The Technology Gap in the Banking Industry; Disarray over Electronic Systems and Marketing Creates Window of Vulnerability
Kutler, Jeffrey, American Banker
In 1974 the Federal Reserve Board made a fateful decision: It would not get involved in building and operating a fully electronic funds transfer system for consumer payments in the United States.
The reasons for the Fed's denial have been lost in a haze of political disputes, recriminations, and revisionism. Not lost is the fact that a consistent, nationwide method for the efficient transfer of funds from consumers to retail merchants has never been implemented.
Quite the contrary. The technology for handling massive volumes of consumer payments has advanced more quickly than bankers' ability to assimilate it. Fragmented in its very structure, the banking industry has approached its payment-systems opportunities in a confused and incoherent way.
Consumers, the bulk of whose transactions must flow through any payment system in order for it to achieve maximum efficiency, simply haven't been educated in the benefits and advantages of electronic funds transfer. A banking industry unable to agree within itself as to the nature and promise of EFT cannot be expected to transmit the necessary messages to the marketplace.
Into the breach have stepped a number of outside firms who are expert in the technology and its capabilities, which even bankers agree can exceed anything that has yet appeared on the scene.
These corporations -- units of General Electric Co., Automatic Data Processing Inc., the Tymshare subsidiary of McDonnell Douglas, and perhaps eventually AT&T -- individually or together have demonstrated that they can wrest at least a measure of control over payment systems from the depository institutions who once owned them exclusively.
The rivalry for payment system access and control has been intensifying for almost as long as the theoretical "cashless" or "checkless" society has been part of banking visionaries' vocabulary.
In other words, for almost two full decades, the banks have been losing their grip of payment systems, hence technology, hence their future. They have been told so by officials of the Federal Reserve System, by their trade associations, by outside experts such as Arthur D. Little Inc., and by internal critics such as Dee W. Hock, the outspoken, recently retired president of Visa International.
To this day, the power within the banking establishment rests not with individuals well versed in electronic technology and its implications, but with people who rose through the ranks of commercial lending -- banking's traditional bread-and-butter. Slowly this is changing: A technologist, John Reed, became chairman of Citicorp, and an avowed payment-systems enthusiast, James G. Cairns, was elected president of the American Bankers Association, both in 1984.
But the banking business remains dominated by the old intermediary function, and most of its profits still come from the net interest margin. So on a Saturday in October at the start of the ABA's annual convention in New York, less than 200 of the 10,000 visiting bankers attended a seminar arranged by Mr. Cairns to enlighten them on the dangers posed by fragmentation in the payment systems.
Clearly, those who run the vast majority of the nation's financial institutions would rather not be bothered with payment-system and technology matters. "Our business is still fundamentally a people-to-people business," they argue, and they are right.
But new entrants into the once protected domain of banking have financial and technological resources that banks acting individually or in groups have been unable or unwilling to confront directly. For example, Sears, Roebuck and American Express are the two biggest financial service industry advertisers. They benefit from national name recognition and from nationwide delivery systems that afford them economies of scale.
In contrast, there are 15,000 entities competing in commercial banking alone. Half of them have only one office. Three-fourths of them have less than $50 million in assets.
They do share in Visa and MasterCard, which take on American Express and the consumer credit operation of Sears. But can the banking industry explain to itself or to its public why it is supporting two payment services companies that seem to be exactly alike in image and function?
The banking community also has formed numerous alliances, within states and across state lines, to provide access to cash and related banking services through networks of automated teller machines. But can anyone explain why there have to be more than 200 separate groups of ATM and point-of-sale network participants, and four or five more -- besides MasterCard and Visa -- that are nationwide in scope?
The multiplicity of electronic networks reflects the underlying fragmentation and factionalization that plague banking in another critical endeavor -- lobbying for advantage in Congress. Inability to arrive at a political consensus between large and small institutions, money centers and regional banks, banks and savings institutions, etc. caused legislative paralysis that has allowed deregulation to proceed de factor rather than de jure.
