Chapter 9

Policy Issues

Chapter 9

Policy Issues

The financial service industry is enjoying aperiod of rapid innovation in supporting tech-nologies. The effort to use those innovationsto best advantage is contributing to rapidchanges in the structure of the industry andin the services it offers. On the one hand, tech-nology motivates change; on the other, facili-tates it.

Through the applications of technology, thefinancial service industry provides the publica choice of modern and efficient services morediverse than was available in the past. Fromanother perspective, the introduction of ex-plicit pricing for services, the increased com-plexity of the menus offered and other effectsfollowing from the introduction of technologyare not amenable to all users.

Changes in basic social institutions almostinvariably raise questions for public policy.The basic tenets that comprise the founda-tions of existing policy may no longer hold; or,if they do, the existing means of realizingestablished goals and objectives may no longerbe workable. Relationships between and amongindividuals and institutions may be altered inways that make some relatively worse offwhile others become relatively better off. Theresults of such shifts can be political pressuresfor new or modified policy goals and mecha-nisms for achieving them.

Information technology has made it easy tobypass some legal and regulatory provisions.Some new services or altered service packagesare being delivered through systems that didnot exist when regulatory provisions werewritten, and some services are offered by in-stitutions not covered by the provisions.

It is likely, therefore, that some of these pro-visions now only burden the industry unnec-essarily, cause unplanned distortions in themarket, or place some financial institutions atan unreasonable disadvantage. The very scaleand rapidity of the changes and the fluidityand turbulence in the environment within

which financial institutions are now operatingcould cause excessive risk for these organiza-tions and their customers. It is also possiblethat some of the ends sought in existing lawsare no longer appropriate or useful.

Formulating policy issues and options withregard to these changes meets with one imme-diate and serious challenge. Changes are com-ing about so rapidly and in so many diversedirections that it is difficult for financial in-stitutions themselves or for outside observersto anticipate the patterns that will eventuallyprevail.

Nevertheless, it is possible to foresee someof the broad patterns likely to emerge and toanticipate in a general way their likely conse-quences. It is important to do so because pol-icy decisions made or avoided now may havefar-reaching consequences. For example, somepotential benefits of the new technology maynot be realized. Costs and benefits may be in-equitably distributed. Unnecessary burdensmay be imposed on industry or on consumers.Civil rights and liberties may be compromised.

Policy is promulgated through legislationand regulation; it can also be imposed throughless formal, political activities such as Presi-dential “jaw-boning.” Policy alters marketforces and the relative power of the factorsthat determine price and product mix. For ex-ample, limitations on interest rates led tobundling of financial services which, in turn,resulted in cross subsidies. Services could thenbe provided to some who could not have af-forded them had they been required to payprices based on a true allocation of costs. Now,technology, combined with other forces, is cre-ating an industry structure that explicitlycharges for services on the basis of fullyallocated costs. Some people may not be ableto afford them. If this is judged contrary tothe larger public good, it becomes the task ofthe policymaker to adjust those circumstancesthrough carefully designed policies.

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Thus, even though significant uncertainties To identify the public policy issues relatedabout the future remain, it is essential that an to financial services it is necessary to lookassessment of the implications of advanced more closely at relationships between finan-technologies for the financial service industry cial services and broad national objectivesbe made. Many of the policy issues discussed that reflect various public interests in thosebelow are not new. Competition and consoli- services.dation, fair play, privacy, and security havealways been concerns in financial servicedelivery, even with older paper-based tech-nology.

Public Interests in Financial Services

Some of the major laws and regulations re-lated to financial institutions express explic-itly and implicitly national objectives relatedto financial services. There is a strong publicinterest in the maintenance of financial insti-tutions that will:

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assure and facilitate transactions neces-sary for a strong and growing level of eco-nomic activity in the Nation and in all re-gions and communities;encourage savings and capital formation;protect the savings and investment of in-dividuals, families, businesses, and socialinstitutions;avoid excessive concentration of economicand financial resources; andsupport and strengthen the competitiveposition of the United States in worldtrade.

implicit in the concept of the public interestare also the basic national objectives of na-tional security, equal treatment under law, anda host of well-established civil rights and lib-erties. Therefore, financial service systemsshould:

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not compromise national security, or theability of the Government to implementforeign policies;not adversely affect the exercise of civilrights and liberties; andnot discriminate against some people bydepriving them of necessary financial

services or placing an unfair burden onthem in using those services.

There are also specific Government concernsand interests in financial services. BecauseFederal, State, and local governments are ma-jor users of financial services, they have aspecial interest in efficiency, low cost, andsecurity in making and receiving payments.For example, the U.S. Department of theTreasury wants to move toward direct depositof all Federal payments to reduce the costs ofthis huge volume of transactions.

Finally, the degree to which the introductionof advanced systems for delivering and usingfinancial services may affect the ability ofgovernment to use monetary and fiscal policyas tools for ensuring economic stability andgrowth remains unknown. The increase intransactions and income velocity as a resultof this technology could make it more difficultto intervene in unsatisfactory general econom-ic conditions through instruments of monetarypolicy. Use of information technology, bychanging the velocity of money, changes theeffective stock of money in the economy at anyone time. Technologies can facilitate the de-livery of services that effectively monetizeassets that in the past were considered illiquid(e.g., the ability to draw on home equity as aline of credit). This could complicate attemptsto use monetary policy to reduce inflationarypressures or to stimulate stagnant conditions,although what the effect will be in practice is

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far from certain. At least, it will be more dif- more rapidly, which could be both beneficialficult to define or estimate the stock of money. and risky—under the worst possible scenario,The speed of transactions will cause the con- it could lead to economic fibrillation.sequences of policy interventions to be felt

Possible Changes in theFinancial Service

Information processing and telecommunica-tion technologies, as applied to financial serv-ices,

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have seven direct and significant effects:

They remove geographic and temporalconstraints on the delivery of financialservices and allow them to be deliveredfrom remote locations and to new andwidely dispersed locations, such as homesand offices.They allow transactions to be completedalmost instantaneously, increasing thevelocity of money in the system.They facilitate complex networks and in-terrelationships between institutions,markets, and geographical areas.They provide the flexibility for manyalternative combinations of services andservice features, allowing both “bundled”and narrowly targeted services.They improve productivity and, in general,lower the costs of providing services.They increase the capitalization of finan-cial services, providing opportunity fornew providers of intermediate and sharedfacility services to financial service insti-tutions.They create the possibility of electroniclegal tender and the opportunity to mon-etize a wide variety of assets.

Current and anticipated changes in thestructure of the industry and service deliverymechanisms, assuming no interference withpresent trends, include:

• Increased diversity in the nature of insti-tutions within the industry, in which

Structure of theIndustry

traditional categories of depository andnondepository institutions are no longersharply delineated and in which the linebetween financial and nonfinancial insti-tutions, as defined by products and serv-ices, is blurred.Development of large, diversified finan-cial institutions offering a wide range ofretail services and service locations sothat users may have many financial rela-tionships with the same institution.Some vertical as well as horizontal inte-gration as diversified firms acquire the in-ternal capabilities to perform functionsfor which they previously turned to thewholesale market.Development of many small, highly spe-cialized institutions that target narrowmarkets and specified groups of clients.Continuing mergers and a trend towardabsorption of middle-sized institutions,especially those having a strong local orregional orientation.Rapid product proliferation-i. e., pro-liferation of services that are functionallysimilar but differ in regulatory restric-tions and interest rates and in the distri-bution of responsibility or risk betweenproviders and users.Greatly increased functional integrationof the national financial service industrythrough technological networks and insti-tutional relationships.Great reduction in the significance of timeof day and location in delivery of finan-cial services.

226 ● Effects of Information Technology on Financial Services Systems

In developing national policy about fi-nancial services, policymakers should takeinto consideration six critically important 4.questions:

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What national objectives should be sought 5.

in framing policies related to financialservices?Is there a need for a thorough restructur- 6.ing of the regulatory system as opposedto marginal corrections?How much competition is appropriate

Generic ConsiderationsFinancial Service

and desirable in this sector of theeconomy?What institutions or services is it essen-tial to preserve and for what purposes?What is the appropriate level of risk forproviders and users of financial servicesto assume, and how should that risk bedistributed?How can the financial service industrysupport a strong U.S. role in the worldeconomy?

In the sections that follow, salient policyquestions pertaining to the financial serviceindustry are presented, and some of the alter-natives for dealing with them identified. Thefirst group includes two broad general ques-tions, the second deals with issues related toindustry structure, and the third discussesrisk allocation issues.

General Policy Issues

Issue 1: What are the alternative approachesthat could be used if a review andrestructuring of laws and regulations relatedto financial services were undertaken?

Information processing and communicationtechnologies have already had a profound ef-fect on the handling of financial data. The ca-pabilities that these technologies offer—effi-ciency, speed, integration of activities over awide area, flexibility, and networking-arepowerful. Because these technologies changeboth the way data is handled and the wayfunds are transferred between competing uses,they affect the allocation of resources in adynamic economy. Moreover, the technologieswill continue to develop rapidly and probablyin unforeseen ways.

