Electronic Finance:

Reshaping the Financial Landscape around the World

Stijn Claessens, Thomas Glaessner, and Daniela Klingebiel

Abstract

Because financial services are highly dependent on technology and well-suited to remote
delivery, technological advances and the advent of the Internet are causing dramatic changes in
the industry. This revolution could accelerate financial sector development by lowering the costs,
increasing the breadth and quality, and widening access to financial services. This paper analyses
the changes in the industry and their implications for public policy. It finds that, over the long
term, there will be an opportunity to reduce the financial sector safety net and correspondingly
prudential regulation and supervision. Over the short term, authorities should be wary to extend
the safety net. In addition, competition policy, consumer protection, and consumer education will
become more important. Though these issues are more advanced in developed countries, they are
quickly becoming more relevant in emerging markets.

The authors are from the World Bank’s Financial Sector Strategy and Policy Group. The opinions
expressed here do not necessarily reflect those of the World Bank, its executive directors, or its
member countries. The authors are grateful to Gerard Caprio, Simeon Djankov, Andrew Hughes
Hallet, Patrick Honohan, Jeppe Furbo Ladekarl, Ignacio Mas, Andrew Procter, Larry Promisel, Roy
Ramos, Anthony Santomero, Andrew Sheng, John Williamson and World Bank seminar participants
for useful comments, to Paul Holtz and David Willey for editorial assistance, and to Angelina Maraya
and Rose Vo for crucial aid in preparing the manuscript for publication.
 Executive Summary

Economic integration within and across countries, deregulation, advances in

telecommunications, and the growth of the Internet and wireless communication technologies are
dramatically changing the structure and nature of financial services. Internet and related
technologies are more than just new distribution channels—they are a different way of providing
financial services.
Using credit scoring and other data mining techniques, for example, providers can create
and tailor products without much human input and at very low cost. They can also better stratify
their customer base and allow consumers to build preference profiles online. This not only
permits the personalization of information and services, it also allows much more personalized
pricing of financial services and much more effective identification of credit risks. At the same
time, the Internet allows new financial service providers to compete more effectively for
customers. All these forces are delivering large benefits to consumers of financial services at the
retail and commercial levels.
These technological advances are changing the face of the financial services industry.
New providers are emerging within and across countries, including online banks and brokerages,
and companies which allow consumers to compare financial services such as mortgage loans and
insurance policies. Nonfinancial entities are also entering the market, including
telecommunication and utility companies that offer payment and other services. Vertically
integrated financial service companies are growing rapidly and creating synergies by combining
brand names, distribution networks, and financial service production.
In addition, trading systems—for equities, fixed income, and foreign exchange—are
consolidating and going global. Trading is moving toward electronic platforms not tied to any
location. Electronic trading and communication networks have lowered the costs of trading and
allow for better price determination.
These changes, particularly the emergence of e-finance, call for a review of public policy
in four areas: safety and soundness, competition policy, consumer and investor protection, and
global public policy. The changes can accelerate financial sector development by lowering the
costs, increasing the breadth and quality, and widening access to financial services. But the
changes also require a reassessment of the approach to financial sector development, particularly
in emerging markets.

Safety and Soundness

Developments in technology and deregulation are eroding the nature of what has made banks
special. On the lending side, e-finance allows non-deposit-taking financial institutions and
capital markets to reach far more borrowers, including small and medium-size enterprises. On

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the deposit and payments system side, many deposit substitutes (such as stored value cards
issued by merchandisers) are emerging and many nonbanks (such as mutual funds) are offering
accounts. These and other changes make banks less special and challenge authorities to
reevaluate the need for a financial sector safety net—broadly defined to include public deposit
insurance, a lender of last resort facility, and prudential regulation.
Incentives for private parties to reduce the special nature of banks depend on the degree
to which governments provide banks with preferential treatment. Without a smaller safety net,
banks could continue to remain special—though not necessarily for the right reasons. These
developments raise a number of issues for public policy:

• Over the long run, there may be less need for a financial sector safety net, including
prudential regulation and supervision of banks.
• Authorities should be wary to extend guarantees to new deposit substitutes, as the moral
hazard implications could be substantial.
• Over the short run, authorities could require nonfinancial corporations to provide payment
services through bank subsidiaries. Over the long run, authorities may want to consider
separating payment from other credit services and allow freer entry in payment services.
• Changes make it necessary to adjust traditional supervision processes (assessment of risk
controls, definition of fit and proper tests) and address emerging issues (requirements for
opening a virtual bank, requirements for related financial service providers).
• E-finance will lower the franchise value of incumbent institutions. Thus failure resolution
processes will become more important, and bank assistance systems will have to be
reviewed. Stability issues require careful analysis of the degree to which profits will decline
and shift between financial products and institutions.

Competition Policy

From a competition policy point of view, markets for financial services can increasingly be
treated like other markets. Technology is reducing asymmetric informationoften a reason for
treating financial services differently from other products. Risks are being addressed through
continuous mark-to-market and collateral arrangements. And products are becoming more
homogeneous.
At the same time, reaping the benefits of technological innovations increasingly depends
on the degree to which entry is allowed and uncompetitive structures are avoided. Competition
policy for financial services is thus both more feasible and more important.

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• Competition policy for financial services will increasingly need to be harmonized worldwide,
and different regulators should coordinate sanctions for violations. Freer trade in financial
services will be critical for consumers to obtain the benefits of technological gains
• Defining markets, a critical element of competition tests, is becoming more difficult. Many
nonfinancial products are taking on properties of financial contracts, and many markets are
going global.
• For most financial services and markets, economies of scale and scope are unlikely to be
sufficient barriers to entry, because technology is reducing the extent of increasing returns to
scale.
• Some sunk costs can be entry barriers, although this should not be overstated.
• Network externalities can create entry barriers. Entry policies for self-regulating
organizations involved in network-oriented services, such as trading systems,, will become
more important. Tradeoffs will arise between preventing first-mover advantages, protecting
intellectual property rights, and meeting the desires of consumers for such services.
• Links between banking and commerce and increased vertical integration could hamper
competition. New strategic alliances—say, between telecommunication companies and
financial service providers—could allow for joint control of carriage and content in certain
financial services, possibly denying consumers access to a full array of services.
• Competition policy will increasingly require that authorities simultaneously define
technology and information policies. In some cases authorities may even need to subsidize
the development of technology if the externalities are not adequately internalized (as when a
basic technology needs to be shown to be technologically feasible). Mergers and joint
ventures by information companies and their relation to financial service companies are one
of many areas that will require a lot more scrutiny.

Consumer and Investor Protection

E-finance has made consumer and investor protection a more important function of public
policy. Issues include security, privacy, and transparency. Consumer and investor protection
raises the role of standards, who can best develop such standards, and who should enforce them.

• Security risks are being dealt with but will continue to require oversight. With technological
developments—cryptographic techniques, cards with built-in chips and other verification
techniques—complete security is already or nearly possible. Still, regulators may need to
encourage or require operators to adopt best practice standards. Further protocols and legal
changes, including for digital signatures, will be needed to facilitate electronic transactions.
• Privacy issues are becoming more important. The Internet has greatly simplified the
collection and sharing of credit and other data on individuals and businesses, and technology

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 has lowered the costs of processing and using such information. Global standards and
protocols will be needed to assure desired privacy levels, to enable cross-border provision of
financial services, and to allow global service providers to operate efficiently.
• The proliferation of financial products, delivery channels, and institutions, along with the
speed of innovation, have allowed easier comparison of prices and products. But the links
between infomediaries and financial service providers can lead to less transparency on the
service being offered. An important transparency issue in capital markets will be assuring
fairness and best execution and trading practices. Solutions will likely vary by country and
market.
• With increased cross-border transactions, it will be difficult to identify the legislative or
regulatory authority for investor protection. Furthermore, the emergence of nontraditional
service providers complicates investor protection mechanisms based on current institutional
frameworks. Government agencies need not directly intervene to combat these problems,
however. Instead more intense efforts should be made to educate consumers. Authorities
should set minimum disclosure standards for new financial intermediaries and possibly for
self-regulating organizationsincluding entities that certify information providers, such as
credit bureaus, credit rating agencies, accounting boards, and auditors.

Global Public Policy

While e-finance offers many gains, it may increase risks.

• Limits on cross-border financial services will become costlier and more distorting as the
Internet expands its reach, the location of providers becomes more difficult to pinpoint,
solicitation harder to define, and the definition of a financial service more complex.
Regulators will have to decide on the best way to phase out such limits. A comprehensive
approach would be the global equivalent to the EU approach of a single license (passport),
allowing full cross-border provision with home rule regulation.
• Today competition and market forces resolve many investor protection issues because
consumers and investors choose the environments that provide them with the greatest
certainty. But as e-finance expands, less informed consumers will gain access to markets,
raising issues for cross-border investor protection and transparency. Even with a “global
passport” approach and harmonized standards, regulators may need to protect consumers
accessing offshore financial services.
• Increased globalization requires increased coordination. Greater use of technology with
global externalities involves operational risks (such as computer breakdowns). Access of new
trading systems to contingent financing is also unclear, especially on a global basis. In
general, the links between operators and resulting systemic risks have become harder to

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 understand. Risk safeguards will have to be extended within and across countries, with
greater information sharing among regulators and self-regulating organizations.
• The easy spread of information—and misinformation—could make asset prices and capital
flows more volatile. Herding, turbulence, and contagion may increase, and countries may
become more vulnerable to attacks on their currency. Capital account restrictions will be
more difficult under e-finance, and the growing number of creditors complicates coordination
prior to or during a financial crisis, particularly in emerging markets. Though these problems
are not new, policy solutions have been elusive.

