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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



F o r e w o r d

In 1982, the House Committee on Banking, Finance, and Urban Affairs; theHouse Committee on Energy and Commerce (expressing the special interest of its 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 the

types 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 t he finan cial service indust ry. The str ucture of the indust ry ha s changed sig-nificantly in recent years as firms not traditionally viewed as financial serviceproviders ha ve tak en a dvant age of opport un ities creat ed by technology to ent erthe market. New technology-based services have emerged. These changes are theresu lt of the int eraction of techn ology with oth er forces such a s overa ll 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 industrystr ucture, mar kets for financial services, and relat ionships between th e indust ryan d t he legal/regulatory environmen t 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 an d do not necessarily represent th e views of th e member sof the advisory panel or any of the others who have contributed.

JOHN H. GIBBONS Director

.,. ///



F i n a n c i a l S e r v ic e s Ad v i so r y P a n e l Me m b e r s

Almarin Phillips,ChairmanHoler Professor of Management, University of Pennsylvania

Donald I. Baker, Esq.P a r t n e rSutherland, 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 Hefner

Senior Vice President1st Interstate BancardEdward J. Kane

The Everett D. Reese Professor of Banking in Monetary Economics

Ohio State University

Jerome SvigalsElectronic Banking ConsultantIBM Corp.

Willis H. Ware

Corporate Research Staff The Rand Corp.Steven Weinstein

Vice President–Technology StrategyAmerican Express

Milton Wessel, Esq.General CounselADAPSO

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

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O TA F i n a n c i a l S e r v i ce s As s e s s m e n t S t a f f

John Andelin, Assistant Director, OTAS cience, Inform ation an d N atural Resources Division

Frederick W. Weingarten,Communication and Information Technologies Program Manager

Project Staff Zalman A. Shaven,Project Director

Phyllis Oren stein 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,S ecretary

Marsha Williams,Secretary

Renee S. Lloyd,S ecretary

Jeanette V. Contee,S ecretary

ContractorsMaria 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



F i n a n c ia l S er v i ce s I n d u s t r y C o n s u m e r Wor k s h o p P a r t i c ip a n t s

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 Reista dConsultantReistad Corp.

F i n a n c i a l S er v i c e s I n d u s t r y Te c h n o l o gya n d S c e n a r i o s Wo r k s h o p P a r t i c ip a n t s

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.

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F i n a n c i a l S e r v ic e s R e v ie w e r s

John B. BentonPres identThe 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 Eitingon

President—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 Gross

Vice President, MarketingComputer Systems & Resources

Arthur LeMayPres identArthur E. LeMay Co.

Jeffrey A. LebowitzVice President for Strategic Planning

Federal National Mortgage AssociationFrederick R. Levy

Manager of Financial OperationsFMR Corp.

Alan LipisPres identElectronic Banking Inc.

Lois MartinVice PresidentThe First National Bank of Saint Paul

John T. McGee

Vice President, Corporate AffairsSecurities Industry Automation Corp.Russell Morris

Assistant Commissioner, Federal FinanceDepartment of the Treasury

Michael RadowSenior AssociateCentury-IV Partners

Louise RosemanRegulatory LiaisonVISA, USA

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C o n t e n t s

C h a p t e r P a g e

1.

2.

3.

4.

5.

6.

7.

8.

9.

1 0 ,

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

Present and Future Technologies Supporting the Financial

Ser vice Indus tr y . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19The Secur it ies In du st ry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

Retail F ina ncial Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97

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

The In t e rna t i ona l Env i ronmen t fo r F inanc i a l Se rv i ce s . . . 153

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

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

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

Future Scenarios for the Financial Service Industry, 1990-95 . . . . . . . . 251Appendix: Glossary of Terms . . . . . . . . . . . . 267

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

i x



C h a p t e r 1

Overv i ew



Major Findings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Industry Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Legal/Regu lat ory Envir onment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Fin an cial Ser vice Delivery Syst ems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Consumer Interests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Safety a nd Soundness of th e Indus tr y . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Financial Services in the Future.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Influence of Technology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Financial Service Providers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Users of Fin an cial Ser vices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Congressional Policy Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .General Policy Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Structural Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Risk Allocat ion Is su es . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4455

66

7788

99

1013

FiguresFigure No . P a g e

l. Organizations Comprising the Financial Service Industry andTheir Pr oducts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

2. Factors Affecting Financial Service Providers . . . . . . . . . . . . . . . . . . . . . . 4



.— — .

C h a p t e r 1

O v e r v i e w

This report focuses on the relationship be-tween t echn ology and change, both past an dfuture, 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 th e 1970’s, an d t he r at e of cha nge 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 Financial

Service 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 Payment

Credit cards InsuranceSOURCE Office of Technology Assessment

The existing legal/regulatory str ucture haroots that extend back 50 years; changes inthe financial service industry have challengedsome of its premises. Since the mid-1970’sCongress has devoted considerable attentioto the financial service industr y and has enacted several major pieces of legislation. Manyof the regulations govern ing the indu stry a rbeing relaxed. However, continued congressional attention is needed because not all othe salient issues have been resolved.

In t he last few years, ban ks legally able toperate outside traditional banking regulationhave appeared; retailers of food and generamerchandise have emerged as major suppliersof finan cial services; cha nges in law a nd regulation have enabled banks, savings and loanassociations, and credit unions to broaden themix of services they offer and enter marketpreviously closed to them. At the same timefirms whose financial service offerings are vir-tually unregulated compete directly with tradi-tiona l, regulated providers.

Information processing and communicationtechnologies are being used to enha nce exising services, to implement new ones, and tmake them available in new ways. Money mar-ket mutual funds, operated by investmencompanies and securities broker/dealers, per-mit shareholders to redeem shares by writ ingthe equivalent of a check. Banks, dependinheavily on information processing and commu-nication technologies, are beginning to offesecurities through discount brokerage subsidiaries. Banks, credit unions, and savingand loan associations join networks of automated teller machines that enable accounholders to obtain cash 24 hours a day frommachines that are available nationwide. Bothsecur ities dealers and banks ha ve developesystems t ha t a llow accoun t h olders with pe

3



4 • Effects o f Iformation Technology on Financial Service Systems

sonal computes to transfer funds between ac- financial service industry. However, other fac-count s, pay bills, and order th e purchase a nd tors such as the legal/regulatory environment,sale of secur ities. 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.

M a j o r F i n d i n g s

The chan ges that have tak en place in th e fi-nancial service industry affect a number of areas including indust ry stru ctu re, the legal/ regulatory environment, financial service de-livery systems, consumer interests, and thesafety a nd soun dness of th e indust ry. Majorfindings in each of these areas are summarizedbelow.

In d u s t r y S t r u c t u r e

q Rapid and dr ama tic chan ge in t he finan cialservice industry will not persist indefinitely.There will be a period of stabilization, prob-

q

ably over the coming decade, after whichthe financial service industry is likely to re-turn to a more orderly evolutionary pattern.Firms are in th e 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 different

from 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 mark ets such as serving the n eeds



6 q Effects of /formation Technology on Financial Services Systems

•

q

q

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

Co n s u m e r In t e r e s t s

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 increasedra nge of choice an d may pa y 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 t rend to explicit pr icing and th eentry of new providers into the financialservice indust ry. However, to tak e 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 a ndinstitutions, 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 somefina ncial service providers. Some ma y 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

q

q

services if they are to be able to functionas members of society.Survey data show that consu mers a re 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-cident s of compromised pr ivacy 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-tr onically delivered financial services bea r

greater responsibility for detecting errorsand initiating the procedures for correctingthem than do customers using paper-basedsystems.

S a f e t y a n d S o u n d n e s s o f t h e I n d u s t r y

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 an d int egrityof fina ncial services system s, 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 q 7

and loan associations, and credit unions. vestments that offer higher return. YetFunds entrusted to other institutions re- based on experience to date, there is nceive little, if any, of this Federal protection. evidence that the fundamental safety anThe changes in the financial service indus- soundness of the industry have been appre-t ry have led to s ignificant movement of ciably compromised by the movemefunds from accounts in insured, closely funds from federally insured accounts.

supervised institutions to alternative in-

F i n a n c ia l Se r v ic e s in t h e F u t u r e

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 curren cy and coin dur ing the last quar terof this century. Some saw particular promisein specific technology-based services (e.g.,super-check, an instrum ent tha t would use oneorder to direct payment to multiple creditors,and t elephone bill payment ) th at ha s 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 servicesth an were available in th e past, much un cer-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 of funds from their accounts to those of mer-chants at the t ime purchases are made. How-ever, the specifics of th e systems th at will beused to implement this service remain open toquestion. OTA’s analysis of general trends be-ing followed by t he finan cial service indu str y

represents many points of view now held bknowledgeable observers.

I n fl u e n c e o f Te c h n o l og y

The financial service industry of the futurwill be quite different. The established trenof increasingly heavy dependen ce on technoogy for delivering services will continue. Serv-ices will be provided by a wide variety of istitutions. Barring a major restructuring oth e wholesale side of the finan cial ser vice idustry, small financial service firms will bable to obta in access t o the t echn ologies th ewill require to remain viable. Although reltively few firms are likely to provide servicnationwide, it is likely that the existence oflarge number of small, specialized financiservice organizations will prevent the few fromdominating the ma rket.

Commun icat ion will be key to delivering fnancial services in the future. Networks grow-ing out of those used to connect shared sytems of automat ed teller m achines are liketo provide the basis of systems permittinelectronic initiation of fund transfers from themerchant’s counter. Systems providing accessto funds from virtually any place in the Ntion regardless of where they are deposited arenow being developed and are likely to be in usein the next few years. Advanced communiction technologies including satellite relayvideo cable, fiber optics and cellular radio willfind wide application in the financial serviindustry.

Decreasing computer costs will create thopportunity for large numbers of individu

35-505 0 - 84 - 2 : QL 3



8 q Effects of Information Technology on Financial Services Systems —

consum ers a nd m ana gers 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,int eractive fina ncial service delivery system sof the future. Computers that accept voice in-puts and recognize fingerprints may becomecost effective for financial service delivery sys-tems by th e tu rn of the centu ry. 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.

F i n a n c i a l S e r v ic e P r o v id e r s

Banks, savings and loan associations, andcredit unions probably will concentrate ontra nsaction 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 th e 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-t ions, such as payments and withdrawals, onlyin exceptional cases.

Securities broker/ dealers, long providers of transaction 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 t he 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.

U se r s o f F inanc i a l Se rv i c e s

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 of corporate 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 conjun ction 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 institu tions may develop an d operat e th enetwork 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 while

jewelry is kept at home rather than in the bankvault). Orders to buy or sell stocks and bondscould be entered from home and executed onan a utomat ed exchan ge. Consu mers ma y 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.



10 . Effects of Information Technology on Financial Services S y s t e m s

tected through a combination of insurance andexamination programs. However, new en-trants into the financial service industry,man y of whom ar e subject t o neith er Federa lnor State regulation, now compete with regu-lated traditional financial service firms. Be-

cause the nat ur e of competition in t he finan -cial service indust ry h as chan ged, traditionalprotections implemented through existing reg-ulation have lost some of their effectiveness.

Regulations applicable to the financial serv-ice indust ry ha ve been eased in recent years.Cont rols on int erest r at es 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-na tively, it ma y modify the out comes of ma r-ket forces to mitigate adverse affects onspecific groups. For example, if the marketwere to compel individuals to ha ve at least oneaccount with a financial service provider, Con-gress might choose to provide a means for en-suring th at al l are able to obtain a satisfactorypackage of services.

S t r u c t u r a l I s s u e s

Consolidation in the Financial Service Industryq What levels of concentration in the finan-

cial service industry are consistent with thegoal of preserving competition a mong pr o-viders of financial service?There are 40,000 banks, savings and loan as-

sociations, and credit unions in the UnitedSta tes. Thousands of oth er 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 insti tutions are enter-ing new markets and competing both amongthemselves, and with other industries, moredeliberately and directly than ever before. New

entrants are providing services in areas that ,in th e past, have been reserved to traditionalfinancial service institutions. In the face of technological 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 r eduction in t he nu mber 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 Bankingq What modifications, if any, could be insti-

tuted regarding restrictions on interstate

banking?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 th ese restrictions an d some Stat es 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 tha n t hey are at present. For example, al linstitutions 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-mat ed teller net works could be r elaxed.

Limitations on interstate banking stemmed,in par t, from concern s th at some ban ks serv-ing regional or national markets could achievean unwarranted degree of economic power and

th at local needs for capital would remain un-met as funds were concentrated in major mon-ey centers. An a lterna tive for addressing t helatter would be to strengthen requirementsthat institutions taking deposits meet needsfor credit of th e ar ea from which deposits ar egathered before funds are made available toregional or national markets.

Market Segmentationq How might law and regulation be used to

focus the attention of various classes of fi-

nancial service providers on specific marketareas?

The existing policy structure more or lesscompartmentalizes the financial service indus-tr y by fun ction. Ban ks m ay ta ke deposits, in-suran ce compan ies may u nderwrite insura nce.Insurance companies may not take depositsand banks may not underwrite insurance.Nevert heless, new ent ran ts to financial serv-ice markets have been able to offer servicesin dir ect compet ition with th ose for whom, inth e past , specific mar ket segment s ha d 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 structurwithin which they must operate.

Congress may choose to resolve this issuby permitt ing banks and other insti tutions tooffer financial services th at ra nge over a broadspectr um, ena bling th em to be more responsive to compet itive offerings of oth ers. Ba npowers could be broadened to include thunderwriting of securities and insurance, foexample. Alternatively, powers to affect merg-ers between financial service providers anfirms from outside the financial service indus-try could be modified. To an extent, this wouldrepresent a continuation of current practice inwhich t he Federal Home Loan Bank Board h aspermitted mergers across State lines betweensavings and loan associations. Under the pro-visions of the Garn-St Germain Act of 1982banks have been permitted to acquire distressed, out-of-State savings and loan assocations.

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

Relationship to Telecommunication Policyq How will further deregulation of telecom

mu nications a ffect t he finan cial service industry?Financial service providers depend heavily

on telecommunications to deliver services ttheir clients; and, therefore, they are sensitiveto chan ges in th at industr y. Many have builand operate sophisticated private telecommu-nication networks. Without adequate telecom-munication capabilities, the financial servicindust ry cannot meet th e needs of its clientsChanges in telecommunication costs have a di-rect and immediate effect on both providers

and users of financial service.The telecommu nicat ions indu stry is u ndergoing 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,an d th e opera tions of th e finan cial service in-dustry will become closer.

The formula tion of telecommun icat ion 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.

Compet i t ion Be tween Regu la ted andUnregu la ted Serv ice Prov ide r sq What steps could be taken to realign the

legal/regulatory structure to make it con-form more closely to the changing structureof the financial service industry?Many fina ncial services offered by un regu-

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 an d net works to commu nicat e 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 ser vice providers, in some circums ta ncesthe 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 an d th e Stat es could becontinu ed. Alterna tively, Congress could fol-low th e model for t he insu ran ce industr y and

defer t o th e Sta tes for a ll regulat ion of finan-cial services. At the other extreme, Congresscould preempt all State regulation of the finan-cial service industry. Regardless of the levelof the Federa l presence, and in cont rast withth e present practice of distributing r esponsi-bility, all Federal regulation of financial serv-ices could be combined a nd a ssigned t o a sin-gle agency. The focus of regulation could beshifted from the institutions providing serv-ice to the functions performed regardless of the 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 Operationsq 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 of which are more stringent than those of theUnited States, may restr ict the int ernationaloperat ions of Amer ican fina ncial service pro-viders. Some n ations have suggested th at 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 cont inue t he pr esent cour se an d tonot expand the privacy protections now inplace. Alternatively, it may adjust privacy lawas it relates t o finan cial services as a meansof redu cing potent ial bar riers t o Amer ican fi-nancial service providers other nations mayraise.



Ch. l—Overview q 1 3 —

Access to the Clearing Systemsq What organizations could be granted access

to the mechanisms for clearing checks, se-curities, and other payment instrumentssuch as credit card drafts?Banks and savings and loan associations are

th e only institu tions with direct access to th epayments system. This may give them a com-petitive advantage over other offerors of checking account substitutes, credit cards,and debit cards. Some securities brokers of-fer a ccount s from which funds m ay be dra wnby 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 insti tution 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 paymentsmecha nism. 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, thefut ure could see t he development an d opera-tion of significant systems for transferringfun ds without t he involvement of bank s an dother t radi t ional providers of paymentservices.

The Federal Reserve System was estab-lished, in par t, to assu re smooth operat ion of the check-processing system. Congress maydecide that the operability of the payment sys-tem can only be assured if it remains undercont rol of the ban ks a nd sa vings an d loan as-sociations. On th e other h and, Congress maychoose to open access to the payment systemto others, such as data processing service or-gan izations, willing t o meet specific crit eria.Or, it may open the system to all who would join without establishing specific criteria formembership .

Ris k A l l o c a t i o n I s s u e s

C o n t r o l o f I n t e r e s t Ratesq What alternatives for regulating interest

rates are available to Congress?Federal controls on the interest rates paid

by 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-port un ities creat ed by new entr an ts t o th e fina ncial service industr y. These new entra nt shave relied heavily on advanced telecommunication and information processing tech-

nologies to implement their offerings. Constr ained int erest r at es effectively limited t hesupply of funds to some classes of investments.In m an y cases, policymakers ha ve reacted t othese 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, regulated interest rates nationwide. Other al-ternatives include maintaining controls oninterest rates paid on federally insured ac-counts and ceding to the States control of alinterest rates paid within their boundaries.

Allocation of Riskq What are the alternatives for apportioning

risk between financial institutions and theircustomers and clients?Deposit insurance protects holders of ac-

counts in covered institutions from loss oassets 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 prin cipal, th ey often carr y a h igher level o



14 . Effects of Information Technology on Financial Services Systems

risk for account holders. However, becauseFederal agencies that insure deposits have preferred t o find mer ger part ners for distr essedinstitutions instead of closing them, depositinsurance has implicitly provided protectionfor stockholders and holders of large depos-its as well as the owners of accounts withbalan ces below th e limits of insu ra nce 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 insur ance has been k ey in t he pol-icy fram ework designed t o susta in t he sa fetyand soundness of the financial service indus-tr y. Congress ma y choose to continu e it in it spresent 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 of risk the insurance program is required toun derwrite. Furt her, deposit insur ance couldbe extended to accounts not now covered.

Lifeline Financial Servicesq

What is necessary to assure an adequatelevel of financial service to all segments of the 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 t o some m inima l set of fina ncial 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 su ch a package of services in-cluding the possibility that all providers of transaction 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 of a policy th at would govern th e tim ing of debitsan d credits t o an accoun t t o ensu re equitabletreatment of consumers may be advisable.

Privacyq Some changes in the delivery of financial

services increase the possibility that the pri-vacy of citizens could be eroded or violated.How can Congress reduce that possibility?Systems that use information processing

and 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 fina ncial services exacer-bates potential t hrea ts t o individual pr ivacy.

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,surr ender pr ivacy to a degree, Congress ma ychoose to require they be provided a statementdisclosing the degree to which privacy is likely

to be compr omised. A program of monitoringand enforcing rights to privacy might be es-tabl ished.



Ch. 1—Overview q 75 —

Security and Integrity of Delivery Systemsq Are additional actions needed to safeguard

the integrity of nat ional payment and t ran s-action systems against risk of disruptionsfrom systems failure, hostile attack, andnatural disasters?

System security a nd int egrity ha ve 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 syst emic failur e. While electr onic system sovercome 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-mat ed system fails. For example, if a ban k isunable to perform routine transaction process-ing because of a system failure, it may not beable to sett le its a ccoun ts with oth er instit u-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 a ltern at ives are available for cont rol-

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 clientsNew combina tions of telecomm un icat ion a ndcomputer processing for delivering financiaservices provide new avenues for theft. Assafeguards are put in place, new methods operpetrating 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 a re h esitant to report incidents of theft involving technology-based sys-tems in fear both of lessening the confidenceof th eir customers a nd of revealing system vul-nerabilities to potential predators.

In dealing with this issue, Congress maycontinue to rely on existing law and law enforcement capabilities. Because the issue is notwell understood, Congress may wish to gatheradditional information regarding the probleman d alt erna tive solutions either before a ctingor following initial steps to deal with the mostsalient aspects of the issue. In the short term,it may modify the law to more clearly deawith the obvious problems (e.g., clarifying the

treatm ent of those who steal data) th at haveaccompanied the inclusion of advanced technologies in systems for delivering financiaservices. 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.



C h a p t e r 2

P r e se n t a n d F u t u r eTec h n o lo gie s S u p p o r t i n g t h e

F i n a n cia l S er v ic e I n d u s t r y



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

Compu ter H ar dwa re Syst ems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Microcomputer Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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

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

Telecomm un icat ions Technologies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .The Swit ched Te leph one Network . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Pr ivat e-Line Telecommu nicat ions F acilities . . . . . . . . . . . . . . . . . . . . . . . . .Alternatives to Switched Networks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Video-Relat ed Communicat ion Techn ologies . . . . . . . . . . . . . . . . . . . . . . . .Future Telecommunication Technologies . . . . . . . . . . . . . . . . . . . . . . . . . . .

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

Specific Techn ologies for Deliverin g Fin an cial Services . . . . . . . . . . . . . . . . .Card Technologies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Document and Currency Readers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Customer Service Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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

Appendix 2A: Har dware Componen ts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Chip Technology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Computer Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Appendix 2B: Systems and Support Software . . . . . . . . . . . . . . . . . . . . . . , .Pr esent Opera tin g an d Support System s . . . . . . . . . . . . . . . . . . . . . . . . . .The Future for Operating and Support Systems. . . . . . . . . . . . . . . . . . . . .

Table

19

2020

2223

252628

303032323334

363638

38384142

43

444444

454546

Table No . P a g el. General-Purpose Application Processors . . . . . . . . . . . . . . . . . . . . . . . . . . .23



C h a p t e r 2

P r e se n t a n d F u t u r e Te ch n o lo gie sS u p p o r t in g t h e F in a n c ia l S er v ic e I n d u s t r y

I n t r o d u c t i o n

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 billionan nu ally), credit card d ra fts (over 3.5 billionannually), and securities trades (over 30 bil-lion shares traded annually) would swamp anymanu al system tha t t ried to handle them. In

fact, during the 1960’s, trading days for theNew York Stock Exchange were shortened be-cause t he broker/dealers were unable to han -dle the workload.

Yet, even with all of its sophistication in theapplication of technology, the fina ncial 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 i tems a minute,all other aspects of check processing are man-ual, and telecommunications is not used in the

check-processing cycle. Checks a re st ill 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 draftsar e manu ally 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 andencoura ge fur th er migrat ion from paper- an dlabor-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 s lowed, 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 stock

ownership provide an alternative.In the future, the costs of hardware used to

implement advanced systems for delivering fi-nancial services will continue their long-termdecline. New technologies such as the proc-essor in a card a nd n ew systems t o establishthe authenticity of the order to execute a fi-nancial transaction will become available. Ingeneral, the ability of the financial service in-dust ry to ta ke advan ta ge of the t echn ology isnot likely to approach the rate at which itbecomes available. There is little cha nce tha t

technology will limit the industry any time inth e foreseeable fut ur e.Historically, the initial applications of tech-

nology “automated’ existing processes. Forexample, the application of computers to ac-count maintenance simply translated exist ingmanual processes into automated ones. Theadoption of MICR* encoding on checks hasdone little to change the way checks are used.Thus, early applicat ion of automat ion in t hefinancial 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 th e fun dament al chara c-ter of the financial services consumed by users.Automated teller machine (ATM) networks,

*MICR—magnetic ink character recognition.

19



20 q 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.

Techn ologies waiting in t he wings ha ve the

potential for changing the basic character of th e systems u sed 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 th e smar t 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 t o understand present and futu retr ends in th e financial service indust ry, 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 chap ter describes the ba sic technologiesthat are and could be applied for delivering fi-nancial services. The purpose is to create anappreciat ion for t he potential an d th e limita-tions of the technologies for facilitating changein t he financial service indust ry. Yet, one mustunderstand that the technologies constitutebut one of a number of forces operating to

shape t he fina ncial service industr y and t hatth eir potent ial may n ot be r ealizable becau seof other constraints that are operating.

C om p u t e r H a r d w a r e Sy st e m s

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 widely

applied for t he delivery of financial services.These large computer systems generally re-quire dedicated facilities and support from anonsite t eam of inform at ion processing pr ofes-sionals. For all practical purposes, providersof financial services can buy computing powerappropriate to their needs from a number of well-established man ufactu rers. Fu rth er, be-cause of the way computer manufacturersdesign a nd enha nce their pr oduct 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 greater

capacity 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.

M i c r o c o m p u t e r S y s t e m s

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 th e greatest impact on th e operat ionsof 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 h as only limited capacity to par-ticipate in a financial service system becauseit has neither communication nor significant

data 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 taxpreparat ion.

A cassette recorder costing about $50 wouldpermit the user to load prerecorded programsand save intermediate results so that theywould n ot h ave to be reentered int o the com-puter manually every time they are to be used.

A disc drive offering fast er a nd more reliableaccess to data and programs can be purchasedfor some units for about $250. A printer thatcan be used to mak e paper r ecords for u serswould cost another $250. Applications theuser may wish to run may require the addi-tion of memory expansion modules that costmore th an th e origina l $100 price of th e com-

puter. The user will, in some cases, have tospend $200 or more on an accessory requiredfor making the connections between the per-ipherals an d th e comput er. 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 with

a computer operated by the financial serviceprovider a personal c o m p u t e r m u s t beequipped 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 t hat can be tr ansm itted over th e 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 of the 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 t he long run . The prices of all 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-tr ibuted video games are on the mar ket, 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 th e fut ur e. Therefore, comput ers th at canbe used by individuals to receive financial serv-ices both at home and work are likely to be wellwith in rea ch of a large portion of th e 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 thatth ey will spend substa ntial su ms if they per-ceive utility in a product. Historically, this ha sbeen true with television; more recently, withvideo recorders. However, it remains to beseen whether a large number of individuals will

be willing to invest in inform at ion p rocessingand telecommunication equipment capable of interacting 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.

L a r g e C o m p u t e r S y s t e m s

While there will be significant changes in the

capabilities of computers at the low end of thespectru m th at will enable a larger nu mber of people to access the technology, changes at thehigh end of the scale will also occur. Speedsof computation and the basic architecture of computers 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 altern at ive tokey input part icularly in telephone-orientedsystems in which the user would use voice toissue payment an d 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 q 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 t o user s will occur . Fu nctions su ch

Table 1 .—General-Purpose Application Processors

1982 1987 1992

Small: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-purpose

building blocks at minimal cost to meet theneeds of specific applications. As a result, notonly will the computers used to deliver finan-cial ser vices 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 th e needs of th e cust omers u sing 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 th e package of products a nd serv-ices being provided, thus overcoming any

hesitan cy to acquire a nd 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 an d int egrity. If onecomponent fails, the probability th at systemoperation will continue at some degraded levelof performance is high. Providers and usersof systems for delivering financial services willbenefit from an increase in t he availability of

*A d~PoS~acceptor would ha ve the capa bilityto count cashand readtheamounts of checks as they ar e deposited.

35-505 0 - 84 - 3 : QL 3



Ch. 2—Present and Future Technologies Supporting the Financial Service Industry q 25

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 an d provide a response timethat ranges from 30 to 90 seconds. PaulHefner of Firs t In ter sta te Ban corp 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, if th ey begin t o handle the t ran saction volumesforeseen by some.

Already, both user s an d providers of fina n-cial services ha ve 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 nu mber 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 degree to which advanced systems for delivering fina ncial services ha ve been a ccepted h abeen the lack of processing capabilities in thehan ds of man y potent ial users and su ppliersThe fact that many potential participants inthe financial service industry are installincomputers for a variety of reasons is creatina latent capability for either using or delivering financial products because the marginacost of such a move could be minimal.

The long-term impact of changes in the capabilities of comput ers on t he u sers a nd providers 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 buying equipment because its cost is droppingThe result is a decreasing marginal cost of en-try for potential users and providers of advanced financial services systems. Higher po-tential levels of participation will encouragthe deployment of advanced systems and, inth e absence of oth er bar riers t o their acceptance, will result in th eir achieving a greatelevel 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 computer technology will most likely continue toutpace the demands of the financial servicindustry, and therefore, lack of sufficient com-puter power will not be one of the factors thatwill limit the development of new systems fordelivering fina ncial ser vices.

S o f t w a r e

A 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 maint enance to ensure th at t heoperations. 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 operais being built, thorough t estin g 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 da ta 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 advent

of new tools for software development, how-ever, should increa se t he pr oductivity of soft-ware professionals somewhat. Furthermore, agreater tendency to purchase an d 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 th e end-user a nd is designed tocarry out functions unique to the particulars i tuat ion.

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.

P r e s e n t A p p l i c a t i o n s S o f t w a r e

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 reta in either in-house sta ff or a consult -ant/contractor to build application packagesuniquely tailored to his needs. Because pro-gram development remains labor-intensive,th is can be a costly process, a significan t por-tion of which is the cost incurred-after thesystem becomes operational-for maintainingthe programs, correcting errors as they are dis-covered, and ma king changes as th e needs of the 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-na nce. Experienced organ izations ha ve foundthat over 70 percent of the resources spent onthese staffs is for maintaining existing sys-tems, leaving only 30 percent for developingnew a pplicat ions program s.

Fina ncial service organ izations ha ve devel-oped a huge body of proprietary software overthe years. Included are applications tha t 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 . Regulat ory changes su ch as t heimposition 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-put ers h as brought th e power of th e techn ol-ogy within reach for the individual user, it hasalso had a n impa ct on t he costs of system de-velopment and maintenance. Consumers nowident ify applications in wh ich t he sm all com-

*Re~lationE is th e Federal Reserve Board Regulation im-plementing the consumer protection provisions of the EFT Acof 1978.




puter can provide significant benefit and eitherwrite the programs themselves or with helpa t minimal cost. Generally, the small packagesfor personal computers which result are usedfor a nalytical applications th at ar e often ta i-lored t o the specific work ing ha bits of th e 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-trat ive tasks that require the manipulation of large 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 marketdat a an d generate informa tion 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 th e 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 forth eir own u se an d later offered to oth ers. Inother cases, the package was developed to bemarketed commercially. In this environment,all benefit because the costs of development

and maint enan ce are potentially spread overmultiple users.

Systems for processing checks and servic-ing deposit accounts and outstanding loanshave been developed by both financial institutions and data-processing service organiza-

tions a nd ar e widely used th roughout th e industry. 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 meet ing his n eeds and th eneither modify it with internal resources or re-tain the original developer or another party tomake the required chan ges. This approach hasthe disadvantage for both the vendor and theuser that multiple versions of a basic package

must be supported. Costs and difficulty omaint enan ce are both increased as,almost in -variably, the m odifications ma de periodicallyto the basic packageand the changes made tomeet specific user needs generateconflictsthat require basicchanges in the software toresolve. Some marketers of software systemsmitigate this problem by including featuresthat permitthe user to customize the packageat specific points inthe processingcycle 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 smalcomput ers t han with lar ge. However, operators of large installations are turning with in-creasing frequency to generalized softwarepackages. Prepackaged software for microcomputers has enabled significant numbers of users in the financial service industry to applyinformation processing and telecommunication resources to the operation of their businesses without needing to become proficientechnically 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 operated 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 periphera l ones in distributed pr ocess-ing environments.

Experience has shown that safeguardsagainst copying or modifying software caneasily be circumvented by individuals whohave a moderate degree of technical sophisti-cat ion. This pr esents a pr oblem t o operat orsof systems for delivering financial serviceselectronically to a large number of people. If the 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 system

operator and other users.One way to avoid this problem is to distrib-

ute software in cartridge form, in the form of hardware, a technique that is being tried byat least one marketer of home banking serv-ices. Although this minimizes the chances of modifying the softwa re, user s whose comput -ers do not accept cartridges are eliminatedfrom the market. Moreover, it does nothing tostop the potential intruder who obtains thefunctional specificat ions of th e cart ridge or isable to copy the program from the cartridge

to 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 mak e th is medium of softwar e dis-tribution more widely accepted for financialservices.

A p p l i c a t i o n s S o f t w a r e i n t h e F u t u r e

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-

plicat ion program s will cont inue t o evolve. Inth e near term , the empha sis 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 usersan d pr oviders of services in order to improveoverall management of financial resources.Even where batch pr ocessing is most desira-ble, tra nsaction da ta will be ent ered intera c-tively and accumulated until a batch process-ing program designed to han dle 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 th e needs of classes of individua ls onthe assumption that the requirements of mem-bers of a group for comput er su pport ar e ap-proximately the same. This assumption holdsfor people engaged in routine activities, butit ten ds to break down at th e upper levels of organizations. In t he futu re, generalized sys-

IThematerial in this section draws heavily on the report,“Future Information Processing Technology -1983° preparefor the Institute of Computer Sciencean d Technology and theDefense Intelligence Agency.

*Batchapplications me those when data are a ssembled overa period of time and are processed periodically, frequently oa fixed cycle.



Ch. 2–Present and Future Technologies Supporting the Financial Service Industry q 29

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 comput er user online and th e forma tto 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 instr uction is needed a ndw-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 th e forma t in which da ta 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 deviceatta ched to a computer t hat isused instea d of keys to control the movement of the cursor, th eindicator on a video display that indicates wher e the n ext char-acter will be formed.

“Windowing” technologies that permit theuser to display the results of multiple processes simultaneously on the screen will improve the u tility of the t echn ology to the u sers.They will allow the users to concurrently viewdata from multiple sources and select thosei tems most useful to the task at hand. For ex-ample, the user may use one window to reviewth e sta tu s of a t ran saction a ccount , a secondto project cash flow, and a third to enter anorder with a broker/dealer to buy or sell a secu-rity u sing a telecommu nicat ion line t ha t connects 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 problemsolving session, a microcomputer will be usedto access a data base on a large computer sys-tem, retrieve the da ta needed to address theproblem, and store it locally on a small discApplications running on the microcomputewill perform th e required a nalysis, and a fterthis h as been completed, the centr al dat a basewill be modified as r equired. In fact, in somorganizations, 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 industrythis could mean that financial advisors andcoun selors will be augmen ted, or possibly replaced, by automated systems. Research inartificial intelligence and expert systems hasshown some valuable results. However, thereis considerable uncertaint y about when suchsystems will be sophisticated enough to havan operational impact on the financial serviceindustry.




Te l e c o m m u n i c a t i o n s Te c h n o l o g i e s

Telecommun icat ion 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, an d local a rea networks.

The divestitu re of the operating t elephonecompanies by American Telephone & Tele-graph (AT&T) in 1984 substantially changes

the 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 as

remote ban king an d shopping an d off-mar ketsecurities t ra ding 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 commun icat ion technologies. Chan gesin the technologies, policies, and economics of comm un icat ion will directly a ffect th e designof systems for delivering financial services, thecost schedules facing both users and providersof financial services, and, hence, the structureof the financial service industry.

T h e S w it c h e d Te le p h o n e Ne t w o r k

The most widely available communicationfacility is the switched telephone network thatserves virt ua lly every place of work an d 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 t o handle a relatively large num ber of




P r i v a t e - L i n e Te l e c o m m u n i c a t i o n sF a c i l i t i e s

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 th e points t ha t m eets specifiedelectrical characteristics. This eliminates theproblems of uncerta in qua lity a nd relativelyslow access* when dial-up lines are used. Whilethere is no assurance that the same physicalcircuit will be made available a t a ll times, ortha t the signa ls will not be mu ltiplexed 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.

Institu tions with sufficient n eed 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 t ra nsponders on commu nicat ion

satellites, and others ha ve leased circuits onvideo cable systems. Financial service orga-nizations are among the heaviest users of thevideo cable that ru ns from midtown Manha t-tan to the Wall Street area in New York City.Aetna Insurance Co. is one of the three pri-mary partners in Satell i te 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 of the teleport installation planned for New York.

*Thetime requiredto dial a number~d go through t he log-on procedures that must be used in a dial-up environment.

Fiber optics offers gr eat er capa city an d 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 var iety of commun icat ion services,including the transmission of both voice anddata. Digital, private, automated branch ex-cha nges are being insta lled to man age 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 mayha ve access. The user of a local ar ea networkwith gateways to the switched telephone net-work has access to all of the data and proc-essing resour ces th at comprise t he local n et-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.

A l t e r n a t i v e s t o S w i t c h e d N e t w o r k s

Because the switched telephone network,where “hard” connections are established andmaintained for the duration of a conversationbetween the parties, is not particularly wellsuited to tr affic tha t is char acterized 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 as

others that use interactive computer facilities*EIWtronic m ~ is the technology Of Sendingmess%es e~ec-

tronicallybetween compu ters. 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 nu mber of point s between wh ichonly limited traffic volumes pass. Because itis oriented to handling messages that are fairlyshort in length an d ar e spread over consider-able periods of time, packet switching is par-ticular ly suited t o the t ype of tra ffic 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 of interest 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 justifyth e expense of a dedicat ed line. For exam ple,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 t he m ercha nt s access to POS servicesat lower costs than if communication serviceswere paid for independently. This could bedone by connecting to a specific institution,th us eliminat ing choice of a financial ser viceprovider for individual tenants of the shoppingcenter. On t he other h and, th e shopping cen-ter owner could conceivably provide access toa gat eway that would permit individua l mer-chants almost unconstrained freedom in se-lecting financial service providers.

Vi d e o - R e l a t e d C o m m u n i c a t i o nTe c h n o l o g i e s

Considerable attention has been given in re-cent years to using technologies built aroundsome modification of the common television

set for distributing information, including financial services. The services offered are gen-erally built around alphan umeric displays oinformation that fill one television screen. Thequality of graphic capabilities varies from sys-tem t o system, but none presently offers an ysignifican t degree of an imat ion. H owever, withsome systems, computer programs will betra nsmitt ed to the u ser ’s term inal at relativelylow speed and then executed in the customer ’sterminal to produce animated graphics. Oneapplicat ion for t his t echn ique is the distribution of video games; other applications are

likely to follow.While video-based systems have been some-

what accepted in Eu rope, th ey are still in t heexperimental 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 term inal capa ble of part icipating in the system. Three general types ex-ist: teletex, videotex, and cable television.

In teletex, fram es are tra nsmit ted 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 essentially a one-way system because there is neither 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 l imited capac-ity of the channel would effectively limit suchan application. Full-frame teletex, an alterna-tive to transmitting the textual information

during the blanking pulse, is the dedication of a 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 pr ice quotat ions, bu t it would not bepossible to tailor the information to the needsof a specific subscriber. Transaction initiation,except t hrough t he u se 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 t o tr an smit th e required informa tion t ousers, 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 persona l comput er display. A verylarge number of frames is available, and it ispossible to char ge for each fram e viewed (theuser requests specific fra mes). Some a pplica-tions, su ch as th ose related to finan cial serv-ices, permit the user to enter data that is thenprocessed (e.g., a mortgage amortization

schedule 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 tha t h as 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 th e program being tr an s-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 transferredra pidly and loaded int o a user ’s compu ter forprocessing at a convenient time.

