September 15, 1996 eCONOMIC COMMeNTORY Federal Reserve Bank of Cleveland

The Functions and Future of Retail Banking by Jerry L. Jordan

Ar the tum of the century, one of the • Origins of Banks largest employers in America was the Economies have always developed Societies have always developed U.S . Ice Trust, which cut, stored, and methods for providing financial serv­ -ways to provide financial services. delivered ice for people's "iceboxes." ices. Over time, the providers of these Although medieval goldsmiths may Today, that industry employs only a frac­ services have adapted to changes in seem worlds removed from today's tion of the workforce it once did. This technology and customer preferences. commercial banks, they have one happened not because people stopped Functions that today are identified with important trait in common: Both consuming cool fresh food, but because "banking" were performed by the succeeded as financial intermedi­ the refrigerator-a product born of new organizers of the Champagne Fairs in aries because they were able to pro­ technology-all but eliminated the need the twelfth and thirteenth centuries. vide the services their customers for ice blocks. In contrast, the Fisher They issued tokens to participating mer­ wanted using the best technology Company, which produced carriages and chants, with each token representing available at the time. In this look at buggies in the early years of the century, deposits of coin, plate, and bullion that the future of the retail banking is still in the business of making automo­ had been tested. The merchants used industry, Federal Reserve Bank of tive bodies. these tokens to net out their accounts Cleveland President Jerry Jordan before settling in the deposited gold. At explains that as technology and What does the future hold for the retail the same time, scriveners- clerks who deregulation transform the financial banking industry? That depends on wrote letters and contracts in an illiter­ marketplace, it will be critical to whether it continues to provide value to ate age-reduced transaction costs. understand the services that people its customers. The challenge for bank desire and explore banks' compara­ managers and supervisors is to under­ Most professors of money and banking tive advantages in supplying them. stand what customers want-to distin­ fondly describe how medieval gold­ guish between cutting ice and keeping smiths accepted gold for safekeeping, food cold. In my view, understanding and how the receipts they issued eventu­ the services that people demand and ally became money. The goldsmiths exploring banks' comparative advan­ assayed bullion samples, certified their tage in supplying them will be crucial in quality, and issued receipts that were determining the future of the retail easier to carry than metal. Thus, they banking industry. added value by producing verifiable information and reducing transaction By considering the value-adding activi­ costs. From here, it was but a short step ties of banks, I hope to provide a frame­ to making loans.1 work for evaluating profitable opportu­ nities and assessing competition from Institutions more recognizable as banks, other banks, money market funds, or such as the Casa de San Giorgio in 1407 even phone and computer software com­ and the Bank of Amsterdam in 1609, panies. I also examine how new methods arose on the continent.2 These firms pro­ of delivering financial services may vided safekeeping and security, assessed affect the role of the Federal Reserve in and certified quality, and enabled transfer regard to money, the payments system, and banking supervision. payments. Although fund transfers had to industry, such as "commercial banking" Second, commercial banks as legally be conducted at the bank, transaction or "insurance underwriting." However, defined today may disappear in the costs were relatively low compared to there is no guarantee that one type of future, but some organization will per­ carting gold through the streets.3 heavily taxed, heavily regulated industry form the functions they now provide: that has been granted a particular "char­ payments, pooling, and risk manage­ This brief history holds several lessons. ter" will survive-quite the opposite. ment on the liabilities side, and resource First, many of these functions still sur­ transfers and risk management on the vive, though modern banks' methods of Consider savings accounts, which trans­ assets side. Again, these particular com­ providing loans and a convenient means fer purchasing power from the present to binations may not be undertaken by a of payment are considerably different. the future. This saving function can also single entity, just as the functions of Second, the institutional form has be accomplished by investing in com­ making jewelry and accepting deposits changed dramatically-from guild to mon stock. Although these methods in­ no longer exist jointly. corporation. For example, banking and volve different risks, buying a put option goldsmithing are no longer combined.4 can remove an important element of risk In the future, firms may serve customers from holding stock.6 The