Impact on Developing Countries

Especially in developing countries where access to and the quality of financial services is
limited, electronic finance and globalization offers important opportunities. Electronic finance
has the potential to improve the quality and scope of financial services and opportunities for
trading risks and can provide widened access to financial services to a much greater set of retail
and commercial clients by offering a more cost effective delivery of services. Emerging markets
are starting to participate in the e-finance revolution, with a significant impact in some markets.
• The low efficiency and quality of financial services and the skewed profile of users favor
migration toward e-finance in many emerging markets. In some emerging markets, for
example, online banking is already on par with that in developed countries. In some countries
a lack of regulatory barriers and initial markets has made new entry across a spectrum of
services attractive. In other countries entry has been more specialized.
• E-finance will offer fewer choices to economies with poorly capitalized banking systems,
weak regulations, and extensive guarantees on liabilities. To reduce the risk of financial
crises, regulatory approaches in developing countries should recognize weak governance and
institutions, scarce human resources, and concentrated ownership structure. These
impairments make textbook solutions difficult and argue for simpler approaches. More entry
by foreign financial institutions will often be the best way forward.
• E-finance will require a reassessment of the approach to financial sector development. E-
finance allows much easier access to global capital and financial service providers. As
financial services are imported, the need for a domestic safety net and corresponding
regulation and supervision declines. As financial services can be imported from abroad the
issue is raised whether small, undiversified economies should have domestic equity and debt
markets—and, in the extreme, banking systems.
• For many countries, e-finance offers opportunities to quickly widen access to and improve
financial services. To achieve such gains will require that emerging market countries give far
greater priority to improving key information infrastructure, modernize and strengthen their
legal systems, and improve technology related infrastructure (e. g. telecoms)

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 Electronic Finance:
Reshaping the Financial Landscape around the World

Economic integration within and across countries, deregulation, advances in

telecommunications, and the growth of the Internet and wireless communication technologies are
dramatically changing the structure and nature of financial services. Internet and related
technologies are more than just new distribution channels—they are a completely different way
of providing financial services.
The changes affecting financial services, particularly the emergence of e-finance, call for
a review of public policy in four areas: safety and soundness, competition policy, consumer and
investor protection, and global public policy. The changes can accelerate financial sector
development by lowering the costs, increasing the breadth and quality, and widening access to
financial services—including access to capital for a much broader set of companies. But the
changes also require a reassessment of the approach to financial sector development, particularly
in emerging markets.
This paper first reviews the extent and speed of technology-driven changes in financial
services. It then analyzes implications of these changes for public policy. It finds a need to limit
public responsibility for a financial sector safety net, including prudential regulation and
supervision. As the safety net is shrunk, competition policy and consumer and investor
protection will become more important. Though these issues are more advanced in developed
countries, they are quickly becoming more relevant in emerging markets.

Recent Trends in Financial Services

Many of the recent trends in financial services have been driven by the globalization of financial
markets. Financial services have also been reshaped by technological and structural changes,
including the lowering of regulatory barriers.

Globalization

Increased financial integration. Reductions in trade barriers and transportation costs and
advances in communications technology have accelerated international economic integration.
Between 1987 and 1997 world trade in goods increased from 21 to 30 percent of global GDP
(World Bank 1999). The complementarity of trade in financial services with trade in goods and a
greater ability to trade services across borders have increased the demand for financial services.
Cross-border capital flows have been the most important financial service delivery
mechanism. Commercial bank claims on foreigners, the largest conduit of international capital
flows, increased from $7.7 trillion in 1980 to $11.0 trillion in 1999. Private capital flows to

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emerging markets rose from $50 billion in 1980 to more than $200 billion in 1999 (World Bank
2000a).
But capital flows are just one way that financial institutions in one country can provide a
loan or facilitate a security issue to an entity in another country. A financial institution can also
obtain a physical presence in another country by acquiring a financial institution or by opening a
branch or subsidiary. The costs of establishing a physical presence have declined, and cross-
border entry has increased.

Increased mergers and acquisitions within and across borders. Governments have
removed entry barriers through legal and regulatory measures such as the Riegle-Neal Act in the
United States and the Single Market Program in the European Union. Aided by technological
developments, these changes have lowered barriers to entry and increased bank consolidation
and mergers and acquisitions among financial institutions, both within and across borders.
Globally, mergers and acquisitions in financial services jumped from $85 billion in 1991
to $534 billion in 1998 (BIS 1999). In the United States mergers and acquisitions rose from $25
billion (1998 dollars) in the mid-1980s to $250 billion in 1998. Since 1980 the number of U.S.
banks has dropped 40 percent. In the European Union the number of banks has fallen by 25
percent since 1985. Similarly, Argentina, Brazil, Chile, the Republic of Korea, and Mexico have
seen a significant decline in the number of domestic banks in recent years.

Lower barriers between markets. Consolidation is also being driven by the dismantling of
regulatory barriers separating banking, insurance, and securities activities.1 Boundaries between
different financial intermediaries are being blurred, and universal (or integrated) banking is
becoming the norm. The recent merger of Citigroup (banking) and the Travelers Group
(insurance) is the most dramatic example of this trend.
An important market incentive for this reduction in barriers has been the
disintermediation of bank assets and liabilities by capital market transactions. Commercial paper
and bond sales have substituted for bank loans, and mutual funds and securities for bank
deposits. These forces pressure banks to expand their financial services to cater to all customer
needs and preferences. Advances in information and communication technology further facilitate
the delivery of a broad array of financial services through one provider.

The new world of financial services

Technology is revamping the ways in which financial services are produced and delivered. In
addition it is fundamentally changing the industrial structure of the financial services industry
worldwide.

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 Technological advances. Internet and wireless communication technologies are having a
profound effect on financial services. These technologies are more than just new distribution
channels—they are a completely different way of providing financial services.
Using credit scoring and other data mining techniques, for example, providers can create
and tailor products without much human input and at very low cost. They can better stratify their
customer base through analysis of Internet-collected data and allow consumers to build
preference profiles online. This permits not only personalization of information and services but
also allows much more personalized pricing of financial services and much more effective
identification monitoring of credit risks. At the same time, the Internet allows new financial
service providers to compete more effectively for customers because it does not distinguish
between traditional “bricks and mortar” providers of financial services and those without
physical presence. All these forces are delivering large benefits to consumers at the retail and
commercial levels.

Changes in industry structure. These technological advances are changing the face of the
financial services industry (Box 1). New types of service providers are entering the market
within and across countries, including online banks and brokerages, mono-liners, and so called
aggregators (which allow consumers to compare financial services such as mortgage loans and
insurance policies) (see Table 1). Nonfinancial entities are also entering the market, including
telecommunication and utility companies that offer payment and other services through their
distribution networks and customer relationships. To reap the benefits of the new technology,
and in response to this new entry, banks, insurance companies, and the like are joining in the
electronic delivery of financial services—setting up in-house online activities or completely new
ventures such as virtual banks.
Thus the delivery of financial services is moving away from a bricks-and-mortar delivery
channel to a multitude of electronic and other channels, with portals and aggregators offering
new distribution and advertisement channels for financial services. Vertically integrated financial
service companies are growing rapidly and creating synergies by combining brand names,
distribution networks, and financial service production. For example, companies associated with
portals (America Online, Yahoo, Microsoft) and major telecommunication companies (Deutsche
Telecom, Telefonica) are developing strategic relationships or ownership links with major
financial service companies, banks (such as the Bank of East Asia with Yahoo), or each other
(Telefonica and Lycos). At the same time, many major financial institutions (Morgan Lab,
Goldman Sachs, Chase, Merrill Lynch, Morgan Stanley) are part owners of promising Internet
start-ups. And goods-producing companies are taking advantage of bank distribution networks
(Citidollars with a variety of consumer-related companies). These developments are changing the
competitive landscape for financial services and will continue to erode the franchise value of
existing financial service providers that are inefficient or do not adopt competitive business
models.

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 Figure 1: The new world of financial services

Vertically Integrated Financial Conglomerates

Vertically Integrated Mixed Conglomerates
Electronic
Enablers S1, Checkfree, Sanchez, Online, System Access, Back-offices

Financial Home Banking, M ortgages, Brokerage, I nsurance, e-Wallets, Electronic

Products Bill Presentment & Payment, Checking, Business Services, Credit Cards

Financial Specialized Financial Services Providers Financial Telecom/Utility

“ I nstitutions” Conglomerates Companies
.com

Aggregators LendingTree.com Dollarex.com AdvanceMortgage.com Ins_web.com

Portals
Distribution Citi
Private N etworks

Access Devices Wireless

Brick and M ortars PC with M odems TV Phone Kiosks Devices

Box 1. The New World of Financial Service Providers

Financial services are now offered through a multitude of delivery channels, from traditional brick-and-mortar
brokerages to wireless devices. Six steps can be distinguished in the production and distribution of financial
services, though in practice these steps often overlap or are vertically integrated.

Access devices (rather than a teller or branch) are becoming many customers’ first point of contact with financial
services. These devices include personal computers, personal digital assistants (such as Palm Pilots), televisions
equipped with Internet access, cellular phones, and other wireless communication devices. These channels will be
complemented by low-cost “branches,” kiosks (standalone computers connected to bank systems), and other public
access devices in supermarkets, convenience stores, and common areas (airports, train stations).

Portals are becoming the critical link between access devices and financial service companies. Portals offer access
to a range of financial service providers, often for free or a fixed price, but generate revenue from fees paid by
providers referred through the portal. These include specialized portals developed by financial services companies as
well as general portals such as the U.S.-based America Online, Lycos, Yahoo!, and Microsoft along with others in
emerging markets (Paxnet and Thinkpool in Korea, Terra in Latin America). Portal companies attempt to process
and personalize information to capture consumers. Portals are proliferating rapidly, even in emerging markets.
Korea, for example, is home to 300 portals, many of which function as a gateway for financial service providers. In
addition, customers can access financial service providers through many private networks and some financial
services providers have established their own specialized portals.

Aggregators complement portals, allowing consumers to compare mortgage, insurance, or lending products offered
by suppliers of financial services. In addition, quasi-aggregators are emerging that aggregate or display prices of
financial products offered by different suppliers or even conduct single or block reverse auctions of mortgage loans

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or insurance products (as with Dollar Dex in Singapore). Finally, other specialized companies are undertaking
functions on behalf of larger banks or insurance companies and developing online techniques to mine data and offer
personalized financial products to consumers.