Some argue that, just as the effectivenessof many laws and regulations has already been

in FramingPolicy

significantly diminished by information tech-nology and associated structural changes inthe industry, any regulatory revisions madenow will also be subject to rapid obsolescence,as new technological capabilities are de-veloped.

But piecemeal revision is in fact well under-way. The question is whether it should con-tinue to be done in bits and pieces, laggingbehind and reacting to changes; or whether anew system of laws and regulations should bedesigned to guide and control future changes?

Two of the most recent pieces of legislationwere developed in reaction to changes that hadalready occurred in the market. The Deposi-tory Institutions Deregulation and MonetaryControl Act of 1980 was partly motivated bya finding of the courts that the deployment ofautomated teller machines (ATMs) by thriftinstitutions violated existing law. Offerings ofzero-balance checking accounts by commercialbanks and other newly developed services alsochallenged the existing legal regulatory struc-ture. If Congress had not acted, significant in-vestment in advanced equipment and servicesthat had proved attractive to consumerswould have had to be abandoned. The Garn-St Germain Act of 1982 was passed in partbecause the rise in short-term interest rateshad caused funds to shift out of depository in-

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stitutions to money market funds and hadthrown the cost of liabilities and the earningsof assets held by the thrift industry so far outof balance that the viability of these institu-tions was threatened.

The rate of change in the financial serviceindustry has not abated since the passage ofthis legislation. There is every expectationthat coming years will see changes occurringat an equal or faster rate than that of the re-cent past. Financial service providers willcontinue to rely heavily on technology to workaround policies they believe limit their abil-ity to operate effectively in a changing envi-ronment.

Policy Options for Issue 1Congress has two options:

1. Continually fine tune the legal/regula-tory structure to account for short-termchanges and trends in the forces thatshape the financial service industry.

2. Undertake a fundamental redesign of thepolicy structure governing the financialservice industry.

Option 1: Continue to modify existing legal/regu-l a to ry s t ruc ture to re f lec t shor t - te rm changes.

This course reduces the possibility thatthere will be an abrupt change in the opera-tions of the financial service industry. Con-gress would continue its ongoing oversight ofthe financial service industry and continuallyfine tune policy to meet the needs of evolvingconditions. However, congress may find itselftrying to mitigate the undesirable effects ofchange after the time has passed when preven-tive measures might have been taken. Also,the structure that may result from this ap-proach is likely to become so complex andcumbersome that it will hamper the efforts ofthe financial service industry to serve theneeds of the Nation.

Option 2. Undertake a fundamental redesign of thepolicy structure.

Congress may choose to step back from theproblem, the changes that have taken place inthe conditions that shaped existing policy, and

Ch. 9—Policy Issues ● 227

formulate new policies. Such a policy struc-ture, because it would be coherent in its treat-ment of the elements of the market and theindustry and clear in its concepts of nationalneeds and the public interest, is likely to bemore robust in the face of future change thanpolicies developed incrementally.

A comprehensive review and reformulationof the policy structure governing the financialservice industry will require time; and the rateof change in the industry will not abate whilenew policies are being formulated. Ongoingevents will require response and divert atten-tion from the long-term perspective. The taskis difficult but, realistically, doable.

Issue 2: What are the mechanisms available toCongress for implementing policy pertainingto the financial service industry?

Specifically, how should tradeoffs be madebetween the objectives of maximum economicefficiency, protection of local interests, andother social objectives?

Policy Options for Issue 2Congress has three broad options:

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Continue relative deregulation or market-determined solutions by continuing torelax constraints on the industry and bytaking little action to neutralize eventstaking place in the market.Deregulate, taking into account the fac-tors that have changed the effects of vari-ous provisions of the old structure on pro-viders and users of financial services.Instead of comprehensive regulation ofmost services, establish compensatoryprograms that work through the market-place to bring about conditions deemeddesirable. (Organizations such as the Fed-eral Home Loan Mortgage Corporationand the open market operations of theFederal Reserve serve as precedents forthis alternative.)

Option 1: Continue deregulation.

Congress may conclude that maximum eco-nomic efficiency, both in delivering servicesand in using those services to direct funds to

228 Ž Effects of Information Technology on Financial Services Systems

productive uses, is necessary to support a ris-ing level of economic activity. If Congress alsoconcludes that the best way to assure this effi-ciency is to free the financial service industryto respond sensitively to market forces, thenit may opt for further deregulation.

The industry, if allowed to follow the pathit is now on, will effectively become less regu-lated over the next decade. Much of the ma-jor legislation focusing on depository institu-tions and investment banking has alreadybeen neutralized by events or has been revisedto accommodate past changes. Major new en-trants in the financial service market operateoutside the purview of the existing regulatorystructure. Some States have taken actionsthat further reduce the effectiveness of ex-isting Federal legislation.

It is necessary to remember, however, thatderegulation at the Federal level will in alllikelihood result in greater diversity in Stateregulatory strategies. This lack of consistencycould itself introduce inefficiencies in the fi-nancial service sector. The patchwork of Stateregulation has already posed difficulties forthose that want to deploy regional and nation-wide ATM networks. Institutions now seek toestablish portable activities such as credit cardprocessing in States that permit them thegreatest freedom. This will affect the marketby introducing inefficiencies in allocation offinancial resources and service delivery mech-anisms and could result in a mix of financialservice products in some States that is quali-tatively different from that available in otherStates.

The number and diversity of options avail-able to users will increase and will be fully ade-quate to sustain and promote a healthy over-all level of economic activity in the Nation.However, the benefits of these services maycarry some risk of pulling financial resourcesaway from some local communities and ofcompromising some socioeconomic objectives.The general effect will be to shift financialresources toward their highest economic usewithout regard for social values. There is, forexample, some possibility that funds will drain

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from regions or communities in economic dis-tress or with a less attractive balance betweenrisks and return than other regions. Large na-tional institutions may be less interested incommunity needs than small local banks.Banks are required, under the Community Re-investment Act, to give high priority tomeeting the needs of their communities, al-though there has been little pressure to do so.Other kinds of financial institutions do nothave this requirement. Unless ease of entry fornew competitors continues and the market op-portunities are sufficiently attractive to drawthem in, local needs may go unmet, and Con-gress will then be faced with the need of rec-tifying inequities.

Alternatively Congress could limit the per-centage of loan capacity that a financial insti-tution makes available for national and inter-national use. The highest economic use forresources is not always the same as the high-est social priority. An adequate supply ofhousing and opportunities for home ownershipare, for example, generally accepted as nation-al policy objectives. So, too, are protection ofsmall farms and small business opportunities.

Under strong competitive pressures, helpedalong by rate fluctuations and a tight moneysupply, money may tend to move away fromlong-term, fixed-interest loans, such as mort-gages. This could have significant detrimen-tal impacts on the supply and cost of housing,the construction and real estate industries,their suppliers, and government housing pro-grams unless alternative loan instruments aredeveloped. Money may also be funneled awayfrom loans for local entrepreneurs and smallbusinesses and from rural banks that supplyseasonal loans to farmers.

On the other hand, as financial resources aredrawn into high-growth areas, they will tendto moderate interest rates and have a stabiliz-ing effect. This would continue the functionof redistributing financial resources that hasbeen historically performed by the financialservice industry.

Thus, policies that encourage highly compet-itive national money and capital markets may

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produce significant economic benefits, eventhough there is a potential penalty in termsof limiting the funds available for social pro-grams that have been considered to havehigh social value but produce little tangibleproduct.

Option 2: New regulations.

If, on the other hand, Congress chooses todevelop a new regulatory structure for the fi-nancial service industry, it will be faced withthe formidable task of identifying a set of pol-icy variables that will be comparatively insen-sitive to changes brought about through theoperation of market forces coupled with theinfluence of technological change. Some havesuggested, for example, that regulation be byfunction, as is the case with the Fair CreditReporting Act, which places specific require-ments on all who offer credit to the public.Others believe that regulation by specific prod-uct would be appropriate. For example, anyprovider could offer a federally insured ac-count as long as specific criteria with respectto reserves and auditability were met. Stillothers would continue the regulatory focus oninstitutions, and others would focus on thesystems used for delivering services. Somecombination of these approaches could beviable. Each has its strengths and weaknesses.None would be simple to develop, and allwould be difficult to insulate from the kindsof changes now taking place and those ex-pected in the future.

Option 3: No comprehensive regulation; instead,active Federal role in marketplace.

Finally, Congress could establish a role asan active participant in the marketplace forthe Federal Government. It could, for exam-ple, provide payment services for areas aban-doned by firms in the private sector. It couldenter the financial markets, as it now does inthe case of mortgages and student loans, toassure the availability of funds for sociallyworthwhile products. As noted, market inter-vention of this type has a precedent and doesnot put the Government in the position of hav-ing to anticipate the specific effects of tech-nology and market forces on the availability

of capital and on the accessibility of servicesto the public. Such a policy would be robust.It could, however, add substantially to budgetdeficits.

At a minimum, some Federal presence be-yond an insurance program to ensure the safe-ty and soundness of the financial service in-dustry is likely to be required. But a debatesuch as the one about the Federal Reserve asa provider of financial services is likely to de-velop and intensify over time whenever Gov-ernment actions encroach in areas the privatesector feels it can serve adequately. Also theGovernment may not be able to adjust rapidlyenough to changes in market conditions to re-act in a way that does not introduce instabili-ties into the marketplace.

