Contemporary Banking Theory - Research Paper Example

Running Head: BANKING AND ICT'S Banking and ICT's of the of the The aim of this paper is to address the function of ICT in the banking sector. In global companies, banking experts require steady and non-stop access to information services. In modern global banking firms, ICTs are intensively utilised for electronic transactional processing and in supporting banking experts in accomplishing their global tasks across geographical locations and time zones. The use of ICTs by global bankers is crucial to access real-time information, anytime and anywhere. In their remote mobility, banking experts may experience technology failure or difficulties in accessing information services. This inability of the banking mobile experts in utilising ICTs could have serious consequences in terms of risk on the bank operations and profit. TABLE OF CONTENTS Chapter # Description Pg # Chapter 1 Introduction Pg # 3 Chapter 2 Literature Review Pg # 5 Chapter 3 Methodology Pg # 10 Chapter 4 Discussion & Analysis Pg # 14 Chapter 5 Conclusion Pg # 17 References Pg # 19 Chapter 1 Introduction Digital technology has greatly reduced the costs of compiling, processing, and distributing information. Information and communications technology (ICT) invigorates markets by enhancing the flow of information, not in creating certainty, but making information more symmetric. The rise of the Internet, for example, has increased transparency, improving the ability of all market participants to determine the available range of prices for financial instruments and financial services (Clemons and Hitt, 2000, 4). Indeed, information-driven disintermediation is not limited to the financial sector: "The flow of information turns client relationships into markets. This phenomenon is cropping up in fields as diverse as travel agencies, real estate and the auctioning of flowers in Amsterdam" (Anon., 1998). The new markets that hand information to consumers also tend to push down prices. This is a dangerous prospect for branded goods like banking products and services, which behave increasingly like commodities. Moreover, technology has continually lowered the transaction costs of direct financing, facilitating the emergence of new electronic markets, payments and settlement networks, and new market-based risk and wealth management systems. Disintermediation is accompanied by securitization. Large firms increasingly raise finance directly from the financial markets. Companies with secure cash flows create securities from (or "securitize") these "assets," the value of which is determined by the volume and reliability of the cash flows (Holland et al., 1998, 222). The securities are then sold publicly or privately to institutional investors. Securitization of assets disintermediates banks from their traditional role of lenders to the corporate sector. Financial deregulation and information technology have both contributed to the growing dominance of capital markets by facilitating access for new issuers and investors. Forces For Change Powerful forces for change are forging the future shape of the banking industry. These include demographic, technological, and regulatory factors. Undergirding these developments is the continuing closer integration of national economies and financial systems through the process known as Globalisation. Changing Customer Needs and Preferences Populations are aging rapidly, at least in the developed Western democracies. The prospect of rising aged-dependency ratios is focusing governments and individuals on alternative means of funding retirement incomes. "Pay-as-you-go" pension schemes, under which the younger (working) generation funds the retirement incomes of the older (retired) generation, are not viable when the aged-dependency ratio rises beyond certain limits. Governments are responding by inducing individuals to make greater provision for their own incomes in retirement, restricting the availability of publicly funded pensions to the genuinely indigent. A mixture of incentive and compulsion characterizes the efforts of most Western governments to date. Chapter 2 Literature Review The banking industry is affected as individuals seek higher rates of return on their savings. By their nature, banks offer a low-risk, low-return savings vehicle. Increasingly, those forced to fund their own retirement must earn higher rates of return on their savings. This in turn requires them to accept higher levels of commercial risk than have traditionally been offered through the banking system. Riskier investment products have been sought in the nonbank sector, including various forms of collective investment vehicles, such as mutual funds and equity trusts. Banks have found their traditional deposit products increasingly less attractive to savers and have been obliged to offer investment-linked savings products. As a result, banks have moved into the burgeoning field of wealth management, in which they offer higher-risk, higher-return savings products through their funds management subsidiaries. This has reoriented the focus of banks' retail operations away from the passive receipt of idle balances to the active pursuit of funds under management. As customers' needs have changed, so have their preferences become more sophisticated. The typical bank customer is now more attuned to the basics of financial analysis. They are more aware of the options available and are much better tutored in the means of discerning value for money. Although customers need a more sophisticated mix of products to meet their financial needs in retirement, they are generally also better informed. This makes the task of attracting savings far more challenging for banks. This trend can be expected to continue. Technology Advances in ICT have profoundly altered the banking business. This is not surprising given that banking is an information-intensive industry. Technology has enabled banks to innovate in a range of areas, including products, distribution channels, organisational structures, internal processes, and customer relations management. These changes create both new threats and new opportunities. In particular, technology has increased the competitiveness of banking as an industry, not least because it facilitates comparison-shopping and the entry of new providers. Some areas in which technology is changing the face of banking include: Automation/computerization of standard transactions; for example, Automating payment services, thus reducing the need for paper checks, paper records, and bricks-and-mortar branches; Standardizing credit analyses for loan applications. Decentralization of back-office support Modern