Effects of Information Technology on

Financial 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 Documents

U.S. Government Printing Office, Washington, D.C. 20402
Foreword

In 1982, the House Committee on Banking, Finance, and Urban Affairs; the

House 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 requested

OTA to assess the impacts of information processing and telecommunication technologies 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 change

in the financial service industry. The structure of the industry has changed significantly in recent years as firms not traditionally viewed as financial service

providers have taken advantage of opportunities created by technology to enter

the market. New technology-based services have emerged. These changes are the

result of the interaction of technology with other forces such as overall economic

conditions, societal pressures, and the legal/regulatory environment in which the

financial service industry operates.

This report describes the technologies now and likely to be available to providers and users of financial services. It analyzes the present structure of the financial service industry, its service offerings, its relationships with users of financial

services, and observable trends. Implications of possible future trends for industry

structure, markets for financial services, and relationships between the industry

and the legal/regulatory environment are explored.

For the purposes of this report, the financial service industry has been divided

into three segments: 1) retail financial services, 2) the securities industry, and 3)

wholesale financial services. We focus on the opportunities that may be created

for consumers and problems they may encounter as the financial service industry

continues to evolve. Policy questions likely to be of interest to Congress and alternatives 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 and

on other information provided by a variety of persons and organizations. We are

grateful for this support and assistance. Two workshops, one dealing with

technology and industry trends, and the other with consumer issues, provided

much valuable information. Members of the advisory panel were particularly

helpful with their contributions. However, the contents of this report are the sole

responsibility of OTA and do not necessarily represent the views of the members

of the advisory panel or any of the others who have contributed.

JOHN H. GIBBONS

Director

.,. ///
Financial Services Advisory Panel Members

Almarin Phillips, Chairman

Holer Professor of Management, University of Pennsylvania

Donald I. Baker, Esq.

Partner

Sutherland, Asbill & Brennan

Paul Baran

Chairman of Board

PacketCable, Inc.

Lynne Barr

Partner

Gaston-Snow & Ely Bartlett

Robert Capone

Vice President and Director

J. C. Penney Co., Inc.

Kent Colton

Executive Vice President

National Association of Home Builders

Richard J. Darwin

Manager

Battelle Memorial Institute

Gerald Ely

Division Director

Merrill Lynch Capital Market

John Farnsworth

Senior Vice President

Bank of America

Paul Hefner

Senior Vice President

1st Interstate Bancard

Edward J. Kane

The Everett D. Reese Professor of

Banking in Monetary Economics

Ohio State University

Jerome Svigals

Electronic Banking Consultant

IBM Corp.

Willis H. Ware

Corporate Research Staff

The Rand Corp.

Steven Weinstein

Vice President–Technology Strategy

American Express

Milton Wessel, Esq.

General Counsel

ADAPSO

Frederick G. Withington

Vice President, Information Systems

Arthur D. Little, Inc.

iv
OTA Financial Services Assessment Staff

John Andelin, Assistant Director, OTA

Science, Information and Natural Resources Division

Frederick W. Weingarten, Communication and Information Technologies Program Manager

Project Staff

Zalman A. Shaven, Project Director

Phyllis Orenstein Bresler, In-house Contractor

Margaretta McFarland Rothenberg, Research Analyst

Charla M. Rath, In-house Contractor

Administrative Staff

Elizabeth A. Emanuel, Administrative Assistant

Shirley Gayheart, Secretary

Jennifer Nelson, Secretary

Marsha Williams, Secretary

Renee S. Lloyd, Secretary

Jeanette V. Contee, Secretary

Contractors

Maria T. Arminio, ICS Group, Inc.

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

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

Arthur E. LeMay, SEI, Inc.

Kathryn M. White, Editorial Consultant
Financial Services Industry Consumer Workshop Participants

Stanley Bess

Systems Program Manager

J. C. Penney Co., Inc.

Ellen Broadman

Minority Chief Counsel

United States Senate

James L. Brown

Associate Professor of Law

Director of Center for Consumer Affairs

University of Wisconsin-Extension

Meredith M. Fernstrom

Senior Vice President-Public Responsibility

American Express Co.

Edward J. Kane

Everett D. Reese Professor of Banking

in Monetary Economics

Ohio State University

Mark Leymaster

Staff Attorney

National Consumer Law Center

Barbara Quint

Money Management Editor

Family Circle

Dale Reistad

Consultant

Reistad Corp.

Financial Services Industry Technology

and Scenarios Workshop Participants

Thelma V. Rutherford

Private Citizen

Michael Van Buskirk

Assistant Vice President of

Corporate Affairs

Bane One Corp.

C. M. Baker

Director of Planning

Navy Federal Credit Union

Edwin B. Cox

Senior Management Consultant

Arthur D. Little, Inc.

Richard J. Darwin

Manager

Battelle Memorial Institute

Ronald Glidden

Senior Vice President

Life Insurance Co. of Virginia

Frederick R. Levy

Manager of Financial Operations

FMR Corp.

Robert Lucky

Executive Director, Research

AT&T Bell Laboratories

Deborah Smith

Vice President

Beneficial Corp.

Daniel F. Sullivan

Senior Vice President, Operations

ISFA Corp.

Blake Greenley

Vice President

Citibank N.A.

vi
Financial Services Reviewers

John B. Benton

President

The ICS Group, Inc.

Janice Booker

Director, Federal Treasury Department

Comptroller of the Currency

John Briggs

P. O. S.–Debit Card Project Manager

Mobile Corp.

Raymond Cocchi

Vice President

National Association of Securities

Dealers, Inc.

Dan Eitingon

President—Chief Executive Officer

MoneyCare

Jesse Filkins

Senior Attorney

Board of Governors of the Federal Reserve

John Fisher

Vice President

Bane One Corp.

Gregory J. Furman

Managing Director of Advertising and

Sales Promotion

New York Stock Exchange, Inc.

Shelley Gross

Vice President, Marketing

Computer Systems & Resources

Arthur LeMay

President

Arthur E. LeMay Co.

Jeffrey A. Lebowitz

Vice President for Strategic Planning

Federal National Mortgage Association

Frederick R. Levy

Manager of Financial Operations

FMR Corp.

Alan Lipis

President

Electronic Banking Inc.

Lois Martin

Vice President

The First National Bank of Saint Paul

John T. McGee

Vice President, Corporate Affairs

Securities Industry Automation Corp.

Russell Morris

Assistant Commissioner, Federal Finance

Department of the Treasury

Michael Radow

Senior Associate

Century-IV Partners

Louise Roseman

Regulatory Liaison

VISA, USA

vii
Contents

Chapter Page

1.

2.

3.

4.

5.

6.

7.

8.

9.

10,

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

Present and Future Technologies Supporting the Financial

Service Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

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

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

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

The International Environment for Financial Services . . . 153

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

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

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

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

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

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

ix
Chapter 1

Overview
Major Findings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Industry Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Legal/Regulatory Environment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Financial Service Delivery Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Consumer Interests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Safety and Soundness of the Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Financial Services in the Future.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Influence of Technology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Financial Service Providers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Users of Financial Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Congressional Policy Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

General Policy Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Structural Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Risk Allocation Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4

4

5

5

6

6

7

7

8

8

9

9

10

13

Figures

Figure No. Page

l. Organizations Comprising the Financial Service Industry and

Their Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

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

Chapter 1

Overview

This report focuses on the relationship between technology and change, both past and

future, in the financial service industry. The

roles of technology as both a motivator and

a facilitator of change are analyzed. Other

agents of change are considered only to the extent that they help define the market for new

technology or its impact.

The financial service industry (see fig. 1) is

markedly different from what it was at the end

of the 1970’s, and the rate of change will only

slow slightly during the remainder of the

1980’s. Advancing information and communication technologies are key factors that have

changed the nature of financial services: the

ways in which they are created, delivered,

priced, received, and used. Relationships between and among users and providers of financial services are changing.

Figure 1 .—Organizations Comprising the Financial

Service Industry and Their Products

Financial service providers:

Banks Data processing

Thrift institutions Telecommunications

Dry goods merchants Insurance companies

Credit card providers Etc.

Financial service Industry products:

Credit Debit cards

Deposit-taking Check authorization cards

Brokerage Information services

Investment Payment

Credit cards Insurance

SOURCE Office of Technology Assessment

The existing legal/regulatory structure has

roots that extend back 50 years; changes in

the financial service industry have challenged

some of its premises. Since the mid-1970’s,

Congress has devoted considerable attention

to the financial service industry and has enacted several major pieces of legislation. Many

of the regulations governing the industry are

being relaxed. However, continued congressional attention is needed because not all of

the salient issues have been resolved.

In the last few years, banks legally able to

operate outside traditional banking regulation

have appeared; retailers of food and general

merchandise have emerged as major suppliers

of financial services; changes in law and regulation have enabled banks, savings and loan

associations, and credit unions to broaden the

mix of services they offer and enter markets

previously closed to them. At the same time,

firms whose financial service offerings are virtually unregulated compete directly with traditional, regulated providers.

Information processing and communication

technologies are being used to enhance existing services, to implement new ones, and to

make them available in new ways. Money market mutual funds, operated by investment

companies and securities broker/dealers, permit shareholders to redeem shares by writing

the equivalent of a check. Banks, depending

heavily on information processing and communication technologies, are beginning to offer

securities through discount brokerage subsidiaries. Banks, credit unions, and savings

and loan associations join networks of automated teller machines that enable account

holders to obtain cash 24 hours a day from

machines that are available nationwide. Both

securities dealers and banks have developed

systems that allow account holders with per3
 4 • Effects of Iformation Technology on Financial Service Systems

sonal computes to transfer funds between ac- financial service industry. However, other faccounts, pay bills, and order the purchase and tors such as the legal/regulatory environment,

sale of securities. general economic conditions, and the demands

Observers consistently and correctly point of users have also had significant impact on

to technology as a key factor responsible for the industry (see fig. 2).

the rapidity and magnitude of change in the

Figure 2.— Factors Affecting

Financial Service Providers

Financial service providers

I I

Users of financial service

SOURCE: Office of Technology Assessment.

Major Findings

The changes that have taken place in the financial service industry affect a number of

areas including industry structure, the legal/

regulatory environment, financial service delivery systems, consumer interests, and the

safety and soundness of the industry. Major

findings in each of these areas are summarized

below.

Industry Structure

● Rapid and dramatic change in the financial

service industry will not persist indefinitely.

There will be a period of stabilization, prob-

●

ably over the coming decade, after which

the financial service industry is likely to return to a more orderly evolutionary pattern.

Firms are in the process of broadening the

scope of their service offerings, a trend that

will continue during the coming decade. The

future mix of financial services offered by

each class of provider will be much different

from what it is now. Some will offer the full

range of financial service including taking

deposits, extending credit, underwriting insurance and securities offerings, and securities brokerage. Others will target narrowly

defined markets such as serving the needs
Ch. l—Overview ● 5

of medical and legal professionals. Data

processing and communication services are

likely to be increasingly important offerings

by financial service firms.

So long as firms can continue to enter the

financial service industry with ease, the

likelihood of the industry becoming dominated by a small number of providers is

minimal.

Because of the affordability of information

processing and telecommunication services

for firms of all sizes, access to technologies

does not constitute a barrier to entry into

financial service markets. Technology may

actually facilitate entry. A small firm, by

obtaining communication and processing

services from others can enter a market and

compete with firms many times its size. On

the other hand, if the existing accessibility

of processing services does not continue, entry into the financial service industry by

small firms may be foreclosed.

The ability to move information quickly, reliably, and accurately is essential to success

for both providers and users of financial

services. Organizations controlling extensive distribution and/or communication systems are entering and will continue to enter markets as providers of financial

services.

By facilitating the flow of information nationwide, information processing and telecommunication technologies have contributed to the development of national markets

for financial services. Investors and users

of capital benefit to the extent that their offers receive broader exposure than they

would in a local or regional market. On the

other hand, market conditions are not uniform nationwide; and opportunities may be

more favorable in some areas than in others.

Thus, there is a possibility that the existence of national capital markets will draw

funds from some regions and cause their

needs to remain unfulfilled.

Legal/Regulatory Environment

The legal/regulatory structure now governing the financial service industry dates from

●

●

●

●

the 1930’s. Technological, social, and economic factors are causing considerable

change in the types of services offered, the

types of firms offering them, and the demands of the consumer. In light of the

changes that have taken place, this may be

the time to reconsider the overall legal/regulatory structure governing the financial

service industry.

Policies that have assumed a specific industry structure or service mix seem to be particularly vulnerable to unanticipated effects

when new technologies are introduced. For

example, the assumption that only banks

will take deposits was undermined by the

application of technology by firms other

than banks to support offerings such as the

money market account.

Some recent changes in State banking law

modify the way in which Federal law affects

financial service institutions. In the past,

States have generally supported policies for

the financial service industry consistent

with those of the Federal Government. This

is no longer always true. Some banking organizations have established subsidiaries in

States that have adopted policies favorable

to them and use information processing and

telecommunications to distribute services

nationwide.

Financial Service Delivery Systems

Financial service providers have used information processing and communication technologies to overcome some of the limitations, such as those restricting interstate

banking, imposed on them by law and regulation. This has lessened distinctions between various classes of financial service

providers, allowed the entry of firms not

previously classed as financial service providers into the financial service industry,

and allowed banks to enter into new businesses such as the operation of data processing service bureaus.

Telecommunication policy is a major factor

determining the price to the user of telecommunication services. Because telecommunication is a key component of financial serv-
6 ● Effects of /formation Technology on Financial Services Systems

•

●

●

ice delivery systems, telecommunication

policy directly affects the design and viability of those systems.

Consumer Interests

Because financial service providers are now

able to use price as an instrument for competition, more and more financial services

will be priced explicitly. “Free” checking accounts will disappear; brokers are likely to

specifically charge for advisory services.

Customers may be offered an increased

range of choice and may pay only for services used. However, the elimination of some

of the subsidies once hidden in “free” financial services may not be popular. The true

costs of meeting the financial service needs

of society will be more easily recognizable.

There is increased flexibility in selecting financial services and the types of institutions from which they are obtained as a result of the trend to explicit pricing and the

entry of new providers into the financial

service industry. However, to take advantage of these opportunities, consumers must

be sufficiently familiar with the available

options. Many have taken advantage of new

options they perceive to be in their interests.

In spite of broader choices of services and

institutions, some consumers are finding

their options constrained. Checks, for example, often are no longer an acceptable payment medium unless the person can also

present one or more credit cards to demonstrate financial responsibility. Some consumers are not welcome as clients to some

financial service providers. Some may prefer to avoid financial institutions but find

that increasing use of technology-based financial service systems propels them towards becoming clients of financial service

providers. Lack of access to some financial

services may implicitly limit or deny access

to other goods and services (e.g., it is currently very difficult to rent a car if you do

not have a major credit card). At some

point, consumers may require guaranteed

access to some minimal level of financial

●

●

services if they are to be able to function

as members of society.

Survey data show that consumers are concerned with the effects of changes in the financial service industry on their ability to

preserve personal privacy. Privacy issues,

on the other hand, are not presently prominent on the congressional agenda. If incidents of compromised privacy are widely

reported in the future, it may again be a

focus of public policy debate.

In many cases, a financial institution has

no document bearing an authorizing signature that can be reviewed before an electronically issued order is executed. Errors

in electronic financial systems may only

become visible on the periodic account

statement. Therefore, customers of electronically delivered financial services bear

greater responsibility for detecting errors

and initiating the procedures for correcting

them than do customers using paper-based

systems.

Safety and Soundness of the Industry

Increasing use of information processing

and communication technologies requires

that both providers and users take precautions to ensure the integrity and security

of financial service delivery systems. Although the use of technology may improve

some aspects of the security and integrity

of financial services systems, new vulnerabilities maybe introduced. Computer-based

authorization systems reduce the opportunity for fraudulent use of stolen credit

cards. However, if an account number is

compromised without the knowledge of the

legitimate owner, its fraudulent use may not

be discovered until a statement is received.

Thus, the perpetrator may have a significant period after obtaining an account number to commit fraud with relatively little

chance of detection.

The existing regulatory structure promotes

safety and soundness of the financial service industry by providing Federal insurance

for funds deposited in many banks, savings
Ch. 1—Overview ● 7

and loan associations, and credit unions. vestments that offer higher return. Yet,

Funds entrusted to other institutions re- based on experience to date, there is no

ceive little, if any, of this Federal protection. evidence that the fundamental safety and

The changes in the financial service indus- soundness of the industry have been appretry have led to significant movement of ciably compromised by the movement of

funds from accounts in insured, closely funds from federally insured accounts.

supervised institutions to alternative inFinancial Services in the Future

Forecasts of the financial service industry

prepared over the last 10 to 15 years have not

been particularly accurate. Many of the earlier

efforts foresaw the virtual elimination of the

check and significant decrease in requirements

for currency and coin during the last quarter

of this century. Some saw particular promise

in specific technology-based services (e.g.,

super-check, an instrument that would use one

order to direct payment to multiple creditors,

and telephone bill payment) that has not yet

been realized.

Experts continue to prepare forecasts for

the financial service industry. Firms continue

to develop and bring to market what they believe to be promising services. Some are labeled experimental while others are designated

as operational systems. Although forecasters

appear to have developed more realistic pictures of future markets for financial services

than were available in the past, much uncertainty remains.

Experience to date will not support an attempt to develop a detailed picture of the financial service industry of the future, but

some general trends (e.g., ever-increasing use

of advanced technology to deliver financial

services) are clearer now than they have been.

For example, there is little doubt among industry observers that customers will electronically order the immediate transfer of

funds from their accounts to those of merchants at the time purchases are made. However, the specifics of the systems that will be

used to implement this service remain open to

question. OTA’s analysis of general trends being followed by the financial service industry

represents many points of view now held by

knowledgeable observers.

Influence of Technology

The financial service industry of the future

will be quite different. The established trend

of increasingly heavy dependence on technology for delivering services will continue. Services will be provided by a wide variety of institutions. Barring a major restructuring of

the wholesale side of the financial service industry, small financial service firms will be

able to obtain access to the technologies they

will require to remain viable. Although relatively few firms are likely to provide service

nationwide, it is likely that the existence of a

large number of small, specialized financial

service organizations will prevent the few from

dominating the market.

Communication will be key to delivering financial services in the future. Networks growing out of those used to connect shared systems of automated teller machines are likely

to provide the basis of systems permitting

electronic initiation of fund transfers from the

merchant’s counter. Systems providing access

to funds from virtually any place in the Nation regardless of where they are deposited are

now being developed and are likely to be in use

in the next few years. Advanced communication technologies including satellite relays,

video cable, fiber optics and cellular radio will

find wide application in the financial service

industry.

Decreasing computer costs will create the

opportunity for large numbers of individual

35-505 0 - 84 - 2 : QL 3
8 ● Effects of Information Technology on Financial Services Systems

—

consumers and managers of small businesess

to take advantage of technology in using financial services. Large computers will be used

to support the data bases and the communication processing needed to operate the large,

interactive financial service delivery systems

of the future. Computers that accept voice inputs and recognize fingerprints may become

cost effective for financial service delivery systems by the turn of the century. Small, inexpensive personal computers in both home and

office will make it possible for customers to

interact with a multiplicity of financial service offerors. Computer processor and memory

chips imbedded in plastic cards may find wide

spread use in the financial service industry.

Financial Service Providers

Banks, savings and loan associations, and

credit unions probably will concentrate on

transaction processing and place less emphasis on gathering deposits and providing financing. Emphasis will be placed on computer and

telecommunication-based systems for delivering financial services. Included in the services offered will be data processing, securities

brokerage, and, possibly, insurance. In the

future, branches will be dominated by a variety of machines the consumer will use to directly interact with financial service systems.

Institutional personnel will serve more of an

advisory role and handle customer transactions, such as payments and withdrawals, only

in exceptional cases.

Securities broker/ dealers, long providers of

transaction services, will compete directly

with banks, savings and loan associations, and

credit unions in many areas. Today they already offer a variety of services such as money

market funds that are designed to give the

customer ease of access to financial assets.

This trend will continue, and the future is

likely to see higher levels of activity by securities broker/dealers in processing an increasingly broad variety of transactions. Retailers

of food and general merchandise and possibly

other types of organizations will be attracted

to the financial service industry. They will see

opportunities to profitably apply technological resources which are in hand or within reach

to offer transaction processing services.

Firms that have established information

processing and telecommunication facilities

are likely to be particularly active in the financial service industry. New entrants into the industry will have roots in such varied areas as

retail food and dry goods merchandising, petroleum production and distribution, and communications. Traditional providers of financial

services are likely to continue the present

trend toward diversifying their offerings, often

entering into areas that have been closed to

them in the past.

Users of Financial Services

Financial services will be delivered to the

customer at a convenient location with little

need for clients to visit the offices of a financial service provider. The present tendency of

corporate financial officers to use terminals in

their offices to manage funds will extend to

smaller businesses. Although the trend is not

yet clearly established, individual consumers

are likely to use home terminals to interact

with financial service delivery systems.

Consumer financial service packages are

likely to be offered in conjunction with other

information-based consumer services such as

home shopping, investment advisories, recreational services such as computer games, travel

reservations, and the purchase of tickets to

sporting and theatrical events. Financial service institutions may develop and operate the

network used to distribute these services or

they may participate in networks assembled

and operated by others.

Consumers may use terminals to order

banks to pay bills or to purchase securities.

They may enjoy more flexibility in services

used. For example, rather than carrying a

fixed amount of insurance, a terminal could

be used to vary it in response to changing

needs (e.g., increasing coverage for theft while

jewelry is kept at home rather than in the bank

vault). Orders to buy or sell stocks and bonds

could be entered from home and executed on

an automated exchange. Consumers may use

home information systems to analyze their financial positions and to help make decisions

on investment opportunities. Using these and

other capabilities will give the consumer

greater personal control over his assets.
--

Ch. 1—Overview ● 9 ———— —

Consumers may find that they need an account with a financial institution to have access to a variety of services. Some employers

may require direct deposit of payroll checks.

Alternatively, employers may offer employees

the option of writing checks against salary

held in a company account in return for being

paid daily. Consumers may need an account

to be able to use shop at home and travel reservation services.

Although technical differences will remain,

operational distinctions between services offered by various classes of providers will

diminish. It will be more difficult for users to

differentiate between them. For example,

though a money market fund offered by a

securities dealer is quite different from a demand deposit offered by a bank, both meet

similar needs for consumers as accounts from

which funds can easily be withdrawn.

Congressional Policy Issues

The results of changes already observed in

the financial service industry and those possible in the future are not consistent with some

of the key assumptions underlying the present Federal policy structure. Growing direct

competition between banking and the securities industry, the appearance of new classes

of financial service providers, and the changes

following from rapid increase in reliance on advanced technologies to deliver financial services exemplify shifts that have taken place.

Therefore, Congress is faced with significant

questions about the relevance and utility of

present public policy. In addressing these

questions, Congress will find it necessary to

resolve conflicts between the need to reconcile

conflicting interests, on the one hand, and to

create a climate conducive to the development

of new financial services and delivery systems

beneficial to both users and providers on the

other.

General Policy Considerations

Restructuring the Policy Framework

● What are the alternative approaches that

could be used if a review and restructuring

of laws and regulations related to financial

services were undertaken?

The financial service industry has changed

since the 1930’s when most of its present policy structure was developed. Rapid change, encouraged by technology and other market

forces, is expected to abate in the 1980’s or

1990’s. Although Congress has commissioned

comprehensive reviews of the financial service industry and the legal/regulatory structure

governing it and has addressed some specific

changes in the industry, legislation revisiting

the fundamental premises of existing policy

has not been enacted.

One alternative is continuation of the present approach of incrementally adjusting the

policy framework as the financial service industry continues to evolve. Some of the steps

taken using this approach are in anticipation

of future events; others are taken in response

to events in the marketplace. Alternatively,

the entire legal and regulatory structure governing the financial service industry could be

reviewed and recast in a form deemed suitable

in light of expectations for the future.

Implementation of Policy

● What are the mechanisms available to Congress for implementing policy pertaining to

the financial service industry?

Historically, Congress has implemented policy for the financial service industry through

one of the most pervasive regulatory structures applied to American industry. Public policy has focused on ensuring the safety and

soundness of financial institutions because of

their unique role in society. To this end, the

assets of the clients of many financial service

institutions, particularly banks, have been pro-
10 . Effects of Information Technology on Financial Services Systems

tected through a combination of insurance and

examination programs. However, new entrants into the financial service industry,

many of whom are subject to neither Federal

nor State regulation, now compete with regulated traditional financial service firms. Because the nature of competition in the financial service industry has changed, traditional

protections implemented through existing regulation have lost some of their effectiveness.

Regulations applicable to the financial service industry have been eased in recent years.

Controls on interest rates have been relaxed

and bank holding companies have become

freer to broaden the lines of services (e.g., data

processing) they offer.

As Congress continues to develop and refine

policy for the financial service industry, one

of the tools at its disposal is its ability to vary

the degree of regulation applicable to providers of various financial services. Alternatively, it may modify the outcomes of market forces to mitigate adverse affects on

specific groups. For example, if the market

were to compel individuals to have at least one

account with a financial service provider, Congress might choose to provide a means for ensuring that all are able to obtain a satisfactory

package of services.

Structural Issues

Consolidation in the Financial Service Industry

● What levels of concentration in the financial service industry are consistent with the

goal of preserving competition among providers of financial service?

There are 40,000 banks, savings and loan associations, and credit unions in the United

States. Thousands of other organizations including securities broker/dealers, consumer finance companies, merchants, and insurance

companies also provide financial service. A

goal of Federal financial services policy has

been to preserve competition and prevent concentration in that industry.

Technology-based financial service systems

are changing the nature of competition within

the industry. Financial institutions are entering new markets and competing both among

themselves, and with other industries, more

deliberately and directly than ever before. New

entrants are providing services in areas that,

in the past, have been reserved to traditional

financial service institutions. In the face of

technological change and competition, mergers involving both traditional financial service providers and new entrants have taken

place. It is possible that these changes will result in a net reduction in the number of providers and will reduce competition in the financial service industry. Some observers are

concerned that this could lead to excessive

concentration of economic power.

Congress may find that in light of other

trends affecting the financial service industry,

the trend toward greater consolidation in the

industry is acceptable. Alternatively, it may

use one of several available strategies to limit

consolidation. For example, specific criteria for

controlling entry to and exit from the industry could be established.

Restrictions on Interstate Banking

● What modifications, if any, could be instituted regarding restrictions on interstate

banking?

While Federal law limits interstate branching by institutions allowed to take deposits,

it does not prevent interstate activities by

these organizations. Banks have established

interstate networks of offices that market

services other than deposit-taking, such as

lending. Some financial institutions have used

technology-based delivery systems to circumvent these restrictions and some States have

passed laws that permit regional interstate

banking. Federal law now permits acquisition

of one financial institution by another in a different State under specified circumstances.

Unregulated competitors of depository institutions 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 retention of present policies with respect to interstate operations of financial service organizations, reducing or removing restrictions

completely, or making restrictions more inclusive than they are at present. For example, all

institutions that offer deposit-taking services

could be made subject to restrictions on interstate operations. Loopholes in existing law

and regulation could be closed. Restrictions

on interstate deposit-taking through automated teller networks could be relaxed.

Limitations on interstate banking stemmed,

in part, from concerns that some banks serving regional or national markets could achieve

an unwarranted degree of economic power and

that local needs for capital would remain unmet as funds were concentrated in major money centers. An alternative for addressing the

latter would be to strengthen requirements

that institutions taking deposits meet needs

for credit of the area from which deposits are

gathered before funds are made available to

regional or national markets.

Market Segmentation

● How might law and regulation be used to

focus the attention of various classes of financial service providers on specific market

areas?

The existing policy structure more or less

compartmentalizes the financial service industry by function. Banks may take deposits, insurance companies may underwrite insurance.

Insurance companies may not take deposits

and banks may not underwrite insurance.

Nevertheless, new entrants to financial service markets have been able to offer services

in direct competition with those for whom, in

the past, specific market segments had been

reserved. Operators of investment funds, for

example, offer services that share many features of deposit accounts offered by banks. In

some instances, the traditional providers have

been unable to respond fully to their new competitors because of the regulatory structure

within which they must operate.

Congress may choose to resolve this issue

by permitting banks and other institutions to

offer financial services that range over a broad

spectrum, enabling them to be more responsive to competitive offerings of others. Bank

powers could be broadened to include the

underwriting of securities and insurance, for

example. Alternatively, powers to affect mergers between financial service providers and

firms from outside the financial service industry could be modified. To an extent, this would

represent a continuation of current practice in

which the Federal Home Loan Bank Board has

permitted mergers across State lines between

savings and loan associations. Under the provisions of the Garn-St Germain Act of 1982,

banks have been permitted to acquire distressed, out-of-State savings and loan associations.

A third alternative would see the implementation of policy encouraging financial service

providers to engage in activities with clear social benefits. Examples would be incentives encouraging all providers of financial services

to finance home ownership and educational

programs.

Relationship to Telecommunication Policy

● How will further deregulation of telecommunications affect the financial service industry?

Financial service providers depend heavily

on telecommunications to deliver services to

their clients; and, therefore, they are sensitive

to changes in that industry. Many have built

and operate sophisticated private telecommunication networks. Without adequate telecommunication capabilities, the financial service

industry cannot meet the needs of its clients.

Changes in telecommunication costs have a direct and immediate effect on both providers

and users of financial service.

The telecommunications industry is undergoing fundamental changes that are altering

the nature of the services available to its customers and the prices that will be charged. As
12 . Effects of /formation Technology on Financial Services Systems

financial service delivery systems designed for

direct interaction with customers become

more commonplace, relationships between the

product mix, operating characteristics and

structure of the telecommunications industry,

and the operations of the financial service industry will become closer.

The formulation of telecommunication policy is extremely complex and beyond the scope

of this report. However, Congress should remain aware that telecommunication policy

directly influences the economics of financial

service delivery systems and, hence, the mix

of financial services that will be offered.

Competition Between Regulated and

Unregulated Service Providers

● What steps could be taken to realign the

legal/regulatory structure to make it conform more closely to the changing structure

of the financial service industry?

Many financial services offered by unregulated firms are comparable to those marketed

by regulated institutions. For example, money

market mutual funds marketed by securities

dealers have attributes in common with some

of the various checking accounts offered by

banks. Retailers of food and general merchandise are building networks of automated teller

machines and networks to communicate payment data in direct competition with those

built and operated by financial institutions.

While the user may not perceive any real difference between the offerings of various financial service providers, in some circumstances

the existing legal/regulatory structure does

not cover the activities of non-traditional providers. Users of these unregulated services

often do not receive the same protections provided with services offered by regulated institutions.

Congressional options for addressing this

question range over a broad spectrum. The

present dual system of regulation by both the

Federal Government and the States could be

continued. Alternatively, Congress could follow the model for the insurance industry and

defer to the States for all regulation of financial services. At the other extreme, Congress

could preempt all State regulation of the financial service industry. Regardless of the level

of the Federal presence, and in contrast with

the present practice of distributing responsibility, all Federal regulation of financial services could be combined and assigned to a single agency. The focus of regulation could be

shifted from the institutions providing service to the functions performed regardless of

the nature of the organization performing

them. For example, rather than regulating

banks as a means of controlling deposit-taking, regulate all organizations that perform the

deposit-taking function regardless of the other

lines of commerce in which they may have interests.

Barriers to International Operations

● The concerns of foreign governments regarding the protection of individual privacy

could lead to the erection of barriers for

American financial service firms doing business overseas. What steps could the United

States take to address these concerns or circumvent the barriers?

Foreign government implementation of personal privacy protection programs, some of

which are more stringent than those of the

United States, may restrict the international

operations of American financial service providers. Some nations have suggested that they

may limit the movement of personal data

across their borders to and from others that

do not meet their standards for privacy protection. The United States may find the operations of its financial service industry limited

by privacy policies of foreign governments.

Congress, in considering this issue, may

choose to continue the present course and to

not expand the privacy protections now in

place. Alternatively, it may adjust privacy law

as it relates to financial services as a means

of reducing potential barriers to American financial service providers other nations may

raise.
Ch. l—Overview ● 1 3

—

Access to the Clearing Systems

● What organizations could be granted access

to the mechanisms for clearing checks, securities, and other payment instruments

such as credit card drafts?

Banks and savings and loan associations are

the only institutions with direct access to the

payments system. This may give them a competitive advantage over other offerors of

checking account substitutes, credit cards,

and debit cards. Some securities brokers offer accounts from which funds may be drawn

by either a paper draft or debit card and other

organizations, such as the American Automobile Association which offers VISA, issue bank

credit cards. However, offerors of payment instruments that are neither banks nor savings

and loan associations, almost without exception, must obtain payment-processing services

from an institution that has access to the payments mechanism.

In light of the technologies now available,

some argue that other types of institutions

should also be granted access to the payments

mechanism. One major merchant is now permitted to enter transactions into one of the

bank card networks without using the services of a financial institution. Conceivably, the

future could see the development and operation of significant systems for transferring

funds without the involvement of banks and

other traditional providers of payment

services.

The Federal Reserve System was established, in part, to assure smooth operation of

the check-processing system. Congress may

decide that the operability of the payment system can only be assured if it remains under

control of the banks and savings and loan associations. On the other hand, Congress may

choose to open access to the payment system

to others, such as data processing service organizations, willing to meet specific criteria.

Or, it may open the system to all who would

join without establishing specific criteria for

membership.

Risk Allocation Issues

Control of Interest Rates

● What alternatives for regulating interest

rates are available to Congress?

Federal controls on the interest rates paid

by federally insured institutions are being

phased out. States impose limits on the interest rates that may be charged on some types

of loans. In recent years, when market rates

have exceeded both Federal and State limits,

significant quantities of funds have moved

from banks, credit unions, and savings and

loan associations to alternative investment opportunities created by new entrants to the financial service industry. These new entrants

have relied heavily on advanced telecommunication and information processing technologies to implement their offerings. Constrained interest rates effectively limited the

supply of funds to some classes of investments.

In many cases, policymakers have reacted to

these movements by changing the legal limits

on interest rates paid and charged.

Congress may choose to ensure total decontrol of interest rates by preempting State

usury laws. Alternatively, the same mechanism could be used to establish uniform, regulated interest rates nationwide. Other alternatives include maintaining controls on

interest rates paid on federally insured accounts and ceding to the States control of all

interest rates paid within their boundaries.

Allocation of Risk

● What are the alternatives for apportioning

risk between financial institutions and their

customers and clients?

Deposit insurance protects holders of accounts in covered institutions from loss of

assets up to the limits of the insurance. Although some noninsured accounts share many

of the attributes of insured accounts, because

the account holder is not protected from loss

of principal, they often carry a higher level of
14 . Effects of Information Technology on Financial Services Systems

risk for account holders. However, because

Federal agencies that insure deposits have pre

ferred to find merger partners for distressed

institutions instead of closing them, deposit

insurance has implicitly provided protection

for stockholders and holders of large deposits as well as the owners of accounts with

balances below the limits of insurance coverage. Some argue that managers of financial institutions take unjustified risks because they

feel they are implicitly protected by deposit

insurance. It has also been suggested that

depositors and others with whom an institution deals do not review the condition of the

institutions with which they conduct business

as carefully as they might because of the presence of deposit insurance.

Deposit insurance has been key in the policy framework designed to sustain the safety

and soundness of the financial service industry. Congress may choose to continue it in its

present form where the same insurance rates

apply to all covered institutions. Alternatively, the premiums charged insured institutions could be modified to reflect the level of

risk the insurance program is required to

underwrite. Further, deposit insurance could

be extended to accounts not now covered.

Lifeline Financial Services

● What is necessary to assure an adequate

level of financial service to all segments of

the population and to protect other basic

consumer rights and interests?

Individuals who so choose have been able

to avoid dealings with providers of financial

services. However, the ability of consumers to

avoid dealings with the financial service industry is being limited by such factors as pressure from employers and government to accept payments by direct deposit and the

increasing role of the credit card as an item

of identification. In the future, it is likely that

access to some minimal set of financial services will be essential for all citizens.

Congress, in approaching this issue, may

find it necessary to define a minimal set of financial services needed by virtually the entire

populace. It may then wish to specify alternative institutional structures that could be

used to deliver such a package of services including the possibility that all providers of

transaction accounts be required to offer the

“lifeline” package. Congress may wish to define the rights of consumers to payment services and the information regarding them that

needs be provided to users. Consideration of

a policy that would govern the timing of debits

and credits to an account to ensure equitable

treatment of consumers may be advisable.

Privacy

● Some changes in the delivery of financial

services increase the possibility that the privacy of citizens could be eroded or violated.

How can Congress reduce that possibility?

Systems that use information processing

and telecommunication technologies for delivering financial services gather data more rapidly and make it more accessible than do

paper-based systems. Information on the financial activity of individuals can be accumulated and used without their knowledge

or consent. Existing law provides some protection from intrusion on financial data by the

Federal Government, but virtually no protection from the use of this information by State

and local governments or private parties and

organizations. Increasing use of electronic systems for delivering financial services exacerbates potential threats to individual privacy.

One alternative open to Congress is to explicitly define the rights of citizens to privacy.

Because users of financial services must, by

the nature of the systems used to deliver them,

surrender privacy to a degree, Congress may

choose to require they be provided a statement

disclosing the degree to which privacy is likely

to be compromised. A program of monitoring

and enforcing rights to privacy might be established.
Ch. 1—Overview ● 7 5 —

Security and Integrity of Delivery Systems

● Are additional actions needed to safeguard

the integrity of national payment and transaction systems against risk of disruptions

from systems failure, hostile attack, and

natural disasters?

System security and integrity have always

been of paramount concern to the financial

service industry. Both paper-based and electronic systems for delivering financial services

are vulnerable to attack from the outside and

to systemic failure. While electronic systems

overcome some of the vulnerabilities inherent

in paper-based systems, new problems are introduced. Continued operability of many major computer-based systems can only be

assured through the availability of redundant

automated systems. In these cases, some system failures can threaten the existence of a financial institution since manual processing is

not possible in the event that a primary automated system fails. For example, if a bank is

unable to perform routine transaction processing because of a system failure, it may not be

able to settle its accounts with other institutions on time and, as a result, may fail.

Although recognition of the problems of system security and integrity is becoming more

widespread, its true magnitude is not known.

Additional information is needed before reasonable public policy alternatives can be identified. Therefore, Congress may wish to either

hold hearings or establish a national commission to assemble additional information prior

to undertaking a specific legislative program.

Possibly the Federal Emergency Management

Agency could help meet this need for information.

Vulnerability of Financial Service Systems

to Theft

• What alternatives are available for controlling the risk of theft from or associated with

financial service institutions?

Theft of assets is a constant threat for financial service providers and their clients.

New combinations of telecommunication and

computer processing for delivering financial

services provide new avenues for theft. As

safeguards are put in place, new methods of

perpetrating crime against financial service

systems are found. Some of them, theft of data

under some circumstances for example, are not

clearly covered by existing law. Some financial

service providers are hesitant to report incidents of theft involving technology-based systems in fear both of lessening the confidence

of their customers and of revealing system vulnerabilities to potential predators.

In dealing with this issue, Congress may

continue to rely on existing law and law enforcement capabilities. Because the issue is not

well understood, Congress may wish to gather

additional information regarding the problem

and alternative solutions either before acting

or following initial steps to deal with the most

salient aspects of the issue. In the short term,

it may modify the law to more clearly deal

with the obvious problems (e.g., clarifying the

treatment of those who steal data) that have

accompanied the inclusion of advanced technologies in systems for delivering financial

services. Additional resources and technological capabilities could be made available to law

enforcement authorities. Penalties against

both the perpetrators of crime and those that

conceal it could be increased.
Chapter 2

Present and Future

Technologies Supporting the

Financial Service Industry
Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Computer Hardware Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Microcomputer Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Large Computer Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Future Computer Hardware . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Software . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Present Applications Software . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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

Telecommunications Technologies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

The Switched Telephone Network . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Private-Line Telecommunications Facilities . . . . . . . . . . . . . . . . . . . . . . . . .

Alternatives to Switched Networks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Video-Related Communication Technologies . . . . . . . . . . . . . . . . . . . . . . . .

Future Telecommunication Technologies . . . . . . . . . . . . . . . . . . . . . . . . . . .

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

System Security. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

System Integrity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Specific Technologies for Delivering Financial Services . . . . . . . . . . . . . . . . .

Card Technologies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Document and Currency Readers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Customer Service Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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

Appendix 2A: Hardware Components . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Chip Technology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Computer Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Appendix 2B: Systems and Support Software . . . . . . . . . . . . . . . . . . . . . . , .

Present Operating and Support Systems . . . . . . . . . . . . . . . . . . . . . . . . . .

The Future for Operating and Support Systems. . . . . . . . . . . . . . . . . . . . .

Table

19

20

20

22

23

25

26

28

30

30

32

32

33

34

36

36

38

38

38

41

42

43

44

44

44

45

45

46

Table No. Page

l. General-Purpose Application Processors . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Chapter 2

Present and Future Technologies

Supporting the Financial Service Industry

Introduction

Quite simply, the financial service industry

could not provide the level of service it does

without the support of advanced information

processing and telecommunication technologies. The numbers of checks (over 37 billion

annually), credit card drafts (over 3.5 billion

annually), and securities trades (over 30 billion shares traded annually) would swamp any

manual system that tried to handle them. In

fact, during the 1960’s, trading days for the

New York Stock Exchange were shortened because the broker/dealers were unable to handle the workload.

Yet, even with all of its sophistication in the

application of technology, the financial service industry has not yet exhausted the potential of the technologies now available. Even

though large computers support check reader/

sorters handling thousands of items a minute,

all other aspects of check processing are manual, and telecommunications is not used in the

check-processing cycle. Checks are still manually encoded with the amount by proof operators at the bank of first deposit or, in return

for a reduced processing fee, at the retailer

location. Return item processing remains a

manual operation. Similarly, credit card drafts

are manually encoded before processing, and

the securities industry still processes millions

of stock certificates manually.

As the economics of the technologies continue to improve, market pressures to apply

them more extensively increase. They help and

encourage further migration from paper- and

labor-intensive implementations to electronic,

self-service, and remote-based banking.

Operational considerations limit more widespread realization of the potential of the technologies. For example, only in recent years has

the annual rate of growth in the number of

checks slowed, from about 7 percent to about

5 percent. The fact that many are unwilling

to forgo return of the physical check to retain

as proof of payment limits the possibility of

implementing meaningful check truncation

programs. Similarly, many still take delivery

of physical stock certificates, even though

book-entry systems for recording the stock

ownership provide an alternative.

In the future, the costs of hardware used to

implement advanced systems for delivering financial services will continue their long-term

decline. New technologies such as the processor in a card and new systems to establish

the authenticity of the order to execute a financial transaction will become available. In

general, the ability of the financial service industry to take advantage of the technology is

not likely to approach the rate at which it

becomes available. There is little chance that

technology will limit the industry any time in

the foreseeable future.

Historically, the initial applications of technology “automated’ existing processes. For

example, the application of computers to account maintenance simply translated existing

manual processes into automated ones. The

adoption of MICR* encoding on checks has

done little to change the way checks are used.

Thus, early application of automation in the

financial service industry had little, if any, direct effect on the users of financial services.

On the other hand, systems now being deployed are changing the fundamental character of the financial services consumed by users.

Automated teller machine (ATM) networks,

*MICR—magnetic ink character recognition.

19
20 ● Effects of Information Technology on Financial Services Systems

for example, enable users to obtain cash at

locations that cannot be served directly by the

financial institution holding the account.

Moreover, funds are accessible around the

clock.

Technologies waiting in the wings have the

potential for changing the basic character of

the systems used to deliver financial services

and, as a result, the structure of the financial

service industry. Remote banking via such diverse technologies as teletex, home computers,

and multifunction transaction work stations

installed in the offices of financial institutions

could be implemented with technologies now

available.

The so-called smart card, lingering just over

the horizon, has the potential for changing the

basic character of currency from paper to electronic. Market viability remains to be demonstrated and sufficient developmental capital

allocated. In addition, an infrastructure of terminals capable of supporting the smart card,

either supplementing or replacing the existing

infrastructure for handling magnetic stripe

technology, must be put in place before this

technology can become a significant factor.

In order to understand present and future

trends in the financial service industry, it is

essential to have a grasp of present and emerging information processing and telecommunication technologies and of their relationship

to present and future products and services.

This chapter describes the basic technologies

that are and could be applied for delivering financial services. The purpose is to create an

appreciation for the potential and the limitations of the technologies for facilitating change

in the financial service industry. Yet, one must

understand that the technologies constitute

but one of a number of forces operating to

shape the financial service industry and that

their potential may not be realizable because

of other constraints that are operating.

Computer Hardware Systems

The providers of financial services have been

among the leading users of medium- to largescale processors, and only the very largest

scientific computers have not yet been widely

applied for the delivery of financial services.

These large computer systems generally require dedicated facilities and support from an

onsite team of information processing professionals. For all practical purposes, providers

of financial services can buy computing power

appropriate to their needs from a number of

well-established manufacturers. Further, because of the way computer manufacturers

design and enhance their product lines, organizations are able to have reasonable expectations that they will be able to make the transition, as needed, to machines of greater

capacity with a minimum of operational disruption. However, even with the decreases

that have occurred in the costs of medium- to

large-scale computer systems, they are still

priced beyond the means of many of the

smaller financial service organizations that

could benefit from having access to them.

Microcomputer Systems

Changes in the technology of computer processors at the low end of the capacity spectrum

(i.e., those with the most limited capacity) are

having the greatest impact on the operations

of the financial service industry. Both users

and providers are using them heavily. Microcomputers range in price from less than $100

to almost $10,000 (for some of the more elaborate systems now on the market). However,

a $100 unit has only limited capacity to participate in a financial service system because

it has neither communication nor significant

data storage capacity. Additional capabilities

must be added if the user wants to use the various financial application packages being marketed 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 that

consists of the equivalent of several thousand transistors

budgeting and accounting systems, checkbook

balancing programs, securities price trend

analysis, portfolio analysis, and income tax

preparation.

A cassette recorder costing about $50 would

permit the user to load prerecorded programs

and save intermediate results so that they

would not have to be reentered into the computer manually every time they are to be used.

A disc drive offering faster and more reliable

access to data and programs can be purchased

for some units for about $250. A printer that

can be used to make paper records for users

would cost another $250. Applications the

user may wish to run may require the addition of memory expansion modules that cost

more than the original $100 price of the computer. The user will, in some cases, have to

spend $200 or more on an accessory required

for making the connections between the peripherals and the computer. Yet even with all

these additions, the user would still have a system limited to local use and applicable principally only to recordkeeping and analysis of

data entered into the computer by the user.

To take advantage of home banking and

stock market transaction services, information

utilities, and home shopping services that entail interaction of a personal computer with

a computer operated by the financial service

provider a personal computer must be

equipped with suitable data communication

equipment. These include a feature that does

the processing required to establish and main-
22 ● Effects of Information Technology on Financial Services Systems

tain a telecommunication connection (RS-232

interface) and a unit (modem) connected to the

telephone line for converting digital pulses

used internally by the computer to analog

signals that can be transmitted over the conventional telephone lines of a switched telephone network. In addition, programs to support the communication function or to handle

the financial application would have to be procured, at a cost ranging from under $100 to

$250 or more, depending on the complexity of

the application. Although a disc drive and expansion interface might be required for such

a function, a printer would most likely be a

discretionary purchase.

Thus, while computers can be acquired for

$100 or less, the person who would like to use

them either to receive financial services and/or

to perform financial analysis is more realistically looking at an investment that is closer

to $700 or $800. However, this situation is not

likely to persist in the long run. The prices of

all computing equipment are falling. Some

vendors are selling modems for under $100,

and the price of disc drives continues to fall.

Computer modules that work with widely distributed video games are on the market, and

they are expected to offer the user significant

improvement in the performance-to-cost ratio

for equipment that could be used in conjunction with various future financial service offerings. In addition, small, battery-powered,

portable computers that can be carried in a

briefcase and have a built-in modem and RS232 interface are now available for under

$1,000, a price that will undoubtedly be lower

in the future. Therefore, computers that can

be used by individuals to receive financial services both at home and work are likely to be well

within reach of a large portion of the population within the 1988 to 1993 time frame.

Another alternative would be development

of very inexpensive specialized devices oriented to users of financial services. These

could use cartridges similar to those used with

television game machines, very simple control

mechanisms, and a television to display the

data. Some providers may even develop applications that use a TV game machine as the key

processing element. In this environment, users

may actually have several terminal devices to

interact with financial service systems, each

of which is dedicated to the offerings of a particular provider. Simple, inexpensive, dedicated devices may find extensive application

in point-of-sale (POS) systems as well as those

designed to deliver services to consumers. The

availability of terminals for users at little or

no cost could be a strong impetus to increasing significantly the rate of adoption of advanced systems for delivering financial

services.

People have demonstrated repeatedly that

they will spend substantial sums if they perceive utility in a product. Historically, this has

been true with television; more recently, with

video recorders. However, it remains to be

seen whether a large number of individuals will

be willing to invest in information processing

and telecommunication equipment capable of

interacting with systems for delivering financial services to the home. Success of financial

service offerings may depend on minimizing

the investment of potential customers and,

perhaps, what other services may be available

through the same systems.

Large Computer Systems

While there will be significant changes in the

capabilities of computers at the low end of the

spectrum that will enable a larger number of

people to access the technology, changes at the

high end of the scale will also occur. Speeds

of computation and the basic architecture of

computers will change so that there will be a

marked increase in the performance-to-cost

ratios over those now available. The raw computer power for applications such as image

and voice processing will become available.

Both applications have potential for the financial service industry. Voice recognition applications could be used as an alternative to

key input particularly in telephone-oriented

systems in which the user would use voice to

issue payment and other directives to financial service systems. Applications of image

processing systems, some of which are now be-
Ch. 2—Present and Future Technologies Supporting the Financial Service Industry ● 23 —.. . —-- — .———..—— - ——.

ing tested, could range from processing fingerprints for identifying the user of a remote service device to reading information on checks as

part of check processing. As the cost of equipment continues to fall, more providers of financial services will find the equipment affordable. In addition, customers will become better

equipped to take advantage of the various

services offered (see table 1).

Future Computer Hardware

During the coming 10 years, changes in computer hardware that are generally invisible but

beneficial to users will occur. Functions such

Table 1 .—General-Purpose Application Processors

1982 1987 1992

Small:

Cost (dollars in thousands) . . . . 12 8 5

Storage (megabytes) . . . . . . . . . . 0.5 1 2

Speed (millions of instructions

per minute) . . . . . . . . . . ... . 0.05 0.1 0.4

Medium:

Cost . . . . . . . . . . . . . . . . . . . . 100 60 40

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

Speed . . . . . . . . . . . . . . . . . . . . 0.2 1.0 4

Large:

cost . . . . . . . . . . . . . . . . . . . . .. ..1,400 600 400

Storage. . . . . . . . . . . . . . . . . . . . . . 8 16 48

Speed . . . . . . . . . . . . . . . . . . . . . . . 4 8 24

SOURCE Arthur D Little, Inc “Application of Technology for Providing Financial

Services, ” April 1983

as those needed for system control and the

processing of some programing languages now

implemented in software will be moved to the

hardware. Special-purpose machines featuring

applications built into hardware will be assembled from a variety of general-purpose

building blocks at minimal cost to meet the

needs of specific applications. As a result, not

only will the computers used to deliver financial services be less expensive, they will also

be more reliable.

From the users’ point of view, this will reduce the complexity of computer systems,

while at the same time enabling him to select

a computer that is more or less tailored to the

applications it must support. For example,

suites of special-purpose machines in facilities

operated by financial institutions, mixed to

meet the needs of the customers using them,

will be possible. Some devices could be used

only for balance inquiry and the kinds of transactions now performed through an ATM.

Others could be used to submit loan applications and/or initiate securities transactions. A

single cash dispenser/deposit acceptor* could

serve multiple user stations, thus keeping

overall system costs down. Financial institutions may find it in their interest to provide

customers with terminal devices specifically

oriented to the package of products and services being provided, thus overcoming any

hesitancy to acquire and use general-purpose

computer hardware that requires some specific

knowledge of the technologies.

Computer architecture will be increasingly

modular, with functions divided between and

among various system components. On the

one hand, this will make it possible for users

to configure systems to meet their specific requirements, while on the other, it will tend to

increase system reliability and integrity. If one

component fails, the probability that system

operation will continue at some degraded level

of performance is high. Providers and users

of systems for delivering financial services will

benefit from an increase in the availability of

*A d~PoS~acceptor would have the capability to count cash

and read the amounts of checks as they are deposited.

35-505 0 - 84 - 3 : QL 3
24 ● Effects of /formation Technology on Financial Services Systems

fault-tolerant systems to support online applications. The mean time between failure for

such systems is measured in years, since they

are designed to continue operating without

degradation in performance in all but the most

catastrophic circumstances.

Alternatives to keyboard entry will increase

the flexibility and attractiveness to users of

self-service financial systems that are accessible from remote locations. For example, the

user will be able to communicate instructions

to a computer by touching one of a few control buttons or an image on a screen. Already,

touch screens are available on devices that

range from wristwatches to computers, and

greater application of these in the future can

be expected. Limited voice input capabilities

will be available, but continuous speech language processing will not be possible before

the turn of the century, if then. Optical character recognition technologies will continue to

become more cost effective, and there will be

some capabilities to process handwritten input. Systems that use the signature to identify the user rather than a personal identification number coupled with a machine readable

card could come into use by the middle of the

coming decade. On net balance, these alternatives will reduce the use of multiple keystrokes

needed to respond to requests for information,

and hence will reduce barriers to use and increase efficiency of the new systems for delivering financial services.

Greater use will be made of color and graphics in computer output. The ability to transmit

pictures easily will mean that the user will

have less need to read. Video disc technology

could be coupled with computers, especially

in such applications as home shopping and

others that require catalog-type data. Video

“catalogs” could show the shopper multiple

views of an item and could be updated frequently to show newly arrived merchandise

and to reflect price changes. Voice synthesizers have become very affordable, and they

will be used both to support graphics displays

and to provide computer output through the

standard voice telephone. Displays will become more compact and will blend more completely into the background than is now the

case, thus making them more acceptable in

both the home and office. The telephone will

become a multipurpose instrument capable of

receiving alphanumeric as well as graphic

data, in addition to its conventional use for

voice transmission. Such devices are already

on the market for applications in the business

environment.

The key to the future will be ease of use. As

new terminals become available and are capable of presenting and transmitting information

in a multiplicity of formats, user anxiety relating to the technology used to interact with

systems for delivering financial services

should approach the level now experienced

with the telephone or the handheld calculator.

Future providers and users of financial services will have the choice of using networks of

small processors or the minicomputers and

mainframes that will soon become affordable

for them. To some extent, they, like everyone

else who acquires information-processing capabilities, will be able to choose the equipment

that best meets their requirements for processing and their philosophies of product design

and management. Factors such as system

security, reliability, and integrity will be taken

into account. Other factors will be the availability of appropriate software packages and

the costs of telecommunication services.

In some specialized applications, however,

the large computer system will continue to

dominate. For example, significant computer

power is required to support the check reader/

sorters used widely throughout the financial

service community. While electronic banking

will lessen the growth in check volumes, they

will remain high. Therefore, requirements for

supporting check-processing equipment will

continue into the foreseeable future. New applications implementing processing of voice

and/or handwriting will also require the power

of mainframe computer systems. In addition,

microcomputers may not be capable of man-

@g future telecommunication functions that

will become even more significant to the financial service industry.
Ch. 2—Present and Future Technologies Supporting the Financial Service Industry ● 2 5

Online POS systems will consume substantial processing and communication resources.

Interchange networks that serve ATM systems are designed to handle 4 to 10 transactions per second and provide a response time

that ranges from 30 to 90 seconds. Paul

Hefner of First Interstate Bancorp of California, points out that POS networks will have

to handle hundreds of transactions per second

and provide a response on the order of 6

seconds. Thus, the processing capacity required to support these networks may begin

to approach the limits of the technology, if

they begin to handle the transaction volumes

foreseen by some.

Already, both users and providers of financial services have put in place a considerable

portion of the hardware infrastructure that

will be key to delivering financial services.

Banks and other financial service providers

have been long-time users of computers, as

have the major dry goods retailers. However,

an increasing number of small stores are installing electronic cash registers and computers from which they will be able to build

in the future. Some grocery chains have made

heavy use of computers to automate the checkout process and inventory systems for individual stores. Major firms regularly use

automated systems to generate payrolls and

pay suppliers. Smaller firms are increasingly

turning to data service bureaus or installing

small computers to obtain comparable services. Also, considerable numbers of consumers

are acquiring computers that could be configured to perform the processing required to

interact with financial service delivery

systems.

One of the factors that has limited the degree to which advanced systems for delivering financial services have been accepted has

been the lack of processing capabilities in the

hands of many potential users and suppliers.

The fact that many potential participants in

the financial service industry are installing

computers for a variety of reasons is creating

a latent capability for either using or delivering financial products because the marginal

cost of such a move could be minimal.

The long-term impact of changes in the capabilities of computers on the users and providers of financial services is not so much that

the raw computational capability of the equipment will increase. Rather, an increasing number of individuals and organizations are buying equipment because its cost is dropping.

The result is a decreasing marginal cost of entry for potential users and providers of advanced financial services systems. Higher potential levels of participation will encourage

the deployment of advanced systems and, in

the absence of other barriers to their acceptance, will result in their achieving a greater

level of economic viability than would be possible with the present level of equipage.

Generally, the financial service industry has

not demanded access to the largest computers

to handle its applications. Advances in computer technology will most likely continue to

outpace the demands of the financial service

industry, and therefore, lack of sufficient computer power will not be one of the factors that

will limit the development of new systems for

delivering financial services.

Software

A computer is useless without software: the ing a program to be operational, and an ongoprograms that instruct a computer to perform ing program of maintenance to ensure that the

operations. The development of software software remains responsive to user needs and

depends on the careful and precise definition to remove errors that are almost invariably

of requirements by those for whom a system identified after a program is declared operais being built, thorough testing before declar- tional. All of these operations are labor-
26 ● Effects of Information Technology on Financial Services Systems

intensive, and therefore very expensive. The

cost of software is determined by its complexity rather than the size of the machine on

which it is to operate or the volumes of data

that are to be processed. Generally, however,

larger machines are needed to use the more

complex software packages that support the

larger data bases.

Although the cost of computer hardware

will continue to decrease, the cost of computer

software may not, or may not decrease as

much. Software development remains a laborintensive activity and is likely to remain so

into the 1988 to 1993 time frame. However,

more widespread use of software packages will

lower costs for individual users.

Until now, resources for software development have fallen short of demand. The advent

of new tools for software development, however, should increase the productivity of software professionals somewhat. Furthermore, a

greater tendency to purchase and modify application packages to meet specific needs as

a substitute for the development of application packages by each end-user organization

will reduce the apparent shortfall of software

development resources in the future.

There are three basic classes of software—

systems software, support software, and applications software. Systems software controls

the minute-to-minute operations of the computer by allocating resources and scheduling

tasks. Support software is typically used for

such functions as controlling a communications network, monitoring transaction processing, managing the data base environment,

or furnishing tools intended to improve the

productivity of programmers and, in some cases,

end-users. Applications software directly interfaces with the end-user and is designed to

carry out functions unique to the particular

situation.

Systems and support software, including

data base management systems, are discussed

in appendix 2B to this chapter. Applications

software and its use for delivering financial

services is described in the sections that

follow.

Present Applications Software

The acquisition of applications software has

always been the responsibility of the user organization. Today the computer user has three

options for acquiring software. First, the user

can retain either in-house staff or a consultant/contractor to build application packages

uniquely tailored to his needs. Because program development remains labor-intensive,

this can be a costly process, a significant portion of which is the cost incurred-after the

system becomes operational-for maintaining

the programs, correcting errors as they are discovered, and making changes as the needs of

the organization evolve. For operators of large

scale computer systems, such as those used

by many providers of financial services, this

has been the only option considered. Large

staffs of highly trained professionals have

been assembled and supported to handle the

tasks of system development and maintenance. Experienced organizations have found

that over 70 percent of the resources spent on

these staffs is for maintaining existing systems, leaving only 30 percent for developing

new applications programs.

Financial service organizations have developed a huge body of proprietary software over

the years. Included are applications that range

from internal accounting systems to those

that support home banking products. When

a new product such as a money market mutual

fund is offered, its introduction must often be

preceded by a significant software development effort. Regulatory changes such as the

imposition of Regulation E* can also result in

major software development efforts or the

need to make significant changes to existing

software systems.

However, just as the advent of small computers has brought the power of the technology within reach for the individual user, it has

also had an impact on the costs of system development and maintenance. Consumers now

identify applications in which the small com-

*Re~lation E is the Federal Reserve Board Regulation implementing the consumer protection provisions of the EFT Act

of 1978.
Ch. 2—Present and Future Technologies Supporting the Financial Service Industry ● 2 7

puter can provide significant benefit and either

write the programs themselves or with help

at minimal cost. Generally, the small packages

for personal computers which result are used

for analytical applications that are often tailored to the specific working habits of the individuals using them. To some extent, the personal computer has replaced the worksheet

and personal file system that have always

been the tools of the professional analyst and

decisionmaker. This software is not suitable

for account maintenance and other administrative tasks that require the manipulation of

large data bases and the processing of a large

number of transactions. On the other hand, a

portion of these applications depend on being

able to access the major corporate data bases

that are maintained by the large, central computer facility.

In one example, a microcomputer is used to

help farmers generate the information required

to support applications for loans. Another application using a voice response unit and input from a 12-key telephone has been developed by a financial analyst to process market

data and generate information used for portfolio management. Automated spread-sheet

programs running on microcomputers have

also become popular tools among users and

providers of financial services. Users have

found that for some purposes the information

generated by a microcomputer running all

night can be just as satisfactory as the same

data produced in a few minutes on a large, centralized computer. Further, the user of the

microcomputer may be able to avoid hassles

often encountered when a data processing department is asked to implement an application.

Over the years, the usefulness of applications packages has been recognized across an

industry, and significant numbers of packages

are now developed and offered for sale or lease

to a variety of users. In some cases, the

packages were developed by organizations for

their own use and later offered to others. In

other cases, the package was developed to be

marketed commercially. In this environment,

all benefit because the costs of development

and maintenance are potentially spread over

multiple users.

Systems for processing checks and servicing deposit accounts and outstanding loans

have been developed by both financial institutions and data-processing service organizations and are widely used throughout the industry. Organizations that have developed the

software for home banking applications are actively marketing it to providers.

Thus, as a second option, the user can acquire an application package that comes as

close as possible to meeting his needs and then

either modify it with internal resources or retain the original developer or another party to

make the required changes. This approach has

the disadvantage for both the vendor and the

user that multiple versions of a basic package

must be supported. Costs and difficulty of

maintenance are both increased as, almost invariably, the modifications made periodically

to the basic package and the changes made to

meet specific user needs generate conflicts

that require basic changes in the software to

resolve. Some marketers of software systems

mitigate this problem by including features

that permit the user to customize the package

at specific points in the processing cycle without actually modifying the basic program.

The third option for the user is to acquire

and use an application package as is. This option is more often used by users with small

computers than with large. However, operators of large installations are turning with increasing frequency to generalized software

packages. Prepackaged software for microcomputers has enabled significant numbers of

users in the financial service industry to apply

information processing and telecommunication resources to the operation of their businesses without needing to become proficient

technically in the operation and use of the

technology.

To use these various packages, the user need

not purchase or lease the computers on which

the applications run. Time on systems operated by others can be purchased, an option

that has enabled many smaller providers of fi-
28 ● Effects of /formation Technology on Financial Services Systems

nancial services to take advantage of available

technologies. In many cases, banks and service bureaus that develop application packages

also sell the machine time required to run

them. In others, those with excess processing

resources available sell them. For example, the

largest processors of bank card transactions

are service organizations, not banks. Check

processing and account maintenance is often

performed by other than the institution offering the service.

Conventionally, the medium for distributing

software is either floppy disc or magnetic tape.

Telecommunication links between computers

are also used for transferring software. This

technique is used to distribute programs for

large computer systems and for providing programs stored on large central computers to

small peripheral ones in distributed processing environments.

Experience has shown that safeguards

against copying or modifying software can

easily be circumvented by individuals who

have a moderate degree of technical sophistication. This presents a problem to operators

of systems for delivering financial services

electronically to a large number of people. If

the software used to access a service from the

customer’s premises can be altered, a compromise of system integrity or security could result, causing damages for both the system

operator and other users.

One way to avoid this problem is to distribute software in cartridge form, in the form of

hardware, a technique that is being tried by

at least one marketer of home banking services. Although this minimizes the chances of

modifying the software, users whose computers do not accept cartridges are eliminated

from the market. Moreover, it does nothing to

stop the potential intruder who obtains the

functional specifications of the cartridge or is

able to copy the program from the cartridge

to another medium. In these cases, the intruder could modify the program to perform unauthorized functions, just as it is possible to

modify software distributed using other, more

conventional media. On the other hand, a major computer manufacturer has announced a

microcomputer that accepts program cartridges; this is likely to provide the impetus

needed to make this medium of software distribution more widely accepted for financial

services.

Applications Software in the Future

The evolution of applications software in the

future is likely to be relatively slow because

of the huge base of operational programs, representing an investment of billions of dollars,

that is now installed.’ Language development

will be constrained because in many areas new

languages will have to be compatible with

those used to implement the installed base.

Even though there is considerable inertia in

the form of installed application systems, application programs will continue to evolve. In

the near term, the emphasis will be on modifying batch applications* to operate interactively where it is reasonable to do so. Specific

attention is being given to providing the most

up-to-date information possible to both users

and providers of services in order to improve

overall management of financial resources.

Even where batch processing is most desirable, transaction data will be entered interactively and accumulated until a batch processing program designed to handle the accumulated data is run. Eventually, however, interactive processing will dominate and up-to-theminute data will be available to all who need it.

Most programs today have been developed

to meet the needs of classes of individuals on

the assumption that the requirements of members of a group for computer support are approximately the same. This assumption holds

for people engaged in routine activities, but

it tends to break down at the upper levels of

organizations. In the future, generalized sysIThe material in this section draws heavily on the report,

“Future Information Processing Technology -1983° prepared

for the Institute of Computer Science and Technology and the

Defense Intelligence Agency. *Batch applications me those when data are assembled over

a period of time and are processed periodically, frequently on

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

terns and capabilities will be more easily tailored to the specific needs of individuals. Users

will be provided the facility to set application

parameters to meet their individual needs. Obvious examples that already exist are the ability to request the detail to be used in prompting the computer user online and the format

to be used for displaying data. The user unfamiliar with an application can be led through

it step by step, while those who have mastered

the operations required can be freed of the burden of detailed instructions.

Applications will be self-teaching to a great

degree. Many, as already illustrated by the

systems that support ATMs, will be menudriven; users will not be required to learn and

use commands. Today, a growing number include tutorial features; but in the future the

user will have greater facility in selecting the

specific points where instruction is needed and

w-ill be able to obtain help without interrupting

the ongoing flow of processing. Audio-visual

display technology, heavily dependent on video discs, may figure greatly in implementing

this capability.

Users will have a larger variety of options

in selecting the format in which data is presented. Color graphics will come into more

widespread use and users will have greater

capabilities to manipulate graphic images in

addition to already existing facilities for manipulating and analyzing combinations of numeric and alphabetic data. For example, the

capability of manipulating a trend line for one

variable and seeing its effects on other trends

will be possible. Mice, * light-pens, and voice

input/output will greatly facilitate interaction

between the user and information system.

*A mou9e i9 a small device attached to a computer that is

used instead of keys to control the movement of the cursor, the

indicator on a video display that indicates where the next character will be formed.

“Windowing” technologies that permit the

user to display the results of multiple processes simultaneously on the screen will improve the utility of the technology to the users.

They will allow the users to concurrently view

data from multiple sources and select those

items most useful to the task at hand. For example, the user may use one window to review

the status of a transaction account, a second

to project cash flow, and a third to enter an

order with a broker/dealer to buy or sell a security using a telecommunication line that connects directly to the broker/dealer’s computer.

More of the processing capability will be resident at the user site and will therefore be

much more of a personal tool. Large systems

may be limited to being repositories of data

to which the user is provided access on a “need

to know” basis. At the start of a problemsolving session, a microcomputer will be used

to access a data base on a large computer system, retrieve the data needed to address the

problem, and store it locally on a small disc.

Applications running on the microcomputer

will perform the required analysis, and after

this has been completed, the central data base

will be modified as required. In fact, in some

organizations, this mode of problem-solving

is already quite commonplace.

Knowledge-based systems, one of the areas

in the general field of research known as artificial intelligence, will become more generally

available. For the financial service industry,

this could mean that financial advisors and

counselors will be augmented, or possibly replaced, by automated systems. Research in

artificial intelligence and expert systems has

shown some valuable results. However, there

is considerable uncertainty about when such

systems will be sophisticated enough to have

an operational impact on the financial service

industry.
30 ● Effects of Information Technology on Financial Services Systems

Telecommunications Technologies

Telecommunication technology provides an

indispensable lifeline to users and providers

of financial services. Of the number of alternative telecommunication technologies from

which suppliers and users of financial services

are able to choose, the most common is the

switched telephone network. But, both providers and users of financial services also construct and use a variety of alternatives, which

include such diverse technologies as private

microwave links, satellite transponders, video

cable, public packet switched networks, leased

lines, and local area networks.

The divestiture of the operating telephone

companies by American Telephone & Telegraph (AT&T) in 1984 substantially changes

the communication environment in which providers and users of financial services operate.

Both local and long-distance telephone rates

are likely to change. Competition from nonBell suppliers of telecommunication services

and equipment is already significant and is

likely to increase in magnitude and kind in

light of the divestiture. Those who enter markets as providers of equipment and services

are likely to intensify competition further.

Both suppliers and users of financial services are heavily dependent on telecommunication services, and as systems to deliver financial services directly to customer premises

become more widely deployed, this dependPhoto credit Raca/.M//go Corp

Network control console like those used to manage

major financial service telecommunication networks

ency will increase. Securities markets, card

and check authorization systems, and cash

management services are now totally dependent on telecommunication. Products such as

remote banking and shopping and off-market

securities trading have a dependency equally

great. The premium placed on timely financial

information is increasing, and the only way to

meet this requirement is through the application of communication technologies. Changes

in the technologies, policies, and economics of

communication will directly affect the design

of systems for delivering financial services, the

cost schedules facing both users and providers

of financial services, and, hence, the structure

of the financial service industry.

The Switched Telephone Network

The most widely available communication

facility is the switched telephone network that

serves virtually every place of work and residence in the United States. Only a limited

number of locations can send and receive telecommunication traffic without using this network for a portion of the route. Subscribers

to non-AT&T long-distance networks generally access them through the facilities of local

operating companies. In fact, some of the alternative services actually use long-distance

circuits provided by AT&T.

The switched telephone network is basically

designed to handle analog voice traffic. Generally, digital data sent between computers

and between computers and terminals must

be converted from digital to analog format for

transmission through the network. Network

facilities capable of carrying the digital signals

and thus eliminating the need for this conversion/reconversion process are now coming into

use and will eventually replace the analog links

in the system. In this environment, voice as

well as data will be transmitted through the

network using a digital format.

The switched telephone network was designed to handle a relatively large number of
Ch. 2—Present and Future Technologies Supporting the Financial Service Industry ● 3 1

calls of short duration in which the parties are

speaking a high percentage of the time the connection is maintained. A circuit is established

between the parties for the duration of the call.

Whether or not there is traffic on the connecting circuit, the facilities used to maintain the

connection are denied to others. A POS terminal connected continuously through the

switched telephone network may be used only

intermittently. Although this constitutes an

inefficient use of network resources, a merchant may desire to maintain such a connection in order to minimize the time required to

process a transaction at the point of sale.

The common telephone is by far the primary

terminal used with the switched telephone system. Although it functions well for voice communication, its capabilities as an instrument

for data entry are limited, and those for receiving other than voice response are almost nonexistent. The 12-key tone pad is a moderately

effective data entry device that can be used

to transmit numeric data to a computer with

relative ease, but it transmits alphabetic data

awkwardly. It has been used for applications

such as telephone bill paying and balance inquiry. In those locations where tone service

is not available, an easily acquired attachment

to the traditional dial telephone or widely

available dual-mode instruments allows the

user to transmit the tone codes required for

certain services. This operation requires use

of either a tone generator placed over the

microphone of the handset or a type of telephone now available that can switch between

dial pulse and push-button tone operation.

With either, the customer can make a connection using conventional dialing and then

switch to tone output to communicate with an

electronic device. If financial service providers’

applications can conform with the capabilities

of the voice telephone as a data communication device, a significant portion of the Nation

could have immediate access to computerbased financial services. Marketers of such

services have been limited in the past by the

lack of capabilities of the stand-alone telephone as an input/output device. If successful

market penetration occurs, home computers

may offer a more viable alternative for delivering service.

Presently, commercial users in some areas

have specialized, switched digital service. In

the future, virtually all customers will have

digital network service available, primarily

through the digital termination services

planned by operators of the switched telephone network. As outlined in greater detail

in the next section, each digital line will have

substantially more capacity than is now available in the conventional voice circuit and will

be considerably more versatile.

Wide Area Telephone Service (WATS) is a

specialized service offered through the

switched telephone network. This service

allows a fixed number of hours per month of

calling for a specific geographic area. INWATS permits incoming calls at no charge to

the caller, and WATS, or OUT-WATS, permits the subscriber to originate calls using the

service. IN/OUT-WATS permits both. Financial institutions and others use this service to

expand their markets geographically without

establishing physical presence in the targeted

areas. The availability of toll-free calling encourages the remote customer, who might be

unwilling to incur a toll call charge, to contact

the institution. The service is particularly valuable to depository institutions that face restrictions on the geographic areas in which

they can establish facilities.

In addition to the common voice telephone,

many other types of communication devices

can be attached to the switched telephone network. Included are computers, simple terminals, and facsimile terminals. These can provide for interaction with humans and/or

unattended operation. However, all currently

cost more than the voice telephone. Service

providers must recognize this cost differential

when planning the deployment of a system

that depends on the user acquiring the required terminal equipment.
32 ● Effects of Information Technology on Financial Services Systems

Private-Line Telecommunications

Facilities

Many commercial organizations and government agencies use leased circuits for their internal communication needs. Providers of financial services are among the heaviest users

of such facilities, and some operate large

global networks for moving funds and information.

A leased circuit guarantees access to a circuit between the points that meets specified

electrical characteristics. This eliminates the

problems of uncertain quality and relatively

slow access* when dial-up lines are used. While

there is no assurance that the same physical

circuit will be made available at all times, or

that the signals will not be multiplexed with

others between various points along the route,

the quality of the line becomes invariant from

the user’s point of view. This minimizes the

variability of one of the elements critical to

overall reliability and integrity of financial

service systems.

Institutions with sufficient need and funds

can install their own circuits; in some cases,

private microwave networks have been established. Fiber optics and coaxial cables are used

for networks confined to a limited area, such

as an office building or factory complex. Some

have leased transponders on communication

satellites, and others have leased circuits on

video cable systems. Financial service organizations are among the heaviest users of the

video cable that runs from midtown Manhattan to the Wall Street area in New York City.

Aetna Insurance Co. is one of the three primary partners in Satellite Business Systems,

a major communication venture. New technologies will increase such options. For example,

the installation of teleport facilities will make

satellite communication available to a larger

community of users and offers the opportunity

to bypass local telephone facilities completely.

Merrill Lynch is one of the major backers of

the teleport installation planned for New York.

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

Fiber optics offers greater capacity and security of transmission than do copper conductors of comparable size, properties that are

particularly attractive in areas like the financial district in New York, where the available

space in conduits for wires has been almost exhausted.

A communication technology of growing importance is local area networks, which are installed within an organization’s facilities to

provide a variety of communication services,

including the transmission of both voice and

data. Digital, private, automated branch exchanges are being installed to manage some

of these networks. Others have been developed

by manufacturers of office computer equipment and emphasize such features as sharing

of data resources and electronic mail. * Characteristically, all of these networks provide

gateways to the switched telephone network,

including the private, value-added carriers and

any private networks to which the user may

have access. The user of a local area network

with gateways to the switched telephone network has access to all of the data and processing resources that comprise the local network and, using the same terminal equipment,

to other facilities that are external to it.

All of the classes of equipment that will

operate with the switched public network will

also operate with private networks.

Alternatives to Switched Networks

Because the switched telephone network,

where “hard” connections are established and

maintained for the duration of a conversation

between the parties, is not particularly well

suited to traffic that is characterized by relatively short bursts of activity separated by

long periods of silence, alternative technologies more suited to data traffic are used by

providers 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 Sending mess%es e~ectronically between computers. Messages are stored on the addressee’s computer system to be retrieved, read, and disposed

of at his/her convenience.
Ch. 2—Present and Future Technologies Supporting the Financial Service Industry . 33

to deliver financial services, are characterized

by this kind of bursty traffic pattern.

One of these is packet switching, in which

messages are broken down into small packets,

each of which is routed separately through the

network. One property of this technology is

that the cost of communication becomes more

a function of the volume of traffic handled

than the distances involved. Also, there is minimal penalty for having a network that includes a large number of points between which

only limited traffic volumes pass. Because it

is oriented to handling messages that are fairly

short in length and are spread over considerable periods of time, packet switching is particularly suited to the type of traffic likely to

be generated by providers and users of financial services. POS systems and systems for

trading securities are candidates for this technology.

Multiplexing, a well-established and widely

used group of technologies that permit a communication circuit to be shared more or less

simultaneously by multiple users, is also of

interest to providers and users of financial

services. These technologies permit a single,

high-capacity circuit to be used for various applications, none of which could alone justify

the expense of a dedicated line. For example,

if local communication costs rise, as some predict, the operator of a shopping center could

establish a connection to a financial network

or a specific financial institution that would

permit the merchants access to POS services

at lower costs than if communication services

were paid for independently. This could be

done by connecting to a specific institution,

thus eliminating choice of a financial service

provider for individual tenants of the shopping

center. On the other hand, the shopping center owner could conceivably provide access to

a gateway that would permit individual merchants almost unconstrained freedom in selecting financial service providers.

Video-Related Communication

Technologies

Considerable attention has been given in recent years to using technologies built around

some modification of the common television

set for distributing information, including financial services. The services offered are generally built around alphanumeric displays of

information that fill one television screen. The

quality of graphic capabilities varies from system to system, but none presently offers any

significant degree of animation. However, with

some systems, computer programs will be

transmitted to the user’s terminal at relatively

low speed and then executed in the customer’s

terminal to produce animated graphics. One

application for this technique is the distribution of video games; other applications are

likely to follow.

While video-based systems have been somewhat accepted in Europe, they are still in the

experimental stage in the United States,

where only a limited number of systems is in

operation. One of the principal drawbacks encountered is the price of a modified television

set or specialized terminal capable of participating in the system. Three general types exist: teletex, videotex, and cable television.

In teletex, frames are transmitted over the

air during the blanking pulse in the television

signal, the period when the raster on the television returns from the lower right comer of the

screen to the upper left. Because the technique

repeatedly transmits a limited number of

frames that can be selectively captured by the

terminal equipment, the capacity per channel

for offering adequate response to users is limited to about 25 to 100 frames. This is essentially a one-way system because there is neither a path over which the user can respond

to the system nor a means for sending a signal

to a specific receiver. Users can, however, use

a telephone connection to transmit to the sys-
34 ● Effects of /formation Technology on Financial Services Systems

tern. Conceptually, an address routing message to a specific receiver could be added to

the transmitted frame, but the limited capacity of the channel would effectively limit such

an application. Full-frame teletex, an alternative to transmitting the textual information

during the blanking pulse, is the dedication of

a channel to a telex application. Capacity could

then increase to about 1,500 frames per channel. Application of this technique is generally

limited to dissemination of advertising and

bulletin board type of information. Included

could be price quotations, but it would not be

possible to tailor the information to the needs

of a specific subscriber. Transaction initiation,

except through the use of an auxiliary channel such as telephone, is not possible because

there is no direct path from the user to the

source of the information.

Videotex generally uses the telephone network to transmit the required information to

users, who are able to interact with the information source, selecting material from a large

library that is directed only to the user’s television set or personal computer display. A very

large number of frames is available, and it is

possible to charge for each frame viewed (the

user requests specific frames). Some applications, such as those related to financial services, permit the user to enter data that is then

processed (e.g., a mortgage amortization

schedule is produced when the user enters

principal, term, and interest rate). Because

data is directed only to a specific terminal, personal information such as account balances

can be delivered using this technology. The capacity of the telephone channel limits the degree of animation that can be offered, and the

data transmitted is generally confined to text,

numeric tables, or fixed graphics.

The third technique, cable television, uses

video cable, with all of the transmission

capacity inherent in that medium. The Warner-Amex QUBE system that has been operating in Columbus, Ohio, for some time offers

considerable capabilities for delivering text to

specific users and a low data rate return channel for reacting to specific user input. It therefore has considerable potential for delivering

financial services. This system includes provision for interactive response from users to

questions posed by the program being transmitted. Applications include all of those possible with videotex and others that can make

use of the capacity of the television cable.

Large amounts of data, such as historical

stock market information, can be transferred

rapidly and loaded into a user’s computer for

processing at a convenient time.

Future Telecommunication Technologies

Generally, telecommunication technologies

will continue to provide the means by which

financial and payment information is transmitted rapidly from point to point. In many

ways, the specifics of telecommunication technology are of minor interest to users and providers of financial services. As long as sufficient capacity is available at an affordable

price, the needs of the financial service industry will be met.

While voice communication will continue

indefinitely to dominate the traffic handled by

the common switched telephone network,

transmission technology is changing. Digital

transmission will replace the analog signals

now used most commonly. Voice will be digitally encoded and will share circuits with data,

video, and facsimile transmissions. This will

mean that users of telecommunication services will be able to interweave voice and various forms of data on the same circuit. Systems

that offer these capabilities to commerical customers are being marketed. For example, a financial service consultant is able to send a

table of data showing the expected results of

alternative investment opportunities for display on a client’s terminal in the midst of a

normal conversation. Even now, terminal devices capable of supporting such usage patterns are coming on the market.

The concept of a telephone industry ISDN

(Integrated Services Data Network) is emerging and will reach fruition sometime before the

end of the century. An ISDN is a network in

which all traffic is represented digitally, and

various types are freely mixed as traffic passes
Ch. 2—Present and Future Technologies Supporting the Financial Service Industry ● 3 5

from origin to destination. However, because

of the magnitude of converting the installed

plant, ISDN capabilities may not be available

to significant portions of the subscribers to

switched telephone services for some time beyond the turn of the century. Further, while

there is now no compelling reason for making

ISDN generally available to consumers, there

is a distinct possibility that a force driving in

that direction will emerge and will hasten the

deployment of ISDN. For example, if consumers become heavy users of information utilities, their needs for transmitting and receiving significant volumes of data could stimulate

development and deployment of ISDN facilities.

Users of telecommunication systems built

in accordance with the ISDN concept, or a less

general one called “Digital Termination Service, ” that shares many concepts with it, may

be provided with a single high-capacity communication line. The capacity of this line

would then be allocated among various applications at the user’s discretion. Some may

choose to use it for multiple voice lines, while

others may allocate a portion to data and another to voice. Allocations could be changed

dynamically in response to user needs. At one

point, several people could be using the facility for a number of simultaneous conversations, which could include conference calls. At

another point, a single user could use part of

the capacity to carry on a conversation, while

the remainder is used to access information resources. Using advanced software technologies, the user could also interact simultaneously with multiple information providers. For

example, an individual may review account

balances, along with economic statistics and

historical data provided by independent vendors of information services, in formulating investment decisions.

Although one could assume that the vehicle for implementing ISDN will be the framework provided by the switched telephone network, there is no technical reason why this

need be the case. Most private locations, such

as homes and places of business, will be able

to have telecommunications delivered over at

least two types of networks, switched telephone and video cable. Either could be used

to implement ISDN-like concepts. The cable

television systems may enjoy some cost and

bandwidth advantage over the telephone network. The transmission capacity of a cable is

much greater than that of most ordinary telephone circuits, and the cost of serving a subscriber is less.

Designers and users of financial service systems will be able to choose from a variety of

telecommunication technologies in designing

and accessing services. Some new telecommunication technologies will have greater capacity than the switched telephone network of today, but development of new techniques to

extend the capacity of the present telephone

plant are evolving. For example, dial telephone

lines are now routinely used to transmit at

2,400 bits per second, a rate that could not be

realized with acceptable error rates several

years ago, and rates as high as 9,600 bits per

second are becoming possible. Switched telephone networks are expected to evolve slowly

from conventional copper wires to fiber optic

circuits. Fiber optics have transmission capacities far greater than those of the present copper conductors. However, as is now the case,

some network segments will always be carried

by radio transmission, as exemplified by the

use of microwave and satellite facilities.

Technologies such as cellular radio and digital termination services are now being offered

commercially for the first time. These are expected to come into widespread use by the

mid-1990’s. In addition, direct broadcast satellite systems will soon become operational

and may be used in some systems for delivering financial services.

There will be a diversity of telecommunication networks in the coming years. Various

vendors of telecommunication services and

technologies will try to offer systems that

most effectively serve certain classes of users.

While there is a proliferation of systems, vendors recognize that they will have to provide

for the interoperability of communication facilities. Gateways between private networks
36 ● Effects of /formation Technology on Financial Services Systems

and public transmission facilities are now

almost mandatory. Thus, users and providers

of financial services will be able to communicate between and among themselves with minimal concern for the particular technologies

used in implementing financial service systems. The emergence of other alternatives to

conventional switched telephone services

should be expected over the coming 10-year

period. These new services will almost certainly offer opportunities of value to both

users and providers of financial services.

Now, and probably more so in the future,

numbers of telecommunication options available to all users, including individuals, will be

available. Users will be able to closely align

services procured with needs. But the full benefits of the ability to choose from a range of

options will be realized only if the customer

expends the effort needed to evaluate the alternatives. In all likelihood, independent development of system designs and seeking the

vendor best able to meet the need will be required. Not all potential users who could benefit from this approach will be prepared to take

it, with the result that they will probably settle for something much less than the best

available communication facility at the most

advantageous price. To the degree that communication costs become relatively more significant for providers and users of financial

services, this shortfall could affect their basic

ability to compete in the market with others

not carrying a similar burden.

System Security and Integrity

Security has long been an area of concern

to providers and users of financial services.

Traditionally, banks have been characterized

by large metal doors and imposing vaults with

massive and complex locking mechanisms. Financial service providers stress the safety of

assets in attracting customers, and customer

trust is a keystone of the financial service industry.

Increasing use of telecommunication and information-processing technologies in conjunction with financial services raises two areas

of concern that relate to the basic soundness

of the financial service industry: system security and system integrity. System security

deals with the problem of those who would attack the system from the outside, including

those who work with the system but would

attempt to invoke operations they are not

authorized to perform. System integrity addresses the problems that arise with recovering a system without loss of data in the event

of a failure.

System Security

As demonstrated by the young people in

Milwaukee in 1983, it is not difficult for individuals with minimal equipment and training to penetrate some computer systems

which contain sensitive information. In the

Milwaukee caper, one of the computers compromised, using a common home computer

and telephone line, belongs to a major west

coast bank. Other instances of penetration of

computers used by providers of financial services are on record; and some experts believe

that only a relatively small portion of the security breaches that occur are detected, and

fewer are reported outside of the victim organization.

