ELECTRONIC COMMERCE AND BANKING
Electronic Commerce and Banking
“Banking is vital to a healthy economy. Banks are not” [AS95]. This quote succinctly captures the structural and operational tumult occurring in the fi-nancial services industry. Banking as a business can be subdivided into five broad types: retail, domestic wholesale, international wholesale, invest-ment, and trust. Of all these types, retail and investment banking are most affected by online technological innovations and are the ones that stand to profit most from electronic commerce.
The role of electronic commerce in banking is multifaceted-impacted by changes in technology, rapid deregulation of many parts of finance, the emergence of new banking institutions, and basic economic restructuring. Given these environmental changes, banks are reassessing their cost and profit structures.
Many banks feel that in order to be profitable they need to reduce operating expenses and maintain strict cost control. This philosophy is evident in the many mergers and acquisitions occurring in the banking industry. The challenge behind bank restructuring lies in adequately operationalzing the notion of cost control.
Technology is the predominant solution for controlling costs. Banks are
Increasingly turning toward technology to help reduce operating costs and still provide adequate customer service. Innovation and technology are becoming the key differentiators in the financial services business. Advance in networking, processing, and decision analytics have allowed institutions to lower service costs. Technology has also accelerated the pace of product innovation.
For example, sophisticated arbitrage instruments like deriva-tives are changing the nature of investment banking. The Securities and Exchange Commission’s decision to allow Spring Street Brewery to trade its stock online may also fundamentally change investment banking by disinter mediating the traditional role of underwriting.
Technology is enabling the development of new products and services. For example, technology is capable of replacing or expediting tedious finan-cial exercises like check writing, filing taxes, and transferring funds. Although large businesses have automated these tasks, many small busi-nesses and most households still do them manually. This is not surprising; large businesses have been undergoing computerization for more than thirty years, whereas PCs have been entering households in significant numbers only in the last few years.
Technology is changing the interaction between banks and consumers. In particular, technological innovations have enabled the following capabil-ities: online delivery of bank brochures and marketing information; elec-tronic access to bank statements; ability to request the transfer of funds between accounts; electronic bill payment and presentment; ability to use multiple financial software products with “memory” (thus
eliminating the need to re-enter the same data); online payments—encrypted credit cards for transferring payment instructions between merchant, bank, customer; and finally,
micro payments (or nickel-and-dime transactions using electronic cash and electronic checks). These online capabilities increase the fa-cility and speed of retail banking.
However, new technology is a double-edged sword. While it enables banks to be more competitive through huge investments, it also enables new competition from fast-moving,
Non banking firms. This trend can be seen in the area of online payments, where recent innovations have pro-vided an opportunity for nonbanks to break into the banking business, threatening the banking stronghold on one of the last key services provided by banks. The present nature of online payments is a clear indication that if the banking industry fails to meet the demand for new products, there are many industries that are both willing and able to fill the void.
Technology also creates problems in the product development life-cy-cle. In the past banks had the luxury of long roll-out periods because suc-cessful investment in retail banking required a large monetary commitment for product development. This
financial requirement pre-vented new participants from entering the market and was a key determi-nant of success. This is no longer the case. Instead of a single institution doing everything, technology allows the creation of a “virtual financial institution”
made up of firms, each contributing the best-of-breed software or products to the overall product. In this new “virtual model,” banks compete with the twelve-to eighteen-month product development times of companies like Intuit or Netscape, which have product life-cycle times of only six to nine months.
Clearly, the impetus for drastic change in the banking industry does not come from forces within banking; it is from competitive pressure outside the industry. It is important to determine the origins of this competition as well as to ask three questions more relevant to managers: What are the di-mensions of nonbank financial services competition? What is the role of the Web, Internet, and electronic commerce in this competition?
How can finan-cial institutions effectively leverage the “legacy” information infrastructure to thwart nonbank competition?
This chapter addresses these questions and presents an overview of changing dynamics in the banking industry that, together with technological changes, are creating the need to
rethink the ex-isting paradigm of financial services.
Changing Dynamics In Banking Industry
In recent years, there has been a major change in the way banks strive for increased profitability. In the past, the banking industry was chiefly con-cerned with asset quality and capitalization; if the bank was performing well along these two dimensions, then the bank would likely be profitable. Today, performing well on asset quality and capitalization is not enough. Banks need to find new ways to increase revenues in a
“mature market” for most traditional banking services, particularly consumer credit. A thorough understanding of this competitive environment is needed before banks can determine their online strategy.
