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2001 ECONOMIC AND FINANCIAL SUMMIT ACADEMIA SINICA Taipei, Taiwan January 18, 2001 ..................................................................... Productivity, Innovation, and Internet Banking in the United States Hello. I am pleased to be here in Taipei today, participating in this important summit with such illustrious company. I found the presentations this morning to be interesting and informative in describing some of the ways in which technology is influencing the evolution of financial markets in Taiwan, and the challenges that this evolution raises for policymakers. I would like to give a U.S. perspective on “the knowledge-based economy and the development of the financial industry,” as this panel session is entitled. I will begin with a fairly broad perspective on productivity growth in the United States. The resurgence in productivity since the mid-1990s has underpinned the relatively strong performance of the U.S. economy, at least up until recently. Over longer time horizons, productivity growth to a large extent reflects innovation, and the financial industry provides a good example of this innovative process. After my broad discussion of productivity and innovation, I will spend the remainder of my allotted time discussing the U.S. experience to date with one particular form of financial innovation: Internet banking. That discussion will highlight not only the very large potential benefits of innovation, but also the challenges and risks that innovation often raises for established firms, for potential entrepreneurs, and for regulators. Indeed, the industry is marked by continuing evolution. To begin, what do we mean by a knowledge-based economy? I think one should be careful not to interpret the term “knowledge-based economy” too narrowly, as if it referred only to, say, the Internet or communications or business and financial services. I prefer to think of the term more broadly as applying to the entire economy. It is important to remember that even in traditional “old-economy” industries, such as steel or autos, the pace of technical change has been very rapid. Indeed, it is hard to think of any sector of industrialized economies—whether labeled “high-tech” or not, whether the final product is a good or a service—where knowledge, information, and innovation do not play an important role. Michael Moskow Speeches 2001 351 Innovation affects our economy quite directly by affecting productivity. The resurgence in U.S. productivity growth since the mid-1990s has been widely noted. Labor productivity—defined as output per hour worked— rose at a lackluster 1.4 percent per year between 1973 and 1995. Since the end of 1995, U.S. labor productivity growth has averaged about 3 percent per year—just like the 1950s and 1960s. Rapid rates of investment, especially in information technology, have raised the amount of capital used by each worker, raising productivity; but that’s not the entire story. Another important part of the resurgence is the rapid pace of innovation. These include innovations in technology, innovations in management processes, and what economists call creative destruction—the process by which firms that innovate replace those that don’t. In the long run, the pace of innovation is the most important determinant of an economy’s growth prospects and, hence, of the welfare of its citizens. Consider first the extraordinary technological advances we’ve seen in recent years. This innovation is conceptually distinct from simply giving each worker more computing power, that is, more capital, or what economists call capital deepening. Innovation refers to the invention of new high-tech products rather than simply firms’ purchase of these products. Technological innovation by engineers, computer programmers, and others, has been extremely rapid over the course of this expansion. But high-tech wizards aren’t the only innovators in our economy. Many innovations come in the form of how we do things, rather than simply what we use to do them. Managers are constantly finding better ways to enhance their firms’ performance such as reducing inventory, improving logistics, and finding better ways to organize production and reduce inefficiency. Another form of innovation is people processes which have been revamped during this expansion as well. Firms today truly see workers as human resources, and are creating work environments that foster problem solving. This brings me to the process of “creative destruction.” An important part of productivity growth comes from firms that are innovative replacing those that are less so. Obviously, over time, productive firms tend to prosper, while less productive firms lose market share and eventually shut down. The resulting resource allocation leads to productivity improvements for the whole economy. So although some firms shrink or even disappear, the process of creative destruction helps increase overall productivity in the long run. Recent years provide numerous examples of creative destruction. These include traditional industries, such as steel. The steel industry used to be dominated by enormous plants employing tens of thousands of workers. The erosion of markets served by these large integrated mills and their replacement with innovative mini-mills is a classic example of creative destruction. Although a very different industry, similar forces are at work in the provision of financial services. In the remainder of my remarks, I would like to focus on one example of financial services innovation: Internet banking. This example illustrates a general lesson: innovation offers large benefits, but the very process of innovation is inherently disruptive as firms struggle to understand and compete in the new market environment. For the past three years, we have heard promises that the Internet would provide banks with competitive advantage, improved customer service and access, revenue generation and expense reduction. More recently, banks have begun citing customer retention as their primary motive to offer online functionality. The extent to which these promises can be kept remains to be seen. With competitive pressures intensifying, large and small banks alike have sought to deliver a broader range of products and services through innovative channels such as the Internet. Initially used to publish marketing 352 Michael Moskow Speeches 2001 information, bank Web sites have evolved into facilities offering transactional services, personalization, and in the latest generation, interactive marketing capabilities. According to the FDIC, the number of banks and thrifts in the U.S. with Web sites has increased from approximately 130 at year-end 1995 to just over 4,600 as of September 2000, or about 46 percent of all insured banks and thrifts in the country. Of these, 1,850 or 18.5 percent, have full transactional capabilities. The numbers continue to be dominated by larger banks, many of which were early participants, but the availability of competitively-priced turnkey solutions has enabled increasing numbers of smaller banks to provide banking services via the Internet. Although conventional