Mr. Ferguson discusses the consumer side of electronic banking and its implications for Federal Reserve policy development  (Central Bank Articles and Speeches, 29 Sep 98)
Central bank: fed | Type: speech | Date: 1998-09-29

Mr.

Ferguson discusses the consumer side of electronic banking and its implications for Federal Reserve policy development Remarks by Mr. Roger W.

Ferguson, Jr., a member of the Board of Governors of the US Federal Res System, at the Bank Administration Institute's Symposium on Payments System Strategy he Washington, D.C. on 29/9/98.

## Electronic Banking:

Where are the customers?

What do they think?

What does it mean for the Federal Reserve?It is my pleasure to be here this afternoon, and I want to thank the inviting me to speak to this symposium on payments system strategy.

The focus of my r today will be on the interaction between electronic banking and the household sector, interaction should influence our 'strategic' thinking about the evolution of the d electronic banking by households, and what this may mean for the strategies the Federal should adopt in developing policy in the payments area, and in other areas as well.

So comments will, by necessity, by quite speculative, and perhaps even somewhat controvers my desire is to contribute positively to efforts by all market participants to underst to the rapidly changing and highly uncertain world of electronic commerce.

## What is Electronic Banking?I will begin by defining what I mean by electronic banking.

I would propos we use a very broad definition.

Thus, at one end I would include telephone banking, cre ATMs, and direct deposit, all of which are fairly mature and familiar products, but on certainly electronically based.

At the other end are stored-value cards and Internet-b value products, products that are still mostly in the experimental stage.

In the midd cards, a product that has been around for a number of years but which only recently achieve wide market penetration, electronic bill payment innovations, and PC banking, product that is becoming increasingly robust and sophisticated.

Defining electronic b this way has many advantages, not the least of which is that it helps us to see electr as a continuum that has, in fact, been evolving for quite some time.

An implicatio perspective is that lessons learned from past electronic developments may help us understand both today and the future.

## Who uses Electronic Banking?In

the Federal Reserve's 1995 Survey of Consumer Finances of over 4,0 American households, we asked a series of questions regarding households' use of electr other banking products.

Our intent was to establish some benchmark data for 1995, whic then be used with data from future surveys to track and analyze electronic banking. effort to establish some benchmarks, let me summarize briefly what reality appeared 1995.Our survey results indicated that, in 1995, use of an electronic techn transact at a financial institution was common, but hardly the dominant form of co business.

Ignoring credit cards, which were widely used, the most commonly used inst was direct deposit, a relatively old and well-established electronic technology. estimated 50 percent of households used direct deposit, this usage rate paled compared the most commonly used means for transacting at a financial institution.

The most cmeans was the 'in-person' visit, employed by 87 percent of households.

Indeed, the seco popular technology was the mail, used by an estimated 57 percent of households.Other electronic technologies, including even the telephone and ATMs, w employed by substantially smaller portions of the population.

Stored-value cards did show up in numbers sufficient to estimate reliably a national percentage, and use of th for transacting at a financial institution was scarcely out of its diapers as fa technology that households actually used.

Still, some form of electronic technology wa by almost 70 percent of American households, even excluding credit cards from the calculPerhaps the most interesting and important results from our 1995 su concerned the importance of education, income, financial assets, and age for the use of banking products by US households.

Indeed, when trying to describe who used elect banking it seemed difficult to underestimate the importance of education, even after c for factors such as income and age.

An important break point appeared to be achieving college degree, a level of education held by the heads of less than one-third of h Households with annual incomes below $25,000 were particularly unlikely to use elect and households with annual incomes above $50,000 appeared relatively likely to do addition, households with heads under the age of 35 were considerably more likely to us debit cards, and the computer.

The only use of electronic technology that increased wit direct deposit, a reflection of the importance of the direct deposit of Social Securi On balance, these results suggested that, in 1995, the potential market for relat electronic banking products was highly specialized.

Since 1995 the world of electronic has certainly changed.

But how much has it changed?

Unfortunately, we do not seem to very clear picture of the overall trends.

As I am sure each of you is well aware, esti current state-of-the-world, and projections of the future state-of-the-world are all o Use of debit cards is on the rise, and continued growth is frequently predicted.

