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. Paul Hefner Partner Senior Vice President Sutherland, Asbill & Brennan 1st Interstate Bancard Paul Baran Edward J. Kane Chairman of Board The Everett D. Reese Professor of PacketCable, Inc. Banking in Monetary Economics Ohio State University Lynne Barr Partner Gaston-Snow & Ely Bartlett Jerome Svigals Electronic Banking Consultant Robert Capone IBM Corp. Vice President and Director J. C. Penney Co., Inc. Willis H. Ware Corporate Research Staff Kent Colton The Rand Corp. Executive Vice President National Association of Home Builders Steven Weinstein Vice President–Technology Strategy Richard J. Darwin American Express Manager Battelle Memorial Institute Milton Wessel, Esq. General Counsel Gerald Ely ADAPSO Division Director Merrill Lynch Capital Market Frederick G. Withington Vice President, Information Systems John Farnsworth Arthur D. Little, Inc. Senior Vice President Bank of America

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 Mark Leymaster Systems Program Manager Staff Attorney J. C. Penney Co., Inc. National Consumer Law Center Ellen Broadman Barbara Quint Minority Chief Counsel Money Management Editor United States Senate Family Circle James L. Brown Dale Reistad Associate Professor of Law Consultant Director of Center for Consumer Affairs Reistad Corp. University of Wisconsin-Extension Thelma V. Rutherford Meredith M. Fernstrom Private Citizen Senior Vice President-Public Responsibility Michael Van Buskirk American Express Co. Assistant Vice President of Edward J. Kane Corporate Affairs Everett D. Reese Professor of Banking Bane One Corp. in Monetary Economics Ohio State University

Financial Services Industry Technology and Scenarios Workshop Participants

C. M. Baker Frederick R. Levy Director of Planning Manager of Financial Operations Navy Federal Credit Union FMR Corp. Edwin B. Cox Robert Lucky Senior Management Consultant Executive Director, Research Arthur D. Little, Inc. AT&T Bell Laboratories Richard J. Darwin Deborah Smith Manager Vice President Battelle Memorial Institute Beneficial Corp. Ronald Glidden Daniel F. Sullivan Senior Vice President Senior Vice President, Operations Life Insurance Co. of Virginia ISFA Corp. Blake Greenley Vice President Citibank N.A.

vi Financial Services Reviewers

John B. Benton Arthur LeMay President President The ICS Group, Inc. Arthur E. LeMay Co. Janice Booker Jeffrey A. Lebowitz Director, Federal Treasury Department Vice President for Strategic Planning Comptroller of the Currency Federal National Mortgage Association John Briggs Frederick R. Levy P. O. S.–Debit Card Project Manager Manager of Financial Operations Mobile Corp. FMR Corp. Raymond Cocchi Alan Lipis Vice President President National Association of Securities Electronic Banking Inc. Dealers, Inc. Lois Martin Dan Eitingon Vice President President—Chief Executive Officer The First National Bank of Saint Paul MoneyCare John T. McGee Jesse Filkins Vice President, Corporate Affairs Senior Attorney Securities Industry Automation Corp. Board of Governors of the Federal Reserve Russell Morris John Fisher Assistant Commissioner, Federal Finance Vice President Department of the Treasury Bane One Corp. Michael Radow Gregory J. Furman Senior Associate Managing Director of Advertising and Century-IV Partners Sales Promotion Louise Roseman New York Stock Exchange, Inc. Regulatory Liaison Shelley Gross VISA, USA Vice President, Marketing Computer Systems & Resources

vii Contents

Chapter Page 1. Overview ...... 3 2. Present and Future Technologies Supporting the Financial Service Industry ...... 19

3. The Securities Industry ...... 51 4. Retail Financial Services ...... 97 5. Wholesale Financial Services ...... 137 6. The International Environment for Financial Services . . . 153

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

8. Findings ...... 191

9. Policy Issues ...... 223 10, Future Scenarios for the Financial Service Industry, 1990-95 ...... 251 Appendix: Glossary of Terms ...... 267 Index ...... 279

ix Chapter 1 Overview Major Findings ...... 4 Industry Structure ...... 4 Legal/Regulatory Environment ...... 5 Financial Service Delivery Systems ...... 5 Consumer Interests ...... 6 Safety and Soundness of the Industry ...... 6

Financial Services in the Future...... 7 Influence of Technology ...... 7 Financial Service Providers ...... 8 Users of Financial Services ...... 8

Congressional Policy Issues ...... 9 General Policy Considerations ...... 9 Structural Issues ...... 10 Risk Allocation Issues ...... 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 be- The existing legal/regulatory structure has tween technology and change, both past and roots that extend back 50 years; changes in future, in the financial service industry. The the financial service industry have challenged roles of technology as both a motivator and some of its premises. Since the mid-1970’s, a facilitator of change are analyzed. Other Congress has devoted considerable attention agents of change are considered only to the ex- to the financial service industry and has en- tent that they help define the market for new acted several major pieces of legislation. Many technology or its impact. of the regulations governing the industry are The financial service industry (see fig. 1) is being relaxed. However, continued congres- markedly different from what it was at the end sional attention is needed because not all of of the 1970’s, and the rate of change will only the salient issues have been resolved. slow slightly during the remainder of the In the last few years, banks legally able to 1980’s. Advancing information and communi- operate outside traditional banking regulation cation technologies are key factors that have have appeared; retailers of food and general changed the nature of financial services: the merchandise have emerged as major suppliers ways in which they are created, delivered, of financial services; changes in law and reg- priced, received, and used. Relationships be- ulation have enabled banks, savings and loan tween and among users and providers of finan- associations, and credit unions to broaden the cial services are changing. mix of services they offer and enter markets previously closed to them. At the same time, Figure 1 .—Organizations Comprising the Financial Service Industry and Their Products firms whose financial service offerings are virtually unregulated compete directly with tradi- Financial service providers: tional, regulated providers. Banks Data processing Thrift institutions Telecommunications Information processing and communication Dry goods merchants Insurance companies technologies are being used to enhance exist- Credit card providers Etc. ing 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 Financial service Industry products: and loan associations join networks of auto- Credit Debit cards Deposit-taking Check authorization cards mated teller machines that enable account Brokerage Information services holders to obtain cash 24 hours a day from Investment Payment machines that are available nationwide. Both Credit cards Insurance securities dealers and banks have developed

SOURCE Office of Technology Assessment systems that allow account holders with per-

3 4 • Effects of Iformation Technology on Financial Service Systems sonal computes to transfer funds between ac- financial service industry. However, other fac- counts, 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 fi- ably over the coming decade, after which nancial service industry affect a number of the financial service industry is likely to re- areas including industry structure, the legal/ turn to a more orderly evolutionary pattern. regulatory environment, financial service de- ● Firms are in the process of broadening the livery systems, consumer interests, and the scope of their service offerings, a trend that safety and soundness of the industry. Major will continue during the coming decade. The findings in each of these areas are summarized future mix of financial services offered by below. each class of provider will be much different from what it is now. Some will offer the full Industry Structure range of financial service including taking deposits, extending credit, underwriting in- ● Rapid and dramatic change in the financial surance and securities offerings, and secu- service industry will not persist indefinitely. rities brokerage. Others will target narrowly There will be a period of stabilization, prob- defined markets such as serving the needs Ch. l—Overview ● 5 of medical and legal professionals. Data the 1930’s. Technological, social, and eco- processing and communication services are nomic factors are causing considerable likely to be increasingly important offerings change in the types of services offered, the by financial service firms. types of firms offering them, and the de- So long as firms can continue to enter the mands of the consumer. In light of the financial service industry with ease, the changes that have taken place, this may be likelihood of the industry becoming domi- the time to reconsider the overall legal/reg- nated by a small number of providers is ulatory structure governing the financial minimal. service industry. Because of the affordability of information ● Policies that have assumed a specific indus- processing and telecommunication services try structure or service mix seem to be par- for firms of all sizes, access to technologies ticularly vulnerable to unanticipated effects does not constitute a barrier to entry into when new technologies are introduced. For financial service markets. Technology may example, the assumption that only banks actually facilitate entry. A small firm, by will take deposits was undermined by the obtaining communication and processing application of technology by firms other services from others can enter a market and than banks to support offerings such as the compete with firms many times its size. On money market account. the other hand, if the existing accessibility ● Some recent changes in State banking law of processing services does not continue, en- modify the way in which Federal law affects try into the financial service industry by financial service institutions. In the past, small firms may be foreclosed. States have generally supported policies for The ability to move information quickly, re- the financial service industry consistent liably, and accurately is essential to success with those of the Federal Government. This for both providers and users of financial is no longer always true. Some banking or- services. Organizations controlling exten- ganizations have established subsidiaries in sive distribution and/or communication sys- States that have adopted policies favorable tems are entering and will continue to en- to them and use information processing and ter markets as providers of financial telecommunications to distribute services services. nationwide. By facilitating the flow of information nationwide, information processing and tele- Financial Service Delivery Systems communication technologies have contributed to the development of national markets ● Financial service providers have used infor- for financial services. Investors and users mation processing and communication tech- of capital benefit to the extent that their of- nologies to overcome some of the limita- fers receive broader exposure than they tions, such as those restricting interstate would in a local or regional market. On the banking, imposed on them by law and reg- other hand, market conditions are not uni- ulation. This has lessened distinctions be- form nationwide; and opportunities may be tween various classes of financial service more favorable in some areas than in others. providers, allowed the entry of firms not Thus, there is a possibility that the exist- previously classed as financial service pro- ence of national capital markets will draw viders into the financial service industry, funds from some regions and cause their and allowed banks to enter into new busi- needs to remain unfulfilled. nesses such as the operation of data processing service bureaus. ● Legal/Regulatory Environment Telecommunication policy is a major factor determining the price to the user of telecom- The legal/regulatory structure now govern- munication services. Because telecommuni- ing the financial service industry dates from cation is a key component of financial serv- 6 ● Effects of /formation Technology on Financial Services Systems

ice delivery systems, telecommunication services if they are to be able to function policy directly affects the design and via- as members of society. bility of those systems. ● Survey data show that consumers are concerned with the effects of changes in the fi- Consumer Interests nancial service industry on their ability to preserve personal privacy. Privacy issues, • Because financial service providers are now on the other hand, are not presently promi- able to use price as an instrument for com- nent on the congressional agenda. If in- petition, more and more financial services cidents of compromised privacy are widely will be priced explicitly. “Free” checking ac- reported in the future, it may again be a counts will disappear; brokers are likely to focus of public policy debate. specifically charge for advisory services. ● In many cases, a financial institution has Customers may be offered an increased no document bearing an authorizing signa- range of choice and may pay only for serv- ture that can be reviewed before an elec- ices used. However, the elimination of some tronically issued order is executed. Errors of the subsidies once hidden in “free” finan- in electronic financial systems may only cial services may not be popular. The true become visible on the periodic account costs of meeting the financial service needs statement. Therefore, customers of elec- of society will be more easily recognizable. tronically delivered financial services bear ● There is increased flexibility in selecting fi- greater responsibility for detecting errors nancial services and the types of institu- and initiating the procedures for correcting tions from which they are obtained as a re- them than do customers using paper-based sult of the trend to explicit pricing and the systems. entry of new providers into the financial service industry. However, to take advan- Safety and Soundness of the Industry tage of these opportunities, consumers must be sufficiently familiar with the available Increasing use of information processing options. Many have taken advantage of new and communication technologies requires options they perceive to be in their interests. that both providers and users take precau- ● In spite of broader choices of services and tions to ensure the integrity and security institutions, some consumers are finding of financial service delivery systems. Al- their options constrained. Checks, for exam- though the use of technology may improve ple, often are no longer an acceptable pay- some aspects of the security and integrity ment medium unless the person can also of financial services systems, new vulnera- present one or more credit cards to demon- bilities maybe introduced. Computer-based strate financial responsibility. Some con- authorization systems reduce the oppor- sumers are not welcome as clients to some tunity for fraudulent use of stolen credit financial service providers. Some may pre- cards. However, if an account number is fer to avoid financial institutions but find compromised without the knowledge of the that increasing use of technology-based fi- legitimate owner, its fraudulent use may not nancial service systems propels them to- be discovered until a statement is received. wards becoming clients of financial service Thus, the perpetrator may have a signifi- providers. Lack of access to some financial cant period after obtaining an account num- services may implicitly limit or deny access ber to commit fraud with relatively little to other goods and services (e.g., it is cur- chance of detection. rently very difficult to rent a car if you do The existing regulatory structure promotes not have a major credit card). At some safety and soundness of the financial serv- point, consumers may require guaranteed ice industry by providing Federal insurance access to some minimal level of financial 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 appre- try 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 in-

Financial Services in the Future

Forecasts of the financial service industry represents many points of view now held by prepared over the last 10 to 15 years have not knowledgeable observers. been particularly accurate. Many of the earlier efforts foresaw the virtual elimination of the Influence of Technology check and significant decrease in requirements for currency and coin during the last quarter The financial service industry of the future of this century. Some saw particular promise will be quite different. The established trend in specific technology-based services (e.g., of increasingly heavy dependence on technol- super-check, an instrument that would use one ogy for delivering services will continue. Serv- order to direct payment to multiple creditors, ices will be provided by a wide variety of in- and telephone bill payment) that has not yet stitutions. Barring a major restructuring of been realized. the wholesale side of the financial service industry, small financial service firms will be Experts continue to prepare forecasts for able to obtain access to the technologies they the financial service industry. Firms continue will require to remain viable. Although rela- to develop and bring to market what they be- tively few firms are likely to provide service lieve to be promising services. Some are la- nationwide, it is likely that the existence of a beled experimental while others are designated large number of small, specialized financial as operational systems. Although forecasters service organizations will prevent the few from appear to have developed more realistic pic- dominating the market. tures of future markets for financial services than were available in the past, much uncer- Communication will be key to delivering fi- tainty remains. nancial services in the future. Networks growing out of those used to connect shared sys- Experience to date will not support an at- tems of automated teller machines are likely tempt to develop a detailed picture of the fi- to provide the basis of systems permitting nancial service industry of the future, but electronic initiation of fund transfers from the some general trends (e.g., ever-increasing use merchant’s counter. Systems providing access of advanced technology to deliver financial to funds from virtually any place in the Na- services) are clearer now than they have been. tion regardless of where they are deposited are For example, there is little doubt among in- now being developed and are likely to be in use dustry observers that customers will elec- in the next few years. Advanced communica- tronically order the immediate transfer of tion technologies including satellite relays, funds from their accounts to those of mer- video cable, fiber optics and cellular radio will chants at the time purchases are made. How- find wide application in the financial service ever, the specifics of the systems that will be industry. used to implement this service remain open to question. OTA’s analysis of general trends be- Decreasing computer costs will create the ing followed by the financial service industry 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 Firms that have established information to take advantage of technology in using fi- processing and telecommunication facilities nancial services. Large computers will be used are likely to be particularly active in the finan- to support the data bases and the communi- cial service industry. New entrants into the in- cation processing needed to operate the large, dustry will have roots in such varied areas as interactive financial service delivery systems retail food and dry goods merchandising, pe- of the future. Computers that accept voice in- troleum production and distribution, and com- puts and recognize fingerprints may become munications. Traditional providers of financial cost effective for financial service delivery sys- services are likely to continue the present tems by the turn of the century. Small, inex- trend toward diversifying their offerings, often pensive personal computers in both home and entering into areas that have been closed to office will make it possible for customers to them in the past. interact with a multiplicity of financial service offerors. Computer processor and memory Users of Financial Services chips imbedded in plastic cards may find wide spread use in the financial service industry. Financial services will be delivered to the customer at a convenient location with little Financial Service Providers need for clients to visit the offices of a financial service provider. The present tendency of Banks, savings and loan associations, and corporate financial officers to use terminals in credit unions probably will concentrate on their offices to manage funds will extend to transaction processing and place less empha- smaller businesses. Although the trend is not sis on gathering deposits and providing financ- yet clearly established, individual consumers ing. Emphasis will be placed on computer and are likely to use home terminals to interact telecommunication-based systems for deliv- with financial service delivery systems. ering financial services. Included in the serv- Consumer financial service packages are ices offered will be data processing, securities likely to be offered in conjunction with other brokerage, and, possibly, insurance. In the information-based consumer services such as future, branches will be dominated by a vari- home shopping, investment advisories, recrea- ety of machines the consumer will use to ditional services such as computer games, travel rectly interact with financial service systems. reservations, and the purchase of tickets to Institutional personnel will serve more of an sporting and theatrical events. Financial serv- advisory role and handle customer transac- ice institutions may develop and operate the tions, such as payments and withdrawals, only network used to distribute these services or in exceptional cases. they may participate in networks assembled Securities broker/ dealers, long providers of and operated by others. transaction services, will compete directly Consumers may use terminals to order with banks, savings and loan associations, and banks to pay bills or to purchase securities. credit unions in many areas. Today they al- They may enjoy more flexibility in services ready offer a variety of services such as money used. For example, rather than carrying a market funds that are designed to give the fixed amount of insurance, a terminal could customer ease of access to financial assets. be used to vary it in response to changing This trend will continue, and the future is needs (e.g., increasing coverage for theft while likely to see higher levels of activity by secu- jewelry is kept at home rather than in the bank rities broker/dealers in processing an increas- vault). Orders to buy or sell stocks and bonds ingly broad variety of transactions. Retailers could be entered from home and executed on of food and general merchandise and possibly an automated exchange. Consumers may use other types of organizations will be attracted home information systems to analyze their fi- to the financial service industry. They will see nancial positions and to help make decisions opportunities to profitably apply technologi- on investment opportunities. Using these and cal resources which are in hand or within reach other capabilities will give the consumer to offer transaction processing services. greater personal control over his assets. --

Ch. 1—Overview ● 9 —————

Consumers may find that they need an ac- Although technical differences will remain, count with a financial institution to have ac- operational distinctions between services of- cess to a variety of services. Some employers fered by various classes of providers will may require direct deposit of payroll checks. diminish. It will be more difficult for users to Alternatively, employers may offer employees differentiate between them. For example, the option of writing checks against salary though a money market fund offered by a held in a company account in return for being securities dealer is quite different from a de- paid daily. Consumers may need an account mand deposit offered by a bank, both meet to be able to use shop at home and travel res- similar needs for consumers as accounts from ervation services. which funds can easily be withdrawn.

Congressional Policy Issues

The results of changes already observed in 1990’s. Although Congress has commissioned the financial service industry and those pos- comprehensive reviews of the financial serv- sible in the future are not consistent with some ice industry and the legal/regulatory structure of the key assumptions underlying the pres- governing it and has addressed some specific ent Federal policy structure. Growing direct changes in the industry, legislation revisiting competition between banking and the securi- the fundamental premises of existing policy ties industry, the appearance of new classes has not been enacted. of financial service providers, and the changes One alternative is continuation of the pres- following from rapid increase in reliance on ad- ent approach of incrementally adjusting the vanced technologies to deliver financial serv- policy framework as the financial service in- ices exemplify shifts that have taken place. dustry continues to evolve. Some of the steps Therefore, Congress is faced with significant taken using this approach are in anticipation questions about the relevance and utility of of future events; others are taken in response present public policy. In addressing these to events in the marketplace. Alternatively, questions, Congress will find it necessary to the entire legal and regulatory structure gov- resolve conflicts between the need to reconcile erning the financial service industry could be conflicting interests, on the one hand, and to reviewed and recast in a form deemed suitable create a climate conducive to the development in light of expectations for the future. of new financial services and delivery systems beneficial to both users and providers on the other. Implementation of Policy General Policy Considerations ● What are the mechanisms available to Con- gress for implementing policy pertaining to Restructuring the Policy Framework the financial service industry? ● What are the alternative approaches that Historically, Congress has implemented pol- could be used if a review and restructuring icy for the financial service industry through of laws and regulations related to financial one of the most pervasive regulatory struc- services were undertaken? tures applied to American industry. Public pol- The financial service industry has changed icy has focused on ensuring the safety and since the 1930’s when most of its present pol- soundness of financial institutions because of icy structure was developed. Rapid change, en- their unique role in society. To this end, the couraged by technology and other market assets of the clients of many financial service forces, is expected to abate in the 1980’s or institutions, particularly banks, have been pro- 10 . Effects of Information Technology on Financial Services Systems tected through a combination of insurance and Technology-based financial service systems examination programs. However, new en- are changing the nature of competition within trants into the financial service industry, the industry. Financial institutions are enter- many of whom are subject to neither Federal ing new markets and competing both among nor State regulation, now compete with regu- themselves, and with other industries, more lated traditional financial service firms. Be- deliberately and directly than ever before. New cause the nature of competition in the finan- entrants are providing services in areas that, cial service industry has changed, traditional in the past, have been reserved to traditional protections implemented through existing reg- financial service institutions. In the face of ulation have lost some of their effectiveness. technological change and competition, mergers involving both traditional financial serv- Regulations applicable to the financial service providers and new entrants have taken ice industry have been eased in recent years. place. It is possible that these changes will re- Controls on interest rates have been relaxed sult in a net reduction in the number of pro- and bank holding companies have become viders and will reduce competition in the fi- freer to broaden the lines of services (e.g., data nancial service industry. Some observers are processing) they offer. concerned that this could lead to excessive As Congress continues to develop and refine concentration of economic power. policy for the financial service industry, one Congress may find that in light of other of the tools at its disposal is its ability to vary trends affecting the financial service industry, the degree of regulation applicable to pro- the trend toward greater consolidation in the viders of various financial services. Alter- industry is acceptable. Alternatively, it may natively, it may modify the outcomes of mar- use one of several available strategies to limit ket forces to mitigate adverse affects on consolidation. For example, specific criteria for specific groups. For example, if the market controlling entry to and exit from the indus- were to compel individuals to have at least one try could be established. account with a financial service provider, Con- gress might choose to provide a means for ensuring that all are able to obtain a satisfactory Restrictions on Interstate Banking package of services. ● What modifications, if any, could be instituted regarding restrictions on interstate Structural Issues banking? Consolidation in the Financial Service Industry While Federal law limits interstate branching by institutions allowed to take deposits, ● What levels of concentration in the finan- it does not prevent interstate activities by cial service industry are consistent with the these organizations. Banks have established goal of preserving competition among pro- interstate networks of offices that market viders of financial service? services other than deposit-taking, such as There are 40,000 banks, savings and loan as- lending. Some financial institutions have used sociations, and credit unions in the United technology-based delivery systems to circum- States. Thousands of other organizations in- vent these restrictions and some States have cluding securities broker/dealers, consumer fi- passed laws that permit regional interstate nance companies, merchants, and insurance banking. Federal law now permits acquisition companies also provide financial service. A of one financial institution by another in a dif- goal of Federal financial services policy has ferent State under specified circumstances. been to preserve competition and prevent con- Unregulated competitors of depository insti- centration in that industry. tutions are able to establish offices without re- Ch. 1—Overview • 11 —

gard to geographic boundaries and, hence, petitors because of the regulatory structure may offer services nationwide. within which they must operate. Available options for Congress include re- Congress may choose to resolve this issue tention of present policies with respect to in- by permitting banks and other institutions to terstate operations of financial service orga- offer financial services that range over a broad nizations, reducing or removing restrictions spectrum, enabling them to be more respon- completely, or making restrictions more inclu- sive to competitive offerings of others. Bank sive than they are at present. For example, all powers could be broadened to include the institutions that offer deposit-taking services underwriting of securities and insurance, for could be made subject to restrictions on inter- example. Alternatively, powers to affect merg- state operations. Loopholes in existing law ers between financial service providers and and regulation could be closed. Restrictions firms from outside the financial service indus- on interstate deposit-taking through auto- try could be modified. To an extent, this would mated teller networks could be relaxed. represent a continuation of current practice in which the Federal Home Loan Bank Board has Limitations on interstate banking stemmed, permitted mergers across State lines between in part, from concerns that some banks serv- savings and loan associations. Under the pro- ing regional or national markets could achieve visions of the Garn-St Germain Act of 1982, an unwarranted degree of economic power and banks have been permitted to acquire dis- that local needs for capital would remain un- tressed, out-of-State savings and loan associ- met as funds were concentrated in major mon- ations. ey centers. An alternative for addressing the latter would be to strengthen requirements A third alternative would see the implemen- that institutions taking deposits meet needs tation of policy encouraging financial service for credit of the area from which deposits are providers to engage in activities with clear so- gathered before funds are made available to cial benefits. Examples would be incentives en- regional or national markets. couraging all providers of financial services to finance home ownership and educational Market Segmentation programs.

● How might law and regulation be used to Relationship to Telecommunication Policy focus the attention of various classes of fi- ● How will further deregulation of telecom- nancial service providers on specific market munications affect the financial service in- areas? dustry? The existing policy structure more or less Financial service providers depend heavily compartmentalizes the financial service indus- on telecommunications to deliver services to try by function. Banks may take deposits, in- their clients; and, therefore, they are sensitive surance companies may underwrite insurance. to changes in that industry. Many have built Insurance companies may not take deposits and operate sophisticated private telecommu- and banks may not underwrite insurance. nication networks. Without adequate telecom- Nevertheless, new entrants to financial serv- munication capabilities, the financial service ice markets have been able to offer services industry cannot meet the needs of its clients. in direct competition with those for whom, in Changes in telecommunication costs have a di- the past, specific market segments had been rect and immediate effect on both providers reserved. Operators of investment funds, for and users of financial service. example, offer services that share many features of deposit accounts offered by banks. In The telecommunications industry is under- some instances, the traditional providers have going fundamental changes that are altering been unable to respond fully to their new com- 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 defer to the States for all regulation of finan- direct interaction with customers become cial services. At the other extreme, Congress more commonplace, relationships between the could preempt all State regulation of the finan- product mix, operating characteristics and cial service industry. Regardless of the level structure of the telecommunications industry, of the Federal presence, and in contrast with and the operations of the financial service in- the present practice of distributing responsi- dustry will become closer. bility, all Federal regulation of financial services could be combined and assigned to a sin- The formulation of telecommunication pol- gle agency. The focus of regulation could be icy is extremely complex and beyond the scope shifted from the institutions providing serv- of this report. However, Congress should re- ice to the functions performed regardless of main aware that telecommunication policy the nature of the organization performing directly influences the economics of financial them. For example, rather than regulating service delivery systems and, hence, the mix banks as a means of controlling deposit-tak- of financial services that will be offered. ing, regulate all organizations that perform the deposit-taking function regardless of the other Competition Between Regulated and lines of commerce in which they may have in- Unregulated Service Providers terests. ● What steps could be taken to realign the legal/regulatory structure to make it con- Barriers to International Operations form more closely to the changing structure of the financial service industry? ● The concerns of foreign governments regarding the protection of individual privacy Many financial services offered by unregu- could lead to the erection of barriers for lated firms are comparable to those marketed American financial service firms doing busi- by regulated institutions. For example, money ness overseas. What steps could the United market mutual funds marketed by securities States take to address these concerns or cir- dealers have attributes in common with some cumvent the barriers? of the various checking accounts offered by banks. Retailers of food and general merchan- Foreign government implementation of per- dise are building networks of automated teller sonal privacy protection programs, some of machines and networks to communicate pay- which are more stringent than those of the ment data in direct competition with those United States, may restrict the international built and operated by financial institutions. operations of American financial service pro- While the user may not perceive any real dif- viders. Some nations have suggested that they ference between the offerings of various finan- may limit the movement of personal data cial service providers, in some circumstances across their borders to and from others that the existing legal/regulatory structure does do not meet their standards for privacy pro- not cover the activities of non-traditional protection. The United States may find the oper- viders. Users of these unregulated services ations of its financial service industry limited often do not receive the same protections pro- by privacy policies of foreign governments. vided with services offered by regulated insti- Congress, in considering this issue, may tutions. choose to continue the present course and to Congressional options for addressing this not expand the privacy protections now in question range over a broad spectrum. The place. Alternatively, it may adjust privacy law present dual system of regulation by both the as it relates to financial services as a means Federal Government and the States could be of reducing potential barriers to American fi- continued. Alternatively, Congress could fol- nancial service providers other nations may low the model for the insurance industry and raise. Ch. l—Overview ● 13 —

Access to the Clearing Systems Risk Allocation Issues ● What organizations could be granted access Control of Interest Rates to the mechanisms for clearing checks, securities, and other payment instruments ● What alternatives for regulating interest such as credit card drafts? rates are available to Congress? Banks and savings and loan associations are Federal controls on the interest rates paid the only institutions with direct access to the by federally insured institutions are being payments system. This may give them a com- phased out. States impose limits on the inter- petitive advantage over other offerors of est rates that may be charged on some types checking account substitutes, credit cards, of loans. In recent years, when market rates and debit cards. Some securities brokers of- have exceeded both Federal and State limits, fer accounts from which funds may be drawn significant quantities of funds have moved by either a paper draft or debit card and other from banks, credit unions, and savings and organizations, such as the American Automo- loan associations to alternative investment op- bile Association which offers VISA, issue bank portunities created by new entrants to the fi- credit cards. However, offerors of payment in- nancial service industry. These new entrants struments that are neither banks nor savings have relied heavily on advanced telecommu- and loan associations, almost without excep- nication and information processing tech- tion, must obtain payment-processing services nologies to implement their offerings. Con- from an institution that has access to the pay- strained interest rates effectively limited the ments mechanism. supply of funds to some classes of investments. In many cases, policymakers have reacted to In light of the technologies now available, these movements by changing the legal limits some argue that other types of institutions on interest rates paid and charged. should also be granted access to the payments mechanism. One major merchant is now per- Congress may choose to ensure total decon- mitted to enter transactions into one of the trol of interest rates by preempting State bank card networks without using the serv- usury laws. Alternatively, the same mecha- ices of a financial institution. Conceivably, the nism could be used to establish uniform, reg- future could see the development and opera- ulated interest rates nationwide. Other al- tion of significant systems for transferring ternatives include maintaining controls on funds without the involvement of banks and interest rates paid on federally insured ac- other traditional providers of payment counts and ceding to the States control of all services. interest rates paid within their boundaries. The Federal Reserve System was established, in part, to assure smooth operation of Allocation of Risk the check-processing system. Congress may ● What are the alternatives for apportioning decide that the operability of the payment sys- risk between financial institutions and their tem can only be assured if it remains under customers and clients? control of the banks and savings and loan associations. On the other hand, Congress may Deposit insurance protects holders of ac- choose to open access to the payment system counts in covered institutions from loss of to others, such as data processing service or- assets up to the limits of the insurance. Al- ganizations, willing to meet specific criteria. though some noninsured accounts share many Or, it may open the system to all who would of the attributes of insured accounts, because join without establishing specific criteria for the account holder is not protected from loss membership. of principal, they often carry a higher level of 14 . Effects of Information Technology on Financial Services Systems risk for account holders. However, because Congress, in approaching this issue, may Federal agencies that insure deposits have pre find it necessary to define a minimal set of fi- ferred to find merger partners for distressed nancial services needed by virtually the entire institutions instead of closing them, deposit populace. It may then wish to specify alter- insurance has implicitly provided protection native institutional structures that could be for stockholders and holders of large depos- used to deliver such a package of services in- its as well as the owners of accounts with cluding the possibility that all providers of balances below the limits of insurance cover- transaction accounts be required to offer the age. Some argue that managers of financial in- “lifeline” package. Congress may wish to de- stitutions take unjustified risks because they fine the rights of consumers to payment serv- feel they are implicitly protected by deposit ices and the information regarding them that insurance. It has also been suggested that needs be provided to users. Consideration of depositors and others with whom an institu- a policy that would govern the timing of debits tion deals do not review the condition of the and credits to an account to ensure equitable institutions with which they conduct business treatment of consumers may be advisable. as carefully as they might because of the presence of deposit insurance. Privacy

Deposit insurance has been key in the pol- ● Some changes in the delivery of financial icy framework designed to sustain the safety services increase the possibility that the pri- and soundness of the financial service indus- vacy of citizens could be eroded or violated. try. Congress may choose to continue it in its How can Congress reduce that possibility? present form where the same insurance rates Systems that use information processing apply to all covered institutions. Alterna- and telecommunication technologies for deliv- tively, the premiums charged insured institu- ering financial services gather data more rap- tions could be modified to reflect the level of idly and make it more accessible than do risk the insurance program is required to paper-based systems. Information on the fi- underwrite. Further, deposit insurance could nancial activity of individuals can be ac- be extended to accounts not now covered. cumulated and used without their knowledge or consent. Existing law provides some pro- Lifeline Financial Services tection from intrusion on financial data by the Federal Government, but virtually no protec- ● What is necessary to assure an adequate tion from the use of this information by State level of financial service to all segments of and local governments or private parties and the population and to protect other basic organizations. Increasing use of electronic sys- consumer rights and interests? tems for delivering financial services exacer- bates potential threats to individual privacy. Individuals who so choose have been able to avoid dealings with providers of financial One alternative open to Congress is to ex- services. However, the ability of consumers to plicitly define the rights of citizens to privacy. avoid dealings with the financial service indus- Because users of financial services must, by try is being limited by such factors as pres- the nature of the systems used to deliver them, sure from employers and government to ac- surrender privacy to a degree, Congress may cept payments by direct deposit and the choose to require they be provided a statement increasing role of the credit card as an item disclosing the degree to which privacy is likely of identification. In the future, it is likely that to be compromised. A program of monitoring access to some minimal set of financial serv- and enforcing rights to privacy might be es- ices will be essential for all citizens. tablished. Ch. 1—Overview ● 75 —

Security and Integrity of Delivery Systems Vulnerability of Financial Service Systems to Theft ● Are additional actions needed to safeguard the integrity of national payment and trans- • What alternatives are available for control- action systems against risk of disruptions ling the risk of theft from or associated with from systems failure, hostile attack, and financial service institutions? natural disasters? Theft of assets is a constant threat for fi- System security and integrity have always nancial service providers and their clients. been of paramount concern to the financial New combinations of telecommunication and service industry. Both paper-based and elec- computer processing for delivering financial tronic systems for delivering financial services services provide new avenues for theft. As are vulnerable to attack from the outside and safeguards are put in place, new methods of to systemic failure. While electronic systems perpetrating crime against financial service overcome some of the vulnerabilities inherent systems are found. Some of them, theft of data in paper-based systems, new problems are in- under some circumstances for example, are not troduced. Continued operability of many ma- clearly covered by existing law. Some financial jor computer-based systems can only be service providers are hesitant to report inci- assured through the availability of redundant dents of theft involving technology-based sys- automated systems. In these cases, some systems in fear both of lessening the confidence tem failures can threaten the existence of a fi- of their customers and of revealing system vul- nancial institution since manual processing is nerabilities to potential predators. not possible in the event that a primary auto- In dealing with this issue, Congress may mated system fails. For example, if a bank is continue to rely on existing law and law en- unable to perform routine transaction process- forcement capabilities. Because the issue is not ing because of a system failure, it may not be well understood, Congress may wish to gather able to settle its accounts with other institu- additional information regarding the problem tions on time and, as a result, may fail. and alternative solutions either before acting Although recognition of the problems of sys- or following initial steps to deal with the most tem security and integrity is becoming more salient aspects of the issue. In the short term, widespread, its true magnitude is not known. it may modify the law to more clearly deal Additional information is needed before rea- with the obvious problems (e.g., clarifying the sonable public policy alternatives can be iden- treatment of those who steal data) that have tified. Therefore, Congress may wish to either accompanied the inclusion of advanced tech- hold hearings or establish a national commis- nologies in systems for delivering financial sion to assemble additional information prior services. Additional resources and technologi- to undertaking a specific legislative program. cal capabilities could be made available to law Possibly the Federal Emergency Management enforcement authorities. Penalties against Agency could help meet this need for infor- both the perpetrators of crime and those that mation. conceal it could be increased. Chapter 2 Present and Future Technologies Supporting the Financial Service Industry Introduction...... 19

Computer Hardware Systems ...... 20 Microcomputer Systems ...... 20 Large Computer Systems ...... 22 Future Computer Hardware ...... 23

Software ...... 25 Present Applications Software ...... 26 Applications Software in the Future...... 28

Telecommunications Technologies ...... 30 The Switched Telephone Network ...... 30 Private-Line Telecommunications Facilities ...... 32 Alternatives to Switched Networks ...... 32 Video-Related Communication Technologies ...... 33 Future Telecommunication Technologies ...... 34

System Security and Integrity ...... 36 System Security...... 36 System Integrity ...... 38

Specific Technologies for Delivering Financial Services ...... 38 Card Technologies ...... 38 Document and Currency Readers ...... 41 Customer Service Equipment ...... 42

Technology and the Structure of the Financial Service Industry ...... 43

Appendix 2A: Hardware Components ...... 44 Chip Technology ...... 44 Computer Systems ...... 44

Appendix 2B: Systems and Support Software ...... , . 45 Present Operating and Support Systems ...... 45 The Future for Operating and Support Systems...... 46

Table

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 the annual rate of growth in the number of could not provide the level of service it does checks slowed, from about 7 percent to about without the support of advanced information 5 percent. The fact that many are unwilling processing and telecommunication technolo- to forgo return of the physical check to retain gies. The numbers of checks (over 37 billion as proof of payment limits the possibility of annually), credit card drafts (over 3.5 billion implementing meaningful check truncation annually), and securities trades (over 30 bil- programs. Similarly, many still take delivery lion shares traded annually) would swamp any of physical stock certificates, even though manual system that tried to handle them. In book-entry systems for recording the stock fact, during the 1960’s, trading days for the ownership provide an alternative. New York Stock Exchange were shortened be- In the future, the costs of hardware used to cause the broker/dealers were unable to han- implement advanced systems for delivering fi- dle the workload. nancial services will continue their long-term Yet, even with all of its sophistication in the decline. New technologies such as the proc- application of technology, the financial serv- essor in a card and new systems to establish ice industry has not yet exhausted the poten- the authenticity of the order to execute a fi- tial of the technologies now available. Even nancial transaction will become available. In though large computers support check reader/ general, the ability of the financial service in- sorters handling thousands of items a minute, dustry to take advantage of the technology is all other aspects of check processing are man- not likely to approach the rate at which it ual, and telecommunications is not used in the becomes available. There is little chance that check-processing cycle. Checks are still man- technology will limit the industry any time in ually encoded with the amount by proof oper- the foreseeable future. ators at the bank of first deposit or, in return Historically, the initial applications of tech- for a reduced processing fee, at the retailer nology “automated’ existing processes. For location. Return item processing remains a example, the application of computers to ac- manual operation. Similarly, credit card drafts count maintenance simply translated existing are manually encoded before processing, and manual processes into automated ones. The the securities industry still processes millions adoption of MICR* encoding on checks has of stock certificates manually. done little to change the way checks are used. As the economics of the technologies con- Thus, early application of automation in the tinue to improve, market pressures to apply financial service industry had little, if any, di- them more extensively increase. They help and rect effect on the users of financial services. encourage further migration from paper- and On the other hand, systems now being de- labor-intensive implementations to electronic, ployed are changing the fundamental charac- self-service, and remote-based banking. ter of the financial services consumed by users. Automated teller machine (ATM) networks, Operational considerations limit more widespread realization of the potential of the technologies. For example, only in recent years has *MICR—magnetic ink character recognition.

19 20 ● Effects of Information Technology on Financial Services Systems

for example, enable users to obtain cash at minals capable of supporting the smart card, locations that cannot be served directly by the either supplementing or replacing the existing financial institution holding the account. infrastructure for handling magnetic stripe Moreover, funds are accessible around the technology, must be put in place before this clock. technology can become a significant factor. Technologies waiting in the wings have the In order to understand present and future potential for changing the basic character of trends in the financial service industry, it is the systems used to deliver financial services essential to have a grasp of present and emerg- and, as a result, the structure of the financial ing information processing and telecommuni- service industry. Remote banking via such dication technologies and of their relationship verse technologies as teletex, home computers, to present and future products and services. and multifunction transaction work stations This chapter describes the basic technologies installed in the offices of financial institutions that are and could be applied for delivering fi- could be implemented with technologies now nancial services. The purpose is to create an available. appreciation for the potential and the limitations of the technologies for facilitating change The so-called smart card, lingering just over in the financial service industry. Yet, one must the horizon, has the potential for changing the understand that the technologies constitute basic character of currency from paper to elec- but one of a number of forces operating to tronic. Market viability remains to be demon- shape the financial service industry and that strated and sufficient developmental capital their potential may not be realizable because allocated. In addition, an infrastructure of ter- of other constraints that are operating.

Computer Hardware Systems

The providers of financial services have been smaller financial service organizations that among the leading users of medium- to large- could benefit from having access to them. scale processors, and only the very largest scientific computers have not yet been widely Microcomputer Systems applied for the delivery of financial services. These large computer systems generally re- Changes in the technology of computer proc- quire dedicated facilities and support from an essors at the low end of the capacity spectrum onsite team of information processing profes- (i.e., those with the most limited capacity) are sionals. For all practical purposes, providers having the greatest impact on the operations of financial services can buy computing power of the financial service industry. Both users appropriate to their needs from a number of and providers are using them heavily. Micro- well-established manufacturers. Further, be- computers range in price from less than $100 cause of the way computer manufacturers to almost $10,000 (for some of the more elabo- design and enhance their product lines, orga- rate systems now on the market). However, nizations are able to have reasonable expec- a $100 unit has only limited capacity to par- tations that they will be able to make the tran- ticipate in a financial service system because sition, as needed, to machines of greater it has neither communication nor significant capacity with a minimum of operational dis- data storage capacity. Additional capabilities ruption. However, even with the decreases must be added if the user wants to use the var- that have occurred in the costs of medium- to ious financial application packages being mar- large-scale computer systems, they are still keted for personal computers. These include, priced beyond the means of many of the 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

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 per-

Photo credit. L/S/ Computer Products ipherals and the computer. Yet even with all Printed circuit card of the type used in microcomputers. these additions, the user would still have a sys- Each of the rectangular cases contains a circuit that tem limited to local use and applicable prin- consists of the equivalent of several thousand transistors cipally only to recordkeeping and analysis of data entered into the computer by the user. budgeting and accounting systems, checkbook To take advantage of home banking and balancing programs, securities price trend stock market transaction services, information analysis, portfolio analysis, and income tax utilities, and home shopping services that en- preparation. tail interaction of a personal computer with A cassette recorder costing about $50 would a computer operated by the financial service permit the user to load prerecorded programs provider a personal computer must be and save intermediate results so that they equipped with suitable data communication would not have to be reentered into the com- equipment. These include a feature that does puter manually every time they are to be used. the processing required to establish and main- 22 ● Effects of Information Technology on Financial Services Systems tain a telecommunication connection (RS-232 processing element. In this environment, users interface) and a unit (modem) connected to the may actually have several terminal devices to telephone line for converting digital pulses interact with financial service systems, each used internally by the computer to analog of which is dedicated to the offerings of a par- signals that can be transmitted over the con- ticular provider. Simple, inexpensive, dedi- ventional telephone lines of a switched tele- cated devices may find extensive application phone network. In addition, programs to sup- in point-of-sale (POS) systems as well as those port the communication function or to handle designed to deliver services to consumers. The the financial application would have to be pro- availability of terminals for users at little or cured, at a cost ranging from under $100 to no cost could be a strong impetus to increas- $250 or more, depending on the complexity of ing significantly the rate of adoption of ad- the application. Although a disc drive and ex- vanced systems for delivering financial pansion interface might be required for such services. a function, a printer would most likely be a People have demonstrated repeatedly that discretionary purchase. they will spend substantial sums if they per- Thus, while computers can be acquired for ceive utility in a product. Historically, this has $100 or less, the person who would like to use been true with television; more recently, with them either to receive financial services and/or video recorders. However, it remains to be to perform financial analysis is more realis- seen whether a large number of individuals will tically looking at an investment that is closer be willing to invest in information processing to $700 or $800. However, this situation is not and telecommunication equipment capable of likely to persist in the long run. The prices of interacting with systems for delivering finan- all computing equipment are falling. Some cial services to the home. Success of financial vendors are selling modems for under $100, service offerings may depend on minimizing and the price of disc drives continues to fall. the investment of potential customers and, Computer modules that work with widely dis- perhaps, what other services may be available tributed video games are on the market, and through the same systems. they are expected to offer the user significant improvement in the performance-to-cost ratio for equipment that could be used in conjunc- Large Computer Systems tion with various future financial service of- While there will be significant changes in the ferings. In addition, small, battery-powered, capabilities of computers at the low end of the portable computers that can be carried in a spectrum that will enable a larger number of briefcase and have a built-in modem and RS- people to access the technology, changes at the 232 interface are now available for under high end of the scale will also occur. Speeds $1,000, a price that will undoubtedly be lower of computation and the basic architecture of in the future. Therefore, computers that can computers will change so that there will be a be used by individuals to receive financial serv- marked increase in the performance-to-cost ices both at home and work are likely to be well ratios over those now available. The raw com- within reach of a large portion of the popula- puter power for applications such as image tion within the 1988 to 1993 time frame. and voice processing will become available. Another alternative would be development Both applications have potential for the finan- of very inexpensive specialized devices ori- cial service industry. Voice recognition ap- ented to users of financial services. These plications could be used as an alternative to could use cartridges similar to those used with key input particularly in telephone-oriented television game machines, very simple control systems in which the user would use voice to mechanisms, and a television to display the issue payment and other directives to finan- data. Some providers may even develop appli- cial service systems. Applications of image cations that use a TV game machine as the key processing systems, some of which are now be- Ch. 2—Present and Future Technologies Supporting the Financial Service Industry ● 23 —.. .—-- — .———..—— - ——.

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 ing tested, could range from processing finger- only for balance inquiry and the kinds of trans- prints for identifying the user of a remote serv- actions now performed through an ATM. ice device to reading information on checks as Others could be used to submit loan applica- part of check processing. As the cost of equip- tions and/or initiate securities transactions. A ment continues to fall, more providers of fi- single cash dispenser/deposit acceptor* could nancial services will find the equipment afford- serve multiple user stations, thus keeping able. In addition, customers will become better overall system costs down. Financial institu- equipped to take advantage of the various tions may find it in their interest to provide services offered (see table 1). customers with terminal devices specifically oriented to the package of products and serv- Future Computer Hardware ices being provided, thus overcoming any hesitancy to acquire and use general-purpose During the coming 10 years, changes in com- computer hardware that requires some specific puter hardware that are generally invisible but knowledge of the technologies. beneficial to users will occur. Functions such Computer architecture will be increasingly Table 1 .—General-Purpose Application Processors modular, with functions divided between and among various system components. On the 1992 1982 1987 one hand, this will make it possible for users Small: Cost (dollars in thousands) . . . . 12 8 5 to configure systems to meet their specific re- Storage (megabytes) ...... 0.5 1 2 quirements, while on the other, it will tend to Speed (millions of instructions increase system reliability and integrity. If one per minute) ...... 0.05 0.1 0.4 Medium: component fails, the probability that system Cost ...... 100 60 40 operation will continue at some degraded level Storage...... 1 2 8 of performance is high. Providers and users Speed ...... 0.2 1.0 4 Large: of systems for delivering financial services will cost ...... 1,400 600 400 benefit from an increase in the availability of Storage...... 8 16 48 Speed ...... 4 8 24 would SOURCE Arthur D Little, Inc “Application of Technology for Providing Financial *A d~PoS~acceptor have the capability to count cash Services, ” April 1983 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 ap- pletely into the background than is now the plications. The mean time between failure for case, thus making them more acceptable in such systems is measured in years, since they both the home and office. The telephone will are designed to continue operating without become a multipurpose instrument capable of degradation in performance in all but the most receiving alphanumeric as well as graphic catastrophic circumstances. data, in addition to its conventional use for voice transmission. Such devices are already Alternatives to keyboard entry will increase on the market for applications in the business the flexibility and attractiveness to users of environment. self-service financial systems that are accessible from remote locations. For example, the The key to the future will be ease of use. As user will be able to communicate instructions new terminals become available and are capa- to a computer by touching one of a few con- ble of presenting and transmitting information trol buttons or an image on a screen. Already, in a multiplicity of formats, user anxiety re- touch screens are available on devices that lating to the technology used to interact with range from wristwatches to computers, and systems for delivering financial services greater application of these in the future can should approach the level now experienced be expected. Limited voice input capabilities with the telephone or the handheld calculator. will be available, but continuous speech language processing will not be possible before Future providers and users of financial serv- the turn of the century, if then. Optical char- ices will have the choice of using networks of acter recognition technologies will continue to small processors or the minicomputers and become more cost effective, and there will be mainframes that will soon become affordable some capabilities to process handwritten infor them. To some extent, they, like everyone put. Systems that use the signature to iden- else who acquires information-processing ca- tify the user rather than a personal identificat- pabilities, will be able to choose the equipment ion number coupled with a machine readable that best meets their requirements for proc- card could come into use by the middle of the essing and their philosophies of product design coming decade. On net balance, these alterna- and management. Factors such as system tives will reduce the use of multiple keystrokes security, reliability, and integrity will be taken needed to respond to requests for information, into account. Other factors will be the avail- and hence will reduce barriers to use and inability of appropriate software packages and crease efficiency of the new systems for deliv- the costs of telecommunication services. ering financial services. In some specialized applications, however, Greater use will be made of color and graph- the large computer system will continue to ics in computer output. The ability to transmit dominate. For example, significant computer pictures easily will mean that the user will power is required to support the check reader/ have less need to read. Video disc technology sorters used widely throughout the financial could be coupled with computers, especially service community. While electronic banking in such applications as home shopping and will lessen the growth in check volumes, they others that require catalog-type data. Video will remain high. Therefore, requirements for “catalogs” could show the shopper multiple supporting check-processing equipment will views of an item and could be updated fre- continue into the foreseeable future. New ap- quently to show newly arrived merchandise plications implementing processing of voice and to reflect price changes. Voice synthe- and/or handwriting will also require the power sizers have become very affordable, and they of mainframe computer systems. In addition, will be used both to support graphics displays microcomputers may not be capable of man- and to provide computer output through the @g future telecommunication functions that standard voice telephone. Displays will be- will become even more significant to the finan- come more compact and will blend more com- cial service industry. Ch. 2—Present and Future Technologies Supporting the Financial Service Industry ● 25

Online POS systems will consume substan- One of the factors that has limited the de- tial processing and communication resources. gree to which advanced systems for deliver- Interchange networks that serve ATM sys- ing financial services have been accepted has tems are designed to handle 4 to 10 transac- been the lack of processing capabilities in the tions per second and provide a response time hands of many potential users and suppliers. that ranges from 30 to 90 seconds. Paul The fact that many potential participants in Hefner of First Interstate Bancorp of Califor- the financial service industry are installing nia, points out that POS networks will have computers for a variety of reasons is creating to handle hundreds of transactions per second a latent capability for either using or deliver- and provide a response on the order of 6 ing financial products because the marginal seconds. Thus, the processing capacity re- cost of such a move could be minimal. quired to support these networks may begin The long-term impact of changes in the ca- to approach the limits of the technology, if pabilities of computers on the users and pro- they begin to handle the transaction volumes viders of financial services is not so much that foreseen by some. the raw computational capability of the equip- Already, both users and providers of finan- ment will increase. Rather, an increasing num- cial services have put in place a considerable ber of individuals and organizations are buy- portion of the hardware infrastructure that ing equipment because its cost is dropping. will be key to delivering financial services. The result is a decreasing marginal cost of en- Banks and other financial service providers try for potential users and providers of ad- have been long-time users of computers, as vanced financial services systems. Higher po- have the major dry goods retailers. However, tential levels of participation will encourage an increasing number of small stores are in- the deployment of advanced systems and, in stalling electronic cash registers and com- the absence of other barriers to their accept- puters from which they will be able to build ance, will result in their achieving a greater in the future. Some grocery chains have made level of economic viability than would be possi- heavy use of computers to automate the check- ble with the present level of equipage. out process and inventory systems for in- Generally, the financial service industry has dividual stores. Major firms regularly use not demanded access to the largest computers automated systems to generate payrolls and to handle its applications. Advances in com- pay suppliers. Smaller firms are increasingly puter technology will most likely continue to turning to data service bureaus or installing outpace the demands of the financial service small computers to obtain comparable serv- industry, and therefore, lack of sufficient com- ices. Also, considerable numbers of consumers puter power will not be one of the factors that are acquiring computers that could be con- will limit the development of new systems for figured to perform the processing required to delivering financial services. interact with financial service delivery systems.

Software

A computer is useless without software: the ing a program to be operational, and an ongo- programs that instruct a computer to perform ing program of 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 opera- is 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 Present Applications Software cost of software is determined by its complexity rather than the size of the machine on The acquisition of applications software has which it is to operate or the volumes of data always been the responsibility of the user orga- that are to be processed. Generally, however, nization. Today the computer user has three larger machines are needed to use the more options for acquiring software. First, the user complex software packages that support the can retain either in-house staff or a consult- larger data bases. ant/contractor to build application packages uniquely tailored to his needs. Because pro- Although the cost of computer hardware gram development remains labor-intensive, will continue to decrease, the cost of computer this can be a costly process, a significant por- software may not, or may not decrease as tion of which is the cost incurred-after the much. Software development remains a labor- system becomes operational-for maintaining intensive activity and is likely to remain so the programs, correcting errors as they are dis- into the 1988 to 1993 time frame. However, covered, and making changes as the needs of more widespread use of software packages will the organization evolve. For operators of large lower costs for individual users. scale computer systems, such as those used Until now, resources for software develop- by many providers of financial services, this ment have fallen short of demand. The advent has been the only option considered. Large of new tools for software development, how- staffs of highly trained professionals have ever, should increase the productivity of soft- been assembled and supported to handle the ware professionals somewhat. Furthermore, a tasks of system development and mainte- greater tendency to purchase and modify ap- nance. Experienced organizations have found plication packages to meet specific needs as that over 70 percent of the resources spent on a substitute for the development of applica- these staffs is for maintaining existing sys- tion packages by each end-user organization tems, leaving only 30 percent for developing will reduce the apparent shortfall of software new applications programs. development resources in the future. Financial service organizations have devel- There are three basic classes of software— oped a huge body of proprietary software over systems software, support software, and ap- the years. Included are applications that range plications software. Systems software controls from internal accounting systems to those the minute-to-minute operations of the com- that support home banking products. When puter by allocating resources and scheduling a new product such as a money market mutual tasks. Support software is typically used for fund is offered, its introduction must often be such functions as controlling a communica- preceded by a significant software develop- tions network, monitoring transaction proc- ment effort. Regulatory changes such as the essing, managing the data base environment, imposition of Regulation E* can also result in or furnishing tools intended to improve the major software development efforts or the productivity of programmers and, in some cases, need to make significant changes to existing end-users. Applications software directly in- software systems. terfaces with the end-user and is designed to However, just as the advent of small com- carry out functions unique to the particular puters has brought the power of the technol- situation. ogy within reach for the individual user, it has Systems and support software, including also had an impact on the costs of system de- data base management systems, are discussed velopment and maintenance. Consumers now in appendix 2B to this chapter. Applications identify applications in which the small com- software and its use for delivering financial *Re~lation E is the Federal Reserve Board Regulation im- services is described in the sections that plementing the consumer protection provisions of the EFT Act follow. of 1978. Ch. 2—Present and Future Technologies Supporting the Financial Service Industry ● 27 puter can provide significant benefit and either and maintenance are potentially spread over write the programs themselves or with help multiple users. at minimal cost. Generally, the small packages Systems for processing checks and servic- for personal computers which result are used ing deposit accounts and outstanding loans for analytical applications that are often tai- have been developed by both financial insti- lored to the specific working habits of the in- tutions and data-processing service organiza- dividuals using them. To some extent, the per- tions and are widely used throughout the in- sonal computer has replaced the worksheet dustry. Organizations that have developed the and personal file system that have always software for home banking applications are ac- been the tools of the professional analyst and tively marketing it to providers. decisionmaker. This software is not suitable for account maintenance and other adminis- Thus, as a second option, the user can ac- trative tasks that require the manipulation of quire an application package that comes as large data bases and the processing of a large close as possible to meeting his needs and then number of transactions. On the other hand, a either modify it with internal resources or re- portion of these applications depend on being tain the original developer or another party to able to access the major corporate data bases make the required changes. This approach has that are maintained by the large, central com- the disadvantage for both the vendor and the puter facility. user that multiple versions of a basic package must be supported. Costs and difficulty of In one example, a microcomputer is used to maintenance are both increased as, almost in- help farmers generate the information required variably, the modifications made periodically to support applications for loans. Another ap- to the basic package and the changes made to plication using a voice response unit and in- meet specific user needs generate conflicts put from a 12-key telephone has been devel- that require basic changes in the software to oped by a financial analyst to process market resolve. Some marketers of software systems data and generate information used for port- mitigate this problem by including features folio management. Automated spread-sheet that permit the user to customize the package programs running on microcomputers have at specific points in the processing cycle with- also become popular tools among users and out actually modifying the basic program. providers of financial services. Users have found that for some purposes the information The third option for the user is to acquire generated by a microcomputer running all and use an application package as is. This op- night can be just as satisfactory as the same tion is more often used by users with small data produced in a few minutes on a large, cen- computers than with large. However, opera- tralized computer. Further, the user of the tors of large installations are turning with in- microcomputer may be able to avoid hassles creasing frequency to generalized software often encountered when a data processing de- packages. Prepackaged software for micro- partment is asked to implement an appli- computers has enabled significant numbers of cation. users in the financial service industry to apply information processing and telecommunica- Over the years, the usefulness of application resources to the operation of their busi- tions packages has been recognized across an nesses without needing to become proficient industry, and significant numbers of packages technically in the operation and use of the are now developed and offered for sale or lease technology. to a variety of users. In some cases, the packages were developed by organizations for To use these various packages, the user need their own use and later offered to others. In not purchase or lease the computers on which other cases, the package was developed to be the applications run. Time on systems oper- marketed commercially. In this environment, ated by others can be purchased, an option all benefit because the costs of development that has enabled many smaller providers of fi- 28 ● Effects of /formation Technology on Financial Services Systems nancial services to take advantage of available jor computer manufacturer has announced a technologies. In many cases, banks and serv- microcomputer that accepts program car- ice bureaus that develop application packages tridges; this is likely to provide the impetus also sell the machine time required to run needed to make this medium of software dis- them. In others, those with excess processing tribution more widely accepted for financial resources available sell them. For example, the services. largest processors of bank card transactions are service organizations, not banks. Check Applications Software in the Future processing and account maintenance is often performed by other than the institution offer- The evolution of applications software in the ing the service. future is likely to be relatively slow because of the huge base of operational programs, rep- Conventionally, the medium for distributing resenting an investment of billions of dollars, software is either floppy disc or magnetic tape. that is now installed.’ Language development Telecommunication links between computers will be constrained because in many areas new are also used for transferring software. This languages will have to be compatible with technique is used to distribute programs for those used to implement the installed base. large computer systems and for providing programs stored on large central computers to Even though there is considerable inertia in small peripheral ones in distributed process- the form of installed application systems, ap- ing environments. plication programs will continue to evolve. In the near term, the emphasis will be on modi- Experience has shown that safeguards fying batch applications* to operate interac- against copying or modifying software can tively where it is reasonable to do so. Specific easily be circumvented by individuals who attention is being given to providing the most have a moderate degree of technical sophisti- up-to-date information possible to both users cation. This presents a problem to operators and providers of services in order to improve of systems for delivering financial services overall management of financial resources. electronically to a large number of people. If Even where batch processing is most desira- the software used to access a service from the ble, transaction data will be entered interac- customer’s premises can be altered, a compro- tively and accumulated until a batch process- mise of system integrity or security could re- ing program designed to handle the accumu- sult, causing damages for both the system lated data is run. Eventually, however, interac- operator and other users. tive processing will dominate and up-to-the- One way to avoid this problem is to distrib- minute data will be available to all who need it. ute software in cartridge form, in the form of Most programs today have been developed hardware, a technique that is being tried by to meet the needs of classes of individuals on at least one marketer of home banking serv- the assumption that the requirements of mem- ices. Although this minimizes the chances of bers of a group for computer support are ap- modifying the software, users whose comput- proximately the same. This assumption holds ers do not accept cartridges are eliminated for people engaged in routine activities, but from the market. Moreover, it does nothing to it tends to break down at the upper levels of stop the potential intruder who obtains the organizations. In the future, generalized sys- functional specifications of the cartridge or is able to copy the program from the cartridge IThe material in this section draws heavily on the report, to another medium. In these cases, the intru- “Future Information Processing Technology -1983° prepared der could modify the program to perform un- for the Institute of Computer Science and Technology and the Defense Intelligence Agency. authorized functions, just as it is possible to *Batch applications me those when data are assembled over modify software distributed using other, more a period of time and are processed periodically, frequently on conventional media. On the other hand, a ma- a fixed cycle. Ch. 2–Present and Future Technologies Supporting the Financial Service Industry ● 29 terns and capabilities will be more easily tai- “Windowing” technologies that permit the lored to the specific needs of individuals. Users user to display the results of multiple proc- will be provided the facility to set application esses simultaneously on the screen will im- parameters to meet their individual needs. Ob- prove the utility of the technology to the users. vious examples that already exist are the abil- They will allow the users to concurrently view ity to request the detail to be used in prompt- data from multiple sources and select those ing the computer user online and the format items most useful to the task at hand. For ex- to be used for displaying data. The user unfa- ample, the user may use one window to review miliar with an application can be led through the status of a transaction account, a second it step by step, while those who have mastered to project cash flow, and a third to enter an the operations required can be freed of the bur- order with a broker/dealer to buy or sell a secu- den of detailed instructions. rity using a telecommunication line that con- nects directly to the broker/dealer’s computer. Applications will be self-teaching to a great degree. Many, as already illustrated by the More of the processing capability will be res- systems that support ATMs, will be menu- ident at the user site and will therefore be driven; users will not be required to learn and much more of a personal tool. Large systems use commands. Today, a growing number in- may be limited to being repositories of data clude tutorial features; but in the future the to which the user is provided access on a “need user will have greater facility in selecting the to know” basis. At the start of a problem- specific points where instruction is needed and solving session, a microcomputer will be used w-ill be able to obtain help without interrupting to access a data base on a large computer sys- the ongoing flow of processing. Audio-visual tem, retrieve the data needed to address the display technology, heavily dependent on vid- problem, and store it locally on a small disc. eo discs, may figure greatly in implementing Applications running on the microcomputer this capability. will perform the required analysis, and after this has been completed, the central data base Users will have a larger variety of options will be modified as required. In fact, in some in selecting the format in which data is pre- organizations, this mode of problem-solving sented. Color graphics will come into more is already quite commonplace. widespread use and users will have greater capabilities to manipulate graphic images in Knowledge-based systems, one of the areas addition to already existing facilities for main the general field of research known as arti- nipulating and analyzing combinations of nu- ficial intelligence, will become more generally meric and alphabetic data. For example, the available. For the financial service industry, capability of manipulating a trend line for one this could mean that financial advisors and variable and seeing its effects on other trends counselors will be augmented, or possibly re- will be possible. Mice, * light-pens, and voice placed, by automated systems. Research in input/output will greatly facilitate interaction artificial intelligence and expert systems has between the user and information system. shown some valuable results. However, there is considerable uncertainty about when such *A mou9e i9 a small device attached to a computer that is systems will be sophisticated enough to have used instead of keys to control the movement of the cursor, the indicator on a video display that indicates where the next char- an operational impact on the financial service acter will be formed. industry. 30 ● Effects of Information Technology on Financial Services Systems

Telecommunications Technologies

Telecommunication technology provides an ency will increase. Securities markets, card indispensable lifeline to users and providers and check authorization systems, and cash of financial services. Of the number of alter- management services are now totally depend- native telecommunication technologies from ent on telecommunication. Products such as which suppliers and users of financial services remote banking and shopping and off-market are able to choose, the most common is the securities trading have a dependency equally switched telephone network. But, both provid- great. The premium placed on timely financial ers and users of financial services also con- information is increasing, and the only way to struct and use a variety of alternatives, which meet this requirement is through the applica- include such diverse technologies as private tion of communication technologies. Changes microwave links, satellite transponders, video in the technologies, policies, and economics of cable, public packet switched networks, leased communication will directly affect the design lines, and local area networks. of systems for delivering financial services, the cost schedules facing both users and providers The divestiture of the operating telephone of financial services, and, hence, the structure companies by American Telephone & Tele- of the financial service industry. graph (AT&T) in 1984 substantially changes the communication environment in which providers and users of financial services operate. The Switched Telephone Network Both local and long-distance telephone rates are likely to change. Competition from non- The most widely available communication Bell suppliers of telecommunication services facility is the switched telephone network that and equipment is already significant and is serves virtually every place of work and resi- likely to increase in magnitude and kind in dence in the United States. Only a limited light of the divestiture. Those who enter mar- number of locations can send and receive tel- kets as providers of equipment and services ecommunication traffic without using this net- are likely to intensify competition further. work for a portion of the route. Subscribers to non-AT&T long-distance networks gener- Both suppliers and users of financial serv- ally access them through the facilities of local ices are heavily dependent on telecommunica- operating companies. In fact, some of the al- tion services, and as systems to deliver finan- ternative services actually use long-distance cial services directly to customer premises circuits provided by AT&T. become more widely deployed, this depend- The switched telephone network is basically designed to handle analog voice traffic. Gen- erally, 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. Photo credit Raca/.M//go Corp

Network control console like those used to manage The switched telephone network was de- major financial service telecommunication networks signed to handle a relatively large number of Ch. 2—Present and Future Technologies Supporting the Financial Service Industry ● 31 calls of short duration in which the parties are phone as an input/output device. If successful speaking a high percentage of the time the con- market penetration occurs, home computers nection is maintained. A circuit is established may offer a more viable alternative for deliv- between the parties for the duration of the call. ering service. Whether or not there is traffic on the connecting circuit, the facilities used to maintain the Presently, commercial users in some areas connection are denied to others. A POS ter- have specialized, switched digital service. In minal connected continuously through the the future, virtually all customers will have switched telephone network may be used only digital network service available, primarily intermittently. Although this constitutes an through the digital termination services inefficient use of network resources, a mer- planned by operators of the switched tele- chant may desire to maintain such a connec- phone network. As outlined in greater detail tion in order to minimize the time required to in the next section, each digital line will have process a transaction at the point of sale. substantially more capacity than is now available in the conventional voice circuit and will The common telephone is by far the primary be considerably more versatile. terminal used with the switched telephone system. Although it functions well for voice com- Wide Area Telephone Service (WATS) is a munication, its capabilities as an instrument specialized service offered through the for data entry are limited, and those for receiv- switched telephone network. This service ing other than voice response are almost non- allows a fixed number of hours per month of existent. The 12-key tone pad is a moderately calling for a specific geographic area. IN- effective data entry device that can be used WATS permits incoming calls at no charge to to transmit numeric data to a computer with the caller, and WATS, or OUT-WATS, per- relative ease, but it transmits alphabetic data mits the subscriber to originate calls using the awkwardly. It has been used for applications service. IN/OUT-WATS permits both. Finan- such as telephone bill paying and balance in- cial institutions and others use this service to quiry. In those locations where tone service expand their markets geographically without is not available, an easily acquired attachment establishing physical presence in the targeted to the traditional dial telephone or widely areas. The availability of toll-free calling en- available dual-mode instruments allows the courages the remote customer, who might be user to transmit the tone codes required for unwilling to incur a toll call charge, to contact certain services. This operation requires use the institution. The service is particularly val- of either a tone generator placed over the uable to depository institutions that face re- microphone of the handset or a type of tele- strictions on the geographic areas in which phone now available that can switch between they can establish facilities. dial pulse and push-button tone operation. In addition to the common voice telephone, With either, the customer can make a connec- many other types of communication devices tion using conventional dialing and then can be attached to the switched telephone net- switch to tone output to communicate with an work. Included are computers, simple termi- electronic device. If financial service providers’ nals, and facsimile terminals. These can pro- applications can conform with the capabilities vide for interaction with humans and/or of the voice telephone as a data communica- unattended operation. However, all currently tion device, a significant portion of the Nation cost more than the voice telephone. Service could have immediate access to computer- providers must recognize this cost differential based financial services. Marketers of such when planning the deployment of a system services have been limited in the past by the that depends on the user acquiring the re- lack of capabilities of the stand-alone tele- quired terminal equipment. 32 ● Effects of Information Technology on Financial Services Systems

Private-Line Telecommunications Fiber optics offers greater capacity and secu- Facilities rity of transmission than do copper conductors of comparable size, properties that are Many commercial organizations and govern- particularly attractive in areas like the finan- ment agencies use leased circuits for their in- cial district in New York, where the available ternal communication needs. Providers of fi- space in conduits for wires has been almost ex- nancial services are among the heaviest users hausted. of such facilities, and some operate large global networks for moving funds and infor- A communication technology of growing im- mation. portance is local area networks, which are installed within an organization’s facilities to A leased circuit guarantees access to a cir- provide a variety of communication services, cuit between the points that meets specified including the transmission of both voice and electrical characteristics. This eliminates the data. Digital, private, automated branch ex- problems of uncertain quality and relatively changes are being installed to manage some slow access* when dial-up lines are used. While of these networks. Others have been developed there is no assurance that the same physical by manufacturers of office computer equip- circuit will be made available at all times, or ment and emphasize such features as sharing that the signals will not be multiplexed with of data resources and electronic mail. * Char- others between various points along the route, acteristically, all of these networks provide the quality of the line becomes invariant from gateways to the switched telephone network, the user’s point of view. This minimizes the including the private, value-added carriers and variability of one of the elements critical to any private networks to which the user may overall reliability and integrity of financial have access. The user of a local area network service systems. with gateways to the switched telephone net- Institutions with sufficient need and funds work has access to all of the data and proc- can install their own circuits; in some cases, essing resources that comprise the local net- private microwave networks have been estab- work and, using the same terminal equipment, lished. Fiber optics and coaxial cables are used to other facilities that are external to it. for networks confined to a limited area, such All of the classes of equipment that will as an office building or factory complex. Some operate with the switched public network will have leased transponders on communication also operate with private networks. satellites, and others have leased circuits on video cable systems. Financial service orga- Alternatives to Switched Networks nizations are among the heaviest users of the video cable that runs from midtown Manhat- Because the switched telephone network, tan to the Wall Street area in New York City. where “hard” connections are established and Aetna Insurance Co. is one of the three pri- maintained for the duration of a conversation mary partners in Satellite Business Systems, between the parties, is not particularly well a major communication venture. New technol- suited to traffic that is characterized by rela- ogies will increase such options. For example, tively short bursts of activity separated by the installation of teleport facilities will make long periods of silence, alternative technolo- satellite communication available to a larger gies more suited to data traffic are used by community of users and offers the opportunity providers and users of financial services. POS, to bypass local telephone facilities completely. ATM, and home banking systems, as well as Merrill Lynch is one of the major backers of others that use interactive computer facilities the teleport installation planned for New York. *EIWtronic m~ is the technology Of Sending mess%es e~ec- tronically between computers. Messages are stored on the ad- *The time required to dial a number ~d go through the log- dressee’s computer system to be retrieved, read, and disposed on procedures that must be used in a dial-up environment. of at his/her convenience. Ch. 2—Present and Future Technologies Supporting the Financial Service Industry . 33 to deliver financial services, are characterized Video-Related Communication by this kind of bursty traffic pattern. Technologies One of these is packet switching, in which Considerable attention has been given in re- messages are broken down into small packets, cent years to using technologies built around each of which is routed separately through the some modification of the common television network. One property of this technology is set for distributing information, including fi- that the cost of communication becomes more nancial services. The services offered are gen- a function of the volume of traffic handled erally built around alphanumeric displays of than the distances involved. Also, there is min- information that fill one television screen. The imal penalty for having a network that in- quality of graphic capabilities varies from sys- cludes a large number of points between which tem to system, but none presently offers any only limited traffic volumes pass. Because it significant degree of animation. However, with is oriented to handling messages that are fairly some systems, computer programs will be short in length and are spread over consider- transmitted to the user’s terminal at relatively able periods of time, packet switching is par- low speed and then executed in the customer’s ticularly suited to the type of traffic likely to terminal to produce animated graphics. One be generated by providers and users of finan- application for this technique is the distribu- cial services. POS systems and systems for tion of video games; other applications are trading securities are candidates for this tech- likely to follow. nology. While video-based systems have been some- Multiplexing, a well-established and widely what accepted in Europe, they are still in the used group of technologies that permit a com- experimental stage in the United States, munication circuit to be shared more or less where only a limited number of systems is in simultaneously by multiple users, is also of operation. One of the principal drawbacks en- interest to providers and users of financial countered is the price of a modified television services. These technologies permit a single, set or specialized terminal capable of partici- high-capacity circuit to be used for various ap- pating in the system. Three general types ex- plications, none of which could alone justify ist: teletex, videotex, and cable television. the expense of a dedicated line. For example, if local communication costs rise, as some pre- In teletex, frames are transmitted over the dict, the operator of a shopping center could air during the blanking pulse in the television establish a connection to a financial network signal, the period when the raster on the televi- or a specific financial institution that would sion returns from the lower right comer of the permit the merchants access to POS services screen to the upper left. Because the technique at lower costs than if communication services repeatedly transmits a limited number of were paid for independently. This could be frames that can be selectively captured by the done by connecting to a specific institution, terminal equipment, the capacity per channel thus eliminating choice of a financial service for offering adequate response to users is lim- provider for individual tenants of the shopping ited to about 25 to 100 frames. This is essen- center. On the other hand, the shopping cen- tially a one-way system because there is nei- ter owner could conceivably provide access to ther a path over which the user can respond a gateway that would permit individual mer- to the system nor a means for sending a signal chants almost unconstrained freedom in se- to a specific receiver. Users can, however, use lecting financial service providers. a telephone connection to transmit to the sys- 34 ● Effects of /formation Technology on Financial Services Systems

tern. Conceptually, an address routing mes- financial services. This system includes pro- sage to a specific receiver could be added to vision for interactive response from users to the transmitted frame, but the limited capac- questions posed by the program being trans- ity of the channel would effectively limit such mitted. Applications include all of those possi- an application. Full-frame teletex, an alterna- ble with videotex and others that can make tive to transmitting the textual information use of the capacity of the television cable. during the blanking pulse, is the dedication of Large amounts of data, such as historical a channel to a telex application. Capacity could stock market information, can be transferred then increase to about 1,500 frames per chan- rapidly and loaded into a user’s computer for nel. Application of this technique is generally processing at a convenient time. limited to dissemination of advertising and bulletin board type of information. Included Future Telecommunication Technologies could be price quotations, but it would not be possible to tailor the information to the needs Generally, telecommunication technologies of a specific subscriber. Transaction initiation, will continue to provide the means by which except through the use of an auxiliary chan- financial and payment information is trans- nel such as telephone, is not possible because mitted rapidly from point to point. In many there is no direct path from the user to the ways, the specifics of telecommunication tech- source of the information. nology are of minor interest to users and providers of financial services. As long as suffi- Videotex generally uses the telephone net- cient capacity is available at an affordable work to transmit the required information to price, the needs of the financial service indus- users, who are able to interact with the infor- try will be met. mation source, selecting material from a large library that is directed only to the user’s televi- While voice communication will continue sion set or personal computer display. A very indefinitely to dominate the traffic handled by large number of frames is available, and it is the common switched telephone network, possible to charge for each frame viewed (the transmission technology is changing. Digital user requests specific frames). Some applica- transmission will replace the analog signals tions, such as those related to financial serv- now used most commonly. Voice will be digi- ices, permit the user to enter data that is then tally encoded and will share circuits with data, processed (e.g., a mortgage amortization video, and facsimile transmissions. This will schedule is produced when the user enters mean that users of telecommunication serv- principal, term, and interest rate). Because ices will be able to interweave voice and vari- data is directed only to a specific terminal, per- ous forms of data on the same circuit. Systems sonal information such as account balances that offer these capabilities to commerical cus- can be delivered using this technology. The ca- tomers are being marketed. For example, a fi- pacity of the telephone channel limits the de- nancial service consultant is able to send a gree of animation that can be offered, and the table of data showing the expected results of data transmitted is generally confined to text, alternative investment opportunities for dis- numeric tables, or fixed graphics. play on a client’s terminal in the midst of a normal conversation. Even now, terminal de- The third technique, cable television, uses vices capable of supporting such usage pat- video cable, with all of the transmission terns are coming on the market. capacity inherent in that medium. The War- ner-Amex QUBE system that has been oper- The concept of a telephone industry ISDN ating in Columbus, Ohio, for some time offers (Integrated Services Data Network) is emerg- considerable capabilities for delivering text to ing and will reach fruition sometime before the specific users and a low data rate return chan- end of the century. An ISDN is a network in nel for reacting to specific user input. It there- which all traffic is represented digitally, and fore has considerable potential for delivering various types are freely mixed as traffic passes Ch. 2—Present and Future Technologies Supporting the Financial Service Industry ● 35 from origin to destination. However, because least two types of networks, switched tele- of the magnitude of converting the installed phone and video cable. Either could be used plant, ISDN capabilities may not be available to implement ISDN-like concepts. The cable to significant portions of the subscribers to television systems may enjoy some cost and switched telephone services for some time be- bandwidth advantage over the telephone net- yond the turn of the century. Further, while work. The transmission capacity of a cable is there is now no compelling reason for making much greater than that of most ordinary tel- ISDN generally available to consumers, there ephone circuits, and the cost of serving a sub- is a distinct possibility that a force driving in scriber is less. that direction will emerge and will hasten the deployment of ISDN. For example, if consum- Designers and users of financial service sys- ers become heavy users of information utili- tems will be able to choose from a variety of ties, their needs for transmitting and receiv- telecommunication technologies in designing ing significant volumes of data could stimulate and accessing services. Some new telecommu- development and deployment of ISDN fa- nication technologies will have greater capac- cilities. ity than the switched telephone network of today, but development of new techniques to Users of telecommunication systems built extend the capacity of the present telephone in accordance with the ISDN concept, or a less plant are evolving. For example, dial telephone general one called “Digital Termination Serv- lines are now routinely used to transmit at ice, ” that shares many concepts with it, may 2,400 bits per second, a rate that could not be be provided with a single high-capacity com- realized with acceptable error rates several munication line. The capacity of this line years ago, and rates as high as 9,600 bits per would then be allocated among various appli- second are becoming possible. Switched tele- cations at the user’s discretion. Some may phone networks are expected to evolve slowly choose to use it for multiple voice lines, while from conventional copper wires to fiber optic others may allocate a portion to data and an- circuits. Fiber optics have transmission capac- other to voice. Allocations could be changed ities far greater than those of the present cop- dynamically in response to user needs. At one per conductors. However, as is now the case, point, several people could be using the facil- some network segments will always be carried ity for a number of simultaneous conversa- by radio transmission, as exemplified by the tions, which could include conference calls. At use of microwave and satellite facilities. another point, a single user could use part of the capacity to carry on a conversation, while Technologies such as cellular radio and dig- the remainder is used to access information re- ital termination services are now being offered sources. Using advanced software technolo- commercially for the first time. These are ex- gies, the user could also interact simultane- pected to come into widespread use by the ously with multiple information providers. For mid-1990’s. In addition, direct broadcast sat- example, an individual may review account ellite systems will soon become operational balances, along with economic statistics and and may be used in some systems for deliv- historical data provided by independent ven- ering financial services. dors of information services, in formulating in- There will be a diversity of telecommunica- vestment decisions. tion networks in the coming years. Various Although one could assume that the vehi- vendors of telecommunication services and cle for implementing ISDN will be the frame- technologies will try to offer systems that work provided by the switched telephone net- most effectively serve certain classes of users. work, there is no technical reason why this While there is a proliferation of systems, ven- need be the case. Most private locations, such dors recognize that they will have to provide as homes and places of business, will be able for the interoperability of communication fa- to have telecommunications delivered over at cilities. Gateways between private networks 36 ● Effects of /formation Technology on Financial Services Systems and public transmission facilities are now efits of the ability to choose from a range of almost mandatory. Thus, users and providers options will be realized only if the customer of financial services will be able to communi- expends the effort needed to evaluate the alter- cate between and among themselves with min- natives. In all likelihood, independent devel- imal concern for the particular technologies opment of system designs and seeking the used in implementing financial service sys- vendor best able to meet the need will be re- tems. The emergence of other alternatives to quired. Not all potential users who could ben- conventional switched telephone services efit from this approach will be prepared to take should be expected over the coming 10-year it, with the result that they will probably set- period. These new services will almost cer- tle for something much less than the best tainly offer opportunities of value to both available communication facility at the most users and providers of financial services. advantageous price. To the degree that communication costs become relatively more sig- Now, and probably more so in the future, nificant for providers and users of financial numbers of telecommunication options avail- services, this shortfall could affect their basic able to all users, including individuals, will be ability to compete in the market with others available. Users will be able to closely align not carrying a similar burden. services procured with needs. But the full ben-

System Security and Integrity

Security has long been an area of concern System Security to providers and users of financial services. Traditionally, banks have been characterized As demonstrated by the young people in by large metal doors and imposing vaults with Milwaukee in 1983, it is not difficult for in- massive and complex locking mechanisms. Fi- dividuals with minimal equipment and train- nancial service providers stress the safety of ing to penetrate some computer systems assets in attracting customers, and customer which contain sensitive information. In the trust is a keystone of the financial service in- Milwaukee caper, one of the computers com- dustry. promised, using a common home computer and telephone line, belongs to a major west Increasing use of telecommunication and in- coast bank. Other instances of penetration of formation-processing technologies in conjunc- computers used by providers of financial serv- tion with financial services raises two areas ices are on record; and some experts believe of concern that relate to the basic soundness that only a relatively small portion of the secu- of the financial service industry: system security breaches that occur are detected, and rity and system integrity. System security fewer are reported outside of the victim orga- deals with the problem of those who would at- nization. tack the system from the outside, including those who work with the system but would Historically, embezzlers from within and attempt to invoke operations they are not check forgers and confidence artists from with- authorized to perform. System integrity ad- out have threatened the financial service in- dresses the problems that arise with recover- dustry. Computers, particularly those acces- ing a system without loss of data in the event sible through telecommunication networks, of a failure. 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-technol- or organizations could launch their attacks ogy environment, the assets of an organiza- from any telephone, including those in motel tion and the proprietary information on which rooms and pay stations, from which they could it bases its business operations are subject to operate undisturbed for brief periods. At least remote-access thefts. one computer now on the market fits nicely into a large purse and can be used to initiate Attacks on financial institutions through an attack on a financial institution from any their own processing systems can directly vic- location where a standard modular telephone timize those institutions’ clients. A thief who connector can be found. Some devices can be robs a bank at gunpoint steals from the insti- set up to operate unattended, and then re- tution; the electronic thief can reach directly trieved. into the accounts of individuals. The burden of detecting the crime, reporting it to the orga- Not all attacks on financial service systems nization holding the account, and recovering must be so sophisticated. Individual consum- the lost assets could shift from the institution ers of financial services and various user or- to the account holder. When the thief’s booty ganizations have demonstrated a marked yet is information rather than financial assets, nei- unwitting ability to aid the thieves who would ther the specific individual nor the institution victimize them. Personal identification num- affected may ever become aware of the fact bers (PINs), given to account holders to use that the system has been penetrated. in depositing and withdrawing money from ATMs, are written on access cards. Telephone Threats to a system can materialize both numbers and key access codes are written on from within and outside the target organiza- communication terminals and bulletin boards tion. Employees throughout an organization in clear view of those unauthorized to have can individually or in concert attempt to com- them. In one instance, an enthusiastic user of promise a system. Technical personnel can an ATM demonstrated the use of the machine modify operational programs or write new to a complete stranger and, in the process, re- ones to perform improper operations. Similar- vealed his PIN to all within 20 feet. A vari- ly, nontechnical personnel can seek to perform ety of comparatively simple scams, that range operations not authorized to them or misuse from asking individuals for PINs and the use powers with which they are entrusted. of their cards to retrieving used carbons show- Programmers have written codes that credit ing account numbers from the trash cans of the fractional cent from an interest computa- organizations that accept cards in payment of tion to their personal accounts and fail to re- accounts, have been used to compromise finan- port properly the overdraft conditions in those cial service systems. accounts. Some programs to perform unau- Computer-to-computer communication is thorized operations destroy themselves after now used to initiate and execute a substantial completing their task, leaving no trace of their number of financial transactions, a practice existence. A few people used computers to that will become more widespread in the fu- create and maintain millions of dollars worth ture. Therefore, the problem of authenticating of bogus insurance policies in the Equity the “signature” of a computer that partici- Funding case, a task that would not have been pates in financial transactions in order to au- possible without the technology. thenticate the transactions will become as crit- Conceptually, it is possible for anyone to use ical as that of establishing the identity of international telecommunication facilities to human users. Although under study, no such attack financial institutions without ever com- technique has emerged that shows promise for ing within the jurisdiction of American law en- wide adoption by the financial service indus- forcement officials, much less being in close try. Finding a solution that will be acceptable physical proximity to the institutions they are for use by individual consumers and others not attacking. With relative impunity, individuals sophisticated in the design and operation of 38 ● Effects of /formation Technology on Financial Services Systems — advanced technological systems constitutes tions will be interrupted for a period of time. the most difficult subset of problems in this Such interruptions may be the result of attack area. by an outsider, natural calamity such as an earthquake, or the inadvertent error of an au- Providers of financial services, aware of the thorized user of the system. Thus, systems threats to their systems, are taking steps to must be built so that they can be restored to tighten security. Various devices and tech- full operation without loss of data or transac- niques exist for minimizing the vulnerability tions in process at the time of failure. This is of computers and communication networks a particularly important factor in delivering used to deliver financial services. The use of financial services because lack of system in- data encryption techniques is growing, and a tegrity could result in a situation where the system in which the PIN is never accessible level of confidence so essential to the viability in clear text to any human is available and in of such systems is degraded. use by many financial institutions. Physical security around computer facilities is the focus The problem of providing for system integ- of considerable attention, and research de- rity is largely a technical one. Increasing use signed to overcome the known weaknesses of of telecommunications adds new dimensions the PIN as an access code is continuing. to the problem, but a number of well-accepted Nevertheless, human ingenuity and fallibility practices aimed at ensuring system integrity will probably counteract attempts to provide exist. It remains for the operators of financial foolproof security for computer systems. service systems to ensure that those practices are followed during the design, implementa- System Integrity tion, and operational phases of the system lifecycle. All systems, whether manual or automated, will at some time fail in the sense that opera-

Specific Technologies for Delivering Financial Services

Applications of general-purpose information ment that is then processed. Most often, the processing and telecommunication technolo- consumer is making use of a credit service and gies specific to the needs of the financial serv- is billed by the credit provider. Today, em- ice industry have been developed. Included are bossed plastic cards are also used to originate technologies for accessing systems and han- debit transactions that are processed over the dling items such as cash and checks that are same network as credit transactions. unique to the financial service industry. Generally, the data are recorded on the magnetic stripe on the card by the card issuer Card Technologies before it is sent to the account holder and they are not changed during the life of the card. Embossed/Magnetic Stripe Card This striped card has room for about 1,000 bits The embossed plastic card with a strip of of data. Allowing for the information that magnetic tape embedded in the back has be- must originally be recorded on the card, there come almost ubiquitous. This device provides is just not enough room to record transaction the primary means for accessing credit and data. Technologically, however, there is no rea- debit services that are delivered through both son why data on the stripe could not be altered paper-based and electronic systems. Common- after issuance. On the other hand, the limited ly, the card is presented at the point of sale, capacity of the stripe and the cost of deploy- and an impression is taken on a paper docu- ing sufficient terminals with the capability of Ch. 2—Present and Future Technologies Supporting the Financial Service Industry ● 39 recording data on the stripe makes this device ever, its potential use is likely. As described generally unsuitable for applications that by S. Berton Latamore: would require changing the data repeatedly. The card can store digital data signifying Also, the stripe is easily readable, eliminating the bearer’s fingerprint, voiceprint, or even the possibility of building security into the the pattern made by capillaries in the card. retina. A stand-alone card-reading machine, However, the same basic technology is used equipped with a microprocessor, would check whether this biological data on the card in the Washington, D. C., subway farecard sys- matched that of the card-holder. The card is tem. When a farecard is purchased, the being developed by Drexler Technology of amount is recorded by the machine dispens- Mountain View, Calif. The company’s Drex- ing the card. Each time it is used, the starting on card stores 1.2 megabits, or roughly point of the trip is recorded, and when the 30,000 words–nearly 1,000 times more than passenger exits the subway system, the a magnetic stripe card. amount of the fare is computed and deducted The Drexler cards are coated with a two- from the balance on the card. In this system, layer plastic film. The top layer is embedded the magnetic stripe is mounted on a paper with microscopic pieces of silver, giving the backing, and the card is generally disposed of material a highly reflective, metallic look. To after only a few cycles, a lifetime that would write data, a low-power laser melts pits in the not be suitable for a card that is to be used top layer to expose the unsilvered—and un- repeatedly over an extended period. reflective-bottom layer. To read the card, a laser scans the surface, and a photodetector Data on magnetic stripes are read by ATMs senses the presence and absence of pits as and special terminals used by some merchants highs and lows in the intensity of the re- at the point of sale. Merchant terminals pri- flected light.2 marily facilitate the process of obtaining a Unlike the magnetic stripe, the laser mate- transaction authorization from the card issuer rial cannot be erased and rewritten; pits are by eliminating the requirement for either the physical holes that cannot be refilled. clerk in the store or an authorization clerk at the issuer’s facility to key in the account num- Electron Card* ber. Some merchant terminals also print the necessary information on the paper document, Electron cards, first distributed in early fall further reducing clerical workload. of 1983 by VISA, U. S. A., combine three encoding technologies on the back of the plastic Among the problems with the embossed/ card-the banking industry’s magnetic stripe, magnetic stripe card is that it is relatively easy the retail industry’s optical character recogni- to copy or counterfeit. Several technologies tion, and the universal product code bar have been developed to overcome this prob- code.** The card, which is not embossed and lem. Data can be recorded in the laser card by cannot imprint paper forms, is an attempt to burning pits in a reflective material that can embrace both the banking and retail environ- be sensed by an appropriate reader. Once re- ment with a move toward a more secure elec- corded, the data can be neither altered nor tronic environment than presently exists. The erased. Holography is being used on some card card will feature a direct debit option but will blanks to create a background image that is very difficult to reproduce. ‘J. Berton Latamore, “Putting Intelligence in Your Market, ” Iljgh l“eclmology, published by High Technology Publishing Corp., June 1983, p. 16. Laser Card f *“Electron ’ card is a trade name for a VISA card. The laser card, or memory card, is just mak- **Optic~ ch~ac~r recognition (OCR): the process of reading . a stylized type face with an optical sensor. Universal product ing its debut. At this date the laser card is not code (UPC): a bar code now imprinted on many items that is used by the financial service industry; how- 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 placing chips in all its VISA cards, the future presently replaces proprietary ATM access of the smart card is uncertain. Some suggest cards. A full-scale POS project is expected to that it represents the wave of the future, while get under way in mid-1984. The card will mi- others see it as a technology in search of an grate to full-service use at points of sale. application. If it is to come into widespread use, merchant terminals will have to be gen- Use of the electron card is intended to re- erally available. Development of a card with duce the number of paper checks, resulting in reusable memory could also enhance the util- lower processing costs, less fraud, and faster ity of the concept. service at the point of sale. Cardholders will have electronic access to cash through a global In its current form, the smart card is a mod- network of ATMs and to goods, services, and ification of the conventional plastic card it is cash at many locations. Authorization will be intended to replace. It contains a microproc- provided electronically at the time and point essor chip, but because it includes neither a of each transaction and will be fully controlled keyboard nor display, it can be used only with by the card issuer. a terminal device that provides power and the appropriate input/output capabilities. The processor card, or “smart card, ” developed in France, contains a tiny embedded com- However, there is no reason why a smart puter chip with about 1,000 times the storage card that includes a keyboard and display of the conventional magnetic stripe. However, could not be built. Calculators that are no once data are recorded in the memory, they larger than the card are available with such cannot be simply altered, and their memory features; and an interface to a merchant or fi- cells cannot be directly reused. The smart card nancial institution termina1 could be provided. contains processing capabilities that enhance Such a card could include in its functions the its security and flexibility. A standard for its ability to determine the balance remaining and format has recently been adopted, eliminating to review the transactions for which it has some of the uncertainty that may have been been used. Multifunction cards that contain limiting its adoption. The user plugs the card more than one processor could also be built. into a terminal that then queries the card The smart card could evolve as an alterna- memory as part of the processing to validate tive to cash following the general model of the the transaction. Once authorized, the transac- fare card used by some subway systems, in- tion data can be recorded in the card’s mem- cluding that in Washington, D.C. The user ory for later retrieval. With present technol- could “charge’ the card with funds from a de- ogy, the card costs in the range of $5 to $10 pository account and the funds would be dec- and is good for approximately 200 transac- remented for the amount due each time it is tions before its memory is full. used. Terminals for recording value in the card Even though Carte Bleu, a group member could even be located at home, giving the con- of VISA International, France, has begun sumer 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.

