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Challenges of the "E-Banking Revolution" Saleh M. Nsouli and Andrea Schaechter Electronic banking is the wave of the future. It provides enormous benefits to consumers in terms of the ease and cost of transactions. But it also poses new challenges for country authorities in regulating and supervising the financial system and in designing and implementing macroeconomic policy.
Electronic banking has been around for some time in the form of automatic teller machines and telephone transactions. More recently, it has been transformed by the Internet, a new delivery channel for banking services that benefits both customers and banks. Access is fast, convenient, and available around the clock, whatever the customer's location (see illustration above). Plus, banks can provide services more efficiently and at substantially lower costs. For example, a typical customer transaction costing about $1 in a traditional "brick and mortar" bank branch or $0.60 through a phone call costs only about $0.02 online. Electronic banking also makes it easier for customers to compare banks' services and products, can increase competition among banks, and allows banks to penetrate new markets and thus expand their geographical reach. Some even see electronic banking as an opportunity for countries with underdeveloped financial systems to leapfrog developmental stages. Customers in such countries can access services more easily from banks abroad and through wireless communication systems, which are developing more rapidly than traditional "wired" communication networks. The flip side of this technological boom is that electronic banking is not only susceptible to, but may exacerbate, some of the same risks—particularly governance, legal, operational, and reputational—inherent in traditional banking. In addition, it poses new challenges. In response, many national regulators have already modified their regulations to achieve their main objectives: ensuring the safety and soundness of the domestic banking system, promoting market discipline, and protecting customer rights and the public trust in the banking system. Policymakers are also becoming increasingly aware of the greater potential impact of macroeconomic policy on capital movements. Trends in electronic banking Internet banking is gaining ground. Banks increasingly operate websites through which customers are able not only to inquire about account balances and interest and exchange rates but also to conduct a range of transactions. Unfortunately, data on Internet banking are scarce, and differences in definitions make cross-country comparisons difficult. Even so, one finds that Internet banking is particularly widespread in Austria, Korea, the Scandinavian countries, Singapore, Spain, and Switzerland, where more than 75 percent of all banks offer such services (see chart). The Scandinavian countries have the largest number of Internet users, with up to one-third of bank customers in Finland and Sweden taking advantage of e-banking.
In the United States, Internet banking is still concentrated in the largest banks. In mid-2001, 44 percent of national banks maintained transactional websites, almost double the number in the third quarter of 1999. These banks account for over 90 percent of national banking system assets. The larger banks tend to offer a wider array of electronic banking services, including loan applications and brokerage services. While most U.S. consumers have accounts with banks that offer Internet services, only about 6 percent of them use these services. To date, most banks have combined the new electronic delivery channels with traditional brick and mortar branches ("brick and click" banks), but a small number have emerged that offer their products and services predominantly, or only, through electronic distribution channels. These "virtual" or Internet-only banks do not have a branch network but might have a physical presence, for example, an administrative office or nonbranch facilities like kiosks or automatic teller machines. The United States has about 30 virtual banks; Asia has 2, launched in 2000 and 2001; and the European Union has several—either as separately licensed entities or as subsidiaries or branches of brick and mortar banks. New challenges for regulators This changing financial landscape brings with it new challenges for bank management and regulatory and supervisory authorities. The major ones stem from increased cross-border transactions resulting from drastically lower transaction costs and the greater ease of banking activities, and from the reliance on technology to provide banking services with the necessary security. Regulatory risk. Because the Internet allows services to be provided from anywhere in the world, there is a danger that banks will try to avoid regulation and supervision. What can regulators do? They can require even banks that provide their services from a remote location through the Internet to be licensed. Licensing would be particularly appropriate where supervision is weak and cooperation between a virtual bank and the home supervisor is not adequate. Licensing is the norm, for example, in the United States and most of the countries of the European Union. A virtual bank licensed outside these jurisdictions that wishes to offer electronic banking services and take deposits in these countries must first establish a licensed branch. Determining when a bank's electronic services trigger the need for a license can be difficult, but indicators showing where banking services originate and where they are provided can help. For example, a virtual bank licensed in country X is not seen as taking deposits in country Y if customers make their deposits by posting checks to an address in country X. If a customer makes a deposit at an automatic teller machine in country Y, however, that transaction would most likely be considered deposit taking in country Y. Regulators need to establish guidelines to clarify the gray areas between these two cases. Legal risk. Electronic banking carries heightened legal risks for banks. Banks can potentially expand the geographical scope of their services faster through electronic banking than through traditional banks. In some cases, however, they might not be fully versed in a jurisdiction's local laws and regulations before they begin to offer services there, either with a license or without a license if one is not required. When a license is not required, a virtual bank—lacking contact with its host country supervisor—may find it even more difficult to stay abreast of regulatory changes. As a consequence, virtual banks could unknowingly violate customer protection laws, including on data collection and privacy, and regulations on soliciting. In doing so, they expose themselves to losses through lawsuits or crimes that are not prosecuted because of jurisdictional disputes. Money laundering is an age-old criminal activity that has been greatly facilitated by electronic banking because of the anonymity it affords. Once a customer opens an account, it is impossible for banks to identify whether the nominal account holder is conducting a transaction or even where the transaction is taking place. To combat money laundering, many countries have issued specific guidelines on identifying customers. They typically comprise recommendations for verifying an individual's identity and address before a customer account is opened and for monitoring online transactions, which requires great vigilance. In a report issued in 2000, the Organization for Economic Cooperation and Development's Financial Action Task Force raised another concern. With electronic banking