Public computer networks, in particular the Internet, have the potential to transform the financial services sector by providing a fast, cheap way to sell financial services. Low setup costs and the transnationality of the Internet could remove significant barriers to entry in the financial services industry. Cross-border provision of services and the high mobility of network banks could challenge the ability of national and international authorities to establish and enforce banking regulations. This paper considers the supervision and regulation of banks providing financial services on public computer networks for the mass retail market, i.e., deposit taking and lending of money on retail and small- and medium-size company markets.
Network (Internet) Banks
Regulation of Network Banks
The Internet's explosive growth has initiated considerable activity in the financial services industry. For this industry, the Internet and, in particular, the World Wide Web, serve as a new vehicle for transmitting financial information, comparable to the invention of the telegraph 150 years ago and its use for transmitting financial information. Although computer networks only transport financial information, many predict radical changes including the "dissolution of geographic markets into virtual financial systems" and the "loss of national independence."
These predictions are simplistic and are not based on analyzing this issue. However, the facts are (a) financial services are information commodities and (b) public computer networks offer a fast, cheap way to trade information. Public computer networks can radically improve efficiency and competition in the financial services sector. Increased efficiency and competition rely on three characteristics of these networks:
- Marginal costs of selling financial information over computer networks are small - in fact, typically negligible - compared with more traditional information channels;
- Public computer networks are essentially borderless, giving rise to the cross-border provision of financial services;
- Setup costs to establish a financial services business on a public computer network are small, which increases the contestability of financial services markets.
Considering these characteristics, public computer networks would affect banking competition and banking regulation. While the small setup costs and the cross-border provision of financial services would spur competition, it is the Internet's borderless nature that could pose a major challenge for the regulation and supervision of financial intermediaries.
The mass retail market, i.e., deposits taking and the lending of money on retail and small- and medium-size company markets could be affected most. The retail sector, so far, has been less affected by telecommunication technology than have other financial sectors and the mass retail market has remained largely a national business. In contrast, large corporate banking is already international and the cross-border provision of financial services in these markets is the rule rather than the exception. The prospect of an international mass retail market for financial services is a likely candidate for public concern and intervention because regulatory efforts are often directed toward protecting small depositors.
In this paper, the first section on Network banks distinguishes network retail banking and "traditional" retail banking; the second section on banking regulation identifies the need for public intervention in the banking industry; and the third section examines supervision and regulation of network banks.
Network (Internet) Banks
Exponential growth of the Internet started when the World Wide Web was invented in the early 1990s . The emergence of financial service providers on the World Wide Web is more recent. Security First Network Bank in Atlanta, Georgia, was the first bank to use the Web as its main channel for offering traditional financial services, such as transaction accounts. The bank opened its business on October 18, 1995.
Despite its youth, the Web has initiated many activities in the financial services industry; in December 1996, more than 1,490 banking institutions were providing financial information on it . There is also a growing demand for online financial services. For example, Wells Fargo in San Francisco increased its online banking base from 20,000 to 270,000 users in 18 months .
Because banking on the Internet is so new, no systematic research on Internet-based financial services and their economic implications is available. Existing literature consists entirely of anecdotal evidence from individual companies, usually in trade journal articles with no empirical basis (Kalakota 1996). Moreover, there exists no research on the prudential regulation of network banks.
Analysis of network banks and their regulation must start with identifying the characteristics distinguishing network banking from traditional banking. Our main proposition is that in the relation between network banks and customers the physical location of the network bank or the customer plays no role. We term this fact the irrelevance of physical location. In all other respects network banking works like traditional retail banking. In particular, they could provide the same services: facilitating transactions, portfolio management, risk transformation, and monitoring [see the next section, "Network (internet) Banks"].
The irrelevance of physical location is based on the fact that marginal costs of providing financial services on a public computer network are not related to a customer's location; more importantly, a customer's marginal costs for obtaining financial services are independent of the bank's location. In contrast, the "traditional" retail bank's location is an important (cost) factor for bank customers and banks. In "traditional banking" a customer's marginal costs for obtaining financial services increase with distance to his bank. Consequently, traditional banks compete for location and (over) invest in branches and ATM-systems to collect deposits (Neven, 1990).
