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Effects of Information Technology on

Financial Services Systems

September 1984

NTIS order #PB85-152619


Recommended Citation:
Effects of Information Technology on Financial Services Systems (Washington, D. C.: U.S.
Congress, Office of Technology Assessment, OTA-CIT-202, September 1984).

Library of Congress Catalog Card Number 84-601102

For sale by the Superintendent of Documents


U.S. Government Printing Office, Washington, D.C. 20402
Foreword
In 1982, the House Committee on Banking, Finance, and Urban Affairs; the
House Committee on Energy and Commerce (expressing the special interest of
its Subcommittee on Telecommunications, Consumer Protection, and Finance);
and the Senate Committee on Banking, Housing, and Urban Affairs requested
OTA to assess the impacts of information processing and telecommunication tech-
nologies on financial service systems. This report presents the results of that work.
The effects of technology on the internal operations, the structure and the
types of services offered by the financial service industry have been profound.
Technology has been and continues to be both a motivator and facilitator of change
in the financial service industry. The structure of the industry has changed sig-
nificantly in recent years as firms not traditionally viewed as financial service
providers have taken advantage of opportunities created by technology to enter
the market. New technology-based services have emerged. These changes are the
result of the interaction of technology with other forces such as overall economic
conditions, societal pressures, and the legal/regulatory environment in which the
financial service industry operates.
This report describes the technologies now and likely to be available to pro-
viders and users of financial services. It analyzes the present structure of the finan-
cial service industry, its service offerings, its relationships with users of financial
services, and observable trends. Implications of possible future trends for industry
structure, markets for financial services, and relationships between the industry
and the legal/regulatory environment are explored.
For the purposes of this report, the financial service industry has been divided
into three segments: 1) retail financial services, 2) the securities industry, and 3)
wholesale financial services. We focus on the opportunities that may be created
for consumers and problems they may encounter as the financial service industry
continues to evolve. Policy questions likely to be of interest to Congress and alter-
natives that are available for dealing with them are identified and analyzed. Finally,
alternative scenarios for the financial service industry of the future are offered.
In performing this assessment OTA relied heavily on published materials and
on other information provided by a variety of persons and organizations. We are
grateful for this support and assistance. Two workshops, one dealing with
technology and industry trends, and the other with consumer issues, provided
much valuable information. Members of the advisory panel were particularly
helpful with their contributions. However, the contents of this report are the sole
responsibility of OTA and do not necessarily represent the views of the members
of the advisory panel or any of the others who have contributed.

JOHN H. GIBBONS
Director

.,.
///
Financial Services Advisory Panel Members

Almarin Phillips, Chairman


Holer Professor of Management, University of Pennsylvania

Donald I. Baker, Esq. Paul Hefner


Partner Senior Vice President
Sutherland, Asbill & Brennan 1st Interstate Bancard
Paul Baran Edward J. Kane
Chairman of Board The Everett D. Reese Professor of
PacketCable, Inc. Banking in Monetary Economics
Ohio State University
Lynne Barr
Partner
Gaston-Snow & Ely Bartlett Jerome Svigals
Electronic Banking Consultant
Robert Capone IBM Corp.
Vice President and Director
J. C. Penney Co., Inc. Willis H. Ware
Corporate Research Staff
Kent Colton The Rand Corp.
Executive Vice President
National Association of Home Builders Steven Weinstein
Vice President–Technology Strategy
Richard J. Darwin American Express
Manager
Battelle Memorial Institute Milton Wessel, Esq.
General Counsel
Gerald Ely ADAPSO
Division Director
Merrill Lynch Capital Market Frederick G. Withington
Vice President, Information Systems
John Farnsworth Arthur D. Little, Inc.
Senior Vice President
Bank of America

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OTA Financial Services Assessment Staff

John Andelin, Assistant Director, OTA


Science, Information and Natural Resources Division

Frederick W. Weingarten, Communication and Information Technologies Program Manager

Project Staff
Zalman A. Shaven, Project Director
Phyllis Orenstein Bresler, In-house Contractor
Margaretta McFarland Rothenberg, Research Analyst
Charla M. Rath, In-house Contractor

Administrative Staff
Elizabeth A. Emanuel, Administrative Assistant
Shirley Gayheart, Secretary
Jennifer Nelson, Secretary
Marsha Williams, Secretary
Renee S. Lloyd, Secretary
Jeanette V. Contee, Secretary

Contractors
Maria T. Arminio, ICS Group, Inc.
Vary T. Coates, J. F. Coates, Inc.
Edwin B. Cox, Arthur D. Little, Inc.
Arthur E. LeMay, SEI, Inc.
Kathryn M. White, Editorial Consultant
Financial Services Industry Consumer Workshop Participants

Stanley Bess Mark Leymaster


Systems Program Manager Staff Attorney
J. C. Penney Co., Inc. National Consumer Law Center
Ellen Broadman Barbara Quint
Minority Chief Counsel Money Management Editor
United States Senate Family Circle
James L. Brown Dale Reistad
Associate Professor of Law Consultant
Director of Center for Consumer Affairs Reistad Corp.
University of Wisconsin-Extension Thelma V. Rutherford
Meredith M. Fernstrom Private Citizen
Senior Vice President-Public Responsibility Michael Van Buskirk
American Express Co. Assistant Vice President of
Edward J. Kane Corporate Affairs
Everett D. Reese Professor of Banking Bane One Corp.
in Monetary Economics
Ohio State University

Financial Services Industry Technology


and Scenarios Workshop Participants

C. M. Baker Frederick R. Levy


Director of Planning Manager of Financial Operations
Navy Federal Credit Union FMR Corp.
Edwin B. Cox Robert Lucky
Senior Management Consultant Executive Director, Research
Arthur D. Little, Inc. AT&T Bell Laboratories
Richard J. Darwin Deborah Smith
Manager Vice President
Battelle Memorial Institute Beneficial Corp.
Ronald Glidden Daniel F. Sullivan
Senior Vice President Senior Vice President, Operations
Life Insurance Co. of Virginia ISFA Corp.
Blake Greenley
Vice President
Citibank N.A.

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Financial Services Reviewers

John B. Benton Arthur LeMay


President President
The ICS Group, Inc. Arthur E. LeMay Co.
Janice Booker Jeffrey A. Lebowitz
Director, Federal Treasury Department Vice President for Strategic Planning
Comptroller of the Currency Federal National Mortgage Association
John Briggs Frederick R. Levy
P. O. S.–Debit Card Project Manager Manager of Financial Operations
Mobile Corp. FMR Corp.
Raymond Cocchi Alan Lipis
Vice President President
National Association of Securities Electronic Banking Inc.
Dealers, Inc. Lois Martin
Dan Eitingon Vice President
President—Chief Executive Officer The First National Bank of Saint Paul
MoneyCare John T. McGee
Jesse Filkins Vice President, Corporate Affairs
Senior Attorney Securities Industry Automation Corp.
Board of Governors of the Federal Reserve Russell Morris
John Fisher Assistant Commissioner, Federal Finance
Vice President Department of the Treasury
Bane One Corp. Michael Radow
Gregory J. Furman Senior Associate
Managing Director of Advertising and Century-IV Partners
Sales Promotion Louise Roseman
New York Stock Exchange, Inc. Regulatory Liaison
Shelley Gross VISA, USA
Vice President, Marketing
Computer Systems & Resources

vii
Contents

Chapter Page
1. Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
2. Present and Future Technologies Supporting the Financial
Service Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
3. The Securities Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
4. Retail Financial Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
5. Wholesale Financial Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137
6. The International Environment for Financial Services . . . 153
7. The Consumer of Financial Services. . . . . . . . . . . . . . . . . . . . . . . . 167
8. Findings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191
9. Policy Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223
10, Future Scenarios for the Financial Service Industry, 1990-95 . . . . . . . . 251
Appendix: Glossary of Terms . . . . . . . . . . . . 267
Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279

ix
Chapter 1

Overview
Major Findings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Industry Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Legal/Regulatory Environment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Financial Service Delivery Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Consumer Interests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Safety and Soundness of the Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

Financial Services in the Future.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7


Influence of Technology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Financial Service Providers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Users of Financial Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

Congressional Policy Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9


General Policy Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Structural Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Risk Allocation Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

Figures
Figure No. Page
l. Organizations Comprising the Financial Service Industry and
Their Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
2. Factors Affecting Financial Service Providers . . . . . . . . . . . . . . . . . . . . . . 4
.— —.

Chapter 1

Overview
This report focuses on the relationship be- The existing legal/regulatory structure has
tween technology and change, both past and roots that extend back 50 years; changes in
future, in the financial service industry. The the financial service industry have challenged
roles of technology as both a motivator and some of its premises. Since the mid-1970’s,
a facilitator of change are analyzed. Other Congress has devoted considerable attention
agents of change are considered only to the ex- to the financial service industry and has en-
tent that they help define the market for new acted several major pieces of legislation. Many
technology or its impact. of the regulations governing the industry are
The financial service industry (see fig. 1) is being relaxed. However, continued congres-
markedly different from what it was at the end sional attention is needed because not all of
of the 1970’s, and the rate of change will only the salient issues have been resolved.
slow slightly during the remainder of the In the last few years, banks legally able to
1980’s. Advancing information and communi- operate outside traditional banking regulation
cation technologies are key factors that have have appeared; retailers of food and general
changed the nature of financial services: the merchandise have emerged as major suppliers
ways in which they are created, delivered, of financial services; changes in law and reg-
priced, received, and used. Relationships be- ulation have enabled banks, savings and loan
tween and among users and providers of finan- associations, and credit unions to broaden the
cial services are changing. mix of services they offer and enter markets
previously closed to them. At the same time,
Figure 1 .—Organizations Comprising the Financial
Service Industry and Their Products firms whose financial service offerings are vir-
tually unregulated compete directly with tradi-
Financial service providers: tional, regulated providers.
Banks Data processing
Thrift institutions Telecommunications Information processing and communication
Dry goods merchants Insurance companies technologies are being used to enhance exist-
Credit card providers Etc.
ing services, to implement new ones, and to
make them available in new ways. Money mar-
ket mutual funds, operated by investment
companies and securities broker/dealers, per-
mit shareholders to redeem shares by writing
the equivalent of a check. Banks, depending
heavily on information processing and commu-
nication technologies, are beginning to offer
securities through discount brokerage sub-
sidiaries. Banks, credit unions, and savings
Financial service Industry products: and loan associations join networks of auto-
Credit Debit cards
Deposit-taking Check authorization cards mated teller machines that enable account
Brokerage Information services holders to obtain cash 24 hours a day from
Investment Payment machines that are available nationwide. Both
Credit cards Insurance
securities dealers and banks have developed
SOURCE Office of Technology Assessment systems that allow account holders with per-

3
4 • Effects of Iformation Technology on Financial Service Systems

sonal computes to transfer funds between ac- financial service industry. However, other fac-
counts, pay bills, and order the purchase and tors such as the legal/regulatory environment,
sale of securities. general economic conditions, and the demands
Observers consistently and correctly point of users have also had significant impact on
to technology as a key factor responsible for the industry (see fig. 2).
the rapidity and magnitude of change in the

Figure 2.— Factors Affecting


Financial Service Providers

Financial service providers

I I

Users of financial service

SOURCE: Office of Technology Assessment.

Major Findings
The changes that have taken place in the fi- ably over the coming decade, after which
nancial service industry affect a number of the financial service industry is likely to re-
areas including industry structure, the legal/ turn to a more orderly evolutionary pattern.
regulatory environment, financial service de- ● Firms are in the process of broadening the
livery systems, consumer interests, and the scope of their service offerings, a trend that
safety and soundness of the industry. Major will continue during the coming decade. The
findings in each of these areas are summarized future mix of financial services offered by
below. each class of provider will be much different
from what it is now. Some will offer the full
Industry Structure range of financial service including taking
deposits, extending credit, underwriting in-
● Rapid and dramatic change in the financial surance and securities offerings, and secu-
service industry will not persist indefinitely. rities brokerage. Others will target narrowly
There will be a period of stabilization, prob- defined markets such as serving the needs
Ch. l—Overview ● 5

of medical and legal professionals. Data the 1930’s. Technological, social, and eco-
processing and communication services are nomic factors are causing considerable
likely to be increasingly important offerings change in the types of services offered, the
by financial service firms. types of firms offering them, and the de-
So long as firms can continue to enter the mands of the consumer. In light of the
financial service industry with ease, the changes that have taken place, this may be
likelihood of the industry becoming domi- the time to reconsider the overall legal/reg-
nated by a small number of providers is ulatory structure governing the financial
minimal. service industry.
Because of the affordability of information ● Policies that have assumed a specific indus-
processing and telecommunication services try structure or service mix seem to be par-
for firms of all sizes, access to technologies ticularly vulnerable to unanticipated effects
does not constitute a barrier to entry into when new technologies are introduced. For
financial service markets. Technology may example, the assumption that only banks
actually facilitate entry. A small firm, by will take deposits was undermined by the
obtaining communication and processing application of technology by firms other
services from others can enter a market and than banks to support offerings such as the
compete with firms many times its size. On money market account.
the other hand, if the existing accessibility ● Some recent changes in State banking law
of processing services does not continue, en- modify the way in which Federal law affects
try into the financial service industry by financial service institutions. In the past,
small firms may be foreclosed. States have generally supported policies for
The ability to move information quickly, re- the financial service industry consistent
liably, and accurately is essential to success with those of the Federal Government. This
for both providers and users of financial is no longer always true. Some banking or-
services. Organizations controlling exten- ganizations have established subsidiaries in
sive distribution and/or communication sys- States that have adopted policies favorable
tems are entering and will continue to en- to them and use information processing and
ter markets as providers of financial telecommunications to distribute services
services. nationwide.
By facilitating the flow of information na-
tionwide, information processing and tele- Financial Service Delivery Systems
communication technologies have contrib-
uted to the development of national markets ● Financial service providers have used infor-
for financial services. Investors and users mation processing and communication tech-
of capital benefit to the extent that their of- nologies to overcome some of the limita-
fers receive broader exposure than they tions, such as those restricting interstate
would in a local or regional market. On the banking, imposed on them by law and reg-
other hand, market conditions are not uni- ulation. This has lessened distinctions be-
form nationwide; and opportunities may be tween various classes of financial service
more favorable in some areas than in others. providers, allowed the entry of firms not
Thus, there is a possibility that the exist- previously classed as financial service pro-
ence of national capital markets will draw viders into the financial service industry,
funds from some regions and cause their and allowed banks to enter into new busi-
needs to remain unfulfilled. nesses such as the operation of data proc-
essing service bureaus.
Legal/Regulatory Environment
● Telecommunication policy is a major factor
determining the price to the user of telecom-
The legal/regulatory structure now govern- munication services. Because telecommuni-
ing the financial service industry dates from cation is a key component of financial serv-
6 ● Effects of /formation Technology on Financial Services Systems

ice delivery systems, telecommunication services if they are to be able to function


policy directly affects the design and via- as members of society.
bility of those systems. ● Survey data show that consumers are con-
cerned with the effects of changes in the fi-
Consumer Interests nancial service industry on their ability to
preserve personal privacy. Privacy issues,
• Because financial service providers are now on the other hand, are not presently promi-
able to use price as an instrument for com- nent on the congressional agenda. If in-
petition, more and more financial services cidents of compromised privacy are widely
will be priced explicitly. “Free” checking ac- reported in the future, it may again be a
counts will disappear; brokers are likely to focus of public policy debate.
specifically charge for advisory services. ● In many cases, a financial institution has
Customers may be offered an increased no document bearing an authorizing signa-
range of choice and may pay only for serv- ture that can be reviewed before an elec-
ices used. However, the elimination of some tronically issued order is executed. Errors
of the subsidies once hidden in “free” finan- in electronic financial systems may only
cial services may not be popular. The true become visible on the periodic account
costs of meeting the financial service needs statement. Therefore, customers of elec-
of society will be more easily recognizable. tronically delivered financial services bear
● There is increased flexibility in selecting fi- greater responsibility for detecting errors
nancial services and the types of institu- and initiating the procedures for correcting
tions from which they are obtained as a re- them than do customers using paper-based
sult of the trend to explicit pricing and the systems.
entry of new providers into the financial
service industry. However, to take advan- Safety and Soundness of the Industry
tage of these opportunities, consumers must
be sufficiently familiar with the available Increasing use of information processing
options. Many have taken advantage of new and communication technologies requires
options they perceive to be in their interests. that both providers and users take precau-
● In spite of broader choices of services and tions to ensure the integrity and security
institutions, some consumers are finding of financial service delivery systems. Al-
their options constrained. Checks, for exam- though the use of technology may improve
ple, often are no longer an acceptable pay- some aspects of the security and integrity
ment medium unless the person can also of financial services systems, new vulnera-
present one or more credit cards to demon- bilities maybe introduced. Computer-based
strate financial responsibility. Some con- authorization systems reduce the oppor-
sumers are not welcome as clients to some tunity for fraudulent use of stolen credit
financial service providers. Some may pre- cards. However, if an account number is
fer to avoid financial institutions but find compromised without the knowledge of the
that increasing use of technology-based fi- legitimate owner, its fraudulent use may not
nancial service systems propels them to- be discovered until a statement is received.
wards becoming clients of financial service Thus, the perpetrator may have a signifi-
providers. Lack of access to some financial cant period after obtainin g an account num-
services may implicitly limit or deny access ber to commit fraud with relatively little
to other goods and services (e.g., it is cur- chance of detection.
rently very difficult to rent a car if you do The existing regulatory structure promotes
not have a major credit card). At some safety and soundness of the financial serv-
point, consumers may require guaranteed ice industry by providing Federal insurance
access to some minimal level of financial for funds deposited in many banks, savings
Ch. 1—Overview ● 7

and loan associations, and credit unions. vestments that offer higher return. Yet,
Funds entrusted to other institutions re- based on experience to date, there is no
ceive little, if any, of this Federal protection. evidence that the fundamental safety and
The changes in the financial service indus- soundness of the industry have been appre-
try have led to significant movement of ciably compromised by the movement of
funds from accounts in insured, closely funds from federally insured accounts.
supervised institutions to alternative in-

Financial Services in the Future


Forecasts of the financial service industry represents many points of view now held by
prepared over the last 10 to 15 years have not knowledgeable observers.
been particularly accurate. Many of the earlier
efforts foresaw the virtual elimination of the Influence of Technology
check and significant decrease in requirements
for currency and coin during the last quarter The financial service industry of the future
of this century. Some saw particular promise will be quite different. The established trend
in specific technology-based services (e.g., of increasingly heavy dependence on technol-
super-check, an instrument that would use one ogy for delivering services will continue. Serv-
order to direct payment to multiple creditors, ices will be provided by a wide variety of in-
and telephone bill payment) that has not yet stitutions. Barring a major restructuring of
been realized. the wholesale side of the financial service in-
dustry, small financial service firms will be
Experts continue to prepare forecasts for
able to obtain access to the technologies they
the financial service industry. Firms continue
will require to remain viable. Although rela-
to develop and bring to market what they be-
tively few firms are likely to provide service
lieve to be promising services. Some are la-
nationwide, it is likely that the existence of a
beled experimental while others are designated
large number of small, specialized financial
as operational systems. Although forecasters
service organizations will prevent the few from
appear to have developed more realistic pic-
dominating the market.
tures of future markets for financial services
than were available in the past, much uncer- Communication will be key to delivering fi-
tainty remains. nancial services in the future. Networks grow-
ing out of those used to connect shared sys-
Experience to date will not support an at-
tems of automated teller machines are likely
tempt to develop a detailed picture of the fi-
to provide the basis of systems permitting
nancial service industry of the future, but
electronic initiation of fund transfers from the
some general trends (e.g., ever-increasing use
merchant’s counter. Systems providing access
of advanced technology to deliver financial
to funds from virtually any place in the Na-
services) are clearer now than they have been.
tion regardless of where they are deposited are
For example, there is little doubt among in-
now being developed and are likely to be in use
dustry observers that customers will elec-
in the next few years. Advanced communica-
tronically order the immediate transfer of
tion technologies including satellite relays,
funds from their accounts to those of mer-
video cable, fiber optics and cellular radio will
chants at the time purchases are made. How-
find wide application in the financial service
ever, the specifics of the systems that will be
industry.
used to implement this service remain open to
question. OTA’s analysis of general trends be- Decreasing computer costs will create the
ing followed by the financial service industry opportunity for large numbers of individual

35-505 0 - 84 - 2 : QL 3
8 ● Effects of Information Technology on Financial Services Systems

consumers and managers of small businesess Firms that have established information
to take advantage of technology in using fi- processing and telecommunication facilities
nancial services. Large computers will be used are likely to be particularly active in the finan-
to support the data bases and the communi- cial service industry. New entrants into the in-
cation processing needed to operate the large, dustry will have roots in such varied areas as
interactive financial service delivery systems retail food and dry goods merchandising, pe-
of the future. Computers that accept voice in- troleum production and distribution, and com-
puts and recognize fingerprints may become munications. Traditional providers of financial
cost effective for financial service delivery sys- services are likely to continue the present
tems by the turn of the century. Small, inex- trend toward diversifying their offerings, often
pensive personal computers in both home and entering into areas that have been closed to
office will make it possible for customers to them in the past.
interact with a multiplicity of financial serv-
ice offerors. Computer processor and memory Users of Financial Services
chips imbedded in plastic cards may find wide
spread use in the financial service industry. Financial services will be delivered to the
customer at a convenient location with little
Financial Service Providers need for clients to visit the offices of a finan-
cial service provider. The present tendency of
Banks, savings and loan associations, and corporate financial officers to use terminals in
credit unions probably will concentrate on their offices to manage funds will extend to
transaction processing and place less empha- smaller businesses. Although the trend is not
sis on gathering deposits and providing financ- yet clearly established, individual consumers
ing. Emphasis will be placed on computer and are likely to use home terminals to interact
telecommunication-based systems for deliv- with financial service delivery systems.
ering financial services. Included in the serv- Consumer financial service packages are
ices offered will be data processing, securities likely to be offered in conjunction with other
brokerage, and, possibly, insurance. In the information-based consumer services such as
future, branches will be dominated by a vari- home shopping, investment advisories, recrea-
ety of machines the consumer will use to di- tional services such as computer games, travel
rectly interact with financial service systems. reservations, and the purchase of tickets to
Institutional personnel will serve more of an sporting and theatrical events. Financial serv-
advisory role and handle customer transac- ice institutions may develop and operate the
tions, such as payments and withdrawals, only network used to distribute these services or
in exceptional cases. they may participate in networks assembled
Securities broker/ dealers, long providers of and operated by others.
transaction services, will compete directly Consumers may use terminals to order
with banks, savings and loan associations, and banks to pay bills or to purchase securities.
credit unions in many areas. Today they al- They may enjoy more flexibility in services
ready offer a variety of services such as money used. For example, rather than carrying a
market funds that are designed to give the fixed amount of insurance, a terminal could
customer ease of access to financial assets. be used to vary it in response to changing
This trend will continue, and the future is needs (e.g., increasing coverage for theft while
likely to see higher levels of activity by secu- jewelry is kept at home rather than in the bank
rities broker/dealers in processing an increas- vault). Orders to buy or sell stocks and bonds
ingly broad variety of transactions. Retailers could be entered from home and executed on
of food and general merchandise and possibly an automated exchange. Consumers may use
other types of organizations will be attracted home information systems to analyze their fi-
to the financial service industry. They will see nancial positions and to help make decisions
opportunities to profitably apply technologi- on investment opportunities. Using these and
cal resources which are in hand or within reach other capabilities will give the consumer
to offer transaction processing services. greater personal control over his assets.
--

Ch. 1—Overview ● 9
—————

Consumers may find that they need an ac- Although technical differences will remain,
count with a financial institution to have ac- operational distinctions between services of-
cess to a variety of services. Some employers fered by various classes of providers will
may require direct deposit of payroll checks. diminish. It will be more difficult for users to
Alternatively, employers may offer employees differentiate between them. For example,
the option of writing checks against salary though a money market fund offered by a
held in a company account in return for being securities dealer is quite different from a de-
paid daily. Consumers may need an account mand deposit offered by a bank, both meet
to be able to use shop at home and travel res- similar needs for consumers as accounts from
ervation services. which funds can easily be withdrawn.

Congressional Policy Issues


The results of changes already observed in 1990’s. Although Congress has commissioned
the financial service industry and those pos- comprehensive reviews of the financial serv-
sible in the future are not consistent with some ice industry and the legal/regulatory structure
of the key assumptions underlying the pres- governing it and has addressed some specific
ent Federal policy structure. Growing direct changes in the industry, legislation revisiting
competition between banking and the securi- the fundamental premises of existing policy
ties industry, the appearance of new classes has not been enacted.
of financial service providers, and the changes
One alternative is continuation of the pres-
following from rapid increase in reliance on ad-
ent approach of incrementally adjusting the
vanced technologies to deliver financial serv-
policy framework as the financial service in-
ices exemplify shifts that have taken place.
dustry continues to evolve. Some of the steps
Therefore, Congress is faced with significant
taken using this approach are in anticipation
questions about the relevance and utility of
of future events; others are taken in response
present public policy. In addressing these
to events in the marketplace. Alternatively,
questions, Congress will find it necessary to the entire legal and regulatory structure gov-
resolve conflicts between the need to reconcile
erning the financial service industry could be
conflicting interests, on the one hand, and to reviewed and recast in a form deemed suitable
create a climate conducive to the development
in light of expectations for the future.
of new financial services and delivery systems
beneficial to both users and providers on the
other. Implementation of Policy
General Policy Considerations ● What are the mechanisms available to Con-
gress for implementing policy pertaining to
Restructuring the Policy Framework the financial service industry?
● What are the alternative approaches that Historically, Congress has implemented pol-
could be used if a review and restructuring icy for the financial service industry through
of laws and regulations related to financial one of the most pervasive regulatory struc-
services were undertaken? tures applied to American industry. Public pol-
The financial service industry has changed icy has focused on ensuring the safety and
since the 1930’s when most of its present pol- soundness of financial institutions because of
icy structure was developed. Rapid change, en- their unique role in society. To this end, the
couraged by technology and other market assets of the clients of many financial service
forces, is expected to abate in the 1980’s or institutions, particularly banks, have been pro-
10 . Effects of Information Technology on Financial Services Systems

tected through a combination of insurance and Technology-based financial service systems


examination programs. However, new en- are changing the nature of competition within
trants into the financial service industry, the industry. Financial institutions are enter-
many of whom are subject to neither Federal ing new markets and competing both among
nor State regulation, now compete with regu- themselves, and with other industries, more
lated traditional financial service firms. Be- deliberately and directly than ever before. New
cause the nature of competition in the finan- entrants are providing services in areas that,
cial service industry has changed, traditional in the past, have been reserved to traditional
protections implemented through existing reg- financial service institutions. In the face of
ulation have lost some of their effectiveness. technological change and competition, merg-
ers involving both traditional financial serv-
Regulations applicable to the financial serv-
ice providers and new entrants have taken
ice industry have been eased in recent years.
place. It is possible that these changes will re-
Controls on interest rates have been relaxed
sult in a net reduction in the number of pro-
and bank holding companies have become
viders and will reduce competition in the fi-
freer to broaden the lines of services (e.g., data
nancial service industry. Some observers are
processing) they offer.
concerned that this could lead to excessive
As Congress continues to develop and refine concentration of economic power.
policy for the financial service industry, one Congress may find that in light of other
of the tools at its disposal is its ability to vary trends affecting the financial service industry,
the degree of regulation applicable to pro- the trend toward greater consolidation in the
viders of various financial services. Alter- industry is acceptable. Alternatively, it may
natively, it may modify the outcomes of mar- use one of several available strategies to limit
ket forces to mitigate adverse affects on consolidation. For example, specific criteria for
specific groups. For example, if the market controlling entry to and exit from the indus-
were to compel individuals to have at least one try could be established.
account with a financial service provider, Con-
gress might choose to provide a means for en-
suring that all are able to obtain a satisfactory Restrictions on Interstate Banking
package of services. ● What modifications, if any, could be insti-
tuted regarding restrictions on interstate
Structural Issues banking?
Consolidation in the Financial Service Industry While Federal law limits interstate branch-
ing by institutions allowed to take deposits,
● What levels of concentration in the finan-
it does not prevent interstate activities by
cial service industry are consistent with the
these organizations. Banks have established
goal of preserving competition among pro-
interstate networks of offices that market
viders of financial service?
services other than deposit-taking, such as
There are 40,000 banks, savings and loan as- lending. Some financial institutions have used
sociations, and credit unions in the United technology-based delivery systems to circum-
States. Thousands of other organizations in- vent these restrictions and some States have
cluding securities broker/dealers, consumer fi- passed laws that permit regional interstate
nance companies, merchants, and insurance banking. Federal law now permits acquisition
companies also provide financial service. A of one financial institution by another in a dif-
goal of Federal financial services policy has ferent State under specified circumstances.
been to preserve competition and prevent con- Unregulated competitors of depository insti-
centration in that industry. tutions are able to establish offices without re-
Ch. 1—Overview • 11

gard to geographic boundaries and, hence, petitors because of the regulatory structure
may offer services nationwide. within which they must operate.
Available options for Congress include re- Congress may choose to resolve this issue
tention of present policies with respect to in- by permitting banks and other institutions to
terstate operations of financial service orga- offer financial services that range over a broad
nizations, reducing or removing restrictions spectrum, enabling them to be more respon-
completely, or making restrictions more inclu- sive to competitive offerings of others. Bank
sive than they are at present. For example, all powers could be broadened to include the
institutions that offer deposit-taking services underwriting of securities and insurance, for
could be made subject to restrictions on inter- example. Alternatively, powers to affect merg-
state operations. Loopholes in existing law ers between financial service providers and
and regulation could be closed. Restrictions firms from outside the financial service indus-
on interstate deposit-taking through auto- try could be modified. To an extent, this would
mated teller networks could be relaxed. represent a continuation of current practice in
which the Federal Home Loan Bank Board has
Limitations on interstate banking stemmed, permitted mergers across State lines between
in part, from concerns that some banks serv- savings and loan associations. Under the pro-
ing regional or national markets could achieve visions of the Garn-St Germain Act of 1982,
an unwarranted degree of economic power and banks have been permitted to acquire dis-
that local needs for capital would remain un- tressed, out-of-State savings and loan associ-
met as funds were concentrated in major mon- ations.
ey centers. An alternative for addressing the
latter would be to strengthen requirements A third alternative would see the implemen-
that institutions taking deposits meet needs tation of policy encouraging financial service
for credit of the area from which deposits are providers to engage in activities with clear so-
gathered before funds are made available to cial benefits. Examples would be incentives en-
regional or national markets. couraging all providers of financial services
to finance home ownership and educational
Market Segmentation programs.

● How might law and regulation be used to Relationship to Telecommunication Policy


focus the attention of various classes of fi- ● How will further deregulation of telecom-
nancial service providers on specific market munications affect the financial service in-
areas? dustry?
The existing policy structure more or less Financial service providers depend heavily
compartmentalizes the financial service indus- on telecommunications to deliver services to
try by function. Banks may take deposits, in- their clients; and, therefore, they are sensitive
surance companies may underwrite insurance. to changes in that industry. Many have built
Insurance companies may not take deposits and operate sophisticated private telecommu-
and banks may not underwrite insurance. nication networks. Without adequate telecom-
Nevertheless, new entrants to financial serv- munication capabilities, the financial service
ice markets have been able to offer services industry cannot meet the needs of its clients.
in direct competition with those for whom, in Changes in telecommunication costs have a di-
the past, specific market segments had been rect and immediate effect on both providers
reserved. Operators of investment funds, for and users of financial service.
example, offer services that share many fea-
tures of deposit accounts offered by banks. In The telecommunications industry is under-
some instances, the traditional providers have going fundamental changes that are altering
been unable to respond fully to their new com- the nature of the services available to its cus-
tomers and the prices that will be charged. As
12 . Effects of /formation Technology on Financial Services Systems

financial service delivery systems designed for defer to the States for all regulation of finan-
direct interaction with customers become cial services. At the other extreme, Congress
more commonplace, relationships between the could preempt all State regulation of the finan-
product mix, operating characteristics and cial service industry. Regardless of the level
structure of the telecommunications industry, of the Federal presence, and in contrast with
and the operations of the financial service in- the present practice of distributing responsi-
dustry will become closer. bility, all Federal regulation of financial serv-
ices could be combined and assigned to a sin-
The formulation of telecommunication pol-
gle agency. The focus of regulation could be
icy is extremely complex and beyond the scope
shifted from the institutions providing serv-
of this report. However, Congress should re-
ice to the functions performed regardless of
main aware that telecommunication policy
the nature of the organization performing
directly influences the economics of financial
them. For example, rather than regulating
service delivery systems and, hence, the mix
banks as a means of controlling deposit-tak-
of financial services that will be offered.
ing, regulate all organizations that perform the
deposit-taking function regardless of the other
Competition Between Regulated and
lines of commerce in which they may have in-
Unregulated Service Providers terests.
● What steps could be taken to realign the
legal/regulatory structure to make it con-
Barriers to International Operations
form more closely to the changing structure
of the financial service industry? ● The concerns of foreign governments re-
garding the protection of individual privacy
Many financial services offered by unregu-
could lead to the erection of barriers for
lated firms are comparable to those marketed
American financial service firms doing busi-
by regulated institutions. For example, money
ness overseas. What steps could the United
market mutual funds marketed by securities States take to address these concerns or cir-
dealers have attributes in common with some cumvent the barriers?
of the various checking accounts offered by
banks. Retailers of food and general merchan- Foreign government implementation of per-
dise are building networks of automated teller sonal privacy protection programs, some of
machines and networks to communicate pay- which are more stringent than those of the
ment data in direct competition with those United States, may restrict the international
built and operated by financial institutions. operations of American financial service pro-
While the user may not perceive any real dif- viders. Some nations have suggested that they
ference between the offerings of various finan- may limit the movement of personal data
cial service providers, in some circumstances across their borders to and from others that
the existing legal/regulatory structure does do not meet their standards for privacy pro-
not cover the activities of non-traditional pro- tection. The United States may find the oper-
viders. Users of these unregulated services ations of its financial service industry limited
often do not receive the same protections pro- by privacy policies of foreign governments.
vided with services offered by regulated insti-
Congress, in considering this issue, may
tutions.
choose to continue the present course and to
Congressional options for addressing this not expand the privacy protections now in
question range over a broad spectrum. The place. Alternatively, it may adjust privacy law
present dual system of regulation by both the as it relates to financial services as a means
Federal Government and the States could be of reducing potential barriers to American fi-
continued. Alternatively, Congress could fol- nancial service providers other nations may
low the model for the insurance industry and raise.
Ch. l—Overview ● 13

Access to the Clearing Systems Risk Allocation Issues


● What organizations could be granted access Control of Interest Rates
to the mechanisms for clearing checks, se-
curities, and other payment instruments ● What alternatives for regulating interest
such as credit card drafts? rates are available to Congress?
Banks and savings and loan associations are Federal controls on the interest rates paid
the only institutions with direct access to the by federally insured institutions are being
payments system. This may give them a com- phased out. States impose limits on the inter-
petitive advantage over other offerors of est rates that may be charged on some types
checking account substitutes, credit cards, of loans. In recent years, when market rates
and debit cards. Some securities brokers of- have exceeded both Federal and State limits,
fer accounts from which funds may be drawn significant quantities of funds have moved
by either a paper draft or debit card and other from banks, credit unions, and savings and
organizations, such as the American Automo- loan associations to alternative investment op-
bile Association which offers VISA, issue bank portunities created by new entrants to the fi-
credit cards. However, offerors of payment in- nancial service industry. These new entrants
struments that are neither banks nor savings have relied heavily on advanced telecommu-
and loan associations, almost without excep- nication and information processing tech-
tion, must obtain payment-processing services nologies to implement their offerings. Con-
from an institution that has access to the pay- strained interest rates effectively limited the
ments mechanism. supply of funds to some classes of investments.
In many cases, policymakers have reacted to
In light of the technologies now available, these movements by changing the legal limits
some argue that other types of institutions on interest rates paid and charged.
should also be granted access to the payments
mechanism. One major merchant is now per- Congress may choose to ensure total decon-
mitted to enter transactions into one of the trol of interest rates by preempting State
bank card networks without using the serv- usury laws. Alternatively, the same mecha-
ices of a financial institution. Conceivably, the nism could be used to establish uniform, reg-
future could see the development and opera- ulated interest rates nationwide. Other al-
tion of significant systems for transferring ternatives include maintaining controls on
funds without the involvement of banks and interest rates paid on federally insured ac-
other traditional providers of payment counts and ceding to the States control of all
services. interest rates paid within their boundaries.
The Federal Reserve System was estab-
lished, in part, to assure smooth operation of Allocation of Risk
the check-processing system. Congress may
● What are the alternatives for apportioning
decide that the operability of the payment sys-
risk between financial institutions and their
tem can only be assured if it remains under
customers and clients?
control of the banks and savings and loan as-
sociations. On the other hand, Congress may Deposit insurance protects holders of ac-
choose to open access to the payment system counts in covered institutions from loss of
to others, such as data processing service or- assets up to the limits of the insurance. Al-
ganizations, willing to meet specific criteria. though some noninsured accounts share many
Or, it may open the system to all who would of the attributes of insured accounts, because
join without establishing specific criteria for the account holder is not protected from loss
membership. of principal, they often carry a higher level of
14 . Effects of Information Technology on Financial Services Systems

risk for account holders. However, because Congress, in approaching this issue, may
Federal agencies that insure deposits have pre find it necessary to define a minimal set of fi-
ferred to find merger partners for distressed nancial services needed by virtually the entire
institutions instead of closing them, deposit populace. It may then wish to specify alter-
insurance has implicitly provided protection native institutional structures that could be
for stockholders and holders of large depos- used to deliver such a package of services in-
its as well as the owners of accounts with cluding the possibility that all providers of
balances below the limits of insurance cover- transaction accounts be required to offer the
age. Some argue that managers of financial in- “lifeline” package. Congress may wish to de-
stitutions take unjustified risks because they fine the rights of consumers to payment serv-
feel they are implicitly protected by deposit ices and the information regarding them that
insurance. It has also been suggested that needs be provided to users. Consideration of
depositors and others with whom an institu- a policy that would govern the timing of debits
tion deals do not review the condition of the and credits to an account to ensure equitable
institutions with which they conduct business treatment of consumers may be advisable.
as carefully as they might because of the pres-
ence of deposit insurance. Privacy
Deposit insurance has been key in the pol- ● Some changes in the delivery of financial
icy framework designed to sustain the safety services increase the possibility that the pri-
and soundness of the financial service indus- vacy of citizens could be eroded or violated.
try. Congress may choose to continue it in its How can Congress reduce that possibility?
present form where the same insurance rates Systems that use information processing
apply to all covered institutions. Alterna- and telecommunication technologies for deliv-
tively, the premiums charged insured institu- ering financial services gather data more rap-
tions could be modified to reflect the level of idly and make it more accessible than do
risk the insurance program is required to paper-based systems. Information on the fi-
underwrite. Further, deposit insurance could nancial activity of individuals can be ac-
be extended to accounts not now covered. cumulated and used without their knowledge
or consent. Existing law provides some pro-
Lifeline Financial Services tection from intrusion on financial data by the
Federal Government, but virtually no protec-
● What is necessary to assure an adequate tion from the use of this information by State
level of financial service to all segments of and local governments or private parties and
the population and to protect other basic organizations. Increasing use of electronic sys-
consumer rights and interests? tems for delivering financial services exacer-
bates potential threats to individual privacy.
Individuals who so choose have been able
to avoid dealings with providers of financial One alternative open to Congress is to ex-
services. However, the ability of consumers to plicitly define the rights of citizens to privacy.
avoid dealings with the financial service indus- Because users of financial services must, by
try is being limited by such factors as pres- the nature of the systems used to deliver them,
sure from employers and government to ac- surrender privacy to a degree, Congress may
cept payments by direct deposit and the choose to require they be provided a statement
increasing role of the credit card as an item disclosing the degree to which privacy is likely
of identification. In the future, it is likely that to be compromised. A program of monitoring
access to some minimal set of financial serv- and enforcing rights to privacy might be es-
ices will be essential for all citizens. tablished.
Ch. 1—Overview ● 75

Security and Integrity of Delivery Systems Vulnerability of Financial Service Systems


to Theft
● Are additional actions needed to safeguard
the integrity of national payment and trans- • What alternatives are available for control-
action systems against risk of disruptions ling the risk of theft from or associated with
from systems failure, hostile attack, and financial service institutions?
natural disasters?
Theft of assets is a constant threat for fi-
System security and integrity have always nancial service providers and their clients.
been of paramount concern to the financial New combinations of telecommunication and
service industry. Both paper-based and elec- computer processing for delivering financial
tronic systems for delivering financial services services provide new avenues for theft. As
are vulnerable to attack from the outside and safeguards are put in place, new methods of
to systemic failure. While electronic systems perpetrating crime against financial service
overcome some of the vulnerabilities inherent systems are found. Some of them, theft of data
in paper-based systems, new problems are in- under some circumstances for example, are not
troduced. Continued operability of many ma- clearly covered by existing law. Some financial
jor computer-based systems can only be service providers are hesitant to report inci-
assured through the availability of redundant dents of theft involving technology-based sys-
automated systems. In these cases, some sys- tems in fear both of lessening the confidence
tem failures can threaten the existence of a fi- of their customers and of revealing system vul-
nancial institution since manual processing is nerabilities to potential predators.
not possible in the event that a primary auto- In dealing with this issue, Congress may
mated system fails. For example, if a bank is continue to rely on existing law and law en-
unable to perform routine transaction process- forcement capabilities. Because the issue is not
ing because of a system failure, it may not be well understood, Congress may wish to gather
able to settle its accounts with other institu- additional information regarding the problem
tions on time and, as a result, may fail. and alternative solutions either before acting
Although recognition of the problems of sys- or following initial steps to deal with the most
tem security and integrity is becoming more salient aspects of the issue. In the short term,
widespread, its true magnitude is not known. it may modify the law to more clearly deal
Additional information is needed before rea- with the obvious problems (e.g., clarifying the
sonable public policy alternatives can be iden- treatment of those who steal data) that have
tified. Therefore, Congress may wish to either accompanied the inclusion of advanced tech-
hold hearings or establish a national commis- nologies in systems for delivering financial
sion to assemble additional information prior services. Additional resources and technologi-
to undertaking a specific legislative program. cal capabilities could be made available to law
Possibly the Federal Emergency Management enforcement authorities. Penalties against
Agency could help meet this need for infor- both the perpetrators of crime and those that
mation. conceal it could be increased.
Chapter 2

Present and Future


Technologies Supporting the
Financial Service Industry
Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

Computer Hardware Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20


Microcomputer Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Large Computer Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Future Computer Hardware . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

Software . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Present Applications Software . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
Applications Software in the Future.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

Telecommunications Technologies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
The Switched Telephone Network . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Private-Line Telecommunications Facilities . . . . . . . . . . . . . . . . . . . . . . . . . 32
Alternatives to Switched Networks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
Video-Related Communication Technologies . . . . . . . . . . . . . . . . . . . . . . . . 33
Future Telecommunication Technologies . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

System Security and Integrity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36


System Security. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
System Integrity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38

Specific Technologies for Delivering Financial Services . . . . . . . . . . . . . . . . . 38


Card Technologies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
Document and Currency Readers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
Customer Service Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42

Technology and the Structure of the Financial Service Industry . . . . . . . . . 43

Appendix 2A: Hardware Components . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44


Chip Technology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
Computer Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

Appendix 2B: Systems and Support Software . . . . . . . . . . . . . . . . . . . . . . , . 45


Present Operating and Support Systems . . . . . . . . . . . . . . . . . . . . . . . . . . 45
The Future for Operating and Support Systems. . . . . . . . . . . . . . . . . . . . . 46

Table
Table No. Page
l. General-Purpose Application Processors . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Chapter 2

Present and Future Technologies


Supporting the Financial Service Industry

Introduction
Quite simply, the financial service industry the annual rate of growth in the number of
could not provide the level of service it does checks slowed, from about 7 percent to about
without the support of advanced information 5 percent. The fact that many are unwilling
processing and telecommunication technolo- to forgo return of the physical check to retain
gies. The numbers of checks (over 37 billion as proof of payment limits the possibility of
annually), credit card drafts (over 3.5 billion implementing meaningful check truncation
annually), and securities trades (over 30 bil- programs. Similarly, many still take delivery
lion shares traded annually) would swamp any of physical stock certificates, even though
manual system that tried to handle them. In book-entry systems for recording the stock
fact, during the 1960’s, trading days for the ownership provide an alternative.
New York Stock Exchange were shortened be-
In the future, the costs of hardware used to
cause the broker/dealers were unable to han-
implement advanced systems for delivering fi-
dle the workload.
nancial services will continue their long-term
Yet, even with all of its sophistication in the decline. New technologies such as the proc-
application of technology, the financial serv- essor in a card and new systems to establish
ice industry has not yet exhausted the poten- the authenticity of the order to execute a fi-
tial of the technologies now available. Even nancial transaction will become available. In
though large computers support check reader/ general, the ability of the financial service in-
sorters handling thousands of items a minute, dustry to take advantage of the technology is
all other aspects of check processing are man- not likely to approach the rate at which it
ual, and telecommunications is not used in the becomes available. There is little chance that
check-processing cycle. Checks are still man- technology will limit the industry any time in
ually encoded with the amount by proof oper- the foreseeable future.
ators at the bank of first deposit or, in return
Historically, the initial applications of tech-
for a reduced processing fee, at the retailer
nology “automated’ existing processes. For
location. Return item processing remains a
example, the application of computers to ac-
manual operation. Similarly, credit card drafts
count maintenance simply translated existing
are manually encoded before processing, and
manual processes into automated ones. The
the securities industry still processes millions
adoption of MICR* encoding on checks has
of stock certificates manually.
done little to change the way checks are used.
As the economics of the technologies con- Thus, early application of automation in the
tinue to improve, market pressures to apply financial service industry had little, if any, di-
them more extensively increase. They help and rect effect on the users of financial services.
encourage further migration from paper- and On the other hand, systems now being de-
labor-intensive implementations to electronic, ployed are changing the fundamental charac-
self-service, and remote-based banking. ter of the financial services consumed by users.
Automated teller machine (ATM) networks,
Operational considerations limit more wide-
spread realization of the potential of the tech-
nologies. For example, only in recent years has *MICR—magnetic ink character recognition.

19
20 ● Effects of Information Technology on Financial Services Systems

for example, enable users to obtain cash at minals capable of supporting the smart card,
locations that cannot be served directly by the either supplementing or replacing the existing
financial institution holding the account. infrastructure for handling magnetic stripe
Moreover, funds are accessible around the technology, must be put in place before this
clock. technology can become a significant factor.
Technologies waiting in the wings have the In order to understand present and future
potential for changing the basic character of trends in the financial service industry, it is
the systems used to deliver financial services essential to have a grasp of present and emerg-
and, as a result, the structure of the financial ing information processing and telecommuni-
service industry. Remote banking via such di- cation technologies and of their relationship
verse technologies as teletex, home computers, to present and future products and services.
and multifunction transaction work stations This chapter describes the basic technologies
installed in the offices of financial institutions that are and could be applied for delivering fi-
could be implemented with technologies now nancial services. The purpose is to create an
available. appreciation for the potential and the limita-
tions of the technologies for facilitating change
The so-called smart card, lingering just over in the financial service industry. Yet, one must
the horizon, has the potential for changing the understand that the technologies constitute
basic character of currency from paper to elec- but one of a number of forces operating to
tronic. Market viability remains to be demon- shape the financial service industry and that
strated and sufficient developmental capital their potential may not be realizable because
allocated. In addition, an infrastructure of ter- of other constraints that are operating.

Computer Hardware Systems


The providers of financial services have been smaller financial service organizations that
among the leading users of medium- to large- could benefit from having access to them.
scale processors, and only the very largest
scientific computers have not yet been widely Microcomputer Systems
applied for the delivery of financial services.
These large computer systems generally re- Changes in the technology of computer proc-
quire dedicated facilities and support from an essors at the low end of the capacity spectrum
onsite team of information processing profes- (i.e., those with the most limited capacity) are
sionals. For all practical purposes, providers having the greatest impact on the operations
of financial services can buy computing power of the financial service industry. Both users
appropriate to their needs from a number of and providers are using them heavily. Micro-
well-established manufacturers. Further, be- computers range in price from less than $100
cause of the way computer manufacturers to almost $10,000 (for some of the more elabo-
design and enhance their product lines, orga- rate systems now on the market). However,
nizations are able to have reasonable expec- a $100 unit has only limited capacity to par-
tations that they will be able to make the tran- ticipate in a financial service system because
sition, as needed, to machines of greater it has neither communication nor significant
capacity with a minimum of operational dis- data storage capacity. Additional capabilities
ruption. However, even with the decreases must be added if the user wants to use the var-
that have occurred in the costs of medium- to ious financial application packages being mar-
large-scale computer systems, they are still keted for personal computers. These include,
priced beyond the means of many of the for example, such diverse applications as home
Ch. 2—Present and Future Technologies Supporting the Financial Service Industry . 21

Phofo credtf Mfcro Genera/ Corp

Two widely used microcomputer systems

A disc drive offering faster and more reliable


access to data and programs can be purchased
for some units for about $250. A printer that
can be used to make paper records for users
would cost another $250. Applications the
user may wish to run may require the addi-
tion of memory expansion modules that cost
more than the original $100 price of the com-
puter. The user will, in some cases, have to
spend $200 or more on an accessory required
for making the connections between the per-
Photo credit. L/S/ Computer Products ipherals and the computer. Yet even with all
Printed circuit card of the type used in microcomputers. these additions, the user would still have a sys-
Each of the rectangular cases contains a circuit that tem limited to local use and applicable prin-
consists of the equivalent of several thousand transistors cipally only to recordkeeping and analysis of
data entered into the computer by the user.
budgeting and accounting systems, checkbook
To take advantage of home banking and
balancing programs, securities price trend
stock market transaction services, information
analysis, portfolio analysis, and income tax
utilities, and home shopping services that en-
preparation.
tail interaction of a personal computer with
A cassette recorder costing about $50 would a computer operated by the financial service
permit the user to load prerecorded programs provider a personal computer must be
and save intermediate results so that they equipped with suitable data communication
would not have to be reentered into the com- equipment. These include a feature that does
puter manually every time they are to be used. the processing required to establish and main-
22 ● Effects of Information Technology on Financial Services Systems

tain a telecommunication connection (RS-232 processing element. In this environment, users


interface) and a unit (modem) connected to the may actually have several terminal devices to
telephone line for converting digital pulses interact with financial service systems, each
used internally by the computer to analog of which is dedicated to the offerings of a par-
signals that can be transmitted over the con- ticular provider. Simple, inexpensive, dedi-
ventional telephone lines of a switched tele- cated devices may find extensive application
phone network. In addition, programs to sup- in point-of-sale (POS) systems as well as those
port the communication function or to handle designed to deliver services to consumers. The
the financial application would have to be pro- availability of terminals for users at little or
cured, at a cost ranging from under $100 to no cost could be a strong impetus to increas-
$250 or more, depending on the complexity of ing significantly the rate of adoption of ad-
the application. Although a disc drive and ex- vanced systems for delivering financial
pansion interface might be required for such services.
a function, a printer would most likely be a
People have demonstrated repeatedly that
discretionary purchase.
they will spend substantial sums if they per-
Thus, while computers can be acquired for ceive utility in a product. Historically, this has
$100 or less, the person who would like to use been true with television; more recently, with
them either to receive financial services and/or video recorders. However, it remains to be
to perform financial analysis is more realis- seen whether a large number of individuals will
tically looking at an investment that is closer be willing to invest in information processing
to $700 or $800. However, this situation is not and telecommunication equipment capable of
likely to persist in the long run. The prices of interacting with systems for delivering finan-
all computing equipment are falling. Some cial services to the home. Success of financial
vendors are selling modems for under $100, service offerings may depend on minimizing
and the price of disc drives continues to fall. the investment of potential customers and,
Computer modules that work with widely dis- perhaps, what other services may be available
tributed video games are on the market, and through the same systems.
they are expected to offer the user significant
improvement in the performance-to-cost ratio
for equipment that could be used in conjunc- Large Computer Systems
tion with various future financial service of-
While there will be significant changes in the
ferings. In addition, small, battery-powered,
capabilities of computers at the low end of the
portable computers that can be carried in a
spectrum that will enable a larger number of
briefcase and have a built-in modem and RS-
people to access the technology, changes at the
232 interface are now available for under
high end of the scale will also occur. Speeds
$1,000, a price that will undoubtedly be lower of computation and the basic architecture of
in the future. Therefore, computers that can
computers will change so that there will be a
be used by individuals to receive financial serv-
marked increase in the performance-to-cost
ices both at home and work are likely to be well
ratios over those now available. The raw com-
within reach of a large portion of the popula-
puter power for applications such as image
tion within the 1988 to 1993 time frame.
and voice processing will become available.
Another alternative would be development Both applications have potential for the finan-
of very inexpensive specialized devices ori- cial service industry. Voice recognition ap-
ented to users of financial services. These plications could be used as an alternative to
could use cartridges similar to those used with key input particularly in telephone-oriented
television game machines, very simple control systems in which the user would use voice to
mechanisms, and a television to display the issue payment and other directives to finan-
data. Some providers may even develop appli- cial service systems. Applications of image
cations that use a TV game machine as the key processing systems, some of which are now be-
Ch. 2—Present and Future Technologies Supporting the Financial Service Industry ● 23
—.. . —-- — .———..—— - ——.

as those needed for system control and the


processing of some programing languages now
implemented in software will be moved to the
hardware. Special-purpose machines featuring
applications built into hardware will be as-
sembled from a variety of general-purpose
building blocks at minimal cost to meet the
needs of specific applications. As a result, not
only will the computers used to deliver finan-
cial services be less expensive, they will also
be more reliable.
From the users’ point of view, this will re-
duce the complexity of computer systems,
while at the same time enabling him to select
a computer that is more or less tailored to the
applications it must support. For example,
suites of special-purpose machines in facilities
operated by financial institutions, mixed to
meet the needs of the customers using them,
will be possible. Some devices could be used
ing tested, could range from processing finger- only for balance inquiry and the kinds of trans-
prints for identifying the user of a remote serv- actions now performed through an ATM.
ice device to reading information on checks as Others could be used to submit loan applica-
part of check processing. As the cost of equip- tions and/or initiate securities transactions. A
ment continues to fall, more providers of fi- single cash dispenser/deposit acceptor* could
nancial services will find the equipment afford- serve multiple user stations, thus keeping
able. In addition, customers will become better overall system costs down. Financial institu-
equipped to take advantage of the various tions may find it in their interest to provide
services offered (see table 1). customers with terminal devices specifically
oriented to the package of products and serv-
Future Computer Hardware ices being provided, thus overcoming any
hesitancy to acquire and use general-purpose
During the coming 10 years, changes in com-
computer hardware that requires some specific
puter hardware that are generally invisible but
knowledge of the technologies.
beneficial to users will occur. Functions such
Computer architecture will be increasingly
Table 1 .—General-Purpose Application Processors modular, with functions divided between and
among various system components. On the
1982 1987 1992
one hand, this will make it possible for users
Small:
Cost (dollars in thousands) . . . . 12 8 5 to configure systems to meet their specific re-
Storage (megabytes) . . . . . . . . . . 0.5 1 2 quirements, while on the other, it will tend to
Speed (millions of instructions increase system reliability and integrity. If one
per minute) . . . . . . . . . . ... . 0.05 0.1 0.4
component fails, the probability that system
Medium:
Cost . . . . . . . . . . . . . . . . . . . . 100 60 40 operation will continue at some degraded level
Storage. . . . . . . . . . . . . . . . . . . . . . 1 2 8 of performance is high. Providers and users
Speed . . . . . . . . . . . . . . . . . . . . 0.2 1.0 4
Large: of systems for delivering financial services will
cost . . . . . . . . . . . . . . . . . . . . .. ..1,400 600 400 benefit from an increase in the availability of
Storage. . . . . . . . . . . . . . . . . . . . . . 8 16 48
Speed . . . . . . . . . . . . . . . . . . . . . . . 4 8 24
SOURCE Arthur D Little, Inc “Application of Technology for Providing Financial
*A d~PoS~acceptor would have the capability to count cash
Services, ” April 1983 and read the amounts of checks as they are deposited.

