Roger W Ferguson, Jr: Information technology
in banking and supervision
Remarks by Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal
Reserve System, at the Financial Services Conference 2000, St. Louis University, St. Louis, Missouri
on 20 October 2000.
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I am pleased to speak with you today on technological innovation in the financial services sector. As
you may know, technology and its impact have been key areas of focus at the Federal Reserve in
recent years. As my colleagues on the Federal Reserve Board have often noted, technological
innovation affects not just banking, financial services, and regulatory policy, but also the direction of
the economy and its capacity for continued growth.
Some argue that dramatic structural changes are in store for the financial services industry as a result
of the Internet revolution; others see a continuation of trends already under way. What is clear is that
the last few years have seen a truly phenomenal pace of new technology adoption among even the
most conservative banking organizations. A number of financial trade publications are now devoted
almost entirely to emerging technologies and the latest financial technology ventures. We know that
many banks are making what seem like huge investments in technology to maintain and upgrade their
infrastructure, in order not only to provide new electronic information-based services, but also to
manage their risk positions and pricing. At the same time, new off-the-shelf electronic services, such
as on-line retail banking, are making it possible for very small institutions to take advantage of new
technologies at quite reasonable costs. These developments may ultimately change the competitive
landscape in financial services in ways that we cannot predict today.
Technology is also changing the supervisory and regulatory landscape. It is creating new tools for
supervisors and new supervisory challenges. Technology-driven issues such as privacy and the nature
of electronic communications have reached the forefront of the policy agenda. And the line between
electronic banking and electronic commerce is becoming more difficult to define clearly.
I would like to explore more deeply a few of these issues in my remarks today.
Technology investments
More than most other industries, financial institutions rely on gathering, processing, analyzing, and
providing information in order to meet the needs of customers. Given the importance of information in
banking, it is not surprising that banks were among the earliest adopters of automated information
processing technology. The technological revolution in banking actually began in the 1950s, well
before it began in most other industries, when the first automated bookkeeping machines were
installed at a few US banks. Automation in banking became common over the following decade as
bankers quickly realized that much of their labor-intensive, information-handling processes could be
automated on the computer. A second revolution occurred in the 1970s with the advent of electronic
payments technology. Recognizing the importance of information security, the financial services
industry during the late 1970s and early 1980s was also the first to implement encryption technologies
on a widespread basis. The euphoria surrounding the Internet today seems very similar to that era,
when the first nationwide credit card and electronic funds transfer systems were built.
As we could in earlier decades, we can identify three main reasons financial institutions are investing
in technology. First, as in the 1950s and 1960s, they anticipate reductions in operating costs through
such efficiencies as the streamlining back-office processing and the elimination of error-prone manual
input of data. Second, institutions see opportunities to serve their current customers and attract new
customers by offering new products and services as well as enhancing the convenience and value of
existing products and services. Third, with more powerful data storage and analysis technologies,
institutions are able to develop and implement sophisticated risk- and information-management
systems and techniques.
While in hindsight it is clear that many of the earlier investments met those objectives, it is unclear
whether today's most highly touted investments have done so, or will do so in the future. For example,
the rush to set up Internet banks of a few years ago seems to have slowed, tempered by the experience
of the few pioneers in this area, who found that although technology risks and hurdles are
surmountable, the basic imperative of making a profit is often not. Smart cards are another example of
an innovation that, although widely heralded several years ago as the next new personal banking
device, has yet to be proved a convenient substitute for currency and coin.
Overall, the impact of the current technology investment boom in the financial services sector is
difficult to assess. We know that productivity in financial services, like productivity in the rest of the
service sector, is very hard to measure. The problem is due partly to the difficulty of measuring output
accurately when the quality of service is changing as a result of such factors as greater convenience
and speed and lower risk. Measuring output in the financial services sector is particularly controversial
because so many services, such as deposits, provide services directly to customers and at the same
time fund loans. Moreover, measuring the inputs used to produce outputs is difficult. We have not, for
example, traditionally required from financial institutions, as part of the supervisory process, any
reporting of technology-related investments and expenditures. Lack of consistent data significantly
limits systematic industrywide or peer group analysis by supervisors or economic researchers that
would shed light on some of these questions.
As I consider the very recent, admittedly mixed, experience of the financial services sector with
technologies - looking at the examples of Internet banking, on-line banking, smart cards, and
ATMs - it seems that several lessons emerge. First, many of the investments have been made to
automate existing processes, but the challenge of fundamentally rethinking the process from start to
finish - the so-called core process redesign that is necessary to reap the full benefit of the current
generation of technologies - has proved daunting. This is in part because many of the services that
banks are attempting to automate currently are "joint goods", that is, the production and consumption
of the product or service depend on the inputs or behaviors of many players outside of the bank and
even outside of the financial industry. For example, the flow of services from checks depends on a
complex of economic actors, including consumers willing to write checks, merchants willing to accept
them, and an infrastructure in place to clear and settle them. Attempting to automate part of the check
process by imaging or to replace checks with a single instrument, such as the debit card, requires
cooperation among all the organizations that support a checking transaction. Internet banks are another
example of these interdependencies. Many Internet banks have discovered that they are using any
savings in "brick and mortar" operating costs to pay "bounties", or fees, to other Internet sites that
refer new customers and to operate call centers to field the customer inquiries that invariably arise.
