Andrew Crockett: Financial Stability in the Light of the Increasing Importance
of Online-Banking and E-Commerce
Lecture by Mr Andrew Crockett, General Manager of the Bank for International Settlements and
Chairman of the Financial Stability Forum, at the Center for Financial Studies at the Johann Wolfgang
Goethe University, for the Colloquium Series on "Financial Markets and E-Commerce", Frankfurt,
31 January 2001.
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Introduction: Revolution and uncertainty
It is a great pleasure to speak in the Colloquium Series on "Financial Markets and E-Commerce",
organised by the Center for Financial Studies. Over the years, the Center has gained a well-deserved
reputation for high-quality analysis of topical issues facing the financial sector. And this Colloquium
series is a good illustration of its ability to identify timely subjects and bring different perspectives to
bear on them. In dealing with the subject of electronic finance, I will naturally take the view of an
official sector observer, with a particular interest in financial stability implications.
I should admit at the outset that I approach the topic with a variety of feelings. One is enthusiasm.
The internet, and the other innovations made possible by information technology advances, have the
potential to transform the financial industry in ways that will bring enormous benefit to businesses and
consumers alike. Many of you who are deeply involved in the development of e-finance will
understand the excitement of being involved at this technological and business frontier.
A second feeling, however, is one of uncertainty. Although a lot has been written about e-finance, it is
difficult to identify at this stage what will prove to be its essential characteristics. We inevitably tend to
look at the future wearing the spectacles of the past. This does not always help us to distinguish
innovations of lasting significance from those of more passing interest.
Finally - and this may not surprise you from me - there is a feeling of caution. Any major change in
the financial industry carries some risk of undermining financial stability. Only when we understand the
risks involved can we be confident about the approaches we use to manage them.
Both the private sector and the official sector have much to do to ensure that the potential gains from
new technology are effectively exploited without undermining the resilience of the financial system.
This aspect will be the main focus of my remarks this afternoon. I will discuss what e-finance means
for financial institutions, for markets and for the official sector.
But before doing that, I would like to make two general remarks. The first is that e-finance has the
potential to be more than just another incremental change in ways of doing business; it could be a real
revolution. The second is that the precise nature of e-finance development in the years ahead is
impossible to predict. Let me elaborate a little on these two points as they have important implications.
First, the issue of the scope of change. Some argue that e-finance is simply another technology wave
adding a new delivery channel. On this view, relatively few new policy issues arise, although many
existing dilemmas may be accentuated. The other view is that the financial landscape will be
fundamentally transformed by the new technology. I find myself much closer to this second view.
Earlier waves of technological advance focussed on the of information, for example, the
elaboration
development and pricing of new hedging instruments; and on the transmission of information, i.e.
faster and cheaper communication of product and price data. The wave based on the internet makes a
further quantum jump. As you know, the internet relies on open networks and standards, allowing
much wider and easier access by consumers. This is a radical change. Recall that the previous
electronic technologies employed by the financial services sector were generally based on proprietary
networks and standards with restricted access.
There are good grounds for supposing that the internet and financial services have unique synergies:
the internet offers convenience, price transparency, broader access to information and lower cost;
financial services are information-intensive and generally require no physical delivery. E-finance has
the potential, not only to take business away from traditional, "bricks-and-mortar" delivery systems but
also to introduce new business models, changing financial structure and driving financial
consolidation. I will come back to these points in a moment.
This does not of course mean that the financial system is going to be transformed overnight. During
the last year we have witnessed an enormous swing in sentiment towards e-commerce from almost
frenzied over-optimism to much greater realism, and even pessimism. A huge number of companies
were created and many have since died without generating any profit. So far, the financial industry has
been largely spared in this cycle of entrepreneurial creation and destruction, partly because of
prudential limits of entry through licensing rules. Such a situation will not necessarily persist, however.