Structural Issues

Issue 3: What levels of concentration in thefinancial service industry are consistent withthe goal of preserving competition amongproviders of financial service?

One of the fundamental objectives in finan-cial service policy has been to prevent the ex-cessive concentration of economic and finan-cial resources in relatively few powerfulorganizations. This has, for example, been themotivation for prohibitions on interstate bank-ing and intrastate branching, for preservingthe unique role of banks by limiting their activ-ities, for insisting on sharp separation betweencategories of financial institutions, and forcontrolling interest rates according to the typeof accounts covered. These provisions were inpart to protect smaller or specialized institu-tions, especially local institutions, against un-fair competition from very large institutionsand in part to maintain a diversity of nicheswithin which competition could flourish.

These regulatory strategies have been over-taken by the use of information technologythat destroys the advantage of proximity,allowing institutions to share data banks anddelivery mechanisms and by institutional rela-tionships that ignore both jurisdictionalboundaries and regulatory definitions of in-

230 . Effects of Information Technology on Financial Services Systems

stitutional categories. The new technologyalso has paradoxical effects on economies ofscale. To compete in a national money market,an institution must offer its services to a widermarket, deliver them without regard to the lo-cation of the user, and support these activi-ties with a large volume of transactions. Onthe other hand, through access to shared net-works and wholesale support services, evenvery small institutions can now enter and re-main viable in local markets.

Regulatory strategies have already beenmodified to respond to these economic andtechnological pressures, but on a piecemealbasis. As a result, traditional financial in-stitutions are fiercely competing with oneanother and with new organizations, includingnonfinancial institutions, that are enteringtheir markets. It is not clear how existing an-titrust tests apply to this sector in these cir-cumstances, since it becomes progressivelymore difficult to define markets. It is clear,however, that in spite of–or because of–thefierce competition now underway, the poten-tial exists for increased concentration of finan-cial resources and for the development throughrepeated mergers and acquisitions of largeorganizations with excessive size or power infinancial markets.

It is possible that the kind of competitive-ness that was desirable in the past, as meas-ured by the number and size of institutionsand the scope of their markets, is no longerappropriate in view of several changes:

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the increased size of the population,the increased level of U.S. economic ac-tivity,the increased size of industrial markets,the increased scale of commercial organi-zations,the increased volume of internationaltrade,the increased diversity of services,the redefinition of the roles of financial in-stitutions, andthe decreased advantage of proximity forusers of financial services.

Congress will want to consider in the con-text of these changes whether intense and in-creasingly uncontrolled competition will workto the detriment of some important segmentsof the industry, will encourage financial insti-tutions to take excessive risks, or will resultin harmful consolidation of economic and fi-nancial power.

Policy Options for Issue 3

Option 1: Allow market forces to continue as a pri-mary determiner of the evolutionary path forthe financial service industry even though theymay create major consolidated, national serv-ices organizations.

As long as entry barriers remain low, smallfirms are likely to appear on the scene to meetlocal needs. If banks remain subject to specialrestrictions, they will be at a competitive dis-advantage relative to other kinds of financialinstitutions in operating in the national mar-ket. Continued reliance on existing antitrustlegislation to prevent excessive concentrationof financial power would face increasing diffi-culty in defining markets and market partici-pants for the purpose of antitrust enforcementactions.

Option 2: Define criteria under which mergerswould permitted and firms would be allowedto enter or leave a market.

Again, with this option, it would be difficultto define market boundaries for the purposeof evaluating adequacy of competition follow-ing a merger. Problems of defining minimalservices levels and alternatives for meetingthem would have to be resolved before deci-sions on permitting firms to exit a marketcould be made. Unless the law were structuredto prevent it, unregulated services providerswould continue to use new technologies to en-ter the market outside of the existing regula-tory structures. Such entrants would affectthe competitive balance in a market and wouldbe free to exit even though the result wouldbe a level of service that falls below accept-able minimums.

Ch. 9—Policy Issues • 231—— — — — . — . . — —

One or more organizations, public or private,could be assigned the role of provider of lastresort to fill voids in the availability of finan-cial services. However, regulators would thenbe faced with the problem of determining whenalternative suppliers have, in fact, abandoneda market, making it necessary to call on suchproviders.

Option 3: Highly regulate only a specific set of fi-nancial services.

The model of the telecommunication indus-try could be followed, in which a specific setof financial services such as deposit-takingwould be highly regulated. Competition inthese product areas would be tightly con-trolled and maintained so that the marketcould not be controlled by just a few firms. Allother financial services could be offered byalmost any type of institution in a virtuallyunregulated market. The regulated financialservice institutions could offer unregulatedproducts only through arms-length subsid-iaries so that there would be no cross-subsi-dization between regulated and unregulatedservices. This approach would have the advan-tage that those financial services where safetyand soundness is of greatest concern would betightly controlled, and competition would bepreserved. But the fact that technologicalmeans would almost always be found to by-pass any boundaries that might be drawn be-tween product areas suggests that this ap-proach will be difficult to implement.

The definition of basic financial services—those to be regulated-and the identificationof those offering them would be difficult. Serv-ice providers would, using innovative informa-tion technology, tend to design services thatclosely approximate but are not technicallyidentical to regulated services and to offerthem in the unregulated market. There wouldbe no guarantee of adequate competition inthe unregulated markets, and antitrust lawswould provide the only means through whichexcessive concentration of financial powercould be prevented.

Issue 4: What modifications, if any, couldbe instituted regarding restrictions oninterstate banking?

Restrictions on interstate banking were in-tended to prevent financial resources and con-trol over credit from becoming progressivelyconsolidated in a few powerful institutions.They were also meant to maintain a local orien-tation and interest and to preserve for con-sumers the convenience and access affordedby proximity to financial services. Lately,these restrictions have been in large partrendered ineffective. The sharing of ATM net-works allows some banking functions to becarried out from remote locations. Somebanks, with regulatory approval, have boughtbanks and savings and loan associations inseveral States. Nondepository institutions of-fer services nationwide that are perceived byusers as functionally equivalent to traditionalbank accounts. Regional and national net-works have made proximity to the service pro-vider no longer a necessary measure of con-venience for the user. However, restrictions oninterstate banking still place banks at somedisadvantage vis-`a-vis other financial institu-tions. For example, facilities to accept demanddeposits generally are not placed across Statelines, but corporate clients are provided thisservice indirectly by means of zero-balance ac-counts linked to consolidation accounts inanother State. Interstate banking restrictionshave probably protected some inefficient in-stitutions that would otherwise have beendriven out of the market.

Policy Options for Issue 4Option 1: Remove or modify restrictions on in-

terstate banking.

Congress could act systematically to removeall remaining restrictions on interstate bank-ing. To do this would require Federal legisla-tion repealing the interstate banking prohi-bitions in the McFadden Act and the BankHolding Company Act, thus withdrawing Fed-eral consent to State statutes Mocking in-

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232 Effects of Information Technology on Financial Services Systems

terstate commerce. The overall effect wouldbe further dissociation of financial service in-stitutions from orientation toward a particularcommunity, market, or region, and further in-tegration of a national financial service mar-ket. Removing restrictions on interstate bank-ing would tend to strengthen a trend towardconsolidation, since some financial institutionswould probably not survive competition withlarge national firms. On the other hand, it ispossible that financial services might be ex-tended to some now underserved or isolatedcommunities from depository institutions inneighboring States.

Congress could, by amendment to the Mc-Fadden and Bank Holding Company Acts,modify restrictions on interstate banking toallow and encourage areawide banking in mul-tistate metropolitan areas, or regional bank-ing in multistate market areas (as is alreadydone in New England under an interstatecompact).

Option 2: Reinforce limitations on interstatebanking.

Alternatively, Congress could strengthenrestrictions on interstate banking by remov-ing all loopholes. The Federal Reserve has justmoved to plug one loophole by redefining com-mercial deposits to include NOW and SuperNOW accounts. Following the reasoning thatled Congress to pass legislation legitimatizingATMs deployed by savings and loan associa-tions after the courts had declared them il-legal, it does not appear feasible nor desirableto dismantle interstate ATM networks or toprohibit the cash management programs of-fered by brokers. It would be possible to ex-tend reserve requirements to all institutionsthat operate depositlike accounts, includingsecurities dealers. This might, however, implygiving all of these institutions access to thepayments system or to deposit insurance.

One possibility is to establish rigid criteriafor entry to and exit from the market, includ-ing criteria for permitting mergers. But, suchcriteria would be hard to define and enforcebecause institutional boundaries and productlines have already become so blurred. Criteria

would have to be defined in terms of marketshare or in terms of control over deposits ortotal assets. Given the heterogeneity andfluidity of the industry, this would also be hardto do.

Other possibilities are to continue to prohib-it holding companies from owning depositoryinstitutions in more than one State, as was thecase until the 1980’s, or to subject all deposi-tory institutions to a rigid prohibition on in-terstate banking, which would require preemp-tion of State laws and extension of relevantFederal laws to cover savings and loans andcredit unions.