The irrelevance of the physical location has two implications. First, it enables cross-border trade of financial services in the retail market. Without legal restrictions, agents can shop for financial services anywhere on this planet as long as the network bank has access to a local ATM network to obtain cash. However, the emergence of electronic money, respectively digital cash, could even remove this requirement. White (1996) has stressed this fact:What strikes me as the most exciting potential development to come from the new payment technologies is that, as they lower the cost of wiring money from $20 to 2 cents or less per transaction, they give ordinary small savers affordable access to offshore banking. With direct deposit of paychecks and with analog currency available at ATMs whenever we want it, many of us no longer need to visit our bank in person. Why not keep your accounts with a reputable bank (perhaps a branch of a major Swiss bank) in the Bahamas or Cayman Islands?
Second, network banks can move their physical location without changing their relation to their customers. In particular, they can move their business across nations "overnight". Thus, network banks can react faster than traditional banks to changing economic conditions and regulatory requirements. For example, they can easily shift their production to low factor cost countries and nations with inexpensive regulatory regimes.
Any attempt to understand the prudential regulation of banks requires examining the nature of financial intermediation, the potential for market failures, and the attempt to correct these failures through public intervention. The theory of financial intermediation stresses four functions of financial intermediaries: 
- facilitating transactions
- portfolio management
- risk transformation, and
According to the first function, financial intermediaries facilitate transactions by organizing the payment system. They offer check clearing and payment products such as credit cards, debit cards, and travelers checks. The second function, portfolio management, refers to the management of diversified portfolios consisting of financial liabilities issued by firms and governments and sold to the public. The third function, risk transformation, refers to the transformation of risky assets issued by firms into fixed interest deposits demanded by households and to the transformation of illiquid assets into liquid liabilities to provide liquidity insurance to households. The fourth function, monitoring, refers to monitoring activities of financial intermediaries, which reduces problems of moral hazard and asymmetric information in relation between firms and financiers (Hellwig, 1991).
Banking regulation theory is closely linked to these functions. The issue is twofold:
- Which functions, if any, justify public intervention?
- If intervention is justified, what kinds of regulations are appropriate?
It is commonly accepted that any banking regulation must rely on some form of market failure. If banks were only to offer transaction and portfolio management services, regulations would be unnecessary. Fama (1980) demonstrates that these two functions do not cause market failures. The potential for market failures is associated with the third and fourth functions. Particularly, it is the financing of illiquid assets with short-term deposits and the potential of bank runs that create a need for public intervention and the establishment of a safety net to guarantee the stability of the financial system (Baltensperger and Dermine, 1990).
Diamond and Dybvig's (1983) were the first to model bank runs. Their model suggests an equilibrium in which all depositors try to close their accounts, forcing the bank to sell illiquid assets, resulting in the failure of the otherwise solvent bank. The interesting aspect of their model is that there is no underlying real reason for the bank run: the illiquid asset is a completely safe investment. It is the expectation about the behavior of other depositors that drives the behavior of any individual. In the bank run equilibrium, these expectations are fulfilled.
A related type of market failure stresses the "contagious" nature of bank runs (Baltensperger and Dermine, 1987). A bank failure can trigger a run on other, solvent banks when bank customers of the solvent bank assume that the value of banks assets are highly correlated with each other. In most countries there exists a public deposit insurance or a lender-of-last-resort agency to prevent bank runs. Deposit insurance makes deposits risk-free, thereby eliminating the incentive for early withdrawals.
An additional basis for market failures is asymmetric information between banks and their depositors. Banks are better informed about the quality of their loans and the security of their assets than depositors are. Depositors can improve their information by monitoring banks; monitoring bank solvency, however, is expensive and requires skills small depositors may not have. In addition, information about bank solvency has the characteristic of a public good. This view is emphasized in Dewatripont and Tirole (1992, p. 17):One neglected, although certainly quantitatively important, feature of banks [ is ] the dispersed nature of the debt-holders or depositors. Small depositors typically have no time or expertise to perform the monitoring and control that the optimal governance structure [∑] requires. And even if they did, they would be tempted to free ride on each other's monitoring and exercise of control.
