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Vol 1, No. 5
October 10, 1996

To subscribe to this monthly newletter on information technology and society, send the message "subscribe" to enodelist@garnet.berkeley.edu

-- Nathan Newman, Progressive Communications,

IT'S A WONDERFUL LIFE pictured the local banker as a fixture of the community--whether as evil oppressor like Mr.Potter or local savior like Jimmy Stewart's George Bailey. Either way, it was hard to think of the community without seeing it as a reflection of the local banks.

Those local banks are increasingly a thing of the past, done in by regulatory changes but more importantly by technology that has encouraged bigger, more national and even international banks. Electronic banking is a key part of the strategy of banks trying to go global. Part of this change is shear survival: banks have less and less a percentage of people's savings, so banks are fighting each other for every dime. The Federal Reserve has found that in the last twenty years, household financial assets deposited in interest-bearing accounts has dropped from 27.5 percent of family assets down to 16 percent. The median value of those assets has fallen substantially just in the last few years as more and more of those assets are moved into mutual funds and other investments. With mutual funds exploding from just $57 billion in 1979 to $2 trillion by 1996, banks are rushing to use new technology to hold onto their place in the financial lives of people.

Bigger banks have used technology to both slash their costs and expand their operations, usually at the expense of traditional community banks. The disappearance of the local bank branch is just the most obvious sign of the deep cost-cutting involved. Automatic teller machines were the first wave of electronic banking to begin to replace the local branch, while Internet banking is coming up fast. With alternatives costing as little as 15 percent of comparable branch transactions (and with the costs dropping quickly), banks are seeking every opportunity to push into electronic banking.

All banks are looking to cash in on to an estimated 15% of customers who, according to at least one major survey, would prefer to conduct routine banking over a computer. In 1995, 754,000 households banked by computer, according to a study performed by Jupiter Communications, a New York consulting firm. They project that as many as 13 million households will be banking from home by the year 2000.

If any entrant into Internet banking shows the promise (or the threat) of banking without geography, its the appearance in 1995 of Security First Network Bank (SFNB), the first independent bank with no physical branches doing all business electronically. The creation of an otherwise obscure Savings & Loan from Kentucky in October 1995, SFNB built on a collaboration with Hewlett- Packard to launch the bank and a software subsidiary, Five Paces, to sell Internet-banking software to other banks. Within months, SFNB had a few hundred customers which grew to 4000 customers in all fifty states who had opened checking accounts by August 1996. An initial $100 deposit gets a customer an ATM card or a VISA debit card and the ability to check balances any time on Security First's home page on the World Wide Web. By the end of 1996, SFNB will be offering customers on-line discount stock brokerage and insurance services and even a few physical branches around the country. With $44.6 million in assets, SFNB is obviously not a big player yet but its success is a threat to more established banks.

And nowhere is that threat felt more than in northern California where a majority of Security First's initial customers have come, showing clearly that while the Internet is global, the Bay Area is where everything seems to break ground first. Wells Fargo and Bank of America, the largest banks in the region, have suddenly realized that their traditional regional territory is under threat from banks that can reach their traditional customers from anywhere over the Internet. Mack Hicks, a Vice President at Bank of America, sees the Internet ending the relevancy of economic regions, especially for banks: "In an industrial society, cities were appropriate because of the regional nature of business and the delivery of services, in the information age there is no boundary for the delivery of services so there is no reason for regions. You want to compete in the international region."

Bank of America has established an Internet home banking service allowing balance queries, account info, bill payment and funds transfer. Their rival Wells Fargo has been much more aggressive. Hicks notes that Wells Fargo has been using the Internet to transform itself from being a large regional bank into a major international player: "They can put up a good Web site and give new strategies and services that give them an international presence with no cost for brick and mortar. You don't have to open a branch in London and New York with the new technology."

As electronic commerce expands, paper is sucked out of the banking system, taking away most traditional fees earned by banks for dealing with those paper checks. The migration to debit and smart cards, electronic cash wallets and electronic bill presentment bypasses most of the points where local banks collect any fee, leaving them scrambling for a role. Argues Ira Morrow, research director of Stamford, CT-based Gartner Group, "Many [banks] make a nice tidy fee-based business operating lock boxes. If there's no check and no bill and no reconciliation, there's no lock box." Larger banks with corporate customers see the key to adaptation as changing their focus to new services that integrate customer's overall cash management. Wells Fargo highlights its combining of electronic bill payment with managing companies receivables process. Vince Hruska, Wells Fargo Vice President and manager of electronic commerce products, argues that larger banks can deliver this broad range of corporate financial services, "I'm the person that can deliver that to the company," says Hruska.

