Corporate Governance and Product Innovation (COPI)

A research project funded by the Targeted Socio-Economic Research (TSER)

programme of the European Commission (DGXII) under the Fourth Framework
Programme, European Commission (Contract No. SOE1-CT98-1113). Coordinated by
Professor Andrew Tylecote of Sheffield University Management School (SUMS) at the
University of Sheffield (UK).

Innovation in Banking:

A review from the point of view of Corporate

Governance
Submitted to the Commission: October 2000

Andrew Tylecote and Saide Tarhan*

Sheffield University
Management School and Department of Economics
9 Mappin Street
Sheffield S1 4DT
United Kingdom

Tel: 44 (0) 114 2223415

Fax: 44 (0) 114 222 3348
Email: a.tylecote@sheffield.ac.uk,

*Demirbank, Maslax Subesi, S0870 Istanbul, Turkey.

MBA Student, University of Sheffield, 1999

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Innovation in Banking: a review from the point of view of
corporate governance.1

Andrew Tylecote and Saide Tarhan

1. Introduction

Even 10 years ago, banking in every advanced country was a mature industry dominated by
large oligopolistic firms, whose position was fundamentally a comfortable one. They were
protected by regulation, in Europe, at least until the mid 1980s (Franke, 1997) and by a number
of effective barriers to entry: reputation, economies of scale of various kinds, including the very
high cost of acquiring the branch network which was the basis of retail banking. 2 During the
1970s and 80s they had become aware that information technology had much to offer their
industry - hardly surprising, given that their business was mainly to do with the storage,
processing and transmission of information. They were able to use it to gently bring down the
real cost of their back-office activities, to introduce a number of product innovations, and to
introduce what are conventionally called “delivery innovations” like ATMs, Automatic Teller
Machines. (For the authors, to be able to get cash at any time of the day or night seems like a
product innovation of considerable importance, but we will follow the convention.)

Any oligopoly will seek to differentiate its products, and to compete for market share on that
basis rather than on price. Accordingly, the emphasis in innovation in banking was on product
and delivery innovation. Of course, process innovation could cut costs and thus increase profits,
but this was not an urgent necessity in an industry where management was generally not under
much pressure to increase profits - because they were usually quite high, unless top management
had thrown itself into some ill-advised splurge of lending to bad Third World risks; or because
the bank was under some form of ownership (state or mutual) which gave no importance to
profit anyway. (Mutual banks remain important in Europe: as of 1996-7, their share of retail
deposits in Europe was around 18% in Britain, 37% in France, with Italy, Germany, Finland
and the Netherlands in ascending order between (Economist 1999a)). Given the underlying
trend to expansion of financial services, the result was to roughly maintain the level of
employment in banking.

1
This paper draws crucially on a number of interviews conducted with senior individuals in all but one of
the five main British banks, plus a London stockbroking firm with particular expertise in banking, during
autumn 1999. For reasons of confidentiality the source of most statements drawing on these interviews is
not given. We wish nonetheless to express our gratitude to all those in the industry who helped us.
2
Regulation was tight in the US in a number of ways but seemed to constrain innovation less.
For example ‘the prohibition of universal banking in the USA gave the investment banks a
strong incentive to gain at the expense of commercial banks by securitised deals’ taking
advantage of the fact that there were few barriers to innovative securities transactions in the
USA. (Franke, p.13).

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Under these circumstances, even in the late 80s, innovation was not a matter of great
importance for corporate governance - and corporate governance was not a matter of great
importance for innovation. Shareholders and other stakeholders were only belatedly learning
(as they had learnt long before, for example, in a high technology industry like pharmaceuticals)
that their interests would be much affected by how management responded to the challenge of
technological change. They were not driving technology forward; nor, on the other hand, was
their thirst for immediate profit doing much to hold it back, since spending on technological
innovation was only a modest fraction of profits.

The writing was, however, on the wall. Information technology had the potential to make
everything they did, very cheap to do - an attractive prospect for them so long as they could
hold the oligopolistic ring, but ultimately bound to undermine the barriers to entry. IT also had
the potential, by cheapening transactions (particularly at a distance), for unbundling their
products and production to an unheard-of degree. The unbundling of products takes place
gradually, once the right technical and regulatory conditions exist, through the demystification
of financial products. (Franke, 1997). Gradually the customers come to understand the
interactions within a ‘bundled’ package of components so that the package is demystified (a
broker of some kind may of course help them in this). They then unbundle the package and
demand only those components for which the price offered on financial markets is attractive to
them. One classic bundle is the current account, which in the UK and most of Europe provides
funds transfers free but pays no interest on deposits. This is now being unbundled.

The learning process of consumers interacts with the natural tendency of financial institutions to
trade with one another in well-established markets, in order to reduce their risks and increase
their liquidity. (Franke). This has encouraged the unbundling, or vertical disintegration, of what
might be called the financial production process. A mortgage lender, for example, used to need
to raise the capital wherewith to make the loans. The most convenient way to do that was to
take deposits in the same branches as it made the loans from. Now, the making of the loan can
be done (and in the US frequently is) by a firm which does not then hold it, but sells it on as an
asset with an income stream. The lender then needs neither capital nor branches in which to take
deposits. Nor does he need branches in which to meet the client: the interaction can be at a
distance, either through the telephone, or using more advanced forms of telecommunications.
The Bank of Scotland, for example, has now broken into mortgage lending in Ireland and the
Netherlands. “BoS forced existing lenders in Ireland to cut their rates when it began to offer
much cheaper home loans over the telephone, using its existing Scottish call centres.” (Graham,
2000). Information technology offers far greater possibilities for unbundling in the future.
“Imagine a vast electronic exchange on which millions of bids and offers are constantly
flickering. It could be globally available on the Internet. Intelligent matching systems of this kind
mean that there is almost no cost to finding the best price available at a given time….. These
technologies enable the financiers to exploit their unbundling skills to the full.” (Economist,
1999b, p.114).

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What ‘strings’ then remain, by which the product bundle is to be held together? No longer will
there be the synergies existing within branches, when the customer interacts with the bank by
phone or other telecommunications. What is left are
• the reputational effects of a bank ‘brand’. This is not much protection against competition:
once entry is technically easy, then any brand which offers a degree of reassurance - a well-
known foreign bank, an insurance company, a large supermarket chain - can compete for
market share.
• the customer database which informs the bank what to offer to whom, and what to refuse.
A large customer database is an asset, and it may be convenient for a bank to use its own
retail customer database as the basis of selling other financial services to its customers.
However, data is now easily traded among firms - as information about bad risks long has
been.
• The synergistic effects of a web-site - a virtual branch, in the sense that visiting a site for one
purpose makes it relatively easy to conduct (or in the first instance find out about) another
service which is provided on the site, or at least by the bank. This is better than nothing, but
it is much easier to visit a number of bank sites in cyberspace than to visit the same number
of offices out in real space.

Banks are then staring at a new world in which they will not be able to charge, for the basic
financial services customers want, much more than they will cost to produce, which is very little.
Many of the less basic services will cost next to nothing either. Price competition will force an
unbundling, which will reveal the high price of those services which are still expensive to provide
- a heart-to-heart talk to the manager, for example - and the customer will respond accordingly.
Suddenly technological change is no longer a matter of a marginal cut in profits now and a
modest increase later - it is corporate life and death (Gardener et al., 1999).

One view of the outcome of the coming struggle is that there will be a return to oligopoly but on
a world level: “Looking ahead, I believe that our industry will end up structured something like
the world oil industry: a few very large electronic banking firms challenged by a competitive
fringe of smaller niche players.” (Marcel Ospel, the chief executive of UBS, the Swiss banking
group, quoted in Graham, 2000.) If that is so, the change might in principle take place through a
massive wave of mergers, mostly cross-border. But cross-border mergers are even more
difficult to consummate successfully than the domestic variety (as we shall see, both suffer from
the problems of combining IT inheritances, as well as the familiar problems of corporate culture,
etc.). Moreover, as we shall argue below, internet banking can benefit greatly from having the
technological equivalent of a greenfield site. It can certainly operate easily and effectively across
borders. First-e is based in Dublin but operates under a French banking licence and offers
current and savings accounts in the UK. Lloyds-TSB, one of the strongest banks in Europe, has
chosen to expand into the Eurozone with an internet bank without any acquisitions (Graham,
2000). It thus seems to us likely that a strong position in the new world banking market will be
won by mastering the vital new technological competences better and quicker than rivals, rather
than gained by the inheritance of an existing market share.

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These competences are not evenly distributed across the advanced economies. Graham (2000)
quotes an IBM/Interbrand study as finding that as of 1999 Citibank (US), Swedbank
(Sweden), Merita-Nordbanken (Finland-Sweden) and SEB (Sweden) were the top four bank
brands (in that order) on the internet. There were, by the end of 1999, however, over 1000
financial services companies operating on the internet in Europe, well spread by country. Banks,
non-banks and new start-ups are all entering the internet-based financial services market in large
numbers. Given the ‘e-premium’ evident on world stock markets in the late 1990s, capital for
entry, particularly by start-ups, has been very cheap to raise. (Noble, 1999.)