According to Dewatripont and Tirole (1992), when a bank is in trouble, bank managers and equity holders have an incentive to gamble for resurrection. As a consequence, debt holders of banks, i.e., depositors, must take control when bank performance is bad because their incentives are to limit risk taking. A large number of small free-riding depositors, however, cannot perform this task, which suggests a role for public intervention. A public agency would have to regulate banks ex-ante by imposing capital requirements and limiting the growth of deposits. In addition, a public agency would have to intervene ex post acting on behalf of small depositors in bad times.
In summary, modern theory of financial intermediation suggests two reasons for public intervention:
- The possibility of bank runs.
- Asymmetric information between banks and a larger number of small depositors who are free-riding on each other's monitoring and exercise of control.
A final note is required, here. Any banking regulation induces unwanted side effects. For example, deposit insurance that prevents bank runs lowers the incentives of banks to invest prudentially. The U. S. deposit insurance system, for example, is blamed for hundreds of billions of dollars of taxpayers' losses by creating moral hazards. Deposit insurance lowers the reputation-building incentives of financial institutions. As a consequence, financial institutions are likely to take more risks and to monitor less than with no deposit insurance. Present regulatory theory does not offer clear-cut recommendations, owing to the complexity of the welfare analysis (Vives, 1991). It is therefore important to balance carefully the benefits of any regulation versus the potential for harmful side effects. This issue is constantly under debate and opinions of the profession disagree widely.
Supervision and Regulation of Network Banks
This section considers whether network banks provide additional reasons for public intervention and whether they require different treatments. In the first section ofthis paper we noted that in the relationship between the network bank and the customer the physical location of either party is irrelevant. In second section, we identified two reasons for public intervention: bank runs and the asymmetric information between banks and their depositors. Here, we identify three questions with regard to the supervision and regulation of network banks. The questions are not outlined in detail. They should be read with the previous discussion in mind.
Could the provision of financial services via public computer networks increase the need for banking regulation and supervision?An increase in public intervention would be necessary if network banks were more vulnerable to bank failures, bank runs, and systemic risks. Consider the potential for bank runs first. Network bank are more vulnerable to bank runs for the following reasons:
- Information and rumors spread quickly across the Internet. The rapid spread of information is most relevant for so-called fundamental or information-based bank runs. In a fundamental bank run depositors realize that the value of assets in the bank is low and that withdrawing is the dominant strategy (Vives, 1991). The rapid spread of rumors could also increase the potential for panic bank runs, which are unrelated to any fundamentals. This issue reminds us of the many virus alerts that sweep through the Internet. For example, postings on the Internet about a plain electronic mail message that, when opened, erases all files on the reader's hard disk induces panic; in reality it is not possible to get infected by just a plain e-mail message (although attachments can carry all sorts of troubles).
- Public computer networks provide fast access of depositors to their accounts. With the push of a button, agents can transfer money from one account to another and from one bank to another bank. As a consequence, during a bank run a network bank has less time to react appropriately and to take necessary measures, such as liquidating assets, to prevent the bank failure.
- Fast access to a bank and the rapid spread of rumors and information also make network banks more vulnerable to the contagious nature of bank runs. Information about the failure of one bank can trigger runs on other solvent network banks. Again, network banking could increase the speed of such events, thereby reducing the ability of banks and governmental officials to react in a timely manner.
- Security concerns are the main reason for banks' cautious approach toward banking on the Internet. At the initial stage, before network banks mature, breach of security could be a major source for instability and bank runs. Depositors could react very sensitive to any news or rumors that affect their wealth.
The second reason for market failures is asymmetric information between bank and a large number of free-riding depositors and the incentives of bank management and equity holders to gamble for resurrection when the bank is in trouble.
- To be able to gamble for resurrection, bank managers and equity holders try to avoid outside interference. Manipulating performance measures and gains trading is one way to do this (Dewatripont and Tirole, 1993). For example, the bank in trouble could sell undervalued assets even though it would be profitable to keep them. Network banks have an additional means to avoid outside interference: they can move or credibly threaten to move their business to a location where public authorities are less likely to intervene. In fact, the sheer threat of dislocation could soften governmental authorities.