Financial institutions serve as conglomerate providers of financial services that are global brands (Citigroup,
Deutsche Bank, Warburg) and as specialized financial services companies. Partly in response to the entry and to
reap the benefits of new technology, incumbents (banks, large insurance companies) are consolidating around
recognized brand names to position themselves in an environment of increased commoditization and electronic
delivery. Merrill Lynch and HSBC, for example, recently announced a joint venture in private banking that
combines HSBC’s network with Merrill Lynch’s product range. Large telecommunication companies that already
have access to a large distribution network of customers are starting to provide payment and other services. In
addition, telecom companies are forming alliances to extend their global network to financial services delivered
online. Examples include Deutsche Telecom, Telefonica, AT&T, and Telemex. And increasingly specialized
financial service providers—so called mono-liners in all mainline financial services areas, from mortgage lending or
personal loans to insurance to brokerage to payment services—are establishing online operations.

Financial products are being commoditized or tailored to the needs of customers. Such products are distributed
through specialized financial service providers or financial conglomerates.

Enabling companies support existing financial service providers as well as specialized financial service providers
and virtual banks. Specialized software engineering companies such as S1, Checkfree, Sanchez, and System Access
provide e-finance system solutions that are completely integrated and permit the rapid adaptation needed in today’s
world.

Table 1. Providers of Electronic Finance

Type of financial United States Europe Asia Latin America

service
Online Banks Telebanc Egg Bank, Smile OUB (Singapore, to Banco1
Net.B@nk Advance Bank, Bank be established)
X Bank Girotel, Comdirect, Dah Sing (Hong
Wingspanbank Diba, Entrium, First Kong, to be
E, Santander established)
Augsburger Aktien-
bank

Online Lenders E-LOAN EuropeLoan

Mortgage.com (Belgium)
NextCard
Finet
Intuit/Quicken

Aggregators InsWeb InsuranceCity DollarDEX Dineronet

AnswerFinancial (Germany) (Singapore, HK, (Argentinia)
Lending Tree Interhyp (Germany) soon in Malaysia and Zonafinanciera
Quotesmith.com Taiwan)
Intuit/Quicken Eisland.com (Sing.)
Admortgage.com
(HK)
e-finance.com (HK)

Online Brokers Schwab.com Consors (Germany) Boom Securities Patagon (Arg.,

E-Trade Direct Anlage (HK), Brazil, Chile,
TD Waterhouse (Germany) Taiwan: Polaris, Mexico)
DU Directs Avanza (Sweden) Kong Chen, Socopa
Fidelity.com Masterlink Brazil: Souza Barros,
Ameritrade Korea: Daishin, LG Novacao, Hedging

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Type of financial United States Europe Asia Latin America
service
Sec., Samsung Sec. Griffo, Coin Valores
CB Capitales (Chile

Financial Portals Yahoo!Finance eXchange Holdings Hong Kong: Investshop (Brazil)

Microsoft Network (UK) Quamnet, Baby Patagon
Intuit/Quicken bfinance (France) Boom, Dineronet
America Online FTYourMoney (UK) asiabondportal (Argentina)
Motley Fool Sing.: Quicken/SPH Zonafinanciera
TheStreet.com Korea: PaxNet, LatinStocks
Thinkpool, Net LatinInvestor
Invest Consejero
China: 99stock.com,
stockstar.com,
homeway
Enablers Security First (S1) eBiz Solutions
Sanchez, Corrllian Finese Alliance
Digital Insight I-ayala
iXL Enterprises System Access
Online Resources The Edge Consult.
Alltell, Bisys, Fiserv S1 Singapore
EDS, M&I, Ebx.com
724 Solutions

E-payments CheckFree, QSI (Australia)

Spectrum, First Ecom (Hong
CyberCash, Mondex, Kong)
CyberSource, V-check (Singapore)
Entrust, Verisign,
Intelidata, Sterling
Commerce,
DotsConnect,
First Ecom

Source: Hussey et al 2000, Country Sources.

Changes in trading systems. Driven by advances in communications technology, trading

systems are consolidating and going global. Trading is moving toward electronic platforms not
tied to any location. (Nasdaq’s computers are based in Turnbull, Connecticut, for example, but
traders are located around the globe.) New electronic systems have lowered the transaction costs
of trading and allow for better price determination because electronic execution and matching
techniques imply less chance of market manipulation. These advantages are more important in
markets that had not yet converted to electronic trading (such as the United States) than in those
where electronic trading is the norm (such as Europe). The new technology also allows for much
easier cross-border trading.
Combined with globalization, these forces are putting pressure on incumbent stock
exchanges. They have responded with mergers and alliances (Table 2). Because many exchanges
are self-regulating agencies, the pressures for change usually do not come from within the
industry. Rather, they come from users or investors who want to pay smaller commissions, effect
trades more quickly, and maintain anonymity on placed orders (Box 2).

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 Table 2. Features of International Stock Markets and Exchanges
Market or exchange Average daily trading Market
volume (billions of Capitalization Links with other exchanges or electronic communication
U.S. dollars) (billions of U.S. networks
dollars)
New York Stock Exchange 35.0 12,000 Preliminary talks with Toronto Stock Exchange,
Euronext, and Mexico’s Bolsa; cooperative links with
Tokyo Stock Exchange
Nasdaq Stock Market 41.5 5,020 All electronic communication networks trade Nasdaq
stocks; deals with Osaka Stock Exchange, Deutsche
Boerse, London Stock Exchange, Quebec government,
Hong Kong Stock Exchange, and Australian Stock
Exchange
Tokyo Stock Exchange 6.8 4,100 Cooperative links with exchanges in the Republic of
Korea, the Philippines, Singapore, and Thailand, as well
as with the New York Stock Exchange
London Stock Exchange 13.5 2,800 Deutsche Boerse merger, Nasdaq joint venture
Toronto Stock Exchange 2.85 1,700 New York Stock Exchange, Euronext, Hong Kong Stock
Exchange, Mexican Bolsa, São Paulo Bovespa
Deutsche Boerse 4.53 1,500 Merger with London Stock Exchange (iX), Nasdaq joint
venture, MarketXT joint venture
Paris Bourse 4.18 1,500 Euronext alliance
Hong Kong Stock Exchange 1.5 568 Co-listing agreement with Nasdaq, New York Stock
Exchange
Australian Stock Exchange 0.8 370 Nasdaq, Singapore Stock Exchange
São Paulo Bovespa 0.4 208 London Stock Exchange, Lisboa Stock Exchange,
Argentina’s Caja de Valores
Globally 148.8 35,005.4

Source: The Wall Street Journal; Federation Internationale de Bourses de Valeures.

Box 2. The Massive Shifts in Stock Markets and Exchanges

A revolution in under way in the way financial (and nonfinancial) contracts are traded. These changes have involved
traditional exchanges as well as business-to-business (B2B) transactions.

A number of electronic order routing and trading networks have emerged in recent years. These networks have
evolved into order-driven matching systems that are electronically provided to participants seeking anonymity.
Electronic communication networks started out as pools of liquidity feeding into existing markets but now serve as
alternative trading outlets in several developed and some emerging capital markets (as with Ark Access in Asia). In
some markets these networks account for a large share of total trading (one-quarter of the dollar volume of Nasdaq
in the United States).

Other alternative trading systems are being set up around the world, often with links to existing trading systems. For
example, Instinet began as a local interdealer broker and dealer but now has automatic routings to a number of stock
exchanges. There is speculation that a few trading systems will soon allow investors to trade 24 hours a day.
Exchanges are recognizing that their services—trading systems—are increasingly becoming a commoditized
product offered through other means. Eventually, traditional stock markets such as the New York Stock Exchange
will cease to exist in their current form.

Reflecting these competitive pressures, and the more general desire for increased liquidity through larger markets,
many stock exchanges in developed countries have established links, merged, or even de-mutualized (that is,
become for-profit organizations rather than cooperative (mutual), not-for-profit organizations. Recent examples
include the (proposed) mergers between the Amsterdam, Brussels, and Paris exchanges and between the London and

13
Frankfurt exchanges (the so-called iX), joint ventures and alliances between Nasdaq and stock exchanges in
Australia, Canada, Hong Kong (China), and Japan, and a joint venture between Nasdaq and the proposed iX focused
on growth stocks. The Singapore and Australian stock exchanges recently agreed to cross-list all traded shares. The
New York Stock Exchange has formed alliances with the Tokyo Stock Exchange, Hong Kong Stock Exchange,
Australian Stock Exchange, Toronto Stock Exchange, Mexican Bolsa, São Paulo Bovespa, and Euronext to trade
through linked exchanges 24 hours a day. The consolidation of these markets—accounting for more than 60 percent
of global market turnover—is leading to a smaller number of very large markets.

Figure 2 summarizes recent developments in financial products and services along two
dimensions: ease of commoditization and existence of entry barriers. Entry has been particularly
strong in financial services that could be easily unbundled and commoditized and that offered
attractive initial margins. These include many nonbanking financial services, including
brokerage, trading systems, some retail banking services, and new services such as bill
presentment or even payment gateways for business-to-business (B2B) commerce. Because these
services are subject to less regulation, new entrants could easily innovate with new technology
and could show limited or no earnings without raising supervisory concern. As these new
entrants gained market share and consolidated their position, some started to diversify into more
highly regulated banking services. An example is E-trade’s recent acquisition of a bank to
provide the full range of financial services to its retail clients.

Figure 2. Potential Competition and Commoditization in Financial Services

High Bill presentment

Deposit and Stock markets
payment services Brokerage services
Lending to large firms
Lending to small firms
Ease of Deposit substitutes
Lending to medium- Retail banking services
commoditization
size firms

Investment
advice and corporate services
Low

High Low
Barriers to entry

Services involving sunk costs and low commoditization, such as corporate advisory
services or mergers and acquisitions within investment banking, have seen much less new entry.
Instead the trend has been toward global consolidation to reap the advantages of reputation,

14
brand name, and economies of scale. Although deposit-taking and many traditional payment
services exhibit large potential for commoditization—through online banks, payment services
using “smart” cards, and other technologies—entry has been limited, in part because of
regulatory barriers. From a production point of view, however, these services could easily
migrate to the high commoditization, low entry barrier sector.

