Banking on the Internet?

"The future of Internet according to a British Telecom official will depend on 'finding a reliable way of paying cash within the system,'" wrote Jim Harding in the Financial Times. An addendum to this might be that the future of individual banks will depend on the role they choose to play in this process.

Historically, banks have had the good fortune to manage a proprietary conduit between depositors and borrowers, a conduit that to varying de degrees established a somewhat personal relationship between a bank and its customer. One factor that added stability to this relationship was the "inertia of cash." The inertia of cash can be described as the level of effort required by a customer to move the relationship to another bank.

Sweeping technological changes have brought millions into the on-line age. These changes accelerate the move towards reducing the inertia of cash. One wave in this tide of change is occurring on the Internet where the need for electronic money, or e-money, has been recognized by several consortiums working towards its creation. These organizations realize that the 40 million people on the Internet today represent a huge single segment market that is ready to explode with commerce when a reliable means of paying cash is established. Repeating banking history, these new wave electronic banks currently deploy a plethora of proprietary systems, each with its own brand of "cash." This is analogous to each bank or consortium issuing its own currency which is accepted only by participating vendors. These groups, while building on traditional banking experience, may or may not have considered JP Getty's words, "In a time of rapid change, experience is your own worst enemy."

Given the sophistication of Internet users, it is unlikely that they will accept en masse the inconvenience of dealing with multiple "electronic currencies." The evolution to open e-money is inevitable and will thus remove the last vestiges of inertia in cash.

When Bill Gates said, "Give me a piece of the transaction business and banks will be dinosaurs," he recognized that e-money was coming and that the business of banking in tomorrow's world would consist of two distinct components, namely electronic transaction processing and core banking. Banks are the logical heirs to the electronic transaction processing backbone, and they are unlikely to face extinction unless they fail to claim their heritage and rightful role.

With third party on-line service providers publishing lists of institutions that offer the best rates for deposits and borrowings, customers will increasingly come to view financial instruments as commodities. Funds will move electronically, without impediment, across states, countries and the world, seeking the "best deal" for each customer. The customer will be a market segment of one. Although brick and mortar will still be needed, its role will decline. Customers will expect 24 hours on-line service. The role of paper transactions such as checks will diminish. These changes will not happen overnight. But the early bird will catch the first and most profitable market segment, the one that is already on the Internet.

The choice that banks need to make is whether they will participate in the development and ownership of this open system or whether they will function as a commodity provider, albeit one that will attempt to create brand recognition, on this new electronic transaction backbone.

WHO'S ON FIRST?

Almost every US bank is involved in some form of electronic transaction processing. Electronic processing in this context would include ACH, wire transfers, debit cards, credit cards and ATMs. When we look at the Internet dimension of electronic banking, however, the picture is quite different. A small but growing group of banks have a presence on the Internet in the form of 'Web' pages. These pages which describe the bank and its products could be described as advertising.

When we look for institutions that actually facilitate payment processing on the Internet, the list moves from banks to non-bank companies. These companies use existing funding vehicles to create e-money. Three that warrant on-line examination are CyberCash, DigiCash and First Virtual.

Conceptually, there are three methods employed to facilitate purchases over the Internet. One relies on existing credit/debit card architecture, proprietary software and encryption to pass otherwise confidential information over a public network. Another employs electronic mail features of the Internet combined with a credit card relationship that the purchaser must establish in advance by phone. The last operates a "Russian Roulette" system. In this model, unencrypted credit card information is passed over the Internet to complete purchases. Vendors who wish to trade in the secure mode are required to establish a relationship with the appropriate e-money processing company.

CLAIMING THE HERITAGE

What can banks do to build, manage and own the electronic backbone? What are the challenges? As in all development projects, the first step is scope definition. Although being first in this market is of great value, having a quality product is probably more so. This can be seen by the demise of companies like Visicalc and MultiMate who were both first entrants into their markets. Scope definition must therefore be powered by a visionary business team with a sound understanding of technology issues. The team must be charged to produce a complete scope definition within a relatively short time.

The second step will be laying out the project plan. The plan must detail how each element in the scope definition will be addressed. Costs, staffing and timelines are some of the issues that need to be spelled out in the plan. To accomplish this, the team will need access to leading technology specialists and a team of researchers. Not all challenges need a new solution. For certain issues, the optimal solution might be licensing or some form of joint-venture. In other instances, the team will need to build their own "bridges."

Some of the more obvious issues that will require careful analysis include how to build an open and yet measurable (for billing purposes) architecture; how to provide security to users, both customers and other banks, while maintaining user privacy; determining what the appropriate technologies are; and how to leverage the transactions Rowing over the electronic backbone into new business opportunities.

The end product, a plan that outlines costs, timelines, and "how to," will be the basis of the implementation phase.