Historically, embezzlers from within and

check forgers and confidence artists from without have threatened the financial service industry. Computers, particularly those accessible through telecommunication networks,

add new dimensions to the vulnerabilities of
Ch. 2—Present and Future Technologies Supporting the Financial Service Industry ● 37

—

financial service providers. In a high-technology environment, the assets of an organization and the proprietary information on which

it bases its business operations are subject to

remote-access thefts.

Attacks on financial institutions through

their own processing systems can directly victimize those institutions’ clients. A thief who

robs a bank at gunpoint steals from the institution; the electronic thief can reach directly

into the accounts of individuals. The burden

of detecting the crime, reporting it to the organization holding the account, and recovering

the lost assets could shift from the institution

to the account holder. When the thief’s booty

is information rather than financial assets, neither the specific individual nor the institution

affected may ever become aware of the fact

that the system has been penetrated.

Threats to a system can materialize both

from within and outside the target organization. Employees throughout an organization

can individually or in concert attempt to compromise a system. Technical personnel can

modify operational programs or write new

ones to perform improper operations. Similarly, nontechnical personnel can seek to perform

operations not authorized to them or misuse

powers with which they are entrusted.

Programmers have written codes that credit

the fractional cent from an interest computation to their personal accounts and fail to report properly the overdraft conditions in those

accounts. Some programs to perform unauthorized operations destroy themselves after

completing their task, leaving no trace of their

existence. A few people used computers to

create and maintain millions of dollars worth

of bogus insurance policies in the Equity

Funding case, a task that would not have been

possible without the technology.

Conceptually, it is possible for anyone to use

international telecommunication facilities to

attack financial institutions without ever coming within the jurisdiction of American law enforcement officials, much less being in close

physical proximity to the institutions they are

attacking. With relative impunity, individuals

or organizations could launch their attacks

from any telephone, including those in motel

rooms and pay stations, from which they could

operate undisturbed for brief periods. At least

one computer now on the market fits nicely

into a large purse and can be used to initiate

an attack on a financial institution from any

location where a standard modular telephone

connector can be found. Some devices can be

set up to operate unattended, and then retrieved.

Not all attacks on financial service systems

must be so sophisticated. Individual consumers of financial services and various user organizations have demonstrated a marked yet

unwitting ability to aid the thieves who would

victimize them. Personal identification numbers (PINs), given to account holders to use

in depositing and withdrawing money from

ATMs, are written on access cards. Telephone

numbers and key access codes are written on

communication terminals and bulletin boards

in clear view of those unauthorized to have

them. In one instance, an enthusiastic user of

an ATM demonstrated the use of the machine

to a complete stranger and, in the process, revealed his PIN to all within 20 feet. A variety of comparatively simple scams, that range

from asking individuals for PINs and the use

of their cards to retrieving used carbons showing account numbers from the trash cans of

organizations that accept cards in payment of

accounts, have been used to compromise financial service systems.

Computer-to-computer communication is

now used to initiate and execute a substantial

number of financial transactions, a practice

that will become more widespread in the future. Therefore, the problem of authenticating

the “signature” of a computer that participates in financial transactions in order to authenticate the transactions will become as critical as that of establishing the identity of

human users. Although under study, no such

technique has emerged that shows promise for

wide adoption by the financial service industry. Finding a solution that will be acceptable

for use by individual consumers and others not

sophisticated in the design and operation of
38 ● Effects of /formation Technology on Financial Services Systems

—

advanced technological systems constitutes

the most difficult subset of problems in this

area.

Providers of financial services, aware of the

threats to their systems, are taking steps to

tighten security. Various devices and techniques exist for minimizing the vulnerability

of computers and communication networks

used to deliver financial services. The use of

data encryption techniques is growing, and a

system in which the PIN is never accessible

in clear text to any human is available and in

use by many financial institutions. Physical

security around computer facilities is the focus

of considerable attention, and research designed to overcome the known weaknesses of

the PIN as an access code is continuing.

Nevertheless, human ingenuity and fallibility

will probably counteract attempts to provide

foolproof security for computer systems.

System Integrity

All systems, whether manual or automated,

will at some time fail in the sense that operations will be interrupted for a period of time.

Such interruptions may be the result of attack

by an outsider, natural calamity such as an

earthquake, or the inadvertent error of an authorized user of the system. Thus, systems

must be built so that they can be restored to

full operation without loss of data or transactions in process at the time of failure. This is

a particularly important factor in delivering

financial services because lack of system integrity could result in a situation where the

level of confidence so essential to the viability

of such systems is degraded.

The problem of providing for system integrity is largely a technical one. Increasing use

of telecommunications adds new dimensions

to the problem, but a number of well-accepted

practices aimed at ensuring system integrity

exist. It remains for the operators of financial

service systems to ensure that those practices

are followed during the design, implementation, and operational phases of the system

lifecycle.

Specific Technologies for Delivering Financial Services

Applications of general-purpose information

processing and telecommunication technologies specific to the needs of the financial service industry have been developed. Included are

technologies for accessing systems and handling items such as cash and checks that are

unique to the financial service industry.

Card Technologies

Embossed/Magnetic Stripe Card

The embossed plastic card with a strip of

magnetic tape embedded in the back has become almost ubiquitous. This device provides

the primary means for accessing credit and

debit services that are delivered through both

paper-based and electronic systems. Commonly, the card is presented at the point of sale,

and an impression is taken on a paper document that is then processed. Most often, the

consumer is making use of a credit service and

is billed by the credit provider. Today, embossed plastic cards are also used to originate

debit transactions that are processed over the

same network as credit transactions.

Generally, the data are recorded on the magnetic stripe on the card by the card issuer

before it is sent to the account holder and they

are not changed during the life of the card.

This striped card has room for about 1,000 bits

of data. Allowing for the information that

must originally be recorded on the card, there

is just not enough room to record transaction

data. Technologically, however, there is no reason why data on the stripe could not be altered

after issuance. On the other hand, the limited

capacity of the stripe and the cost of deploying sufficient terminals with the capability of
Ch. 2—Present and Future Technologies Supporting the Financial Service Industry ● 3 9

recording data on the stripe makes this device

generally unsuitable for applications that

would require changing the data repeatedly.

Also, the stripe is easily readable, eliminating

the possibility of building security into the

card.

However, the same basic technology is used

in the Washington, D. C., subway farecard system. When a farecard is purchased, the

amount is recorded by the machine dispensing the card. Each time it is used, the starting

point of the trip is recorded, and when the

passenger exits the subway system, the

amount of the fare is computed and deducted

from the balance on the card. In this system,

the magnetic stripe is mounted on a paper

backing, and the card is generally disposed of

after only a few cycles, a lifetime that would

not be suitable for a card that is to be used

repeatedly over an extended period.

Data on magnetic stripes are read by ATMs

and special terminals used by some merchants

at the point of sale. Merchant terminals primarily facilitate the process of obtaining a

transaction authorization from the card issuer

by eliminating the requirement for either the

clerk in the store or an authorization clerk at

the issuer’s facility to key in the account number. Some merchant terminals also print the

necessary information on the paper document,

further reducing clerical workload.

Among the problems with the embossed/

magnetic stripe card is that it is relatively easy

to copy or counterfeit. Several technologies

have been developed to overcome this problem. Data can be recorded in the laser card by

burning pits in a reflective material that can

be sensed by an appropriate reader. Once recorded, the data can be neither altered nor

erased. Holography is being used on some card

blanks to create a background image that is

very difficult to reproduce.

Laser Card

The laser card, or memory card, is just making its debut. At this date the laser card is not

used by the financial service industry; however, its potential use is likely. As described

by S. Berton Latamore:

The card can store digital data signifying

the bearer’s fingerprint, voiceprint, or even

the pattern made by capillaries in the

retina. A stand-alone card-reading machine,

equipped with a microprocessor, would check

whether this biological data on the card

matched that of the card-holder. The card is

being developed by Drexler Technology of

Mountain View, Calif. The company’s Drexon card stores 1.2 megabits, or roughly

30,000 words–nearly 1,000 times more than

a magnetic stripe card.

The Drexler cards are coated with a twolayer plastic film. The top layer is embedded

with microscopic pieces of silver, giving the

material a highly reflective, metallic look. To

write data, a low-power laser melts pits in the

top layer to expose the unsilvered—and unreflective-bottom layer. To read the card, a

laser scans the surface, and a photodetector

senses the presence and absence of pits as

highs and lows in the intensity of the reflected light.2

Unlike the magnetic stripe, the laser material cannot be erased and rewritten; pits are

physical holes that cannot be refilled.

Electron Card*

Electron cards, first distributed in early fall

of 1983 by VISA, U. S. A., combine three encoding technologies on the back of the plastic

card-the banking industry’s magnetic stripe,

the retail industry’s optical character recognition, and the universal product code bar

code.** The card, which is not embossed and

cannot imprint paper forms, is an attempt to

embrace both the banking and retail environment with a move toward a more secure electronic environment than presently exists. The

card will feature a direct debit option but will

‘J. Berton Latamore, “Putting Intelligence in Your Market, ”

Iljgh l“eclmology, published by High Technology Publishing

Corp., June 1983, p. 16.

*“Electron f’ card is a trade name for a VISA card.

**Optic~ ch~ac~r recognition (OCR): the process of reading .

a stylized type face with an optical sensor. Universal product

code (UPC): a bar code now imprinted on many items that is

read by a suitably equipped terminal.

35-595 0 - 84 - 4 : QL 3
40 ● Effects of Information Technology on Financial Services Systems

also have the capabilities of a credit card. It

presently replaces proprietary ATM access

cards. A full-scale POS project is expected to

get under way in mid-1984. The card will migrate to full-service use at points of sale.

Use of the electron card is intended to reduce the number of paper checks, resulting in

lower processing costs, less fraud, and faster

service at the point of sale. Cardholders will

have electronic access to cash through a global

network of ATMs and to goods, services, and

cash at many locations. Authorization will be

provided electronically at the time and point

of each transaction and will be fully controlled

by the card issuer.

The processor card, or “smart card, ” developed in France, contains a tiny embedded computer chip with about 1,000 times the storage

of the conventional magnetic stripe. However,

once data are recorded in the memory, they

cannot be simply altered, and their memory

cells cannot be directly reused. The smart card

contains processing capabilities that enhance

its security and flexibility. A standard for its

format has recently been adopted, eliminating

some of the uncertainty that may have been

limiting its adoption. The user plugs the card

into a terminal that then queries the card

memory as part of the processing to validate

the transaction. Once authorized, the transaction data can be recorded in the card’s memory for later retrieval. With present technology, the card costs in the range of $5 to $10

and is good for approximately 200 transactions before its memory is full.

Even though Carte Bleu, a group member

of VISA International, France, has begun

Photo credit: High Technology, June 1983

The French smart card contains a microprocessor

capable of interchanging information with another

computer

placing chips in all its VISA cards, the future

of the smart card is uncertain. Some suggest

that it represents the wave of the future, while

others see it as a technology in search of an

application. If it is to come into widespread

use, merchant terminals will have to be generally available. Development of a card with

reusable memory could also enhance the utility of the concept.

In its current form, the smart card is a modification of the conventional plastic card it is

intended to replace. It contains a microprocessor chip, but because it includes neither a

keyboard nor display, it can be used only with

a terminal device that provides power and the

appropriate input/output capabilities.

However, there is no reason why a smart

card that includes a keyboard and display

could not be built. Calculators that are no

larger than the card are available with such

features; and an interface to a merchant or financial institution termina1 could be provided.

Such a card could include in its functions the

ability to determine the balance remaining and

to review the transactions for which it has

been used. Multifunction cards that contain

more than one processor could also be built.

The smart card could evolve as an alternative to cash following the general model of the

fare card used by some subway systems, including that in Washington, D.C. The user

could “charge’ the card with funds from a depository account and the funds would be decremented for the amount due each time it is

used. Terminals for recording value in the card

could even be located at home, giving the consumer the ability to obtain the equivalent of

cash. Card readers could be provided at each

cash register or POS terminal to allow a consumer to verify the card’s balance. Hard currency dispensers, rather like the common

change machine, could allow the smart card

to serve as the equivalent of a large-denomination bill.

In the future, applications of card technology will become more widespread. Already,

there are telephones which accept magnetic

stripe cards and other vending machines may
Ch. 2—Present and Future Technologies Supporting the Financial Service Industry . 41

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

deployed by the French Government’s

Telecommunications Administration

be designed to accept them also. As the facilites for online transaction authorization and

direct debit of accounts from point of sale are

deployed more widely, the utility of card technology will increase. In the long run, however,

the plastic card could be displaced if a secure,

practical means of user identification that depends on the physical characteristics of the individual could be developed as an alternative.

Signature dynamics, fingerprint readers, and

sensors that process the pattern of blood vessels in the retina of the eye are technologies

that show some promise. It remains to be seen

which, if any, will ever be operational.

However, all of the security features that

could be implemented have flaws. For example, if an intruder can capture the digital

representation of a fingerprint before it is

encoded and inject it into a system being attacked, the user’s “key” will have been compromised. When this happens with a conventional PIN, a replacement code is issued and

the old one invalidated. The question that follows the compromise of a fingerprint or a retinal pattern is: “What replacement code is to

be issued?” On the other hand, if the data

stream associated with a system that uses the

signature dynamic is compromised, a possible

replacement could be some alternative phrase

with which the user identifies himself.

Document and Currency Readers

The cost of processing billions of paper

items is becoming prohibitive for an industry

losing some of its principal sources of revenue,

and the pressure to find lower cost processing alternatives is intense. Reading of checks

encoded with magnetic ink has been commonplace for over a decade, and credit card vouchers are generally transferred to magnetic tape

for processing. However, aside from some limited applications such as making change, financial document readers are in very limited

use in the United States.

One of the major suppliers of ATMs has announced a model that will accept and timestamp individual checks. It will also be able

to dispense currency and coin in any amount.

Models that accept and count Japanese currency are already in use. Thus, the technology

to provide deposit verification by the ATM is

Photo credit Burroughs Corp

Reader/sorter processes checks and other documents

at the rate of 1,625 per minute
42 • Effects of Information Technology on Financial Services Systems

just over the horizon and is likely to increase

the utility of these machines substantially.

Systems that process credit and debit card

transactions already truncate the paper flow

at the earliest practical time. Instead of moving paper, the data are recorded on magnetic

media and transferred electronically for processing by the card issuer. Documents are

coded so that they can be retrieved if necessary. Moreover, credit unions and savings and

loan associations generally do not return

drafts on NOW accounts to the account holder, also truncating paper flow. However, with

relatively few exceptions, commercial banks

still return canceled checks with monthly

statements; and attempts to stop this practice at least for individual accounts have met

with considerable resistance.

In the long term, however, banks and other

depository institutions will develop and deploy

systems in which checks are truncated or terminated at the bank of first deposit. Issuers

will be provided the means for retrieving either

the original or an acceptable photocopy if

needed. The issues standing in the way of such

a change are related more to legal and market problems than to lack of suitable technologies. For example, who in such a system

Photo credit Burroughs Corp

Document encoder used to record data on checks in a

machine-readable format

would be responsible if a forged check were

processed against an account? Consumers use

and hold canceled checks in lieu of receipts,

especially for tax purposes. What alternatives

would be acceptable to the Internal Revenue

Service?

Customer Service Equipment

Cash dispensers were the first terminals

made available for customer use by financial

institutions. These were followed by the multifunction ATMs now in widespread use that

are capable of initiating bill payments, transfers between accounts, and other types of

transactions, in addition to accepting deposPhoto credit: Diebold Corp

Inner workings of an automated teller machine
Ch. 2—Present and Future Technologies Supporting the Financial Service industry ● 4 3

its and dispensing cash. The functional capabilities of these machines are continuing to increase and they are becoming capable of

handling increasingly diverse kinds of transactions. Counter to this trend, however, some institutions are making available specialized

machines to perform balance inquiries and are

supplementing full-service ATMs with cash

dispensers so that customers requiring only

cash will not have to wait behind those with

more complex transactions.

There may be a movement to customer service machines that have a wide range of capabilities. Some may be of limited purpose, for

such applications as cash dispensing and balance inquiry. Others may have the capabilities

of the ATMs of today: accepting deposits,

moving money between accounts, paying bills,

and dispensing cash. Still others may be used

for time-consuming but infrequent transactions, such as the filing of a loan application

or ordering securities transactions.

In the future, a number of “customer work

stations” could be available in a lobby area.

These could be configured so that the customer could sit at a desk and accomplish a number of tasks, including making a deposit or

withdrawing funds. Then, when the bulk of the

work is finished, the customer could go to a

device supporting many terminals that accepts the deposit or another that would dispense cash. Express terminals for customers

with limited needs could also be provided.

Bank branches without human tellers are

operating, and some institutions are shrinking their networks of full-service branches.

Some of these automated branches provide

only telephone communication for the customer in need of assistance. Others are

manned by a customer representative who is

available to answer questions and market

services, but who performs none of the teller

functions, such as accepting deposits or paying withdrawals.

Technology and the Structure of the

Financial Services Industry

One of the impacts of present and future

technologies on systems for delivering financial services is that there is a real possibility

of redistribution of function between and

among traditional suppliers and potential new

entrants. Whereas the payment system has

been reserved largely by the banks, because

only they have access to facilities for clearing

and settlement, movement of funds electronically makes it possible to avoid the traditional

payment system and to effect net settlement

directly between members of a community

that have agreed to the necessary implementing conventions. Alternative means of distributing information could diminish the role of

brokers for such varied products as securities,

real estate, and insurance. Telecommunication

systems that are capable of message switching are implicitly capable of performing the interchange function for payment networks.

Retailers and other cash-oriented businesses,

such as gas stations, are motivated by losses

from bad checks and card fraud to take steps

that minimize their exposure. For example, an

ATM in a supermarket has the potential for

relieving the requirement to cash checks while

minimizing the amount of currency and coin

that is held at each store location and subject

to theft.

On the other hand, what is technologically

feasible may be neither possible nor desirable.

Consumers may balk at accepting new service delivery mechanisms. Legal/regulatory constraints may limit options, and the potential

providers of the services may opt not to implement them for any of a variety of reasons.

Further, changes in the technologies modify

the parameters that bound system design alternatives. Those that are attractive now may

become undesirable in the future, while new

alternatives not now feasible may emerge.
44 . Effects of Information Technology on Financial Services Systems

Appendix 2A: Hardware Components

Chip Technology

The fundamental building block for information

processing and telecommunication is the silicon

chip. Many thousands of electronic components,

constituting an infinite variety of electronic circuits, can be fabricated with these chips. The newest computers have memory chips capable of storing 64,000 bits of information; chips capable of

storing 256,000 bits of data are now emerging.

Chips with 1 million electronic components are in

the laboratory stage of development.

Processor chips used in today’s large microcomputers tend to include only the functions needed

for performing the required logical and arithmetic

operations. Memory for data storage and circuitry

to facilitate the movement of data between the

processor and various peripheral devices such as

disc drives and telephone communication links

usually require additional chips mounted on the

same printed circuit board as the processor. A

single chip which includes the processor, memory,

and other supporting circuits, is in widespread use

for many appliances and devices. But most of the

home computers and larger units separate this

functionality into several separate chips.

Silicon chips in use today tend to be less than

one-quarter inch on each side. Dr. Gene Amdahl

has suggested that it maybe possible to fabricate

economically chips that are several inches on a

side. If so, performance-to-cost ratios for electronic

equipment could rise significantly because the

larger size would limit the need for physical interconnection between chips which is one of the major costs of fabrication. One of the major factors

reducing the cost of consumer products, such as

home computers and video games, has been the

decrease in the number of chips required in these

devices as it has become possible to pack more and

more onto a single chip. Also, because the speed

of an electronic circuit is limited by the distance

between its components, the ability to manufacture very large chips could translate into significant increases in processing speeds for the devices

that use them.

Computer Systems

A computer system consists of a number of subassemblies that are collected in much the same

manner as a component high fidelity system. It

includes a central processor, high-speed random

access memory to which data and programs are

moved when they are active on the system, and

peripheral storage devices, such as disc and tape

drives that store data and programs not immediately needed by ongoing processing operations.

Additional components, depending on the system

configuration, might be printers, card readers, and

devices specifically designed to handle the telecommunication function.

The heart of any computer system is its central

processor. It is the subsystem that performs the

instructional program written to support a specific

application. Processors can be fabricated on a

single chip or may require several cabinets of components. For any type, the key to increasing speed

and minimizing costs of fabrication and operation

is to minimize the physical dimensions of the processor and the number of discrete components required.

Most modern systems use more than one processor. In a small desktop computer, for example,

one processor on a chip may perform the primary

work of a machine while other processors perform

supporting roles, such as generating the characters on the screen of the terminal through which

the user communicates with the system. Large

systems may use networks of processors to perform the variety of functions required of a machine. Small systems are capable of tens of thousands of operations per second, and some larger

commercial systems can perform millions of operations per second. Computer systems capable of

billions of operations per second are just over the

horizon.

The central memory of a computer contains the

program instructions and data that comprise the

elements of an application system when it is active. A small desktop computer may have storage

for as few as 1,000 characters of information, while

large systems used by providers of financial services may have main memory capacity measured

in tens of millions of characters. More commonly,

desktop computers with main memory capacities

ranging from 48,000 to 256,000 characters are

used for financial service applications both by individual users and providers of financial services.

Even though some financial service applications

can run on computers with as little as 16,000 characters of main memory, computers with memories

much smaller than 48,000 characters tend to be
Ch. 2—Present and Future

too small to conveniently hold the programs and

data required for serious financial services applications. Larger systems used by providers of financial services include main memories that commonly range in capacity from 1 million to 8 million

characters.

Disc drives, another system component, have

large capacities relative to the main, random access memory of a computer and permit processors

to access individual records in a fraction of a secAppendix 2B: Systems

Present Operating and

Support Systems

The sophistication of systems and support software generally varies directly with the capabilities

of the computer on which it is to be used. Large

mainframe computers are supported by comprehensive software packages that provide extensive

capabilities to those capable of using them. This

is to be expected because the larger computer can

be utilized effectively only if most of its operations

are controlled automatically. At the other extreme,

software for microcomputers is much more rudimentary in its scope of functions. The user of a

microcomputer is in direct control of virtually all

operations, and the services of a complex operating system would be of only limited benefit. However, operating systems even for the smallest computers are expanding in terms of the capabilities

offered.

Twenty years ago, systems software and some

support software were furnished free to users by

the manufacturers of computer equipment. However, unbundling of software and hardware has

been common industry practice for a number of

years, and today’s user pays for each of the system and software support modules used. Operating system and support software is expensive both

in terms of the direct cost and overhead imposed.

These software packages can soak up a considerable portion of available computer resources. Thus,

a small system with support facilities limited to

a single application may, in some cases, be more

effective than a large machine burdened with large

amounts of overhead. One manufacturer, in fact,

had to expand significantly the available memory

on one of its larger models to accommodate the

burden of operating system and support software.

Technologies Supporting the Financial Service Industry ● 4 5

end. For example, the interchangeable floppy discs

used with a computer having 48,000 or so characters of main memory will have a capacity of

100,000 to over 1 million characters. Hard, noninterchangeable discs used with such systems can

have a capacity of 5 million to 40 million characters. Discs used with large-scale computers have

capacities of hundreds of millions of characters,

and many can be attached to each system.

and

Data

Support Software

Base Management Software

Data base management systems constitute a

specialized software technology of particular importance to providers and users of financial services. This software facilitates the tasks of organizing and accessing large quantities of data where

relationships between the various elements comprising a data base are complex and where diverse

communities of users access various subsets of

the data base. By permitting the sharing of data

throughout an organization, the costs of data collection, maintenance, and dissemination are controlled, and all users are able to base their decisions on a common body of information.

Data base technology insulates data bases from

the application programs that access them and can

significantly improve system integrity and security. Depending on the data base system, users can

be limited to accessing only specific data elements,

and further, the operations permitted them can be

controlled by the data base administrator. Audit

trails that record the identity of all who access

data and the operations performed can be generated. For example, some users may be permitted

only to retrieve data, while others may both retrieve and change a specific set of data elements.

Permission to add new elements to a data base can

be denied both of these groups and given, instead,

to other units within the organization.

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

much of the data critical to an organization is concentrated in only a few data bases. Compromise

of a data base management system can lead to significant damage to the organization that is affected. In such an environment, the organization

can become vulnerable if management does not
46 . Effects of /formation Technology on Financial Services Systems

fully use those data base management system features which are designed to ensure system security and integrity. Although there is no such thing

as perfect security for any system, data base management technology can allow a higher degree of

system security and integrity than possible when

collections of individual files are used by each application system.

Software Development Tools

The rate of productivity increase for application

programmers in the past has been small relative

to the rate of increase in the performance-to-cost

ratios of computer hardware. However, a new

group of tools is becoming available to help alleviate this problem. Data base management technology discussed in the previous section is one

such tool. In addition, there are interactive, terminal-oriented systems that support application

programmers by minimizing the steps they have

to execute to write and test new programs and

modify existing ones. Management techniques

that emphasize modularity in design and make extensive use of procedures for controlling systems

configuration have also proved beneficial.

In addition, advanced languages have made it

easier for programmers to develop the required

computer codes. Procedure-oriented languages

permit the end-user to interact directly with generalized systems and minimize the need for application programmers to develop applications customized to the needs of each user.

Perhaps the major breakthrough has been in

programmerless application generators. For example, general-purpose spreadsheets, such as Lotus

1, 2, 3 and VisiOn, allow nonprogrammers to develop complex models and display their results

graphically.

The Future for Operating and

Support Systemsl

Support functions such as telecommunication,

data management, allocation of hardware resources, and job scheduling will be performed by

highly modular support software. More functions

now performed by the operating system will be

performed in hardware. New emphasis will be placed on the security features and the user will comI Most of the concepts relating to the future of system and support software are drawn from, Future Information Processing Technology,

1983, prepared jointly for the Institute for Computer Sciences and Technology and the Defense Intelligence Agency.

municate with the operating system through

higher level commands.

Users will be able to select capabilities that are

tailored to their needs and pay only for those. Generally, ease of use will increase and users will not

be required to learn separate ways for dealing with

various classes of applications. For example, all

terminals will be able to communicate will all applications because the required protocol conversions will be performed automatically. It will be

possible for major systems to operate in multiple

sites as a single entity because access to and allocation of resources will be controlled by the system and support software. Worldwide distributed

networks will be feasible by the mid-1990’s. The

ability to distribute functions among multiple cooperating processors will serve to increase system

reliability and integrity. In addition, the various

support packages will develop so that they have

great facility to recognize and recover from errors

and will be able to notify the appropriate user of

transactions that could not be successfully processed because of either a hardware or software error. A key feature of operating system and support software will be its ability to diagnose system

problems and dynamically reallocate system components. User installations will have to expend

minimal effort to support software packages.

One manufacturer of microcomputers is already

marketing an operating system that provides the

user with the facility of moving easily from one

application to another without the need of explicitly terminating one and initiating a second. As

additional applications are added to the repertoire,

they can be integrated with operating system so

that the user is faced with a single, integrated entity rather than a number of disjoint applications.

Integrated, multifunction software packages for

microcomputers are well established in the market; and although they do not constitute operating systems, they offer some of the features one

would expect to find in an operating system.

This trend toward easing the burden of detail on

the end-user of computer systems is expected to

be a major theme in the development of system

and supporting software into the indefinite future.

At some point, the user will no longer have to recognize the existence of a discrete operating system and will be able to focus all attention on the

applications that are being used.

Many of the features of the operating systems

for large computers are already becoming available

for microcomputers. Some of the software development tools that are now available on large com-
Ch. 2—Present and Future Technologies Supporting the Financial Service Industry • 47

—

puters are being implemented on small ones. One

manufacturer has added to its product line a microcomputer that will run a variant of the virtual

memory operating system used on its large systems. Networks of small computers will become

the functional equivalents of large central systems

in many operating environments. The emergence

of such capabilities is foreshadowed by some of the

office systems that are already being deployed by

some manufacturers.

By the mid-1990’s, large computers may function largely as repositories of data and support

only the largest processing systems. Small computers directly controlled by end-users will perform most of the processing functions and report

generation that will be required. Some installations are already approaching this state.

Tools for system development and maintenance

will be of growing importance over the coming decade. As more generalized functions are moved into

the hardware, the operating system and support

software, the tasks required of applications programmers will be simplified and, hence, less costly

to accomplish. A key element in realizing the benefit of this technology will be the ability of management and technicians to understand its capabilities and apply it intelligently in supporting

applications systems.

The same system development and maintenance

tools that will benefit professional technicians will

also help end-users interact directly with computer

and communication systems without the need for

intermediation by members of technical staffs. The

support functions will complement the generalized,

user-oriented application systems that will be

available; and, together, they will provide the enduser with a powerful package of tools for applying the technologies that will be at his disposal.
Chapter 3

The Securities Industry
Contents

Page

Structure of the Securities Industry . . . . . . . . . . . . . . . . . . . . ... , . . . . . . . . 51

The Development of the Securities Industry in the United States . . . . . . 51

Organizations Composing the Securities Industry . . . . . . . . . . . . . . . . . . . 52

Industry Users.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57

The Regulatory Structure of the Securities Industry . . . . . . . . . . . . . . . . . 59

Characteristics of the Securities Industry . . . . . . . . . . . . . . . . . . . . . . . . . . 62

New Entrants to the Securities Industry. . . . . . . . . . . . . . . . . . . . . . . . . . . 63

The Securities Industry and the International Market . . . . . . . . . . . . . . . 64

The Effects of Information Technology on the Structure of the

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

The Functions of the Securities Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64

The Securities Industry as an Advisor.. . . . . . . . . . . . . . . . . . . . . . . . . . . . 65

Acceptance of Risk by the Securities Industry . . . . . . . . . . . . . . . . . . . . . . 67

Marketing by the Securities Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69

Technology and the Functions of the Securities Industry . . . . . . . . . . . . 75

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

Appendix 3A: Securities Instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76

Corporate Capital Structure: Debt and Equity Issues . . . . . . . . . . . . . . . . 76

Short-Term Debt–Money Market Securities.. . . . . . . . . . . . . . . . . . . . . . . 83

Options and Futures Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84

Appendix 3B: Capital Formation and the Functions of the

Securities Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91

Private Sources of Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92

Venture Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92

Public Offerings of Securities of a Corporation . . . . . . . . . . . . . . . . . . . . . . 93

Tables

Table No. Page

2. Contracts Traded-Futures Exchanges: A Comparison of

1983 and 1982 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56

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

Figures

Figure No. Page

3. Average Daily Share Volume New York Stock Exchange

1963 to 1983 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54

4. Volume of Futures Trading, 1958-83 (millions of contracts traded) . . . . . 58

5. Overview of SIAC Facility Management for NSCC Services . . . . . . . . . . 74
Chapter 3

The Securities Industry

The securities industry in the United States,

which developed to help young American business gain financing from European investors,

continues to bring together those who need

capital and those wishing to invest. The industry directs its concentrated expertise on financial markets toward its intermediary role of

facilitating the development of capital. It provides advice, accepts risk, and offers marketing services to ensure that an orderly market

for the issuing and trading of securities* is

maintained.

XFO~ PUW{)=S of this study, securities include debt and equity

issues used to develop capital (stocks and bonds, money-market

securities, and instruments which have been developed to allow

hedging and speculation in securities and commodity

market s—i. e., options and futures contracts). These instruments, as well as investment tools which developed from the

packaging of securities instruments, such as mutual funds and

central asset accounts, are described in app. 3A.

Since the introduction of the telegraph 140

years ago, communications technologies have

been used by the industry to convey information on which the operations of securities industry depend. However, while the securities

industry has always applied state-of-the-art

technology to its operations, the level of technology used today and likely to be available

tomorrow is beyond what could have been

dreamed of when the telegraph was applied in

1844.

In this chapter, the structure, functions, and

instruments of the securities industry are described. The impact that the application of

computer and communications technologies

has had in these areas is reviewed

ble future effects are discussed.

Structure of the Securities Industry

The structure of the securities industry has

been shaped by the demands of users, national

policy objectives regarding the financial service industry, practical operational concerns,

and competitive market forces. In this section,

a brief overview of the development of the current structure of the securities industry and

a description of the organizations and competitive forces comprising the industry will be

provided. Present and future effects of information technology on the structure of the industry will be discussed.

The Development of the Securities

Industry in the United States

The securities industry in the United States

developed to meet the capital demands of the

new Nation. One side effect of the independence won in the Revolutionary War was war

debt. This was funded by the issuance of interest-paying bonds, for which a secondary

market shortly developed.1 At the

and possisame time

the need to finance development in the new

Nation was recognized. The burgeoning securities industry provided a vital link to European capital markets and also a means of

transferring capital within the United States.

The basic role filled by the securities industry in the late 1700’s is still a driving force

behind its operations today: to provide a means

of interaction for those seeking capital and

those wishing to invest.

Two factors which quickly emerged as essential to the operation of the securities industry

were the maintenance of an orderly market

and the availability of trading information.

Twenty-four brokers, conducting trading under

a buttonwood tree, subscribed to a brokers’

agreement that formed the first stock market

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

51
52 ● Effects of Information Technology on Financial Services Systems —

in New York on May 17, 1792.2 This market

became the New York Stock Exchange. In

what is now known as the “Buttonwood

Agreement, ” the brokers focused on working

together to assure they would be able to trade

securities smoothly and fairly.

Information on trading and prices has always been essential to trading decisions. Securities firms and exchanges clustered (as on

Wall Street) to facilitate the communications

needed for the operation of the market. A

newspaper first published stock prices in 1815.

Prior to the introduction of the industry’s first

technology-based information system, the

electric stock ticker (in 1867), messengers

literally ran from the trading floor to brokers’

offices with information.

Early refinement and expansion of securities

trading can be related to three communications technologies: the telegraph, the transatlantic cable, and the telephone.3 These technologies improved information flows on which

the markets are dependent. The telegraph

linked exchanges, brokers, and investors

throughout the country and made decisionmaking on investments by someone not on

Wall Street practical for the first time. This

technology offered the first hope of a national,

noncentralized market. The transatlantic

cable, completed in 1866, made an international market feasible at a time when American industry was still very much dependent

on financing from European investors. Telephones were first used to convey orders from

brokers to the floor of the New York Stock Exchange in 1878, 2 years after the first successful test of that technology.

The adoption of these communications technologies and the stock ticker were based on

the recognition that the faster and more accurately information flows, the better securities markets function. The introduction of new

technologies today is largely based on this

assumption.

Organizations Composing the

Securities Industry

Three types of organizations traditionally

compose the securities industry: investment

banks perform the services surrounding a public offering of the stocks and bonds of a corporation; brokers manage the buying and selling of securities; and exchanges provide a

vehicle for setting prices and actually conducting transactions.

Investment Banks

The activities of investment banks are centered on the development of capital. The Banking Act of 1933, commonly called “Glass-Steagall, ” required that investment banking be

separated from commercial banking because

of the sometimes incongruent objectives and

the different levels of risk associated with

these kinds of organizations. Investment

banks fall into two categories: originating

firms and distribution firms. Originating firms

developed largely as intermediaries between

European financiers and young American industry, and they remain major players in the

development of securities offerings. Distribution firms come together in syndication, under

the guidance of an originating firm, to guarantee and sell the securities of an issuer.4

The four leading investment banks in both

domestic and foreign financing are Salomon

Brothers, Inc.; Morgan Stanley Inc.; First

Boston Inc.; and Goldman Sachs & Co. Merrill Lynch, Pierce, Fenner, & Smith Inc. (Merrill Lynch) and Paine, Webber, Jackson, &

Curtis (Paine Webber) have a significant share

of the domestic market. Three levels of purchasers and sellers are reached through investment bank activities: first, the issuers of securities, those corporations and governments

that purchase investment bank services; second, the investors in new issues; and third, the

intermediaries who bring these two parties

together—other investment bankers, distri-

‘New York Stock Exchange 1983 Fact Book (New York: New

York Stock Exchange, June 1983), p. 66.

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

4Sarnuel L. Hayes III, “The Transformation of Investment

Banking, ” Harvard Busines 12ew”ew, January-February 1979,

pp. 153-170.
—

Ch. 3—The Securities Industry ● 5 3

buting underwriters, and commercial banks.

Investment banks assume the risk of a public offering of investments by guaranteeing

their purchase—i.e., underwriting them.

The nature of competition within investment banking is changing. Price competition

is cutting fees for underwriting to new lows.

In addition, simplification of securities registration requirements could make underwriters

unnecessary. Nevertheless, the need to transfer risk continues to provide a strong incentive for utilizing the services of investment

banks.

Brokerage Houses

Full-service brokerage houses perform trades

in securities and commodities and provide financial counseling services supported by indepth research and analysis of markets and

industries. This segment of the industry is

dominated by firms which are subsidiaries of

companies that offer a range of financial management services. Six national brokerage

houses lead the industry. They are: Merrill

Lynch; E. F. Hutton & Co.; Shearson/American Express; Prudential Bache; Dean Witter

Reynolds; and Paine Webber. There are also

many regional firms, such as Alex Brown &

Sons, which play major roles in trading either

nationwide or regionally.

This portion of the industry has been affected by the abolition of fixed commission

rates in 1975. While brokerage houses in the

past competed on the reputation of their research and the quality of their service, price

competition has also become a factor. Discounters, who concentrate on the transaction

side of the business, have entered the market

and have attracted a significant portion of

both institutional and individual trading. In

response to this market entrance, many fullservice brokerage houses are taking steps to

distinguish their services and to increase client loyalty. Increased efforts are being directed toward product development and promotion.

Exchanges

The fundamental role of all exchanges in the

securities industry is to provide an orderly

marketplace for trading. Exchanges provide

a central location and a structure in which

buyers and sellers can conduct trades. Exchanges are operated on a membership basis.

“Seats,” memberships that carry the right to

trade on an exchange, are purchased by firms

or individuals desiring access to its market.

Members agree to direct all trades on listed

securities through the exchange floor. This

allows the exchanges to manage the markets

better–for example, to halt trading on a security, if necessary, with the assurance that

member firms will not trade off-market.

Stocks and bonds, options, and futures contracts are usually traded on separate exchanges. This specialization is a carry-over

from the separate formation of capital and

commodity markets.

Stock Exchanges.– Stock exchanges are independent players in the securities industry

and have two functions: performing transactions and accepting risk. Stock exchanges act

as a secondary securities market for both debt

and equity issues, providing flexibility and

choice for investors. Potential investors in new

issues can evaluate the desirability of the instrument in light of their ability to sell it, and

therefore may recognize a lower opportunity

cost. The existence of secondary markets also

increases the available investment choices

since securities other than new issues are made

available.

There are seven major stock exchanges:

New York, American, Boston, Cincinnati, Midwest, Pacific, and Philadelphia. In 1982, 80.8

percent of the total share volume of registered

exchanges was traded on the New York Stock

Exchange (NYSE). The National Association

of Securities Dealers, Inc. (NASD) operates a

quotation system and clearing facility for the

over-the-counter market. The automated quotation system, NASDAQ,5 has been responsi5National Association of %curities Dealers Automatic Quotation System.
54 • Effects of Information Technology on Financial Services Systems

Figure 3.—Average Daily Share Volume

New York Stock Exchange 1963 to 1983

85,334 85,000

[1! !

82500

80,000

7750 0

75,000

72,500

70,000

SOURCE Futures Industry Assoclatlon, Inc

ble for a dramatic increase in trading volume

in over-the-counter stocks, an indication of the

importance of information flows to trading.

Options Exchanges. –The goal of options

exchanges is to provide a continuously competitive and orderly market environment for

the purchase and sale of options.6 Each exchange determines standards regarding which

options may be traded on that exchange. They

select the underlying securities on which options may be traded based on factors such as

‘American Stock Exchange, Inc., et al., Understanding the

Risks and U=s of Listed Options, 1982.

Photo credit. New York Stock Exchange

The trading floor of the New York Stock Exchange: 1984

the number of shares held by the public and

trading volume.

The principal established marketplaces for

the trading of options are: the American Stock

Exchange; the Chicago Board Options Exchange; the Pacific Stock Exchange; and

the Philadelphia Stock Exchange. These exchanges compose the Options Price Reporting

Authority (OPRA). Trading information from

all of the options exchanges is coordinated in

OPRA’s automated last-sale reporting system. This system, developed and operated by

the Securities Industry Automation Corp.,

provides a consolidated tape of last sale and

quote information. The exchanges also formed

the 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 conassigns exercises. ducted in price auctions on the trading floor.

Options exchanges aid in industry self-regulation by developing and enforcing rules concerning the handling of accounts by brokers,

trading hours, and position and exercise limits.

Options exchanges and the OCC are regulated

by the Securities and Exchange Commission

(SEC).

Futures Exchanges.—The principal responsibility of a commodity futures exchange is to

ensure the existence of competitive markets

free of price manipulation for the trading of

The exchanges are operated on a membership

basis, and exchange regulations and policies

are set by their boards of directors and subject to approval of the Commodity Futures

Trading Commission (CFTC). There are many

futures exchanges in the United States. The

largest is the Chicago Board of Trade, which

in 1983 handled 44.89 percent of total trading

volume (see table 2.)

‘Futures Industry Associates, Inc., “Roles Played by Each

Participant, ” Futures Trading Course and Handbook, Washington, D. C., 1983, p. I I-4.

35-505 0 - 84 - 5 : QL 3
56 ● Effects of /formation Technology on Financial Services Systems

Exchange

1. Chicago Board of Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2. Chicago Mercantile Exchange. . . . . . . . . . . . . . . . . . . . . . . .

3. Commodity Exchange, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . .

4. Coffee, Sugar & Cocoa Exchange

5. New York Mercantile Exchange . . . . . . . . . . . . . . . . . . . .

6. New York Futures Exchange . . . . . . . . . . . . . . . . . . . . . . . . .

7. MidAmerica Commodity Exchange . . . . . . . . . . . . . . . . . . .

8. New York Cotton Exchange. . . . . . . . . . . . . . . . . . . . . . . . . .

9. Kansas City Board of Trade. . . . . . . . . . . . . . . . . . . . . . . . . .

10. Minneapolis Grain Exchange. . . . . . . . . . . . . . . . . . . . . . . . .

11. New Orleans Commodity Exchange . . . . . . . . . . . . . . . . . . .

1983

Contracts

62,811,523

37,830,044

20,014,597

4,876,069

3,926,589

3,510,285

3,166,537

1,703,105

1,693,042

379,607

13,542

139,924,940

Percent

44.89

27.04

14.30

3.48

2.81

2.51

2.26

1.22

1.21

0.27

0.01

100.00

1982

Contracts Percent Rank

48,206,790 42,89 (1)

33,574,286 29.87 (2)

17,520,712 15.59 (3)

3,252,512 2.89 (4)

2,649,941 2.36 (5)

1,451,442 1.29 (9)

2,397,721 2.13 (6)

1,479,781 1.32 (8)

1,493,558 1,33 (7)

346,264 0.31 (lo)

27,872 0.02 (11)

, . 112.400.879 100.00

SOURCE: Futures Industry Association.

, ,
Ch. 3—The Securities Industry ● 57

— — — — —

The exchanges play a major role in self-regulation of the futures industry. In this role

they are required to perform four activities:

surveillance of market activity to detect and

prevent situations conducive to price distortion; surveillance of trading practices to detect

and prevent trading abuses; investigation of

rule violations and customer complaints; and

examination of members’ books and records.8

The introduction of new investment products,

such as stock futures, indicates that activity

on futures exchanges may be expected to grow

over the next several years. The regulatory

and operational role of the exchanges will become more complex. Information technology

is being applied to facilitate the operations of

the exchanges and will play an increasingly

important role in their activities.

Industry Users

The demands and characteristics of users of

the industry are major determinants of industry structure. The organizations of the securities industry serve as intermediaries between

two sets of users: capital seekers and investors.

Organizations Seeking Capital

While the focus of much of the activity of

securities industry is on secondary markets,

the underlying demand for capital is the reason the industry exists. In 1982, the value of

new issues of common stock publicly offered

was $23.4 billion; new, publicly offered debt

obligations totaled $45.2 billion. Private placements of debt and equity totaled $22.3 billion.

As the U.S. economy completes its evolution

to an information economy, it may be expected

that a great number of both new firms and existing corporations with growing operations

will be seeking capital through both private

and public sources.

Corporations will demand more rapid access

to their capital than ever before because of the

effect of information technology on the over8U. S. General Accounting Office, Survey of Investor Protection and the Regulation of Financial Intermediaries, 1983, pp.

28-29.

all economy. Business decisions are being

made more quickly, and delays in financing

will not be tolerated.

Institutional Investors

Institutional investors include special-interest funds and companies such as pension

funds, mutual funds, insurance companies,

and private foundations that have a goal of

producing income for a specific organizational

use and deal in large blocks of securities. They

demand prompt, efficient transactions and extensive information.

Since the passage of the Employee Retirement Income Security Act (ERISA), the impact of these investors on the total market has

increased substantially. Trades in 10,000 -

share blocks, a measure of institutional involvement, have increased to over 44 percent

of total share volume. g The broker must also

be willing to assume risk by buying from the

institutional investor because he demands a

high level of liquidity. At the same time, the

importance of this segment of the market has

led to price competition following the deregulation of commission rates in 1975.

The demands of institutional investors have

been, in large part, responsible for much of the

automation of trading and clearing by the securities industry. Exchanges need to attract

institutional capital to maintain the marketplace, yet information technology, combined

with institutional traders’ level of market expertise, makes off-market trading a viable alternative for these traders. The volume of

trading conducted by institutional investors

makes those investors valuable clients for

both brokers and exchanges.

Pension funds are the most significant institutional investors in capital markets. In 1980,

these funds held 13.4 percent of the total market value of NYSE listed stocks.10 Two factors

that have contributed to the growing importance of pension funds, both as savings vehicles and institutional investors, are the aging

‘Securities Industry Association data. IONew York Stock Exchange 1983 Fact Book, op. cit., P. 52.
58 . Effects of Information Technology on Financial Services Systems

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 ’83

SOURCE New York Stock Exchange data

of the population and ERISA. Since there has for the benefit of shareholders. Shares are sold

been great interest in individual retirement to investors for the net asset value plus any

planning, pension funds may be expected to applicable sales charges. The return for the inbe a major player in securities markets. vestor in a mutual fund is similar to that for

any corporate shareholder: the investor profA 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
Ch. 3—The Securities Industry ● 5 9

funds are significant as institutional investors

because they usually trade in large volumes.

Funds are classified by investment strategy

and fall into three categories: income funds,

which strive to provide a current income for

investors; growth funds, which focus on longterm appreciation; and income and growth

funds, which try to be all things to all people.

Generally, funds that seek a higher return for

investors are more risky. For example, some

funds, such as the Phoenix Fund of Merrill

Lynch, are composed of securities of failing

companies that are believed to have the potential to rebound. While the risk level is

higher than average, shareholders in this type

of fund have less exposure to risk than if they

were to invest in individual securities, and

they benefit from high yield.

Mutual funds frequently specialize in specific types of securities, such as government

bonds, or in securities from a particular type

of industry. Money market mutual funds invest only in money market securities, which

are by definition short term. For this reason,

money market mutual funds are considered

less risky and are more liquid than the traditional mutual funds. Money market funds

have three basic objectives: to preserve shareholder capital; to maintain liquidity; and, in

light of these two objectives, to achieve the

highest possible current income.” Money market instruments are generally written in high

denominations and are only accessible to many

investors because they are able to pool their

investment dollars in the funds. The money

market benefits from the funds because a large

quantity of capital not otherwise available is

attracted.

Individual Investors

The typical individual investor in securities

is an affluent consumer who demands information and advice geared toward his requirements. The sales of mutual funds, a proxy indicator of the level of individual involvement

in the securities market, are rebounding after

a period of decline. This upswing, plus recog-

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

nized opportunity to market new investment

products, has generated renewed interest in

individual investors by the securities industry.

There has been tremendous growth in the

number of stockholders. NYSE reports that

42.36 million Americans own shares of U.S.

corporations or stock mutual funds, an increase of 10.1 million since 1981. ]2 Of particular significance to the securities industry is the

tremendous growth in the number of first-time

investors, 7.3 million since 1981. This growth

ma-y be attributable to several factors, including the strength of the stock market during

the early 1980’s, corporate employee stock

purchase plans, and most notably, changing

demographics.

The “aging” baby-boom generation, now approaching peak investment years, may cause

an increase in the number of people investing.

People are waiting longer to get married for

the first time and have families and therefore

are likely to be able to invest at a younger age.

While securities firms once targeted their services towards a small portion of the population,

their market has become more diverse in terms

of both age and income.

Securities firms have been expanding their

product lines and the scope of financial services they provide to meet the demands of the

individual investor. Movement by firms into

other areas, such as insurance and real estate,

is an attempt to draw clients at an earlier

stage in their financial lifecycle and to fill all

of their financial needs.

The Regulatory Structure of the

Securities Industry

Federal regulations enacted in the 1930’s

disallowed involvement by depository institutions in securities activities because of concerns about the effects of risk associated with

these transactions on the stability and soundness of banks. Such restrictions separated capital creation from the banking activities of corporations, such as the extension of operating

‘

zJon Friedman and Tom Petruno, “Record 42M of Us Are Wall Street Investors, ” USA Today, Dec. 1, 1983, sec. A, p. 1.
60 • Effects of /formation Technology on Financial Services Systems

—

credit and transaction accounts. These restrictions were intended to assure that depository

institutions acted in the best interests of

depositors.

The regulatory structure of the securities industry recognizes that capital and money markets are essential to the health of all sectors

of the national economy. Legislation concerning the securities industry has focused on

three areas: providing for disclosure to investors, promoting self-regulation by the industry, and facilitating the development of a

national market for securities. Federal regulation that is focused directly on the commodities futures segment of the industry is similarly designed and seeks to protect markets

and individual traders.

Securities and commodities trading is overseen by a two-tier regulatory system: Federal

and State government and industry. Federal

regulation is focused on the oversight of markets and investor protection. State regulation

of securities, commonly called “blue sky

laws,” since they were designed to prevent the

sale of securities with the investment potential of the blue sky, preceded Federal regulation, and the right of States to regulate was

preserved when the first major legislation concerning the operation of the securities industry, the Securities Act of 1933, was passed.

While Federal regulation focuses on disclosure without value judgment on the worth

of the securities, State laws may actually involve licensing. Registration of an issue may

be refused by a State authority, which would

prohibit sale in that State.13 State laws differ,

but efforts to develop uniform laws are being

led by the North American Securities Administrators Association.

Self-regulation is imposed and enforced by

the exchanges and by industry associations.

While the industry began formally supervising its own operations with the development

of the Buttonwood Agreement, the self-regulatory system was first recognized by Congress and subject to Federal Government

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

supervision with the passage of the Securities

Exchange Act of 1934.

Federal Regulatory Agencies

Several Federal agencies play roles in the

activities of the securities industry. The Small

Business Administration licenses and regulates Small Business Investment Corporations, a type of venture capital firm. The

Board of Governors of the Federal Reserve

regulates the extension of credit by brokers,

as mandated in the Securities Exchange Act

of 1934, and has a major impact on the industry by regulating the activities of banks.

However, responsibility for regulating the

securities industry is held by SEC, and responsibility for the futures industry, by CFTC.

SEC was established by the Securities Exchange Act of 1934. Its regulatory activities

are based on the belief that disclosure is the

preferable means of assuring the smooth operation of securities markets; it is not invasive

to the operations of industry players, and it

retains investor choice. SEC also acts to prevent price manipulation of securities and regulates the the practices of exchanges, brokers,

and dealers. It acts in conjunction with the industry self-regulatory agencies and oversees

their activities.

While not a regulatory agency, the Securities Investor Protection Corp. (SIPC), a quasigovernmental organization, has brought a uniform investor protection policy to the securities industry. SIPC operates as a private nonprofit membership corporation whose primary

function is to provide financial protection for

the clients of failed securities firms. The corporation was mandated by the Securities Investor Protection Act of 1970 in response to

problems that occurred in the late 1960’s

throughout the brokerage industry as stock

prices fluctuated widely and volume on the exchanges increased dramatically.

The only function of SIPC is to insure accounts. It covers shortages in accounts of up

to $500,000, including coverage for as much

as $100,000 in cash, for each account. Since

it began operation in December 1970, it has
Ch. 3—The Securities Industry . 61

paid out more than $133 million in claims. ’4

SIPC assesses an annual fee on each of the

7,000 brokerage houses in the United States,

which are required to be members of the corporation, to maintain the $150 million level it

is required by law to keep available to satisfy

claims. At times, SIPC has acted as trustee

in cases of brokerage house liquidations and

as such has distributed payments to customers as accounts were settled.

The corporation relies on SEC and the securities industry’s self-regulating organizations for notification that a member firm is in

danger of collapse. If SIPC determines that

the customers of the brokerage house are in

need of its protection, it begins what is termed

a “customer protection proceeding, ” which is

a liquidation procedure. SEC is the only organization that can sue SIPC to force it to begin

liquidation proceedings.

CFTC is responsible for regulating commodity futures trading on organized exchanges. It acts to prevent price manipulation,

attempts to corner market dissemination of

false or misleading information, and mishandling of traders’ margin money and equity.15

It reviews and approves the instruments

traded on the futures exchanges-i. e., futures

contracts. CFTC oversees the activities of exchanges and other self-regulatory associations.

Disclosure for the futures industry involves

not only the characteristics of specific contracts, but also the level of risk involved in this

type of investment. All potential investors in

futures markets are informed that they may

experience large losses as well as gains and

that it maybe difficult to liquidate a position.

Industry Self-Regulatory Agencies

Industry associations and exchanges establish and enforce rules concerning the operations of the securities industry, rules that are

often more stringent than Federal regulations.

An implicit objective of self-regulatory agencies is to maintain the autonomy of the indus14 Christine Davies, “Brokerage Failures Bring Agency to

Life, ” USA Today, Mar. 9, 1983.

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

try. To meet this goal, these organizations try

to ensure that the behavior of the industry is

above reproach. They play a major role in overseeing the markets, market systems, and the

individuals active in the industry. Self-regulatory agencies also have an educational role

in dealing with both members of the industry

and the public.

The two most significant securities industry self-regulatory organizations are NASD

and NYSE. Their roles may be expected to

grow as they continue to carry a great portion

of all securities trading. The National Futures

Association (NFA) is the self-regulatory organization of the futures industry.

NASD is a self-regulatory agency responsible for regulating the over-the-counter securities market and for promoting high standards of operation throughout the industry. It

also establishes standards of professional competence. NASD was empowered through the

Maloney Act of 1938 amendments to the Securities Exchange Act of 1934. Its central purpose—to promote high standards of commercial honor and just and equitable principles of

trade throughout the industry—has become

even more important to the industry as technology is applied.

NYSE oversees the operation of the exchange marketplace and administers rules and

regulations related to the maintenance of orderly markets and the standards of professional competence. ” NYSE is also a major source

of information concerning the industry as a

whole.

In 1981 NFA was designated a “registered

futures association” by CFTC, which oversees

its activities, with congressional endorsement.

It began operating on October 1, 1982. NFA

was formed in recognition of the continuing

growth of futures trading to bring a uniform

system of self-regulation to its activities.

NFA works toward four fundamental purposes: strengthening industry self-regulation

by regulating those segments of the futures

“U.S. General Accounting Office, op. cit., p. 24.
62 ● Effects of Information Technology on Financial Services Systems

industry that were previously outside the

scope of self-regulatory organizations; eliminating duplication in self-regulation, thereby

controlling expenses; eliminating overlap and

conflicts in self-regulation of the industry by

providing uniform standards; and aiding effective regulation by removing unnecessary

regulatory constraints.17

Trends in Industry Regulation

Trading volume and the number of types of

securities instruments have been increasing.

The securities industry is being entered by

players from other sectors of the financial

services industry and by outside industries.

It is likely that more demands will be placed

on the oversight functions of the regulatory

system. However, while the importance of this

role is increasing, technology will facilitate this

function by improving information flows on

the operations of the industry.

While the oversight role may be streamlined, standards and education will require

more attention. Changes in industry functions

and the introduction of new products (facilitated by the application of information technology) will require an expansion of the educational role of the regulatory agencies. The

continuing development of technology-based

systems necessitates coordination of standards to ensure that different markets, both domestically and internationally, can interact.

Characteristics of the Securities Industry

Concentration

The securities industry is heavily concentrated. In 1982, the 25 largest firms, out of

nearly 550 Securities Industry Association

member firms, controlled nearly 75 percent of

the total capital of the industry. The 10 largest

investment banks controlled two-thirds of the

profits for that segment. This high level of concentration results, in part, from the large number of mergers, reorganizations, and liquidations that occurred during the 1970’s. The

l~NatiOn~ FUtUreS Association, A %rtnership Between the

Public and the Industry, Chicago, 1983, p. 11.

consolidation activity was spawned by rising

business costs for the industry and the weight

of transaction processing, as the volume of

trade had increased throughout the 1960’s.

Throughout the 1970’s several vertical

mergers between brokers and investment

banks occurred-most notably the acquisition

of Reynolds Securities by broker Dean Witter & Co. and the purchase of White Weld by

Merrill Lynch. These mergers integrated new

issue management with the distribution of securities and may be considered an early move

toward consolidation throughout the financial

services industry.

Recent acquisitions and mergers seen in the

securities industry have frequently involved

players from other financial services industries. The product lines of firms are becoming

both horizontally and vertically integrated

with lines previously only offered outside of

the securities industry.

Movement Toward a National

Securities Market

The Securities Acts Amendments of 1975

directed SEC and the securities industry to

create a national market system for both

transacting and clearance. Movement in this

direction is having a profound effect on the

structure of the securities industry. Exchanges have been linked to a degree not previously seen, through development of technology-based information systems such as the

Intermarket Trading System. Clearing systems involving the National Securities Clearing Corp. have made same-day settlement a

possibility.

The driving force in developing systems that

make a national market possible is the Securities Industry Automation Corp. (SIAC). The

great increase in the volume of trading on the

major exchanges in the late 1960’s made it evident that the securities market needs the capability to deal with extensive volume. SIAC

was organized both to operate and to develop

more efficient and effective ways of dealing

with the transaction process. SIAC systems

support order processing, trading, and report-
3333333333. —

Ch. 3—The Securities Industry ● 6 3

— — —— ———- — — . ——— . —

ing functions, as well as clearance and settlement for stocks, bonds, options, and financial

futures. The corporation is owned by the New

York and American Stock Exchanges,

One of the major impacts of SIAC on the

securities industry is that it makes the development and refinement of technological systems a continual process. This should prevent

or at least limit the lag between the identification of a need that could be best addressed

with a technology-based system and the application of a solution.

New Entrants to the Securities Industry

Entrance by Depository Institutions

An amendment, effective September 9,

1983, to Regulation Y of the Federal Reserve

Board has added securities brokerage and

related margin lending to the list of activities

permissible for bank holding companies. This

action, which extends from previous approval

by the Government for the acquisition of retail

discount brokers by bank holding companies

(notably the BankAmerica Corp. acquisition

of Charles Schwab), may increase the interest

among bank holding companies in entering the

securities industry. ]8

The motivation of banks for providing discount brokerage services may be seen as either

a reaction to market conditions or an attempt

to protect market shares. Since many brokerage houses are offering investment opportunities that serve functions similiar to depository accounts, often with more flexibility and

higher rates of return, the consumer’s perceived need for a bank may be decreased. One

motivation for providing brokerage services

may be to prevent the potential luring away

of other portions of a depositor’s business.

While acquisition of a discount broker provides one method of expansion into securities

for depository institutions, economies in operations made possible by the application information technology have made other means

of market entrance possible. Twenty-five sav-

—-————

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

ings and loan associations and savings banks

own ISFA Holding Co., Ltd., which operates

INVEST, a brokerage service, through a

wholly owned subsidiary. Thrift institutions,

which would not be able to enter the brokerage

business independently, can offer transaction

and advice investment services to their customers by subscribing to INVEST.

Special INVEST centers are placed in

branches where they are accessible and evident to customers, yet remain separate and

distinct, by order of SEC and the Federal

Home Loan Bank Board, from the other operations of the thrift. Just as the securities industry is developing and offering new products

to retain clients, this is also a basic motivation behind INVEST. Thrifts are thus able to

expand the services they can offer their customers.

Trades conducted through new alternative

brokerage services are executed through the

exchanges, usually by way of a clearing broker. The securities industry finds itself in the

position of servicing competitors, a situation

that is quite common throughout the financial

service industry. As capabilities and economies found in information technology continue to grow, more entrants maybe expected

and the wholesale portion of the securities industry will probably grow.

Possible Entrants to the Securities Industry

Players throughout the financial service industry, including the securities industry, have

been expanding their product lines to fill as

many of their clients’ needs as possible. Recognized economies of scope usually underlie

this expansion of distribution systems, both

for information and for community presence,

and in terms of complementing current product lines. Providers often feel they can retain

their customer base by entering other lines of

financial services.

The entrance of other financial service players into the securities industry is already occurring. Several insurance companies have

purchased regional brokers, and some depositories have acquired discount brokers. Shear-
64 ● Effects of Information Technology on Financial Services Systems

son/American Express and Prudential Bache

are both results of mergers between players

in different sections of the financial services

industry. Consolidation within the financial

service industry is likely to continue.

Others, not traditionally thought of as providers of financial services, have also entered

the securities industry. The most widely cited

example is Sears’ entrance through the acquisition of Dean Witter.

Other players who may recognize significant

economies of scope in entering the securities

industry are firms in the communications and

computer industries. These firms might be in

an especially strong position to enter the

wholesale side for the securities industry. Barriers to entry, such as exchange membership,

may be overcome by technology. Computer

and communications technologies allow for the

creation of information and transacting systems not dependent on the current industry

structure.

The Securities Industry and the

International Market

The securities industry has its roots in the

need for the American economy to interact in

the international capital markets. However,

prior to the completion of the transatlantic

cable in 1866, a real international market could

not exist because it was impossible to convey

information in any meaningful time frame. Information technology has made it possible for

the American securities industry to interact

in the international market, while economic

forces have made it essential.

Information technology has allowed a global

capital market to develop, resulting in increased opportunities both for investors and

capital seekers. Foreign individuals and institutions made purchases and sales of $79.8 billion of domestic corporate stock in 1982, and

transactions in all securities resulted in a net

inflow of $14.3 billion in capital to the United

States. ’g

Communications technologies are so advanced that a market anywhere in the world

can be selected for trading. This could have

significant impacts on the stability of the economies of nations. For example, the halting of

trading on an exchange in one country could

simply result in new trade in another nation.

It is not clear what impact large differences

in the valuation of a security by different countries could have on capital markets. International issues in the development of capital

markets are being considered by various organizations. One such organization is the

Federation Internationale des Bourses de Valeurs, an association of 30 stock exchanges in

20 countries.

The Effects of Information Technology on

the Structure of the Securities Industry

The application of information technology

in the securities industry affects its structure

by facilitating the flow of information to such

an extent that it removes geographic constraints on market participants and allows for

development of international capital markets.

It may also place additional barriers to entry

to the securities industry. Without adequate

access to telecommunication services, for example, a securities firm cannot function.

1

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

The Functions of the Securities Industry

The most significant role of the securities

industry is in the development of capital. The

institutions and players of the securities industry facilitate the development of capital

structures of organizations and corporations.

While it would be possible for organizations

in search of financing and potential investors

to interact directly, the market structure that
Ch. 3—The Securities industry ● 6 5

has developed provides needed services more

efficiently. Since most corporations and organizations do not approach capital markets frequently, financing with the aid of the securities industry is usually more cost effective

than direct attempts because of the expertise

securities institutions have in analyzing securities markets and in locating potential investors, and because of the ability of the securities industry to accept risk.

The use of information and communication

technologies by the industry is nearly universal, and adjustments may be expected in operations as the value of technology is realized.

However, while information technology may

change the way in which the securities industry performs its activities, and may even facilitate attempts by investors to act on their

own behalf, it is expected that the basic functions of the securities industry will remain an

essential part of the development of capital.

In this section, an overview of the functions

of the industry and the emerging effect of the

application of information technology on these

roles will be described. The significance of the

advisory, risk-accepting, and marketing functions of the securities industry to the process

of gathering capital will be outlined, and the

effect of information technology on this process will be summarized. Specific approaches

to capital formation are discussed in appendix 3B.

The Securities Industry as an Advisor

In its advisory role, the securities industry

provides information and offers guidance to

its clients. It is able to advise organizations

seeking capital on the type of financing most

desirable, whether through private or public

means, and, perhaps most significantly, what

the timing for entering the capital market

should be. These decisions are based on the objectives of the firm. Factors to be considered

include the risk and return associated with

various issuing organizations and instruments. Timing of buy and sell decisions is also

part of this advice function.

Information Dissemination

Information technology affects information

dissemination by the securities industry in

several ways. Information is now less costly

to gather, store, and access than it was in

largely manual systems. Therefore, not only

is it likely that the quantity and quality of

available information will increase, but also

that more information will be sought. Investors and other parties interacting with the

securities industry may be expected to make

better and more satisfying decisions because

of the increased availability of information.

Technology has already had a major impact

on information flows throughout the securities

industry, and it appears that the resultant

changes may have major impacts on the operation and, in time, the structure of the securities industry. Information technology enhances the reporting of securities trades. The

Consolidated Quotation System, which went

online in 1978, collects and disseminates quotation information from exchanges across the

Nation and calculates and appends the national Best Bid and Offer to the quotation information. 20 Communication technology

makes it possible to transmit this information

in real time to system subscribers nationwide.

A similar system is in place on the NYSE for

debt issues. The Automated Bond System provides current quotation and trade information

for more than 80 percent of the exchange-listed

bonds.21 This system has improved the quality

of information available on bond trading.

Information technology may increase the

independent role investors assume as information monitors, particularly the individual

investors. Although massive quantities of financial information are currently available

through a variety of media, such as newspapers, radio, and television, and through publicly available consolidated tapes, individual

investors may expect to have even more in-

‘“Securities Industry Automation Corp., Annual Report, New

York, 1982. 21 New York Stock Exchange, Amual Report 1982, New York.
66 . Effects of Information Technology on financial Services Systems

formation at their disposal. While a “more is

better” philosophy is usually applied to information, the result can be confusing, deceptive,

and frustrating to users. Moreover, information gathered by intermediaries within the

securities industry may require translation to

a form that can be used by clients.

The adoption of home information systems,

particularly interactive cable and personal

computer systems, may change the way in

which this information is gathered and used.

E. F. Hutton and Dean Witter provide customers with securities research that can be accessed via home computers.22 It is not clear

how investors will use this information. The

continual availability of new information may

result in more frequent trading; however,

home systems may just be, in the aggregate,

a new medium. Investors may evaluate no

more information than they did in the past.

Computer and communication technologies

have increased the speed with which information is available to the mass market. With the

systems now available, investors may become

less dependent on a broker or dealer for updated information. An example of this type of

system is Pocket Quote, produced by Telemet

America, Inc. The basis of Pocket Quote is an

1 l-ounce programmable receiver, which looks

like a calculator and can be used to monitor

the New York and American Stock Exchanges

as well as option exchanges. Information, including price and trade volume, on up to 20

securities specified by the user is transmitted,

subject to a 15-minute delay. The data are

broadcast in a scrambled form on FM side

bands, using a digital signal. Not only is the

information readily available to the investor,

but the system can be programed to page the

user automatically at any time there is “news”

about any investment instrument in which he/

she is interested.

The potential for investors to act immediately on information continually updated and

transmitted via such systems may affect the

stability of securities markets. The ability of

“Tim Barrington, “Stock Trading by Computer Enters

Homes, ” The Wall Street Journal, Oct. 6, 1983.

the market to correct itself in unusual situations may be destroyed. In the long run, this

may be a severe disadvantage for the investor,

particularly the small investor, who may find

himself bearing both transaction and lost opportunity costs because of action taken be

cause of basically meaningless market fluctuations.

Counseling

The nature of counseling may be changed

by the amount and type of information and

supporting analytical tools available. Research

is expected to become pivotal rather than passive in the investment advisory function.23

Analysis and recommendations presented by

securities industry intermediaries to clients

concerning potential investments may be more

detailed and, to complement this process, analysis of the financial needs of the individual

may also improve.

Increased availability of information technology has changed the nature of counseling

by placing more sophisticated analytical tools

in the hands of both advisors and investors

who may not have had access to these tools

in the past. This change may affect the way

in which investment decisions are made and

the quality of these decisions.24

The reliance on information technology for

analysis of personal investment needs, objectives, and choices may indicate an initial move

in the industry to reemphasize individual human judgment and perhaps a reemphasis of

the client/broker relationship. It is not clear

what the impact of this change will be; however, a decline in personalized service, based

on the evaluation by the broker of the client’s

financial objectives, may occur.

While counseling may be displaced in some

areas within the securities industry, its importance as a separate and unique service of the

industry has been highlighted in some cases.

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

24 Lee B. Spencer, “The Electric Library, ” remarks to the

American Bar Association, Federal Regulation of Securities

Committee, Nov. 19, 1982.
Ch. 3—The Securities Industry ● 6 7

Advice, particularly counseling, has been unbundled from the total package of services offered in a new service supplied by Merrill

Lynch, called “Pathfinder.” For a set fee, the

client receives what amounts to a financial

checkup. The evaluation provides guidance to

the investor in a somewhat objective framework. The success of this product may be an

indication of the future role of advice within

the securities industry.

Acceptance of Risk by the

Securities Industry

The securities industry accepts risk that

might otherwise be experienced by individuals

or organizations seeking investment. It does

this in two ways: through underwriting and

by the extension of credit through margin.

Underwriting refers to the assumption of risk

by an investment bank or other third party

at the time of a public offering. The extension

of credit by brokerage houses is referred to as

margin.

Underwriting New Issues

Underwriting involves the purchase of securities from the issuing company and the

subsequent resale of the instruments to the

public. This service, which is usually performed by investment bankers, is essential to

firms in need of capital that are not in the business of marketing securities. It allows them

to receive the funds they need while transferring the marketing function to an expert who

may be expected to be more effective in reaching prospective investors.

The underwriter accepts some of the risk

associated with a public offering. He prevents

lag time by assuring that the issuing corporation has access to the funds it is attempting

to raise when needed. By buying the public offering from the firm in search of financing, the

underwriter makes it easier for the management of the firm to plan the use of the funds

generated. The issuing organization may be

less concerned about the flow of cash the sale

produces because it is usually guaranteed a

fixed price and can use those funds when the

agreement with the investment bank or other

underwriter is closed.

In most cases, the underwriter also assumes

risk by assuring that the issue will be sold, and

he accepts the risk that market fluctuations

or initial pricing mistakes may influence the

success of the issue. Offerings underwritten

on a “best efforts” basis, where the underwriter does not bear the risk of an unsuccessful

offering, permit those issuers in a startup or

developmental stage, whose issues may be

considered to be more risky, to have access to

the public capital markets.

Underwriters earn money by buying securities at a lower price than they resell them for

to investors. The difference in price, or spread,

is a major consideration in the selection of an

investment bank by a firm. A prospective client for an underwriter may choose an investment bank through two methods: competitive

bidding or negotiation. Both systems have advantages, and experts disagree on which provides the best price for the capital seeker. The

advantage of the negotiated system is that the

issuing firm and the underwriter work together to make decisions about the pricing and

timing of the issue.

The company using a competitive bidding

system invites offers from investment bankers. This process is required for many public

utilities and most municipal offerings. But

while some experts believe it results in higher

net proceeds for the issuing organization (because of the forces of competition), it has disadvantages. Much of the benefit of the advisory function that the issuing company would

enjoy in a negotiated situation is lost. A higher

price may be received, but this largely depends

on the health of the market at the time of the

offering. In a depressed market, investment

bankers are less likely to compete for a public offering, and therefore the price received

may be lower.

It is also typical for investment banks to

minimize their risk by forming syndicates.

This spreads risk and benefit because of their

pooled sales force and allows a number of

underwriting firms to participate together in
68 • Effects of Information Technology on Financial Services Systems

large public offerings. Changes in industry

structure, particularly consolidation among investment banks, may affect this operation.

The presence of an underwriter provides a

valuable service for the prospective investor.

Investment bankers are expected to examine

the corporate records with due diligence and

are liable to defrauded investors if they fail

their due-diligence obligations and miss any

misstatement or omission of material fact by

the issuer in the prospectus. Therefore, not

only does an underwriter assure that the issue

will be sold in a “firm commitment” offering,

but it also provides an oversight function of

the issuer on behalf of prospective investors.

The underwriter also frequently accepts risk

through providing a secondary market for securities by maintaining a position in the stock.

This activity, called “making a market, ” is

similar to the role played by securities specialists, which is discussed in a later section. The

underwriter quotes “bid” and “asked” prices

for the security based on market supply and

demand and intervenes as a buyer or seller,

when necessary. The original offering of a debt

or equity issue may be expected to be more

successful when the potential investors know

that the existence of a secondary market is

guaranteed.

Information technology may affect the

underwriting function by decreasing the time

between the initial development of a securities

issue and its sale, lessening the need of capital seekers to be protected against this lag.

Pricing decisions and market evaluations may

be more certain if the time frame in which the

security is offered is lessened.

Price competition has been increasing in the

area of underwriting. Since the use of syndicates is decreasing, there is a greater need for

individual firms to have substantial capital if

they are to continue functioning as underwriters.25 Information technology may be a contributing factor in the advent of bought deals

that involve the purchase of an entire issue,

usually by a single underwriter who has not

lined up buyers in advance. While information

technology may allow underwriters to locate

buyers quickly, more risk is involved in this

method than with a traditional syndicate.

The emphasis on price competition maybe

a disadvantage for corporations entering capital markets because the benefits of advice on

pricing and timing of an issue is sacrificed.

While sophisticated analytical tools, which information technology may enhance, may assist corporations seeking financing in evaluating various possibilities, this type of

analysis may not be tailored to the needs and

objectives of corporations to the same extent

as the information and counseling services provided by an underwriter.

Margin

“Margin” refers to the amount of money

paid by an investor to acquire a security

through credit instead of cash. At the end of

1982, the securities industry held nearly $13

billion ($12.98 million) in margin debt secured

by nearly $39 billion ($38.88 million) worth of

collateral. 26

The Securities Exchange Act of 1934 empowers the Federal Reserve Board to regulate

this extension of credit. Brokers are permitted

to extend regulated credit on stocks and convertible bonds traded on registered exchanges

as well as some select over-the-counter stocks.

Initial margin requirements, set by the Federal Reserve Board, currently call for a deposit

equal to 50 percent of the total value for both

stocks and convertible bonds. Stock exchanges and other self-regulatory agencies of

the industry have individual requirements for

the opening and maintenance of margin accounts. For example, the NYSE requires an

initial deposit of at least $2,000 and the maintenance of equity of the customer at 25 percent of the value of securities carried.

The advent of home equity access accounts,

encouraged by advances in information technology, may increase the amount of margin

25A. F. Ehrbar, “Upheaval in Investment Banking, ” Fortune,

Aug. 23, 1982, pp. 90-95, Z6New york Stock Exchange 1963 Fact Book, OP. cit., Il. 46.
-..

Ch. 3—The Securities Industry ● 6 9

— —

debt and change the nature of collateral. While

some accounts restrict this use of credit drawn

from home equity for the purchase of securities, in many situations this is acceptable.

Margin takes on a different meaning in option and futures contract trading. In futures

trading, margin refers to the amount of money

or collateral which a client is required to deposit with his broker to insure the broker

against losses on open futures contracts. Option writers must, similarly, deposit cash or

securities with their brokers so that the brokers are covered in case of an assignment.

Margin plays an important role in speculation in securities markets. A frequently used

strategy in the buying and selling of securities is the “short” position. In this case, an

investor sells securities he does not own, but

has borrowed, to make delivery in the hopes

that the price will decline before it is necessary for him to return the security. This activity can be extremely risky. However, it accounts for a significant amount of market

activity. In 1982, 1.5 billion shares, in round

lots, were sold short, an amount that was 9.3

percent of all reported securities sales.27

Information technology may decrease the

significance of margin as a convenience for

brokerage customers because it eases access

to assets and facilitates funds transfers. Customers may be able to finance securities purchases using other assets whose liquidity has

increased as a result of increased use of information technology. It is not clear what the net

effect will be; however, the use of electronic

funds transfers may largely eliminate the use

of margin by brokerage houses to provide

float.

Marketing by the Securities Industry

For purposes of discussing the securities industry, “marketing” is defined as those activities designed to identify and meet the needs

of clients; i.e., both seekers of capital and investors. It is assumed that these clients do not

demand a specific product or type of service,

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

At one time the operations of the securities

industry were centered on what was possible,

given the regulatory framework and its business concerns. Now, a new awareness of the

importance of basic marketing to retain and

develop business is evident, resulting in research to support activities in product development and promotion and the targeting of

specific segments of the population for specialized products. Given the competition the industry faces in its traditional and new product lines, especially from new entrants into the

financial service industry, the marketing function may be expected to continue to grow in

importance for the foreseeable future.

Information technology may affect those

marketing functions of the securities industry

that comprise product development, sales or

brokerage, and pricing.

Product Development

In recent years, the regulatory restraints on

the financial service industry have decreased,

and the securities industry has found competitors in what at one time were strictly separate

businesses. These developments have occurred

when the securities industry was observing a

continual demographic and psychographic

change among its potential retail clients, a

growing institutional market, and more complex financial needs among organizations seeking capital.

Shifts in the area of product development

are seen mainly in the way products are packaged, specifically in the variety of mutual

funds and money market mutual funds that

have been developed. It is not yet clear how

patent and copyright laws will affect the development of information technology-based financial services products. If financial service

products become patentable, some securities

industry experts believe that competition

could be stifled.28 Many financial service products are similar in both character and features,

“New York Stock Exchange 1983 Fact Book, op. cit., p. 48.

“’’Merrill Lynch Wins Cash Account Row With Dean Witter, ” The Wall Street Journal, Dec. 29, 1983, sec. 1, p. 2.
70 • Effects of Information Technology on Financial Services Systems

and therefore, there is an inherent possibility

of patent infringement. Differentiating products by attribute has not been of great interest

to the financial service industry, which has

competed by geographic market and comparative return and cost.

Information technology has created interest

in patenting financial service products because

communications and computer technologies

have broadened markets. Products that at one

time may have been offered locally now compete nationally. Therefore, protection of product may become as necessary as the positioning of the product.

The patentability of financial products is

now being tested in cases involving the central-asset account. In response to perceived

consumer demand, most major firms in the

securities industry, including Dean Witter,

Paine Webber, Shearson/American Express,

and Prudential Bache, have introduced these

accounts, which are combination margin accounts and investment funds. Merrill Lynch

led the development of asset management

accounts with its introduction of the cash

management account in 1977, for which it received patents in August 1982 and March

1983, and, with over 1 million accounts, is the

market leader. Following the receipt of its patent, Merrill Lynch notified competitors that

it was imposing an annual licensing fee of $10

on all asset management accounts. Initially,

this levy was not taken seriously throughout

the industry; however, without admitting any

patent infringement, Dean Witter resolved its

dispute with Merrill Lynch about the accounts

in late December 1983 for $1 million. The firms

agreed to “grant each other a nonexclusive,

royalty-free license to use any improvements

or changes either might make relating to central-asset accounts. ”29

If financial service accounts are routinely

patented, investors may find that their choices

are limited, since the patent may be a barrier

to entry into some product lines for some service providers. Since players within the securi29Ibid.

ties industry may be expected to make efforts

to distinguish similar products legally, patenting may also increase consumer confusion

about product features and attributes.

Brokerage

Brokerage involves bringing together buyers and sellers, facilitating trades through the

maintenance of a marketplace, and assuring

that the trade is complete. The significance of

this activity as part of the operations of the

securities industry cannot be overestimated.

Traditionally, all of the costs of supporting an

investment bank or brokerage house were recovered through this portion of the business.

The services provided to clients, such as research support and advice, were bundled into

the commission rate for purchasers of securities and into the spread on new issues for investment banks.

The heart of brokerage with retail clients has

been personal selling. The relationship between the investor and the individual broker

has been fairly constant, and typically, the accounts a registered representative develops

while with a particular brokerage house move

with him if he/she switches firms. Firms within

the industry have expended great effort in attempts to retain clients. The development of

new products unique to particular houses may

encourage a loyalty to the company rather

than to the broker. It is not yet clear how this

might change the character of the industry.

Most technology-encouraged competition is

occurring within the selling function of retail

and institutional brokerage. The end of standardized commissions on the sale of securities

(1975) has encouraged the entrance of discounters into this market. Discount brokers

complete trades for investors at prices that are

generally lower than the commission charged

by full-service brokers. Usually, the service

provided by discounters is limited; e.g., these

firms usually do not support extensive research and advice operations. However, they

do fill the needs of a portion of the market.

About 15 percent of trading by individual investors is handled by discounters.
Ch. 3—The Securities Industry ● 7 1

Access to information technology for individuals will facilitate direct selling of securities to investors without the interaction of a

broker. This type of system is particularly

adaptable for discount brokers whose service

is basically order-taking. C. D. Anderson &

Go., a small discount broker, developed the

first home brokerage system, and other brokerage houses are expected to enter this market. 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 convenience, without dealing with a broker.

Transactions

Congress mandated the development of a

computerized national stock market system

in 1975, believing that by linking all market

centers, such a market would expose securities to a greater number of buyers and sellers,

and an investor would have the chance to obtain the best price available. This system was

also expected to provide competition to

NYSE, which dominated the market with 80

to 90 percent of the trading volume.

The Cincinnati Stock Exchange was expected by many industry experts to become

the basis of an automated national stock exchange. The exchange was supported by Merrill Lynch, the largest firm within the securities industry. In July 1983 Merrill Lynch

withdrew a large portion of its business from

the Cincinnati Stock Exchange and returned

it to the floor of NYSE, noting that not only

had the Cincinnati Stock Exchange failed to

gain the volume anticipated, but that NYSE

had improved.

While NYSE is still largely based on a system of auction pricing and securities specialists, the adoption of systems made feasible by

the application of information technology has

allowed it largely to eliminate problems associated with high volume. In addition, communications systems have been developed that

allow users of NYSE to enjoy many of the

benefits of a national system by providing information on the activities of regional ex-

‘°Carrington, op. cit.

●

35-505 0 - 84 - 6 : QL 3

changes. One such system, the Intermarket

Trading System (ITS), may be seen as being

indicative of a trend toward a national market for securities trading.

ITS allows brokers, specialists, and market

makers to interact with their counterparts at

other markets. The system, maintained by

SIAC, currently involves eight stock exchanges: New York, American, Boston, Philadelphia, Cincinnati, Midwest, Pacific, and, to

a limited extent, NASDAQ.

ITS provides a mechanism through which

the most favorable exchange setting can be

chosen for a transaction. * At NYSE, the best

price from any member of ITS, as well as the

NYSE floor price, is displayed. If it is advisable for a trader to deal on an exchange other

than the one at which he is operating, he can

enter his order by contacting his counterpart

there. At the end of 1982, 1,039 issues were

eligible for trading on ITS. NYSE reports that

this represents most of the stocks traded on

more than one exchange.

The Designated Order Turnaround (DOT)

system was introduced in 1973 to route small

orders (599 shares or less). It reports electronically between NYSE and member firms.

DOT bypasses floor brokers by routing orders

directly to the appropriate trading post on the

floor of the exchange and, following execution,

back to the member firm on the same electronic circuit. Over 80 percent of the 5.7 million market orders processed through DOT in

1982 were executed and reported back to the

member firm within 2 minutes.31 This system

minimizes the cost to member firms of handling small transactions while giving small investors the benefit of timely execution of their

trades. DOT may also provide a better price

than would normally be received by a small

investor. A trade made through DOT is

matched by computer for price with the most

recent trade of that issue. The investor benefits because the price he receives may have

*For Purpows of this discussion, “transacting” is defined as

the physical execution of trades.

“New York Stock Exchange 1983 Fact Book, op. cit.
72 . Effects of Information Technology on Financial Services Systems

resulted from price negotiation on a much

larger order.32

Another technology-dependent system that

facilitates transacting is the Opening Automated Report Service (OARS). OARS makes

efficient and accurate processing of market

orders, that are received at NYSE prior to the

start of daily trading, possible without causing unnecessary delays in the opening of trading, and transmits computer-generated reports

to the originating member firm.33 This system

is especially valuable to specialists on days

with high trading volume, which have recently

been occurring with great regularity.

Future developments in transacting enhanced by information technology may include

the bypassing of intermediaries in the process of selling. Some experts believe that the

adoption of home information systems may

make it more common for investors to complete transactions between themselves privately or to gain direct access to exchange

floors. While it does not appear that the possibility of off-market trading is having a major impact on the individual investor at this

time, institutional investors have at times

found it advantageous to trade off-market.

About 500 brokerage houses, pension funds,

insurance companies, and other institutional

investors are linked through AutEx Systems,

a nationwide computer network. The potential

of this system for trading was demonstrated

by its use in creating a market in a stock for

which trading had been closed by NYSE. Jefferies & Co. is a discount broker specializing

in institutional trading. It is not a member of

any major exchange and therefore is able to

make a market in an exchange-listed stock

without going through the exchange. Following a request by a client, Jefferies announced

over the AutEx System that it was making

a market in the closed stock. The company

traded a total of about 8 million shares of the

stock off-market.34

3’Desmond Smith, “The Wiring of Wall Street, ” The New

York Times Magazine, Oct. 23, 1983, p. 109.

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

p. 33.

“Smith, op. cit., p. 73.

Given that the primary responsibility of securities exchanges is to maintain an orderly

market, technology, the great facilitator of

their operations, could also be a major undermining force for the exchanges. It is basically

meaningless to stop trading for a security on

an exchange if the end result is simply that

trading is moved off of the exchange and conducted without the prudent management of

the specialist. It may be essential for exchanges to continue trading a given security

in all but the most unusual situations.

Clearance and Settlement of Securities

Clearance and settlement activities consummate trades through the exchange of securities and funds.35 As with any marketplace, an

action recognizable to all parties involved is

necessary for finalizing a transaction. Given

the great number of participants in the securities industry, it is essential that transactions

be closed as efficiently as possible in a manner that is acceptable to all parties involved.

The increasing volume of trade and the continuing development of new securities products has made it necessary to refine settlement

and clearance. Since ownership is merely contractual until the process is finalized, delays

in settlement and clearance could have a severe effect on the operation of securities markets. An industrywide effort is under way to

move toward a national settlement and clearance procedure through the adoption of standardized proofs of ownership that are not paperbased, such as book entry, and to facilitate effective, marketwide clearance through the use

of automated systems that assist in the closing of positions.

Clearance and settlement are recognized as

an important portion of the national market

system. The formation in 1977 of the National

Securities Clearing Corp. (NSCC), for which

SIAC (Securities Industry Automation Corp.)

is facilities manager, encouraged movement

toward a national clearing system. NSCC combined the clearing corporations of NYSE, the

‘sNational Securities Clearing Corp., Annual Report 1980,

New York.

v
American Stock Exchange, and NASD. It has

provided more efficient clearing at lower costs

per trade for listed and over-the-counter

trading than was previously possible. SIAC

facility management for NSCC services integrates several major processes and entities

in the settlement process (see fig. 5).