F u t u r e Te l e c o m m u n i c a t i o n Te c h n o l o g i e s

Genera lly, telecommun icat ion 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-tr y 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 will

mean that users of telecommunication serv-ices will be able to interweave voice and vari-ous forms of data on the same circuit. Systemsth at offer t hese capabilities to comm erical cus-tomers are being marketed. For example, a fi-nancial service consultant is able to send atable of data showing the expected results of altern at ive investment opport un ities 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 an d will reach fruition somet ime before theend of the century. An ISDN is a network inwhich all traffic is represented digitally, andvarious types a re freely mixed a s t raffic 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, while

there is now no compelling reason for makingISDN generally available to consumers, thereis a dist inct possibility th at 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 t ran smitt ing 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, ” th at shar es man y concepts with it, ma ybe provided with a s ingle high-capa city 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, whileoth ers may allocat e a port ion to data and a n-other to voice. Allocations could be changeddynamically in response to user needs. At onepoint , several people could be us ing t he facil-ity for a number of simultaneous conversa-tions, which could include conference calls. At

another point, a single user could use pa rt of the 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 da ta 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 h omes and places of business, will be ableto have telecommunications delivered over at

least two types of networks, switched telephone 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 tr an smission capacity of a cable i

much greater than that of most ordinary telephone 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 otelecommunication technologies in designinand 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 th e capacity of the pr esent telephoneplant are evolving. For exam ple, dial telephone

lines are now routinely used to transmit at2,400 bits per second, a r at e th at could not berealized with acceptable error rates severayears ago, and r ates a s high as 9,600 bits pesecond ar e becoming possible. Switched t elephone networks are expected to evolve slowlyfrom conventiona l copper wires t o fiber opticircuits. Fiber optics have transmission capac-ities far greater than those of the present cop-per conductors. However, as is now the casesome network segments will always be carriedby radio transmission, as exemplified by thuse of microwave and satellite facilities.

Technologies such as cellular radio and dig-ital termination services are now being offeredcomm ercially for th e first time. These ar e expected to come into widespread use by themid-1990’s. In addition, direct broadcast satellite systems will soon become operationaand may be used in some systems for delivering finan cial ser vices.

There will be a diversit y of telecommun ication 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 facilities. Gateways between pr ivate n etwork




and public transmission facilities are nowalmost mandatory. Thus, users and providersof financial services will be able to communi-cate between an d am ong th emselves with m in-imal concern for the particular technologiesused in implementing financial service sys-

tems. The emergence of oth er a lterna tives 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 of options 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 t he n eed 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 mostadvant ageous price. To th e degree tha t com-mu nication cost s become r elatively 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.

S y s t e m S e c u r i t y a n d I n t e g r i t y

Security has long been an area of concernto providers and users of financial services.Traditiona lly, banks ha ve been cha racterizedby large metal doors and imposing vaults withmassive and complex locking mechanisms. Fi-nancial service providers stress the safety of assets in at tr acting cust omers, 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 t ha t r elate to th e basic soun dnessof 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.

S y s t e m S e c u r i t y

As demonstrated by the young people inMilwaukee in 1983, it is not difficult for in-dividuals with m inimal equipment a nd tr ain-ing to penetrate some computer systemswhich contain sensitive information. In theMilwaukee caper, one of the computers com-promised, using a common home computer

and telephone line, belongs to a major westcoast bank . Other inst ances of penetr at ion of computers used by providers of financial serv-ices are on record; and some experts believeth at only a relatively small portion of th e secu-rity breaches that occur are detected, andfewer are reported outside of the victim orga-nizat ion.

Historically, embezzlers from within andcheck forgers and confidence artists from with-out have th reat ened th e financial service in-dust ry. Comput ers, par ticularly t hose acces-

sible through telecommunication networks,add new dimensions to th e vulnerabilities of



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

their own processing systems can directly vic-tim ize those inst itu tions’ clients. A th ief 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 th e account holder. When t he t hief ’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 with in and outside th e tar get 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 performoperat ions n ot a ut horized to them or misusepowers with which they are entrusted.

Program mers h ave writ ten codes tha t creditthe fractional cent from an interest computa-tion to th eir personal accoun ts and fail to re-port properly the overdraft conditions in thoseaccounts. Some programs to perform unau-th orized operat ions destroy th emselves 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 EquityFun ding case, a ta sk th at 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 th e 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 attackfrom any telephone, including those in moterooms and pay stations, from which they couldoperate undisturbed for brief periods. At leastone computer now on the market fits nicelinto a large purse an d can be used t o initiatan att ack on a financial institu tion from anlocation where a standard modular telephoneconnector can be found. Some devices can bset up to operate unattended, and then retr ieved.

Not all attacks on financial service systemsmust be so sophisticated. Individual consumers of financial services and various user oganizations have demonstrated a marked yetunwitting ability to aid the thieves who wouldvictimize them. Personal identification numbers (PINs), given to account holders to usin depositing and withdrawing money fromATMs, are written on access cards. Telephonenu mbers a nd k ey access codes are written ocommunication terminals and bulletin boardsin clear view of those unauthorized to havthem. In one instance, an enthusiastic user of an ATM demonstrated the use of the machineto a complete stranger and, in the process, re-vealed his PIN to all within20 feet. A vari-ety of comparatively simple scams, that rangefrom asking individuals for P INs an d th e usof their cards to retrieving used carbons show-ing account numbers from the trash cans oorganizations that accept cards in payment of accounts, h ave been u sed to compr omise finan -cial service systems.

Computer-to-computer communication inow used to init iate and execute a substantialnumber of financial transactions, a practicthat will become more widespread in the future. 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 ohu man users. Although under study, no suctechnique has emerged that shows promise forwide adoption by the financial service indutry. Finding a solution that will be acceptablefor use by individua l consumer s an d others notsophisticated in the design and operation



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

advanced technological systems constitutesthe most difficult subset of problems in thisa r e a .

Providers of financial services, aware of thethr eats 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 of data 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. Physicalsecur ity ar oun d compu ter facilities is t he focusof considerable attention, and research de-signed to overcome the kn own weaknesses of the PIN as an access code is continuing.Nevertheless, human ingenuity and fallibilitywill probably counteract attempts to providefoolproof security for computer systems.

Sys tem In tegr i ty

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

tions will be int errupt ed for a per iod of time.Such interrupt ions m ay be the result of at tackby 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 pr oblem of providing for system int eg-rity is largely a technical one. Increasing useof telecommunications adds new dimensionsto the problem, but a number of well-acceptedpractices aimed at ensu ring 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.

S p e c i fi c Te c h n o lo g ie s f or D e li ve r i n g F i n a n c ia l S e r v ic e s

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 a nd checks th at a reunique to the financial service industry.

Card Technologies

Embossed/Magnetic Stripe CardThe embossed plastic card with a strip of

magnet ic ta pe embedded in t he 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, th e car d is presented a t t he point of sale,and an impression is taken on a paper docu-

ment th at is then processed. Most often, th econsumer 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 n ot enough room t o record tra nsactiondata. Technologically, however, there is no rea-son why data on the stripe could not be alteredafter issuance. On the other hand, the l imitedcapacity of the stripe and the cost of deploy-ing sufficient t ermin als with th e capa bility of




also have the capabilities of a credit card. Itpresently replaces proprietary ATM accesscards . A full-scale P OS pr oject is expected t oget un der wa y 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 globalnet work of ATMs and to goods, ser vices, an dcash a t m an y locations. Aut horizat ion 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 smar t cardcont ains processing capabilities t hat enha nceits security and flexibility. A standard for itsformat has recently been adopted, eliminatingsome of the uncertainty that may have beenlimiting its a doption. The u ser plugs th e cardinto a terminal that then queries the cardmemory as par t of the pr ocessing to validatethe transaction. Once authorized, the transac-tion da ta can be recorded in the card’s mem -ory for la ter retr ieval. 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, th e fut ur eof the sma rt car d is uncerta in. 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 term inals 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-ificat ion of the convent iona l plast ic car d 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 institutiontermina1 could be provided.Such a card could include in its functions t heability 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 smar t card could evolve as an altern a-tive to cash following the general model of thefare card used by some subway systems, in-cluding that in Washington, D.C. The user

could “char ge’ th e card with fun ds from a de-pository accoun t a nd t he 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 a bility to obtain t he equivalent of cash. Card reader s could be provided at eachcash r egister or POS t ermina l 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-na tion 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 t o accept th em a lso. As the facil-ites for online transaction authorization anddirect debit of account s from point of sale a redeployed 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 an d inject it int o a system being a t-tacked, the user’s “key” will have been com-promised. When t his ha ppens with a conven-tional PIN, a replacement code is issued an d

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 datstream associated with a system that uses thesignature dynamic is compromised, a possible

replacement could be some alternative phrasewith which the user identifies himself.

Document and Currency Readers

The cost of processing billions of papeitems is becoming prohibitive for an industrlosing some of its principal sources of revenue,and the pressure to find lower cost procesing alter na tives is inten se. Readin g of checkencoded with magnetic ink has been common-place for over a decade, and credit card vouch-ers are generally transferred to magnetic tape

for processing. However, aside from some lim-ited applications such as making change, fnan cial documen t r eaders ar e in very limiteuse in the United States.

One of the major suppliers of ATMs has an-nounced a model that will accept and timstamp individual checks. It will also be abto dispense currency and coin in any amount.Models that accept and count Japanese curency are already in use. Thus, the technologyto provide deposit verificat ion by th e ATM

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 t he horizon a nd is likely to increa sethe utility of these machines substantially.

Systems th at process credit an d debit cardtransactions already truncate the paper flowat the earliest practical time. Instead of mov-ing paper, the dat a a re recorded on magnetic

media 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 if needed. 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?

C u s t o m e r S e r vi c e E qu i p m e n t

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 of transactions, 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 q 43

its and dispensing cash. The functional capa-bilities of these machines are continuing to in-crease and they are becoming capable of handling increasingly diverse kinds of transac-tions. Counter to this trend, however, some in-stitutions are making available specialized

machines 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 th at ha ve a wide ran ge of capa-bilities. Some ma y be of limited pur pose, 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 t he futu re, a n umber of “cust omer workstations” could be available in a lobby areaThese could be configured so that the custom-er could sit a t a desk and accomplish a n umber of tasks, including making a deposit owithdrawing funds. Then, when the bulk of the

work is finished, the customer could go to device supporting many terminals that accepts the deposit or another that would dispense cash. Express t erminals for cust omerwith limited needs could also be provided.

Bank branches without human tellers aroperating, and some institutions are shrinking their networks of full-service branchesSome of these automated branches providonly telephone communication for the customer in need of assistance. Others arman ned by a cust omer repr esentat ive who iavailable to answer questions and markeservices, but who performs none of the tellefunctions, such as accepting deposits or paying withdrawals.

Tec h n o lo gy a n d t h e S t r u c t u r e o f t h eF i n a n c i a l S e r v i c e s I n d u s t r y

One of the impacts of present and futuretechnologies on system s 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 th ey ha ve access t o facilities for clear ingan d sett lement, movement of fun ds electr on-ically mak es it possible to avoid t he t radit iona lpayment system an d to effect n et sett lementdirectly between members of a communitythat have agreed to the necessary implement-ing conventions. Alternative means of distrib-uting information could diminish the role of brokers for such varied products as securities,real estate, and insurance. Telecommunicationsystems t hat 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 sta tions, are motivated by lossefrom bad checks an d card fraud t o take step

that minimize their exposure. For example, anATM in a supermarket has the potential forelieving the requirement to cash checks whileminimizing the amount of currency and coithat is held at each store location and subjectto theft.

On the other hand, what is technologicallfeasible may be neither possible nor desirable.Consumers may balk at accepting new service delivery mechanisms. Legal/regulatory con-straints may limit options, and the potentiproviders of the services may opt not to implement them for any of a variety of reasonFurther, changes in the technologies modifthe par ameters th at bound system design aternatives. Those that are attractive now maybecome undesirable in the future, while nealternatives not now feasible may emerge.




Ap p e n d ix 2A: H a r d w a r e C o m p o n e n t s

C h i p Te c h n o l o gy

Th e 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 of storing 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 comput ers and larger units separa te 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 t ha t ar e 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-conn ection between chips which is one of th e 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.

Co m p u t e r S ys t e m s

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 th at st ore data and pr ograms 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 i ts 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 u ser comm unicates 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 of billions 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 a s 1,000 chara cters of inform at ion, wh ilelarge 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 fina ncial service ap plicat ions both by in-dividual users and providers of financial services.Even though some financial service applicationscan run on comput ers with a s l i t t le 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-

Ap p e n d i x 2B : S y s t e m s

P r e s e n t O p e r a t i n g a n dS u p p or t S y s t e m s

The sophistication of system s an d 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 softwar e packages tha t pr ovide extens ivecapabilities to those capable of using them. Thisis to be expected becau se th e larger compu ter 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 alloperat ions, a nd t he ser vices of a complex opera t-ing syst em would be of only limited ben efit. How-ever, operating systems even for the smallest com-

puters are expanding in terms of the capabilitiesoffered.Twenty years ago, systems software and some

support 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 of years, 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 ter ms of the direct cost and overhead imposed.These softwar e packages can soak u p a consider-able portion of available computer resources. Thus,a small system with support facilities limited to

a s ingle applicat ion may, in s ome 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 q 45

end. For example, the interchangeable floppy dused with a computer having 48,000 or so char-acters of main memory will have a capacity of 100,000 to over 1 million characters. Hard, noterchangeable 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.

a n d

Data

S u p p o r t S o f t w a r e

Base Management SoftwareData base management systems consti tute a

specialized software technology of particular im-portance to providers and users of financial serv-ices. This software facilitates the tasks of orgaing and accessing large quantities of data whererelationships between the various elements com-prising a data base are complex and where divcommunities of users access various subsets of the 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 fthe application programs that access them andsignificantly improve system integrity and secu-rity. Depending on the data base system, users be limited to accessing only specific data elemand further, the operations permitted them cancontrolled 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.Perm ission t o add new elements to a da ta basebe denied both of these groups and given, instto other units within the organization.

On the other hand, data base management tems “put all of the eggs in one basket” in that

much of the data critical to an organization is centrated in only a few data bases. Compromiseof a da ta base ma nagement system can lead tonificant damage to the organization that is af-fected. In such an environment, the organizationcan become vulnerable if management does not



46 . Effects of /formation T e c h n o l o g y o n Financia l Services Systems

fullyuse 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 of system security and integrity than possible whencollections of individual files are used by each ap-plication system.

Software Development ToolsThe rate of productivity increase for application

programmers 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 t o write a nd t est new programs a ndmodify 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.

Perha ps the ma jor breakt hrough has been inprogr am merless 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.

T h e F u t u r e f o r O p e r a t i n g a n dS u p p o r t S y s t e m s l

Support functions such as telecommunication,dat a m ana gement, allocat ion of har dware re-sources, and job scheduling will be performed byhighly modular support software. More functionsnow perform ed by th e opera ting 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 of transactions 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-ti ty 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 systems

for 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—

put ers ar e being implemented on sma ll ones. Onemanu facturer h as a dded to its pr oduct 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 ma ny operat ing environment s. The emergence

of such capabilities is foreshadowed by some of theoffice system s t hat ar e alr eady being deployed bysome m anufactur ers.

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 pr ocessing functions and reportgeneration that will be required. Some installa-tions are already approaching this state.

Tools for syst em development and ma inten ancewill be of growing importance over the coming dec-

ade. As more generalized functions are moved intothe ha rdware, the operat ing system an d supporsoftware, the tasks required of applications programmers will be simplified and, hence, less costlyto accomplish. A key element in realizing the ben-efit of this technology will be the ability of management and t echnicians to understa nd its capa

bilities and apply it intelligently in supportingapplications systems.The same system development and maintenance

tools that will benefit professional technicians willalso help end-users interact directly with computerand comm unication systems with out th e need fointermediation 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 applying the technologies that will be at his disposal.



C h a p t e r 3

Th e Se cu r i t ie s I n d u s t r y



C o n t e n t s

P a g eStructure of the Securities Industry . . . . . . . . . . . . . . . . . . . . ... , . . . . . . . . 51

The Development of the Securities Industry in the United States . . . . . . 51Organizations Composing the Securities Industry . . . . . . . . . . . . . . . . . . . 52In du st ry U ser s.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57

The Regulatory Structure of the Securities Industry . . . . . . . . . . . . . . . . . 59Cha ra cterist ics of the Secur ities In dustr y . . . . . . . . . . . . . . . . . . . . . . . . . . 62New Ent ra nt s t o the Secur ities In dust ry. . . . . . . . . . . . . . . . . . . . . . . . . . . 63The Securit ies Indust ry an d th e Int erna tional Market . . . . . . . . . . . . . . . 64The Effects of Information Technology on the Structure of the

Secur ities In du st ry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64

The Functions of the Securities Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64The Secur ities In dus tr y as an Advisor.. . . . . . . . . . . . . . . . . . . . . . . . . . . . 65Acceptance of Risk by the Securities Industry . . . . . . . . . . . . . . . . . . . . . . 67Market ing by th e Securit ies Indus tr y . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69Technology and the Functions of the Securities Industry . . . . . . . . . . . . 75

The Effects of Information Technology insecurities Instruments . . . . . . . 75Appendix 3A: Securities Instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76

Corpora t e Cap i t a l S t r uc t u re : Deb t a nd Equ i ty I s su es . . . . . . . . . . . . . . . . 76Shor t -Term Debt–Money Mark e t Secu r i t i e s . . . . . . . . . . . . . . . . . . . . . . . . 83Opt ions an d Fu tu res Con tr ac t s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .84

Appendix 3B: Capital Formation and the Functions of theSecur ities In du st ry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91

Pr ivat e Sour ces of Fu nd s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92Vent ure Capit al . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92Public Offerings of Securities of a Corporation . . . . . . . . . . . . . . . . . . . . . . 93

Tables

Table No . P a g e

2. Contracts Traded-Futures Exchanges: A Comparison of 1983 and 1982 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56

3A-1. Meet Active Venture Capitalists, 1982 . . . . . . . . . . . . . . . . . . . . . . . . . 93

F i g u r e s

Figu r e N o. P a g e3. 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



C h a p t e r 3

T h e S e cu r i t ie s I n d u s t r y

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 of facilitating the development of capital. It pro-vides advice, accept s risk , and offers mar ket -ing services to ensure that an orderly marketfor the issuing and trading of securities* ismaintained.

XFO~ PUW{)=S of this study,securities include debtand equityissues used to develop capital (stocks and bonds, money-market

securities, and instruments which have been developed to allowhedging and speculation in securities and commoditymarkets—i.e., options and futures contracts). These instru-ments, as well as investment tools which developed from thepackaging of securities instrument s, such as mutua l 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 information on which the operations of securities industry 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 t his chapt er, the st ructure, functions, andinstruments of the securities industry are de-scribed. The impact that the application ocomputer and communications technologieshas had in these areas is reviewedble future effects are discussed.

S t r u c t u r e o f t h e S ec u r i t ie s In d u s t r y

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-mat ion t echn ology on t he st ructur e of th e in-dustry will be discussed.

The Development of the SecuritiesIndustry in the Uni ted States

The securit ies 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 t he

and possi-

same t imethe need to finance development in the newNation was recognized. The burgeoning secu-rities indust ry provided a vital link to Eu ropean capital markets and also a means oftransferring capital within the United States.The basic role filled by the securities industry 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 informationTwenty-four brokers, conducting trading undera buttonwood tree, subscribed to a brokersagreement 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 “ButtonwoodAgreem ent , ” th e 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.

Ear ly 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 pra ctical 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 wer e first used t o convey order s 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.

O rg a n i z a t i o n s C o m p o s i n g t h eS e c u r i t i e s I n d u s t r y

Three types of organizations traditionallycompose the secur ities industr y: 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 BanksThe activities of investment banks ar e cen-

tered on the development of capital. The Bank-ing Act of 1933, commonly called “Glass-Stea-gall, ” required that investment banking besepara ted from commer cial bank ing becauseof the sometimes incongruent objectives and

the different levels of risk associated withthese kinds of organizations. Investmentbanks fall into two categories: originatingfirms and distribution firms. Originating firmsdeveloped lar gely as interm ediaries betweenEur opean financiers and young American in-dustr y, and t hey remain ma jor players in th edevelopmen t of securit ies offerings. Distr ibu-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, &Curt is (Pa ine Webber) have a significant shar eof 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 governmentsth at pur cha se investmen t ban k services; sec-ond, the investors in new issues; and third, theintermediaries who bring these two partiestogether—other investment bankers, distri-

‘NewYork S t o c k 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.

4SarnuelL. Hayes III,“The Transformation of InvestmentBanking, ” Harvard Busines 12ew”ew,Ja nuary-February 1979,pp. 153-170.



Ch. 3—The Securities Industry q 53

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

The nature of competition within invest-ment banking is changing. Price competitionis cutting fees for underwriting to new lows.In addit ion, simplificat ion of secur ities r egis-trat ion 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 HousesFull-service brokerage houses perform trades

in securit ies 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 of companies 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; Prudent ial Bache; Dean Witt erReynolds; 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 commissionrat es in 1975. While brokerage houses in t hepast competed on the reputation of their re-search and the quality of their service, pricecompetition has also become a factor. Dis-coun ters, who concentra te on t he t ra nsactionside of the business, have entered the marketand have attracted a significant portion of both institutional and individual trading. Inresponse to this market entrance, many full-service brokerage houses ar e tak ing steps todistinguish their services and to increase cli-ent loyalty. Increased efforts are being di-rected toward pr oduct development an d pro-motion.

ExchangesThe fundamental role of all exchanges in the

securities industry is to provide an orderlmarketplace for trading. Exchanges provida central location and a structure in whichbuyers and sellers can conduct trades. Exchanges are operated on a membership basis.“Seats,” memberships t hat carr y the right ttrade on an exchange, are purchased by firmsor individuals desiring access to its marketMembers agree to direct all trades on listesecurities through the exchange floor. Thiallows the exchan ges to man age the ma rketbetter–for example, to halt trading on a security, if necessary, with the assurance thamember firms will not trade off-marketStocks and bonds, options, and futures contracts are usually traded on separate exchanges. This specialization is a carry-ovefrom the separate formation of capital andcommodity markets.

Stock Exchanges.–Stock exchanges are in-dependent players in the securities industrand have two functions: performing transactions and accepting risk. Stock exchanges acas a secondary securities market for both debtand equity issues, providing flexibility anchoice for investors. Potential investors in newissues can evaluate t he desirability of th e instrument in light of their ability to sell it, andtherefore may recognize a lower opportunitcost. The existence of secondary markets alsoincreases the available investment choicesince securities other than new issues are madeavailable.

There are seven major stock exchangesNew York, American, Boston, Cincinnati, Mid-west, Pa cific, and Ph iladelphia. In 1982, 80.percent of the total share volume of registeredexchanges was traded on the New York StockExchan ge (NYSE). The Na tional Associat ioof Secur ities Dea lers, In c. (NASD) opera tes quota tion system a nd clearing facility for t hover-the-counter market. The automated quo-tation system, NASDAQ,5 has been responsi-

5NationalAssociation of %curitiesDealers Automatic Quotation 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

75,000

72,50070,000

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.

O p t i o n s E x c h a n g e s .–The goal of optionsexchanges is to provide a continuously com-petitive and orderly mar ket en vironmen t 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 t raded ba sed on factors su ch a s

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

Photo credit. New York Stock Exchange

The trading floor of the New York Stock Exchange: 1984

th e num ber 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-cha nges compose th eOptions Price Reporting

Authority (OPRA). Trading information fromall of th e options excha nges is coordinat ed inOPRA’s automated last-sale reporting sys-

tem. This system, developed a nd operat ed 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 pr ice auct ions on the t rading floo

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 toensur e th e existence of competitive ma rket sfree of price manipulation for the trading of

The exchanges are operated on a membershipbasis, and exchange regulations and policiesar e set by th eir boards of directors a nd su b-

ject to approval of the Commodity FuturesTrading Commission (CFTC). There are manyfutures exchanges in the United States. Thelargest is th e Chicago Boar d of Trade, whichin 1983 handled 44.89 percent of total tradingvolume (see table 2.)

‘Futures Industry Associates, Inc., “Roles Played by Participant, ”Futures Tradin g Course and Han dbook, Wash-ington, D. C., 1983, p. II-4.

35-505 0 - 84 - 5 : QL 3




Exchange1. 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 . . . . . . . . . . . . . . . . . . .

1983Contracts62,811,52337,830,04420,014,597

4,876,0693,926,5893,510,2853,166,5371,703,1051,693,042

379,60713,542

139,924,940

Percent44.8927.0414.30

3.482.812.512.261.221.210.270.01

100.00

1982Contracts Percent Rank48,206,790 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 Indus t ry q 57— — — — —

The exchanges play a major role in self-reg-ulation of the futures industry. In this rolethey are required to perform four activities:surveillanceof mar ketactivity to detect andprevent situations conduciveto price distor-tion; surveillance of trading practicesto detectand prevent trading abuses; investigationof rule violations and customer complaints;andexaminationof mem bers ’ booksand records.8The 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 roleof th eexcha nges willbe-come more complex. Information technologyis being appliedto facilitatethe operationsof the exchanges and will playan increasinglyimportant role in their activities.

Industry UsersThe demands an d characteristics of users of

the industry are major determinantsof indus-t ry structure. The organizationsof the secu-rities industry serve a s intermediaries betweentwo sets of users: capital seekersand in -vestors .

Organizations Seeking Capita lWhile the focus of much of the activity of

securities industryis on secondary markets,the un derlying demand for capitalis the rea-son the industry exists. In 1982,the value of new issues of commonstock publicly offeredwas $23.4 billion;new, publicly offered debtobligations totaled $45.2 billion. Private place-ments of debt a nd equity totaled $22.3 billion.As the U.S. economy completesit s evolutionto an informat ion economy,it ma y beexpectedthat 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 access

to their capitalthan everbefore becauseof theeffect of information technologyon the over-8U. S. General Accounting Office,Survey of Investor Protec-

t ion and the R egulation of Financial Intermediaries, 1983, pp.28-29.

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

Institutional InvestorsInstitutional investors include special-in-

terest fundsand companies suchas pensionfunds, mutual funds, insurance companies,and private foundations thathave a goal of producing income for a specific organizationaluse and dealin largeblocksof securities. Theydemand prompt, efficient transactionsand ex-tensive information.

Since the passage of th e Employee Retire-ment Income Security Act (ERISA),the im -pact of th eseinvestorson t he totalmarket hasincreased substantially. Trades in10,000 -share blocks, a measure of institutional in-volvement,have increased to over 44 percentof total sharevolume. g The broker must alsobe willing to assume riskby buying fromt heinstitutional investor becausehe demands ahigh levelof liquidity. At the sametime, t heimportanceof th is segment of themarket 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 theautomationof tra ding and clearingby the se-curities industry. Exchanges needto attractinstitutional capitalto 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 cl ients 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 factorsth at have cont ributed t o the growing impor-

ta nce of pension funds, both a s savings vehicles and institutional investors, are the aging

‘Securities Industry Association data.IONew York StockExchange 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 t he benefit of sha reholders. Shar es ar e 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 mut ual fund is similar to tha t 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



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 of depositors.

The regulatory structure of the securities in-dustry r ecognizes tha t capital an d m oney mar -

kets a re essential t o 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 anat ional m ark et for securities. Federal regu-lation that is focused directly on the commodi-ties fut ures segment of the indust ry 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 secur ities with th e 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 t he worthof the securities, Sta te laws m ay actua lly in-volve licensing. Registration of an issue maybe refused by a Stat e au th ority, which wouldprohibit sale in that State.13 State laws differ,but effort s to develop un iform laws a re beingled by the North American Securities Admin-istrators Association.

Self-regulation is imposed an d en forced bythe exchanges and by industry associations.While the industry began formally supervis-ing its own opera tions with t he 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 AgenciesSeveral Federal agencies play roles in the

activities of the securities industry. The Small

Business 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 m an dated in th e Securities Exchange Actof 1934, and has a major impact on the in-dust ry by regulating t he a ctivities 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 ba sed on th e belief th at disclosur e is th epreferable means of assuring the smooth oper-ation of securities markets; it is not invasiveto the operations of industry players, and itret ain s 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 overseesth eir a ctivities.

While not a regulatory agency, the Securi-ties Investor Protection Corp. (SIPC), a quasi-governmental organization, has brought a uni-form investor p rotection policy to th e securi-t ies industry. SIPC operates as a private non-profit membership corporation whose primaryfunction is to pr ovide financial protection forth e client s of failed securit ies firm s. The cor-porat ion was m anda ted by the Securit ies In-vestor Protection Act of 1970 in response toproblems that occurred in the late 1960’sthroughout the brokerage industry as stockprices fluctua ted widely and volume on th e ex-chan ges increased dr ama tically.

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 th an $133 million in claims. ’4SIPC assesses an annual fee on each of the7,000 brokerage houses in the United States,which ar e requir ed to be members of th e 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 ha s distributed payment s to cust om-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 thatth e cust omers of the brokerage house ar e 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 of false 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 investm ent . All poten tia l investors infutu res markets a re informed tha t t hey mayexperience large losses as well as gains andthat it maybe difficult to liquidate a position.

Industry Self-Regulatory AgenciesIndustry associations and exchanges estab-

lish and enforce rules concerning the opera-tions of the securities industry, rules that areoften more str ingent t han Federal regulations.

An implicit objective of self-regulatory agen-cies is to maintain the autonomy of the indus-

14Christine Davies, “Brokerage Failures Bring Agency toLife, ”US AToday, Mar. 9, 1983.

“U.S.General Accounting Office, op. cit., p. 26.

try. To meet this goal, these organizations tryto ensure th at th e behavior of th e industr y 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 pu blic.

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 a gency responsi-ble for regulating the over-the-counter secu-rities market and for promoting high stand-

ards of operat ion t hroughout th e industr y. Italso establishes st an dard s of professiona l com-petence. NASD was empowered thr ough th eMaloney 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 of trade throughout the industry—has becomeeven more import an t t o th e industr y as tech-nology is applied.

NYSE oversees the operation of the ex-change marketplace and administers rules andregulations related to th e maint enan ce of or-derly markets and the standards of profession-al competence. ”NYSE is also a ma jor sour ceof 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

“U.S.General Accounting Office, op. cit., p. 24.



62 q Effects of Information Technology on Financial Services S y s t e m s

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 indust ry byproviding uniform standards; and aiding ef-fective regulation by removing unnecessaryregulatory constraints.17

Trends in Industry RegulationTrading volume and the number of types of

securities 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 this

function 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. Thecont inu ing developmen t of techn ology-basedsystems necessitates coordination of stand-ards to ensure that different markets, both do-

mestically and intern at ionally, can intera ct.Characteristics of the Securities Industry

ConcentrationThe securities industry is heavily concen-

trated. In 1982, the 25 largest firms, out of nearly 550 Securities Industry Associationmember firms, controlled nearly 75 percent of the 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~ FUtUreSAssociation, A %rtnership Between th ePublic an d th e Industry, Chicago, 1983, p. 11.

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

Throughout the 1970’s several verticalmergers between brokers and investment

banks occurred-most notably the acquisitionof Reynolds Securities by broker Dean Wit-ter & Co. and t he pu rchase 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 indu str y.

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 of the securities industry.

Movement Toward a NationalSecur ities Market

The Securities Acts Amendments of 1975directed SEC and the securities industry tocreate a national market system for bothtra nsacting and clearance. Movement in t hisdirection 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. ha ve made sam e-day sett lement 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 securit ies 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-



. —

Ch. 3—The Securities Industry q 63 — — — — ———- — — . —— — . —

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 thesecurit ies industry is that i t 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 InstitutionsAn 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 Governmen t for t he a cquisition of retaildiscount brokers by bank holding companies(notably the BankAmerica Corp. acquisitionof Charles Schwab), may increase the interestamong bank holding companies in entering thesecur ities industr y.]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 th at serve fun ctions 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 discoun t br oker 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 opera tesINVEST, a brokerage service, through awholly owned subsidiary. Thrift institutionswhich would not be able to enter the brokeragebusiness independently, can offer transactionand advice investment services to th eir 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 t hu s able toexpand the services they can offer their cus-tomers .

Trades condu cted th rough new alterna tivebrokerage services ar e execut ed th rough th eexchanges, usually by way of a clearing broker. The securities industry finds itself in theposition of servicing competitors, a situationtha t is quite comm on thr oughout th e finan cialservice industry. As capabilities and econ-omies found in information technology continue to grow, more entrants maybe expectedand the wholesale portion of the securities in-dustry will probably grow.

Possible Entrants to the Securities IndustryPlayers throughout the financial service in-

dustry, including the securities industry, havebeen expanding their product lines to fill asma ny of their clients’ needs as possible. Recognized economies of scope usually underlithis expansion of distribution systems, bothfor in format ion a nd for commun ity presen ceand in terms of complementing current prod-uct lines. Providers often feel they can retaintheir customer base by entering other lines of financial services.

The entrance of other financial service play-ers int o the securities industr y is already occurring. Several insurance companies havepurchased regional brokers, and some depos-itories have acquired discount brokers. Shear-




son/American Express an d Pr udent ial Bacheare both results of mergers between playersin d ifferen t sections of th e financial ser vicesindustry. 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 ent ering th e securit iesindustry 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 thecreat ion of informa tion and tra nsacting sys-tems not dependent on th e current industrystructure.

T h e S e c u r it i e s In d u s t r y a n d t h eIn t e r n a t i o n a l Ma r k e t

The securities indust ry has its r oots in t heneed for the American economy to interact inthe international capital markets. However,prior to the completion of the transatlanticcable in 1866, a real international market could

not exist becau se it wa s 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 opport un ities both for investors an dcapital seekers. Foreign individuals and insti-tutions made purchases and sales of $79.8 bil-lion of domestic corporat e st ock 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 tha t a ma rket a nywhere in the worldcan be selected for trading. This could havesignificant impacts on the stability of the econ-omies of nations. For example, the halting of trading 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-tr ies could have on capital mar kets. Intern a-tional issues in the development of capitalmar kets ar e 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.

T h e E f f e c t s o f I n f o r m a t i o n Te c h n o l o g y o nt h e S t r u c t u r e o f t h e S e c u r it i e s In d u s t r y

The application of information technologyin the securities industry affects its structureby facilitating the flow of information to suchan extent that it removes geographic con-straint s on ma rket pa rt icipants a nd a llows fordevelopment of international capital markets.It may also place additional barriers to entryto the securities industry. Without adequateaccess t o telecommun icat ion services, for ex-ample, a securities firm cannot function.

1’New Y ork S tock Exchan ge 1983 Fact Book,op. cit., p. 63.

T h e F u n c t io n s o f t h e S ec u r i t ie s I n d u s t r y

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 q 65

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 expertise

securities institutions have in analyzing secu-rities markets and in locating potential inves-tors, an d because of th e ability of th e secur i-ties industry to accept risk.

The use of information and communicationtechnologies by the industry is nearly univer-sal, and a djustment s ma y be expected in op-erations as the value of technology is realized.However, while information technology maychange the way in which the securities indus-tr y performs its activities, and m ay even fa-cilitat e at tempt s by investors to act on th eirown 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 capita l forma tion are discussed in appen-

dix 3B.The Securities Industry as an Advisor

In its advisory role, th e securities indu stryprovides information and offers guidance toits clients. It is able to advise organizationsseeking capita l on t he t ype of financing mostdesirable, whether t hrough pr ivat e or pu blicmeans, and, perhaps most significantly, whatthe timing for entering the capital marketshould be. These decisions are based on the ob-

jectives of the firm. F actors to be cons ideredinclude the risk and return associated withvarious issuing organizations and instru-ments. Timing of buy and sell decisions is alsopart of this advice function.

Information DisseminationInformat ion technology affects informat ion

dissemination 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 oavailable information will increase, but alsothat more information will be sought. Investors and other parties interacting with thesecur ities industr y may be expected t o 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 wenonline in 1978, collects and disseminates quo-tation information from exchanges across theNation and calculates and appends the national 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 t he NYSE fodebt 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 information monitors, particularly the individuainvestors. Although massive quantities of financial information are currently availablethrough a variety of media, such as newspapers, radio, and television, and through pub-licly available consolidated tapes, individuainvestors may expect to have even more in

‘“Securities Industry Automation Corp.,A n n u a lReport, NewYork, 1982.21New York Stock Exchange,AmualReport 1982, NewYork.



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 fru str ating to users. Moreover, informa -tion gathered by intermediaries within thesecurit ies 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 t his informa tion is gath ered and u sed.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 th e aggregat e,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 u p-dated information. An example of this type of system 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 Exchanges

as well as option excha nges. Inform at ion, 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 au tomatically at an y t ime th ere 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, ” T he Wall Street Journal , Oct. 6, 1983.

th e mark et to correct itself in un usu al situa-tions may be destroyed. In the long run, t hismay be a severe disadvantage for the investor,particularly the small investor, who may findhimself bearing both tr ansa ction an d lost op-portunity costs because of action taken because of basically meaningless market fluc-tuations.

CounselingThe nature of counseling may be changed

by the amount and type of information andsupporting an alytical t ools ava ilable. Researchis expected to become pivotal rather than pas-sive in the investment advisory function.23

Analysis an d recommenda tions 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 investmen t decisions a re ma de andthe quality of these decisions.24

The reliance on informat ion technology foranalysis of personal investment needs, objec-tives, and choices m ay indicate a n in itial m ovein the industry to reemphasize individual hu-man judgment and perhaps a reemphasis of the client/broker relationship. It is not clearwhat the impact of this change will be; how-ever, a decline in per sonalized 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 theindust ry ha s been highlighted in some cases.

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

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




Advice, part icular ly counseling, has been un-bundled from the total package of services of-fered in a new service supplied by MerrillLynch, called “Pa th finder .” For a set fee, theclient receives what amounts to a financialcheckup. The evaluation provides guidance to

the investor in a somewhat objective frame-work. The success of this product may be anindication of the futur e role of advice with inthe securities industry.

Acceptance of Risk by theSecurit ies Industry

The securities industry accepts risk thatmight otherwise be experienced by individualsor organ izations 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 IssuesUnderwriting 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 n eed of capital th at are n ot in the busi-ness of marketin g securit ies. It allows th emto 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 t o plan th e use of th e fun dsgenerated. The issuing organization may beless concerned about the flow of cash the saleproduces because it is usually guaranteed afixed price an d can u se th ose funds when t he

agreement with the investment bank or otherunderwriter is closed.

In m ost cases, the u nderwriter 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 t hose issuers in a sta rt up odevelopmental stage, whose issues may beconsidered to be more risky, to have access tothe public capital markets.

Underwriters earn money by buying securities at a lower price than they resell them forto investors. The difference in price, or spread,is a major consideration in the selection of aninvestm ent ban k 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. Theadvanta ge of the negotiated system is tha t t heissuing firm and the underwriter work together to make decisions about the pricing andtiming of the issue.

