The virtual threat

The Internet has already forced wrenching change on the financial-services industry—and the revolution has barely begun, says Simon Long

THE most remarkable thing about the effect of the Internet on the financial-services sector is not how pervasive it has been; it is how limited a transformation it has so far wrought. Financial institutions, after all, deal in a product—money—that for many of their customers has long been “virtual”. Bank-account holders are used to the notion that their cash is represented by a series of numbers on a monthly statement generated by a computer, or by the glowing green figures of a cash machine. And they have become accustomed to making payments using pieces of plastic backed with a clever magnetic strip. The Internet might have been designed for the distribution, monitoring and management of this ubiquitous electronic commodity.

More worryingly for the firms that make their living out of arranging financial transactions, the Internet might also have been designed to do away with them. Banks and other financial firms are intermediaries, standing between lenders and borrowers, savers and spenders. For decades, banks in rich countries have been fretting about how to cope with “disintermediation”: lenders dealing direct with borrowers (as many do already in the capital markets), without using a bank’s balance sheet to add a layer of cost. The Internet is, potentially, the greatest force for disintermediation the banks have ever had to tackle. Other intermediaries, such as retailers, face the same problem. But money, unlike, say, an item of clothing, is a commodity that can actually be used, transferred and delivered electronically.

Samuel Theodore, of Moody’s, a credit-rating agency, believes the banks are currently undergoing their “fourth disintermediation”. The first involved savings, and the growth of mutual funds, specialised pension funds and life-insurance policies at the expense of bank deposits; the second saw the capital markets take on some of the banks’ traditional role as providers of credit; in the third, advances in technology helped to streamline back-office operations. Now, in the fourth stage, the distribution of banking products is being disintermediated. This process has been going on for some years, with the spread of automated teller machines (ATMs) and, over the past decade or so, telephone banking and PC-based proprietary systems; but the Internet hugely enlarges its scope.

Spotty youth

Yet, except for one activity, share-trading, and one part of the world, Scandinavia, Internet-based financial retailing is, if not in its infancy, then scarcely at puberty. And wholesale banking, although it relies heavily on complex electronic trading systems and information technology, is still conducted mostly on closed proprietary networks. To be sure, there are some signs that the disintermediation the industry fears may be starting. Internet banks, with their low costs—and their dot.com habit of paying more attention to the acquisition of customers than the turning of profits—have drawn deposits away from off-line banks in some countries. And in the capital markets, bond issues and share offerings have been syndicated and distributed over the Internet. Some highly rated borrowers have for years been borrowing through their own issues of commercial paper. The Internet can only enhance the appeal of do-it-yourself fund-raising.

But these are just the early signs of an upheaval that is gathering momentum by the day. There are a number of reasons why many online financial services have been slow to catch on, and why they can now be expected to develop faster. Concerns about the security of Internet transactions, a particularly important issue for financial dealings, are gradually being eased. Internet use, even in the rich world, has been patchy, but is spreading fast. And whereas conducting financial transactions online up to now has often been clunky and annoying, the technology is improving all the time. Those technological advances are also liberating the Internet from the confines of the PC.

Most important, financial institutions themselves, which in the past have often resisted change, may now become its most ardent promoters. Having invested heavily in their own systems, banks were understandably reluctant to jettison them for web-based replacements. And adapting their own processes for the Internet has often proved cumbersome and difficult. Moreover, until recently banks faced little pressure from their customers to change what were seen as useful but boring services, much the same as electricity and gas. But soon, in many countries, customers will expect an online service as a matter of course.

The banks' staff, too, have been reluctant to abandon the old ways of doing things. Besides, those old ways have often been extremely profitable, so change threatens not just working habits, but the bottom line too. Now, however, almost every financial firm, from the swankiest Wall Street investment bank to the provider of microcredit to the very poor, has found that it has no choice but to invest in an “Internet strategy”. And having invested in it, it will need to persuade its customers to use it. So in areas where the advantages of doing business online may not be obvious to the consumer—notably in retail banking—the banks may find themselves trying to coax, bribe and bully reluctant customers online.

The banks' conservatism, on which they used to pride themselves, has become an embarrassment. It has also been spotted by the new breed of Internet entrepreneur taking aim at the banks’ business. The models are firms such as E*Trade and Charles Schwab, discount stockbrokers that found in the Internet a means of challenging even the biggest and most prestigious traditional firms. Now commercial and investment banks, fund managers and financial advisers are all vying with each other to present themselves as Internet-savvy, and boasting about their investment in online services.