functions pro­ by bundling certain frnancial services • The Functional Approach vided by savings accounts need not be that are currently provided separately, or to Financial Services provided by a depository institution. may even merge banking-like services There have been several government with non-banking services such as con­ attempts, particularly in the United Something similar bas happened with cert and sporting event tickets, vacation States since the 1930s, to separate mortgages. In years past, people pur­ planning, and so on. They may utilize "financial service" activities into distinct chased houses by using personal sav­ electronic delivery vehicles accessible industries. These industries can, and do, ings. Later, the funds came from mort­ via the Internet. Some activities that we exist separate! y in market economies, as gage loans using the savings of other regard today as inappropriate, difficult, long as they perform functions that peo­ families within the community. Now, or even illegal for banks will most likely ple value. Adopting afunctional per­ home purchases are financed by non­ change, and may do so sooner than we spective, therefore, permits a deeper bank loans funded by investors in the expect. In the end, firms that find ways look into the well of issues surrounding mortgage-backed securities market. to deliver the services that the public the future of banking. When firms adapt wants will prosper. to competitive forces, we should expect Characteristically, commercial banks them to alter their product mixes, deliv­ have funded themselves with liquid lia­ Already, the New Zealand government ery vehicles, and corporate structures to bilities and have made illiquid loans. appears open to the idea of eliminating fulfill their functional role.5 They do, however, provide various the distinction between corporations other services to their customers. Func­ chartered as commercial banks and those

As frnan~ial intermediai.ies, banks per­ tionally, then, a "bank" is a combination incorporated for other business pur­ form six broad functions: 1) conducting of financial service activities. Legally, poses. Customers of public utilities, such exchange (clearing and settling claims), however, it is a corporation that receives as phone companies, may carry interest­ 2) funding large-scale enterprises (pool­ a batiking charter and is subject to the bearing balances and instruct these ing resources), 3) transferring purchas­ rules and regulations thereof. Typically, organizations to credit the accounts of ing power across time and distance, 4) these strictures prevent banks or their other merchants. Indeed, the government providing risk management (hedging, holding companies from offering some may even permit some non-bank busi­ diversification, and insurance), 5) moni­ services that are readily available in the nesses to maintain settlement accounts at toring borrower performance (mitigating marketplace because of concerns about the Reserve Bank of New Zealand. adverse incentives), and 6) providing safety and soundness. What, then, would be called a "bank"? information about the relative supply and demand for credit. This prompts two important observa­ • Money tions: First, the functional definition of Evolution of the financial services indus­ Commercial banks perform all of these "banking" is not synonymous with the try carries implications for money and functions, but so do other organizations. legal definition. Thus, a financial hold­ monetary policy. Just as we are chal­ Although people will continue to make ing company owning a frnance com­ lenged to rethink what a bank is, we will payments, save for the future, and insure pany, a venture capital firm, and a be challenged to rethink what money is. themselves, one ca.J.llot assume that the money market mutual fund has a fair existing corporate forms will survive claim to be called a bank under the func­ Money will, of course, remain the same (remember the goldsmiths). For eco­ tional approach. Conversely, a chartered from an economist's perspective-a nomic reasons, combinations of products bank that specializes in global custody medium commonly accepted in trade for may exist at a certain time within one arrangements or serves only as a clear­ goods and services. But in practical inghouse for credit cards is, functionally terms, if the set of firms engaged in speaking, not a bank. banking broadens, then might not the lia­ bilities of the new entrants also circulate among the public as exchange media? If In thinking functionally, the initial ten­ physical location of its stores as a means people wish to conduct transactions with dency is to assume that everything can ~,d~ring financial services, pro­ electronic vehicles that today's banks are be outsourced, broken up, and reduced vides proG~nterexample . slow to develop and offer, is it unreason­ to a commodity. Experience, however, able to conjecture that other commercial suggests otherwise. For example, until What underlies thi S'~nd away from firms will step into the marketing void? recently, people diversified the risk in physical location? As Adam Smith their stock portfolio by