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September 15, 1996

Federal Reserve Bank of Cleveland

The Functions and Future
of Retail Banking
by Jerry L. Jordan


the tum of the century, one of the
largest employers in America was the
U.S . Ice Trust, which cut, stored, and
delivered ice for people's "iceboxes."
Today, that industry employs only a fraction of the workforce it once did. This
happened not because people stopped
consuming cool fresh food, but because
the refrigerator- a product born of new
technology-all but eliminated the need
for ice blocks. In contrast, the Fisher
Company, which produced carriages and
buggies in the early years of the century,
is still in the business of making automotive bodies.
What does the future hold for the retail
banking industry? That depends on
whether it continues to provide value to
its customers. The challenge for bank
managers and supervisors is to understand what customers want-to distinguish between cutting ice and keeping
food cold. In my view, understanding
the services that people demand and
exploring banks' comparative advantage in supplying them will be crucial in
determining the future of the retail
banking industry.
By considering the value-adding activities of banks, I hope to provide a framework for evaluating profitable opportunities and assessing competition from
other banks, money market funds, or
even phone and computer software companies. I also examine how new methods
of delivering financial services may
affect the role of the Federal Reserve in
regard to money, the payments system,
and banking supervision.


Origins of Banks

Economies have always developed
methods for providing financial services. Over time, the providers of these
services have adapted to changes in
technology and customer preferences.
Functions that today are identified with
"banking" were performed by the
organizers of the Champagne Fairs in
the twelfth and thirteenth centuries.
They issued tokens to participating merchants, with each token representing
deposits of coin, plate, and bullion that
had been tested. The merchants used
these tokens to net out their accounts
before settling in the deposited gold. At
the same time, scriveners - clerks who
wrote letters and contracts in an illiterate age-reduced transaction costs.
Most professors of money and banking
fondly describe how medieval goldsmiths accepted gold for safekeeping,
and how the receipts they issued eventually became money. The goldsmiths
assayed bullion samples, certified their
quality, and issued receipts that were
easier to carry than metal. Thus, they
added value by producing verifiable
information and reducing transaction
costs. From here, it was but a short step
to making loans. 1
Institutions more recognizable as banks,
such as the Casa de San Giorgio in 1407
and the Bank of Amsterdam in 1609,
arose on the continent. 2 These firms provided safekeeping and security, assessed
and certified quality, and enabled transfer


Societies have always developed
ways to provide financial services.
Although medieval goldsmiths may
seem worlds removed from today's
commercial banks, they have one
important trait in common: Both
succeeded as financial intermediaries because they were able to provide the services their customers
wanted using the best technology
available at the time. In this look at
the future of the retail banking
industry, Federal Reserve Bank of
Cleveland President Jerry Jordan
explains that as technology and
deregulation transform the financial
marketplace, it will be critical to
understand the services that people
desire and explore banks' comparative advantages in supplying them.

payments. Although fund transfers had to
be conducted at the bank, transaction
costs were relatively low compared to
carting gold through the streets. 3
This brief history holds several lessons.
First, many of these functions still survive, though modern banks ' methods of
providing loans and a convenient means
of payment are considerably different.
Second, the institutional form has
changed dramatically-from guild to
corporation. For example, banking and
goldsmithing are no longer combined. 4

• The Functional Approach
to Financial Services
There have been several government
attempts, particularly in the United
States since the 1930s, to separate
"financial service" activities into distinct
industries. These industries can, and do,
exist separate! y in market economies, as
long as they perform functions that people value. Adopting afunctional perspective, therefore, permits a deeper
look into the well of issues surrounding
the future of banking. When firms adapt
to competitive forces, we should expect
them to alter their product mixes, delivery vehicles, and corporate structures to
fulfill their functional role. 5
As frnan~ial intermediai.ies, banks perform six broad functions: 1) conducting
exchange (clearing and settling claims),
2) funding large-scale enterprises (pooling resources), 3) transferring purchasing power across time and distance, 4)
providing risk management (hedging,
diversification, and insurance), 5) monitoring borrower performance (mitigating
adverse incentives), and 6) providing
information about the relative supply
and demand for credit.
Commercial banks perform all of these
functions, but so do other organizations.
Although people will continue to make
payments, save for the future, and insure
themselves, one ca.J.llot assume that the
existing corporate forms will survive
(remember the goldsmiths). For economic reasons, combinations of products
may exist at a certain time within one