We therefore expect death will be the outcome within a few years for any bank which does not
both manage to win in the cut-throat struggle for market share in ‘traditional’ banking services
(the movement of money, the taking of deposits, and the making of loans) and to use IT to
develop lucrative new services. In Europe in general, following the United States, the pressure
from shareholders is growing, and efficiency and shareholder value are increasingly being
emphasised as bank objectives (Gardener et al., 1999). Thus both corporate governance and
innovation are much more salient issues than before; and the interaction between them has now
become of crucial importance, in determining, first, which bank decided early and shrewdly on a
major commitment to technical change; second, which bank is able and willing to resource such
a commitment most generously and to manage it most skilfully. This report will examine:
• What are the main innovations which have been recently introduced, and will soon be
introduced?
• What are the processes by which they are taking place?
• What are the implications of these processes for corporate governance, and the
implications of corporate governance for these processes?

We shall focus mainly in this report on retail banking, or to be more precise banks’ retail
activities. This reflects the growing importance of retail business to banks, as the increased
intermediation of corporate credit flows through financial markets – the shift from loans to
bonds – has tended to reduce their ‘wholesale’ business. It has become the more important to
banks to retain their retail customers and extend the range of financial services they provide
them (including insurance) – thus the strategy of allfinanz or bancassurance (Gardener et al.,
1999). Another response has been to follow their corporate customers into the stock market
and develop their investment banking and securities operations (Gardener et al., 1999). We
do not discuss this here; what we do look at, because of its relationship with internet banking,
is the scope for bank involvement in e-commerce and e-procurement.

2 Product and Delivery Innovations in Banking

2.1 The Shift to Relationship-Oriented Retail Banking

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Traditionally the relationship between the bank and its customers has been via the branch
network. The head office had responsibility for the overall clearing network, the size of the
branch network and the training of the staff in the branch network. The bank monitored the
organisations’ performance and defined the limits for making decisions, but the information
available to both branch staff and their customer was only what existed in one geographical
location. (Gandy and Chapman,1996)

Customer Customer Customer

Bank Branch Bank Branch Bank Branch

Clearing Decision Clearing Decision Clearing Decision

Central Clearing Head Office

Figure 2.1.1 Traditional Banking Structure

Source: Gandy & Chapman, 1996.

However, the modern bank cannot rely on its branch network alone. Customers are now
demanding new, more convenient, delivery systems. The telephone banking service is now well
established and increasingly people expect up-to-date ‘information-based banking services’.
Services like Internet banking or interactive TV banking offer the customer two things: they
provide traditional banking services, but also offer much greater access to information on their
account status and on the bank’s many other services.
Information is provided in various layers which can be accessed both by the bank staff and by
the customers themselves.

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 C u s t o m e r s

Telephone, Branch, Electronic Banking, etc.

Shared Information

Clearing Systems Head Office Risk Monitoring

Figure 2.1.2 Relationship-Oriented Banking Structure

Gandy & Chapman, 1996

Retail banks have as a consequence of this a variety of options. They have many different
products and many different ways of delivering them. They have to decide which products they
wish to sell; whether they wish to build those products themselves; how they should deliver
them, and who they wish to deliver them to. Technology underlies all these decision-making
processes. This makes technology’s influence over retail banking enormous. They must be able
to use local processing power to deliver a variety of products through different media.
Decentralised client/server computing allows banks to address customers in a variety of
environments, via branches, ATM networks, over home PCs and so on. These, in turn, rely on
network technologies to pass data around the bank to the appropriate transaction processors
and databases.

Choices have been enhanced through the applications of technology. The consensus view at the
time Gandy and Chapman (1996) wrote, was that in the long term success depends on building
an infrastructure which allows banks to offer a uniform service delivered through different
channels, giving ready access to consolidated data concerning both individuals and the whole of
the customer base, and which allows for the rapid development and introduction of new
products. Each major new delivery mechanism and product, beginning with telephone banking,
can, however, be satisfactorily employed in isolation. Particularly if some unbundling is
accepted, this is an entirely feasible alternative.

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A critical problem for established banks is that adding an extra service, such as a statement over
the phone, does not, initially, cut costs. It is an extra service for customers usually introduced as
a response to competitive pressures. Setting up the system and organising the personnel to run it
can only increase costs. It is only as the new delivery channel is used as a substitute for the old,
and the staff and other costs required by the old are progressively cut, that the bank can even
get back to the initial cost position.

A complete service to customers, no matter which delivery mechanism they are involved with,
requires a central architecture which enables all elements of the bank to access all relevant
information, in the format that they require. This allows customers to move smoothly among
new and old methods of interacting with the bank without losing their old relationship. The ability
to do this is critical in facilitating the movement of customers away from traditional branch
banking into a setting where the branch is used as a sales and advisory centre.
Thus the bank can deliver the service whilst reducing costs arising from the old infrastructure.
Datawarehousing, client/server architectures and multimedia delivery systems play a key part
here.

The new technologies allow banks to turn their back on the fast moving consumer goods
(FMCG) mass marketing style of selling products, and have made it possible to develop instead
a more targeted approach to dealing with customer needs. Traditional mass marketing is a
scattergun approach, the alternative approach is micro-marketing to the specific needs of
individual customers. Such approaches generate a higher percentage of sales, and also increase
customers’ satisfaction with the service of the institution, as customers are not constantly
bombarded with irrelevant offers. Thus the other term now used to describe the banks’ new
posture is ‘customer-orientation’ (Smith and Walter, 1997). This means, among other things,
that banks are structured according to customer groupings, with separate departments for
• Retail banking for small private customers
• Banking for high net worth individuals
• Institutional investors
• Corporate finance
instead of (or perhaps alongside) the old product-based structure in terms of
• Lending activities
• Payments services activities
• Brokerage activities
• etc.

Micro-marketing means developing tools which enable central marketing units to target the
individual customer for specific services. The development of customer information systems
(CIS) able to deliver this can also be exploited at the customer service level. The CIS system
can also be used to develop a ‘virtual personal banking’ service by distributing this information
to customer-facing employees. Giving branch workers or telephone operators access to a
screen outlining the customer’s financial history with the institution and their personal
background, allows them to deal knowledgeably with a customer’s requirements.

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 2.2 Delivery Innovations in Retail Banking

There are many different ways in which a bank can do business with its customers:
• Traditional branch
• Automated Teller Machine
• Multimedia Information Kiosk
• Telephone banking - call centres
• Telephone banking - voice recognition facilities
• Home Electronic Banking
1. via the Internet
2. Private modem to modem links
3. Interactive Television
4. Smart Phones

The Role of the Branch Network

Banks currently deliver most of their services via some form of high street branch network.
However, the nature of the branch is changing. In the light of these changes, one radical view is
that the cost of branch networks will be so high, that individual banks will not be able to afford
to deliver them independently, resulting in ‘free branches’. The free branch would be similar to
free houses which can choose which brewer’s products they wish to sell based on customer
preferences and brewers’ incentives.
In the past the branch played a major part in the actual processing of transactions. Increasingly
however, these activities are being stripped out of the branch network and in some cases even
out-sourced completely from the organisation.

Multimedia ATM Kiosk

Multimedia ATM services can reduce the cost of transactions. The multimedia ATM kiosk is a
relatively new development, but it is expected - or was, before home electronic banking took
off - to become one of the most important methods of interacting with customers. In this
environment, ATMs are provided for transactions, for cash withdrawal, deposit, transfer
between accounts and bill payments. Cross sale is undertaken by experts centred in the bank’s
telephone/virtual banking call centre who appear in the branch on a video conferencing system.
(Gandy and Chapman 1996)

Telephone Banking
Telephone banking is seen as being one of the most important new channels for delivering
banking services. As with electronic home banking there are various ways of offering telephone
banking services.
Telephone banking is about immediacy: there is no time for the call centre staff to log on to the
customer’s current account system and then have to log on to a different system to get their
mortgage status. Often the response to this problem has been to build banks within banks. The
classic example of this breed is First Direct, a UK telephone bank set up by Midland Bank as a

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wholly-owned subsidiary in the late 1980s. First Direct’s centralised call centre uses modern
open systems technology to deliver to each customer representative, instantly, full information,
on screen, on the client’s relationship with the bank, and only uses Midland Bank’s main
technology infrastructure for transaction processing. It is easier for a bank to deliver a modern
banking environment into one small central centre than to try to apply the technology across the
bank. Ominously for the future competitive climate, First Direct’s market strategy has of
necessity been one of attack. Given its separate branding, it is basically as easy to take on a
non-Midland customer at First Direct as a current Midland customer. It is certainly much more
profitable for Midland overall! First Direct is aimed at winning market share for a new brand
that happens to be owned by Midland. It is not an attempt to defend the current customer
base, as only a few of them are offered the First Direct service (Gandy and Chapman, 1996).
The defensive alternative to the First Direct model has been the development of telephone
services as an addition to the branch network. Initially, this was bound to be a rather incoherent
bolt-on arrangement. However, as banks work on integrating their customer information,
making this information accessible to customer-facing staff, then the full integration of branch
and telephone-based services starts to become possible.