The company using a competitive biddingsystem invites offers from investment bankers. This process is required for many publiutilities and most municipal offerings. Buwhile some experts believe it results in highernet proceeds for t he issu ing organizat ion (because of the forces of competition), it has disadvantages. Much of the benefit of the advisory function that the issuing company wouldenjoy in a n egotiat ed situa tion is lost. Ahigherprice 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 syndicatesThis spreads risk and benefit because of theipooled sales force and allows a number ounderwriting firms to participate together in



68 Effects of Information Technology on Financial Services Systems

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

The presence of an u nderwriter provides avalua ble service for th e prospective invest or.Investment bankers are expected to examine

the corporate records with due diligence andare liable to defrauded investors if they failtheir due-diligence obligations and miss anymissta tement or omission of material fact bythe issuer in the prospectus. Therefore, notonly does an u nderwriter assure t hat the issuewill be sold in a “firm commitment” offering,but it also provides an oversight function of th e 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 secur ity based on m ark et 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 if they are to continue functioning as underwrit-ers.25 Information technology may be a con-tributing factor in the advent of bought dealsth at involve th e purchase of an entire issue,

usu ally by a single underwriter wh o has n otlined 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 of analysis may not be tailored to the needs andobjectives of corpora tions t o the s am e exten tas the information and counseling services pro-vided by an underwriter.

Margin“Margin” refers to the amount of money

paid by an investor to acquire a securityth rough credit in stead of cash. At t he end of 1982, the securities industry held nearly $13billion ($12.98 million) in margin debt securedby nearly $39 billion ($38.88 million) worth of collateral.26

The Securities Exchange Act of 1934 em-powers the Federal Reserve Board to regulatethis extension of credit. Brokers are permittedto extend r egulated credit on stocks a nd 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 of the 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, Z6Newy or k Stock Exchange 1963 Fact Book, OP . cit., Il . 46 .



-..

Ch. 3—The Securities Industry q 69 — —

debt and change the nature of collateral. Whilesome accounts restrict this use of credit drawnfrom h ome equity for t he pu rchase of secur i-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 orsecur ities with t heir brokers so th at t he bro-kers a re covered in case of an assignment .

Margin plays an important role in specula-tion in securities mar kets. A frequent ly usedstrategy in the buying and selling of securi-ties is the “short” position. In this case, aninvestor sells securit ies he does not own, but

has 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 sha res, in r oundlots, 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 Securit ies Industry

For pu rposes of discussing t he securities in-dustry, “marketing” is defined as those activ-ities designed to identify and meet t he n eedsof client s; i.e., both seekers of capita l an d in -vestors. It is assumed that these clients do notdema nd a specific product or t ype of service,

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

At one time the operations of the securitiesindustry were centered on what was possible,given th e regulatory fram ework an d its bu siness concerns. Now, a new awareness of the

import ance of basic marketing t o retain a nddevelop business is evident, resulting in research to support activities in product development and promotion and the targeting ofspecific segments of the population for special-ized products. Given the competition the indust ry faces in its t raditional and new product 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 those

marketing functions of the securities industrythat comprise product development, sales orbrokerage, and pricing.

Product DevelopmentIn r ecent years, the regulatory restraints on

the financial service industry have decreased,and the securities industry has found competi-tors in what at one t ime were str ict ly separa tebusinesses. These development s h ave occur redwhen 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 mutuafunds an d money market mu tual funds thathave been developed. It is not yet clear howpatent and copyright laws will affect the development of information technology-based fi-na ncial services pr oducts. If finan cial ser viceproducts become patentable, some securities

industry experts believe that competitioncould be stifled.28 Many financial service prod-ucts are similar in both character and features,

“N ew York S tock Exchan ge 1983 Fact Book, op. cit.,p. 48 .“’’Merrill Lynch Wins Cash Account Row With DeanWit-

ter,” Th e Wall S treet Journal , Dec. 29, 1983, sec. 1, p. 2.




and therefore, there is an inherent possibilityof patent infringement. Differentiating prod-ucts by attr ibute h as n ot been of great interestto the financial service industry, which hascompeted by geographic market and compara-tive return and cost.

Information technology has created interestin pa tent ing fina ncial service products becau secommunications 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 responseto perceivedconsumer demand,most major firms in the

securities 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 cashmana gement account in 1977, for whichit 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 $10

on a ll asset ma na gement accoun ts. Initially,this levy was not taken seriously throughoutthe industry; however, without admitt ing 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 t o use an y improvement sor changes either might make relating to cen-tr al-asset accounts. ”29

If financial service accounts are routinelypatented, investors may find that their choicesare l imited, since the patent may be a barrierto ent ry int o some pr oduct lines for some ser v-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 a nd a ttr ibutes.

Brokerage

Brokerage involves bringing together buy-er s and sellers, facilitating trades through themaintenance of a marketplace, and assuringt ha t the t r ade is complete. The significance of this activity as part of the operations of thesecur ities industr y can not be overestimat ed.Traditionally, all of the costs of supporting aninvestment bank or brokerage house were re-covered through this portion of the business.The services providedto clients, such as re-search support and advice, were bundled intothe commission rate for purchasers of securi-ties and into the spr ead on new issues for in-vestment banks.

The heart of brokerage withretail clients hasbeen personal selling. The relationship be-tween th e investor a nd t he individua l 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 of new products unique to particular houses mayencourage a loyalty to the company rather

t han to the broker. It is not yet clear how thismight change the character of the industry.Most technology-encouraged competition is

occur ring with in t he selling fun ction of ret ailand institutional brokerage. The end of stand-ar dized commissions on th e sale of securities(1975) has encouraged the entrance of dis-counters intothis 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 tr ading by individua l in-vestors is handled by discounters.



Ch . 3—The Securities Industry q 71

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-ke t .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.

Transac t ions

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 wasa lso expec ted to provide compet i t ion toNYSE, which dominated the market with 80to 90 percent of the trading volume.

The Cincinnat i 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-t ies industry. In July 1983 Merri l l Lynch

withdrew 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.

q

35-505 0 - 84 - 6 : QL3

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

ITS allows brokers, specialists, and markemakers to interact with their counterparts aother markets. The system, maintained bySIAC, currently involves eight stock exchanges: New York, American, Boston, Phila-delphia, Cincinna ti, Midwest, Pa cific, and,toa limited extent, NASDAQ.

ITS provides a mechanism through whichthe most favorable exchange setting can bechosen for a transaction. * At NYSE, the besprice from any member of ITS, as well as thNYSE floor price, is displayed. If it is advisable for a trader to deal on an exchange othethan the one at which he is operating, he can

enter his order by contacting his counterparthere. At the end of 1982, 1,039 issues wereligible for trading on ITS. NYSE reportst h a tthis representsmost of the st ocks t rad edo nmore than one exchange.

The Designated Order Turnaround(DOT)system wa s introduced in 1973 to route smallorders (599 shares or less). It reports electronically between NYSE and member firmsDOT bypasses floor brokers by routing orderdirectly to the appropriate trading post on thfloor of the exchange and, following executionback to the member firm on the same electronic circuit. Over 80 percent of the 5.7 million market orders processed through DOT i1982 were executed and reported back to thmember firm within 2 minutes.31 This systemminimizes the cost to member firms of handling small transactions while giving small investors the benefit of timely execution of theitrades. DOT may also provide a better pricthan would normally be received by a smalinves to r. A t r ade made t h rough DOT i smatched by computer for price with the mosrecent trade of that issue. The investor bene

fits because the price he receives may have

*ForPurpowsof this discussion,“transacting” is defined athe physical execution of trades.

“NewYork Stock Exchange 1983 Fact Book, op. cit.



72 . Effects of Information Technology on Financial Services S y s t e m s

resulted from price negotiationon a muchlarger order.32

Another technology-dependent system thatfacilitates transactingis the Opening Auto-mated Report Service (OARS). OARSmakesefficient 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 deve lopments in t ransac t ing en-hanced by information technology may includethe bypassing of intermediaries in the proc-ess of selling. Some experts believe that the

adoption 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 t imesfound it advantageous to trade off-market.

About 500 brokerage houses, pension funds,insurance companies,and other inst i tut ionalinvestors 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 of any 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 i t was makinga market in the closed stock. The companytraded a total of about 8 million shares of the

stock off-market.34

3’DesmondSmith , “The Wiring of Wall Street, ”The NewYork Tim es Magazine, Oct. 23, 1983, p. 109.

33NewYork Stock Exchan ge,AnnualReport 1982, NewYork,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 of their 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 of the special is t . I t may be essent ial for ex-changes to continue trading a given securityin all but the most unusual situations.

Clea rance and Se t t l emen t o f Secur i t i e s

Cleara nce an d settlementactivities consu m-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 to

move 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

‘sNationalSecurities Clearing Corp.,A n n u a l Report 1980, NewYork.

v



American Stock Exchange, and NASD. It hasprovided more efficient clearing at lower costsper t rade for l is ted 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 act ing as the issuer of a l l c leared 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

———“SecuritiesIndust ry Automation Corp., A Decade of Pro-

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


provide a framework for price adjustments forsecurit ies. Price in it s m ostpure formis a func-tion of supply and demand. For securities, thiis generally defined to mean the net presentvalue of anticipated cash flow, in terms owhat is received in interest or dividends andresale. Initial pricing decisions on new issueare particularly sensitive for the securities industry since the risk associated with errorsusually falls totally on the underwriter. If thprice is not in line with value as perceived bthe market, the issue will not be bought.

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

The operation of the secondary market fosecurities provides a method for correctinprices. Securities specialists perform a pricinfunction on exchange floors in fulfilling theifunction of maintaining an orderly marketThe specialist, an independent businesspersonperforms this function as an auctioneer, buyerand seller of securities. He makes a value judg

ment about the opening price of a security athe beginning of each day when opening trading. Although no trading may occur throughout the day, this establishes a price of record

The specialist facili tates trades by interested brokers on the floor and stands in as abuyer or seller at t imes when demand andsupply on the floor do not mesh. By standinin as a buyer or seller, the specialist maintainan order ly marke t by assur ing tha t p r icechanges occur in small increments. This allowinvestors to assess the market situation of

security in a rational fashion.NYSE now offers a technology-based sys

tem through which investors can more easilinteract with the market when they want tsell a security at a set price. The limit orde



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

1S T O C K

O R R O W ” W R 1 1 { E k

O R D E R o u t5 E R I I L L I

+ +

+CONTINUOUS

NET SETTLEMENT

+

.

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D E L I \ ’ E RYS E R \ ’I C E S

r & +

.~O~EY SE’1”’I’LE.MENT

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F+O R R E S P O \ D t \ TDF 1 .} & [ 01 1 F( I I o \

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II

# q q

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 sewlcesalso provided for the Options Clearing Corp Paclflc Clearing Corp and Depository Trust Co

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 investmentins t ruments of corpora t ions 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.

Te c h n o l o g y a n d t h e F u n c t i o n so f t h e S e c u r i t i e s In d u s t r y

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

seeking financing, the number of potential investors, and the level of trading demandedhave all increased to levels that could not banticipated when the securities industry wadeveloping. The one element which has not increased is the number of hours in a day, and

technology makes it possible to overcome thahandicap in processing the level of activitydemanded by the market .

Time and distance are no longer obstaclesto communications for the securities industryBecause of this, securities markets may become less location-dependent and, as a resultless physically structured. It will be necessarfor the industry to make efforts to assure thathe basic purpose of the markets is retained

Information technology wil l generate afaster reaction by the securities industry to

changes in market conditions and consumerdemands because communications and computer capabilit ies may lessen consumer response time. The market can be expected tooperate at a more rapid pace, and while it maybe possible to monitor change more preciselythis market will require quick and well-developed decisionmaking.

T h e E ffe c t s o f I n fo r m a t i on Te c h n o lo g y o n

S ec u r i t ie s In s t r u m e n t sSecurities instruments are designed to satis-

fy both the goals of investors and the need of corporations 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 of technology 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 environment. As information technology changes thway in which the securities industry operatesthe relative importance of various investmeninstruments may be affected by informationtechnology.

Third, interest in instruments that are nowon the market may be predictive of which investment products may best meet future demands of consumers in terms of liquidity, leveof risk, and return. This type of activity hasalready been seen in the financial service market in the development of money market mutual funds, which were patterned after the ide




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 the

calculation 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 secu r i t i e s p roduc t , a l t hough i t 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 character is t ics of invest-ment instruments may be expected to changein four ways because of the application of in-formation technology: l iquidi ty of instru-ments, the packaging of securities products,the way in which potential investments areanalyzed, and the importance of speculativemarke t s .

The liquidity of an investment instru mentis determined both by the contractual term of the 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 secur ities mar kets. 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 shortt ime 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 tha t will be seen in securit ies mar ketsmay 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.

A p p e n d i x 3 A : S e c u r i t i e s I n s t r u m e n t sThis appendix describes, the characteristics of

debt and equity instrumen ts as well as options an dfutur e cont ra cts. The r elationship of inform at iontechnology to these products and the future effectsof this technology are outlined.

C or p o r a t e C a p i t a l S t r u c t u r e :D e b t a n d E q u i t y I s s u e s

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 st ructures a s th ere 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 organ ization. The retu rn offered an d 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 right s proport iona l to th e value of th e shar eof 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 m oney is borrowed on a long-term ba sis,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 th e secur ity but caus e the bondholder nei-th er benefit nor loss in term s of retu rn , 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 mar ket interest rat es. 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 matu rity. The financial benefit t heinvestor realizes from the bond depends on mar-

ket conditions at purchase and investment oppor-tun ities at the t ime of matur ity. A bond issue ma ybe 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 bond s 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 th e property. From t he investor’s point oview, 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 mospopular form of bond issue across the economy andare particularly useful for industries in whichman y assets ma y be inta ngible, such as in publish-ing, or have a limited lifecycle, as is the case inmany high-technology industries. Most issues odebentur es include a n egative pledge claus e thaprovides that the firm will issue no new debt hav-ing priority over t he bonds covered by the agreement. This helps ensure that the risk to the investor does not increase over t he life of the bondDebentures are usually subordinate to bank loansand sh ort-term debts.

BEARER BONDS AND

FULLY REGISTERED BONDSRegistration of bonds affects the extent to which

the investor is protected in case of loss or theftthe way in which interest is paid, and the ease withwhich ownership can be traced and transferredThe ownership of a fully registered bond is recorded in th e register of th e issuing organizat ioor agent. Company records comprise proof of own-ership, and interest is paid directly to the holdeof record. If the bond is traded, the issuer or agentmust be notified so that ownership rights may btransferred.

For a bearer bond, the certificate issued at thtime the debt instrument is developed is the onlproof of ownersh ip. Ownership rights ar e enjoyeby whoever has possession of that certificate athe moment. Many investors find that the easwith which t he bonds ma y be transferred and t hlack of traceability outweighs the risk of losing thepaper. This type of bond is an extremely flexiblecashlike instrum ent.

Whether a debt instrument is a registered bondor a bearer bond affects its value and appropriate-ness as an investment for particular investorsSince July 1, 1983, the Federal Government harequired all new bonds to be registered to makit easier for the Internal Revenue Service to determine 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 .



78 q Effe c t s of Information Technology on Financial Services Systems

bearer bond is eliminated from the market, someincrease in demand for different instruments thatsafeguard t he privacy of the investor t o 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 th e financial instit ut ion 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 m ost cases, immediat e use is gran ted.The payment system for bond coupons is extreme-ly paper -based. The physical coupon “follows” thecollection process.

Gregura s and Carlile suggest th at as n ew tech-nologies make it possible to record essential infor-mat ion in the ph ysical coupon in a format t hat can

be used by electronic systems, this type of systemwill allow financial inst itut ions quicker access t otheir funds and, as a result, benefit the investor.’Information contained in the coupon could betransformed to electronic form at the point atwhich t he coupon enter s th e redempt ion pr ocess.

The electr onic system proposed would resu lt inlittle, if any, change in t he action required by th einvestor. Presentation of coupons would remainth e sa me; from th e investor’s viewpoint th e 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 curr ent labor-intens ivesystem 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 of system will nat ur ally decline.

The payment of interest on registered bonds iseasier because the paying agent knows the holderand initiates the payment process. Gregura s an dCarlile note that there is a great potential to useautomated clearing houses (ACHS) for these trans-actions, F ollowing th e issua nce of a paymen t or-

‘Fred M. G r e g u r a s 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 interestpayment s, which would be credited t o an a ccountspecified by the bondholder. Savings would resultfrom the elimination of check-processing costs.

RETIREMENT OF BONDSBonds may be retired by payment at final

maturity; 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 m at ur es. The call price is usu ally above theface value of the bond, but generally this premiumdecreases as the m atu rity date is approached. Acorporation may move to call a bond because of a drop in mar ket int erest r at es or t o be free of re-strictive protective covenants that may have beennecessary to gain financing initially. The initialdebt cont ra ct specifies whet her th e 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 a nticipated when thedebt instrument was selected for investment islost. The investor ma y find it necessar y to selectan a lternat ive investment. If interest rat es havedropped since the original investment, the investormust not only bear additional transaction costsbut also, in some cases, select between less attrac-tive investment alternat ives.

For ta x purposes, the income gained by the in-vestor from th e call premium is trea ted as a capi-tal gain. For the corporation it is deducted as anexpense from ordina ry income. Man y expert s 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 corpora tion may wish t o refund an issue t o es-cape restrictive protective covenants, but the mostcomm on reason is to ta ke advan ta ge of a drop in

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




mark et interest r ates. Market conditions mu st beextremely favorable for the issuing corporation to justify 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 an y overlap period.

The repaymen t of a t otal issue of bonds a t m a-turity could present a severe cash strain for theissuer. Th erefore, t wo methods ha ve 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 mat ur ity dat es.The ent ire package of bonds is issued by the cor-porat ion at the sam e time, but t he bonds mat ureindividually in successive years.

Most bond issues carry a provision requiringthat the corporation retire a given number of bonds per year through a sinking fund managedby a trustee. The bond issuer makes payments into

the fund, with which the trustee finances the re-tirem ent, by calling or pur chasing bonds s elected(usually) by lottery. While calling before the an-t icipated mat urity date may be u ndesirable for theinvestor, most investors value the assurance of or-derly retirement of debt and liquidity provided bya s inking fund provision. F or bondholders whoseinstrum ents ar e not called, the sinking fund m ayrepresent a reduction in r isk, as the t otal am ountof debt the organization holds is continuallyreduced.

PAYMENT OF INTERESTThe 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 pa rt of a cont ra c-tual agreement, Also, unlike preferred stock, which

is discussed later, the decision to pay interestbelongs to management r ath er th an t he board odirectors. If not pa id, int erest a ccum ulat es and isenior to preferred and common stock dividendsand su bordinated debt.

Income bonds a re un popular with invest ors because the income str eam from their investmen t iun predictable. Some expert s also believe tha t t hepast association of this instrument with corporations, particularly railroads, trying to avoidbankruptcy has made them unattractive to in-vestors. As a result, income bonds are used primarily in reorganizations, which of course mayperpetuate their negative image.’

Return paid on a zero-coupon bond is embodiedentir ely in pr ice appr eciation to mat ur ity. No periodic inter est pa yment is ma de, This bond offertwo advantages to the investor: the bond cannotbe called, so the holder experiences no reinvestment risk, and an exact return is assured if the in-strument is held to maturity. For tax purposesthe investor must declare the interest accrued ina given year as interest income, despite the facthat this money is not available for his use. Thecorporat ion a lso deducts t he int erest expense fothe 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 imarket interest rates fall during the lifetime of thebond,

Two types of bonds, floating-rate and indexedhave become more popular in response to the con-cerns of both issuers and investors that long-termdebt instr um ents h ave genera lly 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 bond s, which include instruments for whichthe interest rate is set in relation to 90-day Treas-ury bills, may be attractive to an investor whobelieves th at interest r ates a re likely to rise during 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 onindexed bonds is tied to the ra teof inflation and therefore is considered fixed in realterms. These bonds become popular in times ohigh inflation. In theory, any index can be selectedas a basis for setting the rate paid on this type o

61 bid., p. 551,



—

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

technology may change the approach of organiza-tions sear ching for finan ce and investors seekingdebt instruments as the following impacts of themain advantages of aut omat ed systems ar e felt:increased speed of handling information, moreprecise and less expensive analysis, and improvedcommunication systems.

EquityA firm may also decide to gather capital through

issuing equity, or ownership rights, in the form of corporate stock. The investor receives with theshares of stock he owns rights proportional to thetotal amount of stock issued by the corporation.Equity capital str engthens th e balance sheet an denha nces the futur e borr owing power of the com-pany. Decisions to issue debt or equity are usu-ally based on wha t will maximize the m arket valueof the corporation.

From the point of view of potential investors,

the purchase of equity may give the opportunityto sha re in th e growth of th e compan y. As some,if not all, of the r etur n r eceived may be in t he formof capital gains, the investor may find a tax advan-tage in equity investments. Equity shareholdersma y also receive an income st ream in t he form of dividends as a form of ret ur n on their ownersh ip,In some cases, this return may be greater thanwhat would be realized from a debt investment.While tax laws have been subject to change, att imes there have been ta x advanta ges from incomein the form of dividends rat her t han 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 forth e debts of the corporat ion. Additional r ights of holders of comm on stock in clude a claim on com-pany assets in the case of bankruptcy, followingthe claims of creditors and holders of preferred

q 8 1

stock; the right t o main ta in their sh ar e of ownership thr ough pur chase of new shares issued by thecorpora tion; the right to inform at ion on t he operat ion of th e firm, to the extent th at it is competitively feasible; and the right to transfer ownershipto another investor.

The most significant benefit for the owner ocommon stock is the right to maintain control oth e corporat ion t hr ough t he election of the boardof directors, who in turn appoint the officers of thefirm a nd r epresent th e interests of the holders oequity 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 themthr ough th e board.

Preferred stock is considered a safer investmentbecause holders of these shares have a claim onthe assets of the company before holders of common st ock, although after th e holders of debt, ithe case of bankruptcy. Owning such stock alsocarries a prior claim to income in the form odividends. However, the preferred stockholdeusu ally enjoys only limited voting r ights, so th ahe 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 tstockholders at the behest of the board of directors. Dividends are only declared when the payment will not impair th e operat ion of th e firm olegally compr omise its cont ra ctual r elationshipstionships.

Two significan t dim ensions of the dividend policy 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 thratio of dividends to earnings. While the lattemay appear more rat ional, it is rar ely used. Considerat ion of the r etur n expected by st ockholderhas led most corporations to pay a stable dolladividend when possible, indicating the importanceof income a s a motivation for investing in equitissues.

Decisions on long-run dividend payout ratiomay be bas ed on th e objectives of th e owners anmanagement of the firm. The reinvestment of significant portion of earnings may result in highergrowth for t he corporat ion a s a wh ole and m aybat tr active to investors desir ing long-term incom

‘Lawrence D.Schal l and CharlesW. Haley, Introduction to F i n a n -cial Afanagement (New York: McGraw-Hill, Inc., 1980),p. 366,



82 q Effects of Information Te c h n o l o g y o n Financial Services Systems

in th e form of capital gains. In t his case, earningsar e used as a form of int erna l finan cing, and anydividend paid is from earnings left over afterfinancing objectives are met. If the shareholdersof th e corpora tion ar e inter ested in m ore immedi-ate income, a fixed payout may be used. In thiscase, the amount of money available for internal

financing 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 of ownership, 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 more

directly thr ough th e use of new t echn ologies m ayalso 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 of the firm may be a benefit; however, managementsand boar ds of directors m ay 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 benefitth e issuer s of equity by lowering operat ing 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 of ownership will differ. The success of this type of program 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 t he a ctu al payingof dividends. Operation costs for this activity maybe expected t o decline as recordkeeping a nd s ort-ing activities can be automated. It may also bepossible to use electronic funds transfer for thepayment of dividends. While initial costs for th istype of system may be high, the resulting efficien-

cies and the decrease in postage costs may be of great benefit.

Conver t ib le Secur i t ies

Pr eferred st ock or bonds t hat can be convert edto common stock at the option of the holder arecalled convert ible secur ities. Su ch securit ies 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 inter est pa ymentsand conversion opportunity. This instrument is at-tr active for th e issuing corporat ion becaus e gen-erally a lower-than-market rate of interest may beoffered, owing to the conversion option. A corpora-tion ma y view a convert ible bond a s both a short -run debt and long-run equity issue without thecost of two separ at e issues. Convertibles ar e con-sidered deferred common stock financing. Theseinstrum ents were also traditionally attr active tonew or speculative corporat ions u nable to gath erequity capital on other terms or to corporationswith low-grade credit ratings.

Compar ed to th e issua nce of comm on s tock, th eissuance of convertible bonds creates less dilutionof earning per shar e at the t ime the bonds are firstoffered an d at th e time of conversion. At th e 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 an d st ability at th e time of conversion,as indicated by th e fact t ha t t he conversion priceis higher than the market price of the commonstock at the time the bond is issued.

The st ock pa ckage st ipulated in t he 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 m ay be less str ingent at the t ime the bondsare issued because of both the benefits to be re-ceived before conversion and the anticipation of participating in corporate growth at the time of conversion.



The tax provisions of typical convertible bondsma y be beneficial for in vestors . The conver sion of the bond to common stock is considered a tax-freetr an saction by the Int erna l Revenue Service. Theyear-plus-one holding period for long-term capitalgains on any subsequent sale of the common stockis counted from th e time t he bond, not t he st ock,

is issued.One variation on convertibles that often resultsfrom failed takeover bids is theexchangeablebond, which can be converted to the stock stipu-lated in the bond contract of a corporation. Thisstipula ted st ock may be issued by someone otherthan the issuer of the bond. The exchangeablebond requires the investor to evaluate the creditpotential of th e issuing corporat ion a nd t he long-range growth and earning potential of the firmwhose common stock is involved. Tax provisionsmu st a lso be a m ajor concern for such an investor.g

The Int erna l Revenue Ser vice considers th is 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 th an th e 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 nature

of th e instr um ent m ay be less of a disincentive topotential issuers and investors. Growth in thisar ea m ay be expected, however, to be relat ed pri-marily to the fiscal needs of corporations involvedand to the demands of consumers.

S h o r t - Te r m D e b t –M o n e y M a r k e t S e c u r i t i e s

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, Ju ne 20, 1983,

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

The Accumu lation a n d Allocation of Wealth [New York: McGraw-Hill,Inc. 1974), p. 14’7.

Ch. 3— The Securities Industry q 83

securities and, as the market demands, it is l ikelythat 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 investment

tools.A Treasury bill is a short-ter m debt of th e 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. Treasur y weeklyfor 91- and 182-day debt issues an d mont hly 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 seconda ry m ar ket has developed. Therefore,bills can be tr aded before th e mat ur ity 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.

Comm ercial paper is a short-term debt issued byfinance companies and some other corporationsInt erest r at es for commercial paper ar e genera llyhigher t han for Tr easur y bills becaus e of the riskfactors involved in private firms. Many companiesuse commercial paper to supplement bank loansIn general, it is a less expensive method of financ-ing for prime quality obligatory than loans (be-cause banks a re not used as int ermediaries) andma y fill a n eed at a time wh en th e issuan ce of long-

term debt is not appropriate. The issuance of com-mercial paper lacks the supportive, interactivenature of a relationship between a corporation anda commer cial bank .

Commercial paper may be sold directly by theissuing corporation or through a dealer. Sincedealers screen the instruments to a certain extent,comm ercial paper placed by a dealer m ay be lessrisky for an investor, although comm ercial paperdirectly placed by some major corporations is overy 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 of compa nies th at do not h ave a very high financialreputat ion is r arely marketa ble.

Banker-s’ acceptances, which originated at aboutthe same timeas international trading, continueto play a significan t r ole in importing a nd export-ing. A ban ker ’s acceptan ce is issu ed by a corpora -

tion and guaranteed by a commercial bank. Theacceptan ce is a liability of the bank and is tr adedin money markets based on the reputation andcredit standing of the bank. The instrument s ar eof value in international trade, owing to the time-lags that can occur because of the physical aspectsof transporting goods and because of the uncer-ta inty with which many tr aders a pproach foreignmarkets .

Certificates of deposit are negotiable securitiesissued by commer cial ban ks. They h ave 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 certificate

matures, The risk associated is dependent on thequality of the issuing bank. Certificates can betraded in a secondary m arket before matur ity; thismarket is particularly active for the certificates of deposit 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 therefore

has the potential to offer a great deal of flexibility.Major questions involving repurchase agree-ments center on the level of risk involved and howth e t ra nsa ction sh ould be classified. Historically,repurchase agreements were considered extremelysafe tra nsa ctions, alth ough th ey ar e 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 instr ument 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 inst rum ent an d 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 of technology 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 t he characteristics of various instrum ents t o

the demands of investors. The proliferation of money market mutual funds and demand accountsmay be a result of this opportunity.

O p t i o n s a n d F u t u r e s C o n t r a c t s

The capital ma rket investor’s investmen t 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-tuat ions of capital mar kets, but ar e not essential

to the capital structure of individual firms.Off-shoot investmen t 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 of under lying products or secur ities. The interest of the investor is focused on the price fluctuationsof the product, usually in a relatively short timefram e, rath er th an on t he intr insic operations of the 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 t he products a nd ha s led to furt her growthin option and future contracts trading.

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




Opt ions

Options provide a meth od of part icipating in asecurities market without ownership of actual debtor equity instr umen ts. An option is a tra dable in-stru ment th at grant s an investor the right to buy(a call option) or th e right to sell (a pu t 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 t he time t heoption 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 real

estate, 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, th e timing of mark et changes, as wellas direction, must be correctly evaluated by theinvestor to assur e tha t t he 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 theun derlying secur ity. More sh ar es of stock m ay berepresented collectively through outstanding op-tions than have been issued by the corporation.

While option writing and buying may be part of a complex investment portfolio that includes debtand equity instruments of an institution, the oper-at ions of option mar kets a re, in a pr actical senseat least, totally separate from t he 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 marketstr uctur e; therefore, t he influence of inform at iontechnology on th is st ru cture 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 t heir knowledge of the potent ial declinesand rises of a corporation but have no direct stakein its operations. In the basic options mar ket,players may be involved in four activities: buyingcall options, buying put options, writing call options, or writing put options.

An option buyer hopes to profit from or protecthimself from a change in the price of the underlying 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: exercise it by buying the under lying securities, selit 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 t he cont ra ct is self-motivated a nd will result only from his evaluation of the market.

The writer, on the other hand, is obligated to buy

or sell the underlying security under the conditionsspecified in the contract. His continued involvement with the instrument is not voluntary andwhile in some cases may not be required, is legallyenforceable. Both writers and buyers of optioncan liquidate their positions by purchasing offsetting options before the expiration or exercisof the option.

The motivation of an investor to buy a call option may be related to two separate strategies. Hemay hope to participate in the benefits of a risin stock prices with a limited current investmenand therefore may buy call options to achieveleverage or establish a future price at which he

plans to purchase the security. He may also bemotivated to purchase call options to limit riskeither as part of a conservative overall investmentstrategy or to hedge a short stock position.

For the individual investor, leverage may bemeasur ed thr ough t he percenta ge of total a ssetnecessary to invest for a given rate of return. Iis assumed that the financial assets of an individual ar e finite and t hat each investm ent decision is evaluated by its opportunity cost. Achieving leverage could be the motivation for buyincall options for an investor who expected the priceof an issu e to ris e. The cost of buying a call optiofor a given number of shares of stock represent

a much smaller investment than does the purchase




of th e 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 t o his in-vestment . Absolute r etur n or loss will usua lly 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 it s price to rise but wh o do not ha ve the cashto make the investment. The call option estab-lishes a guaranteed maximum price for the secu-rity. This str at egy is part icular ly useful if th e 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 ra th er t han stock limits a bso-lute risk, since the investor exposes less of hisasset s to th e mar ket. A comm on, conservat ive in-vestment strategy is to purchase call options andinvest th e difference between the options a nd t heprice of the u nderlying secur ity in a low-risk in-strument, such as Treasury bills. Any loss in-curred through the options investment would beat leas t par tially off-set by th e interest earn ed 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, th at is, selling securit ies he does not ownin anticipation of a price decline. This investortheoretically exposes himself to unlimited loss if th e price of the stock increases becaus e he wouldbe forced to pay market prices to deliver the secu-rities. By buying call options, the investor whotakes a short position establishes his maximumpur chase price for the securit ies he is selling an d

therefore insures himself against limitless loss. Of course, if the m arket behaves in the ma nner a ntic-ipated by th e short seller, the pr ice 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 gran ts the h older t he right t o sell at a n es-tablished price, and therefore it can be used forleverage a nd for limiting r isk. As with call options,th e investor m ust ha ve correctly ana lyzed 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 st ock he holds. This str at egy may be par ticu-larly attractive as protection for an individual whoha s a significant portion of his as sets invest ed 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 t han th e buyer does. A writer of calloptions may be required to sell the underlyingsecurity to a holder at the exercise price at anytime dur ing th e life of th e option. Conversely, th ewriter of a put option m ay be required t o buy th eunderlying 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 m ay be covered, wherein t he wr iterowns 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 t he m ost 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 underlyingsecur ity, option writing m ay great ly increase h isincome-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 th e exercise price and premium received forthe option and, in theory, is limitless. The un-covered call writer must be extremely sensitive toany factors in t he economy at large or for th e 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. Putsma y, alterna tively, be secur ed with cash equal t othe option exercise price. No additional margin re-quirements will be required in this case, and in-terest ma y be earn ed by the writer on th e 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 t o the writ erof that option. The opportunity to purchase thespecified securities may also be a motivating fac-tor in some cases. In a st able or r ising mark et, 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 an d str addles are th e two most commonmultiple-options investment strategies. Spreadsare used to limit risk in option transactions andinvolve writing an d buying th e sam e 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 drast ically chan ged. The writer of spreads generally anticipates little change in theprice of the u nderlying secur ity. A stable mar ketprovides his best opportunity for profit.

The investor who anticipates a great cha nge 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 p ut option for the sa me secu-rity. Both the call and the put should have thesame exercise prices and expiration dates. Buyingstr addles has limited risk becaus e 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 thatth ere will be litt le, if any, cha nge in t he pr ice of the security and, therefore, that if an exercise wereassigned, profit from pr emium income would in-sur e a net profit after costs of sat isfying the exer-cise conditions. Risk for str addle writ ers is limit-less, as a subst an tial loss can be incur red on bothpositions if the m ar ket pr ice for th e security fluc-tuat es more than expected.

PRICING OF OPTIONS

The pr emium (i.e., price) of an option is subjectto change an d is in fluenced by char acteristics 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 intr insic value an y time t he 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 h as n o intrinsic value, and t he premiumis based only on time value.

Time value represents an evaluation by an in-vestor of th e potential of the option to increase invalue owing to a change in th e price of the un der-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 t hepossibility of profitably exercising or selling of theoption is more remote. Increasing interest ratesgenerally result in increases in time value.

Wa r r a n t s

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 itself at any time is dependent on the current price of the stock of the issuing corporation. Warrants areoften offered wit h debt issues by corporat ions tomake t he debt issues more at tra ctive to potentialinvestors. They offer a par ticipat ion r ight of sort s

if 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 t he war ra nt . It m ay have a s pecific expira tiondate or be perpetual. The contract also specifieswheth er it can be tra ded, as with oth er 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 a

warrant is exercised, the corporation issues newshares of stock; therefore, the earnings of the com-pan y, from t he point of view of the sh ar eholders,are diluted. This situation complicates valuationboth of the stock of the corporation and of thewarran t .

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 ma y 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 mar kets by investors, brokers, corpora-tions issuing securities on which options are writ-ten, and market observers and regulators. Thisma y become increasingly importa nt as t he use of options as an investment instrument grows.

F u t u r e s

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 th e fut ur e. Futu re cont ra cts can be devel-oped for anything and are traded on establishedexchanges for physical commodities such as porkbellies an d coffee, for fina ncial instr um ents, 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 andoth er necessary goods becau se tr an sportat ion 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-chan ge risks.

Comm odity futu res m ar kets developed becaus eof the need in both agricultural and industrialsocieties to minim ize the potent ial 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 deman d for pr oducts m ade from commodi-ties only available for a very short time. Theseprocessors n eed to ha ve the comm odity a vailableat a predictable price when it is needed. By pro-viding a r eliable mean s t o conduct fut ur e 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 levels

can be absorbed with only a minimum direct im-pact on producers and processors of commodities.

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




This allows the pr oducers a nd pr ocessors t o oper-at e at lower cost t ha n would be possible if th ey 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 that

products will be available when n eeded at a r ela-tively predictable price and therefore approach themar ket in ra tional mann er. 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 FU TURESThe t aking of a position in futur e cont ra cts for

a pr oduct on which one depends in one’s pr imar yeconomic activity is called h edging. For exam ple,General Foods m ight be expected t o 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 of stocks, usu ally a grouping which is u sed in an in-dex of market behavior. Due to practical limita-t ions, these futu res are settled thr ough cash rat herthan the actual purchase or sale of the underlyingsecurities.

The availability of stock futu res t hr ough whichan investor can hedge against swings that affectthe entire st ock mar ket may add a great deal of stability to that market and is expected to be of great significance to inst itut ional in vestors, wh ohold a growing proport ion of all shar es. Investorsmay be more judicious in their response to mar-ket chan ges because their r isk ma y be minimizedby the holding of offsetting positions in stock

“Ibid.

futures, and therefore the stock market may become 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 investor for stability will be transferred to direct par-

ticipation in capital markets. More money may beavailable for corporate capital formation; however, 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 t hat risk wa s bad fothe stock market when, in fact, it was the market’sreason for being. It is essential that some means

of projecting what th e impact of the possible endof the need for a risk-accepting role by stock exchanges 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 economy; however, it is not clear what impact a catastrophic event in t he futures ma rket m ight haveon the entire capital formation process.

THE EFFECT OF INFORMATIONTECHNOLOGY ON FUTURES

Futu res ma rkets pr ovide a glimpse of what t hepossible impacts of information technology on thesecurities industry as a whole may be. The poten-tial of information technology was available asman y of the operat ions of this segment of th e indust ry were developed.

Modern futures markets need both man and ma-chine to operate. Human decisionmaking has beenand will cont inue t o be th e one irr eplaceable andessential char acteristic of any successful mar ketHowever, 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 ma rkets with the precision an d at t hevolume demanded by the mar ket without th e application of information technology; for examplefor 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 m ar ket could nothave grown to its current size and importance. Itsabsence would have effectively foreclosed the pos-sibility of responding t o the dem an ds of the econ-omy for the level and quality of operations nowseen.

Mutua l Fun ds

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 meth od of part icipatin g in th e 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 l iquidity 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 sm aller a mount of in-vestment capital th an can th e securities market,as the money invested is pooled with that fromother participants. The investor may also takeadva nt age of the p ossible benefits of a diversifiedportfolio that he m ight not ha ve been a ble to sup-port by directly par ticipat ing in capital or moneymar kets. For th e investor interested in an en tireindustry rather than a specific company, certainfunds allow such a focusing of investments.

Mutual funds that are made up of corporatebonds and st ocks ar e significan t t o th e format ionof capital because th ey attr act investment moneyto the market that would not otherwise have beenavailable. While some mutual funds centered oncapital ma rkets h ave char ged high tran saction fees(called a load), their a vailability ha s increased bothconsumer options and competition for investmentdollars throughout the financial service industry.The a pplicat ion of inform at ion technology to th edevelopment and marketing of mutual funds shouldincrease th e nu mber a nd var iety 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 requ estingwire 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 m ana gement instru ment 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 m oney mar ket securities result in higheryields than those offered on similar securities of smaller denomination.14 The holder o f sha r e s i n amoney market mutual fund benefits from thishigher rate of return.