Photo credit: High Technology, June 1983 In the future, applications of card technology will become more widespread. Already, The French smart card contains a microprocessor capable of interchanging information with another there are telephones which accept magnetic computer stripe cards and other vending machines may Ch. 2—Present and Future Technologies Supporting the Financial Service Industry . 41

the old one invalidated. The question that follows the compromise of a fingerprint or a ret- inal 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 vouch- ers 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. A newly designed pay telephone produced by Flonic- Schlumberger in Paris accepts smart cards. It is being One of the major suppliers of ATMs has an- deployed by the French Government’s nounced a model that will accept and time- Telecommunications Administration stamp individual checks. It will also be able to dispense currency and coin in any amount. be designed to accept them also. As the facil- Models that accept and count Japanese cur- ites for online transaction authorization and rency are already in use. Thus, the technology direct debit of accounts from point of sale are to provide deposit verification by the ATM is 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 ves- sels 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 com- Photo credit Burroughs Corp promised. When this happens with a conven- Reader/sorter processes checks and other documents tional PIN, a replacement code is issued and 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 would be responsible if a forged check were the utility of these machines substantially. processed against an account? Consumers use and hold canceled checks in lieu of receipts, Systems that process credit and debit card especially for tax purposes. What alternatives transactions already truncate the paper flow would be acceptable to the Internal Revenue at the earliest practical time. Instead of mov- Service? ing paper, the data are recorded on magnetic media and transferred electronically for processing by the card issuer. Documents are Customer Service Equipment coded so that they can be retrieved if neces- Cash dispensers were the first terminals sary. Moreover, credit unions and savings and made available for customer use by financial loan associations generally do not return institutions. These were followed by the mul- drafts on NOW accounts to the account hold- tifunction ATMs now in widespread use that er, also truncating paper flow. However, with are capable of initiating bill payments, trans- relatively few exceptions, commercial banks fers between accounts, and other types of still return canceled checks with monthly transactions, in addition to accepting depos- 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 ter- minated 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

Photo credit: Diebold Corp Document encoder used to record data on checks in a machine-readable format Inner workings of an automated teller machine Ch. 2—Present and Future Technologies Supporting the Financial Service industry ● 43 its and dispensing cash. The functional capa- In the future, a number of “customer work bilities of these machines are continuing to in- stations” could be available in a lobby area. crease and they are becoming capable of These could be configured so that the custom- handling increasingly diverse kinds of transac- er could sit at a desk and accomplish a num- tions. Counter to this trend, however, some in- ber of tasks, including making a deposit or stitutions are making available specialized withdrawing funds. Then, when the bulk of the machines to perform balance inquiries and are work is finished, the customer could go to a supplementing full-service ATMs with cash device supporting many terminals that ac- dispensers so that customers requiring only cepts the deposit or another that would dis- cash will not have to wait behind those with pense cash. Express terminals for customers more complex transactions. with limited needs could also be provided. There may be a movement to customer serv- Bank branches without human tellers are ice machines that have a wide range of capa- operating, and some institutions are shrink- bilities. Some may be of limited purpose, for ing their networks of full-service branches. such applications as cash dispensing and bal- Some of these automated branches provide ance inquiry. Others may have the capabilities only telephone communication for the cus- of the ATMs of today: accepting deposits, tomer in need of assistance. Others are moving money between accounts, paying bills, manned by a customer representative who is and dispensing cash. Still others may be used available to answer questions and market for time-consuming but infrequent transac- services, but who performs none of the teller tions, such as the filing of a loan application functions, such as accepting deposits or pay- or ordering securities transactions. ing withdrawals.

Technology and the Structure of the Financial Services Industry

One of the impacts of present and future such as gas stations, are motivated by losses technologies on systems for delivering finan- from bad checks and card fraud to take steps cial services is that there is a real possibility that minimize their exposure. For example, an of redistribution of function between and ATM in a supermarket has the potential for among traditional suppliers and potential new relieving the requirement to cash checks while entrants. Whereas the payment system has minimizing the amount of currency and coin been reserved largely by the banks, because that is held at each store location and subject only they have access to facilities for clearing to theft. and settlement, movement of funds electronically makes it possible to avoid the traditional On the other hand, what is technologically payment system and to effect net settlement feasible may be neither possible nor desirable. directly between members of a community Consumers may balk at accepting new serv- that have agreed to the necessary implement- ice delivery mechanisms. Legal/regulatory con- ing conventions. Alternative means of distrib- straints may limit options, and the potential uting information could diminish the role of providers of the services may opt not to im- brokers for such varied products as securities, plement them for any of a variety of reasons. real estate, and insurance. Telecommunication Further, changes in the technologies modify systems that are capable of message switch- the parameters that bound system design al- ing are implicitly capable of performing the in- ternatives. Those that are attractive now may terchange function for payment networks. become undesirable in the future, while new Retailers and other cash-oriented businesses, alternatives not now feasible may emerge. 44 . Effects of Information Technology on Financial Services Systems

Appendix 2A: Hardware Components

Chip Technology includes a central processor, high-speed random access memory to which data and programs are The fundamental building block for information moved when they are active on the system, and processing and telecommunication is the silicon peripheral storage devices, such as disc and tape chip. Many thousands of electronic components, drives that store data and programs not immedi- constituting an infinite variety of electronic cir- ately needed by ongoing processing operations. cuits, can be fabricated with these chips. The new- Additional components, depending on the system est computers have memory chips capable of stor- configuration, might be printers, card readers, and ing 64,000 bits of information; chips capable of devices specifically designed to handle the telecom- storing 256,000 bits of data are now emerging. munication function. Chips with 1 million electronic components are in The heart of any computer system is its central the laboratory stage of development. processor. It is the subsystem that performs the Processor chips used in today’s large microcom- instructional program written to support a specific puters tend to include only the functions needed application. Processors can be fabricated on a for performing the required logical and arithmetic single chip or may require several cabinets of com- operations. Memory for data storage and circuitry ponents. For any type, the key to increasing speed to facilitate the movement of data between the and minimizing costs of fabrication and operation processor and various peripheral devices such as is to minimize the physical dimensions of the proc- disc drives and telephone communication links essor and the number of discrete components re- usually require additional chips mounted on the quired. same printed circuit board as the processor. A Most modern systems use more than one proc- single chip which includes the processor, memory, essor. In a small desktop computer, for example, and other supporting circuits, is in widespread use one processor on a chip may perform the primary for many appliances and devices. But most of the work of a machine while other processors perform home computers and larger units separate this supporting roles, such as generating the charac- functionality into several separate chips. ters on the screen of the terminal through which Silicon chips in use today tend to be less than the user communicates with the system. Large one-quarter inch on each side. Dr. Gene Amdahl systems may use networks of processors to per- has suggested that it maybe possible to fabricate form the variety of functions required of a ma- economically chips that are several inches on a chine. Small systems are capable of tens of thou- side. If so, performance-to-cost ratios for electronic sands of operations per second, and some larger equipment could rise significantly because the commercial systems can perform millions of oper- larger size would limit the need for physical inter- ations per second. Computer systems capable of connection between chips which is one of the ma- billions of operations per second are just over the jor costs of fabrication. One of the major factors horizon. reducing the cost of consumer products, such as The central memory of a computer contains the home computers and video games, has been the program instructions and data that comprise the decrease in the number of chips required in these elements of an application system when it is ac- devices as it has become possible to pack more and tive. A small desktop computer may have storage more onto a single chip. Also, because the speed for as few as 1,000 characters of information, while of an electronic circuit is limited by the distance large systems used by providers of financial serv- between its components, the ability to manufac- ices may have main memory capacity measured ture very large chips could translate into signifi- in tens of millions of characters. More commonly, cant increases in processing speeds for the devices desktop computers with main memory capacities that use them. ranging from 48,000 to 256,000 characters are used for financial service applications both by in- Computer Systems dividual users and providers of financial services. Even though some financial service applications A computer system consists of a number of sub- can run on computers with as little as 16,000 char- assemblies that are collected in much the same acters of main memory, computers with memories manner as a component high fidelity system. It much smaller than 48,000 characters tend to be Ch. 2—Present and Future Technologies Supporting the Financial Service Industry ● 45 too small to conveniently hold the programs and end. For example, the interchangeable floppy discs data required for serious financial services applica- used with a computer having 48,000 or so char- tions. Larger systems used by providers of finan- acters of main memory will have a capacity of cial services include main memories that com- 100,000 to over 1 million characters. Hard, nonin- monly range in capacity from 1 million to 8 million terchangeable discs used with such systems can characters. have a capacity of 5 million to 40 million charac- Disc drives, another system component, have ters. Discs used with large-scale computers have large capacities relative to the main, random ac- capacities of hundreds of millions of characters, cess memory of a computer and permit processors and many can be attached to each system. to access individual records in a fraction of a sec-

Appendix 2B: Systems and Support Software

Present Operating and Data Base Management Software Support Systems Data base management systems constitute a The sophistication of systems and support soft- specialized software technology of particular im- ware generally varies directly with the capabilities portance to providers and users of financial serv- of the computer on which it is to be used. Large ices. This software facilitates the tasks of organiz- mainframe computers are supported by compre- ing and accessing large quantities of data where hensive software packages that provide extensive relationships between the various elements com- capabilities to those capable of using them. This prising a data base are complex and where diverse is to be expected because the larger computer can communities of users access various subsets of be utilized effectively only if most of its operations the data base. By permitting the sharing of data throughout an organization, the costs of data col- are controlled automatically. At the other extreme, lection, maintenance, and dissemination are con- software for microcomputers is much more rudimentary in its scope of functions. The user of a trolled, and all users are able to base their deci- microcomputer is in direct control of virtually all sions on a common body of information. operations, and the services of a complex operat- Data base technology insulates data bases from ing system would be of only limited benefit. How- the application programs that access them and can ever, operating systems even for the smallest com- significantly improve system integrity and secu- puters are expanding in terms of the capabilities rity. Depending on the data base system, users can offered. be limited to accessing only specific data elements, Twenty years ago, systems software and some and further, the operations permitted them can be support software were furnished free to users by controlled by the data base administrator. Audit the manufacturers of computer equipment. How- trails that record the identity of all who access ever, unbundling of software and hardware has data and the operations performed can be gener- been common industry practice for a number of ated. For example, some users may be permitted years, and today’s user pays for each of the sys- only to retrieve data, while others may both re- tem and software support modules used. Operat- trieve and change a specific set of data elements. ing system and support software is expensive both Permission to add new elements to a data base can in terms of the direct cost and overhead imposed. be denied both of these groups and given, instead, These software packages can soak up a consider- to other units within the organization. able portion of available computer resources. Thus, On the other hand, data base management sys- a small system with support facilities limited to tems “put all of the eggs in one basket” in that a single application may, in some cases, be more much of the data critical to an organization is con- effective than a large machine burdened with large centrated in only a few data bases. Compromise amounts of overhead. One manufacturer, in fact, of a data base management system can lead to sig- had to expand significantly the available memory nificant damage to the organization that is af- on one of its larger models to accommodate the fected. In such an environment, the organization burden of operating system and support software. can become vulnerable if management does not 46 . Effects of /formation Technology on Financial Services Systems fully use those data base management system fea- municate with the operating system through tures which are designed to ensure system secu- higher level commands. rity and integrity. Although there is no such thing Users will be able to select capabilities that are as perfect security for any system, data base man- tailored to their needs and pay only for those. Gen- agement technology can allow a higher degree of erally, ease of use will increase and users will not system security and integrity than possible when be required to learn separate ways for dealing with collections of individual files are used by each ap- various classes of applications. For example, all plication system. terminals will be able to communicate will all applications because the required protocol conver- Software Development Tools sions will be performed automatically. It will be possible for major systems to operate in multiple The rate of productivity increase for application sites as a single entity because access to and allo- programmers in the past has been small relative cation of resources will be controlled by the sys- to the rate of increase in the performance-to-cost tem and support software. Worldwide distributed ratios of computer hardware. However, a new networks will be feasible by the mid-1990’s. The group of tools is becoming available to help alle- ability to distribute functions among multiple co- viate this problem. Data base management tech- operating processors will serve to increase system nology discussed in the previous section is one reliability and integrity. In addition, the various such tool. In addition, there are interactive, ter- support packages will develop so that they have minal-oriented systems that support application great facility to recognize and recover from errors programmers by minimizing the steps they have and will be able to notify the appropriate user of to execute to write and test new programs and transactions that could not be successfully proc- modify existing ones. Management techniques essed because of either a hardware or software er- that emphasize modularity in design and make ex- ror. A key feature of operating system and sup- tensive use of procedures for controlling systems port software will be its ability to diagnose system configuration have also proved beneficial. problems and dynamically reallocate system com- In addition, advanced languages have made it ponents. User installations will have to expend easier for programmers to develop the required minimal effort to support software packages. computer codes. Procedure-oriented languages One manufacturer of microcomputers is already permit the end-user to interact directly with gen- marketing an operating system that provides the eralized systems and minimize the need for ap- user with the facility of moving easily from one plication programmers to develop applications cus- application to another without the need of expli- tomized to the needs of each user. citly terminating one and initiating a second. As Perhaps the major breakthrough has been in additional applications are added to the repertoire, programmerless application generators. For exam- they can be integrated with operating system so ple, general-purpose spreadsheets, such as Lotus that the user is faced with a single, integrated en- 1, 2, 3 and VisiOn, allow nonprogrammers to de- tity rather than a number of disjoint applications. velop complex models and display their results Integrated, multifunction software packages for graphically. microcomputers are well established in the market; and although they do not constitute operat- The Future for Operating and ing systems, they offer some of the features one Support Systemsl would expect to find in an operating system. This trend toward easing the burden of detail on Support functions such as telecommunication, the end-user of computer systems is expected to data management, allocation of hardware re- be a major theme in the development of system sources, and job scheduling will be performed by and supporting software into the indefinite future. highly modular support software. More functions At some point, the user will no longer have to rec- now performed by the operating system will be ognize the existence of a discrete operating sys- performed in hardware. New emphasis will be plac- tem and will be able to focus all attention on the ed on the security features and the user will com- applications that are being used. Many of the features of the operating systems I Most of the concepts relating to the future of system and support for large computers are already becoming available software are drawn from, Future Information Processing Technology, 1983, prepared jointly for the Institute for Computer Sciences and Tech- for microcomputers. Some of the software devel- nology and the Defense Intelligence Agency. opment 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 ade. As more generalized functions are moved into manufacturer has added to its product line a mi- the hardware, the operating system and support crocomputer that will run a variant of the virtual software, the tasks required of applications pro- memory operating system used on its large sys- grammers will be simplified and, hence, less costly tems. Networks of small computers will become to accomplish. A key element in realizing the ben- the functional equivalents of large central systems efit of this technology will be the ability of man- in many operating environments. The emergence agement and technicians to understand its capa- of such capabilities is foreshadowed by some of the bilities and apply it intelligently in supporting office systems that are already being deployed by applications systems. some manufacturers. The same system development and maintenance By the mid-1990’s, large computers may func- tools that will benefit professional technicians will tion largely as repositories of data and support also help end-users interact directly with computer only the largest processing systems. Small com- and communication systems without the need for puters directly controlled by end-users will per- intermediation by members of technical staffs. The form most of the processing functions and report support functions will complement the generalized, generation that will be required. Some installa- user-oriented application systems that will be tions are already approaching this state. available; and, together, they will provide the end- Tools for system development and maintenance user with a powerful package of tools for apply- will be of growing importance over the coming dec- ing 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, Since the introduction of the telegraph 140 which developed to help young American busi- years ago, communications technologies have ness gain financing from European investors, been used by the industry to convey informa- continues to bring together those who need tion on which the operations of securities in- capital and those wishing to invest. The indus- dustry depend. However, while the securities try directs its concentrated expertise on finan- industry has always applied state-of-the-art cial markets toward its intermediary role of technology to its operations, the level of tech- facilitating the development of capital. It pro- nology used today and likely to be available vides advice, accepts risk, and offers market- tomorrow is beyond what could have been ing services to ensure that an orderly market dreamed of when the telegraph was applied in for the issuing and trading of securities* is 1844. maintained. In this chapter, the structure, functions, and XFO~ PUW{)=S of this study, securities include debt and equity instruments of the securities industry are de- issues used to develop capital (stocks and bonds, money-market scribed. The impact that the application of securities, and instruments which have been developed to allow hedging and speculation in securities and commodity computer and communications technologies market s—i. e., options and futures contracts). These instru- has had in these areas is reviewed and possi- ments, as well as investment tools which developed from the ble future effects are discussed. packaging of securities instruments, such as mutual funds and central asset accounts, are described in app. 3A.

Structure of the Securities Industry

The structure of the securities industry has market shortly developed.1 At the same time been shaped by the demands of users, national the need to finance development in the new policy objectives regarding the financial serv- Nation was recognized. The burgeoning secu- ice industry, practical operational concerns, rities industry provided a vital link to Euro- and competitive market forces. In this section, pean capital markets and also a means of a brief overview of the development of the cur- transferring capital within the United States. rent structure of the securities industry and The basic role filled by the securities indus- a description of the organizations and compet- try in the late 1700’s is still a driving force itive forces comprising the industry will be behind its operations today: to provide a means provided. Present and future effects of infor- of interaction for those seeking capital and mation technology on the structure of the in- those wishing to invest. dustry will be discussed. Two factors which quickly emerged as essential to the operation of the securities industry The Development of the Securities were the maintenance of an orderly market Industry in the United States and the availability of trading information. Twenty-four brokers, conducting trading under The securities industry in the United States a buttonwood tree, subscribed to a brokers’ developed to meet the capital demands of the agreement that formed the first stock market new Nation. One side effect of the independ- ence won in the Revolutionary War was war debt. This was funded by the issuance of in- IMarketpIace-A Brief History of the New York Stock Ex- terest-paying bonds, for which a secondary change (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 Organizations Composing the became the New York Stock Exchange. In Securities Industry what is now known as the “Buttonwood Agreement, ” the brokers focused on working Three types of organizations traditionally together to assure they would be able to trade compose the securities industry: investment securities smoothly and fairly. banks perform the services surrounding a public offering of the stocks and bonds of a cor- Information on trading and prices has al- poration; brokers manage the buying and sell- ways been essential to trading decisions. Se- ing of securities; and exchanges provide a curities firms and exchanges clustered (as on vehicle for setting prices and actually conduct- Wall Street) to facilitate the communications ing transactions. needed for the operation of the market. A newspaper first published stock prices in 1815. Investment Banks Prior to the introduction of the industry’s first technology-based information system, the The activities of investment banks are cen- electric stock ticker (in 1867), messengers tered on the development of capital. The Bank- literally ran from the trading floor to brokers’ ing Act of 1933, commonly called “Glass-Stea- offices with information. gall, ” required that investment banking be separated from commercial banking because Early refinement and expansion of securities of the sometimes incongruent objectives and trading can be related to three communica- the different levels of risk associated with tions technologies: the telegraph, the trans- 3 these kinds of organizations. Investment atlantic cable, and the telephone. These tech- banks fall into two categories: originating nologies improved information flows on which firms and distribution firms. Originating firms the markets are dependent. The telegraph developed largely as intermediaries between linked exchanges, brokers, and investors European financiers and young American in- throughout the country and made decision- dustry, and they remain major players in the making on investments by someone not on development of securities offerings. Distribu- Wall Street practical for the first time. This tion firms come together in syndication, under technology offered the first hope of a national, the guidance of an originating firm, to guar- noncentralized market. The transatlantic antee and sell the securities of an issuer.4 cable, completed in 1866, made an international market feasible at a time when Ameri- The four leading investment banks in both can industry was still very much dependent domestic and foreign financing are Salomon on financing from European investors. Tele- Brothers, Inc.; Morgan Stanley Inc.; First phones were first used to convey orders from Boston Inc.; and Goldman Sachs & Co. Mer- brokers to the floor of the New York Stock Ex- rill Lynch, Pierce, Fenner, & Smith Inc. (Mer- change in 1878, 2 years after the first suc- rill Lynch) and Paine, Webber, Jackson, & cessful test of that technology. Curtis (Paine Webber) have a significant share of the domestic market. Three levels of pur- The adoption of these communications tech- chasers and sellers are reached through invest- nologies and the stock ticker were based on ment bank activities: first, the issuers of secu- the recognition that the faster and more ac- rities, those corporations and governments curately information flows, the better securi- that purchase investment bank services; sec- ties markets function. The introduction of new ond, the investors in new issues; and third, the technologies today is largely based on this intermediaries who bring these two parties assumption. together—other investment bankers, distri-

‘New York Stock Exchange 1983 Fact Book (New York: New York Stock Exchange, June 1983), p. 66. 4Sarnuel L. Hayes III, “The Transformation of Investment ‘Marketplace-A Bn”ef History of the New York Stock Ex- Banking, ” Harvard Busines 12ew”ew, January-February 1979, change, op. cit. pp. 153-170. —

Ch. 3—The Securities Industry ● 53 buting underwriters, and commercial banks. Exchanges Investment banks assume the risk of a pub- The fundamental role of all exchanges in the lic offering of investments by guaranteeing securities industry is to provide an orderly their purchase—i.e., underwriting them. marketplace for trading. Exchanges provide The nature of competition within invest- a central location and a structure in which ment banking is changing. Price competition buyers and sellers can conduct trades. Ex- is cutting fees for underwriting to new lows. changes are operated on a membership basis. In addition, simplification of securities regis- “Seats,” memberships that carry the right to tration requirements could make underwriters trade on an exchange, are purchased by firms unnecessary. Nevertheless, the need to trans- or individuals desiring access to its market. fer risk continues to provide a strong incen- Members agree to direct all trades on listed tive for utilizing the services of investment securities through the exchange floor. This banks. allows the exchanges to manage the markets better–for example, to halt trading on a security, if necessary, with the assurance that Brokerage Houses member firms will not trade off-market. Full-service brokerage houses perform trades Stocks and bonds, options, and futures con- in securities and commodities and provide fi- tracts are usually traded on separate ex- nancial counseling services supported by in- changes. This specialization is a carry-over depth research and analysis of markets and from the separate formation of capital and industries. This segment of the industry is commodity markets. dominated by firms which are subsidiaries of Stock Exchanges.– Stock exchanges are in- companies that offer a range of financial man- dependent players in the securities industry agement services. Six national brokerage and have two functions: performing transac- houses lead the industry. They are: Merrill tions and accepting risk. Stock exchanges act Lynch; E. F. Hutton & Co.; Shearson/Ameri- as a secondary securities market for both debt can Express; Prudential Bache; Dean Witter and equity issues, providing flexibility and Reynolds; and Paine Webber. There are also choice for investors. Potential investors in new many regional firms, such as Alex Brown & issues can evaluate the desirability of the in- Sons, which play major roles in trading either strument in light of their ability to sell it, and nationwide or regionally. therefore may recognize a lower opportunity cost. The existence of secondary markets also This portion of the industry has been af- increases the available investment choices fected by the abolition of fixed commission since securities other than new issues are made rates in 1975. While brokerage houses in the available. past competed on the reputation of their research and the quality of their service, price There are seven major stock exchanges: competition has also become a factor. Dis- New York, American, Boston, Cincinnati, Mid- counters, who concentrate on the transaction west, Pacific, and Philadelphia. In 1982, 80.8 side of the business, have entered the market percent of the total share volume of registered and have attracted a significant portion of exchanges was traded on the New York Stock both institutional and individual trading. In Exchange (NYSE). The National Association response to this market entrance, many full- of Securities Dealers, Inc. (NASD) operates a service brokerage houses are taking steps to quotation system and clearing facility for the distinguish their services and to increase cli- over-the-counter market. The automated quo- ent loyalty. Increased efforts are being di- tation system, NASDAQ,5 has been responsi- rected toward product development and pro- 5National Association of %curities Dealers Automatic Quota- motion. tion 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 82500

80,000

77500 75,000 72,500 70,000 [1!!

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 SOURCE Futures Industry Assoclatlon, Inc trading volume.

ble for a dramatic increase in trading volume The principal established marketplaces for in over-the-counter stocks, an indication of the the trading of options are: the American Stock importance of information flows to trading. Exchange; the Chicago Board Options Ex- change; the Pacific Stock Exchange; and Options Exchanges. –The goal of options the Philadelphia Stock Exchange. These ex- exchanges is to provide a continuously com- changes compose the Options Price Reporting petitive and orderly market environment for Authority (OPRA). Trading information from the purchase and sale of options.6 Each ex- all of the options exchanges is coordinated in change determines standards regarding which OPRA’s automated last-sale reporting sys- options may be traded on that exchange. They tem. This system, developed and operated by select the underlying securities on which op- the Securities Industry Automation Corp., tions may be traded based on factors such as provides a consolidated tape of last sale and ‘American Stock Exchange, Inc., et al., Understanding the quote information. The exchanges also formed Risks and U=s of Listed Options, 1982. 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 con- assigns exercises. ducted in price auctions on the trading floor. The exchanges are operated on a membership Options exchanges aid in industry self-reg- basis, and exchange regulations and policies ulation by developing and enforcing rules con- are set by their boards of directors and sub- cerning the handling of accounts by brokers, ject to approval of the Commodity Futures trading hours, and position and exercise limits. Trading Commission (CFTC). There are many Options exchanges and the OCC are regulated futures exchanges in the United States. The by the Securities and Exchange Commission largest is the Chicago Board of Trade, which (SEC). in 1983 handled 44.89 percent of total trading Futures Exchanges.—The principal respon- volume (see table 2.) sibility of a commodity futures exchange is to ‘Futures Industry Associates, Inc., “Roles Played by Each ensure the existence of competitive markets Participant, ” Futures Trading Course and Handbook, Wash- free of price manipulation for the trading of ington, D. C., 1983, p. I I-4.

35-505 0 - 84 - 5 : QL 3 56 ● Effects of /formation Technology on Financial Services Systems

1983 1982 Exchange Contracts Percent Contracts Percent Rank 1. Chicago Board of Trade ...... 62,811,523 44.89 48,206,790 42,89 (1) 2. Chicago Mercantile Exchange...... 37,830,044 27.04 33,574,286 29.87 (2) 3. Commodity Exchange, Inc...... 20,014,597 14.30 17,520,712 15.59 (3) 4. Coffee, Sugar & Cocoa Exchange 4,876,069 3.48 3,252,512 2.89 (4) 5. New York Mercantile Exchange ...... 3,926,589 2.81 2,649,941 2.36 (5) 6. New York Futures Exchange ...... 3,510,285 2.51 1,451,442 1.29 (9) 7. MidAmerica Commodity Exchange ...... 3,166,537 2.26 2,397,721 2.13 (6) 8. New York Cotton Exchange...... 1,703,105 1.22 1,479,781 1.32 (8) 9. Kansas City Board of Trade...... 1,693,042 1.21 1,493,558 1,33 (7) 10. Minneapolis Grain Exchange...... 379,607 0.27 346,264 0.31 (lo) 11. New Orleans Commodity Exchange ...... 13,542 0.01 27,872 0.02 (11) 139,924,940,. 100.00 112.400.879,, 100.00 SOURCE: Futures Industry Association. Ch. 3—The Securities Industry ● 57 ——— ——

The exchanges play a major role in self-reg- all economy. Business decisions are being ulation of the futures industry. In this role made more quickly, and delays in financing they are required to perform four activities: will not be tolerated. surveillance of market activity to detect and prevent situations conducive to price distor- Institutional Investors tion; surveillance of trading practices to detect Institutional investors include special-in- and prevent trading abuses; investigation of terest funds and companies such as pension rule violations and customer complaints; and funds, mutual funds, insurance companies, examination of members’ books and records.8 and private foundations that have a goal of The introduction of new investment products, producing income for a specific organizational such as stock futures, indicates that activity use and deal in large blocks of securities. They on futures exchanges may be expected to grow demand prompt, efficient transactions and ex- over the next several years. The regulatory tensive information. and operational role of the exchanges will become more complex. Information technology Since the passage of the Employee Retire- is being applied to facilitate the operations of ment Income Security Act (ERISA), the im- the exchanges and will play an increasingly pact of these investors on the total market has important role in their activities. increased substantially. Trades in 10,000 - share blocks, a measure of institutional in- Industry Users volvement, have increased to over 44 percent of total share volume. g The broker must also The demands and characteristics of users of be willing to assume risk by buying from the the industry are major determinants of indus- institutional investor because he demands a try structure. The organizations of the secu- high level of liquidity. At the same time, the rities industry serve as intermediaries between importance of this segment of the market has two sets of users: capital seekers and in- led to price competition following the deregula- vestors. tion of commission rates in 1975.

Organizations Seeking Capital The demands of institutional investors have been, in large part, responsible for much of the While the focus of much of the activity of automation of trading and clearing by the se- securities industry is on secondary markets, curities industry. Exchanges need to attract the underlying demand for capital is the rea- institutional capital to maintain the market- son the industry exists. In 1982, the value of place, yet information technology, combined new issues of common stock publicly offered with institutional traders’ level of market ex- was $23.4 billion; new, publicly offered debt pertise, makes off-market trading a viable al- obligations totaled $45.2 billion. Private place- ternative for these traders. The volume of ments of debt and equity totaled $22.3 billion. trading conducted by institutional investors As the U.S. economy completes its evolution makes those investors valuable clients for to an information economy, it may be expected both brokers and exchanges. that a great number of both new firms and existing corporations with growing operations Pension funds are the most significant insti- will be seeking capital through both private tutional investors in capital markets. In 1980, and public sources. these funds held 13.4 percent of the total market value of NYSE listed stocks.10 Two factors Corporations will demand more rapid access that have contributed to the growing impor- to their capital than ever before because of the tance of pension funds, both as savings vehi- effect of information technology on the over- cles and institutional investors, are the aging

8 U. S. General Accounting Office, Survey of Investor Protec- tion and the Regulation of Financial Intermediaries, 1983, pp. ‘Securities Industry Association data. 28-29. 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 in- be a major player in securities markets. vestor in a mutual fund is similar to that for any corporate shareholder: the investor prof- A mutual fund is a company whose principal its from the assumed expertise of the company line of commerce is investment in securities management in investment decisions. Mutual Ch. 3—The Securities Industry ● 59 funds are significant as institutional investors nized opportunity to market new investment because they usually trade in large volumes. products, has generated renewed interest in individual investors by the securities industry. Funds are classified by investment strategy and fall into three categories: income funds, There has been tremendous growth in the which strive to provide a current income for number of stockholders. NYSE reports that investors; growth funds, which focus on long- 42.36 million Americans own shares of U.S. term appreciation; and income and growth corporations or stock mutual funds, an in- funds, which try to be all things to all people. crease of 10.1 million since 1981. ]2 Of particu- Generally, funds that seek a higher return for lar significance to the securities industry is the investors are more risky. For example, some tremendous growth in the number of first-time funds, such as the Phoenix Fund of Merrill investors, 7.3 million since 1981. This growth Lynch, are composed of securities of failing ma-y be attributable to several factors, includ- companies that are believed to have the po- ing the strength of the stock market during tential to rebound. While the risk level is the early 1980’s, corporate employee stock higher than average, shareholders in this type purchase plans, and most notably, changing of fund have less exposure to risk than if they demographics. were to invest in individual securities, and The “aging” baby-boom generation, now ap- they benefit from high yield. proaching peak investment years, may cause Mutual funds frequently specialize in spe- an increase in the number of people investing. cific types of securities, such as government People are waiting longer to get married for bonds, or in securities from a particular type the first time and have families and therefore of industry. Money market mutual funds in- are likely to be able to invest at a younger age. vest only in money market securities, which While securities firms once targeted their serv- are by definition short term. For this reason, ices towards a small portion of the population, money market mutual funds are considered their market has become more diverse in terms less risky and are more liquid than the tradi- of both age and income. tional mutual funds. Money market funds Securities firms have been expanding their have three basic objectives: to preserve share- product lines and the scope of financial serv- holder capital; to maintain liquidity; and, in ices they provide to meet the demands of the light of these two objectives, to achieve the individual investor. Movement by firms into highest possible current income.” Money mar- other areas, such as insurance and real estate, ket instruments are generally written in high is an attempt to draw clients at an earlier denominations and are only accessible to many stage in their financial lifecycle and to fill all investors because they are able to pool their of their financial needs. investment dollars in the funds. The money market benefits from the funds because a large quantity of capital not otherwise available is The Regulatory Structure of the attracted. Securities Industry Federal regulations enacted in the 1930’s Individual Investors disallowed involvement by depository institu- The typical individual investor in securities tions in securities activities because of con- is an affluent consumer who demands infor- cerns about the effects of risk associated with mation and advice geared toward his require- these transactions on the stability and sound- ments. The sales of mutual funds, a proxy in- ness of banks. Such restrictions separated cap- dicator of the level of individual involvement ital creation from the banking activities of cor- in the securities market, are rebounding after porations, such as the extension of operating a period of decline. This upswing, plus recog- ‘zJon Friedman and Tom Petruno, “Record 42M of Us Are “U.S. General Accounting Office, op. cit., p. 60. 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 restric- supervision with the passage of the Securities tions were intended to assure that depository Exchange Act of 1934. institutions acted in the best interests of depositors. Federal Regulatory Agencies The regulatory structure of the securities in- Several Federal agencies play roles in the dustry recognizes that capital and money mar- activities of the securities industry. The Small kets are essential to the health of all sectors Business Administration licenses and regu- of the national economy. Legislation concern- lates Small Business Investment Corpora- ing the securities industry has focused on tions, a type of venture capital firm. The three areas: providing for disclosure to in- Board of Governors of the Federal Reserve vestors, promoting self-regulation by the in- regulates the extension of credit by brokers, dustry, and facilitating the development of a as mandated in the Securities Exchange Act national market for securities. Federal regu- of 1934, and has a major impact on the in- lation that is focused directly on the commodi- dustry by regulating the activities of banks. ties futures segment of the industry is simi- However, responsibility for regulating the larly designed and seeks to protect markets securities industry is held by SEC, and respon- and individual traders. sibility for the futures industry, by CFTC. Securities and commodities trading is over- SEC was established by the Securities Ex- seen by a two-tier regulatory system: Federal change Act of 1934. Its regulatory activities and State government and industry. Federal are based on the belief that disclosure is the regulation is focused on the oversight of mar- preferable means of assuring the smooth oper- kets and investor protection. State regulation ation of securities markets; it is not invasive of securities, commonly called “blue sky to the operations of industry players, and it laws,” since they were designed to prevent the retains investor choice. SEC also acts to pre- sale of securities with the investment poten- vent price manipulation of securities and reg- tial of the blue sky, preceded Federal regula- ulates the the practices of exchanges, brokers, tion, and the right of States to regulate was and dealers. It acts in conjunction with the in- preserved when the first major legislation con- dustry self-regulatory agencies and oversees cerning the operation of the securities indus- their activities. try, the Securities Act of 1933, was passed. While not a regulatory agency, the Securi- While Federal regulation focuses on dis- ties Investor Protection Corp. (SIPC), a quasi- closure without value judgment on the worth governmental organization, has brought a uni- of the securities, State laws may actually inform investor protection policy to the securi- volve licensing. Registration of an issue may ties industry. SIPC operates as a private non- be refused by a State authority, which would profit membership corporation whose primary prohibit sale in that State.13 State laws differ, function is to provide financial protection for but efforts to develop uniform laws are being the clients of failed securities firms. The cor- led by the North American Securities Admin- poration was mandated by the Securities In- istrators Association. vestor Protection Act of 1970 in response to problems that occurred in the late 1960’s Self-regulation is imposed and enforced by throughout the brokerage industry as stock the exchanges and by industry associations. prices fluctuated widely and volume on the ex- While the industry began formally supervis- changes increased dramatically. ing its own operations with the development of the Buttonwood Agreement, the self-regu- The only function of SIPC is to insure ac- latory system was first recognized by Con- counts. It covers shortages in accounts of up gress and subject to Federal Government to $500,000, including coverage for as much as $100,000 in cash, for each account. Since 13U.S. General Accounting Office, op. cit., p. 22. it began operation in December 1970, it has Ch. 3—The Securities Industry . 61 paid out more than $133 million in claims. ’4 try. To meet this goal, these organizations try SIPC assesses an annual fee on each of the to ensure that the behavior of the industry is 7,000 brokerage houses in the United States, above reproach. They play a major role in over- which are required to be members of the cor- seeing the markets, market systems, and the poration, to maintain the $150 million level it individuals active in the industry. Self-regu- is required by law to keep available to satisfy latory agencies also have an educational role claims. At times, SIPC has acted as trustee in dealing with both members of the industry in cases of brokerage house liquidations and and the public. as such has distributed payments to custom- The two most significant securities indus- ers as accounts were settled. try self-regulatory organizations are NASD The corporation relies on SEC and the se- and NYSE. Their roles may be expected to curities industry’s self-regulating organiza- grow as they continue to carry a great portion tions for notification that a member firm is in of all securities trading. The National Futures danger of collapse. If SIPC determines that Association (NFA) is the self-regulatory orga- the customers of the brokerage house are in nization of the futures industry. need of its protection, it begins what is termed NASD is a self-regulatory agency responsi- a “customer protection proceeding, ” which is ble for regulating the over-the-counter secu- a liquidation procedure. SEC is the only orga- rities market and for promoting high stand- nization that can sue SIPC to force it to begin ards of operation throughout the industry. It liquidation proceedings. also establishes standards of professional com- CFTC is responsible for regulating competence. NASD was empowered through the modity futures trading on organized ex- Maloney Act of 1938 amendments to the Se- changes. It acts to prevent price manipulation, curities Exchange Act of 1934. Its central pur- attempts to corner market dissemination of pose—to promote high standards of commer- false or misleading information, and mishan- cial honor and just and equitable principles of dling of traders’ margin money and equity.15 trade throughout the industry—has become It reviews and approves the instruments even more important to the industry as tech- traded on the futures exchanges-i. e., futures nology is applied. contracts. CFTC oversees the activities of ex- NYSE oversees the operation of the exchanges and other self-regulatory associations. change marketplace and administers rules and Disclosure for the futures industry involves regulations related to the maintenance of or- not only the characteristics of specific con- derly markets and the standards of profession- tracts, but also the level of risk involved in this al competence. ” NYSE is also a major source type of investment. All potential investors in of information concerning the industry as a futures markets are informed that they may whole. experience large losses as well as gains and In 1981 NFA was designated a “registered that it maybe difficult to liquidate a position. futures association” by CFTC, which oversees its activities, with congressional endorsement. Industry Self-Regulatory Agencies It began operating on October 1, 1982. NFA Industry associations and exchanges estab- was formed in recognition of the continuing lish and enforce rules concerning the opera- growth of futures trading to bring a uniform tions of the securities industry, rules that are system of self-regulation to its activities. often more stringent than Federal regulations. NFA works toward four fundamental pur- An implicit objective of self-regulatory agen- poses: strengthening industry self-regulation cies is to maintain the autonomy of the indus- by regulating those segments of the futures 14 Christine Davies, “Brokerage Failures Bring Agency to Life, ” USA Today, Mar. 9, 1983. “U.S. General Accounting Office, op. cit., p. 26. “U.S. General Accounting Office, op. cit., p. 24. 62 ● Effects of Information Technology on Financial Services Systems industry that were previously outside the consolidation activity was spawned by rising scope of self-regulatory organizations; elim- business costs for the industry and the weight inating duplication in self-regulation, thereby of transaction processing, as the volume of controlling expenses; eliminating overlap and trade had increased throughout the 1960’s. conflicts in self-regulation of the industry by Throughout the 1970’s several vertical providing uniform standards; and aiding ef- mergers between brokers and investment fective regulation by removing unnecessary 17 banks occurred-most notably the acquisition regulatory constraints. of Reynolds Securities by broker Dean Wit- ter & Co. and the purchase of White Weld by Trends in Industry Regulation Merrill Lynch. These mergers integrated new Trading volume and the number of types of issue management with the distribution of se- securities instruments have been increasing. curities and may be considered an early move The securities industry is being entered by toward consolidation throughout the financial players from other sectors of the financial services industry. services industry and by outside industries. Recent acquisitions and mergers seen in the It is likely that more demands will be placed securities industry have frequently involved on the oversight functions of the regulatory players from other financial services indus- system. However, while the importance of this tries. The product lines of firms are becoming role is increasing, technology will facilitate this both horizontally and vertically integrated function by improving information flows on with lines previously only offered outside of the operations of the industry. the securities industry. While the oversight role may be streamlined, standards and education will require Movement Toward a National more attention. Changes in industry functions Securities Market and the introduction of new products (facili- The Securities Acts Amendments of 1975 tated by the application of information tech- directed SEC and the securities industry to nology) will require an expansion of the educa- create a national market system for both tional role of the regulatory agencies. The transacting and clearance. Movement in this continuing development of technology-based direction is having a profound effect on the systems necessitates coordination of stand- structure of the securities industry. Ex- ards to ensure that different markets, both do- changes have been linked to a degree not pre- mestically and internationally, can interact. viously seen, through development of technology-based information systems such as the Characteristics of the Securities Industry Intermarket Trading System. Clearing sys- Concentration tems involving the National Securities Clear- ing Corp. have made same-day settlement a The securities industry is heavily concen- possibility. trated. In 1982, the 25 largest firms, out of nearly 550 Securities Industry Association The driving force in developing systems that member firms, controlled nearly 75 percent of make a national market possible is the Securi- the total capital of the industry. The 10 largest ties Industry Automation Corp. (SIAC). The investment banks controlled two-thirds of the great increase in the volume of trading on the profits for that segment. This high level of con- major exchanges in the late 1960’s made it evi- centration results, in part, from the large num- dent that the securities market needs the ca- ber of mergers, reorganizations, and liquida- pability to deal with extensive volume. SIAC tions that occurred during the 1970’s. The was organized both to operate and to develop more efficient and effective ways of dealing l~NatiOn~ FUtUreS Association, A %rtnership Between the with the transaction process. SIAC systems Public and the Industry, Chicago, 1983, p. 11. support order processing, trading, and report- 3333333333. —

Ch. 3—The Securities Industry ● 63 ——— — ———- — —. ——— .— ing functions, as well as clearance and settle- ings and loan associations and savings banks ment for stocks, bonds, options, and financial own ISFA Holding Co., Ltd., which operates futures. The corporation is owned by the New INVEST, a brokerage service, through a York and American Stock Exchanges, wholly owned subsidiary. Thrift institutions, which would not be able to enter the brokerage One of the major impacts of SIAC on the business independently, can offer transaction securities industry is that it makes the devel- and advice investment services to their cus- opment and refinement of technological sys- tomers by subscribing to INVEST. tems a continual process. This should prevent or at least limit the lag between the identifica- Special INVEST centers are placed in tion of a need that could be best addressed branches where they are accessible and evi- with a technology-based system and the appli- dent to customers, yet remain separate and cation of a solution. distinct, by order of SEC and the Federal Home Loan Bank Board, from the other opera- New Entrants to the Securities Industry tions of the thrift. Just as the securities industry is developing and offering new products Entrance by Depository Institutions to retain clients, this is also a basic motiva- An amendment, effective September 9, tion behind INVEST. Thrifts are thus able to 1983, to Regulation Y of the Federal Reserve expand the services they can offer their cus- Board has added securities brokerage and tomers. related margin lending to the list of activities Trades conducted through new alternative permissible for bank holding companies. This brokerage services are executed through the action, which extends from previous approval exchanges, usually by way of a clearing bro- by the Government for the acquisition of retail ker. The securities industry finds itself in the discount brokers by bank holding companies position of servicing competitors, a situation (notably the BankAmerica Corp. acquisition that is quite common throughout the financial of Charles Schwab), may increase the interest service industry. As capabilities and econ- among bank holding companies in entering the omies found in information technology con- securities industry. ]8 tinue to grow, more entrants maybe expected The motivation of banks for providing dis- and the wholesale portion of the securities in- count brokerage services may be seen as either dustry will probably grow. a reaction to market conditions or an attempt to protect market shares. Since many broker- Possible Entrants to the Securities Industry age houses are offering investment opportu- Players throughout the financial service in- nities that serve functions similiar to depos- dustry, including the securities industry, have itory accounts, often with more flexibility and been expanding their product lines to fill as higher rates of return, the consumer’s per- many of their clients’ needs as possible. Rec- ceived need for a bank may be decreased. One ognized economies of scope usually underlie motivation for providing brokerage services this expansion of distribution systems, both may be to prevent the potential luring away for information and for community presence, of other portions of a depositor’s business. and in terms of complementing current prod- While acquisition of a discount broker pro- uct lines. Providers often feel they can retain vides one method of expansion into securities their customer base by entering other lines of for depository institutions, economies in op- financial services. erations made possible by the application in- The entrance of other financial service play- formation technology have made other means ers into the securities industry is already oc- of market entrance possible. Twenty-five sav- curring. Several insurance companies have —-———— purchased regional brokers, and some depos- ‘“Federal Reserve Press Release, Aug. 11, 1983. itories have acquired discount brokers. Shear- 64 ● Effects of Information Technology on Financial Services Systems

son/American Express and Prudential Bache creased opportunities both for investors and are both results of mergers between players capital seekers. Foreign individuals and insti- in different sections of the financial services tutions made purchases and sales of $79.8 bil- industry. Consolidation within the financial lion of domestic corporate stock in 1982, and service industry is likely to continue. transactions in all securities resulted in a net inflow of $14.3 billion in capital to the United Others, not traditionally thought of as pro- States. ’g viders of financial services, have also entered the securities industry. The most widely cited Communications technologies are so ad- example is Sears’ entrance through the acqui- vanced that a market anywhere in the world sition of Dean Witter. can be selected for trading. This could have significant impacts on the stability of the econ- Other players who may recognize significant omies of nations. For example, the halting of economies of scope in entering the securities trading on an exchange in one country could industry are firms in the communications and simply result in new trade in another nation. computer industries. These firms might be in It is not clear what impact large differences an especially strong position to enter the in the valuation of a security by different coun- wholesale side for the securities industry. Bar- tries could have on capital markets. Interna- riers to entry, such as exchange membership, tional issues in the development of capital may be overcome by technology. Computer markets are being considered by various or- and communications technologies allow for the ganizations. One such organization is the creation of information and transacting sys- Federation Internationale des Bourses de Va- tems not dependent on the current industry leurs, an association of 30 stock exchanges in structure. 20 countries. The Securities Industry and the The Effects of Information Technology on International Market the Structure of the Securities Industry The securities industry has its roots in the The application of information technology need for the American economy to interact in in the securities industry affects its structure the international capital markets. However, by facilitating the flow of information to such prior to the completion of the transatlantic an extent that it removes geographic con- cable in 1866, a real international market could straints on market participants and allows for not exist because it was impossible to convey development of international capital markets. information in any meaningful time frame. In- It may also place additional barriers to entry formation technology has made it possible for to the securities industry. Without adequate the American securities industry to interact access to telecommunication services, for ex- in the international market, while economic ample, a securities firm cannot function. forces have made it essential. Information technology has allowed a global capital market to develop, resulting in in- 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 structures of organizations and corporations. industry is in the development of capital. The While it would be possible for organizations institutions and players of the securities in- in search of financing and potential investors dustry facilitate the development of capital to interact directly, the market structure that Ch. 3—The Securities industry ● 65 has developed provides needed services more Information Dissemination efficiently. Since most corporations and orga- Information technology affects information nizations do not approach capital markets fre- dissemination by the securities industry in quently, financing with the aid of the securi- several ways. Information is now less costly ties industry is usually more cost effective to gather, store, and access than it was in than direct attempts because of the expertise largely manual systems. Therefore, not only securities institutions have in analyzing secu- is it likely that the quantity and quality of rities markets and in locating potential inves- available information will increase, but also tors, and because of the ability of the securi- that more information will be sought. Inves- ties industry to accept risk. tors and other parties interacting with the The use of information and communication securities industry may be expected to make technologies by the industry is nearly univer- better and more satisfying decisions because sal, and adjustments may be expected in op- of the increased availability of information. erations as the value of technology is realized. Technology has already had a major impact However, while information technology may on information flows throughout the securities change the way in which the securities indus- industry, and it appears that the resultant try performs its activities, and may even fa- changes may have major impacts on the oper- cilitate attempts by investors to act on their ation and, in time, the structure of the securi- own behalf, it is expected that the basic func- ties industry. Information technology en- tions of the securities industry will remain an hances the reporting of securities trades. The essential part of the development of capital. Consolidated Quotation System, which went In this section, an overview of the functions online in 1978, collects and disseminates quo- of the industry and the emerging effect of the tation information from exchanges across the application of information technology on these Nation and calculates and appends the na- roles will be described. The significance of the tional Best Bid and Offer to the quotation in- advisory, risk-accepting, and marketing func- 20 formation. Communication technology tions of the securities industry to the process makes it possible to transmit this information of gathering capital will be outlined, and the in real time to system subscribers nationwide. effect of information technology on this proc- A similar system is in place on the NYSE for ess will be summarized. Specific approaches debt issues. The Automated Bond System pro- to capital formation are discussed in appen- vides current quotation and trade information dix 3B. for more than 80 percent of the exchange-listed bonds.21 This system has improved the quality The Securities Industry as an Advisor of information available on bond trading. In its advisory role, the securities industry Information technology may increase the provides information and offers guidance to independent role investors assume as infor- its clients. It is able to advise organizations mation monitors, particularly the individual seeking capital on the type of financing most investors. Although massive quantities of fi- desirable, whether through private or public nancial information are currently available means, and, perhaps most significantly, what through a variety of media, such as news- the timing for entering the capital market papers, radio, and television, and through pub- should be. These decisions are based on the ob- licly available consolidated tapes, individual jectives of the firm. Factors to be considered investors may expect to have even more in- include the risk and return associated with various issuing organizations and instru- ‘“Securities Industry Automation Corp., Annual Report, New ments. Timing of buy and sell decisions is also York,21 1982. part of this advice function. 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 the market to correct itself in unusual situa- better” philosophy is usually applied to infor- tions may be destroyed. In the long run, this mation, the result can be confusing, deceptive, may be a severe disadvantage for the investor, and frustrating to users. Moreover, informa- particularly the small investor, who may find tion gathered by intermediaries within the himself bearing both transaction and lost op- securities industry may require translation to portunity costs because of action taken be a form that can be used by clients. cause of basically meaningless market fluctuations. The adoption of home information systems, particularly interactive cable and personal Counseling computer systems, may change the way in which this information is gathered and used. The nature of counseling may be changed E. F. Hutton and Dean Witter provide cus- by the amount and type of information and tomers with securities research that can be ac- supporting analytical tools available. Research cessed via home computers.22 It is not clear is expected to become pivotal rather than pas- how investors will use this information. The sive in the investment advisory function.23 continual availability of new information may Analysis and recommendations presented by result in more frequent trading; however, securities industry intermediaries to clients home systems may just be, in the aggregate, concerning potential investments may be more a new medium. Investors may evaluate no detailed and, to complement this process, anal- more information than they did in the past. ysis of the financial needs of the individual may also improve. Computer and communication technologies have increased the speed with which informa- Increased availability of information tech- tion is available to the mass market. With the nology has changed the nature of counseling systems now available, investors may become by placing more sophisticated analytical tools less dependent on a broker or dealer for up- in the hands of both advisors and investors dated information. An example of this type of who may not have had access to these tools system is Pocket Quote, produced by Telemet in the past. This change may affect the way America, Inc. The basis of Pocket Quote is an in which investment decisions are made and 1 l-ounce programmable receiver, which looks the quality of these decisions.24 like a calculator and can be used to monitor The reliance on information technology for the New York and American Stock Exchanges analysis of personal investment needs, objec- as well as option exchanges. Information, in- tives, and choices may indicate an initial move cluding price and trade volume, on up to 20 in the industry to reemphasize individual hu- securities specified by the user is transmitted, man judgment and perhaps a reemphasis of subject to a 15-minute delay. The data are the client/broker relationship. It is not clear broadcast in a scrambled form on FM side what the impact of this change will be; how- bands, using a digital signal. Not only is the ever, a decline in personalized service, based information readily available to the investor, on the evaluation by the broker of the client’s but the system can be programed to page the financial objectives, may occur. user automatically at any time there is “news” about any investment instrument in which he/ While counseling may be displaced in some she is interested. areas within the securities industry, its importance as a separate and unique service of the The potential for investors to act immedi- industry has been highlighted in some cases. ately on information continually updated and transmitted via such systems may affect the “Thomas Moore, “Ball Takes Bache and Runs With It, ” For- stability of securities markets. The ability of tune, Jan. 24, 1983, pp. 97-98. 24 Lee B. Spencer, “The Electric Library, ” remarks to the “Tim Barrington, “Stock Trading by Computer Enters American Bar Association, Federal Regulation of Securities Homes, ” The Wall Street Journal, Oct. 6, 1983. Committee, Nov. 19, 1982. Ch. 3—The Securities Industry ● 67

Advice, particularly counseling, has been un- agreement with the investment bank or other bundled from the total package of services of- underwriter is closed. fered in a new service supplied by Merrill In most cases, the underwriter also assumes Lynch, called “Pathfinder.” For a set fee, the risk by assuring that the issue will be sold, and client receives what amounts to a financial he accepts the risk that market fluctuations checkup. The evaluation provides guidance to or initial pricing mistakes may influence the the investor in a somewhat objective frame- success of the issue. Offerings underwritten work. The success of this product may be an on a “best efforts” basis, where the under- indication of the future role of advice within writer does not bear the risk of an unsuccessful the securities industry. offering, permit those issuers in a startup or developmental stage, whose issues may be Acceptance of Risk by the considered to be more risky, to have access to Securities Industry the public capital markets. The securities industry accepts risk that Underwriters earn money by buying secu- might otherwise be experienced by individuals rities at a lower price than they resell them for or organizations seeking investment. It does to investors. The difference in price, or spread, this in two ways: through underwriting and is a major consideration in the selection of an by the extension of credit through margin. investment bank by a firm. A prospective cli- Underwriting refers to the assumption of risk ent for an underwriter may choose an invest- by an investment bank or other third party ment bank through two methods: competitive at the time of a public offering. The extension bidding or negotiation. Both systems have ad- of credit by brokerage houses is referred to as vantages, and experts disagree on which pro- margin. vides the best price for the capital seeker. The advantage of the negotiated system is that the Underwriting New Issues issuing firm and the underwriter work together to make decisions about the pricing and Underwriting involves the purchase of se- timing of the issue. curities from the issuing company and the subsequent resale of the instruments to the The company using a competitive bidding public. This service, which is usually per- system invites offers from investment bank- formed by investment bankers, is essential to ers. This process is required for many public firms in need of capital that are not in the busi- utilities and most municipal offerings. But ness of marketing securities. It allows them while some experts believe it results in higher to receive the funds they need while transfer- net proceeds for the issuing organization (be- ring the marketing function to an expert who cause of the forces of competition), it has dis- may be expected to be more effective in reach- advantages. Much of the benefit of the advi- ing prospective investors. sory function that the issuing company would enjoy in a negotiated situation is lost. A higher The underwriter accepts some of the risk price may be received, but this largely depends associated with a public offering. He prevents on the health of the market at the time of the lag time by assuring that the issuing corpora- offering. In a depressed market, investment tion has access to the funds it is attempting bankers are less likely to compete for a pub- to raise when needed. By buying the public of- lic offering, and therefore the price received fering from the firm in search of financing, the may be lower. underwriter makes it easier for the management of the firm to plan the use of the funds It is also typical for investment banks to generated. The issuing organization may be minimize their risk by forming syndicates. less concerned about the flow of cash the sale This spreads risk and benefit because of their produces because it is usually guaranteed a pooled sales force and allows a number of fixed price and can use those funds when the underwriting firms to participate together in 68 • Effects of Information Technology on Financial Services Systems

large public offerings. Changes in industry usually by a single underwriter who has not structure, particularly consolidation among in- lined up buyers in advance. While information vestment banks, may affect this operation. technology may allow underwriters to locate buyers quickly, more risk is involved in this The presence of an underwriter provides a method than with a traditional syndicate. valuable service for the prospective investor. Investment bankers are expected to examine The emphasis on price competition maybe the corporate records with due diligence and a disadvantage for corporations entering cap- are liable to defrauded investors if they fail ital markets because the benefits of advice on their due-diligence obligations and miss any pricing and timing of an issue is sacrificed. misstatement or omission of material fact by While sophisticated analytical tools, which in- the issuer in the prospectus. Therefore, not formation technology may enhance, may as- only does an underwriter assure that the issue sist corporations seeking financing in evalu- will be sold in a “firm commitment” offering, ating various possibilities, this type of but it also provides an oversight function of analysis may not be tailored to the needs and the issuer on behalf of prospective investors. objectives of corporations to the same extent as the information and counseling services pro- The underwriter also frequently accepts risk vided by an underwriter. through providing a secondary market for securities by maintaining a position in the stock. Margin This activity, called “making a market, ” is similar to the role played by securities special- “Margin” refers to the amount of money ists, which is discussed in a later section. The paid by an investor to acquire a security underwriter quotes “bid” and “asked” prices through credit instead of cash. At the end of for the security based on market supply and 1982, the securities industry held nearly $13 demand and intervenes as a buyer or seller, billion ($12.98 million) in margin debt secured when necessary. The original offering of a debt by nearly $39 billion ($38.88 million) worth of or equity issue may be expected to be more collateral. 26 successful when the potential investors know The Securities Exchange Act of 1934 em- that the existence of a secondary market is powers the Federal Reserve Board to regulate guaranteed. this extension of credit. Brokers are permitted Information technology may affect the to extend regulated credit on stocks and con- underwriting function by decreasing the time vertible bonds traded on registered exchanges between the initial development of a securities as well as some select over-the-counter stocks. issue and its sale, lessening the need of capi- Initial margin requirements, set by the Fed- tal seekers to be protected against this lag. eral Reserve Board, currently call for a deposit Pricing decisions and market evaluations may equal to 50 percent of the total value for both be more certain if the time frame in which the stocks and convertible bonds. Stock ex- security is offered is lessened. changes and other self-regulatory agencies of the industry have individual requirements for Price competition has been increasing in the the opening and maintenance of margin ac- area of underwriting. Since the use of syndi- counts. For example, the NYSE requires an cates is decreasing, there is a greater need for initial deposit of at least $2,000 and the main- individual firms to have substantial capital if tenance of equity of the customer at 25 per- they are to continue functioning as underwrit- cent of the value of securities carried. ers.25 Information technology may be a contributing factor in the advent of bought deals The advent of home equity access accounts, that involve the purchase of an entire issue, 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 ● 69 ——

debt and change the nature of collateral. While but rather, that the clients recognize an un- some accounts restrict this use of credit drawn filled need and seek a way to meet it. from home equity for the purchase of securi- At one time the operations of the securities ties, in many situations this is acceptable. industry were centered on what was possible, Margin takes on a different meaning in op- given the regulatory framework and its busi- tion and futures contract trading. In futures ness concerns. Now, a new awareness of the trading, margin refers to the amount of money importance of basic marketing to retain and or collateral which a client is required to de- develop business is evident, resulting in re- posit with his broker to insure the broker search to support activities in product devel- against losses on open futures contracts. Op- opment and promotion and the targeting of tion writers must, similarly, deposit cash or specific segments of the population for special- securities with their brokers so that the bro- ized products. Given the competition the in- kers are covered in case of an assignment. dustry faces in its traditional and new product lines, especially from new entrants into the Margin plays an important role in specula- financial service industry, the marketing function in securities markets. A frequently used tion may be expected to continue to grow in strategy in the buying and selling of securi- importance for the foreseeable future. ties is the “short” position. In this case, an investor sells securities he does not own, but Information technology may affect those has borrowed, to make delivery in the hopes marketing functions of the securities industry that the price will decline before it is neces- that comprise product development, sales or sary for him to return the security. This activ- brokerage, and pricing. ity can be extremely risky. However, it accounts for a significant amount of market Product Development activity. In 1982, 1.5 billion shares, in round In recent years, the regulatory restraints on lots, were sold short, an amount that was 9.3 27 the financial service industry have decreased, percent of all reported securities sales. and the securities industry has found competi- Information technology may decrease the tors in what at one time were strictly separate significance of margin as a convenience for businesses. These developments have occurred brokerage customers because it eases access when the securities industry was observing a to assets and facilitates funds transfers. Cus- continual demographic and psychographic tomers may be able to finance securities pur- change among its potential retail clients, a chases using other assets whose liquidity has growing institutional market, and more com- increased as a result of increased use of infor- plex financial needs among organizations seek- mation technology. It is not clear what the net ing capital. effect will be; however, the use of electronic Shifts in the area of product development funds transfers may largely eliminate the use are seen mainly in the way products are pack- of margin by brokerage houses to provide aged, specifically in the variety of mutual float. funds and money market mutual funds that have been developed. It is not yet clear how Marketing by the Securities Industry patent and copyright laws will affect the de- For purposes of discussing the securities in- velopment of information technology-based fi- dustry, “marketing” is defined as those activ- nancial services products. If financial service ities designed to identify and meet the needs products become patentable, some securities industry experts believe that competition of clients; i.e., both seekers of capital and in- 28 vestors. It is assumed that these clients do not could be stifled. Many financial service prod- demand a specific product or type of service, ucts are similar in both character and features, “’’Merrill Lynch Wins Cash Account Row With Dean Wit- “New York Stock Exchange 1983 Fact Book, op. cit., p. 48. ter, ” 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 ties industry may be expected to make efforts of patent infringement. Differentiating prod- to distinguish similar products legally, patent- ucts by attribute has not been of great interest ing may also increase consumer confusion to the financial service industry, which has about product features and attributes. competed by geographic market and comparative return and cost. Brokerage Information technology has created interest Brokerage involves bringing together buy- in patenting financial service products because ers and sellers, facilitating trades through the communications and computer technologies maintenance of a marketplace, and assuring have broadened markets. Products that at one that the trade is complete. The significance of time may have been offered locally now com- this activity as part of the operations of the pete nationally. Therefore, protection of prod- securities industry cannot be overestimated. uct may become as necessary as the position- Traditionally, all of the costs of supporting an ing of the product. investment bank or brokerage house were re- covered through this portion of the business. The patentability of financial products is The services provided to clients, such as re- now being tested in cases involving the cen- search support and advice, were bundled into tral-asset account. In response to perceived the commission rate for purchasers of securi- consumer demand, most major firms in the ties and into the spread on new issues for insecurities industry, including Dean Witter, vestment banks. Paine Webber, Shearson/American Express, and Prudential Bache, have introduced these The heart of brokerage with retail clients has accounts, which are combination margin ac- been personal selling. The relationship be- counts and investment funds. Merrill Lynch tween the investor and the individual broker led the development of asset management has been fairly constant, and typically, the ac- accounts with its introduction of the cash counts a registered representative develops management account in 1977, for which it re- while with a particular brokerage house move ceived patents in August 1982 and March with him if he/she switches firms. Firms within 1983, and, with over 1 million accounts, is the the industry have expended great effort in at- market leader. Following the receipt of its pat- tempts to retain clients. The development of ent, Merrill Lynch notified competitors that new products unique to particular houses may it was imposing an annual licensing fee of $10 encourage a loyalty to the company rather on all asset management accounts. Initially, than to the broker. It is not yet clear how this this levy was not taken seriously throughout might change the character of the industry. the industry; however, without admitting any Most technology-encouraged competition is patent infringement, Dean Witter resolved its occurring within the selling function of retail dispute with Merrill Lynch about the accounts and institutional brokerage. The end of stand- in late December 1983 for $1 million. The firms ardized commissions on the sale of securities agreed to “grant each other a nonexclusive, (1975) has encouraged the entrance of dis- royalty-free license to use any improvements counters into this market. Discount brokers or changes either might make relating to cen- 29 complete trades for investors at prices that are tral-asset accounts. ” generally lower than the commission charged If financial service accounts are routinely by full-service brokers. Usually, the service patented, investors may find that their choices provided by discounters is limited; e.g., these are limited, since the patent may be a barrier firms usually do not support extensive re- to entry into some product lines for some serv- search and advice operations. However, they ice providers. Since players within the securi- do fill the needs of a portion of the market. About 15 percent of trading by individual in- 29Ibid. vestors is handled by discounters. Ch. 3—The Securities Industry ● 71

Access to information technology for indi- changes. One such system, the Intermarket viduals will facilitate direct selling of securi- Trading System (ITS), may be seen as being ties to investors without the interaction of a indicative of a trend toward a national mar- broker. This type of system is particularly ket for securities trading. adaptable for discount brokers whose service ITS allows brokers, specialists, and market is basically order-taking. C. D. Anderson & makers to interact with their counterparts at Go., a small discount broker, developed the other markets. The system, maintained by first home brokerage system, and other bro- SIAC, currently involves eight stock ex- kerage houses are expected to enter this mar- 30 changes: New York, American, Boston, Phila- ket. C. D. Anderson’s system allows clients, delphia, Cincinnati, Midwest, Pacific, and, to who pay a hook-up charge and a usage charge, a limited extent, NASDAQ. to enter buy and sell orders at their convenience, without dealing with a broker. ITS provides a mechanism through which the most favorable exchange setting can be Transactions chosen for a transaction. * At NYSE, the best price from any member of ITS, as well as the Congress mandated the development of a NYSE floor price, is displayed. If it is advis- computerized national stock market system able for a trader to deal on an exchange other in 1975, believing that by linking all market than the one at which he is operating, he can centers, such a market would expose securi- enter his order by contacting his counterpart ties to a greater number of buyers and sellers, there. At the end of 1982, 1,039 issues were and an investor would have the chance to ob- eligible for trading on ITS. NYSE reports that tain the best price available. This system was this represents most of the stocks traded on also expected to provide competition to more than one exchange. NYSE, which dominated the market with 80 to 90 percent of the trading volume. The Designated Order Turnaround (DOT) system was introduced in 1973 to route small The Cincinnati Stock Exchange was ex- orders (599 shares or less). It reports elec- pected by many industry experts to become tronically between NYSE and member firms. the basis of an automated national stock ex- DOT bypasses floor brokers by routing orders change. The exchange was supported by Mer- directly to the appropriate trading post on the rill Lynch, the largest firm within the securi- floor of the exchange and, following execution, ties industry. In July 1983 Merrill Lynch back to the member firm on the same elec- withdrew a large portion of its business from tronic circuit. Over 80 percent of the 5.7 mil- the Cincinnati Stock Exchange and returned lion market orders processed through DOT in it to the floor of NYSE, noting that not only 1982 were executed and reported back to the had the Cincinnati Stock Exchange failed to 31 member firm within 2 minutes. This system gain the volume anticipated, but that NYSE minimizes the cost to member firms of han- had improved. dling small transactions while giving small in- While NYSE is still largely based on a sys- vestors the benefit of timely execution of their tem of auction pricing and securities special- trades. DOT may also provide a better price ists, the adoption of systems made feasible by than would normally be received by a small the application of information technology has investor. A trade made through DOT is allowed it largely to eliminate problems asso- matched by computer for price with the most ciated with high volume. In addition, commu- recent trade of that issue. The investor bene- nications systems have been developed that fits because the price he receives may have allow users of NYSE to enjoy many of the benefits of a national system by providing information on the activities of regional ex- *For Purpows of this discussion, “transacting” is defined as the physical execution of trades. ‘°Carrington, op. cit. “New York Stock Exchange 1983 Fact Book, op. cit.

●

35-505 0 - 84 - 6 : QL 3 72 . Effects of Information Technology on Financial Services Systems

resulted from price negotiation on a much Given that the primary responsibility of se- larger order.32 curities exchanges is to maintain an orderly market, technology, the great facilitator of Another technology-dependent system that their operations, could also be a major under- facilitates transacting is the Opening Auto- mining force for the exchanges. It is basically mated Report Service (OARS). OARS makes meaningless to stop trading for a security on efficient and accurate processing of market an exchange if the end result is simply that orders, that are received at NYSE prior to the trading is moved off of the exchange and con- start of daily trading, possible without caus- ducted without the prudent management of ing unnecessary delays in the opening of trad- the specialist. It may be essential for ex- ing, and transmits computer-generated reports changes to continue trading a given security to the originating member firm.33 This system in all but the most unusual situations. is especially valuable to specialists on days with high trading volume, which have recently Clearance and Settlement of Securities been occurring with great regularity. Clearance and settlement activities consum- Future developments in transacting en- mate trades through the exchange of securi- hanced by information technology may include 35 ties and funds. As with any marketplace, an the bypassing of intermediaries in the proc- action recognizable to all parties involved is ess of selling. Some experts believe that the necessary for finalizing a transaction. Given adoption of home information systems may the great number of participants in the secu- make it more common for investors to com- rities industry, it is essential that transactions plete transactions between themselves pri- be closed as efficiently as possible in a man- vately or to gain direct access to exchange ner that is acceptable to all parties involved. floors. While it does not appear that the possibility of off-market trading is having a ma- The increasing volume of trade and the con- jor impact on the individual investor at this tinuing development of new securities prod- time, institutional investors have at times ucts has made it necessary to refine settlement found it advantageous to trade off-market. and clearance. Since ownership is merely contractual until the process is finalized, delays About 500 brokerage houses, pension funds, in settlement and clearance could have a se- insurance companies, and other institutional vere effect on the operation of securities mar- investors are linked through AutEx Systems, kets. An industrywide effort is under way to a nationwide computer network. The potential move toward a national settlement and clear- of this system for trading was demonstrated ance procedure through the adoption of stand- by its use in creating a market in a stock for ardized proofs of ownership that are not paper- which trading had been closed by NYSE. Jef- based, such as book entry, and to facilitate ef- feries & Co. is a discount broker specializing fective, marketwide clearance through the use in institutional trading. It is not a member of of automated systems that assist in the clos- any major exchange and therefore is able to ing of positions. make a market in an exchange-listed stock without going through the exchange. Follow- Clearance and settlement are recognized as ing a request by a client, Jefferies announced an important portion of the national market over the AutEx System that it was making system. The formation in 1977 of the National a market in the closed stock. The company Securities Clearing Corp. (NSCC), for which traded a total of about 8 million shares of the SIAC (Securities Industry Automation Corp.) stock off-market.34 is facilities manager, encouraged movement toward a national clearing system. NSCC com- 3’Desmond Smith, “The Wiring of Wall Street, ” The New York Times Magazine, Oct. 23, 1983, p. 109. bined the clearing corporations of NYSE, the 33New York Stock Exchange, Annual Report 1982, New York, p. 33. ‘sNational Securities Clearing Corp., Annual Report 1980, “Smith, op. cit., p. 73. New York. v Ch. 3—The Securities Industry ● 73

American Stock Exchange, and NASD. It has provide a framework for price adjustments for provided more efficient clearing at lower costs securities. Price in its most pure form is a func- per trade for listed and over-the-counter tion of supply and demand. For securities, this trading than was previously possible. SIAC is generally defined to mean the net present facility management for NSCC services in- value of anticipated cash flow, in terms of tegrates several major processes and entities what is received in interest or dividends and in the settlement process (see fig. 5). resale. Initial pricing decisions on new issues are particularly sensitive for the securities in- One pivotal change in the settlement proc- dustry since the risk associated with errors ess was the development of Continuous Net usually falls totally on the underwriter. If the Settlement (CNS). CNS represented a change price is not in line with value as perceived by in accounting approach to the provision of con- the market, the issue will not be bought. tinuous net positions against the clearing system rather than a daily balance order ac- Pricing for securities in secondary markets counting.” In addition to improving clearing may be done on a historic basis or by auction. operations, savings recognized through the ap- Automated trading systems are based on a plication of CNS have included manpower and historic pricing mechanism; that is, the price same-day delivery of securities. An important of an instrument is determined by its past link in this system is the Regional Interface behavior. Prices in the auction system are Operation, which allows member organiza- determined by market demand. Proponents of tions to trade on any exchange and bring set- this system believe that the auction gives a tlement to the clearing facility of their choice. truer evaluation of the worth of the issue and is therefore beneficial in the aggregate to both The Options Clearing Corp. (OCC), which is sellers and buyers. owned by the options exchanges, is the clearing entity for options trading. It supports the The operation of the secondary market for clearing members and participant exchanges securities provides a method for correcting by acting as the issuer of all cleared and prices. Securities specialists perform a pricing settled options, guaranteeing option contract function on exchange floors in fulfilling their performance and fungibility, and effectively function of maintaining an orderly market. performing trade clearance, settlement and The specialist, an independent businessperson, associated clearing functions, and other secu- performs this function as an auctioneer, buyer, rities industry services.37 The primary objec- and seller of securities. He makes a value judg- tive of OCC is to provide these services in the ment about the opening price of a security at most cost-effective manner. the beginning of each day when opening trading. Although no trading may occur through- Information technology has been essential out the day, this establishes a price of record. in the refinement of the clearing and settlement process. It will affect it further through The specialist facilitates trades by inter- some changes that will be felt in the market ested brokers on the floor and stands in as a as a whole. If substantial trading is conducted buyer or seller at times when demand and off-market, general access to the automated supply on the floor do not mesh. By standing settlement system may be demanded. in as a buyer or seller, the specialist maintains an orderly market by assuring that price Pricing changes occur in small increments. This allows investors to assess the market situation of a Pricing occurs at two points in the securi- security in a rational fashion. ties industry: investment bankers assist in the initial pricing of new issues, and exchanges NYSE now offers a technology-based sys- ——— “Securities Industry Automation Corp., A Decade of Pro- tem through which investors can more easily gress, New York, 1982, p. 8. interact with the market when they want to ‘“The Options Clearing Corp., Annual Report 19/?1, Chicago. sell a security at a set price. The limit order Figure 5.— Overview of SIAC Facility Management for NSCC Services

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SOURCE. Securities Industry Automation Corp Ch. 3—The Securities Industry w 75 —————— — ——. —-—— —.— system electronically files orders to buy or sell seeking financing, the number of potential in- when a specific price is reached. These orders vestors, and the level of trading demanded are delivered to the appropriate trading post have all increased to levels that could not be or member firm on the floor. Orders can be anticipated when the securities industry was limited to a single day or to their cancellation. developing. The one element which has not increased is the number of hours in a day, and In the context of the securities industry, technology makes it possible to overcome that pricing has referred solely to the investment handicap in processing the level of activity instruments of corporations and organiza- demanded by the market. tions. Pricing can also be expanded to the actual services of the industry, whose basic func- Time and distance are no longer obstacles tions are being unbundled. Although within to communications for the securities industry. the securities industry pricing is most clearly Because of this, securities markets may be- evident in the selling and advising function, come less location-dependent and, as a result, it is a factor throughout the entire financial less physically structured. It will be necessary service industry. The securities industry may for the industry to make efforts to assure that have an advantage relative to other financial the basic purpose of the markets is retained. service providers in this area because of the Information technology will generate a expertise it has in analyzing markets and in faster reaction by the securities industry to pricing issues. changes in market conditions and consumer demands because communications and com- Technology and the Functions puter capabilities may lessen consumer re- of the Securities Industry sponse time. The market can be expected to operate at a more rapid pace, and while it may Technology is changing not the functions of be possible to monitor change more precisely, the securities industry, but rather how they this market will require quick and well-devel- are performed. The number of corporations oped decisionmaking.