purchasing a lot pointed out long ago, speci~zation New payment technologies should be of different stocks themselves. Now a makes knowledge "lumpy." According regarded as innovations that enhance mutual fund does this for many inves­ to Milton Friedman's more modem productivity and welfare just as surely as tors, but they still incur the search and example, no single person knows how to any other new product. The challenge transaction costs of finding a good fund. make a pencil ; its production requires faced by the Federal Reserve is to ensure Very sophisticated investors bypass the coordinated activity of many ~pert s . that we can adapt our own operating mutual funds and invest directly in stock Banks can use technology to deliv~r practices and monetary policies to main­ index futures. Others have moved to a experts from afar, and this allows further tain financial stability and control the new class of intermediary, the fund fam­ specialization. Hiring an expert in price level. Today, banks hold our liabili­ ily (such as Schwab or Fidelity), which options, although uneconomical for a ties because they must meet reserve makes it easy to choose, evaluate, and local branch, would prove useful for the requirements, because they find having transfer between different mutual funds. 0.1 percent of clients nationwide who Reserve Bank balances instrumental in (An Internet search engine that does this trade options. settling transactions with other banks, is probably not far behind.) Still others and because the public uses Federal have returned to commercial banks, Despite the risk of bedazzlement (or Reserve notes in transactions. trusting them to assist in seeking out and cynicism) with the glories of informa­ evaluating funds. tion technology, it is worth asking what Required reserves are already declining. functions this technology can perform. In the future, the demand for central The collection of functions currently Because people care about changes in bank money will depend on the Fed's known as banking has survived-so far their overall portfolio, new technology usefulness in net settlement and on the -for several reasons. It provides serv­ can be used to integrate different types public's interest in using Fed liabilities ices more efficiently, effectively, and of financial accounts-across multiple for transactions instead of those of cheaply than if they were handled sepa­ vendors, checking and mortgage another issuer. Does the public want to rately. Banks can use the information accounts, car loans, mutual funds, use an electronic traveler's check issued from deposits to better price and monitor stocks, bonds, and so on. It can also be by American Express, or an electronic loans. This gives bankers a decisive in­ used to reduce search costs-the pro­ Federal Reserve note? formation advantage because the unique gram or search engine on a home com­ information content of illiquid loans, puter can act as an intelligent agent on • Implications of the such as small business loans, prevents the user's behalf.7 All of this is far Functional Approach them from being easily pooled and secu­ removed from the fourteenth century The functional approach, by focusing on ritized. Banks have also survived because scrivener dispensing advice, but it serves banks' comparative advantages, helps their organization solves incentive prob­ the same function-that ofreducing bankers determine the most efficient lems. Funding themselves with a liquid transaction and information costs. way to provide the financial services liability having a specific payout guaran­ their customers desire. A complemen­ tee gives banks a strong incentive to Information technology also aids in tary approach is to think about what monitor the illiquid loans on their asset automating the delivery of payment serv­ functions can be profitably outsourced. side. Indeed, we trust banks as "dele­ ices, thereby reducing the need for paper Money market mutual funds, for exam­ gated monitors" precisely because their checks, paper records, and brick-and­ ple, outsource some risk management. structure has evolved to solve this incen­ mortar bank branches. Some problems Unlike banks, they do not handle loan tive problem. will persist, although in a different form: portfolios. By engaging in loan sales and Complaints about long lines or surly securitization, a banking firm can out­ The question for the future is, "What is tellers will be replaced by complaints source the transfer and pooling func­ the cheapest way to integrate and about computer programs that crash. tions, but retain the credit evaluation and deliver banking functions?" Generally, monitoring (for example, risk manage­ people and technology will matter more Technology also aids in making pay­ ment and incentive) functions. than physical location. People will ments, a fascinating area that raises phone or e-mail an expert rather than important issues for both monetary pol­ talk face-to-face with a local teller, icy and banking. Will future deposits especially when expertise is vital-in assume a different form, and if so, will life insurance, financial planning, and the combination of assets