Money mark et mu tua l funds h ave enjoyed major market success. While information technologyis not directly responsible for this, ma ny indu str yexperts believe th at it would not ha ve been possi-ble, from an operational or business point of view,to introduce this type of fund without the supportof comm un icat ion an d compu ter 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 of individual 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 q 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.

C e n t r a l A s s e t A c c o u n t s

The central asset account is considered by manyto be the single most important investment prod-uct of the next decade. ’5 In developing th e ma rket -leading Cash Management Account, Merrill Lynchrecognized that the financial needs of a single cus-tomer are interrelated and form well-defined typesof systems.The centra l asset a ccount att emptsto 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 its

user. The accounts offer a centralized method of controlling assets and, as free credit balances inthe zero-balance account are “swept” into a moneymar ket fund, both liquidity and r eturn are ma xi-mized for the investor.

Nearly all ma jor s ecur ities firm s offer a centr alasset account. While they have the same basiccomponents, their features often differ. Among the

i ~T & Fin8nCia] .~crt,ices I n d u st r \ ’ of 7’omorrou r,a N?pOrt prepared h)’the Committeeto 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 Federa l HomeI .oan Bank of San Francisco,Strategic[~lannjng for ~conomjc an d Technological Chan ge in th e Financial S erl’-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 an d an an-nua l 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 conditionsespecially high in terest ra tes. As conditions ha vchanged, the growth of these accounts has declined.l8 The significance of the a ccount in t he longru n is difficult to judge, although it seems likelthat it will continue to serve the needs of a segment of the market. One important feature of acentral asset account is that it allows brokers tofill more of their customers’ financial needs fomore of their personal financial lifecycle.19 Thismakes the account a valuable tool for financiaservice offerers, as it may help to attract and retain customers.

“Joseph Diamond, “Central Asset Accounts Developed by the Securities Industries, ”Financial S ervices Institute Han dbook, 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 t o the Investment Company Institut e, Sept. 30, 1982, p. 62

Ap p e n d i x 3B : C a p i t a l F o r m a t i o n a n d t h eo f t h e S e cu r i t i es In d u s t r y

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

F u n c t i o n s

style, and financial his-of advising, underwriting; and marketing to gather tory, as well as th e-am oun t of capita l needed andcapital by bringing investors and organizations in market conditions, all contribute to the decisionneed of capita l togeth er in t wo ways: through pr i- on wheth er t o attempt to finance through pr ivatvate sources an d th rough public offerings. Finan - or public offerings. An overview of the role thcial advisors may assist the firm in determining securities industry plays in both private andwhich path to follow. The characteristics of the lic financing is provided below,




P r i v a t e S o u r c e s o f F u n d s

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, particularlyth ose in highly competit ive industr ies. However,becau se th e firm is only likely to approacha limitednumber of investors and because the assurancesassociated witha regulated public offering maynot be found in private financing, the firm mayfind it necessary to paya higher rate of interestor return on money obtained and m ay find that thecreditor or holder of equity h asa greater interestin the operations of the firm than investors in pub-lic issues.

Pr iva te P lacement s

A corporation may sell an entire issue of securi-ties dir ectly to a single investor or sma ll group of investors. 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 ma y be mitigated by the a pplicat ion 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.

Pr iv i l eged Subsc r ip t ion Bas i s

An offering of stock onlyto existing stockhold-ers is termeda privileged subscription, or rights,offering. In ma ny cases equity holders are granteda preemptive right in the articles of incorporationof the compan y tha t r equires th e firm to give cur -rent shareholders the opportunity to maintaintheir “position,” tha t is, percent share of totalowners hip, any time a new issue is made. In t hissitua tion each sh ar eholder is issued one right foreach sha re of stock owned. The num ber of rights

needed to purchase new shares are specified in theoffering; however, the shareholder is assured thathe will be able to pur chase new sha res in pr opor-tion to his current stake.

A privileged subscription may provide basicmarketing advantages to the issuing corporationand therefore to the shareholders, even those who

opt not to purchase additional shares. The tar-geted mar ket for t he offering is kn own t o have aninterest. Assumed knowledge of the corporationand the costs associated with the offering are usu-ally lower than they would be for an offering toth e general pu blic. Often, flota tion costs ar e ha lf those of a public issue. From the point of view of the 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.

Ve n t u r e C a p i t a l

Venture capital is money invested in new orsmall businesses by corporations or individualsth at a re not directly involved in the ma nagementof the business, although they may provide advice.The investor is usually granted a large enoughsha re of equity in th e ventu re t o 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 areat tr acted for several rea sons. Not only is the ra teof return significantly higher, but as it is in theform of capital gains rather than dividends, it istaxed at a lower r ate. Organizations t hat 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



94 q Effects of /formation Technology on Financial Services Symtems — . — . — — — — —

of the company and of investment markets; theability of the firm to attract an underwriter, if needed; and th e ability and desire of th e corpora -tion to adhere to disclosure requirements. Infor-mation technology may ease these problems byaiding in t he a nalysis of decision factors an d pos-sibly by shortening the issue process and there-fore the disruption of business.

Feder al laws govern ing 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 th e cur rent condition an d hist ory of theissuing firm. It attempts to provide informationon which a decision to invest can be made but doesnot cont ain any type of objective judgment on th eadvisability of investing in the described issue.

Informat ion technology may a ffect 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 willra dically change t he p hysical activity of going pu b-lic. Paper was t he logical medium th rough whichinformation could be transmitted in the 1930’s,when m any of the curren tly applicable secur ities

laws were enacted.2 It was cheaper an d more reli-able than the communications technologies of theday, notably telephone an d ra dio, and was ea sierto use.

Paper was never intended to be a sa cred 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 reexamina tion of th e 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 fast er dissem inat ion 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.



C h a p t e r 4

R e t a il F in a n c ia l S e r v ic e s



C o n t e n t sP a g e

Int rodu ct ion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 7

Deposi t Fun ct ion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 9Direct Deposi t . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100Poin t -of-Sale Sys t em s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . 101Lockbox Oper at ions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 1Dem an d Depos i t Accou nt s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102Draft s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 02Giro Trans fers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 2Traveler ’s Chec ks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 03Savings Accou nt s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 03Insu ran ce . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 06Accounts With Other Nondeposi tory Ins t i tu t ions . . . . . . . . . . . . . . . . . . 107

Exte ns ion o f Cred it . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 8Com m ercia l Credi t . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110Cons um er Cre dit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110

Elect ron ic Fu nd s Tran sfer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114Automated Teller Machines . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115POS Full Fun ds Tra ns fer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 3

Financial Information Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126Chec k Auth orizat ion . . . . . . . . . . . . . . . . . . . .Credi t Aut ho rizat ion . . . . . . . . . . . . . . . . . . . .Providers of Inform at ion Services . . . . . . . . .

Home Informat ion Sys t em s . . . . . . . . . . . . . . . .Te c h n o lo g y o f H o m e I n fo r m a t i o n S e r v ic e s .D e ve l o p e r s o f H o m e I n fo r m a t i o n S y s t e m s . .Cos t s o f Home In fo rmat ion Sys tems . . . . . .

T h e M a rk e t fo r H o m e I n f or m a t i on S y s t e m sImpl i ca t ions o f Home In fo rmat ion Sys tems

TablesTable No .3 . Compar i son o f Depos i to ry Ins t rumen t s and4.Nat ion wide ACH Volum e . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . 12 7

. . . . . . . . . . . . . . . . . . . . . . . 12 7

. . . . . . . . . . . . . . . . . . . . . . . 127

. . . . . . . . . . . . . . . . . . . . . . . 1 2 8

. . . . . . . . . . . . . . . . . . . . . . . 1 2 9

. . . . . . . . . . . . . . . . . . . . . . . 1 2 9

. . . . . . . . . . . . . . . . . . . . . . . 1 3 1

. . . . . . . . . . . . . . . . . . . . . . .1 3 1

. . . . . . . . . . . . . . . . . . . . . . . 1 3 1

P a g eAccou n ts . . . . . . . . . . . . . . 100. . . . . . . . . . . . . . . . . . . . . . . 1 0 1

5 . G r o w t h P r o j e c t i o n s fo r t h e C IR R US S y s t e m s , I n c . , Na t i o n a lATM Net work . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 20

6. Pr in cipal Chara ct er is t ics of HIS Users . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 2

FiguresFigure No. P a g e

6. Penet ra t ion of Direct Deposi t Socia l Secur i ty Payments . . . . . . . . . . . 1017. Rela t ive Use of ATM Funct ions , 1974-$1 . . + ~ . . . . . . . . . . . . . . . . . . . . 1168. Number of ATMs in Use, 1973-81 . . . . . . . . . . . . . . . .q . . . . . . . . . . . . . 11 89 . Average Num ber o f Mon th ly Tran sac t ions Pe r ATM, 197 4-81 . . . . . . . 11 8

10 .ATMs in th e Uni ted Sta te s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12111 . Pene t ra t ion Curve fo r Chec k Alte rn a t ives . . . . . . . . . .. . .. . .. . . . . . . . 133



.

C h a p t e r 4

R e t a il F in a n c ia l S e r v ic e s


The retail financial service industry consistsof those organizat ions (e .g. , banks, credi tunions, insurance companies , consumer f i -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 factor ing 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 purposesof 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-nan cial services. However, because the security industr y 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 account s receivable toa third party, who then assumes the risk and costs of servic-ing them.

‘State of New York,Report of th e Execu t i \ e Adtisor}. C o m m -

i s s i o n on Insurance lndus t r? ’ Regulat or?’ 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 occupying a unique place in the industry. Depos-itors place a very high degree of trust in theinstitutions holding their funds. At the sametime, because deposi tory inst i tut ions playsuch an important role of intermediation between sources of funds and those having needof them, they are in a position to exert a measure of control over virtually all other economiactivities.

Retail financial services, especially those offered by banks, have been heavily regulatedby both S ta te and Federa l Governments .Rates paid on deposits have been largely de-regulated, but limits on the rates charged onconsumer loans remain in force. Depository institutions are generally limited to offeringprescribed products to predefined marketsBanks, for example, are limited with regardto the geographic area served, while creditunions are l imited to serving only groupswhose members share a common bond, suchas employment with a specific firm. Generallybank holding companies are not permitted toenter lines of commerce not closely associatedwith banking. Depository institutions are examined to ensure that they are pursuing business in a manner consistent with preservinginstitutional safety and soundness, and manyof their business decisions (e.g., effectingmergers, opening branches, offering new products) are reviewed by regulators prior to implementation.

Depository institutions enjoy some unique

benefits in exchange for heavy regulationsOnly they can take deposits and offer accountthat are federally insured. Depository institutions are unique in having access to the various systems used to transfer funds.

97




Today, insurance companies, providers of services 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 in sur an ce compan ies, ar eregulated, while others, such as providers of traveler’s checks, are virtually unregulated.All, to an ever-increasing degree, are broaden-ing th eir ra nge of business activities and, t osome extent, are encroaching on areas pre-viously served by others, including those here-tofore exclusively reserved to depository in-s t i tu t ions .

Information processing and telecommunica-tion technologies have contributed to thebroadening of product lines by providers of retail financial services. New entrants havebeen able to develop and offer products thatcompet e directly with th ose previously ava il-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 th etechnologies, 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 t o facilita te collection a nd 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 t ha t specific types of inst itu tions 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

entr an ts 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 t o 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 a re n ot permitt ed t o 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 Mast erCard a re th e two principalbank card products offered nationwide. How-ever, in addition to being offered by banks,th ese are n ow issued by such varied organi-zations as the American Automobile Associa-tion and various brokerage houses th at offerth em in conjunction with asset m ana gementaccounts. 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 of networks of ATMs. Some of these accept only

th e card of one inst itut ion, while oth ers 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-




In essence, a deposit differs from an invest-ment in th at th e depositor expects t o be ableto recover the amount deposited, often withsome interest, with virtually no risk of loss.The depository institution holds itself readyto pay the a mount of the deposit un der 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-stitu tion stan ds ready to pay on deman d. Onthe other hand, if the owner of a certificate of deposit 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 shar es in money mark et mu tu alfun ds t ha t include th e 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 t o 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 contractual

provisions 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 operat ing near -deposit pr oducts in a man -ner that closely approximates the operationof a true deposit account, the customers willsee the former as being a close substitute forthe la t ter.

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 th e financial service indust ry an d t heformulation 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 compar ison of the vari-ous depository instruments and accounts dis-cussed in more detail below.

D i r e c t D e p o s i t

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 issuing

the payment and the receiver and is commonlyTable 3.—Comparison of Depository Instruments and Accounts

Penalty MinimumInterest- Withdrawal Mandatory for early deposit or

Instrument or type of account bear ing notic e r eques t depos it per iod 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 deposit a . . . . . . . . . . . . . . . . . . . .Yes Yes Yes Yes YesMoney market deposit account. . . . . . . . . . . . . Yes Optional No No YesNOW account b . . . . . . . . . . . . . . . . . . . . . . . . . . Yes Optional No No OptionalSuper NOW account b . . . . . . . . . . . . . . . . . . . . . Yes Opt ional No No Yes

Savings bond . . . . . . . . . . . . . . . . . . . . . . . . . . . .Yes Yes Yes Yes YesSavings certificate. . . . . . . . . . . . . . . . . . . . . . . . Yes N/A Yes N/A YesaEffe~t jve Oct 1, 19&3, Interest rat e ceilings ar e el iminated 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 No t 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 of direct deposit; but this proportion had grownto 33 percent by 1982. The Department of theTreasur y hopes for furt her increases.

Direct deposit tr ansactions st art ed as papertransactions, but the rising volume of suchpayments has encouraged the use of the ACHnetwork an d systems, which depend heavilyon the interchange of magnetic tape (see table

4). 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 pa yingbank 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 40 0c

-

11 0/0o =.-E 30 0c.-UI

z 20 0E

$Q 10 0

0 1

1978

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 q 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 . . . . . . . . . 33 1324,163 123,353,594

1980 ......, . . 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 theACH will increaseonce a critical volume has been achieved bythe flows to and from large organizations. Asthis occurs, users with smaller volumes opayments should gradua lly be absorbed intothe system.

Point-of-Sale Systems

Point-of-sale (POS) systems, discussed indetail later in this chapter, also function as adeposit-taking m ethod. In some cases, reta iclerks will accept funds for deposit to custom-ers’ accounts. In others, the financial institution 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 service industry is to institute an electronic proc-ess through which t ran sactions m ay 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 posoffice, opening it and crediting the funds, orreceiving the opened letters and crediting thefunds to the company’s account. A fee is imposed for each function the financial institution performs for the company.

Lockbox operations are used to speed thecollection of remittances and reduce “float”*

*An amount of money represented at any one timeoutstanding and in the process of collection. The pebetween receipt of notification of payment by the creditothe actual debiting of the consumer’s account.



Ch. 4—Retail Financial . . . —

person m aking the payment instru cts t he in-stitution holding his funds to transfer themto the account of the payee in the name of another 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, generally

with 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 mechan ism an d is consid-ered a deposit instrum ent.

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 pra ctice extremely liquid. Un tilrecently, 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-

4J ack Revel], Banking& EFT—A Stu dy of the Implications,p. 143.

Services q 103

ing the accumulation of funds sufficient fosupporting higher denomination and higheyielding investments. They are also frequentlyused to establish and maintain a relationshipwith an institution for the purpose of eventually using other services, such as loans andcheck cashing.

Savings a ccount s t ake th e following form1. Conventional savings accoun ts. Conven-

tional savings accounts offered by depos-itory inst itut ions a re designed prima rilfor individuals. Savings accounts may beissued in passbook or statement form andinvolve the institution’s periodic issuanceof summa ries of deposits a nd withdra wals. 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 r ar ely, if ever, imposed, and for the most part, individualsregard these accounts as being very liquid. As defined by the Federal Reservea savings account from which more thath ree telephonic or pr eaut horized tra nsfers are permitted per month is considereda transaction account, with the specifiexception of the money market deposiaccount.

Savings accounts presently have a reg-ulated interest rate set by Federal author-

ities and governed by the DepositoryInsti tutions Deregulation Committee(DIDC). Until these ceilings are finallyphased out (scheduled for 1986), the ceil-ing is imposed on interest rates for federally insured banks and thrift institutions. 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 pr ovidein all but a very few depository institutions. 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 inmut ual 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-istra tion (CUNA) insur es accounts held infederally cha rter ed credit unions. In ad-dition, some Stat es ha ve insu ran ce pro-grams to cover deposits in State-char-tered institutions, such as savings andloan associations, that are not eligible forFederal deposit in sura nce.

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 the

bank without penalty prior to theirmaturity date. The most commonly of-fered maturities are 91 days, 180 days,and 1 year. Although most CD rates ar etied 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 Institu tions 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 a ccoun ts. The act t ran sferredthe authority to set interest rate ceil ings

on deposits at federally insured commer-cial banks, savings and loan associations,and mutual savings banks to the DIDC,whose members a re th e Secreta ry of th eTreasury; 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 r ates, dur ing which th e 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 of such ceilings. ) During the transitionperiod, credit unions are subject to sepa-rate regulations. In 1986, all RegulationQ authority expires, CUNA’s authority

to set interest rate ceilings for credit un-ions t erminat es, an d th e DIDC ceases toexist .

Under DIDMCA, the committee haseliminated (effective Oct. 1, 1983) all in-ter est r at e 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 t o 31 days. Also, th e committ eehas eliminated other regulations on timedeposits except for the minimum early

withdrawal 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 withdra wal penalt ies: for time de-posits with original maturities or required

notice 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-petit ive edge previously en joyed by non-depositor institu tions 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 appearsto be more con-cerned with return on investment thanthe risk associated with placing funds out-side of federally insured depository insti-tu t ions .

Money market deposit account. T h emoney market deposit account, a high-yielding liquid a ccount, wa s a ut horized bythe Garn-St Germain Depository Insti tu-

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 h as n o 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-part y tra nsfers, including up to thr ee bydraft and up to three preauthorized trans-fers per month. There are no restrictions

on making withdrawals from the accountin person, by messenger or mail, or byATM. The funds are federally insured. If the minimum balance falls below $2,500,the interest on the funds reverts t o thestatement/passbook rate and remains atthat rate u ntil the balance is brought upto $2,500. Unlike some restrictions im-posed by the money mar ket funds, th ereis no minimu m on t he size of an accountwithdra wals or deposits.

Negotiable order of withdrawal (NOW)and Super NOW account. NOW a n dSuper 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 q 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 require a minimum to open the account, al-though most institut ions require a minimum balance of $500.

The Super NOW account is primarila combination of the NOW account anthe money market deposit account. ThSuper NOW, which DIDC authorized aa financial instrument as of January 1983,requires a minimum initial deposit o$2,500 and an average balance in anmonth of $2,500. The account has no interest rate ceiling, although the funds re-

vert to a conventional savings accounyielding the regulated interestz-ate underRegulation Q if the account falls belowthe minimum balance. Additionally, a 7day 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 asavings deposits. These accounts are notavailable to for-profit businesses. Theare available to Federal, State, and localgovernm ents, a s well as t o 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 increments to a stated value at maturityBonds may be redeemed before maturity,but t he interest ra te becomes higher thlonger the bond is held.S avin gs certificates. Tailored to the needsof individuals in terms of deposit tim(generally 90 days, 5 years, 10 years), sav-ings certificat es have interest rat es thaare dependent on maturity t ime and cur-rent rates. Savings certificates are nonegotiable and are issued by depositorinstitutions for $100 up to $100,000There is a pena lty for ear ly withdr awa



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

The latest figures’ indicate deposits, as of October 1983, in various savings instruments:

Super NOW accounts: $27 billionNOW accounts: $100 billionmoney market deposit accounts: $369

billion

money market funds: $138 billion*I n s u r a n c e

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-sura nce indust ry has access to an enormousamount of capital. Insurance companies areenormous financial intermediaries in that theycollect and invest vast amount s 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 out lets. Theirinvestment decisions are based on a philoso-phy of maximizing their rate of return withinth e boun ds of Stat e investm ent laws a nd onthe principle of safeguarding the security of the 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 every

household. They tak e such forms as au tomo-bile insurance, property insurance, and healthinsuran ce. Such a strong presence permits th eindust ry to intr oduce an d mark et new finan-cial products and services with relative ease.Insu ra nce compan ies now offer severa l prod-ucts that are treated like deposits. Two newproducts int roduced into the ma rket in 1983are quite int eresting—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-count s with un limited access, lines of credit ,an overdraft, and a Gold Mast erCard, whichdoes not carry a line of credit. The customers’money market accounts are debited eachmonth to cover card charges. The checkingand char ge card operat ions a re ha ndled by alocal bank for the insurance company. The in-vestmen t a ccount s ar e offered in conjun ctionwith 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 un iversal life insu rance, which is an in-vestment vehicle. It functions like a deposi-tory instru ment and is a flexible investmentvehicle with a ccess t o mut ua l fun ds. 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 paya ble 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-pan ies’ lending a bility. Th e policyholder ha sth e right to borrow from th e insur an ce com-pany any amount up to the cash value, at aspecified rate of interest. Moreover, earningson insu ran ce are pa rtially tax-exempt .

J ust 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 instit ut ions.Also, modifying software for existing systemsenables th e compan y to creat e 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 man y ways. Insuran ce 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 ar e used t o tie int o car riers where t heyare able to obtain quotes and to underwrite

Ch, 4—Retail Financial Services 107 — — —

business themselves. Many large networks arebeing developed th at enable th e agent to obtain 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 convertingth e informa tion electronically and tra nsmitting it online to the carrier, allowing the carrier 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 companies are able to tie into networks that

provide important and timely informationused to assess and ma nage risk.

Accounts With OtherNondeposi tory Inst i tut ions

Insurance companies, large retailers, andvirtu ally every kind of fina ncial service organization offer individual retirement accounts(IRAs), money market funds, and a myriad of investment services. Although the funds invested by individuals into nondepository insti-tutions are not federally insured, this fact has

not prevented individuals from investing inthese instruments. The amount of money thathas shifted from depository inst itut ions intonondepository institutions has been significant. Previously, these types of institutionswere very different from each other. When theconcept of commercial ban king wa s first conceived, commercial bank ers made litt le or n oeffort to attract individual deposits, concentrat ing 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 wa s limited.

Today, tha t ha s changed dr ast ically. Com-mercial banks fiercely compete with other de-



10 8 q Effects of Informa tion Technology onFinancial Services Systems

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 of regulators or the providers themselves. An in-dividual can easily establish an IRA or Keogh(retirement) account, obtain a loan, and use achecking or checklike accoun t or savings a c-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.

Pr ior to the int roduction of money ma rketdeposit 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 th eir liabilities and reduced cus-tomer ear nings on short-term asset h oldingsin 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 inter est pa id on m oney in savings andreceived on money loaned. The spread resultedfrom below-ma rket ra tes pa id becau se of th eregulatory 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 firm s such a s AmericanExpress, which owns Fireman’s Fund Ameri-

can Life Insura nce Co., to mar ket a dditionalservices directly to their strong credit cardbase. They can offer insurance services andhave the premiums be added directly to theAmerican Express card account.

E x t e n s i o n o f C r e d i t

One of th e principal functions of the finan -cial service industry is intermediation betweenholders of assets and those in need of funds.Funds are gathered thr ough th e 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 th e pr incipal sources of revenu e for th e 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 ~s o madeavailable by investors who tak e anequity position in the organization requiring funds. Equity in-struments and t he mar kets for t hem are described inch.3.

regulation of the rates paid on deposits hasbeen to nar row this different ial an d cause fi-nancial service providers to look elsewhere forrevenue. They have turned to informationprocessing and telecommunication technol-ogies t o improve the efficiency of their int er-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 fina ncial ser vice pr oviders.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 q 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 a ssets as a total package and to mana gethem as such. The goal of some institutionsis to place themselves in th e 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 overdr aft a ccoun t, t he sa me checkor debit card that is used to draw funds froma transaction account is the instrument usedto activat e th e line of credit when th e fun dsin 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 th e rea sons a credit cardissuer can guarantee payment to the merchant

acceptin g it is th e ability to keep tr ack 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 controlling costs of processing and to facilitateth e timely posting of tran sactions to cust omers’ accoun ts. Some merchant s su bmit t ran saction data electronically to card issuers to fa-

cilitate processing.Credit has long been a tool of the retail in

dust ry. Card ba ses have been creat ed on t heassumption t hat they help create and maintain customer loyalty and facilitate impulsepurchases. Advertisements are regularly included with customer bills. While most retail-ers do not rely heavily on revenues generatedfrom r etail receivables, th e 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 isactivat ing a line of credit so that an altern ative can be offered. Also, retailers question thepropriety of card issuers charging the samdiscount 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 creditGenerally, 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 prima ry credit mar ketsas a n issu er of debt. Also, one of th e prima rymeans used t o implement monetar y policy itrading by the Federal Reserve System inFederal Government securities in the openmarke t .

Fur th er complicat ing the credit ma rkets isthe multiplicity of providers of credit services.Depository institu tions and r etail merchant

have 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 pr ice.

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 department

stores 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 t o t ime an d the t otal am ountof credit available, Minimum paymentsare required, and t he maximum a mountof 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, bu t also for obtaining cash ad-vances. With the exception of cash ad-

vances, the cardholder can pay the entireamount due without finance charges.

C o m m e r c i a l C r e d i t

Commercial credit is the credit extended to

businesses 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 m arket, where i t 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.

C o n s u m e r C r e d i t

Consumer credit is a specified amount of credit that is extended to individuals primar-ily for personal, family, or household purposesby a nu mber of types of inst itut ions t hat 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 r epayment either monthly, qua rt erly, 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 r egular 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.

OverdraftsCredit can also be extended through an over-

draft, which is a check or payment order writ-ten against a demand deposit or transactionaccount for fun ds in excess of the ba lance. Itmust be arranged in advance, and when hon-ored by t he depository inst itut ion, t he 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 ChecksCredit card checks a re special dra fts 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 a moun t is char gedautomatically 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.

C r e d i t C a r d s

With the advent of electronic banking systems, the plastic card has become commonplace in today’s financial institutions andretail organizations. Nearly all customer/bankcommunication terminals—ATMs, remoteservice units, POS terminals-use card technology in some form. The card is used to access funds in various accounts and as a medium 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 minimizth e amount of paper used in ha ndling credicards, and online credit authorization hahelped encoura ge card use becaus e it ent ailless of a waiting period. The transaction canbe approved and completed within a timeframe that is acceptable to the customerToday, there ar e man y online POS term inalfor credit authorization throughout the UnitedStat es. Genera lly, any credit card can be accepted by the systems, which operate ovesta ndar d telephone lines.

Credit cards offer the individual the abilitto defer payment of part of the balance dueas par t of an extens ion of credit. A dollar, o

floor, limit is established, which permits using‘FederalReser\ ’eBoard,L’redit Cards in the U.S. Eccmon]L\ r—

Th eir im pact on Costs, I]rices an d Retail Saies, J uly 27, 1983,p. 1.




the card without credit authorization at thetime of purchase. For pu rchases over t he r e-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 the

card-issuing organizations have imposed an-nu al fees t o the cardh older for u se of th e card.Interest paid on outstanding balances fallsunder Sta te usur y laws. Certain Stat e 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 int erest, card fees, or both, sothat the card-distributing organization is able

to operate un der the ban king laws of the St atewhere the processing is done.Card-issuing organizations impose a nnu al

fees on credit cards as a wa y to genera te 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 m onth ly statement char ges 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 count ries. Over 100 million car dsha ve been issued, a llowing consu mer s access

to 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 t ha t t ran sferred near ly 1 billiontransactions between member insti tutions in1983.7

For processing purposes there is no distinc-tion between a VISA debit or credit card. The

same processing procedures apply for bothcards; therefore, only the card-issuing institu-t ion 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 l imit 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 an oth er an d ma yhave slightly different policies. Generally, themost important competition exists betweenbanks as they attempt to sign consumer a ndmerchant accounts. The merchant discount of-fered to encourage acceptance of the card atan establishment is one of th e primar y 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 controls

tend generally to be the ones applying fromtime to time to consumer credit. The controlsinclude compliance in u sury limits a nd t rut hin lending as set forth in Regulation Z.

To examine critically the national bank cardsystems an d the m ember inst itut ion’s role asan extender of credit in the financial serviceindust ry requires some ana lysis. Inher ent inevery payment device are two separate anddistinct services. The first is payment forgoods and s ervices, and th e second is the ex-tension of credit. The first has traditionally

been priced in free and open competition andha s not been su bject t o usury laws. The sec-

7VISA, U. S. A.,Credit Controls and Bank Cards Analysis and Proposal, 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-sti tutes payment service and what consti tutesextension of credit.

The national card systems have also ex-panded their use to include card access toATM networks. Several ATM systems estab-lished by bank s u se VISA or Mast erCard a sthe access card to a proprietary system. How-ever, both VISA and MasterCard have also setup their own national ATM networks to com-pete with na tional int ercha nges. 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 institutionsha ve moved their processing centers to th eseStates. 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 the

laws 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 ann ual fee, and the m onth ly stat e-ment must be paid in full. As the name implies,

these cards are intended mostly for travel andbusiness use. Travel an d entert ainment cardcompanies generally follow more stringentguidelines in issuing th e char ge card th an doissuers of oth er cards.

Several elite versions of the travel and en-tertainment card exist; for example, the Amer-ican Express Gold Car d. These elite car ds 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



— -— ——

Ch. 4—Retail financial Services q 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 t ha t h ave been ma de pos-sible by the elimination of paper-based trans-

actions, which are personnel-intensive and,therefore, costly. Electronic financialservices,however, are not pervasive. While the deploy-ment of ATMs, for example, appearsto beprevalent in m ajor cities, smaller t owns a ndremote areas of the country still rely on tradi-tional systems for delivering financial services,although th is pictu re is ra pidly chan ging.While individuals depend on tr aditional serv-ices, many of the financial service providersrely on automation for theease and efficiencyof operating the services. Network systemscontinue to expand because communicationand information technologies enablea broadergeographic base to be served and allow in-creased transaction volume withouta propor-tional increase inc o s t s .

EFT has come to play an important role inthe financialservice industry. Although EFTsystems ha ve been operational since th e late1960’s, it wasn’t until the mid-1970’s thatth eir a ccepta nce becam e more obvious . Elec-tronically transferring funds today involvesseveral methods: direct deposit, credit andcheck authorizationat point of sale, an dmost

nota bly, use of the ATM. Tosome

degree, al-though they havenot penetrated the marketas greatlyas the ATM, the POS termina l andremote information systems, suchas 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 witha fixed sumof cash ina 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, allowingcon-sumers to withdraw cash from a bank account,make deposits, borrow cash againsta line of

credit, obtain a cash advance on a credit card,pay bills, transfer funds fromone account toanother, and inquire about account balances.(The relativeuse of ATM functions is illus-trated in fig. 7.) Credit can be obtained eitherby granting of overdraft limits or, in some

cases, 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 of information are placed on the magnetic stripevaries. A g rea t deal of attention has been paidto the standards being developed for the plas-tic car d.

Although thecost of ATMs has fallen sig-nificantly since their introduction, “the costof ATMs is unlikelyto fall as rapidly as tha tof ma ny oth er par ts of an electr onic fundstransfer system because of the various me-chanical parts that are necessary. The capacityto process transactions and information willbecome much cheaper as intelligent terminalsar e 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 theme-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 researchare available

SOURCE Economic Review Federal Reserve Bank of Atlanta, August 1983

that ATMs will provide both competitive ad-vantage and significant return on investmentover t he n ext decade. To soften th e high costof such systems, especially ATM networks,many financial insti tutions have entered intoshar ing 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-ter ior 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 r elative securit y.

The largesuccess of ATM deployment hascreat ed another tr end in bank bran ching. In-stea d of building la rge, full-service bra nchesth at are personnel-intensive and very costly,many organizations are replacing these struc-tur es with sa telli te branches, which a re sm all-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 the

number of ATMs in use from 1974 to 1981.Figure 9 i l lustrates the increases in the aver-age number of transactions performed at eachATM.

AT M S y s t e m s

ATM services can be offered in one of fourways: a proprietary system, a shared system,an interchange system, an d a piggyback sys-tem. In a proprietary system, or “single insti-tution” system, only the customers of thebank that developed and installed the ATM

system 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-stitu tions 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



Ch. 4—Retail Financial Services q 119 .——.

network, owned and operated by the NetworkExchange of metropolitan Washington, D.C.The objective of th e Safeway progra m for in -store ATMs is to increase store traffic andsales by providing customers with full-service,one-stop shopping convenience. Safeway h ascommitted 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 t he par ticipating finan cial institut ionsin generating new accounts that can access thein-store ATM services.

Par ticipation in th e program is on a t ran s-action-fee basis. National Transaction Sys-tems, Inc. (NTSI), will provide ATMs; install,maint ain, an d service th em; and perform allrequired transaction processing, funds trans-fer, settlement accounting, billing, and cus-tomer service opera tions required t o 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 insti tutions’host computers. Initially, the only functionavailable will be cash dispensing, selected bythe financial institutions from the followingth ree service-level opt ions :

1.

2.

Direct host link. The part icipating inst i-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 h ost fin k wit h “stan d-in “process-ing. NTSI maintains a cardholder author-ization file and control parameters on theNTSI computer for processing the partic-ipat ing fina ncial inst itut ion’s cardh olderSafeway Cash Machine withdra wal tra ns-actions when the institution’s host com-put er is not available. In addition t o the

3.

dedicated data circuit and modems, theinstitution pays a service fee for thestand-in processing option.Full stand-in processing. NTSI mainta insthe 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 a ccordance with th e inst itut ion’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, & Sm ith 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 t o expand th e 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 th e switch th at oper-ates th e 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.,th e Money Excha nge ha s operated a s one ofthe first shared networks on an interstatebasis. Shared/int erchan ge systems allow th esmall institution to compete with other finan-cial institutions in the ATM competition. Thefeasibility of all financial instit ut ions opera t-ing switches and deploying ATMs within a

35-505 0 - 84 - 9 : QL 3



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

containedarea is un economical. By opera tingin a shar ed/interchange environment , the fi-nancial institution can extend the geographicreach of its market and earn income from theATM.

CIRRUS—National ATM Network

The CIRRUS Syst em, Inc., isa 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 to

banks. CIRRUS does not preclude its mem-bers from joining other net works, 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 linkto the CIRRUS switch andmay share their connection with the cor-respondent m embers t hey license.

3. Correspondent. Correspondent membersare linkedto the CIRRUS stitch thr oughth e principal or associate m embers 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 m ake a withdrawal from h is 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 t he a mount of cash th eir cust omersmay 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 n ecessar y to comply with th e net work ’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 m embers pay the m embership 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 1985

Number 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 int erchan ge fees every time a nother in-stitu tion’s cardholder u ses th eir machines totra nsact ban king business. Card-issuing insti-tutions are permitted to charge their custom-ers for the privilege of being linked to the

CIRRUS network. Associate members canshar e th eir direct link to th e CIRRUS switchwith other inst itut ions for a fee, an d 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 Leg i s l a t ion

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 4000

700 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 t he ra teof 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 locat ed notmore than 3,500 yards from the bank’s prem-ises need not be shared, but those located moretha n 3,500 yards from the ba nk’s m ain prem -ises must be made available on a nondiscrim-inat ory 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 sh arp cont rast to th e restr ictive 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 likeStat e, or by a n ational institution which h asits principal place of business in the State andwhich is u sing the ter minal.

The statu te requires tha t regulations pr o-hibit, with regard to a shared terminal, anyadvertising that suggests or implies exclusiveownership or control of the terminal by a fi-nan cial institu tion or group of institut ions.13

Wisconsin law made possible the first sharedATM network in the United States and oneof the lar gest.

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.Zimmerand Th eresa A.13inhom,The Law of Ekc-t ronic Funds Transfer, Card Services, inc., 1980, pp. I 1-11 toI 1-13.

“Ibid., p. WI-1.

Financial Institutions, ” theact 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 gra ndfath er clause th at exemptedfrom the prohibi t ion cer ta in e lectronicbranches established before December 31,1981. To qualify for the exception, the ATMhad to dispense only cash, traveler’s checks,or both , and ha d to be limited solely to the useof customers of the financial institution that

established it.The new law empowers Massachusetts insti-

tu tions to link th eir ATMs to regional or n a-tional networks. It also permits a financialinstitution, organization, or bank holding com-pany, or its subsidiary organized outside of Massachusetts , to share any ATM establishedand used by a Massachusett s finan cial 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, orshar e electr onic branches in Massachusett s.

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 insti tutions 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 q 123 — — . . — — — — — — ———.—

Massachusetts institution is involved. ” All of the participating States passed legislation ap-proving the interstate branching.

There a re n o 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 consum er an d t he bank ing comm unity.

P O S F u l l F u n d s Tr a n s f e r

The t erm “point of sale” covers a va riety of services rendered through machines located atretail establishments. POS terminals are gen-erally clerk-operated devices located at thecheckout or convenience count er of reta il es-tablishments. Electronic cash register ver-sions of these term inals h ave been in opera-tion for several years, maintaining storerecords on sales , inventor ies , 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 want s to delay payment by char ging thepurchase or wants t he 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 th rough cash payments a nd check a ndcredit 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 thecar dholder’s a ccoun t, wh ich ma y 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< Trans fe r Association,llrashin~~ton Report ,

t J a n , 11, 19H3.

ment fun ds. 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 associatesth e use of a plast ic card with t he elimina tionof float, which allows a grace period before ac-tual payment is required. Also, many peoplein the industry have referred to the debit cardas a paper less check, which is one of th e rea-sons t hat reta ilers ha ve been relucta nt 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 encour ages use of direct debit a t 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, ra nging 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 n ot r epresented.Second, many of the stores that signed up forthe program were inconvenient to the majorityof the cardholders, and these stores alsotended t o sell products at a h igher cost t handid discount stores.

Direc t Deb i t POS

R e t a i l Stores.–Although previously notman y POS systems operated in r etail stores,there is tremendous potential for their use.One of the most successful direct debit POSprograms is in Des Moines, Iowa. There, Da hlsand Hy-Vee supermarkets operate direct debitPOS systems at the checkout counter, the first

such 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 theretai ler 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-

mat ed at a bout 50@, and an EFT t ran sactioncosts about 30©. The higher the volume inEFT, the lower the per transaction cost be-cause of the high fixed overhead. ”15

Oi l and Gas Companies .–Thegasoline 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 a re st an d-alone t erminals.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.l o M m a g e m e n t InformationSystems We e k , Ju ly 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 th at aut omat-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, tomaint ain its loyal cust omer base a nd t o gen-erate new business. Mobil representatives feelth at direct debit at th is stage would aliena tecustomers .

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 au tomated pump and t hen 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 th e next da y.The benefits to both banks and oil companiesare savings of millions of dollars. In mostcases, th e bank or network operat or 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, Shell

Oil, and Gastown in Cleveland, Wells FargoBank a nd Shell service stat ions in San Fra n-cisco, First City National Bank of Houstonand Exxon Co.



Ch. 4—Retail Financial Services q 125 -—— —— — — . . — ———— —

N a t i o n a l P O S S y s t e m s

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-t lements.

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 st at ions can mak e 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 t o POS activity. However, if th eregulation 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 SystemsThe POS terminal can also be used for check

authorization, permitting the customer to ob-tain approval of a check for payment by run-ning a verification of the check-cashing recordth rough a comput er. 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-

*RegulationD is a uniform reserve requirementon 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 t hat l ists card nu mbers of bad credit r isks.