Five distinct factors contribute to the new competitive environment:
• Changing consumer needs driven by online commerce
• Optimization of branch networks in order to reduce costs,
• Changing demographic trends and potential new consumer markets
• Cross-industry competition caused by deregulation, and
• New online financial products. Changing Consumer Needs
Consumer requirements have changed substantially in the last decade. Customers want to access account-related information, download account data for use with personal finance software products, transfer funds between accounts, and pay bills electronically. Of course, along with these services, banks must be able to supply/guarantee the privacy and confidentiality that customers demand, which is not a trivial matter to implement on the part of the banks.
Many consumer requirements are based on a simple premise: customers and financial institutions both seek closer and more multifaceted relation-ships with one another. Customers want to be able to bank at their conve-nience, including over the weekend or late at night. Bankers want more stable and long-term relationships with their customers.
From the bank’s perspective, developing and maintaining this relation-ship is difficult. Although financial products are essentially information products and financial institutions are highly automated, there is a gulf be-tween automated information and the bank’s ability to reach the consumer in a unified way. This gulf is filled with established methods, such as branches, postage and mail, advertising, and people on telephones. These methods can be costly and impersonal. Electronic banking provides a method of communication that will enable the bank customer to be reached, served, and sold
products and services in their homes and offices whenever it is convenient for them-twenty-four hours a day, seven days a week.
Technology-based Financial Services Products
The growing importance of computer technology is another factor compli-cating predictions about the future structure of banking. Some observers be-lieve that additional development of electronic cash, such as smart cards, could stimulate further banking consolidation. They point to the fact that the start-up costs associated with electronic payments technologies can be high, in part because electronic cash requires large investments in computer software and other resources to establish a network of secure electronic transactions. Such large fixed costs have led these observers to warn that a few financial services providers-those with the resources to absorb those costs-could come to
dominate the payments system.
In contrast, the development of electronic banking might actually in-crease competition in banking markets and lower bank operating costs. Electronic banking offers an inexpensive alternative to branching to expand a bank’s customer base, and many banks are using electronic banking to in-crease service to their customers. Many banks have started Web sites on the Internet, and many plan to offer banking services over the Internet. Some banks are already offering certain banking services over the telephone. Smart cards and other forms of electronic cash could be the key to con-sumer acceptance of home banking, eventually allowing banks to reduce the number of their physical branches.
Electronic Commerce and Banking
“Banking is vital to a healthy economy. Banks are not” [AS95]. This quote succinctly captures the structural and operational tumult occurring in the fi-nancial services industry. Banking as a business can be subdivided into five broad types: retail, domestic wholesale, international wholesale, invest-ment, and trust. Of all these types, retail and investment banking are most affected by online technological innovations and are the ones that stand to profit most from electronic commerce.
The role of electronic commerce in banking is multifaceted-impacted by changes in technology, rapid deregulation of many parts of finance, the emergence of new banking institutions, and basic economic restructuring. Given these environmental changes, banks are reassessing their cost and profit structures.
Many banks feel that in order to be profitable they need to reduce operating expenses and maintain strict cost control. This philosophy is evident in the many mergers and acquisitions occurring in the banking industry. The challenge behind bank restructuring lies in adequately operationalzing the notion of cost control.
Technology is the predominant solution for controlling costs. Banks are
Increasingly turning toward technology to help reduce operating costs and still provide adequate customer service. Innovation and technology are becoming the key differentiators in the financial services business. Advance in networking, processing, and decision analytics have allowed institutions to lower service costs. Technology has also accelerated the pace of product innovation.
For example, sophisticated arbitrage instruments like deriva-tives are changing the nature of investment banking. The Securities and Exchange Commission’s decision to allow Spring Street Brewery to trade its stock online may also fundamentally change investment banking by disinter mediating the traditional role of underwriting.
Technology is enabling the development of new products and services. For example, technology is capable of replacing or expediting tedious finan-cial exercises like check writing, filing taxes, and transferring funds. Although large businesses have automated these tasks, many small busi-nesses and most households still do them manually. This is not surprising; large businesses have been undergoing computerization for more than thirty years, whereas PCs have been entering households in significant numbers only in the last few years.
Technology is changing the interaction between banks and consumers. In particular, technological innovations have enabled the following capabil-ities: online delivery of bank brochures and marketing information; elec-tronic access to bank statements; ability to request the transfer of funds between accounts; electronic bill payment and presentment; ability to use multiple financial software products with “memory” (thus
eliminating the need to re-enter the same data); online payments—encrypted credit cards for transferring payment instructions between merchant, bank, customer; and finally,
micro payments (or nickel-and-dime transactions using electronic cash and electronic checks). These online capabilities increase the fa-cility and speed of retail banking.