My second general remark concerns the nature of change. If we accept that e-finance will ultimately
have a major impact on the financial industry, exactly how the changes will take place is quite
uncertain. True, some trends may be relatively easy to understand. For instance, the shift to online
has been most noteworthy in the case of brokerage, somewhat less in banking, and much less
impressive in other sectors. The advantage of real time transactions is clear in the case of securities
and foreign exchange dealing. But it is less evident for mortgages, sales of insurance products and so
on.
Looking ahead, however, it is difficult to know which technologies will work best, how customers will
respond and so on. The fast pace of developments means that there is considerable uncertainty about
which parts of the financial system will feel the greatest stress. How quickly institutions will have to
adapt to changes remains uncertain. From what we have learnt so far, the adoption of online delivery
seems to differ across sectors, mainly reflecting the complexity and time-sensitivity of the product or
service.
Uncertainty about the nature of the prospective changes has some major implications for both the
private and the public sector. The private sector would be prudent to maintain a questioning attitude
about specific IT developments. It is wise to recall examples of earlier over-estimation of demand for
technical products such as smart cards. Although many electronic purse pilot schemes are still in
place, the customer resistance they have encountered has turned initial euphoria into, at best,
cautious optimism. Another example would be pure internet banks, which have had only a limited
success so far.
In making IT investment decisions, firms need to balance two conflicting considerations. On the one
hand, technology is constantly changing and prospective returns on new technology may be
undermined by still newer technology. This calls for caution and the need to discount future returns
heavily. On the other hand, so-called "network effects" may create "first mover" advantages that
encourage market players to adopt quickly the latest technology, without awaiting a full evaluation of
costs and benefits.
The public sector faces a dilemma too. On the one hand, the authorities cannot predict the future
shape of the financial industry. This argues against actions that risk stifling the process of innovation,
for example by regulations that "freeze the present". On the other hand, there is a danger of new
unregulated developments going too far, too quickly. It may then be more difficult to introduce prudent
guidelines: once the genie is out of the bottle, it may be difficult to put it back.
Balancing these two concerns is not easy. In principle, the public sector should be
"technologyneutral", neither favouring nor hindering particular technical approaches. But what this means in
practice may vary across countries and industry sectors. Many European countries, for instance,
favour limiting e-finance to regulated institutions. The United States, on the other hand, tends to favour
a more hands-off approach in dealing with the types of institutions that deliver financial products and
the types of delivery channels used. However, US supervisors are strong advocates of the systematic
on-site inspection of unregulated service providers. You may remember a similar difference in views
between the EU and the US as to the issuance of e-money several years ago.
Against the background of these general remarks, let me now address some specific aspects of
efinance developments. First, I will take a look at the implications of prospective trends for banks and
other financial institutions. Second, I will review implications for markets. Next, I will outline some key
risks in these developments. I will conclude my remarks with some preliminary thoughts on an official
sector agenda.
Implications for banks and other financial institutions
There are many ways of classifying the implications of e-finance for the institutions involved, but I will
group them under six headings. First, it is becoming clear that the physical start-up costs of
efinancial institutions are lower than those of traditional institutions. Even the cost of setting up IT
systems - sometimes regarded as a barrier to new entry - can be reduced by outsourcing to a
wellestablished service provider. Lower cost barriers to entry could well intensify competition and increase
the threat of disintermediation of existing institutions.
Because it is cheaper to open a selling point on the internet than to open a network of physical
branches, the distribution cost and marginal operating costs of electronic-based platforms are
significantly lower. This impact will be significant in sectors that rely on a high-cost network of agents,
who can be replaced by electronic communication of content. These agents, whether employees or
independent contractors, may not have enough special advantages over firms that engage in direct
distribution to justify the widening cost differences.
Secondly, e-finance is between banks and other institutions. The internet,
blurring the barriers
combined with data-processing advances and deregulation, is reinforcing the trend to de-couple
manufacturing of financial products from their distribution. Institutions now find it easier to retail
products they have not themselves produced. Though it remains an open question how much further
this integration of financial activities will progress, the boundaries between banks, brokers and insurers
are likely to be further eroded. One force behind this is increasing consumer demand for personalised
money management services, which is pushing banks to respond with products that cross financial
boundaries. These "hybrid financial services" are nothing new, but the advent of technologies such as
fixed and mobile internet as well as digital TV promises to transform both their design and their
delivery.