The Effects of Information Technology on Securities Instruments

Securities instruments are designed to satis- they evolve in a technology-intensive environ- fy both the goals of investors and the need of ment. As information technology changes the corporations and organizations to gather cap- way in which the securities industry operates, ital to finance industrial research and devel- the relative importance of various investment opment and resulting expansion or diversifica- instruments may be affected by information tion. Securities instruments are of interest in technology. discussions of the effect of information technology on the financial service industry for Third, interest in instruments that are now several reasons. First, the direct impact of on the market may be predictive of which in- technology on the securities industry, from the vestment products may best meet future de- point of view of the consumer, may be most mands of consumers in terms of liquidity, level strongly felt in the way in which the character- of risk, and return. This type of activity has istics of investment instruments are changed. already been seen in the financial service mar- Second, the intrinsic characteristics of secu- ket in the development of money market mu- rities instruments may affect the way in which tual funds, which were patterned after the idea 76 . Effects of Information Technology on Financial Services Systems of mutual funds and met the consumer de- The liquidity of an investment instrument mand for more liquidity. is determined both by the contractual term of the instrument and the speed with which the The development and trading of securities investor can trade or redeem the instrument. instruments is largely dependent on the appli- New communications technologies, notably in- cation of information technology. Such tech- teractive cable and the adoption of personal nology has also had a major impact on the computers with networking capabilities, have calculation and payment of return and the been applied to allow investors greater access recording of ownership. The rate of growth to securities markets. For example, systems seen in options and many types of futures con- available to individual investors provide up- tracts would not have been possible without dated information continually on price and sig- communications and computer technologies. nificant activities involving securities in which As securities markets become more technolo- the investor is interested. Easier access to this gy-based, it must be expected that investment information changes the way investments are instruments will also. analyzed by making it easier for the investor However, it is unlikely that technology will to make decisions on his portfolio in a short be the sole cause of the development of any time frame. new securities product, although it may Securities products are being packaged, change the characteristics of some investment often with products from other financial serv- products or expand their application to such ice industries, to fill a wider range of investors’ an extent that they are different in function financial needs. This trend is likely to continue and operations. As a result of these changes, as the number of investment options increases both investors and their advisors will have to and the demands of users become increasingly examine their methods of evaluating potential more complex. Much of the new product devel- investments. The characteristics of invest- opment that will be seen in securities markets ment instruments may be expected to change may result from the increasing role of specu- in four ways because of the application of in- lative markets. The ability of investors to use formation technology: liquidity of instru- speculative markets is increased by the appli- ments, the packaging of securities products, cation of information technology. the way in which potential investments are analyzed, and the importance of speculative markets.

Appendix 3A: Securities Instruments

This appendix describes, the characteristics of through this structure. There can be as many debt and equity instruments as well as options and unique capital structures as there are corporations. future contracts. The relationship of information The financing plan chosen reflects the operating technology to these products and the future effects and growth objectives of the organization. of this technology are outlined. 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 Corporate Capital Structure: issuing organization. The return offered and risk Debt and Equity Issues involved for the investor also differs substantially. When debt is issued through bonds, the investor The capital structure of a firm is determined by becomes a creditor to the organization; the firm the mix of securities it issues. Capital is developed assumes a noncontingent obligation to pay the in- through internal sources—i.e., retained earnings— vestor a definite sum of money. Equity issues and through the issuance of debt and equity. A grant ownership in the corporation in return for corporation tries to maximize its market value investment. Such shares of stock represent owner- Ch. 3—The Securities Industry ● 77 ship rights proportional to the value of the share against the property. From the investor’s point of of the firm purchased at the time of investment. view, the value of the mortgage lies more in the Financing through debt is developed both potential resale value of the pledged property in through money markets and capital markets. the case of corporate failure than in the exclusivity Money markets are basically wholesale markets involved. whose major function is liquidity management. Debentures are guaranteed by the general credit They are centered on short-term instruments of the corporation. They have become the most through which organizations can manage such popular form of bond issue across the economy and operating factors as cash flow. Capital markets are particularly useful for industries in which are centered on long-term securities, including many assets may be intangible, such as in publish- both debt issues and stock, and represent the ing, or have a limited lifecycle, as is the case in development of financing for long-term projects many high-technology industries. Most issues of and goals for the organization, such as equip- debentures include a negative pledge clause that ment purchases, research and development, and provides that the firm will issue no new debt hav- expansion. ing priority over the bonds covered by the agreement. This helps ensure that the risk to the in- Long-Term Debt—Corporate Bonds vestor does not increase over the life of the bond. Debentures are usually subordinate to bank loans When money is borrowed on a long-term basis, and short-term debts. the contract representing this debt takes the form of a bond. A corporate bond is a fixed, noncon- BEARER BONDS AND tingent, long-term obligation to pay a definite sum FULLY REGISTERED BONDS of money and interest on that amount. The for- Registration of bonds affects the extent to which tunes of the corporation affect the resale poten- the investor is protected in case of loss or theft, tial of the security but cause the bondholder nei- the way in which interest is paid, and the ease with ther benefit nor loss in terms of return, assuming which ownership can be traced and transferred. that the corporation does not default on the issue. The ownership of a fully registered bond is re- The market value of the instrument is the pres- corded in the register of the issuing organization ent value of the payments stream to the investor, or agent. Company records comprise proof of own- using market interest rates. The bondholder is a ership, and interest is paid directly to the holder creditor to the corporation and as such has a claim of record. If the bond is traded, the issuer or agent on the assets prior to any by the owners. Corporate must be notified so that ownership rights may be bonds have a fixed return, known as a coupon rate, transferred. and a specific maturity. The financial benefit the For a bearer bond, the certificate issued at the investor realizes from the bond depends on mar- time the debt instrument is developed is the only ket conditions at purchase and investment oppor- proof of ownership. Ownership rights are enjoyed tunities at the time of maturity. A bond issue may by whoever has possession of that certificate at be distinguished in several ways, most notably: the moment. Many investors find that the ease how the contract is guaranteed in case of bank- with which the bonds may be transferred and the ruptcy, call provisions, registration, the way in lack of traceability outweighs the risk of losing the which interest is paid, and the way in which the paper. This type of bond is an extremely flexible, bond issue is retired. cashlike instrument. SECURED AND UNSECURED BONDS Whether a debt instrument is a registered bond or a bearer bond affects its value and appropriate- Bonds may be classified as secured, or mort- ness as an investment for particular investors. gage, bonds or unsecured bonds, called deben- Since July 1, 1983, the Federal Government has tures. Mortgage bonds are backed by specific cor- required all new bonds to be registered to make porate assets and were historically most popular it easier for the Internal Revenue Service to de- among regulated industries, such as railroads and termine to whom interest is paid and to trace any utilities. A closed-end provision in a mortgage con- changes in ownership. However, there is still a sig- tract requires that the corporation secure no ad- nificant secondary market in bearer bonds. ’ As the ditional bonds on the lien. The majority of contracts, however, include an open-end provision “’The High Price of Financial Privacy, ” Ilusiness W’eek. Aug. 1, 1983, that allows for the issuance of additional bonds p. 97. 78 ● Effects of Information Technology on Financial Services Systems

bearer bond is eliminated from the market, some der specifying which accounts should be paid by increase in demand for different instruments that the bond issuer or paying agent bank, the ACH safeguard the privacy of the investor to a similar could take responsibility for routing these interest degree may be expected. payments, which would be credited to an account A significant difference between bearer and reg- specified by the bondholder. Savings would result istered bonds from the point of view of both issu- from the elimination of check-processing costs. ers and investors is the way in which interest is paid. The holder of a bearer bond initiates the pay- RETIREMENT OF BONDS ment of interest by depositing the appropriate cou- Bonds may be retired by payment at final pon at the financial institution of his choice. Fed- maturity; by conversion to common stock if the eral Reserve collection mechanisms are used by the instruments are convertible; by refunding, through institution to obtain credit for the interest due. enacting a call provision; or through periodic re- Usually, the depositor is paid the interest by the payment, if the bond is a sinking fund or serial financial institution prior to the completion of this bond issue. process; in most cases, immediate use is granted. Many bonds contain a provision allowing the The payment system for bond coupons is extreme- corporation to “call” or repurchase the debt in- ly paper-based. The physical coupon “follows” the struments at any time. This gives corporations collection process. flexibility if market conditions change before the Greguras and Carlile suggest that as new tech- bond matures. The call price is usually above the nologies make it possible to record essential infor- face value of the bond, but generally this premium mation in the physical coupon in a format that can decreases as the maturity date is approached. A be used by electronic systems, this type of system corporation may move to call a bond because of will allow financial institutions quicker access to a drop in market interest rates or to be free of re- their funds and, as a result, benefit the investor.’ strictive protective covenants that may have been Information contained in the coupon could be necessary to gain financing initially. The initial transformed to electronic form at the point at debt contract specifies whether the call provision which the coupon enters the redemption process. is immediate, that is, can be invoked at any time The electronic system proposed would result in following issue, or deferred, in which case the in- little, if any, change in the action required by the vestor is assured that no call will take place for investor. Presentation of coupons would remain a definite period of time, usually 5 to 10 years. the same; from the investor’s viewpoint the cou- Call provisions become a disadvantage to inves- pon is already truncated since it is never returned tors when the stable return anticipated when the to the holder. Cost-saving benefits result for the debt instrument was selected for investment is issuer of the bond, the paying agent, and the fi- lost. The investor may find it necessary to select nancial institution used by the bondholder. Gre- an alternative investment. If interest rates have guras and Carlile point out that computer sort ca- dropped since the original investment, the investor pability could replace the current labor-intensive 3 must not only bear additional transaction costs system used by issuer and holder. The electronic but also, in some cases, select between less attrac- system would be faster and would facilitate the de- tive investment alternatives. velopment of computerized bookkeeping and set- For tax purposes, the income gained by the in- tlement systems. It is not clear how the end of new vestor from the call premium is treated as a capi- issues of bearer bonds will affect the possibility tal gain. For the corporation it is deducted as an of automating the interest payment process, al- expense from ordinary income. Many experts be- though the potential application of this type of lieve that the net tax advantages received by the system will naturally decline. investors and the corporation make call provisions The payment of interest on registered bonds is attractive to both parties.4 easier because the paying agent knows the holder Refunding involves the replacement of one bond and initiates the payment process. Greguras and issue, prior to maturity, with a new issue of bonds. Carlile note that there is a great potential to use A corporation may wish to refund an issue to es- automated clearing houses (ACHS) for these trans- cape restrictive protective covenants, but the most actions, Following the issuance of a payment or- common reason is to take advantage of a drop in

‘Fred M. Greguras and Larry L. Carlile, “The Use of Electronic f3ank- ing for Bond Coupon Payments, 1980. ‘James C. Van Home, Financial Management and Policy (Englewood ‘Ibid. Cliffs, N. J.: Prentice-Half, Inc., 1983), p, 555. Ch. 3—The Securities Industry ● 79 market interest rates. Market conditions must be is discussed later, the decision to pay interest extremely favorable for the issuing corporation to belongs to management rather than the board of justify the expenses involved in refunding, which directors. If not paid, interest accumulates and is include the cost of calling the old bonds, issuing senior to preferred and common stock dividends the new bonds, and, possibly, expenses resulting and subordinated debt. from the payment of interest on the old bonds dur- Income bonds are unpopular with investors being any overlap period. cause the income stream from their investment is The repayment of a total issue of bonds at ma- unpredictable. Some experts also believe that the turity could present a severe cash strain for the past association of this instrument with corpora- issuer. Therefore, two methods have been devel- tions, particularly railroads, trying to avoid oped through which debt issues are retired in a bankruptcy has made them unattractive to in- more controlled and gradual manner: the issuance vestors. As a result, income bonds are used pri- of serial bonds and sinking fund provisions. Serial marily in reorganizations, which of course may bonds give an investor a choice of maturity dates. perpetuate their negative image.’ The entire package of bonds is issued by the cor- Return paid on a zero-coupon bond is embodied poration at the same time, but the bonds mature entirely in price appreciation to maturity. No pe- individually in successive years. riodic interest payment is made, This bond offers Most bond issues carry a provision requiring two advantages to the investor: the bond cannot that the corporation retire a given number of be called, so the holder experiences no reinvest- bonds per year through a sinking fund managed ment risk, and an exact return is assured if the in- by a trustee. The bond issuer makes payments into strument is held to maturity. For tax purposes, the fund, with which the trustee finances the re- the investor must declare the interest accrued in tirement, by calling or purchasing bonds selected a given year as interest income, despite the fact (usually) by lottery. While calling before the an- that this money is not available for his use. The ticipated maturity date may be undesirable for the corporation also deducts the interest expense for investor, most investors value the assurance of or- the year accrued, although no actual payment is derly retirement of debt and liquidity provided by made. While the corporation enjoys the advantage a sinking fund provision. For bondholders whose of no cash outlay until the maturity date of the instruments are not called, the sinking fund may bond, the no-call provision is a disadvantage if represent a reduction in risk, as the total amount market interest rates fall during the lifetime of the of debt the organization holds is continually bond, reduced. Two types of bonds, floating-rate and indexed, have become more popular in response to the con- PAYMENT OF INTEREST cerns of both issuers and investors that long-term The return of most debt investments is embod- debt instruments have generally been locked into ied in a periodic interest payment referred to as a rate of interest that reflected market conditions the coupon. It is designed to compensate the in- at the time of issue, but that may not be desirable vestor for the time-value of money, the lost oppor- if market conditions change. For example, floating- tunity cost, and the risk assumed. Usually, this rate bonds, which include instruments for which is a semiannual payment. The market value of the the interest rate is set in relation to 90-day Treas- bond is determined by the present value of this ury bills, may be attractive to an investor who stream of payments. Bonds with less traditional believes that interest rates are likely to rise dur- payment schedules have developed in response to ing the lifetime of the bonds, and to an issuer who market pressures. These include income bonds, feels rates will fall. To both parties the uncertainty zero- and low-coupon bonds, indexed bonds, and about the return that will be received and the cost floating-rate bonds. of the borrowed funds may be disadvantages. While most bonds are strictly debts of the cor- The return on indexed bonds is tied to the rate poration, for which interest must be paid regard- of inflation and therefore is considered fixed in real less of the corporation’s financial situation, inter- terms. These bonds become popular in times of est is only paid on income bonds when the earnings high inflation. In theory, any index can be selected of the corporation permit. The corporation benefits as a basis for setting the rate paid on this type of 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 61 bid., p. 551, 80 ● Effects of Information Technology on Financial Services Systems

bond; however, in the United States the Consumer Information technology may be expected to Price Index is generally used. create more competition in rating bonds as the Information technology may be expected to in- capacities of new online computers and interactive crease the number and complexity of different cable are explored. As technologies become more types of interest-paying plans for bonds. Indexed sophisticated and interactive systems become less and floating rates can be designed to respond more costly, it has become possible to personalize rating quickly to changes in the base line on which inter- services to the objectives of the individual investor est is determined. This may result in some confu- in real time. sion for bondholders, as change may occur at such a rapid rate that the logic behind it may not be BOND TRUSTEES perceived. More complex interest-paying arrange- As will be discussed later, the interests of the ments will require special attention to the dis- shareholders of a corporation are represented by closure of these bond characteristics for investors, the board of directors. Bondholders have a special a role likely to be the responsibility of brokers and representative—the trustee—who is not part of issuers of bonds. corporate management and who is expected to act in bondholders’ best interests. Paid by the issu- RATING OF BONDS ing corporation, the trustee is usually a commer- Two highly respected rating services for bonds cial bank. The responsibilities of the trustee for are Moody’s Investors Service and Standard and bond issues over $1 million are specified in the Poor’s. Their ratings result from an analysis of the Trust Indenture Act of 1939 and involve protect- financial and business propects of the issuer and ing the rights of the bondholders by ensuring both are used by individuals and financial institutions that the initial contract is legal and, following the as a tool for assessing risk. issue, that the corporation fulfills its contractual Moody’s Investors Service offers nine possible responsibilities to the bondholders. This act, which ratings, ranging from a low of C, which represents is administered by the Securities and Exchange extremely poor prospects for the issuer, to a high Commission (SEC), requires that the trustee act of Aaa, which represents an extremely low amount strictly in the best interests of the bondholders. of risk and predicts that it is unlikely that any neg- It is the responsibility of the trustee to act to ative change will affect the issue. Generally, orga- protect the interests of the bondholders if the com- nizations with poor ratings must pay a higher rate pany is in default—that is, fails to meet the provi- of interest to borrow funds to compensate lenders sions of the bond contract. This responsibility has for risk. been brought to the forefront by the recent default It is rare for the rating of an issue to change. on Washington Public Power Supply System Any reevaluation by Moody’s or Standard and (WPPSS) bonds. A problem the bond trustee ap- Poor’s indicates a very substantial change in the pears to be encountering is reaching and purvey- condition of the issuing firm and attracts a great ing information to the 78,000 holders of the bonds. deal of attention from investors. in spite of the press received by the WPPSS de- Those bonds that Moody’s rates “Baa,” the fault and the efforts by the trustees to reach and fourth highest rating, or above are considered inform bondholders, it appears that, prior to the investment-grade bonds. Some financial institu- first missed coupon payment on the WPPPS bonds, tions, including some commercial banks and many many bondholders did not know or did not under- pension funds, are not allowed to invest in any stand that there was a problem.7 Communication issues that do not make this grade. Some experts technology may facilitate attempts by the trustees believe that rating services have caused certain to reach bondholders in the future by improving types of organizations, particularly municipal gov- information flows and corporate recordkeeping. ernments, to pay higher than warranted interest rates because of unfavorable and perhaps some- THE EFFECT OF INFORMATION what subjective ratings.6 However, investment TECHNOLOGY ON LONG-TERM counselors and investors still rely heavily on the DEBT INSTRUMENTS rating services. Long-term debt is likely to remain a significant part of corporate capital structure. Information

‘Lynn Asinof, “WPPSS Begins to Cause Pain for Investors, ” The ‘Brealily and Myers, p. 468. Wall Street Journal, Dec. 28, 1983, p. 15. —

Ch. 3—The Securities Industry ● 81 — .—.——. . — technology may change the approach of organiza- stock; the right to maintain their share of owner- tions searching for finance and investors seeking ship through purchase of new shares issued by the debt instruments as the following impacts of the corporation; the right to information on the oper- main advantages of automated systems are felt: ation of the firm, to the extent that it is competi- increased speed of handling information, more tively feasible; and the right to transfer ownership precise and less expensive analysis, and improved to another investor. communication systems. The most significant benefit for the owner of common stock is the right to maintain control of Equity the corporation through the election of the board of directors, who in turn appoint the officers of the A firm may also decide to gather capital through firm and represent the interests of the holders of issuing equity, or ownership rights, in the form of equity in the firm. The management of the corpora- corporate stock. The investor receives with the tion is expected to act in accordance with the shares of stock he owns rights proportional to the goals of the owners and to be accountable to them total amount of stock issued by the corporation. through the board. Equity capital strengthens the balance sheet and Preferred stock is considered a safer investment enhances the future borrowing power of the com- because holders of these shares have a claim on pany. Decisions to issue debt or equity are usu- the assets of the company before holders of com- ally based on what will maximize the market value mon stock, although after the holders of debt, in of the corporation. the case of bankruptcy. Owning such stock also From the point of view of potential investors, carries a prior claim to income in the form of the purchase of equity may give the opportunity dividends. However, the preferred stockholder to share in the growth of the company. As some, usually enjoys only limited voting rights, so that if not all, of the return received may be in the form he has less impact on the operation of the corpora- of capital gains, the investor may find a tax advan- tion than do common stockholders. tage in equity investments. Equity shareholders may also receive an income stream in the form of DIVIDENDS dividends as a form of return on their ownership, In some cases, this return may be greater than Depending on the corporation’s profits, corpora- what would be realized from a debt investment. tion earnings may be used to pay dividends to While tax laws have been subject to change, at stockholders at the behest of the board of direc- times there have been tax advantages from income tors. Dividends are only declared when the payment will not impair the operation of the firm or in the form of dividends rather than interest. legally compromise its contractual relationships. A firm may sell equity in two forms: common stock or preferred stock. The choice will depend tionships. on the financial structure and objectives of the cor- Two significant dimensions of the dividend policy of a corporation are dividend stability and long- poration and on industry and market conditions. a The equity profile of a corporation may be ex- run dividend payout ratio. A dividend may be tremely complex. Both common and preferred stable in terms of real dollars paid out or in the ratio of dividends to earnings. While the latter stocks may be issued, and several varieties of preferred stock may be active simultaneously. may appear more rational, it is rarely used. Con- sideration of the return expected by stockholders COMMON AND PREFERRED STOCK has led most corporations to pay a stable dollar dividend when possible, indicating the importance Common stock is generally more significant of income as a motivation for investing in equity than other types of securities in the capital struc- issues. ture of a firm. The holders of common stock have Decisions on long-run dividend payout ratios residual rights to the income of the firm, which may be based on the objectives of the owners and they usually receive in the form of dividends. At management of the firm. The reinvestment of a the same time, the liability of individual share- significant portion of earnings may result in higher holders is usually legally limited, particularly for growth for the corporation as a whole and maybe the debts of the corporation. Additional rights of attractive to investors desiring long-term income holders of common stock include a claim on company assets in the case of bankruptcy, following ‘Lawrence D. Schall and Charles W. Haley, Introduction to Finan- the claims of creditors and holders of preferred cial 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 likely to be most directly felt in the actual paying are used as a form of internal financing, and any of dividends. Operation costs for this activity may dividend paid is from earnings left over after be expected to decline as recordkeeping and sort- financing objectives are met. If the shareholders ing activities can be automated. It may also be of the corporation are interested in more immedi- possible to use electronic funds transfer for the ate income, a fixed payout may be used. In this payment of dividends. While initial costs for this case, the amount of money available for internal type of system may be high, the resulting efficien- financing would differ from year to year as it cies and the decrease in postage costs may be of would be, in a sense, the residual part of earnings. great benefit.

THE EFFECT OF INFORMATION TECHNOLOGY ON EQUITY Convertible Securities Information technology may be expected to af- Preferred stock or bonds that can be converted fect equity instruments directly in three areas: the to common stock at the option of the holder are payment of dividends, the recording and proof of called convertible securities. Such securities offer ownership, and the transfer of ownership. The a middle ground to investors who demand lower transfer of ownership of stock will be examined as risk than common stock carries yet want to par- a function of the securities industry in a later ticipate in the growth of a corporation. section. Convertible bonds offer both interest payments The improved ability of shareholders to moni- and conversion opportunity. This instrument is at- tor and analyze the activities of corporations more tractive for the issuing corporation because gen- directly through the use of new technologies may erally a lower-than-market rate of interest may be also have some impact on individual firms. The offered, owing to the conversion option. A corpora- magnitude of this impact will largely depend on tion may view a convertible bond as both a short- the characteristics of the ownership of the corpora- run debt and long-run equity issue without the tions involved. An increased awareness by the cost of two separate issues. Convertibles are con- shareholders of the environment and operation of sidered deferred common stock financing. These the firm may be a benefit; however, managements instruments were also traditionally attractive to and boards of directors may find an increased de- new or speculative corporations unable to gather mand for information dissemination and respon- equity capital on other terms or to corporations siveness. with low-grade credit ratings. Detailed records are maintained on who the cor- Compared to the issuance of common stock, the poration’s shareholders of record are to assure that issuance of convertible bonds creates less dilution they receive their ownership rights. While tradi- of earning per share at the time the bonds are first tionally this operation was solely paper-based and offered and at the time of conversion. At the time involved the issuance of certificates that served the bonds are issued, no stock is involved; at con- as proof of ownership, there is some indication that version, the size of the conversion generally adds the application of information technology is facil- fewer shares than a new issue of common stock itating a movement toward a book entry system. would. Usually, it is expected that the financial This type of arrangement is expected to benefit condition of the issuing firm will be improved in the issuers of equity by lowering operating costs, both yield and stability at the time of conversion, including those of printing and postage, and to as indicated by the fact that the conversion price benefit the holders of equity by making it easier is higher than the market price of the common to transfer ownership of these securities. stock at the time the bond is issued. Book entry may require some adjustment by The stock package stipulated in the conversion shareholders because the mechanics of proof of plan may be more favorable to the organization ownership will differ. The success of this type of than one designed later when changing market program will depend largely on how apparent and conditions could be taken into account. The expec- important the benefits involved are to the in- tations of investors for the common stock provi- vestor, particularly when trading. sion may be less stringent at the time the bonds The mechanics of developing a dividend policy are issued because of both the benefits to be re- may be aided by the application of information ceived before conversion and the anticipation of technology; however, the value of improvements participating in corporate growth at the time of in communications and computer capabilities is conversion. Ch. 3— The Securities Industry ● 83

The tax provisions of typical convertible bonds securities and, as the market demands, it is likely may be beneficial for investors. The conversion of that additional instruments will be developed. the bond to common stock is considered a tax-free These short-term debt instruments include Treas- transaction by the Internal Revenue Service. The ury bills, certificates of deposit, commercial paper, year-plus-one holding period for long-term capital bankers’ acceptances, and repurchase agreements. gains on any subsequent sale of the common stock They are important to corporations in money man- is counted from the time the bond, not the stock, agement as both financing tools and investment is issued. tools. One variation on convertibles that often results A Treasury bill is a short-term debt of the U.S. from failed takeover bids is the exchangeable Government. The bills are sold on an auction basis bond, which can be converted to the stock stipu- at a discount from face value. Since the U.S. Gov- lated in the bond contract of a corporation. This ernment is continually borrowing to pay off debts, stipulated stock may be issued by someone other Treasury bills are issued on a very frequent basis. than the issuer of the bond. The exchangeable Biddings are closed by the U.S. Treasury weekly bond requires the investor to evaluate the credit for 91- and 182-day debt issues and monthly for potential of the issuing corporation and the long- 9- and 12-month bills. Short maturities and the range growth and earning potential of the firm backing of the U.S. Government make them de- whose common stock is involved. Tax provisions sirable investments. must also be a major concern for such an investor. g Although the market is quite short-term, an ac- The Internal Revenue Service considers this con- tive secondary market has developed. Therefore, version to be the equivalent of two cash trans- bills can be traded before the maturity date, add- actions because the securities of two different cor- ing to their liquidity. Treasury bills are a desirable porations are involved. Since the bond would not short-term investment tool for corporate investors be redeemed by a rational investor unless the stock because of the high level of liquidity and low level sells for more than the original cost of the bond, of risk they carry. a taxable gain is realized. Commercial paper is a short-term debt issued by Recently, the interest in this bond instrument finance companies and some other corporations. by both corporations and investors has grown. Interest rates for commercial paper are generally While in the past institutional investors domi- higher than for Treasury bills because of the risk nated this compromise market, individuals are factors involved in private firms. Many companies becoming more active. Information technology use commercial paper to supplement bank loans. may be expected to affect convertible instruments In general, it is a less expensive method of financ- to the extent that it makes more sophisticated ing for prime quality obligatory than loans (be- analysis cost effective for investors and financial cause banks are not used as intermediaries) and intermediaries, and therefore the complex nature may fill a need at a time when the issuance of long- of the instrument may be less of a disincentive to term debt is not appropriate. The issuance of com- potential issuers and investors. Growth in this mercial paper lacks the supportive, interactive area may be expected, however, to be related pri- nature of a relationship between a corporation and marily to the fiscal needs of corporations involved a commercial bank. and to the demands of consumers. Commercial paper may be sold directly by the issuing corporation or through a dealer. Since Short-Term Debt– dealers screen the instruments to a certain extent, commercial paper placed by a dealer may be less Money Market Securities risky for an investor, although commercial paper The essential characteristic of money market directly placed by some major corporations is of securities is their liquidity. This derives from their very high quality. The investor holds an unsecured short maturity, by definition less than 1 year, and short-term promissory note as evidence of the the generally high quality of the issuing organiza- debt, and the instrument is tradable in money tion. ’” There are several types of money market markets. — Commercial paper is designed to avoid a require- “’Investing in Convertible Bonds,” Business U’eek, June 20, 1983, ment of registration with the SEC. Because of past p. 191. problems in commercial paper markets- specifical- ‘“Roland 1. Robinson and Dwayne Wrightsman, Financial ,$fm-kets; The Accumulation and Allocation of Wealth [New York: McGraw-Hill, ly, those generated by the bankruptcy of Penn Inc. 1974), p. 14’7. Central-investors have caused the market to 84 ● Effects of Information Technology on Financial Services Systems become quite conservative. Commercial paper of Congressional action is expected to confirm this companies that do not have a very high financial stance. 11 reputation is rarely marketable. The short-term debt market has been greatly af- Banker-s’ acceptances, which originated at about fected by the use of information technology. The the same time as international trading, continue nature of some short-term debt includes a definite to play a significant role in importing and export- end-date for the instruments. Improvements in ing. A banker’s acceptance is issued by a corpora- sorting and transacting brought about by comput- tion and guaranteed by a commercial bank. The er capabilities may extend the effective lifecycle acceptance is a liability of the bank and is traded of the instrument since it can be marketed more in money markets based on the reputation and quickly. The availability of better data and the im- credit standing of the bank. The instruments are proved ability to analyze information about the of value in international trade, owing to the time- debt instrument and about the issuing organiza- lags that can occur because of the physical aspects tion may affect the market for short-term debt in- of transporting goods and because of the uncer- struments. The potential of short-term debt in- tainty with which many traders approach foreign struments as investment tools may be expected markets. to improve to the extent that the application of Certificates of deposit are negotiable securities technology will refine this evaluative process. issued by commercial banks. They have fixed ma- Information technology may also improve the turities and pay interest to maturity. Yields on cer- packaging of short-term debt instruments by al- tificates of deposit are higher than for Treasury lowing securities industry marketers to match bet- bills and are paid at the time the certificate ter the characteristics of various instruments to matures, The risk associated is dependent on the the demands of investors. The proliferation of quality of the issuing bank. Certificates can be money market mutual funds and demand accounts traded in a secondary market before maturity; this may be a result of this opportunity. market is particularly active for the certificates of deposit issued by major commercial banks. Options and Futures Contracts Repurchase agreements stipulate that the short- term securities sold will be repurchased by the The capital market investor’s investment goals seller. They are frequently issued by bond dealers may not be completely met by debt and equity to finance inventories. U.S. Government securities issues. The desire of investors to increase their li- are the usual basis for the agreement through quidity or return or to limit risk has led to the de- which an investor “purchases” the securities while velopment of instruments that comprise what may agreeing to resell them at a specified time and be considered a second-tier securities market. price. The term of repurchase agreements may be These securities are based on the fortunes and fluc- for several months or for overnight, and therefore tuations of capital markets, but are not essential has the potential to offer a great deal of flexibility. to the capital structure of individual firms. Major questions involving repurchase agree- Off-shoot investment products include options ments center on the level of risk involved and how on stocks and bonds and futures contracts on com- the transaction should be classified. Historically, modities, currencies, and market indices. These in- repurchase agreements were considered extremely struments are all based on the market behavior of safe transactions, although they are not federally underlying products or securities. The interest of insured, because they involve Government secu- the investor is focused on the price fluctuations rities and are handled by recognized players in the of the product, usually in a relatively short time financial service industry. However, recent col- frame, rather than on the intrinsic operations of lapses of dealers caused some investors to experi- the firm. Interest in options and futures contracts ence high losses. investment has led to the development of an in- The qualification of repurchase agreements as dustry structure specializing in these products, in- a sale or debt has created some controversy cluding exchanges and clearing corporations. The throughout the financial service industry. The In- development of this structure has increased inter- ternal Revenue Service has held that it is a col- est in the products and has led to further growth lateralized debt, and therefore the investor would in option and future contracts trading. be liable for interest income received. Dealers in Government securities sales disagree and consider “’’The Repo Market Is Still in Shock, ” Business Week, Apr. 4, 1983, the instrument to be a purchase/sale agreement. p. 74. Ch. 3—The Securities Industry ● 85

Options PARTICIPATING IN THE OPTIONS MARKET Options provide a method of participating in a Participants in options markets attempt to prof- securities market without ownership of actual debt it from their knowledge of the potential declines or equity instruments. An option is a tradable in- and rises of a corporation but have no direct stake strument that grants an investor the right to buy in its operations. In the basic options market, (a call option) or the right to sell (a put option) a players may be involved in four activities: buying specific security at a given price for a limited call options, buying put options, writing call op- amount of time. It is a legal contract in which two tions, or writing put options. factors are explicitly stated: the expiration date An option buyer hopes to profit from or protect and the exercise price. The value of an option is himself from a change in the price of the under- directly related to the market price of the underlying security. The holder of a call option has the lying security. The exercise price of an option in- right to buy a security at a specified price. This dicates the change anticipated in the market. The investor may do three things with this right: ex- exercise price of a call option (at which the investor ercise it by buying the underlying securities, sell can buy the underlying security) is, at the time the it to another investor, or let it expire. He has no option is issued, generally higher than the market legal obligation to make any transaction of the price of the security. Conversely, the exercise price underlying security. Further action on his part in- of a put option, which entitles the holder to sell volving the contract is self-motivated and will re- the security, is generally lower than the market sult only from his evaluation of the market. price. Options may be written and sold for real The writer, on the other hand, is obligated to buy estate, debt instruments, and foreign currencies; or sell the underlying security under the conditions they have recently become most significant in specified in the contract. His continued involve- equity markets. ment with the instrument is not voluntary and, Options are “wasting assets”; that is, after the while in some cases may not be required, is legally specified expiration date, they have no value. enforceable. Both writers and buyers of options Therefore, the timing of market changes, as well can liquidate their positions by purchasing off- as direction, must be correctly evaluated by the setting options before the expiration or exercise investor to assure that the potential value of the of the option. investment is realized. The writer of an option, ex- The motivation of an investor to buy a call op- cept for warrants, which are discussed below, is tion may be related to two separate strategies. He not controlled by the organization named in the may hope to participate in the benefits of a rise underlying security. More shares of stock may be in stock prices with a limited current investment represented collectively through outstanding op- and therefore may buy call options to achieve tions than have been issued by the corporation. leverage or establish a future price at which he While option writing and buying may be part of plans to purchase the security. He may also be a complex investment portfolio that includes debt motivated to purchase call options to limit risk, and equity instruments of an institution, the oper- either as part of a conservative overall investment ations of option markets are, in a practical sense strategy or to hedge a short stock position. at least, totally separate from the capital structure For the individual investor, leverage may be of a corporation. measured through the percentage of total assets While options have been traded among individu- necessary to invest for a given rate of return. It als for many years, the market has grown and is assumed that the financial assets of an in- become more sophisticated since the organization dividual are finite and that each investment deci- of regulated exchanges in the mid-1970’s. The sion is evaluated by its opportunity cost. Achiev- trading of options entails a relatively new market ing leverage could be the motivation for buying structure; therefore, the influence of information call options for an investor who expected the price technology on this structure is quite visible. For of an issue to rise. The cost of buying a call option example, options use book entry rather than cer- for a given number of shares of stock represents tificates as proof of ownership. 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 in- While the buyer of call options generally acts in vestment may result in the case of a rise in the anticipation of increases in the price of the under- price of the stock to the holder of a call option. lying security, the buyer of put options attempts However, it must be recognized that with a highly to profit from or limit risk if the price declines. The leveraged investment, a larger share of the invest- option grants the holder the right to sell at an es- ment may be lost. Since options are wasting as- tablished price, and therefore it can be used for sets, the investor must be correct in his evalua- leverage and for limiting risk. As with call options, tion of the timing as well as the likelihood of a price the investor must have correctly analyzed the di- increase in order to profit from his purchase of op- rection of the price change and the timing of the tions. If the option expires without being exer- change in order to profit. cised, the investor’s loss would be equal to his in- The conservative investor can use put options vestment. Absolute return or loss will usually be as a hedge against a substantial decline in the price lower for the option investor than if he held the of a stock he holds. This strategy may be particu- equivalent number of shares of stock. larly attractive as protection for an individual who Options are also bought by investors who would has a significant portion of his assets invested in like to invest in the underlying security and ex- a single security. However, it must be recognized pect its price to rise but who do not have the cash that the insurance provided only lasts through the to make the investment. The call option estab- life of the option and that the cost of the option lishes a guaranteed maximum price for the secu- cuts into the investor’s potential profits. rity. This strategy is particularly useful if the in- The writer of an option exposes himself to far vestor anticipates receiving a flow of cash before greater risk than the buyer does. A writer of call the expiration of the option. If the price of the options may be required to sell the underlying stock falls below the exercise price, the investor security to a holder at the exercise price at any may purchase the security at the market price and time during the life of the option. Conversely, the consider the option a sunk cost. writer of a put option may be required to buy the While investment in options increases the lever- underlying security from the holder at any time age and establishes the price of future stock for during the contract. the investor, the lower dollar investment required The writer of call options is motivated by the to buy call options rather than stock limits abso- possibility of gaining a return through premium lute risk, since the investor exposes less of his income, Calls may be covered, wherein the writer assets to the market. A common, conservative in- owns the specified underlying security, or uncov- vestment strategy is to purchase call options and ered, wherein the writer would be required to pur- invest the difference between the options and the chase the security at market cost if he is assigned price of the underlying security in a low-risk in- an exercise. Leverage for an investment portfolio strument, such as Treasury bills. Any loss in- may be the most significant motivating factor for curred through the options investment would be the writer of covered calls. Return from the under- at least partially off-set by the interest earned on lying security may be realized both through divid- the investment of the remainder. ends or interest paid and through income received Decreasing risk may also motivate an investor from premiums. While the covered call writer may to purchase call options if he maintains an ex- hope to maintain his position in the underlying tremely risky position in equity markets by sell- security, option writing may greatly increase his ing short, that is, selling securities he does not own income-producing potential. in anticipation of a price decline. This investor The writer of uncovered calls is the player at theoretically exposes himself to unlimited loss if most risk in the options market. His potential loss the price of the stock increases because he would may equal the market price of the stock less the be forced to pay market prices to deliver the secu- sum of the exercise price and premium received for rities. By buying call options, the investor who the option and, in theory, is limitless. The un- takes a short position establishes his maximum covered call writer must be extremely sensitive to purchase price for the securities he is selling and any factors in the economy at large or for the cor- therefore insures himself against limitless loss. Of poration that may cause a significant price in- course, if the market behaves in the manner antic- crease. ipated by the short seller, the price of the option A writer of put options is obligated to buy the is lost profit. specified underlying security at the exercise price Ch. 3—The Securities Industry . 87 at any time until the option expires, The put writer equals the premium price and, theoretically, un- must have sufficient liquid assets to buy the secu- limited profit potential. However, the price change rity and, as an exercise is only likely when the ex- must be significant in order for the investor to ercise price is higher than the market price, he profit, and the investor must be correct in his must anticipate paying more than the value of the evaluation of the timing of the change. Straddle security. The option writer who trades through an writers are generally motivated by their belief that exchange is required to deposit cash or securities, there will be little, if any, change in the price of referred to as margin, with a brokerage firm. Puts the security and, therefore, that if an exercise were may, alternatively, be secured with cash equal to assigned, profit from premium income would in- the option exercise price. No additional margin re- sure a net profit after costs of satisfying the exer- quirements will be required in this case, and in- cise conditions. Risk for straddle writers is limit- terest may be earned by the writer on the cash de- less, as a substantial loss can be incurred on both posited. positions if the market price for the security fluc- Investors are usually motivated to write puts tuates more than expected. by a desire to earn income from premiums, the price paid by the buyer of an option to the writer PRICING OF OPTIONS of that option. The opportunity to purchase the The premium (i.e., price) of an option is subject specified securities may also be a motivating fac- to change and is influenced by characteristics of tor in some cases. In a stable or rising market, it the option, the underlying security, and general is possible to earn premium income with relatively economic conditions. Factors influencing the pre- low risk; however, demand for put options may be mium include the expiration date of the actual in- expected to be fairly low in this circumstance. strument, the price and volatility of the underlying Some put writers hope to acquire the stock at a security, supply and demand effects on the option net cost which, considering premium income, is market for the specific security, and, on the whole less than the current value of the stock. as well, interest rates. The premium for an option The four possible ways of participating in the is comprised of intrinsic value and time value. An options market may be combined by an investor option has intrinsic value any time the difference to form a strategy he believes is most likely to between the exercise price of the option and the meet his investment goals of producing income or market price of the security works to the advan- limiting risk. The options tactics chosen are influ- tage of the holder. Anytime this is not the case, enced by the investor’s expectations about how the option has no intrinsic value, and the premium the price of the underlying security is likely to is based only on time value. change in direction and magnitude. Time value represents an evaluation by an in- Spreads and straddles are the two most common vestor of the potential of the option to increase in multiple-options investment strategies. Spreads value owing to a change in the price of the under- are used to limit risk in option transactions and lying security prior to expiration of the option. involve writing and buying the same type of op- Time value may generally be expected to decline tion, calls or puts, for the same specified security. as the expiration date approaches and as the pos- The options generally have different expiration sibility of fluctuation in the security price de- dates or exercise prices. If the investor were creases. It is also influenced by the amount of dif- assigned an exercise for the option he wrote, the ference between the exercise price and the market spread benefits would disappear, and his risk posi- price of the underlying security. A large difference tion would be drastically changed. The writer of may result in a decrease in time value because the spreads generally anticipates little change in the possibility of profitably exercising or selling of the price of the underlying security. A stable market option is more remote. Increasing interest rates provides his best opportunity for profit. generally result in increases in time value. The investor who anticipates a great change in the price of an underlying security but is unsure Warrants of the direction or magnitude may maintain a straddle position. The straddler either writes or A warrant is unique because it is issued by the buys both a call and a put option for the same secu- corporation that issues the underlying security rity. Both the call and the put should have the and, as such, is part of the capital structure of the same exercise prices and expiration dates. Buying firm. A warrant is a type of call option that grants straddles has limited risk because maximum loss 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 Futures at the time of issue. The value of the warrant itself at any time is dependent on the current price of Futures, or future contracts, are legally binding the stock of the issuing corporation. Warrants are agreements that call for the purchase or sale of real often offered with debt issues by corporations to or hypothetical items at a stated price at some make the debt issues more attractive to potential time in the future. Future contracts can be devel- investors. They offer a participation right of sorts oped for anything and are traded on established if the corporation grows. The investor benefits exchanges for physical commodities such as pork from the fixed return of the debt investment as bellies and coffee, for financial instruments, and well as the opportunity to purchase stock at an for hypothetical stock portfolios. established price. Even though future markets at one time were As with all options, an exercise price is specified focused only on commodities; they have expanded for the warrant. It may have a specific expiration greatly. In the past, communities needed to be self- date or be perpetual. The contract also specifies sufficient in their production of foodstuffs and whether it can be traded, as with other option in- other necessary goods because transportation be- struments, or be exercised only by the holder. tween regions was not efficient. As lack of trans- Unlike other options, warrants directly affect portation became less of a barrier to trade, com- the capital structure of a corporation. A call or put modities markets developed that allowed for option is exercised through a capital market and specialization in production and made a wider with no net change in the number of shares out- assortment of goods available. Centralized com- standing for the corporation. However, when a modity markets made more extensive trading pos- warrant is exercised, the corporation issues new sible, and future markets grew from them to ad- shares of stock; therefore, the earnings of the com- dress price-change risks. pany, from the point of view of the shareholders, Commodity futures markets developed because are diluted. This situation complicates valuation of the need in both agricultural and industrial both of the stock of the corporation and of the societies to minimize the potential impact of un- warrant. known and hard-to-predict forces that influence the price and availability of resources and prod- THE EFFECT OF INFORMATION ucts. For example, through the use of futures con- TECHNOLOGY ON OPTIONS tracts, food processors are able to set definite maximum prices for the commodities they will need for Information technology is likely to continue to production throughout the entire year. Most crops facilitate the development and trading of options. are only harvestable for a very short period of time Because option markets have only recently be- in any year, and it is desirable for farmers to be come highly structured and have been heavily de- able to sell all of the harvest at that time to avoid pendent on technology from their inception, the the need for expensive storage. While the demand continuing application of communications and for some food products, such as turkey and pump- computer technologies in these markets is not kins, may be seasonal, food processors face a year- likely to lead to major revisions in ways of doing round demand for products made from commodi- business to the same extent as they have in debt ties only available for a very short time. These and equity markets. Options may serve as a test- processors need to have the commodity available ing ground of sorts for new technologies, and tech- at a predictable price when it is needed. By pro- nology use in this area may presage future applica- viding a reliable means to conduct future buying tions throughout the securities industry. and selling, futures markets have served to equal- The use of personal computers and sophisticated ize the marketing of most seasonal farm crops. 12 communications technologies may spur the devel- The development of futures markets centered opment and marketing of option contracts by in- around the desire to transfer risk. The play of the dividuals and may lessen the role of brokers in market attracts a large quantity of risk capital bringing writers and buyers together. Information through which changes in commodity price levels technology should also facilitate the monitoring can be absorbed with only a minimum direct im- of option markets by investors, brokers, corpora- pact on producers and processors of commodities. tions issuing securities on which options are written, and market observers and regulators. This ‘2 Future Industry Association, “Development of Commodity Ex- may become increasingly important as the use of changes, ” Futures Trading Course and Handbook, Washington, D. C.: options as an investment instrument grows. 1983, p. 1-4. Ch. 3—The Securities Industry ● 89

This allows the producers and processors to oper- futures, and therefore the stock market may be- ate at lower cost than would be possible if they had come less volatile. to bear the entire risk of market fluctuations. In If the stock market becomes less volatile, it turn, this lowers prices to the public. ” must be expected that funds currently held in Commodity futures markets help effect stability mutual funds or the savings instruments of depos- in consumer prices. Because food processors can itory institutions because of the desire of the in- bound their costs, consumers are assured that vestor for stability will be transferred to direct par- products will be available when needed at a rela- ticipation in capital markets. More money may be tively predictable price and therefore approach the available for corporate capital formation; how- market in rational manner. This price stability is ever, this may be at the expense of the banking both of importance to the general economy of the structure. Nation and of social interest, since allocations Questions that must be addressed are: what hap- through Government programs, such as food pens to the risk that is transferred away from the stamps, can be set with some certainty as to what stock market? and what effect will this transfer market conditions will be for the recipients. have on the market? The result may be that the assumers of risk, in this case players in stock THE OPERATIONS OF FUTURES futures, may be expected to be advised better and The taking of a position in future contracts for more able to accept this position. a product on which one depends in one’s primary One cannot blindly accept that risk was bad for economic activity is called hedging. For example, the stock market when, in fact, it was the market’s General Foods might be expected to hold a posi- reason for being. It is essential that some means tion in coffee futures contracts to guarantee the of projecting what the impact of the possible end maximum price it would need to pay for beans for of the need for a risk-accepting role by stock ex- future production. In the discussion of futures, changes will mean to the process of capital forma- hedging is not a speculative strategy but rather tion be available. It is also necessary to determine refers only to the activities of players who face risk what, if any, effect the activities of markets in because of possible fluctuations in price and avail- stock futures will have on the inherent soundness ability of an actual commodity. of capital markets. Stock futures may cushion the stock market from changes in the general econ- STOCK FUTURES omy; however, it is not clear what impact a catastrophic event in the futures market might have Options, which were discussed in an earlier sec- on the entire capital formation process. tion, 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 THE EFFECT OF INFORMATION highly diversified investors, and stock futures may TECHNOLOGY ON FUTURES offer inherent price change protection to these in- Futures markets provide a glimpse of what the vestors. Stock futures are contracts that call for possible impacts of information technology on the the buying or selling of a mythical basket of securities industry as a whole may be. The poten- stocks, usually a grouping which is used in an in- tial of information technology was available as dex of market behavior. Due to practical limita- many of the operations of this segment of the in- tions, these futures are settled through cash rather dustry were developed. than the actual purchase or sale of the underlying Modern futures markets need both man and ma- securities. chine to operate. Human decisionmaking has been The availability of stock futures through which and will continue to be the one irreplaceable and an investor can hedge against swings that affect essential characteristic of any successful market. the entire stock market may add a great deal of However, the volume of trading demanded by cur- stability to that market and is expected to be of rent market conditions requires a level of opera- great significance to institutional investors, who tions not feasible for mortals in a free society at hold a growing proportion of all shares. Investors an acceptable cost. It would be impossible to op- may be more judicious in their response to mar- erate futures markets with the precision and at the ket changes because their risk may be minimized volume demanded by the market without the ap- by the holding of offsetting positions in stock plication of information technology; for example, for performing simple tasks, such as sorting faster, “Ibid. that would be impossible for a human work force. 90 ● Effects of Information Technology on Financial Services Systems

Computer and communications technology did Money market mutual funds are one of the more generate a futures market; however, if these tech- liquid instruments available to investors. The nologies were not available, the market could not liquidity of this type of investment is demon- have grown to its current size and importance. Its strated by the fact that, in many cases, sharehold- absence would have effectively foreclosed the pos- ers may access their funds by writing drafts, as sibility of responding to the demands of the econ- quickly as a bank checking account by requesting omy for the level and quality of operations now wire transfers, or in some cases, by using an auto- seen. mated teller machine (ATM). Such funds invest in short-term money market Mutual Funds securities and, because of the nature of the underlying securities, are extremely liquid and relatively The importance of mutual funds as institutional risk-free. Money market mutual funds are a valu- investors is discussed earlier in this report; how- able cash management instrument for businesses ever, these funds also have a role in the securities and an extremely valuable tool for individual in- industry in the role of investment instruments. vestors, both the “small” and the more affluent. Mutual funds offer investors a way of partici- Money market mutual funds give investors ac- pating in securities markets without directly pur- cess to money market securities on terms that chasing capital or money market securities. An in- they could not likely match themselves. Econ- vestor may be attracted to a mutual fund as a sort omies found in issuing and servicing large-denom- of proxy method of participating in the securities ination money market securities result in higher market. The individual benefits from the expertise yields than those offered on similar securities of of the fund management, and risk is generally smaller denomination. 14 The holder of shares in a lower than that through direct participation, al- money market mutual fund benefits from this though actual risk differs significantly, based on higher rate of return. the investment strategy of the fund. Mutual funds Money market mutual funds have enjoyed ma- allow investors greater liquidity than capital mar- jor market success. While information technology kets; shares are redeemable at any time at current is not directly responsible for this, many industry asset value less applicable redemption fees. experts believe that it would not have been possi- Mutual funds have traditionally been especially ble, from an operational or business point of view, important for the small investor because they can to introduce this type of fund without the support frequently be entered with a smaller amount of in- of communication and computer technologies. In- vestment capital than can the securities market, formation technology makes it possible to retain as the money invested is pooled with that from the highly liquid character of the funds by simpli- other participants. The investor may also take fying access for the investor. The level of trading advantage of the possible benefits of a diversified in short-term securities required by the funds portfolio that he might not have been able to sup- would be difficult to complete physically without port by directly participating in capital or money the assistance of information technology. markets. For the investor interested in an entire The number and variety of capital and money industry rather than a specific company, certain market mutual funds will probably continue to funds allow such a focusing of investments. grow. While this growth will provide more options Mutual funds that are made up of corporate for investors, it may also have an impact on the bonds and stocks are significant to the formation way in which securities markets operate. Although of capital because they attract investment money information on the investments of the fund is in- to the market that would not otherwise have been cluded in prospectuses and periodic reports to available. While some mutual funds centered on shareholders, it is not clear that the individuals in- capital markets have charged high transaction fees vesting in the fund take an active interest in what (called a load), their availability has increased both instruments their money is invested in. While the consumer options and competition for investment pool effectively lowers risk, the responsiveness of dollars throughout the financial service industry. individual shareholders is markedly lower than The application of information technology to the development and marketing of mutual funds should increase the number and variety of funds available “William Jackson, ‘ Money Market Mutual Funds, ” Congressional to consumers. Research Service Issue Brief No. 81057, Jan. 20, 1983. Ch. 3— The Securities Industry ● 91 would be expected in normal market circum- features that distinguish accounts are: how fre- stances. The institutional investor behaves dif- quently “sweeps” of free credit balances occur, ferently, for better or worse, because he makes whether a charge or debit card is issued for access, decisions differently, and this may have an impact the offering of excess insurance coverage; whether on securities markets. the account is accessible through an ATM network, and the availability of a bank overdraft line Central Asset Accounts of credit.17 The accounts have been targeted toward the upscale market, an estimated 10 to 12 The central asset account is considered by many percent of the population. A substantial minimum to be the single most important investment prod- opening deposit of securities or cash, usually of be- uct of the next decade. ’5 In developing the market- tween $15,000 and $20,000, is required and an an- leading Cash Management Account, Merrill Lynch nual fee is charged. recognized that the financial needs of a single cus- Merrill Lynch first offered the Cash Manage- tomer are interrelated and form well-defined types ment Account in 1977 and as market leader now of systems. The central asset account attempts has nearly 1 million accounts, The market growth to meet an investor’s full range of financial needs that central asset accounts experienced may have with three basic components: the securities margin been attributable in part to market conditions, account, the money market fund account, and a especially high interest rates. As conditions have zero-balance bank loan account that can be ac- changed, the growth of these accounts has de- cessed by check or card. A central asset account clined.l8 The significance of the account in the long provides a full range of financial services to its run is difficult to judge, although it seems likely user. The accounts offer a centralized method of that it will continue to serve the needs of a seg- controlling assets and, as free credit balances in ment of the market. One important feature of a the zero-balance account are “swept” into a money central asset account is that it allows brokers to market fund, both liquidity and return are maxi- fill more of their customers’ financial needs for mized for the investor. more of their personal financial lifecycle. 19 This Nearly all major securities firms offer a central makes the account a valuable tool for financial asset account. While they have the same basic service offerers, as it may help to attract and re- components, their features often differ. Among the tain customers. 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 In- “Joseph Diamond, “Central Asset Accounts Developed by the Secu- dustry, National Association of Securities Dealers, November 1982, rities Industries, ” Financial Services Institute Handbook, vol. 1, p. 358; p. 20 prepared for distribution at the Practicing Law Institute Financial Serv- “Herbert M Allison, Jr., “The Perspective of a Diversified Finan- ices Institute Program, Feb. 14-15, 1983. cial Services Company, ’ panel presentation at the Eighth Annual Con- “Alice Arvan, “Asset Accounts Reach Out for Broader Markets, ” ference of the Federal Home I.oan Bank of San Francisco, Strategic .4merican Banker, May 20, 1983, p. 9. [~lannjng for ~conomjc and Technological Change in the Financial Serl’- ‘William L. White, “The Outlook for Money Market Mutual Funds, ” ices Industr~,, San Francisco, Calif,, Dec. 9-10, 19/32, p, 157. a report to the Investment Company Institute, Sept. 30, 1982, p. 62,

Appendix 3B: Capital Formation and the Functions of the Securities Industry

The securities industry performs its functions firm, its size, management style, and financial his- of 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 pub- which 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 needed to purchase new shares are specified in the offering; however, the shareholder is assured that Seeking capital through private sources may of- he will be able to purchase new shares in propor- fer salient advantages for many corporations. Reg- tion to his current stake. ulatory requirements associated with public issues A privileged subscription may provide basic are avoided. This may save time and, more impor- marketing advantages to the issuing corporation tantly, the avoidance of disclosure requirements and therefore to the shareholders, even those who may be an advantage for many firms, particularly opt not to purchase additional shares. The tar- those in highly competitive industries. However, geted market for the offering is known to have an because the firm is only likely to approach a limited interest. Assumed knowledge of the corporation number of investors and because the assurances and the costs associated with the offering are usu- associated with a regulated public offering may ally lower than they would be for an offering to not be found in private financing, the firm may the general public. Often, flotation costs are half find it necessary to pay a higher rate of interest those of a public issue. From the point of view of or return on money obtained and may find that the the investor, margin requirements for a purchase creditor or holder of equity has a greater interest through a rights offering are generally lower than in the operations of the firm than investors in pub- in other circumstances. lic issues. The corporation may identify two major disadvantages with a rights offering. First, to attract Private Placements investors, the price per share may have to be lower than would be assigned in a public issue. As a A corporation may sell an entire issue of securi- lower total amount of capital may be raised by the ties directly to a single investor or small group of issue, earnings per share may be diluted. Second, investors. Such an action is referred to as a pri- the increased number of actual shareholders result- vate or direct placement and may involve either ing from a public offering may be desirable for the debt or equity issues, although more commonly, corporation. The greater the number of stockhold- debt instruments are involved. Private placement ers, the more likely that management will retain offers several advantages over a public offering for control of the operations of the company. 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 Venture Capital potential investor through a placement agent. The issue may also be more directly tailored both to Venture capital is money invested in new or the needs of the borrower and the investor in the small businesses by corporations or individuals terms outlined and in the timing of the issue. that are not directly involved in the management A potential disadvantage of this type of offer- of the business, although they may provide advice. ing may be mitigated by the application of infor- The investor is usually granted a large enough mation technology; that is, the location of suitable share of equity in the venture to exercise signifi- potential investors in a time frame that allows the cant control of the corporation and, in cases where capital seeker to plan the use of the funds with the venture is successful, to receive a significant some precision. Communications technologies may return. The equity is frequently issued in the form streamline brokerage private offerings. of letter stock, a private placement that cannot be resold until the issue is registered with the SEC, Privileged Subscription Basis which may be years later. Although it may be an extremely risky invest- An offering of stock only to existing stockhold- ment, individuals who are venture capitalists are ers is termed a privileged subscription, or rights, attracted for several reasons. Not only is the rate offering. In many cases equity holders are granted of return significantly higher, but as it is in the a preemptive right in the articles of incorporation form of capital gains rather than dividends, it is of the company that requires the firm to give cur- taxed at a lower rate. Organizations that provide rent shareholders the opportunity to maintain venture capital are part of many corporate fami- their “position,” that is, percent share of total lies, not only because of their primary goal of fi- ownership, any time a new issue is made. In this nancial returns but also because of other tangible situation each shareholder is issued one right for business benefits the venture capital relationship each share of stock owned. The number of rights can provide. Several investment banks have formed Ch 3— The Securities Industry ● 93

Table 3A-l.— Most Active Venture Capitalists, 1982 venture capitalists and the seekers of financing to . —. . locate one another. 1982 total An important source of venture capital for small investment 1981 Rank Name of firm (in millions) rank businesses are Small Business Investment Cor- porations (SBICs). These firms are licensed and 1. The Hillman Co. ., .. ., ...... 101.5 1 2. Allstate Insurance Co. regulated by the Small Business Administration Venture Capital Division ... . 64.2 9 under a program established by the Small Busi- 3. First Chicago Investment Corp. 48.5 2 ness Investment Act of 1958 to contribute to the 4. General Electric Venture Capital development of small businesses. SBICs are pri- Corp. (G. E. Corp.) ...... 41.6 27 5. Brentwood Associates ., ...... 35 10 vately owned and operated investment firms, but 6. E, M. Warburg Pincus & Co, . . . 33.9 12 are eligible to receive some Federal funding. Cap- 7. TA Associates (Tucker Anthony ital is developed in the form of equity or long-term & R. L. Day) ...... 32.3 4 loans. 8. Security Pacific Capital Corp. . . 32.25 8 These firms are an important part of the capital 9. Citicorp Venture Capital Ltd. . 30.5 3 10. BT Capital Corp. formation process for small businesses that might (Bankers Trust N.Y.)...... 26 45 be at a disadvantage in competing for venture cap- SO-URCE Venture June 1983 ital. Information technology may be expected to facilitate the development of financing between venture capital units in the hope of handling even- SBICs and businesses by making it easier for both tual public issues if the company experiences to identify potential investment arrangements. hoped-for growth. The desire to attract and retain customers is an incentive also for commercial Public Offerings of Securities banks and insurance companies. of a Corporation Some major corporations, particularly in the energy and electronics fields, have formed venture The decision by the management of a privately capital units because of interest in financial return held corporation to “go public” is based on their and the hope of gaining access to new ideas and objectives and strategies for the future of that technology that may be beneficial to the corpora- business. The desire to acquire capital, to in- tion. The need of established industrial giants to crease the liquidity of the original owners, and to maintain the pace of technological innovation may strengthen the balance sheet of the corporation encourage further entry into the venture capital must be weighed against the expense involved in market. such a move, the increased vulnerability of the cor- For a small or new corporation, venture capital- poration to general market conditions, and the ne- ists may provide a valuable source of financing. cessity that management take on additional re- Intermediaries in the securities industry provide sponsibility for the actions of the corporation and, assistance to this capital seeker. They help locate possibly, relinquish control of it. a potential investor whose objectives are in line There is no strict formula through which the de- with those of the organization in need of financ- cision to go public can be made. Going public may ing and assure that the financial arrangement de- involve a significant change in the structure and veloped is in the best interests of the firm in both operation of a firm, and this change must be as- the long and short runs. sessed in terms of the objectives of the owners and Venture capital has become more plentiful in the management of the company, The decision cannot past several years. Industry experts attribute this be assessed individually; it must be considered in to changes in Federal Government policies that re- light of other alternatives such as private funding duced capital gains tax in 1978 and 1981 and re- or additional investment by the owners, In eval- laxed pension trust fund investment rules in 1979. ’ uating the option of going public, several matters Information technology may have an impact on must be considered; these include business, ac- venture capital financing because it may facilitate counting, legal, and regulatory considerations. analysis of possible deals, New communication ca- Careful attention must be paid to the planning pabilities may also make it easier for prospective 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 ] (J S. (;eneral Accounting office, (;otw-nment-IndustrJ, Cooperation (’an Enhance The \renture (’apitaI Process, Report to Senator I,loyd to be considered by the corporation include tim- Bentsen, Joint k;conomic (’ornmittee, Aug 1 !.2, 1982, p. 4. ing 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 laws were enacted.2 It was cheaper and more reliability of the firm to attract an underwriter, if able than the communications technologies of the needed; and the ability and desire of the corpora- day, notably telephone and radio, and was easier tion to adhere to disclosure requirements. Infor- to use. mation technology may ease these problems by Paper was never intended to be a sacred medium aiding in the analysis of decision factors and pos- for conveying information about securities offer- sibly by shortening the issue process and there- ings. Its use was specified because it was the most fore the disruption of business. practical choice. The vast improvement in quality Federal laws governing public offerings by cor- and cost of information technology has turned the porations or organizations require the disclosure table on the comparative effectiveness of paper of information on which investment decisions can and communications media. Recognition of this be based. A prospectus is information provided to change is causing a reexamination of the process potential investors in a new securities issue that of filing new offerings with the SEC. describes the current condition and history of the The SEC is trying to make the volumes of in- issuing firm. It attempts to provide information formation it receives easier to manage and use by on which a decision to invest can be made but does applying information technology to its information not contain any type of objective judgment on the gathering and dissemination process. Some ex- advisability of investing in the described issue. perts advocate the eventual movement toward Information technology may affect public offer- paperless filing and information dissemination. ings by corporations in several ways. First, the Potentially, a system based on information tech- essential requirement of Federal securities laws is nology could result in faster dissemination of in- the provision of information to potential investors. formation and more efficient review and storage It is quite likely that the application of informa- processes. tion technology for disseminating information will radically change the physical activity of going public. Paper was the logical medium through which Lee B. Spencer, Jr., “The Electric Library, ” Remarks to the American information could be transmitted in the 1930’s, Bar Association, Federal Regulation of Securities Committee, Nov. 19, when many of the currently applicable securities 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 ...... 127 Credit Authorization ...... 127 Providers of Information Services ...... 127

Home Information Systems ...... 128 Technology of Home Information Services ...... 129 Developers of Home Information Systems...... 129 Costs of Home Information Systems ...... 131 The Market for Home Information Systems ...... 131 Implications of Home Information Systems ...... 131

Tables Table No. Page 3. Comparison of Depository Instruments and Accounts ...... 100 4.Nationwide ACH Volume ...... 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 Historically, deposit-taking has been viewed of those organizations (e.g., banks, credit as a special activity in the economy, and de- unions, insurance companies, consumer fi- pository institutions have been viewed as oc- nance companies) that deliver products to end- cupying a unique place in the industry. Depos- users. * Consumers comprise the largest and itors place a very high degree of trust in the most visible single group of end-users of finan- institutions holding their funds. At the same cial services, but business and government time, because depository institutions play both have roles as customers for retail finan- such an important role of intermediation be- cial services. Included among retail financial tween sources of funds and those having need products are depository accounts, extensions of them, they are in a position to exert a meas- of credit, and payment services.** ure of control over virtually all other economic activities. According to 1982 figures, the industry en- compasses more than 90,000 business entities, Retail financial services, especially those of- including 15,000 commercial banks, 4,000 fered by banks, have been heavily regulated savings and loan associations, 1,000 mutual by both State and Federal Governments. savings banks, 22,000 credit unions, 1,000 in- Rates paid on deposits have been largely de- vestment banks, 5,000 broker/dealers, 1,000 regulated, but limits on the rates charged on mutual funds, 1,000 mortgage banks, 3,000 consumer loans remain in force. Depository in- pension funds and pension fund managers stitutions are generally limited to offering (other than banks and insurers), 2,000 life and prescribed products to predefined markets. health insurance companies, 3,000 property Banks, for example, are limited with regard and casualty insurance companies, and more to the geographic area served, while credit than 33,000 insurance brokerage agencies, as unions are limited to serving only groups well as numerous factoring companies,*** whose members share a common bond, such leasing companies, credit card or traveler’s as employment with a specific firm. Generally, check issuers, and finance companies. In 1980, bank holding companies are not permitted to the financial service industry (excluding real enter lines of commerce not closely associated estate) contributed $100.4 billion, or 5 percent, with banking. Depository institutions are ex- to the U.S. national income.1 amined to ensure that they are pursuing business in a manner consistent with preserving *For the purposes of this assessment, wholesale financial serv- institutional safety and soundness, and many ices, as contrasted to retail, are those provided by one finan- of their business decisions (e.g., effecting cial institution to another in a way that is largely invisible to the end-user. mergers, opening branches, offering new prod- **Customers of securities brokers are also users of retail fi- ucts) are reviewed by regulators prior to im- nancial services. However, because the security industry is plementation. governed by a body of policy unique to it that separates it from retail banking and other retail financial services, it is treated Depository institutions enjoy some unique in ch. 3 of this report. ***Factoring is the process of selling accounts receivable to benefits in exchange for heavy regulations. a third party, who then assumes the risk and costs of servic- Only they can take deposits and offer accounts ing them. that are federally insured. Depository institu- ‘State of New York, Report of the Executi\e Adtisor}. Comm- ission on Insurance lndustr?’ Regulator?’ Reform, May 6, tions are unique in having access to the vari- 1982, p. 101. ous systems used to transfer funds.

97 98 • Effects of Information Technology on Financial Services Systems

Today, insurance companies, providers of entrants who rely heavily on advanced tech- services such as credit cards and traveler’s nologies to implement their offerings gener- checks, consumer finance companies, dry ally fall outside the boundaries of existing reg- goods merchants, investment companies, and ulation. food retailers also provide retail financial services. Some, such as insurance companies, are The financial service industry is becoming regulated, while others, such as providers of homogenized to a significant degree, and dif- traveler’s checks, are virtually unregulated. ferentiation between products has become less All, to an ever-increasing degree, are broaden- apparent, particularly from the point of view ing their range of business activities and, to of individual consumers. Commercial banks some extent, are encroaching on areas pre- and savings and loan associations are now per- viously served by others, including those here- mitted to serve many of the same clientele. For tofore exclusively reserved to depository in- example, recent legislation gave savings and stitutions. loan associations the power to make some commercial loans, a product that could not Information processing and telecommunica- previously be offered. While securities broker/ tion technologies have contributed to the dealers are not permitted to offer depository broadening of product lines by providers of accounts, they do offer shares in money mar- retail financial services. New entrants have ket funds that have properties very similar to been able to develop and offer products that deposits. Insurance companies offer universal compete directly with those previously avail- life policies that share many properties with able only from depository institutions. Dis- self-directed investment accounts offered by tance and location have lost much of their sig- others. nificance as factors limiting the market served by a service provider. In addition, by using the VISA and MasterCard are the two principal technologies, new classes of products have bank card products offered nationwide. How- been developed. Foremost among these are ever, in addition to being offered by banks, those that deliver financial services to remote these are now issued by such varied organi- locations, such as the home, office, merchant’s zations as the American Automobile Associa- counter and unstaffed branches. Others, such tion and various brokerage houses that offer as services to facilitate collection and invest- them in conjunction with asset management ment of cash, are directed to the business com- accounts. Travel and entertainment cards can munit y. be used with automated teller machines (ATMs) to obtain either cash or traveler’s As noted, law and regulation are significant checks. In some cases, a plastic card is used forces shaping the financial service industry to access a depository account (e.g., checking). and guiding its day-to-day operations. The ex- Plastic cards can also be used to draw on a line isting legal regulatory structure dates largely of credit either to pay for a purchase or to ob- from the 1930’s and is built on the assump- tain a cash advance. The same card can be tion that specific types of institutions will be used for both purposes. However, the finance the only ones offering each type of service. For charges are assessed differently for the cash example, transaction accounts are assumed to advance and the credit purchase. be offered only by banks; and thrift institutions are assumed to focus their lending activ- One of the major developments of the 1980’s ities on home mortgages. Thus, even though has been the development and deployment of the intent was to regulate by function, the networks of ATMs. Some of these accept only focus of legislation has been on the institutions the card of one institution, while others per- rather than on the products they offer. As a mit access to accounts held in any one of a result, the offering of new products by unreg- number of institutions. Most of these net- ulated providers is often found to lie outside works are offered by depository institutions the existing legal/regulatory structure. New or consortia of depository institutions. How- Ch. 4—Retail Financial Services ● 99 ——— ————. .— ever, retail dry goods merchants, supermarket straints and therefore come to the market with chain operators, and operators of convenience varying strengths and weaknesses. Others, by stores are now establishing networks and of- way of contrast, seek to serve specific groups, fering financial institutions the opportunity such as members of the professions with prod- to access them. ucts tailored to their particular needs. The market appears ready to support service pro- More generally, telecommunication has been viders across the full spectrum of possible a major factor in the development of financial product menus. products in the 1980’s. Providing remote banking services has been a key area in the Fluidity in the structure of the financial ser- development of financial services. Publishing vice industry limits the utility of any descrip- companies are combining with financial serv- tion that focuses on the institutions that com- ice providers and communication companies prise it. A list of providers would almost to deliver financial services directly to the certainly omit some and include others that homes of consumers. Grocery chains are es- arguably could have been omitted. Because tablishing networks of ATMs that compete product lines of various classes of providers directly with those offered by banks. Banks of financial services are close substitutes for offer cash management services to business, one another, descriptions of each of the classes enabling corporate cash managers to control of providers would become redundant. funds on deposit with institutions worldwide and to manage them to the best advantage of Therefore, the approach taken to describing their employers. the retail financial service industry in this assessment is to focus on the functions per- Other developments of the 1980’s have been formed for the customers and then to relate the emergence of the financial supermarket those functions by way of example to the or- and the specialized supplier of financial serv- ganizations that provide them. The classes ices. Several organizations have used differ- of functions described are treated under the ing strategies to develop into horizontally in- headings: tegrated suppliers of financial services. The remarkable point is that some find their roots deposit/withdrawal function, in insurance, others in retailing, and yet others extension of credit, in banking. Under the existing 1egal/regula- electronic funds transfer, and tory structure, all operate within differing con- financial information services.

Deposit Function

Technically, the function of accepting depos- lowing methods: in person, by mail or tape, or its is strictly limited to depository institutions. electronically via ATM or other remote ter- Simply defined, a deposit is a placement of minal or by the Automated Clearing House cash, checks, or drafts with a financial insti- (ACH).* In paper-based systems, access to de- tution for credit to a customer’s account. De- posits depends on the physical transfer of posits become a liability to the financial insti- documents such as a check or draft.** How- tution since they represent an obligation to ever, electronic technologies have helped rev- repay funds. The deposit function is the tradi- olutionize this function. tional banking process by which funds are accepted for credit to a demand, savings, or time *The ACH is a computerized facility that helps clear funds transactions among participating institutions electronically. account. Deposits are accounts for holding * *Draft— A n order written on the funds of a third party to funds. The deposit is made by one of the fol- transfer the amount specified to the payee. 100 ● Effects of Information Technology on Financial Services Systems

In essence, a deposit differs from an invest- honored immediately. There may also be no ment in that the depositor expects to be able guarantee that shares will be redeemed at the to recover the amount deposited, often with price originally paid by the investor. However, some interest, with virtually no risk of loss. as long as institutions continue the practice The depository institution holds itself ready of operating near-deposit products in a man- to pay the amount of the deposit under con- ner that closely approximates the operation ditions that are consistent with the contract of a true deposit account, the customers will under which it was taken. In the case of a de- see the former as being a close substitute for mand deposit, for example, the depository in- the latter. stitution stands ready to pay on demand. On In this environment, not all of those offer- the other hand, if the owner of a certificate of ing deposit or near-deposit products operate deposit withdraws the funds prior to maturity, under the same set of rules. This variation in- a significant penalty is extracted that, in some troduces new elements into the calculus used cases, involves loss of principal as well as in- by those responsible for the safety and sound- terest. ness of the financial service industry and the In the present environment, firms other formulation and execution of fiscal and mone- than depository institutions offer products tary policy. In the sections that follow, the that are operationally similar to a deposit from various types of deposit-like products and the customer’s point of view. For example, associated deposit-taking services are de- securities broker/dealers and investment com- scribed. panies offer shares in money market mutual Table 3 presents a comparison of the vari- funds that include the option of redemption ous depository instruments and accounts dis- by means of a draft written against the in- cussed in more detail below. vestor’s holding. A whole-life insurance policy accumulates cash value that is available to the owner. Direct Deposit Some will tend to view these products as de- Direct deposit is most often used to effect posits because, operationally, the funds are payment from either private or public organi- available virtually on demand. The expecta- zations to recipients of salaries, pensions, and tion is that payment will be made by the pro- entitlements. It is actually a preauthorized vider even though there may be contractual credit arrangement between the party issuing provisions that an order to pay need not be 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

bNot available to commercial businesses N/A–Not applicable SOURCE Office of Technology Assessment Ch. 4—Retail Financial Services ● 101 —.. used for recurring payments. One of the Table 4.—Nationwide ACH Volume largest users of direct deposit is the U.S. De- — Government - partment of the Treasury, for Social Security Year Private (Social Security) payments. It is also widely used for mili- 1976 ...... 4,283,770 46,646,999 tary payroll and other regular Government 1977 ...... 10,344,192 69,694,741 payments. 1978 ...... 18,612,263 93,207,073 1979 ...... 331324,163 123,353,594 Figure 6 shows the increasing rate at which 1980 ...... , . . 63,362,597 144,112,204 Social Security recipients have been willing to 1981 ...... 117,019,927 164,157,190 1982 ...... 174,613,862 —-. 176,821,896 accept payment by direct deposit. In 1978, SOURCE National Clearing House Association only 11 percent were willing to make use of direct deposit; but this proportion had grown is expected that use of the ACH will increase to 33 percent by 1982. The Department of the once a critical volume has been achieved by Treasury hopes for further increases. the flows to and from large organizations. As this occurs, users with smaller volumes of Direct deposit transactions started as paper payments should gradually be absorbed into transactions, but the rising volume of such the system. payments has encouraged the use of the ACH network and systems, which depend heavily on the interchange of magnetic tape (see table Point-of-Sale Systems 4). The process involves coding payment in- Point-of-sale (POS) systems, discussed in formation in machine-readable form and mov- detail later in this chapter, also function as a ing it between banks on computer tapes or, in deposit-taking method. In some cases, retail some cases, over telephone lines. The paying clerks will accept funds for deposit to custom- bank or organization consolidates all its ers’ accounts. In others, the financial institu- payments for a certain date and submits them tion will operate a station or counter in the on magnetic tape through the ACH. The ACH retail store at which deposits are accepted. A then routes the payment information to each third alternative is the placement of an ATM receiving bank. The tape can be sent in ad- at the retail store location. The ultimate goal vance with the information predated. For ex- of POS implementation in the financial serv- ample, stock dividend checks could be proc- ice industry is to institute an electronic processed through the ACH for direct deposit. It ess through which transactions may be instantaneously debited/credited. Figure 6.— Penetration of Direct Deposit Social Security Payments Lockbox Operations

~ 500 In lockbox operations, payments go directly 250/o 280/o 330/0 UY 400 to a post office box that is controlled by the c 11 0/0 o payee’s financial institution. The services pro- .-= - vided include picking up the mail at the post E 300 m .-c office, opening it and crediting the funds, or UI receiving the opened letters and crediting the z 200 funds to the company’s account. A fee is im- E $ posed for each function the financial institu- Q 100 tion performs for the company.