Some way might be found to strengthen andbroaden the Community Reinvestment Act,possibly by requiring local development loansat a level pegged to the level of depositsgathered from an area. This would be a factorlimiting the flow of funds out of the areas gen-erating them.Issue 5: How might law and regulation be used

to focus the attention of various classes offinancial service providers on specificmarket areas?

Federal policy since the 1930’s has allocatedspecific functions to specific financial institu-tions. But recently, a combination of techno-logical innovations and market forces has sig-nificantly weakened the functional distinctionsbetween types of financial institutions. Thiscondition has developed gradually, with fewof the steps along the path involving positivedecisions by policymakers. It may be appro-priate now for Congress to reexamine the ques-tion of whether public interests still requirethe limiting of some roles and functions to aspecial category of financial institutions.

Banks and thrifts are unique institutions because they alone have access to the paymentsystem. Funds are transferred from one ac-count to another only within banks. All trans-actions not carried out by exchange of cur-rency (except for some internal clearing) areultimately culminated within the banking sys-tem, and all financial institutions must ulti-mately call on a bank for the final step in de-livering a service. Banks also allocate creditby making and guaranteeing commercial loans.

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Ch. 9—Policy Issues . 233—

Because of this dependence, the safety andsoundness of banks-and public confidence inthem—are an essential underpinning of theeconomy. National policy therefore has alwaysbeen to treat banks differently from otherkinds of financial institutions and to prohibitthem from engaging in other kinds of commer-cial activity. Specifically, the goals of this pol-icy

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insure the soundness of banks (originallythe purpose of both reserve requirementsand depository insurance);limit the risks that banks could assume;prevent conflicts of interest, such aswould occur if banks directed investmentto or allocated credit to commercial activ-ities in which the bank had an equity in-terest, or if banks required borrowers topurchase insurance underwritten by thebank; andprevent concentration of financial re-sources by forbidding banks to partici-pate in certain kinds of investment activ-ities, such as underwriting stock issuesand casualty or life insurance.

Other financial institutions, and in somecases nonfinancial institutions, are now en-croaching on activities once limited to banks—i.e., offering accounts that consumers per-ceive as functional equivalents of depositoryaccounts but with the advantage of higher in-terest rates. Nondepository institutions arebuying banks, gaining access to the paymentmechanism through them, and acquiring theirassets and customers, They are then abrogat-ing one or more of the two functions thatdefine a bank (i.e., accepting commercial de-posits, making commercial loans) in order toescape Bank Holding Company Act prohibi-tions on nonfinancial activities.

Banks and bank holding companies, in re-taliation, are seeking to expand into otherservices, for example, offering insurance inStates where laws permit and increasing theirofferings of data processing services. Low-costor free deposits, the traditional source of fundsfor banks, are drying up as corporations prac-tice zero-balance banking and savers transfer

their money to higher interest accounts andmoney market funds. This forces banks to tryto expand their customer base by offering agreater diversity of services and to increasefees.

However, as banks and other depository in-stitutions expand their activities into otherlines of commerce, the level of risk they aresubject to may increase. Any increase in in-stitutional risk is accompanied by an increasein the levels of risk for both the stockholdersand clients of the institution to the extent theyare not covered by deposit insurance. Ulti-mately, the level of risk facing the financialservice industry as a whole would increase.

The general policy of deregulation suggeststhat financial institutions could compete onan equal basis if barriers between varioustypes were dissolved. For example, thrift in-stitutions were, for a time, severely threatenedwhen they were stuck with low-yield port-folios when interest rates rose; they may beso threatened again. Federal policy has beento try to save troubled thrift institutions byallowing, encouraging, or arranging mergers.This includes mergers across State lines andmergers of mutual savings banks with com-mercial banks. More recently, Federal savingsand loan associations have been allowed by theGarn-St Germain Act of 1982 to offer con-sumer loans of up to 20 percent of assets andto offer other consumer services so that theirportfolios will contain assets and liabilitieswith better matched maturities.

On the other hand, thrift institutions in thepast received some preferential treatment be-cause they are the major source of loans forhousing. An adequate supply of housing anda high rate of home ownership are widely ac-cepted as social policy objectives, and a declinein the housing market has severe impacts onother sectors of the economy.

Policy Options for Issue 5

Option 1: Modify powers to offer financial services.

Congress could repeal Federal laws and reg-ulations limiting the services that banks can

234 ● Effects of Information Technology on Financial Services Systems

offer and the activities in which they can en-gage. The U.S. Treasury has proposed thatthrough holding company subsidiaries banksbe allowed to engage in virtually all financialservices. This is a movement toward deregula-tion, to “put all the players on a level playingfield. ” It would be likely to increase the pur-chase of banks by other financial and non-financial institutions and to stimulate thebuying up of small banks by bank holdingcompanies. It would increase the possibilityof banks exerting pressure on customers tobuy nonbank services or products.

Congress could instead tighten the loopholesin laws and reaffirm the special and limitedrole of banks. Institutions that accept govern-mentally insured deposits could be permittedto offer only limited other services. Institu-tions that provide other services (either finan-cial or nonfinancial) could be forbidden to ownor control institutions that accept insured de-posits.

A third possibility is to extend the barriersagainst banks diversifying their services bybringing all State banks (including those thatare not Federal Reserve System members)under the Glass/Steagall Act through Federalpreemption, so that States cannot use per-missive laws to attract banks into relocation.

Finally, Congress could make modificationsin laws and regulations to restrict (or allow)specific activities. It has been proposed for ex-ample that banks or bank holding companiesbe permitted to:

underwrite mortgage-backed securitiesand offer mortgages so as to lower mort-gage interest rates through increasingcompetition (as the Federal NationalMortgage Association already does);offer mutual funds, in order to bring downmanagement fees and sales commissions;andunderwrite municipal revenue bonds, tosupplement the effects of discount broker-age in increasing the market and lower-

ing costs for municipal and State gov-ernments.

Option 2: Modify powers to effect mergers.

Congress could continue to allow other in-stitutions to merge with or buy savings andloan (S&L) associations. If the acquiring firmsuse the savings and loan associations assources of cash, the general effect will be agradual reduction in money available for mort-gages. Any company can now buy an S&L.Only if the company owns more than oneS&L—and is therefore an S&L holding com-pany-must it restrict its activities to hous-ing finance, or even continue to offer housingfinance. Nonfinancial institutions have alreadyseized on the opportunity to buy S&Ls to gainaccess to some of the privileges and preroga-tives of depository institutions, for example,federally insured accounts.

Congress can continue to allow mergers be-tween thrift institutions, as the Federal HomeLoan Bank Board is now doing. The likely out-come will be a smaller number of larger thriftinstitutions, but this may not solve the prob-lem of attracting an adequate supply of funds.

Option 3: Provide incentives to support specificactivities.

Congress could further provide capital as-sistance for thrift institutions. A Federal sub-sidy for thrift institutions could be justifiedon the grounds of the high social priority ofhousing, but it would add to Federal expendi-tures, increase the Federal deficit, and set aprecedent when other financial institutionsrun into trouble. Congress could revise taxlaws to encourage S&Ls to diversify their serv-ices further and to broaden their revenue base.It is not clear whether without this incentivethe S&Ls will diversify enough to generate in-creased earnings.

Congress may want to provide incentives tostimulate other sources of mortgage moneyrather than attempting to turn back the clockon thrift institutions, which may not be opera-tionally possible.

Ch. 9—Policy Issues ● 235— —

Issue 6: How will further deregulation oftelecommunications affect the financialservice industry?

An important consideration for future finan-cial service policy will be the cost of telecom-munications. As a result of the breakup ofAT&T, Congress is now coming to grips witha broader issue of control of telecommunica-tion costs; specifically, with the issues of ac-cess charges. It is expected that following thebreakup, long-distance telephone rates will de-cline as a result of increased competition be-tween suppliers, while local communicationrates will tend to rise to compensate regionaltelephone companies for the loss of incomefrom the Bell system. Congress is debatingwhether to levy a monthly access charge forall telephone use, which would tend to decreasethe need for high overall local rates.

The distribution of function within the de-sign of a system to deliver financial servicesis directly related to communication costs. In-creased costs for local communications maydiscourage the use of third-party data proc-essors, and small financial institutions mayfind it more difficult to enter the market orsurvive in the market. Financial institutionswill attempt to move data processing towardthe end-user in order to minimize the time auser must remain connected with a service pro-vider’s computer, i.e., encourage home bank-ing. But consumers may reject this service en-tirely if either entry or maintenance costs aretoo high.

Comment on Issue 6. –The factors and rela-tionships that must be considered in develop-ing telecommunication policy are extremelycomplex and full consideration of them isbeyond the scope of this assessment. How-ever, Congress should be aware that telecom-munication costs have a strong and direct in-fluence on the economics of financial servicedelivery systems. Changes in telecommunica-tion policy can result in the need to modify thestructure of financial service delivery systemsconsiderably.

Issue 7: What steps could be taken to realignthe legal/regulatory structure to make itconform closely to the changing structure ofthe financial service industry?

