has encouraged the entrance of dis-counters into this market. Discount brokerscomplete trades for investors at prices that aregenerally lower than the commission chargedby full-service brokers. Usually, the serviceprovided by discounters is limited; e.g., thesefirms usually do not support extensive re-search and advice operations. However, theydo fill the needs of a portion of the market.About 15 percent of trading by individual in-vestors is handled by discounters.


Access to information technology for indi-viduals will facilitate direct selling of securi-ties to investors without the interaction of abroker. This type of system is particularlyadaptable for discount brokers whose serviceis basically order-taking. C. D. Anderson &Go., a small discount broker, developed thefirst home brokerage system, and other bro-kerage houses are expected to enter this mar-ket. 30 C. D. Anderson’s system allows clients,who pay a hook-up charge and a usage charge,to enter buy and sell orders at their conven-ience, without dealing with a broker.

Transactions

Congress mandated the development of acomputerized national stock market systemin 1975, believing that by linking all marketcenters, such a market would expose securi-ties to a greater number of buyers and sellers,and an investor would have the chance to ob-tain the best price available. This system wasalso expected to provide competition toNYSE, which dominated the market with 80to 90 percent of the trading volume.

The Cincinnati Stock Exchange was ex-pected by many industry experts to becomethe basis of an automated national stock ex-change. The exchange was supported by Mer-rill Lynch, the largest firm within the securi-ties industry. In July 1983 Merrill Lynchwithdrew a large portion of its business fromthe Cincinnati Stock Exchange and returnedit to the floor of NYSE, noting that not onlyhad the Cincinnati Stock Exchange failed togain the volume anticipated, but that NYSEhad improved.

While NYSE is still largely based on a sys-tem of auction pricing and securities special-ists, the adoption of systems made feasible bythe application of information technology hasallowed it largely to eliminate problems asso-ciated with high volume. In addition, commu-nications systems have been developed thatallow users of NYSE to enjoy many of thebenefits of a national system by providing in-formation on the activities of regional ex-

‘°Carrington, op. cit.

●

35-505 0 - 84 - 6 : QL 3

changes. One such system, the IntermarketTrading System (ITS), may be seen as beingindicative of a trend toward a national mar-ket for securities trading.

ITS allows brokers, specialists, and marketmakers to interact with their counterparts atother markets. The system, maintained bySIAC, currently involves eight stock ex-changes: New York, American, Boston, Phila-delphia, Cincinnati, Midwest, Pacific, and, toa limited extent, NASDAQ.

ITS provides a mechanism through whichthe most favorable exchange setting can bechosen for a transaction. * At NYSE, the bestprice from any member of ITS, as well as theNYSE floor price, is displayed. If it is advis-able for a trader to deal on an exchange otherthan the one at which he is operating, he canenter his order by contacting his counterpartthere. At the end of 1982, 1,039 issues wereeligible for trading on ITS. NYSE reports thatthis represents most of the stocks traded onmore than one exchange.

The Designated Order Turnaround (DOT)system was introduced in 1973 to route smallorders (599 shares or less). It reports elec-tronically between NYSE and member firms.DOT bypasses floor brokers by routing ordersdirectly to the appropriate trading post on thefloor of the exchange and, following execution,back to the member firm on the same elec-tronic circuit. Over 80 percent of the 5.7 mil-lion market orders processed through DOT in1982 were executed and reported back to themember firm within 2 minutes.31 This systemminimizes the cost to member firms of han-dling small transactions while giving small in-vestors the benefit of timely execution of theirtrades. DOT may also provide a better pricethan would normally be received by a smallinvestor. A trade made through DOT ismatched by computer for price with the mostrecent trade of that issue. The investor bene-fits because the price he receives may have

*For Purpows of this discussion, “transacting” is defined asthe physical execution of trades.

“New York Stock Exchange 1983 Fact Book, op. cit.


resulted from price negotiation on a muchlarger order.32

Another technology-dependent system thatfacilitates transacting is the Opening Auto-mated Report Service (OARS). OARS makesefficient and accurate processing of marketorders, that are received at NYSE prior to thestart of daily trading, possible without caus-ing unnecessary delays in the opening of trad-ing, and transmits computer-generated reportsto the originating member firm.33 This systemis especially valuable to specialists on dayswith high trading volume, which have recentlybeen occurring with great regularity.

Future developments in transacting en-hanced by information technology may includethe bypassing of intermediaries in the proc-ess of selling. Some experts believe that theadoption of home information systems maymake it more common for investors to com-plete transactions between themselves pri-vately or to gain direct access to exchangefloors. While it does not appear that the pos-sibility of off-market trading is having a ma-jor impact on the individual investor at thistime, institutional investors have at timesfound it advantageous to trade off-market.

About 500 brokerage houses, pension funds,insurance companies, and other institutionalinvestors are linked through AutEx Systems,a nationwide computer network. The potentialof this system for trading was demonstratedby its use in creating a market in a stock forwhich trading had been closed by NYSE. Jef-feries & Co. is a discount broker specializingin institutional trading. It is not a member ofany major exchange and therefore is able tomake a market in an exchange-listed stockwithout going through the exchange. Follow-ing a request by a client, Jefferies announcedover the AutEx System that it was makinga market in the closed stock. The companytraded a total of about 8 million shares of thestock off-market.34

3’Desmond Smith, “The Wiring of Wall Street, ” The NewYork Times Magazine, Oct. 23, 1983, p. 109.

33New York Stock Exchange, Annual Report 1982, New York,p. 33.

“Smith, op. cit., p. 73.

Given that the primary responsibility of se-curities exchanges is to maintain an orderlymarket, technology, the great facilitator oftheir operations, could also be a major under-mining force for the exchanges. It is basicallymeaningless to stop trading for a security onan exchange if the end result is simply thattrading is moved off of the exchange and con-ducted without the prudent management ofthe specialist. It may be essential for ex-changes to continue trading a given securityin all but the most unusual situations.

Clearance and Settlement of Securities

Clearance and settlement activities consum-mate trades through the exchange of securi-ties and funds.35 As with any marketplace, anaction recognizable to all parties involved isnecessary for finalizing a transaction. Giventhe great number of participants in the secu-rities industry, it is essential that transactionsbe closed as efficiently as possible in a man-ner that is acceptable to all parties involved.

The increasing volume of trade and the con-tinuing development of new securities prod-ucts has made it necessary to refine settlementand clearance. Since ownership is merely con-tractual until the process is finalized, delaysin settlement and clearance could have a se-vere effect on the operation of securities mar-kets. An industrywide effort is under way tomove toward a national settlement and clear-ance procedure through the adoption of stand-ardized proofs of ownership that are not paper-based, such as book entry, and to facilitate ef-fective, marketwide clearance through the useof automated systems that assist in the clos-ing of positions.

Clearance and settlement are recognized asan important portion of the national marketsystem. The formation in 1977 of the NationalSecurities Clearing Corp. (NSCC), for whichSIAC (Securities Industry Automation Corp.)is facilities manager, encouraged movementtoward a national clearing system. NSCC com-bined the clearing corporations of NYSE, the

‘sNational Securities Clearing Corp., Annual Report 1980,New York.

v

American Stock Exchange, and NASD. It hasprovided more efficient clearing at lower costsper trade for listed and over-the-countertrading than was previously possible. SIACfacility management for NSCC services in-tegrates several major processes and entitiesin the settlement process (see fig. 5).

One pivotal change in the settlement proc-ess was the development of Continuous NetSettlement (CNS). CNS represented a changein accounting approach to the provision of con-tinuous net positions against the clearing sys-tem rather than a daily balance order ac-counting.” In addition to improving clearingoperations, savings recognized through the ap-plication of CNS have included manpower andsame-day delivery of securities. An importantlink in this system is the Regional InterfaceOperation, which allows member organiza-tions to trade on any exchange and bring set-tlement to the clearing facility of their choice.

The Options Clearing Corp. (OCC), which isowned by the options exchanges, is the clear-ing entity for options trading. It supports theclearing members and participant exchangesby acting as the issuer of all cleared andsettled options, guaranteeing option contractperformance and fungibility, and effectivelyperforming trade clearance, settlement andassociated clearing functions, and other secu-rities industry services.37 The primary objec-tive of OCC is to provide these services in themost cost-effective manner.

Information technology has been essentialin the refinement of the clearing and settle-ment process. It will affect it further throughsome changes that will be felt in the marketas a whole. If substantial trading is conductedoff-market, general access to the automatedsettlement system may be demanded.

Pricing

Pricing occurs at two points in the securi-ties industry: investment bankers assist in theinitial pricing of new issues, and exchanges

———“Securities Industry Automation Corp., A Decade of Pro-

gress, New York, 1982, p. 8.‘“The Options Clearing Corp., Annual Report 19/?1, Chicago.


provide a framework for price adjustments forsecurities. Price in its most pure form is a func-tion of supply and demand. For securities, thisis generally defined to mean the net presentvalue of anticipated cash flow, in terms ofwhat is received in interest or dividends andresale. Initial pricing decisions on new issuesare particularly sensitive for the securities in-dustry since the risk associated with errorsusually falls totally on the underwriter. If theprice is not in line with value as perceived bythe market, the issue will not be bought.

Pricing for securities in secondary marketsmay be done on a historic basis or by auction.Automated trading systems are based on ahistoric pricing mechanism; that is, the priceof an instrument is determined by its pastbehavior. Prices in the auction system aredetermined by market demand. Proponents ofthis system believe that the auction gives atruer evaluation of the worth of the issue andis therefore beneficial in the aggregate to bothsellers and buyers.

The operation of the secondary market forsecurities provides a method for correctingprices. Securities specialists perform a pricingfunction on exchange floors in fulfilling theirfunction of maintaining an orderly market.The specialist, an independent businessperson,performs this function as an auctioneer, buyer,and seller of securities. He makes a value judg-ment about the opening price of a security atthe beginning of each day when opening trad-ing. Although no trading may occur through-out the day, this establishes a price of record.

The specialist facilitates trades by inter-ested brokers on the floor and stands in as abuyer or seller at times when demand andsupply on the floor do not mesh. By standingin as a buyer or seller, the specialist maintainsan orderly market by assuring that pricechanges occur in small increments. This allowsinvestors to assess the market situation of asecurity in a rational fashion.

NYSE now offers a technology-based sys-tem through which investors can more easilyinteract with the market when they want tosell a security at a set price. The limit order

Figure 5.— Overview of SIAC Facility Management for NSCC Services

t 1

I S T O C KBORROW” WR11{ E k

I O R D E R o u t5ERI ILL

I

+ +

+CONTINUOUS

NET SETTLEMENT

+

.

r

DELI\’ERYSER\’ICES

r & +

.~O~EY SE’1”’I’LE.MENT

-f-2&qiI

F+CORRESPO\Dt\TDF1 .} & [ 011 F( I Io\

\ATIO\A!TKA>\FER SFRY ICE

II

# ● ●

NOTE In addition to acting as faclllty manager for the National Securltles Clearing Corp , SIAC provides clearing serwces for AMEX options. AMEX gold coins and NYFE futures Support sewlcesare also provided for the Options Clearing Corp Paclflc Clearing Corp and Depository Trust Co

SOURCE. Securities Industry Automation Corp

Ch. 3—The Securities Industry w 75— — — — — — — ——. —-—— —.—

system electronically files orders to buy or sellwhen a specific price is reached. These ordersare delivered to the appropriate trading postor member firm on the floor. Orders can belimited to a single day or to their cancellation.

In the context of the securities industry,pricing has referred solely to the investmentinstruments of corporations and organiza-tions. Pricing can also be expanded to the ac-tual services of the industry, whose basic func-tions are being unbundled. Although withinthe securities industry pricing is most clearlyevident in the selling and advising function,it is a factor throughout the entire financialservice industry. The securities industry mayhave an advantage relative to other financialservice providers in this area because of theexpertise it has in analyzing markets and inpricing issues.

Technology and the Functionsof the Securities Industry

Technology is changing not the functions ofthe securities industry, but rather how theyare performed. The number of corporations

seeking financing, the number of potential in-vestors, and the level of trading demandedhave all increased to levels that could not beanticipated when the securities industry wasdeveloping. The one element which has not in-creased is the number of hours in a day, andtechnology makes it possible to overcome thathandicap in processing the level of activitydemanded by the market.

Time and distance are no longer obstaclesto communications for the securities industry.Because of this, securities markets may be-come less location-dependent and, as a result,less physically structured. It will be necessaryfor the industry to make efforts to assure thatthe basic purpose of the markets is retained.

Information technology will generate afaster reaction by the securities industry tochanges in market conditions and consumerdemands because communications and com-puter capabilities may lessen consumer re-sponse time. The market can be expected tooperate at a more rapid pace, and while it maybe possible to monitor change more precisely,this market will require quick and well-devel-oped decisionmaking.

The Effects of Information Technology onSecurities Instruments

Securities instruments are designed to satis-fy both the goals of investors and the need ofcorporations and organizations to gather cap-ital to finance industrial research and devel-opment and resulting expansion or diversifica-tion. Securities instruments are of interest indiscussions of the effect of information tech-nology on the financial service industry forseveral reasons. First, the direct impact oftechnology on the securities industry, from thepoint of view of the consumer, may be moststrongly felt in the way in which the character-istics of investment instruments are changed.Second, the intrinsic characteristics of secu-rities instruments may affect the way in which

they evolve in a technology-intensive environ-ment. As information technology changes theway in which the securities industry operates,the relative importance of various investmentinstruments may be affected by informationtechnology.

Third, interest in instruments that are nowon the market may be predictive of which in-vestment products may best meet future de-mands of consumers in terms of liquidity, levelof risk, and return. This type of activity hasalready been seen in the financial service mar-ket in the development of money market mu-tual funds, which were patterned after the idea


of mutual funds and met the consumer de-mand for more liquidity.

The development and trading of securitiesinstruments is largely dependent on the appli-cation of information technology. Such tech-nology has also had a major impact on thecalculation and payment of return and therecording of ownership. The rate of growthseen in options and many types of futures con-tracts would not have been possible withoutcommunications and computer technologies.As securities markets become more technolo-gy-based, it must be expected that investmentinstruments will also.

However, it is unlikely that technology willbe the sole cause of the development of anynew securities product, although it maychange the characteristics of some investmentproducts or expand their application to suchan extent that they are different in functionand operations. As a result of these changes,both investors and their advisors will have toexamine their methods of evaluating potentialinvestments. The characteristics of invest-ment instruments may be expected to changein four ways because of the application of in-formation technology: liquidity of instru-ments, the packaging of securities products,the way in which potential investments areanalyzed, and the importance of speculativemarkets.

The liquidity of an investment instrumentis determined both by the contractual term ofthe instrument and the speed with which theinvestor can trade or redeem the instrument.New communications technologies, notably in-teractive cable and the adoption of personalcomputers with networking capabilities, havebeen applied to allow investors greater accessto securities markets. For example, systemsavailable to individual investors provide up-dated information continually on price and sig-nificant activities involving securities in whichthe investor is interested. Easier access to thisinformation changes the way investments areanalyzed by making it easier for the investorto make decisions on his portfolio in a shorttime frame.

Securities products are being packaged,often with products from other financial serv-ice industries, to fill a wider range of investors’financial needs. This trend is likely to continueas the number of investment options increasesand the demands of users become increasinglymore complex. Much of the new product devel-opment that will be seen in securities marketsmay result from the increasing role of specu-lative markets. The ability of investors to usespeculative markets is increased by the appli-cation of information technology.

Appendix 3A: Securities InstrumentsThis appendix describes, the characteristics of

debt and equity instruments as well as options andfuture contracts. The relationship of informationtechnology to these products and the future effectsof this technology are outlined.

Corporate Capital Structure:Debt and Equity Issues

The capital structure of a firm is determined bythe mix of securities it issues. Capital is developedthrough internal sources—i.e., retained earnings—and through the issuance of debt and equity. Acorporation tries to maximize its market value

through this structure. There can be as manyunique capital structures as there are corporations.The financing plan chosen reflects the operatingand growth objectives of the organization.

While the basic purpose of all debt and equityissues of a firm is the same, to gather capital, theyrepresent different costs and concessions for theissuing organization. The return offered and riskinvolved for the investor also differs substantially.When debt is issued through bonds, the investorbecomes a creditor to the organization; the firmassumes a noncontingent obligation to pay the in-vestor a definite sum of money. Equity issuesgrant ownership in the corporation in return forinvestment. Such shares of stock represent owner-


ship rights proportional to the value of the shareof the firm purchased at the time of investment.

Financing through debt is developed boththrough money markets and capital markets.Money markets are basically wholesale marketswhose major function is liquidity management.They are centered on short-term instrumentsthrough which organizations can manage suchoperating factors as cash flow. Capital marketsare centered on long-term securities, includingboth debt issues and stock, and represent thedevelopment of financing for long-term projectsand goals for the organization, such as equip-ment purchases, research and development, andexpansion.

Long-Term Debt—Corporate Bonds

When money is borrowed on a long-term basis,the contract representing this debt takes the formof a bond. A corporate bond is a fixed, noncon-tingent, long-term obligation to pay a definite sumof money and interest on that amount. The for-tunes of the corporation affect the resale poten-tial of the security but cause the bondholder nei-ther benefit nor loss in terms of return, assumingthat the corporation does not default on the issue.

The market value of the instrument is the pres-ent value of the payments stream to the investor,using market interest rates. The bondholder is acreditor to the corporation and as such has a claimon the assets prior to any by the owners. Corporatebonds have a fixed return, known as a coupon rate,and a specific maturity. The financial benefit theinvestor realizes from the bond depends on mar-ket conditions at purchase and investment oppor-tunities at the time of maturity. A bond issue maybe distinguished in several ways, most notably:how the contract is guaranteed in case of bank-ruptcy, call provisions, registration, the way inwhich interest is paid, and the way in which thebond issue is retired.

SECURED AND UNSECURED BONDS

Bonds may be classified as secured, or mort-gage, bonds or unsecured bonds, called deben-tures. Mortgage bonds are backed by specific cor-porate assets and were historically most popularamong regulated industries, such as railroads andutilities. A closed-end provision in a mortgage con-tract requires that the corporation secure no ad-ditional bonds on the lien. The majority of con-tracts, however, include an open-end provisionthat allows for the issuance of additional bonds

against the property. From the investor’s point ofview, the value of the mortgage lies more in thepotential resale value of the pledged property inthe case of corporate failure than in the exclusivityinvolved.

Debentures are guaranteed by the general creditof the corporation. They have become the mostpopular form of bond issue across the economy andare particularly useful for industries in whichmany assets may be intangible, such as in publish-ing, or have a limited lifecycle, as is the case inmany high-technology industries. Most issues ofdebentures include a negative pledge clause thatprovides that the firm will issue no new debt hav-ing priority over the bonds covered by the agree-ment. This helps ensure that the risk to the in-vestor does not increase over the life of the bond.Debentures are usually subordinate to bank loansand short-term debts.

BEARER BONDS ANDFULLY REGISTERED BONDS

Registration of bonds affects the extent to whichthe investor is protected in case of loss or theft,the way in which interest is paid, and the ease withwhich ownership can be traced and transferred.The ownership of a fully registered bond is re-corded in the register of the issuing organizationor agent. Company records comprise proof of own-ership, and interest is paid directly to the holderof record. If the bond is traded, the issuer or agentmust be notified so that ownership rights may betransferred.

For a bearer bond, the certificate issued at thetime the debt instrument is developed is the onlyproof of ownership. Ownership rights are enjoyedby whoever has possession of that certificate atthe moment. Many investors find that the easewith which the bonds may be transferred and thelack of traceability outweighs the risk of losing thepaper. This type of bond is an extremely flexible,cashlike instrument.

Whether a debt instrument is a registered bondor a bearer bond affects its value and appropriate-ness as an investment for particular investors.Since July 1, 1983, the Federal Government hasrequired all new bonds to be registered to makeit easier for the Internal Revenue Service to de-termine to whom interest is paid and to trace anychanges in ownership. However, there is still a sig-nificant secondary market in bearer bonds. ’ As the

“’The High Price of Financial Privacy, ” Ilusiness W’eek. Aug. 1, 1983,p. 97.


bearer bond is eliminated from the market, someincrease in demand for different instruments thatsafeguard the privacy of the investor to a similardegree may be expected.

A significant difference between bearer and reg-istered bonds from the point of view of both issu-ers and investors is the way in which interest ispaid. The holder of a bearer bond initiates the pay-ment of interest by depositing the appropriate cou-pon at the financial institution of his choice. Fed-eral Reserve collection mechanisms are used by theinstitution to obtain credit for the interest due.Usually, the depositor is paid the interest by thefinancial institution prior to the completion of thisprocess; in most cases, immediate use is granted.The payment system for bond coupons is extreme-ly paper-based. The physical coupon “follows” thecollection process.

Greguras and Carlile suggest that as new tech-nologies make it possible to record essential infor-mation in the physical coupon in a format that canbe used by electronic systems, this type of systemwill allow financial institutions quicker access totheir funds and, as a result, benefit the investor.’Information contained in the coupon could betransformed to electronic form at the point atwhich the coupon enters the redemption process.

The electronic system proposed would result inlittle, if any, change in the action required by theinvestor. Presentation of coupons would remainthe same; from the investor’s viewpoint the cou-pon is already truncated since it is never returnedto the holder. Cost-saving benefits result for theissuer of the bond, the paying agent, and the fi-nancial institution used by the bondholder. Gre-guras and Carlile point out that computer sort ca-pability could replace the current labor-intensivesystem used by issuer and holder.3 The electronicsystem would be faster and would facilitate the de-velopment of computerized bookkeeping and set-tlement systems. It is not clear how the end of newissues of bearer bonds will affect the possibilityof automating the interest payment process, al-though the potential application of this type ofsystem will naturally decline.

The payment of interest on registered bonds iseasier because the paying agent knows the holderand initiates the payment process. Greguras andCarlile note that there is a great potential to useautomated clearing houses (ACHS) for these trans-actions, Following the issuance of a payment or-

‘Fred M. Greguras and Larry L. Carlile, “The Use of Electronic f3ank-ing for Bond Coupon Payments, 1980.

‘Ibid.

der specifying which accounts should be paid bythe bond issuer or paying agent bank, the ACHcould take responsibility for routing these interestpayments, which would be credited to an accountspecified by the bondholder. Savings would resultfrom the elimination of check-processing costs.

RETIREMENT OF BONDS

Bonds may be retired by payment at finalmaturity; by conversion to common stock if theinstruments are convertible; by refunding, throughenacting a call provision; or through periodic re-payment, if the bond is a sinking fund or serialbond issue.

Many bonds contain a provision allowing thecorporation to “call” or repurchase the debt in-struments at any time. This gives corporationsflexibility if market conditions change before thebond matures. The call price is usually above theface value of the bond, but generally this premiumdecreases as the maturity date is approached. Acorporation may move to call a bond because ofa drop in market interest rates or to be free of re-strictive protective covenants that may have beennecessary to gain financing initially. The initialdebt contract specifies whether the call provisionis immediate, that is, can be invoked at any timefollowing issue, or deferred, in which case the in-vestor is assured that no call will take place fora definite period of time, usually 5 to 10 years.

Call provisions become a disadvantage to inves-tors when the stable return anticipated when thedebt instrument was selected for investment islost. The investor may find it necessary to selectan alternative investment. If interest rates havedropped since the original investment, the investormust not only bear additional transaction costsbut also, in some cases, select between less attrac-tive investment alternatives.

For tax purposes, the income gained by the in-vestor from the call premium is treated as a capi-tal gain. For the corporation it is deducted as anexpense from ordinary income. Many experts be-lieve that the net tax advantages received by theinvestors and the corporation make call provisionsattractive to both parties.4

Refunding involves the replacement of one bondissue, prior to maturity, with a new issue of bonds.A corporation may wish to refund an issue to es-cape restrictive protective covenants, but the mostcommon reason is to take advantage of a drop in

‘James C. Van Home, Financial Management and Policy (EnglewoodCliffs, N. J.: Prentice-Half, Inc., 1983), p, 555.


market interest rates. Market conditions must beextremely favorable for the issuing corporation tojustify the expenses involved in refunding, whichinclude the cost of calling the old bonds, issuingthe new bonds, and, possibly, expenses resultingfrom the payment of interest on the old bonds dur-ing any overlap period.

The repayment of a total issue of bonds at ma-turity could present a severe cash strain for theissuer. Therefore, two methods have been devel-oped through which debt issues are retired in amore controlled and gradual manner: the issuanceof serial bonds and sinking fund provisions. Serialbonds give an investor a choice of maturity dates.The entire package of bonds is issued by the cor-poration at the same time, but the bonds matureindividually in successive years.

Most bond issues carry a provision requiringthat the corporation retire a given number ofbonds per year through a sinking fund managedby a trustee. The bond issuer makes payments intothe fund, with which the trustee finances the re-tirement, by calling or purchasing bonds selected(usually) by lottery. While calling before the an-ticipated maturity date may be undesirable for theinvestor, most investors value the assurance of or-derly retirement of debt and liquidity provided bya sinking fund provision. For bondholders whoseinstruments are not called, the sinking fund mayrepresent a reduction in risk, as the total amountof debt the organization holds is continuallyreduced.

PAYMENT OF INTEREST

The return of most debt investments is embod-ied in a periodic interest payment referred to asthe coupon. It is designed to compensate the in-vestor for the time-value of money, the lost oppor-tunity cost, and the risk assumed. Usually, thisis a semiannual payment. The market value of thebond is determined by the present value of thisstream of payments. Bonds with less traditionalpayment schedules have developed in response tomarket pressures. These include income bonds,zero- and low-coupon bonds, indexed bonds, andfloating-rate bonds.

While most bonds are strictly debts of the cor-poration, for which interest must be paid regard-less of the corporation’s financial situation, inter-est is only paid on income bonds when the earningsof the corporation permit. The corporation benefitsfrom the tax advantages of debt, since any interestpaid is deductible because it is part of a contrac-tual agreement, Also, unlike preferred stock, which

is discussed later, the decision to pay interestbelongs to management rather than the board ofdirectors. If not paid, interest accumulates and issenior to preferred and common stock dividendsand subordinated debt.

Income bonds are unpopular with investors be-cause the income stream from their investment isunpredictable. Some experts also believe that thepast association of this instrument with corpora-tions, particularly railroads, trying to avoidbankruptcy has made them unattractive to in-vestors. As a result, income bonds are used pri-marily in reorganizations, which of course mayperpetuate their negative image.’

Return paid on a zero-coupon bond is embodiedentirely in price appreciation to maturity. No pe-riodic interest payment is made, This bond offerstwo advantages to the investor: the bond cannotbe called, so the holder experiences no reinvest-ment risk, and an exact return is assured if the in-strument is held to maturity. For tax purposes,the investor must declare the interest accrued ina given year as interest income, despite the factthat this money is not available for his use. Thecorporation also deducts the interest expense forthe year accrued, although no actual payment ismade. While the corporation enjoys the advantageof no cash outlay until the maturity date of thebond, the no-call provision is a disadvantage ifmarket interest rates fall during the lifetime of thebond,

Two types of bonds, floating-rate and indexed,have become more popular in response to the con-cerns of both issuers and investors that long-termdebt instruments have generally been locked intoa rate of interest that reflected market conditionsat the time of issue, but that may not be desirableif market conditions change. For example, floating-rate bonds, which include instruments for whichthe interest rate is set in relation to 90-day Treas-ury bills, may be attractive to an investor whobelieves that interest rates are likely to rise dur-ing the lifetime of the bonds, and to an issuer whofeels rates will fall. To both parties the uncertaintyabout the return that will be received and the costof the borrowed funds may be disadvantages.

The return on indexed bonds is tied to the rateof inflation and therefore is considered fixed in realterms. These bonds become popular in times ofhigh inflation. In theory, any index can be selectedas a basis for setting the rate paid on this type of

61 bid., p. 551,


bond; however, in the United States the ConsumerPrice Index is generally used.

Information technology may be expected to in-crease the number and complexity of differenttypes of interest-paying plans for bonds. Indexedand floating rates can be designed to respond morequickly to changes in the base line on which inter-est is determined. This may result in some confu-sion for bondholders, as change may occur at sucha rapid rate that the logic behind it may not beperceived. More complex interest-paying arrange-ments will require special attention to the dis-closure of these bond characteristics for investors,a role likely to be the responsibility of brokers andissuers of bonds.

RATING OF BONDS

Two highly respected rating services for bondsare Moody’s Investors Service and Standard andPoor’s. Their ratings result from an analysis of thefinancial and business propects of the issuer andare used by individuals and financial institutionsas a tool for assessing risk.

Moody’s Investors Service offers nine possibleratings, ranging from a low of C, which representsextremely poor prospects for the issuer, to a highof Aaa, which represents an extremely low amountof risk and predicts that it is unlikely that any neg-ative change will affect the issue. Generally, orga-nizations with poor ratings must pay a higher rateof interest to borrow funds to compensate lendersfor risk.

It is rare for the rating of an issue to change.Any reevaluation by Moody’s or Standard andPoor’s indicates a very substantial change in thecondition of the issuing firm and attracts a greatdeal of attention from investors.

Those bonds that Moody’s rates “Baa,” thefourth highest rating, or above are consideredinvestment-grade bonds. Some financial institu-tions, including some commercial banks and manypension funds, are not allowed to invest in anyissues that do not make this grade. Some expertsbelieve that rating services have caused certaintypes of organizations, particularly municipal gov-ernments, to pay higher than warranted interestrates because of unfavorable and perhaps some-what subjective ratings.6 However, investmentcounselors and investors still rely heavily on therating services.

Information technology may be expected tocreate more competition in rating bonds as thecapacities of new online computers and interactivecable are explored. As technologies become moresophisticated and interactive systems become lesscostly, it has become possible to personalize ratingservices to the objectives of the individual investorin real time.

BOND TRUSTEES

As will be discussed later, the interests of theshareholders of a corporation are represented bythe board of directors. Bondholders have a specialrepresentative—the trustee—who is not part ofcorporate management and who is expected to actin bondholders’ best interests. Paid by the issu-ing corporation, the trustee is usually a commer-cial bank. The responsibilities of the trustee forbond issues over $1 million are specified in theTrust Indenture Act of 1939 and involve protect-ing the rights of the bondholders by ensuring boththat the initial contract is legal and, following theissue, that the corporation fulfills its contractualresponsibilities to the bondholders. This act, whichis administered by the Securities and ExchangeCommission (SEC), requires that the trustee actstrictly in the best interests of the bondholders.

It is the responsibility of the trustee to act toprotect the interests of the bondholders if the com-pany is in default—that is, fails to meet the provi-sions of the bond contract. This responsibility hasbeen brought to the forefront by the recent defaulton Washington Public Power Supply System(WPPSS) bonds. A problem the bond trustee ap-pears to be encountering is reaching and purvey-ing information to the 78,000 holders of the bonds.

in spite of the press received by the WPPSS de-fault and the efforts by the trustees to reach andinform bondholders, it appears that, prior to thefirst missed coupon payment on the WPPPS bonds,many bondholders did not know or did not under-stand that there was a problem.7 Communicationtechnology may facilitate attempts by the trusteesto reach bondholders in the future by improvinginformation flows and corporate recordkeeping.

THE EFFECT OF INFORMATIONTECHNOLOGY ON LONG-TERM

DEBT INSTRUMENTS

Long-term debt is likely to remain a significant

‘Brealily and Myers, p. 468.

part of corporate capital structure. Information

‘Lynn Asinof, “WPPSS Begins to Cause Pain for Investors, ” TheWall Street Journal, Dec. 28, 1983, p. 15.

—

Ch. 3—The Securities Industry— .—.——. . —

technology may change the approach of organiza-tions searching for finance and investors seekingdebt instruments as the following impacts of themain advantages of automated systems are felt:increased speed of handling information, moreprecise and less expensive analysis, and improvedcommunication systems.

Equity

A firm may also decide to gather capital throughissuing equity, or ownership rights, in the form ofcorporate stock. The investor receives with theshares of stock he owns rights proportional to thetotal amount of stock issued by the corporation.Equity capital strengthens the balance sheet andenhances the future borrowing power of the com-pany. Decisions to issue debt or equity are usu-ally based on what will maximize the market valueof the corporation.

From the point of view of potential investors,the purchase of equity may give the opportunityto share in the growth of the company. As some,if not all, of the return received may be in the formof capital gains, the investor may find a tax advan-tage in equity investments. Equity shareholdersmay also receive an income stream in the form ofdividends as a form of return on their ownership,In some cases, this return may be greater thanwhat would be realized from a debt investment.While tax laws have been subject to change, attimes there have been tax advantages from incomein the form of dividends rather than interest.

A firm may sell equity in two forms: commonstock or preferred stock. The choice will dependon the financial structure and objectives of the cor-poration and on industry and market conditions.The equity profile of a corporation may be ex-tremely complex. Both common and preferredstocks may be issued, and several varieties of pre-ferred stock may be active simultaneously.

COMMON AND PREFERRED STOCK

Common stock is generally more significantthan other types of securities in the capital struc-ture of a firm. The holders of common stock haveresidual rights to the income of the firm, whichthey usually receive in the form of dividends. Atthe same time, the liability of individual share-holders is usually legally limited, particularly forthe debts of the corporation. Additional rights ofholders of common stock include a claim on com-pany assets in the case of bankruptcy, followingthe claims of creditors and holders of preferred

● 8 1

stock; the right to maintain their share of owner-ship through purchase of new shares issued by thecorporation; the right to information on the oper-ation of the firm, to the extent that it is competi-tively feasible; and the right to transfer ownershipto another investor.

The most significant benefit for the owner ofcommon stock is the right to maintain control ofthe corporation through the election of the boardof directors, who in turn appoint the officers of thefirm and represent the interests of the holders ofequity in the firm. The management of the corpora-tion is expected to act in accordance with thegoals of the owners and to be accountable to themthrough the board.

Preferred stock is considered a safer investmentbecause holders of these shares have a claim onthe assets of the company before holders of com-mon stock, although after the holders of debt, inthe case of bankruptcy. Owning such stock alsocarries a prior claim to income in the form ofdividends. However, the preferred stockholderusually enjoys only limited voting rights, so thathe has less impact on the operation of the corpora-tion than do common stockholders.

DIVIDENDS

Depending on the corporation’s profits, corpora-tion earnings may be used to pay dividends tostockholders at the behest of the board of direc-tors. Dividends are only declared when the pay-ment will not impair the operation of the firm orlegally compromise its contractual relationships.tionships.

Two significant dimensions of the dividend pol-icy of a corporation are dividend stability and long-run dividend payout ratio. a A dividend may bestable in terms of real dollars paid out or in theratio of dividends to earnings. While the lattermay appear more rational, it is rarely used. Con-sideration of the return expected by stockholdershas led most corporations to pay a stable dollardividend when possible, indicating the importanceof income as a motivation for investing in equityissues.

Decisions on long-run dividend payout ratiosmay be based on the objectives of the owners andmanagement of the firm. The reinvestment of asignificant portion of earnings may result in highergrowth for the corporation as a whole and maybeattractive to investors desiring long-term income

‘Lawrence D. Schall and Charles W. Haley, Introduction to Finan-cial Afanagement (New York: McGraw-Hill, Inc., 1980), p. 366,


in the form of capital gains. In this case, earningsare used as a form of internal financing, and anydividend paid is from earnings left over afterfinancing objectives are met. If the shareholdersof the corporation are interested in more immedi-ate income, a fixed payout may be used. In thiscase, the amount of money available for internalfinancing would differ from year to year as itwould be, in a sense, the residual part of earnings.

THE EFFECT OF INFORMATIONTECHNOLOGY ON EQUITY

Information technology may be expected to af-fect equity instruments directly in three areas: thepayment of dividends, the recording and proof ofownership, and the transfer of ownership. Thetransfer of ownership of stock will be examined asa function of the securities industry in a latersection.

The improved ability of shareholders to moni-tor and analyze the activities of corporations moredirectly through the use of new technologies mayalso have some impact on individual firms. Themagnitude of this impact will largely depend onthe characteristics of the ownership of the corpora-tions involved. An increased awareness by theshareholders of the environment and operation ofthe firm may be a benefit; however, managementsand boards of directors may find an increased de-mand for information dissemination and respon-siveness.

Detailed records are maintained on who the cor-poration’s shareholders of record are to assure thatthey receive their ownership rights. While tradi-tionally this operation was solely paper-based andinvolved the issuance of certificates that servedas proof of ownership, there is some indication thatthe application of information technology is facil-itating a movement toward a book entry system.This type of arrangement is expected to benefitthe issuers of equity by lowering operating costs,including those of printing and postage, and tobenefit the holders of equity by making it easierto transfer ownership of these securities.

Book entry may require some adjustment byshareholders because the mechanics of proof ofownership will differ. The success of this type ofprogram will depend largely on how apparent andimportant the benefits involved are to the in-vestor, particularly when trading.

The mechanics of developing a dividend policymay be aided by the application of informationtechnology; however, the value of improvementsin communications and computer capabilities is

likely to be most directly felt in the actual payingof dividends. Operation costs for this activity maybe expected to decline as recordkeeping and sort-ing activities can be automated. It may also bepossible to use electronic funds transfer for thepayment of dividends. While initial costs for thistype of system may be high, the resulting efficien-cies and the decrease in postage costs may be ofgreat benefit.

Convertible Securities

Preferred stock or bonds that can be convertedto common stock at the option of the holder arecalled convertible securities. Such securities offera middle ground to investors who demand lowerrisk than common stock carries yet want to par-ticipate in the growth of a corporation.

Convertible bonds offer both interest paymentsand conversion opportunity. This instrument is at-tractive for the issuing corporation because gen-erally a lower-than-market rate of interest may beoffered, owing to the conversion option. A corpora-tion may view a convertible bond as both a short-run debt and long-run equity issue without thecost of two separate issues. Convertibles are con-sidered deferred common stock financing. Theseinstruments were also traditionally attractive tonew or speculative corporations unable to gatherequity capital on other terms or to corporationswith low-grade credit ratings.

Compared to the issuance of common stock, theissuance of convertible bonds creates less dilutionof earning per share at the time the bonds are firstoffered and at the time of conversion. At the timethe bonds are issued, no stock is involved; at con-version, the size of the conversion generally addsfewer shares than a new issue of common stockwould. Usually, it is expected that the financialcondition of the issuing firm will be improved inboth yield and stability at the time of conversion,as indicated by the fact that the conversion priceis higher than the market price of the commonstock at the time the bond is issued.

The stock package stipulated in the conversionplan may be more favorable to the organizationthan one designed later when changing marketconditions could be taken into account. The expec-tations of investors for the common stock provi-sion may be less stringent at the time the bondsare issued because of both the benefits to be re-ceived before conversion and the anticipation ofparticipating in corporate growth at the time ofconversion.

The tax provisions of typical convertible bondsmay be beneficial for investors. The conversion ofthe bond to common stock is considered a tax-freetransaction by the Internal Revenue Service. Theyear-plus-one holding period for long-term capitalgains on any subsequent sale of the common stockis counted from the time the bond, not the stock,is issued.

One variation on convertibles that often resultsfrom failed takeover bids is the exchangeablebond, which can be converted to the stock stipu-lated in the bond contract of a corporation. Thisstipulated stock may be issued by someone otherthan the issuer of the bond. The exchangeablebond requires the investor to evaluate the creditpotential of the issuing corporation and the long-range growth and earning potential of the firmwhose common stock is involved. Tax provisionsmust also be a major concern for such an investor. g

The Internal Revenue Service considers this con-version to be the equivalent of two cash trans-actions because the securities of two different cor-porations are involved. Since the bond would notbe redeemed by a rational investor unless the stocksells for more than the original cost of the bond,a taxable gain is realized.

Recently, the interest in this bond instrumentby both corporations and investors has grown.While in the past institutional investors domi-nated this compromise market, individuals arebecoming more active. Information technologymay be expected to affect convertible instrumentsto the extent that it makes more sophisticatedanalysis cost effective for investors and financialintermediaries, and therefore the complex natureof the instrument may be less of a disincentive topotential issuers and investors. Growth in thisarea may be expected, however, to be related pri-marily to the fiscal needs of corporations involvedand to the demands of consumers.

Short-Term Debt–Money Market Securities

The essential characteristic of money marketsecurities is their liquidity. This derives from theirshort maturity, by definition less than 1 year, andthe generally high quality of the issuing organiza-tion. ’” There are several types of money market

—“’Investing in Convertible Bonds,” Business U’eek, June 20, 1983,

p. 191.‘“Roland 1. Robinson and Dwayne Wrightsman, Financial ,$fm-kets;

The Accumulation and Allocation of Wealth [New York: McGraw-Hill,Inc. 1974), p. 14’7.

Ch. 3— The Securities Industry ● 83

securities and, as the market demands, it is likelythat additional instruments will be developed.These short-term debt instruments include Treas-ury bills, certificates of deposit, commercial paper,bankers’ acceptances, and repurchase agreements.They are important to corporations in money man-agement as both financing tools and investmenttools.

A Treasury bill is a short-term debt of the U.S.Government. The bills are sold on an auction basisat a discount from face value. Since the U.S. Gov-ernment is continually borrowing to pay off debts,Treasury bills are issued on a very frequent basis.Biddings are closed by the U.S. Treasury weeklyfor 91- and 182-day debt issues and monthly for9- and 12-month bills. Short maturities and thebacking of the U.S. Government make them de-sirable investments.

Although the market is quite short-term, an ac-tive secondary market has developed. Therefore,bills can be traded before the maturity date, add-ing to their liquidity. Treasury bills are a desirableshort-term investment tool for corporate investorsbecause of the high level of liquidity and low levelof risk they carry.

Commercial paper is a short-term debt issued byfinance companies and some other corporations.Interest rates for commercial paper are generallyhigher than for Treasury bills because of the riskfactors involved in private firms. Many companiesuse commercial paper to supplement bank loans.In general, it is a less expensive method of financ-ing for prime quality obligatory than loans (be-cause banks are not used as intermediaries) andmay fill a need at a time when the issuance of long-term debt is not appropriate. The issuance of com-mercial paper lacks the supportive, interactivenature of a relationship between a corporation anda commercial bank.

Commercial paper may be sold directly by theissuing corporation or through a dealer. Sincedealers screen the instruments to a certain extent,commercial paper placed by a dealer may be lessrisky for an investor, although commercial paperdirectly placed by some major corporations is ofvery high quality. The investor holds an unsecuredshort-term promissory note as evidence of thedebt, and the instrument is tradable in moneymarkets.

Commercial paper is designed to avoid a require-ment of registration with the SEC. Because of pastproblems in commercial paper markets- specifical-ly, those generated by the bankruptcy of PennCentral-investors have caused the market to


become quite conservative. Commercial paper ofcompanies that do not have a very high financialreputation is rarely marketable.

Banker-s’ acceptances, which originated at aboutthe same time as international trading, continueto play a significant role in importing and export-ing. A banker’s acceptance is issued by a corpora-tion and guaranteed by a commercial bank. Theacceptance is a liability of the bank and is tradedin money markets based on the reputation andcredit standing of the bank. The instruments areof value in international trade, owing to the time-lags that can occur because of the physical aspectsof transporting goods and because of the uncer-tainty with which many traders approach foreignmarkets.

Certificates of deposit are negotiable securitiesissued by commercial banks. They have fixed ma-turities and pay interest to maturity. Yields on cer-tificates of deposit are higher than for Treasurybills and are paid at the time the certificatematures, The risk associated is dependent on thequality of the issuing bank. Certificates can betraded in a secondary market before maturity; thismarket is particularly active for the certificates ofdeposit issued by major commercial banks.

Repurchase agreements stipulate that the short-term securities sold will be repurchased by theseller. They are frequently issued by bond dealersto finance inventories. U.S. Government securitiesare the usual basis for the agreement throughwhich an investor “purchases” the securities whileagreeing to resell them at a specified time andprice. The term of repurchase agreements may befor several months or for overnight, and thereforehas the potential to offer a great deal of flexibility.

Major questions involving repurchase agree-ments center on the level of risk involved and howthe transaction should be classified. Historically,repurchase agreements were considered extremelysafe transactions, although they are not federallyinsured, because they involve Government secu-rities and are handled by recognized players in thefinancial service industry. However, recent col-lapses of dealers caused some investors to experi-ence high losses.

The qualification of repurchase agreements asa sale or debt has created some controversythroughout the financial service industry. The In-ternal Revenue Service has held that it is a col-lateralized debt, and therefore the investor wouldbe liable for interest income received. Dealers inGovernment securities sales disagree and considerthe instrument to be a purchase/sale agreement.

Congressional action is expected to confirm thisstance. 11

The short-term debt market has been greatly af-fected by the use of information technology. Thenature of some short-term debt includes a definiteend-date for the instruments. Improvements insorting and transacting brought about by comput-er capabilities may extend the effective lifecycleof the instrument since it can be marketed morequickly. The availability of better data and the im-proved ability to analyze information about thedebt instrument and about the issuing organiza-tion may affect the market for short-term debt in-struments. The potential of short-term debt in-struments as investment tools may be expectedto improve to the extent that the application oftechnology will refine this evaluative process.

Information technology may also improve thepackaging of short-term debt instruments by al-lowing securities industry marketers to match bet-ter the characteristics of various instruments tothe demands of investors. The proliferation ofmoney market mutual funds and demand accountsmay be a result of this opportunity.

Options and Futures Contracts

The capital market investor’s investment goalsmay not be completely met by debt and equityissues. The desire of investors to increase their li-quidity or return or to limit risk has led to the de-velopment of instruments that comprise what maybe considered a second-tier securities market.These securities are based on the fortunes and fluc-tuations of capital markets, but are not essentialto the capital structure of individual firms.

Off-shoot investment products include optionson stocks and bonds and futures contracts on com-modities, currencies, and market indices. These in-struments are all based on the market behavior ofunderlying products or securities. The interest ofthe investor is focused on the price fluctuationsof the product, usually in a relatively short timeframe, rather than on the intrinsic operations ofthe firm. Interest in options and futures contractsinvestment has led to the development of an in-dustry structure specializing in these products, in-cluding exchanges and clearing corporations. Thedevelopment of this structure has increased inter-est in the products and has led to further growthin option and future contracts trading.

“’’The Repo Market Is Still in Shock, ” Business Week, Apr. 4, 1983,p. 74.


Options

Options provide a method of participating in asecurities market without ownership of actual debtor equity instruments. An option is a tradable in-strument that grants an investor the right to buy(a call option) or the right to sell (a put option) aspecific security at a given price for a limitedamount of time. It is a legal contract in which twofactors are explicitly stated: the expiration dateand the exercise price. The value of an option isdirectly related to the market price of the under-lying security. The exercise price of an option in-dicates the change anticipated in the market. Theexercise price of a call option (at which the investorcan buy the underlying security) is, at the time theoption is issued, generally higher than the marketprice of the security. Conversely, the exercise priceof a put option, which entitles the holder to sellthe security, is generally lower than the marketprice. Options may be written and sold for realestate, debt instruments, and foreign currencies;they have recently become most significant inequity markets.

Options are “wasting assets”; that is, after thespecified expiration date, they have no value.Therefore, the timing of market changes, as wellas direction, must be correctly evaluated by theinvestor to assure that the potential value of theinvestment is realized. The writer of an option, ex-cept for warrants, which are discussed below, isnot controlled by the organization named in theunderlying security. More shares of stock may berepresented collectively through outstanding op-tions than have been issued by the corporation.While option writing and buying may be part ofa complex investment portfolio that includes debtand equity instruments of an institution, the oper-ations of option markets are, in a practical senseat least, totally separate from the capital structureof a corporation.

While options have been traded among individu-als for many years, the market has grown andbecome more sophisticated since the organizationof regulated exchanges in the mid-1970’s. Thetrading of options entails a relatively new marketstructure; therefore, the influence of informationtechnology on this structure is quite visible. Forexample, options use book entry rather than cer-tificates as proof of ownership.

PARTICIPATING IN THE OPTIONS MARKET

Participants in options markets attempt to prof-it from their knowledge of the potential declinesand rises of a corporation but have no direct stakein its operations. In the basic options market,players may be involved in four activities: buyingcall options, buying put options, writing call op-tions, or writing put options.

An option buyer hopes to profit from or protecthimself from a change in the price of the under-lying security. The holder of a call option has theright to buy a security at a specified price. Thisinvestor may do three things with this right: ex-ercise it by buying the underlying securities, sellit to another investor, or let it expire. He has nolegal obligation to make any transaction of theunderlying security. Further action on his part in-volving the contract is self-motivated and will re-sult only from his evaluation of the market.

The writer, on the other hand, is obligated to buyor sell the underlying security under the conditionsspecified in the contract. His continued involve-ment with the instrument is not voluntary and,while in some cases may not be required, is legallyenforceable. Both writers and buyers of optionscan liquidate their positions by purchasing off-setting options before the expiration or exerciseof the option.

The motivation of an investor to buy a call op-tion may be related to two separate strategies. Hemay hope to participate in the benefits of a risein stock prices with a limited current investmentand therefore may buy call options to achieveleverage or establish a future price at which heplans to purchase the security. He may also bemotivated to purchase call options to limit risk,either as part of a conservative overall investmentstrategy or to hedge a short stock position.

For the individual investor, leverage may bemeasured through the percentage of total assetsnecessary to invest for a given rate of return. Itis assumed that the financial assets of an in-dividual are finite and that each investment deci-sion is evaluated by its opportunity cost. Achiev-ing leverage could be the motivation for buyingcall options for an investor who expected the priceof an issue to rise. The cost of buying a call optionfor a given number of shares of stock representsa much smaller investment than does the purchase


of the shares. A higher percentage of return on in-vestment may result in the case of a rise in theprice of the stock to the holder of a call option.However, it must be recognized that with a highlyleveraged investment, a larger share of the invest-ment may be lost. Since options are wasting as-sets, the investor must be correct in his evalua-tion of the timing as well as the likelihood of a priceincrease in order to profit from his purchase of op-tions. If the option expires without being exer-cised, the investor’s loss would be equal to his in-vestment. Absolute return or loss will usually belower for the option investor than if he held theequivalent number of shares of stock.

Options are also bought by investors who wouldlike to invest in the underlying security and ex-pect its price to rise but who do not have the cashto make the investment. The call option estab-lishes a guaranteed maximum price for the secu-rity. This strategy is particularly useful if the in-vestor anticipates receiving a flow of cash beforethe expiration of the option. If the price of thestock falls below the exercise price, the investormay purchase the security at the market price andconsider the option a sunk cost.

While investment in options increases the lever-age and establishes the price of future stock forthe investor, the lower dollar investment requiredto buy call options rather than stock limits abso-lute risk, since the investor exposes less of hisassets to the market. A common, conservative in-vestment strategy is to purchase call options andinvest the difference between the options and theprice of the underlying security in a low-risk in-strument, such as Treasury bills. Any loss in-curred through the options investment would beat least partially off-set by the interest earned onthe investment of the remainder.

Decreasing risk may also motivate an investorto purchase call options if he maintains an ex-tremely risky position in equity markets by sell-ing short, that is, selling securities he does not ownin anticipation of a price decline. This investortheoretically exposes himself to unlimited loss ifthe price of the stock increases because he wouldbe forced to pay market prices to deliver the secu-rities. By buying call options, the investor whotakes a short position establishes his maximumpurchase price for the securities he is selling andtherefore insures himself against limitless loss. Ofcourse, if the market behaves in the manner antic-ipated by the short seller, the price of the optionis lost profit.

While the buyer of call options generally acts inanticipation of increases in the price of the under-lying security, the buyer of put options attemptsto profit from or limit risk if the price declines. Theoption grants the holder the right to sell at an es-tablished price, and therefore it can be used forleverage and for limiting risk. As with call options,the investor must have correctly analyzed the di-rection of the price change and the timing of thechange in order to profit.

The conservative investor can use put optionsas a hedge against a substantial decline in the priceof a stock he holds. This strategy may be particu-larly attractive as protection for an individual whohas a significant portion of his assets invested ina single security. However, it must be recognizedthat the insurance provided only lasts through thelife of the option and that the cost of the optioncuts into the investor’s potential profits.

The writer of an option exposes himself to fargreater risk than the buyer does. A writer of calloptions may be required to sell the underlyingsecurity to a holder at the exercise price at anytime during the life of the option. Conversely, thewriter of a put option may be required to buy theunderlying security from the holder at any timeduring the contract.

The writer of call options is motivated by thepossibility of gaining a return through premiumincome, Calls may be covered, wherein the writerowns the specified underlying security, or uncov-ered, wherein the writer would be required to pur-chase the security at market cost if he is assignedan exercise. Leverage for an investment portfoliomay be the most significant motivating factor forthe writer of covered calls. Return from the under-lying security may be realized both through divid-ends or interest paid and through income receivedfrom premiums. While the covered call writer mayhope to maintain his position in the underlyingsecurity, option writing may greatly increase hisincome-producing potential.

The writer of uncovered calls is the player atmost risk in the options market. His potential lossmay equal the market price of the stock less thesum of the exercise price and premium received forthe option and, in theory, is limitless. The un-covered call writer must be extremely sensitive toany factors in the economy at large or for the cor-poration that may cause a significant price in-crease.

A writer of put options is obligated to buy thespecified underlying security at the exercise price

Ch. 3—The Securities Industry . 87

at any time until the option expires, The put writermust have sufficient liquid assets to buy the secu-rity and, as an exercise is only likely when the ex-ercise price is higher than the market price, hemust anticipate paying more than the value of thesecurity. The option writer who trades through anexchange is required to deposit cash or securities,referred to as margin, with a brokerage firm. Putsmay, alternatively, be secured with cash equal tothe option exercise price. No additional margin re-quirements will be required in this case, and in-terest may be earned by the writer on the cash de-posited.

Investors are usually motivated to write putsby a desire to earn income from premiums, theprice paid by the buyer of an option to the writerof that option. The opportunity to purchase thespecified securities may also be a motivating fac-tor in some cases. In a stable or rising market, itis possible to earn premium income with relativelylow risk; however, demand for put options may beexpected to be fairly low in this circumstance.Some put writers hope to acquire the stock at anet cost which, considering premium income, isless than the current value of the stock.

The four possible ways of participating in theoptions market may be combined by an investorto form a strategy he believes is most likely tomeet his investment goals of producing income orlimiting risk. The options tactics chosen are influ-enced by the investor’s expectations about howthe price of the underlying security is likely tochange in direction and magnitude.

Spreads and straddles are the two most commonmultiple-options investment strategies. Spreadsare used to limit risk in option transactions andinvolve writing and buying the same type of op-tion, calls or puts, for the same specified security.The options generally have different expirationdates or exercise prices. If the investor wereassigned an exercise for the option he wrote, thespread benefits would disappear, and his risk posi-tion would be drastically changed. The writer ofspreads generally anticipates little change in theprice of the underlying security. A stable marketprovides his best opportunity for profit.

The investor who anticipates a great change inthe price of an underlying security but is unsureof the direction or magnitude may maintain astraddle position. The straddler either writes orbuys both a call and a put option for the same secu-rity. Both the call and the put should have thesame exercise prices and expiration dates. Buyingstraddles has limited risk because maximum loss

equals the premium price and, theoretically, un-limited profit potential. However, the price changemust be significant in order for the investor toprofit, and the investor must be correct in hisevaluation of the timing of the change. Straddlewriters are generally motivated by their belief thatthere will be little, if any, change in the price ofthe security and, therefore, that if an exercise wereassigned, profit from premium income would in-sure a net profit after costs of satisfying the exer-cise conditions. Risk for straddle writers is limit-less, as a substantial loss can be incurred on bothpositions if the market price for the security fluc-tuates more than expected.

PRICING OF OPTIONS

The premium (i.e., price) of an option is subjectto change and is influenced by characteristics ofthe option, the underlying security, and generaleconomic conditions. Factors influencing the pre-mium include the expiration date of the actual in-strument, the price and volatility of the underlyingsecurity, supply and demand effects on the optionmarket for the specific security, and, on the wholeas well, interest rates. The premium for an optionis comprised of intrinsic value and time value. Anoption has intrinsic value any time the differencebetween the exercise price of the option and themarket price of the security works to the advan-tage of the holder. Anytime this is not the case,the option has no intrinsic value, and the premiumis based only on time value.

Time value represents an evaluation by an in-vestor of the potential of the option to increase invalue owing to a change in the price of the under-lying security prior to expiration of the option.Time value may generally be expected to declineas the expiration date approaches and as the pos-sibility of fluctuation in the security price de-creases. It is also influenced by the amount of dif-ference between the exercise price and the marketprice of the underlying security. A large differencemay result in a decrease in time value because thepossibility of profitably exercising or selling of theoption is more remote. Increasing interest ratesgenerally result in increases in time value.

Warrants

A warrant is unique because it is issued by thecorporation that issues the underlying securityand, as such, is part of the capital structure of thefirm. A warrant is a type of call option that grantsthe holder the right to purchase company stock

35-505 0 - 84 - 7 : QL 3


at a stated price, usually somewhat above marketat the time of issue. The value of the warrant itselfat any time is dependent on the current price ofthe stock of the issuing corporation. Warrants areoften offered with debt issues by corporations tomake the debt issues more attractive to potentialinvestors. They offer a participation right of sortsif the corporation grows. The investor benefitsfrom the fixed return of the debt investment aswell as the opportunity to purchase stock at anestablished price.

As with all options, an exercise price is specifiedfor the warrant. It may have a specific expirationdate or be perpetual. The contract also specifieswhether it can be traded, as with other option in-struments, or be exercised only by the holder.

Unlike other options, warrants directly affectthe capital structure of a corporation. A call or putoption is exercised through a capital market andwith no net change in the number of shares out-standing for the corporation. However, when awarrant is exercised, the corporation issues newshares of stock; therefore, the earnings of the com-pany, from the point of view of the shareholders,are diluted. This situation complicates valuationboth of the stock of the corporation and of thewarrant.

THE EFFECT OF INFORMATIONTECHNOLOGY ON OPTIONS

Information technology is likely to continue tofacilitate the development and trading of options.Because option markets have only recently be-come highly structured and have been heavily de-pendent on technology from their inception, thecontinuing application of communications andcomputer technologies in these markets is notlikely to lead to major revisions in ways of doingbusiness to the same extent as they have in debtand equity markets. Options may serve as a test-ing ground of sorts for new technologies, and tech-nology use in this area may presage future applica-tions throughout the securities industry.

The use of personal computers and sophisticatedcommunications technologies may spur the devel-opment and marketing of option contracts by in-dividuals and may lessen the role of brokers inbringing writers and buyers together. Informationtechnology should also facilitate the monitoringof option markets by investors, brokers, corpora-tions issuing securities on which options are writ-ten, and market observers and regulators. Thismay become increasingly important as the use ofoptions as an investment instrument grows.

Futures

Futures, or future contracts, are legally bindingagreements that call for the purchase or sale of realor hypothetical items at a stated price at sometime in the future. Future contracts can be devel-oped for anything and are traded on establishedexchanges for physical commodities such as porkbellies and coffee, for financial instruments, andfor hypothetical stock portfolios.