The hodgepodge of electronic banking networks replicates the general political situation and is just as useless. The high-speed communication technology on which these networks depend by nature requires industry unity. Maximum cost efficiency stems from the maximum transaction volume that the industry at large can contribute. If that volume is dispersed among many networks, as it is today, the benefits are hard to come by.
The opposite of fragmentation is central engineering, or a single network, which to many participants smacks of communism or something close to it. There would be no competition, these observers claim, and that is simply un-American.
Somewhat between chaos and central planning lies a middle ground that the banking industry had better commandeer before some of its dreaded competitors take over that most crucial payments function. Central Planning Proposed
In the late 1960s and early 1970s, central operation of a national payment system -- by none other than the Federal Reserve Board -- was seriously proposed and discussed. Today such a proposal would be dismissed out of hand, given commercial bankers' unease with the Fed as a competitor in the limited sector of EFT known as the automated clearing house. But many of the terms used in that early debate resurfaced in the 1980s as bankers reexamined duplication and redundancy in payment systems both wholesale and retail.
One participant in that early dialogue was John Fisher, an Ohio bank marketer who concluded during one of the nation's first point-of-sale terminal experiments that a single bank could not profitably operate such an EFT system alone. Extending his logic, Mr. Fisher, now senior vice president of Banc One Corp., Columbus, suggested that the best way to build a centralized EFT system open to all banks and their customers would be to let the Federal Reserve do it.
At the time, commercial banks were the only financial institutions with the power to offer checking account, and the Fed was the principal operator of the check clearing and settlement system. If banking was to develop a more efficient payment instrument out of the paper check while keeping control over its development "within the family," Mr. Fisher reasoned, then the Fed was the most logical provider of the new electronic mechanism.
While Mr. Fisher's bank, then named City National Bank & Trust, was running its local point-of-sale pilots known as POST I and POST II, another, more far-reaching study was underway in the South -- the Atlanta Payments Project. Funded by several Atlanta banks, the Georgia Institute of Technology, and, importantly, the Federal Reserve Bank of Atlanta, these researchers similarly proposed direct Federal Reserve System involvement in electronic payment systems that would displace the costly and inefficient checking system.
The Atlanta Payments Project published a report in March 1974 that laid the groundwork for the Fed-operated national automated clearing house system. Following the example of California banks six years earlier, the Atlanta banks formed a Committee on Paperless Entries to process and clear preauthorized, interbank debit and credits such as payroll checks, bill payments, and, eventually, Social Security disbursements (which today are the most numerous ACH payment).
Lost in the shuffle of the early ACH movement was the atlanta project's proposal, along the lines of Mr. fisher's, that the Federal Reserve establish a true electronic funds transfer mechanism in which all banks could participate. Geared for point-of-sale transactions, such a system would involve the nearly instantaneous movement of funds from buyer to seller. The ACH was different -- although the payments were processed electronically, they were "batched" and handled in a relatively slow processing schedule that was considered unsuitable for "true EFT."
Mr. Fisher and the research director of the Atlanta Payments Project, Allen H. Lipis (who now heads the consulting firm Electronic Banking, Inc., in Atlanta), presented their point-of-sale ideas to George W. Mitchell, the vice chairman of the Federal Reserve Board and a promoter of electronic payment alternatives. Mr. Mitchell promised his support. In Atlanta, the regional Federal Reserver Bank was willing to go forward with a POS test. The Fed Backs Away
The Federal Reserve Bank of Cleveland, however, completed a cost/benefit analysis of an electronic payment network serving participating banks and points of sale throughout the Fourth Federal Reserve District. It said it would cost $100 million over 10 years to put such a system in place, market, and operate it. Also, it would take the full 10 years for the system to break even by displacing paper checks and reducing the average cost per transaction.