35-505 0 - 84 - 3 : QL 3
24 ● Effects of /formation Technology on Financial Services Systems

fault-tolerant systems to support online ap- pletely into the background than is now the
plications. The mean time between failure for case, thus making them more acceptable in
such systems is measured in years, since they both the home and office. The telephone will
are designed to continue operating without become a multipurpose instrument capable of
degradation in performance in all but the most receiving alphanumeric as well as graphic
catastrophic circumstances. data, in addition to its conventional use for
voice transmission. Such devices are already
Alternatives to keyboard entry will increase
on the market for applications in the business
the flexibility and attractiveness to users of
environment.
self-service financial systems that are access-
ible from remote locations. For example, the The key to the future will be ease of use. As
user will be able to communicate instructions new terminals become available and are capa-
to a computer by touching one of a few con- ble of presenting and transmitting information
trol buttons or an image on a screen. Already, in a multiplicity of formats, user anxiety re-
touch screens are available on devices that lating to the technology used to interact with
range from wristwatches to computers, and systems for delivering financial services
greater application of these in the future can should approach the level now experienced
be expected. Limited voice input capabilities with the telephone or the handheld calculator.
will be available, but continuous speech lan-
guage processing will not be possible before Future providers and users of financial serv-
the turn of the century, if then. Optical char- ices will have the choice of using networks of
acter recognition technologies will continue to small processors or the minicomputers and
become more cost effective, and there will be mainframes that will soon become affordable
some capabilities to process handwritten in- for them. To some extent, they, like everyone
put. Systems that use the signature to iden- else who acquires information-processing ca-
tify the user rather than a personal identificat- pabilities, will be able to choose the equipment
ion number coupled with a machine readable that best meets their requirements for proc-
card could come into use by the middle of the essing and their philosophies of product design
coming decade. On net balance, these alterna- and management. Factors such as system
tives will reduce the use of multiple keystrokes security, reliability, and integrity will be taken
needed to respond to requests for information, into account. Other factors will be the avail-
and hence will reduce barriers to use and in- ability of appropriate software packages and
crease efficiency of the new systems for deliv- the costs of telecommunication services.
ering financial services.
In some specialized applications, however,
Greater use will be made of color and graph- the large computer system will continue to
ics in computer output. The ability to transmit dominate. For example, significant computer
pictures easily will mean that the user will power is required to support the check reader/
have less need to read. Video disc technology sorters used widely throughout the financial
could be coupled with computers, especially service community. While electronic banking
in such applications as home shopping and will lessen the growth in check volumes, they
others that require catalog-type data. Video will remain high. Therefore, requirements for
“catalogs” could show the shopper multiple supporting check-processing equipment will
views of an item and could be updated fre- continue into the foreseeable future. New ap-
quently to show newly arrived merchandise plications implementing processing of voice
and to reflect price changes. Voice synthe- and/or handwriting will also require the power
sizers have become very affordable, and they of mainframe computer systems. In addition,
will be used both to support graphics displays microcomputers may not be capable of man-
and to provide computer output through the @g future telecommunication functions that
standard voice telephone. Displays will be- will become even more significant to the finan-
come more compact and will blend more com- cial service industry.
Ch. 2—Present and Future Technologies Supporting the Financial Service Industry ● 25

Online POS systems will consume substan- One of the factors that has limited the de-
tial processing and communication resources. gree to which advanced systems for deliver-
Interchange networks that serve ATM sys- ing financial services have been accepted has
tems are designed to handle 4 to 10 transac- been the lack of processing capabilities in the
tions per second and provide a response time hands of many potential users and suppliers.
that ranges from 30 to 90 seconds. Paul The fact that many potential participants in
Hefner of First Interstate Bancorp of Califor- the financial service industry are installing
nia, points out that POS networks will have computers for a variety of reasons is creating
to handle hundreds of transactions per second a latent capability for either using or deliver-
and provide a response on the order of 6 ing financial products because the marginal
seconds. Thus, the processing capacity re- cost of such a move could be minimal.
quired to support these networks may begin
The long-term impact of changes in the ca-
to approach the limits of the technology, if
pabilities of computers on the users and pro-
they begin to handle the transaction volumes
viders of financial services is not so much that
foreseen by some.
the raw computational capability of the equip-
Already, both users and providers of finan- ment will increase. Rather, an increasing num-
cial services have put in place a considerable ber of individuals and organizations are buy-
portion of the hardware infrastructure that ing equipment because its cost is dropping.
will be key to delivering financial services. The result is a decreasing marginal cost of en-
Banks and other financial service providers try for potential users and providers of ad-
have been long-time users of computers, as vanced financial services systems. Higher po-
have the major dry goods retailers. However, tential levels of participation will encourage
an increasing number of small stores are in- the deployment of advanced systems and, in
stalling electronic cash registers and com- the absence of other barriers to their accept-
puters from which they will be able to build ance, will result in their achieving a greater
in the future. Some grocery chains have made level of economic viability than would be possi-
heavy use of computers to automate the check- ble with the present level of equipage.
out process and inventory systems for in-
Generally, the financial service industry has
dividual stores. Major firms regularly use
not demanded access to the largest computers
automated systems to generate payrolls and
to handle its applications. Advances in com-
pay suppliers. Smaller firms are increasingly
puter technology will most likely continue to
turning to data service bureaus or installing
outpace the demands of the financial service
small computers to obtain comparable serv-
industry, and therefore, lack of sufficient com-
ices. Also, considerable numbers of consumers
puter power will not be one of the factors that
are acquiring computers that could be con-
will limit the development of new systems for
figured to perform the processing required to
delivering financial services.
interact with financial service delivery
systems.

Software
A computer is useless without software: the ing a program to be operational, and an ongo-
programs that instruct a computer to perform ing program of maintenance to ensure that the
operations. The development of software software remains responsive to user needs and
depends on the careful and precise definition to remove errors that are almost invariably
of requirements by those for whom a system identified after a program is declared opera-
is being built, thorough testing before declar- tional. All of these operations are labor-
26 ● Effects of Information Technology on Financial Services Systems

intensive, and therefore very expensive. The Present Applications Software


cost of software is determined by its complex-
ity rather than the size of the machine on The acquisition of applications software has
which it is to operate or the volumes of data always been the responsibility of the user orga-
that are to be processed. Generally, however, nization. Today the computer user has three
larger machines are needed to use the more options for acquiring software. First, the user
complex software packages that support the can retain either in-house staff or a consult-
larger data bases. ant/contractor to build application packages
uniquely tailored to his needs. Because pro-
Although the cost of computer hardware gram development remains labor-intensive,
will continue to decrease, the cost of computer this can be a costly process, a significant por-
software may not, or may not decrease as tion of which is the cost incurred-after the
much. Software development remains a labor- system becomes operational-for maintaining
intensive activity and is likely to remain so the programs, correcting errors as they are dis-
into the 1988 to 1993 time frame. However, covered, and making changes as the needs of
more widespread use of software packages will the organization evolve. For operators of large
lower costs for individual users. scale computer systems, such as those used
Until now, resources for software develop- by many providers of financial services, this
ment have fallen short of demand. The advent has been the only option considered. Large
of new tools for software development, how- staffs of highly trained professionals have
ever, should increase the productivity of soft- been assembled and supported to handle the
ware professionals somewhat. Furthermore, a tasks of system development and mainte-
greater tendency to purchase and modify ap- nance. Experienced organizations have found
plication packages to meet specific needs as that over 70 percent of the resources spent on
a substitute for the development of applica- these staffs is for maintaining existing sys-
tion packages by each end-user organization tems, leaving only 30 percent for developing
will reduce the apparent shortfall of software new applications programs.
development resources in the future. Financial service organizations have devel-
There are three basic classes of software— oped a huge body of proprietary software over
systems software, support software, and ap- the years. Included are applications that range
plications software. Systems software controls from internal accounting systems to those
the minute-to-minute operations of the com- that support home banking products. When
puter by allocating resources and scheduling a new product such as a money market mutual
tasks. Support software is typically used for fund is offered, its introduction must often be
such functions as controlling a communica- preceded by a significant software develop-
tions network, monitoring transaction proc- ment effort. Regulatory changes such as the
essing, managing the data base environment, imposition of Regulation E* can also result in
or furnishing tools intended to improve the major software development efforts or the
productivity of programmers and, in some cases, need to make significant changes to existing
end-users. Applications software directly in- software systems.
terfaces with the end-user and is designed to However, just as the advent of small com-
carry out functions unique to the particular puters has brought the power of the technol-
situation. ogy within reach for the individual user, it has
Systems and support software, including also had an impact on the costs of system de-
data base management systems, are discussed velopment and maintenance. Consumers now
in appendix 2B to this chapter. Applications identify applications in which the small com-
software and its use for delivering financial *Re~lation E is the Federal Reserve Board Regulation im-
services is described in the sections that plementing the consumer protection provisions of the EFT Act
follow. of 1978.
Ch. 2—Present and Future Technologies Supporting the Financial Service Industry ● 27

puter can provide significant benefit and either and maintenance are potentially spread over
write the programs themselves or with help multiple users.
at minimal cost. Generally, the small packages
Systems for processing checks and servic-
for personal computers which result are used
ing deposit accounts and outstanding loans
for analytical applications that are often tai-
have been developed by both financial insti-
lored to the specific working habits of the in-
tutions and data-processing service organiza-
dividuals using them. To some extent, the per-
tions and are widely used throughout the in-
sonal computer has replaced the worksheet
dustry. Organizations that have developed the
and personal file system that have always
software for home banking applications are ac-
been the tools of the professional analyst and
tively marketing it to providers.
decisionmaker. This software is not suitable
for account maintenance and other adminis- Thus, as a second option, the user can ac-
trative tasks that require the manipulation of quire an application package that comes as
large data bases and the processing of a large close as possible to meeting his needs and then
number of transactions. On the other hand, a either modify it with internal resources or re-
portion of these applications depend on being tain the original developer or another party to
able to access the major corporate data bases make the required changes. This approach has
that are maintained by the large, central com- the disadvantage for both the vendor and the
puter facility. user that multiple versions of a basic package
must be supported. Costs and difficulty of
In one example, a microcomputer is used to
maintenance are both increased as, almost in-
help farmers generate the information required
variably, the modifications made periodically
to support applications for loans. Another ap-
to the basic package and the changes made to
plication using a voice response unit and in-
meet specific user needs generate conflicts
put from a 12-key telephone has been devel-
that require basic changes in the software to
oped by a financial analyst to process market
resolve. Some marketers of software systems
data and generate information used for port-
mitigate this problem by including features
folio management. Automated spread-sheet
that permit the user to customize the package
programs running on microcomputers have
at specific points in the processing cycle with-
also become popular tools among users and
out actually modifying the basic program.
providers of financial services. Users have
found that for some purposes the information The third option for the user is to acquire
generated by a microcomputer running all and use an application package as is. This op-
night can be just as satisfactory as the same tion is more often used by users with small
data produced in a few minutes on a large, cen- computers than with large. However, opera-
tralized computer. Further, the user of the tors of large installations are turning with in-
microcomputer may be able to avoid hassles creasing frequency to generalized software
often encountered when a data processing de- packages. Prepackaged software for micro-
partment is asked to implement an appli- computers has enabled significant numbers of
cation. users in the financial service industry to apply
information processing and telecommunica-
Over the years, the usefulness of applica-
tion resources to the operation of their busi-
tions packages has been recognized across an
nesses without needing to become proficient
industry, and significant numbers of packages
technically in the operation and use of the
are now developed and offered for sale or lease
technology.
to a variety of users. In some cases, the
packages were developed by organizations for To use these various packages, the user need
their own use and later offered to others. In not purchase or lease the computers on which
other cases, the package was developed to be the applications run. Time on systems oper-
marketed commercially. In this environment, ated by others can be purchased, an option
all benefit because the costs of development that has enabled many smaller providers of fi-
28 ● Effects of /formation Technology on Financial Services Systems

nancial services to take advantage of available jor computer manufacturer has announced a
technologies. In many cases, banks and serv- microcomputer that accepts program car-
ice bureaus that develop application packages tridges; this is likely to provide the impetus
also sell the machine time required to run needed to make this medium of software dis-
them. In others, those with excess processing tribution more widely accepted for financial
resources available sell them. For example, the services.
largest processors of bank card transactions
are service organizations, not banks. Check Applications Software in the Future
processing and account maintenance is often
performed by other than the institution offer- The evolution of applications software in the
ing the service. future is likely to be relatively slow because
of the huge base of operational programs, rep-
Conventionally, the medium for distributing resenting an investment of billions of dollars,
software is either floppy disc or magnetic tape. that is now installed.’ Language development
Telecommunication links between computers will be constrained because in many areas new
are also used for transferring software. This languages will have to be compatible with
technique is used to distribute programs for those used to implement the installed base.
large computer systems and for providing pro-
grams stored on large central computers to Even though there is considerable inertia in
small peripheral ones in distributed process- the form of installed application systems, ap-
ing environments. plication programs will continue to evolve. In
the near term, the emphasis will be on modi-
Experience has shown that safeguards fying batch applications* to operate interac-
against copying or modifying software can tively where it is reasonable to do so. Specific
easily be circumvented by individuals who attention is being given to providing the most
have a moderate degree of technical sophisti- up-to-date information possible to both users
cation. This presents a problem to operators and providers of services in order to improve
of systems for delivering financial services overall management of financial resources.
electronically to a large number of people. If Even where batch processing is most desira-
the software used to access a service from the ble, transaction data will be entered interac-
customer’s premises can be altered, a compro- tively and accumulated until a batch process-
mise of system integrity or security could re- ing program designed to handle the accumu-
sult, causing damages for both the system lated data is run. Eventually, however, interac-
operator and other users. tive processing will dominate and up-to-the-
One way to avoid this problem is to distrib- minute data will be available to all who need it.
ute software in cartridge form, in the form of Most programs today have been developed
hardware, a technique that is being tried by to meet the needs of classes of individuals on
at least one marketer of home banking serv- the assumption that the requirements of mem-
ices. Although this minimizes the chances of bers of a group for computer support are ap-
modifying the software, users whose comput- proximately the same. This assumption holds
ers do not accept cartridges are eliminated for people engaged in routine activities, but
from the market. Moreover, it does nothing to it tends to break down at the upper levels of
stop the potential intruder who obtains the organizations. In the future, generalized sys-
functional specifications of the cartridge or is
able to copy the program from the cartridge IThe material in this section draws heavily on the report,
to another medium. In these cases, the intru- “Future Information Processing Technology -1983° prepared
der could modify the program to perform un- for the Institute of Computer Science and Technology and the
authorized functions, just as it is possible to Defense Intelligence Agency.
*Batch applications me those when data are assembled over
modify software distributed using other, more a period of time and are processed periodically, frequently on
conventional media. On the other hand, a ma- a fixed cycle.
Ch. 2–Present and Future Technologies Supporting the Financial Service Industry ● 29

terns and capabilities will be more easily tai- “Windowing” technologies that permit the
lored to the specific needs of individuals. Users user to display the results of multiple proc-
will be provided the facility to set application esses simultaneously on the screen will im-
parameters to meet their individual needs. Ob- prove the utility of the technology to the users.
vious examples that already exist are the abil- They will allow the users to concurrently view
ity to request the detail to be used in prompt- data from multiple sources and select those
ing the computer user online and the format items most useful to the task at hand. For ex-
to be used for displaying data. The user unfa- ample, the user may use one window to review
miliar with an application can be led through the status of a transaction account, a second
it step by step, while those who have mastered to project cash flow, and a third to enter an
the operations required can be freed of the bur- order with a broker/dealer to buy or sell a secu-
den of detailed instructions. rity using a telecommunication line that con-
nects directly to the broker/dealer’s computer.
Applications will be self-teaching to a great
degree. Many, as already illustrated by the More of the processing capability will be res-
systems that support ATMs, will be menu- ident at the user site and will therefore be
driven; users will not be required to learn and much more of a personal tool. Large systems
use commands. Today, a growing number in- may be limited to being repositories of data
clude tutorial features; but in the future the to which the user is provided access on a “need
user will have greater facility in selecting the to know” basis. At the start of a problem-
specific points where instruction is needed and solving session, a microcomputer will be used
w-ill be able to obtain help without interrupting to access a data base on a large computer sys-
the ongoing flow of processing. Audio-visual tem, retrieve the data needed to address the
display technology, heavily dependent on vid- problem, and store it locally on a small disc.
eo discs, may figure greatly in implementing Applications running on the microcomputer
this capability. will perform the required analysis, and after
this has been completed, the central data base
Users will have a larger variety of options
will be modified as required. In fact, in some
in selecting the format in which data is pre-
organizations, this mode of problem-solving
sented. Color graphics will come into more
is already quite commonplace.
widespread use and users will have greater
capabilities to manipulate graphic images in Knowledge-based systems, one of the areas
addition to already existing facilities for ma- in the general field of research known as arti-
nipulating and analyzing combinations of nu- ficial intelligence, will become more generally
meric and alphabetic data. For example, the available. For the financial service industry,
capability of manipulating a trend line for one this could mean that financial advisors and
variable and seeing its effects on other trends counselors will be augmented, or possibly re-
will be possible. Mice, * light-pens, and voice placed, by automated systems. Research in
input/output will greatly facilitate interaction artificial intelligence and expert systems has
between the user and information system. shown some valuable results. However, there
is considerable uncertainty about when such
*A mou9e i9 a small device attached to a computer that is systems will be sophisticated enough to have
used instead of keys to control the movement of the cursor, the
indicator on a video display that indicates where the next char- an operational impact on the financial service
acter will be formed. industry.
30 ● Effects of Information Technology on Financial Services Systems

Telecommunications Technologies
Telecommunication technology provides an ency will increase. Securities markets, card
indispensable lifeline to users and providers and check authorization systems, and cash
of financial services. Of the number of alter- management services are now totally depend-
native telecommunication technologies from ent on telecommunication. Products such as
which suppliers and users of financial services remote banking and shopping and off-market
are able to choose, the most common is the securities trading have a dependency equally
switched telephone network. But, both provid- great. The premium placed on timely financial
ers and users of financial services also con- information is increasing, and the only way to
struct and use a variety of alternatives, which meet this requirement is through the applica-
include such diverse technologies as private tion of communication technologies. Changes
microwave links, satellite transponders, video in the technologies, policies, and economics of
cable, public packet switched networks, leased communication will directly affect the design
lines, and local area networks. of systems for delivering financial services, the
cost schedules facing both users and providers
The divestiture of the operating telephone of financial services, and, hence, the structure
companies by American Telephone & Tele-
of the financial service industry.
graph (AT&T) in 1984 substantially changes
the communication environment in which pro-
viders and users of financial services operate. The Switched Telephone Network
Both local and long-distance telephone rates
are likely to change. Competition from non- The most widely available communication
Bell suppliers of telecommunication services facility is the switched telephone network that
and equipment is already significant and is serves virtually every place of work and resi-
likely to increase in magnitude and kind in dence in the United States. Only a limited
light of the divestiture. Those who enter mar- number of locations can send and receive tel-
kets as providers of equipment and services ecommunication traffic without using this net-
are likely to intensify competition further. work for a portion of the route. Subscribers
to non-AT&T long-distance networks gener-
Both suppliers and users of financial serv- ally access them through the facilities of local
ices are heavily dependent on telecommunica- operating companies. In fact, some of the al-
tion services, and as systems to deliver finan- ternative services actually use long-distance
cial services directly to customer premises circuits provided by AT&T.
become more widely deployed, this depend-
The switched telephone network is basically
designed to handle analog voice traffic. Gen-
erally, digital data sent between computers
and between computers and terminals must
be converted from digital to analog format for
transmission through the network. Network
facilities capable of carrying the digital signals
and thus eliminating the need for this conver-
sion/reconversion process are now coming into
use and will eventually replace the analog links
in the system. In this environment, voice as
well as data will be transmitted through the
Photo credit Raca/.M//go Corp
network using a digital format.
Network control console like those used to manage The switched telephone network was de-
major financial service telecommunication networks signed to handle a relatively large number of
Ch. 2—Present and Future Technologies Supporting the Financial Service Industry ● 31

calls of short duration in which the parties are phone as an input/output device. If successful
speaking a high percentage of the time the con- market penetration occurs, home computers
nection is maintained. A circuit is established may offer a more viable alternative for deliv-
between the parties for the duration of the call. ering service.
Whether or not there is traffic on the connec-
ting circuit, the facilities used to maintain the Presently, commercial users in some areas
connection are denied to others. A POS ter- have specialized, switched digital service. In
minal connected continuously through the the future, virtually all customers will have
switched telephone network may be used only digital network service available, primarily
intermittently. Although this constitutes an through the digital termination services
inefficient use of network resources, a mer- planned by operators of the switched tele-
chant may desire to maintain such a connec- phone network. As outlined in greater detail
tion in order to minimize the time required to in the next section, each digital line will have
process a transaction at the point of sale. substantially more capacity than is now avail-
able in the conventional voice circuit and will
The common telephone is by far the primary be considerably more versatile.
terminal used with the switched telephone sys-
tem. Although it functions well for voice com- Wide Area Telephone Service (WATS) is a
munication, its capabilities as an instrument specialized service offered through the
for data entry are limited, and those for receiv- switched telephone network. This service
ing other than voice response are almost non- allows a fixed number of hours per month of
existent. The 12-key tone pad is a moderately calling for a specific geographic area. IN-
effective data entry device that can be used WATS permits incoming calls at no charge to
to transmit numeric data to a computer with the caller, and WATS, or OUT-WATS, per-
relative ease, but it transmits alphabetic data mits the subscriber to originate calls using the
awkwardly. It has been used for applications service. IN/OUT-WATS permits both. Finan-
such as telephone bill paying and balance in- cial institutions and others use this service to
quiry. In those locations where tone service expand their markets geographically without
is not available, an easily acquired attachment establishing physical presence in the targeted
to the traditional dial telephone or widely areas. The availability of toll-free calling en-
available dual-mode instruments allows the courages the remote customer, who might be
user to transmit the tone codes required for unwilling to incur a toll call charge, to contact
certain services. This operation requires use the institution. The service is particularly val-
of either a tone generator placed over the uable to depository institutions that face re-
microphone of the handset or a type of tele- strictions on the geographic areas in which
phone now available that can switch between they can establish facilities.
dial pulse and push-button tone operation. In addition to the common voice telephone,
With either, the customer can make a connec- many other types of communication devices
tion using conventional dialing and then can be attached to the switched telephone net-
switch to tone output to communicate with an work. Included are computers, simple termi-
electronic device. If financial service providers’ nals, and facsimile terminals. These can pro-
applications can conform with the capabilities vide for interaction with humans and/or
of the voice telephone as a data communica- unattended operation. However, all currently
tion device, a significant portion of the Nation cost more than the voice telephone. Service
could have immediate access to computer- providers must recognize this cost differential
based financial services. Marketers of such when planning the deployment of a system
services have been limited in the past by the that depends on the user acquiring the re-
lack of capabilities of the stand-alone tele- quired terminal equipment.
32 ● Effects of Information Technology on Financial Services Systems

Private-Line Telecommunications Fiber optics offers greater capacity and secu-


Facilities rity of transmission than do copper conduc-
tors of comparable size, properties that are
Many commercial organizations and govern- particularly attractive in areas like the finan-
ment agencies use leased circuits for their in- cial district in New York, where the available
ternal communication needs. Providers of fi- space in conduits for wires has been almost ex-
nancial services are among the heaviest users hausted.
of such facilities, and some operate large
global networks for moving funds and infor- A communication technology of growing im-
mation. portance is local area networks, which are in-
stalled within an organization’s facilities to
A leased circuit guarantees access to a cir- provide a variety of communication services,
cuit between the points that meets specified including the transmission of both voice and
electrical characteristics. This eliminates the data. Digital, private, automated branch ex-
problems of uncertain quality and relatively changes are being installed to manage some
slow access* when dial-up lines are used. While of these networks. Others have been developed
there is no assurance that the same physical by manufacturers of office computer equip-
circuit will be made available at all times, or ment and emphasize such features as sharing
that the signals will not be multiplexed with of data resources and electronic mail. * Char-
others between various points along the route, acteristically, all of these networks provide
the quality of the line becomes invariant from gateways to the switched telephone network,
the user’s point of view. This minimizes the including the private, value-added carriers and
variability of one of the elements critical to any private networks to which the user may
overall reliability and integrity of financial have access. The user of a local area network
service systems. with gateways to the switched telephone net-
Institutions with sufficient need and funds work has access to all of the data and proc-
can install their own circuits; in some cases, essing resources that comprise the local net-
private microwave networks have been estab- work and, using the same terminal equipment,
lished. Fiber optics and coaxial cables are used to other facilities that are external to it.
for networks confined to a limited area, such All of the classes of equipment that will
as an office building or factory complex. Some operate with the switched public network will
have leased transponders on communication also operate with private networks.
satellites, and others have leased circuits on
video cable systems. Financial service orga- Alternatives to Switched Networks
nizations are among the heaviest users of the
video cable that runs from midtown Manhat- Because the switched telephone network,
tan to the Wall Street area in New York City. where “hard” connections are established and
Aetna Insurance Co. is one of the three pri- maintained for the duration of a conversation
mary partners in Satellite Business Systems, between the parties, is not particularly well
a major communication venture. New technol- suited to traffic that is characterized by rela-
ogies will increase such options. For example, tively short bursts of activity separated by
the installation of teleport facilities will make long periods of silence, alternative technolo-
satellite communication available to a larger gies more suited to data traffic are used by
community of users and offers the opportunity providers and users of financial services. POS,
to bypass local telephone facilities completely. ATM, and home banking systems, as well as
Merrill Lynch is one of the major backers of others that use interactive computer facilities
the teleport installation planned for New York.
*EIWtronic m~ is the technology Of Sending mess%es e~ec-
tronically between computers. Messages are stored on the ad-
*The time required to dial a number ~d go through the log- dressee’s computer system to be retrieved, read, and disposed
on procedures that must be used in a dial-up environment. of at his/her convenience.
Ch. 2—Present and Future Technologies Supporting the Financial Service Industry . 33

to deliver financial services, are characterized Video-Related Communication


by this kind of bursty traffic pattern. Technologies
One of these is packet switching, in which
Considerable attention has been given in re-
messages are broken down into small packets,
cent years to using technologies built around
each of which is routed separately through the
some modification of the common television
network. One property of this technology is
set for distributing information, including fi-
that the cost of communication becomes more
nancial services. The services offered are gen-
a function of the volume of traffic handled
erally built around alphanumeric displays of
than the distances involved. Also, there is min-
information that fill one television screen. The
imal penalty for having a network that in-
quality of graphic capabilities varies from sys-
cludes a large number of points between which
tem to system, but none presently offers any
only limited traffic volumes pass. Because it
significant degree of animation. However, with
is oriented to handling messages that are fairly
some systems, computer programs will be
short in length and are spread over consider-
transmitted to the user’s terminal at relatively
able periods of time, packet switching is par-
low speed and then executed in the customer’s
ticularly suited to the type of traffic likely to
terminal to produce animated graphics. One
be generated by providers and users of finan-
application for this technique is the distribu-
cial services. POS systems and systems for
tion of video games; other applications are
trading securities are candidates for this tech-
likely to follow.
nology.
While video-based systems have been some-
Multiplexing, a well-established and widely
what accepted in Europe, they are still in the
used group of technologies that permit a com-
experimental stage in the United States,
munication circuit to be shared more or less
where only a limited number of systems is in
simultaneously by multiple users, is also of
operation. One of the principal drawbacks en-
interest to providers and users of financial
countered is the price of a modified television
services. These technologies permit a single,
set or specialized terminal capable of partici-
high-capacity circuit to be used for various ap-
pating in the system. Three general types ex-
plications, none of which could alone justify
ist: teletex, videotex, and cable television.
the expense of a dedicated line. For example,
if local communication costs rise, as some pre- In teletex, frames are transmitted over the
dict, the operator of a shopping center could air during the blanking pulse in the television
establish a connection to a financial network signal, the period when the raster on the televi-
or a specific financial institution that would sion returns from the lower right comer of the
permit the merchants access to POS services screen to the upper left. Because the technique
at lower costs than if communication services repeatedly transmits a limited number of
were paid for independently. This could be frames that can be selectively captured by the
done by connecting to a specific institution, terminal equipment, the capacity per channel
thus eliminating choice of a financial service for offering adequate response to users is lim-
provider for individual tenants of the shopping ited to about 25 to 100 frames. This is essen-
center. On the other hand, the shopping cen- tially a one-way system because there is nei-
ter owner could conceivably provide access to ther a path over which the user can respond
a gateway that would permit individual mer- to the system nor a means for sending a signal
chants almost unconstrained freedom in se- to a specific receiver. Users can, however, use
lecting financial service providers. a telephone connection to transmit to the sys-
34 ● Effects of /formation Technology on Financial Services Systems

tern. Conceptually, an address routing mes- financial services. This system includes pro-
sage to a specific receiver could be added to vision for interactive response from users to
the transmitted frame, but the limited capac- questions posed by the program being trans-
ity of the channel would effectively limit such mitted. Applications include all of those possi-
an application. Full-frame teletex, an alterna- ble with videotex and others that can make
tive to transmitting the textual information use of the capacity of the television cable.
during the blanking pulse, is the dedication of Large amounts of data, such as historical
a channel to a telex application. Capacity could stock market information, can be transferred
then increase to about 1,500 frames per chan- rapidly and loaded into a user’s computer for
nel. Application of this technique is generally processing at a convenient time.
limited to dissemination of advertising and
bulletin board type of information. Included Future Telecommunication Technologies
could be price quotations, but it would not be
possible to tailor the information to the needs Generally, telecommunication technologies
of a specific subscriber. Transaction initiation, will continue to provide the means by which
except through the use of an auxiliary chan- financial and payment information is trans-
nel such as telephone, is not possible because mitted rapidly from point to point. In many
there is no direct path from the user to the ways, the specifics of telecommunication tech-
source of the information. nology are of minor interest to users and pro-
viders of financial services. As long as suffi-
Videotex generally uses the telephone net-
cient capacity is available at an affordable
work to transmit the required information to
price, the needs of the financial service indus-
users, who are able to interact with the infor-
try will be met.
mation source, selecting material from a large
library that is directed only to the user’s televi- While voice communication will continue
sion set or personal computer display. A very indefinitely to dominate the traffic handled by
large number of frames is available, and it is the common switched telephone network,
possible to charge for each frame viewed (the transmission technology is changing. Digital
user requests specific frames). Some applica- transmission will replace the analog signals
tions, such as those related to financial serv- now used most commonly. Voice will be digi-
ices, permit the user to enter data that is then tally encoded and will share circuits with data,
processed (e.g., a mortgage amortization video, and facsimile transmissions. This will
schedule is produced when the user enters mean that users of telecommunication serv-
principal, term, and interest rate). Because ices will be able to interweave voice and vari-
data is directed only to a specific terminal, per- ous forms of data on the same circuit. Systems
sonal information such as account balances that offer these capabilities to commerical cus-
can be delivered using this technology. The ca- tomers are being marketed. For example, a fi-
pacity of the telephone channel limits the de- nancial service consultant is able to send a
gree of animation that can be offered, and the table of data showing the expected results of
data transmitted is generally confined to text, alternative investment opportunities for dis-
numeric tables, or fixed graphics. play on a client’s terminal in the midst of a
normal conversation. Even now, terminal de-
The third technique, cable television, uses
vices capable of supporting such usage pat-
video cable, with all of the transmission
terns are coming on the market.
capacity inherent in that medium. The War-
ner-Amex QUBE system that has been oper- The concept of a telephone industry ISDN
ating in Columbus, Ohio, for some time offers (Integrated Services Data Network) is emerg-
considerable capabilities for delivering text to ing and will reach fruition sometime before the
specific users and a low data rate return chan- end of the century. An ISDN is a network in
nel for reacting to specific user input. It there- which all traffic is represented digitally, and
fore has considerable potential for delivering various types are freely mixed as traffic passes
Ch. 2—Present and Future Technologies Supporting the Financial Service Industry ● 35

from origin to destination. However, because least two types of networks, switched tele-
of the magnitude of converting the installed phone and video cable. Either could be used
plant, ISDN capabilities may not be available to implement ISDN-like concepts. The cable
to significant portions of the subscribers to television systems may enjoy some cost and
switched telephone services for some time be- bandwidth advantage over the telephone net-
yond the turn of the century. Further, while work. The transmission capacity of a cable is
there is now no compelling reason for making much greater than that of most ordinary tel-
ISDN generally available to consumers, there ephone circuits, and the cost of serving a sub-
is a distinct possibility that a force driving in scriber is less.
that direction will emerge and will hasten the
deployment of ISDN. For example, if consum- Designers and users of financial service sys-
ers become heavy users of information utili- tems will be able to choose from a variety of
ties, their needs for transmitting and receiv- telecommunication technologies in designing
ing significant volumes of data could stimulate and accessing services. Some new telecommu-
development and deployment of ISDN fa- nication technologies will have greater capac-
cilities. ity than the switched telephone network of to-
day, but development of new techniques to
Users of telecommunication systems built extend the capacity of the present telephone
in accordance with the ISDN concept, or a less plant are evolving. For example, dial telephone
general one called “Digital Termination Serv- lines are now routinely used to transmit at
ice, ” that shares many concepts with it, may 2,400 bits per second, a rate that could not be
be provided with a single high-capacity com- realized with acceptable error rates several
munication line. The capacity of this line years ago, and rates as high as 9,600 bits per
would then be allocated among various appli- second are becoming possible. Switched tele-
cations at the user’s discretion. Some may phone networks are expected to evolve slowly
choose to use it for multiple voice lines, while from conventional copper wires to fiber optic
others may allocate a portion to data and an- circuits. Fiber optics have transmission capac-
other to voice. Allocations could be changed ities far greater than those of the present cop-
dynamically in response to user needs. At one per conductors. However, as is now the case,
point, several people could be using the facil- some network segments will always be carried
ity for a number of simultaneous conversa- by radio transmission, as exemplified by the
tions, which could include conference calls. At use of microwave and satellite facilities.
another point, a single user could use part of
the capacity to carry on a conversation, while Technologies such as cellular radio and dig-
the remainder is used to access information re- ital termination services are now being offered
sources. Using advanced software technolo- commercially for the first time. These are ex-
gies, the user could also interact simultane- pected to come into widespread use by the
ously with multiple information providers. For mid-1990’s. In addition, direct broadcast sat-
example, an individual may review account ellite systems will soon become operational
balances, along with economic statistics and and may be used in some systems for deliv-
historical data provided by independent ven- ering financial services.
dors of information services, in formulating in- There will be a diversity of telecommunica-
vestment decisions. tion networks in the coming years. Various
Although one could assume that the vehi- vendors of telecommunication services and
cle for implementing ISDN will be the frame- technologies will try to offer systems that
work provided by the switched telephone net- most effectively serve certain classes of users.
work, there is no technical reason why this While there is a proliferation of systems, ven-
need be the case. Most private locations, such dors recognize that they will have to provide
as homes and places of business, will be able for the interoperability of communication fa-
to have telecommunications delivered over at cilities. Gateways between private networks
36 ● Effects of /formation Technology on Financial Services Systems

and public transmission facilities are now efits of the ability to choose from a range of
almost mandatory. Thus, users and providers options will be realized only if the customer
of financial services will be able to communi- expends the effort needed to evaluate the alter-
cate between and among themselves with min- natives. In all likelihood, independent devel-
imal concern for the particular technologies opment of system designs and seeking the
used in implementing financial service sys- vendor best able to meet the need will be re-
tems. The emergence of other alternatives to quired. Not all potential users who could ben-
conventional switched telephone services efit from this approach will be prepared to take
should be expected over the coming 10-year it, with the result that they will probably set-
period. These new services will almost cer- tle for something much less than the best
tainly offer opportunities of value to both available communication facility at the most
users and providers of financial services. advantageous price. To the degree that com-
munication costs become relatively more sig-
Now, and probably more so in the future,
nificant for providers and users of financial
numbers of telecommunication options avail-
services, this shortfall could affect their basic
able to all users, including individuals, will be
ability to compete in the market with others
available. Users will be able to closely align
not carrying a similar burden.
services procured with needs. But the full ben-

System Security and Integrity


Security has long been an area of concern System Security
to providers and users of financial services.
Traditionally, banks have been characterized As demonstrated by the young people in
by large metal doors and imposing vaults with Milwaukee in 1983, it is not difficult for in-
massive and complex locking mechanisms. Fi- dividuals with minimal equipment and train-
nancial service providers stress the safety of ing to penetrate some computer systems
assets in attracting customers, and customer which contain sensitive information. In the
trust is a keystone of the financial service in- Milwaukee caper, one of the computers com-
dustry. promised, using a common home computer
and telephone line, belongs to a major west
Increasing use of telecommunication and in- coast bank. Other instances of penetration of
formation-processing technologies in conjunc- computers used by providers of financial serv-
tion with financial services raises two areas ices are on record; and some experts believe
of concern that relate to the basic soundness that only a relatively small portion of the secu-
of the financial service industry: system secu- rity breaches that occur are detected, and
rity and system integrity. System security fewer are reported outside of the victim orga-
deals with the problem of those who would at- nization.
tack the system from the outside, including
those who work with the system but would Historically, embezzlers from within and
attempt to invoke operations they are not check forgers and confidence artists from with-
authorized to perform. System integrity ad- out have threatened the financial service in-
dresses the problems that arise with recover- dustry. Computers, particularly those acces-
ing a system without loss of data in the event sible through telecommunication networks,
of a failure. add new dimensions to the vulnerabilities of
Ch. 2—Present and Future Technologies Supporting the Financial Service Industry 37

financial service providers. In a high-technol- or organizations could launch their attacks


ogy environment, the assets of an organiza- from any telephone, including those in motel
tion and the proprietary information on which rooms and pay stations, from which they could
it bases its business operations are subject to operate undisturbed for brief periods. At least
remote-access thefts. one computer now on the market fits nicely
into a large purse and can be used to initiate
Attacks on financial institutions through
an attack on a financial institution from any
their own processing systems can directly vic-
location where a standard modular telephone
timize those institutions’ clients. A thief who
connector can be found. Some devices can be
robs a bank at gunpoint steals from the insti-
set up to operate unattended, and then re-
tution; the electronic thief can reach directly
trieved.
into the accounts of individuals. The burden
of detecting the crime, reporting it to the orga- Not all attacks on financial service systems
nization holding the account, and recovering must be so sophisticated. Individual consum-
the lost assets could shift from the institution ers of financial services and various user or-
to the account holder. When the thief’s booty ganizations have demonstrated a marked yet
is information rather than financial assets, nei- unwitting ability to aid the thieves who would
ther the specific individual nor the institution victimize them. Personal identification num-
affected may ever become aware of the fact bers (PINs), given to account holders to use
that the system has been penetrated. in depositing and withdrawing money from
ATMs, are written on access cards. Telephone
Threats to a system can materialize both
numbers and key access codes are written on
from within and outside the target organiza-
communication terminals and bulletin boards
tion. Employees throughout an organization
in clear view of those unauthorized to have
can individually or in concert attempt to com-
them. In one instance, an enthusiastic user of
promise a system. Technical personnel can
an ATM demonstrated the use of the machine
modify operational programs or write new
to a complete stranger and, in the process, re-
ones to perform improper operations. Similar-
vealed his PIN to all within 20 feet. A vari-
ly, nontechnical personnel can seek to perform
ety of comparatively simple scams, that range
operations not authorized to them or misuse
from asking individuals for PINs and the use
powers with which they are entrusted.
of their cards to retrieving used carbons show-
Programmers have written codes that credit ing account numbers from the trash cans of
the fractional cent from an interest computa- organizations that accept cards in payment of
tion to their personal accounts and fail to re- accounts, have been used to compromise finan-
port properly the overdraft conditions in those cial service systems.
accounts. Some programs to perform unau-
Computer-to-computer communication is
thorized operations destroy themselves after
now used to initiate and execute a substantial
completing their task, leaving no trace of their
number of financial transactions, a practice
existence. A few people used computers to
that will become more widespread in the fu-
create and maintain millions of dollars worth
ture. Therefore, the problem of authenticating
of bogus insurance policies in the Equity
the “signature” of a computer that partici-
Funding case, a task that would not have been
pates in financial transactions in order to au-
possible without the technology.
thenticate the transactions will become as crit-
Conceptually, it is possible for anyone to use ical as that of establishing the identity of
international telecommunication facilities to human users. Although under study, no such
attack financial institutions without ever com- technique has emerged that shows promise for
ing within the jurisdiction of American law en- wide adoption by the financial service indus-
forcement officials, much less being in close try. Finding a solution that will be acceptable
physical proximity to the institutions they are for use by individual consumers and others not
attacking. With relative impunity, individuals sophisticated in the design and operation of
38 ● Effects of /formation Technology on Financial Services Systems

advanced technological systems constitutes tions will be interrupted for a period of time.
the most difficult subset of problems in this Such interruptions may be the result of attack
area. by an outsider, natural calamity such as an
earthquake, or the inadvertent error of an au-
Providers of financial services, aware of the
thorized user of the system. Thus, systems
threats to their systems, are taking steps to
must be built so that they can be restored to
tighten security. Various devices and tech-
full operation without loss of data or transac-
niques exist for minimizing the vulnerability
tions in process at the time of failure. This is
of computers and communication networks
a particularly important factor in delivering
used to deliver financial services. The use of
financial services because lack of system in-
data encryption techniques is growing, and a
tegrity could result in a situation where the
system in which the PIN is never accessible level of confidence so essential to the viability
in clear text to any human is available and in
of such systems is degraded.
use by many financial institutions. Physical
security around computer facilities is the focus The problem of providing for system integ-
of considerable attention, and research de- rity is largely a technical one. Increasing use
signed to overcome the known weaknesses of of telecommunications adds new dimensions
the PIN as an access code is continuing. to the problem, but a number of well-accepted
Nevertheless, human ingenuity and fallibility practices aimed at ensuring system integrity
will probably counteract attempts to provide exist. It remains for the operators of financial
foolproof security for computer systems. service systems to ensure that those practices
are followed during the design, implementa-
System Integrity tion, and operational phases of the system
lifecycle.
All systems, whether manual or automated,
will at some time fail in the sense that opera-

Specific Technologies for Delivering Financial Services


Applications of general-purpose information ment that is then processed. Most often, the
processing and telecommunication technolo- consumer is making use of a credit service and
gies specific to the needs of the financial serv- is billed by the credit provider. Today, em-
ice industry have been developed. Included are bossed plastic cards are also used to originate
technologies for accessing systems and han- debit transactions that are processed over the
dling items such as cash and checks that are same network as credit transactions.
unique to the financial service industry.
Generally, the data are recorded on the mag-
netic stripe on the card by the card issuer
Card Technologies before it is sent to the account holder and they
are not changed during the life of the card.
Embossed/Magnetic Stripe Card
This striped card has room for about 1,000 bits
The embossed plastic card with a strip of of data. Allowing for the information that
magnetic tape embedded in the back has be- must originally be recorded on the card, there
come almost ubiquitous. This device provides is just not enough room to record transaction
the primary means for accessing credit and data. Technologically, however, there is no rea-
debit services that are delivered through both son why data on the stripe could not be altered
paper-based and electronic systems. Common- after issuance. On the other hand, the limited
ly, the card is presented at the point of sale, capacity of the stripe and the cost of deploy-
and an impression is taken on a paper docu- ing sufficient terminals with the capability of
Ch. 2—Present and Future Technologies Supporting the Financial Service Industry ● 39

recording data on the stripe makes this device ever, its potential use is likely. As described
generally unsuitable for applications that by S. Berton Latamore:
would require changing the data repeatedly. The card can store digital data signifying
Also, the stripe is easily readable, eliminating the bearer’s fingerprint, voiceprint, or even
the possibility of building security into the the pattern made by capillaries in the
card. retina. A stand-alone card-reading machine,
However, the same basic technology is used equipped with a microprocessor, would check
whether this biological data on the card
in the Washington, D. C., subway farecard sys- matched that of the card-holder. The card is
tem. When a farecard is purchased, the being developed by Drexler Technology of
amount is recorded by the machine dispens- Mountain View, Calif. The company’s Drex-
ing the card. Each time it is used, the starting on card stores 1.2 megabits, or roughly
point of the trip is recorded, and when the 30,000 words–nearly 1,000 times more than
passenger exits the subway system, the a magnetic stripe card.
amount of the fare is computed and deducted The Drexler cards are coated with a two-
from the balance on the card. In this system, layer plastic film. The top layer is embedded
the magnetic stripe is mounted on a paper with microscopic pieces of silver, giving the
backing, and the card is generally disposed of material a highly reflective, metallic look. To
after only a few cycles, a lifetime that would write data, a low-power laser melts pits in the
not be suitable for a card that is to be used top layer to expose the unsilvered—and un-
repeatedly over an extended period. reflective-bottom layer. To read the card, a
laser scans the surface, and a photodetector
Data on magnetic stripes are read by ATMs senses the presence and absence of pits as
and special terminals used by some merchants highs and lows in the intensity of the re-
at the point of sale. Merchant terminals pri- flected light.2
marily facilitate the process of obtaining a Unlike the magnetic stripe, the laser mate-
transaction authorization from the card issuer rial cannot be erased and rewritten; pits are
by eliminating the requirement for either the physical holes that cannot be refilled.
clerk in the store or an authorization clerk at
the issuer’s facility to key in the account num- Electron Card*
ber. Some merchant terminals also print the
necessary information on the paper document, Electron cards, first distributed in early fall
further reducing clerical workload. of 1983 by VISA, U. S. A., combine three en-
coding technologies on the back of the plastic
Among the problems with the embossed/ card-the banking industry’s magnetic stripe,
magnetic stripe card is that it is relatively easy the retail industry’s optical character recogni-
to copy or counterfeit. Several technologies tion, and the universal product code bar
have been developed to overcome this prob- code.** The card, which is not embossed and
lem. Data can be recorded in the laser card by cannot imprint paper forms, is an attempt to
burning pits in a reflective material that can embrace both the banking and retail environ-
be sensed by an appropriate reader. Once re- ment with a move toward a more secure elec-
corded, the data can be neither altered nor tronic environment than presently exists. The
erased. Holography is being used on some card card will feature a direct debit option but will
blanks to create a background image that is
very difficult to reproduce. ‘J. Berton Latamore, “Putting Intelligence in Your Market, ”
Iljgh l“eclmology, published by High Technology Publishing
Laser Card Corp., June 1983, p. 16.
*“Electron f’ card is a trade name for a VISA card.
The laser card, or memory card, is just mak- **Optic~ ch~ac~r recognition (OCR): the process of reading .
a stylized type face with an optical sensor. Universal product
ing its debut. At this date the laser card is not code (UPC): a bar code now imprinted on many items that is
used by the financial service industry; how- read by a suitably equipped terminal.

35-595 0 - 84 - 4 : QL 3
40 ● Effects of Information Technology on Financial Services Systems

also have the capabilities of a credit card. It placing chips in all its VISA cards, the future
presently replaces proprietary ATM access of the smart card is uncertain. Some suggest
cards. A full-scale POS project is expected to that it represents the wave of the future, while
get under way in mid-1984. The card will mi- others see it as a technology in search of an
grate to full-service use at points of sale. application. If it is to come into widespread
use, merchant terminals will have to be gen-
Use of the electron card is intended to re-
erally available. Development of a card with
duce the number of paper checks, resulting in
reusable memory could also enhance the util-
lower processing costs, less fraud, and faster
ity of the concept.
service at the point of sale. Cardholders will
have electronic access to cash through a global In its current form, the smart card is a mod-
network of ATMs and to goods, services, and ification of the conventional plastic card it is
cash at many locations. Authorization will be intended to replace. It contains a microproc-
provided electronically at the time and point essor chip, but because it includes neither a
of each transaction and will be fully controlled keyboard nor display, it can be used only with
by the card issuer. a terminal device that provides power and the
appropriate input/output capabilities.
The processor card, or “smart card, ” devel-
oped in France, contains a tiny embedded com- However, there is no reason why a smart
puter chip with about 1,000 times the storage card that includes a keyboard and display
of the conventional magnetic stripe. However, could not be built. Calculators that are no
once data are recorded in the memory, they larger than the card are available with such
cannot be simply altered, and their memory features; and an interface to a merchant or fi-
cells cannot be directly reused. The smart card nancial institution termina1 could be provided.
contains processing capabilities that enhance Such a card could include in its functions the
its security and flexibility. A standard for its ability to determine the balance remaining and
format has recently been adopted, eliminating to review the transactions for which it has
some of the uncertainty that may have been been used. Multifunction cards that contain
limiting its adoption. The user plugs the card more than one processor could also be built.
into a terminal that then queries the card
The smart card could evolve as an alterna-
memory as part of the processing to validate
tive to cash following the general model of the
the transaction. Once authorized, the transac- fare card used by some subway systems, in-
tion data can be recorded in the card’s mem-
cluding that in Washington, D.C. The user
ory for later retrieval. With present technol-
could “charge’ the card with funds from a de-
ogy, the card costs in the range of $5 to $10
pository account and the funds would be dec-
and is good for approximately 200 transac-
remented for the amount due each time it is
tions before its memory is full.
used. Terminals for recording value in the card
Even though Carte Bleu, a group member could even be located at home, giving the con-
of VISA International, France, has begun sumer the ability to obtain the equivalent of
cash. Card readers could be provided at each
cash register or POS terminal to allow a con-
sumer to verify the card’s balance. Hard cur-
rency dispensers, rather like the common
change machine, could allow the smart card
to serve as the equivalent of a large-denomi-
nation bill.
Photo credit: High Technology, June 1983 In the future, applications of card technol-
The French smart card contains a microprocessor
ogy will become more widespread. Already,
capable of interchanging information with another there are telephones which accept magnetic
computer stripe cards and other vending machines may
Ch. 2—Present and Future Technologies Supporting the Financial Service Industry . 41

the old one invalidated. The question that fol-


lows the compromise of a fingerprint or a ret-
inal pattern is: “What replacement code is to
be issued?” On the other hand, if the data
stream associated with a system that uses the
signature dynamic is compromised, a possible
replacement could be some alternative phrase
with which the user identifies himself.

Document and Currency Readers


The cost of processing billions of paper
items is becoming prohibitive for an industry
losing some of its principal sources of revenue,
and the pressure to find lower cost process-
ing alternatives is intense. Reading of checks
encoded with magnetic ink has been common-
place for over a decade, and credit card vouch-
ers are generally transferred to magnetic tape
for processing. However, aside from some lim-
ited applications such as making change, fi-
nancial document readers are in very limited
use in the United States.
A newly designed pay telephone produced by Flonic-
Schlumberger in Paris accepts smart cards. It is being One of the major suppliers of ATMs has an-
deployed by the French Government’s nounced a model that will accept and time-
Telecommunications Administration
stamp individual checks. It will also be able
to dispense currency and coin in any amount.
be designed to accept them also. As the facil- Models that accept and count Japanese cur-
ites for online transaction authorization and rency are already in use. Thus, the technology
direct debit of accounts from point of sale are to provide deposit verification by the ATM is
deployed more widely, the utility of card tech-
nology will increase. In the long run, however,
the plastic card could be displaced if a secure,
practical means of user identification that de-
pends on the physical characteristics of the in-
dividual could be developed as an alternative.
Signature dynamics, fingerprint readers, and
sensors that process the pattern of blood ves-
sels in the retina of the eye are technologies
that show some promise. It remains to be seen
which, if any, will ever be operational.
However, all of the security features that
could be implemented have flaws. For exam-
ple, if an intruder can capture the digital
representation of a fingerprint before it is
encoded and inject it into a system being at-
tacked, the user’s “key” will have been com- Photo credit Burroughs Corp

promised. When this happens with a conven- Reader/sorter processes checks and other documents
tional PIN, a replacement code is issued and at the rate of 1,625 per minute
42 • Effects of Information Technology on Financial Services Systems

just over the horizon and is likely to increase would be responsible if a forged check were
the utility of these machines substantially. processed against an account? Consumers use
and hold canceled checks in lieu of receipts,
Systems that process credit and debit card
especially for tax purposes. What alternatives
transactions already truncate the paper flow
would be acceptable to the Internal Revenue
at the earliest practical time. Instead of mov-
Service?
ing paper, the data are recorded on magnetic
media and transferred electronically for proc-
essing by the card issuer. Documents are Customer Service Equipment
coded so that they can be retrieved if neces- Cash dispensers were the first terminals
sary. Moreover, credit unions and savings and made available for customer use by financial
loan associations generally do not return institutions. These were followed by the mul-
drafts on NOW accounts to the account hold- tifunction ATMs now in widespread use that
er, also truncating paper flow. However, with are capable of initiating bill payments, trans-
relatively few exceptions, commercial banks fers between accounts, and other types of
still return canceled checks with monthly transactions, in addition to accepting depos-
statements; and attempts to stop this prac-
tice at least for individual accounts have met
with considerable resistance.
In the long term, however, banks and other
depository institutions will develop and deploy
systems in which checks are truncated or ter-
minated at the bank of first deposit. Issuers
will be provided the means for retrieving either
the original or an acceptable photocopy if
needed. The issues standing in the way of such
a change are related more to legal and mar-
ket problems than to lack of suitable technol-
ogies. For example, who in such a system

Photo credit Burroughs Corp

Photo credit: Diebold Corp


Document encoder used to record data on checks in a
machine-readable format Inner workings of an automated teller machine
Ch. 2—Present and Future Technologies Supporting the Financial Service industry ● 43

its and dispensing cash. The functional capa- In the future, a number of “customer work
bilities of these machines are continuing to in- stations” could be available in a lobby area.
crease and they are becoming capable of These could be configured so that the custom-
handling increasingly diverse kinds of transac- er could sit at a desk and accomplish a num-
tions. Counter to this trend, however, some in- ber of tasks, including making a deposit or
stitutions are making available specialized withdrawing funds. Then, when the bulk of the
machines to perform balance inquiries and are work is finished, the customer could go to a
supplementing full-service ATMs with cash device supporting many terminals that ac-
dispensers so that customers requiring only cepts the deposit or another that would dis-
cash will not have to wait behind those with pense cash. Express terminals for customers
more complex transactions. with limited needs could also be provided.
There may be a movement to customer serv- Bank branches without human tellers are
ice machines that have a wide range of capa- operating, and some institutions are shrink-
bilities. Some may be of limited purpose, for ing their networks of full-service branches.
such applications as cash dispensing and bal- Some of these automated branches provide
ance inquiry. Others may have the capabilities only telephone communication for the cus-
of the ATMs of today: accepting deposits, tomer in need of assistance. Others are
moving money between accounts, paying bills, manned by a customer representative who is
and dispensing cash. Still others may be used available to answer questions and market
for time-consuming but infrequent transac- services, but who performs none of the teller
tions, such as the filing of a loan application functions, such as accepting deposits or pay-
or ordering securities transactions. ing withdrawals.