However, new technology is a double-edged sword. While it enables banks to be more competitive through huge investments, it also enables new competition from fast-moving,
Non banking firms. This trend can be seen in the area of online payments, where recent innovations have pro-vided an opportunity for nonbanks to break into the banking business, threatening the banking stronghold on one of the last key services provided by banks. The present nature of online payments is a clear indication that if the banking industry fails to meet the demand for new products, there are many industries that are both willing and able to fill the void.
Technology also creates problems in the product development life-cy-cle. In the past banks had the luxury of long roll-out periods because suc-cessful investment in retail banking required a large monetary commitment for product development. This
financial requirement pre-vented new participants from entering the market and was a key determi-nant of success. This is no longer the case. Instead of a single institution doing everything, technology allows the creation of a “virtual financial institution”
made up of firms, each contributing the best-of-breed software or products to the overall product. In this new “virtual model,” banks compete with the twelve-to eighteen-month product development times of companies like Intuit or Netscape, which have product life-cycle times of only six to nine months.
Clearly, the impetus for drastic change in the banking industry does not come from forces within banking; it is from competitive pressure outside the industry. It is important to determine the origins of this competition as well as to ask three questions more relevant to managers: What are the di-mensions of nonbank financial services competition? What is the role of the Web, Internet, and electronic commerce in this competition?
How can finan-cial institutions effectively leverage the “legacy” information infrastructure to thwart nonbank competition?
This chapter addresses these questions and presents an overview of changing dynamics in the banking industry that, together with technological changes, are creating the need to
rethink the ex-isting paradigm of financial services.
Changing Dynamics In Banking Industry
In recent years, there has been a major change in the way banks strive for increased profitability. In the past, the banking industry was chiefly con-cerned with asset quality and capitalization; if the bank was performing well along these two dimensions, then the bank would likely be profitable. Today, performing well on asset quality and capitalization is not enough. Banks need to find new ways to increase revenues in a
“mature market” for most traditional banking services, particularly consumer credit. A thorough understanding of this competitive environment is needed before banks can determine their online strategy.
Five distinct factors contribute to the new competitive environment:
• Changing consumer needs driven by online commerce
• Optimization of branch networks in order to reduce costs,
• Changing demographic trends and potential new consumer markets
• Cross-industry competition caused by deregulation, and
• New online financial products. Changing Consumer Needs
Consumer requirements have changed substantially in the last decade. Customers want to access account-related information, download account data for use with personal finance software products, transfer funds between accounts, and pay bills electronically. Of course, along with these services, banks must be able to supply/guarantee the privacy and confidentiality that customers demand, which is not a trivial matter to implement on the part of the banks.
Many consumer requirements are based on a simple premise: customers and financial institutions both seek closer and more multifaceted relation-ships with one another. Customers want to be able to bank at their conve-nience, including over the weekend or late at night. Bankers want more stable and long-term relationships with their customers.
From the bank’s perspective, developing and maintaining this relation-ship is difficult. Although financial products are essentially information products and financial institutions are highly automated, there is a gulf be-tween automated information and the bank’s ability to reach the consumer in a unified way. This gulf is filled with established methods, such as branches, postage and mail, advertising, and people on telephones. These methods can be costly and impersonal. Electronic banking provides a method of communication that will enable the bank customer to be reached, served, and sold
products and services in their homes and offices whenever it is convenient for them-twenty-four hours a day, seven days a week.
Technology-based Financial Services Products
The growing importance of computer technology is another factor compli-cating predictions about the future structure of banking. Some observers be-lieve that additional development of electronic cash, such as smart cards, could stimulate further banking consolidation. They point to the fact that the start-up costs associated with electronic payments technologies can be high, in part because electronic cash requires large investments in computer software and other resources to establish a network of secure electronic transactions. Such large fixed costs have led these observers to warn that a few financial services providers-those with the resources to absorb those costs-could come to
dominate the payments system.
In contrast, the development of electronic banking might actually in-crease competition in banking markets and lower bank operating costs. Electronic banking offers an inexpensive alternative to branching to expand a bank’s customer base, and many banks are using electronic banking to in-crease service to their customers. Many banks have started Web sites on the Internet, and many plan to offer banking services over the Internet. Some banks are already offering certain banking services over the telephone. Smart cards and other forms of electronic cash could be the key to con-sumer acceptance of home banking, eventually allowing banks to reduce the number of their physical branches.
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