One pivotal change in the settlement process was the development of Continuous Net

Settlement (CNS). CNS represented a change

in accounting approach to the provision of continuous net positions against the clearing system rather than a daily balance order accounting.” In addition to improving clearing

operations, savings recognized through the application of CNS have included manpower and

same-day delivery of securities. An important

link in this system is the Regional Interface

Operation, which allows member organizations to trade on any exchange and bring settlement to the clearing facility of their choice.

The Options Clearing Corp. (OCC), which is

owned by the options exchanges, is the clearing entity for options trading. It supports the

clearing members and participant exchanges

by acting as the issuer of all cleared and

settled options, guaranteeing option contract

performance and fungibility, and effectively

performing trade clearance, settlement and

associated clearing functions, and other securities industry services.37 The primary objective of OCC is to provide these services in the

most cost-effective manner.

Information technology has been essential

in the refinement of the clearing and settlement process. It will affect it further through

some changes that will be felt in the market

as a whole. If substantial trading is conducted

off-market, general access to the automated

settlement system may be demanded.

Pricing

Pricing occurs at two points in the securities industry: investment bankers assist in the

initial pricing of new issues, and exchanges ———

“Securities Industry Automation Corp., A Decade of Progress, New York, 1982, p. 8.

‘“The Options Clearing Corp., Annual Report 19/?1, Chicago.

Ch. 3—The Securities Industry ● 7 3

provide a framework for price adjustments for

securities. Price in its most pure form is a function of supply and demand. For securities, this

is generally defined to mean the net present

value of anticipated cash flow, in terms of

what is received in interest or dividends and

resale. Initial pricing decisions on new issues

are particularly sensitive for the securities industry since the risk associated with errors

usually falls totally on the underwriter. If the

price is not in line with value as perceived by

the market, the issue will not be bought.

Pricing for securities in secondary markets

may be done on a historic basis or by auction.

Automated trading systems are based on a

historic pricing mechanism; that is, the price

of an instrument is determined by its past

behavior. Prices in the auction system are

determined by market demand. Proponents of

this system believe that the auction gives a

truer evaluation of the worth of the issue and

is therefore beneficial in the aggregate to both

sellers and buyers.

The operation of the secondary market for

securities provides a method for correcting

prices. Securities specialists perform a pricing

function on exchange floors in fulfilling their

function of maintaining an orderly market.

The specialist, an independent businessperson,

performs this function as an auctioneer, buyer,

and seller of securities. He makes a value judgment about the opening price of a security at

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

The specialist facilitates trades by interested brokers on the floor and stands in as a

buyer or seller at times when demand and

supply on the floor do not mesh. By standing

in as a buyer or seller, the specialist maintains

an orderly market by assuring that price

changes occur in small increments. This allows

investors to assess the market situation of a

security in a rational fashion.

NYSE now offers a technology-based system through which investors can more easily

interact with the market when they want to

sell a security at a set price. The limit order
Figure 5.— Overview of SIAC Facility Management for NSCC Services

t 1

I

STOCK

BORROW” WR11{ E k

I

ORDER out

5ERI ILL I

+ +

+

CONTINUOUS

NET SETTLEMENT

+

.

r

DELI\’ERY

SER\’ICES

r & +

.~O~EY SE’1”’I’LE.MENT

-f-2&q

i

I

F+CORRESPO\Dt\T

DF1 .} & [ 011 F( I Io\

\ATIO\A!

TKA>\FER SFRY ICE

II

# ● ●

NOTE In addition to acting as faclllty manager for the National Securltles Clearing Corp , SIAC provides clearing serwces for AMEX options. AMEX gold coins and NYFE futures Support sewlces

are also provided for the Options Clearing Corp Paclflc Clearing Corp and Depository Trust Co

SOURCE. Securities Industry Automation Corp
Ch. 3—The Securities Industry w 75

————— — — ——. —-—— —.—

system electronically files orders to buy or sell

when a specific price is reached. These orders

are delivered to the appropriate trading post

or member firm on the floor. Orders can be

limited to a single day or to their cancellation.

In the context of the securities industry,

pricing has referred solely to the investment

instruments of corporations and organizations. Pricing can also be expanded to the actual services of the industry, whose basic functions are being unbundled. Although within

the securities industry pricing is most clearly

evident in the selling and advising function,

it is a factor throughout the entire financial

service industry. The securities industry may

have an advantage relative to other financial

service providers in this area because of the

expertise it has in analyzing markets and in

pricing issues.

Technology and the Functions

of the Securities Industry

Technology is changing not the functions of

the securities industry, but rather how they

are performed. The number of corporations

seeking financing, the number of potential investors, and the level of trading demanded

have all increased to levels that could not be

anticipated when the securities industry was

developing. The one element which has not increased is the number of hours in a day, and

technology makes it possible to overcome that

handicap in processing the level of activity

demanded by the market.

Time and distance are no longer obstacles

to communications for the securities industry.

Because of this, securities markets may become less location-dependent and, as a result,

less physically structured. It will be necessary

for the industry to make efforts to assure that

the basic purpose of the markets is retained.

Information technology will generate a

faster reaction by the securities industry to

changes in market conditions and consumer

demands because communications and computer capabilities may lessen consumer response time. The market can be expected to

operate at a more rapid pace, and while it may

be possible to monitor change more precisely,

this market will require quick and well-developed decisionmaking.

The Effects of Information Technology on

Securities Instruments

Securities instruments are designed to satisfy both the goals of investors and the need of

corporations and organizations to gather capital to finance industrial research and development and resulting expansion or diversification. Securities instruments are of interest in

discussions of the effect of information technology on the financial service industry for

several reasons. First, the direct impact of

technology on the securities industry, from the

point of view of the consumer, may be most

strongly felt in the way in which the characteristics of investment instruments are changed.

Second, the intrinsic characteristics of securities instruments may affect the way in which

they evolve in a technology-intensive environment. As information technology changes the

way in which the securities industry operates,

the relative importance of various investment

instruments may be affected by information

technology.

Third, interest in instruments that are now

on the market may be predictive of which investment products may best meet future demands of consumers in terms of liquidity, level

of risk, and return. This type of activity has

already been seen in the financial service market in the development of money market mutual funds, which were patterned after the idea
76 . Effects of Information Technology on Financial Services Systems

of mutual funds and met the consumer demand for more liquidity.

The development and trading of securities

instruments is largely dependent on the application of information technology. Such technology has also had a major impact on the

calculation and payment of return and the

recording of ownership. The rate of growth

seen in options and many types of futures contracts would not have been possible without

communications and computer technologies.

As securities markets become more technology-based, it must be expected that investment

instruments will also.

However, it is unlikely that technology will

be the sole cause of the development of any

new securities product, although it may

change the characteristics of some investment

products or expand their application to such

an extent that they are different in function

and operations. As a result of these changes,

both investors and their advisors will have to

examine their methods of evaluating potential

investments. The characteristics of investment instruments may be expected to change

in four ways because of the application of information technology: liquidity of instruments, the packaging of securities products,

the way in which potential investments are

analyzed, and the importance of speculative

markets.

The liquidity of an investment instrument

is determined both by the contractual term of

the instrument and the speed with which the

investor can trade or redeem the instrument.

New communications technologies, notably interactive cable and the adoption of personal

computers with networking capabilities, have

been applied to allow investors greater access

to securities markets. For example, systems

available to individual investors provide updated information continually on price and significant activities involving securities in which

the investor is interested. Easier access to this

information changes the way investments are

analyzed by making it easier for the investor

to make decisions on his portfolio in a short

time frame.

Securities products are being packaged,

often with products from other financial service industries, to fill a wider range of investors’

financial needs. This trend is likely to continue

as the number of investment options increases

and the demands of users become increasingly

more complex. Much of the new product development that will be seen in securities markets

may result from the increasing role of speculative markets. The ability of investors to use

speculative markets is increased by the application of information technology.

Appendix 3A: Securities Instruments

This appendix describes, the characteristics of

debt and equity instruments as well as options and

future contracts. The relationship of information

technology to these products and the future effects

of this technology are outlined.

Corporate Capital Structure:

Debt and Equity Issues

The capital structure of a firm is determined by

the mix of securities it issues. Capital is developed

through internal sources—i.e., retained earnings—

and through the issuance of debt and equity. A

corporation tries to maximize its market value

through this structure. There can be as many

unique capital structures as there are corporations.

The financing plan chosen reflects the operating

and growth objectives of the organization.

While the basic purpose of all debt and equity

issues of a firm is the same, to gather capital, they

represent different costs and concessions for the

issuing organization. The return offered and risk

involved for the investor also differs substantially.

When debt is issued through bonds, the investor

becomes a creditor to the organization; the firm

assumes a noncontingent obligation to pay the investor a definite sum of money. Equity issues

grant ownership in the corporation in return for

investment. Such shares of stock represent owner-
Ch. 3—The Securities Industry ● 7 7

ship rights proportional to the value of the share

of the firm purchased at the time of investment.

Financing through debt is developed both

through money markets and capital markets.

Money markets are basically wholesale markets

whose major function is liquidity management.

They are centered on short-term instruments

through which organizations can manage such

operating factors as cash flow. Capital markets

are centered on long-term securities, including

both debt issues and stock, and represent the

development of financing for long-term projects

and goals for the organization, such as equipment purchases, research and development, and

expansion.

Long-Term Debt—Corporate Bonds

When money is borrowed on a long-term basis,

the contract representing this debt takes the form

of a bond. A corporate bond is a fixed, noncontingent, long-term obligation to pay a definite sum

of money and interest on that amount. The fortunes of the corporation affect the resale potential of the security but cause the bondholder neither benefit nor loss in terms of return, assuming

that the corporation does not default on the issue.

The market value of the instrument is the present value of the payments stream to the investor,

using market interest rates. The bondholder is a

creditor to the corporation and as such has a claim

on the assets prior to any by the owners. Corporate

bonds have a fixed return, known as a coupon rate,

and a specific maturity. The financial benefit the

investor realizes from the bond depends on market conditions at purchase and investment opportunities at the time of maturity. A bond issue may

be distinguished in several ways, most notably:

how the contract is guaranteed in case of bankruptcy, call provisions, registration, the way in

which interest is paid, and the way in which the

bond issue is retired.

SECURED AND UNSECURED BONDS

Bonds may be classified as secured, or mortgage, bonds or unsecured bonds, called debentures. Mortgage bonds are backed by specific corporate assets and were historically most popular

among regulated industries, such as railroads and

utilities. A closed-end provision in a mortgage contract requires that the corporation secure no additional bonds on the lien. The majority of contracts, however, include an open-end provision

that allows for the issuance of additional bonds

against the property. From the investor’s point of

view, the value of the mortgage lies more in the

potential resale value of the pledged property in

the case of corporate failure than in the exclusivity

involved.

Debentures are guaranteed by the general credit

of the corporation. They have become the most

popular form of bond issue across the economy and

are particularly useful for industries in which

many assets may be intangible, such as in publishing, or have a limited lifecycle, as is the case in

many high-technology industries. Most issues of

debentures include a negative pledge clause that

provides that the firm will issue no new debt having priority over the bonds covered by the agreement. This helps ensure that the risk to the investor does not increase over the life of the bond.

Debentures are usually subordinate to bank loans

and short-term debts.

BEARER BONDS AND

FULLY REGISTERED BONDS

Registration of bonds affects the extent to which

the investor is protected in case of loss or theft,

the way in which interest is paid, and the ease with

which ownership can be traced and transferred.

The ownership of a fully registered bond is recorded in the register of the issuing organization

or agent. Company records comprise proof of ownership, and interest is paid directly to the holder

of record. If the bond is traded, the issuer or agent

must be notified so that ownership rights may be

transferred.

For a bearer bond, the certificate issued at the

time the debt instrument is developed is the only

proof of ownership. Ownership rights are enjoyed

by whoever has possession of that certificate at

the moment. Many investors find that the ease

with which the bonds may be transferred and the

lack of traceability outweighs the risk of losing the

paper. This type of bond is an extremely flexible,

cashlike instrument.

Whether a debt instrument is a registered bond

or a bearer bond affects its value and appropriateness as an investment for particular investors.

Since July 1, 1983, the Federal Government has

required all new bonds to be registered to make

it easier for the Internal Revenue Service to determine to whom interest is paid and to trace any

changes in ownership. However, there is still a significant secondary market in bearer bonds. ’ As the

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

p. 97.
78 ● Effects of Information Technology on Financial Services Systems

bearer bond is eliminated from the market, some

increase in demand for different instruments that

safeguard the privacy of the investor to a similar

degree may be expected.

A significant difference between bearer and registered bonds from the point of view of both issuers and investors is the way in which interest is

paid. The holder of a bearer bond initiates the payment of interest by depositing the appropriate coupon at the financial institution of his choice. Federal Reserve collection mechanisms are used by the

institution to obtain credit for the interest due.

Usually, the depositor is paid the interest by the

financial institution prior to the completion of this

process; in most cases, immediate use is granted.

The payment system for bond coupons is extremely paper-based. The physical coupon “follows” the

collection process.

Greguras and Carlile suggest that as new technologies make it possible to record essential information in the physical coupon in a format that can

be used by electronic systems, this type of system

will allow financial institutions quicker access to

their funds and, as a result, benefit the investor.’

Information contained in the coupon could be

transformed to electronic form at the point at

which the coupon enters the redemption process.

The electronic system proposed would result in

little, if any, change in the action required by the

investor. Presentation of coupons would remain

the same; from the investor’s viewpoint the coupon is already truncated since it is never returned

to the holder. Cost-saving benefits result for the

issuer of the bond, the paying agent, and the financial institution used by the bondholder. Greguras and Carlile point out that computer sort capability could replace the current labor-intensive

system used by issuer and holder.3 The electronic

system would be faster and would facilitate the development of computerized bookkeeping and settlement systems. It is not clear how the end of new

issues of bearer bonds will affect the possibility

of automating the interest payment process, although the potential application of this type of

system will naturally decline.

The payment of interest on registered bonds is

easier because the paying agent knows the holder

and initiates the payment process. Greguras and

Carlile note that there is a great potential to use

automated clearing houses (ACHS) for these transactions, Following the issuance of a payment or-

‘Fred M. Greguras and Larry L. Carlile, “The Use of Electronic f3anking for Bond Coupon Payments, 1980.

‘Ibid.

der specifying which accounts should be paid by

the bond issuer or paying agent bank, the ACH

could take responsibility for routing these interest

payments, which would be credited to an account

specified by the bondholder. Savings would result

from the elimination of check-processing costs.

RETIREMENT OF BONDS

Bonds may be retired by payment at final

maturity; by conversion to common stock if the

instruments are convertible; by refunding, through

enacting a call provision; or through periodic repayment, if the bond is a sinking fund or serial

bond issue.

Many bonds contain a provision allowing the

corporation to “call” or repurchase the debt instruments at any time. This gives corporations

flexibility if market conditions change before the

bond matures. The call price is usually above the

face value of the bond, but generally this premium

decreases as the maturity date is approached. A

corporation may move to call a bond because of

a drop in market interest rates or to be free of restrictive protective covenants that may have been

necessary to gain financing initially. The initial

debt contract specifies whether the call provision

is immediate, that is, can be invoked at any time

following issue, or deferred, in which case the investor is assured that no call will take place for

a definite period of time, usually 5 to 10 years.

Call provisions become a disadvantage to investors when the stable return anticipated when the

debt instrument was selected for investment is

lost. The investor may find it necessary to select

an alternative investment. If interest rates have

dropped since the original investment, the investor

must not only bear additional transaction costs

but also, in some cases, select between less attractive investment alternatives.

For tax purposes, the income gained by the investor from the call premium is treated as a capital gain. For the corporation it is deducted as an

expense from ordinary income. Many experts believe that the net tax advantages received by the

investors and the corporation make call provisions

attractive to both parties.4

Refunding involves the replacement of one bond

issue, prior to maturity, with a new issue of bonds.

A corporation may wish to refund an issue to escape restrictive protective covenants, but the most

common reason is to take advantage of a drop in

‘James C. Van Home, Financial Management and Policy (Englewood

Cliffs, N. J.: Prentice-Half, Inc., 1983), p, 555.
Ch. 3—The Securities Industry ● 7 9

market interest rates. Market conditions must be

extremely favorable for the issuing corporation to

justify the expenses involved in refunding, which

include the cost of calling the old bonds, issuing

the new bonds, and, possibly, expenses resulting

from the payment of interest on the old bonds during any overlap period.

The repayment of a total issue of bonds at maturity could present a severe cash strain for the

issuer. Therefore, two methods have been developed through which debt issues are retired in a

more controlled and gradual manner: the issuance

of serial bonds and sinking fund provisions. Serial

bonds give an investor a choice of maturity dates.

The entire package of bonds is issued by the corporation at the same time, but the bonds mature

individually in successive years.

Most bond issues carry a provision requiring

that the corporation retire a given number of

bonds per year through a sinking fund managed

by a trustee. The bond issuer makes payments into

the fund, with which the trustee finances the retirement, by calling or purchasing bonds selected

(usually) by lottery. While calling before the anticipated maturity date may be undesirable for the

investor, most investors value the assurance of orderly retirement of debt and liquidity provided by

a sinking fund provision. For bondholders whose

instruments are not called, the sinking fund may

represent a reduction in risk, as the total amount

of debt the organization holds is continually

reduced.

PAYMENT OF INTEREST

The return of most debt investments is embodied in a periodic interest payment referred to as

the coupon. It is designed to compensate the investor for the time-value of money, the lost opportunity cost, and the risk assumed. Usually, this

is a semiannual payment. The market value of the

bond is determined by the present value of this

stream of payments. Bonds with less traditional

payment schedules have developed in response to

market pressures. These include income bonds,

zero- and low-coupon bonds, indexed bonds, and

floating-rate bonds.

While most bonds are strictly debts of the corporation, for which interest must be paid regardless of the corporation’s financial situation, interest is only paid on income bonds when the earnings

of the corporation permit. The corporation benefits

from the tax advantages of debt, since any interest

paid is deductible because it is part of a contractual agreement, Also, unlike preferred stock, which

is discussed later, the decision to pay interest

belongs to management rather than the board of

directors. If not paid, interest accumulates and is

senior to preferred and common stock dividends

and subordinated debt.

Income bonds are unpopular with investors because the income stream from their investment is

unpredictable. Some experts also believe that the

past association of this instrument with corporations, particularly railroads, trying to avoid

bankruptcy has made them unattractive to investors. As a result, income bonds are used primarily in reorganizations, which of course may

perpetuate their negative image.’

Return paid on a zero-coupon bond is embodied

entirely in price appreciation to maturity. No periodic interest payment is made, This bond offers

two advantages to the investor: the bond cannot

be called, so the holder experiences no reinvestment risk, and an exact return is assured if the instrument is held to maturity. For tax purposes,

the investor must declare the interest accrued in

a given year as interest income, despite the fact

that this money is not available for his use. The

corporation also deducts the interest expense for

the year accrued, although no actual payment is

made. While the corporation enjoys the advantage

of no cash outlay until the maturity date of the

bond, the no-call provision is a disadvantage if

market interest rates fall during the lifetime of the

bond,

Two types of bonds, floating-rate and indexed,

have become more popular in response to the concerns of both issuers and investors that long-term

debt instruments have generally been locked into

a rate of interest that reflected market conditions

at the time of issue, but that may not be desirable

if market conditions change. For example, floatingrate bonds, which include instruments for which

the interest rate is set in relation to 90-day Treasury bills, may be attractive to an investor who

believes that interest rates are likely to rise during the lifetime of the bonds, and to an issuer who

feels rates will fall. To both parties the uncertainty

about the return that will be received and the cost

of the borrowed funds may be disadvantages.

The return on indexed bonds is tied to the rate

of inflation and therefore is considered fixed in real

terms. These bonds become popular in times of

high inflation. In theory, any index can be selected

as a basis for setting the rate paid on this type of

6

1 bid., p. 551,
80 ● Effects of Information Technology on Financial Services Systems

bond; however, in the United States the Consumer

Price Index is generally used.

Information technology may be expected to increase the number and complexity of different

types of interest-paying plans for bonds. Indexed

and floating rates can be designed to respond more

quickly to changes in the base line on which interest is determined. This may result in some confusion for bondholders, as change may occur at such

a rapid rate that the logic behind it may not be

perceived. More complex interest-paying arrangements will require special attention to the disclosure of these bond characteristics for investors,

a role likely to be the responsibility of brokers and

issuers of bonds.

RATING OF BONDS

Two highly respected rating services for bonds

are Moody’s Investors Service and Standard and

Poor’s. Their ratings result from an analysis of the

financial and business propects of the issuer and

are used by individuals and financial institutions

as a tool for assessing risk.

Moody’s Investors Service offers nine possible

ratings, ranging from a low of C, which represents

extremely poor prospects for the issuer, to a high

of Aaa, which represents an extremely low amount

of risk and predicts that it is unlikely that any negative change will affect the issue. Generally, organizations with poor ratings must pay a higher rate

of interest to borrow funds to compensate lenders

for risk.

It is rare for the rating of an issue to change.

Any reevaluation by Moody’s or Standard and

Poor’s indicates a very substantial change in the

condition of the issuing firm and attracts a great

deal of attention from investors.

Those bonds that Moody’s rates “Baa,” the

fourth highest rating, or above are considered

investment-grade bonds. Some financial institutions, including some commercial banks and many

pension funds, are not allowed to invest in any

issues that do not make this grade. Some experts

believe that rating services have caused certain

types of organizations, particularly municipal governments, to pay higher than warranted interest

rates because of unfavorable and perhaps somewhat subjective ratings.6 However, investment

counselors and investors still rely heavily on the

rating services.

Information technology may be expected to

create more competition in rating bonds as the

capacities of new online computers and interactive

cable are explored. As technologies become more

sophisticated and interactive systems become less

costly, it has become possible to personalize rating

services to the objectives of the individual investor

in real time.

BOND TRUSTEES

As will be discussed later, the interests of the

shareholders of a corporation are represented by

the board of directors. Bondholders have a special

representative—the trustee—who is not part of

corporate management and who is expected to act

in bondholders’ best interests. Paid by the issuing corporation, the trustee is usually a commercial bank. The responsibilities of the trustee for

bond issues over $1 million are specified in the

Trust Indenture Act of 1939 and involve protecting the rights of the bondholders by ensuring both

that the initial contract is legal and, following the

issue, that the corporation fulfills its contractual

responsibilities to the bondholders. This act, which

is administered by the Securities and Exchange

Commission (SEC), requires that the trustee act

strictly in the best interests of the bondholders.

It is the responsibility of the trustee to act to

protect the interests of the bondholders if the company is in default—that is, fails to meet the provisions of the bond contract. This responsibility has

been brought to the forefront by the recent default

on Washington Public Power Supply System

(WPPSS) bonds. A problem the bond trustee appears to be encountering is reaching and purveying information to the 78,000 holders of the bonds.

in spite of the press received by the WPPSS default and the efforts by the trustees to reach and

inform bondholders, it appears that, prior to the

first missed coupon payment on the WPPPS bonds,

many bondholders did not know or did not understand that there was a problem.7 Communication

technology may facilitate attempts by the trustees

to reach bondholders in the future by improving

information flows and corporate recordkeeping.

THE EFFECT OF INFORMATION

TECHNOLOGY ON LONG-TERM

DEBT INSTRUMENTS

Long-term debt is likely to remain a significant

‘Brealily and Myers, p. 468.

part of corporate capital structure. Information

‘Lynn Asinof, “WPPSS Begins to Cause Pain for Investors, ” The

Wall Street Journal, Dec. 28, 1983, p. 15.
—

Ch. 3—The Securities Industry

— .—.——. . —

technology may change the approach of organizations searching for finance and investors seeking

debt instruments as the following impacts of the

main advantages of automated systems are felt:

increased speed of handling information, more

precise and less expensive analysis, and improved

communication systems.

Equity

A firm may also decide to gather capital through

issuing equity, or ownership rights, in the form of

corporate stock. The investor receives with the

shares of stock he owns rights proportional to the

total amount of stock issued by the corporation.

Equity capital strengthens the balance sheet and

enhances the future borrowing power of the company. Decisions to issue debt or equity are usually based on what will maximize the market value

of the corporation.

From the point of view of potential investors,

the purchase of equity may give the opportunity

to share in the growth of the company. As some,

if not all, of the return received may be in the form

of capital gains, the investor may find a tax advantage in equity investments. Equity shareholders

may also receive an income stream in the form of

dividends as a form of return on their ownership,

In some cases, this return may be greater than

what would be realized from a debt investment.

While tax laws have been subject to change, at

times there have been tax advantages from income

in the form of dividends rather than interest.

A firm may sell equity in two forms: common

stock or preferred stock. The choice will depend

on the financial structure and objectives of the corporation and on industry and market conditions.

The equity profile of a corporation may be extremely complex. Both common and preferred

stocks may be issued, and several varieties of preferred stock may be active simultaneously.

COMMON AND PREFERRED STOCK

Common stock is generally more significant

than other types of securities in the capital structure of a firm. The holders of common stock have

residual rights to the income of the firm, which

they usually receive in the form of dividends. At

the same time, the liability of individual shareholders is usually legally limited, particularly for

the debts of the corporation. Additional rights of

holders of common stock include a claim on company assets in the case of bankruptcy, following

the claims of creditors and holders of preferred

● 8 1

stock; the right to maintain their share of ownership through purchase of new shares issued by the

corporation; the right to information on the operation of the firm, to the extent that it is competitively feasible; and the right to transfer ownership

to another investor.

The most significant benefit for the owner of

common stock is the right to maintain control of

the corporation through the election of the board

of directors, who in turn appoint the officers of the

firm and represent the interests of the holders of

equity in the firm. The management of the corporation is expected to act in accordance with the

goals of the owners and to be accountable to them

through the board.

Preferred stock is considered a safer investment

because holders of these shares have a claim on

the assets of the company before holders of common stock, although after the holders of debt, in

the case of bankruptcy. Owning such stock also

carries a prior claim to income in the form of

dividends. However, the preferred stockholder

usually enjoys only limited voting rights, so that

he has less impact on the operation of the corporation than do common stockholders.

DIVIDENDS

Depending on the corporation’s profits, corporation earnings may be used to pay dividends to

stockholders at the behest of the board of directors. Dividends are only declared when the payment will not impair the operation of the firm or

legally compromise its contractual relationships.

tionships.

Two significant dimensions of the dividend policy of a corporation are dividend stability and longrun dividend payout ratio. a A dividend may be

stable in terms of real dollars paid out or in the

ratio of dividends to earnings. While the latter

may appear more rational, it is rarely used. Consideration of the return expected by stockholders

has led most corporations to pay a stable dollar

dividend when possible, indicating the importance

of income as a motivation for investing in equity

issues.

Decisions on long-run dividend payout ratios

may be based on the objectives of the owners and

management of the firm. The reinvestment of a

significant portion of earnings may result in higher

growth for the corporation as a whole and maybe

attractive to investors desiring long-term income

‘Lawrence D. Schall and Charles W. Haley, Introduction to Financial Afanagement (New York: McGraw-Hill, Inc., 1980), p. 366,
82 ● Effects of Information Technology on Financial Services Systems

in the form of capital gains. In this case, earnings

are used as a form of internal financing, and any

dividend paid is from earnings left over after

financing objectives are met. If the shareholders

of the corporation are interested in more immediate income, a fixed payout may be used. In this

case, the amount of money available for internal

financing would differ from year to year as it

would be, in a sense, the residual part of earnings.

THE EFFECT OF INFORMATION

TECHNOLOGY ON EQUITY

Information technology may be expected to affect equity instruments directly in three areas: the

payment of dividends, the recording and proof of

ownership, and the transfer of ownership. The

transfer of ownership of stock will be examined as

a function of the securities industry in a later

section.

The improved ability of shareholders to monitor and analyze the activities of corporations more

directly through the use of new technologies may

also have some impact on individual firms. The

magnitude of this impact will largely depend on

the characteristics of the ownership of the corporations involved. An increased awareness by the

shareholders of the environment and operation of

the firm may be a benefit; however, managements

and boards of directors may find an increased demand for information dissemination and responsiveness.

Detailed records are maintained on who the corporation’s shareholders of record are to assure that

they receive their ownership rights. While traditionally this operation was solely paper-based and

involved the issuance of certificates that served

as proof of ownership, there is some indication that

the application of information technology is facilitating a movement toward a book entry system.

This type of arrangement is expected to benefit

the issuers of equity by lowering operating costs,

including those of printing and postage, and to

benefit the holders of equity by making it easier

to transfer ownership of these securities.

Book entry may require some adjustment by

shareholders because the mechanics of proof of

ownership will differ. The success of this type of

program will depend largely on how apparent and

important the benefits involved are to the investor, particularly when trading.

The mechanics of developing a dividend policy

may be aided by the application of information

technology; however, the value of improvements

in communications and computer capabilities is

likely to be most directly felt in the actual paying

of dividends. Operation costs for this activity may

be expected to decline as recordkeeping and sorting activities can be automated. It may also be

possible to use electronic funds transfer for the

payment of dividends. While initial costs for this

type of system may be high, the resulting efficiencies and the decrease in postage costs may be of

great benefit.

Convertible Securities

Preferred stock or bonds that can be converted

to common stock at the option of the holder are

called convertible securities. Such securities offer

a middle ground to investors who demand lower

risk than common stock carries yet want to participate in the growth of a corporation.

Convertible bonds offer both interest payments

and conversion opportunity. This instrument is attractive for the issuing corporation because generally a lower-than-market rate of interest may be

offered, owing to the conversion option. A corporation may view a convertible bond as both a shortrun debt and long-run equity issue without the

cost of two separate issues. Convertibles are considered deferred common stock financing. These

instruments were also traditionally attractive to

new or speculative corporations unable to gather

equity capital on other terms or to corporations

with low-grade credit ratings.

Compared to the issuance of common stock, the

issuance of convertible bonds creates less dilution

of earning per share at the time the bonds are first

offered and at the time of conversion. At the time

the bonds are issued, no stock is involved; at conversion, the size of the conversion generally adds

fewer shares than a new issue of common stock

would. Usually, it is expected that the financial

condition of the issuing firm will be improved in

both yield and stability at the time of conversion,

as indicated by the fact that the conversion price

is higher than the market price of the common

stock at the time the bond is issued.

The stock package stipulated in the conversion

plan may be more favorable to the organization

than one designed later when changing market

conditions could be taken into account. The expectations of investors for the common stock provision may be less stringent at the time the bonds

are issued because of both the benefits to be received before conversion and the anticipation of

participating in corporate growth at the time of

conversion.
The tax provisions of typical convertible bonds

may be beneficial for investors. The conversion of

the bond to common stock is considered a tax-free

transaction by the Internal Revenue Service. The

year-plus-one holding period for long-term capital

gains on any subsequent sale of the common stock

is counted from the time the bond, not the stock,

is issued.

One variation on convertibles that often results

from failed takeover bids is the exchangeable

bond, which can be converted to the stock stipulated in the bond contract of a corporation. This

stipulated stock may be issued by someone other

than the issuer of the bond. The exchangeable

bond requires the investor to evaluate the credit

potential of the issuing corporation and the longrange growth and earning potential of the firm

whose common stock is involved. Tax provisions

must also be a major concern for such an investor. g

The Internal Revenue Service considers this conversion to be the equivalent of two cash transactions because the securities of two different corporations are involved. Since the bond would not

be redeemed by a rational investor unless the stock

sells for more than the original cost of the bond,

a taxable gain is realized.

Recently, the interest in this bond instrument

by both corporations and investors has grown.

While in the past institutional investors dominated this compromise market, individuals are

becoming more active. Information technology

may be expected to affect convertible instruments

to the extent that it makes more sophisticated

analysis cost effective for investors and financial

intermediaries, and therefore the complex nature

of the instrument may be less of a disincentive to

potential issuers and investors. Growth in this

area may be expected, however, to be related primarily to the fiscal needs of corporations involved

and to the demands of consumers.

Short-Term Debt–

Money Market Securities

The essential characteristic of money market

securities is their liquidity. This derives from their

short maturity, by definition less than 1 year, and

the generally high quality of the issuing organization. ’” There are several types of money market

—

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

p. 191.

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

The Accumulation and Allocation of Wealth [New York: McGraw-Hill,

Inc. 1974), p. 14’7.

Ch. 3— The Securities Industry ● 83

securities and, as the market demands, it is likely

that additional instruments will be developed.

These short-term debt instruments include Treasury bills, certificates of deposit, commercial paper,

bankers’ acceptances, and repurchase agreements.

They are important to corporations in money management as both financing tools and investment

tools.

A Treasury bill is a short-term debt of the U.S.

Government. The bills are sold on an auction basis

at a discount from face value. Since the U.S. Government is continually borrowing to pay off debts,

Treasury bills are issued on a very frequent basis.

Biddings are closed by the U.S. Treasury weekly

for 91- and 182-day debt issues and monthly for

9- and 12-month bills. Short maturities and the

backing of the U.S. Government make them desirable investments.

Although the market is quite short-term, an active secondary market has developed. Therefore,

bills can be traded before the maturity date, adding to their liquidity. Treasury bills are a desirable

short-term investment tool for corporate investors

because of the high level of liquidity and low level

of risk they carry.

Commercial paper is a short-term debt issued by

finance companies and some other corporations.

Interest rates for commercial paper are generally

higher than for Treasury bills because of the risk

factors involved in private firms. Many companies

use commercial paper to supplement bank loans.

In general, it is a less expensive method of financing for prime quality obligatory than loans (because banks are not used as intermediaries) and

may fill a need at a time when the issuance of longterm debt is not appropriate. The issuance of commercial paper lacks the supportive, interactive

nature of a relationship between a corporation and

a commercial bank.

Commercial paper may be sold directly by the

issuing corporation or through a dealer. Since

dealers screen the instruments to a certain extent,

commercial paper placed by a dealer may be less

risky for an investor, although commercial paper

directly placed by some major corporations is of

very high quality. The investor holds an unsecured

short-term promissory note as evidence of the

debt, and the instrument is tradable in money

markets.

Commercial paper is designed to avoid a requirement of registration with the SEC. Because of past

problems in commercial paper markets- specifically, those generated by the bankruptcy of Penn

Central-investors have caused the market to
84 ● Effects of Information Technology on Financial Services Systems

become quite conservative. Commercial paper of

companies that do not have a very high financial

reputation is rarely marketable.

Banker-s’ acceptances, which originated at about

the same time as international trading, continue

to play a significant role in importing and exporting. A banker’s acceptance is issued by a corporation and guaranteed by a commercial bank. The

acceptance is a liability of the bank and is traded

in money markets based on the reputation and

credit standing of the bank. The instruments are

of value in international trade, owing to the timelags that can occur because of the physical aspects

of transporting goods and because of the uncertainty with which many traders approach foreign

markets.

Certificates of deposit are negotiable securities

issued by commercial banks. They have fixed maturities and pay interest to maturity. Yields on certificates of deposit are higher than for Treasury

bills and are paid at the time the certificate

matures, The risk associated is dependent on the

quality of the issuing bank. Certificates can be

traded in a secondary market before maturity; this

market is particularly active for the certificates of

deposit issued by major commercial banks.

Repurchase agreements stipulate that the shortterm securities sold will be repurchased by the

seller. They are frequently issued by bond dealers

to finance inventories. U.S. Government securities

are the usual basis for the agreement through

which an investor “purchases” the securities while

agreeing to resell them at a specified time and

price. The term of repurchase agreements may be

for several months or for overnight, and therefore

has the potential to offer a great deal of flexibility.

Major questions involving repurchase agreements center on the level of risk involved and how

the transaction should be classified. Historically,

repurchase agreements were considered extremely

safe transactions, although they are not federally

insured, because they involve Government securities and are handled by recognized players in the

financial service industry. However, recent collapses of dealers caused some investors to experience high losses.

The qualification of repurchase agreements as

a sale or debt has created some controversy

throughout the financial service industry. The Internal Revenue Service has held that it is a collateralized debt, and therefore the investor would

be liable for interest income received. Dealers in

Government securities sales disagree and consider

the instrument to be a purchase/sale agreement.

Congressional action is expected to confirm this

stance. 11

The short-term debt market has been greatly affected by the use of information technology. The

nature of some short-term debt includes a definite

end-date for the instruments. Improvements in

sorting and transacting brought about by computer capabilities may extend the effective lifecycle

of the instrument since it can be marketed more

quickly. The availability of better data and the improved ability to analyze information about the

debt instrument and about the issuing organization may affect the market for short-term debt instruments. The potential of short-term debt instruments as investment tools may be expected

to improve to the extent that the application of

technology will refine this evaluative process.

Information technology may also improve the

packaging of short-term debt instruments by allowing securities industry marketers to match better the characteristics of various instruments to

the demands of investors. The proliferation of

money market mutual funds and demand accounts

may be a result of this opportunity.

Options and Futures Contracts

The capital market investor’s investment goals

may not be completely met by debt and equity

issues. The desire of investors to increase their liquidity or return or to limit risk has led to the development of instruments that comprise what may

be considered a second-tier securities market.

These securities are based on the fortunes and fluctuations of capital markets, but are not essential

to the capital structure of individual firms.

Off-shoot investment products include options

on stocks and bonds and futures contracts on commodities, currencies, and market indices. These instruments are all based on the market behavior of

underlying products or securities. The interest of

the investor is focused on the price fluctuations

of the product, usually in a relatively short time

frame, rather than on the intrinsic operations of

the firm. Interest in options and futures contracts

investment has led to the development of an industry structure specializing in these products, including exchanges and clearing corporations. The

development of this structure has increased interest in the products and has led to further growth

in option and future contracts trading.

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

p. 74.
Ch. 3—The Securities Industry ● 8 5

Options

Options provide a method of participating in a

securities market without ownership of actual debt

or equity instruments. An option is a tradable instrument that grants an investor the right to buy

(a call option) or the right to sell (a put option) a

specific security at a given price for a limited

amount of time. It is a legal contract in which two

factors are explicitly stated: the expiration date

and the exercise price. The value of an option is

directly related to the market price of the underlying security. The exercise price of an option indicates the change anticipated in the market. The

exercise price of a call option (at which the investor

can buy the underlying security) is, at the time the

option is issued, generally higher than the market

price of the security. Conversely, the exercise price

of a put option, which entitles the holder to sell

the security, is generally lower than the market

price. Options may be written and sold for real

estate, debt instruments, and foreign currencies;

they have recently become most significant in

equity markets.

Options are “wasting assets”; that is, after the

specified expiration date, they have no value.

Therefore, the timing of market changes, as well

as direction, must be correctly evaluated by the

investor to assure that the potential value of the

investment is realized. The writer of an option, except for warrants, which are discussed below, is

not controlled by the organization named in the

underlying security. More shares of stock may be

represented collectively through outstanding options than have been issued by the corporation.

While option writing and buying may be part of

a complex investment portfolio that includes debt

and equity instruments of an institution, the operations of option markets are, in a practical sense

at least, totally separate from the capital structure

of a corporation.

While options have been traded among individuals for many years, the market has grown and

become more sophisticated since the organization

of regulated exchanges in the mid-1970’s. The

trading of options entails a relatively new market

structure; therefore, the influence of information

technology on this structure is quite visible. For

example, options use book entry rather than certificates as proof of ownership.

PARTICIPATING IN THE OPTIONS MARKET

Participants in options markets attempt to profit from their knowledge of the potential declines

and rises of a corporation but have no direct stake

in its operations. In the basic options market,

players may be involved in four activities: buying

call options, buying put options, writing call options, or writing put options.

An option buyer hopes to profit from or protect

himself from a change in the price of the underlying security. The holder of a call option has the

right to buy a security at a specified price. This

investor may do three things with this right: exercise it by buying the underlying securities, sell

it to another investor, or let it expire. He has no

legal obligation to make any transaction of the

underlying security. Further action on his part involving the contract is self-motivated and 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 conditions

specified in the contract. His continued involvement with the instrument is not voluntary and,

while in some cases may not be required, is legally

enforceable. Both writers and buyers of options

can liquidate their positions by purchasing offsetting options before the expiration or exercise

of the option.

The motivation of an investor to buy a call option may be related to two separate strategies. He

may hope to participate in the benefits of a rise

in stock prices with a limited current investment

and therefore may buy call options to achieve

leverage or establish a future price at which he

plans to purchase the security. He may also be

motivated to purchase call options to limit risk,

either as part of a conservative overall investment

strategy or to hedge a short stock position.

For the individual investor, leverage may be

measured through the percentage of total assets

necessary to invest for a given rate of return. It

is assumed that the financial assets of an individual are finite and that each investment decision is evaluated by its opportunity cost. Achieving leverage could be the motivation for buying

call options for an investor who expected the price

of an issue to rise. The cost of buying a call option

for a given number of shares of stock represents

a much smaller investment than does the purchase
86 • Effects of Information Technology on Financial Services Systems

of the shares. A higher percentage of return on investment may result in the case of a rise in the

price of the stock to the holder of a call option.

However, it must be recognized that with a highly

leveraged investment, a larger share of the investment may be lost. Since options are wasting assets, the investor must be correct in his evaluation of the timing as well as the likelihood of a price

increase in order to profit from his purchase of options. If the option expires without being exercised, the investor’s loss would be equal to his investment. Absolute return or loss will usually be

lower for the option investor than if he held the

equivalent number of shares of stock.

Options are also bought by investors who would

like to invest in the underlying security and expect its price to rise but who do not have the cash

to make the investment. The call option establishes a guaranteed maximum price for the security. This strategy is particularly useful if the investor anticipates receiving a flow of cash before

the expiration of the option. If the price of the

stock falls below the exercise price, the investor

may purchase the security at the market price and

consider the option a sunk cost.

While investment in options increases the leverage and establishes the price of future stock for

the investor, the lower dollar investment required

to buy call options rather than stock limits absolute risk, since the investor exposes less of his

assets to the market. A common, conservative investment strategy is to purchase call options and

invest the difference between the options and the

price of the underlying security in a low-risk instrument, such as Treasury bills. Any loss incurred through the options investment would be

at least partially off-set by the interest earned on

the investment of the remainder.

Decreasing risk may also motivate an investor

to purchase call options if he maintains an extremely risky position in equity markets by selling short, that is, selling securities he does not own

in anticipation of a price decline. This investor

theoretically exposes himself to unlimited loss if

the price of the stock increases because he would

be forced to pay market prices to deliver the securities. By buying call options, the investor who

takes a short position establishes his maximum

purchase price for the securities he is selling and

therefore insures himself against limitless loss. Of

course, if the market behaves in the manner anticipated by the short seller, the price of the option

is lost profit.

While the buyer of call options generally acts in

anticipation of increases in the price of the underlying security, the buyer of put options attempts

to profit from or limit risk if the price declines. The

option grants the holder the right to sell at an established price, and therefore it can be used for

leverage and for limiting risk. As with call options,

the investor must have correctly analyzed the direction of the price change and the timing of the

change in order to profit.

The conservative investor can use put options

as a hedge against a substantial decline in the price

of a stock he holds. This strategy may be particularly attractive as protection for an individual who

has a significant portion of his assets invested in

a single security. However, it must be recognized

that the insurance provided only lasts through the

life of the option and that the cost of the option

cuts into the investor’s potential profits.

The writer of an option exposes himself to far

greater risk than the buyer does. A writer of call

options may be required to sell the underlying

security to a holder at the exercise price at any

time during the life of the option. Conversely, the

writer of a put option may be required to buy the

underlying security from the holder at any time

during the contract.

The writer of call options is motivated by the

possibility of gaining a return through premium

income, Calls may be covered, wherein the writer

owns the specified underlying security, or uncovered, wherein the writer would be required to purchase the security at market cost if he is assigned

an exercise. Leverage for an investment portfolio

may be the most significant motivating factor for

the writer of covered calls. Return from the underlying security may be realized both through dividends or interest paid and through income received

from premiums. While the covered call writer may

hope to maintain his position in the underlying

security, option writing may greatly increase his

income-producing potential.

The writer of uncovered calls is the player at

most risk in the options market. His potential loss

may equal the market price of the stock less the

sum of the exercise price and premium received for

the option and, in theory, is limitless. The uncovered call writer must be extremely sensitive to

any factors in the economy at large or for the corporation that may cause a significant price increase.

A writer of put options is obligated to buy the

specified underlying security at the exercise price
Ch. 3—The Securities Industry . 87

at any time until the option expires, The put writer

must have sufficient liquid assets to buy the security and, as an exercise is only likely when the exercise price is higher than the market price, he

must anticipate paying more than the value of the

security. The option writer who trades through an

exchange is required to deposit cash or securities,

referred to as margin, with a brokerage firm. Puts

may, alternatively, be secured with cash equal to

the option exercise price. No additional margin requirements will be required in this case, and interest may be earned by the writer on the cash deposited.

Investors are usually motivated to write puts

by a desire to earn income from premiums, the

price paid by the buyer of an option to the writer

of that option. The opportunity to purchase the

specified securities may also be a motivating factor in some cases. In a stable or rising market, it

is possible to earn premium income with relatively

low risk; however, demand for put options may be

expected to be fairly low in this circumstance.

Some put writers hope to acquire the stock at a

net cost which, considering premium income, is

less than the current value of the stock.

The four possible ways of participating in the

options market may be combined by an investor

to form a strategy he believes is most likely to

meet his investment goals of producing income or

limiting risk. The options tactics chosen are influenced by the investor’s expectations about how

the price of the underlying security is likely to

change in direction and magnitude.

Spreads and straddles are the two most common

multiple-options investment strategies. Spreads

are used to limit risk in option transactions and

involve writing and buying the same type of option, calls or puts, for the same specified security.

The options generally have different expiration

dates or exercise prices. If the investor were

assigned an exercise for the option he wrote, the

spread benefits would disappear, and his risk position would be drastically changed. The writer of

spreads generally anticipates little change in the

price of the underlying security. A stable market

provides his best opportunity for profit.

The investor who anticipates a great change in

the price of an underlying security but is unsure

of the direction or magnitude may maintain a

straddle position. The straddler either writes or

buys both a call and a put option for the same security. Both the call and the put should have the

same exercise prices and expiration dates. Buying

straddles has limited risk because maximum loss

equals the premium price and, theoretically, unlimited profit potential. However, the price change

must be significant in order for the investor to

profit, and the investor must be correct in his

evaluation of the timing of the change. Straddle

writers are generally motivated by their belief that

there will be little, if any, change in the price of

the security and, therefore, that if an exercise were

assigned, profit from premium income would insure a net profit after costs of satisfying the exercise conditions. Risk for straddle writers is limitless, as a substantial loss can be incurred on both

positions if the market price for the security fluctuates more than expected.

PRICING OF OPTIONS

The premium (i.e., price) of an option is subject

to change and is influenced by characteristics of

the option, the underlying security, and general

economic conditions. Factors influencing the premium include the expiration date of the actual instrument, the price and volatility of the underlying

security, supply and demand effects on the option

market for the specific security, and, on the whole

as well, interest rates. The premium for an option

is comprised of intrinsic value and time value. An

option has intrinsic value any time the difference

between the exercise price of the option and the

market price of the security works to the advantage of the holder. Anytime this is not the case,

the option has no intrinsic value, and the premium

is based only on time value.

Time value represents an evaluation by an investor of the potential of the option to increase in

value owing to a change in the price of the underlying security prior to expiration of the option.

Time value may generally be expected to decline

as the expiration date approaches and as the possibility of fluctuation in the security price decreases. It is also influenced by the amount of difference between the exercise price and the market

price of the underlying security. A large difference

may result in a decrease in time value because the

possibility of profitably exercising or selling of the

option is more remote. Increasing interest rates

generally result in increases in time value.

Warrants

A warrant is unique because it is issued by the

corporation that issues the underlying security

and, as such, is part of the capital structure of the

firm. A warrant is a type of call option that grants

the holder the right to purchase company stock

35-505 0 - 84 - 7 : QL 3
88 ● Effects of Information Technology on Financial Services Systems

at a stated price, usually somewhat above market

at 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 are

often offered with debt issues by corporations to

make the debt issues more attractive to potential

investors. They offer a participation right of sorts

if the corporation grows. The investor benefits

from the fixed return of the debt investment as

well as the opportunity to purchase stock at an

established price.

As with all options, an exercise price is specified

for the warrant. It may have a specific expiration

date or be perpetual. The contract also specifies

whether it can be traded, as with other option instruments, or be exercised only by the holder.

Unlike other options, warrants directly affect

the capital structure of a corporation. A call or put

option is exercised through a capital market and

with no net change in the number of shares outstanding for the corporation. However, when a

warrant is exercised, the corporation issues new

shares of stock; therefore, the earnings of the company, from the point of view of the shareholders,

are diluted. This situation complicates valuation

both of the stock of the corporation and of the

warrant.

THE EFFECT OF INFORMATION

TECHNOLOGY ON OPTIONS

Information technology is likely to continue to

facilitate the development and trading of options.

Because option markets have only recently become highly structured and have been heavily dependent on technology from their inception, the

continuing application of communications and

computer technologies in these markets is not

likely to lead to major revisions in ways of doing

business to the same extent as they have in debt

and equity markets. Options may serve as a testing ground of sorts for new technologies, and technology use in this area may presage future applications throughout the securities industry.

The use of personal computers and sophisticated

communications technologies may spur the development and marketing of option contracts by individuals and may lessen the role of brokers in

bringing writers and buyers together. Information

technology should also facilitate the monitoring

of option markets by investors, brokers, corporations issuing securities on which options are written, and market observers and regulators. This

may become increasingly important as the use of

options as an investment instrument grows.

Futures

Futures, or future contracts, are legally binding

agreements that call for the purchase or sale of real

or hypothetical items at a stated price at some

time in the future. Future contracts can be developed for anything and are traded on established

exchanges for physical commodities such as pork

bellies and coffee, for financial instruments, and

for hypothetical stock portfolios.

Even though future markets at one time were

focused only on commodities; they have expanded

greatly. In the past, communities needed to be selfsufficient in their production of foodstuffs and

other necessary goods because transportation between regions was not efficient. As lack of transportation became less of a barrier to trade, commodities markets developed that allowed for

specialization in production and made a wider

assortment of goods available. Centralized commodity markets made more extensive trading possible, and future markets grew from them to address price-change risks.

Commodity futures markets developed because

of the need in both agricultural and industrial

societies to minimize the potential impact of unknown and hard-to-predict forces that influence

the price and availability of resources and products. For example, through the use of futures contracts, food processors are able to set definite maximum prices for the commodities they will need for

production throughout the entire year. Most crops

are only harvestable for a very short period of time

in any year, and it is desirable for farmers to be

able to sell all of the harvest at that time to avoid

the need for expensive storage. While the demand

for some food products, such as turkey and pumpkins, may be seasonal, food processors face a yearround demand for products made from commodities only available for a very short time. These

processors need to have the commodity available

at a predictable price when it is needed. By providing a reliable means to conduct future buying

and selling, futures markets have served to equalize the marketing of most seasonal farm crops. 12

The development of futures markets centered

around the desire to transfer risk. The play of the

market attracts a large quantity of risk capital

through which changes in commodity price levels

can be absorbed with only a minimum direct impact on producers and processors of commodities.

‘

2 Future Industry Association, “Development of Commodity Exchanges, ” Futures Trading Course and Handbook, Washington, D. C.:

1983, p. 1-4.
Ch. 3—The Securities Industry ● 8 9

This allows the producers and processors to operate at lower cost than would be possible if they had

to bear the entire risk of market fluctuations. In

turn, this lowers prices to the public. ”

Commodity futures markets help effect stability

in consumer prices. Because food processors can

bound their costs, consumers are assured that

products will be available when needed at a relatively predictable price and therefore approach the

market in rational manner. This price stability is

both of importance to the general economy of the

Nation and of social interest, since allocations

through Government programs, such as food

stamps, can be set with some certainty as to what

market conditions will be for the recipients.

THE OPERATIONS OF FUTURES

The taking of a position in future contracts for

a product on which one depends in one’s primary

economic activity is called hedging. For example,

General Foods might be expected to hold a position in coffee futures contracts to guarantee the

maximum price it would need to pay for beans for

future production. In the discussion of futures,

hedging is not a speculative strategy but rather

refers only to the activities of players who face risk

because of possible fluctuations in price and availability of an actual commodity.

STOCK FUTURES

Options, which were discussed in an earlier section, allow for the transfer of risk associated with

a particular debt or equity issue. Broad changes

in the stock market prices pose a blanket risk to

highly diversified investors, and stock futures may

offer inherent price change protection to these investors. Stock futures are contracts that call for

the buying or selling of a mythical basket of

stocks, usually a grouping which is used in an index of market behavior. Due to practical limitations, these futures are settled through cash rather

than the actual purchase or sale of the underlying

securities.

The availability of stock futures through which

an investor can hedge against swings that affect

the entire stock market may add a great deal of

stability to that market and is expected to be of

great significance to institutional investors, who

hold a growing proportion of all shares. Investors

may be more judicious in their response to market changes because their risk may be minimized

by 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, it

must be expected that funds currently held in

mutual funds or the savings instruments of depository institutions because of the desire of the investor for stability will be transferred to direct participation in capital markets. More money may be

available for corporate capital formation; however, this may be at the expense of the banking

structure.

Questions that must be addressed are: what happens to the risk that is transferred away from the

stock market? and what effect will this transfer

have on the market? The result may be that the

assumers of risk, in this case players in stock

futures, may be expected to be advised better and

more able to accept this position.

One cannot blindly accept that risk was bad for

the stock market when, in fact, it was the market’s

reason for being. It is essential that some means

of projecting what the impact of the possible end

of the need for a risk-accepting role by stock exchanges will mean to the process of capital formation be available. It is also necessary to determine

what, if any, effect the activities of markets in

stock futures will have on the inherent soundness

of capital markets. Stock futures may cushion the

stock market from changes in the general economy; however, it is not clear what impact a catastrophic event in the futures market might have

on the entire capital formation process.

THE EFFECT OF INFORMATION

TECHNOLOGY ON FUTURES

Futures markets provide a glimpse of what the

possible impacts of information technology on the

securities industry as a whole may be. The potential of information technology was available as

many of the operations of this segment of the industry were developed.

Modern futures markets need both man and machine to operate. Human decisionmaking has been

and will continue to be the one irreplaceable and

essential characteristic of any successful market.

However, the volume of trading demanded by current market conditions requires a level of operations not feasible for mortals in a free society at

an acceptable cost. It would be impossible to operate futures markets with the precision and at the

volume demanded by the market without the application of information technology; for example,

for performing simple tasks, such as sorting faster,

that would be impossible for a human work force.
90 ● Effects of Information Technology on Financial Services Systems

Computer and communications technology did

generate a futures market; however, if these technologies were not available, the market could not

have grown to its current size and importance. Its

absence would have effectively foreclosed the possibility of responding to the demands of the economy for the level and quality of operations now

seen.

Mutual Funds

The importance of mutual funds as institutional

investors is discussed earlier in this report; however, these funds also have a role in the securities

industry in the role of investment instruments.

Mutual funds offer investors a way of participating in securities markets without directly purchasing capital or money market securities. An investor may be attracted to a mutual fund as a sort

of proxy method of participating in the securities

market. The individual benefits from the expertise

of the fund management, and risk is generally

lower than that through direct participation, although actual risk differs significantly, based on

the investment strategy of the fund. Mutual funds

allow investors greater liquidity than capital markets; shares are redeemable at any time at current

asset value less applicable redemption fees.

Mutual funds have traditionally been especially

important for the small investor because they can

frequently be entered with a smaller amount of investment capital than can the securities market,

as the money invested is pooled with that from

other participants. The investor may also take

advantage of the possible benefits of a diversified

portfolio that he might not have been able to support by directly participating in capital or money

markets. For the investor interested in an entire

industry rather than a specific company, certain

funds allow such a focusing of investments.

Mutual funds that are made up of corporate

bonds and stocks are significant to the formation

of capital because they attract investment money

to the market that would not otherwise have been

available. While some mutual funds centered on

capital markets have charged high transaction fees

(called a load), their availability has increased both

consumer options and competition for investment

dollars throughout the financial service industry.

The application of information technology to the

development and marketing of mutual funds should

increase the number and variety of funds available

to consumers.

Money market mutual funds are one of the more

liquid instruments available to investors. The

liquidity of this type of investment is demonstrated by the fact that, in many cases, shareholders may access their funds by writing drafts, as

quickly as a bank checking account by requesting

wire transfers, or in some cases, by using an automated teller machine (ATM).

Such funds invest in short-term money market

securities and, because of the nature of the underlying securities, are extremely liquid and relatively

risk-free. Money market mutual funds are a valuable cash management instrument for businesses

and an extremely valuable tool for individual investors, both the “small” and the more affluent.

Money market mutual funds give investors access to money market securities on terms that

they could not likely match themselves. Economies found in issuing and servicing large-denomination money market securities result in higher

yields than those offered on similar securities of

smaller denomination. 14 The holder of shares in a

money market mutual fund benefits from this

higher rate of return.

Money market mutual funds have enjoyed major market success. While information technology

is not directly responsible for this, many industry

experts believe that it would not have been possible, from an operational or business point of view,

to introduce this type of fund without the support

of communication and computer technologies. Information technology makes it possible to retain

the highly liquid character of the funds by simplifying access for the investor. The level of trading

in short-term securities required by the funds

would be difficult to complete physically without

the assistance of information technology.

The number and variety of capital and money

market mutual funds will probably continue to

grow. While this growth will provide more options

for investors, it may also have an impact on the

way in which securities markets operate. Although

information on the investments of the fund is included in prospectuses and periodic reports to

shareholders, it is not clear that the individuals investing in the fund take an active interest in what

instruments their money is invested in. While the

pool effectively lowers risk, the responsiveness of

individual shareholders is markedly lower than

“William Jackson, ‘ Money Market Mutual Funds, ” Congressional

Research Service Issue Brief No. 81057, Jan. 20, 1983.
Ch. 3— The Securities Industry ● 91

would be expected in normal market circumstances. The institutional investor behaves differently, for better or worse, because he makes

decisions differently, and this may have an impact

on securities markets.

Central Asset Accounts

The central asset account is considered by many

to be the single most important investment product of the next decade. ’5 In developing the marketleading Cash Management Account, Merrill Lynch

recognized that the financial needs of a single customer are interrelated and form well-defined types

of systems. The central asset account attempts

to meet an investor’s full range of financial needs

with three basic components: the securities margin

account, the money market fund account, and a

zero-balance bank loan account that can be accessed by check or card. A central asset account

provides a full range of financial services to its

user. The accounts offer a centralized method of

controlling assets and, as free credit balances in

the zero-balance account are “swept” into a money

market fund, both liquidity and return are maximized for the investor.

Nearly all major securities firms offer a central

asset account. While they have the same basic

components, their features often differ. Among the

i ~T& Fin8nCia] .~crt,ices Industr\’ of 7’omorrour, a N?pOrt prepared h)’

the Committee to I?xamine the Future Structure of the Securities Industry, National Association of Securities Dealers, November 1982,

p. 20

“Herbert M Allison, Jr., “The Perspective of a Diversified Financial Services Company, ’ panel presentation at the Eighth Annual Conference of the Federal Home I.oan Bank of San Francisco, Strategic

[~lannjng for ~conomjc and Technological Change in the Financial Serl’-

ices Industr~,, San Francisco, Calif,, Dec. 9-10, 19/32, p, 157.

features that distinguish accounts are: how frequently “sweeps” of free credit balances occur,

whether a charge or debit card is issued for access,

the offering of excess insurance coverage; whether

the account is accessible through an ATM network, and the availability of a bank overdraft line

of credit.17 The accounts have been targeted

toward the upscale market, an estimated 10 to 12

percent of the population. A substantial minimum

opening deposit of securities or cash, usually of between $15,000 and $20,000, is required and an annual fee is charged.

Merrill Lynch first offered the Cash Management Account in 1977 and as market leader now

has nearly 1 million accounts, The market growth

that central asset accounts experienced may have

been attributable in part to market conditions,

especially high interest rates. As conditions have

changed, the growth of these accounts has declined.l8 The significance of the account in the long

run is difficult to judge, although it seems likely

that it will continue to serve the needs of a segment of the market. One important feature of a

central asset account is that it allows brokers to

fill more of their customers’ financial needs for

more of their personal financial lifecycle. 19 This

makes the account a valuable tool for financial

service offerers, as it may help to attract and retain customers.

“Joseph Diamond, “Central Asset Accounts Developed by the Securities Industries, ” Financial Services Institute Handbook, vol. 1, p. 358;

prepared for distribution at the Practicing Law Institute Financial Services Institute Program, Feb. 14-15, 1983.

“Alice Arvan, “Asset Accounts Reach Out for Broader Markets, ”

.4merican Banker, May 20, 1983, p. 9.

‘William L. White, “The Outlook for Money Market Mutual Funds, ”

a report to the Investment Company Institute, Sept. 30, 1982, p. 62,

Appendix 3B: Capital Formation and the

of the Securities Industry

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

Functions

style, and financial hisof advising, underwriting; and marketing to gather tory, as well as the-amount of capital needed and

capital by bringing investors and organizations in market conditions, all contribute to the decision

need of capital together in two ways: through pri- on whether to attempt to finance through private

vate sources and through public offerings. Finan- or public offerings. An overview of the role the

cial advisors may assist the firm in determining securities industry plays in both private and pubwhich path to follow. The characteristics of the lic financing is provided below,
92 ● Effects of /formation Technology on Financial Services Systems

Private Sources of Funds

Seeking capital through private sources may offer salient advantages for many corporations. Regulatory requirements associated with public issues

are avoided. This may save time and, more importantly, the avoidance of disclosure requirements

may be an advantage for many firms, particularly

those in highly competitive industries. However,

because the firm is only likely to approach a limited

number of investors and because the assurances

associated with a regulated public offering may

not be found in private financing, the firm may

find it necessary to pay a higher rate of interest

or return on money obtained and may find that the

creditor or holder of equity has a greater interest

in the operations of the firm than investors in public issues.

Private Placements

A corporation may sell an entire issue of securities directly to a single investor or small group of

investors. Such an action is referred to as a private or direct placement and may involve either

debt or equity issues, although more commonly,

debt instruments are involved. Private placement

offers several advantages over a public offering for

the issuing firm. It is generally quicker and cheaper,

as registration of the issue with the SEC is not

needed, and the firm deals either directly with the

potential investor through a placement agent. The

issue may also be more directly tailored both to

the needs of the borrower and the investor in the

terms outlined and in the timing of the issue.

A potential disadvantage of this type of offering may be mitigated by the application of information technology; that is, the location of suitable

potential investors in a time frame that allows the

capital seeker to plan the use of the funds with

some precision. Communications technologies may

streamline brokerage private offerings.

Privileged Subscription Basis

An offering of stock only to existing stockholders is termed a privileged subscription, or rights,

offering. In many cases equity holders are granted

a preemptive right in the articles of incorporation

of the company that requires the firm to give current shareholders the opportunity to maintain

their “position,” that is, percent share of total

ownership, any time a new issue is made. In this

situation each shareholder is issued one right for

each share of stock owned. The number of rights

needed to purchase new shares are specified in the

offering; however, the shareholder is assured that

he will be able to purchase new shares in proportion to his current stake.

A privileged subscription may provide basic

marketing advantages to the issuing corporation

and therefore to the shareholders, even those who

opt not to purchase additional shares. The targeted market for the offering is known to have an

interest. Assumed knowledge of the corporation

and the costs associated with the offering are usually lower than they would be for an offering to

the general public. Often, flotation costs are half

those of a public issue. From the point of view of

the investor, margin requirements for a purchase

through a rights offering are generally lower than

in other circumstances.

The corporation may identify two major disadvantages with a rights offering. First, to attract

investors, the price per share may have to be lower

than would be assigned in a public issue. As a

lower total amount of capital may be raised by the

issue, earnings per share may be diluted. Second,

the increased number of actual shareholders resulting from a public offering may be desirable for the

corporation. The greater the number of stockholders, the more likely that management will retain

control of the operations of the company.

Venture Capital

Venture capital is money invested in new or

small businesses by corporations or individuals

that are not directly involved in the management

of the business, although they may provide advice.

The investor is usually granted a large enough

share of equity in the venture to exercise significant control of the corporation and, in cases where

the venture is successful, to receive a significant

return. The equity is frequently issued in the form

of letter stock, a private placement that cannot be

resold until the issue is registered with the SEC,

which may be years later.

Although it may be an extremely risky investment, individuals who are venture capitalists are

attracted for several reasons. Not only is the rate

of return significantly higher, but as it is in the

form of capital gains rather than dividends, it is

taxed at a lower rate. Organizations that provide

venture capital are part of many corporate families, not only because of their primary goal of financial returns but also because of other tangible

business benefits the venture capital relationship

can provide. Several investment banks have formed
Table 3A-l.— Most Active Venture Capitalists, 1982

. —. .

1982 total

investment

Rank Name of firm (in millions)

1. The Hillman Co. ., .. ., . . . . . . . . 101.5

2. Allstate Insurance Co.

Venture Capital Division ... . 64.2

3. First Chicago Investment Corp. 48.5

4. General Electric Venture Capital

Corp. (G. E. Corp.) . . . . . . ... 41.6

5. Brentwood Associates ., . . . . . . 35

6. E, M. Warburg Pincus & Co, . . . 33.9

7. TA Associates (Tucker Anthony

& R. L. Day) . . . . . . . . . . . ... . . 32.3

8. Security Pacific Capital Corp. . . 32.25

9. Citicorp Venture Capital Ltd. . 30.5

10. BT Capital Corp.

(Bankers Trust N.Y.). . . . . . . 26

S O

-URCE Venture June 1983

1981

rank

1

9

2

27

10

12

4

8

3

45

venture capital units in the hope of handling eventual public issues if the company experiences

hoped-for growth. The desire to attract and retain

customers is an incentive also for commercial

banks and insurance companies.

Some major corporations, particularly in the energy and electronics fields, have formed venture

capital units because of interest in financial return

and the hope of gaining access to new ideas and

technology that may be beneficial to the corporation. The need of established industrial giants to

maintain the pace of technological innovation may

encourage further entry into the venture capital

market.

For a small or new corporation, venture capitalists may provide a valuable source of financing.

Intermediaries in the securities industry provide

assistance to this capital seeker. They help locate

a potential investor whose objectives are in line

with those of the organization in need of financing and assure that the financial arrangement developed is in the best interests of the firm in both

the long and short runs.

Venture capital has become more plentiful in the

past several years. Industry experts attribute this

to changes in Federal Government policies that reduced capital gains tax in 1978 and 1981 and relaxed pension trust fund investment rules in 1979. ’

Information technology may have an impact on

venture capital financing because it may facilitate

analysis of possible deals, New communication capabilities may also make it easier for prospective

] (J S. (;eneral Accounting office, (;otw-nment-IndustrJ, Cooperation

(’an Enhance The \renture (’apitaI Process, Report to Senator I,loyd

Bentsen, Joint k;conomic (’ornmittee, Aug 1 !.2, 1982, p. 4.

Ch 3— The Securities Industry ● 9 3

venture capitalists and the seekers of financing to

locate one another.

An important source of venture capital for small

businesses are Small Business Investment Corporations (SBICs). These firms are licensed and

regulated by the Small Business Administration

under a program established by the Small Business Investment Act of 1958 to contribute to the

development of small businesses. SBICs are privately owned and operated investment firms, but

are eligible to receive some Federal funding. Capital is developed in the form of equity or long-term

loans.

These firms are an important part of the capital

formation process for small businesses that might

be at a disadvantage in competing for venture capital. Information technology may be expected to

facilitate the development of financing between

SBICs and businesses by making it easier for both

to identify potential investment arrangements.

Public Offerings of Securities

of a Corporation

The decision by the management of a privately

held corporation to “go public” is based on their

objectives and strategies for the future of that

business. The desire to acquire capital, to increase the liquidity of the original owners, and to

strengthen the balance sheet of the corporation

must be weighed against the expense involved in

such a move, the increased vulnerability of the corporation to general market conditions, and the necessity that management take on additional responsibility for the actions of the corporation and,

possibly, relinquish control of it.

There is no strict formula through which the decision to go public can be made. Going public may

involve a significant change in the structure and

operation of a firm, and this change must be assessed in terms of the objectives of the owners and

management of the company, The decision cannot

be assessed individually; it must be considered in

light of other alternatives such as private funding

or additional investment by the owners, In evaluating the option of going public, several matters

must be considered; these include business, accounting, legal, and regulatory considerations.

Careful attention must be paid to the planning

of an offering to assure that the normal operation

of the firm is not disrupted and that maximum

value is derived from the offering, Major factors

to be considered by the corporation include timing of the issue, both in terms of the operations
94 ● Effects of /formation Technology on Financial Services Symtems

— . — .—— — — —

of the company and of investment markets; the

ability of the firm to attract an underwriter, if

needed; and the ability and desire of the corporation to adhere to disclosure requirements. Information technology may ease these problems by

aiding in the analysis of decision factors and possibly by shortening the issue process and therefore the disruption of business.

Federal laws governing public offerings by corporations or organizations require the disclosure

of information on which investment decisions can

be based. A prospectus is information provided to

potential investors in a new securities issue that

describes the current condition and history of the

issuing firm. It attempts to provide information

on which a decision to invest can be made but does

not contain any type of objective judgment on the

advisability of investing in the described issue.

Information technology may affect public offerings by corporations in several ways. First, the

essential requirement of Federal securities laws is

the provision of information to potential investors.

It is quite likely that the application of information technology for disseminating information will

radically change the physical activity of going public. Paper was the logical medium through which

information could be transmitted in the 1930’s,

when many of the currently applicable securities

laws were enacted.2 It was cheaper and more reliable than the communications technologies of the

day, notably telephone and radio, and was easier

to use.

Paper was never intended to be a sacred medium

for conveying information about securities offerings. Its use was specified because it was the most

practical choice. The vast improvement in quality

and cost of information technology has turned the

table on the comparative effectiveness of paper

and communications media. Recognition of this

change is causing a reexamination of the process

of filing new offerings with the SEC.

The SEC is trying to make the volumes of information it receives easier to manage and use by

applying information technology to its information

gathering and dissemination process. Some experts advocate the eventual movement toward

paperless filing and information dissemination.

Potentially, a system based on information technology could result in faster dissemination of information and more efficient review and storage

processes.

Lee B. Spencer, Jr., “The Electric Library, ” Remarks to the American

Bar Association, Federal Regulation of Securities Committee, Nov. 19,

1982.
Chapter 4

Retail Financial Services
Contents

Page

Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97

Deposit Function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99

Direct Deposit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

Point-of-Sale Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ... ....... 101

Lockbox Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101

Demand Deposit Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102

Drafts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102

Giro Transfers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102

Traveler’s Checks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103

Savings Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103

Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106

Accounts With Other Nondepository Institutions . . . . . . . . . . . . . . . . . . 107

Extension of Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108

Commercial Credit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110

Consumer Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110

Electronic Funds Transfer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114

Automated Teller Machines . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115

POS Full Funds Transfer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123

Financial Information Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126

Check Authorization . . . . . . . . . . . . . . . . . . . .

Credit Authorization . . . . . . . . . . . . . . . . . . . .

Providers of Information Services . . . . . . . . .

Home Information Systems . . . . . . . . . . . . . . . .

Technology of Home Information Services .

Developers of Home Information Systems. .

Costs of Home Information Systems . . . . . .

The Market for Home Information Systems

Implications of Home Information Systems

Tables

Table No.

3. Comparison of Depository Instruments and

4.Nationwide ACH Volume . . . . . . . . . . . . . . .

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

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

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

. . . . . . . . . . . . . . . . . . . . . . . 128

. . . . . . . . . . . . . . . . . . . . . . . 129

. . . . . . . . . . . . . . . . . . . . . . . 129

. . . . . . . . . . . . . . . . . . . . . . . 131

. . . . . . . . . . . . . . . . . . . . . . . 131

. . . . . . . . . . . . . . . . . . . . . . . 131

Page

Accounts . . . . . . . . . . . . . . 100

. . . . . . . . . . . . . . . . . . . . . . . 101

5. Growth Projections for the CIRRUS Systems, Inc., National

ATM Network.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120

6. Principal Characteristics of HIS Users . . . . . . . . . . . . . . . . . . . . . . . . . . . 132

Figures

Figure No. Page

6. Penetration of Direct Deposit Social Security Payments . . . . . . . . . . . 101

7. Relative Use of ATM Functions, 1974-$1 .. + ~ . . . . . . . . . . . . . ....... 116

8. Number of ATMs in Use, 1973-81 . . . . . . . . . . . . . . . . ● . . . . . . . . . . . . . 118

9. Average Number of Monthly Transactions Per ATM, 1974-81 . . . . . . . 118

10.ATMs in the United States . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121

11. Penetration Curve for Check Alternatives. . . . . . . . ......... . . . . . . . 133
.

Chapter 4

Retail Financial Services

Introduction

The retail financial service industry consists

of those organizations (e.g., banks, credit

unions, insurance companies, consumer finance companies) that deliver products to endusers. * Consumers comprise the largest and

most visible single group of end-users of financial services, but business and government

both have roles as customers for retail financial services. Included among retail financial

products are depository accounts, extensions

of credit, and payment services.**

According to 1982 figures, the industry encompasses more than 90,000 business entities,

including 15,000 commercial banks, 4,000

savings and loan associations, 1,000 mutual

savings banks, 22,000 credit unions, 1,000 investment banks, 5,000 broker/dealers, 1,000

mutual funds, 1,000 mortgage banks, 3,000

pension funds and pension fund managers

(other than banks and insurers), 2,000 life and

health insurance companies, 3,000 property

and casualty insurance companies, and more

than 33,000 insurance brokerage agencies, as

well as numerous factoring companies,***

leasing companies, credit card or traveler’s

check issuers, and finance companies. In 1980,

the financial service industry (excluding real

estate) contributed $100.4 billion, or 5 percent,

to the U.S. national income.1

*For the purposes of this assessment, wholesale financial services, as contrasted to retail, are those provided by one financial institution to another in a way that is largely invisible to

the end-user. **Customers of securities brokers are also users of retail financial services. However, because the security industry is

governed by a body of policy unique to it that separates it from

retail banking and other retail financial services, it is treated

in ch. 3 of this report. ***Factoring is the process of selling accounts receivable to

a third party, who then assumes the risk and costs of servicing them.

‘State of New York, Report of the Executi\e Adtisor}. Commission on Insurance lndustr?’ Regulator?’ Reform, May 6,

1982, p. 101.

Historically, deposit-taking has been viewed

as a special activity in the economy, and depository institutions have been viewed as occupying a unique place in the industry. Depositors place a very high degree of trust in the

institutions holding their funds. At the same

time, because depository institutions play

such an important role of intermediation between sources of funds and those having need

of them, they are in a position to exert a measure of control over virtually all other economic

activities.

Retail financial services, especially those offered by banks, have been heavily regulated

by both State and Federal Governments.

Rates paid on deposits have been largely deregulated, but limits on the rates charged on

consumer loans remain in force. Depository institutions are generally limited to offering

prescribed products to predefined markets.

Banks, for example, are limited with regard

to the geographic area served, while credit

unions are limited to serving only groups

whose members share a common bond, such

as employment with a specific firm. Generally,

bank holding companies are not permitted to

enter lines of commerce not closely associated

with banking. Depository institutions are examined to ensure that they are pursuing business in a manner consistent with preserving

institutional safety and soundness, and many

of their business decisions (e.g., effecting

mergers, opening branches, offering new products) are reviewed by regulators prior to implementation.

Depository institutions enjoy some unique

benefits in exchange for heavy regulations.

Only they can take deposits and offer accounts

that are federally insured. Depository institutions are unique in having access to the various systems used to transfer funds.

97
98 • Effects of Information Technology on Financial Services Systems

Today, insurance companies, providers of

services such as credit cards and traveler’s

checks, consumer finance companies, dry

goods merchants, investment companies, and

food retailers also provide retail financial services. Some, such as insurance companies, are

regulated, while others, such as providers of

traveler’s checks, are virtually unregulated.

All, to an ever-increasing degree, are broadening their range of business activities and, to

some extent, are encroaching on areas previously served by others, including those heretofore exclusively reserved to depository institutions.

Information processing and telecommunication technologies have contributed to the

broadening of product lines by providers of

retail financial services. New entrants have

been able to develop and offer products that

compete directly with those previously available only from depository institutions. Distance and location have lost much of their significance as factors limiting the market served

by a service provider. In addition, by using the

technologies, new classes of products have

been developed. Foremost among these are

those that deliver financial services to remote

locations, such as the home, office, merchant’s

counter and unstaffed branches. Others, such

as services to facilitate collection and investment of cash, are directed to the business communit y.

As noted, law and regulation are significant

forces shaping the financial service industry

and guiding its day-to-day operations. The existing legal regulatory structure dates largely

from the 1930’s and is built on the assumption that specific types of institutions will be

the only ones offering each type of service. For

example, transaction accounts are assumed to

be offered only by banks; and thrift institutions are assumed to focus their lending activities on home mortgages. Thus, even though

the intent was to regulate by function, the

focus of legislation has been on the institutions

rather than on the products they offer. As a

result, the offering of new products by unregulated providers is often found to lie outside

the existing legal/regulatory structure. New

entrants who rely heavily on advanced technologies to implement their offerings generally fall outside the boundaries of existing regulation.

The financial service industry is becoming

homogenized to a significant degree, and differentiation between products has become less

apparent, particularly from the point of view

of individual consumers. Commercial banks

and savings and loan associations are now permitted to serve many of the same clientele. For

example, recent legislation gave savings and

loan associations the power to make some

commercial loans, a product that could not

previously be offered. While securities broker/

dealers are not permitted to offer depository

accounts, they do offer shares in money market funds that have properties very similar to

deposits. Insurance companies offer universal

life policies that share many properties with

self-directed investment accounts offered by

others.

VISA and MasterCard are the two principal

bank card products offered nationwide. However, in addition to being offered by banks,

these are now issued by such varied organizations as the American Automobile Association and various brokerage houses that offer

them in conjunction with asset management

accounts. Travel and entertainment cards can

be used with automated teller machines

(ATMs) to obtain either cash or traveler’s

checks. In some cases, a plastic card is used

to access a depository account (e.g., checking).

Plastic cards can also be used to draw on a line

of credit either to pay for a purchase or to obtain a cash advance. The same card can be

used for both purposes. However, the finance

charges are assessed differently for the cash

advance and the credit purchase.

One of the major developments of the 1980’s

has been the development and deployment of

networks of ATMs. Some of these accept only

the card of one institution, while others permit access to accounts held in any one of a

number of institutions. Most of these networks are offered by depository institutions

or consortia of depository institutions. How-
Ch. 4—Retail Financial Services ● 9 9

——— ————. . —

ever, retail dry goods merchants, supermarket

chain operators, and operators of convenience

stores are now establishing networks and offering financial institutions the opportunity

to access them.

More generally, telecommunication has been

a major factor in the development of financial

products in the 1980’s. Providing remote

banking services has been a key area in the

development of financial services. Publishing

companies are combining with financial service providers and communication companies

to deliver financial services directly to the

homes of consumers. Grocery chains are establishing networks of ATMs that compete

directly with those offered by banks. Banks

offer cash management services to business,

enabling corporate cash managers to control

funds on deposit with institutions worldwide

and to manage them to the best advantage of

their employers.

Other developments of the 1980’s have been

the emergence of the financial supermarket

and the specialized supplier of financial services. Several organizations have used differing strategies to develop into horizontally integrated suppliers of financial services. The

remarkable point is that some find their roots

in insurance, others in retailing, and yet others

in banking. Under the existing 1egal/regulatory structure, all operate within differing conDeposit

Technically, the function of accepting deposits is strictly limited to depository institutions.

Simply defined, a deposit is a placement of

cash, checks, or drafts with a financial institution for credit to a customer’s account. Deposits become a liability to the financial institution since they represent an obligation to

repay funds. The deposit function is the traditional banking process by which funds are accepted for credit to a demand, savings, or time

account. Deposits are accounts for holding

funds. The deposit is made by one of the folstraints and therefore come to the market with

varying strengths and weaknesses. Others, by

way of contrast, seek to serve specific groups,

such as members of the professions with products tailored to their particular needs. The

market appears ready to support service providers across the full spectrum of possible

product menus.

Fluidity in the structure of the financial service industry limits the utility of any description that focuses on the institutions that comprise it. A list of providers would almost

certainly omit some and include others that

arguably could have been omitted. Because

product lines of various classes of providers

of financial services are close substitutes for

one another, descriptions of each of the classes

of providers would become redundant.

Therefore, the approach taken to describing

the retail financial service industry in this

assessment is to focus on the functions performed for the customers and then to relate

those functions by way of example to the organizations that provide them. The classes

of functions described are treated under the

headings:

deposit/withdrawal function,

extension of credit,

electronic funds transfer, and

financial information services.

Function

lowing methods: in person, by mail or tape, or

electronically via ATM or other remote terminal or by the Automated Clearing House

(ACH).* In paper-based systems, access to deposits depends on the physical transfer of

documents such as a check or draft.** However, electronic technologies have helped revolutionize this function.

*The ACH is a computerized facility that helps clear funds

transactions among participating institutions electronically. * *Draft— A n order written on the funds of a third party to

transfer the amount specified to the payee.
100 ● Effects of Information Technology on Financial Services Systems

In essence, a deposit differs from an investment in that the depositor expects to be able

to recover the amount deposited, often with

some interest, with virtually no risk of loss.

The depository institution holds itself ready

to pay the amount of the deposit under conditions that are consistent with the contract

under which it was taken. In the case of a demand deposit, for example, the depository institution stands ready to pay on demand. On

the other hand, if the owner of a certificate of

deposit withdraws the funds prior to maturity,

a significant penalty is extracted that, in some

cases, involves loss of principal as well as interest.

In the present environment, firms other

than depository institutions offer products

that are operationally similar to a deposit from

the customer’s point of view. For example,

securities broker/dealers and investment companies offer shares in money market mutual

funds that include the option of redemption

by means of a draft written against the investor’s holding. A whole-life insurance policy accumulates cash value that is available

to the owner.

Some will tend to view these products as deposits because, operationally, the funds are

available virtually on demand. The expectation is that payment will be made by the provider even though there may be contractual

provisions that an order to pay need not be

honored immediately. There may also be no

guarantee that shares will be redeemed at the

price originally paid by the investor. However,

as long as institutions continue the practice

of operating near-deposit products in a manner that closely approximates the operation

of a true deposit account, the customers will

see the former as being a close substitute for

the latter.

In this environment, not all of those offering deposit or near-deposit products operate

under the same set of rules. This variation introduces new elements into the calculus used

by those responsible for the safety and soundness of the financial service industry and the

formulation and execution of fiscal and monetary policy. In the sections that follow, the

various types of deposit-like products and

associated deposit-taking services are described.

Table 3 presents a comparison of the various depository instruments and accounts discussed in more detail below.

Direct Deposit

Direct deposit is most often used to effect

payment from either private or public organizations to recipients of salaries, pensions, and

entitlements. It is actually a preauthorized

credit arrangement between the party issuing

the payment and the receiver and is commonly

Table 3.—Comparison of Depository Instruments and Accounts

Penalty Minimum

Interest- Withdrawal Mandatory for early deposit or

Instrument or type of account bearing notice request deposit period withdrawal balance

Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . No No No No No

Draft . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Yes Optional No No No

Traveler’s check . . . . . . . . . . . . . . . . . . . . . . . . . . No No No No No

Conventional savings account . . . . . . . . . . . . . Yes Optional No No No

Credit union account . . . . . . . . . . . . . . . . . . . . . Yes Optional No No No

Certificate of deposita . . . . . . . . . . . . . . . . . . . .Yes Yes Yes Yes Yes

Money market deposit account. . . . . . . . . . . . . Yes Optional No No Yes

NOW accountb . . . . . . . . . . . . . . . . . . . . . . . . . . Yes Optional No No Optional

Super NOW accountb . . . . . . . . . . . . . . . . . . . . . Yes Optional No No Yes

Savings bond . . . . . . . . . . . . . . . . . . . . . . . . . . . .Yes Yes Yes Yes Yes

Savings certificate. . . . . . . . . . . . . . . . . . . . . . . . Yes N/A Yes N/A Yes

aEffe~t jve Oct 1, 19&3, Interest rate ceilings are eliminated on all time deposits with original maturity or requ i red periods of more than 31 days, and on time deposits

of $2,500 or more with original maturity or required notice periods of 7 to 31 days

b No t available to commercial businesses

N/A–Not applicable

SOURCE Office of Technology Assessment
— . .

used for recurring payments. One of the

largest users of direct deposit is the U.S. Department of the Treasury, for Social Security

payments. It is also widely used for military payroll and other regular Government

payments.

Figure 6 shows the increasing rate at which

Social Security recipients have been willing to

accept payment by direct deposit. In 1978,

only 11 percent were willing to make use of

direct deposit; but this proportion had grown

to 33 percent by 1982. The Department of the

Treasury hopes for further increases.

Direct deposit transactions started as paper

transactions, but the rising volume of such

payments has encouraged the use of the ACH

network and systems, which depend heavily

on the interchange of magnetic tape (see table

4). The process involves coding payment information in machine-readable form and moving it between banks on computer tapes or, in

some cases, over telephone lines. The paying

bank or organization consolidates all its

payments for a certain date and submits them

on magnetic tape through the ACH. The ACH

then routes the payment information to each

receiving bank. The tape can be sent in advance with the information predated. For example, stock dividend checks could be processed through the ACH for direct deposit. It

Figure 6.— Penetration of Direct Deposit Social

Security Payments

500 ~

UY 400

c

-

11 0/0

o

=.-

E 300

c.-

UI

z 200

E

$Q 100

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 ● 101

Table 4.—Nationwide ACH Volume

—

Government -

Year Private (Social Security)

1976 . . . . . . . . . 4,283,770 46,646,999

1977 . . . . . . . . . 10,344,192 69,694,741

1978 . . . . . . . 18,612,263 93,207,073

1979 . . . . . . . . . 331324,163 123,353,594

1980 ......, . . 63,362,597 144,112,204

1981 . . . . . . . . . 117,019,927 164,157,190

1982 . . . . . . . . . 174,613,862 — -176,821,896

.

SOURCE National Clearing House Association

is expected that use of the ACH will increase

once a critical volume has been achieved by

the flows to and from large organizations. As

this occurs, users with smaller volumes of

payments should gradually be absorbed into

the system.

Point-of-Sale Systems

Point-of-sale (POS) systems, discussed in

detail later in this chapter, also function as a

deposit-taking method. In some cases, retail

clerks will accept funds for deposit to customers’ accounts. In others, the financial institution will operate a station or counter in the

retail store at which deposits are accepted. A

third alternative is the placement of an ATM

at the retail store location. The ultimate goal

of POS implementation in the financial service industry is to institute an electronic process through which transactions may be instantaneously debited/credited.