The total cost and slow payback put off Federal Reserve System officials in Washington. Their involvement in all-encompassing EFT networks became even less probable after the Fed invited comments on proposed EFT-oriented amendments to its Regulation J, which delineated central bank responsibilities in payment systems.
When the Reg. J changes made it seem as if the Federal Reserve was moving in on their territory, both MasterCard and Visa generated a storm of protest.
They contended that a government agency, independent though it may be, should not provide services that the private sector was perfectly capable of providing. Citicorp, the aggressive bank holding company which in the early 1970s espoused a "go it alone" philosophy on EFT, joined the anti-Fed alliance, fearing the worst of a government-coordinated network.
Congress showed little interest in resolving these issues as President Nixon neared impeachment. Instead, it created a National Commission on Electronic Fund transfers to provide guidance -- little of which Congress took when the commission finally completed its work in 1977. In deference to the commission and to the outcry over Regulation J, the Federal Reserve pulled back and Governor Mitchell didn't press the case for central bank involvement in EFT at the point of sale.
In June 1974, the Fed made it official by notifying the Atlanta Payments Project that the Federal Reserve Banks would not have the authority to operate point-of-sale networks for banks.
Gamely, Atlanta's largest bank, First National, initiated what was to become the nation's most famous point-of-sale service -- Honest Face. A prelude to the debit card, this local check guarantee card was a marketing success but was never profitable. The bank sold Honest Face to a nonbank company, Telecredit Inc., in 1981.
On the theory that single banks could not profit from proprietary POS programs, several other Atlanta banks joined forces to take on Honest FAce. Their venture sputtered and died.
In Ohio, Mr. Fisher tried going down more than one POS avenue, failing to build the "universal" sharing and acceptance that he was convinced would bring the concept to fruition. Now his bank is a promoter of the Visa electron card, which is designed to appeal as much to merchants as to bank customers.
In contrast to its POS decision, the Federal Reserve Board decided that the automated clearing house network had the characteristics of a natural monopoly -- meaning one provider could build and maintain the infrastructure more efficiently than two or mroe competitors. Determining that no private company could run the ACH at a profit given the meager transaction volumes then expected, the Federal Reserve took the ACH under its wing and granted banks access for an artificially low price in hopes of attracting profitable volumes. Fundamental Questions Unanswered
In 1984, the national payment-system situation is more confused than it was when its foundations were laid in the mid-1970s.
Events have borne out the recommendations of the National EFT Commission. It called on the U.S. government, primarily the Federal Reserve, to keep away from point-of-sale networks segments of the country or society were being denied their benefits, or if the case could be made that POS is a "natural monopoly" as the ACH was assumed to be.
The commission also said it was appropriate for the Federal Reserve to continue to nurture the ACH through its early stages at a subsidized price per transaction.
Yet the number of checks written annually in the United States has climbed at least 5% a year to well over 40 billion by most estimates. Growth in credit card, ACH, ATM, and POS transactions has put little if any dent in the number of checks written by American consumers.
These noncash means of payment have probably generated more gross transactions -- and more demand on banks' data processing capacity -- than would have occurred had these new methods not come on the scene. The 300 to 400 million annual ATM transactions probably have increased the amount of cash in circulation, which is inefficient for retailers and for the tax collector who is trying to do away with the underground economy.
meanwhile, the Fed's ACH monopoly has been effectively broken up, and with it the preferential pricing that caused the private sector to rebel. Instead of completely subsidizing ACH transaction fees, the central bank in 1985 will recover about 80% of its costs, rising to 100% by 1986. Then, unless the Fed provides a truly competitive service, the private sector will win the business away.
By private sector is meant General Electric Information Services Co. and Automatic Data Processing, which see dollar signs in those unrealized billions of potential ACH transactions. Ironically, bankers seeking a better price -- apparently not concerned about losing their hold on payment systems -- opened the ACH doors to these nonbank competitors.