In the United States, POS experiments havebeen conducted since 1974. Very few systemsinvolving instant transfer have survived, andthe most important functions of POS, unti

online direct debit system s were in place, havebeen check verificat ion a nd credit card au th or-ization. One explanation for this very limitedsuccess could be that the experiments havegenerally looked for evidence of profitabilitywithin a few months of insta llat ion, whereathe change in social habits involved in moving from cash and checks t o inst ant tr ansfetakes a great deal longer.

Costs of P OS S y s t e m s

For several years merchant s an d finan ciainsti tutions h ave been a t an impasse over howto implement electronic payment systemsespecially 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 t he cost t o bborne by reta ilers an d bank s. Another is t hconcern about merchant discount fees. Mosbanks charge the merchant the same fee fordebit card transactions as they do for credicard transactions. The argument made by the

merchant is tha t debit cards function in lieuof a pa per check a nd t herefore t he merchanshould not pay th e 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-nan cial institu tions typically base th eir debicards on the magnetic stripe technology usedfor years on bank credit cards. Grocery retail-ers, on the other hand, typically base their

technology on an optical scanner that readbar 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 ha ndheld 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 th at are int egral com-ponents of their own ECRS.17 Naturally, f inan-cial institutions and the merchants are weddedto their r espective investment s. It is un real-istic to expect th e merchan ts to give up t heirtechnology in order t o accept electr onic 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 n ext decade, with man y new systemsbeing built upon existing ATM networks.Both the banks and retailers stand to gainfrom the resulting reduction in the volume of paper 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 systemsmu st be designed in close cooperat ion wit h t heindividual retailers, not just the ma rkets t hesystems 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, a nd cash tr ansa ctions. However, whenPOS services become commonplace, the useof cash and checks a s a payment mecha nismwill still exist. Disconcerting cost trends areleading merchant s an d finan cial institut ionsto seek lower cost alternatives for POS trans-actions. EFT is the method by which this goalcan be reached.

F i n a n c ia l In fo r m a t i o n S e r v ic e s

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 andWhar ton E conometr ics, which pr ovide 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,par ticular ly check verificat ion. Check verifi-cation validates the authenticity of the checkor its presenter. This system is accessed onlinethrough a telephone or terminal by the retailer.The ret ailer pays for th is service, generally apercentage of the value of the check. These



Ch. 4—Retail Financial Services q 127 — .

systems are run by third-party organizationsand banks that maintain negative files.

C h e c k A u t h o r i z a t i o n

Check authorization systems may be pro-vided and ma intained by the pa rty 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.

C r e d i t A u t h o r i z a t i o n

Credit authorization is yet another informa-tion service vehicle available to the retailer.It operat es by allowing th e 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-tr ibuted by th e card compa nies, indicat ing lostor stolen card numbers or by placing a call to

an operat or wh o will aut horize or refuse t hetransaction 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 of sale and ensu re th at th e 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.

P r o v id e r s o f In f o r m a t i o n S e r v ic e s

Many kinds of organizations are informationproviders. Depository institutions use and pro-

vide information in unique ways. For example, the services they perform include provid-ing stat us informa tion t o their cust omers ona very regular basis. The most familiar proc-esses are inquiry of account balances or fundscredit ed or inquiries regar ding specific check

clearing. Today, much of the status inquiry in-formation is processed by online teller ter-minals with direct access to the accounts being questioned.

Service organizations provide accounting in-formation services to customers, such as information services about payroll or accountsreceivable/payable or other services necessaryfor efficiently ru nn ing th e organ ization without 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 investment brokers a nd insu ran ce firms. (The brokera ge indus tr y is covered in ch. 3 of th is report.) Insurance information is compiled byactuarial scientists and categorized by riskage, 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 insurance, al though premiums and risk are de-

termined by actuarial methods.The informa tion pr ovider in t he insu ran ce

industry is the insurance salesman. Althoughmuch informa tion about general insu ran ce iaccessed 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 insurance information is provided through computer/CRT* terminals that display rates andalso give an explanation of the types of insur-an ce available. The insura nce industr y is look-

ing at furt her a utomat ing the delivery of insurance information.

*CRT terminal—video terminals that display data on a cath-ode-ray tube.




The following scenario may present itself inth e near fut ure. Through videotex and h omeinformation 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 au toma tically debited from th e 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 an d banks.

Mortgage servicing is another aspect of finan cial inform at ion services. Mortgage ban k-ers and a growing number of commercial, mu-tua l 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 financial

commitment needs. Batch transmission andinquiry modes to a central location are usedvia dial-up and leased tra nsmission 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.

tr an sfer fun ds 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 toman age and cont rol 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. Int erest ingly, th ese groups include notonly the a ffluent mar ket bu t also youn g 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-nan cial service groups use t he sa me 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-t inued at such a rapid pace that , for example,information processing power, which oncetook a roomful of large equipment, is nowavailable in portable machinery.

H o m e I n f o r m a t i o n S y s t e m sHome informat ions e r v i c e s a r e a w a y b y Home information systems (HIS) started in

which financial information services can be de- a relatively minor way in the United Stateslivered to u sers of home comput er t ermina ls. 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 t he service. When th e telephonebill paymen t service was first intr oduced, mostof the systems required t he customer t o 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 s ervices did n otatt ract a large customer base, and m any of theearly programs have come to a halt.

Te c h n o l og y o f H o m eI n f o r m a t i o n S e r v i c e s

The introduction of videotex played a keyrole in th e developmen t of home inform at ionsystems. 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 of telecommunications 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 syst ems h ave become opera tiona l 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 with

HIS 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 stat ed, 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 a nd th e economics of home ban k-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 transmitt ed 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 tha t a re up a nd ru nning), informa tioncompanies, entertainment companies, and thelike. Several systems are being developed ascosponsored, joint ventures by consortia omajor banks and corporations. One example

**A modem transmits digitalor computer information overtelephone lines by manipulating it electronically and also pro-tects the lines from undesirable signals that might cause interference with other users.

19Revel], op. cit., p. 50.



130 q 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 Hu tt on’s compu ter s in NewYork City for information about their ac-counts, such as cash management and margin

balances, 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 other

color possibilities. The J. C. Penney cataloginventory system is immediately and aut omat -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 fromT h eOfficial Airline Guid e and Grolier Academic

Am erican En cylopedia 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 withinth e system stan dard, including th e 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 VideoFinancialcompu ter system will tie in dir ectly to th e fi-nancial organizations offering the service.These financial institutions will assist the net-work operat or in enrolling the consu mer a ndwill provide the da ta to VideoFina ncial to sup-port the h ome terminal r equest.

Over 50 information providers, includingmajor wire services, educational organizations,reference and finan cial book publishers , uni-versities, libraries, and professional organiza-tions provide information for Viewtron.



—

—-—— —.

Interestingly, the advent of HIS has en-couraged cooperation instead of competitionam ong th e var ious finan cial service pr oviders.

C os t s o f H om e I n fo r m a t i on S y s t e m s

Cost is one of the major issues associatedwith the success of the HIS program. TheViewtron videotex costs are as follows:

q Subscript ion t o the Viewtron s ervice: $12per month for access to nearly all View-tron services.

• Commun icat ion char ges to access View-tron: approximat ely $14 per month (ap-proximat ely $1 per hour to access View-tron).

A serious consideration is the influence of local 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 of these services. *

T h e M a r k e t f o r H o m eIn f or m a t i o n S y st e m s

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 of various types. The home terminal has greatpotent ial as th e major investmen t, shopping,and news information source for affluent con-sumers . Additionally, it ha s been stat ed tha tmany 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 ent erta inment informa tion (e.g., restaurant and movie guides); stock exchange in-formation; shopping capabilities; and bankingapplications in a form similar to that of selfservice banking. Users of these systems canpay bills, transfer funds, check balances, review banking statements, and keep up-to-datefina ncial r ecords.

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 appealingThere are problems, however, with respect toacceptance of the system, hardware and com-munication costs, and, most importantlychanging 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, compatibility, or specificity.

I m p l i c a t i o n s o f H o m e I n f o r m a t i o n S y s t e m s

It appears likely that home banking systemswill be tied to other services such as informa-tion services, entertainment, and even business uses. Also, any institution, whether finan-

cial or nonfinancial, will be in a position toprovide financial services t hr ough a videotenetwork 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 retai l 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 barrierand offer payment services nationwide. * Bythe same token, nonbank operators will be able

..-. .—*Banks have long been able to conduct business natio

by opening offices (usually via holding company affiliasubsidiary corporations) for business loans. This is alsfor mortgage companies and consumer finance compan




Table 6.—Principal Characteristics of HIS Users

Level ofCharacteristic importance CommentsAge High Research studies indicate most potential customers of

HIS/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 potential

customers of HIS/home banking. Men and women rankabout equally in intent to purchase.PRONTO pilot research shows, however, men were more

frequent 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 TV

communication 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 such

as HISS.The various systems that have been and are

being implemented for effecting payments areessentially designed to be substit ut es for t hepaper 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 ha s grown slowly during th e first yearsfollowing introduction. For successful prod-ucts, this has been followed by a period of rapid 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 q 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 , at

wha t r at e will new ser vices grow? Second, atwhat level of penetration by each product willthe market become effectively saturated?

Not all potent ial user s of a ser vice will usethat service. It has taken decades for the levelof penet ra tion for checking account s t o 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 todayth at r equires a termina l costing several hundred dollars may be quite different from whatit will be for a derivative of that service thais implemented using a terminal that costs lessthan $100.

The time constants that determine the steep-ness of the curve may also vary in responsto events in t he ma rket. For example, the rat eof 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 t he other h ana series of events that demonstrate inherenweaknesses in advanced payment systemcould slow the rate of growth of some products. In general, the impacts of events armost likely to vary from product to producin the mix that comprises the offerings of thefinancial service industry.

In t he past , great promise has been h eld outfor various payment pr oducts tha t ha s yet tma ter ialize. However, increa sing u se of computers and telecommunication throughout so-ciety and the dynamism of the financial serv-ice industr y may be creating an environmenmore favorable t o the a doption of new systemsfor delivering financial services. Thus, theis a higher degree of confidence than in thpast that the middle stage of the “S” curvwill be reached, but the timing continues t

be uncertain. The problem becomes one oclosely monitoring developments in the finan-cial service industry to identify those areamost likely to reach a critical mass and tassess on an ongoing basis the benefits ancosts to society of the changes that are expected.



C h a p t e r 5

Wh olesa le F in a n c ia l Se r v ice s



.

C h a p t e r 5

Wh o le s a le F i n a n c ia l S e r v ic e s

Retail suppliers of financial services provide

consumers with a variety of products and serv-ices, including deposit-tak ing, 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 toan other (e.g., cash to notes receivable or viceversa). For example, institutions can purchasedebt instr umen ts in secondary mar kets, 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 suchfeatu res as loan pa rticipation and t he 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 a vailable, th e organizations th at part ici-pat e in this segment of th e industr y, th e 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 th e VISA service, is a wholesaler t ha t p ro-vides the interchange services that are essen-tial to the operating concepts embodied in

bank card organizations. On th e oth er ha nd

VISA International actively markets its prod-ucts on behalf of its members and is highly vis-ible to the consu mers. In t his sense it can bviewed as a retailer of financial services.

Wholesale an d ret ail fina ncial services wicontinue to overlap in the future as the imple-mentation of advanced financial service deliv-ery systems tightens the coupling between theorganizations th at perform the various functions that are required to deliver servicesHowever, for the moment, it remains useful to describe wholesale and retail serviceseparately.

On the one hand, the earliest applicationof information processing and telecommunica-tion technologies were in the area of wholesalefinancial services much more than in retailCheck processing and account maintenancservices have been provided by third-partoperators for years. Wire transfers of fundhave been used since before the turn of the cen-tu ry. On th e oth er han d, there are wholesalservices th at are not par ticularly susceptiblto au tomation. Arra nging loan part icipationmay rely heavily on t elecommun icat ions, buthe process is not really automated.

However, wholesale financial services arnot really separable from other financial serv-ices that may benefit greatly from the applica-tion of advanced technologies. Thus, policietha t are directed a t chan ges result ing directlyfrom the application of advanced technologiesto the entire financial service industry are alsolikely to impact wholesale fina ncial serviceTherefore, i t is important that the reader whois concerned with developing policy for the fi-nancial service industry be aware of the furange of services provided by the financiaservice industry.

137



138 • Effects of Information Technology on Financial Services Systems ——.—.—.

T h e R o le o f Te c h n o lo g y in Wh o le s a l eF i n a n c ia l S e r v i ce S y s t e m s

The financial service indust ry was one of theear ly user s of advanced t echn ology 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 andinform at ion t echn ologies ha ve made possibleth e extension of wholesale fina ncial 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 packages

has 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 asth ey can be developed an d supported only withsignifican t 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 of marketing and delivering services are largelysepar able. Mana gers of fina ncial 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 portfolioth rough its own effort s, or it can part icipatewith others who undertake the active market-ing of credit services. Additionally, an orga-nization can acquire and support the facilitiesnecessary for performing the data processingent ailed in delivering finan cial services, or itcan buy those services from third parties. Fur-ther, just as m erchan disers can setup a n orga-nization to buy in quantity for a group, finan-cial service providers can realize economies of scale and scope by joining a consortium, ornetwork, that establishes an organization toperform transaction processing.

P r o d u c t s Av a i l a b l e i n W h o l e s a l e M a r k e t s

A s s e t a n d L i a b i l i t y P r o d u c t s main in a position to provide additional financ-ing to retail customers. If this were notpossi-

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 th eir customers) to meet deman ds 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-party processors:

ADPEDSDecimus

Control DataCSC/lnfonetFDR (AMEX subsidiary)Financial service institutions, joint syndications, and

proprietary T&E cards: Rocky Mountain Bank Card (PLUS)CIRRUSVISAMaster CardAmerican ExpressNonprofit or governmental service or network providers: Swift Federal ReserveFederal Home Loan BankBank WireNew York Clearing House

Banks, other depository financial institutions, and associations: First Interstate BancorpBank OneCiti-BankChemical BankBank of AmericaCUNACalifornia Credit Union LeagueGESCOMid ContinentDatalineOther 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 q _— — ——. ———

enabling the financial service industry to

139

in -termediate between those with funds to investan d th ose who require funds.

In this context, commercial firms that seltheir receivables are users of wholesale finan-cial services. Using these services, manufacturers a nd merchants ar e able to obtain th eworking capital needed to support their inven-tories of end-products, work in pr ogress, 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 du e cour se. In tu rn , the borrowebenefits by continuing to deal with the organization t hat originat ed the loan th roughouits 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 handwill place commercial paper in t he wh olesalemar kets an d use t he proceeds to support theirlending activities. Because they can borrow

large amounts at favorable interest rates andreceive a relatively high yield on their loanportfolios, a favorable spread is generated thatcan cover both th eir operat ing expenses a nda profit.

At times, a lender will have the opportunityto place a loan t ha t eith er 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 oth ers th at will spread t he overall risk




and make available sufficient funds to meetth e needs of th e borrower. Also, bank s, as pa rtof their relationships with th eir correspond-ents, will routinely allow the correspondentsto participate in loans that they place. Insur-ance compan ies behave in mu ch t he sam e way

when they share indirect placements and askor permit others to share in the underwrit ingof casu alt y coverage. Securities dealers formsyndicates to underwrite offerings of debt orequity instru ments.

P r o c e s s i n g P r o d u c t s

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-format ion pr ocessing an d telecommun icat iontechnologies has become mandatory.

Among the processing products offered byth e providers of wholesale finan cial ser vicesare the processing of checks and credit anddebit car d dra fts; th e processing required tosupport all types of depository products; andinformation services, such as credit/checkaut horizat ion and economic dat a and modelsthat are used for analysis and decision sup-port. Also included is the processing requiredto consolidate and disburse funds as part of offerings of cash management services.

Tran saction processing facilita tes th e execu-tion of an order given by th e owner of an ac-count to credit or debit it. For all practical pur-poses, from the point of information flows thatare creat ed, the t ype of accoun ts posted dur-ing the transaction is immaterial . In fact , major 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 activit ies. Instead, they tur n t o third par-ties, many of whom are not conventionallyclassified as fina ncial instit ut ions, t o providethe processing capabilities required. Retailers

of 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 sett lement are elements cri t i-cal to the operation of a system that supportsth e delivery of fina ncial services. At presen t,only depository institutions have in place asystem for clearing cash items involving thetr ansfer of money between virtua lly any pa r-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 a nd bond tr ansa ctions, and by oilcompanies for accounting for balances of crudeoil moved between them, exist; but not withth e wide area of applicability found in th e sys-tem operated by the depository institutionsfor set tling on m oney tran sfers. On t he 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 of structural 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 man agement account s th at 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 q 141———.——————— — — . . . —— — -

through a depository institution. Only oneretailer has been given direct access to a major bank card network, and the rules of thecard-issuing organization have been changedto preclude another nondepository institutionbeing granted such access.

Informat ion Products

Financial data provide the basis for decision-making for individual organization and for theeconomy as a whole. Treasu rer s for both p ri-vate corporations and public agencies mustha ve knowledge of the funds available to th emand 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 paymen t. Opportu nit ies for investing idle

funds 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 tha t en able th euser to build, estima te, and validat e 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 th at most organizations can mak euse 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 th an not t hese ar e 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 an d warran ts th at t hey 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 thoseth at ta ke all responsibility for system opera-tions and operate their own facilities apartfrom those of their clients. Second, some pro-viders sell or lease softwar e 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 d esigned t o meet th e needs of th e clientorganization. Third, some providers offer“turnkey” services in which they design andinstall systems for their cl ients and then turnth em over t o the clients, who tak e over day-to-day operations. In the last category areth ose offering facilities ma na gement serviceswhere the service provider effectively takesover the operation of the processing depart-ment of the client organization, even thoughth e depart ment may be ph ysically locat ed inthe client’s facilities.



142 q Effects of /formation Technology on Financial Services Systems — — ——— .— —.

P r o v i d e r s o f W h o l e s a l e F i n a n c i a l S e r v i c e s

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 th e var ious classes of firms activein th e financial service indust ry an d th e de-gree of competit ion bet ween t he very diversefirms that are providers of wholesale financialservices.

Examina tion of ta ble 7 shows that th ere isconsiderable opportunity for both vertical and

horizontal 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.

Lar ge commercial bank s provide exam plesof vertically integrated operations. They per-form check processing, operate credit anddebit car d systems, and su pport net works of automated teller machines (ATMs), some of which 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 sett lement networks. Loan participa-tion and clearin g account s a re offered t o cor-respondents. Also, they provide secondarymar kets for debt instr ument s, 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 n ot a ut horized to offer investmentadvice regarding securities to their clients.Further, they are permitted to offer data proc-essing services to others only to the extentth at such services are incidenta l 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 holdingcompa nies a re not free t o offer t he 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-tegrat ion of commercial banks an d other de-pository inst itu tions is increasing. Some nowoffer discoun t br okerage services, and other sare 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 themar ket with a very broad ra nge of finan cialservice 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 toward

horizontal integration, only a minimal level of coordination has been achieved between thevarious constituent elements, and, therefore,th e degree of horizont al int egrat ion a chievedto this point appears to be minimal.



146 q 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 ban ks a nd t hrift 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 t he informa tion processing industr ythan 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, and

others t hat already operate in th is market if it chooses to enter. Operators of food chainsand oth ers ar e installing ATM networks a ndinviting 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 t he long ru n. Fina lly, as shown intable 8, various data processing service bu-reau s and softwar e suppliers meet th e 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 aun ique 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 a nd sale of Government securit ies.It is a major factor in the clearing of checksand a provider of currency and coin to thebanking system.

The na tiona l system of au tomated clear inghouses (ACHs), except for the one in New

York, is owned and operat ed by the F ederalReserve System. Recently, ACHS have broad-ened their capabilities to process individualcustomer-initiated transactions. The bulk of the 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 of

providing services, some argue that its pric-ing still puts private suppliers of altern at iveservices at a disadvan ta ge. Some a lso 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-tut ions t hat 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 ar eas 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 s ervices. Also, th ere is a movement toseparate ACH operations from the FederalGovernment . Therefore, its futu re r ole as anactive participant as a provider of financialservices is open to question.



.—

Ch . 5—Wholesale financial Services q 147 —

T h e I m p o r t a n c e o f Ac c e s s t o D a t aa n d t o t h e P a y m e n t s M ech a n i sm

Since only the depository institutions haveaccess to the payments mechanism for thetr ansfer of funds, all oth er institu tions 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 the

finan cial da ta of its cust omers 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. Theargum ent follows th at restr ictions are n eces-sary on th e opera tions of depository institu-tions with r egard t o the informa tion 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 these

organizations ha ve to a customer’s dat a, an dthe 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 t he su pport of advanced 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 fina ncial services th atth ey now enjoy. Greater sha red u se 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 of wholesale financial services are more accus-tomed t o dealing with advanced technologiesthan consumers are. These organizations havefor years been using technology-based applica-

t ions, such as cash m ana gement services, thatwill not be significant in the consumer mar-ketplace for many year s. Therefore, for th osewho operate in wholesale financial service mar-kets, fut ure changes will not be as tr aum at icas t hey may be for t he rema inder of th e pub-lic that is generally not accustomed to deal-ing with relatively sophisticated systems.Thus, the changes that tak e place in the wholesale services are less likely to attract wide-spread attention than those provided to thegeneral public at reta il.



Ch. 5—Wholesale Financial Services q 149 — . ————. .— —————...—— —

Increasing use will be made of telecomm un i-cations to deliver financial services, and therewill be new opportunities for telecommunica-tion providers to function as providers of wholesale 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 of wholesale 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 an oth er, with th e major a s-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 th e funds.

Developers of th e inform at ion u tilities 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 informa tion utility are t hen a ble 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 throughth e informa tion ut ility.

People who have evaluated t he m ark et 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 toth e home. Var ious t ypes of firm s will assem-ble these packages an d, 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 providespath s to man y providers and t he opport un ityto 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.



C h a p t e r 6

The International Environment forFinancial Services



9

C o n t e n t s

PageIntroduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153

The Growth of International Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153New Directions in Int ern at iona l Ban king. . . . . . . . . . . . . . . . . . . . . . . . . . 154Mult ina tional Ba nkin g . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155

Financial Markets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157Money Ma rk et s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157Int ern at iona l Fina ncial Informat ion Syst ems . . . . . . . . . . . . . . . . . . . . . . 157

Int ern at iona l Int erbank Comm un icat ions . . . . . . . . . . . . . . . . . . . . . . . . . . . 158New York Clea rin g House Associat ion . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158Society for Worldwide Interbank Financial Telecommunication . . . . . . . 158

The Effects of Technology on International Payment Systems . . . . . . . . . 161Corporat e and Retail Ma rk ets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161

Vulnera bility of th e Fin an cial Syst em . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162Security and Integrity of the Financial System . . . . . . . . . . . . . . . . . . . . 163Error Resolution in International Electronic Funds Transfer . . . . . . . . . 163Foreign Telecommunications and Information Policies . . . . . . . . . . . . . . 163

F i g u r e s

Figure No. Page12.Daily System Traffic Volumes (average: end of year) . . . . . . . . . . . . . . 15913. Cumulative System Volumes (end of year) . . . . . . . . . . . . . . . . . . . . . . . 159

.



C h a p t e r 6

T h e In t e r n a t i on a l E n v ir o n m e n t fo rF i n a n c i a l S e r v i c e s

I n t r o d u c t i o nThe economies of the world have become

increasingly interdependent trading econo-mies. The financial service industry supportsthese activities by providing the means totra nsfer payment for goods a nd services pur -chased intern ationally and by acting as a n 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-dust ry becomes more importan t t o the worldeconomy.

Changes are t aking place in th e structure of financial markets as well as the structure of the industry and its participants. Commu-nication and information technologies havehelped to make ma rket s th at 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 th at in order to insure access to manyof the foreign money markets, it was neces-

sary that they establish a presence, eitherth rough a bran ch or a n a ffiliat e. A final r easonfor 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 anu mber of new entr ant s in t he field. Smallerbanks have been able to part icipate 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 Int erban k F i-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 foun ders.

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 identifyth e individual impacts of the t echn ologies 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.

T h e G r o w t h o f I n t e r n a t i o n a l B a n k i n g

Post-World War II developments in capital in turn expanded the role of the private bank-movement and the restructuring of the foreign ing commu nity t o support th ese tra de flows.exchange system helped foster trade, which Moreover, the development of multinational

153



154 q 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-nat ional lending. Event ually, the m ovementto increased internationalization of financialactivity was supported by changes in bankstrategy and management and by insti tutionaland st ructural changes in internat ional m oneyand credit ma rkets.

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 developed

nations 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 annu al rat eof 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 t heir great est growth from1965 to 1970, when average ann ual chan geswere 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 of assets in 1981, and from 11.3 percent of liabil-ities in 1970 to 23.4 percent of liabilities in1981.2

— — —*A eurocurrencyis a depositaccount at a European bank

denominated in a currency other than that of the host bank.‘R. M. Pecchioli, ‘Z’he Internat ionah”sat ion of B d ”n g : Th e

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 of demands 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 of trade. 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-na tional financial intermediation.4

New Directions inInternational Banking

It is impossible in this report to provide acomprehensive survey of all the changes in in-terna tional ban king techniques; rather, impor-tant product innovations will be highlighted,along with the entry into new markets.

Sources of International FundingInternational banking strategy does not

generally distinguish between domestic and in-tern at iona l fun ding, since, for t he most pa rt ,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 Stat es for m any years and in t he Eur o-dollar mar ket 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.



156 q Effects of Information Technology on Financial Services S y s t e m s

arated from the international activities of banks. (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 developedconcurrent ly with interna tional ban king, 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 market s abroad.

During the past two decades this activityhas increased considerably. The number of overseas 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 of their 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 BankingOffshore banking is any banking activity

within a country’s borders, but outside itsbanking system. There is considerable debateas to exactly which nations of the world shouldbe consider ed offshore cent ers. 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 UnitedStat es first per mitt ed th e development of in-tern at iona l ban king facilities (IBFs) in Decem-ber 1981 in an attempt to bring back much of the 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-ment s to Regulat ions D an d Q and a re simi-lar to an off-shore “shell” bran ch th at opera teson-shore.

The developmen t of off-shore ban king 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. This

can 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 AbroadThe 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 q 157 —— —— —.—.———. —-.—.

Foreign Banks in the United StatesThe 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

——— -— ————12Pecchioli, op. cit., p, 59; ( 1961 and 1978) Federal Reserve

Board 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 somecontent ion t hat the system does not t reat U.S.and foreign banks totally equally, but for themost part, foreign banks must abide by thesame regulations as U.S. banks.

F i n a n c ia l Ma r k e t s

Money Markets

Perhaps the most remarkable growth inbank use of foreign money markets as sourcesof funds in the last 20 years occurred in the

eurocur rency mar kets,Banks’ rapidly growing involvement in

euro-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-tiona l stimu lus t o 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 interban k commu nicat ion techniquesalso had a significant effect on the ability of banks t o participate in th ese markets.

Flexible exchange rates have enhanced theacceptability of the eurocurrency markets as‘‘substitutes’ for the foreign exchange mar-ket with respect to hedging.

——13Pecchioli, op. cit., pp. 19-20.

International FinancialInformat ion Systems

Comput er-based bu siness informa tion sys-tems are finding widespread application in the

financial 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 in74countries. ’4 By far the leader in this service,Reuters competes with other n onban k fina n-cial data providers in the United States andabroad, as well as with t he informa tion ser v-ices of finan cial inst itut ions. Th e Reut ers ser v-ice is un ique in th at, a s a videotex system, italso provides th e opport un ity for the user todeal in the markets and may eventually allowth e user to confirm and complete deals usinga t erminal.

The informa tion provided in t hese 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 n ow

essential information, providing a competitiveedge to its user. This in tu rn has forced most — — — —

14Paul Walton, “A Boon for the Money Markets, ”FinancialTimes,Dec. 14, 1983, p. 28.



15 8 q 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 th e long ru n,alyst for the growth of these systems. either by each organization’s having a central-

An an noying side-effect of th ese syst ems is ized information function that feeds into itsth e proliferat ion of terminals and th e incom- own data system, or by existing vendors of-

fering their services on compatible systems.patibility of systems. A dealer, in order to have

access to a variety of information sources, may

I n t e r n a t i o n a l I n t e r b a n k

Much of the int ernat ional banking a ctivitydescribed in th e preceding sections ta kes placevia sophisticated international communicationfacilities. This is particularly true for inter-bank tr ansfers of informa tion and fun ds. Asinternational banking has grown, so too hasthe importance of these functions. In recogni-tion of th is, man y of the lar ge, money-cent erbanks formed private telecommunication net-works to help ease some of the problems asso-ciated with massive paper flows. Interbanktra nsfers a re generally high-value tr an sfers.

New York Clearing House Association

In 1970, th e 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 a n a ut omat ed system. Since its in-ception, CHIPS has been almost entirely auto-mat ed, although for a short period in th e 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.

cialn ot

C o m m u n i c a t i o n s

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 tra nsmission n etwork. 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 tran smit 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 of smaller U.S. banks, in order to provide the vol-ume necessary to support the system.



Ch. 6—The international Environment for Financial Services q 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 fina ncial tra nsa ctions per da y

(see figs. 12 and 13).17 This represents aboutfour times the combined total transactions of the two private sector bank payment networksin the United States, Bankwire and CHIPS.18

SWIFT is not a clearing or settling networkan d does not rea d the messages as th ey passthrough the system; therefore, the value ofth ese tra nsa ctions is difficult to determ ine.

16 SWIFT: Ten Years,specialanniversaryissue of the genera lintroductory 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, J anua ry 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 Telecom-municationMay 1983)




U.S. traffic over the network is higher thanth at of any oth er n at ion; in 1982 it was 17.7percent of tota l 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.Plan s ar e to insta ll 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 financialtr ansm ission network in term s of volume, ithas cont inued t o seek n ew business opport u-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 Ba nker, 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 th is bus inessarea and therefore plans to expand its revenueproducing message traffic in other areas. In1982, SWIFT formed direct interface with theCEDEL and Euroclear bond clearing systems

and Master Card Inter nat ional to use SWIFTfor t ra nsmission of tran saction or set tlementinformation.

SWIFT has also begun a controversial newprogram to offer new financial services, spe-cifically balan ce report ing. 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, th ese ban ks 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 al though 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 ma nagement services,

“B. Kok, “The Business Future, ”Proc&d”ngs From SWIFT International Banking Se m ”na r(SIBOS ‘83), Sept.26-30, 1983,Montr eux, Switzerland, p. 12.



Ch. 6—The International Environment for Financial Services . 161-.

T h e E ffe c t o f Te c h n o lo g y o n I n t e r n a t i on a lP a y m e n t S y s t e m s

J. R. S. Revell distinguishes between twoclasses of payments in his work, Banking and

Electronic 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 of the 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 of transactions.

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.

th eir nat ur e han dle 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 crossman y int ernat iona l bounda ries. For the mul-tinat iona l corpora tion, foreign excha nge fluctu at ions 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-nat ional cash m anagement i s that the ma nag-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 computer

to invest smaller amounts according to rou-tines decided in advance. ”24

“Ibid.,p. 155.



— .-. .

Ch. 6—The International Environment for Financial Services q 163 — . — — . — . - —

th e growth in volume of finan cial flows sepa -rat e from but related to the pa yment 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 of

these transfers and the participation of small-er, nonmoney center banks, thus helpingchange the character and structure of inter-nat ional bank ing.

Security and Integrity of theFinancial System

Communication and information technol-ogies have increased the interdependency of th e part icipants within th e financial system.The intern ational finan cial system ma y 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 tointernat ional events th at results from comm u-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 operat ions a re 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, generally

more 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 suffered

under 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 ma y be caused byth e delay of a tr ansm ission, t he int roductionof faulty information, or a participant’s in-ability to settle the day’s transactions. Delaysand faulty informa tion m ay ar ise from har d-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. Cur rencies, account ing meth od-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 a nd st rictly 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 nat ions an d between par ticular n ationsand multina tional businesses. It is primarilythe informational f lows, rather than paymentflows, with which most nations are ostensibly

concerned.“Herbert F. I . ingl, “Risk Allocation in In tern ationalI n t e r -

bank Electronic Fund Transfers: CHIPS and SW1F T, ” H a r -~“ard International I,awr Journal, \’ol. 22, No. 3, fall 1981,pp.630-631.



164 q Effects of Information Technology on Financial Services Systems — . — — —

Sovereign nations assert legitimate reasonsfor, and a right to, monitor and control TBDF.Pr imar y among these reasons ar e protectionof th e privacy of their citizens, indust ria l 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 worldt rade .

As the inform at ion t echn ology indu str y be-comes increasingly important in internationaltr ade, more coun tr ies ar e 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-nat ional finan ce include ra pid comm un icat ionsand 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 of dat a pr ocessing are such t ha t it is more effi-cient to centralize the process.

For a variety of reasons, there have beensuggestions that nations limit the flow of per-sona l dat a 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 international

borders would be affected by such restrictions.Therefore, limitations on TBDF could causesignifican t problems for th e financial ser viceindustr y, which finds deman ds for int erna tion-al services increasing.

The economic and industrial development justification of restrictions of TBDF have astheir impetus the rising import an ce 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 h ave ta ken t he r out e 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 wa s allowed in th e large J apa nese 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 policiestha t t hr eaten to discont inue access to leasedlines, begin u sage-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 of locational sensit ivity in da ta processing. It iscommon for large corporations to center theirprocessing facilities in one na tion. For exam-ple, SWIFT’s data processing and transmis-sion centers for its 52 member count ries ar elocat ed in 3 count ries: the N ether lands, 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 pursues

domestic 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 facilitiesout side its border s.



C h a p t e r 7

The Consumer of Financial Services



—

Ch a p t e r 7

T h e C on s u m e r o f F i n a n c ia l S e r v ic e s


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 import an t pa rt of th e 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 of other 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, and

certain of the institutional problems withthese implementations are resolved, the effectsof technology on the consumer of financialservices are bound to become more evident.

Historically, the ban king sector of the finan-cial service industry has been either enamoredof or totally uninterested in pursuing the con-

‘The consumer, as defined h ere, is an individual u ser of per-sonal financial services.

sumer as a potential customer. It appearshowever, that competition is changing somof the indifference of banks toward this market. “It was n ot regulation or legislation th aallowed nonbank institutions to exploit the op-portunities available in upscale credit card(American Express), in discount brokerag(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 consumeratt i tudes that gave the near-bank competitorsthe upper hand in these product areas.’” Aa r esult, th e consu mer is beginning t o wielmore power in product development; recenevents are changing consumer financial serv-ices from being product-driven to being ma rket-driven. It is not clear, however, if all con-sumer s ar e benefiting from th ese chan ges.

Consu mer protection r egulation h as in t hpast dealt with t he protection and fair tr eatment of consumers in the financial servicsystem. Implicit in the formulation of publipolicy has also been the recognition of the po-tential impact of technology-based systems on

the consumer. However, it is important tofully understand the changes taking placeth eir impact on t he role and behavior of thconsumer, 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 Th e Retail Banking R e \ ’o lu t i o n :An International Perspec-tit’e, Patrick F r a z e rand Dimitri }Tittas (eds.) (1.ondon: Nlichae lI,afferty Publications, 1982), p. 7.

C o n s u m e r F i n a n c i a l S e r v i c e sConsumers seek financial services to fa- instruments, to balance present consumption

cilitate payment, to balance current income against future earnings with credit instruagainst futu re consum ption t hrough savings ments, to secure growth in capital, and to safe-

167

35 -505 ~ - 84 - 12 : QL 3



168 • Effects of / forma tion Technology on Financial Services Systems — — . — — —.

guard th eir assets. A rat iona l consu mer 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 of each 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 of money 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-stan ding assets a nd liabilities for t he 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 consu mers h ave begun using th emoney market fund for savings. The figuresfor 1982 do not reflect, however, the more re-

‘William L. White. “The Outlook for Money Market MutualFun ds, ” Report to the Inves tment Compa ny Inst i tute, 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 account s.

Life insurance funds are also used for ac-cumulating savings; however, because of their

low ra te of retu rn, t heir pr imary 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 the

net wort h of the individua l.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 a nd 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 ten dency to save rat herth an borrow, and a pat tern 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 q 169

Table 9.— Household Financial Assets and Liabilities, 1982 (billions of dollars)

Asse t s :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 r e se rves . , . , . , . . . . ,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 profit orqanlzat!ons

aNot elsewhere class lf~ed

$2,781.31.982.7

798,6

1,316,289.5

1,226,81,316.2

935.316.0

85.3$5,381.0

1,674.41.101,0

36.4344.8

85,933.373 0

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 m ost pa rt , consu mer n eeds can notbe met without th e assistan ce of an int erme-diary that provides access to payment sys-tems and markets, expert knowledge andadvice, th e pooling of a large n um ber of indi-vidual risks (as with insurance protection), ora d iversified portfolio for a m inimu m invest-ment (as with investment compan ies).

In the past, consumer financial institutionsspecialized in individual products and services.As a result there were some insti tutions 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. Recentrends in the marketplace and in regulation arebeginning to break down the strict distinctionsbetween institutions. Many consumers aradapting readily to the changes and are chang-ing traditional relationships with some finan-cial inst itut ions.

Prior to these recent events, the most widelyrecognized finan cial r elationsh ip for th e consumer was with a depository institution, espe-cially with a bank. Banks provided the consumer 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 / 0of 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 bank s an dwill accept fairly standardized products.’ How-ever, it a lso shows tha t t here is very little con-sumer loyalty toward a particular insti tution;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 merchant s, and h e want s 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 thepas t, most so-called consu mer loyalty was il-lusory in t hat banks had a m onopoly on cer-ta in t ypes of tran saction account s an d 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 a version, was gener-ally necessary to offset the risk associatedwith t he instru ments offered thr ough t hese in-s t i tu t ions .

It is evident th at consu mers ha ve also hadfairly complex financial relationships withnontr aditional finan cial service pr oviders. H is-torically, retailers have extended credit toth eir cust omers t o purchase goods an d serv-ices. From this has developed a fairly substan-tial number of consumers with revolving creditlines, and credit cards to access these lines of

credit. Sears and J. C. Penney have two of the

‘Arth ur D. Little, Inc., Issue and Needs in the Nat ion’s P ay-ment System, The Association of Reserve City Ban kers, April1982, p. 35.

5Paul Horvitz, American Ba nker, New York, Sept. 24, 1982.

largest card bases in the Un ited States anhave filled certain consumer financial needs foryears. Both are favorably placed in the finan-cial service marketplace because the consumerrecognizes their names. As the consumer becomes used to nontraditional providers of f

nancial services, he may willingly accept reta ilers a s providers.Consum ers ma y obtain cash from a variet

of other places besides banks; for example, in-dividuals routinely cash checks at a groceror conven ience store solely for t he pur pose cash acquisition. Although these retailers arenot financial institutions in the traditionasense, they certainly have provided consumerswith financial services in the past. Grocerstores have used check guarantee systems fora n umber of years, an d as m entioned earliein this report, some are beginning to offer moretechnologically sophisticated services—for ex-ample, onsite ATMs.

