The Effect of Internet Technology on the Retail Banking Sector - Assignment Example

The Effect of Internet Technology on the Retail Banking Sector: A Transaction Cost Economics Analysis Dhruv March 2006 Table of Contents Abstract 3 Introduction 4 Definitions 4 Internet Technology (IT) 4 Retail Banking Sector (RBS) 7 Literature review 8 Conceptual Framework-TCE 9 TCE & Information Technology Internet Technology & Trust 11 Research Question 12 Research Design 12 Problems and Challenges of Internet banking Gains of Internet Banking Discussion Appendix A Appendix B Appendix C References Abstract A galore of Information Technologies developed over the past ten to fifteen years became integrated to create the network of computer networks which we now call the Internet. These Information Technologies we collectively describe as "Internet Technology". Incidentally they form the appropriate technology to influence the way we bank and the way we define money. The rise of internet connectivity and low cost access to the Internet has encouraged banks to create a brand-new "brand" of banking, called synonymously as "online banking", "e-banking" or "Internet banking". Money too has moved from plastic cards to a form called "e-cash", "e-money" that is highly portable and tradable over the Internet with its attendant risks and advantages. Transaction costs-the hitherto hidden but significant costs of doing business in the past, have come crashing in the Internet Age. In this paper, we examine Williamson's Transaction Cost Economics (TCE) and use it to analyze the impact of Internet Technology on the retail banking sector. Built into Internet technology are features that accelerate information availability, make information "Always Available" to the consumer and almost always secure and private. The benefits to society at large of unleashing Internet technology to retail banking are discussed. The attendant risks from hacking and loss of valuable financial information are also considered. The future society of low transaction costs, high availability of money and its sociological and financial implications are speculated on. 1.Introduction In this essay, we define "Internet Technology" broadly and "Retail Banking" and its services. We then proceed to explore further in depth the developments in Internet Technology in the last 10 -15 years that have led to the development we call "Internet banking". We then focus our attention on the "retail banking" sector of Internet banking. We use transaction cost economics (TCE) to analyze the "effect" of Internet technology on the retail banking sector. In this analysis, we highlight the benefits, threats and challenges and take a futuristic tour of the direction of Internet banking in the next ten years and its sociological effect on a new meaning of transaction costs. 2.0 Definitions In this section, we define the Internet, Internet technologies and retail banking and take a survey of developments in the past ten years in Internet technology as it relates to banking in general and retail banking transactions in particular. 2.1 Internet Technology The Internet is defined by Webopedia (2006) as "a global network connecting millions of computers" The University of California at Berkeley (UCBerkeley, 2006) provides this definition: "The Internet is a network of networks, linking computers to computers sharing the TCP/IP protocols. Each runs software to provide or " serve" information and/or to access and view information. The Internet is the transport vehicle for the information stored in files or documents on another computer. It can be compared to an international communications utility servicing computers". Internet technology is understood as the hardware, software and communications technologies that make the Internet function the way it does. These include high-speed networks and switching technologies, and the associated protocols such as Transmission control protocol, Internet Protocol (TCP/IP), switching technologies and routers developed by Cisco and database technologies developed by Oracle and operating systems developed by Microsoft. Encryption Technologies developed by RSA have also come to in to help in information security and authentication. Servers and workstations developed by IT giants like IBM and HP have also given us the visible interface for communicating on the internet. Internet technology is not complete without mention of Satellite communication links and associated software and peripherals. Of course information needs to be stored physically and storage technologies too have played a significant role in the development of the modern Internet. The developments in Voice over the Internet (VOIP) and other multi-media technology like video conferencing are all making information accessible in at low transaction costs. The table below lists under hardware and software the key technologies that have merged to give the Internet today its present value. Those marked (*) can be classified as hardware and software. Table 1: Internet Technology: An integration of Information Technologies that make the Internet work. These various information technologies that make the Internet work the way it works are worth exploring further to help us understand eventually their impact on banking philosophy and transaction costs. Database Technology as developed by Oracle has played a very significant role in the managing data and information on a large scale. Starting with Oracle 8i, the first Database Management system designed for the Internet and continuing to Oracle 9i, it became possible to offer customers "dependable access to critical data" in a reliable secure and timely(no downtime) manner. (Oracle, July 2001, pp.61). Oracle 9i Database Management System (DBMS) in particular included what Oracle described as "High-Availability Architecture" By this Oracle means that: "The data stored in your database is available and accessible to your applications regardless of events such as planned backups or disasters. Oracle 9i Database contains a host of components that address the challenges of making a system highly available such as Real Application Clusters for server high availability and increase scalability, Fast Restart for bringing a failed system back online quickly, recovery manager for combating data failure, Flashback Query and log miner for reversing human error, and Online Redefinition for performing routine maintenance without taking the database offline". This "integration of internet technology directly into the database application server and development tools" in 2001 through Oracle 9i Database has led to a new level of scalability--- the ability of servers and workstations to operate at the size most appropriate for a business (Spicer, 2001). With the development of Oracle 10g in early 2004, it became possible for servers to adapt and completely avoid downtime for data exchanges and thus increase high availability from 99.99 percent to 100 percent. (Kelly, 2004). In addition, Integration "the coordination of disparate processes, applications, and systems so that they can be centrally controlled and can function together as a unified whole" (Lipson, 2001), has become a central issue to companies in the Internet age as they look at ways to save money in a global economy. Oracle 9i Database offers several integration tools that have lowered the costs of doing business. Retail Banking Retail banking has been defined, Investopedia (2006). as: "typical mass-market banking where individual customers use local branches of larger commercial banks. Services offered include: savings and checking accounts, mortgages, personal loans, debit cards, credit cards, and so forth". The retail-banking sector has changed dramatically since 1968 when the first automatic teller machine (ATM) was introduced. Before then all banking transactions -such as funds withdrawals, funds transfer and account enquiries--required face-to-face interaction between a customer and the bank teller. The cost to the bank of these transactions included the teller's salary, premises maintenance costs and related costs The coming of ATMs automated all these and significantly reduced transaction costs. As of 1999, according to The Wall Street Journal reports, ATMs had reduced transaction costs to 40 cents from a high of $2 per transaction (Jordan & Katz, 1999). Internet banking became an option for US bank customers in the late 1990 and has grown rapidly since then. As of 2005, more than 34 million customers were Internet banking with the 10 largest US banks, a 50 percent increase according to research reports from ComScore Networks (Strasburg & Kerby, 2005). A similar growth is recorded in the European retail banking industry where 70 million were projected to have switched to Internet banking as of 2004. Even though retail banks have grown significantly, problems exist in the areas of trust and financial security for their customers. This will be discussed in details in a latter section of this research proposal. Literature Review In this review we examine the development of Internet retail banking. It is also synonymously referred to in the literature as "online banking", "e-banking" and "multimedia banking". Vijayan, Perumal & Shanmugam (2004) traced three "waves' of "multimedia Banking". The first multimedia technology wave was centred on automatic teller machines(ATMs) and telephones,. The second wave embraced PCs and Online Services and the third wave, still on, saw the emergence of E-cash and interactive video. In this third wave, they asserted, " cash can be transferred via smart card devices incorporating digital signature technology hooked to any multimedia communication devices such as PC, personal digital assistant(PDA), mobile phone or interactive television." (pp.2). Perumal & Shanmugam (2004) distinguish three types of Internet banking: Information oriented, Communication based and Transaction intensive. At the information oriented "basic' level, the bank has just established an informative website but no transactions can be processed online. At the communication level of growth, customers can interact with the bank via e-mail, account enquiry and get responses but not in real time or immediately. At the transaction level, customer interact with the banks' network in real time and can perform normal banking transactions as though they were in the physical bank. One of the observed effects on Internet Banking has been the reduction of transaction costs associated with banking. In a study by Booz-Allen & Hamilton (2003), they found that it costs times less to conduct banking transaction via internet than a "customer walking into the branch bank". The Internet banking too was three times cheaper than using the ATM, they found. This correlates with a similar study by Niemiec (2001). He showed that web-based transactions cost much less than traditional paper-based processing as shown in the table 2 below. Kell (2006) examined the role of realtime information in banking, particularly with global Real Time Gross Settlements (RTGS) in place. He observed that under this new RTGS payment system, settlements occur continously "thoughout the day in real time" he attributes this development to regulations such as Sarbanes Oxley and Basel II that require "accuraate, timely and complete reporting". This was enabled too by SWIFTnet which stipulates the modus operandi for information exchange in real-time between banks, security houses and corporate bodies. Area Non-Web Web-based e-Travel $41 $13 iProcurement $150 $35 Expense Reporting $25 $10 Training $250 $2 Table 2: Cost differentials