What effect have the changes had?

Widely available real-time market information lowers the cost of financial services by
easing uncertainty, mitigating asymmetric information, and reducing transaction costs associated
with paper processing or human error. In addition, new distribution channels have opened up,
search costs have fallen for consumers, and new entities (including telecom and utility
companies) are providing financial services.

Lower costs for providing financial services. The technology on which the financial
service industry depends has become much cheaper, and in the past 20 years computer power has
risen by a factor of 10,000 (World Bank 1999). Similar changes are occurring in
telecommunications—in the past 20 years the cost of voice transmission circuits have fallen by a
factor of more than 10,000]. Communication costs have fallen sharply in most countries, and the
rapidly growing importance of broadband and wireless Internet-based communication systems—
such as Blue Tooth or wireless application protocol (WAP)—indicate that costs will continue to
fall and Internet access will continue to widen. The Internet eliminates many processing steps
and labor costs, while avoiding or reducing the fixed costs of branches and related maintenance.
A typical customer transaction through a branch or phone call costs about $1, but that transaction
costs just $0.02 online (Figure 3). Overhead expenses for Internet banks are 1 percent of assets or
less, compared with 2–3 percent for brick-and-mortar banks.

15
 Figure 3. The Internet Slashes the Cost of Transactions

1 .2 0

1 .0 0

0 .8 0

0 .6 0

0 .4 0

0 .2 0

0 .0 0
B ra n ch T e le p h o n e ATM P C B a n k in g I n te r n e t

Source: Goldman Sachs and Boston Consulting Group.

The Internet and other technological advances have shrunk economies of scale in the
production of financial services (Table 3). The main financial service still exhibiting increasing
returns to scale is the medium-size loan market, because large databases of credit history are
required to build a credit-scoring model for medium-size clients. This gives larger lenders a
potential competitive advantage. For most credit, however, economies of scale have become
small, because the fixed costs associated with screening small borrowers (less than $100,000)
have dropped significantly.
Financial service providers using the Web can avoid many technology conflicts, such as
separate interface-to-core systems for automated teller machine (ATM), branch, call center, or
kiosk transactions. Web-based financial services unify the Internet as a communication standard
by combining a Web browser, a display standard, and a Web server as the access point into back-
end operational systems. As a result, cross-selling of products becomes easier and economies of
scope increase.

16
 Table 3. Characteristics of Financial Service Provision in an Internet World

Economies of scale Commoditization Up-front costs; Network

branding, externalities
advertising
Retail services
Payment ●● ●●●● ●● ●●●●
Lending/mortgage ●● ●●●● ●● ●
Discount brokerage services ●● ●●●● ●●● ●●
Investment advice ●● ●●● ●●●● ●●
Mutual funds ●● ●●● ●●● ●●
Insurance ●● ●●● ●●● ●●
Wholesale services
Commercial lending
Large ●● ●●● ●● ●
Medium-size ●●● ●●● ●● ●
Corporate services ●● ●● ●●●● ●
(underwriting, mergers and
acquisition advice, risk
management)
Large-value payments ●●● ●●● ●●●● ●●●●
systems
Markets
Trading systems/exchanges ●● ●●●● ●●● ●●●●
B2B exchanges ●● ●●●● ●● ●●●●
New services
E-payment providers ●● ●●● ●● ●●●●
Enablers ●● ●● ●● ●●●
Financial portals ● ● ●●● ●●●●
Aggregators ●● ●●● ●● ●●
Note: ● means none, ●● means low, ●●● means medium, and ●●●● means high.
Source: Authors’ assessments.

The lowering of scale economies has increased competition, particularly among financial
services that can easily be unbundled and commoditized through automation (see Table 2). These
include payment and brokerage services, mortgage loans, insurance, and even trade finance.
Most of these services require limited initial capital outlays and no unique technology. Lower
transaction costs can substantially increase competition for providers and cost savings for
consumers. To retain market share, online brokerage firms have been forced to radically
restructure the way they deliver brokerage services. Brokerage commissions and fees fell from
an average of $52.89 a trade in early 1996 to $15.67 in mid-1998—and by mid-2000, some
online brokerage services had reduced their commissions to zero. Electronic communication
network commissions, now at $0.05 a share, are continuing to fall. Barriers to entry based on
ownership of physical facilities are disappearing, and incumbent institutions are being forced to
merge or in some cases to de-mutualize to even have a chance of remaining viable.

17
 In the past, sunk costs were important entry barriers in the financial services industry.
Examples of sunk costs include branch networks, knowledge about local borrowers, access to
payments systems, branding advantages involving large up-front advertising expenses,
perceptions of size and safety, long-lasting customer relationships, and substantial up-front
investments in technology. But sunk costs are becoming less important in financial services,
partly because electronic delivery modes do not rely on a branch network (see Table 2).
At the same time, new entry barriers are being created through first-mover advantages.
Once a new entrant is established as a service provider, other new entrants will have to spend a
lot on advertising to attract new customers (as E-trade and Ameritrade have done in the United
States). In product areas such as underwriting and mergers and acquisitions advice, financial
services exhibit low levels of commoditization and still require relationship capital, a certain
size, and a brand name to compete effectively. But these services enjoy few or no network
externalities and are increasingly subject to global competition. The scope for a contestable
market will then depend on the size of the market. A limited number of financial institutions
involved in underwriting, but operating on a global basis, present a very different competitive
environment than would a few players in a small market (say, less than $1 billion).
Although declining economies of scale, increasing standardization and commoditization,
and declining up-front costs foster competition, this need not be the case for services that exhibit
network externalities. A financial service exhibits network externalities if the value of the service
rises with the number of market participants using it. Payment services, for example, have
decreasing economies of scale, low up-front costs, and ease of commoditization. But payment
services are subject to large network externalities, because the value of electronic payment
services largely depends on the degree to which users adopt a common standard. The financial
service provider that manages to create this common standard will end up with a large share of
the market, decreasing competition. Similar characteristics apply to trading systems and
exchanges (traditional or B2B), to financial portals, and to a lesser extent to e-enablers (see
Table 2).

Benefits for consumers and corporations. The benefits of cheaper financial services will
be shared by providers and consumers. With the advent of new types of intermediaries, such as
aggregators, consumers can increasingly compare prices for financial services (Figure 3; see also
Box 1). Aggregators can bring together many suppliers of financial services and coordinate
information flows in a rational way. Lending Tree, for example, allows customers to compare a
wider base of potential lenders than is possible or cost-effective using traditional loan agents or
direct communication channels. Since Lending Tree prequalifies loan applicants, lenders can
find creditworthy customers inexpensively. The Internet also allows consumers to more easily
combine financial services from different providers. This is done through comparison shopping
companies and through portals (see Box 1).

18
 Commercial borrowers that undertake B2B transactions and treasury operations will also
benefit from lower transaction and search costs and from increasing access to financial services
for small and medium-size enterprises. In the case of small and medium-size enterprises, new
online companies such as garage.com and techpacific.com provide a full array of services to
start-up companies, including legal services, Web design, accounting services to assist in
preparing accounts and meeting disclosure standards, branding and advertisement, investor
relations, and so on. These companies are used by investors (venture capital arms of nonfinancial
and financial companies) to screen potential start-up ideas. In addition, the use of the Internet for
data mining in lending holds promise for improving the outreach of financial services to very
small companies.

Implications for Public Policy

All governments, even the most market-oriented, regulate and supervise the financial
sector for reasons of safety and soundness, systemic stability, competitiveness and antitrust
concerns, and consumer protection. The recent changes in financial services raise questions
about whether the current approach to financial sector regulation is adequate, whether traditional
reasons for regulation and supervision remain valid, and what areas (competition policy and
consumer protection) deserve increased emphasis. The key public policy findings are
summarized in Table 4.

Safety and soundness

The need for a financial sector safety net—and associated prudential regulation and
supervision—arises from the need to treat deposit-taking institutions differently from other
economic agents. This was not always the case. Except for the lender of last resort facility, most
aspects of the safety net—which also includes deposit insurance and central bank operations in
respect to the payments system—were adopted by today’s developed countries only after 1930.
Prudential regulation and safety nets are a more recent phenomenon in most emerging markets,
but were introduced at relatively low levels of development.

Is there a need for a safety net in the long run? To answer this question, one must first
ask if current developments in technology and deregulation are eroding the nature of what has
made banks special (Box 3). Banks are no longer the only deposit-taking institutions. Many
substitutes for banks’ deposit products have emerged, and alternative payment mechanisms have
developed.
The importance of banks as lending institutions is also waning, and capital markets have
become increasingly important sources of corporate financing in developed countries. The

19
 increased reliance on securities markets for funding is especially pronounced among large
businesses, which use the commercial paper market to fill short-term financing needs and the
bond market for long-term needs. Capital markets also affect many other segments of borrowers
through asset- and mortgage-backed securities.
Nonbank sources of financing are also becoming more important in many countries. The
decline in the special character of banks, at least in industrialized countries, is further
demonstrated by the fact that—with a few notable exceptions—the cost of bank failures (in terms
of real output losses) has declined because corporations have had access to alternative forms of
financing.