industry, such as "commercial banking"
or "insurance underwriting." However,
there is no guarantee that one type of
heavily taxed, heavily regulated industry
that has been granted a particular "charter" will survive-quite the opposite.
Consider savings accounts, which transfer purchasing power from the present to
the future. This saving function can also
be accomplished by investing in common stock. Although these methods involve different risks, buying a put option
can remove an important element of risk
from holding stock. 6 The functions provided by savings accounts need not be
provided by a depository institution.
Something similar bas happened with
mortgages. In years past, people purchased houses by using personal savings. Later, the funds came from mortgage loans using the savings of other
families within the community. Now,
home purchases are financed by nonbank loans funded by investors in the
mortgage-backed securities market.
Characteristically, commercial banks
have funded themselves with liquid liabilities and have made illiquid loans.
They do, however, provide various
other services to their customers. Functionally, then, a "bank" is a combination
of financial service activities. Legally,
however, it is a corporation that receives
a batiking charter and is subject to the
rules and regulations thereof. Typically,
these strictures prevent banks or their
holding companies from offering some
services that are readily available in the
marketplace because of concerns about
safety and soundness.
This prompts two important observations: First, the functional definition of
"banking" is not synonymous with the
legal definition. Thus, a financial holding company owning a frnance company, a venture capital firm, and a
money market mutual fund has a fair
claim to be called a bank under the functional approach. Conversely, a chartered
bank that specializes in global custody
arrangements or serves only as a clearinghouse for credit cards is, functionally
speaking, not a bank.

Second, commercial banks as legally
defined today may disappear in the
future, but some organization will perform the functions they now provide:
payments, pooling, and risk management on the liabilities side, and resource
transfers and risk management on the
assets side. Again, these particular combinations may not be undertaken by a
single entity, just as the functions of
making jewelry and accepting deposits
no longer exist jointly.
In the future, firms may serve customers
by bundling certain frnancial services
that are currently provided separately, or
may even merge banking-like services
with non-banking services such as concert and sporting event tickets, vacation
planning, and so on. They may utilize
electronic delivery vehicles accessible
via the Internet. Some activities that we
regard today as inappropriate, difficult,
or even illegal for banks will most likely
change, and may do so sooner than we
expect. In the end, firms that find ways
to deliver the services that the public
wants will prosper.
Already, the New Zealand government
appears open to the idea of eliminating
the distinction between corporations
chartered as commercial banks and those
incorporated for other business purposes. Customers of public utilities, such
as phone companies, may carry interestbearing balances and instruct these
organizations to credit the accounts of
other merchants. Indeed, the government
may even permit some non-bank businesses to maintain settlement accounts at
the Reserve Bank of New Zealand.
What, then, would be called a "bank"?



Evolution of the financial services industry carries implications for money and
monetary policy. Just as we are challenged to rethink what a bank is, we will
be challenged to rethink what money is.
Money will, of course, remain the same
from an economist's perspective-a
medium commonly accepted in trade for
goods and services. But in practical
terms, if the set of firms engaged in
banking broadens, then might not the liabilities of the new entrants also circulate

among the public as exchange media? If
people wish to conduct transactions with
electronic vehicles that today 's banks are
slow to develop and offer, is it unreasonable to conjecture that other commercial
firms will step into the marketing void?
New payment technologies should be
regarded as innovations that enhance
productivity and welfare just as surely as
any other new product. The challenge
faced by the Federal Reserve is to ensure
that we can adapt our own operating
practices and monetary policies to maintain financial stability and control the
price level. Today, banks hold our liabilities because they must meet reserve
requirements, because they find having
Reserve Bank balances instrumental in
settling transactions with other banks,
and because the public uses Federal
Reserve notes in transactions.
Required reserves are already declining.
In the future, the demand for central
bank money will depend on the Fed's
usefulness in net settlement and on the
public's interest in using Fed liabilities
for transactions instead of those of
another issuer. Does the public want to
use an electronic traveler's check issued
by American Express, or an electronic
Federal Reserve note?