An number of banks are providing PC banking services and it will be interesting to see whe product offerings currently being developed will substantially increase market penetra particularly as household PCs with modems become more ubiquitous.

Experience wi stored-value cards has not come close to meeting the expectations that some had sever ago.

Most stored-value card pilots seem to suggest that, while the technology works, and business demand is weak.Recent Federal Reserve research on the use of the ACH shows that while A volume continues to increase at double-digit rates, a significant untapped market rema than half of households surveyed earlier this year receive one or more payments vi deposit and about one-third of all businesses surveyed offer this payment option (wi three-quarters of medium and large companies offering it).

More than one-third of hou surveyed use ACH direct payment and only 13 percent of businesses offer this payment (although almost three-quarters of utility companies offer it).

Users of both direct direct debit report very high satisfaction levels; nonusers cite more difficult probl and lack of availability.

In addition, nonusers of direct payment expressed concern option would diminish their control over payments, as well as reduce privacy and securitIt is interesting to note that when one looks at the incidence of c complaints received by the Federal Reserve Board, electronic banking does not stand o troublesome area.

For example, through July of this year, only two percent of t complaints involved electronic funds transfer transactions.

For the entire year of 1997 and one-half percent of all complaints were so directed.

## What Might the Future Hold?So, what, on balance, should we expect in the future?

It is useful to con question in the context of both the typical product life cycle as well as in relation key factors for the success of new payment services.

Some retail payment services, such value products, are at the beginning of the product life cycle, and it is not clear wh succeed and eventually have mass acceptance and which will fall by the wayside.

P payment is somewhat farther along the life cycle curve, but still has relatively l penetration.The most interesting group of technologies, in my judgment, are those have recently moved out of their limited niche markets into mass adoption.

A short l include the Internet, which is a whole new distribution system in itself; debit cards existing credit card and regional ATM networks; and on-line investing, which relies Internet.

The Internet really only blossomed into mass adoption in the mid to late 1990 advent of numerous simple tools for 'surfing the web.' On-line investing has just begu into early mass adoption.

Some apparent reasons for its success include our long e boom, a graying population looking towards retirement, significantly lower transaction the provision of associated investor information and services.

Finally, heavily market debit cards that provide consumers with global merchant access and the convenience of card have fueled debit's sharp volume gains.As our research indicates, one electronic banking service that has moved we mass adoption is direct deposit.

Users value the convenience, reliability, and secur means of payment.

Credit cards have moved even further along in the product life cycle.This brings me to two key factors underlying the successful adoption of payments method.

The first key factor, as we have seen with direct deposit, ATMs, debi and on-line investing, is that reaching a critical customer mass is highly depend comprehensive infrastructure.

There must be a distribution system that saturates the ta and has resolved most 'soft' infrastructure issues--standards, protocols, and legal f before widespread consumer availability will occur.

Debit cards and on-line investing h this a step further to reduce the time from product introduction to early mass ad piggybacking upon existing networks.

These infrastructure issues are critical becaus electronic banking products that customers can use is the obvious first step in havin that customers will use.

Similarly, resolving some of these 'soft' infrastructure ques the balance in risk-reward calculation that providers must make in deciding whether t new product introductions.Second, for customer preferences to shift to a new payment mechanis customers must perceive that, on net, the new mechanism is more advantageous to them existing alternatives.

Is the new product more convenient to use?

More secure?

Less ex Does it facilitate better recordkeeping?

Before customers try a new payment product, not be in a position to compare fully how it stacks up with respect to these attribute payment method they currently use.

Unfortunately, in many cases they cannot easily comp relative cost of the new payment method with an existing method.

In this regard, somewhat puzzling that some banks that advocate the migration of retail payments from p electronics nonetheless have pricing structures that appear to run counter to that obje

## Competitive and Market Issues Raised by Payments System DevelopmentsThe

evolution of the retail payments system raises several interesting related to competition.

First is the tension between cooperation and competition providers.

Cooperation may help ensure interoperability across products of competing providers and increase providers' willingness to accept new technologies and payment innovations, which can reduce the risk and cost for each participant.

Competition coordination among providers may provide the market with a broader choice of pay innovations, but may delay user acceptance and the associated economies of scale and prices that may result from volume growth.A related issue is how the evolution of retail payments and the increasing on electronics will affect the competitive balance between small and large financial i To date, small institutions have proved very adept at maintaining their competitive via effects of the widespread use of some of the more recent innovations in electronic however, are unclear.