Thirdly, the rapidity of change and the unfamiliarity of the names of some new players highlight the
critical importance of public trust. As I mentioned earlier, pure internet banks have not so far been
very successful, in part because of problems of public acceptance. While technology has been
lowering barriers to entry, brand establishment and customer acquisition have remained
disproportionately expensive, particularly in banking. One survey indicates that even the most
promising demographic groups - such as young, educated, wealthy, active consumers of financial
services - are unlikely to switch to technology firms for financial products. A "brand premium" is
probably the best protector of established banks against pure internet banks. The fact that some
banks that started as pure internet operations have opened physical branches as "relationship
enhancers", or acquired ATM networks for the consumers' cash withdrawal and deposit convenience,
illustrates the continuing importance of physical presence. This experience seems to suggest that the
choice is not that of "clicks-versus-bricks": it may be "clicks-and-mortar" (or multi-channel distribution)
that will have the ultimate advantage.
However, the need to inspire the trust of the public does not necessarily favour existing banks,
because firms that have built up consumer trust and achieved high degree of name recognition in
other lines of business (Siemens, Sony, General Electric, etc) may also command confidence. While
hardly unique to e-finance, the increasing reliance on untested and sophisticated technology implies a
greater need to have a brand name that the public knows and trusts. It may lead to new forms of
conglomerate that bring together financial and non-financial companies. The most serious challenge to
the banking industry probably comes from the entry of telecommunication companies that already
possess the necessary IT skills, exercise command over an important delivery channel and have built
an extensive customer base.
The fourth consequence, then, is the increased likelihood of entry of non-financial institutions into
financial activity. A major challenge for supervisors is the adaptation of supervisory techniques that are
traditionally used in licensing new entry (such as fit and proper tests; the clarification of business
plans; policies on mergers and acquisitions; etc). And the very meaning of concepts such as
consolidated supervision becomes problematic in this context, as does the distinction between
banking and commerce.
Fifthly, some believe that the internet will speed up the process of financial industry consolidation,
both cross-border and cross-sector. Operating costs that are low relative to those of initial start up
costs, give rise to significantly increased potential for economies of scale. In order to pursue these,
financial service companies are increasingly forming alliances with IT vendors and telecommunication
companies. Large client lists made available through consolidation increase the profitability of the
provision of a broad range of different financial products. As I have already said, name recognition
also favours big players. E-banking facilitates cross-border expansion at minimum cost. Moreover, the
resources devoted to foreign e-banking business (staff, computing resources, etc) can more easily be
centralised, so that service output can be readily switched from one foreign market to another. It is
much easier to retrench quickly from a virtual offering than a branch-based one. However, full fledged
consolidation is not inevitable since strategic alliances could in principle achieve the same goal of
saving costs without requiring a full merger. The merger of back office functions is a case in point.
The sixth and final implication is the most difficult to come to grips with, yet it is arguably the most
important. It is the potential of e-finance to create new and radically In
different business models.
the current model, a bank makes use of private information it has gathered about its customers in
evaluating and pricing credit risk. The internet, by transforming information gathering and by altering
the way communication is handled, will make several new models possible.
One example of such a new business model that has attracted much attention is that of the so-called
"aggregators", firms that offer customers one-stop shopping for financial and non-financial products
offered by a multitude of suppliers. By monitoring the transaction patterns of their customers, such
firms are uniquely placed to observe individual consumption patterns and obtain information on the
financial profile of an individual. Such information can in turn be used to directly market financial
products, assess credit risk etc. This poses various threats to banks. Banks may lose their direct links
and delivery channels to reach customers. At the same time, banks fear being held responsible for the
mishandling of confidential customer data by the aggregator.