Home Electronic Banking

Banking services are one of the key elements in establishing electronic media as a viable
environment in which to carry out commercial activity. In many ways banking is already a
virtual concept to most people. They routinely use their bank account to deposit wages and
then draw down on those wages without ever going into the branch. Indeed the use of
electronic delivery can potentially increase service levels and improve relationships with
customers above current levels.
The use of interactive electronic links to customers could go some way towards re-establishing
links and providing the customer with greater levels of information about both their own financial
situation and about the services offered by the bank.

There are two general strategies being adopted by the banks:

• proprietary or closed access
• open access

Banks (who were not alone in this) generally underestimated the speed and importance of the
spread of the Internet. Accordingly, until the late 1990s the preference was to invest in
proprietary banking systems. These systems link a home-based device directly to the bank’s
host computers. The home system could be a PC or a dedicated terminal such as Royal Bank
of Scotland’s HOBS. These systems offer the security of a direct link between the customer
and the bank without having to pass through any intervening servers, and mean that the
relationship between the bank and its customer is on a one-to-one basis.
However, older systems of this type often do not allow features such as easy export to
spreadsheets or a Windows interface.
Such systems are now being eclipsed by the spread of Internet banking. (See below).
However, it will probably be decades before the use of the internet becomes virtually universal -

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presumably a large proportion of those now over 40 will be reluctant to adopt it - and so there
is a clear opening for the use of more familiar electronic media, such as TV. Thus HSBC
launched TV banking for their existing customers in November 1999, in collaboration with
Panasonic (as hardware supplier) and B Sky B (as satellite broadcaster). This is an interactive
digital multimedia system: the loop between bank and customer is completed by the phone line,
which carries the customer's messages to the bank (Allen, 19993).

Internet banking

It was the emergence in the mid 1990s of solid standards for internet security which allowed the
net to gain a decisive advantage over closed access PC banking (Goodwin, 1997). Some US
banks were quick to take advantage of the new opportunity, but (for reasons we shall discuss
below) Swedish and Finnish banks were even quicker, at least in terms of overall market
penetration (Lehman Brothers, 1999). According to Jacquelot (1999), the good news for the
banks is that the internet is opening unimagined possibilities in terms of cost reductions, the
creation of new services, and the personalisation of client relations. The bad news is that the
internet also provides consumers with unprecedented freedom of choice and opens the door to
completely new competitors, to the extent that banks must now ask themselves if they are in fact
the best placed to offer internet banking services.

In terms of cost, the web can certainly be seen as an extraordinary opportunity. According to
consultants Booz Allen & Hamilton, the unit cost of a banking transaction is one euro in a bank
branch, 0.5 euros by telephone, 0.25 euros at an automatic cash point and a mere 0.12 euros
via an internet site. Very low fixed costs associated with this new type of transaction explain
this statistic. The investment required by a bank to set up an internet site, and the accompanying
maintenance costs, is very much lower than for opening a bank branch, as pointed out by Thier
Saada, a senior associate with Booz Allen. (Jacquelot, 1999.)

Internet

ATM

Telephone

Branch

0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00

Figure 2.11 Estimated bank transaction costs (Euro per transaction)

3
Martin Allen, IT Manager - Financial Services; interview, October 1999.

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Source: Jacquelot, 1999

Lehman Brothers (1999) indicates that the evidence from Sweden is that average unit costs for
the internet bank are one tenth of those for branch transactions, and a fifth of those for
telephone banking. However, marginal costs are clearly close to zero compared with marginal
costs for other forms of delivery. As an example, the unit cost of SEB’s internet bank has
apparently fallen 34% in the last year, despite considerable enhancements in functionality.

As with the other major delivery innovation, telephone banking, there are three alternative
options:
• add it as an extra service within an existing operation,
• create an internet bank which is separate so far as the customer is concerned, but may
share back-office functions with a conventional bank, as convenient.
• create a completely separate internet bank.

BNP, like many other European banks, has chosen to ‘develop multiple distribution, by
gambling on the complementary nature of the different modes of service provision’. (Lehman
Brothers, 1999, p 12.) This means that, depending on their requirement, the same client can
either go to a bank counter, perform an operation via the internet, or place an order by phone.
As pointed out above, in the first instance this approach carries the disadvantage of extra costs,
so long as the existing branch infrastructure remains.

To set up a separate internet bank gives the opportunity to lower unit costs drastically. Of
course if this involved cannibalising the existing client base it might be a rather false economy.
The obvious course then is to develop a quite separate brand, as First Direct did for telephone
banking, so as to take customers from all existing banks more or less equally. On the other
hand, one then cannot take advantage of existing customer loyalty. The balance of advantage is
likely to depend on the initial market structure. If it is highly concentrated, as in the Nordic
countries (see below), there may be little to gain by a separate identity. Moreover
cannibalisation need not necessarily be to the bank's disadvantage. The majority of retail clients
of most retail banks for the greatest part of the time make losses for the bank. This is because
they are intensive users of transaction services, but generate relatively little revenue. These
clients become profitable only when they take some higher value products, a mortgage or a life
assurance policy. The internet holds the prospect of reducing transaction costs so sharply that
these clients become profit-making, even if only at a low level. What this requires for an overall
gain is that the fixed cost infrastructure of branches be cut back as those transactions are being
switched away from them. (Lehman Brothers (1999))

Lehman Brothers (1999) believe that internet delivery will rapidly dominate the industry, but
existing banks have a fair chance at remaining the major financial service providers in this
environment by levering off their convenient existing payments infrastructure.

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A new entrant from outside banking, like Prudential's Egg, can only follow a completely stand-
alone policy. They cannot benefit from existing reputation, brand loyalty, or payments
infrastructure; but they have the advantage of the technological equivalent of a greenfield site,
and they do not have to concern themselves with the consequences for existing operations.
(Noble, 1999).

Internet Banking in Europe

Table 2.11.1 Internet Penetration in Europe

Internet users Total population Proportion of

1998 ranking population using
(million) (million) internet* (%)
Finland 1,6 5,1 30,8
Norway 1,3 4,4 30,5
Sweden 2,6 8,8 29,3
Denmark 1,0 5,3 18,0
Switzerland 1,0 7,1 14,1
UK 8,1 58,1 13,9
Netherlands 2,0 15,3 12,8
Germany 7,1 82,1 8,7
Belgium 0,8 10,2 7,7
Ireland 0,3 3,7 7,1
Austria 0,5 8,1 6,7
Spain 2,0 39,3 5,0
France 2,8 58,6 4,8
Italy 2,1 57,6 3,7
Portugal 0,3 10,0 2,6
Greece 0,2 10,5 2,3
Europe 33,6 384,2 8,8
* Based on the population including children

Source: Lehman Brothers, 1999

Scandinavia (particularly Finland) has some of the highest rates of internet penetration in the
world. It also has a very high level of mobile phone penetration (witness the fact that two of
the world’s three leading mobile telephone equipment manufacturers are based in the region).
In that sense, it should be no surprise that the banks have found take-up of internet banking
services relatively rapid. (Lehman Brothers (1999).) The banking system itself was well
prepared for electronic banking, with very little paper processing in the system. (This itself is a
result of high labour costs and historical full employment, as well as a geographically dispersed
population, forcing the banks to substitute labour with technology ahead of most of the world.)
This explains why Sweden and Finland have become the first markets in the world where
banking competition is really making the shift to internet-based distribution.

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Merita Nordbanken

Merita (Finland) - recently merged with Nordbanken of Sweden - is particularly interesting, in

that its high level of internet banking and comprehensive service offering provides the first test of
the thesis that scope of service may enhance the customer value of the internet offering.

The problems of providing banking services in a geographical area as thinly populated as

Finland, led the bank to be one of the early adopters of proprietary, PC Banking. More
importantly, while many banks found this a relatively poor return project, in the particular
conditions of the Finnish market it proved a substantial success, so that Merita entered the
1990s with an installed base of PC banking customers of some 200,000 subscribers (in a
population of 5m). The same economic/demographic structure has also favoured the growth of
the internet in Finland, and it has more internet lines per capita than any other European country.
Merita shifted its services to internet-based systems in 1996 and now has almost 600,000
clients using this channel, over 10% of the entire Finnish population and according to the bank
42% of its own active account base. The bank expects to pass the 50% level before year-end.

Merita’s offering is full-function, including loans and account opening services. It had a fully
operational e-commerce payments system in 1996 (called ‘Solo’) and in 1998 added billing,
identification and e-signature capabilities. The bank has a potentially significant agreement with
Nokia in the field of wireless banking. The WAP protocol is likely to be the most widely
adopted format for linking data with mobile handsets, with around three-quarters of the world’s
handset production already committed to supporting this standard in the future. Nokia and
MeritaNordbanken have agreed to develop jointly banking applications based on this standard.
(Lehman Brothers, 1999).