between Web and non-web transactions Conceptual Framework---TCE In this section we shall summarize the foundations of Transaction Cost Economics (TCE), and how it can be used to study and analyze the effects of Internet technology on retail banking. The original concepts of TCE were advanced by R. Coase, a Nobel Prize laureate in his 1937 paper: The nature of the Firm and developed by Oliver Williamson in his book Transition Cost Economics; Basically, TCE tries to answer the "Why" of a firm's existence. It strongly assumes that firms are out to maximize their profits and minimize their costs. It defines costs as dual in nature: production costs and transaction costs. Wikipedia, the free Internet encyclopedia defines "transaction cost" as "a cost incurred in making an economic exchange"(Wikipedia, 2006). Extending the definition of transaction costs, Steven Cheung (1992) described it as equivalent to "institutional costs", costs attributed to the presence of institutions. Today, TCE has been extended to behaviours outside the traditional buying and selling to include transactions of social and psychological values that may have remote economic significance. Williamson (1979) in developing the theory of TCE made two assumptions that determine the circumstances that influence the value of transaction costs. The first of the "assumptions" is concerned with the use of information which he described as "bounded rationality'. Williamson stated that our limited cognitive powers make it impossible for us to process fast enough all the information we have at our disposal. The second of the assumptions is concerned with choice in a given circumstance. He calls it "opportunism". Williamson states that people will act opportunistically "with guile' some of the time and that "you never can tell in advance who is an opportunist and who is not". Williamson superimposes on the two assumptions three variables that interact with the assumptions to produce new economic relationships and scenarios. The variables are transaction frequency, Uncertainty in Transaction and Asset Specificity. A transaction can be of high or low frequency, low or high uncertainty. It may involve assets that are non-specific or specific. Williamson argues that "spot market" transactions have little uncertainty and long term transactions tend to have "built in" uncertainty. This uncertainty is further compounded by "bounded rationality" and opportunism. Asset Specificity, regarded as the most important component in TCE, states that transaction costs will tend to go down by vertical integration in cases where assets are valuable in the context of a specific transaction. The table below summarizes the relationship between uncertainty, asset specificity and the governance structure in a firm. Asset Specificity Low for both parties High for both parties High for one party, low for one party Uncertainty High Contract/vertical integration Vertical Integration Vertical Integration Low Spot contract Long-term contract Vertical Integration Table 4: Uncertainty, Asset Specificity relationship (adapted from Transaction Cost Economics, 2006) Trust & TCE Critics of TCE have pointed out certain weaknesses in the theory. The most glaring are that TCE does not include trust and reputation as fundamental in transactions. Trust has been defined by Mayer, Davis and Schoorman(1995) as the "willingness of a party to be vulnerable to the actions of another party based on the expectation that the other will perform a particular action important to the trustor, irrespective of the ability to monitor or control that other party". Latter day TCE theorists: (Bradach & Eccles, 1989) and (Chiles & McMackin, 1996) have successfully integrated trust in the development of the theory. We shall see latter in this proposal that trust really becomes a major issue in the growth of electronic markets (E-commerce) and in particular Internet banking. Though it neatly separates production and transaction costs, in practice transaction costs are very difficult to quantify and measure.(Transaction cost economics, 2006). Transaction Costs Economics and Information Technology Cordella and Simon (1997) have made a detailed study of the relationship of Information Technology to transactions costs. Ciborra (1993) had argued that the greater availability of information to decision makers reduces uncertainty in transactions and hence reduces the cost associated with transactions. Cordella and Simon (1997) found that even though the volume of transactions may increase, the decreasing cost per transaction achieved by information technology compensates and reduces the total transaction cost. This collaborates with the previous studies reported on this effect (Booz-Allen & Hamilton, 2003). Steinfield & Whitten (1998), in their study of E-commerce markets observed that "lack of trust" was an inhibitor in the growth of the market. Internet Technology and Trust Information security and privacy is fundamental in all business transactions. In the Internet age, information becomes even the key exchange and its security and privacy become major problems to be solved. Technology deployed in networked systems have increased information security and in the process increased the trust value of Internet based transactions. Such technologies include: cryptography, authentication and privacy, digital signatures and electronic payment systems. Dahl and Resnick (1996) defined cryptography as "the science of scrambling messages so it unreadable by everyone except the person who has the proper key to decrypt the message" (pp.123). Encryption protects sensitive or private information from unauthorized viewers as it travel over the Internet. Encryption works with two keys: Public key an private key. The public key is available to the public but the private