In a move to counter attempts by non-financial players to enter the banking market, banks could
capitalise on their brand name and the trust they enjoy with the public by expanding into services like
certification, digital signatures and secure communication. An important issue in that context is
evenhandedness in the official treatment of financial and non-financial firms. As you know, supervisors are
usually reluctant to allow banks to expand into non-financial commercial business. But how can and
should they react to traffic in the opposite direction?
Implications for markets
I turn now to the implications for financial markets. Internet technology is beginning to have a major
impact on the structure and functioning of exchanges and trading systems. In equity markets,
automated trading systems that use computer software to match buy and sell orders have developed
rapidly. These Electronic Communications Networks (ECNs) are expanding not only in the United
States but also in Europe, in part benefiting from the continuing development of an equity culture
among retail investors.
On-line trading is more cost-efficient, accelerates trade execution and potentially expands the price
information available to investors. As a result, traditional dealers are finding their margins coming
under increasing pressure. Some of the larger dealers may try to respond by chasing volume, which
electronic trading can facilitate. Others may unbundle their services and concentrate on certain niches.
Some may just withdraw totally from trading and concentrate on advice and research.
An important issue arising from the growing reliance on electronic trading is its impact on market
liquidity. Market liquidity is a multi-faceted concept and it is therefore very difficult to assess the
relationship between electronic trading and liquidity. On the one hand, electronic trading leads to
tighter pricing (ie lower bid-ask spreads) in equity and securities markets by decreasing transaction
costs. Thus one dimension of liquidity may be improved. But there are two other factors that may
reduce liquidity. First, in some currently centralised markets, lower barriers to entry may mean that
new trading systems proliferate, none of which individually is particularly liquid. Markets may therefore
become more fragmented. Second, by reducing bid-ask spreads, electronic trading will tend to reduce
the profitability of active market-making, causing financial institutions to scale back this activity.
Markets may become shallower, resulting in increased intra-day volatility and a less efficient
pricediscovery mechanism. This may be all the more likely in periods of market stress, and may exacerbate
turbulence. This is an unresolved issue on which we need to keep a close eye.
The use of electronic trading is also spreading in other financial markets where contracts have
historically been traded over-the-counter (OTC). A recent report by the Committee on the Global
Financial System1 suggests that electronic trading in foreign exchange and fixed income securities is
centralising many OTC markets and putting some dealers under pressure. However, the report found
no conclusive evidence that these developments have led to a marked reduction in liquidity.
A final concern is about the difficulty of transposing existing market standards to trading platforms
which are purely virtual. For example, securities regulators will want to ensure that disclosure
standards are not avoided by marketing new issues directly on the internet. Investment advisers are
often required to be licensed and "suitability" obligations are imposed. It is not clear how these
requirements would apply to advice offered on a website.
Key risks in these developments
Let me next discuss potential risks in these developments. Needless to say, assessing and dealing
with these risks is the key challenge to central bankers and other regulators and supervisors
worldwide. But this is not easy. Not only is reliable data on the current situation difficult to come by, its
growth is extremely hard to predict. While e-broking, some types of e-banking and some e-trading
have spread much more rapidly than earlier predicted, e-money developments have failed to meet
earlier expectations of growth.
Even when trends have been identified, it is necessary to distinguish between developments that
simply raise familiar prudential oversight problems in a new guise, and those that give rise to totally
new challenges. It will inevitably be difficult to make such a distinction. It is hard to isolate the
contribution of the internet separately from the effects of other complementary innovations, and
equally difficult to distinguish internet effects from other long-term industry trends and exogenous
factors. With these caveats, let me list several key risks that merit attention. I will group them under
four headings.
Firstly, there is the risk of strategic and business misjudgements. Needless to say, this is always a
possibility during periods of rapid technological change characterised by the kind of uncertainty I
discussed earlier. A characteristic of internet-related firms has been the acceptance of high initial costs
in the hope of long-term profits. The absence of a simple short-term profit test, given relatively little
near-term revenue, makes it very difficult for companies to assess whether their strategy is working.