Even though future markets at one time werefocused only on commodities; they have expandedgreatly. In the past, communities needed to be self-sufficient in their production of foodstuffs andother necessary goods because transportation be-tween regions was not efficient. As lack of trans-portation became less of a barrier to trade, com-modities markets developed that allowed forspecialization in production and made a widerassortment of goods available. Centralized com-modity markets made more extensive trading pos-sible, and future markets grew from them to ad-dress price-change risks.

Commodity futures markets developed becauseof the need in both agricultural and industrialsocieties to minimize the potential impact of un-known and hard-to-predict forces that influencethe price and availability of resources and prod-ucts. For example, through the use of futures con-tracts, food processors are able to set definite max-imum prices for the commodities they will need forproduction throughout the entire year. Most cropsare only harvestable for a very short period of timein any year, and it is desirable for farmers to beable to sell all of the harvest at that time to avoidthe need for expensive storage. While the demandfor some food products, such as turkey and pump-kins, may be seasonal, food processors face a year-round demand for products made from commodi-ties only available for a very short time. Theseprocessors need to have the commodity availableat a predictable price when it is needed. By pro-viding a reliable means to conduct future buyingand selling, futures markets have served to equal-ize the marketing of most seasonal farm crops. 12

The development of futures markets centeredaround the desire to transfer risk. The play of themarket attracts a large quantity of risk capitalthrough which changes in commodity price levelscan be absorbed with only a minimum direct im-pact on producers and processors of commodities.

‘2 Future Industry Association, “Development of Commodity Ex-changes, ” Futures Trading Course and Handbook, Washington, D. C.:1983, p. 1-4.


This allows the producers and processors to oper-ate at lower cost than would be possible if they hadto bear the entire risk of market fluctuations. Inturn, this lowers prices to the public. ”

Commodity futures markets help effect stabilityin consumer prices. Because food processors canbound their costs, consumers are assured thatproducts will be available when needed at a rela-tively predictable price and therefore approach themarket in rational manner. This price stability isboth of importance to the general economy of theNation and of social interest, since allocationsthrough Government programs, such as foodstamps, can be set with some certainty as to whatmarket conditions will be for the recipients.

THE OPERATIONS OF FUTURES

The taking of a position in future contracts fora product on which one depends in one’s primaryeconomic activity is called hedging. For example,General Foods might be expected to hold a posi-tion in coffee futures contracts to guarantee themaximum price it would need to pay for beans forfuture production. In the discussion of futures,hedging is not a speculative strategy but ratherrefers only to the activities of players who face riskbecause of possible fluctuations in price and avail-ability of an actual commodity.

STOCK FUTURES

Options, which were discussed in an earlier sec-tion, allow for the transfer of risk associated witha particular debt or equity issue. Broad changesin the stock market prices pose a blanket risk tohighly diversified investors, and stock futures mayoffer inherent price change protection to these in-vestors. Stock futures are contracts that call forthe buying or selling of a mythical basket ofstocks, usually a grouping which is used in an in-dex of market behavior. Due to practical limita-tions, these futures are settled through cash ratherthan the actual purchase or sale of the underlyingsecurities.

The availability of stock futures through whichan investor can hedge against swings that affectthe entire stock market may add a great deal ofstability to that market and is expected to be ofgreat significance to institutional investors, whohold a growing proportion of all shares. Investorsmay be more judicious in their response to mar-ket changes because their risk may be minimizedby the holding of offsetting positions in stock

“Ibid.

futures, and therefore the stock market may be-come less volatile.

If the stock market becomes less volatile, itmust be expected that funds currently held inmutual funds or the savings instruments of depos-itory institutions because of the desire of the in-vestor for stability will be transferred to direct par-ticipation in capital markets. More money may beavailable for corporate capital formation; how-ever, this may be at the expense of the bankingstructure.

Questions that must be addressed are: what hap-pens to the risk that is transferred away from thestock market? and what effect will this transferhave on the market? The result may be that theassumers of risk, in this case players in stockfutures, may be expected to be advised better andmore able to accept this position.

One cannot blindly accept that risk was bad forthe stock market when, in fact, it was the market’sreason for being. It is essential that some meansof projecting what the impact of the possible endof the need for a risk-accepting role by stock ex-changes will mean to the process of capital forma-tion be available. It is also necessary to determinewhat, if any, effect the activities of markets instock futures will have on the inherent soundnessof capital markets. Stock futures may cushion thestock market from changes in the general econ-omy; however, it is not clear what impact a cata-strophic event in the futures market might haveon the entire capital formation process.

THE EFFECT OF INFORMATIONTECHNOLOGY ON FUTURES

Futures markets provide a glimpse of what thepossible impacts of information technology on thesecurities industry as a whole may be. The poten-tial of information technology was available asmany of the operations of this segment of the in-dustry were developed.

Modern futures markets need both man and ma-chine to operate. Human decisionmaking has beenand will continue to be the one irreplaceable andessential characteristic of any successful market.However, the volume of trading demanded by cur-rent market conditions requires a level of opera-tions not feasible for mortals in a free society atan acceptable cost. It would be impossible to op-erate futures markets with the precision and at thevolume demanded by the market without the ap-plication of information technology; for example,for performing simple tasks, such as sorting faster,that would be impossible for a human work force.


Computer and communications technology didgenerate a futures market; however, if these tech-nologies were not available, the market could nothave grown to its current size and importance. Itsabsence would have effectively foreclosed the pos-sibility of responding to the demands of the econ-omy for the level and quality of operations nowseen.

Mutual Funds

The importance of mutual funds as institutionalinvestors is discussed earlier in this report; how-ever, these funds also have a role in the securitiesindustry in the role of investment instruments.

Mutual funds offer investors a way of partici-pating in securities markets without directly pur-chasing capital or money market securities. An in-vestor may be attracted to a mutual fund as a sortof proxy method of participating in the securitiesmarket. The individual benefits from the expertiseof the fund management, and risk is generallylower than that through direct participation, al-though actual risk differs significantly, based onthe investment strategy of the fund. Mutual fundsallow investors greater liquidity than capital mar-kets; shares are redeemable at any time at currentasset value less applicable redemption fees.

Mutual funds have traditionally been especiallyimportant for the small investor because they canfrequently be entered with a smaller amount of in-vestment capital than can the securities market,as the money invested is pooled with that fromother participants. The investor may also takeadvantage of the possible benefits of a diversifiedportfolio that he might not have been able to sup-port by directly participating in capital or moneymarkets. For the investor interested in an entireindustry rather than a specific company, certainfunds allow such a focusing of investments.

Mutual funds that are made up of corporatebonds and stocks are significant to the formationof capital because they attract investment moneyto the market that would not otherwise have beenavailable. While some mutual funds centered oncapital markets have charged high transaction fees(called a load), their availability has increased bothconsumer options and competition for investmentdollars throughout the financial service industry.The application of information technology to thedevelopment and marketing of mutual funds shouldincrease the number and variety of funds availableto consumers.

Money market mutual funds are one of the moreliquid instruments available to investors. Theliquidity of this type of investment is demon-strated by the fact that, in many cases, sharehold-ers may access their funds by writing drafts, asquickly as a bank checking account by requestingwire transfers, or in some cases, by using an auto-mated teller machine (ATM).

Such funds invest in short-term money marketsecurities and, because of the nature of the under-lying securities, are extremely liquid and relativelyrisk-free. Money market mutual funds are a valu-able cash management instrument for businessesand an extremely valuable tool for individual in-vestors, both the “small” and the more affluent.

Money market mutual funds give investors ac-cess to money market securities on terms thatthey could not likely match themselves. Econ-omies found in issuing and servicing large-denom-ination money market securities result in higheryields than those offered on similar securities ofsmaller denomination. 14 The holder of shares in amoney market mutual fund benefits from thishigher rate of return.

Money market mutual funds have enjoyed ma-jor market success. While information technologyis not directly responsible for this, many industryexperts believe that it would not have been possi-ble, from an operational or business point of view,to introduce this type of fund without the supportof communication and computer technologies. In-formation technology makes it possible to retainthe highly liquid character of the funds by simpli-fying access for the investor. The level of tradingin short-term securities required by the fundswould be difficult to complete physically withoutthe assistance of information technology.

The number and variety of capital and moneymarket mutual funds will probably continue togrow. While this growth will provide more optionsfor investors, it may also have an impact on theway in which securities markets operate. Althoughinformation on the investments of the fund is in-cluded in prospectuses and periodic reports toshareholders, it is not clear that the individuals in-vesting in the fund take an active interest in whatinstruments their money is invested in. While thepool effectively lowers risk, the responsiveness ofindividual shareholders is markedly lower than

“William Jackson, ‘ Money Market Mutual Funds, ” CongressionalResearch Service Issue Brief No. 81057, Jan. 20, 1983.

Ch. 3— The Securities Industry ● 91

would be expected in normal market circum-stances. The institutional investor behaves dif-ferently, for better or worse, because he makesdecisions differently, and this may have an impacton securities markets.

Central Asset Accounts

The central asset account is considered by manyto be the single most important investment prod-uct of the next decade. ’5 In developing the market-leading Cash Management Account, Merrill Lynchrecognized that the financial needs of a single cus-tomer are interrelated and form well-defined typesof systems. The central asset account attemptsto meet an investor’s full range of financial needswith three basic components: the securities marginaccount, the money market fund account, and azero-balance bank loan account that can be ac-cessed by check or card. A central asset accountprovides a full range of financial services to itsuser. The accounts offer a centralized method ofcontrolling assets and, as free credit balances inthe zero-balance account are “swept” into a moneymarket fund, both liquidity and return are maxi-mized for the investor.

Nearly all major securities firms offer a centralasset account. While they have the same basiccomponents, their features often differ. Among the

i ~T& Fin8nCia] .~crt,ices Industr\’ of 7’omorrour, a N?pOrt prepared h)’the Committee to I?xamine the Future Structure of the Securities In-dustry, National Association of Securities Dealers, November 1982,p. 20

“Herbert M Allison, Jr., “The Perspective of a Diversified Finan-cial Services Company, ’ panel presentation at the Eighth Annual Con-ference of the Federal Home I.oan Bank of San Francisco, Strategic[~lannjng for ~conomjc and Technological Change in the Financial Serl’-ices Industr~,, San Francisco, Calif,, Dec. 9-10, 19/32, p, 157.

features that distinguish accounts are: how fre-quently “sweeps” of free credit balances occur,whether a charge or debit card is issued for access,the offering of excess insurance coverage; whetherthe account is accessible through an ATM net-work, and the availability of a bank overdraft lineof credit.17 The accounts have been targetedtoward the upscale market, an estimated 10 to 12percent of the population. A substantial minimumopening deposit of securities or cash, usually of be-tween $15,000 and $20,000, is required and an an-nual fee is charged.

Merrill Lynch first offered the Cash Manage-ment Account in 1977 and as market leader nowhas nearly 1 million accounts, The market growththat central asset accounts experienced may havebeen attributable in part to market conditions,especially high interest rates. As conditions havechanged, the growth of these accounts has de-clined.l8 The significance of the account in the longrun is difficult to judge, although it seems likelythat it will continue to serve the needs of a seg-ment of the market. One important feature of acentral asset account is that it allows brokers tofill more of their customers’ financial needs formore of their personal financial lifecycle. 19 Thismakes the account a valuable tool for financialservice offerers, as it may help to attract and re-tain customers.

“Joseph Diamond, “Central Asset Accounts Developed by the Secu-rities Industries, ” Financial Services Institute Handbook, vol. 1, p. 358;prepared for distribution at the Practicing Law Institute Financial Serv-ices Institute Program, Feb. 14-15, 1983.

“Alice Arvan, “Asset Accounts Reach Out for Broader Markets, ”.4merican Banker, May 20, 1983, p. 9.

‘William L. White, “The Outlook for Money Market Mutual Funds, ”a report to the Investment Company Institute, Sept. 30, 1982, p. 62,

Appendix 3B: Capital Formation and theof the Securities Industry

The securities industry performs its functions firm, its size, management

Functions

style, and financial his-of advising, underwriting; and marketing to gather tory, as well as the-amount of capital needed andcapital by bringing investors and organizations in market conditions, all contribute to the decisionneed of capital together in two ways: through pri- on whether to attempt to finance through privatevate sources and through public offerings. Finan- or public offerings. An overview of the role thecial advisors may assist the firm in determining securities industry plays in both private and pub-which path to follow. The characteristics of the lic financing is provided below,


Private Sources of Funds

Seeking capital through private sources may of-fer salient advantages for many corporations. Reg-ulatory requirements associated with public issuesare avoided. This may save time and, more impor-tantly, the avoidance of disclosure requirementsmay be an advantage for many firms, particularlythose in highly competitive industries. However,because the firm is only likely to approach a limitednumber of investors and because the assurancesassociated with a regulated public offering maynot be found in private financing, the firm mayfind it necessary to pay a higher rate of interestor return on money obtained and may find that thecreditor or holder of equity has a greater interestin the operations of the firm than investors in pub-lic issues.

Private Placements

A corporation may sell an entire issue of securi-ties directly to a single investor or small group ofinvestors. Such an action is referred to as a pri-vate or direct placement and may involve eitherdebt or equity issues, although more commonly,debt instruments are involved. Private placementoffers several advantages over a public offering forthe issuing firm. It is generally quicker and cheaper,as registration of the issue with the SEC is notneeded, and the firm deals either directly with thepotential investor through a placement agent. Theissue may also be more directly tailored both tothe needs of the borrower and the investor in theterms outlined and in the timing of the issue.

A potential disadvantage of this type of offer-ing may be mitigated by the application of infor-mation technology; that is, the location of suitablepotential investors in a time frame that allows thecapital seeker to plan the use of the funds withsome precision. Communications technologies maystreamline brokerage private offerings.

Privileged Subscription Basis

An offering of stock only to existing stockhold-ers is termed a privileged subscription, or rights,offering. In many cases equity holders are granteda preemptive right in the articles of incorporationof the company that requires the firm to give cur-rent shareholders the opportunity to maintaintheir “position,” that is, percent share of totalownership, any time a new issue is made. In thissituation each shareholder is issued one right foreach share of stock owned. The number of rights

needed to purchase new shares are specified in theoffering; however, the shareholder is assured thathe will be able to purchase new shares in propor-tion to his current stake.

A privileged subscription may provide basicmarketing advantages to the issuing corporationand therefore to the shareholders, even those whoopt not to purchase additional shares. The tar-geted market for the offering is known to have aninterest. Assumed knowledge of the corporationand the costs associated with the offering are usu-ally lower than they would be for an offering tothe general public. Often, flotation costs are halfthose of a public issue. From the point of view ofthe investor, margin requirements for a purchasethrough a rights offering are generally lower thanin other circumstances.

The corporation may identify two major dis-advantages with a rights offering. First, to attractinvestors, the price per share may have to be lowerthan would be assigned in a public issue. As alower total amount of capital may be raised by theissue, earnings per share may be diluted. Second,the increased number of actual shareholders result-ing from a public offering may be desirable for thecorporation. The greater the number of stockhold-ers, the more likely that management will retaincontrol of the operations of the company.

Venture Capital

Venture capital is money invested in new orsmall businesses by corporations or individualsthat are not directly involved in the managementof the business, although they may provide advice.The investor is usually granted a large enoughshare of equity in the venture to exercise signifi-cant control of the corporation and, in cases wherethe venture is successful, to receive a significantreturn. The equity is frequently issued in the formof letter stock, a private placement that cannot beresold until the issue is registered with the SEC,which may be years later.

Although it may be an extremely risky invest-ment, individuals who are venture capitalists areattracted for several reasons. Not only is the rateof return significantly higher, but as it is in theform of capital gains rather than dividends, it istaxed at a lower rate. Organizations that provideventure capital are part of many corporate fami-lies, not only because of their primary goal of fi-nancial returns but also because of other tangiblebusiness benefits the venture capital relationshipcan provide. Several investment banks have formed

Table 3A-l.— Most Active Venture Capitalists, 1982. —. .

1982 totalinvestment

Rank Name of firm (in millions)

1. The Hillman Co. ., .. ., . . . . . . . . 101.52. Allstate Insurance Co.

Venture Capital Division ... . 64.23. First Chicago Investment Corp. 48.54. General Electric Venture Capital

Corp. (G. E. Corp.) . . . . . . ... 41.65. Brentwood Associates ., . . . . . . 356. E, M. Warburg Pincus & Co, . . . 33.97. TA Associates (Tucker Anthony

& R. L. Day) . . . . . . . . . . . ... . . 32.38. Security Pacific Capital Corp. . . 32.259. Citicorp Venture Capital Ltd. . 30.5

10. BT Capital Corp.(Bankers Trust N.Y.). . . . . . . 26

S O-URCE Venture June 1983

1981rank

1

92

271012

483

45

venture capital units in the hope of handling even-tual public issues if the company experienceshoped-for growth. The desire to attract and retaincustomers is an incentive also for commercialbanks and insurance companies.

Some major corporations, particularly in the en-ergy and electronics fields, have formed venturecapital units because of interest in financial returnand the hope of gaining access to new ideas andtechnology that may be beneficial to the corpora-tion. The need of established industrial giants tomaintain the pace of technological innovation mayencourage further entry into the venture capitalmarket.

For a small or new corporation, venture capital-ists may provide a valuable source of financing.Intermediaries in the securities industry provideassistance to this capital seeker. They help locatea potential investor whose objectives are in linewith those of the organization in need of financ-ing and assure that the financial arrangement de-veloped is in the best interests of the firm in boththe long and short runs.

Venture capital has become more plentiful in thepast several years. Industry experts attribute thisto changes in Federal Government policies that re-duced capital gains tax in 1978 and 1981 and re-laxed pension trust fund investment rules in 1979. ’Information technology may have an impact onventure capital financing because it may facilitateanalysis of possible deals, New communication ca-pabilities may also make it easier for prospective

] (J S. (;eneral Accounting office, (;otw-nment-IndustrJ, Cooperation(’an Enhance The \renture (’apitaI Process, Report to Senator I,loydBentsen, Joint k;conomic (’ornmittee, Aug 1 !.2, 1982, p. 4.

Ch 3— The Securities Industry ● 9 3

venture capitalists and the seekers of financing tolocate one another.

An important source of venture capital for smallbusinesses are Small Business Investment Cor-porations (SBICs). These firms are licensed andregulated by the Small Business Administrationunder a program established by the Small Busi-ness Investment Act of 1958 to contribute to thedevelopment of small businesses. SBICs are pri-vately owned and operated investment firms, butare eligible to receive some Federal funding. Cap-ital is developed in the form of equity or long-termloans.

These firms are an important part of the capitalformation process for small businesses that mightbe at a disadvantage in competing for venture cap-ital. Information technology may be expected tofacilitate the development of financing betweenSBICs and businesses by making it easier for bothto identify potential investment arrangements.

Public Offerings of Securitiesof a Corporation

The decision by the management of a privatelyheld corporation to “go public” is based on theirobjectives and strategies for the future of thatbusiness. The desire to acquire capital, to in-crease the liquidity of the original owners, and tostrengthen the balance sheet of the corporationmust be weighed against the expense involved insuch a move, the increased vulnerability of the cor-poration to general market conditions, and the ne-cessity that management take on additional re-sponsibility for the actions of the corporation and,possibly, relinquish control of it.

There is no strict formula through which the de-cision to go public can be made. Going public mayinvolve a significant change in the structure andoperation of a firm, and this change must be as-sessed in terms of the objectives of the owners andmanagement of the company, The decision cannotbe assessed individually; it must be considered inlight of other alternatives such as private fundingor additional investment by the owners, In eval-uating the option of going public, several mattersmust be considered; these include business, ac-counting, legal, and regulatory considerations.

Careful attention must be paid to the planningof an offering to assure that the normal operationof the firm is not disrupted and that maximumvalue is derived from the offering, Major factorsto be considered by the corporation include tim-ing of the issue, both in terms of the operations

94 ● Effects of /formation Technology on Financial Services Symtems— . — .—— — — —

of the company and of investment markets; theability of the firm to attract an underwriter, ifneeded; and the ability and desire of the corpora-tion to adhere to disclosure requirements. Infor-mation technology may ease these problems byaiding in the analysis of decision factors and pos-sibly by shortening the issue process and there-fore the disruption of business.

Federal laws governing public offerings by cor-porations or organizations require the disclosureof information on which investment decisions canbe based. A prospectus is information provided topotential investors in a new securities issue thatdescribes the current condition and history of theissuing firm. It attempts to provide informationon which a decision to invest can be made but doesnot contain any type of objective judgment on theadvisability of investing in the described issue.

Information technology may affect public offer-ings by corporations in several ways. First, theessential requirement of Federal securities laws isthe provision of information to potential investors.It is quite likely that the application of informa-tion technology for disseminating information willradically change the physical activity of going pub-lic. Paper was the logical medium through whichinformation could be transmitted in the 1930’s,when many of the currently applicable securities

laws were enacted.2 It was cheaper and more reli-able than the communications technologies of theday, notably telephone and radio, and was easierto use.

Paper was never intended to be a sacred mediumfor conveying information about securities offer-ings. Its use was specified because it was the mostpractical choice. The vast improvement in qualityand cost of information technology has turned thetable on the comparative effectiveness of paperand communications media. Recognition of thischange is causing a reexamination of the processof filing new offerings with the SEC.

The SEC is trying to make the volumes of in-formation it receives easier to manage and use byapplying information technology to its informationgathering and dissemination process. Some ex-perts advocate the eventual movement towardpaperless filing and information dissemination.Potentially, a system based on information tech-nology could result in faster dissemination of in-formation and more efficient review and storageprocesses.

Lee B. Spencer, Jr., “The Electric Library, ” Remarks to the AmericanBar Association, Federal Regulation of Securities Committee, Nov. 19,1982.

Chapter 4

Retail Financial Services

ContentsPage

Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97

Deposit Function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99Direct Deposit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100Point-of-Sale Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ... ....... 101Lockbox Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101Demand Deposit Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102Drafts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102Giro Transfers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102Traveler’s Checks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103Savings Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106Accounts With Other Nondepository Institutions . . . . . . . . . . . . . . . . . . 107

Extension of Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108Commercial Credit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110Consumer Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110

Electronic Funds Transfer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114Automated Teller Machines . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115POS Full Funds Transfer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123

Financial Information Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126Check Authorization . . . . . . . . . . . . . . . . . . . .Credit Authorization . . . . . . . . . . . . . . . . . . . .Providers of Information Services . . . . . . . . .

Home Information Systems . . . . . . . . . . . . . . . .Technology of Home Information Services .Developers of Home Information Systems. .Costs of Home Information Systems . . . . . .The Market for Home Information SystemsImplications of Home Information Systems

TablesTable No.3. Comparison of Depository Instruments and4.Nationwide ACH Volume . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . 127

. . . . . . . . . . . . . . . . . . . . . . . 127

. . . . . . . . . . . . . . . . . . . . . . . 127

. . . . . . . . . . . . . . . . . . . . . . . 128

. . . . . . . . . . . . . . . . . . . . . . . 129

. . . . . . . . . . . . . . . . . . . . . . . 129

. . . . . . . . . . . . . . . . . . . . . . . 131

. . . . . . . . . . . . . . . . . . . . . . . 131

. . . . . . . . . . . . . . . . . . . . . . . 131

PageAccounts . . . . . . . . . . . . . . 100. . . . . . . . . . . . . . . . . . . . . . . 101

5. Growth Projections for the CIRRUS Systems, Inc., NationalATM Network.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120

6. Principal Characteristics of HIS Users . . . . . . . . . . . . . . . . . . . . . . . . . . . 132

FiguresFigure No. Page

6. Penetration of Direct Deposit Social Security Payments . . . . . . . . . . . 1017. Relative Use of ATM Functions, 1974-$1 .. + ~ . . . . . . . . . . . . . ....... 1168. Number of ATMs in Use, 1973-81 . . . . . . . . . . . . . . . . ● . . . . . . . . . . . . . 1189. Average Number of Monthly Transactions Per ATM, 1974-81 . . . . . . . 118

10.ATMs in the United States . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12111. Penetration Curve for Check Alternatives. . . . . . . . ......... . . . . . . . 133

.

Chapter 4

Retail Financial Services

Introduction

The retail financial service industry consistsof those organizations (e.g., banks, creditunions, insurance companies, consumer fi-nance companies) that deliver products to end-users. * Consumers comprise the largest andmost visible single group of end-users of finan-cial services, but business and governmentboth have roles as customers for retail finan-cial services. Included among retail financialproducts are depository accounts, extensionsof credit, and payment services.**

According to 1982 figures, the industry en-compasses more than 90,000 business entities,including 15,000 commercial banks, 4,000savings and loan associations, 1,000 mutualsavings banks, 22,000 credit unions, 1,000 in-vestment banks, 5,000 broker/dealers, 1,000mutual funds, 1,000 mortgage banks, 3,000pension funds and pension fund managers(other than banks and insurers), 2,000 life andhealth insurance companies, 3,000 propertyand casualty insurance companies, and morethan 33,000 insurance brokerage agencies, aswell as numerous factoring companies,***leasing companies, credit card or traveler’scheck issuers, and finance companies. In 1980,the financial service industry (excluding realestate) contributed $100.4 billion, or 5 percent,to the U.S. national income.1

*For the purposes of this assessment, wholesale financial serv-ices, as contrasted to retail, are those provided by one finan-cial institution to another in a way that is largely invisible tothe end-user.

**Customers of securities brokers are also users of retail fi-nancial services. However, because the security industry isgoverned by a body of policy unique to it that separates it fromretail banking and other retail financial services, it is treatedin ch. 3 of this report.

***Factoring is the process of selling accounts receivable toa third party, who then assumes the risk and costs of servic-ing them.

‘State of New York, Report of the Executi\e Adtisor}. Comm-ission on Insurance lndustr?’ Regulator?’ Reform, May 6,1982, p. 101.

Historically, deposit-taking has been viewedas a special activity in the economy, and de-pository institutions have been viewed as oc-cupying a unique place in the industry. Depos-itors place a very high degree of trust in theinstitutions holding their funds. At the sametime, because depository institutions playsuch an important role of intermediation be-tween sources of funds and those having needof them, they are in a position to exert a meas-ure of control over virtually all other economicactivities.

Retail financial services, especially those of-fered by banks, have been heavily regulatedby both State and Federal Governments.Rates paid on deposits have been largely de-regulated, but limits on the rates charged onconsumer loans remain in force. Depository in-stitutions are generally limited to offeringprescribed products to predefined markets.Banks, for example, are limited with regardto the geographic area served, while creditunions are limited to serving only groupswhose members share a common bond, suchas employment with a specific firm. Generally,bank holding companies are not permitted toenter lines of commerce not closely associatedwith banking. Depository institutions are ex-amined to ensure that they are pursuing busi-ness in a manner consistent with preservinginstitutional safety and soundness, and manyof their business decisions (e.g., effectingmergers, opening branches, offering new prod-ucts) are reviewed by regulators prior to im-plementation.

Depository institutions enjoy some uniquebenefits in exchange for heavy regulations.Only they can take deposits and offer accountsthat are federally insured. Depository institu-tions are unique in having access to the vari-ous systems used to transfer funds.

97


Today, insurance companies, providers ofservices such as credit cards and traveler’schecks, consumer finance companies, drygoods merchants, investment companies, andfood retailers also provide retail financial serv-ices. Some, such as insurance companies, areregulated, while others, such as providers oftraveler’s checks, are virtually unregulated.All, to an ever-increasing degree, are broaden-ing their range of business activities and, tosome extent, are encroaching on areas pre-viously served by others, including those here-tofore exclusively reserved to depository in-stitutions.

Information processing and telecommunica-tion technologies have contributed to thebroadening of product lines by providers ofretail financial services. New entrants havebeen able to develop and offer products thatcompete directly with those previously avail-able only from depository institutions. Dis-tance and location have lost much of their sig-nificance as factors limiting the market servedby a service provider. In addition, by using thetechnologies, new classes of products havebeen developed. Foremost among these arethose that deliver financial services to remotelocations, such as the home, office, merchant’scounter and unstaffed branches. Others, suchas services to facilitate collection and invest-ment of cash, are directed to the business com-munit y.

As noted, law and regulation are significantforces shaping the financial service industryand guiding its day-to-day operations. The ex-isting legal regulatory structure dates largelyfrom the 1930’s and is built on the assump-tion that specific types of institutions will bethe only ones offering each type of service. Forexample, transaction accounts are assumed tobe offered only by banks; and thrift institu-tions are assumed to focus their lending activ-ities on home mortgages. Thus, even thoughthe intent was to regulate by function, thefocus of legislation has been on the institutionsrather than on the products they offer. As aresult, the offering of new products by unreg-ulated providers is often found to lie outsidethe existing legal/regulatory structure. New

entrants who rely heavily on advanced tech-nologies to implement their offerings gener-ally fall outside the boundaries of existing reg-ulation.

The financial service industry is becominghomogenized to a significant degree, and dif-ferentiation between products has become lessapparent, particularly from the point of viewof individual consumers. Commercial banksand savings and loan associations are now per-mitted to serve many of the same clientele. Forexample, recent legislation gave savings andloan associations the power to make somecommercial loans, a product that could notpreviously be offered. While securities broker/dealers are not permitted to offer depositoryaccounts, they do offer shares in money mar-ket funds that have properties very similar todeposits. Insurance companies offer universallife policies that share many properties withself-directed investment accounts offered byothers.

VISA and MasterCard are the two principalbank card products offered nationwide. How-ever, in addition to being offered by banks,these are now issued by such varied organi-zations as the American Automobile Associa-tion and various brokerage houses that offerthem in conjunction with asset managementaccounts. Travel and entertainment cards canbe used with automated teller machines(ATMs) to obtain either cash or traveler’schecks. In some cases, a plastic card is usedto access a depository account (e.g., checking).Plastic cards can also be used to draw on a lineof credit either to pay for a purchase or to ob-tain a cash advance. The same card can beused for both purposes. However, the financecharges are assessed differently for the cashadvance and the credit purchase.

One of the major developments of the 1980’shas been the development and deployment ofnetworks of ATMs. Some of these accept onlythe card of one institution, while others per-mit access to accounts held in any one of anumber of institutions. Most of these net-works are offered by depository institutionsor consortia of depository institutions. How-

Ch. 4—Retail Financial Services ● 9 9— — — — — — — . . —

ever, retail dry goods merchants, supermarketchain operators, and operators of conveniencestores are now establishing networks and of-fering financial institutions the opportunityto access them.

More generally, telecommunication has beena major factor in the development of financialproducts in the 1980’s. Providing remotebanking services has been a key area in thedevelopment of financial services. Publishingcompanies are combining with financial serv-ice providers and communication companiesto deliver financial services directly to thehomes of consumers. Grocery chains are es-tablishing networks of ATMs that competedirectly with those offered by banks. Banksoffer cash management services to business,enabling corporate cash managers to controlfunds on deposit with institutions worldwideand to manage them to the best advantage oftheir employers.

Other developments of the 1980’s have beenthe emergence of the financial supermarketand the specialized supplier of financial serv-ices. Several organizations have used differ-ing strategies to develop into horizontally in-tegrated suppliers of financial services. Theremarkable point is that some find their rootsin insurance, others in retailing, and yet othersin banking. Under the existing 1egal/regula-tory structure, all operate within differing con-

Deposit

Technically, the function of accepting depos-its is strictly limited to depository institutions.Simply defined, a deposit is a placement ofcash, checks, or drafts with a financial insti-tution for credit to a customer’s account. De-posits become a liability to the financial insti-tution since they represent an obligation torepay funds. The deposit function is the tradi-tional banking process by which funds are ac-cepted for credit to a demand, savings, or timeaccount. Deposits are accounts for holdingfunds. The deposit is made by one of the fol-

straints and therefore come to the market withvarying strengths and weaknesses. Others, byway of contrast, seek to serve specific groups,such as members of the professions with prod-ucts tailored to their particular needs. Themarket appears ready to support service pro-viders across the full spectrum of possibleproduct menus.

Fluidity in the structure of the financial ser-vice industry limits the utility of any descrip-tion that focuses on the institutions that com-prise it. A list of providers would almostcertainly omit some and include others thatarguably could have been omitted. Becauseproduct lines of various classes of providersof financial services are close substitutes forone another, descriptions of each of the classesof providers would become redundant.

Therefore, the approach taken to describingthe retail financial service industry in thisassessment is to focus on the functions per-formed for the customers and then to relatethose functions by way of example to the or-ganizations that provide them. The classesof functions described are treated under theheadings:

deposit/withdrawal function,extension of credit,electronic funds transfer, andfinancial information services.

Function

lowing methods: in person, by mail or tape, orelectronically via ATM or other remote ter-minal or by the Automated Clearing House(ACH).* In paper-based systems, access to de-posits depends on the physical transfer ofdocuments such as a check or draft.** How-ever, electronic technologies have helped rev-olutionize this function.

*The ACH is a computerized facility that helps clear fundstransactions among participating institutions electronically.

* *Draft— A n order written on the funds of a third party totransfer the amount specified to the payee.


In essence, a deposit differs from an invest-ment in that the depositor expects to be ableto recover the amount deposited, often withsome interest, with virtually no risk of loss.The depository institution holds itself readyto pay the amount of the deposit under con-ditions that are consistent with the contractunder which it was taken. In the case of a de-mand deposit, for example, the depository in-stitution stands ready to pay on demand. Onthe other hand, if the owner of a certificate ofdeposit withdraws the funds prior to maturity,a significant penalty is extracted that, in somecases, involves loss of principal as well as in-terest.

In the present environment, firms otherthan depository institutions offer productsthat are operationally similar to a deposit fromthe customer’s point of view. For example,securities broker/dealers and investment com-panies offer shares in money market mutualfunds that include the option of redemptionby means of a draft written against the in-vestor’s holding. A whole-life insurance pol-icy accumulates cash value that is availableto the owner.

Some will tend to view these products as de-posits because, operationally, the funds areavailable virtually on demand. The expecta-tion is that payment will be made by the pro-vider even though there may be contractualprovisions that an order to pay need not be

honored immediately. There may also be noguarantee that shares will be redeemed at theprice originally paid by the investor. However,as long as institutions continue the practiceof operating near-deposit products in a man-ner that closely approximates the operationof a true deposit account, the customers willsee the former as being a close substitute forthe latter.

In this environment, not all of those offer-ing deposit or near-deposit products operateunder the same set of rules. This variation in-troduces new elements into the calculus usedby those responsible for the safety and sound-ness of the financial service industry and theformulation and execution of fiscal and mone-tary policy. In the sections that follow, thevarious types of deposit-like products andassociated deposit-taking services are de-scribed.

Table 3 presents a comparison of the vari-ous depository instruments and accounts dis-cussed in more detail below.

Direct Deposit

Direct deposit is most often used to effectpayment from either private or public organi-zations to recipients of salaries, pensions, andentitlements. It is actually a preauthorizedcredit arrangement between the party issuingthe payment and the receiver and is commonly

Table 3.—Comparison of Depository Instruments and Accounts

Penalty MinimumInterest- Withdrawal Mandatory for early deposit or

Instrument or type of account bearing notice request deposit period withdrawal balanceCheck . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . No No No No NoDraft . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Yes Optional No No NoTraveler’s check . . . . . . . . . . . . . . . . . . . . . . . . . . No No No No NoConventional savings account . . . . . . . . . . . . . Yes Optional No No NoCredit union account . . . . . . . . . . . . . . . . . . . . . Yes Optional No No NoCertificate of deposita . . . . . . . . . . . . . . . . . . . .Yes Yes Yes Yes YesMoney market deposit account. . . . . . . . . . . . . Yes Optional No No YesNOW accountb . . . . . . . . . . . . . . . . . . . . . . . . . . Yes Optional No No OptionalSuper NOW accountb . . . . . . . . . . . . . . . . . . . . . Yes Optional No No YesSavings bond . . . . . . . . . . . . . . . . . . . . . . . . . . . .Yes Yes Yes Yes YesSavings certificate. . . . . . . . . . . . . . . . . . . . . . . . Yes N/A Yes N/A YesaEffe~t jve Oct 1, 19&3, Interest rate ceilings are eliminated on all time deposits with original maturity or requ i red periods of more than 31 days, and on time deposits

of $2,500 or more with original maturity or required notice periods of 7 to 31 daysb Not available to commercial businessesN/A–Not applicable

SOURCE Office of Technology Assessment

— . .

used for recurring payments. One of thelargest users of direct deposit is the U.S. De-partment of the Treasury, for Social Securitypayments. It is also widely used for mili-tary payroll and other regular Governmentpayments.

Figure 6 shows the increasing rate at whichSocial Security recipients have been willing toaccept payment by direct deposit. In 1978,only 11 percent were willing to make use ofdirect deposit; but this proportion had grownto 33 percent by 1982. The Department of theTreasury hopes for further increases.

Direct deposit transactions started as papertransactions, but the rising volume of suchpayments has encouraged the use of the ACHnetwork and systems, which depend heavilyon the interchange of magnetic tape (see table4). The process involves coding payment in-formation in machine-readable form and mov-ing it between banks on computer tapes or, insome cases, over telephone lines. The payingbank or organization consolidates all itspayments for a certain date and submits themon magnetic tape through the ACH. The ACHthen routes the payment information to eachreceiving bank. The tape can be sent in ad-vance with the information predated. For ex-ample, stock dividend checks could be proc-essed through the ACH for direct deposit. It

Figure 6.— Penetration of Direct Deposit SocialSecurity Payments

5 0 0 ~

UY 400c

-

11 0/0o=.-E 300c.-UIz 200E$Q 100

0 11978

250/o 280/o 330/0

m

1979 1980 1981 1982

Direct deposit

1’-] Checks

SOURCE Economic Review Federal Reserve Bank of Atlanta, August 1983 p 33

Ch. 4—Retail Financial Services ● 101

Table 4.—Nationwide ACH Volume—

G o v e r n m e n t -

Year Private (Social Security)

1976 . . . . . . . . . 4,283,770 46,646,9991977 . . . . . . . . . 10,344,192 69,694,7411978 . . . . . . . 18,612,263 93,207,0731979 . . . . . . . . . 331324,163 123,353,5941980 ......, . . 63,362,597 144,112,2041981 . . . . . . . . . 117,019,927 164,157,1901982 . . . . . . . . . 174,613,862 176,821,896— - .SOURCE National Clearing House Association

is expected that use of the ACH will increaseonce a critical volume has been achieved bythe flows to and from large organizations. Asthis occurs, users with smaller volumes ofpayments should gradually be absorbed intothe system.

Point-of-Sale Systems

Point-of-sale (POS) systems, discussed indetail later in this chapter, also function as adeposit-taking method. In some cases, retailclerks will accept funds for deposit to custom-ers’ accounts. In others, the financial institu-tion will operate a station or counter in theretail store at which deposits are accepted. Athird alternative is the placement of an ATMat the retail store location. The ultimate goalof POS implementation in the financial serv-ice industry is to institute an electronic proc-ess through which transactions may be instan-taneously debited/credited.

Lockbox Operations

In lockbox operations, payments go directlyto a post office box that is controlled by thepayee’s financial institution. The services pro-vided include picking up the mail at the postoffice, opening it and crediting the funds, orreceiving the opened letters and crediting thefunds to the company’s account. A fee is im-posed for each function the financial institu-tion performs for the company.

Lockbox operations are used to speed thecollection of remittances and reduce “float”*

*An amount of money represented at any one time by checksoutstanding and in the process of collection. The period of timebetween receipt of notification of payment by the creditor andthe actual debiting of the consumer’s account.

102 ● Effects of Information Technology on Financial Services Systems—.-— - .-— — ——.———

by eliminating the time required to transferpayment from a company to the financial in-stitution. Interestingly, lockbox operations areoffered by other institutions, also. For exam-ple, in July 1983, Sears Roebuck & Co. an-nounced that it would provide retail lockboxprocessing for Pittsburgh’s Mellon Bank inseven cities across the country. With its na-tional presence, Sears is in a unique positionto offer such services. This arrangement willnot only reduce float for the bank’s corporatecustomers but also decrease processing costs,since a larger number of the checks receivedcould be processed locally and not as inter-regional items through the Federal ReserveBoard’s check processing system. As noted inAmerican Banker, “Interstate banking restric-tions have prevented banks from opening of-fices around the country to accept deposits,and thus most banks have operated lockboxesonly within their own State. Lately, however,a number of banks have begun to expand theirgeographic coverage through joint marketingarrangements and correspondent relation-ships. ‘‘2

Demand Deposit Accounts

For users of demand deposit accounts, in-stitutions make funds explicitly available tothe user without any optional or contractualdelay. Demand deposits represent a significantportion of the domestic money supply. As ofDecember 31, 1981, demand deposits for allcommercial banks totaled $370 billion.3 Achecking account is a demand deposit account.The check is the instrument that activates thechecking account and is the end-product of theoriginal written instructions used by an indi-vidual to make a payment from a credit bal-ance. A written check is deposited into an ac-count (the collecting bank) by the creditor,wherein it circulates within the banking sys-tem as an instrument to debit the account ofthe debtor at his bank (the paying bank).

By law, demand deposits do not yield in-terest for the account holder. Although sev-

‘American Banker, July 29, 1983.3Federal Reserve Statistical Release, April 1983.

—

eral other types of accounts use a check to ac-cess funds, these accounts are not considereddemand deposit accounts.

Drafts

Drafts are essentially an expanded collectionservice, with funds being transferred when thepayer orders the bank to pay the draft. Theyare used by credit unions, which technicallyclassify their transactions as purchases ofshares in equity accounts and money marketfunds. Credit unions began to offer share draftaccounts as a competitive tool against thechecking accounts offered by banks. The draftitself is debited against the individual’s ac-count. Although to the consumer, a draft looksand works much the same way as a check, itdiffers in two ways: 1) it may have a specifiedtime constraint and can be drawn on an in-dividual, corporation, or bank; and 2) the in-itiative for payment of goods is taken by theseller, not the buyer.

The three types of drafts are: 1) sight–pay-able immediately on presentation; 2) arrival—payable on arrival of goods; and 3) time—payable at a fixed date. There is a consider-able amount of float associated with checks/drafts because funds need not be in the bankon which the item is drawn until the day thecheck/draft reaches the bank and is presentedfor collection. Float in this case can work tothe advantage of the depositor in that fundsalso do not sit idle. The company can trans-fer the amount needed to cover the check/draft, leaving the balance in higher yieldinginvestments.

Although presently a heavily paper-basedinstrument, drafts are being converted into aform of electronic billing service whereby ven-dors can collect from customers by sending anelectronic debit (draft) to their account.

Giro Transfers

While checks are a way to effect a debittransfer, the giro, which is an instrument notused in the United States, is a way of makinga credit transfer. To effect a giro payment, the

Ch. 4—Retail Financial. . . —

person making the payment instructs the in-stitution holding his funds to transfer themto the account of the payee in the name ofanother institution. This is in contrast to acheck given to the creditor that is finally pre-sented at the debtor’s bank for payment. Giroorganizations usually send a statement to eachaccount holder every day on which transac-tions are recorded; this is expensive in postalcosts. “The notable feature is that the aver-age value of paper giro transfers is higher thanthe average value of check payments in allcountries except the United Kingdom.”4

Traveler’s Checks

Another form of a deposit transaction is thetraveler’s check. The traveler’s check is “paidfor” in advance by the purchaser, generallywith a premium of 1 percent of the value. Itis considered a deposit because the funds areheld by the issuing company until the travel-er’s check is redeemed by the purchaser. Thisinstrument works and is accepted, for themost part, like cash. It can be a universallyaccepted payment mechanism and is consid-ered a deposit instrument.

Savings Accounts

A savings account is an interest-bearing ac-count used to accumulate and safekeep funds.Institutions retain the optional right to requirewritten notice of an intended withdrawal,often not less than 14 days before withdrawalis made.

Despite the notice requirement, a savingsaccount is in practice extremely liquid. Untilrecently, most people used their savings ac-count as a long-term savings/investment vehi-cle, even though several alternatives offeredhigher explicit interest. However, new optionsavailable have made the consumer more con-cerned with earning explicit interest on hismoney. As a result, savings accounts are be-ing increasingly used only as short-term repos-itories or as interim investment vehicles dur-

4Jack Revel], Banking& EFT—A Study of the Implications,p. 143.

Services ● 103

ing the accumulation of funds sufficient forsupporting higher denomination and higheryielding investments. They are also frequentlyused to establish and maintain a relationshipwith an institution for the purpose of even-tually using other services, such as loans andcheck cashing.

Savings accounts take the following forms:

1. Conventional savings accounts. Conven-tional savings accounts offered by depos-itory institutions are designed primarilyfor individuals. Savings accounts may beissued in passbook or statement form andinvolve the institution’s periodic issuanceof summaries of deposits and withdraw-als. Savings deposits do not have matur-ity dates, but a hold may be requiredbefore withdrawal-most often on depos-its made by check, but possibly on cashdeposits, also. This is rarely, if ever, im-posed, and for the most part, individualsregard these accounts as being very liq-uid. As defined by the Federal Reserve,a savings account from which more thanthree telephonic or preauthorized trans-fers are permitted per month is considereda transaction account, with the specificexception of the money market depositaccount.

Savings accounts presently have a reg-ulated interest rate set by Federal author-ities and governed by the DepositoryInstitutions Deregulation Committee(DIDC). Until these ceilings are finallyphased out (scheduled for 1986), the ceil-ing is imposed on interest rates for fed-erally insured banks and thrift institu-tions. Effective January 1, 1984, thedifferential interest rates on passbooksavings accounts and 7- to 3 l-day depos-its under $2,500 at both thrifts and com-mercial banks were removed, with eachhaving a ceiling of 5% percent.

Federal deposit insurance of up to$100,000 per account holder is providedin all but a very few depository institu-tions. The Federal Deposit Insurance Cor-poration (FDIC) insures accounts in com-mercial banks chartered by both the

35-505 0 - 84 - 8 : QL 3


2.

——- —

Federal and State Governments and inmutual savings banks. The Federal Sav-ings and Loan Insurance Corporation in-sures accounts in federally chartered sav-ings and loan associations and savingsbanks. The Credit Union National Admin-istration (CUNA) insures accounts held infederally chartered credit unions. In ad-dition, some States have insurance pro-grams to cover deposits in State-char-tered institutions, such as savings andloan associations, that are not eligible forFederal deposit insurance.

Credit unions provide savings servicesas well, including savings accounts (whichare insured up to $100,000 per member byCUNA, investment certificates, moneymarket certificates, share savings ac-counts, and individual retirement ac-counts.Time deposits. The owner of a time de-posit accepts limitations on his withdraw-al rights. The account is established withthe idea that the funds are on deposit fora negotiated period of time in return forreceiving an offered interest rate. Certif-icates of deposit (CDs) are interest-bear-ing time deposit instruments issued by adepository institution for amounts thatcan vary from as little as $100 up to morethan $100,000. CDs pay interest at matur-ity and cannot be withdrawn from thebank without penalty prior to theirmaturity date. The most commonly of-fered maturities are 91 days, 180 days,and 1 year. Although most CD rates aretied to Treasury bills and longer termTreasury securities, some of the funds doreceive an unregulated market rate of in-terest. Large CDs are typically issued innegotiable form, so they may be tradedin an organized market.

The Depository Institutions Deregula-tion and Monetary Control Act of 1980(DIDMCA) was enacted to provide for theorderly phase-out and the ultimate elim-ination of ceilings on the maximum ratesof interest and dividends that maybe paidon deposit accounts. The act transferredthe authority to set interest rate ceilings

on deposits at federally insured commer-cial banks, savings and loan associations,and mutual savings banks to the DIDC,whose members are the Secretary of theTreasury; the Chairman of the Federal Reserve Board; representatives of FDIC, theFederal Home Loan Bank Board, andCUNA; and the Comptroller of the Cur-rency, a nonvoting member. The law pro-vides for a 6-year phase-out of ceilings ondeposit rates, during which the commit-tee has the discretion to set ceiling rateson deposits based on economic conditions.(The committee has been given a schedulefor targeting the gradual phase-out ofsuch ceilings. ) During the transitionperiod, credit unions are subject to sepa-rate regulations. In 1986, all RegulationQ authority expires, CUNA’s authorityto set interest rate ceilings for credit un-ions terminates, and the DIDC ceases toexist.

Under DIDMCA, the committee haseliminated (effective Oct. 1, 1983) all in-terest rate ceilings on (a) all time depos-its with original maturities or requirednotice periods of more than 31 days; and(b) time deposits of $2,500 or more, withoriginal maturities or required notice peri-ods of 7 to 31 days. Also, the committeehas eliminated other regulations on timedeposits except for the minimum earlywithdrawal penalties; a minimum de-nomination of $2,500 for ceiling-free timedeposits with original maturities or re-quired notice periods of 7 to 31 days; cur-rent ceiling on time deposits of less than$2,500, with original maturities or re-quired notice periods of 7 to 31 days; andagency rules that require a l-percentage-point differential between a loan rate andthe rate on a time deposit securing a loan.

DIDC also established new minimumearly withdrawal penalties: for time de-posits with original maturities or requirednotice periods of 32 days to 1 year, lossof 1 month’s simple interest; for time de-posits with original maturities or requirednotice periods of more than 1 year, lossof 3 months’ simple interest.

3.

4

These changes helped reduce the com-petitive edge previously enjoyed by non-depositor institutions against depositoryinstitutions because a large number of fi-nancial services being offered by the non-depositor institutions were attractive,offered higher interest rate return, andwere not subject to regulation. Fundsplaced outside of the depository institu-tions are not federally insured; however,the individual appears to be more con-cerned with return on investment thanthe risk associated with placing funds out-side of federally insured depository insti-tutions.Money market deposit account. Themoney market deposit account, a high-yielding liquid account, was authorized bythe Garn-St Germain Depository Institu-tions Act of 1982 to allow commercialbanks and thrift institutions to competewith money market mutual funds. The ac-count is available to all depositors, in-cluding businesses. It requires an initialbalance of at least $2,500 and has no in-terest rate ceiling. A ‘7-day hold on with-drawal can be imposed by the depositoryinstitution. Additionally, the money mar-ket account allows for up to six third-party transfers, including up to three bydraft and up to three preauthorized trans-fers per month. There are no restrictionson making withdrawals from the accountin person, by messenger or mail, or byATM. The funds are federally insured. Ifthe minimum balance falls below $2,500,the interest on the funds reverts to thestatement/passbook rate and remains atthat rate until the balance is brought upto $2,500. Unlike some restrictions im-posed by the money market funds, thereis no minimum on the size of an accountwithdrawals or deposits.Negotiable order of withdrawal (NOW)and Super NOW account. NOW andSuper NOW accounts are unique savingsinstruments because they are interest-earning transaction accounts. Althoughthey can be accessed by a check, they arenot considered demand accounts because

5.

6.

Ch. 4—Retail Financial Services ● 105—————- — — — . . — —

the offering institution can impose a holdbefore honoring the withdrawal, althoughit is a restriction unlikely to be enforced.Individuals regard these accounts as rath-er liquid, and most are probably unawareof the restrictions that can be enforced.The NOW account does not legally re-quire a minimum to open the account, al-though most institutions require a mini-mum balance of $500.

The Super NOW account is primarilya combination of the NOW account andthe money market deposit account. TheSuper NOW, which DIDC authorized asa financial instrument as of January 1983,requires a minimum initial deposit of$2,500 and an average balance in anymonth of $2,500. The account has no in-terest rate ceiling, although the funds re-vert to a conventional savings accountyielding the regulated interest z-ate underRegulation Q if the account falls belowthe minimum balance. Additionally, a 7-day notice of withdrawal maybe required.Because the notice of withdrawal require-ment applies to such funds, they are cate-gorized not as demand deposits, but assavings deposits. These accounts are notavailable to for-profit businesses. Theyare available to Federal, State, and localgovernments, as well as to nonprofit orga-nizations and individuals.Savings bonds. Savings bonds are sold bythe U.S. Government to generate revenue.They are issued at a discount and appre-ciate at a rising rate in specified incre-ments to a stated value at maturity.Bonds may be redeemed before maturity,but the interest rate becomes higher thelonger the bond is held.Savings certificates. Tailored to the needsof individuals in terms of deposit time(generally 90 days, 5 years, 10 years), sav-ings certificates have interest rates thatare dependent on maturity time and cur-rent rates. Savings certificates are notnegotiable and are issued by depositoryinstitutions for $100 up to $100,000.There is a penalty for early withdrawal.

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

The latest figures’ indicate deposits, as ofOctober 1983, in various savings instruments:

Super NOW accounts: $27 billionNOW accounts: $100 billionmoney market deposit accounts: $369

billionmoney market funds: $138 billion*

Insurance

In today’s competitive environment, com-mercial banks, savings and loan associations,and savings banks not only vie with oneanother to attract new deposits, but also com-pete with many nondepository organizations.One of the largest providers of financial serv-ices is the insurance industry. It has a sizablecustomer base (insurance products are used inalmost every household or business) and is amajor lender of funds to businesses. The in-surance industry has access to an enormousamount of capital. Insurance companies areenormous financial intermediaries in that theycollect and invest vast amounts of premiumson policies. Life insurance companies collectpremiums from policyholders, invest the re-ceipts until needed, pay death benefits to heirsof those who die, and make payments to thosewho redeem policies and/or take out loansagainst their cash value.

Insurance companies channel funds into va-rious investment outlets and qualify as signif-icant allocators of financial resources in theeconomy. Their investments are made inalmost every sector of the capital market andin a wide array of investment outlets. Theirinvestment decisions are based on a philoso-phy of maximizing their rate of return withinthe bounds of State investment laws and onthe principle of safeguarding the security ofthe funds invested.

Life insurance saving differs fundamentallyfrom saving through deposit-type institutionsfor at least three reasons: first, it is long-termand contractual in nature and is thereforemore stable; second, it is motivated primar-

—— —.—‘Federal Reserve Statistical Release, Dec. 16, 1983.*These funds are not federally insured.

ily by the desire for family financial protectionin the event of death; and third, it is ordinarilyexpected to be left intact until the death of theinsured rather than withdrawn for some con-sumer expenditure.

Insurance policies exist in almost everyhousehold. They take such forms as automo-bile insurance, property insurance, and healthinsurance. Such a strong presence permits theindustry to introduce and market new finan-cial products and services with relative ease.Insurance companies now offer several prod-ucts that are treated like deposits. Two newproducts introduced into the market in 1983are quite interesting—one works like a cashmanagement plan for businesses under $10million; the other works as a securities andcash management service. These accountsfeature money market funds, checking ac-counts with unlimited access, lines of credit,an overdraft, and a Gold MasterCard, whichdoes not carry a line of credit. The customers’money market accounts are debited eachmonth to cover card charges. The checkingand charge card operations are handled by alocal bank for the insurance company. The in-vestment accounts are offered in conjunctionwith an investment firm. Both products re-quire a minimum of $10,000, and customersare penalized whenever their monthly averagedrops below $5,000 for 2 consecutive months.

Another instrument of the insurance indus-try is universal life insurance, which is an in-vestment vehicle. It functions like a deposi-tory instrument and is a flexible investmentvehicle with access to mutual funds. It offersthe policyholder flexibility because the cashvalue buildup or funding phase—-which makesit appear to be a savings instrument-and thepure life insurance phase of the traditionalwhole-life insurance policy are separated. Acompany can declare competitive interestrates on the funding phase, and the policyhold-er can vary the amount and frequency of pre-mium payments and the amount of deathbenefits.

Whole life insurance provides a constantamount of insurance for the same premiumover a lifetime. It is payable to a beneficiary

——..——

at the death of the policyholder, and premiumsare payable for a specified number of years ora lifetime. A policyholder is entitled to the cashvalue if he cancels the policy. Since the poli-cyholder may borrow from the insurance com-pany against the cash value of the policy, pol-icy reserves may be viewed equally as a legalliability of the insurance company and as aninvestment of the policyholder. Life insurancecompanies make loans against the cash valueof whole-life insurance policies. These accountsplay a significant role in the insurance com-panies’ lending ability. The policyholder hasthe right to borrow from the insurance com-pany any amount up to the cash value, at aspecified rate of interest. Moreover, earningson insurance are partially tax-exempt.

Just as insurers will increasingly competein the provision of financial services, otherfinancial service providers will increasinglycompete with insurers in the provision of in-surance. The unbundling of insurance prod-ucts has revealed that there are significantfunctions in the operation of insurance thatinvolve the performance of noninsuranceservices.

The insurance industry is in a position to ex-pand its service offerings to include a myriadof financial products. This is possible for sev-eral reasons. As discussed, some insuranceproducts being offered resemble existing prod-ucts being offered by depository institutions.Also, modifying software for existing systemsenables the company to create new productsand services. For example, insurance com-panies could easily offer a money market fundand additional services that can be imple-mented with relative ease and minimal capital.

The insurance industry is adapting automa-tion in many ways. Insurance agents, for ex-ample, are internally incorporating automa-tion to manage office functions, such as clientinformation and accounts receivable and pay-able. They are applying automation to increaseefficiency and to improve marketing. Exter-nally, communication and information technol-ogies are used to tie into carriers where theyare able to obtain quotes and to underwrite

Ch, 4—Retail Financial Services • 107— — —

business themselves. Many large networks arebeing developed that enable the agent to ob-tain pertinent information online as well asdirectly relay information to the carrier.

Technology is used to support other serv-ices of the insurance industry as well. Claimsservices, for example, are now becoming auto-mated. The claims process, which is heavilypaper-based, is being handled by convertingthe information electronically and transmit-ting it online to the carrier, allowing the car-rier to deal with the claim more effectively andto maintain more control over the settlementprocess.

The automation of risk management serv-ices for large corporations allows them to han-dle in-house insurance analysis. These com-panies are able to tie into networks thatprovide important and timely informationused to assess and manage risk.

Accounts With OtherNondepository Institutions

Insurance companies, large retailers, andvirtually every kind of financial service orga-nization offer individual retirement accounts(IRAs), money market funds, and a myriad ofinvestment services. Although the funds in-vested by individuals into nondepository insti-tutions are not federally insured, this fact hasnot prevented individuals from investing inthese instruments. The amount of money thathas shifted from depository institutions intonondepository institutions has been signifi-cant. Previously, these types of institutionswere very different from each other. When theconcept of commercial banking was first con-ceived, commercial bankers made little or noeffort to attract individual deposits, concen-trating primarily on attracting demand depos-its from businesses. Conversely, the savingsbanks and savings and loan organizationswere not authorized to offer checking ac-counts, and their range of time and savingsdeposits was limited.

Today, that has changed drastically. Com-mercial banks fiercely compete with other de-


pository institutions, insurance companies,and brokerage houses/investment firms forconsumer deposits. All of these organizationsoffer accounts that can serve the customer insimilar ways. However, the range of servicesavailable to the customer are not as markedlydifferent from the customer’s point of view asthe products seem from the point of view ofregulators or the providers themselves. An in-dividual can easily establish an IRA or Keogh(retirement) account, obtain a loan, and use achecking or checklike account or savings ac-count from any depository institution. He/shecan obtain similar instruments from nondepos-itor institutions such as insurance com-panies, retailers, and investment firms withcash management accounts.