PEERING INTO THE CRYSTAL BALL

Developing a scope definition and a project plan requires a model of customer needs. Businesses flourish by meeting needs. The means by which those needs are met will vary over time. For example, a warrior has always needed weapons and armor. Providers of weapons and armor have changed over the centuries but the need continues to be met. Providers who failed to change with the times were replaced by "upstarts" who grasped the new realities and acted upon them. Through it all, the warrior's needs, as a market segment, continued to be met. A focus on financial needs blended with an understanding of technology trends will be core to scope definition and project plan development.

Financial needs can to some degree be tied into a Maslow type model. In today's society, cash and cash equivalents are prerequisites to meet the three basic needs outlined by Maslow. For our discussion, we will refer to this as the 'Human Financial Needs" model, or the HuFiN model. It is safe to forecast that customers' foremost financial need will be a means to receive and make cash equivalent payments. The second level of need on our HuFiN model would include receiving and making non-cash payments. This would lead us to the third financial need, the need to borrow and invest. A comparison of the HuFiN and Maslow models might appear as shown below. (Model omitted)

What are the core banking activities that currently support these needs and, based on current indications, how might those needs be met in the future?

From a bank's perspective, the retail banking fund-gathering activity encompasses both the first and second level needs on the HuFiN model. These activities, however, only meet the consumer component of the third HuFiN need, the need to borrow and invest. Larger borrowings require a loan origination activity and a loan servicing activity. Non-retail investments may require a Brokerage type activity. Core banking activities can, therefore, be narrowed to payment- and deposit-related cash and non-cash services, consumer investment and borrowings services, and non-consumer investment and borrowings services. In the retail banking business, subcategories of these could be loan origination, loan servicing and brokerage activities. Banks that wish to be brand-name commodity providers in any of the activities must plan on being the best in class.

To be a peer group leader in the years ahead, we must heed JP Getty's words. Rather than paving existing circuitous paths, we need to let go of experience, exercise good informed judgment to anticipate future trends and to unequivocally position ourselves, through forward looking technology deployment, to meet the future we project.

To help us reach informed conclusions on the more distant and yet imminent future, the table below looks at the future that is here. (Table omitted)

The electronic backbone that banks need to build is clearly more than the Internet. It encompasses a host of non-branch electronic transactions that must seamlessly operate with a variety of electronic interfaces. Although solutions need to consider multiple electronic interfaces, many of those who would be viewed as a prime market segment in any customer profiling process for tomorrow's banking are on the Internet today--ready to try new banking concepts. The Internet must, therefore, be viewed as an important step in the development of the bank of tomorrow.

TRADITIONAL BANKING TRENDS

The last 15 years have seen numerous changes in banking. Deregulation, increasing customer sophistication and technology development have generated several persistent and somewhat ominous trends. Three of these that impact core banking activities are discussed below.

Deposit Base

There will always be a group of risk averse savers; the universe of this type depositor is smaller than the current deposit base. The trend of a declining deposit base at banks can, therefore, reasonably be expected to continue. This points to a strategy that emphasizes the building of fee-based retail banking relationships that have a deposit account component rather than a balance-based business with a fee component. These fee based relationships must be technology-based solutions to meet customer needs.

Technology companies are, in my view, a serious risk to the entire checking end of the retail banking business. Companies offering on-line check paying are already encroaching on this sector of banking. Limited access to the checking system has, thus far, restricted their growth. If access to the banking system is all that precludes their full expansion into checking, it is not improbable that a technology company may acquire a bank to facilitate full access. The loss of the basic checking business has the potential of stripping banks of their current "core" transaction relationship with customers.

Banks need to be innovative and increase their technology focus to develop fee-based services that are profitable in a low balance environment. In addition, they must offer "one-stop shopping center" type fee-based investment opportunities for "excess" funds.

Real Estate & Consumer Loans

Real estate and consumer lenders will increasingly utilize new technology. "Computer" based lending will be dependent on databases that cover most real estate and consumer credit related information. On the consumer side, the database industry is well established. As one example, the credit card business, which uses third party credit information, has undergone consolidation as the value of smaller portfolios to large efficient operations exceeded the value of those portfolios to their owners. This trend can be expected in other consumer loan markets except for those that are based on personal contact.

Assuming that comprehensive real estate data is made available by a third party service provider, the only factors affecting a lender's performance over the long haul will be operating costs and customer service. Both operating costs and service quality will, to a large extent, be determined by sound work flow development and the effective utilization of technology. Inasmuch as companies like TRW and Dun & Bradstreet have created a business out of credit ratings, a new core business awaits the company that delivers an electronic real estate valuation system. Such a system would, in metropolitan areas, cover most tract housing and enable loan approvals, subject to information verification over the phone. This trend can be seen developing in certain North American markets. How does your origination operation plan to leverage this technology? Does your bank have a role in developing and owning a part of this database?

Loan Servicing

Loan Servicing is a business activity that is currently closely aligned with loan originations. Over the last few years, this business has seen significant consolidation. The consolidation trend can be expected to continue as long as disparity in loan servicing costs between best in class and others remain.

