1. © 2001 Bank for International Settlements BIS-BRI-BIZ Bank for International Settlements Banque des Règlements Internationaux Banca dei Regolamenti Internazionali Bank für Internationalen Zahlungsausgleich 1 Creating “e-finance friendly” regulatory and institutional framework Setsuya Sato Bank for International Settlements The UNCTAD Expert Meeting on finance and e-finance for SMEs 24 October 2001, Palais des Nations, Geneva

2. © 2001 Bank for International Settlements 2 Structure of presentation Implications for banks and financial markets Key risks Official sector agenda Conclusions

3. © 2001 Bank for International Settlements 3 Implications for banks Disintermediation Blurring barriers between banks and others Public trust Entry of non-banks Financial consolidation New business models

4. © 2001 Bank for International Settlements 4 (1) disintermediation lower start-up/operating costs  lower barrier to entry  intensify competition and increase (a threat of) disintermediation impact more significant in sectors that rely on high-cost network of agents for distribution entering is easy, staying is difficult – economies of scale – network externalities – switching cost – brand names

5. © 2001 Bank for International Settlements 5 (2) blurring barriers internet de-coupled manufacturing of financial products from distribution  banks can retail products they do not produce  blur boundaries between banks/brokers/insurers increasing consumer demand for personalised money management services push banks to offer products that cross financial boundaries technology (mobile internet, digital TV) adds complexity to design and delivery of “hybrid financial services”

6. © 2001 Bank for International Settlements 6 (3) public trust pure internet banks not very successful because of insufficient public trust – brand marketing and customer acquisition disproportionately expensive – even promising demographics (young, educated, wealthy, IT savvy) don’t switch to tech firms for financial products – a “brand premium” is the best protector of established banks “clicks-versus-bricks”  “clicks-and-mortar” (multi-channel distribution) has the advantage – pure internet banks opened physical branches (“relationship enhancers”) or acquired ATM networks

7. © 2001 Bank for International Settlements 7 (4) entry of non-banks the need for public trust does not necessarily favour existing banks – non-banks with customer trust and name recognition also command confidence (Sony, Volks Wagen, GE) greater reliance on untested and sophisticated technology implies greater need for “name” – new form of conglomerate of financial and non- financial companies – entry of telecom companies (IT skills, extensive customer base) is the most serious threat to banks supervisory challenges – validity of licensing rules (fit and proper, business plans, etc)? meaning of consolidated supervision?

8. © 2001 Bank for International Settlements 8 (5) financial consolidation internet speeds up financial consolidation, both cross-border and cross-sector – high fixed costs + low operating costs  economies of scale – larger client list enables the provision of more diversified and profitable services – name recognition favours big players e-banking facilitates cross-border expansion at minimum cost – centralized resources (staff, computing resources) for foreign e-banking can be switched between countries – easier to retrench quickly from a virtual offering than a branch-based one

9. © 2001 Bank for International Settlements 9 (6) new business models “aggregators” allow customers to group all financial transactions on one site (one-stop shopping); threats to banks – lose direct links/delivery channel to reach customers – banks may be held responsible for mishandling of confidential customer data by the aggregator banks respond by capitalizing on brand names and public trust – certification, digital signatures, secure communication services even-handedness in treating financial and non- financial firms – supervisors usually reluctant to allow banks to expand into non-financial commercial business

10. © 2001 Bank for International Settlements 10 Implications for financial markets

11. © 2001 Bank for International Settlements 11 e-trading and market liquidity tighter pricing (lower bid-ask spreads) by decreasing transaction costs  improved liquidity? or, less liquidity? lower barriers to entry encourage proliferation of new trading systems (ECNs), none of which is individually particularly liquid  markets become more fragmented? e-trading reduces bid-ask spreads and the profitability of active market-making  dealers scale back this activity  shallower markets with prices adjusting more abruptly to changes in expectations? (more likely in periods of market stress, exacerbate turbulence)

12. © 2001 Bank for International Settlements 12 Key risks Strategic and business misjudgement Complex operational risks Legal and regulatory uncertainty Systemic risk

13. © 2001 Bank for International Settlements 13 (1) business misjudgement risk during periods of rapid technical change e-finance firms accept high initial costs in the hope of long-term profits – difficult to validate this strategy due to the absence of short-term profit test with little near-term revenue – mistakes evident from volatility of high-tech stocks and failure of many high-profile ventures banks can make big mistakes in their e-finance strategies – bank management needs to be more IT- knowledgeable than in the past

14. © 2001 Bank for International Settlements 14 (1) misjudgement (contd.) prudent to maintain skeptical attitude about specific IT developments – earlier over-estimation of demand for technical products (e-purse, pure internet-only banks) two conflicting considerations in IT investment decisions (1) technology constantly changing  prospective returns on new technology undermined by still newer technology  need for discounting future returns heavily (2) “network effects”  “first mover” advantage  adopt latest technology without fully assessing costs and benefits

15. © 2001 Bank for International Settlements 15 (2) complex operational risks outsourcing core technologies and processing operations  oversight of service providers becomes difficult (how far? by what mechanisms?) complex arrangements between a financial institution and a chain of service providers (main contractors with multiple sub- contractors) is not fully aware of concentration of service providers amplify the problem if several banks use the same system