Prior to the introduction of money marketdeposit accounts and Super NOW accounts,depository institutions were restricted as tothe maximum interest payable on demand de-posit accounts and savings accounts, with theexception of jumbo CDs and similar instru-ments. These restrictions helped reduce bank

payouts on their liabilities and reduced cus-tomer earnings on short-term asset holdingsin depository institutions. Since depository in-stitutions could not compete on interest rates,they competed on the basis of services, whichwere actually subsidized by the spread be-tween interest paid on money in savings andreceived on money loaned. The spread resultedfrom below-market rates paid because of theregulatory environment. This is changing.Zero-balance accounts are becoming wide-spread. Financial service providers have cometo rely more heavily on fee income fromservices.

Large financial service providers have theprivilege of offering several types of financialproducts. For example, the use of informationtechnologies enables firms such as AmericanExpress, which owns Fireman’s Fund Ameri-can Life Insurance Co., to market additionalservices directly to their strong credit cardbase. They can offer insurance services andhave the premiums be added directly to theAmerican Express card account.

Extension of Credit

One of the principal functions of the finan-cial service industry is intermediation betweenholders of assets and those in need of funds.Funds are gathered through the deposit-tak-ing activities described in the preceding sec-tion. Extending credit, described in the follow-ing pages, is one of the mechanisms used tomake funds available to those requiringthem. *

Historically, credit extension has been oneof the principal sources of revenue for the fi-nancial service industry. The rate differentialbetween that paid on deposits and thatcharged on loans was sufficiently great to sup-port many of the services offered by financialinstitutions. However, one of the effects of de-.——

*FundS are ~so made available by investors who take anequity position in the organization requiring funds. Equity in-struments and the markets for them are described in ch. 3.

regulation of the rates paid on deposits hasbeen to narrow this differential and cause fi-nancial service providers to look elsewhere forrevenue. They have turned to informationprocessing and telecommunication technol-ogies to improve the efficiency of their inter-nal operations and as the foundation on whichnew revenue-generating products can be built.One of the most promising opportunities forcost saving is converting as many paper-based transactions as possible to electronicprocesses.

Interest rate fluctuations, such as those ex-perienced over the past several years, havemade the problem of portfolio managementmore difficult for financial service providers.Some found themselves faced with the prob-lem of supporting long-term, fixed-rate loanportfolios with short-term, expensive depos-

Ch. 4—Retail Financial Services ● 109— -.

its and few options for correcting the im-balance. Congress increased the powers of sav-ings and loan associations to help themovercome this problem.

One of the responses of the financial serv-ice industry to the disappearance of the in-terest spread has been to encourage individu-als and businesses to view all of their liabilitiesand assets as a total package and to managethem as such. The goal of some institutionsis to place themselves in the role of financialadvisor to their customers. On the one hand,these institutions would like to generate rev-enue by providing advisory services for whicha fee may be charged or services that wouldattract business and customer loyalty, result-ing in most financial service needs being pur-chased from a single organization.

To this end, service providers are using theircredit products to increase the effective li-quidity of assets held by consumers. In addi-tion to such traditional offerings as creditcards, they are creating lines of credit securedby a variety of assets that range from homeequity to securities portfolios. Ease of ac-tivating lines of credit is emphasized. In thecase of an overdraft account, the same checkor debit card that is used to draw funds froma transaction account is the instrument usedto activate the line of credit when the fundsin the account are exhausted. Some institu-tions issue checks that can be used to drawagainst home equity at the convenience of thecustomer. The customer benefits by being ina position to take advantage of opportunitiesto make either purchases or investments onfavorable terms that may be available only forlimited periods.

Information processing and telecommunica-tion technologies are key elements in support-ing the viability of the credit products that arenow offered. One of the reasons a credit cardissuer can guarantee payment to the merchantaccepting it is the ability to keep track of ac-count activity and effectively to halt its usealmost instantaneously if circumstances re-quire. The processing and clearing of creditcard drafts would be virtually impossible with-

out the technologies. Paper is truncated earlyin the processing cycle as one factor in con-trolling costs of processing and to facilitatethe timely posting of transactions to custom-ers’ accounts. Some merchants submit trans-action data electronically to card issuers to fa-cilitate processing.

Credit has long been a tool of the retail in-dustry. Card bases have been created on theassumption that they help create and main-tain customer loyalty and facilitate impulsepurchases. Advertisements are regularly in-cluded with customer bills. While most retail-ers do not rely heavily on revenues generatedfrom retail receivables, the funds generatedcan be considerable.

Some retailers see third-party cards such asthose offered by banks as an interference intheir relationship with their customers. Retail-ers feel they should know when a customer isactivating a line of credit so that an alterna-tive can be offered. Also, retailers question thepropriety of card issuers charging the samediscount for a card transaction, whether it acti-vates a line of credit (credit card) or is usedto access a transaction account (debit card) inlieu of a check.

While individuals make extensive use of avariety of credit services, businesses andgovernments are also major users of credit.Generally, these users are quite sophisticatedand use a number of services that are not avail-able to the general public. The Federal Govern-ment is active in the primary credit marketsas an issuer of debt. Also, one of the primarymeans used to implement monetary policy istrading by the Federal Reserve System inFederal Government securities in the openmarket.

Further complicating the credit markets isthe multiplicity of providers of credit services.Depository institutions and retail merchantshave been mentioned. However, among otherparticipants in the market are consumer finan-cial companies, mortgage bankers, insurancecompanies, pension funds, and acceptance cor-porations, such as those operated by major

110 Ž Effects of Information Technology on Financial Services Systems— — . ———.—

automobile and appliance companies. Privateindividuals also make loans, as is the casewhen the seller of a home takes a second mort-gage from the buyer for a portion of the pur-chase price.

Credit is extended in the following ways:

1.

2.

3.

4.

1nstallment credit—a direct loan to an in-dividual or business, repaid in fixed, peri-odic payments; it is a type of closed-endedcredit. A typical example is a car paymentloan.Open-ended credit, often called revolvingcredit—funds that are available under anagreement that allows the borrower toborrow several times, up to specifiedcredit limits, with interest and withoutfurther investigation of creditworthiness.Many charge accounts at departmentstores and credit card accounts are ex-amples. Since part of the loan is repaidover time, the borrower can again drawagainst the line up to the predefine limit.This type of credit is often open-endedwith respect to time and the total amountof credit available, Minimum paymentsare required, and the maximum amountof credit extended is limited.Closed-ended credit—a loan that is ex-tended for a predetermined amount. Theborrower cannot reopen it by obtainingextra funds under the original lendingagreement.Line of credit–the amount of credit alender will extend to a borrower over aperiod of time, where the borrower candraw on the lineup to some fixed limit athis/her discretion. Generally it involves aspecified amount of money a customermay borrow without filing a new loan ap-plication. A personal line of credit onchecking accounts is one example; thecredit card with a line of credit is another.Each month, the individual cardholderchooses between complete payment of theinvoice or extended credit, with the choiceof making a minimum payment. The cred-it is used not only for purchases and creditpayment, but also for obtaining cash ad-vances. With the exception of cash ad-

vances, the cardholder can pay the entireamount due without finance charges.

Commercial Credit

Commercial credit is the credit extended tobusinesses by various lenders. Commercialbanks are the primary funders of commercialcredit, but recent legislation gave savings andloan associations limited power to participatein this market. Others, such as acceptance cor-porations, leasing companies, and factoringcompanies are also active. Generally, the debtis short term and is used to meet requirementsfor working capital, such as the funding of re-ceivables or inventory.

Much commercial lending activity is conven-tionally viewed in the category of wholesalerather than retail financial services. For exam-ple, commercial banks will purchase consumerdebt from consumer finance companies, whichthen lend the funds to individuals at higherrates than banks charge. Commercial lendersalso finance capital acquisitions through third-party leases that cover such items as aircraftand computers.

Commercial organizations will also floatdebt in the open market, where it may be pur-chased by any variety of lenders. One is short-term commercial paper; but, as discussed inthe chapter on the securities industry, long-term bonds are also issued.

Consumer Credit

Consumer credit is a specified amount ofcredit that is extended to individuals primar-ily for personal, family, or household purposesby a number of types of institutions that in-clude issuers of travel and entertainmentcards, retail merchants, consumer finance com-panies, and acceptance corporations. Early on,depository institutions began to recognize thatconsumer loans were not only an asset to thebank, but also a contribution to the overalleconomy. Consumer credit loans are extendedto individuals or small businesses and providefor repayment either monthly, quarterly, an-nually, or in full at maturity. Consumer credit

Ch. 4—Retail Financial Services Ž 111— — — — — — .—————— — — — —

can be extended through loans, overdrafts,credit card checks, and credit cards.

Loans

The extension of credit is perhaps best rec-ognized in the form of a loan. Simply defined,a loan is money lent, generally to be repaidwith interest. Loans can be made on a securedbasis, where the funds are protected by pledgedcollateral, or on an unsecured basis, where thefunds are extended with no pledge of collater-al. Loans are made to consumers and busi-nesses on a regular basis. A loan is an agree-ment between two parties. The lender does nothave to be a financial institution. Loans canbe secured by life insurance, contracts, depos-its in financial institutions, securities, or per-sonal and real property. Banks, acceptancecorporations, consumer finance companies,and credit unions are major lenders of con-sumer credit.

Overdrafts

Credit can also be extended through an over-draft, which is a check or payment order writ-ten against a demand deposit or transactionaccount for funds in excess of the balance. Itmust be arranged in advance, and when hon-ored by the depository institution, the over-draft creates a loan. If approval for overdraftprivileges has not been obtained in advance,overdrafts are prohibited. Basically, the over-draft can be defined as an instrument thatoperates with a credit limit, fixed by the in-stitution for each customer and reviewed peri-odically. Since the application of an overdraftis typically for personal use, it is rarely se-cured. The arrangements for repayment of theoverdraft are set by each institution.

Credit Card Checks

Credit card checks are special drafts writ-ten against a credit card account rather thana demand deposit account. They are issued inconjunction with a credit card account and ac-cess a credit line. They work just like a per-sonal check; however, the amount is chargedautomatically to the credit card balance at

time of use. Credit card checks are treated ascash advances, with the monthly statementreflecting the advance. When used, interest ispaid on money borrowed from the day thecheck is written. Merchants do not have to paythe discount and service fee associated withall card transactions when credit card checksare used.

The development of credit cards has helpedsatisfy the demand from consumers for a moreconvenient way to finance their day-to-daycredit needs.

Credit Cards

With the advent of electronic banking sys-tems, the plastic card has become common-place in today’s financial institutions andretail organizations. Nearly all customer/bankcommunication terminals—ATMs, remoteservice units, POS terminals-use card tech-nology in some form. The card is used to ac-cess funds in various accounts and as a me-dium to extend credit. Today, almost 600million credit card accounts exist in the UnitedStates, and 7 out of 10 households have atleast one credit card. Outstanding balanceson credit card accounts total more than $75billion.’

Electronic processing has helped minimizethe amount of paper used in handling creditcards, and online credit authorization hashelped encourage card use because it entailsless of a waiting period. The transaction canbe approved and completed within a timeframe that is acceptable to the customer.Today, there are many online POS terminalsfor credit authorization throughout the UnitedStates. Generally, any credit card can be ac-cepted by the systems, which operate overstandard telephone lines.

Credit cards offer the individual the abilityto defer payment of part of the balance dueas part of an extension of credit. A dollar, orfloor, limit is established, which permits using

‘Federal Reser\’e Board, L’redit Cards in the U.S. Eccmon]L\r—Their impact on Costs, I]rices and Retail Saies, July 27, 1983,p. 1.


the card without credit authorization at thetime of purchase. For purchases over the re-quired floor limit, credit approval is necessary.Ceilings are generally set on the total amountthe cardholder may have outstanding.

Over the past several years, many of thecard-issuing organizations have imposed an-nual fees to the cardholder for use of the card.Interest paid on outstanding balances fallsunder State usury laws. Certain State laws,however, place rigid standards on such ac-tions. The result has been: 1) higher annual in-terest rate charges to the cardholder, wherepermitted by usury laws; or 2) the relocationby the card-distributing organization of itscredit card processing facilities into Statessuch as Delaware and South Dakota, whichpermit higher interest, card fees, or both, sothat the card-distributing organization is ableto operate under the banking laws of the Statewhere the processing is done.

Card-issuing organizations impose annualfees on credit cards as a way to generate ad-ditional income. These funds were needed be-cause of the high interest rates financial insti-tutions were paying for funds. Additionally,the annual fee charge is a way to generate in-come from those individuals who use the bankcredit card as a convenience mechanism andwho pay the monthly statement charges in fulland therefore do not incur interest charges.

Basically, there are three kinds of creditcards: bank cards, travel and entertainmentcards, and retail and nonbank cards.

Bank Cards.-The bank credit card hasbecome an integral part of the American life-style. Bank credit card systems have a struc-ture all their own. The two major bank creditcard systems are VISA and MasterCard.VISA International is owned by over 15,000member financial institutions located inalmost 100 countries. Over 100 million cardshave been issued, allowing consumers accessto checking accounts, savings accounts, in-vestments, and lines of credit. VISA U.S.A.is jointly owned by U.S. financial institutions,including banks, savings and loans, creditunions, and mutual savings banks. VISA oper-

ates a worldwide electronic data communica-tion system that transferred nearly 1 billiontransactions between member institutions in1983.7

For processing purposes there is no distinc-tion between a VISA debit or credit card. Thesame processing procedures apply for bothcards; therefore, only the card-issuing institu-tion and the cardholder are familiar with thefunction of a particular VISA card.

Each card-issuing financial institution setsthe policies for its own customers in the VISAsystem. These policies are regulated by appli-cable State laws that limit maximum chargeson credit card accounts, the method of as-sessment of finance charges, and minimumcharges that can be imposed on credit card ac-counts. Different card-issuing banks nation-ally may compete with one another and mayhave slightly different policies. Generally, themost important competition exists betweenbanks as they attempt to sign consumer andmerchant accounts. The merchant discount of-fered to encourage acceptance of the card atan establishment is one of the primary com-petition tools.

Bank credit cards have become subject tocredit controls because of their role in extend-ing consumer credit. They are recognized asinstruments for installment lending to con-sumers and as loans by banks. The controlstend generally to be the ones applying fromtime to time to consumer credit. The controlsinclude compliance in usury limits and truthin lending as set forth in Regulation Z.

To examine critically the national bank cardsystems and the member institution’s role asan extender of credit in the financial serviceindustry requires some analysis. Inherent inevery payment device are two separate anddistinct services. The first is payment forgoods and services, and the second is the ex-tension of credit. The first has traditionallybeen priced in free and open competition andhas not been subject to usury laws. The sec-

7VISA, U. S. A., Credit Controls and Bank Cards Analysis andProposal, March 1980.

. ..

Ch. 4—Retail Financial Services . 113— —

ond has traditionally been subject to usurylaws. Whether the card is used solely as a pay-ment device or as a credit device, by deferringpayment of the full balance, is determined bythe cardholder. The use of electronic technol-ogy and plastic cards has made it possible tocombine multiple functions in a single device,blurring the distinction between what con-stitutes payment service and what constitutesextension of credit.

The national card systems have also ex-panded their use to include card access toATM networks. Several ATM systems estab-lished by banks use VISA or MasterCard asthe access card to a proprietary system. How-ever, both VISA and MasterCard have also setup their own national ATM networks to com-pete with national interchanges. They are inthe process, like other national ATM inter-change networks, of attracting ATM networksfrom across the United States to join their sys-tems. VISA also plans to establish a globalATM network.

Because Delaware and South Dakota allowhigher interest charges or annual fees for thebank card, a number of depository institutionshave moved their processing centers to theseStates. Although technically it makes no dif-ference where the actual processing is done,the critical elements are the type and locationof the organization issuing the card and thelaws that govern the State where the cards arebeing distributed. Credit cards are also distrib-uted by nondepository organizations, such asthe American Automobile Association, and bybrokerage houses. These cards are, however,tied to a financial institution for processingand credit extension.

Travel and Entertainment Cards. -Traveland entertainment cards serve the generalpublic in relatively the same manner as a bankcard. They offer the possibility of deferringpayment. Generally, the monthly limit asso-ciated with these cards is far greater than thatof the bank card; some are issued with nopreset expenditure limit. The cardholder ischarged an annual fee, and the monthly state-ment must be paid in full. As the name implies,

these cards are intended mostly for travel andbusiness use. Travel and entertainment cardcompanies generally follow more stringentguidelines in issuing the charge card than doissuers of other cards.

Several elite versions of the travel and en-tertainment card exist; for example, the Amer-ican Express Gold Card. These elite cards of-fer check-writing privileges and a higher floorlimit for purchasing goods (which exceed thosefor the conventional card). Both the Gold andconventional cards provide access to ATMsand traveler’s check dispensers and ease ofcheck cashing at hotels and American Expressoffices.

Photo credit: American Express Co

Automated traveler’s check dispenser

114 ● Effects of Information Technology on Financial Services Systems— . — — — - — — . — — . — — — — — . — — . — — —

Travel and entertainment card transactionsare consummated in the same manner as withbank cards. The difference is, however, thatthe drafts are accumulated and billed monthlyto the consumer, with the full amount duewithin a specified period after billing. Sincethis process is considered a payment service,its cost is unrelated to the funds outstanding,which are not considered a loan of money withrespect to usury statutes or annual percent-age rate disclosures. Usury statutes applyonly when the cardholder elects to pay ininstallments through a prearranged line ofcredit with a financial institution.

Retail and Nonbank Cards. -Retail creditcards are distributed by both large and smallretail and service organizations, which havebeen in the business of extending credit to in-dividuals and organizations for some time andwere the leaders in establishing the credit card.Large chains of retail stores, gas/oil com-panies, and hotel and travel businesses runtheir own credit card operations. Sears Roe-buck, the largest issuer of retail credit cardsin the United States, accepts only the Searscredit card in its stores.8 J. C. Penney, also a

‘Nilson Report, June 1983.

major retailer, accepts not only the J. C. Pen-ney proprietary credit card but also VISA andMasterCard. J. C. Penney, for example, has avery complex electronic network system, ena-bling it to service accounts online throughoutthe country. The Penney system supports35,000 online terminals, allowing access to theVISA system directly without the need for afinancial institution intermediary. It is theonly retailer to do so. Retailers continue to en-courage the use of their proprietary creditcards for several reasons: 1) to provide conve-nience to their customers, 2) to tie their cus-tomer base to their stores, and 3) to facilitateimpulse purchases.

Card operations can also cross companies.J. C. Penney, for example, processes credittransactions for oil companies. The authoriza-tion is accomplished by running dedicatedlines from the service station to the nearestPenney store. The signal is then sent over themain trunk line to the data center where theauthorization file is maintained. The informa-tion is captured and transmitted to provide abasis for generating customer invoices.

Electronic Funds Transfer

Funds transfer is defined as any transfer offunds by means of a check, draft, or similarpaper instrument or by electronic meansthrough a terminal, telephone, computer, ormagnetic tape so as to order, instruct, orauthorize a financial institution to debit orcredit an account. A transaction can take sev-eral forms: cash purchase, charge purchase,purchase by check or draft, deposit to an ac-count, withdrawal from an account, or a debitfrom one account to another account ownedby the same party, interbank, or intrabank.A currency-based funds transfer uses cash orcoin. A paper-based transfer of funds is ac-tivated by check, draft, or bank card/chargecard (when the transaction is not tied directly

to a communication system that facilitates animmediate debit or credit).

Electronic funds transfer (EFT) enables con-sumers to carry out financial transactions viaelectronic devices instead of using paper mon-ey or checks. Electronic funds transfers canbe carried out through use of an ACH, a homebanking system, an ATM, or a POS system.One example of an EFT transaction is the useof an access card, a plastic card encoded withan identification number to trigger the elec-tronic impulses. Although debit cards allowaccess to an account with adequate funds,some debit cards may also be used to borrowmoney, thus becoming all-purpose transactioncards.

— -— ——

Ch. 4—Retail financial Services ● 115— — — — - —. — -- -— —— .—

Automation and electronic payment sys-tems have often been at the forefront of recentchanges in financial service organizations. Cer-tainly one main effect of these changes lies inthe cost reductions that have been made pos-sible by the elimination of paper-based trans-actions, which are personnel-intensive and,therefore, costly. Electronic financial services,however, are not pervasive. While the deploy-ment of ATMs, for example, appears to beprevalent in major cities, smaller towns andremote areas of the country still rely on tradi-tional systems for delivering financial services,although this picture is rapidly changing.While individuals depend on traditional serv-ices, many of the financial service providersrely on automation for the ease and efficiencyof operating the services. Network systemscontinue to expand because communicationand information technologies enable a broadergeographic base to be served and allow in-creased transaction volume without a propor-tional increase in costs.

EFT has come to play an important role inthe financial service industry. Although EFTsystems have been operational since the late1960’s, it wasn’t until the mid-1970’s thattheir acceptance became more obvious. Elec-tronically transferring funds today involvesseveral methods: direct deposit, credit andcheck authorization at point of sale, and mostnotably, use of the ATM. To some degree, al-though they have not penetrated the marketas greatly as the ATM, the POS terminal andremote information systems, such as homebanking, also play significant roles.

Automated Teller Machines

The first applications of automation in cus-tomer services were very simple cash dispens-ers that provided the user with a fixed sumof cash in a single denomination. These sys-tems generally operated off-line, so the trans-action was not a direct debit. Now ATM sys-tems offer most of the same transactioncapabilities as a branch bank, allowing con-sumers to withdraw cash from a bank account,make deposits, borrow cash against a line of

credit, obtain a cash advance on a credit card,pay bills, transfer funds from one account toanother, and inquire about account balances.(The relative use of ATM functions is illus-trated in fig. 7.) Credit can be obtained eitherby granting of overdraft limits or, in somecases, through using a credit card rather thana debit card to activate the machine to obtaina cash advance. Systems vary, however; someare merely cash dispensers, although the tech-nology of the different systems is basically thesame.

The plastic card’s magnetic stripe is the“key” that unlocks the machine for use. Theway the data are encoded and what items ofinformation are placed on the magnetic stripevaries. A great deal of attention has been paidto the standards being developed for the plas-tic card.

Although the cost of ATMs has fallen sig-nificantly since their introduction, “the costof ATMs is unlikely to fall as rapidly as thatof many other parts of an electronic fundstransfer system because of the various me-chanical parts that are necessary. The capacityto process transactions and information willbecome much cheaper as intelligent terminalsare developed, with display screens and key-boards being largely electronic. There aremany mechanical parts in the dispensing ofcash, in the printer, and in the mechanisms foraccepting funds. A further result of the me-chanical nature of cash dispensing is the short-er life of currency because it quickly becomesunsuitable for use in cash dispensers’ ‘g

With the ever-increasing operating costs fortraditional delivery systems, the customer de-mand for new services, and the competitionfrom new as well as traditional sources, mostorganizations in the financial service industryrealize the need to use automated banking sys-tems. The initial cost of establishing an ATMis high, but it is far less expensive than build-ing a branch bank. And, unlike a branch, it canbe operated around the clock at a fairly lowincremental cost. Therefore, many bankers feel

9Revel], op. cit., p. 44.

116 . Effects of Information Technology on Financial Services Systems—-—-.—— —.

Figure 7.— Relative Use of ATM Functions,a 1974-81

1974

Cash

c

withdra75 ”/0

Balance transfers4 %

1976

:ash withdra74 ”/0

Balance transfers3%

1981

lithdr760/o

Payments2%

p osits19 ”/0

Payments2%

osits1%

nts

Balance transfers4%

aExcluding balance lnquiries. Includes only Years for which estimates based onfield research are available

SOURCE Economic Review Federal Reserve Bank of Atlanta, August 1983

that ATMs will provide both competitive ad-vantage and significant return on investmentover the next decade. To soften the high costof such systems, especially ATM networks,many financial institutions have entered intosharing arrangements.

The ATM, which is operated by the custom-er, can be located in a variety of places. In theUnited States many are installed either in themain banking space of bank offices, in lobbiespartitioned off from branches, or on the ex-terior of a building. They can also be locatedaway from the main bank, at shopping centers,grocery stores, gas stations, offices, and fac-tories. Almost all systems are or will be online.The customer’s plastic card allows him/her togain access to the ATM location outside bank-ing hours and to conduct his banking businessin relative security.

The large success of ATM deployment hascreated another trend in bank branching. In-stead of building large, full-service branchesthat are personnel-intensive and very costly,many organizations are replacing these struc-tures with satellite branches, which are small-scale, highly automated, full-service, and gen-erally require management by only two orthree personnel. ATMs, for the most part, re-place the teller; personnel are there to handlegeneral information or other personal busi-ness. Figure 8 illustrates the growth in thenumber of ATMs in use from 1974 to 1981.Figure 9 illustrates the increases in the aver-age number of transactions performed at eachATM.

ATM Systems

ATM services can be offered in one of fourways: a proprietary system, a shared system,an interchange system, and a piggyback sys-tem. In a proprietary system, or “single insti-tution” system, only the customers of thebank that developed and installed the ATMsystem may use the machines. In a shared sys-tem, a group of financial institutions mutuallyresearches, installs, markets, and operates thesystem. In an interchange system, separate in-stitutions with ATM programs or even sepa-

. . . .


r— .- J

—— .—

t– — — J

Photo credits: Steven Rothenberg

Consumers can obtain cash through a variety of service delivery systems


Figure 8.— Number of ATMs in Use, 1973-81

“ 50Annual growth rate

/45

. A

.1

40

35

1973 1975 1977 1979 1981

Average annual growth rate, 1973-81

34.780/o

SOURCE Economic Review, Federal Reserve Bank of Atlanta, August 1983, p 16.

Figure 9.—Average Number of Monthly Transactionsper ATM,a 1974-81

7 ’ 0 0 0~6,000

t

c.-

1974 1976 1981aDoes not include balance inquiries, includes only years for which estimates

based on field research are available

SOURCE Economic Review, Federal Reserve Bank of Atlanta, August 1983, p 16

rate, shared systems allow one another’scustomers to use their machines. The term“shared system” is associated with an inter-change system. Generally, there is an inter-change fee associated with using another insti-tution’s ATMs. A piggyback system occurswhen one institution with equipment allowsthe customers of other institutions to use itsmachines .10—

‘“Norman Penny and Donald Baker, The Law of ElectronicFunds Transfer Systems, (Boston, Mass.: Warren, Gorham &Lament, year), p. 6.03.

Shared ATM Systems

The number of shared and interchange sys-tems is growing rapidly. As national ATM in-terchange proliferates, shared systems suchas Plus and CIRRUS allow customers accessto their funds on a national basis. National in-terchange systems, however, are not being runonly by banking organizations. ADP, Inc., andAmerican Express have also begun develop-ing and marketing national ATM interchangenetworks. Supermarkets and retailers are alsopositioning themselves in the ATM arena.

There are, however, limitations to the kindsof services available through the national net-works. Presently, because Federal regulationprohibits interstate deposit-taking,* most sys-tems serve as cash dispensers and provide in-formation about account balances. The feesimposed for using national ATM systems areset by the individual networks and range from$0.75 to $1.30 per transaction. A portion ofthe fee goes to the financial institution whosemachine is being used, and a portion goes tothe organization running the system.

Not all ATM systems are run by bankingorganizations. With the advent of regional andnational ATM networks, ownership of thesenetworks by third parties has become a ma-jor business. The systems operate in two ways:the third-party company can own, deploy, andoperate the ATM network, with the financialorganization paying a transaction fee eachtime its customers use the machine, or thethird party can be the switch operator, receiv-ing either a percentage of the transaction feeor a fixed monthly fee for its processing ef-forts. These systems are developed on a local,regional, and national basis and are in directcompetition with bank-run systems.

Safeway–an Oakland, Calif., supermarketchain-has announced plans to develop andmarket a national ATM network. Presently,Safeway participates in a shared interchange

*Reciprocity agreement,g exist among several states. ‘heMassachusetts Legislature passed a bill in 1983 entitled “AnAct Relative to Branch Offices and Acquisitions of FinancialInstitutions, ” that permits interstate deployment of ATMs anddeposit-taking among five New England States.

Ch. 4—Retail Financial Services ● 119.——.

network, owned and operated by the NetworkExchange of metropolitan Washington, D.C.The objective of the Safeway program for in-store ATMs is to increase store traffic andsales by providing customers with full-service,one-stop shopping convenience. Safeway hascommitted to installing common-access ATMsin key stores throughout California. TheWashington, D. C., program, however, is pres-ently not a participant of the Safeway ATMprogram being developed in Oakland. To at-tract the maximum number of prospectiveshoppers, Safeway will promote both the avail-ability of the ATM services at its stores andthe financial institution cards that can accessthe machines. Safeway is also prepared toassist the participating financial institutionsin generating new accounts that can access thein-store ATM services.

Participation in the program is on a trans-action-fee basis. National Transaction Sys-tems, Inc. (NTSI), will provide ATMs; install,maintain, and service them; and perform allrequired transaction processing, funds trans-fer, settlement accounting, billing, and cus-tomer service operations required to supportthe Safeway ATM program. Safeway cashmachines will be linked to NTSI switchingand processing system via leased telephonedata circuit. Other leased data circuits will linkthe switch with the participating institutions’host computers. Initially, the only functionavailable will be cash dispensing, selected bythe financial institutions from the followingthree service-level options:

1.

2.

Direct host link. The participating insti-tution’s computer is linked directly to theNTSI switching processor. The institu-tion pays for the dedicated data circuitand modems associated with its host com-puter link to the NTSI switch.Direct host fink with “stand-in “process-ing. NTSI maintains a cardholder author-ization file and control parameters on theNTSI computer for processing the partic-ipating financial institution’s cardholderSafeway Cash Machine withdrawal trans-actions when the institution’s host com-puter is not available. In addition to the

3.

dedicated data circuit and modems, theinstitution pays a service fee for thestand-in processing option.Full stand-in processing. NTSI maintainsthe participating institution’s cardhold-er file online at NTSI. NTSI verifies thecardholder’s personal identification num-ber and authorizes or denies the card-holder’s Safeway Cash Machine trans-action in accordance with the institution’sauthorization parameters and cardholderpositive file information, updated daily bythe institution’s processor. The institu-tion pays an additional service fee for thisstand-in processing option.

Merrill Lynch, Pierce, Fenner, & Smith Inc.,has signed an agreement with Safeway Stores,Inc., that will enable the brokerage concern’scustomers to tie into the Safeway ATM net-work. Merrill Lynch customers who have oneof its Cash Management Accounts, which linka securities account and money market fundswith “check” writing privileges and a VISAcard, can use the VISA card to obtain cash atSafeway stores. This is expected to begin inearly March 1984; it will be limited, for thepresent time, to California locations. However,Merrill Lynch expects to expand the servicesto include nationwide access.

In Florida, Publix supermarkets has also es-tablished its own ATM network, which it of-fers for use to any bank in the State (operatedon a piggyback basis). Fees are imposed forevery transaction a customer makes at a Pub-lix terminal. In addition to deploying theATM, Publix also runs the switch that oper-ates the system.

Shared systems exist primarily on a local/re-gional basis. The Tyme Corp. of Wisconsin hasoperated as one of the first shared systems inthe United States, and in Washington, D. C.,the Money Exchange has operated as one ofthe first shared networks on an interstatebasis. Shared/interchange systems allow thesmall institution to compete with other finan-cial institutions in the ATM competition. Thefeasibility of all financial institutions operat-ing switches and deploying ATMs within a

35-505 0 - 84 - 9 : QL 3

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

contained area is uneconomical. By operatingin a shared/interchange environment, the fi-nancial institution can extend the geographicreach of its market and earn income from theATM.

CIRRUS—National ATM Network

The CIRRUS System, Inc., is a not-for-pro-fit membership corporation that allows itsmembers to offer their customers the conven-ience of nationwide ATM access. Incorporatedin June 1982, CIRRUS is headquartered inOak Brook, Ill. When fully operational, it willserve 41 States. Growth projections for thesystem are summarized in table 5.

Membership in CIRRUS is exclusively re-served for banks, savings and loans, and creditunions. Associate membership is limited tobanks. CIRRUS does not preclude its mem-bers from joining other networks, nor does itrequire the sharing of other electronic services,such as POS terminals. There are three classesof membership for the CIRRUS System:

1. Principal. Principal members have ex-clusive marketing rights in their terri-tories. They may share their link to theCIRRUS switch, run by the National Bankof Detroit, by licensing correspondentmembers. Principal members are requiredto add their ATMs to the network.

2. Associate. Associate members also havea direct link to the CIRRUS switch andmay share their connection with the cor-respondent members they license.

3. Correspondent. Correspondent membersare linked to the CIRRUS stitch throughthe principal or associate members wholicense them.

CIRRUS allows its members to offer theircustomers the convenience of nationwideATM access. Using a CIRRUS card at an

ATM deployed by any CIRRUS member, acustomer can make a withdrawal from his sav-ings or checking account, check balances, andaccess a line of credit. All CIRRUS ATMsmust accept the cards of every CIRRUS mem-ber; however, individual members may setlimits on the amount of cash their customersmay withdraw at a time. CIRRUS ATMsmust also be online in order to authorize trans-actions. The CIRRUS switch, maintained bythe National Bank of Detroit, does not providebackup authorizations for its members. Thenetwork ensures against switching downtimeby utilizing an ACI/Tandem computer.

Individual CIRRUS members are responsi-ble for the cost of hooking up to the switchand maintaining the connection. They mustalso pay for hardware and software modifica-tions necessary to comply with the network’soperating rules.

Associate members pay a one-time entrancefee of $25,000 to join the network, connectwith the switch, and reserve the right to li-cense correspondent members. Correspondentmembers’ entrance fees are set by agreementwith the licensing banks. Ongoing member-ship fees for the CIRRUS System are $2,500per month for associate members; correspon-dent members pay the membership fees set bytheir licensing bank. There are also process-ing and interchange fees. Each time a CIRRUScardholder uses his ATM card at a bank otherthan his own, the card issuer pays the switch$0.25 for processing the transaction. For with-drawals and for accessing a line of credit, thecard issuer also pays the institution deploy-ing the ATM an additional $0.50 interchangefee per transaction. For balance inquiries andother transactions, the card issuer pays themachine-deploying institution a $0.25 inter-change fee.

Table 5.—Growth Projections for the CIRRUS System, Inc., National ATM Network

1982 1983 1984 1985Number of CIRRUS participants . . . . . . . . . 682 862 1,760 2,297Number of CIRRUS ATMs deployed . . . . . . 3,364 5)015 7,210 8,839Number of CIRRUS cardholders . . . . . . . . . 14,600,000 18,000,000 28,900,000 32,700,000SOURCE The CIRRUS System, Inc

. .—


ATM-deploying institutions earn revenuefrom interchange fees every time another in-stitution’s cardholder uses their machines totransact banking business. Card-issuing insti-tutions are permitted to charge their custom-ers for the privilege of being linked to theCIRRUS network. Associate members canshare their direct link to the CIRRUS switchwith other institutions for a fee, and no mat-ter how many correspondents an associatesigns up, it never has to pay more than its flatmonthly membership fee. Members of theCIRRUS network are free to join othernetworks.

When fully operational, CIRRUS will linkover 5,200 ATMs serving over 16 million cus-

tomers. The national ATM switch is designedto handle at least two transactions per second.This represents a daily capacity of 173,000transactions.11

ATM Deployment Legislation

Deployment of ATMs remains dependent onState-by-State banking legislation. Figure 10shows the number of ATMs in each of theStates in 1983. Certain States, such as Illinois,have very strict, off-premise deployment laws.Illinois permits State-chartered banks toestablish ATMs subject to a number of geo-graphic, time, and number restrictions. First,

“CIRRUS Systems, Inc., Oak Brook, Ill.

Figure IO.— ATMs in the United States

1 1 1

SOURCE Economic Review, Federal Reserve Bank of Atlanta, August 1983, p 13

Legend Total ATMs

B

1700 to 4000700 to 1700500 to 700300 to 500200 to 300

Less than 100


prior to January 1, 1980, a bank may estab-lish not more than two ATMs, each no morethan 3,500 yards from its main office. Second,commencing January 1, 1980, a bank may es-tablish an additional eight ATMs, at the rateof two per year. Third, prior to January 1,1981, these ATMs maybe located only withinthe county of a bank’s main office. Finally,subsequent to January 1, 1981, a maximumof four of the eight ATMs may be locatedwithin an adjacent county. ATMs located notmore than 3,500 yards from the bank’s prem-ises need not be shared, but those located morethan 3,500 yards from the bank’s main prem-ises must be made available on a nondiscrim-inatory basis for use by customers of any otherbank that would be permitted (under the stat-utory geographic restrictions) to establish anATM at that particular location. ’z

In sharp contrast to the restrictive Illinoislaw is Wisconsin legislation on terminal de-ployment and usage:

Facilities established under the WisconsinEFT statutory provisions must be availableon a nondiscriminatory basis for use by anylike institution which has its principal placeof business in the State, or by any other likeinstitution which obtains the consent of a likeState, or by a national institution which hasits principal place of business in the State andwhich is using the terminal.

The statute requires that regulations pro-hibit, with regard to a shared terminal, anyadvertising that suggests or implies exclusiveownership or control of the terminal by a fi-nancial institution or group of institutions. 13

Wisconsin law made possible the first sharedATM network in the United States and oneof the largest.

Massachusetts went one step further. Inearly 1983 a law was passed that, for the firsttime, permits Massachusetts financial insti-tutions to link their ATMs to regional and na-tional interchanges. Entitled “An Act Rela-tive to Branch Offices and Acquisitions of

“Robert C. Zimmer and Theresa A. 13inhom, The Law of Ekc-tronic Funds Transfer, Card Services, inc., 1980, pp. I 1-11 toI 1-13.

“Ibid., p. WI-1.

Financial Institutions, ” the act establishesnew authority for mergers, branching, elec-tronic branching, and mortgage lending byMassachusetts financial institutions. Whilethe act is generally limited in its operation toactivities involving five New England States,the EFT provisions are expressly exemptedfrom such limitations. Under prior law, no out-of-State financial institution nor bank holdingcompany was permitted to purchase, estab-lish, install, lease, use, or share an ATM inMassachusetts. The sole exception was al-lowed in a grandfather clause that exemptedfrom the prohibition certain electronicbranches established before December 31,1981. To qualify for the exception, the ATMhad to dispense only cash, traveler’s checks,or both, and had to be limited solely to the useof customers of the financial institution thatestablished it.

The new law empowers Massachusetts insti-tutions to link their ATMs to regional or na-tional networks. It also permits a financialinstitution, organization, or bank holding com-pany, or its subsidiary organized outside ofMassachusetts, to share any ATM establishedand used by a Massachusetts financial insti-tution or organization, provided that the shar-ing entity limits its customers to cash with-drawals, advances against preauthorized linesof credit, and check cashing. Moreover, anyout-of-State nondepository financial institu-tion that establishes electronic branches thatdispense only traveler’s checks and are limitedto use by the nondepository’s own customers,such as American Express’s Express CashProgram, are allowed to establish, use, orshare electronic branches in Massachusetts.

Finally, the new law authorizes financial in-stitutions, organizations, and bank holdingcompanies in Conneticut, Maine, New Hamp-shire, Rhode Island, and Vermont to purchase,establish, install, operate, lease, or use elec-tronic branches. That is, whereas the prior lawpermitted institutions from any State to shareATMs established and used by Massachusettsinstitutions, the new law allows New Englandinstitutions themselves to establish and useATMs in Massachusetts, whether or not a

-—— —=—— . .—

Ch. 4—Retail Financial Services ● 123— — . . — — — — —— ———.—

Massachusetts institution is involved. ” All ofthe participating States passed legislation ap-proving the interstate branching.

There are no uniform guidelines on ATM de-ployment that each State follows in makingits EFT deployment laws. Each State’s legis-lature determines what approach will be bestfor the consumer and the banking community.

POS Full Funds Transfer

The term “point of sale” covers a variety ofservices rendered through machines located atretail establishments. POS terminals are gen-erally clerk-operated devices located at thecheckout or convenience counter of retail es-tablishments. Electronic cash register ver-sions of these terminals have been in opera-tion for several years, maintaining storerecords on sales, inventories, accountsreceivable, and the like. Now, POS deviceshave been linked to financial institution com-puters, allowing retail customers to receive ap-proval for check cashing and electronically ini-tiate transfers from their accounts to theretailer’s, the latter being POS full fundstransfer. In some installations, customers canmake deposits to their accounts. POS devicesaccept either a plastic credit card or a plasticdebit card, depending on whether the cus-tomer wants to delay payment by charging thepurchase or wants the purchase deducted di-rectly from his/her account. As electronic POSsystems proliferate, their use will probably re-place many of the paper transactions accom-plished through cash payments and check andcredit transactions.

The debit card, another means of facilitatingfunds transfer at point of sale, functions muchthe same way a credit card functions exceptthat when the transaction is received by theissuing financial institution, it is debited to thecardholder’s account, which may be a check-ing, savings, NOW, or other form of deposi-tory account. Some securities firms havedistributed debit cards to access cash manage-

—. —..41+:lc~tr0niC F’und< Transfer Association, llrashin~~ton Report,

tJan, 11, 19H3.

ment funds. The card may also have an over-draft credit line. There has been much cus-tomer resistance to using a debit card at thepoint of sale because the customer associatesthe use of a plastic card with the eliminationof float, which allows a grace period before ac-tual payment is required. Also, many peoplein the industry have referred to the debit cardas a paperless check, which is one of the rea-sons that retailers have been reluctant to ac-cept it. Presently, retailers can accept acceptand process checks for less than the fee im-posed for processing a debit or credit cardtransaction. These differences have resultedin controversy between the retailer and card-issuing institutions.

Another form of debit card transaction atpoint of sale gives the cardholder a rebate,which encourages use of direct debit at pointof sale. Customers use the card, which worksonline, to debit their account directly to anyparticipating retailer. The retailer receives in-stant credit, and the customer receives a re-bate, ranging anywhere from 2 to 5 percent,directly credited to his savings account. Oneof the most successful of these programs isthat of the Wilmington (Delaware) SavingsFund Society. Most of the other programs,however, have been unsuccessful. First of all,a significant card base was not represented.Second, many of the stores that signed up forthe program were inconvenient to the majorityof the cardholders, and these stores alsotended to sell products at a higher cost thandid discount stores.

Direct Debit POS

Retail Stores.–Although previously notmany POS systems operated in retail stores,there is tremendous potential for their use.One of the most successful direct debit POSprograms is in Des Moines, Iowa. There, Dahlsand Hy-Vee supermarkets operate direct debitPOS systems at the checkout counter, the firstsuch systems in the United States. Custom-ers of these supermarkets can pay for grocerieswith a proprietary debit card issued by Nor-west Bank, which automatically debits thecardholder’s account. ITS, Inc., operates the


computer switch that makes EFT possible forsome of the 205 participating Iowa banks, sav-ings and loans, and credit unions. The Hy-Veesupermarket does about 4,000 POS trans-actions per month; Dahl’s does about 2,000 permonth. Each location paid about $18,000 toinstall magnetic stripe readers and keyboardadd-ons to the NCR cash registers and to buythe processors and software. However, volumesales of the systems should cut costs. More-over, the store receives good funds the nextday.

Retailers and banks both benefit by havingaccess to the customer’s float, and both theretailer and the bank are assured the funds aregood. “To encourage direct debit use, bankerswill price check transactions higher than theirdebit card counterparts to nudge consumersalong. The cost of processing one check is esti-mated at about 50@, and an EFT transactioncosts about 30©. The higher the volume inEFT, the lower the per transaction cost be-cause of the high fixed overhead. ”15

Oil and Gas Companies.–The gasoline sta-tion is currently the focus of much POS activ-ity because it generates more transaction vol-ume than any other kind of retailer.16 Manylarge oil and gas companies are installing POSterminals at service stations. A few directdebit POS terminals are being deployed di-rectly into the gas pumps, although the ma-jority are stand-alone terminals.

While still in its infancy, the idea of deploy-ing POS terminals at service stations is be-coming more accepted because of the increasein self-service gas stations, because more sta-tions are remaining open 24 hours a day, andbecause service stations are often vulnerableto robberies. To help reduce the tremendousvolume of cash generated each week by gaso-line purchases, major oil companies and banksacross the country are joining forces to testPOS terminals at the pumps, using proprie-tary credit cards or bank debit cards as an

“Forbes, Aug. 29, 1983, p. 46.loMmagement Information Systems Week, July 27, 1983,

p. 81.

—

alternative method of payment. Most of thetests at the service station involve agreementsbetween oil companies and financial institu-tions under which customers can pay for pur-chases using bank debit cards that automat-ically debit the amount of purchase from theirchecking accounts. However, there is addition-al interest in proprietary credit card trans-actions at points of sale. Mobil Oil Co., for ex-ample, has 2,400 POS terminals linked to itsKansas City processing center, which capturesall transaction information via electronic draftcapture. Since the system is online the infor-mation is transmitted immediately. This POSsystem enables Mobil to capture billing infor-mation electronically, saving internal costs byreducing the amount of paper used in suchtransactions. Mobil implemented a credit POSsystem, which could easily convert to a hybridsystem supporting both debit and credit, tomaintain its loyal customer base and to gen-erate new business. Mobil representatives feelthat direct debit at this stage would alienatecustomers.

The POS transaction begins by the servicestation clerk inserting the card into a POS ter-minal. In some cases, the customer inserts thecard into an automated pump and then keysin his own personal identification number(PIN). By implementing direct debit POS ter-minals, the customer’s account is automat-ically debited, and the retailer’s account is gen-erally credited immediately or the next day.The benefits to both banks and oil companiesare savings of millions of dollars. In mostcases, the bank or network operator receivesa transaction fee for each purchase. The oilcompany saves by being assured of good fundsand by receiving payment immediately. Thisis a significant issue because the general lagtime for credit card sales draft, according toa Mobil Oil Co. official, is 10 days.

Some POS test situations currently underway are being done by AmeriTrust Bank, ShellOil, and Gastown in Cleveland, Wells FargoBank and Shell service stations in San Fran-cisco, First City National Bank of Houstonand Exxon Co.

Ch. 4—Retail Financial Services ● 125-—— —— — — . . ————— —

National POS Systems

Large-scale communication networks are be-ing developed, primarily by the major creditcard industry, to connect thousands of POSretail terminals with financial institutionswithin a State, region, and, ultimately, the Na-tion. These networks will include computerizedswitching centers and a base for clearing set-tlements.

In addition, oil companies, banks, and otherretailers are considering national POS net-works. Tests are being conducted by LibertyNational Bank & Trust Co. of Oklahoma Cityand a Southwest oil dealer whereby terminalswill be deployed at stations offering the fol-lowing services: automated dispensing at thepump, an ATM inside the station for purchas-ing convenience items, and a commercial de-pository that is wired to the ATM so thathigh-volume stations can make deposits.

At the present time, POS systems are be-ing allowed by regulators to access time andsavings accounts; however, this could change.Regulation D* is not being strictly interpretedwith respect to POS activity. However, if theregulation were strictly interpreted, a largenumber of financial institutions, savings andloans, and savings banks, would be prohibitedfrom actively participating in a POS system.

Other Uses of POS Systems

The POS terminal can also be used for checkauthorization, permitting the customer to ob-tain approval of a check for payment by run-ning a verification of the check-cashing recordthrough a computer. Likewise, the POS sys-tem enables merchants to verify the availabil-ity of funds in a customer’s account or his ac-cess to credit before completing the sale. Aswith ATMs, customer access to POS terminalsis usually by plastic card and PIN. This is analternative to manual authorization and veri-fication, which is handled by accessing a neg-

*Regulation D is a uniform reserve requirement on all depos-itory institutions with transaction accounts or on personal timedeposits. It requires submitting reports on all deposits to theFederal Reserve Board and sets phase-in schedules for reserverequirements.

ative file or by having the retailer check a man-ual that lists card numbers of bad credit risks.

In the United States, POS experiments havebeen conducted since 1974. Very few systemsinvolving instant transfer have survived, andthe most important functions of POS, untilonline direct debit systems were in place, havebeen check verification and credit card author-ization. One explanation for this very limitedsuccess could be that the experiments havegenerally looked for evidence of profitabilitywithin a few months of installation, whereasthe change in social habits involved in mov-ing from cash and checks to instant transfertakes a great deal longer.

Costs of POS Systems

For several years merchants and financialinstitutions have been at an impasse over howto implement electronic payment systems,especially retail EFT systems. The differingperspectives reflect differences in technologiesbeing used, in terminal ownership, in customerbases, and in approaches in pricing the service.

One of the main concerns associated withimplementing POS systems is the cost to beborne by retailers and banks. Another is theconcern about merchant discount fees. Mostbanks charge the merchant the same fee fordebit card transactions as they do for creditcard transactions. The argument made by themerchant is that debit cards function in lieuof a paper check and therefore the merchantshould not pay the same discount fee. A POSsystem can all but eliminate float, reducecredit risks, require the merchant to keep lesscash on hand, and ease check approval.

Technology has also been a basis for conflictbetween the merchants and POS operators. Fi-nancial institutions typically base their debitcards on the magnetic stripe technology usedfor years on bank credit cards. Grocery retail-ers, on the other hand, typically base theirtechnology on an optical scanner that readsbar codes on product labels and transmits theinformation to an electronic cash register(ECR). Department stores typically prefer op-tical character recognition characters read

126 • Effects of Information Technology on Financial Services Systems—

from merchandise tags and proprietary creditcards with a handheld wand. Product and cus-tomer information is fed into an ECR to ef-fect electronic payments.

Financial institutions tend to prefer owningthe necessary terminals and charging mer-chants a user’s fee for making transactionsthrough them. On the other hand, retailerstend to prefer devices that are integral com-ponents of their own ECRS.17 Naturally, finan-cial institutions and the merchants are weddedto their respective investments. It is unreal-istic to expect the merchants to give up theirtechnology in order to accept electronic pay-ments. Developments such as VISA’s “elec-tron card” are aimed at simplifying thisproblem.

Another issue with respect to POS systemsis the volume of sales to be handled. It hasbeen argued that to be viable economically, thePOS system must become competitive withcash; otherwise, there is no incentive for theretailer or the customer to use it. The customeris faced with loss of float, and the retailer isfaced with transaction fees, which cash pay-ments do not require. Under these conditions,systems that are shared among all the banks—.- ——_——

“’’Debit Cards at the Cross Roads, ” Economic Review, March1983, pp. 37-38.

in an area and that provide for the recruitmentof most retail outlets stand the greatestchance of success.

POS systems will undoubtedly increase dur-ing the next decade, with many new systemsbeing built upon existing ATM networks.Both the banks and retailers stand to gainfrom the resulting reduction in the volume ofpaper transfers. However, merchants contendthat since a debit card transaction saves finan-cial institutions time and money relative to acheck transaction, merchants should enjoysome of the savings. It has become quiteapparent that in order for POS systems to de-velop and operate efficiently, the systemsmust be designed in close cooperation with theindividual retailers, not just the markets thesystems serve.

The technology necessary to operate elec-tronic debit and facilitate POS transactionsexists today. It is the intention that electronicdebit cards will substitute for check, creditcard, and cash transactions. However, whenPOS services become commonplace, the useof cash and checks as a payment mechanismwill still exist. Disconcerting cost trends areleading merchants and financial institutionsto seek lower cost alternatives for POS trans-actions. EFT is the method by which this goalcan be reached.

Financial Information Services

There are many forms of information serv-ices in the financial service industry. They in-clude check or credit authorization/verifica-tion; status information on account balances;identification verification; billing and fundsdue information (e.g., preauthorized pay-ments); accounting information with respectto general ledger, payroll, accounts payable,accounts receivable; and modeling and analyti-cal services, such as Chase Econometrics andWharton Econometrics, which provide accessto data bases, econometric models and mod-

eling tools, and various other analyticalpackages.

All financial service providers use informa-tion services. Retailers are perhaps one of thelargest users of specific information services,particularly check verification. Check verifi-cation validates the authenticity of the checkor its presenter. This system is accessed onlinethrough a telephone or terminal by the retailer.The retailer pays for this service, generally apercentage of the value of the check. These

Ch. 4—Retail Financial Services ● 127— .

systems are run by third-party organizationsand banks that maintain negative files.

Check Authorization

Check authorization systems may be pro-vided and maintained by the party acceptingthe check, by a financial institution, or by athird party engaged in such a business. Thesystems may be designed to access bank rec-ords directly or may rely on secondary datasources. In some systems, check approval isaccompanied by a guarantee of payment. Inan EFT system, a customer’s plastic card andPIN can be used to access the system and ver-ify the available balance. This is accomplishedby placing the check into a terminal and key-ing in the appropriate information. The checkis then validated and accepted at point of sale.

Credit Authorization

Credit authorization is yet another informa-tion service vehicle available to the retailer.It operates by allowing the customer’s creditcard to be read by a financial service terminalwhile a central computer verifies that the cardis valid and the customer’s account has suffi-cient funds. This can also be accomplishedmanually by checking a printed document, dis-tributed by the card companies, indicating lostor stolen card numbers or by placing a call toan operator who will authorize or refuse thetransaction based on information from a database. This inquiry process is supposed to re-duce the risk of credit fraud or of extendingcredit in excess of an imposed credit limit.

Information service systems allow for real-time access and reduction of risk at point ofsale and ensure that the retailer will receivethe funds. The risk is transferred to the partyauthorizing the funds. This service guaranteespayment to the retailer and is attractive de-spite the fact that the retailer must pay apremium to insure the funds.

Providers of Information Services

Many kinds of organizations are informationproviders. Depository institutions use and pro-

vide information in unique ways. For exam-ple, the services they perform include provid-ing status information to their customers ona very regular basis. The most familiar proc-esses are inquiry of account balances or fundscredited or inquiries regarding specific checkclearing. Today, much of the status inquiry in-formation is processed by online teller ter-minals with direct access to the accounts be-ing questioned.

Service organizations provide accounting in-formation services to customers, such as in-formation services about payroll or accountsreceivable/payable or other services necessaryfor efficiently running the organization with-out the added costs of implementing an auto-mated system in-house. A wide variety offirms, including financial service providers, of-fers these services.

Two other key information service providersin the financial service industry are invest-ment brokers and insurance firms. (The bro-kerage industry is covered in ch. 3 of this re-port.) Insurance information is compiled byactuarial scientists and categorized by risk,age, and the like. Much of this information isavailable to individual brokers through onlinevideotex terminals. Insurance information re-quires some customization in order to meet thespecific needs of the party requesting the in-surance, although premiums and risk are de-termined by actuarial methods.

The information provider in the insuranceindustry is the insurance salesman. Althoughmuch information about general insurance isaccessed to data bases via terminals, the proc-essing of this information still requires the per-sonal interaction of the salesman and client toprovide the service adequately. Some insur-ance information is provided through com-puter/CRT* terminals that display rates andalso give an explanation of the types of insur-ance available. The insurance industry is look-ing at further automating the delivery of in-surance information.

*CRT terminal—video terminals that display data on a cath-ode-ray tube.


The following scenario may present itself inthe near future. Through videotex and homeinformation systems, insurance informationcan be transmitted and reviewed by an in-dividual. If the need presented itself, for ex-ample, an individual would be able to increasethe amount of homeowner’s insurance for aspecific period of time, say a weekend, if heplanned to be out of town. The insurance pol-icy modifications could be done instantane-ously, and the additional premium paymentcould be automatically debited from the cashvalue of other insurance policies.

Several of the larger banks in the UnitedStates offer financial, securities, and invest-ment analyses; payment products, models anddata bases to corporations, other banks, insur-ance companies, financial institutions, andgovernment agencies. An example is terminal-based cash management for major corpora-tions and banks.

Mortgage servicing is another aspect offinancial information services. Mortgage bank-ers and a growing number of commercial, mu-tual savings bank, and savings and loan cus-tomers use this type of service for servicingtheir portfolios of mortgage loans, which in-clude taxes, escrows, and insurance. Loan clos-ing documentation and mortgage preparationsystems are available to help customers of theservice keep track of inventories and financialcommitment needs. Batch transmission andinquiry modes to a central location are usedvia dial-up and leased transmission lines. Inthis manner, nationwide service is providedfrom a single location.l8

Information services provide immediate ac-cess to financial information and are used to

18 Herbert A. Schulke, Jr., “Electronic Financial Systems, ”Innovations in Telecommunications, Academic Press, Inc.,1982, p. 1038.

transfer funds efficiently from one account toanother. For example, in a corporate environ-ment, real-time access and videotex technol-ogy allows a treasurer or financial advisor tomanage and control all of the investment ac-counts. Through the same technology, invest-ments can be transferred on a daily or perhapseven hourly basis.

Many organizations today conduct financialcounseling programs for all ages and groups.These groups organize to seek sound financialguidance and to plan for long-range moneygoals. Interestingly, these groups include notonly the affluent market but also young pro-fessionals and middle-income individuals whohave become far more educated and concernedabout how their finances are handled.

Different sectors of the financial service in-dustry require different information services.For example, a bank loan officer may inven-tory data to assess liquidity and solvency. Fi-nancial analysts are concerned with equity in-vestment decisions and are likely to place moreimportance on earnings-per-share and capitalaccount data. On the other hand, various fi-nancial service groups use the same informa-tion in different ways in the decision process.

Service industries, such as banking, securi-ties, and insurance, whose business operationsrely heavily on information services, are find-ing that the whole environment in which theyoperate is changing rapidly. Earlier develop-ments in information technology were suchthat only large corporations could take advan-tage of its capabilities. However, over the lastseveral years, technical innovation has con-tinued at such a rapid pace that, for example,information processing power, which oncetook a roomful of large equipment, is nowavailable in portable machinery.

Home Information Systems

Home information services are a way by Home information systems (HIS) started inwhich financial information services can be de- a relatively minor way in the United Stateslivered to users of home computer terminals. several years ago with the introduction of bill

Ch. 4—Retail Financial Services • 129. — — . —. —. —.—— — — -

paying by telephone. The original impetuscame from thrift institutions, which saw tele-phone bill payment as a way to offer trans-action accounts, thereby partially circumvent-ing the law forbidding payment of interest ondemand deposits. Soon commercial banks be-gan offering the service. When the telephonebill payment service was first introduced, mostof the systems required the customer to callin and give oral instructions over the telephoneto an operator to perform banking services,specifically bill payment. Automation was in-troduced and made available to customerswith touch-tone phones, although most sys-tems still relied on operators during the busi-ness hours and on recorded messages at othertimes. Telephone bill paying services did notattract a large customer base, and many of theearly programs have come to a halt.