Laws and regulations generally apply to spe-cific categories of service providers. The oper-ational differences between depository andnondepository institutions are progressivelyeroding, but these categories are still subjectto different regulatory bodies. They have, insome cases, different interest rate ceilings, andthey are subject to different restrictions on in-terstate operations and on intrastate branch-ing. A financial institution, in fact, can some-times select its regulatory climate by changingits organizational structure. S&L associationsenjoy special tax incentives if a majority oftheir activities are housing loans. Accounts indepository institutions are federally insured,while other kinds of accounts are not. Thebuyer of services has different benefits, dif-ferent risks, and different safeguards andrights, according to which service provider isselected. The consumer, however, is oftenunaware of the subtle and detailed differences.

Policy Options for Issue 7

The problem of how best to design, or revise,a regulatory structure for the financial serv-ice industry involves many subsidiary issues,such as Federal deregulation versus Federalpreemption, institutional versus functionalregulation, and self-regulation versus govern-ment regulation. The options considered beloware not necessarily mutually exclusive:

Option 1: Design regulations to apply to func-tionally defined services and achieve specificpolicy objectives, without regard to the institu-tional provider of the services.

This option would put all financial institu-tions competing for a particular market nicheon a more equal footing. It would mean, how-ever, that each of an institution’s services orfunctional activities would be considered sep-arately. Yet the total mix of services offered

236 Effects of Information Technology on Financial Services Systems— . — — — —

would affect the behavior of the providing in-stitution, the level of risk that it assumes, andits relative power in the marketplace. If vari-ous regulations were administered by differentregulatory agencies, each financial institutionmight be subject to multiple regulatory agen-cies that may at times have overlapping orcontradictory requirements and restrictions.

Option 2: Federally preempt all State legislationand regulation of financial services.

This option would provide consistency andreduce uncertainty for the industry with thepossible result that financial service providerswould become more active in developing anddeploying services that the public would findattractive and useful. Yet the existing dualbanking system has served well in meetingvarying needs for financial services. Federalpreemption would eliminate this duality andcould reduce the degree of responsiveness offinancial service providers in meeting localneeds.

Option 3: Abolish all Federal regulations, allow-ing the States to control financial services fully.

This alternative would allow each State themaximum opportunity to achieve local objec-tives and to meet local needs for financial serv-ices. It would also encourage many practicalexperiments and much innovation as Statesadopt alternative regulatory strategies. ButStates would also be prevented by the Com-merce clause of the U.S. Constitution frombarring entry by out-of-State banks. Nation-wide financial service institutions would, however, suffer from the inconsistencies in restric-tions and requirements.

Option 4: Combine all Federal regulatory functionspertaining to financial services under one Fed-eral agency, mandated to develop an internallyconsistent system of regulations for all finan-cial services.

On the one hand, this alternative would in-troduce a degree of consistency into the regu-latory structure that is now lacking. Institu-tions would no longer be in a position wherethey seek charters from the agency that bestsuits their intended mode of operation. The in-

creasing homogeneity of the market for finan-cial services would be recognized in a unifiedregulatory structure.

Yet, the regulators serve the interests of specific constituencies that consist of both the in-stitutions they oversee and their customers.If this diversity of perspective were elimi-nated, specific needs could go unmet.

Issue 8: Concerns of foreign governmentsregarding the protection of individualprivacy could lead to the erection of barriersfor American financial service firms doingbusiness overseas. What steps could theUnited States take to address theseconcerns or circumvent the barriers?

Not only is the Nation continually movingtoward a more highly integrated national econ-omy, but it is increasingly knit into a globaleconomy in which markets, trade patterns, fis-cal and monetary policies, and currencies arelinked across national boundaries.

Worldwide delivery of financial services has,for well over a century, depended on telecom-munications and is now more than ever com-pletely dependent on advanced technologies.Rapid and free movement of funds and relateddata internationally is essential. Financial in-stitutions and other types of enterprises havebranched across national boundaries and de-pend heavily on being able to move data freely,and confidentially, between plants and officesin several countries. The ability to accessresources anywhere in the world from anyother location has become an important fac-tor in the operation of multinational corpora-tions and in international trade.

Financial service organizations operate cen-tralized systems that concentrate data proc-essing for worldwide networks at one or a veryfew centralized points. Some, such as thosethat provide credit authorizations at point ofsale, must be accessible from thousands of lo-cations and must have a high degree of reli-ability. They move customer transaction dataat high speed across all boundaries.

Ch. 9—Policy Issues ● 237

The ability to initiate a transaction from aremote location unfortunately also implies theability to initiate fraudulent transactions; tomonitor, interfere with, or extract data froma system from remote locations.

In a sudden hostile confrontation withanother country, such as occurred with theIranian hostage situation, the option of freez-ing the assets in the United States of theforeign power may be lost. Electronic execu-tion of an order to transfer the assets fromU.S. jurisdiction could be completed morequickly than a freeze order could be made ef-fective. Foreign-owned banks might also, insome situations, provide to their governmentsor industries privileged information about U.S.industry.

Some nations have passed laws limiting thecollection and dissemination of data associatedwith individual accounts across their borders,whether to safeguard the privacy of citizens,to protect trade positions, in the interest ofnational security, or for other reasons. Somenations are taking the position that they willnot allow some kinds of data to be sent to na-tions that do not have restrictions on accessand movement of data that are at least asstringent as their own.

Such restrictions could cause problems forU.S. firms because this country has not cho-sen to restrict the collection and disseminationof data in ways that would be seen to meetsuch requirements. To do so may place theUnited States in a position of establishing do-mestic policy in response to requirements aris-ing abroad, a situation that may become morecommon as the global economy becomes morehighly integrated and interactive.

A related concern is the possibility that in-ternational data-processing centers concen-trated in a few countries are vulnerable to ter-rorist or military attack. As the reliable andorderly flow of international informationbecomes more critical to the U.S. economy,policy makers and national security plannersmust be aware of these vulnerabilities.

Worldwide information services may tendto increase global debt exposure and undersome conditions could be destabilizing toworld currency, commodity, and security mar-kets. However, they could also be used tomonitor and control international debts andrepayments better and to overcome the desta-bilizing effects of a major debt default.

The national interest here is threefold: tostimulate and support the U.S. position inworld markets, to further U.S. internationaldiplomatic objectives, and to maintain na-tional security.

Policy Options for Issue 8

Option 1: Establish no stronger protections for in-dividual privacy’ than already’ exist.

The United States might test the proposi-tion that the desire to have full financial rela-tionships with institutions in the UnitedStates will be strong enough to overcome allother considerations. But the possibility ex-ists that foreign governments with strongprivacy protection laws may not be willing toallow the free flow of financial and paymentdata to and from the United States withoutspecific protections instituted at a level com-mensurate with those provided their own citi-zens within their own borders. Any foreignbans that are instituted may focus only onelectronic transmission of personal data to andfrom the United States, in which case the alter-native of using nonelectronic media would stillbe available but could result in significant de-lays in the movement of funds and data.

At this point there is no compelling forcemotivating change. It does not appear to bean imminent probability that one or more na-tions will significantly restrict the movementof financial data to and from the UnitedStates. But this situation could changerapidly, and if this option is chosen Congresswill want to continue monitoring develop-ments in this area.

238 Effects of Information Technology on Financial Services Systems

Option 2: Institute policies defining more preciselythe conditions under which financial data canbe collected and disseminated across nationalboundaries.

Under this option, U.S. privacy protectionlaw would be harmonized with foreign laws toa greater extent, at least in the case of finan-cial services data. Such policy might becomenecessary, should foreign privacy laws cometo be applied to data transmitted and storedin computer systems on U.S. territory. Al-though Federal privacy law has not, in gen-eral, been applied to privately held data sys-tems nor is there presently significant overtdomestic pressure to extend it in that direc-tion, precedent does exist in the particular caseof banks for Federal laws concerning the han-dling of personal information.

Issue 9: What organizations could be grantedaccess to the mechanisms for clearingchecks, securities, and other paymentinstruments such as credit card drafts?

Only depository institutions now have directaccess to the payments mechanism-clearingaccounts with the Federal Reserve System,membership in local and regional clearing-houses, and membership in automated clear-ing house associations. Securities broker/deal-ers clear listed stocks and bonds through theorganized exchanges, and market makers clearissues traded over the counter. Clearing mech-anisms provide the means by which funds aretransferred between and among accounts heldby approximately 40,000 institutions in theUnited States. Without this means of convey-ing payment instructions between institutionsand settling accounts, there would be no pay-ment medium other than cash. Similar net-works exist between the airlines for clearingamong carriers that honor one another’s tick-ets and between petroleum companies for set-tling crude oil accounts.

The essential elements of a clearing mecha-nism are the existence of an account throughwhich net settlement can be accomplished anda means for transferring instructions that tellthe account holder the amount to be trans-ferred and the party to be credited. Banks

have traditionally been the only ones able toestablish settlement accounts and be party tothe network for accomplishing the required in-formation transfers.

In the present environment, nondepositoryfinancial institutions establish relationshipswith banks to obtain access to the paymentmechanism. Drafts on accounts held by thenondepository institutions are cleared throughthe existing payment system and paid froma common account, normally maintained atzero balance, at a clearing bank. Only whenthe drafts are presented to the nondepositoryinstitution with whom the individual customerdeals are the funds debited from the individ-ual’s account.