key(code) is known only by the intended recipient of the message. The other issues relating to the security of a message are authenthication and privacy. Authentication uses crytoptography to ensure the validility of a message. In the language of TCE, authentication reduces "uncertainty" in the message or information. Privacy is concerned with the message been read only by the intended recipient. Privacy and authentication are fundamental concerns in all online transactions including online banking. Digital signatures are small messages encrypted with the sender's private key and attached to the main message. Even though the information in the digital signature is freely available , it uniquely verifies who the sender is. Digital signatures are coded so that if the message is tampered with, it is obvious to the receiver. Electronic payment systems (EPS) have also come in as a significant factor in the entire transaction trust system of the unfolding digital economy that forms the foundations of Internet banking. Dahl and lesnick (1996) define EPS as "any method of getting paid online"(pp.70). They outline the characteristics of "the perfect" EPS as one that cannot be lost, stolen or forged; has zero transaction cost and is acceptable worldwide. The perfect EPS aslo can be used for any size of small or large payment, supports credit and debit payments and can transfer money transactions immediately with almost no time delays. Anonymity in transactions and immunity from inflation and devaluation round up the qualities of the perfect EPS . It is obvious from the last three characteristics that uncertainty in transactions is reduced to the lowest, if not altogether eliminated. The instruments for implementing the perfect EPS include, according to Dahl and Lesnick (1996), encrpted and unecrypted credit cards, electronic credit cards and checks and electronic cash also known as e-cash. E-cash, the digital equivalent of dollars and cents, is fast gaining popularity because of its anonymity, ease of use and encrypted nature. In their study of E-commerce markets using transaction cost approach, Thompson, Wang and Leong (2004) found that by facilitating ease of search for consumers interested in auto purchase, the Internet lowered transaction costs. Cordella and Simon (1997) showed that transaction costs can be broken down into infrastructure costs and coordination costs. He calls them: "costs due to uncertainty in the organization". The role of information technology they argued is to "make more information available to decision makers", and in the process of reducing uncertainty, transaction costs will come down. The structure of the digital economy, as outlined above, in addition to increasing trust in transactions also lowers transaction costs as indicated in the above studies. Research Questions In this study, we shall focus on exploring the following research questions: 1. By how much have transaction costs changed for the Internet banking consumer 2. What factors are hindering widespread acceptance of Internet Banking 3. How do retail banks quantify transaction costs in Internet banking Research Design & Methodology In the design of this research we are going to use the evaluation and assessment approach. Let us look at the first research question: By how much have transaction costs changed for the Internet banking consumer We are going to identify say three major banks in a city and randomly select customers who bank with these banks. A questionnaire will be designed and administered to these customers. A sample questionnaire is shown in appendix A. In exploring the second research question above: "What factors are hindering widespread acceptance of Internet banking" our sample population will be those who dislike Internet banking and are not using it. A questionnaire fit for the sample population is shown in Appendix B. The third research question: "How do retail banks quantify transaction costs in Internet banking" is directly addressed to retail banks as the sample population. A suitable questionnaire for this sample population is shown in Appendix C. Data Collection & Analysis The designed questionnaires will be administered to 100 randomly selected individuals who bank in three major banks in the city. Each questionnaire of Appendix A and B will have 100 persons to send it to. Appendix C Questionnaire will be sent to 10 major Internet retail Bankers. They will be sent by e-mail and returned by e-mail. A time period of two weeks will be given respondents with reminder e-mail. All respondents will be thanked for participating in the evaluation/assessment study on Internet banking. The collected data will be analyzed using a standard statistical package such as SPSS. Problems and Challenges of Internet Banking Internet Technology (IT) creates a number of risks to Retail Banking Sector (RBS). The most obvious is online financial fraud and customer Identity Theft. TowerGroup estimated that in 2004, over 137 million dollars were stolen from bank accounts. They also attribute a loss of 50 million dollars to Identity Theft in 2004.