and liabilities mutual funds, for example. Sears, that defines banking remain profitable? whose strategy had been to rely on the Technology can be readily used to pro­ A Level Playing Field. Like the In the end, functional regulation may vide substitutes for banks. As people Champagne Fairs of old, in which mer­ not be adequate, because some func­ increasingly make payments electroni­ chants could participate if they agreed tional combinations pose incentive and cally, and as software searches the Web to obey certain rules (such as having informational problems. After all, it for the best loan rates, banks may be their gold assayed), regulation must not was the combination of long-term reduced to mere commodity providers. discriminate between different financial assets and short-term liabilities that got Examples abound of businesses that service providers. Banks generally the savings and loans in trouble. Still, were once strictly wholesalers, but that applaud this rule when they talk about with these principles, the new financial now deal directly with the public. Tech­ finance companies, mutual funds, and landscape may benefit from a regula­ nology is an integral part of this retail­ insurance companies not facing Com­ tory environment that promotes eco­ ing transformation. In time, network munity Reinvestment Act exams, but nomic efficiency. interface programs-such as Java, are less enthusiastic about allowing Netscape, or their successors-may Goldman Sachs or Microsoft Corpora­ • Conclusion become identified with banks in peo­ tion access to FedWire. The BAI report Laws and regulations that attempt to ple's minds, and in reality. Goldsmiths' hoped to advance the goal of a level "wall off' certain business lines from receipts did not start out as money­ playing field when it called for eliminat­ others in the same corporate entity cre­ they were receipts for money-but in ing outmoded compliance burdens, such ate strong reactions in the marketplace. time, the interface became the reality. as dual antitrust reviews.9 Unregulated competitors rush to fill the void, and the regulated firms attempt to New technology might also enable Functional Regulation. Regulation avoid the regulatory barriers by creating banks to become the interface, however. should focus less on institutions and new products that offer their clients the Already, banks are becoming mutual more on functions. The Securities and desired functionality. 12 Even if regula­ funds for some people. Apollo Bank in Exchange Commission is well equipped tory barriers initially can be justified Pennsylvania has become an Internet to handle securities-related problems. due to some threat to financial stability, service provider. One scenario is that Let them do so and make the regula­ the justification may become outmoded on-line, banks will become like a store tions, whether the securities are under­ overtime. in the mall. Another scenario is that written by Merrill Lynch or the local banks may become the mall, with finan­ bank. Conversely, the extension­ Ultimately, the greatest disaster would cial planning software that lists their whlch again banks may not like to con­ not be a world without banks or bank customers' bank accounts, credit card template - is that Merrill Lynch must regulators, uncomfortable as that transi­ limits, and home equity balances on­ submit to Federal Reserve examinations tion might be. Rather, it would be a screen, and that provides the ease of when making loans or using FedWire. IO drastic failure of innovation. People navigation and delivery that lets people today are far better off for having transact with confidence. Value-added Supervision. Supervi­ refrigerators -even if the ice-cutters' sion and regulation must consider the union disagrees. • Regulation dynamic combination and recombina­ As the financial marketplace evolves, so tion of functions occurring today. It too must financial regulation and regu­ should be less concerned with playing lating institutions. Just as "banking" "financial cop" and more concerned functions need not be provided by with helping fums work safely and effi­ I banks, those functions known as "regu­ ciently. Ideally, banks will one day treat lation" need not be provided by regula­ Federal Reserve exams more like a re­ tors. Regulators should be clear about port from Arthur Anderson or Moody's what function they are providing and than an ordeal to be survived. The re­ about how they provide it. An insightful moval of unfair taxes and subsidies I set of reform proposals comes from the posited under the level-playing-field Bank Administration Institute (BAl).8 principle should make regulations less Although from a functional viewpoint burdensome, and banks less eager to the report concentrates excessively on find ways around them. 11 the health of the banking industry, it nev­ ertheless provides a wealth of ideas on how regulation can stop hindering banks from providing these functions. From my broader perspective, regulatory reform must rest on three principles: •Footnotes 7. For example, products such as Bargain­ 1. It is interesting to note the heavy role of Finder, which is