Banks and other organizations are not re-stricted in establishing arrangements for proc-essing drafts similar to those in existence be-tween operators of money market funds andbanks.

For example, if the employees were agree-able, an employer could make an arrangementwhereby employees are credited daily on thecompany’s books with wages earned and arepermitted to write drafts against those funds.The employer would then fund an accountwith a depository institution to cover draftsas they are presented and debit the accountsof individual employees for appropriateamounts. Regardless of the balance betweenbenefits and drawbacks, such an arrangementwould be operationally feasible.

The arrangements for clearing through a de-pository institution with access to the pay-ment mechanism can be seen as being some-what artificial. Given the technologies nowavailable for moving and processing paymentinformation, one could argue that othersbesides banks be given the option of estab-lishing clearing accounts with institutions thatoffer them. A routing-transit number wouldhave to be issued to any organization per-mitted such access to the clearing mechanism.

The question remains as to whether it is inthe public interest to allow such arrangements.On the one hand, the existing regulatory struc-ture provides assurances that parties to the

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Ch. 9—Policy Issues ● 239

clearing mechanism will be able to settle ac-counts as required. Opening the mechanismto unsupervised nondepository institutionsnot bound to existing requirements to meetsettlement schedules could weaken the systemand hence decrease the safety and soundnessof the financial system as a whole. Under ex-isting arrangements between banks and fundmanagers, the bank must settle with the pay-ment system, even if the fund fails to meet itsobligations. On the other hand, requirementscould be established to ensure safety andsoundness of the system that would have tobe met by nondepository organizations thatmay be granted direct access to the paymentmechanism.

Policy Options for Issue 9

Option 1: Retain restrictions on access to thepayments mechanism.

Congress could choose to retain the presentsystem whereby membership in clearing sys-tems is limited to organizations meeting spe-cific criteria. One could argue that the pres-ent mechanism works well and has been ableto accommodate the changes that have takenplace in the financial service industry. Thesafety and soundness of the industry havebeen well protected, and changes that createthe possibility of weakening either should notbe allowed.

On the other hand, there is a real possibil-ity that innovative people will develop clear-ing systems that will operate outside of es-tablished channels. Off-market trading is areality, and there is nothing to prevent theemergence of analogous systems for clearingpayments. Nondepositor institutions havealready gained access to the payment mecha-nism by acquiring banks and S&L associa-tions. Electronic systems (especially packetswitching) will lead to diverse channels fortransmission and perhaps settlement, as willthe requirement for explicit pricing of FederalReserve services. Thus, as in so many otherparts of the lega.1.regulatory structure govern-ing the financial service industry, the presentrules for access to the payments mechanism

may be circumvented by applications of avail-able technologies.

In the extreme, Congress could rule that allpayments pass through the established pay-ments mechanism. However, with the exist-ence of private clearing arrangements betweenfinancial institutions and the multiplicity ofsystems for clearing payments, it would be ex-tremely difficult to codify exactly what con-stitutes the established payments mechanismand the characteristics of clearing arrange-ments that would not be permitted under sucha policy.

Option 2: Open the payments mechanism to otherthan depository institutions.

At the other extreme, Congress could openthe payments mechanism to all who wouldjoin. As indicated, blanket access couldweaken the safety and soundness of the finan-cial service industry in that occasions wherethere would be failure to settle would becomemore likely.

As an interim step, the payments mecha-nism could be opened to nondepository orga-nizations that would be willing to meet criteriadesigned to ensure continued integrity of thesystem. Such requirements could include pro-visions for maintaining reserves and provi-sions that members be audited to determineif they meet criteria for membership or thatthey obtain performance bonds or insurancethat guarantees their ability to settle.

Yet, exclusivity of access to the paymentmechanism by depository institutions bal-ances some of the relative disadvantages ofsuch an arrangement under the present legal/regulatory structure that limits the range ofactivities in which depository institutions canengage. The major sources of revenue of de-pository institutions in the future will bepayments for services provided rather thanthe spread between the rates at which fundsare obtained and those at which they are lent.Opening the payment mechanism to otherscould substantially affect revenues of deposi-tory institutions and, ultimately, becausealternative sources of revenue are limited,

240 . Effects of /formation Technology on Financial Services Systems

their ability to remain viable competitors inthe marketplace.

Issue 10: What alternatives for regulatinginterest rates are available to Congress?

In recent years, when market rates have ex-ceeded Federal and State limits, significantquantities of funds have moved from banks,credit unions, and S&L associations to alter-native investment opportunities created bynew entrants to the financial service industry.These new entrants have relied heavily on ad-vanced telecommunication and informationprocessing technologies to implement theirofferings. Constrained interest rates effec-tively limited the supply of funds to some in-vestments.

Complete deregulation of interest rateswould allow service offerings to respond tomarket forces, the price of services to be helddown by competitive pressures, and interestrates to reflect national market conditions.However, to the extent that firms do notrecognize the costs their actions impose onothers, market forces may not reflect all socialpriorities. ’ It may be in the public interest,under some circumstances, to modify or con-strain the action of market forces on interestrates in order to preserve certain social ob-jectives.

Interest rates, other than for corporate de-mand deposits, will be essentially decontrolledby 1986 as Regulation Q is phased out. It ispossible that this situation could, under someconditions, result in the equivalent of pricewars. Financial institutions have been knownto raise interest rates to unsupportable levelsin attempts to attract deposits. Widespreadactions of this type could lead to an excessivenumber of financial institution failures, andas a result, could seriously destabilize the econ-omy. Selective control of demand deposits andsavings account interest rates is likely to cause

IControls on the rates paid on deposits by depository insti-tutions, controlled under the Regulation Q system of ceilings,are being phased out under provisions of the Depository Insti-tutions Deregulation and Monetary Control Act of 1980.

funds to be drained from depository institu-tions. Usury laws restrict the supply of creditwhen interest rates are rising.

Policy Options for Issue 10

Option 1: Federally regulate all interest rates forall financial services and all institutions; pre-empt State usury laws.

Assuming the Government would set a na-tional rate, this option would create uniformity of interest rates across the Nation. Fundswould not be moved from area to area insearch of higher returns while they become vir-tually unavailable to those in need of creditin areas where rates have been capped at belowmarket levels. Interest rate ceilings might belifted to improve customer access to credit andto attract savings and investments; interestrates might be capped to reduce inflation oreconomic instability. They might be manipu-lated to preserve, for example, a housing dif-ferential.

On the other hand, the ability to set rateslocally helps ensure their responsiveness ofcredit markets to local needs. This would belost if the Federal Government were to pre-empt all regulation of interest rates.

There is no reason that a national rate beset. Rates could be set regionally or set interms of ranges rather than at specific values.Such strategies could mitigate some of the dis-advantages of this alternative, but the diffi-culty of implementing them operationallyshould not be underestimated.

Option 2: Completely deregulate interest rates.

In economic theory, at least, this optionwould allow funds to flow to highest value usesin terms of the costs and benefits included inthe calculus. However, if indirect costs andbenefits are not recognized, the resultingallocation of resources could be suboptimal.It would increase the availability of credit, butcredit could be priced to levels that would ef-fectively deny it to some consumers or causethem to change their way of life as they divertfunds to cover its cost.

Ch. 9—Policy Issues ● 241—

Option 3: Federally cap interest rates only for ac-counts covered by deposit insurance.

This option would cause money to be with-drawn from depository institutions when mar-ket interest rates rise, leaving more consumersexposed to risk because their assets would bein uninsured accounts.

Yet, some may view the reduced return asa cost of security and be willing to incur it.Limiting the return paid customers would re-duce the pressure on institutions to make themore risky investments that provide higheryield, thus limiting the exposure of the insur-ance fund.

Option d: Allow States to regulate interest rateson all services delivered within the State, wheth-er or not they are delivered by State-charteredinstitutions.

Under this option, States may try using con-trolled interest rates to attract businesses.Such tactics could significantly disturb the na-tional money market. On the other hand, mar-ket forces complemented by the ease withwhich information can be rapidly distributedover wide areas would limit the options of theStates. Individually, they would be able toselectively cut some rates within a relativelynarrow range to support specific policies; butno one State would have the power to estab-lish rates at levels substantially different fromthe norm. Experience has shown, for example,that States have not been able to artificiallydepress interest rates on loans made withintheir jurisdiction when significantly higherrates were permitted elsewhere.

Risk Allocation Issues

Issue 11: What are the alternatives forapportioning risk between financialinstitutions and their customers and clients?

The purposes of deposit insurance are: 1) toprotect the funds of individuals, households,and small businesses against loss when finan-cial institutions fail; and 2) to prevent thewidespread economic instability that would re-sult from cascading institutional failures as aresult of a sudden loss of public confidence.

Deposit insurance covers only traditional de-mand deposits and savings accounts in com-mercial banks and equivalent consumer ac-counts with S&L associations, savings banks,and credit unions.

At present, the Federal Deposit InsuranceCorporation (FIDC) protects the depositor’sprincipal up to $100,000. Securities InvestorProtection Corp. insurance, on the other hand,guarantees the investor’s shares, e.g., againstbroker’s failure to deliver, but not the valueof those shares. The “discount window” oper-ated by the Federal Reserve System providesfunds to banks that are temporarily unable tomeet their reserve requirements and thus alsofunctions as a kind of insurance for the veryshort term.