wisdom would suggest that smaller banks are at a disadvantage in the financial services arena, this has generally not been the case over the Internet. By forging cooperative alliances with technology, insurance, brokerage and other firms, many small banks are keeping pace with larger organizations. Larger banks can utilize their brand identity and larger budgets for technology and marketing, but smaller banks often better understand the needs of their customers and respond quickly with personalized service. With the introduction of Internet banking, three fundamental delivery alternatives now exist: 1) traditional, or “brick and mortar” branches, where consumers obtain financial services from a physical location; 2) Internet only, also referred to as “branchless” or “pure-play,” where the customer obtains services via the Internet without any face-to-face interaction with bank personnel; and 3) “brick and click,” representing a combination of the traditional and virtual delivery channels. The relative success of these various strategies remains to be determined. Three recent studies conducted by U.S. federal regulatory agencies suggest different conclusions about the earnings impact of offering banking services over the Internet. Two of these studies, completed by economists at the Office of the Comptroller of the Currency and the Federal Reserve Bank of Kansas City, concluded that banks delivering services over the Internet are more profitable than those that do not. However, these studies did not establish a causal relationship—it may simply be that well-managed, highly profitable banks have been the first banks to give their customers the Internet option. A third study, conducted by the Federal Reserve Bank of Chicago, focused on “pure-play” Internet-only banks and concluded that they are less profitable than their counterparts at the same stage of development. That study found that savings on physical infrastructure are offset by higher labor costs, and that generating revenues and core customers is difficult for these banks. One way to reconcile these divergent results is to remember that the Internet is a new bank distribution channel—not a new bank product—and may be most efficiently used in a strategic combination with other, more traditional distribution channels. Regardless of a bank’s initial approach to the Internet, it is certain that strategies will continue to evolve. Most recently, some Internet-only banks have come full circle by establishing selected physical locations to improve customer accessibility. Despite analysts’ tendency to talk of Internet strategy as an overall business strategy, the Internet represents but one channel among many to service customers. Clearly, these strategies must be aligned. While the first Internet banks may have achieved a degree of competitive advantage, as more financial institutions begin offering similar services, that advantage is not sustainable. Instead, banks may yet find that Internet banking can increase efficiency and customer loyalty. Thus, as they maximize these benefits, banks will need to focus more on their core competencies and seek that industry niche consistent with the overall organizational strategy to remain competitive. In today’s more complex world, the diversity of financial product choices facing consumers and businesses is nothing short of amazing. That complexity has provided consumers with more choices, but it has also Michael Moskow Speeches 2001 353 presented new challenges for public policy as well. In order to modernize our banking laws and make them more consistent with marketplace realities, the US Congress enacted the Gramm-Leach-Bliley Act in late 1999. This statute ensures that the financial services industry is able to expand and innovate with far fewer artificial constraints. To deliver innovative products and services, banks must make tradeoffs in their choices about the use of new technologies among key attributes such as cost, convenience, safety and complexity. As we have seen with Internet banking, these tradeoffs may shift to reflect evolving strategic objectives. Regulations typically have implicit assumptions about these important tradeoffs, which may preempt adjustments by users and providers of the new technologies. Even well intended regulations can potentially wind up addressing the wrong problem or short-circuiting creative innovations. Public policymakers, charged with ensuring a safe and sound banking system, should therefore exercise restraint and resist calls for premature regulation. Moreover, they should ensure that existing regulations receive periodic review to maintain appropriate industry safeguards, while not prohibiting or impeding innovation. And where barriers to innovation and competition exist, they should be removed, provided they do not conflict with other important policies. In this changing environment, supervisors are also being challenged to adapt and refine their programs to accommodate innovations in traditional banking. The supervisory strategy used to address banking innovations over the past decade has been a risk-focused approach that moves well beyond earlier, one-size-fits-all examinations to conduct a more effective and less burdensome process. This approach has been tailored to distinguish between larger, more complex banking organizations, on the one hand, and the more traditional, smaller organizations on the other. Institutions with characteristics that fall somewhere in the middle are flexibly accommodated, permitting us to focus more on risk-management procedures than on actual portfolios. By customizing our supervisory methodology, we are attempting to leverage market forces in the supervision of banks. This strategy enables us to be better prepared to respond to the increasing complexity and evolving diversity of our supervisory caseload. Chicago-based supervisory staff undertook two technology initiatives last year to do just that. First, in cooperation with the San Francisco Reserve Bank, we created a informational website to share examination and risk-management information among the System’s IT supervisory community. Second, we constructed a technology lab to raise our examiners technical product knowledge and practical expertise. While the lab represents a significant commitment to continuing education of the Reserve System’s IT professional staff, this resource will also be made available for the benefit of other U.S. and foreign bank supervisors in the IT community. To conclude, innovation is crucially important to the long-term well-being of an economy. But innovation raises substantial challenges for everyone whom it affects. Internet banking offers just one example of the continuing evolution of an industry in the face of rapid innovation. Indeed, the fluidity of the financial marketplace raises challenges for regulators, who must be flexible enough to ensure that innovation is not stifled, while also ensuring that the financial industry remains safe and sound. Thank you for giving me this opportunity to discuss my views on the U.S. experience with you. 354 Michael Moskow Speeches 2001
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