0 1 Lockbox operations are used to speed the 1978 1979 1980 1981 1982 collection of remittances and reduce “float”* Direct deposit *An amount of money represented at any one time by checks outstanding and in the process of collection. The period of time 1’-] Checks between receipt of notification of payment by the creditor and SOURCE Economic Review Federal Reserve Bank of Atlanta, August 1983 p 33 the actual debiting of the consumer’s account. 102 ● Effects of Information Technology on Financial Services Systems —.-— - .-— — ——.——— — by eliminating the time required to transfer eral other types of accounts use a check to ac- payment from a company to the financial in- cess funds, these accounts are not considered stitution. Interestingly, lockbox operations are demand deposit accounts. offered by other institutions, also. For example, in July 1983, Sears Roebuck & Co. an- Drafts nounced that it would provide retail lockbox processing for Pittsburgh’s Mellon Bank in Drafts are essentially an expanded collection seven cities across the country. With its na- service, with funds being transferred when the tional presence, Sears is in a unique position payer orders the bank to pay the draft. They to offer such services. This arrangement will are used by credit unions, which technically not only reduce float for the bank’s corporate classify their transactions as purchases of customers but also decrease processing costs, shares in equity accounts and money market since a larger number of the checks received funds. Credit unions began to offer share draft could be processed locally and not as inter- accounts as a competitive tool against the regional items through the Federal Reserve checking accounts offered by banks. The draft Board’s check processing system. As noted in itself is debited against the individual’s ac- American Banker, “Interstate banking restric- count. Although to the consumer, a draft looks tions have prevented banks from opening of- and works much the same way as a check, it fices around the country to accept deposits, differs in two ways: 1) it may have a specified and thus most banks have operated lockboxes time constraint and can be drawn on an in- only within their own State. Lately, however, dividual, corporation, or bank; and 2) the in- a number of banks have begun to expand their itiative for payment of goods is taken by the geographic coverage through joint marketing seller, not the buyer. arrangements and correspondent relation- The three types of drafts are: 1) sight–pay- ships. ‘‘2 able immediately on presentation; 2) arrival— payable on arrival of goods; and 3) time— Demand Deposit Accounts payable at a fixed date. There is a consider- For users of demand deposit accounts, in- able amount of float associated with checks/ stitutions make funds explicitly available to drafts because funds need not be in the bank the user without any optional or contractual on which the item is drawn until the day the delay. Demand deposits represent a significant check/draft reaches the bank and is presented portion of the domestic money supply. As of for collection. Float in this case can work to December 31, 1981, demand deposits for all the advantage of the depositor in that funds commercial banks totaled $370 billion.3 A also do not sit idle. The company can trans- checking account is a demand deposit account. fer the amount needed to cover the check/ The check is the instrument that activates the draft, leaving the balance in higher yielding checking account and is the end-product of the investments. original written instructions used by an indi- Although presently a heavily paper-based vidual to make a payment from a credit bal- instrument, drafts are being converted into a ance. A written check is deposited into an ac- form of electronic billing service whereby ven- count (the collecting bank) by the creditor, dors can collect from customers by sending an wherein it circulates within the banking sys- electronic debit (draft) to their account. tem as an instrument to debit the account of the debtor at his bank (the paying bank). Giro Transfers By law, demand deposits do not yield interest for the account holder. Although sev- While checks are a way to effect a debit transfer, the giro, which is an instrument not ‘American Banker, July 29, 1983. used in the United States, is a way of making 3Federal Reserve Statistical Release, April 1983. a credit transfer. To effect a giro payment, the Ch. 4—Retail Financial Services ● 103 . . . — person making the payment instructs the in- ing the accumulation of funds sufficient for stitution holding his funds to transfer them supporting higher denomination and higher to the account of the payee in the name of yielding investments. They are also frequently another institution. This is in contrast to a used to establish and maintain a relationship check given to the creditor that is finally pre- with an institution for the purpose of even- sented at the debtor’s bank for payment. Giro tually using other services, such as loans and organizations usually send a statement to each check cashing. account holder every day on which transac- Savings accounts take the following forms: tions are recorded; this is expensive in postal costs. “The notable feature is that the aver- 1. Conventional savings accounts. Conven- age value of paper giro transfers is higher than tional savings accounts offered by depos- the average value of check payments in all itory institutions are designed primarily countries except the United Kingdom.”4 for individuals. Savings accounts may be issued in passbook or statement form and Traveler’s Checks involve the institution’s periodic issuance of summaries of deposits and withdraw- Another form of a deposit transaction is the als. Savings deposits do not have matur- traveler’s check. The traveler’s check is “paid ity dates, but a hold may be required for” in advance by the purchaser, generally before withdrawal-most often on depos- with a premium of 1 percent of the value. It its made by check, but possibly on cash is considered a deposit because the funds are deposits, also. This is rarely, if ever, im- held by the issuing company until the travel- posed, and for the most part, individuals er’s check is redeemed by the purchaser. This regard these accounts as being very liq- instrument works and is accepted, for the uid. As defined by the Federal Reserve, most part, like cash. It can be a universally a savings account from which more than accepted payment mechanism and is consid- three telephonic or preauthorized trans- ered a deposit instrument. fers are permitted per month is considered a transaction account, with the specific Savings Accounts exception of the money market deposit account. A savings account is an interest-bearing ac- Savings accounts presently have a reg- count used to accumulate and safekeep funds. ulated interest rate set by Federal author- Institutions retain the optional right to require ities and governed by the Depository written notice of an intended withdrawal, Institutions Deregulation Committee often not less than 14 days before withdrawal (DIDC). Until these ceilings are finally is made. phased out (scheduled for 1986), the ceil- Despite the notice requirement, a savings ing is imposed on interest rates for fed- account is in practice extremely liquid. Until erally insured banks and thrift institu- recently, most people used their savings actions. Effective January 1, 1984, the count as a long-term savings/investment vehi- differential interest rates on passbook cle, even though several alternatives offered savings accounts and 7- to 3 l-day depos- higher explicit interest. However, new options its under $2,500 at both thrifts and com- available have made the consumer more con- mercial banks were removed, with each cerned with earning explicit interest on his having a ceiling of 5% percent. money. As a result, savings accounts are be- Federal deposit insurance of up to ing increasingly used only as short-term repos- $100,000 per account holder is provided itories or as interim investment vehicles dur- in all but a very few depository institutions. The Federal Deposit Insurance Cor- 4 Jack Revel], Banking& EFT—A Study of the Implications, poration (FDIC) insures accounts in com- p. 143. mercial banks chartered by both the

35-505 0 - 84 - 8 : QL 3 104 •——- Effects — of Information Technology on Financial Services Systems

Federal and State Governments and in on deposits at federally insured commer- mutual savings banks. The Federal Sav- cial banks, savings and loan associations, ings and Loan Insurance Corporation in- and mutual savings banks to the DIDC, sures accounts in federally chartered sav- whose members are the Secretary of the ings and loan associations and savings Treasury; the Chairman of the Federal Re banks. The Credit Union National Admin- serve Board; representatives of FDIC, the istration (CUNA) insures accounts held in Federal Home Loan Bank Board, and federally chartered credit unions. In ad- CUNA; and the Comptroller of the Cur- dition, some States have insurance pro- rency, a nonvoting member. The law programs to cover deposits in State-char- vides for a 6-year phase-out of ceilings on tered institutions, such as savings and deposit rates, during which the commit- loan associations, that are not eligible for tee has the discretion to set ceiling rates Federal deposit insurance. on deposits based on economic conditions. Credit unions provide savings services (The committee has been given a schedule as well, including savings accounts (which for targeting the gradual phase-out of are insured up to $100,000 per member by such ceilings. ) During the transition CUNA, investment certificates, money period, credit unions are subject to sepa- market certificates, share savings ac- rate regulations. In 1986, all Regulation counts, and individual retirement ac- Q authority expires, CUNA’s authority counts. to set interest rate ceilings for credit un- 2. Time deposits. The owner of a time de- ions terminates, and the DIDC ceases to posit accepts limitations on his withdraw- exist. al rights. The account is established with Under DIDMCA, the committee has the idea that the funds are on deposit for eliminated (effective Oct. 1, 1983) all in- a negotiated period of time in return for terest rate ceilings on (a) all time depos- receiving an offered interest rate. Certif- its with original maturities or required icates of deposit (CDs) are interest-bear- notice periods of more than 31 days; and ing time deposit instruments issued by a (b) time deposits of $2,500 or more, with depository institution for amounts that original maturities or required notice peri- can vary from as little as $100 up to more ods of 7 to 31 days. Also, the committee than $100,000. CDs pay interest at matur- has eliminated other regulations on time ity and cannot be withdrawn from the deposits except for the minimum early bank without penalty prior to their withdrawal penalties; a minimum de- maturity date. The most commonly of- nomination of $2,500 for ceiling-free time fered maturities are 91 days, 180 days, deposits with original maturities or re- and 1 year. Although most CD rates are quired notice periods of 7 to 31 days; cur- tied to Treasury bills and longer term rent ceiling on time deposits of less than Treasury securities, some of the funds do $2,500, with original maturities or re- receive an unregulated market rate of in- quired notice periods of 7 to 31 days; and terest. Large CDs are typically issued in agency rules that require a l-percentage- negotiable form, so they may be traded point differential between a loan rate and in an organized market. the rate on a time deposit securing a loan. The Depository Institutions Deregula- DIDC also established new minimum tion and Monetary Control Act of 1980 early withdrawal penalties: for time de- (DIDMCA) was enacted to provide for the posits with original maturities or required orderly phase-out and the ultimate elim- notice periods of 32 days to 1 year, loss ination of ceilings on the maximum rates of 1 month’s simple interest; for time de- of interest and dividends that maybe paid posits with original maturities or required on deposit accounts. The act transferred notice periods of more than 1 year, loss the authority to set interest rate ceilings of 3 months’ simple interest. Ch. 4—Retail Financial Services ● 105 —————- ———..——

These changes helped reduce the com- the offering institution can impose a hold petitive edge previously enjoyed by non- before honoring the withdrawal, although depositor institutions against depository it is a restriction unlikely to be enforced. institutions because a large number of fi- Individuals regard these accounts as rath- nancial services being offered by the non- er liquid, and most are probably unaware depositor institutions were attractive, of the restrictions that can be enforced. offered higher interest rate return, and The NOW account does not legally re- were not subject to regulation. Funds quire a minimum to open the account, al- placed outside of the depository institu- though most institutions require a mini- tions are not federally insured; however, mum balance of $500. the individual appears to be more con- The Super NOW account is primarily cerned with return on investment than a combination of the NOW account and the risk associated with placing funds out- the money market deposit account. The side of federally insured depository insti- Super NOW, which DIDC authorized as tutions. a financial instrument as of January 1983, 3. Money market deposit account. The requires a minimum initial deposit of money market deposit account, a high- $2,500 and an average balance in any yielding liquid account, was authorized by month of $2,500. The account has no in- the Garn-St Germain Depository Institu- terest rate ceiling, although the funds re- tions Act of 1982 to allow commercial vert to a conventional savings account banks and thrift institutions to compete yielding the regulated interest z-ate under with money market mutual funds. The ac- Regulation Q if the account falls below count is available to all depositors, in- the minimum balance. Additionally, a 7- cluding businesses. It requires an initial day notice of withdrawal maybe required. balance of at least $2,500 and has no in- Because the notice of withdrawal require- terest rate ceiling. A ‘7-day hold on with- ment applies to such funds, they are cate- drawal can be imposed by the depository gorized not as demand deposits, but as institution. Additionally, the money mar- savings deposits. These accounts are not ket account allows for up to six third- available to for-profit businesses. They party transfers, including up to three by are available to Federal, State, and local draft and up to three preauthorized trans- governments, as well as to nonprofit orga- fers per month. There are no restrictions nizations and individuals. on making withdrawals from the account in person, by messenger or mail, or by 5. Savings bonds. Savings bonds are sold by ATM. The funds are federally insured. If the U.S. Government to generate revenue. the minimum balance falls below $2,500, They are issued at a discount and appre- the interest on the funds reverts to the ciate at a rising rate in specified increments to a stated value at maturity. statement/passbook rate and remains at that rate until the balance is brought up Bonds may be redeemed before maturity, to $2,500. Unlike some restrictions im- but the interest rate becomes higher the posed by the money market funds, there longer the bond is held. is no minimum on the size of an account 6. Savings certificates. Tailored to the needs withdrawals or deposits. of individuals in terms of deposit time 4 Negotiable order of withdrawal (NOW) (generally 90 days, 5 years, 10 years), sav- and Super NOW account. NOW and ings certificates have interest rates that Super NOW accounts are unique savings are dependent on maturity time and cur- instruments because they are interest- rent rates. Savings certificates are not earning transaction accounts. Although negotiable and are issued by depository they can be accessed by a check, they are institutions for $100 up to $100,000. not considered demand accounts because There is a penalty for early withdrawal. 106 . Effects of Information Technology on Financial Services Systems ——— — —.——.....——

The latest figures’ indicate deposits, as of ily by the desire for family financial protection October 1983, in various savings instruments: in the event of death; and third, it is ordinarily expected to be left intact until the death of the Super NOW accounts: $27 billion insured rather than withdrawn for some con- NOW accounts: $100 billion sumer expenditure. money market deposit accounts: $369 billion Insurance policies exist in almost every money market funds: $138 billion* household. They take such forms as automobile insurance, property insurance, and health Insurance insurance. Such a strong presence permits the industry to introduce and market new finan- In today’s competitive environment, com- cial products and services with relative ease. mercial banks, savings and loan associations, Insurance companies now offer several prod- and savings banks not only vie with one ucts that are treated like deposits. Two new another to attract new deposits, but also com- products introduced into the market in 1983 pete with many nondepository organizations. are quite interesting—one works like a cash One of the largest providers of financial serv- management plan for businesses under $10 ices is the insurance industry. It has a sizable million; the other works as a securities and customer base (insurance products are used in cash management service. These accounts almost every household or business) and is a feature money market funds, checking ac- major lender of funds to businesses. The in- counts with unlimited access, lines of credit, surance industry has access to an enormous an overdraft, and a Gold MasterCard, which amount of capital. Insurance companies are does not carry a line of credit. The customers’ enormous financial intermediaries in that they money market accounts are debited each collect and invest vast amounts of premiums month to cover card charges. The checking on policies. Life insurance companies collect and charge card operations are handled by a premiums from policyholders, invest the re- local bank for the insurance company. The in- ceipts until needed, pay death benefits to heirs vestment accounts are offered in conjunction of those who die, and make payments to those with an investment firm. Both products re- who redeem policies and/or take out loans quire a minimum of $10,000, and customers against their cash value. are penalized whenever their monthly average Insurance companies channel funds into va- drops below $5,000 for 2 consecutive months. rious investment outlets and qualify as signif- Another instrument of the insurance indus- icant allocators of financial resources in the try is universal life insurance, which is an in- economy. Their investments are made in vestment vehicle. It functions like a deposi- almost every sector of the capital market and tory instrument and is a flexible investment in a wide array of investment outlets. Their vehicle with access to mutual funds. It offers investment decisions are based on a philoso- the policyholder flexibility because the cash phy of maximizing their rate of return within value buildup or funding phase—-which makes the bounds of State investment laws and on it appear to be a savings instrument-and the the principle of safeguarding the security of pure life insurance phase of the traditional the funds invested. whole-life insurance policy are separated. A Life insurance saving differs fundamentally company can declare competitive interest from saving through deposit-type institutions rates on the funding phase, and the policyhold- for at least three reasons: first, it is long-term er can vary the amount and frequency of pre- and contractual in nature and is therefore mium payments and the amount of death more stable; second, it is motivated primar- benefits. —— —.— Whole life insurance provides a constant ‘Federal Reserve Statistical Release, Dec. 16, 1983. amount of insurance for the same premium *These funds are not federally insured. over a lifetime. It is payable to a beneficiary Ch, 4—Retail Financial Services • 107 ——..—— ——— at the death of the policyholder, and premiums business themselves. Many large networks are are payable for a specified number of years or being developed that enable the agent to ob- a lifetime. A policyholder is entitled to the cash tain pertinent information online as well as value if he cancels the policy. Since the poli- directly relay information to the carrier. cyholder may borrow from the insurance com- Technology is used to support other serv- pany against the cash value of the policy, pol- ices of the insurance industry as well. Claims icy reserves may be viewed equally as a legal services, for example, are now becoming auto- liability of the insurance company and as an mated. The claims process, which is heavily investment of the policyholder. Life insurance paper-based, is being handled by converting companies make loans against the cash value the information electronically and transmit- of whole-life insurance policies. These accounts ting it online to the carrier, allowing the car- play a significant role in the insurance com- rier to deal with the claim more effectively and panies’ lending ability. The policyholder has to maintain more control over the settlement the right to borrow from the insurance com- process. pany any amount up to the cash value, at a specified rate of interest. Moreover, earnings The automation of risk management serv- on insurance are partially tax-exempt. ices for large corporations allows them to handle in-house insurance analysis. These com- Just as insurers will increasingly compete panies are able to tie into networks that in the provision of financial services, other provide important and timely information financial service providers will increasingly used to assess and manage risk. compete with insurers in the provision of insurance. The unbundling of insurance products has revealed that there are significant Accounts With Other functions in the operation of insurance that Nondepository Institutions involve the performance of noninsurance Insurance companies, large retailers, and services. virtually every kind of financial service orga- The insurance industry is in a position to ex- nization offer individual retirement accounts pand its service offerings to include a myriad (IRAs), money market funds, and a myriad of of financial products. This is possible for sev- investment services. Although the funds in- eral reasons. As discussed, some insurance vested by individuals into nondepository insti- products being offered resemble existing prod- tutions are not federally insured, this fact has ucts being offered by depository institutions. not prevented individuals from investing in Also, modifying software for existing systems these instruments. The amount of money that enables the company to create new products has shifted from depository institutions into and services. For example, insurance com- nondepository institutions has been signifi- panies could easily offer a money market fund cant. Previously, these types of institutions and additional services that can be imple- were very different from each other. When the mented with relative ease and minimal capital. concept of commercial banking was first con- ceived, commercial bankers made little or no The insurance industry is adapting automa- effort to attract individual deposits, concen- tion in many ways. Insurance agents, for ex- trating primarily on attracting demand depos- ample, are internally incorporating automa- its from businesses. Conversely, the savings tion to manage office functions, such as client banks and savings and loan organizations information and accounts receivable and pay- were not authorized to offer checking ac- able. They are applying automation to increase counts, and their range of time and savings efficiency and to improve marketing. Exter- deposits was limited. nally, communication and information technologies are used to tie into carriers where they Today, that has changed drastically. Com- are able to obtain quotes and to underwrite mercial banks fiercely compete with other de- 108 ● Effects of Information Technology on Financial Services Systems pository institutions, insurance companies, payouts on their liabilities and reduced cus- and brokerage houses/investment firms for tomer earnings on short-term asset holdings consumer deposits. All of these organizations in depository institutions. Since depository in- offer accounts that can serve the customer in stitutions could not compete on interest rates, similar ways. However, the range of services they competed on the basis of services, which available to the customer are not as markedly were actually subsidized by the spread be- different from the customer’s point of view as tween interest paid on money in savings and the products seem from the point of view of received on money loaned. The spread resulted regulators or the providers themselves. An in- from below-market rates paid because of the dividual can easily establish an IRA or Keogh regulatory environment. This is changing. (retirement) account, obtain a loan, and use a Zero-balance accounts are becoming wide- checking or checklike account or savings ac- spread. Financial service providers have come count from any depository institution. He/she to rely more heavily on fee income from can obtain similar instruments from nondepos- services. itor institutions such as insurance com- Large financial service providers have the panies, retailers, and investment firms with privilege of offering several types of financial cash management accounts. products. For example, the use of information Prior to the introduction of money market technologies enables firms such as American deposit accounts and Super NOW accounts, Express, which owns Fireman’s Fund Ameri- depository institutions were restricted as to can Life Insurance Co., to market additional the maximum interest payable on demand de- services directly to their strong credit card posit accounts and savings accounts, with the base. They can offer insurance services and exception of jumbo CDs and similar instru- have the premiums be added directly to the ments. These restrictions helped reduce bank American Express card account.

Extension of Credit

One of the principal functions of the finan- regulation of the rates paid on deposits has cial service industry is intermediation between been to narrow this differential and cause fi- holders of assets and those in need of funds. nancial service providers to look elsewhere for Funds are gathered through the deposit-tak- revenue. They have turned to information ing activities described in the preceding sec- processing and telecommunication technol- tion. Extending credit, described in the follow- ogies to improve the efficiency of their inter- ing pages, is one of the mechanisms used to nal operations and as the foundation on which make funds available to those requiring new revenue-generating products can be built. them. * One of the most promising opportunities for cost saving is converting as many paper- Historically, credit extension has been one based transactions as possible to electronic of the principal sources of revenue for the fi- processes. nancial service industry. The rate differential between that paid on deposits and that Interest rate fluctuations, such as those ex- charged on loans was sufficiently great to sup- perienced over the past several years, have port many of the services offered by financial made the problem of portfolio management institutions. However, one of the effects of de- more difficult for financial service providers. .—— *FundS are ~so made available by investors who take an Some found themselves faced with the prob- equity position in the organization requiring funds. Equity in- lem of supporting long-term, fixed-rate loan struments and the markets for them are described in ch. 3. portfolios with short-term, expensive depos- Ch. 4—Retail Financial Services ● 109 — -. its and few options for correcting the im- out the technologies. Paper is truncated early balance. Congress increased the powers of sav- in the processing cycle as one factor in con- ings and loan associations to help them trolling costs of processing and to facilitate overcome this problem. the timely posting of transactions to customers’ accounts. Some merchants submit trans- One of the responses of the financial serv- action data electronically to card issuers to fa- ice industry to the disappearance of the in- cilitate processing. terest spread has been to encourage individuals and businesses to view all of their liabilities Credit has long been a tool of the retail in- and assets as a total package and to manage dustry. Card bases have been created on the them as such. The goal of some institutions assumption that they help create and main- is to place themselves in the role of financial tain customer loyalty and facilitate impulse advisor to their customers. On the one hand, purchases. Advertisements are regularly in- these institutions would like to generate rev- cluded with customer bills. While most retail- enue by providing advisory services for which ers do not rely heavily on revenues generated a fee may be charged or services that would from retail receivables, the funds generated attract business and customer loyalty, result- can be considerable. ing in most financial service needs being purchased from a single organization. Some retailers see third-party cards such as those offered by banks as an interference in To this end, service providers are using their their relationship with their customers. Retail- credit products to increase the effective li- ers feel they should know when a customer is quidity of assets held by consumers. In addi- activating a line of credit so that an alterna- tion to such traditional offerings as credit tive can be offered. Also, retailers question the cards, they are creating lines of credit secured propriety of card issuers charging the same by a variety of assets that range from home discount for a card transaction, whether it acti- equity to securities portfolios. Ease of ac- vates a line of credit (credit card) or is used tivating lines of credit is emphasized. In the to access a transaction account (debit card) in case of an overdraft account, the same check lieu of a check. or debit card that is used to draw funds from a transaction account is the instrument used While individuals make extensive use of a to activate the line of credit when the funds variety of credit services, businesses and in the account are exhausted. Some institu- governments are also major users of credit. tions issue checks that can be used to draw Generally, these users are quite sophisticated against home equity at the convenience of the and use a number of services that are not avail- customer. The customer benefits by being in able to the general public. The Federal Govern- a position to take advantage of opportunities ment is active in the primary credit markets to make either purchases or investments on as an issuer of debt. Also, one of the primary favorable terms that may be available only for means used to implement monetary policy is limited periods. trading by the Federal Reserve System in Federal Government securities in the open Information processing and telecommunica- market. tion technologies are key elements in supporting the viability of the credit products that are Further complicating the credit markets is now offered. One of the reasons a credit card the multiplicity of providers of credit services. issuer can guarantee payment to the merchant Depository institutions and retail merchants accepting it is the ability to keep track of ac- have been mentioned. However, among other count activity and effectively to halt its use participants in the market are consumer finan- almost instantaneously if circumstances re- cial companies, mortgage bankers, insurance quire. The processing and clearing of credit companies, pension funds, and acceptance cor- card drafts would be virtually impossible with- porations, such as those operated by major 110 Ž Effects of Information Technology on Financial Services Systems —— . ———.— automobile and appliance companies. Private vances, the cardholder can pay the entire individuals also make loans, as is the case amount due without finance charges. when the seller of a home takes a second mortgage from the buyer for a portion of the pur- Commercial Credit chase price. Commercial credit is the credit extended to Credit is extended in the following ways: businesses by various lenders. Commercial 1. 1nstallment credit—a direct loan to an in- banks are the primary funders of commercial dividual or business, repaid in fixed, peri- credit, but recent legislation gave savings and odic payments; it is a type of closed-ended loan associations limited power to participate credit. A typical example is a car payment in this market. Others, such as acceptance cor- loan. porations, leasing companies, and factoring 2. Open-ended credit, often called revolving companies are also active. Generally, the debt credit—funds that are available under an is short term and is used to meet requirements agreement that allows the borrower to for working capital, such as the funding of re- borrow several times, up to specified ceivables or inventory. credit limits, with interest and without Much commercial lending activity is conven- further investigation of creditworthiness. tionally viewed in the category of wholesale Many charge accounts at department rather than retail financial services. For exam- stores and credit card accounts are ex- ple, commercial banks will purchase consumer amples. Since part of the loan is repaid debt from consumer finance companies, which over time, the borrower can again draw then lend the funds to individuals at higher against the line up to the predefine limit. rates than banks charge. Commercial lenders This type of credit is often open-ended also finance capital acquisitions through third- with respect to time and the total amount party leases that cover such items as aircraft of credit available, Minimum payments and computers. are required, and the maximum amount of credit extended is limited. Commercial organizations will also float 3. Closed-ended credit—a loan that is ex- debt in the open market, where it may be pur- tended for a predetermined amount. The chased by any variety of lenders. One is short- borrower cannot reopen it by obtaining term commercial paper; but, as discussed in extra funds under the original lending the chapter on the securities industry, long- agreement. term bonds are also issued. 4. Line of credit–the amount of credit a lender will extend to a borrower over a Consumer Credit period of time, where the borrower can draw on the lineup to some fixed limit at Consumer credit is a specified amount of his/her discretion. Generally it involves a credit that is extended to individuals primar- specified amount of money a customer ily for personal, family, or household purposes may borrow without filing a new loan ap- by a number of types of institutions that in- plication. A personal line of credit on clude issuers of travel and entertainment checking accounts is one example; the cards, retail merchants, consumer finance com- credit card with a line of credit is another. panies, and acceptance corporations. Early on, Each month, the individual cardholder depository institutions began to recognize that chooses between complete payment of the consumer loans were not only an asset to the invoice or extended credit, with the choice bank, but also a contribution to the overall of making a minimum payment. The cred- economy. Consumer credit loans are extended it is used not only for purchases and credit to individuals or small businesses and provide payment, but also for obtaining cash ad- for repayment either monthly, quarterly, an- vances. With the exception of cash ad- nually, or in full at maturity. Consumer credit Ch. 4—Retail Financial Services Ž 111 —— — — — — .—————— ——— — can be extended through loans, overdrafts, time of use. Credit card checks are treated as credit card checks, and credit cards. cash advances, with the monthly statement reflecting the advance. When used, interest is Loans paid on money borrowed from the day the check is written. Merchants do not have to pay The extension of credit is perhaps best rec- the discount and service fee associated with ognized in the form of a loan. Simply defined, all card transactions when credit card checks a loan is money lent, generally to be repaid are used. with interest. Loans can be made on a secured basis, where the funds are protected by pledged The development of credit cards has helped collateral, or on an unsecured basis, where the satisfy the demand from consumers for a more funds are extended with no pledge of collater- convenient way to finance their day-to-day al. Loans are made to consumers and busi- credit needs. nesses on a regular basis. A loan is an agreement between two parties. The lender does not Credit Cards have to be a financial institution. Loans can With the advent of electronic banking sys- be secured by life insurance, contracts, depos- tems, the plastic card has become common- its in financial institutions, securities, or per- place in today’s financial institutions and sonal and real property. Banks, acceptance retail organizations. Nearly all customer/bank corporations, consumer finance companies, communication terminals—ATMs, remote and credit unions are major lenders of con- service units, POS terminals-use card tech- sumer credit. nology in some form. The card is used to access funds in various accounts and as a me- Overdrafts dium to extend credit. Today, almost 600 Credit can also be extended through an over- million credit card accounts exist in the United draft, which is a check or payment order writ- States, and 7 out of 10 households have at ten against a demand deposit or transaction least one credit card. Outstanding balances account for funds in excess of the balance. It on credit card accounts total more than $75 must be arranged in advance, and when hon- billion.’ ored by the depository institution, the over- Electronic processing has helped minimize draft creates a loan. If approval for overdraft the amount of paper used in handling credit privileges has not been obtained in advance, cards, and online credit authorization has overdrafts are prohibited. Basically, the over- helped encourage card use because it entails draft can be defined as an instrument that less of a waiting period. The transaction can operates with a credit limit, fixed by the in- be approved and completed within a time stitution for each customer and reviewed peri- frame that is acceptable to the customer. odically. Since the application of an overdraft Today, there are many online POS terminals is typically for personal use, it is rarely se- for credit authorization throughout the United cured. The arrangements for repayment of the States. Generally, any credit card can be ac- overdraft are set by each institution. cepted by the systems, which operate over standard telephone lines. Credit Card Checks Credit cards offer the individual the ability Credit card checks are special drafts writ- to defer payment of part of the balance due ten against a credit card account rather than as part of an extension of credit. A dollar, or a demand deposit account. They are issued in floor, limit is established, which permits using conjunction with a credit card account and access a credit line. They work just like a per- ‘Federal Reser\’e Board, L’redit Cards in the U.S. Eccmon]L\r— sonal check; however, the amount is charged Their impact on Costs, I]rices and Retail Saies, July 27, 1983, automatically to the credit card balance at p. 1. 112 ● Effects of Information Technology on Financial Services Systems the card without credit authorization at the ates a worldwide electronic data communica- time of purchase. For purchases over the re- tion system that transferred nearly 1 billion quired floor limit, credit approval is necessary. transactions between member institutions in Ceilings are generally set on the total amount 1983.7 the cardholder may have outstanding. For processing purposes there is no distinc- Over the past several years, many of the tion between a VISA debit or credit card. The card-issuing organizations have imposed an- same processing procedures apply for both nual fees to the cardholder for use of the card. cards; therefore, only the card-issuing institu- Interest paid on outstanding balances falls tion and the cardholder are familiar with the under State usury laws. Certain State laws, function of a particular VISA card. however, place rigid standards on such ac- Each card-issuing financial institution sets tions. The result has been: 1) higher annual in- the policies for its own customers in the VISA terest rate charges to the cardholder, where system. These policies are regulated by appli- permitted by usury laws; or 2) the relocation cable State laws that limit maximum charges by the card-distributing organization of its on credit card accounts, the method of as- credit card processing facilities into States sessment of finance charges, and minimum such as Delaware and South Dakota, which charges that can be imposed on credit card ac- permit higher interest, card fees, or both, so counts. Different card-issuing banks nation- that the card-distributing organization is able ally may compete with one another and may to operate under the banking laws of the State have slightly different policies. Generally, the where the processing is done. most important competition exists between Card-issuing organizations impose annual banks as they attempt to sign consumer and fees on credit cards as a way to generate ad- merchant accounts. The merchant discount of- ditional income. These funds were needed be- fered to encourage acceptance of the card at cause of the high interest rates financial insti- an establishment is one of the primary com- tutions were paying for funds. Additionally, petition tools. the annual fee charge is a way to generate in- Bank credit cards have become subject to come from those individuals who use the bank credit controls because of their role in extend- credit card as a convenience mechanism and ing consumer credit. They are recognized as who pay the monthly statement charges in full instruments for installment lending to con- and therefore do not incur interest charges. sumers and as loans by banks. The controls Basically, there are three kinds of credit tend generally to be the ones applying from cards: bank cards, travel and entertainment time to time to consumer credit. The controls cards, and retail and nonbank cards. include compliance in usury limits and truth in lending as set forth in Regulation Z. Bank Cards.-The bank credit card has become an integral part of the American life- To examine critically the national bank card style. Bank credit card systems have a struc- systems and the member institution’s role as ture all their own. The two major bank credit an extender of credit in the financial service card systems are VISA and MasterCard. industry requires some analysis. Inherent in VISA International is owned by over 15,000 every payment device are two separate and member financial institutions located in distinct services. The first is payment for almost 100 countries. Over 100 million cards goods and services, and the second is the ex- have been issued, allowing consumers access tension of credit. The first has traditionally to checking accounts, savings accounts, in- been priced in free and open competition and vestments, and lines of credit. VISA U.S.A. has not been subject to usury laws. The sec- is jointly owned by U.S. financial institutions, 7 including banks, savings and loans, credit VISA, U. S. A., Credit Controls and Bank Cards Analysis and unions, and mutual savings banks. VISA oper- Proposal, March 1980. ...

Ch. 4—Retail Financial Services . 113 — — ond has traditionally been subject to usury these cards are intended mostly for travel and laws. Whether the card is used solely as a pay- business use. Travel and entertainment card ment device or as a credit device, by deferring companies generally follow more stringent payment of the full balance, is determined by guidelines in issuing the charge card than do the cardholder. The use of electronic technol- issuers of other cards. ogy and plastic cards has made it possible to Several elite versions of the travel and en- combine multiple functions in a single device, tertainment card exist; for example, the Amer- blurring the distinction between what con- ican Express Gold Card. These elite cards of- stitutes payment service and what constitutes fer check-writing privileges and a higher floor extension of credit. limit for purchasing goods (which exceed those The national card systems have also ex- for the conventional card). Both the Gold and panded their use to include card access to conventional cards provide access to ATMs ATM networks. Several ATM systems estab- and traveler’s check dispensers and ease of lished by banks use VISA or MasterCard as check cashing at hotels and American Express the access card to a proprietary system. How- offices. ever, 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 state- Photo credit: American Express Co ment must be paid in full. As the name implies, Automated traveler’s check dispenser 114 ● Effects of Information Technology on Financial Services Systems —.———-——.—— .—— — —— . ——. ———

Travel and entertainment card transactions major retailer, accepts not only the J. C. Pen- are consummated in the same manner as with ney proprietary credit card but also VISA and bank cards. The difference is, however, that MasterCard. J. C. Penney, for example, has a the drafts are accumulated and billed monthly very complex electronic network system, ena- to the consumer, with the full amount due bling it to service accounts online throughout within a specified period after billing. Since the country. The Penney system supports this process is considered a payment service, 35,000 online terminals, allowing access to the its cost is unrelated to the funds outstanding, VISA system directly without the need for a which are not considered a loan of money with financial institution intermediary. It is the respect to usury statutes or annual percent- only retailer to do so. Retailers continue to en- age rate disclosures. Usury statutes apply courage the use of their proprietary credit only when the cardholder elects to pay in cards for several reasons: 1) to provide conve- installments through a prearranged line of nience to their customers, 2) to tie their cus- credit with a financial institution. tomer base to their stores, and 3) to facilitate impulse purchases. Retail and Nonbank Cards. -Retail credit cards are distributed by both large and small Card operations can also cross companies. retail and service organizations, which have J. C. Penney, for example, processes credit been in the business of extending credit to in- transactions for oil companies. The authoriza- dividuals and organizations for some time and tion is accomplished by running dedicated were the leaders in establishing the credit card. lines from the service station to the nearest Large chains of retail stores, gas/oil com- Penney store. The signal is then sent over the panies, and hotel and travel businesses run main trunk line to the data center where the their own credit card operations. Sears Roe- authorization file is maintained. The informa- buck, the largest issuer of retail credit cards tion is captured and transmitted to provide a in the United States, accepts only the Sears basis for generating customer invoices. credit card in its stores.8 J. C. Penney, also a

‘Nilson Report, June 1983.

Electronic Funds Transfer

Funds transfer is defined as any transfer of to a communication system that facilitates an funds by means of a check, draft, or similar immediate debit or credit). paper instrument or by electronic means Electronic funds transfer (EFT) enables con- through a terminal, telephone, computer, or sumers to carry out financial transactions via magnetic tape so as to order, instruct, or electronic devices instead of using paper mon- authorize a financial institution to debit or ey or checks. Electronic funds transfers can credit an account. A transaction can take sev- be carried out through use of an ACH, a home eral forms: cash purchase, charge purchase, banking system, an ATM, or a POS system. purchase by check or draft, deposit to an ac- One example of an EFT transaction is the use count, withdrawal from an account, or a debit of an access card, a plastic card encoded with from one account to another account owned an identification number to trigger the elec- by the same party, interbank, or intrabank. tronic impulses. Although debit cards allow A currency-based funds transfer uses cash or access to an account with adequate funds, coin. A paper-based transfer of funds is ac- some debit cards may also be used to borrow tivated by check, draft, or bank card/charge money, thus becoming all-purpose transaction card (when the transaction is not tied directly cards. — -— ——

Ch. 4—Retail financial Services ● 115 ————- —. — -- -— —— .—

Automation and electronic payment sys- credit, obtain a cash advance on a credit card, tems have often been at the forefront of recent pay bills, transfer funds from one account to changes in financial service organizations. Cer- another, and inquire about account balances. tainly one main effect of these changes lies in (The relative use of ATM functions is illus- the cost reductions that have been made pos- trated in fig. 7.) Credit can be obtained either sible by the elimination of paper-based trans- by granting of overdraft limits or, in some actions, which are personnel-intensive and, cases, through using a credit card rather than therefore, costly. Electronic financial services, a debit card to activate the machine to obtain however, are not pervasive. While the deploy- a cash advance. Systems vary, however; some ment of ATMs, for example, appears to be are merely cash dispensers, although the tech- prevalent in major cities, smaller towns and nology of the different systems is basically the remote areas of the country still rely on tradi- same. tional systems for delivering financial services, The plastic card’s magnetic stripe is the although this picture is rapidly changing. “key” that unlocks the machine for use. The While individuals depend on traditional serv- way the data are encoded and what items of ices, many of the financial service providers information are placed on the magnetic stripe rely on automation for the ease and efficiency varies. A great deal of attention has been paid of operating the services. Network systems to the standards being developed for the plas- continue to expand because communication tic card. and information technologies enable a broader geographic base to be served and allow in- Although the cost of ATMs has fallen sig- creased transaction volume without a propor- nificantly since their introduction, “the cost tional increase in costs. of ATMs is unlikely to fall as rapidly as that of many other parts of an electronic funds EFT has come to play an important role in transfer system because of the various me- the financial service industry. Although EFT chanical parts that are necessary. The capacity systems have been operational since the late to process transactions and information will 1960’s, it wasn’t until the mid-1970’s that become much cheaper as intelligent terminals their acceptance became more obvious. Elec- are developed, with display screens and key- tronically transferring funds today involves boards being largely electronic. There are several methods: direct deposit, credit and many mechanical parts in the dispensing of check authorization at point of sale, and most cash, in the printer, and in the mechanisms for notably, use of the ATM. To some degree, al- accepting funds. A further result of the me- though they have not penetrated the market chanical nature of cash dispensing is the short- as greatly as the ATM, the POS terminal and er life of currency because it quickly becomes remote information systems, such as home g unsuitable for use in cash dispensers’ ‘ banking, also play significant roles. With the ever-increasing operating costs for Automated Teller Machines traditional delivery systems, the customer demand for new services, and the competition The first applications of automation in cus- from new as well as traditional sources, most tomer services were very simple cash dispens- organizations in the financial service industry ers that provided the user with a fixed sum realize the need to use automated banking sys- of cash in a single denomination. These systems. The initial cost of establishing an ATM tems generally operated off-line, so the trans- is high, but it is far less expensive than build- action was not a direct debit. Now ATM sys- ing a branch bank. And, unlike a branch, it can tems offer most of the same transaction be operated around the clock at a fairly low capabilities as a branch bank, allowing con- incremental cost. Therefore, many bankers feel sumers to withdraw cash from a bank account, make deposits, borrow cash against a line of 9Revel], op. cit., p. 44. 116 . Effects of Information Technology on Financial Services Systems —-—-.—— —.

Figure 7.— Relative Use of ATM Functions,a 1974-81 that ATMs will provide both competitive ad- 1974 vantage and significant return on investment over the next decade. To soften the high cost Cash withdra of such systems, especially ATM networks, 75 ”/0 many financial institutions have entered into sharing arrangements. The ATM, which is operated by the custom- Payments er, can be located in a variety of places. In the 2% United States many are installed either in the main banking space of bank offices, in lobbies posits partitioned off from branches, or on the ex- 19 ”/0 terior of a building. They can also be located away from the main bank, at shopping centers, Balance transfers grocery stores, gas stations, offices, and fac- 4% tories. Almost all systems are or will be online. The customer’s plastic card allows him/her to gain access to the ATM location outside bank- 1976 ing hours and to conduct his banking business in relative security. c:ash withdra 74 ”/0 The large success of ATM deployment has created another trend in bank branching. In- stead of building large, full-service branches that are personnel-intensive and very costly, Payments many organizations are replacing these struc- 2% tures with satellite branches, which are small- scale, highly automated, full-service, and generally require management by only two or osits 1% three personnel. ATMs, for the most part, replace the teller; personnel are there to handle Balance transfers 3% general information or other personal business. Figure 8 illustrates the growth in the number of ATMs in use from 1974 to 1981. 1981 Figure 9 illustrates the increases in the average number of transactions performed at each lithdr ATM. 760/o ATM Systems ATM services can be offered in one of four nts 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 sys- Balance transfers tem, a group of financial institutions mutually 4% a researches, installs, markets, and operates the Excluding balance lnquiries. Includes only Years for which estimates based on field research are available system. In an interchange system, separate in- SOURCE Economic Review Federal Reserve Bank of Atlanta, August 1983 stitutions 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 Shared ATM Systems “ 50 Annual growth rate The number of shared and interchange sys- 45 tems is growing rapidly. As national ATM in- / terchange proliferates, shared systems such 40 as Plus and CIRRUS allow customers access . A to their funds on a national basis. National in- 35 . terchange systems, however, are not being run 1 only by banking organizations. ADP, Inc., and American Express have also begun developing and marketing national ATM interchange networks. Supermarkets and retailers are also 1973 1975 1977 1979 1981 positioning themselves in the ATM arena. Average annual growth rate, 1973-81 34.780/o There are, however, limitations to the kinds of services available through the national net- SOURCE Economic Review, Federal Reserve Bank of Atlanta, August 1983, p 16. works. Presently, because Federal regulation prohibits interstate deposit-taking,* most sys- Figure 9.—Average Number of Monthly Transactions tems serve as cash dispensers and provide in- per ATM,a 1974-81 formation about account balances. The fees imposed for using national ATM systems are 7 ’ 000~ set by the individual networks and range from 6,000 $0.75 to $1.30 per transaction. A portion of t 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 c .- 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 1974 1976 1981 time its customers use the machine, or the aDoes not include balance inquiries, includes only years for which estimates third party can be the switch operator, receiv- based on field research are available SOURCE Economic Review, Federal Reserve Bank of Atlanta, August 1983, p 16 ing either a percentage of the transaction fee or a fixed monthly fee for its processing ef- rate, shared systems allow one another’s forts. These systems are developed on a local, customers to use their machines. The term regional, and national basis and are in direct “shared system” is associated with an inter- competition with bank-run systems. change system. Generally, there is an inter- Safeway–an Oakland, Calif., supermarket change fee associated with using another insti- chain-has announced plans to develop and tution’s ATMs. A piggyback system occurs market a national ATM network. Presently, when one institution with equipment allows Safeway participates in a shared interchange the customers of other institutions to use its machines .10 *Reciprocity agreement,g exist among several states. ‘he — Massachusetts Legislature passed a bill in 1983 entitled “An ‘“Norman Penny and Donald Baker, The Law of Electronic Act Relative to Branch Offices and Acquisitions of Financial Funds Transfer Systems, (Boston, Mass.: Warren, Gorham & Institutions, ” that permits interstate deployment of ATMs and Lament, year), p. 6.03. deposit-taking among five New England States. Ch. 4—Retail Financial Services ● 119 .——. network, owned and operated by the Network dedicated data circuit and modems, the Exchange of metropolitan Washington, D.C. institution pays a service fee for the The objective of the Safeway program for in- stand-in processing option. store ATMs is to increase store traffic and 3. Full stand-in processing. NTSI maintains sales by providing customers with full-service, the participating institution’s cardhold- one-stop shopping convenience. Safeway has er file online at NTSI. NTSI verifies the committed to installing common-access ATMs cardholder’s personal identification num- in key stores throughout California. The ber and authorizes or denies the card- Washington, D. C., program, however, is pres- holder’s Safeway Cash Machine trans- ently not a participant of the Safeway ATM action in accordance with the institution’s program being developed in Oakland. To at- authorization parameters and cardholder tract the maximum number of prospective positive file information, updated daily by shoppers, Safeway will promote both the avail- the institution’s processor. The institu- ability of the ATM services at its stores and tion pays an additional service fee for this the financial institution cards that can access stand-in processing option. the machines. Safeway is also prepared to assist the participating financial institutions Merrill Lynch, Pierce, Fenner, & Smith Inc., in generating new accounts that can access the has signed an agreement with Safeway Stores, in-store ATM services. Inc., that will enable the brokerage concern’s customers to tie into the Safeway ATM net- Participation in the program is on a trans- work. Merrill Lynch customers who have one action-fee basis. National Transaction Sys- of its Cash Management Accounts, which link tems, Inc. (NTSI), will provide ATMs; install, a securities account and money market funds maintain, and service them; and perform all with “check” writing privileges and a VISA required transaction processing, funds trans- card, can use the VISA card to obtain cash at fer, settlement accounting, billing, and cus- Safeway stores. This is expected to begin in tomer service operations required to support early March 1984; it will be limited, for the the Safeway ATM program. Safeway cash present time, to California locations. However, machines will be linked to NTSI switching Merrill Lynch expects to expand the services and processing system via leased telephone to include nationwide access. data circuit. Other leased data circuits will link the switch with the participating institutions’ In Florida, Publix supermarkets has also es- host computers. Initially, the only function tablished its own ATM network, which it of- available will be cash dispensing, selected by fers for use to any bank in the State (operated the financial institutions from the following on a piggyback basis). Fees are imposed for three service-level options: every transaction a customer makes at a Pub- lix terminal. In addition to deploying the 1. Direct host link. The participating insti- ATM, Publix also runs the switch that oper- tution’s computer is linked directly to the ates the system. NTSI switching processor. The institution pays for the dedicated data circuit Shared systems exist primarily on a local/re- and modems associated with its host com- gional basis. The Tyme Corp. of Wisconsin has puter link to the NTSI switch. operated as one of the first shared systems in 2. Direct host fink with “stand-in “process- the United States, and in Washington, D. C., ing. NTSI maintains a cardholder author- the Money Exchange has operated as one of ization file and control parameters on the the first shared networks on an interstate NTSI computer for processing the partic- basis. Shared/interchange systems allow the ipating financial institution’s cardholder small institution to compete with other finan- Safeway Cash Machine withdrawal trans- cial institutions in the ATM competition. The actions when the institution’s host com- feasibility of all financial institutions operat- puter is not available. In addition to the ing 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 ATM deployed by any CIRRUS member, a in a shared/interchange environment, the fi- customer can make a withdrawal from his sav- nancial institution can extend the geographic ings or checking account, check balances, and reach of its market and earn income from the access a line of credit. All CIRRUS ATMs ATM. must accept the cards of every CIRRUS member; however, individual members may set CIRRUS—National ATM Network limits on the amount of cash their customers may withdraw at a time. CIRRUS ATMs The CIRRUS System, Inc., is a not-for-pro- must also be online in order to authorize trans- fit membership corporation that allows its actions. The CIRRUS switch, maintained by members to offer their customers the conven- the National Bank of Detroit, does not provide ience of nationwide ATM access. Incorporated backup authorizations for its members. The in June 1982, CIRRUS is headquartered in network ensures against switching downtime Oak Brook, Ill. When fully operational, it will by utilizing an ACI/Tandem computer. serve 41 States. Growth projections for the system are summarized in table 5. Individual CIRRUS members are responsi- Membership in CIRRUS is exclusively re- ble for the cost of hooking up to the switch served for banks, savings and loans, and credit and maintaining the connection. They must unions. Associate membership is limited to also pay for hardware and software modifica- banks. CIRRUS does not preclude its mem- tions necessary to comply with the network’s bers from joining other networks, nor does it operating rules. require the sharing of other electronic services, such as POS terminals. There are three classes Associate members pay a one-time entrance of membership for the CIRRUS System: fee of $25,000 to join the network, connect with the switch, and reserve the right to li- 1. Principal. Principal members have ex- cense correspondent members. Correspondent clusive marketing rights in their terri- members’ entrance fees are set by agreement tories. They may share their link to the with the licensing banks. Ongoing member- CIRRUS switch, run by the National Bank ship fees for the CIRRUS System are $2,500 of Detroit, by licensing correspondent per month for associate members; correspon- members. Principal members are required dent members pay the membership fees set by to add their ATMs to the network. their licensing bank. There are also process- 2. Associate. Associate members also have ing and interchange fees. Each time a CIRRUS a direct link to the CIRRUS switch and cardholder uses his ATM card at a bank other may share their connection with the cor- than his own, the card issuer pays the switch respondent members they license. $0.25 for processing the transaction. For with- 3. Correspondent. Correspondent members drawals and for accessing a line of credit, the are linked to the CIRRUS stitch through card issuer also pays the institution deploy- the principal or associate members who ing the ATM an additional $0.50 interchange license them. fee per transaction. For balance inquiries and CIRRUS allows its members to offer their other transactions, the card issuer pays the customers the convenience of nationwide machine-deploying institution a $0.25 inter- ATM access. Using a CIRRUS card at an change fee.

Table 5.—Growth Projections for the CIRRUS System, Inc., National ATM Network

1982 1983 1984 1985 Number of CIRRUS participants ...... 682 862 1,760 2,297

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 tomers. The national ATM switch is designed from interchange fees every time another in- to handle at least two transactions per second. stitution’s cardholder uses their machines to This represents a daily capacity of 173,000 transact banking business. Card-issuing insti- transactions.11 tutions are permitted to charge their customers for the privilege of being linked to the ATM Deployment Legislation CIRRUS network. Associate members can Deployment of ATMs remains dependent on share their direct link to the CIRRUS switch State-by-State banking legislation. Figure 10 with other institutions for a fee, and no matter how many correspondents an associate shows the number of ATMs in each of the States in 1983. Certain States, such as Illinois, signs up, it never has to pay more than its flat have very strict, off-premise deployment laws. monthly membership fee. Members of the Illinois permits State-chartered banks to CIRRUS network are free to join other establish ATMs subject to a number of geo- networks. graphic, time, and number restrictions. First, When fully operational, CIRRUS will link over 5,200 ATMs serving over 16 million cus- “CIRRUS Systems, Inc., Oak Brook, Ill.

Figure IO.— ATMs in the United States

Legend Total ATMs

1700 to 4000 700 to 1700 500 to 700 300 to 500 200 to 300 B Less than 100 1 1 1 SOURCE Economic Review, Federal Reserve Bank of Atlanta, August 1983, p 13 122 ● Effects of Information Technology on Financial Services Systems —

prior to January 1, 1980, a bank may estab- Financial Institutions, ” the act establishes lish not more than two ATMs, each no more new authority for mergers, branching, elec- than 3,500 yards from its main office. Second, tronic branching, and mortgage lending by commencing January 1, 1980, a bank may es- Massachusetts financial institutions. While tablish an additional eight ATMs, at the rate the act is generally limited in its operation to of two per year. Third, prior to January 1, activities involving five New England States, 1981, these ATMs maybe located only within the EFT provisions are expressly exempted the county of a bank’s main office. Finally, from such limitations. Under prior law, no out- subsequent to January 1, 1981, a maximum of-State financial institution nor bank holding of four of the eight ATMs may be located company was permitted to purchase, estab- within an adjacent county. ATMs located not lish, install, lease, use, or share an ATM in more than 3,500 yards from the bank’s prem- Massachusetts. The sole exception was al- ises need not be shared, but those located more lowed in a grandfather clause that exempted than 3,500 yards from the bank’s main prem- from the prohibition certain electronic ises must be made available on a nondiscrim- branches established before December 31, inatory basis for use by customers of any other 1981. To qualify for the exception, the ATM bank that would be permitted (under the stat- had to dispense only cash, traveler’s checks, utory geographic restrictions) to establish an or both, and had to be limited solely to the use ATM at that particular location. ’z of customers of the financial institution that In sharp contrast to the restrictive Illinois established it. law is Wisconsin legislation on terminal de- The new law empowers Massachusetts insti- ployment and usage: tutions to link their ATMs to regional or national networks. It also permits a financial Facilities established under the Wisconsin EFT statutory provisions must be available institution, organization, or bank holding com- on a nondiscriminatory basis for use by any pany, or its subsidiary organized outside of like institution which has its principal place Massachusetts, to share any ATM established of business in the State, or by any other like and used by a Massachusetts financial insti- institution which obtains the consent of a like tution or organization, provided that the shar- State, or by a national institution which has ing entity limits its customers to cash with- its principal place of business in the State and drawals, advances against preauthorized lines which is using the terminal. of credit, and check cashing. Moreover, any The statute requires that regulations pro- out-of-State nondepository financial institu- hibit, with regard to a shared terminal, any tion that establishes electronic branches that advertising that suggests or implies exclusive dispense only traveler’s checks and are limited ownership or control of the terminal by a fi- to use by the nondepository’s own customers, nancial institution or group of institutions. 13 such as American Express’s Express Cash Wisconsin law made possible the first shared Program, are allowed to establish, use, or ATM network in the United States and one share electronic branches in Massachusetts. of the largest. Finally, the new law authorizes financial in- Massachusetts went one step further. In stitutions, organizations, and bank holding early 1983 a law was passed that, for the first companies in Conneticut, Maine, New Hamp- time, permits Massachusetts financial insti- shire, Rhode Island, and Vermont to purchase, tutions to link their ATMs to regional and na- establish, install, operate, lease, or use elec- tional interchanges. Entitled “An Act Rela- tronic branches. That is, whereas the prior law tive to Branch Offices and Acquisitions of permitted institutions from any State to share ATMs established and used by Massachusetts “Robert C. Zimmer and Theresa A. 13inhom, The Law of Ekc- institutions, the new law allows New England tronic Funds Transfer, Card Services, inc., 1980, pp. I 1-11 to I 1-13. institutions themselves to establish and use “Ibid., p. WI-1. ATMs in Massachusetts, whether or not a -—— —=—— . .—

Ch. 4—Retail Financial Services ● 123 — — ..————— — ———.—

Massachusetts institution is involved. ” All of ment funds. The card may also have an over- the participating States passed legislation ap- draft credit line. There has been much cus- proving the interstate branching. tomer resistance to using a debit card at the point of sale because the customer associates There are no uniform guidelines on ATM de- the use of a plastic card with the elimination ployment that each State follows in making of float, which allows a grace period before ac- its EFT deployment laws. Each State’s legis- tual payment is required. Also, many people lature determines what approach will be best in the industry have referred to the debit card for the consumer and the banking community. as a paperless check, which is one of the reasons that retailers have been reluctant to ac- POS Full Funds Transfer cept it. Presently, retailers can accept accept The term “point of sale” covers a variety of and process checks for less than the fee im- services rendered through machines located at posed for processing a debit or credit card retail establishments. POS terminals are gen- transaction. These differences have resulted erally clerk-operated devices located at the in controversy between the retailer and card- checkout or convenience counter of retail es- issuing institutions. tablishments. Electronic cash register ver- Another form of debit card transaction at sions of these terminals have been in opera- point of sale gives the cardholder a rebate, tion for several years, maintaining store which encourages use of direct debit at point records on sales, inventories, accounts of sale. Customers use the card, which works receivable, and the like. Now, POS devices online, to debit their account directly to any have been linked to financial institution com- participating retailer. The retailer receives in- puters, allowing retail customers to receive ap- stant credit, and the customer receives a re- proval for check cashing and electronically ini- bate, ranging anywhere from 2 to 5 percent, tiate transfers from their accounts to the directly credited to his savings account. One retailer’s, the latter being POS full funds of the most successful of these programs is transfer. In some installations, customers can that of the Wilmington (Delaware) Savings make deposits to their accounts. POS devices Fund Society. Most of the other programs, accept either a plastic credit card or a plastic however, have been unsuccessful. First of all, debit card, depending on whether the cus- a significant card base was not represented. tomer wants to delay payment by charging the Second, many of the stores that signed up for purchase or wants the purchase deducted di- the program were inconvenient to the majority rectly from his/her account. As electronic POS of the cardholders, and these stores also systems proliferate, their use will probably re- tended to sell products at a higher cost than place many of the paper transactions accom- did discount stores. plished through cash payments and check and credit transactions. Direct Debit POS The debit card, another means of facilitating Retail Stores.–Although previously not funds transfer at point of sale, functions much many POS systems operated in retail stores, the same way a credit card functions except there is tremendous potential for their use. that when the transaction is received by the One of the most successful direct debit POS issuing financial institution, it is debited to the programs is in Des Moines, Iowa. There, Dahls cardholder’s account, which may be a check- and Hy-Vee supermarkets operate direct debit ing, savings, NOW, or other form of deposi- POS systems at the checkout counter, the first tory account. Some securities firms have such systems in the United States. Custom- distributed debit cards to access cash manage- ers of these supermarkets can pay for groceries with a proprietary debit card issued by Nor- —. —.. west Bank, which automatically debits the 41+:lc~tr0niC F’und< Transfer Association, llrashin~~ton Report, tJan, 11, 19H3. cardholder’s account. ITS, Inc., operates the 124 ● Effects of Information Technology on Financial Services Systems — computer switch that makes EFT possible for alternative method of payment. Most of the some of the 205 participating Iowa banks, sav- tests at the service station involve agreements ings and loans, and credit unions. The Hy-Vee between oil companies and financial institu- supermarket does about 4,000 POS trans- tions under which customers can pay for pur- actions per month; Dahl’s does about 2,000 per chases using bank debit cards that automat- month. Each location paid about $18,000 to ically debit the amount of purchase from their install magnetic stripe readers and keyboard checking accounts. However, there is addition- add-ons to the NCR cash registers and to buy al interest in proprietary credit card trans- the processors and software. However, volume actions at points of sale. Mobil Oil Co., for ex- sales of the systems should cut costs. More- ample, has 2,400 POS terminals linked to its over, the store receives good funds the next Kansas City processing center, which captures day. all transaction information via electronic draft capture. Since the system is online the infor- Retailers and banks both benefit by having mation is transmitted immediately. This POS access to the customer’s float, and both the system enables Mobil to capture billing infor- retailer and the bank are assured the funds are mation electronically, saving internal costs by good. “To encourage direct debit use, bankers reducing the amount of paper used in such will price check transactions higher than their transactions. Mobil implemented a credit POS debit card counterparts to nudge consumers system, which could easily convert to a hybrid along. The cost of processing one check is esti- system supporting both debit and credit, to mated at about 50@, and an EFT transaction maintain its loyal customer base and to gen- costs about 30©. The higher the volume in erate new business. Mobil representatives feel EFT, the lower the per transaction cost be- 15 that direct debit at this stage would alienate cause of the high fixed overhead. ” customers. Oil and Gas Companies.–The gasoline sta- The POS transaction begins by the service tion is currently the focus of much POS activ- station clerk inserting the card into a POS ter- ity because it generates more transaction vol- 16 minal. In some cases, the customer inserts the ume than any other kind of retailer. Many card into an automated pump and then keys large oil and gas companies are installing POS in his own personal identification number terminals at service stations. A few direct (PIN). By implementing direct debit POS ter- debit POS terminals are being deployed di- minals, the customer’s account is automat- rectly into the gas pumps, although the ma- ically debited, and the retailer’s account is gen- jority are stand-alone terminals. erally credited immediately or the next day. While still in its infancy, the idea of deploy- The benefits to both banks and oil companies ing POS terminals at service stations is be- are savings of millions of dollars. In most coming more accepted because of the increase cases, the bank or network operator receives in self-service gas stations, because more sta- a transaction fee for each purchase. The oil tions are remaining open 24 hours a day, and company saves by being assured of good funds because service stations are often vulnerable and by receiving payment immediately. This to robberies. To help reduce the tremendous is a significant issue because the general lag volume of cash generated each week by gaso- time for credit card sales draft, according to line purchases, major oil companies and banks a Mobil Oil Co. official, is 10 days. across the country are joining forces to test Some POS test situations currently under POS terminals at the pumps, using proprie- way are being done by AmeriTrust Bank, Shell tary credit cards or bank debit cards as an Oil, and Gastown in Cleveland, Wells Fargo Bank and Shell service stations in San Fran- “Forbes, Aug. 29, 1983, p. 46. loMmagement Information Systems Week, July 27, 1983, cisco, First City National Bank of Houston p. 81. and Exxon Co. Ch. 4—Retail Financial Services ● 125 -—— —— ——..————— —

National POS Systems ative file or by having the retailer check a man- Large-scale communication networks are be- ual that lists card numbers of bad credit risks. ing developed, primarily by the major credit In the United States, POS experiments have card industry, to connect thousands of POS been conducted since 1974. Very few systems retail terminals with financial institutions involving instant transfer have survived, and within a State, region, and, ultimately, the Na- the most important functions of POS, until tion. These networks will include computerized online direct debit systems were in place, have switching centers and a base for clearing set- been check verification and credit card author- tlements. ization. One explanation for this very limited In addition, oil companies, banks, and other success could be that the experiments have retailers are considering national POS net- generally looked for evidence of profitability works. Tests are being conducted by Liberty within a few months of installation, whereas National Bank & Trust Co. of Oklahoma City the change in social habits involved in mov- and a Southwest oil dealer whereby terminals ing from cash and checks to instant transfer will be deployed at stations offering the fol- takes a great deal longer. lowing services: automated dispensing at the pump, an ATM inside the station for purchas- Costs of POS Systems ing convenience items, and a commercial de- For several years merchants and financial pository that is wired to the ATM so that institutions have been at an impasse over how high-volume stations can make deposits. to implement electronic payment systems, At the present time, POS systems are be- especially retail EFT systems. The differing ing allowed by regulators to access time and perspectives reflect differences in technologies savings accounts; however, this could change. being used, in terminal ownership, in customer Regulation D* is not being strictly interpreted bases, and in approaches in pricing the service. with respect to POS activity. However, if the One of the main concerns associated with regulation were strictly interpreted, a large implementing POS systems is the cost to be number of financial institutions, savings and borne by retailers and banks. Another is the loans, and savings banks, would be prohibited concern about merchant discount fees. Most from actively participating in a POS system. banks charge the merchant the same fee for debit card transactions as they do for credit Other Uses of POS Systems card transactions. The argument made by the The POS terminal can also be used for check merchant is that debit cards function in lieu authorization, permitting the customer to ob- of a paper check and therefore the merchant tain approval of a check for payment by run- should not pay the same discount fee. A POS ning a verification of the check-cashing record system can all but eliminate float, reduce through a computer. Likewise, the POS sys- credit risks, require the merchant to keep less tem enables merchants to verify the availabil- cash on hand, and ease check approval. ity of funds in a customer’s account or his ac- Technology has also been a basis for conflict cess to credit before completing the sale. As between the merchants and POS operators. Fi- with ATMs, customer access to POS terminals nancial institutions typically base their debit is usually by plastic card and PIN. This is an cards on the magnetic stripe technology used alternative to manual authorization and veri- for years on bank credit cards. Grocery retail- fication, which is handled by accessing a neg- ers, on the other hand, typically base their technology on an optical scanner that reads *Regulation D is a uniform reserve requirement on all depos- bar codes on product labels and transmits the itory institutions with transaction accounts or on personal time information to an electronic cash register deposits. It requires submitting reports on all deposits to the Federal Reserve Board and sets phase-in schedules for reserve (ECR). Department stores typically prefer op- requirements. tical character recognition characters read 126 • Effects of Information Technology on Financial Services Systems —

from merchandise tags and proprietary credit in an area and that provide for the recruitment cards with a handheld wand. Product and cus- of most retail outlets stand the greatest tomer information is fed into an ECR to ef- chance of success. fect electronic payments. POS systems will undoubtedly increase dur- Financial institutions tend to prefer owning ing the next decade, with many new systems the necessary terminals and charging mer- being built upon existing ATM networks. chants a user’s fee for making transactions Both the banks and retailers stand to gain through them. On the other hand, retailers from the resulting reduction in the volume of tend to prefer devices that are integral com- paper transfers. However, merchants contend 17 ponents of their own ECRS. Naturally, finan- that since a debit card transaction saves financial institutions and the merchants are wedded cial institutions time and money relative to a to their respective investments. It is unreal- check transaction, merchants should enjoy istic to expect the merchants to give up their some of the savings. It has become quite technology in order to accept electronic pay- apparent that in order for POS systems to de- ments. Developments such as VISA’s “elec- velop and operate efficiently, the systems tron card” are aimed at simplifying this must be designed in close cooperation with the problem. individual retailers, not just the markets the systems serve. Another issue with respect to POS systems is the volume of sales to be handled. It has The technology necessary to operate elec- been argued that to be viable economically, the tronic debit and facilitate POS transactions POS system must become competitive with exists today. It is the intention that electronic cash; otherwise, there is no incentive for the debit cards will substitute for check, credit retailer or the customer to use it. The customer card, and cash transactions. However, when is faced with loss of float, and the retailer is POS services become commonplace, the use faced with transaction fees, which cash pay- of cash and checks as a payment mechanism ments do not require. Under these conditions, will still exist. Disconcerting cost trends are systems that are shared among all the banks leading merchants and financial institutions —.- ——_—— to seek lower cost alternatives for POS trans- “’’Debit Cards at the Cross Roads, ” Economic Review, March actions. EFT is the method by which this goal 1983, pp. 37-38. can be reached.

Financial Information Services

There are many forms of information serv- eling tools, and various other analytical ices in the financial service industry. They in- packages. clude check or credit authorization/verification; status information on account balances; All financial service providers use informa- identification verification; billing and funds tion services. Retailers are perhaps one of the due information (e.g., preauthorized pay- largest users of specific information services, ments); accounting information with respect particularly check verification. Check verifi- to general ledger, payroll, accounts payable, cation validates the authenticity of the check accounts receivable; and modeling and analyti- or its presenter. This system is accessed online cal services, such as Chase Econometrics and through a telephone or terminal by the retailer. Wharton Econometrics, which provide access The retailer pays for this service, generally a to data bases, econometric models and mod- percentage of the value of the check. These Ch. 4—Retail Financial Services ● 127 —. systems are run by third-party organizations vide information in unique ways. For exam- and banks that maintain negative files. ple, the services they perform include providing status information to their customers on Check Authorization a very regular basis. The most familiar processes are inquiry of account balances or funds Check authorization systems may be pro- credited or inquiries regarding specific check vided and maintained by the party accepting clearing. Today, much of the status inquiry in- the check, by a financial institution, or by a formation is processed by online teller ter- third party engaged in such a business. The minals with direct access to the accounts be- systems may be designed to access bank rec- ing questioned. ords directly or may rely on secondary data sources. In some systems, check approval is Service organizations provide accounting in- accompanied by a guarantee of payment. In formation services to customers, such as in- an EFT system, a customer’s plastic card and formation services about payroll or accounts PIN can be used to access the system and ver- receivable/payable or other services necessary ify the available balance. This is accomplished for efficiently running the organization with- by placing the check into a terminal and key- out the added costs of implementing an auto- ing in the appropriate information. The check mated system in-house. A wide variety of is then validated and accepted at point of sale. firms, including financial service providers, offers these services. Credit Authorization Two other key information service providers in the financial service industry are invest- Credit authorization is yet another informa- ment brokers and insurance firms. (The bro- tion service vehicle available to the retailer. kerage industry is covered in ch. 3 of this re- It operates by allowing the customer’s credit port.) Insurance information is compiled by card to be read by a financial service terminal actuarial scientists and categorized by risk, while a central computer verifies that the card age, and the like. Much of this information is is valid and the customer’s account has suffi- available to individual brokers through online cient funds. This can also be accomplished videotex terminals. Insurance information re- manually by checking a printed document, dis- quires some customization in order to meet the tributed by the card companies, indicating lost specific needs of the party requesting the in- or stolen card numbers or by placing a call to surance, although premiums and risk are dean operator who will authorize or refuse the termined by actuarial methods. transaction based on information from a data base. This inquiry process is supposed to re- The information provider in the insurance duce the risk of credit fraud or of extending industry is the insurance salesman. Although credit in excess of an imposed credit limit. much information about general insurance is accessed to data bases via terminals, the proc- Information service systems allow for real- essing of this information still requires the per- time access and reduction of risk at point of sonal interaction of the salesman and client to sale and ensure that the retailer will receive provide the service adequately. Some insur- the funds. The risk is transferred to the party ance information is provided through com- authorizing the funds. This service guarantees puter/CRT* terminals that display rates and payment to the retailer and is attractive de- also give an explanation of the types of insur- spite the fact that the retailer must pay a ance available. The insurance industry is look- premium to insure the funds. ing at further automating the delivery of insurance information. Providers of Information Services

Many kinds of organizations are information *CRT terminal—video terminals that display data on a cath- providers. Depository institutions use and pro- ode-ray tube. 128 ● Effects of Information Technology on Financial Services Systems

The following scenario may present itself in transfer funds efficiently from one account to the near future. Through videotex and home another. For example, in a corporate environ- information systems, insurance information ment, real-time access and videotex technol- can be transmitted and reviewed by an in- ogy allows a treasurer or financial advisor to dividual. If the need presented itself, for ex- manage and control all of the investment ac- ample, an individual would be able to increase counts. Through the same technology, invest- the amount of homeowner’s insurance for a ments can be transferred on a daily or perhaps specific period of time, say a weekend, if he even hourly basis. planned to be out of town. The insurance pol- Many organizations today conduct financial icy modifications could be done instantane- counseling programs for all ages and groups. ously, and the additional premium payment These groups organize to seek sound financial could be automatically debited from the cash guidance and to plan for long-range money value of other insurance policies. goals. Interestingly, these groups include not Several of the larger banks in the United only the affluent market but also young pro- States offer financial, securities, and invest- fessionals and middle-income individuals who ment analyses; payment products, models and have become far more educated and concerned data bases to corporations, other banks, insur- about how their finances are handled. ance companies, financial institutions, and Different sectors of the financial service in- government agencies. An example is terminal- dustry require different information services. based cash management for major corpora- For example, a bank loan officer may inven- tions and banks. tory data to assess liquidity and solvency. Fi- Mortgage servicing is another aspect of nancial analysts are concerned with equity in- financial information services. Mortgage bank- vestment decisions and are likely to place more ers and a growing number of commercial, mu- importance on earnings-per-share and capital tual savings bank, and savings and loan cus- account data. On the other hand, various fi- tomers use this type of service for servicing nancial service groups use the same informa- their portfolios of mortgage loans, which in- tion in different ways in the decision process. clude taxes, escrows, and insurance. Loan clos- Service industries, such as banking, securi- ing documentation and mortgage preparation ties, and insurance, whose business operations systems are available to help customers of the rely heavily on information services, are find- service keep track of inventories and financial ing that the whole environment in which they commitment needs. Batch transmission and operate is changing rapidly. Earlier develop- inquiry modes to a central location are used ments in information technology were such via dial-up and leased transmission lines. In that only large corporations could take advan- this manner, nationwide service is provided l8 tage of its capabilities. However, over the last from a single location. several years, technical innovation has con- Information services provide immediate ac- tinued at such a rapid pace that, for example, cess to financial information and are used to information processing power, which once

18 took a roomful of large equipment, is now Herbert A. Schulke, Jr., “Electronic Financial Systems, ” Innovations in Telecommunications, Academic Press, Inc., available in portable machinery. 1982, p. 1038.

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 or cable lines. Some systems provide a hybrid came from thrift institutions, which saw telecommunication delivery, using cable for in- phone bill payment as a way to offer trans- coming information and the telephone for out- action accounts, thereby partially circumvent- going information. In-place cable lines are pri- ing the law forbidding payment of interest on marily one-way communication lines, although demand deposits. Soon commercial banks be- most new cable lines being laid today are two- gan offering the service. When the telephone way cable lines. bill payment service was first introduced, most Home computers also allow interaction with of the systems required the customer to call HIS and are becoming popular for receiving in and give oral instructions over the telephone the services. A modem** can be used to tie to an operator to perform banking services, the home computer to the information source specifically bill payment. Automation was in- by telephone lines. A CRT or television screen troduced and made available to customers acts as the visual display terminal. The home with touch-tone phones, although most sys- banking software which runs the system is dis- tems still relied on operators during the busi- tributed by the participating financial insti- ness hours and on recorded messages at other tution. times. Telephone bill paying services did not attract a large customer base, and many of the As stated, cable plays an increasing role in early programs have come to a halt. the delivery of home information services. “The latest cable television systems now be- Technology of Home ing developed will transform the technology Information Services of videotex and the economics of home banking. The use of coaxial or fiber optic cables The introduction of videotex played a key gives much greater bandwidth, which provides role in the development of home information three substantial technical advantages: 1) the systems. Videotex—a generic term that refers possibility of carrying a large number of chan- to computer-based information retrieval sys- nels, up to 100 or more; 2) a more satisfactory tems that display text and graphics via video and speedy interactive facility; and 3) a much screen—is a product of the convergence of improved ability to produce pictures (impor- telecommunications and computing technol- tant in using home shopping).’’” Direct broad- ogies. Through teletex* and videotex, one-way casting by satellite, which is being developed, and two-way computer-based retrieval sys- is another method by which information can tems, information can be widely disseminated be transmitted into the home. for viewing on modified television sets or on personal computers. In the last year or so, full Developers of Home Information Systems videotex systems have become operational in several countries, giving the user the ability Home information systems are being devel- to send communications to the system com- oped by a myriad of organizations that include puter for onward transmission. Because the depository institutions (presently Bank of videotex system is interactive, it can be used America and Chemical Bank are marketing to facilitate financial transactions. The system systems that are up and running), information functions in several ways. One way uses a companies, entertainment companies, and the videotex terminal and a television (which acts like. Several systems are being developed as as a visual display unit); the communication cosponsored, joint ventures by consortia of with the system is supplied by telephone lines major banks and corporations. One example

*Teletex is a one-way system that displays alphabetic and **A modem transmits digital or computer information over graphic information on a modified television set. Videotex dis- telephone lines by manipulating it electronically and also pro- plays the same sorts of information as teletex but also provides tects the lines from undesirable signals that might cause in- a communication path for the user to interact with the service terference with other users. provider. 19Revel], op. cit., p. 50. 130 ● Effects of Information Technology on Financial Services Systems —. —

of a major project is the Viewtron Program Applause, the home banking software of- in Miami, Fla. The Viewtron system will be fered by VideoFinancial Services, will supply supported by computers from seven major cor- a variety of services. The home banking activ- porations from around the country and will be ities include bill payment, funds transfer and linked to Viewdata Corp. ’s Viewtron com- account information, and special financial re- puters in Miami. The gateways are American quests. VideoFinancial Services also provides Express—subscribers will have access to a va- credit authorization and settlement for credit riety of services offered by this company; Com- card shopping orders placed on Viewtron. The modity News Services—subscribers will be system permits each participating financial provided with instant and delayed stock mar- organization to specify unique features within ket and commodity price quotations; and E. the system standard, including the use of in- F. Hutton–subscribers will be able to track dividual colors and graphics. Presently, 12 their personal investments and receive invest- Florida banks and savings and loans will pro- ment advice with “Huttonline,” the first elec- vide home banking to Viewtron subscribers tronic information service offered by a retail via VideoFinancial Services’ computers in Or- brokerage house. E. F. Hutton customers will lando, Fla. be able to access Hutton’s computers in New As a financial gateway, VideoFinancial pro- York City for information about their ac- poses to provide the Applause service to all counts, such as cash management and margin sections of the country through any videotex balances, portfolio positions and market val- network. To support such an objective, Video- ues, open orders, and recent transactions. All Financial expects to establish regional data Viewtron subscribers will be able to order centers, where practical and necessary, to in- E. F. Hutton market comments and invest- terconnect the financial industry to the re- ment advice and send electronic mail to E. F. gional network operator. The system will be Hutton offices. Viewtron subscribers will also streamlined. First, the home terminals will tie be able to order J. C. Penney catalog merchan- directly to the network operator, who will be dise by using a direct link to J. C. Penney com- fully responsible for promoting, enrolling, and puters in Atlanta. They will receive online or- billing the consumer for the network service. der confirmation upon completion of their Communications, terminals, and data base order. If the requested item is not available management will be provided and managed by in the color requested, the J. C. Penney com- the service provider. The network will then puter will offer the Viewtron subscriber other feed into the VideoFinancial computer system. color possibilities. The J. C. Penney catalog VideoFinancial will either connect online with inventory system is immediately and automat- or provide batch processing for subscribing fi- ically updated. In addition to processing the nancial organizations and will be responsible catalog order, the gateway to J. C. Penney will for developing and maintaining the home bank- also provide for credit authorization for the J. ing software package. The VideoFinancial C. Penney card, as well as for VISA and Mas- computer system will tie in directly to the fi- tercard. In addition, information from The nancial organizations offering the service. Official Airline Guide and Grolier Academic These financial institutions will assist the net- American Encylopedia will also be available. work operator in enrolling the consumer and The financial gateway to the system, Video- will provide the data to VideoFinancial to sup- Financial Services, is jointly owned by four port the home terminal request. major bank holding companies: Southeast Over 50 information providers, including Banking Corp., Miami; Wachovia Corp., Win- major wire services, educational organizations, ston-Salem, N. C.; Bane One Corp., Columbus, reference and financial book publishers, uni- Ohio; and Security Pacific Corp., Los Angeles, versities, libraries, and professional organiza- Calif. tions provide information for Viewtron. —

Ch. 4—Retail Financial Services . 131 —-—— —. -. —. . .———...—————— —— —

Interestingly, the advent of HIS has en- Systems now in operation serve interactive couraged cooperation instead of competition facilities, providing travel services, sports, and among the various financial service providers. general entertainment information (e.g., res- taurant and movie guides); stock exchange in- Costs of Home Information Systems formation; shopping capabilities; and banking applications in a form similar to that of self- Cost is one of the major issues associated service banking. Users of these systems can with the success of the HIS program. The pay bills, transfer funds, check balances, re- Viewtron videotex costs are as follows: view banking statements, and keep up-to-date financial records. ● Subscription to the Viewtron service: $12 per month for access to nearly all View- The elderly may be another target market tron services. for such systems. The ease of being able to • Communication charges to access View- accomplish shopping and banking from the tron: approximately $14 per month (ap- home, it seems, would be very appealing. proximately $1 per hour to access View- There are problems, however, with respect to tron). acceptance of the system, hardware and com- A serious consideration is the influence of munication costs, and, most importantly, local communication costs and their impact on changing behavior patterns. Principal charac- HIS. It is possible that communication costs teristics of HIS users are listed in table 6. could increase to such a degree that the cost For consumers to adopt and use home infor- of making a local call discourages use or forces mation innovation, it must be associated with development of new types of local links. such advantages as convenience, compatibil- Consumer acceptance of home banking/ ity, or specificity. home information systems will be based on several other factors besides the natural in- Implications of clination toward using these services. These Home Information Systems factors include price of obtaining the hardware/software needed to use these services, It appears likely that home banking systems price of using the services, and availability of will be tied to other services such as informa- these services. * tion services, entertainment, and even business uses. Also, any institution, whether financial or nonfinancial, will be in a position to The Market for Home provide financial services through a videotex Information Systems network and to support these services in much Much speculation has been associated with the same way as Merrill Lynch operates its the home information market. Several leading cash management accounts. authorities have targeted the affluent segment Home banking and its impact on branch of the population as the major users of the banking has some major consequences. With home terminal. Their claim is that many con- a single investment in a computer installation, sumers with incomes over $40,000 per year a new entrant to the retail banking market has have an insatiable need for information of the whole national market open to it. As long various types. The home terminal has great as it has the necessary computing capacity to potential as the major investment, shopping, handle the accounts of its customers, any bank and news information source for affluent con- will be able to leap over geographic barriers sumers. Additionally, it has been stated that and offer payment services nationwide. * By many affluent consumers feel strongly that the same token, nonbank operators will be able they can conduct their own financial trans- ..-. .— actions better than bank personnel can, and *Banks have long been able to conduct business nationwide some find it enjoyable. by opening offices (usually via holding company affiliates or —.. t subsidiary corporations) for business loans. This is also true * Informa ion from Reistad Corp.—research conclusions. 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 checks has declined during the last several extent that they are legally permitted to do so. years and check usage in absolute terms may begin to fall between now and the end of the It is important to note that ATM, POS, and century, no one expects checks to be totally HIS will work together in the future. POS sys- replaced. tems and ATMs will share network lines, and these systems will eventually reach out to in- Historically, usage of new consumer prod- corporate other remote terminal activity such ucts has grown slowly during the first years as HISS. following introduction. For successful products, this has been followed by a period of The various systems that have been and are rapid growth. Then, as the level of saturation being implemented for effecting payments are is approached, growth again slows. Overall, ” essentially designed to be substitutes for the this creates the “S” curve shown in figure 11. paper check. While the rate of growth of This being the case, two questions relating to Ch. 4—Retail Financial Services ● 133 ———

Figure 11 .—Penetration Curve for Check Alternatives penetration for a home banking service today that requires a terminal costing several hun- dred 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 steep- ness 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, 1977 78 79 80 81 82 83 84 85 86 a series of events that demonstrate inherent SOURCE Economic Review, Federal Reserve Bank of Atlanta August 1983 p 33 weaknesses in advanced payment systems could slow the rate of growth of some products. In general, the impacts of events are the substitution of new payment products for most likely to vary from product to product the paper check remain unanswered. First, at in the mix that comprises the offerings of the what rate will new services grow? Second, at financial service industry. what level of penetration by each product will the market become effectively saturated? In the past, great promise has been held out for various payment products that has yet to Not all potential users of a service will use materialize. However, increasing use of com- that service. It has taken decades for the level puters and telecommunication throughout so- of penetration for checking accounts to reach ciety and the dynamism of the financial serv- the 85- to 90-percent penetration level, where ice industry may be creating an environment it now rests. Further, it is not reasonable to more favorable to the adoption of new systems assume that the level of maximum market for delivering financial services. Thus, there penetration is the same for all products. Over is a higher degree of confidence than in the the long term, for example, the proportion that past that the middle stage of the “S” curve uses ATMs may far exceed that which uses will be reached, but the timing continues to home information and banking services. be uncertain. The problem becomes one of Further, the level of maximum penetration closely monitoring developments in the finan- may vary with time. As technology evolves cial service industry to identify those areas and its costs continue to drop, and as the prod- most likely to reach a critical mass and to ucts are funded, the proportion of potential assess on an ongoing basis the benefits and users who actually become buyers may change. costs to society of the changes that are ex- For example, the maximum potential market pected. Chapter 5 Wholesale Financial Services ,

Contents

Page The Role of Technology 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 bank card organizations. On the other hand, consumers with a variety of products and serv- VISA International actively markets its prod- ices, including deposit-taking, securities bro- ucts on behalf of its members and is highly vis- kerage, and credit extension. Wholesalers, in ible to the consumers. In this sense it can be turn, provide a variety of services to retailers, viewed as a retailer of financial services. services that may be grouped under two broad headings. First are the wholesale products Wholesale and retail financial services will that affect the balance sheets of the providers, continue to overlap in the future as the imple- usually by converting assets from one form to mentation of advanced financial service deliv- another (e.g., cash to notes receivable or vice ery systems tightens the coupling between the versa). For example, institutions can purchase organizations that perform the various func- debt instruments in secondary markets, or a tions that are required to deliver services. bank may participate in a loan syndicated by However, for the moment, it remains use- its correspondent. Historically, depository in- ful to describe wholesale and retail services stitutions have always been suppliers and separately. users of this class of wholesale services. They On the one hand, the earliest applications have established and maintained correspond- of information processing and telecommunica- ent relationships that have included such tion technologies were in the area of wholesale features as loan participation and the opera- financial services much more than in retail. tion of secondary markets for various debt in- Check processing and account maintenance struments, without relying on automated services have been provided by third-party processing. operators for years. Wire transfers of funds A second class of wholesale products com- have been used since before the turn of the cen- prises mainly processing and information serv- tury. On the other hand, there are wholesale ices. Included in this group are check and services that are not particularly susceptible credit card processing, general accounting and to automation. Arranging loan participations account maintenance services, and communi- may rely heavily on telecommunications, but cation services. This chapter describes the the process is not really automated. wholesale financial products and services that However, wholesale financial services are are available, the organizations that partici- not really separable from other financial serv- pate in this segment of the industry, the role ices that may benefit greatly from the applica- of technology, and the trends that are pre- tion of advanced technologies. Thus, policies sently in evidence. that are directed at changes resulting directly Changes in the financial service industry from the application of advanced technologies have shaded the fine lines between wholesale to the entire financial service industry are also and retail services. For example, from the likely to impact wholesale financial services. point of view of each organization that issues Therefore, it is important that the reader who a VISA card, VISA International, the parent is concerned with developing policy for the fi- of the VISA service, is a wholesaler that pro- nancial service industry be aware of the full vides the interchange services that are essen- range of services provided by the financial tial to the operating concepts embodied in 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 mation processing equipment and the increas- early users of advanced technology for prod- ing availability of low-cost software packages uct delivery. Transaction volumes of checks has brought within reach the decision support and credit cards now exceed the industry’s systems and other capabilities not previously ability to process transactions manually, and available to small institutions. (The large sys- the increasing time value of money and the tems for transaction procession and general variety of alternatives for investment have accounting are not included in this group as placed a premium on the ability to move funds they can be developed and supported only with and information rapidly and accurately over significant resources.) wide geographic areas. Even for small organizations, the accessibility of economical proc- While all organizations need access to tech- essing services has been crucial for survival. nology, not all have to develop processing capabilities within their own organizations. The Most of these processing services could not problems of processing and other aspects of be delivered without the availability of the ad- marketing and delivering services are largely vanced communication and information proc- separable. Managers of financial service pro- essing technologies. Further, because of the viders are faced with the same “make or buy” heavy dependence of service providers on decisions that confront those responsible for these technologies, firms with expertise cen- a manufacturing facility. A depository insti- tered in the technologies rather than in the de- tution can either generate a loan portfolio livery of financial services have recognized and through its own efforts, or it can participate developed opportunities in the financial serv- with others who undertake the active market- ice industry as providers of wholesale finan- ing of credit services. Additionally, an orga- cial services. In addition, communication and nization can acquire and support the facilities information technologies have made possible necessary for performing the data processing the extension of wholesale financial services entailed in delivering financial services, or it products to include features that could not can buy those services from third parties. Fur- have been offered without the technologies. ther, just as merchandisers can setup an orga- Historically, the costs of establishing and nization to buy in quantity for a group, finan- maintaining the processing capabilities re- cial service providers can realize economies of quired to support the delivery of financial serv- scale and scope by joining a consortium, or ices have been beyond the means of many network, that establishes an organization to retailers. Now, however, the low cost of infor- 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 possi- The 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 replace assets in secondary markets is key to —

Ch. 5—Wholesale Financial Services ● 139 — . — _— — ——. ———

Table 7.—Major Providers of Wholesale enabling the financial service industry to in- Financial Services termediate between those with funds to invest Nonbank and nonfinancial service company third-party and those who require funds. processors: ADP In this context, commercial firms that sell EDS their receivables are users of wholesale finan- Decimus cial services. Using these services, manufac- Control Data CSC/lnfonet turers and merchants are able to obtain the FDR (AMEX subsidiary) working capital needed to support their inven- Financial service institutions, joint syndications, and tories of end-products, work in progress, and proprietary T&E cards: raw materials. Rocky Mountain Bank Card (PLUS) CIRRUS The originator of a loan may, under some cir- VISA Master Card cumstances, sell the debt in the secondary American Express market while retaining the rights to service Nonprofit or governmental service or network providers: the loan. In this way, the capital is turned Swift over, but the originator of the loan continues Federal Reserve Federal Home Loan Bank to benefit from a stream of fees paid by the Bank Wire holders in due course. In turn, the borrower New York Clearing House benefits by continuing to deal with the orga- Banks, other depository financial institutions, and nization that originated the loan throughout associations: First Interstate Bancorp its life, even though it no longer holds the Bank One debt in its portfolio. Of course, the opposite Citi-Bank situation, where the original lender retains the Chemical Bank Bank of America debt and buys processing services from CUNA another organization, can occur; or the origina- California Credit Union League tor may sell the loan and retain none of the GESCO Mid Continent servicing functions. Dataline Small loan companies, on the other hand, Other industry groups: Brokerage firms: will place commercial paper in the wholesale Merrill Lynch markets and use the proceeds to support their E, F. Hutton lending activities. Because they can borrow Paine Webber Retailers (including grocery chains): large amounts at favorable interest rates and Sears receive a relatively high yield on their loan J, C. Penney portfolios, a favorable spread is generated that Montgomery Ward May Co. can cover both their operating expenses and Federated Department Stores a profit. Safeway Kroger At times, a lender will have the opportunity Insurance: to place a loan that either exceeds the funds Prudential Insurance Co. Equitable Life Insurance available or creates an unacceptable risk in Aetna Life Insurance that the amount to be lent would be excessive- Consumer finance corporations: ly great relative to the net worth of the orga- Beneficial Corp Dial Corp. nization. Regulations also limit the size of a Mortgage Brokers: loan that can be made to any other borrower. Loomis & Nettleson Under these circumstances, the lender may Trust Companies: syndicate the loan by obtaining contributions Trust Co,. of the West SOURCE ICS Group Inc Harbor City, Calif from others that will spread the overall risk 140 . Effects of Information Technology on Financial Services Systems and make available sufficient funds to meet sources to develop and operate such systems the needs of the borrower. Also, banks, as part internally, and others choose not to undertake of their relationships with their correspond- such activities. Instead, they turn to third parents, will routinely allow the correspondents ties, many of whom are not conventionally to participate in loans that they place. Insur- classified as financial institutions, to provide ance companies behave in much the same way the processing capabilities required. Retailers when they share indirect placements and ask of financial services decide on the degree to or permit others to share in the underwriting which they will be vertically integrated and of casualty coverage. Securities dealers form turn to wholesalers for those services they can- syndicates to underwrite offerings of debt or not or choose not to provide for themselves. equity instruments. Clearing and settlement are elements critical to the operation of a system that supports Processing Products the delivery of financial services. At present, only depository institutions have in place a As noted, the delivery of financial services system for clearing cash items involving the depends heavily on the processing and trans- transfer of money between virtually any par- mission of large amounts of data. For all prac- ties in society. Specialized systems, such as tical purposes, the application of advanced in- those operated by the airlines for settling fees formation processing and telecommunication for services provided to holders of tickets technologies has become mandatory. issued by others, by securities brokers for set- Among the processing products offered by tling stock and bond transactions, and by oil the providers of wholesale financial services companies for accounting for balances of crude are the processing of checks and credit and oil moved between them, exist; but not with debit card drafts; the processing required to the wide area of applicability found in the sys- support all types of depository products; and tem operated by the depository institutions information services, such as credit/check for settling on money transfers. On the other authorization and economic data and models hand, there is no reason why alternatives for that are used for analysis and decision sup- settling money transfers that would not in- port. Also included is the processing required volve the depository institutions could not be to consolidate and disburse funds as part of established. Systems supporting the opera- offerings of cash management services. tions of the nonbank credit cards provide one such example. Transaction processing facilitates the execution of an order given by the owner of an ac- Some wholesale products exist because of count to credit or debit it. For all practical pur- structural constraints within the industry. As poses, from the point of information flows that noted, depository institutions are the only are created, the type of accounts posted dur- ones that have access to the payments mech- ing the transaction is immaterial. In fact, ma- anism. Therefore, when others offer products jor bank card processors use the same systems such as cash management accounts that give to process debit and credit card transactions, the retail user the ability to write a draft and only the customer and financial institu- against the account, arrangements must be tion that holds the customer’s account knows made with depository institutions for payment whether a line of credit or a demand deposit of the draft through the payments mechanism. account or other type of account is debited. The same type of arrangement holds for organizations that offer or accept one or more For this assessment, the critical point is that of the major bank credit cards. Thus, any secu- the systems used to process orders against ac- rities dealer or private association that makes counts are large and complex and are there- arrangements to issue a bank card and any fore expensive to build, operate, and maintain. organization that accepts the bank card must Hence, many organizations do not have there- arrange for clearing or payment services .— ... —-— .—..