Interactive Data Corp., a computer and communications service company owned by Chase Manhattan Corp., also expects to play a role in the ACH. This would keep the ACH in the banking family, and in fact Chase is organizing its own alternative to the New York Automated Clearing House.
Through it all, if bankers haven't noticed, they are paying more for a basic ACH transaction than they did before the Fed consented to escalate its prices. The National ACH Association recently made a "conservative estimate" that the system would save $16.9 million over three years as a result of private-sector competition with the Fed. But to date the banking industry has paid a price to admit competitors into the ACH -- a price that cannot be justified if, as the Fed used to say, it really is a natural monopoly.
Conversely, in retail electronic payments the unfettered market spawned a swarm of competing networks, in some cases functionally equivalent to and undifferentiable from each other. Now there are calls for rationalization and consolidation -- if not into a centrally administered, natural monpoly then certainly toward something closer to the forgotten Ohio and Atlanta proposals of the early 1970s.
Many observers of the retail payments scene are focusing their attention on negotiations now underway between MasterCard and Visa, which are owned by virtually the same group of banks, to combine some of their duplicative data processing and communications resources. Already, these two formerly bitter rivals have agreed to join forces to combat fraud and counterfeiting.
But the big payoff to the industry will come if their back offices can be merged, thereby cutting up to half of the credit card industry's infrastructure costs. Their two separate marketing programs and/or service marks might eventually be combined into one, enhancing economies of scale, but this suggestion is still rejected as heresy.
Discussions between MasterCard and Visa directors over the past 15 months have been kept secret, but a fundamental difference over communications technology is known to separate them. MasterCard has thrown in its lot with Tymshare and its packet switching network, which of course is not bank-owned. Visa contends that banking should control its communications facilities, and Visa is partial to the IBM-based System Network Architecture.
If MasterCard and Visa do overcome whatever obstacles remain to reaching an accommodation, then it may be taken as a model for the ATM-POS-debit card sector to coalesce along the same lines. Alex W. Hart, executive vice president of First Interstate Bancorp and an influential participant in several consumer payment systems (he is a co-founder of the Cirrus ATM network and a director of MasterCard), has publicly called for a consolidation of debit card identities into one or a few that consumers will immediately identify with instantaneous funds transfer, just as MasterCard and Visa connote credit.
Others share the view, at least in private, that there are too many systems each trying to do the same things, to the detriment of the industry at large.
As in the ACH, nonbank providers have made a move toward payment systems control. J.C. Penney and Sears are both selling their excess communications capacity to other merchants, notably oil companies. One petroleum retailer, Exxon, has issued its own debit card in Arizona that relies on the automated clearing house for interbank settlement. Via the ACH the funds don't move instantaneously, but transaction prices are considerably lower than in an on-line, real-time, "true EFT" mode.
Besides agreement in principle on consolidation, what will it take for the banking industry to get on the right technological track in the race against nonbank technology providers?
Less fragmentation will help. This will require diplomacy and friendly persuasion. People such as Mr. Hart and Mr. Fisher will have to convince a broad cross-section of the banking industry that cooperation is in their best financial and marketing interests.
Bankers have not only failed to grasp the essence and implications of technology. Bankers in general simply do not comprehend their current cost structures let alone the benefits promised by EFT. They have to learn cost accounting, a relatively new science within banking.
If consumer electronic payments is a scale-intensive business, then an economic case can be made to encourage combination of resources into one or a few super-systems whose unit costs are minimal. The case can be argued intuitively. For example, MasterCard-Visa peace might be worth $20 million or $50 million or $100 million a year savings. Unfortunately, $100 million spread over 15,000 banks, even in proportion to their credit card receivables, will not excite a lot of bank chief executives or stockholders.
In this technological era, bankers must recognize that their problems are as much attributable to technology as to marketing. To this extent the problems are shared industrywide.
Technology is what allows a Sears or an American Express or a Merrill Lynch to make new assaults on banking's turf. Unlike banks, new entrants are free of the fixed overhead of brick-and-mortar branches in questionable locations of varying profitability.