Technology and the Structure of the


Financial Services Industry
One of the impacts of present and future such as gas stations, are motivated by losses
technologies on systems for delivering finan- from bad checks and card fraud to take steps
cial services is that there is a real possibility that minimize their exposure. For example, an
of redistribution of function between and ATM in a supermarket has the potential for
among traditional suppliers and potential new relieving the requirement to cash checks while
entrants. Whereas the payment system has minimizing the amount of currency and coin
been reserved largely by the banks, because that is held at each store location and subject
only they have access to facilities for clearing to theft.
and settlement, movement of funds electron-
ically makes it possible to avoid the traditional On the other hand, what is technologically
payment system and to effect net settlement feasible may be neither possible nor desirable.
directly between members of a community Consumers may balk at accepting new serv-
that have agreed to the necessary implement- ice delivery mechanisms. Legal/regulatory con-
ing conventions. Alternative means of distrib- straints may limit options, and the potential
uting information could diminish the role of providers of the services may opt not to im-
brokers for such varied products as securities, plement them for any of a variety of reasons.
real estate, and insurance. Telecommunication Further, changes in the technologies modify
systems that are capable of message switch- the parameters that bound system design al-
ing are implicitly capable of performing the in- ternatives. Those that are attractive now may
terchange function for payment networks. become undesirable in the future, while new
Retailers and other cash-oriented businesses, alternatives not now feasible may emerge.
44 . Effects of Information Technology on Financial Services Systems

Appendix 2A: Hardware Components


Chip Technology includes a central processor, high-speed random
access memory to which data and programs are
The fundamental building block for information moved when they are active on the system, and
processing and telecommunication is the silicon peripheral storage devices, such as disc and tape
chip. Many thousands of electronic components, drives that store data and programs not immedi-
constituting an infinite variety of electronic cir- ately needed by ongoing processing operations.
cuits, can be fabricated with these chips. The new- Additional components, depending on the system
est computers have memory chips capable of stor- configuration, might be printers, card readers, and
ing 64,000 bits of information; chips capable of devices specifically designed to handle the telecom-
storing 256,000 bits of data are now emerging. munication function.
Chips with 1 million electronic components are in The heart of any computer system is its central
the laboratory stage of development. processor. It is the subsystem that performs the
Processor chips used in today’s large microcom- instructional program written to support a specific
puters tend to include only the functions needed application. Processors can be fabricated on a
for performing the required logical and arithmetic single chip or may require several cabinets of com-
operations. Memory for data storage and circuitry ponents. For any type, the key to increasing speed
to facilitate the movement of data between the and minimizing costs of fabrication and operation
processor and various peripheral devices such as is to minimize the physical dimensions of the proc-
disc drives and telephone communication links essor and the number of discrete components re-
usually require additional chips mounted on the quired.
same printed circuit board as the processor. A Most modern systems use more than one proc-
single chip which includes the processor, memory, essor. In a small desktop computer, for example,
and other supporting circuits, is in widespread use one processor on a chip may perform the primary
for many appliances and devices. But most of the work of a machine while other processors perform
home computers and larger units separate this supporting roles, such as generating the charac-
functionality into several separate chips. ters on the screen of the terminal through which
Silicon chips in use today tend to be less than the user communicates with the system. Large
one-quarter inch on each side. Dr. Gene Amdahl systems may use networks of processors to per-
has suggested that it maybe possible to fabricate form the variety of functions required of a ma-
economically chips that are several inches on a chine. Small systems are capable of tens of thou-
side. If so, performance-to-cost ratios for electronic sands of operations per second, and some larger
equipment could rise significantly because the commercial systems can perform millions of oper-
larger size would limit the need for physical inter- ations per second. Computer systems capable of
connection between chips which is one of the ma- billions of operations per second are just over the
jor costs of fabrication. One of the major factors horizon.
reducing the cost of consumer products, such as The central memory of a computer contains the
home computers and video games, has been the program instructions and data that comprise the
decrease in the number of chips required in these elements of an application system when it is ac-
devices as it has become possible to pack more and tive. A small desktop computer may have storage
more onto a single chip. Also, because the speed for as few as 1,000 characters of information, while
of an electronic circuit is limited by the distance large systems used by providers of financial serv-
between its components, the ability to manufac- ices may have main memory capacity measured
ture very large chips could translate into signifi- in tens of millions of characters. More commonly,
cant increases in processing speeds for the devices desktop computers with main memory capacities
that use them. ranging from 48,000 to 256,000 characters are
used for financial service applications both by in-
Computer Systems dividual users and providers of financial services.
Even though some financial service applications
A computer system consists of a number of sub- can run on computers with as little as 16,000 char-
assemblies that are collected in much the same acters of main memory, computers with memories
manner as a component high fidelity system. It much smaller than 48,000 characters tend to be
Ch. 2—Present and Future Technologies Supporting the Financial Service Industry ● 45

too small to conveniently hold the programs and end. For example, the interchangeable floppy discs
data required for serious financial services applica- used with a computer having 48,000 or so char-
tions. Larger systems used by providers of finan- acters of main memory will have a capacity of
cial services include main memories that com- 100,000 to over 1 million characters. Hard, nonin-
monly range in capacity from 1 million to 8 million terchangeable discs used with such systems can
characters. have a capacity of 5 million to 40 million charac-
Disc drives, another system component, have ters. Discs used with large-scale computers have
large capacities relative to the main, random ac- capacities of hundreds of millions of characters,
cess memory of a computer and permit processors and many can be attached to each system.
to access individual records in a fraction of a sec-

Appendix 2B: Systems and Support Software


Present Operating and Data Base Management Software
Support Systems Data base management systems constitute a
The sophistication of systems and support soft- specialized software technology of particular im-
ware generally varies directly with the capabilities portance to providers and users of financial serv-
of the computer on which it is to be used. Large
ices. This software facilitates the tasks of organiz-
mainframe computers are supported by compre-
ing and accessing large quantities of data where
hensive software packages that provide extensive
relationships between the various elements com-
capabilities to those capable of using them. This prising a data base are complex and where diverse
is to be expected because the larger computer can communities of users access various subsets of
be utilized effectively only if most of its operations
the data base. By permitting the sharing of data
are controlled automatically. At the other extreme,
throughout an organization, the costs of data col-
lection, maintenance, and dissemination are con-
software for microcomputers is much more rudi-
mentary in its scope of functions. The user of a
trolled, and all users are able to base their deci-
microcomputer is in direct control of virtually all
sions on a common body of information.
operations, and the services of a complex operat- Data base technology insulates data bases from
ing system would be of only limited benefit. How- the application programs that access them and can
ever, operating systems even for the smallest com- significantly improve system integrity and secu-
puters are expanding in terms of the capabilities rity. Depending on the data base system, users can
offered. be limited to accessing only specific data elements,
Twenty years ago, systems software and some and further, the operations permitted them can be
support software were furnished free to users by controlled by the data base administrator. Audit
the manufacturers of computer equipment. How- trails that record the identity of all who access
ever, unbundling of software and hardware has data and the operations performed can be gener-
been common industry practice for a number of ated. For example, some users may be permitted
years, and today’s user pays for each of the sys- only to retrieve data, while others may both re-
tem and software support modules used. Operat- trieve and change a specific set of data elements.
ing system and support software is expensive both Permission to add new elements to a data base can
in terms of the direct cost and overhead imposed. be denied both of these groups and given, instead,
These software packages can soak up a consider- to other units within the organization.
able portion of available computer resources. Thus, On the other hand, data base management sys-
a small system with support facilities limited to tems “put all of the eggs in one basket” in that
a single application may, in some cases, be more much of the data critical to an organization is con-
effective than a large machine burdened with large centrated in only a few data bases. Compromise
amounts of overhead. One manufacturer, in fact, of a data base management system can lead to sig-
had to expand significantly the available memory nificant damage to the organization that is af-
on one of its larger models to accommodate the fected. In such an environment, the organization
burden of operating system and support software. can become vulnerable if management does not
46 . Effects of /formation Technology on Financial Services Systems

fully use those data base management system fea- municate with the operating system through
tures which are designed to ensure system secu- higher level commands.
rity and integrity. Although there is no such thing Users will be able to select capabilities that are
as perfect security for any system, data base man- tailored to their needs and pay only for those. Gen-
agement technology can allow a higher degree of erally, ease of use will increase and users will not
system security and integrity than possible when be required to learn separate ways for dealing with
collections of individual files are used by each ap- various classes of applications. For example, all
plication system. terminals will be able to communicate will all ap-
plications because the required protocol conver-
Software Development Tools sions will be performed automatically. It will be
possible for major systems to operate in multiple
The rate of productivity increase for application sites as a single entity because access to and allo-
programmers in the past has been small relative cation of resources will be controlled by the sys-
to the rate of increase in the performance-to-cost tem and support software. Worldwide distributed
ratios of computer hardware. However, a new networks will be feasible by the mid-1990’s. The
group of tools is becoming available to help alle- ability to distribute functions among multiple co-
viate this problem. Data base management tech- operating processors will serve to increase system
nology discussed in the previous section is one reliability and integrity. In addition, the various
such tool. In addition, there are interactive, ter- support packages will develop so that they have
minal-oriented systems that support application great facility to recognize and recover from errors
programmers by minimizing the steps they have and will be able to notify the appropriate user of
to execute to write and test new programs and transactions that could not be successfully proc-
modify existing ones. Management techniques essed because of either a hardware or software er-
that emphasize modularity in design and make ex- ror. A key feature of operating system and sup-
tensive use of procedures for controlling systems port software will be its ability to diagnose system
configuration have also proved beneficial. problems and dynamically reallocate system com-
In addition, advanced languages have made it ponents. User installations will have to expend
easier for programmers to develop the required minimal effort to support software packages.
computer codes. Procedure-oriented languages One manufacturer of microcomputers is already
permit the end-user to interact directly with gen- marketing an operating system that provides the
eralized systems and minimize the need for ap- user with the facility of moving easily from one
plication programmers to develop applications cus- application to another without the need of expli-
tomized to the needs of each user. citly terminating one and initiating a second. As
Perhaps the major breakthrough has been in additional applications are added to the repertoire,
progr ammerless application generators. For exam- they can be integrated with operating system so
ple, general-purpose spreadsheets, such as Lotus that the user is faced with a single, integrated en-
1, 2, 3 and VisiOn, allow nonprogrammers to de- tity rather than a number of disjoint applications.
velop complex models and display their results Integrated, multifunction software packages for
graphically. microcomputers are well established in the mar-
ket; and although they do not constitute operat-
The Future for Operating and ing systems, they offer some of the features one
Support Systemsl would expect to find in an operating system.
This trend toward easing the burden of detail on
Support functions such as telecommunication, the end-user of computer systems is expected to
data management, allocation of hardware re- be a major theme in the development of system
sources, and job scheduling will be performed by and supporting software into the indefinite future.
highly modular support software. More functions At some point, the user will no longer have to rec-
now performed by the operating system will be ognize the existence of a discrete operating sys-
performed in hardware. New emphasis will be plac- tem and will be able to focus all attention on the
ed on the security features and the user will com- applications that are being used.
Many of the features of the operating systems
I Most of the concepts relating to the future of system and support for large computers are already becoming available
software are drawn from, Future Information Processing Technology,
1983, prepared jointly for the Institute for Computer Sciences and Tech- for microcomputers. Some of the software devel-
nology and the Defense Intelligence Agency. opment tools that are now available on large com-
Ch. 2—Present and Future Technologies Supporting the Financial Service Industry • 47

puters are being implemented on small ones. One ade. As more generalized functions are moved into
manufacturer has added to its product line a mi- the hardware, the operating system and support
crocomputer that will run a variant of the virtual software, the tasks required of applications pro-
memory operating system used on its large sys- grammers will be simplified and, hence, less costly
tems. Networks of small computers will become to accomplish. A key element in realizing the ben-
the functional equivalents of large central systems efit of this technology will be the ability of man-
in many operating environments. The emergence agement and technicians to understand its capa-
of such capabilities is foreshadowed by some of the bilities and apply it intelligently in supporting
office systems that are already being deployed by applications systems.
some manufacturers. The same system development and maintenance
By the mid-1990’s, large computers may func- tools that will benefit professional technicians will
tion largely as repositories of data and support also help end-users interact directly with computer
only the largest processing systems. Small com- and communication systems without the need for
puters directly controlled by end-users will per- intermediation by members of technical staffs. The
form most of the processing functions and report support functions will complement the generalized,
generation that will be required. Some installa- user-oriented application systems that will be
tions are already approaching this state. available; and, together, they will provide the end-
Tools for system development and maintenance user with a powerful package of tools for apply-
will be of growing importance over the coming dec- ing the technologies that will be at his disposal.
Chapter 3

The Securities Industry


Contents

Page
Structure of the Securities Industry . . . . . . . . . . . . . . . . . . . . ... , . . . . . . . . 51
The Development of the Securities Industry in the United States . . . . . . 51
Organizations Composing the Securities Industry . . . . . . . . . . . . . . . . . . . 52
Industry Users.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
The Regulatory Structure of the Securities Industry . . . . . . . . . . . . . . . . . 59
Characteristics of the Securities Industry . . . . . . . . . . . . . . . . . . . . . . . . . . 62
New Entrants to the Securities Industry. . . . . . . . . . . . . . . . . . . . . . . . . . . 63
The Securities Industry and the International Market . . . . . . . . . . . . . . . 64
The Effects of Information Technology on the Structure of the
Securities Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64

The Functions of the Securities Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64


The Securities Industry as an Advisor.. . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
Acceptance of Risk by the Securities Industry . . . . . . . . . . . . . . . . . . . . . . 67
Marketing by the Securities Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
Technology and the Functions of the Securities Industry . . . . . . . . . . . . 75

The Effects of Information Technology insecurities Instruments . . . . . . . 75

Appendix 3A: Securities Instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76


Corporate Capital Structure: Debt and Equity Issues . . . . . . . . . . . . . . . . 76
Short-Term Debt–Money Market Securities.. . . . . . . . . . . . . . . . . . . . . . . 83
Options and Futures Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .84

Appendix 3B: Capital Formation and the Functions of the


Securities Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
Private Sources of Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92
Venture Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92
Public Offerings of Securities of a Corporation . . . . . . . . . . . . . . . . . . . . . . 93

Tables
Table No. Page
2. Contracts Traded-Futures Exchanges: A Comparison of
1983 and 1982 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
3A-1. Meet Active Venture Capitalists, 1982 . . . . . . . . . . . . . . . . . . . . . . . . . 93

Figures

Figure No. Page


3. Average Daily Share Volume New York Stock Exchange
1963 to 1983 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
4. Volume of Futures Trading, 1958-83 (millions of contracts traded) . . . . . 58
5. Overview of SIAC Facility Management for NSCC Services . . . . . . . . . . 74
Chapter 3

The Securities Industry


The securities industry in the United States, Since the introduction of the telegraph 140
which developed to help young American busi- years ago, communications technologies have
ness gain financing from European investors, been used by the industry to convey informa-
continues to bring together those who need tion on which the operations of securities in-
capital and those wishing to invest. The indus- dustry depend. However, while the securities
try directs its concentrated expertise on finan- industry has always applied state-of-the-art
cial markets toward its intermediary role of technology to its operations, the level of tech-
facilitating the development of capital. It pro- nology used today and likely to be available
vides advice, accepts risk, and offers market- tomorrow is beyond what could have been
ing services to ensure that an orderly market dreamed of when the telegraph was applied in
for the issuing and trading of securities* is 1844.
maintained.
In this chapter, the structure, functions, and
XFO~ PUW{)=S of this study, securities include debt and equity instruments of the securities industry are de-
issues used to develop capital (stocks and bonds, money-market scribed. The impact that the application of
securities, and instruments which have been developed to allow
hedging and speculation in securities and commodity computer and communications technologies
market s—i. e., options and futures contracts). These instru- has had in these areas is reviewed and possi-
ments, as well as investment tools which developed from the ble future effects are discussed.
packaging of securities instruments, such as mutual funds and
central asset accounts, are described in app. 3A.

Structure of the Securities Industry


The structure of the securities industry has market shortly developed.1 At the same time
been shaped by the demands of users, national the need to finance development in the new
policy objectives regarding the financial serv- Nation was recognized. The burgeoning secu-
ice industry, practical operational concerns, rities industry provided a vital link to Euro-
and competitive market forces. In this section, pean capital markets and also a means of
a brief overview of the development of the cur- transferring capital within the United States.
rent structure of the securities industry and The basic role filled by the securities indus-
a description of the organizations and compet- try in the late 1700’s is still a driving force
itive forces comprising the industry will be behind its operations today: to provide a means
provided. Present and future effects of infor- of interaction for those seeking capital and
mation technology on the structure of the in- those wishing to invest.
dustry will be discussed.
Two factors which quickly emerged as essen-
tial to the operation of the securities industry
The Development of the Securities were the maintenance of an orderly market
Industry in the United States and the availability of trading information.
Twenty-four brokers, conducting trading under
The securities industry in the United States
a buttonwood tree, subscribed to a brokers’
developed to meet the capital demands of the
agreement that formed the first stock market
new Nation. One side effect of the independ-
ence won in the Revolutionary War was war
debt. This was funded by the issuance of in- IMarketpIace-A Brief History of the New York Stock Ex-
terest-paying bonds, for which a secondary change (New York: New York Stock Exchange, Inc., 1982).

51
52 ● Effects of Information Technology on Financial Services Systems

in New York on May 17, 1792.2 This market Organizations Composing the
became the New York Stock Exchange. In Securities Industry
what is now known as the “Buttonwood
Agreement, ” the brokers focused on working Three types of organizations traditionally
together to assure they would be able to trade compose the securities industry: investment
securities smoothly and fairly. banks perform the services surrounding a pub-
lic offering of the stocks and bonds of a cor-
Information on trading and prices has al- poration; brokers manage the buying and sell-
ways been essential to trading decisions. Se- ing of securities; and exchanges provide a
curities firms and exchanges clustered (as on vehicle for setting prices and actually conduct-
Wall Street) to facilitate the communications ing transactions.
needed for the operation of the market. A
newspaper first published stock prices in 1815. Investment Banks
Prior to the introduction of the industry’s first
technology-based information system, the The activities of investment banks are cen-
electric stock ticker (in 1867), messengers tered on the development of capital. The Bank-
literally ran from the trading floor to brokers’ ing Act of 1933, commonly called “Glass-Stea-
offices with information. gall, ” required that investment banking be
separated from commercial banking because
Early refinement and expansion of securities
of the sometimes incongruent objectives and
trading can be related to three communica- the different levels of risk associated with
tions technologies: the telegraph, the trans- these kinds of organizations. Investment
atlantic cable, and the telephone.3 These tech- banks fall into two categories: originating
nologies improved information flows on which firms and distribution firms. Originating firms
the markets are dependent. The telegraph developed largely as intermediaries between
linked exchanges, brokers, and investors European financiers and young American in-
throughout the country and made decision- dustry, and they remain major players in the
making on investments by someone not on development of securities offerings. Distribu-
Wall Street practical for the first time. This tion firms come together in syndication, under
technology offered the first hope of a national, the guidance of an originating firm, to guar-
noncentralized market. The transatlantic antee and sell the securities of an issuer.4
cable, completed in 1866, made an interna-
tional market feasible at a time when Ameri- The four leading investment banks in both
can industry was still very much dependent domestic and foreign financing are Salomon
on financing from European investors. Tele- Brothers, Inc.; Morgan Stanley Inc.; First
phones were first used to convey orders from Boston Inc.; and Goldman Sachs & Co. Mer-
brokers to the floor of the New York Stock Ex- rill Lynch, Pierce, Fenner, & Smith Inc. (Mer-
change in 1878, 2 years after the first suc- rill Lynch) and Paine, Webber, Jackson, &
cessful test of that technology. Curtis (Paine Webber) have a significant share
of the domestic market. Three levels of pur-
The adoption of these communications tech- chasers and sellers are reached through invest-
nologies and the stock ticker were based on ment bank activities: first, the issuers of secu-
the recognition that the faster and more ac- rities, those corporations and governments
curately information flows, the better securi- that purchase investment bank services; sec-
ties markets function. The introduction of new ond, the investors in new issues; and third, the
technologies today is largely based on this intermediaries who bring these two parties
assumption. together—other investment bankers, distri-

‘New York Stock Exchange 1983 Fact Book (New York: New
York Stock Exchange, June 1983), p. 66. 4Sarnuel L. Hayes III, “The Transformation of Investment
‘Marketplace-A Bn”ef History of the New York Stock Ex- Banking, ” Harvard Busines 12ew”ew, January-February 1979,
change, op. cit. pp. 153-170.

Ch. 3—The Securities Industry ● 53

buting underwriters, and commercial banks. Exchanges


Investment banks assume the risk of a pub-
The fundamental role of all exchanges in the
lic offering of investments by guaranteeing
securities industry is to provide an orderly
their purchase—i.e., underwriting them.
marketplace for trading. Exchanges provide
The nature of competition within invest- a central location and a structure in which
ment banking is changing. Price competition buyers and sellers can conduct trades. Ex-
is cutting fees for underwriting to new lows. changes are operated on a membership basis.
In addition, simplification of securities regis- “Seats,” memberships that carry the right to
tration requirements could make underwriters trade on an exchange, are purchased by firms
unnecessary. Nevertheless, the need to trans- or individuals desiring access to its market.
fer risk continues to provide a strong incen- Members agree to direct all trades on listed
tive for utilizing the services of investment securities through the exchange floor. This
banks. allows the exchanges to manage the markets
better–for example, to halt trading on a se-
curity, if necessary, with the assurance that
Brokerage Houses member firms will not trade off-market.
Full-service brokerage houses perform trades Stocks and bonds, options, and futures con-
in securities and commodities and provide fi- tracts are usually traded on separate ex-
nancial counseling services supported by in- changes. This specialization is a carry-over
depth research and analysis of markets and from the separate formation of capital and
industries. This segment of the industry is commodity markets.
dominated by firms which are subsidiaries of Stock Exchanges.– Stock exchanges are in-
companies that offer a range of financial man- dependent players in the securities industry
agement services. Six national brokerage and have two functions: performing transac-
houses lead the industry. They are: Merrill tions and accepting risk. Stock exchanges act
Lynch; E. F. Hutton & Co.; Shearson/Ameri- as a secondary securities market for both debt
can Express; Prudential Bache; Dean Witter and equity issues, providing flexibility and
Reynolds; and Paine Webber. There are also choice for investors. Potential investors in new
many regional firms, such as Alex Brown & issues can evaluate the desirability of the in-
Sons, which play major roles in trading either strument in light of their ability to sell it, and
nationwide or regionally. therefore may recognize a lower opportunity
cost. The existence of secondary markets also
This portion of the industry has been af- increases the available investment choices
fected by the abolition of fixed commission since securities other than new issues are made
rates in 1975. While brokerage houses in the available.
past competed on the reputation of their re-
search and the quality of their service, price There are seven major stock exchanges:
competition has also become a factor. Dis- New York, American, Boston, Cincinnati, Mid-
counters, who concentrate on the transaction west, Pacific, and Philadelphia. In 1982, 80.8
side of the business, have entered the market percent of the total share volume of registered
and have attracted a significant portion of exchanges was traded on the New York Stock
both institutional and individual trading. In Exchange (NYSE). The National Association
response to this market entrance, many full- of Securities Dealers, Inc. (NASD) operates a
service brokerage houses are taking steps to quotation system and clearing facility for the
distinguish their services and to increase cli- over-the-counter market. The automated quo-
ent loyalty. Increased efforts are being di- tation system, NASDAQ,5 has been responsi-
rected toward product development and pro- 5National Association of %curities Dealers Automatic Quota-
motion. tion System.
54 • Effects of Information Technology on Financial Services Systems

Figure 3.—Average Daily Share Volume


New York Stock Exchange 1963 to 1983
85,334 85,000
82500

80,000
77500

75,000
72,500
[ 1 ! !
70,000

Photo credit. New York Stock Exchange

The trading floor of the New York Stock Exchange: 1984

the number of shares held by the public and


SOURCE Futures Industry Assoclatlon, Inc
trading volume.

ble for a dramatic increase in trading volume The principal established marketplaces for
in over-the-counter stocks, an indication of the the trading of options are: the American Stock
importance of information flows to trading. Exchange; the Chicago Board Options Ex-
change; the Pacific Stock Exchange; and
Options Exchanges. –The goal of options the Philadelphia Stock Exchange. These ex-
exchanges is to provide a continuously com- changes compose the Options Price Reporting
petitive and orderly market environment for Authority (OPRA). Trading information from
the purchase and sale of options.6 Each ex- all of the options exchanges is coordinated in
change determines standards regarding which OPRA’s automated last-sale reporting sys-
options may be traded on that exchange. They tem. This system, developed and operated by
select the underlying securities on which op- the Securities Industry Automation Corp.,
tions may be traded based on factors such as provides a consolidated tape of last sale and
‘American Stock Exchange, Inc., et al., Understanding the quote information. The exchanges also formed
Risks and U=s of Listed Options, 1982. the Options Clearing Corp. (OCC), which ac-
Ch. 3—The Securities Industry • 55

;red/t New York Stock Exchange

The trading floor of the New York Stock Exchange: 1930

tually issues the exchange-traded options and futures contracts.7 Futures trading is con-
assigns exercises. ducted in price auctions on the trading floor.
The exchanges are operated on a membership
Options exchanges aid in industry self-reg-
basis, and exchange regulations and policies
ulation by developing and enforcing rules con-
are set by their boards of directors and sub-
cerning the handling of accounts by brokers,
ject to approval of the Commodity Futures
trading hours, and position and exercise limits.
Trading Commission (CFTC). There are many
Options exchanges and the OCC are regulated
futures exchanges in the United States. The
by the Securities and Exchange Commission
largest is the Chicago Board of Trade, which
(SEC).
in 1983 handled 44.89 percent of total trading
Futures Exchanges.—The principal respon- volume (see table 2.)
sibility of a commodity futures exchange is to
‘Futures Industry Associates, Inc., “Roles Played by Each
ensure the existence of competitive markets Participant, ” Futures Trading Course and Handbook, Wash-
free of price manipulation for the trading of ington, D. C., 1983, p. I I-4.

35-505 0 - 84 - 5 : QL 3
56 ● Effects of /formation Technology on Financial Services Systems

1983 1982
Exchange Contracts Percent Contracts Percent Rank
1. Chicago Board of Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62,811,523 44.89 48,206,790 42,89 (1)
2. Chicago Mercantile Exchange. . . . . . . . . . . . . . . . . . . . . . . . 37,830,044 27.04 33,574,286 29.87 (2)
3. Commodity Exchange, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . 20,014,597 14.30 17,520,712 15.59 (3)
4. Coffee, Sugar & Cocoa Exchange 4,876,069 3.48 3,252,512 2.89 (4)
5. New York Mercantile Exchange . . . . . . . . . . . . . . . . . . . . 3,926,589 2.81 2,649,941 2.36 (5)
6. New York Futures Exchange . . . . . . . . . . . . . . . . . . . . . . . . . 3,510,285 2.51 1,451,442 1.29 (9)
7. MidAmerica Commodity Exchange . . . . . . . . . . . . . . . . . . . 3,166,537 2.26 2,397,721 2.13 (6)
8. New York Cotton Exchange. . . . . . . . . . . . . . . . . . . . . . . . . . 1,703,105 1.22 1,479,781 1.32 (8)
9. Kansas City Board of Trade. . . . . . . . . . . . . . . . . . . . . . . . . . 1,693,042 1.21 1,493,558 1,33 (7)
10. Minneapolis Grain Exchange. . . . . . . . . . . . . . . . . . . . . . . . . 379,607 0.27 346,264 0.31 (lo)
11. New Orleans Commodity Exchange . . . . . . . . . . . . . . . . . . . 13,542 0.01 27,872 0.02 (11)
, .
139,924,940 100.00 112.400.879
, , 100.00
SOURCE: Futures Industry Association.
Ch. 3—The Securities Industry ● 57
— — — — —

The exchanges play a major role in self-reg- all economy. Business decisions are being
ulation of the futures industry. In this role made more quickly, and delays in financing
they are required to perform four activities: will not be tolerated.
surveillance of market activity to detect and
prevent situations conducive to price distor- Institutional Investors
tion; surveillance of trading practices to detect Institutional investors include special-in-
and prevent trading abuses; investigation of
terest funds and companies such as pension
rule violations and customer complaints; and funds, mutual funds, insurance companies,
examination of members’ books and records. 8 and private foundations that have a goal of
The introduction of new investment products,
producing income for a specific organizational
such as stock futures, indicates that activity use and deal in large blocks of securities. They
on futures exchanges may be expected to grow
demand prompt, efficient transactions and ex-
over the next several years. The regulatory
tensive information.
and operational role of the exchanges will be-
come more complex. Information technology Since the passage of the Employee Retire-
is being applied to facilitate the operations of ment Income Security Act (ERISA), the im-
the exchanges and will play an increasingly pact of these investors on the total market has
important role in their activities. increased substantially. Trades in 10,000 -
share blocks, a measure of institutional in-
Industry Users volvement, have increased to over 44 percent
g
of total share volume. The broker must also
The demands and characteristics of users of be willing to assume risk by buying from the
the industry are major determinants of indus- institutional investor because he demands a
try structure. The organizations of the secu- high level of liquidity. At the same time, the
rities industry serve as intermediaries between importance of this segment of the market has
two sets of users: capital seekers and in- led to price competition following the deregula-
vestors. tion of commission rates in 1975.

Organizations Seeking Capital The demands of institutional investors have


been, in large part, responsible for much of the
While the focus of much of the activity of automation of trading and clearing by the se-
securities industry is on secondary markets, curities industry. Exchanges need to attract
the underlying demand for capital is the rea- institutional capital to maintain the market-
son the industry exists. In 1982, the value of place, yet information technology, combined
new issues of common stock publicly offered with institutional traders’ level of market ex-
was $23.4 billion; new, publicly offered debt pertise, makes off-market trading a viable al-
obligations totaled $45.2 billion. Private place- ternative for these traders. The volume of
ments of debt and equity totaled $22.3 billion. trading conducted by institutional investors
As the U.S. economy completes its evolution makes those investors valuable clients for
to an information economy, it may be expected both brokers and exchanges.
that a great number of both new firms and ex-
isting corporations with growing operations Pension funds are the most significant insti-
will be seeking capital through both private tutional investors in capital markets. In 1980,
and public sources. these funds held 13.4 percent of the total mar-
ket value of NYSE listed stocks.10 Two factors
Corporations will demand more rapid access that have contributed to the growing impor-
to theircapital than ever before because of the tance of pension funds, both as savings vehi-
effect of information technology on the over- cles and institutional investors, are the aging
8
U. S. General Accounting Office, Survey of Investor Protec-
tion and the Regulation of Financial Intermediaries, 1983, pp. ‘Securities Industry Association data.
28-29. IONew York Stock Exchange 1983 Fact Book, op. cit., P. 52.
58 . Effects of Information Technology on Financial Services Systems

Figure 4.—Volume of Futures Trading, 1958-83 (millions of contracts traded)

1958 ’59’60 ’61 ‘62’63 ’64 ’65 ’66 ’67‘68’69’70 ’71 ’72 ’73 ’74 ‘75’76’77 ’78 ’79 ’80 ’81 ’82 ’83
SOURCE New York Stock Exchange data

of the population and ERISA. Since there has for the benefit of shareholders. Shares are sold
been great interest in individual retirement to investors for the net asset value plus any
planning, pension funds may be expected to applicable sales charges. The return for the in-
be a major player in securities markets. vestor in a mutual fund is similar to that for
any corporate shareholder: the investor prof-
A mutual fund is a company whose principal its from the assumed expertise of the company
line of commerce is investment in securities management in investment decisions. Mutual
Ch. 3—The Securities Industry ● 59

funds are significant as institutional investors nized opportunity to market new investment
because they usually trade in large volumes. products, has generated renewed interest in
individual investors by the securities industry.
Funds are classified by investment strategy
and fall into three categories: income funds, There has been tremendous growth in the
which strive to provide a current income for number of stockholders. NYSE reports that
investors; growth funds, which focus on long- 42.36 million Americans own shares of U.S.
term appreciation; and income and growth corporations or stock mutual funds, an in-
funds, which try to be all things to all people. crease of 10.1 million since 1981. ]2 Of particu-
Generally, funds that seek a higher return for lar significance to the securities industry is the
investors are more risky. For example, some tremendous growth in the number of first-time
funds, such as the Phoenix Fund of Merrill investors, 7.3 million since 1981. This growth
Lynch, are composed of securities of failing ma-y be attributable to several factors, includ-
companies that are believed to have the po- ing the strength of the stock market during
tential to rebound. While the risk level is the early 1980’s, corporate employee stock
higher than average, shareholders in this type purchase plans, and most notably, changing
of fund have less exposure to risk than if they demographics.
were to invest in individual securities, and
The “aging” baby-boom generation, now ap-
they benefit from high yield.
proaching peak investment years, may cause
Mutual funds frequently specialize in spe- an increase in the number of people investing.
cific types of securities, such as government People are waiting longer to get married for
bonds, or in securities from a particular type the first time and have families and therefore
of industry. Money market mutual funds in- are likely to be able to invest at a younger age.
vest only in money market securities, which While securities firms once targeted their serv-
are by definition short term. For this reason, ices towards a small portion of the population,
money market mutual funds are considered their market has become more diverse in terms
less risky and are more liquid than the tradi- of both age and income.
tional mutual funds. Money market funds
Securities firms have been expanding their
have three basic objectives: to preserve share-
product lines and the scope of financial serv-
holder capital; to maintain liquidity; and, in
ices they provide to meet the demands of the
light of these two objectives, to achieve the
individual investor. Movement by firms into
highest possible current income.” Money mar-
other areas, such as insurance and real estate,
ket instruments are generally written in high
is an attempt to draw clients at an earlier
denominations and are only accessible to many
stage in their financial lifecycle and to fill all
investors because they are able to pool their
of their financial needs.
investment dollars in the funds. The money
market benefits from the funds because a large
quantity of capital not otherwise available is The Regulatory Structure of the
attracted. Securities Industry
Federal regulations enacted in the 1930’s
Individual Investors
disallowed involvement by depository institu-
The typical individual investor in securities tions in securities activities because of con-
is an affluent consumer who demands infor- cerns about the effects of risk associated with
mation and advice geared toward his require- these transactions on the stability and sound-
ments. The sales of mutual funds, a proxy in- ness of banks. Such restrictions separated cap-
dicator of the level of individual involvement ital creation from the banking activities of cor-
in the securities market, are rebounding after porations, such as the extension of operating
a period of decline. This upswing, plus recog-
‘zJon Friedman and Tom Petruno, “Record 42M of Us Are
“U.S. General Accounting Office, op. cit., p. 60. Wall Street Investors, ” USA Today, Dec. 1, 1983, sec. A, p. 1.
60 • Effects of /formation Technology on Financial Services Systems

credit and transaction accounts. These restric- supervision with the passage of the Securities
tions were intended to assure that depository Exchange Act of 1934.
institutions acted in the best interests of
depositors. Federal Regulatory Agencies
The regulatory structure of the securities in- Several Federal agencies play roles in the
dustry recognizes that capital and money mar- activities of the securities industry. The Small
kets are essential to the health of all sectors Business Administration licenses and regu-
of the national economy. Legislation concern- lates Small Business Investment Corpora-
ing the securities industry has focused on tions, a type of venture capital firm. The
three areas: providing for disclosure to in- Board of Governors of the Federal Reserve
vestors, promoting self-regulation by the in- regulates the extension of credit by brokers,
dustry, and facilitating the development of a as mandated in the Securities Exchange Act
national market for securities. Federal regu- of 1934, and has a major impact on the in-
lation that is focused directly on the commodi- dustry by regulating the activities of banks.
ties futures segment of the industry is simi- However, responsibility for regulating the
larly designed and seeks to protect markets securities industry is held by SEC, and respon-
and individual traders. sibility for the futures industry, by CFTC.
Securities and commodities trading is over- SEC was established by the Securities Ex-
seen by a two-tier regulatory system: Federal change Act of 1934. Its regulatory activities
and State government and industry. Federal are based on the belief that disclosure is the
regulation is focused on the oversight of mar- preferable means of assuring the smooth oper-
kets and investor protection. State regulation ation of securities markets; it is not invasive
of securities, commonly called “blue sky to the operations of industry players, and it
laws,” since they were designed to prevent the retains investor choice. SEC also acts to pre-
sale of securities with the investment poten- vent price manipulation of securities and reg-
tial of the blue sky, preceded Federal regula- ulates the the practices of exchanges, brokers,
tion, and the right of States to regulate was and dealers. It acts in conjunction with the in-
preserved when the first major legislation con- dustry self-regulatory agencies and oversees
cerning the operation of the securities indus- their activities.
try, the Securities Act of 1933, was passed.
While not a regulatory agency, the Securi-
While Federal regulation focuses on dis- ties Investor Protection Corp. (SIPC), a quasi-
closure without value judgment on the worth governmental organization, has brought a uni-
of the securities, State laws may actually in- form investor protection policy to the securi-
volve licensing. Registration of an issue may ties industry. SIPC operates as a private non-
be refused by a State authority, which would profit membership corporation whose primary
prohibit sale in that State.13 State laws differ, function is to provide financial protection for
but efforts to develop uniform laws are being the clients of failed securities firms. The cor-
led by the North American Securities Admin- poration was mandated by the Securities In-
istrators Association. vestor Protection Act of 1970 in response to
problems that occurred in the late 1960’s
Self-regulation is imposed and enforced by
throughout the brokerage industry as stock
the exchanges and by industry associations.
prices fluctuated widely and volume on the ex-
While the industry began formally supervis-
changes increased dramatically.
ing its own operations with the development
of the Buttonwood Agreement, the self-regu- The only function of SIPC is to insure ac-
latory system was first recognized by Con- counts. It covers shortages in accounts of up
gress and subject to Federal Government to $500,000, including coverage for as much
as $100,000 in cash, for each account. Since
13
U.S. General Accounting Office, op. cit., p. 22. it began operation in December 1970, it has
Ch. 3—The Securities Industry . 61

paid out more than $133 million in claims. ’4 try. To meet this goal, these organizations try
SIPC assesses an annual fee on each of the to ensure that the behavior of the industry is
7,000 brokerage houses in the United States, above reproach. They play a major role in over-
which are required to be members of the cor- seeing the markets, market systems, and the
poration, to maintain the $150 million level it individuals active in the industry. Self-regu-
is required by law to keep available to satisfy latory agencies also have an educational role
claims. At times, SIPC has acted as trustee in dealing with both members of the industry
in cases of brokerage house liquidations and and the public.
as such has distributed payments to custom-
The two most significant securities indus-
ers as accounts were settled.
try self-regulatory organizations are NASD
The corporation relies on SEC and the se- and NYSE. Their roles may be expected to
curities industry’s self-regulating organiza- grow as they continue to carry a great portion
tions for notification that a member firm is in of all securities trading. The National Futures
danger of collapse. If SIPC determines that Association (NFA) is the self-regulatory orga-
the customers of the brokerage house are in nization of the futures industry.
need of its protection, it begins what is termed
NASD is a self-regulatory agency responsi-
a “customer protection proceeding, ” which is
ble for regulating the over-the-counter secu-
a liquidation procedure. SEC is the only orga-
rities market and for promoting high stand-
nization that can sue SIPC to force it to begin
ards of operation throughout the industry. It
liquidation proceedings.
also establishes standards of professional com-
CFTC is responsible for regulating com- petence. NASD was empowered through the
modity futures trading on organized ex- Maloney Act of 1938 amendments to the Se-
changes. It acts to prevent price manipulation, curities Exchange Act of 1934. Its central pur-
attempts to corner market dissemination of pose—to promote high standards of commer-
false or misleading information, and mishan- cial honor and just and equitable principles of
dling of traders’ margin money and equity.15 trade throughout the industry—has become
It reviews and approves the instruments even more important to the industry as tech-
traded on the futures exchanges-i. e., futures nology is applied.
contracts. CFTC oversees the activities of ex-
NYSE oversees the operation of the ex-
changes and other self-regulatory associations.
change marketplace and administers rules and
Disclosure for the futures industry involves regulations related to the maintenance of or-
not only the characteristics of specific con- derly markets and the standards of profession-
tracts, but also the level of risk involved in this al competence. ” NYSE is also a major source
type of investment. All potential investors in of information concerning the industry as a
futures markets are informed that they may whole.
experience large losses as well as gains and
In 1981 NFA was designated a “registered
that it maybe difficult to liquidate a position.
futures association” by CFTC, which oversees
its activities, with congressional endorsement.
Industry Self-Regulatory Agencies
It began operating on October 1, 1982. NFA
Industry associations and exchanges estab- was formed in recognition of the continuing
lish and enforce rules concerning the opera- growth of futures trading to bring a uniform
tions of the securities industry, rules that are system of self-regulation to its activities.
often more stringent than Federal regulations.
NFA works toward four fundamental pur-
An implicit objective of self-regulatory agen-
poses: strengthening industry self-regulation
cies is to maintain the autonomy of the indus-
by regulating those segments of the futures
14
Christine Davies, “Brokerage Failures Bring Agency to
Life, ” USA Today, Mar. 9, 1983.
“U.S. General Accounting Office, op. cit., p. 26. “U.S. General Accounting Office, op. cit., p. 24.
62 ● Effects of Information Technology on Financial Services Systems

industry that were previously outside the consolidation activity was spawned by rising
scope of self-regulatory organizations; elim- business costs for the industry and the weight
inating duplication in self-regulation, thereby of transaction processing, as the volume of
controlling expenses; eliminating overlap and trade had increased throughout the 1960’s.
conflicts in self-regulation of the industry by
Throughout the 1970’s several vertical
providing uniform standards; and aiding ef-
mergers between brokers and investment
fective regulation by removing unnecessary
banks occurred-most notably the acquisition
regulatory constraints.17 of Reynolds Securities by broker Dean Wit-
ter & Co. and the purchase of White Weld by
Trends in Industry Regulation
Merrill Lynch. These mergers integrated new
Trading volume and the number of types of issue management with the distribution of se-
securities instruments have been increasing. curities and may be considered an early move
The securities industry is being entered by toward consolidation throughout the financial
players from other sectors of the financial services industry.
services industry and by outside industries. Recent acquisitions and mergers seen in the
It is likely that more demands will be placed
securities industry have frequently involved
on the oversight functions of the regulatory players from other financial services indus-
system. However, while the importance of this tries. The product lines of firms are becoming
role is increasing, technology will facilitate this
both horizontally and vertically integrated
function by improving information flows on
with lines previously only offered outside of
the operations of the industry.
the securities industry.
While the oversight role may be stream-
lined, standards and education will require Movement Toward a National
more attention. Changes in industry functions Securities Market
and the introduction of new products (facili- The Securities Acts Amendments of 1975
tated by the application of information tech-
directed SEC and the securities industry to
nology) will require an expansion of the educa-
create a national market system for both
tional role of the regulatory agencies. The transacting and clearance. Movement in this
continuing development of technology-based
direction is having a profound effect on the
systems necessitates coordination of stand-
structure of the securities industry. Ex-
ards to ensure that different markets, both do-
changes have been linked to a degree not pre-
mestically and internationally, can interact.
viously seen, through development of technol-
ogy-based information systems such as the
Characteristics of the Securities Industry Intermarket Trading System. Clearing sys-
Concentration tems involving the National Securities Clear-
ing Corp. have made same-day settlement a
The securities industry is heavily concen- possibility.
trated. In 1982, the 25 largest firms, out of
nearly 550 Securities Industry Association The driving force in developing systems that
member firms, controlled nearly 75 percent of make a national market possible is the Securi-
the total capital of the industry. The 10 largest ties Industry Automation Corp. (SIAC). The
investment banks controlled two-thirds of the great increase in the volume of trading on the
profits for that segment. This high level of con- major exchanges in the late 1960’s made it evi-
centration results, in part, from the large num- dent that the securities market needs the ca-
ber of mergers, reorganizations, and liquida- pability to deal with extensive volume. SIAC
tions that occurred during the 1970’s. The was organized both to operate and to develop
more efficient and effective ways of dealing
l~NatiOn~ FUtUreS Association, A %rtnership Between the with the transaction process. SIAC systems
Chicago, 1983, p. 11.
Public and the Industry, support order processing, trading, and report-
3 3 3. —

Ch. 3—The Securities Industry ● 63


— — —— ———- — — . ——— .—

ing functions, as well as clearance and settle- ings and loan associations and savings banks
ment for stocks, bonds, options, and financial own ISFA Holding Co., Ltd., which operates
futures. The corporation is owned by the New INVEST, a brokerage service, through a
York and American Stock Exchanges, wholly owned subsidiary. Thrift institutions,
which would not be able to enter the brokerage
One of the major impacts of SIAC on the business independently, can offer transaction
securities industry is that it makes the devel-
and advice investment services to their cus-
opment and refinement of technological sys-
tomers by subscribing to INVEST.
tems a continual process. This should prevent
or at least limit the lag between the identifica- Special INVEST centers are placed in
tion of a need that could be best addressed branches where they are accessible and evi-
with a technology-based system and the appli- dent to customers, yet remain separate and
cation of a solution. distinct, by order of SEC and the Federal
Home Loan Bank Board, from the other opera-
New Entrants to the Securities Industry tions of the thrift. Just as the securities indus-
try is developing and offering new products
Entrance by Depository Institutions to retain clients, this is also a basic motiva-
An amendment, effective September 9, tion behind INVEST. Thrifts are thus able to
1983, to Regulation Y of the Federal Reserve expand the services they can offer their cus-
Board has added securities brokerage and tomers.
related margin lending to the list of activities Trades conducted through new alternative
permissible for bank holding companies. This brokerage services are executed through the
action, which extends from previous approval exchanges, usually by way of a clearing bro-
by the Government for the acquisition of retail ker. The securities industry finds itself in the
discount brokers by bank holding companies position of servicing competitors, a situation
(notably the BankAmerica Corp. acquisition that is quite common throughout the financial
of Charles Schwab), may increase the interest service industry. As capabilities and econ-
among bank holding companies in entering the omies found in information technology con-
securities industry. ]8 tinue to grow, more entrants maybe expected
The motivation of banks for providing dis- and the wholesale portion of the securities in-
count brokerage services may be seen as either dustry will probably grow.
a reaction to market conditions or an attempt
to protect market shares. Since many broker- Possible Entrants to the Securities Industry
age houses are offering investment opportu- Players throughout the financial service in-
nities that serve functions similiar to depos- dustry, including the securities industry, have
itory accounts, often with more flexibility and been expanding their product lines to fill as
higher rates of return, the consumer’s per- many of their clients’ needs as possible. Rec-
ceived need for a bank may be decreased. One ognized economies of scope usually underlie
motivation for providing brokerage services this expansion of distribution systems, both
may be to prevent the potential luring away for information and for community presence,
of other portions of a depositor’s business. and in terms of complementing current prod-
While acquisition of a discount broker pro- uct lines. Providers often feel they can retain
vides one method of expansion into securities their customer base by entering other lines of
for depository institutions, economies in op- financial services.
erations made possible by the application in- The entrance of other financial service play-
formation technology have made other means ers into the securities industry is already oc-
of market entrance possible. Twenty-five sav- curring. Several insurance companies have
—-———— purchased regional brokers, and some depos-
‘“Federal Reserve Press Release, Aug. 11, 1983. itories have acquired discount brokers. Shear-
64 ● Effects of Information Technology on Financial Services Systems

son/American Express and Prudential Bache creased opportunities both for investors and
are both results of mergers between players capital seekers. Foreign individuals and insti-
in different sections of the financial services tutions made purchases and sales of $79.8 bil-
industry. Consolidation within the financial lion of domestic corporate stock in 1982, and
service industry is likely to continue. transactions in all securities resulted in a net
inflow of $14.3 billion in capital to the United
Others, not traditionally thought of as pro-
States. ’g
viders of financial services, have also entered
the securities industry. The most widely cited Communications technologies are so ad-
example is Sears’ entrance through the acqui- vanced that a market anywhere in the world
sition of Dean Witter. can be selected for trading. This could have
significant impacts on the stability of the econ-
Other players who may recognize significant
omies of nations. For example, the halting of
economies of scope in entering the securities
trading on an exchange in one country could
industry are firms in the communications and
simply result in new trade in another nation.
computer industries. These firms might be in
It is not clear what impact large differences
an especially strong position to enter the
in the valuation of a security by different coun-
wholesale side for the securities industry. Bar-
tries could have on capital markets. Interna-
riers to entry, such as exchange membership,
tional issues in the development of capital
may be overcome by technology. Computer
markets are being considered by various or-
and communications technologies allow for the
ganizations. One such organization is the
creation of information and transacting sys-
Federation Internationale des Bourses de Va-
tems not dependent on the current industry
leurs, an association of 30 stock exchanges in
structure.
20 countries.
The Securities Industry and the
The Effects of Information Technology on
International Market
the Structure of the Securities Industry
The securities industry has its roots in the
The application of information technology
need for the American economy to interact in
in the securities industry affects its structure
the international capital markets. However,
by facilitating the flow of information to such
prior to the completion of the transatlantic
an extent that it removes geographic con-
cable in 1866, a real international market could
straints on market participants and allows for
not exist because it was impossible to convey
development of international capital markets.
information in any meaningful time frame. In-
It may also place additional barriers to entry
formation technology has made it possible for
to the securities industry. Without adequate
the American securities industry to interact
access to telecommunication services, for ex-
in the international market, while economic
ample, a securities firm cannot function.
forces have made it essential.
Information technology has allowed a global
capital market to develop, resulting in in- 1
’New York Stock Exchange 1983 Fact Book, op. cit., p. 63.

The Functions of the Securities Industry


The most significant role of the securities structures of organizations and corporations.
industry is in the development of capital. The While it would be possible for organizations
institutions and players of the securities in- in search of financing and potential investors
dustry facilitate the development of capital to interact directly, the market structure that
Ch. 3—The Securities industry ● 65

has developed provides needed services more Information Dissemination


efficiently. Since most corporations and orga-
Information technology affects information
nizations do not approach capital markets fre-
dissemination by the securities industry in
quently, financing with the aid of the securi-
several ways. Information is now less costly
ties industry is usually more cost effective
to gather, store, and access than it was in
than direct attempts because of the expertise
largely manual systems. Therefore, not only
securities institutions have in analyzing secu-
is it likely that the quantity and quality of
rities markets and in locating potential inves-
available information will increase, but also
tors, and because of the ability of the securi-
that more information will be sought. Inves-
ties industry to accept risk.
tors and other parties interacting with the
The use of information and communication securities industry may be expected to make
technologies by the industry is nearly univer- better and more satisfying decisions because
sal, and adjustments may be expected in op- of the increased availability of information.
erations as the value of technology is realized.
Technology has already had a major impact
However, while information technology may
on information flows throughout the securities
change the way in which the securities indus-
industry, and it appears that the resultant
try performs its activities, and may even fa-
changes may have major impacts on the oper-
cilitate attempts by investors to act on their
ation and, in time, the structure of the securi-
own behalf, it is expected that the basic func-
ties industry. Information technology en-
tions of the securities industry will remain an
hances the reporting of securities trades. The
essential part of the development of capital.
Consolidated Quotation System, which went
In this section, an overview of the functions
online in 1978, collects and disseminates quo-
of the industry and the emerging effect of the
tation information from exchanges across the
application of information technology on these
Nation and calculates and appends the na-
roles will be described. The significance of the
tional Best Bid and Offer to the quotation in-
advisory, risk-accepting, and marketing func-
formation. 20 Communication technology
tions of the securities industry to the process
makes it possible to transmit this information
of gathering capital will be outlined, and the
in real time to system subscribers nationwide.
effect of information technology on this proc-
A similar system is in place on the NYSE for
ess will be summarized. Specific approaches
debt issues. The Automated Bond System pro-
to capital formation are discussed in appen-
vides current quotation and trade information
dix 3B.
for more than 80 percent of the exchange-listed
bonds. 21 This system has improved the quality
The Securities Industry as an Advisor of information available on bond trading.
In its advisory role, the securities industry Information technology may increase the
provides information and offers guidance to independent role investors assume as infor-
its clients. It is able to advise organizations mation monitors, particularly the individual
seeking capital on the type of financing most investors. Although massive quantities of fi-
desirable, whether through private or public nancial information are currently available
means, and, perhaps most significantly, what through a variety of media, such as news-
the timing for entering the capital market papers, radio, and television, and through pub-
should be. These decisions are based on the ob- licly available consolidated tapes, individual
jectives of the firm. Factors to be considered investors may expect to have even more in-
include the risk and return associated with
various issuing organizations and instru-
‘“Securities Industry Automation Corp., Annual Report, New
ments. Timing of buy and sell decisions is also York, 1982.
21
part of this advice function. New York Stock Exchange, Amual Report 1982, New York.
66 . Effects of Information Technology on financial Services Systems

formation at their disposal. While a “more is the market to correct itself in unusual situa-
better” philosophy is usually applied to infor- tions may be destroyed. In the long run, this
mation, the result can be confusing, deceptive, may be a severe disadvantage for the investor,
and frustrating to users. Moreover, informa- particularly the small investor, who may find
tion gathered by intermediaries within the himself bearing both transaction and lost op-
securities industry may require translation to portunity costs because of action taken be
a form that can be used by clients. cause of basically meaningless market fluc-
tuations.
The adoption of home information systems,
particularly interactive cable and personal
Counseling
computer systems, may change the way in
which this information is gathered and used. The nature of counseling may be changed
E. F. Hutton and Dean Witter provide cus- by the amount and type of information and
tomers with securities research that can be ac- supporting analytical tools available. Research
cessed via home computers.22 It is not clear is expected to become pivotal rather than pas-
how investors will use this information. The sive in the investment advisory function.23
continual availability of new information may Analysis and recommendations presented by
result in more frequent trading; however, securities industry intermediaries to clients
home systems may just be, in the aggregate, concerning potential investments may be more
a new medium. Investors may evaluate no detailed and, to complement this process, anal-
more information than they did in the past. ysis of the financial needs of the individual
may also improve.
Computer and communication technologies
have increased the speed with which informa- Increased availability of information tech-
tion is available to the mass market. With the nology has changed the nature of counseling
systems now available, investors may become by placing more sophisticated analytical tools
less dependent on a broker or dealer for up- in the hands of both advisors and investors
dated information. An example of this type of who may not have had access to these tools
system is Pocket Quote, produced by Telemet in the past. This change may affect the way
America, Inc. The basis of Pocket Quote is an in which investment decisions are made and
1 l-ounce programmable receiver, which looks the quality of these decisions.24
like a calculator and can be used to monitor
The reliance on information technology for
the New York and American Stock Exchanges
analysis of personal investment needs, objec-
as well as option exchanges. Information, in-
tives, and choices may indicate an initial move
cluding price and trade volume, on up to 20
in the industry to reemphasize individual hu-
securities specified by the user is transmitted,
man judgment and perhaps a reemphasis of
subject to a 15-minute delay. The data are
the client/broker relationship. It is not clear
broadcast in a scrambled form on FM side
what the impact of this change will be; how-
bands, using a digital signal. Not only is the
ever, a decline in personalized service, based
information readily available to the investor,
on the evaluation by the broker of the client’s
but the system can be programed to page the
financial objectives, may occur.
user automatically at any time there is “news”
about any investment instrument in which he/ While counseling may be displaced in some
she is interested. areas within the securities industry, its impor-
tance as a separate and unique service of the
The potential for investors to act immedi-
industry has been highlighted in some cases.
ately on information continually updated and
transmitted via such systems may affect the
stability of securities markets. The ability of “Thomas Moore, “Ball Takes Bache and Runs With It, ” For-
tune,
24
Jan.
24, 1983, pp. 97-98.
Lee B. Spencer, “The Electric Library, ” remarks to the
“Tim Barrington, “Stock Trading by Computer Enters American Bar Association, Federal Regulation of Securities
Homes, ” The Wall Street Journal, Oct. 6, 1983. Committee, Nov. 19, 1982.
Ch. 3—The Securities Industry ● 67

Advice, particularly counseling, has been un- agreement with the investment bank or other
bundled from the total package of services of- underwriter is closed.
fered in a new service supplied by Merrill
In most cases, the underwriter also assumes
Lynch, called “Pathfinder.” For a set fee, the
risk by assuring that the issue will be sold, and
client receives what amounts to a financial
he accepts the risk that market fluctuations
checkup. The evaluation provides guidance to
or initial pricing mistakes may influence the
the investor in a somewhat objective frame-
success of the issue. Offerings underwritten
work. The success of this product may be an
on a “best efforts” basis, where the under-
indication of the future role of advice within
writer does not bear the risk of an unsuccessful
the securities industry.
offering, permit those issuers in a startup or
developmental stage, whose issues may be
Acceptance of Risk by the considered to be more risky, to have access to
Securities Industry the public capital markets.
The securities industry accepts risk that Underwriters earn money by buying secu-
might otherwise be experienced by individuals rities at a lower price than they resell them for
or organizations seeking investment. It does to investors. The difference in price, or spread,
this in two ways: through underwriting and is a major consideration in the selection of an
by the extension of credit through margin. investment bank by a firm. A prospective cli-
Underwriting refers to the assumption of risk ent for an underwriter may choose an invest-
by an investment bank or other third party ment bank through two methods: competitive
at the time of a public offering. The extension bidding or negotiation. Both systems have ad-
of credit by brokerage houses is referred to as vantages, and experts disagree on which pro-
margin. vides the best price for the capital seeker. The
advantage of the negotiated system is that the
Underwriting New Issues issuing firm and the underwriter work to-
gether to make decisions about the pricing and
Underwriting involves the purchase of se-
timing of the issue.
curities from the issuing company and the
subsequent resale of the instruments to the The company using a competitive bidding
public. This service, which is usually per- system invites offers from investment bank-
formed by investment bankers, is essential to ers. This process is required for many public
firms in need of capital that are not in the busi- utilities and most municipal offerings. But
ness of marketing securities. It allows them while some experts believe it results in higher
to receive the funds they need while transfer- net proceeds for the issuing organization (be-
ring the marketing function to an expert who cause of the forces of competition), it has dis-
may be expected to be more effective in reach- advantages. Much of the benefit of the advi-
ing prospective investors. sory function that the issuing company would
enjoy in a negotiated situation is lost. A higher
The underwriter accepts some of the risk
price may be received, but this largely depends
associated with a public offering. He prevents
on the health of the market at the time of the
lag time by assuring that the issuing corpora-
offering. In a depressed market, investment
tion has access to the funds it is attempting
bankers are less likely to compete for a pub-
to raise when needed. By buying the public of-
lic offering, and therefore the price received
fering from the firm in search of financing, the
may be lower.
underwriter makes it easier for the manage-
ment of the firm to plan the use of the funds It is also typical for investment banks to
generated. The issuing organization may be minimize their risk by forming syndicates.
less concerned about the flow of cash the sale This spreads risk and benefit because of their
produces because it is usually guaranteed a pooled sales force and allows a number of
fixed price and can use those funds when the underwriting firms to participate together in
68 • Effects of Information Technology on Financial Services Systems

large public offerings. Changes in industry usually by a single underwriter who has not
structure, particularly consolidation among in- lined up buyers in advance. While information
vestment banks, may affect this operation. technology may allow underwriters to locate
buyers quickly, more risk is involved in this
The presence of an underwriter provides a method than with a traditional syndicate.
valuable service for the prospective investor.
Investment bankers are expected to examine The emphasis on price competition maybe
the corporate records with due diligence and a disadvantage for corporations entering cap-
are liable to defrauded investors if they fail ital markets because the benefits of advice on
their due-diligence obligations and miss any pricing and timing of an issue is sacrificed.
misstatement or omission of material fact by While sophisticated analytical tools, which in-
the issuer in the prospectus. Therefore, not formation technology may enhance, may as-
only does an underwriter assure that the issue sist corporations seeking financing in evalu-
will be sold in a “firm commitment” offering, ating various possibilities, this type of
but it also provides an oversight function of analysis may not be tailored to the needs and
the issuer on behalf of prospective investors. objectives of corporations to the same extent
as the information and counseling services pro-
The underwriter also frequently accepts risk
vided by an underwriter.
through providing a secondary market for se-
curities by maintaining a position in the stock.
Margin
This activity, called “making a market, ” is
similar to the role played by securities special- “Margin” refers to the amount of money
ists, which is discussed in a later section. The paid by an investor to acquire a security
underwriter quotes “bid” and “asked” prices through credit instead of cash. At the end of
for the security based on market supply and 1982, the securities industry held nearly $13
demand and intervenes as a buyer or seller, billion ($12.98 million) in margin debt secured
when necessary. The original offering of a debt by nearly $39 billion ($38.88 million) worth of
or equity issue may be expected to be more collateral. 26
successful when the potential investors know
The Securities Exchange Act of 1934 em-
that the existence of a secondary market is
powers the Federal Reserve Board to regulate
guaranteed.
this extension of credit. Brokers are permitted
Information technology may affect the to extend regulated credit on stocks and con-
underwriting function by decreasing the time vertible bonds traded on registered exchanges
between the initial development of a securities as well as some select over-the-counter stocks.
issue and its sale, lessening the need of capi- Initial margin requirements, set by the Fed-
tal seekers to be protected against this lag. eral Reserve Board, currently call for a deposit
Pricing decisions and market evaluations may equal to 50 percent of the total value for both
be more certain if the time frame in which the stocks and convertible bonds. Stock ex-
security is offered is lessened. changes and other self-regulatory agencies of
the industry have individual requirements for
Price competition has been increasing in the the opening and maintenance of margin ac-
area of underwriting. Since the use of syndi- counts. For example, the NYSE requires an
cates is decreasing, there is a greater need for initial deposit of at least $2,000 and the main-
individual firms to have substantial capital if tenance of equity of the customer at 25 per-
they are to continue functioning as underwrit- cent of the value of securities carried.
ers. 25 Information technology may be a con-
tributing factor in the advent of bought deals The advent of home equity access accounts,
that involve the purchase of an entire issue, encouraged by advances in information tech-
nology, may increase the amount of margin
25A. F. Ehrbar, “Upheaval in Investment Banking, ” Fortune,
Aug. 23, 1982, pp. 90-95, Z6New york Stock Exchange 1963 Fact Book, OP. cit., Il. 46.
-..