communications networks allow back-office support and operations (including call centres) to be located at a distance from retail points of delivery (sometimes even offshore). Creating value for customers Integrating different types of financial accounts-across multiple vendors, checking and mortgage accounts, car loans, mutual funds, and so on; Customizing products to specific needs and circumstances; Improving service times and sales capabilities (e.g., cross-selling). Making payments Facilitating customer-initiated electronic payments; Creating digital cash. Customer information and data-mining systems Improving services to existing customers or bundling information for sale to other players. Globalisation The freer flow of goods, services, capital, and labor across borders is heightening competition in national markets. This is especially true of information based services, including financial services. The ICT revolution has created a global communications network across which it is increasingly easy to exchange information and trade financial claims. Globalisation offers enormous opportunities to efficient and innovative participants. It also threatens the inefficient and those who resist change. Competition intensifies as its scope becomes increasingly global. The demands of increasingly global customers are pushing banks to create new organisational structures, offering bank products, knowledge, and expertise, and managing relationships on a global scale. Networked information systems and electronic delivery channels facilitate global coordination and management of banking business (Holland et al., 1998, 220). Chapter 3 Methodology State Of Play The forces for change, including the underlying drift from intermediaries to markets, have produced four clear trends in the banking industry: increasing competition, consolidation, convergence, and connectedness. The Future "If you want to know what the next 125 years will be like for banking, look at the last 125-and add in the computer and the Internet" (Johnson, 1999, 11). This is the view of Hjalma Johnson, former president of the British Bankers' Association. Johnson seems to imply that the Internet will not fundamentally alter the business of banking. In fact, the ICT revolution strikes at the very heart of what banks do. By undermining information asymmetry, the Internet has the potential to eliminate banking as surely as the advent of steamships eliminated sailing ships from commercial shipping lanes. While banking may well go the way of tall ships and stagecoaches, banks as corporations need not. The Wells Fargo Company once operated stagecoaches. It exited the transport business and is now in banking. Whether Wells Fargo chooses to change industries again remains to be seen, but the company could stay in the financial services business and just give up banking. People's need for transport services survived the transition from stagecoaches to railroads to automobiles. People's need for intertemporal exchange, payments services, and a trusted third party will similarly survive the demise of banking. Banking adds value when information is asymmetric. The business of banking developed as a substitute for missing financial markets. The markets went missing because information was insufficiently symmetric between potential borrowers and lenders, leading to an absence of trust. Without trust, the two parties were not prepared to deal. Banks resolved this dilemma by interposing a balance sheet between ultimate borrowers and lenders. By writing separate agreements between themselves and lenders, and themselves and borrowers, banks eliminated the need for the two parties to trust each other. But why would the parties trust the banks instead Through judicious use of debt contracts on either side of a balance sheet, maintaining confidentiality through the "banker-customer" relationship and participating directly in the payments system, "banking" was born. Balance-sheet banking allowed banks to plug the gap and replace missing markets for financial claims. But the basis of banking is asymmetric information. As information becomes more symmetric, thanks to the Internet and ICT, the reason financial markets went missing in the first place no longer applies. While balance-sheet banking is an effective substitute for markets, it is expensive. Balance sheets require equity capital-indeed; a minimum amount must be subscribed by law in most jurisdictions. Financial markets operate without the need for capital to be held in reserve. If they exist, financial markets will therefore operate more cheaply and at least as effectively as their substitute-balance-sheet banking. The spate of merger activity within the banking industry and between banks and other financial institutions can be traced to the same evolution away from balance-sheet intermediation. As banking declines and financial market exchange arises in its place, banks find themselves with excess capital. Capital that once supported balance-sheet intermediation is now surplus to requirements as banks move their business toward investment banking, securities trading, and other forms of off balance-sheet, market-linked activities. Banks have three options to deploy the surplus capital: repay their own shareholders; acquire the business of a competitor, in the process repaying its shareholders; or merge two or more institutions in the hope of reaping cost and revenue economies of scale. The third strategy does not reduce the capital base of the merged institution but aims to improve the rate of return on invested funds. The intention is to extend the life of balance-sheet activity for as long as possible in the face of increasing competition from market-based financial activity. But there will probably always be some residual information asymmetry. Wherever information asymmetry persists, balance-sheet intermediation will always have a role. Retail finance suggests itself as the obvious final stronghold of information asymmetry. Unlike wholesale finance, retail borrowers and lenders may always be sufficiently lacking in sophistication as to warrant the use of traditional banking products. Nevertheless, one should not push the point too far-after all, retail mortgages and consumer credit loans were among the first to be disintermediated. What Will Banks Do The future of banking is one of steady retreat into the remaining pockets of information asymmetry. The more ubiquitous ICT becomes, the more redundant traditional balance-sheet intermediation will become. An analogous pattern will be observed in the insurance industry, with the gradual demise of balance-sheet insurance products and their replacement by market-based instruments. Accompanying