Table 4. Public Policy Issues for the Financial Sector

Current issues Future issues Transition issues
Safety net Safety net Safety net
-- Banks are considered special because -- Banks are no longer special because many -- Authorities should be wary of
they extend essential credit to firms, substitutes have emerged for deposit and lending extending the safety net to non-
provide payment services, and are products. Thus there may be less of a need for a public deposit-taking activities and
inherently fragile and susceptible to safety net, and correspondingly less need for prudential deposit substitutes. They should
runs. regulation and supervision. require financial service providers
-- Thus governments have provided -- Government should increasingly allow the private with non-deposit-taking activities
safety nets—regulation and sector to find mechanisms to curb excessive risk to adopt a bank holding company
supervision, deposit insurance, lender taking. structure or a narrow banking
of last resort facilities—to minimize the -- More efficient interbank markets reduce the need for structure.
adverse effects of bank failures. lender of last resort facilities. -- With increased competition and
-- But safety and soundness regulation -- Moreover, banks’ special role in the payments the decline in franchise value,
and deposit insurance pose barriers to system is declining as technology allows for the decapitalized institutions will
the entry of new firms and favor unbundling of payment and credit services. Thus have incentives to gamble for
incumbent firms. The safety net also authorities may want to separate payment from other resurrection. Thus governments
raises moral hazard issues. credit services and allow freer entry to the payments need to strengthen failure
system. resolution mechanisms and
reduce extensive guarantees that
often apply to all financial system
liabilities.
Competition policy Competition policy
-- Because banks are considered As the safety net is eliminated, markets for financial
special, competition policy is subsumed services can be treated like any other product from a
under prudential policy. Competition competition policy point of view. This means that:
policy aims to ensure an adequate -- Freer trade in financial services will become even
franchise value for banks to enhance more important.
their soundness and incentives for -- Scale and scope economies are unlikely to be
prudent behavior. effective barriers to entry.
-- Tools of competition policy include -- Sunk costs, externalities, and vertical integration
minimum capital requirements, capital may be barriers to entry and could hamper competition.
adequacy, and fit and proper test. -- Market and product definitions, which are critical for
competition tests, will be difficult to define.
- With globalization, competition policy will have to be
coordinated worldwide.
Consumer protection Consumer protection Consumer protection
-- Consumer protection issues relate to security risk, -- How to modify legislation and
privacy, transparency of information, and investor regulations credibly to permit
protection. proper enforcement including the
-- Key public policy areas include defining consumer area of minimum disclosure.

20
Current issues Future issues Transition issues
protection standards, defining minimum standards for
self-regulating organizations, and ensuring incentives
for enforcement of such standards..

Box 3. Why Have Banks Been Considered to be Special?

Banks have traditionally been considered special for two reasons. First, they provide credit to other firms and
manage the flow of payments throughout the economy. Disruptions in the credit supply and a breakdown in the
payments system could have large spillover effects for the rest of the economy in terms of reduced real output. Bank
failures or losses in capital can lead to contractions in aggregate bank credit, with large social costs to bank
borrowers outside the banking system. Second, banks are inherently fragile and susceptible to contagious runs owing
to the combination of information asymmetries, intertemporal contracting, demandable par value debt, and high
leverage (Diamond and Dybvig 1983). Even small shocks to solvency may lead to costly systemic runs, where
depositors overreact to information and force the closure of even solvent institutions. Historically, clearing houses
and other private monitors have limited the risk taking of financial institutions and so dealt with some of these
concerns. More recently, governments have responded to the special nature of banks by providing a safety net.
It has also been argued that banks are special because only banks can provide some essential forms of credit
to corporations, especially forms of short-term liquidity. Kashyap, Rajan, and Stein (1999) argue that banks can
provide short-term liquidity more cheaply than other institutions because they combine committed lending (such as
lines of credit) with deposit-taking services. The authors contend that banks are more cost-efficient in providing
liquidity because deposits act like loan commitments, since deposits can be withdrawn at any time. As a result banks
need a buffer stock of liquid assets to support their provision of demand deposits, just as they need a buffer stock to
support their loan commitments. Since banks offer lending and deposit-taking services together, they can economize
on the quantity of cash and safe securities they hold, thereby maintaining a smaller buffer than would be required by
two financial intermediaries offering these services separately. These savings allow banks to provide liquidity to
their customers at a lower cost than other financial institutions. Diamond and Rajan (1998) argue further that the
somewhat fragile capital structure of banks, which subjects them to runs, disciplines them to monitor corporations
properly.
Finally, banks have historically played a dominant role in the provision of payment services, as these services
were often linked with the extension of credit and the exchange of bank claims.

E-finance allows non-deposit-taking financial institutions and capital markets to reach far
more borrowers, because transaction costs are lower and information is more widely available.
Advances in information technology are reducing asymmetric information and, accordingly,
banks’ proprietary information about borrowers. Small and medium-size firms have greater
access to financing because of better credit scoring and securitization techniques. As a result, and
especially in industrialized countries, banks are providing fewer balance-sheet-based services.
In this context, private parties’ incentives to reduce the special nature of banks will
depend on the degree to which governments provide banks with preferential treatment. Without a
reduced safety net, banks could continue to remain special—though not necessarily for the right
reasons. A smaller safety net also diminishes the need for prudential regulation and supervision.

Revisiting banks’ role in the payments system over the short term. In most countries
banks make up the core of the payments system. This dominant role developed because payment
services were often linked with credit extension and the exchange of bank claims. But this is no
longer the case. Many mutual funds and most brokerage houses permit individuals to

21
automatically deposit their paychecks in cash management accounts, from which routine
payments can be made automatically and irregular payments can be made by check or phone 24
hours a day. Money market accounts can be linked to a credit card that also functions as a debit
card at ATMs (Allen and Santomero 1999). While payments through the account are still cleared
through a bank, this is not the essential part of the transaction. Rather, it is a regulatory artifact.
Technological progress allows for the further unbundling of credit and payments services,
reducing banks’ importance in the provision of payments services. New nonbank providers of
payments services use new technologies (e-mail transfers, stored value cards, smart cards) to
provide payment functions. Balances on stored value cards can typically be transferred without
involving a depository institution directly (Osterberg and Thomson 1998). Thus payment
services now offer a continuum of options ranging from new types of services—including barter
forms (frequent flier miles, bonus points), Internet-enabled payment gateway, e-money, and
stored value cards—to traditional transfers of transaction accounts held at banks.
From a regulatory point of view, these developments raise the question of which payment
services should fall under regulatory oversight and what institutions should have access to the
payments system. Regulatory authorities can define payment services rather broadly and extend
existing regulation to all types of payment providers and their activities. Or they can define
payment services narrowly to transaction and checking accounts at banks (deposit–taking
institutions chartered by the regulator).
As an example, in many countries stored value or even multi-purpose cards are offered
by a range of providers, including transport companies. But do stored-valued cards issued by
nonfinancial entities constitute depositssince the cards carry a balanceand should they be
regulated and covered by deposit insurance schemes? The decision of which alternative services
to regulate will matter greatly, particularly if the form of regulation is prudential as opposed to
consumer-protection related as the former implies that the services are considered to be covered
by the safety net. Since the new types of payment services cover a continuum of modalities,
authorities need to evaluate carefully where to draw the line and be cognizant up front of a
possible shifting of the line over time due to political and other pressures. Authorities should be
especially wary to extend deposit guarantees to new deposit substitutes because the moral hazard
implications can be substantial.
Similarly, authorities have to decide whether to open access to the payments system to
nonbanks and, if so, in what form. In most countries only banks have access to the payments
system, and alternative providers of payment services have to clear through banks. Restricting
access to the payments system to banks allows incumbent banks to preserve a core part of their
franchise value. Allowing direct entry by nonbanks and nonfinancial companies (telecom and
utility companies, brokers) will reduce the franchise value of banks and risk increasing overlap
and blurring of lines between financial and nonfinancial companies. This could enlarge the safety
net, even if by default.

22
 Over the short term, to limit the blurring of lines, regulatory authorities could require
nonfinancial corporations to provide payment services through bank subsidiaries. More
generally, authorities may want to signal clearly what type of services or institutions they will
continue to regulate and supervise and require that providers offering deposit substitutes indicate
to their customers that these are uninsured products and that the credit risk is not assumed by a
public deposit insurance scheme. Over the long run, authorities may want to separate payment
from other credit services and may want to allow freer entry in payment services. Furthermore,
these developments necessitate a review of the central bank’s role in the payments system and
the way it provides comfort to payments system participants.

Preventing the extension of the safety net over the short run. Redesigning the safety net is
all the more urgent because of the risks that it will otherwise be extended in the short run rather
than being reduced. Financial services have become more complex, with increasingly blurred
distinctions between products and institutions and between the financial and nonfinancial
companies providing these services. As financial service providers extend their activities, an
extension of the safety net to nonbanking activities of financial service providers could occur
without policy change. Governments may end up taking on a much larger range of risks, most of
them unrelated to any economic reasons for a public safety net in the first place.
As one way of limiting the risks of extending the safety net, regulatory authorities could
require financial institutions with nondeposit banking activities to adopt a bank holding company
structure under which deposit-taking activities are performed through a separately capitalized
subsidiary. Or authorities could require financial service providers that offer insured deposit
products to offer these in separately capitalized subsidiaries that are only allowed to hold “safe
assets” such as government bonds (that is, narrow banking).
Similarly, central banks should reexamine their lender of last resort function. In
particular, to prevent liquidity support from becoming solvency support, as during the East Asia
crisis, central banks need to carefully define this function and clearly lay out conditions that
ensure that support is provided as a last resort to solvent institutions. Yet given technological
and market changes, central banks may find it increasingly difficult to limit their lender of last
resort support in the future.

Supervisory issues. Many of the changes under way will render less effective the current
approach to supervision. In addition, many new regulatory issues will arise. With financial
services increasingly being provided by financial institutions offering a wide range of services
and having extensive links to nonfinancial companies, supervision will become more difficult.
Traditional supervisory processes—such as those used to assess a bank’s risk controls and the
definition of fit and proper tests for mergers and acquisitions or entry—will need to be reviewed.
Portals will present new supervisory issues, such as whether they are deemed to provide
investment advice. Should aggregator companies be licensed, regulated, or supervised? What if

23
underneath they are a holding company where a bank is also present? How can the holding
company be “ring fenced” so that a bank will not come to the rescue of its holding company?
More generally, how should one define the extent of consolidated supervision in the new world
of financial services? And how can one ensure greater coordination of prudential regulation and
supervision with competition policy?
Governments will need to evaluate the public policy objectivessystemic risks,
competition policy, consumer protectionthey aim to achieve and adapt regulation and
supervision accordingly. In this context of shifting overall objectives, there will also be a need to
revisit the structure of supervision. Traditionally, many countries have aligned their supervisory
system by type of financial institution. If financial institutions increasingly operate as integrated
entities and new entities emerge that offer the same or similar financial services, then the type of
institution becomes hard to define. For example, banks now sell securities, and securities firms
offer cash-account products that compete with bank deposits. This breakdown of product and
service barriers results in jurisdictional overlap among supervisors.
The functional approach to supervision tries to deal with some of the drawbacks of the
institutional approach by organizing supervision by economic function (deposit taking,
underwriting, and so on). But since product definitions continue to evolve and often defy
categorization, as with certain derivatives, the functional approach has drawbacks. Yet neither
the institutional nor the functional approach does explicitly consider the public policy objectives
for supervision as they tend to focus on institutional or industry-specific issues. Regulators are
thus not necessarily focussed on why to regulate in the first place. By contrast, the objective
approach has the benefit that policy objectives per se are not mixed with product and entity
concepts. Regulation and supervision apply to activities that affect specific public policy goals,
irrespective of product definition on sector and intermediary boundaries. Thus the objective
approach can ensure a more consistent regulatory environment and a level playing field among
different financial service providers and be more flexible.