SEB

SEB was the first mover in Sweden, with a functional internet offering available a good quarter
before most of its competitors (in late 1996). The company also has the advantage of a
favourable demographic client mix, with a relatively upscale retail business. SEB’s ‘internet
branch’ offers a full range of retail banking products, including bill payment, stock and fund sales
and insurance. The site receives more than 1m log-ins per month. It revamped its retail offering
in April and it is working on putting its trade finance capabilities onto the internet, and has
imminent plans to allow the personalisation of its clients’ web home pages. The bank also has
ambitions to use the service to extend its geographic client base at least into the Baltic and other
Nordic states.

In a recent study (June 1999) sponsored by IBM which looked at the quality and functionality
of internet banking offerings, the Swedish banks scored a remarkable coup. The study ranked
Citigroup first overall, but Swedish/Swedish-Finnish institutions held the next three places.
Interestingly the other major European banks to feature in the top ten were the two large Swiss
institutions (UBS at 5, CS at 9) and HSBC/Midland at number 10. With the Prudential’s Egg

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venture ranking number 8 European players held 7 of the ten top places. (Note the
conspicuous absence of French, Italian and German banks. The French and the Germans have
the excuse that they had millions of customers already using Minitel and its German equivalent,
T-Online, since the 1980s. (Graham, 2000b) When these switch to the internet they could catch
up.)

The Opportunities of Internet Banking

Lehman Brothers (1999) states that all Scandinavian banks agree that internet customers
generate greater revenue than average (about twice the normal retail customer level). These
customers are typically from higher earning households and they are usually primary customers
of the bank as opposed to one-product buyers. It may be that the same individuals are one-
product buyers at other institutions, but they are likely to choose to use the internet function of
their main bank.
The financial impact on the Swedish banks of internet banking is likely to become visible over
the next few years. Ominously, “Scandinavian banks have not benefited, in share price terms,
from their technological edge. The development of excellent internet banking services may have
helped them defend their customer bases, but it has not enabled them to resist pressure on
margins.” (Graham, 2000b).
In the short run, the crucial calculation is the interplay between the price reductions the banks
offer to customers and the rate at which they can reduce their cost bases. The amount of
incremental cost in building/updating their internet banking systems appears to be small, although
this may be partly down to the fact that the banks largely have been high spenders in the
technology field and have relatively good, modern internal processes. In the longer term, the
issues of cross-selling, competition from new entrants, and the value of the banks as ‘financial
services hubs’ will come into play. The new entrants are extremely dangerous. “We estimate
that an online direct UK-bank-in-a-box’ can now be set up in five months for as little as £10m
($16.5m.) (advertising apart).” (Buckle, 2000.) Moreover, as pointed out by Noble (1999), a
substantial number of new entrants have already taken advantage of the stock market
enthusiasm for the internet and raised the necessary capital very cheaply as equity. They are,
effectively, already in. (Hall et al., 1999).

Mobile Phones and the Internet

Mobile phones offer a route to the Internet in which Europe, with its lead on mobiles, may steal
a march on the United States. “Mobile is the key revolution. This whole perception that e-
commerce equals the computer is, I think, misguided. The future of e-commerce is in mobile
telephony” (Jean-Paul Votron, head of international consumer banking and e-commerce
operations at ABN Amro, quoted in Graham, 2000b.) Merita has a potentially significant
agreement with Nokia in the field of wireless banking. The Wireless application protocol
(WAP) is likely to be the most widely adopted format for linking data with mobile handsets,
with around three-quarters of the world’s handset production already committed to supporting
this standard in the future. ‘ Nokia and MeritaNordbanken have agreed to develop jointly
banking applications based on this standard.’ (Lehman Brothers, June 99, pp.9-10). (WAP)

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phones have now been released in Europe, and a handful of banks, including the inevitable
Merita Nordbanken as well as the more surprising Woolwich (UK), are launching services this
year. The small screen size will tend to restrict the medium to simpler transactional services. It is
argued that “Because the mobile phone is a more personal device than a personal computer,
that may give banks an advantage in keeping customers – avoiding the disintermediation that the
net has brought.” (Graham, 2000b).

Internet Stockbroking in Europe

Stockbroking is not a core banking business, still less is retail brokerage a core part of retail
banking, but in most European countries (the UK being the main exception) the large banks
seem to dominate the business. It has been one of their most profitable activities (JPMorgan,
1999). Discount broking having been around in the United States ever since brokerage
commissions were deregulated by the SEC in 1975, it was an obvious area for use of the
Internet, and US brokers began doing so in 1996. US banks quickly followed (Ransford,
1999). It is a business where transaction costs are generally very transparent to clients, where
the execution offered by the internet prompts increased trading and where it is natural for clients
to integrate the service with price and news information. From the client’s perspective each
trade is a transaction decision which he wants executed efficiently and cheaply. (Lehman
Brothers (1999)) Characteristics of this business, price transparency, a trade-by-trade decision
process, and a significant cost advantage to the electronic player, are close to ideal for internet-
based new entrants. Internet stockbroking is a clear success. Online trades were around 7% of
the US market in Q1 of 1997, 16% in Q1 of 1999. According to JP Morgan (1999),
traditional players such as Merrill Lynch and Prudential Securities were slow to respond to the
internet threat. These traditional brokers thought that it was better to cede clients to the new
entrants rather than run the risk of repricing their current relationships at very much reduced
levels. However, the extent of the growth of the new entrants to internet stockbroking, has
convinced them that this approach is no longer viable.

JP Morgan (1999) expect the online brokerage industry to ‘take Europe by storm’ (p4). They
forecast that European internet brokerage accounts will rise five-fold from 400000 at the end of
1998 to almost 2.5 million by the end of 2000 and over 8 million by the end of 2002. Their
table of the top twenty European discount brokers is dominated by European banks, but clearly
the barriers to entry are low.

2.3 Banks and Electronic Commerce

Banks are an integral part of the value chain in retail and service industries. It is the bank which
enables transactions to take place by processing the exchange of money. However, the very
nature of retailing is beginning to change with the advent of ‘virtual’ shopping based on
distribution of services via multimedia electronic networks.
The concept of home shopping long predates the internet. Catalogue shopping has been long
established, mainly due to the potentially great distances between customers and retail outlets.
In recent years TV-based home shopping, with orders being taken over the telephone, has

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become big business in the US with QVC turning over $4 billion dollars per annum (Gandy and
Chapman, 1996). However, while TV home shopping gives the potential buyer the chance to
see the product, it is still a sequential service. Catalogues give buyers more information and
random access, but they lack the ability to really show off the goods.
Now of course e-commerce has taken off. These services can be used to give customers direct
access to manufacturers and service providers alike. Products can be investigated and orders
taken via the same system. Unlike home shopping, e-commerce offers access to services as
well as manufactured goods. (Of course, as we have seen banking services are a particularly
attractive candidate for such treatment – you get the service over the net, whereas with
manufactures someone still has to send them through the post.) Banks currently run the money
transaction systems of high street shopping. It is argued that in the ‘virtual’ shopping mall, most
of the transaction can be controlled by non-banks. The customer’s money resides in their
bank’s account, an item is bought over a network, the transaction is passed via the network to
the service provider and it is then sent to the bank for final transfer. The bank only knows the
transaction has taken place when the demand is made, and they have not earned anything from
processing the transaction.
Much was made of this threat to the role of banks as money transactions are replaced by these
new virtual ones. In response, banks were key players in the formation of the consortiums which
have been developing these new retail services. By doing so they have preserved their role as
the processor of payments on the new systems. This processing role is not much different to the
role that the banks play as merchant acquirers in credit and debit card payments. If banks do
not perform this role in the virtual shopping malls then another element in the value chain will
take on the role. The effect is to take away fees earned from the transaction. However, the
critical problem is not this function itself. The main problem is that banks will be threatened in
their role as the key lending institutions in enabling consumer purchases. Products on the
Internet or other network could easily be sold with associated financing built in, reducing the
likelihood of using bank facilities or bank-issued credit and debit cards. It is also thought to be
a good forum for customers to select lending products. Search engines provided by third party
organisations could be used to find the most appropriate and cheapest lending product for a
purchase. These services could be used for any borrowing that the customer wants to do,
whether they are buying from a virtual mall or a real one.
According to Luengo (1999), some 170 million people will have access to the internet in
Europe in 2003 – nearly four times more than the current 44 million. This figure assumes that,
by then, Europe will equal the on-line population of the US. Moreover, Anderson Consulting
asserted that in three years earnings from e-commerce in Europe will be equivalent to 55% of
such income in the US-a figure of nearly $430bn, a huge rise on the $298m of 1998.
Lehman Brothers (1999), remarked that some groups of banks are already positioning
themselves to be e-commerce hubs. Indeed, Merita in Finland is already functioning e-
commerce hub and the second most popular Finnish internet site. Furthermore, they have set up
an e-shopping mall in Finland, bringing together a lot of smallish businesses. Since they have a
large number of individual customers and also a large number of small business accounts, it is
easy to match these two parties on the Internet. Customers can be given credit instantly, and the

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transactions are instant. Compared to credit cards the losses through fraud are negligible since
Merita holds the accounts of the transactors. (JPMorgan, 1999).
The next generation of offerings (which will be in place in the course of the current year) will
offer high scope for personalisation of each customer’s entry pages to the bank.