- The high level of anonymity between bank customer and network bank could increase the difficulties of depositors to monitor banks. Moreover, network banking could increase dispersion of depositors, which could increase further the difficulties of depositors to monitor and exercise control when the bank is in trouble.
In summary, network banks are more vulnerable to bank runs because news and rumors spread quickly over public computer networks. The main source of instability could be security problems. Network banks have also more options to avoid outside interference in order to gamble for resurrection because they can credibly threaten to move their business. As a consequence, network banks should be regulated and supervised at least to the same degree as ordinary banks. In the initial stage, before network banking matures, the potential for bank runs suggests that governmental authorities should monitor network banks as closely as possible and provide information to the public. This would be also to the advantage of network banks because it would give the public more confidence to use these banks, which in turn would help network banking to take off.
A final note is required here. Although network banks are more vulnerable to bank runs and the gamble for resurrection problem, network banking provides no new, previously unknown type of market failure. Network banking does not fundamentally alter the characteristics of banking; network banks provide the same financial services and are in all respects ordinary firms with management, equity holders and debt holders.How does the international dimension of network banking potentially affect supervision and regulation?Existing regulations for retail banking, deposit insurance, and lender-of-last-resort facilities are designed to deal with domestic or branches of foreign retail banks with domestic depositors. In first section of this paper we concluded that a customer's marginal costs of buying financial services are independent of the network bank's physical location. Thus, in the absence of legal restrictions, network banks could attract a large number of foreign customers, giving rise to the following issues for supervision and regulation:
- For many types of cross-border financial services, it is unclear which nations' regulations would apply, leaving unresolved and nebulous legal issues regarding network banking.
- Regulatory regimes of different countries compete with each other. Restrictive regulations hurt local financial institutions and they lose business to financial intermediaries elsewhere. Thus, "soft" countries can attract foreign customers. The retail sector has so far been less affected by these developments because the costs of offshore banking for small depositors have been too high. Network banking could reduce these costs enough to make offshore banking profitable for small depositors and increase the pressure to soften regulations in the retail sector.
- Regulatory regimes not only compete for customers but also for financial institutions. Thus, a "soft" country could attract financial intermediaries to settle down in its jurisdiction. The sheer threat of loosing banks could prevent implementation and rigorous enforcement of regulations in the retail sector.
Who will regulate and supervise network banks operating in various countries?According to Baltensperger and Dermine (1990, p. 18) international banking raises two specific issues:The first concerns supervision and regulation. Does domestic regulation apply to other banks operating in the country ("national treatment principle") or does it apply to the foreign component of domestic banks ("home country principle")? The second issue concerns the extent of responsibility of the domestic lender of the last resort and of the domestic insurance system. Do they cover branches or subsidiaries of domestic banks operating abroad? Do they cover branches and subsidiaries of foreign banks operating domestically?
In the international banking context, one specific issue is to determine which country is responsible for regulating and supervising of foreign branches of banks. The U. S., for example, applies the "national treatment" principle to foreign banking organizations operating in its jurisdiction. In contrast, the European Commission has opted for the "home country principal."
Network banking and international banking differ in one important respect: network banks do not establish branches. Consequently, regulators of network banks face a different problem. They would either have to supervise and regulate banks in their jurisdiction that mainly attract funds and lend to foreign residents. Or, they would have to supervise and regulate network banks established in a foreign country with a large number of domestic customers. Thus, the question is: who is going to regulate a network bank with mostly foreign customers? The difference between international banking and network banking is depicted in Graph 1 and Graph 2 below.
Graph 1 shows the flow of deposits when residents of country B are customers of a network bank located in country A. There is a cross-border flow of deposits from country B to country A. In contrast, in international banking, as shown in Graph 2, the "traditional" retail bank, located in country A, establishes a branch in country B and attracts deposits of residents of country B. Consequently, there is no cross-border flow of deposits.
In the context of network banking, the problem is to determine which country - in terms of efficiency - is responsible for supervising and regulating a network bank that attracts mostly small depositors and borrowers form abroad. A related question is: which country should provide the safety net? For example, will it be necessary and, if so, feasible to insure a large number of citizens who have uninsured deposits abroad?
