The role of information technology in the profit and cost efficiency improvements of the banking sector.

ABSTRACT

Information technology has tremendously stimulated expansion of the banking networks and range of the offered services during recent years. This paper examines the impact of the progress in information technology on the profit and cost efficiencies of the U.S. banking sector during the period of 1992-2003. We test relationships between the level of implemented technology and the banks efficiency. The research shows a positive correlation between the level of implemented IT and both, assets profitability and cost savings. Although for all US banks the efficiency has increased, the improvements of the cost efficiency were relatively much smaller than in the case of profit efficiency. These results indicate that introduction of the new range of services at a bank, on one hand, generate additional revenues, but, on the other hand, imply new, significant cost charges. This means, broadening the range of the banking services may lead, at some point, to a very strong increase of cost of their processing, what put in question possibility to achieve economy of scale by banks conducting such type of banking.

Keywords: Banking, Banking Technology, Banking Efficiency

1. INTRODUCTION

All banking services, as electronic payments, loans, deposits, or securities have become heavily dependable on information and telecommunication technology. This is the main reason why banks are the biggest users of IT equipment. Due to the complexity of banking services, every opportunity to speed up their performance or to make them more accessible for customers is very well welcomed by banks. However with improvements of the quality of services, the important question appears if this process can provide the economic value for banks? Unfortunately not every increase in the customers satisfaction transfers into the higher bank profits, especially in the case of very expensive investments in IT and telecommunication equipment. This research on the effect of the IT progress on the level of the banking efficiency may help to understand how investments in technology should be structured and what economic results should banks expect.

The analysis of banking performance, with regards to the role of IT, faces a challenging issue of the definition of the level of the technology progress. Among many IT intensive banking services, derivatives require huge investments in hardware and software. With developments in IT more banks introduce these services for their customers, making them standard activities. Such features of derivatives and regularity of their application persuaded us to make the ratio of derivatives over average assets a measure for the level of the total IT utilization in banks.

Structural changes of the banking sector and increasing networks of offices are the areas where information technology may be fully implemented and stimulate creation of new generations of banking software. Technological progress has enabled to implement deregulation of the banking sector, removing barriers in intra- and interstate banking and branching, granting them more flexibility in terms of introducing new services, which predominantly took place in the 1980s and 1990s. Although every banking operation requires some IT applications, researches vary on the subject of the relationship between the level of employed hardware and software, and the value of the banking efficiency increase. All researchers agree on the importance of IT for the further developments of the banking industry, but some of them have found lack of proportionality between the increase in the scale of IT utilization and the increase in banks profitability (Thakor, 1999; Olazabal, 2002). We have addressed this problem testing correlation of the level of IT progress and assets profitability--ROA, and cost efficiency [C.sub.eff] for the U.S. banking sector for the period of 1992-2003. To compute relationships between these variables regression line program and correlation were applied.

The paper is organized as follows. Section 2 presents the background information how recent IT developments have reshaped banking services. Section 3 discuses the consequences of technological progress for the growth of the U.S. banks efficiency. Section 4 summarizes the literature and empirical studies and concludes.

2. THE EFFECT OF TECHNOLOGICAL INNOVATION ON THE BANKING INDUSTRY

Intensive transformation of the U.S. banking sector has been started in the first half of the 1980s and was intensified during the decade of the 1990s. Developments in IT and deregulation of interstate and intrastate banking and branching effected with a strong concentration of the U.S. banking industry. The process resulted in the gigantic reduction of the number of banks. However, at the same time, banking restructuring has broadened the range of banking services and increased the number of branches, making banking networks nation- and even worldwide (Table 1). Additionally, the period of IT developments and banking deregulation was associated with serious restructuring of the U.S. economy. National and international transfer of securities, goods, and services in such environment have created demand for currency, deposits, loans, and other new services by international financial institutions, contributing to development of the range of banking services and new channels of their distribution.

New IT--related services can be distinguished into four main categories (Berger, 2003):

* Internet banking,

* Electronic payments,

* Security investments,

* Information exchanges.