As a result of intermediation (consumersshifting their money to other kinds of accountswhich give them a higher return), a large pro-portion of liquid assets and savings are notnow covered by insurance. As banks diversifyinto other activities, they increase their riskof failure. The advantage of being covered byFederal insurance is one incentive for non-depositor institutions to buy banks and S&I,associations (increasing the tendency towardconsolidation of financial resources).

Returns on investment recognize and re-ward acceptance of risk. Although deposit in-surance provides an implied safety net formanagers and stockholders of depository in-stitutions, the price of increased efficiency isincreased risk, if only because resources aretightly allocated, reserves are reduced, andmargins for error are slimmer. The more effi-cient firms allow less room for error; and,therefore, the expected cost of a mistake in-creases. With a higher level of competition be-tween financial institutions, the more efficientinstitutions will survive and some less efficientones will fail. This is a benefit in economicterms, but because financial institutions playa critical role in modern society, their in-creased failure rate necessarily touches on thepublic interest in a way that risks assumed byother kinds of organizations do not. Suchfailures expose individuals, families, small

242 ● Effects of /formation Technology on Financial Services Systems

businesses, and major corporations not cov-ered by deposit insurance to risk of loss of cap-ital or lifetime savings.

Two aspects of risk are involved here: oper-ational risk (failure to settle, an implicit riskthat is increased by the speed that new tech-nology contributes to transactions and settle-ments) and institutional risk (institutionalfailure because of bad asset management). Op-erational failures, if they shake the confidenceof customers, can greatly increase the risk ofinstitutional failure. This was the problem thatdeposit insurance was designed to solve. How-ever, deposit insurance itself may encouragefirms to take excessive institutional risks byimplicitly protecting them from the conse-quences of bad judgment.

Excessive risk assumed by financial insti-tutions could affect the stability of the econ-omy, if there is ever a series of cascadinginstitutional failures in which each firm’s col-lapse causes the collapse of others. At pres-ent, a combination of governmental actions toprotect the deposit insurance fund (generally,allowing or arranging a merger between an en-dangered institution and another stronger one)and ad hoc cooperative actions by large finan-cial institutions to shore up the market, nearlyalways prevents the spreading of undue detri-mental consequences following any threatenedor actual financial institution failure. But thespeed at which funds are transferred and set-tlements are made today may make these res-olutions much more difficult. Institutional fi-nancial crises could spread rapidly.

Many transactions will be timesensitive. IfA fails to pay B, and B is therefore unable topay C and D, these disruptive events will mul-tiply with great speed. The increased numberof daily or hourly transactions, the rapid turn-over of assets, the smaller reserves held by aninstitution relative to the number and dollarvalue of transactions, and the complex inter-relationships between financial institutionswill contribute to the sensitivity of the fi-nancial system to short-term perturbations.

The result will be to increase the sensitivityof institutional equilibrium to even minor per-turbations and to decrease the ability to con-trol the secondary effects of disturbances.

Policy Options for Issue 11

Option 1: Retain Federal insurance, as it is now,for traditional depository institutions only.

Continuing the present program is consist-ent with policy that has provided adequateprotection for the great majority of accountholders and many holders of stock in financialinstitutions for over half a century. However,some argue that it gives managers of insuredinstitutions a false sense of security and per-mits them to take risks they might not takein the absence of the insurance. Thus, insuredinstitutions enjoy some competitive advan-tage over others in all lines of business inwhich they engage.

Option 2: Extend Federal insurance to certain ac-counts that are not held by institutions now el-igible for insurance, but only to a specified lowlevel per account or per customer.

An extension of Federal insurance to all ac-counts that function either as transaction orsaving accounts would eliminate a differencebetween suppliers of financial services that isimportant to many. Providers that are now in-sured would lose a factor that gives themsomething of a competitive advantage overthose that cannot offer insured accounts.Vulnerability of the financial service industryarising from the exposure of depositors whohave placed funds in uninsured accountswould be reduced.

Limiting the maximum amount of insurancewould continue protection for the small depos-itor that has been provided historically. Alarger proportion of the depositors would beexposed to loss. Possibly the propensity of theinsuring agencies to find merger partners fordistressed institutions would be reduced be-cause the outlay of funds required if an insti-tution were closed would be limited. Compara-tively uninsured depositors would tend to

Ch. 9—Policy Issues ● 243

exert pressure on financial institutions toavoid unjustified risks and to use sound judg-ment in making loans and in asset manage-ment. Large depositors might also be offeredthe option of buying insurance for deposits ex-ceeding the limits of Federal insurance.

Option 3: Vary the insurance coverage and costwith risk.

This would permit insured institutions toposition themselves in the market in a man-ner analogous to the way mutual funds char-acterize themselves. Some funds are growth-oriented while others seek stability and try togenerate income for their investors. Deposi-tory institutions willing to take higher riskscould purchase insurance at a premium price.Alternatively, depositors could elect to receivehigher interest rates in return for dealing withan institution that provides only a reducedlevel of insurance coverage. In this environ-ment, the depositor would have greater op-tions than is now the case. However, theoverall exposure of depositors to loss could in-crease if a significant proportion chose insti-tutions offering lower levels of deposit in-surance.

Issue 12: What is necessary to assure anadequate level of financial service to allsegments of the population and to protectother basic consumer rights and interests?In any case, people require some level of fi-

nancial services in order to carry out their day-to-day activities and participate productivelyin the economy. They must at a minimum havea way of receiving and making payments, andgenerally some access to credit. Moreover, onecan argue that they need mechanisms throughwhich they can express preferences for specificservices from among the alternatives that maybe offered.

Because of the restructuring of the indus-try and its services, some traditional servicesmay disappear, and others will be explicitlypriced for the first time, or limited to certaincategories of customers. For example, tellerservice may be limited to those with substan-tial balances, and merchants may be unwill-

ing to accept or to cash checks. Market forceswill tend to cause financial service institutionsto encourage higher income customers, whoare likely to have discretionary income to saveor invest, and to discourage lower income cus-tomers with little discretionary income. Somelow-profit services will probably be dropped.

Technology is making it possible for govern-ment agencies to operate more efficiently withregard to making payments. Direct deposit ofall government payments is a long-range ob-jective of the U.S. Department of the Treas-ury. This would include payments to State andlocal governments and contractors, and alsoentitlement payments and Federal employeepaychecks. The move to direct deposit mayconflict with the wishes of some recipients.Realistically, it is likely that some people willbe pressured by government or other employ-ers to accept payment by direct deposit evenwhen they object to doing so.

Float is not a right or entitlement; rather,it is an attribute of a system that requiressome period to process payment orders. It isclear, however, that many corporate cash man-agers, households, and many small businesseshave in the past counted on float in manag-ing their incomes. Because of information andcommunication technology, debits to accountsare in some situations virtually instantaneous,while crediting of deposits made by checkmust wait until the check is cleared. The cus-tomer sees this as an inequity, especially if heor she is charged for overdraft or automaticloan privileges during the lengthened gap. Infact, some financial institutions do abuse thissituation. The technological capability toshorten the gap is available, but financial in-stitutions need an economic incentive to applyit.

The right of consumers to full and under-standable information about their rights, theirrisks, and their obligations in using new kindsof financial services may need explicit protec-tion. Subtle legal distinctions between func-tionally similar services are not necessarily ob-vious to users, and information provided byfinancial institutions is not always clear, com-

244 . Effects of Information Technology on Financial Services Systems— —

plete, or in comparable terms. Significant op-portunity exists for misleading advertising offinancial services.

Policy Options for Issue 12

Option 1: Define minimal services to be providedto consumers.

Congress could require all financial institu-tions, or those financial institutions choosingto offer certain services (e.g., accounts thatfunction much like traditional demand depos-it or savings accounts) to provide certain“lifeline” services, such as teller service or han-dling of direct deposit Federal payments, with-out cost to all of those desiring them. Alter-natively, it could allow cost-based pricing.Congress could encourage institutions toestablish an account that can only be debitedelectronically as a minimal service for somewho misuse checking accounts but would liketo benefit from such services as direct deposit.This might, for example, be a condition ex-acted in return for deposit insurance.

At the same time, Congress may wish toprohibit mandatory direct deposit of pay-ments or to define legal rights to choice of pay-ment mechanisms, at least in some situations.

Because financial information technologyconfers on the depository institution, whichalone has access to the payments system, fullcontrol over the timing of debits and creditsto accounts, Congress may wish to regulatethe exercise of this power to assure that con-sumers are treated equitably.

Option 2: Define the rights of users to informationregarding availability of financial serviceoptions.

New or revised legislation maybe necessaryto define the rights of users to full and com-parable information about financial serviceoptions and alternatives, and to establish amechanism for implementing and enforcingthese rights. An explicit policy of “informedconsent” may be desirable. However, the costsof such regulations should also be considered.

Issue 13: Some changes in the delivery of fi-nancial services increase the possibility thatthe privacy of citizens could be eroded orviolated. How can Congress reduce thepossibility?