Lockbox Operations

In lockbox operations, payments go directly

to a post office box that is controlled by the

payee’s financial institution. The services provided include picking up the mail at the post

office, opening it and crediting the funds, or

receiving the opened letters and crediting the

funds 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 the

collection of remittances and reduce “float”*

*An amount of money represented at any one time by checks

outstanding and in the process of collection. The period of time

between receipt of notification of payment by the creditor and

the actual debiting of the consumer’s account.
102 ● Effects of Information Technology on Financial Services Systems —.-— - .-— — ——.———

by eliminating the time required to transfer

payment from a company to the financial institution. Interestingly, lockbox operations are

offered by other institutions, also. For example, in July 1983, Sears Roebuck & Co. announced that it would provide retail lockbox

processing for Pittsburgh’s Mellon Bank in

seven cities across the country. With its national presence, Sears is in a unique position

to offer such services. This arrangement will

not only reduce float for the bank’s corporate

customers but also decrease processing costs,

since a larger number of the checks received

could be processed locally and not as interregional items through the Federal Reserve

Board’s check processing system. As noted in

American Banker, “Interstate banking restrictions have prevented banks from opening offices around the country to accept deposits,

and thus most banks have operated lockboxes

only within their own State. Lately, however,

a number of banks have begun to expand their

geographic coverage through joint marketing

arrangements and correspondent relationships. ‘‘2

Demand Deposit Accounts

For users of demand deposit accounts, institutions make funds explicitly available to

the user without any optional or contractual

delay. Demand deposits represent a significant

portion of the domestic money supply. As of

December 31, 1981, demand deposits for all

commercial banks totaled $370 billion.3 A

checking account is a demand deposit account.

The check is the instrument that activates the

checking account and is the end-product of the

original written instructions used by an individual to make a payment from a credit balance. A written check is deposited into an account (the collecting bank) by the creditor,

wherein it circulates within the banking system as an instrument to debit the account of

the debtor at his bank (the paying bank).

By law, demand deposits do not yield interest for the account holder. Although sev-

‘American Banker, July 29, 1983.

3Federal Reserve Statistical Release, April 1983.

—

eral other types of accounts use a check to access funds, these accounts are not considered

demand deposit accounts.

Drafts

Drafts are essentially an expanded collection

service, with funds being transferred when the

payer orders the bank to pay the draft. They

are used by credit unions, which technically

classify their transactions as purchases of

shares in equity accounts and money market

funds. Credit unions began to offer share draft

accounts as a competitive tool against the

checking accounts offered by banks. The draft

itself is debited against the individual’s account. Although to the consumer, a draft looks

and works much the same way as a check, it

differs in two ways: 1) it may have a specified

time constraint and can be drawn on an individual, corporation, or bank; and 2) the initiative for payment of goods is taken by the

seller, not the buyer.

The three types of drafts are: 1) sight–payable immediately on presentation; 2) arrival—

payable on arrival of goods; and 3) time—

payable at a fixed date. There is a considerable amount of float associated with checks/

drafts because funds need not be in the bank

on which the item is drawn until the day the

check/draft reaches the bank and is presented

for collection. Float in this case can work to

the advantage of the depositor in that funds

also do not sit idle. The company can transfer the amount needed to cover the check/

draft, leaving the balance in higher yielding

investments.

Although presently a heavily paper-based

instrument, drafts are being converted into a

form of electronic billing service whereby vendors can collect from customers by sending an

electronic debit (draft) to their account.

Giro Transfers

While checks are a way to effect a debit

transfer, the giro, which is an instrument not

used in the United States, is a way of making

a credit transfer. To effect a giro payment, the
Ch. 4—Retail Financial

. . . —

person making the payment instructs the institution holding his funds to transfer them

to the account of the payee in the name of

another institution. This is in contrast to a

check given to the creditor that is finally presented at the debtor’s bank for payment. Giro

organizations usually send a statement to each

account holder every day on which transactions are recorded; this is expensive in postal

costs. “The notable feature is that the average value of paper giro transfers is higher than

the average value of check payments in all

countries except the United Kingdom.”4

Traveler’s Checks

Another form of a deposit transaction is the

traveler’s check. The traveler’s check is “paid

for” in advance by the purchaser, generally

with a premium of 1 percent of the value. It

is considered a deposit because the funds are

held by the issuing company until the traveler’s check is redeemed by the purchaser. This

instrument works and is accepted, for the

most part, like cash. It can be a universally

accepted payment mechanism and is considered a deposit instrument.

Savings Accounts

A savings account is an interest-bearing account used to accumulate and safekeep funds.

Institutions retain the optional right to require

written notice of an intended withdrawal,

often not less than 14 days before withdrawal

is made.

Despite the notice requirement, a savings

account is in practice extremely liquid. Until

recently, most people used their savings account as a long-term savings/investment vehicle, even though several alternatives offered

higher explicit interest. However, new options

available have made the consumer more concerned with earning explicit interest on his

money. As a result, savings accounts are being increasingly used only as short-term repositories or as interim investment vehicles dur4

Jack Revel], Banking& EFT—A Study of the Implications,

p. 143.

Services ● 103

ing the accumulation of funds sufficient for

supporting higher denomination and higher

yielding investments. They are also frequently

used to establish and maintain a relationship

with an institution for the purpose of eventually using other services, such as loans and

check cashing.

Savings accounts take the following forms:

1. Conventional savings accounts. Conventional savings accounts offered by depository institutions are designed primarily

for individuals. Savings accounts may be

issued in passbook or statement form and

involve the institution’s periodic issuance

of summaries of deposits and withdrawals. Savings deposits do not have maturity dates, but a hold may be required

before withdrawal-most often on deposits made by check, but possibly on cash

deposits, also. This is rarely, if ever, imposed, and for the most part, individuals

regard these accounts as being very liquid. As defined by the Federal Reserve,

a savings account from which more than

three telephonic or preauthorized transfers are permitted per month is considered

a transaction account, with the specific

exception of the money market deposit

account.

Savings accounts presently have a regulated interest rate set by Federal authorities and governed by the Depository

Institutions Deregulation Committee

(DIDC). Until these ceilings are finally

phased out (scheduled for 1986), the ceiling is imposed on interest rates for federally insured banks and thrift institutions. Effective January 1, 1984, the

differential interest rates on passbook

savings accounts and 7- to 3 l-day deposits under $2,500 at both thrifts and commercial banks were removed, with each

having a ceiling of 5% percent.

Federal deposit insurance of up to

$100,000 per account holder is provided

in all but a very few depository institutions. The Federal Deposit Insurance Corporation (FDIC) insures accounts in commercial banks chartered by both the

35-505 0 - 84 - 8 : QL 3
104 • Effects of Information Technology on Financial Services Systems

2.

——- —

Federal and State Governments and in

mutual savings banks. The Federal Savings and Loan Insurance Corporation insures accounts in federally chartered savings and loan associations and savings

banks. The Credit Union National Administration (CUNA) insures accounts held in

federally chartered credit unions. In addition, some States have insurance programs to cover deposits in State-chartered institutions, such as savings and

loan associations, that are not eligible for

Federal deposit insurance.

Credit unions provide savings services

as well, including savings accounts (which

are insured up to $100,000 per member by

CUNA, investment certificates, money

market certificates, share savings accounts, and individual retirement accounts.

Time deposits. The owner of a time deposit accepts limitations on his withdrawal rights. The account is established with

the idea that the funds are on deposit for

a negotiated period of time in return for

receiving an offered interest rate. Certificates of deposit (CDs) are interest-bearing time deposit instruments issued by a

depository institution for amounts that

can vary from as little as $100 up to more

than $100,000. CDs pay interest at maturity and cannot be withdrawn from the

bank without penalty prior to their

maturity date. The most commonly offered maturities are 91 days, 180 days,

and 1 year. Although most CD rates are

tied to Treasury bills and longer term

Treasury securities, some of the funds do

receive an unregulated market rate of interest. Large CDs are typically issued in

negotiable form, so they may be traded

in an organized market.

The Depository Institutions Deregulation and Monetary Control Act of 1980

(DIDMCA) was enacted to provide for the

orderly phase-out and the ultimate elimination of ceilings on the maximum rates

of interest and dividends that maybe paid

on deposit accounts. The act transferred

the authority to set interest rate ceilings

on deposits at federally insured commercial banks, savings and loan associations,

and mutual savings banks to the DIDC,

whose members are the Secretary of the

Treasury; the Chairman of the Federal Re

serve Board; representatives of FDIC, the

Federal Home Loan Bank Board, and

CUNA; and the Comptroller of the Currency, a nonvoting member. The law provides for a 6-year phase-out of ceilings on

deposit rates, during which the committee has the discretion to set ceiling rates

on deposits based on economic conditions.

(The committee has been given a schedule

for targeting the gradual phase-out of

such ceilings. ) During the transition

period, credit unions are subject to separate regulations. In 1986, all Regulation

Q authority expires, CUNA’s authority

to set interest rate ceilings for credit unions terminates, and the DIDC ceases to

exist.

Under DIDMCA, the committee has

eliminated (effective Oct. 1, 1983) all interest rate ceilings on (a) all time deposits with original maturities or required

notice periods of more than 31 days; and

(b) time deposits of $2,500 or more, with

original maturities or required notice periods of 7 to 31 days. Also, the committee

has eliminated other regulations on time

deposits except for the minimum early

withdrawal penalties; a minimum denomination of $2,500 for ceiling-free time

deposits with original maturities or required notice periods of 7 to 31 days; current ceiling on time deposits of less than

$2,500, with original maturities or required notice periods of 7 to 31 days; and

agency rules that require a l-percentagepoint differential between a loan rate and

the rate on a time deposit securing a loan.

DIDC also established new minimum

early withdrawal penalties: for time deposits with original maturities or required

notice periods of 32 days to 1 year, loss

of 1 month’s simple interest; for time deposits with original maturities or required

notice periods of more than 1 year, loss

of 3 months’ simple interest.
3.

4

These changes helped reduce the competitive edge previously enjoyed by nondepositor institutions against depository

institutions because a large number of financial services being offered by the nondepositor institutions were attractive,

offered higher interest rate return, and

were not subject to regulation. Funds

placed outside of the depository institutions are not federally insured; however,

the individual appears to be more concerned with return on investment than

the risk associated with placing funds outside of federally insured depository institutions.

Money market deposit account. The

money market deposit account, a highyielding liquid account, was authorized by

the Garn-St Germain Depository Institutions Act of 1982 to allow commercial

banks and thrift institutions to compete

with money market mutual funds. The account is available to all depositors, including businesses. It requires an initial

balance of at least $2,500 and has no interest rate ceiling. A ‘7-day hold on withdrawal can be imposed by the depository

institution. Additionally, the money market account allows for up to six thirdparty transfers, including up to three by

draft and up to three preauthorized transfers per month. There are no restrictions

on making withdrawals from the account

in person, by messenger or mail, or by

ATM. The funds are federally insured. If

the minimum balance falls below $2,500,

the interest on the funds reverts to the

statement/passbook rate and remains at

that rate until the balance is brought up

to $2,500. Unlike some restrictions imposed by the money market funds, there

is no minimum on the size of an account

withdrawals or deposits.

Negotiable order of withdrawal (NOW)

and Super NOW account. NOW and

Super NOW accounts are unique savings

instruments because they are interestearning transaction accounts. Although

they can be accessed by a check, they are

not considered demand accounts because

5.

6.

Ch. 4—Retail Financial Services ● 105 —————- ———..— —

the offering institution can impose a hold

before honoring the withdrawal, although

it is a restriction unlikely to be enforced.

Individuals regard these accounts as rather liquid, and most are probably unaware

of the restrictions that can be enforced.

The NOW account does not legally require a minimum to open the account, although most institutions require a minimum balance of $500.

The Super NOW account is primarily

a combination of the NOW account and

the money market deposit account. The

Super NOW, which DIDC authorized as

a financial instrument as of January 1983,

requires a minimum initial deposit of

$2,500 and an average balance in any

month of $2,500. The account has no interest rate ceiling, although the funds revert to a conventional savings account

yielding the regulated interest z-ate under

Regulation Q if the account falls below

the minimum balance. Additionally, a 7-

day notice of withdrawal maybe required.

Because the notice of withdrawal requirement applies to such funds, they are categorized not as demand deposits, but as

savings deposits. These accounts are not

available to for-profit businesses. They

are available to Federal, State, and local

governments, as well as to nonprofit organizations and individuals.

Savings bonds. Savings bonds are sold by

the U.S. Government to generate revenue.

They are issued at a discount and appreciate at a rising rate in specified increments to a stated value at maturity.

Bonds may be redeemed before maturity,

but the interest rate becomes higher the

longer the bond is held.

Savings certificates. Tailored to the needs

of individuals in terms of deposit time

(generally 90 days, 5 years, 10 years), savings certificates have interest rates that

are dependent on maturity time and current rates. Savings certificates are not

negotiable and are issued by depository

institutions for $100 up to $100,000.

There is a penalty for early withdrawal.
106 . Effects of Information Technology on Financial Services Systems

— — — — —.——.....— —

The latest figures’ indicate deposits, as of

October 1983, in various savings instruments:

Super NOW accounts: $27 billion

NOW accounts: $100 billion

money market deposit accounts: $369

billion

money market funds: $138 billion*

Insurance

In today’s competitive environment, commercial banks, savings and loan associations,

and savings banks not only vie with one

another to attract new deposits, but also compete with many nondepository organizations.

One of the largest providers of financial services is the insurance industry. It has a sizable

customer base (insurance products are used in

almost every household or business) and is a

major lender of funds to businesses. The insurance industry has access to an enormous

amount of capital. Insurance companies are

enormous financial intermediaries in that they

collect and invest vast amounts of premiums

on policies. Life insurance companies collect

premiums from policyholders, invest the receipts until needed, pay death benefits to heirs

of those who die, and make payments to those

who redeem policies and/or take out loans

against their cash value.

Insurance companies channel funds into various investment outlets and qualify as significant allocators of financial resources in the

economy. Their investments are made in

almost every sector of the capital market and

in a wide array of investment outlets. Their

investment decisions are based on a philosophy of maximizing their rate of return within

the bounds of State investment laws and on

the principle of safeguarding the security of

the funds invested.

Life insurance saving differs fundamentally

from saving through deposit-type institutions

for at least three reasons: first, it is long-term

and contractual in nature and is therefore

more 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 protection

in the event of death; and third, it is ordinarily

expected to be left intact until the death of the

insured rather than withdrawn for some consumer expenditure.

Insurance policies exist in almost every

household. They take such forms as automobile insurance, property insurance, and health

insurance. Such a strong presence permits the

industry to introduce and market new financial products and services with relative ease.

Insurance companies now offer several products that are treated like deposits. Two new

products introduced into the market in 1983

are quite interesting—one works like a cash

management plan for businesses under $10

million; the other works as a securities and

cash management service. These accounts

feature money market funds, checking accounts with unlimited access, lines of credit,

an overdraft, and a Gold MasterCard, which

does not carry a line of credit. The customers’

money market accounts are debited each

month to cover card charges. The checking

and charge card operations are handled by a

local bank for the insurance company. The investment accounts are offered in conjunction

with an investment firm. Both products require a minimum of $10,000, and customers

are penalized whenever their monthly average

drops below $5,000 for 2 consecutive months.

Another instrument of the insurance industry is universal life insurance, which is an investment vehicle. It functions like a depository instrument and is a flexible investment

vehicle with access to mutual funds. It offers

the policyholder flexibility because the cash

value buildup or funding phase—-which makes

it appear to be a savings instrument-and the

pure life insurance phase of the traditional

whole-life insurance policy are separated. A

company can declare competitive interest

rates on the funding phase, and the policyholder can vary the amount and frequency of premium payments and the amount of death

benefits.

Whole life insurance provides a constant

amount of insurance for the same premium

over a lifetime. It is payable to a beneficiary
——..——

at the death of the policyholder, and premiums

are payable for a specified number of years or

a lifetime. A policyholder is entitled to the cash

value if he cancels the policy. Since the policyholder may borrow from the insurance company against the cash value of the policy, policy reserves may be viewed equally as a legal

liability of the insurance company and as an

investment of the policyholder. Life insurance

companies make loans against the cash value

of whole-life insurance policies. These accounts

play a significant role in the insurance companies’ lending ability. The policyholder has

the right to borrow from the insurance company any amount up to the cash value, at a

specified rate of interest. Moreover, earnings

on insurance are partially tax-exempt.

Just as insurers will increasingly compete

in the provision of financial services, other

financial service providers will increasingly

compete with insurers in the provision of insurance. The unbundling of insurance products has revealed that there are significant

functions in the operation of insurance that

involve the performance of noninsurance

services.

The insurance industry is in a position to expand its service offerings to include a myriad

of financial products. This is possible for several reasons. As discussed, some insurance

products being offered resemble existing products being offered by depository institutions.

Also, modifying software for existing systems

enables the company to create new products

and services. For example, insurance companies could easily offer a money market fund

and additional services that can be implemented with relative ease and minimal capital.

The insurance industry is adapting automation in many ways. Insurance agents, for example, are internally incorporating automation to manage office functions, such as client

information and accounts receivable and payable. They are applying automation to increase

efficiency and to improve marketing. Externally, communication and information technologies are used to tie into carriers where they

are able to obtain quotes and to underwrite

Ch, 4—Retail Financial Services • 107

— — —

business themselves. Many large networks are

being developed that enable the agent to obtain pertinent information online as well as

directly relay information to the carrier.

Technology is used to support other services of the insurance industry as well. Claims

services, for example, are now becoming automated. The claims process, which is heavily

paper-based, is being handled by converting

the information electronically and transmitting it online to the carrier, allowing the carrier to deal with the claim more effectively and

to maintain more control over the settlement

process.

The automation of risk management services for large corporations allows them to handle in-house insurance analysis. These companies are able to tie into networks that

provide important and timely information

used to assess and manage risk.

Accounts With Other

Nondepository Institutions

Insurance companies, large retailers, and

virtually every kind of financial service organization offer individual retirement accounts

(IRAs), money market funds, and a myriad of

investment services. Although the funds invested by individuals into nondepository institutions are not federally insured, this fact has

not prevented individuals from investing in

these instruments. The amount of money that

has shifted from depository institutions into

nondepository institutions has been significant. Previously, these types of institutions

were very different from each other. When the

concept of commercial banking was first conceived, commercial bankers made little or no

effort to attract individual deposits, concentrating primarily on attracting demand deposits from businesses. Conversely, the savings

banks and savings and loan organizations

were not authorized to offer checking accounts, and their range of time and savings

deposits was limited.

Today, that has changed drastically. Commercial banks fiercely compete with other de-
108 ● Effects of Information Technology on Financial Services Systems

pository institutions, insurance companies,

and brokerage houses/investment firms for

consumer deposits. All of these organizations

offer accounts that can serve the customer in

similar ways. However, the range of services

available to the customer are not as markedly

different from the customer’s point of view as

the products seem from the point of view of

regulators or the providers themselves. An individual can easily establish an IRA or Keogh

(retirement) account, obtain a loan, and use a

checking or checklike account or savings account from any depository institution. He/she

can obtain similar instruments from nondepositor institutions such as insurance companies, retailers, and investment firms with

cash management accounts.

Prior to the introduction of money market

deposit accounts and Super NOW accounts,

depository institutions were restricted as to

the maximum interest payable on demand deposit accounts and savings accounts, with the

exception of jumbo CDs and similar instruments. These restrictions helped reduce bank

payouts on their liabilities and reduced customer earnings on short-term asset holdings

in depository institutions. Since depository institutions could not compete on interest rates,

they competed on the basis of services, which

were actually subsidized by the spread between interest paid on money in savings and

received on money loaned. The spread resulted

from below-market rates paid because of the

regulatory environment. This is changing.

Zero-balance accounts are becoming widespread. Financial service providers have come

to rely more heavily on fee income from

services.

Large financial service providers have the

privilege of offering several types of financial

products. For example, the use of information

technologies enables firms such as American

Express, which owns Fireman’s Fund American Life Insurance Co., to market additional

services directly to their strong credit card

base. They can offer insurance services and

have the premiums be added directly to the

American Express card account.

Extension of Credit

One of the principal functions of the financial service industry is intermediation between

holders of assets and those in need of funds.

Funds are gathered through the deposit-taking activities described in the preceding section. Extending credit, described in the following pages, is one of the mechanisms used to

make funds available to those requiring

them. *

Historically, credit extension has been one

of the principal sources of revenue for the financial service industry. The rate differential

between that paid on deposits and that

charged on loans was sufficiently great to support many of the services offered by financial

institutions. However, one of the effects of de-

.——*FundS are ~so made available by investors who take an

equity position in the organization requiring funds. Equity instruments and the markets for them are described in ch. 3.

regulation of the rates paid on deposits has

been to narrow this differential and cause financial service providers to look elsewhere for

revenue. They have turned to information

processing and telecommunication technologies to improve the efficiency of their internal operations and as the foundation on which

new revenue-generating products can be built.

One of the most promising opportunities for

cost saving is converting as many paperbased transactions as possible to electronic

processes.

Interest rate fluctuations, such as those experienced over the past several years, have

made the problem of portfolio management

more difficult for financial service providers.

Some found themselves faced with the problem of supporting long-term, fixed-rate loan

portfolios with short-term, expensive depos-
Ch. 4—Retail Financial Services ● 109

— -.

its and few options for correcting the imbalance. Congress increased the powers of savings and loan associations to help them

overcome this problem.

One of the responses of the financial service industry to the disappearance of the interest spread has been to encourage individuals and businesses to view all of their liabilities

and assets as a total package and to manage

them as such. The goal of some institutions

is to place themselves in the role of financial

advisor to their customers. On the one hand,

these institutions would like to generate revenue by providing advisory services for which

a fee may be charged or services that would

attract business and customer loyalty, resulting in most financial service needs being purchased from a single organization.

To this end, service providers are using their

credit products to increase the effective liquidity of assets held by consumers. In addition to such traditional offerings as credit

cards, they are creating lines of credit secured

by a variety of assets that range from home

equity to securities portfolios. Ease of activating lines of credit is emphasized. In the

case of an overdraft account, the same check

or debit card that is used to draw funds from

a transaction account is the instrument used

to activate the line of credit when the funds

in the account are exhausted. Some institutions issue checks that can be used to draw

against home equity at the convenience of the

customer. The customer benefits by being in

a position to take advantage of opportunities

to make either purchases or investments on

favorable terms that may be available only for

limited periods.

Information processing and telecommunication technologies are key elements in supporting the viability of the credit products that are

now offered. One of the reasons a credit card

issuer can guarantee payment to the merchant

accepting it is the ability to keep track of account activity and effectively to halt its use

almost instantaneously if circumstances require. The processing and clearing of credit

card drafts would be virtually impossible without the technologies. Paper is truncated early

in the processing cycle as one factor in controlling costs of processing and to facilitate

the timely posting of transactions to customers’ accounts. Some merchants submit transaction data electronically to card issuers to facilitate processing.

Credit has long been a tool of the retail industry. Card bases have been created on the

assumption that they help create and maintain customer loyalty and facilitate impulse

purchases. Advertisements are regularly included with customer bills. While most retailers do not rely heavily on revenues generated

from retail receivables, the funds generated

can be considerable.

Some retailers see third-party cards such as

those offered by banks as an interference in

their relationship with their customers. Retailers feel they should know when a customer is

activating a line of credit so that an alternative can be offered. Also, retailers question the

propriety of card issuers charging the same

discount for a card transaction, whether it activates a line of credit (credit card) or is used

to access a transaction account (debit card) in

lieu of a check.

While individuals make extensive use of a

variety of credit services, businesses and

governments are also major users of credit.

Generally, these users are quite sophisticated

and use a number of services that are not available to the general public. The Federal Government is active in the primary credit markets

as an issuer of debt. Also, one of the primary

means used to implement monetary policy is

trading by the Federal Reserve System in

Federal Government securities in the open

market.

Further complicating the credit markets is

the multiplicity of providers of credit services.

Depository institutions and retail merchants

have been mentioned. However, among other

participants in the market are consumer financial companies, mortgage bankers, insurance

companies, pension funds, and acceptance corporations, such as those operated by major
110 Ž Effects of Information Technology on Financial Services Systems

—— . ———.—

automobile and appliance companies. Private

individuals also make loans, as is the case

when the seller of a home takes a second mortgage from the buyer for a portion of the purchase price.

Credit is extended in the following ways:

1.

2.

3.

4.

1nstallment credit—a direct loan to an individual or business, repaid in fixed, periodic payments; it is a type of closed-ended

credit. A typical example is a car payment

loan.

Open-ended credit, often called revolving

credit—funds that are available under an

agreement that allows the borrower to

borrow several times, up to specified

credit limits, with interest and without

further investigation of creditworthiness.

Many charge accounts at department

stores and credit card accounts are examples. Since part of the loan is repaid

over time, the borrower can again draw

against the line up to the predefine limit.

This type of credit is often open-ended

with respect to time and the total amount

of credit available, Minimum payments

are required, and the maximum amount

of credit extended is limited.

Closed-ended credit—a loan that is extended for a predetermined amount. The

borrower cannot reopen it by obtaining

extra funds under the original lending

agreement.

Line of credit–the amount of credit a

lender will extend to a borrower over a

period of time, where the borrower can

draw on the lineup to some fixed limit at

his/her discretion. Generally it involves a

specified amount of money a customer

may borrow without filing a new loan application. A personal line of credit on

checking accounts is one example; the

credit card with a line of credit is another.

Each month, the individual cardholder

chooses between complete payment of the

invoice or extended credit, with the choice

of making a minimum payment. The credit is used not only for purchases and credit

payment, but also for obtaining cash advances. With the exception of cash advances, the cardholder can pay the entire

amount due without finance charges.

Commercial Credit

Commercial credit is the credit extended to

businesses by various lenders. Commercial

banks are the primary funders of commercial

credit, but recent legislation gave savings and

loan associations limited power to participate

in this market. Others, such as acceptance corporations, leasing companies, and factoring

companies are also active. Generally, the debt

is short term and is used to meet requirements

for working capital, such as the funding of receivables or inventory.

Much commercial lending activity is conventionally viewed in the category of wholesale

rather than retail financial services. For example, commercial banks will purchase consumer

debt from consumer finance companies, which

then lend the funds to individuals at higher

rates than banks charge. Commercial lenders

also finance capital acquisitions through thirdparty leases that cover such items as aircraft

and computers.

Commercial organizations will also float

debt in the open market, where it may be purchased by any variety of lenders. One is shortterm commercial paper; but, as discussed in

the chapter on the securities industry, longterm bonds are also issued.

Consumer Credit

Consumer credit is a specified amount of

credit that is extended to individuals primarily for personal, family, or household purposes

by a number of types of institutions that include issuers of travel and entertainment

cards, retail merchants, consumer finance companies, and acceptance corporations. Early on,

depository institutions began to recognize that

consumer loans were not only an asset to the

bank, but also a contribution to the overall

economy. Consumer credit loans are extended

to individuals or small businesses and provide

for repayment either monthly, quarterly, annually, 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 recognized in the form of a loan. Simply defined,

a loan is money lent, generally to be repaid

with interest. Loans can be made on a secured

basis, where the funds are protected by pledged

collateral, or on an unsecured basis, where the

funds are extended with no pledge of collateral. Loans are made to consumers and businesses on a regular basis. A loan is an agreement between two parties. The lender does not

have to be a financial institution. Loans can

be secured by life insurance, contracts, deposits in financial institutions, securities, or personal and real property. Banks, acceptance

corporations, consumer finance companies,

and credit unions are major lenders of consumer credit.

Overdrafts

Credit can also be extended through an overdraft, which is a check or payment order written against a demand deposit or transaction

account for funds in excess of the balance. It

must be arranged in advance, and when honored by the depository institution, the overdraft creates a loan. If approval for overdraft

privileges has not been obtained in advance,

overdrafts are prohibited. Basically, the overdraft can be defined as an instrument that

operates with a credit limit, fixed by the institution for each customer and reviewed periodically. Since the application of an overdraft

is typically for personal use, it is rarely secured. The arrangements for repayment of the

overdraft are set by each institution.

Credit Card Checks

Credit card checks are special drafts written against a credit card account rather than

a demand deposit account. They are issued in

conjunction with a credit card account and access a credit line. They work just like a personal check; however, the amount is charged

automatically to the credit card balance at

time of use. Credit card checks are treated as

cash advances, with the monthly statement

reflecting the advance. When used, interest is

paid on money borrowed from the day the

check is written. Merchants do not have to pay

the discount and service fee associated with

all card transactions when credit card checks

are used.

The development of credit cards has helped

satisfy the demand from consumers for a more

convenient way to finance their day-to-day

credit needs.

Credit Cards

With the advent of electronic banking systems, the plastic card has become commonplace in today’s financial institutions and

retail organizations. Nearly all customer/bank

communication terminals—ATMs, remote

service 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 600

million credit card accounts exist in the United

States, and 7 out of 10 households have at

least one credit card. Outstanding balances

on credit card accounts total more than $75

billion.’

Electronic processing has helped minimize

the amount of paper used in handling credit

cards, and online credit authorization has

helped encourage card use because it entails

less of a waiting period. The transaction can

be approved and completed within a time

frame that is acceptable to the customer.

Today, there are many online POS terminals

for credit authorization throughout the United

States. Generally, any credit card can be accepted by the systems, which operate over

standard telephone lines.

Credit cards offer the individual the ability

to defer payment of part of the balance due

as part of an extension of credit. A dollar, or

floor, limit is established, which permits using

‘Federal Reser\’e Board, L’redit Cards in the U.S. Eccmon]L\r—

Their impact on Costs, I]rices and Retail Saies, July 27, 1983,

p. 1.
112 ● Effects of Information Technology on Financial Services Systems

the card without credit authorization at the

time of purchase. For purchases over the required floor limit, credit approval is necessary.

Ceilings are generally set on the total amount

the cardholder may have outstanding.

Over the past several years, many of the

card-issuing organizations have imposed annual fees to the cardholder for use of the card.

Interest paid on outstanding balances falls

under State usury laws. Certain State laws,

however, place rigid standards on such actions. The result has been: 1) higher annual interest rate charges to the cardholder, where

permitted by usury laws; or 2) the relocation

by the card-distributing organization of its

credit card processing facilities into States

such as Delaware and South Dakota, which

permit higher interest, card fees, or both, so

that the card-distributing organization is able

to operate under the banking laws of the State

where the processing is done.

Card-issuing organizations impose annual

fees on credit cards as a way to generate additional income. These funds were needed because of the high interest rates financial institutions were paying for funds. Additionally,

the annual fee charge is a way to generate income from those individuals who use the bank

credit card as a convenience mechanism and

who pay the monthly statement charges in full

and therefore do not incur interest charges.

Basically, there are three kinds of credit

cards: bank cards, travel and entertainment

cards, and retail and nonbank cards.

Bank Cards.-The bank credit card has

become an integral part of the American lifestyle. Bank credit card systems have a structure all their own. The two major bank credit

card systems are VISA and MasterCard.

VISA International is owned by over 15,000

member financial institutions located in

almost 100 countries. Over 100 million cards

have been issued, allowing consumers access

to checking accounts, savings accounts, investments, and lines of credit. VISA U.S.A.

is jointly owned by U.S. financial institutions,

including banks, savings and loans, credit

unions, and mutual savings banks. VISA operates a worldwide electronic data communication system that transferred nearly 1 billion

transactions between member institutions in

1983.7

For processing purposes there is no distinction between a VISA debit or credit card. The

same processing procedures apply for both

cards; therefore, only the card-issuing institution and the cardholder are familiar with the

function of a particular VISA card.

Each card-issuing financial institution sets

the policies for its own customers in the VISA

system. These policies are regulated by applicable State laws that limit maximum charges

on credit card accounts, the method of assessment of finance charges, and minimum

charges that can be imposed on credit card accounts. Different card-issuing banks nationally may compete with one another and may

have slightly different policies. Generally, the

most important competition exists between

banks as they attempt to sign consumer and

merchant accounts. The merchant discount offered to encourage acceptance of the card at

an establishment is one of the primary competition tools.

Bank credit cards have become subject to

credit controls because of their role in extending consumer credit. They are recognized as

instruments for installment lending to consumers and as loans by banks. The controls

tend generally to be the ones applying from

time to time to consumer credit. The controls

include compliance in usury limits and truth

in lending as set forth in Regulation Z.

To examine critically the national bank card

systems and the member institution’s role as

an extender of credit in the financial service

industry requires some analysis. Inherent in

every payment device are two separate and

distinct services. The first is payment for

goods and services, and the second is the extension of credit. The first has traditionally

been priced in free and open competition and

has not been subject to usury laws. The sec7VISA, 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 usury

laws. Whether the card is used solely as a payment device or as a credit device, by deferring

payment of the full balance, is determined by

the cardholder. The use of electronic technology and plastic cards has made it possible to

combine multiple functions in a single device,

blurring the distinction between what constitutes payment service and what constitutes

extension of credit.

The national card systems have also expanded their use to include card access to

ATM networks. Several ATM systems established by banks use VISA or MasterCard as

the access card to a proprietary system. However, both VISA and MasterCard have also set

up their own national ATM networks to compete with national interchanges. They are in

the process, like other national ATM interchange networks, of attracting ATM networks

from across the United States to join their systems. VISA also plans to establish a global

ATM network.

Because Delaware and South Dakota allow

higher interest charges or annual fees for the

bank card, a number of depository institutions

have moved their processing centers to these

States. Although technically it makes no difference where the actual processing is done,

the critical elements are the type and location

of the organization issuing the card and the

laws that govern the State where the cards are

being distributed. Credit cards are also distributed by nondepository organizations, such as

the American Automobile Association, and by

brokerage houses. These cards are, however,

tied to a financial institution for processing

and credit extension.

Travel and Entertainment Cards. -Travel

and entertainment cards serve the general

public in relatively the same manner as a bank

card. They offer the possibility of deferring

payment. Generally, the monthly limit associated with these cards is far greater than that

of the bank card; some are issued with no

preset expenditure limit. The cardholder is

charged an annual fee, and the monthly statement must be paid in full. As the name implies,

these cards are intended mostly for travel and

business use. Travel and entertainment card

companies generally follow more stringent

guidelines in issuing the charge card than do

issuers of other cards.

Several elite versions of the travel and entertainment card exist; for example, the American Express Gold Card. These elite cards offer check-writing privileges and a higher floor

limit for purchasing goods (which exceed those

for the conventional card). Both the Gold and

conventional cards provide access to ATMs

and traveler’s check dispensers and ease of

check cashing at hotels and American Express

offices.

Photo credit: American Express Co

Automated traveler’s check dispenser
114 ● Effects of Information Technology on Financial Services Systems

—.———-——.—— .— — — —— . —— . — — —

Travel and entertainment card transactions

are consummated in the same manner as with

bank cards. The difference is, however, that

the drafts are accumulated and billed monthly

to the consumer, with the full amount due

within a specified period after billing. Since

this process is considered a payment service,

its cost is unrelated to the funds outstanding,

which are not considered a loan of money with

respect to usury statutes or annual percentage rate disclosures. Usury statutes apply

only when the cardholder elects to pay in

installments through a prearranged line of

credit with a financial institution.

Retail and Nonbank Cards. -Retail credit

cards are distributed by both large and small

retail and service organizations, which have

been in the business of extending credit to individuals and organizations for some time and

were the leaders in establishing the credit card.

Large chains of retail stores, gas/oil companies, and hotel and travel businesses run

their own credit card operations. Sears Roebuck, the largest issuer of retail credit cards

in the United States, accepts only the Sears

credit card in its stores.8 J. C. Penney, also a

‘Nilson Report, June 1983.

major retailer, accepts not only the J. C. Penney proprietary credit card but also VISA and

MasterCard. J. C. Penney, for example, has a

very complex electronic network system, enabling it to service accounts online throughout

the country. The Penney system supports

35,000 online terminals, allowing access to the

VISA system directly without the need for a

financial institution intermediary. It is the

only retailer to do so. Retailers continue to encourage the use of their proprietary credit

cards for several reasons: 1) to provide convenience to their customers, 2) to tie their customer base to their stores, and 3) to facilitate

impulse purchases.

Card operations can also cross companies.

J. C. Penney, for example, processes credit

transactions for oil companies. The authorization is accomplished by running dedicated

lines from the service station to the nearest

Penney store. The signal is then sent over the

main trunk line to the data center where the

authorization file is maintained. The information is captured and transmitted to provide a

basis for generating customer invoices.

Electronic Funds Transfer

Funds transfer is defined as any transfer of

funds by means of a check, draft, or similar

paper instrument or by electronic means

through a terminal, telephone, computer, or

magnetic tape so as to order, instruct, or

authorize a financial institution to debit or

credit an account. A transaction can take several forms: cash purchase, charge purchase,

purchase by check or draft, deposit to an account, withdrawal from an account, or a debit

from one account to another account owned

by the same party, interbank, or intrabank.

A currency-based funds transfer uses cash or

coin. A paper-based transfer of funds is activated by check, draft, or bank card/charge

card (when the transaction is not tied directly

to a communication system that facilitates an

immediate debit or credit).

Electronic funds transfer (EFT) enables consumers to carry out financial transactions via

electronic devices instead of using paper money or checks. Electronic funds transfers can

be carried out through use of an ACH, a home

banking system, an ATM, or a POS system.

One example of an EFT transaction is the use

of an access card, a plastic card encoded with

an identification number to trigger the electronic impulses. Although debit cards allow

access to an account with adequate funds,

some debit cards may also be used to borrow

money, thus becoming all-purpose transaction

cards.
— -— ——

Ch. 4—Retail financial Services ● 115

———— - —. — -- -— —— .—

Automation and electronic payment systems have often been at the forefront of recent

changes in financial service organizations. Certainly one main effect of these changes lies in

the cost reductions that have been made possible by the elimination of paper-based transactions, which are personnel-intensive and,

therefore, costly. Electronic financial services,

however, are not pervasive. While the deployment of ATMs, for example, appears to be

prevalent in major cities, smaller towns and

remote areas of the country still rely on traditional systems for delivering financial services,

although this picture is rapidly changing.

While individuals depend on traditional services, many of the financial service providers

rely on automation for the ease and efficiency

of operating the services. Network systems

continue to expand because communication

and information technologies enable a broader

geographic base to be served and allow increased transaction volume without a proportional increase in costs.

EFT has come to play an important role in

the financial service industry. Although EFT

systems have been operational since the late

1960’s, it wasn’t until the mid-1970’s that

their acceptance became more obvious. Electronically transferring funds today involves

several methods: direct deposit, credit and

check authorization at point of sale, and most

notably, use of the ATM. To some degree, although they have not penetrated the market

as greatly as the ATM, the POS terminal and

remote information systems, such as home

banking, also play significant roles.

Automated Teller Machines

The first applications of automation in customer services were very simple cash dispensers that provided the user with a fixed sum

of cash in a single denomination. These systems generally operated off-line, so the transaction was not a direct debit. Now ATM systems offer most of the same transaction

capabilities as a branch bank, allowing consumers to withdraw cash from a bank account,

make deposits, borrow cash against a line of

credit, obtain a cash advance on a credit card,

pay bills, transfer funds from one account to

another, and inquire about account balances.

(The relative use of ATM functions is illustrated in fig. 7.) Credit can be obtained either

by granting of overdraft limits or, in some

cases, through using a credit card rather than

a debit card to activate the machine to obtain

a cash advance. Systems vary, however; some

are merely cash dispensers, although the technology of the different systems is basically the

same.

The plastic card’s magnetic stripe is the

“key” that unlocks the machine for use. The

way the data are encoded and what items of

information are placed on the magnetic stripe

varies. A great deal of attention has been paid

to the standards being developed for the plastic card.

Although the cost of ATMs has fallen significantly since their introduction, “the cost

of ATMs is unlikely to fall as rapidly as that

of many other parts of an electronic funds

transfer system because of the various mechanical parts that are necessary. The capacity

to process transactions and information will

become much cheaper as intelligent terminals

are developed, with display screens and keyboards being largely electronic. There are

many mechanical parts in the dispensing of

cash, in the printer, and in the mechanisms for

accepting funds. A further result of the mechanical nature of cash dispensing is the shorter life of currency because it quickly becomes

unsuitable for use in cash dispensers’ ‘g

With the ever-increasing operating costs for

traditional delivery systems, the customer demand for new services, and the competition

from new as well as traditional sources, most

organizations in the financial service industry

realize the need to use automated banking systems. The initial cost of establishing an ATM

is high, but it is far less expensive than building a branch bank. And, unlike a branch, it can

be operated around the clock at a fairly low

incremental 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

withdra

75 ”/0

Balance transfers

4 %

1976

:ash withdra

74 ”/0

Balance transfers

3%

1981

lithdr

760/o

Payments

2%

p osits

19 ”/0

Payments

2%

osits

1%

nts

Balance transfers

4%

aExcluding balance lnquiries. Includes only Years for which estimates based on

field research are available

SOURCE Economic Review Federal Reserve Bank of Atlanta, August 1983

that ATMs will provide both competitive advantage and significant return on investment

over the next decade. To soften the high cost

of such systems, especially ATM networks,

many financial institutions have entered into

sharing arrangements.

The ATM, which is operated by the customer, can be located in a variety of places. In the

United States many are installed either in the

main banking space of bank offices, in lobbies

partitioned off from branches, or on the exterior of a building. They can also be located

away from the main bank, at shopping centers,

grocery stores, gas stations, offices, and factories. Almost all systems are or will be online.

The customer’s plastic card allows him/her to

gain access to the ATM location outside banking hours and to conduct his banking business

in relative security.

The large success of ATM deployment has

created another trend in bank branching. Instead of building large, full-service branches

that are personnel-intensive and very costly,

many organizations are replacing these structures with satellite branches, which are smallscale, highly automated, full-service, and generally require management by only two or

three personnel. ATMs, for the most part, replace the teller; personnel are there to handle

general information or other personal business. Figure 8 illustrates the growth in the

number of ATMs in use from 1974 to 1981.

Figure 9 illustrates the increases in the average number of transactions performed at each

ATM.

ATM Systems

ATM services can be offered in one of four

ways: a proprietary system, a shared system,

an interchange system, and a piggyback system. In a proprietary system, or “single institution” system, only the customers of the

bank that developed and installed the ATM

system may use the machines. In a shared system, a group of financial institutions mutually

researches, installs, markets, and operates the

system. In an interchange system, separate institutions with ATM programs or even sepa-
 . . . .

Ch. 4—Retail Financial Services ● 117

r — .- J

—— . —

t– — — J

Photo credits: Steven Rothenberg

Consumers can obtain cash through a variety of service delivery systems
118 ● Effects of Information Technology on Financial Services Systems

Figure 8.— Number of ATMs in Use, 1973-81

“ 50

Annual growth rate

/

45

. A

.

1

40

35

1973 1975 1977 1979 1981

Average annual growth rate, 1973-81

34.780/o

SOURCE Economic Review, Federal Reserve Bank of Atlanta, August 1983, p 16.

Figure 9.—Average Number of Monthly Transactions

per ATM,a 1974-81

7

’

0 0 0

~

6,000

t

c.-

1974 1976 1981

aDoes not include balance inquiries, includes only years for which estimates

based on field research are available

SOURCE Economic Review, Federal Reserve Bank of Atlanta, August 1983, p 16

rate, shared systems allow one another’s

customers to use their machines. The term

“shared system” is associated with an interchange system. Generally, there is an interchange fee associated with using another institution’s ATMs. A piggyback system occurs

when one institution with equipment allows

the customers of other institutions to use its

machines .10

—

‘“Norman Penny and Donald Baker, The Law of Electronic

Funds Transfer Systems, (Boston, Mass.: Warren, Gorham &

Lament, year), p. 6.03.

Shared ATM Systems

The number of shared and interchange systems is growing rapidly. As national ATM interchange proliferates, shared systems such

as Plus and CIRRUS allow customers access

to their funds on a national basis. National interchange systems, however, are not being run

only by banking organizations. ADP, Inc., and

American Express have also begun developing and marketing national ATM interchange

networks. Supermarkets and retailers are also

positioning themselves in the ATM arena.

There are, however, limitations to the kinds

of services available through the national networks. Presently, because Federal regulation

prohibits interstate deposit-taking,* most systems serve as cash dispensers and provide information about account balances. The fees

imposed for using national ATM systems are

set by the individual networks and range from

$0.75 to $1.30 per transaction. A portion of

the fee goes to the financial institution whose

machine is being used, and a portion goes to

the organization running the system.

Not all ATM systems are run by banking

organizations. With the advent of regional and

national ATM networks, ownership of these

networks by third parties has become a major business. The systems operate in two ways:

the third-party company can own, deploy, and

operate the ATM network, with the financial

organization paying a transaction fee each

time its customers use the machine, or the

third party can be the switch operator, receiving either a percentage of the transaction fee

or a fixed monthly fee for its processing efforts. These systems are developed on a local,

regional, and national basis and are in direct

competition with bank-run systems.

Safeway–an Oakland, Calif., supermarket

chain-has announced plans to develop and

market a national ATM network. Presently,

Safeway participates in a shared interchange

*Reciprocity agreement,g exist among several states. ‘he

Massachusetts Legislature passed a bill in 1983 entitled “An

Act Relative to Branch Offices and Acquisitions of Financial

Institutions, ” that permits interstate deployment of ATMs and

deposit-taking among five New England States.
Ch. 4—Retail Financial Services ● 119

.——.

network, owned and operated by the Network

Exchange of metropolitan Washington, D.C.

The objective of the Safeway program for instore ATMs is to increase store traffic and

sales by providing customers with full-service,

one-stop shopping convenience. Safeway has

committed to installing common-access ATMs

in key stores throughout California. The

Washington, D. C., program, however, is presently not a participant of the Safeway ATM

program being developed in Oakland. To attract the maximum number of prospective

shoppers, Safeway will promote both the availability of the ATM services at its stores and

the financial institution cards that can access

the machines. Safeway is also prepared to

assist the participating financial institutions

in generating new accounts that can access the

in-store ATM services.

Participation in the program is on a transaction-fee basis. National Transaction Systems, Inc. (NTSI), will provide ATMs; install,

maintain, and service them; and perform all

required transaction processing, funds transfer, settlement accounting, billing, and customer service operations required to support

the Safeway ATM program. Safeway cash

machines will be linked to NTSI switching

and processing system via leased telephone

data circuit. Other leased data circuits will link

the switch with the participating institutions’

host computers. Initially, the only function

available will be cash dispensing, selected by

the financial institutions from the following

three service-level options:

1.

2.

Direct host link. The participating institution’s computer is linked directly to the

NTSI switching processor. The institution pays for the dedicated data circuit

and modems associated with its host computer link to the NTSI switch.

Direct host fink with “stand-in “processing. NTSI maintains a cardholder authorization file and control parameters on the

NTSI computer for processing the participating financial institution’s cardholder

Safeway Cash Machine withdrawal transactions when the institution’s host computer is not available. In addition to the

3.

dedicated data circuit and modems, the

institution pays a service fee for the

stand-in processing option.

Full stand-in processing. NTSI maintains

the participating institution’s cardholder file online at NTSI. NTSI verifies the

cardholder’s personal identification number and authorizes or denies the cardholder’s Safeway Cash Machine transaction in accordance with the institution’s

authorization parameters and cardholder

positive file information, updated daily by

the institution’s processor. The institution pays an additional service fee for this

stand-in processing option.

Merrill Lynch, Pierce, Fenner, & Smith Inc.,

has signed an agreement with Safeway Stores,

Inc., that will enable the brokerage concern’s

customers to tie into the Safeway ATM network. Merrill Lynch customers who have one

of its Cash Management Accounts, which link

a securities account and money market funds

with “check” writing privileges and a VISA

card, can use the VISA card to obtain cash at

Safeway stores. This is expected to begin in

early March 1984; it will be limited, for the

present time, to California locations. However,

Merrill Lynch expects to expand the services

to include nationwide access.

In Florida, Publix supermarkets has also established its own ATM network, which it offers for use to any bank in the State (operated

on a piggyback basis). Fees are imposed for

every transaction a customer makes at a Publix terminal. In addition to deploying the

ATM, Publix also runs the switch that operates the system.

Shared systems exist primarily on a local/regional basis. The Tyme Corp. of Wisconsin has

operated as one of the first shared systems in

the United States, and in Washington, D. C.,

the Money Exchange has operated as one of

the first shared networks on an interstate

basis. Shared/interchange systems allow the

small institution to compete with other financial institutions in the ATM competition. The

feasibility of all financial institutions operating switches and deploying ATMs within a

35-505 0 - 84 - 9 : QL 3
120 . Effects of Information Technology on Financial Services Systems

———— —.— ——.——— —

contained area is uneconomical. By operating

in a shared/interchange environment, the financial institution can extend the geographic

reach of its market and earn income from the

ATM.

CIRRUS—National ATM Network

The CIRRUS System, Inc., is a not-for-profit membership corporation that allows its

members to offer their customers the convenience of nationwide ATM access. Incorporated

in June 1982, CIRRUS is headquartered in

Oak Brook, Ill. When fully operational, it will

serve 41 States. Growth projections for the

system are summarized in table 5.

Membership in CIRRUS is exclusively reserved for banks, savings and loans, and credit

unions. Associate membership is limited to

banks. CIRRUS does not preclude its members from joining other networks, nor does it

require the sharing of other electronic services,

such as POS terminals. There are three classes

of membership for the CIRRUS System:

1. Principal. Principal members have exclusive marketing rights in their territories. They may share their link to the

CIRRUS switch, run by the National Bank

of Detroit, by licensing correspondent

members. Principal members are required

to add their ATMs to the network.

2. Associate. Associate members also have

a direct link to the CIRRUS switch and

may share their connection with the correspondent members they license.

3. Correspondent. Correspondent members

are linked to the CIRRUS stitch through

the principal or associate members who

license them.

CIRRUS allows its members to offer their

customers the convenience of nationwide

ATM access. Using a CIRRUS card at an

ATM deployed by any CIRRUS member, a

customer can make a withdrawal from his savings or checking account, check balances, and

access a line of credit. All CIRRUS ATMs

must accept the cards of every CIRRUS member; however, individual members may set

limits on the amount of cash their customers

may withdraw at a time. CIRRUS ATMs

must also be online in order to authorize transactions. The CIRRUS switch, maintained by

the National Bank of Detroit, does not provide

backup authorizations for its members. The

network ensures against switching downtime

by utilizing an ACI/Tandem computer.

Individual CIRRUS members are responsible for the cost of hooking up to the switch

and maintaining the connection. They must

also pay for hardware and software modifications necessary to comply with the network’s

operating rules.

Associate members pay a one-time entrance

fee of $25,000 to join the network, connect

with the switch, and reserve the right to license correspondent members. Correspondent

members’ entrance fees are set by agreement

with the licensing banks. Ongoing membership fees for the CIRRUS System are $2,500

per month for associate members; correspondent members pay the membership fees set by

their licensing bank. There are also processing and interchange fees. Each time a CIRRUS

cardholder uses his ATM card at a bank other

than his own, the card issuer pays the switch

$0.25 for processing the transaction. For withdrawals and for accessing a line of credit, the

card issuer also pays the institution deploying the ATM an additional $0.50 interchange

fee per transaction. For balance inquiries and

other transactions, the card issuer pays the

machine-deploying institution a $0.25 interchange 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 2,297

Number of CIRRUS ATMs deployed . . . . . . 3,364 5)015 7,210 8,839

Number of CIRRUS cardholders . . . . . . . . . 14,600,000 18,000,000 28,900,000 32,700,000

SOURCE The CIRRUS System, Inc
.

.—

Ch. 4—Retail Financial Services ● 121

ATM-deploying institutions earn revenue

from interchange fees every time another institution’s cardholder uses their machines to

transact banking business. Card-issuing institutions are permitted to charge their customers for the privilege of being linked to the

CIRRUS network. Associate members can

share their direct link to the CIRRUS switch

with other institutions for a fee, and no matter how many correspondents an associate

signs up, it never has to pay more than its flat

monthly membership fee. Members of the

CIRRUS network are free to join other

networks.

When fully operational, CIRRUS will link

over 5,200 ATMs serving over 16 million customers. The national ATM switch is designed

to handle at least two transactions per second.

This represents a daily capacity of 173,000

transactions.11

ATM Deployment Legislation

Deployment of ATMs remains dependent on

State-by-State banking legislation. Figure 10

shows the number of ATMs in each of the

States in 1983. Certain States, such as Illinois,

have very strict, off-premise deployment laws.

Illinois permits State-chartered banks to

establish ATMs subject to a number of geographic, 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 1700

500 to 700

300 to 500

200 to 300

Less than 100
122 ● Effects of Information Technology on Financial Services Systems

—

prior to January 1, 1980, a bank may establish not more than two ATMs, each no more

than 3,500 yards from its main office. Second,

commencing January 1, 1980, a bank may establish an additional eight ATMs, at the rate

of two per year. Third, prior to January 1,

1981, these ATMs maybe located only within

the county of a bank’s main office. Finally,

subsequent to January 1, 1981, a maximum

of four of the eight ATMs may be located

within an adjacent county. ATMs located not

more than 3,500 yards from the bank’s premises need not be shared, but those located more

than 3,500 yards from the bank’s main premises must be made available on a nondiscriminatory basis for use by customers of any other

bank that would be permitted (under the statutory geographic restrictions) to establish an

ATM at that particular location. ’z

In sharp contrast to the restrictive Illinois

law is Wisconsin legislation on terminal deployment and usage:

Facilities established under the Wisconsin

EFT statutory provisions must be available

on a nondiscriminatory basis for use by any

like institution which has its principal place

of business in the State, or by any other like

institution which obtains the consent of a like

State, or by a national institution which has

its principal place of business in the State and

which is using the terminal.

The statute requires that regulations prohibit, with regard to a shared terminal, any

advertising that suggests or implies exclusive

ownership or control of the terminal by a financial institution or group of institutions. 13

Wisconsin law made possible the first shared

ATM network in the United States and one

of the largest.

Massachusetts went one step further. In

early 1983 a law was passed that, for the first

time, permits Massachusetts financial institutions to link their ATMs to regional and national interchanges. Entitled “An Act Relative to Branch Offices and Acquisitions of

“Robert C. Zimmer and Theresa A. 13inhom, The Law of Ekctronic Funds Transfer, Card Services, inc., 1980, pp. I 1-11 to

I 1-13.

“Ibid., p. WI-1.

Financial Institutions, ” the act establishes

new authority for mergers, branching, electronic branching, and mortgage lending by

Massachusetts financial institutions. While

the act is generally limited in its operation to

activities involving five New England States,

the EFT provisions are expressly exempted

from such limitations. Under prior law, no outof-State financial institution nor bank holding

company was permitted to purchase, establish, install, lease, use, or share an ATM in

Massachusetts. The sole exception was allowed in a grandfather clause that exempted

from the prohibition certain electronic

branches established before December 31,

1981. To qualify for the exception, the ATM

had to dispense only cash, traveler’s checks,

or both, and had to be limited solely to the use

of customers of the financial institution that

established it.

The new law empowers Massachusetts institutions to link their ATMs to regional or national networks. It also permits a financial

institution, organization, or bank holding company, or its subsidiary organized outside of

Massachusetts, to share any ATM established

and used by a Massachusetts financial institution or organization, provided that the sharing entity limits its customers to cash withdrawals, advances against preauthorized lines

of credit, and check cashing. Moreover, any

out-of-State nondepository financial institution that establishes electronic branches that

dispense only traveler’s checks and are limited

to use by the nondepository’s own customers,

such as American Express’s Express Cash

Program, are allowed to establish, use, or

share electronic branches in Massachusetts.

Finally, the new law authorizes financial institutions, organizations, and bank holding

companies in Conneticut, Maine, New Hampshire, Rhode Island, and Vermont to purchase,

establish, install, operate, lease, or use electronic branches. That is, whereas the prior law

permitted institutions from any State to share

ATMs established and used by Massachusetts

institutions, the new law allows New England

institutions themselves to establish and use

ATMs in Massachusetts, whether or not a
-—— —=—— . .—

Ch. 4—Retail Financial Services ● 123

— — ..———— — — ———.—

Massachusetts institution is involved. ” All of

the participating States passed legislation approving the interstate branching.

There are no uniform guidelines on ATM deployment that each State follows in making

its EFT deployment laws. Each State’s legislature determines what approach will be best

for the consumer and the banking community.

POS Full Funds Transfer

The term “point of sale” covers a variety of

services rendered through machines located at

retail establishments. POS terminals are generally clerk-operated devices located at the

checkout or convenience counter of retail establishments. Electronic cash register versions of these terminals have been in operation for several years, maintaining store

records on sales, inventories, accounts

receivable, and the like. Now, POS devices

have been linked to financial institution computers, allowing retail customers to receive approval for check cashing and electronically initiate transfers from their accounts to the

retailer’s, the latter being POS full funds

transfer. In some installations, customers can

make deposits to their accounts. POS devices

accept either a plastic credit card or a plastic

debit card, depending on whether the customer wants to delay payment by charging the

purchase or wants the purchase deducted directly from his/her account. As electronic POS

systems proliferate, their use will probably replace many of the paper transactions accomplished through cash payments and check and

credit transactions.

The debit card, another means of facilitating

funds transfer at point of sale, functions much

the same way a credit card functions except

that when the transaction is received by the

issuing financial institution, it is debited to the

cardholder’s account, which may be a checking, savings, NOW, or other form of depository account. Some securities firms have

distributed debit cards to access cash manage-

—. —..

41+:lc~tr0niC F’und< Transfer Association, llrashin~~ton Report,

tJan, 11, 19H3.

ment funds. The card may also have an overdraft credit line. There has been much customer resistance to using a debit card at the

point of sale because the customer associates

the use of a plastic card with the elimination

of float, which allows a grace period before actual payment is required. Also, many people

in the industry have referred to the debit card

as a paperless check, which is one of the reasons that retailers have been reluctant to accept it. Presently, retailers can accept accept

and process checks for less than the fee imposed for processing a debit or credit card

transaction. These differences have resulted

in controversy between the retailer and cardissuing institutions.

Another form of debit card transaction at

point of sale gives the cardholder a rebate,

which encourages use of direct debit at point

of sale. Customers use the card, which works

online, to debit their account directly to any

participating retailer. The retailer receives instant credit, and the customer receives a rebate, ranging anywhere from 2 to 5 percent,

directly credited to his savings account. One

of the most successful of these programs is

that of the Wilmington (Delaware) Savings

Fund Society. Most of the other programs,

however, have been unsuccessful. First of all,

a significant card base was not represented.

Second, many of the stores that signed up for

the program were inconvenient to the majority

of the cardholders, and these stores also

tended to sell products at a higher cost than

did discount stores.

Direct Debit POS

Retail Stores.–Although previously not

many POS systems operated in retail stores,

there is tremendous potential for their use.

One of the most successful direct debit POS

programs is in Des Moines, Iowa. There, Dahls

and Hy-Vee supermarkets operate direct debit

POS systems at the checkout counter, the first

such systems in the United States. Customers of these supermarkets can pay for groceries

with a proprietary debit card issued by Norwest Bank, which automatically debits the

cardholder’s account. ITS, Inc., operates the
124 ● Effects of Information Technology on Financial Services Systems

computer switch that makes EFT possible for

some of the 205 participating Iowa banks, savings and loans, and credit unions. The Hy-Vee

supermarket does about 4,000 POS transactions per month; Dahl’s does about 2,000 per

month. Each location paid about $18,000 to

install magnetic stripe readers and keyboard

add-ons to the NCR cash registers and to buy

the processors and software. However, volume

sales of the systems should cut costs. Moreover, the store receives good funds the next

day.

Retailers and banks both benefit by having

access to the customer’s float, and both the

retailer and the bank are assured the funds are

good. “To encourage direct debit use, bankers

will price check transactions higher than their

debit card counterparts to nudge consumers

along. The cost of processing one check is estimated at about 50@, and an EFT transaction

costs about 30©. The higher the volume in

EFT, the lower the per transaction cost because of the high fixed overhead. ”15

Oil and Gas Companies.–The gasoline station is currently the focus of much POS activity because it generates more transaction volume than any other kind of retailer.16 Many

large oil and gas companies are installing POS

terminals at service stations. A few direct

debit POS terminals are being deployed directly into the gas pumps, although the majority are stand-alone terminals.

While still in its infancy, the idea of deploying POS terminals at service stations is becoming more accepted because of the increase

in self-service gas stations, because more stations are remaining open 24 hours a day, and

because service stations are often vulnerable

to robberies. To help reduce the tremendous

volume of cash generated each week by gasoline purchases, major oil companies and banks

across the country are joining forces to test

POS terminals at the pumps, using proprietary credit cards or bank debit cards as an

“Forbes, Aug. 29, 1983, p. 46.

loMmagement Information Systems Week, July 27, 1983,

p. 81.

—

alternative method of payment. Most of the

tests at the service station involve agreements

between oil companies and financial institutions under which customers can pay for purchases using bank debit cards that automatically debit the amount of purchase from their

checking accounts. However, there is additional interest in proprietary credit card transactions at points of sale. Mobil Oil Co., for example, has 2,400 POS terminals linked to its

Kansas City processing center, which captures

all transaction information via electronic draft

capture. Since the system is online the information is transmitted immediately. This POS

system enables Mobil to capture billing information electronically, saving internal costs by

reducing the amount of paper used in such

transactions. Mobil implemented a credit POS

system, which could easily convert to a hybrid

system supporting both debit and credit, to

maintain its loyal customer base and to generate new business. Mobil representatives feel

that direct debit at this stage would alienate

customers.

The POS transaction begins by the service

station clerk inserting the card into a POS terminal. In some cases, the customer inserts the

card into an automated pump and then keys

in his own personal identification number

(PIN). By implementing direct debit POS terminals, the customer’s account is automatically debited, and the retailer’s account is generally credited immediately or the next day.

The benefits to both banks and oil companies

are savings of millions of dollars. In most

cases, the bank or network operator receives

a transaction fee for each purchase. The oil

company saves by being assured of good funds

and by receiving payment immediately. This

is a significant issue because the general lag

time for credit card sales draft, according to

a Mobil Oil Co. official, is 10 days.

Some POS test situations currently under

way are being done by AmeriTrust Bank, Shell

Oil, and Gastown in Cleveland, Wells Fargo

Bank and Shell service stations in San Francisco, First City National Bank of Houston

and Exxon Co.
Ch. 4—Retail Financial Services ● 125

-—— —— ——.. ————— —

National POS Systems

Large-scale communication networks are being developed, primarily by the major credit

card industry, to connect thousands of POS

retail terminals with financial institutions

within a State, region, and, ultimately, the Nation. These networks will include computerized

switching centers and a base for clearing settlements.

In addition, oil companies, banks, and other

retailers are considering national POS networks. Tests are being conducted by Liberty

National Bank & Trust Co. of Oklahoma City

and a Southwest oil dealer whereby terminals

will be deployed at stations offering the following services: automated dispensing at the

pump, an ATM inside the station for purchasing convenience items, and a commercial depository that is wired to the ATM so that

high-volume stations can make deposits.

At the present time, POS systems are being allowed by regulators to access time and

savings accounts; however, this could change.

Regulation D* is not being strictly interpreted

with respect to POS activity. However, if the

regulation were strictly interpreted, a large

number of financial institutions, savings and

loans, and savings banks, would be prohibited

from actively participating in a POS system.

Other Uses of POS Systems

The POS terminal can also be used for check

authorization, permitting the customer to obtain approval of a check for payment by running a verification of the check-cashing record

through a computer. Likewise, the POS system enables merchants to verify the availability of funds in a customer’s account or his access to credit before completing the sale. As

with ATMs, customer access to POS terminals

is usually by plastic card and PIN. This is an

alternative to manual authorization and verification, which is handled by accessing a neg-

*Regulation D is a uniform reserve requirement on all depository institutions with transaction accounts or on personal time

deposits. It requires submitting reports on all deposits to the

Federal Reserve Board and sets phase-in schedules for reserve

requirements.

ative file or by having the retailer check a manual that lists card numbers of bad credit risks.

In the United States, POS experiments have

been conducted since 1974. Very few systems

involving instant transfer have survived, and

the most important functions of POS, until

online direct debit systems were in place, have

been check verification and credit card authorization. One explanation for this very limited

success could be that the experiments have

generally looked for evidence of profitability

within a few months of installation, whereas

the change in social habits involved in moving from cash and checks to instant transfer

takes a great deal longer.

Costs of POS Systems

For several years merchants and financial

institutions have been at an impasse over how

to implement electronic payment systems,

especially retail EFT systems. The differing

perspectives reflect differences in technologies

being used, in terminal ownership, in customer

bases, and in approaches in pricing the service.

One of the main concerns associated with

implementing POS systems is the cost to be

borne by retailers and banks. Another is the

concern about merchant discount fees. Most

banks charge the merchant the same fee for

debit card transactions as they do for credit

card transactions. The argument made by the

merchant is that debit cards function in lieu

of a paper check and therefore the merchant

should not pay the same discount fee. A POS

system can all but eliminate float, reduce

credit risks, require the merchant to keep less

cash on hand, and ease check approval.

Technology has also been a basis for conflict

between the merchants and POS operators. Financial institutions typically base their debit

cards on the magnetic stripe technology used

for years on bank credit cards. Grocery retailers, on the other hand, typically base their

technology on an optical scanner that reads

bar codes on product labels and transmits the

information to an electronic cash register

(ECR). Department stores typically prefer optical character recognition characters read
126 • Effects of Information Technology on Financial Services Systems —

from merchandise tags and proprietary credit

cards with a handheld wand. Product and customer information is fed into an ECR to effect electronic payments.

Financial institutions tend to prefer owning

the necessary terminals and charging merchants a user’s fee for making transactions

through them. On the other hand, retailers

tend to prefer devices that are integral components of their own ECRS.

17 Naturally, financial institutions and the merchants are wedded

to their respective investments. It is unrealistic to expect the merchants to give up their

technology in order to accept electronic payments. Developments such as VISA’s “electron card” are aimed at simplifying this

problem.

Another issue with respect to POS systems

is the volume of sales to be handled. It has

been argued that to be viable economically, the

POS system must become competitive with

cash; otherwise, there is no incentive for the

retailer or the customer to use it. The customer

is faced with loss of float, and the retailer is

faced with transaction fees, which cash payments do not require. Under these conditions,

systems that are shared among all the banks

—.- ——_——

“’’Debit Cards at the Cross Roads, ” Economic Review, March

1983, pp. 37-38.

in an area and that provide for the recruitment

of most retail outlets stand the greatest

chance of success.

POS systems will undoubtedly increase during the next decade, with many new systems

being built upon existing ATM networks.

Both the banks and retailers stand to gain

from the resulting reduction in the volume of

paper transfers. However, merchants contend

that since a debit card transaction saves financial institutions time and money relative to a

check transaction, merchants should enjoy

some of the savings. It has become quite

apparent that in order for POS systems to develop and operate efficiently, the systems

must be designed in close cooperation with the

individual retailers, not just the markets the

systems serve.

The technology necessary to operate electronic debit and facilitate POS transactions

exists today. It is the intention that electronic

debit cards will substitute for check, credit

card, and cash transactions. However, when

POS services become commonplace, the use

of cash and checks as a payment mechanism

will still exist. Disconcerting cost trends are

leading merchants and financial institutions

to seek lower cost alternatives for POS transactions. EFT is the method by which this goal

can be reached.

Financial Information Services

There are many forms of information services in the financial service industry. They include check or credit authorization/verification; status information on account balances;

identification verification; billing and funds

due information (e.g., preauthorized payments); accounting information with respect

to general ledger, payroll, accounts payable,

accounts receivable; and modeling and analytical services, such as Chase Econometrics and

Wharton Econometrics, which provide access

to data bases, econometric models and modeling tools, and various other analytical

packages.

All financial service providers use information services. Retailers are perhaps one of the

largest users of specific information services,

particularly check verification. Check verification validates the authenticity of the check

or its presenter. This system is accessed online

through a telephone or terminal by the retailer.

The retailer pays for this service, generally a

percentage of the value of the check. These
Ch. 4—Retail Financial Services ● 127 — .

systems are run by third-party organizations

and banks that maintain negative files.

Check Authorization

Check authorization systems may be provided and maintained by the party accepting

the check, by a financial institution, or by a

third party engaged in such a business. The

systems may be designed to access bank records directly or may rely on secondary data

sources. In some systems, check approval is

accompanied by a guarantee of payment. In

an EFT system, a customer’s plastic card and

PIN can be used to access the system and verify the available balance. This is accomplished

by placing the check into a terminal and keying in the appropriate information. The check

is then validated and accepted at point of sale.

Credit Authorization

Credit authorization is yet another information service vehicle available to the retailer.

It operates by allowing the customer’s credit

card to be read by a financial service terminal

while a central computer verifies that the card

is valid and the customer’s account has sufficient funds. This can also be accomplished

manually by checking a printed document, distributed by the card companies, indicating lost

or stolen card numbers or by placing a call to

an operator who will authorize or refuse the

transaction based on information from a data

base. This inquiry process is supposed to reduce the risk of credit fraud or of extending

credit in excess of an imposed credit limit.

Information service systems allow for realtime access and reduction of risk at point of

sale and ensure that the retailer will receive

the funds. The risk is transferred to the party

authorizing the funds. This service guarantees

payment to the retailer and is attractive despite the fact that the retailer must pay a

premium to insure the funds.

Providers of Information Services

Many kinds of organizations are information

providers. Depository institutions use and provide information in unique ways. For example, the services they perform include providing status information to their customers on

a very regular basis. The most familiar processes are inquiry of account balances or funds

credited or inquiries regarding specific check

clearing. Today, much of the status inquiry information is processed by online teller terminals with direct access to the accounts being questioned.

Service organizations provide accounting information services to customers, such as information services about payroll or accounts

receivable/payable or other services necessary

for efficiently running the organization without the added costs of implementing an automated system in-house. A wide variety of

firms, including financial service providers, offers these services.

Two other key information service providers

in the financial service industry are investment brokers and insurance firms. (The brokerage industry is covered in ch. 3 of this report.) Insurance information is compiled by

actuarial scientists and categorized by risk,

age, and the like. Much of this information is

available to individual brokers through online

videotex terminals. Insurance information requires some customization in order to meet the

specific needs of the party requesting the insurance, although premiums and risk are determined by actuarial methods.

The information provider in the insurance

industry is the insurance salesman. Although

much information about general insurance is

accessed to data bases via terminals, the processing of this information still requires the personal interaction of the salesman and client to

provide the service adequately. Some insurance information is provided through computer/CRT* terminals that display rates and

also give an explanation of the types of insurance available. The insurance industry is looking at further automating the delivery of insurance information.

*CRT terminal—video terminals that display data on a cathode-ray tube.
128 ● Effects of Information Technology on Financial Services Systems

The following scenario may present itself in

the near future. Through videotex and home

information systems, insurance information

can be transmitted and reviewed by an individual. If the need presented itself, for example, an individual would be able to increase

the amount of homeowner’s insurance for a

specific period of time, say a weekend, if he

planned to be out of town. The insurance policy modifications could be done instantaneously, and the additional premium payment

could be automatically debited from the cash

value of other insurance policies.

Several of the larger banks in the United

States offer financial, securities, and investment analyses; payment products, models and

data bases to corporations, other banks, insurance companies, financial institutions, and

government agencies. An example is terminalbased cash management for major corporations and banks.

Mortgage servicing is another aspect of

financial information services. Mortgage bankers and a growing number of commercial, mutual savings bank, and savings and loan customers use this type of service for servicing

their portfolios of mortgage loans, which include taxes, escrows, and insurance. Loan closing documentation and mortgage preparation

systems are available to help customers of the

service keep track of inventories and financial

commitment needs. Batch transmission and

inquiry modes to a central location are used

via dial-up and leased transmission lines. In

this manner, nationwide service is provided

from a single location.l8

Information services provide immediate access to financial information and are used to

18 Herbert A. Schulke, Jr., “Electronic Financial Systems, ”

Innovations in Telecommunications, Academic Press, Inc.,

1982, p. 1038.

transfer funds efficiently from one account to

another. For example, in a corporate environment, real-time access and videotex technology allows a treasurer or financial advisor to

manage and control all of the investment accounts. Through the same technology, investments can be transferred on a daily or perhaps

even hourly basis.

Many organizations today conduct financial

counseling programs for all ages and groups.

These groups organize to seek sound financial

guidance and to plan for long-range money

goals. Interestingly, these groups include not

only the affluent market but also young professionals and middle-income individuals who

have become far more educated and concerned

about how their finances are handled.

Different sectors of the financial service industry require different information services.

For example, a bank loan officer may inventory data to assess liquidity and solvency. Financial analysts are concerned with equity investment decisions and are likely to place more

importance on earnings-per-share and capital

account data. On the other hand, various financial service groups use the same information in different ways in the decision process.

Service industries, such as banking, securities, and insurance, whose business operations

rely heavily on information services, are finding that the whole environment in which they

operate is changing rapidly. Earlier developments in information technology were such

that only large corporations could take advantage of its capabilities. However, over the last

several years, technical innovation has continued at such a rapid pace that, for example,

information processing power, which once

took a roomful of large equipment, is now

available in portable machinery.

Home Information Systems

Home information services are a way by Home information systems (HIS) started in

which financial information services can be de- a relatively minor way in the United States

livered to users of home computer terminals. several years ago with the introduction of bill
Ch. 4—Retail Financial Services • 129

.—— . —. —. —.—— — — -

paying by telephone. The original impetus

came from thrift institutions, which saw telephone bill payment as a way to offer transaction accounts, thereby partially circumventing the law forbidding payment of interest on

demand deposits. Soon commercial banks began offering the service. When the telephone

bill payment service was first introduced, most

of the systems required the customer to call

in and give oral instructions over the telephone

to an operator to perform banking services,

specifically bill payment. Automation was introduced and made available to customers

with touch-tone phones, although most systems still relied on operators during the business hours and on recorded messages at other

times. Telephone bill paying services did not

attract a large customer base, and many of the

early programs have come to a halt.

Technology of Home

Information Services

The introduction of videotex played a key

role in the development of home information

systems. Videotex—a generic term that refers

to computer-based information retrieval systems that display text and graphics via video

screen—is a product of the convergence of

telecommunications and computing technologies. Through teletex* and videotex, one-way

and two-way computer-based retrieval systems, information can be widely disseminated

for viewing on modified television sets or on

personal computers. In the last year or so, full

videotex systems have become operational in

several countries, giving the user the ability

to send communications to the system computer for onward transmission. Because the

videotex system is interactive, it can be used

to facilitate financial transactions. The system

functions in several ways. One way uses a

videotex terminal and a television (which acts

as a visual display unit); the communication

with the system is supplied by telephone lines

*Teletex is a one-way system that displays alphabetic and

graphic information on a modified television set. Videotex displays the same sorts of information as teletex but also provides

a communication path for the user to interact with the service

provider.

or cable lines. Some systems provide a hybrid

communication delivery, using cable for incoming information and the telephone for outgoing information. In-place cable lines are primarily one-way communication lines, although

most new cable lines being laid today are twoway cable lines.

Home computers also allow interaction with

HIS and are becoming popular for receiving

the services. A modem** can be used to tie

the home computer to the information source

by telephone lines. A CRT or television screen

acts as the visual display terminal. The home

banking software which runs the system is distributed by the participating financial institution.

As stated, cable plays an increasing role in

the delivery of home information services.

“The latest cable television systems now being developed will transform the technology

of videotex and the economics of home banking. The use of coaxial or fiber optic cables

gives much greater bandwidth, which provides

three substantial technical advantages: 1) the

possibility of carrying a large number of channels, up to 100 or more; 2) a more satisfactory

and speedy interactive facility; and 3) a much

improved ability to produce pictures (important in using home shopping).’’” Direct broadcasting by satellite, which is being developed,

is another method by which information can

be transmitted into the home.

Developers of Home Information Systems

Home information systems are being developed by a myriad of organizations that include

depository institutions (presently Bank of

America and Chemical Bank are marketing

systems that are up and running), information

companies, entertainment companies, and the

like. Several systems are being developed as

cosponsored, joint ventures by consortia of

major banks and corporations. One example

**A modem transmits digital or computer information over

telephone lines by manipulating it electronically and also protects the lines from undesirable signals that might cause interference with other users.

19Revel], op. cit., p. 50.
130 ● Effects of Information Technology on Financial Services Systems

—. —

of a major project is the Viewtron Program

in Miami, Fla. The Viewtron system will be

supported by computers from seven major corporations from around the country and will be

linked to Viewdata Corp. ’s Viewtron computers in Miami. The gateways are American

Express—subscribers will have access to a variety of services offered by this company; Commodity News Services—subscribers will be

provided with instant and delayed stock market and commodity price quotations; and E.

F. Hutton–subscribers will be able to track

their personal investments and receive investment advice with “Huttonline,” the first electronic information service offered by a retail

brokerage house. E. F. Hutton customers will

be able to access Hutton’s computers in New

York City for information about their accounts, such as cash management and margin

balances, portfolio positions and market values, open orders, and recent transactions. All

Viewtron subscribers will be able to order

E. F. Hutton market comments and investment advice and send electronic mail to E. F.

Hutton offices. Viewtron subscribers will also

be able to order J. C. Penney catalog merchandise by using a direct link to J. C. Penney computers in Atlanta. They will receive online order confirmation upon completion of their

order. If the requested item is not available

in the color requested, the J. C. Penney computer will offer the Viewtron subscriber other

color possibilities. The J. C. Penney catalog

inventory system is immediately and automatically updated. In addition to processing the

catalog order, the gateway to J. C. Penney will

also provide for credit authorization for the J.

C. Penney card, as well as for VISA and Mastercard. In addition, information from The

Official Airline Guide and Grolier Academic

American Encylopedia will also be available.

The financial gateway to the system, VideoFinancial Services, is jointly owned by four

major bank holding companies: Southeast

Banking Corp., Miami; Wachovia Corp., Winston-Salem, N. C.; Bane One Corp., Columbus,

Ohio; and Security Pacific Corp., Los Angeles,

Calif.

Applause, the home banking software offered by VideoFinancial Services, will supply

a variety of services. The home banking activities include bill payment, funds transfer and

account information, and special financial requests. VideoFinancial Services also provides

credit authorization and settlement for credit

card shopping orders placed on Viewtron. The

system permits each participating financial

organization to specify unique features within

the system standard, including the use of individual colors and graphics. Presently, 12

Florida banks and savings and loans will provide home banking to Viewtron subscribers

via VideoFinancial Services’ computers in Orlando, Fla.

As a financial gateway, VideoFinancial proposes to provide the Applause service to all

sections of the country through any videotex

network. To support such an objective, VideoFinancial expects to establish regional data

centers, where practical and necessary, to interconnect the financial industry to the regional network operator. The system will be

streamlined. First, the home terminals will tie

directly to the network operator, who will be

fully responsible for promoting, enrolling, and

billing the consumer for the network service.

Communications, terminals, and data base

management will be provided and managed by

the service provider. The network will then

feed into the VideoFinancial computer system.

VideoFinancial will either connect online with

or provide batch processing for subscribing financial organizations and will be responsible

for developing and maintaining the home banking software package. The VideoFinancial

computer system will tie in directly to the financial organizations offering the service.

These financial institutions will assist the network operator in enrolling the consumer and

will provide the data to VideoFinancial to support the home terminal request.

Over 50 information providers, including

major wire services, educational organizations,

reference and financial book publishers, universities, libraries, and professional organizations provide information for Viewtron.
—

—-—— — .

Interestingly, the advent of HIS has encouraged cooperation instead of competition

among the various financial service providers.

Costs of Home Information Systems

Cost is one of the major issues associated

with the success of the HIS program. The

Viewtron videotex costs are as follows:

● Subscription to the Viewtron service: $12

per month for access to nearly all Viewtron services.

• Communication charges to access Viewtron: approximately $14 per month (approximately $1 per hour to access Viewtron).

A serious consideration is the influence of

local communication costs and their impact on

HIS. It is possible that communication costs

could increase to such a degree that the cost

of making a local call discourages use or forces

development of new types of local links.

Consumer acceptance of home banking/

home information systems will be based on

several other factors besides the natural inclination toward using these services. These

factors include price of obtaining the hardware/software needed to use these services,

price of using the services, and availability of

these services. *

The Market for Home

Information Systems

Much speculation has been associated with

the home information market. Several leading

authorities have targeted the affluent segment

of the population as the major users of the

home terminal. Their claim is that many consumers with incomes over $40,000 per year

have an insatiable need for information of

various types. The home terminal has great

potential as the major investment, shopping,

and news information source for affluent consumers. Additionally, it has been stated that

many affluent consumers feel strongly that

they can conduct their own financial transactions better than bank personnel can, and

some find it enjoyable.

— . .

* Information from Reistad Corp.—research conclusions.

Ch. 4—Retail Financial Services . 131

-. —. . .———...————— — —— —

Systems now in operation serve interactive

facilities, providing travel services, sports, and

general entertainment information (e.g., restaurant and movie guides); stock exchange information; shopping capabilities; and banking

applications in a form similar to that of selfservice banking. Users of these systems can

pay bills, transfer funds, check balances, review banking statements, and keep up-to-date

financial records.

The elderly may be another target market

for such systems. The ease of being able to

accomplish shopping and banking from the

home, it seems, would be very appealing.

There are problems, however, with respect to

acceptance of the system, hardware and communication costs, and, most importantly,

changing behavior patterns. Principal characteristics of HIS users are listed in table 6.

For consumers to adopt and use home information innovation, it must be associated with

such advantages as convenience, compatibility, or specificity.

Implications of

Home Information Systems

It appears likely that home banking systems

will be tied to other services such as information services, entertainment, and even business uses. Also, any institution, whether financial or nonfinancial, will be in a position to

provide financial services through a videotex

network and to support these services in much

the same way as Merrill Lynch operates its

cash management accounts.

Home banking and its impact on branch

banking has some major consequences. With

a single investment in a computer installation,

a new entrant to the retail banking market has

the whole national market open to it. As long

as it has the necessary computing capacity to

handle the accounts of its customers, any bank

will be able to leap over geographic barriers

and offer payment services nationwide. * By

the same token, nonbank operators will be able

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

by opening offices (usually via holding company affiliates or

subsidiary corporations) for business loans. This is also true

for mortgage companies and consumer finance companies.
132 ● Effects of Information Technology on Financial Services Systems

Table 6.—Principal Characteristics of HIS Users

Level of

Characteristic importance Comments

Age 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 rank

about 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 banking

increases.

In all studies the majority who are interested in HIS have

attained a college degree or higher.

Occupation Low Research indicates interest in HIS/home banking is not

dependent on occupation. Blue collar workers and

professional alike are likely to be interested in HIS.

Interest increases gradually from a lower level among

housewives to high levels among managerial

employees. Those working in the home or retired are

less likely to be interested.

Family status Low Research indicates married and not married, with family

or without, are equally likely to be interested in

HIS/home banking.

Income Moderate Research indicates as income increases, the likelihood

to high of interest in HIS/home banking increases. However,

among very high income households ($50,000/year and

up) the likelihood of interest in home banking

declines somewhat.

Financial Moderate Research indicates that users of ATMs, Telephone BiII

services Paying, and frequent check writers are more likely to

users 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 gadgetry

product users are somewhat more likely to be interested in HIS.

However, a large portion of those interested in HIS do

not own or intend to purchase a personal computer.

Among PRONTO pilot users, half had computer

terminals (outside the home) prior to participating in

the test.

SOURCE The Reistad Corp , Clearwater, Fla

to compete with banks in these services to the

extent that they are legally permitted to do so.

It is important to note that ATM, POS, and

HIS will work together in the future. POS systems and ATMs will share network lines, and

these systems will eventually reach out to incorporate other remote terminal activity such

as HISS.

The various systems that have been and are

being implemented for effecting payments are

essentially designed to be substitutes for the

paper check. While the rate of growth of

checks has declined during the last several

years and check usage in absolute terms may

begin to fall between now and the end of the

century, no one expects checks to be totally

replaced.

Historically, usage of new consumer products has grown slowly during the first years

following introduction. For successful products, this has been followed by a period of

rapid growth. Then, as the level of saturation

is approached, growth again slows. Overall, ”

this creates the “S” curve shown in figure 11.

This being the case, two questions relating to
Ch. 4—Retail Financial Services ● 133 ———

Figure 11 .—Penetration Curve for Check Alternatives

1977 78 79 80 81 82 83 84 85 86

SOURCE Economic Review, Federal Reserve Bank of Atlanta August 1983 p 33

the substitution of new payment products for

the paper check remain unanswered. First, at

what rate will new services grow? Second, at

what level of penetration by each product will

the market become effectively saturated?

Not all potential users of a service will use

that service. It has taken decades for the level

of penetration for checking accounts to reach

the 85- to 90-percent penetration level, where

it now rests. Further, it is not reasonable to

assume that the level of maximum market

penetration is the same for all products. Over

the long term, for example, the proportion that

uses ATMs may far exceed that which uses

home information and banking services.

Further, the level of maximum penetration

may vary with time. As technology evolves

and its costs continue to drop, and as the products are funded, the proportion of potential

users who actually become buyers may change.

For example, the maximum potential market

penetration for a home banking service today

that requires a terminal costing several hundred dollars may be quite different from what

it will be for a derivative of that service that

is implemented using a terminal that costs less

than $100.

The time constants that determine the steepness of the curve may also vary in response

to events in the market. For example, the rate

of growth in some electronically delivered services may increase in response to a requirement

that all employees of firms over a specified size

be paid by direct deposit. On the other hand,

a series of events that demonstrate inherent

weaknesses in advanced payment systems

could slow the rate of growth of some products. In general, the impacts of events are

most likely to vary from product to product

in the mix that comprises the offerings of the

financial service industry.

In the past, great promise has been held out

for various payment products that has yet to

materialize. However, increasing use of computers and telecommunication throughout society and the dynamism of the financial service industry may be creating an environment

more favorable to the adoption of new systems

for delivering financial services. Thus, there

is a higher degree of confidence than in the

past that the middle stage of the “S” curve

will be reached, but the timing continues to

be uncertain. The problem becomes one of

closely monitoring developments in the financial service industry to identify those areas

most likely to reach a critical mass and to

assess on an ongoing basis the benefits and

costs to society of the changes that are expected.
Chapter 5

Wholesale Financial Services
Contents

The Role of Technology

,

Page

in Wholesale Financial Service Systems . . . . . . . 138

Products Available in Wholesale Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . 138

Asset and Liability Products. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138

Processing Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ......... 140

Information Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141

Nonprocessing Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141

Providers of wholesale Financial Services. . . . . . . . . . . . . . . . . . . . . . . . . . . 142

The Importance of Access to Data and to the Payments Mechanism . . . . 147

Future of Wholesale Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148

Tables

Table No. Page

7. Major Providers of Wholesale Financial Services . . . . . . . . . . . . . . . . . . . 139

8. Product Provider Mapping . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143-145

,/
.

Chapter 5

Wholesale Financial Services

Retail suppliers of financial services provide

consumers with a variety of products and services, including deposit-taking, securities brokerage, and credit extension. Wholesalers, in

turn, provide a variety of services to retailers,

services that may be grouped under two broad

headings. First are the wholesale products

that affect the balance sheets of the providers,

usually by converting assets from one form to

another (e.g., cash to notes receivable or vice

versa). For example, institutions can purchase

debt instruments in secondary markets, or a

bank may participate in a loan syndicated by

its correspondent. Historically, depository institutions have always been suppliers and

users of this class of wholesale services. They

have established and maintained correspondent relationships that have included such

features as loan participation and the operation of secondary markets for various debt instruments, without relying on automated

processing.

A second class of wholesale products comprises mainly processing and information services. Included in this group are check and

credit card processing, general accounting and

account maintenance services, and communication services. This chapter describes the

wholesale financial products and services that

are available, the organizations that participate in this segment of the industry, the role

of technology, and the trends that are presently in evidence.