For example, PC banking may free smaller institutions from a dependence on 'bricks and mortar,' and thus greatly expand their geographic r Alternatively, it may be that large institutions will have an advantage in being able t technical overhead and manage the security concerns required to offer a wide range of services on the Internet.Electronic banking may also have implications for Federal Reserve polic several arenas outside of the payments system.

While it is too early to say with any cer the implications of electronic banking will be, and my comments must therefore be t highly speculative, I would like to give you a feel for my thinking by suggesting two a believe are appropriate subjects for strategic thinking.Electronic banking may prove to be important in the analysis of the compe implications of bank mergers and acquisitions.

A cornerstone of our current appro enforcing the antitrust laws is the definition of a local geographic market for the cl products and services - primarily insured accounts and loans and transaction services businesses.

On-line banking conducted via a household's or a small business' personal c has obvious possible implications for the reasonableness of using a local geographic While current usage of PC banking is too small to affect our methodology significantl judgment this is clearly an area that we need to monitor and study, and, if necessary, to adapt our procedures accordingly.

In this regard, I would note that good data on the banking by households and small businesses is a must.Electronic banking raises similar issues for our evaluation of the Com Reinvestment Act performance of banks.

Here again, a fundamental aspect of our cu approach is definition of the relevant geographic area.

These are complex topics and t still clearly out, but, in my view, they are areas that deserve careful watching.

## Federal Reserve Payments System RoleClearly, an efficient and smoothly functioning payments system is critica health and stability of the financial markets and the economy more broadly.

Although surely room for continuing improvement, the U.S.

payments system fares quite well compared to other countries.

As the central bank, the Federal Reserve has a keen in fostering continuing improvements in the efficiency and integrity of the U.S. paymentsWe work to achieve this objective through several important payments system roles, t regulator, service provider, and facilitator.

As regulator, we are always open to your for revisiting regulations that may pose impediments to payments system innovatio considering changes to existing regulations, we would assess how the change might aff public good.

For example, is the original public policy rationale for the regulation no valid?

Would the proposed change make society better off?As service provider, the Federal Reserve is working closely with the indu enhance the ACH marketing and education that is needed to substantially increase penetration.

The market research that I discussed earlier is important in helping to efforts.

In addition, the Reserve Banks are providing ACH EDI transaction capabilit customers to facilitate the use of the ACH for vendor payments.

In the check service, t Banks are presenting an increasing number of checks electronically (ECP currently rep about 14 percent of Fed check collection volume), are introducing a wider array of che services, and are developing pilot programs to learn more about ECP.

To facilitate the of transactions that clear outside the Federal Reserve, the Reserve Banks will introducing an enhanced net settlement service, which provides better finality, securi controls than the net settlement service used by most private clearing arrangements todaFinally, as facilitator, we are eager to hear about your efforts, both th and the failures, and to learn what consumers think.

If we are to make informed deci policy and regulatory issues in this rapidly changing environment, we must have a understanding of market developments and the implications of policy choices.

I do not the Federal Reserve should dictate or promote any specific 'vision' of the future system, particularly with respect to the small-dollar retail payment mechanisms.

The ma will be the ultimate judge of the future direction of the payments system.

We should un however, the payment mechanism attributes customers are demanding, and the products services you are developing to meet that demand, so that we can shape policies in the market realities.

## ConclusionIn closing, I hope that my discussion has provided some additional insig the

consumer side of electronic banking and its implications for Federal Reserve development.

I would like to again extend my personal welcome for your suggestions on h improve the climate for payments system innovation, and to share with us your experienc electronic banking.

The insights that we obtain from an ongoing dialogue with i representatives need to be augmented with further research in this area.

In this regard Reserve plans to undertake a major research effort in 1999 that will include su consumers, businesses, and depository institutions about the use of retail payments.

T will gather data on the use of various retail payment instruments and the use of tec facilitate retail payments, and will also explore public perceptions about retai instruments.

We look forward to sharing the results of these surveys with you.

They provide both the Federal Reserve and the private sector with a much broader base of inf from which to evaluate policies and initiatives.