Another lesson from the history of technology in banking is that so many of the costs in banking are
shared across products, and even across customers. Therefore, an investment that might have a
positive impact on one customer base or product may not have the desired impact on the overall cost
base. I believe that the early history of ATMs illustrates this lesson. The ATM was originally
introduced as a way to reduce costs of the branch network. Although the ATM succeeded in moving
small-value withdrawal transactions from branches, that accounted for only a portion of the customers
served and the transactions performed by a branch network. Therefore, early ATM networks added
cost without substituting for branch networks. For ATMs to become truly economically attractive,
they had to evolve to offer a fuller range of products for a greater proportion of bank customers.
Indeed, ATMs now offer more services and more locations, and they have started to make a positive
return on investment.
The third possible lesson from the history of technology in banking is that banking services may be a
class of services for which demand and supply interact so that new supply creates additional demand.
Clearly, creating different channels for retail access to banking services, such as branches, PC
banking, phone banking, ATMs, and the Internet, has neither significantly reduced the demand for any
of those channels nor led to significant bank cost savings. This situation may in part reflect banks'
reluctance to use pricing as an incentive for customers to change their behavior and move to newer
technologies. However, it may also reflect the fact that the increased convenience of these different
channels is simply translating into a permanent increase in consumer welfare and not necessarily into a
permanent increase in revenue or a permanent reduction in costs. In this regard, banks that are not
early adopters will admit privately that their investments in new technologies for customer access are
largely defensive measures. New channels, such as on-line banking, are not generally leading to
increases in the customer base at banks that offer them; instead, customers (particularly the most
sophisticated who have ready access to technology) have begun to expect these services and may
readily switch providers if their expectations are not met. Thus, banks have recognized that they need
to offer the conveniences of newer technologies merely to retain their existing customers.
Federal Reserve research has found an interesting caveat to the above statement: Banks that either are
early adopters of new technologies or are particularly effective at using such technologies do have
temporarily higher revenues but do not have cost savings. Revenue enhancements are the foundation
of higher profitability. The elevation of profitability is expected to be temporary, however. As others
adopt similar technologies, rates of return on new investment fall, and profitability for all banks
returns to normal. The net result is an increase in consumer welfare but, as I have just stated, not a
long-term reduction in cost or a long-term increase in profitability.
The fourth lesson is that the mixed effect of technology in banking more recently may simply reflect
the fact that technology can replace relatively simple, repetitive functions, such as the basic
calculations and internally oriented back-office support functions that were automated initially. But so
much of banking still involves higher-level judgments. These are judgments that can be informed by
the types of computations performed by computers, but ultimately they cannot be made by computers.
Risk management, reserving policy and underwriting larger C&I loans are, it appears, areas in which
technology is an important adjunct to the judgment of experienced managers but ultimately is not a
replacement for the experience a banker brings to the undertaking. This is reflected in the fact that risk
modeling seems to be further advanced for market risk than for credit risk.
We know that investments in newer technologies must be made to modernize existing operations, to
face competitive challenges, and to meet customer expectations. Indeed, some of these investments
will also be made in the hope of achieving cost savings and other efficiencies. However, I would
suggest that bank management needs to enter these investments recognizing that the full benefits may
not be gained quickly; may, if gained, be competed away; and may, indeed, not be captured at all.
History teaches that costs may emerge long before expected revenues, and that operational risk can
either decrease or increase as a result of making major technology investments. As I will emphasize in
a moment, bank managers would be wise to monitor carefully the progress of large technology
projects, marking major milestones clearly and holding technology management accountable. Given
the size, complexity, and business risk of many modern technology investments, these investments
clearly should be a top management interest and are a top management responsibility.
Technology in banking supervision
Technology also plays a key role in the Federal Reserve's longer-term process of modernizing its
approach to banking supervision and regulation. I will briefly touch on a few examples.
The Federal Reserve and other banking supervisors are reviewing our processes and policies to make
sure we are adequately prepared to fulfill our supervisory responsibilities. Part of this task involves
better understanding the role and risks of technology in banking organizations. The Year 2000
experience was instructive to many within the supervisory community on the importance of
technology to financial business processes. We are attempting to preserve the lessons we learned by
integrating technology considerations into our ongoing supervisory process in several ways.
For example, traditionally, the Federal Reserve and the other federal banking agencies have conducted
separate reviews of information technology operations and had assigned these activities separate
examination ratings (similar to CAMELS ratings). Earlier this year, we decided to merge these
reviews into the mainstream bank supervision process. Like banks, examiners must learn to consider
how information technology affects the bank's financial risks and results, rather than treating it as a
separate function. The privacy provisions of the Gramm-Leach-Bliley Act have also made information
security a priority for supervisors. Although we have always reviewed information security as part of
the supervisory process, the new law requires us to set consistent expectations for all institutions.