Ch. 3—The Securities Industry ● 69


— —

debt and change the nature of collateral. While but rather, that the clients recognize an un-
some accounts restrict this use of credit drawn filled need and seek a way to meet it.
from home equity for the purchase of securi-
At one time the operations of the securities
ties, in many situations this is acceptable.
industry were centered on what was possible,
Margin takes on a different meaning in op- given the regulatory framework and its busi-
tion and futures contract trading. In futures ness concerns. Now, a new awareness of the
trading, margin refers to the amount of money importance of basic marketing to retain and
or collateral which a client is required to de- develop business is evident, resulting in re-
posit with his broker to insure the broker search to support activities in product devel-
against losses on open futures contracts. Op- opment and promotion and the targeting of
tion writers must, similarly, deposit cash or specific segments of the population for special-
securities with their brokers so that the bro- ized products. Given the competition the in-
kers are covered in case of an assignment. dustry faces in its traditional and new prod-
uct lines, especially from new entrants into the
Margin plays an important role in specula-
financial service industry, the marketing func-
tion in securities markets. A frequently used
tion may be expected to continue to grow in
strategy in the buying and selling of securi-
importance for the foreseeable future.
ties is the “short” position. In this case, an
investor sells securities he does not own, but Information technology may affect those
has borrowed, to make delivery in the hopes marketing functions of the securities industry
that the price will decline before it is neces- that comprise product development, sales or
sary for him to return the security. This activ- brokerage, and pricing.
ity can be extremely risky. However, it ac-
counts for a significant amount of market Product Development
activity. In 1982, 1.5 billion shares, in round
In recent years, the regulatory restraints on
lots, were sold short, an amount that was 9.3
the financial service industry have decreased,
percent of all reported securities sales.27
and the securities industry has found competi-
Information technology may decrease the tors in what at one time were strictly separate
significance of margin as a convenience for businesses. These developments have occurred
brokerage customers because it eases access when the securities industry was observing a
to assets and facilitates funds transfers. Cus- continual demographic and psychographic
tomers may be able to finance securities pur- change among its potential retail clients, a
chases using other assets whose liquidity has growing institutional market, and more com-
increased as a result of increased use of infor- plex financial needs among organizations seek-
mation technology. It is not clear what the net ing capital.
effect will be; however, the use of electronic
Shifts in the area of product development
funds transfers may largely eliminate the use
are seen mainly in the way products are pack-
of margin by brokerage houses to provide
aged, specifically in the variety of mutual
float.
funds and money market mutual funds that
have been developed. It is not yet clear how
Marketing by the Securities Industry patent and copyright laws will affect the de-
For purposes of discussing the securities in- velopment of information technology-based fi-
dustry, “marketing” is defined as those activ- nancial services products. If financial service
ities designed to identify and meet the needs products become patentable, some securities
of clients; i.e., both seekers of capital and in- industry experts believe that competition
vestors. It is assumed that these clients do not could be stifled.28 Many financial service prod-
demand a specific product or type of service, ucts are similar in both character and features,
“’’Merrill Lynch Wins Cash Account Row With Dean Wit-
“New York Stock Exchange 1983 Fact Book, op. cit., p. 48. ter, ” The Wall Street Journal, Dec. 29, 1983, sec. 1, p. 2.
70 • Effects of Information Technology on Financial Services Systems

and therefore, there is an inherent possibility ties industry may be expected to make efforts
of patent infringement. Differentiating prod- to distinguish similar products legally, patent-
ucts by attribute has not been of great interest ing may also increase consumer confusion
to the financial service industry, which has about product features and attributes.
competed by geographic market and compara-
tive return and cost. Brokerage
Information technology has created interest Brokerage involves bringing together buy-
in patenting financial service products because ers and sellers, facilitating trades through the
communications and computer technologies maintenance of a marketplace, and assuring
have broadened markets. Products that at one that the trade is complete. The significance of
time may have been offered locally now com- this activity as part of the operations of the
pete nationally. Therefore, protection of prod- securities industry cannot be overestimated.
uct may become as necessary as the position- Traditionally, all of the costs of supporting an
ing of the product. investment bank or brokerage house were re-
covered through this portion of the business.
The patentability of financial products is
The services provided to clients, such as re-
now being tested in cases involving the cen-
search support and advice, were bundled into
tral-asset account. In response to perceived
the commission rate for purchasers of securi-
consumer demand, most major firms in the
ties and into the spread on new issues for in-
securities industry, including Dean Witter,
vestment banks.
Paine Webber, Shearson/American Express,
and Prudential Bache, have introduced these The heart of brokerage with retail clients has
accounts, which are combination margin ac- been personal selling. The relationship be-
counts and investment funds. Merrill Lynch tween the investor and the individual broker
led the development of asset management has been fairly constant, and typically, the ac-
accounts with its introduction of the cash counts a registered representative develops
management account in 1977, for which it re- while with a particular brokerage house move
ceived patents in August 1982 and March with him if he/she switches firms. Firms within
1983, and, with over 1 million accounts, is the the industry have expended great effort in at-
market leader. Following the receipt of its pat- tempts to retain clients. The development of
ent, Merrill Lynch notified competitors that new products unique to particular houses may
it was imposing an annual licensing fee of $10 encourage a loyalty to the company rather
on all asset management accounts. Initially, than to the broker. It is not yet clear how this
this levy was not taken seriously throughout might change the character of the industry.
the industry; however, without admitting any
Most technology-encouraged competition is
patent infringement, Dean Witter resolved its
occurring within the selling function of retail
dispute with Merrill Lynch about the accounts
and institutional brokerage. The end of stand-
in late December 1983 for $1 million. The firms
ardized commissions on the sale of securities
agreed to “grant each other a nonexclusive,
(1975) has encouraged the entrance of dis-
royalty-free license to use any improvements
counters into this market. Discount brokers
or changes either might make relating to cen-
complete trades for investors at prices that are
tral-asset accounts. ”29
generally lower than the commission charged
If financial service accounts are routinely by full-service brokers. Usually, the service
patented, investors may find that their choices provided by discounters is limited; e.g., these
are limited, since the patent may be a barrier firms usually do not support extensive re-
to entry into some product lines for some serv- search and advice operations. However, they
ice providers. Since players within the securi- do fill the needs of a portion of the market.
About 15 percent of trading by individual in-
29
Ibid. vestors is handled by discounters.
Ch. 3—The Securities Industry ● 71

Access to information technology for indi- changes. One such system, the Intermarket
viduals will facilitate direct selling of securi- Trading System (ITS), may be seen as being
ties to investors without the interaction of a indicative of a trend toward a national mar-
broker. This type of system is particularly ket for securities trading.
adaptable for discount brokers whose service
ITS allows brokers, specialists, and market
is basically order-taking. C. D. Anderson &
makers to interact with their counterparts at
Go., a small discount broker, developed the
other markets. The system, maintained by
first home brokerage system, and other bro-
SIAC, currently involves eight stock ex-
kerage houses are expected to enter this mar-
changes: New York, American, Boston, Phila-
ket. 30 C. D. Anderson’s system allows clients,
delphia, Cincinnati, Midwest, Pacific, and, to
who pay a hook-up charge and a usage charge,
a limited extent, NASDAQ.
to enter buy and sell orders at their conven-
ience, without dealing with a broker. ITS provides a mechanism through which
the most favorable exchange setting can be
Transactions chosen for a transaction. * At NYSE, the best
price from any member of ITS, as well as the
Congress mandated the development of a
NYSE floor price, is displayed. If it is advis-
computerized national stock market system
able for a trader to deal on an exchange other
in 1975, believing that by linking all market
than the one at which he is operating, he can
centers, such a market would expose securi-
enter his order by contacting his counterpart
ties to a greater number of buyers and sellers,
there. At the end of 1982, 1,039 issues were
and an investor would have the chance to ob-
eligible for trading on ITS. NYSE reports that
tain the best price available. This system was
this represents most of the stocks traded on
also expected to provide competition to
more than one exchange.
NYSE, which dominated the market with 80
to 90 percent of the trading volume. The Designated Order Turnaround (DOT)
system was introduced in 1973 to route small
The Cincinnati Stock Exchange was ex-
orders (599 shares or less). It reports elec-
pected by many industry experts to become
tronically between NYSE and member firms.
the basis of an automated national stock ex-
DOT bypasses floor brokers by routing orders
change. The exchange was supported by Mer-
directly to the appropriate trading post on the
rill Lynch, the largest firm within the securi-
floor of the exchange and, following execution,
ties industry. In July 1983 Merrill Lynch
back to the member firm on the same elec-
withdrew a large portion of its business from
tronic circuit. Over 80 percent of the 5.7 mil-
the Cincinnati Stock Exchange and returned
lion market orders processed through DOT in
it to the floor of NYSE, noting that not only
1982 were executed and reported back to the
had the Cincinnati Stock Exchange failed to
member firm within 2 minutes.31 This system
gain the volume anticipated, but that NYSE
minimizes the cost to member firms of han-
had improved.
dling small transactions while giving small in-
While NYSE is still largely based on a sys- vestors the benefit of timely execution of their
tem of auction pricing and securities special- trades. DOT may also provide a better price
ists, the adoption of systems made feasible by than would normally be received by a small
the application of information technology has investor. A trade made through DOT is
allowed it largely to eliminate problems asso- matched by computer for price with the most
ciated with high volume. In addition, commu- recent trade of that issue. The investor bene-
nications systems have been developed that fits because the price he receives may have
allow users of NYSE to enjoy many of the
benefits of a national system by providing in-
formation on the activities of regional ex- *For Purpows of this discussion, “transacting” is defined as
the physical execution of trades.
‘°Carrington, op. cit. “New York Stock Exchange 1983 Fact Book, op. cit.

35-505 0 - 84 - 6 : QL 3
72 . Effects of Information Technology on Financial Services Systems

resulted from price negotiation on a much Given that the primary responsibility of se-
larger order.32 curities exchanges is to maintain an orderly
market, technology, the great facilitator of
Another technology-dependent system that
their operations, could also be a major under-
facilitates transacting is the Opening Auto-
mining force for the exchanges. It is basically
mated Report Service (OARS). OARS makes
meaningless to stop trading for a security on
efficient and accurate processing of market
an exchange if the end result is simply that
orders, that are received at NYSE prior to the
trading is moved off of the exchange and con-
start of daily trading, possible without caus-
ducted without the prudent management of
ing unnecessary delays in the opening of trad-
the specialist. It may be essential for ex-
ing, and transmits computer-generated reports
changes to continue trading a given security
to the originating member firm.33 This system
in all but the most unusual situations.
is especially valuable to specialists on days
with high trading volume, which have recently
Clearance and Settlement of Securities
been occurring with great regularity.
Clearance and settlement activities consum-
Future developments in transacting en-
mate trades through the exchange of securi-
hanced by information technology may include
ties and funds.35 As with any marketplace, an
the bypassing of intermediaries in the proc-
action recognizable to all parties involved is
ess of selling. Some experts believe that the
necessary for finalizing a transaction. Given
adoption of home information systems may
the great number of participants in the secu-
make it more common for investors to com-
rities industry, it is essential that transactions
plete transactions between themselves pri-
be closed as efficiently as possible in a man-
vately or to gain direct access to exchange
ner that is acceptable to all parties involved.
floors. While it does not appear that the pos-
sibility of off-market trading is having a ma- The increasing volume of trade and the con-
jor impact on the individual investor at this tinuing development of new securities prod-
time, institutional investors have at times ucts has made it necessary to refine settlement
found it advantageous to trade off-market. and clearance. Since ownership is merely con-
tractual until the process is finalized, delays
About 500 brokerage houses, pension funds,
in settlement and clearance could have a se-
insurance companies, and other institutional
vere effect on the operation of securities mar-
investors are linked through AutEx Systems,
kets. An industrywide effort is under way to
a nationwide computer network. The potential
move toward a national settlement and clear-
of this system for trading was demonstrated
ance procedure through the adoption of stand-
by its use in creating a market in a stock for
ardized proofs of ownership that are not paper-
which trading had been closed by NYSE. Jef-
based, such as book entry, and to facilitate ef-
feries & Co. is a discount broker specializing
fective, marketwide clearance through the use
in institutional trading. It is not a member of
of automated systems that assist in the clos-
any major exchange and therefore is able to
ing of positions.
make a market in an exchange-listed stock
without going through the exchange. Follow- Clearance and settlement are recognized as
ing a request by a client, Jefferies announced an important portion of the national market
over the AutEx System that it was making system. The formation in 1977 of the National
a market in the closed stock. The company Securities Clearing Corp. (NSCC), for which
traded a total of about 8 million shares of the SIAC (Securities Industry Automation Corp.)
stock off-market. 34 is facilities manager, encouraged movement
toward a national clearing system. NSCC com-
3’Desmond Smith, “The Wiring of Wall Street, ” The New bined the clearing corporations of NYSE, the
York Times Magazine, Oct. 23, 1983, p. 109.
33
New York Stock Exchange, Annual Report 1982, New York,
p. 33. ‘sNational Securities Clearing Corp., Annual Report 1980,
“Smith, op. cit., p. 73. New York.

v
Ch. 3—The Securities Industry ● 73

American Stock Exchange, and NASD. It has provide a framework for price adjustments for
provided more efficient clearing at lower costs securities. Price in its most pure form is a func-
per trade for listed and over-the-counter tion of supply and demand. For securities, this
trading than was previously possible. SIAC is generally defined to mean the net present
facility management for NSCC services in- value of anticipated cash flow, in terms of
tegrates several major processes and entities what is received in interest or dividends and
in the settlement process (see fig. 5). resale. Initial pricing decisions on new issues
are particularly sensitive for the securities in-
One pivotal change in the settlement proc-
dustry since the risk associated with errors
ess was the development of Continuous Net
usually falls totally on the underwriter. If the
Settlement (CNS). CNS represented a change
price is not in line with value as perceived by
in accounting approach to the provision of con-
the market, the issue will not be bought.
tinuous net positions against the clearing sys-
tem rather than a daily balance order ac- Pricing for securities in secondary markets
counting.” In addition to improving clearing may be done on a historic basis or by auction.
operations, savings recognized through the ap- Automated trading systems are based on a
plication of CNS have included manpower and historic pricing mechanism; that is, the price
same-day delivery of securities. An important of an instrument is determined by its past
link in this system is the Regional Interface behavior. Prices in the auction system are
Operation, which allows member organiza- determined by market demand. Proponents of
tions to trade on any exchange and bring set- this system believe that the auction gives a
tlement to the clearing facility of their choice. truer evaluation of the worth of the issue and
is therefore beneficial in the aggregate to both
The Options Clearing Corp. (OCC), which is
sellers and buyers.
owned by the options exchanges, is the clear-
ing entity for options trading. It supports the The operation of the secondary market for
clearing members and participant exchanges securities provides a method for correcting
by acting as the issuer of all cleared and prices. Securities specialists perform a pricing
settled options, guaranteeing option contract function on exchange floors in fulfilling their
performance and fungibility, and effectively function of maintaining an orderly market.
performing trade clearance, settlement and The specialist, an independent businessperson,
associated clearing functions, and other secu- performs this function as an auctioneer, buyer,
rities industry services. 37 The primary objec- and seller of securities. He makes a value judg-
tive of OCC is to provide these services in the ment about the opening price of a security at
most cost-effective manner. the beginning of each day when opening trad-
ing. Although no trading may occur through-
Information technology has been essential
out the day, this establishes a price of record.
in the refinement of the clearing and settle-
ment process. It will affect it further through The specialist facilitates trades by inter-
some changes that will be felt in the market ested brokers on the floor and stands in as a
as a whole. If substantial trading is conducted buyer or seller at times when demand and
off-market, general access to the automated supply on the floor do not mesh. By standing
settlement system may be demanded. in as a buyer or seller, the specialist maintains
an orderly market by assuring that price
Pricing changes occur in small increments. This allows
investors to assess the market situation of a
Pricing occurs at two points in the securi-
security in a rational fashion.
ties industry: investment bankers assist in the
initial pricing of new issues, and exchanges NYSE now offers a technology-based sys-
———
“Securities Industry Automation Corp., A Decade of Pro- tem through which investors can more easily
gress, New York,1982, p. 8. interact with the market when they want to
‘“The Options Clearing Corp., Annual Report 19/?1, Chicago. sell a security at a set price. The limit order
Figure 5.— Overview of SIAC Facility Management for NSCC Services

+ +

-f-2&q i
I

t 1
I STOCK
BORROW” WR11{ E k

CONTINUOUS DELI\’ERY
I ORDER out
5ERI ILL
I + NET SETTLEMENT SER\’ICES
I
I

F+
CORRESPO\Dt\T
DF1 .} & [ 011 F( I Io\

+ \ATIO\A!
TKA>\FER SFRY ICE

. & +

r
r

.~O~EY SE’1”’I’LE.MENT

# ● ●

NOTE In addition to acting as faclllty manager for the National Securltles Clearing Corp , SIAC provides clearing serwces for AMEX options. AMEX gold coins and NYFE futures Support sewlces
are also provided for the Options Clearing Corp Paclflc Clearing Corp and Depository Trust Co

SOURCE. Securities Industry Automation Corp


Ch. 3—The Securities Industry w 75
—————— — ——. —-—— —.—

system electronically files orders to buy or sell seeking financing, the number of potential in-
when a specific price is reached. These orders vestors, and the level of trading demanded
are delivered to the appropriate trading post have all increased to levels that could not be
or member firm on the floor. Orders can be anticipated when the securities industry was
limited to a single day or to their cancellation. developing. The one element which has not in-
creased is the number of hours in a day, and
In the context of the securities industry,
technology makes it possible to overcome that
pricing has referred solely to the investment
handicap in processing the level of activity
instruments of corporations and organiza-
demanded by the market.
tions. Pricing can also be expanded to the ac-
tual services of the industry, whose basic func- Time and distance are no longer obstacles
tions are being unbundled. Although within to communications for the securities industry.
the securities industry pricing is most clearly Because of this, securities markets may be-
evident in the selling and advising function, come less location-dependent and, as a result,
it is a factor throughout the entire financial less physically structured. It will be necessary
service industry. The securities industry may for the industry to make efforts to assure that
have an advantage relative to other financial the basic purpose of the markets is retained.
service providers in this area because of the
Information technology will generate a
expertise it has in analyzing markets and in
faster reaction by the securities industry to
pricing issues.
changes in market conditions and consumer
demands because communications and com-
Technology and the Functions puter capabilities may lessen consumer re-
of the Securities Industry sponse time. The market can be expected to
operate at a more rapid pace, and while it may
Technology is changing not the functions of be possible to monitor change more precisely,
the securities industry, but rather how they this market will require quick and well-devel-
are performed. The number of corporations oped decisionmaking.

The Effects of Information Technology on


Securities Instruments
Securities instruments are designed to satis- they evolve in a technology-intensive environ-
fy both the goals of investors and the need of ment. As information technology changes the
corporations and organizations to gather cap- way in which the securities industry operates,
ital to finance industrial research and devel- the relative importance of various investment
opment and resulting expansion or diversifica- instruments may be affected by information
tion. Securities instruments are of interest in technology.
discussions of the effect of information tech-
nology on the financial service industry for Third, interest in instruments that are now
several reasons. First, the direct impact of on the market may be predictive of which in-
technology on the securities industry, from the vestment products may best meet future de-
point of view of the consumer, may be most mands of consumers in terms of liquidity, level
strongly felt in the way in which the character- of risk, and return. This type of activity has
istics of investment instruments are changed. already been seen in the financial service mar-
Second, the intrinsic characteristics of secu- ket in the development of money market mu-
rities instruments may affect the way in which tual funds, which were patterned after the idea
76 . Effects of Information Technology on Financial Services Systems

of mutual funds and met the consumer de- The liquidity of an investment instrument
mand for more liquidity. is determined both by the contractual term of
the instrument and the speed with which the
The development and trading of securities
investor can trade or redeem the instrument.
instruments is largely dependent on the appli-
New communications technologies, notably in-
cation of information technology. Such tech-
teractive cable and the adoption of personal
nology has also had a major impact on the
computers with networking capabilities, have
calculation and payment of return and the
been applied to allow investors greater access
recording of ownership. The rate of growth
to securities markets. For example, systems
seen in options and many types of futures con-
available to individual investors provide up-
tracts would not have been possible without
dated information continually on price and sig-
communications and computer technologies.
nificant activities involving securities in which
As securities markets become more technolo-
the investor is interested. Easier access to this
gy-based, it must be expected that investment
information changes the way investments are
instruments will also.
analyzed by making it easier for the investor
However, it is unlikely that technology will to make decisions on his portfolio in a short
be the sole cause of the development of any time frame.
new securities product, although it may
Securities products are being packaged,
change the characteristics of some investment
often with products from other financial serv-
products or expand their application to such
ice industries, to fill a wider range of investors’
an extent that they are different in function
financial needs. This trend is likely to continue
and operations. As a result of these changes,
as the number of investment options increases
both investors and their advisors will have to
and the demands of users become increasingly
examine their methods of evaluating potential
more complex. Much of the new product devel-
investments. The characteristics of invest-
opment that will be seen in securities markets
ment instruments may be expected to change
may result from the increasing role of specu-
in four ways because of the application of in- lative markets. The ability of investors to use
formation technology: liquidity of instru-
speculative markets is increased by the appli-
ments, the packaging of securities products,
cation of information technology.
the way in which potential investments are
analyzed, and the importance of speculative
markets.

Appendix 3A: Securities Instruments


This appendix describes, the characteristics of through this structure. There can be as many
debt and equity instruments as well as options and unique capital structures as there are corporations.
future contracts. The relationship of information The financing plan chosen reflects the operating
technology to these products and the future effects and growth objectives of the organization.
of this technology are outlined. While the basic purpose of all debt and equity
issues of a firm is the same, to gather capital, they
represent different costs and concessions for the
Corporate Capital Structure: issuing organization. The return offered and risk
Debt and Equity Issues involved for the investor also differs substantially.
When debt is issued through bonds, the investor
The capital structure of a firm is determined by becomes a creditor to the organization; the firm
the mix of securities it issues. Capital is developed assumes a noncontingent obligation to pay the in-
through internal sources—i.e., retained earnings— vestor a definite sum of money. Equity issues
and through the issuance of debt and equity. A grant ownership in the corporation in return for
corporation tries to maximize its market value investment. Such shares of stock represent owner-
Ch. 3—The Securities Industry ● 77

ship rights proportional to the value of the share against the property. From the investor’s point of
of the firm purchased at the time of investment. view, the value of the mortgage lies more in the
Financing through debt is developed both potential resale value of the pledged property in
through money markets and capital markets. the case of corporate failure than in the exclusivity
Money markets are basically wholesale markets involved.
whose major function is liquidity management. Debentures are guaranteed by the general credit
They are centered on short-term instruments of the corporation. They have become the most
through which organizations can manage such popular form of bond issue across the economy and
operating factors as cash flow. Capital markets are particularly useful for industries in which
are centered on long-term securities, including many assets may be intangible, such as in publish-
both debt issues and stock, and represent the ing, or have a limited lifecycle, as is the case in
development of financing for long-term projects many high-technology industries. Most issues of
and goals for the organization, such as equip- debentures include a negative pledge clause that
ment purchases, research and development, and provides that the firm will issue no new debt hav-
expansion. ing priority over the bonds covered by the agree-
ment. This helps ensure that the risk to the in-
Long-Term Debt—Corporate Bonds vestor does not increase over the life of the bond.
Debentures are usually subordinate to bank loans
When money is borrowed on a long-term basis, and short-term debts.
the contract representing this debt takes the form
of a bond. A corporate bond is a fixed, noncon- BEARER BONDS AND
tingent, long-term obligation to pay a definite sum FULLY REGISTERED BONDS
of money and interest on that amount. The for-
Registration of bonds affects the extent to which
tunes of the corporation affect the resale poten-
the investor is protected in case of loss or theft,
tial of the security but cause the bondholder nei-
the way in which interest is paid, and the ease with
ther benefit nor loss in terms of return, assuming
which ownership can be traced and transferred.
that the corporation does not default on the issue.
The ownership of a fully registered bond is re-
The market value of the instrument is the pres-
corded in the register of the issuing organization
ent value of the payments stream to the investor,
or agent. Company records comprise proof of own-
using market interest rates. The bondholder is a
ership, and interest is paid directly to the holder
creditor to the corporation and as such has a claim
of record. If the bond is traded, the issuer or agent
on the assets prior to any by the owners. Corporate
must be notified so that ownership rights may be
bonds have a fixed return, known as a coupon rate,
transferred.
and a specific maturity. The financial benefit the
For a bearer bond, the certificate issued at the
investor realizes from the bond depends on mar-
time the debt instrument is developed is the only
ket conditions at purchase and investment oppor-
proof of ownership. Ownership rights are enjoyed
tunities at the time of maturity. A bond issue may
by whoever has possession of that certificate at
be distinguished in several ways, most notably:
the moment. Many investors find that the ease
how the contract is guaranteed in case of bank-
with which the bonds may be transferred and the
ruptcy, call provisions, registration, the way in
lack of traceability outweighs the risk of losing the
which interest is paid, and the way in which the
paper. This type of bond is an extremely flexible,
bond issue is retired.
cashlike instrument.
SECURED AND UNSECURED BONDS Whether a debt instrument is a registered bond
or a bearer bond affects its value and appropriate-
Bonds may be classified as secured, or mort- ness as an investment for particular investors.
gage, bonds or unsecured bonds, called deben- Since July 1, 1983, the Federal Government has
tures. Mortgage bonds are backed by specific cor- required all new bonds to be registered to make
porate assets and were historically most popular it easier for the Internal Revenue Service to de-
among regulated industries, such as railroads and termine to whom interest is paid and to trace any
utilities. A closed-end provision in a mortgage con- changes in ownership. However, there is still a sig-
tract requires that the corporation secure no ad- nificant secondary market in bearer bonds. ’ As the
ditional bonds on the lien. The majority of con-
tracts, however, include an open-end provision “’The High Price of Financial Privacy, ” Ilusiness W’eek. Aug. 1, 1983,
that allows for the issuance of additional bonds p. 97.
78 ● Effects of Information Technology on Financial Services Systems

bearer bond is eliminated from the market, some der specifying which accounts should be paid by
increase in demand for different instruments that the bond issuer or paying agent bank, the ACH
safeguard the privacy of the investor to a similar could take responsibility for routing these interest
degree may be expected. payments, which would be credited to an account
A significant difference between bearer and reg- specified by the bondholder. Savings would result
istered bonds from the point of view of both issu- from the elimination of check-processing costs.
ers and investors is the way in which interest is
paid. The holder of a bearer bond initiates the pay- RETIREMENT OF BONDS
ment of interest by depositing the appropriate cou- Bonds may be retired by payment at final
pon at the financial institution of his choice. Fed- maturity; by conversion to common stock if the
eral Reserve collection mechanisms are used by the instruments are convertible; by refunding, through
institution to obtain credit for the interest due. enacting a call provision; or through periodic re-
Usually, the depositor is paid the interest by the payment, if the bond is a sinking fund or serial
financial institution prior to the completion of this bond issue.
process; in most cases, immediate use is granted. Many bonds contain a provision allowing the
The payment system for bond coupons is extreme- corporation to “call” or repurchase the debt in-
ly paper-based. The physical coupon “follows” the struments at any time. This gives corporations
collection process. flexibility if market conditions change before the
Greguras and Carlile suggest that as new tech- bond matures. The call price is usually above the
nologies make it possible to record essential infor- face value of the bond, but generally this premium
mation in the physical coupon in a format that can decreases as the maturity date is approached. A
be used by electronic systems, this type of system corporation may move to call a bond because of
will allow financial institutions quicker access to a drop in market interest rates or to be free of re-
their funds and, as a result, benefit the investor.’ strictive protective covenants that may have been
Information contained in the coupon could be necessary to gain financing initially. The initial
transformed to electronic form at the point at debt contract specifies whether the call provision
which the coupon enters the redemption process. is immediate, that is, can be invoked at any time
The electronic system proposed would result in following issue, or deferred, in which case the in-
little, if any, change in the action required by the vestor is assured that no call will take place for
investor. Presentation of coupons would remain a definite period of time, usually 5 to 10 years.
the same; from the investor’s viewpoint the cou- Call provisions become a disadvantage to inves-
pon is already truncated since it is never returned tors when the stable return anticipated when the
to the holder. Cost-saving benefits result for the debt instrument was selected for investment is
issuer of the bond, the paying agent, and the fi- lost. The investor may find it necessary to select
nancial institution used by the bondholder. Gre- an alternative investment. If interest rates have
guras and Carlile point out that computer sort ca- dropped since the original investment, the investor
pability could replace the current labor-intensive must not only bear additional transaction costs
system used by issuer and holder.3 The electronic but also, in some cases, select between less attrac-
system would be faster and would facilitate the de- tive investment alternatives.
velopment of computerized bookkeeping and set- For tax purposes, the income gained by the in-
tlement systems. It is not clear how the end of new vestor from the call premium is treated as a capi-
issues of bearer bonds will affect the possibility tal gain. For the corporation it is deducted as an
of automating the interest payment process, al- expense from ordinary income. Many experts be-
though the potential application of this type of lieve that the net tax advantages received by the
system will naturally decline. investors and the corporation make call provisions
The payment of interest on registered bonds is attractive to both parties. 4
easier because the paying agent knows the holder Refunding involves the replacement of one bond
and initiates the payment process. Greguras and issue, prior to maturity, with a new issue of bonds.
Carlile note that there is a great potential to use A corporation may wish to refund an issue to es-
automated clearing houses (ACHS) for these trans- cape restrictive protective covenants, but the most
actions, Following the issuance of a payment or- common reason is to take advantage of a drop in
‘Fred M. Greguras and Larry L. Carlile, “The Use of Electronic f3ank-
ing for Bond Coupon Payments, 1980. ‘James C. Van Home, Financial Management and Policy (Englewood
‘Ibid. Cliffs, N. J.: Prentice-Half, Inc., 1983), p, 555.
Ch. 3—The Securities Industry ● 79

market interest rates. Market conditions must be is discussed later, the decision to pay interest
extremely favorable for the issuing corporation to belongs to management rather than the board of
justify the expenses involved in refunding, which directors. If not paid, interest accumulates and is
include the cost of calling the old bonds, issuing senior to preferred and common stock dividends
the new bonds, and, possibly, expenses resulting and subordinated debt.
from the payment of interest on the old bonds dur- Income bonds are unpopular with investors be-
ing any overlap period. cause the income stream from their investment is
The repayment of a total issue of bonds at ma- unpredictable. Some experts also believe that the
turity could present a severe cash strain for the past association of this instrument with corpora-
issuer. Therefore, two methods have been devel- tions, particularly railroads, trying to avoid
oped through which debt issues are retired in a bankruptcy has made them unattractive to in-
more controlled and gradual manner: the issuance vestors. As a result, income bonds are used pri-
of serial bonds and sinking fund provisions. Serial marily in reorganizations, which of course may
bonds give an investor a choice of maturity dates. perpetuate their negative image.’
The entire package of bonds is issued by the cor- Return paid on a zero-coupon bond is embodied
poration at the same time, but the bonds mature entirely in price appreciation to maturity. No pe-
individually in successive years. riodic interest payment is made, This bond offers
Most bond issues carry a provision requiring two advantages to the investor: the bond cannot
that the corporation retire a given number of be called, so the holder experiences no reinvest-
bonds per year through a sinking fund managed ment risk, and an exact return is assured if the in-
by a trustee. The bond issuer makes payments into strument is held to maturity. For tax purposes,
the fund, with which the trustee finances the re- the investor must declare the interest accrued in
tirement, by calling or purchasing bonds selected a given year as interest income, despite the fact
(usually) by lottery. While calling before the an- that this money is not available for his use. The
ticipated maturity date may be undesirable for the corporation also deducts the interest expense for
investor, most investors value the assurance of or- the year accrued, although no actual payment is
derly retirement of debt and liquidity provided by made. While the corporation enjoys the advantage
a sinking fund provision. For bondholders whose of no cash outlay until the maturity date of the
instruments are not called, the sinking fund may bond, the no-call provision is a disadvantage if
represent a reduction in risk, as the total amount market interest rates fall during the lifetime of the
of debt the organization holds is continually bond,
reduced. Two types of bonds, floating-rate and indexed,
have become more popular in response to the con-
PAYMENT OF INTEREST cerns of both issuers and investors that long-term
The return of most debt investments is embod- debt instruments have generally been locked into
ied in a periodic interest payment referred to as a rate of interest that reflected market conditions
the coupon. It is designed to compensate the in- at the time of issue, but that may not be desirable
vestor for the time-value of money, the lost oppor- if market conditions change. For example, floating-
tunity cost, and the risk assumed. Usually, this rate bonds, which include instruments for which
is a semiannual payment. The market value of the the interest rate is set in relation to 90-day Treas-
bond is determined by the present value of this ury bills, may be attractive to an investor who
stream of payments. Bonds with less traditional believes that interest rates are likely to rise dur-
payment schedules have developed in response to ing the lifetime of the bonds, and to an issuer who
market pressures. These include income bonds, feels rates will fall. To both parties the uncertainty
zero- and low-coupon bonds, indexed bonds, and about the return that will be received and the cost
floating-rate bonds. of the borrowed funds may be disadvantages.
While most bonds are strictly debts of the cor- The return on indexed bonds is tied to the rate
poration, for which interest must be paid regard- of inflation and therefore is considered fixed in real
less of the corporation’s financial situation, inter- terms. These bonds become popular in times of
est is only paid on income bonds when the earnings high inflation. In theory, any index can be selected
of the corporation permit. The corporation benefits as a basis for setting the rate paid on this type of
from the tax advantages of debt, since any interest
paid is deductible because it is part of a contrac-
tual agreement, Also, unlike preferred stock, which 6
1 bid., p. 551,
80 ● Effects of Information Technology on Financial Services Systems

bond; however, in the United States the Consumer Information technology may be expected to
Price Index is generally used. create more competition in rating bonds as the
Information technology may be expected to in- capacities of new online computers and interactive
crease the number and complexity of different cable are explored. As technologies become more
types of interest-paying plans for bonds. Indexed sophisticated and interactive systems become less
and floating rates can be designed to respond more costly, it has become possible to personalize rating
quickly to changes in the base line on which inter- services to the objectives of the individual investor
est is determined. This may result in some confu- in real time.
sion for bondholders, as change may occur at such
a rapid rate that the logic behind it may not be BOND TRUSTEES
perceived. More complex interest-paying arrange- As will be discussed later, the interests of the
ments will require special attention to the dis- shareholders of a corporation are represented by
closure of these bond characteristics for investors, the board of directors. Bondholders have a special
a role likely to be the responsibility of brokers and representative—the trustee—who is not part of
issuers of bonds. corporate management and who is expected to act
in bondholders’ best interests. Paid by the issu-
RATING OF BONDS ing corporation, the trustee is usually a commer-
Two highly respected rating services for bonds cial bank. The responsibilities of the trustee for
are Moody’s Investors Service and Standard and bond issues over $1 million are specified in the
Poor’s. Their ratings result from an analysis of the Trust Indenture Act of 1939 and involve protect-
financial and business propects of the issuer and ing the rights of the bondholders by ensuring both
are used by individuals and financial institutions that the initial contract is legal and, following the
as a tool for assessing risk. issue, that the corporation fulfills its contractual
Moody’s Investors Service offers nine possible responsibilities to the bondholders. This act, which
ratings, ranging from a low of C, which represents is administered by the Securities and Exchange
extremely poor prospects for the issuer, to a high Commission (SEC), requires that the trustee act
of Aaa, which represents an extremely low amount strictly in the best interests of the bondholders.
of risk and predicts that it is unlikely that any neg- It is the responsibility of the trustee to act to
ative change will affect the issue. Generally, orga- protect the interests of the bondholders if the com-
nizations with poor ratings must pay a higher rate pany is in default—that is, fails to meet the provi-
of interest to borrow funds to compensate lenders sions of the bond contract. This responsibility has
for risk. been brought to the forefront by the recent default
It is rare for the rating of an issue to change. on Washington Public Power Supply System
Any reevaluation by Moody’s or Standard and (WPPSS) bonds. A problem the bond trustee ap-
Poor’s indicates a very substantial change in the pears to be encountering is reaching and purvey-
condition of the issuing firm and attracts a great ing information to the 78,000 holders of the bonds.
deal of attention from investors. in spite of the press received by the WPPSS de-
Those bonds that Moody’s rates “Baa,” the fault and the efforts by the trustees to reach and
fourth highest rating, or above are considered inform bondholders, it appears that, prior to the
investment-grade bonds. Some financial institu- first missed coupon payment on the WPPPS bonds,
tions, including some commercial banks and many many bondholders did not know or did not under-
pension funds, are not allowed to invest in any stand that there was a problem. 7 Communication
issues that do not make this grade. Some experts technology may facilitate attempts by the trustees
believe that rating services have caused certain to reach bondholders in the future by improving
types of organizations, particularly municipal gov- information flows and corporate recordkeeping.
ernments, to pay higher than warranted interest
rates because of unfavorable and perhaps some- THE EFFECT OF INFORMATION
what subjective ratings.6 However, investment TECHNOLOGY ON LONG-TERM
counselors and investors still rely heavily on the DEBT INSTRUMENTS
rating services.
Long-term debt is likely to remain a significant
part of corporate capital structure. Information

‘Lynn Asinof, “WPPSS Begins to Cause Pain for Investors, ” The


‘Brealily and Myers, p. 468. Wall Street Journal, Dec. 28, 1983, p. 15.

Ch. 3—The Securities Industry ● 81


— .—.——. . —

technology may change the approach of organiza- stock; the right to maintain their share of owner-
tions searching for finance and investors seeking ship through purchase of new shares issued by the
debt instruments as the following impacts of the corporation; the right to information on the oper-
main advantages of automated systems are felt: ation of the firm, to the extent that it is competi-
increased speed of handling information, more tively feasible; and the right to transfer ownership
precise and less expensive analysis, and improved to another investor.
communication systems. The most significant benefit for the owner of
common stock is the right to maintain control of
Equity the corporation through the election of the board
of directors, who in turn appoint the officers of the
A firm may also decide to gather capital through firm and represent the interests of the holders of
issuing equity, or ownership rights, in the form of equity in the firm. The management of the corpora-
corporate stock. The investor receives with the tion is expected to act in accordance with the
shares of stock he owns rights proportional to the goals of the owners and to be accountable to them
total amount of stock issued by the corporation. through the board.
Equity capital strengthens the balance sheet and Preferred stock is considered a safer investment
enhances the future borrowing power of the com- because holders of these shares have a claim on
pany. Decisions to issue debt or equity are usu- the assets of the company before holders of com-
ally based on what will maximize the market value mon stock, although after the holders of debt, in
of the corporation. the case of bankruptcy. Owning such stock also
From the point of view of potential investors, carries a prior claim to income in the form of
the purchase of equity may give the opportunity dividends. However, the preferred stockholder
to share in the growth of the company. As some, usually enjoys only limited voting rights, so that
if not all, of the return received may be in the form he has less impact on the operation of the corpora-
of capital gains, the investor may find a tax advan- tion than do common stockholders.
tage in equity investments. Equity shareholders
may also receive an income stream in the form of DIVIDENDS
dividends as a form of return on their ownership,
In some cases, this return may be greater than Depending on the corporation’s profits, corpora-
what would be realized from a debt investment. tion earnings may be used to pay dividends to
While tax laws have been subject to change, at stockholders at the behest of the board of direc-
times there have been tax advantages from income tors. Dividends are only declared when the pay-
ment will not impair the operation of the firm or
in the form of dividends rather than interest.
legally compromise its contractual relationships.
A firm may sell equity in two forms: common
stock or preferred stock. The choice will depend tionships.
on the financial structure and objectives of the cor- Two significant dimensions of the dividend pol-
poration and on industry and market conditions. icy of a corporation are dividend stability and long-
The equity profile of a corporation may be ex- run dividend payout ratio. a A dividend may be
tremely complex. Both common and preferred stable in terms of real dollars paid out or in the
ratio of dividends to earnings. While the latter
stocks may be issued, and several varieties of pre-
ferred stock may be active simultaneously. may appear more rational, it is rarely used. Con-
sideration of the return expected by stockholders
COMMON AND PREFERRED STOCK has led most corporations to pay a stable dollar
dividend when possible, indicating the importance
Common stock is generally more significant of income as a motivation for investing in equity
than other types of securities in the capital struc- issues.
ture of a firm. The holders of common stock have Decisions on long-run dividend payout ratios
residual rights to the income of the firm, which may be based on the objectives of the owners and
they usually receive in the form of dividends. At management of the firm. The reinvestment of a
the same time, the liability of individual share- significant portion of earnings may result in higher
holders is usually legally limited, particularly for growth for the corporation as a whole and maybe
the debts of the corporation. Additional rights of attractive to investors desiring long-term income
holders of common stock include a claim on com-
pany assets in the case of bankruptcy, following ‘Lawrence D. Schall and Charles W. Haley, Introduction to Finan-
the claims of creditors and holders of preferred cial Afanagement (New York: McGraw-Hill, Inc., 1980), p. 366,
82 ● Effects of Information Technology on Financial Services Systems

in the form of capital gains. In this case, earnings likely to be most directly felt in the actual paying
are used as a form of internal financing, and any of dividends. Operation costs for this activity may
dividend paid is from earnings left over after be expected to decline as recordkeeping and sort-
financing objectives are met. If the shareholders ing activities can be automated. It may also be
of the corporation are interested in more immedi- possible to use electronic funds transfer for the
ate income, a fixed payout may be used. In this payment of dividends. While initial costs for this
case, the amount of money available for internal type of system may be high, the resulting efficien-
financing would differ from year to year as it cies and the decrease in postage costs may be of
would be, in a sense, the residual part of earnings. great benefit.

THE EFFECT OF INFORMATION


TECHNOLOGY ON EQUITY Convertible Securities
Information technology may be expected to af- Preferred stock or bonds that can be converted
fect equity instruments directly in three areas: the to common stock at the option of the holder are
payment of dividends, the recording and proof of called convertible securities. Such securities offer
ownership, and the transfer of ownership. The a middle ground to investors who demand lower
transfer of ownership of stock will be examin ed as risk than common stock carries yet want to par-
a function of the securities industry in a later ticipate in the growth of a corporation.
section. Convertible bonds offer both interest payments
The improved ability of shareholders to moni- and conversion opportunity. This instrument is at-
tor and analyze the activities of corporations more tractive for the issuing corporation because gen-
directly through the use of new technologies may erally a lower-than-market rate of interest may be
also have some impact on individual firms. The offered, owing to the conversion option. A corpora-
magnitude of this impact will largely depend on tion may view a convertible bond as both a short-
the characteristics of the ownership of the corpora- run debt and long-run equity issue without the
tions involved. An increased awareness by the cost of two separate issues. Convertibles are con-
shareholders of the environment and operation of sidered deferred common stock financing. These
the firm may be a benefit; however, managements instruments were also traditionally attractive to
and boards of directors may find an increased de- new or speculative corporations unable to gather
mand for information dissemination and respon- equity capital on other terms or to corporations
siveness. with low-grade credit ratings.
Detailed records are maintained on who the cor- Compared to the issuance of common stock, the
poration’s shareholders of record are to assure that issuance of convertible bonds creates less dilution
they receive their ownership rights. While tradi- of earning per share at the time the bonds are first
tionally this operation was solely paper-based and offered and at the time of conversion. At the time
involved the issuance of certificates that served the bonds are issued, no stock is involved; at con-
as proof of ownership, there is some indication that version, the size of the conversion generally adds
the application of information technology is facil- fewer shares than a new issue of common stock
itating a movement toward a book entry system. would. Usually, it is expected that the financial
This type of arrangement is expected to benefit condition of the issuing firm will be improved in
the issuers of equity by lowering operating costs, both yield and stability at the time of conversion,
including those of printing and postage, and to as indicated by the fact that the conversion price
benefit the holders of equity by making it easier is higher than the market price of the common
to transfer ownership of these securities. stock at the time the bond is issued.
Book entry may require some adjustment by The stock package stipulated in the conversion
shareholders because the mechanics of proof of plan may be more favorable to the organization
ownership will differ. The success of this type of than one designed later when changing market
program will depend largely on how apparent and conditions could be taken into account. The expec-
important the benefits involved are to the in- tations of investors for the common stock provi-
vestor, particularly when trading. sion may be less stringent at the time the bonds
The mechanics of developing a dividend policy are issued because of both the benefits to be re-
may be aided by the application of information ceived before conversion and the anticipation of
technology; however, the value of improvements participating in corporate growth at the time of
in communications and computer capabilities is conversion.
Ch. 3— The Securities Industry ● 83

The tax provisions of typical convertible bonds securities and, as the market demands, it is likely
may be beneficial for investors. The conversion of that additional instruments will be developed.
the bond to common stock is considered a tax-free These short-term debt instruments include Treas-
transaction by the Internal Revenue Service. The ury bills, certificates of deposit, commercial paper,
year-plus-one holding period for long-term capital bankers’ acceptances, and repurchase agreements.
gains on any subsequent sale of the common stock They are important to corporations in money man-
is counted from the time the bond, not the stock, agement as both financing tools and investment
is issued. tools.
One variation on convertibles that often results A Treasury bill is a short-term debt of the U.S.
from failed takeover bids is the exchangeable Government. The bills are sold on an auction basis
bond, which can be converted to the stock stipu- at a discount from face value. Since the U.S. Gov-
lated in the bond contract of a corporation. This ernment is continually borrowing to pay off debts,
stipulated stock may be issued by someone other Treasury bills are issued on a very frequent basis.
than the issuer of the bond. The exchangeable Biddings are closed by the U.S. Treasury weekly
bond requires the investor to evaluate the credit for 91- and 182-day debt issues and monthly for
potential of the issuing corporation and the long- 9- and 12-month bills. Short maturities and the
range growth and earning potential of the firm backing of the U.S. Government make them de-
whose common stock is involved. Tax provisions sirable investments.
must also be a major concern for such an investor. g Although the market is quite short-term, an ac-
The Internal Revenue Service considers this con- tive secondary market has developed. Therefore,
version to be the equivalent of two cash trans- bills can be traded before the maturity date, add-
actions because the securities of two different cor- ing to their liquidity. Treasury bills are a desirable
porations are involved. Since the bond would not short-term investment tool for corporate investors
be redeemed by a rational investor unless the stock because of the high level of liquidity and low level
sells for more than the original cost of the bond, of risk they carry.
a taxable gain is realized. Commercial paper is a short-term debt issued by
Recently, the interest in this bond instrument finance companies and some other corporations.
by both corporations and investors has grown. Interest rates for commercial paper are generally
While in the past institutional investors domi- higher than for Treasury bills because of the risk
nated this compromise market, individuals are factors involved in private firms. Many companies
becoming more active. Information technology use commercial paper to supplement bank loans.
may be expected to affect convertible instruments In general, it is a less expensive method of financ-
to the extent that it makes more sophisticated ing for prime quality obligatory than loans (be-
analysis cost effective for investors and financial cause banks are not used as intermediaries) and
intermediaries, and therefore the complex nature may fill a need at a time when the issuance of long-
of the instrument may be less of a disincentive to term debt is not appropriate. The issuance of com-
potential issuers and investors. Growth in this mercial paper lacks the supportive, interactive
area may be expected, however, to be related pri- nature of a relationship between a corporation and
marily to the fiscal needs of corporations involved a commercial bank.
and to the demands of consumers. Commercial paper may be sold directly by the
issuing corporation or through a dealer. Since
Short-Term Debt– dealers screen the instruments to a certain extent,
commercial paper placed by a dealer may be less
Money Market Securities risky for an investor, although commercial paper
The essential characteristic of money market directly placed by some major corporations is of
securities is their liquidity. This derives from their very high quality. The investor holds an unsecured
short maturity, by definition less than 1 year, and short-term promissory note as evidence of the
the generally high quality of the issuing organiza- debt, and the instrument is tradable in money
tion. ’” There are several types of money market markets.
— Commercial paper is designed to avoid a require-
“’Investing in Convertible Bonds,” Business U’eek, June 20, 1983, ment of registration with the SEC. Because of past
p. 191. problems in commercial paper markets- specifical-
‘“Roland 1. Robinson and Dwayne Wrightsman, Financial ,$fm-kets;
The Accumulation and Allocation of Wealth [New York: McGraw-Hill, ly, those generated by the bankruptcy of Penn
Inc. 1974), p. 14’7. Central-investors have caused the market to
84 ● Effects of Information Technology on Financial Services Systems

become quite conservative. Commercial paper of Congressional action is expected to confirm this
companies that do not have a very high financial stance. 11
reputation is rarely marketable. The short-term debt market has been greatly af-
Banker-s’ acceptances, which originated at about fected by the use of information technology. The
the same time as international trading, continue nature of some short-term debt includes a definite
to play a significant role in importing and export- end-date for the instruments. Improvements in
ing. A banker’s acceptance is issued by a corpora- sorting and transacting brought about by comput-
tion and guaranteed by a commercial bank. The er capabilities may extend the effective lifecycle
acceptance is a liability of the bank and is traded of the instrument since it can be marketed more
in money markets based on the reputation and quickly. The availability of better data and the im-
credit standing of the bank. The instruments are proved ability to analyze information about the
of value in international trade, owing to the time- debt instrument and about the issuing organiza-
lags that can occur because of the physical aspects tion may affect the market for short-term debt in-
of transporting goods and because of the uncer- struments. The potential of short-term debt in-
tainty with which many traders approach foreign struments as investment tools may be expected
markets. to improve to the extent that the application of
Certificates of deposit are negotiable securities technology will refine this evaluative process.
issued by commercial banks. They have fixed ma- Information technology may also improve the
turities and pay interest to maturity. Yields on cer- packaging of short-term debt instruments by al-
tificates of deposit are higher than for Treasury lowing securities industry marketers to match bet-
bills and are paid at the time the certificate ter the characteristics of various instruments to
matures, The risk associated is dependent on the the demands of investors. The proliferation of
quality of the issuing bank. Certificates can be money market mutual funds and demand accounts
traded in a secondary market before maturity; this may be a result of this opportunity.
market is particularly active for the certificates of
deposit issued by major commercial banks. Options and Futures Contracts
Repurchase agreements stipulate that the short-
term securities sold will be repurchased by the The capital market investor’s investment goals
seller. They are frequently issued by bond dealers may not be completely met by debt and equity
to finance inventories. U.S. Government securities issues. The desire of investors to increase their li-
are the usual basis for the agreement through quidity or return or to limit risk has led to the de-
which an investor “purchases” the securities while velopment of instruments that comprise what may
agreeing to resell them at a specified time and be considered a second-tier securities market.
price. The term of repurchase agreements may be These securities are based on the fortunes and fluc-
for several months or for overnight, and therefore tuations of capital markets, but are not essential
has the potential to offer a great deal of flexibility. to the capital structure of individual firms.
Major questions involving repurchase agree- Off-shoot investment products include options
ments center on the level of risk involved and how on stocks and bonds and futures contracts on com-
the transaction should be classified. Historically, modities, currencies, and market indices. These in-
repurchase agreements were considered extremely struments are all based on the market behavior of
safe transactions, although they are not federally underlying products or securities. The interest of
insured, because they involve Government secu- the investor is focused on the price fluctuations
rities and are handled by recognized players in the of the product, usually in a relatively short time
financial service industry. However, recent col- frame, rather than on the intrinsic operations of
lapses of dealers caused some investors to experi- the firm. Interest in options and futures contracts
ence high losses. investment has led to the development of an in-
The qualification of repurchase agreements as dustry structure specializing in these products, in-
a sale or debt has created some controversy cluding exchanges and clearing corporations. The
throughout the financial service industry. The In- development of this structure has increased inter-
ternal Revenue Service has held that it is a col- est in the products and has led to further growth
lateralized debt, and therefore the investor would in option and future contracts trading.
be liable for interest income received. Dealers in
Government securities sales disagree and consider “’’The Repo Market Is Still in Shock, ” Business Week, Apr. 4, 1983,
the instrument to be a purchase/sale agreement. p. 74.
Ch. 3—The Securities Industry ● 85

Options PARTICIPATING IN THE OPTIONS MARKET


Options provide a method of participating in a Participants in options markets attempt to prof-
securities market without ownership of actual debt it from their knowledge of the potential declines
or equity instruments. An option is a tradable in- and rises of a corporation but have no direct stake
strument that grants an investor the right to buy in its operations. In the basic options market,
(a call option) or the right to sell (a put option) a players may be involved in four activities: buying
specific security at a given price for a limited call options, buying put options, writing call op-
amount of time. It is a legal contract in which two tions, or writing put options.
factors are explicitly stated: the expiration date An option buyer hopes to profit from or protect
and the exercise price. The value of an option is himself from a change in the price of the under-
directly related to the market price of the under- lying security. The holder of a call option has the
lying security. The exercise price of an option in- right to buy a security at a specified price. This
dicates the change anticipated in the market. The investor may do three things with this right: ex-
exercise price of a call option (at which the investor ercise it by buying the underlying securities, sell
can buy the underlying security) is, at the time the it to another investor, or let it expire. He has no
option is issued, generally higher than the market legal obligation to make any transaction of the
price of the security. Conversely, the exercise price underlying security. Further action on his part in-
of a put option, which entitles the holder to sell volving the contract is self-motivated and will re-
the security, is generally lower than the market sult only from his evaluation of the market.
price. Options may be written and sold for real The writer, on the other hand, is obligated to buy
estate, debt instruments, and foreign currencies; or sell the underlying security under the conditions
they have recently become most significant in specified in the contract. His continued involve-
equity markets. ment with the instrument is not voluntary and,
Options are “wasting assets”; that is, after the while in some cases may not be required, is legally
specified expiration date, they have no value. enforceable. Both writers and buyers of options
Therefore, the timing of market changes, as well can liquidate their positions by purchasing off-
as direction, must be correctly evaluated by the setting options before the expiration or exercise
investor to assure that the potential value of the of the option.
investment is realized. The writer of an option, ex- The motivation of an investor to buy a call op-
cept for warrants, which are discussed below, is tion may be related to two separate strategies. He
not controlled by the organization named in the may hope to participate in the benefits of a rise
underlying security. More shares of stock may be in stock prices with a limited current investment
represented collectively through outstanding op- and therefore may buy call options to achieve
tions than have been issued by the corporation. leverage or establish a future price at which he
While option writing and buying may be part of plans to purchase the security. He may also be
a complex investment portfolio that includes debt motivated to purchase call options to limit risk,
and equity instruments of an institution, the oper- either as part of a conservative overall investment
ations of option markets are, in a practical sense strategy or to hedge a short stock position.
at least, totally separate from the capital structure For the individual investor, leverage may be
of a corporation. measured through the percentage of total assets
While options have been traded among individu- necessary to invest for a given rate of return. It
als for many years, the market has grown and is assumed that the financial assets of an in-
become more sophisticated since the organization dividual are finite and that each investment deci-
of regulated exchanges in the mid-1970’s. The sion is evaluated by its opportunity cost. Achiev-
trading of options entails a relatively new market ing leverage could be the motivation for buying
structure; therefore, the influence of information call options for an investor who expected the price
technology on this structure is quite visible. For of an issue to rise. The cost of buying a call option
example, options use book entry rather than cer- for a given number of shares of stock represents
tificates as proof of ownership. a much smaller investment than does the purchase
86 • Effects of Information Technology on Financial Services Systems

of the shares. A higher percentage of return on in- While the buyer of call options generally acts in
vestment may result in the case of a rise in the anticipation of increases in the price of the under-
price of the stock to the holder of a call option. lying security, the buyer of put options attempts
However, it must be recognized that with a highly to profit from or limit risk if the price declines. The
leveraged investment, a larger share of the invest- option grants the holder the right to sell at an es-
ment may be lost. Since options are wasting as- tablished price, and therefore it can be used for
sets, the investor must be correct in his evalua- leverage and for limiting risk. As with call options,
tion of the timing as well as the likelihood of a price the investor must have correctly analyzed the di-
increase in order to profit from his purchase of op- rection of the price change and the timing of the
tions. If the option expires without being exer- change in order to profit.
cised, the investor’s loss would be equal to his in- The conservative investor can use put options
vestment. Absolute return or loss will usually be as a hedge against a substantial decline in the price
lower for the option investor than if he held the of a stock he holds. This strategy may be particu-
equivalent number of shares of stock. larly attractive as protection for an individual who
Options are also bought by investors who would has a significant portion of his assets invested in
like to invest in the underlying security and ex- a single security. However, it must be recognized
pect its price to rise but who do not have the cash that the insurance provided only lasts through the
to make the investment. The call option estab- life of the option and that the cost of the option
lishes a guaranteed maximum price for the secu- cuts into the investor’s potential profits.
rity. This strategy is particularly useful if the in- The writer of an option exposes himself to far
vestor anticipates receiving a flow of cash before greater risk than the buyer does. A writer of call
the expiration of the option. If the price of the options may be required to sell the underlying
stock falls below the exercise price, the investor security to a holder at the exercise price at any
may purchase the security at the market price and time during the life of the option. Conversely, the
consider the option a sunk cost. writer of a put option may be required to buy the
While investment in options increases the lever- underlying security from the holder at any time
age and establishes the price of future stock for during the contract.
the investor, the lower dollar investment required The writer of call options is motivated by the
to buy call options rather than stock limits abso- possibility of gaining a return through premium
lute risk, since the investor exposes less of his income, Calls may be covered, wherein the writer
assets to the market. A common, conservative in- owns the specified underlying security, or uncov-
vestment strategy is to purchase call options and ered, wherein the writer would be required to pur-
invest the difference between the options and the chase the security at market cost if he is assigned
price of the underlying security in a low-risk in- an exercise. Leverage for an investment portfolio
strument, such as Treasury bills. Any loss in- may be the most significant motivating factor for
curred through the options investment would be the writer of covered calls. Return from the under-
at least partially off-set by the interest earned on lying security may be realized both through divid-
the investment of the remainder. ends or interest paid and through income received
Decreasing risk may also motivate an investor from premiums. While the covered call writer may
to purchase call options if he maintains an ex- hope to maintain his position in the underlying
tremely risky position in equity markets by sell- security, option writing may greatly increase his
ing short, that is, selling securities he does not own income-producing potential.
in anticipation of a price decline. This investor The writer of uncovered calls is the player at
theoretically exposes himself to unlimited loss if most risk in the options market. His potential loss
the price of the stock increases because he would may equal the market price of the stock less the
be forced to pay market prices to deliver the secu- sum of the exercise price and premium received for
rities. By buying call options, the investor who the option and, in theory, is limitless. The un-
takes a short position establishes his maximum covered call writer must be extremely sensitive to
purchase price for the securities he is selling and any factors in the economy at large or for the cor-
therefore insures himself against limitless loss. Of poration that may cause a significant price in-
course, if the market behaves in the manner antic- crease.
ipated by the short seller, the price of the option A writer of put options is obligated to buy the
is lost profit. specified underlying security at the exercise price
Ch. 3—The Securities Industry . 87

at any time until the option expires, The put writer equals the premium price and, theoretically, un-
must have sufficient liquid assets to buy the secu- limited profit potential. However, the price change
rity and, as an exercise is only likely when the ex- must be significant in order for the investor to
ercise price is higher than the market price, he profit, and the investor must be correct in his
must anticipate paying more than the value of the evaluation of the timing of the change. Straddle
security. The option writer who trades through an writers are generally motivated by their belief that
exchange is required to deposit cash or securities, there will be little, if any, change in the price of
referred to as margin, with a brokerage firm. Puts the security and, therefore, that if an exercise were
may, alternatively, be secured with cash equal to assigned, profit from premium income would in-
the option exercise price. No additional margin re- sure a net profit after costs of satisfying the exer-
quirements will be required in this case, and in- cise conditions. Risk for straddle writers is limit-
terest may be earned by the writer on the cash de- less, as a substantial loss can be incurred on both
posited. positions if the market price for the security fluc-
Investors are usually motivated to write puts tuates more than expected.
by a desire to earn income from premiums, the
price paid by the buyer of an option to the writer PRICING OF OPTIONS
of that option. The opportunity to purchase the The premium (i.e., price) of an option is subject
specified securities may also be a motivating fac- to change and is influenced by characteristics of
tor in some cases. In a stable or rising market, it the option, the underlying security, and general
is possible to earn premium income with relatively economic conditions. Factors influencing the pre-
low risk; however, demand for put options may be mium include the expiration date of the actual in-
expected to be fairly low in this circumstance. strument, the price and volatility of the underlying
Some put writers hope to acquire the stock at a security, supply and demand effects on the option
net cost which, considering premium income, is market for the specific security, and, on the whole
less than the current value of the stock. as well, interest rates. The premium for an option
The four possible ways of participating in the is comprised of intrinsic value and time value. An
options market may be combined by an investor option has intrinsic value any time the difference
to form a strategy he believes is most likely to between the exercise price of the option and the
meet his investment goals of producing income or market price of the security works to the advan-
limiting risk. The options tactics chosen are influ- tage of the holder. Anytime this is not the case,
enced by the investor’s expectations about how the option has no intrinsic value, and the premium
the price of the underlying security is likely to is based only on time value.
change in direction and magnitude. Time value represents an evaluation by an in-
Spreads and straddles are the two most common vestor of the potential of the option to increase in
multiple-options investment strategies. Spreads value owing to a change in the price of the under-
are used to limit risk in option transactions and lying security prior to expiration of the option.
involve writing and buying the same type of op- Time value may generally be expected to decline
tion, calls or puts, for the same specified security. as the expiration date approaches and as the pos-
The options generally have different expiration sibility of fluctuation in the security price de-
dates or exercise prices. If the investor were creases. It is also influenced by the amount of dif-
assigned an exercise for the option he wrote, the ference between the exercise price and the market
spread benefits would disappear, and his risk posi- price of the underlying security. A large difference
tion would be drastically changed. The writer of may result in a decrease in time value because the
spreads generally anticipates little change in the possibility of profitably exercising or selling of the
price of the underlying security. A stable market option is more remote. Increasing interest rates
provides his best opportunity for profit. generally result in increases in time value.
The investor who anticipates a great change in
the price of an underlying security but is unsure Warrants
of the direction or magnitude may maintain a
straddle position. The straddler either writes or A warrant is unique because it is issued by the
buys both a call and a put option for the same secu- corporation that issues the underlying security
rity. Both the call and the put should have the and, as such, is part of the capital structure of the
same exercise prices and expiration dates. Buying firm. A warrant is a type of call option that grants
straddles has limited risk because maximum loss the holder the right to purchase company stock