When a domestic network bank has mostly foreign depositors, the incentives of domestic regulators to supervise the bank or to step in and provide lender-of-last-resort assistance when the bank is in trouble could be affected. Consider, for example, a Swiss network bank that attracts a large number of small German depositors and borrowers. When the banks fails, the Germans would be hurt while Switzerland's reputation as a safe haven would suffer. If the bank were sufficiently large, both countries would have an incentive to step in as a lender of last resort. However, the German Bundesbank would prefer the Swiss National Bank to do the dirty work and the Swiss National Bank would like to see the German Bundesbank step in. In contrast, consider the failure of a Swiss bank subsidiary operating in Germany. The failure of this bank would hurt not only German customers but also German's reputation as a safe haven. It would also, but to a lesser extent, damage Switzerland's reputation for secure investments.
While this is an extreme example, it shows that the incentives of regulators and lender-of-last-resort agencies could respond differently when a bank's customer base consists mainly of foreign residents. It also shows that supervision and regulation of network banks is inherently an international policy issue. To create a stable financial environment, international coordination is essential.
The Internet, particularly the World Wide Web, is changing our lives. Public computer networks are part of today's technology that drives the information revolution - an analogy to the industrial revolution of two centuries ago. This analogy stresses the common feeling that some significant and exciting developments are underway. The financial sector could be radically changed by information technologies, and public computer networks could play a major role in this turmoil. The financial services sector could be affected comparably more than any other sector in the economy because financial services are information commodities which can be easily traded on public computer networks.
Two results emerge from this analysis.
- Network banks are more vulnerable to bank runs and the "gamble for resurrection" problem. Bank runs are more likely because news and rumors spread quickly across public computer networks and depositors can transfer funds with the push of a button. Consequently, a bank facing a bank run and public regulatory agencies have less time to take appropriate measures to prevent the bank's failure. At the initial stage, before network banking majors, security problems could be a major source for instability. The "gamble for resurrection" problem is aggravated because bank managers who want to avoid outside interference can credibly threaten to move their business to another jurisdiction. This credible threat could make public agencies "soft" and lower their incentives to intervene or close an insolvent bank when it is optimal to do so.
- The transnationality of network banks could increase the difficulty of enforcing national and supranational banking regulations for the following reasons. First, for many types of cross-border financial services it would be unclear as of which nation's regulations apply. Second, regulatory regimes for different countries compete with each other. Thus, a "soft" country can attract customers and financial institutions. Third, the incentives to supervise, regulate, and provide the safety net for network banks could be affected when the bank's customer base consists mainly of foreign residents.
A major conclusion of the banking literature is that the need for public intervention comes from the potential instability of banking markets (Baltensperger and Dermine, 1990). Lack of enforcement and lack of adequate regulations could adversely affect the financial system's stability. Despite its importance, there exists no systematic research on the economic implications of financial intermediation on public computer networks. This paper is a first incomplete step in analyzing the economic implications of network banks. Further analysis will be valuable in identifying emerging problems, and it will be a base for future policy recommendations. In particular, the emergence of network banks requires revision of current national and international banking regulations. It is important that new regulations be based on reliable analysis to avoid either overreaction that would stifle these innovations or neglect the potential for instability in the world of banking.
The AuthorAleksander Berentsen is affliated with the Department of Economics of the University of Bern.
URL: http://www-vwi.unibe.ch /staff/berentsen/aleks.htm
Electronic mail: firstname.lastname@example.org
1. See, for example, Baltensperger and Dermine (1987; 1990), Dewatripont and Tirole (1994), and Vives (1991). For a recent survey of modern banking theory literature, consider Bhattacharaya and Thakor (1993).
2. For a history and definition of the World Wide Web consider the essay "A Little History of the World Wide Web" at http://www.w3.org/pub/WWW/History.html
3. However, most banks maintain a Web site for advertising purposes only; source: Online Banking Report, 1996 (December), http://www.netbanker.com
4. Source: Online Banking Report, 1996 (December), http://www.netbanker.com
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Copyright © 1997, First Monday
Supervision and Regulation of Network Banks by Aleksander Berentsen.
First Monday, Volume 2, Number 8 - 4 August 1997