Citizens necessarily accept some diminutionof privacy, or potential diminution of privacy,by engaging in any transaction other than ex-change of currency. Nevertheless, some as-pects of information technology greatly in-crease the opportunities for and the likelihoodof invasion of privacy because data banks areaggregated, shared, and subject to unauthor-ized access, including access from remote lo-cations.

The aggregation of financial data increasesits commercial value, reduces the costs of ac-cessing and using it, and thereby increases theincentive for misuse. Information technologyalso allows information to be propagatedwidely and rapidly, so that information harm-ful to the interests of a citizen (e.g., informa-tion about debt or payment behavior, whetherthis information is corrector incorrect) can af-fect that citizen’s economic relationships inany location. The potential for loss of privacyis, however, not limited to financial or eco-nomic matters: to the extent that a citizen’stransactions are effected through informationtechnology, his/her location and daily activi-ties and relationships become potentially sub-ject to monitoring and recording. Informationsystems not related to financial services caninvolve similar risks.

It is the potential for this invasion of pri-vacy, rather than evidence that it is occurringor has occurred, that concerns some citizens.It is likely that there is increased sharing offinancial information and increased use of fi-nancial data for multiple purposes (e.g., mail-ing lists sorted according to information aboutthe people on the lists). Furthermore, mostcitizens are probably unaware of the extent towhich this occurs, of the extent to which lawand business practice is able to assume the cit-izen’s consent to this sharing of information

Ch. 9—Policy Issues ● 245— — — . —— —-—

as a condition of accepting a service, or ofrights and protections associated with variousfinancial services.

Policy Options for Issue 13

Option 1: Strengthen, expand, and explicitly definethe citizen rights to privacy in accepting financ-ial services (and conversely, rights to accessand sharing of information by providers of fi-nancial and information services).

At present, insofar as a legal base exists forthese rights, some of the protective legal pro-visions apply only to electronic media, andsome apply only to paper-based services. Pro-tection from intrusion only by the FederalGovernment is provided. But some financialservices combine these modes, some are intransition between them, and some appear tohave no explicit safeguards for the citizen.

While legally defined rights to privacy maybe a desirable step in the direction of assur-ing privacy in using financial services, it maynot be a sufficient step. Such legal safeguardsshould probably not depend for enforcementon victims’ complaints. It is in the nature ofinformation and its applications that citizensare unlikely to know when they have been thevictims of invasions of their privacy until thedamage has been done. Even then, they maybe unable to trace unauthorized informationor misinformation back to its source, to iden-tify the offender, or to document that theabuse occurred.

Option Z: Institute by law a program of inform-ing citizens about risks to privacy that cannotbe avoided in accepting financial servicesthrough information technology (a policy of in-formed consent, to use the model of medicalservices delivery).

This option at least has the advantage ofallowing citizens to decide whether they willaccept the risk and of challenging the indus-try to find ways of reducing those risks. How-ever, it could have the undesired effect of de-creasing public acceptance of and confidencein some financial services.

Option 3: Mandate a program of monitoring andenforcing privacy rights.

This option would require additional author-ity to inspect and monitor financial service in-stitutions, and the allocation of resources forsome Federal agency (e.g., the Federal Bureauof Investigation or the Department of theTreasury) to develop enhanced inspection ca-pabilities as well as to implement the program.Furthermore, such an inspection program mayincrease anxieties about the possibility thatthe Government itself may violate the privacyof citizens through misuse of financial infor-mation about them.

Issue 14: Are additional actions needed tosafeguard the integrity of the nationalpayment and transaction systems againstrisk of disruptions from systems failure,hostile attack, and natural disasters?

Information technology and especially tele-communication links and networks create newvulnerabilities to accidental or deliberate dis-ruptions, and also greatly expand the geo-graphical extent of the impacts. With a highlyintegrated national economy and financialservice industry and increased velocity ofmoney, a local or regional disruption of finan-cial activities rapidly propagates and cancause turmoil throughout the system, even ifthere is no irretrievable loss of data.

Natural disasters, civil disorders, militaryattack, or any form of emergency may destroysome communication links or require thatothers be taken over by emergency manage-ment teams. Thieves, saboteurs, political dis-sidents, terrorists, or others could attack in-formation banks and communication links orthreaten to do so, in effect holding hostage theassets of the public.

The direct effects of disruption of financialtransactions and payments, of data banks, orof communication links are largely independ-ent of whether the disruption is accidental ordeliberate. The long-range effects of creatingan attractive target for internal political vio-

246 . Effects of Information Technology on Financial Services Systems————-

lence or international terrorism are, however,worthy of special policy concern.

Little is known, at least publicly, about thepresent level of understanding of the magni-tude of the vulnerabilities of financial servicesystems to systemic failure, external attack,and natural phenomena. Similarly, knowledgeabout the extent of preparation to deal withthem, by either the private or public sectorsis limited. Industry representatives haveperiodically stated that there are enough re-dundant network capabilities and backup databanks to handle any foreseeable contingencies.At a minimum, the Bank Protection Act couldbe broadened to cover all financial institutions.The act requires Federal regulatory agenciesto establish minimum security standards forbanks. The expertise of the Federal Emergen-cy Management Agency (FEMA) could bebrought to bear.

Whether or not the security measures takenby financial institutions at present are ade-quate is not clear, but the issue is clearly onethat affects the public interest because the po-tential impacts of disruption are broad andcritical to the national welfare. Actions takento reduce these vulnerabilities run the risk of:

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negating some of the benefits of informa-tion technology; for example, requiringpaper-based records, and creating redun-dant data bases and communication links,which could reduce the savings in timeand/or add to the costs of services; andincreasing opportunities for erosion ofprivacy.

Policy Options for Issue 14Option 1: Hold hearings for further consideration

of the present and long-term effects of depend-ence on information and communication tech-nologies on the vunerability of critical economicand social systems and processes in the contextof emergency management, civil defense, andnational security.

Option 2: Create a national commission or an in-teragency task force to gather expert opinionsfrom the financial service industry and from thevarious fields of emergency management, na-tional security, civil liberties, and the like toassess these risks and recommend appropriatemeans of reducing or managing them.

Issue 15: What alternatives are availablefor controlling the risk of theft fromor associated with financial serviceinstitutions?

Facts about theft (of funds or of informa-tion) associated with financial service institu-tions’ use of information technology are ob-scure. Because public confidence is critical tothis industry, it is not in the interests of fi-nancial service institutions to call attention tothefts, whether perpetrated within the indus-try or directed against the industry. Folkloreand anecdotal evidence suggests that com-puter-based thefts are often not immediatelydiscovered, often not solved, and often notprosecuted and that criminals are sometimesinformally granted immunity from prosecu-tion in return for revealing how they carriedout the theft and for designing ways of pre-venting it from being done again. Some ex-perts say that information technology hasprobably reduced the incidence of thefts offunds but greatly increased the average lossfrom a theft. Clearly, it has made the theft offinancial data more attractive, since data arenow aggregated into large, easily tapped databanks and since the theft of data need not in-volve actual removal of documents or otherphysical media from protected premises. In-formation technology has also:

increased Federal responsibility for theftfrom financial institutions since it moreoften involves communication links;created the need for more sophisticateddetection and documentation techniques;andtransferred risk from institutions (thetarget of armed bank robbery) to individ-ual customers (whose accounts may befraudulently debited).

Policy Options for Issue 15

Option 1: Rely on the financial service industryand traditional law enforcement agencies to con-trol crime.

Some believe that theft from financial insti-tutions perpetrated with at least some involvement of computers and telecommunication isincreasing despite ongoing efforts of the indus-

Ch. 9—Policy Issues ● 247

try and law enforcement authorities. Further,they do not see this rate of increase abating.If this is true, steps to augment present effortsare required; and even then, this option maynot meet the challenge.

On the other hand, the level of consciousnessof the problem among financial service pro-viders is increasing. Greater attention is be-ing given to security of advanced systems fordelivering financial services. However, it isstill too early to know if the efforts will proveadequate.

Option 2: Expand the resources and technologicalcapabilities of Federal enforcement agencies(FBI, Treasury) to deal with computer-relatedtheft and to train and assist local law enforce-ment agencies.

This option could increase the requirementsfor auditing and inspection of financial insti-tutions’ records. However, this may have theadditional side effect of increasing concernover potential erosion of privacy and mayalso require additional audit trails and paperrecords, which add to the costs of providingfinancial services.

Option 3: Increase the penalties against per-petrators and against financial institutions for

concealing or failing to report thefts or sus-pected thefts of funds or data.

Increased penalties for theft may deter somepotential perpetrators. Increased penalties forfailing to report theft will tend to bring to lightdata that clarify the magnitude of the prob-lem and encourage the interchange of dataneeded to deal with it. On the other hand, ifthe data that surface cause the public to loseconfidence in the financial service industry,the net effect could be negative and the sta-bility of the industry threatened. Further, ifthe data show the success rate of thieves tobe high or provide sufficient detail on the tech-niques that have been used, the end resultcould be an increase in crimes against finan-cial service institutions.

Option 4: Mandate a national commission to studycomputer-related crime and identify necessaryactions for its control.

Computer-based crime, which is by no meanslimited to that involving funds or financialservices, is on the increase. A national com-mission to study all aspects of this modernproblem would serve many policy needs.

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