35-505 0 - 84 - 7 : QL 3
88 ● Effects of Information Technology on Financial Services Systems

at a stated price, usually somewhat above market Futures


at the time of issue. The value of the warrant itself
at any time is dependent on the current price of Futures, or future contracts, are legally binding
the stock of the issuing corporation. Warrants are agreements that call for the purchase or sale of real
often offered with debt issues by corporations to or hypothetical items at a stated price at some
make the debt issues more attractive to potential time in the future. Future contracts can be devel-
investors. They offer a participation right of sorts oped for anything and are traded on established
if the corporation grows. The investor benefits exchanges for physical commodities such as pork
from the fixed return of the debt investment as bellies and coffee, for financial instruments, and
well as the opportunity to purchase stock at an for hypothetical stock portfolios.
established price. Even though future markets at one time were
As with all options, an exercise price is specified focused only on commodities; they have expanded
for the warrant. It may have a specific expiration greatly. In the past, communities needed to be self-
date or be perpetual. The contract also specifies sufficient in their production of foodstuffs and
whether it can be traded, as with other option in- other necessary goods because transportation be-
struments, or be exercised only by the holder. tween regions was not efficient. As lack of trans-
Unlike other options, warrants directly affect portation became less of a barrier to trade, com-
the capital structure of a corporation. A call or put modities markets developed that allowed for
option is exercised through a capital market and specialization in production and made a wider
with no net change in the number of shares out- assortment of goods available. Centralized com-
standing for the corporation. However, when a modity markets made more extensive trading pos-
warrant is exercised, the corporation issues new sible, and future markets grew from them to ad-
shares of stock; therefore, the earnin gs of the com- dress price-change risks.
pany, from the point of view of the shareholders, Commodity futures markets developed because
are diluted. This situation complicates valuation of the need in both agricultural and industrial
both of the stock of the corporation and of the societies to minimize the potential impact of un-
warrant. known and hard-to-predict forces that influence
the price and availability of resources and prod-
THE EFFECT OF INFORMATION ucts. For example, through the use of futures con-
TECHNOLOGY ON OPTIONS tracts, food processors are able to set definite max-
imum prices for the commodities they will need for
Information technology is likely to continue to
production throughout the entire year. Most crops
facilitate the development and trading of options.
are only harvestable for a very short period of time
Because option markets have only recently be-
in any year, and it is desirable for farmers to be
come highly structured and have been heavily de-
able to sell all of the harvest at that time to avoid
pendent on technology from their inception, the
the need for expensive storage. While the demand
continuing application of communications and
for some food products, such as turkey and pump-
computer technologies in these markets is not
kins, may be seasonal, food processors face a year-
likely to lead to major revisions in ways of doing
round demand for products made from commodi-
business to the same extent as they have in debt
ties only available for a very short time. These
and equity markets. Options may serve as a test-
processors need to have the commodity available
ing ground of sorts for new technologies, and tech-
at a predictable price when it is needed. By pro-
nology use in this area may presage future applica-
viding a reliable means to conduct future buying
tions throughout the securities industry.
and selling, futures markets have served to equal-
The use of personal computers and sophisticated
ize the marketing of most seasonal farm crops. 12
communications technologies may spur the devel-
The development of futures markets centered
opment and marketing of option contracts by in-
around the desire to transfer risk. The play of the
dividuals and may lessen the role of brokers in
market attracts a large quantity of risk capital
bringing writers and buyers together. Information
through which changes in commodity price levels
technology should also facilitate the monitoring
can be absorbed with only a minimum direct im-
of option markets by investors, brokers, corpora-
pact on producers and processors of commodities.
tions issuing securities on which options are writ-
ten, and market observers and regulators. This
‘2 Future Industry Association, “Development of Commodity Ex-
may become increasingly important as the use of changes, ” Futures Trading Course and Handbook, Washington, D. C.:
options as an investment instrument grows. 1983, p. 1-4.
Ch. 3—The Securities Industry ● 89

This allows the producers and processors to oper- futures, and therefore the stock market may be-
ate at lower cost than would be possible if they had come less volatile.
to bear the entire risk of market fluctuations. In If the stock market becomes less volatile, it
turn, this lowers prices to the public. ” must be expected that funds currently held in
Commodity futures markets help effect stability mutual funds or the savings instruments of depos-
in consumer prices. Because food processors can itory institutions because of the desire of the in-
bound their costs, consumers are assured that vestor for stability will be transferred to direct par-
products will be available when needed at a rela- ticipation in capital markets. More money may be
tively predictable price and therefore approach the available for corporate capital formation; how-
market in rational manner. This price stability is ever, this may be at the expense of the banking
both of importance to the general economy of the structure.
Nation and of social interest, since allocations Questions that must be addressed are: what hap-
through Government programs, such as food pens to the risk that is transferred away from the
stamps, can be set with some certainty as to what stock market? and what effect will this transfer
market conditions will be for the recipients. have on the market? The result may be that the
assumers of risk, in this case players in stock
THE OPERATIONS OF FUTURES futures, may be expected to be advised better and
The taking of a position in future contracts for more able to accept this position.
a product on which one depends in one’s primary One cannot blindly accept that risk was bad for
economic activity is called hedging. For example, the stock market when, in fact, it was the market’s
General Foods might be expected to hold a posi- reason for being. It is essential that some means
tion in coffee futures contracts to guarantee the of projecting what the impact of the possible end
maximum price it would need to pay for beans for of the need for a risk-accepting role by stock ex-
future production. In the discussion of futures, changes will mean to the process of capital forma-
hedging is not a speculative strategy but rather tion be available. It is also necessary to determine
refers only to the activities of players who face risk what, if any, effect the activities of markets in
because of possible fluctuations in price and avail- stock futures will have on the inherent soundness
ability of an actual commodity. of capital markets. Stock futures may cushion the
stock market from changes in the general econ-
STOCK FUTURES omy; however, it is not clear what impact a cata-
strophic event in the futures market might have
Options, which were discussed in an earlier sec- on the entire capital formation process.
tion, allow for the transfer of risk associated with
a particular debt or equity issue. Broad changes
in the stock market prices pose a blanket risk to THE EFFECT OF INFORMATION
highly diversified investors, and stock futures may TECHNOLOGY ON FUTURES
offer inherent price change protection to these in- Futures markets provide a glimpse of what the
vestors. Stock futures are contracts that call for possible impacts of information technology on the
the buying or selling of a mythical basket of securities industry as a whole may be. The poten-
stocks, usually a grouping which is used in an in- tial of information technology was available as
dex of market behavior. Due to practical limita- many of the operations of this segment of the in-
tions, these futures are settled through cash rather dustry were developed.
than the actual purchase or sale of the underlying Modern futures markets need both man and ma-
securities. chine to operate. Human decisionmaking has been
The availability of stock futures through which and will continue to be the one irreplaceable and
an investor can hedge against swings that affect essential characteristic of any successful market.
the entire stock market may add a great deal of However, the volume of trading demanded by cur-
stability to that market and is expected to be of rent market conditions requires a level of opera-
great significance to institutional investors, who tions not feasible for mortals in a free society at
hold a growing proportion of all shares. Investors an acceptable cost. It would be impossible to op-
may be more judicious in their response to mar- erate futures markets with the precision and at the
ket changes because their risk may be minimized volume demanded by the market without the ap-
by the holding of offsetting positions in stock plication of information technology; for example,
for performing simple tasks, such as sorting faster,
“Ibid. that would be impossible for a human work force.
90 ● Effects of Information Technology on Financial Services Systems

Computer and communications technology did Money market mutual funds are one of the more
generate a futures market; however, if these tech- liquid instruments available to investors. The
nologies were not available, the market could not liquidity of this type of investment is demon-
have grown to its current size and importance. Its strated by the fact that, in many cases, sharehold-
absence would have effectively foreclosed the pos- ers may access their funds by writing drafts, as
sibility of responding to the demands of the econ- quickly as a bank checking account by requesting
omy for the level and quality of operations now wire transfers, or in some cases, by using an auto-
seen. mated teller machine (ATM).
Such funds invest in short-term money market
Mutual Funds securities and, because of the nature of the under-
lying securities, are extremely liquid and relatively
The importance of mutual funds as institutional risk-free. Money market mutual funds are a valu-
investors is discussed earlier in this report; how- able cash management instrument for businesses
ever, these funds also have a role in the securities and an extremely valuable tool for individual in-
industry in the role of investment instruments. vestors, both the “small” and the more affluent.
Mutual funds offer investors a way of partici- Money market mutual funds give investors ac-
pating in securities markets without directly pur- cess to money market securities on terms that
chasing capital or money market securities. An in- they could not likely match themselves. Econ-
vestor may be attracted to a mutual fund as a sort omies found in issuing and servicing large-denom-
of proxy method of participating in the securities ination money market securities result in higher
market. The individual benefits from the expertise yields than those offered on similar securities of
of the fund management, and risk is generally smaller denomination. The holder of shares in a
14

lower than that through direct participation, al- money market mutual fund benefits from this
though actual risk differs significantly, based on higher rate of return.
the investment strategy of the fund. Mutual funds Money market mutual funds have enjoyed ma-
allow investors greater liquidity than capital mar- jor market success. While information technology
kets; shares are redeemable at any time at current is not directly responsible for this, many industry
asset value less applicable redemption fees. experts believe that it would not have been possi-
Mutual funds have traditionally been especially ble, from an operational or business point of view,
important for the small investor because they can to introduce this type of fund without the support
frequently be entered with a smaller amount of in- of communication and computer technologies. In-
vestment capital than can the securities market, formation technology makes it possible to retain
as the money invested is pooled with that from the highly liquid character of the funds by simpli-
other participants. The investor may also take fying access for the investor. The level of trading
advantage of the possible benefits of a diversified in short-term securities required by the funds
portfolio that he might not have been able to sup- would be difficult to complete physically without
port by directly participating in capital or money the assistance of information technology.
markets. For the investor interested in an entire The number and variety of capital and money
industry rather than a specific company, certain market mutual funds will probably continue to
funds allow such a focusing of investments. grow. While this growth will provide more options
Mutual funds that are made up of corporate for investors, it may also have an impact on the
bonds and stocks are significant to the formation way in which securities markets operate. Although
of capital because they attract investment money information on the investments of the fund is in-
to the market that would not otherwise have been cluded in prospectuses and periodic reports to
available. While some mutual funds centered on shareholders, it is not clear that the individuals in-
capital markets have charged high transaction fees vesting in the fund take an active interest in what
(called a load), their availability has increased both instruments their money is invested in. While the
consumer options and competition for investment pool effectively lowers risk, the responsiveness of
dollars throughout the financial service industry. individual shareholders is markedly lower than
The application of information technology to the
development and marketing of mutual funds should
increase the number and variety of funds available “William Jackson, ‘ Money Market Mutual Funds, ” Congressional
to consumers. Research Service Issue Brief No. 81057, Jan. 20, 1983.
Ch. 3— The Securities Industry ● 91

would be expected in normal market circum- features that distinguish accounts are: how fre-
stances. The institutional investor behaves dif- quently “sweeps” of free credit balances occur,
ferently, for better or worse, because he makes whether a charge or debit card is issued for access,
decisions differently, and this may have an impact the offering of excess insurance coverage; whether
on securities markets. the account is accessible through an ATM net-
work, and the availability of a bank overdraft line
Central Asset Accounts of credit.17 The accounts have been targeted
toward the upscale market, an estimated 10 to 12
The central asset account is considered by many percent of the population. A substantial minimum
to be the single most important investment prod- opening deposit of securities or cash, usually of be-
uct of the next decade. ’5 In developing the market- tween $15,000 and $20,000, is required and an an-
leading Cash Management Account, Merrill Lynch nual fee is charged.
recognized that the financial needs of a single cus- Merrill Lynch first offered the Cash Manage-
tomer are interrelated and form well-defined types ment Account in 1977 and as market leader now
of systems. The central asset account attempts has nearly 1 million accounts, The market growth
to meet an investor’s full range of financial needs that central asset accounts experienced may have
with three basic components: the securities margin been attributable in part to market conditions,
account, the money market fund account, and a especially high interest rates. As conditions have
zero-balance bank loan account that can be ac- changed, the growth of these accounts has de-
cessed by check or card. A central asset account clined.l8 The significance of the account in the long
provides a full range of financial services to its run is difficult to judge, although it seems likely
user. The accounts offer a centralized method of that it will continue to serve the needs of a seg-
controlling assets and, as free credit balances in ment of the market. One important feature of a
the zero-balance account are “swept” into a money central asset account is that it allows brokers to
market fund, both liquidity and return are maxi- fill more of their customers’ financial needs for
mized for the investor. more of their personal financial lifecycle. 19 This
Nearly all major securities firms offer a central makes the account a valuable tool for financial
asset account. While they have the same basic service offerers, as it may help to attract and re-
components, their features often differ. Among the tain customers.
i ~T& Fin8nCia] .~crt,ices Industr\’ of 7’omorrour, a N?pOrt prepared h)’
the Committee to I?xamine the Future Structure of the Securities In- “Joseph Diamond, “Central Asset Accounts Developed by the Secu-
dustry, National Association of Securities Dealers, November 1982, rities Industries, ” Financial Services Institute Handbook, vol. 1, p. 358;
p. 20 prepared for distribution at the Practicing Law Institute Financial Serv-
“Herbert M Allison, Jr., “The Perspective of a Diversified Finan- ices Institute Program, Feb. 14-15, 1983.
cial Services Company, ’ panel presentation at the Eighth Annual Con- “Alice Arvan, “Asset Accounts Reach Out for Broader Markets, ”
ference of the Federal Home I.oan Bank of San Francisco, Strategic .4merican Banker, May 20, 1983, p. 9.
[~lannjng for ~conomjc and Technological Change in the Financial Serl’- ‘William L. White, “The Outlook for Money Market Mutual Funds, ”
ices Industr~,, San Francisco, Calif,, Dec. 9-10, 19/32, p, 157. a report to the Investment Company Institute, Sept. 30, 1982, p. 62,

Appendix 3B: Capital Formation and the Functions


of the Securities Industry
The securities industry performs its functions firm, its size, management style, and financial his-
of advising, underwriting; and marketing to gather tory, as well as the-amount of capital needed and
capital by bringing investors and organizations in market conditions, all contribute to the decision
need of capital together in two ways: through pri- on whether to attempt to finance through private
vate sources and through public offerings. Finan- or public offerings. An overview of the role the
cial advisors may assist the firm in determining securities industry plays in both private and pub-
which path to follow. The characteristics of the lic financing is provided below,
92 ● Effects of /formation Technology on Financial Services Systems

Private Sources of Funds needed to purchase new shares are specified in the
offering; however, the shareholder is assured that
Seeking capital through private sources may of- he will be able to purchase new shares in propor-
fer salient advantages for many corporations. Reg- tion to his current stake.
ulatory requirements associated with public issues A privileged subscription may provide basic
are avoided. This may save time and, more impor- marketing advantages to the issuing corporation
tantly, the avoidance of disclosure requirements and therefore to the shareholders, even those who
may be an advantage for many firms, particularly opt not to purchase additional shares. The tar-
those in highly competitive industries. However, geted market for the offering is known to have an
because the firm is only likely to approach a limited interest. Assumed knowledge of the corporation
number of investors and because the assurances and the costs associated with the offering are usu-
associated with a regulated public offering may ally lower than they would be for an offering to
not be found in private financing, the firm may the general public. Often, flotation costs are half
find it necessary to pay a higher rate of interest those of a public issue. From the point of view of
or return on money obtained and may find that the the investor, margin requirements for a purchase
creditor or holder of equity has a greater interest through a rights offering are generally lower than
in the operations of the firm than investors in pub- in other circumstances.
lic issues. The corporation may identify two major dis-
advantages with a rights offering. First, to attract
Private Placements investors, the price per share may have to be lower
than would be assigned in a public issue. As a
A corporation may sell an entire issue of securi- lower total amount of capital may be raised by the
ties directly to a single investor or small group of issue, earnings per share may be diluted. Second,
investors. Such an action is referred to as a pri- the increased number of actual shareholders result-
vate or direct placement and may involve either ing from a public offering may be desirable for the
debt or equity issues, although more commonly, corporation. The greater the number of stockhold-
debt instruments are involved. Private placement ers, the more likely that management will retain
offers several advantages over a public offering for control of the operations of the company.
the issuing firm. It is generally quicker and cheaper,
as registration of the issue with the SEC is not
needed, and the firm deals either directly with the Venture Capital
potential investor through a placement agent. The
issue may also be more directly tailored both to Venture capital is money invested in new or
the needs of the borrower and the investor in the small businesses by corporations or individuals
terms outlined and in the timing of the issue. that are not directly involved in the management
A potential disadvantage of this type of offer- of the business, although they may provide advice.
ing may be mitigated by the application of infor- The investor is usually granted a large enough
mation technology; that is, the location of suitable share of equity in the venture to exercise signifi-
potential investors in a time frame that allows the cant control of the corporation and, in cases where
capital seeker to plan the use of the funds with the venture is successful, to receive a significant
some precision. Communications technologies may return. The equity is frequently issued in the form
streamline brokerage private offerings. of letter stock, a private placement that cannot be
resold until the issue is registered with the SEC,
Privileged Subscription Basis which may be years later.
Although it may be an extremely risky invest-
An offering of stock only to existing stockhold- ment, individuals who are venture capitalists are
ers is termed a privileged subscription, or rights, attracted for several reasons. Not only is the rate
offering. In many cases equity holders are granted of return significantly higher, but as it is in the
a preemptive right in the articles of incorporation form of capital gains rather than dividends, it is
of the company that requires the firm to give cur- taxed at a lower rate. Organizations that provide
rent shareholders the opportunity to maintain venture capital are part of many corporate fami-
their “position,” that is, percent share of total lies, not only because of their primary goal of fi-
ownership, any time a new issue is made. In this nancial returns but also because of other tangible
situation each shareholder is issued one right for business benefits the venture capital relationship
each share of stock owned. The number of rights can provide. Several investment banks have formed
Ch 3— The Securities Industry ● 93

Table 3A-l.— Most Active Venture Capitalists, 1982 venture capitalists and the seekers of financing to
. —. . locate one another.
1982 total An important source of venture capital for small
investment 1981
Rank Name of firm (in millions) rank
businesses are Small Business Investment Cor-
1 porations (SBICs). These firms are licensed and
1. The Hillman Co. ., .. ., . . . . . . . . 101.5
2. Allstate Insurance Co. regulated by the Small Business Administration
Venture Capital Division ... . 64.2 9 under a program established by the Small Busi-
3. First Chicago Investment Corp. 48.5 2 ness Investment Act of 1958 to contribute to the
4. General Electric Venture Capital development of small businesses. SBICs are pri-
Corp. (G. E. Corp.) . . . . . . ... 41.6 27
5. Brentwood Associates ., . . . . . . 35 10
vately owned and operated investment firms, but
6. E, M. Warburg Pincus & Co, . . . 33.9 12 are eligible to receive some Federal funding. Cap-
7. TA Associates (Tucker Anthony ital is developed in the form of equity or long-term
& R. L. Day) . . . . . . . . . . . ... . . 32.3 4 loans.
8. Security Pacific Capital Corp. . . 32.25 8
3
These firms are an important part of the capital
9. Citicorp Venture Capital Ltd. . 30.5
10. BT Capital Corp. formation process for small businesses that might
(Bankers Trust N.Y.). . . . . . . 26 45 be at a disadvantage in competing for venture cap-
-
S O URCE Venture June 1983 ital. Information technology may be expected to
facilitate the development of financing between
venture capital units in the hope of handling even- SBICs and businesses by making it easier for both
tual public issues if the company experiences to identify potential investment arrangements.
hoped-for growth. The desire to attract and retain
customers is an incentive also for commercial Public Offerings of Securities
banks and insurance companies. of a Corporation
Some major corporations, particularly in the en-
ergy and electronics fields, have formed venture The decision by the management of a privately
capital units because of interest in financial return held corporation to “go public” is based on their
and the hope of gaining access to new ideas and objectives and strategies for the future of that
technology that may be beneficial to the corpora- business. The desire to acquire capital, to in-
tion. The need of established industrial giants to crease the liquidity of the original owners, and to
maintain the pace of technological innovation may strengthen the balance sheet of the corporation
encourage further entry into the venture capital must be weighed against the expense involved in
market. such a move, the increased vulnerability of the cor-
For a small or new corporation, venture capital- poration to general market conditions, and the ne-
ists may provide a valuable source of financing. cessity that management take on additional re-
Intermediaries in the securities industry provide sponsibility for the actions of the corporation and,
assistance to this capital seeker. They help locate possibly, relinquish control of it.
a potential investor whose objectives are in line There is no strict formula through which the de-
with those of the organization in need of financ- cision to go public can be made. Going public may
ing and assure that the financial arrangement de- involve a significant change in the structure and
veloped is in the best interests of the firm in both operation of a firm, and this change must be as-
the long and short runs. sessed in terms of the objectives of the owners and
Venture capital has become more plentiful in the management of the company, The decision cannot
past several years. Industry experts attribute this be assessed individually; it must be considered in
to changes in Federal Government policies that re- light of other alternatives such as private funding
duced capital gains tax in 1978 and 1981 and re- or additional investment by the owners, In eval-
laxed pension trust fund investment rules in 1979. ’ uating the option of going public, several matters
Information technology may have an impact on must be considered; these include business, ac-
venture capital financing because it may facilitate counting, legal, and regulatory considerations.
analysis of possible deals, New communication ca- Careful attention must be paid to the planning
pabilities may also make it easier for prospective of an offering to assure that the normal operation
of the firm is not disrupted and that maximum
value is derived from the offering, Major factors
] (J S. (;eneral Accounting office, (;otw-nment-IndustrJ, Cooperation
(’an Enhance The \renture (’apitaI Process, Report to Senator I,loyd to be considered by the corporation include tim-
Bentsen, Joint k;conomic (’ornmittee, Aug 1 !.2, 1982, p. 4. ing of the issue, both in terms of the operations
94 ● Effects of /formation Technology on Financial Services Symtems
— . — .—— — — —

of the company and of investment markets; the laws were enacted.2 It was cheaper and more reli-
ability of the firm to attract an underwriter, if able than the communications technologies of the
needed; and the ability and desire of the corpora- day, notably telephone and radio, and was easier
tion to adhere to disclosure requirements. Infor- to use.
mation technology may ease these problems by Paper was never intended to be a sacred medium
aiding in the analysis of decision factors and pos- for conveying information about securities offer-
sibly by shortening the issue process and there- ings. Its use was specified because it was the most
fore the disruption of business. practical choice. The vast improvement in quality
Federal laws governing public offerings by cor- and cost of information technology has turned the
porations or organizations require the disclosure table on the comparative effectiveness of paper
of information on which investment decisions can and communications media. Recognition of this
be based. A prospectus is information provided to change is causing a reexamination of the process
potential investors in a new securities issue that of filing new offerings with the SEC.
describes the current condition and history of the The SEC is trying to make the volumes of in-
issuing firm. It attempts to provide information formation it receives easier to manage and use by
on which a decision to invest can be made but does applying information technology to its information
not contain any type of objective judgment on the gathering and dissemination process. Some ex-
advisability of investing in the described issue. perts advocate the eventual movement toward
Information technology may affect public offer- paperless filing and information dissemination.
ings by corporations in several ways. First, the Potentially, a system based on information tech-
essential requirement of Federal securities laws is nology could result in faster dissemination of in-
the provision of information to potential investors. formation and more efficient review and storage
It is quite likely that the application of informa- processes.
tion technology for disseminating information will
radically change the physical activity of going pub-
lic. Paper was the logical medium through which
Lee B. Spencer, Jr., “The Electric Library, ” Remarks to the American
information could be transmitted in the 1930’s, Bar Association, Federal Regulation of Securities Committee, Nov. 19,
when many of the currently applicable securities 1982.
Chapter 4

Retail Financial Services


Contents
Page
Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97

Deposit Function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
Direct Deposit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
Point-of-Sale Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ... ....... 101
Lockbox Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
Demand Deposit Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
Drafts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
Giro Transfers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
Traveler’s Checks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
Savings Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
Accounts With Other Nondepository Institutions . . . . . . . . . . . . . . . . . . 107

Extension of Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108


Commercial Credit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110
Consumer Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110

Electronic Funds Transfer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114


Automated Teller Machines . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
POS Full Funds Transfer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123

Financial Information Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126


Check Authorization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127
Credit Authorization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127
Providers of Information Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127

Home Information Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128


Technology of Home Information Services . ....................... 129
Developers of Home Information Systems. . ....................... 129
Costs of Home Information Systems . . . . . . ....................... 131
The Market for Home Information Systems ....................... 131
Implications of Home Information Systems ....................... 131

Tables
Table No. Page
3. Comparison of Depository Instruments and Accounts . . . . . . . . . . . . . . 100
4.Nationwide ACH Volume . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
5. Growth Projections for the CIRRUS Systems, Inc., National
ATM Network.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120
6. Principal Characteristics of HIS Users . . . . . . . . . . . . . . . . . . . . . . . . . . . 132

Figures
Figure No. Page
6. Penetration of Direct Deposit Social Security Payments . . . . . . . . . . . 101
7. Relative Use of ATM Functions, 1974-$1 .. + ~ . . . . . . . . . . . . . ....... 116
8. Number of ATMs in Use, 1973-81 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118

9. Average Number of Monthly Transactions Per ATM, 1974-81 . . . . . . . 118


10.ATMs in the United States . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
11. Penetration Curve for Check Alternatives. . . . . . . . ......... . . . . . . . 133
.

Chapter 4

Retail Financial Services

Introduction
The retail financial service industry consists Historically, deposit-taking has been viewed
of those organizations (e.g., banks, credit as a special activity in the economy, and de-
unions, insurance companies, consumer fi- pository institutions have been viewed as oc-
nance companies) that deliver products to end- cupying a unique place in the industry. Depos-
users. * Consumers comprise the largest and itors place a very high degree of trust in the
most visible single group of end-users of finan- institutions holding their funds. At the same
cial services, but business and government time, because depository institutions play
both have roles as customers for retail finan- such an important role of intermediation be-
cial services. Included among retail financial tween sources of funds and those having need
products are depository accounts, extensions of them, they are in a position to exert a meas-
of credit, and payment services.** ure of control over virtually all other economic
activities.
According to 1982 figures, the industry en-
compasses more than 90,000 business entities, Retail financial services, especially those of-
including 15,000 commercial banks, 4,000 fered by banks, have been heavily regulated
savings and loan associations, 1,000 mutual by both State and Federal Governments.
savings banks, 22,000 credit unions, 1,000 in- Rates paid on deposits have been largely de-
vestment banks, 5,000 broker/dealers, 1,000 regulated, but limits on the rates charged on
mutual funds, 1,000 mortgage banks, 3,000 consumer loans remain in force. Depository in-
pension funds and pension fund managers stitutions are generally limited to offering
(other than banks and insurers), 2,000 life and prescribed products to predefined markets.
health insurance companies, 3,000 property Banks, for example, are limited with regard
and casualty insurance companies, and more to the geographic area served, while credit
than 33,000 insurance brokerage agencies, as unions are limited to serving only groups
well as numerous factoring companies,*** whose members share a common bond, such
leasing companies, credit card or traveler’s as employment with a specific firm. Generally,
check issuers, and finance companies. In 1980, bank holding companies are not permitted to
the financial service industry (excluding real enter lines of commerce not closely associated
estate) contributed $100.4 billion, or 5 percent, with banking. Depository institutions are ex-
to the U.S. national income.1 amined to ensure that they are pursuing busi-
ness in a manner consistent with preserving
*For the purposes of this assessment, wholesale financial serv- institutional safety and soundness, and many
ices, as contrasted to retail, are those provided by one finan- of their business decisions (e.g., effecting
cial institution to another in a way that is largely invisible to
the end-user. mergers, opening branches, offering new prod-
**Customers of securities brokers are also users of retail fi- ucts) are reviewed by regulators prior to im-
nancial services. However, because the security industry is plementation.
governed by a body of policy unique to it that separates it from
retail banking and other retail financial services, it is treated Depository institutions enjoy some unique
in ch. 3 of this report.
***Factoring is the process of selling accounts receivable to benefits in exchange for heavy regulations.
a third party, who then assumes the risk and costs of servic- Only they can take deposits and offer accounts
ing them. that are federally insured. Depository institu-
‘State of New York, Report of the Executi\e Adtisor}. Comm-
ission on Insurance lndustr?’ Regulator?’ Reform, May 6, tions are unique in having access to the vari-
1982, p. 101. ous systems used to transfer funds.

97
98 • Effects of Information Technology on Financial Services Systems

Today, insurance companies, providers of entrants who rely heavily on advanced tech-
services such as credit cards and traveler’s nologies to implement their offerings gener-
checks, consumer finance companies, dry ally fall outside the boundaries of existing reg-
goods merchants, investment companies, and ulation.
food retailers also provide retail financial serv-
ices. Some, such as insurance companies, are The financial service industry is becoming
regulated, while others, such as providers of homogenized to a significant degree, and dif-
traveler’s checks, are virtually unregulated. ferentiation between products has become less
All, to an ever-increasing degree, are broaden- apparent, particularly from the point of view
ing their range of business activities and, to of individual consumers. Commercial banks
some extent, are encroaching on areas pre- and savings and loan associations are now per-
viously served by others, including those here- mitted to serve many of the same clientele. For
tofore exclusively reserved to depository in- example, recent legislation gave savings and
stitutions. loan associations the power to make some
commercial loans, a product that could not
Information processing and telecommunica- previously be offered. While securities broker/
tion technologies have contributed to the dealers are not permitted to offer depository
broadening of product lines by providers of accounts, they do offer shares in money mar-
retail financial services. New entrants have ket funds that have properties very similar to
been able to develop and offer products that deposits. Insurance companies offer universal
compete directly with those previously avail- life policies that share many properties with
able only from depository institutions. Dis- self-directed investment accounts offered by
tance and location have lost much of their sig- others.
nificance as factors limiting the market served
by a service provider. In addition, by using the VISA and MasterCard are the two principal
technologies, new classes of products have bank card products offered nationwide. How-
been developed. Foremost among these are ever, in addition to being offered by banks,
those that deliver financial services to remote these are now issued by such varied organi-
locations, such as the home, office, merchant’s zations as the American Automobile Associa-
counter and unstaffed branches. Others, such tion and various brokerage houses that offer
as services to facilitate collection and invest- them in conjunction with asset management
ment of cash, are directed to the business com- accounts. Travel and entertainment cards can
munit y. be used with automated teller machines
(ATMs) to obtain either cash or traveler’s
As noted, law and regulation are significant checks. In some cases, a plastic card is used
forces shaping the financial service industry to access a depository account (e.g., checking).
and guiding its day-to-day operations. The ex- Plastic cards can also be used to draw on a line
isting legal regulatory structure dates largely of credit either to pay for a purchase or to ob-
from the 1930’s and is built on the assump- tain a cash advance. The same card can be
tion that specific types of institutions will be used for both purposes. However, the finance
the only ones offering each type of service. For charges are assessed differently for the cash
example, transaction accounts are assumed to advance and the credit purchase.
be offered only by banks; and thrift institu-
tions are assumed to focus their lending activ- One of the major developments of the 1980’s
ities on home mortgages. Thus, even though has been the development and deployment of
the intent was to regulate by function, the networks of ATMs. Some of these accept only
focus of legislation has been on the institutions the card of one institution, while others per-
rather than on the products they offer. As a mit access to accounts held in any one of a
result, the offering of new products by unreg- number of institutions. Most of these net-
ulated providers is often found to lie outside works are offered by depository institutions
the existing legal/regulatory structure. New or consortia of depository institutions. How-
Ch. 4—Retail Financial Services ● 99
——— ————. .—

ever, retail dry goods merchants, supermarket straints and therefore come to the market with
chain operators, and operators of convenience varying strengths and weaknesses. Others, by
stores are now establishing networks and of- way of contrast, seek to serve specific groups,
fering financial institutions the opportunity such as members of the professions with prod-
to access them. ucts tailored to their particular needs. The
market appears ready to support service pro-
More generally, telecommunication has been
viders across the full spectrum of possible
a major factor in the development of financial
product menus.
products in the 1980’s. Providing remote
banking services has been a key area in the Fluidity in the structure of the financial ser-
development of financial services. Publishing vice industry limits the utility of any descrip-
companies are combining with financial serv- tion that focuses on the institutions that com-
ice providers and communication companies prise it. A list of providers would almost
to deliver financial services directly to the certainly omit some and include others that
homes of consumers. Grocery chains are es- arguably could have been omitted. Because
tablishing networks of ATMs that compete product lines of various classes of providers
directly with those offered by banks. Banks of financial services are close substitutes for
offer cash management services to business, one another, descriptions of each of the classes
enabling corporate cash managers to control of providers would become redundant.
funds on deposit with institutions worldwide
and to manage them to the best advantage of Therefore, the approach taken to describing
their employers. the retail financial service industry in this
assessment is to focus on the functions per-
Other developments of the 1980’s have been formed for the customers and then to relate
the emergence of the financial supermarket those functions by way of example to the or-
and the specialized supplier of financial serv- ganizations that provide them. The classes
ices. Several organizations have used differ- of functions described are treated under the
ing strategies to develop into horizontally in- headings:
tegrated suppliers of financial services. The
remarkable point is that some find their roots deposit/withdrawal function,
in insurance, others in retailing, and yet others extension of credit,
in banking. Under the existing 1egal/regula- electronic funds transfer, and
tory structure, all operate within differing con- financial information services.

Deposit Function
Technically, the function of accepting depos- lowing methods: in person, by mail or tape, or
its is strictly limited to depository institutions. electronically via ATM or other remote ter-
Simply defined, a deposit is a placement of minal or by the Automated Clearing House
cash, checks, or drafts with a financial insti- (ACH).* In paper-based systems, access to de-
tution for credit to a customer’s account. De- posits depends on the physical transfer of
posits become a liability to the financial insti- documents such as a check or draft.** How-
tution since they represent an obligation to ever, electronic technologies have helped rev-
repay funds. The deposit function is the tradi- olutionize this function.
tional banking process by which funds are ac-
cepted for credit to a demand, savings, or time *The ACH is a computerized facility that helps clear funds
transactions among participating institutions electronically.
account. Deposits are accounts for holding * *Draft— A n order written on the funds of a third party to
funds. The deposit is made by one of the fol- transfer the amount specified to the payee.
100 ● Effects of Information Technology on Financial Services Systems

In essence, a deposit differs from an invest- honored immediately. There may also be no
ment in that the depositor expects to be able guarantee that shares will be redeemed at the
to recover the amount deposited, often with price originally paid by the investor. However,
some interest, with virtually no risk of loss. as long as institutions continue the practice
The depository institution holds itself ready of operating near-deposit products in a man-
to pay the amount of the deposit under con- ner that closely approximates the operation
ditions that are consistent with the contract of a true deposit account, the customers will
under which it was taken. In the case of a de- see the former as being a close substitute for
mand deposit, for example, the depository in- the latter.
stitution stands ready to pay on demand. On In this environment, not all of those offer-
the other hand, if the owner of a certificate of ing deposit or near-deposit products operate
deposit withdraws the funds prior to maturity,
under the same set of rules. This variation in-
a significant penalty is extracted that, in some troduces new elements into the calculus used
cases, involves loss of principal as well as in- by those responsible for the safety and sound-
terest. ness of the financial service industry and the
In the present environment, firms other formulation and execution of fiscal and mone-
than depository institutions offer products tary policy. In the sections that follow, the
that are operationally similar to a deposit from various types of deposit-like products and
the customer’s point of view. For example, associated deposit-taking services are de-
securities broker/dealers and investment com- scribed.
panies offer shares in money market mutual
Table 3 presents a comparison of the vari-
funds that include the option of redemption ous depository instruments and accounts dis-
by means of a draft written against the in- cussed in more detail below.
vestor’s holding. A whole-life insurance pol-
icy accumulates cash value that is available
to the owner. Direct Deposit
Some will tend to view these products as de- Direct deposit is most often used to effect
posits because, operationally, the funds are payment from either private or public organi-
available virtually on demand. The expecta- zations to recipients of salaries, pensions, and
tion is that payment will be made by the pro- entitlements. It is actually a preauthorized
vider even though there may be contractual credit arrangement between the party issuing
provisions that an order to pay need not be the payment and the receiver and is commonly

Table 3.—Comparison of Depository Instruments and Accounts

Penalty Minimum
Interest- Withdrawal Mandatory for early deposit or
Instrument or type of account bearing notice request deposit period withdrawal balance
Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . No No No No No
Draft . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Yes Optional No No No
Traveler’s check . . . . . . . . . . . . . . . . . . . . . . . . . . No No No No No
Conventional savings account . . . . . . . . . . . . . Yes Optional No No No
Credit union account . . . . . . . . . . . . . . . . . . . . . Yes Optional No No No
Certificate of deposita . . . . . . . . . . . . . . . . . . . .Yes Yes Yes Yes Yes
Money market deposit account. . . . . . . . . . . . . Yes Optional No No Yes
NOW accountb . . . . . . . . . . . . . . . . . . . . . . . . . . Yes Optional No No Optional
Super NOW accountb . . . . . . . . . . . . . . . . . . . . . Yes Optional No No Yes
Savings bond . . . . . . . . . . . . . . . . . . . . . . . . . . . .Yes Yes Yes Yes Yes
Savings certificate. . . . . . . . . . . . . . . . . . . . . . . . Yes N/A Yes N/A Yes
aEffe~t jve Oct 1, 19&3, Interest rate ceilings are eliminated on all time deposits with original maturity or requ i red periods of more than 31 days, and on time deposits
of $2,500 or more with original maturity or required notice periods of 7 to 31 days
b No t available to commercial businesses
N/A–Not applicable
SOURCE Office of Technology Assessment
Ch. 4—Retail Financial Services ● 101
— . .

used for recurring payments. One of the Table 4.—Nationwide ACH Volume
largest users of direct deposit is the U.S. De- —
-
Government
partment of the Treasury, for Social Security Year Private (Social Security)
payments. It is also widely used for mili- 1976 . . . . . . . . . 4,283,770 46,646,999
tary payroll and other regular Government 1977 . . . . . . . . . 10,344,192 69,694,741
payments. 1978 . . . . . . . 18,612,263 93,207,073
1979 . . . . . . . . . 331324,163 123,353,594
Figure 6 shows the increasing rate at which 1980 ......, . . 63,362,597 144,112,204
1981 . . . . . . . . . 117,019,927 164,157,190
Social Security recipients have been willing to 1982 . . . . . . . . . 174,613,862 — - . 176,821,896
accept payment by direct deposit. In 1978, SOURCE National Clearing House Association
only 11 percent were willing to make use of
direct deposit; but this proportion had grown is expected that use of the ACH will increase
to 33 percent by 1982. The Department of the once a critical volume has been achieved by
Treasury hopes for further increases. the flows to and from large organizations. As
this occurs, users with smaller volumes of
Direct deposit transactions started as paper payments should gradually be absorbed into
transactions, but the rising volume of such the system.
payments has encouraged the use of the ACH
network and systems, which depend heavily
on the interchange of magnetic tape (see table Point-of-Sale Systems
4). The process involves coding payment in- Point-of-sale (POS) systems, discussed in
formation in machine-readable form and mov- detail later in this chapter, also function as a
ing it between banks on computer tapes or, in deposit-taking method. In some cases, retail
some cases, over telephone lines. The paying clerks will accept funds for deposit to custom-
bank or organization consolidates all its ers’ accounts. In others, the financial institu-
payments for a certain date and submits them tion will operate a station or counter in the
on magnetic tape through the ACH. The ACH retail store at which deposits are accepted. A
then routes the payment information to each third alternative is the placement of an ATM
receiving bank. The tape can be sent in ad- at the retail store location. The ultimate goal
vance with the information predated. For ex- of POS implementation in the financial serv-
ample, stock dividend checks could be proc- ice industry is to institute an electronic proc-
essed through the ACH for direct deposit. It ess through which transactions may be instan-
taneously debited/credited.
Figure 6.— Penetration of Direct Deposit Social
Security Payments Lockbox Operations
~
5 0 0
280/o 330/0 In lockbox operations, payments go directly
250/o
UY 400 to a post office box that is controlled by the
c 11 0/0
o payee’s financial institution. The services pro-
=
.-- vided include picking up the mail at the post
E 300 m
c
.- office, opening it and crediting the funds, or
UI
z receiving the opened letters and crediting the
200
E
funds to the company’s account. A fee is im-
$ posed for each function the financial institu-
Q 100
tion performs for the company.
0 1 Lockbox operations are used to speed the
1978 1979 1980 1981 1982 collection of remittances and reduce “float”*
Direct deposit *An amount of money represented at any one time by checks
1’-] Checks outstanding and in the process of collection. The period of time
between receipt of notification of payment by the creditor and
SOURCE Economic Review Federal Reserve Bank of Atlanta, August 1983 p 33 the actual debiting of the consumer’s account.
102 ● Effects of Information Technology on Financial Services Systems
—.-— - .-— — ——.——— —

by eliminating the time required to transfer eral other types of accounts use a check to ac-
payment from a company to the financial in- cess funds, these accounts are not considered
stitution. Interestingly, lockbox operations are demand deposit accounts.
offered by other institutions, also. For exam-
ple, in July 1983, Sears Roebuck & Co. an- Drafts
nounced that it would provide retail lockbox
processing for Pittsburgh’s Mellon Bank in Drafts are essentially an expanded collection
seven cities across the country. With its na- service, with funds being transferred when the
tional presence, Sears is in a unique position payer orders the bank to pay the draft. They
to offer such services. This arrangement will are used by credit unions, which technically
not only reduce float for the bank’s corporate classify their transactions as purchases of
customers but also decrease processing costs, shares in equity accounts and money market
since a larger number of the checks received funds. Credit unions began to offer share draft
could be processed locally and not as inter- accounts as a competitive tool against the
regional items through the Federal Reserve checking accounts offered by banks. The draft
Board’s check processing system. As noted in itself is debited against the individual’s ac-
American Banker, “Interstate banking restric- count. Although to the consumer, a draft looks
tions have prevented banks from opening of- and works much the same way as a check, it
fices around the country to accept deposits, differs in two ways: 1) it may have a specified
and thus most banks have operated lockboxes time constraint and can be drawn on an in-
only within their own State. Lately, however, dividual, corporation, or bank; and 2) the in-
a number of banks have begun to expand their itiative for payment of goods is taken by the
geographic coverage through joint marketing seller, not the buyer.
arrangements and correspondent relation-
The three types of drafts are: 1) sight–pay-
ships. ‘‘2
able immediately on presentation; 2) arrival—
payable on arrival of goods; and 3) time—
Demand Deposit Accounts payable at a fixed date. There is a consider-
For users of demand deposit accounts, in- able amount of float associated with checks/
stitutions make funds explicitly available to drafts because funds need not be in the bank
the user without any optional or contractual on which the item is drawn until the day the
delay. Demand deposits represent a significant check/draft reaches the bank and is presented
portion of the domestic money supply. As of for collection. Float in this case can work to
December 31, 1981, demand deposits for all the advantage of the depositor in that funds
commercial banks totaled $370 billion.3 A also do not sit idle. The company can trans-
checking account is a demand deposit account. fer the amount needed to cover the check/
The check is the instrument that activates the draft, leaving the balance in higher yielding
checking account and is the end-product of the investments.
original written instructions used by an indi- Although presently a heavily paper-based
vidual to make a payment from a credit bal- instrument, drafts are being converted into a
ance. A written check is deposited into an ac- form of electronic billing service whereby ven-
count (the collecting bank) by the creditor, dors can collect from customers by sending an
wherein it circulates within the banking sys- electronic debit (draft) to their account.
tem as an instrument to debit the account of
the debtor at his bank (the paying bank).
Giro Transfers
By law, demand deposits do not yield in-
terest for the account holder. Although sev- While checks are a way to effect a debit
transfer, the giro, which is an instrument not
‘American July 29, 1983.
Banker, used in the United States, is a way of making
3
Federal Reserve Statistical Release, April 1983. a credit transfer. To effect a giro payment, the
Ch. 4—Retail Financial Services ● 103
. . . —

person making the payment instructs the in- ing the accumulation of funds sufficient for
stitution holding his funds to transfer them supporting higher denomination and higher
to the account of the payee in the name of yielding investments. They are also frequently
another institution. This is in contrast to a used to establish and maintain a relationship
check given to the creditor that is finally pre- with an institution for the purpose of even-
sented at the debtor’s bank for payment. Giro tually using other services, such as loans and
organizations usually send a statement to each check cashing.
account holder every day on which transac-
Savings accounts take the following forms:
tions are recorded; this is expensive in postal
costs. “The notable feature is that the aver- 1. Conventional savings accounts. Conven-
age value of paper giro transfers is higher than tional savings accounts offered by depos-
the average value of check payments in all itory institutions are designed primarily
countries except the United Kingdom.”4 for individuals. Savings accounts may be
issued in passbook or statement form and
Traveler’s Checks involve the institution’s periodic issuance
of summaries of deposits and withdraw-
Another form of a deposit transaction is the als. Savings deposits do not have matur-
traveler’s check. The traveler’s check is “paid ity dates, but a hold may be required
for” in advance by the purchaser, generally before withdrawal-most often on depos-
with a premium of 1 percent of the value. It its made by check, but possibly on cash
is considered a deposit because the funds are deposits, also. This is rarely, if ever, im-
held by the issuing company until the travel- posed, and for the most part, individuals
er’s check is redeemed by the purchaser. This regard these accounts as being very liq-
instrument works and is accepted, for the uid. As defined by the Federal Reserve,
most part, like cash. It can be a universally a savings account from which more than
accepted payment mechanism and is consid- three telephonic or preauthorized trans-
ered a deposit instrument. fers are permitted per month is considered
a transaction account, with the specific
Savings Accounts exception of the money market deposit
account.
A savings account is an interest-bearing ac- Savings accounts presently have a reg-
count used to accumulate and safekeep funds. ulated interest rate set by Federal author-
Institutions retain the optional right to require ities and governed by the Depository
written notice of an intended withdrawal, Institutions Deregulation Committee
often not less than 14 days before withdrawal (DIDC). Until these ceilings are finally
is made. phased out (scheduled for 1986), the ceil-
Despite the notice requirement, a savings ing is imposed on interest rates for fed-
account is in practice extremely liquid. Until erally insured banks and thrift institu-
recently, most people used their savings ac- tions. Effective January 1, 1984, the
count as a long-term savings/investment vehi- differential interest rates on passbook
cle, even though several alternatives offered savings accounts and 7- to 3 l-day depos-
higher explicit interest. However, new options its under $2,500 at both thrifts and com-
available have made the consumer more con- mercial banks were removed, with each
cerned with earning explicit interest on his having a ceiling of 5% percent.
money. As a result, savings accounts are be- Federal deposit insurance of up to
ing increasingly used only as short-term repos- $100,000 per account holder is provided
itories or as interim investment vehicles dur- in all but a very few depository institu-
tions. The Federal Deposit Insurance Cor-
4
Jack Revel], Banking& EFT—A Study of the Implications, poration (FDIC) insures accounts in com-
p. 143. mercial banks chartered by both the

35-505 0 - 84 - 8 : QL 3
104 • Effects of Information Technology on Financial Services Systems
——- —

Federal and State Governments and in on deposits at federally insured commer-


mutual savings banks. The Federal Sav- cial banks, savings and loan associations,
ings and Loan Insurance Corporation in- and mutual savings banks to the DIDC,
sures accounts in federally chartered sav- whose members are the Secretary of the
ings and loan associations and savings Treasury; the Chairman of the Federal Re
banks. The Credit Union National Admin- serve Board; representatives of FDIC, the
istration (CUNA) insures accounts held in Federal Home Loan Bank Board, and
federally chartered credit unions. In ad- CUNA; and the Comptroller of the Cur-
dition, some States have insurance pro- rency, a nonvoting member. The law pro-
grams to cover deposits in State-char- vides for a 6-year phase-out of ceilings on
tered institutions, such as savings and deposit rates, during which the commit-
loan associations, that are not eligible for tee has the discretion to set ceiling rates
Federal deposit insurance. on deposits based on economic conditions.
Credit unions provide savings services (The committee has been given a schedule
as well, including savings accounts (which for targeting the gradual phase-out of
are insured up to $100,000 per member by such ceilings. ) During the transition
CUNA, investment certificates, money period, credit unions are subject to sepa-
market certificates, share savings ac- rate regulations. In 1986, all Regulation
counts, and individual retirement ac- Q authority expires, CUNA’s authority
counts. to set interest rate ceilings for credit un-
2. Time deposits. The owner of a time de- ions terminates, and the DIDC ceases to
posit accepts limitations on his withdraw- exist.
al rights. The account is established with Under DIDMCA, the committee has
the idea that the funds are on deposit for eliminated (effective Oct. 1, 1983) all in-
a negotiated period of time in return for terest rate ceilings on (a) all time depos-
receiving an offered interest rate. Certif- its with original maturities or required
icates of deposit (CDs) are interest-bear- notice periods of more than 31 days; and
ing time deposit instruments issued by a (b) time deposits of $2,500 or more, with
depository institution for amounts that original maturities or required notice peri-
can vary from as little as $100 up to more ods of 7 to 31 days. Also, the committee
than $100,000. CDs pay interest at matur- has eliminated other regulations on time
ity and cannot be withdrawn from the deposits except for the minimum early
bank without penalty prior to their withdrawal penalties; a minimum de-
maturity date. The most commonly of- nomination of $2,500 for ceiling-free time
fered maturities are 91 days, 180 days, deposits with original maturities or re-
and 1 year. Although most CD rates are quired notice periods of 7 to 31 days; cur-
tied to Treasury bills and longer term rent ceiling on time deposits of less than
Treasury securities, some of the funds do $2,500, with original maturities or re-
receive an unregulated market rate of in- quired notice periods of 7 to 31 days; and
terest. Large CDs are typically issued in agency rules that require a l-percentage-
negotiable form, so they may be traded point differential between a loan rate and
in an organized market. the rate on a time deposit securing a loan.
The Depository Institutions Deregula- DIDC also established new minimum
tion and Monetary Control Act of 1980 early withdrawal penalties: for time de-
(DIDMCA) was enacted to provide for the posits with original maturities or required
orderly phase-out and the ultimate elim- notice periods of 32 days to 1 year, loss
ination of ceilings on the maximum rates of 1 month’s simple interest; for time de-
of interest and dividends that maybe paid posits with original maturities or required
on deposit accounts. The act transferred notice periods of more than 1 year, loss
the authority to set interest rate ceilings of 3 months’ simple interest.
Ch. 4—Retail Financial Services ● 105
—————- — — — . . — —

These changes helped reduce the com- the offering institution can impose a hold
petitive edge previously enjoyed by non- before honoring the withdrawal, although
depositor institutions against depository it is a restriction unlikely to be enforced.
institutions because a large number of fi- Individuals regard these accounts as rath-
nancial services being offered by the non- er liquid, and most are probably unaware
depositor institutions were attractive, of the restrictions that can be enforced.
offered higher interest rate return, and The NOW account does not legally re-
were not subject to regulation. Funds quire a minimum to open the account, al-
placed outside of the depository institu- though most institutions require a mini-
tions are not federally insured; however, mum balance of $500.
the individual appears to be more con- The Super NOW account is primarily
cerned with return on investment than a combination of the NOW account and
the risk associated with placing funds out- the money market deposit account. The
side of federally insured depository insti- Super NOW, which DIDC authorized as
tutions. a financial instrument as of January 1983,
3. Money market deposit account. T h e requires a minimum initial deposit of
money market deposit account, a high- $2,500 and an average balance in any
yielding liquid account, was authorized by month of $2,500. The account has no in-
the Garn-St Germain Depository Institu- terest rate ceiling, although the funds re-
tions Act of 1982 to allow commercial vert to a conventional savings account
banks and thrift institutions to compete yielding the regulated interest z-ate under
with money market mutual funds. The ac- Regulation Q if the account falls below
count is available to all depositors, in- the minimum balance. Additionally, a 7-
cluding businesses. It requires an initial day notice of withdrawal maybe required.
balance of at least $2,500 and has no in- Because the notice of withdrawal require-
terest rate ceiling. A ‘7-day hold on with- ment applies to such funds, they are cate-
drawal can be imposed by the depository gorized not as demand deposits, but as
institution. Additionally, the money mar- savings deposits. These accounts are not
ket account allows for up to six third- available to for-profit businesses. They
party transfers, including up to three by are available to Federal, State, and local
draft and up to three preauthorized trans- governments, as well as to nonprofit orga-
fers per month. There are no restrictions nizations and individuals.
on making withdrawals from the account
5. Savings bonds. Savings bonds are sold by
in person, by messenger or mail, or by
ATM. The funds are federally insured. If the U.S. Government to generate revenue.
the minimum balance falls below $2,500, They are issued at a discount and appre-
the interest on the funds reverts to the ciate at a rising rate in specified incre-
ments to a stated value at maturity.
statement/passbook rate and remains at
that rate until the balance is brought up Bonds may be redeemed before maturity,
to $2,500. Unlike some restrictions im- but the interest rate becomes higher the
posed by the money market funds, there longer the bond is held.
is no minimum on the size of an account 6. Savings certificates. Tailored to the needs
withdrawals or deposits. of individuals in terms of deposit time
4 Negotiable order of withdrawal (NOW) (generally 90 days, 5 years, 10 years), sav-
and Super NOW account. NOW a n d ings certificates have interest rates that
Super NOW accounts are unique savings are dependent on maturity time and cur-
instruments because they are interest- rent rates. Savings certificates are not
earning transaction accounts. Although negotiable and are issued by depository
they can be accessed by a check, they are institutions for $100 up to $100,000.
not considered demand accounts because There is a penalty for early withdrawal.
106 . Effects of Information Technology on Financial Services Systems
— — — — —.——.....——

The latest figures’ indicate deposits, as of ily by the desire for family financial protection
October 1983, in various savings instruments: in the event of death; and third, it is ordinarily
expected to be left intact until the death of the
Super NOW accounts: $27 billion insured rather than withdrawn for some con-
NOW accounts: $100 billion sumer expenditure.
money market deposit accounts: $369
billion Insurance policies exist in almost every
money market funds: $138 billion* household. They take such forms as automo-
bile insurance, property insurance, and health
Insurance insurance. Such a strong presence permits the
industry to introduce and market new finan-
In today’s competitive environment, com- cial products and services with relative ease.
mercial banks, savings and loan associations, Insurance companies now offer several prod-
and savings banks not only vie with one ucts that are treated like deposits. Two new
another to attract new deposits, but also com- products introduced into the market in 1983
pete with many nondepository organizations. are quite interesting—one works like a cash
One of the largest providers of financial serv- management plan for businesses under $10
ices is the insurance industry. It has a sizable million; the other works as a securities and
customer base (insurance products are used in cash management service. These accounts
almost every household or business) and is a feature money market funds, checking ac-
major lender of funds to businesses. The in- counts with unlimited access, lines of credit,
surance industry has access to an enormous an overdraft, and a Gold MasterCard, which
amount of capital. Insurance companies are does not carry a line of credit. The customers’
enormous financial intermediaries in that they money market accounts are debited each
collect and invest vast amounts of premiums month to cover card charges. The checking
on policies. Life insurance companies collect and charge card operations are handled by a
premiums from policyholders, invest the re- local bank for the insurance company. The in-
ceipts until needed, pay death benefits to heirs vestment accounts are offered in conjunction
of those who die, and make payments to those with an investment firm. Both products re-
who redeem policies and/or take out loans quire a minimum of $10,000, and customers
against their cash value. are penalized whenever their monthly average
Insurance companies channel funds into va- drops below $5,000 for 2 consecutive months.
rious investment outlets and qualify as signif- Another instrument of the insurance indus-
icant allocators of financial resources in the try is universal life insurance, which is an in-
economy. Their investments are made in vestment vehicle. It functions like a deposi-
almost every sector of the capital market and tory instrument and is a flexible investment
in a wide array of investment outlets. Their vehicle with access to mutual funds. It offers
investment decisions are based on a philoso- the policyholder flexibility because the cash
phy of maximizing their rate of return within value buildup or funding phase—-which makes
the bounds of State investment laws and on it appear to be a savings instrument-and the
the principle of safeguarding the security of pure life insurance phase of the traditional
the funds invested. whole-life insurance policy are separated. A
Life insurance saving differs fundamentally company can declare competitive interest
from saving through deposit-type institutions rates on the funding phase, and the policyhold-
for at least three reasons: first, it is long-term er can vary the amount and frequency of pre-
and contractual in nature and is therefore mium payments and the amount of death
more stable; second, it is motivated primar- benefits.