Ch. 5—Wholesale Financial Services ● 141 ———.——————— — — ...———-

through a depository institution. Only one programs, and other support services used by retailer has been given direct access to a ma- retailers. As the capability to develop gener- jor bank card network, and the rules of the alized software packages increases and users card-issuing organization have been changed recognize that most organizations can make to preclude another nondepository institution use of generalized packages, as opposed to de- being granted such access. veloping unique application systems for themselves, the importance of the products pro- Information Products duced by this segment of the wholesale financial service industry will increase. Financial data provide the basis for decisionmaking for individual organization and for the Also included in this group are communica- economy as a whole. Treasurers for both pri- tions services that are particularly oriented to vate corporations and public agencies must the needs of the financial service industry. have knowledge of the funds available to them However, more often than not these are gen- and the demands being placed on them. They eral-purpose communications facilities that must be able to consolidate easily those funds can be used for any number of applications, collected over wide geographic areas and to and only the fact that the operators make a disburse them so that they meet obligations specific point of marketing them to the finan- for payment. Opportunities for investing idle cial service industry sets them apart from funds must be identified and exploited. These others and warrants that they be mentioned services together compose what are commonly in the context of this assessment. offered as cash management packages. Other Firms that provide wholesale processing/fa- processing services, as shown in table 7, that cilities management services can be placed in depend heavily on the corporate data of the one of four subclasses. First, there are those individual client organizations are also offered that take all responsibility for system opera- by wholesale financial service providers. tions and operate their own facilities apart At a broader level, financial service organi- from those of their clients. Second, some pro- zations collect and market a variety of data viders sell or lease software or equipment, and used in decision support systems. Some also the users take all responsibility for day-to-day provide modeling and other prepackaged ca- operations. In this case, services from several pabilities that can be used to analyze data. In wholesale providers may be combined in a sys- some cases, completely developed models that tem designed to meet the needs of the client can be used for experimentation by the users organization. Third, some providers offer are offered; in others, facilities that enable the “turnkey” services in which they design and user to build, estimate, and validate models install systems for their clients and then turn uniquely designed for a specific purpose are them over to the clients, who take over day- provided; and in still others, both capabilities to-day operations. In the last category are are available. those offering facilities management services where the service provider effectively takes over the operation of the processing depart- Nonprocessing Services ment of the client organization, even though Some wholesale financial services entail no the department may be physically located in processing capabilities. These services gener- the client’s facilities. ally include provision of equipment, computer 142 ● Effects of /formation Technology on Financial Services Systems — — ——— .— —.

Providers of Wholesale Financial Services

The list of firms comprising the providers gages and merchant and producer receivables of wholesale financial services is quite diverse. created by others. Table 7 demonstrates this diversity, listing major categories of providers of financial serv- The degree of horizontal integration per- ices and citing specific examples of firms fall- mitted commercial banks is limited. By law, ing within each group. Table 8 shows which commercial banks can underwrite neither cor- classes of firms provide each of the various porate equity issues nor life or casualty insur- classes of services identified in table 7. It ance other than creditor life insurance. Secu- shows the breadth of the product lines offered rities trading is limited to ordering trades for by each of the various classes of firms active the convenience of bank customers or the oper- in the financial service industry and the de- ations of trust departments. Commercial gree of competition between the very diverse banks are not authorized to offer investment firms that are providers of wholesale financial advice regarding securities to their clients. services. Further, they are permitted to offer data processing services to others only to the extent Examination of table 7 shows that there is that such services are incidental to the busi- considerable opportunity for both vertical and ness of banking. While recent rulings by the horizontal integration for providers of whole- Federal Reserve Board (e.g., the CitiShare sale financial services. On the other hand, the case) have broadened the scope of permitted existence of a variety of specialized firms activities, commercial banks and bank holding argues that, until now, the economics govern- companies are not free to offer the full range ing the operation of providers of wholesale fi- of data processing and communication prod- nancial services has not encouraged either ver- ucts that they could conceivably market. tical or horizontal integration. While some argue that either pattern of integration offers On the other hand, even in the face of exist- significant economies of both scale and scope, ing restrictions, the degree of horizontal in- alternatives exist for achieving both econ- tegration of commercial banks and other de- omies. Notably, competitors in the market- pository institutions is increasing. Some now place are able to join in the creation of whole- offer discount brokerage services, and others sale services while maintaining an active are developing connections with insurance competitive environment based on end-prod- companies or are setting up subsidiaries that uct differentiation in retail markets. can offer insurance under the laws of the States in which they are chartered. Large commercial banks provide examples of vertically integrated operations. They per- Some merchandisers are also entering the form check processing, operate credit and market with a very broad range of financial debit card systems, and support networks of service products. One provides retail credit automated teller machines (ATMs), some of service in direct support of its merchandising which are strictly proprietary, while others are activities, a full line of insurance services, real shared and may permit access by thrift insti- estate and securities brokerage, and, in a lim- tutions as well as by other commercial banks. ited number of States, deposit-taking through Some have arrangements with nonbank issu- subsidiary thrift institutions. Yet even though ers of either credit or debit cards to provide this organization appears to be moving toward the required interface with appropriate clear- horizontal integration, only a minimal level of ing and settlement networks. Loan participa- coordination has been achieved between the tion and clearing accounts are offered to cor- various constituent elements, and, therefore, respondents. Also, they provide secondary the degree of horizontal integration achieved markets for debt instruments, including mort- to this point appears to be minimal. Ch. 5— Wholesale Financial Services ● 143 —

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In another area, one of the major providers purchase and sale of Government securities. of a nonbank credit card has become one of the It is a major factor in the clearing of checks largest wholesale providers of card processing and a provider of currency and coin to the services to others. This provider also offers an banking system. extensive package of traveler’s checks and The national system of automated clearing card-oriented credit services through partici- houses (ACHs), except for the one in New pating commercial banks and thrift institutions. York, is owned and operated by the Federal Among the nonbank providers of wholesale Reserve System. Recently, ACHS have broad- financial services are those that operate com- ened their capabilities to process individual munications facilities, networks of ATMs that customer-initiated transactions. The bulk of are shared among various depository institu- the traffic handled by ACHs is generated by tions, and independent processors, with roots the Federal Government in the form of payroll more in the information processing industry and payments to recipients of entitlements, than in the financial service industry. With its such as social security. divestiture, American Telephone & Telegraph The role of the Federal Reserve in these mar- will be able to provide enhanced services spe- kets has been controversial for some time. cifically tailored to the financial service indus- Even though Congress mandated that the try. However, it will have to compete with Federal Government recover the full costs of other telecommunications carriers, banks, and providing services, some argue that its pric- others that already operate in this market if ing still puts private suppliers of alternative it chooses to enter. Operators of food chains services at a disadvantage. Some also see an and others are installing ATM networks and inherent conflict of interest between the Fed- inviting the depository institutions to join eral Government as a supplier of services on them. This trend has raised the thought the one hand and as a regulator of the insti- among some bankers that they may not be tutions that are its customers on the other. able to retain their control over the payments system in the long run. Finally, as shown in The Federal Reserve is charged with ensur- table 8, various data processing service bu- ing the orderly movement of funds nationwide reaus and software suppliers meet the needs in order to provide a healthy climate for com- of significant portions of the financial commu- merce. In some areas it is meeting with com- nity for processing services, and there are petition. However, in others, such as providing some indications that they would like to ex- service to institutions in remote areas that pand their role in the future. cannot profitably be served by the private sector, it continues to meet a real need. The Federal Reserve System occupies a unique role as a provider of wholesale finan- Volumes of checks processed by the Federal cial services. It is a lender of last resort to de- Reserve declined after the institution of pric- pository institutions in need of funds to meet ing for services. Also, there is a movement to reserve requirements. Through the Open Mar- separate ACH operations from the Federal ket Desk at the Federal Reserve Bank of New Government. Therefore, its future role as an York, it markets Federal Government debt active participant as a provider of financial and implements monetary policy through the 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 could make it impossible for a company to re- access to the payments mechanism for the main in business. transfer of funds, all other institutions must In general, the trend to greater reliance on work through them. For example, money mar- advanced information processing and telecom- ket mutual funds, on which customers can munication technologies in support of systems write drafts, conventionally maintain a zero- for delivery of wholesale financial services will balance account with a depository institution continue indefinitely into the future. To some that is funded at a level sufficient to cover the extent, those providers of wholesale financial drafts presented each day. They then use services who do not perform processing inter- transaction data supplied by the depository nally will become more dependent on the prod- institution to post appropriate debits against ucts of others, and therefore may lose some customer accounts. of the flexibility in designing and operating On the other hand, the depository institu- systems for delivering financial services that tion can have available to it virtually all of the they now enjoy. Greater shared use of process- financial data of its customers because all paying systems, driven by the economics of sys- ments transactions pass through its hands. tem development, deployment, maintenance, Because it has access to the data and the and operation, will mean that competition be- means to act on them on behalf of the cus- tween the various producers of financial serv- tomer, some argue that depository institutions ices will, in the future, be based on factors occupy a unique place that puts potential com- other than the features of the processing sys- petitors at a significant disadvantage. The tems used by the competing organizations. argument follows that restrictions are neces- Finally, both the providers and users of sary on the operations of depository institu- wholesale financial services are more accus- tions with regard to the information process- tomed to dealing with advanced technologies ing services they may offer so that they will than consumers are. These organizations have not benefit unjustly from the position they en- for years been using technology-based applica- joy. Thus, at issue is the degree of access these tions, such as cash management services, that organizations have to a customer’s data, and will not be significant in the consumer mar- the payment mechanism and the relative ad- ketplace for many years. Therefore, for those vantage the firm enjoys in the marketplace. who operate in wholesale financial service mar- To the extent that wholesale financial serv- kets, future changes will not be as traumatic ices can be provided only with the support of as they may be for the remainder of the pub- advanced technologies, a point of no return lic that is generally not accustomed to deal- has been passed in which the only possible ing with relatively sophisticated systems. backup to an automated system is another Thus, the changes that take place in the whole automated system. Further, in this environ- sale services are less likely to attract wide- ment, all providers of the services need access spread attention than those provided to the to the technologies, and lack of such access general public at retail. 148 ● Effects of Information Technology on Financial Services Systems

Future of Wholesale Services

Although much attention has been focused have put pressures on operating margins that on the entry of new types of providers of fi- will stimulate all providers of financial serv- nancial services into retail markets, the ices to take whatever steps are required to im- maturity of participation in wholesale markets prove productivity. Since only limited num- by nontraditional financial service providers bers of institutions are in a position to support is proportionately much greater. Since finan- major new product development efforts, many cial service firms have established a high de- will look to third parties to create the capa- gree of sophistication in the use of the tech- bilities that are needed. nologies and they are more familiar with the operational requirements of the industry than Banks and other traditional providers may anyone else, those with adequate resources be expected to extend their customer base out- and the inclination to do so will remain sig- side of their traditional boundaries. Holders nificant factors in the market for wholesale fi- of financial assets are in a position to argue nancial services. On the other hand, because that they have both the knowledge to build the information processing and telecommuni- the capabilities needed by their customers and cations industries have developed the exper- immediate access to the data used by the tise to analyze and meet the requirements of system. others, firms not ordinarily identified with the financial service industry will increasingly On the other hand, data processing service challenge traditional financial service firms in organizations can marshal many of the same the market for wholesale services. arguments as banks to claim that they are in a position to provide a wide range of payment The introduction of advanced networking and information services to a broad client has broadened existing relationships between base. However, they are somewhat limited in providers of financial services to include the their ability to offer complete payment sys- new products and services that have become tems because they can initiate payments only available. For example, a bank will contract through a financial institution that has access with a securities dealer to clear drafts that are to the payments mechanism. processed through the payments systems in addition to providing the more traditional In the long run, however, processing tech- banking services. Institutions that have nology is neutral; and the ability to succeed benefited internally from investments in sys- as a provider of wholesale financial services tems incorporating advanced technologies to depends on the level at which requirements are increase productivity, have often offered them understood and operationally viable systems on the open market to others who, in turn, are implemented. Systems that meet the needs have also been able to increase productivity. of the users and are supported adequately will succeed in the market regardless of where the On the other hand, developers of new prod- processing is done. As improved processing ucts try to benefit from the revenue generated technologies become available, providers of by franchising those products to others. The wholesale financial services will adopt and franchisees benefit because they do not have market them. Adoption on the wholesale side to incur the costs of designing and develop- of the financial service industry will be more ing the systems to support new product offer- rapid than on the retail side because changes ings. One major money center bank is follow- in wholesale services are less likely to be visi- ing this strategy in offering its home banking ble to the end-users. Competitive impact in the service to banks nationwide. retail market will be minimal because there These types of relationships will continue will be little, if any, requirement for consumers into the indefinite future. Economic conditions to change their behavior patterns. —

Ch. 5—Wholesale Financial Services ● 149 — . ————. .— —————...—— —

Increasing use will be made of telecommuni- various institutions operate somewhat inde- cations to deliver financial services, and there pendently of one another, with the major as- will be new opportunities for telecommunica- sociations providing facilities for interchange. tion providers to function as providers of On the other hand, American Express has im- wholesale financial services. In addition to pro- plemented a major network that takes advan- viding neutral communications capabilities, as tage of ATMs installed by participating they have in the past, they are in a position banks. Money can be accessed from any finan- to offer enhanced services to the financial serv- cial institution designated by the customer; ice industry. Some may position themselves and American Express moves funds from the as operators of networks and provide gate- institution holding the customer’s account to ways between these networks and others. the one that has dispensed the funds. Transaction interchange could become a major area of activity. Food retailers that install Developers of the information utilities now and operate ATM networks also fall in this becoming operational are in general agreement category. that financial services will comprise a key element of the packages to be offered. Informa- Technologies that offer opportunities for by- tion providers are positioning themselves as passing telephone companies that provide gateways to financial service providers, and, local service have considerable potential for therefore, are functioning in a wholesale capac- providers of financial services. Already, a ity. They contract with retail providers who television cable from central Manhattan to the define the services that will be provided Wall Street area carries considerable traffic through the information utility. Subscribers generated by providers of financial services. to the information utility are then able to se- The teleport concept being implemented in lect the retail financial service packages to New York and considered elsewhere offers the which they will subscribe. Such arrangements opportunity for bypassing both local and long- complement shop-at-home and travel arrange- distance carriers. Since the switched telephone ment services that may also be offered through network is not particularly suited to carrying the information utility. large volumes of data traffic, and costs for local communication are expected to increase People who have evaluated the market for significantly in coming years, bypass technol- home information services now generally agree ogies and those that offer them will be an im- that no one product offered by itself will be portant factor in the development of the finan- viable. The packaging of financial services cial service industry. with other information and, possibly, entertainment products will be critical to the suc- Conceivably, the major long-distance car- cess of services that distribute information to riers will become significant providers of the home. Various types of firms will assem- wholesale financial services, with offerings ble these packages and, in effect, will be pro- that range from networks dedicated to specific viding the wholesale functions. Some, as in the users to networks that include the processing case of Knight-Ridder, will be publishers that required for online, real-time clearing of pay- assemble and perform much of the marketing ment transactions. The switches that run for the products of various providers. Others, these networks are computers capable of per- like Chemical Bank, may be the creators of one forming the processing required to provide the part of the service and assemble other parts clearing function. of the package from offerings of other sup- Given the evolution of regional ATM net- pliers. Still others may provide a totally neu- works, the focus of nationwide service could tral communications service that provides be the facilities that provide for interchange paths to many providers and the opportunity between networks rather than the develop- to interchange information between them. ment of monolithic networks that cover the Such a service would rely on each provider to country. This outcome would generally follow perform all of the marketing and other activi- the model of the bank card systems, where the ties 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 sary that they establish a presence, either increasingly interdependent trading econo- through a branch or an affiliate. A final reason mies. The financial service industry supports for multinational branching by U.S. banks, these activities by providing the means to was that regulation, taxation, and supervision transfer payment for goods and services pur- of institutions in other nations was more often chased internationally and by acting as an in- favorable to the conduct of their business. termediary between those nations with excess In the past 20 years there has also been a funds and those in need of funds. As the econ- number of new entrants in the field. Smaller omies of individual nations become more in- banks have been able to participate in inter- tertwined, the role of the financial service in- national finance through the use of innovative dustry becomes more important to the world lending arrangements. Nonbank financial economy. service providers have developed large, inter- Changes are taking place in the structure of national networks to facilitate retail flows. financial markets as well as the structure of SWIFT (Society for Worldwide Interbank Fi- the industry and its participants. Commu- nancial Telecommunication), a network estab- nication and information technologies have lished by the banking community to facilitate helped to make markets that were once local international interbank transfers, is on the or regional in character, global. Funds travel verge of offering traditional bank services, per- across national boundaries with such ease that haps in direct competition with its founders. disequilibrium is offset. This flow of funds These relationships rely heavily on both the became increasingly evident in the 1970’s with flow of information and the international the excess capital available from oil-rich transfer of funds. Information technologies nations. therefore found early application in the inter- Separate from, but related to, changes in fi- national financial arena, beginning with the nancial markets are the structural changes telegraph. It is difficult to assess and identify taking place in the industry itself. During the the individual impacts of the technologies on rise of multinational corporate activity in the this segment of financial service activities, 1960’s and 1970’s, banks moved abroad to fol- since the use of the technology is so prevalent. low corporate customers. In addition, banks In many ways much of the activity in the in- found that in order to insure access to many ternational financial markets could not occur of the foreign money markets, it was neces- without the technology.

The Growth of International Banking

Post-World War II developments in capital in turn expanded the role of the private bank- movement 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 finan- R. M. Pecchioli, in a recent OECD report, cial services connected with direct investment attributes the evolution of international bank- operations and established new requirements ing’s structural features to a number of fac- for the conduct of multinational business. tors: changes in the international economic and financial environment, the evolution of At first, international financial activities ex- demands for financial services by borrowers panded in traditional ways: through the ex- and investors alike, and the spreading of tech- change markets and accepted ways of inter- 3 nological facilities. The events of the 1960’s national lending. Eventually, the movement were, for the most part, the result of the grad- to increased internationalization of financial ual recovery of the world economy from the activity was supported by changes in bank devastation of war, and the liberalization of strategy and management and by institutional trade. The 1970’s, however, brought major and structural changes in international money structural changes to the world economy; and credit markets. world payments balances became more severe, By all counts the growth of international and there were major structural changes in the banking has been phenomenal. The Organiza- international payment and financial systems, tion for Economic Cooperation and Develop- all of which gave banks a pivotal role in inter- ment (OECD) has compiled figures on the national financial intermediation.4 growth of international banking in developed nations over the last two decades. Although New Directions in there is no comprehensive measurement for International Banking world banking activity, and many measure- ments of this activity include double-counting It is impossible in this report to provide a and inflated figures, the gross figures and the comprehensive survey of all the changes in in- net figures (which should eliminate the double- ternational banking techniques; rather, impor- counting) are strikingly similar. In the period tant product innovations will be highlighted, from 1975 to 1981, net international bank along with the entry into new markets. lending increased by an average annual rate of 23.9 percent, while the net size of the Sources of International Funding eurocurrency market* increased by 21.6 per- International banking strategy does not cent. Although the figures for this period show generally distinguish between domestic and in- considerable growth, the eurocurrency mar- ternational funding, since, for the most part, kets experienced their greatest growth from banks will follow an overall assets and liabili- 1965 to 1970, when average annual changes l ties management policy. Two major sources were 37.7 percent. of funding in the international market are the Similar statistics illustrating the relative im- certificate of deposit (CD) and the floating rate portance of foreign business of banks show note (FRN). CDs are negotiable receipts for that the average growth of foreign business large deposits; they have been used in the for OECD banks as a whole has been from 12.1 United States for many years and in the Euro- percent of assets in 1970 to 23.7 percent of dollar market since 1967.5 London is, by far, assets in 1981, and from 11.3 percent of liabil- the leading center for CDs. In 1981, foreign ities in 1970 to 23.4 percent of liabilities in currency CDs issued by London banks totaled 1981. 2 more than U.S. $75 billion, most of which was actually denominated in dollars.6 FRNs, which ——— are borrowing instruments used by banks, *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 ‘Ibid., p. 17. Policy Issues (Paris: Organization for Economic Cooperation ‘Ibid. and Development, 1983), p. 16. 51 bid., p. 28. ‘Ibid., p. 19. 6Pecchioli, op. cit., p. 28. —

Ch. 6—The lnternational Environment for Financial Services ● 155 have a position of slightly less importance in Syndicated lending is the process by which international funding, although recently their very large amounts of funds are raised by al- importance has grown. Generally FRNs allow lowing the participation of a number of banks. banks to secure funds for longer terms than The benefit to the borrower is that these funds those available through the deposit market.’ can be raised through a single operation. The benefit to the lender is that risk is spread A unique aspect of international funding, among many banks, and institutions that however, is the reliance on interbank deposits could not undertake such a loan on their own as a major source of funds. Although it is dif- 10 can participate. ficult to measure, the interbank market is by far the largest source of international funding. The current “international debt crisis, ’ Recent estimates place this market between where developing countries are unable to two-thirds and three-quarters of total exter- repay their loans to developed nations, has nal and eurocurrency liabilities of reporting brought generally into question the risk of in- banks, or close to U.S. $1,000 billion.a What ternational lending and, specifically, the role is not reflected in these figures is that the vol- of syndicated lending in exposing a greater ume of trading is very heavy, reaching the pro- number of institutions to risk. It became clear portions of the foreign exchange markets. The that smaller banks were becoming involved in effects of information and communication international lending. It is not possible to ad- technologies can be readily observed in this dress, in the scope of this report, the issue of area. They are reflected in the high velocity the possible mismatching of liabilities and and volume of trading, as well as in the par- assets that can occur as a result of loan syn- ticipation in the wholesale market of many dication and the subsequent risk and foreign smaller, nonmoney center banks.9 loan exposure. Instead, the extent to which communication and information technologies International Lending contribute to the situation should be noted. During the 1970’s there was a rise in the Technologies affect the ease with which willingness of private banks to finance devel- banks can become involved in international opment projects. Much of this came about as lending. These same technologies may also a result of the inability of domestic markets help in better monitoring and control of inter- to absorb excess capital. Recently, the multinational debt and repayment, helping to over- lateral lending agencies, in particular the World come the international destabilizing effects of Bank, have announced cofinancing projects, a major default. In response to the severity in which private banks are allowed to partici- of the situation, and the possibility of major- pate. These projects are thought to appeal to country loan defaults, a number of large multi- smaller banks, which value the ability of the national banks established the Institute of World Bank to assess the viability of devel- International Finance. The purpose of the in- opment projects. stitute is to provide valuable risk information about countries to member banks that are Innovations have also occurred in the flex- making loan decisions. The information is pro- ibility of the structure of the loaned funds, as vided to members via an institutional network, well as in the markets approached. As banks’ using international telecommunication 1ines. international assets have increased, their approaches to the marketplace have changed. The most evident of these changes is in the Multinational Banking development of international credits through Multinational banking can be loosely de- loan syndication. fined as the branching abroad of banks. Mul- “Ibid. tinational banking cannot be completely sep-

9‘Ibid, pp. 29-30. cit., and Elec- —. Pecchioli, op. p. 29; ,J. R. S. Revell, Banking 10 tronic Funds Transfers, date, p. 156. Pecchioli, op. cit., p. 32. 156 ● Effects of Information Technology on Financial Services Systems

arated from the international activities of Offshore Banking banks. (Much of what is described in the pre- Offshore banking is any banking activity vious sections can and does take place in within a country’s borders, but outside its branches of U.S. banks located outside of this banking system. There is considerable debate country. ) Multinational banking developed as to exactly which nations of the world should concurrently with international banking, but be considered offshore centers. For example, has different causal factors. the City of London provides favorable condi- The first movement of banks to set up tions for off-shore banking, although it would branches in foreign countries was generally in not be a conventional member of the group support of multinational corporate activities. considered off-shore centers. The United As trade became more important and these ac- States first permitted the development of in- tivities increased in the 1960’s, banks found ternational banking facilities (IBFs) in Decem- it necessary to follow their clients abroad. ber 1981 in an attempt to bring back much of Eventually, international banking grew and the Euromarket business, which had fled this national economies and money markets be- country due to State tax laws and Regulation came intertwined, and the banking community D. IBFs are banks located in the United realized that its physical presence was neces- States, but because of the nature of their busi- sary to secure and maintain market share as ness are not subject to some of the regulations well as to participate in the developing finan- under which banks operate domestically. Both cial markets abroad. U.S. banks and foreign banks operating in this country can establish IBFs. They are estab- During the past two decades this activity lished through State and local laws and amend- has increased considerably. The number of ments to Regulations D and Q and are simi- overseas branches and agencies on a world- lar to an off-shore “shell” branch that operates wide basis increased from 112 banks with on-shore. 4,390 branches in 1961 to 387 banks with 4,329 branches in 1978. ” The development of off-shore banking centers is facilitated by information technologies, Methods of participation in foreign markets which tend to make the industry less location- include everything from full-service branches sensitive. Nations have developed a sophisti- to the establishment of “shell branches, ” cated communication system solely for the which are booking offices located in foreign support of the financial service industry. This countries that do not administer the business can encourage further migration of the players carried on their books and have no contact out of more regulated environments, which in with the local market. Each method has its turn makes it extremely difficult for the U.S. benefits, depending on the motivation of the Government to implement policy and to con- parent institution. trol the flow of funds in the United States. —— 1lPecchioli, op. cit., p. 59. Pecchioli explains the seeming con- U.S. Branching Abroad tradiction between the claim that multinational banking activity increased and the actual number of overseas branches decreased. The movement of U.S. banks abroad co- “In fact the decline in the number of total branches between 1961 and 1978 is an ‘artificial’ one in that it reflects a sharp incided with the multinationalization of Amer- decline of branches of European banks (United Kingdom and ican corporations. However, there were added French banks in particular) in African and a few Asian coun- incentives for U.S. banks to go multinational tries which, following a policy of indigenisation motivated by economic nationalism, introduced restrictive legislation and in- that were perhaps not evident in other nations, duced takeovers by nationals during the period under re- in particular domestic, a regulatory structure view . . . [T]his policy led parent banks to change the form of that restricted U.S. banks from branching out- their presence in these countries from branches to affiliates. If branches in these countries are excluded from the total, the side of a limited geographic area and limited size of the global network more than doubled in the period under their potential market share in the United consideration. States. Ch. 6—The International Environment for Financial Services ● 157 —— —— —.—.———. —-. —.

Foreign Banks in the United States under the regulatory structure than were U.S. bank branches. With the International Bank- The number of branches and agencies of for- ing Act of 1978 much of the so-called discrim- eign banks in the United States increased from ination against U.S. banks in their home mar- 34 in 1961 to 241 in 1978 and to 452 in 1983. ’2 ket was done away with. There is still some Until 1978, foreign bank branches in the contention that the system does not treat U.S. United States were treated very differently and foreign banks totally equally, but for the ——— -— ———— most part, foreign banks must abide by the 12 Pecchioli, op. cit., p, 59; ( 1961 and 1978) Federal Reserve Board of Governors. 1983. same regulations as U.S. banks.

Financial Markets

Money Markets International Financial Perhaps the most remarkable growth in Information Systems bank use of foreign money markets as sources Computer-based business information sys- of funds in the last 20 years occurred in the tems are finding widespread application in the eurocurrency markets, financial service industry, particularly in in- Banks’ rapidly growing involvement in ternational finance. A major figure in this area euro-market business was largely by response is Reuters, the world’s oldest international to two basic elements: perception of the profit news agency. Reuters Monitor provides infor- opportunities arising from differential regula- mation on worldwide money markets to finan- tory provisions applying to international and cial institutions via 15,000 terminals in 74 domestic business and increased reliance on countries. ’4 By far the leader in this service, portfolio diversification as a means for reduc- Reuters competes with other nonbank finan- ing risk exposure. Over the years, an addi- cial data providers in the United States and tional stimulus to the expansion of euro- abroad, as well as with the information serv- currency transactions was provided by the ices of financial institutions. The Reuters serv- growing familiarity of customers, both depositors and borrowers, with the peculiar tech- ice is unique in that, as a videotex system, it niques of foreign currency operations and par- also provides the opportunity for the user to ticularly by the proved depth and resiliency deal in the markets and may eventually allow of the interbank markets in foreign curren- the user to confirm and complete deals using cies. 13 a terminal. The eurocurrency market provided banks in The information provided in these systems countries with undeveloped money markets has always been available, it was just not the opportunity to enhance the management readily accessible. In the case of the money of their liquidity. The development of sophis- markets, the information provided by these ticated interbank communication techniques services was not previously available in one also had a significant effect on the ability of place. Often these services provided addi- banks to participate in these markets. tional, useful information or information that could be found elsewhere in newspapers or Flexible exchange rates have enhanced the reports. However, what was once useful is now acceptability of the eurocurrency markets as essential information, providing a competitive ‘‘substitutes’ for the foreign exchange mar- edge to its user. This in turn has forced most ket with respect to hedging. ———— 14 —— Financial 13 Paul Walton, “A Boon for the Money Markets, ” Pecchioli, op. cit., pp. 19-20. 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 situ- the 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 centralized information function that feeds into its An annoying side-effect of these systems is own data system, or by existing vendors of- the proliferation of terminals and the incom- fering their services on compatible systems. patibility of systems. A dealer, in order to have access to a variety of information sources, may

International Interbank Communications

Much of the international banking activity cial telecommunication networks. SWIFT is described in the preceding sections takes place not a financial organization nor a telecom- via sophisticated international communication munication common carrier; instead, it is a facilities. This is particularly true for inter- nonprofit cooperative society that links mem- bank transfers of information and funds. As ber banks worldwide through a data process- international banking has grown, so too has ing and transmission network. SWIFT owns the importance of these functions. In recogni- and operates its own processing facilities and tion of this, many of the large, money-center leases communication lines from national or banks formed private telecommunication net- international carriers. works to help ease some of the problems asso- SWIFT was initiated by a group of Euro- ciated with massive paper flows. Interbank pean bankers who were searching for a better transfers are generally high-value transfers. way than mail or telex to transmit messages to correspondent banks. In response to the in- New York Clearing House Association crease in international financial volume in the In 1970, the New York Clearing House As- 1950’s and 1960’s, a number of banks had sociation began operating the Clearing House established internal communication and proc- Interbank Payments System (CHIPS). CHIPS essing systems. These proprietary systems was founded to help meet the need perceived usually connected only branches and affiliates by a few of the large New York money-center of the banking groups, and therefore trans- banks for an automated system. Since its in- actions involving a number of banks would ception, CHIPS has been almost entirely auto- often rely on a paper-based system. Another mated, although for a short period in the be- drawback of these proprietary systems was ginning some of the clearing was paper-based. that they established a myriad of standards, Although CHIPS has not stated any intention comparable to the different gauges of railroad of expanding geographically, it is responsible track one still encounters when crossing some for moving among banks an estimated 90 per- national boundaries. The creation of SWIFT cent of the U.S. dollars exchanged in interna- was in response to the need to establish a rapid tional commerce.15 communication and processing system, which was universal and standardized, was for all international interbank transfers and was avail- Society for Worldwide Interbank able to all banks. SWIFT was also seen as a Financial Telecommunication way to compete with these intrabank commu- SWIFT, founded in 1973 and operational in nication systems, particularly those of large 1977, is the largest of the international finan- U.S. banks but eventually also a number of —.—— — smaller U.S. banks, in order to provide the vol- “’’CHIPS: More Than Just a Clearing System, ” Transition, ume necessary to support the system. February 1983, p. 20. Ch. 6—The international Environment for Financial Services ● 159 .—— —— — — .— — ——

When SWIFT was incorporated in Belgium (see figs. 12 and 13).17 This represents about in 1973, it was owned by 239 European, North four times the combined total transactions of American, and Japanese banks in 15 countries. the two private sector bank payment networks In its first year of operation, SWIFT averaged in the United States, Bankwire and CHIPS. 18 51,700 transactions per day. ” As of April SWIFT is not a clearing or settling network 1983, the SWIFT system served 1,063 mem- and does not read the messages as they pass ber banks in 52 countries, of which 33 were through the system; therefore, the value of operational countries, and processed an aver- these transactions is difficult to determine. age of 360,000 financial transactions per day

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)

}, II t ( II II I

-,1 1, I i ]{ II I

———.— ] y-- 51 -w ..1 ), I I II II 1

I I 11 ( I ,1 1( I

SOURCE SWIFT Ten Years special anniversary issue of the general Introductory brochure (Brussels Belgium Society for Worldwide Interbank Financial Telecom- munication May 1983)

Figure 13.—Cumulative System Volumes (end of year) \lll I 1( )\\

I -1$

1981 169.081 000

SOURCE SWIFT Ten Years special anniversary Issue of the general Introductory brochure ( Brussels Belgium Society for Worldwide lnterbank Financial Telecom- munication May 1983) 160 ● Effects of Information Technology on Financial Services Systems

U.S. traffic over the network is higher than nancial market.22 SWIFT management fore- that of any other nation; in 1982 it was 17.7 sees a leveling off of revenue in this business percent of total volume, an increase from the area and therefore plans to expand its revenue 1981 figure of 16 percent.19 Yet only 141 U.S. producing message traffic in other areas. In banks participate in the system. Carl Reuter- 1982, SWIFT formed direct interface with the skiold, SWIFT’s general manager, estimates CEDEL and Euroclear bond clearing systems “that as many as 500 U.S. banks are involved and MasterCard International to use SWIFT sufficiently in international banking to merit for transmission of transaction or settlement SWIFT membership. ”20 information. After 6 years of operation SWIFT is enter- SWIFT has also begun a controversial new ing a new phase of operation. In 1982 it was program to offer new financial services, spe- able to amortize completely the development cifically balance reporting. Many U.S. banks costs of the network, and for the first year, view the proposed changes as potential com- broke even. This has occurred even though petition for services that banks currently of- SWIFT raised the basic per-message charge fer. However, if balance reporting does not only once, to 18 Belgian francs (about 35 to lead to other types of cash management serv- 40 U.S. cents) .21 ices, these banks will not challenge SWIFT’s entry into this business area. SWIFT manage- SWIFT’s plans for expansion include an im- ment maintains that the balance reporting provement in technical transmission and proc- service will be invisible to corporations and essing facilities, commonly called SWIFT II. will remain an interbank service. There is evi- Plans are to install a new, more powerful com- dence that although U.S. banks may be wary puter system between 1985 and 1987 on a of the changes, European banks may be en- country-by-country basis. SWIFT will finance couraging the implementation of these new the new system internally from operating services. revenues. Another service that SWIFT management Although SWIFT enjoys a comfortable posi- intends to expand is the provision of intra- tion as the primary international financial country financial communications. transmission network in terms of volume, it has continued to seek new business opportu- One of the primary achievements of SWIFT nities. By September 1983, SWIFT estimated for international banking has been the stand- that it offered its base service to approxi- ardization of international, interbank com- mately 90 percent of the total international fi- munications. With respect to new services, SWIFT intends to play the same role, thereby helping to establish international standards —— in cash management services, ‘gRobert Trigaux, “SWIFT Executives and Bankers Mull the System’s Future, “ American Banker, New York, May 17, 1983, p. 1. “B. Kok, “The Business Future, ” Proc&d”ngs From SWIFT ‘“Ibid., p. 31. International Banking Sem”nar(SIBOS ‘83), Sept. 26-30, 1983, 2’ Ibid., p. 31. 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 their nature handle increased volume of pay- classes of payments in his work, Banking and ments much better than paper-based systems. Electronic Funds Transfers.23 Borrowing from One of the distinguishing characteristics of the work of J. M. Keynes, Revell separates in- the international market is that, as in the do- ternational financial flows into two categories: mestic market, corporate customers demand those involving the transfer of income and the cash management services from financial serv- payment for goods and services by nonfinan- ice providers. The basic principle of these serv- cial business and households, or the “indus- ices is to maintain low operational balances, trial circulation” (corporate and retail pay- with the majority of funds invested and earn- ments), and those involving foreign exchange, ing interest. The impact of communication and the money market, and the capital market, or information technologies on the ability of a “financial circulations. ” It is a useful distinc- corporation to manage its financial position tion when one is concerned with the impact of is similar to that in the domestic market; i.e., the technology on payment flows, for it would the manager is able to react immediately to appear that certain characteristics of informa- information and to adjust the corporate finan- tion technology will have different effects on cial position accordingly. The difference in the the different types of flow. By using these two international market is that these transfers classifications, the specific impacts of the tech- take place in multiple currencies and cross nology can be defined more clearly. many international boundaries. For the mul- Information technologies have had a great tinational corporation, foreign exchange fluc- impact on operations in both areas. The mech- tuations provide a great incentive for initiat- anisms of these markets have been described ing electronic transfers. The technology allows in previous sections. What follows are specific the user to react instantaneously, often pro- examples of the effect of technology on the two tecting the corporation from foreign exchange types of flows. In retail and corporate markets, losses in times of economic turbulence. the technologies have led to a range of new, Another difference from the domestic mar- technology-based products, adding to the ketplace that affects the complexity of inter- choices available to the individual and corpora- national cash management is that the manag- tion in international financial transactions. In er must rely on information from a multiplicity financial markets the technologies have pri- of sources in dispersed places, to the point marily affected the velocity and volume of where flows of information are beginning to transactions. rival payment flows in importance. It is easy to reach Revell’s conclusion that, “The ulti- Corporate and Retail Markets mate objective is that the corporate treasurer In many of the normal payments associated at head office shall have an up-to-the-minute with trade, it is not speed of transaction which summary of the cash position in all currencies is of importance. Since trade payments are on a single VDU [video display unit] on his scheduled for particular days each month, the desk; he will then initiate the larger transfers settlement of accounts could easily continue of funds himself, leaving the bank computer to invest smaller amounts according to rou- to be handled by mail, taking the delay into 24 account. However, electronic payments add tines decided in advance. ” some control over these payments, and by

23 Revell , op. Cit., p. 154. “Ibid., p. 155. 162 • Effects of InformaTion Technology on financial Services Systems

Technological Innovation in Retail Services The developments outside the United States with respect to retail services are in many Since many innovations in corporate and re- ways similar to the domestic innovations that tail flow of funds often take place in the in- have been described in previous sections. ternational side first, it is useful to study what What differs in many cases is not the technol- is going on in the international marketplace ogy itself, but the commitment of the various to help project developments in the domestic governments and the structure of the finan- arena. cial service industry in a particular nation. One of the distinct differences between tech- Often, technological innovations are easier to nological innovation in the U.S. financial serv- implement under a regulatory structure that ice industry and that in foreign nations is the differs from the U.S. regulatory structure. For level of government subsidy of technical de- example, in Great Britain, BT and IBM are velopments that affect the financial service in- currently discussing an electronic POS system dustry. For example, the smart card, the ap- with the London clearing banks. Since the plications and functions of which are discussed banking industry in Great Britain is highly in chapter 2, was developed by the French concentrated, agreement with these banks Ministry of Post and Telecommunications (and assuming subsequent agreement with (PTT). Although the card has other uses, it will British retailers) will ensure a national POS be used for electronic banking, particularly for system. payments. The French have also conducted Some innovation in retail services takes various trials in point-of-sale (POS) systems place across national borders. Members of and have also introduced on a limited scale a Eurocheque International recently agreed on videotex system that will eventually be capa- a “eurocheque” ATM standard that will allow ble of handling financial transactions. The the crossborder use of the eurocheque guar- charge for this service is provided to the con- antee card. VISA International plans a simi- sumer as part of his monthly telephone charge. lar service on a worldwide basis. The impetus The British videotex system, Prestel, was de- for much of this activity has been the growth veloped by British Telecom (BT, then part of of international travel and the consequent the British Post Office), the telecommunica- need by the traveler for ready access to bank tions authority. Again, although the system accounts worldwide. has other applications, its service is in direct competition with other, commercially developed systems.

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 interdependence of national currencies, nation- the financial services to support it, not only in the actual support of trade through tradi- al markets, and national economic policies. tional 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 sepa- all cases clearly place liability, especially when rate from but related to the payment flows as- transactions involve multiple parties. It has sociated with world trade. One aspect of these been recommended that the party initiating money and capital markets is the interbank the transaction be responsible, which is not transfer. The application of information tech- acceptable to all parties. nologies permits both the increased volume of There is a similarity between losses suffered these transfers and the participation of small- under CHIPS or SWIFT and those under er, nonmoney center banks, thus helping other payment systems. They can be classified change the character and structure of inter- in three ways: principal losses, interest losses, national banking. and losses resulting from foreign exchange fluctuations. “These losses may be caused by Security and Integrity of the the delay of a transmission, the introduction Financial System of faulty information, or a participant’s inability to settle the day’s transactions. Delays Communication and information technol- and faulty information may arise from hard- ogies have increased the interdependency of ware and software failure, mistakes by person- the participants within the financial system. nel involved in processing the transaction, and The international financial system may now fraud. The failure to settle, on the other hand, be more vulnerable than ever to upheaval, is usually caused by the failure of one of the both economic and political, in foreign coun- transferring banks. “25 tries. At issue within this area is the question of the increased vulnerability of all parties to international events that results from commu- Foreign Telecommunications and nication and information technologies. Information Policies The technologies have created new oppor- Although the force from within the indus- tunities for attacking systems for delivering try is toward the flow of information through- financial services. System integrity, the ability out the world, integration of the world econ- of a system to recover from damage, is a sali- omy and the world financial system is by no ent issue when a significant portion of the re- means as simple as the integration of a domes- quired operations are performed without hu- tic economy. Currencies, accounting method- man intervention. For example, financial ology, and regulatory and supervisory struc- service institutions can be attacked by perpe- ture all differ among nations. In support of trators electronically and off-site. Some sys- trade activity, information flows across na- tems have reached a stage of complexity where tional boundaries: information which includes they can be backed up only with automated both personal and strictly financial data, in- systems, and in the case of interruption to formation which travels via sophisticated tele- service, they can be restored to operation only communications systems, and information with automated recovery procedures. processed by state-of-the-art technologies. These flows, known as transborder data flows Error Resolution in International (TBDF), have caused conflict and controversy Electronic Funds Transfer among nations and between particular nations and multinational businesses. It is primarily With increasing global interdependence and the informational flows, rather than payment increasingly complex transactions, generally flows, with which most nations are ostensibly more than two parties are involved in a single concerned. transaction, and therefore a multitude of systems are also involved. The issue as defined “Herbert F. I.ingl, “Risk Allocation in International Inter- bank Electronic Fund Transfers: CHIPS and SW1 FT, ” Har- here is that of responsibility in the case of loss ~“ard International I,awr Journal, \’ol. 22, No. 3, fall 1981, pp. or error. Simple bilateral contracts do not in 630-631. 164 ● Effects of Information Technology on Financial Services Systems —. —— —

Sovereign nations assert legitimate reasons The economic and industrial development for, and a right to, monitor and control TBDF. justification of restrictions of TBDF have as Primary among these reasons are protection their impetus the rising importance of infor- of the privacy of their citizens, industrial de- mation and communication technologies to the velopment, and national security. However, world economy. As traditional manufacturing sovereign rights and national information pol- industries stagnate and high-technology infor- icy are frequently in direct conflict with the mation industries grow, it is to every nation’s interests of large, multinational organizations, advantage to encourage a sound, strong infor- including financial service providers. This con- mation industry. Although national policy flict of interest in turn can impede the progress strategies differ, it is evident that some na- of a global financial system and perhaps world tions have taken the route of protectionism. trade. For example, Brazil has stringent requirements on the import of data processing equip- As the information technology industry be- ment in order to encourage the growth of local comes increasingly important in international industry. Until recently, little foreign competi- trade, more countries are seeking to protect tion was allowed in the large Japanese com- their indigenous communication and informa- munications and information technology and tion industries and are therefore creating legal services market. These types of activities, al- barriers to the flow of information. This has though they may protect indigenous industry, an impact on the financial service industry, have a tendency to increase overall costs to whose primary function is the distribution and users. processing of information. More specifically affecting the financial The requirements of multinational and inter- service industry are those national policies national finance include rapid communications that threaten to discontinue access to leased and efficient data processing. Certain restric- lines, begin usage-sensitive pricing schemes, tions by foreign governments—e.g., that all and demand that industry use local commu- data are processed locally-can severely ham- nication facilities. The objections of banks and per these activities. The current economies of other financial service providers is not only data processing are such that it is more effi- that this will increase their costs, but that cient to centralize the process. transmittals over public lines make control over sensitive information more difficult. For a variety of reasons, there have been suggestions that nations limit the flow of per- National security concerns seem to center sonal data across their borders. Some would around the economies of scale and the lack of limit the effects of restrictions to data iden- locational sensitivity in data processing. It is tifiable with natural persons while others would common for large corporations to center their include both natural and legal persons. In- processing facilities in one nation. For exam- cluded has been the suggestion that limita- ple, SWIFT’s data processing and transmis- tions on TBDF be focused on curtailing the sion centers for its 52 member countries are flow of data to nations that have not imposed located in 3 countries: the Netherlands, Bel- privacy standards at a level consistent with gium, and the United States. Such centraliza- those of the nation imposing them. However, tion engenders the fear that sensitive informa- much of the data of interest to the financial tion will be stored in a foreign country, or that service industry pertains to specific individ- a nation may be cut off from information in uals, and its movement across international a time of national crisis. As SWIFT pursues borders would be affected by such restrictions. domestic interbank markets, these fears be- Therefore, limitations on TBDF could cause come well-founded; it is entirely possible for significant problems for the financial service one nation’s domestic retail and interbank fi- industry, which finds demands for internation- nancial information to be stored at facilities al services increasing. 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 char- sumer as a potential customer. It appears, acteristics distinct from all other financial however, that competition is changing some service user groups. Approximately 80 million of the indifference of banks toward this mar- households comprise this group; and as such, ket. “It was not regulation or legislation that it is an important part of the U.S. economy. allowed nonbank institutions to exploit the op- Household deposits provide the financial serv- portunities available in upscale credit cards ice industry with nearly $2 trillion in loanable (American Express), in discount brokerage funds. In addition, consumers have a diversity (Merrill Lynch), and in automated payroll serv- of needs and compose a highly segmented mar- ices (ADP). Rather it was the failure of banks ket, Consumers, in comparison to their use of to engage in effective marketing and their lack other instruments, also make the least use of innovation and understanding of consumer of technology-based financial services and attitudes that gave the near-bank competitors products. the upper hand in these product areas.’” As a result, the consumer is beginning to wield It is readily accepted that although some more power in product development; recent movement has been made toward consumer events are changing consumer financial serv- acceptance of technological devices in bank- ices from being product-driven to being mar- ing, the time horizon for acceptance by the ket-driven. It is not clear, however, if all con- total population will be much longer than 10 sumers are benefiting from these changes. years. There are currently some highly visible examples of the effect of technological change Consumer protection regulation has in the on this market segment (e.g., the rapid accept- past dealt with the protection and fair treat- ance of automated teller machines (ATMs)), ment of consumers in the financial service but certain institutional relationships have system. Implicit in the formulation of public been affected little by the technology. As some policy has also been the recognition of the po- new systems are implemented, however, and tential impact of technology-based systems on certain of the institutional problems with the consumer. However, it is important to these implementations are resolved, the effects fully understand the changes taking place, of technology on the consumer of financial their impact on the role and behavior of the services are bound to become more evident. consumer, what new issues will arise because of these changes, and existing issues that have Historically, the banking sector of the finan- not been adequately addressed. cial service industry has been either enamored ————— of or totally uninterested in pursuing the con- ‘Richard Rosenberg, Vice Chairman of W’ells Fargo, as quoted in The Retail Banking Re\’olution: An International Perspec- ‘The consumer, as defined here, is an individual user of per- tit’e, Patrick Frazer and Dimitri }Tittas (eds. ) (1.ondon: Nlichael sonal financial services. 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 instru- against future consumption through savings ments, to secure growth in capital, and to safe-

167

- - 35 505 ~ 84 - 12 : QL 3 168 • Effects of /formation Technology on Financial Services Systems ——.— — —. guard their assets. A rational consumer who cent movement of funds out of money market wants to maximize his objectives will desire funds into their depository equivalent, money control over the means (i.e., assets and income) market deposit accounts. These figures will be to those ends. The degree of his control is reflected in 1983 end-of-year accounts. measured by the extent to which his assets Life insurance funds are also used for ac- meet his needs. cumulating savings; however, because of their In this regard, Professor William White, in low rate of return, their primary function is his report to the Investment Company Insti- insurance against risk. Individuals also invest tute, The Outlook for Money Market Mutual a considerable amount in securities, both cor- Funds, defines the demand of consumers for porate and government. specific financial products and services as aris- Home mortgages, although they represent ing not from the particular product or serv- a liability relationship for the consumer, are, ice, but from features of the consumer and his in effect, instruments of negative savings in environment. Demand arises first from the ne- which the consumer initially creates a debt cessity for the individual consumer to meet relationship with an institution. However, as certain basic needs, which can be classified as the consumer decreases his debt, he earns convenience, return, liquidity, security, credit equity in the property; as the value of the availability, and, to some extent, personal property increases over time, it increases the service. The investment behavior of the con- net worth of the individual. sumer is related to the relative importance of each of these needs, which in turn is based on The relationship of assets to liabilities and the individual’s economic environment and his the choice of instruments for investment lifecycle stage. Also of importance is the less varies with the age and income of the consum- tangible factor of individual tastes and prefer. This is depicted graphically in figure 14. erences. 3 The primary earning years are between the ages of 20 and 70, when generally the con- Consumer Savings and sumer earns more than he consumes. With Investment Behavior age, savings and investment behavior of the consumer changes. Generally, in youth, the The term “investment” throughout this sec- consumer will be more consumption-oriented; tion is not used in its macroeconomic sense, as age and income progress, the consumer will that is, the purchase of capital goods. For this be more future-oriented. The consumer’s basic chapter the term means the commitment of needs of convenience, higher return, security, money specifically to earn a profit, most often liquidity, credit availability, and personal secu- by purchasing securities. “Savings” are de- rity often correspond with this lifecycle and fined as asset accounts in which an individ- directly influence which financial service and ual accumulates funds for future consumption. products he selects. For the most recent statement of total out- Although aggregate information on the sav- standing assets and liabilities for the house- ings habits of consumers reflects a propensity hold sector, see table 9. to invest, an overall tendency to save rather The primary savings instruments used by than borrow, and a pattern of savings highly individuals are time and savings deposits, pen- correlated to age, consumers differ in their ob- sion funds, and home mortgages. In recent jectives for asset management. The financial years, more consumers have begun using the service industry has recently begun to react money market fund for savings. The figures to these differences and to provide services to for 1982 do not reflect, however, the more re- meet very individual needs in addition to providing instruments that have widespread use ‘William L. White. “The Outlook for Money Market Mutual Funds, ” Report to the Investment Company Institute, Sept. (e.g., checking and savings accounts, bank 30, 1982, pp. 28-29. 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 ., $2,781.3 Deposits ., ., ...... 1.982.7 Checkable deposits and currency ...... 307.3 Small time and savings deposits . . . 1,322,9 Money market fund shares ...... 206.6 Large time deposits ., . . . . 145.9 Credit market instruments ., . . . . 798,6 U.S. Government securities ., ... 377.0 Treasury issues ...... 291,8 Savings bonds ...... 68.3 Other Treasury ... , ...... 223.4 Agency issues . 85.2 State and local obligations . . . . . 129.0 Corporate and foreign bonds ...... 64.5 Mortgages ...... , ., 186,5 Open market paper...... 41.6 Corporate equities ...... 1,316,2 Mutual fund shares ., ...... 89.5 Other corporate equities ...... 1,226,8 Life insurance reserves ., ...... 1,316.2 Pension fund reserves ., ., ., ... ., 935.3 Security credit ...... 16.0 Miscellaneous assets ...... 85.3 Total assets ...... $5,381.0 Liabilities: Credit market instruments . ., ., 1,674.4 Home mortgages ...... 1.101,0 Other mortgages ...... 36.4 Installment consumer credit . . . . 344.8 Other consumer credit ... ., ., 85,9 Bank loans n.e.c.a ...... 33.3 Other loans ...... 730 Security credit ...... 28.8 Trade credit ...... 22.2 Deferred and unpaid life insurance premiums 15.5 Total liabilities...... $1,740,9 NOTE Households Include not for profit orqanlzat!ons aNot elsewhere class lf~ed SOURCE Board of Governors Federal Reserve System Flow of funds Accounts: August 1983

Providers of Consumer Financial Services vided for his/her insurance needs, Regulation tended to support this specialization. Recent For the most part, consumer needs cannot trends in the marketplace and in regulation are be met without the assistance of an interme- beginning to break down the strict distinctions diary that provides access to payment sys- between institutions. Many consumers are tems and markets, expert knowledge and adapting readily to the changes and are chang- advice, the pooling of a large number of indi- ing traditional relationships with some finan- vidual risks (as with insurance protection), or cial institutions. a diversified portfolio for a minimum investment (as with investment companies). Prior to these recent events, the most widely In the past, consumer financial institutions recognized financial relationship for the con- specialized in individual products and services. sumer was with a depository institution, espe- As a result there were some institutions that cially with a bank. Banks provided the con- provided for the payment needs of the consumer access to the payments mechanism sumer, some which provided for his/her sav- through checking accounts and met some cred- ings and credit needs, and still others that pro- it and savings needs. Savings institutions pro- 170 . Effects of Information Technology on Financial Services Systems — —. .—

Figure 14.— Lifecycle of Consumer Needs

I Earned income (excluding investment income and transfers)

F=/ \ ~~ o 10 20 30 40 50 60 70 age in years ~~~ ~ Usually First Prime working and earning Supported by income supported by jobs years from savings, retire- parents 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 New financial activities Resulting financial service(s) requirements

Teens- First jobs (though often still Transaction accounts, simple savings 20’s with parent support). accounts or instruments (e.g. U.S. savings bonds). Often, college. Education loans. Often, car or other major purchase. Auto or other loans Auto insurance. —. -. 20’s First home purchase or more saving Home mortgage. to prepare for home purchase. More sophisticated savings instruments, Marriage and first children. Various loans (general credit). Related: perceived need for greater Insurance, savings life, health, home insurance, security to protect family. .— — – 30’s Prime working-and earning years: 60’s Higher income, Tax shelters Larger saving base being built, More sophisticated investment vehicles: as foundation for children securities, money target funds, real education and other expenses, estate, insurance purchases. and for old age. real-estate pension plans. More business travel. Financial advice often desired. More income for personal travel. Traveler’s checks, travel and entertainment credit cards.

0 High /0 of time working, especially Cash dispensers, debit cards. two career couples (2 earner families): result - need for greater convenience in transactions, more mail order and overall purchases. —— . 60’s ‘- Often retirement or less working ‘- Financial advice, to plan for supporting time, more leisure, less earned a standard of living income. 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 largest card bases in the United States and unions provided services similar to those pro- have filled certain consumer financial needs for vided by both commercial banks and savings years. Both are favorably placed in the finan- institutions. cial service marketplace because the consumer recognizes their names. As the consumer be- Recent research shows that the typical con- comes used to nontraditional providers of fi- sumer deals with only one or two banks and nancial services, he may willingly accept re- will accept fairly standardized products.’ How- tailers as providers. ever, it also shows that there is very little consumer loyalty toward a particular institution; Consumers may obtain cash from a variety if another institution can meet the needs of the of other places besides banks; for example, in- consumer better, the consumer usually moves dividuals routinely cash checks at a grocery his business. A consumer “wants to be able or convenience store solely for the purpose of to use a credit card to purchase goods and cash acquisition. Although these retailers are services from merchants, and he wants to be not financial institutions in the traditional able to use a piece of plastic (preferably the sense, they certainly have provided consumers same one, perhaps) to obtain cash from a ma- with financial services in the past. Grocery chine. He does not care who issued the card stores have used check guarantee systems for or who wrote the programs accessing the ma- a number of years, and as mentioned earlier chines any more than he cares who manufac- in this report, some are beginning to offer more tured the machine. This has been borne out technologically sophisticated services—for ex- by the rapid movement of funds out of tradi- ample, onsite ATMs. tional deposit accounts in the 1970’s to ac- The ways in which the financial service in- counts with a higher rate of return. In the dustry is changing are described more fully past, most so-called consumer loyalty was il- elsewhere in this report. The effect of these lusory in that banks had a monopoly on cer- changes on the consumer has been to offer him tain types of transaction accounts and often a greater realm of choice in the institutions had a geographic monopoly, as well. with which he can do business. Individuals with higher discretionary incomes, a desire for high growth of assets, and Consumer Payment Methods lower risk aversion will generally have a relationship with a securities house. High income, Like the business sector, the consumer requires payment mechanisms to acquire goods or, in its place, low risk aversion, was gener- and services. Recent research has postulated ally necessary to offset the risk associated that a consumer seeks as many as 11 specific with the instruments offered through these in- attributes in a payment system: budgeting, stitutions. documentation, reversibility, spending con- It is evident that consumers have also had trol, transaction record, leverage potential, fairly complex financial relationships with acceptability, transaction time, transfer time, nontraditional financial service providers. His- social desirability/prestige, and security.6 Each torically, retailers have extended credit to consumer will choose his method of payment their customers to purchase goods and serv- according to his priorities and to his percep- ices. From this has developed a fairly substan- tion of a particular method as having the speci- tial number of consumers with revolving credit fied attributes. lines, and credit cards to access these lines of credit. Sears and J. C. Penney have two of the By far, the most commonly used medium of exchange for point-of-sale (POS) purchases is

‘Arthur D. Little, Inc., Issue and Needs in the Nation’s Pay- ‘Elizabeth C. Hirschman, “Situational Perception of Prod- ment System, The Association of Reserve City Bankers, April uct Prototypes Within the Product Class of Consumer Pa~’ment 1982, p. 35. Systems. ” The Journal of Genera) PsJ’choJogTr, \ol. 106, 1982, 5Paul Horvitz, American Banker, New York, Sept. 24, 1982. p. 127. 172 ● Effects of Information Technology on Financial Services Systems

cash, particularly for small transactions. The charge cards and, except in certain instances, primary attributes of cash are convenience and do not provide long-term credit to the con- acceptability. Since cash is universally nego- sumer. When they were introduced, the con- tiable and requires no personal identification sumer did not have highly developed credit for use, cash transactions also have the addi- needs. T&E cards met the additional consumer tional attribute of privacy; however, these needs of spending control and leverage poten- same qualities make cash a less secure medium tial. In addition, the high membership fees and of exchange. For the approximately 17 percent apparent exclusivity of the cards provided of all households that have no relationship a sense of social prestige. Although it was with a financial service institution, either cash thought that with the introduction and wide- or (in specific instances) money orders or cash- spread use of bank credit cards, the number iers’ checks, are the only instruments of pay- of T&E cards in circulation would dwindle and ment available. their usefulness would be outdated, their number has actually grown. Many consumers use checks to meet these needs. Studies show that the consumer’s use Bank credit cards9 are used in most cases of checks has consistently been in the range as an alternative to cash or checks for POS of 50 percent for bill payment, 31 percent for transactions. Their line of credit added flexibil- retail purchases, 9 percent for payments to ity to consumer payment mechanisms. Bank other individuals, and 8 percent for cash ac- cards are perceived by the consumer to be quisition. 7 The figures for cash acquisition are more acceptable and less time-consuming to probably low, since many checks written to use than checks and less risky than cash. They retail institutions are actually for acquiring also provide the consumer with proof of pay- cash. In 1979, consumers’ checks accounted ment, which facilitates returns or reimburse- for approximately 53 percent of all checks ment. The majority of credit card users do not written, or 17 billion transactions.8 actually use the credit option associated with the card, paying instead the full amount owed Until the 1950’s, the personal check was 10 each month. The card is viewed more as an truly the only widely used alternative to cash instrument of cash management. Tables 10 for payments. In recent years, however, the and 11 show overall consumer holding and use check has become less negotiable; consumers of credit cards. frequently are required to have additional .—— identification and some proof of creditworthi- 9The term “bank credit cards” is rapidly becoming somewhat ness in order to use a check for POS purchases. of a misnomer. This term commonly refers to VISA and Master- In part, the decreasing negotiability and lack Card interchange cards, which in the past were issued by banks. However, these cards (although for the most part still issued of national acceptance of the check led to the by banks) now provide access to a variety of’ accounts, including explosion in the availability and use of other central asset accounts offered by securities houses.

O E payment mechanisms for the consumer—e.g., I c o n o m ” c Review, Op. cit. traveler’s checks, retail credit cards, travel and Table 10.—Credit Card Holding entertainment (T&E) cards, the bank credit (families holding cards as percent of all families) card (in the 1960’s), and, most recently, the debit card. Year Type of credit card The traveler’s check and the T&E card pro- 1977 1978 1981 1982 Any ...... 63 64 66 70 vided the consumer with payment mecha- Gasoline ...... 34 34 30 35 nisms more negotiable than the check, with Bank ... , ...... 38 40 45 51 a attributes of convenience and acceptability, General purpose . . . 8 10 14 14 Retail store ...... 53 50 57 63 yet more secure than cash. T&E cards are Other b ...... 6 5 7 NA a Travel and entertainment cards. ‘See Economic Review, “Special Issue: Displacing the Check” blncludes airline cards, car.rental cards, and others not classified elsewhere (Atlanta, Ga: Federal Reserve Bank of Atlanta, August 1983), NA—not available, p. 8. SOURCE Data collected for the Federal Reserve Board by the Survey Research ‘Ibid., p. 26. Center, University of Michigan. .—

Ch. 7—The Consumer of Financial Services ● 173 .

Table 11 .—Credit Card Use ingly complex. In the early part of this cen- (families using cards as percent of all families) tury, households operated almost entirely on —. — —— Year a current basis; using credit was an indication Type of credit card -1971 1977 1978 1981 1982 of mismanagement of household accounts. Pri- Any ...... 50’ 60 62 62 ‘- NA or to the 1930’s, credit relationships with fi- Gasoline ...... 33 31 32 27 31 nancial institutions were not common. Retail Bank ...... 19 25 37 39 47 establishments were more likely to extend General purposeb . . . 5 7 9 12 13 Retail store . . . . 45 50 48 51 57 credit in direct relationship to consumer pur- Other c ...... NA 4 3 5 chases. At that time, it was postulated, house- — — NA—— aData ;or 1970 bTravel and entertainment cards holds could manage credit to help balance cur- clncludes al rl( ne cards and car rental cards rent consumption wants and needs against NA—not avaliable future income. 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 Since then, as described earlier in this report, there has been an exponential growth in In the 1970’s, considerable speculation de- consumer credit and in institutions and in- veloped about a future “cashless society” (i.e., struments to serve these needs. In the 20 years a system where cash as well as checks would from 1960 to 1980, total household liabilities become obsolete, having been replaced by elec- as a proportion of total household assets grew tronic payment mechanisms). However, de- from 21 to 35 percent. ” This growth also re- spite the growth of electronic alternatives, the flects, in part, a change in attitude by the con- use of checks as a method of payment contin- sumer. Credit is no longer the last resort of ued to grow at approximately 5 to 6 percent a mismanaged household, but a means of im- per year throughout most of the 1970’s and proving one’s living standard. has only recently begun to slow. It still con- The primary long-term instrument for dec- tinues to increase at about 2 percent per year. ades was the installment loan, where a bulk Traveler’s checks and credit cards do not re- sum was borrowed by the consumer from a quire a check be written at point of sale; how- bank or consumer finance corporation to fi- ever, the majority of them rely on the check nance a large-ticket purchase of a durable for reconciliation of accounts. The only in- good, and repaid in installments over a speci- struments besides the check that provide the fied period of time. Another example of con- consumer direct access to his account are the sumer credit was the retail revolving account, debit card, preauthorized payments, and ATM in which a consumer could charge a particu- payments. In 1979, 97 percent of all debits to lar amount on store-granted credit and repay individual accounts were by check. The other the outstanding balance monthly. 3 percent of debits to consumer accounts were In the 1960’s the first bank credit cards were distributed thus: 1.3 percent to preauthorized introduced, adding yet another source of con- paper drafts, 0.4 percent to preauthorized sumer credit. As mentioned previously, the automated clearing house payments, and 1.1 bank card is used primarily for its conven- percent to ATMs. ” The current system is ience; however, the credit uses of these cards, merely a reflection of the acceptance of these which were innovative when introduced, de- alternative media rather than an example of serve exploration. one replacing the other. The bank card offers essentially two types Growth of Consumer Credit of credit options for the consumer: short-term credit to bridge cash shortages between pay- The relationship of the consumer to the pro- checks and longer term installment credit. The vider of financial services has grown increas- “Board of Governors, Federal Reserve System, Flow of Funds “Ibid. Accounts, August 1983, September 1979. 174 • Effects of Information Technology on Financial Services Systems ———— — —. .— latter is provided with only one credit appli- and minimal risk aversion. In time, as double- cation, the consumer may borrow the exact digit inflation continued and the spread grew amount he wishes within his credit limit and between interest earned in these funds and have considerable payment flexibility. About that earned in bank time deposits, other, more two-fifths of credit card holders use these op- risk-averse individuals began investing in tions on a regular basis. these instruments. This phenomenon was partly responsible for the movement within Recent Innovations in Consumer Congress to deregulate parts of the banking Financial Services industry, a movement that eventually allowed depositories to offer accounts bearing higher, In the past decade, inflation, interest rates, more competitive interest rates. and the lifting of particular banking regula- In response to competition and profit oppor- tions have affected how consumers manage tunities, depository institutions have also their assets. Events of the last decade have begun offering discount brokerage services to increased the number of investment options their customers, making it possible for some open to the consumer of financial services and consumers to meet a number of their savings expanded the range of consumers who use and investment objectives with one firm. How- these services. For example, tax-exempt in- ever, since banks are not allowed to offer ad- come is available to all consumers through In- vice on investments, except in the case of trust dividual Retirement Accounts (IRAs), and customers, this service is still limited to a money market funds and money market de- financially sophisticated class of consumers. posit accounts allow the small investor access On the other hand, nondepository institutions, to high interest rates. such as securities firms, have added services that have the appearance of depository instru- Nontraditional Providers and Instruments ments, yet the qualities a consumer seeks for Recent changes in the industry have also af- managing his assets. Since consumer percep- fected the way the industry provides financial tion of the instruments is the same, a con- services to the consumer and have introduced sumer may not differentiate between the two new players to the marketplace. In the 1970’s, choices. the inflation rate and the resultant high op- The Depository Institutions Deregulation portunity cost of standard consumer savings and Monetary Control Act of 1980 provided instruments led to a phenomenon known as new opportunities for the consumer. This act Funds flowed out of the “disintermediation.” allowed depository institutions nationwide to depository institutions into nontraditional in- offer NOW accounts through which the con- struments and institutions. New instruments sumer earns interest on an account that is not were created outside the interest rate-regu- differentiated in use from a checking account. lated environment of the banking community. These accounts already comprise one-third of One of these, the money market fund, allows all checkable deposits. ” Also enacted by the the small saver to earn higher interest rates same legislation was the provision that fed- and thereby preserve assets. This instrument erally chartered savings and thrift institutions is a particularly appealing alternative because could offer consumer loans for up to 20 per- it also offers checklike privileges through cent of assets. share drafts. Although there is usually a minimum amount the consumer can withdraw Complexity of the Marketplace from his account with a draft, in many cases it meets his liquidity needs. The present marketplace offers greater choice yet greater confusion for the individual. The initial target of these funds was the so- called upscale market; that is, those individ- ~Bomd of Governors, Federal Reserve System, Money Stink uals with relatively high discretionary incomes Measures and I.iquid Assets, Dec. 30, 1983. Ch. 7—The Consumer of Financial Services ● 175

The consumer must be more aware of the par- also push these consumers out of the bank, ticulars of investment and must deal with a further limiting their access to information changed environment that no longer offers services. him standard investment opportunities keyed to his position in life. The result is an increas- Technology-Based Services ingly complex relationship between financial There is little evidence to support the notion institutions and the consumer. that consumers specifically demand technol- For example, high and uncertain interest ogy-based services; the demand for services is rates also led to an industry-led innovation in still a reflection of the overall needs of the con- the home mortgage market. During the 1970’s, sumer. There is perhaps a particular class of the variable rate mortgage was introduced. In consumers, referred to as “innovators,” who addition, the equity loan was introduced into willingly accept new technological applica- the home mortgage market. This loan, which tions. The market for these services evolved allows a homeowner access to the equity in his as the consumer discovered that technology- home, is much the same as a second mortgage; based services had specific attributes of re- however, second mortgages are traditionally mote location and self-service and that they used for specific purposes such as home im- provided a payment alternative. The use of provements. Most of the promotion of these technology in financial services can help alter loans, under the rubric of “credit manage- consumer demand for financial services by merit, ” encourages their use for virtually all providing him easier access to his assets. purposes, exposing the consumer to the loss Some financial service innovations men- of his home if he is unable to meet payments tioned in the previous section were facilitated on the loan. by technological change; e.g., variable rate The solution to this situation is not neces- mortgages require information-processing fa- sarily to increase the information available to cilities in order to be cost effective. This sec- the consumer. Often educational differences tion distinguishes between those innovations or a predisposition by the consumer precludes that require technology in the backroom sense him from processing the information in a way and those that require the consumer to have that would facilitate his decisionmaking. And, direct contact with the technology or those it is likely that particular groups of individuals where technology changes the behavior of the will be more affected than others. Certain consumer with respect to financial services. groups may beat particular disadvantage; for Previous sections of this report illustrate the example, the elderly and the uneducated. way that communication and information There is also some question whether there technologies have affected the way the finan- will be a conflict if the provider of services is cial services industry operates. The informa- also the major provider of information about tional nature of the financial service product these services. For the most part, only wealthy led to the early application of automation in individuals have access to financial advice, this industry, particularly in internal and either through bank trust departments or se- intra-industry operations. However, when curities brokers. Discount brokerages provide these technological solutions were applied to access to financial markets for less wealthy the marketplace, especially as new products consumers, but without the advice function. and services in the consumer segment, the Middle-income consumers have in the past benefits were not so clear nor the implemen- relied on banks for some financial advice, but tations so easy. In particular, when depository in more complex systems, banks are often not institutions attempted to transfer their cost- in the position to offer sound advice to this saving technological solutions to the consumer segment of the consumer markets, owing to market, they were faced with a diverse, often a lack of trained personnel. Technology may reluctant market. 176 • Effects of Information Technology on Financial Services Systems

Consumer Acceptance of Technology cent.15 It should be noted, however, that the value of deposits received at an ATM far ex- Some attempts at introducing technology- ceeds the value of withdrawals. Also, ATM based products and services to the consumer cash withdrawals tend to be for amounts that of financial services succeeded and some failed. are half the value of withdrawals facilitated It became evident from these attempts that by a human teller. technological solutions had to consider consumer need. Examples of such new technol- Also interesting to note is that use of the ogies include ATMs, automatic direct deposit machines during normal banking hours is in- systems, preauthorized payments, POS funds creasing, which represents a change in con- transfer and check guarantee, and home infor- sumer attitude about the primary attributes mation systems, most of which have been de- of the machines. Originally, ATMs were seen scribed in previous sections of this report. as convenient for obtaining cash 24 hours a What follows are descriptions of consumer day. In this sense they were direct competitors acceptance and attitudes toward these tech- with retailers who provided this service. How- nologies. ever, with the change in pattern of use during banking hours, there is some indication Automated Teller Machines that they are beginning to replace the human teller as a source of cash. This is partly due The ATM is an example of electronic funds to the greater reliability of the newer machines transfer (EFT) that is highly visible to the con- and to the increasing acceptance of the ma- sumer of financial services. By 1981, the Bank chines by a greater number of people. In many Marketing Association (BMA) reported that cases, the institution deploying the ATM en- nearly 100 percent of the population was aware courages its use in order to lower the per- 14 of ATMs. Of that figure approximately 32 transaction cost of the system and therefore percent actually use an ATM for financial the costs to the institution. transactions, which is an increase from 10 percent in 1977. When further broken down, this Research shows a strong correlation be- figure reveals that only slightly more than half tween age and ATM use. The most frequent of the 32 percent use an ATM more than once user of an ATM is young; use peaks in the 25- every 2 weeks. The growth of ATM use has to 34-year-old range, with a dramatic fall-off followed the typical pattern of technological in use among members of the population over diffusion—that is, from initial use by “inno- 65. ’6 There is some evidence that those young- vators” to rapid, widespread use. The Federal er than 25, although not frequent users of Reserve Bank of Atlanta in a recent analysis ATMs, have a high level of acceptance, and of check displacement has estimated that the when they establish firmer relationships with saturation level for the ATM will be reached financial institutions, they too will become fre when the percentage of actual users reaches quent users of the technology. It is expected 65 percent of all possible users. that the age factor will become less important with time, although when is unclear. The primary pattern of use of an ATM is for cash acquisition. According to Linda Fenner Isolated experiences indicate that one fac- Zimmer, a noted ATM consultant, the pattern tor that can hinder the use of ATMs by the of use of the ATM has remained relatively con- elderly is inexperience with technology. In cer- stant since its introduction: cash withdrawals tain situations, by providing the elderly cus- represent approximately 75 percent of the vol- tomer with assistance, many of these reserva- ume of use of ATMs; deposits, 19 percent; bal- tions can be overcome. However, this will not ance transfers, 4 percent; and payments, 1 per- always be the case, and it cannot be over- looked that convenience and remote location

“Bank Marketing Association (BMA), Payment Attitudes ‘“Econom”c Review, op. cit., p. 17. Change Evaluation (PACE III 1981), Chicago, p. 2.1. “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 con- payer services are an example of consumer sumer of financial services. Tradition and the reluctance to use a service to meet needs which human factor can play important roles in this they believe are adequately met through other group’s use of financial services, and therefore services. Acceptance of this method of pay- in their acceptance of technological services. ment has not been very high, and there has been little growth in the service in the past few Automatic Direct Deposit years.