All this has created a strange, contradictory world. Clever young things with a bright idea and a few million dollars of venture capital behind them talk cheerily of the demise of traditional banks. Bill Gates, no less, said six years ago that banking is necessary, but banks are not. Now, the story goes, they are irredeemably hampered by their “legacy systems”—their existing management structures, staffing levels and computers—and by their “channel conflicts”—between what they do now, and online methods of sales and distribution. Their bosses simply do not “get it”. Or, even if they do, their institutions are so deeply rooted in the old economy and pre-Internet styles of business that there is no point in turning them around.

The dinosaurs in the supposedly stuffy offices of these big banks and securities firms appear unaware that a meteorite may be on its way to obliterate them. On the contrary, resolutely upbeat online-service managers, often rather self-conscious in their tieless, suitless new-economy uniforms, claim they are having the times of their lives. Never has technology revealed so many new avenues for developing the business. It is, says Denis O’Leary, who runs Chase Manhattan’s Chase.com, “a golden age”.

Not least because, in the industrialized West, many firms have been making bigger profits than ever. Years of economic expansion and bull markets have yielded good income from traditional lending, from trading and from investment. The only obvious cloud in the sky is that banks’ share prices seem not to reflect this (see chart 1). Indeed, in some countries, such as Britain, they imply that the market expects banks’ profits to collapse in the next few years. Even the stockmarket seems to believe the dot.com wannabes, and rewards them with much richer valuations than boring old-economy banks.

Still kicking

And yet this survey will argue that many of the older institutions have a good story to tell. The “legacy systems” at which the upstarts scoff have one big virtue: they have tended, by and large, to work. Big banks process trillions of dollars a day. It is almost inconceivable that they might close down for a few hours because some clever Internet saboteur has found a way of snarling up their technology (as has recently happened to some of the biggest websites). Existing banks have customers in numbers that newcomers can only dream of, and even unpopular incumbents benefit from their customers’ inertia.

The Internet also brings established firms huge opportunities as well as threats. To take two important examples, it offers ways of cutting costs and of marketing products much more efficiently. For years, in America, Europe, Japan and elsewhere, the industry has been consolidating: bank after bank has been taken over by or teamed up with an institution in a complementary line of business. Usually, these deals are justified to shareholders by the extra returns that can be generated once overlapping costs are stripped out. The Internet, potentially, offers a way of taking a knife to whole layers of costs. Once a customer is convinced to carry out most of his transactions online, his account becomes much cheaper to administer.

The other much-cited benefit of consolidation is “cross-selling”—of insurance policies to bank-account holders, for example. Yet so far this has rarely been all that successful in practice. The Internet can be a precision-guided marketing tool. For example, if you apply online for a credit card from NextCard, an American Internet operation, you will be offered a choice of three charging structures. To qualify for the most favourable, you have to transfer a certain outstanding balance from your other credit cards. That sum will—fancy that!—be the actual total of your other balances, which NextCard has just ascertained online from the credit bureaus. Or, in wholesale finance, suppose you are a potential investor in a company’s initial public offering of shares, and have just finished watching the boss boosting his company’s prospects on Merrill Lynch’s online investment-banking service. The phone rings. And yes, it is a Merrill Lynch salesman who knows you have been watching, and thinks that now may be the moment to clinch a sale.

But, for banks, each of these pluses comes with a minus. Because costs are so much lower for Internet-based transactions, the barriers to entry are lower as well, which implies that margins will come under pressure. And although the Internet makes well-directed sales pitches easier, that is hardly compensation for the precariousness of online customer relationships. Once your client is on the Internet, he is only a mouse-click away from your competitor, and more and more financial sites, search engines and portals will be pushing competing products at him. That, too, will squeeze margins.

Viewed from this perspective, for many financial institutions the Internet is a double bind. Embrace it, and you may still find yourself losing business, or at least seeing profit margins dwindle. But ignoring it could be terminal. This survey will argue that the pressures for change have become irresistible. It concentrates on places where the process is most advanced—America and Europe—but the same lessons apply everywhere. Big financial institutions are global firms. And on the Internet, change spreads like wildfire. The stockmarket with the highest proportion of Internet trading is not, as you might think, in New York, but in Seoul.

To make the challenge for the industry even more daunting, the revolution also encompasses the very architecture of many of the world’s biggest financial markets. Stock, commodity and futures exchanges, clearing and settlement systems are also being forced to consolidate and modernize, to prepare for the day when financial transactions are settled instantaneously.

In public, no bank boss these days would admit to anything less than wholehearted enthusiasm for the online adventure. In private, however, some still see it as just another distribution channel, perhaps less important than others, such as the telephone. A few still cling to the dream that it is a fad they have to indulge because their shareholders seem to like it. Even such non-believers, however, are being forced by the market to formulate an online strategy. If they are too slow, or get it wrong, the consequences for their firms could be deadly. And if they still need convincing, they need only look at what has happened, in just four years, to stockbroking.