—— —.— Whole life insurance provides a constant


‘Federal Reserve Statistical Release, Dec. 16, 1983. amount of insurance for the same premium
*These funds are not federally insured. over a lifetime. It is payable to a beneficiary
Ch, 4—Retail Financial Services • 107
——..—— — — —

at the death of the policyholder, and premiums business themselves. Many large networks are
are payable for a specified number of years or being developed that enable the agent to ob-
a lifetime. A policyholder is entitled to the cash tain pertinent information online as well as
value if he cancels the policy. Since the poli- directly relay information to the carrier.
cyholder may borrow from the insurance com- Technology is used to support other serv-
pany against the cash value of the policy, pol-
ices of the insurance industry as well. Claims
icy reserves may be viewed equally as a legal
services, for example, are now becoming auto-
liability of the insurance company and as an
mated. The claims process, which is heavily
investment of the policyholder. Life insurance paper-based, is being handled by converting
companies make loans against the cash value
the information electronically and transmit-
of whole-life insurance policies. These accounts ting it online to the carrier, allowing the car-
play a significant role in the insurance com- rier to deal with the claim more effectively and
panies’ lending ability. The policyholder has to maintain more control over the settlement
the right to borrow from the insurance com- process.
pany any amount up to the cash value, at a
specified rate of interest. Moreover, earnings The automation of risk management serv-
on insurance are partially tax-exempt. ices for large corporations allows them to han-
dle in-house insurance analysis. These com-
Just as insurers will increasingly compete panies are able to tie into networks that
in the provision of financial services, other provide important and timely information
financial service providers will increasingly
used to assess and manage risk.
compete with insurers in the provision of in-
surance. The unbundling of insurance prod-
ucts has revealed that there are significant Accounts With Other
functions in the operation of insurance that Nondepository Institutions
involve the performance of noninsurance
Insurance companies, large retailers, and
services. virtually every kind of financial service orga-
The insurance industry is in a position to ex- nization offer individual retirement accounts
pand its service offerings to include a myriad (IRAs), money market funds, and a myriad of
of financial products. This is possible for sev- investment services. Although the funds in-
eral reasons. As discussed, some insurance vested by individuals into nondepository insti-
products being offered resemble existing prod- tutions are not federally insured, this fact has
ucts being offered by depository institutions. not prevented individuals from investing in
Also, modifying software for existing systems these instruments. The amount of money that
enables the company to create new products has shifted from depository institutions into
and services. For example, insurance com- nondepository institutions has been signifi-
panies could easily offer a money market fund cant. Previously, these types of institutions
and additional services that can be imple- were very different from each other. When the
mented with relative ease and minimal capital. concept of commercial banking was first con-
ceived, commercial bankers made little or no
The insurance industry is adapting automa-
effort to attract individual deposits, concen-
tion in many ways. Insurance agents, for ex- trating primarily on attracting demand depos-
ample, are internally incorporating automa-
its from businesses. Conversely, the savings
tion to manage office functions, such as client banks and savings and loan organizations
information and accounts receivable and pay-
were not authorized to offer checking ac-
able. They are applying automation to increase
counts, and their range of time and savings
efficiency and to improve marketing. Exter- deposits was limited.
nally, communication and information technol-
ogies are used to tie into carriers where they Today, that has changed drastically. Com-
are able to obtain quotes and to underwrite mercial banks fiercely compete with other de-
108 Effects of Information Technology on
● Financial Services Systems

pository institutions, insurance companies, payouts on their liabilities and reduced cus-
and brokerage houses/investment firms for tomer earnings on short-term asset holdings
consumer deposits. All of these organizations in depository institutions. Since depository in-
offer accounts that can serve the customer in stitutions could not compete on interest rates,
similar ways. However, the range of services they competed on the basis of services, which
available to the customer are not as markedly were actually subsidized by the spread be-
different from the customer’s point of view as tween interest paid on money in savings and
the products seem from the point of view of received on money loaned. The spread resulted
regulators or the providers themselves. An in- from below-market rates paid because of the
dividual can easily establish an IRA or Keogh regulatory environment. This is changing.
(retirement) account, obtain a loan, and use a Zero-balance accounts are becoming wide-
checking or checklike account or savings ac- spread. Financial service providers have come
count from any depository institution. He/she to rely more heavily on fee income from
can obtain similar instruments from nondepos- services.
itor institutions such as insurance com- Large financial service providers have the
panies, retailers, and investment firms with privilege of offering several types of financial
cash management accounts. products. For example, the use of information
Prior to the introduction of money market technologies enables firms such as American
deposit accounts and Super NOW accounts, Express, which owns Fireman’s Fund Ameri-
depository institutions were restricted as to can Life Insurance Co., to market additional
the maximum interest payable on demand de- services directly to their strong credit card
posit accounts and savings accounts, with the base. They can offer insurance services and
exception of jumbo CDs and similar instru- have the premiums be added directly to the
ments. These restrictions helped reduce bank American Express card account.

Extension of Credit
One of the principal functions of the finan- regulation of the rates paid on deposits has
cial service industry is intermediation between been to narrow this differential and cause fi-
holders of assets and those in need of funds. nancial service providers to look elsewhere for
Funds are gathered through the deposit-tak- revenue. They have turned to information
ing activities described in the preceding sec- processing and telecommunication technol-
tion. Extending credit, described in the follow- ogies to improve the efficiency of their inter-
ing pages, is one of the mechanisms used to nal operations and as the foundation on which
make funds available to those requiring new revenue-generating products can be built.
them. * One of the most promising opportunities for
cost saving is converting as many paper-
Historically, credit extension has been one
based transactions as possible to electronic
of the principal sources of revenue for the fi-
processes.
nancial service industry. The rate differential
between that paid on deposits and that Interest rate fluctuations, such as those ex-
charged on loans was sufficiently great to sup- perienced over the past several years, have
port many of the services offered by financial made the problem of portfolio management
institutions. However, one of the effects of de- more difficult for financial service providers.
.—— Some found themselves faced with the prob-
*FundS are ~so made available by investors who take an
equity position in the organization requiring funds. Equity in- lem of supporting long-term, fixed-rate loan
struments and the markets for them are described in ch. 3. portfolios with short-term, expensive depos-
Ch. 4—Retail Financial Services ● 109
— -.

its and few options for correcting the im- out the technologies. Paper is truncated early
balance. Congress increased the powers of sav- in the processing cycle as one factor in con-
ings and loan associations to help them trolling costs of processing and to facilitate
overcome this problem. the timely posting of transactions to custom-
ers’ accounts. Some merchants submit trans-
One of the responses of the financial serv- action data electronically to card issuers to fa-
ice industry to the disappearance of the in-
cilitate processing.
terest spread has been to encourage individu-
als and businesses to view all of their liabilities Credit has long been a tool of the retail in-
and assets as a total package and to manage dustry. Card bases have been created on the
them as such. The goal of some institutions assumption that they help create and main-
is to place themselves in the role of financial tain customer loyalty and facilitate impulse
advisor to their customers. On the one hand, purchases. Advertisements are regularly in-
these institutions would like to generate rev- cluded with customer bills. While most retail-
enue by providing advisory services for which ers do not rely heavily on revenues generated
a fee may be charged or services that would from retail receivables, the funds generated
attract business and customer loyalty, result- can be considerable.
ing in most financial service needs being pur-
chased from a single organization. Some retailers see third-party cards such as
those offered by banks as an interference in
To this end, service providers are using their their relationship with their customers. Retail-
credit products to increase the effective li- ers feel they should know when a customer is
quidity of assets held by consumers. In addi- activating a line of credit so that an alterna-
tion to such traditional offerings as credit tive can be offered. Also, retailers question the
cards, they are creating lines of credit secured propriety of card issuers charging the same
by a variety of assets that range from home discount for a card transaction, whether it acti-
equity to securities portfolios. Ease of ac- vates a line of credit (credit card) or is used
tivating lines of credit is emphasized. In the to access a transaction account (debit card) in
case of an overdraft account, the same check lieu of a check.
or debit card that is used to draw funds from
a transaction account is the instrument used While individuals make extensive use of a
to activate the line of credit when the funds variety of credit services, businesses and
in the account are exhausted. Some institu- governments are also major users of credit.
tions issue checks that can be used to draw Generally, these users are quite sophisticated
against home equity at the convenience of the and use a number of services that are not avail-
customer. The customer benefits by being in able to the general public. The Federal Govern-
a position to take advantage of opportunities ment is active in the primary credit markets
to make either purchases or investments on as an issuer of debt. Also, one of the primary
favorable terms that may be available only for means used to implement monetary policy is
limited periods. trading by the Federal Reserve System in
Federal Government securities in the open
Information processing and telecommunica- market.
tion technologies are key elements in support-
ing the viability of the credit products that are Further complicating the credit markets is
now offered. One of the reasons a credit card the multiplicity of providers of credit services.
issuer can guarantee payment to the merchant Depository institutions and retail merchants
accepting it is the ability to keep track of ac- have been mentioned. However, among other
count activity and effectively to halt its use participants in the market are consumer finan-
almost instantaneously if circumstances re- cial companies, mortgage bankers, insurance
quire. The processing and clearing of credit companies, pension funds, and acceptance cor-
card drafts would be virtually impossible with- porations, such as those operated by major
110 Ž Effects of Information Technology on Financial Services Systems
— — . ———.—

automobile and appliance companies. Private vances, the cardholder can pay the entire
individuals also make loans, as is the case amount due without finance charges.
when the seller of a home takes a second mort-
gage from the buyer for a portion of the pur- Commercial Credit
chase price.
Commercial credit is the credit extended to
Credit is extended in the following ways: businesses by various lenders. Commercial
1. 1nstallment credit—a direct loan to an in- banks are the primary funders of commercial
dividual or business, repaid in fixed, peri- credit, but recent legislation gave savings and
odic payments; it is a type of closed-ended loan associations limited power to participate
credit. A typical example is a car payment in this market. Others, such as acceptance cor-
loan. porations, leasing companies, and factoring
2. Open-ended credit, often called revolving companies are also active. Generally, the debt
credit—funds that are available under an is short term and is used to meet requirements
agreement that allows the borrower to for working capital, such as the funding of re-
borrow several times, up to specified ceivables or inventory.
credit limits, with interest and without Much commercial lending activity is conven-
further investigation of creditworthiness. tionally viewed in the category of wholesale
Many charge accounts at department rather than retail financial services. For exam-
stores and credit card accounts are ex- ple, commercial banks will purchase consumer
amples. Since part of the loan is repaid debt from consumer finance companies, which
over time, the borrower can again draw then lend the funds to individuals at higher
against the line up to the predefine limit. rates than banks charge. Commercial lenders
This type of credit is often open-ended also finance capital acquisitions through third-
with respect to time and the total amount party leases that cover such items as aircraft
of credit available, Minimum payments and computers.
are required, and the maximum amount
of credit extended is limited. Commercial organizations will also float
3. Closed-ended credit—a loan that is ex- debt in the open market, where it may be pur-
tended for a predetermined amount. The chased by any variety of lenders. One is short-
borrower cannot reopen it by obtaining term commercial paper; but, as discussed in
extra funds under the original lending the chapter on the securities industry, long-
agreement. term bonds are also issued.
4. Line of credit–the amount of credit a
lender will extend to a borrower over a Consumer Credit
period of time, where the borrower can
draw on the lineup to some fixed limit at Consumer credit is a specified amount of
his/her discretion. Generally it involves a credit that is extended to individuals primar-
specified amount of money a customer ily for personal, family, or household purposes
may borrow without filing a new loan ap- by a number of types of institutions that in-
plication. A personal line of credit on clude issuers of travel and entertainment
checking accounts is one example; the cards, retail merchants, consumer finance com-
credit card with a line of credit is another. panies, and acceptance corporations. Early on,
Each month, the individual cardholder depository institutions began to recognize that
chooses between complete payment of the consumer loans were not only an asset to the
invoice or extended credit, with the choice bank, but also a contribution to the overall
of making a minimum payment. The cred- economy. Consumer credit loans are extended
it is used not only for purchases and credit to individuals or small businesses and provide
payment, but also for obtaining cash ad- for repayment either monthly, quarterly, an-
vances. With the exception of cash ad- nually, or in full at maturity. Consumer credit
Ch. 4—Retail Financial Services Ž 111
— — — — — — .—————— ——— —

can be extended through loans, overdrafts, time of use. Credit card checks are treated as
credit card checks, and credit cards. cash advances, with the monthly statement
reflecting the advance. When used, interest is
Loans paid on money borrowed from the day the
check is written. Merchants do not have to pay
The extension of credit is perhaps best rec-
the discount and service fee associated with
ognized in the form of a loan. Simply defined,
all card transactions when credit card checks
a loan is money lent, generally to be repaid
are used.
with interest. Loans can be made on a secured
basis, where the funds are protected by pledged The development of credit cards has helped
collateral, or on an unsecured basis, where the satisfy the demand from consumers for a more
funds are extended with no pledge of collater- convenient way to finance their day-to-day
al. Loans are made to consumers and busi- credit needs.
nesses on a regular basis. A loan is an agree-
ment between two parties. The lender does not Credit Cards
have to be a financial institution. Loans can
With the advent of electronic banking sys-
be secured by life insurance, contracts, depos-
tems, the plastic card has become common-
its in financial institutions, securities, or per-
place in today’s financial institutions and
sonal and real property. Banks, acceptance
retail organizations. Nearly all customer/bank
corporations, consumer finance companies,
communication terminals—ATMs, remote
and credit unions are major lenders of con-
service units, POS terminals-use card tech-
sumer credit.
nology in some form. The card is used to ac-
cess funds in various accounts and as a me-
Overdrafts
dium to extend credit. Today, almost 600
Credit can also be extended through an over- million credit card accounts exist in the United
draft, which is a check or payment order writ- States, and 7 out of 10 households have at
ten against a demand deposit or transaction least one credit card. Outstanding balances
account for funds in excess of the balance. It on credit card accounts total more than $75
must be arranged in advance, and when hon- billion.’
ored by the depository institution, the over-
Electronic processing has helped minimize
draft creates a loan. If approval for overdraft
the amount of paper used in handling credit
privileges has not been obtained in advance,
cards, and online credit authorization has
overdrafts are prohibited. Basically, the over-
helped encourage card use because it entails
draft can be defined as an instrument that
less of a waiting period. The transaction can
operates with a credit limit, fixed by the in-
be approved and completed within a time
stitution for each customer and reviewed peri-
frame that is acceptable to the customer.
odically. Since the application of an overdraft
Today, there are many online POS terminals
is typically for personal use, it is rarely se-
for credit authorization throughout the United
cured. The arrangements for repayment of the
States. Generally, any credit card can be ac-
overdraft are set by each institution.
cepted by the systems, which operate over
standard telephone lines.
Credit Card Checks
Credit cards offer the individual the ability
Credit card checks are special drafts writ-
to defer payment of part of the balance due
ten against a credit card account rather than
as part of an extension of credit. A dollar, or
a demand deposit account. They are issued in
floor, limit is established, which permits using
conjunction with a credit card account and ac-
cess a credit line. They work just like a per- ‘Federal Reser\’e Board, L’redit Cards in the U.S. Eccmon]L\r—
sonal check; however, the amount is charged Their impact on Costs, I]rices and Retail Saies, July 27, 1983,
automatically to the credit card balance at p. 1.
112 ● Effects of Information Technology on Financial Services Systems

the card without credit authorization at the ates a worldwide electronic data communica-
time of purchase. For purchases over the re- tion system that transferred nearly 1 billion
quired floor limit, credit approval is necessary. transactions between member institutions in
Ceilings are generally set on the total amount 1983. 7
the cardholder may have outstanding. For processing purposes there is no distinc-
Over the past several years, many of the tion between a VISA debit or credit card. The
card-issuing organizations have imposed an- same processing procedures apply for both
nual fees to the cardholder for use of the card. cards; therefore, only the card-issuing institu-
Interest paid on outstanding balances falls tion and the cardholder are familiar with the
under State usury laws. Certain State laws, function of a particular VISA card.
however, place rigid standards on such ac-
Each card-issuing financial institution sets
tions. The result has been: 1) higher annual in- the policies for its own customers in the VISA
terest rate charges to the cardholder, where
system. These policies are regulated by appli-
permitted by usury laws; or 2) the relocation cable State laws that limit maximum charges
by the card-distributing organization of its on credit card accounts, the method of as-
credit card processing facilities into States sessment of finance charges, and minimum
such as Delaware and South Dakota, which charges that can be imposed on credit card ac-
permit higher interest, card fees, or both, so
counts. Different card-issuing banks nation-
that the card-distributing organization is able
ally may compete with one another and may
to operate under the banking laws of the State have slightly different policies. Generally, the
where the processing is done. most important competition exists between
Card-issuing organizations impose annual banks as they attempt to sign consumer and
fees on credit cards as a way to generate ad- merchant accounts. The merchant discount of-
ditional income. These funds were needed be- fered to encourage acceptance of the card at
cause of the high interest rates financial insti- an establishment is one of the primary com-
tutions were paying for funds. Additionally, petition tools.
the annual fee charge is a way to generate in- Bank credit cards have become subject to
come from those individuals who use the bank credit controls because of their role in extend-
credit card as a convenience mechanism and ing consumer credit. They are recognized as
who pay the monthly statement charges in full instruments for installment lending to con-
and therefore do not incur interest charges. sumers and as loans by banks. The controls
Basically, there are three kinds of credit tend generally to be the ones applying from
cards: bank cards, travel and entertainment time to time to consumer credit. The controls
cards, and retail and nonbank cards. include compliance in usury limits and truth
in lending as set forth in Regulation Z.
Bank Cards.-The bank credit card has
become an integral part of the American life- To examine critically the national bank card
style. Bank credit card systems have a struc- systems and the member institution’s role as
ture all their own. The two major bank credit an extender of credit in the financial service
card systems are VISA and MasterCard. industry requires some analysis. Inherent in
VISA International is owned by over 15,000 every payment device are two separate and
member financial institutions located in distinct services. The first is payment for
almost 100 countries. Over 100 million cards goods and services, and the second is the ex-
have been issued, allowing consumers access tension of credit. The first has traditionally
to checking accounts, savings accounts, in- been priced in free and open competition and
vestments, and lines of credit. VISA U.S.A. has not been subject to usury laws. The sec-
is jointly owned by U.S. financial institutions,
including banks, savings and loans, credit 7
VISA, U. S. A., Credit Controls and Bank Cards Analysis and
unions, and mutual savings banks. VISA oper- Proposal, March 1980.
. ..

Ch. 4—Retail Financial Services . 113


— —

ond has traditionally been subject to usury these cards are intended mostly for travel and
laws. Whether the card is used solely as a pay- business use. Travel and entertainment card
ment device or as a credit device, by deferring companies generally follow more stringent
payment of the full balance, is determined by guidelines in issuing the charge card than do
the cardholder. The use of electronic technol- issuers of other cards.
ogy and plastic cards has made it possible to
Several elite versions of the travel and en-
combine multiple functions in a single device,
tertainment card exist; for example, the Amer-
blurring the distinction between what con-
ican Express Gold Card. These elite cards of-
stitutes payment service and what constitutes
fer check-writing privileges and a higher floor
extension of credit.
limit for purchasing goods (which exceed those
The national card systems have also ex- for the conventional card). Both the Gold and
panded their use to include card access to conventional cards provide access to ATMs
ATM networks. Several ATM systems estab- and traveler’s check dispensers and ease of
lished by banks use VISA or MasterCard as check cashing at hotels and American Express
the access card to a proprietary system. How- offices.
ever, both VISA and MasterCard have also set
up their own national ATM networks to com-
pete with national interchanges. They are in
the process, like other national ATM inter-
change networks, of attracting ATM networks
from across the United States to join their sys-
tems. VISA also plans to establish a global
ATM network.
Because Delaware and South Dakota allow
higher interest charges or annual fees for the
bank card, a number of depository institutions
have moved their processing centers to these
States. Although technically it makes no dif-
ference where the actual processing is done,
the critical elements are the type and location
of the organization issuing the card and the
laws that govern the State where the cards are
being distributed. Credit cards are also distrib-
uted by nondepository organizations, such as
the American Automobile Association, and by
brokerage houses. These cards are, however,
tied to a financial institution for processing
and credit extension.
Travel and Entertainment Cards. -Travel
and entertainment cards serve the general
public in relatively the same manner as a bank
card. They offer the possibility of deferring
payment. Generally, the monthly limit asso-
ciated with these cards is far greater than that
of the bank card; some are issued with no
preset expenditure limit. The cardholder is
charged an annual fee, and the monthly state- Photo credit: American Express Co

ment must be paid in full. As the name implies, Automated traveler’s check dispenser
114 ● Effects of Information Technology on Financial Services Systems
—.———-——.—— .—— —— — . — — . — — —

Travel and entertainment card transactions major retailer, accepts not only the J. C. Pen-
are consummated in the same manner as with ney proprietary credit card but also VISA and
bank cards. The difference is, however, that MasterCard. J. C. Penney, for example, has a
the drafts are accumulated and billed monthly very complex electronic network system, ena-
to the consumer, with the full amount due bling it to service accounts online throughout
within a specified period after billing. Since the country. The Penney system supports
this process is considered a payment service, 35,000 online terminals, allowing access to the
its cost is unrelated to the funds outstanding, VISA system directly without the need for a
which are not considered a loan of money with financial institution intermediary. It is the
respect to usury statutes or annual percent- only retailer to do so. Retailers continue to en-
age rate disclosures. Usury statutes apply courage the use of their proprietary credit
only when the cardholder elects to pay in cards for several reasons: 1) to provide conve-
installments through a prearranged line of nience to their customers, 2) to tie their cus-
credit with a financial institution. tomer base to their stores, and 3) to facilitate
impulse purchases.
Retail and Nonbank Cards. -Retail credit
cards are distributed by both large and small Card operations can also cross companies.
retail and service organizations, which have J. C. Penney, for example, processes credit
been in the business of extending credit to in- transactions for oil companies. The authoriza-
dividuals and organizations for some time and tion is accomplished by running dedicated
were the leaders in establishing the credit card. lines from the service station to the nearest
Large chains of retail stores, gas/oil com- Penney store. The signal is then sent over the
panies, and hotel and travel businesses run main trunk line to the data center where the
their own credit card operations. Sears Roe- authorization file is maintained. The informa-
buck, the largest issuer of retail credit cards tion is captured and transmitted to provide a
in the United States, accepts only the Sears basis for generating customer invoices.
credit card in its stores.8 J. C. Penney, also a
‘Nilson Report, June 1983.

Electronic Funds Transfer


Funds transfer is defined as any transfer of to a communication system that facilitates an
funds by means of a check, draft, or similar immediate debit or credit).
paper instrument or by electronic means Electronic funds transfer (EFT) enables con-
through a terminal, telephone, computer, or sumers to carry out financial transactions via
magnetic tape so as to order, instruct, or electronic devices instead of using paper mon-
authorize a financial institution to debit or ey or checks. Electronic funds transfers can
credit an account. A transaction can take sev- be carried out through use of an ACH, a home
eral forms: cash purchase, charge purchase, banking system, an ATM, or a POS system.
purchase by check or draft, deposit to an ac- One example of an EFT transaction is the use
count, withdrawal from an account, or a debit of an access card, a plastic card encoded with
from one account to another account owned an identification number to trigger the elec-
by the same party, interbank, or intrabank. tronic impulses. Although debit cards allow
A currency-based funds transfer uses cash or access to an account with adequate funds,
coin. A paper-based transfer of funds is ac- some debit cards may also be used to borrow
tivated by check, draft, or bank card/charge money, thus becoming all-purpose transaction
card (when the transaction is not tied directly cards.
— -— ——

Ch. 4—Retail financial Services ● 115


— — — — - —. — -- -— —— .—

Automation and electronic payment sys- credit, obtain a cash advance on a credit card,
tems have often been at the forefront of recent pay bills, transfer funds from one account to
changes in financial service organizations. Cer- another, and inquire about account balances.
tainly one main effect of these changes lies in (The relative use of ATM functions is illus-
the cost reductions that have been made pos- trated in fig. 7.) Credit can be obtained either
sible by the elimination of paper-based trans- by granting of overdraft limits or, in some
actions, which are personnel-intensive and, cases, through using a credit card rather than
therefore, costly. Electronic financial services, a debit card to activate the machine to obtain
however, are not pervasive. While the deploy- a cash advance. Systems vary, however; some
ment of ATMs, for example, appears to be are merely cash dispensers, although the tech-
prevalent in major cities, smaller towns and nology of the different systems is basically the
remote areas of the country still rely on tradi- same.
tional systems for delivering financial services,
The plastic card’s magnetic stripe is the
although this picture is rapidly changing.
“key” that unlocks the machine for use. The
While individuals depend on traditional serv-
way the data are encoded and what items of
ices, many of the financial service providers
information are placed on the magnetic stripe
rely on automation for the ease and efficiency
varies. A great deal of attention has been paid
of operating the services. Network systems
to the standards being developed for the plas-
continue to expand because communication
tic card.
and information technologies enable a broader
geographic base to be served and allow in- Although the cost of ATMs has fallen sig-
creased transaction volume without a propor- nificantly since their introduction, “the cost
tional increase in costs. of ATMs is unlikely to fall as rapidly as that
of many other parts of an electronic funds
EFT has come to play an important role in
transfer system because of the various me-
the financial service industry. Although EFT
chanical parts that are necessary. The capacity
systems have been operational since the late
to process transactions and information will
1960’s, it wasn’t until the mid-1970’s that
become much cheaper as intelligent terminals
their acceptance became more obvious. Elec-
are developed, with display screens and key-
tronically transferring funds today involves
boards being largely electronic. There are
several methods: direct deposit, credit and
many mechanical parts in the dispensing of
check authorization at point of sale, and most
notably, use of the ATM. To some degree, al- cash, in the printer, and in the mechanisms for
accepting funds. A further result of the me-
though they have not penetrated the market
chanical nature of cash dispensing is the short-
as greatly as the ATM, the POS terminal and
er life of currency because it quickly becomes
remote information systems, such as home
unsuitable for use in cash dispensers’ ‘ g
banking, also play significant roles.
With the ever-increasing operating costs for
Automated Teller Machines traditional delivery systems, the customer de-
mand for new services, and the competition
The first applications of automation in cus- from new as well as traditional sources, most
tomer services were very simple cash dispens- organizations in the financial service industry
ers that provided the user with a fixed sum realize the need to use automated banking sys-
of cash in a single denomination. These sys- tems. The initial cost of establishing an ATM
tems generally operated off-line, so the trans- is high, but it is far less expensive than build-
action was not a direct debit. Now ATM sys- ing a branch bank. And, unlike a branch, it can
tems offer most of the same transaction be operated around the clock at a fairly low
capabilities as a branch bank, allowing con- incremental cost. Therefore, many bankers feel
sumers to withdraw cash from a bank account,
9
make deposits, borrow cash against a line of Revel], op. cit., p. 44.
116 . Effects of Information Technology on Financial Services Systems
—-—-.—— —.

Figure 7.— Relative Use of ATM Functions,a 1974-81 that ATMs will provide both competitive ad-
1974 vantage and significant return on investment
over the next decade. To soften the high cost
Cash withdra of such systems, especially ATM networks,
75 ”/0 many financial institutions have entered into
sharing arrangements.
The ATM, which is operated by the custom-
Payments er, can be located in a variety of places. In the
2% United States many are installed either in the
main banking space of bank offices, in lobbies
p osits partitioned off from branches, or on the ex-
19 ”/0 terior of a building. They can also be located
away from the main bank, at shopping centers,
Balance transfers grocery stores, gas stations, offices, and fac-
4% tories. Almost all systems are or will be online.
The customer’s plastic card allows him/her to
gain access to the ATM location outside bank-
1976
ing hours and to conduct his banking business
in relative security.
c:ash withdra
74 ”/0 The large success of ATM deployment has
created another trend in bank branching. In-
stead of building large, full-service branches
that are personnel-intensive and very costly,
Payments
many organizations are replacing these struc-
2%
tures with satellite branches, which are small-
scale, highly automated, full-service, and gen-
erally require management by only two or
osits
1%
three personnel. ATMs, for the most part, re-
Balance transfers
place the teller; personnel are there to handle
3% general information or other personal busi-
ness. Figure 8 illustrates the growth in the
number of ATMs in use from 1974 to 1981.
1981 Figure 9 illustrates the increases in the aver-
age number of transactions performed at each
lithdr ATM.
760/o
ATM Systems
ATM services can be offered in one of four
nts ways: a proprietary system, a shared system,
an interchange system, and a piggyback sys-
tem. In a proprietary system, or “single insti-
tution” system, only the customers of the
bank that developed and installed the ATM
system may use the machines. In a shared sys-
Balance transfers tem, a group of financial institutions mutually
4%
a
Excluding balance lnquiries. Includes only Years for which estimates based on
researches, installs, markets, and operates the
field research are available system. In an interchange system, separate in-
SOURCE Economic Review Federal Reserve Bank of Atlanta, August 1983 stitutions with ATM programs or even sepa-
. . . .

Ch. 4—Retail Financial Services ● 117

.- r
— J

—— .—

t– — — J

Photo credits: Steven Rothenberg

Consumers can obtain cash through a variety of service delivery systems


118 ● Effects of Information Technology on Financial Services Systems

Figure 8.— Number of ATMs in Use, 1973-81 Shared ATM Systems


“ 50
Annual growth rate The number of shared and interchange sys-
45 tems is growing rapidly. As national ATM in-
/ terchange proliferates, shared systems such
40 as Plus and CIRRUS allow customers access
. A to their funds on a national basis. National in-
35 terchange systems, however, are not being run
.
1 only by banking organizations. ADP, Inc., and
American Express have also begun develop-
ing and marketing national ATM interchange
1973 1975 1977 1979 1981
networks. Supermarkets and retailers are also
positioning themselves in the ATM arena.
Average annual growth rate, 1973-81
34.780/o There are, however, limitations to the kinds
SOURCE Economic Review, Federal Reserve Bank of Atlanta, August 1983, p 16.
of services available through the national net-
works. Presently, because Federal regulation
prohibits interstate deposit-taking,* most sys-
Figure 9.—Average Number of Monthly Transactions tems serve as cash dispensers and provide in-
per ATM,a 1974-81 formation about account balances. The fees
imposed for using national ATM systems are
7
’ 0 0 0
~ set by the individual networks and range from
6,000 $0.75 to $1.30 per transaction. A portion of
t the fee goes to the financial institution whose
machine is being used, and a portion goes to
the organization running the system.

c
Not all ATM systems are run by banking
.-
organizations. With the advent of regional and
national ATM networks, ownership of these
networks by third parties has become a ma-
jor business. The systems operate in two ways:
the third-party company can own, deploy, and
operate the ATM network, with the financial
organization paying a transaction fee each
1974 1976 1981 time its customers use the machine, or the
aDoes not include balance inquiries, includes only years for which estimates
based on field research are available
third party can be the switch operator, receiv-
SOURCE Economic Review, Federal Reserve Bank of Atlanta, August 1983, p 16
ing either a percentage of the transaction fee
or a fixed monthly fee for its processing ef-
rate, shared systems allow one another’s forts. These systems are developed on a local,
customers to use their machines. The term regional, and national basis and are in direct
“shared system” is associated with an inter- competition with bank-run systems.
change system. Generally, there is an inter- Safeway–an Oakland, Calif., supermarket
change fee associated with using another insti- chain-has announced plans to develop and
tution’s ATMs. A piggyback system occurs market a national ATM network. Presently,
when one institution with equipment allows Safeway participates in a shared interchange
the customers of other institutions to use its
machines .10 *Reciprocity agreement,g exist among several states. ‘he
— Massachusetts Legislature passed a bill in 1983 entitled “An
‘“Norman Penny and Donald Baker, The Law of Electronic Act Relative to Branch Offices and Acquisitions of Financial
Funds Transfer Systems, (Boston, Mass.: Warren, Gorham & Institutions, ” that permits interstate deployment of ATMs and
Lament, year), p. 6.03. deposit-taking among five New England States.
Ch. 4—Retail Financial Services ● 119
.——.

network, owned and operated by the Network dedicated data circuit and modems, the
Exchange of metropolitan Washington, D.C. institution pays a service fee for the
The objective of the Safeway program for in- stand-in processing option.
store ATMs is to increase store traffic and 3. Full stand-in processing. NTSI maintains
sales by providing customers with full-service, the participating institution’s cardhold-
one-stop shopping convenience. Safeway has er file online at NTSI. NTSI verifies the
committed to installing common-access ATMs cardholder’s personal identification num-
in key stores throughout California. The ber and authorizes or denies the card-
Washington, D. C., program, however, is pres- holder’s Safeway Cash Machine trans-
ently not a participant of the Safeway ATM action in accordance with the institution’s
program being developed in Oakland. To at- authorization parameters and cardholder
tract the maximum number of prospective positive file information, updated daily by
shoppers, Safeway will promote both the avail- the institution’s processor. The institu-
ability of the ATM services at its stores and tion pays an additional service fee for this
the financial institution cards that can access stand-in processing option.
the machines. Safeway is also prepared to
assist the participating financial institutions Merrill Lynch, Pierce, Fenner, & Smith Inc.,
in generating new accounts that can access the has signed an agreement with Safeway Stores,
in-store ATM services. Inc., that will enable the brokerage concern’s
customers to tie into the Safeway ATM net-
Participation in the program is on a trans- work. Merrill Lynch customers who have one
action-fee basis. National Transaction Sys- of its Cash Management Accounts, which link
tems, Inc. (NTSI), will provide ATMs; install, a securities account and money market funds
maintain, and service them; and perform all with “check” writing privileges and a VISA
required transaction processing, funds trans- card, can use the VISA card to obtain cash at
fer, settlement accounting, billing, and cus- Safeway stores. This is expected to begin in
tomer service operations required to support early March 1984; it will be limited, for the
the Safeway ATM program. Safeway cash present time, to California locations. However,
machines will be linked to NTSI switching Merrill Lynch expects to expand the services
and processing system via leased telephone to include nationwide access.
data circuit. Other leased data circuits will link
the switch with the participating institutions’ In Florida, Publix supermarkets has also es-
host computers. Initially, the only function tablished its own ATM network, which it of-
available will be cash dispensing, selected by fers for use to any bank in the State (operated
the financial institutions from the following on a piggyback basis). Fees are imposed for
three service-level options: every transaction a customer makes at a Pub-
lix terminal. In addition to deploying the
1. Direct host link. The participating insti- ATM, Publix also runs the switch that oper-
tution’s computer is linked directly to the ates the system.
NTSI switching processor. The institu-
tion pays for the dedicated data circuit Shared systems exist primarily on a local/re-
and modems associated with its host com- gional basis. The Tyme Corp. of Wisconsin has
puter link to the NTSI switch. operated as one of the first shared systems in
2. Direct host fink with “stand-in “process- the United States, and in Washington, D. C.,
ing. NTSI maintains a cardholder author- the Money Exchange has operated as one of
ization file and control parameters on the the first shared networks on an interstate
NTSI computer for processing the partic- basis. Shared/interchange systems allow the
ipating financial institution’s cardholder small institution to compete with other finan-
Safeway Cash Machine withdrawal trans- cial institutions in the ATM competition. The
actions when the institution’s host com- feasibility of all financial institutions operat-
puter is not available. In addition to the ing switches and deploying ATMs within a

35-505 0 - 84 - 9 : QL 3
120 . Effects of Information Technology on Financial Services Systems
———— —.— ——.——— —

contained area is uneconomical. By operating ATM deployed by any CIRRUS member, a


in a shared/interchange environment, the fi- customer can make a withdrawal from his sav-
nancial institution can extend the geographic ings or checking account, check balances, and
reach of its market and earn income from the access a line of credit. All CIRRUS ATMs
ATM. must accept the cards of every CIRRUS mem-
ber; however, individual members may set
CIRRUS—National ATM Network limits on the amount of cash their customers
may withdraw at a time. CIRRUS ATMs
The CIRRUS System, Inc., is a not-for-pro- must also be online in order to authorize trans-
fit membership corporation that allows its actions. The CIRRUS switch, maintained by
members to offer their customers the conven-
the National Bank of Detroit, does not provide
ience of nationwide ATM access. Incorporated
backup authorizations for its members. The
in June 1982, CIRRUS is headquartered in
network ensures against switching downtime
Oak Brook, Ill. When fully operational, it will
by utilizing an ACI/Tandem computer.
serve 41 States. Growth projections for the
system are summarized in table 5.
Individual CIRRUS members are responsi-
Membership in CIRRUS is exclusively re- ble for the cost of hooking up to the switch
served for banks, savings and loans, and credit and maintaining the connection. They must
unions. Associate membership is limited to also pay for hardware and software modifica-
banks. CIRRUS does not preclude its mem- tions necessary to comply with the network’s
bers from joining other networks, nor does it operating rules.
require the sharing of other electronic services,
such as POS terminals. There are three classes Associate members pay a one-time entrance
of membership for the CIRRUS System: fee of $25,000 to join the network, connect
with the switch, and reserve the right to li-
1. Principal. Principal members have ex- cense correspondent members. Correspondent
clusive marketing rights in their terri- members’ entrance fees are set by agreement
tories. They may share their link to the with the licensing banks. Ongoing member-
CIRRUS switch, run by the National Bank ship fees for the CIRRUS System are $2,500
of Detroit, by licensing correspondent per month for associate members; correspon-
members. Principal members are required dent members pay the membership fees set by
to add their ATMs to the network. their licensing bank. There are also process-
2. Associate. Associate members also have ing and interchange fees. Each time a CIRRUS
a direct link to the CIRRUS switch and
cardholder uses his ATM card at a bank other
may share their connection with the cor- than his own, the card issuer pays the switch
respondent members they license.
$0.25 for processing the transaction. For with-
3. Correspondent. Correspondent members drawals and for accessing a line of credit, the
are linked to the CIRRUS stitch through card issuer also pays the institution deploy-
the principal or associate members who ing the ATM an additional $0.50 interchange
license them. fee per transaction. For balance inquiries and
CIRRUS allows its members to offer their other transactions, the card issuer pays the
customers the convenience of nationwide machine-deploying institution a $0.25 inter-
ATM access. Using a CIRRUS card at an change fee.

Table 5.—Growth Projections for the CIRRUS System, Inc., National ATM Network

1982 1983 1984 1985


Number of CIRRUS participants . . . . . . . . . 682 862 1,760 2,297
Number of CIRRUS ATMs deployed . . . . . . 3,364 5)015 7,210 8,839
Number of CIRRUS cardholders . . . . . . . . . 14,600,000 18,000,000 28,900,000 32,700,000
SOURCE The CIRRUS System, Inc
. .—

Ch. 4—Retail Financial Services ● 121

ATM-deploying institutions earn revenue tomers. The national ATM switch is designed
from interchange fees every time another in- to handle at least two transactions per second.
stitution’s cardholder uses their machines to This represents a daily capacity of 173,000
transact banking business. Card-issuing insti- transactions.11
tutions are permitted to charge their custom-
ers for the privilege of being linked to the ATM Deployment Legislation
CIRRUS network. Associate members can
Deployment of ATMs remains dependent on
share their direct link to the CIRRUS switch
State-by-State banking legislation. Figure 10
with other institutions for a fee, and no mat-
ter how many correspondents an associate shows the number of ATMs in each of the
States in 1983. Certain States, such as Illinois,
signs up, it never has to pay more than its flat
have very strict, off-premise deployment laws.
monthly membership fee. Members of the
Illinois permits State-chartered banks to
CIRRUS network are free to join other
establish ATMs subject to a number of geo-
networks.
graphic, time, and number restrictions. First,
When fully operational, CIRRUS will link
over 5,200 ATMs serving over 16 million cus- “CIRRUS Systems, Inc., Oak Brook, Ill.

Figure IO.— ATMs in the United States

Legend Total ATMs

1700 to 4000
700 to 1700
500 to 700
300 to 500
200 to 300
B Less than 100
1 1 1

SOURCE Economic Review, Federal Reserve Bank of Atlanta, August 1983, p 13


122 ● Effects of Information Technology on Financial Services Systems

prior to January 1, 1980, a bank may estab- Financial Institutions, ” the act establishes
lish not more than two ATMs, each no more new authority for mergers, branching, elec-
than 3,500 yards from its main office. Second, tronic branching, and mortgage lending by
commencing January 1, 1980, a bank may es- Massachusetts financial institutions. While
tablish an additional eight ATMs, at the rate the act is generally limited in its operation to
of two per year. Third, prior to January 1, activities involving five New England States,
1981, these ATMs maybe located only within the EFT provisions are expressly exempted
the county of a bank’s main office. Finally, from such limitations. Under prior law, no out-
subsequent to January 1, 1981, a maximum of-State financial institution nor bank holding
of four of the eight ATMs may be located company was permitted to purchase, estab-
within an adjacent county. ATMs located not lish, install, lease, use, or share an ATM in
more than 3,500 yards from the bank’s prem- Massachusetts. The sole exception was al-
ises need not be shared, but those located more lowed in a grandfather clause that exempted
than 3,500 yards from the bank’s main prem- from the prohibition certain electronic
ises must be made available on a nondiscrim- branches established before December 31,
inatory basis for use by customers of any other 1981. To qualify for the exception, the ATM
bank that would be permitted (under the stat- had to dispense only cash, traveler’s checks,
utory geographic restrictions) to establish an or both, and had to be limited solely to the use
ATM at that particular location. ’z of customers of the financial institution that
In sharp contrast to the restrictive Illinois established it.
law is Wisconsin legislation on terminal de- The new law empowers Massachusetts insti-
ployment and usage: tutions to link their ATMs to regional or na-
tional networks. It also permits a financial
Facilities established under the Wisconsin
EFT statutory provisions must be available institution, organization, or bank holding com-
on a nondiscriminatory basis for use by any pany, or its subsidiary organized outside of
like institution which has its principal place Massachusetts, to share any ATM established
of business in the State, or by any other like and used by a Massachusetts financial insti-
institution which obtains the consent of a like tution or organization, provided that the shar-
State, or by a national institution which has ing entity limits its customers to cash with-
its principal place of business in the State and drawals, advances against preauthorized lines
which is using the terminal. of credit, and check cashing. Moreover, any
The statute requires that regulations pro- out-of-State nondepository financial institu-
hibit, with regard to a shared terminal, any tion that establishes electronic branches that
advertising that suggests or implies exclusive dispense only traveler’s checks and are limited
ownership or control of the terminal by a fi- to use by the nondepository’s own customers,
nancial institution or group of institutions. 13 such as American Express’s Express Cash
Wisconsin law made possible the first shared Program, are allowed to establish, use, or
ATM network in the United States and one share electronic branches in Massachusetts.
of the largest. Finally, the new law authorizes financial in-
Massachusetts went one step further. In stitutions, organizations, and bank holding
early 1983 a law was passed that, for the first companies in Conneticut, Maine, New Hamp-
time, permits Massachusetts financial insti- shire, Rhode Island, and Vermont to purchase,
tutions to link their ATMs to regional and na- establish, install, operate, lease, or use elec-
tional interchanges. Entitled “An Act Rela- tronic branches. That is, whereas the prior law
tive to Branch Offices and Acquisitions of permitted institutions from any State to share
ATMs established and used by Massachusetts
“Robert C. Zimmer and Theresa A. 13inhom, The Law of Ekc- institutions, the new law allows New England
Card Services, inc., 1980, pp. I 1-11 to
tronic Funds Transfer,
I 1-13. institutions themselves to establish and use
“Ibid., p. WI-1. ATMs in Massachusetts, whether or not a
-—— —=—— . .—

Ch. 4—Retail Financial Services ● 123


— — . . — — — —— — ———.—

Massachusetts institution is involved. ” All of ment funds. The card may also have an over-
the participating States passed legislation ap- draft credit line. There has been much cus-
proving the interstate branching. tomer resistance to using a debit card at the
point of sale because the customer associates
There are no uniform guidelines on ATM de-
the use of a plastic card with the elimination
ployment that each State follows in making of float, which allows a grace period before ac-
its EFT deployment laws. Each State’s legis- tual payment is required. Also, many people
lature determines what approach will be best in the industry have referred to the debit card
for the consumer and the banking community. as a paperless check, which is one of the rea-
sons that retailers have been reluctant to ac-
POS Full Funds Transfer cept it. Presently, retailers can accept accept
The term “point of sale” covers a variety of and process checks for less than the fee im-
services rendered through machines located at posed for processing a debit or credit card
retail establishments. POS terminals are gen- transaction. These differences have resulted
erally clerk-operated devices located at the in controversy between the retailer and card-
checkout or convenience counter of retail es- issuing institutions.
tablishments. Electronic cash register ver- Another form of debit card transaction at
sions of these terminals have been in opera- point of sale gives the cardholder a rebate,
tion for several years, maintaining store which encourages use of direct debit at point
records on sales, inventories, accounts of sale. Customers use the card, which works
receivable, and the like. Now, POS devices online, to debit their account directly to any
have been linked to financial institution com- participating retailer. The retailer receives in-
puters, allowing retail customers to receive ap- stant credit, and the customer receives a re-
proval for check cashing and electronically ini- bate, ranging anywhere from 2 to 5 percent,
tiate transfers from their accounts to the directly credited to his savings account. One
retailer’s, the latter being POS full funds of the most successful of these programs is
transfer. In some installations, customers can that of the Wilmington (Delaware) Savings
make deposits to their accounts. POS devices Fund Society. Most of the other programs,
accept either a plastic credit card or a plastic however, have been unsuccessful. First of all,
debit card, depending on whether the cus- a significant card base was not represented.
tomer wants to delay payment by charging the Second, many of the stores that signed up for
purchase or wants the purchase deducted di- the program were inconvenient to the majority
rectly from his/her account. As electronic POS of the cardholders, and these stores also
systems proliferate, their use will probably re- tended to sell products at a higher cost than
place many of the paper transactions accom- did discount stores.
plished through cash payments and check and
credit transactions. Direct Debit POS
The debit card, another means of facilitating Retail Stores.–Although previously not
funds transfer at point of sale, functions much many POS systems operated in retail stores,
the same way a credit card functions except there is tremendous potential for their use.
that when the transaction is received by the One of the most successful direct debit POS
issuing financial institution, it is debited to the programs is in Des Moines, Iowa. There, Dahls
cardholder’s account, which may be a check- and Hy-Vee supermarkets operate direct debit
ing, savings, NOW, or other form of deposi- POS systems at the checkout counter, the first
tory account. Some securities firms have such systems in the United States. Custom-
distributed debit cards to access cash manage- ers of these supermarkets can pay for groceries
with a proprietary debit card issued by Nor-
—. —.. west Bank, which automatically debits the
41+:lc~tr0niCF’und< Transfer Association, llrashin~~ton Report,
tJan, 11, 19H3. cardholder’s account. ITS, Inc., operates the
124 ● Effects of Information Technology on Financial Services Systems

computer switch that makes EFT possible for alternative method of payment. Most of the
some of the 205 participating Iowa banks, sav- tests at the service station involve agreements
ings and loans, and credit unions. The Hy-Vee between oil companies and financial institu-
supermarket does about 4,000 POS trans- tions under which customers can pay for pur-
actions per month; Dahl’s does about 2,000 per chases using bank debit cards that automat-
month. Each location paid about $18,000 to ically debit the amount of purchase from their
install magnetic stripe readers and keyboard checking accounts. However, there is addition-
add-ons to the NCR cash registers and to buy al interest in proprietary credit card trans-
the processors and software. However, volume actions at points of sale. Mobil Oil Co., for ex-
sales of the systems should cut costs. More- ample, has 2,400 POS terminals linked to its
over, the store receives good funds the next Kansas City processing center, which captures
day. all transaction information via electronic draft
capture. Since the system is online the infor-
Retailers and banks both benefit by having mation is transmitted immediately. This POS
access to the customer’s float, and both the system enables Mobil to capture billing infor-
retailer and the bank are assured the funds are mation electronically, saving internal costs by
good. “To encourage direct debit use, bankers reducing the amount of paper used in such
will price check transactions higher than their transactions. Mobil implemented a credit POS
debit card counterparts to nudge consumers
system, which could easily convert to a hybrid
along. The cost of processing one check is esti-
system supporting both debit and credit, to
mated at about 50@, and an EFT transaction maintain its loyal customer base and to gen-
costs about 30©. The higher the volume in erate new business. Mobil representatives feel
EFT, the lower the per transaction cost be- that direct debit at this stage would alienate
cause of the high fixed overhead. ” 15 customers.
Oil and Gas Companies.–The gasoline sta- The POS transaction begins by the service
tion is currently the focus of much POS activ- station clerk inserting the card into a POS ter-
ity because it generates more transaction vol-
minal. In some cases, the customer inserts the
ume than any other kind of retailer.16 Many card into an automated pump and then keys
large oil and gas companies are installing POS in his own personal identification number
terminals at service stations. A few direct (PIN). By implementing direct debit POS ter-
debit POS terminals are being deployed di- minals, the customer’s account is automat-
rectly into the gas pumps, although the ma- ically debited, and the retailer’s account is gen-
jority are stand-alone terminals. erally credited immediately or the next day.
While still in its infancy, the idea of deploy- The benefits to both banks and oil companies
ing POS terminals at service stations is be- are savings of millions of dollars. In most
coming more accepted because of the increase cases, the bank or network operator receives
in self-service gas stations, because more sta- a transaction fee for each purchase. The oil
tions are remaining open 24 hours a day, and company saves by being assured of good funds
because service stations are often vulnerable and by receiving payment immediately. This
to robberies. To help reduce the tremendous is a significant issue because the general lag
volume of cash generated each week by gaso- time for credit card sales draft, according to
line purchases, major oil companies and banks a Mobil Oil Co. official, is 10 days.
across the country are joining forces to test
Some POS test situations currently under
POS terminals at the pumps, using proprie-
way are being done by AmeriTrust Bank, Shell
tary credit cards or bank debit cards as an
Oil, and Gastown in Cleveland, Wells Fargo
“Forbes, Aug. 29, 1983, p. 46.
Bank and Shell service stations in San Fran-
loMmagement Information Systems Week, July 27, 1983, cisco, First City National Bank of Houston
p. 81. and Exxon Co.
Ch. 4—Retail Financial Services ● 125
-—— —— — — . . ————— —

National POS Systems ative file or by having the retailer check a man-
Large-scale communication networks are be- ual that lists card numbers of bad credit risks.
ing developed, primarily by the major credit In the United States, POS experiments have
card industry, to connect thousands of POS been conducted since 1974. Very few systems
retail terminals with financial institutions involving instant transfer have survived, and
within a State, region, and, ultimately, the Na- the most important functions of POS, until
tion. These networks will include computerized online direct debit systems were in place, have
switching centers and a base for clearing set- been check verification and credit card author-
tlements. ization. One explanation for this very limited
In addition, oil companies, banks, and other success could be that the experiments have
retailers are considering national POS net- generally looked for evidence of profitability
works. Tests are being conducted by Liberty within a few months of installation, whereas
National Bank & Trust Co. of Oklahoma City the change in social habits involved in mov-
and a Southwest oil dealer whereby terminals ing from cash and checks to instant transfer
will be deployed at stations offering the fol- takes a great deal longer.
lowing services: automated dispensing at the
pump, an ATM inside the station for purchas- Costs of POS Systems
ing convenience items, and a commercial de- For several years merchants and financial
pository that is wired to the ATM so that institutions have been at an impasse over how
high-volume stations can make deposits. to implement electronic payment systems,
At the present time, POS systems are be- especially retail EFT systems. The differing
ing allowed by regulators to access time and perspectives reflect differences in technologies
savings accounts; however, this could change. being used, in terminal ownership, in customer
Regulation D* is not being strictly interpreted bases, and in approaches in pricing the service.
with respect to POS activity. However, if the One of the main concerns associated with
regulation were strictly interpreted, a large implementing POS systems is the cost to be
number of financial institutions, savings and borne by retailers and banks. Another is the
loans, and savings banks, would be prohibited concern about merchant discount fees. Most
from actively participating in a POS system. banks charge the merchant the same fee for
debit card transactions as they do for credit
Other Uses of POS Systems card transactions. The argument made by the
The POS terminal can also be used for check merchant is that debit cards function in lieu
authorization, permitting the customer to ob- of a paper check and therefore the merchant
tain approval of a check for payment by run- should not pay the same discount fee. A POS
ning a verification of the check-cashing record system can all but eliminate float, reduce
through a computer. Likewise, the POS sys- credit risks, require the merchant to keep less
tem enables merchants to verify the availabil- cash on hand, and ease check approval.
ity of funds in a customer’s account or his ac- Technology has also been a basis for conflict
cess to credit before completing the sale. As between the merchants and POS operators. Fi-
with ATMs, customer access to POS terminals nancial institutions typically base their debit
is usually by plastic card and PIN. This is an cards on the magnetic stripe technology used
alternative to manual authorization and veri- for years on bank credit cards. Grocery retail-
fication, which is handled by accessing a neg- ers, on the other hand, typically base their
technology on an optical scanner that reads
*Regulation D is a uniform reserve requirement on all depos- bar codes on product labels and transmits the
itory institutions with transaction accounts or on personal time information to an electronic cash register
deposits. It requires submitting reports on all deposits to the
Federal Reserve Board and sets phase-in schedules for reserve (ECR). Department stores typically prefer op-
requirements. tical character recognition characters read
126 • Effects of Information Technology on Financial Services Systems

from merchandise tags and proprietary credit in an area and that provide for the recruitment
cards with a handheld wand. Product and cus- of most retail outlets stand the greatest
tomer information is fed into an ECR to ef- chance of success.
fect electronic payments. POS systems will undoubtedly increase dur-
Financial institutions tend to prefer owning ing the next decade, with many new systems
the necessary terminals and charging mer- being built upon existing ATM networks.
chants a user’s fee for making transactions Both the banks and retailers stand to gain
through them. On the other hand, retailers from the resulting reduction in the volume of
tend to prefer devices that are integral com- paper transfers. However, merchants contend
ponents of their own ECRS.17 Naturally, finan- that since a debit card transaction saves finan-
cial institutions and the merchants are wedded cial institutions time and money relative to a
to their respective investments. It is unreal- check transaction, merchants should enjoy
istic to expect the merchants to give up their some of the savings. It has become quite
technology in order to accept electronic pay- apparent that in order for POS systems to de-
ments. Developments such as VISA’s “elec- velop and operate efficiently, the systems
tron card” are aimed at simplifying this must be designed in close cooperation with the
problem. individual retailers, not just the markets the
systems serve.
Another issue with respect to POS systems
is the volume of sales to be handled. It has The technology necessary to operate elec-
been argued that to be viable economically, the tronic debit and facilitate POS transactions
POS system must become competitive with exists today. It is the intention that electronic
cash; otherwise, there is no incentive for the debit cards will substitute for check, credit
retailer or the customer to use it. The customer card, and cash transactions. However, when
is faced with loss of float, and the retailer is POS services become commonplace, the use
faced with transaction fees, which cash pay- of cash and checks as a payment mechanism
ments do not require. Under these conditions, will still exist. Disconcerting cost trends are
systems that are shared among all the banks leading merchants and financial institutions
—.- ——_—— to seek lower cost alternatives for POS trans-
“’’Debit Cards at the Cross Roads, ” Economic Review, March actions. EFT is the method by which this goal
1983, pp. 37-38. can be reached.

Financial Information Services


There are many forms of information serv- eling tools, and various other analytical
ices in the financial service industry. They in- packages.
clude check or credit authorization/verifica-
tion; status information on account balances; All financial service providers use informa-
identification verification; billing and funds tion services. Retailers are perhaps one of the
due information (e.g., preauthorized pay- largest users of specific information services,
ments); accounting information with respect particularly check verification. Check verifi-
to general ledger, payroll, accounts payable, cation validates the authenticity of the check
accounts receivable; and modeling and analyti- or its presenter. This system is accessed online
cal services, such as Chase Econometrics and through a telephone or terminal by the retailer.
Wharton Econometrics, which provide access The retailer pays for this service, generally a
to data bases, econometric models and mod- percentage of the value of the check. These
Ch. 4—Retail Financial Services ● 127
— .

systems are run by third-party organizations vide information in unique ways. For exam-
and banks that maintain negative files. ple, the services they perform include provid-
ing status information to their customers on
Check Authorization a very regular basis. The most familiar proc-
esses are inquiry of account balances or funds
Check authorization systems may be pro- credited or inquiries regarding specific check
vided and maintained by the party accepting clearing. Today, much of the status inquiry in-
the check, by a financial institution, or by a formation is processed by online teller ter-
third party engaged in such a business. The minals with direct access to the accounts be-
systems may be designed to access bank rec- ing questioned.
ords directly or may rely on secondary data
sources. In some systems, check approval is Service organizations provide accounting in-
accompanied by a guarantee of payment. In formation services to customers, such as in-
an EFT system, a customer’s plastic card and formation services about payroll or accounts
PIN can be used to access the system and ver- receivable/payable or other services necessary
ify the available balance. This is accomplished for efficiently running the organization with-
by placing the check into a terminal and key- out the added costs of implementing an auto-
ing in the appropriate information. The check mated system in-house. A wide variety of
is then validated and accepted at point of sale. firms, including financial service providers, of-
fers these services.
Credit Authorization Two other key information service providers
in the financial service industry are invest-
Credit authorization is yet another informa- ment brokers and insurance firms. (The bro-
tion service vehicle available to the retailer. kerage industry is covered in ch. 3 of this re-
It operates by allowing the customer’s credit port.) Insurance information is compiled by
card to be read by a financial service terminal actuarial scientists and categorized by risk,
while a central computer verifies that the card age, and the like. Much of this information is
is valid and the customer’s account has suffi- available to individual brokers through online
cient funds. This can also be accomplished videotex terminals. Insurance information re-
manually by checking a printed document, dis- quires some customization in order to meet the
tributed by the card companies, indicating lost specific needs of the party requesting the in-
or stolen card numbers or by placing a call to surance, although premiums and risk are de-
an operator who will authorize or refuse the termined by actuarial methods.
transaction based on information from a data
base. This inquiry process is supposed to re- The information provider in the insurance
duce the risk of credit fraud or of extending industry is the insurance salesman. Although
credit in excess of an imposed credit limit. much information about general insurance is
accessed to data bases via terminals, the proc-
Information service systems allow for real- essing of this information still requires the per-
time access and reduction of risk at point of sonal interaction of the salesman and client to
sale and ensure that the retailer will receive provide the service adequately. Some insur-
the funds. The risk is transferred to the party ance information is provided through com-
authorizing the funds. This service guarantees puter/CRT* terminals that display rates and
payment to the retailer and is attractive de- also give an explanation of the types of insur-
spite the fact that the retailer must pay a ance available. The insurance industry is look-
premium to insure the funds. ing at further automating the delivery of in-
surance information.
Providers of Information Services
Many kinds of organizations are information *CRT terminal—video terminals that display data on a cath-
providers. Depository institutions use and pro- ode-ray tube.
128 ● Effects of Information Technology on Financial Services Systems

The following scenario may present itself in transfer funds efficiently from one account to
the near future. Through videotex and home another. For example, in a corporate environ-
information systems, insurance information ment, real-time access and videotex technol-
can be transmitted and reviewed by an in- ogy allows a treasurer or financial advisor to
dividual. If the need presented itself, for ex- manage and control all of the investment ac-
ample, an individual would be able to increase counts. Through the same technology, invest-
the amount of homeowner’s insurance for a ments can be transferred on a daily or perhaps
specific period of time, say a weekend, if he even hourly basis.
planned to be out of town. The insurance pol-
Many organizations today conduct financial
icy modifications could be done instantane-
counseling programs for all ages and groups.
ously, and the additional premium payment
These groups organize to seek sound financial
could be automatically debited from the cash
guidance and to plan for long-range money
value of other insurance policies.
goals. Interestingly, these groups include not
Several of the larger banks in the United only the affluent market but also young pro-
States offer financial, securities, and invest- fessionals and middle-income individuals who
ment analyses; payment products, models and have become far more educated and concerned
data bases to corporations, other banks, insur- about how their finances are handled.
ance companies, financial institutions, and
Different sectors of the financial service in-
government agencies. An example is terminal-
dustry require different information services.
based cash management for major corpora-
For example, a bank loan officer may inven-
tions and banks.
tory data to assess liquidity and solvency. Fi-
Mortgage servicing is another aspect of nancial analysts are concerned with equity in-
financial information services. Mortgage bank- vestment decisions and are likely to place more
ers and a growing number of commercial, mu- importance on earnings-per-share and capital
tual savings bank, and savings and loan cus- account data. On the other hand, various fi-
tomers use this type of service for servicing nancial service groups use the same informa-
their portfolios of mortgage loans, which in- tion in different ways in the decision process.
clude taxes, escrows, and insurance. Loan clos-
Service industries, such as banking, securi-
ing documentation and mortgage preparation
ties, and insurance, whose business operations
systems are available to help customers of the
rely heavily on information services, are find-
service keep track of inventories and financial
ing that the whole environment in which they
commitment needs. Batch transmission and
operate is changing rapidly. Earlier develop-
inquiry modes to a central location are used
ments in information technology were such
via dial-up and leased transmission lines. In
that only large corporations could take advan-
this manner, nationwide service is provided
tage of its capabilities. However, over the last
from a single location.l8
several years, technical innovation has con-
Information services provide immediate ac- tinued at such a rapid pace that, for example,
cess to financial information and are used to information processing power, which once
18
Herbert A. Schulke, Jr., “Electronic Financial Systems, ”
took a roomful of large equipment, is now
Innovations in Telecommunications, Academic Press, Inc., available in portable machinery.
1982, p. 1038.