• Implications of the
Functional Approach
The functional approach, by focusing on
banks' comparative advantages, helps
bankers determine the most efficient
way to provide the financial services
their customers desire. A complementary approach is to think about what
functions can be profitably outsourced.
Money market mutual funds, for example, outsource some risk management.
Unlike banks, they do not handle loan
portfolios. By engaging in loan sales and
securitization, a banking firm can outsource the transfer and pooling functions, but retain the credit evaluation and
monitoring (for example, risk management and incentive) functions.

In thinking functionally, the initial tendency is to assume that everything can
be outsourced, broken up, and reduced
to a commodity. Experience, however,
suggests otherwise. For example, until
recently, people diversified the risk in
their stock portfolio by purchasing a lot
of different stocks themselves. Now a
mutual fund does this for many investors, but they still incur the search and
transaction costs of finding a good fund .
Very sophisticated investors bypass
mutual funds and invest directly in stock
index futures. Others have moved to a
new class of intermediary, the fund family (such as Schwab or Fidelity), which
makes it easy to choose, evaluate, and
transfer between different mutual funds .
(An Internet search engine that does this
is probably not far behind.) Still others
have returned to commercial banks,
trusting them to assist in seeking out and
evaluating funds .
The collection of functions currently
known as banking has survived-so far
-for several reasons. It provides services more efficiently, effectively, and
cheaply than if they were handled separately. Banks can use the information
from deposits to better price and monitor
loans. This gives bankers a decisive information advantage because the unique
information content of illiquid loans,
such as small business loans, prevents
them from being easily pooled and securitized. Banks have also survived because
their organization solves incentive problems. Funding themselves with a liquid
liability having a specific payout guarantee gives banks a strong incentive to
monitor the illiquid loans on their asset
side. Indeed, we trust banks as "delegated monitors" precisely because their
structure has evolved to solve this incentive problem.
The question for the future is, "What is
the cheapest way to integrate and
deliver banking functions?" Generally,
people and technology will matter more
than physical location. People will
phone or e-mail an expert rather than
talk face-to-face with a local teller,
especially when expertise is vital-in
life insurance, financial planning, and
mutual funds, for example. Sears,
whose strategy had been to rely on the

physical location of its stores as a means

~,d~ring financial services, provides proG~nterexample.

What underlies thiS'~nd away from
physical location? As Adam Smith
pointed out long ago, speci~zation
makes knowledge "lumpy." According
to Milton Friedman's more modem
example, no single person knows how to
make a pencil ; its production requires
the coordinated activity of many ~perts.
Banks can use technology to deliv~r
experts from afar, and this allows further
specialization. Hiring an expert in
options, although uneconomical for a
local branch, would prove useful for the
0.1 percent of clients nationwide who
trade options.
Despite the risk of bedazzlement (or
cynicism) with the glories of information technology, it is worth asking what
functions this technology can perform.
Because people care about changes in
their overall portfolio, new technology
can be used to integrate different types
of financial accounts-across multiple
vendors, checking and mortgage
accounts, car loans, mutual funds,
stocks, bonds, and so on. It can also be
used to reduce search costs-the program or search engine on a home computer can act as an intelligent agent on
the user 's behalf.7 All of this is far
removed from the fourteenth century
scrivener dispensing advice, but it serves
the same function-that ofreducing
transaction and information costs.
Information technology also aids in
automating the delivery of payment services, thereby reducing the need for paper
checks, paper records, and brick-andmortar bank branches. Some problems
will persist, although in a different form:
Complaints about long lines or surly
tellers will be replaced by complaints
about computer programs that crash.
Technology also aids in making payments, a fascinating area that raises
important issues for both monetary policy and banking. Will future deposits
assume a different form, and if so, will
the combination of assets and liabilities
that defines banking remain profitable?