Impacts on financial stability. Financial service providers will see their franchise values
decline as financial products are commoditized and new entrants emerge. Franchise values will
fall more for institutions that derive much of their earnings from services that are being
commoditized. The easier that cross-border financial service provision and establishment
become, the higher will be the loss of franchise value of financial institutions.
At the same time, deregulation and new technology can allow entities to use their brand
name to cross-sell a wide range of products, and the Internet permits new markets to be tapped at
low marginal costs. Thus well-established institutions with good technology might be able to
exploit first-mover advantages and gain significant shares of new markets or retain franchise
value. Reduced profitability might also be offset as deregulation allows institutions to diversify
their risks across geographic and product barriers.2 In addition, information technology has

24
allowed the creation, valuation, and exchange of financial instruments that unbundle and
redistribute risks among market participants, widening the scope for risk management.
Thus incumbent financial institutions might lose profitability but gain lower risk. And
existing players may have incentives to consolidate, because under current regulations, size
provides more assured access to the public safety net, and counterparties and customers may
perceive such financial institutions as being too big too fail. Stability issues are thus not just
supervisory issues, but require a dynamic analysis of the means and degree to which profits will
shift between financial products and among institutions.

Competition policy

Competition policy aims at ensuring general access, efficient production, and fair pricing.
Competition policy has traditionally been associated with public utilities, railways, power and
natural gas, roads, and more recently software (Microsoft). But until recently competition policy
was not viewed as critical for financial services or more broadly in the formulation of policy
relating to industries involved in information production (Kahn 1998; Dewatripoint and Tirole
1994; Baumol and others 1982; Shapiro and Varian 1999).
In the financial sector, regulations have generally tried to maintain the franchise value of
incumbent institutions while fostering competition, which might reduce this value. The main
tools of financial sector “competition” policy have been initial capital requirements, fit and
proper tests in allowing entry, capital adequacy requirements, restrictions on the structure of
ownership or activities, and extrajudicial exit procedures. Only in some areas, such as self-
regulating organizations (SROs; SROs are legally defined in some countries and their processes
and standards are subject to oversight) or pension services, has competition policy been applied
to financial services (Glaessner 1993; Bossone and Promisel 1999).
As noted, recent changes are making financial services more like other goods and
services and financial product markets more akin to nonfinancial markets. Technology is leading
to specialization in the production of financial services and the development of separate markets,
particularly wholesale markets, insulated from other financial markets. For example, these
markets deal with risk through continuous mark-to-market and collateral arrangements, reducing
the chance of systemic risk. The recent advent of straight-through processing of transactions will
further reduce operational risks and risks relating to human error.
These developments make competition policy for financial services more feasible. At the
same time, the speed of technological innovation in financial service provision—and its
associated benefits—are increasingly becoming a function of the degree to which entry by
nonfinancial and financial entities is allowed. This is making competition policy more important
but, as noted, also raises issues with respect to extension of the safety net.

25
 The need for competition policy traditionally arises from increasing economies of scale
and scope, nonexcludability in consumption of a good, sunk costs in the production or
distribution of a good, links between production and distribution networks, and existence of
network externalities. Any competition policy requires definition and analysis. For financial
services, several issues need to be clarified: what market definition to use, what constitutes
market power, what are the barriers to entry, and what are allowable ownership structures—
vertical and horizontal—within an industry. A specific issue to analyze is what are permissible
links between financial and nonfinancial institutions. And given the increased importance of new
(quasi-) financial service providers, the question arise whether such providers need to be subject
to competition policy as well.

It is increasingly hard to define products, markets, and barriers to competition. All

competition tests require a definition of the product and market. But it is getting harder to
precisely define a financial product and its market. Many traditional nonfinancial services are
taking on characteristics of financial contracts. The creation of cash equivalents, derivative
markets in weather and power (such as enermetrix.com), and other derivative contracts settled in
cash defy classification into distinct categories of financial or nonfinancial services. The
continuum from cash (notes) to stored value cards to barter-type arrangements competing not
just as cash substitutes, but also on many other dimensions, make it hard to define the concept of
payment services or even a deposit precisely.
It is obviously awkward to define barriers to entry in the provision of a service that
cannot be well defined. Moreover, market sizes are changing. Changes in the delivery modes for
retail financial services are reducing barriers to entry in many financial service areas that were
once local, making traditional market concentration measures meaningless. Many markets have
become global, rendering a geographic definition of markets more difficult. In countries such as
New Zealand and in some Latin American and Eastern European countries, foreign banks
account for more than two-thirds of the local market.
With markets going global, nontariff and nonquantity barriers have become more
important for financial services. The ability of foreign financial institutions to provide financial
services on a global basis can be hampered by differences in laws (such as differences in laws
relating to bank secrecy and “knowing the customer” provisions relating to money laundering
and fraud), regulations, and conventions. Globalization raises the threshold for such
nondiscriminatory structural barriers because they can be anticompetitive actions. But they are
not easily measurable or likely to be harmonized in the short run.
Empirical techniques may be the only way to test the contestability of a market, but it
will be difficult to find robust models for this. Global markets nonetheless call for a global
competition policy framework, or at least for increased coordination among countries’
competition policies. Furthermore, because different industries will be involved in the production

26
and delivery of financial services, regulators within and across countries will have to coordinate
how they define and assess violations of competition policy.

Scale and scope economies need not present barriers to entry. If a good or service is
subject to scale or scope economies, the resulting imperfect competition may create entry
barriers unless markets are contestable. Competition policy concerns about economies of scale
become less important as globalization expands market size. Similarly, economies of scope may
become less important as market size increases. Sunk costs are changing rapidly through
electronic delivery modes that do not rely on a branch network and are becoming less important
for a number of financial services (see Table 2). As such, sunk costs are unlikely barriers to entry
for most financial services. Sunk costs might still be important for investment advice and
corporate services, but these services are increasingly subject to global competition.
In some product markets, network externalities may become important for competition
policy because they can create entry barriers once critical mass is reached, and market
participants will have strong incentives to internalize these externalities and the associated rents.
Markets involving network externalities warrant regulation to assure access and efficient
outcomes (Weinberg 1997; Shaprio and Varian 1999; Simons and Stavins 1998). Network
externalities arise especially in areas like payment services and trading systems.
For example, ATM systems in the United States started as small, private proprietary
systems, then standardized and, over time, linked up nationally without creating serious
competitive concerns. In many continental European countries, single nationwide networks with
adequate access developed as banking systems were concentrated. But in some countries
regulators had to force more open access on these networks, regulate pricing policies, limit
exclusivity agreements, and overcome incumbent (first-mover) advantage. Similarly,
governments may need to force public access on other network services, trading systems, or
electronic communication networks. Finally, in some cases governments may have a role
precisely when network externalities are difficult to internalize, as when a basic technology must
be shown to be technologically feasible. In the case of the Internet, it may not have reached
critical mass as quickly as it did without the early subsidies provided by government.

Organizational structures will affect competition. Partly because of the many network
features of financial services, much of the infrastructure of a financial system—clearing houses,
stock exchanges, credit bureaus, rating agencies—is owned by market participants. Competition
within the industry depends on the ownership and governance structures of these entities, often
called SROs or self-regulating associations (SRAs; SRAs are associations that set standards for
members that are not subject to external regulatory or supervisory oversight). There can, for
example, be advantages and disadvantages in terms of access between “mutual” and
“commercial” ownership of trading systems.

27
 The recent intention of exchanges in Australia, Hong Kong (China), the United States,
and elsewhere to de-mutualize reflects competition from new electronic exchanges as well as
competition across existing exchanges and suggests disadvantages to the mutual model. In
Europe many stock exchanges have long been for-profit organizations. At the same time, trading
systems owned by a few large players may be uncompetitive because there will be a natural
incentive to limit access.
Many of these organizations are already subject to oversight by their SROs and have their
own ownership and corporate governance framework, which should help limit conflicts of
interest, depreciation of listing standards, and desires to limit competition. The knowledge that
network externalities can be realized only if exchange practices are deemed fair will discipline
any anticompetitive practices of a corporatized exchange. Still, in some markets de-
mutualization, coupled with global competition for order flow, has led to a weakening of listing
standards and to more lax surveillance than might be appropriate. Hence in Australia and Hong
Kong (China) some self-regulating functions have been reassumed by regulators. Competition
and securities regulators will continue to examine SROs and review corporate governance and
ownership in terms of access and competition. Providing incentives for private parties to avoid
such difficulties will be challenging.