Attaining the appropriate balance in assessing technology operations within the supervisory process is
not a simple matter, however. For example, over the last year, the number of banks supervised by the
Federal Reserve that are offering banking services to their customers over the Internet has more than
doubled. As supervisors, we recognize that this kind of sudden change can lead to risks. We are
developing training for our examiners on how to review Internet banking operations, and maintaining
a sufficiently up-to-date knowledge base will be a constant challenge for supervisors. However, we
need to avoid the temptation to view electronic banking and other technology related operations as a
new business line or risk area for which we need to develop a whole new supervisory or
riskmanagement framework. And to date, these operations remain a relatively small part of most banks'
operations, and we have not seen them generating higher levels of supervisory concerns.
Despite our more integrated view, it is important to recognize that supervisors cannot be responsible
for ensuring that the technology employed by financial institutions always works exactly as expected.
In fact, there are many technology related risks and pitfalls that are rightfully the concern of a financial
institution's shareholders, but not necessarily of its supervisors. I do not see bank supervisors hiring
legions of network engineers to advise banks on which firewall or encryption technology to use. Even
if we felt that a detail-oriented technical approach was warranted, our public-sector resources simply
could not support it. Moreover, it is not clear that this type of approach would be consistent with our
increased supervisory focus on banks' risk-management processes and control infrastructure rather
than on conducting detailed technical reviews. In fact, most of the technology related issues we have
encountered as supervisors, such as problems integrating disparate systems that invariably arise in
bank mergers, are not the result of inadequate technology, but of inadequate planning or project
management. The Federal Reserve has reviewed more than a dozen bank holding company
applications over the last year or so that have involved Internet ventures. We have found that when
supervisory issues were identified, they generally involved managerial or financial concerns rather
than concerns about the viability, reliability, or security of the technology. What this suggests to me is
that the core risks and core competencies of banking and financial services will change only gradually
while banks find new ways of reaching customers through new technology.
The international regulatory community has also increased its focus on these issues. As you may
know, there is currently a project under way in the Basel Committee on Banking Supervision to
evaluate capital requirements for operational and other risks. The process is difficult, both
conceptually and in practice. There is little industry consensus about what should or should not be
included in the definition of operational risk and about how best to allocate capital. Operational
failures and occasional financial losses are routine events that in many cases can be incorporated into
the pricing of services. We do not yet have a good handle on what portion of operational loss events is
expected or unexpected. Many larger banks are now developing their own models to measure and
estimate operational risk and to allocate capital to cover this risk. The Federal Reserve is currently
developing new approaches to assessing operational risk in our supervisory process, but a common
view on this topic is probably several years away.
Finally, in our day-to-day supervision of banking organizations, US regulators have recognized the
need for an ongoing, more risk focused approach, particularly for large, complex, internationally
active banks. We need to stay abreast of the nature of their activities and of their management and
control processes. A continuous flow of information helps examiners tailor on-site reviews to the
circumstances and activities at each institution, so that our time is well spent understanding the bank's
management process and identifying weaknesses in key systems and controls. Throughout this
process, the Federal Reserve is looking at areas in which we can use technology to perform our
supervisory responsibilities more effectively. We are implementing a number of automated tools for
examiners to use for gathering and analyzing information that can aid the supervisory process without
burdening the institutions we supervise.
Legal and regulatory distinctions
Just as the Federal Reserve is modernizing its approach to supervision, so too our banking laws are
being modernized. While these laws have historically ensured the separation of banking and
commerce in this country, the information-based nature of electronic commerce and its close relation
to electronic financial services is challenging this distinction. Traditionally, banks have largely been
technology users or buyers. Today, some financial organizations aspire to emulate technology
companies, both by participating in the development of new technologies for financial products and
services and, potentially, by earning the kind of capital markets support that we have seen for
technology companies in recent years. Whether this fit will be harmonious is yet to be seen.
Nevertheless, it is imperative that we modernize our approach to traditional banking restrictions.
The Federal Reserve and state and national chartering authorities have begun to consider the range of
electronic commerce activities that financial institutions may operate or own. We recently issued a
proposal on "finder" activities that would allow financial holding companies to provide, or invest in,
services that bring together buyers and sellers of nonfinancial products. These activities would
encompass, for example, hosting an Internet marketplace or operating an Internet auction site. We are
considering other areas of technology and electronic commerce activities that would be considered
permissible for financial organizations while still preserving the core distinctions between banking and
commerce.
Conclusion
In conclusion, we can expect financial institutions to continue experimenting with new technologies
and electronic, information-based services. I believe that this is an area with great potential, yet the
uncertainties are large and the payoff horizon is unknown. Banks and supervisors need to recognize
that it is acceptable - and even expected - to make some investments that do not pay off. We also know
there have been, and will continue to be, technological glitches - computers and web sites go down
occasionally, and e-mail gets lost. The new Internet world is a punishing one for these routine
mistakes, and financial institutions have strong incentives to take precautions and to fix problems well
before they reach supervisors' and policymakers' attention. The information-based nature of financial
services is unlikely to change. I am confident that banks and other financial institutions will continue
to find new and better ways to put technology to their and their customers' best use, and that they will
manage the technology and the business risks associated with these investments.