16. © 2001 Bank for International Settlements 16 (3) legal/regulatory uncertainty “where is the headquarter of e-finance firms?” – physical or legal? definition of home and host supervisors, clarification of division of responsibilities – licensing in the “targeted” host country? common standards across countries desirable to avoid e-finance firms moving headquarters to laxer supervisory regimes – similar considerations apply to different sectors – risk of “regulatory arbitrage” must be kept in mind

17. © 2001 Bank for International Settlements 17 (4) systemic risk many institutions use similar software programs  could be hit simultaneously no computer systems “hacker-proof”; failure of internet service provider pose major disruption – so far incidents relatively minor and contained greater numbers of new and different firms – difficult to monitor links between various actors and assess risks barriers between financial/non-financial firms become more blurred – sources of possible systemic threat harder to identify other?

18. © 2001 Bank for International Settlements 18 Official sector agenda Structure of the financial industry Co-ordination problems A flexible and adaptive regulatory approach Additional prudential buffers for risk- seeking institutions Market and operational integrity

19. © 2001 Bank for International Settlements 19 (1) structure of financial industry transformation could raise systemic concerns – greater importance of unregulated entities outside the reach of supervisor prudential concerns about individual institutions/markets need to be supplemented by systemic risk-focused perspectives – market dynamics, industry structure, etc. too few reliable data on e-finance itself – piecemeal market statistics, based on different definitions and assumptions, including optimistic biases – need for a clearer conceptual framework to pose relevant questions

20. © 2001 Bank for International Settlements 20 (2) co-ordination problems problems regardless of whether supervision is organized product-wise or institution-wise since bank become less “special”, be aware of linkages between banks/insurance/securities – greater need for consultation and coordination between regulators across sectors since depositors less familiar with e-banks, deposits can be withdrawn faster – e-banks may be more susceptible to runs than traditional banks – cyberspace may leave far less time for crisis management and resolution

21. © 2001 Bank for International Settlements 21 (3) a flexible regulatory approach does not mean absence of regulations – licensing rules (for banks, investment advisers, etc) will remain crucial in maintaining high standards in the financial system and building public confidence public sector’s dilemma (1) public sector cannot predict future shape of financial industry  should not stifle trial-and-error process of innovation (2) a danger of new unregulated developments going too far, too quickly  more difficult to impose prudent guidelines

22. © 2001 Bank for International Settlements 22 (3) regulatory approach (contd.) “technology-neutral” (or e-neutral) differs in different countries or sectors –EU (limiting e-finance to regulated institutions) vs US (hands-off) –US supervisors are strong advocates of on-site systematic inspection of unregulated service providers old regulatory mind-set no longer appropriate – need for guidance, not rules – need for more emphasis on operational and reputational risks – use of advanced technology for more effective monitoring

23. © 2001 Bank for International Settlements 23 (4) prudential buffers are e-banks inherently riskier? – arguable, but some aspects of e-banks deserve much more careful examination –generally offer higher interest rates to attract deposits, can be rapidly transferred to another bank –vulnerable to operational breakdowns and security breaches by “hackers” –credit assessment at a distance less well-understood need for additional prudential buffers? – in some jurisdictions, e-banks cannot be established except through conversion of existing local banks (Singapore, Hong Kong) – some countries require a physical presence within their national jurisdiction, but difficult to enforce

24. © 2001 Bank for International Settlements 24 (5) market/operational integrity secure and orderly operation of banking and financial systems at all times crucial to allow customers to do financial transactions online – “virtually closed“ network supported by robust technology to ensure security (eg cryptography, digital signature) – reliable clearing and settlement infrastructure that meet CPSS Core Principles – STP to support efficient and robust back-office – disclosure for listing and licensing for investment advisers

25. © 2001 Bank for International Settlements 25 Conclusions assessing and dealing with potential risks is the key challenge to central bankers and supervisors worldwide not only is reliable data on the current situation hard to find, its growth extremely hard to predict even once the trends are identified, hard to distinguish between familiar issues in new guise and totally new challenges hard to isolate the contribution of internet separately from complementary innovations and long-term industry trends

26. © 2001 Bank for International Settlements 26 Conclusions (contd.) regular and deep exchange of information between central banks, supervisors and market players all the more important (Basel-based Committees, FSF) periodic reappraisal of global e-finance landscape and main policy issues vital the private sector to play a full part

27. © 2001 Bank for International Settlements 27 Thank you. Questions?

28. © 2001 Bank for International Settlements 28 Annex 1: Barriers to entry

29. © 2001 Bank for International Settlements 29 Annex 2: Co-ordination problems

30. © 2001 Bank for International Settlements 30 Annex 3: Market integrity

31. © 2001 Bank for International Settlements 31 Annex 4: Account aggregator

32. © 2001 Bank for International Settlements 32 Account aggregator (contd) allow users to electronically access personal account information from a multitude of unrelated sources through a single user name and password information can be gathered from Web sites without the site owners’ knowledge (“screen scraping”)  privacy and security concerns Web site owners (financial institutions) are unable to differentiate between the customer and the aggregator when either logs on  if a loss/security breach occurs, there will be no audit trail banks sued aggregators, but soon withdrew their suits  banks decided to provide the service themselves; customers want this service from their bank (public trust issue)