Technology of HomeInformation Services

The introduction of videotex played a keyrole in the development of home informationsystems. Videotex—a generic term that refersto computer-based information retrieval sys-tems that display text and graphics via videoscreen—is a product of the convergence oftelecommunications and computing technol-ogies. Through teletex* and videotex, one-wayand two-way computer-based retrieval sys-tems, information can be widely disseminatedfor viewing on modified television sets or onpersonal computers. In the last year or so, fullvideotex systems have become operational inseveral countries, giving the user the abilityto send communications to the system com-puter for onward transmission. Because thevideotex system is interactive, it can be usedto facilitate financial transactions. The systemfunctions in several ways. One way uses avideotex terminal and a television (which actsas a visual display unit); the communicationwith the system is supplied by telephone lines

*Teletex is a one-way system that displays alphabetic andgraphic information on a modified television set. Videotex dis-plays the same sorts of information as teletex but also providesa communication path for the user to interact with the serviceprovider.

or cable lines. Some systems provide a hybridcommunication delivery, using cable for in-coming information and the telephone for out-going information. In-place cable lines are pri-marily one-way communication lines, althoughmost new cable lines being laid today are two-way cable lines.

Home computers also allow interaction withHIS and are becoming popular for receivingthe services. A modem** can be used to tiethe home computer to the information sourceby telephone lines. A CRT or television screenacts as the visual display terminal. The homebanking software which runs the system is dis-tributed by the participating financial insti-tution.

As stated, cable plays an increasing role inthe delivery of home information services.“The latest cable television systems now be-ing developed will transform the technologyof videotex and the economics of home bank-ing. The use of coaxial or fiber optic cablesgives much greater bandwidth, which providesthree substantial technical advantages: 1) thepossibility of carrying a large number of chan-nels, up to 100 or more; 2) a more satisfactoryand speedy interactive facility; and 3) a muchimproved ability to produce pictures (impor-tant in using home shopping).’’” Direct broad-casting by satellite, which is being developed,is another method by which information canbe transmitted into the home.

Developers of Home Information Systems

Home information systems are being devel-oped by a myriad of organizations that includedepository institutions (presently Bank ofAmerica and Chemical Bank are marketingsystems that are up and running), informationcompanies, entertainment companies, and thelike. Several systems are being developed ascosponsored, joint ventures by consortia ofmajor banks and corporations. One example

**A modem transmits digital or computer information overtelephone lines by manipulating it electronically and also pro-tects the lines from undesirable signals that might cause in-terference with other users.

19Revel], op. cit., p. 50.

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

of a major project is the Viewtron Programin Miami, Fla. The Viewtron system will besupported by computers from seven major cor-porations from around the country and will belinked to Viewdata Corp. ’s Viewtron com-puters in Miami. The gateways are AmericanExpress—subscribers will have access to a va-riety of services offered by this company; Com-modity News Services—subscribers will beprovided with instant and delayed stock mar-ket and commodity price quotations; and E.F. Hutton–subscribers will be able to tracktheir personal investments and receive invest-ment advice with “Huttonline,” the first elec-tronic information service offered by a retailbrokerage house. E. F. Hutton customers willbe able to access Hutton’s computers in NewYork City for information about their ac-counts, such as cash management and marginbalances, portfolio positions and market val-ues, open orders, and recent transactions. AllViewtron subscribers will be able to orderE. F. Hutton market comments and invest-ment advice and send electronic mail to E. F.Hutton offices. Viewtron subscribers will alsobe able to order J. C. Penney catalog merchan-dise by using a direct link to J. C. Penney com-puters in Atlanta. They will receive online or-der confirmation upon completion of theirorder. If the requested item is not availablein the color requested, the J. C. Penney com-puter will offer the Viewtron subscriber othercolor possibilities. The J. C. Penney cataloginventory system is immediately and automat-ically updated. In addition to processing thecatalog order, the gateway to J. C. Penney willalso provide for credit authorization for the J.C. Penney card, as well as for VISA and Mas-tercard. In addition, information from TheOfficial Airline Guide and Grolier AcademicAmerican Encylopedia will also be available.

The financial gateway to the system, Video-Financial Services, is jointly owned by fourmajor bank holding companies: SoutheastBanking Corp., Miami; Wachovia Corp., Win-ston-Salem, N. C.; Bane One Corp., Columbus,Ohio; and Security Pacific Corp., Los Angeles,Calif.

Applause, the home banking software of-fered by VideoFinancial Services, will supplya variety of services. The home banking activ-ities include bill payment, funds transfer andaccount information, and special financial re-quests. VideoFinancial Services also providescredit authorization and settlement for creditcard shopping orders placed on Viewtron. Thesystem permits each participating financialorganization to specify unique features withinthe system standard, including the use of in-dividual colors and graphics. Presently, 12Florida banks and savings and loans will pro-vide home banking to Viewtron subscribersvia VideoFinancial Services’ computers in Or-lando, Fla.

As a financial gateway, VideoFinancial pro-poses to provide the Applause service to allsections of the country through any videotexnetwork. To support such an objective, Video-Financial expects to establish regional datacenters, where practical and necessary, to in-terconnect the financial industry to the re-gional network operator. The system will bestreamlined. First, the home terminals will tiedirectly to the network operator, who will befully responsible for promoting, enrolling, andbilling the consumer for the network service.Communications, terminals, and data basemanagement will be provided and managed bythe service provider. The network will thenfeed into the VideoFinancial computer system.VideoFinancial will either connect online withor provide batch processing for subscribing fi-nancial organizations and will be responsiblefor developing and maintaining the home bank-ing software package. The VideoFinancialcomputer system will tie in directly to the fi-nancial organizations offering the service.These financial institutions will assist the net-work operator in enrolling the consumer andwill provide the data to VideoFinancial to sup-port the home terminal request.

Over 50 information providers, includingmajor wire services, educational organizations,reference and financial book publishers, uni-versities, libraries, and professional organiza-tions provide information for Viewtron.

—

—-—— —.

Interestingly, the advent of HIS has en-couraged cooperation instead of competitionamong the various financial service providers.

Costs of Home Information Systems

Cost is one of the major issues associatedwith the success of the HIS program. TheViewtron videotex costs are as follows:

● Subscription to the Viewtron service: $12per month for access to nearly all View-tron services.

• Communication charges to access View-tron: approximately $14 per month (ap-proximately $1 per hour to access View-tron).

A serious consideration is the influence oflocal communication costs and their impact onHIS. It is possible that communication costscould increase to such a degree that the costof making a local call discourages use or forcesdevelopment of new types of local links.

Consumer acceptance of home banking/home information systems will be based onseveral other factors besides the natural in-clination toward using these services. Thesefactors include price of obtaining the hard-ware/software needed to use these services,price of using the services, and availability ofthese services. *

The Market for HomeInformation Systems

Much speculation has been associated withthe home information market. Several leadingauthorities have targeted the affluent segmentof the population as the major users of thehome terminal. Their claim is that many con-sumers with incomes over $40,000 per yearhave an insatiable need for information ofvarious types. The home terminal has greatpotential as the major investment, shopping,and news information source for affluent con-sumers. Additionally, it has been stated thatmany affluent consumers feel strongly thatthey can conduct their own financial trans-actions better than bank personnel can, andsome find it enjoyable.— . .

* Information from Reistad Corp.—research conclusions.

Ch. 4—Retail Financial Services . 131-. —. . .— — — . . . — — — — — — —— —

Systems now in operation serve interactivefacilities, providing travel services, sports, andgeneral entertainment information (e.g., res-taurant and movie guides); stock exchange in-formation; shopping capabilities; and bankingapplications in a form similar to that of self-service banking. Users of these systems canpay bills, transfer funds, check balances, re-view banking statements, and keep up-to-datefinancial records.

The elderly may be another target marketfor such systems. The ease of being able toaccomplish shopping and banking from thehome, it seems, would be very appealing.There are problems, however, with respect toacceptance of the system, hardware and com-munication costs, and, most importantly,changing behavior patterns. Principal charac-teristics of HIS users are listed in table 6.

For consumers to adopt and use home infor-mation innovation, it must be associated withsuch advantages as convenience, compatibil-ity, or specificity.

Implications ofHome Information Systems

It appears likely that home banking systemswill be tied to other services such as informa-tion services, entertainment, and even busi-ness uses. Also, any institution, whether finan-cial or nonfinancial, will be in a position toprovide financial services through a videotexnetwork and to support these services in muchthe same way as Merrill Lynch operates itscash management accounts.

Home banking and its impact on branchbanking has some major consequences. Witha single investment in a computer installation,a new entrant to the retail banking market hasthe whole national market open to it. As longas it has the necessary computing capacity tohandle the accounts of its customers, any bankwill be able to leap over geographic barriersand offer payment services nationwide. * Bythe same token, nonbank operators will be able

..-. .—*Banks have long been able to conduct business nationwide

by opening offices (usually via holding company affiliates orsubsidiary corporations) for business loans. This is also truefor mortgage companies and consumer finance companies.


Table 6.—Principal Characteristics of HIS Users

Level ofCharacteristic importance Comments

Age High Research studies indicate most potential customers ofHIS/home banking can be clearly identified by age.Two principal groups are 18-34 and 35-49.

Sex Low Research indicates sex is not an identifier for potentialcustomers of HIS/home banking. Men and women rankabout equally in intent to purchase.

PRONTO pilot research shows, however, men were morefrequent users.

Education Moderate Research indicates as the level of education increases,the propensity to purchase HIS/home bankingincreases.

In all studies the majority who are interested in HIS haveattained a college degree or higher.

Occupation Low Research indicates interest in HIS/home banking is notdependent on occupation. Blue collar workers andprofessional alike are likely to be interested in HIS.Interest increases gradually from a lower level amonghousewives to high levels among managerialemployees. Those working in the home or retired areless likely to be interested.

Family status Low Research indicates married and not married, with familyor without, are equally likely to be interested inHIS/home banking.

Income Moderate Research indicates as income increases, the likelihoodto high of interest in HIS/home banking increases. However,

among very high income households ($50,000/year andup) the likelihood of interest in home bankingdeclines somewhat.

Financial Moderate Research indicates that users of ATMs, Telephone BiIIservices Paying, and frequent check writers are more likely tousers be interested in HIS. However, a substantial number

of those interested do not use these services.

Electronic Moderate Research indicates personal computer owners, cable TVcommunication subscribers and those attracted by electronic gadgetryproduct users are somewhat more likely to be interested in HIS.

However, a large portion of those interested in HIS donot own or intend to purchase a personal computer.Among PRONTO pilot users, half had computerterminals (outside the home) prior to participating inthe test.

SOURCE The Reistad Corp , Clearwater, Fla

to compete with banks in these services to theextent that they are legally permitted to do so.

It is important to note that ATM, POS, andHIS will work together in the future. POS sys-tems and ATMs will share network lines, andthese systems will eventually reach out to in-corporate other remote terminal activity suchas HISS.

The various systems that have been and arebeing implemented for effecting payments areessentially designed to be substitutes for thepaper check. While the rate of growth of

checks has declined during the last severalyears and check usage in absolute terms maybegin to fall between now and the end of thecentury, no one expects checks to be totallyreplaced.

Historically, usage of new consumer prod-ucts has grown slowly during the first yearsfollowing introduction. For successful prod-ucts, this has been followed by a period ofrapid growth. Then, as the level of saturationis approached, growth again slows. Overall, ”this creates the “S” curve shown in figure 11.This being the case, two questions relating to

Ch. 4—Retail Financial Services ● 133———

Figure 11 .—Penetration Curve for Check Alternatives

1977 78 79 80 81 82 83 84 85 86

SOURCE Economic Review, Federal Reserve Bank of Atlanta August 1983 p 33

the substitution of new payment products forthe paper check remain unanswered. First, atwhat rate will new services grow? Second, atwhat level of penetration by each product willthe market become effectively saturated?

Not all potential users of a service will usethat service. It has taken decades for the levelof penetration for checking accounts to reachthe 85- to 90-percent penetration level, whereit now rests. Further, it is not reasonable toassume that the level of maximum marketpenetration is the same for all products. Overthe long term, for example, the proportion thatuses ATMs may far exceed that which useshome information and banking services.

Further, the level of maximum penetrationmay vary with time. As technology evolvesand its costs continue to drop, and as the prod-ucts are funded, the proportion of potentialusers who actually become buyers may change.For example, the maximum potential market

penetration for a home banking service todaythat requires a terminal costing several hun-dred dollars may be quite different from whatit will be for a derivative of that service thatis implemented using a terminal that costs lessthan $100.

The time constants that determine the steep-ness of the curve may also vary in responseto events in the market. For example, the rateof growth in some electronically delivered serv-ices may increase in response to a requirementthat all employees of firms over a specified sizebe paid by direct deposit. On the other hand,a series of events that demonstrate inherentweaknesses in advanced payment systemscould slow the rate of growth of some prod-ucts. In general, the impacts of events aremost likely to vary from product to productin the mix that comprises the offerings of thefinancial service industry.

In the past, great promise has been held outfor various payment products that has yet tomaterialize. However, increasing use of com-puters and telecommunication throughout so-ciety and the dynamism of the financial serv-ice industry may be creating an environmentmore favorable to the adoption of new systemsfor delivering financial services. Thus, thereis a higher degree of confidence than in thepast that the middle stage of the “S” curvewill be reached, but the timing continues tobe uncertain. The problem becomes one ofclosely monitoring developments in the finan-cial service industry to identify those areasmost likely to reach a critical mass and toassess on an ongoing basis the benefits andcosts to society of the changes that are ex-pected.

Chapter 5

Wholesale Financial Services

Contents

The Role of Technology

,

Page

in Wholesale Financial Service Systems . . . . . . . 138

Products Available in Wholesale Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . 138Asset and Liability Products. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138Processing Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ......... 140Information Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141Nonprocessing Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141

Providers of wholesale Financial Services. . . . . . . . . . . . . . . . . . . . . . . . . . . 142

The Importance of Access to Data and to the Payments Mechanism . . . . 147

Future of Wholesale Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148

Tables

Table No. Page

7. Major Providers of Wholesale Financial Services . . . . . . . . . . . . . . . . . . . 1398. Product Provider Mapping . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143-145

,/

.

Chapter 5

Wholesale Financial Services

Retail suppliers of financial services provideconsumers with a variety of products and serv-ices, including deposit-taking, securities bro-kerage, and credit extension. Wholesalers, inturn, provide a variety of services to retailers,services that may be grouped under two broadheadings. First are the wholesale productsthat affect the balance sheets of the providers,usually by converting assets from one form toanother (e.g., cash to notes receivable or viceversa). For example, institutions can purchasedebt instruments in secondary markets, or abank may participate in a loan syndicated byits correspondent. Historically, depository in-stitutions have always been suppliers andusers of this class of wholesale services. Theyhave established and maintained correspond-ent relationships that have included suchfeatures as loan participation and the opera-tion of secondary markets for various debt in-struments, without relying on automatedprocessing.

A second class of wholesale products com-prises mainly processing and information serv-ices. Included in this group are check andcredit card processing, general accounting andaccount maintenance services, and communi-cation services. This chapter describes thewholesale financial products and services thatare available, the organizations that partici-pate in this segment of the industry, the roleof technology, and the trends that are pre-sently in evidence.

Changes in the financial service industryhave shaded the fine lines between wholesaleand retail services. For example, from thepoint of view of each organization that issuesa VISA card, VISA International, the parentof the VISA service, is a wholesaler that pro-vides the interchange services that are essen-tial to the operating concepts embodied in

bank card organizations. On the other hand,VISA International actively markets its prod-ucts on behalf of its members and is highly vis-ible to the consumers. In this sense it can beviewed as a retailer of financial services.

Wholesale and retail financial services willcontinue to overlap in the future as the imple-mentation of advanced financial service deliv-ery systems tightens the coupling between theorganizations that perform the various func-tions that are required to deliver services.However, for the moment, it remains use-ful to describe wholesale and retail servicesseparately.

On the one hand, the earliest applicationsof information processing and telecommunica-tion technologies were in the area of wholesalefinancial services much more than in retail.Check processing and account maintenanceservices have been provided by third-partyoperators for years. Wire transfers of fundshave been used since before the turn of the cen-tury. On the other hand, there are wholesaleservices that are not particularly susceptibleto automation. Arranging loan participationsmay rely heavily on telecommunications, butthe process is not really automated.

However, wholesale financial services arenot really separable from other financial serv-ices that may benefit greatly from the applica-tion of advanced technologies. Thus, policiesthat are directed at changes resulting directlyfrom the application of advanced technologiesto the entire financial service industry are alsolikely to impact wholesale financial services.Therefore, it is important that the reader whois concerned with developing policy for the fi-nancial service industry be aware of the fullrange of services provided by the financialservice industry.

137

138 • Effects of Information Technology on Financial Services Systems——.—. —.

The Role of Technology in WholesaleFinancial Service Systems

The financial service industry was one of theearly users of advanced technology for prod-uct delivery. Transaction volumes of checksand credit cards now exceed the industry’sability to process transactions manually, andthe increasing time value of money and thevariety of alternatives for investment haveplaced a premium on the ability to move fundsand information rapidly and accurately overwide geographic areas. Even for small orga-nizations, the accessibility of economical proc-essing services has been crucial for survival.

Most of these processing services could notbe delivered without the availability of the ad-vanced communication and information proc-essing technologies. Further, because of theheavy dependence of service providers onthese technologies, firms with expertise cen-tered in the technologies rather than in the de-livery of financial services have recognized anddeveloped opportunities in the financial serv-ice industry as providers of wholesale finan-cial services. In addition, communication andinformation technologies have made possiblethe extension of wholesale financial servicesproducts to include features that could nothave been offered without the technologies.

Historically, the costs of establishing andmaintaining the processing capabilities re-quired to support the delivery of financial serv-ices have been beyond the means of manyretailers. Now, however, the low cost of infor-

mation processing equipment and the increas-ing availability of low-cost software packageshas brought within reach the decision supportsystems and other capabilities not previouslyavailable to small institutions. (The large sys-tems for transaction procession and generalaccounting are not included in this group asthey can be developed and supported only withsignificant resources.)

While all organizations need access to tech-nology, not all have to develop processing ca-pabilities within their own organizations. Theproblems of processing and other aspects ofmarketing and delivering services are largelyseparable. Managers of financial service pro-viders are faced with the same “make or buy”decisions that confront those responsible fora manufacturing facility. A depository insti-tution can either generate a loan portfoliothrough its own efforts, or it can participatewith others who undertake the active market-ing of credit services. Additionally, an orga-nization can acquire and support the facilitiesnecessary for performing the data processingentailed in delivering financial services, or itcan buy those services from third parties. Fur-ther, just as merchandisers can setup an orga-nization to buy in quantity for a group, finan-cial service providers can realize economies ofscale and scope by joining a consortium, ornetwork, that establishes an organization toperform transaction processing.

Products Available in Wholesale Markets

Asset and Liability Products main in a position to provide additional financ-ing to retail customers. If this were not possi-

The asset and liability products shown in ble, retailers would be solely dependent on thetable 7 include those where the wholesaler ac- generation of new liabilities (deposits fromquires an asset from the retailer, generally in their customers) to meet demands for creditexchange for cash. These services allow the from the markets served. Thus, the ability toretailer to turn over its portfolio and thus replace assets in secondary markets is key to

—

— . —

Table 7.—Major Providers of WholesaleFinancial Services

Nonbank and nonfinancial service company third-partyprocessors:

ADPEDSDecimusControl DataCSC/lnfonetFDR (AMEX subsidiary)

Financial service institutions, joint syndications, andproprietary T&E cards:

Rocky Mountain Bank Card (PLUS)CIRRUSVISAMaster CardAmerican Express

Nonprofit or governmental service or network providers:SwiftFederal ReserveFederal Home Loan BankBank WireNew York Clearing House

Banks, other depository financial institutions, andassociations:

First Interstate BancorpBank OneCiti-BankChemical BankBank of AmericaCUNACalifornia Credit Union LeagueGESCOMid ContinentDataline

Other industry groups:Brokerage firms:

Merrill LynchE, F. HuttonPaine Webber

Retailers (including grocery chains):SearsJ, C. PenneyMontgomery WardMay Co.Federated Department StoresSafewayKroger

Insurance:Prudential Insurance Co.Equitable Life InsuranceAetna Life Insurance

Consumer finance corporations:Beneficial CorpDial Corp.

Mortgage Brokers:Loomis & Nettleson

Trust Companies:Trust Co, of the West.

SOURCE ICS Group Inc Harbor City, Calif

Ch. 5—Wholesale Financial Services ●

_— — ——. ———

enabling the financial service industry to

139

in-termediate between those with funds to investand those who require funds.

In this context, commercial firms that selltheir receivables are users of wholesale finan-cial services. Using these services, manufac-turers and merchants are able to obtain theworking capital needed to support their inven-tories of end-products, work in progress, andraw materials.

The originator of a loan may, under some cir-cumstances, sell the debt in the secondarymarket while retaining the rights to servicethe loan. In this way, the capital is turnedover, but the originator of the loan continuesto benefit from a stream of fees paid by theholders in due course. In turn, the borrowerbenefits by continuing to deal with the orga-nization that originated the loan throughoutits life, even though it no longer holds thedebt in its portfolio. Of course, the oppositesituation, where the original lender retains thedebt and buys processing services fromanother organization, can occur; or the origina-tor may sell the loan and retain none of theservicing functions.

Small loan companies, on the other hand,will place commercial paper in the wholesalemarkets and use the proceeds to support theirlending activities. Because they can borrowlarge amounts at favorable interest rates andreceive a relatively high yield on their loanportfolios, a favorable spread is generated thatcan cover both their operating expenses anda profit.

At times, a lender will have the opportunityto place a loan that either exceeds the fundsavailable or creates an unacceptable risk inthat the amount to be lent would be excessive-ly great relative to the net worth of the orga-nization. Regulations also limit the size of aloan that can be made to any other borrower.Under these circumstances, the lender maysyndicate the loan by obtaining contributionsfrom others that will spread the overall risk


and make available sufficient funds to meetthe needs of the borrower. Also, banks, as partof their relationships with their correspond-ents, will routinely allow the correspondentsto participate in loans that they place. Insur-ance companies behave in much the same waywhen they share indirect placements and askor permit others to share in the underwritingof casualty coverage. Securities dealers formsyndicates to underwrite offerings of debt orequity instruments.

Processing Products

As noted, the delivery of financial servicesdepends heavily on the processing and trans-mission of large amounts of data. For all prac-tical purposes, the application of advanced in-formation processing and telecommunicationtechnologies has become mandatory.

Among the processing products offered bythe providers of wholesale financial servicesare the processing of checks and credit anddebit card drafts; the processing required tosupport all types of depository products; andinformation services, such as credit/checkauthorization and economic data and modelsthat are used for analysis and decision sup-port. Also included is the processing requiredto consolidate and disburse funds as part ofofferings of cash management services.

Transaction processing facilitates the execu-tion of an order given by the owner of an ac-count to credit or debit it. For all practical pur-poses, from the point of information flows thatare created, the type of accounts posted dur-ing the transaction is immaterial. In fact, ma-jor bank card processors use the same systemsto process debit and credit card transactions,and only the customer and financial institu-tion that holds the customer’s account knowswhether a line of credit or a demand depositaccount or other type of account is debited.

For this assessment, the critical point is thatthe systems used to process orders against ac-counts are large and complex and are there-fore expensive to build, operate, and maintain.Hence, many organizations do not have there-

sources to develop and operate such systemsinternally, and others choose not to undertakesuch activities. Instead, they turn to third par-ties, many of whom are not conventionallyclassified as financial institutions, to providethe processing capabilities required. Retailersof financial services decide on the degree towhich they will be vertically integrated andturn to wholesalers for those services they can-not or choose not to provide for themselves.

Clearing and settlement are elements criti-cal to the operation of a system that supportsthe delivery of financial services. At present,only depository institutions have in place asystem for clearing cash items involving thetransfer of money between virtually any par-ties in society. Specialized systems, such asthose operated by the airlines for settling feesfor services provided to holders of ticketsissued by others, by securities brokers for set-tling stock and bond transactions, and by oilcompanies for accounting for balances of crudeoil moved between them, exist; but not withthe wide area of applicability found in the sys-tem operated by the depository institutionsfor settling on money transfers. On the otherhand, there is no reason why alternatives forsettling money transfers that would not in-volve the depository institutions could not beestablished. Systems supporting the opera-tions of the nonbank credit cards provide onesuch example.

Some wholesale products exist because ofstructural constraints within the industry. Asnoted, depository institutions are the onlyones that have access to the payments mech-anism. Therefore, when others offer productssuch as cash management accounts that givethe retail user the ability to write a draftagainst the account, arrangements must bemade with depository institutions for paymentof the draft through the payments mechanism.The same type of arrangement holds for or-ganizations that offer or accept one or moreof the major bank credit cards. Thus, any secu-rities dealer or private association that makesarrangements to issue a bank card and anyorganization that accepts the bank card mustarrange for clearing or payment services

.— ... —-— .—..

Ch. 5—Wholesale Financial Services ● 141———.——————— — — . . . —— — -

through a depository institution. Only oneretailer has been given direct access to a ma-jor bank card network, and the rules of thecard-issuing organization have been changedto preclude another nondepository institutionbeing granted such access.

Information Products

Financial data provide the basis for decision-making for individual organization and for theeconomy as a whole. Treasurers for both pri-vate corporations and public agencies musthave knowledge of the funds available to themand the demands being placed on them. Theymust be able to consolidate easily those fundscollected over wide geographic areas and todisburse them so that they meet obligationsfor payment. Opportunities for investing idlefunds must be identified and exploited. Theseservices together compose what are commonlyoffered as cash management packages. Otherprocessing services, as shown in table 7, thatdepend heavily on the corporate data of theindividual client organizations are also offeredby wholesale financial service providers.

At a broader level, financial service organi-zations collect and market a variety of dataused in decision support systems. Some alsoprovide modeling and other prepackaged ca-pabilities that can be used to analyze data. Insome cases, completely developed models thatcan be used for experimentation by the usersare offered; in others, facilities that enable theuser to build, estimate, and validate modelsuniquely designed for a specific purpose areprovided; and in still others, both capabilitiesare available.

Nonprocessing Services

Some wholesale financial services entail noprocessing capabilities. These services gener-ally include provision of equipment, computer

programs, and other support services used byretailers. As the capability to develop gener-alized software packages increases and usersrecognize that most organizations can makeuse of generalized packages, as opposed to de-veloping unique application systems for them-selves, the importance of the products pro-duced by this segment of the wholesalefinancial service industry will increase.

Also included in this group are communica-tions services that are particularly oriented tothe needs of the financial service industry.However, more often than not these are gen-eral-purpose communications facilities thatcan be used for any number of applications,and only the fact that the operators make aspecific point of marketing them to the finan-cial service industry sets them apart fromothers and warrants that they be mentionedin the context of this assessment.

Firms that provide wholesale processing/fa-cilities management services can be placed inone of four subclasses. First, there are thosethat take all responsibility for system opera-tions and operate their own facilities apartfrom those of their clients. Second, some pro-viders sell or lease software or equipment, andthe users take all responsibility for day-to-dayoperations. In this case, services from severalwholesale providers may be combined in a sys-tem designed to meet the needs of the clientorganization. Third, some providers offer“turnkey” services in which they design andinstall systems for their clients and then turnthem over to the clients, who take over day-to-day operations. In the last category arethose offering facilities management serviceswhere the service provider effectively takesover the operation of the processing depart-ment of the client organization, even thoughthe department may be physically located inthe client’s facilities.

142 ● Effects of /formation Technology on Financial Services Systems— — ——— .— —.

Providers of Wholesale Financial Services

The list of firms comprising the providersof wholesale financial services is quite diverse.Table 7 demonstrates this diversity, listingmajor categories of providers of financial serv-ices and citing specific examples of firms fall-ing within each group. Table 8 shows whichclasses of firms provide each of the variousclasses of services identified in table 7. Itshows the breadth of the product lines offeredby each of the various classes of firms activein the financial service industry and the de-gree of competition between the very diversefirms that are providers of wholesale financialservices.

Examination of table 7 shows that there isconsiderable opportunity for both vertical andhorizontal integration for providers of whole-sale financial services. On the other hand, theexistence of a variety of specialized firmsargues that, until now, the economics govern-ing the operation of providers of wholesale fi-nancial services has not encouraged either ver-tical or horizontal integration. While someargue that either pattern of integration offerssignificant economies of both scale and scope,alternatives exist for achieving both econ-omies. Notably, competitors in the market-place are able to join in the creation of whole-sale services while maintaining an activecompetitive environment based on end-prod-uct differentiation in retail markets.

Large commercial banks provide examplesof vertically integrated operations. They per-form check processing, operate credit anddebit card systems, and support networks ofautomated teller machines (ATMs), some ofwhich are strictly proprietary, while others areshared and may permit access by thrift insti-tutions as well as by other commercial banks.Some have arrangements with nonbank issu-ers of either credit or debit cards to providethe required interface with appropriate clear-ing and settlement networks. Loan participa-tion and clearing accounts are offered to cor-respondents. Also, they provide secondarymarkets for debt instruments, including mort-

gages and merchant and producer receivablescreated by others.

The degree of horizontal integration per-mitted commercial banks is limited. By law,commercial banks can underwrite neither cor-porate equity issues nor life or casualty insur-ance other than creditor life insurance. Secu-rities trading is limited to ordering trades forthe convenience of bank customers or the oper-ations of trust departments. Commercialbanks are not authorized to offer investmentadvice regarding securities to their clients.Further, they are permitted to offer data proc-essing services to others only to the extentthat such services are incidental to the busi-ness of banking. While recent rulings by theFederal Reserve Board (e.g., the CitiSharecase) have broadened the scope of permittedactivities, commercial banks and bank holdingcompanies are not free to offer the full rangeof data processing and communication prod-ucts that they could conceivably market.

On the other hand, even in the face of exist-ing restrictions, the degree of horizontal in-tegration of commercial banks and other de-pository institutions is increasing. Some nowoffer discount brokerage services, and othersare developing connections with insurancecompanies or are setting up subsidiaries thatcan offer insurance under the laws of theStates in which they are chartered.

Some merchandisers are also entering themarket with a very broad range of financialservice products. One provides retail creditservice in direct support of its merchandisingactivities, a full line of insurance services, realestate and securities brokerage, and, in a lim-ited number of States, deposit-taking throughsubsidiary thrift institutions. Yet even thoughthis organization appears to be moving towardhorizontal integration, only a minimal level ofcoordination has been achieved between thevarious constituent elements, and, therefore,the degree of horizontal integration achievedto this point appears to be minimal.

Ch. 5— Wholesale Financial Services ● 143—

x x x

—

x x x-1 x xx x

—.

a3u?ulj JwLJnsuo~ x x

— .—

x x x x

xx x

—.

aouejnsul x I x x x x X x x x x x

x x x

x x

. .

xt- -x x x x x x X x x x x x x x

— —

x x Xxxx

—————. -—.—. -——

x

x

— .-—

x x x x x x lx x x x

-1 --— ———— -— —

Xxxx x x x x

—

X x x x x x x x x x

-— — . —

.

sdol]ei~ossvUeol pue s6ul Aes

x x x x x x

——. — .——

x x Xxxx X x x x x x

——

Xxxx Xxxx

— .—. — - — -

Xxxx x x x x x x x x x

—. .- ——-.—— —-—. —

x Xxxx X x x x x x

————————. — — - – L — — ——

x x x

—.

x

——. — —.—

xx xx xXxxx

,.

VIal

0,C.L .

rala)= :

‘ >> .0

cm


x x x x x

—— —. —-

X

.—-.

aweulj Jawnsuo

x x

.- -—

x X x x x x x

—..—

x

-— .--— —

x

sweq3 Jaw IIe]a} x x x x x

Suolufl llpaJ[

—-

suoileloossvUPO1 pue s6umeS

x x x

X x x x x x x x x x x x

—

KXxxx xxx x x x x

-—

x Xxxx x x x

paseq aa~]J!?d pllq] pU1

luapuodsaJJo~ s~ueExxx x xx Xxxx x x x X x x x x x x x x x x

x x x x x x

x x

.—— ——

x x x x x Xxxx x x x x x x x x x x x x

xsuol)eolpukyueg

—— —saovdas

AiJed-pJlql)fUEqUON

<Xxxx x x x x x

..,.. .,...,... .

. .

..,. . . . . g:. . . . . . . . . . . .. . . . . . . . . . . . ..., %:. . . . . . . . . Q .

. . . . . . . . . . . ., ...,,,.,,.. : .9 :

.,. . .. ,..

.

. . . . .. .,. .,..,P’:(7i ::,

.,...,.

cvcm

&i

Ch. 5—Wholesale Financial Services ● 145—

ISflJl x x x

—

—

x

—

—

——. —

x

— ——1- ——. —..

t–––— ——. — —

x x x

—

x x x x x Xxxx x x x Xxxx

! a3ueJ nsu i

L-- ‘-

x l

x x x

—

x x x

x x X x x x x x x x x x x

suolie130ssvueol pue s6ulheS

gn r- saueq le13Jawo: x x x x-1r- —

paseq aajf\JL?d 13Jlu~ PUE

luapuodsaj]o~ SHUWx

.—

.

x x x Xxxx X x x x x x x x X x x x x x

Iail

x x x

I

Suol]mlpuktiuefj

x x x x x X x x x x x x

1x x x x x x x

I sa3(AJasI x x Xxxx x x x x x x

,,,.

Xxxx

:: :v,. “: : : : : :

,.,..

-“

.

,.. .. .

,.. ,.

:: :,..

.,.,.

.,..

:?:5.Cr,C.- .0

.CJ).U

146 ● Effects of Information Technology on Financial Services Systems. — — — — —. — - . —

In another area, one of the major providersof a nonbank credit card has become one of thelargest wholesale providers of card processingservices to others. This provider also offers anextensive package of traveler’s checks andcard-oriented credit services through partici-pating commercial banks and thrift institutions.

Among the nonbank providers of wholesalefinancial services are those that operate com-munications facilities, networks of ATMs thatare shared among various depository institu-tions, and independent processors, with rootsmore in the information processing industrythan in the financial service industry. With itsdivestiture, American Telephone & Telegraphwill be able to provide enhanced services spe-cifically tailored to the financial service indus-try. However, it will have to compete withother telecommunications carriers, banks, andothers that already operate in this market ifit chooses to enter. Operators of food chainsand others are installing ATM networks andinviting the depository institutions to jointhem. This trend has raised the thoughtamong some bankers that they may not beable to retain their control over the paymentssystem in the long run. Finally, as shown intable 8, various data processing service bu-reaus and software suppliers meet the needsof significant portions of the financial commu-nity for processing services, and there aresome indications that they would like to ex-pand their role in the future.

The Federal Reserve System occupies aunique role as a provider of wholesale finan-cial services. It is a lender of last resort to de-pository institutions in need of funds to meetreserve requirements. Through the Open Mar-ket Desk at the Federal Reserve Bank of NewYork, it markets Federal Government debtand implements monetary policy through the

purchase and sale of Government securities.It is a major factor in the clearing of checksand a provider of currency and coin to thebanking system.

The national system of automated clearinghouses (ACHs), except for the one in NewYork, is owned and operated by the FederalReserve System. Recently, ACHS have broad-ened their capabilities to process individualcustomer-initiated transactions. The bulk ofthe traffic handled by ACHs is generated bythe Federal Government in the form of payrolland payments to recipients of entitlements,such as social security.

The role of the Federal Reserve in these mar-kets has been controversial for some time.Even though Congress mandated that theFederal Government recover the full costs ofproviding services, some argue that its pric-ing still puts private suppliers of alternativeservices at a disadvantage. Some also see aninherent conflict of interest between the Fed-eral Government as a supplier of services onthe one hand and as a regulator of the insti-tutions that are its customers on the other.

The Federal Reserve is charged with ensur-ing the orderly movement of funds nationwidein order to provide a healthy climate for com-merce. In some areas it is meeting with com-petition. However, in others, such as providingservice to institutions in remote areas thatcannot profitably be served by the private sec-tor, it continues to meet a real need.

Volumes of checks processed by the FederalReserve declined after the institution of pric-ing for services. Also, there is a movement toseparate ACH operations from the FederalGovernment. Therefore, its future role as anactive participant as a provider of financialservices is open to question.

.—

Ch. 5—Wholesale financial Services ● 147—

The Importance of Access to Dataand to the Payments Mechanism

Since only the depository institutions haveaccess to the payments mechanism for thetransfer of funds, all other institutions mustwork through them. For example, money mar-ket mutual funds, on which customers canwrite drafts, conventionally maintain a zero-balance account with a depository institutionthat is funded at a level sufficient to cover thedrafts presented each day. They then usetransaction data supplied by the depositoryinstitution to post appropriate debits againstcustomer accounts.

On the other hand, the depository institu-tion can have available to it virtually all of thefinancial data of its customers because all pay-ments transactions pass through its hands.Because it has access to the data and themeans to act on them on behalf of the cus-tomer, some argue that depository institutionsoccupy a unique place that puts potential com-petitors at a significant disadvantage. Theargument follows that restrictions are neces-sary on the operations of depository institu-tions with regard to the information process-ing services they may offer so that they willnot benefit unjustly from the position they en-joy. Thus, at issue is the degree of access theseorganizations have to a customer’s data, andthe payment mechanism and the relative ad-vantage the firm enjoys in the marketplace.

To the extent that wholesale financial serv-ices can be provided only with the support ofadvanced technologies, a point of no returnhas been passed in which the only possiblebackup to an automated system is anotherautomated system. Further, in this environ-ment, all providers of the services need accessto the technologies, and lack of such access

could make it impossible for a company to re-main in business.

In general, the trend to greater reliance onadvanced information processing and telecom-munication technologies in support of systemsfor delivery of wholesale financial services willcontinue indefinitely into the future. To someextent, those providers of wholesale financialservices who do not perform processing inter-nally will become more dependent on the prod-ucts of others, and therefore may lose someof the flexibility in designing and operatingsystems for delivering financial services thatthey now enjoy. Greater shared use of process-ing systems, driven by the economics of sys-tem development, deployment, maintenance,and operation, will mean that competition be-tween the various producers of financial serv-ices will, in the future, be based on factorsother than the features of the processing sys-tems used by the competing organizations.

Finally, both the providers and users ofwholesale financial services are more accus-tomed to dealing with advanced technologiesthan consumers are. These organizations havefor years been using technology-based applica-tions, such as cash management services, thatwill not be significant in the consumer mar-ketplace for many years. Therefore, for thosewho operate in wholesale financial service mar-kets, future changes will not be as traumaticas they may be for the remainder of the pub-lic that is generally not accustomed to deal-ing with relatively sophisticated systems.Thus, the changes that take place in the wholesale services are less likely to attract wide-spread attention than those provided to thegeneral public at retail.


Future of Wholesale Services

Although much attention has been focusedon the entry of new types of providers of fi-nancial services into retail markets, thematurity of participation in wholesale marketsby nontraditional financial service providersis proportionately much greater. Since finan-cial service firms have established a high de-gree of sophistication in the use of the tech-nologies and they are more familiar with theoperational requirements of the industry thananyone else, those with adequate resourcesand the inclination to do so will remain sig-nificant factors in the market for wholesale fi-nancial services. On the other hand, becausethe information processing and telecommuni-cations industries have developed the exper-tise to analyze and meet the requirements ofothers, firms not ordinarily identified with thefinancial service industry will increasinglychallenge traditional financial service firms inthe market for wholesale services.

The introduction of advanced networkinghas broadened existing relationships betweenproviders of financial services to include thenew products and services that have becomeavailable. For example, a bank will contractwith a securities dealer to clear drafts that areprocessed through the payments systems inaddition to providing the more traditionalbanking services. Institutions that havebenefited internally from investments in sys-tems incorporating advanced technologies toincrease productivity, have often offered themon the open market to others who, in turn,have also been able to increase productivity.

On the other hand, developers of new prod-ucts try to benefit from the revenue generatedby franchising those products to others. Thefranchisees benefit because they do not haveto incur the costs of designing and develop-ing the systems to support new product offer-ings. One major money center bank is follow-ing this strategy in offering its home bankingservice to banks nationwide.

These types of relationships will continueinto the indefinite future. Economic conditions

have put pressures on operating margins thatwill stimulate all providers of financial serv-ices to take whatever steps are required to im-prove productivity. Since only limited num-bers of institutions are in a position to supportmajor new product development efforts, manywill look to third parties to create the capa-bilities that are needed.

Banks and other traditional providers maybe expected to extend their customer base out-side of their traditional boundaries. Holdersof financial assets are in a position to arguethat they have both the knowledge to buildthe capabilities needed by their customers andimmediate access to the data used by thesystem.

On the other hand, data processing serviceorganizations can marshal many of the samearguments as banks to claim that they are ina position to provide a wide range of paymentand information services to a broad clientbase. However, they are somewhat limited intheir ability to offer complete payment sys-tems because they can initiate payments onlythrough a financial institution that has accessto the payments mechanism.

In the long run, however, processing tech-nology is neutral; and the ability to succeedas a provider of wholesale financial servicesdepends on the level at which requirements areunderstood and operationally viable systemsare implemented. Systems that meet the needsof the users and are supported adequately willsucceed in the market regardless of where theprocessing is done. As improved processingtechnologies become available, providers ofwholesale financial services will adopt andmarket them. Adoption on the wholesale sideof the financial service industry will be morerapid than on the retail side because changesin wholesale services are less likely to be visi-ble to the end-users. Competitive impact in theretail market will be minimal because therewill be little, if any, requirement for consumersto change their behavior patterns.

—

Ch. 5—Wholesale Financial Services ● 149— . ————. .— —————...—— —

Increasing use will be made of telecommuni-cations to deliver financial services, and therewill be new opportunities for telecommunica-tion providers to function as providers ofwholesale financial services. In addition to pro-viding neutral communications capabilities, asthey have in the past, they are in a positionto offer enhanced services to the financial serv-ice industry. Some may position themselvesas operators of networks and provide gate-ways between these networks and others.Transaction interchange could become a ma-jor area of activity. Food retailers that installand operate ATM networks also fall in thiscategory.

Technologies that offer opportunities for by-passing telephone companies that providelocal service have considerable potential forproviders of financial services. Already, atelevision cable from central Manhattan to theWall Street area carries considerable trafficgenerated by providers of financial services.The teleport concept being implemented inNew York and considered elsewhere offers theopportunity for bypassing both local and long-distance carriers. Since the switched telephonenetwork is not particularly suited to carryinglarge volumes of data traffic, and costs forlocal communication are expected to increasesignificantly in coming years, bypass technol-ogies and those that offer them will be an im-portant factor in the development of the finan-cial service industry.

Conceivably, the major long-distance car-riers will become significant providers ofwholesale financial services, with offeringsthat range from networks dedicated to specificusers to networks that include the processingrequired for online, real-time clearing of pay-ment transactions. The switches that runthese networks are computers capable of per-forming the processing required to provide theclearing function.

Given the evolution of regional ATM net-works, the focus of nationwide service couldbe the facilities that provide for interchangebetween networks rather than the develop-ment of monolithic networks that cover thecountry. This outcome would generally followthe model of the bank card systems, where the

various institutions operate somewhat inde-pendently of one another, with the major as-sociations providing facilities for interchange.On the other hand, American Express has im-plemented a major network that takes advan-tage of ATMs installed by participatingbanks. Money can be accessed from any finan-cial institution designated by the customer;and American Express moves funds from theinstitution holding the customer’s account tothe one that has dispensed the funds.

Developers of the information utilities nowbecoming operational are in general agreementthat financial services will comprise a key ele-ment of the packages to be offered. Informa-tion providers are positioning themselves asgateways to financial service providers, and,therefore, are functioning in a wholesale capac-ity. They contract with retail providers whodefine the services that will be providedthrough the information utility. Subscribersto the information utility are then able to se-lect the retail financial service packages towhich they will subscribe. Such arrangementscomplement shop-at-home and travel arrange-ment services that may also be offered throughthe information utility.

People who have evaluated the market forhome information services now generally agreethat no one product offered by itself will beviable. The packaging of financial serviceswith other information and, possibly, enter-tainment products will be critical to the suc-cess of services that distribute information tothe home. Various types of firms will assem-ble these packages and, in effect, will be pro-viding the wholesale functions. Some, as in thecase of Knight-Ridder, will be publishers thatassemble and perform much of the marketingfor the products of various providers. Others,like Chemical Bank, may be the creators of onepart of the service and assemble other partsof the package from offerings of other sup-pliers. Still others may provide a totally neu-tral communications service that providespaths to many providers and the opportunityto interchange information between them.Such a service would rely on each provider toperform all of the marketing and other activi-ties required to support its customers.

Chapter 6

The International Environment forFinancial Services

9

Contents

PageIntroduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153

The Growth of International Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153New Directions in International Banking. . . . . . . . . . . . . . . . . . . . . . . . . . 154Multinational Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155

Financial Markets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157Money Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157International Financial Information Systems . . . . . . . . . . . . . . . . . . . . . . 157

International Interbank Communications . . . . . . . . . . . . . . . . . . . . . . . . . . . 158New York Clearing House Association . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158Society for Worldwide Interbank Financial Telecommunication . . . . . . . 158

The Effects of Technology on International Payment Systems . . . . . . . . . 161Corporate and Retail Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161

Vulnerability of the Financial System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162Security and Integrity of the Financial System . . . . . . . . . . . . . . . . . . . . 163Error Resolution in International Electronic Funds Transfer . . . . . . . . . 163Foreign Telecommunications and Information Policies . . . . . . . . . . . . . . 163

Figures

Figure No. Page12.Daily System Traffic Volumes (average: end of year) . . . . . . . . . . . . . . 15913. Cumulative System Volumes (end of year) . . . . . . . . . . . . . . . . . . . . . . . 159

.

Chapter 6

The International Environment forFinancial Services

Introduction

The economies of the world have becomeincreasingly interdependent trading econo-mies. The financial service industry supportsthese activities by providing the means totransfer payment for goods and services pur-chased internationally and by acting as an in-termediary between those nations with excessfunds and those in need of funds. As the econ-omies of individual nations become more in-tertwined, the role of the financial service in-dustry becomes more important to the worldeconomy.

Changes are taking place in the structure offinancial markets as well as the structure ofthe industry and its participants. Commu-nication and information technologies havehelped to make markets that were once localor regional in character, global. Funds travelacross national boundaries with such ease thatdisequilibrium is offset. This flow of fundsbecame increasingly evident in the 1970’s withthe excess capital available from oil-richnations.

Separate from, but related to, changes in fi-nancial markets are the structural changestaking place in the industry itself. During therise of multinational corporate activity in the1960’s and 1970’s, banks moved abroad to fol-low corporate customers. In addition, banksfound that in order to insure access to manyof the foreign money markets, it was neces-

sary that they establish a presence, eitherthrough a branch or an affiliate. A final reasonfor multinational branching by U.S. banks,was that regulation, taxation, and supervisionof institutions in other nations was more oftenfavorable to the conduct of their business.

In the past 20 years there has also been anumber of new entrants in the field. Smallerbanks have been able to participate in inter-national finance through the use of innovativelending arrangements. Nonbank financialservice providers have developed large, inter-national networks to facilitate retail flows.SWIFT (Society for Worldwide Interbank Fi-nancial Telecommunication), a network estab-lished by the banking community to facilitateinternational interbank transfers, is on theverge of offering traditional bank services, per-haps in direct competition with its founders.

These relationships rely heavily on both theflow of information and the internationaltransfer of funds. Information technologiestherefore found early application in the inter-national financial arena, beginning with thetelegraph. It is difficult to assess and identifythe individual impacts of the technologies onthis segment of financial service activities,since the use of the technology is so prevalent.In many ways much of the activity in the in-ternational financial markets could not occurwithout the technology.

The Growth of International Banking

Post-World War II developments in capital in turn expanded the role of the private bank-movement and the restructuring of the foreign ing community to support these trade flows.exchange system helped foster trade, which Moreover, the development of multinational

153

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

corporate activity expanded the need for finan-cial services connected with direct investmentoperations and established new requirementsfor the conduct of multinational business.

At first, international financial activities ex-panded in traditional ways: through the ex-change markets and accepted ways of inter-national lending. Eventually, the movementto increased internationalization of financialactivity was supported by changes in bankstrategy and management and by institutionaland structural changes in international moneyand credit markets.

By all counts the growth of internationalbanking has been phenomenal. The Organiza-tion for Economic Cooperation and Develop-ment (OECD) has compiled figures on thegrowth of international banking in developednations over the last two decades. Althoughthere is no comprehensive measurement forworld banking activity, and many measure-ments of this activity include double-countingand inflated figures, the gross figures and thenet figures (which should eliminate the double-counting) are strikingly similar. In the periodfrom 1975 to 1981, net international banklending increased by an average annual rateof 23.9 percent, while the net size of theeurocurrency market* increased by 21.6 per-cent. Although the figures for this period showconsiderable growth, the eurocurrency mar-kets experienced their greatest growth from1965 to 1970, when average annual changeswere 37.7 percent.l

Similar statistics illustrating the relative im-portance of foreign business of banks showthat the average growth of foreign businessfor OECD banks as a whole has been from 12.1percent of assets in 1970 to 23.7 percent ofassets in 1981, and from 11.3 percent of liabil-ities in 1970 to 23.4 percent of liabilities in1981. 2

———*A eurocurrency is a deposit account at a European bank

denominated in a currency other than that of the host bank.‘R. M. Pecchioli, ‘Z’he Internationah”sation of Bd”ng: The

Policy Issues (Paris: Organization for Economic Cooperationand Development, 1983), p. 16.

‘Ibid., p. 19.

R. M. Pecchioli, in a recent OECD report,attributes the evolution of international bank-ing’s structural features to a number of fac-tors: changes in the international economicand financial environment, the evolution ofdemands for financial services by borrowersand investors alike, and the spreading of tech-nological facilities.3 The events of the 1960’swere, for the most part, the result of the grad-ual recovery of the world economy from thedevastation of war, and the liberalization oftrade. The 1970’s, however, brought majorstructural changes to the world economy;world payments balances became more severe,and there were major structural changes in theinternational payment and financial systems,all of which gave banks a pivotal role in inter-national financial intermediation.4

New Directions inInternational Banking

It is impossible in this report to provide acomprehensive survey of all the changes in in-ternational banking techniques; rather, impor-tant product innovations will be highlighted,along with the entry into new markets.

Sources of International Funding

International banking strategy does notgenerally distinguish between domestic and in-ternational funding, since, for the most part,banks will follow an overall assets and liabili-ties management policy. Two major sourcesof funding in the international market are thecertificate of deposit (CD) and the floating ratenote (FRN). CDs are negotiable receipts forlarge deposits; they have been used in theUnited States for many years and in the Euro-dollar market since 1967.5 London is, by far,the leading center for CDs. In 1981, foreigncurrency CDs issued by London banks totaledmore than U.S. $75 billion, most of which wasactually denominated in dollars.6 FRNs, whichare borrowing instruments used by banks,

‘Ibid., p. 17.‘Ibid.51 bid., p. 28.6Pecchioli, op. cit., p. 28.

—

Ch. 6—The lnternational Environment for Financial Services ● 155

have a position of slightly less importance ininternational funding, although recently theirimportance has grown. Generally FRNs allowbanks to secure funds for longer terms thanthose available through the deposit market.’

A unique aspect of international funding,however, is the reliance on interbank depositsas a major source of funds. Although it is dif-ficult to measure, the interbank market is byfar the largest source of international funding.Recent estimates place this market betweentwo-thirds and three-quarters of total exter-nal and eurocurrency liabilities of reportingbanks, or close to U.S. $1,000 billion.a Whatis not reflected in these figures is that the vol-ume of trading is very heavy, reaching the pro-portions of the foreign exchange markets. Theeffects of information and communicationtechnologies can be readily observed in thisarea. They are reflected in the high velocityand volume of trading, as well as in the par-ticipation in the wholesale market of manysmaller, nonmoney center banks.9

International Lending

During the 1970’s there was a rise in thewillingness of private banks to finance devel-opment projects. Much of this came about asa result of the inability of domestic marketsto absorb excess capital. Recently, the multi-lateral lending agencies, in particular the WorldBank, have announced cofinancing projects,in which private banks are allowed to partici-pate. These projects are thought to appeal tosmaller banks, which value the ability of theWorld Bank to assess the viability of devel-opment projects.

Innovations have also occurred in the flex-ibility of the structure of the loaned funds, aswell as in the markets approached. As banks’international assets have increased, their ap-proaches to the marketplace have changed.The most evident of these changes is in thedevelopment of international credits throughloan syndication.

“Ibid.‘Ibid, pp. 29-30.9Pecchioli, op. cit., p. 29; ,J. R. S. Revell, Banking and Elec-

tronic Funds Transfers, date, p. 156.

Syndicated lending is the process by whichvery large amounts of funds are raised by al-lowing the participation of a number of banks.The benefit to the borrower is that these fundscan be raised through a single operation. Thebenefit to the lender is that risk is spreadamong many banks, and institutions thatcould not undertake such a loan on their owncan participate. 10

The current “international debt crisis, ’where developing countries are unable torepay their loans to developed nations, hasbrought generally into question the risk of in-ternational lending and, specifically, the roleof syndicated lending in exposing a greaternumber of institutions to risk. It became clearthat smaller banks were becoming involved ininternational lending. It is not possible to ad-dress, in the scope of this report, the issue ofthe possible mismatching of liabilities andassets that can occur as a result of loan syn-dication and the subsequent risk and foreignloan exposure. Instead, the extent to whichcommunication and information technologiescontribute to the situation should be noted.

Technologies affect the ease with whichbanks can become involved in internationallending. These same technologies may alsohelp in better monitoring and control of inter-national debt and repayment, helping to over-come the international destabilizing effects ofa major default. In response to the severityof the situation, and the possibility of major-country loan defaults, a number of large multi-national banks established the Institute ofInternational Finance. The purpose of the in-stitute is to provide valuable risk informationabout countries to member banks that aremaking loan decisions. The information is pro-

vided to members via an institutional network,using international telecommunication 1ines.

Multinational Banking

Multinational banking can be loosely de-fined as the branching abroad of banks. Mul-tinational banking cannot be completely sep-

—.10Pecchioli, op. cit., p. 32.


arated from the international activities ofbanks. (Much of what is described in the pre-vious sections can and does take place inbranches of U.S. banks located outside of thiscountry. ) Multinational banking developedconcurrently with international banking, buthas different causal factors.

The first movement of banks to set upbranches in foreign countries was generally insupport of multinational corporate activities.As trade became more important and these ac-tivities increased in the 1960’s, banks foundit necessary to follow their clients abroad.Eventually, international banking grew andnational economies and money markets be-came intertwined, and the banking communityrealized that its physical presence was neces-sary to secure and maintain market share aswell as to participate in the developing finan-cial markets abroad.

During the past two decades this activityhas increased considerably. The number ofoverseas branches and agencies on a world-wide basis increased from 112 banks with4,390 branches in 1961 to 387 banks with4,329 branches in 1978. ”

Methods of participation in foreign marketsinclude everything from full-service branchesto the establishment of “shell branches, ”which are booking offices located in foreigncountries that do not administer the businesscarried on their books and have no contactwith the local market. Each method has itsbenefits, depending on the motivation of theparent institution.

——1lPecchioli, op. cit., p. 59. Pecchioli explains the seeming con-

tradiction between the claim that multinational banking activityincreased and the actual number of overseas branches decreased.“In fact the decline in the number of total branches between1961 and 1978 is an ‘artificial’ one in that it reflects a sharpdecline of branches of European banks (United Kingdom andFrench banks in particular) in African and a few Asian coun-tries which, following a policy of indigenisation motivated byeconomic nationalism, introduced restrictive legislation and in-duced takeovers by nationals during the period under re-view . . . [T]his policy led parent banks to change the form oftheir presence in these countries from branches to affiliates.If branches in these countries are excluded from the total, thesize of the global network more than doubled in the period underconsideration.

Offshore Banking

Offshore banking is any banking activitywithin a country’s borders, but outside itsbanking system. There is considerable debateas to exactly which nations of the world shouldbe considered offshore centers. For example,the City of London provides favorable condi-tions for off-shore banking, although it wouldnot be a conventional member of the groupconsidered off-shore centers. The UnitedStates first permitted the development of in-ternational banking facilities (IBFs) in Decem-ber 1981 in an attempt to bring back much ofthe Euromarket business, which had fled thiscountry due to State tax laws and RegulationD. IBFs are banks located in the UnitedStates, but because of the nature of their busi-ness are not subject to some of the regulationsunder which banks operate domestically. BothU.S. banks and foreign banks operating in thiscountry can establish IBFs. They are estab-lished through State and local laws and amend-ments to Regulations D and Q and are simi-lar to an off-shore “shell” branch that operateson-shore.

The development of off-shore banking cen-ters is facilitated by information technologies,which tend to make the industry less location-sensitive. Nations have developed a sophisti-cated communication system solely for thesupport of the financial service industry. Thiscan encourage further migration of the playersout of more regulated environments, which inturn makes it extremely difficult for the U.S.Government to implement policy and to con-trol the flow of funds in the United States.

U.S. Branching Abroad

The movement of U.S. banks abroad co-incided with the multinationalization of Amer-ican corporations. However, there were addedincentives for U.S. banks to go multinationalthat were perhaps not evident in other nations,in particular domestic, a regulatory structurethat restricted U.S. banks from branching out-side of a limited geographic area and limitedtheir potential market share in the UnitedStates.

Ch. 6—The International Environment for Financial Services ● 157—— —— —.—.———. —-. —.

Foreign Banks in the United States

The number of branches and agencies of for-eign banks in the United States increased from34 in 1961 to 241 in 1978 and to 452 in 1983. ’2

Until 1978, foreign bank branches in theUnited States were treated very differently——— -— ————

12 Pecchioli, op. cit., p, 59; ( 1961 and 1978) Federal ReserveBoard of Governors. 1983.

under the regulatory structure than were U.S.bank branches. With the International Bank-ing Act of 1978 much of the so-called discrim-ination against U.S. banks in their home mar-ket was done away with. There is still somecontention that the system does not treat U.S.and foreign banks totally equally, but for themost part, foreign banks must abide by thesame regulations as U.S. banks.

Financial Markets

Money Markets

Perhaps the most remarkable growth inbank use of foreign money markets as sourcesof funds in the last 20 years occurred in theeurocurrency markets,

Banks’ rapidly growing involvement ineuro-market business was largely by responseto two basic elements: perception of the profitopportunities arising from differential regula-tory provisions applying to international anddomestic business and increased reliance onportfolio diversification as a means for reduc-ing risk exposure. Over the years, an addi-tional stimulus to the expansion of euro-currency transactions was provided by thegrowing familiarity of customers, both depos-itors and borrowers, with the peculiar tech-niques of foreign currency operations and par-ticularly by the proved depth and resiliencyof the interbank markets in foreign curren-cies. 13

The eurocurrency market provided banks incountries with undeveloped money marketsthe opportunity to enhance the managementof their liquidity. The development of sophis-ticated interbank communication techniquesalso had a significant effect on the ability ofbanks to participate in these markets.

Flexible exchange rates have enhanced theacceptability of the eurocurrency markets as‘‘substitutes’ for the foreign exchange mar-ket with respect to hedging.

——13 Pecchioli, op. cit., pp. 19-20.