Changes in the financial service industry

have shaded the fine lines between wholesale

and retail services. For example, from the

point of view of each organization that issues

a VISA card, VISA International, the parent

of the VISA service, is a wholesaler that provides the interchange services that are essential to the operating concepts embodied in

bank card organizations. On the other hand,

VISA International actively markets its products on behalf of its members and is highly visible to the consumers. In this sense it can be

viewed as a retailer of financial services.

Wholesale and retail financial services will

continue to overlap in the future as the implementation of advanced financial service delivery systems tightens the coupling between the

organizations that perform the various functions that are required to deliver services.

However, for the moment, it remains useful to describe wholesale and retail services

separately.

On the one hand, the earliest applications

of information processing and telecommunication technologies were in the area of wholesale

financial services much more than in retail.

Check processing and account maintenance

services have been provided by third-party

operators for years. Wire transfers of funds

have been used since before the turn of the century. On the other hand, there are wholesale

services that are not particularly susceptible

to automation. Arranging loan participations

may rely heavily on telecommunications, but

the process is not really automated.

However, wholesale financial services are

not really separable from other financial services that may benefit greatly from the application of advanced technologies. Thus, policies

that are directed at changes resulting directly

from the application of advanced technologies

to the entire financial service industry are also

likely to impact wholesale financial services.

Therefore, it is important that the reader who

is concerned with developing policy for the financial service industry be aware of the full

range of services provided by the financial

service industry.

137
138 • Effects of Information Technology on Financial Services Systems

——.—. — .

The Role of Technology in Wholesale

Financial Service Systems

The financial service industry was one of the

early users of advanced technology for product delivery. Transaction volumes of checks

and credit cards now exceed the industry’s

ability to process transactions manually, and

the increasing time value of money and the

variety of alternatives for investment have

placed a premium on the ability to move funds

and information rapidly and accurately over

wide geographic areas. Even for small organizations, the accessibility of economical processing services has been crucial for survival.

Most of these processing services could not

be delivered without the availability of the advanced communication and information processing technologies. Further, because of the

heavy dependence of service providers on

these technologies, firms with expertise centered in the technologies rather than in the delivery of financial services have recognized and

developed opportunities in the financial service industry as providers of wholesale financial services. In addition, communication and

information technologies have made possible

the extension of wholesale financial services

products to include features that could not

have been offered without the technologies.

Historically, the costs of establishing and

maintaining the processing capabilities required to support the delivery of financial services have been beyond the means of many

retailers. Now, however, the low cost of information processing equipment and the increasing availability of low-cost software packages

has brought within reach the decision support

systems and other capabilities not previously

available to small institutions. (The large systems for transaction procession and general

accounting are not included in this group as

they can be developed and supported only with

significant resources.)

While all organizations need access to technology, not all have to develop processing capabilities within their own organizations. The

problems of processing and other aspects of

marketing and delivering services are largely

separable. Managers of financial service providers are faced with the same “make or buy”

decisions that confront those responsible for

a manufacturing facility. A depository institution can either generate a loan portfolio

through its own efforts, or it can participate

with others who undertake the active marketing of credit services. Additionally, an organization can acquire and support the facilities

necessary for performing the data processing

entailed in delivering financial services, or it

can buy those services from third parties. Further, just as merchandisers can setup an organization to buy in quantity for a group, financial service providers can realize economies of

scale and scope by joining a consortium, or

network, that establishes an organization to

perform transaction processing.

Products Available in Wholesale Markets

Asset and Liability Products main in a position to provide additional financing to retail customers. If this were not possiThe asset and liability products shown in ble, retailers would be solely dependent on the

table 7 include those where the wholesaler ac- generation of new liabilities (deposits from

quires an asset from the retailer, generally in their customers) to meet demands for credit

exchange for cash. These services allow the from the markets served. Thus, the ability to

retailer to turn over its portfolio and thus re- place assets in secondary markets is key to
—

— . —

Table 7.—Major Providers of Wholesale

Financial Services

Nonbank and nonfinancial service company third-party

processors:

ADP

EDS

Decimus

Control Data

CSC/lnfonet

FDR (AMEX subsidiary)

Financial service institutions, joint syndications, and

proprietary T&E cards:

Rocky Mountain Bank Card (PLUS)

CIRRUS

VISA

Master Card

American Express

Nonprofit or governmental service or network providers:

Swift

Federal Reserve

Federal Home Loan Bank

Bank Wire

New York Clearing House

Banks, other depository financial institutions, and

associations:

First Interstate Bancorp

Bank One

Citi-Bank

Chemical Bank

Bank of America

CUNA

California Credit Union League

GESCO

Mid Continent

Dataline

Other industry groups:

Brokerage firms:

Merrill Lynch

E, F. Hutton

Paine Webber

Retailers (including grocery chains):

Sears

J, C. Penney

Montgomery Ward

May Co.

Federated Department Stores

Safeway

Kroger

Insurance:

Prudential Insurance Co.

Equitable Life Insurance

Aetna Life Insurance

Consumer finance corporations:

Beneficial Corp

Dial Corp.

Mortgage Brokers:

Loomis & Nettleson

Trust Companies:

Trust Co, of the West

.

SOURCE ICS Group Inc Harbor City, Calif

Ch. 5—Wholesale Financial Services ●

_— — ——. ———

enabling the financial service industry to

139

intermediate between those with funds to invest

and those who require funds.

In this context, commercial firms that sell

their receivables are users of wholesale financial services. Using these services, manufacturers and merchants are able to obtain the

working capital needed to support their inventories of end-products, work in progress, and

raw materials.

The originator of a loan may, under some circumstances, sell the debt in the secondary

market while retaining the rights to service

the loan. In this way, the capital is turned

over, but the originator of the loan continues

to benefit from a stream of fees paid by the

holders in due course. In turn, the borrower

benefits by continuing to deal with the organization that originated the loan throughout

its life, even though it no longer holds the

debt in its portfolio. Of course, the opposite

situation, where the original lender retains the

debt and buys processing services from

another organization, can occur; or the originator may sell the loan and retain none of the

servicing functions.

Small loan companies, on the other hand,

will place commercial paper in the wholesale

markets and use the proceeds to support their

lending activities. Because they can borrow

large amounts at favorable interest rates and

receive a relatively high yield on their loan

portfolios, a favorable spread is generated that

can cover both their operating expenses and

a profit.

At times, a lender will have the opportunity

to place a loan that either exceeds the funds

available or creates an unacceptable risk in

that the amount to be lent would be excessively great relative to the net worth of the organization. Regulations also limit the size of a

loan that can be made to any other borrower.

Under these circumstances, the lender may

syndicate the loan by obtaining contributions

from others that will spread the overall risk
140 . Effects of Information Technology on Financial Services Systems

and make available sufficient funds to meet

the needs of the borrower. Also, banks, as part

of their relationships with their correspondents, will routinely allow the correspondents

to participate in loans that they place. Insurance companies behave in much the same way

when they share indirect placements and ask

or permit others to share in the underwriting

of casualty coverage. Securities dealers form

syndicates to underwrite offerings of debt or

equity instruments.

Processing Products

As noted, the delivery of financial services

depends heavily on the processing and transmission of large amounts of data. For all practical purposes, the application of advanced information processing and telecommunication

technologies has become mandatory.

Among the processing products offered by

the providers of wholesale financial services

are the processing of checks and credit and

debit card drafts; the processing required to

support all types of depository products; and

information services, such as credit/check

authorization and economic data and models

that are used for analysis and decision support. Also included is the processing required

to consolidate and disburse funds as part of

offerings of cash management services.

Transaction processing facilitates the execution of an order given by the owner of an account to credit or debit it. For all practical purposes, from the point of information flows that

are created, the type of accounts posted during the transaction is immaterial. In fact, major bank card processors use the same systems

to process debit and credit card transactions,

and only the customer and financial institution that holds the customer’s account knows

whether a line of credit or a demand deposit

account or other type of account is debited.

For this assessment, the critical point is that

the systems used to process orders against accounts are large and complex and are therefore expensive to build, operate, and maintain.

Hence, many organizations do not have theresources to develop and operate such systems

internally, and others choose not to undertake

such activities. Instead, they turn to third parties, many of whom are not conventionally

classified as financial institutions, to provide

the processing capabilities required. Retailers

of financial services decide on the degree to

which they will be vertically integrated and

turn to wholesalers for those services they cannot or choose not to provide for themselves.

Clearing and settlement are elements critical to the operation of a system that supports

the delivery of financial services. At present,

only depository institutions have in place a

system for clearing cash items involving the

transfer of money between virtually any parties in society. Specialized systems, such as

those operated by the airlines for settling fees

for services provided to holders of tickets

issued by others, by securities brokers for settling stock and bond transactions, and by oil

companies for accounting for balances of crude

oil moved between them, exist; but not with

the wide area of applicability found in the system operated by the depository institutions

for settling on money transfers. On the other

hand, there is no reason why alternatives for

settling money transfers that would not involve the depository institutions could not be

established. Systems supporting the operations of the nonbank credit cards provide one

such example.

Some wholesale products exist because of

structural constraints within the industry. As

noted, depository institutions are the only

ones that have access to the payments mechanism. Therefore, when others offer products

such as cash management accounts that give

the retail user the ability to write a draft

against the account, arrangements must be

made with depository institutions for payment

of the draft through the payments mechanism.

The same type of arrangement holds for organizations that offer or accept one or more

of the major bank credit cards. Thus, any securities dealer or private association that makes

arrangements to issue a bank card and any

organization that accepts the bank card must

arrange for clearing or payment services
.— ... —-— .—..

Ch. 5—Wholesale Financial Services ● 141 ———.——————— — — ... —— — -

through a depository institution. Only one

retailer has been given direct access to a major bank card network, and the rules of the

card-issuing organization have been changed

to preclude another nondepository institution

being granted such access.

Information Products

Financial data provide the basis for decisionmaking for individual organization and for the

economy as a whole. Treasurers for both private corporations and public agencies must

have knowledge of the funds available to them

and the demands being placed on them. They

must be able to consolidate easily those funds

collected over wide geographic areas and to

disburse them so that they meet obligations

for payment. Opportunities for investing idle

funds must be identified and exploited. These

services together compose what are commonly

offered as cash management packages. Other

processing services, as shown in table 7, that

depend heavily on the corporate data of the

individual client organizations are also offered

by wholesale financial service providers.

At a broader level, financial service organizations collect and market a variety of data

used in decision support systems. Some also

provide modeling and other prepackaged capabilities that can be used to analyze data. In

some cases, completely developed models that

can be used for experimentation by the users

are offered; in others, facilities that enable the

user to build, estimate, and validate models

uniquely designed for a specific purpose are

provided; and in still others, both capabilities

are available.

Nonprocessing Services

Some wholesale financial services entail no

processing capabilities. These services generally include provision of equipment, computer

programs, and other support services used by

retailers. As the capability to develop generalized software packages increases and users

recognize that most organizations can make

use of generalized packages, as opposed to developing unique application systems for themselves, the importance of the products produced by this segment of the wholesale

financial service industry will increase.

Also included in this group are communications services that are particularly oriented to

the needs of the financial service industry.

However, more often than not these are general-purpose communications facilities that

can be used for any number of applications,

and only the fact that the operators make a

specific point of marketing them to the financial service industry sets them apart from

others and warrants that they be mentioned

in the context of this assessment.

Firms that provide wholesale processing/facilities management services can be placed in

one of four subclasses. First, there are those

that take all responsibility for system operations and operate their own facilities apart

from those of their clients. Second, some providers sell or lease software or equipment, and

the users take all responsibility for day-to-day

operations. In this case, services from several

wholesale providers may be combined in a system designed to meet the needs of the client

organization. Third, some providers offer

“turnkey” services in which they design and

install systems for their clients and then turn

them over to the clients, who take over dayto-day operations. In the last category are

those offering facilities management services

where the service provider effectively takes

over the operation of the processing department of the client organization, even though

the department may be physically located in

the client’s facilities.
142 ● Effects of /formation Technology on Financial Services Systems

— — ——— .— —.

Providers of Wholesale Financial Services

The list of firms comprising the providers

of wholesale financial services is quite diverse.

Table 7 demonstrates this diversity, listing

major categories of providers of financial services and citing specific examples of firms falling within each group. Table 8 shows which

classes of firms provide each of the various

classes of services identified in table 7. It

shows the breadth of the product lines offered

by each of the various classes of firms active

in the financial service industry and the degree of competition between the very diverse

firms that are providers of wholesale financial

services.

Examination of table 7 shows that there is

considerable opportunity for both vertical and

horizontal integration for providers of wholesale financial services. On the other hand, the

existence of a variety of specialized firms

argues that, until now, the economics governing the operation of providers of wholesale financial services has not encouraged either vertical or horizontal integration. While some

argue that either pattern of integration offers

significant economies of both scale and scope,

alternatives exist for achieving both economies. Notably, competitors in the marketplace are able to join in the creation of wholesale services while maintaining an active

competitive environment based on end-product differentiation in retail markets.

Large commercial banks provide examples

of vertically integrated operations. They perform check processing, operate credit and

debit card systems, and support networks of

automated teller machines (ATMs), some of

which are strictly proprietary, while others are

shared and may permit access by thrift institutions as well as by other commercial banks.

Some have arrangements with nonbank issuers of either credit or debit cards to provide

the required interface with appropriate clearing and settlement networks. Loan participation and clearing accounts are offered to correspondents. Also, they provide secondary

markets for debt instruments, including mortgages and merchant and producer receivables

created by others.

The degree of horizontal integration permitted commercial banks is limited. By law,

commercial banks can underwrite neither corporate equity issues nor life or casualty insurance other than creditor life insurance. Securities trading is limited to ordering trades for

the convenience of bank customers or the operations of trust departments. Commercial

banks are not authorized to offer investment

advice regarding securities to their clients.

Further, they are permitted to offer data processing services to others only to the extent

that such services are incidental to the business of banking. While recent rulings by the

Federal Reserve Board (e.g., the CitiShare

case) have broadened the scope of permitted

activities, commercial banks and bank holding

companies are not free to offer the full range

of data processing and communication products that they could conceivably market.

On the other hand, even in the face of existing restrictions, the degree of horizontal integration of commercial banks and other depository institutions is increasing. Some now

offer discount brokerage services, and others

are developing connections with insurance

companies or are setting up subsidiaries that

can offer insurance under the laws of the

States in which they are chartered.

Some merchandisers are also entering the

market with a very broad range of financial

service products. One provides retail credit

service in direct support of its merchandising

activities, a full line of insurance services, real

estate and securities brokerage, and, in a limited number of States, deposit-taking through

subsidiary thrift institutions. Yet even though

this organization appears to be moving toward

horizontal integration, only a minimal level of

coordination has been achieved between the

various constituent elements, and, therefore,

the degree of horizontal integration achieved

to this point appears to be minimal.
Ch. 5— Wholesale Financial Services ● 143 —

x x x

—

x x x

-1 x xx x

—.

a3u?ulj JwLJnsuo~ x x

— .—

x x x x

xx x

—.

aouejnsul x I x x x x Xxx xx x

x x x

x x

. .

xt- -

x x x x x x Xx xx x x x x

— —

x x Xxxx

— —————. -—.—. -—

x

x

— .-—

x x x x x x

l

x x x x

-1 —— -— — --— ——

Xxxx x x x x

—

Xx xx x x x x x x

-— — . —

.

sdol]ei~ossv

Ueol pue s6ul Aes x x x x x x

——. — .——

x x Xxxx Xx xxx x

——

Xxxx Xxxx

—.—. —-— -

Xxxx x x x x x x x x x

—. .- ——-.—— —-—. —

x Xxxx Xx xxx x

— .——-–L— — — ————————

x x x

—.

x

——. — —.—

Xxxx xx xx x

,.

VI

al

0

,C .L .

ral

a)= : ‘ >

> .0

c

m
144 ● Effects of /formation Technology on Financial Services Systems

x x x x x

—— —. —-

X

.—-.

aweulj Jawnsuo

x x

.- -—

x Xxx x x x

—..—

x

-— .--— —

x

sweq3 Jaw IIe]a} x x x x x

Suolufl llpaJ[

—-

suoileloossv

UPO1 pue s6umeS

x x x

Xxxxxxx xxx x x

—

KXxxx xxx x x x x

-—

x Xxxx xx x

paseq aa

~]J!?d pllq] pU1

luapuodsaJJo~ s~ueE

xxx x xx Xxxx xx x Xxxxx xx x x x x

x x x x x x

x x

.—— ——

x x x x x Xxxx x x x x x x x x x x x x

x

suol)eolpuk

yueg

—— —

saovdas

AiJed-pJlql

)fUEqUON

<Xxxx xxx x x

.

.,.

. .

,..

.

,..

. .

. .

.

.

,. . . . . g:

. . . . . . . . . . . .

. . . . . . . . . . . . .

.., %:

. . . . . . . . . Q .

. . . . . . . . . . . .

, ...,,,.,,.. : .9 :

.,

. . .

.

,..

.

. . . . .

. .

,. .,.

.,

P’:

(7i ::,

.

,..

.,.

c

v

c

m&i
Ch. 5—Wholesale Financial Services ● 145 —

ISflJl x x x

—

—

x

—

—

——. —

x

— —— 1- ——. —..

t–––

— ——. — —

x x x

—

x x x x x Xxxx xx x Xxxx

!

a3ueJ nsu i L-- ‘-

x l

x x x

—

x x x

x x Xx xxx x x xxx x

suolie130ssv

ueol pue s6ulheS

g

n r- saueq le13Jawo: x x x x

-1r- paseq—

aaj

f\JL?d 13Jlu~ PUE

luapuodsaj]o~ SHUW

x

.—

.

x x x Xxxx Xxxxx xx x Xxx xx x

I

ail

x x x

I Suol]mlpuk

tiuefj x x x x x Xxx x x x x

1 x x xxx x x

I sa3(AJas

I x x Xxxx xx x x x x

,,,

.

Xxxx

:: : v

,. “: : : : : :

,.

,..

-“

.

,.

. .

. .

,.. ,.

:: :

,..

.,.

,.

.

,..

:?

:5

.Cr ,C.- .0

.CJ) .U
146 ● Effects of Information Technology on Financial Services Systems

.——— — —. —- . —

In another area, one of the major providers

of a nonbank credit card has become one of the

largest wholesale providers of card processing

services to others. This provider also offers an

extensive package of traveler’s checks and

card-oriented credit services through participating commercial banks and thrift institutions.

Among the nonbank providers of wholesale

financial services are those that operate communications facilities, networks of ATMs that

are shared among various depository institutions, and independent processors, with roots

more in the information processing industry

than in the financial service industry. With its

divestiture, American Telephone & Telegraph

will be able to provide enhanced services specifically tailored to the financial service industry. However, it will have to compete with

other telecommunications carriers, banks, and

others that already operate in this market if

it chooses to enter. Operators of food chains

and others are installing ATM networks and

inviting the depository institutions to join

them. This trend has raised the thought

among some bankers that they may not be

able to retain their control over the payments

system in the long run. Finally, as shown in

table 8, various data processing service bureaus and software suppliers meet the needs

of significant portions of the financial community for processing services, and there are

some indications that they would like to expand their role in the future.

The Federal Reserve System occupies a

unique role as a provider of wholesale financial services. It is a lender of last resort to depository institutions in need of funds to meet

reserve requirements. Through the Open Market Desk at the Federal Reserve Bank of New

York, it markets Federal Government debt

and implements monetary policy through the

purchase and sale of Government securities.

It is a major factor in the clearing of checks

and a provider of currency and coin to the

banking system.

The national system of automated clearing

houses (ACHs), except for the one in New

York, is owned and operated by the Federal

Reserve System. Recently, ACHS have broadened their capabilities to process individual

customer-initiated transactions. The bulk of

the traffic handled by ACHs is generated by

the Federal Government in the form of payroll

and payments to recipients of entitlements,

such as social security.

The role of the Federal Reserve in these markets has been controversial for some time.

Even though Congress mandated that the

Federal Government recover the full costs of

providing services, some argue that its pricing still puts private suppliers of alternative

services at a disadvantage. Some also see an

inherent conflict of interest between the Federal Government as a supplier of services on

the one hand and as a regulator of the institutions that are its customers on the other.

The Federal Reserve is charged with ensuring the orderly movement of funds nationwide

in order to provide a healthy climate for commerce. In some areas it is meeting with competition. However, in others, such as providing

service to institutions in remote areas that

cannot profitably be served by the private sector, it continues to meet a real need.

Volumes of checks processed by the Federal

Reserve declined after the institution of pricing for services. Also, there is a movement to

separate ACH operations from the Federal

Government. Therefore, its future role as an

active participant as a provider of financial

services is open to question.
.—

Ch. 5—Wholesale financial Services ● 147 —

The Importance of Access to Data

and to the Payments Mechanism

Since only the depository institutions have

access to the payments mechanism for the

transfer of funds, all other institutions must

work through them. For example, money market mutual funds, on which customers can

write drafts, conventionally maintain a zerobalance account with a depository institution

that is funded at a level sufficient to cover the

drafts presented each day. They then use

transaction data supplied by the depository

institution to post appropriate debits against

customer accounts.

On the other hand, the depository institution can have available to it virtually all of the

financial data of its customers because all payments transactions pass through its hands.

Because it has access to the data and the

means to act on them on behalf of the customer, some argue that depository institutions

occupy a unique place that puts potential competitors at a significant disadvantage. The

argument follows that restrictions are necessary on the operations of depository institutions with regard to the information processing services they may offer so that they will

not benefit unjustly from the position they enjoy. Thus, at issue is the degree of access these

organizations have to a customer’s data, and

the payment mechanism and the relative advantage the firm enjoys in the marketplace.

To the extent that wholesale financial services can be provided only with the support of

advanced technologies, a point of no return

has been passed in which the only possible

backup to an automated system is another

automated system. Further, in this environment, all providers of the services need access

to the technologies, and lack of such access

could make it impossible for a company to remain in business.

In general, the trend to greater reliance on

advanced information processing and telecommunication technologies in support of systems

for delivery of wholesale financial services will

continue indefinitely into the future. To some

extent, those providers of wholesale financial

services who do not perform processing internally will become more dependent on the products of others, and therefore may lose some

of the flexibility in designing and operating

systems for delivering financial services that

they now enjoy. Greater shared use of processing systems, driven by the economics of system development, deployment, maintenance,

and operation, will mean that competition between the various producers of financial services will, in the future, be based on factors

other than the features of the processing systems used by the competing organizations.

Finally, both the providers and users of

wholesale financial services are more accustomed to dealing with advanced technologies

than consumers are. These organizations have

for years been using technology-based applications, such as cash management services, that

will not be significant in the consumer marketplace for many years. Therefore, for those

who operate in wholesale financial service markets, future changes will not be as traumatic

as they may be for the remainder of the public that is generally not accustomed to dealing with relatively sophisticated systems.

Thus, the changes that take place in the whole

sale services are less likely to attract widespread attention than those provided to the

general public at retail.
148 ● Effects of Information Technology on Financial Services Systems

Future of Wholesale Services

Although much attention has been focused

on the entry of new types of providers of financial services into retail markets, the

maturity of participation in wholesale markets

by nontraditional financial service providers

is proportionately much greater. Since financial service firms have established a high degree of sophistication in the use of the technologies and they are more familiar with the

operational requirements of the industry than

anyone else, those with adequate resources

and the inclination to do so will remain significant factors in the market for wholesale financial services. On the other hand, because

the information processing and telecommunications industries have developed the expertise to analyze and meet the requirements of

others, firms not ordinarily identified with the

financial service industry will increasingly

challenge traditional financial service firms in

the market for wholesale services.

The introduction of advanced networking

has broadened existing relationships between

providers of financial services to include the

new products and services that have become

available. For example, a bank will contract

with a securities dealer to clear drafts that are

processed through the payments systems in

addition to providing the more traditional

banking services. Institutions that have

benefited internally from investments in systems incorporating advanced technologies to

increase productivity, have often offered them

on the open market to others who, in turn,

have also been able to increase productivity.

On the other hand, developers of new products try to benefit from the revenue generated

by franchising those products to others. The

franchisees benefit because they do not have

to incur the costs of designing and developing the systems to support new product offerings. One major money center bank is following this strategy in offering its home banking

service to banks nationwide.

These types of relationships will continue

into the indefinite future. Economic conditions

have put pressures on operating margins that

will stimulate all providers of financial services to take whatever steps are required to improve productivity. Since only limited numbers of institutions are in a position to support

major new product development efforts, many

will look to third parties to create the capabilities that are needed.

Banks and other traditional providers may

be expected to extend their customer base outside of their traditional boundaries. Holders

of financial assets are in a position to argue

that they have both the knowledge to build

the capabilities needed by their customers and

immediate access to the data used by the

system.

On the other hand, data processing service

organizations can marshal many of the same

arguments as banks to claim that they are in

a position to provide a wide range of payment

and information services to a broad client

base. However, they are somewhat limited in

their ability to offer complete payment systems because they can initiate payments only

through a financial institution that has access

to the payments mechanism.

In the long run, however, processing technology is neutral; and the ability to succeed

as a provider of wholesale financial services

depends on the level at which requirements are

understood and operationally viable systems

are implemented. Systems that meet the needs

of the users and are supported adequately will

succeed in the market regardless of where the

processing is done. As improved processing

technologies become available, providers of

wholesale financial services will adopt and

market them. Adoption on the wholesale side

of the financial service industry will be more

rapid than on the retail side because changes

in wholesale services are less likely to be visible to the end-users. Competitive impact in the

retail market will be minimal because there

will be little, if any, requirement for consumers

to change their behavior patterns.
—

Ch. 5—Wholesale Financial Services ● 149 — . ————. .— —————...—— —

Increasing use will be made of telecommunications to deliver financial services, and there

will be new opportunities for telecommunication providers to function as providers of

wholesale financial services. In addition to providing neutral communications capabilities, as

they have in the past, they are in a position

to offer enhanced services to the financial service industry. Some may position themselves

as operators of networks and provide gateways between these networks and others.

Transaction interchange could become a major area of activity. Food retailers that install

and operate ATM networks also fall in this

category.

Technologies that offer opportunities for bypassing telephone companies that provide

local service have considerable potential for

providers of financial services. Already, a

television cable from central Manhattan to the

Wall Street area carries considerable traffic

generated by providers of financial services.

The teleport concept being implemented in

New York and considered elsewhere offers the

opportunity for bypassing both local and longdistance carriers. Since the switched telephone

network is not particularly suited to carrying

large volumes of data traffic, and costs for

local communication are expected to increase

significantly in coming years, bypass technologies and those that offer them will be an important factor in the development of the financial service industry.

Conceivably, the major long-distance carriers will become significant providers of

wholesale financial services, with offerings

that range from networks dedicated to specific

users to networks that include the processing

required for online, real-time clearing of payment transactions. The switches that run

these networks are computers capable of performing the processing required to provide the

clearing function.

Given the evolution of regional ATM networks, the focus of nationwide service could

be the facilities that provide for interchange

between networks rather than the development of monolithic networks that cover the

country. This outcome would generally follow

the model of the bank card systems, where the

various institutions operate somewhat independently of one another, with the major associations providing facilities for interchange.

On the other hand, American Express has implemented a major network that takes advantage of ATMs installed by participating

banks. Money can be accessed from any financial institution designated by the customer;

and American Express moves funds from the

institution holding the customer’s account to

the one that has dispensed the funds.

Developers of the information utilities now

becoming operational are in general agreement

that financial services will comprise a key element of the packages to be offered. Information providers are positioning themselves as

gateways to financial service providers, and,

therefore, are functioning in a wholesale capacity. They contract with retail providers who

define the services that will be provided

through the information utility. Subscribers

to the information utility are then able to select the retail financial service packages to

which they will subscribe. Such arrangements

complement shop-at-home and travel arrangement services that may also be offered through

the information utility.

People who have evaluated the market for

home information services now generally agree

that no one product offered by itself will be

viable. The packaging of financial services

with other information and, possibly, entertainment products will be critical to the success of services that distribute information to

the home. Various types of firms will assemble these packages and, in effect, will be providing the wholesale functions. Some, as in the

case of Knight-Ridder, will be publishers that

assemble and perform much of the marketing

for the products of various providers. Others,

like Chemical Bank, may be the creators of one

part of the service and assemble other parts

of the package from offerings of other suppliers. Still others may provide a totally neutral communications service that provides

paths to many providers and the opportunity

to interchange information between them.

Such a service would rely on each provider to

perform all of the marketing and other activities required to support its customers.
Chapter 6

The International Environment for

Financial Services
9

Contents

Page

Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153

The Growth of International Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153

New Directions in International Banking. . . . . . . . . . . . . . . . . . . . . . . . . . 154

Multinational Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155

Financial Markets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157

Money Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157

International Financial Information Systems . . . . . . . . . . . . . . . . . . . . . . 157

International Interbank Communications . . . . . . . . . . . . . . . . . . . . . . . . . . . 158

New York Clearing House Association . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158

Society for Worldwide Interbank Financial Telecommunication . . . . . . . 158

The Effects of Technology on International Payment Systems . . . . . . . . . 161

Corporate and Retail Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161

Vulnerability of the Financial System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162

Security and Integrity of the Financial System . . . . . . . . . . . . . . . . . . . . 163

Error Resolution in International Electronic Funds Transfer . . . . . . . . . 163

Foreign Telecommunications and Information Policies . . . . . . . . . . . . . . 163

Figures

Figure No. Page

12.Daily System Traffic Volumes (average: end of year) . . . . . . . . . . . . . . 159

13. Cumulative System Volumes (end of year) . . . . . . . . . . . . . . . . . . . . . . . 159

.
Chapter 6

The International Environment for

Financial Services

Introduction

The economies of the world have become

increasingly interdependent trading economies. The financial service industry supports

these activities by providing the means to

transfer payment for goods and services purchased internationally and by acting as an intermediary between those nations with excess

funds and those in need of funds. As the economies of individual nations become more intertwined, the role of the financial service industry becomes more important to the world

economy.

Changes are taking place in the structure of

financial markets as well as the structure of

the industry and its participants. Communication and information technologies have

helped to make markets that were once local

or regional in character, global. Funds travel

across national boundaries with such ease that

disequilibrium is offset. This flow of funds

became increasingly evident in the 1970’s with

the excess capital available from oil-rich

nations.

Separate from, but related to, changes in financial markets are the structural changes

taking place in the industry itself. During the

rise of multinational corporate activity in the

1960’s and 1970’s, banks moved abroad to follow corporate customers. In addition, banks

found that in order to insure access to many

of the foreign money markets, it was necessary that they establish a presence, either

through a branch or an affiliate. A final reason

for multinational branching by U.S. banks,

was that regulation, taxation, and supervision

of institutions in other nations was more often

favorable to the conduct of their business.

In the past 20 years there has also been a

number of new entrants in the field. Smaller

banks have been able to participate in international finance through the use of innovative

lending arrangements. Nonbank financial

service providers have developed large, international networks to facilitate retail flows.

SWIFT (Society for Worldwide Interbank Financial Telecommunication), a network established by the banking community to facilitate

international interbank transfers, is on the

verge of offering traditional bank services, perhaps in direct competition with its founders.

These relationships rely heavily on both the

flow of information and the international

transfer of funds. Information technologies

therefore found early application in the international financial arena, beginning with the

telegraph. It is difficult to assess and identify

the individual impacts of the technologies on

this segment of financial service activities,

since the use of the technology is so prevalent.

In many ways much of the activity in the international financial markets could not occur

without the technology.

The Growth of International Banking

Post-World War II developments in capital in turn expanded the role of the private bankmovement and the restructuring of the foreign ing community to support these trade flows.

exchange system helped foster trade, which Moreover, the development of multinational

153
154 ● Effects of Information Technology on Financial Services Systems ————

corporate activity expanded the need for financial services connected with direct investment

operations and established new requirements

for the conduct of multinational business.

At first, international financial activities expanded in traditional ways: through the exchange markets and accepted ways of international lending. Eventually, the movement

to increased internationalization of financial

activity was supported by changes in bank

strategy and management and by institutional

and structural changes in international money

and credit markets.

By all counts the growth of international

banking has been phenomenal. The Organization for Economic Cooperation and Development (OECD) has compiled figures on the

growth of international banking in developed

nations over the last two decades. Although

there is no comprehensive measurement for

world banking activity, and many measurements of this activity include double-counting

and inflated figures, the gross figures and the

net figures (which should eliminate the doublecounting) are strikingly similar. In the period

from 1975 to 1981, net international bank

lending increased by an average annual rate

of 23.9 percent, while the net size of the

eurocurrency market* increased by 21.6 percent. Although the figures for this period show

considerable growth, the eurocurrency markets experienced their greatest growth from

1965 to 1970, when average annual changes

were 37.7 percent.l

Similar statistics illustrating the relative importance of foreign business of banks show

that the average growth of foreign business

for OECD banks as a whole has been from 12.1

percent of assets in 1970 to 23.7 percent of

assets in 1981, and from 11.3 percent of liabilities in 1970 to 23.4 percent of liabilities in

1981. 2

——— *A eurocurrency is a deposit account at a European bank

denominated in a currency other than that of the host bank.

‘R. M. Pecchioli, ‘Z’he Internationah”sation of Bd”ng: The

Policy Issues (Paris: Organization for Economic Cooperation

and Development, 1983), p. 16.

‘Ibid., p. 19.

R. M. Pecchioli, in a recent OECD report,

attributes the evolution of international banking’s structural features to a number of factors: changes in the international economic

and financial environment, the evolution of

demands for financial services by borrowers

and investors alike, and the spreading of technological facilities.3 The events of the 1960’s

were, for the most part, the result of the gradual recovery of the world economy from the

devastation of war, and the liberalization of

trade. The 1970’s, however, brought major

structural changes to the world economy;

world payments balances became more severe,

and there were major structural changes in the

international payment and financial systems,

all of which gave banks a pivotal role in international financial intermediation.4

New Directions in

International Banking

It is impossible in this report to provide a

comprehensive survey of all the changes in international banking techniques; rather, important product innovations will be highlighted,

along with the entry into new markets.

Sources of International Funding

International banking strategy does not

generally distinguish between domestic and international funding, since, for the most part,

banks will follow an overall assets and liabilities management policy. Two major sources

of funding in the international market are the

certificate of deposit (CD) and the floating rate

note (FRN). CDs are negotiable receipts for

large deposits; they have been used in the

United States for many years and in the Eurodollar market since 1967.5 London is, by far,

the leading center for CDs. In 1981, foreign

currency CDs issued by London banks totaled

more than U.S. $75 billion, most of which was

actually denominated in dollars.6 FRNs, which

are borrowing instruments used by banks,

‘Ibid., p. 17.

‘Ibid. 51 bid., p. 28.

6Pecchioli, op. cit., p. 28.
—

Ch. 6—The lnternational Environment for Financial Services ● 155

have a position of slightly less importance in

international funding, although recently their

importance has grown. Generally FRNs allow

banks to secure funds for longer terms than

those available through the deposit market.’

A unique aspect of international funding,

however, is the reliance on interbank deposits

as a major source of funds. Although it is difficult to measure, the interbank market is by

far the largest source of international funding.

Recent estimates place this market between

two-thirds and three-quarters of total external and eurocurrency liabilities of reporting

banks, or close to U.S. $1,000 billion.a What

is not reflected in these figures is that the volume of trading is very heavy, reaching the proportions of the foreign exchange markets. The

effects of information and communication

technologies can be readily observed in this

area. They are reflected in the high velocity

and volume of trading, as well as in the participation in the wholesale market of many

smaller, nonmoney center banks.9

International Lending

During the 1970’s there was a rise in the

willingness of private banks to finance development projects. Much of this came about as

a result of the inability of domestic markets

to absorb excess capital. Recently, the multilateral lending agencies, in particular the World

Bank, have announced cofinancing projects,

in which private banks are allowed to participate. These projects are thought to appeal to

smaller banks, which value the ability of the

World Bank to assess the viability of development projects.

Innovations have also occurred in the flexibility of the structure of the loaned funds, as

well as in the markets approached. As banks’

international assets have increased, their approaches to the marketplace have changed.

The most evident of these changes is in the

development of international credits through

loan syndication.

“Ibid.

‘Ibid, pp. 29-30.

9Pecchioli, op. cit., p. 29; ,J. R. S. Revell, Banking and Electronic Funds Transfers, date, p. 156.

Syndicated lending is the process by which

very large amounts of funds are raised by allowing the participation of a number of banks.

The benefit to the borrower is that these funds

can be raised through a single operation. The

benefit to the lender is that risk is spread

among many banks, and institutions that

could not undertake such a loan on their own

can participate. 10

The current “international debt crisis, ’

where developing countries are unable to

repay their loans to developed nations, has

brought generally into question the risk of international lending and, specifically, the role

of syndicated lending in exposing a greater

number of institutions to risk. It became clear

that smaller banks were becoming involved in

international lending. It is not possible to address, in the scope of this report, the issue of

the possible mismatching of liabilities and

assets that can occur as a result of loan syndication and the subsequent risk and foreign

loan exposure. Instead, the extent to which

communication and information technologies

contribute to the situation should be noted.

Technologies affect the ease with which

banks can become involved in international

lending. These same technologies may also

help in better monitoring and control of international debt and repayment, helping to overcome the international destabilizing effects of

a major default. In response to the severity

of the situation, and the possibility of majorcountry loan defaults, a number of large multinational banks established the Institute of

International Finance. The purpose of the institute is to provide valuable risk information

about countries to member banks that are

making loan decisions. The information is provided to members via an institutional network,

using international telecommunication 1ines.

Multinational Banking

Multinational banking can be loosely defined as the branching abroad of banks. Multinational banking cannot be completely sep-

—.

10Pecchioli, op. cit., p. 32.
156 ● Effects of Information Technology on Financial Services Systems

arated from the international activities of

banks. (Much of what is described in the previous sections can and does take place in

branches of U.S. banks located outside of this

country. ) Multinational banking developed

concurrently with international banking, but

has different causal factors.

The first movement of banks to set up

branches in foreign countries was generally in

support of multinational corporate activities.

As trade became more important and these activities increased in the 1960’s, banks found

it necessary to follow their clients abroad.

Eventually, international banking grew and

national economies and money markets became intertwined, and the banking community

realized that its physical presence was necessary to secure and maintain market share as

well as to participate in the developing financial markets abroad.

During the past two decades this activity

has increased considerably. The number of

overseas branches and agencies on a worldwide basis increased from 112 banks with

4,390 branches in 1961 to 387 banks with

4,329 branches in 1978. ”

Methods of participation in foreign markets

include everything from full-service branches

to the establishment of “shell branches, ”

which are booking offices located in foreign

countries that do not administer the business

carried on their books and have no contact

with the local market. Each method has its

benefits, depending on the motivation of the

parent institution.

——1lPecchioli, op. cit., p. 59. Pecchioli explains the seeming contradiction between the claim that multinational banking activity

increased and the actual number of overseas branches decreased.

“In fact the decline in the number of total branches between

1961 and 1978 is an ‘artificial’ one in that it reflects a sharp

decline of branches of European banks (United Kingdom and

French banks in particular) in African and a few Asian countries which, following a policy of indigenisation motivated by

economic nationalism, introduced restrictive legislation and induced takeovers by nationals during the period under review . . . [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, the

size of the global network more than doubled in the period under

consideration.

Offshore Banking

Offshore banking is any banking activity

within a country’s borders, but outside its

banking system. There is considerable debate

as to exactly which nations of the world should

be considered offshore centers. For example,

the City of London provides favorable conditions for off-shore banking, although it would

not be a conventional member of the group

considered off-shore centers. The United

States first permitted the development of international banking facilities (IBFs) in December 1981 in an attempt to bring back much of

the Euromarket business, which had fled this

country due to State tax laws and Regulation

D. IBFs are banks located in the United

States, but because of the nature of their business are not subject to some of the regulations

under which banks operate domestically. Both

U.S. banks and foreign banks operating in this

country can establish IBFs. They are established through State and local laws and amendments to Regulations D and Q and are similar to an off-shore “shell” branch that operates

on-shore.

The development of off-shore banking centers is facilitated by information technologies,

which tend to make the industry less locationsensitive. Nations have developed a sophisticated communication system solely for the

support of the financial service industry. This

can encourage further migration of the players

out of more regulated environments, which in

turn makes it extremely difficult for the U.S.

Government to implement policy and to control the flow of funds in the United States.

U.S. Branching Abroad

The movement of U.S. banks abroad coincided with the multinationalization of American corporations. However, there were added

incentives for U.S. banks to go multinational

that were perhaps not evident in other nations,

in particular domestic, a regulatory structure

that restricted U.S. banks from branching outside of a limited geographic area and limited

their potential market share in the United

States.
Ch. 6—The International Environment for Financial Services ● 157

—— —— —.—.———. —-. —.

Foreign Banks in the United States

The number of branches and agencies of foreign banks in the United States increased from

34 in 1961 to 241 in 1978 and to 452 in 1983. ’2

Until 1978, foreign bank branches in the

United States were treated very differently

——— -— ———— 12 Pecchioli, 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 Banking Act of 1978 much of the so-called discrimination against U.S. banks in their home market was done away with. There is still some

contention that the system does not treat U.S.

and foreign banks totally equally, but for the

most part, foreign banks must abide by the

same regulations as U.S. banks.

Financial Markets

Money Markets

Perhaps the most remarkable growth in

bank use of foreign money markets as sources

of funds in the last 20 years occurred in the

eurocurrency markets,

Banks’ rapidly growing involvement in

euro-market business was largely by response

to two basic elements: perception of the profit

opportunities arising from differential regulatory provisions applying to international and

domestic business and increased reliance on

portfolio diversification as a means for reducing risk exposure. Over the years, an additional stimulus to the expansion of eurocurrency transactions was provided by the

growing familiarity of customers, both depositors and borrowers, with the peculiar techniques of foreign currency operations and particularly by the proved depth and resiliency

of the interbank markets in foreign currencies. 13

The eurocurrency market provided banks in

countries with undeveloped money markets

the opportunity to enhance the management

of their liquidity. The development of sophisticated interbank communication techniques

also had a significant effect on the ability of

banks to participate in these markets.

Flexible exchange rates have enhanced the

acceptability of the eurocurrency markets as

‘‘substitutes’ for the foreign exchange market with respect to hedging.

——13 Pecchioli, op. cit., pp. 19-20.

International Financial

Information Systems

Computer-based business information systems are finding widespread application in the

financial service industry, particularly in international finance. A major figure in this area

is Reuters, the world’s oldest international

news agency. Reuters Monitor provides information on worldwide money markets to financial institutions via 15,000 terminals in 74

countries. ’4 By far the leader in this service,

Reuters competes with other nonbank financial data providers in the United States and

abroad, as well as with the information services of financial institutions. The Reuters service is unique in that, as a videotex system, it

also provides the opportunity for the user to

deal in the markets and may eventually allow

the user to confirm and complete deals using

a terminal.

The information provided in these systems

has always been available, it was just not

readily accessible. In the case of the money

markets, the information provided by these

services was not previously available in one

place. Often these services provided additional, useful information or information that

could be found elsewhere in newspapers or

reports. However, what was once useful is now

essential information, providing a competitive

edge to its user. This in turn has forced most

——— 14 —

Paul Walton, “A Boon for the Money Markets, ” Financial

Times, Dec. 14, 1983, p. 28.
158 ● Effects of Information Technology on Financial Services Systems

——. .—— —... —. —

institutions wishing to be competitive to use need four or five different terminals. This situthe systems. Technology has provided the cat- ation is bound to right itself in the long run,

alyst for the growth of these systems. either by each organization’s having a centralAn annoying side-effect of these systems is ized information function that feeds into its

the proliferation of terminals and the incom- own data system, or by existing vendors offering their services on compatible systems. patibility of systems. A dealer, in order to have

access to a variety of information sources, may

International Interbank

Much of the international banking activity

described in the preceding sections takes place

via sophisticated international communication

facilities. This is particularly true for interbank transfers of information and funds. As

international banking has grown, so too has

the importance of these functions. In recognition of this, many of the large, money-center

banks formed private telecommunication networks to help ease some of the problems associated with massive paper flows. Interbank

transfers are generally high-value transfers.

New York Clearing House Association

In 1970, the New York Clearing House Association began operating the Clearing House

Interbank Payments System (CHIPS). CHIPS

was founded to help meet the need perceived

by a few of the large New York money-center

banks for an automated system. Since its inception, CHIPS has been almost entirely automated, although for a short period in the beginning some of the clearing was paper-based.

Although CHIPS has not stated any intention

of expanding geographically, it is responsible

for moving among banks an estimated 90 percent of the U.S. dollars exchanged in international commerce.15

Society for Worldwide Interbank

Financial Telecommunication

SWIFT, founded in 1973 and operational in

1977, is the largest of the international finan-

—.—— —

“’’CHIPS: More Than Just a Clearing System, ” Transition,

February 1983, p. 20.

cial

not

Communications

telecommunication networks. SWIFT is

a financial organization nor a telecommunication common carrier; instead, it is a

nonprofit cooperative society that links member banks worldwide through a data processing and transmission network. SWIFT owns

and operates its own processing facilities and

leases communication lines from national or

international carriers.

SWIFT was initiated by a group of European bankers who were searching for a better

way than mail or telex to transmit messages

to correspondent banks. In response to the increase in international financial volume in the

1950’s and 1960’s, a number of banks had

established internal communication and processing systems. These proprietary systems

usually connected only branches and affiliates

of the banking groups, and therefore transactions involving a number of banks would

often rely on a paper-based system. Another

drawback of these proprietary systems was

that they established a myriad of standards,

comparable to the different gauges of railroad

track one still encounters when crossing some

national boundaries. The creation of SWIFT

was in response to the need to establish a rapid

communication and processing system, which

was universal and standardized, was for all international interbank transfers and was available to all banks. SWIFT was also seen as a

way to compete with these intrabank communication systems, particularly those of large

U.S. banks but eventually also a number of

smaller U.S. banks, in order to provide the volume necessary to support the system.
Ch. 6—The international Environment for Financial Services ● 159

.—— —— — — .— — ——

When SWIFT was incorporated in Belgium

in 1973, it was owned by 239 European, North

American, and Japanese banks in 15 countries.

In its first year of operation, SWIFT averaged

51,700 transactions per day. ” As of April

1983, the SWIFT system served 1,063 member banks in 52 countries, of which 33 were

operational countries, and processed an average of 360,000 financial transactions per day

(see figs. 12 and 13).17 This represents about

four times the combined total transactions of

the two private sector bank payment networks

in the United States, Bankwire and CHIPS. 18

SWIFT is not a clearing or settling network

and does not read the messages as they pass

through the system; therefore, the value of

these transactions is difficult to determine.

16 SWIFT: Ten Years, special anniversary issue of the general

introductory brochure (Brussels, Belgium: Society for World- 17 SWIFT, “Facts About SWIFT, ’4 April 1983.

wide Interbank Financial Telecommunication, May 1983), p. 25. 18 ’’Executive Suite, ” Transition, January 1983, p. 2.

Figure 12.— Daily System Traffic Volumes (average: end of year)

———. — ] y-- 51 -w

}, II t ( II II I

-,1 1, I i ]{ II I

..1 ), I I II II 1

I I 11 ( I ,1 1( I

11

SOURCE SWIFT Ten Years special anniversary issue of the general Introductory brochure (Brussels Belgium Society for Worldwide Interbank Financial Telecommunication May 1983)

Figure 13.—Cumulative System Volumes (end of year)

\lll I 1( )\ \

I -1$

1981 169.081 000

SOURCE SWIFT Ten Years special anniversary Issue of the general Introductory brochure ( Brussels Belgium Society for Worldwide lnterbank Financial Telecommunication May 1983)
160 ● Effects of Information Technology on Financial Services Systems

U.S. traffic over the network is higher than

that of any other nation; in 1982 it was 17.7

percent of total volume, an increase from the

1981 figure of 16 percent.19 Yet only 141 U.S.

banks participate in the system. Carl Reuterskiold, SWIFT’s general manager, estimates

“that as many as 500 U.S. banks are involved

sufficiently in international banking to merit

SWIFT membership. ”20

After 6 years of operation SWIFT is entering a new phase of operation. In 1982 it was

able to amortize completely the development

costs of the network, and for the first year,

broke even. This has occurred even though

SWIFT raised the basic per-message charge

only once, to 18 Belgian francs (about 35 to

40 U.S. cents) .21

SWIFT’s plans for expansion include an improvement in technical transmission and processing facilities, commonly called SWIFT II.

Plans are to install a new, more powerful computer system between 1985 and 1987 on a

country-by-country basis. SWIFT will finance

the new system internally from operating

revenues.

Although SWIFT enjoys a comfortable position as the primary international financial

transmission network in terms of volume, it

has continued to seek new business opportunities. By September 1983, SWIFT estimated

that it offered its base service to approximately 90 percent of the total international fi-

——

‘

gRobert Trigaux, “SWIFT Executives and Bankers Mull the

System’s Future,“ American Banker, New York, May 17, 1983,

p. 1.

‘“Ibid., p. 31.

2’ Ibid., p. 31.

nancial market.22 SWIFT management foresees a leveling off of revenue in this business

area and therefore plans to expand its revenue

producing message traffic in other areas. In

1982, SWIFT formed direct interface with the

CEDEL and Euroclear bond clearing systems

and MasterCard International to use SWIFT

for transmission of transaction or settlement

information.

SWIFT has also begun a controversial new

program to offer new financial services, specifically balance reporting. Many U.S. banks

view the proposed changes as potential competition for services that banks currently offer. However, if balance reporting does not

lead to other types of cash management services, these banks will not challenge SWIFT’s

entry into this business area. SWIFT management maintains that the balance reporting

service will be invisible to corporations and

will remain an interbank service. There is evidence that although U.S. banks may be wary

of the changes, European banks may be encouraging the implementation of these new

services.

Another service that SWIFT management

intends to expand is the provision of intracountry financial communications.

One of the primary achievements of SWIFT

for international banking has been the standardization of international, interbank communications. With respect to new services,

SWIFT intends to play the same role, thereby

helping to establish international standards

in cash management services,

“B. Kok, “The Business Future, ” Proc&d”ngs From SWIFT

International Banking Sem”nar(SIBOS ‘83), Sept. 26-30, 1983,

Montreux, Switzerland, p. 12.
Ch. 6—The International Environment for Financial Services . 161

-.

The Effect of Technology on International

Payment Systems

J. R. S. Revell distinguishes between two

classes of payments in his work, Banking and

Electronic Funds Transfers.23 Borrowing from

the work of J. M. Keynes, Revell separates international financial flows into two categories:

those involving the transfer of income and the

payment for goods and services by nonfinancial business and households, or the “industrial circulation” (corporate and retail payments), and those involving foreign exchange,

the money market, and the capital market, or

“financial circulations. ” It is a useful distinction when one is concerned with the impact of

the technology on payment flows, for it would

appear that certain characteristics of information technology will have different effects on

the different types of flow. By using these two

classifications, the specific impacts of the technology can be defined more clearly.

Information technologies have had a great

impact on operations in both areas. The mechanisms of these markets have been described

in previous sections. What follows are specific

examples of the effect of technology on the two

types of flows. In retail and corporate markets,

the technologies have led to a range of new,

technology-based products, adding to the

choices available to the individual and corporation in international financial transactions. In

financial markets the technologies have primarily affected the velocity and volume of

transactions.

Corporate and Retail Markets

In many of the normal payments associated

with trade, it is not speed of transaction which

is of importance. Since trade payments are

scheduled for particular days each month, the

settlement of accounts could easily continue

to be handled by mail, taking the delay into

account. However, electronic payments add

some control over these payments, and by

23Revell , op. Cit., p. 154.

their nature handle increased volume of payments much better than paper-based systems.

One of the distinguishing characteristics of

the international market is that, as in the domestic market, corporate customers demand

cash management services from financial service providers. The basic principle of these services is to maintain low operational balances,

with the majority of funds invested and earning interest. The impact of communication and

information technologies on the ability of a

corporation to manage its financial position

is similar to that in the domestic market; i.e.,

the manager is able to react immediately to

information and to adjust the corporate financial position accordingly. The difference in the

international market is that these transfers

take place in multiple currencies and cross

many international boundaries. For the multinational corporation, foreign exchange fluctuations provide a great incentive for initiating electronic transfers. The technology allows

the user to react instantaneously, often protecting the corporation from foreign exchange

losses in times of economic turbulence.

Another difference from the domestic marketplace that affects the complexity of international cash management is that the manager must rely on information from a multiplicity

of sources in dispersed places, to the point

where flows of information are beginning to

rival payment flows in importance. It is easy

to reach Revell’s conclusion that, “The ultimate objective is that the corporate treasurer

at head office shall have an up-to-the-minute

summary of the cash position in all currencies

on a single VDU [video display unit] on his

desk; he will then initiate the larger transfers

of funds himself, leaving the bank computer

to invest smaller amounts according to routines decided in advance. ”24

“Ibid., p. 155.
162 • Effects of InformaTion Technology on financial Services Systems

Technological Innovation in Retail Services

Since many innovations in corporate and retail flow of funds often take place in the international side first, it is useful to study what

is going on in the international marketplace

to help project developments in the domestic

arena.

One of the distinct differences between technological innovation in the U.S. financial service industry and that in foreign nations is the

level of government subsidy of technical developments that affect the financial service industry. For example, the smart card, the applications and functions of which are discussed

in chapter 2, was developed by the French

Ministry of Post and Telecommunications

(PTT). Although the card has other uses, it will

be used for electronic banking, particularly for

payments. The French have also conducted

various trials in point-of-sale (POS) systems

and have also introduced on a limited scale a

videotex system that will eventually be capable of handling financial transactions. The

charge for this service is provided to the consumer as part of his monthly telephone charge.

The British videotex system, Prestel, was developed by British Telecom (BT, then part of

the British Post Office), the telecommunications authority. Again, although the system

has other applications, its service is in direct

competition with other, commercially developed systems.

The developments outside the United States

with respect to retail services are in many

ways similar to the domestic innovations that

have been described in previous sections.

What differs in many cases is not the technology itself, but the commitment of the various

governments and the structure of the financial service industry in a particular nation.

Often, technological innovations are easier to

implement under a regulatory structure that

differs from the U.S. regulatory structure. For

example, in Great Britain, BT and IBM are

currently discussing an electronic POS system

with the London clearing banks. Since the

banking industry in Great Britain is highly

concentrated, agreement with these banks

(and assuming subsequent agreement with

British retailers) will ensure a national POS

system.

Some innovation in retail services takes

place across national borders. Members of

Eurocheque International recently agreed on

a “eurocheque” ATM standard that will allow

the crossborder use of the eurocheque guarantee card. VISA International plans a similar service on a worldwide basis. The impetus

for much of this activity has been the growth

of international travel and the consequent

need by the traveler for ready access to bank

accounts worldwide.

Vulnerability of the Financial System

The application of advanced financial infor- World trade relies heavily on the integrity of

mation technologies occurs in nearly all in- transnational transactions and payments; this

dustrialized nations and in many of the newly in turn depends heavily on the reliability and

industrializing nations. This is in response to, security of the transborder flow of data.

and will further enhance, the ongoing growth As world trade has expanded, so too have of global economic activity and the increasing the financial services to support it, not only interdependence of national currencies, national markets, and national economic policies. in the actual support of trade through traditional bank lending and transfer mechanisms,

Expanding world trade, which is responsible but also in the provision of flexible money and

to a great extent for this financial activity, is capital markets. The use of new technologies

increasingly important to the U.S. economy. in the financial service industry has facilitated
—— — .-. .

Ch. 6—The International Environment for Financial Services ● 163

— . — —.— .- —

the growth in volume of financial flows separate from but related to the payment flows associated with world trade. One aspect of these

money and capital markets is the interbank

transfer. The application of information technologies permits both the increased volume of

these transfers and the participation of smaller, nonmoney center banks, thus helping

change the character and structure of international banking.

Security and Integrity of the

Financial System

Communication and information technologies have increased the interdependency of

the participants within the financial system.

The international financial system may now

be more vulnerable than ever to upheaval,

both economic and political, in foreign countries. At issue within this area is the question

of the increased vulnerability of all parties to

international events that results from communication and information technologies.

The technologies have created new opportunities for attacking systems for delivering

financial services. System integrity, the ability

of a system to recover from damage, is a salient issue when a significant portion of the required operations are performed without human intervention. For example, financial

service institutions can be attacked by perpetrators electronically and off-site. Some systems have reached a stage of complexity where

they can be backed up only with automated

systems, and in the case of interruption to

service, they can be restored to operation only

with automated recovery procedures.

Error Resolution in International

Electronic Funds Transfer

With increasing global interdependence and

increasingly complex transactions, generally

more than two parties are involved in a single

transaction, and therefore a multitude of systems are also involved. The issue as defined

here is that of responsibility in the case of loss

or error. Simple bilateral contracts do not in

all cases clearly place liability, especially when

transactions involve multiple parties. It has

been recommended that the party initiating

the transaction be responsible, which is not

acceptable to all parties.

There is a similarity between losses suffered

under CHIPS or SWIFT and those under

other payment systems. They can be classified

in three ways: principal losses, interest losses,

and losses resulting from foreign exchange

fluctuations. “These losses may be caused by

the delay of a transmission, the introduction

of faulty information, or a participant’s inability to settle the day’s transactions. Delays

and faulty information may arise from hardware and software failure, mistakes by personnel involved in processing the transaction, and

fraud. The failure to settle, on the other hand,

is usually caused by the failure of one of the

transferring banks. “25

Foreign Telecommunications and

Information Policies

Although the force from within the industry is toward the flow of information throughout the world, integration of the world economy and the world financial system is by no

means as simple as the integration of a domestic economy. Currencies, accounting methodology, and regulatory and supervisory structure all differ among nations. In support of

trade activity, information flows across national boundaries: information which includes

both personal and strictly financial data, information which travels via sophisticated telecommunications systems, and information

processed by state-of-the-art technologies.

These flows, known as transborder data flows

(TBDF), have caused conflict and controversy

among nations and between particular nations

and multinational businesses. It is primarily

the informational flows, rather than payment

flows, with which most nations are ostensibly

concerned.

“Herbert F. I.ingl, “Risk Allocation in International Interbank Electronic Fund Transfers: CHIPS and SW1 FT, ” Har-

~“ard International I,awr Journal, \’ol. 22, No. 3, fall 1981, pp.

630-631.
164 ● Effects of Information Technology on Financial Services Systems

— . — — —

Sovereign nations assert legitimate reasons

for, and a right to, monitor and control TBDF.

Primary among these reasons are protection

of the privacy of their citizens, industrial development, and national security. However,

sovereign rights and national information policy are frequently in direct conflict with the

interests of large, multinational organizations,

including financial service providers. This conflict of interest in turn can impede the progress

of a global financial system and perhaps world

trade.

As the information technology industry becomes increasingly important in international

trade, more countries are seeking to protect

their indigenous communication and information industries and are therefore creating legal

barriers to the flow of information. This has

an impact on the financial service industry,

whose primary function is the distribution and

processing of information.

The requirements of multinational and international finance include rapid communications

and efficient data processing. Certain restrictions by foreign governments—e.g., that all

data are processed locally-can severely hamper these activities. The current economies of

data processing are such that it is more efficient to centralize the process.

For a variety of reasons, there have been

suggestions that nations limit the flow of personal data across their borders. Some would

limit the effects of restrictions to data identifiable with natural persons while others would

include both natural and legal persons. Included has been the suggestion that limitations on TBDF be focused on curtailing the

flow of data to nations that have not imposed

privacy standards at a level consistent with

those of the nation imposing them. However,

much of the data of interest to the financial

service industry pertains to specific individuals, and its movement across international

borders would be affected by such restrictions.

Therefore, limitations on TBDF could cause

significant problems for the financial service

industry, which finds demands for international services increasing.

The economic and industrial development

justification of restrictions of TBDF have as

their impetus the rising importance of information and communication technologies to the

world economy. As traditional manufacturing

industries stagnate and high-technology information industries grow, it is to every nation’s

advantage to encourage a sound, strong information industry. Although national policy

strategies differ, it is evident that some nations have taken the route of protectionism.

For example, Brazil has stringent requirements on the import of data processing equipment in order to encourage the growth of local

industry. Until recently, little foreign competition was allowed in the large Japanese communications and information technology and

services market. These types of activities, although they may protect indigenous industry,

have a tendency to increase overall costs to

users.

More specifically affecting the financial

service industry are those national policies

that threaten to discontinue access to leased

lines, begin usage-sensitive pricing schemes,

and demand that industry use local communication facilities. The objections of banks and

other financial service providers is not only

that this will increase their costs, but that

transmittals over public lines make control

over sensitive information more difficult.

National security concerns seem to center

around the economies of scale and the lack of

locational sensitivity in data processing. It is

common for large corporations to center their

processing facilities in one nation. For example, SWIFT’s data processing and transmission centers for its 52 member countries are

located in 3 countries: the Netherlands, Belgium, and the United States. Such centralization engenders the fear that sensitive information will be stored in a foreign country, or that

a nation may be cut off from information in

a time of national crisis. As SWIFT pursues

domestic interbank markets, these fears become well-founded; it is entirely possible for

one nation’s domestic retail and interbank financial information to be stored at facilities

outside its borders.
Chapter 7

The Consumer of Financial Services
. .

Contents

Page

Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167

Consumer Financial Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167

Consumer Savings and Investment Behavior . . . . . . . . . . . . . . . . . . . . . . 168

Providers of Consumer Financial Services . . . . . . . . . . . . . . . . . . . . . . . . . 169

Consumer Payment Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171

Growth of Consumer Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173

Recent Innovations in Consumer Financial Services . . . . . . . . . . . . . . . . 174

Automated Teller Machines . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176

Automatic Direct Deposit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178

Telephone Billpayer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178

Point-of-Sale Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178

Home Information Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178

Pricing Structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178

Opportunity Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179

Information Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179

Communication Costs .. .. .. .. .. .. .. $. .. ... ... .$...... . . . . . . . . . . 179

Competition and Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179

Public Policy and the Financial Service Consumer. . . . . . . . . . . . . . . . . . . . 180

Regulations Relating to Consumer Finance. .’. . . . . . . . . . . . . . . . . . . . . . 180

Consumer Credit Protection Act . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182

Regulations Z and M . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182

Electronic Funds Transfer Act . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183

Transition From Paper-Based to Technology-Based Systems . . . . . . . . . . . 184

Security of Consumer Assets in a Technology-Based System . . . . . . . . . 184

Privacy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185

Consumer Rights to Financial Services . . . . . . . . . . . . . . . . . . . . . . . . . . . 186

Tables

Table No. Page

9. Household Financial Assets and Liabilities, 1982

(billions of dollars). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169

IO. Credit Card Holding (families holding cards as percent of

all families). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172

11. Credit Carouse (families using cards as percent of all families) . . . . 173

12. Summary of Variances in Regulation and Investor Protection. . . . . . . 181

Figure

Figure No. Page

14. Lifecycle of Consumer Needs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170
—

Chapter 7

The Consumer of Financial Services

Introduction

Consumers’ of financial services have characteristics distinct from all other financial

service user groups. Approximately 80 million

households comprise this group; and as such,

it is an important part of the U.S. economy.

Household deposits provide the financial service industry with nearly $2 trillion in loanable

funds. In addition, consumers have a diversity

of needs and compose a highly segmented market, Consumers, in comparison to their use of

other instruments, also make the least use

of technology-based financial services and

products.

It is readily accepted that although some

movement has been made toward consumer

acceptance of technological devices in banking, the time horizon for acceptance by the

total population will be much longer than 10

years. There are currently some highly visible

examples of the effect of technological change

on this market segment (e.g., the rapid acceptance of automated teller machines (ATMs)),

but certain institutional relationships have

been affected little by the technology. As some

new systems are implemented, however, and

certain of the institutional problems with

these implementations are resolved, the effects

of technology on the consumer of financial

services are bound to become more evident.

Historically, the banking sector of the financial service industry has been either enamored

of or totally uninterested in pursuing the con-

‘The consumer, as defined here, is an individual user of personal financial services.

sumer as a potential customer. It appears,

however, that competition is changing some

of the indifference of banks toward this market. “It was not regulation or legislation that

allowed nonbank institutions to exploit the opportunities available in upscale credit cards

(American Express), in discount brokerage

(Merrill Lynch), and in automated payroll services (ADP). Rather it was the failure of banks

to engage in effective marketing and their lack

of innovation and understanding of consumer

attitudes that gave the near-bank competitors

the upper hand in these product areas.’” As

a result, the consumer is beginning to wield

more power in product development; recent

events are changing consumer financial services from being product-driven to being market-driven. It is not clear, however, if all consumers are benefiting from these changes.

Consumer protection regulation has in the

past dealt with the protection and fair treatment of consumers in the financial service

system. Implicit in the formulation of public

policy has also been the recognition of the potential impact of technology-based systems on

the consumer. However, it is important to

fully understand the changes taking place,

their impact on the role and behavior of the

consumer, what new issues will arise because

of these changes, and existing issues that have

not been adequately addressed.

—————

‘Richard Rosenberg, Vice Chairman of W’ells Fargo, as quoted

in The Retail Banking Re\’olution: An International Perspectit’e, Patrick Frazer and Dimitri }Tittas (eds. ) (1.ondon: Nlichael

I,afferty Publications, 1982), p. 7.

Consumer Financial Services

Consumers seek financial services to fa- instruments, to balance present consumption

cilitate payment, to balance current income against future earnings with credit instruagainst future consumption through savings ments, to secure growth in capital, and to safe167

35 -505 ~ - 84 - 12 : QL 3
168 • Effects of /formation Technology on Financial Services Systems

——. — — —.

guard their assets. A rational consumer who

wants to maximize his objectives will desire

control over the means (i.e., assets and income)

to those ends. The degree of his control is

measured by the extent to which his assets

meet his needs.

In this regard, Professor William White, in

his report to the Investment Company Institute, The Outlook for Money Market Mutual

Funds, defines the demand of consumers for

specific financial products and services as arising not from the particular product or service, but from features of the consumer and his

environment. Demand arises first from the necessity for the individual consumer to meet

certain basic needs, which can be classified as

convenience, return, liquidity, security, credit

availability, and, to some extent, personal

service. The investment behavior of the consumer is related to the relative importance of

each of these needs, which in turn is based on

the individual’s economic environment and his

lifecycle stage. Also of importance is the less

tangible factor of individual tastes and preferences. 3

Consumer Savings and

Investment Behavior

The term “investment” throughout this section is not used in its macroeconomic sense,

that is, the purchase of capital goods. For this

chapter the term means the commitment of

money specifically to earn a profit, most often

by purchasing securities. “Savings” are defined as asset accounts in which an individual accumulates funds for future consumption.

For the most recent statement of total outstanding assets and liabilities for the household sector, see table 9.

The primary savings instruments used by

individuals are time and savings deposits, pension funds, and home mortgages. In recent

years, more consumers have begun using the

money market fund for savings. The figures

for 1982 do not reflect, however, the more re-

‘William L. White. “The Outlook for Money Market Mutual

Funds, ” Report to the Investment Company Institute, Sept.

30, 1982, pp. 28-29.

cent movement of funds out of money market

funds into their depository equivalent, money

market deposit accounts. These figures will be

reflected in 1983 end-of-year accounts.

Life insurance funds are also used for accumulating savings; however, because of their

low rate of return, their primary function is

insurance against risk. Individuals also invest

a considerable amount in securities, both corporate and government.

Home mortgages, although they represent

a liability relationship for the consumer, are,

in effect, instruments of negative savings in

which the consumer initially creates a debt

relationship with an institution. However, as

the consumer decreases his debt, he earns

equity in the property; as the value of the

property increases over time, it increases the

net worth of the individual.

The relationship of assets to liabilities and

the choice of instruments for investment

varies with the age and income of the consumer. This is depicted graphically in figure 14.

The primary earning years are between the

ages of 20 and 70, when generally the consumer earns more than he consumes. With

age, savings and investment behavior of the

consumer changes. Generally, in youth, the

consumer will be more consumption-oriented;

as age and income progress, the consumer will

be more future-oriented. The consumer’s basic

needs of convenience, higher return, security,

liquidity, credit availability, and personal security often correspond with this lifecycle and

directly influence which financial service and

products he selects.

Although aggregate information on the savings habits of consumers reflects a propensity

to invest, an overall tendency to save rather

than borrow, and a pattern of savings highly

correlated to age, consumers differ in their objectives for asset management. The financial

service industry has recently begun to react

to these differences and to provide services to

meet very individual needs in addition to providing instruments that have widespread use

(e.g., checking and savings accounts, bank

credit cards, or mortgages).
Ch. 7—The Consumer of Financial Services ● 169

Table 9.— Household Financial Assets and Liabilities, 1982 (billions of dollars)

Assets:

Deposit and credit market instruments . ,

Deposits ., ., . . ... ... . . .

Checkable deposits and currency . . . . . .

Small time and savings deposits . . .

Money market fund shares . . . . . . . . .

Large time deposits ., . . . .

Credit market instruments ., . . . .

U.S. Government securities ., .. .

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 ., . . . . . .

Pension fund reserves ., ., ., ... .,

Security credit . . . . . . . . .

Miscellaneous assets . . . . . . . . . .

Total assets . . . . . . . . . . . . .

Liabilities:

Credit market instruments . ., .,

Home mortgages . . . . . . . . . . . . . . . . . . .

Other mortgages . . . . . . . . . . . . .

Installment consumer credit . . . .

Other consumer credit ... ., . ,

Bank loans n.e.c.a

. . . . . . . . ... . . . .

Other loans . . . ... . . . .

Security credit . . . . . . . . . . .

Trade credit . . . . . . . . . . . . . . . . . . . . . . . .

Deferred and unpaid life insurance premiums

Total liabilities. .. .. ... . . . .

NOTE Households Include not for profit orqanlzat!ons

aNot elsewhere class lf~ed

$2,781.3

1.982.7

798,6

1,316,2

89.5

1,226,8

1,316.2

935.3

16.0

85.3

$5,381.0

1,674.4

1.101,0

36.4

344.8

85,9

33.3

730

28.8

22.2

15.5

$1,740,9

307.3

1,322,9

206.6

145.9

377.0

129.0

64.5

186,5

41.6

291,8

68.3

223.4

85.2

SOURCE Board of Governors Federal Reserve System Flow of funds Accounts: August 1983

Providers of Consumer Financial Services

For the most part, consumer needs cannot

be met without the assistance of an intermediary that provides access to payment systems and markets, expert knowledge and

advice, the pooling of a large number of individual risks (as with insurance protection), or

a diversified portfolio for a minimum investment (as with investment companies).

In the past, consumer financial institutions

specialized in individual products and services.

As a result there were some institutions that

provided for the payment needs of the consumer, some which provided for his/her savings and credit needs, and still others that provided for his/her insurance needs, Regulation

tended to support this specialization. Recent

trends in the marketplace and in regulation are

beginning to break down the strict distinctions

between institutions. Many consumers are

adapting readily to the changes and are changing traditional relationships with some financial institutions.

Prior to these recent events, the most widely

recognized financial relationship for the consumer was with a depository institution, especially with a bank. Banks provided the consumer access to the payments mechanism

through checking accounts and met some credit 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 income

supported by jobs years from savings, retireparents family ment or welfare

benefits

For the purposes of the financial services industry, people do not become consumers (do not buy) financial services usually

until at least their teens:

General age

Teens20’s

20’s

30’s

60’s

60’s ‘-

New financial activities

First jobs (though often still

with 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 children

education and other expenses,

and for old age.

More business travel.

More income for personal travel.

High 0

/0 of time working, especially

two career couples (2 earner

families): result - need for

greater convenience in transactions, more mail order and

overall purchases. —— .

Often retirement or less working ‘-

time, more leisure, less earned

income.

Resulting financial service(s) requirements

Transaction accounts, simple savings

accounts or instruments (e.g. U.S.

savings bonds).

Education loans.

Auto or other loans

Auto insurance.

Home mortgage.

-.

More sophisticated savings instruments,

Various loans (general credit).

Insurance, savings

life, health, home insurance,

.— —

Tax shelters

More sophisticated investment vehicles:

securities, money target funds, real

estate, insurance purchases.

real-estate pension plans.

Financial advice often desired.

Traveler’s checks, travel and entertainment credit cards.

Cash dispensers, debit cards.

Financial advice, to plan for supporting

a standard of living

lesser risk, higher current Income

(securities), investments, pension

trust, estate planning.

SOURCE William L White, “The Outlook for Money Market Mutual Funds, ” 1982
Ch. 7—The Consumer of Financial Services ● 171

vialed savings and mortgage services. Credit

unions provided services similar to those provided by both commercial banks and savings

institutions.

Recent research shows that the typical consumer deals with only one or two banks and

will accept fairly standardized products.’ However, it also shows that there is very little consumer loyalty toward a particular institution;

if another institution can meet the needs of the

consumer better, the consumer usually moves

his business. A consumer “wants to be able

to use a credit card to purchase goods and

services from merchants, and he wants to be

able to use a piece of plastic (preferably the

same one, perhaps) to obtain cash from a machine. He does not care who issued the card

or who wrote the programs accessing the machines any more than he cares who manufactured the machine. This has been borne out

by the rapid movement of funds out of traditional deposit accounts in the 1970’s to accounts with a higher rate of return. In the

past, most so-called consumer loyalty was illusory in that banks had a monopoly on certain types of transaction accounts and often

had a geographic monopoly, as well.

Individuals with higher discretionary incomes, a desire for high growth of assets, and

lower risk aversion will generally have a relationship with a securities house. High income,

or, in its place, low risk aversion, was generally necessary to offset the risk associated

with the instruments offered through these institutions.

It is evident that consumers have also had

fairly complex financial relationships with

nontraditional financial service providers. Historically, retailers have extended credit to

their customers to purchase goods and services. From this has developed a fairly substantial number of consumers with revolving credit

lines, and credit cards to access these lines of

credit. Sears and J. C. Penney have two of the

‘Arthur D. Little, Inc., Issue and Needs in the Nation’s Payment System, The Association of Reserve City Bankers, April

1982, p. 35.

5Paul Horvitz, American Banker, New York, Sept. 24, 1982.

largest card bases in the United States and

have filled certain consumer financial needs for

years. Both are favorably placed in the financial service marketplace because the consumer

recognizes their names. As the consumer becomes used to nontraditional providers of financial services, he may willingly accept retailers as providers.

Consumers may obtain cash from a variety

of other places besides banks; for example, individuals routinely cash checks at a grocery

or convenience store solely for the purpose of

cash acquisition. Although these retailers are

not financial institutions in the traditional

sense, they certainly have provided consumers

with financial services in the past. Grocery

stores have used check guarantee systems for

a number of years, and as mentioned earlier

in this report, some are beginning to offer more

technologically sophisticated services—for example, onsite ATMs.

The ways in which the financial service industry is changing are described more fully

elsewhere in this report. The effect of these

changes on the consumer has been to offer him

a greater realm of choice in the institutions

with which he can do business.

Consumer Payment Methods

Like the business sector, the consumer requires payment mechanisms to acquire goods

and services. Recent research has postulated

that a consumer seeks as many as 11 specific

attributes in a payment system: budgeting,

documentation, reversibility, spending control, transaction record, leverage potential,

acceptability, transaction time, transfer time,

social desirability/prestige, and security.6 Each

consumer will choose his method of payment

according to his priorities and to his perception of a particular method as having the specified attributes.

By far, the most commonly used medium of

exchange for point-of-sale (POS) purchases is

‘Elizabeth C. Hirschman, “Situational Perception of Product Prototypes Within the Product Class of Consumer Pa~’ment

Systems. ” The Journal of Genera) PsJ’choJogTr, \ol. 106, 1982,

p. 127.
172 ● Effects of Information Technology on Financial Services Systems

cash, particularly for small transactions. The

primary attributes of cash are convenience and

acceptability. Since cash is universally negotiable and requires no personal identification

for use, cash transactions also have the additional attribute of privacy; however, these

same qualities make cash a less secure medium

of exchange. For the approximately 17 percent

of all households that have no relationship

with a financial service institution, either cash

or (in specific instances) money orders or cashiers’ checks, are the only instruments of payment available.

Many consumers use checks to meet these

needs. Studies show that the consumer’s use

of checks has consistently been in the range

of 50 percent for bill payment, 31 percent for

retail purchases, 9 percent for payments to

other individuals, and 8 percent for cash acquisition. 7 The figures for cash acquisition are

probably low, since many checks written to

retail institutions are actually for acquiring

cash. In 1979, consumers’ checks accounted

for approximately 53 percent of all checks

written, or 17 billion transactions.8

Until the 1950’s, the personal check was

truly the only widely used alternative to cash

for payments. In recent years, however, the

check has become less negotiable; consumers

frequently are required to have additional

identification and some proof of creditworthiness in order to use a check for POS purchases.

In part, the decreasing negotiability and lack

of national acceptance of the check led to the

explosion in the availability and use of other

payment mechanisms for the consumer—e.g.,

traveler’s checks, retail credit cards, travel and

entertainment (T&E) cards, the bank credit

card (in the 1960’s), and, most recently, the

debit card.

The traveler’s check and the T&E card provided the consumer with payment mechanisms more negotiable than the check, with

attributes of convenience and acceptability,

yet more secure than cash. T&E cards are

‘See Economic Review, “Special Issue: Displacing the Check”

(Atlanta, Ga: Federal Reserve Bank of Atlanta, August 1983),

p. 8.

‘Ibid., p. 26.

charge cards and, except in certain instances,

do not provide long-term credit to the consumer. When they were introduced, the consumer did not have highly developed credit

needs. T&E cards met the additional consumer

needs of spending control and leverage potential. In addition, the high membership fees and

apparent exclusivity of the cards provided

a sense of social prestige. Although it was

thought that with the introduction and widespread use of bank credit cards, the number

of T&E cards in circulation would dwindle and

their usefulness would be outdated, their number has actually grown.

Bank credit cards9 are used in most cases

as an alternative to cash or checks for POS

transactions. Their line of credit added flexibility to consumer payment mechanisms. Bank

cards are perceived by the consumer to be

more acceptable and less time-consuming to

use than checks and less risky than cash. They

also provide the consumer with proof of payment, which facilitates returns or reimbursement. The majority of credit card users do not

actually use the credit option associated with

the card, paying instead the full amount owed

each month.10 The card is viewed more as an

instrument of cash management. Tables 10

and 11 show overall consumer holding and use

of credit cards.

9

.—— The term “bank credit cards” is rapidly becoming somewhat

of a misnomer. This term commonly refers to VISA and MasterCard interchange cards, which in the past were issued by banks.

However, these cards (although for the most part still issued

by banks) now provide access to a variety of’ accounts, including

central asset accounts offered by securities houses.

I O Ec o n o m ” c Review, Op. cit .

Table 10.—Credit Card Holding

(families holding cards as percent of all families)

Year

Type of credit card 1977 1978 1981 1982

Any . . . . . . . . . . . . . . . 63 64 66 70

Gasoline . . . . . . . . . . . 34 34 30 35

Bank ... , . . . . . . . . . . 38 40 45 51

General purposea . . . 8 10 14 14

Retail store . . . . . . . . 53 50 57 63

Other b. . . . . . . . . . . . . 6 5 7 NA

a

Travel and entertainment cards.

blncludes airline cards, car.rental cards, and others not classified elsewhere

NA—not available,

SOURCE Data collected for the Federal Reserve Board by the Survey Research

Center, University of Michigan.
.—

Ch. 7—The Consumer of Financial Services ● 173

.

Table 11 .—Credit Card Use

(families using cards as percent of all families)

— . — ——

Year

Type of credit card -

197 1 1977 1978 1981 1982

Any ... . . . . . . . . . . . . 50’ 60 62 62 ‘- NA

Gasoline ... . . . 33 31 32 27 31

Bank . . . . . . . . . . . . . . 19 25 37 39 47

General purpose

b . . . 5 7 9 12 13

Retail store . . . . 45 50 48 51 57

Other c . . . . . . . . . . . . NA 4 3 5 NA — aData ;or 1970

— ——

bTravel and entertainment cards

clncludes al rl( ne cards and car rental cards

NA—not avaliable

SOURCES 1970 Survey of Consumer Finances: 1971-72 Survey of Consumers,

and data collected for the Federal Reserve Board by the Survey

Research Center, University of Michigan

In the 1970’s, considerable speculation developed about a future “cashless society” (i.e.,

a system where cash as well as checks would

become obsolete, having been replaced by electronic payment mechanisms). However, despite the growth of electronic alternatives, the

use of checks as a method of payment continued to grow at approximately 5 to 6 percent

per year throughout most of the 1970’s and

has only recently begun to slow. It still continues to increase at about 2 percent per year.

Traveler’s checks and credit cards do not require a check be written at point of sale; however, the majority of them rely on the check

for reconciliation of accounts. The only instruments besides the check that provide the

consumer direct access to his account are the

debit card, preauthorized payments, and ATM

payments. In 1979, 97 percent of all debits to

individual accounts were by check. The other

3 percent of debits to consumer accounts were

distributed thus: 1.3 percent to preauthorized

paper drafts, 0.4 percent to preauthorized

automated clearing house payments, and 1.1

percent to ATMs. ” The current system is

merely a reflection of the acceptance of these

alternative media rather than an example of

one replacing the other.

Growth of Consumer Credit

The relationship of the consumer to the provider of financial services has grown increas-

“Ibid.

ingly complex. In the early part of this century, households operated almost entirely on

a current basis; using credit was an indication

of mismanagement of household accounts. Prior to the 1930’s, credit relationships with financial institutions were not common. Retail

establishments were more likely to extend

credit in direct relationship to consumer purchases. At that time, it was postulated, households could manage credit to help balance current consumption wants and needs against

future income.

Since then, as described earlier in this report, there has been an exponential growth in

consumer credit and in institutions and instruments to serve these needs. In the 20 years

from 1960 to 1980, total household liabilities

as a proportion of total household assets grew

from 21 to 35 percent. ” This growth also reflects, in part, a change in attitude by the consumer. Credit is no longer the last resort of

a mismanaged household, but a means of improving one’s living standard.

The primary long-term instrument for decades was the installment loan, where a bulk

sum was borrowed by the consumer from a

bank or consumer finance corporation to finance a large-ticket purchase of a durable

good, and repaid in installments over a specified 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 repay

the outstanding balance monthly.

In the 1960’s the first bank credit cards were

introduced, adding yet another source of consumer credit. As mentioned previously, the

bank 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 types

of credit options for the consumer: short-term

credit to bridge cash shortages between paychecks and longer term installment credit. The

“Board of Governors, Federal Reserve System, Flow of Funds

Accounts, August 1983, September 1979.
174 • Effects of Information Technology on Financial Services Systems ——— —— —. .—

latter is provided with only one credit application, the consumer may borrow the exact

amount he wishes within his credit limit and

have considerable payment flexibility. About

two-fifths of credit card holders use these options on a regular basis.

Recent Innovations in Consumer

Financial Services

In the past decade, inflation, interest rates,

and the lifting of particular banking regulations have affected how consumers manage

their assets. Events of the last decade have

increased the number of investment options

open to the consumer of financial services and

expanded the range of consumers who use

these services. For example, tax-exempt income is available to all consumers through Individual Retirement Accounts (IRAs), and

money market funds and money market deposit accounts allow the small investor access

to high interest rates.

Nontraditional Providers and Instruments

Recent changes in the industry have also affected the way the industry provides financial

services to the consumer and have introduced

new players to the marketplace. In the 1970’s,

the inflation rate and the resultant high opportunity cost of standard consumer savings

instruments led to a phenomenon known as

“disintermediation.” Funds flowed out of the

depository institutions into nontraditional instruments and institutions. New instruments

were created outside the interest rate-regulated environment of the banking community.

One of these, the money market fund, allows

the small saver to earn higher interest rates

and thereby preserve assets. This instrument

is a particularly appealing alternative because

it also offers checklike privileges through

share drafts. Although there is usually a minimum amount the consumer can withdraw

from his account with a draft, in many cases

it meets his liquidity needs.

The initial target of these funds was the socalled upscale market; that is, those individuals with relatively high discretionary incomes

and minimal risk aversion. In time, as doubledigit inflation continued and the spread grew

between interest earned in these funds and

that earned in bank time deposits, other, more

risk-averse individuals began investing in

these instruments. This phenomenon was

partly responsible for the movement within

Congress to deregulate parts of the banking

industry, a movement that eventually allowed

depositories to offer accounts bearing higher,

more competitive interest rates.

In response to competition and profit opportunities, depository institutions have also

begun offering discount brokerage services to

their customers, making it possible for some

consumers to meet a number of their savings

and investment objectives with one firm. However, since banks are not allowed to offer advice on investments, except in the case of trust

customers, this service is still limited to a

financially sophisticated class of consumers.

On the other hand, nondepository institutions,

such as securities firms, have added services

that have the appearance of depository instruments, yet the qualities a consumer seeks for

managing his assets. Since consumer perception of the instruments is the same, a consumer may not differentiate between the two

choices.

The Depository Institutions Deregulation

and Monetary Control Act of 1980 provided

new opportunities for the consumer. This act

allowed depository institutions nationwide to

offer NOW accounts through which the consumer earns interest on an account that is not

differentiated in use from a checking account.

These accounts already comprise one-third of

all checkable deposits. ” Also enacted by the

same legislation was the provision that federally chartered savings and thrift institutions

could offer consumer loans for up to 20 percent of assets.

Complexity of the Marketplace

The present marketplace offers greater

choice yet greater confusion for the individual.

~Bomd of Governors, Federal Reserve System, Money Stink

Measures and I.iquid Assets, Dec. 30, 1983.
Ch. 7—The Consumer of Financial Services ● 175

The consumer must be more aware of the particulars of investment and must deal with a

changed environment that no longer offers

him standard investment opportunities keyed

to his position in life. The result is an increasingly complex relationship between financial

institutions and the consumer.

For example, high and uncertain interest

rates also led to an industry-led innovation in

the home mortgage market. During the 1970’s,

the variable rate mortgage was introduced. In

addition, the equity loan was introduced into

the home mortgage market. This loan, which

allows a homeowner access to the equity in his

home, is much the same as a second mortgage;

however, second mortgages are traditionally

used for specific purposes such as home improvements. Most of the promotion of these

loans, under the rubric of “credit managemerit, ” encourages their use for virtually all

purposes, exposing the consumer to the loss

of his home if he is unable to meet payments

on the loan.

The solution to this situation is not necessarily to increase the information available to

the consumer. Often educational differences

or a predisposition by the consumer precludes

him from processing the information in a way

that would facilitate his decisionmaking. And,

it is likely that particular groups of individuals

will be more affected than others. Certain

groups may beat particular disadvantage; for

example, the elderly and the uneducated.

There is also some question whether there

will be a conflict if the provider of services is

also the major provider of information about

these services. For the most part, only wealthy

individuals have access to financial advice,

either through bank trust departments or securities brokers. Discount brokerages provide

access to financial markets for less wealthy

consumers, but without the advice function.

Middle-income consumers have in the past

relied on banks for some financial advice, but

in more complex systems, banks are often not

in the position to offer sound advice to this

segment of the consumer markets, owing to

a lack of trained personnel. Technology may

also push these consumers out of the bank,

further limiting their access to information

services.