Internet banking--Most of the commercial banks allow customers to perform transactions through the web site. They may range from checking the account balance through transferring funds to loan applications. As of the end of 2000, 37.3 percent of national banks provided transactional web sites, and another 27.7 percent of these institutions offered informational web sites (Furst, Lang, and Nicole, 2000). The level of Internet services differs by the size of banks. The largest banks, with assets of the value exceeding US $10 billion, are fully equipped in transactional web sites, while only 20 percent of the smallest banks of the asset value below US $100 million provide such web sites.

Rather small number of banks, called Internet-only banks, offers services exclusively through interactive web sites with access to the ATM network. Split opinions exist about efficiency of such banks. In March 2002, FDIC reported operations of 20 Internet-only banks in the USA. However, around twelve of such banks have been recently dissolved due to their poor performance (Berger, Demsetz, and Strahan, 1999). Some studies also indicate very inefficient performance of small newly established Internet-only institutions with less than three-year experience. The research on the novo banks showed that completely new traditional banks achieved much better financial results than Internet--only banks (DeYoung 2002).

Electronic payments--the main new forms of electronic payment are: smart cards and software-based products making payment over the Internet (Arbussa Reixach, 2001). They allow obtaining cost savings due to less work-intensive operations and paper-documentations. Increasingly popularity of electronic payments caused reduction of the share of check payments in the total number of payment transactions from 85.8 percent in 1990 to 66.9 percent in 2002, with prediction of 49.2 percent in 2005 (US Census Bureau). At the same time the share of card payments 14.4 percent to 30.7 percent, and the number of credit card transactions has grown from 10.4 billion to 21.2 billion, with prediction of 24.4 billion for 2005. Additionally the number of credit cards transactions has risen extremely rapidly from 0.3 billion to 13.3 billion, with predicted growth to 22.7 billion in 2005 These numbers indicate the growing importance of the payment services made with debit cards, primary used at ATMs and POS (Point of Sales). To serve a larger group of customers, banks are constantly shifting their location out of branches toward supermarkets and other commercial facilities. According to American Bankers Association the share of off-branch ATMs has grown from 25.4 percent in 1994 to 64.2 percent in 2003 (Table 1). ABA states that the total number of ATM transactions grew from 7.7 billion in 1993 to 10.8 billion in 2003. Among the U.S. banks, there are four of them, which have developed very extensive ATM networks: Bank of America (14,200 ATMs), American Express (7,100), U.S. Bancorp (6,663), and Wells Fargo (6,353).

Another element of the electronic payment system is an automated clearinghouse (ACH). The ACH is the paperless-entry facility that acts on behalf of local, regional, or national association of commercial banks to make direct deposits and preauthorized payments (Mote and Wilcox, 2002). The first ACH was established in California in 1972. However, the ACH payments processed by the Federal Reserve have more than quadrupled from 915 million in 1990 to 3.8 billion in 2000.

Security investments--the IT progress and deregulation of the banking industry were foundations for new, very sophisticated investment services, among them derivative securities. The character of these securities is based on the idea of deriving the value from another underlying security or asset, such as: foreign currencies, interest rates, equities, commodities, and credits. The most common examples of derivative securities are: options, futures, swaps, structured note. Banks have engaged in derivatives markets very substantially in recent years. The total amount of these contracts at the U.S. banks grew from US $8,765 billion in 1992 to US $71,366 billion in 2003; it means more than eight times bigger. Additionally, in 2003 for all commercial banks the total value of derivatives was 9.73 times bigger than the value of average assets. Considering the importance of these services for the incomes and profitability of the banking sector, we have chosen the [IT.sub.est] ratio, defined as derivatives over assets as a measure of the level of IT developments in the banking sector (Table 1).

Information exchanges--they are institutions used by banks and other creditors to share data relevant to the creditworthiness of loan applicants. They collect available data from various financial institutions, trade creditors, any public records, and other sources and next aggregate them to provide credit reports and credit scores. They may operate as pubic or private entities. Information exchanges are extremely IT driven organizations, and running huge number of records may achieve economy of scale.