International FinancialInformation Systems

Computer-based business information sys-tems are finding widespread application in thefinancial service industry, particularly in in-ternational finance. A major figure in this areais Reuters, the world’s oldest internationalnews agency. Reuters Monitor provides infor-mation on worldwide money markets to finan-cial institutions via 15,000 terminals in 74countries. ’4 By far the leader in this service,Reuters competes with other nonbank finan-cial data providers in the United States andabroad, as well as with the information serv-ices of financial institutions. The Reuters serv-ice is unique in that, as a videotex system, italso provides the opportunity for the user todeal in the markets and may eventually allowthe user to confirm and complete deals usinga terminal.

The information provided in these systemshas always been available, it was just notreadily accessible. In the case of the moneymarkets, the information provided by theseservices was not previously available in oneplace. Often these services provided addi-tional, useful information or information thatcould be found elsewhere in newspapers orreports. However, what was once useful is nowessential information, providing a competitiveedge to its user. This in turn has forced most

— — — —14 Paul Walton, “A Boon for the Money Markets, ” Financial

Times, Dec. 14, 1983, p. 28.

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

institutions wishing to be competitive to use need four or five different terminals. This situ-the systems. Technology has provided the cat- ation is bound to right itself in the long run,alyst for the growth of these systems. either by each organization’s having a central-

An annoying side-effect of these systems isized information function that feeds into its

the proliferation of terminals and the incom-own data system, or by existing vendors of-fering their services on compatible systems.

patibility of systems. A dealer, in order to haveaccess to a variety of information sources, may

International Interbank

Much of the international banking activitydescribed in the preceding sections takes placevia sophisticated international communicationfacilities. This is particularly true for inter-bank transfers of information and funds. Asinternational banking has grown, so too hasthe importance of these functions. In recogni-tion of this, many of the large, money-centerbanks formed private telecommunication net-works to help ease some of the problems asso-ciated with massive paper flows. Interbanktransfers are generally high-value transfers.

New York Clearing House Association

In 1970, the New York Clearing House As-sociation began operating the Clearing HouseInterbank Payments System (CHIPS). CHIPSwas founded to help meet the need perceivedby a few of the large New York money-centerbanks for an automated system. Since its in-ception, CHIPS has been almost entirely auto-mated, although for a short period in the be-ginning some of the clearing was paper-based.Although CHIPS has not stated any intentionof expanding geographically, it is responsiblefor moving among banks an estimated 90 per-cent of the U.S. dollars exchanged in interna-tional commerce.15

Society for Worldwide InterbankFinancial Telecommunication

SWIFT, founded in 1973 and operational in1977, is the largest of the international finan-—.—— —

“’’CHIPS: More Than Just a Clearing System, ” Transition,February 1983, p. 20.

cialnot

Communications

telecommunication networks. SWIFT isa financial organization nor a telecom-

munication common carrier; instead, it is anonprofit cooperative society that links mem-ber banks worldwide through a data process-ing and transmission network. SWIFT ownsand operates its own processing facilities andleases communication lines from national orinternational carriers.

SWIFT was initiated by a group of Euro-pean bankers who were searching for a betterway than mail or telex to transmit messagesto correspondent banks. In response to the in-crease in international financial volume in the1950’s and 1960’s, a number of banks hadestablished internal communication and proc-essing systems. These proprietary systemsusually connected only branches and affiliatesof the banking groups, and therefore trans-actions involving a number of banks wouldoften rely on a paper-based system. Anotherdrawback of these proprietary systems wasthat they established a myriad of standards,comparable to the different gauges of railroadtrack one still encounters when crossing somenational boundaries. The creation of SWIFTwas in response to the need to establish a rapidcommunication and processing system, whichwas universal and standardized, was for all in-ternational interbank transfers and was avail-able to all banks. SWIFT was also seen as away to compete with these intrabank commu-nication systems, particularly those of largeU.S. banks but eventually also a number ofsmaller U.S. banks, in order to provide the vol-ume necessary to support the system.

Ch. 6—The international Environment for Financial Services ● 159.—— —— — — .— — ——

When SWIFT was incorporated in Belgiumin 1973, it was owned by 239 European, NorthAmerican, and Japanese banks in 15 countries.In its first year of operation, SWIFT averaged51,700 transactions per day. ” As of April1983, the SWIFT system served 1,063 mem-ber banks in 52 countries, of which 33 wereoperational countries, and processed an aver-age of 360,000 financial transactions per day

(see figs. 12 and 13).17 This represents aboutfour times the combined total transactions ofthe two private sector bank payment networksin the United States, Bankwire and CHIPS. 18

SWIFT is not a clearing or settling networkand does not read the messages as they passthrough the system; therefore, the value ofthese transactions is difficult to determine.

16 SWIFT: Ten Years, special anniversary issue of the generalintroductory brochure (Brussels, Belgium: Society for World-

17 SWIFT, “Facts About SWIFT, ’4 April 1983.wide Interbank Financial Telecommunication, May 1983), p. 25.

18 ’’Executive Suite, ” Transition, January 1983, p. 2.

Figure 12.— Daily System Traffic Volumes (average: end of year)

— — — . —] y-- 51 -w

}, II t ( II II I

-,1 1, I i ]{ II I

..1 ), I I II II 1

I I 11 ( I ,1 1( I

11

SOURCE SWIFT Ten Years special anniversary issue of the general Introductory brochure (Brussels Belgium Society for Worldwide Interbank Financial Telecom-munication May 1983)

Figure 13.—Cumulative System Volumes (end of year)

\lll I 1( ) \ \

I -1$

1981 169.081 000

S O U R C E SWIFT Ten Years special anniversary Issue of the general Introductory brochure ( Brussels Belgium Society for Worldwide lnterbank Financial T e l e c o m -municat ion May 1983)


U.S. traffic over the network is higher thanthat of any other nation; in 1982 it was 17.7percent of total volume, an increase from the1981 figure of 16 percent.19 Yet only 141 U.S.banks participate in the system. Carl Reuter-skiold, SWIFT’s general manager, estimates“that as many as 500 U.S. banks are involvedsufficiently in international banking to meritSWIFT membership. ”20

After 6 years of operation SWIFT is enter-ing a new phase of operation. In 1982 it wasable to amortize completely the developmentcosts of the network, and for the first year,broke even. This has occurred even thoughSWIFT raised the basic per-message chargeonly once, to 18 Belgian francs (about 35 to40 U.S. cents) .21

SWIFT’s plans for expansion include an im-provement in technical transmission and proc-essing facilities, commonly called SWIFT II.Plans are to install a new, more powerful com-puter system between 1985 and 1987 on acountry-by-country basis. SWIFT will financethe new system internally from operatingrevenues.

Although SWIFT enjoys a comfortable posi-tion as the primary international financialtransmission network in terms of volume, ithas continued to seek new business opportu-nities. By September 1983, SWIFT estimatedthat it offered its base service to approxi-mately 90 percent of the total international fi-

——‘gRobert Trigaux, “SWIFT Executives and Bankers Mull the

System’s Future, “ American Banker, New York, May 17, 1983,p. 1.

‘“Ibid., p. 31.2’ Ibid., p. 31.

nancial market.22 SWIFT management fore-sees a leveling off of revenue in this businessarea and therefore plans to expand its revenueproducing message traffic in other areas. In1982, SWIFT formed direct interface with theCEDEL and Euroclear bond clearing systemsand MasterCard International to use SWIFTfor transmission of transaction or settlementinformation.

SWIFT has also begun a controversial newprogram to offer new financial services, spe-cifically balance reporting. Many U.S. banksview the proposed changes as potential com-petition for services that banks currently of-fer. However, if balance reporting does notlead to other types of cash management serv-ices, these banks will not challenge SWIFT’sentry into this business area. SWIFT manage-ment maintains that the balance reportingservice will be invisible to corporations andwill remain an interbank service. There is evi-dence that although U.S. banks may be waryof the changes, European banks may be en-couraging the implementation of these newservices.

Another service that SWIFT managementintends to expand is the provision of intra-country financial communications.

One of the primary achievements of SWIFTfor international banking has been the stand-ardization of international, interbank com-munications. With respect to new services,SWIFT intends to play the same role, therebyhelping to establish international standardsin cash management services,

“B. Kok, “The Business Future, ” Proc&d”ngs From SWIFTInternational Banking Sem”nar(SIBOS ‘83), Sept. 26-30, 1983,Montreux, Switzerland, p. 12.

Ch. 6—The International Environment for Financial Services . 161-.

The Effect of Technology on InternationalPayment Systems

J. R. S. Revell distinguishes between twoclasses of payments in his work, Banking andElectronic Funds Transfers.23 Borrowing fromthe work of J. M. Keynes, Revell separates in-ternational financial flows into two categories:those involving the transfer of income and thepayment for goods and services by nonfinan-cial business and households, or the “indus-trial circulation” (corporate and retail pay-ments), and those involving foreign exchange,the money market, and the capital market, or“financial circulations. ” It is a useful distinc-tion when one is concerned with the impact ofthe technology on payment flows, for it wouldappear that certain characteristics of informa-tion technology will have different effects onthe different types of flow. By using these twoclassifications, the specific impacts of the tech-nology can be defined more clearly.

Information technologies have had a greatimpact on operations in both areas. The mech-anisms of these markets have been describedin previous sections. What follows are specificexamples of the effect of technology on the twotypes of flows. In retail and corporate markets,the technologies have led to a range of new,technology-based products, adding to thechoices available to the individual and corpora-tion in international financial transactions. Infinancial markets the technologies have pri-marily affected the velocity and volume oftransactions.

Corporate and Retail Markets

In many of the normal payments associatedwith trade, it is not speed of transaction whichis of importance. Since trade payments arescheduled for particular days each month, thesettlement of accounts could easily continueto be handled by mail, taking the delay intoaccount. However, electronic payments addsome control over these payments, and by

23Revell , op. Cit., p. 154.

their nature handle increased volume of pay-ments much better than paper-based systems.

One of the distinguishing characteristics ofthe international market is that, as in the do-mestic market, corporate customers demandcash management services from financial serv-ice providers. The basic principle of these serv-ices is to maintain low operational balances,with the majority of funds invested and earn-ing interest. The impact of communication andinformation technologies on the ability of acorporation to manage its financial positionis similar to that in the domestic market; i.e.,the manager is able to react immediately toinformation and to adjust the corporate finan-cial position accordingly. The difference in theinternational market is that these transferstake place in multiple currencies and crossmany international boundaries. For the mul-tinational corporation, foreign exchange fluc-tuations provide a great incentive for initiat-ing electronic transfers. The technology allowsthe user to react instantaneously, often pro-tecting the corporation from foreign exchangelosses in times of economic turbulence.

Another difference from the domestic mar-ketplace that affects the complexity of inter-national cash management is that the manag-er must rely on information from a multiplicityof sources in dispersed places, to the pointwhere flows of information are beginning torival payment flows in importance. It is easyto reach Revell’s conclusion that, “The ulti-mate objective is that the corporate treasurerat head office shall have an up-to-the-minutesummary of the cash position in all currencieson a single VDU [video display unit] on hisdesk; he will then initiate the larger transfersof funds himself, leaving the bank computerto invest smaller amounts according to rou-tines decided in advance. ”24

“Ibid., p. 155.

162 • Effects of InformaTion Technology on financial Services Systems

Technological Innovation in Retail Services

Since many innovations in corporate and re-tail flow of funds often take place in the in-ternational side first, it is useful to study whatis going on in the international marketplaceto help project developments in the domesticarena.

One of the distinct differences between tech-nological innovation in the U.S. financial serv-ice industry and that in foreign nations is thelevel of government subsidy of technical de-velopments that affect the financial service in-dustry. For example, the smart card, the ap-plications and functions of which are discussedin chapter 2, was developed by the FrenchMinistry of Post and Telecommunications(PTT). Although the card has other uses, it willbe used for electronic banking, particularly forpayments. The French have also conductedvarious trials in point-of-sale (POS) systemsand have also introduced on a limited scale avideotex system that will eventually be capa-ble of handling financial transactions. Thecharge for this service is provided to the con-sumer as part of his monthly telephone charge.The British videotex system, Prestel, was de-veloped by British Telecom (BT, then part ofthe British Post Office), the telecommunica-tions authority. Again, although the systemhas other applications, its service is in directcompetition with other, commercially devel-oped systems.

The developments outside the United Stateswith respect to retail services are in manyways similar to the domestic innovations thathave been described in previous sections.What differs in many cases is not the technol-ogy itself, but the commitment of the variousgovernments and the structure of the finan-cial service industry in a particular nation.Often, technological innovations are easier toimplement under a regulatory structure thatdiffers from the U.S. regulatory structure. Forexample, in Great Britain, BT and IBM arecurrently discussing an electronic POS systemwith the London clearing banks. Since thebanking industry in Great Britain is highlyconcentrated, agreement with these banks(and assuming subsequent agreement withBritish retailers) will ensure a national POSsystem.

Some innovation in retail services takesplace across national borders. Members ofEurocheque International recently agreed ona “eurocheque” ATM standard that will allowthe crossborder use of the eurocheque guar-antee card. VISA International plans a simi-lar service on a worldwide basis. The impetusfor much of this activity has been the growthof international travel and the consequentneed by the traveler for ready access to bankaccounts worldwide.

Vulnerability of the Financial System

The application of advanced financial infor- World trade relies heavily on the integrity ofmation technologies occurs in nearly all in- transnational transactions and payments; thisdustrialized nations and in many of the newly in turn depends heavily on the reliability andindustrializing nations. This is in response to, security of the transborder flow of data.and will further enhance, the ongoing growth As world trade has expanded, so too haveof global economic activity and the increasing the financial services to support it, not onlyinterdependence of national currencies, nation-al markets, and national economic policies. in the actual support of trade through tradi-

tional bank lending and transfer mechanisms,Expanding world trade, which is responsible but also in the provision of flexible money and

to a great extent for this financial activity, is capital markets. The use of new technologiesincreasingly important to the U.S. economy. in the financial service industry has facilitated

—— — .-. .

Ch. 6—The International Environment for Financial Services ● 163— . — — . — . - —

the growth in volume of financial flows sepa-rate from but related to the payment flows as-sociated with world trade. One aspect of thesemoney and capital markets is the interbanktransfer. The application of information tech-nologies permits both the increased volume ofthese transfers and the participation of small-er, nonmoney center banks, thus helpingchange the character and structure of inter-national banking.

Security and Integrity of theFinancial System

Communication and information technol-ogies have increased the interdependency ofthe participants within the financial system.The international financial system may nowbe more vulnerable than ever to upheaval,both economic and political, in foreign coun-tries. At issue within this area is the questionof the increased vulnerability of all parties tointernational events that results from commu-nication and information technologies.

The technologies have created new oppor-tunities for attacking systems for deliveringfinancial services. System integrity, the abilityof a system to recover from damage, is a sali-ent issue when a significant portion of the re-quired operations are performed without hu-man intervention. For example, financialservice institutions can be attacked by perpe-trators electronically and off-site. Some sys-tems have reached a stage of complexity wherethey can be backed up only with automatedsystems, and in the case of interruption toservice, they can be restored to operation onlywith automated recovery procedures.

Error Resolution in InternationalElectronic Funds Transfer

With increasing global interdependence andincreasingly complex transactions, generallymore than two parties are involved in a singletransaction, and therefore a multitude of sys-tems are also involved. The issue as definedhere is that of responsibility in the case of lossor error. Simple bilateral contracts do not in

all cases clearly place liability, especially whentransactions involve multiple parties. It hasbeen recommended that the party initiatingthe transaction be responsible, which is notacceptable to all parties.

There is a similarity between losses sufferedunder CHIPS or SWIFT and those underother payment systems. They can be classifiedin three ways: principal losses, interest losses,and losses resulting from foreign exchangefluctuations. “These losses may be caused bythe delay of a transmission, the introductionof faulty information, or a participant’s in-ability to settle the day’s transactions. Delaysand faulty information may arise from hard-ware and software failure, mistakes by person-nel involved in processing the transaction, andfraud. The failure to settle, on the other hand,is usually caused by the failure of one of thetransferring banks. “25

Foreign Telecommunications andInformation Policies

Although the force from within the indus-try is toward the flow of information through-out the world, integration of the world econ-omy and the world financial system is by nomeans as simple as the integration of a domes-tic economy. Currencies, accounting method-ology, and regulatory and supervisory struc-ture all differ among nations. In support oftrade activity, information flows across na-tional boundaries: information which includesboth personal and strictly financial data, in-formation which travels via sophisticated tele-communications systems, and informationprocessed by state-of-the-art technologies.These flows, known as transborder data flows(TBDF), have caused conflict and controversyamong nations and between particular nationsand multinational businesses. It is primarilythe informational flows, rather than paymentflows, with which most nations are ostensiblyconcerned.

“Herbert F. I.ingl, “Risk Allocation in International Inter-bank Electronic Fund Transfers: CHIPS and SW1 FT, ” Har-~“ard International I,awr Journal, \’ol. 22, No. 3, fall 1981, pp.630-631.

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

Sovereign nations assert legitimate reasonsfor, and a right to, monitor and control TBDF.Primary among these reasons are protectionof the privacy of their citizens, industrial de-velopment, and national security. However,sovereign rights and national information pol-icy are frequently in direct conflict with theinterests of large, multinational organizations,including financial service providers. This con-flict of interest in turn can impede the progressof a global financial system and perhaps worldtrade.

As the information technology industry be-comes increasingly important in internationaltrade, more countries are seeking to protecttheir indigenous communication and informa-tion industries and are therefore creating legalbarriers to the flow of information. This hasan impact on the financial service industry,whose primary function is the distribution andprocessing of information.

The requirements of multinational and inter-national finance include rapid communicationsand efficient data processing. Certain restric-tions by foreign governments—e.g., that alldata are processed locally-can severely ham-per these activities. The current economies ofdata processing are such that it is more effi-cient to centralize the process.

For a variety of reasons, there have beensuggestions that nations limit the flow of per-sonal data across their borders. Some wouldlimit the effects of restrictions to data iden-tifiable with natural persons while others wouldinclude both natural and legal persons. In-cluded has been the suggestion that limita-tions on TBDF be focused on curtailing theflow of data to nations that have not imposedprivacy standards at a level consistent withthose of the nation imposing them. However,much of the data of interest to the financialservice industry pertains to specific individ-uals, and its movement across internationalborders would be affected by such restrictions.Therefore, limitations on TBDF could causesignificant problems for the financial serviceindustry, which finds demands for internation-al services increasing.

The economic and industrial developmentjustification of restrictions of TBDF have astheir impetus the rising importance of infor-mation and communication technologies to theworld economy. As traditional manufacturingindustries stagnate and high-technology infor-mation industries grow, it is to every nation’sadvantage to encourage a sound, strong infor-mation industry. Although national policystrategies differ, it is evident that some na-tions have taken the route of protectionism.For example, Brazil has stringent require-ments on the import of data processing equip-ment in order to encourage the growth of localindustry. Until recently, little foreign competi-tion was allowed in the large Japanese com-munications and information technology andservices market. These types of activities, al-though they may protect indigenous industry,have a tendency to increase overall costs tousers.

More specifically affecting the financialservice industry are those national policiesthat threaten to discontinue access to leasedlines, begin usage-sensitive pricing schemes,and demand that industry use local commu-nication facilities. The objections of banks andother financial service providers is not onlythat this will increase their costs, but thattransmittals over public lines make controlover sensitive information more difficult.

National security concerns seem to centeraround the economies of scale and the lack oflocational sensitivity in data processing. It iscommon for large corporations to center theirprocessing facilities in one nation. For exam-ple, SWIFT’s data processing and transmis-sion centers for its 52 member countries arelocated in 3 countries: the Netherlands, Bel-gium, and the United States. Such centraliza-tion engenders the fear that sensitive informa-tion will be stored in a foreign country, or thata nation may be cut off from information ina time of national crisis. As SWIFT pursuesdomestic interbank markets, these fears be-come well-founded; it is entirely possible forone nation’s domestic retail and interbank fi-nancial information to be stored at facilitiesoutside its borders.

Chapter 7

The Consumer of Financial Services

. .

Contents

PageIntroduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167

Consumer Financial Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167Consumer Savings and Investment Behavior . . . . . . . . . . . . . . . . . . . . . . 168Providers of Consumer Financial Services . . . . . . . . . . . . . . . . . . . . . . . . . 169Consumer Payment Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171Growth of Consumer Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173Recent Innovations in Consumer Financial Services . . . . . . . . . . . . . . . . 174Automated Teller Machines . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176Automatic Direct Deposit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178Telephone Billpayer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178Point-of-Sale Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178Home Information Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178Pricing Structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178Opportunity Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179Information Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179Communication Costs .. .. .. .. .. .. .. $. .. ... ... .$...... . . . . . . . . . . 179Competition and Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179

Public Policy and the Financial Service Consumer. . . . . . . . . . . . . . . . . . . . 180Regulations Relating to Consumer Finance. .’. . . . . . . . . . . . . . . . . . . . . . 180Consumer Credit Protection Act . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182Regulations Z and M . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182Electronic Funds Transfer Act . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183

Transition From Paper-Based to Technology-Based Systems . . . . . . . . . . . 184Security of Consumer Assets in a Technology-Based System . . . . . . . . . 184Privacy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185Consumer Rights to Financial Services . . . . . . . . . . . . . . . . . . . . . . . . . . . 186

Tables

Table No. Page9. Household Financial Assets and Liabilities, 1982

(billions of dollars). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169IO. Credit Card Holding (families holding cards as percent of

all families). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17211. Credit Carouse (families using cards as percent of all families) . . . . 17312. Summary of Variances in Regulation and Investor Protection. . . . . . . 181

Figure

Figure No. Page14. Lifecycle of Consumer Needs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170

—

Chapter 7

The Consumer of Financial Services

Introduction

Consumers’ of financial services have char-acteristics distinct from all other financialservice user groups. Approximately 80 millionhouseholds comprise this group; and as such,it is an important part of the U.S. economy.Household deposits provide the financial serv-ice industry with nearly $2 trillion in loanablefunds. In addition, consumers have a diversityof needs and compose a highly segmented mar-ket, Consumers, in comparison to their use ofother instruments, also make the least useof technology-based financial services andproducts.

It is readily accepted that although somemovement has been made toward consumeracceptance of technological devices in bank-ing, the time horizon for acceptance by thetotal population will be much longer than 10years. There are currently some highly visibleexamples of the effect of technological changeon this market segment (e.g., the rapid accept-ance of automated teller machines (ATMs)),but certain institutional relationships havebeen affected little by the technology. As somenew systems are implemented, however, andcertain of the institutional problems withthese implementations are resolved, the effectsof technology on the consumer of financialservices are bound to become more evident.

Historically, the banking sector of the finan-cial service industry has been either enamoredof or totally uninterested in pursuing the con-

‘The consumer, as defined here, is an individual user of per-sonal financial services.

sumer as a potential customer. It appears,however, that competition is changing someof the indifference of banks toward this mar-ket. “It was not regulation or legislation thatallowed nonbank institutions to exploit the op-portunities available in upscale credit cards(American Express), in discount brokerage(Merrill Lynch), and in automated payroll serv-ices (ADP). Rather it was the failure of banksto engage in effective marketing and their lackof innovation and understanding of consumerattitudes that gave the near-bank competitorsthe upper hand in these product areas.’” Asa result, the consumer is beginning to wieldmore power in product development; recentevents are changing consumer financial serv-ices from being product-driven to being mar-ket-driven. It is not clear, however, if all con-sumers are benefiting from these changes.

Consumer protection regulation has in thepast dealt with the protection and fair treat-ment of consumers in the financial servicesystem. Implicit in the formulation of publicpolicy has also been the recognition of the po-tential impact of technology-based systems onthe consumer. However, it is important tofully understand the changes taking place,their impact on the role and behavior of theconsumer, what new issues will arise becauseof these changes, and existing issues that havenot been adequately addressed.—————

‘Richard Rosenberg, Vice Chairman of W’ells Fargo, as quotedin The Retail Banking Re\’olution: An International Perspec-tit’e, Patrick Frazer and Dimitri }Tittas (eds. ) (1.ondon: NlichaelI,afferty Publications, 1982), p. 7.

Consumer Financial Services

Consumers seek financial services to fa- instruments, to balance present consumptioncilitate payment, to balance current income against future earnings with credit instru-against future consumption through savings ments, to secure growth in capital, and to safe-

167

35 -505 ~ - 84 - 12 : QL 3

168 • Effects of /formation Technology on Financial Services Systems— — . — — —.

guard their assets. A rational consumer whowants to maximize his objectives will desirecontrol over the means (i.e., assets and income)to those ends. The degree of his control ismeasured by the extent to which his assetsmeet his needs.

In this regard, Professor William White, inhis report to the Investment Company Insti-tute, The Outlook for Money Market MutualFunds, defines the demand of consumers forspecific financial products and services as aris-ing not from the particular product or serv-ice, but from features of the consumer and hisenvironment. Demand arises first from the ne-cessity for the individual consumer to meetcertain basic needs, which can be classified asconvenience, return, liquidity, security, creditavailability, and, to some extent, personalservice. The investment behavior of the con-sumer is related to the relative importance ofeach of these needs, which in turn is based onthe individual’s economic environment and hislifecycle stage. Also of importance is the lesstangible factor of individual tastes and pref-erences. 3

Consumer Savings andInvestment Behavior

The term “investment” throughout this sec-tion is not used in its macroeconomic sense,that is, the purchase of capital goods. For thischapter the term means the commitment ofmoney specifically to earn a profit, most oftenby purchasing securities. “Savings” are de-fined as asset accounts in which an individ-ual accumulates funds for future consumption.For the most recent statement of total out-standing assets and liabilities for the house-hold sector, see table 9.

The primary savings instruments used byindividuals are time and savings deposits, pen-sion funds, and home mortgages. In recentyears, more consumers have begun using themoney market fund for savings. The figuresfor 1982 do not reflect, however, the more re-

‘William L. White. “The Outlook for Money Market MutualFunds, ” Report to the Investment Company Institute, Sept.30, 1982, pp. 28-29.

cent movement of funds out of money marketfunds into their depository equivalent, moneymarket deposit accounts. These figures will bereflected in 1983 end-of-year accounts.

Life insurance funds are also used for ac-cumulating savings; however, because of theirlow rate of return, their primary function isinsurance against risk. Individuals also investa considerable amount in securities, both cor-porate and government.

Home mortgages, although they representa liability relationship for the consumer, are,in effect, instruments of negative savings inwhich the consumer initially creates a debtrelationship with an institution. However, asthe consumer decreases his debt, he earnsequity in the property; as the value of theproperty increases over time, it increases thenet worth of the individual.

The relationship of assets to liabilities andthe choice of instruments for investmentvaries with the age and income of the consum-er. This is depicted graphically in figure 14.The primary earning years are between theages of 20 and 70, when generally the con-sumer earns more than he consumes. Withage, savings and investment behavior of theconsumer changes. Generally, in youth, theconsumer will be more consumption-oriented;as age and income progress, the consumer willbe more future-oriented. The consumer’s basicneeds of convenience, higher return, security,liquidity, credit availability, and personal secu-rity often correspond with this lifecycle anddirectly influence which financial service andproducts he selects.

Although aggregate information on the sav-ings habits of consumers reflects a propensityto invest, an overall tendency to save ratherthan borrow, and a pattern of savings highlycorrelated to age, consumers differ in their ob-jectives for asset management. The financialservice industry has recently begun to reactto these differences and to provide services tomeet very individual needs in addition to pro-viding instruments that have widespread use(e.g., checking and savings accounts, bankcredit cards, or mortgages).

Ch. 7—The Consumer of Financial Services ● 169

Table 9.— Household Financial Assets and Liabilities, 1982 (billions of dollars)

Assets:D e p o s i t a n d c r e d i t m a r k e t i n s t r u m e n t s . ,

Deposits ., ., . . ... ... . . .Checkable deposits and currency . . . . . .Small time and savings deposits . . .Money market fund shares . . . . . . . . .Large time deposits ., . . . .

Credit market instruments ., . . . .U . S . G o v e r n m e n t s e c u r i t i e s . , . . .

Treasury issues . . . . . . . . .Savings bonds ... . . . . . .Other Treasury ... , . . . . . .

Agency issues .State and local obligations . . . . .Corporate and foreign bonds . . . . . .Mortgages . . . . . . . ., .,Open market paper. . . . . . . . . . . .

Corporate equities . . . . . . . . . .Mutual fund shares ., ... . . . . .Other corporate equities . . . . . .

Life insurance reserves ., . . . . . .Pens ion fund reserves . , . , . , . . . . ,Security credit . . . . . . . . .Miscellaneous assets . . . . . . . . . .

Total assets . . . . . . . . . . . . .

Liabilities:Credit market instruments . ., .,

Home mortgages . . . . . . . . . . . . . . . . . . .Other mortgages . . . . . . . . . . . . .Installment consumer credit . . . .O t h e r c o n s u m e r c r e d i t . . . . , . ,Bank loans n.e.c.a . . . . . . . . ... . . . .Other loans . . . ... . . . .Security credit . . . . . . . . . . .Trade credit . . . . . . . . . . . . . . . . . . . . . . . .Deferred and unpaid life insurance premiums

Total liabilities. .. .. ... . . . .N O T E Households Include not for prof i t orqanlzat!ons

aNot elsewhere class lf~ed

$2,781.31.982.7

798,6

1,316,289.5

1,226,81,316.2

935.316.085.3

$5,381.0

1,674.41.101,0

36.4344.8

85,933.3730

28.822.215.5

$1,740,9

307.31,322,9

206.6145.9

377.0

129.064.5

186,541.6

291,868.3

223.485.2

SOURCE Board of Governors Federal Reserve System Flow of funds Accounts: August 1983

Providers of Consumer Financial Services

For the most part, consumer needs cannotbe met without the assistance of an interme-diary that provides access to payment sys-tems and markets, expert knowledge andadvice, the pooling of a large number of indi-vidual risks (as with insurance protection), ora diversified portfolio for a minimum invest-ment (as with investment companies).

In the past, consumer financial institutionsspecialized in individual products and services.As a result there were some institutions thatprovided for the payment needs of the con-sumer, some which provided for his/her sav-ings and credit needs, and still others that pro-

vided for his/her insurance needs, Regulationtended to support this specialization. Recenttrends in the marketplace and in regulation arebeginning to break down the strict distinctionsbetween institutions. Many consumers areadapting readily to the changes and are chang-ing traditional relationships with some finan-cial institutions.

Prior to these recent events, the most widelyrecognized financial relationship for the con-sumer was with a depository institution, espe-cially with a bank. Banks provided the con-sumer access to the payments mechanismthrough checking accounts and met some cred-it and savings needs. Savings institutions pro-

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

Figure 14.— Lifecycle of Consumer Needs

I Earned income (excluding investment income and transfers)

F=/ \~~

o 10 20 30 40 50 60 70 age in years~~~ ~

Usually First Prime working and earning Supported by incomesupported by jobs years from savings, retire-

parents family ment or welfarebenefits

For the purposes of the financial services industry, people do not become consumers (do not buy) financial services usuallyuntil at least their teens:

General age

Teens-20’s

20’s

30’s60’s

60’s ‘-

New financial activities

First jobs (though often stillwith parent support).

Often, college.Often, car or other major purchase.

— .First home purchase or more saving

to prepare for home purchase.Marriage and first children.Related: perceived need for greater

security to protect family.

Prime working-and earning years: –

Higher income,Larger saving base being built,

as foundation for childreneducation and other expenses,and for old age.

More business travel.More income for personal travel.

High 0/0 of time working, especiallytwo career couples (2 earnerfamilies): result - need forgreater convenience in trans-actions, more mail order andoverall purchases.—— .

Often retirement or less working ‘-

time, more leisure, less earnedincome.

Resulting financial service(s) requirements

Transaction accounts, simple savingsaccounts or instruments (e.g. U.S.savings bonds).

Education loans.Auto or other loansAuto insurance.

Home mortgage.-.

More sophisticated savings instruments,Various loans (general credit).Insurance, savings

life, health, home insurance,.— —

Tax sheltersMore sophisticated investment vehicles:securities, money target funds, realestate, insurance purchases.real-estate pension plans.

Financial advice often desired.Traveler’s checks, travel and entertain-

ment credit cards.Cash dispensers, debit cards.

Financial advice, to plan for supportinga standard of livinglesser risk, higher current Income(securities), investments, pensiontrust, estate planning.

SOURCE William L White, “The Outlook for Money Market Mutual Funds, ” 1982


vialed savings and mortgage services. Creditunions provided services similar to those pro-vided by both commercial banks and savingsinstitutions.

Recent research shows that the typical con-sumer deals with only one or two banks andwill accept fairly standardized products.’ How-ever, it also shows that there is very little con-sumer loyalty toward a particular institution;if another institution can meet the needs of theconsumer better, the consumer usually moveshis business. A consumer “wants to be ableto use a credit card to purchase goods andservices from merchants, and he wants to beable to use a piece of plastic (preferably thesame one, perhaps) to obtain cash from a ma-chine. He does not care who issued the cardor who wrote the programs accessing the ma-chines any more than he cares who manufac-tured the machine. This has been borne outby the rapid movement of funds out of tradi-tional deposit accounts in the 1970’s to ac-counts with a higher rate of return. In thepast, most so-called consumer loyalty was il-lusory in that banks had a monopoly on cer-tain types of transaction accounts and oftenhad a geographic monopoly, as well.

Individuals with higher discretionary in-comes, a desire for high growth of assets, andlower risk aversion will generally have a rela-tionship with a securities house. High income,or, in its place, low risk aversion, was gener-ally necessary to offset the risk associatedwith the instruments offered through these in-stitutions.

It is evident that consumers have also hadfairly complex financial relationships withnontraditional financial service providers. His-torically, retailers have extended credit totheir customers to purchase goods and serv-ices. From this has developed a fairly substan-tial number of consumers with revolving creditlines, and credit cards to access these lines ofcredit. Sears and J. C. Penney have two of the

‘Arthur D. Little, Inc., Issue and Needs in the Nation’s Pay-ment System, The Association of Reserve City Bankers, April1982, p. 35.

5Paul Horvitz, American Banker, New York, Sept. 24, 1982.

largest card bases in the United States andhave filled certain consumer financial needs foryears. Both are favorably placed in the finan-cial service marketplace because the consumerrecognizes their names. As the consumer be-comes used to nontraditional providers of fi-nancial services, he may willingly accept re-tailers as providers.

Consumers may obtain cash from a varietyof other places besides banks; for example, in-dividuals routinely cash checks at a groceryor convenience store solely for the purpose ofcash acquisition. Although these retailers arenot financial institutions in the traditionalsense, they certainly have provided consumerswith financial services in the past. Grocerystores have used check guarantee systems fora number of years, and as mentioned earlierin this report, some are beginning to offer moretechnologically sophisticated services—for ex-ample, onsite ATMs.

The ways in which the financial service in-dustry is changing are described more fullyelsewhere in this report. The effect of thesechanges on the consumer has been to offer hima greater realm of choice in the institutionswith which he can do business.

Consumer Payment Methods

Like the business sector, the consumer re-quires payment mechanisms to acquire goodsand services. Recent research has postulatedthat a consumer seeks as many as 11 specificattributes in a payment system: budgeting,documentation, reversibility, spending con-trol, transaction record, leverage potential,acceptability, transaction time, transfer time,social desirability/prestige, and security.6 Eachconsumer will choose his method of paymentaccording to his priorities and to his percep-tion of a particular method as having the speci-fied attributes.

By far, the most commonly used medium ofexchange for point-of-sale (POS) purchases is

‘Elizabeth C. Hirschman, “Situational Perception of Prod-uct Prototypes Within the Product Class of Consumer Pa~’mentSystems. ” The Journal of Genera) PsJ’choJogTr, \ol. 106, 1982,p. 127.


cash, particularly for small transactions. Theprimary attributes of cash are convenience andacceptability. Since cash is universally nego-tiable and requires no personal identificationfor use, cash transactions also have the addi-tional attribute of privacy; however, thesesame qualities make cash a less secure mediumof exchange. For the approximately 17 percentof all households that have no relationshipwith a financial service institution, either cashor (in specific instances) money orders or cash-iers’ checks, are the only instruments of pay-ment available.

Many consumers use checks to meet theseneeds. Studies show that the consumer’s useof checks has consistently been in the rangeof 50 percent for bill payment, 31 percent forretail purchases, 9 percent for payments toother individuals, and 8 percent for cash ac-quisition. 7 The figures for cash acquisition areprobably low, since many checks written toretail institutions are actually for acquiringcash. In 1979, consumers’ checks accountedfor approximately 53 percent of all checkswritten, or 17 billion transactions.8

Until the 1950’s, the personal check wastruly the only widely used alternative to cashfor payments. In recent years, however, thecheck has become less negotiable; consumersfrequently are required to have additionalidentification and some proof of creditworthi-ness in order to use a check for POS purchases.In part, the decreasing negotiability and lackof national acceptance of the check led to theexplosion in the availability and use of otherpayment mechanisms for the consumer—e.g.,traveler’s checks, retail credit cards, travel andentertainment (T&E) cards, the bank creditcard (in the 1960’s), and, most recently, thedebit card.

The traveler’s check and the T&E card pro-vided the consumer with payment mecha-nisms more negotiable than the check, withattributes of convenience and acceptability,yet more secure than cash. T&E cards are

‘See Economic Review, “Special Issue: Displacing the Check”(Atlanta, Ga: Federal Reserve Bank of Atlanta, August 1983),p. 8.

‘Ibid., p. 26.

charge cards and, except in certain instances,do not provide long-term credit to the con-sumer. When they were introduced, the con-sumer did not have highly developed creditneeds. T&E cards met the additional consumerneeds of spending control and leverage poten-tial. In addition, the high membership fees andapparent exclusivity of the cards provideda sense of social prestige. Although it wasthought that with the introduction and wide-spread use of bank credit cards, the numberof T&E cards in circulation would dwindle andtheir usefulness would be outdated, their num-ber has actually grown.

Bank credit cards9 are used in most casesas an alternative to cash or checks for POStransactions. Their line of credit added flexibil-ity to consumer payment mechanisms. Bankcards are perceived by the consumer to bemore acceptable and less time-consuming touse than checks and less risky than cash. Theyalso provide the consumer with proof of pay-ment, which facilitates returns or reimburse-ment. The majority of credit card users do notactually use the credit option associated withthe card, paying instead the full amount owedeach month.10 The card is viewed more as aninstrument of cash management. Tables 10and 11 show overall consumer holding and useof credit cards.

.——9The term “bank credit cards” is rapidly becoming somewhat

of a misnomer. This term commonly refers to VISA and Master-Card interchange cards, which in the past were issued by banks.However, these cards (although for the most part still issuedby banks) now provide access to a variety of’ accounts, includingcentral asset accounts offered by securities houses.

I O Ec o n o m” c R e v i e w , O p . c i t .

Table 10.—Credit Card Holding(families holding cards as percent of all families)

YearType of credit card 1977 1978 1981 1982Any . . . . . . . . . . . . . . . 63 64 66 70Gasoline . . . . . . . . . . . 34 34 30 35Bank ... , . . . . . . . . . . 38 40 45 51General purposea . . . 8 10 14 14Retail store . . . . . . . . 53 50 57 63Other b. . . . . . . . . . . . . 6 5 7 NAaTravel and entertainment cards.blncludes airline cards, car.rental cards, and others not classified elsewhereNA—not available,

SOURCE Data collected for the Federal Reserve Board by the Survey ResearchCenter, University of Michigan.

.—

Ch. 7—The Consumer of Financial Services ● 173.

Table 11 .—Credit Card Use(families using cards as percent of all families)

— . — ——Year

Type of credit card -1 9 7 1 1977 1978 1981 1982

Any ... . . . . . . . . . . . . 50’ 60 62 62 ‘- NAGasoline ... . . . 33 31 32 27 31Bank . . . . . . . . . . . . . . 19 25 37 39 47Genera l purposeb . . . 5 7 9 12 13Retail store . . . . 45 50 48 51 57Other c . . . . . . . . . . . . NA 4 3 5 NA—aData ;or 1970

— ——

bTravel and entertainment cardsclncludes al rl( ne cards and car rental cards

NA—not avaliable

SOURCES 1970 Survey of Consumer Finances: 1971-72 Survey of Consumers,and data collected for the Federal Reserve Board by the SurveyResearch Center, University of Michigan

In the 1970’s, considerable speculation de-veloped about a future “cashless society” (i.e.,a system where cash as well as checks wouldbecome obsolete, having been replaced by elec-tronic payment mechanisms). However, de-spite the growth of electronic alternatives, theuse of checks as a method of payment contin-ued to grow at approximately 5 to 6 percentper year throughout most of the 1970’s andhas only recently begun to slow. It still con-tinues to increase at about 2 percent per year.

Traveler’s checks and credit cards do not re-quire a check be written at point of sale; how-ever, the majority of them rely on the checkfor reconciliation of accounts. The only in-struments besides the check that provide theconsumer direct access to his account are thedebit card, preauthorized payments, and ATMpayments. In 1979, 97 percent of all debits toindividual accounts were by check. The other3 percent of debits to consumer accounts weredistributed thus: 1.3 percent to preauthorizedpaper drafts, 0.4 percent to preauthorizedautomated clearing house payments, and 1.1percent to ATMs. ” The current system ismerely a reflection of the acceptance of thesealternative media rather than an example ofone replacing the other.

Growth of Consumer Credit

The relationship of the consumer to the pro-vider of financial services has grown increas-

“Ibid.

ingly complex. In the early part of this cen-tury, households operated almost entirely ona current basis; using credit was an indicationof mismanagement of household accounts. Pri-or to the 1930’s, credit relationships with fi-nancial institutions were not common. Retailestablishments were more likely to extendcredit in direct relationship to consumer pur-chases. At that time, it was postulated, house-holds could manage credit to help balance cur-rent consumption wants and needs againstfuture income.

Since then, as described earlier in this re-port, there has been an exponential growth inconsumer credit and in institutions and in-struments to serve these needs. In the 20 yearsfrom 1960 to 1980, total household liabilitiesas a proportion of total household assets grewfrom 21 to 35 percent. ” This growth also re-flects, in part, a change in attitude by the con-sumer. Credit is no longer the last resort ofa mismanaged household, but a means of im-proving one’s living standard.

The primary long-term instrument for dec-ades was the installment loan, where a bulksum was borrowed by the consumer from abank or consumer finance corporation to fi-nance a large-ticket purchase of a durablegood, and repaid in installments over a speci-fied period of time. Another example of con-sumer credit was the retail revolving account,in which a consumer could charge a particu-lar amount on store-granted credit and repaythe outstanding balance monthly.

In the 1960’s the first bank credit cards wereintroduced, adding yet another source of con-sumer credit. As mentioned previously, thebank card is used primarily for its conven-ience; however, the credit uses of these cards,which were innovative when introduced, de-serve exploration.

The bank card offers essentially two typesof credit options for the consumer: short-termcredit to bridge cash shortages between pay-checks and longer term installment credit. The

“Board of Governors, Federal Reserve System, Flow of FundsAccounts, August 1983, September 1979.

174 • Effects of Information Technology on Financial Services Systems— — — —— —. .—

latter is provided with only one credit appli-cation, the consumer may borrow the exactamount he wishes within his credit limit andhave considerable payment flexibility. Abouttwo-fifths of credit card holders use these op-tions on a regular basis.

Recent Innovations in ConsumerFinancial Services

In the past decade, inflation, interest rates,and the lifting of particular banking regula-tions have affected how consumers managetheir assets. Events of the last decade haveincreased the number of investment optionsopen to the consumer of financial services andexpanded the range of consumers who usethese services. For example, tax-exempt in-come is available to all consumers through In-dividual Retirement Accounts (IRAs), andmoney market funds and money market de-posit accounts allow the small investor accessto high interest rates.

Nontraditional Providers and Instruments

Recent changes in the industry have also af-fected the way the industry provides financialservices to the consumer and have introducednew players to the marketplace. In the 1970’s,the inflation rate and the resultant high op-portunity cost of standard consumer savingsinstruments led to a phenomenon known as“disintermediation.” Funds flowed out of thedepository institutions into nontraditional in-struments and institutions. New instrumentswere created outside the interest rate-regu-lated environment of the banking community.One of these, the money market fund, allowsthe small saver to earn higher interest ratesand thereby preserve assets. This instrumentis a particularly appealing alternative becauseit also offers checklike privileges throughshare drafts. Although there is usually a min-imum amount the consumer can withdrawfrom his account with a draft, in many casesit meets his liquidity needs.

The initial target of these funds was the so-called upscale market; that is, those individ-uals with relatively high discretionary incomes

and minimal risk aversion. In time, as double-digit inflation continued and the spread grewbetween interest earned in these funds andthat earned in bank time deposits, other, morerisk-averse individuals began investing inthese instruments. This phenomenon waspartly responsible for the movement withinCongress to deregulate parts of the bankingindustry, a movement that eventually alloweddepositories to offer accounts bearing higher,more competitive interest rates.

In response to competition and profit oppor-tunities, depository institutions have alsobegun offering discount brokerage services totheir customers, making it possible for someconsumers to meet a number of their savingsand investment objectives with one firm. How-ever, since banks are not allowed to offer ad-vice on investments, except in the case of trustcustomers, this service is still limited to afinancially sophisticated class of consumers.On the other hand, nondepository institutions,such as securities firms, have added servicesthat have the appearance of depository instru-ments, yet the qualities a consumer seeks formanaging his assets. Since consumer percep-tion of the instruments is the same, a con-sumer may not differentiate between the twochoices.

The Depository Institutions Deregulationand Monetary Control Act of 1980 providednew opportunities for the consumer. This actallowed depository institutions nationwide tooffer NOW accounts through which the con-sumer earns interest on an account that is notdifferentiated in use from a checking account.These accounts already comprise one-third ofall checkable deposits. ” Also enacted by thesame legislation was the provision that fed-erally chartered savings and thrift institutionscould offer consumer loans for up to 20 per-cent of assets.

Complexity of the Marketplace

The present marketplace offers greaterchoice yet greater confusion for the individual.

~Bomd of Governors, Federal Reserve System, Money StinkMeasures and I.iquid Assets, Dec. 30, 1983.


The consumer must be more aware of the par-ticulars of investment and must deal with achanged environment that no longer offershim standard investment opportunities keyedto his position in life. The result is an increas-ingly complex relationship between financialinstitutions and the consumer.

For example, high and uncertain interestrates also led to an industry-led innovation inthe home mortgage market. During the 1970’s,the variable rate mortgage was introduced. Inaddition, the equity loan was introduced intothe home mortgage market. This loan, whichallows a homeowner access to the equity in hishome, is much the same as a second mortgage;however, second mortgages are traditionallyused for specific purposes such as home im-provements. Most of the promotion of theseloans, under the rubric of “credit manage-merit, ” encourages their use for virtually allpurposes, exposing the consumer to the lossof his home if he is unable to meet paymentson the loan.

The solution to this situation is not neces-sarily to increase the information available tothe consumer. Often educational differencesor a predisposition by the consumer precludeshim from processing the information in a waythat would facilitate his decisionmaking. And,it is likely that particular groups of individualswill be more affected than others. Certaingroups may beat particular disadvantage; forexample, the elderly and the uneducated.

There is also some question whether therewill be a conflict if the provider of services isalso the major provider of information aboutthese services. For the most part, only wealthyindividuals have access to financial advice,either through bank trust departments or se-curities brokers. Discount brokerages provideaccess to financial markets for less wealthyconsumers, but without the advice function.Middle-income consumers have in the pastrelied on banks for some financial advice, butin more complex systems, banks are often notin the position to offer sound advice to thissegment of the consumer markets, owing toa lack of trained personnel. Technology may

also push these consumers out of the bank,further limiting their access to informationservices.

Technology-Based Services

There is little evidence to support the notionthat consumers specifically demand technol-ogy-based services; the demand for services isstill a reflection of the overall needs of the con-sumer. There is perhaps a particular class ofconsumers, referred to as “innovators,” whowillingly accept new technological applica-tions. The market for these services evolvedas the consumer discovered that technology-based services had specific attributes of re-mote location and self-service and that theyprovided a payment alternative. The use oftechnology in financial services can help alterconsumer demand for financial services byproviding him easier access to his assets.

Some financial service innovations men-tioned in the previous section were facilitatedby technological change; e.g., variable ratemortgages require information-processing fa-cilities in order to be cost effective. This sec-tion distinguishes between those innovationsthat require technology in the backroom senseand those that require the consumer to havedirect contact with the technology or thosewhere technology changes the behavior of theconsumer with respect to financial services.

Previous sections of this report illustrate theway that communication and informationtechnologies have affected the way the finan-cial services industry operates. The informa-tional nature of the financial service productled to the early application of automation inthis industry, particularly in internal andintra-industry operations. However, whenthese technological solutions were applied tothe marketplace, especially as new productsand services in the consumer segment, thebenefits were not so clear nor the implemen-tations so easy. In particular, when depositoryinstitutions attempted to transfer their cost-saving technological solutions to the consumermarket, they were faced with a diverse, oftenreluctant market.


Consumer Acceptance of Technology

Some attempts at introducing technology-based products and services to the consumerof financial services succeeded and some failed.It became evident from these attempts thattechnological solutions had to consider con-sumer need. Examples of such new technol-ogies include ATMs, automatic direct depositsystems, preauthorized payments, POS fundstransfer and check guarantee, and home infor-mation systems, most of which have been de-scribed in previous sections of this report.What follows are descriptions of consumeracceptance and attitudes toward these tech-nologies.

Automated Teller Machines

The ATM is an example of electronic fundstransfer (EFT) that is highly visible to the con-sumer of financial services. By 1981, the BankMarketing Association (BMA) reported thatnearly 100 percent of the population was awareof ATMs.14 Of that figure approximately 32percent actually use an ATM for financialtransactions, which is an increase from 10 per-cent in 1977. When further broken down, thisfigure reveals that only slightly more than halfof the 32 percent use an ATM more than onceevery 2 weeks. The growth of ATM use hasfollowed the typical pattern of technologicaldiffusion—that is, from initial use by “inno-vators” to rapid, widespread use. The FederalReserve Bank of Atlanta in a recent analysisof check displacement has estimated that thesaturation level for the ATM will be reachedwhen the percentage of actual users reaches65 percent of all possible users.

The primary pattern of use of an ATM is forcash acquisition. According to Linda FennerZimmer, a noted ATM consultant, the patternof use of the ATM has remained relatively con-stant since its introduction: cash withdrawalsrepresent approximately 75 percent of the vol-ume of use of ATMs; deposits, 19 percent; bal-ance transfers, 4 percent; and payments, 1 per-

cent.15 It should be noted, however, that thevalue of deposits received at an ATM far ex-ceeds the value of withdrawals. Also, ATMcash withdrawals tend to be for amounts thatare half the value of withdrawals facilitatedby a human teller.

Also interesting to note is that use of themachines during normal banking hours is in-creasing, which represents a change in con-sumer attitude about the primary attributesof the machines. Originally, ATMs were seenas convenient for obtaining cash 24 hours aday. In this sense they were direct competitorswith retailers who provided this service. How-ever, with the change in pattern of use dur-ing banking hours, there is some indicationthat they are beginning to replace the humanteller as a source of cash. This is partly dueto the greater reliability of the newer machinesand to the increasing acceptance of the ma-chines by a greater number of people. In manycases, the institution deploying the ATM en-courages its use in order to lower the per-transaction cost of the system and thereforethe costs to the institution.

Research shows a strong correlation be-tween age and ATM use. The most frequentuser of an ATM is young; use peaks in the 25-to 34-year-old range, with a dramatic fall-offin use among members of the population over65. ’6 There is some evidence that those young-er than 25, although not frequent users ofATMs, have a high level of acceptance, andwhen they establish firmer relationships withfinancial institutions, they too will become frequent users of the technology. It is expectedthat the age factor will become less importantwith time, although when is unclear.

Isolated experiences indicate that one fac-tor that can hinder the use of ATMs by theelderly is inexperience with technology. In cer-tain situations, by providing the elderly cus-tomer with assistance, many of these reserva-tions can be overcome. However, this will notalways be the case, and it cannot be over-looked that convenience and remote location

“Bank Marketing Association (BMA), Payment AttitudesChange Evaluation (PACE III 1981), Chicago, p. 2.1.

‘“Econom”c Review, op. cit., p. 17.“Bank Marketing Association, op. cit., p. 2.50,

Ch. 7— The Consumer of Financia/ Services ● 177— .— —— . — . — ——————

. . . . . .

zo0-Jm

178 • Effects of Information Technology on Financial Services Systems— . -

are not always important to the elderly con-sumer of financial services. Tradition and thehuman factor can play important roles in thisgroup’s use of financial services, and thereforein their acceptance of technological services.

Automatic Direct Deposit

In an automatic direct deposit system, someform of income is automatically deposited inan individual’s account on a regular basis. Ex-amples include direct deposit of Social Secu-rity checks by the Government or of payrollby the private sector. Direct deposit is anotherexample of technology-based service of whichthe general population is nearly 100 percentaware. According to the 1981 BMA survey,36 percent of respondents’ households useautomatic deposit, and 80 percent of these hada very favorable opinion of the service.17 In the5 years between 1978 and 1981, penetrationof direct deposit of Social Security benefitsgrew from 11 to 33 percent of all such pay-ments. It is the eventual goal of the U.S.Treasury that all Social Security payments bemade by direct deposit.18

The premise on which direct deposit is sold,particularly with respect to Social Securitypayments to the elderly, is that it decreasesconsumer vulnerability to theft. Other aspectsof the service to which the consumer respondsfavorably are convenience, the speed of ac-count crediting, and the regularity of depos-its (particularly when the recipient is out oftown). On the other hand, the consumer per-ceives the system raising service charges onhis account and providing increased access toothers of his personal account information. 19

Telephone Billpayer

Telephone billpayer systems are not alwaysfully automated, but are considered here be-cause they represent an innovative use oftechnology-in this case, the telephone—to fa-cilitate consumer payments. Telephone bill-

“Ibid. p. 3.4.‘nEconomic Review, op. cit., p. 33.“Bank Marketing Association, op. cit.

payer services are an example of consumerreluctance to use a service to meet needs whichthey believe are adequately met through otherservices. Acceptance of this method of pay-ment has not been very high, and there hasbeen little growth in the service in the past fewyears.

Point-of-Sale Systems

There is little substantial information onconsumer attitudes toward POS debit systemsor POS check guarantee systems. In general,most consumers are unaware of these systems,except in areas where there have been trials.The introduction of the debit card in the UnitedStates was closely tied to consumer reactionto early POS experiments. Consumers foundthey did not care to carry basic necessities oncredit cards.

Home Information Systems

Home information systems are described atlength in chapter 4. There is little agreementon the potential for consumer acceptance ofthis service. One of the major constraints toits growth is the pricing of the systems. Thereis currently a great debate about what peoplewill pay for these services and about what theyperceive the value of these services to be.While these questions remain unanswered, itis difficult to say how rapidly the services willgrow and when and if they will become a massmedium and therefore open to every level ofconsumer.

Once more, the perceived market for theservice is the upscale consumer. To the con-sumer who earns less than $40,000 per yearand writes few checks, the system may not becost effective. For the time being, pricing ofboth equipment and the services may precludethe participation of the lower income consumerin this case.

Pricing Structures

Past financial services were often perceivedby the consumer to be free or, relative to otherexpenses, inexpensive. There was either no

——— -.— ——— - —— —

charge or a minimal “service charge. Finan-cial institutions earned their profit through thedifference in explicit and implicit rates chargedon assets and paid on liabilities. Through com-petitive and economic pressures this spreadnarrowed, and the income to banks thereforedecreased.

Fee income makes up an increasingly largeportion of overall bank income. All evidenceindicates that this trend will continue, the pric-ing structure in the future will be cost-based,and service will be explicitly priced.

In addition, pressures from outside the in-dustry are increasing the price of service tothe consumer. For instance, as it becomesmore important for the individual to be in-formed fully in order to make profitable deci-sions, the cost of information also becomes afactor. A number of such exogenous forces af-fect the total cost of service to the consumer.

Opportunity Costs

Based on evidence that financial decision-making is becoming more complex for the con-sumer, opportunity costs are paid because ofthe greater amount of time the consumer willhave to spend in order to make the correct in-vestment. When interest rates are high, theopportunity costs, in the form of foregone in-come from higher rate investments, are great-er. Some of this cost will be lessened by de-regulation of interest rates paid on deposits.

Information Costs

In order to make profitable decisions, theconsumer needs access to more informationthan previously and will most likely have topay for this information. In its current form,information is not always accessible to the con-sumer. Again, it is questionable whether theconsumer will willingly pay for information.For the wealthier, upscale consumer, for whomthe return is obvious and greatest, there maybe a willingness to pay for information. In gen-eral, one of the questions facing providers ofelectronic information is how valuable does theconsumer perceive the information to be andtherefore how much will he pay?

Ch. 7—The Consumer of Financial Services ● 179—. — .

Communication Costs

It seems inevitable that local communica-tions costs will rise; however, at what rate isstill uncertain. The eventual price to the con-sumer will depend on the structure of Federalregulation of local rates and, barring Federalregulation, the decisions State governmentsmake about regulation of the communicationindustry. If home information systems becomethe major way for consumers to obtain infor-mation and transact business, the communi-cation costs of these transactions could alsorise.

Competition and Costs

In an economic sense, competition is consid-ered good for the consumer in the aggregate:it results in greater options at lower price. In-creased competition in the financial serviceindustry has provided the consumer with in-creased options. Although products and serv-ices are now explicitly priced, they may wellbe cheaper to the consumer because he will re-ceive higher return on assets. However, ifother investment motivations of the consumerare considered—e.g., security of assets—therelationship of competition to the relative posi-tion of the consumer is less clear.

To really judge the effect of competition onthe consumer, the distinctions between thevarious market segments must be maintained.The consumer with a high discretionary in-come may benefit from increased choice andfrom instruments with a higher rate of return.To those who consider financial institutionsessentially service organizations and the safe-keeper of funds, the high fees for very limitedservice may place them in a situation wherethey are worse off than previously. They mayhave fewer choices in a competitive environ-ment than in a regulated environment.

In his study Banking and Electronic FundTransfers: A Study of the Implications,J. R. S. Revell states that price is the singlemost important factor affecting the long-termgrowth of acceptance of EFT services. If thetrend in financial service fees continues towardcost-based, or explicit, pricing, there will even-


tually be an economic incentive for individuals ingly and are encouraging migration to newer,to use EFT. Some financial institutions have technology-based services and delivery mech-already begun to price their services accord- anisms through pricing strategies.

Public Policy and the Financial Service Consumer

An important policy objective of the legis-lation of the 1930’s was to provide for thesafety of consumer deposits. This was accom-plished through regulations designed to ensurethe overall safety and soundness of the sys-tem and Federal deposit insurance programs.