The "banking is a people business" retort no longer holds water when millions of dollars are being poured into electronic systems in the name of efficiency and personalized service. Calling it a marketing problem seems to fall flat when one realizes that despite the sophistication demonstrated recently by bank marketers, they as much as technologists are in a managerial back seat, equally far removed from banking's easy-money traditions.
Recognizing the technological imperative, Bank of America has taken a page out of Citicorp's and John Reed's book. Just as Mr. Reed came out of Massachusetts Institute of Technology and Goodyear Tire & Rubber Co. to run Citibank's operations division as the labor-intensive factory it was, Bank of America hired Max Hopper out of American Airlines to run its retail back office as the high-speed information factory that it is becoming.
No bank, or any private company for that matter, exceeds the transaction speed of the airline industry's computer networks. Using the Transaction Processing Facility, an IBM architecture, American and other airlines' reservation and communications computers can handle up to 800 transactions per second. Interlink, the large-scale point-of-sale network of five California banks that expects to begin operation in 1985, will use the Transaction Processing Facility provided by Visa, whose normal IBM 3083-E computer configuration can handle "only" 125 authorizations and responses per second.
At Bank of America, a member of Interlink, Visa, MasterCard, and the Plus ATM network, Max Hopper is talking about peak capacity of seveal thousand transactions per second. He has hired Jerome Svigals, a well-trained technologist who spent 30 years with IBM, to help him achieve that goal which far exceeds current needs in the airline industry as well as banking.
Is this overkill, or is Bank of America moving correctly to become an information channel when banking's traditional intermediary function becomes obsolete? Should Bank of America be doing this alone, or should a project on this scale be centrally coordinated within Visa or MasterCard or some other
recognized authority so that its benefits are maximally distributed throughout the banking system?
More basically, those engaged in technology-based activities must ask when it is in their interests to cooperate, and when they are better off competing. In most European countries, banks have willingly shared access to communications networks and processing channels, concentrating their competitive energies on serving consumers. Even at that, consumer banking services in some industrialized countries are regulated by cartel pricing. Americans would frown upon that, though they might be eager to obtain brokerage and insurance services from banks as are available in much of Europe.
In the United States, European-style cooperation would not have been tolerated in the early, trust-busting years of this century. Nor would a single, monolithic network for electronic transactions be likely to pass antitrust muster in a country where bigness is still treated with suspicion.
But it is clear that something is needed that is bigger and more cohesive and coherent than the fragmented EFT networks currently in existence. Bankers have been either unable or unwilling, and probably both, to reach a consensus on exactly what kind of system or systems they need, whether for ATMs or POS or home banking, and on where to draw the line between cooperation and competition.
Within the industry, it is a problem of politics and communication. In relation to customers, it is a problem of marketing and projecting a consistent and comprehensible image. But fundamentally it is a problem of technology and bankers' ability -- or inability -- to manage it.
Bankers may wish that their technology gap is as fleeting or imaginary as other gaps on the national scene, such as the missile gap in the 1960s, the credibility gap in the 1970s, the window of vulnerability in the 1980s.
But the banking industry is truly besieged by companies unencumbered by outmoded regulations and well versed in the applications, costs, and marketability of technology. Bankers must close ranks in relatively short order if they are to close the technology gap. If they fail, then the lessons of pioneers such as Mr. Fisher and Honest Face and Plus and Cirrus and other networks will have been learned in vain, and bankers will have ceded control over their last bastion of exclusive advantage.…
Questia, a part of Gale, Cengage Learning. www.questia.com
Publication information: Article title: The Technology Gap in the Banking Industry; Disarray over Electronic Systems and Marketing Creates Window of Vulnerability. Contributors: Kutler, Jeffrey - Author. Magazine title: American Banker. Volume: 149. Publication date: December 10, 1984. Page number: 20+. © 2009 SourceMedia, Inc. COPYRIGHT 1984 Gale Group.