this transition will be a substantial reduction in the capital requirements of banks and insurance companies. Both industries will shed capital as they evolve away from capital-intensive balance-sheet intermediation. Chapter 4 Discussion and Analysis The future of banks will not be in banking but rather in the market exchange of financial instruments. Banks will retain their expertise in financial matters and exploit this advantage by becoming expert in the use of financial markets to achieve the objectives of ultimate borrowers and lenders. Although this seems an obvious transition for banks to make, and it is already well under way, we should not underestimate the cultural challenge involved. Traditional bankers are managers of balance-sheet claims; they are not traders. The culture of the trader is quite foreign to the dyed-in-the-wool banker. Indeed, there is something bordering on mutual contempt between the two traditional rivals. For banks to embrace the future, they must accept the need for a complete attitude makeover. The future for banks will revolve around financial markets, and their success will be governed by their expertise as traders and advisers to those who trade. Banks that understand this point have already sought to acquire or merge with funds managers and brokers. The aim is to infuse the culture of the finance house throughout the bank. Unless bankers start to think and act like traders, the transition will never be made and banks will go the way of banking-or leave the financial services industry, a possibility canvassed below. While the future belongs to the markets and not the balance sheet, there is one dimension in which the balance sheet will remain important, at least for a time. Banks engaged in the creation and marketing of securities for clients ("investment banking" as it is known) can add value not just through the ingenuity of the design of the securities and the skill with which they are traded. Indeed, much of the value to be added in investment banking resides in the originality of the structure of the deal. But it is equally important when securities are new to the market for an investment banker to be able to reassure a client that the funds will be forthcoming, even if the market turns down. One way in which this can be done is to use the balance sheet. At least until markets are so complete that the creation of genuinely new securities is a rarity, if not an impossibility, there will be a continuing role for the balance sheet to complement trading activity. Banks with strong balance sheets will have an edge on those without, precisely because they can "warehouse" claims that prove difficult or costly to sell. The balance sheet will still offer a means of providing liquidity insurance or a capital guarantee, at least until financial markets become so ubiquitous and complete that the same can be achieved through market exchange. As long as banking exists, it will be done by banks. The same cannot be said of the other functions currently performed by banks. We saw that nonbanks and even nonfinancial firms are entering markets traditionally served by banks. This is feasible where the advance of the market has superseded the balance sheet or where the function did not rely on balance-sheet skills in the first place. An example in this latter category is payments services. The provision of payment services is an area in which banks have rapidly lost their competitive advantage. This is due in part to the advance of technology and in part to financial deregulation, which has opened the way for nonbanks to clear and settle payments through the central bank. But at base the provision of payments services was always just an "add on" for banks. Any institution with a large customer base and regular cash flow can create a payments service, as many telcos and utilities have demonstrated. The underlying claims can be settled using accounts with a bank or with the central bank or, depending on the regulatory regime, with a private clearinghouse established for the express purpose. Accounts do not even need to be kept in standard units of account. Loyalty points schemes operated by retailers, airlines, and credit card companies can easily become a substitute payments system as points are exchanged for an ever-widening array of goods and services. Chapter 5 Conclusion At present, banks are still at the core of the payments system. This is unlikely to continue far into the future. The Internet provides the ultimate opportunity for nonbanks to develop cashless payments systems without the involvement of banks (or even central banks). PayPal is a rapidly growing, Internet-based cashless payment service that operates increasingly independently of the banking system. Obligations are settled through PayPal and are effectively claims to the assets of PayPal. Similar schemes offering claims to gold and portfolios of securities have also been developed. The point is that this is an area in which the uniqueness of banks is fast disappearing. The future of banks will not be as dominant players in the provision of payments services. Whereas some banks will successfully evolve from balance-sheet managers into expert financial traders, others may withdraw from financial markets altogether. If the quintessential banker's skill is the creation of trust and this can no longer be done cost-efficiently through the use of balance sheets, some banks may choose to find other means of continuing in the trust business outside the financial services industry. This would make sense if e-commerce grows as fast as expected, since the need for a trusted third party is essential in online market exchange. Banks could leverage their existing brands to establish verification and certification businesses based on the collection and reliable storage of important financial and other data. The "banker-customer" relationship could evolve into a relationship in which individuals and companies pay banks to act as trusted third parties, verifying reputations and other data when requested as part of commercial exchange. Given that banks have traditionally managed relationships based on resolving information asymmetry, a translation of their role in this way keeps faith with their historical roots and plays to their time-honoured competitive strengths. Even if this were to be the haven into which old "square-rigged" banks sail, they will not have the harbour to themselves. Many firms, including credit ratings agencies and security firms-even some online operators like eVerify-have spied out the same opportunity. Wherever banks turn, the story will be the same-a crowded marketplace. 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