currently used to search for government even at the dawn of banking his­ the lowest-priced compact disks, could be Jerry L. Jordan is president and chief execu­ tory. Although other merchants also offered adapted to search for the best price on certifi­ - tive officer of the Federal Reserve Bank of credit in medieval times, goldsmiths became cates of deposit. Banks could also adopt Cleveland. This article was excerpted from a important because of government interven­ SearchSpace, a computer program used in speech that President Jordan presented to the tion. Both Henry VIII's suppression of mon­ Italy to predict loan defaults. asteries and religious charities (1545) and seventy-sixth Executive Retail Conference of Charles I's seizure of the specie and bullion 8. See McKinsey & Company, Building Bet­ the Chicago Consumer Bankers Association, ter Banks: The Case for Performance-Based from the Tower of London mint (1640) con­ October 1, 1996. siderably increased goldsmiths' deposits of Regulation, Chicago: Bank Administration gold and silver. Institute, 1996. Economic Commentary is now available

2. The Bank of Amsterdam was made 9. The report provides specific proposals to electronically through the Cleveland Fed's famous by Adam Smith's description in The achieve a level playing field. One set of rec­ home page on the World Wide Web: ommendations aims to "liberate full cus­ Wealth ofNati ons. http://www.clev.frb.org. tomer service capabilities" by eliminating 3. Deposit and lending functions at these applications for new, unregulated products. institutions were often separated to prevent Another set aims to free up the organization loans from being funded by deposits. The of banks in order to "empower full corporate Bank of England formally separated the two governance." These proposals seek to permit functions in 1844 with Peel's Act, but the well-managed banks to hold equity invest­ Riksbank of Sweden was separated into a ments and undertake merchant banking ac­ "narrow" bank and a lending bank from the tivity. Notification would replace application start (1656). for both bank and non-bank acquisitions (including branches and ATMs), and would 4. Note that goldsmiths, as part of a guild likewise replace the requirements for ap­ system, were not corporations either. For an proval of headquarters expansion and divi­ in-depth look at the history of scriveners, dend outputs. goldsmiths, and early banking, see Charles P. Kindleberger, A Financial History of Western 10. The BAI report called for "risk-based Europe, Boston: Allen & Unwin, 1984. supervision" and insightfully looked for ways that regulation could be accomplished 5. The functional approach to economic more efficiently without regulators. Thus, a analysis has a long history. Economist Frank greater use of external and internal audits, Knight described the basic economic func­ coupled with increased disclosure and tions as answers to a set of questions that any reliance on market indicators, would go far in society must answer-what to produce, how this direction. New Zealand, for example, has to produce it, and how to distribute the out­ mandated that banks publicly display their put. See Frank H. Knight, "Social Economic credit ratings. Organization," in William Breit and Harold M. Hochman, eds., Readings in Microeco­ 11. The BAI report explicitly recognized the nomics, Hinsdale, Ill.: Dryden Press, 1971, Federal Reserve Bank of Cleveland's "value­ pp. 3-19. For a more detailed look at the added supervision" approach of structuring functional approach to financial markets, see more efficient exams, improving communi­ Robert C. Merton and Zvi Bodie, "A Con­ cations between banks and their supervisors, ceptual Framework for Analyzing the Finan­ and rapidly identifying hazardous risk. The cial Environment," in Dwight B. Crane et al., report stressed that supervision should con­ eds., The Global Financial System: A Func­ centrate on a bank's risk management capa­ tional Perspective, Boston: Harvard Business bilities, assessing internal controls and audit School Press, 1995, pp. 3-31. procedures. The Nick Leesons of the world remind us that these procedures and controls 6. An option is a contract that gives the truly matter to the bottom line. holder the right, but not the obligation, to make an exchange. For example, a call 12. See Joao Cabral dos Santos, "Glass­ option on a stock gives the owner the right to Steagall and the Regulatory Dialectic," Fed­ buy a fixed number of shares of a specified eral Reserve Bank of Cleveland, Economic common stock at a fixed price (the strike Commentary, February 15, 1996. price). A put option gives the owner the right to sell at a specified price. Economic Commentary is published 20 times a year by the Federal Reserve Bank of Cleveland. Copies of the titles listed below are available through the Corporate Communications & Community Affairs Department. Call 1-800-543-3489 (OH, PA, WV) or 216- 579-2001, then immediately key in 1-5-3 on your touch-tone phone to reach the publication request option. If you prefer to fax your order, the number is 216-579-2477.

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