The ways in which th e finan cial service industry is changing are described more fullelsewhere in this report. The effect of theschanges on the consumer has been to offer hima greater realm of choice in the institutionwith which he can do business.

Consumer Payment Methods

Like the business sector, the consu mer r e

quires payment mechanisms to acquire goodsand services. Recent research h as postu latethat a consumer seeks as many as 11 specificattributes in a payment system: budgetingdocumentation, reversibility, spending control, transaction record, leverage potentiaacceptability, transaction time, transfer time,social desirability/prestige, and security.6 Eachconsum er will choose his m eth od of paymenaccording to his priorities and to his perception of a particular method as having the speci-fied attributes.

By far, the most commonly used medium of exchange for point-of-sale (POS) purchases is

‘Elizabeth C. H irschman , “Situa tional P erceptionof Prod-uct Prototypes Within the Product Class of ConsumerPa~’mentSystems. ” The J ournal of Genera) PsJ’choJogTr, \ ol . 106, 1982,p. 127.




cash, particularly for small transactions. Theprimary attributes of cash are convenience andaccepta bility. Since cash is un iversally 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 insta nces) money order s or cash -iers’ checks, ar e the only instr um ent s of pay-ment available.

Many consum ers u se checks to meet t heseneeds. Studies show tha t t he consum er’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 na tional a ccepta nce of the check led to theexplosion in th e ava ilability and u se of oth erpayment 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 car d.

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‘SeeEconomic Review,“Special Issue:Displacingthe Check”

(Atlant a, Ga: Federa l Reserve Bank of Atlant a, 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 th ey 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 consum er paymen t m echa nisms. Bankcards are perceived by the consumer to be

more acceptable and less time-consuming touse than checks and less risky than cash. Theyalso provide the consu mer 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 a s aninstrument of cash management. Tables 10and 11 show overall consumer holding a nd useof credit cards.

.——9The term “bank credit cards” is rapidly becoming somewhat

of a m isnomer. This term commonly refers to VISA and Ma ster-Card interchange cards, which in the past were issued by banks.However, th ese car ds (although for th e most part s till issuedby banks) now provide access to a variety of’ accounts, includingcentra l asset a ccounts offered by securities houses.

I O E c 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 35 Bank ... , . . . . . . . . . . 38 40 45 51General purpose a . . . 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 q 173 .

Table 11 .—Credit Card Use(families using cards as percent of all families)

— . — ——

YearType of credit card -1 9 7 1 1977 1978 1981 1982Any ... . . . . . . . . . . . . 50’ 60 62 62 ‘ - NAGasoline ... . . . 33 31 32 27 31Bank . . . . . . . . . . . . . . 19 25 37 39 47Genera l pu rpose b . . . 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 cardsNA—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 th e 1970’s, considerable speculat ion 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 t o grow at a pproximately 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 rath er th an an example of one r eplacing th e oth er.

Growth of Consumer Credit

The relationship of the consumer to the pro-vider of financial services ha s grown increas-

“Ibid.

ingly complex. In the early part of this centu ry, households operat ed almost ent irely ona current basis; using credit was an indicationof mismanagement of household accounts. Pri-or to the 1930’s, credit relationships with financial institutions were not common. Retail

establishments 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 againsfuture income.

Since th en, as described ear lier in th is report, there has been an exponential growth inconsumer credit and in institutions and instruments to serve these needs. In the 20 yearsfrom 1960 to 1980, tota l househ old liabilitieas a proportion of total household assets grewfrom 21 t o 35 percent . ” This growth also reflects, 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 prima ry long-term instr umen t for decades was the installment loan, where a bulksum was borrowed by the consumer from abank or consumer finance corporation to finance a large-ticket purchase of a durablegood, and repaid in installments over a speci-fied period of time. Another example of consumer credit was the retail revolving account,

in which a consumer could charge a particular 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 convenience; however, the credit uses of these cards,which were innovative when introduced, deserve exploration.

The bank card offers essentially two typeof credit options for the consumer: short-termcredit t o bridge cash shorta ges between paychecks and longer term installment credit. The

“Board of Governors, Federal Reserve System, Flowof Fund s Accounts, August 1983, September 1979.



174 • Effects of Information Technology on Fina ncial Services Systems— — — —— —. .—

latter is provided with only one credit appli-cation, the consumer may borrow the exactamount he wishes with in his credit limit an dha ve considerable paymen t 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 th e lifting of part icular banking r egula-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 int erest rat es.

Nontraditional Providers and InstrumentsRecent changes in the industry have also af-

fected the way the industry provides financialservices to the consumer and have introducednew players t o the m ar ketplace. In th e 1970’s,the inflation rate and the resultant high op-portu nity cost of standa rd consu mer savingsinstruments led to a phenomenon known as“disintermediation.”Funds flowed out of thedepository institutions into nontraditional in-struments and insti tutions. New instrumentswere created outside the interest rate-regu-lated environment of the banking community.One of these, the money market fund, allowsthe small saver t o earn higher interest ra tesand 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 withdraw

from his account with a draft, in many casesit meets his liquidity needs.The initial target of these funds was the so-

called upscale mark et; tha t 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 andtha t ear ned in bank t ime deposits , other, m orerisk-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 savingsan d investm ent objectives with one firm. H ow-ever, since ban ks a re n ot allowed to offer ad-vice on investmen ts, except in th e case of trust

customers, 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 provided

new opportunities for the consumer. This actallowed depository institutions nationwide tooffer NOW accounts through which the con-sumer ear ns interest on an a ccount tha t is notdifferentiated in use from a checking account.These accounts already comprise one-third of all checkable deposits. ” Also enacted by t hesame legislation was t he pr ovision th at fed-erally char tered savings and thr ift insti tutionscould offer consumer loans for up to 20 per-cent of assets.

Complexity of the MarketplaceThe present marketplace offers greater

choice yet greater confusion for the individual.

~Bomd of Governors, F ederal ReserveS y s t e m ,Money Stink Measures and I.iquid Asse t s , Dec. 3 0 , 1983 .




The consum er mu st be more aware of the pa r-ticulars of investment and must deal with achanged environment that no longer offershim standard investment opportunit ies keyedto his position in life. The result is an increas-ingly complex relat ionsh ip between finan cialinstitutions and the consumer.

For example, high and uncertain interestrates also led to an industry-led innovation inth e home mortgage mar ket. Dur ing 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 solut ion to th is situa tion is not n eces-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 th erewill be a conflict if the provider of services isalso the ma jor pr ovider of inform at ion a boutthese 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 bankfurther limiting their access to informationservices.

Technology-Based ServicesThere is little evidence to support t he n otion

that consumers specifically demand technology-based services; the demand for services isstill a reflection of the overall needs of the con-sumer. There is perha ps a pa rt icular class oconsumers, referred to as “innovators,” whowillingly accept new technological applications. The market for these services evolvedas the consumer discovered that technologybased services had specific attributes of remote location and self-service and that theyprovided a payment alternative. The use otechnology in financial services can help alterconsumer demand for financial services byproviding him easier access to his assets.

Some financial service innovations mentioned in the previous section were facilitatedby technological change; e.g., variable ratemortgages require information-processing fa-cilities in order to be cost effective. This section 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 informational nature of the financial service producled to the early application of automation inthis industry, particularly in internal andintra-industry operations. However, whenth ese technological solutions were applied toth e ma rket place, especially as new pr oductsand services in the consumer segment, thebenefits were not so clear nor the implementations so easy. In particular, when depositoryinstitutions attempted to transfer their costsaving technological solutions to the consumermarket, they were faced with a diverse, oftenreluctant market .




Consumer Acceptance of TechnologySome a tt empts at intr oducing t echn ology-

based products an d services to th e consu merof 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 fundstr an sfer (EFT) tha t is h ighly visible to th e con-sum er of finan cial services. By 1981, the Ba nkMarketing 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 half of 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 Atlan ta in a recent ana lysisof check displacement has estimated that thesaturation level for the ATM will be reachedwhen t he percentage of actual u sers rea ches65 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 hum an teller.

Also interesting to note is that use of themachines during normal banking hours is in-creasing, which represents a change in con-sumer att itude about t he primary attributesof th e ma chines. 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 machines

and 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-tr an saction cost of the system a nd t hereforethe costs to the institution.

Research shows a strong correlation be-tween age an d ATM use. The most frequentuser of an ATM is young; use peaks in the 25-to 34-year -old r an ge, with a d ra ma tic fall-off in use among members of the population over65. ’6 There is some evidence that those young-

er than 25, although not frequent users of ATMs, 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 u nclear.

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 Mar keting Associat ion (BMA), P a y m e n t AttitudesChange Evaluation (PACE III 1981), Chicago, p. 2.1.

‘“Econ om ”c Review, op. cit., p. 17.“Bank Marketing Association, op. cit., p. 2.50,



Ch. 7— The Consumer of Financia/ Services q 177 — .— —— . —. — ——————

. . . . . .

zo0-Jm



178 • Effects of Information Technology on Financial Services Systems —. -

are n ot a lways importan t t o the elderly con-sumer of financial services. Tradition and thehuman factor can play important roles in thisgroup’s use of financial services, and thereforein th eir a ccepta nce of techn ological s ervices.

Automatic Direct DepositIn an automatic direct deposit system, some

form of income is au toma tically deposited inan individual’s account on a regular basis. Ex-am ples include dir ect deposit of Social Secu-rity checks by the Government or of payrollby the private sector. Direct deposit is anotherexample of technology-based service of whichth e general population is near ly 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, penetra tionof 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 of town). On the other h and, th e consu mer 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 aut omat ed, but a re considered her e be-cause they represent an innovative use of technology-in this case, the telephone—to fa-cilitate consumer payments. Telephone bill-

“Ibid. p. 3.4.‘n Economic 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 few

years.Point-of-Sale Systems

There is little substantial information onconsumer att i tudes 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 car ds.

Home Informat ion Systems

Home information systems are described atlength in chapter 4. There is little agreementon the potential for consumer acceptance of this 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 an d if th ey will become a ma ssmedium and therefore open to every level of consumer.

Once more, the perceived market for theservice is the upscale consumer. To the con-sumer who earn s less tha n $40,000 per yearand writes few checks, the system may not becost effective. For the time being, pricing of both equipment and the services may precludethe participation of the lower income consumerin th is case.

Pricing StructuresPast financial services were often perceived

by the consumer to be free or, relat ive to oth erexpenses, inexpensive. There was either no




tually be an economic incentive for individuals ingly and are encouraging migration to newer,to use E FT. Some finan cial institut ions have technology-based services and delivery mech-already begun to price their services accord- anisms through pricing strategies.

P u b l ic P o lic y a n d t h e F i n a n c ia l Se r v i ce C on s u m e rAn 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 ensureth e overall safety and soundness of the sys-tem and Federal deposit insurance programs.

Deregulation has made it possible for a num-ber of new instit ut ions t o ent er t he bat tle forconsumer funds. A diversity of institutionsnow offers similar pr oducts to the consum er;

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 of protection to the consumer. Adherence to cer-tain safety and soundness regulations requiredof depositories is not r equired of other finan-cial inst itut ions. H owever, t hese n oninsur edinst itu tions offer ser vices similar to th ose of-fered by insured institutions and have, in fact,drawn accoun ts a way from th e insured inst i-tutions. Only the effect on the consumer, notthe equity, of this situation for the various in-

stitu tions, will be discussed h ere. Importan teffects are those which are perceived by theconsumer and therefore are reflected as changesin investment behavior and those which areimperceptible to the consu mer bu t m ay ha velong-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 an d group investors u nderdifferent financial arr an gement s.

Under current Federal and State regulatorystructure, the consumer ’s deposits at a partic-ular depository inst itu tion 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 h eld by broker/dealers. These losses willoccur u sua lly only if th e instit ut ion goes int oinsolvency.

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 mut ual fund an d the money market mu-tual fund. The consumer is covered neither formarket losses nor for losses that are the re-sult of mismanagement. I t appears that manyconsumers consider the money market mutualfund a higher interest-bearing type of deposit,and a re not aware tha t th eir accoun ts 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 differen t t ypes of fina ncial instit ut ionsnow offer the same services. In many cases thedifference between choices among instrumentsis imperceptible to the consu mer in th at it isrelated to the regulatory structure of the in-



Table 12.—Summary of Variances in Regulation and Investor Protection

Entit les Involved InvestorI n e st ab li sh in g p ro te ct io nrules and primarilyregulations provided by

Federal and State Onsite

Types of servicesInsurance RegulatorInsuranceType of Institution coverageDepository Institutions

. Banks $100,000 perq Savings and loan accountq 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 StateGover nment authorities

Variabledepositoryinstitutionregulators

examinationand accountInsurance

InformationdisclosurerequirementsSRO onsiteexaminationsand marketsurveillanceInformationdisclosurerequirementsand onsiteexaminationsInformationdisclosure,SRO onsiteexaminationsand marketsurveillanceOnsiteexaminations

State sponsored Credit unionsinsurance NCUA Statep ro gr am s– no authorit iesonet’

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 of

these regulations. Certainly it is necessarythat he know his rights and liabilities with re-spect to the use of certain instruments.Toward t his end, Congress requires t ha t 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 ActThe following congressional acts are con-

sumer-oriented, and most are amendments to

th e Consu mer Cr edit Pr otection Act of 1968.That act was one of the first major pieces of consumer 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 tha t ma y 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-pan ies, and reta ilers wh o extend credit.

Regulations Z and M

Covered under Regulations Z and M arethree separate acts:

q

q

q

Truth in Lending (Regulation Z)–This actcovers closed-end and open-end consumercredit transactions. The primary purposeis to disclose the costs and terms of credit

arrangements 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 t he ma nner in which custom-ers are billed on their open-end credit ac-count s, and h ow finance cha rges ar e 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 the

importance of credit to the consumer.Fair Credit Reporting Act–Title VI of the Consumer Credit Protection Act, ef-fective in 1971. The purpose of this act



Ch. 7—The Consumer of Financial Services • 183

is to make certa in th at credit reports onconsumers are fair, current, and accurate.It gives the consumer certain rights to ex-amine credit information about himself and to correct any errors that might bepresent. In addition, the act imposesother responsibilities on the credit report-ing agencies —i.e., th ey mu st mak e certa inthat all users of their information are ob-taining reports for legitimate purposes.

q 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 ActThe E lectr onic Fu nds Transfer Act (EFTA)

amended Title IX of the Consumer Credit Pro-tection Act by establishing rights and respon-sibilities for EFTs. These r ights a nd 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 t hat 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 E FT, as in t hecase of an ATM cash withdrawal or electronicPOS terminals, his liability is limited underEFTA (although not to the extent as u nder th eConsumer 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 t he consum er ha s recourse un der 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 the

card, but it is doubtful whether they would rec-ognize a distinction between a debit processedelectr onically and one pr ocessed in t he pa persystem. It is also reasonable to assume thatthe consumer perceives no difference betweenall of the tr an sactions in a r egulatory 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




Tr a n s i t i o n F r o m P a p e r - B a s e d t oTe c h n o l o g y - B a s e d S y s t e m s

It is conventional to regard householdsrather as passive participants in the move

towards 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 t he growth of technology-based serv-ices is the float. In recent years the float hasbecome increasingly shorter. Technology-basedpayment systems could event ually make th efloat 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-men t, 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 point s of entr y into the syst em, 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 ha s revolved around th e relat ive 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 become

more obvious.With th e ATM, th e consu mer’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 of

them. 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 q 185 — — — .- — —

tion number (PIN). The use of a PIN has anu mber of flaws. For example, if th e 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 accepta ble to th e 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 t he most a cceptable altern at iveto both th e industr y and t he consu mer, sinceit is the predominant means of identificationused in financial services today. It will be sometime, however, before th e t echn ology will beapplied to financial services.

The use of ATMs presents personal securityproblems, beyond th ose 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 bankbran ches can be insecure when u sed out sideof 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 account s a re debited. Ther eis 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 use

of 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 ma y ultimat ely lower th e finan cial burdenfor the consumer.

Pr ivacy

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 ba sic definition, privacy is the freedomfrom unauthorized intrusion, the authority inthis case coming from the individual. However, in the course of everyday life the con-sumer has given up some of these rights,or

has “authorized” certain intrusions into hislife. The distinction between what is explicitlyauthorized and what is not is unclear. Privacyis considered one of the primary concerns othe individual when choosing financial services.




Much controversy surrounds the issue of EFT a nd privacy; tha t is , whether th e systemsthat consti tute 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 t he 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 th e 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 areperha ps easily tr acked on a case-by-case ba sis.Although electronic payments secure the con-sumer from some types of prying, they mayin fact m ake h im 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-it

has been dismissed by certain experts as a subject 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 sta tement.

Even when the issue is more clearly definedth ere is only slight ly more r esista nce to elec-tr onic system s because of privacy issues. Forexample, in the same BMA survey, 20 percentof users and 25 percent of nonusers sa id tha t

21National Commission on ElectronicFundTransfers, EFTin the United States: Policy Recommendations and the Public Interest, Oct. 28, 1977, Washin gton, 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. I t appears that consumers forthe most part do not perceive privacy as a ma-

jor issu e for concern in t heir choice of EF T sys-tems; other, more mar ket-oriented qu estionsseem 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 of videotex 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 of information, government access, security, sub-scriber access, correction of errors, applica-tions to third parties, future revisions, andretention of information.22

These guidelines a re n ot binding to the in-dustry, and certain VIA members plan toadopt t heir own compa ny pr ivacy code basedon VIA guidelines. Several financial serviceinstitutions, in particular bank card providers,have corporat e guidelines t o protect th e pri-vacy of their account holders.

Consumer Rights to Financial Services

Techn ology may increase a ccess t o the sys-tem for a number of people and expand choice‘Zzvideotex Indus t ry ASSmiatiOn,“Model Privacy Guidelinesfor VideotexSystems, ” June 1983.



Ch. 7— The Consumer of Financial Services q 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 int roducing some of th e 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 m et by t he t echn ology; however, morepersonalized services may be unavailable tothem. This tendency plus fee-for-service pric-ing may transfer the costs to the consumer ina way t ha t is inequita ble. Even if the cost of home information services technology dropsand communications costs rise, certain lowermiddle-income segments of the populationmay st ill be barred from pa rticipating in t hesystem. That segment of th e populat ion t ha tcannot 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 s tores) or th ey may be

forced from the system completely. Thisbrings into question the safety and soundnessof these nonbank depositories and whetherth ey 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 serviceinsti tutions. I t 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 techn ology-based systems is still min i-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.



C h a p t e r 8

Findings



.

C o n t e n t s

PageConclusion 1: Applications of Technology and the Changed Nature of

Fin an cial Ser vices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192

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

Conclusion 3: Interaction Between Technology and the LegalRegulatory Str uctu re Governin g Banking . . . . . . . . . . . . . . . . . . . . . . . . . 198

Conclusion 4: Financial Options for the Consumer. . . . . . . . . . . . . . . . . . . . 201The Equity of Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203Mar ket ing t o th e Consum er . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203Cha nges in P ricing S tr uctur e. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204The Implications of Technology-Based Products. . . . . . . . . . . . . . . . . . . . 205

Conclusion 5: Security and Integrity of the Financial Service System . . . 205Theft of Fu nd s. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205Syst em In tegrit y . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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 . . . 215Ant itr ust Implicat ions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215

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



19 2 q Effects of /formation Technology on Financial Services Systems

In light of the accelerating rate of change try. However,a number of conclusions thatin the financial service industry and in the bound the range of possibilities have beeneconomy in general, it is not reasonableto developed, and these are presented in thismak e any firm predictions about t he stru ctur e chapter.and character of the financial service indus-

C o n c l u s i on 1: Ap p li ca t i on s o f Te c h n o lo g y a n d t h eC h a n g e d N a t u r e o f F i n a n c i a l S e r v i c e s

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 th e dat e of deposit t o the dat e of withdrawal 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 th e int roduction of techn ologyhave been imperceptible to customers. For ex-ample, one month a statement may be pre-pared on an account ing machine and th e 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 rat her th an hu man 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 conn ection to th e network bythe retailer.

In some ways, the rate of change in thefinan cial service indu str y is accelerating in r e-sponse to the assimilation of rapidly advanc-ing technologies. On the other hand, the reluc-ta nce of a significan t n um ber of users to ada ptto the changes is limiting the rate of changein t he indust ry. Only a litt le over 30 percentof th e recipient s of Social Securit y paymen tsha ve agreed to accept pa yment by direct de-posit, thus limiting the ability of the Departmentof the Treasury to realize the full benefits of applying the available technologies. Public re-action t o a requirement by one bank tha t 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 par ticularly importa nt inthe programs of card issuers to limit fraud andlosses to bad debt. One of the key features of the 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 arere-luctant to accept a paper check at the pointof sale, preferring instead to avoid the risk of loss 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




financial service industry could not functionas it pr esently does. Furt her, 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 from

historical patterns could have a direct and major impa ct on t he costs of delivering finan cialservices, the structure of the industry, and thedistribution of costs among the various par-t ic ipants .

For example, home banking systems havegenerally been designed so that the user needmake only a minimal investment in t erminalequipment 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 a vailable and t ha t t he cost t o theuser of a lengthy, interactive session with ahost comput er will be minimal. On t he otherhand, if local telecommunication costs rise sig-nificantly, such systems may have to be rede-signed to minimize the connection time be-tween t he u ser an d th e provider’s comput er;th is could resu lt in excessive cost to th e userof a terminal. Similarly, the large amounts of capital 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, an d who benefits from it h avelong been at issue. The various financial serv-ice par ticipant s h ave developed str ategies tota ke advan ta ge of float th at ran ge 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 ispostm ark ed on or before t he 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 n eeded for day-to-daytransactions into investment accounts thatpay market rates of interest. Then, funds canbe moved to tr an saction a ccoun ts t ha t eitherpay no interest or pa y below-mar ket int erestrates for minimal periods to meet require-ments for disbursements and/or to receivefunds from others. The net effect of thistenden cy will be a constan tly increasing down-ward pr essure on th e balances of tran sactionaccounts held by depository institutions andothers.

C on c lu s io n 2: R e s t r u c t u r in g t h eF i n a n c i a l S e r v i c e I n d u s t r y

Some patterns in the ongoing restructuringThe structure of the financial service indus-of the financial service industry are discernible: try was, at one time, clearly defined. Most

the present fluidity and rapid change will con- individuals and businesses conducted their fi-t inue 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 t he finan cial service indu stry consistsof a variety of organizations, ran ging from t ra-ditional depository institutions and relatedfinancial organizations that have expandedservices, such as securities firms, to suchnontraditional financial service providers assupermarkets and retail department stores. Avar iety of organizat ions offer in vestmen t 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 an d reta in 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 t ime when the competit ive characterof the financial service industry was very dif-ferent from what it is today. For example, reg-ulations which set ceilings on deposit interestrat es at federally insu red commercial banks,savings and loan associations, and mutual sav-ings banks restricted the ability of depositoryinstitutions to compete with money marketfunds, a product development tha t wa s 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 Ins tit ut ions Act of 1982 amen dednu merous Federal banking laws and creat edfive 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-tu nity cost of standar d consu mer sa vings in-struments, result ing in a phenomenon knownas “disintermediation.” Funds flowed out ofthe depository institutions into nontraditionalinstruments and insti tutions as many individ-uals shifted their assets in order to obtain thehigh interest rates. Many of these new instru-ment s were created by organizations out sideof 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, u sually $500.

In the new competitive climate, nontradi-tional financial service institutions quicklyrealized th e tr emendous potential in pr ovid-ing financial services. They also realized theease with which they could enter th is indus-try. For example, J. C. Penney, a major na-tional retailer, operates a highly sophisticatedonline commu nications system th at 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 compa nies. Ou tside of its rolein financial services as an extender of creditto reta il cust omers, J . C. Penney ha s 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-mar kets intend t o replace banks an d others a soperators of switches for financial transactionnetworks and are highly competitive in thisarea. They are also taking a major role in thedecisionmaking surrounding these activities.Petr oleum compan ies, with t heir vast chainsof retail gas stations, are following the leadof the dry goods and grocery chains.

Unlike most depository inst itut ions, ma nysecurities 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 fun ds, 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 mar ket. 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 mar ket t hr ough n etworks of compan y-

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 th e indust ry re-organizes. National Ent erprise Ban k, whichopened in Washington, D. C., in August of 1983, is one such ban k. Ent erprise is aimedat professionals—doctors, lawyers, dentists,

accoun tan ts, and consult ant s. 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 of interest 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 t hing superbly. It is possible th at th eindustry 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 sh arp cont rast to th e specialty provideris the financial supermarket. Offered as a one-stop fina ncial cent er offering ban king, 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 brokerage

services 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 i ts long-

term viability been demonstrated.Legal barriers still hinder the entry of some

businesses into t he financial service ma rketand 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 barr iers prevent brokeragehouses from operating as a financial supermar-ket in th e tr ue 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 afinan cial superma rket, a nu mber of mergersand acquisitions may be necessary. Severalnonbank providers have acquired banks tohave access to the payments m echan ism andFederal deposit insurance. These financial con-glomerates have come along much faster thanexpected becau se of th e profoun d chan ges ininsurance, banking, and securities broughtabout by the interplay of high interest rat es,technology, and regulation.

Aside from economic conditions, whichmany claim are a driving factor behind the

changing 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 t echn ologies allow a firm t o 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 in format ion.

Ch. 8—Findings q 197

The significant chan ges in th e stru ctur e 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 th e systems th atsupport financial services ar e already in thehan ds of new entr ant s because su ch t echnol-ogies can also be applied to support many dif-ferent industries. As a result , many potentialentrants are able to offer financial servicesusing esta blished comput er a nd commu nica-tion systems. Some firms have entered themarket for retail financial services, some havebecome wholesale providers, and others haveentered both mark ets.

Industry restructuring has brought aboutsignificant potential for industry consolidation

as the functions that support the industrybegin to overlap. While depository institutionsare technically the only organizations allowedto accept deposits, nondepository organiza-tions h ave developed products t ha t a re near -deposits and thus compete with products ofdepository insti tutions. 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 opportunit ies and that accumulate cash

value, 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 of ATMs. 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 En gland St at es (Conn ect-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 h avereciprocity agreements for interstatedeposit-taking by ATM–e.g., Washington, D. C., and Ma ryland.

pace that it is no longer a question of whencert ain cha nges 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,th ere are indicat ions t hat th e finan cial serv-ice indust ry is changing from a tra ditional t oa 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 th at 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 and

players in th e industry, and a ma rket willingto test them.

C o n c l u s i o n 3 : I n t e r a c t i o n B e t w e e n Te c h n o l o g y a n dt h e L e g a l R e g u l a t o r y S t r u c t u r e G o v e r n i n g B a n k i n g

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 and

products. Both Federal a nd St at e legislat ivebodies 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 ban king system were a result of the Great

Depression of the early 1930’s. The restric-tions were an at tempt t o 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 Ba nkin g Acts of 1933 an d 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 t o the industry th ey regulate.

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



—


th e fun ction. The inst itut ional lines ar e nowfuzzy.

Existing Federal laws and regulations havemade it increasingly difficult for banks to com-pete against new entrants into the marketswhere th ey ha ve traditionally had an almostexclusive franchise. Several points must beconsidered, however. Banking is looked uponas a special business th at 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 of depositories to risk. On the other hand, ex-isting regulations are designed to preventbanks from exerting undue influence overother lines of commerce.

Pr esently, the roles of th e various F ederalagencies with respect to regulating depositoryinstitu tions a re 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 dua l bank ing 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 becaus e, for t he m ost par t,th e goals of regulat ion were comm only sha red.However, this a ppears 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 demonstra ted th at theywill esta blish offices in St at es th at offer a par -ticularly favorable regulatory climate.

One of the concerns depository institutionface is that a growing number of differentlregulated financial service organizations arable to offer a broader range of financial serv-ices than the depository itself can offer. Foexample, Merrill Lynch can offer securitie

services, real estate services, and a packagof additional financial instruments, such athe money market fund (cash management ac-counts which serve as high interest-earninsavings instru ments), and, to a l imited extent,transaction accounts. While it is possible fonontraditional providers to compete head-thead with banks by offering new substitu tefor banking products, depository institutiondo not have the same leverage.

Many of the nontraditional financial service providers are improving their positions vis-a-vis ban ks by est ablishing or a cquirin g commercial banks or thrift organizations (e.gDreyfus Corp./Lincoln State Bank of EasOrange, N.J.). Travelers Insurance Co. has re-quested regulatory approval to offer FDICinsured* instr ument s to i ts customers t hrougha trust subsidiary. Depository institutions, ex-cept in some States and for some grandfat hered ins titu tions, are n ot allowed to owinsurance companies nor are they under ancircumstances allowed to provide a full rangeof investment services, although holding com-pany affiliates may engage in discount brokerage.

Organizations, however, have found ways tocircumvent th e existing fina ncial service reulatory structure. Technology has certainlbeen one of the driving factors. The ATM, foexample, enables interstate access to individ-ual bank accounts, and in some instances localregulatory authorities and legislation havpermitted interstate deposit-taking, as wel(Douglas a nd McFadden Acts, pr ohibiting iterstate banking and deposit-taking, respetively, are ineffective.) This same technologis being applied by nondepository institutions,such as su permar kets a nd other retailers (e.g.,

* Federa l Deposit Insu ranceCorporation.

35-505 0 - 84 - 14 : QL 3



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

Pu blix superm ark et, Safeway, Sears) to pro-vide services in direct competition with banksand/or their subsidiaries and service corpora-tions. These organizations are n ot tak ing 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 a ble to solicit business a nd esta b-lish corporate offices on an interstate basis.Advanced communication systems enable real-time access to finan cial inform at ion so th at 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 result

of 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 th e Federal Reserve andth e Comptr oller of th e Curr ency ha ve takenactions to slow, if not halt, increases in the

numbers 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 sa vings ban kshave acquired savings and loan associationsin other States. A major money center com-mercial bank has been permitted to acquiretwo sizable out -of-Sta te savings a nd loan asso-ciations.

Many new regulations, primarily those af-fecting electr onic funds t ra nsfers (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 tocreat e a paper d ocum ent a t t he 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 t hat h ave put banks a t 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 m ix of products a nd services th at 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 t he regulatory str ucture) 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 t itles th at 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 Federa l ReserveBoard has pu t out forcomment a pro -

posal to cover paper-based tr ans actions under Regulat ion E.It ha s also issued a pr oposed 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 Sta te laws. The most recent exam-ple of this is South Dakota’s allowing Statebanks to own full-line insurance companies.Out -of-Stat e ban k h olding compa nies, 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 institu tions providing t he sa me t ypesof financial services. Additionally, its pro-ponent s believe it would provide compet itiveequity among the depository institutions and

nonbank institutions.

Technology development, economic conditions, an d other m ark et forces ha ve chan gethe structure of the industry to such a degreetha t t he boun daries in th e existing legal regulatory framework have less and less of an im-pact. ATM systems permit access to accountson a n at ional basis; they even permit accesto 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 arweakening, 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 thfinancial system. Technology and mar keforces ha ve intr oduced significant changes ithe industry. Based on available evidencetechnology has brought about no apparent re-duction in the safety and soundness of the in-dustry. The changes have encouraged Congress to begin reexamining existing legislation,but for the most part Congress has directeits most recent efforts toward catching uwith the events that have been occurring ispite of the legal regulatory barriers. In lightof the realities of the technology, regulatorconsideration and emphasis may be betteplaced on the impacts of new services on pro-viders and users rather than on the technologi-cal developments that ultimately drive them.

C o n c l u s i on 4 : F i n a n c ia l Op t i on s fo r t h e C o n s u m e r

A primary consequence of the changes in fi-na ncial services ha s been th e prolifera tion of options 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 a nd invest-ment options and a greater variety of insti-tutions providing financial services to theconsum er t ha n ever before. Choices ha ve ex-

panded in all areas of financial decisionmaking.

Since the introduction of the bank credicard in th e late 1960’s, the consu mer ha s ben-efited from the convenience of a readily accept-able payment mechanism, which provides means 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 relativel




small am ount s of money at su bstant ially high-er interest ra tes than with ban k 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 mar ket accoun ts an d interest-bearingaccounts that are the functional equivalent of checking 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 t heregulations affecting Individual RetirementAccounts (IRAs), all consumers can enjoysome tax-postponed income. The systematicdismantling of Regulation Q will eventuallycompletely deregulate int erest r at es on t imeand savings deposits.

The individual also has a greater number of options with r espect to th e 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, differentiat ing th eir products an d 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 paperins t rument .

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-ket ing–th e offering of services ta ilored t o thespecific needs of small groups-is availablethrough financial service boutiques. The up-scale consumer and specific occupational groups(e.g., farmers) benefit.

Techn ology provides t he competit ive 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 introducedth rough videotex services an d t he comput er.Point-of-sale (POS) electr onic payment s sys-tems, which were attempted in the1970’s, arebeing attempted again in specific trials.

The distinction between those options avail-able to the consumer through technologicalmean s an d th ose which seem t o be the resu ltof 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 manu al systems.

*Physical deposit-tak ing services cannot be offered at a lllocations.



—

Ch. 8—Findings q 203 — — .— .- ——

The Equity of Choice

Choice, in an economic sense, is good, andas such, the assumption underlying thein -crease in financial management options is thatit mu st benefit t he consu mer. However, twobasic issues must be examined in this context:

1. Do all consumer s a ctu ally benefit from t hecurrent expansion of choice in instrumentsand institutions?

2. Are t here coun tervailing t rends in t he 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 consum ers a re becoming asset man ag-

ers. However, although most consumers areaware of the choices available to them, manyare still confused by the options. Certainsegment s of society will prosper u nder a sys-tem of great er choice: they will have th e nec-essary information and know-how to make useof the information to their financial advantage.However, oth er segment s m ay be less fort u-na te. According t o the available tra de 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-sum ers r equire 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-stitu tions would have inst itut ed the sam e 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 ar

problems or can carry out functions not possible through an ATM.In order for the consumer to take advantage

of the increased number of alternatives avail-able for financial management, he must under-stand their function and benefits. Commercialbanks and savings institutions may not bequipped to provide consumers with the informed assistance necessary for helping themmake increasingly sophisticated decisions. Inman y cases t he ban k employee knows as litle about the new products and services as thecustomer he is trying to help. Although thconsumer may prefer to deal with a local institution, he will tend to do business withth ose institu tions t hat not only offer him t hbest return, but also provide good information.In some cases, tha t will be th e local inst itution; in others, it will be an institu tion wita regional or national presence and a more so-phisticated mar keting approach. This, in tur n,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 int erest . In th e past , one bank ’s products were the equivalent of the next bank’sthe products offered were straightforward, andcompetition was based not on the relativmerits of each but on the “extras’ ’-i.e., thservice offered. Although Truth in LendinAct 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 n o longer clear wha t t he pur pose androle of depository institutions is. No longer dosuch institutions have a unique niche in thmar ketplace. Under t hese circumst an ces, in



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

formation available to the consumer maysometimes be biased. In the highly chargedcompetitive at mosphere th at now prevails inthe financial service industry, informationmay either obscure the real situation or inflateits advantages. A particularly vivid example

occurr ed the first year t hat 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 shouldapp ly the prin ciple of “caveat empt or” to th emanagement of his financial affairs, he hascome to perceive banks as noncompetitive, andhe conducts his business with banks based onth is perception.

In a ddition to th e issue of consu mer 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.Edu cat iona l differences or th e 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 decisions

about 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 nocert ifying process or st an dar d form of educa-tion required for these advisors.

Second, it could also eventually affect thenumber of options offered by the industry. If institu tions find th at th eir client ele are con-fused and unwilling to spend the time to makea decision among a wide variety of choices, theinstitu tions may decrease t he nu mber 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 situation

may evolve where the industry is allowed tooffer many alternatives but chooses to offera limited selection based on the preference of a particular market segment or, -perhaps,mass market .

Changes in Pricing Structure

t h e

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 to

be charged for th e cost of th eir ser vices. In ahighly competitive, deregulatory atmosphere,cross-subsidization is infeasible because thelarger, more profitable account holders willtend to move to those institutions where theycan earn t he highest interest ra te.

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 notha ve a choice; for example, most h ouseholdsneed 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 transactionsar e hea vily payment-oriented.



Ch. 8—Findings q 205 .— — —

The Implications of Technology-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 deploymentan d u se 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 beganencour aging d irect deposit of Social Securit ypayments, 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 r equire th at 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-— ———

‘EconomicReview, Federa l Reserve Board of Atlanta, August1983, p. 33.

termediaries, either because the consumechooses not to establish this relationship obecause he is an undesirable customer andtherefore cannot find a financial institutionwilling to do business with him. With direcdeposit there is pressure on both the individual

and the institution to form a relationship. Thispressure for institutions is in direct oppositionto the competitive pressures they feel from therest of the indust ry to rid t hemselves of unprofitable accounts. Yet, these accounts neednot be unprofitable for the bank if it chargeappropriately for its service. However, the po-tential exists of charging an individual, whis in essence forced into the system, a disproportionat ely high port ion of his in come. There is some argument for the subsidizationof these accoun ts, but with t he curren t competitive state of the industry, it is doubtfuthat 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 payth ese costs.

As direct deposit of government transfepayments becomes more common, other regular income payments may also be paid direct-ly. The issu e on a lar ger scale isnot only wh opays for the service, but also whether the con-sumer can be forced to establish a relationshipwith a financial service intermediary in order

to receive his salary.*sOme ~ndil~idu~s LISP Ser},icesfor a Jrariet?r of nOrll lat i \ ’er ea -

sons that m ayactuall}’ be moreexpensi~’e than wouldbecharged by a financial institution.

C o n c l u s i on 5: S e c u r i t y a n d I n t e g r i t y o f t h eF i n a n c i a l S e r v i c e S y s t e m

The application of advanced information tech- Theft of Funds

nologies to financial services significantlychanges the ways in which, and the extent to There ar e two kinds of threat s to finan ciawhich, payment and transaction systems and service systems: 1) th ose th reat s inher ent ithe users of these systems are vulnerable to sys- the system, that usually require technical solu-tem failure, disruption, theft, error, and invasiont ions; and 2) those that are perpetrated by in-of user privacy. dividuals who wish to compromise the system



. .

—

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

The smar t card is an oth er new technologyclaimed to be more secure than existing cardtechnologies. The microchip-implanted cardhas different levels of security, but the futurerole of th e smar t card in t he financial serviceindustry remains unclear.

In the commercial environment, the securityof payment systems is alsoa n issue of signifi-cance. The increasing use of computers to ini-t iate payments automatically raises the needto establish t he identit y of the comput er ini-tiat ing a financial t ran saction, justas, in thepast , it ha s been necessar y to establish posi-tively that a payment order issued by a humanis auth entic. Finan cial systems t ha t 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 l imitaccessto financial information that may be of valueto an intruder, even if there is no unauthorized

transfer of funds. Finally, superimposed onthese requirements are all of the concerns thatpertain to individual users of financial serv-ices, particular services that entail remoteac-cess to financial service systems.

Sys tem In tegr i ty

Systems for delivering financial services canalso be compromised by a number of factorsthat are inherent in the operating environmentbut are, noneth eless, capable of interr upt ingservice.