Home Information Systems


Home information services are a way by Home information systems (HIS) started in
which financial information services can be de- a relatively minor way in the United States
livered to users of home computer terminals. several years ago with the introduction of bill
Ch. 4—Retail Financial Services • 129
. — — . —. —. —.—— — —-

paying by telephone. The original impetus or cable lines. Some systems provide a hybrid
came from thrift institutions, which saw tele- communication delivery, using cable for in-
phone bill payment as a way to offer trans- coming information and the telephone for out-
action accounts, thereby partially circumvent- going information. In-place cable lines are pri-
ing the law forbidding payment of interest on marily one-way communication lines, although
demand deposits. Soon commercial banks be- most new cable lines being laid today are two-
gan offering the service. When the telephone way cable lines.
bill payment service was first introduced, most
Home computers also allow interaction with
of the systems required the customer to call
HIS and are becoming popular for receiving
in and give oral instructions over the telephone
the services. A modem** can be used to tie
to an operator to perform banking services,
the home computer to the information source
specifically bill payment. Automation was in-
by telephone lines. A CRT or television screen
troduced and made available to customers
acts as the visual display terminal. The home
with touch-tone phones, although most sys-
banking software which runs the system is dis-
tems still relied on operators during the busi-
tributed by the participating financial insti-
ness hours and on recorded messages at other
tution.
times. Telephone bill paying services did not
attract a large customer base, and many of the As stated, cable plays an increasing role in
early programs have come to a halt. the delivery of home information services.
“The latest cable television systems now be-
Technology of Home ing developed will transform the technology
Information Services of videotex and the economics of home bank-
ing. The use of coaxial or fiber optic cables
The introduction of videotex played a key gives much greater bandwidth, which provides
role in the development of home information three substantial technical advantages: 1) the
systems. Videotex—a generic term that refers possibility of carrying a large number of chan-
to computer-based information retrieval sys- nels, up to 100 or more; 2) a more satisfactory
tems that display text and graphics via video and speedy interactive facility; and 3) a much
screen—is a product of the convergence of improved ability to produce pictures (impor-
telecommunications and computing technol- tant in using home shopping).’’” Direct broad-
ogies. Through teletex* and videotex, one-way casting by satellite, which is being developed,
and two-way computer-based retrieval sys- is another method by which information can
tems, information can be widely disseminated be transmitted into the home.
for viewing on modified television sets or on
personal computers. In the last year or so, full Developers of Home Information Systems
videotex systems have become operational in
several countries, giving the user the ability Home information systems are being devel-
to send communications to the system com- oped by a myriad of organizations that include
puter for onward transmission. Because the depository institutions (presently Bank of
videotex system is interactive, it can be used America and Chemical Bank are marketing
to facilitate financial transactions. The system systems that are up and running), information
functions in several ways. One way uses a companies, entertainment companies, and the
videotex terminal and a television (which acts like. Several systems are being developed as
as a visual display unit); the communication cosponsored, joint ventures by consortia of
with the system is supplied by telephone lines major banks and corporations. One example

*Teletex is a one-way system that displays alphabetic and **A modem transmits digital or computer information over
graphic information on a modified television set. Videotex dis- telephone lines by manipulating it electronically and also pro-
plays the same sorts of information as teletex but also provides tects the lines from undesirable signals that might cause in-
a communication path for the user to interact with the service terference with other users.
provider. 19
Revel], op. cit., p. 50.
130 ● Effects of Information Technology on Financial Services Systems
—. —

of a major project is the Viewtron Program Applause, the home banking software of-
in Miami, Fla. The Viewtron system will be fered by VideoFinancial Services, will supply
supported by computers from seven major cor- a variety of services. The home banking activ-
porations from around the country and will be ities include bill payment, funds transfer and
linked to Viewdata Corp. ’s Viewtron com- account information, and special financial re-
puters in Miami. The gateways are American quests. VideoFinancial Services also provides
Express—subscribers will have access to a va- credit authorization and settlement for credit
riety of services offered by this company; Com- card shopping orders placed on Viewtron. The
modity News Services—subscribers will be system permits each participating financial
provided with instant and delayed stock mar- organization to specify unique features within
ket and commodity price quotations; and E. the system standard, including the use of in-
F. Hutton–subscribers will be able to track dividual colors and graphics. Presently, 12
their personal investments and receive invest- Florida banks and savings and loans will pro-
ment advice with “Huttonline,” the first elec- vide home banking to Viewtron subscribers
tronic information service offered by a retail via VideoFinancial Services’ computers in Or-
brokerage house. E. F. Hutton customers will lando, Fla.
be able to access Hutton’s computers in New
As a financial gateway, VideoFinancial pro-
York City for information about their ac-
poses to provide the Applause service to all
counts, such as cash management and margin
sections of the country through any videotex
balances, portfolio positions and market val-
network. To support such an objective, Video-
ues, open orders, and recent transactions. All
Financial expects to establish regional data
Viewtron subscribers will be able to order
centers, where practical and necessary, to in-
E. F. Hutton market comments and invest-
terconnect the financial industry to the re-
ment advice and send electronic mail to E. F.
gional network operator. The system will be
Hutton offices. Viewtron subscribers will also
streamlined. First, the home terminals will tie
be able to order J. C. Penney catalog merchan-
directly to the network operator, who will be
dise by using a direct link to J. C. Penney com-
fully responsible for promoting, enrolling, and
puters in Atlanta. They will receive online or-
billing the consumer for the network service.
der confirmation upon completion of their
Communications, terminals, and data base
order. If the requested item is not available
management will be provided and managed by
in the color requested, the J. C. Penney com-
the service provider. The network will then
puter will offer the Viewtron subscriber other
feed into the VideoFinancial computer system.
color possibilities. The J. C. Penney catalog
VideoFinancial will either connect online with
inventory system is immediately and automat-
or provide batch processing for subscribing fi-
ically updated. In addition to processing the
nancial organizations and will be responsible
catalog order, the gateway to J. C. Penney will
for developing and maintaining the home bank-
also provide for credit authorization for the J.
ing software package. The VideoFinancial
C. Penney card, as well as for VISA and Mas-
computer system will tie in directly to the fi-
tercard. In addition, information from The
nancial organizations offering the service.
Official Airline Guide and Grolier Academic
These financial institutions will assist the net-
American Encylopedia will also be available.
work operator in enrolling the consumer and
The financial gateway to the system, Video- will provide the data to VideoFinancial to sup-
Financial Services, is jointly owned by four port the home terminal request.
major bank holding companies: Southeast Over 50 information providers, including
Banking Corp., Miami; Wachovia Corp., Win- major wire services, educational organizations,
ston-Salem, N. C.; Bane One Corp., Columbus, reference and financial book publishers, uni-
Ohio; and Security Pacific Corp., Los Angeles, versities, libraries, and professional organiza-
Calif. tions provide information for Viewtron.

Ch. 4—Retail Financial Services . 131


—-—— —. -. —. . .— — — . . . — — — — — — —— —

Interestingly, the advent of HIS has en- Systems now in operation serve interactive
couraged cooperation instead of competition facilities, providing travel services, sports, and
among the various financial service providers. general entertainment information (e.g., res-
taurant and movie guides); stock exchange in-
Costs of Home Information Systems formation; shopping capabilities; and banking
applications in a form similar to that of self-
Cost is one of the major issues associated service banking. Users of these systems can
with the success of the HIS program. The pay bills, transfer funds, check balances, re-
Viewtron videotex costs are as follows: view banking statements, and keep up-to-date
●Subscription to the Viewtron service: $12 financial records.
per month for access to nearly all View- The elderly may be another target market
tron services. for such systems. The ease of being able to
• Communication charges to access View- accomplish shopping and banking from the
tron: approximately $14 per month (ap- home, it seems, would be very appealing.
proximately $1 per hour to access View- There are problems, however, with respect to
tron). acceptance of the system, hardware and com-
A serious consideration is the influence of munication costs, and, most importantly,
local communication costs and their impact on changing behavior patterns. Principal charac-
HIS. It is possible that communication costs teristics of HIS users are listed in table 6.
could increase to such a degree that the cost For consumers to adopt and use home infor-
of making a local call discourages use or forces mation innovation, it must be associated with
development of new types of local links. such advantages as convenience, compatibil-
Consumer acceptance of home banking/ ity, or specificity.
home information systems will be based on
several other factors besides the natural in- Implications of
clination toward using these services. These Home Information Systems
factors include price of obtaining the hard-
ware/software needed to use these services, It appears likely that home banking systems
price of using the services, and availability of will be tied to other services such as informa-
these services. * tion services, entertainment, and even busi-
ness uses. Also, any institution, whether finan-
cial or nonfinancial, will be in a position to
The Market for Home provide financial services through a videotex
Information Systems network and to support these services in much
Much speculation has been associated with the same way as Merrill Lynch operates its
the home information market. Several leading cash management accounts.
authorities have targeted the affluent segment Home banking and its impact on branch
of the population as the major users of the banking has some major consequences. With
home terminal. Their claim is that many con- a single investment in a computer installation,
sumers with incomes over $40,000 per year a new entrant to the retail banking market has
have an insatiable need for information of the whole national market open to it. As long
various types. The home terminal has great as it has the necessary computing capacity to
potential as the major investment, shopping, handle the accounts of its customers, any bank
and news information source for affluent con- will be able to leap over geographic barriers
sumers. Additionally, it has been stated that and offer payment services nationwide. * By
many affluent consumers feel strongly that the same token, nonbank operators will be able
they can conduct their own financial trans- ..-. .—
actions better than bank personnel can, and *Banks have long been able to conduct business nationwide
some find it enjoyable. by opening offices (usually via holding company affiliates or
—.. subsidiary corporations) for business loans. This is also true
* Information from Reistad Corp.—research conclusions. for mortgage companies and consumer finance companies.
132 ● Effects of Information Technology on Financial Services Systems

Table 6.—Principal Characteristics of HIS Users

Level of
Characteristic importance Comments
Age High Research studies indicate most potential customers of
HIS/home banking can be clearly identified by age.
Two principal groups are 18-34 and 35-49.
Sex Low Research indicates sex is not an identifier for potential
customers of HIS/home banking. Men and women rank
about equally in intent to purchase.
PRONTO pilot research shows, however, men were more
frequent users.
Education Moderate Research indicates as the level of education increases,
the propensity to purchase HIS/home banking
increases.
In all studies the majority who are interested in HIS have
attained a college degree or higher.
Occupation Low Research indicates interest in HIS/home banking is not
dependent on occupation. Blue collar workers and
professional alike are likely to be interested in HIS.
Interest increases gradually from a lower level among
housewives to high levels among managerial
employees. Those working in the home or retired are
less likely to be interested.
Family status Low Research indicates married and not married, with family
or without, are equally likely to be interested in
HIS/home banking.
Income Moderate Research indicates as income increases, the likelihood
to high of interest in HIS/home banking increases. However,
among very high income households ($50,000/year and
up) the likelihood of interest in home banking
declines somewhat.
Financial Moderate Research indicates that users of ATMs, Telephone BiII
services Paying, and frequent check writers are more likely to
users be interested in HIS. However, a substantial number
of those interested do not use these services.
Electronic Moderate Research indicates personal computer owners, cable TV
communication subscribers and those attracted by electronic gadgetry
product users are somewhat more likely to be interested in HIS.
However, a large portion of those interested in HIS do
not own or intend to purchase a personal computer.
Among PRONTO pilot users, half had computer
terminals (outside the home) prior to participating in
the test.
SOURCE The Reistad Corp , Clearwater, Fla

to compete with banks in these services to the checks has declined during the last several
extent that they are legally permitted to do so. years and check usage in absolute terms may
begin to fall between now and the end of the
It is important to note that ATM, POS, and century, no one expects checks to be totally
HIS will work together in the future. POS sys- replaced.
tems and ATMs will share network lines, and
these systems will eventually reach out to in- Historically, usage of new consumer prod-
corporate other remote terminal activity such ucts has grown slowly during the first years
as HISS. following introduction. For successful prod-
ucts, this has been followed by a period of
The various systems that have been and are rapid growth. Then, as the level of saturation
being implemented for effecting payments are is approached, growth again slows. Overall, ”
essentially designed to be substitutes for the this creates the “S” curve shown in figure 11.
paper check. While the rate of growth of This being the case, two questions relating to
Ch. 4—Retail Financial Services ● 133
———

Figure 11 .—Penetration Curve for Check Alternatives penetration for a home banking service today
that requires a terminal costing several hun-
dred dollars may be quite different from what
it will be for a derivative of that service that
is implemented using a terminal that costs less
than $100.
The time constants that determine the steep-
ness of the curve may also vary in response
to events in the market. For example, the rate
of growth in some electronically delivered serv-
ices may increase in response to a requirement
that all employees of firms over a specified size
1977 78 79 80 81 82 83 84 85 86
be paid by direct deposit. On the other hand,
a series of events that demonstrate inherent
SOURCE Economic Review, Federal Reserve Bank of Atlanta August 1983 p 33 weaknesses in advanced payment systems
could slow the rate of growth of some prod-
ucts. In general, the impacts of events are
the substitution of new payment products for
most likely to vary from product to product
the paper check remain unanswered. First, at
in the mix that comprises the offerings of the
what rate will new services grow? Second, at
financial service industry.
what level of penetration by each product will
the market become effectively saturated? In the past, great promise has been held out
for various payment products that has yet to
Not all potential users of a service will use
materialize. However, increasing use of com-
that service. It has taken decades for the level
puters and telecommunication throughout so-
of penetration for checking accounts to reach
ciety and the dynamism of the financial serv-
the 85- to 90-percent penetration level, where
ice industry may be creating an environment
it now rests. Further, it is not reasonable to
more favorable to the adoption of new systems
assume that the level of maximum market
for delivering financial services. Thus, there
penetration is the same for all products. Over
is a higher degree of confidence than in the
the long term, for example, the proportion that
past that the middle stage of the “S” curve
uses ATMs may far exceed that which uses
will be reached, but the timing continues to
home information and banking services.
be uncertain. The problem becomes one of
Further, the level of maximum penetration closely monitoring developments in the finan-
may vary with time. As technology evolves cial service industry to identify those areas
and its costs continue to drop, and as the prod- most likely to reach a critical mass and to
ucts are funded, the proportion of potential assess on an ongoing basis the benefits and
users who actually become buyers may change. costs to society of the changes that are ex-
For example, the maximum potential market pected.
Chapter 5

Wholesale Financial Services


,

Contents

Page
The Role of Technology in Wholesale Financial Service Systems . . . . . . . 138

Products Available in Wholesale Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . 138


Asset and Liability Products. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138
Processing Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ......... 140
Information Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141
Nonprocessing Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141

Providers of wholesale Financial Services. . . . . . . . . . . . . . . . . . . . . . . . . . . 142

The Importance of Access to Data and to the Payments Mechanism . . . . 147

Future of Wholesale Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148

Tables
Table No. Page
7. Major Providers of Wholesale Financial Services . . . . . . . . . . . . . . . . . . . 139
8. Product Provider Mapping . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143-145

,/
.

Chapter 5

Wholesale Financial Services

Retail suppliers of financial services provide bank card organizations. On the other hand,
consumers with a variety of products and serv- VISA International actively markets its prod-
ices, including deposit-taking, securities bro- ucts on behalf of its members and is highly vis-
kerage, and credit extension. Wholesalers, in ible to the consumers. In this sense it can be
turn, provide a variety of services to retailers, viewed as a retailer of financial services.
services that may be grouped under two broad
headings. First are the wholesale products Wholesale and retail financial services will
that affect the balance sheets of the providers, continue to overlap in the future as the imple-
usually by converting assets from one form to mentation of advanced financial service deliv-
another (e.g., cash to notes receivable or vice ery systems tightens the coupling between the
versa). For example, institutions can purchase organizations that perform the various func-
debt instruments in secondary markets, or a tions that are required to deliver services.
bank may participate in a loan syndicated by However, for the moment, it remains use-
its correspondent. Historically, depository in- ful to describe wholesale and retail services
stitutions have always been suppliers and separately.
users of this class of wholesale services. They On the one hand, the earliest applications
have established and maintained correspond- of information processing and telecommunica-
ent relationships that have included such tion technologies were in the area of wholesale
features as loan participation and the opera- financial services much more than in retail.
tion of secondary markets for various debt in- Check processing and account maintenance
struments, without relying on automated services have been provided by third-party
processing. operators for years. Wire transfers of funds
A second class of wholesale products com- have been used since before the turn of the cen-
prises mainly processing and information serv- tury. On the other hand, there are wholesale
ices. Included in this group are check and services that are not particularly susceptible
credit card processing, general accounting and to automation. Arranging loan participations
account maintenance services, and communi- may rely heavily on telecommunications, but
cation services. This chapter describes the the process is not really automated.
wholesale financial products and services that
However, wholesale financial services are
are available, the organizations that partici-
not really separable from other financial serv-
pate in this segment of the industry, the role
ices that may benefit greatly from the applica-
of technology, and the trends that are pre-
tion of advanced technologies. Thus, policies
sently in evidence.
that are directed at changes resulting directly
Changes in the financial service industry from the application of advanced technologies
have shaded the fine lines between wholesale to the entire financial service industry are also
and retail services. For example, from the likely to impact wholesale financial services.
point of view of each organization that issues Therefore, it is important that the reader who
a VISA card, VISA International, the parent is concerned with developing policy for the fi-
of the VISA service, is a wholesaler that pro- nancial service industry be aware of the full
vides the interchange services that are essen- range of services provided by the financial
tial to the operating concepts embodied in service industry.

137
138 • Effects of Information Technology on Financial Services Systems
——.—. —.

The Role of Technology in Wholesale


Financial Service Systems
The financial service industry was one of the mation processing equipment and the increas-
early users of advanced technology for prod- ing availability of low-cost software packages
uct delivery. Transaction volumes of checks has brought within reach the decision support
and credit cards now exceed the industry’s systems and other capabilities not previously
ability to process transactions manually, and available to small institutions. (The large sys-
the increasing time value of money and the tems for transaction procession and general
variety of alternatives for investment have accounting are not included in this group as
placed a premium on the ability to move funds they can be developed and supported only with
and information rapidly and accurately over significant resources.)
wide geographic areas. Even for small orga-
nizations, the accessibility of economical proc- While all organizations need access to tech-
essing services has been crucial for survival. nology, not all have to develop processing ca-
pabilities within their own organizations. The
Most of these processing services could not
problems of processing and other aspects of
be delivered without the availability of the ad-
marketing and delivering services are largely
vanced communication and information proc-
separable. Managers of financial service pro-
essing technologies. Further, because of the
viders are faced with the same “make or buy”
heavy dependence of service providers on
decisions that confront those responsible for
these technologies, firms with expertise cen-
a manufacturing facility. A depository insti-
tered in the technologies rather than in the de-
tution can either generate a loan portfolio
livery of financial services have recognized and
through its own efforts, or it can participate
developed opportunities in the financial serv-
with others who undertake the active market-
ice industry as providers of wholesale finan-
ing of credit services. Additionally, an orga-
cial services. In addition, communication and
nization can acquire and support the facilities
information technologies have made possible
necessary for performing the data processing
the extension of wholesale financial services
entailed in delivering financial services, or it
products to include features that could not
can buy those services from third parties. Fur-
have been offered without the technologies.
ther, just as merchandisers can setup an orga-
Historically, the costs of establishing and nization to buy in quantity for a group, finan-
maintaining the processing capabilities re- cial service providers can realize economies of
quired to support the delivery of financial serv- scale and scope by joining a consortium, or
ices have been beyond the means of many network, that establishes an organization to
retailers. Now, however, the low cost of infor- perform transaction processing.

Products Available in Wholesale Markets


Asset and Liability Products main in a position to provide additional financ-
ing to retail customers. If this were not possi-
The asset and liability products shown in ble, retailers would be solely dependent on the
table 7 include those where the wholesaler ac- generation of new liabilities (deposits from
quires an asset from the retailer, generally in their customers) to meet demands for credit
exchange for cash. These services allow the from the markets served. Thus, the ability to
retailer to turn over its portfolio and thus re- place assets in secondary markets is key to

Ch. 5—Wholesale Financial Services ● 139


— . — _— — ——. ———

Table 7.—Major Providers of Wholesale enabling the financial service industry to in-
Financial Services termediate between those with funds to invest
Nonbank and nonfinancial service company third-party and those who require funds.
processors:
ADP In this context, commercial firms that sell
EDS their receivables are users of wholesale finan-
Decimus cial services. Using these services, manufac-
Control Data
CSC/lnfonet turers and merchants are able to obtain the
FDR (AMEX subsidiary) working capital needed to support their inven-
Financial service institutions, joint syndications, and tories of end-products, work in progress, and
proprietary T&E cards: raw materials.
Rocky Mountain Bank Card (PLUS)
CIRRUS The originator of a loan may, under some cir-
VISA
Master Card cumstances, sell the debt in the secondary
American Express market while retaining the rights to service
Nonprofit or governmental service or network providers: the loan. In this way, the capital is turned
Swift over, but the originator of the loan continues
Federal Reserve
Federal Home Loan Bank to benefit from a stream of fees paid by the
Bank Wire holders in due course. In turn, the borrower
New York Clearing House benefits by continuing to deal with the orga-
Banks, other depository financial institutions, and nization that originated the loan throughout
associations:
First Interstate Bancorp its life, even though it no longer holds the
Bank One debt in its portfolio. Of course, the opposite
Citi-Bank situation, where the original lender retains the
Chemical Bank
Bank of America debt and buys processing services from
CUNA another organization, can occur; or the origina-
California Credit Union League tor may sell the loan and retain none of the
GESCO
Mid Continent servicing functions.
Dataline
Small loan companies, on the other hand,
Other industry groups:
Brokerage firms: will place commercial paper in the wholesale
Merrill Lynch markets and use the proceeds to support their
E, F. Hutton lending activities. Because they can borrow
Paine Webber
Retailers (including grocery chains): large amounts at favorable interest rates and
Sears receive a relatively high yield on their loan
J, C. Penney portfolios, a favorable spread is generated that
Montgomery Ward
May Co. can cover both their operating expenses and
Federated Department Stores a profit.
Safeway
Kroger At times, a lender will have the opportunity
Insurance: to place a loan that either exceeds the funds
Prudential Insurance Co.
Equitable Life Insurance available or creates an unacceptable risk in
Aetna Life Insurance that the amount to be lent would be excessive-
Consumer finance corporations: ly great relative to the net worth of the orga-
Beneficial Corp
Dial Corp. nization. Regulations also limit the size of a
Mortgage Brokers: loan that can be made to any other borrower.
Loomis & Nettleson Under these circumstances, the lender may
Trust Companies:
Trust Co,. of the West syndicate the loan by obtaining contributions
SOURCE ICS Group Inc Harbor City, Calif from others that will spread the overall risk
140 . Effects of Information Technology on Financial Services Systems

and make available sufficient funds to meet sources to develop and operate such systems
the needs of the borrower. Also, banks, as part internally, and others choose not to undertake
of their relationships with their correspond- such activities. Instead, they turn to third par-
ents, will routinely allow the correspondents ties, many of whom are not conventionally
to participate in loans that they place. Insur- classified as financial institutions, to provide
ance companies behave in much the same way the processing capabilities required. Retailers
when they share indirect placements and ask of financial services decide on the degree to
or permit others to share in the underwriting which they will be vertically integrated and
of casualty coverage. Securities dealers form turn to wholesalers for those services they can-
syndicates to underwrite offerings of debt or not or choose not to provide for themselves.
equity instruments.
Clearing and settlement are elements criti-
cal to the operation of a system that supports
Processing Products the delivery of financial services. At present,
only depository institutions have in place a
As noted, the delivery of financial services system for clearing cash items involving the
depends heavily on the processing and trans- transfer of money between virtually any par-
mission of large amounts of data. For all prac- ties in society. Specialized systems, such as
tical purposes, the application of advanced in- those operated by the airlines for settling fees
formation processing and telecommunication for services provided to holders of tickets
technologies has become mandatory. issued by others, by securities brokers for set-
Among the processing products offered by tling stock and bond transactions, and by oil
the providers of wholesale financial services companies for accounting for balances of crude
are the processing of checks and credit and oil moved between them, exist; but not with
debit card drafts; the processing required to the wide area of applicability found in the sys-
support all types of depository products; and tem operated by the depository institutions
information services, such as credit/check for settling on money transfers. On the other
authorization and economic data and models hand, there is no reason why alternatives for
that are used for analysis and decision sup- settling money transfers that would not in-
port. Also included is the processing required volve the depository institutions could not be
to consolidate and disburse funds as part of established. Systems supporting the opera-
offerings of cash management services. tions of the nonbank credit cards provide one
such example.
Transaction processing facilitates the execu-
tion of an order given by the owner of an ac- Some wholesale products exist because of
count to credit or debit it. For all practical pur- structural constraints within the industry. As
poses, from the point of information flows that noted, depository institutions are the only
are created, the type of accounts posted dur- ones that have access to the payments mech-
ing the transaction is immaterial. In fact, ma- anism. Therefore, when others offer products
jor bank card processors use the same systems such as cash management accounts that give
to process debit and credit card transactions, the retail user the ability to write a draft
and only the customer and financial institu- against the account, arrangements must be
tion that holds the customer’s account knows made with depository institutions for payment
whether a line of credit or a demand deposit of the draft through the payments mechanism.
account or other type of account is debited. The same type of arrangement holds for or-
ganizations that offer or accept one or more
For this assessment, the critical point is that of the major bank credit cards. Thus, any secu-
the systems used to process orders against ac- rities dealer or private association that makes
counts are large and complex and are there- arrangements to issue a bank card and any
fore expensive to build, operate, and maintain. organization that accepts the bank card must
Hence, many organizations do not have there- arrange for clearing or payment services
.— ... —-— .—..

Ch. 5—Wholesale Financial Services ● 141


———.——————— — — . . . —— — -

through a depository institution. Only one programs, and other support services used by
retailer has been given direct access to a ma- retailers. As the capability to develop gener-
jor bank card network, and the rules of the alized software packages increases and users
card-issuing organization have been changed recognize that most organizations can make
to preclude another nondepository institution use of generalized packages, as opposed to de-
being granted such access. veloping unique application systems for them-
selves, the importance of the products pro-
Information Products duced by this segment of the wholesale
financial service industry will increase.
Financial data provide the basis for decision-
making for individual organization and for the Also included in this group are communica-
economy as a whole. Treasurers for both pri- tions services that are particularly oriented to
vate corporations and public agencies must the needs of the financial service industry.
have knowledge of the funds available to them However, more often than not these are gen-
and the demands being placed on them. They eral-purpose communications facilities that
must be able to consolidate easily those funds can be used for any number of applications,
collected over wide geographic areas and to and only the fact that the operators make a
disburse them so that they meet obligations specific point of marketing them to the finan-
for payment. Opportunities for investing idle cial service industry sets them apart from
funds must be identified and exploited. These others and warrants that they be mentioned
services together compose what are commonly in the context of this assessment.
offered as cash management packages. Other Firms that provide wholesale processing/fa-
processing services, as shown in table 7, that cilities management services can be placed in
depend heavily on the corporate data of the one of four subclasses. First, there are those
individual client organizations are also offered that take all responsibility for system opera-
by wholesale financial service providers. tions and operate their own facilities apart
At a broader level, financial service organi- from those of their clients. Second, some pro-
zations collect and market a variety of data viders sell or lease software or equipment, and
used in decision support systems. Some also the users take all responsibility for day-to-day
provide modeling and other prepackaged ca- operations. In this case, services from several
pabilities that can be used to analyze data. In wholesale providers may be combined in a sys-
some cases, completely developed models that tem designed to meet the needs of the client
can be used for experimentation by the users organization. Third, some providers offer
are offered; in others, facilities that enable the “turnkey” services in which they design and
user to build, estimate, and validate models install systems for their clients and then turn
uniquely designed for a specific purpose are them over to the clients, who take over day-
provided; and in still others, both capabilities to-day operations. In the last category are
are available. those offering facilities management services
where the service provider effectively takes
over the operation of the processing depart-
Nonprocessing Services
ment of the client organization, even though
Some wholesale financial services entail no the department may be physically located in
processing capabilities. These services gener- the client’s facilities.
ally include provision of equipment, computer
142 ● Effects of /formation Technology on Financial Services Systems
— — ——— .— —.

Providers of Wholesale Financial Services


The list of firms comprising the providers gages and merchant and producer receivables
of wholesale financial services is quite diverse. created by others.
Table 7 demonstrates this diversity, listing
major categories of providers of financial serv- The degree of horizontal integration per-
ices and citing specific examples of firms fall- mitted commercial banks is limited. By law,
ing within each group. Table 8 shows which commercial banks can underwrite neither cor-
classes of firms provide each of the various porate equity issues nor life or casualty insur-
classes of services identified in table 7. It ance other than creditor life insurance. Secu-
shows the breadth of the product lines offered rities trading is limited to ordering trades for
by each of the various classes of firms active the convenience of bank customers or the oper-
in the financial service industry and the de- ations of trust departments. Commercial
gree of competition between the very diverse banks are not authorized to offer investment
firms that are providers of wholesale financial advice regarding securities to their clients.
services. Further, they are permitted to offer data proc-
essing services to others only to the extent
Examination of table 7 shows that there is that such services are incidental to the busi-
considerable opportunity for both vertical and ness of banking. While recent rulings by the
horizontal integration for providers of whole- Federal Reserve Board (e.g., the CitiShare
sale financial services. On the other hand, the case) have broadened the scope of permitted
existence of a variety of specialized firms activities, commercial banks and bank holding
argues that, until now, the economics govern- companies are not free to offer the full range
ing the operation of providers of wholesale fi- of data processing and communication prod-
nancial services has not encouraged either ver- ucts that they could conceivably market.
tical or horizontal integration. While some
argue that either pattern of integration offers On the other hand, even in the face of exist-
significant economies of both scale and scope, ing restrictions, the degree of horizontal in-
alternatives exist for achieving both econ- tegration of commercial banks and other de-
omies. Notably, competitors in the market- pository institutions is increasing. Some now
place are able to join in the creation of whole- offer discount brokerage services, and others
sale services while maintaining an active are developing connections with insurance
competitive environment based on end-prod- companies or are setting up subsidiaries that
uct differentiation in retail markets. can offer insurance under the laws of the
States in which they are chartered.
Large commercial banks provide examples
of vertically integrated operations. They per- Some merchandisers are also entering the
form check processing, operate credit and market with a very broad range of financial
debit card systems, and support networks of service products. One provides retail credit
automated teller machines (ATMs), some of service in direct support of its merchandising
which are strictly proprietary, while others are activities, a full line of insurance services, real
shared and may permit access by thrift insti- estate and securities brokerage, and, in a lim-
tutions as well as by other commercial banks. ited number of States, deposit-taking through
Some have arrangements with nonbank issu- subsidiary thrift institutions. Yet even though
ers of either credit or debit cards to provide this organization appears to be moving toward
the required interface with appropriate clear- horizontal integration, only a minimal level of
ing and settlement networks. Loan participa- coordination has been achieved between the
tion and clearing accounts are offered to cor- various constituent elements, and, therefore,
respondents. Also, they provide secondary the degree of horizontal integration achieved
markets for debt instruments, including mort- to this point appears to be minimal.
Ch. 5— Wholesale Financial Services ● 143

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144 ● Effects of /formation Technology on Financial Services Systems

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.,... ,.. ,..,.,. (7i ::,

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&i
Ch. 5—Wholesale Financial Services 145 ●

ISflJl x x x

——. —

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x

— ——

— ——. — — —
t–––
! a3ueJ nsu i x x x

L-- ‘- — —

x x x x x Xxxx x x x Xxxx x l

x x x x

— —
suolie130ssv


x x x
ueol pue s6ulheS

g
r- —

r-
n saueq le13Jawo: x x X x x x x x x xxx x x x x x
-1

paseq aaj
f\JL?d 13Jlu~ PUE x x x x Xxxx X x x x x x x x X x x x x x
I luapuodsaj]o~ SHUW
ail .—

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tiuefj
xx x x x X x x x x x x

II sa3(AJas
x x Xxxx x x x x x x Xxxx x x x x x x x
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146 Effects of
● Information Technology on Financial Services Systems
. — — — — —. —- . —

In another area, one of the major providers purchase and sale of Government securities.
of a nonbank credit card has become one of the It is a major factor in the clearing of checks
largest wholesale providers of card processing and a provider of currency and coin to the
services to others. This provider also offers an banking system.
extensive package of traveler’s checks and
The national system of automated clearing
card-oriented credit services through partici-
houses (ACHs), except for the one in New
pating commercial banks and thrift institutions.
York, is owned and operated by the Federal
Among the nonbank providers of wholesale Reserve System. Recently, ACHS have broad-
financial services are those that operate com- ened their capabilities to process individual
munications facilities, networks of ATMs that customer-initiated transactions. The bulk of
are shared among various depository institu- the traffic handled by ACHs is generated by
tions, and independent processors, with roots the Federal Government in the form of payroll
more in the information processing industry and payments to recipients of entitlements,
than in the financial service industry. With its such as social security.
divestiture, American Telephone & Telegraph The role of the Federal Reserve in these mar-
will be able to provide enhanced services spe-
kets has been controversial for some time.
cifically tailored to the financial service indus- Even though Congress mandated that the
try. However, it will have to compete with
Federal Government recover the full costs of
other telecommunications carriers, banks, and
providing services, some argue that its pric-
others that already operate in this market if
ing still puts private suppliers of alternative
it chooses to enter. Operators of food chains
services at a disadvantage. Some also see an
and others are installing ATM networks and
inherent conflict of interest between the Fed-
inviting the depository institutions to join
eral Government as a supplier of services on
them. This trend has raised the thought
the one hand and as a regulator of the insti-
among some bankers that they may not be
tutions that are its customers on the other.
able to retain their control over the payments
system in the long run. Finally, as shown in The Federal Reserve is charged with ensur-
table 8, various data processing service bu- ing the orderly movement of funds nationwide
reaus and software suppliers meet the needs in order to provide a healthy climate for com-
of significant portions of the financial commu- merce. In some areas it is meeting with com-
nity for processing services, and there are petition. However, in others, such as providing
some indications that they would like to ex- service to institutions in remote areas that
pand their role in the future. cannot profitably be served by the private sec-
tor, it continues to meet a real need.
The Federal Reserve System occupies a
unique role as a provider of wholesale finan- Volumes of checks processed by the Federal
cial services. It is a lender of last resort to de- Reserve declined after the institution of pric-
pository institutions in need of funds to meet ing for services. Also, there is a movement to
reserve requirements. Through the Open Mar- separate ACH operations from the Federal
ket Desk at the Federal Reserve Bank of New Government. Therefore, its future role as an
York, it markets Federal Government debt active participant as a provider of financial
and implements monetary policy through the services is open to question.
.—

Ch. 5—Wholesale financial Services ● 147


The Importance of Access to Data


and to the Payments Mechanism
Since only the depository institutions have could make it impossible for a company to re-
access to the payments mechanism for the main in business.
transfer of funds, all other institutions must
In general, the trend to greater reliance on
work through them. For example, money mar-
advanced information processing and telecom-
ket mutual funds, on which customers can
munication technologies in support of systems
write drafts, conventionally maintain a zero-
for delivery of wholesale financial services will
balance account with a depository institution
continue indefinitely into the future. To some
that is funded at a level sufficient to cover the
extent, those providers of wholesale financial
drafts presented each day. They then use
services who do not perform processing inter-
transaction data supplied by the depository
nally will become more dependent on the prod-
institution to post appropriate debits against
ucts of others, and therefore may lose some
customer accounts.
of the flexibility in designing and operating
On the other hand, the depository institu- systems for delivering financial services that
tion can have available to it virtually all of the they now enjoy. Greater shared use of process-
financial data of its customers because all pay- ing systems, driven by the economics of sys-
ments transactions pass through its hands. tem development, deployment, maintenance,
Because it has access to the data and the and operation, will mean that competition be-
means to act on them on behalf of the cus- tween the various producers of financial serv-
tomer, some argue that depository institutions ices will, in the future, be based on factors
occupy a unique place that puts potential com- other than the features of the processing sys-
petitors at a significant disadvantage. The tems used by the competing organizations.
argument follows that restrictions are neces-
Finally, both the providers and users of
sary on the operations of depository institu-
wholesale financial services are more accus-
tions with regard to the information process-
tomed to dealing with advanced technologies
ing services they may offer so that they will
than consumers are. These organizations have
not benefit unjustly from the position they en-
for years been using technology-based applica-
joy. Thus, at issue is the degree of access these
tions, such as cash management services, that
organizations have to a customer’s data, and
will not be significant in the consumer mar-
the payment mechanism and the relative ad-
ketplace for many years. Therefore, for those
vantage the firm enjoys in the marketplace.
who operate in wholesale financial service mar-
To the extent that wholesale financial serv- kets, future changes will not be as traumatic
ices can be provided only with the support of as they may be for the remainder of the pub-
advanced technologies, a point of no return lic that is generally not accustomed to deal-
has been passed in which the only possible ing with relatively sophisticated systems.
backup to an automated system is another Thus, the changes that take place in the whole
automated system. Further, in this environ- sale services are less likely to attract wide-
ment, all providers of the services need access spread attention than those provided to the
to the technologies, and lack of such access general public at retail.
148 ● Effects of Information Technology on Financial Services Systems

Future of Wholesale Services


Although much attention has been focused have put pressures on operating margins that
on the entry of new types of providers of fi- will stimulate all providers of financial serv-
nancial services into retail markets, the ices to take whatever steps are required to im-
maturity of participation in wholesale markets prove productivity. Since only limited num-
by nontraditional financial service providers bers of institutions are in a position to support
is proportionately much greater. Since finan- major new product development efforts, many
cial service firms have established a high de- will look to third parties to create the capa-
gree of sophistication in the use of the tech- bilities that are needed.
nologies and they are more familiar with the
operational requirements of the industry than Banks and other traditional providers may
anyone else, those with adequate resources be expected to extend their customer base out-
and the inclination to do so will remain sig- side of their traditional boundaries. Holders
nificant factors in the market for wholesale fi- of financial assets are in a position to argue
nancial services. On the other hand, because that they have both the knowledge to build
the information processing and telecommuni- the capabilities needed by their customers and
cations industries have developed the exper- immediate access to the data used by the
tise to analyze and meet the requirements of system.
others, firms not ordinarily identified with the
financial service industry will increasingly On the other hand, data processing service
challenge traditional financial service firms in organizations can marshal many of the same
the market for wholesale services. arguments as banks to claim that they are in
a position to provide a wide range of payment
The introduction of advanced networking and information services to a broad client
has broadened existing relationships between base. However, they are somewhat limited in
providers of financial services to include the their ability to offer complete payment sys-
new products and services that have become tems because they can initiate payments only
available. For example, a bank will contract through a financial institution that has access
with a securities dealer to clear drafts that are to the payments mechanism.
processed through the payments systems in
addition to providing the more traditional In the long run, however, processing tech-
banking services. Institutions that have nology is neutral; and the ability to succeed
benefited internally from investments in sys- as a provider of wholesale financial services
tems incorporating advanced technologies to depends on the level at which requirements are
increase productivity, have often offered them understood and operationally viable systems
on the open market to others who, in turn, are implemented. Systems that meet the needs
have also been able to increase productivity. of the users and are supported adequately will
succeed in the market regardless of where the
On the other hand, developers of new prod-
processing is done. As improved processing
ucts try to benefit from the revenue generated
technologies become available, providers of
by franchising those products to others. The
wholesale financial services will adopt and
franchisees benefit because they do not have
market them. Adoption on the wholesale side
to incur the costs of designing and develop-
of the financial service industry will be more
ing the systems to support new product offer-
rapid than on the retail side because changes
ings. One major money center bank is follow-
in wholesale services are less likely to be visi-
ing this strategy in offering its home banking
ble to the end-users. Competitive impact in the
service to banks nationwide.
retail market will be minimal because there
These types of relationships will continue will be little, if any, requirement for consumers
into the indefinite future. Economic conditions to change their behavior patterns.

Ch. 5—Wholesale Financial Services ● 149


— . ————. .— —————...—— —

Increasing use will be made of telecommuni- various institutions operate somewhat inde-
cations to deliver financial services, and there pendently of one another, with the major as-
will be new opportunities for telecommunica- sociations providing facilities for interchange.
tion providers to function as providers of On the other hand, American Express has im-
wholesale financial services. In addition to pro- plemented a major network that takes advan-
viding neutral communications capabilities, as tage of ATMs installed by participating
they have in the past, they are in a position banks. Money can be accessed from any finan-
to offer enhanced services to the financial serv- cial institution designated by the customer;
ice industry. Some may position themselves and American Express moves funds from the
as operators of networks and provide gate- institution holding the customer’s account to
ways between these networks and others. the one that has dispensed the funds.
Transaction interchange could become a ma-
jor area of activity. Food retailers that install Developers of the information utilities now
and operate ATM networks also fall in this becoming operational are in general agreement
category. that financial services will comprise a key ele-
ment of the packages to be offered. Informa-
Technologies that offer opportunities for by- tion providers are positioning themselves as
passing telephone companies that provide gateways to financial service providers, and,
local service have considerable potential for therefore, are functioning in a wholesale capac-
providers of financial services. Already, a ity. They contract with retail providers who
television cable from central Manhattan to the define the services that will be provided
Wall Street area carries considerable traffic through the information utility. Subscribers
generated by providers of financial services. to the information utility are then able to se-
The teleport concept being implemented in lect the retail financial service packages to
New York and considered elsewhere offers the which they will subscribe. Such arrangements
opportunity for bypassing both local and long- complement shop-at-home and travel arrange-
distance carriers. Since the switched telephone ment services that may also be offered through
network is not particularly suited to carrying the information utility.
large volumes of data traffic, and costs for
local communication are expected to increase People who have evaluated the market for
significantly in coming years, bypass technol- home information services now generally agree
ogies and those that offer them will be an im- that no one product offered by itself will be
portant factor in the development of the finan- viable. The packaging of financial services
cial service industry. with other information and, possibly, enter-
tainment products will be critical to the suc-
Conceivably, the major long-distance car-
cess of services that distribute information to
riers will become significant providers of
the home. Various types of firms will assem-
wholesale financial services, with offerings
ble these packages and, in effect, will be pro-
that range from networks dedicated to specific
viding the wholesale functions. Some, as in the
users to networks that include the processing
case of Knight-Ridder, will be publishers that
required for online, real-time clearing of pay-
assemble and perform much of the marketing
ment transactions. The switches that run
for the products of various providers. Others,
these networks are computers capable of per-
like Chemical Bank, may be the creators of one
forming the processing required to provide the
part of the service and assemble other parts
clearing function.
of the package from offerings of other sup-
Given the evolution of regional ATM net- pliers. Still others may provide a totally neu-
works, the focus of nationwide service could tral communications service that provides
be the facilities that provide for interchange paths to many providers and the opportunity
between networks rather than the develop- to interchange information between them.
ment of monolithic networks that cover the Such a service would rely on each provider to
country. This outcome would generally follow perform all of the marketing and other activi-
the model of the bank card systems, where the ties required to support its customers.
Chapter 6

The International Environment for


Financial Services
9

Contents

Page
Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153

The Growth of International Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153


New Directions in International Banking. . . . . . . . . . . . . . . . . . . . . . . . . . 154
Multinational Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155

Financial Markets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157


Money Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157
International Financial Information Systems . . . . . . . . . . . . . . . . . . . . . . 157

International Interbank Communications . . . . . . . . . . . . . . . . . . . . . . . . . . . 158


New York Clearing House Association . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158
Society for Worldwide Interbank Financial Telecommunication . . . . . . . 158

The Effects of Technology on International Payment Systems . . . . . . . . . 161


Corporate and Retail Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161

Vulnerability of the Financial System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162


Security and Integrity of the Financial System . . . . . . . . . . . . . . . . . . . . 163
Error Resolution in International Electronic Funds Transfer . . . . . . . . . 163
Foreign Telecommunications and Information Policies . . . . . . . . . . . . . . 163

Figures
Figure No. Page
12.Daily System Traffic Volumes (average: end of year) . . . . . . . . . . . . . . 159
13. Cumulative System Volumes (end of year) . . . . . . . . . . . . . . . . . . . . . . . 159

.
Chapter 6

The International Environment for


Financial Services

Introduction
The economies of the world have become sary that they establish a presence, either
increasingly interdependent trading econo- through a branch or an affiliate. A final reason
mies. The financial service industry supports for multinational branching by U.S. banks,
these activities by providing the means to was that regulation, taxation, and supervision
transfer payment for goods and services pur- of institutions in other nations was more often
chased internationally and by acting as an in- favorable to the conduct of their business.
termediary between those nations with excess
In the past 20 years there has also been a
funds and those in need of funds. As the econ-
number of new entrants in the field. Smaller
omies of individual nations become more in-
banks have been able to participate in inter-
tertwined, the role of the financial service in-
national finance through the use of innovative
dustry becomes more important to the world
lending arrangements. Nonbank financial
economy.
service providers have developed large, inter-
Changes are taking place in the structure of national networks to facilitate retail flows.
financial markets as well as the structure of SWIFT (Society for Worldwide Interbank Fi-
the industry and its participants. Commu- nancial Telecommunication), a network estab-
nication and information technologies have lished by the banking community to facilitate
helped to make markets that were once local international interbank transfers, is on the
or regional in character, global. Funds travel verge of offering traditional bank services, per-
across national boundaries with such ease that haps in direct competition with its founders.
disequilibrium is offset. This flow of funds These relationships rely heavily on both the
became increasingly evident in the 1970’s with
flow of information and the international
the excess capital available from oil-rich
transfer of funds. Information technologies
nations.
therefore found early application in the inter-
Separate from, but related to, changes in fi- national financial arena, beginning with the
nancial markets are the structural changes telegraph. It is difficult to assess and identify
taking place in the industry itself. During the the individual impacts of the technologies on
rise of multinational corporate activity in the this segment of financial service activities,
1960’s and 1970’s, banks moved abroad to fol- since the use of the technology is so prevalent.
low corporate customers. In addition, banks In many ways much of the activity in the in-
found that in order to insure access to many ternational financial markets could not occur
of the foreign money markets, it was neces- without the technology.

The Growth of International Banking


Post-World War II developments in capital in turn expanded the role of the private bank-
movement and the restructuring of the foreign ing community to support these trade flows.
exchange system helped foster trade, which Moreover, the development of multinational

153
154 ● Effects of Information Technology on Financial Services Systems
————

corporate activity expanded the need for finan- R. M. Pecchioli, in a recent OECD report,
cial services connected with direct investment attributes the evolution of international bank-
operations and established new requirements ing’s structural features to a number of fac-
for the conduct of multinational business. tors: changes in the international economic
and financial environment, the evolution of
At first, international financial activities ex-
demands for financial services by borrowers
panded in traditional ways: through the ex-
and investors alike, and the spreading of tech-
change markets and accepted ways of inter-
nological facilities.3 The events of the 1960’s
national lending. Eventually, the movement
were, for the most part, the result of the grad-
to increased internationalization of financial
ual recovery of the world economy from the
activity was supported by changes in bank
devastation of war, and the liberalization of
strategy and management and by institutional
trade. The 1970’s, however, brought major
and structural changes in international money
structural changes to the world economy;
and credit markets.
world payments balances became more severe,
By all counts the growth of international and there were major structural changes in the
banking has been phenomenal. The Organiza- international payment and financial systems,
tion for Economic Cooperation and Develop- all of which gave banks a pivotal role in inter-
ment (OECD) has compiled figures on the national financial intermediation.4
growth of international banking in developed
nations over the last two decades. Although New Directions in
there is no comprehensive measurement for International Banking
world banking activity, and many measure-
ments of this activity include double-counting It is impossible in this report to provide a
and inflated figures, the gross figures and the comprehensive survey of all the changes in in-
net figures (which should eliminate the double- ternational banking techniques; rather, impor-
counting) are strikingly similar. In the period tant product innovations will be highlighted,
from 1975 to 1981, net international bank along with the entry into new markets.
lending increased by an average annual rate
of 23.9 percent, while the net size of the Sources of International Funding
eurocurrency market* increased by 21.6 per-
International banking strategy does not
cent. Although the figures for this period show
generally distinguish between domestic and in-
considerable growth, the eurocurrency mar-
ternational funding, since, for the most part,
kets experienced their greatest growth from
banks will follow an overall assets and liabili-
1965 to 1970, when average annual changes
ties management policy. Two major sources
were 37.7 percent.l
of funding in the international market are the
Similar statistics illustrating the relative im- certificate of deposit (CD) and the floating rate
portance of foreign business of banks show note (FRN). CDs are negotiable receipts for
that the average growth of foreign business large deposits; they have been used in the
for OECD banks as a whole has been from 12.1 United States for many years and in the Euro-
percent of assets in 1970 to 23.7 percent of dollar market since 1967.5 London is, by far,
assets in 1981, and from 11.3 percent of liabil- the leading center for CDs. In 1981, foreign
ities in 1970 to 23.4 percent of liabilities in currency CDs issued by London banks totaled
1981. 2 more than U.S. $75 billion, most of which was
actually denominated in dollars.6 FRNs, which
——— are borrowing instruments used by banks,
*A eurocurrency is a deposit account at a European bank
denominated in a currency other than that of the host bank.
‘R. M. Pecchioli, ‘Z’he Internationah”sation of Bd”ng: The ‘Ibid., p. 17.
Policy Issues (Paris: Organization for Economic Cooperation ‘Ibid.
5
and Development, 1983), p. 16. 6
1 bid., p. 28.
‘Ibid., p. 19. Pecchioli, op. cit., p. 28.

Ch. 6—The lnternational Environment for Financial Services ● 155

have a position of slightly less importance in Syndicated lending is the process by which
international funding, although recently their very large amounts of funds are raised by al-
importance has grown. Generally FRNs allow lowing the participation of a number of banks.
banks to secure funds for longer terms than The benefit to the borrower is that these funds
those available through the deposit market.’ can be raised through a single operation. The
benefit to the lender is that risk is spread
A unique aspect of international funding,
among many banks, and institutions that
however, is the reliance on interbank deposits
could not undertake such a loan on their own
as a major source of funds. Although it is dif-
can participate. 10
ficult to measure, the interbank market is by
far the largest source of international funding. The current “international debt crisis, ’
Recent estimates place this market between where developing countries are unable to
two-thirds and three-quarters of total exter- repay their loans to developed nations, has
nal and eurocurrency liabilities of reporting brought generally into question the risk of in-
banks, or close to U.S. $1,000 billion.a What ternational lending and, specifically, the role
is not reflected in these figures is that the vol- of syndicated lending in exposing a greater
ume of trading is very heavy, reaching the pro- number of institutions to risk. It became clear
portions of the foreign exchange markets. The that smaller banks were becoming involved in
effects of information and communication international lending. It is not possible to ad-
technologies can be readily observed in this dress, in the scope of this report, the issue of
area. They are reflected in the high velocity the possible mismatching of liabilities and
and volume of trading, as well as in the par- assets that can occur as a result of loan syn-
ticipation in the wholesale market of many dication and the subsequent risk and foreign
smaller, nonmoney center banks.9 loan exposure. Instead, the extent to which
communication and information technologies
International Lending contribute to the situation should be noted.
During the 1970’s there was a rise in the Technologies affect the ease with which
willingness of private banks to finance devel- banks can become involved in international
opment projects. Much of this came about as lending. These same technologies may also
a result of the inability of domestic markets help in better monitoring and control of inter-
to absorb excess capital. Recently, the multi- national debt and repayment, helping to over-
lateral lending agencies, in particular the World come the international destabilizing effects of
Bank, have announced cofinancing projects, a major default. In response to the severity
in which private banks are allowed to partici- of the situation, and the possibility of major-
pate. These projects are thought to appeal to country loan defaults, a number of large multi-
smaller banks, which value the ability of the national banks established the Institute of
World Bank to assess the viability of devel- International Finance. The purpose of the in-
opment projects. stitute is to provide valuable risk information
about countries to member banks that are
Innovations have also occurred in the flex-
making loan decisions. The information is pro-
ibility of the structure of the loaned funds, as
vided to members via an institutional network,
well as in the markets approached. As banks’
using international telecommunication 1ines.
international assets have increased, their ap-
proaches to the marketplace have changed.
The most evident of these changes is in the Multinational Banking
development of international credits through Multinational banking can be loosely de-
loan syndication. fined as the branching abroad of banks. Mul-
“Ibid. tinational banking cannot be completely sep-
‘Ibid,
9
pp. 29-30.
Pecchioli, op. cit., p. 29; ,J. R. S. Revell, Banking and Elec- —. 10
tronic Funds Transfers, date, p. 156. Pecchioli, op. cit., p. 32.
156 ● Effects of Information Technology on Financial Services Systems

arated from the international activities of Offshore Banking


banks. (Much of what is described in the pre- Offshore banking is any banking activity
vious sections can and does take place in within a country’s borders, but outside its
branches of U.S. banks located outside of this banking system. There is considerable debate
country. ) Multinational banking developed as to exactly which nations of the world should
concurrently with international banking, but be considered offshore centers. For example,
has different causal factors. the City of London provides favorable condi-
The first movement of banks to set up tions for off-shore banking, although it would
branches in foreign countries was generally in not be a conventional member of the group
support of multinational corporate activities. considered off-shore centers. The United
As trade became more important and these ac- States first permitted the development of in-
tivities increased in the 1960’s, banks found ternational banking facilities (IBFs) in Decem-
it necessary to follow their clients abroad. ber 1981 in an attempt to bring back much of
Eventually, international banking grew and the Euromarket business, which had fled this
national economies and money markets be- country due to State tax laws and Regulation
came intertwined, and the banking community D. IBFs are banks located in the United
realized that its physical presence was neces- States, but because of the nature of their busi-
sary to secure and maintain market share as ness are not subject to some of the regulations
well as to participate in the developing finan- under which banks operate domestically. Both
cial markets abroad. U.S. banks and foreign banks operating in this
country can establish IBFs. They are estab-
During the past two decades this activity
lished through State and local laws and amend-
has increased considerably. The number of ments to Regulations D and Q and are simi-
overseas branches and agencies on a world- lar to an off-shore “shell” branch that operates
wide basis increased from 112 banks with on-shore.
4,390 branches in 1961 to 387 banks with
4,329 branches in 1978. ” The development of off-shore banking cen-
ters is facilitated by information technologies,
Methods of participation in foreign markets
which tend to make the industry less location-
include everything from full-service branches
sensitive. Nations have developed a sophisti-
to the establishment of “shell branches, ” cated communication system solely for the
which are booking offices located in foreign support of the financial service industry. This
countries that do not administer the business can encourage further migration of the players
carried on their books and have no contact out of more regulated environments, which in
with the local market. Each method has its turn makes it extremely difficult for the U.S.
benefits, depending on the motivation of the Government to implement policy and to con-
parent institution. trol the flow of funds in the United States.
—— 1l
Pecchioli, op. cit., p. 59. Pecchioli explains the seeming con- U.S. Branching Abroad
tradiction between the claim that multinational banking activity
increased and the actual number of overseas branches decreased. The movement of U.S. banks abroad co-
“In fact the decline in the number of total branches between incided with the multinationalization of Amer-
1961 and 1978 is an ‘artificial’ one in that it reflects a sharp
decline of branches of European banks (United Kingdom and ican corporations. However, there were added
French banks in particular) in African and a few Asian coun- incentives for U.S. banks to go multinational
tries which, following a policy of indigenisation motivated by that were perhaps not evident in other nations,
economic nationalism, introduced restrictive legislation and in-
duced takeovers by nationals during the period under re- in particular domestic, a regulatory structure
view . . . [T]his policy led parent banks to change the form of that restricted U.S. banks from branching out-
their presence in these countries from branches to affiliates. side of a limited geographic area and limited
If branches in these countries are excluded from the total, the
size of the global network more than doubled in the period under their potential market share in the United
consideration. States.
Ch. 6—The International Environment for Financial Services ● 157
—— —— —.—.———. —-. —.