Technology can be readily used to provide substitutes for banks. As people
increasingly make payments electronically, and as software searches the Web
for the best loan rates, banks may be
reduced to mere commodity providers.
Examples abound of businesses that
were once strictly wholesalers, but that
now deal directly with the public. Technology is an integral part of this retailing transformation. In time, network
interface programs-such as Java,
Netscape, or their successors-may
become identified with banks in people's minds, and in reality. Goldsmiths'
receipts did not start out as moneythey were receipts for money-but in
time, the interface became the reality.

A Level Playing Field. Like the

New technology might also enable
banks to become the interface, however.
Already, banks are becoming mutual
funds for some people. Apollo Bank in
Pennsylvania has become an Internet
service provider. One scenario is that
on-line, banks will become like a store
in the mall. Another scenario is that
banks may become the mall, with financial planning software that lists their
customers' bank accounts, credit card
limits, and home equity balances onscreen, and that provides the ease of
navigation and delivery that lets people
transact with confidence.

Functional Regulation. Regulation



As the financial marketplace evolves, so
too must financial regulation and regulating institutions. Just as "banking"
functions need not be provided by
banks, those functions known as "regulation" need not be provided by regulators. Regulators should be clear about
what function they are providing and
about how they provide it. An insightful
set of reform proposals comes from the
Bank Administration Institute (BAl).8
Although from a functional viewpoint
the report concentrates excessively on
the health of the banking industry, it nevertheless provides a wealth of ideas on
how regulation can stop hindering banks
from providing these functions. From
my broader perspective, regulatory
reform must rest on three principles:

Champagne Fairs of old, in which merchants could participate if they agreed
to obey certain rules (such as having
their gold assayed), regulation must not
discriminate between different financial
service providers. Banks generally
applaud this rule when they talk about
finance companies, mutual funds, and
insurance companies not facing Community Reinvestment Act exams, but
are less enthusiastic about allowing
Goldman Sachs or Microsoft Corporation access to FedWire. The BAI report
hoped to advance the goal of a level
playing field when it called for eliminating outmoded compliance burdens, such
as dual antitrust reviews.9

should focu s less on institutions and
more on functions. The Securities and
Exchange Commission is well equipped
to handle securities-related problems.
Let them do so and make the regulations, whether the securities are underwritten by Merrill Lynch or the local
bank. Conversely, the extensionwhlch again banks may not like to contemplate - is that Merrill Lynch must
submit to Federal Reserve examinations
when making loans or using FedWire. IO

Value-added Supervision. Supervision and regulation must consider the
dynamic combination and recombination of functions occurring today. It
should be less concerned with playing
"financial cop" and more concerned
with helping fums work safely and efficiently. Ideally, banks will one day treat
Federal Reserve exams more like a report from Arthur Anderson or Moody 's
than an ordeal to be survived. The removal of unfair taxes and subsidies
posited under the level-playing-field
principle should make regulations less
burdensome, and banks less eager to
find ways around them. 11

In the end, functional regulation may
not be adequate, because some functional combinations pose incentive and
informational problems. After all, it
was the combination of long-term
assets and short-term liabilities that got
the savings and loans in trouble. Still,
with these principles, the new financial
landscape may benefit from a regulatory environment that promotes economic efficiency.



Laws and regulations that attempt to
"wall off' certain business lines from
others in the same corporate entity create strong reactions in the marketplace.
Unregulated competitors rush to fill the
void, and the regulated firms attempt to
avoid the regulatory barriers by creating
new products that offer their clients the
desired functionality. 12 Even if regulatory barriers initially can be justified
due to some threat to financial stability,
the justification may become outmoded
Ultimately, the greatest disaster would
not be a world without banks or bank
regulators, uncomfortable as that transition might be. Rather, it would be a
drastic failure of innovation. People
today are far better off for having
refrigerators -even if the ice-cutters'
union disagrees.