In the more traditional systems for deliver-ing financial services, breakdown of system in-tegrit y is possible. Records can be lost, a longwith the audit trails necessary to reconstructthem. Checks and balances built intoproce-

Ch. 8—Findings q 207 — — . .

dures for processing transactions can be circumvented for expediency or can fail tooperate under an unanticipated set of circum-stances. However, human involvement in thedelivery systems can be instrumental in detecting breakdowns of system integrity whenthey occur and in implementing the stepsto

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, themay be built t o include pr otections t hat cannot be incorporated into simpler systems.

Computer programs, for example, are designed and built to handle a predetermined setof conditions. Any data values not falling into

one of the defined categories should be re jected by the program and examples of suchoccurrences should be included in the testconducted before a program is put into operation. However, even though computer programs are “validated,” exhaustive testing inot physically possible, and there is always thechance that some combination of data can bentered 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, t hough significan t, can go unnoticed for years. In the aggregate, the impacts could be significant, although no onincident 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, part icular 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 of time. Also, mechan ical failur e of a disk d rivcan cause data to be destroyed. Although so-phisticated techniques exist for detecting errors in data recorded on magnetic media, someerrors remain undetected. These problems are



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

reasonably well understood, and the tech-niques for n eutr alizing them a re str aightfor-ward and relatively inexpensive if operatingmanagement is willing to pay sufficient atten-tion to them and the system design incor-porat es 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 ava ilable and verifiable, serv-ice cann ot 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 beyond

the means of competent technical management,To a very significant degree, a financial serv-

ice indust ry operat es on t he t rust 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-tu re, virtu ally all providers of fina ncial 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-quir ed for the solut ion of th ese 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 t he 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 of systems.

Although technological systems may havea lower error rate than those using manualprocessing, those errors may be more difficultto detect a nd r esolve. In contr ast , a hum an er-ror can often be resolved immediat ely. A sig-nificant problem regarding some advancedsystems for delivering financial services is thatthere is no guarantee that a paper record of a transaction is ever created. While Regula-t ion 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 th at 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 consu mer t o stop a pa y order via t he au to-mated clearing house (ACH).

Regulations Relating to Consumer FinanceThe consumer facing choices between simi-

lar f inancial instruments is probably unaware



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

h a v i o r a l 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-dust ry today encoura ges the a ccumu lation of personal information to help minimize the costof bad accounts and to segment a market of potential 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 guaran tee th at th e informa -tion is inaccessible through other means, legalor otherwise.

Privacy is not entirely a domestic issue.Coun tr ies out side th e United Stat es, notablyin Europe, express considerable concern forprotecting the privacy of individuals and, insome instance, businesses. Some have limitedor pr ohibited the m ovement of dat a r elatingto 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 th e issue.

C o n c l u s i o n 6 : I n t e g r a t i o n o f C a p i t a l M a r k e t sAdvanced financial information systems have

forced 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 creat ed, driven by th e demandsof users and facilitated by the application of information and communication technologies.Financial institutions began moving capital ona n ational scale when it was recognized th atcapital 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 th eir expertise. The a bility of an organiza-tion or individual to participate in a capitalmarket is restricted by the quality and quan-tity of informa tion available on th e ma rket,

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 th e paper issued.

Congress mandated the development of anational market system for securities in 1975.Nat iona l mark ets ar e advant ageous for capi-tal seekers and investors. The truer and moreequitable pricing of fun ds th at results from ex-posure to larger m arkets is deman ded by mar-ket part icipants. This impact is demonstratedby th e success of th e Na tional Associat ion of Securities Dealers Automatic Quotation Sys-tem (NASDAQ), which provides nationalmarket exposure to what in the past were

over-the-counter stocks. Trading volume onNASDAQ has reached the levels of the NewYork Stock Exchange as investors are at-




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 dir ectly th e cause of an increase inthe velocity of money, without its applicationthe velocity could not have increased to thelevel demanded by the market. This type of const raint could h ave a severe impact on th eeconomy.

It is now generally accepted that there is notechnological constraint to the trading of assets at whatever speed is demanded by themarket. Almarin Phil l ips 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 an d securit ies industries in thelast several years.

As the banking industry moves toward mul-tiple settlements du ring a business day, fail-ure to adopt the needed technology could re-sult in a massive movement of funds out of the financial service industry by corporatecash managers. An indication of this poten-tial was seen in t he movement to tra de secu-rities off organized exchanges in the early1970’s, when it appear ed th at th e excha ngescould 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 th e Financial Services Industry, Pr oceedings of theEighth Annual Conference, Federal Home Loan Bank of SanFr an cisco, 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 ar e not uncommon on t he NewYork St ock E xcha nge, on which a daily aver-age of less than 17 million shares were tradedin 1972. And high volum e no longer r equiresthe 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 f irms 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 thetr emendous growth of money mar ket mu tu alfunds 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 m ajor impa ct on t he world by intertwiningthe economies of culturally and politically di-verse n at ions. Also, worldwide finan cial cen-ters h ave emerged in coun tries such a s HongKong an d Bahr ain. Unlike a domestic mar ket,however, there is no overriding intern at ionalsystem through which a global economy couldbe governed. Whereas the United States of America share a common Federal Governmentand political and cultural rooting, this type of

relationship does n ot exist between na tions.61VYSE1 9 8 3 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 q 213 -. .—.— ———- .- ——

The differences between telecommunicationindustries and regulations in various countriesmust be recognized as a barr ier 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

th e eurocur rency mark et for r edeployment ointernat ional capital . 8

Commun icat ion t echn ologies have also ha da par ticularly strong impact on intern ationawholesale or interbank activities. Interbankactivities provide a large portion of the fundsfor international investment. The use of tech-nology has allowed small banks for the firstime to become involved in internationalbanking.

‘I bid., p. 20.

C o n c lu s io n 7 : E n t r a n t s I n t o t h e

F i n a n c i a l S e r v i c e I n d u s t r yThe 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 presen t leader s in th e fi-nancial service industry —e.g., Citicorp, Sears,ADP, and Merrill Lynch–indicates that strongdistribution an d commu nication systems a remajor 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-dus t ry.

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 directing of decisions. Information may be arepresent at ion of or collateral t o the t ran sfeof value. At the same time, cost and accessibility considerations have led to a change inpreference for electronic systems from theonce-practical paper-based systems for mantypes of information. The transfer of financialservice records is cha nging from th e physicatransportation of documents to the electronicexcha nge of informat ion. Th e commun icat ionsystems developed to meet this demand arefar more technology-dependent and capitalintensive 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 importa nce of technology in comm un ica-tion systems is found in time, as well as dollar,considerations.

Availability of Services to Small

Financial Service ProvidersLack of access to sophisticated communica-

tion and distribution systems could poten-tia lly be a significan t ba rr ier to sma ll serviceproviders both for entering and competing infinancial service markets. A tier of wholesalersof data processing and communications serv-ices has developed t o 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-tur es ha ve provided mar ket opport unities 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-nicat ion system. J . C. Penn ey has a pplied itscommunication network to the processing of oil 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 entr an ts m ay be foundin established communication firms such asAT&T and MCI, which may find it cost effec-tive to enter the financial service industr y aswholesalers of services or, because of theirestablished systems of customer service, as di-rect service providers.

A successful distribution system may be

judged 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 systemsshar e ma ny of the chara cteristics of commu -

nication systems and are usually dependenton information technology for operation.

Esta blished distribution systems m ay easeentry barriers to new markets. When Searsentered the financial service market, it had thebenefit of an established system of retail

stores thr ough which it h ad commu nity 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-form at ion on customer tr affic an d 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-dustr y may include corporations th at enjoy astrong distribution system such as gasolineretailers. These corporations have a presencethrough gas stations in urban and rural areas

throughout 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 a nd distr ibution systems ha ve increasedthe number of options available to financialservice consum ers by ma king a wider r an geof product offerings and delivery mechanismsavailable. Communication and computer tech-nology has made it possible to develop farmore diverse an d complex investmen t pack-ages that serve a greater range of investors.In addition, the refinement and increased




C o n c lu s io n 8: C o m p e t i t i on in t h e M a r k e t sfo r F i n a n c ia l Se r v ic e s

A major u ncerta inty in the chan ging stru ctur eof 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 compar tmen ta lized str uctur e of th e fi-nan cial service indust ry esta blished over th epast 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 itself to dominate the banking industry. Becausebanks were limited only to the banking andrelated business, banks were also effectivelykept from u sing their u nique position in th eeconomy 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.

Significan t nu mbers of th ose concerned withthe long-term effects of the changes now tak-ing place in t he financial service indust ry ha ve

expressed concern that one of the outcomeswill be consolidat ion. Th e nu mber of firms inthe industry would be reduced to a point wherea small number could dominate the market.Such concentration would directly contraveneone of th e cent ral t hemes embodied in est ab-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 havegenera lly been successful in broadening com-petit ion in th e face of the existing legal/regu-latory structure. In recent years, Congressha s repea tedly been called on t o 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 th e advan ced technologies. New entr an ts,taking advantage of the advanced systems,have repeatedly demonstrated their ability tocompete successfully with larger firms in t hemarketplace. As long as this alternative ex-ists, there are few barriers to entering the fi-nancial service industry.



. —

Ch. 8—Findings q 217 ———

Another concern expressed by some is thata financial service industry dominated by afew national organizations would no longer beresponsive to local n eeds of th e communit iesin which they operate. On the one hand, easeof entry will continue to minimize the chance

that 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 of the areas that generate it. As the pervasive-ness of technology-based systems for m an ag-ing financial resources increases, intermedia-tion by banks will become a less significantportion of bank activities because depositsfrom wh ich loan portfolios a re gener at ed 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 t he local bank s th at had

previously 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 ha nd,this statement says nothing about the propen-sity or the ability of an organization to entea m ark et t hr ough t he pr ocess of acquisitionone which Hammer indicates is likely to bsuccessful. Nor does it say anything abou

their propensity to continue to serve locaneeds if a dominant position in a market iestabl ished.

Evidence indicates that the propensity ocustomers to switch financial institutions irelatively low and that there must be some sig-nificant event to motivate such a change. Othe other hand, some believe that packages of services could provide the necessary motivation for customers to change financial serviceproviders and that once new, complex relation-ships have been established, the inclination tomove in th e fut ure will be lower tha n in thpast. Securities firms assume that they wibe able to establish a high degree of customerloyalty because th ey are able t o offer ser vicregardless of wheth er th e cust omer is h omeon a short t rip, or perm an ently relocat ing ta new area . * Thus, th e firms th at can esta blish a national presence and offer a comprehen-sive package of interrelated services may bable to genera te a degree of cus tomer loyalttha t could enable them to dominat e the finan-cial service industry.

The States are not waiting for the FederaGovernment to modify its position with regardto the policies that help shape the structurof the financial service industry. Laws thawould permit regional banking have beepassed in New En glan d. Some Sta tes, SoutDakota an d Delaware am ong them, ha ve enacted legislation designed to attract financialservice organizations. Thus, even though pro-hibitions of int ersta te ban king based on Federal law may continue in force, regional bank-

‘zFrederick Hammer, Executive Vice President, ChaseManhattan Bank of New York, in testimony in oversight ings before the Committee on Ban king, Housing and Ur bfairs, U.S. Senat e, May 3, 1983.

*The s t r a t e ~ is also intended to change th eloyalty of thecustomer from the account representative to the firm, a lem that has been facing securities broker/dealers for some



218 . E ffects of Information Technology on Financial Services Systems

ing in significant areas of the country couldemerge. Also, organizations that provide fi-nan cial services in n ationwide markets oper-ating from St ates t hat have passed permissivelegislation may emer ge. Federal law permit sinterstate and cross-industry mergers when i t

can be demonstra ted th at t hey will serve thepublic interest .No clear picture of the future structure of

the financial service industry exists. Someforesee considerable consolidation, with manyfewer firms serving the public than at present.Some believe that the industry will consist of a small number of large firms serving nationalmarkets and a large number of small firmsspecializing in specific market niches. On theoth er han d, oth ers cont end th at t he 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 an d the other tr aditional par-ticipan ts in th e mar ket. New classes of firmshave already established themselves in the fi-na ncial service indust ry, and t here is no rea-son that the trend should not continue. Thus,policies need to be form ula ted to account forthe influence of the technologies and the op-port un ities they create for t he ent ry of firmsthat have not previously been providers of fi-na ncial services.

A key element in the present structure of the financial service industr y is tha t t he cus-tomer ha s t he option of investing fun ds in anaccoun t insu red by the F ederal Government .This type of insur an ce was one of th e elementsin the 1930’s program to restore confidence inth e financial service industr y. Becau se of th eexistence 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 th e regulators t o step in t o 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 Penn

Square 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 th e long r un th ere isa distinct possibility that the deposits held byfinancial institutions will continue to shrinkrelative to all financial assets. Investors infunctiona l equivalent s of depository account sthat are not insured would then be exposed toloss of principal in the event of institutionalfailure, with t he result t hat th e sensitivity of the 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 clearlyth e elements of a m ark et in order to ana lyzethe 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 tha n t hey were in th e past.

New entrants often compete only in some

parts of the financial service market. For ex-ample, a supermarket that operates a networkof ATMs is in d irect compet ition with deposi-tory institu tions th at offer compar able serv-ices. On the other hand, the supermarket



Ch. 8—Findings q 219 —

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

Even within the community of depositoryinstitutions, care must be taken in definingmarkets. The small, local bank is not a factorin th e mark et for cash ma na gement servicesoffered t o the largest corporat ions in t he coun-tr y. Conversely, a bra nch operat ed by a m a-

jor money center bank may bean insignificantfactor in a mar ket dominated by a sma ll butvery successful bank.

The changing structure of the financial serv-ice industry will exacerbate this problem in thefutu re. Thus, great care mu st be tak en in sug-gesting that one institution will be able todominate t he others in a ma rket. Unless th estatement 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 considered in its totality over time, the integratedfirm could domina te a market, possibly overpowering ma rket 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 unintentionally trigger undesirable impacts.



C h a p t e r 9

Policy Issues



C h a p t e r 9

P o lic y I ss u e s

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-tat es it.

Through the applications of technology, thefinancial service industry provides the publica choice of modern and efficient services morediverse tha n was a vailable in t he past . Fromanother perspective, the introduction of ex-plicit pricing for services, th e 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 off while others become relatively better off. Theresults of such sh ifts can be political pr essuresfor 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 n ow only burden th e indust ry un nec-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 an d t heir customers. It is also possiblethat some of the ends sought in existing lawsare no longer a ppropriate or u seful.

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 man y diversedirections that it is difficult for financial institutions themselves or for outside observersto anticipate the patterns that will eventuallyprevail.

Nevertheless, it is possible to foresee some

of th e broad pa tt erns likely to emerge and toanticipate in a general way their likely conse-quences. It is important to do so because pol-icy decisions ma de or avoided now may h avfar-reaching consequences. For example, somepotent ial benefits of th e new t echn ology 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 through

less formal, political activities such a s Pr esidential “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 finan cial services which, in tu rnresulted in cross subsidies. Services could thenbe provided to some who could not have afforded 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 fullyallocat ed cost s. Some people may not be a blto afford them. If this is judged contrary toth e larger public good, it becomes t he t ask othe policymaker to adjust those circumstancesthrough carefully designed policies.

223



224 • Effects of Information Technology on Financial Services Systems —.— —

Thus, even though significant uncertainties To ident ify th e public policy issues relat edabout t he futu re remain, i t 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 th at reflect various pu blic int erests in th osebelow 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.

P u b lic I n t e r e s t s in F i n a n c ia l S er v ic e s

Some of the major laws and regulations re-lated to financial institutions express explic-itly and implicitly na tional objectives relat ed

to finan cial services. There is a s tr ong publicinterest in the maintenance of financial insti-tutions that will:

q

q

q

q

q

assu re an d facilita te tr an sactions n eces-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 economic

and financial resources; andsupport and strengthen the competitiveposition of the United States in worldt rade .

implicit in the concept of the public interestar e also th e basic na tional objectives of na -tional security, equal treatment under law, anda host of well-established civil rights and lib-erties. Therefore, financial service systemsshould:

q

q

q

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 mak ing and receiving payments.For example, the U.S. Department of theTreasury wants to move toward direct depositof all Federal payments to reduce the costs of this huge volume of transactions.

Finally, the degree to which the introductionof advanced systems for delivering and usin gfinancial services may affect the ability of government to use monetary and fiscal policyas tools for ensuring economic stability andgrowth remains unknown. The increase intra nsactions an d 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 monetar y policy to reduce inflat iona rypressures or to st imulate stagnant conditions,although what the effect will be in practice is



.—

Ch . 9—Policy Issues q 225 — —

far from certa in. 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 tr an sactions will cause t he con- it could lead to economic fibrillation.sequences of policy interventions to be felt

P o s sib le C h a n g e s i n t h eF i n a n c i a l S e r v i c e

Information processing and telecommunica-tion technologies, as applied to financial serv-ices,

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have seven direct and significant effects:

They remove geographic and temporalconstraints on the delivery of financialservices an d allow them to be deliveredfrom remote locations and to new and

widely dispersed locations, such as homesan d 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 nar rowly ta rgeted 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-tu t ions .They creat e th e possibility of electr oniclegal 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 with

present t rends, include: Increased diversity in the na tu re of insti-tutions within the industry, in which

S t r u c t u r e o f t h eI n d u s t r y

traditional categories of depository andnondepository institutions are no longershar ply delineated a nd in wh ich t he linebetween financial and nonfinancial insti-tutions, as defined by products and serv-ices, is blurr ed.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 sm all, highly spe-cialized institutions that target narrowmarkets and specified groups of clients.Continuing mergers and a trend toward

absorption of middle-sized institutions,especially those having a st rong local orregional orientation.Rapid product proliferation-i. e., pro-liferation of services that are functionallysimilar but differ in regulatory restric-t ions and interest rates and in the distr i-bution of responsibility or risk betweenproviders and users.Greatly increased functional integrationof the national financial service industrythrough technological networks and insti-tu tiona l relat ionsh ips.Great reduction in the significance of timeof day and location in delivery of finan-cial services.



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stitutions to money market funds and hadthrown the cost of liabilities and the earningsof assets held by the thrift industry so far outof balance th at th e viability of th ese institu -tions was thr eatened.

The rate of change in the financial serviceindustry has not abated since the passage of this legislation. There is every expectationthat coming years will see changes occurringat a n equal or faster rate th an t hat 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 str ucture to accoun t for sh ort-termchanges and trends in the forces thatshape th e finan cial service indust ry.

2. Undertake a fundamental redesign of thepolicy structure governing the financialservice industry.

Option 1: Contin ue to m odify existing legal/ regu-la tory s t ructure to ref lect shor t - term changes .

This course reduces the possibility thatthere will be an abrupt change in the opera-tions of the financial service industry. Con-gress would cont inue its ongoing oversight of the financial service industry and continuallyfine tune policy to meet the needs of evolvingconditions. However, congress may find itself trying to mitigate the undesirable effects of change 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 of the financial service industry to serve theneeds of th e Nat ion.

Option 2. Undertake a fundamental redesign of the policy 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 q 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 theindust ry an d clear in its concepts of nat ionalneeds an d t he pu blic int erest, is likely to bemore robust in the face of future change thanpolicies developed incremen ta lly.

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.

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Continue relative deregulation or market-determined solutions by continuing torelax const raint s on t he indust ry and bytaking little action to neutralize eventstaking place in th e 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 al ternative.)

Option 1: Continu e d eregulation.

Congress may conclude that maximum eco-nomic efficiency, both in delivering servicesan d in using t hose services to direct funds to




productive uses, is necessary to support a ris-ing level of economic activity. If Congress alsoconcludes th at th e best way t o assure t his effi-ciency is to free the financial service industryto respond sensitively to market forces, thenit may opt for further deregulation.

The indu str y, if allowed t o follow th e pa thit is now on, will effectively become less regu-lated over t he n ext decade. Much of the ma -

jor legislation focusing on depository in stit u-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 r esult in greater diversity in St at eregulatory 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 of

financial 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 otherS ta tes .

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 of compromising 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

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from regions or communities in economic dis-tress or with a less attractive balance betweenrisks and retur n th an 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.

Alter na tively Congres s could limit t he 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 of housing and opportunities for home ownershipare, for example, generally accepted as nation-al policy objectives. So, too, are protection of small farms and small business opportunities.

Under strong competitive pressures, helpedalong by rat e fluctua tions a nd a tight m oneysupply, 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 un less alternative loan instr ument s aredeveloped. Money may also be funneled awayfrom loans for local ent repren eurs an d sma llbusinesses and from ru ra l ban ks tha t supplyseasonal loan s to far mers.

On the other hand, as financial resources aredra wn into high-growth a reas, t hey will tendto moderate interest rates and have a stabiliz-ing effect. This would continue the functionof redistributing fina ncial r esour ces th at has

been historically performed by the financialservice industr y.Thus, policies that encourage highly compet-

itive national money and capital markets may




stitutional categories. The new technologyalso has paradoxical effects on economies of scale. 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 insti tutions can now enter and re-main viable in local ma rkets.

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 largeorganizat ions with excessive size or power infinancial markets.

It is possible that the kind of competitive-ness that was desirable in t he past, as meas-

ured by the number and size of institutionsand the scope of their markets, is no longerappropriate in view of several changes:

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the increased size of the population,the increased level of U.S. economic ac-tivity,th e increased size of indust rial ma rkets,the increased scale of commercial organi-zations,the increased volume of internationalt rade ,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 for the 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 financialinsti tutions in operating in the national mar-ket. Cont inued reliance on existing ant itrus tlegislation to prevent excessive concentrationof financial power would face increasing diffi-culty in defining markets and market part ici-pants for the purpose of antitrust enforcementactions.

Option 2: Define criteria under which mergerswould permitted and firms would be allowed to enter or leave a market.

Again, with this option, it would be difficultto define mar ket bounda ries for t he pu rposeof 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, un regulated s ervices 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 ass igned t he r ole 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 virtuallyun regulated mar ket. The regulat ed finan cialservice 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 unr egulated 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-tr ol over credit from becoming pr ogressivelyconsolidated in a few powerful institutionsThey were also meant to maintain a local orien-tation and interest and to preserve for consumers 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 by

users as functionally equivalent to traditionalbank accounts. Regional and national networks have made proximity to the service pro-vider no longer a necessary measure of convenience 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 thiservice indirectly by means of zero-balance ac-counts linked to consolidation accounts inanother State. Interstate banking restrict ions

have probably protected some inefficient institutions 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 restrict ions on interstate bank-ing. To do this would requ ire Federal legislation repealing the interstate banking prohibitions in the McFadden Act and the BankHolding Company Act, thus withdrawing Fed-eral consent to State statutes Mocking in

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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 pr obably not sur vive compet ition withlarge nat ional firms. On t he other ha nd, it ispossible that financial services might be ex-tended to some now underserved or isolat edcommunities 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-tista te metr opolitan a reas, or regiona l bank-ing in multistate market areas (as is alreadydone in New England under an interstatecompact).

Option 2: Reinforce limitations on i n t e r s t a t ebanking.

Alternatively, Congress could strengthenrestr ictions on int ersta te ban king by remov-ing all loopholes. The Federal Reserve has justmoved to plug one loophole by redefining com-mercial deposits to include NOW and SuperNOW account s. Following the reasoning tha t

led Congress to pass legislation legitimatizingATMs deployed by savings a nd 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 t o est ablish r igid 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 h olding compa nies from owning depositoryinstitutions in more than one State, as was thecase un til t he 1980’s, or to su bject a ll 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 un ions.

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 factor

limiting 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 of financial service providers on specificmarket areas?Federal policy since the 1930’s has allocated

specific 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. This

condition has developed gradually, with fewof th e steps a long th e pat h 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 insti tutions becaus e th ey alone h ave access to th e 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 th e 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.



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Ch. 9—Policy Issues . 233 —

Because of this dependence, the safety andsoundn ess 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 activit y. Specifically, the goals of this pol-icy

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have been t o:insure the soundness of banks (originallythe purpose of both reserve requirementsand depository insurance);limit th e risks that banks could assum e;prevent conflicts of interest, such aswould occur if banks directed investmentto or allocated credit to commercial activ-i t ies in which the bank had an equity in-terest , or if banks required borrowers t opurchase 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 fun ctiona l equivalent s 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 ban k (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 compan ies, in re-taliation, are seeking to expand into otherservices, for example, offering insurance inStat es 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 othelines of commerce, the level of risk they aresubject to may increase. Any increase in institutional risk is accompanied by an increasein t he levels of risk for both th e stockholderand clients of the institution to the extent theyare not covered by deposit insurance. Ultimately, the level of risk facing the financiaservice industry as a whole would increase.

The general policy of deregulation suggeststhat financial institutions could compete onan equal basis if barriers between various

types were dissolved. For example, thrift institutions were, for a time, severely threatenedwhen they were stuck with low-yield portfolios when interest rat es rose; th ey may bso thr eatened again. Federal policy has beento try to save troubled thrift institutions byallowing, encouraging, or arranging mergers.This includes mergers a cross Stat e lines andmergers of mutual savings banks with commercial banks. More recently, Federal savingsand loan associations have been allowed by theGarn-St Germain Act of 1982 to offer consumer loans of up to 20 percent of assets and

to offer other consumer services so that theirportfolios will contain assets and liabilitiewith better mat ched mat urities.

On the other hand, thrif t insti tutions in thepast received some preferential treatment be-cause they are the major source of loans fohousing. An adequate supply of housing ana high rate of home ownership are widely accepted as social policy objectives, and a declinein th e housing mar ket h as severe impacts oother sectors of the economy.

Policy Options for Issue5Option 1: Modify powers t o offer financial services.

Congress could repeal Federal laws and reg-ulations limiting th e services tha t ban ks can



Ch. 9—Policy Issues q 235 — —

Issue 6: How will further deregulation of telecommunications affect the financialservice industry?An important consideration for future finan-

cial ser vice policy will be t he cost of telecom-munications. As a result of the breakup of AT&T, Congress is now coming to grips witha broader issue of cont rol of telecommun ica-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 r esult 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 syst em t o deliver finan cial 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 ma rket. Fina ncial institut ionswill att empt to move dat a pr ocessing towar dth e end-user in order t o 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 a nd r ela-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 t he n eed to modify th estructure of financial service delivery systemsconsiderably.

Issue 7: What st eps could be ta kento realignthe legal/regulatory structure to make itconform closely to the changing structure of the financial service industry?Laws and regulations generally apply to spe-

cific categories of service providers. The oper-

ational differences between depository annondepository institutions are progressiveleroding, but these categories are still subjecto different regulatory bodies. They have, isome 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 otheir activities are housing loans. Accounts indepository institu tions are federally insu redwhile other kinds of accounts are not. Thbuyer of services has different benefits, diferent risks, and different safeguards anright s, according t o which service provider selected. The consumer, however, is ofteunaware of the subtle and detailed differences.


The problem of how best to design, or revise,a r egulatory structur e for t he fina ncial service industry involves many subsidiary issues,

such as Federa l deregulat ion versus F ederapreemption, institutional versus functionaregulation, 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 specific policy objectives, wit hout regard to th e institu -tional provider of the services.

This option would put all financial institutions competing for a particular market nicheon a more equal footing. It would mean, how-ever, that each of an institution’s services ofunctional 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 orcont radictory requirement s an d restr ictions.Option 2: Federally preem pt all S tate legislation

and regulation of financial services.

This option would provide consistency an dreduce uncertainty for the industry with thepossible result that financial service providerswould become more active in developing a nddeploying services th at th e public would findattractive and useful. Yet the existing dualbanking system has served well in meetingvarying needs for financial services. Federal

preemption would eliminat e this du ality andcould reduce the degree of responsiveness of financial 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 thema ximum opport un ity t o 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. ButStat es would also be prevent ed by the Com-merce clause of the U.S. Constitution frombarr ing entr y by out -of-Stat e ban ks. Nat ion-wide financial service institutions would, however, suffer from the inconsistencies in restric-tions and requirements.Option 4: Combine all Federal regulatory functions

pertaini ng t o finan cial services u nd er 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 structur e tha t is now lacking. Instit u-tions would no longer be in a position whereth ey seek cha rt ers from the agency th at 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 moving

toward 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 n at ional boun daries.

Worldwide delivery of financial services has,for well over a century, depended on telecom-mun ications an d is now more tha n 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 have

bran ched across na tional boundar ies 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 a nd in international t rade.

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 those

th at provide credit au th orizations a t point of sale, must be accessible from thousands of lo-cat ions a nd m ust ha ve a high degree of reli-ability. They move customer transaction dataat high speed across all boun daries.



Ch. 9—Policy Issues q 23 7

The ability to initiate a tra nsaction from aremote location unfortunately also implies theability to initiate fraudu lent t ran sactions; tomonitor, inter fere with, or extract da ta 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.i ndus t ry.

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 of national security, or for other reasons. Somenations are taking the posit ion that they willnot allow some kinds of data to be sent to na-tions th at do not have rest rictions on a ccessand movement of data that are at least asstringent as their own.

Such r estr ictions 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 si tuation th at may become m orecommon 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 milita ry at tack. As th e 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 undesome conditions could be destabilizing tworld currency, commodity, and security mar-kets. However, they could also be used tomonitor and control international debts anrepayments better and to overcome the desta-bilizing effects of a major debt default.

The national interest here is threefold: tstimulate and support the U.S. position inworld markets, to further U.S. internationadiplomatic objectives, and to maintain national security.


Option 1: Establish no stronger protections for in-divid ual privacy’ tha n already’ exist.

The United States might test the proposition that the desire to have full financial rela-tionships with institutions in the UnitedStates will be strong enough to overcome aother considerations. But the possibility exists that foreign governments with stronprivacy protection laws m ay not be willing tallow the free flow of financial an d pa ymendata to and from t he United Stat es withouspecific protections inst itu ted a t a level commensurate with those provided their own citi-

zens within their own borders. Any foreigbans 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 forcmotivating change. It does not appear to ban imminent probabil i ty that one or more na-tions will significantly restrict the movementof financial data to and from the UnitedStates. But this si tuation could changera pidly, an d if th is option is chosen Congreswill want to continue monitoring developments in this area.




Option 2: Institute policies defining more preciselythe conditions u nder wh ich fin ancial 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 s ervices da ta . Such policy might becomenecessary, should foreign privacy laws cometo be applied to data tra nsmitted an d storedin computer systems on U.S. territory. Al-though Federal privacy law has not, in gen-eral, been a pplied to privately held data sys-tems nor is t here pr esently significan t overtdomestic pressure t o extend it in th at 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 paymentinstrumentssuch as credit card drafts?Only depository institutions now have direct

access 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 an d bonds t hrough t heorganized 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 insti tutionsand 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 a re t he existence of an accoun t th roughwhich net settlement can be accomplished anda means for transferring instructions that tel lthe account holder the amount to be trans-ferred and the party to be credited. Banks

ha ve traditionally been th e only ones a ble toestablish sett lement accounts and be party tothe network for accomplishing the required in-forma tion tra nsfers.

In the present environment, nondepositoryfinancial institu tions establish r elationshipswith 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 t he funds debited from t he 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 th ey are present ed and debit the accountsof individual employees for appropriate

amounts. 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 mechan ism can be seen a s 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 i t is inthe public interest to allow such arrangements.On the one hand, the existing regulatory struc-tur e provides assurances th at 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 th e financial system a s a whole. Under ex-ist ing arrangements between banks and fundmanagers, the bank must sett le 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 gran ted direct access to the pa ymentmechanism.

Policy Options for Issue 9Option 1: Retain restrictions on access to the

payments mechanism.Congress could choose to retain the present

system 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 cha nges tha t createthe possibility of weakening either should notbe allowed.

On t he other h and, th ere is a real possibil-ity t ha t in novative 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 sett lement, as willthe requirement for explicit pricing of Federal

Reserve services. Thus, as in so many otherparts of the lega.1.regulatory structure govern-ing the financial service industry, the presentrules for a ccess to th e payment s 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 between

financial institut ions and th e mu ltiplicity osystems for clearing payments, it would be ex-tremely difficult to codify exactly what con-sti tutes the established payments mechanismand the characteristics of clearing arrange-ments t hat would not be permitt ed under sucha policy.Option 2: Open the payments mechanism to other

than depository institutions.

At the other extreme, Congress could openthe payments mechanism to all who would join. As indicated, blanket access could

weaken 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 organizations that would be willing to meet criteriadesigned t o ensure cont inued int egrity of thesystem. Such requirements could include pro-visions for maintaining reserves and provi-sions that members be audited to determineif th ey meet criteria for m embership or th atth ey obtain performa nce bonds or insura ncethat guarantees their ability to settle.

Yet, exclusivity of access to the paymentmechanism by depository institutions bal-ances some of the relative disadvantages osuch an arrangement under the present legal/ regulatory structure that limits the range oactivities in which depository institutions canengage. The major sources of revenue of depository 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 su bsta nt ially affect r evenues of depository 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 m arket rat es 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 t he su pply of fun ds t o some in-vestments.

Complete deregulation of interest rateswould allow service offerings to respond tomarket forces, the price of services to be helddown by competitive pressu res, an d int erestrates to reflect national market conditions.However, to the extent that firms do notrecognize the costs their actions impose onoth ers, ma rket forces ma y not r eflect all socialpriorities. ’ It may be in the public interest,un der some circumst an ces, 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-tut ions Deregulation an d Monetar y Control Act of 1980.

fun ds t o be drained from depository inst itu-tions. Usury laws restrict the supply of creditwhen interest ra tes are rising.


Option 1: Federally regulate all interest rates for all financial services and all institutions; pre-empt State usury laws.

Assuming th e 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 or

economic inst ability. They might be ma nipu -lat ed to preser ve, for exam ple, a housing dif-ferential .

On the other hand, the ability to set rateslocally helps ensure their responsiveness of credit markets to local needs. This would belost if th e Federal Governm ent 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-

advant ages of this altern at ive, but t he diffi-culty of implementing them operationallyshould not be underestimated.Opti on 2: Com pletely deregula te interest rates.

In economic theory, at least, this optionwould allow funds to flow to highest value usesin ter ms of th e costs an d benefits included inthe calculus. However, if indirect costs andbenefits are not recognized, the resultingallocation of resources could be suboptimal.It would in crease th e availability of credit, butcredit could be priced to levels that would ef-

fectively deny it t o some consu mer s or causethem to change their way of life as they divertfunds to cover its cost.



Ch. 9—Policy Issues q 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 un insured a ccoun ts.

Yet, some ma y view the r educed ret ur n a sa cost of security and be willing to incur it.Limiting the return paid customers would re-duce the pressure on insti tutions to make themore risky investments that provide higheryield, thus limiting the exposure of the insur-ance fund.Option d : Allow S tates to regulate int erest rat es

on all services delivered with in th e Sta te, wheth-er or not t hey are delivered by S tat e-chartered institutions.

Under this option, States may try using con-trolled interest rates to attract businesses.Such t actics could significan tly distur b th e na -tional money market. On the other han d, 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 Sta te would have th e power to estab-lish rates at levels substantially different fromthe norm. Experience has shown, for example,

th at Sta tes ha ve not been a ble to art ificiallydepress 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 un ions.

At pr esent, the F ederal Deposit Insu ran ce

Corporation (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 (consumers

shifting 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 oth er a ctivities, they increase th eir riskof failure. The advant age of being covered byFederal insurance is one incentive for non-depositor institut ions t o buy bank s an d 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-stit ut ions, t he 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 play

a critical role in modern society, their in-creased failure rate necessarily touches on thepublic interest in a wa y that r isks assumed byother kinds of organizations do not. Suchfailures expose individuals, families, small




businesses, and major corporations not cov-ered by deposit insurancet o 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 of institutional failure. This was the problem thatdeposit insurance was designed to solve. How-ever, deposit insurance itself may encouragefirms t o take excessive institu tional 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-t lements are made today may make these res-olut ions mu ch m ore difficult . Inst itu tional fi-nancial crises could spread rapidly.

Many transactions will be timesensitive. If A fails to pay B, and B is th erefore una ble 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 aninstitu tion relat ive to the nu mber an d dollarvalue of tr ansa ctions, and th e 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-tu rbat ions a nd t o decrease t he a bility to con-trol the secondary effects of disturbances.


Option 1: Retain Federal insurance, as it is now, for traditional depository institutions only.

Cont inuing th e 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 insuredinstitu tions a false sense of secur ity and per-mits them t o take risks th ey might n ot t akein the absence of the insurance. Thus, insuredinstitutions enjoy some competitive advan-tage over others in all lines of business in

which they engage.Option 2: Extend F ederal insuran ce to certain ac-

counts that are not held by institutions now el-igible for in suran ce, 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 account s would eliminat e a differencebetween suppliers of financial services that isimporta nt to many. Providers th at are now in-sured would lose a factor that gives themsomething of a competitive advantage over

those 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 theinsur ing agencies to find m erger par tn ers fordistressed inst itut ions would be r educed 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-men t. Lar ge depositors m ight a lso be offeredthe option of buying insurance for deposits ex-ceeding t he limits of Federal insu ra nce.

Option 3: Vary the insurance coverage and cost with risk.

This would permit insured institutions toposition themselves in the market in a man-ner a nalogous to the way mut ual funds char -acterize themselves. Some funds are growth-oriented while others seek stability and try togenerate income for their investors. Deposi-tory institut ions willing to ta ke h igher 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 isnecessary 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 a rgue that they need mechan isms throughwhich they can express preferences for specificservices from among the alternatives that maybe offered.

Because of the r estru ctur ing 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 merchan ts m ay 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 of all government payments is a long-range ob-

jective of the U.S. Department of the Treas-ury. This would include payments to State andlocal governm ents and contr actors, a nd alsoentitlement payment s and Federa l 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 check

must 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 t he gap is a vailable, 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 of fina ncial services.


Opti on 1: Define m ini m al services to be provid ed to consumers.Congress could require all financial institu-

tions, or t hose finan cial inst itu tions 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 debited

electronically 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 retu rn for deposit insu ran ce.

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, full

control over the timing of debits and creditsto accounts, Congress may wish to regulateth e exercise of this power to assu re t ha t con-sumers ar e treat ed equitably.Option 2: Define th e rights of users to informat ion

regarding availabil i ty of f inancial 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 enforcing

these 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 diminution

of 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, r educes t he costs of ac-cessing and using it, and thereby increases the

incentive for misu se. Inform at ion technologyalso allows information to be propagatedwidely and rapidly, so that information harm-ful to th e int erest s of a citizen (e.g., inform a-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 mat ters: to th e extent t ha t a citizen’stransactions are effected through informationtechnology, his/her locat ion an d da ily 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 of finan cial informat ion a nd increased u se 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 to

which th is occurs, of th e extent to which lawand business practice is able to assume the cit-izen’s consent to this sharing of information



Ch. 9—Policy Issues q 245 — — — . —— —-—

as a condition of accepting a service, or of rights and protections associated with variousfinancial services.

Policy Options forIssue 13Option 1: Strengthen, expand, and explicitly define

the 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 intransit ion between them, and some appear tohave no explicit safeguards for the citizen.

While legally defined rights to privacy maybe a desirable step in th e 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 of informa tion and its a pplications t hat citizensare unlikely to know when they have been thevictims of invasions of th eir pr ivacy un til th edama ge has been done. Even then , they maybe una ble to trace una ut horized informa tionor misinform at ion 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 cannot be avoided in accepting financial servicesthrough inform ation technology (a policy of in-

form ed consent, to use the mod el of m edicalservices delivery).