That mistakes can be made is quite evident from the volatility of high-tech stocks and the failure of
many high-profile ventures. Banks can also make big mistakes in their e-finance strategies. Bank
managements today need to be more knowledgeable about IT matters than in the past.
The second risk is resulting from reliance on complex technology. Such risks can arise
operational,
not only when technology is developed in-house but also when it is outsourced. The practice of
outsourcing core technologies and processing operations raises questions about how far, and by what
mechanisms, a bank's management should oversee the operations of service providers. The
existence of increasingly complex arrangements between a financial institution and a whole chain of
service providers - a main contractor with multiple sub-contractors providing the various different
elements of the IT architecture - creates novel oversight problems. A recent report by the Basel
Committee on Banking Supervision2 suggests that the comfort from outsourcing may be illusory.
The third risk arises from legal and regulatory uncertainty in e-finance transactions. Even a question
of "Where is the headquarters of an e-finance firm?" cannot always be answered easily. Another
question is whether location is physical or legal. Under such circumstances, it is all the more important
that the definition of home and host supervisors and the division of responsibilities between them be
clarified. This should include any requirement for licensing in the "targeted" host country. It is also all
the more desirable that common standards are set and enforced across countries to avoid financial
firms moving their notional headquarters to laxer supervisory regimes. Cross-border mergers of
exchanges would pose even harder questions. Similar considerations apply to different sectors of the
financial industry within one country. The risks of "regulatory arbitrage" must be kept clearly in mind.
The fourth risk I want to note is systemic risk. Because financial institutions use similar software
programs, there is a risk that many large institutions could be simultaneously subject to a common
adverse shock. This was one worry about the 2000 year bug, which happily turned out to be
well-contained. But can we rely on always being so fortunate? A simultaneous technology-related
problem would be a potential systemic nightmare.
We know that there is no computer systems technology that is absolutely "hacker-proof". And the more
open platform the greater the risk. A failure of a large internet service provider could be a major
disruption. So far, incidents have been relatively minor, but the risk remains. For instance, insufficient
or inadequate segregation between internal systems for retail and large-value payments could allow
the breach of the lighter security net around a lower value system, such as a bank's retail website,
which would in turn allow entry to a high value system via the bank's internal network.
Moreover, the deeper involvement of greater numbers of new and different firms - including
nonfinancial firms - in financial markets may make it much more difficult to monitor the links between the
various actors and to assess the risks to which they are exposed. As the links between financial and
non-financial markets become more pervasive, the sources of systemic threat are likely to become
harder to identify.
An official sector agenda
I come now to my final substantive point, which concerns the official sector agenda for dealing with
some of these issues. I have five points to make. First, and I put this above all else, the official sector
should do some serious thinking about how e-finance could change the structure of the finance
industry. Is it possible that the impact could be revolutionary and rapid? The transformations
engendered by the spread of e-finance could at some point raise systemic concerns for central banks,
particularly given the greater importance of unregulated entities outside the present reach of
supervisors. Prudential concerns about individual institutions and markets may need to be
supplemented from the perspective of systemic risk to address directly market dynamics and industry
structure issues.
Ironically, while the internet has vastly expanded the availability of information, there are too few
reliable data on e-finance itself. The statistics produced by market analysts are generally piecemeal,
based on different definitions and assumptions and sometimes include optimistic biases. But before
new data collection systems are considered, a clearer conceptual framework is needed to pose
relevant questions. We need the help of the private sector and of the academic community in this
endeavour.
Secondly, as discussed earlier, e-finance is also likely to blur further the distinctions between different
financial sectors as well as products. This will pose co-ordination problems for financial regulators,
regardless of whether supervision is organised along product or institutional lines. It will make banks
less "special". There is a need to be aware of linkages across sectors, particularly links between
banks, insurance companies and securities companies. This implies a greater need for consultation
and co-ordination among regulators. As depositors are less familiar with e-banks, and know deposits
can be withdrawn faster, e-banks may be more susceptible to erosion of their deposit base than
traditional banks. The challenges for banks, supervisors and central banks will remain the same, but
the nature of cyberspace may leave them far less time for crisis management and resolution.