Even in core areas of loans, smaller banks are losing out to bigger national banks as new technology cuts out the need for local intermediaries. Home mortgages are increasingly based on national lending criterion determined and managed by central banking institutions like Fannie Mae and Freddie Mac. Using an infrastructure of fast computers, data base software and high speed communication networks, new "data mining" techniques allow lenders to manage data to identify key patterns and relationships in customer data to determine whether loans should be granted. All of these technologies require technical and statistical sophistication that small banks cannot afford. And as on-line networks strengthen, any intermediary between customers and the ultimate loan approver could be subject to elimination.

Home mortgages have been moving towards centralization for the last decade and a half but even more significant for regional economies is the recent emergence of a national loan market for small business loans--once the quintessential part of local economic development decision-making. Until just a few years ago, large institutions had little advantage in loaning to small business; each loan was evaluated based on business plans, balance sheets, cash flow and profits. There were few economies of scale. Because of the uncertainty of small business survival, the assumption was that only local banks had any chance of betting on the right loans, so local bankers with knowledge of an area had pretty much free reign in the area of small business lending.

Computer technology has changed all that as small business loans have begun to be evaluated using the same statistical methods as individual consumer loans. Using a system known as credit scoring, lenders no longer perform detailed financial reviews of each borrower. Instead, they use a few key pieces of information to predict the probability that a borrower will repay, then offer the loan to those deemed worth taking a risk on. The cost of processing each small business loan thereby drops from thousands of dollars to merely a few hundred, opening the way to apply mass market techniques to these loans.

Big banks are displacing community banks in this game for two reasons. First, the costs of the computers, software and databases involved in this new system are far beyond the resources of most small banks. "The capital cost is significant, and if you are not doing volume, you can't recover it," notes BankAmerica small business lending chief Janet Garufis. In that sense, the balance of power is tilting toward large regional or national lenders.

Wells Fargo is one bank pioneering the development of an in- house system to give it a dominant edge over rivals. Using data collected on its own customers as a guide to its evaluation of data to predict losses, it began expanding the database as it expanded small business loans in California beginning in 1991. This was combined with increasing technology in back-office operations to reduce paper and drive costs down. "We engineered out the number of times a human hand touches a loan," says executive vice president Lucy Reid, who heads the bank's national small business direct marketing program. Within California, the results were spectacular. In 1989, Wells had only 1% of all small business loans held by California banks. By 1995, Wells had more than 16% of all small business loans.

By 1994, Wells Fargo was ready to go national using direct marketing techniques to attract customers outside California. By 1995, five million small business loan solicitations were mailed nationally. Outside of California, Wells concentrated solely on loans under $100,000 using credit scoring to sort potential customers into eight risk categories with different loan rates offered to each group. By June 1995, total commercial loans under $1 million at Wells had jumped to 117,392; that year, Wells earned a stellar 32% return on equity in its small business credit portfolio.

Smaller banks are being squeezed not only because they can't afford to invest in the computer technology and in-house databases, but also because they just aren't big enough to treat loans as large as $100,000 as statistics that can repay or default based on probability tables. David Payne, chief executive of $2.4-billion-asset Westamerica Bancorp. in San Rafael, CA, argues "I have to look at each deal to repay as agreed." Local knowledge of the economy is no longer the competitive advantage it once was for local banks as low cost, mass market loans become possible due to the new computer technology. Big banks end up with the advantage as they can average out good and bad returns over a much broader capital base.

Direct mail, telemarketing and now Internet marketing such loans nationwide to small business is replacing the local community bank as the source of small capital. And as the confidence of the mega banks grow using these computerized techniques, they are moving towards targetting larger business loans, further threatening community banks. All of these changes are undermining traditions that linked local businesses and local capital in a shared fate in the growth of their region. As capital nationalizes, local businesses will be able to find loans irregardless of the health of local banks, while local banks will no longer have to depend on growth in their local region to find places to invest their capital.

For the rest of us, this opens up new services if we are deemed to be good customers by the credit-rating computers but for the rest of society, the danger is a new form of electronic redlining as they become invisible to the marketing thrust of these international banks. With banks having a national and even international focus for business, no banks will see a particular region as their domain or responsibility. Local communities once had some political hold on local banks (through tools like the Community Reinvestment Act), but in the age of the megabank, they are finding that those tools are increasingly impotent. With the disappearance of specifically local capital, the threads that bind the economic life of rich and poor within regions are loosening even more.

ENODE: to loose, untie a knot; to solve a riddle.

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