This option at least has the advantage of allowing citizens t o decide wheth er t hey willaccept the risk and of challenging the indus-try to find ways of reducing those risks. How-

ever, it could h ave t he u ndes ired effect of de-creasing public acceptance of and confidencein some fina ncial services.

Option 3: Mandate a program of monitoring and enforcing privacy rights.

This option would require additional author-ity to inspect and monitor financial service in-stit ut ions, and t he a llocation of resour ces fosome Federal agency (e.g., the Federal Bureau

of Investigation or the Department of theTreasur y) to develop enha nced inspection capabilities as well as to implement the program.Fur therm ore, such a n inspection program m ayincrease anxieties about the possibility thathe Government itself may violate the privacyof citizens th rough misuse of finan cial information a bout 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 geographical extent of the impacts. With a highlyintegrated national economy and financiaservice industry and increased velocity omoney, a local or regional disruption of finan-cial activities rapidly propagates and cancau se tur moil thr oughout t he system, even ith ere is no irret rievable loss of dat a.

Nat ur al disast ers, civil disorders, m ilitar yattack, or any form of emergency may destroysome communication links or require thaoth ers be t aken over by emergency mana gement teams. Thieves, saboteurs, political dis-sidents, terr orists, or others could at ta ck information banks and communication links othreaten to do so, in effect holding hostage theassets of the public.

The direct effects of disruption of financiatransactions and payments, of data banks, orof communication links are largely independ-

ent of whether the disruption is accidental ordeliberat e. The long-ra nge effects of crea tinan at tr active ta rget for intern al political vio




try and law enforcement authorit ies. Further,th ey do not see th is rat e of increase abat ing.If this is true, steps to augment present effortsare r equired; an d even t hen, th is option m aynot meet th e cha llenge.

On the other hand, the level of consciousnessof the problem among financial service pro-viders is increasing. Great er at tent ion is be-ing given to securit y of advanced systems fordelivering financial services. However, it isstill too early to know if the efforts will proveadequate.

Option 2: Expan d the resources an d techn ologicalcapabilities of Federal enforcement agencies(FBI, Treasury) to deal with computer-related theft and to train and assist local law enforce-ment agencies.

This option could increase the requirements

for au diting a nd in spection of finan cial inst i-tu tions’ records . However, this may ha ve theadditional side effect of increasing concernover potential erosion of privacy and mayalso require additional audit trails and paperrecords, which add to the costs of providingfina ncial 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, ith e data th at surface cau se the pu blic to loseconfidence in the financial service industry,th e net effect could be negat ive and t he st a-bility of the industry threatened. Further, ithe 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 financial service institutions.Option 4: Man date a n ational comm ission to stud y

computer-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 commission to study all aspects of this modernproblem would serve many policy needs.

35-505 0 - 84 - 17 : QL 3



Ch a p t e r 1 0

Future Scenarios for theFinancial Service Industry, 1990-95



C o n t e n t s

PageScenario 1: Ext en sion of Pr esen t Tr end s. . . . . . . . . . . . . . . . . . . . . . . . . . . . 252

Scen a r io Z: Piecem ea l Regu la tion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255

Scena rio 3: The G lobal F ina ncial Ser vices In du st ry. . . . . . . . . . . . . . . . . . .25 8Scena rio 4: Pr osperit y a nd In novat ion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261



Ch a p t e r 1 0

F u t u r e S ce n a r io s fo r t h eF i n a n c ia l S e r v ic e I n d u s t r y, 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 of the industry or the development of public pol-icy relevant to it.

Scenarios are not predictions of what willha ppen in th e fut ur e nor do th ey 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 encoura ged to suggest a lterna tivesfor both and to develop the logic that flowsfrom those that are identified.

Scena rios also serve to boun d a p roblem in

that 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 th e proponent s an d opponent s 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 su ch t hat precipitous changes th at coulddisadvantage significant groups within society

in 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 t herefore should comma nd t he at tent ionof 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 th e mark et. 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 t o 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 th e ma rketfor consumer financial services have little, if anything, 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 ha ve been a pplied t o 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-dust ry and its relat ionships with its custom-ers have not changed radically from what theyar e 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 t o alternat iveinvestm ent vehicles offered by other t ypes of institutions. 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-na rio. Att ention is dra wn t o the pr oblems of compet ition between pr oviders of services ininternational markets, the movement of for-eign providers into American mar kets and of U.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 t he four th scenario, Congress ha s ta kensteps to completely overhaul the legal/regula-tory framework governing operations of thefinancial service industry. Most of the regu-latory fun ctions of the St ates ha ve been pr e-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 t o personal privacy an d t he security of financial service systems.

S c e n a r i o 1: E x t e n s io n o f

The Economy .—Business as usual, continu- Th e

P r e s e n t T r e n d s

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 payment s an d tr ansa ctions;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, development

of intelligent media, dispersed delivery of serv-ices, and automation of lower value trans-actions. Driven by the need to control costs,financial inst itut ions h ave reduced th e num -ber of manned branches, and the primary vehi-



Ch. 10—Future Scenarios for the Financial Service Industry, 1990-95 q 253

cle for delivering financial services is theshar ed aut omat ed facility th rough which t hecustomer 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, an d an oth er 5 percent ar eOriental), 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-tr ial” society, Over 60 percent of all jobs ar eclassifed as information handling. Automatedequipment is u sed in virtu ally all aspects of human activity, including nearly all manufac-tu ring, and t he great majority of th e 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 unemploymenttha t a re blamed at least in par t on increased

aut omat ion, there has n ever been any strongpublic resistance to automation, certainly notto automated financial services. A public thatenthusiastically embraced Pacman and othervideo games was not likely to object t o aut o-mat ed teller m achines (ATMs) and POS t er-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 tha t can be used without char geby 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, t herefore r efuse t o use th em.

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-educat ed and like to take an activerole in asset man agement. With a mind-boggling number of options in choosing financiaservices and investment opportunities thacan be tailored to their needs or to their specialinterests, asset management has become apopular hobby. Financial management software proliferates with its own best-seller list,and friends get together with portable terminals to argue the latest rage in investmentstrategies. Marital counselors and divorcelawyers report that people are as likely to fightover money management as over child custody, 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 account s, tra nsaction 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 relationships 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 sh ift fun ds r apidly 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 th e combinat ion can be ma de to include anaccount that falls under Federal deposit in-surance.

About 20 major r emote 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, ” represent ingprofessional, administrative, and office work-

ers) have in m an y compan ies negotiat ed pro-gram s in wh ich emp loyees have th e option of being 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 equitysecurit ies operat e in a nat iona l and, in somecases, an international arena. Funds flow tothose areas where they can earn the best re-tu rn at an appropriate level of risk. Regionswith spar se or declining populat ions, 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 havera il service, find it mu ch m ore difficult to at -tra ct n ew capital. Rura l banks can no longerafford t o make a loan to carr y the st ruggling

family farm until the crop comes in. The Fed-eral Government is under increasing pressureto provide new social programs to help thesecommuni t ies .

Relatively few large ret ailers, securit y bro-kers and dealers, insurance companies, and oildistributors have established nationwide dis-tr ibution system s for finan cial services h eavilybased on existing customer relationships, telecommunications, and information-processingtechnology. On the other hand, because somelegislation restricting interstate operations isstill in force, no commercial bank is am ong theleading financial supermarkets. Some commer-cial banks use networks to deliver services na-tionwide in competition with th e 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 professional

and 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 fromdat a processing to tra nsa ctions processing tocompensate for their small size. Their whole-sale suppliers sometimes compete with th emfor a retail market, and there are increasingcomplaints from th e small firms about r isingcosts 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 account s to identify and t ra ck 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-sti tutions, and others of that interruption wasappr oximat ely $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 Nat ion. Even t hough th ere 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 seconda ry mar kets t o insu r-ance compan ies and retirement funds tha t u sethem 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 an d giant fina nciasupermarkets, 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.Th rifts: 4,400; decline in decade—12 percent.

Au tom ated t ran sact ions : 20 pe rcen t bynumber, 87.5 percent by value.

ATMs: 48,000.

Home banking systems: 20, used primarilyby 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.O u t s t a n d i n g i s s u e s : p r i v a c y, s y s t e m s

security.

S c e n a r i o 2 : P i e c e m e a l R e g u l a t i o n

The Economy .—Gradual recovery fromrecession; continuing large Federal deficitsdampen economic activity, keep interest rateshigh, and cause a continuing high rate of unemployment .

Policy. -No thorough revision of regulation.Piecemeal chan ges occur , genera lly 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 theres t r ic t ions .

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 specialists

can 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 q Effects of /nforrnation Technology on Finanancia/ Services Systems

missive than in the past, States still play adominan t r ole in regula tion 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 institution

that 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 bank s 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 owned

by, any other k ind of inst itut ion. Neither ex-treme seems to be ideal for banks. There havebeen a number of messy bank failures, wherebanks have participated in a broad range of new 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-stitu tions t ha t include insu ran ce compan ies,investment brokers, and retailers, is stretchedto the ut most in tr ying to salvage as ma ny of th ese institu tions a s possible in order t o pre-vent further drain on the insurance funds.

Usually that salvage is done t hrough m ergers,an d th e num ber of depository inst itut ions isslowly but steadily shrinking.

Many th rift inst itut ions h ave 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-era l-pur pose, widely diversified, financial in-s t i tu t ions .

In States where banks are strictly limitedand protected as having a unique role, theyhave seen their resources dwindle as custom-ers remove fun ds to invest t hem t hrough in-sti tutions that can operate across State l ines.States that adopted this strategy generally didso in order to protect local banks, especially

farm -oriented ban ks, but th ey now find th atthe 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 compet ition within th eindustry, 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 t ime 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 th e next a nd realisticallyhave little hope of using their limited cash tomak e 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 th at 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 save

or 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 inst itu tional 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, while

they 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 silly

if 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 q 257

One mark of growing disaffection with fi-nan cial institutions is an increasing numberof consum er lawsu its, something almost un-heard of a few years ago.

Local banks play on these sentiments by em-phasizing their hometown image, stressing the

comfort of friendly personal ser vice, an d be-ing community boosters by sponsoring localsports teams and advertising their sympathyfor local small businessmen and farmers. Theyrely more a nd m ore on sma ll savers and oldcustomers. Large corporations find financialservice inst itut ions th at can help them ma n-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 metropolitan

areas; despite t heir na me, they ar e 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 t he old-fash ioned 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 q 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 al l , because they distrust large insti-tu tions. Employers who want to save moneyon their paperwork are inclined to suspect thatsuch employees are trying to evade taxes orchild support pa yments or are in th e count ryillegally. 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-

icant ly 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 th ere is much less mar keting 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

S c e n a r i o

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 insti tutions 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, butth e large institut ions dominat e the economyand the general long-range trend seems to betoward greater consolidation of financial re-sources.

Statist ics:

Banks: 13,000; decline in decade–13 percent.Th rifts: 4,050; decline in decade—19 percent.

Broker/ dealers: 4,000; decline in decade–20 percent.

Transac t ions au toma ted : 18 percent bynu mber, 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 : T h e G lo b a l F i n a n c ia l S e r v ic e s In d u s t r y

The Economy.–Accelerated growth in world specialty chemicals-an d in ser vices an d agr i-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 financiaially biotechnology, new-generation computers, service is a cornerstone of international trade;



Ch. 10–Future Scenarios for the Financial Service Industry, 1990-95 q 259 —

cooperat ion with other na tions to regularizeand encourage an orderly world market.

The Scenario.—The volume of world tradecontinues to increase. Both industrialized andindustr ializing na tions compete for ra w 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 takeadvant age of lower costs for la nd, labor, ra wma terials, an d r egulatory compliance in devel-oping countries. Bulk chemical production forinternational markets, for example, has largelybeen ta ken over by Third World coun tr ies. Aglobal division of labor is evolving, and it mayeventually narrow the gap between rich andpoor countries by providing a viable nichefor everyone, as H erma n Ka hn predicted 20years ago.

The United States ha s 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 infra str ucture, an d th is hastended t o add to the bu rden 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. Manyintern at ional inform at ion services use sat ellite communications. Traditional communica-

tions links, such as telephone a nd t elegraphcables, are highly vulnerable to the politicalinstability, terrorism, and local wars that havebeen the curse of the last two decades, as wellas t o government al restr ictions on the tr an sborder flow of data. As it is, there are continu-ing inter na tional dispu tes over freedom of financial 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-

tern at iona l thieves to try to cont rol, capt ur eor manipulate it to their own advantage.The reluctance of the United Sta tes, in the

1980’s, to cooperate with other countries insetting up mutually acceptable safeguards forthe transborder flow of data resulted in somediplomatic problems and a regrettable loss of national prestige as well as some damage toU.S. tra de positions. The ma jor h oldout a mongWestern 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,nat ional m arkets, na tional currencies, and na-tional transactions systems are closely tied toone another. In most si tuations, 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 excur sions in mar kets r eveal th is 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 coun tr ies. Since th en, th ese networkshave been used more systematically to moni-tor an d cont rol int erna tiona l debt exposures,debt management, and repayment schedules.But setting up mechanisms to allow this tohappen has entailed complex diplomatic nego-tiat ions 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 international

transactions 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 of the largest financial institutions, including major bank s, ha ve some foreign ownership. Ma nyU.S. banks also have branches or affiliates inother coun tr ies.

Many experts, both within and outside of the government, worry about the effect of these 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 of th em ha ve far more financial resources tha nmost 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 da ys. A year la ter 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 the

Black 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 tr ade dem an ds U.S. coop-eration with and leadership in the continuingdevelopmen t of a worldwide finan cial 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, which

is now revolutionizing consumer services, andcan potent ially revolut ionize all form s of rec-ordkeeping throughout the economy and soci-ety. The American financial service industryaccount s for a significan t sh ar e of the export



—

Ch. 10—Future Scenarios for the Financia/ Service Industry, 1990-95 q 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 of man y small count ries.

The growth and integration of the worldeconomy in the long run may well be the most

significant force for world peace. It could beth e sour ce an d wellspring of th e gradua l 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. f inancial insti tutions withsom e foreign own ership: 13 percent .

Percent of U.S. f inancial insti tutions withinternational branches or affiliates: 17 percent.

Automated t ransact ions : 35 pe rcen t bynum ber, 91 percent by value.

Direct deposit (international payments): 97 percent of Federal payments.

Outstanding issues: control of terrorism,monitoring and control of Third Worlddebts .

Statist ics:

Bank s: 15,750; increase in decade–5 percent.Thrifts: 5,100; increase in decade-2 percent.

S ce n a r io 4: P r o sp e r i t y a n d I n n o v a t io nThe Economy .–Booming prosperity. The

United States has a commanding lead in sev-eral h igh-technology indu stries a nd a st rongrole in int erna tional t rade. An era of innova-tion an d 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-st i tutions and to consumers.

The Scenar io.– Rapid advan cements in t hebiological sciences are spawning new indus-tr ies, 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 au tomation.

Recognizing that a strong national economydemands efficiency and reliability in nation-wide transactions, and also demands that al lregions and commu nities pa rticipat e produc-tively in th at na tional economy, Congress t ook

decisive steps in 1985 to revamp laws an d reg-ulations pertaining to financial services. Mostaspects of financial service delivery were decisively preempted to prevent State laws fromdistorting the legal and institutional infrastru ctu re n ecessary for an efficient n at ionapayments system. Prohibitions on interstatbanking were removed, but banks were allowedto engage in diversified financial services onlyby carefully segregating them from traditional

depository-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 timerelated and other requirements and mustclearly inform users of the differences. All financial service regulation is focused on thenat ure of the service and i ts r isks and r eturn srather than on the nature of the institutionproviding the service or the mechanismsthrough which it is delivered. The exceptionto this ru le is th at institu tions providing certain basic “lifeline” services or committinspecified 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-t ivit ies.

Administration and enforcement of Federal

financial service laws and regulations has beenlargely centr alized an d r ationalized un der 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 bedecent ra lized, yet well-coordina ted. Th e pro-liferation of information technologies and sys-tems has been comparable to the spread of electrification in the 1930’s and 1940’s. The

thrust in financial information technology hasbeen toward automation of lower value trans-actions and the development of intelligentmedia—the smart card and i ts descendants.

ATMs are now being replaced by automatedresource control centers (ARCCS) that not onlydispense curr ency but aut omat ically tran sferfunds between accounts. Most stores, gas sta-tions, and the like, have POS terminals, al-though people do a great deal of their shop-p ing t h rough the i r home compu te r s .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 br okers a nd general-pur pose financialadvisors fiercely competing for customers. Thebrokers work on coremission; the financial ad-visors charge by the hour and are supposedto be more disint erested. But th ere are some

shoddy operat ors 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 int erest s, if not downr ight s cams, al-though most of them are probably useful andeffective.

Businesses have established powerful tele-commu nicat ion n etworks t hat are u sed 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 ba lances in a ccoun ts receiv-able. Members of the clearing community havegenerally agreed to settle a credit balan ce 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 of a broker. Electronic messages bearing thecomput er signat ur es of both buyer an d 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 q 263

known as informed consent laws, but in prac-tice these laws are difficult to enforce becauseit is ha rd for victims t o detect and pr ove sec-ondar y use of dat a from a given source. Fed-eral laws also specifically forbid governmentagencies to have access to such data for other

than narrowly defined purposes (i.e., tax levy),but civil libert arian s point out t hat th is 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 financialdat a for socially useful pu rposes such as crimedetection and military intelligence.

Securit y is an oth er importa nt problem forseveral reasons. Because the financial servicesystem is so highly networked nationwide, thepotential gain from a successful th eft is a lmostunlimited. 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 cent ra l to th e economy, an d 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 an d t echn ologi-cal reasons).

Protection of financial information andtransaction mechanisms in the event of natu-ral disast ers or militar y att ack is also a Fed-eral responsibility. The Federal Government

has developed standards and requirements forboth backup systems and redundant databanks, but the industry protests that the costs

are excessively burdensome, many technicaexperts question the adequacy of the standards, 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 r equiring financial institut ionsto direct a percentage of resource investmentto certain high-priority social programs are acontinuing political issue. There is constandispute between those who want to add newsocial priorities to the list of preferred in-vestments (which carry definite tax advantages) 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 worldt rade .

Statist ics:

Banks: 16,500; increase in decade–10 percent.Thrifts: 5,200; increase in decade-4 percent.

Automated t ransact ions : 35 percen t bynu mber, 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 wi thout deposi tory

accounts: 7 percent .Technology: development of intelligent me-

dia, ATMs that automatically transferfunds between accounts.

Issues: requirements for preferred socialinvestments, growing computer-basedtheft .



Append ix



A p p e n d i x

G lo ss a r y o f Te r m s

This appendix provides summary definitions of financial service products discussed at various pointin 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 Products1.

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 Inst i tut ion Productsa. Direct Depositb. Check Access Certificate of Depositc. IRA, Keoghd. Eurodollarse. Imprest or Sweep Accountf. Single Premium Deferred Annuities

(SPDA)Margin AccountsMarket MakingLeveraged LeasesRetai l BankingMiddle and Inst i tut ional Market LendingRepurchase AgreementsMoney Market SecuritiesOther Inves tment Fundsa. Money’ Market Fundb. Real Estatec. Liquidityd. Growthe. MunicipalMor tgage LendingCSVIJI LoansReal Property Equit iesInsurance Premium FinancingActuarial AccrualsAnnuit ies

Tran saction Products (Paper-Based)24 .25 .26 .27 .

28 .

29.30 .

31 .32 .33 .34 .35 .36 .37 .38 ,39 .40 .41 .42 .43 .

Cash ProcessingPayrol lMoney Orders/Traveler’s ChecksMortgage ServicingBack-End Processing

a.c.d.e.f.g.

i. j.k.

Instal lment Loan ServicingMortgage Loan ServicingCommercial Loan ServicingDemand Depos i t Account ingSavings Deposi t AccountingTerm Depos i t Account ingGeneral Ledger ControlCollateral ControlCash ControlTrus t Account ingI tem Process ing

WholesalelRetai l LockboxCheck Guarantee/Authorizat ionSecurities SafekeepingPersonal TrustEscrow AccountingNote CollectionMor tgage Bank ingCollection Service (Brokerage)Private PlacementEqu i ty Broke ragePublic OfferingRelocat ion ManagementReal Estate BrokerageSecuri t ies Set t lementAnnuit ies

Transaction Products(Electronic-Based)44. Data Base Access45. Branch Automat ion

a. Platform Automation

2 6 7

35 -505 0 - 84 - 19 , Q L 3



268 q 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 TerminalsSet t lement and Clearinga. Set t lementb. ClearingAutomated Clearing House/ElectronicClearing House

Wire Transfer (Domestic and International)Cash Managementa. Depository Transfer Checkb. Concentration Accountingc . Automated Inves tment Accountsd. Cash Forecast ingBusiness Banking Productsa. Account Reconciliationb. Account Consolidationc. Balance Availability Reportingd. Balance Concentration/Sweepe. Automatic Customer Billingf. Deposit Reconciliationg. Account Payable Check Writing

Point-of-Sale SystemsHome BankingATM Sys t emsCommingled Investment PoolsDirect Deposi tFunds Movement and InquiryInternat ional Banking Productsa. Letters of Creditb. Credit Inquiryc. Foreign Exchanged. Draft Collectione. Syndicationf. Dollar ConnectionStock Transfer

Commercial PaperOpt ions /FuturesEqui ty BrokerageIndex Funds BrokerageBond BrokerageFund ManagementDebit CardsSecurities SettlementDiscount BrokerageSecurities LendingCertificates of Deposit Brokeragea. Straightb. StripInsurance Services Account

Information Services7 1 . Cash Requirements Forecast ing72. Working Capital and Cash Flow Analysis73. Investment Return Optimizat ion Analysis

7 4 . Consumer Financial Analysis75. Business Financial Analysis76. Debt Issue Rating and Quotation Services77. Credit Reporting Agencies

Glossary of Terms: FinancialProducts and Services

Asset and Liability ProductsAsset and liability productsare t hose generic

products that impact the balance sheets of finan-c ia l ins t i tu t ions . Asse t p roducts a re genera l lyloans, while liability products are depository inna ture .

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).Pr oject F inan ce—Similar to syndicat ed loan s(in fact, most are syndicated), project financeinvolves very specialized lending to major gov-ernments and their capt ive industr ies .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 ac t ing in a t ransparen t fash ion foranother lender, whereby the first provides thefunding source while the second generates themarketing and approval process. Two commontypes of indirect funding are: 1) correspondentbank overl ines, where a bank automatical lyparticipates 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 q 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 this

service for their correspondents that are toosmall to establish such facilities themselves.Banker’s Acceptance–These obligations of the bank (guaranteed payment under lettersof credit) can be eith er a ssets or liabilities orboth, depending on whether the bankis dis-counting them to the public against its guar-antee of payment.Trus t Receipt F inan cing–Genera lly providedby lar ge comm ercial lenders t o ban ks an d th epublic to enable th em t o finan ce inventory—either finished or r aw.Depository Financial Institution Products:a.

b.

c.

Direct Deposit–The process whereby a

check’s issu er delivers t he check directly toth e payee’s ban k for credit to his or h er a c-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-min i s t r a t i on compensa t i on and pens ionpaymen t s .Check Access Certificate of Deposit–Abundled product that includes allowing theconsumer to write checks against a line of credit secured by a term deposit in a ba nk.

IRA/Keogh–A tax deferment product of-fered not only by banks (where it is a t ermdeposit product), but also by NDFIs, suchas insurance underwriters, securitiesbro-kers, consumer finance companies, mort-gage bankers, and others. These offerorsprovide t rus tee serv ices under IRA andKeogh plans, thereby playing in the trans-action services arena.1 ) IRAs—A retirement savings program for

individuals t o which yearly ta x-deducti-ble contributions up to a specified limitcan be made. The amounts contributedare not taxed until withdrawal. With-

drawal is not permitt ed 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 balance

above 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.S in gle-P r em iu m D efe r r e d A n n u i t ie s(SPDA)– Products designed toprovide afuture pay-out of deposits based on an ac-tuarial formula. Currently, only insuranceunderwriters are empowered to offer mosttypes o f annu i t i e s. Such annu i t i es havesome form of tax avoidance characteristics

Margin Accounts–Margin accounts enable

reta il cust omers to leverage equity purchaseup t o a fixed percent age, The under lying debis provided by th e ma jor money-cent er ba nksto securities brokers who mark up the priceand end-loan to the consumer.Mark et Mak ing (Equity Positions)–The practice of buying and selling securities for a broker’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 capitaequipment 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 products offered by the pa rent . An example wouldbe ownership of a retail bank by a securitiesbroker, as in t he r ecent case of Dreyfus CorpMiddle and Institutional Market Lending–A1-ternatives to funds offered by commerciabanks for middle market and institutionamarket borrowings using the proceeds of pub-lic or private debt placements to make loanto these types of borrowers.Repurchase Agreements–A contract betweena seller (bank, thrift, credit union, securitiebroker, and others) and buyer of Federal Gov-ernment or other securities, whereby the selleagrees to buy back the securities at an agreedupon price after a stated period of time.Money Market Securities—private andGov-

ernment obligations with a maturity of 1 year




17.

18.

19.

20 .

or less. These include U.S. Treasury bills,banker s acceptan ces, lar ge 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 sh ort-term, h ighly liquid securi-t ies that pays the investor a market rate of interest an d 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 concentra ting th eirinvestments in cash or near-cash in-vestments.Growth–Those funds concentrating theirinvestments in speculative growth-oriented

securities 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 of

increasing 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 ra tes .

Real Property Equities–The ta king 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 of insurance underwriter; is the tax-deferred an-nuity, which only these industry members areable to offer with long-ter m guar ant eed rat esof return. Such annuities can be single-pay-ment or multiple-payment plans an d periodicor single pay out , or t hey can be st ru ctured t obe 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.Th eprocessor may also process the account debitto offset the credits for the checks, payrollta xes, and m iscellaneous withh oldings.Money Orders/Traveler’s Checks–Negotiabletender forms issued by depository and NDFIs

in 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 int ermediar y tha t 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.

Insta llment 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 q 271

29 .

c.

d.

e.

f.

g.

h.

i.

j.

k.

Commercial Loan Servicing–Process of servicing 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 thathan dles the accrua l 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 t he inst itut ion’s genera l 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 of checks, 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 ins titu -tions themselves to service their own loanportfolios. “Wholesale” refers to r eceivablesflows tha t involve a few items with la rge dollaramounts per item.“Retail” refers to thoseflows with a large num ber of items a nd sm alper-item dollar amounts.Check Guarantee/Authorization-The processof providing merchants and other vendorswith assur ance that a par ticular 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 pr ocess genera lly involves a r ela-tionship between merchant and bank in con-tr ast with electronic-based pr ocedures 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 electr onic applicat ions whenbanks provide the service to their customersfor paperless securities, such as Treasury billsan d 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. Genera lly, the m ortgagebank er will be equipped with th e originat ionsystem and will tap national secondary mar-




36.

37.

38.

39.

40 .

kets for funding. In many cases, nondepos-itor mortgage banker s will be supported withwareh ousing lines of credit from ba nks to fa-cilitate timely funding of loans. These ad-vances are ultimately repaid through filling of commitments with funds purchased in theopen market. Three common secondary mar-ketmakers exist–Federal National MortgageAssociat ion, Govern ment Nat ional Mort gageAssociation, 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 of entering for collection the interest coupons of municipal, 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.Fr equent offerors in clude securities br okers,banks, and thrift institutions.Private Placement–The business of sellingth e long-term debt or equity instr umen ts of aclient directly to one or more financial insti-tutions without going to the public market.Equity Brokerage—The trading of securitieson beha lf of a broker ’s clients eith er on one of the 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 th eir per iodic job-relatedrelocat ions by advancing th e equity in ownedreal estate, th us 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 realesta te compa nies or r enewed offerings of theservices through existing securities brokerageoffices.Securities Settlement–The process of trans-ferring t itle between buyers an d 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 inowners hip on the books of th e tr ans fer a gent.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 of a particular l ife 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 andman ipulate data or to take a ction 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.

Plat form Automation—The s econd step inthe branch automation process is that of automating the functions of the administra-tive and loan platforms. In most cases,automation amounts to teller-terminal emu-lation with access t o 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 conductbankin g business. Ma chine configurat ions



..—


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.

Set t lement and Clearing:a. Settlement—In interchange, the process of

b

c a r d h o l d e r b a n k s a n d m e r c h a n t b a n k seither 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-r ing t i t le , where appropriate.Clearing–A banking term referr ing 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 fac i l i ty tha t per forms in te r-member ( f inancia l ins t i tu t ions) c lear ing of paperless entr ies between such inst i tut ions.Most ACHS are operated by the Federal Re-serve and use rules, procedures, and programsdeveloped on a local basis by their participat-ing f inancial inst i tut ions 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 t rans-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 receivingen d of t he D TC s ys te m o r o t h e r

cash-gathering mechanism.A u t o m a t e d I n v e s t m e n t A c c o u n t s – T h o s ecash concentrat ion accounts that are pre-programmed to sweep balances in excess oa 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 inst i tut ion 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—Customerspro-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 .Accoun t Conso l ida t i on–The c r ea t i on o fmultiple accounts that are actual subsets ofa single account. The funds reside in one ac-count, but statements are prepared for eachsubaccount . This is part icularly at t ract iveto customers with multiple-branch profitcenters . The process requi res addi t iona lMICR* encoding on each separate set ofchecks.Balance Availability Reporting—Requiresthat a bank provide inter-da}’ balance re-port ing as checks and deposi ts 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 marke t ins t ruments .



274 q 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 ba nk, usu ally 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 a nd tr ansmitt ing 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 ar e capa-ble of gathering all data necessary for draft orcheck pr ocessing an d ena ble 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 t ransa ction.Home Banking–Though in its infancy, homebankin g 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 pu rchases from t he 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 th at perform s 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 un der br an ch a ut omationin that the ATM system may also involvecredit authorization, check verification, draftdata capture, and transaction processing.Comingled Investment Pools–Enable banksto leverage their investm ent expert ise to pro-vide investment services to their customers di-rectly or t o oth er inst itut ions on a corr espon-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 ins ur ance premium s overtime, t he ISA offers th e 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,an d leasing compan ies).Funds Movement and Inquiry-Generic termsfor electronic-based cash management serv-ices, including funds transfer (wire-based) andaccess to data base inform at ion on th e distri-bution of available fun ds (e.g., Where ar e th ey?Collected or uncollected? Ingestible?).International Banking Products–These prod-ucts are provided to enable the customers of banks and thrift institutions either to do busi-ness in t he global ma rket or to have access tofunds while tr aveling worldwide.




a.

b.

c.

d.

e.

f.

Letters of Credit–Letters of credit (LCS)are evidence of financial institution’swill-ingness to underwrite the deal ings of i tscustomers in arrangements where the cus-tomer is unknown to the seller of the prod-uct or in countries where the extension of tr ade credit t o foreigner s is forbidden (e.g.,

Japan). While the actual letter is paper-based, the a dvice and LC nu mber is tr ans-mitted electronically through the bankingnetwork t o the cust omer’s seller (alth oughthe LC may be required by a buyer as a per-formance bond). Trade LCS will probablynever be completely electronic because of the extra documentation required, such asbills of lading, port en tr y receipts, a nd 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 thr ough either th eir 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 foreignexchan ge mark et t o protect their positionsagainst adverse currency exchange rates.Foreign tr avelers often need t o use foreigncurrency that they can purchase in theUnited States prior to departing. Banksrely heavily on electronic messages to keepabrea st of foreign money mar kets, n ot only

for th eir own accounts but also for th ose of their customers,Draft Collection-–Involves processingdrafts received or delivered under letters of credit 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 ra tewith potential syndicate members, intend-ing to reap a spread differential profit.Dollar Collection– Involves the service of processing checks drawn on U.S. banks andpresented to customers of foreign banks.

,5 8 .

59 .

60 .

61 .

62 .

63 .

64 .

65 .

This is a service of the international correspondent bank community and involvesthe settlement of cash letters. While the volume in cash letters is extremely high, themajori ty of cash and dollar set t lement isdone by a handful of the largest U.S. banks

Stock Transfer-Banks ac t as the t ransfer

agents for publicly held stocks. In this capacity they are required to process the changeof ownership of billions of shares each monthIt is important that these institutions maintain a data base that provides ownership records to verify ownership, a service accessed bnot only the corporation stock issuers but alsthe securi t ies industry.Commercial Paper–Short-term (270 days oless), unsecured promissory notes issued bybusinesses of significant financial strength owhose paper is backed by a letter of credifrom a major bank. Brokers are merely one otwo ways commercial paper is marketed. Th

major exception is Citicorp, which brokers itown commercial paper.o p t i o n s / F u t u r e s – o p t i o n s ” a r e a t r a d e a b l eright to buy or sell securities. Futures contracts are a legally binding agreement that cafor the purchase or sale of a real or hypothetical commodity at a s tated price and futurepoint in time.Equity Brokerage—The trading of securitieon behalf of a broker’s clients on one of thgreat number of stock exchanges.Index Funds Brokerage–The se l l ing fundswhose yields are defined by specified stock indices such as Dow Jones Industr ials , Stand

ard and Poor ’s, and the Wilshire Index.Bond Brokerage–The brokerage of debt instruments of strong corporations to clientsFund Managemen t–The con t inua l a r r angement and rearrangement of the bank balancsheet or that of any trust or fiduciary fund inan a t tempt to maximize prof i t s , subjec t tohaving sufficient liquidity and making safe inves tmen t s .Debit Cards–A plastic card issued by a financial institution to its own customers that, busage, credits or debits the customer ’s personal account (checking, savings, or line ocredit). The card may be proprietary or it ma

be a regionally or nationally accepted cardWith regard to the securi t ies industry, debicards are used to access funds on deposit inmoney marke t funds or to access l ines ocredit secured by securities portfolios or reaproper ty.



276 q Effects of /formation Technology on Financial Services Systems —

6 6 . 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 of deposit .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 Services7 1 . Cash Requirements Forecasting—A system

tha t u ses financial institu tion customer dataon receivables, payables, and capital spending

to 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-t ies and expresses the same as a net negativeor positive working capital position.

7 3 , Investment Return Optimization Analysis—A product used by banks and their customersto evaluate a lternat ive investment scenariosusing a targeted internal rate of return as theprimary algorithm. This product enables thebanks and their customers to develop parallelviews of customer investment requirements

and 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-ment s mechan ism to assist consu mers inhousehold budgeting. It uses additional infor-mation provided by the customer on checksand deposit documents to organize paymentsand r eceipts dat a in a fashion t hat enablesthe consumer to visualize how the householdbudget is spent, i.e., residence, entertainment,food, utilities, tax-deductible items, an d n on-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 securities

brokers, pension plan a dministrations, 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.



H



— —

I n d e x—. — ————- ——— —-—

ADP, Inc., 118Aetna Insur an ce Co., 32Alex Brown & Sons, 53Amda hl, 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, 119Cart e Bleu, 40Cash Management Account, 91, 119C. D. Anderson & Co., 71certificate of deposit (CD), 84, 104, 154Chemical Ban k, 129, 149Chicago Board Options Exchange, 54Chicago Board of Trade, 55Cincinna ti St ock E xchan ge, 71CIRRUS System, Inc., 120, 121Citibank, 203Clearing House Interbank Payment System

(CHIPS), 158commercial paper, 83Commodity Fu tur es Tra ding Commission (CFTC),

55, 60Commodity News Services, 130Consolidated Quotation System, 65consumer financial services, 167-187

consu mer services, 167-180automated teller machines, 176aut omatic direct deposit, 178costs, 179growth of credit, 173home inform ation systems, 178payment methods, 171point-of-sale systems, 178pricing st ructur es, 178providers, 169recent inn ovat ions, 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

Continu ous Net Sett lement (CNS), 73Credit U nion Nat ional Administrat ion (CUNA), 104

Dahls supermarkets, 123Dean Witter, 53, 62, 64, 66, 70Delawa re, 112, 113, 123, 217Departm ent of Treasu ry, 101Depository Institutions Deregulation Committee,

10 3Designat ed Order Tu rna round (DOT), 71Digital Termina tion Service, 35Drexler Technology, Mountain View, Calif., 39

E. F. Hutton & Co., 53, 66, 130

Federal

Federa lFedera lFedera lFedera l

Deposit Insurance Corporation (FDIC), 103,24 1

Home Loan Ban k Board, 11, 63, 199Reserve Bank of Atlan ta, 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,

10 4findings, 191-219

applicat ions of technology and changed na tur e of financial ser vices, 192

competition in the markets, 216entrants into the financial services industry, 213financial options for consumers, 201

integration of capital markets, 210interaction between technology and the legalregulatory structure governing banking,19 8

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,

16 2futu re scena rios, 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

27 9



Index q 281—

consolidat ion, 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, 231restr ucturing the policy framework, 9, 226security and integrity of delivery systems, 15vulnerability of financial services systems to theft,

15, 246Pru dential Bache, 53, 64Publix Supermar kets, Florida, 119

repurchase agreeements, 84retail financial services, 97-133

deposit fun ction, 99-108accounts with other nondepository institutions,

10 7deman d deposit account s, 102direct deposit, 100drafts, 102giro tran sfers, 102insuran ce, 106lockbox operat ions, 101point-of-sale system s, 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, 123-126

costs of POS systems, 125direct debit POS, 123National POS systems, 125

extension of credit, 108-114commercial credit, 110consumer credit, 110

financial information services, 126-128check a uth orization, 127credit aut horization, 127providers, 127

home information services (HIS), 128characteristics of users, 132costs, 131developers of, 129implications of, 131mar ket for, 131technology of, 129

Reuters, 157Revell, J. R. S., 161Reynolds Securities, 62

Safeway, 118, 119Saloman Br others, 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, 68under writing new issues, 67

advisory role, 65coun seling, 66informa tion disseminat ion, 65

marketing, 69-75brokerage, 70cleara nce and set tlement of securities, 72pricing, 73product development, 69tra nsactions, 71

information technology, effects of, 75-76instruments, 76-91

corporate capital str ucture, 76-83convertible securities, 82equity, 81-82long-term debt-corporate bonds, 77-81

options and future contracts, 84centr al asset accounts, 91futures, 88mutu al funds, 90options, 85warrants , 87

short-term debt-money ma rket securities, 83-84structure of, 51-64

characteristics, 62

composition, 52brokerage houses, 53exchanges, 53investment banks, 52

development, 51effects of information technology, 64industr y users, 57-59

individual investors, 59institu tional investors, 57

international market , 64new entrant s, 63regulatory structure, 59

Federal agencies, 60self-regu lat ory agencies, 61tren ds in regulation, 62

Securities Industry Automation Corp. (SIAC), 54,62, 71, 72

Securities Investor Protection Corp. (SIPC), 60, 61,180, 241

Shear son/American Express, 53, 63Small Business Administra tion, 60



282 q Effects of Information Technology on Finaricia/ Services Systems —. — —

Small Business Investment Corporations, 60Society for Worldwide Interbank Financial Tele-

communication (SWIFT), 153, 158, 159,

Telemet America, Inc., 66Treasur y bill, 83Tyme Corp., Wisconsin, 119