The Financial Stability Forum3, which brings together national regulatory authorities and international
standard setters, has a special role to play in this effort of cross sector cooperation and coordination.
As you may know, the Forum prepared a mapping of e-finance issues and international groups
working on them. A contact group that comprises of Chairpersons of the various e-finance working
groups of the standard setting bodies and Basel-based Committees has now been established to
examine areas where enhanced cross-sector cooperation and coordination on e-finance issues would
be beneficial. In time, it may be necessary to extend and formalise the current network of contacts.
Thirdly, a flexible and adaptive regulatory approach becomes vital. This does not mean an absence
of regulations. In particular, licensing rules for banks, investment advisers, etc, will remain crucial in
maintaining high standards in the financial system and building public confidence. But it does mean
that the old regulatory mind-set is no longer appropriate. This will be particularly so in the world of
efinance where change is the norm. There is a need for guidance, not rules. Different contexts require
different responses. There will have to be more emphasis on operational and reputational risk.
Efinance raises many additional complexities: for example, the question of "What is a bank?" becomes
even more difficult to answer. Moreover, the answer could well differ from one supervisory jurisdiction
to another. The good news is that advanced technology permits more effective monitoring of the
complex issues that technology has created. For example, the use of intelligent electronic agents
should enable consumers to monitor their journey through cyberspace and warn them when they are
entering a site whose privacy policies do not match their preferences.
Fourthly, there may be cases where additional prudential buffers for risk-seeking institutions are
needed. It can be debated whether e-banks are inherently riskier than traditional banks, but some
aspects of e-banks do require much more careful examination. They have generally needed to offer
higher interest rates to attract deposits, which can be very rapidly transferred to another bank. They
may be more vulnerable to operational breakdowns and security breaches by "hackers" as I
mentioned earlier. The management challenges, such as credit assessment at a distance, are less
well-understood, though technologies could be employed to monitor and overcome these risks. It is
interesting to note that in some countries (for example, Singapore and Hong Kong), e-banks cannot be
established except through the conversion of existing local banks. Some countries require a physical
presence for e-banks within their national jurisdiction, but this may be difficult to enforce.
Fifthly, it is important to make sure that the current levels of market and operational integrity are not
undermined by the development of e-finance. A continued effort will be required to transpose
disclosure for listing as well as licensing for investment advisers to purely virtual markets, however
difficult this might be. The information technology infrastructure supporting the settlement of financial
market transactions must be entirely reliable. The safe and orderly operation of banking and financial
systems at all times is essential to ensure public trust. Security is critical to allow customers to do
financial transactions online. It is important that a "virtually closed" network is built supported by robust
technology such as cryptography and digital signature. As long as online payments are cleared and
settled through the existing clearing and settlement infrastructure that complies with "best practice",
such as the Core Principles recently published by the Committee on Payment and Settlement
Systems4, the development of e-finance should have only a limited impact on payment system risks.
E-finance will continue to increase the demand for more efficient and robust back-office operations.
This "straight-through" processing will not only reduce operational risks by minimising errors caused by
human intervention but also reduce settlement risks by shortening the settlement cycle.
Conclusion
I will end by saying a few words about cooperation between the private and the public sector in
charting the way forward. I began by noting that we have much to learn about the development of
efinance and its impact on the financial system. Some challenges are novel, while other may be old
issues in new guise. The net impact of conflicting forces will vary significantly by product, by player
and by market. While it is retail financial services that have been most radically transformed by the
internet to date, there may be a major impact on the business-to-business segment in the medium
term. The business models will also keep evolving with the enabling technologies (such as mobile data
communications or interactive TVs) bringing about major change in the nature of financial services.
But which business models will work, and which will fail, is difficult to know at this stage. How these
models will behave under stress as well as during normal market conditions is also very difficult to
predict.
These uncertainties make it all the more important to have a regular and deep exchange of information
between central banks, supervisors and the private market players. Periodic reappraisal of the global
e-finance landscap