Entry by nonbanks, links with banks, and vertical integration can affect competition.
Authorities have generally allowed markets and actors to proceed with little restriction, with
entry in financial services by nonfinancial entities and strategic alliances between financial and
nonfinancial entities. Entry by nonfinancial entities has increased competition, particularly in
services traditionally provided by banks. As noted, aggregators such as Lending Tree in the
United States, Advantage Mortgage in Hong Kong (China), and Dollar Dex in Singapore have
increased competition and widened access in mortgage markets. New payment services, such as
the Octopus card in Hong Kong (China), bypass banks and lower the costs and increase the
quality of services. New entities in the brokerage business have sharply lowered commissions in
many countries.
But the mixing of brand names, distribution networks, and financial services is leading to
complex ownership and alliance structures, and extensive vertical integration could undermine
competition. Links can lead to less benefits for consumers when they exploit reputation or
involve sunk-cost investment to reduce competition on price..3 Mixed conglomerate structures
can also challenge a basic principle of competition policy, the separation of content and carriage.
Some mixed conglomerates—such as a telecom company merged with a financial service
provider—will be able to control content and carriage and can limit access to networks by buyers
of services, or to suppliers that wish to access potential customers.
As long as new entry is possible in important parts of the chain or the complete chain,
these vertical links may not inhibit competition. Lack of competition may not result in higher
prices for financial services, but it could reduce product and process innovation. To ensure

28
competition and innovation, restrictions may be called for on such vertical or horizontal links. In
considering such restrictions, authorities will have to balance many issues, including the
potential risk diversification benefits of mixed conglomerates and the benefits for competition of
entry by nonfinancial entities in the financial service sector.

Consumer protection

The advent of e-finance is making consumer protection a more important function of

public policy on financial services. Consumer protection issues include security, privacy,
transparency, and investor protection. Consumer protection raises the role of standards for
consumer protection and market development reasons, as well as who can best develop and
enforce such standards.

Security risks. Because Internet transactions involve “open” systems, they are vulnerable
to interception and fraud, including access to information by unauthorized third parties. (At the
same time, electronic audit trails will permit regulators to trace transactions more easily.) A
(perceived) lack of security can, in the short run, limit the use of the Internet and other electronic
payments systems to small-denomination transactions, which do not warrant the costs and risks
of engaging in fraud.
But cryptographic techniques for ensuring transaction security are rapidly improving, and
almost fully secure for consumer transactions. Further technological developments—better
cryptographic techniques, cards with built-in chips, and other verification techniques—are
expected to soon provide the security needed for large transactions. This will thus lead to
complete electronic systems for consumer and B2B transactions. Nevertheless, not all operators
will adopt the required technology and may need to be encouraged or required to do so by
regulators as part of licensing or certification.
In some countries the laws on payment and credit transactions may not be adequate for
Internet-based financial and other transactions.4 Some countries are introducing protocols and
legal changes, including digital signatures and certification of authenticity, to assure the
authenticity of participants and legal standing (including nonrepudiation) of electronic
transactions. This will overcome many security and other risks, stimulating e-commerce and e-
finance. Further changes are no doubt necessary, because in many countries—particularly those
with civil law traditions—market participants may be unwilling to engage in electronic
transactions without third-party certification authority.

Privacy. The Internet raises many privacy issues. It has greatly simplified the collection
and sharing of credit and other data on individuals and businesses, and technology has lowered
the costs of processing and using such information for financial services. This includes the
improper sharing of information within a financial institution or conglomerate. The entry of

29
nonfinancial entities that have their own information sources on consumers (utilities, retailers)
raises additional information-sharing issues. International variations on information-sharing and
privacy and bank secrecy laws further complicate matters. Global standards and protocols that
can be credibly enforced will become increasingly necessary, not only to assure the desired
privacy, but also to allow efficient cross-border provision of financial services.

Transparency. The rapid proliferation of new products, delivery channels, and

institutions has allowed easier comparison of prices and financial products, particularly traded
securities. But the emergence of many new products and providers can reduce transparency on
the exact service being offered. Given the reluctance of consumers to pay for information on the
Internet, for example, information providers typically collect revenues indirectly, including
through referred financial transactions. This could result in less transparency and, to the extent
that referred entities are related, conflicts of interest.
To the extent that entities like portals have both an online and offline business that are not
sufficiently separate, there can be incentives not to disclose material information—or even to
provide disinformation—if doing so helps their offline business. Moreover, access to information
within financial institutions or across related entities can lead to unfair transactions and unfair
advantages because of locks on information and sharing of certain information.
An important transparency issue in capital markets, and more generally, will be
promoting the best execution and trading practices and assuring fairness. Alternative trading
systems and a greater variety of financial products may challenge the fair and efficient operation
of markets. The multitude of products and the possible fragmentation of trading systems will
make price and execution comparisons more difficult, and insiders may be able to get price and
information advantages. Solutions will have to balance the objectives of increased competition
with access and fairness. Solutions will likely vary by country and market.
In capital markets, requiring and disclosing a global limit order book may sometimes be a
solution. In other circumstances a requirement that orders are routed through a stock exchange
may be more appropriate. And in many circumstances, no single solution will suffice. For many
new infomediaries (indirectly) involved in financial service provision, disclosure requirements
and “buyer beware” notifications can be mandated. For other entities, certification or licensing
may be useful.

Investor protection. Investor protection issues will become more complicated with the
increased use of technology and the Internet. With increased cross-border transactions, a key
issue will be identifying the authorized legislative or regulatory body. Under what jurisdiction
falls a trade by an Thai investor of a London-based stock of a German-incorporated company
with its main business in Latin America executed on a trading system incorporated in
Luxembourg with computers based in the United States?

30
 Furthermore, the emergence of nontraditional financial service providers complicates the
application of investor protection mechanisms. For example, in many countries it is unclear
which agency has jurisdiction over electronic communication networks or aggregators indirectly
involved in financial services. The Internet can facilitate fraud and other criminal activity and
arbitrage of regulatory regimes and coverage. Many fly-by-night firms based in “cyber nowhere”
may take advantage of uninformed investors.
Government agencies need not directly intervene to combat these problems and should
avoid unnecessary mission creep. Regulators will mainly want to educate operators and
consumers on the various risks. This is already under way with the U.K. financial Services
Authority warning on the risks of Internet trading and the U.S. Securities and Exchange
Commission warning on day trading on the Internet. Regulators will wish to actively enforce
certain investor protections and pursue cases with high-visibility payoffs. Different approaches
will likely be required for small- and large-denomination transactions.
Regulators will also want to ensure that minimum standards for detecting fraud or
significant operational risks are in place at self-regulating organizations that administer funds to
compensate consumers against fraud, such as the SIPC [Securities Investor Protection
Corporation] fund in the United States. In addition, to the extent that market participants offer
minimum investor protection through alliances with insurance companies or others, authorities
should only be concerned that certain minimum standards are met. The increasingly global
nature of trading and financial services will require greater coordination across countries by
regulators or their equivalents.

Development and enforcement of standards. Given the evolving nature of new

technology, standards for e-commerce and e-finance are lagging market developments. Rapid
developments make it hard to assess whether issuing standards now would help or hinder market
development. Public standards could play into the market structure in unpredictable ways.
Still, there may be good reasons to establish standards at this point (aside from the
general technology standards needed for e-commerce and the Internet). A need could arise, for
example, on standards for pricing structures or limits on pricing practices in (new) payment and
other services. In addition, there may be a need to certify new infomediaries (indirectly) involved
in financial services.
There could be public goods aspects to establishing standards for Internet and e-finance
transactions to remove impediments to their further growth. Private systems or standards for e-
commerce and e-finance may not emerge, or there might be too much fragmentation with too
many standards or too little competition if proprietary standards dominate. Governments could,
after extensive consultations with the private sector, issue policy statements to help develop
industry practices, thereby nurturing the market.
Development and enforcement of standards need not be the exclusive province of the
government, but could also fall to SROs or SRAs.5 Given the international dimensions of e-

31
finance, this will have to be a global effort, differentiated by the various types of e-finance
(private retail payments, B2B transactions, and so on). These efforts will likely be complemented
by private commercial agencies—rating agencies, credit bureaus, information production firms,
new firms—that rate Internet firms. Still, there may be a role for governments to provide
guidance through standards that must be adhered to by any SRA and, in some cases, to fill gaps
left by the market. In any case, SROs and SRAs might need formal backing for their disciplinary
actions.

Global public policy

Harmonization of standards and practices. The increased ability to deliver services

across borders raises a number of issues for the harmonization of standards and practices. First is
the question of the degree to which residents will be allowed access to financial services
provided by foreign firms. While technology will allow domestic residents more flexible access
to services from anywheresuch as an insurance product from a foreign financial institution
purchased on the Internetthe ability to do so will be determined by the rules in the country in
where consumer resides.
Many countries limit the cross-border provision of financial services. They require, for
example, local establishment for foreign financial institutions to be able to solicit business
onshore. They also limit solicitation more implicitly through “know thy customer” rules that
require physical registration before services can be delivered online. These limits will be harder
to impose as the Internet extends its reach and as the location of providers becomes harder to
pinpoint, solicitation harder to define, and the definition of a financial service becomes more
complex. Such limits can then just become costly, distortive, and uncompetitive.
Regulators will have to the decide on the best approach and timing to phase out such
restrictions. A comprehensive approach would be the global equivalent to the EU approach of a
single license (passport) allowing cross-border provision with home rule regulation (Key 2000 ).
This process will take time to develop partly because there will be concern that regulatory and
supervisory systems in some countries are not sufficient to support such a system.
Second, when allowed, cross-border provision raises the issue of which country’s
standards and jurisdiction apply. As standards differ in many areasfor listing requirements,
insolvency arrangements, accounting standards, and the likeinconsistencies can easily arise,
raising transaction costs and reducing benefits. Differences can also lead to regulatory arbitrage
and raise the possibility of a race to the bottom. While standards are increasingly being
harmonizedfor example, the International Organization of Securities Commissions has just
endorsed international accounting standards proposed by the International Accounting Standard
Committeelarge differences remain.
Enforcement and legal recourse across borders can also be complicated. To some extent,
market forces will deal with the issue of legal jurisdiction because consumers of financial

32
services will prefer to deal in environments that provide them with the greatest certaintyas has
been long the case in wholesale markets, where corporations and sovereigns generally choose to
issue or cross-list in a few markets. Nevertheless, as the Internet expands the access of less
informed consumersissuers and investorsto cross-border services, investor protection and
transparency issues may arise. The “global passport approach” would assign the responsibility
for supervision to the home authority, but even with more harmonized standards, that may not be
sufficient. Short of full harmonization in regulation and supervision, regulators may need to act
within their own jurisdictions.
Increased globalization through technology requires greater coordination in many areas.
The spread of alternative trading networks across borders and the entrance of nontraditional
financial service providers, for example, can create new risks. Greater use of technology and
networks with important externalities introduces operational risks of computer breakdowns or
infiltration by hackers on a global scale. Risk safeguards across trading systems, within and
across countries, will need to be developed. Cross-margining or ex post collateral-sharing
agreements will become essential as market trading goes global and involves position taking on
many electronic exchanges. Even with safeguards in place, many new systems will have untested
market stability features, and their operators may lack experience and be subject to spillovers
from nonfinancial parts of the group anywhere in the world. Access of new systems to contingent
financing mechanisms is unclear, especially on a global basis.
In general, the links between operators and systemic risks will become harder to
understand. The Russian and Long Term Capital Management crises of 1998 surprised many.
The lines between financial and other markets will become even more blurred as trading spreads
through power, natural gas, and agricultural commodity contracts, risking greater spillovers from
nonfinancial institutions and markets to financial markets. Going forward, firms and regulators
will be pressed to respond in a timely manner to any disrupting event arising somewhere in the
world, potentially turning once- manageable situations into systemic crises. Risk safeguards will
have to be extended within countries and on a global basis, and greater information sharing will
be necessary among regulators and SROs.