In an automatic direct deposit system, some Point-of-Sale Systems form of income is automatically deposited in an individual’s account on a regular basis. Ex- There is little substantial information on amples include direct deposit of Social Secu- consumer attitudes toward POS debit systems rity checks by the Government or of payroll or POS check guarantee systems. In general, by the private sector. Direct deposit is another most consumers are unaware of these systems, example of technology-based service of which except in areas where there have been trials. the general population is nearly 100 percent The introduction of the debit card in the United aware. According to the 1981 BMA survey, States was closely tied to consumer reaction 36 percent of respondents’ households use to early POS experiments. Consumers found automatic deposit, and 80 percent of these had they did not care to carry basic necessities on a very favorable opinion of the service.17 In the credit cards. 5 years between 1978 and 1981, penetration of direct deposit of Social Security benefits Home Information Systems grew from 11 to 33 percent of all such payments. It is the eventual goal of the U.S. Home information systems are described at Treasury that all Social Security payments be length in chapter 4. There is little agreement made by direct deposit.18 on the potential for consumer acceptance of this service. One of the major constraints to The premise on which direct deposit is sold, its growth is the pricing of the systems. There particularly with respect to Social Security is currently a great debate about what people payments to the elderly, is that it decreases will pay for these services and about what they consumer vulnerability to theft. Other aspects perceive the value of these services to be. of the service to which the consumer responds While these questions remain unanswered, it favorably are convenience, the speed of ac- is difficult to say how rapidly the services will count crediting, and the regularity of depos- grow and when and if they will become a mass its (particularly when the recipient is out of medium and therefore open to every level of town). On the other hand, the consumer per- consumer. ceives the system raising service charges on his account and providing increased access to Once more, the perceived market for the others of his personal account information. 19 service is the upscale consumer. To the consumer who earns less than $40,000 per year Telephone Billpayer and writes few checks, the system may not be cost effective. For the time being, pricing of Telephone billpayer systems are not always both equipment and the services may preclude fully automated, but are considered here be- the participation of the lower income consumer cause they represent an innovative use of in this case. technology-in this case, the telephone—to facilitate consumer payments. Telephone bill- Pricing Structures

“Ibid. p. 3.4. Past financial services were often perceived ‘nEconomic Review, op. cit., p. 33. by the consumer to be free or, relative to other “Bank Marketing Association, op. cit. expenses, inexpensive. There was either no Ch. 7—The Consumer of Financial Services ● 179 ——— -.— ——— - —— — — .—. charge or a minimal “service charge. Finan- Communication Costs cial institutions earned their profit through the difference in explicit and implicit rates charged It seems inevitable that local communica- on assets and paid on liabilities. Through com- tions costs will rise; however, at what rate is petitive and economic pressures this spread still uncertain. The eventual price to the con- narrowed, and the income to banks therefore sumer will depend on the structure of Federal decreased. regulation of local rates and, barring Federal regulation, the decisions State governments Fee income makes up an increasingly large make about regulation of the communication portion of overall bank income. All evidence industry. If home information systems become indicates that this trend will continue, the pric- the major way for consumers to obtain infor- ing structure in the future will be cost-based, mation and transact business, the communi- and service will be explicitly priced. cation costs of these transactions could also In addition, pressures from outside the in- rise. dustry are increasing the price of service to the consumer. For instance, as it becomes Competition and Costs more important for the individual to be in- In an economic sense, competition is consid- formed fully in order to make profitable deci- ered good for the consumer in the aggregate: sions, the cost of information also becomes a it results in greater options at lower price. In- factor. A number of such exogenous forces af- creased competition in the financial service fect the total cost of service to the consumer. industry has provided the consumer with increased options. Although products and serv- Opportunity Costs ices are now explicitly priced, they may well be cheaper to the consumer because he will re- Based on evidence that financial decision- ceive higher return on assets. However, if making is becoming more complex for the con- other investment motivations of the consumer sumer, opportunity costs are paid because of are considered—e.g., security of assets—the the greater amount of time the consumer will relationship of competition to the relative posi- have to spend in order to make the correct in- tion of the consumer is less clear. vestment. When interest rates are high, the opportunity costs, in the form of foregone in- To really judge the effect of competition on come from higher rate investments, are great- the consumer, the distinctions between the er. Some of this cost will be lessened by de- various market segments must be maintained. regulation of interest rates paid on deposits. The consumer with a high discretionary income may benefit from increased choice and Information Costs from instruments with a higher rate of return. To those who consider financial institutions In order to make profitable decisions, the essentially service organizations and the safe- consumer needs access to more information keeper of funds, the high fees for very limited than previously and will most likely have to service may place them in a situation where pay for this information. In its current form, they are worse off than previously. They may information is not always accessible to the con- have fewer choices in a competitive environ- sumer. Again, it is questionable whether the ment than in a regulated environment. consumer will willingly pay for information. For the wealthier, upscale consumer, for whom In his study Banking and Electronic Fund the return is obvious and greatest, there may Transfers: A Study of the Implications, be a willingness to pay for information. In gen- J. R. S. Revell states that price is the single eral, one of the questions facing providers of most important factor affecting the long-term electronic information is how valuable does the growth of acceptance of EFT services. If the consumer perceive the information to be and trend in financial service fees continues toward therefore how much will he pay? 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 mech- already begun to price their services accord- anisms through pricing strategies.

Public Policy and the Financial Service Consumer

An important policy objective of the legis- Under current Federal and State regulatory lation of the 1930’s was to provide for the structure, the consumer’s deposits at a partic- safety of consumer deposits. This was accom- ular depository institution will be covered up plished through regulations designed to ensure to $100,000. In 1970 the Securities Investor the overall safety and soundness of the sys- Protection Corp. (SIPC) was established by an tem and Federal deposit insurance programs. act of Congress, to protect the investor from nonmarket losses involving funds and securi- Deregulation has made it possible for a num- ties held by broker/dealers. These losses will ber of new institutions to enter the battle for occur usually only if the institution goes into consumer funds. A diversity of institutions insolvency. now offers similar products to the consumer; one of the major differences between them, Investment companies currently offer no however, is the extent of their regulatory conform of direct protection for the consumer’s trol. Depositories are, for the most part, in- assets. This is of increasing importance since sured and therefore provide a certain level of recently more consumers are investing in the protection to the consumer. Adherence to cer- instruments of investment companies-i. e., tain safety and soundness regulations required the mutual fund and the money market mu- of depositories is not required of other finan- tual fund. The consumer is covered neither for cial institutions. However, these noninsured market losses nor for losses that are the re- institutions offer services similar to those of- sult of mismanagement. It appears that many fered by insured institutions and have, in fact, consumers consider the money market mutual drawn accounts away from the insured insti- fund a higher interest-bearing type of deposit, tutions. Only the effect on the consumer, not and are not aware that their accounts can be the equity, of this situation for the various in- subject to movements in the marketplace. Al- stitutions, will be discussed here. Important though these firms are not federally insured, effects are those which are perceived by the their investment policies provide either com- consumer and therefore are reflected as changes plete assurance (when they invest in Treasury in investment behavior and those which are bills and insured certificates of deposit) or imperceptible to the consumer but may have known risk. long-term impacts on his relationship with the financial service industry. Regulations Relating to In a recent survey of investor protection pro Consumer Finance vialed by various financial intermediaries, the U.S. General Accounting Office found a num- Product-line extension has allowed new ber of gaps and overlaps in the protections of- players into the financial service marketplace. fered depositors and investors. This informa- Many different types of financial institutions tion is summarized in table 12, which illustrates now offer the same services. In many cases the the variance in investor protections provided difference between choices among instruments to both individual and group investors under is imperceptible to the consumer in that it is different financial arrangements. related to the regulatory structure of the in- Table 12.—Summary of Variances in Regulation and Investor Protection

Entitles Involved Investor In establishing protection Insurance Insurance Regulator rules and primarily Types of services Type of Institution coverage Who Insures backed by responsible for regulations provided by provided Rate of return Advertising Depository Institutions . Banks $100,000 per Federal insurance Federal Insurance Banks FRS Federal and State Onsite Deposit accounts Variable Subject to ● Savings and loan account programs and programs-full faith FDIC OCC depository examination checking regulatory ● Credit unions State-sponsored and credit of U S State institution and account accounts, requirements Insurance Government authorities regulators Insurance commercial and programs personal loans State sponsored Credit unions insurance NCUA State programs–no authorities onet’ Securities brokers $500,000 SlPCr U S Department SEC SEC and Information Securities Subject to strict – ($100. 000 cash) of Treasury: securities disclosure trading legal and per account Industry self- requirements regulatory regulatory SRO onsite requirements organizations examinations and market surveillance Investment None Not Insured N/A SEC SEC Information Investment Variable Subject to strict companies disclosure services legal and requirements regulatory and onsite requirements examinations Commodities None Not Insured N/A CFTC CFTC and Information Commodities Subject to — brokers commodity disclosure, trading regulatory futures Industry SRO onsite requirements self-regulatory examinations organizations and market surveillance Commercial bank Only funds or Not directly N/A OCC. FDIC. FRS Federal and Onsite Personal Variable Not strictly trust departments deposit In Insured State banking examinations Investment regulated Insured accounts authorities corporate trust pensions 182 ● Effects of Information Technology on Financial Services Systems —-—

dustry. As a result, the consumer also may ment Title I of the act, the purpose of which perceive his relationship with banks and non- is to help consumers become fully informed bank institutions to be the same. about credit and leasing arrangements and to prevent advertising that may be misleading. In choosing between similar instruments, it Title I applies to any institution that regularly is difficult to assess the extent to which it is offers credit and leasing plans to people in- necessary for the consumer to be aware of volved in transactions for personal, family, or these regulations. Certainly it is necessary household purposes. This includes consumer that he know his rights and liabilities with re- finance institutions, banks, credit card com- spect to the use of certain instruments. panies, and retailers who extend credit. Toward this end, Congress requires that certain disclosures be issued to the consumer. However, often the consumer does not read Regulations Z and M nor fully understand his rights and respon- Covered under Regulations Z and M are sibilities. This is even more important as serv- three separate acts: ices become more complex. ● Truth in Lending (Regulation Z)–This act When legislation was first enacted to ensure covers closed-end and open-end consumer the safety and soundness of the system and credit transactions. The primary purpose to protect consumer deposits, the economic is to disclose the costs and terms of credit activity of the consumer was quite different arrangements prior to their consumma- than it is now. Legislation of the last two dec- tion so that consumers can compare vari- ades recognizes some of the changes in con- ous plans and fees on an informed basis. sumer behavior and his role in the economy, ● Fair Credit Billing (Regulation Z)–This particularly with respect to credit. act affects the manner in which custom- Increased consumerism has been an impor- ers are billed on their open-end credit ac- tant factor in the formulation of policy in this counts, and how finance charges are cal- area. Consumer protection legislation enacted culated, and the way that disputes about in this era includes the Consumer Credit Pro- the billing can be resolved. tection Act of 1968 and subsequent amend- ● Consumer Leasing (Regulation M)–This ments, the Fair Credit Reporting Act, the act extends Truth in ‘Lending to cover Truth in Lending Act, the Equal Credit Op- leasing arrangements. portunity Act, the Fair Credit Reporting Act, Other amendments to the Consumer Credit and the Electronic Funds Transfer Act, among Protection Act: others. Each represents additional protection of the consumer of financial services from Equal Credit Opportunity Act–Owing discrimination and unfair practices. Consumer largely to the activities of consumer protection legislation plays an important role groups, Congress acknowledged credit as in the relationship between the consumer and a necessity for the consumer in the Equal provider of financial services, as does the reg- Credit Opportunity Act of 1974 (ECOA). ulation derived from this legislation. ECOA prohibits discrimination in credit transactions on the basis of sex or marital Consumer Credit Protection Act status and, as later amended, prohibits discrimination on seven additional bases, The following congressional acts are con- including race, age, and national origin. sumer-oriented, and most are amendments to In this act, Congress also recognized the the Consumer Credit Protection Act of 1968. importance of credit to the consumer. That act was one of the first major pieces of Fair Credit Reporting Act–Title VI of consumer credit legislation passed. Federal the Consumer Credit Protection Act, ef- Reserve Board Regulations Z and M imple- fective in 1971. The purpose of this act Ch. 7—The Consumer of Financial Services • 183

is to make certain that credit reports on bank credit card to be protected from misuse consumers are fair, current, and accurate. of the card under a variety of legislation, or It gives the consumer certain rights to ex- not at all, depending on the type of trans- amine credit information about himself action. For example, if a bank issues an in- and to correct any errors that might be dividual a debit card that is associated with present. In addition, the act imposes an account with a line of credit and is also com- other responsibilities on the credit report- patible with an ATM, the individual can per- ing agencies —i.e., they must make certain form a number of different types of trans- that all users of their information are ob- actions with the same card. If fraudulent use taining reports for legitimate purposes. is made of the card by accessing the line of ● Fair Debt Collection and Practices Act — credit, he has recourse under consumer credit This is Title VIII of the Consumer Credit legislation; if the fraud involves EFT, as in the Protection Act, which became effective in case of an ATM cash withdrawal or electronic 1978 and limits the amount of communi- POS terminals, his liability is limited under cation with a delinquent consumer and EFTA (although not to the extent as under the prohibits undue harassment and specious Consumer Credit Protection Act). activities in connection with consumer If, however, the fraudulent use of the card debt collection. directly debits the person’s bank account in a paper-based transaction, it is not clear Electronic Funds Transfer Act whether the consumer has recourse under cur- The Electronic Funds Transfer Act (EFTA) rent legislation. This is an example where the amended Title IX of the Consumer Credit Pro- same card represents three different instru- tection Act by establishing rights and respon- ments, which, in the case of fraud, would re- sibilities for EFTs. These rights and respon- quire different actions by the consumer. In sibilities are outlined by Regulation E of the recognition of this, the Federal Reserve Board Federal Reserve. has proposed to update Regulation E to include certain debit card transactions. Technology has changed the way the consumer participates in the payments system In terms of financial management, many and therefore some of the protections under consumers are likely to be aware of the dif- previous legislation. EFTA was passed by ference between accessing a line of credit and Congress in anticipation of some of the im- directly debiting their bank accounts with the pacts of EFT on the consumer. Although the card, but it is doubtful whether they would rec- law provides protection to the consumer, there ognize a distinction between a debit processed are some instruments where the level of pro- electronically and one processed in the paper tection is unclear. In addition, many consum- system. It is also reasonable to assume that ers perceive technology-based instruments to the consumer perceives no difference between be the same as their paper-based counterparts, all of the transactions in a regulatory sense. not realizing that rights and liabilities may dif- Regardless of consumer perception, debit card fer, depending on the use of technology. transactions in the paper-based system currently offer little protection to the consumer. It is now possible for an individual who possesses what appears to be a traditional

- 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 Nearly all technology-based services are still rather as passive participants in the move discretionary -i.e., the consumer can make a towards EFT, slowing down progress by their decision whether or not to use them since there reluctance to accept change. To a great extent are paper-based alternatives to meet his basic this is a true picture, the proportion of sophis- financial needs. At some point in the future, ticated households pressing for faster prog- however, this may no longer be true. ress being very small, but it is not the whole story. The very passivity of households means that changes will be accepted if they provide Security of Consumer Assets in a the essential requirements of individual per- Technology-Based System sons, and in most industrial countries significant proportions of the population are already Since technology-based systems provide accustomed to handling plastic cards; they are new points of entry into the system, there is not likely to worry greatly whether the plastic potential for new kinds of fraud. The question card triggers off a paper-based or an electronic of computer security and crime touches every payment, and it is clear that the publicity ap- aspect of the financial service industry. Dis- proach adopted by banks is an important ele- 20 cussion here, however, will be limited to those ment in acceptance by households. ways in which the technology is applied to con- Technology does not in itself meet any consumer services and to the security issues that sumer needs, and since most consumers are arise directly as a result of those applications. reluctant to accept new services when the old Recent concern about consumer financial still meet their needs, technology does not in- services has revolved around the relative secu- sure the acceptance of new services by the con- rity of access devices and the need to identify sumer. However, the use of computers, both positively the EFT user. As the systems beat home and in education, may encourage con- come more complex and as a greater percent- sumer use of technology-based services by fa- age of the population begins to use home bank- miliarizing the consumer with technology and ing and POS systems, problems with the by creating a new class of consumer for whom current means of identification will become the technology is a given. more obvious. One aspect of financial systems that may With the ATM, the consumer’s loss is lim- impede the growth of technology-based serv- ited by the amount of cash he is allowed to ices is the float. In recent years the float has withdraw from the system. Although his liabil- become increasingly shorter. Technology-based ity is limited under EFTA for unauthorized payment systems could eventually make the transactions, when more sophisticated finan- float nonexistent; all transactions could be cial transactions are involved, the consumer’s settled immediately. Currently, the consumer financial loss could be greater if not noted and has the advantage of float in the checking sys- reported within the period of time required by tem. Use of the paper-based debit card has law. This could have an impact on the will- managed to undercut the “free ride’ associ- ingness of the consumer to use these systems ated with credit cards and may eventually and therefore on the rate of acceptance of wipe out all float in the checking system. them. In that event, the market could force the providers of services to secure the systems better. ‘(’J. R. S. Revell, Banking and Electronic Funds Transfer (Paris: Organization for Economic Cooperation and Develop- The current means of identifying an author- ment, 1983), p. 101. ized 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 tutions are unwilling to divulge information number of flaws. For example, if the number on security for fear of discouraging use of the is long, it could be easily forgotten; if it is short systems. or a variation on a number with which the con- In addition, it would appear that the consumer is familiar, such as an address or tele- sumer is more vulnerable in technology-based phone number, the “code” could easily be bro- systems. For example, in a bank robbery, the ken. With a proliferation of electronic debit bank absorbs the loss; in the case of electronic cards, there has been an equal proliferation in robbery, specific accounts are debited. There PINs, making them all the more difficult to is no electronic “till.” The responsibility shifts remember. Although consolidation of services to the consumer to note and report the crime. in a single card would help alleviate this problem, there is little evidence that this will hap- Some perceive technology as a solution to pen in the near future. PINs are also insecure problems that can plague the consumer of fi- in that they do not positively identify the card- nancial services. Credit card fraud, which is holder as an authorized user; they can be frequently cited as a growing problem in the transferred to other individuals. Some con- industry, can be made more difficult by the sumers will keep the PIN together with the use of sophisticated technologies. In many card, a combination as negotiable as cash. ways fraud is a provider problem; the consumer is protected under legislation from illicit use Technologists are currently working on solu- of his credit cards, and if sufficiently informed tions to the identification problem. Examples he can prevent all but a minimal financial loss of alternatives to the PIN are “warm-body” from the fraudulent use of his card. Both identifiers; included in this classification are VISA and MasterCard have introduced or are thumbprints, voice prints, and signature dy- planning the introduction of cards that are ex- namics. Thumbprint recognition is less likely pensive and difficult to counterfeit. It is diffi- to be acceptable to the public, since it would cult to say whether these cards will in the long require that every individual who uses EFT run reduce fraud, since it will be some time has his thumbprint on record. Although there before the effect of their introduction and use are certain problems with development, most will be felt; the cost to produce the cards is industry analysts see signature recognition, much greater. However, if these cards reduce or the more complex technology of signature fraud, for which the consumer implicitly pays, dynamics, as the most acceptable alternative it may ultimately lower the financial burden to both the industry and the consumer, since for the consumer. it is the predominant means of identification used in financial services today. It will be some time, however, before the technology will be Privacy applied to financial services. Any discussion of the issue of privacy and The use of ATMs presents personal security the consumer begins with the difficulty of problems, beyond those purely associated with defining privacy and therefore what it means financial security. Individuals using the ma- for the consumer to be vulnerable in this area. chines may be particularly vulnerable to rob- In its basic definition, privacy is the freedom bery. During normal business hours a tradi- from unauthorized intrusion, the authority in tional “brick and mortar” structure provides this case coming from the individual. How- the individual security during and after a ever, in the course of everyday life the con- transaction. An ATM located away from this sumer has given up some of these rights, or structure could place the user in a vulnerable has “authorized” certain intrusions into his position. Even those ATMs located at bank life. The distinction between what is explicitly branches can be insecure when used outside authorized and what is not is unclear. Privacy of banking hours. It is difficult to assess the is considered one of the primary concerns of seriousness of the problem, because most insti- the individual when choosing financial services. 186 • Effects of Information Technology on Financial Services Systems

Much controversy surrounds the issue of the possibility that someone else would have EFT and privacy; that is, whether the systems access to their account information could cre- that constitute EFT make the individual more ate problems in a telephone bill paying system. vulnerable to violations of privacy. In the final This represents a higher percentage of users, report of the National Commission on Elec- but about the same percentage of nonusers tronic Fund Transfers, privacy was defined as who agree that privacy was an issue for con- “ . . . the individual’s expectation of control cern in the use of home computers. The same over what information about himself is com- is true for data on automatic deposit services. municated to or used by others. ” Further, “the The lowest response to the question was in object of the consumer’s concern regarding reference to the ATM; there is some evidence privacy under EFT is the potential use of his that transactions performed by ATMs are con- financial transaction information to develop sidered more private than transactions using a personal profile. ” 21This use could be as a human teller. It appears that consumers for seemingly harmless as an individual receiving the most part do not perceive privacy as a ma- product solicitations, based on his income and jor issue for concern in their choice of EFT sys- profession, from the financial institution where tems; other, more market-oriented questions he does business, to the capability of the sys- seem to determine consumers’ use of these tem to provide sensitive information about the systems. individual’s behavior patterns. The newer technology-based services, in par- As mentioned earlier, cash is a private ticular home banking, provide new opportu- method of payment. Checks, although less pri- nities for invasion of privacy. As yet there are vate, are a paper-based mechanism, and are no uniform privacy standards for information perhaps easily tracked on a case-by-case basis. gathering. The Videotex Industry Association Although electronic payments secure the con- (VIA), the trade association for the U.S. video- sumer from some types of prying, they may tex industry, has recommended voluntary in fact make him more vulnerable on a large guidelines for maintaining the privacy of scale. EFT transactions are recorded and videotex subscribers. These guidelines suggest stored automatically and provide the poten- ways in which providers of videotex services tial for invasion of privacy. can protect the data that they accumulate and therefore inspire consumer confidence. Ad- Some studies show that privacy currently ditional recommendations cover collection of ranks low as a concern for the individual-it information, government access, security, sub- has been dismissed by certain experts as a subscriber access, correction of errors, applica- ject only of academic concern. A 1982 BMA tions to third parties, future revisions, and study shows that users of home computers 22 retention of information. strongly disagree with the statement that computers would violate privacy. Even non- These guidelines are not binding to the in- users did not list privacy as a major concern; dustry, and certain VIA members plan to they were either “not sure, ” or were in dis- adopt their own company privacy code based agreement. Fewer than 20 percent of total on VIA guidelines. Several financial service nonusers agreed with the statement. institutions, in particular bank card providers, have corporate guidelines to protect the pri- Even when the issue is more clearly defined vacy of their account holders. there is only slightly more resistance to electronic systems because of privacy issues. For example, in the same BMA survey, 20 percent Consumer Rights to Financial Services of users and 25 percent of nonusers said that Technology may increase access to the system for a number of people and expand choice 21National Commission on Electronic Fund Transfers, EFT in the United States: Policy Recommendations and the Public ‘Zzvideotex Industry ASSmiatiOn, “Model Privacy Guidelines Interest, Oct. 28, 1977, Washington, D. C., p. 19. for Videotex Systems, ” June 1983. Ch. 7— The Consumer of Financial Services ● 187 . — — for still others; however, because of price there forced from the system completely. This may be a tendency in technological systems brings into question the safety and soundness for certain groups to be either excluded or per- of these nonbank depositories and whether haps more heavily taxed than others. For ex- they should be regulated. ample, although bank cards will be a primary vehicle for introducing some of the new sys- The trend of a universal electronic payments tems to the consumer, there are many consum- system may put pressure on the financial serv- ers who are ineligible to use them. As a result, ice system to accept people who otherwise nonusers may in effect be blocked from cer- would not have accounts at financial service tain types of financial services. institutions. It may necessitate Federal guarantees to banks that service low-income or low- Technology makes it possible to serve lower balance consumers. This is particularly impor- balance consumers through ATMs, and there- tant when one considers the policy of the U.S. fore lowers the cost of servicing these ac- Treasury to encourage direct deposit, and the counts. Certain needs of these consumers may possible requirement that some consumers not be met by the technology; however, more must participate in the system via govern- personalized services may be unavailable to ment transfer payments processed electron- them. This tendency plus fee-for-service pric- ically. ing may transfer the costs to the consumer in a way that is inequitable. Even if the cost of In the 1970’s in the ECOA, Congress rec- home information services technology drops ognized that in order to be a productive mem- and communications costs rise, certain lower ber of American society, the consumer must middle-income segments of the population have fair access to credit. Although consumer may still be barred from participating in the use of technology-based systems is still mini- system. That segment of the population that mal, there is some evidence that access to tech- cannot maintain a minimum balance in a tradi- nological systems or the financial system in tional account may be served by other nonreg- general will eventually be a necessity. In the ulated institutions (e.g., retailers, and perhaps future, Congress may have to consider to what local grocery or liquor stores) or they may be 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 experienc- make possible and facilitate this transition. A ing a period of tremendous change. Economic considerable number of entrepreneurs see po- factors, specifically those that drove interest tentially profitable opportunities for provid- rates to record levels during the last decade, ing information services directly to consumers, have caused the users of financial services to but, in general, they have yet to find the seek new services. In turn, innovative provid- package of services that will be successful in ers of services have responded to consumers’ the marketplace. Virtually all agree, however, new financial needs and sophistication. that financial services will be an important element of that package. Thus, the forces that At the same time, a number of technologies are changing the basic character of the Ameri- that have been just over the horizon for some can economy are directly affecting the struc- time have begun to mature. For example, com- ture and character of the financial service in- puters, still in infancy during the 1950’s, are dustry. now used to deliver services directly to the consumer without human intervention, and the tendency to use systems based on infor- The foregoing changes have affected the re- mation and telecommunication technologies lationships between and among the various for delivering financial services is increasing. participants in the marketplace. Some perceive The general public’s level of familiarity with themselves to be relatively better off, while computers has increased, providing a fertile others feel they have been put at a disadvan- climate wherein significant numbers of users tage. Some argue in favor of policies that di- now accept the new services. Falling prices for rect the evolution of the industry along pre- electronic equipment and the increasing per- determined paths, while others, somewhat vasiveness of such equipment throughout the fearful of foreclosing opportunities from which economy have further reinforced this trend. there could be widespread benefit in the future, argue that policy should remain neutral in or- In many cases, the basic services offered by der to permit the market to work its will in the financial service industry are not chang- shaping the industry. ing in any fundamental way. A deposit taken through an automated teller machine (ATM) The present rate of change is a transitory is not substantively different from one taken phenomenon, and the structure and character by a human teller. However, the availability of the financial service industry will stabilize of technologies that can quickly process and during the coming decade. However, unless move vast amounts of data has made it pos- some explicit action is taken to preserve the sible for financial service providers to offer present structure of the financial service in- products beyond those that would have been dustry, it will look much different at the turn possible otherwise. For example, the money of the century than it does now. And yet, there market mutual fund could have been offered is no assurance that policy parameters can be a century ago if there had been some means adjusted with a high degree of confidence to of processing the transactions necessary to bring about a specific, desired industry struc- make such a fund work economically. ture. Available and emerging technologies Further, there is a definite trend in the econ- have created many opportunities for innova- omy away from the older “smoke-stack” in- tive people to engineer their way around reg- dustries to the production of information and ulatory barriers to achieve their goals and ob- the development of those technologies that jectives.

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 indus-

Conclusion 1: Applications of Technology and the Changed Nature of Financial Services

The applications of advanced information and In some ways, the rate of change in the telecommunication technologies in systems for financial service industry is accelerating in re- delivering financial services change the way sponse to the assimilation of rapidly advanc- those services are created, delivered, priced, re- ing technologies. On the other hand, the reluc- ceived, accepted, and used. tance of a significant number of users to adapt to the changes is limiting the rate of change Years ago, depository institutions credited in the industry. Only a little over 30 percent interest to savings accounts only quarterly, of the recipients of Social Security payments or even less frequently. Today, most pay in- have agreed to accept payment by direct de- terest from the date of deposit to the date of posit, thus limiting the ability of the Department withdrawal and compound interest at inter- of the Treasury to realize the full benefits of vals so short that they are nearly continuous. applying the available technologies. Public re- This change was encouraged by deposit-rate action to a requirement by one bank that only ceilings and made possible because the insti- customers who held deposit balances of $5,000 tutions installed computers that enabled them or more could receive service by a human teller to handle the computational workload re- caused cancellation of the program. quired to provide the enhanced service. Rapid advances in telecommunication and Sometimes technology can indirectly affect information processing technologies have been the availability of financial services. Technol- followed by applications to the delivery of fi- ogy that facilitated the development of the nancial services. In some cases, the changes bank credit card is particularly important in accompanying the introduction of technology the programs of card issuers to limit fraud and have been imperceptible to customers. For ex- losses to bad debt. One of the key features of ample, one month a statement may be pre- the cards is that the merchant accepting them pared on an accounting machine and the next, is guaranteed the funds as long as the rules on a computer. In others, the changes have re- for acceptance set down by the card issuer are quired users to change the way they use finan- followed. As a result, many merchants are re- cial services and the way they interact with luctant to accept a paper check at the point service providers and systems for delivering of sale, preferring instead to avoid the risk of services (e.g., ATMs rather than human tell- loss the check entails. Thus, indirectly, appli- ers). In addition, as users became more com- cations of technology have reduced the ability petent with the technology, they forced proof consumers to pay for purchases by check. viders of financial services to change the way (Ironically, the same technologies that have in which they interacted with their customers. made the credit card attractive to the mer- J. C. Penney, for example, agreed to accept the chant are being applied to rejuvenate the VISA credit card only after VISA agreed to check. Although they have not fulfilled the ex- permit a direct connection to the network by pectations of a few years ago, check guaran- the retailer. tee and authorization services provide the —

Ch. 8—Findings . 193 .— — same kind of protection from risk for the mer- become operational, the institutions that de- chant that is offered with the credit card.) veloped them can market them to other financial service providers. Purchasers of the pack- Technologies have also lessened the signifi- ages are then able to offer significantly cance of distance and time of day as factors enhanced services without expending large in the delivery of financial services. Telecom- amounts of capital. munication makes immediate interaction between service providers and their customers Historically, only depository institutions possible, regardless of the location of either. have processed payments transactions and The terminal device used by either can be one have had exclusive access to the payments that can be programed to operate unattended, systems. Now, the development of information at hours that are suitable to the schedules of technology has created the opportunity for both users and providers and in ways that others to enter this market. A substantial in- make minimization of communication costs dustry of wholesale service providers not usu- possible. International networks of ATMs now ally seen as financial service providers now being established will allow the consumer to supports retail financial institutions. In fact, access depository accounts in other countries the existence of this industry has made it pos- and will negate existing restrictions on the sible for many smaller retailers to exist. Yet taking of deposits across State lines. Wire many wholesale nonbank processors are denied transfers, for example, can be used to deposit direct access to the payments mechanism, funds to an account without regard to the which, some of them argue, puts them at a bank’s location. competitive disadvantage as providers of wholesale services and limits their ability to Furthermore, technologies have also changed serve the needs of clients who are not part of the nature of the depository account. While the financial service industry. These whole- only chartered depository institutions can take salers see financial institutions competing deposits, others have been able to take advan- with them as providers of information proc- tage of the ability of the technologies to processing services while retaining the advantages ess and transfer large amounts of information that come with exclusive access to the pay- quickly to offer various investment products ments mechanism. that have liquidity approaching that of a deposit. In addition, the importance of banks and On the other hand, financial institutions at- other institutions as depositories for funds is tempt to provide the full package of informa- diminishing. The application of technology has tion processing services needed to support all made it possible for customers to use deposi- of the activities of their clients that are related tory accounts only to collect funds for a short to financial operations and payments. As the period, disburse them rapidly as needed, and dependence on technology for providing finan- place any remaining funds in short-term in- cial services continues to increase in the vestments. In this situation, the depository in- future, this conflict between competing classes stitution must receive the bulk of its income of institutions will become more intense. De- from fees charged for service because the avail- pository institutions, pressured by decreasing ability of funds on deposit that can be invested earnings from deposits, will seek to expand for its own account is limited. Also, a number their base of customers that pays fees for serv- of factors have reduced the spread between the ices at the same time that their competitors fees paid for deposits and those earned when seek to provide alternative sources of finan- the funds are lent out. One way of replacing cial services to those same markets. this income, selling services for fee, is the The financial service industry is dependent course that financial institutions are following. on reliable and effective telecommunication fa- Major capital investments are necessary to cilities for its existence. If financial data, both implement new systems for delivering finan- payments and collateral information, cannot cial services. However, once the systems have be moved rapidly and reliably worldwide, the 194 • Effects of Information Technology on Financial Services Systems

financial service industry could not function sumers issuing checks 2 or 3 days before they as it presently does. Further, systems for de- deposit funds to corporate treasurers disburs- livering financial services have been designed ing funds from remote locations. The technol- to take into account the present configuration ogies, on the one hand, provide the opportu- and cost structure of available telecommunica- nity essentially to eliminate collection float tion facilities. Any significant departure from from the system while, on the other hand, historical patterns could have a direct and ma- offering the payer the opportunity to control jor impact on the costs of delivering financial with absolute certainty the time at which a services, the structure of the industry, and the disbursing account is debited. Businesses, distribution of costs among the various par- then, could revise trade discounts to reflect the ticipants. new realities by allowing, for example, discount if good funds were available after 12 or For example, home banking systems have 13 days instead of allowing it if the check is generally been designed so that the user need postmarked on or before the 10th day. Simi- make only a minimal investment in terminal larly, consumers who know that funds will be equipment and can rely on the computer oper- available on a specific day could schedule their ated by the service provider for the process- payments accordingly, rather than playing ing required. Implicitly, this type of design games with the system, as they do now. assumes that low-cost telecommunication facilities are available and that the cost to the Finally, technologies make it possible for in- user of a lengthy, interactive session with a dividuals, businesses, and government to keep host computer will be minimal. On the other minimal idle balances. Because all parties can hand, if local telecommunication costs rise sig- know exactly when good funds are available nificantly, such systems may have to be rede- and when disbursements must be made, they signed to minimize the connection time be- can move all funds not needed for day-to-day tween the user and the provider’s computer; transactions into investment accounts that this could result in excessive cost to the user pay market rates of interest. Then, funds can of a terminal. Similarly, the large amounts of be moved to transaction accounts that either capital used to establish telecommunication pay no interest or pay below-market interest networks operated by providers of financial rates for minimal periods to meet require- services under present pricing structures could ments for disbursements and/or to receive effectively be lost if changes in telecommunica- funds from others. The net effect of this tion result in prohibitive costs of operation. tendency will be a constantly increasing downward pressure on the balances of transaction Float, its cost, and who benefits from it have accounts held by depository institutions and long been at issue. The various financial serv- others. ice participants have developed strategies to take advantage of float that range from con-

Conclusion 2: Restructuring the Financial Service Industry

Some patterns in the ongoing restructuring The structure of the financial service indus- of the financial service industry are discernible: try was, at one time, clearly defined. Most the present fluidity and rapid change will con- individuals and businesses conducted their fi- tinue for some time, but many uncertainties can- nancial affairs primarily with depository in- not now be resolved and many alternative pos- stitutions such as banks, savings and loan sibilities exist. associations, and credit unions. The financial Ch. 8—Findings • 195 service industry is now changing: new prod- to offer the money market demand account ucts are being developed and offered and the and the Super NOW account. roles of traditional institutions are shifting. Major influences for the recent changes in The simplicity of the industry has all but the industry have been high interest and in- disappeared. flation rates and, therefore, the high oppor- Today the financial service industry consists tunity cost of standard consumer savings in- of a variety of organizations, ranging from tra- struments, resulting in a phenomenon known ditional depository institutions and related as “disintermediation.” Funds flowed out of financial organizations that have expanded the depository institutions into nontraditional services, such as securities firms, to such instruments and institutions as many individ- nontraditional financial service providers as uals shifted their assets in order to obtain the supermarkets and retail department stores. A high interest rates. Many of these new instru- variety of organizations offer investment op- ments were created by organizations outside portunities in an increasingly competitive mar- of the regulated environment of depository in- ket. Promotion of products and target market- stitutions. One example is the money market ing has become increasingly important for mutual fund created by the securities indus- financial service providers who are looking for try, which works like a combination savings new ways to reach users and retain and gain and checking account. Funds invested in market share; e.g., television and direct mail money market mutual funds earn a market advertising has become common. rate of return, and the funds are as liquid, for all practical purposes, as a checking account. Depository institutions have begun offering The customer accesses the account with a brokerage services (INVEST) and insurance share draft, which works in much the same (mutual savings bank life insurance in Massa- way as a check and is considered to be equiv- chusetts and New York). To compete with alent by most users. The only practical dif- other financial service providers they place ference is that, in many cases, there is a mini- greater emphasis on serving the customer on a 24-hour basis as well as on making conven- mum amount for which the draft must be written, usually $500. ience a priority (ATM deployment and home banking). In the new competitive climate, nontraditional financial service institutions quickly Depository institutions are governed by realized the tremendous potential in provid- strong regulations, many of which were writing financial services. They also realized the ten at a time when the competitive character ease with which they could enter this indus- of the financial service industry was very dif- try. For example, J. C. Penney, a major na- ferent from what it is today. For example, reg- tional retailer, operates a highly sophisticated ulations which set ceilings on deposit interest online communications system that supports rates at federally insured commercial banks, over 35,000 online terminals. J. C. Penney ex- savings and loan associations, and mutual sav- panded the usage of its communication sys- ings banks restricted the ability of depository tem and began processing credit card trans- institutions to compete with money market actions for oil companies. Outside of its role funds, a product development that was not an- in financial services as an extender of credit ticipated at the time the regulations were framed. Some regulations, meant to be protec- to retail customers, J. C. Penney has become a financial service provider of a different sort tive, must be adapted to the changes the in- by performing functions normally associated dustry faces. Some new regulations have been necessary. For example, the Garn-St Germain with a bank. Depository Institutions Act of 1982 amended Supermarkets have become focal points for numerous Federal banking laws and created ATM deployment and point-of-sale programs. five new ones, allowing depository institutions Safeway, an Oakland, Calif., supermarket 196 ● Effects of Information Technology on Financial Services Systems chain, has announced plans to develop and bank. It specializes in financing for small, market a national ATM network. Some super- high-technology firms. Many of Palmer Na- markets intend to replace banks and others as tional Bank’s clients have financial service re- operators of switches for financial transaction quirements that are often too small to be of networks and are highly competitive in this interest to big banks with international ex- area. They are also taking a major role in the perience. decisionmaking surrounding these activities. By joining a local, regional, or national net- Petroleum companies, with their vast chains work, these small institutions can immediately of retail gas stations, are following the lead deliver services to a large number of locations of the dry goods and grocery chains. in direct competition with major institutions. Unlike most depository institutions, many Despite speculation, there is little doubt that securities firms have a national presence. They these organizations will survive. Unlike the re- can conduct business nationally with few regional giants, specialty companies and small- strictions. In addition to brokerage and invest- niche companies that cater to a narrow popula- ment banking services, many such firms now tion segment have positioned themselves to offer a wide variety of consumer financial do one thing superbly. It is possible that the products, such as money market funds, with industry may begin to be shaped like a dumb- debit card and ATM access, as well as asset bell, with a large number of small banks serv- management accounts (a combination of a de- ing local needs at one end, a relatively small pository account and a margin account). These number of large banks providing service na- new product offerings have gained a signifi- tionwide at the other and, in the middle, cant market. For example, the Merrill Lynch virtually no midsize banks serving regional Cash Management Account, which works as markets. both a savings and an investment instrument, In sharp contrast to the specialty provider serves over 1 million people. Customers can is the financial supermarket. Offered as a one- access their accounts via telecommunication stop financial center offering banking, insur- networks operated by the securities firm from ance, brokerage, and investment opportuni- any office, regardless of location. ties, the financial supermarket has been a suc- Although insurance companies are licensed cessful concept for both Sears Financial separately by each State, many serve a na- Network and Merrill Lynch, among others. tional market through networks of company- Both of these organizations offer brokerage operated offices and independent agents. services in stocks, bonds, options and futures Many insurance companies are augmenting contracts, insurance, savings instruments, traditional product lines with new offerings mortgages, consumer loans, retirement sav- that directly compete with those offered by ings plans, and even credit cards to their cus- other providers of investment services. tomers. However, the degree to which the service packages of each firm are truly inte- The concept of the “boutique” bank, which grated varies significantly. Financial super- serves a highly specialized market, is becom- markets seem to have found a niche in the ing more widely accepted as the industry re- ever-growing consumer financial service mar- organizes. National Enterprise Bank, which ket. This concept is attractive because of the opened in Washington, D. C., in August of low cost of entering the business as well as 1983, is one such bank. Enterprise is aimed high potential profits. The financial super- at professionals—doctors, lawyers, dentists, market has not yet matured, nor has its long- accountants, and consultants. Its intent is to term viability been demonstrated. serve the affluent professional in a specialized fashion far different from that of a commer- Legal barriers still hinder the entry of some cial bank. Palmer National Bank, in Washing- businesses into the financial service market ton, D. C., is another newly opened boutique and the cross-entry of some providers into Ch. 8—Findings ● 197 other areas of financial services. In most The significant changes in the structure of States, and at the Federal level, banks are the financial industry bring to light several im- barred from insurance (except for credit pol- portant points. Technology has been one key icies), from investment banking, and, to a de- factor enabling nontraditional financial serv- creasing degree, from interstate branching. ice providers to enter the market. The tech- Present regulatory barriers prevent brokerage nologies necessary to drive the systems that houses from operating as a financial supermar- support financial services are already in the ket in the true sense of the word. While bro- hands of new entrants because such technol- kerage houses perhaps come closest to achiev- ogies can also be applied to support many dif- ing true integration, they cannot accept ferent industries. As a result, many potential deposits or have direct access to the payment entrants are able to offer financial services mechanism, and therefore cannot truly offer using established computer and communica- banking services. Although no one is sure tion systems. Some firms have entered the what combinations of businesses will prove to market for retail financial services, some have be the winning ones, to the extent that an or- become wholesale providers, and others have ganization can achieve a greater national entered both markets. recognition in the market, it will enjoy an advantage over its competitors. Industry restructuring has brought about significant potential for industry consolidation For many types of organizations to build a as the functions that support the industry financial supermarket, a number of mergers begin to overlap. While depository institutions and acquisitions may be necessary. Several are technically the only organizations allowed nonbank providers have acquired banks to to accept deposits, nondepository organiza- have access to the payments mechanism and tions have developed products that are near- Federal deposit insurance. These financial con- deposits and thus compete with products of glomerates have come along much faster than depository institutions. Money market mutual expected because of the profound changes in funds, in essence, accept deposits and are insurance, banking, and securities brought viewed by those who own them as savings in- about by the interplay of high interest rates, struments. Insurance contracts, particularly technology, and regulation. those that allow the owner to control the Aside from economic conditions, which allocation of funds among alternative invest- many claim are a driving factor behind the ment opportunities and that accumulate cash changing structure of the financial service value, can also be viewed as close substitutes industry, is the major role technology has for deposit instruments. played. As financial service companies continue to rely heavily on new technologies and The traditional categories of depository and automated processes to provide services, new nondepository institutions are no longer clearly services that could not be offered without the delineated or functionally separate. These support of such technologies emerge. Some changes create more product choice for the new technologies allow a firm to produce two consumer, but also increase the amount of different types of financial services together consumer confusion in choosing and using less expensively than for two individual firms services. Since so many of the products and to produce them separately. Online communi- services from the various financial service cation systems enable instantaneous debit/ organizations are similar, many consumers are credit of financial accounts, and immediate unaware of the significant differences. execution of orders to buy and sell securities. Brokerage sales across the country are facili- Regulation, once a guiding force with re- tated by immediate real-time access to finan- spect to how the industry operated, no longer cial information. has as commanding an influence. Interstate 198 Ž Effects of Information Technology on Financial Services Systems

branching and deposit-taking is now a reality,* pace that it is no longer a question of when influenced considerably by the deployment of certain changes will occur, but of how to im- ATMs. Many State banking laws now provide plement the changes and how they will be ac- for reciprocal interstate branching and may re- cepted. It is difficult to predict the ultimate sult in the emergence of major regional banks consequences of the restructuring; however, that maintain offices in several States. Massa- there are indications that the financial serv- chusetts, for example, passed an act, entitled ice industry is changing from a traditional to “An Act Relative to Branch Offices and Ac- a self-service industry. The overwhelming use quisitions of Financial Institutions, ” that of ATMs and the promise of emerging remote establishes new authority for mergers, branch- banking/remote information systems provide ing, electronic branching, and mortgage lend- evidence for this claim. Many of the consumer- ing by Massachusetts financial institutions. oriented systems that deliver services to the The act is limited in its operation to activities home are being developed by a variety of joint involving five New England States (Connect- ventures that offer a myriad of services, not icut, Rhode Island, Maine, New Hampshire, only in banking but also in entertainment, edu- and Massachusetts). cation, and other financially related services. Although the traditional depository institu- The changes in the structure of the finan- tion will remain, its role may well change. cial service industry now occur at such a rapid There will continue to be new innovations and *several states have reciprocity agreements for interstate players in the industry, and a market willing deposit-taking by ATM–e.g., Washington, D. C., and Maryland. to test them.

Conclusion 3: Interaction Between Technology and the Legal Regulatory Structure Governing Banking

Some of the existing laws and regulations per- the money supply which led to rapid deflation, taining to the financial service industry are inef- a large number of financial institution failures, fective or inapplicable to current and potential and a very high level of unemployment. Today, changes in financial service institutions and the environment is much different, and the products. Both Federal and State legislative needs of both consumers and businesses have bodies have reacted to changes in the market changed. and have either ratified events that have taken place or taken advantage of and encouraged per- The Banking Acts of 1933 and 1935 were de- ceived trends. signed to promote safety and soundness in banking. While safety and soundness are still A significant portion of the regulatory the main concern, the environment and the framework governing the financial service in- consumer/business needs have changed signif- dustry, written in the 1930’s (Banking Acts icantly. Today, only a few of those regulations of 1933-35), 1940’s, and 1950’s (McFadden/ adequately meet the needs for which they were Douglas, Glass/Steagall) is still in force today. designed, and some may actually be detrimen- A large number of the restrictions imposed on tal to the industry they regulate. the banking system were a result of the Great Depression of the early 1930’s. The restric- When the financial service industry first be- tions were an attempt to meet the demands came regulated, the regulations were written for financial services provided by firms that according to functions performed by the spe- were both sound and secure and in an environ- cific institutions, and the legislation became ment conditioned by a significant decline in tied to the institution it regulated instead of —

Ch. 8—Findings ● 199 the function. The institutional lines are now One of the concerns depository institutions fuzzy. face is that a growing number of differently regulated financial service organizations are Existing Federal laws and regulations have able to offer a broader range of financial serv- made it increasingly difficult for banks to com- ices than the depository itself can offer. For pete against new entrants into the markets example, Merrill Lynch can offer securities where they have traditionally had an almost services, real estate services, and a package exclusive franchise. Several points must be of additional financial instruments, such as considered, however. Banking is looked upon the money market fund (cash management ac- as a special business that is key to the econ- counts which serve as high interest-earning omy. Consistent with this view, particular savings instruments), and, to a limited extent, steps were taken to insulate it from other lines transaction accounts. While it is possible for of commerce and to limit the risks that banks nontraditional providers to compete head-to- were permitted to take. The introduction of de- head with banks by offering new substitutes posit insurance helped limit the exposure of for banking products, depository institutions depositories to risk. On the other hand, ex- do not have the same leverage. isting regulations are designed to prevent banks from exerting undue influence over Many of the nontraditional financial serv- other lines of commerce. ice providers are improving their positions vis- a-vis banks by establishing or acquiring com- Presently, the roles of the various Federal mercial banks or thrift organizations (e.g., agencies with respect to regulating depository Dreyfus Corp./Lincoln State Bank of East institutions are complex. National banks are Orange, N.J.). Travelers Insurance Co. has re- chartered by the Comptroller of the Currency. quested regulatory approval to offer FDIC- Federal savings and loan associations and insured* instruments to its customers through Federal savings banks are chartered and reg- a trust subsidiary. Depository institutions, ex- ulated by the Federal Home Loan Bank Board. cept in some States and for some grand- Federal credit unions are regulated and in- fathered institutions, are not allowed to own sured by the National Credit Union Adminis- insurance companies nor are they under any tration. Bank holding companies are regulated circumstances allowed to provide a full range by the Federal Reserve Board. of investment services, although holding com- The United States has maintained a dual pany affiliates may engage in discount bro- system (Federal/State) for the regulation and kerage. supervision of banking. This dual banking sys- Organizations, however, have found ways to tem has played a useful and constructive role circumvent the existing financial service reg- in encouraging innovation in the financial regulatory environment and in helping accommo- ulatory structure. Technology has certainly been one of the driving factors. The ATM, for date local differences in the needs of banking example, enables interstate access to individ- organizations and their customers. The system worked well because, for the most part, ual bank accounts, and in some instances local regulatory authorities and legislation have the goals of regulation were commonly shared. permitted interstate deposit-taking, as well. However, this appears to be breaking down. States are beginning to allow incredible expan- (Douglas and McFadden Acts, prohibiting interstate banking and deposit-taking, respec- sion of power for banks and thrift institutions that go far beyond standards allowed by Fed- tively, are ineffective.) This same technology is being applied by nondepository institutions, eral law and yet still benefit from Federal pro- such as supermarkets and other retailers (e.g., tection. Banks have demonstrated that they will establish offices in States that offer a particularly favorable regulatory climate. * 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 pro- to the present environment. Debit cards at vide services in direct competition with banks point of sale, for example, are still heavily and/or their subsidiaries and service corpora- paper-based and therefore do not fall under the tions. These organizations are not taking de- auspices of Regulation E* (protecting consum- posits and are not under the same banking reg- ers using EFT and governing the use of EFT). ulatory scrutiny as depository institutions, Actually, the debit card, which in most circum- even though the systems being deployed must stances is not processed electronically, falls be- meet all regulatory requirements with respect tween the “regulatory cracks” and is not to Regulation E and other consumer pro- under any regulatory authority when used to tection. create a paper document at the point of sale. Many new payments services and deposit- Notwithstanding Federal and State laws like instruments have sprung up outside the and regulations, wholesale banking has been framework of governmentally protected and done on a national basis for quite a while. supervised depository institutions. Banks are able to solicit business and establish corporate offices on an interstate basis. The administration has reacted to events in Advanced communication systems enable real- the market that have put banks at a compara- time access to financial information so that in- tive disadvantage by suggesting legislation stitutions are able to conduct business, includ- which it entitled, “The Bank Holding Com- ing movements of funds, regardless of the loca- pany Deregulation Act. ” This act would en- tions of their customers. able banks to offer new products and services and would address the following four areas: The “nonbank” bank developed as a result 1) the mix of products and services that would of a loophole to the Bank Holding Company be offered by the commercial banks, 2) the Act. Nonbank banks are commercial banks process for gaining regulatory approval for with either National or State charters that banks entering many of the permitted serv- elect to abstain either from accepting demand ice areas, 3) the reduction of competitive deposits or from making commercial loans– advantage enjoyed by some (because of dis- two activities necessary to fall within the def- parities in the regulatory structure) by mov- inition of a bank for Bank Holding Company ing to functional as opposed to institutional Act purposes. Both the Federal Reserve and regulation, and 4) the limitation on cross-sub- the Comptroller of the Currency have taken sidization by requiring banks to establish seg- actions to slow, if not halt, increases in the regated subsidiaries for offering new products. numbers of nonbank banks and branches. Banks below a certain threshold in size would Congressional actions, responding to mar- be treated differently from larger banks in ket forces and events, have further weakened some respects. the provisions of existing legislation. The Significant changes have occurred to update Garn-St Germain Depository Institutions Act some of the outdated banking legislation and of 1982, for example, permits interstate acqui- incorporate new measures for the banking in- sitions of failing depository institutions if they dustry. One example is the Garn-St Germain meet certain criteria. Several savings banks Act. This comprehensive statute contains have acquired savings and loan associations eight titles that amended numerous Federal in other States. A major money center com- banking laws and created five new ones. mercial bank has been permitted to acquire Another is the Depository Institutions Dereg- two sizable out-of-State savings and loan asso- ulation and Monetary Control Act of 1980, ciations. which, in addition to approving a money mar- Many new regulations, primarily those affecting electronic funds transfers (EFTs) and *The Federal Reserve Board has put out for comment a proposal to cover paper-based transactions under Regulation E. written with the expectation that the delivery It has also issued a proposed rule to bring paper-based debit systems would be fully electronic, do not apply cards under Regulation E [Reg. E; Docket No. R-0502]. Ch. 8—Findings ● 201 ket deposit account for banks, provides for the Technology development, economic condi- phase-out and ultimate elimination of all Fed- tions, and other market forces have changed eral limitations on maximum interest rates the structure of the industry to such a degree paid on deposits in financial institutions. Both that the boundaries in the existing legal reg- were passed in response to compelling changes ulatory framework have less and less of an im- in the marketplace and are designed to correct pact. ATM systems permit access to accounts a lack of competitive parity among competing on a national basis; they even permit access providers of financial services. to money fund accounts held outside of depository institutions (First Boston/Fidelity). Only In some cases, developments in the provi- the limitations on interstate deposit-taking by sion of diversified financial services have been banks seem to be holding up, and these are spurred by State laws. The most recent exam- weakening, as evidenced by interstate ATM ple of this is South Dakota’s allowing State access reciprocity agreements between States banks to own full-line insurance companies. (D. C./Maryland). Out-of-State bank holding companies, recognizing market trends and pressures, have A major goal of financial service regulation shown interest in acquiring or forming South is to assure the safety and soundness of the Dakota banks. Currently, many State legisla- financial system. Technology and market tures have shown interest in liberalizing bank forces have introduced significant changes in regulations in order to allow forms of inter- the industry. Based on available evidence, state banking. technology has brought about no apparent reduction in the safety and soundness of the in- Functional regulation is being considered as dustry. The changes have encouraged Con- an alternative to the present regulatory struc- gress to begin reexamining existing legislation, ture. Such regulation would subject all firms but for the most part Congress has directed performing the same function to the same reg- its most recent efforts toward catching up ulations imposed by the same regulatory agen- with the events that have been occurring in cy. Those who support such a change in regu- spite of the legal regulatory barriers. In light lation feel it will provide a level playing field of the realities of the technology, regulatory for all institutions providing the same types consideration and emphasis may be better of financial services. Additionally, its pro- placed on the impacts of new services on proponents believe it would provide competitive viders and users rather than on the technologi- equity among the depository institutions and cal developments that ultimately drive them. nonbank institutions.

Conclusion 4: Financial Options for the Consumer

A primary consequence of the changes in fi- panded in all areas of financial decision- nancial services has been the proliferation of making. options available to users. While many share Since the introduction of the bank credit common characteristics, there are technical dif- card in the late 1960’s, the consumer has ben- ferences between them that could catch the user efited from the convenience of a readily accept- who is unaware of their true implications. able payment mechanism, which provides a Today, there are more payments and invest- means of payment much more negotiable than ment options and a greater variety of insti- a check but safer than cash. In the mid-1970’s tutions providing financial services to the money market mutual funds were introduced, consumer than ever before. Choices have ex- allowing the consumer to invest relatively 202 Ž Effects of Information Technology on Financial Services Systems

small amounts of money at substantially high- readily accepted than the traditional paper er interest rates than with bank savings and instrument. time deposits— without sacrificing liquidity Another option for the consumer of finan- and at apparently minimal risk. By the 1970’s, cial services is “one-stop shopping” through deregulation legislation recognized both the the financial supermarket, where all banking,* inability of banks to compete explicitly for investment, insurance, and real estate needs small-denomination consumer funds under the can be served in one place. The most visible current interest rate restrictions, as well as the examples are the Sears Financial Centers, importance to some consumers of insured al- which are under the umbrella of a retailing ternatives to money market mutual funds. organization rather than a traditional finan- Also inherent in the legislation was the cial institution. Other national and regional recognition of the importance of consumer sav- retailers as well as bankers and brokers are ings to the health of the economy. considering the same concept. Also, niche mar- Banks can now offer federally insured keting–the offering of services tailored to the money market accounts and interest-bearing specific needs of small groups-is available accounts that are the functional equivalent of through financial service boutiques. The up- checking accounts (NOW and Super NOW ac- scale consumer and specific occupational groups counts). In addition, penalties for early with- (e.g., farmers) benefit. drawal of funds from certificates of deposit Technology provides the competitive edge, have been lessened. Through changes in the making a particular product possible or allow- regulations affecting Individual Retirement ing an institution to take advantage of eco- Accounts (IRAs), all consumers can enjoy nomic conditions. The most widely available some tax-postponed income. The systematic technology-based services are the ATM and dismantling of Regulation Q will eventually automated deposit services (ADS). At-home completely deregulate interest rates on time banking, which began with simple telephone and savings deposits. billpayer services, is now being introduced The individual also has a greater number of through videotex services and the computer. options with respect to the financial institu- Point-of-sale (POS) electronic payments sys- tions with which he can do business. The lift- tems, which were attempted in the 1970’s, are ing of regulatory restrictions and the devel- being attempted again in specific trials. opment of innovative products inside and The distinction between those options avail- outside the banking industry have allowed fi- able to the consumer through technological nancial institutions to become full-service pro- means and those which seem to be the result viders, differentiating their products and ap- of the condition of the economy, product in- proaching different market segments. Savings novation, and legislative changes is not as associations are allowed to extend consumer clear. Many of the options which seem to be credit, which puts them in direct competition the result of economic conditions such as in- with commercial banks and consumer finance terest rates—e.g., the money market fund– corporations and, to a lesser extent, retail are facilitated to a great extent by the tech- organizations. They are also able to offer NOW nology. These funds have been automated and Super NOW accounts. Asset management since their introduction and, considering the accounts available through securities brokers size and number of participants in the in- are accessible through debit and credit cards, dividual funds, might not have been possible which have the same characteristics as the with manual systems. 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 *Physical deposit-taking services cannot be offered at all become a “paperless check” that is more locations. —

Ch. 8—Findings ● 203 ——. — .- ——

The Equity of Choice teller higher than those of an ATM. Others include having fully automated branches in con- Choice, in an economic sense, is good, and venient locations and full-service branches in as such, the assumption underlying the in- limited locations, or creating branches where crease in financial management options is that all teller operations take place at the ATM, but it must benefit the consumer. However, two personnel on location can assist if there are basic issues must be examined in this context: problems or can carry out functions not pos- 1. Do all consumers actually benefit from the sible through an ATM. current expansion of choice in instruments In order for the consumer to take advantage and institutions? of the increased number of alternatives avail- 2. Are there countervailing trends in the fi- able for financial management, he must under- nancial service industry that may even- stand their function and benefits. Commercial tually limit options for the consumer or for banks and savings institutions may not be particular groups of consumers? equipped to provide consumers with the in- There is some evidence that certain classes formed assistance necessary for helping them of consumers are becoming more sophisticated make increasingly sophisticated decisions. In and are demanding new financial services. many cases the bank employee knows as lit- These consumers are becoming asset manag- tle about the new products and services as the ers. However, although most consumers are customer he is trying to help. Although the aware of the choices available to them, many consumer may prefer to deal with a local in- are still confused by the options. Certain stitution, he will tend to do business with segments of society will prosper under a sys- those institutions that not only offer him the tem of greater choice: they will have the nec- best return, but also provide good information. essary information and know-how to make use In some cases, that will be the local institu- of the information to their financial advantage. tion; in others, it will be an institution with However, other segments may be less fortu- a regional or national presence and a more so- nate. According to the available trade press, phisticated marketing approach. This, in turn, it appears that most financial institutions wish may mean a flow of funds out of the community. to attract the upscale market, not the lower Within a single organization, those profiting income and lower balance consumers. from the system and those providing informa- Only a small number of consumers fall with- tion may be the same, creating a potential con- in the definition of upscale, yet nearly all conflict of interest. In the past, one bank’s prod- sumers require financial services of some sort. ucts were the equivalent of the next bank’s, Those consumers who are not upscale are the products offered were straightforward, and likely to experience a decrease in available op- competition was based not on the relative tions. A particularly obvious example of this merits of each but on the “extras’ ’-i.e., the movement occurred in 1983, when Citibank in- service offered. Although Truth in Lending stituted a policy that barred customers with Act regulations require that the terms and in- a balance under $5,000 from dealing with a terest of various credit instruments be clearly human teller, Citibank’s action met with stated for purposes of comparison by the con- strong opposition and was eventually re- sumer, there is no comparable requirement for versed. It is difficult to say whether other in- information about investments. stitutions would have instituted the same or similar policies. Marketing to the Consumer There are more subtle means of reaching the It is no longer clear what the purpose and same end, i.e., moving an institution’s less role of depository institutions is. No longer do profitable customers out of the bank lobby. such institutions have a unique niche in the One way is to price the services of a human marketplace. Under these circumstances, in- 204 ● Effects of Information Technology on Financial Services Systems —— formation available to the consumer may period, with fewer withdrawal penalties. They sometimes be biased. In the highly charged may, however, benefit more from offering only competitive atmosphere that now prevails in specific products to avoid the confusion at- the financial service industry, information tached to infinite choice, in much the same may either obscure the real situation or inflate way that a manufacturer will package his its advantages. A particularly vivid example products in prespecified amounts. A situation occurred the first year that IRAs were made may evolve where the industry is allowed to available. Advertisements stated that the offer many alternatives but chooses to offer holder of an IRA could be a millionaire by a limited selection based on the preference of retirement; however, the ads misled the pub- a particular market segment or, -perhaps, the lic by failing to put the notion in economic mass market. perspective. Although the consumer should apply the principle of “caveat emptor” to the management of his financial affairs, he has Changes in Pricing Structure come to perceive banks as noncompetitive, and he conducts his business with banks based on The one trend that is likely to have the most this perception. significant effect in the near term on the availability of options to the consumer is the ex- In addition to the issue of consumer confu- plicit pricing of services. sion about available options, which in some ways can be solved by making information Competition has forced the industry–in par- available, there is also the question of con- ticular, banks-to reduce the “spread,” or the sumer awareness and education. Consumer re differential, between interest earned on assets search shows that beyond a certain number and paid out on liabilities. In the past, this dif- of variables, the consumer tends to be unable ferential has been the major source of income to process information. Often, increasing the for financial service providers; however, new amount of information available does not help. sources of income are needed to replace income Educational differences or the predisposition lost from the reduction of spread. In addition, of the consumer may preclude him from proc- higher balance, static accounts subsidized ac- essing the information in a way that would fa- tive accounts having a low-to-zero balance. As cilitate decisionmaking. Also, the consumer a result of the change in the industry’s com- needs more time to make intelligent decisions petitive structure, customers are beginning to about the management of his assets, which be charged for the cost of their services. In a could force changes in the industry in a num- highly competitive, deregulatory atmosphere, ber of ways. First, it seems to support the need cross-subsidization is infeasible because the for a class of personal financial advisors. This larger, more profitable account holders will trend is likely to continue as the number and tend to move to those institutions where they complexity of options available to the con- can earn the highest interest rate. sumer increases. Unfortunately, there is no Fee-for-service pricing, in most cases, will certifying process or standard form of educa- encourage the consumer to use those services tion required for these advisors. that are the least expensive and may therefore Second, it could also eventually affect the limit his use of particular products and serv- number of options offered by the industry. If ices. However, in certain cases he may not institutions find that their clientele are con- have a choice; for example, most households fused and unwilling to spend the time to make need checking accounts to manage their ac- a decision among a wide variety of choices, the counts. This trend toward explicit pricing institutions may decrease the number of op- seems to affect payment mechanisms the most tions available. For example, as of October 1, and therefore will have the greatest impact on 1983, banks were allowed to offer certificates those consumers whose financial transactions of deposit in any denomination for any time are heavily payment-oriented. Ch. 8—Findings ● 205 .— — —

The Implications of termediaries, either because the consumer Technology-Based Products chooses not to establish this relationship or because he is an undesirable customer and Recent work published by the Federal Re- therefore cannot find a financial institution serve Bank of Atlanta projects the rate at willing to do business with him. With direct which checks will be displaced by other, elec- deposit there is pressure on both the individual tronic, methods of payment. Although it still and the institution to form a relationship. This represents a small percentage of total account pressure for institutions is in direct opposition activity, the steady growth in the deployment to the competitive pressures they feel from the and use of ATMs shows some willingness by rest of the industry to rid themselves of un- the consumer to accept technology-based serv- profitable accounts. Yet, these accounts need ices when they meet specific needs. In the not be unprofitable for the bank if it charges Atlanta analysis, the first stage of check appropriately for its service. However, the po- displacement will be in the cash-dispensing tential exists of charging an individual, who function. As long as the infrastructure for the is in essence forced into the system, a dis- acceptance of electronic payment remains un- proportionately high portion of his income. * derdeveloped, there will still be a need for There is some argument for the subsidization paper-based instruments. of these accounts, but with the current com- Eventually, the entire population may have petitive state of the industry, it is doubtful to participate in the system. This becomes par- that a financial institution would be willing to ticularly obvious on examination of direct de- bear those costs. It is not unreasonable to ex- posit services. Since the U.S. Treasury began pect the organization that benefits from direct encouraging direct deposit of Social Security deposit, in this case the U.S. Treasury, to pay payments, the penetration of direct deposit these costs. has gone from 11 percent of total payments As direct deposit of government transfer to 33 percent. ] A Social Security system where payments becomes more common, other reg- 100 percent of all transfer payments are ular income payments may also be paid direct- directly deposited would require that all recip- ly. The issue on a larger scale is not only who ients hold accounts with a financial institution pays for the service, but also whether the con- or be provided some alternative means of re- sumer can be forced to establish a relationship ceiving payments electronically. with a financial service intermediary in order Currently, 17 percent of all households do to receive his salary. not have any relationship with financial in- — ——— *sOme ~ndil~idu~s LISP Ser},ices for a Jrariet?r of nOrlllati\’e rea- ‘Economic Review, Federal Reserve Board of Atlanta, August sons that may actuall}’ be more expensi~’e than would be 1983, p. 33. 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 solu- tem failure, disruption, theft, error, and invasion tions; and 2) those that are perpetrated by in- of user privacy. dividuals who wish to compromise the system 206 ● Effects of Information Technology on Financial Services Systems -.

and that require more complex solutions, in- to identify positively the EFT user. As sys- cluding technology. Some types of crime are tems become more complex and a greater per- possible because of the nature of the paper- centage of the population begins to use home based system–e.g., theft of funds sent through banking and POS systems, problems with the the mail, check forgery, and even, to a certain current means of identification will become extent, credit card counterfeiting. Technology- more obvious. With ATM the consumer’s loss based systems can provide solutions; however, is limited by the amount of cash he is allowed by providing new points of entry into the sys- to withdraw from the system. Although his tem, they offer potential for new kinds of liability for unauthorized transactions is fraud. Future crimes involving financial trans- limited, under the Electronic Funds Transfer action and payment systems will primarily in- Act (EFTA), his financial loss could be greater volve a computer simply because one is inevi- when more sophisticated financial trans- tably part of a large-scale, modern-day financial actions are involved and if those transactions system. The question of computer security are not reported within the time required by touches every aspect of the financial service law. This risk could affect the willingness of industry. As the volume of EFT transactions the consumer to use these systems, and there- rises, it becomes increasingly important that fore the rate of acceptance of these services. financial information be secured against un- In that event, the market could force the pro- lawful entry and that a system of law be de- viders of services to secure systems better. It veloped under which computer criminals can should also be noted that to the extent that be prosecuted. the law places responsibility for losses on the provider, it provides additional impetus for Some perceive technology as a solution to providers to secure their financial systems. problems that plague the consumer of financial services. Credit card fraud, which is fre- Solving the identification problem is even quently cited as a growing problem in the in- more difficult when placed in the context of dustry, can be made more difficult by the use the home or workplace. The volume of busi- of sophisticated technologies. Because of con- ness at an ATM may allow the use of expen- sumer protection legislation, fraud is primar- sive identification technologies that would not ily a provider problem. The consumer is pro- be feasible at a place of business, and certainly tected from illicit use of his credit cards, and not at home. Now the major means of iden- if sufficiently informed, he can prevent all but tification in these systems is some form of a minimal financial loss from the fraudulent alphanumeric code or personal identification use of his card. Both VISA and MasterCard number (PIN), again not identifiable with a have introduced or are planning the introduc- specific individual. Although banking termi- tion of cards that are expensive and difficult nals in these locations do not yet dispense cash to counterfeit. It is difficult to say whether or a cash equivalent, they certainly provide the these cards will in the long run reduce fraud, opportunity to transfer funds among accounts since it will be some time before the effect of or to embezzle electronically. These problems their introduction and use will be felt. The cost will become immense if all personal computers to produce these cards will be much greater are equipped to access videotex services and than that for current credit cards. Although electronic financial services and if a larger per- the consumer will explicitly or implicitly pay centage of the population has access to these the cost of the card, it may not mean addi- terminals. tional financial burden for the consumer in the EFT also generates new kinds of personal long run because of the reduced costs of fraud security problems—an individual using an to the card user. ATM to receive cash maybe particularly vul- Recent concern in the area of consumer fi- nerable to robbery. During normal business nancial services has revolved around the rela- hours, a traditional brick and mortar facility tive security of access devices and the need provides the individual with security during . .

Ch. 8—Findings ● 207 — ——.. and after a transaction. An ATM located away dures for processing transactions can be cir- from this structure may place the user in a cumvented for expediency or can fail to vulnerable position. Even those ATMs located operate under an unanticipated set of circum- at bank branches can be unsafe when used in stances. However, human involvement in the nonbanking hours. It is difficult to assess the delivery systems can be instrumental in de- seriousness of the problem because most insti- tecting breakdowns of system integrity when tutions are unwilling to divulge information they occur and in implementing the steps to on security issues for fear of discouraging use repair or minimize the resulting damage. of the systems. Often, the robberies that occur at ATMs are not reported as such. On the other hand, financial service delivery systems that rely heavily on advanced The smart card is another new technology technologies are subject to more breakdown claimed to be more secure than existing card factors than those that can damage or destroy technologies. The microchip-implanted card simpler technologies. At the same time, they has different levels of security, but the future may be built to include protections that can- role of the smart card in the financial service not be incorporated into simpler systems. industry remains unclear. In the commercial environment, the security Computer programs, for example, are de- of payment systems is also an issue of signifi- signed and built to handle a predetermined set cance. The increasing use of computers to ini- of conditions. Any data values not falling into tiate payments automatically raises the need one of the defined categories should be re- to establish the identity of the computer ini- jected by the program and examples of such occurrences should be included in the tests tiating a financial transaction, just as, in the past, it has been necessary to establish posi- conducted before a program is put into oper- tively that a payment order issued by a human ation. However, even though computer pro- is authentic. Financial systems that perform grams are “validated,” exhaustive testing is accounting as well as payment functions must not physically possible, and there is always the be auditable, lest an unauthorized feature be chance that some combination of data can be hidden in the computer programs that consti- entered that will produce totally unanticipated results. If the system operator is lucky, the tute them. Care must be taken to limit access impact will be large enough that it will be to financial information that may be of value to an intruder, even if there is no unauthorized noticed immediately and corrective action can transfer of funds. Finally, superimposed on be taken. On the other hand, if the error is sub- these requirements are all of the concerns that tle, its effects, though significant, can go un- noticed for years. In the aggregate, the im- pertain to individual users of financial serv- pacts could be significant, although no one ices, particular services that entail remote ac- incident may be great enough to instigate cess to financial service systems. steps to correct the error. System Integrity Computers rely on magnetic media for storing data, and these media are generally quite Systems for delivering financial services can reliable. However, since they are not as reliable also be compromised by a number of factors as paper, particular pains have to be taken to that are inherent in the operating environment make sure usable copies of the data are avail- but are, nonetheless, capable of interrupting able when needed. For example, data on mag- service. netic tape will deteriorate with the passage of In the more traditional systems for deliver- time. Also, mechanical failure of a disk drive ing financial services, breakdown of system in- can cause data to be destroyed. Although so- tegrity is possible. Records can be lost, along phisticated techniques exist for detecting er- with the audit trails necessary to reconstruct rors in data recorded on magnetic media, some them. Checks and balances built into proce- errors remain undetected. These problems are 208 ● Effects of Information Technology on Financial Services Systems .—. reasonably well understood, and the tech- tems for delivering financial services depend- niques for neutralizing them are straightfor- ent on advanced technologies. ward and relatively inexpensive if operating management is willing to pay sufficient atten- Specific Consumer Concerns tion to them and the system design incor- porates them. Transition From Paper-Based to Technology-Based Systems Similarly, the use of telecommunications in systems for delivering financial services intro- Competitive pressures within the financial duces threats to system integrity. Quite service industry have fostered the use of tech- simply, if a path between a user and a service nology, augmenting and replacing paper-based provider is not available and verifiable, serv- systems. On the consumer side of the business, ice cannot be delivered. However, several or- however, this force must be reconciled with the ganizations may be involved in operating the demands of the marketplace, which maybe in telecommunication facilities that are used, favor of paper-based systems. As a result, the and the problem arises of identifying the ones implementation of technology has not always that are responsible for detecting and correct- been as easy in this market as in others. ing any errors that may occur. The divestiture However, as technology-based services and of the Bell System complicates this problem products are introduced and accepted in the somewhat, but, again, resolution is not beyond marketplace, certain issues arise that are spe- the means of competent technical management, cifically related to the transition from one system to another, and to the reliability of To a very significant degree, a financial serv- systems. ice industry operates on the trust and confidence of its customers. Thus, the systems used Although technological systems may have to deliver financial services must be reliable a lower error rate than those using manual and verifiable; if not, the basic viability of the processing, those errors may be more difficult industry could come into question. In the fu- to detect and resolve. In contrast, a human er- ture, virtually all providers of financial serv- ror can often be resolved immediately. A sig- ices will rely heavily on information process- nificant problem regarding some advanced ing and communication technologies, and it systems for delivering financial services is that will be virtually impossible for them to revert there is no guarantee that a paper record of to manual systems, even for short periods. The a transaction is ever created. While Regula- application of advanced technologies in sys- tion E requires that a customer be issued a re- tems for delivering financial services intro- ceipt at an ATM, remote financial services ac- duces new vulnerabilities to system integrity. cessed through a terminal located on customer 1f these are not taken into account by the premises are not covered. Thus, an individual designers and operators of these systems, the can initiate a transaction without any tangi- basic trust that customers place in the finan- ble proof of the fact. Also, while a stop-pay- cial service industry could be threatened. ment order can be put on a check that is believed to be lost in the mail, it is not clear that Since the class of problems discussed here an analogous step is possible in cases where are purely operational and can be resolved a payee denies having received an electronic partly with technical solutions and partly with payment. Guidelines are written that enable operational procedures and management con- a consumer to stop a pay order via the auto- trols, the key question is whether operating mated clearing house (ACH). management will devote the resources required for the solution of these problems and whether those who regulate financial institu- Regulations Relating to Consumer Finance tions will include in their reviews of operations The consumer facing choices between simi- those factors that affect the integrity of sys- lar financial instruments is probably unaware . . . .

Ch. 8—Findings ● 209 . .— —- —— —. ——— of their differing regulatory requirements, or on Electronic Fund Transfers, privacy was of his protection under the law. It is now pos- defined as “the individual’s expectation of con- sible for an individual who possesses what ap- trol over what information about himself is pears to be a traditional bank credit card to communicated to or used by others. ” Further, be protected from misuse of the card under a “the object of the consumer’s concern regard- variety of legislation or not at all, depending ing privacy under EFT is the potential use of on the type of transaction. his financial transaction information to develop a personal profile.”2 This use could be If a bank issues an individual a debit card as seemingly harmless as an individual receiv- that is associated with an account with a line ing product solicitations, based on his income of credit and is also an ATM debit card, the and profession, from the financial institution individual can perform a number of different where he does business and could range to the types of transactions with the same card. If capability of the system to provide sensitive his line of credit is accessed fraudulently, the information about behavioral patterns of the owner has recourse under consumer credit leg- individual. islation and under Regulation E if the fraud involves EFT. When ATMs or electronic POS Consumers, for the most part, do not appear terminals are used, his liability is limited under to perceive privacy as a major concern in their EFTA. If, however, the fraudulent use of the choice of EFT systems; other, more market- card directly debits his bank account in a oriented, questions seem to determine their paper-based transaction, the consumer has no use of these systems. A Bank Marketing As- recourse under current legislation. This is an sociation (BMA) survey questionnaire showed example where the same card represents three a low level of concern about privacy with re- different instruments, each of which, in the spect to electronic banking systems. There is case of fraud, would require different actions additional evidence that transactions per- by the consumer. formed by ATMs are considered more private than are transactions using a human teller.’] The consumer is likely to be aware of the difference between accessing a line of credit and The paradox is that other studies show the directly debiting his bank account with the public to be very concerned with privacy, in card, but it is doubtful whether he would rec- particular, the use by government of personal ognize a distinction between a debit that is information. 4 However, correlations have yet processed electronically and one that is proc- to be made between this use and individual essed in the paper system. It is also reason- uses of financial systems. The BMA survey able to assume that the consumer perceives does not question overall the individual’s feel- no differences between the transactions in a ings about financial privacy; it only questions regulatory sense. Of particular importance, the consumer on how secure he perceives spe- regardless of consumer perception, is the fact cific financial services technologies to be and that debit card transactions in the paper-based indicates that users of the technology seem to system offer no protection to the consumer. be less concerned than nonusers with privacy. However, the issue extends further, to the Privacy capability of these systems to track financial Much controversy surrounds the issue of activity, which was impossible on a large scale EFT and privacy —i.e., whether the systems under a paper-based system. Individual be- that enable EFT make the individual more vulnerable to violations of privacy. The diffi- 2National Commission on Electronic Funds Transfer, final re- culty of such a discussion is that since privacy port, October 1977, p. 19. has a different meaning to every individual, ‘Ilank .$! arketing ,Lf ssocjation, Pa.}’ men t .+1 t t) tudes (’f?angf’ l;~aluation, {Chica~o, 111.: BNIA, 1982), p. 2.1 H. violation of privacy is not easily defined. In ‘I,ouis 1 I arris & Associates, Inc., and Alan F. \$’estin, ‘‘The the final report of the National Commission Dimensions of Pri\rac}’, ” 19’79. 210 . Effects of Information Technology on Financial Services Systems — — —

havioral profiles can be compiled in the tradi- Privacy is not entirely a domestic issue. tional system using account records, but only Countries outside the United States, notably with great effort and expense. The same tasks in Europe, express considerable concern for become fairly easy using technology. The com- protecting the privacy of individuals and, in petitive atmosphere in the financial service in- some instance, businesses. Some have limited dustry today encourages the accumulation of or prohibited the movement of data relating personal information to help minimize the cost to their citizens to nations that do not meet of bad accounts and to segment a market of their standards for privacy protection. Hence, potential customers to approach with new pressure for privacy legislation may material- products. The accumulation of this informa- ize from sources outside the United States, tion for marketing purposes allows a ready regardless of the level of concern of American data base for other purposes. Not all com- citizens with the issue. panies have and enforce a strict privacy policy, nor do they guarantee that the information is inaccessible through other means, legal or otherwise.

Conclusion 6: Integration of Capital Markets

Advanced financial information systems have Traditionally, secondary markets for both forced the creation of a highly integrated, na- debt and equity securities facilitate the proc- tionwide capital market and increased the ve- ess of intermediation between regions. Under- locity of money. writers buy securities from the primary issuers A highly integrated, nationwide capital mar- and make them available on local, regional, ket is being created, driven by the demands and national markets. Modern information of users and facilitated by the application of processing and telecommunication technol- information and communication technologies. ogies have provided increased exposure to Financial institutions began moving capital on securities and therefore have increased oppor- a national scale when it was recognized that tunities for issuers to increase net proceeds capital supply and capital demand within re- from the paper issued. gions do not necessarily meet. These institutions have produced a national market Congress mandated the development of a through which needed and available funds national market system for securities in 1975. within and between regions of the country are National markets are advantageous for capi- balanced. Local financial institutions are able tal seekers and investors. The truer and more to serve as intermediaries between their cus- equitable pricing of funds that results from ex- tomers and national markets because of their posure to larger markets is demanded by mar- access to the financial systems and because ket participants. This impact is demonstrated of their expertise. The ability of an organiza- by the success of the National Association of tion or individual to participate in a capital Securities Dealers Automatic Quotation Sys- market is restricted by the quality and quan- tem (NASDAQ), which provides national tity of information available on the market, market exposure to what in the past were and financial service providers have tradi- over-the-counter stocks. Trading volume on tionally had superior access to that infor- NASDAQ has reached the levels of the New mation. York Stock Exchange as investors are at- Ch. 8—Findings ● 211 — . — tracted to issues to which they suddenly have financial decisions. Technology that allows for access. a rapid transfer of information diminishes the importance of location of both service pro- The Effect of a National Capital viders and customers. Return potential has Market on Financial Services enabled the funds to draw a market share from a broad-based population. A national capital market results in competi- Investment funds may draw capital away tion between diverse local and regional require- from depository institutions and therefore the ments for capital. The fundamental problem mortgage market. The individual development associated with the national market is whether of equity represented by home ownership is there is equal access to all potential players. an important cultural and economic value in While information technology facilitates the U.S. society. Historically, the home mortgage communication of information used as the was placed by a depository institution in the basis of financial decisionmaking, and there- same community as the financed property; fore has made it easier and cheaper to partici- however, information technology has facili- pate in the national market, in some cases the tated the nationalization of mortgage capital advantages of a regional market may be lost. markets and changed the ways in which this For example, regional markets may be more capital is developed. The movement away from appropriate for the development of capital for local mortgages may be harmful for consumers new or growing firms that may not be able to in some areas and may remove some incen- compete in a national environment yet make tives for forming ties with local financial in- a unique and valuable contribution to the econ- stitutions. omy of the region. Cost and income characteristics for businesses tend to differ between re- The development of secondary markets for gions, and it may be beneficial for a firm to both long- and short-term debt instruments have its potential level of return evaluated has been a great benefit for smaller financial regionally rather than nationally. While the ac- institutions. Financial institutions, particular- tual cost of money may be equal in a national ly banks, are able to redistribute and balance market, its cost relative to return may differ capital by buying and selling debt contracts between regions. among themselves. Information technology facilitates this process by making it easier for The exposure of securities and loans to na- financial institutions to identify potential tional market circumstances has led to an trading partners and to analyze market oppor- equilibration of securities prices and interest tunities. rates. This trend initially developed on an institutional level and has now encompassed While access to the national capital market consumer markets. Consumers and small busi- through the use of information technology ness customers were at one time dependent on may greatly benefit sophisticated investors, local financial institutions because they did some worry that less sophisticated investors, not have the knowledge required to operate in who need help to interact in a national mar- a financial market beyond their area. The ket, may realize lower returns. The national availability of information on a national level capital market has caused a proliferation of in- results in more equitable choice and quality vestment choices that entail a higher level of in services offered. analysis of personal investment goals and opportunities. The nationalization of capital formation may be a leading cause in the shift in placement of At the same time that a national capital an increasing portion of consumer funds into market has been developing, the velocity of investment instruments, such as money mar- money—a measure of the number of times per ket mutual funds. This movement is an indica- period an average dollar is spent to purchase tion of the importance of information flows in newly produced goods and services—has been 212 • Effects of Information Technology on Financial Services Systems increasing. While the incredible growth in the The increase in trading volume for securi- trading of securities and in asset transactions, ties is another indication of the general quick- as seen in bank deposits, may be driven by ening of the American economy. Share days market forces, it would be physically impos- of 100 million are not uncommon on the New sible to complete the actions required for these York Stock Exchange, on which a daily aver- activities without communications and com- age of less than 17 million shares were traded puter technologies. While information technol- in 1972. And high volume no longer requires ogy is not directly the cause of an increase in the curtailing of trading hours. Long-range the velocity of money, without its application planning by the New York Stock Exchange the velocity could not have increased to the anticipates average daily trading of between level demanded by the market. This type of 200 million and 250 million shares.’ Given the constraint could have a severe impact on the requirement for quick settlement, it would economy. have been physically and fiscally impossible for trading to approach this level without auto It is now generally accepted that there is no mation. technological constraint to the trading of assets at whatever speed is demanded by the Information technology has given both do- market. Almarin Phillips notes that bank de- mestic and multinational firms far greater ca- mand deposits in New York City were turned pability to identify available assets and to di- over 1,200 times a year in 1981 as compared rect them to those investments that offer to an average of 150 times a year in 1970. He maximum return for whatever period those attributes this acceleration to the appearance assets are available. This ability relates to the of new markets, the availability of better in- tremendous growth of money market mutual formation, falling transaction costs, increased funds and accounts that are based on short- liquidity of many assets, and the general rise term investment instruments. in interest rates. These factors have put a premium on the efficient management of liq- Future Impacts of Technology on 5 uid assets. It would be prohibitively expen- Capital Markets sive to complete transactions at the demanded speed without the level of technology applied In an integrated world economy, a high de- by the banking and securities industries in the gree of capital mobility is required to offset last several years. movements in other items of balance of payments. 7 An international capital market has As the banking industry moves toward mul- developed, facilitated by the application of in- tiple settlements during a business day, fail- formation technology. This market is having ure to adopt the needed technology could re- a major impact on the world by intertwining sult in a massive movement of funds out of the economies of culturally and politically di- the financial service industry by corporate verse nations. Also, worldwide financial cen- cash managers. An indication of this poten- ters have emerged in countries such as Hong tial was seen in the movement to trade secu- Kong and Bahrain. Unlike a domestic market, rities off organized exchanges in the early however, there is no overriding international 1970’s, when it appeared that the exchanges system through which a global economy could could not operate at the level demanded. Trad- be governed. Whereas the United States of ing was only returned to the exchanges as in- America share a common Federal Government formation technology increased their capacity and political and cultural rooting, this type of and speed. relationship does not exist between nations. --——-.-..——_—- ‘Almarin Phillips, “Technology and the Nature of Financial Services, ’ Strategic Planning for Econom”c and Technological 61VYSE 1983 Fact Book, p. 4. Change in the Financial Services Industry, Proceedings of the ‘R. M. Pecchioli, The Internationalisation of Banking: The Eighth Annual Conference, Federal Home Loan Bank of San Policy Issues (Paris: Organization for Economic Cooperation Francisco, Dec. 9-10, 198!2, San Francisco, Calif., pp. 5-6. and Development, 1983), p. 115. Ch. 8—Findings ● 213 -. .—.— ———- .- ——

The differences between telecommunication the eurocurrency market for redeployment of industries and regulations in various countries international capital. 8 must be recognized as a barrier to the devel- Communication technologies have also had opment of global capital markets. Information a particularly strong impact on international technology creates new vulnerabilities in in- wholesale or interbank activities. Interbank ternational markets. activities provide a large portion of the funds Information technology has made it possi- for international investment. The use of tech- ble for financial service institutions in different nology has allowed small banks for the first nations to direct excess capital much in the time to become involved in international same way it is directed between regions of the banking. United States. In addition to more sophisticated asset and liability management techniques, improved communication facilities had vast consequences for the rapid emergence of ‘I bid., p. 20.