Technology-Based Services

There is little evidence to support the notion

that consumers specifically demand technology-based services; the demand for services is

still a reflection of the overall needs of the consumer. There is perhaps a particular class of

consumers, referred to as “innovators,” who

willingly accept new technological applications. The market for these services evolved

as the consumer discovered that technologybased services had specific attributes of remote location and self-service and that they

provided a payment alternative. The use of

technology in financial services can help alter

consumer demand for financial services by

providing him easier access to his assets.

Some financial service innovations mentioned in the previous section were facilitated

by technological change; e.g., variable rate

mortgages require information-processing facilities in order to be cost effective. This section distinguishes between those innovations

that require technology in the backroom sense

and those that require the consumer to have

direct contact with the technology or those

where technology changes the behavior of the

consumer with respect to financial services.

Previous sections of this report illustrate the

way that communication and information

technologies have affected the way the financial services industry operates. The informational nature of the financial service product

led to the early application of automation in

this industry, particularly in internal and

intra-industry operations. However, when

these technological solutions were applied to

the marketplace, especially as new products

and services in the consumer segment, the

benefits were not so clear nor the implementations so easy. In particular, when depository

institutions attempted to transfer their costsaving technological solutions to the consumer

market, they were faced with a diverse, often

reluctant market.
176 • Effects of Information Technology on Financial Services Systems

Consumer Acceptance of Technology

Some attempts at introducing technologybased products and services to the consumer

of financial services succeeded and some failed.

It became evident from these attempts that

technological solutions had to consider consumer need. Examples of such new technologies include ATMs, automatic direct deposit

systems, preauthorized payments, POS funds

transfer and check guarantee, and home information systems, most of which have been described in previous sections of this report.

What follows are descriptions of consumer

acceptance and attitudes toward these technologies.

Automated Teller Machines

The ATM is an example of electronic funds

transfer (EFT) that is highly visible to the consumer of financial services. By 1981, the Bank

Marketing Association (BMA) reported that

nearly 100 percent of the population was aware

of ATMs.14 Of that figure approximately 32

percent actually use an ATM for financial

transactions, which is an increase from 10 percent in 1977. When further broken down, this

figure reveals that only slightly more than half

of the 32 percent use an ATM more than once

every 2 weeks. The growth of ATM use has

followed the typical pattern of technological

diffusion—that is, from initial use by “innovators” to rapid, widespread use. The Federal

Reserve Bank of Atlanta in a recent analysis

of check displacement has estimated that the

saturation level for the ATM will be reached

when the percentage of actual users reaches

65 percent of all possible users.

The primary pattern of use of an ATM is for

cash acquisition. According to Linda Fenner

Zimmer, a noted ATM consultant, the pattern

of use of the ATM has remained relatively constant since its introduction: cash withdrawals

represent approximately 75 percent of the volume of use of ATMs; deposits, 19 percent; balance transfers, 4 percent; and payments, 1 percent.15 It should be noted, however, that the

value of deposits received at an ATM far exceeds the value of withdrawals. Also, ATM

cash withdrawals tend to be for amounts that

are half the value of withdrawals facilitated

by a human teller.

Also interesting to note is that use of the

machines during normal banking hours is increasing, which represents a change in consumer attitude about the primary attributes

of the machines. Originally, ATMs were seen

as convenient for obtaining cash 24 hours a

day. In this sense they were direct competitors

with retailers who provided this service. However, with the change in pattern of use during banking hours, there is some indication

that they are beginning to replace the human

teller as a source of cash. This is partly due

to the greater reliability of the newer machines

and to the increasing acceptance of the machines by a greater number of people. In many

cases, the institution deploying the ATM encourages its use in order to lower the pertransaction cost of the system and therefore

the costs to the institution.

Research shows a strong correlation between age and ATM use. The most frequent

user of an ATM is young; use peaks in the 25-

to 34-year-old range, with a dramatic fall-off

in use among members of the population over

65. ’6 There is some evidence that those younger than 25, although not frequent users of

ATMs, have a high level of acceptance, and

when they establish firmer relationships with

financial institutions, they too will become fre

quent users of the technology. It is expected

that the age factor will become less important

with time, although when is unclear.

Isolated experiences indicate that one factor that can hinder the use of ATMs by the

elderly is inexperience with technology. In certain situations, by providing the elderly customer with assistance, many of these reservations can be overcome. However, this will not

always be the case, and it cannot be overlooked that convenience and remote location

“Bank Marketing Association (BMA), Payment Attitudes

Change Evaluation (PACE III 1981), Chicago, p. 2.1.

‘“Econom”c Review, op. cit., p. 17.

“Bank Marketing Association, op. cit., p. 2.50,
Ch. 7— The Consumer of Financia/ Services ● 177

— .— —— . — .— ——————

. . . . . .

z

o

0

-J

m
178 • Effects of Information Technology on Financial Services Systems

— .-

are not always important to the elderly consumer of financial services. Tradition and the

human factor can play important roles in this

group’s use of financial services, and therefore

in their acceptance of technological services.

Automatic Direct Deposit

In an automatic direct deposit system, some

form of income is automatically deposited in

an individual’s account on a regular basis. Examples include direct deposit of Social Security checks by the Government or of payroll

by the private sector. Direct deposit is another

example of technology-based service of which

the general population is nearly 100 percent

aware. According to the 1981 BMA survey,

36 percent of respondents’ households use

automatic deposit, and 80 percent of these had

a very favorable opinion of the service.17 In the

5 years between 1978 and 1981, penetration

of direct deposit of Social Security benefits

grew from 11 to 33 percent of all such payments. It is the eventual goal of the U.S.

Treasury that all Social Security payments be

made by direct deposit.18

The premise on which direct deposit is sold,

particularly with respect to Social Security

payments to the elderly, is that it decreases

consumer vulnerability to theft. Other aspects

of the service to which the consumer responds

favorably are convenience, the speed of account crediting, and the regularity of deposits (particularly when the recipient is out of

town). On the other hand, the consumer perceives the system raising service charges on

his account and providing increased access to

others of his personal account information. 19

Telephone Billpayer

Telephone billpayer systems are not always

fully automated, but are considered here because they represent an innovative use of

technology-in this case, the telephone—to facilitate consumer payments. Telephone bill-

“Ibid. p. 3.4.

‘

nEconomic Review, op. cit., p. 33.

“Bank Marketing Association, op. cit.

payer services are an example of consumer

reluctance to use a service to meet needs which

they believe are adequately met through other

services. Acceptance of this method of payment has not been very high, and there has

been little growth in the service in the past few

years.

Point-of-Sale Systems

There is little substantial information on

consumer attitudes toward POS debit systems

or 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 United

States was closely tied to consumer reaction

to early POS experiments. Consumers found

they did not care to carry basic necessities on

credit cards.

Home Information Systems

Home information systems are described at

length in chapter 4. There is little agreement

on the potential for consumer acceptance of

this service. One of the major constraints to

its growth is the pricing of the systems. There

is currently a great debate about what people

will pay for these services and about what they

perceive the value of these services to be.

While these questions remain unanswered, it

is difficult to say how rapidly the services will

grow and when and if they will become a mass

medium and therefore open to every level of

consumer.

Once more, the perceived market for the

service is the upscale consumer. To the consumer who earns less than $40,000 per year

and writes few checks, the system may not be

cost effective. For the time being, pricing of

both equipment and the services may preclude

the participation of the lower income consumer

in this case.

Pricing Structures

Past financial services were often perceived

by the consumer to be free or, relative to other

expenses, inexpensive. There was either no
——— -.— ——— - —— —

charge or a minimal “service charge. Financial institutions earned their profit through the

difference in explicit and implicit rates charged

on assets and paid on liabilities. Through competitive and economic pressures this spread

narrowed, and the income to banks therefore

decreased.

Fee income makes up an increasingly large

portion of overall bank income. All evidence

indicates that this trend will continue, the pricing structure in the future will be cost-based,

and service will be explicitly priced.

In addition, pressures from outside the industry are increasing the price of service to

the consumer. For instance, as it becomes

more important for the individual to be informed fully in order to make profitable decisions, the cost of information also becomes a

factor. A number of such exogenous forces affect the total cost of service to the consumer.

Opportunity Costs

Based on evidence that financial decisionmaking is becoming more complex for the consumer, opportunity costs are paid because of

the greater amount of time the consumer will

have to spend in order to make the correct investment. When interest rates are high, the

opportunity costs, in the form of foregone income from higher rate investments, are greater. Some of this cost will be lessened by deregulation of interest rates paid on deposits.

Information Costs

In order to make profitable decisions, the

consumer needs access to more information

than previously and will most likely have to

pay for this information. In its current form,

information is not always accessible to the consumer. Again, it is questionable whether the

consumer will willingly pay for information.

For the wealthier, upscale consumer, for whom

the return is obvious and greatest, there may

be a willingness to pay for information. In general, one of the questions facing providers of

electronic information is how valuable does the

consumer perceive the information to be and

therefore how much will he pay?

Ch. 7—The Consumer of Financial Services ● 179 —. — .

Communication Costs

It seems inevitable that local communications costs will rise; however, at what rate is

still uncertain. The eventual price to the consumer will depend on the structure of Federal

regulation of local rates and, barring Federal

regulation, the decisions State governments

make about regulation of the communication

industry. If home information systems become

the major way for consumers to obtain information and transact business, the communication costs of these transactions could also

rise.

Competition and Costs

In an economic sense, competition is considered good for the consumer in the aggregate:

it results in greater options at lower price. Increased competition in the financial service

industry has provided the consumer with increased options. Although products and services are now explicitly priced, they may well

be cheaper to the consumer because he will receive higher return on assets. However, if

other investment motivations of the consumer

are considered—e.g., security of assets—the

relationship of competition to the relative position of the consumer is less clear.

To really judge the effect of competition on

the consumer, the distinctions between the

various market segments must be maintained.

The consumer with a high discretionary income may benefit from increased choice and

from instruments with a higher rate of return.

To those who consider financial institutions

essentially service organizations and the safekeeper of funds, the high fees for very limited

service may place them in a situation where

they are worse off than previously. They may

have fewer choices in a competitive environment than in a regulated environment.

In his study Banking and Electronic Fund

Transfers: A Study of the Implications,

J. R. S. Revell states that price is the single

most important factor affecting the long-term

growth of acceptance of EFT services. If the

trend in financial service fees continues toward

cost-based, or explicit, pricing, there will even-
180 • Effects of Information Technology on Financial Services Systems

tually be an economic incentive for individuals ingly and are encouraging migration to newer,

to use EFT. Some financial institutions have technology-based services and delivery mechalready begun to price their services accord- anisms through pricing strategies.

Public Policy and the Financial Service Consumer

An important policy objective of the legislation of the 1930’s was to provide for the

safety of consumer deposits. This was accomplished through regulations designed to ensure

the overall safety and soundness of the system and Federal deposit insurance programs.

Deregulation has made it possible for a number of new institutions to enter the battle for

consumer funds. A diversity of institutions

now offers similar products to the consumer;

one of the major differences between them,

however, is the extent of their regulatory control. Depositories are, for the most part, insured and therefore provide a certain level of

protection to the consumer. Adherence to certain safety and soundness regulations required

of depositories is not required of other financial institutions. However, these noninsured

institutions offer services similar to those offered by insured institutions and have, in fact,

drawn accounts away from the insured institutions. Only the effect on the consumer, not

the equity, of this situation for the various institutions, will be discussed here. Important

effects are those which are perceived by the

consumer and therefore are reflected as changes

in investment behavior and those which are

imperceptible to the consumer but may have

long-term impacts on his relationship with the

financial service industry.

In a recent survey of investor protection pro

vialed by various financial intermediaries, the

U.S. General Accounting Office found a number of gaps and overlaps in the protections offered depositors and investors. This information is summarized in table 12, which illustrates

the variance in investor protections provided

to both individual and group investors under

different financial arrangements.

Under current Federal and State regulatory

structure, the consumer’s deposits at a particular depository institution will be covered up

to $100,000. In 1970 the Securities Investor

Protection Corp. (SIPC) was established by an

act of Congress, to protect the investor from

nonmarket losses involving funds and securities held by broker/dealers. These losses will

occur usually only if the institution goes into

insolvency.

Investment companies currently offer no

form of direct protection for the consumer’s

assets. This is of increasing importance since

recently more consumers are investing in the

instruments of investment companies-i. e.,

the mutual fund and the money market mutual fund. The consumer is covered neither for

market losses nor for losses that are the result of mismanagement. It appears that many

consumers consider the money market mutual

fund a higher interest-bearing type of deposit,

and are not aware that their accounts can be

subject to movements in the marketplace. Although these firms are not federally insured,

their investment policies provide either complete assurance (when they invest in Treasury

bills and insured certificates of deposit) or

known risk.

Regulations Relating to

Consumer Finance

Product-line extension has allowed new

players into the financial service marketplace.

Many different types of financial institutions

now offer the same services. In many cases the

difference between choices among instruments

is imperceptible to the consumer in that it is

related to the regulatory structure of the in-
Table 12.—Summary of Variances in Regulation and Investor Protection

Entitles Involved Investor

In establishing protection

rules and primarily

regulations provided by

Federal and State Onsite

Insurance Insurance Regulator Types of services

Type of Institution coverage

Depository Institutions

. Banks $100,000 per

● Savings and loan account

● Credit unions

provided

Deposit accounts

checking

accounts,

commercial and

personal loans

Who Insures Advertising

Federal insurance

programs and

State-sponsored

Insurance

programs

backed by responsible for Rate of return

Subject to

regulatory

requirements

Federal Insurance Banks FRS

programs-full faith FDIC OCC

and credit of U S State

Government authorities

Variable

depository

institution

regulators

examination

and account

Insurance

Information

disclosure

requirements

SRO onsite

examinations

and market

surveillance

Information

disclosure

requirements

and onsite

examinations

Information

disclosure,

SRO onsite

examinations

and market

surveillance

Onsite

examinations

State sponsored Credit unions

insurance NCUA State

programs–no authorities

onet’

U S Department SEC

of Treasury:

Securities brokers $500,000 SlPCr

($100. 000 cash)

per account

Securities Subject to strict –

trading legal and

regulatory

requirements

SEC and

securities

Industry selfregulatory

organizations

Investment None

companies

Not Insured N/A SEC Subject to strict

legal and

regulatory

requirements

SEC Investment

services

Variable

Commodities None

brokers

Not Insured N/A CFTC CFTC and

commodity

futures Industry

self-regulatory

organizations

Commodities

trading

Subject to

regulatory

requirements

—

Personal

Investment

corporate trust

pensions

Variable Not strictly

regulated

Commercial bank Only funds or

trust departments deposit In

Not directly

Insured

N/A OCC. FDIC. FRS Federal and

State banking

Insured accounts authorities
182 ● Effects of Information Technology on Financial Services Systems

dustry. As a result, the consumer also may

perceive his relationship with banks and nonbank institutions to be the same.

In choosing between similar instruments, it

is difficult to assess the extent to which it is

necessary for the consumer to be aware of

these regulations. Certainly it is necessary

that he know his rights and liabilities with respect to the use of certain instruments.

Toward this end, Congress requires that certain disclosures be issued to the consumer.

However, often the consumer does not read

nor fully understand his rights and responsibilities. This is even more important as services become more complex.

When legislation was first enacted to ensure

the safety and soundness of the system and

to protect consumer deposits, the economic

activity of the consumer was quite different

than it is now. Legislation of the last two decades recognizes some of the changes in consumer behavior and his role in the economy,

particularly with respect to credit.

Increased consumerism has been an important factor in the formulation of policy in this

area. Consumer protection legislation enacted

in this era includes the Consumer Credit Protection Act of 1968 and subsequent amendments, the Fair Credit Reporting Act, the

Truth in Lending Act, the Equal Credit Opportunity Act, the Fair Credit Reporting Act,

and the Electronic Funds Transfer Act, among

others. Each represents additional protection

of the consumer of financial services from

discrimination and unfair practices. Consumer

protection legislation plays an important role

in the relationship between the consumer and

provider of financial services, as does the regulation derived from this legislation.

Consumer Credit Protection Act

The following congressional acts are consumer-oriented, and most are amendments to

the Consumer Credit Protection Act of 1968.

That act was one of the first major pieces of

consumer credit legislation passed. Federal

Reserve Board Regulations Z and M imple-

—-—

ment Title I of the act, the purpose of which

is to help consumers become fully informed

about credit and leasing arrangements and to

prevent advertising that may be misleading.

Title I applies to any institution that regularly

offers credit and leasing plans to people involved in transactions for personal, family, or

household purposes. This includes consumer

finance institutions, banks, credit card companies, and retailers who extend credit.

Regulations Z and M

Covered under Regulations Z and M are

three separate acts:

●

●

●

Truth in Lending (Regulation Z)–This act

covers closed-end and open-end consumer

credit transactions. The primary purpose

is to disclose the costs and terms of credit

arrangements prior to their consummation so that consumers can compare various plans and fees on an informed basis.

Fair Credit Billing (Regulation Z)–This

act affects the manner in which customers are billed on their open-end credit accounts, and how finance charges are calculated, and the way that disputes about

the billing can be resolved.

Consumer Leasing (Regulation M)–This

act extends Truth in ‘Lending to cover

leasing arrangements.

Other amendments to the Consumer Credit

Protection Act:

Equal Credit Opportunity Act–Owing

largely to the activities of consumer

groups, Congress acknowledged credit as

a necessity for the consumer in the Equal

Credit Opportunity Act of 1974 (ECOA).

ECOA prohibits discrimination in credit

transactions on the basis of sex or marital

status and, as later amended, prohibits

discrimination 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, effective in 1971. The purpose of this act
Ch. 7—The Consumer of Financial Services • 183

is to make certain that credit reports on

consumers are fair, current, and accurate.

It gives the consumer certain rights to examine credit information about himself

and to correct any errors that might be

present. In addition, the act imposes

other responsibilities on the credit reporting agencies—i.e., they must make certain

that all users of their information are obtaining reports for legitimate purposes.

● Fair Debt Collection and Practices Act —

This is Title VIII of the Consumer Credit

Protection Act, which became effective in

1978 and limits the amount of communication with a delinquent consumer and

prohibits undue harassment and specious

activities in connection with consumer

debt collection.

Electronic Funds Transfer Act

The Electronic Funds Transfer Act (EFTA)

amended Title IX of the Consumer Credit Protection Act by establishing rights and responsibilities for EFTs. These rights and responsibilities are outlined by Regulation E of the

Federal Reserve.

Technology has changed the way the consumer participates in the payments system

and therefore some of the protections under

previous legislation. EFTA was passed by

Congress in anticipation of some of the impacts of EFT on the consumer. Although the

law provides protection to the consumer, there

are some instruments where the level of protection is unclear. In addition, many consumers perceive technology-based instruments to

be the same as their paper-based counterparts,

not realizing that rights and liabilities may differ, depending on the use of technology.

It is now possible for an individual who

possesses what appears to be a traditional

bank credit card to be protected from misuse

of the card under a variety of legislation, or

not at all, depending on the type of transaction. For example, if a bank issues an individual a debit card that is associated with

an account with a line of credit and is also compatible with an ATM, the individual can perform a number of different types of transactions with the same card. If fraudulent use

is made of the card by accessing the line of

credit, he has recourse under consumer credit

legislation; if the fraud involves EFT, as in the

case of an ATM cash withdrawal or electronic

POS terminals, his liability is limited under

EFTA (although not to the extent as under the

Consumer Credit Protection Act).

If, however, the fraudulent use of the card

directly debits the person’s bank account in

a paper-based transaction, it is not clear

whether the consumer has recourse under current legislation. This is an example where the

same card represents three different instruments, which, in the case of fraud, would require different actions by the consumer. In

recognition of this, the Federal Reserve Board

has proposed to update Regulation E to include certain debit card transactions.

In terms of financial management, many

consumers are likely to be aware of the difference between accessing a line of credit and

directly debiting their bank accounts with the

card, but it is doubtful whether they would recognize a distinction between a debit processed

electronically and one processed in the paper

system. It is also reasonable to assume that

the consumer perceives no difference between

all of the transactions in a regulatory sense.

Regardless of consumer perception, debit card

transactions in the paper-based system currently offer little protection to the consumer.

35 -505 0 - 84 - 13 , QL 3
184 • Effects of Information Technology on Financial Services Systems

Transition From Paper-Based to

Technology-Based Systems

It is conventional to regard households

rather as passive participants in the move

towards EFT, slowing down progress by their

reluctance to accept change. To a great extent

this is a true picture, the proportion of sophisticated households pressing for faster progress being very small, but it is not the whole

story. The very passivity of households means

that changes will be accepted if they provide

the essential requirements of individual persons, and in most industrial countries significant proportions of the population are already

accustomed to handling plastic cards; they are

not likely to worry greatly whether the plastic

card triggers off a paper-based or an electronic

payment, and it is clear that the publicity approach adopted by banks is an important element in acceptance by households. 20

Technology does not in itself meet any consumer needs, and since most consumers are

reluctant to accept new services when the old

still meet their needs, technology does not insure the acceptance of new services by the consumer. However, the use of computers, both

at home and in education, may encourage consumer use of technology-based services by familiarizing the consumer with technology and

by creating a new class of consumer for whom

the technology is a given.

One aspect of financial systems that may

impede the growth of technology-based services is the float. In recent years the float has

become increasingly shorter. Technology-based

payment systems could eventually make the

float nonexistent; all transactions could be

settled immediately. Currently, the consumer

has the advantage of float in the checking system. Use of the paper-based debit card has

managed to undercut the “free ride’ associated with credit cards and may eventually

wipe out all float in the checking system.

‘(’J. R. S. Revell, Banking and Electronic Funds Transfer

(Paris: Organization for Economic Cooperation and Development, 1983), p. 101.

Nearly all technology-based services are still

discretionary -i.e., the consumer can make a

decision whether or not to use them since there

are paper-based alternatives to meet his basic

financial needs. At some point in the future,

however, this may no longer be true.

Security of Consumer Assets in a

Technology-Based System

Since technology-based systems provide

new points of entry into the system, there is

potential for new kinds of fraud. The question

of computer security and crime touches every

aspect of the financial service industry. Discussion here, however, will be limited to those

ways in which the technology is applied to consumer services and to the security issues that

arise directly as a result of those applications.

Recent concern about consumer financial

services has revolved around the relative security of access devices and the need to identify

positively the EFT user. As the systems become more complex and as a greater percentage of the population begins to use home banking and POS systems, problems with the

current means of identification will become

more obvious.

With the ATM, the consumer’s loss is limited by the amount of cash he is allowed to

withdraw from the system. Although his liability is limited under EFTA for unauthorized

transactions, when more sophisticated financial transactions are involved, the consumer’s

financial loss could be greater if not noted and

reported within the period of time required by

law. This could have an impact on the willingness of the consumer to use these systems

and therefore on the rate of acceptance of

them. In that event, the market could force

the providers of services to secure the systems

better.

The current means of identifying an authorized user at an ATM is a personal identifica-
Ch. 7—The Consumer of Financial Services ● 185

— — — .- — —

tion number (PIN). The use of a PIN has a

number of flaws. For example, if the number

is long, it could be easily forgotten; if it is short

or a variation on a number with which the consumer is familiar, such as an address or telephone number, the “code” could easily be broken. With a proliferation of electronic debit

cards, there has been an equal proliferation in

PINs, making them all the more difficult to

remember. Although consolidation of services

in a single card would help alleviate this problem, there is little evidence that this will happen in the near future. PINs are also insecure

in that they do not positively identify the cardholder as an authorized user; they can be

transferred to other individuals. Some consumers will keep the PIN together with the

card, a combination as negotiable as cash.

Technologists are currently working on solutions to the identification problem. Examples

of alternatives to the PIN are “warm-body”

identifiers; included in this classification are

thumbprints, voice prints, and signature dynamics. Thumbprint recognition is less likely

to be acceptable to the public, since it would

require that every individual who uses EFT

has his thumbprint on record. Although there

are certain problems with development, most

industry analysts see signature recognition,

or the more complex technology of signature

dynamics, as the most acceptable alternative

to both the industry and the consumer, since

it is the predominant means of identification

used in financial services today. It will be some

time, however, before the technology will be

applied to financial services.

The use of ATMs presents personal security

problems, beyond those purely associated with

financial security. Individuals using the machines may be particularly vulnerable to robbery. During normal business hours a traditional “brick and mortar” structure provides

the individual security during and after a

transaction. An ATM located away from this

structure could place the user in a vulnerable

position. Even those ATMs located at bank

branches can be insecure when used outside

of banking hours. It is difficult to assess the

seriousness of the problem, because most institutions are unwilling to divulge information

on security for fear of discouraging use of the

systems.

In addition, it would appear that the consumer is more vulnerable in technology-based

systems. For example, in a bank robbery, the

bank absorbs the loss; in the case of electronic

robbery, specific accounts are debited. There

is no electronic “till.” The responsibility shifts

to the consumer to note and report the crime.

Some perceive technology as a solution to

problems that can plague the consumer of financial services. Credit card fraud, which is

frequently cited as a growing problem in the

industry, can be made more difficult by the

use of sophisticated technologies. In many

ways fraud is a provider problem; the consumer is protected under legislation from illicit use

of his credit cards, and if sufficiently informed

he can prevent all but a minimal financial loss

from the fraudulent use of his card. Both

VISA and MasterCard have introduced or are

planning the introduction of cards that are expensive and difficult to counterfeit. It is difficult to say whether these cards will in the long

run reduce fraud, since it will be some time

before the effect of their introduction and use

will be felt; the cost to produce the cards is

much greater. However, if these cards reduce

fraud, for which the consumer implicitly pays,

it may ultimately lower the financial burden

for the consumer.

Privacy

Any discussion of the issue of privacy and

the consumer begins with the difficulty of

defining privacy and therefore what it means

for the consumer to be vulnerable in this area.

In its basic definition, privacy is the freedom

from unauthorized intrusion, the authority in

this case coming from the individual. However, in the course of everyday life the consumer has given up some of these rights, or

has “authorized” certain intrusions into his

life. The distinction between what is explicitly

authorized and what is not is unclear. Privacy

is considered one of the primary concerns of

the individual when choosing financial services.
186 • Effects of Information Technology on Financial Services Systems

Much controversy surrounds the issue of

EFT and privacy; that is, whether the systems

that constitute EFT make the individual more

vulnerable to violations of privacy. In the final

report of the National Commission on Electronic Fund Transfers, privacy was defined as “

. . . the individual’s expectation of control

over what information about himself is communicated to or used by others. ” Further, “the

object of the consumer’s concern regarding

privacy under EFT is the potential use of his

financial transaction information to develop

a personal profile. ” 21This use could be as

seemingly harmless as an individual receiving

product solicitations, based on his income and

profession, from the financial institution where

he does business, to the capability of the system to provide sensitive information about the

individual’s behavior patterns.

As mentioned earlier, cash is a private

method of payment. Checks, although less private, are a paper-based mechanism, and are

perhaps easily tracked on a case-by-case basis.

Although electronic payments secure the consumer from some types of prying, they may

in fact make him more vulnerable on a large

scale. EFT transactions are recorded and

stored automatically and provide the potential for invasion of privacy.

Some studies show that privacy currently

ranks low as a concern for the individual-it

has been dismissed by certain experts as a subject only of academic concern. A 1982 BMA

study shows that users of home computers

strongly disagree with the statement that

computers would violate privacy. Even nonusers did not list privacy as a major concern;

they were either “not sure, ” or were in disagreement. Fewer than 20 percent of total

nonusers agreed with the statement.

Even when the issue is more clearly defined

there is only slightly more resistance to electronic systems because of privacy issues. For

example, in the same BMA survey, 20 percent

of users and 25 percent of nonusers said that

21National Commission on Electronic Fund Transfers, EFT

in the United States: Policy Recommendations and the Public

Interest, Oct. 28, 1977, Washington, D. C., p. 19.

the possibility that someone else would have

access to their account information could create problems in a telephone bill paying system.

This represents a higher percentage of users,

but about the same percentage of nonusers

who agree that privacy was an issue for concern in the use of home computers. The same

is true for data on automatic deposit services.

The lowest response to the question was in

reference to the ATM; there is some evidence

that transactions performed by ATMs are considered more private than transactions using

a human teller. It appears that consumers for

the most part do not perceive privacy as a major issue for concern in their choice of EFT systems; other, more market-oriented questions

seem to determine consumers’ use of these

systems.

The newer technology-based services, in particular home banking, provide new opportunities for invasion of privacy. As yet there are

no uniform privacy standards for information

gathering. The Videotex Industry Association

(VIA), the trade association for the U.S. videotex industry, has recommended voluntary

guidelines for maintaining the privacy of

videotex subscribers. These guidelines suggest

ways in which providers of videotex services

can protect the data that they accumulate and

therefore inspire consumer confidence. Additional recommendations cover collection of

information, government access, security, subscriber access, correction of errors, applications to third parties, future revisions, and

retention of information.22

These guidelines are not binding to the industry, and certain VIA members plan to

adopt their own company privacy code based

on VIA guidelines. Several financial service

institutions, in particular bank card providers,

have corporate guidelines to protect the privacy of their account holders.

Consumer Rights to Financial Services

Technology may increase access to the system for a number of people and expand choice

‘Zzvideotex Industry ASSmiatiOn, “Model Privacy Guidelines

for Videotex Systems, ” June 1983.
Ch. 7— The Consumer of Financial Services ● 187

. — —

for still others; however, because of price there

may be a tendency in technological systems

for certain groups to be either excluded or perhaps more heavily taxed than others. For example, although bank cards will be a primary

vehicle for introducing some of the new systems to the consumer, there are many consumers who are ineligible to use them. As a result,

nonusers may in effect be blocked from certain types of financial services.

Technology makes it possible to serve lower

balance consumers through ATMs, and therefore lowers the cost of servicing these accounts. Certain needs of these consumers may

not be met by the technology; however, more

personalized services may be unavailable to

them. This tendency plus fee-for-service pricing may transfer the costs to the consumer in

a way that is inequitable. Even if the cost of

home information services technology drops

and communications costs rise, certain lower

middle-income segments of the population

may still be barred from participating in the

system. That segment of the population that

cannot maintain a minimum balance in a traditional account may be served by other nonregulated institutions (e.g., retailers, and perhaps

local grocery or liquor stores) or they may be

forced from the system completely. This

brings into question the safety and soundness

of these nonbank depositories and whether

they should be regulated.

The trend of a universal electronic payments

system may put pressure on the financial service system to accept people who otherwise

would not have accounts at financial service

institutions. It may necessitate Federal guarantees to banks that service low-income or lowbalance consumers. This is particularly important when one considers the policy of the U.S.

Treasury to encourage direct deposit, and the

possible requirement that some consumers

must participate in the system via government transfer payments processed electronically.

In the 1970’s in the ECOA, Congress recognized that in order to be a productive member of American society, the consumer must

have fair access to credit. Although consumer

use of technology-based systems is still minimal, there is some evidence that access to technological systems or the financial system in

general will eventually be a necessity. In the

future, Congress may have to consider to what

extent this access may also be a right.
Chapter 8

Findings
—.

Contents

Page

Conclusion 1: Applications of Technology and the Changed Nature of

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

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

Conclusion 3: Interaction Between Technology and the Legal

Regulatory Structure Governing Banking . . . . . . . . . . . . . . . . . . . . . . . . . 198

Conclusion 4: Financial Options for the Consumer. . . . . . . . . . . . . . . . . . . . 201

The Equity of Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203

Marketing to the Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203

Changes in Pricing Structure. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204

The Implications of Technology-Based Products. . . . . . . . . . . . . . . . . . . . 205

Conclusion 5: Security and Integrity of the Financial Service System . . . 205

Theft of Funds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205

System Integrity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207

Specific Consumer concerns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208

Conclusion 6: Integration of Capital Markets . . . . . . . . . . . . . . . . . . . . . . . . 210

The Effect of a National Capital Market on Financial Services . . . . . . . 211

Future Impacts of Technology on Capital Markets . . . . . . . . . . . . . . . . . 212

Conclusion 7: Entrants Into the Financial Service Industry. . . . . . . . . . . . 213

The Role of Information Technology in Competitiveness . . . . . . . . . . . . . 213

Availability of Services to Small Financial Service Providers . . . . . . . . . 214

Entrance beholders of Communication and Distribution Systems . . . . 214

The Effect of New Entrants on Services Provided . . . . . . . . . . . . . . . . . . 214

The Effect of Telecommunication Regulations on Financial Services . . . 215

Antitrust Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215

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

Findings

The financial service industry is experiencing a period of tremendous change. Economic

factors, specifically those that drove interest

rates to record levels during the last decade,

have caused the users of financial services to

seek new services. In turn, innovative providers of services have responded to consumers’

new financial needs and sophistication.

At the same time, a number of technologies

that have been just over the horizon for some

time have begun to mature. For example, computers, still in infancy during the 1950’s, are

now used to deliver services directly to the

consumer without human intervention, and

the tendency to use systems based on information and telecommunication technologies

for delivering financial services is increasing.

The general public’s level of familiarity with

computers has increased, providing a fertile

climate wherein significant numbers of users

now accept the new services. Falling prices for

electronic equipment and the increasing pervasiveness of such equipment throughout the

economy have further reinforced this trend.

In many cases, the basic services offered by

the financial service industry are not changing in any fundamental way. A deposit taken

through an automated teller machine (ATM)

is not substantively different from one taken

by a human teller. However, the availability

of technologies that can quickly process and

move vast amounts of data has made it possible for financial service providers to offer

products beyond those that would have been

possible otherwise. For example, the money

market mutual fund could have been offered

a century ago if there had been some means

of processing the transactions necessary to

make such a fund work economically.

Further, there is a definite trend in the economy away from the older “smoke-stack” industries to the production of information and

the development of those technologies that

make possible and facilitate this transition. A

considerable number of entrepreneurs see potentially profitable opportunities for providing information services directly to consumers,

but, in general, they have yet to find the

package of services that will be successful in

the marketplace. Virtually all agree, however,

that financial services will be an important element of that package. Thus, the forces that

are changing the basic character of the American economy are directly affecting the structure and character of the financial service industry.

The foregoing changes have affected the relationships between and among the various

participants in the marketplace. Some perceive

themselves to be relatively better off, while

others feel they have been put at a disadvantage. Some argue in favor of policies that direct the evolution of the industry along predetermined paths, while others, somewhat

fearful of foreclosing opportunities from which

there could be widespread benefit in the future,

argue that policy should remain neutral in order to permit the market to work its will in

shaping the industry.

The present rate of change is a transitory

phenomenon, and the structure and character

of the financial service industry will stabilize

during the coming decade. However, unless

some explicit action is taken to preserve the

present structure of the financial service industry, it will look much different at the turn

of the century than it does now. And yet, there

is no assurance that policy parameters can be

adjusted with a high degree of confidence to

bring about a specific, desired industry structure. Available and emerging technologies

have created many opportunities for innovative people to engineer their way around regulatory barriers to achieve their goals and objectives.

191
192 ● Effects of /formation Technology on Financial Services Systems

In light of the accelerating rate of change try. However, a number of conclusions that

in the financial service industry and in the bound the range of possibilities have been

economy in general, it is not reasonable to developed, and these are presented in this

make any firm predictions about the structure chapter.

and character of the financial service indusConclusion 1: Applications of Technology and the

Changed Nature of Financial Services

The applications of advanced information and

telecommunication technologies in systems for

delivering financial services change the way

those services are created, delivered, priced, received, accepted, and used.

Years ago, depository institutions credited

interest to savings accounts only quarterly,

or even less frequently. Today, most pay interest from the date of deposit to the date of

withdrawal and compound interest at intervals so short that they are nearly continuous.

This change was encouraged by deposit-rate

ceilings and made possible because the institutions installed computers that enabled them

to handle the computational workload required to provide the enhanced service.

Rapid advances in telecommunication and

information processing technologies have been

followed by applications to the delivery of financial services. In some cases, the changes

accompanying the introduction of technology

have been imperceptible to customers. For example, one month a statement may be prepared on an accounting machine and the next,

on a computer. In others, the changes have required users to change the way they use financial services and the way they interact with

service providers and systems for delivering

services (e.g., ATMs rather than human tellers). In addition, as users became more competent with the technology, they forced providers of financial services to change the way

in which they interacted with their customers.

J. C. Penney, for example, agreed to accept the

VISA credit card only after VISA agreed to

permit a direct connection to the network by

the retailer.

In some ways, the rate of change in the

financial service industry is accelerating in response to the assimilation of rapidly advancing technologies. On the other hand, the reluctance of a significant number of users to adapt

to the changes is limiting the rate of change

in the industry. Only a little over 30 percent

of the recipients of Social Security payments

have agreed to accept payment by direct deposit, thus limiting the ability of the Department

of the Treasury to realize the full benefits of

applying the available technologies. Public reaction to a requirement by one bank that only

customers who held deposit balances of $5,000

or more could receive service by a human teller

caused cancellation of the program.

Sometimes technology can indirectly affect

the availability of financial services. Technology that facilitated the development of the

bank credit card is particularly important in

the programs of card issuers to limit fraud and

losses to bad debt. One of the key features of

the cards is that the merchant accepting them

is guaranteed the funds as long as the rules

for acceptance set down by the card issuer are

followed. As a result, many merchants are reluctant to accept a paper check at the point

of sale, preferring instead to avoid the risk of

loss the check entails. Thus, indirectly, applications of technology have reduced the ability

of consumers to pay for purchases by check.

(Ironically, the same technologies that have

made the credit card attractive to the merchant are being applied to rejuvenate the

check. Although they have not fulfilled the expectations of a few years ago, check guarantee and authorization services provide the
—

Ch. 8—Findings . 193

. — —

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

Technologies have also lessened the significance of distance and time of day as factors

in the delivery of financial services. Telecommunication makes immediate interaction between service providers and their customers

possible, regardless of the location of either.

The terminal device used by either can be one

that can be programed to operate unattended,

at hours that are suitable to the schedules of

both users and providers and in ways that

make minimization of communication costs

possible. International networks of ATMs now

being established will allow the consumer to

access depository accounts in other countries

and will negate existing restrictions on the

taking of deposits across State lines. Wire

transfers, for example, can be used to deposit

funds to an account without regard to the

bank’s location.

Furthermore, technologies have also changed

the nature of the depository account. While

only chartered depository institutions can take

deposits, others have been able to take advantage of the ability of the technologies to process and transfer large amounts of information

quickly to offer various investment products

that have liquidity approaching that of a deposit. In addition, the importance of banks and

other institutions as depositories for funds is

diminishing. The application of technology has

made it possible for customers to use depository accounts only to collect funds for a short

period, disburse them rapidly as needed, and

place any remaining funds in short-term investments. In this situation, the depository institution must receive the bulk of its income

from fees charged for service because the availability of funds on deposit that can be invested

for its own account is limited. Also, a number

of factors have reduced the spread between the

fees paid for deposits and those earned when

the funds are lent out. One way of replacing

this income, selling services for fee, is the

course that financial institutions are following.

Major capital investments are necessary to

implement new systems for delivering financial services. However, once the systems have

become operational, the institutions that developed them can market them to other financial service providers. Purchasers of the packages are then able to offer significantly

enhanced services without expending large

amounts of capital.

Historically, only depository institutions

have processed payments transactions and

have had exclusive access to the payments

systems. Now, the development of information

technology has created the opportunity for

others to enter this market. A substantial industry of wholesale service providers not usually seen as financial service providers now

supports retail financial institutions. In fact,

the existence of this industry has made it possible for many smaller retailers to exist. Yet

many wholesale nonbank processors are denied

direct access to the payments mechanism,

which, some of them argue, puts them at a

competitive disadvantage as providers of

wholesale services and limits their ability to

serve the needs of clients who are not part of

the financial service industry. These wholesalers see financial institutions competing

with them as providers of information processing services while retaining the advantages

that come with exclusive access to the payments mechanism.

On the other hand, financial institutions attempt to provide the full package of information processing services needed to support all

of the activities of their clients that are related

to financial operations and payments. As the

dependence on technology for providing financial services continues to increase in the

future, this conflict between competing classes

of institutions will become more intense. Depository institutions, pressured by decreasing

earnings from deposits, will seek to expand

their base of customers that pays fees for services at the same time that their competitors

seek to provide alternative sources of financial services to those same markets.

The financial service industry is dependent

on reliable and effective telecommunication facilities for its existence. If financial data, both

payments and collateral information, cannot

be moved rapidly and reliably worldwide, the
194 • Effects of Information Technology on Financial Services Systems

financial service industry could not function

as it presently does. Further, systems for delivering financial services have been designed

to take into account the present configuration

and cost structure of available telecommunication facilities. Any significant departure from

historical patterns could have a direct and major impact on the costs of delivering financial

services, the structure of the industry, and the

distribution of costs among the various participants.

For example, home banking systems have

generally been designed so that the user need

make only a minimal investment in terminal

equipment and can rely on the computer operated by the service provider for the processing required. Implicitly, this type of design

assumes that low-cost telecommunication facilities are available and that the cost to the

user of a lengthy, interactive session with a

host computer will be minimal. On the other

hand, if local telecommunication costs rise significantly, such systems may have to be redesigned to minimize the connection time between the user and the provider’s computer;

this could result in excessive cost to the user

of a terminal. Similarly, the large amounts of

capital used to establish telecommunication

networks operated by providers of financial

services under present pricing structures could

effectively be lost if changes in telecommunication result in prohibitive costs of operation.

Float, its cost, and who benefits from it have

long been at issue. The various financial service participants have developed strategies to

take advantage of float that range from consumers issuing checks 2 or 3 days before they

deposit funds to corporate treasurers disbursing funds from remote locations. The technologies, on the one hand, provide the opportunity essentially to eliminate collection float

from the system while, on the other hand,

offering the payer the opportunity to control

with absolute certainty the time at which a

disbursing account is debited. Businesses,

then, could revise trade discounts to reflect the

new realities by allowing, for example, discount if good funds were available after 12 or

13 days instead of allowing it if the check is

postmarked on or before the 10th day. Similarly, consumers who know that funds will be

available on a specific day could schedule their

payments accordingly, rather than playing

games with the system, as they do now.

Finally, technologies make it possible for individuals, businesses, and government to keep

minimal idle balances. Because all parties can

know exactly when good funds are available

and when disbursements must be made, they

can move all funds not needed for day-to-day

transactions into investment accounts that

pay market rates of interest. Then, funds can

be moved to transaction accounts that either

pay no interest or pay below-market interest

rates for minimal periods to meet requirements for disbursements and/or to receive

funds from others. The net effect of this

tendency will be a constantly increasing downward pressure on the balances of transaction

accounts held by depository institutions and

others.

Conclusion 2: Restructuring the

Financial Service Industry

Some patterns in the ongoing restructuring The structure of the financial service indusof 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 fitinue for some time, but many uncertainties can- nancial affairs primarily with depository innot now be resolved and many alternative pos- stitutions such as banks, savings and loan

sibilities exist. associations, and credit unions. The financial
Ch. 8—Findings • 195

service industry is now changing: new products are being developed and offered and the

roles of traditional institutions are shifting.

The simplicity of the industry has all but

disappeared.

Today the financial service industry consists

of a variety of organizations, ranging from traditional depository institutions and related

financial organizations that have expanded

services, such as securities firms, to such

nontraditional financial service providers as

supermarkets and retail department stores. A

variety of organizations offer investment opportunities in an increasingly competitive market. Promotion of products and target marketing has become increasingly important for

financial service providers who are looking for

new ways to reach users and retain and gain

market share; e.g., television and direct mail

advertising has become common.

Depository institutions have begun offering

brokerage services (INVEST) and insurance

(mutual savings bank life insurance in Massachusetts and New York). To compete with

other financial service providers they place

greater emphasis on serving the customer on

a 24-hour basis as well as on making convenience a priority (ATM deployment and home

banking).

Depository institutions are governed by

strong regulations, many of which were written at a time when the competitive character

of the financial service industry was very different from what it is today. For example, regulations which set ceilings on deposit interest

rates at federally insured commercial banks,

savings and loan associations, and mutual savings banks restricted the ability of depository

institutions to compete with money market

funds, a product development that was not anticipated at the time the regulations were

framed. Some regulations, meant to be protective, must be adapted to the changes the industry faces. Some new regulations have been

necessary. For example, the Garn-St Germain

Depository Institutions Act of 1982 amended

numerous Federal banking laws and created

five new ones, allowing depository institutions

to offer the money market demand account

and the Super NOW account.

Major influences for the recent changes in

the industry have been high interest and inflation rates and, therefore, the high opportunity cost of standard consumer savings instruments, resulting in a phenomenon known

as “disintermediation.” Funds flowed out of

the depository institutions into nontraditional

instruments and institutions as many individuals shifted their assets in order to obtain the

high interest rates. Many of these new instruments were created by organizations outside

of the regulated environment of depository institutions. One example is the money market

mutual fund created by the securities industry, which works like a combination savings

and checking account. Funds invested in

money market mutual funds earn a market

rate of return, and the funds are as liquid, for

all practical purposes, as a checking account.

The customer accesses the account with a

share draft, which works in much the same

way as a check and is considered to be equivalent by most users. The only practical difference is that, in many cases, there is a minimum amount for which the draft must be

written, usually $500.

In the new competitive climate, nontraditional financial service institutions quickly

realized the tremendous potential in providing financial services. They also realized the

ease with which they could enter this industry. For example, J. C. Penney, a major national retailer, operates a highly sophisticated

online communications system that supports

over 35,000 online terminals. J. C. Penney expanded the usage of its communication system and began processing credit card transactions for oil companies. Outside of its role

in financial services as an extender of credit

to retail customers, J. C. Penney has become

a financial service provider of a different sort

by performing functions normally associated

with a bank.

Supermarkets have become focal points for

ATM deployment and point-of-sale programs.

Safeway, an Oakland, Calif., supermarket
196 ● Effects of Information Technology on Financial Services Systems

chain, has announced plans to develop and

market a national ATM network. Some supermarkets intend to replace banks and others as

operators of switches for financial transaction

networks and are highly competitive in this

area. They are also taking a major role in the

decisionmaking surrounding these activities.

Petroleum companies, with their vast chains

of retail gas stations, are following the lead

of the dry goods and grocery chains.

Unlike most depository institutions, many

securities firms have a national presence. They

can conduct business nationally with few restrictions. In addition to brokerage and investment banking services, many such firms now

offer a wide variety of consumer financial

products, such as money market funds, with

debit card and ATM access, as well as asset

management accounts (a combination of a depository account and a margin account). These

new product offerings have gained a significant market. For example, the Merrill Lynch

Cash Management Account, which works as

both a savings and an investment instrument,

serves over 1 million people. Customers can

access their accounts via telecommunication

networks operated by the securities firm from

any office, regardless of location.

Although insurance companies are licensed

separately by each State, many serve a national market through networks of companyoperated offices and independent agents.

Many insurance companies are augmenting

traditional product lines with new offerings

that directly compete with those offered by

other providers of investment services.

The concept of the “boutique” bank, which

serves a highly specialized market, is becoming more widely accepted as the industry reorganizes. National Enterprise Bank, which

opened in Washington, D. C., in August of

1983, is one such bank. Enterprise is aimed

at professionals—doctors, lawyers, dentists,

accountants, and consultants. Its intent is to

serve the affluent professional in a specialized

fashion far different from that of a commercial bank. Palmer National Bank, in Washington, D. C., is another newly opened boutique

bank. It specializes in financing for small,

high-technology firms. Many of Palmer National Bank’s clients have financial service requirements that are often too small to be of

interest to big banks with international experience.

By joining a local, regional, or national network, these small institutions can immediately

deliver services to a large number of locations

in direct competition with major institutions.

Despite speculation, there is little doubt that

these organizations will survive. Unlike the regional giants, specialty companies and smallniche companies that cater to a narrow population segment have positioned themselves to

do one thing superbly. It is possible that the

industry may begin to be shaped like a dumbbell, with a large number of small banks serving local needs at one end, a relatively small

number of large banks providing service nationwide at the other and, in the middle,

virtually no midsize banks serving regional

markets.

In sharp contrast to the specialty provider

is the financial supermarket. Offered as a onestop financial center offering banking, insurance, brokerage, and investment opportunities, the financial supermarket has been a successful concept for both Sears Financial

Network and Merrill Lynch, among others.

Both of these organizations offer brokerage

services in stocks, bonds, options and futures

contracts, insurance, savings instruments,

mortgages, consumer loans, retirement savings plans, and even credit cards to their customers. However, the degree to which the

service packages of each firm are truly integrated varies significantly. Financial supermarkets seem to have found a niche in the

ever-growing consumer financial service market. This concept is attractive because of the

low cost of entering the business as well as

high potential profits. The financial supermarket has not yet matured, nor has its longterm viability been demonstrated.

Legal barriers still hinder the entry of some

businesses into the financial service market

and the cross-entry of some providers into
other areas of financial services. In most

States, and at the Federal level, banks are

barred from insurance (except for credit policies), from investment banking, and, to a decreasing degree, from interstate branching.

Present regulatory barriers prevent brokerage

houses from operating as a financial supermarket in the true sense of the word. While brokerage houses perhaps come closest to achieving true integration, they cannot accept

deposits or have direct access to the payment

mechanism, and therefore cannot truly offer

banking services. Although no one is sure

what combinations of businesses will prove to

be the winning ones, to the extent that an organization can achieve a greater national

recognition in the market, it will enjoy an

advantage over its competitors.

For many types of organizations to build a

financial supermarket, a number of mergers

and acquisitions may be necessary. Several

nonbank providers have acquired banks to

have access to the payments mechanism and

Federal deposit insurance. These financial conglomerates have come along much faster than

expected because of the profound changes in

insurance, banking, and securities brought

about by the interplay of high interest rates,

technology, and regulation.

Aside from economic conditions, which

many claim are a driving factor behind the

changing structure of the financial service

industry, is the major role technology has

played. As financial service companies continue to rely heavily on new technologies and

automated processes to provide services, new

services that could not be offered without the

support of such technologies emerge. Some

new technologies allow a firm to produce two

different types of financial services together

less expensively than for two individual firms

to produce them separately. Online communication systems enable instantaneous debit/

credit of financial accounts, and immediate

execution of orders to buy and sell securities.

Brokerage sales across the country are facilitated by immediate real-time access to financial information.

Ch. 8—Findings ● 197

The significant changes in the structure of

the financial industry bring to light several important points. Technology has been one key

factor enabling nontraditional financial service providers to enter the market. The technologies necessary to drive the systems that

support financial services are already in the

hands of new entrants because such technologies can also be applied to support many different industries. As a result, many potential

entrants are able to offer financial services

using established computer and communication systems. Some firms have entered the

market for retail financial services, some have

become wholesale providers, and others have

entered both markets.

Industry restructuring has brought about

significant potential for industry consolidation

as the functions that support the industry

begin to overlap. While depository institutions

are technically the only organizations allowed

to accept deposits, nondepository organizations have developed products that are neardeposits and thus compete with products of

depository institutions. Money market mutual

funds, in essence, accept deposits and are

viewed by those who own them as savings instruments. Insurance contracts, particularly

those that allow the owner to control the

allocation of funds among alternative investment opportunities and that accumulate cash

value, can also be viewed as close substitutes

for deposit instruments.

The traditional categories of depository and

nondepository institutions are no longer clearly

delineated or functionally separate. These

changes create more product choice for the

consumer, but also increase the amount of

consumer confusion in choosing and using

services. Since so many of the products and

services from the various financial service

organizations are similar, many consumers are

unaware of the significant differences.

Regulation, once a guiding force with respect to how the industry operated, no longer

has 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 provide

for reciprocal interstate branching and may result in the emergence of major regional banks

that maintain offices in several States. Massachusetts, for example, passed an act, entitled

“An Act Relative to Branch Offices and Acquisitions of Financial Institutions, ” that

establishes new authority for mergers, branching, electronic branching, and mortgage lending by Massachusetts financial institutions.

The act is limited in its operation to activities

involving five New England States (Connecticut, Rhode Island, Maine, New Hampshire,

and Massachusetts).

The changes in the structure of the financial service industry now occur at such a rapid

*several states have reciprocity agreements for interstate

deposit-taking by ATM–e.g., Washington, D. C., and Maryland.

pace that it is no longer a question of when

certain changes will occur, but of how to implement the changes and how they will be accepted. It is difficult to predict the ultimate

consequences of the restructuring; however,

there are indications that the financial service industry is changing from a traditional to

a self-service industry. The overwhelming use

of ATMs and the promise of emerging remote

banking/remote information systems provide

evidence for this claim. Many of the consumeroriented systems that deliver services to the

home are being developed by a variety of joint

ventures that offer a myriad of services, not

only in banking but also in entertainment, education, and other financially related services.

Although the traditional depository institution will remain, its role may well change.

There will continue to be new innovations and

players in the industry, and a market willing

to test them.

Conclusion 3: Interaction Between Technology and

the Legal Regulatory Structure Governing Banking

Some of the existing laws and regulations pertaining to the financial service industry are ineffective or inapplicable to current and potential

changes in financial service institutions and

products. Both Federal and State legislative

bodies have reacted to changes in the market

and have either ratified events that have taken

place or taken advantage of and encouraged perceived trends.

A significant portion of the regulatory

framework governing the financial service industry, written in the 1930’s (Banking Acts

of 1933-35), 1940’s, and 1950’s (McFadden/

Douglas, Glass/Steagall) is still in force today.

A large number of the restrictions imposed on

the banking system were a result of the Great

Depression of the early 1930’s. The restrictions were an attempt to meet the demands

for financial services provided by firms that

were both sound and secure and in an environment 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 the

needs of both consumers and businesses have

changed.

The Banking Acts of 1933 and 1935 were designed to promote safety and soundness in

banking. While safety and soundness are still

the main concern, the environment and the

consumer/business needs have changed significantly. Today, only a few of those regulations

adequately meet the needs for which they were

designed, and some may actually be detrimental to the industry they regulate.

When the financial service industry first became regulated, the regulations were written

according to functions performed by the specific institutions, and the legislation became

tied to the institution it regulated instead of
—

Ch. 8—Findings ● 199

the function. The institutional lines are now

fuzzy.

Existing Federal laws and regulations have

made it increasingly difficult for banks to compete against new entrants into the markets

where they have traditionally had an almost

exclusive franchise. Several points must be

considered, however. Banking is looked upon

as a special business that is key to the economy. Consistent with this view, particular

steps were taken to insulate it from other lines

of commerce and to limit the risks that banks

were permitted to take. The introduction of deposit insurance helped limit the exposure of

depositories to risk. On the other hand, existing regulations are designed to prevent

banks from exerting undue influence over

other lines of commerce.

Presently, the roles of the various Federal

agencies with respect to regulating depository

institutions are complex. National banks are

chartered by the Comptroller of the Currency.

Federal savings and loan associations and

Federal savings banks are chartered and regulated by the Federal Home Loan Bank Board.

Federal credit unions are regulated and insured by the National Credit Union Administration. Bank holding companies are regulated

by the Federal Reserve Board.

The United States has maintained a dual

system (Federal/State) for the regulation and

supervision of banking. This dual banking system has played a useful and constructive role

in encouraging innovation in the financial regulatory environment and in helping accommodate local differences in the needs of banking

organizations and their customers. The system worked well because, for the most part,

the goals of regulation were commonly shared.

However, this appears to be breaking down.

States are beginning to allow incredible expansion of power for banks and thrift institutions

that go far beyond standards allowed by Federal law and yet still benefit from Federal protection. Banks have demonstrated that they

will establish offices in States that offer a particularly favorable regulatory climate.

One of the concerns depository institutions

face is that a growing number of differently

regulated financial service organizations are

able to offer a broader range of financial services than the depository itself can offer. For

example, Merrill Lynch can offer securities

services, real estate services, and a package

of additional financial instruments, such as

the money market fund (cash management accounts which serve as high interest-earning

savings instruments), and, to a limited extent,

transaction accounts. While it is possible for

nontraditional providers to compete head-tohead with banks by offering new substitutes

for banking products, depository institutions

do not have the same leverage.

Many of the nontraditional financial service providers are improving their positions visa-vis banks by establishing or acquiring commercial banks or thrift organizations (e.g.,

Dreyfus Corp./Lincoln State Bank of East

Orange, N.J.). Travelers Insurance Co. has requested regulatory approval to offer FDICinsured* instruments to its customers through

a trust subsidiary. Depository institutions, except in some States and for some grandfathered institutions, are not allowed to own

insurance companies nor are they under any

circumstances allowed to provide a full range

of investment services, although holding company affiliates may engage in discount brokerage.

Organizations, however, have found ways to

circumvent the existing financial service regulatory structure. Technology has certainly

been one of the driving factors. The ATM, for

example, enables interstate access to individual bank accounts, and in some instances local

regulatory authorities and legislation have

permitted interstate deposit-taking, as well.

(Douglas and McFadden Acts, prohibiting interstate banking and deposit-taking, respectively, are ineffective.) This same technology

is being applied by nondepository institutions,

such as supermarkets and other retailers (e.g.,

* Federal Deposit Insurance Corporation.

35-505 0 - 84 - 14 : QL 3
200 ● Effects of Information Technology on Financial Services Systems

—.— .

Publix supermarket, Safeway, Sears) to provide services in direct competition with banks

and/or their subsidiaries and service corporations. These organizations are not taking deposits and are not under the same banking regulatory scrutiny as depository institutions,

even though the systems being deployed must

meet all regulatory requirements with respect

to Regulation E and other consumer protection.

Notwithstanding Federal and State laws

and regulations, wholesale banking has been

done on a national basis for quite a while.

Banks are able to solicit business and establish corporate offices on an interstate basis.

Advanced communication systems enable realtime access to financial information so that institutions are able to conduct business, including movements of funds, regardless of the locations of their customers.

The “nonbank” bank developed as a result

of a loophole to the Bank Holding Company

Act. Nonbank banks are commercial banks

with either National or State charters that

elect to abstain either from accepting demand

deposits or from making commercial loans–

two activities necessary to fall within the definition of a bank for Bank Holding Company

Act purposes. Both the Federal Reserve and

the Comptroller of the Currency have taken

actions to slow, if not halt, increases in the

numbers of nonbank banks and branches.

Congressional actions, responding to market forces and events, have further weakened

the provisions of existing legislation. The

Garn-St Germain Depository Institutions Act

of 1982, for example, permits interstate acquisitions of failing depository institutions if they

meet certain criteria. Several savings banks

have acquired savings and loan associations

in other States. A major money center commercial bank has been permitted to acquire

two sizable out-of-State savings and loan associations.

Many new regulations, primarily those affecting electronic funds transfers (EFTs) and

written with the expectation that the delivery

systems would be fully electronic, do not apply

to the present environment. Debit cards at

point of sale, for example, are still heavily

paper-based and therefore do not fall under the

auspices of Regulation E* (protecting consumers using EFT and governing the use of EFT).

Actually, the debit card, which in most circumstances is not processed electronically, falls between the “regulatory cracks” and is not

under any regulatory authority when used to

create a paper document at the point of sale.

Many new payments services and depositlike instruments have sprung up outside the

framework of governmentally protected and

supervised depository institutions.

The administration has reacted to events in

the market that have put banks at a comparative disadvantage by suggesting legislation

which it entitled, “The Bank Holding Company Deregulation Act. ” This act would enable banks to offer new products and services

and would address the following four areas:

1) the mix of products and services that would

be offered by the commercial banks, 2) the

process for gaining regulatory approval for

banks entering many of the permitted service areas, 3) the reduction of competitive

advantage enjoyed by some (because of disparities in the regulatory structure) by moving to functional as opposed to institutional

regulation, and 4) the limitation on cross-subsidization by requiring banks to establish segregated subsidiaries for offering new products.

Banks below a certain threshold in size would

be treated differently from larger banks in

some respects.

Significant changes have occurred to update

some of the outdated banking legislation and

incorporate new measures for the banking industry. One example is the Garn-St Germain

Act. This comprehensive statute contains

eight titles that amended numerous Federal

banking laws and created five new ones.

Another is the Depository Institutions Deregulation and Monetary Control Act of 1980,

which, in addition to approving a money mar-

*The Federal Reserve Board has put out for comment a proposal to cover paper-based transactions under Regulation E.

It has also issued a proposed rule to bring paper-based debit

cards under Regulation E [Reg. E; Docket No. R-0502].
Ch. 8—Findings ● 201

ket deposit account for banks, provides for the

phase-out and ultimate elimination of all Federal limitations on maximum interest rates

paid on deposits in financial institutions. Both

were passed in response to compelling changes

in the marketplace and are designed to correct

a lack of competitive parity among competing

providers of financial services.

In some cases, developments in the provision of diversified financial services have been

spurred by State laws. The most recent example of this is South Dakota’s allowing State

banks to own full-line insurance companies.

Out-of-State bank holding companies, recognizing market trends and pressures, have

shown interest in acquiring or forming South

Dakota banks. Currently, many State legislatures have shown interest in liberalizing bank

regulations in order to allow forms of interstate banking.

Functional regulation is being considered as

an alternative to the present regulatory structure. Such regulation would subject all firms

performing the same function to the same regulations imposed by the same regulatory agency. Those who support such a change in regulation feel it will provide a level playing field

for all institutions providing the same types

of financial services. Additionally, its proponents believe it would provide competitive

equity among the depository institutions and

nonbank institutions.

Technology development, economic conditions, and other market forces have changed

the structure of the industry to such a degree

that the boundaries in the existing legal regulatory framework have less and less of an impact. ATM systems permit access to accounts

on a national basis; they even permit access

to money fund accounts held outside of depository institutions (First Boston/Fidelity). Only

the limitations on interstate deposit-taking by

banks seem to be holding up, and these are

weakening, as evidenced by interstate ATM

access reciprocity agreements between States

(D. C./Maryland).

A major goal of financial service regulation

is to assure the safety and soundness of the

financial system. Technology and market

forces have introduced significant changes in

the industry. Based on available evidence,

technology has brought about no apparent reduction in the safety and soundness of the industry. The changes have encouraged Congress to begin reexamining existing legislation,

but for the most part Congress has directed

its most recent efforts toward catching up

with the events that have been occurring in

spite of the legal regulatory barriers. In light

of the realities of the technology, regulatory

consideration and emphasis may be better

placed on the impacts of new services on providers and users rather than on the technological developments that ultimately drive them.

Conclusion 4: Financial Options for the Consumer

A primary consequence of the changes in financial services has been the proliferation of

options available to users. While many share

common characteristics, there are technical differences between them that could catch the user

who is unaware of their true implications.

Today, there are more payments and investment options and a greater variety of institutions providing financial services to the

consumer than ever before. Choices have expanded in all areas of financial decisionmaking.

Since the introduction of the bank credit

card in the late 1960’s, the consumer has benefited from the convenience of a readily acceptable payment mechanism, which provides a

means of payment much more negotiable than

a check but safer than cash. In the mid-1970’s

money market mutual funds were introduced,

allowing the consumer to invest relatively
202 Ž Effects of Information Technology on Financial Services Systems

small amounts of money at substantially higher interest rates than with bank savings and

time deposits—without sacrificing liquidity

and at apparently minimal risk. By the 1970’s,

deregulation legislation recognized both the

inability of banks to compete explicitly for

small-denomination consumer funds under the

current interest rate restrictions, as well as the

importance to some consumers of insured alternatives to money market mutual funds.

Also inherent in the legislation was the

recognition of the importance of consumer savings to the health of the economy.

Banks can now offer federally insured

money market accounts and interest-bearing

accounts that are the functional equivalent of

checking accounts (NOW and Super NOW accounts). In addition, penalties for early withdrawal of funds from certificates of deposit

have been lessened. Through changes in the

regulations affecting Individual Retirement

Accounts (IRAs), all consumers can enjoy

some tax-postponed income. The systematic

dismantling of Regulation Q will eventually

completely deregulate interest rates on time

and savings deposits.

The individual also has a greater number of

options with respect to the financial institutions with which he can do business. The lifting of regulatory restrictions and the development of innovative products inside and

outside the banking industry have allowed financial institutions to become full-service providers, differentiating their products and approaching different market segments. Savings

associations are allowed to extend consumer

credit, which puts them in direct competition

with commercial banks and consumer finance

corporations and, to a lesser extent, retail

organizations. They are also able to offer NOW

and Super NOW accounts. Asset management

accounts available through securities brokers

are accessible through debit and credit cards,

which have the same characteristics as the

plastic counterparts issued by the banks.

Owing to the broad acceptability of the credit

cards issued by some companies, primarily

VISA and MasterCard, the debit card has

become a “paperless check” that is more

readily accepted than the traditional paper

instrument.

Another option for the consumer of financial services is “one-stop shopping” through

the financial supermarket, where all banking,*

investment, insurance, and real estate needs

can be served in one place. The most visible

examples are the Sears Financial Centers,

which are under the umbrella of a retailing

organization rather than a traditional financial institution. Other national and regional

retailers as well as bankers and brokers are

considering the same concept. Also, niche marketing–the offering of services tailored to the

specific needs of small groups-is available

through financial service boutiques. The upscale consumer and specific occupational groups

(e.g., farmers) benefit.

Technology provides the competitive edge,

making a particular product possible or allowing an institution to take advantage of economic conditions. The most widely available

technology-based services are the ATM and

automated deposit services (ADS). At-home

banking, which began with simple telephone

billpayer services, is now being introduced

through videotex services and the computer.

Point-of-sale (POS) electronic payments systems, which were attempted in the 1970’s, are

being attempted again in specific trials.

The distinction between those options available to the consumer through technological

means and those which seem to be the result

of the condition of the economy, product innovation, and legislative changes is not as

clear. Many of the options which seem to be

the result of economic conditions such as interest rates—e.g., the money market fund–

are facilitated to a great extent by the technology. These funds have been automated

since their introduction and, considering the

size and number of participants in the individual funds, might not have been possible

with manual systems.

*Physical deposit-taking services cannot be offered at all

locations.
—

Ch. 8—Findings ● 203 — — . — .- ——

The Equity of Choice

Choice, in an economic sense, is good, and

as such, the assumption underlying the increase in financial management options is that

it must benefit the consumer. However, two

basic issues must be examined in this context:

1. Do all consumers actually benefit from the

current expansion of choice in instruments

and institutions?

2. Are there countervailing trends in the financial service industry that may eventually limit options for the consumer or for

particular groups of consumers?

There is some evidence that certain classes

of consumers are becoming more sophisticated

and are demanding new financial services.

These consumers are becoming asset managers. However, although most consumers are

aware of the choices available to them, many

are still confused by the options. Certain

segments of society will prosper under a system of greater choice: they will have the necessary information and know-how to make use

of the information to their financial advantage.

However, other segments may be less fortunate. According to the available trade press,

it appears that most financial institutions wish

to attract the upscale market, not the lower

income and lower balance consumers.

Only a small number of consumers fall within the definition of upscale, yet nearly all consumers require financial services of some sort.

Those consumers who are not upscale are

likely to experience a decrease in available options. A particularly obvious example of this

movement occurred in 1983, when Citibank instituted a policy that barred customers with

a balance under $5,000 from dealing with a

human teller, Citibank’s action met with

strong opposition and was eventually reversed. It is difficult to say whether other institutions would have instituted the same or

similar policies.

There are more subtle means of reaching the

same end, i.e., moving an institution’s less

profitable customers out of the bank lobby.

One way is to price the services of a human

teller higher than those of an ATM. Others include having fully automated branches in convenient locations and full-service branches in

limited locations, or creating branches where

all teller operations take place at the ATM, but

personnel on location can assist if there are

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 available for financial management, he must understand their function and benefits. Commercial

banks and savings institutions may not be

equipped to provide consumers with the informed assistance necessary for helping them

make increasingly sophisticated decisions. In

many cases the bank employee knows as little about the new products and services as the

customer he is trying to help. Although the

consumer may prefer to deal with a local institution, he will tend to do business with

those institutions that not only offer him the

best return, but also provide good information.

In some cases, that will be the local institution; in others, it will be an institution with

a regional or national presence and a more sophisticated marketing approach. This, in turn,

may mean a flow of funds out of the community.

Within a single organization, those profiting

from the system and those providing information may be the same, creating a potential conflict of interest. In the past, one bank’s products were the equivalent of the next bank’s,

the products offered were straightforward, and

competition was based not on the relative

merits of each but on the “extras’ ’-i.e., the

service offered. Although Truth in Lending

Act regulations require that the terms and interest of various credit instruments be clearly

stated for purposes of comparison by the consumer, there is no comparable requirement for

information about investments.

Marketing to the Consumer

It is no longer clear what the purpose and

role of depository institutions is. No longer do

such institutions have a unique niche in the

marketplace. Under these circumstances, in-
204 ● Effects of Information Technology on Financial Services Systems — —

formation available to the consumer may

sometimes be biased. In the highly charged

competitive atmosphere that now prevails in

the financial service industry, information

may either obscure the real situation or inflate

its advantages. A particularly vivid example

occurred the first year that IRAs were made

available. Advertisements stated that the

holder of an IRA could be a millionaire by

retirement; however, the ads misled the public by failing to put the notion in economic

perspective. Although the consumer should

apply the principle of “caveat emptor” to the

management of his financial affairs, he has

come to perceive banks as noncompetitive, and

he conducts his business with banks based on

this perception.

In addition to the issue of consumer confusion about available options, which in some

ways can be solved by making information

available, there is also the question of consumer awareness and education. Consumer re

search shows that beyond a certain number

of variables, the consumer tends to be unable

to process information. Often, increasing the

amount of information available does not help.

Educational differences or the predisposition

of the consumer may preclude him from processing the information in a way that would facilitate decisionmaking. Also, the consumer

needs more time to make intelligent decisions

about the management of his assets, which

could force changes in the industry in a number of ways. First, it seems to support the need

for a class of personal financial advisors. This

trend is likely to continue as the number and

complexity of options available to the consumer increases. Unfortunately, there is no

certifying process or standard form of education required for these advisors.

Second, it could also eventually affect the

number of options offered by the industry. If

institutions find that their clientele are confused and unwilling to spend the time to make

a decision among a wide variety of choices, the

institutions may decrease the number of options available. For example, as of October 1,

1983, banks were allowed to offer certificates

of deposit in any denomination for any time

period, with fewer withdrawal penalties. They

may, however, benefit more from offering only

specific products to avoid the confusion attached to infinite choice, in much the same

way that a manufacturer will package his

products in prespecified amounts. A situation

may evolve where the industry is allowed to

offer many alternatives but chooses to offer

a limited selection based on the preference of

a particular market segment or, -perhaps,

mass market.

Changes in Pricing Structure

the

The one trend that is likely to have the most

significant effect in the near term on the availability of options to the consumer is the explicit pricing of services.

Competition has forced the industry–in particular, banks-to reduce the “spread,” or the

differential, between interest earned on assets

and paid out on liabilities. In the past, this differential has been the major source of income

for financial service providers; however, new

sources of income are needed to replace income

lost from the reduction of spread. In addition,

higher balance, static accounts subsidized active accounts having a low-to-zero balance. As

a result of the change in the industry’s competitive structure, customers are beginning to

be charged for the cost of their services. In a

highly competitive, deregulatory atmosphere,

cross-subsidization is infeasible because the

larger, more profitable account holders will

tend to move to those institutions where they

can earn the highest interest rate.

Fee-for-service pricing, in most cases, will

encourage the consumer to use those services

that are the least expensive and may therefore

limit his use of particular products and services. However, in certain cases he may not

have a choice; for example, most households

need checking accounts to manage their accounts. This trend toward explicit pricing

seems to affect payment mechanisms the most

and therefore will have the greatest impact on

those consumers whose financial transactions

are heavily payment-oriented.
Ch. 8—Findings ● 205

. — — —

The Implications of

Technology-Based Products

Recent work published by the Federal Reserve Bank of Atlanta projects the rate at

which checks will be displaced by other, electronic, methods of payment. Although it still

represents a small percentage of total account

activity, the steady growth in the deployment

and use of ATMs shows some willingness by

the consumer to accept technology-based services when they meet specific needs. In the

Atlanta analysis, the first stage of check

displacement will be in the cash-dispensing

function. As long as the infrastructure for the

acceptance of electronic payment remains underdeveloped, there will still be a need for

paper-based instruments.

Eventually, the entire population may have

to participate in the system. This becomes particularly obvious on examination of direct deposit services. Since the U.S. Treasury began

encouraging direct deposit of Social Security

payments, the penetration of direct deposit

has gone from 11 percent of total payments

to 33 percent. ] A Social Security system where

100 percent of all transfer payments are

directly deposited would require that all recipients hold accounts with a financial institution

or be provided some alternative means of receiving payments electronically.

Currently, 17 percent of all households do

not have any relationship with financial in- — ———

‘Economic Review, Federal Reserve Board of Atlanta, August

1983, p. 33.

termediaries, either because the consumer

chooses not to establish this relationship or

because he is an undesirable customer and

therefore cannot find a financial institution

willing to do business with him. With direct

deposit there is pressure on both the individual

and the institution to form a relationship. This

pressure for institutions is in direct opposition

to the competitive pressures they feel from the

rest of the industry to rid themselves of unprofitable accounts. Yet, these accounts need

not be unprofitable for the bank if it charges

appropriately for its service. However, the potential exists of charging an individual, who

is in essence forced into the system, a disproportionately high portion of his income. *

There is some argument for the subsidization

of these accounts, but with the current competitive state of the industry, it is doubtful

that a financial institution would be willing to

bear those costs. It is not unreasonable to expect the organization that benefits from direct

deposit, in this case the U.S. Treasury, to pay

these costs.

As direct deposit of government transfer

payments becomes more common, other regular income payments may also be paid directly. The issue on a larger scale is not only who

pays for the service, but also whether the consumer can be forced to establish a relationship

with a financial service intermediary in order

to receive his salary.

*sOme ~ndil~idu~s LISP Ser},ices for a Jrariet?r of nOrlllati\’e reasons that may actuall}’ be more expensi~’e than would be

charged by a financial institution.

Conclusion 5: Security and Integrity of the

Financial Service System

The application of advanced information tech- Theft of Funds

nologies to financial services significantly

changes the ways in which, and the extent to There are two kinds of threats to financial

which, payment and transaction systems and service systems: 1) those threats inherent in

the users of these systems are vulnerable to sys- the system, that usually require technical solutem failure, disruption, theft, error, and invasion tions; and 2) those that are perpetrated by inof user privacy. dividuals who wish to compromise the system
206 ● Effects of Information Technology on Financial Services Systems

and that require more complex solutions, including technology. Some types of crime are

possible because of the nature of the paperbased system–e.g., theft of funds sent through

the mail, check forgery, and even, to a certain

extent, credit card counterfeiting. Technologybased systems can provide solutions; however,

by providing new points of entry into the system, they offer potential for new kinds of

fraud. Future crimes involving financial transaction and payment systems will primarily involve a computer simply because one is inevitably part of a large-scale, modern-day financial

system. The question of computer security

touches every aspect of the financial service

industry. As the volume of EFT transactions

rises, it becomes increasingly important that

financial information be secured against unlawful entry and that a system of law be developed under which computer criminals can

be prosecuted.

Some perceive technology as a solution to

problems that plague the consumer of financial services. Credit card fraud, which is frequently cited as a growing problem in the industry, can be made more difficult by the use

of sophisticated technologies. Because of consumer protection legislation, fraud is primarily a provider problem. The consumer is protected from illicit use of his credit cards, and

if sufficiently informed, he can prevent all but

a minimal financial loss from the fraudulent

use of his card. Both VISA and MasterCard

have introduced or are planning the introduction of cards that are expensive and difficult

to counterfeit. It is difficult to say whether

these cards will in the long run reduce fraud,

since it will be some time before the effect of

their introduction and use will be felt. The cost

to produce these cards will be much greater

than that for current credit cards. Although

the consumer will explicitly or implicitly pay

the cost of the card, it may not mean additional financial burden for the consumer in the

long run because of the reduced costs of fraud

to the card user.

Recent concern in the area of consumer financial services has revolved around the relative security of access devices and the need

-.

to identify positively the EFT user. As systems become more complex and a greater percentage of the population begins to use home

banking and POS systems, problems with the

current means of identification will become

more obvious. With ATM the consumer’s loss

is limited by the amount of cash he is allowed

to withdraw from the system. Although his

liability for unauthorized transactions is

limited, under the Electronic Funds Transfer

Act (EFTA), his financial loss could be greater

when more sophisticated financial transactions are involved and if those transactions

are not reported within the time required by

law. This risk could affect the willingness of

the consumer to use these systems, and therefore the rate of acceptance of these services.

In that event, the market could force the providers of services to secure systems better. It

should also be noted that to the extent that

the law places responsibility for losses on the

provider, it provides additional impetus for

providers to secure their financial systems.

Solving the identification problem is even

more difficult when placed in the context of

the home or workplace. The volume of business at an ATM may allow the use of expensive identification technologies that would not

be feasible at a place of business, and certainly

not at home. Now the major means of identification in these systems is some form of

alphanumeric code or personal identification

number (PIN), again not identifiable with a

specific individual. Although banking terminals in these locations do not yet dispense cash

or a cash equivalent, they certainly provide the

opportunity to transfer funds among accounts

or to embezzle electronically. These problems

will become immense if all personal computers

are equipped to access videotex services and

electronic financial services and if a larger percentage of the population has access to these

terminals.

EFT also generates new kinds of personal

security problems—an individual using an

ATM to receive cash maybe particularly vulnerable to robbery. During normal business

hours, a traditional brick and mortar facility

provides the individual with security during
. .

—

and after a transaction. An ATM located away

from this structure may place the user in a

vulnerable position. Even those ATMs located

at bank branches can be unsafe when used in

nonbanking hours. It is difficult to assess the

seriousness of the problem because most institutions are unwilling to divulge information

on security issues for fear of discouraging use

of the systems. Often, the robberies that occur at ATMs are not reported as such.

The smart card is another new technology

claimed to be more secure than existing card

technologies. The microchip-implanted card

has different levels of security, but the future

role of the smart card in the financial service

industry remains unclear.

In the commercial environment, the security

of payment systems is also an issue of significance. The increasing use of computers to initiate payments automatically raises the need

to establish the identity of the computer initiating a financial transaction, just as, in the

past, it has been necessary to establish positively that a payment order issued by a human

is authentic. Financial systems that perform

accounting as well as payment functions must

be auditable, lest an unauthorized feature be

hidden in the computer programs that constitute them. Care must be taken to limit access

to financial information that may be of value

to an intruder, even if there is no unauthorized

transfer of funds. Finally, superimposed on

these requirements are all of the concerns that

pertain to individual users of financial services, particular services that entail remote access to financial service systems.

System Integrity

Systems for delivering financial services can

also be compromised by a number of factors

that are inherent in the operating environment

but are, nonetheless, capable of interrupting

service.

In the more traditional systems for delivering financial services, breakdown of system integrity is possible. Records can be lost, along

with the audit trails necessary to reconstruct

them. Checks and balances built into proceCh. 8—Findings ● 207

——. .

dures for processing transactions can be circumvented for expediency or can fail to

operate under an unanticipated set of circumstances. However, human involvement in the

delivery systems can be instrumental in detecting breakdowns of system integrity when

they occur and in implementing the steps to

repair or minimize the resulting damage.

On the other hand, financial service delivery systems that rely heavily on advanced

technologies are subject to more breakdown

factors than those that can damage or destroy

simpler technologies. At the same time, they

may be built to include protections that cannot be incorporated into simpler systems.

Computer programs, for example, are designed and built to handle a predetermined set

of conditions. Any data values not falling into

one of the defined categories should be rejected by the program and examples of such

occurrences should be included in the tests

conducted before a program is put into operation. However, even though computer programs are “validated,” exhaustive testing is

not physically possible, and there is always the

chance that some combination of data can be

entered that will produce totally unanticipated

results. If the system operator is lucky, the

impact will be large enough that it will be

noticed immediately and corrective action can

be taken. On the other hand, if the error is subtle, its effects, though significant, can go unnoticed for years. In the aggregate, the impacts could be significant, although no one

incident may be great enough to instigate

steps to correct the error.

Computers rely on magnetic media for storing data, and these media are generally quite

reliable. However, since they are not as reliable

as paper, particular pains have to be taken to

make sure usable copies of the data are available when needed. For example, data on magnetic tape will deteriorate with the passage of

time. Also, mechanical failure of a disk drive

can cause data to be destroyed. Although sophisticated techniques exist for detecting errors in data recorded on magnetic media, some

errors remain undetected. These problems are
208 ● Effects of Information Technology on Financial Services Systems

. — .

reasonably well understood, and the techniques for neutralizing them are straightforward and relatively inexpensive if operating

management is willing to pay sufficient attention to them and the system design incorporates them.

Similarly, the use of telecommunications in

systems for delivering financial services introduces threats to system integrity. Quite

simply, if a path between a user and a service

provider is not available and verifiable, service cannot be delivered. However, several organizations may be involved in operating the

telecommunication facilities that are used,

and the problem arises of identifying the ones

that are responsible for detecting and correcting any errors that may occur. The divestiture

of the Bell System complicates this problem

somewhat, but, again, resolution is not beyond

the means of competent technical management,

To a very significant degree, a financial service industry operates on the trust and confidence of its customers. Thus, the systems used

to deliver financial services must be reliable

and verifiable; if not, the basic viability of the

industry could come into question. In the future, virtually all providers of financial services will rely heavily on information processing and communication technologies, and it

will be virtually impossible for them to revert

to manual systems, even for short periods. The

application of advanced technologies in systems for delivering financial services introduces new vulnerabilities to system integrity.

1f these are not taken into account by the

designers and operators of these systems, the

basic trust that customers place in the financial service industry could be threatened.

Since the class of problems discussed here

are purely operational and can be resolved

partly with technical solutions and partly with

operational procedures and management controls, the key question is whether operating

management will devote the resources required for the solution of these problems and

whether those who regulate financial institutions will include in their reviews of operations

those factors that affect the integrity of systems for delivering financial services dependent on advanced technologies.

Specific Consumer Concerns

Transition From Paper-Based to

Technology-Based Systems

Competitive pressures within the financial

service industry have fostered the use of technology, augmenting and replacing paper-based

systems. On the consumer side of the business,

however, this force must be reconciled with the

demands of the marketplace, which maybe in

favor of paper-based systems. As a result, the

implementation of technology has not always

been as easy in this market as in others.

However, as technology-based services and

products are introduced and accepted in the

marketplace, certain issues arise that are specifically related to the transition from one

system to another, and to the reliability of

systems.

Although technological systems may have

a lower error rate than those using manual

processing, those errors may be more difficult

to detect and resolve. In contrast, a human error can often be resolved immediately. A significant problem regarding some advanced

systems for delivering financial services is that

there is no guarantee that a paper record of

a transaction is ever created. While Regulation E requires that a customer be issued a receipt at an ATM, remote financial services accessed through a terminal located on customer

premises are not covered. Thus, an individual

can initiate a transaction without any tangible proof of the fact. Also, while a stop-payment order can be put on a check that is believed to be lost in the mail, it is not clear that

an analogous step is possible in cases where

a payee denies having received an electronic

payment. Guidelines are written that enable

a consumer to stop a pay order via the automated clearing house (ACH).

Regulations Relating to Consumer Finance

The consumer facing choices between similar financial instruments is probably unaware
. . . .

Ch. 8—Findings ● 209

. . — —- —— — . ———

of their differing regulatory requirements, or

of his protection under the law. It is now possible for an individual who possesses what appears to be a traditional bank credit card to

be protected from misuse of the card under a

variety of legislation or not at all, depending

on the type of transaction.

If a bank issues an individual a debit card

that is associated with an account with a line

of credit and is also an ATM debit card, the

individual can perform a number of different

types of transactions with the same card. If

his line of credit is accessed fraudulently, the

owner has recourse under consumer credit legislation and under Regulation E if the fraud

involves EFT. When ATMs or electronic POS

terminals are used, his liability is limited under

EFTA. If, however, the fraudulent use of the

card directly debits his bank account in a

paper-based transaction, the consumer has no

recourse under current legislation. This is an

example where the same card represents three

different instruments, each of which, in the

case of fraud, would require different actions

by the consumer.

The consumer is likely to be aware of the difference between accessing a line of credit and

directly debiting his bank account with the

card, but it is doubtful whether he would recognize a distinction between a debit that is

processed electronically and one that is processed in the paper system. It is also reasonable to assume that the consumer perceives

no differences between the transactions in a

regulatory sense. Of particular importance,

regardless of consumer perception, is the fact

that debit card transactions in the paper-based

system offer no protection to the consumer.

Privacy

Much controversy surrounds the issue of

EFT and privacy —i.e., whether the systems

that enable EFT make the individual more

vulnerable to violations of privacy. The difficulty of such a discussion is that since privacy

has a different meaning to every individual,

violation of privacy is not easily defined. In

the final report of the National Commission

on Electronic Fund Transfers, privacy was

defined as “the individual’s expectation of control over what information about himself is

communicated to or used by others. ” Further,

“the object of the consumer’s concern regarding privacy under EFT is the potential use of

his financial transaction information to develop a personal profile.”2 This use could be

as seemingly harmless as an individual receiving product solicitations, based on his income

and profession, from the financial institution

where he does business and could range to the

capability of the system to provide sensitive

information about behavioral patterns of the

individual.

Consumers, for the most part, do not appear

to perceive privacy as a major concern in their

choice of EFT systems; other, more marketoriented, questions seem to determine their

use of these systems. A Bank Marketing Association (BMA) survey questionnaire showed

a low level of concern about privacy with respect to electronic banking systems. There is

additional evidence that transactions performed by ATMs are considered more private

than are transactions using a human teller.’]

The paradox is that other studies show the

public to be very concerned with privacy, in

particular, the use by government of personal

information. 4 However, correlations have yet

to be made between this use and individual

uses of financial systems. The BMA survey

does not question overall the individual’s feelings about financial privacy; it only questions

the consumer on how secure he perceives specific financial services technologies to be and

indicates that users of the technology seem to

be less concerned than nonusers with privacy.

However, the issue extends further, to the

capability of these systems to track financial

activity, which was impossible on a large scale

under a paper-based system. Individual be2National Commission on Electronic Funds Transfer, final report, October 1977, p. 19.

‘Ilank .$! arketing ,Lf ssocjation, Pa.}’ men t .+1 t t) tudes (’f?angf’

l;~aluation, {Chica~o, 111.: BNIA, 1982), p. 2.1 H.

‘I,ouis 1 I arris & Associates, Inc., and Alan F. \$’estin, ‘‘The

Dimensions of Pri\rac}’, ” 19’79.
210 . Effects of Information Technology on Financial Services Systems

— — —

havioral profiles can be compiled in the traditional system using account records, but only

with great effort and expense. The same tasks

become fairly easy using technology. The competitive atmosphere in the financial service industry today encourages the accumulation of

personal information to help minimize the cost

of bad accounts and to segment a market of

potential customers to approach with new

products. The accumulation of this information for marketing purposes allows a ready

data base for other purposes. Not all companies have and enforce a strict privacy policy, nor do they guarantee that the information is inaccessible through other means, legal

or otherwise.

Privacy is not entirely a domestic issue.

Countries outside the United States, notably

in Europe, express considerable concern for

protecting the privacy of individuals and, in

some instance, businesses. Some have limited

or prohibited the movement of data relating

to their citizens to nations that do not meet

their standards for privacy protection. Hence,

pressure for privacy legislation may materialize from sources outside the United States,

regardless of the level of concern of American

citizens with the issue.

Conclusion 6: Integration of Capital Markets

Advanced financial information systems have

forced the creation of a highly integrated, nationwide capital market and increased the velocity of money.