Will market disturbances become more likely? E-finance and greater use of the Internet
facilitate the spread of information and misinformation, increase the speed with which
information will affect asset prices, and could raise volatility. Volatility will be compounded by
greater commoditization, which will lead to far more contracts and assets being traded. With
more trading and less risk sharing through institutions, turbulence and contagion may spread
more easily through markets, and countries may become more vulnerable to attacks on their
currency.
The Internet, with commoditized products and increased participation by less
sophisticated players, will also make it harder for firms to signal the quality of the financial

33
products they offer. These various factors may result in greater herding and volatility (Calvo and
Mendoza 1998; Agenor et al. 1999 ). Herding could also increase prospects for contagion.
These risks can be exacerbated by the fact that e-finance will make it harder to use capital
account restrictions to limit capital flows. Capital account controls require definitions of
financial transactions by nature, country of origin and destination, and underlying parties—
definitions that will be difficult to form and implement in e-finance. Capital account transactions
will result from the purchase or sale of financial instruments that did not used to be part of
capital account movements, which could make capital flows more volatile. An implication for
the international financial architecture is a need to strengthen financial systems, regulation, and
supervision along with tax collection and enforcement.
In addition, e-finance and the potentially much larger and more fragmented number of
creditors can complicate problems of coordinating actions prior to or during a financial crisis—
particularly in emerging markets, where coordinating mechanisms are less developed. The
increased number of investors will make a “bailing in” policy much harder to enforce because of
issues related to the calculation of burdens and loss sharing. Ex ante rules of the game and global
contingency plans will become more important.
These risks are not new, and some have existed without direct consequences on financial
stability and without a direct public policy response. Reasonable policy solutions have been
elusive, regulation can stifle innovation and development, and market solutions may emerge.
Information asymmetries in reputation and quality might be overcome by links between existing
and new players, which could lead to a few firms with established names dominating certain
markets. SRAs and SROs may help avoid market disturbances.
Another private solution may be emergence of private clearing houses for Internet
transactions. Because market participants will find it increasingly difficult to assess the credit
and operational risks of counterparts, there will be a tendency to channel transactions through
fully collateralized intermediaries or special-purpose banks. This could reduce credit risks and
coordination problems (Solomon 1999; McAndrews 1997).
Short of a global approach to cross-border provision (such as a global passport with home
rule regulation and supervision), regulators may, apart from fit and proper and financial tests,
require applicants to demonstrate their commitment to the market. This can mean that there are
preferred modes of entry, such as subsidiaries over branches. The provision of some financial
services may be conditioned on presence or some other pre-commitment mechanism. There may,
for example, be a need for bonding mechanisms, not unlike those used in some insurance
markets, where insurers have to contribute to an indemnity fund before being able to offer
insurance policies.

Impact on Developing Countries

34
Many advances in payment and financial services are starting to affect developing countries. In
these markets the efficiency and quality of financial services lag what the Internet can offer. The
limited penetration and skewed profile (income distribution, education, technical skills,
demographics) of typical users of financial services in developing countries favor online
accounts. Still, Internet penetration has grown rapidly in many developing countries—especially
in Latin America and parts of East Asia.
The degree to which emerging markets will be able to adopt Internet technologies will
depend on their telecommunications infrastructure. Access to the Internet is much less in
emerging markets than in developed countries (Table 5). Reforms to make telecommunications
more competitive deserve priority.

Table 5. Internet Banking in Various Countries and Access to Telecommunications

Country % of Banks % of Banks’ % of Computers
Offering Online Customers Inhabitants with IP Address
Banking Using Online with Mobile Connected to
Banking Phones the Internet,
per 10,000
People
The Americas
U.S. 63 4 26 975
Mexico <10 <1 3 9
Argentina 4 3 8 16
Brazil <50 5 5 10
Europe
United Kingdom 50 2 25 202
Austria 75 4 28 163
Switzerland 75 5 24 289
Denmark 60 5-10 36 359
Finland 85 29 57 996
Sweden 90 11 46 430
Germany 60 2 17 141
Spain/Portugal 90 <2 18/31 62/45
Italy 50 1 36 56
Central Europe 35 <1
Greece 40 <1 19 38
Asia
Hong Kong 25 <2 47 108
Singapore 95 5 35 187
Korea 90 3 30 38
Malaysia 10 <1 10 18
India 10 <1 1 0
Philippines 15 <1 2 1
Taiwan 10 0 22 48
Indonesia 0 0 1 0
Thailand 0 0 3 4
Australia 90 4 29 400
Source: Credit Suisse First Boston Global Bank Team 1999; World Bank 2000b.

35
 The most immediate impacts will also differ by market. In some countries, due to limited
markets or a lack of regulatory barriers, new entry across a spectrum of financial services has
been attractive. In other emerging markets service entry has been more specialized. In several
markets, such as Korea, Internet trading and brokerage have seen rapid growth while more
traditional payment services remain dominated by local banks. In India online banking accounts
and financial services are growing rapidly, and even lower-income customers are moving online
with access provided through cybercafes.
Other markets have seen significant entry in ancillary services. Processar, a Mexican
company, has been developing an Internet-based product for certain pension services, such as
collection, account balance information, and transfer of accounts between private pension fund
administrators. Many ancillary services—credit information, accounting and audits, actuarial
data—will be made available over the Internet. The cost of credit information is falling
dramatically as information becomes available worldwide, as evidenced by the increasingly
global operations of companies like Equifax. This will reduce information barriers to prospective
investors or financial service providers.
Continued economic integration and new delivery channels for financial services, such as
wireless protocols, will increase opportunities for foreign banks to deliver financial services to
remote areas and countries, potentially even revolutionizing micro and agricultural finance.
These developments will increase the scope of financial instruments offered in emerging markets
and the venues for trading risk at lower transaction costs as in these cases of trade finance or
even traditional terms of agricultural storage finance. While a key impediment in many emerging
countries is often the lack of supporting infrastructure, such as telecommunications, changes now
under way offer many countries an opportunity to accelerate financial sector development.

Implications of e-finance for financial stability. E-finance will offer fewer choices to
economies with poorly capitalized banking systems, weak regulatory systems, and extensive
guarantees on liabilities. Options for protecting incumbent institutions will become increasingly
obsolete as consumers go offshore. To reduce the risk of financial crises, regulatory approaches
should recognize the weak governance and institutions, scarce human resources, and
concentrated ownership structures in developing countries. These shortcomings make textbook
solutions difficult and argue for simpler approaches. More entry of foreign financial institutions
will often be a more viable way forward.

New paradigm for financial sector development. E-finance will require a reassessment of
the paradigm that has been used for financial sector development. For all countries, financial
sector safety nets need to be substantially reduced, with less emphasis on prudential regulation
and supervision. For developing countries, e-finance allows much easier access to global capital
and financial service providers, which offers many potential gains, including increased financial
sector stability. As financial services are imported, the need to strengthen regulation and

36
supervision in developing countries declines. It also raises the issue of whether small,
undiversified economies should have domestic equity and debts markets and, in the extreme,
banking systems.
Finally, many countries, e-finance presents opportunities to quickly widen access to and
improve the quality of financial services, such as for consumer, small and medium-size
enterprise lending, and rural finance. Achieving these gains will require a much more intense
focus on three basic areas of reform in emerging markets: strengthening of legal framework,
improvement in key information infrastructure, and improvement in technology related
infrastructure.

37
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 Notes

1
Of 51 developed and emerging markets surveyed by the Institute of International Bankers in 1998, only China had
a “pure” separate banking system—in the sense that banks were not allowed to engage in any securities activities.
The majority (36) of countries, including all EU-countries, allowed integrated banking—that is, banks were allowed
to conduct both banking and securities business, including underwriting, dealing, and brokering all kinds of
securities within the same banking organization. In 15 countries [1 + 36 + 15 + = 52 countries; please reconcile],
financial institutions were allowed to engage—to varying degrees—in securities activities, either through a bank
parent (12) or a bank holding company structure (Institute of Institutional Bankers 1999 ).
2
Barth, Caprio, and Levine (1999) show that countries with fewer restrictions on bank operations are less likely to
face a banking crisis. Closer links between financial and nonfinancial companies spurred by technological
developments do not necessarily result in less risky banking systems (Isimbabi 1994).
3
Gual (1999 ) suggest that competition through price and variable costs leads to less concentration and lower entry
barriers relative to competition based on taking advantage of brand or reputation through investments involving sunk
costs.
4
Many countries are, however, considering legislation for the legal treatment of electronic documents, transactions,
and means of authentication (BIS 1999).
5
We do not discuss here the need to adapt legal statutes and other rules to allow financial transactions conducted in
electronic form and on the Internet to achieve the same legal status as those conducted and filed in paper form. This
has been under way for some time, as through electronic filings with the U.S. Securities and Exchange Commission,
and is also a more general issue affecting e-commerce.

44