It is still not clear what all this may mean for the scale and scope of banks’ operations. In
Lehman Brothers’ view, the banking industry is de-materialising, but holding onto its traditional
role as the intermediary of payments and financial services. Clearly, as its current activities
become cheaper to perform, the industry needs to go quickly up the value chain and add value
to what banks do in business-to-business links faster than ICT process advances can take it
away. Traditional banks used to provide some specific services to customers, who in turn used
to have separate relations with their own customers and suppliers. Now the bank needs to gain
a strategic position in the electronic relationships among its customers. This has already been
pioneered by some commercial companies, such as Ford and BP. They use their high
purchasing power, add their own customers and suppliers to their purchasing to increase their
power further, and as a result they pull the price down, allowing them to share the benefits with
these other companies. (Atkinson, 1999.) Even for one major company to purchase on the net
can give it large gains. “When Sikorsky, the US helicopter manufacturer, for example, asked its
suppliers to bid on the web for a $100 m. propeller contract, it knocked the final price down to
$79 m.” (Grande and Brown, 2000). The US handled $770 bn. of electronic transactions in
1999, compared to $330 bn. for the rest of the world. It is therefore the prime market for the
operation of internet purchasing intermediaries, such as the start-up companies Commerce One
and Arriba. The tools they have tested on the US market are available for the growing
European market. (Grande and Brown, 2000).

Internet purchasing hugely widens the range of possible suppliers but in doing so increases the
buyer’s concern about the trustworthiness of the supplier to deliver on time and to the
specification. The intermediary may take on the task of providing such reassurance, or insuring
the purchase in some way. This is indeed a pre-electronic area for banks to operate in – using
their wide knowledge of business, and no doubt sharing information with other banks, they
would answer customers’ enquiries about the status of other businesses. (Atkinson, 1999).
Now this role can be merged with that of procurement agent. Banks clearly do have some
advantage here, through experience and reputation.

E-procurement through an intermediary can also be used to reduce the administrative costs of
the purchasing operation. Any purchasing department must have a number of lower-level
routines which are essentially the same as those of the other firms in its industry, and probably
many others. It follows that there should be economies of scale in having those routines
performed for a number of similar firms by one provider. (Atkinson, 1999.)

4
2.4 Developments in payments services and process workflows

4
This section draws on Gandy and Chapman (1996).

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The whole payment industry is undergoing radical changes which affect both the economies of
banking services and the flow of economic exchange throughout the whole economy.
The future of virtual payments is far from settled, and some banks are working on Smart Card
payment systems which will revolutionise both virtual payments and high street payments. The
growing interest in Smart Cards reflects the main shift in payments processing. The shift is away
from paper-based and towards direct payments and plastic card payments. For the UK,
figures from the Association for Payment Clearing Services (APACS) show that in 1984, 73%
of the 10,5 million payments processed each day were transferred via paper, mainly cheques.
By 1994 only 52% of the 17 million payments per day were in paper form. Direct debits,
standing orders, and automated clearing via CHAPS had grown to 48% of the market.

Credit and debit cards, smart cards and the use of the electronic purse

It is clear that technology is rapidly changing the nature of the interaction between the bank and
its customers. It is also having a profound affect on the nature of the commodity which is being
transacted, money itself. For thousands of years money was a physical commodity represented
by coinage and paper.
Since the 1960s we have seen the introduction of credit cards, debit cards, direct debits, and
recently electronic wallets and electronic money. In recent years an increasing number of
payments have been made using direct debits and standing orders (usually for regular payments
in the consumer market) and by plastic cards, especially credit and, more recently, debit cards.
Payments by cheques and by paper credit transfer have been slowly falling. The clearing and
issuing of credit cards is dominated by banks, but they have no exclusive control and many non-
banks have entered the market. Banks already had the established position in money clearing
and their position in the card market was a natural continuation. There are a number of
advantages to banks from the replacement of paper payments with plastic payments:

Retailers pay what is known as a Merchant Services Charge which is a percentage of the
payment value. In 1988 the duopoly between Barclays/Visa and The Joint Credit Card
Company (which runs the Access/Mastercard service in the UK) in the merchant acquisition
market broke down. The charge now ranges from 3% to 3.5% for small retailers down to as
little as 1.1% to 1.2% for very large chains. However, of this charge, 1% goes to the
overarching card scheme such as Access or Visa. With increasing card volumes, profitability is
returning to the merchant acquisition market. Card issuers receive an interest payment for all
outstanding balances not paid at the end of the month. Issuers usually also receive an annual
service charge, unless this is waived to encourage users to take multiple cards. Debit card
payments are collected electronically and settled electronically, without the need for manual
checking, greatly reducing transaction costs.
While banks have controlled the majority of the card processing market, non-banks are making
major inroads. They are starting to take business away from banks in both card issuing and
merchant acquisition, although this tends to be confined to the co-sourcing of these services with
banks. The issuing of cards by non-banks has become commonplace. In the US, cards issued

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by General Motors and AT&T have large market shares. These non-traditional issuers of cards
have a number of advantages. By entering into the market later than the banks, they are able to
use the most recently tried and tested techniques in order to build lower cost infrastructures.
They can also charge lower interest rates, either by using their own financial muscle or by
subsidising rates from the profits likely to be made by using the card to cross sell other items.

Credit and Debit Card Technology

Both credit and debit cards use magnetic strip technology. A magnetically-encoded strip on the
back of the card tells the EFTPoS (Electronic Financial Transaction Point of Sale) system what
the card is, and who should confirm the payment. Details of the card and the transaction are
then sent to the acquirer and the issuer for authorisation. The market for EFTPoS systems has
become very large as the authorisation and automation benefits have been exploited. In the
UK, Barclays’ PDQ-EFTPoS terminals and its associated communications infrastructure is the
largest EFTPoS network in the world with nearly 88,000 machines in use. To encourage
retailers to use EFTPoS, Barclays Merchant Services has a deal with British Telecom, where
calls made by PDQ machines for authorisation are free to the retailer. Above all EFTPoS
reduces fraud, which is vital to the payments industry making a profit from the service.

The Electronic Purse: the next step

The electronic purse carries out a number of different functions and tackles the payment process
from a different direction. Payments are made from the card, which holds a record of the
amount of money stored in it. In effect the card is itself the money. This is the reverse of the
traditional debit or credit card, which gives access to an account rather than having a record of
value recorded on it. The difference is made possible by a smart card which has a chip built into
it. The semiconductor chip can take many forms. It could be merely a memory device or could
also have a CPU so that it has in-built intelligence. This makes possible a change in what was
the basic flow of money. The electronic wallet or purse’s main distinction over credit and debit
cards is that it is aimed at being a replacement for cash not cheques. It is an instant transfer of
value without the participation of a clearer.

For the retailer, the advantage is that, like cash, the value is transferred at the time of payment,
reducing the risk of non-payment. For the user it is much easier to carry and use than a cheque
book; and, unlike cash, users have the option of protecting their cards with a PIN number.
Moreover, with the in-built intelligence of the card, further security can be added through the
use of biometrics information. There is a common view that sending credit card details via the
Internet is inherently dangerous, so smart cards with their ability to exchange information
securely over a modem link are seen as a possible solution to the weakness of magnetic strip
cards.

One of the largest experiments with the electronic wallet so far has been in Swindon in the UK:
Mondex International (Gandy and Chapman (1996) Mondex has been one of the most talked
about developments in the payments industry in recent years. Development of MONDEX
started in 1990 with NatWest’s Card Strategy Group. In 1993 Midland Bank (now called

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HSBC) joined MONDEX and it is now a joint venture between the two banks. In 1994
MONDEX International was launched to try to establish the MONDEX payment method as a
global system. MONDEX has to provide a number of devices which will enable the system to
work. To put value on to the card, card holders can access their bank accounts in a number of
ways. One obvious method is using the ATM network to encode the cards. However,
MONDEX has gone further in allowing people to get at their own bank accounts. Users will
have the option to purchase a balance reader and an encoding device attached to their home
telephone system. They are also providing the same service at BT payphones. To do this
requires a number of different types of companies. NatWest and Midland provide payment
services expertise. To support the distributed network, BT has been a major technology
partner.
• BT provides the residential telephone systems and the payphone card encryption units.
• AT&T provides MONDEX-enhanced cash registers.
• De La Rue provides small retail card readers.
• GIS/OKI/Panasonic make electronic wallets.

The MONDEX system is currently the only system being deployed on a global basis with
partners in Europe, North America, South East Asia and Japan. A MONDEX card can only
talk to and exchange value with another MONDEX system. This means that it may prove a
suitable medium of value exchange for electronic media such as the Internet or interactive TV.
Each time a MONDEX card communicates with another MONDEX card or device it creates a
unique electronic signature, which the other card recognises as another MONDEX card. It can
handle up to five currencies, which is vital in a global market place. It is aimed at individuals so
it will be possible for individuals to sell information or services over the Internet without the
costs of having to take credit and debit cards. It is an instant transfer of value so payment to the
retailer is assured.5

2.5 Process Changes in Technology6

Technology is often presented as a clearly divided series of generations. The following table
summarises the history of the shift in computing from centralised mainframe technologies to
decentralised computing. Alongside this is an outline of the business functions these changes
have enabled, i.e. the movement from simply using technology to automate back-office
functions to the use of technology in front-office areas and the creation of completely new
customer services, the first of these being the ATM;

5
For more up-to-date assessments of progress with e-cash, see Szmigin (1999), Birch (1999)
and Christie and Goldie-Scott (1999).
6
This section draws on Gandy and Chapman (1996).