A highly integrated, nationwide capital market is being created, driven by the demands

of users and facilitated by the application of

information and communication technologies.

Financial institutions began moving capital on

a national scale when it was recognized that

capital supply and capital demand within regions do not necessarily meet. These institutions have produced a national market

through which needed and available funds

within and between regions of the country are

balanced. Local financial institutions are able

to serve as intermediaries between their customers and national markets because of their

access to the financial systems and because

of their expertise. The ability of an organization or individual to participate in a capital

market is restricted by the quality and quantity of information available on the market,

and financial service providers have traditionally had superior access to that information.

Traditionally, secondary markets for both

debt and equity securities facilitate the process of intermediation between regions. Underwriters buy securities from the primary issuers

and make them available on local, regional,

and national markets. Modern information

processing and telecommunication technologies have provided increased exposure to

securities and therefore have increased opportunities for issuers to increase net proceeds

from the paper issued.

Congress mandated the development of a

national market system for securities in 1975.

National markets are advantageous for capital seekers and investors. The truer and more

equitable pricing of funds that results from exposure to larger markets is demanded by market participants. This impact is demonstrated

by the success of the National Association of

Securities Dealers Automatic Quotation System (NASDAQ), which provides national

market exposure to what in the past were

over-the-counter stocks. Trading volume on

NASDAQ has reached the levels of the New

York Stock Exchange as investors are at-
Ch. 8—Findings ● 211 — . —

tracted to issues to which they suddenly have

access.

The Effect of a National Capital

Market on Financial Services

A national capital market results in competition between diverse local and regional requirements for capital. The fundamental problem

associated with the national market is whether

there is equal access to all potential players.

While information technology facilitates the

communication of information used as the

basis of financial decisionmaking, and therefore has made it easier and cheaper to participate in the national market, in some cases the

advantages of a regional market may be lost.

For example, regional markets may be more

appropriate for the development of capital for

new or growing firms that may not be able to

compete in a national environment yet make

a unique and valuable contribution to the economy of the region. Cost and income characteristics for businesses tend to differ between regions, and it may be beneficial for a firm to

have its potential level of return evaluated

regionally rather than nationally. While the actual cost of money may be equal in a national

market, its cost relative to return may differ

between regions.

The exposure of securities and loans to national market circumstances has led to an

equilibration of securities prices and interest

rates. This trend initially developed on an institutional level and has now encompassed

consumer markets. Consumers and small business customers were at one time dependent on

local financial institutions because they did

not have the knowledge required to operate in

a financial market beyond their area. The

availability of information on a national level

results in more equitable choice and quality

in services offered.

The nationalization of capital formation may

be a leading cause in the shift in placement of

an increasing portion of consumer funds into

investment instruments, such as money market mutual funds. This movement is an indication of the importance of information flows in

financial decisions. Technology that allows for

a rapid transfer of information diminishes the

importance of location of both service providers and customers. Return potential has

enabled the funds to draw a market share from

a broad-based population.

Investment funds may draw capital away

from depository institutions and therefore the

mortgage market. The individual development

of equity represented by home ownership is

an important cultural and economic value in

U.S. society. Historically, the home mortgage

was placed by a depository institution in the

same community as the financed property;

however, information technology has facilitated the nationalization of mortgage capital

markets and changed the ways in which this

capital is developed. The movement away from

local mortgages may be harmful for consumers

in some areas and may remove some incentives for forming ties with local financial institutions.

The development of secondary markets for

both long- and short-term debt instruments

has been a great benefit for smaller financial

institutions. Financial institutions, particularly banks, are able to redistribute and balance

capital by buying and selling debt contracts

among themselves. Information technology facilitates this process by making it easier for

financial institutions to identify potential

trading partners and to analyze market opportunities.

While access to the national capital market

through the use of information technology

may greatly benefit sophisticated investors,

some worry that less sophisticated investors,

who need help to interact in a national market, may realize lower returns. The national

capital market has caused a proliferation of investment choices that entail a higher level of

analysis of personal investment goals and opportunities.

At the same time that a national capital

market has been developing, the velocity of

money—a measure of the number of times per

period an average dollar is spent to purchase

newly produced goods and services—has been
212 • Effects of Information Technology on Financial Services Systems

increasing. While the incredible growth in the

trading of securities and in asset transactions,

as seen in bank deposits, may be driven by

market forces, it would be physically impossible to complete the actions required for these

activities without communications and computer technologies. While information technology is not directly the cause of an increase in

the velocity of money, without its application

the velocity could not have increased to the

level demanded by the market. This type of

constraint could have a severe impact on the

economy.

It is now generally accepted that there is no

technological constraint to the trading of

assets at whatever speed is demanded by the

market. Almarin Phillips notes that bank demand deposits in New York City were turned

over 1,200 times a year in 1981 as compared

to an average of 150 times a year in 1970. He

attributes this acceleration to the appearance

of new markets, the availability of better information, falling transaction costs, increased

liquidity of many assets, and the general rise

in interest rates. These factors have put a

premium on the efficient management of liquid assets.5 It would be prohibitively expensive to complete transactions at the demanded

speed without the level of technology applied

by the banking and securities industries in the

last several years.

As the banking industry moves toward multiple settlements during a business day, failure to adopt the needed technology could result in a massive movement of funds out of

the financial service industry by corporate

cash managers. An indication of this potential was seen in the movement to trade securities off organized exchanges in the early

1970’s, when it appeared that the exchanges

could not operate at the level demanded. Trading was only returned to the exchanges as information technology increased their capacity

and speed.

--——-.-..——_—-

‘Almarin Phillips, “Technology and the Nature of Financial

Services, ’ Strategic Planning for Econom”c and Technological

Change in the Financial Services Industry, Proceedings of the

Eighth Annual Conference, Federal Home Loan Bank of San

Francisco, Dec. 9-10, 198!2, San Francisco, Calif., pp. 5-6.

The increase in trading volume for securities is another indication of the general quickening of the American economy. Share days

of 100 million are not uncommon on the New

York Stock Exchange, on which a daily average of less than 17 million shares were traded

in 1972. And high volume no longer requires

the curtailing of trading hours. Long-range

planning by the New York Stock Exchange

anticipates average daily trading of between

200 million and 250 million shares.’ Given the

requirement for quick settlement, it would

have been physically and fiscally impossible

for trading to approach this level without auto

mation.

Information technology has given both domestic and multinational firms far greater capability to identify available assets and to direct them to those investments that offer

maximum return for whatever period those

assets are available. This ability relates to the

tremendous growth of money market mutual

funds and accounts that are based on shortterm investment instruments.

Future Impacts of Technology on

Capital Markets

In an integrated world economy, a high degree of capital mobility is required to offset

movements in other items of balance of payments. 7 An international capital market has

developed, facilitated by the application of information technology. This market is having

a major impact on the world by intertwining

the economies of culturally and politically diverse nations. Also, worldwide financial centers have emerged in countries such as Hong

Kong and Bahrain. Unlike a domestic market,

however, there is no overriding international

system through which a global economy could

be governed. Whereas the United States of

America share a common Federal Government

and political and cultural rooting, this type of

relationship does not exist between nations.

61VYSE 1983 Fact Book, p. 4.

‘R. M. Pecchioli, The Internationalisation of Banking: The

Policy Issues (Paris: Organization for Economic Cooperation

and Development, 1983), p. 115.
Ch. 8—Findings ● 213

-. .—.— ———- .- ——

The differences between telecommunication

industries and regulations in various countries

must be recognized as a barrier to the development of global capital markets. Information

technology creates new vulnerabilities in international markets.

Information technology has made it possible for financial service institutions in different

nations to direct excess capital much in the

same way it is directed between regions of the

United States. In addition to more sophisticated asset and liability management techniques, improved communication facilities had

vast consequences for the rapid emergence of

the eurocurrency market for redeployment of

international capital. 8

Communication technologies have also had

a particularly strong impact on international

wholesale or interbank activities. Interbank

activities provide a large portion of the funds

for international investment. The use of technology has allowed small banks for the first

time to become involved in international

banking.

‘I bid., p. 20.

Conclusion 7: Entrants Into the

Financial Service Industry

The major new entrants into the financial service industry are, and will increasingly tend to

be, organizations that already have extensive

distribution and/or communications systems.

A financial service organization that has an

established technology infrastructure usually

has a competitive advantage in three areas:

1) facilitating the intermediary functions of the

financial service industry; 2) providing convenience of location to its customers, including the

increased movement to remote banking and

other financial services; and 3) in general, improving productivity.

The experience of present leaders in the financial service industry —e.g., Citicorp, Sears,

ADP, and Merrill Lynch–indicates that strong

distribution and communication systems are

major factors in their ability to capture and

serve markets. It is expected that the control

of or access to distribution and communication systems will continue to be an important

indication of the potential success of current

industry players and, therefore, an indication

of who will be the new entrants into the financial service industry. The identification of potential entrants is important because they help

determine the competitive character of the industry.

The Role of Information Technology

in Competitiveness

The flow of information is essential to the

orderly operation of financial service markets

because it is essential to the making and directing of decisions. Information may be a

representation of or collateral to the transfer

of value. At the same time, cost and accessibility considerations have led to a change in

preference for electronic systems from the

once-practical paper-based systems for many

types of information. The transfer of financial

service records is changing from the physical

transportation of documents to the electronic

exchange of information. The communication

systems developed to meet this demand are

far more technology-dependent and capitalintensive than their predecessors.

The application of information technology

frequently decreases the costs of delivering financial services. The corporation that can

automate delivery systems has a competitive
214 ● Effects of Information Technology on Financial Services Systems

advantage because it faces lower total costs.

The importance of technology in communication systems is found in time, as well as dollar,

considerations.

Availability of Services to Small

Financial Service Providers

Lack of access to sophisticated communication and distribution systems could potentially be a significant barrier to small service

providers both for entering and competing in

financial service markets. A tier of wholesalers

of data processing and communications services has developed to supply services to endusers or to small financial service providers

that cannot afford to invest in large-scale communications or computer systems.

Entrance by Holders of Communication

and Distribution Systems

Existing information technology infrastructures have provided market opportunities in

the financial service industries for several corporations. For example, a data processing

firm, ADP, is an organization whose entrance

into the financial service industry grew from

holding a sophisticated computer and communication system. J. C. Penney has applied its

communication network to the processing of

oil company credit card transactions. Penney’s

established communication system gave it the

opportunity to expand into new markets.

Given the great value of sophisticated communication systems to operating financial

service systems, new entrants may be found

in established communication firms such as

AT&T and MCI, which may find it cost effective to enter the financial service industry as

wholesalers of services or, because of their

established systems of customer service, as direct service providers.

A successful distribution system may be

judged not only by the number of physical

locations in which an outlet is placed, but also

by the extent to which it provides cohesive

coverage of markets. Distribution systems

share many of the characteristics of communication systems and are usually dependent

on information technology for operation.

Established distribution systems may ease

entry barriers to new markets. When Sears

entered the financial service market, it had the

benefit of an established system of retail

stores through which it had community presence. The availability of these locations for the

offering of financial services eliminated much

of the startup cost involved in selecting appropriate locations for retail businesses, since information on customer traffic and other site

characteristics was available. The opportunity

cost for Sears of extending its line of commerce to financial services may be assumed

to be lower than otherwise might be expected

because much of the cost for distribution channels was already paid.

The distribution system of a player in the

financial service industry involves not only its

physical presence but also its ability to disseminate information. Sears has the most extensive private card base in the Nation, equal

in importance to its retail outlets. Because

Sears had this communication system in place,

it could develop a direct marketing system.

Future entrants into the financial service industry may include corporations that enjoy a

strong distribution system such as gasoline

retailers. These corporations have a presence

through gas stations in urban and rural areas

throughout the Nation, a strong fiscal personality, significant card bases, and sophisticated

POS systems.

The Effect of New Entrants on

Services Provided

The new entrants with strong communication and distribution systems have increased

the number of options available to financial

service consumers by making a wider range

of product offerings and delivery mechanisms

available. Communication and computer technology has made it possible to develop far

more diverse and complex investment packages that serve a greater range of investors.

In addition, the refinement and increased
Ch. 8—Findings ● 215

— — —— ——.———

speed of settlement found through the application of information technology also improves

the quality of service received.

It is possible that, in the long run, the need

for communication and distribution systems

may decrease consumer options if the market

becomes dominated by national firms with litle local presence. However, it does not appear

likely that the market would tolerate this type

of development. Small firms can compete as

long as they are able to access delivery systems built and operated by others.

The possibility of cross-entry into the financial service industry by communication firms

and others may protect consumers from the

effects of monopolization. No matter what

happens to the concentration levels in the financial service industry, the availability of additional and diverse organizations to provide

financial services if market circumstances are

favorable should lead to competitive prices.

The Effect of Telecommunication

Regulations on Financial Services

Most segments of the financial service industry are subject to Federal or State regulation. With the application of communication

technologies, players throughout the financial

service industry may find themselves subject

to regulation both of their products and services and of the systems they use,

While it maybe expected to be a transitional

problem, the applicability of two regulatory

structures to the financial service industry

may hinder its operation by increasing administrative costs. In the extreme, the economic

viability of existing systems could be destroyed. Product development and marketing

activities could be adversely affected by regulatory uncertainty about communication facilities. Regulation of communication services

may limit the ability of financial service providers to realize the potential benefits of new

technologies in internal systems if restraints

on their usage are imposed. As a result, new

systems could be stymied.

Antitrust Implications

Vertical integration may result in greater

market concentration by foreclosing the competitive opportunities of those selling or buying in competition with integrated market

participants. 9 Given that distribution and

communication systems of an organization

may be indicative of possible future entrance

by an organization, these systems should also

be considered in cases of proposed mergers.

Antitrust enforcers should be aware of the

possibility that if dominant communication

carriers move into the payment system it is

possible that their market position in communications may place banks and other financial intermediaries at a competitive disadvantage. 10

Antitrust enforcers should also keep the increasing competitive overlap in mind when

analyzing mergers. The Merger Guidelines

issued by the Department of Justice in 1982

identify both established players and firms

whose production and distribution facilities

could reasonably be adapted for entrance into

a market as market participants.11 The market impact of proposed mergers and acquisitions has to be evaluated, among other factors,

by the likelihood of one of the players independently entering the market of the other as

a competitor. Therefore, distribution and communication organizations outside of the financial service industry that propose a merger

with a current player should be evaluated in

terms of their adaptability to financial applications.

‘Donald 1. Baker and W’illiam Blumenthal, 4 ‘The 1982

Guidelines and IJreexisting Law, ” California Law Ite}’iewr 71,

March 1983, pp. 311-344.

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

‘

l Baker and Blumenthal, op. cit., p. 337. Baker and 131umenthal note that the U.S. Department of tlustice, Nlerger

Guidelines \I, 47 Fed. Reg. 28,493, 28494 (1982) list the following classes of firms as market participants: 1) firms that

currently produce and sell the relevant product, 2) firms whose

existing production and distribution facilities could be shifted

to enable the firm to produce and sell the relevant product

within 6 months of a 5 percent price increase. 3) firms that recycle or recondition products that represent good substitutes for

the rele~.ant product, and 4) vertically integrated firms that produce the relevant product for capti~’e consumption.

35-505 0 - 84 - 15 : QL 3
216 ● Effects of Information Technology on Financial Services Systems

Conclusion 8: Competition in the Markets

for Financial Services

A major uncertainty in the changing structure

of the financial service industry is what degree

of consolidation and concentration of services

will eventually occur. A second major uncertain y is what level and scope of competition in

financial service markets would be appropriate

and desirable for a healthy future economy.

The compartmentalized structure of the financial service industry established over the

past 50 years is in the process of vanishing,

and the future structure of the industry remains as yet undefined. In the past, geographic limitations were placed on the areas a bank

could serve so that none could position itself

to dominate the banking industry. Because

banks were limited only to the banking and

related business, banks were also effectively

kept from using their unique position in the

economy to dominate other industries. However, banks were given an exclusive franchise

for the taking of deposits and access to the

payments system. Only commercial banks

were permitted to offer a demand deposit

account, and only they had access to the

Federal Reserve and the check-clearing

mechanism.

Regulations were promulgated for specific

classes of institutions; so long as there was no

effective way for new entrants to encroach on

the franchises that had been granted in legislation, the structure remained intact and was

generally able to achieve the goals that had

been established for it. However, economic

conditions, in combination with the latent capabilities of advanced information processing

and communication technologies, encouraged

the successful entry of new firms into the financial service industry from such diverse

areas as retailing, communication, and information processing.

Significant numbers of those concerned with

the long-term effects of the changes now taking place in the financial service industry have

expressed concern that one of the outcomes

will be consolidation. The number of firms in

the industry would be reduced to a point where

a small number could dominate the market.

Such concentration would directly contravene

one of the central themes embodied in established policy. Some also express concern that

users of financial services provided by nondepositor institutions may be exposed to unwarranted risk because the firms providing the

services may be prone to accepting a higher

degree of risk than depository institutions are

permitted to take.

Even though firms not traditionally providers of financial services have entered the

industry and operate outside the constraints

imposed on traditional suppliers, they apparently have not weakened it. New entrants have

generally been successful in broadening competition in the face of the existing legal/regulatory structure. In recent years, Congress

has repeatedly been called on to remove constraints that have limited the ability of the

regulated firms in the financial service industry to compete with the new entrants; it has

not been asked to act to protect the ground

taken over from the traditional service providers.

A key parameter for success in the financial

service industry is access to systems based on

advanced information processing and telecommunication technologies. Large service providers have the resources to develop and deploy these systems on their own. However, the

existing infrastructure of wholesale service

providers has made it possible for all firms,

regardless of size, to have the requisite access

to the advanced technologies. New entrants,

taking advantage of the advanced systems,

have repeatedly demonstrated their ability to

compete successfully with larger firms in the

marketplace. As long as this alternative exists, there are few barriers to entering the financial service industry.
. —

Ch. 8—Findings ● 217

———

Another concern expressed by some is that

a financial service industry dominated by a

few national organizations would no longer be

responsive to local needs of the communities

in which they operate. On the one hand, ease

of entry will continue to minimize the chance

that an area would not be served by institutions responsive to its needs. On the other

hand, continuing to regulate the interstate

activities of the banks will not guarantee that

capital will be available to meet the needs of

the areas that generate it. As the pervasiveness of technology-based systems for managing financial resources increases, intermediation by banks will become a less significant

portion of bank activities because deposits

from which loan portfolios are generated will

continue to shrink. There is some indication

that banks will become primarily service providers through which funds flow. Therefore,

policies that are intended to assure the availability of capital for socially worthwhile projects are more likely to be successful if they

focus on nonbank institutions.

Historically, there is some evidence to suggest that large financial institutions are not

necessarily successful in their attempts to enter and dominate markets held by smaller

firms. In areas where they were able to enter,

the larger firms were at least as responsive to

local needs as were the local banks that had

previously provided service. Fears that the

New York City banks would be able to drive

the smaller upstate banks from the market

were expressed when statewide branching was

first permitted.

However, according to a statement by Frederick Hammer, Executive Vice President,

Chase Manhattan Bank of New York, “Virtually all the New York City banks that went

upstate ended up closing most of those

branches. The only branches from those efforts that are profitable are those done by acquisition. In the towns where our banks were

able to branch, we were able to provide new

services. Studies done by the FDIC indicated

that the loan ratios went up in those towns.

The banks were doing a better job of servicing their communities. ’12 On the other hand,

this statement says nothing about the propensity or the ability of an organization to enter

a market through the process of acquisition,

one which Hammer indicates is likely to be

successful. Nor does it say anything about

their propensity to continue to serve local

needs if a dominant position in a market is

established.

Evidence indicates that the propensity of

customers to switch financial institutions is

relatively low and that there must be some significant event to motivate such a change. On

the other hand, some believe that packages of

services could provide the necessary motivation for customers to change financial service

providers and that once new, complex relationships have been established, the inclination to

move in the future will be lower than in the

past. Securities firms assume that they will

be able to establish a high degree of customer

loyalty because they are able to offer service

regardless of whether the customer is home,

on a short trip, or permanently relocating to

a new area. * Thus, the firms that can establish a national presence and offer a comprehensive package of interrelated services may be

able to generate a degree of customer loyalty

that could enable them to dominate the financial service industry.

The States are not waiting for the Federal

Government to modify its position with regard

to the policies that help shape the structure

of the financial service industry. Laws that

would permit regional banking have been

passed in New England. Some States, South

Dakota and Delaware among them, have enacted legislation designed to attract financial

service organizations. Thus, even though prohibitions of interstate banking based on Federal law may continue in force, regional bank-

‘

zFrederick Hammer, Executive Vice President, Chase

Manhattan Bank of New York, in testimony in oversight hearings before the Committee on Banking, Housing and Urban Affairs, U.S. Senate, May 3, 1983.

*The strate~ is also intended to change the loyalty of the

customer from the account representative to the firm, a problem that has been facing securities broker/dealers for some time.
218 . Effects of Information Technology on Financial Services Systems

ing in significant areas of the country could

emerge. Also, organizations that provide financial services in nationwide markets operating from States that have passed permissive

legislation may emerge. Federal law permits

interstate and cross-industry mergers when it

can be demonstrated that they will serve the

public interest.

No clear picture of the future structure of

the financial service industry exists. Some

foresee considerable consolidation, with many

fewer firms serving the public than at present.

Some believe that the industry will consist of

a small number of large firms serving national

markets and a large number of small firms

specializing in specific market niches. On the

other hand, others contend that the financial

service industry is already heavily concentrated in many respects and that it will not

change significantly in the future. Given the

contravening forces operating, there is no

basis for adopting one of these positions or any

others that could be suggested.

However, it is clear that future financial

services will be provided by a variety of firms,

not just banks and the other traditional participants in the market. New classes of firms

have already established themselves in the financial service industry, and there is no reason that the trend should not continue. Thus,

policies need to be formulated to account for

the influence of the technologies and the opportunities they create for the entry of firms

that have not previously been providers of financial services.

A key element in the present structure of

the financial service industry is that the customer has the option of investing funds in an

account insured by the Federal Government.

This type of insurance was one of the elements

in the 1930’s program to restore confidence in

the financial service industry. Because of the

existence of the insurance, depositors with balances below the limit of the insurance are fully

protected and have not suffered losses as a result of any of the failures that have occurred

in recent years. On the other hand, some argue

that the availability of insurance and the readiness of the regulators to step in to protect a

failing institution have resulted in a false sense

of security that has led some institutions to

take unwarranted risks in participating in

deals put together by others. The secondary

effects from the failure and closing of the Penn

Square Bank illustrate this point. They also

argue that these policies protect the stockholders as much as the depositors and, as a

result, the institution will undertake projects

for its own account that represent an undue

degree of risk.

However, the combination of economic forces

and technological applications has resulted in

the movement of deposits from insured accounts in financial institutions. Although the

introduction of insured money market accounts by depository institutions at the beginning of 1983 was accompanied by some increase in deposits, over the long run there is

a distinct possibility that the deposits held by

financial institutions will continue to shrink

relative to all financial assets. Investors in

functional equivalents of depository accounts

that are not insured would then be exposed to

loss of principal in the event of institutional

failure, with the result that the sensitivity of

the financial services industry to disturbances

in the economy could increase significantly.

Antitrust actions in the computer and telecommunication industries have demonstrated

that it is not always possible to define clearly

the elements of a market in order to analyze

the competitiveness of the firms participating

in it. Given the changes in the financial service industry, a situation analogous to that

found with the computer and telecommunication industries is developing. As new entrants

provide financial services, the lines that determine market boundaries become much less

clear than they were in the past.

New entrants often compete only in some

parts of the financial service market. For example, a supermarket that operates a network

of ATMs is in direct competition with depository institutions that offer comparable services. On the other hand, the supermarket
Ch. 8—Findings ● 219 —

would not be a factor in the markets for commercial loans or trust services.

Even within the community of depository

institutions, care must be taken in defining

markets. The small, local bank is not a factor

in the market for cash management services

offered to the largest corporations in the country. Conversely, a branch operated by a major money center bank may bean insignificant

factor in a market dominated by a small but

very successful bank.

The changing structure of the financial service industry will exacerbate this problem in the

future. Thus, great care must be taken in suggesting that one institution will be able to

dominate the others in a market. Unless the

statement is made in full recognition of the

conditions existing in a specific area for a specific package of services, such generalizations

are likely to have little validity.

Conversely, one must recognize that the

ability to offer a package of complementary

services may place a firm at a significant

advantage relative to others with product lines

that are less broad. Even though the horizontally integrated firm may not dominate any

segment of the market in the context of its

competition for specific products, when considered in its totality over time, the integrated

firm could dominate a market, possibly overpowering market competition.

Events to date have not endangered the basic soundness and safety of the financial service industry. However, one cannot assume that

this stability will remain, and constant monitoring of the industry would seem in order. On

the other hand, policies developed in anticipation of events not having a high probability

of occurrence could foreclose benefits or unintentionally trigger undesirable impacts.
Chapter 9

Policy Issues
Chapter 9

Policy Issues

The financial service industry is enjoying a

period of rapid innovation in supporting technologies. The effort to use those innovations

to best advantage is contributing to rapid

changes in the structure of the industry and

in the services it offers. On the one hand, technology motivates change; on the other, facilitates it.

Through the applications of technology, the

financial service industry provides the public

a choice of modern and efficient services more

diverse than was available in the past. From

another perspective, the introduction of explicit pricing for services, the increased complexity of the menus offered and other effects

following from the introduction of technology

are not amenable to all users.

Changes in basic social institutions almost

invariably raise questions for public policy.

The basic tenets that comprise the foundations of existing policy may no longer hold; or,

if they do, the existing means of realizing

established goals and objectives may no longer

be workable. Relationships between and among

individuals and institutions may be altered in

ways that make some relatively worse off

while others become relatively better off. The

results of such shifts can be political pressures

for new or modified policy goals and mechanisms for achieving them.

Information technology has made it easy to

bypass some legal and regulatory provisions.

Some new services or altered service packages

are being delivered through systems that did

not exist when regulatory provisions were

written, and some services are offered by institutions not covered by the provisions.

It is likely, therefore, that some of these provisions now only burden the industry unnecessarily, cause unplanned distortions in the

market, or place some financial institutions at

an unreasonable disadvantage. The very scale

and rapidity of the changes and the fluidity

and turbulence in the environment within

which financial institutions are now operating

could cause excessive risk for these organizations and their customers. It is also possible

that some of the ends sought in existing laws

are no longer appropriate or useful.

Formulating policy issues and options with

regard to these changes meets with one immediate and serious challenge. Changes are coming about so rapidly and in so many diverse

directions that it is difficult for financial institutions themselves or for outside observers

to anticipate the patterns that will eventually

prevail.

Nevertheless, it is possible to foresee some

of the broad patterns likely to emerge and to

anticipate in a general way their likely consequences. It is important to do so because policy decisions made or avoided now may have

far-reaching consequences. For example, some

potential benefits of the new technology may

not be realized. Costs and benefits may be inequitably distributed. Unnecessary burdens

may be imposed on industry or on consumers.

Civil rights and liberties may be compromised.

Policy is promulgated through legislation

and regulation; it can also be imposed through

less formal, political activities such as Presidential “jaw-boning.” Policy alters market

forces and the relative power of the factors

that determine price and product mix. For example, limitations on interest rates led to

bundling of financial services which, in turn,

resulted in cross subsidies. Services could then

be provided to some who could not have afforded them had they been required to pay

prices based on a true allocation of costs. Now,

technology, combined with other forces, is creating an industry structure that explicitly

charges for services on the basis of fully

allocated costs. Some people may not be able

to afford them. If this is judged contrary to

the larger public good, it becomes the task of

the policymaker to adjust those circumstances

through carefully designed policies.

223
224 • Effects of Information Technology on Financial Services Systems

—.— —

Thus, even though significant uncertainties To identify the public policy issues related

about the future remain, it is essential that an to financial services it is necessary to look

assessment of the implications of advanced more closely at relationships between finantechnologies for the financial service industry cial services and broad national objectives

be made. Many of the policy issues discussed that reflect various public interests in those

below are not new. Competition and consoli- services.

dation, fair play, privacy, and security have

always been concerns in financial service

delivery, even with older paper-based technology.

Public Interests in Financial Services

Some of the major laws and regulations related to financial institutions express explicitly and implicitly national objectives related

to financial services. There is a strong public

interest in the maintenance of financial institutions that will:

●

●

●

●

●

assure and facilitate transactions necessary for a strong and growing level of economic activity in the Nation and in all regions and communities;

encourage savings and capital formation;

protect the savings and investment of individuals, families, businesses, and social

institutions;

avoid excessive concentration of economic

and financial resources; and

support and strengthen the competitive

position of the United States in world

trade.

implicit in the concept of the public interest

are also the basic national objectives of national security, equal treatment under law, and

a host of well-established civil rights and liberties. Therefore, financial service systems

should:

●

●

●

not compromise national security, or the

ability of the Government to implement

foreign policies;

not adversely affect the exercise of civil

rights and liberties; and

not discriminate against some people by

depriving them of necessary financial

services or placing an unfair burden on

them in using those services.

There are also specific Government concerns

and interests in financial services. Because

Federal, State, and local governments are major users of financial services, they have a

special interest in efficiency, low cost, and

security in making and receiving payments.

For example, the U.S. Department of the

Treasury wants to move toward direct deposit

of all Federal payments to reduce the costs of

this huge volume of transactions.

Finally, the degree to which the introduction

of advanced systems for delivering and using

financial services may affect the ability of

government to use monetary and fiscal policy

as tools for ensuring economic stability and

growth remains unknown. The increase in

transactions and income velocity as a result

of this technology could make it more difficult

to intervene in unsatisfactory general economic conditions through instruments of monetary

policy. Use of information technology, by

changing the velocity of money, changes the

effective stock of money in the economy at any

one time. Technologies can facilitate the delivery of services that effectively monetize

assets that in the past were considered illiquid

(e.g., the ability to draw on home equity as a

line of credit). This could complicate attempts

to use monetary policy to reduce inflationary

pressures or to stimulate stagnant conditions,

although what the effect will be in practice is
. —

Ch. 9—Policy Issues ● 225

— —

far from certain. At least, it will be more dif- more rapidly, which could be both beneficial

ficult to define or estimate the stock of money. and risky—under the worst possible scenario,

The speed of transactions will cause the con- it could lead to economic fibrillation.

sequences of policy interventions to be felt

Possible Changes in the

Financial Service

Information processing and telecommunication technologies, as applied to financial services,

1.

2.

3.

4.

5.

6.

7.

have seven direct and significant effects:

They remove geographic and temporal

constraints on the delivery of financial

services and allow them to be delivered

from remote locations and to new and

widely dispersed locations, such as homes

and offices.

They allow transactions to be completed

almost instantaneously, increasing the

velocity of money in the system.

They facilitate complex networks and interrelationships between institutions,

markets, and geographical areas.

They provide the flexibility for many

alternative combinations of services and

service features, allowing both “bundled”

and narrowly targeted services.

They improve productivity and, in general,

lower the costs of providing services.

They increase the capitalization of financial services, providing opportunity for

new providers of intermediate and shared

facility services to financial service institutions.

They create the possibility of electronic

legal tender and the opportunity to monetize a wide variety of assets.

Current and anticipated changes in the

structure of the industry and service delivery

mechanisms, assuming no interference with

present trends, include:

• Increased diversity in the nature of institutions within the industry, in which

Structure of the

Industry

traditional categories of depository and

nondepository institutions are no longer

sharply delineated and in which the line

between financial and nonfinancial institutions, as defined by products and services, is blurred.

Development of large, diversified financial institutions offering a wide range of

retail services and service locations so

that users may have many financial relationships with the same institution.

Some vertical as well as horizontal integration as diversified firms acquire the internal capabilities to perform functions

for which they previously turned to the

wholesale market.

Development of many small, highly specialized institutions that target narrow

markets and specified groups of clients.

Continuing mergers and a trend toward

absorption of middle-sized institutions,

especially those having a strong local or

regional orientation.

Rapid product proliferation-i. e., proliferation of services that are functionally

similar but differ in regulatory restrictions and interest rates and in the distribution of responsibility or risk between

providers and users.

Greatly increased functional integration

of the national financial service industry

through technological networks and institutional relationships.

Great reduction in the significance of time

of day and location in delivery of financial services.
226 ● Effects of Information Technology on Financial Services Systems

In developing national policy about financial services, policymakers should take

into consideration six critically important 4.

questions:

1.

2.

3.

What national objectives should be sought 5.

in framing policies related to financial

services?

Is there a need for a thorough restructur- 6. ing of the regulatory system as opposed

to marginal corrections?

How much competition is appropriate

Generic Considerations

Financial Service

and desirable in this sector of the

economy?

What institutions or services is it essential to preserve and for what purposes?

What is the appropriate level of risk for

providers and users of financial services

to assume, and how should that risk be

distributed?

How can the financial service industry

support a strong U.S. role in the world

economy?

In the sections that follow, salient policy

questions pertaining to the financial service

industry are presented, and some of the alternatives for dealing with them identified. The

first group includes two broad general questions, the second deals with issues related to

industry structure, and the third discusses

risk allocation issues.

General Policy Issues

Issue 1: What are the alternative approaches

that could be used if a review and

restructuring of laws and regulations related

to financial services were undertaken?

Information processing and communication

technologies have already had a profound effect on the handling of financial data. The capabilities that these technologies offer—efficiency, speed, integration of activities over a

wide area, flexibility, and networking-are

powerful. Because these technologies change

both the way data is handled and the way

funds are transferred between competing uses,

they affect the allocation of resources in a

dynamic economy. Moreover, the technologies

will continue to develop rapidly and probably

in unforeseen ways.

Some argue that, just as the effectiveness

of many laws and regulations has already been

in Framing

Policy

significantly diminished by information technology and associated structural changes in

the industry, any regulatory revisions made

now will also be subject to rapid obsolescence,

as new technological capabilities are developed.

But piecemeal revision is in fact well underway. The question is whether it should continue to be done in bits and pieces, lagging

behind and reacting to changes; or whether a

new system of laws and regulations should be

designed to guide and control future changes?

Two of the most recent pieces of legislation

were developed in reaction to changes that had

already occurred in the market. The Depository Institutions Deregulation and Monetary

Control Act of 1980 was partly motivated by

a finding of the courts that the deployment of

automated teller machines (ATMs) by thrift

institutions violated existing law. Offerings of

zero-balance checking accounts by commercial

banks and other newly developed services also

challenged the existing legal regulatory structure. If Congress had not acted, significant investment in advanced equipment and services

that had proved attractive to consumers

would have had to be abandoned. The GarnSt Germain Act of 1982 was passed in part

because the rise in short-term interest rates

had caused funds to shift out of depository in-
— - — —

stitutions to money market funds and had

thrown the cost of liabilities and the earnings

of assets held by the thrift industry so far out

of balance that the viability of these institutions was threatened.

The rate of change in the financial service

industry has not abated since the passage of

this legislation. There is every expectation

that coming years will see changes occurring

at an equal or faster rate than that of the recent past. Financial service providers will

continue to rely heavily on technology to work

around policies they believe limit their ability to operate effectively in a changing environment.

Policy Options for Issue 1

Congress has two options:

1. Continually fine tune the legal/regulatory structure to account for short-term

changes and trends in the forces that

shape the financial service industry.

2. Undertake a fundamental redesign of the

policy structure governing the financial

service industry.

Option 1: Continue to modify existing legal/regulatory structure to reflect short-term changes.

This course reduces the possibility that

there will be an abrupt change in the operations of the financial service industry. Congress would continue its ongoing oversight of

the financial service industry and continually

fine tune policy to meet the needs of evolving

conditions. However, congress may find itself

trying to mitigate the undesirable effects of

change after the time has passed when preventive measures might have been taken. Also,

the structure that may result from this approach is likely to become so complex and

cumbersome that it will hamper the efforts of

the financial service industry to serve the

needs of the Nation.

Option 2. Undertake a fundamental redesign of the

policy structure.

Congress may choose to step back from the

problem, the changes that have taken place in

the conditions that shaped existing policy, and

Ch. 9—Policy Issues ● 227

formulate new policies. Such a policy structure, because it would be coherent in its treatment of the elements of the market and the

industry and clear in its concepts of national

needs and the public interest, is likely to be

more robust in the face of future change than

policies developed incrementally.

A comprehensive review and reformulation

of the policy structure governing the financial

service industry will require time; and the rate

of change in the industry will not abate while

new policies are being formulated. Ongoing

events will require response and divert attention from the long-term perspective. The task

is difficult but, realistically, doable.

Issue 2: What are the mechanisms available to

Congress for implementing policy pertaining

to the financial service industry?

Specifically, how should tradeoffs be made

between the objectives of maximum economic

efficiency, protection of local interests, and

other social objectives?

Policy Options for Issue 2

Congress has three broad options:

1.

2.

3.

Continue relative deregulation or marketdetermined solutions by continuing to

relax constraints on the industry and by

taking little action to neutralize events

taking place in the market.

Deregulate, taking into account the factors that have changed the effects of various provisions of the old structure on providers and users of financial services.

Instead of comprehensive regulation of

most services, establish compensatory

programs that work through the marketplace to bring about conditions deemed

desirable. (Organizations such as the Federal Home Loan Mortgage Corporation

and the open market operations of the

Federal Reserve serve as precedents for

this alternative.)

Option 1: Continue deregulation.

Congress may conclude that maximum economic efficiency, both in delivering services

and in using those services to direct funds to
228 Ž Effects of Information Technology on Financial Services Systems

productive uses, is necessary to support a rising level of economic activity. If Congress also

concludes that the best way to assure this efficiency is to free the financial service industry

to respond sensitively to market forces, then

it may opt for further deregulation.

The industry, if allowed to follow the path

it is now on, will effectively become less regulated over the next decade. Much of the major legislation focusing on depository institutions and investment banking has already

been neutralized by events or has been revised

to accommodate past changes. Major new entrants in the financial service market operate

outside the purview of the existing regulatory

structure. Some States have taken actions

that further reduce the effectiveness of existing Federal legislation.

It is necessary to remember, however, that

deregulation at the Federal level will in all

likelihood result in greater diversity in State

regulatory strategies. This lack of consistency

could itself introduce inefficiencies in the financial service sector. The patchwork of State

regulation has already posed difficulties for

those that want to deploy regional and nationwide ATM networks. Institutions now seek to

establish portable activities such as credit card

processing in States that permit them the

greatest freedom. This will affect the market

by introducing inefficiencies in allocation of

financial resources and service delivery mechanisms and could result in a mix of financial

service products in some States that is qualitatively different from that available in other

States.

The number and diversity of options available to users will increase and will be fully adequate to sustain and promote a healthy overall level of economic activity in the Nation.

However, the benefits of these services may

carry some risk of pulling financial resources

away from some local communities and of

compromising some socioeconomic objectives.

The general effect will be to shift financial

resources toward their highest economic use

without regard for social values. There is, for

example, some possibility that funds will drain

—

from regions or communities in economic distress or with a less attractive balance between

risks and return than other regions. Large national institutions may be less interested in

community needs than small local banks.

Banks are required, under the Community Reinvestment Act, to give high priority to

meeting the needs of their communities, although there has been little pressure to do so.

Other kinds of financial institutions do not

have this requirement. Unless ease of entry for

new competitors continues and the market opportunities are sufficiently attractive to draw

them in, local needs may go unmet, and Congress will then be faced with the need of rectifying inequities.

Alternatively Congress could limit the percentage of loan capacity that a financial institution makes available for national and international use. The highest economic use for

resources is not always the same as the highest social priority. An adequate supply of

housing and opportunities for home ownership

are, for example, generally accepted as national policy objectives. So, too, are protection of

small farms and small business opportunities.

Under strong competitive pressures, helped

along by rate fluctuations and a tight money

supply, money may tend to move away from

long-term, fixed-interest loans, such as mortgages. This could have significant detrimental impacts on the supply and cost of housing,

the construction and real estate industries,

their suppliers, and government housing programs unless alternative loan instruments are

developed. Money may also be funneled away

from loans for local entrepreneurs and small

businesses and from rural banks that supply

seasonal loans to farmers.

On the other hand, as financial resources are

drawn into high-growth areas, they will tend

to moderate interest rates and have a stabilizing effect. This would continue the function

of redistributing financial resources that has

been historically performed by the financial

service industry.

Thus, policies that encourage highly competitive national money and capital markets may
Ch. 9—Policy Issues ● 229

———— —— —.——— . ———— — .—

produce significant economic benefits, even

though there is a potential penalty in terms

of limiting the funds available for social programs that have been considered to have

high social value but produce little tangible

product.

Option 2: New regulations.

If, on the other hand, Congress chooses to

develop a new regulatory structure for the financial service industry, it will be faced with

the formidable task of identifying a set of policy variables that will be comparatively insensitive to changes brought about through the

operation of market forces coupled with the

influence of technological change. Some have

suggested, for example, that regulation be by

function, as is the case with the Fair Credit

Reporting Act, which places specific requirements on all who offer credit to the public.

Others believe that regulation by specific product would be appropriate. For example, any

provider could offer a federally insured account as long as specific criteria with respect

to reserves and auditability were met. Still

others would continue the regulatory focus on

institutions, and others would focus on the

systems used for delivering services. Some

combination of these approaches could be

viable. Each has its strengths and weaknesses.

None would be simple to develop, and all

would be difficult to insulate from the kinds

of changes now taking place and those expected in the future.

Option 3: No comprehensive regulation; instead,

active Federal role in marketplace.

Finally, Congress could establish a role as

an active participant in the marketplace for

the Federal Government. It could, for example, provide payment services for areas abandoned by firms in the private sector. It could

enter the financial markets, as it now does in

the case of mortgages and student loans, to

assure the availability of funds for socially

worthwhile products. As noted, market intervention of this type has a precedent and does

not put the Government in the position of having to anticipate the specific effects of technology and market forces on the availability

of capital and on the accessibility of services

to the public. Such a policy would be robust.

It could, however, add substantially to budget

deficits.

At a minimum, some Federal presence beyond an insurance program to ensure the safety and soundness of the financial service industry is likely to be required. But a debate

such as the one about the Federal Reserve as

a provider of financial services is likely to develop and intensify over time whenever Government actions encroach in areas the private

sector feels it can serve adequately. Also the

Government may not be able to adjust rapidly

enough to changes in market conditions to react in a way that does not introduce instabilities into the marketplace.

Structural Issues

Issue 3: What levels of concentration in the

financial service industry are consistent with

the goal of preserving competition among

providers of financial service?

One of the fundamental objectives in financial service policy has been to prevent the excessive concentration of economic and financial resources in relatively few powerful

organizations. This has, for example, been the

motivation for prohibitions on interstate banking and intrastate branching, for preserving

the unique role of banks by limiting their activities, for insisting on sharp separation between

categories of financial institutions, and for

controlling interest rates according to the type

of accounts covered. These provisions were in

part to protect smaller or specialized institutions, especially local institutions, against unfair competition from very large institutions

and in part to maintain a diversity of niches

within which competition could flourish.

These regulatory strategies have been overtaken by the use of information technology

that destroys the advantage of proximity,

allowing institutions to share data banks and

delivery mechanisms and by institutional relationships that ignore both jurisdictional

boundaries and regulatory definitions of in-
230 . Effects of Information Technology on Financial Services Systems

stitutional categories. The new technology

also has paradoxical effects on economies of

scale. To compete in a national money market,

an institution must offer its services to a wider

market, deliver them without regard to the location of the user, and support these activities with a large volume of transactions. On

the other hand, through access to shared networks and wholesale support services, even

very small institutions can now enter and remain viable in local markets.

Regulatory strategies have already been

modified to respond to these economic and

technological pressures, but on a piecemeal

basis. As a result, traditional financial institutions are fiercely competing with one

another and with new organizations, including

nonfinancial institutions, that are entering

their markets. It is not clear how existing antitrust tests apply to this sector in these circumstances, since it becomes progressively

more difficult to define markets. It is clear,

however, that in spite of–or because of–the

fierce competition now underway, the potential exists for increased concentration of financial resources and for the development through

repeated mergers and acquisitions of large

organizations with excessive size or power in

financial markets.

It is possible that the kind of competitiveness that was desirable in the past, as measured by the number and size of institutions

and the scope of their markets, is no longer

appropriate in view of several changes:

●

●

●

●

●

●

●

●

the increased size of the population,

the increased level of U.S. economic activity,

the increased size of industrial markets,

the increased scale of commercial organizations,

the increased volume of international

trade,

the increased diversity of services,

the redefinition of the roles of financial institutions, and

the decreased advantage of proximity for

users of financial services.

Congress will want to consider in the context of these changes whether intense and increasingly uncontrolled competition will work

to the detriment of some important segments

of the industry, will encourage financial institutions to take excessive risks, or will result

in harmful consolidation of economic and financial power.

Policy Options for Issue 3

Option 1: Allow market forces to continue as a primary determiner of the evolutionary path for

the financial service industry even though they

may create major consolidated, national services organizations.

As long as entry barriers remain low, small

firms are likely to appear on the scene to meet

local needs. If banks remain subject to special

restrictions, they will be at a competitive disadvantage relative to other kinds of financial

institutions in operating in the national market. Continued reliance on existing antitrust

legislation to prevent excessive concentration

of financial power would face increasing difficulty in defining markets and market participants for the purpose of antitrust enforcement

actions.

Option 2: Define criteria under which mergers

would permitted and firms would be allowed

to enter or leave a market.

Again, with this option, it would be difficult

to define market boundaries for the purpose

of evaluating adequacy of competition following a merger. Problems of defining minimal

services levels and alternatives for meeting

them would have to be resolved before decisions on permitting firms to exit a market

could be made. Unless the law were structured

to prevent it, unregulated services providers

would continue to use new technologies to enter the market outside of the existing regulatory structures. Such entrants would affect

the competitive balance in a market and would

be free to exit even though the result would

be a level of service that falls below acceptable minimums.
Ch. 9—Policy Issues • 231

— ————.—.. — —

One or more organizations, public or private,

could be assigned the role of provider of last

resort to fill voids in the availability of financial services. However, regulators would then

be faced with the problem of determining when

alternative suppliers have, in fact, abandoned

a market, making it necessary to call on such

providers.

Option 3: Highly regulate only a specific set of financial services.

The model of the telecommunication industry could be followed, in which a specific set

of financial services such as deposit-taking

would be highly regulated. Competition in

these product areas would be tightly controlled and maintained so that the market

could not be controlled by just a few firms. All

other financial services could be offered by

almost any type of institution in a virtually

unregulated market. The regulated financial

service institutions could offer unregulated

products only through arms-length subsidiaries so that there would be no cross-subsidization between regulated and unregulated

services. This approach would have the advantage that those financial services where safety

and soundness is of greatest concern would be

tightly controlled, and competition would be

preserved. But the fact that technological

means would almost always be found to bypass any boundaries that might be drawn between product areas suggests that this approach will be difficult to implement.

The definition of basic financial services—

those to be regulated-and the identification

of those offering them would be difficult. Service providers would, using innovative information technology, tend to design services that

closely approximate but are not technically

identical to regulated services and to offer

them in the unregulated market. There would

be no guarantee of adequate competition in

the unregulated markets, and antitrust laws

would provide the only means through which

excessive concentration of financial power

could be prevented.

Issue 4: What modifications, if any, could

be instituted regarding restrictions on

interstate banking?

Restrictions on interstate banking were intended to prevent financial resources and control over credit from becoming progressively

consolidated in a few powerful institutions.

They were also meant to maintain a local orientation and interest and to preserve for consumers the convenience and access afforded

by proximity to financial services. Lately,

these restrictions have been in large part

rendered ineffective. The sharing of ATM networks allows some banking functions to be

carried out from remote locations. Some

banks, with regulatory approval, have bought

banks and savings and loan associations in

several States. Nondepository institutions offer services nationwide that are perceived by

users as functionally equivalent to traditional

bank accounts. Regional and national networks have made proximity to the service provider no longer a necessary measure of convenience for the user. However, restrictions on

interstate banking still place banks at some

disadvantage vis-`a-vis other financial institutions. For example, facilities to accept demand

deposits generally are not placed across State

lines, but corporate clients are provided this

service indirectly by means of zero-balance accounts linked to consolidation accounts in

another State. Interstate banking restrictions

have probably protected some inefficient institutions that would otherwise have been

driven out of the market.

Policy Options for Issue 4

Option 1: Remove or modify restrictions on interstate banking.

Congress could act systematically to remove

all remaining restrictions on interstate banking. To do this would require Federal legislation repealing the interstate banking prohibitions in the McFadden Act and the Bank

Holding Company Act, thus withdrawing Federal consent to State statutes Mocking in35-505 0 - 84 - 16 : QL 3
232 Effects of Information Technology on Financial Services Systems

terstate commerce. The overall effect would

be further dissociation of financial service institutions from orientation toward a particular

community, market, or region, and further integration of a national financial service market. Removing restrictions on interstate banking would tend to strengthen a trend toward

consolidation, since some financial institutions

would probably not survive competition with

large national firms. On the other hand, it is

possible that financial services might be extended to some now underserved or isolated

communities from depository institutions in

neighboring States.

Congress could, by amendment to the McFadden and Bank Holding Company Acts,

modify restrictions on interstate banking to

allow and encourage areawide banking in multistate metropolitan areas, or regional banking in multistate market areas (as is already

done in New England under an interstate

compact).

Option 2: Reinforce limitations on interstate

banking.

Alternatively, Congress could strengthen

restrictions on interstate banking by removing all loopholes. The Federal Reserve has just

moved to plug one loophole by redefining commercial deposits to include NOW and Super

NOW accounts. Following the reasoning that

led Congress to pass legislation legitimatizing

ATMs deployed by savings and loan associations after the courts had declared them illegal, it does not appear feasible nor desirable

to dismantle interstate ATM networks or to

prohibit the cash management programs offered by brokers. It would be possible to extend reserve requirements to all institutions

that operate depositlike accounts, including

securities dealers. This might, however, imply

giving all of these institutions access to the

payments system or to deposit insurance.

One possibility is to establish rigid criteria

for entry to and exit from the market, including criteria for permitting mergers. But, such

criteria would be hard to define and enforce

because institutional boundaries and product

lines have already become so blurred. Criteria

would have to be defined in terms of market

share or in terms of control over deposits or

total assets. Given the heterogeneity and

fluidity of the industry, this would also be hard

to do.

Other possibilities are to continue to prohibit holding companies from owning depository

institutions in more than one State, as was the

case until the 1980’s, or to subject all depository institutions to a rigid prohibition on interstate banking, which would require preemption of State laws and extension of relevant

Federal laws to cover savings and loans and

credit unions.

Some way might be found to strengthen and

broaden the Community Reinvestment Act,

possibly by requiring local development loans

at a level pegged to the level of deposits

gathered from an area. This would be a factor

limiting the flow of funds out of the areas generating them.

Issue 5: How might law and regulation be used

to focus the attention of various classes of

financial service providers on specific

market areas?

Federal policy since the 1930’s has allocated

specific functions to specific financial institutions. But recently, a combination of technological innovations and market forces has significantly weakened the functional distinctions

between types of financial institutions. This

condition has developed gradually, with few

of the steps along the path involving positive

decisions by policymakers. It may be appropriate now for Congress to reexamine the question of whether public interests still require

the limiting of some roles and functions to a

special category of financial institutions.

Banks and thrifts are unique institutions be

cause they alone have access to the payment

system. Funds are transferred from one account to another only within banks. All transactions not carried out by exchange of currency (except for some internal clearing) are

ultimately culminated within the banking system, and all financial institutions must ultimately call on a bank for the final step in delivering a service. Banks also allocate credit

by making and guaranteeing commercial loans.
.

Ch. 9—Policy Issues . 233

—

Because of this dependence, the safety and

soundness of banks-and public confidence in

them—are an essential underpinning of the

economy. National policy therefore has always

been to treat banks differently from other

kinds of financial institutions and to prohibit

them from engaging in other kinds of commercial activity. Specifically, the goals of this policy

●

●

●

●

have been to:

insure the soundness of banks (originally

the purpose of both reserve requirements

and depository insurance);

limit the risks that banks could assume;

prevent conflicts of interest, such as

would occur if banks directed investment

to or allocated credit to commercial activities in which the bank had an equity interest, or if banks required borrowers to

purchase insurance underwritten by the

bank; and

prevent concentration of financial resources by forbidding banks to participate in certain kinds of investment activities, such as underwriting stock issues

and casualty or life insurance.

Other financial institutions, and in some

cases nonfinancial institutions, are now encroaching on activities once limited to banks

—i.e., offering accounts that consumers perceive as functional equivalents of depository

accounts but with the advantage of higher interest rates. Nondepository institutions are

buying banks, gaining access to the payment

mechanism through them, and acquiring their

assets and customers, They are then abrogating one or more of the two functions that

define a bank (i.e., accepting commercial deposits, making commercial loans) in order to

escape Bank Holding Company Act prohibitions on nonfinancial activities.

Banks and bank holding companies, in retaliation, are seeking to expand into other

services, for example, offering insurance in

States where laws permit and increasing their

offerings of data processing services. Low-cost

or free deposits, the traditional source of funds

for banks, are drying up as corporations practice zero-balance banking and savers transfer

their money to higher interest accounts and

money market funds. This forces banks to try

to expand their customer base by offering a

greater diversity of services and to increase

fees.

However, as banks and other depository institutions expand their activities into other

lines of commerce, the level of risk they are

subject to may increase. Any increase in institutional risk is accompanied by an increase

in the levels of risk for both the stockholders

and clients of the institution to the extent they

are not covered by deposit insurance. Ultimately, the level of risk facing the financial

service industry as a whole would increase.

The general policy of deregulation suggests

that financial institutions could compete on

an equal basis if barriers between various

types were dissolved. For example, thrift institutions were, for a time, severely threatened

when they were stuck with low-yield portfolios when interest rates rose; they may be

so threatened again. Federal policy has been

to try to save troubled thrift institutions by

allowing, encouraging, or arranging mergers.

This includes mergers across State lines and

mergers of mutual savings banks with commercial banks. More recently, Federal savings

and loan associations have been allowed by the

Garn-St Germain Act of 1982 to offer consumer loans of up to 20 percent of assets and

to offer other consumer services so that their

portfolios will contain assets and liabilities

with better matched maturities.

On the other hand, thrift institutions in the

past received some preferential treatment because they are the major source of loans for

housing. An adequate supply of housing and

a high rate of home ownership are widely accepted as social policy objectives, and a decline

in the housing market has severe impacts on

other sectors of the economy.

Policy Options for Issue 5

Option 1: Modify powers to offer financial services.

Congress could repeal Federal laws and regulations limiting the services that banks can
234 ● Effects of Information Technology on Financial Services Systems

offer and the activities in which they can engage. The U.S. Treasury has proposed that

through holding company subsidiaries banks

be allowed to engage in virtually all financial

services. This is a movement toward deregulation, to “put all the players on a level playing

field. ” It would be likely to increase the purchase of banks by other financial and nonfinancial institutions and to stimulate the

buying up of small banks by bank holding

companies. It would increase the possibility

of banks exerting pressure on customers to

buy nonbank services or products.

Congress could instead tighten the loopholes

in laws and reaffirm the special and limited

role of banks. Institutions that accept governmentally insured deposits could be permitted

to offer only limited other services. Institutions that provide other services (either financial or nonfinancial) could be forbidden to own

or control institutions that accept insured deposits.

A third possibility is to extend the barriers

against banks diversifying their services by

bringing all State banks (including those that

are not Federal Reserve System members)

under the Glass/Steagall Act through Federal

preemption, so that States cannot use permissive laws to attract banks into relocation.

Finally, Congress could make modifications

in laws and regulations to restrict (or allow)

specific activities. It has been proposed for example that banks or bank holding companies

be permitted to:

underwrite mortgage-backed securities

and offer mortgages so as to lower mortgage interest rates through increasing

competition (as the Federal National

Mortgage Association already does);

offer mutual funds, in order to bring down

management fees and sales commissions;

and

underwrite municipal revenue bonds, to

supplement the effects of discount brokerage in increasing the market and lowering costs for municipal and State governments.

Option 2: Modify powers to effect mergers.

Congress could continue to allow other institutions to merge with or buy savings and

loan (S&L) associations. If the acquiring firms

use the savings and loan associations as

sources of cash, the general effect will be a

gradual reduction in money available for mortgages. Any company can now buy an S&L.

Only if the company owns more than one

S&L—and is therefore an S&L holding company-must it restrict its activities to housing finance, or even continue to offer housing

finance. Nonfinancial institutions have already

seized on the opportunity to buy S&Ls to gain

access to some of the privileges and prerogatives of depository institutions, for example,

federally insured accounts.

Congress can continue to allow mergers between thrift institutions, as the Federal Home

Loan Bank Board is now doing. The likely outcome will be a smaller number of larger thrift

institutions, but this may not solve the problem of attracting an adequate supply of funds.

Option 3: Provide incentives to support specific

activities.

Congress could further provide capital assistance for thrift institutions. A Federal subsidy for thrift institutions could be justified

on the grounds of the high social priority of

housing, but it would add to Federal expenditures, increase the Federal deficit, and set a

precedent when other financial institutions

run into trouble. Congress could revise tax

laws to encourage S&Ls to diversify their services further and to broaden their revenue base.

It is not clear whether without this incentive

the S&Ls will diversify enough to generate increased earnings.

Congress may want to provide incentives to

stimulate other sources of mortgage money

rather than attempting to turn back the clock

on thrift institutions, which may not be operationally possible.
Ch. 9—Policy Issues ● 235

— —

Issue 6: How will further deregulation of

telecommunications affect the financial

service industry?

An important consideration for future financial service policy will be the cost of telecommunications. As a result of the breakup of

AT&T, Congress is now coming to grips with

a broader issue of control of telecommunication costs; specifically, with the issues of access charges. It is expected that following the

breakup, long-distance telephone rates will decline as a result of increased competition between suppliers, while local communication

rates will tend to rise to compensate regional

telephone companies for the loss of income

from the Bell system. Congress is debating

whether to levy a monthly access charge for

all telephone use, which would tend to decrease

the need for high overall local rates.

The distribution of function within the design of a system to deliver financial services

is directly related to communication costs. Increased costs for local communications may

discourage the use of third-party data processors, and small financial institutions may

find it more difficult to enter the market or

survive in the market. Financial institutions

will attempt to move data processing toward

the end-user in order to minimize the time a

user must remain connected with a service provider’s computer, i.e., encourage home banking. But consumers may reject this service entirely if either entry or maintenance costs are

too high.

Comment on Issue 6. –The factors and relationships that must be considered in developing telecommunication policy are extremely

complex and full consideration of them is

beyond the scope of this assessment. However, Congress should be aware that telecommunication costs have a strong and direct influence on the economics of financial service

delivery systems. Changes in telecommunication policy can result in the need to modify the

structure of financial service delivery systems

considerably.

Issue 7: What steps could be taken to realign

the legal/regulatory structure to make it

conform closely to the changing structure of

the financial service industry?

Laws and regulations generally apply to specific categories of service providers. The operational differences between depository and

nondepository institutions are progressively

eroding, but these categories are still subject

to different regulatory bodies. They have, in

some cases, different interest rate ceilings, and

they are subject to different restrictions on interstate operations and on intrastate branching. A financial institution, in fact, can sometimes select its regulatory climate by changing

its organizational structure. S&L associations

enjoy special tax incentives if a majority of

their activities are housing loans. Accounts in

depository institutions are federally insured,

while other kinds of accounts are not. The

buyer of services has different benefits, different risks, and different safeguards and

rights, according to which service provider is

selected. The consumer, however, is often

unaware of the subtle and detailed differences.

Policy Options for Issue 7

The problem of how best to design, or revise,

a regulatory structure for the financial service industry involves many subsidiary issues,

such as Federal deregulation versus Federal

preemption, institutional versus functional

regulation, and self-regulation versus government regulation. The options considered below

are not necessarily mutually exclusive:

Option 1: Design regulations to apply to functionally defined services and achieve specific

policy objectives, without regard to the institutional provider of the services.

This option would put all financial institutions competing for a particular market niche

on a more equal footing. It would mean, however, that each of an institution’s services or

functional activities would be considered separately. Yet the total mix of services offered
236 Effects of Information Technology on Financial Services Systems

—.— — — —

would affect the behavior of the providing institution, the level of risk that it assumes, and

its relative power in the marketplace. If various regulations were administered by different

regulatory agencies, each financial institution

might be subject to multiple regulatory agencies that may at times have overlapping or

contradictory requirements and restrictions.

Option 2: Federally preempt all State legislation

and regulation of financial services.

This option would provide consistency and

reduce uncertainty for the industry with the

possible result that financial service providers

would become more active in developing and

deploying services that the public would find

attractive and useful. Yet the existing dual

banking system has served well in meeting

varying needs for financial services. Federal

preemption would eliminate this duality and

could reduce the degree of responsiveness of

financial service providers in meeting local

needs.

Option 3: Abolish all Federal regulations, allowing the States to control financial services fully.

This alternative would allow each State the

maximum opportunity to achieve local objectives and to meet local needs for financial services. It would also encourage many practical

experiments and much innovation as States

adopt alternative regulatory strategies. But

States would also be prevented by the Commerce clause of the U.S. Constitution from

barring entry by out-of-State banks. Nationwide financial service institutions would, how

ever, suffer from the inconsistencies in restrictions and requirements.

Option 4: Combine all Federal regulatory functions

pertaining to financial services under one Federal agency, mandated to develop an internally

consistent system of regulations for all financial services.

On the one hand, this alternative would introduce a degree of consistency into the regulatory structure that is now lacking. Institutions would no longer be in a position where

they seek charters from the agency that best

suits their intended mode of operation. The increasing homogeneity of the market for financial services would be recognized in a unified

regulatory structure.

Yet, the regulators serve the interests of spe

cific constituencies that consist of both the institutions they oversee and their customers.

If this diversity of perspective were eliminated, specific needs could go unmet.

Issue 8: Concerns of foreign governments

regarding the protection of individual

privacy could lead to the erection of barriers

for American financial service firms doing

business overseas. What steps could the

United States take to address these

concerns or circumvent the barriers?

Not only is the Nation continually moving

toward a more highly integrated national economy, but it is increasingly knit into a global

economy in which markets, trade patterns, fiscal and monetary policies, and currencies are

linked across national boundaries.

Worldwide delivery of financial services has,

for well over a century, depended on telecommunications and is now more than ever completely dependent on advanced technologies.

Rapid and free movement of funds and related

data internationally is essential. Financial institutions and other types of enterprises have

branched across national boundaries and depend heavily on being able to move data freely,

and confidentially, between plants and offices

in several countries. The ability to access

resources anywhere in the world from any

other location has become an important factor in the operation of multinational corporations and in international trade.

Financial service organizations operate centralized systems that concentrate data processing for worldwide networks at one or a very

few centralized points. Some, such as those

that provide credit authorizations at point of

sale, must be accessible from thousands of locations and must have a high degree of reliability. They move customer transaction data

at high speed across all boundaries.
Ch. 9—Policy Issues ● 237

The ability to initiate a transaction from a

remote location unfortunately also implies the

ability to initiate fraudulent transactions; to

monitor, interfere with, or extract data from

a system from remote locations.

In a sudden hostile confrontation with

another country, such as occurred with the

Iranian hostage situation, the option of freezing the assets in the United States of the

foreign power may be lost. Electronic execution of an order to transfer the assets from

U.S. jurisdiction could be completed more

quickly than a freeze order could be made effective. Foreign-owned banks might also, in

some situations, provide to their governments

or industries privileged information about U.S.

industry.

Some nations have passed laws limiting the

collection and dissemination of data associated

with 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. Some

nations are taking the position that they will

not allow some kinds of data to be sent to nations that do not have restrictions on access

and movement of data that are at least as

stringent as their own.

Such restrictions could cause problems for

U.S. firms because this country has not chosen to restrict the collection and dissemination

of data in ways that would be seen to meet

such requirements. To do so may place the

United States in a position of establishing domestic policy in response to requirements arising abroad, a situation that may become more

common as the global economy becomes more

highly integrated and interactive.

A related concern is the possibility that international data-processing centers concentrated in a few countries are vulnerable to terrorist or military attack. As the reliable and

orderly flow of international information

becomes more critical to the U.S. economy,

policy makers and national security planners

must be aware of these vulnerabilities.

Worldwide information services may tend

to increase global debt exposure and under

some conditions could be destabilizing to

world currency, commodity, and security markets. However, they could also be used to

monitor and control international debts and

repayments better and to overcome the destabilizing effects of a major debt default.

The national interest here is threefold: to

stimulate and support the U.S. position in

world markets, to further U.S. international

diplomatic objectives, and to maintain national security.

Policy Options for Issue 8

Option 1: Establish no stronger protections for individual privacy’ than already’ exist.

The United States might test the proposition that the desire to have full financial relationships with institutions in the United

States will be strong enough to overcome all

other considerations. But the possibility exists that foreign governments with strong

privacy protection laws may not be willing to

allow the free flow of financial and payment

data to and from the United States without

specific protections instituted at a level commensurate with those provided their own citizens within their own borders. Any foreign

bans that are instituted may focus only on

electronic transmission of personal data to and

from the United States, in which case the alternative of using nonelectronic media would still

be available but could result in significant delays in the movement of funds and data.

At this point there is no compelling force

motivating change. It does not appear to be

an imminent probability that one or more nations will significantly restrict the movement

of financial data to and from the United

States. But this situation could change

rapidly, and if this option is chosen Congress

will want to continue monitoring developments in this area.
238 Effects of Information Technology on Financial Services Systems

Option 2: Institute policies defining more precisely

the conditions under which financial data can

be collected and disseminated across national

boundaries.

Under this option, U.S. privacy protection

law would be harmonized with foreign laws to

a greater extent, at least in the case of financial services data. Such policy might become

necessary, should foreign privacy laws come

to be applied to data transmitted and stored

in computer systems on U.S. territory. Although Federal privacy law has not, in general, been applied to privately held data systems nor is there presently significant overt

domestic pressure to extend it in that direction, precedent does exist in the particular case

of banks for Federal laws concerning the handling of personal information.

Issue 9: What organizations could be granted

access to the mechanisms for clearing

checks, securities, and other payment

instruments such as credit card drafts?

Only depository institutions now have direct

access to the payments mechanism-clearing

accounts with the Federal Reserve System,

membership in local and regional clearinghouses, and membership in automated clearing house associations. Securities broker/dealers clear listed stocks and bonds through the

organized exchanges, and market makers clear

issues traded over the counter. Clearing mechanisms provide the means by which funds are

transferred between and among accounts held

by approximately 40,000 institutions in the

United States. Without this means of conveying payment instructions between institutions

and settling accounts, there would be no payment medium other than cash. Similar networks exist between the airlines for clearing

among carriers that honor one another’s tickets and between petroleum companies for settling crude oil accounts.

The essential elements of a clearing mechanism are the existence of an account through

which net settlement can be accomplished and

a means for transferring instructions that tell

the account holder the amount to be transferred and the party to be credited. Banks

have traditionally been the only ones able to

establish settlement accounts and be party to

the network for accomplishing the required information transfers.

In the present environment, nondepository

financial institutions establish relationships

with banks to obtain access to the payment

mechanism. Drafts on accounts held by the

nondepository institutions are cleared through

the existing payment system and paid from

a common account, normally maintained at

zero balance, at a clearing bank. Only when

the drafts are presented to the nondepository

institution with whom the individual customer

deals are the funds debited from the individual’s account.

Banks and other organizations are not restricted in establishing arrangements for processing drafts similar to those in existence between operators of money market funds and

banks.

For example, if the employees were agreeable, an employer could make an arrangement

whereby employees are credited daily on the

company’s books with wages earned and are

permitted to write drafts against those funds.

The employer would then fund an account

with a depository institution to cover drafts

as they are presented and debit the accounts

of individual employees for appropriate

amounts. Regardless of the balance between

benefits and drawbacks, such an arrangement

would be operationally feasible.

The arrangements for clearing through a depository institution with access to the payment mechanism can be seen as being somewhat artificial. Given the technologies now

available for moving and processing payment

information, one could argue that others

besides banks be given the option of establishing clearing accounts with institutions that

offer them. A routing-transit number would

have to be issued to any organization permitted such access to the clearing mechanism.

The question remains as to whether it is in

the public interest to allow such arrangements.

On the one hand, the existing regulatory structure provides assurances that parties to the
. —

Ch. 9—Policy Issues ● 239

clearing mechanism will be able to settle accounts as required. Opening the mechanism

to unsupervised nondepository institutions

not bound to existing requirements to meet

settlement schedules could weaken the system

and hence decrease the safety and soundness

of the financial system as a whole. Under existing arrangements between banks and fund

managers, the bank must settle with the payment system, even if the fund fails to meet its

obligations. On the other hand, requirements

could be established to ensure safety and

soundness of the system that would have to

be met by nondepository organizations that

may be granted direct access to the payment

mechanism.

Policy Options for Issue 9

Option 1: Retain restrictions on access to the

payments mechanism.

Congress could choose to retain the present

system whereby membership in clearing systems is limited to organizations meeting specific criteria. One could argue that the present mechanism works well and has been able

to accommodate the changes that have taken

place in the financial service industry. The

safety and soundness of the industry have

been well protected, and changes that create

the possibility of weakening either should not

be allowed.

On the other hand, there is a real possibility that innovative people will develop clearing systems that will operate outside of established channels. Off-market trading is a

reality, and there is nothing to prevent the

emergence of analogous systems for clearing

payments. Nondepositor institutions have

already gained access to the payment mechanism by acquiring banks and S&L associations. Electronic systems (especially packet

switching) will lead to diverse channels for

transmission and perhaps settlement, as will

the requirement for explicit pricing of Federal

Reserve services. Thus, as in so many other

parts of the lega.1.regulatory structure governing the financial service industry, the present

rules for access to the payments mechanism

may be circumvented by applications of available technologies.

In the extreme, Congress could rule that all

payments pass through the established payments mechanism. However, with the existence of private clearing arrangements between

financial institutions and the multiplicity of

systems for clearing payments, it would be extremely difficult to codify exactly what constitutes the established payments mechanism

and the characteristics of clearing arrangements that would not be permitted under such

a policy.

Option 2: Open the payments mechanism to other

than depository institutions.

At the other extreme, Congress could open

the payments mechanism to all who would

join. As indicated, blanket access could

weaken the safety and soundness of the financial service industry in that occasions where

there would be failure to settle would become

more likely.

As an interim step, the payments mechanism could be opened to nondepository organizations that would be willing to meet criteria

designed to ensure continued integrity of the

system. Such requirements could include provisions for maintaining reserves and provisions that members be audited to determine

if they meet criteria for membership or that

they obtain performance bonds or insurance

that guarantees their ability to settle.

Yet, exclusivity of access to the payment

mechanism by depository institutions balances some of the relative disadvantages of

such an arrangement under the present legal/

regulatory structure that limits the range of

activities in which depository institutions can

engage. The major sources of revenue of depository institutions in the future will be

payments for services provided rather than

the spread between the rates at which funds

are obtained and those at which they are lent.

Opening the payment mechanism to others

could substantially affect revenues of depository institutions and, ultimately, because

alternative sources of revenue are limited,
240 . Effects of /formation Technology on Financial Services Systems

their ability to remain viable competitors in

the marketplace.

Issue 10: What alternatives for regulating

interest rates are available to Congress?

In recent years, when market rates have exceeded Federal and State limits, significant

quantities of funds have moved from banks,

credit unions, and S&L associations to alternative investment opportunities created by

new entrants to the financial service industry.

These new entrants have relied heavily on advanced telecommunication and information

processing technologies to implement their

offerings. Constrained interest rates effectively limited the supply of funds to some investments.

Complete deregulation of interest rates

would allow service offerings to respond to

market forces, the price of services to be held

down by competitive pressures, and interest

rates to reflect national market conditions.

However, to the extent that firms do not

recognize the costs their actions impose on

others, market forces may not reflect all social

priorities. ’ It may be in the public interest,

under some circumstances, to modify or constrain the action of market forces on interest

rates in order to preserve certain social objectives.

Interest rates, other than for corporate demand deposits, will be essentially decontrolled

by 1986 as Regulation Q is phased out. It is

possible that this situation could, under some

conditions, result in the equivalent of price

wars. Financial institutions have been known

to raise interest rates to unsupportable levels

in attempts to attract deposits. Widespread

actions of this type could lead to an excessive

number of financial institution failures, and

as a result, could seriously destabilize the economy. Selective control of demand deposits and

savings account interest rates is likely to cause

IControls on the rates paid on deposits by depository institutions, controlled under the Regulation Q system of ceilings,

are being phased out under provisions of the Depository Institutions Deregulation and Monetary Control Act of 1980.

funds to be drained from depository institutions. Usury laws restrict the supply of credit

when interest rates are rising.

Policy Options for Issue 10

Option 1: Federally regulate all interest rates for

all financial services and all institutions; preempt State usury laws.

Assuming the Government would set a national rate, this option would create uniform

ity of interest rates across the Nation. Funds

would not be moved from area to area in

search of higher returns while they become virtually unavailable to those in need of credit

in areas where rates have been capped at below

market levels. Interest rate ceilings might be

lifted to improve customer access to credit and

to attract savings and investments; interest

rates might be capped to reduce inflation or

economic instability. They might be manipulated to preserve, for example, a housing differential.

On the other hand, the ability to set rates

locally helps ensure their responsiveness of

credit markets to local needs. This would be

lost if the Federal Government were to preempt all regulation of interest rates.

There is no reason that a national rate be

set. Rates could be set regionally or set in

terms of ranges rather than at specific values.

Such strategies could mitigate some of the disadvantages of this alternative, but the difficulty of implementing them operationally

should not be underestimated.

Option 2: Completely deregulate interest rates.

In economic theory, at least, this option

would allow funds to flow to highest value uses

in terms of the costs and benefits included in

the calculus. However, if indirect costs and

benefits are not recognized, the resulting

allocation of resources could be suboptimal.

It would increase the availability of credit, but

credit could be priced to levels that would effectively deny it to some consumers or cause

them to change their way of life as they divert

funds to cover its cost.
Ch. 9—Policy Issues ● 241

—

Option 3: Federally cap interest rates only for accounts covered by deposit insurance.

This option would cause money to be withdrawn from depository institutions when market interest rates rise, leaving more consumers

exposed to risk because their assets would be

in uninsured accounts.

Yet, some may view the reduced return as

a cost of security and be willing to incur it.

Limiting the return paid customers would reduce the pressure on institutions to make the

more risky investments that provide higher

yield, thus limiting the exposure of the insurance fund.

Option d: Allow States to regulate interest rates

on all services delivered within the State, whether or not they are delivered by State-chartered

institutions.

Under this option, States may try using controlled interest rates to attract businesses.

Such tactics could significantly disturb the national money market. On the other hand, market forces complemented by the ease with

which information can be rapidly distributed

over wide areas would limit the options of the

States. Individually, they would be able to

selectively cut some rates within a relatively

narrow range to support specific policies; but

no one State would have the power to establish rates at levels substantially different from

the norm. Experience has shown, for example,

that States have not been able to artificially

depress interest rates on loans made within

their jurisdiction when significantly higher

rates were permitted elsewhere.

Risk Allocation Issues

Issue 11: What are the alternatives for

apportioning risk between financial

institutions and their customers and clients?

The purposes of deposit insurance are: 1) to

protect the funds of individuals, households,

and small businesses against loss when financial institutions fail; and 2) to prevent the

widespread economic instability that would result from cascading institutional failures as a

result of a sudden loss of public confidence.

Deposit insurance covers only traditional demand deposits and savings accounts in commercial banks and equivalent consumer accounts with S&L associations, savings banks,

and credit unions.

At present, the Federal Deposit Insurance

Corporation (FIDC) protects the depositor’s

principal up to $100,000. Securities Investor

Protection Corp. insurance, on the other hand,

guarantees the investor’s shares, e.g., against

broker’s failure to deliver, but not the value

of those shares. The “discount window” operated by the Federal Reserve System provides

funds to banks that are temporarily unable to

meet their reserve requirements and thus also

functions as a kind of insurance for the very

short term.

As a result of intermediation (consumers

shifting their money to other kinds of accounts

which give them a higher return), a large proportion of liquid assets and savings are not

now covered by insurance. As banks diversify

into other activities, they increase their risk

of failure. The advantage of being covered by

Federal insurance is one incentive for nondepositor institutions to buy banks and S&I,

associations (increasing the tendency toward

consolidation of financial resources).

Returns on investment recognize and reward acceptance of risk. Although deposit insurance provides an implied safety net for

managers and stockholders of depository institutions, the price of increased efficiency is

increased risk, if only because resources are

tightly allocated, reserves are reduced, and

margins for error are slimmer. The more efficient firms allow less room for error; and,

therefore, the expected cost of a mistake increases. With a higher level of competition between financial institutions, the more efficient

institutions will survive and some less efficient

ones will fail. This is a benefit in economic

terms, but because financial institutions play

a critical role in modern society, their increased failure rate necessarily touches on the

public interest in a way that risks assumed by

other kinds of organizations do not. Such

failures expose individuals, families, small
242 ● Effects of /formation Technology on Financial Services Systems

businesses, and major corporations not covered by deposit insurance to risk of loss of capital or lifetime savings.

Two aspects of risk are involved here: operational risk (failure to settle, an implicit risk

that is increased by the speed that new technology contributes to transactions and settlements) and institutional risk (institutional

failure because of bad asset management). Operational failures, if they shake the confidence

of customers, can greatly increase the risk of

institutional failure. This was the problem that

deposit insurance was designed to solve. However, deposit insurance itself may encourage

firms to take excessive institutional risks by

implicitly protecting them from the consequences of bad judgment.

Excessive risk assumed by financial institutions could affect the stability of the economy, if there is ever a series of cascading

institutional failures in which each firm’s collapse causes the collapse of others. At present, a combination of governmental actions to

protect the deposit insurance fund (generally,

allowing or arranging a merger between an endangered institution and another stronger one)

and ad hoc cooperative actions by large financial institutions to shore up the market, nearly

always prevents the spreading of undue detrimental consequences following any threatened

or actual financial institution failure. But the

speed at which funds are transferred and settlements are made today may make these resolutions much more difficult. Institutional financial crises could spread rapidly.

Many transactions will be timesensitive. If

A fails to pay B, and B is therefore unable to

pay C and D, these disruptive events will multiply with great speed. The increased number

of daily or hourly transactions, the rapid turnover of assets, the smaller reserves held by an

institution relative to the number and dollar

value of transactions, and the complex interrelationships between financial institutions

will contribute to the sensitivity of the financial system to short-term perturbations.

The result will be to increase the sensitivity

of institutional equilibrium to even minor perturbations and to decrease the ability to control the secondary effects of disturbances.

Policy Options for Issue 11

Option 1: Retain Federal insurance, as it is now,

for traditional depository institutions only.

Continuing the present program is consistent with policy that has provided adequate

protection for the great majority of account

holders and many holders of stock in financial

institutions for over half a century. However,

some argue that it gives managers of insured

institutions a false sense of security and permits them to take risks they might not take

in the absence of the insurance. Thus, insured

institutions enjoy some competitive advantage over others in all lines of business in

which they engage.

Option 2: Extend Federal insurance to certain accounts that are not held by institutions now eligible for insurance, but only to a specified low

level per account or per customer.

An extension of Federal insurance to all accounts that function either as transaction or

saving accounts would eliminate a difference

between suppliers of financial services that is

important to many. Providers that are now insured would lose a factor that gives them

something of a competitive advantage over

those that cannot offer insured accounts.

Vulnerability of the financial service industry

arising from the exposure of depositors who

have placed funds in uninsured accounts

would be reduced.

Limiting the maximum amount of insurance

would continue protection for the small depositor that has been provided historically. A

larger proportion of the depositors would be

exposed to loss. Possibly the propensity of the

insuring agencies to find merger partners for

distressed institutions would be reduced because the outlay of funds required if an institution were closed would be limited. Comparatively uninsured depositors would tend to
Ch. 9—Policy Issues ● 243

exert pressure on financial institutions to

avoid unjustified risks and to use sound judgment in making loans and in asset management. Large depositors might also be offered

the option of buying insurance for deposits exceeding the limits of Federal insurance.

Option 3: Vary the insurance coverage and cost

with risk.

This would permit insured institutions to

position themselves in the market in a manner analogous to the way mutual funds characterize themselves. Some funds are growthoriented while others seek stability and try to

generate income for their investors. Depository institutions willing to take higher risks

could purchase insurance at a premium price.

Alternatively, depositors could elect to receive

higher interest rates in return for dealing with

an institution that provides only a reduced

level of insurance coverage. In this environment, the depositor would have greater options than is now the case. However, the

overall exposure of depositors to loss could increase if a significant proportion chose institutions offering lower levels of deposit insurance.

Issue 12: What is necessary to assure an

adequate level of financial service to all

segments of the population and to protect

other basic consumer rights and interests?

In any case, people require some level of financial services in order to carry out their dayto-day activities and participate productively

in the economy. They must at a minimum have

a way of receiving and making payments, and

generally some access to credit. Moreover, one

can argue that they need mechanisms through

which they can express preferences for specific

services from among the alternatives that may

be offered.

Because of the restructuring of the industry and its services, some traditional services

may disappear, and others will be explicitly

priced for the first time, or limited to certain

categories of customers. For example, teller

service may be limited to those with substantial balances, and merchants may be unwilling to accept or to cash checks. Market forces

will tend to cause financial service institutions

to encourage higher income customers, who

are likely to have discretionary income to save

or invest, and to discourage lower income customers with little discretionary income. Some

low-profit services will probably be dropped.

Technology is making it possible for government agencies to operate more efficiently with

regard to making payments. Direct deposit of

all government payments is a long-range objective of the U.S. Department of the Treasury. This would include payments to State and

local governments and contractors, and also

entitlement payments and Federal employee

paychecks. The move to direct deposit may

conflict with the wishes of some recipients.

Realistically, it is likely that some people will

be pressured by government or other employers to accept payment by direct deposit even

when they object to doing so.

Float is not a right or entitlement; rather,

it is an attribute of a system that requires

some period to process payment orders. It is

clear, however, that many corporate cash managers, households, and many small businesses

have in the past counted on float in managing their incomes. Because of information and

communication technology, debits to accounts

are in some situations virtually instantaneous,

while crediting of deposits made by check

must wait until the check is cleared. The customer sees this as an inequity, especially if he

or she is charged for overdraft or automatic

loan privileges during the lengthened gap. In

fact, some financial institutions do abuse this

situation. The technological capability to

shorten the gap is available, but financial institutions need an economic incentive to apply

it.

The right of consumers to full and understandable information about their rights, their

risks, and their obligations in using new kinds

of financial services may need explicit protection. Subtle legal distinctions between functionally similar services are not necessarily obvious to users, and information provided by

financial institutions is not always clear, com-
244 . Effects of Information Technology on Financial Services Systems

— —

plete, or in comparable terms. Significant opportunity exists for misleading advertising of

financial services.

Policy Options for Issue 12

Option 1: Define minimal services to be provided

to consumers.

Congress could require all financial institutions, or those financial institutions choosing

to offer certain services (e.g., accounts that

function much like traditional demand deposit or savings accounts) to provide certain

“lifeline” services, such as teller service or handling of direct deposit Federal payments, without cost to all of those desiring them. Alternatively, it could allow cost-based pricing.

Congress could encourage institutions to

establish an account that can only be debited

electronically as a minimal service for some

who misuse checking accounts but would like

to benefit from such services as direct deposit.

This might, for example, be a condition exacted in return for deposit insurance.

At the same time, Congress may wish to

prohibit mandatory direct deposit of payments or to define legal rights to choice of payment mechanisms, at least in some situations.

Because financial information technology

confers on the depository institution, which

alone has access to the payments system, full

control over the timing of debits and credits

to accounts, Congress may wish to regulate

the exercise of this power to assure that consumers are treated equitably.

Option 2: Define the rights of users to information

regarding availability of financial service

options.

New or revised legislation maybe necessary

to define the rights of users to full and comparable information about financial service

options and alternatives, and to establish a

mechanism for implementing and enforcing

these rights. An explicit policy of “informed

consent” may be desirable. However, the costs

of such regulations should also be considered.

Issue 13: Some changes in the delivery of financial services increase the possibility that

the privacy of citizens could be eroded or

violated. How can Congress reduce the

possibility?

Citizens necessarily accept some diminution

of privacy, or potential diminution of privacy,

by engaging in any transaction other than exchange of currency. Nevertheless, some aspects of information technology greatly increase the opportunities for and the likelihood

of invasion of privacy because data banks are

aggregated, shared, and subject to unauthorized access, including access from remote locations.

The aggregation of financial data increases

its commercial value, reduces the costs of accessing and using it, and thereby increases the

incentive for misuse. Information technology

also allows information to be propagated

widely and rapidly, so that information harmful to the interests of a citizen (e.g., information about debt or payment behavior, whether

this information is corrector incorrect) can affect that citizen’s economic relationships in

any location. The potential for loss of privacy

is, however, not limited to financial or economic matters: to the extent that a citizen’s

transactions are effected through information

technology, his/her location and daily activities and relationships become potentially subject to monitoring and recording. Information

systems not related to financial services can

involve similar risks.

It is the potential for this invasion of privacy, rather than evidence that it is occurring

or has occurred, that concerns some citizens.

It is likely that there is increased sharing of

financial information and increased use of financial data for multiple purposes (e.g., mailing lists sorted according to information about

the people on the lists). Furthermore, most

citizens are probably unaware of the extent to

which this occurs, of the extent to which law

and business practice is able to assume the citizen’s consent to this sharing of information
Ch. 9—Policy Issues ● 245

——— . —— —-—

as a condition of accepting a service, or of

rights and protections associated with various

financial services.

Policy Options for Issue 13

Option 1: Strengthen, expand, and explicitly define

the citizen rights to privacy in accepting financial services (and conversely, rights to access

and sharing of information by providers of financial and information services).

At present, insofar as a legal base exists for

these rights, some of the protective legal provisions apply only to electronic media, and

some apply only to paper-based services. Protection from intrusion only by the Federal

Government is provided. But some financial

services combine these modes, some are in

transition between them, and some appear to

have no explicit safeguards for the citizen.

While legally defined rights to privacy may

be a desirable step in the direction of assuring privacy in using financial services, it may

not be a sufficient step. Such legal safeguards

should probably not depend for enforcement

on victims’ complaints. It is in the nature of

information and its applications that citizens

are unlikely to know when they have been the

victims of invasions of their privacy until the

damage has been done. Even then, they may

be unable to trace unauthorized information

or misinformation back to its source, to identify the offender, or to document that the

abuse occurred.

Option Z: Institute by law a program of informing citizens about risks to privacy that cannot

be avoided in accepting financial services

through information technology (a policy of informed consent, to use the model of medical

services delivery).

This option at least has the advantage of

allowing citizens to decide whether they will

accept the risk and of challenging the industry to find ways of reducing those risks. However, it could have the undesired effect of decreasing public acceptance of and confidence

in some financial services.

Option 3: Mandate a program of monitoring and

enforcing privacy rights.

This option would require additional authority to inspect and monitor financial service institutions, and the allocation of resources for

some Federal agency (e.g., the Federal Bureau

of Investigation or the Department of the

Treasury) to develop enhanced inspection capabilities as well as to implement the program.

