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Box 2.3. Is internet banking profitable?

Recent studies by the European Central Bank seem to cast some doubt on the profitability of internet banking. Some banks, they reckon, have overestimated the potential for internet banking, possibly as a result of overconfidence in the so-called 'new economy'. Advertising expenses and initial investments are high, while the number of new accounts may not develop as expected. Customers' habits are difficult to change. Further, concerns about security seem to be restraining the expansion of e- banking. As a result, quite a number of European internet banking and brokering projects are facing serious difficulties or have even been abandoned. Internet banking can lead to a reduction in operational costs since it requires a smaller workforce and no physical branch network. On the other hand, if a strategy of very competitive pricing is used to gain market share, profitability may be threatened. Nevertheless, e-banking continues to have strong potential to help banks reduce their costs and operate more efficiently. European banks seem to be well aware of this potential, as expenditure on e-banking is expected to continue to increase in both retail and wholesale areas.

2.5 Current issues in banking

This part outlines the general trends that have characterised the banking sector in most advanced economies over the last twenty years or so. Many of these trends are still ongoing today and for some emerging and developing countries they have just begun to occur. We first describe the main forces that generate change in the banking sector, such as the deregulation and re-regulation processes, competitive pressures, financial innovation and technological change. We then highlight the main trends resulting from these forces of change, in particular conglomeration and globalisation.

2.5.1 Structural and conduct deregulation

Financial deregulation essentially consists of removing controls and rules that in the past have protected financial institutions, especially banks. Structural deregulation, more generally, refers to the opening up, or liberalisation, of financial markets to allow institutions to compete more freely. Specifically, this process encompasses structure and conduct rules deregulation (such as the removal of branch restrictions and credit ceilings, respectively).

In Europe, the benefits of a deregulated market were first identified by Cecchini's 1988 study on the costs of 'non-Europe', that confirmed the importance of deregulating financial sectors within the move towards creating a single European market for goods, services and capital. Cecchini estimated that up to one-third of the total gains from deregulating all economic sectors

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during the first six years after 1992 would come directly and/or indirectly from deregulating financial services. However, in Europe deregulation was boosted mainly by the need to improve competitive viability of the sector.

Deregulation is typically undertaken to improve the performance of the industry being deregulated. If efficiency is raised, the improvement in resource allocation will benefit society and may lead to price reductions and/or service expansion for consumers if competition is sufficient. However, in many cases deregulation is initiated less by a desire to benefit consumers than by a need to improve the competitive viability of the industry [...] One such example [...] is the harmonisation and unification of banking markets in Europe - removing restrictions that have limited the ability of banks in one country from aggressively entering markets in other countries [...].

Berger and Humphrey (1997, p. 190) There is no doubt that the deregulation process has helped in the ending of 'repressed' banking systems and is most likely one of the major contributors to Europe's single market programme (Dermine, 2002). Furthermore, the wide liberalisation and harmonisation processes at the EU level have contributed in creating a business environment where operational efficiency and technology implementation play key roles in shaping banks' strategies. Hunter et al. (2000) identify three joint effects of deregulation and technology. First, the loosening of banking laws coupled with the advantages of technology (in terms of potential economies of scale and other efficiencies) has encouraged the consolidation process. As a result the number of banks has shrunk virtually everywhere. Second, the introduction of new technologies in a deregulated context intensified competition and improved banks' ability to adjust prices and terms of financial products. Finally, the barriers between bank and non-bank financial institutions disappeared, allowing, for example, the rise of universal banking activity. Major structural deregulation has come a little later in the United States and Japan as witnessed by the repeal of the Glass-Steagall Act in 1999 (via the Gramm-Leach-Bliley Act of 1999 that now allows for the establishment of financial services holding companies that can undertake commercial and investment banking as well as insurance activity) as well as the 'Big-bang' reforms in Japan (also in 1999) that also widen the activities of banks' permissible business.

2.5.2 Supervisory re-regulation

One consequence of the process of deregulation has been the increased perceived riskiness of the banking business. Banks rapidly adapted their portfolios and

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strategies to the new environment and their financial activities increasingly took place outside the traditional bank regulatory framework.

In such a context, even strongly market-oriented systems needed to strengthen supervision. This was considered to be an important element in improving the safety and soundness of the overall financial sector. Re-regulation can therefore be defined as the process of implementing new rules, restrictions and controls in response to market participants' efforts to circumvent existing regulations. Alternatively, it can be viewed as a response to minimise any potential adverse effects associated with excessive competition brought about through structural deregulation. Capital adequacy convergence will become a central issue in the need to help level the 'playing fields' on which international banks compete. This has occurred in the context of a gradual shift from direct forms of control, often at the full discretion of regulatory authorities, to more indirect and objective types of controls.