( Strasburg & Kirby, 2005) . One of the popular online fraud techniques is called "phishing". The TowerGroup research report by Tubin (2005), describes the typical phishing attack as "social engineering" where consumers are "manipulated and tricked" into divulging their user names and passwords for accessing their online banking accounts and e-commerce sites. Phishing of recent has gotten more sophisticated, moving from e-mail access to use of spy-ware, trojan horses and keyloggers thatencourage the consumer to "unwittingly" download malware. Malware are computer code or software designed to extract user information from your computer. This illegally extracted user information then forms the basis for the crime known as identity theft. Though anti-virus and anti spyware may be partially successful in curtailing malware, the rapid growth of new malware invented daily by Internet fraudsters seem to beat the capabililities of many traditional anti-virus software, since most consumers do not update as frequently as is necessary, according to a report by America Online and National Cyber security Alliance (Tubin, 2005). Tubin (2005) recommends that stronger authentication technology as "an effective weapon to combat the rising tide of consumer data theft" (pp.14). Such "user-friendly" authentication methods could include in a portable format, something the user knows(e.g. password), the user is( e.g. a biometric identifier) and something the user has( e.g. a secure ID token).In a transaction cost analysis perspective, the Internet fraudstaers exploit the consumers high trust level to perpetrate their cimes of phishing and identiity theft. Of couase they raise the transaction cost to the consumer! Benefits of Internet Banking Strasburg and Kirby (2005), writing on Internet banking, observed that: "Besides providing detailed 24-hour access to account balances, online banking offers customers the ability to receive and pay recurring bills electronically at the click of a mouse, conveniently transfer money between accounts and view scanned images of canceled checks. Online services can eliminate monthly statements that, when mailed in hard-copy form, can be targets for theft." They continued: "The potential long-term savings in time, as well as the reduced costs for certain transactions and stamps, have wide appeal." ACI white paper (2003) on the future of retail banking noted that: "Automated access to banking products and services gives customers the benefits of greater efficiency, accuracy and speed - a compelling suite of push factors".(pp. 2). Another interesting development from Internet banking is the linking of traditional banking services with non-banking services. ACI whitepaper (2003) observed that shopping mall owners " can now offer card processing services as part of their unit rental service, and an insurance company can handle card payments, delivering a wider service while also being able to reduce insurance rates". Discussion It seems then that we are moving into a society where technology has changed the nature of banking as we knew it. Banking is becoming a ubiquitous activity that is not limited to "banks", geography or time. A new concept of transaction cost will emerge that may lead to a radical revision of current transaction cost economic theory, developed before the advent of the digital economy. For example the original TCE theory of Williamson was weak on Trust in transactions. Cryptography, authentication and the database developments pioneered by Oracle corporation and others have become the foundations for the development of the digital economy. In addition, Neogi and Cordell (2005) observed that "trust and confidence" were part of the "infrastructure for the development and efficient functioning of a global, digital economy" and that "unless steps are taken to increase trust and confidence, then citizens are likely to eschew the convenience of the online world for the inconvenience but increased security of the offline world". - Appendix A: By how much have transaction costs changed for the Internet banking consumer Definition of Transaction costs for the consumer: The overhead costs in time, money and convenience of transacting business with your bank. Here is a model questionnaire to be administered to the randomly selected "Internet banking customer" A. Personal Information of Consumer 1. name 2. Sex 3. Age 4. Income level B. Proximity to bank 1. How far do you live from the bank 2. How long does it take to drive down to the bank 3. How long does it take in the bank to complete your transactions 4. How often do you use the bank in a week C. Cost of Internet banking Equipment & Time 1. How much have you spent in the last 2 years to purchase computing and network equipment 2. How much are your month service charges for Internet connection 3. What is your computer maintenance costs/annum 4. How long does an Internet banking operation take to complete 5. How often do you do Internet banking per week D. Qualitative Evaluation of costs 1. Do you think Internet banking is saving you money Yes/No 2. Do you think It is saving you time Yes/No 3. Would you recommend it to your neighbor/friend/relation Yes/No Appendix B: What factors are hindering widespread acceptances of Internet banking A. Personal Information of Consumer 1. Name 2. Sex 3. Age 4. Income level B. Proximity to bank 5. How far do you live from the bank 6. How long does it take to drive down to the bank 7. How long does it take in the bank to complete your transactions 8. How often do you use the bank in a week C. Knowledge of Internet Banking & Computing 9. Are you aware of Internet banking Yes/No 10. Do you have friends/neighbors/ relations using Internet banking 11. Do you have computers at home Yes/No 12. Are they connected to the Internet Yes/No D. Reasons for NOT using Internet banking 1.Why do you not use Internet banking A. Dislike it B. Don't know how to use it C. don't really care! E. Unsafe! Appendix C: How do retail banks quantify transaction costs in Internet banking A. Business Information 1. Bank name 2. No of Branches 3. Year started in Internet Banking 4. Total Personnel in retail banking operations 13. Total Assets 14. Annual Turnover 15. Investment in Information Technology B. Transaction Costs Evaluation 16. Total No. of transactions per week/month/year 17. What does your transaction costs consist of 18. How do you calculate your transaction cost References ACI Whitepaper (2003)The future of retail banking. 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