Modern Banking

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Figure 2.16 Japanese Nikkei 500 banking index compared to the Nikkei 225 index.

Source: Datastream.

bank index in Figure 2.16, it is clear that investors take a dim view of the prospects for the Japanese banking sector – the index consistently underperforms the Nikkei 225 throughout the period. This result is exactly what would be expected, given the severity of the problems experienced by Japanese banks over the last decade. The Japanese case is analysed in some detail in Chapter 8.

2.6.1. Turning Threats into Opportunities

The figures on the performance of banks are mixed. While profitability was fairly static, it appears banks are looking for other sources of income by expanding into non-interest income areas. However, the ratio of cost to income remained largely unchanged, and average costs per employee rose through the 1990s. During the 1970s, 1980s and early 1990s, the share price performance of banks was relatively poor when compared against general price indices in the USA, UK, Japan and Europe. From the mid to late 1990s, British commercial and US investment bank share price performance improved, though the latter was somewhat volatile. By the new century, US, EU and UK banks were either tracking or outperforming the relevant index, suggesting investors have a more positive outlook with respect to banks’ future prospects. Japanese banks are the notable exception to this trend. There are several major changes which the existing highly capitalised banks can (and must) turn into opportunities if they are to survive. They are by no means independent, and include electronic and financial innovations including the introduction

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of ‘‘e-cash’’, the growth of ‘‘non-banks’’ and the trend towards consolidation within national banking sectors.

New technology and innovation

Begin with the emergence of electronic (e-cash) or digital cash and assume, for the moment, that it has replaced currency in circulation – a cashless society [the likelihood of the advent of a cashless society is discussed later in the section]. Based on the development of technology to date, e-cash can consist of stored value cards, network money and e-wallets. Stored value cards store prepaid funds electronically on a chip in the card. Mondex39 and Visa Cash are good examples. The ‘‘smart card’’ is another example of a stored value card, used widely in some parts of Continental Europe. Customers can download cash from their accounts into the card, so they can be used like cash, but are more secure than cash because personal information is stored in the chip, so only the owner can use the card. The reduced chance of fraud (compared to a debit or credit card) makes them attractive to customers and shop owners alike.

Network money is also prepaid but stored on a computer hard disc and transferred between agents via some network such as the internet. Also, assume agents use the e-cash to purchase goods and services by post, the internet or at physical shops. The e-wallet is an electronic version of a credit or debit card. Money is transferred from an individual’s account to the e-wallet, which can be used for internet purchases. All transactions can be traced back to the owner because the e-wallet contains the information.

Some experts have questioned whether the bank intermediary function will be challenged by the growth of e-cash. In this hypothetical world, could the presence of e-cash make banks redundant in the provision of core banking functions? To answer this question, consider each of these functions in turn. First, take payments facilities. To quote King (1999):

‘‘. . .there is no conceptual obstacle to the idea that two individuals engaged in a transaction could settle by a transfer of wealth from one electronic account to another in real time. . .

Eligible assets would be any financial assets [with] a market clearing price in real time. . . the key to such developments is the ability of computers to communicate in real time. . . enabling private sector real time gross settlement.’’ (p. 48)

King is referring to the settlement of transactions – there is no mention of credit. As Freedman (2000) stresses, the world of settlement envisaged by King would require a population of 6 billion having accounts, with funds transferred between them via the purchase or sale of assets.

39 Mondex is an electronic purse – it uses a smart card to store electronic cash. Smart cards have a microchip rather than a magnetic stripe. The chip can store a large amount of information. It is not easily copied (unlike a strip), reducing the opportunity for fraud. An ATM or adapted telephone transfers cash from a bank account to the card. Retailers use a terminal to download cash from the card. A number of pilots took place in the late 1990s – some successful, some not. NatWest has sold all but 5% of Mondex to other firms. Mastercard International bought a 51% shareholding in 1997. Mondex trials in Swindon (UK), Guelph (Canada) and Hong Kong failed. See Tomkin and Baden-Fuller (2000).

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Central banks play an important role in the settlements function. Most of the daily payments made by the household, business and government sectors involve a claim on a bank, and through a given working day, net payments are made to and received from the different banks. Some banks will find their settlement balances at the central bank have increased, others will have declined because they have experienced a net outflow of payments. Banks will use each other or the central bank to ensure their settlement balances at the central bank are kept at some minimum level. The central bank has assumed this role for numerous reasons. It issues the currency, and therefore cannot fail, and it also acts as lender of last resort.40 However, in the event of real time transfers, payments between banks would no longer be necessary (for the reasons given above) and this settlements function could, in theory, disappear.

Turning to the other core functions of the bank, taking deposits and making loans, the chance of banks being replaced is even more remote. With the most advanced technology the chances are slim, because of the time and cost of collecting the information required to locate the optimal place for a deposit, to pool risks with other depositors or to locate the most suitable borrower(s). Any software programme written to undertake these tasks is only as good as its author, and will quickly become dated. Banks are likely to be able to sustain a competitive advantage in an e-cash world because it would be more costly for individuals to replicate the banks’ global risk and information pooling role.

Banks also provide liquidity as a service to their customers. Though technology makes it possible to procure on-line liquidity in the absence of a third party intermediary, changes in liquidity preferences are a different matter. Suppose suitable borrowers are found for depositors, and a term of repayment dates, with interest, is agreed. During the term of agreement, the position of one party is altered: he/she wants the cash earlier or later than agreed. Banks, with a large pool of funds, are able, at a relatively low cost, to satisfy any changes in preferences and to profit from it, either by charging a penalty rate of interest on loan extensions or by reducing the interest paid on deposit, but in cyberspace, in the absence of an intermediary, satisfying changes in consumer preferences becomes far more difficult and costly.

However, the dominance of the payments system by major banks is under threat. Traditionally, the payments system has been a by-product of intermediation, which facilitates the transfer of credits and debits between agents. The growth of electronic delivery of core banking services has already given rise to the emergence of a payments system independent of banks. PayPal is a California-based company that offers business and personal customers a secure means of sending and receiving payments via email. Customers use PayPal if they are reluctant to provide credit card details to unknown internet merchants. Also, for tiny internet firms that cannot afford the cost of offering credit or debit card facilities, PayPal credits them for any purchases made via PayPal. PayPal takes the credit card number and pays for any item on behalf of the customer. Its main source of revenue is fees earned from transactions charges. Its early success was largely due to one major customer – PayPal arranges payments on behalf of e-Bay, an electronic auction site with

40 Another reason would be the traditional use of reserve ratio as a monetary policy tool, which has been abandoned in the developed economies.