The process of supervisory re-regulation has been shaped by global pressures. The first efforts to encourage convergence towards common approaches and standards at the international level were initiated by the Basle Committee on Banking Supervision in the 1970s. Since then capital adequacy standards and associated risk regulation have been important policy issues and fundamental components bank prudential re-regulation. For example, at the EU level the two complementary measures to the Second Banking Directive (Own Funds and Solvency Ratio Directives) dealing with capital adequacy can be considered examples of supevisory prudential re-regulation. The rules implementing Basle II are also examples of supervisory re-regulation.

2.5.3 Competition

Before the deregulation process, in most countries, banks were characterised by relatively high levels of government controls and restrictions that inhibited competition and maintained a protected banking environment. For instance, interest rate restrictions and capital controls were widespread, and branchi ng restrictions existed in many countries. The main purpose of these controls was to ensure stability in the system and prevent banking crises.

In the United States for example, the 1933 Glass-Steagall Act forbade banks from underwriting equities and other corporate securities. Typically, commercial banks undertook traditional banking business, namely deposit taking and lending; deposit prices were regulated and there were maximum rates that banks could charge on loans. In Europe there was a similar setting and in most countries

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government controls and regulatory restrictions limited the competitive environment.

This close supervision of the banking sector dominated structural control, which in turn aimed at ensuring the sound functioning of the market and a better allocation of resources. There is no doubt that competitive pressures on banks have increased as a result of structural deregulation and liberalisation of the sector. In most advanced economies banks now are free to set the prices for their services (loans, deposits and other products such as insurance) and they compete with other banks (domestic and foreign) as well as non-bank financial intermediaries.

Technological advances and innovations in the payment systems have helped to reduce the barriers to cross-border trade in banking services, thereby also promoting greater competition. These fundamental forces of change are discussed below.

2.5.4 Financial innovation and the adoption of new technologies

The definition of 'innovation' includes both the concept of invention (the ongoing research and development function) and diffusion (or adoption) of new products, services or ideas.

Financial innovation, like innovation elsewhere in business, is an ongoing process whereby private parties experiment to try to differentiate their product and services, responding to both sudden and gradual changes in the economy. Financial innovation can be defined as the act of creating and then popularising new financial instruments as well as new financial technologies, institutions and markets. Specifically, we can distinguish:

•Financial system/institutional innovations. Such innovations can affect the financial sector as a whole; they relate to business structures, to the establishment of new types of financial intermediaries, or to changes in the legal and supervisory framework.

•Process innovations. These include the introduction of new business processes leading to increased efficiency, market expansion, etc.

•Product innovations. Such innovations include the introduction of new credit, deposit, insurance, leasing, hire purchase, derivatives and other financial products. Product innovations are introduced to respond better to changes in market demand or to improve efficiency.

In a recent study, Frame and White (2002) define a financial innovation as a new product (e.g., adjustable rate mortgages) or service (e.g., online security

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trading), a novel organisational form (e.g., virtual banks), or new processes (e.g., credit scoring) that reduce costs or risks or that improve quality.

Progress in information technology affects all aspects of banking and can be regarded as one of the main driving forces generating change in the sector. Rapid innovation contributes to the dynamic efficiency of the financial sector, which ultimately affects the overall growth of the economy.

Technology reduces significantly the costs of information management (i.e., collection, storage, processing and transmission) and information asymmetries in financial transactions. It can be used as an important strategic tool for banks to safeguard long-term competitiveness, cost-efficiency and improve their profitability. On the customers' side, technological innovation introduces automated channels (e.g., remote banking) that allow the provision of banking services without face-to-face contact between the bank employee and the customer.

In terms of products and services supplied to customers, the most typical innovations in modern banking concern the payment systems and include the use of a wide range of automated channels for supplying and delivering various banking services and activities. Common examples include developments in the use of: debit and credit cards, standing orders and direct debits, automatic teller machines (ATMs) and EFTPOS (electronic funds transfer at the point-of-sale) terminals, internet and PC banking, telephone/mobile banking and digital TV banking.

Innovation has also resulted in the widespread use of new financial instruments like derivative products. Introduced initially to reduce risk through hedging, derivatives like swaps, options and futures are in fact often used for speculative purposes thereby often exposing banks to excessively high risks. This is because they include contingent claims that represent a financial exposure across markets. Moreover, as these types of transactions do not appear on the bank's balance sheet they are often referred to as 'off-balance sheet' (OBS) business.2

Within banking institutions, technology allows for the use of computer software and databases for the management of information. As pointed out by Hunter et al. (2000) the term 'technological change' can refer not only to changes in machines, computer hardware and software, but also to changes in the way that work is organised. Moreover, technology has allowed banks to adopt various segmentation strategies whereby profitable customers are given a wider range of products and less profitable customers are moved towards lower-cost commoditized services.