3. EFFECT OF TECHNOLOGY ON THE EFFICIENCY OF THE BANKING SECTOR

IT developments affect operations of banking organizations in at least four different ways. (1) IT enables banks to start new depositary services, such as call centers, ATMs, and Internet banking, which give more opportunities to achieve economies of scale, and fewer diseconomies, rather then the same depository services provided through traditional branching networks (Radecki, Wenninger, and Orlow, 1996). In similar way, some wholesale IT-driven products, such as securitization, derivatives, and other off-balance activities are more efficiently provided by large banks, constituting their dominance in the markets of these products. (2) Technological progress causes innovations in producing new banking services that are subject to greater scale economies or fewer diseconomies than the existing technologies, what particularly important for electronic payments and credit scoring services. (3) Advances in IT allow large banks to control investment risks more efficiently than small banks. Well IT--equipped credit risk departments of large banks are able to make riskier, but with highly-expected return investments, improve access to uninsured funding, and save on costly equity capital. (4) Another advantage of the IT progress may come from reduction of managerial diseconomies of scale. IT advances improve monitoring and control within large banks better than within small banks. These technologies may make it easier for managers of large, multi-branch banks to monitor the behavior of their staff, reducing agency problems. Some research based on data from the early and mid-1990s suggest existence of substantial scale efficiency gains from larger sizes and that these economies may have continued increasing during the next years (Berger and Mester, 1997, and Stiroh, 2000).

Developments in IT may also facilitate improvements of revenue efficiencies. Efficient information and telecommunication devices allowed banks to facilitate mergers and acquisitions, extend their office network, and broaden the range of services. As a result, over the period of 1992-2001 the U.S. banking sector experienced a significant concentration of assets; it means the share of top 10 U.S. banks grew from 24% in 1992 to 40% in 2001. Additionally IT developments helped to increase efficiency of banks, improving profitability of their assets (Kozak and Kowalski, 2005). Another study has shown improvements of banks profits resulted from the increase of the number of operations due to utilization of modern technological banking equipment. Bigger capacities of information and telecommunication systems laid foundation for new services or quality improvement of existing one, increasing revenues at the same time. IT contributed to the growth of revenue by improving the risk assessment procedures applied in lending and investment processes. Banks benefited from lower potential losses and higher rates of returns on investments (Berger, Humphrey, and Pulley 1996).

To test the problem how the IT progress impacts the efficiency of the banking industry we have chosen the period of 1992-2003. At that time state and federal banking authorities allowed banks to enter new areas of financial services and eliminated barriers of intra- and interstate banking and branching resulting in extensive networks of banking office and ATMs. Additionally, due to rapid IT developments, banks expanded the range of offered services, adding for example: derivatives or loan securitization, and utilized the Internet as a new channel of services distribution and manage office networks.

Taking into account the growing importance of derivatives for banking operations and revenues, we have chosen the ratio, [I.sub.Test] defined as the derivatives divided by the average assets as the estimation of the level of technology progress of the particular group of banks. Values of derivatives and average assets have been obtained from the Federal Deposit Insurance Corporation, Statistics on Depository Institutions. According to FDIC derivatives represent the sum of the following: credit derivatives, interest-rate contracts (as defined as the notional value of interest-rate swap, futures, forward and option contracts), foreign-exchange-rate contracts, commodity contracts and equity contracts (defined similarly to interest-rate contracts). Average assets represent an annual, year-to-date average of banking assets. The values of IT coefficient were calculated quarterly.

To get a full view of trends in efficiency of the bank performance we have chosen coefficients describing, both profitability and cost efficiency. To assess profit efficiency we took the ROA ratio (return on assets: i.e. net income after taxes and extraordinary items (annualized) as a percent of average total assets). This coefficient is the crucial indicator for the evaluation of the bank performance and represents ability of the bank to generate profits from controlled assets. To measure cost efficiency of banks we have chosen the [C.sub.eff] ratio (efficiency ratio, i.e. non-interest expense, less the amortization expense of intangible assets, as a percent of the sum of net interest income and non-interest income). This factor shows the level of non-interest costs (labor cost, operation cost, and others), which banks have to cover to generate their interest and non-interest incomes. Lower values of this ratio indicate better performance of the bank; it means reduction of operational costs by the bank. Table 1 presents the values of these coefficients for the U.S. banks, as of the end of each year over the examined period.