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 Architecture Processing Application
Developments Methodology Developments
1st generation 1960s batch processing faster cheque handling
automated, more accurate
accounting cheque netting
lower back office costs
2nd generation 1970s- real-time and on-line ATMs credit and debit cards
80s authorisation process
telephone banking
corporate electronic cash
management
3rd generation 1990s client/server co-operative computing
public access networks customer information systems
micro marketing techniques
customer orientated front offices
centralised back offices
home-based banking
(1996).
Table 2.2 Shift in computing from centralised mainframe technologies to decentralised
computing
Adapted from Gandy and Chapman, 1996

Technology Infrastructure
While technology is the catalyst for many of the product and service changes under way,
success is tied to advancing a bank’s technological infrastructure. Process re-engineering,
without improved telecommunications, network computing, and enhanced interconnectivity, is
unlikely to achieve savings of any magnitude. In order to gain competitive advantage banks
invest in mainframes, PC’s, databases, expert systems, analytical software tools - all linked via
local, wide-area, and value-added networks which create a powerful, integrated web. (Ernst &
Young, 1997)

Asynchronous Transfer Mode (AsTM)

One of the most interesting of the new technologies, AsTM is now being for almost all major
network technology products on the market. Its high transmission rates make AsTM attractive
for both imaging and document managing applications. It permits desktop-to-desktop
transmission of multimedia data on a single technology, rather than on separate local and wide
area network technologies.

Local Area Networks (LAN)

No longer tied to ‘dumb’ or non-programmable terminals and monolithic mainframes, banks are
shifting operations to networks. This is being done not only for reasons of cost and efficiency,
but also to improve banks’ ability to move analytical processing control into the field.
Today, banks are still using LAN’s primarily for electronic mail, with 80% of the banks
reporting widespread usage. Bank management has started to make greater use of network

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computing, with 61% of the banks using this enabler for decision support systems. Almost 30%
more of the banks are testing or considering applying network computing to their decision
support requirements.

Changing Role of Data Centres

It appears that the trend to reduce the number of data centres has bottomed out. Consolidation
of merged or acquired data centres will still affect the total number of centres within the industry,
but much of the consolidation work within existing banks has already been completed. Today,
the primary role of the data centre is that of large-scale processor and repository for the bank’s
information. (Ernst & Young’s Survey, 1997).

As repository, the data centre both delivers services to the customer and provides information
to other people working in the banking. In this latter role, the data centre is a principal source
of technical support to bank employees.
As the economics of data storage have changed and database technology improved, information
warehousing has expanded significantly. Over 60% of the banks already warehouse their
customer information file data. 47% of the banks have already installed financial data
repositories, while 42% have warehouses for their loan information.

2.6 The Process of Innovation in Banking and the Role of IT

Gandy and Chapman (1996) see technology as a dynamic force. It forms an increasingly vital
element in the competitive financial service industry, and also alters the very nature of selling and
delivering financial products. Bankers face the certainty that technology will increasingly mould
the future development of the banking industry. At the same time technology firms have come
to the realisation that banking is one of the largest and most sophisticated markets for their
products. The needs of the financial industry are a driving force in the development of new
information-based technologies.

The information revolution is implementing changes at many levels in the banking infrastructure.
What this shows is that technology has moved from its role as a mere means of automating
existing functions to the key determining role in the organisation of financial institutions,
becoming a major factor in the decision-making process and a principal element in delivering
banking services to customers. Now that technology no longer just replicates the actions of a
human being, but institutes entirely new ways of working and interacting with customers,
financial institutions face the enormous task of adapting the technological infrastructure to the
new tasks of interactive decision support and information gathering to whilst steering away from
the use of technology as machines silently devoted to account-keeping.

Technology investments are often justified on the basis of a leap of faith, or with arguments
along the lines that the investment must be made in order to keep up with the competition. That
said, analysis is almost always carried out. The potential costs of an individual IT project can
often be identified relatively easily. A major problem comes with identifying benefits. This is

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particularly true for long term projects. Over a period of years, markets, internal organisational
structures and technology can all change radically. This further complicates the issue of how to
deal with the already nebulous intangible benefits of technology such as improved service levels.

The relationship between the IT staff and the business managers is the key to ensuring that
strategies of both teams coincide to produce realistic development plans which lead to effective
systems. Given that customer satisfaction often plays a major part in assessing the performance
of the IT function, there is an obvious danger of this process becoming quite adversarial.

Interestingly, despite the fact that measurement of performance of IT is largely carried out on the
basis of cost, IT managers when asked how to improve the performance of their section cited
greater integration with users.
‘Better quality of plans actively developed within the business. Active involvement of IT in
business initiatives, and assembling mixed business and IT teams for each and every project.’
‘Move from reactive to proactive response to user needs’.
Clearly then, the organisation of the IT function within the overall organisation will be central to
the effectiveness of systems development. No longer can IT infrastructure be determined in
isolation from business requirements as these demand increasing levels of flexibility and speed of
delivery. The organisation of the IT function will clearly have a major impact on such issues.

Managing the IT Function

Gandy and Chapman (1996) believe organisation and structure of an IT department impinge
very significantly on the success in delivering IT services. There are many factors to take into
consideration. Internally, the structure of the rest of the company, the product lines of the
company and the technology used must be taken into account by the IT section. Externally, it
must arrange its structure to deal with the policy of the company towards outside partners and
suppliers. Large scale monolithic systems have been traditional in bank IT, entailing significant
maintenance requirements and programmed internally or by a third party to order. They are
expensive to purchase and expensive to maintain, it can be concluded. Such large expenditures
are usually made at the corporate level. This type of structure had a number of key advantages:
• The central function can impose a corporate-wide information architecture to ensure that
information sharing is possible.
• They can negotiate from greater strength with IT suppliers.
• Large scale central systems can be used by combining the IT requirements of many
operational divisions into one organisation. Larger systems are more expensive but they
deliver economies of scale in terms of price/performance.
• The organisation can also share technical and human resources across many operational
divisions, leading to economies of scale.

However, in recent years there has been some debate as to the strengths of these advantages as
client/server computing and decentralised management structures have come to dominate.
Smaller scale systems dedicated to fewer individual requirements are now much more
economic. This is due in part to decreases in the cost of small scale computing, and the

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development of more flexible packaged software solutions. Large central organisations can be
too distant from the front line operational staff, making it harder for them to deal with individual
requirements and making business analysis a more difficult task. While a large pool of IT staff
and IT assets are a powerful tool, they will still need to be rationed out to the individual business
requirements of the operating units.

Decentralised IT Operations

With the development of small scale computing and decentralised companies, managers have
often developed their own small IT operations within their own divisions. This has often been
due to the lack of central resources compared to the availability of packaged business solutions
available on small scale computers. It is often quicker and easier to buy a minicomputer such as
an AS/400 or a network of PCs and run a package available off the shelf. The advantages are
quite simple:
• Small local IT groups can be more reactive to individual business needs.
• They are controlled by the business managers who have better understanding of business
priorities.
• IT staff are closer to the users and will learn more about their business.
• They are not subject to the allocation of resources to other IT projects within the company.
While this sounds ideal the disadvantages can be quite severe:
• Decentralised IT operations can lead to many different standards making it hard for the
company to have an overall picture of the information in the company as a whole, an
essential requirement in risk analysis in banks.
• IT resources could be duplicated and underused.
• The smaller units will not be able to call on all the resources that a large central organisation
can deliver.
As a result, many companies are following the structure where IT groups are more closely
associated with individual business lines to ensure smaller scale technologies suit individual
requirements. Other firms are reintegrating their IT function to gain control of the management
information that they require. In recent years a common structure is individual business focused
development: maintenance and support groups dedicated to individual businesses, with a central
core group which maintains control of the overall IT infrastructure and the company-wide
networks. Often this central group will include large scale processing functions. Outsourcing is
potentially possible, freeing even more IT resources for controlling the infrastructure and
supporting individual businesses. Examples of companies who have adopted such an approach
are NatWest Bank, and Nomura International. NatWest’s IT department, which was originally
organised with 3000 staff in one central hub, has been altered so that 1200 staff have moved
out into six units attached to the various types of business.