Furthermore, such an inspection program may

increase anxieties about the possibility that

the Government itself may violate the privacy

of citizens through misuse of financial information about them.

Issue 14: Are additional actions needed to

safeguard the integrity of the national

payment and transaction systems against

risk of disruptions from systems failure,

hostile attack, and natural disasters?

Information technology and especially telecommunication links and networks create new

vulnerabilities to accidental or deliberate disruptions, and also greatly expand the geographical extent of the impacts. With a highly

integrated national economy and financial

service industry and increased velocity of

money, a local or regional disruption of financial activities rapidly propagates and can

cause turmoil throughout the system, even if

there is no irretrievable loss of data.

Natural disasters, civil disorders, military

attack, or any form of emergency may destroy

some communication links or require that

others be taken over by emergency management teams. Thieves, saboteurs, political dissidents, terrorists, or others could attack information banks and communication links or

threaten to do so, in effect holding hostage the

assets of the public.

The direct effects of disruption of financial

transactions and payments, of data banks, or

of communication links are largely independent of whether the disruption is accidental or

deliberate. The long-range effects of creating

an attractive target for internal political vio-
246 . Effects of Information Technology on Financial Services Systems

————-

lence or international terrorism are, however,

worthy of special policy concern.

Little is known, at least publicly, about the

present level of understanding of the magnitude of the vulnerabilities of financial service

systems to systemic failure, external attack,

and natural phenomena. Similarly, knowledge

about the extent of preparation to deal with

them, by either the private or public sectors

is limited. Industry representatives have

periodically stated that there are enough redundant network capabilities and backup data

banks to handle any foreseeable contingencies.

At a minimum, the Bank Protection Act could

be broadened to cover all financial institutions.

The act requires Federal regulatory agencies

to establish minimum security standards for

banks. The expertise of the Federal Emergency Management Agency (FEMA) could be

brought to bear.

Whether or not the security measures taken

by financial institutions at present are adequate is not clear, but the issue is clearly one

that affects the public interest because the potential impacts of disruption are broad and

critical to the national welfare. Actions taken

to reduce these vulnerabilities run the risk of:

●

●

negating some of the benefits of information technology; for example, requiring

paper-based records, and creating redundant data bases and communication links,

which could reduce the savings in time

and/or add to the costs of services; and

increasing opportunities for erosion of

privacy.

Policy Options for Issue 14

Option 1: Hold hearings for further consideration

of the present and long-term effects of dependence on information and communication technologies on the vunerability of critical economic

and social systems and processes in the context

of emergency management, civil defense, and

national security.

Option 2: Create a national commission or an interagency task force to gather expert opinions

from the financial service industry and from the

various fields of emergency management, national security, civil liberties, and the like to

assess these risks and recommend appropriate

means of reducing or managing them.

Issue 15: What alternatives are available

for controlling the risk of theft from

or associated with financial service

institutions?

Facts about theft (of funds or of information) associated with financial service institutions’ use of information technology are obscure. Because public confidence is critical to

this industry, it is not in the interests of financial service institutions to call attention to

thefts, whether perpetrated within the industry or directed against the industry. Folklore

and anecdotal evidence suggests that computer-based thefts are often not immediately

discovered, often not solved, and often not

prosecuted and that criminals are sometimes

informally granted immunity from prosecution in return for revealing how they carried

out the theft and for designing ways of preventing it from being done again. Some experts say that information technology has

probably reduced the incidence of thefts of

funds but greatly increased the average loss

from a theft. Clearly, it has made the theft of

financial data more attractive, since data are

now aggregated into large, easily tapped data

banks and since the theft of data need not involve actual removal of documents or other

physical media from protected premises. Information technology has also:

increased Federal responsibility for theft

from financial institutions since it more

often involves communication links;

created the need for more sophisticated

detection and documentation techniques;

and

transferred risk from institutions (the

target of armed bank robbery) to individual customers (whose accounts may be

fraudulently debited).

Policy Options for Issue 15

Option 1: Rely on the financial service industry

and traditional law enforcement agencies to control crime.

Some believe that theft from financial institutions perpetrated with at least some involve

ment of computers and telecommunication is

increasing despite ongoing efforts of the indus-
Ch. 9—Policy Issues ● 247

try and law enforcement authorities. Further,

they do not see this rate of increase abating.

If this is true, steps to augment present efforts

are required; and even then, this option may

not meet the challenge.

On the other hand, the level of consciousness

of the problem among financial service providers is increasing. Greater attention is being given to security of advanced systems for

delivering financial services. However, it is

still too early to know if the efforts will prove

adequate.

Option 2: Expand the resources and technological

capabilities of Federal enforcement agencies

(FBI, Treasury) to deal with computer-related

theft and to train and assist local law enforcement agencies.

This option could increase the requirements

for auditing and inspection of financial institutions’ records. However, this may have the

additional side effect of increasing concern

over potential erosion of privacy and may

also require additional audit trails and paper

records, which add to the costs of providing

financial services.

Option 3: Increase the penalties against perpetrators and against financial institutions for

concealing or failing to report thefts or suspected thefts of funds or data.

Increased penalties for theft may deter some

potential perpetrators. Increased penalties for

failing to report theft will tend to bring to light

data that clarify the magnitude of the problem and encourage the interchange of data

needed to deal with it. On the other hand, if

the data that surface cause the public to lose

confidence in the financial service industry,

the net effect could be negative and the stability of the industry threatened. Further, if

the data show the success rate of thieves to

be high or provide sufficient detail on the techniques that have been used, the end result

could be an increase in crimes against financial service institutions.

Option 4: Mandate a national commission to study

computer-related crime and identify necessary

actions for its control.

Computer-based crime, which is by no means

limited to that involving funds or financial

services, is on the increase. A national commission to study all aspects of this modern

problem would serve many policy needs.

35-505 0 - 84 - 17 : QL 3
Chapter 10

Future Scenarios for the

Financial Service Industry, 1990-95
Contents

Page

Scenario 1: Extension of Present Trends. . . . . . . . . . . . . . . . . . . . . . . . . . . . 252

Scenario Z: Piecemeal Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255

Scenario 3: The Global Financial Services Industry. . . . . . . . . . . . . . . . . . . 258

Scenario 4: Prosperity and Innovation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261
Chapter 10

Future Scenarios for the

Financial Service Industry, 1990-95

The future of the financial service industry

will be determined by a multiplicity of factors.

Any attempt to enumerate them all would be

futile and the number of combinations in

which they can occur is large. Further, if such

enumeration were possible within a reasonable

time and commitment of resources, the volume

of data generated would be so great that it is

doubtful that the results would be useful to

anyone concerned with either the operation of

the industry or the development of public policy relevant to it.

Scenarios are not predictions of what will

happen in the future nor do they necessarily

enumerate the most likely of the possible alternatives. Rather, they can be used, as they are

in the pages that follow, to illustrate the interplay of variables under specific sets of assumptions. In this application, neither the assumptions on which the scenarios are based or the

conclusions drawn are sacrosanct. In fact, the

reader is encouraged to suggest alternatives

for both and to develop the logic that flows

from those that are identified.

Scenarios also serve to bound a problem in

that they can be used to indicate what may

realistically happen in an extreme but unlikely

case. Because they enumerate the countervailing forces that operate in a given situation,

scenarios tend to eliminate from consideration

some of the simplistic and extreme arguments

both the proponents and opponents of a policy may make in support of their respective

positions. For example, even a rudimentary

analysis of the examples that follow will show

that the forces shaping the financial system

are such that precipitous changes that could

disadvantage significant groups within society

in the immediate future are extremely unlikely. However, these same models indicate that

some of the changes that may materialize over

several years could be detrimental to some,

and therefore should command the attention

of policy makers.

The scenarios that follow are written from

the perspective of an observer of the financial

service industry looking back over the 10

years, 1985 to 1995. They are not mutually exclusive, nor are there sufficient parallels between them for the reader to draw conclusions

about the effect of changes on the industry in

any one variable, such as the rate at which

automated systems for delivering financial

services are accepted in the market. Rather,

each highlights selected areas and suggests

one set of outcomes that could result from the

confluence of forces described.

Yet, by looking at the issues raised in the

several scenarios, the reader should be able to

develop an overall sense of the major considerations that will be faced by the financial

service industry between now and the middle

of the next decade. The goal has been to highlight for the reader the range of variables that

will affect the development of the financial

service industry in the future and suggest implicitly some of the policy issues that may

have to be addressed. These, then, provide a

background for considering the policy issues

and alternatives that are addressed elsewhere

in this report.

The issues of interest from either the operational or the policy point of view vary from

scenario to scenario. If, for example, one is concerned with the evolution of the financial service industry in the international arena, the

variables that determine the rate of acceptance

of new, technology-based services by the

American public are of only secondary interest. Conversely, the salient factors that affect policy decisions dealing with the market

for consumer financial services have little, if

anything, to do with those that determine the

251

35 -505 0 - 84 - 18 : QL ~
252 Effects of Information Technology on Financial Services Systems

patterns of activity in international markets

for financial services.

The first of the scenarios portrays an extension of the present environment in which there

are no major changes in the legal/regulatory

structure governing the financial service industry. Included is the implicit assumption

that the public will generally accept financial

services delivered through applications of advanced information processing and telecommunication technologies. On the one hand, the

technologies have been applied to accommodate differences between groups within the

population. On the other, some have become

less well off because of the postulated changes.

On balance, however, the financial service industry and its relationships with its customers have not changed radically from what they

are today.

The second scenario is postulated on the

premise that there are changes in regulation,

but they take place piecemeal. Generally, they

are developed in reaction to events in the marketplace that either have to be ratified or to

effects which have to be mitigated for one reason or another. For the most part, consumers

have rejected or have shown only very limited

receptivity to financial services delivered

through the application of advanced technologies. However, the contraction in the number of depository institutions has continued

as customers move their funds to alternative

investment vehicles offered by other types of

institutions. The contraction of loanable funds

has made it difficult for some to meet their

needs for credit.

Systems for delivering financial services internationally are the focus of the third scenario. Attention is drawn to the problems of

competition between providers of services in

international markets, the movement of foreign providers into American markets and of

U.S. providers overseas. World trade has blossomed and national economies have become

highly interdependent. The financial service

industry worldwide has been called on to provide the required supporting services.

In the fourth scenario, Congress has taken

steps to completely overhaul the legal/regulatory framework governing operations of the

financial service industry. Most of the regulatory functions of the States have been preempted so that both providers and users of financial services operate in an environment

that is uniform nationwide. It is a time of general prosperity and rapid economic growth.

The acceptance of technology-based financial

service delivery systems has been great, but

among the key issues of concern are those relating to personal privacy and the security of

financial service systems.

Scenario 1: Extension of

The Economy .—Business as usual, continu- The

Present Trends

Scenario.-The financial service indusity and change. A mature economy with an

improving position in world trade, but some

continuing problems with balance between inflation and stagnation.

Policy .-Deregulation: minimum Federal intervention consistent with maintaining the integrity of national payments and transactions;

existing consumer protection regulations (1983)

retained; the Zeros Bill of 1985 voided most

existing Federal provisions regulating services, pricing, and such.

try has been largely deregulated; consumer

protection laws passed in the 1970’s and

1980’s have been retained.

There is continuing experimentation and innovation in information technology with emphasis on network management, development

of intelligent media, dispersed delivery of services, and automation of lower value transactions. Driven by the need to control costs,

financial institutions have reduced the number of manned branches, and the primary vehi-
Ch. 10—Future Scenarios for the Financial Service Industry, 1990-95 ● 253

cle for delivering financial services is the

shared automated facility through which the

customer can interact with a number of service providers. Retailers have invested heavily

in point-of-sale (POS) equipment and have aggressive programs to encourage customers to

make payment by ordering immediate debit

of their accounts. This reduces the merchants’

costs and reduces the total amount of consumer debt, but it also tends to reduce spontaneous or impulse buying.

Given the multilingual population (Hispanic

Americans alone constitute about 12 percent

of the population, and another 5 percent are

Oriental), automated systems have been designed to provide financial services and information in any one of several languages. The

newer voice-response terminals just coming

into widespread use are also being supported

with multilingual systems.

The United States is a fully “post-industrial” society, Over 60 percent of all jobs are

classifed as information handling. Automated

equipment is used in virtually all aspects of

human activity, including nearly all manufacturing, and the great majority of the population under 55 has received at least a high

school education that includes considerable

coursework to develop computer literacy. Despite the fairly high levels of unemployment

that are blamed at least in part on increased

automation, there has never been any strong

public resistance to automation, certainly not

to automated financial services. A public that

enthusiastically embraced Pacman and other

video games was not likely to object to automated teller machines (ATMs) and POS terminals.

However, some elderly people (about 12 percent of the population) and the reading-disadvantaged are uncomfortable with the new

technology. These are also the people least

able to pay for personal service representatives (what used to be called tellers, insurance

agents, etc.). Some banks, savings and loans

(S&Ls), and others have instituted special teller windows that can be used without charge

by these people and by people who only want

to draw out government payments made by

direct deposit. These windows are popularly

known as “charity lines” and many people–

especially senior citizens, who are mostly

women, therefore refuse to use them.

Although there are many unemployed and

an increasing number of retired people, there

are also many single people and a great many

households with dual incomes. People in these

situations are becoming increasingly affluent

and well-educated and like to take an active

role in asset management. With a mind-boggling number of options in choosing financial

services and investment opportunities that

can be tailored to their needs or to their special

interests, asset management has become a

popular hobby. Financial management software proliferates with its own best-seller list,

and friends get together with portable terminals to argue the latest rage in investment

strategies. Marital counselors and divorce

lawyers report that people are as likely to fight

over money management as over child custody, even though most couples have “his,”

“her,” and “their” accounts.

Financial service providers offer technologybased services tailored to the needs of various

groups within society. For some, the service

packages do not differ markedly from those

available today. For others, providers negotiate custom-tailored packages of financial services individually with their clients. Among the

elements of a package, for example, may be

mortgage loans, investment accounts, transaction services, and lines of credit. The terms

of each of the services in a package reflect the

priorities of the clientele. For example, an individual may be willing to accept a 1ower rate

on a line of credit in exchange for a lower one

on a money market fund.

The proliferation of accounts and relationships with financial institutions is in fact striking. Even though financial supermarkets constantly stress the advantages of “one-stop

shopping, ” customer loyalty to one institution

is rare, and customers shift funds rapidly from

one location to another as new gimmicks in financial services are touted. One defensive
254 Effects of Information Technology on Financial Services Systems

.——. —— — —

strategy is the bundling of services, especially

if the combination can be made to include an

account that falls under Federal deposit insurance.

About 20 major remote banking systems are

available nationwide. A number of smaller

remote financial services exist but are only

marginally profitable at best. Most combine

financial services with a variety of information

and entertainment services. Among the dominant institutions in this field are major longdistance telecommunication carriers, newspaper and book publishers, and entertainment

companies. Financial services are delivered

using conventional telephone, direct broadcast

satellite, and two-way television cable.

The newnions (“new unions, ” representing

professional, administrative, and office workers) have in many companies negotiated programs in which employees have the option of

being paid daily with a credit to an account

held by the employer. Employees can access

these accounts through debit cards or in some

cases paper drafts (checks), which are processed through a cooperating financial institution where the employer maintains a zerobalance account to cover debits as they are

presented.

Because financial markets are heavily automated and information is rapidly distributed,

both the issuers and buyers of debt and equity

securities operate in a national and, in some

cases, an international arena. Funds flow to

those areas where they can earn the best return at an appropriate level of risk. Regions

with sparse or declining populations, regions

with obsolete industry and old infrastructure,

communities that were left isolated when a

new highway was built, old farm market centers and rail crossroads that no longer have

rail service, find it much more difficult to attract new capital. Rural banks can no longer

afford to make a loan to carry the struggling

family farm until the crop comes in. The Federal Government is under increasing pressure

to provide new social programs to help these

communities.

Relatively few large retailers, security brokers and dealers, insurance companies, and oil

distributors have established nationwide distribution systems for financial services heavily

based on existing customer relationships, tele

communications, and information-processing

technology. On the other hand, because some

legislation restricting interstate operations is

still in force, no commercial bank is among the

leading financial supermarkets. Some commercial banks use networks to deliver services nationwide in competition with the giants, but

laws in some States prevent them from accepting deposits, which puts them at a significant

disadvantage. Mergers of several of the larger

regional S&L operations have resulted in two

nationwide S&Ls being among the top 20 financial service giants. Although credit unions

operated by the newnions serve professional

and office workers nationwide, charter restrictions keep them from becoming financial supermarkets.

Many small financial institutions are still

doing well. They depend on shared networks

and access to wholesale services ranging from

data processing to transactions processing to

compensate for their small size. Their wholesale suppliers sometimes compete with them

for a retail market, and there are increasing

complaints from the small firms about rising

costs of wholesale services and networks.

Problems in gaining access to shared networks

is probably one major reason that there are

fewer new entrants into the financial service

sector each year.

Insurance companies have nearly all changed

their marketing and distribution processes;

generally those functions are handled by other

institutions.

The U.S. Agency for Family Services has

asked Congress for authority to monitor financial accounts to identify and track missing or

delinquent parents owing child support.

One State has passed a law requiring financial institutions to make automatic payment

of public housing rents from the accounts of
Ch 10—Future Scenarios for the Financial Service Industry, 1990-95 255 —— —

tenants receiving State or Federal assistance

checks.

The 1994 Los Angeles earthquake disrupted

all communication with that region for 3 days

as surviving communications channels were

preempted by emergency management teams.

The Financial Services Association estimates

that the total cost to investors, financial institutions, and others of that interruption was

approximately $4.8 billion.

In spite of these problems, and the slow but

gradual decline in the number of financial service institutions, both large and small financial

service institutions are generally healthy and

generally responsive to the needs of the communities they serve, as well as to the needs

of the Nation. Even though there are clearly

some barriers to entry, a firm usually develops

to respond to the unmet needs of a local population. Mortgages are still available from depository institutions in most communities, but

most are sold in secondary markets to insurance companies and retirement funds that use

them to balance their long-term liabilities with

long-term assets. However, the dynamic of the

financial marketplace has caused the longterm, fixed-rate mortgage to all but disappear.

Young people and people on fixed incomes are

often reluctant to undertake an obligation that

has changeable dimensions. Home ownership

is tending to decline. Developers hesitate to

begin projects that they may not be able to

sell immediately if interest rates go up just

when the development is completed.

Nevertheless, the financial service industry,

now a combination of comparatively small specialized service providers and giant financial

supermarkets, is using technology to provide

an efficient national payments and transactions system and to facilitate redistribution

of financial resources, the primary functions

of the financial service industry.

Statistics:

Banks: 13,800; decline in decade—8 percent.

Thrifts: 4,400; decline in decade—12 percent.

Automated transactions: 20 percent by

number, 87.5 percent by value.

ATMs: 48,000.

Home banking systems: 20, used primarily

by corporations.

POS terminals: proliferating; deployed by 49

percent of depository institutions.

Direct deposits: 64 percent of Federal payments.

Percent of households with no depository

account: 12 percent.

Technology: growing use of debit cards,

voice-activated ATMs.

Outstanding issues: privacy, systems

security.

Scenario 2: Piecemeal Regulation

The Economy .—Gradual recovery from

recession; continuing large Federal deficits

dampen economic activity, keep interest rates

high, and cause a continuing high rate of

unemployment.

Policy. -No thorough revision of regulation.

Piecemeal changes occur, generally to recognize structural changes that have already

occurred in the industry. Many legal/regulatory provisions have merely lapsed because

technology has provided a way around the

restrictions.

The Scenario.–The events of the past decade have resulted in a hodgepodge of laws,

amendments, and regulations, as Federal policymakers and regulators tried to keep up with

rapid changes in the financial service industry that constantly made old laws and regulations ineffective. Only a few legal specialists

can now sort out what rules apply to which

services. A great many provisions today are

cumbersome without being effective.

While Federal laws tend to recognize changes

that have occurred and therefore are more per-
256 ● Effects of /nforrnation Technology on Finanancia/ Services Systems

missive than in the past, States still play a

dominant role in regulation of financial services, and their regulatory strategies vary wide

ly. Some States, for example, still forbid

branch banking; others require that any network must be open to any financial institution

that wants to participate. Financial service

institutions have tended to migrate toward

States with permissive laws. A great many

local depository institutions have been bought

up by larger organizations. Loopholes in Federal laws allowed banks to be converted into

‘‘nonbanks.

In some States, both banks and S&L associations have become virtually financial service supermarkets; in other States, depository

institutions are limited to a few traditional

services and may neither own, nor be owned

by, any other kind of institution. Neither extreme seems to be ideal for banks. There have

been a number of messy bank failures, where

banks have participated in a broad range of

new ventures and taken some questionable

risks. The Federal Deposit Insurance Corporation (FDIC), which is now burdened with insuring quasi-deposits held by a variety of institutions that include insurance companies,

investment brokers, and retailers, is stretched

to the utmost in trying to salvage as many of

these institutions as possible in order to prevent further drain on the insurance funds.

Usually that salvage is done through mergers,

and the number of depository institutions is

slowly but steadily shrinking.

Many thrift institutions have been bought

up by, or been allowed to merge with, other

institutions. Some of these have essentially

abrogated any real commitment to housing finance and have become much like other general-purpose, widely diversified, financial institutions.

In States where banks are strictly limited

and protected as having a unique role, they

have seen their resources dwindle as customers remove funds to invest them through institutions that can operate across State lines.

States that adopted this strategy generally did

so in order to protect local banks, especially

farm-oriented banks, but they now find that

the banks have little money to lend. S&L associations in the same States are generally regulated with a view to preserving their commitment to housing finance, but they are also

having trouble attracting money. Federal depository institutions have widely diversified,

and some of the largest have almost become

financial supermarkets.

There is, overall, less competition within the

industry, as the number of viable institutions

slowly shrinks. Competition is declining in

other ways, as well. After the period of bold

experimentation, when there was rapid proliferation of new kinds of accounts and all kinds

of financial services were constantly elaborated and modified, things began to settle

down in the mid-1980’s. It became apparent

that most customers were satisfied with a few

more-or-less-traditional services and had neither the time nor the desire to try to sort out

the scores of services with fancy names, exaggerated claims, and marginal differences that

almost no one could understand. Most people

have all they can do to stretch their paychecks

from one payday to the next and realistically

have little hope of using their limited cash to

make more money.

As a result, the growth in financial services

has been much slower than some experts predicted a decade ago. The information technology used for financial services was very quickly standardized after the big institutions had

made their basic hardware decisions, and there

has been relatively little innovation in the last

few years.

Large-value transactions were easy to automate, but lower value transactions-the 82

percent of transactions that together account

for only about 12 percent of all the dollars

changing hands-have proven to be much

more difficult. Consumers have not accepted

direct debit from the point of sale and home

banking and information services as expected.

As a result, the paper burden has not been

lightened as much as the financial service industry hoped it would be. Another factor slowing the rate of innovation in financial services
Ch. 10—Future Scenarios for the Financial Service Industry,

has been the great differences between State

laws and regulations that keep large institutions from developing markets of the breadth

necessary for supporting new service offerings. A sluggish economy has reduced the

amount of money people are able to save

or invest and, hence, their demand for new

services.

Part of the problem was unanticipated customer resistance to a perceived increase in

risk. As banks and thrift institutions broadened

their activities and began to expose themselves to more risky ventures and fiercer competition, there were many near-failures. Most

of these were prevented, although at the cost

of a heavy drain on FDIC, but a very few

highly visible institutional collapses, coupled

with several highly publicized electronic thefts,

were enough to shake public confidence. Some

banks and S&Ls had to close their doors

abruptly because they had used poor judgment, overextending themselves when a rapid

turnover of assets, twice-daily settlements,

very thin reserves, and dwindling corporate

deposits made them very vulnerable.

Many people were disgruntled because they

saw—usually in advertisements—people with

a little more discretionary income collecting

high interest rates and multiplying their

assets by using glamorous new services, while

they themselves seemed to be losing out on

the opportunities and paying for services they

once thought of as free.

Many people are in fact put off by the kinds

of records they get from computer-based

transactions of any kind. They are afraid that

they will not recognize errors, or know how to

get them corrected. The whole process seems

cold and faceless, and they are afraid of being

victimized. Most people over 50 have never

felt comfortable with electronic information

technologies. They are afraid of looking silly

if they make mistakes or if they challenge the

computer’s mistakes. All in all, it is more comfortable to deal with a friendly face at the

teller’s window or the familiar insurance man

with his thick black book.

1990-95 ● 257

One mark of growing disaffection with financial institutions is an increasing number

of consumer lawsuits, something almost unheard of a few years ago.

Local banks play on these sentiments by emphasizing their hometown image, stressing the

comfort of friendly personal service, and being community boosters by sponsoring local

sports teams and advertising their sympathy

for local small businessmen and farmers. They

rely more and more on small savers and old

customers. Large corporations find financial

service institutions that can help them manage their funds more profitably, and young affluent customers put their funds in money

market accounts with checking privileges.

Home banking and home information services are limited to the largest metropolitan

areas; despite their name, they are almost exclusively used by large companies. Timemeasured local communication costs, which have

risen steadily, make them unattractive for

most households. These services might have

caught on if women had continued to enter the

work force at the rapid rate of the 1970’s and

early 1980’s, but continuing high unemployment has defeated such hopes, and many

homemakers have plenty of time to pay their

bills the old-fashioned way.

POS terminals are another technology that

failed to spread rapidly despite a very promising start. One problem was the failure to resolve the technical problem of dealing with

three different technologies-magnetic stripe,

uniform product codes, and optical scanners.

With plenty of fairly well-educated people

looking for work, there was less incentive to

automate the retail sales sector, and all but

the very large retail corporations hung back

waiting to see how the technology would shake

down. Besides, customers seem to prefer the

more familiar, slower payment process of

charge accounts, credit cards, or checks. Psychologically, they probably feel that it lets

them hold onto their money a little longer and

gives them a little bit of protection against

merchants who sell inferior goods or make mistakes in their charge accounts.
258 ● Effects of Information Technology on Financia/ Services Systems

There is also continual disquiet about pressure—whether real or perceived—from employers and from governments to agree to direct deposit of paychecks, Social Security

checks, assistance checks, and the like. Many

people see it as a great convenience, and safer

than having checks left in mailboxes or carrying them home from the office. But many people don’t want their boss–or “Big Brother”-

knowing where they bank, or don’t want to

bank at all, because they distrust large institutions. Employers who want to save money

on their paperwork are inclined to suspect that

such employees are trying to evade taxes or

child support payments or are in the country

illegally. Nevertheless, direct deposit is not

growing as much as expected, and many large

organizations have stopped trying to push it.

The securities market has not grown significantly in the last 6 years. This is generally

attributed to the maturing of the economy, the

generally declining size of business enterprises, and the aging of the society. There has

been very low growth in the gross national

product (GNP) for most of this period, and

America’s position in world trade has generally declined. Securities increasingly tend to

be held by pension funds, insurance companies, and other large institutional investors,

and there is much less marketing to individuals than there was a decade ago.

The outstanding characteristic of the financial service industry today is, in short, that

its growth is slow and that it is troubled with

more turbulence and uncertainty. The outstanding characteristic of the financial service mark-et today is

value transactions

Scenario

that it is bifurcated. Largeare automated completely,

and large institutional investors—big corporations, pension funds, insurance companies—

enjoy options that cannot be profitably extended to the average-income person. Large

firms offer a variety of services to institutional

users nationwide and smaller institutions are

strongly oriented toward local and regional

markets and individual or small business customers. With the continuing dispersion and

reconcentration of people and business over

the last 20 years, there is plenty of room for

small, community-oriented institutions, but

the large institutions dominate the economy

and the general long-range trend seems to be

toward greater consolidation of financial resources.

Statistics:

Banks: 13,000; decline in decade–13 percent.

Thrifts: 4,050; decline in decade—19 percent.

Broker/dealers: 4,000; decline in decade–

20 percent.

Transactions automated: 18 percent by

number, 88 percent by value (1983 = 15

percent, 85 percent).

ATMs: 37,000.

Home banking systems: 6, in very large

metropolitan areas.

POS terminals: deployed by 9 percent of depository institutions.

Direct deposit: 46 percent of Federal payments.

Percent of households with no depository accounts: 16 percent.

Technology: innovation slowed or stopped,

service options declining.

Outstanding problems: depository institution failures; consumer litigation.

3: The Global Financial Services Industry

The Economy.– Accelerated growth in world specialty chemicals-and in services and agritrade, with an increasing division of labor cultural commodities.

worldwide. The United States has a strong

position in high-technology products—espec- Policy .-Recognition that efficient financial

ially biotechnology, new-generation computers, service is a cornerstone of international trade;
Ch. 10–Future Scenarios for the Financial Service Industry, 1990-95 ● 259 —

cooperation with other nations to regularize

and encourage an orderly world market.

The Scenario.—The volume of world trade

continues to increase. Both industrialized and

industrializing nations compete for raw materials, energy, and markets. Many Third

World countries, especially around the Pacific

rim, have become increasingly industrialized,

and other small countries in South America

and the Middle East are also making progress.

Trade among Third World countries continues

to increase. Heavy industry has tended to

move from the older advanced nations to take

advantage of lower costs for land, labor, raw

materials, and regulatory compliance in developing countries. Bulk chemical production for

international markets, for example, has largely

been taken over by Third World countries. A

global division of labor is evolving, and it may

eventually narrow the gap between rich and

poor countries by providing a viable niche

for everyone, as Herman Kahn predicted 20

years ago.

The United States has increased its share

in world trade, with nearly all of the growth

in export of services; high-technology (biotechnology, intelligent systems, specialty chemicals, photovoltaics); and agricultural and forest products. Services now account for the

largest share of U.S. exports.

Multinational corporations (of which only

about one-third of the 500 largest are now predominantly American-owned) play a major

role in all countries. Meeting their needs for

financial services has significantly contributed

to a standardization of financial services and

associated technology in the industrialized nations. The advanced countries all have a welldeveloped, highly integrated, financial service

industry, with heavy dependence on information technologies. The newly industrialized

nations are following the same path. Poor

countries that lack the capital and the communications infrastructure to automate their

transactions systems find that this is a significant disadvantage in building indigenous

industry and in trying to enter world trade.

—

Since most countries have a state-owned central bank, their governments would have to

bear the costs of building or modernizing their

financial service infrastructure, and this has

tended to add to the burden of debt of Third

World countries.

U.S. corporations are heavily committed to

international operations and have become

heavy users of automated cash management

services that show treasurers the status of financial resources worldwide and facilitate the

movement of funds across national boundaries

to match requirements for funds with availability of funds.

In most countries, trading and financial activities now operate on a 24-hour basis. Many

international information services use satellite communications. Traditional communications links, such as telephone and telegraph

cables, are highly vulnerable to the political

instability, terrorism, and local wars that have

been the curse of the last two decades, as well

as to governmental restrictions on the transborder flow of data. As it is, there are continuing international disputes over freedom of financial data. With international trade and

transactions critical to the economic welfare

of all nations and an increasingly dominant

factor in every national economy, financial

data is a valuable commodity. That fact continually tempts national governments and international thieves to try to control, capture,

or manipulate it to their own advantage.

The reluctance of the United States, in the

1980’s, to cooperate with other countries in

setting up mutually acceptable safeguards for

the transborder flow of data resulted in some

diplomatic problems and a regrettable loss of

national prestige as well as some damage to

U.S. trade positions. The major holdout among

Western nations against international agreements guaranteeing transborder data flow

has, however, been Switzerland. As an ironic

result of clinging to its sacrosanct privacy

laws, Switzerland has lost much of its preeminence in international banking, although it remains a haven for secret bank accounts.
260 . Effects of /ntormation Technology on Financia/ Services Systems

All of this means that national economies,

national markets, national currencies, and national transactions systems are closely tied to

one another. In most situations, the continual

adjustment and settlement between currencies

and within world markets seems to provide additional stability. But any perturbation affecting one national currency or commodities market immediately affects others, and the failure

of a major bank anywhere in the world has

repercussions in nearly every country. Occasional excursions in markets reveal this vulnerability to instability under sudden shocks.

This occurred several times during the late

1980’s when Third World countries defaulted

on large debts.

In these instances, governments and financial institutions were able to act quickly and

cooperatively to dampen the reactions, in large

part through using the highly developed information systems and financial networks between countries. Since then, these networks

have been used more systematically to monitor and control international debt exposures,

debt management, and repayment schedules.

But setting up mechanisms to allow this to

happen has entailed complex diplomatic negotiations and an elaborate structure of international agreements that was hard for some

countries, such as the United States, to accept.

Because of the large volume of international

transactions and the velocity with which funds

move between countries, national monetary

policies are much less effective, and most countries, certainly those that are not centrally

planned economies, have much less control

over the stock of money in the country. In the

United States, there are now many foreignowned financial institutions; in fact, most of

the largest financial institutions, including major banks, have some foreign ownership. Many

U.S. banks also have branches or affiliates in

other countries.

Many experts, both within and outside of

the government, worry about the effect of

these developments and see them as an erosion of national control over U.S. domestic

economy and external relationships. Through

translational investments and mergers, most

of the world’s large financial institutions have

become multinational corporations. Many of

them have far more financial resources than

most national governments, and inevitably

this gives them great political power. If they

ever acted together, they would very nearly

constitute a world government.

The realization of the close relationship between multinational corporations, especially

financial institutions, and national governments has made these institutions a prime

target for political dissidents, guerrilla movements, displaced populations, and terrorists

of all kinds. The British-owned Barclay Bank

in New York was bombed by the Irish Republican Army in 1986, with 34 fatalities and 109

serious injuries. Overseas protection for facilities, information banks, communications

links, satellite ground stations, and especially

for personnel is costly. Hostile actions against

Americans and American-owned facilities

have several times involved the United States

in dangerous political situations in other countries. In 1992, 10 Americans were held hostage

by rebel forces in the Union of South Africa

for 12 days. A year later a Mexican mob protesting the treatment of illegal immigrants

crossing the U.S. border attacked a U.S. bank

in Mexico City. The administration, which had

been elected with the strong support of the

Black and Hispanic Political Coalition, was

nearly torn apart in its efforts to deal with

these situations.

Despite these severe problems, there can be

little doubt that the United States’ full participation in world trade demands U.S. cooperation with and leadership in the continuing

development of a worldwide financial service

industry. Further, in the development and

sales of advanced financial information systems, the United States is rivaled only by

France, the originator of the smart card, which

is now revolutionizing consumer services, and

can potentially revolutionize all forms of recordkeeping throughout the economy and society. The American financial service industry

accounts for a significant share of the export
—

Ch. 10—Future Scenarios for the Financia/ Service Industry, 1990-95 ● 261

———. -- —— —--- .——. —

of services, the fastest growing sector of U.S.

international trade for over a decade, and supplies most of the financial services needs of

many small countries.

The growth and integration of the world

economy in the long run may well be the most

significant force for world peace. It could be

the source and wellspring of the gradual development of a world political order based not

on unenforced charters or on military power,

but on the economic self-interests of the nations of the world.

Percent of U.S. financial institutions with

some foreign ownership: 13 percent.

Percent of U.S. financial institutions with

international branches or affiliates: 17

percent.

Automated transactions: 35 percent by

number, 91 percent by value.

Direct deposit (international payments): 97

percent of Federal payments.

Outstanding issues: control of terrorism,

monitoring and control of Third World

debts.

Statistics:

Banks: 15,750; increase in decade–5 percent.

Thrifts: 5,100; increase in decade-2 percent.

Scenario 4: Prosperity and Innovation

The Economy .–Booming prosperity. The

United States has a commanding lead in several high-technology industries and a strong

role in international trade. An era of innovation and economic growth is well under way.

Policy .–Regulation by objective, aimed at

preserving competitiveness in the financial services sector while reducing risks to provider institutions and to consumers.

The Scenario.– Rapid advancements in the

biological sciences are spawning new industries, just as advancements in chemistry did

following World War 11, Computer-assisted

design and manufacturing (CAD/CAM) and industrial robotics have significantly lowered

manufacturing costs and have automated

batch or custom manufacturing. Continued

strong growth in the services sector, especially

in export markets, has kept unemployment at

reasonably low levels in spite of the new wave

of automation.

Recognizing that a strong national economy

demands efficiency and reliability in nationwide transactions, and also demands that all

regions and communities participate productively in that national economy, Congress took

decisive steps in 1985 to revamp laws and regulations pertaining to financial services. Most

aspects of financial service delivery were decisively preempted to prevent State laws from

distorting the legal and institutional infrastructure necessary for an efficient national

payments system. Prohibitions on interstate

banking were removed, but banks were allowed

to engage in diversified financial services only

by carefully segregating them from traditional

depository-lending activities.

Only certain kinds of demand accounts qualify for Federal depository insurance, and they

are subject to special regulatory supervision

regardless of the institution offering the service. Other kinds of accounts are carefully distinguished from insured accounts by timerelated and other requirements and must

clearly inform users of the differences. All financial service regulation is focused on the

nature of the service and its risks and returns

rather than on the nature of the institution

providing the service or the mechanisms

through which it is delivered. The exception

to this rule is that institutions providing certain basic “lifeline” services or committing

specified proportions of their resources to a
262 ● Effects of Information Technology on Financial Services Systems

few specified social priorities (e.g., education

loans, housing development, ecological protection, small entrepreneurship) are granted incentives sufficient for encouraging those activities.

Administration and enforcement of Federal

financial service laws and regulations has been

largely centralized and rationalized under a

special agency, the Federal Investment and

Savings Trustee–popularly known, inevitably, as “Tight FIST.”

Information technologies have allowed all

economic sectors to improve their productivity, to operate more efficiently, and to be

decentralized, yet well-coordinated. The proliferation of information technologies and systems has been comparable to the spread of

electrification in the 1930’s and 1940’s. The

thrust in financial information technology has

been toward automation of lower value transactions and the development of intelligent

media—the smart card and its descendants.

ATMs are now being replaced by automated

resource control centers (ARCCS) that not only

dispense currency but automatically transfer

funds between accounts. Most stores, gas stations, and the like, have POS terminals, although people do a great deal of their shopping through their home computers.

Merchants disagree about whether video shoppers or onsite shoppers are more likely to make

impulse purchases; some have concluded that

it is the less affluent shoppers that come to

the store (the poor, the elderly, and those just

browsing for entertainent), and they no longer make much of a special effort to attract

them. This hurts the very small shops that

cannot afford to be on television and that depend on passers-by drawn to the malls by

larger stores.

With computers almost as common as the

telephone and with communication costs low,

home banking is common. There are many

licensed brokers and general-purpose financial

advisors fiercely competing for customers. The

brokers work on coremission; the financial advisors charge by the hour and are supposed

to be more disinterested. But there are some

shoddy operators in both groups in spite of the

watchdogging of both the consumer interest

groups and FIST. Some institutions and some

brokers offer special-interest asset management programs that cater to the customer’s

special interests or pet causes—investment in

such things as the arts, community self-sufficiency projects, alternative energy development, or opportunities for new markets. These

programs also provide opportunities for conflicts of interests, if not downright scams, although most of them are probably useful and

effective.

Businesses have established powerful telecommunication networks that are used for a

variety of purposes. Some groups of firms

where the members both buy from and sell to

the others have established procedures for

electronically settling accounts between and

among themselves with little if any involvement of the financial service industry. Interest

is paid on credit balances in accounts receivable. Members of the clearing community have

generally agreed to settle a credit balance in

an account receivable in good funds on demand. Only when there is a cash settlement

of either a receivable or payable is the conventional payment mechanism operated by the financial service industry used.

Similarly, some have found off-market trading of securities to be in their interest. Electronic bulletin boards are used by both businesses and individuals to post bid or ask prices

for securities, and the transaction is executed

by the principals without the involvement of

a broker. Electronic messages bearing the

computer signatures of both buyer and seller

are sent to the transfer agent and securities

depository instructing them to make the appropriate entries in their records.

Protection of customer privacy and security

of all elements of the financial service delivery system have been major thrusts of congressional action in recent years, but these two

problems are not completely solved. Federal

law prohibits the use of any financial data for

any purpose not specifically approved of by

the subject of the information. These are
. .

Ch. 10—Future Scenarios for the Financial Service Industry, 1990-95 ● 263

known as informed consent laws, but in practice these laws are difficult to enforce because

it is hard for victims to detect and prove secondary use of data from a given source. Federal laws also specifically forbid government

agencies to have access to such data for other

than narrowly defined purposes (i.e., tax levy),

but civil libertarians point out that this is no

protection at all-he who makes a law can violate it–and indeed there are frequently proposals in Congress to allow access to financial

data for socially useful purposes such as crime

detection and military intelligence.

Security is another important problem for

several reasons. Because the financial service

system is so highly networked nationwide, the

potential gain from a successful theft is almost

unlimited. Also, because of the national networking, any disruption or violation of the integrity of the payments system, whether it

stems from natural, technological, or human

causes and whether it is deliberate or accidental, can have major effects on the whole economy. And because financial transactions are

so central to the economy, and economic stability is central to national security, financial

information systems become a target for all

of those, inside or outside the country, who

have reason to attack the U.S. Government.

The Federal Bureau of Investigation has

greatly expanded its capability to control

computer-based crime and has elaborate related training programs for State and local

officials. However, with computers and telecommunications so firmly linked, almost all

computer-based crime, especially directed at

financial services, is now considered a Federal

responsibility (for both legal and technological reasons).

Protection of financial information and

transaction mechanisms in the event of natural disasters or military attack is also a Federal responsibility. The Federal Government

has developed standards and requirements for

both backup systems and redundant data

banks, but the industry protests that the costs

are excessively burdensome, many technical

experts question the adequacy of the standards, and civil libertarians fear that redundant

records provide another opportunity for violations of privacy.

Most financial services are marketed nationwide. A large volume of transactions appears

necessary for assuring an institution’s viability in this fiercely competitive market. The

Federal laws requiring financial institutions

to direct a percentage of resource investment

to certain high-priority social programs are a

continuing political issue. There is constant

dispute between those who want to add new

social priorities to the list of preferred investments (which carry definite tax advantages) and those who see each new addition

as a further step toward a centrally planned

economy.

Despite these problems, there is general

agreement that the national payments and

transaction system is healthy and efficient and

plays a major role in the general prosperity

and in America’s strong position in world

trade.

Statistics:

Banks: 16,500; increase in decade–10 percent.

Thrifts: 5,200; increase in decade-4 percent.

Automated transactions: 35 percent by

number, 91 percent by value.

ATMs and ARCCS: 77,000.

Home banking systems: 70, broadly dispersed, wide coverage.

POS terminals: deployed by 63 percent of

depository institutions.

Direct deposit: 91 percent of Federal payments.

Percent of households without depository

accounts: 7 percent.

Technology: development of intelligent media, ATMs that automatically transfer

funds between accounts.

Issues: requirements for preferred social

investments, growing computer-based

theft.
Appendix
Appendix

Glossary of Terms

This appendix provides summary definitions of financial service products discussed at various points

in this report. The first section contains a listing of financial service products grouped as:

Asset and Liability Products

Transaction Products (Paper-Based)

Transaction Products (Electronic-Based)

Information Systems

The second section contains the definition of each of the items listed in the first. The items in the second section are listed in accordance with the numbering of the items in the first.

Financial Products and Services

Asset and Liability Products

1.

2.

3.

4.

5.

6.

7.

8.

9.

10.

11.

12.

13.

14.

15.

16.

17.

18.

19.

20,

21.

22.

23.

Syndicated Loans

Project Finance

Lease Receivable Finance

Indirect Loan Funding

Revolving Line of Credit

Offshore-Based Lending

Banker’s Acceptances

Trust Receipt Financing

Depository Financial Institution Products

a. Direct Deposit

b. Check Access Certificate of Deposit

c. IRA, Keogh

d. Eurodollars

e. Imprest or Sweep Account

f. Single Premium Deferred Annuities

(SPDA)

Margin Accounts

Market Making

Leveraged Leases

Retail Banking

Middle and Institutional Market Lending

Repurchase Agreements

Money Market Securities

Other Investment Funds

a. Money’ Market Fund

b. Real Estate

c. Liquidity

d. Growth

e. Municipal

Mortgage Lending

CSVIJI Loans

Real Property Equities

Insurance Premium Financing

Actuarial Accruals

Annuities

Transaction Products (Paper-Based)

24.

25.

26.

27.

28.

29.

30.

31.

32.

33.

34.

35.

36.

37.

38,

39.

40.

41.

42.

43.

Cash Processing

Payroll

Money Orders/Traveler’s Checks

Mortgage Servicing

Back-End Processing

a.

c.

d.

e.

f.

g.

i.

j.

k.

Installment Loan Servicing

Mortgage Loan Servicing

Commercial Loan Servicing

Demand Deposit Accounting

Savings Deposit Accounting

Term Deposit Accounting

General Ledger Control

Collateral Control

Cash Control

Trust Accounting

Item Processing

WholesalelRetail Lockbox

Check Guarantee/Authorization

Securities Safekeeping

Personal Trust

Escrow Accounting

Note Collection

Mortgage Banking

Collection Service (Brokerage)

Private Placement

Equity Brokerage

Public Offering

Relocation Management

Real Estate Brokerage

Securities Settlement

Annuities

Transaction Products (Electronic-Based)

44. Data Base Access

45. Branch Automation

a. Platform Automation

2 6 7

35 -505 0 - 84 - 19 , QL 3
268 ● Effects of Information Technology on Financial Services Systems

—— ————.-———- ——— - —

46.

47.

48.

49.

50.

51.

52.

53.

54.

55.

56.

57.

58.

59.

60.

61.

62.

63.

64.

65

66.

67.

68.

69.

70.

b. ATMs

c. Teller Terminals

Settlement and Clearing

a. Settlement

b. Clearing

Automated Clearing House/Electronic

Clearing House

Wire Transfer (Domestic and International)

Cash Management

a. Depository Transfer Check

b. Concentration Accounting

c. Automated Investment Accounts

d. Cash Forecasting

Business Banking Products

a. Account Reconciliation

b. Account Consolidation

c. Balance Availability Reporting

d. Balance Concentration/Sweep

e. Automatic Customer Billing

f. Deposit Reconciliation

g. Account Payable Check Writing

Point-of-Sale Systems

Home Banking

ATM Systems

Commingled Investment Pools

Direct Deposit

Funds Movement and Inquiry

International Banking Products

a. Letters of Credit

b. Credit Inquiry

c. Foreign Exchange

d. Draft Collection

e. Syndication

f. Dollar Connection

Stock Transfer

Commercial Paper

Options/Futures

Equity Brokerage

Index Funds Brokerage

Bond Brokerage

Fund Management

Debit Cards

Securities Settlement

Discount Brokerage

Securities Lending

Certificates of Deposit Brokerage

a. Straight

b. Strip

Insurance Services Account

Information Services

71. Cash Requirements Forecasting

72. Working Capital and Cash Flow Analysis

73. Investment Return Optimization Analysis

74. Consumer Financial Analysis

75. Business Financial Analysis

76. Debt Issue Rating and Quotation Services

77. Credit Reporting Agencies

Glossary of Terms: Financial

Products and Services

Asset and Liability Products

Asset and liability products are those generic

products that impact the balance sheets of financial institutions. Asset products are generally

loans, while liability products are depository in

nature.

1.

2.

3.

4.

5.

Syndicated Loans– Loans inv’olving multiple

banks and nondepository financial institutions

in cases where the overall credit involved is in

excess of each bank’s comfort or legal lending

limit. One bank usually acts as agent for the

others, thereby earning a fee for its efforts

(and therefore becoming a transaction product

provider).

Project Finance—Similar to syndicated loans

(in fact, most are syndicated), project finance

involves very specialized lending to major governments and their captive industries.

Lease Receivable Finance–Loans made to

lessors by insurance companies, pension funds,

depository financial institutions (DFIs), nondepositor financial institutions (NDFIs), secured by retail leases or loans that the lessors

have made to lessees. The lessor’s note from

the bank is secured by the paper, not the

leased asset.

Indirect Loan Funding–Involves a bank or

NDFI acting in a transparent fashion for

another lender, whereby the first provides the

funding source while the second generates the

marketing and approval process. Two common

types of indirect funding are: 1) correspondent

bank overlines, where a bank automatically

participates in its correspondent bank’s credit

packages over a preset limit; and 2) bulk paper purchases, wherein the loan generator

(auto dealer, retailer, lessor) creates paper

through the normal course of its business and

periodically sells the paper and control of the

collateral to a lender (e.g., bank, consumer finance company).

Revolving Line of Credit—Generally a consumer product that enables an individual to

borrow and repay loans under a predetermined and approved limit, this product is often
Appendix: Glossary of Terms ● 269

— .

. — —

6.

7.

8.

9.

wholesaled by banks to NDFIs and retailed

with the latters’ other product lines (money

market account, annuity, debit card),

Offshore-Based Lending-Certain tax benefits

exist that accrue to domestic borrowers who

use offshore lending offices of U.S. banks to

conduct business. Organizations provide this

service for their correspondents that are too

small to establish such facilities themselves.

Banker’s Acceptance–These obligations of

the bank (guaranteed payment under letters

of credit) can be either assets or liabilities or

both, depending on whether the bank is discounting them to the public against its guarantee of payment.

Trust Receipt Financing–Generally provided

by large commercial lenders to banks and the

public to enable them to finance inventory—

either finished or raw.

Depository Financial Institution Products:

a.

b.

c.

Direct Deposit–The process whereby a

check’s issuer delivers the check directly to

the payee’s bank for credit to his or her account. The term is often used to refer to the

Federal Government’s direct deposit program for Social Security checks. It is also

used for military and civilian salary payments, Civil Service and Railroad Retirement annuity payments, and Veterans Administration compensation and pension

payments.

Check Access Certificate of Deposit–A

bundled product that includes allowing the

consumer to write checks against a line of

credit secured by a term deposit in a bank.

IRA/Keogh–A tax deferment product offered not only by banks (where it is a term

deposit product), but also by NDFIs, such

as insurance underwriters, securities brokers, consumer finance companies, mortgage bankers, and others. These offerors

provide trustee services under IRA and

Keogh plans, thereby playing in the transaction services arena.

1 ) IRAs—A retirement savings program for

individuals to which yearly tax-deductible contributions up to a specified limit

can be made. The amounts contributed

are not taxed until withdrawal. Withdrawal is not permitted without penalty

until the individual reaches age 591⁄2.

2) Keogh Plan–A retirement plan for selfemployed persons and their employees to

which yearly tax-deductible contributions up to a specified limit can be made.

10.

11,

12.

13.

14.

15.

16.

d.

e.

f.

Eurodollars–Dolku= denominated deposits

in foreign banking offices. Such services are

provided by correspondents to serve the

overseas finance and deposit needs of the

originating institution customers.

Imprest or Sweep Account—Depository account with a targeted maximum balance

above which funds are swept either to investments or to a concentration account,

and central accounts into which funds deposited with various regional institutions

are collected and then either used to meet

payment obligations or for investment.

Single-Premium Deferred Annuities

(SPDA)– Products designed to provide a

future pay-out of deposits based on an actuarial formula. Currently, only insurance

underwriters are empowered to offer most

types of annuities. Such annuities have

some form of tax avoidance characteristics.

Margin Accounts–Margin accounts enable

retail customers to leverage equity purchases

up to a fixed percentage, The underlying debt

is provided by the major money-center banks

to securities brokers who mark up the price

and end-loan to the consumer.

Market Making (Equity Positions)–The practice of buying and selling securities for a broker’s own account from which it sells to or

buys from its retail or institutional customers.

Leveraged Leases–A 100-percent financing

system that combines borrowed equity and

debt to enable a major utility or other capital

equipment user to acquire functional access to

resources without significant investment.

Retail Banking—The relationship between a

parent and a subsidiary retail bank wherein

the bank provides direct support to the products offered by the parent. An example would

be ownership of a retail bank by a securities

broker, as in the recent case of Dreyfus Corp.

Middle and Institutional Market Lending–A1-

ternatives to funds offered by commercial

banks for middle market and institutional

market borrowings using the proceeds of public or private debt placements to make loans

to these types of borrowers.

Repurchase Agreements–A contract between

a seller (bank, thrift, credit union, securities

broker, and others) and buyer of Federal Government or other securities, whereby the seller

agrees to buy back the securities at an agreedupon price after a stated period of time.

Money Market Securities—private and Government obligations with a maturity of 1 year
270 ● Effects of /formation Technology on Financial Services Systems

17.

18.

19.

20.

or less. These include U.S. Treasury bills,

bankers acceptances, large negotiable certificates of deposit (CDs), commercial paper, finance paper, and short-term tax exempts. The

primary investment vehicle used by the money

market funds offered by both depository institutions and securities dealers.

Other Investment Funds:

a.

b.

c.

d.

e.

Money Market Fund–A mutual fund that

invests in short-term, highly liquid securities that pays the investor a market rate of

interest and permits redemption by means

of a variety of instruments that are convenient for the investor to use.

Real Estate–Those funds concentrating

their investments in real estate equities.

Liquidity-Those funds concentrating their

investments in cash or near-cash investments.

Growth–Those funds concentrating their

investments in speculative growth-oriented

securities that will yield an increase in capital rather than a dividend return.

Municipal–Funds concentrating their investments in securities of political subdivision of a State, including cities, counties,

towns, villages, districts, and authorities,

and designed to yield tax-sheltered income.

Mortgage Lending–The extension of credit

secured by a lien on real property. At one

point, the insurance industry was the single

largest component of the home mortgage market. Today, that is not the case. Insurance

companies are opting to concentrate on the

large commercial property market because of

increasing real estate values and opportunities

to earn additional interest by participating in

increases in rents as well as the secondary

mortgage market. Others participate in the

mortgage market by purchasing individual

mortgages or packages of mortgages assembled and marketed by such organizations as

the Federal Home Loan Mortgage Corporation

(FREDDIE MAC) in secondary markets.

CSVL1 Loans–Loans made against the cash

surrender value of whole life insurance (CSVLI)

policies, which by statute and by contract

must be made at rates well below current market rates.

Real Property Equities–The taking of an

equity position by a financial service provider

as part of the compensation for advancing

funds. A practice of insurance companies and

others that, unlike depository institutions, are

21.

22.

23.

permitted to accept equity positions in real

property in addition to debt instruments.

Insurance Premium Financing—Insurance

companies can lend policyholders the money

to finance their premiums over an extended

period of time. This service is usually accompanied by an insurance services account.

Actuarial Accruals—The liability side of an

insurance company’s balance sheet includes

the current period, actuarial accrual of many

transaction products, and the mandated dividends on premiums paid for life insurance contracts.

Annuities–The principal liability product of

insurance underwriter; is the tax-deferred annuity, which only these industry members are

able to offer with long-term guaranteed rates

of return. Such annuities can be single-payment or multiple-payment plans and periodic

or single pay out, or they can be structured to

be payable to the surviving beneficiary only.

Transaction Products (Paper-Based)

24.

25.

26.

27.

28.

Cash Processing–The service of providing

central vault and central cash handling to

banks, retailers, and other currency- and coindominated businesses.

Payroll—The process of using customer input

to develop payroll checks for employees. The

processor may also process the account debit

to offset the credits for the checks, payroll

taxes, and miscellaneous withholdings.

Money Orders/Traveler’s Checks–Negotiable

tender forms issued by depository and NDFIs

in lieu of cash. Often wholesaled by major correspondents or third parties in “private label”

formats.

Mortgage Servicing—Fee-based service

wherein the needs of the mortgage investor are

served by an intermediary that bills, collects,

and accounts for mortgage payments. The

process can also be incidental to an institution’s normal lending activities. Compensation

is derived through negotiated net settlement

of collections—usually 3/8 to 1⁄2 of 1 percent.

Bank-End Processing:

a.

b.

Installment Loan Servicing–Similar to

mortgage loan servicing; however, no national market exists. Usually provided as a

part of a total financial product servicing

package.

Mortgage Loan Servicing–Same as #27,

above.
Appendix: Glossary of Terms ● 271

29.

c.

d.

e.

f.

g.

h.

i.

j.

k.

Commercial Loan Servicing–Process of

servicing commercial loans that do not normally involve the serial payments found in

installment loan servicing.

Demand Deposit Accounting–Process that

accounts for the account debits and credits

in a demand relationship with a bank.

Savings Deposit Accounting–Process that

accounts for the account debits and credits

in a savings relationship with a thrift institution, bank, or other depository financial

institution that also handles the interest accrual and payment steps.

Term Deposit Accounting–Process that

handles the accrual of interest on term savings relationships for banks, thrifts, and

credit unions, as well as some NDFIs (securities brokers, insurance underwriters).

General Ledger Control–The accounting

process for the internal recordkeeping for industry members usually provided by correspondents, third-party processors, and

general accounting service providers. Banks

also provide this service to their customers.

Collateral Control–A system for monitoring an institution’s collateral under a loan.

It usually entails a Management Information System (MIS), which may interface

with the institution’s general ledger.

Cash Control–A service much like cash

processing, where central vault services are

provided a part of a total back office service package.

Trust Accounting–A second-level accounting system for reconciliation of bank, thrift,

and trust company customer accounts, as

well as calculation of yield, return, and actuarial benefit,

Item Processing--The internal receiving,

recording, and ‘perhaps redistribution of

checks, drafts, or other debit and credit

items written by customers of an institution

or deposited by its customers and drawn on

another institution. This includes posting or

recording of the check in the individual customer’s account and the microfilming and

balancing of all such items received.

Wholesale/Retail Lockbox—Also known as

remote item processing or remittance processing. A banking service provided for the rapid

collection of a customer’s receivables and rapid

credit to the customer’s account. The service

provided by the bank includes collecting mail

from the company’s post office box; sorting,

30.

31.

32.

33.

34,

35.

totaling, and recording the payments; processing the items; and making the necessary bank

deposit or forwarding the funds to another depository.

The service can also be used by the institutions themselves to service their own loan

portfolios. “Wholesale” refers to receivables

flows that involve a few items with large dollar

amounts per item. “Retail” refers to those

flows with a large number of items and small

per-item dollar amounts.

Check Guarantee/Authorization-The process

of providing merchants and other vendors

with assurance that a particular check being

presented has the issuing bank’s ability to pay

behind it. In this mode, check guarantee/

authorization should not be confused with the

electronic-based procedures to be discussed

later. This process generally involves a relationship between merchant and bank in contrast with electronic-based procedures which

involve the use of third-party service.

Securities Safekeeping–Generally provided

by banks to brokers or by banks to correspondent banks, this service insures that

securities are maintained under dual custody.

It can also have electronic applications when

banks provide the service to their customers

for paperless securities, such as Treasury bills

and commercial paper.

Personal Trust—Services wherein financial institutions manage the assets of others for a

fee. Wholesaling aspects involve correspondent relationships and trust companies as

agents for financial institutions without the

necessary infrastructure to support the activity.

Escrow Accounting–Services provided to

escrow agents (title companies or attorneys in

certain geographic areas) that enable the agency

to maintain trust accounts and to report on

the settlement of buyer and seller accounts.

Note Collection–Service wherein the financial

institution acts as collecting agency for a customer on obligations owed by others to the

customer. Historically, this service has been

underpriced by banks and thrifts and frequently is being abandoned, owing to the

heavy costs involved.

Mortgage Banking—The process of acting as

an intermediary between the loan origination

and funding systems. Generally, the mortgage

banker will be equipped with the origination

system and will tap national secondary mar-
272 ● Effects of /formation Technology on Financial Services Systems

36.

37.

38.

39.

40.

kets for funding. In many cases, nondepositor mortgage bankers will be supported with

warehousing lines of credit from banks to facilitate timely funding of loans. These advances are ultimately repaid through filling of

commitments with funds purchased in the

open market. Three common secondary marketmakers exist–Federal National Mortgage

Association, Government National Mortgage

Association, and Federal Home Loan Mortgage Corporation, Securities brokers play a

very active role in supporting this activity

with their efforts to optimize investor returns

by investing client funds in the debt and

equity of these three agencies, as well as sponsoring their own real estate mortgage investment 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 securities) on behalf of others. This service, as in

the case of note collections, was implicitly

rather than explicitly priced for some time and

is rapidly disappearing in many institutions.

Frequent offerors include securities brokers,

banks, and thrift institutions.

Private Placement–The business of selling

the long-term debt or equity instruments of a

client directly to one or more financial institutions without going to the public market.

Equity Brokerage—The trading of securities

on behalf of a broker’s clients either on one of

the great number of securities exchanges or

through an off-market transaction.

Public Offering–The process of taking a privately held company public through underwriting the new securities (guaranteeing a specific price) and then selling them to retail or

institutional clients, or the process of offering

additional stock or debt securities for an

already public company. Requires that the

securities be registered with the Securities and

Exchange Commission and the offering be conducted in accordance with its regulations.

Relocation Management–A relatively new

service of a few brokers, relocation management services assist the employees of corporate employers in their periodic job-related

relocations by advancing the equity in owned

real estate, thus brokering the sale of transferee’s home and the purchase of another in

the receiving city. As of December 31, 1982,

Merrill Lynch had $430 million invested in

equity purchases.

41.

42.

43.

Real Estate Brokerage–Occurs when the

brokerage community expands into real estate

services through acquisition of existing real

estate companies or renewed offerings of the

services through existing securities brokerage

offices.

Securities Settlement–The process of transferring title between buyers and sellers of securities within the 5-day limit. Involves delivering negotiable securities to the buyer, good

funds to the seller and effecting a change in

ownership on the books of the transfer agent.

Annuities–The amount payable according to

contract annually or at other regular intervals

for either a certain or an indefinite period, as

for a stated number of years or for life. Several types of annuities exist, and in most cases

brokers merely sell the annuity programs of

a particular life insurance underwriter,

Transaction Products (Electronic-Based)

44.

45.

Data Base Access–These products require

that the user be equipped with electronic hardware and attendant software to gather and

manipulate data or to take action based on the

data provided. There are essentially two types

of data-based access products-–passive and active. Passive products merely provide the user

with information (e. g., account balances, airline schedules, stock prices). Active products

enable the user to execute formatted transactions in conjunction with the information

(transfer funds, book and pay for reservation,

buy or sell securities, and settle payment).

Branch Automation–Those products designed to enable banks, thrift institutions, and

NDFIs to increase productivity while reducing personnel costs through resource substitution.

a,

b.

Platform Automation—The second step in

the branch automation process is that of

automating the functions of the administrative and loan platforms. In most cases,

automation amounts to teller-terminal emulation with access to small customer information, word processing, and limited personal-computer data-manipulation functions.

The loan authorization function is also provided in some cases.

ATMs–Hardware and software that provide customer access to personal account information and transaction sets to conduct

banking business. Machine configurations
..—

Appendix: Glossary of Terms ● 273

46.

47.

48.

49

range from full function to inquiry only to

cash dispensing only.

c. Teller Terminals—These products enable

banks, thrift institutions, and credit unions

to address extract files and to perform teller

functions against memo post files. Their

functionality is generally limited to transactions involving demand deposit accounts

(DDA) and savings types of accounts.

Settlement and Clearing:

a. Settlement—In interchange, the process of

b

cardholder banks and merchant banks

either paying by draft or drafting upon one

another for payment of bank card transactions. A transfer of funds between two

parties in cash or on the books of a mutual

depository (e.g., the Federal Reserve Bank)

for consummating one or more prior transactions made subject to final accounting.

The conclusion of a transaction by completing all necessary documentation, making the necessary payments, and transferring title, where appropriate.

Clearing–A banking term referring to the

inter-bank presentation of checks, the offsetting of counterclaims, and the settlement

of resulting balances. The term may be used

in a purely local operation or on a nationwide basis.

Automated Clearing House/Electronic Clearing House—A facility that performs intermember (financial institutions) clearing of

paperless entries between such institutions.

Most ACHS are operated by the Federal Reserve and use rules, procedures, and programs

developed on a local basis by their participating financial institutions under the general

direction of the National Automated Clearing

House Association.

Wire Transfer—The process of moving customer money from one place to another without the transfer of paper documents by means

of telecommunication between financial institutions. Larger banks have access to Federal

facilities, while smaller institutions rely on

their correspondent banks to perform the task.

The important characteristics of wire transfer

are speed and the secured nature of transmiss ion.

Cash Management–A generic term for several

discrete products designed to speed the collection of funds receivable and delay the disbursement of funds payable.

a. Depository Transfer Checks—Depositor~’

b.

c.

d.

transfer checks (DTCS) are items processed

through the payments systems and are preauthorized drafts on remote banks used for

the purpose of concentrating cash in a single depository.

Concentration Accounting—The receiving

end of the DTC system or othe r

cash-gathering mechanism.

Automated Investment Accounts–Those

cash concentration accounts that are preprogrammed to sweep balances in excess of

a target amount into interest-earning accounts or investments on behalf of the customer—usually a commercial depositor.

Cash Forecasting-A service whereby a financial institution uses the cash receipts

and disbursement journals of its customers

to develop an analysis of that cornpany's

cash requirements for a given period. This

enables the customer to invest the unneeded

funds for future use.

50. Business Banking Products– The following

products are generally offered by most banks

to their corporate customers and rely heavily

on electronics either for product deliver-?. or

facilitation.

a.

b.

c.

d.

Account Reconciliation—Customers provided either paper-based or electronic-based

information on the checks they have writ -

ten, which, when matched by the bank with

those checks that have cleared, enable the

bank and the customers to maintain a single

cash balance journal.

Account Consolidation–The creation of

multiple accounts that are actual subsets of

a single account. The funds reside in one account, but statements are prepared for each

subaccount. This is particularly attractive

to customers with multiple-branch profit

centers. The process requires additional

MICR* encoding on each separate set of

checks.

Balance Availability Reporting—Requires

that a bank provide inter-da}’ balance reporting as checks and deposits are made

through a business day. This information is

generally transmitted to a terminal in the

customer’s office.

Balance Concentration/Sweep–The receiving depository account for funds drawn off

of subsidiary accounts and then invested in

money market instruments.
274 ● Effects ot /ntorrnation Technology on Financia/ Services Systems

51.

52.

e.

f.

g.

Automatic Customer Billing—A softwaredriven product whereby the customer provides the bank with electronic-based data

on its customers and the bank generates

either paper or electronic debits or bills that

are either mailed or processed through the

ACH.

Deposit Reconciliation–A service, similar

to account reconciliation and account consolidation, that reconciles customers’ deposits by branch or profit center.

Accounts Payable Check Writing–In this

service the bank uses a customer’s accounts

payable journal and discount information to

prepare its checks to vendors. In many

cases, this service is combined with a

remote disbursement account located at

another bank, usually in a city with no Federal Bank ACH.

Point-of-Sale Systems–A point-of-sale (POS)

transaction is a full funds transfer that can be

accomplished by electronically entering transaction data into an electronic payment network and transmitting the payment information to a data base in a depository institution’s

computer. POS systems serve many masters.

Retailers use them to help control inventory

levels, to assist in order management, and to

authorize checks and credit and debit card purchases. More sophisticated systems are capable of gathering all data necessary for draft or

check processing and enable banks to provide

truncated services to cardholders or depositors. In all cases, POS systems reduce the

steps, and therefore the time, required to process a transaction.

Home Banking–Though in its infancy, home

banking is growing rapidly in popularity. The

most common form of home banking today is

telephone billpaying, which enables customers

of banks, thrift institutions, and credit unions

who have touchtone telephones to inquire

about their balances, make account transfers,

and pay certain household bills. This service

has evolved from the marriage of telephone

lines, television monitors, personal computers,

and television cable into several pilot projects

that enable the consumer to perform the aforementioned functions, as well as to inquire

about other bank products, to budget household finances, and to reconcile bank statements. Some pilot projects also enable the consumer to make purchases from the home while

settling on-the-spot through direct debit to a

53.

54.

55

56.

57.

depository account or through a charge to a

credit account.

ATM Systems—An unmanned electronic device that performs basic teller functions such

as accepting deposits, advancing or withdrawing cash, relaying balance-inquiry information,

and allowing transfer between a customer’s account. The device is usually activated by a

magnetically encoded card or by the transmission of a code via a keyboard or keyset. Such

devices may be accessible 24 hours a day. The

definition of an ATM system differs from the

definition of ATMs under branch automation

in that the ATM system may also involve

credit authorization, check verification, draft

data capture, and transaction processing.

Comingled Investment Pools–Enable banks

to leverage their investment expertise to provide investment services to their customers directly or to other institutions on a correspondent basis. Generally, the product takes the

form of employee benefit trust management,

if provided to the public, and funds management, if done on a correspondent basis.

Direct Debit–Several industries rely on the direct debit to settle the purchase of goods or

services. When the ACH concept is fully exploited, many more industries may take advantage of this process. One of the more visible uses of the direct electronic debit is the

insurance settlement account (ISA) used by

the insurance industry. For those policyholders who spread insurance premiums over

time, the ISA offers the processing of preapproved charges to the policyholder’s depository account at virtually any institution in the

Nation. Mortgage bankers have begun using

the direct debit, and it should not be long

before other providers will also. Possible users

include thrift institutions and major providers

of consumer credit (e.g., General Motors Acceptance Corp. (GMAC), Beneficial Finance,

and leasing companies).

Funds Movement and Inquiry-Generic terms

for electronic-based cash management services, including funds transfer (wire-based) and

access to data base information on the distribution of available funds (e.g., Where are they?

Collected or uncollected? Ingestible?).

International Banking Products–These products are provided to enable the customers of

banks and thrift institutions either to do business in the global market or to have access to

funds while traveling worldwide.
Appendix: Glossary of Terms ● 275

a.

b.

c.

d.

e.

f.

Letters of Credit–Letters of credit (LCS)

are evidence of financial institution’s willingness to underwrite the dealings of its

customers in arrangements where the customer is unknown to the seller of the product or in countries where the extension of

trade credit to foreigners is forbidden (e.g.,

Japan). While the actual letter is paperbased, the advice and LC number is transmitted electronically through the banking

network to the customer’s seller (although

the LC may be required by a buyer as a performance bond). Trade LCS will probably

never be completely electronic because of

the extra documentation required, such as

bills of lading, port entry receipts, and insurance.

Credit Inquiry–Dealing in foreign trade requires that information be gathered on behalf of buyers or sellers, and banks have this

capability through either their correspondent networks or through third parties.

Foreign Exchange–Bank customers who

deal heavily in foreign trade must often settle in foreign currency, making it necessary

to deal in the global currency markets.

Banks themselves that are active in foreign

lending frequently participate in the foreign

exchange market to protect their positions

against adverse currency exchange rates.

Foreign travelers often need to use foreign

currency that they can purchase in the

United States prior to departing. Banks

rely heavily on electronic messages to keep

abreast of foreign money markets, not only

for their own accounts but also for those of

their customers,

Draft Collection-–Involves processing

drafts received or delivered under letters of

credit and is a part of the international

clearing process.

Syndication–Forming consortia of banks

to provide credit and clearing services to

real and quasi-governmental agencies of foreign nations as well as their nationalized

and independent banks. International syndications provide offshore project finance.

Usually the syndicating bank guarantees a

borrowing or servicing cost and then negotiates downward from the determined rate

with potential syndicate members, intending to reap a spread differential profit.

Dollar Collection– Involves the service of

processing checks drawn on U.S. banks and

presented to customers of foreign banks.

,58.

59.

60.

61.

62.

63.

64.

65.

This is a service of the international correspondent bank community and involves

the settlement of cash letters. While the volume in cash letters is extremely high, the

majority of cash and dollar settlement is

done by a handful of the largest U.S. banks.

Stock Transfer-Banks act as the transfer

agents for publicly held stocks. In this capacity they are required to process the changes

of ownership of billions of shares each month.

It is important that these institutions maintain a data base that provides ownership records to verify ownership, a service accessed by

not only the corporation stock issuers but also

the securities industry.

Commercial Paper–Short-term (270 days or

less), unsecured promissory notes issued by

businesses of significant financial strength or

whose paper is backed by a letter of credit

from a major bank. Brokers are merely one of

two ways commercial paper is marketed. The

major exception is Citicorp, which brokers its

own commercial paper.

options/Futures–options” are a tradeable

right to buy or sell securities. Futures contracts are a legally binding agreement that call

for the purchase or sale of a real or hypothetical commodity at a stated price and future

point in time.

Equity Brokerage—The trading of securities

on behalf of a broker’s clients on one of the

great number of stock exchanges.

Index Funds Brokerage–The selling funds

whose yields are defined by specified stock indices such as Dow Jones Industrials, Standard and Poor’s, and the Wilshire Index.

Bond Brokerage–The brokerage of debt instruments of strong corporations to clients.

Fund Management–The continual arrangement and rearrangement of the bank balance

sheet or that of any trust or fiduciary fund in

an attempt to maximize profits, subject to

having sufficient liquidity and making safe investments.

Debit Cards–A plastic card issued by a financial institution to its own customers that, by

usage, credits or debits the customer’s personal account (checking, savings, or line of

credit). The card may be proprietary or it may

be a regionally or nationally accepted card.

With regard to the securities industry, debit

cards are used to access funds on deposit in

money market funds or to access lines of

credit secured by securities portfolios or real

property.
276 ● Effects of /formation Technology on Financial Services Systems —

66. Securities Settlement—The process of transferring title between buyers and sellers of securities. This must be conducted within the 5-day

limit.

67, Discount Brokerage—The provision of transaction services only, without the usual investment advice, for substantially reduced commissions.

68. Securities Lending–The process of lending

securities for collateral purposes and short

sales. These securities often end up as collateral for repurchase agreements,

69. Certificates of Deposit Brokerage–The offering to clients of investments in major bank

and 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 schedule of an underlying loan portfolio or a customer’s future need for funds.

70, Insurance Services Account–The principal

transaction product of the insurance industry

is the insurance services account, which combines insurance premium financing with direct

debit of policyholder’s depository account in

banks, thrifts, and credit unions. These debits

can be paper- or electronic-based.

Information Services

71. Cash Requirements Forecasting—A system

that uses financial institution customer data

on receivables, payables, and capital spending

to construct cash budgets and cash flow analyses that the customer can use to manage its

receipts and disbursements more efficiently.

72. Working Capital and Cash Flow Analysis—A

product tied to the cash requirements product

which highlights the shortfalls and excesses

of short-term assets minus short-term liabilities and expresses the same as a net negative

or positive working capital position.

73, Investment Return Optimization Analysis—

A product used by banks and their customers

to evaluate alternative investment scenarios

using a targeted internal rate of return as the

primary algorithm. This product enables the

banks and their customers to develop parallel

views of customer investment requirements

and ensures that the banks play an active role

at the onset of the analysis rather than after

the fact.

74. Consumer Financial Analysis-–This new product uses the industry’s control of the payments mechanism to assist consumers in

household budgeting. It uses additional information provided by the customer on checks

and deposit documents to organize payments

and receipts data in a fashion that enables

the consumer to visualize how the household

budget is spent, i.e., residence, entertainment,

food, utilities, tax-deductible items, and nontax-deductible items.

75. Business Financial Analysis--This new product works much like the consumer financial

analysis product, using a business customer’s

check and deposit input to generate statements that reflect the prior period’s cash basis

profit and loss, and compares same against

preestablished budgets.

76. Debt Issue Rating and Quotation Services—

These information services are provided to major participants, who use them to guide their

investment activities. Also included in the

group are the equity rating and quotation

services used by trust departments of banks

and thrift institutions, as well as securities

brokers, pension plan administrations, and insurance investment fund managers. The vast

majority of these services are electronic-based

and are provided by third parties.

77. Credit Reporting Agencies—These companies

maintain large data bases or-t consumer and

business credit histories and generate reports

for subscribing members, who also provide

current data on their credit consumers.
H
— —

Index

—. — ————- ——— —-—

ADP, Inc., 118

Aetna Insurance Co., 32

Alex Brown & Sons, 53

Amdahl, Gene, 44

American Automobile Association, 13

American Express, 108, 113, 118, 122

American Stock Exchange, 54, 63, 66

American Telephone & Telegraph (AT&T), 30, 146

AutEx Systems, 72

Automated Bond System, 65

Automated Clearing House (ACH), 78, 99, 146

automated 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., 63

Bank of America, 129

bankers’ acceptance, 84

Belgium, 159

British Telecom, 162

“Buttonwood Agreement, ” 52, 60

California, 119

Carte Bleu, 40

Cash Management Account, 91, 119

C. D. Anderson & Co., 71

certificate of deposit (CD), 84, 104, 154

Chemical Bank, 129, 149

Chicago Board Options Exchange, 54

Chicago Board of Trade, 55

Cincinnati Stock Exchange, 71

CIRRUS System, Inc., 120, 121

Citibank, 203

Clearing House Interbank Payment System

(CHIPS), 158

commercial paper, 83

Commodity Futures Trading Commission (CFTC),

55, 60

Commodity News Services, 130

Consolidated Quotation System, 65

consumer financial services, 167-187

consumer services, 167-180

automated teller machines, 176

automatic direct deposit, 178

costs, 179

growth of credit, 173

home information systems, 178

payment methods, 171

point-of-sale systems, 178

pricing structures, 178

providers, 169

recent innovations, 174

savings and investment behavior, 168

telephone billpayer, 178

public policy, 180-183

regulations, 180

Consumer Credit Protection Act, 182

Electronic Funds Transfer Act, 183

Regulations Z and M, 182

transition from paper-based to technology-based

systems, 184-187

privacy, 185

rights, 186

security, 184

Continuous Net Settlement (CNS), 73

Credit Union National Administration (CUNA), 104

Dahls supermarkets, 123

Dean Witter, 53, 62, 64, 66, 70

Delaware, 112, 113, 123, 217

Department of Treasury, 101

Depository Institutions Deregulation Committee,

103

Designated Order Turnaround (DOT), 71

Digital Termination Service, 35

Drexler Technology, Mountain View, Calif., 39

E. F. Hutton & Co., 53, 66, 130

Federal

Federal

Federal

Federal

Federal

Deposit Insurance Corporation (FDIC), 103,

241

Home Loan Bank Board, 11, 63, 199

Reserve Bank of Atlanta, 176, 205

Reserve Bank of New York, 146

Reserve Board. 26, 60, 68, 142

Regulation D, 125, 156

Regulation E, 26

Regulation Q, 156

Federal Reserve System, 146

Federal Savings and Loan Insurance Corporation,

104

findings, 191-219

applications of technology and changed nature of

financial services, 192

competition in the markets, 216

entrants into the financial services industry, 213

financial options for consumers, 201

integration of capital markets, 210

interaction between technology and the legal

regulatory structure governing banking,

198

restructuring the financial service industry, 194

security and integrity of the financial service

system, 205

First Boston, Inc., 52

floating rate note (FRN), 154

Florida, 130

France, 40

French Ministry of Post and Telecommunications,

162

future scenarios, 1990-95, 251-263

extension of present trends, 252

global financial services industry, 258

piecemeal regulations, 255

prosperity and innovation, 261

future of financial services, 7-9

influence of technology, 7

providers, 8

users, 8

279
280 Effects of Iriforrnation Technology on Financial Services Systems ———- .

General Accounting Office, 180

Goldman Sachs & Co., 52

Great Britain, 162

Hefner, Paul, First Interstate Bancorp of California,

25

Hy-Vee supermarket, 123

Illinois, 120, 122

individual retirement accounts (I RAs), 107, 174, 202,

204

Integrated Services Data Network (ISDN), 34, 35

Intermarket Trading System (ITS), 71

international environment, 153-164

effect of technology on payment systems, 161

financial markets, 157-158

growth of international banking, 153-157

multinational banking, 155

new directions, 154

international lending, 155

sources of funding, 154

interbank communications, 158-160

New York Clearing House Association, 158

SWIFT, 158

vulnerability of the financial system, 162-164

INVEST, 63, 195

Iowa, 123

ISFA Holding Co., Ltd., 63

J. C. Penney, 114, 130, 171

Jefferies & Co., 72

Latamore, S. Berton, 39

legislation:

Banking Act of 1933 (Glass-Steagall), 52, 198

Bank Holding Company Act, 200, 231

Bank Holding Company Deregulation Act,

proposed, 200

Consumer Credit Protection Act of 1968, 182

Consumer Leasing, 182

Depository Institutions Deregulation and

Monetary Control Act of 1980, 104, 174,

200, 226

Electronic Funds Transfer Act, 183

Employee Retirement Income Security Act

(ERISA), 57

Equal Credit Opportunity Act, 182

Fair Credit Billing, 182

Fair Credit Reporting Act, 182

Fair Debt Collection and Practices Act, 183

Garn-St Germain Act of 1982, 11, 105, 200, 226,

233

Maloney Act of 1938, 61

Securities Act of 1933, 60

Securities Acts Amendments of 1975, 62

Securities Exchange Act of 1934, 60, 61, 68

Securities Investor Protection Act of 1970, 60

Truth in Lending Act, 182, 203

Liberty National Bank & Trust Co., Oklahoma City,

125

—

magnetic ink character recognition (M ICR), 19

major findings, 4-7

consumer interests, 6

delivery systems, 5

industry structure, 4

legal/regulatory environment, 5

safety and soundness of industry, 6

Massachusetts, 122

MasterCard, 98, 106, 112, 113, 114

Mellon Bank, 102

Merrill Lynch, 32, 52, 53, 59, 67, 70, 91, 119, 131,

167

Mobil Oil Co., 124

Money Exchange, Washington, D. C., 119

Morgan Stanley, Inc., 52

National

National

National

National

National

National

National

National

Network

Association of Securities Dealers

Automatic Quotation System (NASDAQ),

52, 71, 210

Association of Securities Dealers, Inc.

(NASD), 53, 61

Bank of Detroit, 120

Commission on Electronic Fund Transfers,

186

Enterprise Bank, Washington, D. C., 196

Futures Association (NFA), 61

Securities Clearing Corp., 62, 72

Transaction Systems, Inc., 119

Exchange, Washington, D. C., 119

New England States, 122, 217

New York, 32, 146, 149, 217

New York Clearing House Association, 158

New York Stock Exchange, 19, 52, 53, 59, 61, 63,

65, 66, 68, 71, 72, 73

North American Securities Administration

Association, 60

NOW accounts, 105, 202

Opening Automated Report Service (OARS), 72

Options Clearing Corp. (OCC), 54, 55, 73

Organization for Economic Cooperation and

Development (OECD), 154

Pacific Stock Exchange, 54

Paine Webber, 52

“Pathfinder,” 67

Pecchioli, R. M., 154

personal identification numbers (PINs), 37, 41, 124

Philadelphia Stock Exchange, 54

Pocket Quote, 66

point-of-sale (POS) systems, 22, 25, 31, 32, 33, 40,

101, 111, 123, 171, 178

policy issues, 9-15, 223-247

access to clearing systems, 13, 238

allocation of risk, 13, 241

barriers to international operations, 12, 236

changes in structure, 225

competition between regulated and unregulated

providers, 12, 229

congressional options, 227
Index ● 2 8 1

—

consolidation, 10

control of interest rates, 13, 240

generic considerations in framing policy, 226

implementation of policy, 9

lifeline financial services, 14

market segmentation, 11, 232

privacy, 14, 236, 244

public interests, 224

relationship to telecommunication policy, 11, 235

restrictions on interstate banking, 10, 231

restructuring the policy framework, 9, 226

security and integrity of delivery systems, 15

vulnerability of financial services systems to theft,

15, 246

Prudential Bache, 53, 64

Publix Supermarkets, Florida, 119

repurchase agreeements, 84

retail financial services, 97-133

deposit function, 99-108

accounts with other nondepository institutions,

107

demand deposit accounts, 102

direct deposit, 100

drafts, 102

giro transfers, 102

insurance, 106

lockbox operations, 101

point-of-sale systems, 101

savings accounts, 103

traveler’s checks, 103

electronic funds transfer (EFT), 114-126

automated teller machines, 115-123

ATM deployment legislation, 121

ATM systems, 116

CIRRUS–National ATM Network, 120

shared ATM systems, 118

POS full funds transfer, 123-126

costs of POS systems, 125

direct debit POS, 123

National POS systems, 125

extension of credit, 108-114

commercial credit, 110

consumer credit, 110

financial information services, 126-128

check authorization, 127

credit authorization, 127

providers, 127

home information services (HIS), 128

characteristics of users, 132

costs, 131

developers of, 129

implications of, 131

market for, 131

technology of, 129

Reuters, 157

Revell, J. R. S., 161

Reynolds Securities, 62

Safeway, 118, 119

Saloman Brothers, Inc., 52

Satellite Business Systems, 32

Sears Roebuck & Co., 102, 114, 171, 202

Securities and Exchange Commission (SEC), 55, 60,

62

securities industry, 51-94

capital formation, 91-94

private sources of funds, 92

public offerings of securities of a corporation, 93

functions of, 64-75

acceptance of risk, 67

margin, 68

underwriting new issues, 67

advisory role, 65

counseling, 66

information dissemination, 65

marketing, 69-75

brokerage, 70

clearance and settlement of securities, 72

pricing, 73

product development, 69

transactions, 71

information technology, effects of, 75-76

instruments, 76-91

corporate capital structure, 76-83

convertible securities, 82

equity, 81-82

long-term debt-corporate bonds, 77-81

options and future contracts, 84

central asset accounts, 91

futures, 88

mutual funds, 90

options, 85

warrants, 87

short-term debt-money market securities, 83-84

structure of, 51-64

characteristics, 62

composition, 52

brokerage houses, 53

exchanges, 53

investment banks, 52

development, 51

effects of information technology, 64

industry users, 57-59

individual investors, 59

institutional investors, 57

international market, 64

new entrants, 63

regulatory structure, 59

Federal agencies, 60

self-regulatory agencies, 61

trends in regulation, 62

Securities Industry Automation Corp. (SIAC), 54,

62, 71, 72

Securities Investor Protection Corp. (SIPC), 60, 61,

180, 241

Shearson/American Express, 53, 63

Small Business Administration, 60
282 ● Effects of Information Technology on Finaricia/ Services Systems

—. — —

Small Business Investment Corporations, 60

Society for Worldwide Interbank Financial Telecommunication (SWIFT), 153, 158, 159,

160, 163, 164

South Dakota, 112, 113, 217

Super NOW accounts, 105, 108, 202

support technologies, 19-47

computer hardware systems, 20

future hardware, 23

large computers, 22-25

microcomputers, 20-22

hardware components, 44-45

software, 25-29, 45, 46

applications software in the future, 28

specific technologies for delivering financial services, 38

customer service equipment, 42

document and currency renders, 41

electron cards, 39

embossed/magnetic stripe card, 38

laser card, 39

system security and integrity, 36-38

telecommunications, 30-36

future, 34

private-line facilities, 32

switched telephone network, 30

alternatives, 32

video-related communication technologies, 33

Telemet America, Inc., 66

Treasury bill, 83

Tyme Corp., Wisconsin, 119

VideoFinancial Services, 130

Videotex Industry Association, 186

Viewdata Corp., 130

Viewtron Program, Miami, Fla., 130

VISA, 13, 39, 98, 112, 113, 114, 126, 137

Warner-Amex QUBE System, 34

Washington, D. C,, subway farecard system, 39, 40

White, William, 168

White Weld, 62

wholesale financial services, 137-149

data access, 147

future of, 148

~ products available in wholesale markets, 138-141

asset and liability products, 138

major providers, 139

information products, 141

nonprocessing services, 141

processing products, 140

providers, 142-146

role of technology, 138

Wide Area Telephone Service (WATS), 31

Wilmington (Delaware) Savings Fund Society, 123

Wisconsin, 122

Zimmer, Linda Fenner, 176