Analyzing the values of ROA and [C.sub.eff] over the period of 1992-2003 we have found out that the value of the return on assets for the U.S, banking sector has increased by 51 percent. This result suggests that IT improvements, associated with extensive office networks and range of offered services have helped to generate additional revenues for banks. For the same period much smaller reduction of the non-interest costs has been achieved, it means the value of cost efficiency [C.sub.eff] fell by 13 percent. This means that huge number of diverse operations require higher IT investments and additional non-interest charges.

In order to asses relationships between the degree of the IT progress, and the profitability (ROA) and cost efficiency ([C.sub.eff]) we have used the regression analysis. To achieve more precise statistical results, for these calculations we have used quarterly values of ROA, and [C.sub.eff] obtained from FDIC. We have come up to the following regression equations and correlation coefficients:

* Return on assets, ROA versus IT progress:

     ROA = 0.00948 + 0.00046 x    Correlation coefficient:
      [IT.sub.est]                  0.7595

* Cost efficiency, [C.sub.eff] versus IT progress:

     [C.sub.eff]= 0.67874 -       Correlation coefficient:
       0.01378 x [IT.sub.est]       -0.9139

Figures 1 presents linear graphs of changes of profitability and cost efficiency due to IT improvements for the U.S. banking sector for the period of 1992-2003.

[FIGURE 1 OMITTED]

4. CONCLUSIONS

In this paper we examine the effect of the IT progress on the level of profit and cost efficiency of the U.S. banking industry, over the period of 1992-2003. The research provides the following findings:

1. Advances in the information and telecommunication technology were the base for invention of new services and improvements of existing one. The main categories of these products are: Internet banking, electronic payments, investment securities, and information exchanges. New offers provide significant amount of incomes for banks and convenience for their customers. However, on the other side, they require higher investments and generate higher operating costs. The largest banks were the biggest recipients of ICT. They introduced the broadest range of technology-related services. Top U.S. banks (Bank of America, Wells Fargo, Citibank, U.S. Bancorp and others) were the biggest ATM owners, leaders in the Internet banking, and in offering derivative securities.

2. Comparing values of correlation coefficients between the IT developments and efficiency of banks we have found out that technology had a positive impact and was positively correlated with profit efficiency of all U.S. banks (correlation coefficient of 0.7595). At the same time for cost side, we have found out a negative correlation between the level of IT implementation and cost efficiency of banks (correlation coefficient of -0.9139). Negative sign of the correlation means, that with higher commitment to the technology banks can manage to reduce operating costs (labor, amortization, etc).

3. Although IT progress in positive way influences both, profit and cost effectiveness of banks, the changes of the values of ROA and [C.sub.eff] over the period of 1992-2003 have shown a better banks ability to generate additional profits (increase of 51%) then to reduce non-interest costs (reduction of 13%). This observation suggests that intensive technological applications implemented, predominantly by the largest banks, have enabled them to take advantage of the broader range of services, and a larger office and ATM networks to generate higher profits from their assets, however they could not reduce costs of such expansion at the same rate. This puts in question possibility to achieve economy of scale by the largest banks.

REFERENCES:

Arbussa Reixach, A., The Effect of Information and Communication Technologies on the Bankinq Sector and the Payment System, Ph.D. Thesis, University de Girona, Spain, 2001, retrieved on April 11, 2005 from http://www.tdx.cesca.es/TESIS UdG/AVAILABLE/TDX-1120101-181822//taar.pdf.

Berger, A. N., "The Economic Effects of Technological Progress: Evidence from the Banking Industry", Journal of Money, Credit, Banking, Vol. 35 (2), 2003, 141-176.

Berger, A. N., Demsetz, R. S., Strahan, P. E., "The consolidation of the financial services industry: Causes, consequences, and implications for the future", Journal of Banking and Finance, Vol. 23, 1999, 135-194.

Berger, A. N., Humphrey, D. B., and Pulley, L. B., "Do Consumers Pay for One-Stop Banking? Evidence from an Alternative Revenue Function", Journal of Banking and Finance, Vol. 20, 1996, 1601-21.