crossing national boundaries, whose regulatory authorities will investigate and pursue money laundering violations? The answer, according to the task force, lies in coordinating legislation and regulation internationally to avoid the creation of safe havens for criminal activities. Operational risk. The reliance on new technology to provide services makes security and system availability the central operational risk of electronic banking. Security threats can come from inside or outside the system, so banking regulators and supervisors must ensure that banks have appropriate practices in place to guarantee the confidentiality of data, as well as the integrity of the system and the data. Banks' security practices should be regularly tested and reviewed by outside experts to analyze network vulnerabilities and recovery preparedness. Capacity planning to address increasing transaction volumes and new technological developments should take account of the budgetary impact of new investments, the ability to attract staff with the necessary expertise, and potential dependence on external service providers. Managing heightened operational risks needs to become an integral part of banks' overall management of risk, and supervisors need to include operational risks in their safety and soundness evaluations. Reputational risk. Breaches of security and disruptions to the system's availability can damage a bank's reputation. The more a bank relies on electronic delivery channels, the greater the potential for reputational risks. If one electronic bank encounters problems that cause customers to lose confidence in electronic delivery channels as a whole or to view bank failures as systemwide supervisory deficiencies, these problems can potentially affect other providers of electronic banking services. In many countries where electronic banking is becoming the trend, bank supervisors have put in place internal guidance notes for examiners, and many have released risk-management guidelines for banks. Reputational risks also stem from customer misuse of security precautions or ignorance about the need for such precautions. Security risks can be amplified and may result in a loss of confidence in electronic delivery channels. The solution is consumer education—a process in which regulators and supervisors can assist. For example, some bank supervisors provide links on their websites allowing customers to identify online banks with legitimate charters and deposit insurance. They also issue tips on Internet banking, offer consumer help lines, and issue warnings about specific entities that may be conducting unauthorized banking operations in the country. Regulatory tools There are four key tools that regulators need to focus on to address the new challenges posed by the arrival of e-banking. Adaptation. In light of how rapidly technology is changing and what the changes mean for banking activities, keeping regulations up to date has been, and continues to be, a far-reaching, time-consuming, and complex task. In May 2001, the Bank for International Settlements issued its "Risk Management Principles for Electronic Banking," which discusses how to extend, adapt, and tailor the existing risk-management framework to the electronic banking setting. For example, it recommends that a bank's board of directors and senior management review and approve the key aspects of the security control process, which should include measures to authenticate the identity and authorization of customers, promote nonrepudiation of transactions, protect data integrity, and ensure segregation of duties within e-banking systems, databases, and applications. Regulators and supervisors must also ensure that their staffs have the relevant technological expertise to assess potential changes in risks, which may require significant investment in training and in hardware and software. Legalization. New methods for conducting transactions, new instruments, and new service providers will require legal definition, recognition, and permission. For example, it will be essential to define an electronic signature and give it the same legal status as the handwritten signature. Existing legal definitions and permissions—such as the legal definition of a bank and the concept of a national border—will also need to be rethought. Harmonization. International harmonization of electronic banking regulation must be a top priority. This means intensifying cross-border cooperation between supervisors and coordinating laws and regulatory practices internationally and domestically across different regulatory agencies. The problem of jurisdiction that arises from "borderless" transactions is, as of this writing, in limbo. For now, each country must decide who has jurisdiction over electronic banking involving its citizens. The task of international harmonization and cooperation can be viewed as the most daunting in addressing the challenges of electronic banking. Integration. This is the process of including information technology issues and their accompanying operational risks in bank supervisors' safety and soundness evaluations. In addition to the issues of privacy and security, for example, bank examiners will want to know how well the bank's management has elaborated its business plan for electronic banking. A special challenge for regulators will be supervising the functions that are outsourced to third-party vendors. The macroeconomic challenges But the challenges are not limited to regulators. As the advent of e-banking quickly changes the financial landscape and increases the potential for quick cross-border capital movements, macroeconomic policymakers face several difficult questions.
The answers to these questions fall into two emerging strands of thought. First, the technological revolution—particularly the expansion of electronic money but also, more broadly, electronic advances in banking practices—could result in a decoupling of households' and firms' decisions from the purely financial operations of the central bank. Thus, the ability of monetary policy to influence inflation and economic activity would be threatened. Second, as electronic banking expands, financial transaction costs can decline significantly. The result would be tantamount to a reduction in the "sand in the wheels" of the financial sector machinery, making capital flows even easier to effect, with a potential erosion of the effectiveness of domestic monetary policy. In this regard, proponents of the Tobin tax—which would tax short-term capital flows to increase their cost and, thereby, the sand in the wheels—would feel that electronic banking makes an even more compelling case for introducing such a tax. Conclusion While electronic banking can provide a number of benefits for customers and new business opportunities for banks, it exacerbates traditional banking risks. Even though considerable work has been done in some countries in adapting banking and supervision regulations, continuous vigilance and revisions will be essential as the scope of e-banking increases. In particular, there is still a need to establish greater harmonization and coordination at the international level. Moreover, the ease with which capital can potentially be moved between banks and across borders in an electronic environment creates a greater sensitivity to economic policy management. To understand the impact of e-banking on the conduct of economic policy, policymakers need a solid analytical foundation. Without one, the markets will provide the answer, possibly at a high economic cost. Further research on policy-related issues in the period ahead is therefore critical.
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