A senior executive of a major servicer said in June 1994 that their servicing costs were then $60 per loan each year, down from $70, and tat they should be able to lower the costs to 15 within 24 months. With an industry average of $ 75-85, they appear to be leading the peer group.

The number of loan servicers that manage a portfolio large enough to stay in the best of class is limited. Servicing units that are part of a host organization may not feel the pressure of competition, yet to the extent that their cost is above that of the best in class, the servicing unit is being subsidized by the host organization. If this subsidy diminishes the host organization's ability to meet market performance expectations, the organization will be compelled to rethink its decision on 'sell versus retain" of servicing rights.

Faced with these three trends, inaction will irresistibly lead to a fire sale" situation.

WHERE DOES YOUR BANK FIT IN?

With recent news of CompuServe, an on-line service provider, linking up with CyberCash to offer CompuServe Wallet, the concept of trade on Internet is gaining wider acceptance. Many have taken the security problem experienced by Netscape to be one more reason not to venture into banking on the Internet. One article in USA Today, however, relates that a USA Today/IntelliQuest survey found that 5% trust sending credit card information over the Internet and that 8% use the Internet for financial transactions. Given that there are 40 million computers on the Internet, this translates to 2 million who send credit card information over the Internet and 3.2 million that currently perform financial transactions on the Internet. With millions of customers and thousands of vendors waiting for a reliable and inexpensive payment vehicle, this must be viewed as explosive market opportunity.

Reaching a decision as to whether your bank chooses to be an electronic backbone provider or whether it chooses to be a brand-name financial commodity provider which will take advantage of "fire sales" by others, is the first step into the new electronic banking era.

TECHNOLOGY OPTIONS

Cash Equivalent Transactions

Cash will, for the foreseeable future, be needed for a segment of financial activities. For most other activities, a cash equivalent would be just as effective. Widespread acceptance is required for a cash equivalent to be accepted. A portion of credit card customers use their cards as a cash equivalent and pay off balances monthly. These customers utilize the credit feature only occasionally.

A cash equivalent device has been introduced by National Westminster and Midland Bank in the UK with large scale testing in Swindon in mid 1995. In the interim, Hong Kong & Shanghai Bank has announced an agreement to franchise this system through much of Asia. The system meets all cash equivalency needs while providing a deterrent to theft.

Non-Cash Payments (Bills, etc.)

Generally used for larger payments to meet payment requirement and to provide a record of the payment, this can be accomplished by direct debit cards, a direct debit program and touch tone telephone. European Banks offer a "draft" facility. These facilities are used by account holders to pay utilities, telephone, rent, minimum credit card payments and other monthly payments of fixed or variable amount. Checks are supported in conjunction with this facility. The reduction in checks processed is both a convenience to the customer and a cost reduction to the bank.

Unsecured Revolving Loan (Short Term & Small Balance)

There are two groups of users: those who pay their balances off and those who utilize the revolving line of credit. Those who pay off balances monthly ply the cards for what would normally be cash or check purchases. These needs would be met by a cash equivalent or debit card system. Pricing is the issue that determines acceptance of an alternative to credit cards.

Unsecured Loans (Fixed Amount)

Although limits on this can be preset onto an electronic card, there will be a periodic need to re-evaluate credit lines. The results of this analysis may require personal contact at a "brick and mortar" facility. Often unsecured loans are made on an individual basis. Larger balance unsecured loans are, therefore, one area that is least likely to be affected by the electronic backbone.

Real Estate Loans

Loans secured by real estate could be first, second trust deeds or equity lines. Process involves evaluation of credit, property valuation and income streams. A lender in Canada advertises loan approvals in less time than it takes to have a pizza delivered. This is accomplished through a narrow market focus and access to credit and property valuation databases.

Investment of Savings

Customers will need a means to save and invest those savings. Savings can be accomplished by a variety of means, including a "sweep" feature. Investment vehicles offered may be bank products or external investments. In the latter case, the bank acts as a fee broker.

Make International Payments

Retail customers need limited foreign currency access. Some cash equivalent systems provide this as a built-in feature, enabling customers to draw foreign currency at banks in selected countries. For more complex needs, direct customer contact may be required.

Access to Branch

Most questions and customer concerns can be addressed without "brick and mortar," although there is a significant customer acceptance issue in certain market segments. However, brick and mortar is required for large cash transactions, deposit or withdrawal, and other complex interrelated transactions that require physical signatures for legal purposes, at least until graphics authentication technology is widely available.

* George Thomas, FCCA, CMA, is a member of the Charterd Association of Certified Accountants (UK) and of the National Association of Accountants (US), and Vice President, Accounting Manager at Great Western Bank, a multi-regional, consumer oriented financial services company focused on mortgage lending. George can be reached at 71023.2054(at)compuserve.com or wt(at)caprica.com.

Copyright National Association for Bank Cost & Management Accounting 1996
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