The move to package software 7

7
This section draws on Gandy and Chapman (1996)

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If the traditional internal provision of IT services, software and maintenance is known as
insourcing, then the decentralisation of computing has led to the growth of two new phenomena.
These are the purchase of packaged software, and the increasing use of outsourcing
arrangements. Increasingly banks choose to purchase third-party packaged software and there
are a number of good reasons for this:
• The development costs of packaged software is distributed across a number of banks,
decreasing the costs to the individual banks.
• Packaged software writers are distributing costs across many users, allowing them greater
resources for development of new technologies, resulting in better products.
• The increasing scope of demands on IT mean that in-house development is increasingly
uneconomic.
• Packaged software writers can draw on the experiences of a number of users in developing
applications.
• Support is also enhanced by the vendor having experiences of more than one location.
In general, packaged software writers have a greater incentive to produce robust software
which will minimise the support which they have to provide, thus cutting costs.
However, there are also potential disadvantages to using packaged software:
• It is more difficult to differentiate services if they are delivered by standard packages.
• Maintenance and product enhancements are reliant on the continued development
performed by external software producers.
• Software producers have the advantage of being able to use experience gained from many
different banks to develop features for their systems. However, equally it means that
competitive advantages created by one bank may be shared with others via enhancements
to the package.
One of the main problems has been the scale and longevity of the producers of software which
is aimed at the many individual niches making up the financial industry. Many banks have been
left stranded by the collapse of their suppliers, or have found that their systems have not been
enhanced by suppliers and are being overtaken by new packages. In general successful
banking software has come from small specialist firms. However many of these firms have
proved vulnerable over time or have failed to develop next generation systems based on their
original software.

Outsourcing and Co-Sourcing 8

Outsourcing is basically a concept where a company shares or signs over complete

responsibility for delivery of a particular service to an outside party. Information technology is
one area in which this approach is growing. It is a rapidly developing field, with many new ways
of exploiting it being found all the time. According to the market research firm Datamonitor, in
1993 the European outsourcing market for IT was worth $12,76 billion. However, they

8
This section draws on Gandy and Chapman (1996).

- 26 -$WPM54E4.doc
believed that the potential market size was worth $105 billion. This large discrepancy is due in
the main to the changing way in which outside IT suppliers are used.

In recent years outsourcing the operation of IT systems has been supplemented by a move to
outsourcing not just systems, but whole business processes. These processes can be either
internal functions such as payroll processing (which do not have a direct relationship to the
business of the company), moving more recently to operations which were once seen as critical
to the success of the business. A good example of this is the outsourcing of cheque processing.
Once such processes were ring fenced by the company as being too important for third parties
to manage. However, whilst on the one hand the core services of banks are becoming
increasingly technologically intensive these services are also increasingly taking on the
characteristics of hygiene factors, in that they become commoditised to the point where they do
not add to the competitive edge of the bank.

Two major forms of business process outsourcing exist:

1. Outsourcing by a number of banks forming a mutually-owned company to carry out the
process
2. Outsourcing to a third party
The former case is common among smaller and medium-sized institutions, which have more
difficulty in obtaining the economies of scale in order to compete with larger companies. By
sharing a common business process and organising one mutually-owned body to undertake the
work, they can match these economies, allowing the firms to enter markets in which they do not
individually have the scale to operate.

An alternative to complete outsourcing is co-sourcing. With computer services companies

becoming increasingly involved in their customer’s businesses by taking over responsibility for
IT and business functions, it seems logical that they have a stake in the success of the financial
institutions which they work with. Recently this interest has become formalised with outsourcing
companies entering into arrangements where they share their clients’ business risks by
supporting them entering new businesses. Rewards are based on the profits of these new
operations. Increasingly the supply of IT resources is seen as a partnership between a bank and
one or more suppliers. Indeed to start a new operation, a bank may need the support of a large
hardware firm, a specialist software house, a systems integrator, a communications company
and a consultancy.

Advantages of co-sourcing
• Banks can share risk with IT companies.
• Banks get access to latest technologies, but on the basis that the IT provider is paid for
successful exploitation.
• IT firms can get access to business knowledge of banks to exploit their technology.

Disadvantages

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• The arrangement is based on a win/win outcome, which conversely means that both sides
lose if the business fails to deliver. This is a major risk for IT firms which are used to being
paid for delivering systems.
• Management control in the long run may be a problem. IT firms are not likely to want to
have a role in the long term running of banking business themselves, though they will accept
long-run management of the IT.
• Such arrangements may exclude the active participation of the bank’s internal IT teams,
leading to a lack of integration of the overall IT infrastructure.

4. Implications for Corporate Governance

As has been argued in Tylecote and Conesa (1999) and Tylecote (1999), there
three features of technological change which, as and when present, put particular strain on the
corporate governance and financial systems.

The first is novelty. All technological change, by definition, implies some novelty for the firm
conducting it, but progress along a familiar trajectory is less novel than some kind of change of
trajectory. Any leading-edge, high technology sector, like most of biotechnology and software,
will go through frequent changes of trajectory. More mature, medium-technology sectors may
bump over an occasional step-change, as when machine tools adopted computer control. What
such high novelty requires, from the controllers and financiers of firms, is high industry-specific
expertise – a good understanding of what is happening in the relevant technologies and markets
across the sector. The best example of such expertise are Californian venture capitalists: people
or partnerships who put money (and guidance and management) into new firms in one field –
biotechnology, or software, for example – in which they specialise and in which they may also
have started up successful businesses themselves.

The second challenging feature is (low) visibility. Various activities and expenditures – of time
and effort and money - are required to accomplish technological change successfully. Some,
like the acquisition of new plant, and the conduct of research and development in formally-
constituted laboratories, are relatively easy to measure, monitor, and connect with a specific
purpose and outcome: relatively visible. Others – like informal market research (spending time
with one’s customers to discuss their possible future needs) and informal R&D (perhaps using
production equipment to test an idea or make a rough prototype) are of far lower visibility but
may in some circumstances be vital to success. What those controlling and financing firms need
to cope with low visibility, is high firm -specific perceptiveness: the capacity, such as an
experienced manager within the firm might be expected to have, to assess what is going on at
the grass roots.

The third source of strain is the spill-over problem. Mainstream economic theory holds that the
capitalist firm belongs to its shareholders, and should be run in their interests alone – within the
law. Everyone else involved – suppliers, lenders, customers, employees – is connected to the

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firm merely by contracts, that is they sell to it and buy from it at freely negotiated and
renegotiated terms. When the costs of the inputs have been subtracted from the revenues from
the outputs, the residue, if any, is called profit and belongs to the shareholders alone. Firms
should be managed to maximise ‘shareholder value’.

The problem is that the revenues from investments in innovation have a tendency to spill over,
to benefit others besides the shareholders of the innovating firm. Let us imagine (for the sake of
example) that a car company in difficulty had recently brought out some excellent new models,
so well engineered and efficiently manufactured that they had started rapidly to win back market
share. Who would have benefited? The company’s shareholders, obviously. But its suppliers, its
distributors, and its employees would clearly have benefited too; also the government of the
countries in which it operated, in various ways. All those beneficiaries could have been
described as stakeholders in the innovations. As such, it would have been reasonable for them
to have made a proportionate contribution to the success of the innovation. That might have
been by providing finance, but it might also have been by contributing ideas and effort to the
development process; or (in the suppliers’ and distributors’ case) by making complementary
improvements in their own operations; or perhaps (in the employees’ case) by improving their
skills so as to be able to produce the new model more efficiently.

This sort of tit-for-tat would be hopelessly difficult to tie up in a set of contracts. What is needed
here is some kind of general deal or coalition among the stakeholders, such that all of them have
a full incentive to contribute to innovations: an inclusive regime of appropriation. A firm
which is run in the textbook manner will not exploit such opportunities, or will do so in a way
which does not make the most of them, because it will be giving too much attention to allocation
of costs and appropriation of returns. On the other hand, in other cases where spill-overs are
not large, such inclusion may well be cumbersome, and obstruct change. The ‘textbook manner’
may then be preferable.

4.1 Visibility and firm-specific perceptiveness.

One can check off an impressive list of factors making for high visibility in the current processes
of banking innovation:
1. There is no doubt where in any bank is the driving force of innovation: it is in the IT
department. The vast bulk of any up-front expenditure on innovation (as distinct from near-
launch expenditure, which will include a good deal of marketing) goes on IT. “They used to
complain that we were the tail wagging the dog. Now the CEO recognises that we are the
dog”, as one of our interviewees in an IT department told us cheerfully.
2. Nor is it difficult to identify the proportion of the IT spend which is going on innovation, and
that which is going on teething troubles, and that which is going on pure maintenance and
trouble-shooting for existing operations. (By now, the innovative fraction dominates.)
3. As we have seen, although there are some forces making for decentralisation, the case for a
rather high degree of centralisation of the IT operations is strong.

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4. In the terms of Itami, 1994, banking is very much function- rather than product-oriented: the
product – let us take the examples of making a payment or giving information about the
state of an account – may have a high degree of continuity but it is continuity of function
which allows the way the function is performed to change radically; as of course it has done.
(Itami’s counter-example of object orientation is the manufacture of steel or cars, but there
are services like education and medicine which (for the time being at least) are analogous.)
This means that there is probably very little cumulation of skills among the majority of
employees, and innovation will involve retraining or replacing them more than any process of
learning on the job, or contributing to innovation.