Deregulation has made it possible for a num-ber of new institutions to enter the battle forconsumer funds. A diversity of institutionsnow offers similar products to the consumer;one of the major differences between them,however, is the extent of their regulatory con-trol. Depositories are, for the most part, in-sured and therefore provide a certain level ofprotection to the consumer. Adherence to cer-tain safety and soundness regulations requiredof depositories is not required of other finan-cial institutions. However, these noninsuredinstitutions offer services similar to those of-fered by insured institutions and have, in fact,drawn accounts away from the insured insti-tutions. Only the effect on the consumer, notthe equity, of this situation for the various in-stitutions, will be discussed here. Importanteffects are those which are perceived by theconsumer and therefore are reflected as changesin investment behavior and those which areimperceptible to the consumer but may havelong-term impacts on his relationship with thefinancial service industry.

In a recent survey of investor protection provialed by various financial intermediaries, theU.S. General Accounting Office found a num-ber of gaps and overlaps in the protections of-fered depositors and investors. This informa-tion is summarized in table 12, which illustratesthe variance in investor protections providedto both individual and group investors underdifferent financial arrangements.

Under current Federal and State regulatorystructure, the consumer’s deposits at a partic-ular depository institution will be covered upto $100,000. In 1970 the Securities InvestorProtection Corp. (SIPC) was established by anact of Congress, to protect the investor fromnonmarket losses involving funds and securi-ties held by broker/dealers. These losses willoccur usually only if the institution goes intoinsolvency.

Investment companies currently offer noform of direct protection for the consumer’sassets. This is of increasing importance sincerecently more consumers are investing in theinstruments of investment companies-i. e.,the mutual fund and the money market mu-tual fund. The consumer is covered neither formarket losses nor for losses that are the re-sult of mismanagement. It appears that manyconsumers consider the money market mutualfund a higher interest-bearing type of deposit,and are not aware that their accounts can besubject to movements in the marketplace. Al-though these firms are not federally insured,their investment policies provide either com-plete assurance (when they invest in Treasurybills and insured certificates of deposit) orknown risk.

Regulations Relating toConsumer Finance

Product-line extension has allowed newplayers into the financial service marketplace.Many different types of financial institutionsnow offer the same services. In many cases thedifference between choices among instrumentsis imperceptible to the consumer in that it isrelated to the regulatory structure of the in-

Table 12.—Summary of Variances in Regulation and Investor Protection

Entit les Invo lved Investor

In establishing protection

rules and primarilyregulations provided by

Federal and State Onsite

Types of servicesInsurance RegulatorInsuranceType of Institution coverage

Depository Institutions

. Banks $100,000 per● Savings and loan account● Credit unions

provided

Deposit accountscheckingaccounts,commercial andpersonal loans

AdvertisingWho Insures

Federal insuranceprograms andState-sponsoredInsuranceprograms

backed by responsible for Rate of return

Subject toregulatoryrequirements

Federal Insurance Banks FRSprograms-full faith FDIC OCCand credit of U S StateGovernment authorities

Variabledepositoryinstitutionregulators

examinationand accountInsurance

InformationdisclosurerequirementsSRO onsiteexaminationsand marketsurveillance

Informationdisclosurerequirementsand onsiteexaminations

Informationdisclosure,SRO onsiteexaminationsand marketsurveillance

Onsiteexaminations

State sponsored Credit unionsinsurance NCUA Stateprograms–no authoritiesonet’

U S Department SECof Treasury:

Securities brokers $500,000 SlPCr

($100. 000 cash)per account

Securities Subject to strict –trading legal and

regulatoryrequirements

SEC andsecuritiesIndustry self-regulatoryorganizations

Investment Nonecompanies

Not Insured N/A SEC Subject to strictlegal andregulatoryrequirements

SEC Investmentservices

Variable

Commodities Nonebrokers

Not Insured N/A CFTC CFTC andcommodityfutures Industryself-regulatoryorganizations

Commoditiestrading

Subject toregulatoryrequirements

—

PersonalInvestmentcorporate trustpensions

Variable Not strictlyregulated

Commercial bank Only funds ortrust departments deposit In

Not directlyInsured

N/A OCC. FDIC. FRS Federal andState bankingauthoritiesInsured accounts


dustry. As a result, the consumer also mayperceive his relationship with banks and non-bank institutions to be the same.

In choosing between similar instruments, itis difficult to assess the extent to which it isnecessary for the consumer to be aware ofthese regulations. Certainly it is necessarythat he know his rights and liabilities with re-spect to the use of certain instruments.Toward this end, Congress requires that cer-tain disclosures be issued to the consumer.However, often the consumer does not readnor fully understand his rights and respon-sibilities. This is even more important as serv-ices become more complex.

When legislation was first enacted to ensurethe safety and soundness of the system andto protect consumer deposits, the economicactivity of the consumer was quite differentthan it is now. Legislation of the last two dec-ades recognizes some of the changes in con-sumer behavior and his role in the economy,particularly with respect to credit.

Increased consumerism has been an impor-tant factor in the formulation of policy in thisarea. Consumer protection legislation enactedin this era includes the Consumer Credit Pro-tection Act of 1968 and subsequent amend-ments, the Fair Credit Reporting Act, theTruth in Lending Act, the Equal Credit Op-portunity Act, the Fair Credit Reporting Act,and the Electronic Funds Transfer Act, amongothers. Each represents additional protectionof the consumer of financial services fromdiscrimination and unfair practices. Consumerprotection legislation plays an important rolein the relationship between the consumer andprovider of financial services, as does the reg-ulation derived from this legislation.

Consumer Credit Protection Act

The following congressional acts are con-sumer-oriented, and most are amendments tothe Consumer Credit Protection Act of 1968.That act was one of the first major pieces ofconsumer credit legislation passed. FederalReserve Board Regulations Z and M imple-

—-—

ment Title I of the act, the purpose of whichis to help consumers become fully informedabout credit and leasing arrangements and toprevent advertising that may be misleading.Title I applies to any institution that regularlyoffers credit and leasing plans to people in-volved in transactions for personal, family, orhousehold purposes. This includes consumerfinance institutions, banks, credit card com-panies, and retailers who extend credit.

Regulations Z and M

Covered under Regulations Z and M arethree separate acts:

●

●

●

Truth in Lending (Regulation Z)–This actcovers closed-end and open-end consumercredit transactions. The primary purposeis to disclose the costs and terms of creditarrangements prior to their consumma-tion so that consumers can compare vari-ous plans and fees on an informed basis.Fair Credit Billing (Regulation Z)–Thisact affects the manner in which custom-ers are billed on their open-end credit ac-counts, and how finance charges are cal-culated, and the way that disputes aboutthe billing can be resolved.Consumer Leasing (Regulation M)–Thisact extends Truth in ‘Lending to coverleasing arrangements.

Other amendments to the Consumer CreditProtection Act:

Equal Credit Opportunity Act–Owinglargely to the activities of consumergroups, Congress acknowledged credit asa necessity for the consumer in the EqualCredit Opportunity Act of 1974 (ECOA).ECOA prohibits discrimination in credittransactions on the basis of sex or maritalstatus and, as later amended, prohibitsdiscrimination on seven additional bases,including race, age, and national origin.In this act, Congress also recognized theimportance of credit to the consumer.Fair Credit Reporting Act–Title VI ofthe Consumer Credit Protection Act, ef-fective in 1971. The purpose of this act

Ch. 7—The Consumer of Financial Services • 183

is to make certain that credit reports onconsumers are fair, current, and accurate.It gives the consumer certain rights to ex-amine credit information about himselfand to correct any errors that might bepresent. In addition, the act imposesother responsibilities on the credit report-ing agencies —i.e., they must make certainthat all users of their information are ob-taining reports for legitimate purposes.

● Fair Debt Collection and Practices Act —This is Title VIII of the Consumer CreditProtection Act, which became effective in1978 and limits the amount of communi-cation with a delinquent consumer andprohibits undue harassment and speciousactivities in connection with consumerdebt collection.

Electronic Funds Transfer Act

The Electronic Funds Transfer Act (EFTA)amended Title IX of the Consumer Credit Pro-tection Act by establishing rights and respon-sibilities for EFTs. These rights and respon-sibilities are outlined by Regulation E of theFederal Reserve.

Technology has changed the way the con-sumer participates in the payments systemand therefore some of the protections underprevious legislation. EFTA was passed byCongress in anticipation of some of the im-pacts of EFT on the consumer. Although thelaw provides protection to the consumer, thereare some instruments where the level of pro-tection is unclear. In addition, many consum-ers perceive technology-based instruments tobe the same as their paper-based counterparts,not realizing that rights and liabilities may dif-fer, depending on the use of technology.

It is now possible for an individual whopossesses what appears to be a traditional

bank credit card to be protected from misuseof the card under a variety of legislation, ornot at all, depending on the type of trans-action. For example, if a bank issues an in-dividual a debit card that is associated withan account with a line of credit and is also com-patible with an ATM, the individual can per-form a number of different types of trans-actions with the same card. If fraudulent useis made of the card by accessing the line ofcredit, he has recourse under consumer creditlegislation; if the fraud involves EFT, as in thecase of an ATM cash withdrawal or electronicPOS terminals, his liability is limited underEFTA (although not to the extent as under theConsumer Credit Protection Act).

If, however, the fraudulent use of the carddirectly debits the person’s bank account ina paper-based transaction, it is not clearwhether the consumer has recourse under cur-rent legislation. This is an example where thesame card represents three different instru-ments, which, in the case of fraud, would re-quire different actions by the consumer. Inrecognition of this, the Federal Reserve Boardhas proposed to update Regulation E to in-clude certain debit card transactions.

In terms of financial management, manyconsumers are likely to be aware of the dif-ference between accessing a line of credit anddirectly debiting their bank accounts with thecard, but it is doubtful whether they would rec-ognize a distinction between a debit processedelectronically and one processed in the papersystem. It is also reasonable to assume thatthe consumer perceives no difference betweenall of the transactions in a regulatory sense.Regardless of consumer perception, debit cardtransactions in the paper-based system cur-rently offer little protection to the consumer.

35 -505 0 - 84 - 13 , QL 3


Transition From Paper-Based toTechnology-Based Systems

It is conventional to regard householdsrather as passive participants in the movetowards EFT, slowing down progress by theirreluctance to accept change. To a great extentthis is a true picture, the proportion of sophis-ticated households pressing for faster prog-ress being very small, but it is not the wholestory. The very passivity of households meansthat changes will be accepted if they providethe essential requirements of individual per-sons, and in most industrial countries signifi-cant proportions of the population are alreadyaccustomed to handling plastic cards; they arenot likely to worry greatly whether the plasticcard triggers off a paper-based or an electronicpayment, and it is clear that the publicity ap-proach adopted by banks is an important ele-ment in acceptance by households. 20

Technology does not in itself meet any con-sumer needs, and since most consumers arereluctant to accept new services when the oldstill meet their needs, technology does not in-sure the acceptance of new services by the con-sumer. However, the use of computers, bothat home and in education, may encourage con-sumer use of technology-based services by fa-miliarizing the consumer with technology andby creating a new class of consumer for whomthe technology is a given.

One aspect of financial systems that mayimpede the growth of technology-based serv-ices is the float. In recent years the float hasbecome increasingly shorter. Technology-basedpayment systems could eventually make thefloat nonexistent; all transactions could besettled immediately. Currently, the consumerhas the advantage of float in the checking sys-tem. Use of the paper-based debit card hasmanaged to undercut the “free ride’ associ-ated with credit cards and may eventuallywipe out all float in the checking system.

‘(’J. R. S. Revell, Banking and Electronic Funds Transfer(Paris: Organization for Economic Cooperation and Develop-ment, 1983), p. 101.

Nearly all technology-based services are stilldiscretionary -i.e., the consumer can make adecision whether or not to use them since thereare paper-based alternatives to meet his basicfinancial needs. At some point in the future,however, this may no longer be true.

Security of Consumer Assets in aTechnology-Based System

Since technology-based systems providenew points of entry into the system, there ispotential for new kinds of fraud. The questionof computer security and crime touches everyaspect of the financial service industry. Dis-cussion here, however, will be limited to thoseways in which the technology is applied to con-sumer services and to the security issues thatarise directly as a result of those applications.

Recent concern about consumer financialservices has revolved around the relative secu-rity of access devices and the need to identifypositively the EFT user. As the systems be-come more complex and as a greater percent-age of the population begins to use home bank-ing and POS systems, problems with thecurrent means of identification will becomemore obvious.

With the ATM, the consumer’s loss is lim-ited by the amount of cash he is allowed towithdraw from the system. Although his liabil-ity is limited under EFTA for unauthorizedtransactions, when more sophisticated finan-cial transactions are involved, the consumer’sfinancial loss could be greater if not noted andreported within the period of time required bylaw. This could have an impact on the will-ingness of the consumer to use these systemsand therefore on the rate of acceptance ofthem. In that event, the market could forcethe providers of services to secure the systemsbetter.

The current means of identifying an author-ized user at an ATM is a personal identifica-

Ch. 7—The Consumer of Financial Services ● 185— —— .- — —

tion number (PIN). The use of a PIN has anumber of flaws. For example, if the numberis long, it could be easily forgotten; if it is shortor a variation on a number with which the con-sumer is familiar, such as an address or tele-phone number, the “code” could easily be bro-ken. With a proliferation of electronic debitcards, there has been an equal proliferation inPINs, making them all the more difficult toremember. Although consolidation of servicesin a single card would help alleviate this prob-lem, there is little evidence that this will hap-pen in the near future. PINs are also insecurein that they do not positively identify the card-holder as an authorized user; they can betransferred to other individuals. Some con-sumers will keep the PIN together with thecard, a combination as negotiable as cash.

Technologists are currently working on solu-tions to the identification problem. Examplesof alternatives to the PIN are “warm-body”identifiers; included in this classification arethumbprints, voice prints, and signature dy-namics. Thumbprint recognition is less likelyto be acceptable to the public, since it wouldrequire that every individual who uses EFThas his thumbprint on record. Although thereare certain problems with development, mostindustry analysts see signature recognition,or the more complex technology of signaturedynamics, as the most acceptable alternativeto both the industry and the consumer, sinceit is the predominant means of identificationused in financial services today. It will be sometime, however, before the technology will beapplied to financial services.

The use of ATMs presents personal securityproblems, beyond those purely associated withfinancial security. Individuals using the ma-chines may be particularly vulnerable to rob-bery. During normal business hours a tradi-tional “brick and mortar” structure providesthe individual security during and after atransaction. An ATM located away from thisstructure could place the user in a vulnerableposition. Even those ATMs located at bankbranches can be insecure when used outsideof banking hours. It is difficult to assess theseriousness of the problem, because most insti-

tutions are unwilling to divulge informationon security for fear of discouraging use of thesystems.

In addition, it would appear that the con-sumer is more vulnerable in technology-basedsystems. For example, in a bank robbery, thebank absorbs the loss; in the case of electronicrobbery, specific accounts are debited. Thereis no electronic “till.” The responsibility shiftsto the consumer to note and report the crime.

Some perceive technology as a solution toproblems that can plague the consumer of fi-nancial services. Credit card fraud, which isfrequently cited as a growing problem in theindustry, can be made more difficult by theuse of sophisticated technologies. In manyways fraud is a provider problem; the consum-er is protected under legislation from illicit useof his credit cards, and if sufficiently informedhe can prevent all but a minimal financial lossfrom the fraudulent use of his card. BothVISA and MasterCard have introduced or areplanning the introduction of cards that are ex-pensive and difficult to counterfeit. It is diffi-cult to say whether these cards will in the longrun reduce fraud, since it will be some timebefore the effect of their introduction and usewill be felt; the cost to produce the cards ismuch greater. However, if these cards reducefraud, for which the consumer implicitly pays,it may ultimately lower the financial burdenfor the consumer.

Privacy

Any discussion of the issue of privacy andthe consumer begins with the difficulty ofdefining privacy and therefore what it meansfor the consumer to be vulnerable in this area.In its basic definition, privacy is the freedomfrom unauthorized intrusion, the authority inthis case coming from the individual. How-ever, in the course of everyday life the con-sumer has given up some of these rights, orhas “authorized” certain intrusions into hislife. The distinction between what is explicitlyauthorized and what is not is unclear. Privacyis considered one of the primary concerns ofthe individual when choosing financial services.


Much controversy surrounds the issue ofEFT and privacy; that is, whether the systemsthat constitute EFT make the individual morevulnerable to violations of privacy. In the finalreport of the National Commission on Elec-tronic Fund Transfers, privacy was defined as“ . . . the individual’s expectation of controlover what information about himself is com-municated to or used by others. ” Further, “theobject of the consumer’s concern regardingprivacy under EFT is the potential use of hisfinancial transaction information to developa personal profile. ” 21This use could be asseemingly harmless as an individual receivingproduct solicitations, based on his income andprofession, from the financial institution wherehe does business, to the capability of the sys-tem to provide sensitive information about theindividual’s behavior patterns.

As mentioned earlier, cash is a privatemethod of payment. Checks, although less pri-vate, are a paper-based mechanism, and areperhaps easily tracked on a case-by-case basis.Although electronic payments secure the con-sumer from some types of prying, they mayin fact make him more vulnerable on a largescale. EFT transactions are recorded andstored automatically and provide the poten-tial for invasion of privacy.

Some studies show that privacy currentlyranks low as a concern for the individual-ithas been dismissed by certain experts as a sub-ject only of academic concern. A 1982 BMAstudy shows that users of home computersstrongly disagree with the statement thatcomputers would violate privacy. Even non-users did not list privacy as a major concern;they were either “not sure, ” or were in dis-agreement. Fewer than 20 percent of totalnonusers agreed with the statement.

Even when the issue is more clearly definedthere is only slightly more resistance to elec-tronic systems because of privacy issues. Forexample, in the same BMA survey, 20 percentof users and 25 percent of nonusers said that

21National Commission on Electronic Fund Transfers, EFTin the United States: Policy Recommendations and the PublicInterest, Oct. 28, 1977, Washington, D. C., p. 19.

the possibility that someone else would haveaccess to their account information could cre-ate problems in a telephone bill paying system.This represents a higher percentage of users,but about the same percentage of nonuserswho agree that privacy was an issue for con-cern in the use of home computers. The sameis true for data on automatic deposit services.The lowest response to the question was inreference to the ATM; there is some evidencethat transactions performed by ATMs are con-sidered more private than transactions usinga human teller. It appears that consumers forthe most part do not perceive privacy as a ma-jor issue for concern in their choice of EFT sys-tems; other, more market-oriented questionsseem to determine consumers’ use of thesesystems.

The newer technology-based services, in par-ticular home banking, provide new opportu-nities for invasion of privacy. As yet there areno uniform privacy standards for informationgathering. The Videotex Industry Association(VIA), the trade association for the U.S. video-tex industry, has recommended voluntaryguidelines for maintaining the privacy ofvideotex subscribers. These guidelines suggestways in which providers of videotex servicescan protect the data that they accumulate andtherefore inspire consumer confidence. Ad-ditional recommendations cover collection ofinformation, government access, security, sub-scriber access, correction of errors, applica-tions to third parties, future revisions, andretention of information.22

These guidelines are not binding to the in-dustry, and certain VIA members plan toadopt their own company privacy code basedon VIA guidelines. Several financial serviceinstitutions, in particular bank card providers,have corporate guidelines to protect the pri-vacy of their account holders.

Consumer Rights to Financial Services

Technology may increase access to the sys-tem for a number of people and expand choice‘Zzvideotex Industry ASSmiatiOn, “Model Privacy Guidelinesfor Videotex Systems, ” June 1983.

Ch. 7— The Consumer of Financial Services ● 187. — —

for still others; however, because of price theremay be a tendency in technological systemsfor certain groups to be either excluded or per-haps more heavily taxed than others. For ex-ample, although bank cards will be a primaryvehicle for introducing some of the new sys-tems to the consumer, there are many consum-ers who are ineligible to use them. As a result,nonusers may in effect be blocked from cer-tain types of financial services.

Technology makes it possible to serve lowerbalance consumers through ATMs, and there-fore lowers the cost of servicing these ac-counts. Certain needs of these consumers maynot be met by the technology; however, morepersonalized services may be unavailable tothem. This tendency plus fee-for-service pric-ing may transfer the costs to the consumer ina way that is inequitable. Even if the cost ofhome information services technology dropsand communications costs rise, certain lowermiddle-income segments of the populationmay still be barred from participating in thesystem. That segment of the population thatcannot maintain a minimum balance in a tradi-tional account may be served by other nonreg-ulated institutions (e.g., retailers, and perhapslocal grocery or liquor stores) or they may be

forced from the system completely. Thisbrings into question the safety and soundnessof these nonbank depositories and whetherthey should be regulated.

The trend of a universal electronic paymentssystem may put pressure on the financial serv-ice system to accept people who otherwisewould not have accounts at financial serviceinstitutions. It may necessitate Federal guar-antees to banks that service low-income or low-balance consumers. This is particularly impor-tant when one considers the policy of the U.S.Treasury to encourage direct deposit, and thepossible requirement that some consumersmust participate in the system via govern-ment transfer payments processed electron-ically.

In the 1970’s in the ECOA, Congress rec-ognized that in order to be a productive mem-ber of American society, the consumer musthave fair access to credit. Although consumeruse of technology-based systems is still mini-mal, there is some evidence that access to tech-nological systems or the financial system ingeneral will eventually be a necessity. In thefuture, Congress may have to consider to whatextent this access may also be a right.

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


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

—

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


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


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

—


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.

35-505 0 - 84 - 14 : QL 3

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].


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


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


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


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


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


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.


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.

Chapter 9

Policy Issues

Chapter 9

Policy Issues

The financial service industry is enjoying aperiod of rapid innovation in supporting tech-nologies. The effort to use those innovationsto best advantage is contributing to rapidchanges in the structure of the industry andin the services it offers. On the one hand, tech-nology motivates change; on the other, facili-tates it.

Through the applications of technology, thefinancial service industry provides the publica choice of modern and efficient services morediverse than was available in the past. Fromanother perspective, the introduction of ex-plicit pricing for services, the increased com-plexity of the menus offered and other effectsfollowing from the introduction of technologyare not amenable to all users.

Changes in basic social institutions almostinvariably raise questions for public policy.The basic tenets that comprise the founda-tions of existing policy may no longer hold; or,if they do, the existing means of realizingestablished goals and objectives may no longerbe workable. Relationships between and amongindividuals and institutions may be altered inways that make some relatively worse offwhile others become relatively better off. Theresults of such shifts can be political pressuresfor new or modified policy goals and mecha-nisms for achieving them.

Information technology has made it easy tobypass some legal and regulatory provisions.Some new services or altered service packagesare being delivered through systems that didnot exist when regulatory provisions werewritten, and some services are offered by in-stitutions not covered by the provisions.

It is likely, therefore, that some of these pro-visions now only burden the industry unnec-essarily, cause unplanned distortions in themarket, or place some financial institutions atan unreasonable disadvantage. The very scaleand rapidity of the changes and the fluidityand turbulence in the environment within

which financial institutions are now operatingcould cause excessive risk for these organiza-tions and their customers. It is also possiblethat some of the ends sought in existing lawsare no longer appropriate or useful.

Formulating policy issues and options withregard to these changes meets with one imme-diate and serious challenge. Changes are com-ing about so rapidly and in so many diversedirections that it is difficult for financial in-stitutions themselves or for outside observersto anticipate the patterns that will eventuallyprevail.

Nevertheless, it is possible to foresee someof the broad patterns likely to emerge and toanticipate in a general way their likely conse-quences. It is important to do so because pol-icy decisions made or avoided now may havefar-reaching consequences. For example, somepotential benefits of the new technology maynot be realized. Costs and benefits may be in-equitably distributed. Unnecessary burdensmay be imposed on industry or on consumers.Civil rights and liberties may be compromised.

Policy is promulgated through legislationand regulation; it can also be imposed throughless formal, political activities such as Presi-dential “jaw-boning.” Policy alters marketforces and the relative power of the factorsthat determine price and product mix. For ex-ample, limitations on interest rates led tobundling of financial services which, in turn,resulted in cross subsidies. Services could thenbe provided to some who could not have af-forded them had they been required to payprices based on a true allocation of costs. Now,technology, combined with other forces, is cre-ating an industry structure that explicitlycharges for services on the basis of fullyallocated costs. Some people may not be ableto afford them. If this is judged contrary tothe larger public good, it becomes the task ofthe policymaker to adjust those circumstancesthrough carefully designed policies.

223

224 • Effects of Information Technology on Financial Services Systems—.— —

Thus, even though significant uncertainties To identify the public policy issues relatedabout the future remain, it is essential that an to financial services it is necessary to lookassessment of the implications of advanced more closely at relationships between finan-technologies for the financial service industry cial services and broad national objectivesbe made. Many of the policy issues discussed that reflect various public interests in thosebelow are not new. Competition and consoli- services.dation, fair play, privacy, and security havealways been concerns in financial servicedelivery, even with older paper-based tech-nology.

Public Interests in Financial Services

Some of the major laws and regulations re-lated to financial institutions express explic-itly and implicitly national objectives relatedto financial services. There is a strong publicinterest in the maintenance of financial insti-tutions that will:

●

●

●

●

●

assure and facilitate transactions neces-sary for a strong and growing level of eco-nomic activity in the Nation and in all re-gions and communities;encourage savings and capital formation;protect the savings and investment of in-dividuals, families, businesses, and socialinstitutions;avoid excessive concentration of economicand financial resources; andsupport and strengthen the competitiveposition of the United States in worldtrade.

implicit in the concept of the public interestare also the basic national objectives of na-tional security, equal treatment under law, anda host of well-established civil rights and lib-erties. Therefore, financial service systemsshould:

●

●

●

not compromise national security, or theability of the Government to implementforeign policies;not adversely affect the exercise of civilrights and liberties; andnot discriminate against some people bydepriving them of necessary financial

services or placing an unfair burden onthem in using those services.

There are also specific Government concernsand interests in financial services. BecauseFederal, State, and local governments are ma-jor users of financial services, they have aspecial interest in efficiency, low cost, andsecurity in making and receiving payments.For example, the U.S. Department of theTreasury wants to move toward direct depositof all Federal payments to reduce the costs ofthis huge volume of transactions.

Finally, the degree to which the introductionof advanced systems for delivering and usingfinancial services may affect the ability ofgovernment to use monetary and fiscal policyas tools for ensuring economic stability andgrowth remains unknown. The increase intransactions and income velocity as a resultof this technology could make it more difficultto intervene in unsatisfactory general econom-ic conditions through instruments of monetarypolicy. Use of information technology, bychanging the velocity of money, changes theeffective stock of money in the economy at anyone time. Technologies can facilitate the de-livery of services that effectively monetizeassets that in the past were considered illiquid(e.g., the ability to draw on home equity as aline of credit). This could complicate attemptsto use monetary policy to reduce inflationarypressures or to stimulate stagnant conditions,although what the effect will be in practice is

.—

Ch. 9—Policy Issues ● 225— —

far from certain. At least, it will be more dif- more rapidly, which could be both beneficialficult to define or estimate the stock of money. and risky—under the worst possible scenario,The speed of transactions will cause the con- it could lead to economic fibrillation.sequences of policy interventions to be felt

Possible Changes in theFinancial Service

Information processing and telecommunica-tion technologies, as applied to financial serv-ices,

1.

2.

3.

4.

5.

6.

7.

have seven direct and significant effects:

They remove geographic and temporalconstraints on the delivery of financialservices and allow them to be deliveredfrom remote locations and to new andwidely dispersed locations, such as homesand offices.They allow transactions to be completedalmost instantaneously, increasing thevelocity of money in the system.They facilitate complex networks and in-terrelationships between institutions,markets, and geographical areas.They provide the flexibility for manyalternative combinations of services andservice features, allowing both “bundled”and narrowly targeted services.They improve productivity and, in general,lower the costs of providing services.They increase the capitalization of finan-cial services, providing opportunity fornew providers of intermediate and sharedfacility services to financial service insti-tutions.They create the possibility of electroniclegal tender and the opportunity to mon-etize a wide variety of assets.

Current and anticipated changes in thestructure of the industry and service deliverymechanisms, assuming no interference withpresent trends, include:

• Increased diversity in the nature of insti-tutions within the industry, in which

Structure of theIndustry

traditional categories of depository andnondepository institutions are no longersharply delineated and in which the linebetween financial and nonfinancial insti-tutions, as defined by products and serv-ices, is blurred.Development of large, diversified finan-cial institutions offering a wide range ofretail services and service locations sothat users may have many financial rela-tionships with the same institution.Some vertical as well as horizontal inte-gration as diversified firms acquire the in-ternal capabilities to perform functionsfor which they previously turned to thewholesale market.Development of many small, highly spe-cialized institutions that target narrowmarkets and specified groups of clients.Continuing mergers and a trend towardabsorption of middle-sized institutions,especially those having a strong local orregional orientation.Rapid product proliferation-i. e., pro-liferation of services that are functionallysimilar but differ in regulatory restric-tions and interest rates and in the distri-bution of responsibility or risk betweenproviders and users.Greatly increased functional integrationof the national financial service industrythrough technological networks and insti-tutional relationships.Great reduction in the significance of timeof day and location in delivery of finan-cial services.


In developing national policy about fi-nancial services, policymakers should takeinto consideration six critically important 4.questions:

1.

2.

3.

What national objectives should be sought 5.

in framing policies related to financialservices?Is there a need for a thorough restructur- 6.ing of the regulatory system as opposedto marginal corrections?How much competition is appropriate

Generic ConsiderationsFinancial Service

and desirable in this sector of theeconomy?What institutions or services is it essen-tial to preserve and for what purposes?What is the appropriate level of risk forproviders and users of financial servicesto assume, and how should that risk bedistributed?How can the financial service industrysupport a strong U.S. role in the worldeconomy?

In the sections that follow, salient policyquestions pertaining to the financial serviceindustry are presented, and some of the alter-natives for dealing with them identified. Thefirst group includes two broad general ques-tions, the second deals with issues related toindustry structure, and the third discussesrisk allocation issues.

General Policy Issues

Issue 1: What are the alternative approachesthat could be used if a review andrestructuring of laws and regulations relatedto financial services were undertaken?

Information processing and communicationtechnologies have already had a profound ef-fect on the handling of financial data. The ca-pabilities that these technologies offer—effi-ciency, speed, integration of activities over awide area, flexibility, and networking-arepowerful. Because these technologies changeboth the way data is handled and the wayfunds are transferred between competing uses,they affect the allocation of resources in adynamic economy. Moreover, the technologieswill continue to develop rapidly and probablyin unforeseen ways.

Some argue that, just as the effectivenessof many laws and regulations has already been

in FramingPolicy

significantly diminished by information tech-nology and associated structural changes inthe industry, any regulatory revisions madenow will also be subject to rapid obsolescence,as new technological capabilities are de-veloped.

But piecemeal revision is in fact well under-way. The question is whether it should con-tinue to be done in bits and pieces, laggingbehind and reacting to changes; or whether anew system of laws and regulations should bedesigned to guide and control future changes?

Two of the most recent pieces of legislationwere developed in reaction to changes that hadalready occurred in the market. The Deposi-tory Institutions Deregulation and MonetaryControl Act of 1980 was partly motivated bya finding of the courts that the deployment ofautomated teller machines (ATMs) by thriftinstitutions violated existing law. Offerings ofzero-balance checking accounts by commercialbanks and other newly developed services alsochallenged the existing legal regulatory struc-ture. If Congress had not acted, significant in-vestment in advanced equipment and servicesthat had proved attractive to consumerswould have had to be abandoned. The Garn-St Germain Act of 1982 was passed in partbecause the rise in short-term interest rateshad caused funds to shift out of depository in-

— - — —

stitutions to money market funds and hadthrown the cost of liabilities and the earningsof assets held by the thrift industry so far outof balance that the viability of these institu-tions was threatened.

The rate of change in the financial serviceindustry has not abated since the passage ofthis legislation. There is every expectationthat coming years will see changes occurringat an equal or faster rate than that of the re-cent past. Financial service providers willcontinue to rely heavily on technology to workaround policies they believe limit their abil-ity to operate effectively in a changing envi-ronment.

Policy Options for Issue 1Congress has two options:

1. Continually fine tune the legal/regula-tory structure to account for short-termchanges and trends in the forces thatshape the financial service industry.

2. Undertake a fundamental redesign of thepolicy structure governing the financialservice industry.

Option 1: Continue to modify existing legal/regu-l a to ry s t ruc ture to re f lec t shor t - te rm changes.

This course reduces the possibility thatthere will be an abrupt change in the opera-tions of the financial service industry. Con-gress would continue its ongoing oversight ofthe financial service industry and continuallyfine tune policy to meet the needs of evolvingconditions. However, congress may find itselftrying to mitigate the undesirable effects ofchange after the time has passed when preven-tive measures might have been taken. Also,the structure that may result from this ap-proach is likely to become so complex andcumbersome that it will hamper the efforts ofthe financial service industry to serve theneeds of the Nation.

Option 2. Undertake a fundamental redesign of thepolicy structure.

Congress may choose to step back from theproblem, the changes that have taken place inthe conditions that shaped existing policy, and

Ch. 9—Policy Issues ● 227

formulate new policies. Such a policy struc-ture, because it would be coherent in its treat-ment of the elements of the market and theindustry and clear in its concepts of nationalneeds and the public interest, is likely to bemore robust in the face of future change thanpolicies developed incrementally.

A comprehensive review and reformulationof the policy structure governing the financialservice industry will require time; and the rateof change in the industry will not abate whilenew policies are being formulated. Ongoingevents will require response and divert atten-tion from the long-term perspective. The taskis difficult but, realistically, doable.

Issue 2: What are the mechanisms available toCongress for implementing policy pertainingto the financial service industry?

Specifically, how should tradeoffs be madebetween the objectives of maximum economicefficiency, protection of local interests, andother social objectives?

Policy Options for Issue 2Congress has three broad options:

1.

2.

3.

Continue relative deregulation or market-determined solutions by continuing torelax constraints on the industry and bytaking little action to neutralize eventstaking place in the market.Deregulate, taking into account the fac-tors that have changed the effects of vari-ous provisions of the old structure on pro-viders and users of financial services.Instead of comprehensive regulation ofmost services, establish compensatoryprograms that work through the market-place to bring about conditions deemeddesirable. (Organizations such as the Fed-eral Home Loan Mortgage Corporationand the open market operations of theFederal Reserve serve as precedents forthis alternative.)

Option 1: Continue deregulation.

Congress may conclude that maximum eco-nomic efficiency, both in delivering servicesand in using those services to direct funds to


productive uses, is necessary to support a ris-ing level of economic activity. If Congress alsoconcludes that the best way to assure this effi-ciency is to free the financial service industryto respond sensitively to market forces, thenit may opt for further deregulation.

The industry, if allowed to follow the pathit is now on, will effectively become less regu-lated over the next decade. Much of the ma-jor legislation focusing on depository institu-tions and investment banking has alreadybeen neutralized by events or has been revisedto accommodate past changes. Major new en-trants in the financial service market operateoutside the purview of the existing regulatorystructure. Some States have taken actionsthat further reduce the effectiveness of ex-isting Federal legislation.

It is necessary to remember, however, thatderegulation at the Federal level will in alllikelihood result in greater diversity in Stateregulatory strategies. This lack of consistencycould itself introduce inefficiencies in the fi-nancial service sector. The patchwork of Stateregulation has already posed difficulties forthose that want to deploy regional and nation-wide ATM networks. Institutions now seek toestablish portable activities such as credit cardprocessing in States that permit them thegreatest freedom. This will affect the marketby introducing inefficiencies in allocation offinancial resources and service delivery mech-anisms and could result in a mix of financialservice products in some States that is quali-tatively different from that available in otherStates.

The number and diversity of options avail-able to users will increase and will be fully ade-quate to sustain and promote a healthy over-all level of economic activity in the Nation.However, the benefits of these services maycarry some risk of pulling financial resourcesaway from some local communities and ofcompromising some socioeconomic objectives.The general effect will be to shift financialresources toward their highest economic usewithout regard for social values. There is, forexample, some possibility that funds will drain

—

from regions or communities in economic dis-tress or with a less attractive balance betweenrisks and return than other regions. Large na-tional institutions may be less interested incommunity needs than small local banks.Banks are required, under the Community Re-investment Act, to give high priority tomeeting the needs of their communities, al-though there has been little pressure to do so.Other kinds of financial institutions do nothave this requirement. Unless ease of entry fornew competitors continues and the market op-portunities are sufficiently attractive to drawthem in, local needs may go unmet, and Con-gress will then be faced with the need of rec-tifying inequities.

Alternatively Congress could limit the per-centage of loan capacity that a financial insti-tution makes available for national and inter-national use. The highest economic use forresources is not always the same as the high-est social priority. An adequate supply ofhousing and opportunities for home ownershipare, for example, generally accepted as nation-al policy objectives. So, too, are protection ofsmall farms and small business opportunities.

Under strong competitive pressures, helpedalong by rate fluctuations and a tight moneysupply, money may tend to move away fromlong-term, fixed-interest loans, such as mort-gages. This could have significant detrimen-tal impacts on the supply and cost of housing,the construction and real estate industries,their suppliers, and government housing pro-grams unless alternative loan instruments aredeveloped. Money may also be funneled awayfrom loans for local entrepreneurs and smallbusinesses and from rural banks that supplyseasonal loans to farmers.

On the other hand, as financial resources aredrawn into high-growth areas, they will tendto moderate interest rates and have a stabiliz-ing effect. This would continue the functionof redistributing financial resources that hasbeen historically performed by the financialservice industry.

Thus, policies that encourage highly compet-itive national money and capital markets may

Ch. 9—Policy Issues ● 229———— —— —.——— . ———— — .—

produce significant economic benefits, eventhough there is a potential penalty in termsof limiting the funds available for social pro-grams that have been considered to havehigh social value but produce little tangibleproduct.

Option 2: New regulations.

If, on the other hand, Congress chooses todevelop a new regulatory structure for the fi-nancial service industry, it will be faced withthe formidable task of identifying a set of pol-icy variables that will be comparatively insen-sitive to changes brought about through theoperation of market forces coupled with theinfluence of technological change. Some havesuggested, for example, that regulation be byfunction, as is the case with the Fair CreditReporting Act, which places specific require-ments on all who offer credit to the public.Others believe that regulation by specific prod-uct would be appropriate. For example, anyprovider could offer a federally insured ac-count as long as specific criteria with respectto reserves and auditability were met. Stillothers would continue the regulatory focus oninstitutions, and others would focus on thesystems used for delivering services. Somecombination of these approaches could beviable. Each has its strengths and weaknesses.None would be simple to develop, and allwould be difficult to insulate from the kindsof changes now taking place and those ex-pected in the future.

Option 3: No comprehensive regulation; instead,active Federal role in marketplace.

Finally, Congress could establish a role asan active participant in the marketplace forthe Federal Government. It could, for exam-ple, provide payment services for areas aban-doned by firms in the private sector. It couldenter the financial markets, as it now does inthe case of mortgages and student loans, toassure the availability of funds for sociallyworthwhile products. As noted, market inter-vention of this type has a precedent and doesnot put the Government in the position of hav-ing to anticipate the specific effects of tech-nology and market forces on the availability

of capital and on the accessibility of servicesto the public. Such a policy would be robust.It could, however, add substantially to budgetdeficits.

At a minimum, some Federal presence be-yond an insurance program to ensure the safe-ty and soundness of the financial service in-dustry is likely to be required. But a debatesuch as the one about the Federal Reserve asa provider of financial services is likely to de-velop and intensify over time whenever Gov-ernment actions encroach in areas the privatesector feels it can serve adequately. Also theGovernment may not be able to adjust rapidlyenough to changes in market conditions to re-act in a way that does not introduce instabili-ties into the marketplace.

Structural Issues

Issue 3: What levels of concentration in thefinancial service industry are consistent withthe goal of preserving competition amongproviders of financial service?

One of the fundamental objectives in finan-cial service policy has been to prevent the ex-cessive concentration of economic and finan-cial resources in relatively few powerfulorganizations. This has, for example, been themotivation for prohibitions on interstate bank-ing and intrastate branching, for preservingthe unique role of banks by limiting their activ-ities, for insisting on sharp separation betweencategories of financial institutions, and forcontrolling interest rates according to the typeof accounts covered. These provisions were inpart to protect smaller or specialized institu-tions, especially local institutions, against un-fair competition from very large institutionsand in part to maintain a diversity of nicheswithin which competition could flourish.

These regulatory strategies have been over-taken by the use of information technologythat destroys the advantage of proximity,allowing institutions to share data banks anddelivery mechanisms and by institutional rela-tionships that ignore both jurisdictionalboundaries and regulatory definitions of in-


stitutional categories. The new technologyalso has paradoxical effects on economies ofscale. To compete in a national money market,an institution must offer its services to a widermarket, deliver them without regard to the lo-cation of the user, and support these activi-ties with a large volume of transactions. Onthe other hand, through access to shared net-works and wholesale support services, evenvery small institutions can now enter and re-main viable in local markets.

Regulatory strategies have already beenmodified to respond to these economic andtechnological pressures, but on a piecemealbasis. As a result, traditional financial in-stitutions are fiercely competing with oneanother and with new organizations, includingnonfinancial institutions, that are enteringtheir markets. It is not clear how existing an-titrust tests apply to this sector in these cir-cumstances, since it becomes progressivelymore difficult to define markets. It is clear,however, that in spite of–or because of–thefierce competition now underway, the poten-tial exists for increased concentration of finan-cial resources and for the development throughrepeated mergers and acquisitions of largeorganizations with excessive size or power infinancial markets.

It is possible that the kind of competitive-ness that was desirable in the past, as meas-ured by the number and size of institutionsand the scope of their markets, is no longerappropriate in view of several changes:

●

●

●

●

●

●

●

●

the increased size of the population,the increased level of U.S. economic ac-tivity,the increased size of industrial markets,the increased scale of commercial organi-zations,the increased volume of internationaltrade,the increased diversity of services,the redefinition of the roles of financial in-stitutions, andthe decreased advantage of proximity forusers of financial services.

Congress will want to consider in the con-text of these changes whether intense and in-creasingly uncontrolled competition will workto the detriment of some important segmentsof the industry, will encourage financial insti-tutions to take excessive risks, or will resultin harmful consolidation of economic and fi-nancial power.

Policy Options for Issue 3

Option 1: Allow market forces to continue as a pri-mary determiner of the evolutionary path forthe financial service industry even though theymay create major consolidated, national serv-ices organizations.

As long as entry barriers remain low, smallfirms are likely to appear on the scene to meetlocal needs. If banks remain subject to specialrestrictions, they will be at a competitive dis-advantage relative to other kinds of financialinstitutions in operating in the national mar-ket. Continued reliance on existing antitrustlegislation to prevent excessive concentrationof financial power would face increasing diffi-culty in defining markets and market partici-pants for the purpose of antitrust enforcementactions.

Option 2: Define criteria under which mergerswould permitted and firms would be allowedto enter or leave a market.

Again, with this option, it would be difficultto define market boundaries for the purposeof evaluating adequacy of competition follow-ing a merger. Problems of defining minimalservices levels and alternatives for meetingthem would have to be resolved before deci-sions on permitting firms to exit a marketcould be made. Unless the law were structuredto prevent it, unregulated services providerswould continue to use new technologies to en-ter the market outside of the existing regula-tory structures. Such entrants would affectthe competitive balance in a market and wouldbe free to exit even though the result wouldbe a level of service that falls below accept-able minimums.

Ch. 9—Policy Issues • 231—— — — — . — . . — —

One or more organizations, public or private,could be assigned the role of provider of lastresort to fill voids in the availability of finan-cial services. However, regulators would thenbe faced with the problem of determining whenalternative suppliers have, in fact, abandoneda market, making it necessary to call on suchproviders.

Option 3: Highly regulate only a specific set of fi-nancial services.

The model of the telecommunication indus-try could be followed, in which a specific setof financial services such as deposit-takingwould be highly regulated. Competition inthese product areas would be tightly con-trolled and maintained so that the marketcould not be controlled by just a few firms. Allother financial services could be offered byalmost any type of institution in a virtuallyunregulated market. The regulated financialservice institutions could offer unregulatedproducts only through arms-length subsid-iaries so that there would be no cross-subsi-dization between regulated and unregulatedservices. This approach would have the advan-tage that those financial services where safetyand soundness is of greatest concern would betightly controlled, and competition would bepreserved. But the fact that technologicalmeans would almost always be found to by-pass any boundaries that might be drawn be-tween product areas suggests that this ap-proach will be difficult to implement.

The definition of basic financial services—those to be regulated-and the identificationof those offering them would be difficult. Serv-ice providers would, using innovative informa-tion technology, tend to design services thatclosely approximate but are not technicallyidentical to regulated services and to offerthem in the unregulated market. There wouldbe no guarantee of adequate competition inthe unregulated markets, and antitrust lawswould provide the only means through whichexcessive concentration of financial powercould be prevented.

Issue 4: What modifications, if any, couldbe instituted regarding restrictions oninterstate banking?

Restrictions on interstate banking were in-tended to prevent financial resources and con-trol over credit from becoming progressivelyconsolidated in a few powerful institutions.They were also meant to maintain a local orien-tation and interest and to preserve for con-sumers the convenience and access affordedby proximity to financial services. Lately,these restrictions have been in large partrendered ineffective. The sharing of ATM net-works allows some banking functions to becarried out from remote locations. Somebanks, with regulatory approval, have boughtbanks and savings and loan associations inseveral States. Nondepository institutions of-fer services nationwide that are perceived byusers as functionally equivalent to traditionalbank accounts. Regional and national net-works have made proximity to the service pro-vider no longer a necessary measure of con-venience for the user. However, restrictions oninterstate banking still place banks at somedisadvantage vis-`a-vis other financial institu-tions. For example, facilities to accept demanddeposits generally are not placed across Statelines, but corporate clients are provided thisservice indirectly by means of zero-balance ac-counts linked to consolidation accounts inanother State. Interstate banking restrictionshave probably protected some inefficient in-stitutions that would otherwise have beendriven out of the market.

Policy Options for Issue 4Option 1: Remove or modify restrictions on in-

terstate banking.

Congress could act systematically to removeall remaining restrictions on interstate bank-ing. To do this would require Federal legisla-tion repealing the interstate banking prohi-bitions in the McFadden Act and the BankHolding Company Act, thus withdrawing Fed-eral consent to State statutes Mocking in-

35-505 0 - 84 - 16 : QL 3

232 Effects of Information Technology on Financial Services Systems

terstate commerce. The overall effect wouldbe further dissociation of financial service in-stitutions from orientation toward a particularcommunity, market, or region, and further in-tegration of a national financial service mar-ket. Removing restrictions on interstate bank-ing would tend to strengthen a trend towardconsolidation, since some financial institutionswould probably not survive competition withlarge national firms. On the other hand, it ispossible that financial services might be ex-tended to some now underserved or isolatedcommunities from depository institutions inneighboring States.

Congress could, by amendment to the Mc-Fadden and Bank Holding Company Acts,modify restrictions on interstate banking toallow and encourage areawide banking in mul-tistate metropolitan areas, or regional bank-ing in multistate market areas (as is alreadydone in New England under an interstatecompact).

Option 2: Reinforce limitations on interstatebanking.

Alternatively, Congress could strengthenrestrictions on interstate banking by remov-ing all loopholes. The Federal Reserve has justmoved to plug one loophole by redefining com-mercial deposits to include NOW and SuperNOW accounts. Following the reasoning thatled Congress to pass legislation legitimatizingATMs deployed by savings and loan associa-tions after the courts had declared them il-legal, it does not appear feasible nor desirableto dismantle interstate ATM networks or toprohibit the cash management programs of-fered by brokers. It would be possible to ex-tend reserve requirements to all institutionsthat operate depositlike accounts, includingsecurities dealers. This might, however, implygiving all of these institutions access to thepayments system or to deposit insurance.

One possibility is to establish rigid criteriafor entry to and exit from the market, includ-ing criteria for permitting mergers. But, suchcriteria would be hard to define and enforcebecause institutional boundaries and productlines have already become so blurred. Criteria

would have to be defined in terms of marketshare or in terms of control over deposits ortotal assets. Given the heterogeneity andfluidity of the industry, this would also be hardto do.

Other possibilities are to continue to prohib-it holding companies from owning depositoryinstitutions in more than one State, as was thecase until the 1980’s, or to subject all deposi-tory institutions to a rigid prohibition on in-terstate banking, which would require preemp-tion of State laws and extension of relevantFederal laws to cover savings and loans andcredit unions.

Some way might be found to strengthen andbroaden the Community Reinvestment Act,possibly by requiring local development loansat a level pegged to the level of depositsgathered from an area. This would be a factorlimiting the flow of funds out of the areas gen-erating them.Issue 5: How might law and regulation be used

to focus the attention of various classes offinancial service providers on specificmarket areas?

Federal policy since the 1930’s has allocatedspecific functions to specific financial institu-tions. But recently, a combination of techno-logical innovations and market forces has sig-nificantly weakened the functional distinctionsbetween types of financial institutions. Thiscondition has developed gradually, with fewof the steps along the path involving positivedecisions by policymakers. It may be appro-priate now for Congress to reexamine the ques-tion of whether public interests still requirethe limiting of some roles and functions to aspecial category of financial institutions.

Banks and thrifts are unique institutions because they alone have access to the paymentsystem. Funds are transferred from one ac-count to another only within banks. All trans-actions not carried out by exchange of cur-rency (except for some internal clearing) areultimately culminated within the banking sys-tem, and all financial institutions must ulti-mately call on a bank for the final step in de-livering a service. Banks also allocate creditby making and guaranteeing commercial loans.

.

Ch. 9—Policy Issues . 233—

Because of this dependence, the safety andsoundness of banks-and public confidence inthem—are an essential underpinning of theeconomy. National policy therefore has alwaysbeen to treat banks differently from otherkinds of financial institutions and to prohibitthem from engaging in other kinds of commer-cial activity. Specifically, the goals of this pol-icy

●

●

●

●

have been to:

insure the soundness of banks (originallythe purpose of both reserve requirementsand depository insurance);limit the risks that banks could assume;prevent conflicts of interest, such aswould occur if banks directed investmentto or allocated credit to commercial activ-ities in which the bank had an equity in-terest, or if banks required borrowers topurchase insurance underwritten by thebank; andprevent concentration of financial re-sources by forbidding banks to partici-pate in certain kinds of investment activ-ities, such as underwriting stock issuesand casualty or life insurance.

Other financial institutions, and in somecases nonfinancial institutions, are now en-croaching on activities once limited to banks—i.e., offering accounts that consumers per-ceive as functional equivalents of depositoryaccounts but with the advantage of higher in-terest rates. Nondepository institutions arebuying banks, gaining access to the paymentmechanism through them, and acquiring theirassets and customers, They are then abrogat-ing one or more of the two functions thatdefine a bank (i.e., accepting commercial de-posits, making commercial loans) in order toescape Bank Holding Company Act prohibi-tions on nonfinancial activities.

Banks and bank holding companies, in re-taliation, are seeking to expand into otherservices, for example, offering insurance inStates where laws permit and increasing theirofferings of data processing services. Low-costor free deposits, the traditional source of fundsfor banks, are drying up as corporations prac-tice zero-balance banking and savers transfer

their money to higher interest accounts andmoney market funds. This forces banks to tryto expand their customer base by offering agreater diversity of services and to increasefees.

However, as banks and other depository in-stitutions expand their activities into otherlines of commerce, the level of risk they aresubject to may increase. Any increase in in-stitutional risk is accompanied by an increasein the levels of risk for both the stockholdersand clients of the institution to the extent theyare not covered by deposit insurance. Ulti-mately, the level of risk facing the financialservice industry as a whole would increase.

The general policy of deregulation suggeststhat financial institutions could compete onan equal basis if barriers between varioustypes were dissolved. For example, thrift in-stitutions were, for a time, severely threatenedwhen they were stuck with low-yield port-folios when interest rates rose; they may beso threatened again. Federal policy has beento try to save troubled thrift institutions byallowing, encouraging, or arranging mergers.This includes mergers across State lines andmergers of mutual savings banks with com-mercial banks. More recently, Federal savingsand loan associations have been allowed by theGarn-St Germain Act of 1982 to offer con-sumer loans of up to 20 percent of assets andto offer other consumer services so that theirportfolios will contain assets and liabilitieswith better matched maturities.

On the other hand, thrift institutions in thepast received some preferential treatment be-cause they are the major source of loans forhousing. An adequate supply of housing anda high rate of home ownership are widely ac-cepted as social policy objectives, and a declinein the housing market has severe impacts onother sectors of the economy.


Option 1: Modify powers to offer financial services.

Congress could repeal Federal laws and reg-ulations limiting the services that banks can


offer and the activities in which they can en-gage. The U.S. Treasury has proposed thatthrough holding company subsidiaries banksbe allowed to engage in virtually all financialservices. This is a movement toward deregula-tion, to “put all the players on a level playingfield. ” It would be likely to increase the pur-chase of banks by other financial and non-financial institutions and to stimulate thebuying up of small banks by bank holdingcompanies. It would increase the possibilityof banks exerting pressure on customers tobuy nonbank services or products.

Congress could instead tighten the loopholesin laws and reaffirm the special and limitedrole of banks. Institutions that accept govern-mentally insured deposits could be permittedto offer only limited other services. Institu-tions that provide other services (either finan-cial or nonfinancial) could be forbidden to ownor control institutions that accept insured de-posits.

A third possibility is to extend the barriersagainst banks diversifying their services bybringing all State banks (including those thatare not Federal Reserve System members)under the Glass/Steagall Act through Federalpreemption, so that States cannot use per-missive laws to attract banks into relocation.

Finally, Congress could make modificationsin laws and regulations to restrict (or allow)specific activities. It has been proposed for ex-ample that banks or bank holding companiesbe permitted to:

underwrite mortgage-backed securitiesand offer mortgages so as to lower mort-gage interest rates through increasingcompetition (as the Federal NationalMortgage Association already does);offer mutual funds, in order to bring downmanagement fees and sales commissions;andunderwrite municipal revenue bonds, tosupplement the effects of discount broker-age in increasing the market and lower-

ing costs for municipal and State gov-ernments.

Option 2: Modify powers to effect mergers.

Congress could continue to allow other in-stitutions to merge with or buy savings andloan (S&L) associations. If the acquiring firmsuse the savings and loan associations assources of cash, the general effect will be agradual reduction in money available for mort-gages. Any company can now buy an S&L.Only if the company owns more than oneS&L—and is therefore an S&L holding com-pany-must it restrict its activities to hous-ing finance, or even continue to offer housingfinance. Nonfinancial institutions have alreadyseized on the opportunity to buy S&Ls to gainaccess to some of the privileges and preroga-tives of depository institutions, for example,federally insured accounts.

Congress can continue to allow mergers be-tween thrift institutions, as the Federal HomeLoan Bank Board is now doing. The likely out-come will be a smaller number of larger thriftinstitutions, but this may not solve the prob-lem of attracting an adequate supply of funds.

Option 3: Provide incentives to support specificactivities.

Congress could further provide capital as-sistance for thrift institutions. A Federal sub-sidy for thrift institutions could be justifiedon the grounds of the high social priority ofhousing, but it would add to Federal expendi-tures, increase the Federal deficit, and set aprecedent when other financial institutionsrun into trouble. Congress could revise taxlaws to encourage S&Ls to diversify their serv-ices further and to broaden their revenue base.It is not clear whether without this incentivethe S&Ls will diversify enough to generate in-creased earnings.

Congress may want to provide incentives tostimulate other sources of mortgage moneyrather than attempting to turn back the clockon thrift institutions, which may not be opera-tionally possible.

Ch. 9—Policy Issues ● 235— —

Issue 6: How will further deregulation oftelecommunications affect the financialservice industry?

An important consideration for future finan-cial service policy will be the cost of telecom-munications. As a result of the breakup ofAT&T, Congress is now coming to grips witha broader issue of control of telecommunica-tion costs; specifically, with the issues of ac-cess charges. It is expected that following thebreakup, long-distance telephone rates will de-cline as a result of increased competition be-tween suppliers, while local communicationrates will tend to rise to compensate regionaltelephone companies for the loss of incomefrom the Bell system. Congress is debatingwhether to levy a monthly access charge forall telephone use, which would tend to decreasethe need for high overall local rates.

The distribution of function within the de-sign of a system to deliver financial servicesis directly related to communication costs. In-creased costs for local communications maydiscourage the use of third-party data proc-essors, and small financial institutions mayfind it more difficult to enter the market orsurvive in the market. Financial institutionswill attempt to move data processing towardthe end-user in order to minimize the time auser must remain connected with a service pro-vider’s computer, i.e., encourage home bank-ing. But consumers may reject this service en-tirely if either entry or maintenance costs aretoo high.

Comment on Issue 6. –The factors and rela-tionships that must be considered in develop-ing telecommunication policy are extremelycomplex and full consideration of them isbeyond the scope of this assessment. How-ever, Congress should be aware that telecom-munication costs have a strong and direct in-fluence on the economics of financial servicedelivery systems. Changes in telecommunica-tion policy can result in the need to modify thestructure of financial service delivery systemsconsiderably.

Issue 7: What steps could be taken to realignthe legal/regulatory structure to make itconform closely to the changing structure ofthe financial service industry?

Laws and regulations generally apply to spe-cific categories of service providers. The oper-ational differences between depository andnondepository institutions are progressivelyeroding, but these categories are still subjectto different regulatory bodies. They have, insome cases, different interest rate ceilings, andthey are subject to different restrictions on in-terstate operations and on intrastate branch-ing. A financial institution, in fact, can some-times select its regulatory climate by changingits organizational structure. S&L associationsenjoy special tax incentives if a majority oftheir activities are housing loans. Accounts indepository institutions are federally insured,while other kinds of accounts are not. Thebuyer of services has different benefits, dif-ferent risks, and different safeguards andrights, according to which service provider isselected. The consumer, however, is oftenunaware of the subtle and detailed differences.


The problem of how best to design, or revise,a regulatory structure for the financial serv-ice industry involves many subsidiary issues,such as Federal deregulation versus Federalpreemption, institutional versus functionalregulation, and self-regulation versus govern-ment regulation. The options considered beloware not necessarily mutually exclusive:

Option 1: Design regulations to apply to func-tionally defined services and achieve specificpolicy objectives, without regard to the institu-tional provider of the services.

This option would put all financial institu-tions competing for a particular market nicheon a more equal footing. It would mean, how-ever, that each of an institution’s services orfunctional activities would be considered sep-arately. Yet the total mix of services offered

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

would affect the behavior of the providing in-stitution, the level of risk that it assumes, andits relative power in the marketplace. If vari-ous regulations were administered by differentregulatory agencies, each financial institutionmight be subject to multiple regulatory agen-cies that may at times have overlapping orcontradictory requirements and restrictions.

Option 2: Federally preempt all State legislationand regulation of financial services.

This option would provide consistency andreduce uncertainty for the industry with thepossible result that financial service providerswould become more active in developing anddeploying services that the public would findattractive and useful. Yet the existing dualbanking system has served well in meetingvarying needs for financial services. Federalpreemption would eliminate this duality andcould reduce the degree of responsiveness offinancial service providers in meeting localneeds.