1. It is interesting to note the heavy role of
government even at the dawn of banking history. Although other merchants also offered
credit in medieval times, goldsmiths became
important because of government intervention. Both Henry VIII's suppression of monasteries and religious charities (1545) and
Charles I's seizure of the specie and bullion
from the Tower of London mint (1640) considerably increased goldsmiths ' deposits of
gold and silver.
2. The Bank of Amsterdam was made
famous by Adam Smith's description in The
Wealth of Nations.
3. Deposit and lending functions at these
institutions were often separated to prevent
loans from being funded by deposits. The
Bank of England formally separated the two
functions in 1844 with Peel's Act, but the
Riksbank of Sweden was separated into a
"narrow" bank and a lending bank from the
start (1656).

4. Note that goldsmiths, as part of a guild
system, were not corporations either. For an
in-depth look at the history of scriveners,
goldsmiths, and early banking, see Charles P.
Kindleberger, A Financial History of Western
Europe, Boston: Allen & Unwin, 1984.
5. The functional approach to economic
analysis has a long history. Economist Frank
Knight described the basic economic functions as answers to a set of questions that any
society must answer-what to produce, how
to produce it, and how to distribute the output. See Frank H. Knight, "Social Economic
Organization," in William Breit and Harold
M. Hochman, eds., Readings in Microeconomics, Hinsdale, Ill.: Dryden Press, 1971 ,
pp. 3-19. For a more detailed look at the
functional approach to financial markets, see
Robert C. Merton and Zvi Bodie, "A Conceptual Framework for Analyzing the Financial Environment," in Dwight B. Crane et al.,
eds., The Global Financial System: A Functional Perspective, Boston: Harvard Business
School Press, 1995, pp. 3-31.
6. An option is a contract that gives the
holder the right, but not the obligation, to
make an exchange. For example, a call
option on a stock gives the owner the right to
buy a fixed number of shares of a specified
common stock at a fixed price (the strike
price). A put option gives the owner the right
to sell at a specified price.

7. For example, products such as BargainFinder, which is currently used to search for
the lowest-priced compact disks, could be
adapted to search for the best price on certificates of deposit. Banks could also adopt
SearchSpace, a computer program used in
Italy to predict loan defaults.


Jerry L. Jordan is president and chief executive officer of the Federal Reserve Bank of

Cleveland. This article was excerpted from a
speech that President Jordan presented to the
seventy-sixth Executive Retail Conference of

8. See McKinsey & Company, Building Better Banks: The Case for Performance-Based
Regulation, Chicago: Bank Administration
Institute, 1996.

the Chicago Consumer Bankers Association,

9. The report provides specific proposals to
achieve a level playing field. One set of recommendations aims to "liberate full customer service capabilities" by eliminating
applications for new, unregulated products.
Another set aims to free up the organization
of banks in order to "empower full corporate
governance." These proposals seek to permit
well-managed banks to hold equity investments and undertake merchant banking activity. Notification would replace application
for both bank and non-bank acquisitions
(including branches and ATMs), and would
likewise replace the requirements for approval of headquarters expansion and dividend outputs.

electronically through the Cleveland Fed's

October 1, 1996.

Economic Commentary is now available

10. The BAI report called for "risk-based
supervision" and insightfully looked for
ways that regulation could be accomplished
more efficiently without regulators. Thus, a
greater use of external and internal audits,
coupled with increased disclosure and
reliance on market indicators, would go far in
this direction. New Zealand, for example, has
mandated that banks publicly display their
credit ratings .

11. The BAI report explicitly recognized the
Federal Reserve Bank of Cleveland's "valueadded supervision" approach of structuring
more efficient exams, improving communications between banks and their supervisors,
and rapidly identifying hazardous risk. The
report stressed that supervision should concentrate on a bank's risk management capabilities, assessing internal controls and audit
procedures. The Nick Leesons of the world
remind us that these procedures and controls
truly matter to the bottom line.
12. See Joao Cabral dos Santos, "GlassSteagall and the Regulatory Dialectic," Federal Reserve Bank of Cleveland, Economic
Commentary, February 15, 1996.

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Barbara A. Good
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Reducing Working Hours:
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