One caveat is that banking is still in many ways rather country-specific. “The issue in cross-
border deals is that there are no synergies. You can’t share IT. You have different languages,
different tax systems.” (An investment banker, quoted in Graham, 2000a). Retail bankers are
tied in to each country’s cheque clearing system. These factors have tended to deter banks from
cross-border mergers. However, Merita of Finland and Nordbanken of Sweden merged in
1999. ING of the Netherlands bid in December 1999 for Credit Commercial de France – a bid
which was quickly withdrawn, but was still a harbinger of what is no doubt to come in Euroland.

Cross-border mergers will also have to confront a problem which has already become apparent
in domestic mergers like that of Lloyds and TSB. (See interview.) Each bank comes with an
“inheritance” of an existing IT system, hardware and software and the systems that tie them
together, which would be enormously expensive simply to ditch and replace by the other’s
system (having then to retrain all the staff and translate all the data). Integration is then bound to
be a very difficult process – quick but limited if it takes place through some kind of bolted-on
linkage systems, slow and thorough if it takes place through central insistence on each side
acquiring the same type of new systems and gradually shedding the incompatible features.

It is in fact dealing with the inherited peculiarities of even one bank’s system which produces the
lowest visibility. A specific improvement in process or delivery or product may be most quickly
or cheaply provided by a relatively superficial modification or add-on to the existing IT systems,
at the price in future of making further improvements more difficult. Thus if the decision is left to
someone at a relatively low level who is not concerned with or informed about the ‘big picture’,
or if the decision-maker at whatever level is under short term pressures to increase profit or cut
costs, a sub-optimal decision may well be taken.

4.2 Appropriation and inclusiveness.

As usual, there is a close connection between visibility and appropriability, and it runs through
the function-orientation of banking. Since run-of-the-mill employees have no significant
contribution to make to innovation, they are not in the full sense stakeholders in it – there is
nothing to be gained by the sort of commitment skilled engineering workers might have to the
success of their firm, putting effort into improving their skills and their processes and products.
They are of course affected by innovation, but to the extent that process innovation dominates,

- 30 -$WPM54E4.doc
the effect is likely to be negative. The process and delivery innovations taking place in banking
at present have a very large potential for employment destruction, which is precisely why they
are likely to cut costs so much. Product innovations, as usual, tend to increase employment, but
we cannot see them doing much to compensate for the wave of employment destruction which
has already begun. This makes the issue of employee influence very important.

An extremely difficult situation now confronts a mutual bank (building society in the UK), or a
German bank with co-determination, or even a conventional limited company with a traditional
commitment to its employees (a commitment which used to be rather easy to cultivate in the old
cosy oligopolistic days). To be competitive on cost it is necessary to replace large numbers of
employees by IT in both back office and front office. Banks traditionally had the advantage of
employing mostly women, who had a relatively high turnover into and out of family
responsibilities, so that ‘natural wastage’ was high, and adequate so long as job losses were
phased. Increasingly, of course, women are as permanent as men are. Nonetheless, it looked at
one point as though banks throughout Europe would be able to complete a phased run-down of
back-office work, as payments systems etc. were automated, while front office employee
numbers were maintained. Some banks were even happy to recruit out of front and back offices
for software programmers in their IT departments – preferring to train up bright people within
the bank rather than depend on a difficult external labour market or outsourcing. (Cf. interviews
with one of our banks.)

Quite suddenly, in the late 1990s – we would even say, during 1999 - the situation became
more difficult, as it became apparent that internet banking was coming in fast. For those banks
which intended to make this (like other delivery innovations) simply an extra service to given
customers, it implied that more would have to be spent on IT, fast. As one of our interviewees
showed us, this meant an even larger ‘hump’ than expected in the already large IT budget. At
the same time, it was likely that new entrants on an internet-only basis would take some
customers away; and to keep the rest, margins would have to be kept down. This did not bode
well for profits. This probably explains most of the under-performance of bank shares against
the market in the last 3 months of 1999. (They under-performed the stock market by 20 % in
Ireland, 15 % in the UK and Norway, and 10% in Italy. France was a special case because of
hopes of a bidding war over Credit Lyonnais (Graham, 2000a)). But as we have seen already,
shareholder value has become more and more important for the non-mutuals.

The possibility then arose of restoring or maintaining profitability by cutting front office
employment sharply. (Only such a programme could possibly justify the price offered by the
competing Scottish banks for NatWest, for example.) To make sense of this, there would have
to be branch closures, which would of course make possible large savings on rent and much
else. Previously this would have risked losing customers to other banks with a more extensive
branch network – but now, with a whole panoply of alternative delivery systems available to the
customer, the risk might be worth running: and a number of like-minded banks could always
embrace the novel idea of ‘free’ (shared) branches, together.

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A further turn of the screw was the discovery that back-office work could be moved offshore.
We were astonished to hear from one bank that UK customer correspondence with branches
by ordinary letter is dealt with by ordinary letters written in a developing country thousands of
miles away by locally-recruited workers (whose native language, incidentally, is not English).
The relevant information – letter and customer details - was sent by telecommunications to
them, and the reply came back the same way and was then printed off where most convenient in
the UK.

Corporate governance type then became of central importance. When forced to choose, the
conventional shareholder-controlled company, even on the Continent, will put its shareholders’
interests ahead of its employees’. The mutual on the other hand has no shareholders, and even
if it is in principle controlled by its depositors and borrowers, it is effectively a management-
controlled company. Still, it has to cover its costs in order to stay in business and go on
employing anyone. Given enough reserves, it has a wide margin of manoeuvre in the short term,
and it may choose to make a real fight for market share by aggressive innovation. This is what
the Nationwide Building Society has clearly done in the UK (written communication). We are
sceptical about the scope for gaining market share for any established bank: those customers of
other banks who are really alive to the Internet and not offered a good internet service by their
existing bank may well desert to an internet-only bank, and thus reduce the total market
available. Those who are not, are likely to stay where they are. It will thus be a considerable
achievement simply to keep the total number of one’s customers constant, and a further
achievement to increase the number of products one supplies to each. One way of doing better
than that might be to take advantage of branch closures in shareholder-pressured banks, and
proclaim ‘we still have a full branch network’. The risk would be that it would be the poorer
customers who would be acquired, customers who care more about branch access because
they are not on the Internet.

Appropriation and spill-overs in IT

It has been pointed out that any product innovation will be copied within 6 months. Delivery and
process innovations are another matter. There is no effective patent or copyright protection
(except copyright protection for a package offered widely in the market), but competitors
cannot see the software one is using. Of course, they might see it if they carried out some
industrial espionage, or hired a key employee and that employee was willing to break his/her
contract; or if an out-sourcing or co-sourcing IT provider gave the secret away. However, in
most cases the software code as such would be of little or no use, because of the inheritance
problem: specific software has to be written to link up with the software (and hardware)
inheritance of each bank. What would be useful (we have been told by interviewees) would be
the expertise of either the key employees or the outside provider: if one has written, and really
understood, the necessary code for bank x to do a or b, it is fairly easy to do a or b again to the
different specifications of bank y. Here we see that trust, inclusion, stakeholder loyalty, must
be of real value. One chooses one’s IT provider with real care, and cultivates a relationship of

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mutual commitment, if one is making an innovation in a critical technology and hopes to stay
ahead of at least some of one’s rivals for a significant period. One cultivates a similar
relationship with one’s key IT employees, whether by stock options or more old-fashioned
means. Again, IT sourcing can be moved offshore. One of the UK banks outsources a
substantial fraction of their IT to South India. (Interview.) The possibility to put together a large
team at short notice which will work at high speed on an urgent project is very attractive. (We
imagine that the danger of losing expertise to rivals is if anything less than in the UK. A UK
firm’s UK rivals can fairly easily identify and head-hunt its key employees. To find out who
had worked on a rush-job for a rival in South India would be a great deal harder; and no
individual one found would know the overall picture.)

4.3. Novelty and industry-specific expertise; and Conclusion.

As one of our interviewees said about the process of writing software for bank IT, this is not
rocket science. Nonetheless the overall effect of the technological and associated organisational
changes which are taking place in banking is profoundly novel. Few managers, and fewer
shareholders, can have understood what was hitting, or about to hit them, two or three years
ago. It takes considerable industry-specific expertise to understand what is going on in the
industry now – allied with firm-specific perceptiveness to understand what is happening and
what ought to happen in a particular bank, given its specific inheritance of IT and customers. At
the same time there are very obvious conflicts of interest between non-IT employees of the firm
– including many senior managers – and shareholders. There are indeed likely to be similar
conflicts between those employees’ interests (perhaps their short term interests) and the long
term survival of the bank.

We can say that in consequence there may be considerable advantages in a low-inclusion

strategy, in which a small cohesive team of top managers works in shareholders’ interests (either
because they hold stock options or have similar reasons for putting shareholder value first, or
because shareholders exercise intelligent direct control over them) and has no scruples about
making job cuts. This will be particularly the case in a bank which has some catching-up to do
(vide NatWest, after take-over by the Royal Bank of Scotland). At the same time, it may well
be that in the special circumstances of Finland and Sweden a much more inclusive strategy will
pay off for first movers like Merita-Nordbanken: never having the same attachment to branches
in thinly-populated countries, perhaps they had far less employee or senior management
resistance to moving to electronic banking, and did so early enough to avoid market share
losses and any need for forced reductions in employment.

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