Option 3: Abolish all Federal regulations, allow-ing the States to control financial services fully.

This alternative would allow each State themaximum opportunity to achieve local objec-tives and to meet local needs for financial serv-ices. It would also encourage many practicalexperiments and much innovation as Statesadopt alternative regulatory strategies. ButStates would also be prevented by the Com-merce clause of the U.S. Constitution frombarring entry by out-of-State banks. Nation-wide financial service institutions would, however, suffer from the inconsistencies in restric-tions and requirements.

Option 4: Combine all Federal regulatory functionspertaining to financial services under one Fed-eral agency, mandated to develop an internallyconsistent system of regulations for all finan-cial services.

On the one hand, this alternative would in-troduce a degree of consistency into the regu-latory structure that is now lacking. Institu-tions would no longer be in a position wherethey seek charters from the agency that bestsuits their intended mode of operation. The in-

creasing homogeneity of the market for finan-cial services would be recognized in a unifiedregulatory structure.

Yet, the regulators serve the interests of specific constituencies that consist of both the in-stitutions they oversee and their customers.If this diversity of perspective were elimi-nated, specific needs could go unmet.

Issue 8: Concerns of foreign governmentsregarding the protection of individualprivacy could lead to the erection of barriersfor American financial service firms doingbusiness overseas. What steps could theUnited States take to address theseconcerns or circumvent the barriers?

Not only is the Nation continually movingtoward a more highly integrated national econ-omy, but it is increasingly knit into a globaleconomy in which markets, trade patterns, fis-cal and monetary policies, and currencies arelinked across national boundaries.

Worldwide delivery of financial services has,for well over a century, depended on telecom-munications and is now more than ever com-pletely dependent on advanced technologies.Rapid and free movement of funds and relateddata internationally is essential. Financial in-stitutions and other types of enterprises havebranched across national boundaries and de-pend heavily on being able to move data freely,and confidentially, between plants and officesin several countries. The ability to accessresources anywhere in the world from anyother location has become an important fac-tor in the operation of multinational corpora-tions and in international trade.

Financial service organizations operate cen-tralized systems that concentrate data proc-essing for worldwide networks at one or a veryfew centralized points. Some, such as thosethat provide credit authorizations at point ofsale, must be accessible from thousands of lo-cations and must have a high degree of reli-ability. They move customer transaction dataat high speed across all boundaries.


The ability to initiate a transaction from aremote location unfortunately also implies theability to initiate fraudulent transactions; tomonitor, interfere with, or extract data froma system from remote locations.

In a sudden hostile confrontation withanother country, such as occurred with theIranian hostage situation, the option of freez-ing the assets in the United States of theforeign power may be lost. Electronic execu-tion of an order to transfer the assets fromU.S. jurisdiction could be completed morequickly than a freeze order could be made ef-fective. Foreign-owned banks might also, insome situations, provide to their governmentsor industries privileged information about U.S.industry.

Some nations have passed laws limiting thecollection and dissemination of data associatedwith individual accounts across their borders,whether to safeguard the privacy of citizens,to protect trade positions, in the interest ofnational security, or for other reasons. Somenations are taking the position that they willnot allow some kinds of data to be sent to na-tions that do not have restrictions on accessand movement of data that are at least asstringent as their own.

Such restrictions could cause problems forU.S. firms because this country has not cho-sen to restrict the collection and disseminationof data in ways that would be seen to meetsuch requirements. To do so may place theUnited States in a position of establishing do-mestic policy in response to requirements aris-ing abroad, a situation that may become morecommon as the global economy becomes morehighly integrated and interactive.

A related concern is the possibility that in-ternational data-processing centers concen-trated in a few countries are vulnerable to ter-rorist or military attack. As the reliable andorderly flow of international informationbecomes more critical to the U.S. economy,policy makers and national security plannersmust be aware of these vulnerabilities.

Worldwide information services may tendto increase global debt exposure and undersome conditions could be destabilizing toworld currency, commodity, and security mar-kets. However, they could also be used tomonitor and control international debts andrepayments better and to overcome the desta-bilizing effects of a major debt default.

The national interest here is threefold: tostimulate and support the U.S. position inworld markets, to further U.S. internationaldiplomatic objectives, and to maintain na-tional security.


Option 1: Establish no stronger protections for in-dividual privacy’ than already’ exist.

The United States might test the proposi-tion that the desire to have full financial rela-tionships with institutions in the UnitedStates will be strong enough to overcome allother considerations. But the possibility ex-ists that foreign governments with strongprivacy protection laws may not be willing toallow the free flow of financial and paymentdata to and from the United States withoutspecific protections instituted at a level com-mensurate with those provided their own citi-zens within their own borders. Any foreignbans that are instituted may focus only onelectronic transmission of personal data to andfrom the United States, in which case the alter-native of using nonelectronic media would stillbe available but could result in significant de-lays in the movement of funds and data.

At this point there is no compelling forcemotivating change. It does not appear to bean imminent probability that one or more na-tions will significantly restrict the movementof financial data to and from the UnitedStates. But this situation could changerapidly, and if this option is chosen Congresswill want to continue monitoring develop-ments in this area.


Option 2: Institute policies defining more preciselythe conditions under which financial data canbe collected and disseminated across nationalboundaries.

Under this option, U.S. privacy protectionlaw would be harmonized with foreign laws toa greater extent, at least in the case of finan-cial services data. Such policy might becomenecessary, should foreign privacy laws cometo be applied to data transmitted and storedin computer systems on U.S. territory. Al-though Federal privacy law has not, in gen-eral, been applied to privately held data sys-tems nor is there presently significant overtdomestic pressure to extend it in that direc-tion, precedent does exist in the particular caseof banks for Federal laws concerning the han-dling of personal information.

Issue 9: What organizations could be grantedaccess to the mechanisms for clearingchecks, securities, and other paymentinstruments such as credit card drafts?

Only depository institutions now have directaccess to the payments mechanism-clearingaccounts with the Federal Reserve System,membership in local and regional clearing-houses, and membership in automated clear-ing house associations. Securities broker/deal-ers clear listed stocks and bonds through theorganized exchanges, and market makers clearissues traded over the counter. Clearing mech-anisms provide the means by which funds aretransferred between and among accounts heldby approximately 40,000 institutions in theUnited States. Without this means of convey-ing payment instructions between institutionsand settling accounts, there would be no pay-ment medium other than cash. Similar net-works exist between the airlines for clearingamong carriers that honor one another’s tick-ets and between petroleum companies for set-tling crude oil accounts.

The essential elements of a clearing mecha-nism are the existence of an account throughwhich net settlement can be accomplished anda means for transferring instructions that tellthe account holder the amount to be trans-ferred and the party to be credited. Banks

have traditionally been the only ones able toestablish settlement accounts and be party tothe network for accomplishing the required in-formation transfers.

In the present environment, nondepositoryfinancial institutions establish relationshipswith banks to obtain access to the paymentmechanism. Drafts on accounts held by thenondepository institutions are cleared throughthe existing payment system and paid froma common account, normally maintained atzero balance, at a clearing bank. Only whenthe drafts are presented to the nondepositoryinstitution with whom the individual customerdeals are the funds debited from the individ-ual’s account.

Banks and other organizations are not re-stricted in establishing arrangements for proc-essing drafts similar to those in existence be-tween operators of money market funds andbanks.

For example, if the employees were agree-able, an employer could make an arrangementwhereby employees are credited daily on thecompany’s books with wages earned and arepermitted to write drafts against those funds.The employer would then fund an accountwith a depository institution to cover draftsas they are presented and debit the accountsof individual employees for appropriateamounts. Regardless of the balance betweenbenefits and drawbacks, such an arrangementwould be operationally feasible.

The arrangements for clearing through a de-pository institution with access to the pay-ment mechanism can be seen as being some-what artificial. Given the technologies nowavailable for moving and processing paymentinformation, one could argue that othersbesides banks be given the option of estab-lishing clearing accounts with institutions thatoffer them. A routing-transit number wouldhave to be issued to any organization per-mitted such access to the clearing mechanism.

The question remains as to whether it is inthe public interest to allow such arrangements.On the one hand, the existing regulatory struc-ture provides assurances that parties to the

. —


clearing mechanism will be able to settle ac-counts as required. Opening the mechanismto unsupervised nondepository institutionsnot bound to existing requirements to meetsettlement schedules could weaken the systemand hence decrease the safety and soundnessof the financial system as a whole. Under ex-isting arrangements between banks and fundmanagers, the bank must settle with the pay-ment system, even if the fund fails to meet itsobligations. On the other hand, requirementscould be established to ensure safety andsoundness of the system that would have tobe met by nondepository organizations thatmay be granted direct access to the paymentmechanism.


Option 1: Retain restrictions on access to thepayments mechanism.

Congress could choose to retain the presentsystem whereby membership in clearing sys-tems is limited to organizations meeting spe-cific criteria. One could argue that the pres-ent mechanism works well and has been ableto accommodate the changes that have takenplace in the financial service industry. Thesafety and soundness of the industry havebeen well protected, and changes that createthe possibility of weakening either should notbe allowed.

On the other hand, there is a real possibil-ity that innovative people will develop clear-ing systems that will operate outside of es-tablished channels. Off-market trading is areality, and there is nothing to prevent theemergence of analogous systems for clearingpayments. Nondepositor institutions havealready gained access to the payment mecha-nism by acquiring banks and S&L associa-tions. Electronic systems (especially packetswitching) will lead to diverse channels fortransmission and perhaps settlement, as willthe requirement for explicit pricing of FederalReserve services. Thus, as in so many otherparts of the lega.1.regulatory structure govern-ing the financial service industry, the presentrules for access to the payments mechanism

may be circumvented by applications of avail-able technologies.

In the extreme, Congress could rule that allpayments pass through the established pay-ments mechanism. However, with the exist-ence of private clearing arrangements betweenfinancial institutions and the multiplicity ofsystems for clearing payments, it would be ex-tremely difficult to codify exactly what con-stitutes the established payments mechanismand the characteristics of clearing arrange-ments that would not be permitted under sucha policy.

Option 2: Open the payments mechanism to otherthan depository institutions.

At the other extreme, Congress could openthe payments mechanism to all who wouldjoin. As indicated, blanket access couldweaken the safety and soundness of the finan-cial service industry in that occasions wherethere would be failure to settle would becomemore likely.

As an interim step, the payments mecha-nism could be opened to nondepository orga-nizations that would be willing to meet criteriadesigned to ensure continued integrity of thesystem. Such requirements could include pro-visions for maintaining reserves and provi-sions that members be audited to determineif they meet criteria for membership or thatthey obtain performance bonds or insurancethat guarantees their ability to settle.

Yet, exclusivity of access to the paymentmechanism by depository institutions bal-ances some of the relative disadvantages ofsuch an arrangement under the present legal/regulatory structure that limits the range ofactivities in which depository institutions canengage. The major sources of revenue of de-pository institutions in the future will bepayments for services provided rather thanthe spread between the rates at which fundsare obtained and those at which they are lent.Opening the payment mechanism to otherscould substantially affect revenues of deposi-tory institutions and, ultimately, becausealternative sources of revenue are limited,

240 . Effects of /formation Technology on Financial Services Systems

their ability to remain viable competitors inthe marketplace.

Issue 10: What alternatives for regulatinginterest rates are available to Congress?

In recent years, when market rates have ex-ceeded Federal and State limits, significantquantities of funds have moved from banks,credit unions, and S&L associations to alter-native investment opportunities created bynew entrants to the financial service industry.These new entrants have relied heavily on ad-vanced telecommunication and informationprocessing technologies to implement theirofferings. Constrained interest rates effec-tively limited the supply of funds to some in-vestments.

Complete deregulation of interest rateswould allow service offerings to respond tomarket forces, the price of services to be helddown by competitive pressures, and interestrates to reflect national market conditions.However, to the extent that firms do notrecognize the costs their actions impose onothers, market forces may not reflect all socialpriorities. ’ It may be in the public interest,under some circumstances, to modify or con-strain the action of market forces on interestrates in order to preserve certain social ob-jectives.

Interest rates, other than for corporate de-mand deposits, will be essentially decontrolledby 1986 as Regulation Q is phased out. It ispossible that this situation could, under someconditions, result in the equivalent of pricewars. Financial institutions have been knownto raise interest rates to unsupportable levelsin attempts to attract deposits. Widespreadactions of this type could lead to an excessivenumber of financial institution failures, andas a result, could seriously destabilize the econ-omy. Selective control of demand deposits andsavings account interest rates is likely to cause

IControls on the rates paid on deposits by depository insti-tutions, controlled under the Regulation Q system of ceilings,are being phased out under provisions of the Depository Insti-tutions Deregulation and Monetary Control Act of 1980.

funds to be drained from depository institu-tions. Usury laws restrict the supply of creditwhen interest rates are rising.


Option 1: Federally regulate all interest rates forall financial services and all institutions; pre-empt State usury laws.

Assuming the Government would set a na-tional rate, this option would create uniformity of interest rates across the Nation. Fundswould not be moved from area to area insearch of higher returns while they become vir-tually unavailable to those in need of creditin areas where rates have been capped at belowmarket levels. Interest rate ceilings might belifted to improve customer access to credit andto attract savings and investments; interestrates might be capped to reduce inflation oreconomic instability. They might be manipu-lated to preserve, for example, a housing dif-ferential.

On the other hand, the ability to set rateslocally helps ensure their responsiveness ofcredit markets to local needs. This would belost if the Federal Government were to pre-empt all regulation of interest rates.

There is no reason that a national rate beset. Rates could be set regionally or set interms of ranges rather than at specific values.Such strategies could mitigate some of the dis-advantages of this alternative, but the diffi-culty of implementing them operationallyshould not be underestimated.

Option 2: Completely deregulate interest rates.

In economic theory, at least, this optionwould allow funds to flow to highest value usesin terms of the costs and benefits included inthe calculus. However, if indirect costs andbenefits are not recognized, the resultingallocation of resources could be suboptimal.It would increase the availability of credit, butcredit could be priced to levels that would ef-fectively deny it to some consumers or causethem to change their way of life as they divertfunds to cover its cost.

Ch. 9—Policy Issues ● 241—

Option 3: Federally cap interest rates only for ac-counts covered by deposit insurance.

This option would cause money to be with-drawn from depository institutions when mar-ket interest rates rise, leaving more consumersexposed to risk because their assets would bein uninsured accounts.

Yet, some may view the reduced return asa cost of security and be willing to incur it.Limiting the return paid customers would re-duce the pressure on institutions to make themore risky investments that provide higheryield, thus limiting the exposure of the insur-ance fund.

Option d: Allow States to regulate interest rateson all services delivered within the State, wheth-er or not they are delivered by State-charteredinstitutions.

Under this option, States may try using con-trolled interest rates to attract businesses.Such tactics could significantly disturb the na-tional money market. On the other hand, mar-ket forces complemented by the ease withwhich information can be rapidly distributedover wide areas would limit the options of theStates. Individually, they would be able toselectively cut some rates within a relativelynarrow range to support specific policies; butno one State would have the power to estab-lish rates at levels substantially different fromthe norm. Experience has shown, for example,that States have not been able to artificiallydepress interest rates on loans made withintheir jurisdiction when significantly higherrates were permitted elsewhere.

Risk Allocation Issues

Issue 11: What are the alternatives forapportioning risk between financialinstitutions and their customers and clients?

The purposes of deposit insurance are: 1) toprotect the funds of individuals, households,and small businesses against loss when finan-cial institutions fail; and 2) to prevent thewidespread economic instability that would re-sult from cascading institutional failures as aresult of a sudden loss of public confidence.

Deposit insurance covers only traditional de-mand deposits and savings accounts in com-mercial banks and equivalent consumer ac-counts with S&L associations, savings banks,and credit unions.

At present, the Federal Deposit InsuranceCorporation (FIDC) protects the depositor’sprincipal up to $100,000. Securities InvestorProtection Corp. insurance, on the other hand,guarantees the investor’s shares, e.g., againstbroker’s failure to deliver, but not the valueof those shares. The “discount window” oper-ated by the Federal Reserve System providesfunds to banks that are temporarily unable tomeet their reserve requirements and thus alsofunctions as a kind of insurance for the veryshort term.

As a result of intermediation (consumersshifting their money to other kinds of accountswhich give them a higher return), a large pro-portion of liquid assets and savings are notnow covered by insurance. As banks diversifyinto other activities, they increase their riskof failure. The advantage of being covered byFederal insurance is one incentive for non-depositor institutions to buy banks and S&I,associations (increasing the tendency towardconsolidation of financial resources).

Returns on investment recognize and re-ward acceptance of risk. Although deposit in-surance provides an implied safety net formanagers and stockholders of depository in-stitutions, the price of increased efficiency isincreased risk, if only because resources aretightly allocated, reserves are reduced, andmargins for error are slimmer. The more effi-cient firms allow less room for error; and,therefore, the expected cost of a mistake in-creases. With a higher level of competition be-tween financial institutions, the more efficientinstitutions will survive and some less efficientones will fail. This is a benefit in economicterms, but because financial institutions playa critical role in modern society, their in-creased failure rate necessarily touches on thepublic interest in a way that risks assumed byother kinds of organizations do not. Suchfailures expose individuals, families, small


businesses, and major corporations not cov-ered by deposit insurance to risk of loss of cap-ital or lifetime savings.

Two aspects of risk are involved here: oper-ational risk (failure to settle, an implicit riskthat is increased by the speed that new tech-nology contributes to transactions and settle-ments) and institutional risk (institutionalfailure because of bad asset management). Op-erational failures, if they shake the confidenceof customers, can greatly increase the risk ofinstitutional failure. This was the problem thatdeposit insurance was designed to solve. How-ever, deposit insurance itself may encouragefirms to take excessive institutional risks byimplicitly protecting them from the conse-quences of bad judgment.

Excessive risk assumed by financial insti-tutions could affect the stability of the econ-omy, if there is ever a series of cascadinginstitutional failures in which each firm’s col-lapse causes the collapse of others. At pres-ent, a combination of governmental actions toprotect the deposit insurance fund (generally,allowing or arranging a merger between an en-dangered institution and another stronger one)and ad hoc cooperative actions by large finan-cial institutions to shore up the market, nearlyalways prevents the spreading of undue detri-mental consequences following any threatenedor actual financial institution failure. But thespeed at which funds are transferred and set-tlements are made today may make these res-olutions much more difficult. Institutional fi-nancial crises could spread rapidly.

Many transactions will be timesensitive. IfA fails to pay B, and B is therefore unable topay C and D, these disruptive events will mul-tiply with great speed. The increased numberof daily or hourly transactions, the rapid turn-over of assets, the smaller reserves held by aninstitution relative to the number and dollarvalue of transactions, and the complex inter-relationships between financial institutionswill contribute to the sensitivity of the fi-nancial system to short-term perturbations.

The result will be to increase the sensitivityof institutional equilibrium to even minor per-turbations and to decrease the ability to con-trol the secondary effects of disturbances.


Option 1: Retain Federal insurance, as it is now,for traditional depository institutions only.

Continuing the present program is consist-ent with policy that has provided adequateprotection for the great majority of accountholders and many holders of stock in financialinstitutions for over half a century. However,some argue that it gives managers of insuredinstitutions a false sense of security and per-mits them to take risks they might not takein the absence of the insurance. Thus, insuredinstitutions enjoy some competitive advan-tage over others in all lines of business inwhich they engage.

Option 2: Extend Federal insurance to certain ac-counts that are not held by institutions now el-igible for insurance, but only to a specified lowlevel per account or per customer.

An extension of Federal insurance to all ac-counts that function either as transaction orsaving accounts would eliminate a differencebetween suppliers of financial services that isimportant to many. Providers that are now in-sured would lose a factor that gives themsomething of a competitive advantage overthose that cannot offer insured accounts.Vulnerability of the financial service industryarising from the exposure of depositors whohave placed funds in uninsured accountswould be reduced.

Limiting the maximum amount of insurancewould continue protection for the small depos-itor that has been provided historically. Alarger proportion of the depositors would beexposed to loss. Possibly the propensity of theinsuring agencies to find merger partners fordistressed institutions would be reduced be-cause the outlay of funds required if an insti-tution were closed would be limited. Compara-tively uninsured depositors would tend to


exert pressure on financial institutions toavoid unjustified risks and to use sound judg-ment in making loans and in asset manage-ment. Large depositors might also be offeredthe option of buying insurance for deposits ex-ceeding the limits of Federal insurance.

Option 3: Vary the insurance coverage and costwith risk.

This would permit insured institutions toposition themselves in the market in a man-ner analogous to the way mutual funds char-acterize themselves. Some funds are growth-oriented while others seek stability and try togenerate income for their investors. Deposi-tory institutions willing to take higher riskscould purchase insurance at a premium price.Alternatively, depositors could elect to receivehigher interest rates in return for dealing withan institution that provides only a reducedlevel of insurance coverage. In this environ-ment, the depositor would have greater op-tions than is now the case. However, theoverall exposure of depositors to loss could in-crease if a significant proportion chose insti-tutions offering lower levels of deposit in-surance.

Issue 12: What is necessary to assure anadequate level of financial service to allsegments of the population and to protectother basic consumer rights and interests?In any case, people require some level of fi-

nancial services in order to carry out their day-to-day activities and participate productivelyin the economy. They must at a minimum havea way of receiving and making payments, andgenerally some access to credit. Moreover, onecan argue that they need mechanisms throughwhich they can express preferences for specificservices from among the alternatives that maybe offered.

Because of the restructuring of the indus-try and its services, some traditional servicesmay disappear, and others will be explicitlypriced for the first time, or limited to certaincategories of customers. For example, tellerservice may be limited to those with substan-tial balances, and merchants may be unwill-

ing to accept or to cash checks. Market forceswill tend to cause financial service institutionsto encourage higher income customers, whoare likely to have discretionary income to saveor invest, and to discourage lower income cus-tomers with little discretionary income. Somelow-profit services will probably be dropped.

Technology is making it possible for govern-ment agencies to operate more efficiently withregard to making payments. Direct deposit ofall government payments is a long-range ob-jective of the U.S. Department of the Treas-ury. This would include payments to State andlocal governments and contractors, and alsoentitlement payments and Federal employeepaychecks. The move to direct deposit mayconflict with the wishes of some recipients.Realistically, it is likely that some people willbe pressured by government or other employ-ers to accept payment by direct deposit evenwhen they object to doing so.

Float is not a right or entitlement; rather,it is an attribute of a system that requiressome period to process payment orders. It isclear, however, that many corporate cash man-agers, households, and many small businesseshave in the past counted on float in manag-ing their incomes. Because of information andcommunication technology, debits to accountsare in some situations virtually instantaneous,while crediting of deposits made by checkmust wait until the check is cleared. The cus-tomer sees this as an inequity, especially if heor she is charged for overdraft or automaticloan privileges during the lengthened gap. Infact, some financial institutions do abuse thissituation. The technological capability toshorten the gap is available, but financial in-stitutions need an economic incentive to applyit.

The right of consumers to full and under-standable information about their rights, theirrisks, and their obligations in using new kindsof financial services may need explicit protec-tion. Subtle legal distinctions between func-tionally similar services are not necessarily ob-vious to users, and information provided byfinancial institutions is not always clear, com-

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

plete, or in comparable terms. Significant op-portunity exists for misleading advertising offinancial services.


Option 1: Define minimal services to be providedto consumers.

Congress could require all financial institu-tions, or those financial institutions choosingto offer certain services (e.g., accounts thatfunction much like traditional demand depos-it or savings accounts) to provide certain“lifeline” services, such as teller service or han-dling of direct deposit Federal payments, with-out cost to all of those desiring them. Alter-natively, it could allow cost-based pricing.Congress could encourage institutions toestablish an account that can only be debitedelectronically as a minimal service for somewho misuse checking accounts but would liketo benefit from such services as direct deposit.This might, for example, be a condition ex-acted in return for deposit insurance.

At the same time, Congress may wish toprohibit mandatory direct deposit of pay-ments or to define legal rights to choice of pay-ment mechanisms, at least in some situations.

Because financial information technologyconfers on the depository institution, whichalone has access to the payments system, fullcontrol over the timing of debits and creditsto accounts, Congress may wish to regulatethe exercise of this power to assure that con-sumers are treated equitably.

Option 2: Define the rights of users to informationregarding availability of financial serviceoptions.

New or revised legislation maybe necessaryto define the rights of users to full and com-parable information about financial serviceoptions and alternatives, and to establish amechanism for implementing and enforcingthese rights. An explicit policy of “informedconsent” may be desirable. However, the costsof such regulations should also be considered.

Issue 13: Some changes in the delivery of fi-nancial services increase the possibility thatthe privacy of citizens could be eroded orviolated. How can Congress reduce thepossibility?

Citizens necessarily accept some diminutionof privacy, or potential diminution of privacy,by engaging in any transaction other than ex-change of currency. Nevertheless, some as-pects of information technology greatly in-crease the opportunities for and the likelihoodof invasion of privacy because data banks areaggregated, shared, and subject to unauthor-ized access, including access from remote lo-cations.

The aggregation of financial data increasesits commercial value, reduces the costs of ac-cessing and using it, and thereby increases theincentive for misuse. Information technologyalso allows information to be propagatedwidely and rapidly, so that information harm-ful to the interests of a citizen (e.g., informa-tion about debt or payment behavior, whetherthis information is corrector incorrect) can af-fect that citizen’s economic relationships inany location. The potential for loss of privacyis, however, not limited to financial or eco-nomic matters: to the extent that a citizen’stransactions are effected through informationtechnology, his/her location and daily activi-ties and relationships become potentially sub-ject to monitoring and recording. Informationsystems not related to financial services caninvolve similar risks.

It is the potential for this invasion of pri-vacy, rather than evidence that it is occurringor has occurred, that concerns some citizens.It is likely that there is increased sharing offinancial information and increased use of fi-nancial data for multiple purposes (e.g., mail-ing lists sorted according to information aboutthe people on the lists). Furthermore, mostcitizens are probably unaware of the extent towhich this occurs, of the extent to which lawand business practice is able to assume the cit-izen’s consent to this sharing of information

Ch. 9—Policy Issues ● 245— — — . —— —-—

as a condition of accepting a service, or ofrights and protections associated with variousfinancial services.


Option 1: Strengthen, expand, and explicitly definethe citizen rights to privacy in accepting financ-ial services (and conversely, rights to accessand sharing of information by providers of fi-nancial and information services).

At present, insofar as a legal base exists forthese rights, some of the protective legal pro-visions apply only to electronic media, andsome apply only to paper-based services. Pro-tection from intrusion only by the FederalGovernment is provided. But some financialservices combine these modes, some are intransition between them, and some appear tohave no explicit safeguards for the citizen.

While legally defined rights to privacy maybe a desirable step in the direction of assur-ing privacy in using financial services, it maynot be a sufficient step. Such legal safeguardsshould probably not depend for enforcementon victims’ complaints. It is in the nature ofinformation and its applications that citizensare unlikely to know when they have been thevictims of invasions of their privacy until thedamage has been done. Even then, they maybe unable to trace unauthorized informationor misinformation back to its source, to iden-tify the offender, or to document that theabuse occurred.

Option Z: Institute by law a program of inform-ing citizens about risks to privacy that cannotbe avoided in accepting financial servicesthrough information technology (a policy of in-formed consent, to use the model of medicalservices delivery).

This option at least has the advantage ofallowing citizens to decide whether they willaccept the risk and of challenging the indus-try to find ways of reducing those risks. How-ever, it could have the undesired effect of de-creasing public acceptance of and confidencein some financial services.

Option 3: Mandate a program of monitoring andenforcing privacy rights.

This option would require additional author-ity to inspect and monitor financial service in-stitutions, and the allocation of resources forsome Federal agency (e.g., the Federal Bureauof Investigation or the Department of theTreasury) to develop enhanced inspection ca-pabilities as well as to implement the program.Furthermore, such an inspection program mayincrease anxieties about the possibility thatthe Government itself may violate the privacyof citizens through misuse of financial infor-mation about them.

Issue 14: Are additional actions needed tosafeguard the integrity of the nationalpayment and transaction systems againstrisk of disruptions from systems failure,hostile attack, and natural disasters?

Information technology and especially tele-communication links and networks create newvulnerabilities to accidental or deliberate dis-ruptions, and also greatly expand the geo-graphical extent of the impacts. With a highlyintegrated national economy and financialservice industry and increased velocity ofmoney, a local or regional disruption of finan-cial activities rapidly propagates and cancause turmoil throughout the system, even ifthere is no irretrievable loss of data.

Natural disasters, civil disorders, militaryattack, or any form of emergency may destroysome communication links or require thatothers be taken over by emergency manage-ment teams. Thieves, saboteurs, political dis-sidents, terrorists, or others could attack in-formation banks and communication links orthreaten to do so, in effect holding hostage theassets of the public.

The direct effects of disruption of financialtransactions and payments, of data banks, orof communication links are largely independ-ent of whether the disruption is accidental ordeliberate. The long-range effects of creatingan attractive target for internal political vio-

246 . Effects of Information Technology on Financial Services Systems————-

lence or international terrorism are, however,worthy of special policy concern.

Little is known, at least publicly, about thepresent level of understanding of the magni-tude of the vulnerabilities of financial servicesystems to systemic failure, external attack,and natural phenomena. Similarly, knowledgeabout the extent of preparation to deal withthem, by either the private or public sectorsis limited. Industry representatives haveperiodically stated that there are enough re-dundant network capabilities and backup databanks to handle any foreseeable contingencies.At a minimum, the Bank Protection Act couldbe broadened to cover all financial institutions.The act requires Federal regulatory agenciesto establish minimum security standards forbanks. The expertise of the Federal Emergen-cy Management Agency (FEMA) could bebrought to bear.

Whether or not the security measures takenby financial institutions at present are ade-quate is not clear, but the issue is clearly onethat affects the public interest because the po-tential impacts of disruption are broad andcritical to the national welfare. Actions takento reduce these vulnerabilities run the risk of:

●

●

negating some of the benefits of informa-tion technology; for example, requiringpaper-based records, and creating redun-dant data bases and communication links,which could reduce the savings in timeand/or add to the costs of services; andincreasing opportunities for erosion ofprivacy.

Policy Options for Issue 14Option 1: Hold hearings for further consideration

of the present and long-term effects of depend-ence on information and communication tech-nologies on the vunerability of critical economicand social systems and processes in the contextof emergency management, civil defense, andnational security.

Option 2: Create a national commission or an in-teragency task force to gather expert opinionsfrom the financial service industry and from thevarious fields of emergency management, na-tional security, civil liberties, and the like toassess these risks and recommend appropriatemeans of reducing or managing them.

Issue 15: What alternatives are availablefor controlling the risk of theft fromor associated with financial serviceinstitutions?

Facts about theft (of funds or of informa-tion) associated with financial service institu-tions’ use of information technology are ob-scure. Because public confidence is critical tothis industry, it is not in the interests of fi-nancial service institutions to call attention tothefts, whether perpetrated within the indus-try or directed against the industry. Folkloreand anecdotal evidence suggests that com-puter-based thefts are often not immediatelydiscovered, often not solved, and often notprosecuted and that criminals are sometimesinformally granted immunity from prosecu-tion in return for revealing how they carriedout the theft and for designing ways of pre-venting it from being done again. Some ex-perts say that information technology hasprobably reduced the incidence of thefts offunds but greatly increased the average lossfrom a theft. Clearly, it has made the theft offinancial data more attractive, since data arenow aggregated into large, easily tapped databanks and since the theft of data need not in-volve actual removal of documents or otherphysical media from protected premises. In-formation technology has also:

increased Federal responsibility for theftfrom financial institutions since it moreoften involves communication links;created the need for more sophisticateddetection and documentation techniques;andtransferred risk from institutions (thetarget of armed bank robbery) to individ-ual customers (whose accounts may befraudulently debited).


Option 1: Rely on the financial service industryand traditional law enforcement agencies to con-trol crime.

Some believe that theft from financial insti-tutions perpetrated with at least some involvement of computers and telecommunication isincreasing despite ongoing efforts of the indus-


try and law enforcement authorities. Further,they do not see this rate of increase abating.If this is true, steps to augment present effortsare required; and even then, this option maynot meet the challenge.

On the other hand, the level of consciousnessof the problem among financial service pro-viders is increasing. Greater attention is be-ing given to security of advanced systems fordelivering financial services. However, it isstill too early to know if the efforts will proveadequate.

Option 2: Expand the resources and technologicalcapabilities of Federal enforcement agencies(FBI, Treasury) to deal with computer-relatedtheft and to train and assist local law enforce-ment agencies.

This option could increase the requirementsfor auditing and inspection of financial insti-tutions’ records. However, this may have theadditional side effect of increasing concernover potential erosion of privacy and mayalso require additional audit trails and paperrecords, which add to the costs of providingfinancial services.

Option 3: Increase the penalties against per-petrators and against financial institutions for

concealing or failing to report thefts or sus-pected thefts of funds or data.

Increased penalties for theft may deter somepotential perpetrators. Increased penalties forfailing to report theft will tend to bring to lightdata that clarify the magnitude of the prob-lem and encourage the interchange of dataneeded to deal with it. On the other hand, ifthe data that surface cause the public to loseconfidence in the financial service industry,the net effect could be negative and the sta-bility of the industry threatened. Further, ifthe data show the success rate of thieves tobe high or provide sufficient detail on the tech-niques that have been used, the end resultcould be an increase in crimes against finan-cial service institutions.

Option 4: Mandate a national commission to studycomputer-related crime and identify necessaryactions for its control.

Computer-based crime, which is by no meanslimited to that involving funds or financialservices, is on the increase. A national com-mission to study all aspects of this modernproblem would serve many policy needs.

35-505 0 - 84 - 17 : QL 3

Chapter 10

Future Scenarios for theFinancial Service Industry, 1990-95

Contents

PageScenario 1: Extension of Present Trends. . . . . . . . . . . . . . . . . . . . . . . . . . . . 252

Scenario Z: Piecemeal Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255

Scenario 3: The Global Financial Services Industry. . . . . . . . . . . . . . . . . . . 258

Scenario 4: Prosperity and Innovation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261

Chapter 10

Future Scenarios for theFinancial Service Industry, 1990-95

The future of the financial service industrywill be determined by a multiplicity of factors.Any attempt to enumerate them all would befutile and the number of combinations inwhich they can occur is large. Further, if suchenumeration were possible within a reasonabletime and commitment of resources, the volumeof data generated would be so great that it isdoubtful that the results would be useful toanyone concerned with either the operation ofthe industry or the development of public pol-icy relevant to it.

Scenarios are not predictions of what willhappen in the future nor do they necessarilyenumerate the most likely of the possible alter-natives. Rather, they can be used, as they arein the pages that follow, to illustrate the inter-play of variables under specific sets of assump-tions. In this application, neither the assump-tions on which the scenarios are based or theconclusions drawn are sacrosanct. In fact, thereader is encouraged to suggest alternativesfor both and to develop the logic that flowsfrom those that are identified.

Scenarios also serve to bound a problem inthat they can be used to indicate what mayrealistically happen in an extreme but unlikelycase. Because they enumerate the countervail-ing forces that operate in a given situation,scenarios tend to eliminate from considerationsome of the simplistic and extreme argumentsboth the proponents and opponents of a pol-icy may make in support of their respectivepositions. For example, even a rudimentaryanalysis of the examples that follow will showthat the forces shaping the financial systemare such that precipitous changes that coulddisadvantage significant groups within societyin the immediate future are extremely unlike-ly. However, these same models indicate thatsome of the changes that may materialize overseveral years could be detrimental to some,

and therefore should command the attentionof policy makers.

The scenarios that follow are written fromthe perspective of an observer of the financialservice industry looking back over the 10years, 1985 to 1995. They are not mutually ex-clusive, nor are there sufficient parallels be-tween them for the reader to draw conclusionsabout the effect of changes on the industry inany one variable, such as the rate at whichautomated systems for delivering financialservices are accepted in the market. Rather,each highlights selected areas and suggestsone set of outcomes that could result from theconfluence of forces described.

Yet, by looking at the issues raised in theseveral scenarios, the reader should be able todevelop an overall sense of the major con-siderations that will be faced by the financialservice industry between now and the middleof the next decade. The goal has been to high-light for the reader the range of variables thatwill affect the development of the financialservice industry in the future and suggest im-plicitly some of the policy issues that mayhave to be addressed. These, then, provide abackground for considering the policy issuesand alternatives that are addressed elsewherein this report.

The issues of interest from either the oper-ational or the policy point of view vary fromscenario to scenario. If, for example, one is con-cerned with the evolution of the financial serv-ice industry in the international arena, thevariables that determine the rate of acceptanceof new, technology-based services by theAmerican public are of only secondary in-terest. Conversely, the salient factors that af-fect policy decisions dealing with the marketfor consumer financial services have little, ifanything, to do with those that determine the

251

35 -505 0 - 84 - 18 : QL ~


patterns of activity in international marketsfor financial services.

The first of the scenarios portrays an exten-sion of the present environment in which thereare no major changes in the legal/regulatorystructure governing the financial service in-dustry. Included is the implicit assumptionthat the public will generally accept financialservices delivered through applications of ad-vanced information processing and telecom-munication technologies. On the one hand, thetechnologies have been applied to accommo-date differences between groups within thepopulation. On the other, some have becomeless well off because of the postulated changes.On balance, however, the financial service in-dustry and its relationships with its custom-ers have not changed radically from what theyare today.

The second scenario is postulated on thepremise that there are changes in regulation,but they take place piecemeal. Generally, theyare developed in reaction to events in the mar-ketplace that either have to be ratified or toeffects which have to be mitigated for one rea-son or another. For the most part, consumershave rejected or have shown only very limitedreceptivity to financial services deliveredthrough the application of advanced technol-ogies. However, the contraction in the num-ber of depository institutions has continued

as customers move their funds to alternativeinvestment vehicles offered by other types ofinstitutions. The contraction of loanable fundshas made it difficult for some to meet theirneeds for credit.

Systems for delivering financial services in-ternationally are the focus of the third sce-nario. Attention is drawn to the problems ofcompetition between providers of services ininternational markets, the movement of for-eign providers into American markets and ofU.S. providers overseas. World trade has blos-somed and national economies have becomehighly interdependent. The financial serviceindustry worldwide has been called on to pro-vide the required supporting services.

In the fourth scenario, Congress has takensteps to completely overhaul the legal/regula-tory framework governing operations of thefinancial service industry. Most of the regu-latory functions of the States have been pre-empted so that both providers and users of fi-nancial services operate in an environmentthat is uniform nationwide. It is a time of gen-eral prosperity and rapid economic growth.The acceptance of technology-based financialservice delivery systems has been great, butamong the key issues of concern are those re-lating to personal privacy and the security offinancial service systems.

Scenario 1: Extension of

The Economy .—Business as usual, continu- The

Present Trends

Scenario.-The financial service indus-ity and change. A mature economy with animproving position in world trade, but somecontinuing problems with balance between in-flation and stagnation.

Policy .-Deregulation: minimum Federal in-tervention consistent with maintaining the in-tegrity of national payments and transactions;existing consumer protection regulations (1983)retained; the Zeros Bill of 1985 voided mostexisting Federal provisions regulating serv-ices, pricing, and such.

try has been largely deregulated; consumerprotection laws passed in the 1970’s and1980’s have been retained.

There is continuing experimentation and in-novation in information technology with em-phasis on network management, developmentof intelligent media, dispersed delivery of serv-ices, and automation of lower value trans-actions. Driven by the need to control costs,financial institutions have reduced the num-ber of manned branches, and the primary vehi-

Ch. 10—Future Scenarios for the Financial Service Industry, 1990-95 ● 253

cle for delivering financial services is theshared automated facility through which thecustomer can interact with a number of serv-ice providers. Retailers have invested heavilyin point-of-sale (POS) equipment and have ag-gressive programs to encourage customers tomake payment by ordering immediate debitof their accounts. This reduces the merchants’costs and reduces the total amount of con-sumer debt, but it also tends to reduce spon-taneous or impulse buying.

Given the multilingual population (HispanicAmericans alone constitute about 12 percentof the population, and another 5 percent areOriental), automated systems have been de-signed to provide financial services and infor-mation in any one of several languages. Thenewer voice-response terminals just cominginto widespread use are also being supportedwith multilingual systems.

The United States is a fully “post-indus-trial” society, Over 60 percent of all jobs areclassifed as information handling. Automatedequipment is used in virtually all aspects ofhuman activity, including nearly all manufac-turing, and the great majority of the popula-tion under 55 has received at least a highschool education that includes considerablecoursework to develop computer literacy. De-spite the fairly high levels of unemploymentthat are blamed at least in part on increasedautomation, there has never been any strongpublic resistance to automation, certainly notto automated financial services. A public thatenthusiastically embraced Pacman and othervideo games was not likely to object to auto-mated teller machines (ATMs) and POS ter-minals.

However, some elderly people (about 12 per-cent of the population) and the reading-disad-vantaged are uncomfortable with the newtechnology. These are also the people leastable to pay for personal service representa-tives (what used to be called tellers, insuranceagents, etc.). Some banks, savings and loans(S&Ls), and others have instituted special tell-er windows that can be used without chargeby these people and by people who only want

to draw out government payments made bydirect deposit. These windows are popularlyknown as “charity lines” and many people–especially senior citizens, who are mostlywomen, therefore refuse to use them.

Although there are many unemployed andan increasing number of retired people, thereare also many single people and a great manyhouseholds with dual incomes. People in thesesituations are becoming increasingly affluentand well-educated and like to take an activerole in asset management. With a mind-bog-gling number of options in choosing financialservices and investment opportunities thatcan be tailored to their needs or to their specialinterests, asset management has become apopular hobby. Financial management soft-ware proliferates with its own best-seller list,and friends get together with portable ter-minals to argue the latest rage in investmentstrategies. Marital counselors and divorcelawyers report that people are as likely to fightover money management as over child cus-tody, even though most couples have “his,”“her,” and “their” accounts.

Financial service providers offer technology-based services tailored to the needs of variousgroups within society. For some, the servicepackages do not differ markedly from thoseavailable today. For others, providers negoti-ate custom-tailored packages of financial serv-ices individually with their clients. Among theelements of a package, for example, may bemortgage loans, investment accounts, trans-action services, and lines of credit. The termsof each of the services in a package reflect thepriorities of the clientele. For example, an in-dividual may be willing to accept a 1ower rateon a line of credit in exchange for a lower oneon a money market fund.

The proliferation of accounts and relation-ships with financial institutions is in fact strik-ing. Even though financial supermarkets con-stantly stress the advantages of “one-stopshopping, ” customer loyalty to one institutionis rare, and customers shift funds rapidly fromone location to another as new gimmicks in fi-nancial services are touted. One defensive

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

strategy is the bundling of services, especiallyif the combination can be made to include anaccount that falls under Federal deposit in-surance.

About 20 major remote banking systems areavailable nationwide. A number of smallerremote financial services exist but are onlymarginally profitable at best. Most combinefinancial services with a variety of informationand entertainment services. Among the dom-inant institutions in this field are major long-distance telecommunication carriers, news-paper and book publishers, and entertainmentcompanies. Financial services are deliveredusing conventional telephone, direct broadcastsatellite, and two-way television cable.

The newnions (“new unions, ” representingprofessional, administrative, and office work-ers) have in many companies negotiated pro-grams in which employees have the option ofbeing paid daily with a credit to an accountheld by the employer. Employees can accessthese accounts through debit cards or in somecases paper drafts (checks), which are proc-essed through a cooperating financial institu-tion where the employer maintains a zero-balance account to cover debits as they arepresented.

Because financial markets are heavily auto-mated and information is rapidly distributed,both the issuers and buyers of debt and equitysecurities operate in a national and, in somecases, an international arena. Funds flow tothose areas where they can earn the best re-turn at an appropriate level of risk. Regionswith sparse or declining populations, regionswith obsolete industry and old infrastructure,communities that were left isolated when anew highway was built, old farm market cen-ters and rail crossroads that no longer haverail service, find it much more difficult to at-tract new capital. Rural banks can no longerafford to make a loan to carry the strugglingfamily farm until the crop comes in. The Fed-eral Government is under increasing pressureto provide new social programs to help thesecommunities.

Relatively few large retailers, security bro-kers and dealers, insurance companies, and oildistributors have established nationwide dis-tribution systems for financial services heavilybased on existing customer relationships, telecommunications, and information-processingtechnology. On the other hand, because somelegislation restricting interstate operations isstill in force, no commercial bank is among theleading financial supermarkets. Some commer-cial banks use networks to deliver services na-tionwide in competition with the giants, butlaws in some States prevent them from accept-ing deposits, which puts them at a significantdisadvantage. Mergers of several of the largerregional S&L operations have resulted in twonationwide S&Ls being among the top 20 fi-nancial service giants. Although credit unionsoperated by the newnions serve professionaland office workers nationwide, charter restric-tions keep them from becoming financial super-markets.

Many small financial institutions are stilldoing well. They depend on shared networksand access to wholesale services ranging fromdata processing to transactions processing tocompensate for their small size. Their whole-sale suppliers sometimes compete with themfor a retail market, and there are increasingcomplaints from the small firms about risingcosts of wholesale services and networks.Problems in gaining access to shared networksis probably one major reason that there arefewer new entrants into the financial servicesector each year.

Insurance companies have nearly all changedtheir marketing and distribution processes;generally those functions are handled by otherinstitutions.

The U.S. Agency for Family Services hasasked Congress for authority to monitor finan-cial accounts to identify and track missing ordelinquent parents owing child support.

One State has passed a law requiring finan-cial institutions to make automatic paymentof public housing rents from the accounts of

Ch 10—Future Scenarios for the Financial Service Industry, 1990-95 255—— —

tenants receiving State or Federal assistancechecks.

The 1994 Los Angeles earthquake disruptedall communication with that region for 3 daysas surviving communications channels werepreempted by emergency management teams.The Financial Services Association estimatesthat the total cost to investors, financial in-stitutions, and others of that interruption wasapproximately $4.8 billion.

In spite of these problems, and the slow butgradual decline in the number of financial serv-ice institutions, both large and small financialservice institutions are generally healthy andgenerally responsive to the needs of the com-munities they serve, as well as to the needsof the Nation. Even though there are clearlysome barriers to entry, a firm usually developsto respond to the unmet needs of a local pop-ulation. Mortgages are still available from de-pository institutions in most communities, butmost are sold in secondary markets to insur-ance companies and retirement funds that usethem to balance their long-term liabilities withlong-term assets. However, the dynamic of thefinancial marketplace has caused the long-term, fixed-rate mortgage to all but disappear.Young people and people on fixed incomes areoften reluctant to undertake an obligation thathas changeable dimensions. Home ownershipis tending to decline. Developers hesitate to

begin projects that they may not be able tosell immediately if interest rates go up justwhen the development is completed.

Nevertheless, the financial service industry,now a combination of comparatively small spe-cialized service providers and giant financialsupermarkets, is using technology to providean efficient national payments and transac-tions system and to facilitate redistributionof financial resources, the primary functionsof the financial service industry.

Statistics:

Banks: 13,800; decline in decade—8 percent.Thrifts: 4,400; decline in decade—12 percent.Automated transactions: 20 percent by

number, 87.5 percent by value.ATMs: 48,000.Home banking systems: 20, used primarily

by corporations.POS terminals: proliferating; deployed by 49

percent of depository institutions.Direct deposits: 64 percent of Federal pay-

ments.Percent of households with no depository

account: 12 percent.Technology: growing use of debit cards,

voice-activated ATMs.Outstanding issues: privacy, systems

security.

Scenario 2: Piecemeal Regulation

The Economy .—Gradual recovery fromrecession; continuing large Federal deficitsdampen economic activity, keep interest rateshigh, and cause a continuing high rate ofunemployment.

Policy. -No thorough revision of regulation.Piecemeal changes occur, generally to recog-nize structural changes that have alreadyoccurred in the industry. Many legal/regula-tory provisions have merely lapsed becausetechnology has provided a way around therestrictions.

The Scenario.–The events of the past dec-ade have resulted in a hodgepodge of laws,amendments, and regulations, as Federal pol-icymakers and regulators tried to keep up withrapid changes in the financial service indus-try that constantly made old laws and regu-lations ineffective. Only a few legal specialistscan now sort out what rules apply to whichservices. A great many provisions today arecumbersome without being effective.

While Federal laws tend to recognize changesthat have occurred and therefore are more per-

256 ● Effects of /nforrnation Technology on Finanancia/ Services Systems

missive than in the past, States still play adominant role in regulation of financial serv-ices, and their regulatory strategies vary widely. Some States, for example, still forbidbranch banking; others require that any net-work must be open to any financial institutionthat wants to participate. Financial serviceinstitutions have tended to migrate towardStates with permissive laws. A great manylocal depository institutions have been boughtup by larger organizations. Loopholes in Fed-eral laws allowed banks to be converted into‘‘nonbanks.

In some States, both banks and S&L asso-ciations have become virtually financial serv-ice supermarkets; in other States, depositoryinstitutions are limited to a few traditionalservices and may neither own, nor be ownedby, any other kind of institution. Neither ex-treme seems to be ideal for banks. There havebeen a number of messy bank failures, wherebanks have participated in a broad range ofnew ventures and taken some questionablerisks. The Federal Deposit Insurance Corpora-tion (FDIC), which is now burdened with in-suring quasi-deposits held by a variety of in-stitutions that include insurance companies,investment brokers, and retailers, is stretchedto the utmost in trying to salvage as many ofthese institutions as possible in order to pre-vent further drain on the insurance funds.Usually that salvage is done through mergers,and the number of depository institutions isslowly but steadily shrinking.

Many thrift institutions have been boughtup by, or been allowed to merge with, otherinstitutions. Some of these have essentiallyabrogated any real commitment to housing fi-nance and have become much like other gen-eral-purpose, widely diversified, financial in-stitutions.

In States where banks are strictly limitedand protected as having a unique role, theyhave seen their resources dwindle as custom-ers remove funds to invest them through in-stitutions that can operate across State lines.States that adopted this strategy generally didso in order to protect local banks, especially

farm-oriented banks, but they now find thatthe banks have little money to lend. S&L asso-ciations in the same States are generally reg-ulated with a view to preserving their commit-ment to housing finance, but they are alsohaving trouble attracting money. Federal de-pository institutions have widely diversified,and some of the largest have almost becomefinancial supermarkets.

There is, overall, less competition within theindustry, as the number of viable institutionsslowly shrinks. Competition is declining inother ways, as well. After the period of boldexperimentation, when there was rapid prolif-eration of new kinds of accounts and all kindsof financial services were constantly elab-orated and modified, things began to settledown in the mid-1980’s. It became apparentthat most customers were satisfied with a fewmore-or-less-traditional services and had nei-ther the time nor the desire to try to sort outthe scores of services with fancy names, exag-gerated claims, and marginal differences thatalmost no one could understand. Most peoplehave all they can do to stretch their paychecksfrom one payday to the next and realisticallyhave little hope of using their limited cash tomake more money.

As a result, the growth in financial serviceshas been much slower than some experts pre-dicted a decade ago. The information technol-ogy used for financial services was very quick-ly standardized after the big institutions hadmade their basic hardware decisions, and therehas been relatively little innovation in the lastfew years.

Large-value transactions were easy to auto-mate, but lower value transactions-the 82percent of transactions that together accountfor only about 12 percent of all the dollarschanging hands-have proven to be muchmore difficult. Consumers have not accepteddirect debit from the point of sale and homebanking and information services as expected.As a result, the paper burden has not beenlightened as much as the financial service in-dustry hoped it would be. Another factor slow-ing the rate of innovation in financial services

Ch. 10—Future Scenarios for the Financial Service Industry,

has been the great differences between Statelaws and regulations that keep large institu-tions from developing markets of the breadthnecessary for supporting new service offer-ings. A sluggish economy has reduced theamount of money people are able to saveor invest and, hence, their demand for newservices.

Part of the problem was unanticipated cus-tomer resistance to a perceived increase inrisk. As banks and thrift institutions broadenedtheir activities and began to expose them-selves to more risky ventures and fiercer com-petition, there were many near-failures. Mostof these were prevented, although at the costof a heavy drain on FDIC, but a very fewhighly visible institutional collapses, coupledwith several highly publicized electronic thefts,were enough to shake public confidence. Somebanks and S&Ls had to close their doorsabruptly because they had used poor judg-ment, overextending themselves when a rapidturnover of assets, twice-daily settlements,very thin reserves, and dwindling corporatedeposits made them very vulnerable.

Many people were disgruntled because theysaw—usually in advertisements—people witha little more discretionary income collectinghigh interest rates and multiplying theirassets by using glamorous new services, whilethey themselves seemed to be losing out onthe opportunities and paying for services theyonce thought of as free.

Many people are in fact put off by the kindsof records they get from computer-basedtransactions of any kind. They are afraid thatthey will not recognize errors, or know how toget them corrected. The whole process seemscold and faceless, and they are afraid of beingvictimized. Most people over 50 have neverfelt comfortable with electronic informationtechnologies. They are afraid of looking sillyif they make mistakes or if they challenge thecomputer’s mistakes. All in all, it is more com-fortable to deal with a friendly face at theteller’s window or the familiar insurance manwith his thick black book.

1990-95 ● 257

One mark of growing disaffection with fi-nancial institutions is an increasing numberof consumer lawsuits, something almost un-heard of a few years ago.

Local banks play on these sentiments by em-phasizing their hometown image, stressing thecomfort of friendly personal service, and be-ing community boosters by sponsoring localsports teams and advertising their sympathyfor local small businessmen and farmers. Theyrely more and more on small savers and oldcustomers. Large corporations find financialservice institutions that can help them man-age their funds more profitably, and young af-fluent customers put their funds in moneymarket accounts with checking privileges.

Home banking and home information serv-ices are limited to the largest metropolitanareas; despite their name, they are almost ex-clusively used by large companies. Timemeas-ured local communication costs, which haverisen steadily, make them unattractive formost households. These services might havecaught on if women had continued to enter thework force at the rapid rate of the 1970’s andearly 1980’s, but continuing high unemploy-ment has defeated such hopes, and manyhomemakers have plenty of time to pay theirbills the old-fashioned way.

POS terminals are another technology thatfailed to spread rapidly despite a very prom-ising start. One problem was the failure to re-solve the technical problem of dealing withthree different technologies-magnetic stripe,uniform product codes, and optical scanners.With plenty of fairly well-educated peoplelooking for work, there was less incentive toautomate the retail sales sector, and all butthe very large retail corporations hung backwaiting to see how the technology would shakedown. Besides, customers seem to prefer themore familiar, slower payment process ofcharge accounts, credit cards, or checks. Psy-chologically, they probably feel that it letsthem hold onto their money a little longer andgives them a little bit of protection againstmerchants who sell inferior goods or make mis-takes in their charge accounts.

258 ● Effects of Information Technology on Financia/ Services Systems

There is also continual disquiet about pres-sure—whether real or perceived—from em-ployers and from governments to agree to di-rect deposit of paychecks, Social Securitychecks, assistance checks, and the like. Manypeople see it as a great convenience, and saferthan having checks left in mailboxes or carry-ing them home from the office. But many peo-ple don’t want their boss–or “Big Brother”-knowing where they bank, or don’t want tobank at all, because they distrust large insti-tutions. Employers who want to save moneyon their paperwork are inclined to suspect thatsuch employees are trying to evade taxes orchild support payments or are in the countryillegally. Nevertheless, direct deposit is notgrowing as much as expected, and many largeorganizations have stopped trying to push it.

The securities market has not grown signif-icantly in the last 6 years. This is generallyattributed to the maturing of the economy, thegenerally declining size of business enter-prises, and the aging of the society. There hasbeen very low growth in the gross nationalproduct (GNP) for most of this period, andAmerica’s position in world trade has gener-ally declined. Securities increasingly tend tobe held by pension funds, insurance com-panies, and other large institutional investors,and there is much less marketing to individ-uals than there was a decade ago.

The outstanding characteristic of the finan-cial service industry today is, in short, thatits growth is slow and that it is troubled withmore turbulence and uncertainty. The out-standing characteristic of the financial serv-ice mark-et today isvalue transactions

Scenario

that it is bifurcated. Large-are automated completely,

and large institutional investors—big corpora-tions, pension funds, insurance companies—enjoy options that cannot be profitably ex-tended to the average-income person. Largefirms offer a variety of services to institutionalusers nationwide and smaller institutions arestrongly oriented toward local and regionalmarkets and individual or small business cus-tomers. With the continuing dispersion andreconcentration of people and business overthe last 20 years, there is plenty of room forsmall, community-oriented institutions, butthe large institutions dominate the economyand the general long-range trend seems to betoward greater consolidation of financial re-sources.

Statistics:

Banks: 13,000; decline in decade–13 percent.Thrifts: 4,050; decline in decade—19 percent.Broker/dealers: 4,000; decline in decade–

20 percent.Transactions automated: 18 percent by

number, 88 percent by value (1983 = 15percent, 85 percent).

ATMs: 37,000.Home banking systems: 6, in very large

metropolitan areas.POS terminals: deployed by 9 percent of de-

pository institutions.Direct deposit: 46 percent of Federal pay-

ments.Percent of households with no depository ac-

counts: 16 percent.Technology: innovation slowed or stopped,

service options declining.Outstanding problems: depository institu-

tion failures; consumer litigation.

3: The Global Financial Services Industry

The Economy.– Accelerated growth in world specialty chemicals-and in services and agri-trade, with an increasing division of labor cultural commodities.worldwide. The United States has a strongposition in high-technology products—espec- Policy .-Recognition that efficient financialially biotechnology, new-generation computers, service is a cornerstone of international trade;

Ch. 10–Future Scenarios for the Financial Service Industry, 1990-95 ● 259—

cooperation with other nations to regularizeand encourage an orderly world market.

The Scenario.— The volume of world tradecontinues to increase. Both industrialized andindustrializing nations compete for raw ma-terials, energy, and markets. Many ThirdWorld countries, especially around the Pacificrim, have become increasingly industrialized,and other small countries in South Americaand the Middle East are also making progress.Trade among Third World countries continuesto increase. Heavy industry has tended tomove from the older advanced nations to takeadvantage of lower costs for land, labor, rawmaterials, and regulatory compliance in devel-oping countries. Bulk chemical production forinternational markets, for example, has largelybeen taken over by Third World countries. Aglobal division of labor is evolving, and it mayeventually narrow the gap between rich andpoor countries by providing a viable nichefor everyone, as Herman Kahn predicted 20years ago.

The United States has increased its sharein world trade, with nearly all of the growthin export of services; high-technology (biotech-nology, intelligent systems, specialty chemi-cals, photovoltaics); and agricultural and for-est products. Services now account for thelargest share of U.S. exports.