Foreign Banks in the United States under the regulatory structure than were U.S.
bank branches. With the International Bank-
The number of branches and agencies of for-
ing Act of 1978 much of the so-called discrim-
eign banks in the United States increased from
ination against U.S. banks in their home mar-
34 in 1961 to 241 in 1978 and to 452 in 1983. ’2
ket was done away with. There is still some
Until 1978, foreign bank branches in the contention that the system does not treat U.S.
United States were treated very differently and foreign banks totally equally, but for the
———
12
-— ———— most part, foreign banks must abide by the
Pecchioli, op. cit., p, 59; ( 1961 and 1978) Federal Reserve same regulations as U.S. banks.
Board of Governors. 1983.

Financial Markets
Money Markets International Financial
Perhaps the most remarkable growth in Information Systems
bank use of foreign money markets as sources Computer-based business information sys-
of funds in the last 20 years occurred in the tems are finding widespread application in the
eurocurrency markets, financial service industry, particularly in in-
Banks’ rapidly growing involvement in ternational finance. A major figure in this area
euro-market business was largely by response is Reuters, the world’s oldest international
to two basic elements: perception of the profit news agency. Reuters Monitor provides infor-
opportunities arising from differential regula- mation on worldwide money markets to finan-
tory provisions applying to international and cial institutions via 15,000 terminals in 74
domestic business and increased reliance on countries. ’4 By far the leader in this service,
portfolio diversification as a means for reduc- Reuters competes with other nonbank finan-
ing risk exposure. Over the years, an addi- cial data providers in the United States and
tional stimulus to the expansion of euro- abroad, as well as with the information serv-
currency transactions was provided by the ices of financial institutions. The Reuters serv-
growing familiarity of customers, both depos-
itors and borrowers, with the peculiar tech- ice is unique in that, as a videotex system, it
niques of foreign currency operations and par- also provides the opportunity for the user to
ticularly by the proved depth and resiliency deal in the markets and may eventually allow
of the interbank markets in foreign curren- the user to confirm and complete deals using
cies. 13 a terminal.
The eurocurrency market provided banks in The information provided in these systems
countries with undeveloped money markets has always been available, it was just not
the opportunity to enhance the management readily accessible. In the case of the money
of their liquidity. The development of sophis- markets, the information provided by these
ticated interbank communication techniques services was not previously available in one
also had a significant effect on the ability of place. Often these services provided addi-
banks to participate in these markets. tional, useful information or information that
could be found elsewhere in newspapers or
Flexible exchange rates have enhanced the
reports. However, what was once useful is now
acceptability of the eurocurrency markets as
essential information, providing a competitive
‘‘substitutes’ for the foreign exchange mar-
edge to its user. This in turn has forced most
ket with respect to hedging.
—14 — — —
——
13
Paul Walton, “A Boon for the Money Markets, ” Financial
Pecchioli, op. cit., pp. 19-20. Times, Dec.
14, 1983, p. 28.
158 ● Effects of Information Technology on Financial Services Systems
——. .—— —... —. —

institutions wishing to be competitive to use need four or five different terminals. This situ-
the systems. Technology has provided the cat- ation is bound to right itself in the long run,
alyst for the growth of these systems. either by each organization’s having a central-
ized information function that feeds into its
An annoying side-effect of these systems is own data system, or by existing vendors of-
the proliferation of terminals and the incom- fering their services on compatible systems.
patibility of systems. A dealer, in order to have
access to a variety of information sources, may

International Interbank Communications


Much of the international banking activity cial telecommunication networks. SWIFT is
described in the preceding sections takes place not a financial organization nor a telecom-
via sophisticated international communication munication common carrier; instead, it is a
facilities. This is particularly true for inter- nonprofit cooperative society that links mem-
bank transfers of information and funds. As ber banks worldwide through a data process-
international banking has grown, so too has ing and transmission network. SWIFT owns
the importance of these functions. In recogni- and operates its own processing facilities and
tion of this, many of the large, money-center leases communication lines from national or
banks formed private telecommunication net- international carriers.
works to help ease some of the problems asso-
SWIFT was initiated by a group of Euro-
ciated with massive paper flows. Interbank
pean bankers who were searching for a better
transfers are generally high-value transfers.
way than mail or telex to transmit messages
to correspondent banks. In response to the in-
New York Clearing House Association crease in international financial volume in the
In 1970, the New York Clearing House As- 1950’s and 1960’s, a number of banks had
sociation began operating the Clearing House established internal communication and proc-
Interbank Payments System (CHIPS). CHIPS essing systems. These proprietary systems
was founded to help meet the need perceived usually connected only branches and affiliates
by a few of the large New York money-center of the banking groups, and therefore trans-
banks for an automated system. Since its in- actions involving a number of banks would
ception, CHIPS has been almost entirely auto- often rely on a paper-based system. Another
mated, although for a short period in the be- drawback of these proprietary systems was
ginning some of the clearing was paper-based. that they established a myriad of standards,
Although CHIPS has not stated any intention comparable to the different gauges of railroad
of expanding geographically, it is responsible track one still encounters when crossing some
for moving among banks an estimated 90 per- national boundaries. The creation of SWIFT
cent of the U.S. dollars exchanged in interna- was in response to the need to establish a rapid
tional commerce.15 communication and processing system, which
was universal and standardized, was for all in-
ternational interbank transfers and was avail-
Society for Worldwide Interbank
able to all banks. SWIFT was also seen as a
Financial Telecommunication way to compete with these intrabank commu-
SWIFT, founded in 1973 and operational in nication systems, particularly those of large
1977, is the largest of the international finan- U.S. banks but eventually also a number of
—.—— — smaller U.S. banks, in order to provide the vol-
“’’CHIPS: More Than Just a Clearing System, ” Transition, ume necessary to support the system.
February 1983, p. 20.
Ch. 6—The international Environment for Financial Services ● 159
.—— —— — — .— — ——

When SWIFT was incorporated in Belgium (see figs. 12 and 13).17 This represents about
in 1973, it was owned by 239 European, North four times the combined total transactions of
American, and Japanese banks in 15 countries. the two private sector bank payment networks
In its first year of operation, SWIFT averaged in the United States, Bankwire and CHIPS. 18
51,700 transactions per day. ” As of April SWIFT is not a clearing or settling network
1983, the SWIFT system served 1,063 mem- and does not read the messages as they pass
ber banks in 52 countries, of which 33 were through the system; therefore, the value of
operational countries, and processed an aver- these transactions is difficult to determine.
age of 360,000 financial transactions per day
16
SWIFT: Ten Years, special anniversary issue of the general 17
introductory brochure (Brussels, Belgium: Society for World- SWIFT, “Facts About SWIFT, ’4 April 1983.
18
wide Interbank Financial Telecommunication, May 1983), p. 25. ’’Executive Suite, ” Transition, January 1983, p. 2.

Figure 12.— Daily System Traffic Volumes (average: end of year)


}, II t ( II II I

-,1 1, I i ]{ II I

— — — . —
] y-- 51 -w ..1 ), I I II II 1

I I 11 ( I ,1 1( I

11

SOURCE SWIFT Ten Years special anniversary issue of the general Introductory brochure (Brussels Belgium Society for Worldwide Interbank Financial Telecom-
munication May 1983)

Figure 13.—Cumulative System Volumes (end of year)


\lll I 1( ) \ \

I -1$

1981 169.081 000

S O U R C E SWIFT Ten Years special anniversary Issue of the general Introductory brochure ( Brussels Belgium Society for Worldwide lnterbank Financial Telecom-
munication May 1983)
160 ● Effects of Information Technology on Financial Services Systems

U.S. traffic over the network is higher than nancial market.22 SWIFT management fore-
that of any other nation; in 1982 it was 17.7 sees a leveling off of revenue in this business
percent of total volume, an increase from the area and therefore plans to expand its revenue
1981 figure of 16 percent.19 Yet only 141 U.S. producing message traffic in other areas. In
banks participate in the system. Carl Reuter- 1982, SWIFT formed direct interface with the
skiold, SWIFT’s general manager, estimates CEDEL and Euroclear bond clearing systems
“that as many as 500 U.S. banks are involved and MasterCard International to use SWIFT
sufficiently in international banking to merit for transmission of transaction or settlement
SWIFT membership. ”20 information.
After 6 years of operation SWIFT is enter- SWIFT has also begun a controversial new
ing a new phase of operation. In 1982 it was program to offer new financial services, spe-
able to amortize completely the development cifically balance reporting. Many U.S. banks
costs of the network, and for the first year, view the proposed changes as potential com-
broke even. This has occurred even though petition for services that banks currently of-
SWIFT raised the basic per-message charge fer. However, if balance reporting does not
only once, to 18 Belgian francs (about 35 to lead to other types of cash management serv-
40 U.S. cents) .21 ices, these banks will not challenge SWIFT’s
entry into this business area. SWIFT manage-
SWIFT’s plans for expansion include an im-
ment maintains that the balance reporting
provement in technical transmission and proc-
service will be invisible to corporations and
essing facilities, commonly called SWIFT II.
will remain an interbank service. There is evi-
Plans are to install a new, more powerful com-
dence that although U.S. banks may be wary
puter system between 1985 and 1987 on a
of the changes, European banks may be en-
country-by-country basis. SWIFT will finance
couraging the implementation of these new
the new system internally from operating
services.
revenues.
Another service that SWIFT management
Although SWIFT enjoys a comfortable posi-
intends to expand is the provision of intra-
tion as the primary international financial
country financial communications.
transmission network in terms of volume, it
has continued to seek new business opportu- One of the primary achievements of SWIFT
nities. By September 1983, SWIFT estimated for international banking has been the stand-
that it offered its base service to approxi- ardization of international, interbank com-
mately 90 percent of the total international fi- munications. With respect to new services,
SWIFT intends to play the same role, thereby
helping to establish international standards
——
g
in cash management services,
‘ Robert Trigaux, “SWIFT Executives and Bankers Mull the
System’s Future, “ American Banker, New York, May 17, 1983,
p. 1. “B. Kok, “The Business Future, ” Proc&d”ngs From SWIFT
‘“Ibid., p. 31. International Banking Sem”nar(SIBOS ‘83), Sept. 26-30, 1983,
2’ Ibid., p. 31. Montreux, Switzerland, p. 12.
Ch. 6—The International Environment for Financial Services . 161
-.

The Effect of Technology on International


Payment Systems
J. R. S. Revell distinguishes between two their nature handle increased volume of pay-
classes of payments in his work, Banking and ments much better than paper-based systems.
Electronic Funds Transfers.23 Borrowing from
One of the distinguishing characteristics of
the work of J. M. Keynes, Revell separates in-
the international market is that, as in the do-
ternational financial flows into two categories:
mestic market, corporate customers demand
those involving the transfer of income and the
cash management services from financial serv-
payment for goods and services by nonfinan-
ice providers. The basic principle of these serv-
cial business and households, or the “indus-
ices is to maintain low operational balances,
trial circulation” (corporate and retail pay-
with the majority of funds invested and earn-
ments), and those involving foreign exchange,
ing interest. The impact of communication and
the money market, and the capital market, or
information technologies on the ability of a
“financial circulations. ” It is a useful distinc-
corporation to manage its financial position
tion when one is concerned with the impact of
is similar to that in the domestic market; i.e.,
the technology on payment flows, for it would
the manager is able to react immediately to
appear that certain characteristics of informa-
information and to adjust the corporate finan-
tion technology will have different effects on
cial position accordingly. The difference in the
the different types of flow. By using these two
international market is that these transfers
classifications, the specific impacts of the tech-
take place in multiple currencies and cross
nology can be defined more clearly.
many international boundaries. For the mul-
Information technologies have had a great tinational corporation, foreign exchange fluc-
impact on operations in both areas. The mech- tuations provide a great incentive for initiat-
anisms of these markets have been described ing electronic transfers. The technology allows
in previous sections. What follows are specific the user to react instantaneously, often pro-
examples of the effect of technology on the two tecting the corporation from foreign exchange
types of flows. In retail and corporate markets, losses in times of economic turbulence.
the technologies have led to a range of new,
Another difference from the domestic mar-
technology-based products, adding to the
ketplace that affects the complexity of inter-
choices available to the individual and corpora-
national cash management is that the manag-
tion in international financial transactions. In
er must rely on information from a multiplicity
financial markets the technologies have pri-
of sources in dispersed places, to the point
marily affected the velocity and volume of
where flows of information are beginning to
transactions.
rival payment flows in importance. It is easy
to reach Revell’s conclusion that, “The ulti-
Corporate and Retail Markets mate objective is that the corporate treasurer
In many of the normal payments associated at head office shall have an up-to-the-minute
with trade, it is not speed of transaction which summary of the cash position in all currencies
is of importance. Since trade payments are on a single VDU [video display unit] on his
scheduled for particular days each month, the desk; he will then initiate the larger transfers
settlement of accounts could easily continue of funds himself, leaving the bank computer
to be handled by mail, taking the delay into to invest smaller amounts according to rou-
account. However, electronic payments add tines decided in advance. ”24
some control over these payments, and by
23
Revell , op. Cit., p. 154. “Ibid., p. 155.
162 • Effects of InformaTion Technology on financial Services Systems

Technological Innovation in Retail Services The developments outside the United States
with respect to retail services are in many
Since many innovations in corporate and re-
ways similar to the domestic innovations that
tail flow of funds often take place in the in- have been described in previous sections.
ternational side first, it is useful to study what
What differs in many cases is not the technol-
is going on in the international marketplace
ogy itself, but the commitment of the various
to help project developments in the domestic
governments and the structure of the finan-
arena.
cial service industry in a particular nation.
One of the distinct differences between tech- Often, technological innovations are easier to
nological innovation in the U.S. financial serv- implement under a regulatory structure that
ice industry and that in foreign nations is the differs from the U.S. regulatory structure. For
level of government subsidy of technical de- example, in Great Britain, BT and IBM are
velopments that affect the financial service in- currently discussing an electronic POS system
dustry. For example, the smart card, the ap- with the London clearing banks. Since the
plications and functions of which are discussed banking industry in Great Britain is highly
in chapter 2, was developed by the French concentrated, agreement with these banks
Ministry of Post and Telecommunications (and assuming subsequent agreement with
(PTT). Although the card has other uses, it will British retailers) will ensure a national POS
be used for electronic banking, particularly for system.
payments. The French have also conducted Some innovation in retail services takes
various trials in point-of-sale (POS) systems place across national borders. Members of
and have also introduced on a limited scale a Eurocheque International recently agreed on
videotex system that will eventually be capa- a “eurocheque” ATM standard that will allow
ble of handling financial transactions. The the crossborder use of the eurocheque guar-
charge for this service is provided to the con- antee card. VISA International plans a simi-
sumer as part of his monthly telephone charge. lar service on a worldwide basis. The impetus
The British videotex system, Prestel, was de- for much of this activity has been the growth
veloped by British Telecom (BT, then part of of international travel and the consequent
the British Post Office), the telecommunica- need by the traveler for ready access to bank
tions authority. Again, although the system accounts worldwide.
has other applications, its service is in direct
competition with other, commercially devel-
oped systems.

Vulnerability of the Financial System


The application of advanced financial infor- World trade relies heavily on the integrity of
mation technologies occurs in nearly all in- transnational transactions and payments; this
dustrialized nations and in many of the newly in turn depends heavily on the reliability and
industrializing nations. This is in response to, security of the transborder flow of data.
and will further enhance, the ongoing growth
As world trade has expanded, so too have
of global economic activity and the increasing
interdependence of national currencies, nation- the financial services to support it, not only
in the actual support of trade through tradi-
al markets, and national economic policies.
tional bank lending and transfer mechanisms,
Expanding world trade, which is responsible but also in the provision of flexible money and
to a great extent for this financial activity, is capital markets. The use of new technologies
increasingly important to the U.S. economy. in the financial service industry has facilitated
—— — .-. .

Ch. 6—The International Environment for Financial Services ● 163


— . — —.— .-—

the growth in volume of financial flows sepa- all cases clearly place liability, especially when
rate from but related to the payment flows as- transactions involve multiple parties. It has
sociated with world trade. One aspect of these been recommended that the party initiating
money and capital markets is the interbank the transaction be responsible, which is not
transfer. The application of information tech- acceptable to all parties.
nologies permits both the increased volume of
There is a similarity between losses suffered
these transfers and the participation of small-
under CHIPS or SWIFT and those under
er, nonmoney center banks, thus helping
other payment systems. They can be classified
change the character and structure of inter-
in three ways: principal losses, interest losses,
national banking.
and losses resulting from foreign exchange
fluctuations. “These losses may be caused by
Security and Integrity of the the delay of a transmission, the introduction
Financial System of faulty information, or a participant’s in-
ability to settle the day’s transactions. Delays
Communication and information technol- and faulty information may arise from hard-
ogies have increased the interdependency of
ware and software failure, mistakes by person-
the participants within the financial system.
nel involved in processing the transaction, and
The international financial system may now
fraud. The failure to settle, on the other hand,
be more vulnerable than ever to upheaval,
is usually caused by the failure of one of the
both economic and political, in foreign coun- transferring banks. “25
tries. At issue within this area is the question
of the increased vulnerability of all parties to
international events that results from commu- Foreign Telecommunications and
nication and information technologies. Information Policies
The technologies have created new oppor- Although the force from within the indus-
tunities for attacking systems for delivering try is toward the flow of information through-
financial services. System integrity, the ability out the world, integration of the world econ-
of a system to recover from damage, is a sali- omy and the world financial system is by no
ent issue when a significant portion of the re- means as simple as the integration of a domes-
quired operations are performed without hu- tic economy. Currencies, accounting method-
man intervention. For example, financial ology, and regulatory and supervisory struc-
service institutions can be attacked by perpe- ture all differ among nations. In support of
trators electronically and off-site. Some sys- trade activity, information flows across na-
tems have reached a stage of complexity where tional boundaries: information which includes
they can be backed up only with automated both personal and strictly financial data, in-
systems, and in the case of interruption to formation which travels via sophisticated tele-
service, they can be restored to operation only communications systems, and information
with automated recovery procedures. processed by state-of-the-art technologies.
These flows, known as transborder data flows
Error Resolution in International (TBDF), have caused conflict and controversy
Electronic Funds Transfer among nations and between particular nations
and multinational businesses. It is primarily
With increasing global interdependence and the informational flows, rather than payment
increasingly complex transactions, generally flows, with which most nations are ostensibly
more than two parties are involved in a single concerned.
transaction, and therefore a multitude of sys-
tems are also involved. The issue as defined “Herbert F. I.ingl, “Risk Allocation in International Inter-
bank Electronic Fund Transfers: CHIPS and SW1 FT, ” Har-
here is that of responsibility in the case of loss ~“ard International I,awr Journal, \’ol. 22, No. 3, fall 1981, pp.
or error. Simple bilateral contracts do not in 630-631.
164 ● Effects of Information Technology on Financial Services Systems
— . — ——

Sovereign nations assert legitimate reasons The economic and industrial development
for, and a right to, monitor and control TBDF. justification of restrictions of TBDF have as
Primary among these reasons are protection their impetus the rising importance of infor-
of the privacy of their citizens, industrial de- mation and communication technologies to the
velopment, and national security. However, world economy. As traditional manufacturing
sovereign rights and national information pol- industries stagnate and high-technology infor-
icy are frequently in direct conflict with the mation industries grow, it is to every nation’s
interests of large, multinational organizations, advantage to encourage a sound, strong infor-
including financial service providers. This con- mation industry. Although national policy
flict of interest in turn can impede the progress strategies differ, it is evident that some na-
of a global financial system and perhaps world tions have taken the route of protectionism.
trade. For example, Brazil has stringent require-
ments on the import of data processing equip-
As the information technology industry be- ment in order to encourage the growth of local
comes increasingly important in international industry. Until recently, little foreign competi-
trade, more countries are seeking to protect tion was allowed in the large Japanese com-
their indigenous communication and informa- munications and information technology and
tion industries and are therefore creating legal services market. These types of activities, al-
barriers to the flow of information. This has though they may protect indigenous industry,
an impact on the financial service industry, have a tendency to increase overall costs to
whose primary function is the distribution and users.
processing of information.
More specifically affecting the financial
The requirements of multinational and inter- service industry are those national policies
national finance include rapid communications that threaten to discontinue access to leased
and efficient data processing. Certain restric- lines, begin usage-sensitive pricing schemes,
tions by foreign governments—e.g., that all and demand that industry use local commu-
data are processed locally-can severely ham- nication facilities. The objections of banks and
per these activities. The current economies of other financial service providers is not only
data processing are such that it is more effi- that this will increase their costs, but that
cient to centralize the process. transmittals over public lines make control
over sensitive information more difficult.
For a variety of reasons, there have been
suggestions that nations limit the flow of per- National security concerns seem to center
sonal data across their borders. Some would around the economies of scale and the lack of
limit the effects of restrictions to data iden- locational sensitivity in data processing. It is
tifiable with natural persons while others would common for large corporations to center their
include both natural and legal persons. In- processing facilities in one nation. For exam-
cluded has been the suggestion that limita- ple, SWIFT’s data processing and transmis-
tions on TBDF be focused on curtailing the sion centers for its 52 member countries are
flow of data to nations that have not imposed located in 3 countries: the Netherlands, Bel-
privacy standards at a level consistent with gium, and the United States. Such centraliza-
those of the nation imposing them. However, tion engenders the fear that sensitive informa-
much of the data of interest to the financial tion will be stored in a foreign country, or that
service industry pertains to specific individ- a nation may be cut off from information in
uals, and its movement across international a time of national crisis. As SWIFT pursues
borders would be affected by such restrictions. domestic interbank markets, these fears be-
Therefore, limitations on TBDF could cause come well-founded; it is entirely possible for
significant problems for the financial service one nation’s domestic retail and interbank fi-
industry, which finds demands for internation- nancial information to be stored at facilities
al services increasing. outside its borders.
Chapter 7

The Consumer of Financial Services


. .

Contents

Page
Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167

Consumer Financial Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167


Consumer Savings and Investment Behavior . . . . . . . . . . . . . . . . . . . . . . 168
Providers of Consumer Financial Services . . . . . . . . . . . . . . . . . . . . . . . . . 169
Consumer Payment Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171
Growth of Consumer Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173
Recent Innovations in Consumer Financial Services . . . . . . . . . . . . . . . . 174
Automated Teller Machines . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176
Automatic Direct Deposit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178
Telephone Billpayer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178
Point-of-Sale Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178
Home Information Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178
Pricing Structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178
Opportunity Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179
Information Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179
Communication Costs .. .. .. .. .. .. .. $. .. ... ... .$...... . . . . . . . . . . 179
Competition and Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179

Public Policy and the Financial Service Consumer. . . . . . . . . . . . . . . . . . . . 180


Regulations Relating to Consumer Finance. .’. . . . . . . . . . . . . . . . . . . . . . 180
Consumer Credit Protection Act . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182
Regulations Z and M . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182
Electronic Funds Transfer Act . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183

Transition From Paper-Based to Technology-Based Systems . . . . . . . . . . . 184


Security of Consumer Assets in a Technology-Based System . . . . . . . . . 184
Privacy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185
Consumer Rights to Financial Services . . . . . . . . . . . . . . . . . . . . . . . . . . . 186

Tables
Table No. Page
9. Household Financial Assets and Liabilities, 1982
(billions of dollars). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169
IO. Credit Card Holding (families holding cards as percent of
all families). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172
11. Credit Carouse (families using cards as percent of all families) . . . . 173
12. Summary of Variances in Regulation and Investor Protection. . . . . . . 181

Figure
Figure No. Page
14. Lifecycle of Consumer Needs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170

Chapter 7

The Consumer of Financial Services

Introduction
Consumers’ of financial services have char- sumer as a potential customer. It appears,
acteristics distinct from all other financial however, that competition is changing some
service user groups. Approximately 80 million of the indifference of banks toward this mar-
households comprise this group; and as such, ket. “It was not regulation or legislation that
it is an important part of the U.S. economy. allowed nonbank institutions to exploit the op-
Household deposits provide the financial serv- portunities available in upscale credit cards
ice industry with nearly $2 trillion in loanable (American Express), in discount brokerage
funds. In addition, consumers have a diversity (Merrill Lynch), and in automated payroll serv-
of needs and compose a highly segmented mar- ices (ADP). Rather it was the failure of banks
ket, Consumers, in comparison to their use of to engage in effective marketing and their lack
other instruments, also make the least use of innovation and understanding of consumer
of technology-based financial services and attitudes that gave the near-bank competitors
products. the upper hand in these product areas.’” As
a result, the consumer is beginning to wield
It is readily accepted that although some
more power in product development; recent
movement has been made toward consumer
events are changing consumer financial serv-
acceptance of technological devices in bank-
ices from being product-driven to being mar-
ing, the time horizon for acceptance by the
ket-driven. It is not clear, however, if all con-
total population will be much longer than 10
sumers are benefiting from these changes.
years. There are currently some highly visible
examples of the effect of technological change Consumer protection regulation has in the
on this market segment (e.g., the rapid accept- past dealt with the protection and fair treat-
ance of automated teller machines (ATMs)), ment of consumers in the financial service
but certain institutional relationships have system. Implicit in the formulation of public
been affected little by the technology. As some policy has also been the recognition of the po-
new systems are implemented, however, and tential impact of technology-based systems on
certain of the institutional problems with the consumer. However, it is important to
these implementations are resolved, the effects fully understand the changes taking place,
of technology on the consumer of financial their impact on the role and behavior of the
services are bound to become more evident. consumer, what new issues will arise because
of these changes, and existing issues that have
Historically, the banking sector of the finan- not been adequately addressed.
cial service industry has been either enamored —————
of or totally uninterested in pursuing the con- ‘Richard Rosenberg, Vice Chairman of W’ells Fargo, as quoted
in The Retail Banking Re\’olution: An International Perspec-
‘The consumer, as defined here, is an individual user of per- tit’e, Patrick Frazer and Dimitri }Tittas (eds. ) (1.ondon: Nlichael
sonal financial services. I,afferty Publications, 1982), p. 7.

Consumer Financial Services


Consumers seek financial services to fa- instruments, to balance present consumption
cilitate payment, to balance current income against future earnings with credit instru-
against future consumption through savings ments, to secure growth in capital, and to safe-

167

- -
35 505 ~ 84 - 12 :
QL 3
168 • Effects of /formation Technology on Financial Services Systems
— — . — — —.

guard their assets. A rational consumer who cent movement of funds out of money market
wants to maximize his objectives will desire funds into their depository equivalent, money
control over the means (i.e., assets and income) market deposit accounts. These figures will be
to those ends. The degree of his control is reflected in 1983 end-of-year accounts.
measured by the extent to which his assets
Life insurance funds are also used for ac-
meet his needs.
cumulating savings; however, because of their
In this regard, Professor William White, in low rate of return, their primary function is
his report to the Investment Company Insti- insurance against risk. Individuals also invest
tute, The Outlook for Money Market Mutual a considerable amount in securities, both cor-
Funds, defines the demand of consumers for porate and government.
specific financial products and services as aris- Home mortgages, although they represent
ing not from the particular product or serv-
a liability relationship for the consumer, are,
ice, but from features of the consumer and his
in effect, instruments of negative savings in
environment. Demand arises first from the ne-
which the consumer initially creates a debt
cessity for the individual consumer to meet
relationship with an institution. However, as
certain basic needs, which can be classified as
the consumer decreases his debt, he earns
convenience, return, liquidity, security, credit
equity in the property; as the value of the
availability, and, to some extent, personal
property increases over time, it increases the
service. The investment behavior of the con-
net worth of the individual.
sumer is related to the relative importance of
each of these needs, which in turn is based on The relationship of assets to liabilities and
the individual’s economic environment and his the choice of instruments for investment
lifecycle stage. Also of importance is the less varies with the age and income of the consum-
tangible factor of individual tastes and pref- er. This is depicted graphically in figure 14.
erences. 3 The primary earning years are between the
ages of 20 and 70, when generally the con-
Consumer Savings and sumer earns more than he consumes. With
Investment Behavior age, savings and investment behavior of the
consumer changes. Generally, in youth, the
The term “investment” throughout this sec- consumer will be more consumption-oriented;
tion is not used in its macroeconomic sense, as age and income progress, the consumer will
that is, the purchase of capital goods. For this be more future-oriented. The consumer’s basic
chapter the term means the commitment of needs of convenience, higher return, security,
money specifically to earn a profit, most often liquidity, credit availability, and personal secu-
by purchasing securities. “Savings” are de- rity often correspond with this lifecycle and
fined as asset accounts in which an individ- directly influence which financial service and
ual accumulates funds for future consumption. products he selects.
For the most recent statement of total out-
Although aggregate information on the sav-
standing assets and liabilities for the house-
ings habits of consumers reflects a propensity
hold sector, see table 9.
to invest, an overall tendency to save rather
The primary savings instruments used by than borrow, and a pattern of savings highly
individuals are time and savings deposits, pen- correlated to age, consumers differ in their ob-
sion funds, and home mortgages. In recent jectives for asset management. The financial
years, more consumers have begun using the service industry has recently begun to react
money market fund for savings. The figures to these differences and to provide services to
for 1982 do not reflect, however, the more re- meet very individual needs in addition to pro-
viding instruments that have widespread use
‘William L. White. “The Outlook for Money Market Mutual
Funds, ” Report to the Investment Company Institute, Sept. (e.g., checking and savings accounts, bank
30, 1982, pp. 28-29. credit cards, or mortgages).
Ch. 7—The Consumer of Financial Services ● 169

Table 9.— Household Financial Assets and Liabilities, 1982 (billions of dollars)

Assets:
Deposit and credit market instruments ., $2,781.3
Deposits ., ., . . ... ... . . . 1.982.7
Checkable deposits and currency . . . . . . 307.3
Small time and savings deposits . . . 1,322,9
Money market fund shares . . . . . . . . . 206.6
Large time deposits ., . . . . 145.9
Credit market instruments ., . . . . 798,6
U.S. Government securities ., ... 377.0
Treasury issues . . . . . . . . . 291,8
Savings bonds ... . . . . . . 68.3
Other Treasury ... , . . . . . . 223.4
Agency issues . 85.2
State and local obligations . . . . . 129.0
Corporate and foreign bonds . . . . . . 64.5
Mortgages . . . . . . . ., ., 186,5
Open market paper. . . . . . . . . . . . 41.6
Corporate equities . . . . . . . . . . 1,316,2
Mutual fund shares ., ... . . . . . 89.5
Other corporate equities . . . . . . 1,226,8
Life insurance reserves ., . . . . . . 1,316.2
Pension fund reserves ., ., ., ... ., 935.3
Security credit . . . . . . . . . 16.0
Miscellaneous assets . . . . . . . . . . 85.3
Total assets . . . . . . . . . . . . . $5,381.0
Liabilities:
Credit market instruments . ., ., 1,674.4
Home mortgages . . . . . . . . . . . . . . . . . . . 1.101,0
Other mortgages . . . . . . . . . . . . . 36.4
Installment consumer credit . . . . 344.8
Other consumer credit ... ., ., 85,9
Bank loans n.e.c.a . . . . . . . . ... . . . . 33.3
Other loans . . . ... . . . . 730
Security credit . . . . . . . . . . . 28.8
Trade credit . . . . . . . . . . . . . . . . . . . . . . . . 22.2
Deferred and unpaid life insurance premiums 15.5
Total liabilities. .. .. ... . . . . $1,740,9
N O T E Households Include not for profit orqanlzat!ons
aNot elsewhere class lf~ed
S O U R C E B o a r d of Governors Federal Reserve System Flow of funds Accounts: August 1983

Providers of Consumer Financial Services vided for his/her insurance needs, Regulation
tended to support this specialization. Recent
For the most part, consumer needs cannot trends in the marketplace and in regulation are
be met without the assistance of an interme- beginning to break down the strict distinctions
diary that provides access to payment sys- between institutions. Many consumers are
tems and markets, expert knowledge and adapting readily to the changes and are chang-
advice, the pooling of a large number of indi- ing traditional relationships with some finan-
vidual risks (as with insurance protection), or cial institutions.
a diversified portfolio for a minimum invest-
ment (as with investment companies).
Prior to these recent events, the most widely
In the past, consumer financial institutions recognized financial relationship for the con-
specialized in individual products and services. sumer was with a depository institution, espe-
As a result there were some institutions that cially with a bank. Banks provided the con-
provided for the payment needs of the con- sumer access to the payments mechanism
sumer, some which provided for his/her sav- through checking accounts and met some cred-
ings and credit needs, and still others that pro- it and savings needs. Savings institutions pro-
170 . Effects of Information Technology on Financial Services Systems
— —. .—

Figure 14.— Lifecycle of Consumer Needs

I Earned income (excluding investment income and transfers)

F=/
~~
\
o 10 20 30 40 50 60 70 age in years
~~~ ~
Usually First Prime working and earning Supported by income
supported by jobs years from savings, retire-
parents family ment or welfare
benefits
For the purposes of the financial services industry, people do not become consumers (do not buy) financial services usually
until at least their teens:
General age New financial activities Resulting financial service(s) requirements

Teens- First jobs (though often still Transaction accounts, simple savings
20’s with parent support). accounts or instruments (e.g. U.S.
savings bonds).
Often, college. Education loans.
Often, car or other major purchase. Auto or other loans
Auto insurance.
— . -.
20’s First home purchase or more saving Home mortgage.
to prepare for home purchase. More sophisticated savings instruments,
Marriage and first children. Various loans (general credit).
Related: perceived need for greater Insurance, savings
security to protect family. life, health, home insurance,
.— —
30’s Prime working-and earning years: –
60’s Higher income, Tax shelters
Larger saving base being built, More sophisticated investment vehicles:
as foundation for children securities, money target funds, real
education and other expenses, estate, insurance purchases.
and for old age. real-estate pension plans.
More business travel. Financial advice often desired.
More income for personal travel. Traveler’s checks, travel and entertain-
ment credit cards.
High of time working, especially
0
/0 Cash dispensers, debit cards.
two career couples (2 earner
families): result - need for
greater convenience in trans-
actions, more mail order and
overall purchases.
—— .
60’s ‘- Often retirement or less working ‘- Financial advice, to plan for supporting
time, more leisure, less earned a standard of living
income. lesser risk, higher current Income
(securities), investments, pension
trust, estate planning.
SOURCE William L White, “The Outlook for Money Market Mutual Funds, ” 1982
Ch. 7—The Consumer of Financial Services ● 171

vialed savings and mortgage services. Credit largest card bases in the United States and
unions provided services similar to those pro- have filled certain consumer financial needs for
vided by both commercial banks and savings years. Both are favorably placed in the finan-
institutions. cial service marketplace because the consumer
recognizes their names. As the consumer be-
Recent research shows that the typical con-
comes used to nontraditional providers of fi-
sumer deals with only one or two banks and
nancial services, he may willingly accept re-
will accept fairly standardized products.’ How-
tailers as providers.
ever, it also shows that there is very little con-
sumer loyalty toward a particular institution; Consumers may obtain cash from a variety
if another institution can meet the needs of the of other places besides banks; for example, in-
consumer better, the consumer usually moves dividuals routinely cash checks at a grocery
his business. A consumer “wants to be able or convenience store solely for the purpose of
to use a credit card to purchase goods and cash acquisition. Although these retailers are
services from merchants, and he wants to be not financial institutions in the traditional
able to use a piece of plastic (preferably the sense, they certainly have provided consumers
same one, perhaps) to obtain cash from a ma- with financial services in the past. Grocery
chine. He does not care who issued the card stores have used check guarantee systems for
or who wrote the programs accessing the ma- a number of years, and as mentioned earlier
chines any more than he cares who manufac- in this report, some are beginning to offer more
tured the machine. This has been borne out technologically sophisticated services—for ex-
by the rapid movement of funds out of tradi- ample, onsite ATMs.
tional deposit accounts in the 1970’s to ac-
The ways in which the financial service in-
counts with a higher rate of return. In the
dustry is changing are described more fully
past, most so-called consumer loyalty was il-
elsewhere in this report. The effect of these
lusory in that banks had a monopoly on cer-
changes on the consumer has been to offer him
tain types of transaction accounts and often
a greater realm of choice in the institutions
had a geographic monopoly, as well.
with which he can do business.
Individuals with higher discretionary in-
comes, a desire for high growth of assets, and Consumer Payment Methods
lower risk aversion will generally have a rela-
tionship with a securities house. High income, Like the business sector, the consumer re-
quires payment mechanisms to acquire goods
or, in its place, low risk aversion, was gener-
and services. Recent research has postulated
ally necessary to offset the risk associated
that a consumer seeks as many as 11 specific
with the instruments offered through these in-
attributes in a payment system: budgeting,
stitutions.
documentation, reversibility, spending con-
It is evident that consumers have also had trol, transaction record, leverage potential,
fairly complex financial relationships with acceptability, transaction time, transfer time,
nontraditional financial service providers. His- social desirability/prestige, and security. 6 Each
torically, retailers have extended credit to consumer will choose his method of payment
their customers to purchase goods and serv- according to his priorities and to his percep-
ices. From this has developed a fairly substan- tion of a particular method as having the speci-
tial number of consumers with revolving credit fied attributes.
lines, and credit cards to access these lines of
credit. Sears and J. C. Penney have two of the By far, the most commonly used medium of
exchange for point-of-sale (POS) purchases is
‘Arthur D. Little, Inc., Issue and Needs in the Nation’s Pay- ‘Elizabeth C. Hirschman, “Situational Perception of Prod-
ment System, The Association of Reserve City Bankers, April uct Prototypes Within the Product Class of Consumer Pa~’ment
1982, p. 35. Systems. ” The Journal of Genera) PsJ’choJogTr, \ol. 106, 1982,
5
Paul Horvitz, American Banker, New York, Sept. 24, 1982. p. 127.
172 ● Effects of Information Technology on Financial Services Systems

cash, particularly for small transactions. The charge cards and, except in certain instances,
primary attributes of cash are convenience and do not provide long-term credit to the con-
acceptability. Since cash is universally nego- sumer. When they were introduced, the con-
tiable and requires no personal identification sumer did not have highly developed credit
for use, cash transactions also have the addi- needs. T&E cards met the additional consumer
tional attribute of privacy; however, these needs of spending control and leverage poten-
same qualities make cash a less secure medium tial. In addition, the high membership fees and
of exchange. For the approximately 17 percent apparent exclusivity of the cards provided
of all households that have no relationship a sense of social prestige. Although it was
with a financial service institution, either cash thought that with the introduction and wide-
or (in specific instances) money orders or cash- spread use of bank credit cards, the number
iers’ checks, are the only instruments of pay- of T&E cards in circulation would dwindle and
ment available. their usefulness would be outdated, their num-
ber has actually grown.
Many consumers use checks to meet these
needs. Studies show that the consumer’s use Bank credit cards9 are used in most cases
of checks has consistently been in the range as an alternative to cash or checks for POS
of 50 percent for bill payment, 31 percent for transactions. Their line of credit added flexibil-
retail purchases, 9 percent for payments to ity to consumer payment mechanisms. Bank
other individuals, and 8 percent for cash ac- cards are perceived by the consumer to be
quisition. 7 The figures for cash acquisition are more acceptable and less time-consuming to
probably low, since many checks written to use than checks and less risky than cash. They
retail institutions are actually for acquiring also provide the consumer with proof of pay-
cash. In 1979, consumers’ checks accounted ment, which facilitates returns or reimburse-
for approximately 53 percent of all checks ment. The majority of credit card users do not
written, or 17 billion transactions.8 actually use the credit option associated with
the card, paying instead the full amount owed
Until the 1950’s, the personal check was
each month.10 The card is viewed more as an
truly the only widely used alternative to cash
instrument of cash management. Tables 10
for payments. In recent years, however, the
and 11 show overall consumer holding and use
check has become less negotiable; consumers of credit cards.
frequently are required to have additional
.——
identification and some proof of creditworthi- 9
The term “bank credit cards” is rapidly becoming somewhat
ness in order to use a check for POS purchases. of a misnomer. This term commonly refers to VISA and Master-
In part, the decreasing negotiability and lack Card interchange cards, which in the past were issued by banks.
However, these cards (although for the most part still issued
of national acceptance of the check led to the by banks) now provide access to a variety of’ accounts, including
explosion in the availability and use of other central asset accounts offered by securities houses.
payment mechanisms for the consumer—e.g.,
I O Ec o n o m ” c R e v i e w , O p . c i t .

traveler’s checks, retail credit cards, travel and Table 10.—Credit Card Holding
entertainment (T&E) cards, the bank credit (families holding cards as percent of all families)
card (in the 1960’s), and, most recently, the
debit card. Year
Type of credit card 1977 1978 1981 1982
The traveler’s check and the T&E card pro-
Any . . . . . . . . . . . . . . . 63 64 66 70
vided the consumer with payment mecha- Gasoline . . . . . . . . . . . 34 34 30 35
nisms more negotiable than the check, with Bank ... , . . . . . . . . . . 38 40 45 51
attributes of convenience and acceptability, General purposea . . . 8 10 14 14
Retail store . . . . . . . . 53 50 57 63
yet more secure than cash. T&E cards are Other b . . . . . . . . . . . . . 6 5 7 NA
a
Travel and entertainment cards.
‘See Economic Review, “Special Issue: Displacing the Check” blncludes airline cards, car.rental cards, and others not classified elsewhere
(Atlanta, Ga: Federal Reserve Bank of Atlanta, August 1983), NA—not available,
p. 8. SOURCE Data collected for the Federal Reserve Board by the Survey Research
‘Ibid., p. 26. Center, University of Michigan.
.—

Ch. 7—The Consumer of Financial Services ● 173


.

Table 11 .—Credit Card Use ingly complex. In the early part of this cen-
(families using cards as percent of all families) tury, households operated almost entirely on
— . — ——
Year a current basis; using credit was an indication
Type of credit card - 1 9 7 1 1977 1978 1981 1982 of mismanagement of household accounts. Pri-
Any ... . . . . . . . . . . . . 50’ 60 62 62 ‘- NA or to the 1930’s, credit relationships with fi-
Gasoline ... . . . 33 31 32 27 31 nancial institutions were not common. Retail
Bank . . . . . . . . . . . . . . 19 25 37 39 47 establishments were more likely to extend
b
General purpose . . . 5 7 9 12 13
Retail store . . . . 45 50 48 51 57 credit in direct relationship to consumer pur-
c
Other . . . . . . . .— . . . . NA —
4 3 5 NA
——
chases. At that time, it was postulated, house-
a
Data ;or 1970
bTravel and entertainment cards
holds could manage credit to help balance cur-
clncludes al rl( ne cards and car rental cards rent consumption wants and needs against
NA—not avaliable
SOURCES 1970 Survey of Consumer Finances: 1971-72 Survey of Consumers,
future income.
and data collected for the Federal Reserve Board by the Survey
Research Center, University of Michigan Since then, as described earlier in this re-
port, there has been an exponential growth in
In the 1970’s, considerable speculation de- consumer credit and in institutions and in-
veloped about a future “cashless society” (i.e., struments to serve these needs. In the 20 years
a system where cash as well as checks would from 1960 to 1980, total household liabilities
become obsolete, having been replaced by elec- as a proportion of total household assets grew
tronic payment mechanisms). However, de- from 21 to 35 percent. ” This growth also re-
spite the growth of electronic alternatives, the flects, in part, a change in attitude by the con-
use of checks as a method of payment contin- sumer. Credit is no longer the last resort of
ued to grow at approximately 5 to 6 percent a mismanaged household, but a means of im-
per year throughout most of the 1970’s and proving one’s living standard.
has only recently begun to slow. It still con- The primary long-term instrument for dec-
tinues to increase at about 2 percent per year. ades was the installment loan, where a bulk
Traveler’s checks and credit cards do not re- sum was borrowed by the consumer from a
quire a check be written at point of sale; how- bank or consumer finance corporation to fi-
ever, the majority of them rely on the check nance a large-ticket purchase of a durable
for reconciliation of accounts. The only in- good, and repaid in installments over a speci-
struments besides the check that provide the fied period of time. Another example of con-
consumer direct access to his account are the sumer credit was the retail revolving account,
debit card, preauthorized payments, and ATM in which a consumer could charge a particu-
payments. In 1979, 97 percent of all debits to lar amount on store-granted credit and repay
individual accounts were by check. The other the outstanding balance monthly.
3 percent of debits to consumer accounts were In the 1960’s the first bank credit cards were
distributed thus: 1.3 percent to preauthorized introduced, adding yet another source of con-
paper drafts, 0.4 percent to preauthorized sumer credit. As mentioned previously, the
automated clearing house payments, and 1.1 bank card is used primarily for its conven-
percent to ATMs. ” The current system is ience; however, the credit uses of these cards,
merely a reflection of the acceptance of these which were innovative when introduced, de-
alternative media rather than an example of serve exploration.
one replacing the other.
The bank card offers essentially two types
Growth of Consumer Credit of credit options for the consumer: short-term
credit to bridge cash shortages between pay-
The relationship of the consumer to the pro- checks and longer term installment credit. The
vider of financial services has grown increas-
“Board of Governors, Federal Reserve System, Flow of Funds
“Ibid. Accounts, August 1983, September 1979.
174 • Effects of Information Technology on Financial Services Systems
— — — —— —. .—

latter is provided with only one credit appli- and minimal risk aversion. In time, as double-
cation, the consumer may borrow the exact digit inflation continued and the spread grew
amount he wishes within his credit limit and between interest earned in these funds and
have considerable payment flexibility. About that earned in bank time deposits, other, more
two-fifths of credit card holders use these op- risk-averse individuals began investing in
tions on a regular basis. these instruments. This phenomenon was
partly responsible for the movement within
Recent Innovations in Consumer Congress to deregulate parts of the banking
Financial Services industry, a movement that eventually allowed
depositories to offer accounts bearing higher,
In the past decade, inflation, interest rates, more competitive interest rates.
and the lifting of particular banking regula- In response to competition and profit oppor-
tions have affected how consumers manage tunities, depository institutions have also
their assets. Events of the last decade have begun offering discount brokerage services to
increased the number of investment options their customers, making it possible for some
open to the consumer of financial services and consumers to meet a number of their savings
expanded the range of consumers who use and investment objectives with one firm. How-
these services. For example, tax-exempt in- ever, since banks are not allowed to offer ad-
come is available to all consumers through In- vice on investments, except in the case of trust
dividual Retirement Accounts (IRAs), and customers, this service is still limited to a
money market funds and money market de- financially sophisticated class of consumers.
posit accounts allow the small investor access On the other hand, nondepository institutions,
to high interest rates. such as securities firms, have added services
that have the appearance of depository instru-
Nontraditional Providers and Instruments ments, yet the qualities a consumer seeks for
Recent changes in the industry have also af- managing his assets. Since consumer percep-
fected the way the industry provides financial tion of the instruments is the same, a con-
services to the consumer and have introduced sumer may not differentiate between the two
new players to the marketplace. In the 1970’s, choices.
the inflation rate and the resultant high op- The Depository Institutions Deregulation
portunity cost of standard consumer savings and Monetary Control Act of 1980 provided
instruments led to a phenomenon known as new opportunities for the consumer. This act
“disintermediation.” Funds flowed out of the allowed depository institutions nationwide to
depository institutions into nontraditional in- offer NOW accounts through which the con-
struments and institutions. New instruments sumer earns interest on an account that is not
were created outside the interest rate-regu-
differentiated in use from a checking account.
lated environment of the banking community. These accounts already comprise one-third of
One of these, the money market fund, allows all checkable deposits. ” Also enacted by the
the small saver to earn higher interest rates same legislation was the provision that fed-
and thereby preserve assets. This instrument erally chartered savings and thrift institutions
is a particularly appealing alternative because could offer consumer loans for up to 20 per-
it also offers checklike privileges through
cent of assets.
share drafts. Although there is usually a min-
imum amount the consumer can withdraw
Complexity of the Marketplace
from his account with a draft, in many cases
it meets his liquidity needs. The present marketplace offers greater
choice yet greater confusion for the individual.
The initial target of these funds was the so-
called upscale market; that is, those individ- ~Bomd of Governors, Federal Reserve System, Money Stink
uals with relatively high discretionary incomes Measures and I.iquid Assets, Dec. 30, 1983.
Ch. 7—The Consumer of Financial Services ● 175

The consumer must be more aware of the par- also push these consumers out of the bank,
ticulars of investment and must deal with a further limiting their access to information
changed environment that no longer offers services.
him standard investment opportunities keyed
to his position in life. The result is an increas- Technology-Based Services
ingly complex relationship between financial
There is little evidence to support the notion
institutions and the consumer.
that consumers specifically demand technol-
For example, high and uncertain interest ogy-based services; the demand for services is
rates also led to an industry-led innovation in still a reflection of the overall needs of the con-
the home mortgage market. During the 1970’s, sumer. There is perhaps a particular class of
the variable rate mortgage was introduced. In consumers, referred to as “innovators,” who
addition, the equity loan was introduced into willingly accept new technological applica-
the home mortgage market. This loan, which tions. The market for these services evolved
allows a homeowner access to the equity in his as the consumer discovered that technology-
home, is much the same as a second mortgage; based services had specific attributes of re-
however, second mortgages are traditionally mote location and self-service and that they
used for specific purposes such as home im- provided a payment alternative. The use of
provements. Most of the promotion of these technology in financial services can help alter
loans, under the rubric of “credit manage- consumer demand for financial services by
merit, ” encourages their use for virtually all providing him easier access to his assets.
purposes, exposing the consumer to the loss
Some financial service innovations men-
of his home if he is unable to meet payments
tioned in the previous section were facilitated
on the loan.
by technological change; e.g., variable rate
The solution to this situation is not neces- mortgages require information-processing fa-
sarily to increase the information available to cilities in order to be cost effective. This sec-
the consumer. Often educational differences tion distinguishes between those innovations
or a predisposition by the consumer precludes that require technology in the backroom sense
him from processing the information in a way and those that require the consumer to have
that would facilitate his decisionmaking. And, direct contact with the technology or those
it is likely that particular groups of individuals where technology changes the behavior of the
will be more affected than others. Certain consumer with respect to financial services.
groups may beat particular disadvantage; for
Previous sections of this report illustrate the
example, the elderly and the uneducated.
way that communication and information
There is also some question whether there technologies have affected the way the finan-
will be a conflict if the provider of services is cial services industry operates. The informa-
also the major provider of information about tional nature of the financial service product
these services. For the most part, only wealthy led to the early application of automation in
individuals have access to financial advice, this industry, particularly in internal and
either through bank trust departments or se- intra-industry operations. However, when
curities brokers. Discount brokerages provide these technological solutions were applied to
access to financial markets for less wealthy the marketplace, especially as new products
consumers, but without the advice function. and services in the consumer segment, the
Middle-income consumers have in the past benefits were not so clear nor the implemen-
relied on banks for some financial advice, but tations so easy. In particular, when depository
in more complex systems, banks are often not institutions attempted to transfer their cost-
in the position to offer sound advice to this saving technological solutions to the consumer
segment of the consumer markets, owing to market, they were faced with a diverse, often
a lack of trained personnel. Technology may reluctant market.
176 • Effects of Information Technology on Financial Services Systems

Consumer Acceptance of Technology cent.15 It should be noted, however, that the


value of deposits received at an ATM far ex-
Some attempts at introducing technology-
ceeds the value of withdrawals. Also, ATM
based products and services to the consumer
cash withdrawals tend to be for amounts that
of financial services succeeded and some failed.
are half the value of withdrawals facilitated
It became evident from these attempts that
by a human teller.
technological solutions had to consider con-
sumer need. Examples of such new technol- Also interesting to note is that use of the
ogies include ATMs, automatic direct deposit machines during normal banking hours is in-
systems, preauthorized payments, POS funds creasing, which represents a change in con-
transfer and check guarantee, and home infor- sumer attitude about the primary attributes
mation systems, most of which have been de- of the machines. Originally, ATMs were seen
scribed in previous sections of this report. as convenient for obtaining cash 24 hours a
What follows are descriptions of consumer day. In this sense they were direct competitors
acceptance and attitudes toward these tech- with retailers who provided this service. How-
nologies. ever, with the change in pattern of use dur-
ing banking hours, there is some indication
Automated Teller Machines that they are beginning to replace the human
teller as a source of cash. This is partly due
The ATM is an example of electronic funds to the greater reliability of the newer machines
transfer (EFT) that is highly visible to the con- and to the increasing acceptance of the ma-
sumer of financial services. By 1981, the Bank chines by a greater number of people. In many
Marketing Association (BMA) reported that cases, the institution deploying the ATM en-
nearly 100 percent of the population was aware courages its use in order to lower the per-
of ATMs.14 Of that figure approximately 32 transaction cost of the system and therefore
percent actually use an ATM for financial the costs to the institution.
transactions, which is an increase from 10 per-
cent in 1977. When further broken down, this Research shows a strong correlation be-
figure reveals that only slightly more than half tween age and ATM use. The most frequent
of the 32 percent use an ATM more than once user of an ATM is young; use peaks in the 25-
every 2 weeks. The growth of ATM use has to 34-year-old range, with a dramatic fall-off
followed the typical pattern of technological in use among members of the population over
diffusion—that is, from initial use by “inno- 65. ’6 There is some evidence that those young-
vators” to rapid, widespread use. The Federal er than 25, although not frequent users of
Reserve Bank of Atlanta in a recent analysis ATMs, have a high level of acceptance, and
of check displacement has estimated that the when they establish firmer relationships with
saturation level for the ATM will be reached financial institutions, they too will become fre
when the percentage of actual users reaches quent users of the technology. It is expected
65 percent of all possible users. that the age factor will become less important
with time, although when is unclear.
The primary pattern of use of an ATM is for
cash acquisition. According to Linda Fenner Isolated experiences indicate that one fac-
Zimmer, a noted ATM consultant, the pattern tor that can hinder the use of ATMs by the
of use of the ATM has remained relatively con- elderly is inexperience with technology. In cer-
stant since its introduction: cash withdrawals tain situations, by providing the elderly cus-
represent approximately 75 percent of the vol- tomer with assistance, many of these reserva-
ume of use of ATMs; deposits, 19 percent; bal- tions can be overcome. However, this will not
ance transfers, 4 percent; and payments, 1 per- always be the case, and it cannot be over-
looked that convenience and remote location
“Bank Marketing Association (BMA), Payment Attitudes ‘“Econom”c Review, op. cit., p. 17.
Change Evaluation (PACE III 1981), Chicago, p. 2.1. “Bank Marketing Association, op. cit., p. 2.50,
Ch. 7— The Consumer of Financia/ Services ● 177
— .— —— . —.— ——————

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178 • Effects of Information Technology on Financial Services Systems
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are not always important to the elderly con- payer services are an example of consumer
sumer of financial services. Tradition and the reluctance to use a service to meet needs which
human factor can play important roles in this they believe are adequately met through other
group’s use of financial services, and therefore services. Acceptance of this method of pay-
in their acceptance of technological services. ment has not been very high, and there has
been little growth in the service in the past few
Automatic Direct Deposit years.
In an automatic direct deposit system, some Point-of-Sale Systems
form of income is automatically deposited in
an individual’s account on a regular basis. Ex- There is little substantial information on
amples include direct deposit of Social Secu- consumer attitudes toward POS debit systems
rity checks by the Government or of payroll or POS check guarantee systems. In general,
by the private sector. Direct deposit is another most consumers are unaware of these systems,
example of technology-based service of which except in areas where there have been trials.
the general population is nearly 100 percent The introduction of the debit card in the United
aware. According to the 1981 BMA survey, States was closely tied to consumer reaction
36 percent of respondents’ households use to early POS experiments. Consumers found
automatic deposit, and 80 percent of these had they did not care to carry basic necessities on
a very favorable opinion of the service.17 In the credit cards.
5 years between 1978 and 1981, penetration
of direct deposit of Social Security benefits Home Information Systems
grew from 11 to 33 percent of all such pay-
ments. It is the eventual goal of the U.S. Home information systems are described at
Treasury that all Social Security payments be length in chapter 4. There is little agreement
made by direct deposit. 18 on the potential for consumer acceptance of
this service. One of the major constraints to
The premise on which direct deposit is sold, its growth is the pricing of the systems. There
particularly with respect to Social Security is currently a great debate about what people
payments to the elderly, is that it decreases will pay for these services and about what they
consumer vulnerability to theft. Other aspects perceive the value of these services to be.
of the service to which the consumer responds While these questions remain unanswered, it
favorably are convenience, the speed of ac- is difficult to say how rapidly the services will
count crediting, and the regularity of depos- grow and when and if they will become a mass
its (particularly when the recipient is out of medium and therefore open to every level of
town). On the other hand, the consumer per- consumer.
ceives the system raising service charges on
his account and providing increased access to Once more, the perceived market for the
others of his personal account information. 19 service is the upscale consumer. To the con-
sumer who earns less than $40,000 per year
Telephone Billpayer and writes few checks, the system may not be
cost effective. For the time being, pricing of
Telephone billpayer systems are not always both equipment and the services may preclude
fully automated, but are considered here be- the participation of the lower income consumer
cause they represent an innovative use of in this case.
technology-in this case, the telephone—to fa-
cilitate consumer payments. Telephone bill- Pricing Structures

“Ibid. p. 3.4. Past financial services were often perceived


‘nEconomic Review, op. cit., p. 33. by the consumer to be free or, relative to other
“Bank Marketing Association, op. cit. expenses, inexpensive. There was either no
Ch. 7—The Consumer of Financial Services ● 179
——— -.— ——— - —— — —. — .

charge or a minimal “service charge. Finan- Communication Costs


cial institutions earned their profit through the
difference in explicit and implicit rates charged It seems inevitable that local communica-
on assets and paid on liabilities. Through com- tions costs will rise; however, at what rate is
petitive and economic pressures this spread still uncertain. The eventual price to the con-
narrowed, and the income to banks therefore sumer will depend on the structure of Federal
decreased. regulation of local rates and, barring Federal
regulation, the decisions State governments
Fee income makes up an increasingly large make about regulation of the communication
portion of overall bank income. All evidence industry. If home information systems become
indicates that this trend will continue, the pric- the major way for consumers to obtain infor-
ing structure in the future will be cost-based, mation and transact business, the communi-
and service will be explicitly priced. cation costs of these transactions could also
In addition, pressures from outside the in- rise.
dustry are increasing the price of service to
the consumer. For instance, as it become