Conclusion 7: Entrants Into the Financial Service Industry

The major new entrants into the financial serv- determine the competitive character of the in- ice industry are, and will increasingly tend to dustry. be, organizations that already have extensive distribution and/or communications systems. The Role of Information Technology A financial service organization that has an in Competitiveness established technology infrastructure usually has a competitive advantage in three areas: The flow of information is essential to the 1) facilitating the intermediary functions of the orderly operation of financial service markets financial service industry; 2) providing conven- because it is essential to the making and di- ience of location to its customers, including the recting of decisions. Information may be a increased movement to remote banking and representation of or collateral to the transfer other financial services; and 3) in general, im- of value. At the same time, cost and accessi- proving productivity. bility considerations have led to a change in preference for electronic systems from the The experience of present leaders in the fi- once-practical paper-based systems for many nancial service industry —e.g., Citicorp, Sears, types of information. The transfer of financial ADP, and Merrill Lynch–indicates that strong service records is changing from the physical distribution and communication systems are transportation of documents to the electronic major factors in their ability to capture and exchange of information. The communication serve markets. It is expected that the control systems developed to meet this demand are of or access to distribution and communica- far more technology-dependent and capital- tion systems will continue to be an important intensive than their predecessors. indication of the potential success of current industry players and, therefore, an indication The application of information technology of who will be the new entrants into the finan- frequently decreases the costs of delivering ficial service industry. The identification of po- nancial services. The corporation that can tential entrants is important because they help automate delivery systems has a competitive 214 ● Effects of Information Technology on Financial Services Systems advantage because it faces lower total costs. nication systems and are usually dependent The importance of technology in communica- on information technology for operation. tion systems is found in time, as well as dollar, Established distribution systems may ease considerations. entry barriers to new markets. When Sears entered the financial service market, it had the Availability of Services to Small benefit of an established system of retail Financial Service Providers stores through which it had community presence. The availability of these locations for the Lack of access to sophisticated communica- offering of financial services eliminated much tion and distribution systems could poten- of the startup cost involved in selecting appro- tially be a significant barrier to small service priate locations for retail businesses, since in- providers both for entering and competing in formation on customer traffic and other site financial service markets. A tier of wholesalers characteristics was available. The opportunity of data processing and communications serv- cost for Sears of extending its line of com- ices has developed to supply services to end- merce to financial services may be assumed users or to small financial service providers to be lower than otherwise might be expected that cannot afford to invest in large-scale com- because much of the cost for distribution chan- munications or computer systems. nels was already paid. Entrance by Holders of Communication The distribution system of a player in the and Distribution Systems financial service industry involves not only its physical presence but also its ability to dis- Existing information technology infrastruc- seminate information. Sears has the most ex- tures have provided market opportunities in tensive private card base in the Nation, equal the financial service industries for several cor- in importance to its retail outlets. Because porations. For example, a data processing Sears had this communication system in place, firm, ADP, is an organization whose entrance it could develop a direct marketing system. into the financial service industry grew from Future entrants into the financial service in- holding a sophisticated computer and commu- dustry may include corporations that enjoy a nication system. J. C. Penney has applied its strong distribution system such as gasoline communication network to the processing of retailers. These corporations have a presence oil company credit card transactions. Penney’s through gas stations in urban and rural areas established communication system gave it the throughout the Nation, a strong fiscal person- opportunity to expand into new markets. ality, significant card bases, and sophisticated Given the great value of sophisticated com- POS systems. munication systems to operating financial service systems, new entrants may be found in established communication firms such as The Effect of New Entrants on AT&T and MCI, which may find it cost effec- Services Provided tive to enter the financial service industry as The new entrants with strong communica- wholesalers of services or, because of their tion and distribution systems have increased established systems of customer service, as di- the number of options available to financial rect service providers. service consumers by making a wider range A successful distribution system may be of product offerings and delivery mechanisms judged not only by the number of physical available. Communication and computer tech- locations in which an outlet is placed, but also nology has made it possible to develop far by the extent to which it provides cohesive more diverse and complex investment pack- coverage of markets. Distribution systems ages that serve a greater range of investors. share many of the characteristics of commu- In addition, the refinement and increased Ch. 8—Findings ● 215 — — —— ——.——— speed of settlement found through the applica- Antitrust Implications tion of information technology also improves the quality of service received. Vertical integration may result in greater market concentration by foreclosing the com- It is possible that, in the long run, the need petitive opportunities of those selling or buy- for communication and distribution systems ing in competition with integrated market may decrease consumer options if the market participants. 9 Given that distribution and becomes dominated by national firms with lit- communication systems of an organization le local presence. However, it does not appear may be indicative of possible future entrance likely that the market would tolerate this type by an organization, these systems should also of development. Small firms can compete as be considered in cases of proposed mergers. long as they are able to access delivery sys- Antitrust enforcers should be aware of the tems built and operated by others. possibility that if dominant communication The possibility of cross-entry into the finan- carriers move into the payment system it is cial service industry by communication firms possible that their market position in com- and others may protect consumers from the munications may place banks and other financial intermediaries at a competitive disad- effects of monopolization. No matter what 10 happens to the concentration levels in the fi- vantage. nancial service industry, the availability of ad- Antitrust enforcers should also keep the in- ditional and diverse organizations to provide creasing competitive overlap in mind when financial services if market circumstances are analyzing mergers. The Merger Guidelines favorable should lead to competitive prices. issued by the Department of Justice in 1982 identify both established players and firms whose production and distribution facilities The Effect of Telecommunication could reasonably be adapted for entrance into Regulations on Financial Services a market as market participants.11 The mar- Most segments of the financial service in- ket impact of proposed mergers and acquisi- dustry are subject to Federal or State regulations has to be evaluated, among other factors, tion. With the application of communication by the likelihood of one of the players inde- technologies, players throughout the financial pendently entering the market of the other as service industry may find themselves subject a competitor. Therefore, distribution and com- to regulation both of their products and serv- munication organizations outside of the finan- ices and of the systems they use, cial service industry that propose a merger with a current player should be evaluated in While it maybe expected to be a transitional terms of their adaptability to financial ap- problem, the applicability of two regulatory plications. structures to the financial service industry may hinder its operation by increasing admin- ‘Donald 1. Baker and W’illiam Blumenthal, 4 ‘The 1982 Guidelines and IJreexisting Law, ” California Law Ite}’iewr 71, istrative costs. In the extreme, the economic March 1983, pp. 311-344. viability of existing systems could be de- 1ODon~d 1. Baker ad 13everl}~ G. Baker, “Antitrust ~d Com- stroyed. Product development and marketing munications Deregulation, 28 Antitrust Bulletin 1, 1983. ‘l Baker and Blumenthal, op. cit., p. 337. Baker and 131umen- activities could be adversely affected by reg- thal note that the U.S. Department of tlustice, Nlerger ulatory uncertainty about communication fa- Guidelines \I, 47 Fed. Reg. 28,493, 28494 (1982) list the fol- cilities. Regulation of communication services lowing classes of firms as market participants: 1) firms that currently produce and sell the relevant product, 2) firms whose may limit the ability of financial service pro- existing production and distribution facilities could be shifted viders to realize the potential benefits of new to enable the firm to produce and sell the relevant product technologies in internal systems if restraints within 6 months of a 5 percent price increase. 3) firms that recy- cle or recondition products that represent good substitutes for on their usage are imposed. As a result, new the rele~.ant product, and 4) vertically integrated firms that pro- systems could be stymied. duce 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 expressed concern that one of the outcomes of the financial service industry is what degree will be consolidation. The number of firms in of consolidation and concentration of services the industry would be reduced to a point where will eventually occur. A second major uncer- a small number could dominate the market. tain y is what level and scope of competition in Such concentration would directly contravene financial service markets would be appropriate one of the central themes embodied in estab- and desirable for a healthy future economy. lished policy. Some also express concern that users of financial services provided by nonde- The compartmentalized structure of the fi- positor institutions may be exposed to un- nancial service industry established over the warranted risk because the firms providing the past 50 years is in the process of vanishing, services may be prone to accepting a higher and the future structure of the industry re- degree of risk than depository institutions are mains as yet undefined. In the past, geograph- permitted to take. ic limitations were placed on the areas a bank could serve so that none could position itself Even though firms not traditionally pro- to dominate the banking industry. Because viders of financial services have entered the banks were limited only to the banking and industry and operate outside the constraints related business, banks were also effectively imposed on traditional suppliers, they appar- kept from using their unique position in the ently have not weakened it. New entrants have economy to dominate other industries. How- generally been successful in broadening com- ever, banks were given an exclusive franchise petition in the face of the existing legal/regu- for the taking of deposits and access to the latory structure. In recent years, Congress payments system. Only commercial banks has repeatedly been called on to remove con- were permitted to offer a demand deposit straints that have limited the ability of the account, and only they had access to the regulated firms in the financial service indus- Federal Reserve and the check-clearing try to compete with the new entrants; it has mechanism. not been asked to act to protect the ground taken over from the traditional service pro- Regulations were promulgated for specific viders. classes of institutions; so long as there was no effective way for new entrants to encroach on A key parameter for success in the financial the franchises that had been granted in legis- service industry is access to systems based on lation, the structure remained intact and was advanced information processing and telecom- generally able to achieve the goals that had munication technologies. Large service pro- been established for it. However, economic viders have the resources to develop and de- conditions, in combination with the latent ca- ploy these systems on their own. However, the pabilities of advanced information processing existing infrastructure of wholesale service and communication technologies, encouraged providers has made it possible for all firms, the successful entry of new firms into the fi- regardless of size, to have the requisite access nancial service industry from such diverse to the advanced technologies. New entrants, areas as retailing, communication, and infor- taking advantage of the advanced systems, mation processing. have repeatedly demonstrated their ability to compete successfully with larger firms in the Significant numbers of those concerned with marketplace. As long as this alternative ex- the long-term effects of the changes now tak- ists, there are few barriers to entering the fi- ing place in the financial service industry have nancial service industry. .—

Ch. 8—Findings ● 217 ———

Another concern expressed by some is that ing their communities. ’12 On the other hand, a financial service industry dominated by a this statement says nothing about the propen- few national organizations would no longer be sity or the ability of an organization to enter responsive to local needs of the communities a market through the process of acquisition, in which they operate. On the one hand, ease one which Hammer indicates is likely to be of entry will continue to minimize the chance successful. Nor does it say anything about that an area would not be served by institu- their propensity to continue to serve local tions responsive to its needs. On the other needs if a dominant position in a market is hand, continuing to regulate the interstate established. activities of the banks will not guarantee that Evidence indicates that the propensity of capital will be available to meet the needs of customers to switch financial institutions is the areas that generate it. As the pervasive- relatively low and that there must be some sig- ness of technology-based systems for manag- nificant event to motivate such a change. On ing financial resources increases, intermedia- the other hand, some believe that packages of tion by banks will become a less significant services could provide the necessary motiva- portion of bank activities because deposits tion for customers to change financial service from which loan portfolios are generated will providers and that once new, complex relation- continue to shrink. There is some indication ships have been established, the inclination to that banks will become primarily service pro- move in the future will be lower than in the viders through which funds flow. Therefore, past. Securities firms assume that they will policies that are intended to assure the avail- be able to establish a high degree of customer ability of capital for socially worthwhile proj- loyalty because they are able to offer service ects are more likely to be successful if they regardless of whether the customer is home, focus on nonbank institutions. on a short trip, or permanently relocating to Historically, there is some evidence to sug- a new area. * Thus, the firms that can estab- gest that large financial institutions are not lish a national presence and offer a comprehen- necessarily successful in their attempts to en- sive package of interrelated services may be ter and dominate markets held by smaller able to generate a degree of customer loyalty firms. In areas where they were able to enter, that could enable them to dominate the finan- the larger firms were at least as responsive to cial service industry. local needs as were the local banks that had The States are not waiting for the Federal previously provided service. Fears that the Government to modify its position with regard New York City banks would be able to drive to the policies that help shape the structure the smaller upstate banks from the market of the financial service industry. Laws that were expressed when statewide branching was would permit regional banking have been first permitted. passed in New England. Some States, South However, according to a statement by Fred- Dakota and Delaware among them, have en- erick Hammer, Executive Vice President, acted legislation designed to attract financial Chase Manhattan Bank of New York, “Vir- service organizations. Thus, even though pro- tually all the New York City banks that went hibitions of interstate banking based on Fed- upstate ended up closing most of those eral law may continue in force, regional bank- branches. The only branches from those efforts that are profitable are those done by ac- ‘zFrederick Hammer, Executive Vice President, Chase quisition. In the towns where our banks were Manhattan Bank of New York, in testimony in oversight hear- able to branch, we were able to provide new ings before the Committee on Banking, Housing and Urban Af- services. Studies done by the FDIC indicated fairs, U.S. Senate, May 3, 1983. *The strate~ is also intended to change the loyalty of the that the loan ratios went up in those towns. customer from the account representative to the firm, a prob- The banks were doing a better job of servic- lem 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 iness of the regulators to step in to protect a emerge. Also, organizations that provide fi- failing institution have resulted in a false sense nancial services in nationwide markets oper- of security that has led some institutions to ating from States that have passed permissive take unwarranted risks in participating in legislation may emerge. Federal law permits deals put together by others. The secondary interstate and cross-industry mergers when it effects from the failure and closing of the Penn can be demonstrated that they will serve the Square Bank illustrate this point. They also public interest. argue that these policies protect the stockholders as much as the depositors and, as a No clear picture of the future structure of result, the institution will undertake projects the financial service industry exists. Some for its own account that represent an undue foresee considerable consolidation, with many degree of risk. fewer firms serving the public than at present. Some believe that the industry will consist of However, the combination of economic forces a small number of large firms serving national and technological applications has resulted in markets and a large number of small firms the movement of deposits from insured ac- specializing in specific market niches. On the counts in financial institutions. Although the other hand, others contend that the financial introduction of insured money market ac- service industry is already heavily concen- counts by depository institutions at the begin- trated in many respects and that it will not ning of 1983 was accompanied by some in- change significantly in the future. Given the crease in deposits, over the long run there is contravening forces operating, there is no a distinct possibility that the deposits held by basis for adopting one of these positions or any financial institutions will continue to shrink others that could be suggested. relative to all financial assets. Investors in However, it is clear that future financial functional equivalents of depository accounts services will be provided by a variety of firms, that are not insured would then be exposed to not just banks and the other traditional par- loss of principal in the event of institutional ticipants in the market. New classes of firms failure, with the result that the sensitivity of have already established themselves in the fi- the financial services industry to disturbances nancial service industry, and there is no rea- in the economy could increase significantly. son that the trend should not continue. Thus, policies need to be formulated to account for Antitrust actions in the computer and tele- the influence of the technologies and the op- communication industries have demonstrated portunities they create for the entry of firms that it is not always possible to define clearly that have not previously been providers of fi- the elements of a market in order to analyze nancial services. the competitiveness of the firms participating in it. Given the changes in the financial serv- A key element in the present structure of ice industry, a situation analogous to that the financial service industry is that the cus- found with the computer and telecommunica- tomer has the option of investing funds in an tion industries is developing. As new entrants account insured by the Federal Government. provide financial services, the lines that deter- This type of insurance was one of the elements mine market boundaries become much less in the 1930’s program to restore confidence in clear than they were in the past. the financial service industry. Because of the existence of the insurance, depositors with bal- New entrants often compete only in some ances below the limit of the insurance are fully parts of the financial service market. For ex- protected and have not suffered losses as a re- ample, a supermarket that operates a network sult of any of the failures that have occurred of ATMs is in direct competition with deposi- in recent years. On the other hand, some argue tory institutions that offer comparable serv- that the availability of insurance and the read- ices. On the other hand, the supermarket Ch. 8—Findings ● 219 — would not be a factor in the markets for com- Conversely, one must recognize that the mercial loans or trust services. ability to offer a package of complementary services may place a firm at a significant Even within the community of depository advantage relative to others with product lines institutions, care must be taken in defining that are less broad. Even though the horizon- markets. The small, local bank is not a factor tally integrated firm may not dominate any in the market for cash management services segment of the market in the context of its offered to the largest corporations in the coun- competition for specific products, when con- try. Conversely, a branch operated by a ma- sidered in its totality over time, the integrated jor money center bank may bean insignificant firm could dominate a market, possibly over- factor in a market dominated by a small but powering market competition. very successful bank. Events to date have not endangered the ba- The changing structure of the financial serv- sic soundness and safety of the financial service industry will exacerbate this problem in the ice industry. However, one cannot assume that future. Thus, great care must be taken in sug- this stability will remain, and constant moni- gesting that one institution will be able to toring of the industry would seem in order. On dominate the others in a market. Unless the the other hand, policies developed in anticipa- statement is made in full recognition of the tion of events not having a high probability conditions existing in a specific area for a spe- of occurrence could foreclose benefits or un- cific package of services, such generalizations intentionally trigger undesirable impacts. are likely to have little validity. Chapter 9 Policy Issues Chapter 9 Policy Issues

The financial service industry is enjoying a which financial institutions are now operating period of rapid innovation in supporting tech- could cause excessive risk for these organiza- nologies. The effort to use those innovations tions and their customers. It is also possible to best advantage is contributing to rapid that some of the ends sought in existing laws changes in the structure of the industry and are no longer appropriate or useful. in the services it offers. On the one hand, technology motivates change; on the other, facili- Formulating policy issues and options with tates it. regard to these changes meets with one immediate and serious challenge. Changes are com- Through the applications of technology, the ing about so rapidly and in so many diverse financial service industry provides the public directions that it is difficult for financial in- a choice of modern and efficient services more stitutions themselves or for outside observers diverse than was available in the past. From to anticipate the patterns that will eventually another perspective, the introduction of ex- prevail. plicit pricing for services, the increased complexity of the menus offered and other effects Nevertheless, it is possible to foresee some following from the introduction of technology of the broad patterns likely to emerge and to are not amenable to all users. anticipate in a general way their likely consequences. It is important to do so because pol- Changes in basic social institutions almost icy decisions made or avoided now may have invariably raise questions for public policy. far-reaching consequences. For example, some The basic tenets that comprise the founda- potential benefits of the new technology may tions of existing policy may no longer hold; or, not be realized. Costs and benefits may be in- if they do, the existing means of realizing equitably distributed. Unnecessary burdens established goals and objectives may no longer may be imposed on industry or on consumers. be workable. Relationships between and among Civil rights and liberties may be compromised. individuals and institutions may be altered in ways that make some relatively worse off Policy is promulgated through legislation while others become relatively better off. The and regulation; it can also be imposed through results of such shifts can be political pressures less formal, political activities such as Presi- for new or modified policy goals and mecha- dential “jaw-boning.” Policy alters market nisms for achieving them. forces and the relative power of the factors that determine price and product mix. For ex- Information technology has made it easy to ample, limitations on interest rates led to bypass some legal and regulatory provisions. bundling of financial services which, in turn, Some new services or altered service packages resulted in cross subsidies. Services could then are being delivered through systems that did be provided to some who could not have af- not exist when regulatory provisions were forded them had they been required to pay written, and some services are offered by in- prices based on a true allocation of costs. Now, stitutions not covered by the provisions. technology, combined with other forces, is cre- It is likely, therefore, that some of these pro- ating an industry structure that explicitly visions now only burden the industry unnec- charges for services on the basis of fully essarily, cause unplanned distortions in the allocated costs. Some people may not be able market, or place some financial institutions at to afford them. If this is judged contrary to an unreasonable disadvantage. The very scale the larger public good, it becomes the task of and rapidity of the changes and the fluidity the policymaker to adjust those circumstances and turbulence in the environment within 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 finan- technologies 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 re- services or placing an unfair burden on lated to financial institutions express explic- them in using those services. itly and implicitly national objectives related to financial services. There is a strong public There are also specific Government concerns interest in the maintenance of financial insti- and interests in financial services. Because tutions that will: Federal, State, and local governments are major users of financial services, they have a ● assure and facilitate transactions neces- special interest in efficiency, low cost, and sary for a strong and growing level of eco- security in making and receiving payments. nomic activity in the Nation and in all re- For example, the U.S. Department of the gions and communities; Treasury wants to move toward direct deposit ● encourage savings and capital formation; of all Federal payments to reduce the costs of ● protect the savings and investment of in- this huge volume of transactions. dividuals, families, businesses, and social Finally, the degree to which the introduction institutions; ● of advanced systems for delivering and using avoid excessive concentration of economic financial services may affect the ability of and financial resources; and ● government to use monetary and fiscal policy support and strengthen the competitive as tools for ensuring economic stability and position of the United States in world growth remains unknown. The increase in trade. transactions and income velocity as a result of this technology could make it more difficult implicit in the concept of the public interest to intervene in unsatisfactory general econom- are also the basic national objectives of na- ic conditions through instruments of monetary tional security, equal treatment under law, and policy. Use of information technology, by a host of well-established civil rights and lib- changing the velocity of money, changes the erties. Therefore, financial service systems effective stock of money in the economy at any should: one time. Technologies can facilitate the de- ● not compromise national security, or the livery of services that effectively monetize ability of the Government to implement assets that in the past were considered illiquid foreign policies; (e.g., the ability to draw on home equity as a ● not adversely affect the exercise of civil line of credit). This could complicate attempts rights and liberties; and to use monetary policy to reduce inflationary ● not discriminate against some people by pressures or to stimulate stagnant conditions, depriving them of necessary financial 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 Structure of the Financial Service Industry

Information processing and telecommunica- traditional categories of depository and tion technologies, as applied to financial serv- nondepository institutions are no longer ices, have seven direct and significant effects: sharply delineated and in which the line between financial and nonfinancial insti- 1. They remove geographic and temporal tutions, as defined by products and serv- constraints on the delivery of financial ices, is blurred. services and allow them to be delivered Development of large, diversified finan- from remote locations and to new and cial institutions offering a wide range of widely dispersed locations, such as homes retail services and service locations so and offices. that users may have many financial rela- 2. They allow transactions to be completed tionships with the same institution. almost instantaneously, increasing the Some vertical as well as horizontal inte- velocity of money in the system. gration as diversified firms acquire the in- 3. They facilitate complex networks and internal capabilities to perform functions terrelationships between institutions, for which they previously turned to the markets, and geographical areas. wholesale market. 4. They provide the flexibility for many Development of many small, highly spe- alternative combinations of services and cialized institutions that target narrow service features, allowing both “bundled” markets and specified groups of clients. and narrowly targeted services. 5. They improve productivity and, in general, Continuing mergers and a trend toward lower the costs of providing services. absorption of middle-sized institutions, 6. They increase the capitalization of finan- especially those having a strong local or cial services, providing opportunity for regional orientation. new providers of intermediate and shared Rapid product proliferation-i. e., pro- facility services to financial service insti- liferation of services that are functionally tutions. similar but differ in regulatory restric- 7. They create the possibility of electronic tions and interest rates and in the distri- legal tender and the opportunity to mon- bution of responsibility or risk between etize a wide variety of assets. providers and users. Greatly increased functional integration Current and anticipated changes in the of the national financial service industry structure of the industry and service delivery through technological networks and insti- mechanisms, assuming no interference with tutional relationships. present trends, include: Great reduction in the significance of time • Increased diversity in the nature of insti- of day and location in delivery of finan- tutions within the industry, in which cial services. 226 ● Effects of Information Technology on Financial Services Systems

In developing national policy about fi- and desirable in this sector of the nancial services, policymakers should take economy? into consideration six critically important 4. What institutions or services is it essen- questions: tial to preserve and for what purposes? 5. What is the appropriate level of risk for 1. What national objectives should be sought providers and users of financial services in framing policies related to financial to assume, and how should that risk be services? distributed? 2. Is there a need for a thorough restructur- 6. How can the financial service industry ing of the regulatory system as opposed support a strong U.S. role in the world to marginal corrections? economy? 3. How much competition is appropriate

Generic Considerations in Framing Financial Service Policy

In the sections that follow, salient policy significantly diminished by information tech- questions pertaining to the financial service nology and associated structural changes in industry are presented, and some of the alter- the industry, any regulatory revisions made natives for dealing with them identified. The now will also be subject to rapid obsolescence, first group includes two broad general ques- as new technological capabilities are de- tions, the second deals with issues related to veloped. industry structure, and the third discusses But piecemeal revision is in fact well under- risk allocation issues. way. The question is whether it should continue to be done in bits and pieces, lagging General Policy Issues behind and reacting to changes; or whether a new system of laws and regulations should be Issue 1: What are the alternative approaches designed to guide and control future changes? that could be used if a review and restructuring of laws and regulations related Two of the most recent pieces of legislation to financial services were undertaken? were developed in reaction to changes that had Information processing and communication already occurred in the market. The Deposi- technologies have already had a profound ef- tory Institutions Deregulation and Monetary fect on the handling of financial data. The ca- Control Act of 1980 was partly motivated by a finding of the courts that the deployment of pabilities that these technologies offer—effi- automated teller machines (ATMs) by thrift ciency, speed, integration of activities over a institutions violated existing law. Offerings of wide area, flexibility, and networking-are powerful. Because these technologies change zero-balance checking accounts by commercial both the way data is handled and the way banks and other newly developed services also challenged the existing legal regulatory struc- funds are transferred between competing uses, they affect the allocation of resources in a ture. If Congress had not acted, significant in- dynamic economy. Moreover, the technologies vestment in advanced equipment and services will continue to develop rapidly and probably that had proved attractive to consumers in unforeseen ways. would have had to be abandoned. The Garn- St Germain Act of 1982 was passed in part Some argue that, just as the effectiveness because the rise in short-term interest rates of many laws and regulations has already been had caused funds to shift out of depository in- Ch. 9—Policy Issues ● 227 —-— — stitutions to money market funds and had formulate new policies. Such a policy struc- thrown the cost of liabilities and the earnings ture, because it would be coherent in its treat- of assets held by the thrift industry so far out ment of the elements of the market and the of balance that the viability of these institu- industry and clear in its concepts of national tions was threatened. needs and the public interest, is likely to be more robust in the face of future change than The rate of change in the financial service policies developed incrementally. industry has not abated since the passage of this legislation. There is every expectation A comprehensive review and reformulation that coming years will see changes occurring of the policy structure governing the financial at an equal or faster rate than that of the re- service industry will require time; and the rate cent past. Financial service providers will of change in the industry will not abate while continue to rely heavily on technology to work new policies are being formulated. Ongoing around policies they believe limit their abil- events will require response and divert atten- ity to operate effectively in a changing envi- tion from the long-term perspective. The task ronment. is difficult but, realistically, doable.

Issue 2: What are the mechanisms available to Policy Options for Issue 1 Congress for implementing policy pertaining Congress has two options: to the financial service industry? 1. Continually fine tune the legal/regula- Specifically, how should tradeoffs be made tory structure to account for short-term between the objectives of maximum economic changes and trends in the forces that efficiency, protection of local interests, and shape the financial service industry. other social objectives? 2. Undertake a fundamental redesign of the policy structure governing the financial Policy Options for Issue 2 service industry. Congress has three broad options: Option 1: Continue to modify existing legal/regu- 1. Continue relative deregulation or market- latory structure to reflect short-term changes. determined solutions by continuing to This course reduces the possibility that relax constraints on the industry and by there will be an abrupt change in the opera- taking little action to neutralize events tions of the financial service industry. Con- taking place in the market. gress would continue its ongoing oversight of 2. Deregulate, taking into account the fac- the financial service industry and continually tors that have changed the effects of vari- fine tune policy to meet the needs of evolving ous provisions of the old structure on pro- conditions. However, congress may find itself viders and users of financial services. trying to mitigate the undesirable effects of 3. Instead of comprehensive regulation of change after the time has passed when preven- most services, establish compensatory tive measures might have been taken. Also, programs that work through the market- the structure that may result from this ap- place to bring about conditions deemed proach is likely to become so complex and desirable. (Organizations such as the Fed- cumbersome that it will hamper the efforts of eral Home Loan Mortgage Corporation the financial service industry to serve the and the open market operations of the needs of the Nation. Federal Reserve serve as precedents for this alternative.) Option 2. Undertake a fundamental redesign of the policy structure. Option 1: Continue deregulation. Congress may choose to step back from the Congress may conclude that maximum eco- problem, the changes that have taken place in nomic efficiency, both in delivering services the conditions that shaped existing policy, and 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 ris- from regions or communities in economic dis- ing level of economic activity. If Congress also tress or with a less attractive balance between concludes that the best way to assure this effi- risks and return than other regions. Large na- ciency is to free the financial service industry tional institutions may be less interested in to respond sensitively to market forces, then community needs than small local banks. it may opt for further deregulation. Banks are required, under the Community Re- investment Act, to give high priority to The industry, if allowed to follow the path meeting the needs of their communities, al- it is now on, will effectively become less regu- though there has been little pressure to do so. lated over the next decade. Much of the ma- Other kinds of financial institutions do not jor legislation focusing on depository institu- have this requirement. Unless ease of entry for tions and investment banking has already new competitors continues and the market op- been neutralized by events or has been revised portunities are sufficiently attractive to draw to accommodate past changes. Major new en- them in, local needs may go unmet, and Con- trants in the financial service market operate gress will then be faced with the need of rec- outside the purview of the existing regulatory tifying inequities. structure. Some States have taken actions that further reduce the effectiveness of ex- Alternatively Congress could limit the per- isting Federal legislation. centage of loan capacity that a financial institution makes available for national and inter- It is necessary to remember, however, that national use. The highest economic use for deregulation at the Federal level will in all resources is not always the same as the high- likelihood result in greater diversity in State est social priority. An adequate supply of regulatory strategies. This lack of consistency housing and opportunities for home ownership could itself introduce inefficiencies in the fi- are, for example, generally accepted as nation- nancial service sector. The patchwork of State al policy objectives. So, too, are protection of regulation has already posed difficulties for small farms and small business opportunities. those that want to deploy regional and nationwide ATM networks. Institutions now seek to Under strong competitive pressures, helped establish portable activities such as credit card along by rate fluctuations and a tight money processing in States that permit them the supply, money may tend to move away from greatest freedom. This will affect the market long-term, fixed-interest loans, such as mort- by introducing inefficiencies in allocation of gages. This could have significant detrimen- financial resources and service delivery mech- tal impacts on the supply and cost of housing, anisms and could result in a mix of financial the construction and real estate industries, service products in some States that is quali- their suppliers, and government housing pro- tatively different from that available in other grams unless alternative loan instruments are States. developed. Money may also be funneled away from loans for local entrepreneurs and small The number and diversity of options avail- businesses and from rural banks that supply able to users will increase and will be fully ade- seasonal loans to farmers. quate to sustain and promote a healthy over- On the other hand, as financial resources are all level of economic activity in the Nation. drawn into high-growth areas, they will tend However, the benefits of these services may to moderate interest rates and have a stabiliz- carry some risk of pulling financial resources ing effect. This would continue the function away from some local communities and of of redistributing financial resources that has compromising some socioeconomic objectives. been historically performed by the financial The general effect will be to shift financial service industry. resources toward their highest economic use without regard for social values. There is, for Thus, policies that encourage highly compet- example, some possibility that funds will drain itive national money and capital markets may Ch. 9—Policy Issues ● 229 ———— —— —.——— . ———— — .— produce significant economic benefits, even of capital and on the accessibility of services though there is a potential penalty in terms to the public. Such a policy would be robust. of limiting the funds available for social pro- It could, however, add substantially to budget grams that have been considered to have deficits. high social value but produce little tangible At a minimum, some Federal presence be- product. yond an insurance program to ensure the safe- Option 2: New regulations. ty and soundness of the financial service in- If, on the other hand, Congress chooses to dustry is likely to be required. But a debate develop a new regulatory structure for the fi- such as the one about the Federal Reserve as nancial service industry, it will be faced with a provider of financial services is likely to de- the formidable task of identifying a set of pol- velop and intensify over time whenever Gov- icy variables that will be comparatively insen- ernment actions encroach in areas the private sitive to changes brought about through the sector feels it can serve adequately. Also the operation of market forces coupled with the Government may not be able to adjust rapidly influence of technological change. Some have enough to changes in market conditions to re- suggested, for example, that regulation be by act in a way that does not introduce instabili- function, as is the case with the Fair Credit ties into the marketplace. Reporting Act, which places specific requirements on all who offer credit to the public. Structural Issues Others believe that regulation by specific product would be appropriate. For example, any Issue 3: What levels of concentration in the provider could offer a federally insured ac- financial service industry are consistent with count as long as specific criteria with respect the goal of preserving competition among to reserves and auditability were met. Still providers of financial service? others would continue the regulatory focus on One of the fundamental objectives in finan- institutions, and others would focus on the cial service policy has been to prevent the ex- systems used for delivering services. Some cessive concentration of economic and finan- combination of these approaches could be cial resources in relatively few powerful viable. Each has its strengths and weaknesses. organizations. This has, for example, been the None would be simple to develop, and all motivation for prohibitions on interstate bank- would be difficult to insulate from the kinds ing and intrastate branching, for preserving of changes now taking place and those ex- the unique role of banks by limiting their activ- pected in the future. ities, for insisting on sharp separation between Option 3: No comprehensive regulation; instead, categories of financial institutions, and for active Federal role in marketplace. controlling interest rates according to the type of accounts covered. These provisions were in Finally, Congress could establish a role as part to protect smaller or specialized institu- an active participant in the marketplace for tions, especially local institutions, against un- the Federal Government. It could, for exam- fair competition from very large institutions ple, provide payment services for areas aban- and in part to maintain a diversity of niches doned by firms in the private sector. It could within which competition could flourish. enter the financial markets, as it now does in the case of mortgages and student loans, to These regulatory strategies have been over- assure the availability of funds for socially taken by the use of information technology worthwhile products. As noted, market inter- that destroys the advantage of proximity, vention of this type has a precedent and does allowing institutions to share data banks and not put the Government in the position of hav- delivery mechanisms and by institutional rela- ing to anticipate the specific effects of tech- tionships that ignore both jurisdictional nology and market forces on the availability boundaries and regulatory definitions of in- 230 . Effects of Information Technology on Financial Services Systems stitutional categories. The new technology Congress will want to consider in the con- also has paradoxical effects on economies of text of these changes whether intense and in- scale. To compete in a national money market, creasingly uncontrolled competition will work an institution must offer its services to a wider to the detriment of some important segments market, deliver them without regard to the lo- of the industry, will encourage financial insti- cation of the user, and support these activi- tutions to take excessive risks, or will result ties with a large volume of transactions. On in harmful consolidation of economic and fi- the other hand, through access to shared net- nancial power. works and wholesale support services, even very small institutions can now enter and remain viable in local markets. Policy Options for Issue 3 Regulatory strategies have already been Option 1: Allow market forces to continue as a pri- modified to respond to these economic and mary determiner of the evolutionary path for technological pressures, but on a piecemeal the financial service industry even though they basis. As a result, traditional financial in- may create major consolidated, national serv- stitutions are fiercely competing with one ices organizations. another and with new organizations, including As long as entry barriers remain low, small nonfinancial institutions, that are entering firms are likely to appear on the scene to meet their markets. It is not clear how existing an- local needs. If banks remain subject to special titrust tests apply to this sector in these cir- restrictions, they will be at a competitive dis- cumstances, since it becomes progressively advantage relative to other kinds of financial more difficult to define markets. It is clear, institutions in operating in the national mar- however, that in spite of–or because of–the ket. Continued reliance on existing antitrust fierce competition now underway, the poten- legislation to prevent excessive concentration tial exists for increased concentration of finan- of financial power would face increasing diffi- cial resources and for the development through culty in defining markets and market partici- repeated mergers and acquisitions of large pants for the purpose of antitrust enforcement organizations with excessive size or power in actions. financial markets. Option 2: Define criteria under which mergers It is possible that the kind of competitive- would permitted and firms would be allowed ness that was desirable in the past, as meas- to enter or leave a market. ured by the number and size of institutions Again, with this option, it would be difficult and the scope of their markets, is no longer to define market boundaries for the purpose appropriate in view of several changes: of evaluating adequacy of competition follow- ● the increased size of the population, ing a merger. Problems of defining minimal ● the increased level of U.S. economic ac- services levels and alternatives for meeting tivity, them would have to be resolved before deci- ● the increased size of industrial markets, sions on permitting firms to exit a market ● the increased scale of commercial organi- could be made. Unless the law were structured zations, to prevent it, unregulated services providers ● the increased volume of international would continue to use new technologies to en- trade, ter the market outside of the existing regula- ● the increased diversity of services, tory structures. Such entrants would affect ● the redefinition of the roles of financial in- the competitive balance in a market and would stitutions, and be free to exit even though the result would ● the decreased advantage of proximity for be a level of service that falls below accept- users of financial services. able minimums. Ch. 9—Policy Issues • 231 — ————.—..— —

One or more organizations, public or private, Issue 4: What modifications, if any, could could be assigned the role of provider of last be instituted regarding restrictions on resort to fill voids in the availability of finan- interstate banking? cial services. However, regulators would then Restrictions on interstate banking were in- be faced with the problem of determining when tended to prevent financial resources and con- alternative suppliers have, in fact, abandoned trol over credit from becoming progressively a market, making it necessary to call on such consolidated in a few powerful institutions. providers. They were also meant to maintain a local orien- Option 3: Highly regulate only a specific set of fi- tation and interest and to preserve for con- nancial services. sumers the convenience and access afforded by proximity to financial services. Lately, The model of the telecommunication indus- these restrictions have been in large part try could be followed, in which a specific set rendered ineffective. The sharing of ATM net- of financial services such as deposit-taking works allows some banking functions to be would be highly regulated. Competition in carried out from remote locations. Some these product areas would be tightly con- banks, with regulatory approval, have bought trolled and maintained so that the market banks and savings and loan associations in could not be controlled by just a few firms. All several States. Nondepository institutions of- other financial services could be offered by fer services nationwide that are perceived by almost any type of institution in a virtually users as functionally equivalent to traditional unregulated market. The regulated financial bank accounts. Regional and national net- service institutions could offer unregulated works have made proximity to the service pro- products only through arms-length subsid- vider no longer a necessary measure of con- iaries so that there would be no cross-subsi- venience for the user. However, restrictions on dization between regulated and unregulated interstate banking still place banks at some services. This approach would have the advan- disadvantage vis-`a-vis other financial institu- tage that those financial services where safety tions. For example, facilities to accept demand and soundness is of greatest concern would be deposits generally are not placed across State tightly controlled, and competition would be lines, but corporate clients are provided this preserved. But the fact that technological service indirectly by means of zero-balance ac- means would almost always be found to by- counts linked to consolidation accounts in pass any boundaries that might be drawn be- another State. Interstate banking restrictions tween product areas suggests that this ap- have probably protected some inefficient in- proach will be difficult to implement. stitutions that would otherwise have been The definition of basic financial services— driven out of the market. those to be regulated-and the identification of those offering them would be difficult. Serv- Policy Options for Issue 4 ice providers would, using innovative information technology, tend to design services that Option 1: Remove or modify restrictions on in- closely approximate but are not technically terstate banking. identical to regulated services and to offer Congress could act systematically to remove them in the unregulated market. There would all remaining restrictions on interstate bank- be no guarantee of adequate competition in ing. To do this would require Federal legisla- the unregulated markets, and antitrust laws tion repealing the interstate banking prohi- would provide the only means through which bitions in the McFadden Act and the Bank excessive concentration of financial power Holding Company Act, thus withdrawing Fed- could be prevented. eral consent to State statutes Mocking in-

35-505 0 - 84 - 16 : QL 3 232 Effects of Information Technology on Financial Services Systems

terstate commerce. The overall effect would would have to be defined in terms of market be further dissociation of financial service in- share or in terms of control over deposits or stitutions from orientation toward a particular total assets. Given the heterogeneity and community, market, or region, and further in- fluidity of the industry, this would also be hard tegration of a national financial service mar- to do. ket. Removing restrictions on interstate bank- Other possibilities are to continue to prohib- ing would tend to strengthen a trend toward it holding companies from owning depository consolidation, since some financial institutions institutions in more than one State, as was the would probably not survive competition with case until the 1980’s, or to subject all deposi- large national firms. On the other hand, it is tory institutions to a rigid prohibition on in- possible that financial services might be ex- terstate banking, which would require preemp- tended to some now underserved or isolated tion of State laws and extension of relevant communities from depository institutions in Federal laws to cover savings and loans and neighboring States. credit unions. Congress could, by amendment to the Mc- Some way might be found to strengthen and Fadden and Bank Holding Company Acts, broaden the Community Reinvestment Act, modify restrictions on interstate banking to possibly by requiring local development loans allow and encourage areawide banking in mul- at a level pegged to the level of deposits tistate metropolitan areas, or regional bank- gathered from an area. This would be a factor ing in multistate market areas (as is already limiting the flow of funds out of the areas gen- done in New England under an interstate erating them. compact). Issue 5: How might law and regulation be used to focus the attention of various classes of Option 2: Reinforce limitations on interstate financial service providers on specific banking. market areas? Alternatively, Congress could strengthen Federal policy since the 1930’s has allocated restrictions on interstate banking by remov- specific functions to specific financial institu- ing all loopholes. The Federal Reserve has just tions. But recently, a combination of techno- moved to plug one loophole by redefining com- logical innovations and market forces has sig- mercial deposits to include NOW and Super nificantly weakened the functional distinctions NOW accounts. Following the reasoning that between types of financial institutions. This led Congress to pass legislation legitimatizing condition has developed gradually, with few ATMs deployed by savings and loan associa- of the steps along the path involving positive tions after the courts had declared them il- decisions by policymakers. It may be appro- legal, it does not appear feasible nor desirable priate now for Congress to reexamine the ques- to dismantle interstate ATM networks or to tion of whether public interests still require prohibit the cash management programs of- the limiting of some roles and functions to a fered by brokers. It would be possible to ex- special category of financial institutions. tend reserve requirements to all institutions Banks and thrifts are unique institutions be that operate depositlike accounts, including securities dealers. This might, however, imply cause they alone have access to the payment giving all of these institutions access to the system. Funds are transferred from one ac- payments system or to deposit insurance. count to another only within banks. All transactions not carried out by exchange of cur- One possibility is to establish rigid criteria rency (except for some internal clearing) are for entry to and exit from the market, includ- ultimately culminated within the banking sys- ing criteria for permitting mergers. But, such tem, and all financial institutions must ulti- criteria would be hard to define and enforce mately call on a bank for the final step in de- because institutional boundaries and product livering a service. Banks also allocate credit lines have already become so blurred. Criteria by making and guaranteeing commercial loans. .

Ch. 9—Policy Issues . 233 —

Because of this dependence, the safety and their money to higher interest accounts and soundness of banks-and public confidence in money market funds. This forces banks to try them—are an essential underpinning of the to expand their customer base by offering a economy. National policy therefore has always greater diversity of services and to increase been to treat banks differently from other fees. kinds of financial institutions and to prohibit However, as banks and other depository in- them from engaging in other kinds of commer- stitutions expand their activities into other cial activity. Specifically, the goals of this pol- lines of commerce, the level of risk they are icy have been to: subject to may increase. Any increase in in- ● insure the soundness of banks (originally stitutional risk is accompanied by an increase the purpose of both reserve requirements in the levels of risk for both the stockholders and depository insurance); and clients of the institution to the extent they ● limit the risks that banks could assume; are not covered by deposit insurance. Ulti- ● prevent conflicts of interest, such as mately, the level of risk facing the financial would occur if banks directed investment service industry as a whole would increase. to or allocated credit to commercial activ- The general policy of deregulation suggests ities in which the bank had an equity in- that financial institutions could compete on terest, or if banks required borrowers to an equal basis if barriers between various purchase insurance underwritten by the types were dissolved. For example, thrift in- bank; and stitutions were, for a time, severely threatened ● prevent concentration of financial re- when they were stuck with low-yield port- sources by forbidding banks to partici- folios when interest rates rose; they may be pate in certain kinds of investment activ- so threatened again. Federal policy has been ities, such as underwriting stock issues to try to save troubled thrift institutions by and casualty or life insurance. allowing, encouraging, or arranging mergers. Other financial institutions, and in some This includes mergers across State lines and cases nonfinancial institutions, are now en- mergers of mutual savings banks with com- croaching on activities once limited to banks mercial banks. More recently, Federal savings —i.e., offering accounts that consumers per- and loan associations have been allowed by the ceive as functional equivalents of depository Garn-St Germain Act of 1982 to offer con- accounts but with the advantage of higher in- sumer loans of up to 20 percent of assets and terest rates. Nondepository institutions are to offer other consumer services so that their buying banks, gaining access to the payment portfolios will contain assets and liabilities mechanism through them, and acquiring their with better matched maturities. assets and customers, They are then abrogat- On the other hand, thrift institutions in the ing one or more of the two functions that past received some preferential treatment be- define a bank (i.e., accepting commercial de- cause they are the major source of loans for posits, making commercial loans) in order to housing. An adequate supply of housing and escape Bank Holding Company Act prohibi- a high rate of home ownership are widely actions on nonfinancial activities. cepted as social policy objectives, and a decline Banks and bank holding companies, in re- in the housing market has severe impacts on taliation, are seeking to expand into other other sectors of the economy. services, for example, offering insurance in States where laws permit and increasing their Polic Options for Issue 5 offerings of data processing services. Low-cost y or free deposits, the traditional source of funds Option 1: Modify powers to offer financial services. for banks, are drying up as corporations prac- Congress could repeal Federal laws and reg- tice zero-balance banking and savers transfer ulations limiting the services that banks can 234 ● Effects of Information Technology on Financial Services Systems

offer and the activities in which they can ening costs for municipal and State gov- gage. The U.S. Treasury has proposed that ernments. through holding company subsidiaries banks Option 2: Modify powers to effect mergers. be allowed to engage in virtually all financial services. This is a movement toward deregula- Congress could continue to allow other in- tion, to “put all the players on a level playing stitutions to merge with or buy savings and field. ” It would be likely to increase the pur- loan (S&L) associations. If the acquiring firms chase of banks by other financial and non- use the savings and loan associations as financial institutions and to stimulate the sources of cash, the general effect will be a buying up of small banks by bank holding gradual reduction in money available for mort- companies. It would increase the possibility gages. Any company can now buy an S&L. of banks exerting pressure on customers to Only if the company owns more than one buy nonbank services or products. S&L—and is therefore an S&L holding company-must it restrict its activities to hous- Congress could instead tighten the loopholes ing finance, or even continue to offer housing in laws and reaffirm the special and limited finance. Nonfinancial institutions have already role of banks. Institutions that accept govern- seized on the opportunity to buy S&Ls to gain mentally insured deposits could be permitted access to some of the privileges and preroga- to offer only limited other services. Institu- tives of depository institutions, for example, tions that provide other services (either finan- federally insured accounts. cial or nonfinancial) could be forbidden to own or control institutions that accept insured de- Congress can continue to allow mergers be- posits. tween thrift institutions, as the Federal Home Loan Bank Board is now doing. The likely out- A third possibility is to extend the barriers come will be a smaller number of larger thrift against banks diversifying their services by institutions, but this may not solve the prob- bringing all State banks (including those that lem of attracting an adequate supply of funds. are not Federal Reserve System members) Option 3: Provide incentives to support specific under the Glass/Steagall Act through Federal activities. preemption, so that States cannot use permissive laws to attract banks into relocation. Congress could further provide capital assistance for thrift institutions. A Federal sub- Finally, Congress could make modifications sidy for thrift institutions could be justified in laws and regulations to restrict (or allow) on the grounds of the high social priority of specific activities. It has been proposed for ex- housing, but it would add to Federal expendi- ample that banks or bank holding companies tures, increase the Federal deficit, and set a be permitted to: precedent when other financial institutions run into trouble. Congress could revise tax underwrite mortgage-backed securities laws to encourage S&Ls to diversify their serv- and offer mortgages so as to lower mort- ices further and to broaden their revenue base. gage interest rates through increasing It is not clear whether without this incentive competition (as the Federal National the S&Ls will diversify enough to generate in- Mortgage Association already does); creased earnings. offer mutual funds, in order to bring down management fees and sales commissions; Congress may want to provide incentives to and stimulate other sources of mortgage money underwrite municipal revenue bonds, to rather than attempting to turn back the clock supplement the effects of discount broker- on thrift institutions, which may not be opera- age in increasing the market and lower- tionally possible. Ch. 9—Policy Issues ● 235 — —

Issue 6: How will further deregulation of Issue 7: What steps could be taken to realign telecommunications affect the financial the legal/regulatory structure to make it service industry? conform closely to the changing structure of An important consideration for future finan- the financial service industry? cial service policy will be the cost of telecom- Laws and regulations generally apply to spe- munications. As a result of the breakup of cific categories of service providers. The oper- AT&T, Congress is now coming to grips with ational differences between depository and a broader issue of control of telecommunica- nondepository institutions are progressively tion costs; specifically, with the issues of ac- eroding, but these categories are still subject cess charges. It is expected that following the to different regulatory bodies. They have, in breakup, long-distance telephone rates will de- some cases, different interest rate ceilings, and cline as a result of increased competition be- they are subject to different restrictions on in- tween suppliers, while local communication terstate operations and on intrastate branch- rates will tend to rise to compensate regional ing. A financial institution, in fact, can some- telephone companies for the loss of income times select its regulatory climate by changing from the Bell system. Congress is debating its organizational structure. S&L associations whether to levy a monthly access charge for enjoy special tax incentives if a majority of all telephone use, which would tend to decrease their activities are housing loans. Accounts in the need for high overall local rates. depository institutions are federally insured, while other kinds of accounts are not. The The distribution of function within the de- buyer of services has different benefits, dif- sign of a system to deliver financial services ferent risks, and different safeguards and is directly related to communication costs. In- rights, according to which service provider is creased costs for local communications may selected. The consumer, however, is often discourage the use of third-party data proc- unaware of the subtle and detailed differences. essors, and small financial institutions may find it more difficult to enter the market or survive in the market. Financial institutions Policy Options for Issue 7 will attempt to move data processing toward the end-user in order to minimize the time a The problem of how best to design, or revise, user must remain connected with a service pro- a regulatory structure for the financial serv- vider’s computer, i.e., encourage home bank- ice industry involves many subsidiary issues, ing. But consumers may reject this service en- such as Federal deregulation versus Federal tirely if either entry or maintenance costs are preemption, institutional versus functional too high. regulation, and self-regulation versus government regulation. The options considered below Comment on Issue 6. –The factors and rela- are not necessarily mutually exclusive: tionships that must be considered in developing telecommunication policy are extremely Option 1: Design regulations to apply to func- complex and full consideration of them is tionally defined services and achieve specific beyond the scope of this assessment. How- policy objectives, without regard to the institu- ever, Congress should be aware that telecom- tional provider of the services. munication costs have a strong and direct in- This option would put all financial institu- fluence on the economics of financial service tions competing for a particular market niche delivery systems. Changes in telecommunica- on a more equal footing. It would mean, how- tion policy can result in the need to modify the ever, that each of an institution’s services or structure of financial service delivery systems functional activities would be considered sep- considerably. arately. Yet the total mix of services offered 236 Effects of Information Technology on Financial Services Systems —.—— — — would affect the behavior of the providing increasing homogeneity of the market for finan- stitution, the level of risk that it assumes, and cial services would be recognized in a unified its relative power in the marketplace. If vari- regulatory structure. ous regulations were administered by different Yet, the regulators serve the interests of spe regulatory agencies, each financial institution cific constituencies that consist of both the in- might be subject to multiple regulatory agen- stitutions they oversee and their customers. cies that may at times have overlapping or If this diversity of perspective were elimi- contradictory requirements and restrictions. nated, specific needs could go unmet. Option 2: Federally preempt all State legislation and regulation of financial services.

This option would provide consistency and Issue 8: Concerns of foreign governments reduce uncertainty for the industry with the regarding the protection of individual possible result that financial service providers privacy could lead to the erection of barriers would become more active in developing and for American financial service firms doing deploying services that the public would find business overseas. What steps could the attractive and useful. Yet the existing dual United States take to address these banking system has served well in meeting concerns or circumvent the barriers? varying needs for financial services. Federal Not only is the Nation continually moving preemption would eliminate this duality and toward a more highly integrated national econ- could reduce the degree of responsiveness of omy, but it is increasingly knit into a global financial service providers in meeting local economy in which markets, trade patterns, fis- needs. cal and monetary policies, and currencies are Option 3: Abolish all Federal regulations, allow- linked across national boundaries. ing the States to control financial services fully. Worldwide delivery of financial services has, This alternative would allow each State the for well over a century, depended on telecom- maximum opportunity to achieve local objec- munications and is now more than ever com- tives and to meet local needs for financial serv- pletely dependent on advanced technologies. ices. It would also encourage many practical Rapid and free movement of funds and related experiments and much innovation as States data internationally is essential. Financial in- adopt alternative regulatory strategies. But stitutions and other types of enterprises have States would also be prevented by the Com- branched across national boundaries and de- merce clause of the U.S. Constitution from pend heavily on being able to move data freely, barring entry by out-of-State banks. Nation- and confidentially, between plants and offices wide financial service institutions would, how in several countries. The ability to access ever, suffer from the inconsistencies in restric- resources anywhere in the world from any tions and requirements. other location has become an important factor in the operation of multinational corpora- Option 4: Combine all Federal regulatory functions pertaining to financial services under one Fed- tions and in international trade. eral agency, mandated to develop an internally Financial service organizations operate cen- consistent system of regulations for all finan- tralized systems that concentrate data proc- cial services. essing for worldwide networks at one or a very On the one hand, this alternative would in- few centralized points. Some, such as those troduce a degree of consistency into the regu- that provide credit authorizations at point of latory structure that is now lacking. Institu- sale, must be accessible from thousands of lo- tions would no longer be in a position where cations and must have a high degree of reli- they seek charters from the agency that best ability. They move customer transaction data suits their intended mode of operation. The in- at high speed across all boundaries. Ch. 9—Policy Issues ● 237

The ability to initiate a transaction from a Worldwide information services may tend remote location unfortunately also implies the to increase global debt exposure and under ability to initiate fraudulent transactions; to some conditions could be destabilizing to monitor, interfere with, or extract data from world currency, commodity, and security mar- a system from remote locations. kets. However, they could also be used to monitor and control international debts and In a sudden hostile confrontation with repayments better and to overcome the desta- another country, such as occurred with the bilizing effects of a major debt default. Iranian hostage situation, the option of freez- ing the assets in the United States of the The national interest here is threefold: to foreign power may be lost. Electronic execu- stimulate and support the U.S. position in tion of an order to transfer the assets from world markets, to further U.S. international U.S. jurisdiction could be completed more diplomatic objectives, and to maintain na- quickly than a freeze order could be made ef- tional security. fective. Foreign-owned banks might also, in some situations, provide to their governments or industries privileged information about U.S. industry. Policy Options for Issue 8 Some nations have passed laws limiting the Option 1: Establish no stronger protections for in- collection and dissemination of data associated dividual privacy’ than already’ exist. with individual accounts across their borders, The United States might test the proposi- whether to safeguard the privacy of citizens, tion that the desire to have full financial rela- to protect trade positions, in the interest of tionships with institutions in the United national security, or for other reasons. Some States will be strong enough to overcome all nations are taking the position that they will other considerations. But the possibility ex- not allow some kinds of data to be sent to na- ists that foreign governments with strong tions that do not have restrictions on access privacy protection laws may not be willing to and movement of data that are at least as allow the free flow of financial and payment stringent as their own. data to and from the United States without Such restrictions could cause problems for specific protections instituted at a level com- U.S. firms because this country has not cho- mensurate with those provided their own citi- sen to restrict the collection and dissemination zens within their own borders. Any foreign of data in ways that would be seen to meet bans that are instituted may focus only on such requirements. To do so may place the electronic transmission of personal data to and United States in a position of establishing do- from the United States, in which case the alter- mestic policy in response to requirements aris- native of using nonelectronic media would still ing abroad, a situation that may become more be available but could result in significant de- common as the global economy becomes more lays in the movement of funds and data. highly integrated and interactive. At this point there is no compelling force A related concern is the possibility that in- motivating change. It does not appear to be ternational data-processing centers concen- an imminent probability that one or more na- trated in a few countries are vulnerable to ter- tions will significantly restrict the movement rorist or military attack. As the reliable and of financial data to and from the United orderly flow of international information States. But this situation could change becomes more critical to the U.S. economy, rapidly, and if this option is chosen Congress policy makers and national security planners will want to continue monitoring develop- must be aware of these vulnerabilities. ments in this area. 238 Effects of Information Technology on Financial Services Systems

Option 2: Institute policies defining more precisely have traditionally been the only ones able to the conditions under which financial data can establish settlement accounts and be party to be collected and disseminated across national the network for accomplishing the required in- boundaries. formation transfers. Under this option, U.S. privacy protection In the present environment, nondepository law would be harmonized with foreign laws to financial institutions establish relationships a greater extent, at least in the case of finan- with banks to obtain access to the payment cial services data. Such policy might become mechanism. Drafts on accounts held by the necessary, should foreign privacy laws come nondepository institutions are cleared through to be applied to data transmitted and stored the existing payment system and paid from in computer systems on U.S. territory. Al- a common account, normally maintained at though Federal privacy law has not, in gen- zero balance, at a clearing bank. Only when eral, been applied to privately held data sys- the drafts are presented to the nondepository tems nor is there presently significant overt institution with whom the individual customer domestic pressure to extend it in that direc- deals are the funds debited from the individ- tion, precedent does exist in the particular case ual’s account. of banks for Federal laws concerning the handling of personal information. Banks and other organizations are not restricted in establishing arrangements for processing drafts similar to those in existence be- Issue 9: What organizations could be granted tween operators of money market funds and access to the mechanisms for clearing banks. checks, securities, and other payment instruments such as credit card drafts? For example, if the employees were agree- able, an employer could make an arrangement Only depository institutions now have direct whereby employees are credited daily on the access to the payments mechanism-clearing company’s books with wages earned and are accounts with the Federal Reserve System, permitted to write drafts against those funds. membership in local and regional clearing- The employer would then fund an account houses, and membership in automated clear- with a depository institution to cover drafts ing house associations. Securities broker/deal- as they are presented and debit the accounts ers clear listed stocks and bonds through the of individual employees for appropriate organized exchanges, and market makers clear amounts. Regardless of the balance between issues traded over the counter. Clearing mech- benefits and drawbacks, such an arrangement anisms provide the means by which funds are would be operationally feasible. transferred between and among accounts held by approximately 40,000 institutions in the The arrangements for clearing through a de- United States. Without this means of convey- pository institution with access to the paying payment instructions between institutions ment mechanism can be seen as being some- and settling accounts, there would be no pay- what artificial. Given the technologies now ment medium other than cash. Similar net- available for moving and processing payment works exist between the airlines for clearing information, one could argue that others among carriers that honor one another’s tick- besides banks be given the option of estab- ets and between petroleum companies for set- lishing clearing accounts with institutions that tling crude oil accounts. offer them. A routing-transit number would have to be issued to any organization per- The essential elements of a clearing mecha- mitted such access to the clearing mechanism. nism are the existence of an account through which net settlement can be accomplished and The question remains as to whether it is in a means for transferring instructions that tell the public interest to allow such arrangements. the account holder the amount to be trans- On the one hand, the existing regulatory struc- ferred and the party to be credited. Banks ture provides assurances that parties to the . —

Ch. 9—Policy Issues ● 239 clearing mechanism will be able to settle ac- may be circumvented by applications of avail- counts as required. Opening the mechanism able technologies. to unsupervised nondepository institutions In the extreme, Congress could rule that all not bound to existing requirements to meet payments pass through the established pay- settlement schedules could weaken the system ments mechanism. However, with the exist- and hence decrease the safety and soundness ence of private clearing arrangements between of the financial system as a whole. Under ex- financial institutions and the multiplicity of isting arrangements between banks and fund systems for clearing payments, it would be ex- managers, the bank must settle with the pay- tremely difficult to codify exactly what con- ment system, even if the fund fails to meet its stitutes the established payments mechanism obligations. On the other hand, requirements and the characteristics of clearing arrange- could be established to ensure safety and ments that would not be permitted under such soundness of the system that would have to a policy. be met by nondepository organizations that may be granted direct access to the payment Option 2: Open the payments mechanism to other mechanism. than depository institutions. At the other extreme, Congress could open Policy Options for Issue 9 the payments mechanism to all who would Option 1: Retain restrictions on access to the join. As indicated, blanket access could payments mechanism. weaken the safety and soundness of the finan- Congress could choose to retain the present cial service industry in that occasions where there would be failure to settle would become system whereby membership in clearing sys- more likely. tems is limited to organizations meeting specific criteria. One could argue that the pres- As an interim step, the payments mecha- ent mechanism works well and has been able nism could be opened to nondepository orga- to accommodate the changes that have taken nizations that would be willing to meet criteria place in the financial service industry. The designed to ensure continued integrity of the safety and soundness of the industry have system. Such requirements could include pro- been well protected, and changes that create visions for maintaining reserves and provi- the possibility of weakening either should not sions that members be audited to determine be allowed. if they meet criteria for membership or that On the other hand, there is a real possibil- they obtain performance bonds or insurance that guarantees their ability to settle. ity that innovative people will develop clearing systems that will operate outside of es- Yet, exclusivity of access to the payment tablished channels. Off-market trading is a mechanism by depository institutions bal- reality, and there is nothing to prevent the ances some of the relative disadvantages of emergence of analogous systems for clearing such an arrangement under the present legal/ payments. Nondepositor institutions have regulatory structure that limits the range of already gained access to the payment mecha- activities in which depository institutions can nism by acquiring banks and S&L associa- engage. The major sources of revenue of de- tions. Electronic systems (especially packet pository institutions in the future will be switching) will lead to diverse channels for payments for services provided rather than transmission and perhaps settlement, as will the spread between the rates at which funds the requirement for explicit pricing of Federal are obtained and those at which they are lent. Reserve services. Thus, as in so many other Opening the payment mechanism to others parts of the lega.1.regulatory structure govern- could substantially affect revenues of deposi- ing the financial service industry, the present tory institutions and, ultimately, because rules for access to the payments mechanism alternative sources of revenue are limited, 240 . Effects of /formation Technology on Financial Services Systems

their ability to remain viable competitors in funds to be drained from depository institu- the marketplace. tions. Usury laws restrict the supply of credit when interest rates are rising. Issue 10: What alternatives for regulating interest rates are available to Congress? Policy Options for Issue 10 In recent years, when market rates have ex- Option 1: Federally regulate all interest rates for ceeded Federal and State limits, significant all financial services and all institutions; pre- quantities of funds have moved from banks, empt State usury laws. credit unions, and S&L associations to alter- Assuming the Government would set a na- native investment opportunities created by tional rate, this option would create uniform new entrants to the financial service industry. ity of interest rates across the Nation. Funds These new entrants have relied heavily on ad- would not be moved from area to area in vanced telecommunication and information search of higher returns while they become vir- processing technologies to implement their tually unavailable to those in need of credit offerings. Constrained interest rates effec- in areas where rates have been capped at below tively limited the supply of funds to some in- market levels. Interest rate ceilings might be vestments. lifted to improve customer access to credit and Complete deregulation of interest rates to attract savings and investments; interest would allow service offerings to respond to rates might be capped to reduce inflation or market forces, the price of services to be held economic instability. They might be manipu- down by competitive pressures, and interest lated to preserve, for example, a housing dif- rates to reflect national market conditions. ferential. However, to the extent that firms do not On the other hand, the ability to set rates recognize the costs their actions impose on locally helps ensure their responsiveness of others, market forces may not reflect all social credit markets to local needs. This would be priorities. ’ It may be in the public interest, lost if the Federal Government were to pre- under some circumstances, to modify or con- empt all regulation of interest rates. strain the action of market forces on interest rates in order to preserve certain social ob- There is no reason that a national rate be jectives. set. Rates could be set regionally or set in terms of ranges rather than at specific values. Interest rates, other than for corporate de- Such strategies could mitigate some of the dis- mand deposits, will be essentially decontrolled advantages of this alternative, but the diffi- by 1986 as Regulation Q is phased out. It is culty of implementing them operationally possible that this situation could, under some should not be underestimated. conditions, result in the equivalent of price wars. Financial institutions have been known Option 2: Completely deregulate interest rates. to raise interest rates to unsupportable levels In economic theory, at least, this option in attempts to attract deposits. Widespread would allow funds to flow to highest value uses actions of this type could lead to an excessive in terms of the costs and benefits included in number of financial institution failures, and the calculus. However, if indirect costs and as a result, could seriously destabilize the econ- benefits are not recognized, the resulting omy. Selective control of demand deposits and allocation of resources could be suboptimal. savings account interest rates is likely to cause It would increase the availability of credit, but credit could be priced to levels that would ef- IControls on the rates paid on deposits by depository institutions, controlled under the Regulation Q system of ceilings, fectively deny it to some consumers or cause are being phased out under provisions of the Depository Insti- them to change their way of life as they divert tutions Deregulation and Monetary Control Act of 1980. funds to cover its cost. Ch. 9—Policy Issues ● 241 —

Option 3: Federally cap interest rates only for ac- Deposit insurance covers only traditional de- counts covered by deposit insurance. mand deposits and savings accounts in com- This option would cause money to be with- mercial banks and equivalent consumer ac- drawn from depository institutions when mar- counts with S&L associations, savings banks, ket interest rates rise, leaving more consumers and credit unions. exposed to risk because their assets would be At present, the Federal Deposit Insurance in uninsured accounts. Corporation (FIDC) protects the depositor’s Yet, some may view the reduced return as principal up to $100,000. Securities Investor a cost of security and be willing to incur it. Protection Corp. insurance, on the other hand, Limiting the return paid customers would re- guarantees the investor’s shares, e.g., against duce the pressure on institutions to make the broker’s failure to deliver, but not the value more risky investments that provide higher of those shares. The “discount window” oper- yield, thus limiting the exposure of the insur- ated by the Federal Reserve System provides ance fund. funds to banks that are temporarily unable to meet their reserve requirements and thus also Option d: Allow States to regulate interest rates functions as a kind of insurance for the very on all services delivered within the State, whether or not they are delivered by State-chartered short term. institutions. As a result of intermediation (consumers Under this option, States may try using con- shifting their money to other kinds of accounts trolled interest rates to attract businesses. which give them a higher return), a large pro- Such tactics could significantly disturb the na- portion of liquid assets and savings are not tional money market. On the other hand, mar- now covered by insurance. As banks diversify ket forces complemented by the ease with into other activities, they increase their risk which information can be rapidly distributed of failure. The advantage of being covered by over wide areas would limit the options of the Federal insurance is one incentive for non- States. Individually, they would be able to depositor institutions to buy banks and S&I, selectively cut some rates within a relatively associations (increasing the tendency toward narrow range to support specific policies; but consolidation of financial resources). no one State would have the power to estab- Returns on investment recognize and re- lish rates at levels substantially different from ward acceptance of risk. Although deposit in- the norm. Experience has shown, for example, that States have not been able to artificially surance provides an implied safety net for managers and stockholders of depository in- depress interest rates on loans made within their jurisdiction when significantly higher stitutions, the price of increased efficiency is rates were permitted elsewhere. increased risk, if only because resources are tightly allocated, reserves are reduced, and margins for error are slimmer. The more effi- Risk Allocation Issues cient firms allow less room for error; and, therefore, the expected cost of a mistake in- Issue 11: What are the alternatives for creases. With a higher level of competition be- apportioning risk between financial tween financial institutions, the more efficient institutions and their customers and clients? institutions will survive and some less efficient The purposes of deposit insurance are: 1) to ones will fail. This is a benefit in economic protect the funds of individuals, households, terms, but because financial institutions play and small businesses against loss when finan- a critical role in modern society, their in- cial institutions fail; and 2) to prevent the creased failure rate necessarily touches on the widespread economic instability that would re- public interest in a way that risks assumed by sult from cascading institutional failures as a other kinds of organizations do not. Such result of a sudden loss of public confidence. failures expose individuals, families, small 242 ● Effects of /formation Technology on Financial Services Systems businesses, and major corporations not cov- The result will be to increase the sensitivity ered by deposit insurance to risk of loss of cap- of institutional equilibrium to even minor per- ital or lifetime savings. turbations and to decrease the ability to control the secondary effects of disturbances. Two aspects of risk are involved here: operational risk (failure to settle, an implicit risk Policy Options for Issue 11 that is increased by the speed that new technology contributes to transactions and settle- Option 1: Retain Federal insurance, as it is now, for traditional depository institutions only. ments) and institutional risk (institutional failure because of bad asset management). Op- Continuing the present program is consist- erational failures, if they shake the confidence ent with policy that has provided adequate of customers, can greatly increase the risk of protection for the great majority of account institutional failure. This was the problem that holders and many holders of stock in financial deposit insurance was designed to solve. How- institutions for over half a century. However, ever, deposit insurance itself may encourage some argue that it gives managers of insured firms to take excessive institutional risks by institutions a false sense of security and per- implicitly protecting them from the conse- mits them to take risks they might not take quences of bad judgment. in the absence of the insurance. Thus, insured institutions enjoy some competitive advan- Excessive risk assumed by financial insti- tage over others in all lines of business in tutions could affect the stability of the econ- which they engage. omy, if there is ever a series of cascading institutional failures in which each firm’s col- Option 2: Extend Federal insurance to certain ac- lapse causes the collapse of others. At pres- counts that are not held by institutions now el- ent, a combination of governmental actions to igible for insurance, but only to a specified low protect the deposit insurance fund (generally, level per account or per customer. allowing or arranging a merger between an en- An extension of Federal insurance to all ac- dangered institution and another stronger one) counts that function either as transaction or and ad hoc cooperative actions by large finan- saving accounts would eliminate a difference cial institutions to shore up the market, nearly between suppliers of financial services that is always prevents the spreading of undue detri- important to many. Providers that are now in- mental consequences following any threatened sured would lose a factor that gives them or actual financial institution failure. But the something of a competitive advantage over speed at which funds are transferred and set- those that cannot offer insured accounts. tlements are made today may make these res- Vulnerability of the financial service industry olutions much more difficult. Institutional fi- arising from the exposure of depositors who nancial crises could spread rapidly. have placed funds in uninsured accounts Many transactions will be timesensitive. If would be reduced. A fails to pay B, and B is therefore unable to Limiting the maximum amount of insurance pay C and D, these disruptive events will mul- would continue protection for the small depos- tiply with great speed. The increased number itor that has been provided historically. A of daily or hourly transactions, the rapid turn- larger proportion of the depositors would be over of assets, the smaller reserves held by an exposed to loss. Possibly the propensity of the institution relative to the number and dollar insuring agencies to find merger partners for value of transactions, and the complex inter- distressed institutions would be reduced be- relationships between financial institutions cause the outlay of funds required if an insti- will contribute to the sensitivity of the fi- tution were closed would be limited. Compara- nancial system to short-term perturbations. tively uninsured depositors would tend to Ch. 9—Policy Issues ● 243 exert pressure on financial institutions to ing to accept or to cash checks. Market forces avoid unjustified risks and to use sound judg- will tend to cause financial service institutions ment in making loans and in asset manage- to encourage higher income customers, who ment. Large depositors might also be offered are likely to have discretionary income to save the option of buying insurance for deposits ex- or invest, and to discourage lower income cus- ceeding the limits of Federal insurance. tomers with little discretionary income. Some low-profit services will probably be dropped. Option 3: Vary the insurance coverage and cost with risk. Technology is making it possible for govern- This would permit insured institutions to ment agencies to operate more efficiently with position themselves in the market in a man- regard to making payments. Direct deposit of ner analogous to the way mutual funds char- all government payments is a long-range ob- acterize themselves. Some funds are growth- jective of the U.S. Department of the Treas- oriented while others seek stability and try to ury. This would include payments to State and generate income for their investors. Deposi- local governments and contractors, and also tory institutions willing to take higher risks entitlement payments and Federal employee could purchase insurance at a premium price. paychecks. The move to direct deposit may Alternatively, depositors could elect to receive conflict with the wishes of some recipients. higher interest rates in return for dealing with Realistically, it is likely that some people will an institution that provides only a reduced be pressured by government or other employ- level of insurance coverage. In this environ- ers to accept payment by direct deposit even ment, the depositor would have greater op- when they object to doing so. tions than is now the case. However, the Float is not a right or entitlement; rather, overall exposure of depositors to loss could in- it is an attribute of a system that requires crease if a significant proportion chose insti- some period to process payment orders. It is tutions offering lower levels of deposit in- clear, however, that many corporate cash man- surance. agers, households, and many small businesses have in the past counted on float in manag- Issue 12: What is necessary to assure an ing their incomes. Because of information and adequate level of financial service to all communication technology, debits to accounts segments of the population and to protect are in some situations virtually instantaneous, other basic consumer rights and interests? while crediting of deposits made by check In any case, people require some level of fi- must wait until the check is cleared. The cus- nancial services in order to carry out their day- tomer sees this as an inequity, especially if he to-day activities and participate productively or she is charged for overdraft or automatic in the economy. They must at a minimum have loan privileges during the lengthened gap. In a way of receiving and making payments, and fact, some financial institutions do abuse this generally some access to credit. Moreover, one situation. The technological capability to can argue that they need mechanisms through shorten the gap is available, but financial in- which they can express preferences for specific stitutions need an economic incentive to apply services from among the alternatives that may it. be offered. The right of consumers to full and under- Because of the restructuring of the indus- standable information about their rights, their try and its services, some traditional services risks, and their obligations in using new kinds may disappear, and others will be explicitly of financial services may need explicit protec- priced for the first time, or limited to certain tion. Subtle legal distinctions between func- categories of customers. For example, teller tionally similar services are not necessarily ob- service may be limited to those with substan- vious to users, and information provided by tial balances, and merchants may be unwill- financial institutions is not always clear, com- 244 . Effects of Information Technology on Financial Services Systems — — plete, or in comparable terms. Significant op- Issue 13: Some changes in the delivery of fi- portunity exists for misleading advertising of nancial services increase the possibility that financial services. the privacy of citizens could be eroded or violated. How can Congress reduce the Policy Options for Issue 12 possibility? Option 1: Define minimal services to be provided Citizens necessarily accept some diminution to consumers. of privacy, or potential diminution of privacy, by engaging in any transaction other than ex- Congress could require all financial institu- change of currency. Nevertheless, some as- tions, or those financial institutions choosing pects of information technology greatly in- to offer certain services (e.g., accounts that crease the opportunities for and the likelihood function much like traditional demand depos- of invasion of privacy because data banks are it or savings accounts) to provide certain aggregated, shared, and subject to unauthor- “lifeline” services, such as teller service or han- ized access, including access from remote lo- dling of direct deposit Federal payments, with- cations. out cost to all of those desiring them. Alter- natively, it could allow cost-based pricing. The aggregation of financial data increases Congress could encourage institutions to its commercial value, reduces the costs of ac- establish an account that can only be debited cessing and using it, and thereby increases the electronically as a minimal service for some incentive for misuse. Information technology who misuse checking accounts but would like also allows information to be propagated to benefit from such services as direct deposit. widely and rapidly, so that information harm- This might, for example, be a condition ex- ful to the interests of a citizen (e.g., informa- acted in return for deposit insurance. tion about debt or payment behavior, whether this information is corrector incorrect) can af- At the same time, Congress may wish to fect that citizen’s economic relationships in prohibit mandatory direct deposit of pay- any location. The potential for loss of privacy ments or to define legal rights to choice of pay- is, however, not limited to financial or eco- ment mechanisms, at least in some situations. nomic matters: to the extent that a citizen’s Because financial information technology transactions are effected through information confers on the depository institution, which technology, his/her location and daily activi- alone has access to the payments system, full ties and relationships become potentially sub- control over the timing of debits and credits ject to monitoring and recording. Information to accounts, Congress may wish to regulate systems not related to financial services can the exercise of this power to assure that con- involve similar risks. sumers are treated equitably. It is the potential for this invasion of pri- Option 2: Define the rights of users to information vacy, rather than evidence that it is occurring regarding availability of financial service or has occurred, that concerns some citizens. options. It is likely that there is increased sharing of New or revised legislation maybe necessary financial information and increased use of fi- to define the rights of users to full and com- nancial data for multiple purposes (e.g., mail- parable information about financial service ing lists sorted according to information about options and alternatives, and to establish a the people on the lists). Furthermore, most mechanism for implementing and enforcing citizens are probably unaware of the extent to these rights. An explicit policy of “informed which this occurs, of the extent to which law consent” may be desirable. However, the costs and business practice is able to assume the cit- of such regulations should also be considered. izen’s consent to this sharing of information Ch. 9—Policy Issues ● 245 ———. —— —-— as a condition of accepting a service, or of Option 3: Mandate a program of monitoring and rights and protections associated with various enforcing privacy rights. financial services. This option would require additional authority to inspect and monitor financial service in- Policy Options for Issue 13 stitutions, and the allocation of resources for Option 1: Strengthen, expand, and explicitly define some Federal agency (e.g., the Federal Bureau the citizen rights to privacy in accepting financ- of Investigation or the Department of the ial services (and conversely, rights to access Treasury) to develop enhanced inspection ca- and sharing of information by providers of fi- pabilities as well as to implement the program. nancial and information services). Furthermore, such an inspection program may At present, insofar as a legal base exists for increase anxieties about the possibility that these rights, some of the protective legal pro- the Government itself may violate the privacy visions apply only to electronic media, and of citizens through misuse of financial infor- some apply only to paper-based services. Pro- mation about them. tection from intrusion only by the Federal Government is provided. But some financial Issue 14: Are additional actions needed to services combine these modes, some are in safeguard the integrity of the national transition between them, and some appear to payment and transaction systems against have no explicit safeguards for the citizen. risk of disruptions from systems failure, hostile attack, and natural disasters? While legally defined rights to privacy may Information technology and especially tele- be a desirable step in the direction of assuring privacy in using financial services, it may communication links and networks create new not be a sufficient step. Such legal safeguards vulnerabilities to accidental or deliberate disruptions, and also greatly expand the geo- should probably not depend for enforcement on victims’ complaints. It is in the nature of graphical extent of the impacts. With a highly information and its applications that citizens integrated national economy and financial are unlikely to know when they have been the service industry and increased velocity of victims of invasions of their privacy until the money, a local or regional disruption of finan- damage has been done. Even then, they may cial activities rapidly propagates and can be unable to trace unauthorized information cause turmoil throughout the system, even if or misinformation back to its source, to iden- there is no irretrievable loss of data. tify the offender, or to document that the Natural disasters, civil disorders, military abuse occurred. attack, or any form of emergency may destroy some communication links or require that Option Z: Institute by law a program of inform- ing citizens about risks to privacy that cannot others be taken over by emergency manage- be avoided in accepting financial services ment teams. Thieves, saboteurs, political dis- through information technology (a policy of in- sidents, terrorists, or others could attack informed consent, to use the model of medical formation banks and communication links or services delivery). threaten to do so, in effect holding hostage the assets of the public. This option at least has the advantage of allowing citizens to decide whether they will The direct effects of disruption of financial accept the risk and of challenging the indus- transactions and payments, of data banks, or try to find ways of reducing those risks. How- of communication links are largely independ- ever, it could have the undesired effect of de- ent of whether the disruption is accidental or creasing public acceptance of and confidence deliberate. The long-range effects of creating in some financial services. 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. Issue 15: What alternatives are available for controlling the risk of theft from Little is known, at least publicly, about the or associated with financial service present level of understanding of the magni- institutions? tude of the vulnerabilities of financial service systems to systemic failure, external attack, Facts about theft (of funds or of informa- and natural phenomena. Similarly, knowledge tion) associated with financial service institu- about the extent of preparation to deal with tions’ use of information technology are ob- them, by either the private or public sectors scure. Because public confidence is critical to is limited. Industry representatives have this industry, it is not in the interests of fi- periodically stated that there are enough re- nancial service institutions to call attention to dundant network capabilities and backup data thefts, whether perpetrated within the indus- banks to handle any foreseeable contingencies. try or directed against the industry. Folklore At a minimum, the Bank Protection Act could and anecdotal evidence suggests that com- be broadened to cover all financial institutions. puter-based thefts are often not immediately The act requires Federal regulatory agencies discovered, often not solved, and often not to establish minimum security standards for prosecuted and that criminals are sometimes banks. The expertise of the Federal Emergen- informally granted immunity from prosecu- cy Management Agency (FEMA) could be tion in return for revealing how they carried brought to bear. out the theft and for designing ways of pre- venting it from being done again. Some ex- Whether or not the security measures taken perts say that information technology has by financial institutions at present are ade- probably reduced the incidence of thefts of quate is not clear, but the issue is clearly one funds but greatly increased the average loss that affects the public interest because the po- from a theft. Clearly, it has made the theft of tential impacts of disruption are broad and financial data more attractive, since data are critical to the national welfare. Actions taken now aggregated into large, easily tapped data to reduce these vulnerabilities run the risk of: banks and since the theft of data need not in- ● negating some of the benefits of informa- volve actual removal of documents or other tion technology; for example, requiring physical media from protected premises. In- paper-based records, and creating redun- formation technology has also: dant data bases and communication links, increased Federal responsibility for theft which could reduce the savings in time from financial institutions since it more and/or add to the costs of services; and often involves communication links; ● increasing opportunities for erosion of created the need for more sophisticated privacy. detection and documentation techniques; Policy Options for Issue 14 and Option 1: Hold hearings for further consideration transferred risk from institutions (the of the present and long-term effects of depend- target of armed bank robbery) to individ- ence on information and communication tech- ual customers (whose accounts may be nologies on the vunerability of critical economic fraudulently debited). and social systems and processes in the context of emergency management, civil defense, and Policy Options for Issue 15 national security. Option 1: Rely on the financial service industry Option 2: Create a national commission or an in- and traditional law enforcement agencies to con- teragency task force to gather expert opinions trol crime. from the financial service industry and from the various fields of emergency management, na- Some believe that theft from financial insti- tional security, civil liberties, and the like to tutions perpetrated with at least some involve assess these risks and recommend appropriate ment of computers and telecommunication is means of reducing or managing them. increasing despite ongoing efforts of the indus- Ch. 9—Policy Issues ● 247 try and law enforcement authorities. Further, concealing or failing to report thefts or sus- they do not see this rate of increase abating. pected thefts of funds or data. If this is true, steps to augment present efforts Increased penalties for theft may deter some are required; and even then, this option may potential perpetrators. Increased penalties for not meet the challenge. failing to report theft will tend to bring to light On the other hand, the level of consciousness data that clarify the magnitude of the prob- of the problem among financial service pro- lem and encourage the interchange of data viders is increasing. Greater attention is be- needed to deal with it. On the other hand, if ing given to security of advanced systems for the data that surface cause the public to lose delivering financial services. However, it is confidence in the financial service industry, still too early to know if the efforts will prove the net effect could be negative and the sta- adequate. bility of the industry threatened. Further, if the data show the success rate of thieves to Option 2: Expand the resources and technological be high or provide sufficient detail on the tech- capabilities of Federal enforcement agencies niques that have been used, the end result (FBI, Treasury) to deal with computer-related could be an increase in crimes against finan- theft and to train and assist local law enforcement agencies. cial service institutions. This option could increase the requirements Option 4: Mandate a national commission to study for auditing and inspection of financial insti- computer-related crime and identify necessary actions for its control. tutions’ records. However, this may have the additional side effect of increasing concern Computer-based crime, which is by no means over potential erosion of privacy and may limited to that involving funds or financial also require additional audit trails and paper services, is on the increase. A national com- records, which add to the costs of providing mission to study all aspects of this modern financial services. problem would serve many policy needs. Option 3: Increase the penalties against perpetrators and against financial institutions for

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 and therefore should command the attention will be determined by a multiplicity of factors. of policy makers. Any attempt to enumerate them all would be futile and the number of combinations in The scenarios that follow are written from which they can occur is large. Further, if such the perspective of an observer of the financial enumeration were possible within a reasonable service industry looking back over the 10 time and commitment of resources, the volume years, 1985 to 1995. They are not mutually ex- of data generated would be so great that it is clusive, nor are there sufficient parallels be- doubtful that the results would be useful to tween them for the reader to draw conclusions anyone concerned with either the operation of about the effect of changes on the industry in the industry or the development of public pol- any one variable, such as the rate at which icy relevant to it. automated systems for delivering financial services are accepted in the market. Rather, Scenarios are not predictions of what will each highlights selected areas and suggests happen in the future nor do they necessarily one set of outcomes that could result from the enumerate the most likely of the possible alter- confluence of forces described. natives. Rather, they can be used, as they are in the pages that follow, to illustrate the inter- Yet, by looking at the issues raised in the play of variables under specific sets of assump- several scenarios, the reader should be able to tions. In this application, neither the assump- develop an overall sense of the major con- tions on which the scenarios are based or the siderations that will be faced by the financial conclusions drawn are sacrosanct. In fact, the service industry between now and the middle reader is encouraged to suggest alternatives of the next decade. The goal has been to high- for both and to develop the logic that flows light for the reader the range of variables that from those that are identified. will affect the development of the financial service industry in the future and suggest im- Scenarios also serve to bound a problem in plicitly some of the policy issues that may that they can be used to indicate what may have to be addressed. These, then, provide a realistically happen in an extreme but unlikely background for considering the policy issues case. Because they enumerate the countervail- and alternatives that are addressed elsewhere ing forces that operate in a given situation, in this report. scenarios tend to eliminate from consideration some of the simplistic and extreme arguments The issues of interest from either the oper- both the proponents and opponents of a pol- ational or the policy point of view vary from icy may make in support of their respective scenario to scenario. If, for example, one is con- positions. For example, even a rudimentary cerned with the evolution of the financial serv- analysis of the examples that follow will show ice industry in the international arena, the that the forces shaping the financial system variables that determine the rate of acceptance are such that precipitous changes that could of new, technology-based services by the disadvantage significant groups within society American public are of only secondary in- in the immediate future are extremely unlike- terest. Conversely, the salient factors that af- ly. However, these same models indicate that fect policy decisions dealing with the market some of the changes that may materialize over for consumer financial services have little, if several years could be detrimental to some, 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 as customers move their funds to alternative for financial services. investment vehicles offered by other types of institutions. The contraction of loanable funds The first of the scenarios portrays an exten- has made it difficult for some to meet their sion of the present environment in which there needs for credit. are no major changes in the legal/regulatory structure governing the financial service in- Systems for delivering financial services industry. Included is the implicit assumption ternationally are the focus of the third sce- that the public will generally accept financial nario. Attention is drawn to the problems of services delivered through applications of ad- competition between providers of services in vanced information processing and telecom- international markets, the movement of for- munication technologies. On the one hand, the eign providers into American markets and of technologies have been applied to accommo- U.S. providers overseas. World trade has blos- date differences between groups within the somed and national economies have become population. On the other, some have become highly interdependent. The financial service less well off because of the postulated changes. industry worldwide has been called on to pro- On balance, however, the financial service in- vide the required supporting services. dustry and its relationships with its customers have not changed radically from what they In the fourth scenario, Congress has taken are today. steps to completely overhaul the legal/regula- The second scenario is postulated on the tory framework governing operations of the premise that there are changes in regulation, financial service industry. Most of the regu- but they take place piecemeal. Generally, they latory functions of the States have been pre- are developed in reaction to events in the mar- empted so that both providers and users of fi- ketplace that either have to be ratified or to nancial services operate in an environment effects which have to be mitigated for one rea- that is uniform nationwide. It is a time of gen- son or another. For the most part, consumers eral prosperity and rapid economic growth. have rejected or have shown only very limited The acceptance of technology-based financial receptivity to financial services delivered service delivery systems has been great, but through the application of advanced technol- among the key issues of concern are those re- ogies. However, the contraction in the num- lating to personal privacy and the security of ber of depository institutions has continued financial service systems.