Multinational corporations (of which onlyabout one-third of the 500 largest are now pre-dominantly American-owned) play a majorrole in all countries. Meeting their needs forfinancial services has significantly contributedto a standardization of financial services andassociated technology in the industrialized na-tions. The advanced countries all have a well-developed, highly integrated, financial serviceindustry, with heavy dependence on informa-tion technologies. The newly industrializednations are following the same path. Poorcountries that lack the capital and the commu-nications infrastructure to automate theirtransactions systems find that this is a sig-nificant disadvantage in building indigenousindustry and in trying to enter world trade.

—

Since most countries have a state-owned cen-tral bank, their governments would have tobear the costs of building or modernizing theirfinancial service infrastructure, and this hastended to add to the burden of debt of ThirdWorld countries.

U.S. corporations are heavily committed tointernational operations and have becomeheavy users of automated cash managementservices that show treasurers the status of fi-nancial resources worldwide and facilitate themovement of funds across national boundariesto match requirements for funds with avail-ability of funds.

In most countries, trading and financial ac-tivities now operate on a 24-hour basis. Manyinternational information services use satel-lite communications. Traditional communica-tions links, such as telephone and telegraphcables, are highly vulnerable to the politicalinstability, terrorism, and local wars that havebeen the curse of the last two decades, as wellas to governmental restrictions on the trans-border flow of data. As it is, there are continu-ing international disputes over freedom of fi-nancial data. With international trade andtransactions critical to the economic welfareof all nations and an increasingly dominantfactor in every national economy, financialdata is a valuable commodity. That fact con-tinually tempts national governments and in-ternational thieves to try to control, capture,or manipulate it to their own advantage.

The reluctance of the United States, in the1980’s, to cooperate with other countries insetting up mutually acceptable safeguards forthe transborder flow of data resulted in somediplomatic problems and a regrettable loss ofnational prestige as well as some damage toU.S. trade positions. The major holdout amongWestern nations against international agree-ments guaranteeing transborder data flowhas, however, been Switzerland. As an ironicresult of clinging to its sacrosanct privacylaws, Switzerland has lost much of its preem-inence in international banking, although it re-mains a haven for secret bank accounts.

260 . Effects of /ntormation Technology on Financia/ Services Systems

All of this means that national economies,national markets, national currencies, and na-tional transactions systems are closely tied toone another. In most situations, the continualadjustment and settlement between currenciesand within world markets seems to provide ad-ditional stability. But any perturbation affect-ing one national currency or commodities mar-ket immediately affects others, and the failureof a major bank anywhere in the world hasrepercussions in nearly every country. Occa-sional excursions in markets reveal this vul-nerability to instability under sudden shocks.This occurred several times during the late1980’s when Third World countries defaultedon large debts.

In these instances, governments and finan-cial institutions were able to act quickly andcooperatively to dampen the reactions, in largepart through using the highly developed in-formation systems and financial networks be-tween countries. Since then, these networkshave been used more systematically to moni-tor and control international debt exposures,debt management, and repayment schedules.But setting up mechanisms to allow this tohappen has entailed complex diplomatic nego-tiations and an elaborate structure of interna-tional agreements that was hard for somecountries, such as the United States, to accept.

Because of the large volume of internationaltransactions and the velocity with which fundsmove between countries, national monetarypolicies are much less effective, and most coun-tries, certainly those that are not centrallyplanned economies, have much less controlover the stock of money in the country. In theUnited States, there are now many foreign-owned financial institutions; in fact, most ofthe largest financial institutions, including ma-jor banks, have some foreign ownership. ManyU.S. banks also have branches or affiliates inother countries.

Many experts, both within and outside ofthe government, worry about the effect ofthese developments and see them as an ero-sion of national control over U.S. domesticeconomy and external relationships. Through

translational investments and mergers, mostof the world’s large financial institutions havebecome multinational corporations. Many ofthem have far more financial resources thanmost national governments, and inevitablythis gives them great political power. If theyever acted together, they would very nearlyconstitute a world government.

The realization of the close relationship be-tween multinational corporations, especiallyfinancial institutions, and national govern-ments has made these institutions a primetarget for political dissidents, guerrilla move-ments, displaced populations, and terroristsof all kinds. The British-owned Barclay Bankin New York was bombed by the Irish Repub-lican Army in 1986, with 34 fatalities and 109serious injuries. Overseas protection for facil-ities, information banks, communicationslinks, satellite ground stations, and especiallyfor personnel is costly. Hostile actions againstAmericans and American-owned facilitieshave several times involved the United Statesin dangerous political situations in other coun-tries. In 1992, 10 Americans were held hostageby rebel forces in the Union of South Africafor 12 days. A year later a Mexican mob pro-testing the treatment of illegal immigrantscrossing the U.S. border attacked a U.S. bankin Mexico City. The administration, which hadbeen elected with the strong support of theBlack and Hispanic Political Coalition, wasnearly torn apart in its efforts to deal withthese situations.

Despite these severe problems, there can belittle doubt that the United States’ full par-ticipation in world trade demands U.S. coop-eration with and leadership in the continuingdevelopment of a worldwide financial serviceindustry. Further, in the development andsales of advanced financial information sys-tems, the United States is rivaled only byFrance, the originator of the smart card, whichis now revolutionizing consumer services, andcan potentially revolutionize all forms of rec-ordkeeping throughout the economy and soci-ety. The American financial service industryaccounts for a significant share of the export

—

Ch. 10—Future Scenarios for the Financia/ Service Industry, 1990-95 ● 261———. -- —— —--- . — — . —

of services, the fastest growing sector of U.S.international trade for over a decade, and sup-plies most of the financial services needs ofmany small countries.

The growth and integration of the worldeconomy in the long run may well be the mostsignificant force for world peace. It could bethe source and wellspring of the gradual de-velopment of a world political order based noton unenforced charters or on military power,but on the economic self-interests of the na-tions of the world.

Percent of U.S. financial institutions withsome foreign ownership: 13 percent.

Percent of U.S. financial institutions withinternational branches or affiliates: 17percent.

Automated transactions: 35 percent bynumber, 91 percent by value.

Direct deposit (international payments): 97percent of Federal payments.

Outstanding issues: control of terrorism,monitoring and control of Third Worlddebts.

Statistics:

Banks: 15,750; increase in decade–5 percent.Thrifts: 5,100; increase in decade-2 percent.

Scenario 4: Prosperity and Innovation

The Economy .–Booming prosperity. TheUnited States has a commanding lead in sev-eral high-technology industries and a strongrole in international trade. An era of innova-tion and economic growth is well under way.

Policy .–Regulation by objective, aimed atpreserving competitiveness in the financial serv-ices sector while reducing risks to provider in-stitutions and to consumers.

The Scenario.– Rapid advancements in thebiological sciences are spawning new indus-tries, just as advancements in chemistry didfollowing World War 11, Computer-assisteddesign and manufacturing (CAD/CAM) and in-dustrial robotics have significantly loweredmanufacturing costs and have automatedbatch or custom manufacturing. Continuedstrong growth in the services sector, especiallyin export markets, has kept unemployment atreasonably low levels in spite of the new waveof automation.

Recognizing that a strong national economydemands efficiency and reliability in nation-wide transactions, and also demands that allregions and communities participate produc-tively in that national economy, Congress took

decisive steps in 1985 to revamp laws and reg-ulations pertaining to financial services. Mostaspects of financial service delivery were de-cisively preempted to prevent State laws fromdistorting the legal and institutional infra-structure necessary for an efficient nationalpayments system. Prohibitions on interstatebanking were removed, but banks were allowedto engage in diversified financial services onlyby carefully segregating them from traditionaldepository-lending activities.

Only certain kinds of demand accounts qual-ify for Federal depository insurance, and theyare subject to special regulatory supervisionregardless of the institution offering the serv-ice. Other kinds of accounts are carefully dis-tinguished from insured accounts by time-related and other requirements and mustclearly inform users of the differences. All fi-nancial service regulation is focused on thenature of the service and its risks and returnsrather than on the nature of the institutionproviding the service or the mechanismsthrough which it is delivered. The exceptionto this rule is that institutions providing cer-tain basic “lifeline” services or committingspecified proportions of their resources to a


few specified social priorities (e.g., educationloans, housing development, ecological protec-tion, small entrepreneurship) are granted in-centives sufficient for encouraging those ac-tivities.

Administration and enforcement of Federalfinancial service laws and regulations has beenlargely centralized and rationalized under aspecial agency, the Federal Investment andSavings Trustee–popularly known, inevita-bly, as “Tight FIST.”

Information technologies have allowed alleconomic sectors to improve their produc-tivity, to operate more efficiently, and to bedecentralized, yet well-coordinated. The pro-liferation of information technologies and sys-tems has been comparable to the spread ofelectrification in the 1930’s and 1940’s. Thethrust in financial information technology hasbeen toward automation of lower value trans-actions and the development of intelligentmedia—the smart card and its descendants.

ATMs are now being replaced by automatedresource control centers (ARCCS) that not onlydispense currency but automatically transferfunds between accounts. Most stores, gas sta-tions, and the like, have POS terminals, al-though people do a great deal of their shop-ping through their home computers.Merchants disagree about whether video shop-pers or onsite shoppers are more likely to makeimpulse purchases; some have concluded thatit is the less affluent shoppers that come tothe store (the poor, the elderly, and those justbrowsing for entertainent), and they no long-er make much of a special effort to attractthem. This hurts the very small shops thatcannot afford to be on television and that de-pend on passers-by drawn to the malls bylarger stores.

With computers almost as common as thetelephone and with communication costs low,home banking is common. There are manylicensed brokers and general-purpose financialadvisors fiercely competing for customers. Thebrokers work on coremission; the financial ad-visors charge by the hour and are supposedto be more disinterested. But there are some

shoddy operators in both groups in spite of thewatchdogging of both the consumer interestgroups and FIST. Some institutions and somebrokers offer special-interest asset manage-ment programs that cater to the customer’sspecial interests or pet causes—investment insuch things as the arts, community self-suffi-ciency projects, alternative energy develop-ment, or opportunities for new markets. Theseprograms also provide opportunities for con-flicts of interests, if not downright scams, al-though most of them are probably useful andeffective.

Businesses have established powerful tele-communication networks that are used for avariety of purposes. Some groups of firmswhere the members both buy from and sell tothe others have established procedures forelectronically settling accounts between andamong themselves with little if any involve-ment of the financial service industry. Interestis paid on credit balances in accounts receiv-able. Members of the clearing community havegenerally agreed to settle a credit balance inan account receivable in good funds on de-mand. Only when there is a cash settlementof either a receivable or payable is the conven-tional payment mechanism operated by the fi-nancial service industry used.

Similarly, some have found off-market trad-ing of securities to be in their interest. Elec-tronic bulletin boards are used by both busi-nesses and individuals to post bid or ask pricesfor securities, and the transaction is executedby the principals without the involvement ofa broker. Electronic messages bearing thecomputer signatures of both buyer and sellerare sent to the transfer agent and securitiesdepository instructing them to make the ap-propriate entries in their records.

Protection of customer privacy and securityof all elements of the financial service deliv-ery system have been major thrusts of con-gressional action in recent years, but these twoproblems are not completely solved. Federallaw prohibits the use of any financial data forany purpose not specifically approved of bythe subject of the information. These are

. .

Ch. 10—Future Scenarios for the Financial Service Industry, 1990-95 ● 263

known as informed consent laws, but in prac-tice these laws are difficult to enforce becauseit is hard for victims to detect and prove sec-ondary use of data from a given source. Fed-eral laws also specifically forbid governmentagencies to have access to such data for otherthan narrowly defined purposes (i.e., tax levy),but civil libertarians point out that this is noprotection at all-he who makes a law can vio-late it–and indeed there are frequently pro-posals in Congress to allow access to financialdata for socially useful purposes such as crimedetection and military intelligence.

Security is another important problem forseveral reasons. Because the financial servicesystem is so highly networked nationwide, thepotential gain from a successful theft is almostunlimited. Also, because of the national net-working, any disruption or violation of the in-tegrity of the payments system, whether itstems from natural, technological, or humancauses and whether it is deliberate or acciden-tal, can have major effects on the whole econ-omy. And because financial transactions areso central to the economy, and economic sta-bility is central to national security, financialinformation systems become a target for allof those, inside or outside the country, whohave reason to attack the U.S. Government.

The Federal Bureau of Investigation hasgreatly expanded its capability to controlcomputer-based crime and has elaborate re-lated training programs for State and localofficials. However, with computers and tele-communications so firmly linked, almost allcomputer-based crime, especially directed atfinancial services, is now considered a Federalresponsibility (for both legal and technologi-cal reasons).

Protection of financial information andtransaction mechanisms in the event of natu-ral disasters or military attack is also a Fed-eral responsibility. The Federal Governmenthas developed standards and requirements forboth backup systems and redundant databanks, but the industry protests that the costs

are excessively burdensome, many technicalexperts question the adequacy of the stand-ards, and civil libertarians fear that redundantrecords provide another opportunity for viola-tions of privacy.

Most financial services are marketed nation-wide. A large volume of transactions appearsnecessary for assuring an institution’s viabil-ity in this fiercely competitive market. TheFederal laws requiring financial institutionsto direct a percentage of resource investmentto certain high-priority social programs are acontinuing political issue. There is constantdispute between those who want to add newsocial priorities to the list of preferred in-vestments (which carry definite tax advan-tages) and those who see each new additionas a further step toward a centrally plannedeconomy.

Despite these problems, there is generalagreement that the national payments andtransaction system is healthy and efficient andplays a major role in the general prosperityand in America’s strong position in worldtrade.

Statistics:

Banks: 16,500; increase in decade–10 percent.Thrifts: 5,200; increase in decade-4 percent.Automated transactions: 35 percent by

number, 91 percent by value.ATMs and ARCCS: 77,000.Home banking systems: 70, broadly dis-

persed, wide coverage.POS terminals: deployed by 63 percent of

depository institutions.Direct deposit: 91 percent of Federal pay-

ments.Percent of households without depository

accounts: 7 percent.Technology: development of intelligent me-

dia, ATMs that automatically transferfunds between accounts.

Issues: requirements for preferred socialinvestments, growing computer-basedtheft.

Appendix

Appendix

Glossary of Terms

This appendix provides summary definitions of financial service products discussed at various pointsin this report. The first section contains a listing of financial service products grouped as:

Asset and Liability ProductsTransaction Products (Paper-Based)Transaction Products (Electronic-Based)Information SystemsThe second section contains the definition of each of the items listed in the first. The items in the se-

cond section are listed in accordance with the numbering of the items in the first.

Financial Products and Services

Asset and Liability Products

1.2.3.4.5.6.7.8.9.

10.11.12.13.14.15.16.17.

18.19.20,21.22.23.

Syndicated LoansProject FinanceLease Receivable FinanceIndirect Loan FundingRevolving Line of CreditOffshore-Based LendingBanker’s AcceptancesTrust Receipt FinancingDepository Financial Institution Productsa. Direct Depositb. Check Access Certificate of Depositc. IRA, Keoghd. Eurodollarse. Imprest or Sweep Accountf. Single Premium Deferred Annuities

(SPDA)Margin AccountsMarket MakingLeveraged LeasesRetail BankingMiddle and Institutional Market LendingRepurchase AgreementsMoney Market SecuritiesOther Investment Fundsa. Money’ Market Fundb. Real Estatec. Liquidityd. Growthe. MunicipalMortgage LendingCSVIJI LoansReal Property EquitiesInsurance Premium FinancingActuarial AccrualsAnnuities

Transaction Products (Paper-Based)

24.25.26.27.28.

29.30.31.32.33.34.35.36.37.38,39.40.41.42.43.

Cash ProcessingPayrollMoney Orders/Traveler’s ChecksMortgage ServicingBack-End Processing

a.c.d.e.f.g.

i.j.k.

Installment Loan ServicingMortgage Loan ServicingCommercial Loan ServicingDemand Deposit AccountingSavings Deposit AccountingTerm Deposit AccountingGeneral Ledger ControlCollateral ControlCash ControlTrust AccountingItem Processing

WholesalelRetail LockboxCheck Guarantee/AuthorizationSecurities SafekeepingPersonal TrustEscrow AccountingNote CollectionMortgage BankingCollection Service (Brokerage)Private PlacementEquity BrokeragePublic OfferingRelocation ManagementReal Estate BrokerageSecurities SettlementAnnuities

Transaction Products (Electronic-Based)

44. Data Base Access45. Branch Automation

a. Platform Automation

2 6 7

35 -505 0 - 84 - 19 , QL 3

268 ● Effects of Information Technology on Financial Services Systems—— ————.-———- ——— - —

46.

47.

48.49.

50.

51.52.53.54.55.56.57.

58.59.60.61.62.63.64.6566.67.68.69.

70.

b. ATMsc. Teller TerminalsSettlement and Clearinga. Settlementb. ClearingAutomated Clearing House/ElectronicClearing HouseWire Transfer (Domestic and International)Cash Managementa. Depository Transfer Checkb. Concentration Accountingc. Automated Investment Accountsd. Cash ForecastingBusiness Banking Productsa. Account Reconciliationb. Account Consolidationc. Balance Availability Reportingd. Balance Concentration/Sweepe. Automatic Customer Billingf. Deposit Reconciliationg. Account Payable Check WritingPoint-of-Sale SystemsHome BankingATM SystemsCommingled Investment PoolsDirect DepositFunds Movement and InquiryInternational Banking Productsa. Letters of Creditb. Credit Inquiryc. Foreign Exchanged. Draft Collectione. Syndicationf. Dollar ConnectionStock TransferCommercial PaperOptions/FuturesEquity BrokerageIndex Funds BrokerageBond BrokerageFund ManagementDebit CardsSecurities SettlementDiscount BrokerageSecurities LendingCertificates of Deposit Brokeragea. Straightb. StripInsurance Services Account

Information Services

71. Cash Requirements Forecasting72. Working Capital and Cash Flow Analysis73. Investment Return Optimization Analysis

74. Consumer Financial Analysis75. Business Financial Analysis76. Debt Issue Rating and Quotation Services77. Credit Reporting Agencies

Glossary of Terms: FinancialProducts and Services

Asset and Liability Products

Asset and liability products are those genericproducts that impact the balance sheets of finan-cial institutions. Asset products are generallyloans, while liability products are depository innature.

1.

2.

3.

4.

5.

Syndicated Loans– Loans inv’olving multiplebanks and nondepository financial institutionsin cases where the overall credit involved is inexcess of each bank’s comfort or legal lendinglimit. One bank usually acts as agent for theothers, thereby earning a fee for its efforts(and therefore becoming a transaction productprovider).Project Finance—Similar to syndicated loans(in fact, most are syndicated), project financeinvolves very specialized lending to major gov-ernments and their captive industries.Lease Receivable Finance–Loans made tolessors by insurance companies, pension funds,depository financial institutions (DFIs), non-depositor financial institutions (NDFIs), se-cured by retail leases or loans that the lessorshave made to lessees. The lessor’s note fromthe bank is secured by the paper, not theleased asset.Indirect Loan Funding–Involves a bank orNDFI acting in a transparent fashion foranother lender, whereby the first provides thefunding source while the second generates themarketing and approval process. Two commontypes of indirect funding are: 1) correspondentbank overlines, where a bank automaticallyparticipates in its correspondent bank’s creditpackages over a preset limit; and 2) bulk pa-per purchases, wherein the loan generator(auto dealer, retailer, lessor) creates paperthrough the normal course of its business andperiodically sells the paper and control of thecollateral to a lender (e.g., bank, consumer fi-nance company).Revolving Line of Credit—Generally a con-sumer product that enables an individual toborrow and repay loans under a predetermin-ed and approved limit, this product is often

Appendix: Glossary of Terms ● 269— .. — —

6.

7.

8.

9.

wholesaled by banks to NDFIs and retailedwith the latters’ other product lines (moneymarket account, annuity, debit card),Offshore-Based Lending-Certain tax benefitsexist that accrue to domestic borrowers whouse offshore lending offices of U.S. banks toconduct business. Organizations provide thisservice for their correspondents that are toosmall to establish such facilities themselves.Banker’s Acceptance–These obligations ofthe bank (guaranteed payment under lettersof credit) can be either assets or liabilities orboth, depending on whether the bank is dis-counting them to the public against its guar-antee of payment.Trust Receipt Financing–Generally providedby large commercial lenders to banks and thepublic to enable them to finance inventory—either finished or raw.Depository Financial Institution Products:a.

b.

c.

Direct Deposit–The process whereby acheck’s issuer delivers the check directly tothe payee’s bank for credit to his or her ac-count. The term is often used to refer to theFederal Government’s direct deposit pro-gram for Social Security checks. It is alsoused for military and civilian salary pay-ments, Civil Service and Railroad Retire-ment annuity payments, and Veterans Ad-ministration compensation and pensionpayments.Check Access Certificate of Deposit–Abundled product that includes allowing theconsumer to write checks against a line ofcredit secured by a term deposit in a bank.IRA/Keogh–A tax deferment product of-fered not only by banks (where it is a termdeposit product), but also by NDFIs, suchas insurance underwriters, securities bro-kers, consumer finance companies, mort-gage bankers, and others. These offerorsprovide trustee services under IRA andKeogh plans, thereby playing in the trans-action services arena.1 ) IRAs—A retirement savings program for

individuals to which yearly tax-deducti-ble contributions up to a specified limitcan be made. The amounts contributedare not taxed until withdrawal. With-drawal is not permitted without penaltyuntil the individual reaches age 59½.

2) Keogh Plan–A retirement plan for self-employed persons and their employees towhich yearly tax-deductible contribu-tions up to a specified limit can be made.

10.

11,

12.

13.

14.

15.

16.

d.

e.

f.

Eurodollars–Dolku= denominated depositsin foreign banking offices. Such services areprovided by correspondents to serve theoverseas finance and deposit needs of theoriginating institution customers.Imprest or Sweep Account—Depository ac-count with a targeted maximum balanceabove which funds are swept either to in-vestments or to a concentration account,and central accounts into which funds de-posited with various regional institutionsare collected and then either used to meetpayment obligations or for investment.Single-Premium Deferred Annuities(SPDA)– Products designed to provide afuture pay-out of deposits based on an ac-tuarial formula. Currently, only insuranceunderwriters are empowered to offer mosttypes of annuities. Such annuities havesome form of tax avoidance characteristics.

Margin Accounts–Margin accounts enableretail customers to leverage equity purchasesup to a fixed percentage, The underlying debtis provided by the major money-center banksto securities brokers who mark up the priceand end-loan to the consumer.Market Making (Equity Positions)–The prac-tice of buying and selling securities for a bro-ker’s own account from which it sells to orbuys from its retail or institutional customers.Leveraged Leases–A 100-percent financingsystem that combines borrowed equity anddebt to enable a major utility or other capitalequipment user to acquire functional access toresources without significant investment.Retail Banking—The relationship between aparent and a subsidiary retail bank whereinthe bank provides direct support to the prod-ucts offered by the parent. An example wouldbe ownership of a retail bank by a securitiesbroker, as in the recent case of Dreyfus Corp.Middle and Institutional Market Lending–A1-ternatives to funds offered by commercialbanks for middle market and institutionalmarket borrowings using the proceeds of pub-lic or private debt placements to make loansto these types of borrowers.Repurchase Agreements–A contract betweena seller (bank, thrift, credit union, securitiesbroker, and others) and buyer of Federal Gov-ernment or other securities, whereby the selleragrees to buy back the securities at an agreed-upon price after a stated period of time.Money Market Securities—private and Gov-

ernment obligations with a maturity of 1 year


17.

18.

19.

20.

or less. These include U.S. Treasury bills,bankers acceptances, large negotiable certifi-cates of deposit (CDs), commercial paper, fi-nance paper, and short-term tax exempts. Theprimary investment vehicle used by the moneymarket funds offered by both depository insti-tutions and securities dealers.Other Investment Funds:a.

b.

c.

d.

e.

Money Market Fund–A mutual fund thatinvests in short-term, highly liquid securi-ties that pays the investor a market rate ofinterest and permits redemption by meansof a variety of instruments that are con-venient for the investor to use.Real Estate–Those funds concentratingtheir investments in real estate equities.Liquidity-Those funds concentrating theirinvestments in cash or near-cash in-vestments.Growth–Those funds concentrating theirinvestments in speculative growth-orientedsecurities that will yield an increase in cap-ital rather than a dividend return.Municipal–Funds concentrating their in-vestments in securities of political subdivi-sion of a State, including cities, counties,towns, villages, districts, and authorities,and designed to yield tax-sheltered income.

Mortgage Lending–The extension of creditsecured by a lien on real property. At onepoint, the insurance industry was the singlelargest component of the home mortgage mar-ket. Today, that is not the case. Insurancecompanies are opting to concentrate on thelarge commercial property market because ofincreasing real estate values and opportunitiesto earn additional interest by participating inincreases in rents as well as the secondarymortgage market. Others participate in themortgage market by purchasing individualmortgages or packages of mortgages assem-bled and marketed by such organizations asthe Federal Home Loan Mortgage Corporation(FREDDIE MAC) in secondary markets.CSVL1 Loans–Loans made against the cashsurrender value of whole life insurance (CSVLI)policies, which by statute and by contractmust be made at rates well below current mar-ket rates.Real Property Equities–The taking of anequity position by a financial service provideras part of the compensation for advancingfunds. A practice of insurance companies andothers that, unlike depository institutions, are

21.

22.

23.

permitted to accept equity positions in realproperty in addition to debt instruments.Insurance Premium Financing—Insurancecompanies can lend policyholders the moneyto finance their premiums over an extendedperiod of time. This service is usually accom-panied by an insurance services account.Actuarial Accruals—The liability side of aninsurance company’s balance sheet includesthe current period, actuarial accrual of manytransaction products, and the mandated divi-dends on premiums paid for life insurance con-tracts.Annuities–The principal liability product ofinsurance underwriter; is the tax-deferred an-nuity, which only these industry members areable to offer with long-term guaranteed ratesof return. Such annuities can be single-pay-ment or multiple-payment plans and periodicor single pay out, or they can be structured tobe payable to the surviving beneficiary only.

Transaction Products (Paper-Based)

24.

25.

26.

27.

28.

Cash Processing–The service of providingcentral vault and central cash handling tobanks, retailers, and other currency- and coin-dominated businesses.Payroll—The process of using customer inputto develop payroll checks for employees. Theprocessor may also process the account debitto offset the credits for the checks, payrolltaxes, and miscellaneous withholdings.Money Orders/Traveler’s Checks–Negotiabletender forms issued by depository and NDFIsin lieu of cash. Often wholesaled by major cor-respondents or third parties in “private label”formats.Mortgage Servicing—Fee-based servicewherein the needs of the mortgage investor areserved by an intermediary that bills, collects,and accounts for mortgage payments. Theprocess can also be incidental to an institu-tion’s normal lending activities. Compensationis derived through negotiated net settlementof collections—usually 3/8 to ½ of 1 percent.Bank-End Processing:a.

b.

Installment Loan Servicing–Similar tomortgage loan servicing; however, no na-tional market exists. Usually provided as apart of a total financial product servicingpackage.Mortgage Loan Servicing–Same as #27,above.

Appendix: Glossary of Terms ● 271

29.

c.

d.

e.

f.

g.

h.

i.

j.

k.

Commercial Loan Servicing–Process ofservicing commercial loans that do not nor-mally involve the serial payments found ininstallment loan servicing.Demand Deposit Accounting–Process thataccounts for the account debits and creditsin a demand relationship with a bank.Savings Deposit Accounting–Process thataccounts for the account debits and creditsin a savings relationship with a thrift insti-tution, bank, or other depository financialinstitution that also handles the interest ac-crual and payment steps.Term Deposit Accounting–Process thathandles the accrual of interest on term sav-ings relationships for banks, thrifts, andcredit unions, as well as some NDFIs (secu-rities brokers, insurance underwriters).General Ledger Control–The accountingprocess for the internal recordkeeping for in-dustry members usually provided by cor-respondents, third-party processors, andgeneral accounting service providers. Banksalso provide this service to their customers.Collateral Control–A system for monitor-ing an institution’s collateral under a loan.It usually entails a Management Informa-tion System (MIS), which may interfacewith the institution’s general ledger.Cash Control–A service much like cashprocessing, where central vault services areprovided a part of a total back office serv-ice package.Trust Accounting–A second-level account-ing system for reconciliation of bank, thrift,and trust company customer accounts, aswell as calculation of yield, return, and ac-tuarial benefit,Item Processing--The internal receiving,recording, and ‘perhaps redistribution ofchecks, drafts, or other debit and credititems written by customers of an institutionor deposited by its customers and drawn onanother institution. This includes posting orrecording of the check in the individual cus-tomer’s account and the microfilming andbalancing of all such items received.

Wholesale/Retail Lockbox—Also known asremote item processing or remittance process-ing. A banking service provided for the rapidcollection of a customer’s receivables and rapidcredit to the customer’s account. The serviceprovided by the bank includes collecting mailfrom the company’s post office box; sorting,

30.

31.

32.

33.

34,

35.

totaling, and recording the payments; process-ing the items; and making the necessary bankdeposit or forwarding the funds to another de-pository.

The service can also be used by the institu-tions themselves to service their own loanportfolios. “Wholesale” refers to receivablesflows that involve a few items with large dollaramounts per item. “Retail” refers to thoseflows with a large number of items and smallper-item dollar amounts.Check Guarantee/Authorization-The processof providing merchants and other vendorswith assurance that a particular check beingpresented has the issuing bank’s ability to paybehind it. In this mode, check guarantee/authorization should not be confused with theelectronic-based procedures to be discussedlater. This process generally involves a rela-tionship between merchant and bank in con-trast with electronic-based procedures whichinvolve the use of third-party service.Securities Safekeeping–Generally providedby banks to brokers or by banks to corre-spondent banks, this service insures thatsecurities are maintained under dual custody.It can also have electronic applications whenbanks provide the service to their customersfor paperless securities, such as Treasury billsand commercial paper.Personal Trust—Services wherein financial in-stitutions manage the assets of others for afee. Wholesaling aspects involve correspond-ent relationships and trust companies asagents for financial institutions without thenecessary infrastructure to support the ac-tivity.Escrow Accounting–Services provided toescrow agents (title companies or attorneys incertain geographic areas) that enable the agencyto maintain trust accounts and to report onthe settlement of buyer and seller accounts.Note Collection–Service wherein the financialinstitution acts as collecting agency for a cus-tomer on obligations owed by others to thecustomer. Historically, this service has beenunderpriced by banks and thrifts and fre-quently is being abandoned, owing to theheavy costs involved.Mortgage Banking—The process of acting asan intermediary between the loan originationand funding systems. Generally, the mortgagebanker will be equipped with the originationsystem and will tap national secondary mar-


36.

37.

38.

39.

40.

kets for funding. In many cases, nondepos-itor mortgage bankers will be supported withwarehousing lines of credit from banks to fa-cilitate timely funding of loans. These ad-vances are ultimately repaid through filling ofcommitments with funds purchased in theopen market. Three common secondary mar-ketmakers exist–Federal National MortgageAssociation, Government National MortgageAssociation, and Federal Home Loan Mort-gage Corporation, Securities brokers play avery active role in supporting this activitywith their efforts to optimize investor returnsby investing client funds in the debt andequity of these three agencies, as well as spon-soring their own real estate mortgage invest-ment pools.Collection Service (Brokerage)–The process ofentering for collection the interest coupons ofmunicipal, State, and Federal bond obligations(as well as certain non-Government debt secu-rities) on behalf of others. This service, as inthe case of note collections, was implicitlyrather than explicitly priced for some time andis rapidly disappearing in many institutions.Frequent offerors include securities brokers,banks, and thrift institutions.Private Placement–The business of sellingthe long-term debt or equity instruments of aclient directly to one or more financial insti-tutions without going to the public market.Equity Brokerage—The trading of securitieson behalf of a broker’s clients either on one ofthe great number of securities exchanges orthrough an off-market transaction.Public Offering–The process of taking a pri-vately held company public through under-writing the new securities (guaranteeing a spe-cific price) and then selling them to retail orinstitutional clients, or the process of offeringadditional stock or debt securities for analready public company. Requires that thesecurities be registered with the Securities andExchange Commission and the offering be con-ducted in accordance with its regulations.Relocation Management–A relatively newservice of a few brokers, relocation manage-ment services assist the employees of cor-porate employers in their periodic job-relatedrelocations by advancing the equity in ownedreal estate, thus brokering the sale of trans-feree’s home and the purchase of another inthe receiving city. As of December 31, 1982,Merrill Lynch had $430 million invested inequity purchases.

41.

42.

43.

Real Estate Brokerage–Occurs when thebrokerage community expands into real estateservices through acquisition of existing realestate companies or renewed offerings of theservices through existing securities brokerageoffices.Securities Settlement–The process of trans-ferring title between buyers and sellers of secu-rities within the 5-day limit. Involves deliver-ing negotiable securities to the buyer, goodfunds to the seller and effecting a change inownership on the books of the transfer agent.Annuities–The amount payable according tocontract annually or at other regular intervalsfor either a certain or an indefinite period, asfor a stated number of years or for life. Sev-eral types of annuities exist, and in most casesbrokers merely sell the annuity programs ofa particular life insurance underwriter,

Transaction Products (Electronic-Based)

44.

45.

Data Base Access–These products requirethat the user be equipped with electronic hard-ware and attendant software to gather andmanipulate data or to take action based on thedata provided. There are essentially two typesof data-based access products-–passive and ac-tive. Passive products merely provide the userwith information (e. g., account balances, air-line schedules, stock prices). Active productsenable the user to execute formatted trans-actions in conjunction with the information(transfer funds, book and pay for reservation,buy or sell securities, and settle payment).Branch Automation–Those products de-signed to enable banks, thrift institutions, andNDFIs to increase productivity while reduc-ing personnel costs through resource substi-tution.a,

b.

Platform Automation—The second step inthe branch automation process is that ofautomating the functions of the administra-tive and loan platforms. In most cases,automation amounts to teller-terminal emu-lation with access to small customer infor-mation, word processing, and limited per-sonal-computer data-manipulation functions.The loan authorization function is also pro-vided in some cases.ATMs–Hardware and software that pro-vide customer access to personal account in-formation and transaction sets to conductbanking business. Machine configurations

..—


46.

47.

48.

49

range from full function to inquiry only tocash dispensing only.

c. Teller Terminals—These products enablebanks, thrift institutions, and credit unionsto address extract files and to perform tellerfunctions against memo post files. Theirfunctionality is generally limited to trans-actions involving demand deposit accounts(DDA) and savings types of accounts.

Settlement and Clearing:a. Settlement—In interchange, the process of

b

cardholder banks and merchant bankseither paying by draft or drafting upon oneanother for payment of bank card trans-actions. A transfer of funds between twoparties in cash or on the books of a mutualdepository (e.g., the Federal Reserve Bank)for consummating one or more prior trans-actions made subject to final accounting.The conclusion of a transaction by com-pleting all necessary documentation, mak-ing the necessary payments, and transfer-ring title, where appropriate.Clearing–A banking term referring to theinter-bank presentation of checks, the off-setting of counterclaims, and the settlementof resulting balances. The term may be usedin a purely local operation or on a nation-wide basis.

Automated Clearing House/Electronic Clear-ing House—A facility that performs inter-member (financial institutions) clearing ofpaperless entries between such institutions.Most ACHS are operated by the Federal Re-serve and use rules, procedures, and programsdeveloped on a local basis by their participat-ing financial institutions under the generaldirection of the National Automated ClearingHouse Association.Wire Transfer—The process of moving cus-tomer money from one place to another with-out the transfer of paper documents by meansof telecommunication between financial insti-tutions. Larger banks have access to Federalfacilities, while smaller institutions rely ontheir correspondent banks to perform the task.The important characteristics of wire transferare speed and the secured nature of trans-miss ion.Cash Management–A generic term for severaldiscrete products designed to speed the collec-tion of funds receivable and delay the disburse-ment of funds payable.a. Depository Transfer Checks—Depositor~’

b.

c.

d.

transfer checks (DTCS) are items processedthrough the payments systems and are pre-authorized drafts on remote banks used forthe purpose of concentrating cash in a sin-gle depository.Concentration Accounting—The receivingend of the DTC system o r o t h e rcash-gathering mechanism.Automated Investment Accounts–Thosecash concentration accounts that are pre-programmed to sweep balances in excess ofa target amount into interest-earning ac-counts or investments on behalf of the cus-tomer—usually a commercial depositor.Cash Forecasting-A service whereby a fi-nancial institution uses the cash receiptsand disbursement journals of its customersto develop an analysis of that cornpany'scash requirements for a given period. Thisenables the customer to invest the unneededfunds for future use.

50. Business Banking Products– The followingproducts are generally offered by most banksto their corporate customers and rely heavilyon electronics either for product deliver-?. orfacilitation.a.

b.

c.

d.

Account Reconciliation—Customers pro-vided either paper-based or electronic-basedinformation on the checks they have writ -ten, which, when matched by the bank withthose checks that have cleared, enable thebank and the customers to maintain a singlecash balance journal.Account Consolidation–The creation ofmultiple accounts that are actual subsets ofa single account. The funds reside in one ac-count, but statements are prepared for eachsubaccount. This is particularly attractiveto customers with multiple-branch profitcenters. The process requires additionalMICR* encoding on each separate set ofchecks.Balance Availability Reporting—Requiresthat a bank provide inter-da}’ balance re-porting as checks and deposits are madethrough a business day. This information isgenerally transmitted to a terminal in thecustomer’s office.Balance Concentration/Sweep–The receiv-ing depository account for funds drawn offof subsidiary accounts and then invested inmoney market instruments.

274 ● Effects ot /ntorrnation Technology on Financia/ Services Systems

51.

52.

e.

f.

g.

Automatic Customer Billing—A software-driven product whereby the customer pro-vides the bank with electronic-based dataon its customers and the bank generateseither paper or electronic debits or bills thatare either mailed or processed through theACH.Deposit Reconciliation–A service, similarto account reconciliation and account con-solidation, that reconciles customers’ depos-its by branch or profit center.Accounts Payable Check Writing–In thisservice the bank uses a customer’s accountspayable journal and discount information toprepare its checks to vendors. In manycases, this service is combined with aremote disbursement account located atanother bank, usually in a city with no Fed-eral Bank ACH.

Point-of-Sale Systems–A point-of-sale (POS)transaction is a full funds transfer that can beaccomplished by electronically entering trans-action data into an electronic payment net-work and transmitting the payment informa-tion to a data base in a depository institution’scomputer. POS systems serve many masters.Retailers use them to help control inventorylevels, to assist in order management, and toauthorize checks and credit and debit card pur-chases. More sophisticated systems are capa-ble of gathering all data necessary for draft orcheck processing and enable banks to providetruncated services to cardholders or deposi-tors. In all cases, POS systems reduce thesteps, and therefore the time, required to proc-ess a transaction.Home Banking–Though in its infancy, homebanking is growing rapidly in popularity. Themost common form of home banking today istelephone billpaying, which enables customersof banks, thrift institutions, and credit unionswho have touchtone telephones to inquireabout their balances, make account transfers,and pay certain household bills. This servicehas evolved from the marriage of telephonelines, television monitors, personal computers,and television cable into several pilot projectsthat enable the consumer to perform the afore-mentioned functions, as well as to inquireabout other bank products, to budget house-hold finances, and to reconcile bank state-ments. Some pilot projects also enable the con-sumer to make purchases from the home whilesettling on-the-spot through direct debit to a

53.

54.

55

56.

57.

depository account or through a charge to acredit account.ATM Systems—An unmanned electronic de-vice that performs basic teller functions suchas accepting deposits, advancing or withdraw-ing cash, relaying balance-inquiry information,and allowing transfer between a customer’s ac-count. The device is usually activated by amagnetically encoded card or by the transmiss-ion of a code via a keyboard or keyset. Suchdevices may be accessible 24 hours a day. Thedefinition of an ATM system differs from thedefinition of ATMs under branch automationin that the ATM system may also involvecredit authorization, check verification, draftdata capture, and transaction processing.Comingled Investment Pools–Enable banksto leverage their investment expertise to pro-vide investment services to their customers di-rectly or to other institutions on a correspon-dent basis. Generally, the product takes theform of employee benefit trust management,if provided to the public, and funds manage-ment, if done on a correspondent basis.Direct Debit–Several industries rely on the di-rect debit to settle the purchase of goods orservices. When the ACH concept is fully ex-ploited, many more industries may take ad-vantage of this process. One of the more visi-ble uses of the direct electronic debit is theinsurance settlement account (ISA) used bythe insurance industry. For those policy-holders who spread insurance premiums overtime, the ISA offers the processing of preap-proved charges to the policyholder’s deposi-tory account at virtually any institution in theNation. Mortgage bankers have begun usingthe direct debit, and it should not be longbefore other providers will also. Possible usersinclude thrift institutions and major providersof consumer credit (e.g., General Motors Ac-ceptance Corp. (GMAC), Beneficial Finance,and leasing companies).Funds Movement and Inquiry-Generic termsfor electronic-based cash management serv-ices, including funds transfer (wire-based) andaccess to data base information on the distri-bution of available funds (e.g., Where are they?Collected or uncollected? Ingestible?).International Banking Products–These prod-ucts are provided to enable the customers ofbanks and thrift institutions either to do busi-ness in the global market or to have access tofunds while traveling worldwide.


a.

b.

c.

d.

e.

f.

Letters of Credit–Letters of credit (LCS)are evidence of financial institution’s will-ingness to underwrite the dealings of itscustomers in arrangements where the cus-tomer is unknown to the seller of the prod-uct or in countries where the extension oftrade credit to foreigners is forbidden (e.g.,Japan). While the actual letter is paper-based, the advice and LC number is trans-mitted electronically through the bankingnetwork to the customer’s seller (althoughthe LC may be required by a buyer as a per-formance bond). Trade LCS will probablynever be completely electronic because ofthe extra documentation required, such asbills of lading, port entry receipts, and in-surance.Credit Inquiry–Dealing in foreign trade re-quires that information be gathered on be-half of buyers or sellers, and banks have thiscapability through either their correspond-ent networks or through third parties.Foreign Exchange–Bank customers whodeal heavily in foreign trade must often set-tle in foreign currency, making it necessaryto deal in the global currency markets.Banks themselves that are active in foreignlending frequently participate in the foreignexchange market to protect their positionsagainst adverse currency exchange rates.Foreign travelers often need to use foreigncurrency that they can purchase in theUnited States prior to departing. Banksrely heavily on electronic messages to keepabreast of foreign money markets, not onlyfor their own accounts but also for those oftheir customers,Draft Collection-–Involves processingdrafts received or delivered under letters ofcredit and is a part of the internationalclearing process.Syndication–Forming consortia of banksto provide credit and clearing services toreal and quasi-governmental agencies of for-eign nations as well as their nationalizedand independent banks. International syn-dications provide offshore project finance.Usually the syndicating bank guarantees aborrowing or servicing cost and then nego-tiates downward from the determined ratewith potential syndicate members, intend-ing to reap a spread differential profit.Dollar Collection– Involves the service ofprocessing checks drawn on U.S. banks andpresented to customers of foreign banks.

,58.

59.

60.

61.

62.

63.

64.

65.

This is a service of the international cor-respondent bank community and involvesthe settlement of cash letters. While the vol-ume in cash letters is extremely high, themajority of cash and dollar settlement isdone by a handful of the largest U.S. banks.

Stock Transfer-Banks act as the transferagents for publicly held stocks. In this capac-ity they are required to process the changesof ownership of billions of shares each month.It is important that these institutions main-tain a data base that provides ownership rec-ords to verify ownership, a service accessed bynot only the corporation stock issuers but alsothe securities industry.Commercial Paper–Short-term (270 days orless), unsecured promissory notes issued bybusinesses of significant financial strength orwhose paper is backed by a letter of creditfrom a major bank. Brokers are merely one oftwo ways commercial paper is marketed. Themajor exception is Citicorp, which brokers itsown commercial paper.options/Futures–options” are a tradeableright to buy or sell securities. Futures con-tracts are a legally binding agreement that callfor the purchase or sale of a real or hypotheti-cal commodity at a stated price and futurepoint in time.Equity Brokerage—The trading of securitieson behalf of a broker’s clients on one of thegreat number of stock exchanges.Index Funds Brokerage–The selling fundswhose yields are defined by specified stock in-dices such as Dow Jones Industrials, Stand-ard and Poor’s, and the Wilshire Index.Bond Brokerage–The brokerage of debt in-struments of strong corporations to clients.Fund Management–The continual arrange-ment and rearrangement of the bank balancesheet or that of any trust or fiduciary fund inan attempt to maximize profits, subject tohaving sufficient liquidity and making safe in-vestments.Debit Cards–A plastic card issued by a finan-cial institution to its own customers that, byusage, credits or debits the customer’s per-sonal account (checking, savings, or line ofcredit). The card may be proprietary or it maybe a regionally or nationally accepted card.With regard to the securities industry, debitcards are used to access funds on deposit inmoney market funds or to access lines ofcredit secured by securities portfolios or realproperty.

276 ● Effects of /formation Technology on Financial Services Systems—

66. Securities Settlement—The process of trans-ferring title between buyers and sellers of secu-rities. This must be conducted within the 5-daylimit.

67, Discount Brokerage—The provision of trans-action services only, without the usual invest-ment advice, for substantially reduced com-missions.

68. Securities Lending–The process of lendingsecurities for collateral purposes and shortsales. These securities often end up as collat-eral for repurchase agreements,

69. Certificates of Deposit Brokerage–The offer-ing to clients of investments in major bankand savings and loan negotiable certificates ofdeposit.a. Straight—Generally used to designate spot

transactions.b. Strip–Instances where a group of CDs are

sold together to match the maturities sched-ule of an underlying loan portfolio or a cus-tomer’s future need for funds.

70, Insurance Services Account–The principaltransaction product of the insurance industryis the insurance services account, which com-bines insurance premium financing with directdebit of policyholder’s depository account inbanks, thrifts, and credit unions. These debitscan be paper- or electronic-based.

Information Services

71. Cash Requirements Forecasting—A systemthat uses financial institution customer dataon receivables, payables, and capital spendingto construct cash budgets and cash flow anal-yses that the customer can use to manage itsreceipts and disbursements more efficiently.

72. Working Capital and Cash Flow Analysis—Aproduct tied to the cash requirements productwhich highlights the shortfalls and excessesof short-term assets minus short-term liabili-ties and expresses the same as a net negativeor positive working capital position.

73, Investment Return Optimization Analysis—A product used by banks and their customersto evaluate alternative investment scenariosusing a targeted internal rate of return as theprimary algorithm. This product enables thebanks and their customers to develop parallelviews of customer investment requirementsand ensures that the banks play an active roleat the onset of the analysis rather than afterthe fact.

74. Consumer Financial Analysis-–This new prod-uct uses the industry’s control of the pay-ments mechanism to assist consumers inhousehold budgeting. It uses additional infor-mation provided by the customer on checksand deposit documents to organize paymentsand receipts data in a fashion that enablesthe consumer to visualize how the householdbudget is spent, i.e., residence, entertainment,food, utilities, tax-deductible items, and non-tax-deductible items.

75. Business Financial Analysis--This new prod-uct works much like the consumer financialanalysis product, using a business customer’scheck and deposit input to generate state-ments that reflect the prior period’s cash basisprofit and loss, and compares same againstpreestablished budgets.

76. Debt Issue Rating and Quotation Services—These information services are provided to ma-jor participants, who use them to guide theirinvestment activities. Also included in thegroup are the equity rating and quotationservices used by trust departments of banksand thrift institutions, as well as securitiesbrokers, pension plan administrations, and in-surance investment fund managers. The vastmajority of these services are electronic-basedand are provided by third parties.

77. Credit Reporting Agencies—These companiesmaintain large data bases or-t consumer andbusiness credit histories and generate reportsfor subscribing members, who also providecurrent data on their credit consumers.

— —

Index—. — ————- ——— —-—ADP, Inc., 118Aetna Insurance Co., 32Alex Brown & Sons, 53Amdahl, Gene, 44American Automobile Association, 13American Express, 108, 113, 118, 122American Stock Exchange, 54, 63, 66American Telephone & Telegraph (AT&T), 30, 146AutEx Systems, 72Automated Bond System, 65Automated Clearing House (ACH), 78, 99, 146automated teller machine (ATM), 19, 23, 29, 32, 37,

39, 40, 41, 43, 90, 98, 99, 113, 114,115-123, 142, 149, 167, 176, 191, 202

BankAmerica Corp., 63Bank of America, 129bankers’ acceptance, 84Belgium, 159British Telecom, 162“Buttonwood Agreement, ” 52, 60

California, 119Carte Bleu, 40Cash Management Account, 91, 119C. D. Anderson & Co., 71certificate of deposit (CD), 84, 104, 154Chemical Bank, 129, 149Chicago Board Options Exchange, 54Chicago Board of Trade, 55Cincinnati Stock Exchange, 71CIRRUS System, Inc., 120, 121Citibank, 203Clearing House Interbank Payment System

(CHIPS), 158commercial paper, 83Commodity Futures Trading Commission (CFTC),

55, 60Commodity News Services, 130Consolidated Quotation System, 65consumer financial services, 167-187

consumer services, 167-180automated teller machines, 176automatic direct deposit, 178costs, 179growth of credit, 173home information systems, 178payment methods, 171point-of-sale systems, 178pricing structures, 178providers, 169recent innovations, 174savings and investment behavior, 168telephone billpayer, 178

public policy, 180-183regulations, 180Consumer Credit Protection Act, 182Electronic Funds Transfer Act, 183Regulations Z and M, 182

transition from paper-based to technology-basedsystems, 184-187

privacy, 185rights, 186security, 184

Continuous Net Settlement (CNS), 73Credit Union National Administration (CUNA), 104

Dahls supermarkets, 123Dean Witter, 53, 62, 64, 66, 70Delaware, 112, 113, 123, 217Department of Treasury, 101Depository Institutions Deregulation Committee,

103Designated Order Turnaround (DOT), 71Digital Termination Service, 35Drexler Technology, Mountain View, Calif., 39

E. F. Hutton & Co., 53, 66, 130

Federal

FederalFederalFederalFederal

Deposit Insurance Corporation (FDIC), 103,241

Home Loan Bank Board, 11, 63, 199Reserve Bank of Atlanta, 176, 205Reserve Bank of New York, 146Reserve Board. 26, 60, 68, 142

Regulation D, 125, 156Regulation E, 26Regulation Q, 156

Federal Reserve System, 146Federal Savings and Loan Insurance Corporation,

104findings, 191-219

applications of technology and changed nature offinancial services, 192

competition in the markets, 216entrants into the financial services industry, 213financial options for consumers, 201integration of capital markets, 210interaction between technology and the legal

regulatory structure governing banking,198

restructuring the financial service industry, 194security and integrity of the financial service

system, 205First Boston, Inc., 52floating rate note (FRN), 154Florida, 130France, 40French Ministry of Post and Telecommunications,

162future scenarios, 1990-95, 251-263

extension of present trends, 252global financial services industry, 258piecemeal regulations, 255prosperity and innovation, 261

future of financial services, 7-9influence of technology, 7providers, 8users, 8

279

280 Effects of Iriforrnation Technology on Financial Services Systems———-.

General Accounting Office, 180Goldman Sachs & Co., 52Great Britain, 162

Hefner, Paul, First Interstate Bancorp of California,25

Hy-Vee supermarket, 123

Illinois, 120, 122individual retirement accounts (I RAs), 107, 174, 202,

204Integrated Services Data Network (ISDN), 34, 35Intermarket Trading System (ITS), 71international environment, 153-164

effect of technology on payment systems, 161financial markets, 157-158growth of international banking, 153-157

multinational banking, 155new directions, 154

international lending, 155sources of funding, 154

interbank communications, 158-160New York Clearing House Association, 158SWIFT, 158

vulnerability of the financial system, 162-164INVEST, 63, 195Iowa, 123ISFA Holding Co., Ltd., 63

J. C. Penney, 114, 130, 171Jefferies & Co., 72

Latamore, S. Berton, 39legislation:

Banking Act of 1933 (Glass-Steagall), 52, 198Bank Holding Company Act, 200, 231Bank Holding Company Deregulation Act,

proposed, 200Consumer Credit Protection Act of 1968, 182Consumer Leasing, 182Depository Institutions Deregulation and

Monetary Control Act of 1980, 104, 174,200, 226

Electronic Funds Transfer Act, 183Employee Retirement Income Security Act

(ERISA), 57Equal Credit Opportunity Act, 182Fair Credit Billing, 182Fair Credit Reporting Act, 182Fair Debt Collection and Practices Act, 183Garn-St Germain Act of 1982, 11, 105, 200, 226,

233Maloney Act of 1938, 61Securities Act of 1933, 60Securities Acts Amendments of 1975, 62Securities Exchange Act of 1934, 60, 61, 68Securities Investor Protection Act of 1970, 60Truth in Lending Act, 182, 203

Liberty National Bank & Trust Co., Oklahoma City,125

—

magnetic ink character recognition (M ICR), 19major findings, 4-7

consumer interests, 6delivery systems, 5industry structure, 4legal/regulatory environment, 5safety and soundness of industry, 6

Massachusetts, 122MasterCard, 98, 106, 112, 113, 114Mellon Bank, 102Merrill Lynch, 32, 52, 53, 59, 67, 70, 91, 119, 131,

167Mobil Oil Co., 124Money Exchange, Washington, D. C., 119Morgan Stanley, Inc., 52

National

National

NationalNational

NationalNationalNationalNationalNetwork

Association of Securities DealersAutomatic Quotation System (NASDAQ),52, 71, 210

Association of Securities Dealers, Inc.(NASD), 53, 61

Bank of Detroit, 120Commission on Electronic Fund Transfers,

186Enterprise Bank, Washington, D. C., 196Futures Association (NFA), 61Securities Clearing Corp., 62, 72Transaction Systems, Inc., 119Exchange, Washington, D. C., 119

New England States, 122, 217New York, 32, 146, 149, 217New York Clearing House Association, 158New York Stock Exchange, 19, 52, 53, 59, 61, 63,

65, 66, 68, 71, 72, 73North American Securities Administration

Association, 60NOW accounts, 105, 202

Opening Automated Report Service (OARS), 72Options Clearing Corp. (OCC), 54, 55, 73Organization for Economic Cooperation and

Development (OECD), 154

Pacific Stock Exchange, 54Paine Webber, 52“Pathfinder,” 67Pecchioli, R. M., 154personal identification numbers (PINs), 37, 41, 124Philadelphia Stock Exchange, 54Pocket Quote, 66point-of-sale (POS) systems, 22, 25, 31, 32, 33, 40,

101, 111, 123, 171, 178policy issues, 9-15, 223-247

access to clearing systems, 13, 238allocation of risk, 13, 241barriers to international operations, 12, 236changes in structure, 225competition between regulated and unregulated

providers, 12, 229congressional options, 227

Index ● 2 8 1—

consolidation, 10control of interest rates, 13, 240generic considerations in framing policy, 226implementation of policy, 9lifeline financial services, 14market segmentation, 11, 232privacy, 14, 236, 244public interests, 224relationship to telecommunication policy, 11, 235restrictions on interstate banking, 10, 231restructuring the policy framework, 9, 226security and integrity of delivery systems, 15vulnerability of financial services systems to theft,

15, 246Prudential Bache, 53, 64Publix Supermarkets, Florida, 119

repurchase agreeements, 84retail financial services, 97-133

deposit function, 99-108accounts with other nondepository institutions,

107demand deposit accounts, 102direct deposit, 100drafts, 102giro transfers, 102insurance, 106lockbox operations, 101point-of-sale systems, 101savings accounts, 103traveler’s checks, 103

electronic funds transfer (EFT), 114-126automated teller machines, 115-123

ATM deployment legislation, 121ATM systems, 116CIRRUS–National ATM Network, 120shared ATM systems, 118

POS full funds transfer, 123-126costs of POS systems, 125direct debit POS, 123National POS systems, 125

extension of credit, 108-114commercial credit, 110consumer credit, 110

financial information services, 126-128check authorization, 127credit authorization, 127providers, 127

home information services (HIS), 128characteristics of users, 132costs, 131developers of, 129implications of, 131market for, 131technology of, 129

Reuters, 157Revell, J. R. S., 161Reynolds Securities, 62

Safeway, 118, 119Saloman Brothers, Inc., 52Satellite Business Systems, 32Sears Roebuck & Co., 102, 114, 171, 202Securities and Exchange Commission (SEC), 55, 60,

62securities industry, 51-94

capital formation, 91-94private sources of funds, 92public offerings of securities of a corporation, 93

functions of, 64-75acceptance of risk, 67

margin, 68underwriting new issues, 67

advisory role, 65counseling, 66information dissemination, 65

marketing, 69-75brokerage, 70clearance and settlement of securities, 72pricing, 73product development, 69transactions, 71

information technology, effects of, 75-76instruments, 76-91

corporate capital structure, 76-83convertible securities, 82equity, 81-82long-term debt-corporate bonds, 77-81

options and future contracts, 84central asset accounts, 91futures, 88mutual funds, 90options, 85warrants, 87

short-term debt-money market securities, 83-84structure of, 51-64

characteristics, 62composition, 52

brokerage houses, 53exchanges, 53investment banks, 52

development, 51effects of information technology, 64industry users, 57-59

individual investors, 59institutional investors, 57

international market, 64new entrants, 63regulatory structure, 59

Federal agencies, 60self-regulatory agencies, 61trends in regulation, 62

Securities Industry Automation Corp. (SIAC), 54,62, 71, 72

Securities Investor Protection Corp. (SIPC), 60, 61,180, 241

Shearson/American Express, 53, 63Small Business Administration, 60

282 ● Effects of Information Technology on Finaricia/ Services Systems—. — —

Small Business Investment Corporations, 60Society for Worldwide Interbank Financial Tele-

communication (SWIFT), 153, 158, 159,160, 163, 164

South Dakota, 112, 113, 217Super NOW accounts, 105, 108, 202support technologies, 19-47

computer hardware systems, 20future hardware, 23large computers, 22-25microcomputers, 20-22

hardware components, 44-45software, 25-29, 45, 46

applications software in the future, 28specific technologies for delivering financial serv-

ices, 38customer service equipment, 42document and currency renders, 41electron cards, 39embossed/magnetic stripe card, 38laser card, 39

system security and integrity, 36-38telecommunications, 30-36

future, 34private-line facilities, 32switched telephone network, 30

alternatives, 32video-related communication technologies, 33

Telemet America, Inc., 66Treasury bill, 83Tyme Corp., Wisconsin, 119

VideoFinancial Services, 130Videotex Industry Association, 186Viewdata Corp., 130Viewtron Program, Miami, Fla., 130VISA, 13, 39, 98, 112, 113, 114, 126, 137

Warner-Amex QUBE System, 34Washington, D. C,, subway farecard system, 39, 40White, William, 168White Weld, 62wholesale financial services, 137-149

data access, 147future of, 148

~ products available in wholesale markets, 138-141asset and liability products, 138

major providers, 139information products, 141nonprocessing services, 141processing products, 140

providers, 142-146role of technology, 138

Wide Area Telephone Service (WATS), 31Wilmington (Delaware) Savings Fund Society, 123Wisconsin, 122

Zimmer, Linda Fenner, 176