Scenario 1: Extension of Present Trends

The Economy .—Business as usual, continu- The Scenario.-The financial service indus- ity and change. A mature economy with an try has been largely deregulated; consumer improving position in world trade, but some protection laws passed in the 1970’s and continuing problems with balance between in- 1980’s have been retained. flation and stagnation. There is continuing experimentation and in- Policy .-Deregulation: minimum Federal innovation in information technology with em- tervention consistent with maintaining the in- phasis on network management, development tegrity of national payments and transactions; of intelligent media, dispersed delivery of serv- existing consumer protection regulations (1983) ices, and automation of lower value trans- retained; the Zeros Bill of 1985 voided most actions. Driven by the need to control costs, existing Federal provisions regulating serv- financial institutions have reduced the num- ices, pricing, and such. ber 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 to draw out government payments made by shared automated facility through which the direct deposit. These windows are popularly customer can interact with a number of serv- known as “charity lines” and many people– ice providers. Retailers have invested heavily especially senior citizens, who are mostly in point-of-sale (POS) equipment and have ag- women, therefore refuse to use them. gressive programs to encourage customers to Although there are many unemployed and make payment by ordering immediate debit an increasing number of retired people, there of their accounts. This reduces the merchants’ are also many single people and a great many costs and reduces the total amount of con- households with dual incomes. People in these sumer debt, but it also tends to reduce spon- situations are becoming increasingly affluent taneous or impulse buying. and well-educated and like to take an active Given the multilingual population (Hispanic role in asset management. With a mind-bog- Americans alone constitute about 12 percent gling number of options in choosing financial of the population, and another 5 percent are services and investment opportunities that Oriental), automated systems have been de- can be tailored to their needs or to their special signed to provide financial services and infor- interests, asset management has become a mation in any one of several languages. The popular hobby. Financial management soft- newer voice-response terminals just coming ware proliferates with its own best-seller list, into widespread use are also being supported and friends get together with portable ter- with multilingual systems. minals to argue the latest rage in investment strategies. Marital counselors and divorce The United States is a fully “post-indus- lawyers report that people are as likely to fight trial” society, Over 60 percent of all jobs are over money management as over child cus- classifed as information handling. Automated tody, even though most couples have “his,” equipment is used in virtually all aspects of “her,” and “their” accounts. human activity, including nearly all manufacturing, and the great majority of the popula- Financial service providers offer technology- tion under 55 has received at least a high based services tailored to the needs of various school education that includes considerable groups within society. For some, the service coursework to develop computer literacy. De- packages do not differ markedly from those spite the fairly high levels of unemployment available today. For others, providers negoti- that are blamed at least in part on increased ate custom-tailored packages of financial serv- automation, there has never been any strong ices individually with their clients. Among the public resistance to automation, certainly not elements of a package, for example, may be to automated financial services. A public that mortgage loans, investment accounts, trans- enthusiastically embraced Pacman and other action services, and lines of credit. The terms video games was not likely to object to auto- of each of the services in a package reflect the mated teller machines (ATMs) and POS ter- priorities of the clientele. For example, an in- minals. dividual may be willing to accept a 1ower rate on a line of credit in exchange for a lower one However, some elderly people (about 12 per- on a money market fund. cent of the population) and the reading-disad- vantaged are uncomfortable with the new The proliferation of accounts and relation- technology. These are also the people least ships with financial institutions is in fact strik- able to pay for personal service representa- ing. Even though financial supermarkets con- tives (what used to be called tellers, insurance stantly stress the advantages of “one-stop agents, etc.). Some banks, savings and loans shopping, ” customer loyalty to one institution (S&Ls), and others have instituted special tell- is rare, and customers shift funds rapidly from er windows that can be used without charge one location to another as new gimmicks in fi- by these people and by people who only want nancial services are touted. One defensive 254 Effects of Information Technology on Financial Services Systems .——.—— — — strategy is the bundling of services, especially Relatively few large retailers, security bro- if the combination can be made to include an kers and dealers, insurance companies, and oil account that falls under Federal deposit in- distributors have established nationwide dis- surance. tribution systems for financial services heavily based on existing customer relationships, tele About 20 major remote banking systems are communications, and information-processing available nationwide. A number of smaller technology. On the other hand, because some remote financial services exist but are only legislation restricting interstate operations is marginally profitable at best. Most combine still in force, no commercial bank is among the financial services with a variety of information leading financial supermarkets. Some commer- and entertainment services. Among the dom- cial banks use networks to deliver services na- inant institutions in this field are major long- tionwide in competition with the giants, but distance telecommunication carriers, news- laws in some States prevent them from accept- paper and book publishers, and entertainment ing deposits, which puts them at a significant companies. Financial services are delivered disadvantage. Mergers of several of the larger using conventional telephone, direct broadcast regional S&L operations have resulted in two satellite, and two-way television cable. nationwide S&Ls being among the top 20 fi- The newnions (“new unions, ” representing nancial service giants. Although credit unions professional, administrative, and office work- operated by the newnions serve professional ers) have in many companies negotiated pro- and office workers nationwide, charter restric- grams in which employees have the option of tions keep them from becoming financial super- being paid daily with a credit to an account markets. held by the employer. Employees can access Many small financial institutions are still these accounts through debit cards or in some doing well. They depend on shared networks cases paper drafts (checks), which are proc- and access to wholesale services ranging from essed through a cooperating financial institu- data processing to transactions processing to tion where the employer maintains a zero- compensate for their small size. Their whole- balance account to cover debits as they are sale suppliers sometimes compete with them presented. for a retail market, and there are increasing Because financial markets are heavily auto- complaints from the small firms about rising mated and information is rapidly distributed, costs of wholesale services and networks. both the issuers and buyers of debt and equity Problems in gaining access to shared networks securities operate in a national and, in some is probably one major reason that there are cases, an international arena. Funds flow to fewer new entrants into the financial service those areas where they can earn the best re- sector each year. turn at an appropriate level of risk. Regions with sparse or declining populations, regions Insurance companies have nearly all changed with obsolete industry and old infrastructure, their marketing and distribution processes; communities that were left isolated when a generally those functions are handled by other new highway was built, old farm market cen- institutions. ters and rail crossroads that no longer have The U.S. Agency for Family Services has rail service, find it much more difficult to at- asked Congress for authority to monitor finan- tract new capital. Rural banks can no longer cial accounts to identify and track missing or afford to make a loan to carry the struggling delinquent parents owing child support. family farm until the crop comes in. The Fed- eral Government is under increasing pressure One State has passed a law requiring finan- to provide new social programs to help these cial institutions to make automatic payment communities. 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 begin projects that they may not be able to checks. sell immediately if interest rates go up just when the development is completed. The 1994 Los Angeles earthquake disrupted all communication with that region for 3 days Nevertheless, the financial service industry, as surviving communications channels were now a combination of comparatively small spe- preempted by emergency management teams. cialized service providers and giant financial The Financial Services Association estimates supermarkets, is using technology to provide that the total cost to investors, financial in- an efficient national payments and transac- stitutions, and others of that interruption was tions system and to facilitate redistribution approximately $4.8 billion. of financial resources, the primary functions of the financial service industry. In spite of these problems, and the slow but gradual decline in the number of financial serv- Statistics: ice institutions, both large and small financial Banks: 13,800; decline in decade—8 percent. service institutions are generally healthy and Thrifts: 4,400; decline in decade—12 percent. generally responsive to the needs of the com- Automated transactions: 20 percent by munities they serve, as well as to the needs number, 87.5 percent by value. of the Nation. Even though there are clearly ATMs: 48,000. some barriers to entry, a firm usually develops Home banking systems: 20, used primarily to respond to the unmet needs of a local pop- by corporations. ulation. Mortgages are still available from de- POS terminals: proliferating; deployed by 49 pository institutions in most communities, but percent of depository institutions. most are sold in secondary markets to insur- Direct deposits: 64 percent of Federal pay- ance companies and retirement funds that use ments. them to balance their long-term liabilities with Percent of households with no depository long-term assets. However, the dynamic of the account: 12 percent. financial marketplace has caused the long- Technology: growing use of debit cards, term, fixed-rate mortgage to all but disappear. voice-activated ATMs. Young people and people on fixed incomes are Outstanding issues: privacy, systems often reluctant to undertake an obligation that security. has changeable dimensions. Home ownership is tending to decline. Developers hesitate to

Scenario 2: Piecemeal Regulation

The Economy .—Gradual recovery from The Scenario.–The events of the past dec- recession; continuing large Federal deficits ade have resulted in a hodgepodge of laws, dampen economic activity, keep interest rates amendments, and regulations, as Federal pol- high, and cause a continuing high rate of icymakers and regulators tried to keep up with unemployment. rapid changes in the financial service industry that constantly made old laws and regu- Policy. -No thorough revision of regulation. lations ineffective. Only a few legal specialists Piecemeal changes occur, generally to recog- can now sort out what rules apply to which nize structural changes that have already services. A great many provisions today are occurred in the industry. Many legal/regula- cumbersome without being effective. tory provisions have merely lapsed because technology has provided a way around the While Federal laws tend to recognize changes restrictions. 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 farm-oriented banks, but they now find that dominant role in regulation of financial serv- the banks have little money to lend. S&L asso- ices, and their regulatory strategies vary wide ciations in the same States are generally reg- ly. Some States, for example, still forbid ulated with a view to preserving their commit- branch banking; others require that any net- ment to housing finance, but they are also work must be open to any financial institution having trouble attracting money. Federal de- that wants to participate. Financial service pository institutions have widely diversified, institutions have tended to migrate toward and some of the largest have almost become States with permissive laws. A great many financial supermarkets. local depository institutions have been bought There is, overall, less competition within the up by larger organizations. Loopholes in Fed- industry, as the number of viable institutions eral laws allowed banks to be converted into slowly shrinks. Competition is declining in ‘‘nonbanks. other ways, as well. After the period of bold In some States, both banks and S&L asso- experimentation, when there was rapid prolif- ciations have become virtually financial serv- eration of new kinds of accounts and all kinds ice supermarkets; in other States, depository of financial services were constantly elab- institutions are limited to a few traditional orated and modified, things began to settle services and may neither own, nor be owned down in the mid-1980’s. It became apparent by, any other kind of institution. Neither ex- that most customers were satisfied with a few treme seems to be ideal for banks. There have more-or-less-traditional services and had nei- been a number of messy bank failures, where ther the time nor the desire to try to sort out banks have participated in a broad range of the scores of services with fancy names, exag- new ventures and taken some questionable gerated claims, and marginal differences that risks. The Federal Deposit Insurance Corpora- almost no one could understand. Most people tion (FDIC), which is now burdened with in- have all they can do to stretch their paychecks suring quasi-deposits held by a variety of in- from one payday to the next and realistically stitutions that include insurance companies, have little hope of using their limited cash to investment brokers, and retailers, is stretched make more money. to the utmost in trying to salvage as many of As a result, the growth in financial services these institutions as possible in order to pre- has been much slower than some experts prevent further drain on the insurance funds. dicted a decade ago. The information technol- Usually that salvage is done through mergers, ogy used for financial services was very quick- and the number of depository institutions is ly standardized after the big institutions had slowly but steadily shrinking. made their basic hardware decisions, and there Many thrift institutions have been bought has been relatively little innovation in the last up by, or been allowed to merge with, other few years. institutions. Some of these have essentially Large-value transactions were easy to auto- abrogated any real commitment to housing fi- mate, but lower value transactions-the 82 nance and have become much like other gen- percent of transactions that together account eral-purpose, widely diversified, financial infor only about 12 percent of all the dollars stitutions. changing hands-have proven to be much In States where banks are strictly limited more difficult. Consumers have not accepted and protected as having a unique role, they direct debit from the point of sale and home have seen their resources dwindle as custom- banking and information services as expected. ers remove funds to invest them through in- As a result, the paper burden has not been stitutions that can operate across State lines. lightened as much as the financial service in- States that adopted this strategy generally did dustry hoped it would be. Another factor slow- so in order to protect local banks, especially ing the rate of innovation in financial services Ch. 10—Future Scenarios for the Financial Service Industry, 1990-95 ● 257 has been the great differences between State One mark of growing disaffection with fi- laws and regulations that keep large institu- nancial institutions is an increasing number tions from developing markets of the breadth of consumer lawsuits, something almost unnecessary for supporting new service offer- heard of a few years ago. ings. A sluggish economy has reduced the Local banks play on these sentiments by em- amount of money people are able to save phasizing their hometown image, stressing the or invest and, hence, their demand for new comfort of friendly personal service, and be- services. ing community boosters by sponsoring local Part of the problem was unanticipated cus- sports teams and advertising their sympathy tomer resistance to a perceived increase in for local small businessmen and farmers. They risk. As banks and thrift institutions broadened rely more and more on small savers and old their activities and began to expose them- customers. Large corporations find financial selves to more risky ventures and fiercer com- service institutions that can help them man- petition, there were many near-failures. Most age their funds more profitably, and young af- of these were prevented, although at the cost fluent customers put their funds in money of a heavy drain on FDIC, but a very few market accounts with checking privileges. highly visible institutional collapses, coupled Home banking and home information serv- with several highly publicized electronic thefts, ices are limited to the largest metropolitan were enough to shake public confidence. Some areas; despite their name, they are almost ex- banks and S&Ls had to close their doors clusively used by large companies. Timemeas- abruptly because they had used poor judg- ured local communication costs, which have ment, overextending themselves when a rapid risen steadily, make them unattractive for turnover of assets, twice-daily settlements, most households. These services might have very thin reserves, and dwindling corporate caught on if women had continued to enter the deposits made them very vulnerable. work force at the rapid rate of the 1970’s and early 1980’s, but continuing high unemploy- Many people were disgruntled because they ment has defeated such hopes, and many saw—usually in advertisements—people with homemakers have plenty of time to pay their a little more discretionary income collecting bills the old-fashioned way. high interest rates and multiplying their assets by using glamorous new services, while POS terminals are another technology that they themselves seemed to be losing out on failed to spread rapidly despite a very prom- the opportunities and paying for services they ising start. One problem was the failure to re- once thought of as free. solve the technical problem of dealing with three different technologies-magnetic stripe, Many people are in fact put off by the kinds uniform product codes, and optical scanners. of records they get from computer-based With plenty of fairly well-educated people transactions of any kind. They are afraid that looking for work, there was less incentive to they will not recognize errors, or know how to automate the retail sales sector, and all but get them corrected. The whole process seems the very large retail corporations hung back cold and faceless, and they are afraid of being waiting to see how the technology would shake victimized. Most people over 50 have never down. Besides, customers seem to prefer the felt comfortable with electronic information more familiar, slower payment process of technologies. They are afraid of looking silly charge accounts, credit cards, or checks. Psy- if they make mistakes or if they challenge the chologically, they probably feel that it lets computer’s mistakes. All in all, it is more com- them hold onto their money a little longer and fortable to deal with a friendly face at the gives them a little bit of protection against teller’s window or the familiar insurance man merchants who sell inferior goods or make mis- with his thick black book. takes in their charge accounts. 258 ● Effects of Information Technology on Financia/ Services Systems

There is also continual disquiet about pres- and large institutional investors—big corpora- sure—whether real or perceived—from em- tions, pension funds, insurance companies— ployers and from governments to agree to di- enjoy options that cannot be profitably ex- rect deposit of paychecks, Social Security tended to the average-income person. Large checks, assistance checks, and the like. Many firms offer a variety of services to institutional people see it as a great convenience, and safer users nationwide and smaller institutions are than having checks left in mailboxes or carry- strongly oriented toward local and regional ing them home from the office. But many peo- markets and individual or small business cus- ple don’t want their boss–or “Big Brother”- tomers. With the continuing dispersion and knowing where they bank, or don’t want to reconcentration of people and business over bank at all, because they distrust large insti- the last 20 years, there is plenty of room for tutions. Employers who want to save money small, community-oriented institutions, but on their paperwork are inclined to suspect that the large institutions dominate the economy such employees are trying to evade taxes or and the general long-range trend seems to be child support payments or are in the country toward greater consolidation of financial re- illegally. Nevertheless, direct deposit is not sources. growing as much as expected, and many large Statistics: organizations have stopped trying to push it. Banks: 13,000; decline in decade–13 percent. The securities market has not grown signif- Thrifts: 4,050; decline in decade—19 percent. icantly in the last 6 years. This is generally Broker/dealers: 4,000; decline in decade– attributed to the maturing of the economy, the 20 percent. generally declining size of business enter- Transactions automated: 18 percent by prises, and the aging of the society. There has number, 88 percent by value (1983 = 15 been very low growth in the gross national percent, 85 percent). product (GNP) for most of this period, and ATMs: 37,000. America’s position in world trade has gener- Home banking systems: 6, in very large ally declined. Securities increasingly tend to metropolitan areas. be held by pension funds, insurance com- POS terminals: deployed by 9 percent of de- panies, and other large institutional investors, pository institutions. and there is much less marketing to individ- Direct deposit: 46 percent of Federal pay- uals than there was a decade ago. ments. The outstanding characteristic of the finan- Percent of households with no depository ac- cial service industry today is, in short, that counts: 16 percent. its growth is slow and that it is troubled with Technology: innovation slowed or stopped, more turbulence and uncertainty. The out- service options declining. standing characteristic of the financial serv- Outstanding problems: depository institu- ice mark-et today is that it is bifurcated. Large- tion failures; consumer litigation. value transactions are automated completely,

Scenario 3: The Global Financial Services Industry

The Economy.– Accelerated growth in world specialty chemicals-and in services and agri- trade, 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 Since most countries have a state-owned cen- and encourage an orderly world market. tral bank, their governments would have to bear the costs of building or modernizing their The Scenario.— The volume of world trade financial service infrastructure, and this has continues to increase. Both industrialized and tended to add to the burden of debt of Third industrializing nations compete for raw ma- World countries. terials, energy, and markets. Many Third World countries, especially around the Pacific U.S. corporations are heavily committed to rim, have become increasingly industrialized, international operations and have become and other small countries in South America heavy users of automated cash management and the Middle East are also making progress. services that show treasurers the status of fi- Trade among Third World countries continues nancial resources worldwide and facilitate the to increase. Heavy industry has tended to movement of funds across national boundaries move from the older advanced nations to take to match requirements for funds with avail- advantage of lower costs for land, labor, raw ability of funds. materials, and regulatory compliance in devel- In most countries, trading and financial ac- oping countries. Bulk chemical production for tivities now operate on a 24-hour basis. Many international markets, for example, has largely international information services use satel- been taken over by Third World countries. A lite communications. Traditional communica- global division of labor is evolving, and it may tions links, such as telephone and telegraph eventually narrow the gap between rich and cables, are highly vulnerable to the political poor countries by providing a viable niche instability, terrorism, and local wars that have for everyone, as Herman Kahn predicted 20 been the curse of the last two decades, as well years ago. as to governmental restrictions on the trans- The United States has increased its share border flow of data. As it is, there are continu- in world trade, with nearly all of the growth ing international disputes over freedom of fi- in export of services; high-technology (biotech- nancial data. With international trade and nology, intelligent systems, specialty chemi- transactions critical to the economic welfare cals, photovoltaics); and agricultural and for- of all nations and an increasingly dominant est products. Services now account for the factor in every national economy, financial largest share of U.S. exports. data is a valuable commodity. That fact continually tempts national governments and in- Multinational corporations (of which only ternational thieves to try to control, capture, about one-third of the 500 largest are now pre- or manipulate it to their own advantage. dominantly American-owned) play a major role in all countries. Meeting their needs for The reluctance of the United States, in the financial services has significantly contributed 1980’s, to cooperate with other countries in to a standardization of financial services and setting up mutually acceptable safeguards for associated technology in the industrialized na- the transborder flow of data resulted in some tions. The advanced countries all have a well- diplomatic problems and a regrettable loss of developed, highly integrated, financial service national prestige as well as some damage to industry, with heavy dependence on informa- U.S. trade positions. The major holdout among tion technologies. The newly industrialized Western nations against international agree- nations are following the same path. Poor ments guaranteeing transborder data flow countries that lack the capital and the commu- has, however, been Switzerland. As an ironic nications infrastructure to automate their result of clinging to its sacrosanct privacy transactions systems find that this is a sig- laws, Switzerland has lost much of its preem- nificant disadvantage in building indigenous inence in international banking, although it re- industry and in trying to enter world trade. mains a haven for secret bank accounts. 260 . Effects of /ntormation Technology on Financia/ Services Systems

All of this means that national economies, translational investments and mergers, most national markets, national currencies, and na- of the world’s large financial institutions have tional transactions systems are closely tied to become multinational corporations. Many of one another. In most situations, the continual them have far more financial resources than adjustment and settlement between currencies most national governments, and inevitably and within world markets seems to provide ad- this gives them great political power. If they ditional stability. But any perturbation affect- ever acted together, they would very nearly ing one national currency or commodities mar- constitute a world government. ket immediately affects others, and the failure of a major bank anywhere in the world has The realization of the close relationship be- repercussions in nearly every country. Occa- tween multinational corporations, especially sional excursions in markets reveal this vul- financial institutions, and national govern- nerability to instability under sudden shocks. ments has made these institutions a prime This occurred several times during the late target for political dissidents, guerrilla move- 1980’s when Third World countries defaulted ments, displaced populations, and terrorists on large debts. of all kinds. The British-owned Barclay Bank in New York was bombed by the Irish Repub- In these instances, governments and finan- lican Army in 1986, with 34 fatalities and 109 cial institutions were able to act quickly and serious injuries. Overseas protection for facil- cooperatively to dampen the reactions, in large ities, information banks, communications part through using the highly developed in- links, satellite ground stations, and especially formation systems and financial networks be- for personnel is costly. Hostile actions against tween countries. Since then, these networks Americans and American-owned facilities have been used more systematically to moni- have several times involved the United States tor and control international debt exposures, in dangerous political situations in other coun- debt management, and repayment schedules. tries. In 1992, 10 Americans were held hostage But setting up mechanisms to allow this to by rebel forces in the Union of South Africa happen has entailed complex diplomatic nego- for 12 days. A year later a Mexican mob pro- tiations and an elaborate structure of interna- testing the treatment of illegal immigrants tional agreements that was hard for some crossing the U.S. border attacked a U.S. bank countries, such as the United States, to accept. in Mexico City. The administration, which had Because of the large volume of international been elected with the strong support of the transactions and the velocity with which funds Black and Hispanic Political Coalition, was move between countries, national monetary nearly torn apart in its efforts to deal with policies are much less effective, and most coun- these situations. tries, certainly those that are not centrally Despite these severe problems, there can be planned economies, have much less control little doubt that the United States’ full par- over the stock of money in the country. In the ticipation in world trade demands U.S. coop- United States, there are now many foreign- eration with and leadership in the continuing owned financial institutions; in fact, most of development of a worldwide financial service the largest financial institutions, including ma- industry. Further, in the development and jor banks, have some foreign ownership. Many sales of advanced financial information sys- U.S. banks also have branches or affiliates in tems, the United States is rivaled only by other countries. France, the originator of the smart card, which Many experts, both within and outside of is now revolutionizing consumer services, and the government, worry about the effect of can potentially revolutionize all forms of rec- these developments and see them as an ero- ordkeeping throughout the economy and soci- sion of national control over U.S. domestic ety. The American financial service industry economy and external relationships. Through 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. Percent of U.S. financial institutions with international trade for over a decade, and sup- some foreign ownership: 13 percent. plies most of the financial services needs of Percent of U.S. financial institutions with many small countries. international branches or affiliates: 17 percent. The growth and integration of the world Automated transactions: 35 percent by economy in the long run may well be the most number, 91 percent by value. significant force for world peace. It could be Direct deposit (international payments): 97 the source and wellspring of the gradual de- percent of Federal payments. velopment of a world political order based not Outstanding issues: control of terrorism, on unenforced charters or on military power, monitoring and control of Third World but on the economic self-interests of the na- debts. tions of the world. 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 decisive steps in 1985 to revamp laws and reg- United States has a commanding lead in sev- ulations pertaining to financial services. Most eral high-technology industries and a strong aspects of financial service delivery were de- role in international trade. An era of innova- cisively preempted to prevent State laws from tion and economic growth is well under way. distorting the legal and institutional infrastructure necessary for an efficient national Policy .–Regulation by objective, aimed at payments system. Prohibitions on interstate preserving competitiveness in the financial serv- banking were removed, but banks were allowed ices sector while reducing risks to provider institutions and to consumers. to engage in diversified financial services only by carefully segregating them from traditional The Scenario.– Rapid advancements in the depository-lending activities. biological sciences are spawning new indus- Only certain kinds of demand accounts qual- tries, just as advancements in chemistry did ify for Federal depository insurance, and they following World War 11, Computer-assisted are subject to special regulatory supervision design and manufacturing (CAD/CAM) and in- regardless of the institution offering the serv- dustrial robotics have significantly lowered ice. Other kinds of accounts are carefully dis- manufacturing costs and have automated tinguished from insured accounts by time- batch or custom manufacturing. Continued related and other requirements and must strong growth in the services sector, especially clearly inform users of the differences. All fi- in export markets, has kept unemployment at nancial service regulation is focused on the reasonably low levels in spite of the new wave nature of the service and its risks and returns of automation. rather than on the nature of the institution Recognizing that a strong national economy providing the service or the mechanisms demands efficiency and reliability in nation- through which it is delivered. The exception wide transactions, and also demands that all to this rule is that institutions providing cer- regions and communities participate produc- tain basic “lifeline” services or committing tively in that national economy, Congress took specified proportions of their resources to a 262 ● Effects of Information Technology on Financial Services Systems few specified social priorities (e.g., education shoddy operators in both groups in spite of the loans, housing development, ecological protec- watchdogging of both the consumer interest tion, small entrepreneurship) are granted in- groups and FIST. Some institutions and some centives sufficient for encouraging those ac- brokers offer special-interest asset manage- tivities. ment programs that cater to the customer’s special interests or pet causes—investment in Administration and enforcement of Federal such things as the arts, community self-suffi- financial service laws and regulations has been ciency projects, alternative energy develop- largely centralized and rationalized under a ment, or opportunities for new markets. These special agency, the Federal Investment and programs also provide opportunities for con- Savings Trustee–popularly known, inevita- flicts of interests, if not downright scams, al- bly, as “Tight FIST.” though most of them are probably useful and Information technologies have allowed all effective. economic sectors to improve their productivity, to operate more efficiently, and to be Businesses have established powerful tele- decentralized, yet well-coordinated. The pro- communication networks that are used for a liferation of information technologies and sys- variety of purposes. Some groups of firms tems has been comparable to the spread of where the members both buy from and sell to electrification in the 1930’s and 1940’s. The the others have established procedures for thrust in financial information technology has electronically settling accounts between and been toward automation of lower value trans- among themselves with little if any involve- actions and the development of intelligent ment of the financial service industry. Interest media—the smart card and its descendants. is paid on credit balances in accounts receivable. Members of the clearing community have ATMs are now being replaced by automated generally agreed to settle a credit balance in resource control centers (ARCCS) that not only an account receivable in good funds on de- dispense currency but automatically transfer mand. Only when there is a cash settlement funds between accounts. Most stores, gas sta- of either a receivable or payable is the conventions, and the like, have POS terminals, al- tional payment mechanism operated by the fi- though people do a great deal of their shop- nancial service industry used. ping through their home computers. Merchants disagree about whether video shop- Similarly, some have found off-market trad- pers or onsite shoppers are more likely to make ing of securities to be in their interest. Elec- impulse purchases; some have concluded that tronic bulletin boards are used by both busi- it is the less affluent shoppers that come to nesses and individuals to post bid or ask prices the store (the poor, the elderly, and those just for securities, and the transaction is executed browsing for entertainent), and they no long- by the principals without the involvement of er make much of a special effort to attract a broker. Electronic messages bearing the them. This hurts the very small shops that computer signatures of both buyer and seller cannot afford to be on television and that de- are sent to the transfer agent and securities pend on passers-by drawn to the malls by depository instructing them to make the ap- larger stores. propriate entries in their records. With computers almost as common as the Protection of customer privacy and security telephone and with communication costs low, of all elements of the financial service deliv- home banking is common. There are many ery system have been major thrusts of con- licensed brokers and general-purpose financial gressional action in recent years, but these two advisors fiercely competing for customers. The problems are not completely solved. Federal brokers work on coremission; the financial ad- law prohibits the use of any financial data for visors charge by the hour and are supposed any purpose not specifically approved of by to be more disinterested. But there are some 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 prac- are excessively burdensome, many technical tice these laws are difficult to enforce because experts question the adequacy of the stand- it is hard for victims to detect and prove sec- ards, and civil libertarians fear that redundant ondary use of data from a given source. Fed- records provide another opportunity for viola- eral laws also specifically forbid government tions of privacy. agencies to have access to such data for other Most financial services are marketed nation- than narrowly defined purposes (i.e., tax levy), wide. A large volume of transactions appears but civil libertarians point out that this is no necessary for assuring an institution’s viabil- protection at all-he who makes a law can vio- ity in this fiercely competitive market. The late it–and indeed there are frequently pro- Federal laws requiring financial institutions posals in Congress to allow access to financial to direct a percentage of resource investment data for socially useful purposes such as crime to certain high-priority social programs are a detection and military intelligence. continuing political issue. There is constant Security is another important problem for dispute between those who want to add new several reasons. Because the financial service social priorities to the list of preferred in- system is so highly networked nationwide, the vestments (which carry definite tax advan- potential gain from a successful theft is almost tages) and those who see each new addition unlimited. Also, because of the national net- as a further step toward a centrally planned working, any disruption or violation of the in- economy. tegrity of the payments system, whether it Despite these problems, there is general stems from natural, technological, or human agreement that the national payments and causes and whether it is deliberate or acciden- transaction system is healthy and efficient and tal, can have major effects on the whole econ- plays a major role in the general prosperity omy. And because financial transactions are and in America’s strong position in world so central to the economy, and economic sta- trade. bility is central to national security, financial information systems become a target for all Statistics: of those, inside or outside the country, who Banks: 16,500; increase in decade–10 percent. have reason to attack the U.S. Government. Thrifts: 5,200; increase in decade-4 percent. The Federal Bureau of Investigation has Automated transactions: 35 percent by greatly expanded its capability to control number, 91 percent by value. computer-based crime and has elaborate re- ATMs and ARCCS: 77,000. lated training programs for State and local Home banking systems: 70, broadly dis- officials. However, with computers and tele- persed, wide coverage. communications so firmly linked, almost all POS terminals: deployed by 63 percent of computer-based crime, especially directed at depository institutions. financial services, is now considered a Federal Direct deposit: 91 percent of Federal pay- responsibility (for both legal and technologi- ments. cal reasons). Percent of households without depository accounts: 7 percent. Protection of financial information and Technology: development of intelligent me- transaction mechanisms in the event of natu- dia, ATMs that automatically transfer ral disasters or military attack is also a Fed- funds between accounts. eral responsibility. The Federal Government Issues: requirements for preferred social has developed standards and requirements for investments, growing computer-based both backup systems and redundant data theft. banks, but the industry protests that the costs 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 Transaction Products (Paper-Based) Asset and Liability Products 24. Cash Processing 25. Payroll 1. Syndicated Loans 26. Money Orders/Traveler’s Checks 2. Project Finance 27. Mortgage Servicing 3. Lease Receivable Finance 28. Back-End Processing 4. Indirect Loan Funding Installment Loan Servicing 5. Revolving Line of Credit a. Mortgage Loan Servicing 6. Offshore-Based Lending c. Commercial Loan Servicing 7. Banker’s Acceptances d. Demand Deposit Accounting 8. Trust Receipt Financing e. Savings Deposit Accounting 9. Depository Financial Institution Products f. Term Deposit Accounting a. Direct Deposit g. General Ledger Control b. Check Access Certificate of Deposit Collateral Control c. IRA, Keogh i. Cash Control d. Eurodollars j. Trust Accounting e. Imprest or Sweep Account k. Item Processing f. Single Premium Deferred Annuities 29. WholesalelRetail Lockbox (SPDA) 30. Check Guarantee/Authorization 10. Margin Accounts 31. Securities Safekeeping 11. Market Making 32. Personal Trust 12. Leveraged Leases 33. Escrow Accounting 13. Retail Banking 34. Note Collection 14. Middle and Institutional Market Lending 35. Mortgage Banking 15. Repurchase Agreements 36. Collection Service (Brokerage) 16. Money Market Securities 37. Private Placement 17. Other Investment Funds 38, Equity Brokerage a. Money’ Market Fund 39. Public Offering b. Real Estate 40. Relocation Management c. Liquidity 41. Real Estate Brokerage d. Growth 42. Securities Settlement e. Municipal 43. Annuities 18. Mortgage Lending 19. CSVIJI Loans Transaction Products (Electronic-Based) 20, Real Property Equities 21. Insurance Premium Financing 44. Data Base Access 22. Actuarial Accruals 45. Branch Automation 23. Annuities a. Platform Automation

267

35 - 505 0 - 84 - 19 , QL 3 268 ● Effects of Information Technology on Financial Services Systems —— ————.-———- ——— -—

b. ATMs 74. Consumer Financial Analysis c. Teller Terminals 75. Business Financial Analysis 46. Settlement and Clearing 76. Debt Issue Rating and Quotation Services a. Settlement 77. Credit Reporting Agencies b. Clearing 47. Automated Clearing House/Electronic Glossary of Terms: Financial Clearing House 48. Wire Transfer (Domestic and International) Products and Services 49. Cash Management a. Depository Transfer Check Asset and Liability Products b. Concentration Accounting c. Automated Investment Accounts Asset and liability products are those generic d. Cash Forecasting products that impact the balance sheets of finan- 50. Business Banking Products cial institutions. Asset products are generally a. Account Reconciliation loans, while liability products are depository in b. Account Consolidation nature. c. Balance Availability Reporting 1. Syndicated Loans– Loans inv’olving multiple d. Balance Concentration/Sweep banks and nondepository financial institutions e. Automatic Customer Billing in cases where the overall credit involved is in f. Deposit Reconciliation excess of each bank’s comfort or legal lending g. Account Payable Check Writing limit. One bank usually acts as agent for the 51. Point-of-Sale Systems others, thereby earning a fee for its efforts 52. Home Banking (and therefore becoming a transaction product 53. ATM Systems provider). 54. Commingled Investment Pools 2. Project Finance—Similar to syndicated loans 55. Direct Deposit (in fact, most are syndicated), project finance 56. Funds Movement and Inquiry involves very specialized lending to major gov- 57. International Banking Products ernments and their captive industries. a. Letters of Credit 3. Lease Receivable Finance–Loans made to b. Credit Inquiry lessors by insurance companies, pension funds, c. Foreign Exchange depository financial institutions (DFIs), non- d. Draft Collection depositor financial institutions (NDFIs), se- e. Syndication cured by retail leases or loans that the lessors f. Dollar Connection have made to lessees. The lessor’s note from 58. Stock Transfer the bank is secured by the paper, not the 59. Commercial Paper leased asset. 60. Options/Futures 4. Indirect Loan Funding–Involves a bank or 61. Equity Brokerage NDFI acting in a transparent fashion for 62. Index Funds Brokerage another lender, whereby the first provides the 63. Bond Brokerage funding source while the second generates the 64. Fund Management marketing and approval process. Two common 65 Debit Cards types of indirect funding are: 1) correspondent 66. Securities Settlement bank overlines, where a bank automatically 67. Discount Brokerage participates in its correspondent bank’s credit 68. Securities Lending packages over a preset limit; and 2) bulk pa- 69. Certificates of Deposit Brokerage per purchases, wherein the loan generator a. Straight (auto dealer, retailer, lessor) creates paper b. Strip through the normal course of its business and 70. Insurance Services Account periodically sells the paper and control of the collateral to a lender (e.g., bank, consumer fi- Information Services nance company). 5. Revolving Line of Credit—Generally a con- 71. Cash Requirements Forecasting sumer product that enables an individual to 72. Working Capital and Cash Flow Analysis borrow and repay loans under a predetermin- 73. Investment Return Optimization Analysis ed and approved limit, this product is often Appendix: Glossary of Terms ● 269 — .— — .

wholesaled by banks to NDFIs and retailed d. Eurodollars–Dolku= denominated deposits with the latters’ other product lines (money in foreign banking offices. Such services are market account, annuity, debit card), provided by correspondents to serve the 6. Offshore-Based Lending-Certain tax benefits overseas finance and deposit needs of the exist that accrue to domestic borrowers who originating institution customers. use offshore lending offices of U.S. banks to e. Imprest or Sweep Account—Depository ac- conduct business. Organizations provide this count with a targeted maximum balance service for their correspondents that are too above which funds are swept either to in- small to establish such facilities themselves. vestments or to a concentration account, 7. Banker’s Acceptance–These obligations of and central accounts into which funds de- the bank (guaranteed payment under letters posited with various regional institutions of credit) can be either assets or liabilities or are collected and then either used to meet both, depending on whether the bank is dis- payment obligations or for investment. counting them to the public against its guar- f. Single-Premium Deferred Annuities antee of payment. (SPDA)– Products designed to provide a 8. Trust Receipt Financing–Generally provided future pay-out of deposits based on an ac- by large commercial lenders to banks and the tuarial formula. Currently, only insurance public to enable them to finance inventory— underwriters are empowered to offer most either finished or raw. types of annuities. Such annuities have 9. Depository Financial Institution Products: some form of tax avoidance characteristics. a. Direct Deposit–The process whereby a 10. Margin Accounts–Margin accounts enable check’s issuer delivers the check directly to retail customers to leverage equity purchases the payee’s bank for credit to his or her ac- up to a fixed percentage, The underlying debt count. The term is often used to refer to the is provided by the major money-center banks Federal Government’s direct deposit pro- to securities brokers who mark up the price gram for Social Security checks. It is also and end-loan to the consumer. used for military and civilian salary pay- 11, Market Making (Equity Positions)–The prac- ments, Civil Service and Railroad Retire- tice of buying and selling securities for a bro- ment annuity payments, and Veterans Ad- ker’s own account from which it sells to or ministration compensation and pension buys from its retail or institutional customers. payments. 12. Leveraged Leases–A 100-percent financing b. Check Access Certificate of Deposit–A system that combines borrowed equity and bundled product that includes allowing the debt to enable a major utility or other capital consumer to write checks against a line of equipment user to acquire functional access to credit secured by a term deposit in a bank. resources without significant investment. c. IRA/Keogh–A tax deferment product of- 13. Retail Banking—The relationship between a fered not only by banks (where it is a term parent and a subsidiary retail bank wherein deposit product), but also by NDFIs, such the bank provides direct support to the prod- as insurance underwriters, securities bro- ucts offered by the parent. An example would kers, consumer finance companies, mort- be ownership of a retail bank by a securities gage bankers, and others. These offerors broker, as in the recent case of Dreyfus Corp. provide trustee services under IRA and 14. Middle and Institutional Market Lending–A1- Keogh plans, thereby playing in the trans- ternatives to funds offered by commercial action services arena. banks for middle market and institutional 1 ) IRAs—A retirement savings program for market borrowings using the proceeds of pub- individuals to which yearly tax-deducti- lic or private debt placements to make loans ble contributions up to a specified limit to these types of borrowers. can be made. The amounts contributed 15. Repurchase Agreements–A contract between are not taxed until withdrawal. With- a seller (bank, thrift, credit union, securities drawal is not permitted without penalty broker, and others) and buyer of Federal Gov- until the individual reaches age 59½. ernment or other securities, whereby the seller 2) Keogh Plan–A retirement plan for self- agrees to buy back the securities at an agreed- employed persons and their employees to upon price after a stated period of time. which yearly tax-deductible contribu- 16. Money Market Securities—private and Gov- tions up to a specified limit can be made. ernment obligations with a maturity of 1 year 270 ● Effects of /formation Technology on Financial Services Systems

or less. These include U.S. Treasury bills, permitted to accept equity positions in real bankers acceptances, large negotiable certifi- property in addition to debt instruments. cates of deposit (CDs), commercial paper, fi- 21. Insurance Premium Financing—Insurance nance paper, and short-term tax exempts. The companies can lend policyholders the money primary investment vehicle used by the money to finance their premiums over an extended market funds offered by both depository insti- period of time. This service is usually accom- tutions and securities dealers. panied by an insurance services account. 17. Other Investment Funds: 22. Actuarial Accruals—The liability side of an a. Money Market Fund–A mutual fund that insurance company’s balance sheet includes invests in short-term, highly liquid securi- the current period, actuarial accrual of many ties that pays the investor a market rate of transaction products, and the mandated divi- interest and permits redemption by means dends on premiums paid for life insurance con- of a variety of instruments that are contracts. venient for the investor to use. 23. Annuities–The principal liability product of b. Real Estate–Those funds concentrating insurance underwriter; is the tax-deferred an- their investments in real estate equities. nuity, which only these industry members are c. Liquidity-Those funds concentrating their able to offer with long-term guaranteed rates investments in cash or near-cash in- of return. Such annuities can be single-pay- vestments. ment or multiple-payment plans and periodic d. Growth–Those funds concentrating their or single pay out, or they can be structured to investments in speculative growth-oriented be payable to the surviving beneficiary only. securities that will yield an increase in capital rather than a dividend return. Transaction Products (Paper-Based) e. Municipal–Funds concentrating their investments in securities of political subdivi- 24. Cash Processing–The service of providing sion of a State, including cities, counties, central vault and central cash handling to towns, villages, districts, and authorities, banks, retailers, and other currency- and coin- and designed to yield tax-sheltered income. dominated businesses. 18. Mortgage Lending–The extension of credit 25. Payroll—The process of using customer input secured by a lien on real property. At one to develop payroll checks for employees. The point, the insurance industry was the single processor may also process the account debit largest component of the home mortgage mar- to offset the credits for the checks, payroll ket. Today, that is not the case. Insurance taxes, and miscellaneous withholdings. companies are opting to concentrate on the 26. Money Orders/Traveler’s Checks–Negotiable large commercial property market because of tender forms issued by depository and NDFIs increasing real estate values and opportunities in lieu of cash. Often wholesaled by major cor- to earn additional interest by participating in respondents or third parties in “private label” increases in rents as well as the secondary formats. mortgage market. Others participate in the 27. Mortgage Servicing—Fee-based service mortgage market by purchasing individual wherein the needs of the mortgage investor are mortgages or packages of mortgages assem- served by an intermediary that bills, collects, bled and marketed by such organizations as and accounts for mortgage payments. The the Federal Home Loan Mortgage Corporation process can also be incidental to an institu- (FREDDIE MAC) in secondary markets. tion’s normal lending activities. Compensation 19. CSVL1 Loans–Loans made against the cash is derived through negotiated net settlement surrender value of whole life insurance (CSVLI) of collections—usually 3/8 to ½ of 1 percent. policies, which by statute and by contract 28. Bank-End Processing: must be made at rates well below current mar- a. Installment Loan Servicing–Similar to ket rates. mortgage loan servicing; however, no na- 20. Real Property Equities–The taking of an tional market exists. Usually provided as a equity position by a financial service provider part of a total financial product servicing as part of the compensation for advancing package. funds. A practice of insurance companies and b. Mortgage Loan Servicing–Same as #27, others that, unlike depository institutions, are above. Appendix: Glossary of Terms ● 271

c. Commercial Loan Servicing–Process of totaling, and recording the payments; process- servicing commercial loans that do not nor- ing the items; and making the necessary bank mally involve the serial payments found in deposit or forwarding the funds to another de- installment loan servicing. pository. d. Demand Deposit Accounting–Process that The service can also be used by the institu- accounts for the account debits and credits tions themselves to service their own loan in a demand relationship with a bank. portfolios. “Wholesale” refers to receivables e. Savings Deposit Accounting–Process that flows that involve a few items with large dollar accounts for the account debits and credits amounts per item. “Retail” refers to those in a savings relationship with a thrift insti- flows with a large number of items and small tution, bank, or other depository financial per-item dollar amounts. institution that also handles the interest ac- 30. Check Guarantee/Authorization-The process crual and payment steps. of providing merchants and other vendors f. Term Deposit Accounting–Process that with assurance that a particular check being handles the accrual of interest on term sav- presented has the issuing bank’s ability to pay ings relationships for banks, thrifts, and behind it. In this mode, check guarantee/ credit unions, as well as some NDFIs (secu- authorization should not be confused with the rities brokers, insurance underwriters). electronic-based procedures to be discussed g. General Ledger Control–The accounting later. This process generally involves a rela- process for the internal recordkeeping for in- tionship between merchant and bank in con- dustry members usually provided by cor- trast with electronic-based procedures which respondents, third-party processors, and involve the use of third-party service. general accounting service providers. Banks 31. Securities Safekeeping–Generally provided also provide this service to their customers. by banks to brokers or by banks to corre- h. Collateral Control–A system for monitor- spondent banks, this service insures that ing an institution’s collateral under a loan. securities are maintained under dual custody. It usually entails a Management Informa- It can also have electronic applications when tion System (MIS), which may interface banks provide the service to their customers with the institution’s general ledger. for paperless securities, such as Treasury bills i. Cash Control–A service much like cash and commercial paper. processing, where central vault services are 32. Personal Trust—Services wherein financial in- provided a part of a total back office serv- stitutions manage the assets of others for a ice package. fee. Wholesaling aspects involve correspond- j. Trust Accounting–A second-level account- ent relationships and trust companies as ing system for reconciliation of bank, thrift, agents for financial institutions without the and trust company customer accounts, as necessary infrastructure to support the ac- well as calculation of yield, return, and activity. tuarial benefit, 33. Escrow Accounting–Services provided to k. Item Processing--The internal receiving, escrow agents (title companies or attorneys in recording, and ‘perhaps redistribution of certain geographic areas) that enable the agency checks, drafts, or other debit and credit to maintain trust accounts and to report on items written by customers of an institution the settlement of buyer and seller accounts. or deposited by its customers and drawn on 34, Note Collection–Service wherein the financial another institution. This includes posting or institution acts as collecting agency for a cus- recording of the check in the individual customer on obligations owed by others to the tomer’s account and the microfilming and customer. Historically, this service has been balancing of all such items received. underpriced by banks and thrifts and fre- 29. Wholesale/Retail Lockbox—Also known as quently is being abandoned, owing to the remote item processing or remittance process- heavy costs involved. ing. A banking service provided for the rapid 35. Mortgage Banking—The process of acting as collection of a customer’s receivables and rapid an intermediary between the loan origination credit to the customer’s account. The service and funding systems. Generally, the mortgage provided by the bank includes collecting mail banker will be equipped with the origination from the company’s post office box; sorting, system and will tap national secondary mar- 272 ● Effects of /formation Technology on Financial Services Systems

kets for funding. In many cases, nondepos- 41. Real Estate Brokerage–Occurs when the itor mortgage bankers will be supported with brokerage community expands into real estate warehousing lines of credit from banks to fa- services through acquisition of existing real cilitate timely funding of loans. These ad- estate companies or renewed offerings of the vances are ultimately repaid through filling of services through existing securities brokerage commitments with funds purchased in the offices. open market. Three common secondary mar- 42. Securities Settlement–The process of trans- ketmakers exist–Federal National Mortgage ferring title between buyers and sellers of secu- Association, Government National Mortgage rities within the 5-day limit. Involves deliver- Association, and Federal Home Loan Mort- ing negotiable securities to the buyer, good gage Corporation, Securities brokers play a funds to the seller and effecting a change in very active role in supporting this activity ownership on the books of the transfer agent. with their efforts to optimize investor returns 43. Annuities–The amount payable according to by investing client funds in the debt and contract annually or at other regular intervals equity of these three agencies, as well as spon- for either a certain or an indefinite period, as soring their own real estate mortgage invest- for a stated number of years or for life. Sev- ment pools. eral types of annuities exist, and in most cases 36. Collection Service (Brokerage)–The process of brokers merely sell the annuity programs of entering for collection the interest coupons of a particular life insurance underwriter, municipal, State, and Federal bond obligations (as well as certain non-Government debt securities) on behalf of others. This service, as in Transaction Products (Electronic-Based) the case of note collections, was implicitly rather than explicitly priced for some time and 44. Data Base Access–These products require is rapidly disappearing in many institutions. that the user be equipped with electronic hard- Frequent offerors include securities brokers, ware and attendant software to gather and banks, and thrift institutions. manipulate data or to take action based on the 37. Private Placement–The business of selling data provided. There are essentially two types the long-term debt or equity instruments of a of data-based access products-–passive and ac- client directly to one or more financial insti- tive. Passive products merely provide the user tutions without going to the public market. with information (e. g., account balances, air- 38. Equity Brokerage—The trading of securities line schedules, stock prices). Active products on behalf of a broker’s clients either on one of enable the user to execute formatted trans- the great number of securities exchanges or actions in conjunction with the information through an off-market transaction. (transfer funds, book and pay for reservation, 39. Public Offering–The process of taking a pri- buy or sell securities, and settle payment). vately held company public through under- 45. Branch Automation–Those products de- writing the new securities (guaranteeing a spe- signed to enable banks, thrift institutions, and cific price) and then selling them to retail or NDFIs to increase productivity while reduc- institutional clients, or the process of offering ing personnel costs through resource substi- additional stock or debt securities for an tution. already public company. Requires that the a, Platform Automation—The second step in securities be registered with the Securities and the branch automation process is that of Exchange Commission and the offering be con- automating the functions of the administra- ducted in accordance with its regulations. tive and loan platforms. In most cases, 40. Relocation Management–A relatively new automation amounts to teller-terminal emu- service of a few brokers, relocation manage- lation with access to small customer infor- ment services assist the employees of cor- mation, word processing, and limited per- porate employers in their periodic job-related sonal-computer data-manipulation functions. relocations by advancing the equity in owned The loan authorization function is also pro- real estate, thus brokering the sale of trans- vided in some cases. feree’s home and the purchase of another in b. ATMs–Hardware and software that pro- the receiving city. As of December 31, 1982, vide customer access to personal account in- Merrill Lynch had $430 million invested in formation and transaction sets to conduct equity purchases. banking business. Machine configurations ..—

Appendix: Glossary of Terms ● 273

range from full function to inquiry only to transfer checks (DTCS) are items processed cash dispensing only. through the payments systems and are pre- c. Teller Terminals—These products enable authorized drafts on remote banks used for banks, thrift institutions, and credit unions the purpose of concentrating cash in a sin- to address extract files and to perform teller gle depository. functions against memo post files. Their b. Concentration Accounting—The receiving functionality is generally limited to trans- end of the DTC system or other actions involving demand deposit accounts cash-gathering mechanism. (DDA) and savings types of accounts. c. Automated Investment Accounts–Those 46. Settlement and Clearing: cash concentration accounts that are pre- a. Settlement—In interchange, the process of programmed to sweep balances in excess of cardholder banks and merchant banks a target amount into interest-earning ac- either paying by draft or drafting upon one counts or investments on behalf of the cus- another for payment of bank card trans- tomer—usually a commercial depositor. actions. A transfer of funds between two d. Cash Forecasting-A service whereby a fi- parties in cash or on the books of a mutual nancial institution uses the cash receipts depository (e.g., the Federal Reserve Bank) and disbursement journals of its customers for consummating one or more prior trans- to develop an analysis of that cornpany's actions made subject to final accounting. cash requirements for a given period. This The conclusion of a transaction by com- enables the customer to invest the unneeded pleting all necessary documentation, mak- funds for future use. ing the necessary payments, and transfer- 50. Business Banking Products– The following ring title, where appropriate. products are generally offered by most banks b Clearing–A banking term referring to the to their corporate customers and rely heavily inter-bank presentation of checks, the off- on electronics either for product deliver-?. or setting of counterclaims, and the settlement facilitation. of resulting balances. The term may be used a. Account Reconciliation—Customers pro- in a purely local operation or on a nation- vided either paper-based or electronic-based wide basis. information on the checks they have writ - 47. Automated Clearing House/Electronic Clear- ten, which, when matched by the bank with ing House—A facility that performs inter- those checks that have cleared, enable the member (financial institutions) clearing of bank and the customers to maintain a single paperless entries between such institutions. cash balance journal. Most ACHS are operated by the Federal Re- b. Account Consolidation–The creation of serve and use rules, procedures, and programs multiple accounts that are actual subsets of developed on a local basis by their participat- a single account. The funds reside in one ac- ing financial institutions under the general count, but statements are prepared for each direction of the National Automated Clearing subaccount. This is particularly attractive House Association. to customers with multiple-branch profit 48. Wire Transfer—The process of moving cus- centers. The process requires additional tomer money from one place to another with- MICR* encoding on each separate set of out the transfer of paper documents by means checks. of telecommunication between financial insti- c. Balance Availability Reporting—Requires tutions. Larger banks have access to Federal that a bank provide inter-da}’ balance re- facilities, while smaller institutions rely on porting as checks and deposits are made their correspondent banks to perform the task. through a business day. This information is The important characteristics of wire transfer generally transmitted to a terminal in the are speed and the secured nature of trans- customer’s office. miss ion. d. Balance Concentration/Sweep–The receiv- 49 Cash Management–A generic term for several ing depository account for funds drawn off discrete products designed to speed the collec- of subsidiary accounts and then invested in tion of funds receivable and delay the disburse- money market instruments. ment of funds payable. a. Depository Transfer Checks—Depositor~’ 274 ● Effects ot /ntorrnation Technology on Financia/ Services Systems

e. Automatic Customer Billing—A software- depository account or through a charge to a driven product whereby the customer pro- credit account. vides the bank with electronic-based data 53. ATM Systems—An unmanned electronic de- on its customers and the bank generates vice that performs basic teller functions such either paper or electronic debits or bills that as accepting deposits, advancing or withdraw- are either mailed or processed through the ing cash, relaying balance-inquiry information, ACH. and allowing transfer between a customer’s ac- f. Deposit Reconciliation–A service, similar count. The device is usually activated by a to account reconciliation and account con- magnetically encoded card or by the transmiss- solidation, that reconciles customers’ depos- ion of a code via a keyboard or keyset. Such its by branch or profit center. devices may be accessible 24 hours a day. The g. Accounts Payable Check Writing–In this definition of an ATM system differs from the service the bank uses a customer’s accounts definition of ATMs under branch automation payable journal and discount information to in that the ATM system may also involve prepare its checks to vendors. In many credit authorization, check verification, draft cases, this service is combined with a data capture, and transaction processing. remote disbursement account located at 54. Comingled Investment Pools–Enable banks another bank, usually in a city with no Fed- to leverage their investment expertise to pro- eral Bank ACH. vide investment services to their customers di- 51. Point-of-Sale Systems–A point-of-sale (POS) rectly or to other institutions on a correspon- transaction is a full funds transfer that can be dent basis. Generally, the product takes the accomplished by electronically entering transform of employee benefit trust management, action data into an electronic payment net- if provided to the public, and funds manage- work and transmitting the payment informa- ment, if done on a correspondent basis. tion to a data base in a depository institution’s 55 Direct Debit–Several industries rely on the di- computer. POS systems serve many masters. rect debit to settle the purchase of goods or Retailers use them to help control inventory services. When the ACH concept is fully ex- levels, to assist in order management, and to ploited, many more industries may take ad- authorize checks and credit and debit card pur- vantage of this process. One of the more visi- chases. More sophisticated systems are capable uses of the direct electronic debit is the ble of gathering all data necessary for draft or insurance settlement account (ISA) used by check processing and enable banks to provide the insurance industry. For those policy- truncated services to cardholders or deposi- holders who spread insurance premiums over tors. In all cases, POS systems reduce the time, the ISA offers the processing of preap- steps, and therefore the time, required to proc- proved charges to the policyholder’s deposi- ess a transaction. tory account at virtually any institution in the 52. Home Banking–Though in its infancy, home Nation. Mortgage bankers have begun using banking is growing rapidly in popularity. The the direct debit, and it should not be long most common form of home banking today is before other providers will also. Possible users telephone billpaying, which enables customers include thrift institutions and major providers of banks, thrift institutions, and credit unions of consumer credit (e.g., General Motors Ac- who have touchtone telephones to inquire ceptance Corp. (GMAC), Beneficial Finance, about their balances, make account transfers, and leasing companies). and pay certain household bills. This service 56. Funds Movement and Inquiry-Generic terms has evolved from the marriage of telephone for electronic-based cash management serv- lines, television monitors, personal computers, ices, including funds transfer (wire-based) and and television cable into several pilot projects access to data base information on the distri- that enable the consumer to perform the afore- bution of available funds (e.g., Where are they? mentioned functions, as well as to inquire Collected or uncollected? Ingestible?). about other bank products, to budget house- 57. International Banking Products–These prod- hold finances, and to reconcile bank state- ucts are provided to enable the customers of ments. Some pilot projects also enable the con- banks and thrift institutions either to do busi- sumer to make purchases from the home while ness in the global market or to have access to settling on-the-spot through direct debit to a funds while traveling worldwide. Appendix: Glossary of Terms ● 275 a. Letters of Credit–Letters of credit (LCS) This is a service of the international cor- are evidence of financial institution’s will- respondent bank community and involves ingness to underwrite the dealings of its the settlement of cash letters. While the vol- customers in arrangements where the cus- ume in cash letters is extremely high, the tomer is unknown to the seller of the prod- majority of cash and dollar settlement is uct or in countries where the extension of done by a handful of the largest U.S. banks. trade credit to foreigners is forbidden (e.g., ,58. Stock Transfer-Banks act as the transfer Japan). While the actual letter is paper- agents for publicly held stocks. In this capac- based, the advice and LC number is trans- ity they are required to process the changes mitted electronically through the banking of ownership of billions of shares each month. network to the customer’s seller (although It is important that these institutions main- the LC may be required by a buyer as a pertain a data base that provides ownership rec- formance bond). Trade LCS will probably ords to verify ownership, a service accessed by never be completely electronic because of not only the corporation stock issuers but also the extra documentation required, such as the securities industry. bills of lading, port entry receipts, and in- 59. Commercial Paper–Short-term (270 days or surance. less), unsecured promissory notes issued by b. Credit Inquiry–Dealing in foreign trade re- businesses of significant financial strength or quires that information be gathered on be- whose paper is backed by a letter of credit half of buyers or sellers, and banks have this from a major bank. Brokers are merely one of capability through either their correspond- two ways commercial paper is marketed. The ent networks or through third parties. major exception is Citicorp, which brokers its c. Foreign Exchange–Bank customers who own commercial paper. deal heavily in foreign trade must often set- 60. options/Futures–options” are a tradeable tle in foreign currency, making it necessary right to buy or sell securities. Futures con- to deal in the global currency markets. tracts are a legally binding agreement that call Banks themselves that are active in foreign for the purchase or sale of a real or hypotheti- lending frequently participate in the foreign cal commodity at a stated price and future exchange market to protect their positions point in time. against adverse currency exchange rates. 61. Equity Brokerage—The trading of securities Foreign travelers often need to use foreign on behalf of a broker’s clients on one of the currency that they can purchase in the great number of stock exchanges. United States prior to departing. Banks 62. Index Funds Brokerage–The selling funds rely heavily on electronic messages to keep whose yields are defined by specified stock in- abreast of foreign money markets, not only dices such as Dow Jones Industrials, Stand- for their own accounts but also for those of ard and Poor’s, and the Wilshire Index. their customers, 63. Bond Brokerage–The brokerage of debt in- d. Draft Collection-–Involves processing struments of strong corporations to clients. drafts received or delivered under letters of 64. Fund Management–The continual arrange- credit and is a part of the international ment and rearrangement of the bank balance clearing process. sheet or that of any trust or fiduciary fund in e. Syndication–Forming consortia of banks an attempt to maximize profits, subject to to provide credit and clearing services to having sufficient liquidity and making safe in- real and quasi-governmental agencies of for- vestments. eign nations as well as their nationalized 65. Debit Cards–A plastic card issued by a finan- and independent banks. International syn- cial institution to its own customers that, by dications provide offshore project finance. usage, credits or debits the customer’s per- Usually the syndicating bank guarantees a sonal account (checking, savings, or line of borrowing or servicing cost and then nego- credit). The card may be proprietary or it may tiates downward from the determined rate be a regionally or nationally accepted card. with potential syndicate members, intend- With regard to the securities industry, debit ing to reap a spread differential profit. cards are used to access funds on deposit in f. Dollar Collection– Involves the service of money market funds or to access lines of processing checks drawn on U.S. banks and credit secured by securities portfolios or real presented to customers of foreign banks. property. 276 ● Effects of /formation Technology on Financial Services Systems —

66. Securities Settlement—The process of trans- 73, Investment Return Optimization Analysis— ferring title between buyers and sellers of secu- A product used by banks and their customers rities. This must be conducted within the 5-day to evaluate alternative investment scenarios limit. using a targeted internal rate of return as the 67, Discount Brokerage—The provision of trans- primary algorithm. This product enables the action services only, without the usual invest- banks and their customers to develop parallel ment advice, for substantially reduced com- views of customer investment requirements missions. and ensures that the banks play an active role 68. Securities Lending–The process of lending at the onset of the analysis rather than after securities for collateral purposes and short the fact. sales. These securities often end up as collat- 74. Consumer Financial Analysis-–This new prod- eral for repurchase agreements, uct uses the industry’s control of the pay- 69. Certificates of Deposit Brokerage–The offer- ments mechanism to assist consumers in ing to clients of investments in major bank household budgeting. It uses additional infor- and savings and loan negotiable certificates of mation provided by the customer on checks deposit. and deposit documents to organize payments a. Straight—Generally used to designate spot and receipts data in a fashion that enables transactions. the consumer to visualize how the household b. Strip–Instances where a group of CDs are budget is spent, i.e., residence, entertainment, sold together to match the maturities sched- food, utilities, tax-deductible items, and non- ule of an underlying loan portfolio or a cus- tax-deductible items. tomer’s future need for funds. 75. Business Financial Analysis--This new prod- 70, Insurance Services Account–The principal uct works much like the consumer financial transaction product of the insurance industry analysis product, using a business customer’s is the insurance services account, which com- check and deposit input to generate state- bines insurance premium financing with direct ments that reflect the prior period’s cash basis debit of policyholder’s depository account in profit and loss, and compares same against banks, thrifts, and credit unions. These debits preestablished budgets. can be paper- or electronic-based. 76. Debt Issue Rating and Quotation Services— These information services are provided to ma- Information Services jor participants, who use them to guide their investment activities. Also included in the 71. Cash Requirements Forecasting—A system group are the equity rating and quotation that uses financial institution customer data services used by trust departments of banks on receivables, payables, and capital spending and thrift institutions, as well as securities to construct cash budgets and cash flow anal- brokers, pension plan administrations, and in- yses that the customer can use to manage its surance investment fund managers. The vast receipts and disbursements more efficiently. majority of these services are electronic-based 72. Working Capital and Cash Flow Analysis—A and are provided by third parties. product tied to the cash requirements product 77. Credit Reporting Agencies—These companies which highlights the shortfalls and excesses maintain large data bases or-t consumer and of short-term assets minus short-term liabili- business credit histories and generate reports ties and expresses the same as a net negative for subscribing members, who also provide or positive working capital position. current data on their credit consumers. Hndex — —

—. — ————- ——— —-— Index

ADP, Inc., 118 transition from paper-based to technology-based Aetna Insurance Co., 32 systems, 184-187 Alex Brown & Sons, 53 privacy, 185 Amdahl, Gene, 44 rights, 186 American Automobile Association, 13 security, 184 American Express, 108, 113, 118, 122 Continuous Net Settlement (CNS), 73 American Stock Exchange, 54, 63, 66 Credit Union National Administration (CUNA), 104 American Telephone & Telegraph (AT&T), 30, 146 AutEx Systems, 72 Dahls supermarkets, 123 Automated Bond System, 65 Dean Witter, 53, 62, 64, 66, 70 Automated Clearing House (ACH), 78, 99, 146 Delaware, 112, 113, 123, 217 automated teller machine (ATM), 19, 23, 29, 32, 37, Department of Treasury, 101 39, 40, 41, 43, 90, 98, 99, 113, 114, Depository Institutions Deregulation Committee, 115-123, 142, 149, 167, 176, 191, 202 103 Designated Order Turnaround (DOT), 71 BankAmerica Corp., 63 Digital Termination Service, 35 Bank of America, 129 Drexler Technology, Mountain View, Calif., 39 bankers’ acceptance, 84 Belgium, 159 E. F. Hutton & Co., 53, 66, 130 British Telecom, 162 “Buttonwood Agreement, ” 52, 60 Federal Deposit Insurance Corporation (FDIC), 103, 241 Federal Home Loan Bank Board, 11, 63, 199 California, 119 Federal Reserve Bank of Atlanta, 176, 205 Carte Bleu, 40 Federal Reserve Bank of New York, 146 Cash Management Account, 91, 119 Federal Reserve Board. 26, 60, 68, 142 C. D. Anderson & Co., 71 Regulation D, 125, 156 certificate of deposit (CD), 84, 104, 154 Regulation E, 26 Chemical Bank, 129, 149 Regulation Q, 156 Chicago Board Options Exchange, 54 Federal Reserve System, 146 Chicago Board of Trade, 55 Federal Savings and Loan Insurance Corporation, Cincinnati Stock Exchange, 71 104 CIRRUS System, Inc., 120, 121 findings, 191-219 Citibank, 203 applications of technology and changed nature of Clearing House Interbank Payment System financial services, 192 (CHIPS), 158 competition in the markets, 216 commercial paper, 83 entrants into the financial services industry, 213 Commodity Futures Trading Commission (CFTC), financial options for consumers, 201 55, 60 integration of capital markets, 210 Commodity News Services, 130 interaction between technology and the legal Consolidated Quotation System, 65 regulatory structure governing banking, consumer financial services, 167-187 198 consumer services, 167-180 restructuring the financial service industry, 194 automated teller machines, 176 security and integrity of the financial service automatic direct deposit, 178 system, 205 costs, 179 First Boston, Inc., 52 growth of credit, 173 floating rate note (FRN), 154 home information systems, 178 Florida, 130 payment methods, 171 France, 40 point-of-sale systems, 178 French Ministry of Post and Telecommunications, pricing structures, 178 162 providers, 169 future scenarios, 1990-95, 251-263 recent innovations, 174 extension of present trends, 252 savings and investment behavior, 168 global financial services industry, 258 telephone billpayer, 178 piecemeal regulations, 255 public policy, 180-183 prosperity and innovation, 261 regulations, 180 future of financial services, 7-9 Consumer Credit Protection Act, 182 influence of technology, 7 Electronic Funds Transfer Act, 183 providers, 8 Regulations Z and M, 182 users, 8

279 280 Effects of Iriforrnation Technology on Financial Services Systems . — ———-

General Accounting Office, 180 magnetic ink character recognition (M ICR), 19 Goldman Sachs & Co., 52 major findings, 4-7 Great Britain, 162 consumer interests, 6 delivery systems, 5 Hefner, Paul, First Interstate Bancorp of California, industry structure, 4 25 legal/regulatory environment, 5 Hy-Vee supermarket, 123 safety and soundness of industry, 6 Massachusetts, 122 Illinois, 120, 122 MasterCard, 98, 106, 112, 113, 114 individual retirement accounts (I RAs), 107, 174, 202, Mellon Bank, 102 204 Merrill Lynch, 32, 52, 53, 59, 67, 70, 91, 119, 131, Integrated Services Data Network (ISDN), 34, 35 167 Intermarket Trading System (ITS), 71 Mobil Oil Co., 124 international environment, 153-164 Money Exchange, Washington, D. C., 119 effect of technology on payment systems, 161 Morgan Stanley, Inc., 52 financial markets, 157-158 growth of international banking, 153-157 National Association of Securities Dealers multinational banking, 155 Automatic Quotation System (NASDAQ), new directions, 154 52, 71, 210 international lending, 155 National Association of Securities Dealers, Inc. sources of funding, 154 (NASD), 53, 61 interbank communications, 158-160 National Bank of Detroit, 120 New York Clearing House Association, 158 National Commission on Electronic Fund Transfers, SWIFT, 158 186 vulnerability of the financial system, 162-164 National Enterprise Bank, Washington, D. C., 196 INVEST, 63, 195 National Futures Association (NFA), 61 Iowa, 123 National Securities Clearing Corp., 62, 72 ISFA Holding Co., Ltd., 63 National Transaction Systems, Inc., 119 Network Exchange, Washington, D. C., 119 J. C. Penney, 114, 130, 171 New England States, 122, 217 Jefferies & Co., 72 New York, 32, 146, 149, 217 New York Clearing House Association, 158 Latamore, S. Berton, 39 New York Stock Exchange, 19, 52, 53, 59, 61, 63, legislation: 65, 66, 68, 71, 72, 73 Banking Act of 1933 (Glass-Steagall), 52, 198 North American Securities Administration Bank Holding Company Act, 200, 231 Association, 60 Bank Holding Company Deregulation Act, NOW accounts, 105, 202 proposed, 200 Consumer Credit Protection Act of 1968, 182 Opening Automated Report Service (OARS), 72 Consumer Leasing, 182 Options Clearing Corp. (OCC), 54, 55, 73 Depository Institutions Deregulation and Organization for Economic Cooperation and Monetary Control Act of 1980, 104, 174, Development (OECD), 154 200, 226 Electronic Funds Transfer Act, 183 Pacific Stock Exchange, 54 Employee Retirement Income Security Act Paine Webber, 52 (ERISA), 57 “Pathfinder,” 67 Equal Credit Opportunity Act, 182 Pecchioli, R. M., 154 Fair Credit Billing, 182 personal identification numbers (PINs), 37, 41, 124 Fair Credit Reporting Act, 182 Philadelphia Stock Exchange, 54 Fair Debt Collection and Practices Act, 183 Pocket Quote, 66 Garn-St Germain Act of 1982, 11, 105, 200, 226, point-of-sale (POS) systems, 22, 25, 31, 32, 33, 40, 233 101, 111, 123, 171, 178 Maloney Act of 1938, 61 policy issues, 9-15, 223-247 Securities Act of 1933, 60 access to clearing systems, 13, 238 Securities Acts Amendments of 1975, 62 allocation of risk, 13, 241 Securities Exchange Act of 1934, 60, 61, 68 barriers to international operations, 12, 236 Securities Investor Protection Act of 1970, 60 changes in structure, 225 Truth in Lending Act, 182, 203 competition between regulated and unregulated Liberty National Bank & Trust Co., Oklahoma City, providers, 12, 229 125 congressional options, 227 Index ● 281 —

consolidation, 10 Safeway, 118, 119 control of interest rates, 13, 240 Saloman Brothers, Inc., 52 generic considerations in framing policy, 226 Satellite Business Systems, 32 implementation of policy, 9 Sears Roebuck & Co., 102, 114, 171, 202 lifeline financial services, 14 Securities and Exchange Commission (SEC), 55, 60, market segmentation, 11, 232 62 privacy, 14, 236, 244 securities industry, 51-94 public interests, 224 capital formation, 91-94 relationship to telecommunication policy, 11, 235 private sources of funds, 92 restrictions on interstate banking, 10, 231 public offerings of securities of a corporation, 93 restructuring the policy framework, 9, 226 functions of, 64-75 security and integrity of delivery systems, 15 acceptance of risk, 67 vulnerability of financial services systems to theft, margin, 68 15, 246 underwriting new issues, 67 Prudential Bache, 53, 64 advisory role, 65 Publix Supermarkets, Florida, 119 counseling, 66 information dissemination, 65 repurchase agreeements, 84 marketing, 69-75 retail financial services, 97-133 brokerage, 70 deposit function, 99-108 clearance and settlement of securities, 72 accounts with other nondepository institutions, pricing, 73 107 product development, 69 demand deposit accounts, 102 transactions, 71 direct deposit, 100 information technology, effects of, 75-76 drafts, 102 instruments, 76-91 giro transfers, 102 corporate capital structure, 76-83 insurance, 106 convertible securities, 82 lockbox operations, 101 equity, 81-82 point-of-sale systems, 101 long-term debt-corporate bonds, 77-81 savings accounts, 103 options and future contracts, 84 traveler’s checks, 103 central asset accounts, 91 electronic funds transfer (EFT), 114-126 futures, 88 automated teller machines, 115-123 mutual funds, 90 ATM deployment legislation, 121 options, 85 ATM systems, 116 warrants, 87 CIRRUS–National ATM Network, 120 short-term debt-money market securities, 83-84 shared ATM systems, 118 structure of, 51-64 POS full funds transfer, 123-126 characteristics, 62 costs of POS systems, 125 composition, 52 direct debit POS, 123 brokerage houses, 53 National POS systems, 125 exchanges, 53 extension of credit, 108-114 investment banks, 52 commercial credit, 110 development, 51 consumer credit, 110 effects of information technology, 64 financial information services, 126-128 industry users, 57-59 check authorization, 127 individual investors, 59 credit authorization, 127 institutional investors, 57 providers, 127 international market, 64 home information services (HIS), 128 new entrants, 63 characteristics of users, 132 regulatory structure, 59 costs, 131 Federal agencies, 60 developers of, 129 self-regulatory agencies, 61 implications of, 131 trends in regulation, 62 market for, 131 Securities Industry Automation Corp. (SIAC), 54, technology of, 129 62, 71, 72 Reuters, 157 Securities Investor Protection Corp. (SIPC), 60, 61, Revell, J. R. S., 161 180, 241 Reynolds Securities, 62 Shearson/American Express, 53, 63 Small Business Administration, 60 282 ● Effects of Information Technology on Finaricia/ Services Systems —. — —

Small Business Investment Corporations, 60 Telemet America, Inc., 66 Society for Worldwide Interbank Financial Tele- Treasury bill, 83 communication (SWIFT), 153, 158, 159, Tyme Corp., Wisconsin, 119 160, 163, 164 South Dakota, 112, 113, 217 VideoFinancial Services, 130 Super NOW accounts, 105, 108, 202 Videotex Industry Association, 186 support technologies, 19-47 Viewdata Corp., 130 computer hardware systems, 20 Viewtron Program, Miami, Fla., 130 future hardware, 23 VISA, 13, 39, 98, 112, 113, 114, 126, 137 large computers, 22-25 microcomputers, 20-22 Warner-Amex QUBE System, 34 hardware components, 44-45 Washington, D. C,, subway farecard system, 39, 40 software, 25-29, 45, 46 White, William, 168 applications software in the future, 28 White Weld, 62 specific technologies for delivering financial serv- wholesale financial services, 137-149 ices, 38 data access, 147 customer service equipment, 42 future of, 148 document and currency renders, 41 ~ products available in wholesale markets, 138-141 electron cards, 39 asset and liability products, 138 embossed/magnetic stripe card, 38 major providers, 139 laser card, 39 information products, 141 system security and integrity, 36-38 nonprocessing services, 141 telecommunications, 30-36 processing products, 140 future, 34 providers, 142-146 private-line facilities, 32 role of technology, 138 switched telephone network, 30 Wide Area Telephone Service (WATS), 31 alternatives, 32 Wilmington (Delaware) Savings Fund Society, 123 video-related communication technologies, 33 Wisconsin, 122

Zimmer, Linda Fenner, 176