Berger, A. N., and Mester, L. J., "Efficiency and Productivity Trends in the U.S. Commercial Banking Industry: A Comparison of the 1980's and 1990's", Working Paper CSLS Conference on Service Sector Productivity and Productivity Paradox, Ottawa, April 11-12, 1997.

Berger, A. N., and Mester, L. J., "Inside the Black Box: What Explains Differences in the Efficiencies of Financial Institutions?", Journal of Banking and Finance, Vol. 21, 1997, 895-947.

DeYoung, R., Hunter, W. C., and Udell G. F., "Whither the community bank? relationship finance in the information age", Chicago Fed Letter, No. 178, 2002.

Furst, K., Lang, W. W., and Nicole, D. E., "Who Offers Internet Banking", Quarterly Journal, Vol. 19 (2), 2000, 29-48.

Kozak, S. J. and Kowalski, K. X., "Effect of Technology on Consolidation Level and Efficiency of Banking System", Proceedings of the International Conference on Information and Communication Technology in Management ICTM-2005, May 23-25, 2005, Melaka, Malaysia.

Olazabal, N. G., "Banking: The IT paradox: Despite much higher IT outlays by the retail-banking industry, its labor productivity growth rates have actually dropped. What went wrong?", The McKensey Quarterly, No. 1,2002, 47-51.

Radecki, L. J., Wenninger, J., and Orlow, D. K., "Bank branches in supermarkets", Current Issues in Economics and Finance--Federal Reserve Bank of New York, Vol. 2, 1996, 13.

Stiroh, K. J., "How Did Bank Holding Companies Prosper in the 1990s?", Journal of Banking and Finance Vol. 24, 2000, 1703-1745.

Thakor, A. V., "Information technology and financial services consolidation", Journal of Banking and Finance, Vol. 23, 1999, 697-700.

Statistical Abstract of the United States: Editions: 2000, 2001, 2002, 2003, and 2004-2005, U.S. Census Bureau, April 2005 from http://www.census.gov/prod/www/statistical-abstract-04.html

Mohammad Eyadat, California State University-Dominguez Hills, Carson, CA, USA Sylvester J. Kozak, National Bank of Poland-on leave, Polish Consulate General, Los Angeles, CA, USA

Dr. Mohammad Eyadat earned his Ph.D. at the Claremont Graduate University, CA. Currently he is a faculty member of CIS department at California State University, Dominguez Hills.

Dr. Sylwester J. Kozak earned his Ph.D. in economics at the Technical University in Radom, Poland in 2004. Currently he is serving as a commercial consul at the Consulate General of Poland in Los Angeles, CA. In his research he specializes on the domestic and international consolidation of the banking industry and its impact on profit and cost efficiency, and prices at banks.

TABLE 1: STRUCTURE, IT UTILIZATION, AND EFFICIENCY OF THE U.S.
BANKING SECTOR, 1992-2003

Year   Average Assets   Number of   Number of   Number of
        (in US $ mn)      banks     branches     ATMs (1)

1992     3,430,654       11,466      51,935       87,330
1993     3,580,097       10,960      52,868       94,822
1994     3,876,446       10,452      55,145      109,080
1995     4,159,923        9,942      56,512      122,706
1996     4,399,809        9,530      57,789      139,134
1997     4,800,592        9,143      60,325      165,000
1998     5,213,168        8,774      61,957      187,000
1999     5,478,199        8,581      63,684      227,000
2000     5,982,052        8,315      64,079      273,000
2001     6,412,148        8,080      65,564      324,000
2002     6,756,759        7,888      66,185      352,000
2003     7,333,139        7,770      67,390      371,000

Year    [IT.sub.est]     ROA in    [C.sub.eff]
            (2)            (%)       in (%)

1992        2.55          0.93        64.68
1993        3.32          1.20        63.85
1994        4.07          1.15        63.44
1995        4.13          1.17        61.76
1996        4.61          1.19        60.80
1997        5.29          1.23        59.14
1998        6.40          1.14        61.02
1999        6.37          1.32        58.73
2000        6.81          1.18        58.56
2001        7.09          1.15        57.89
2002        8.35          1.30        55.89
2003        9.73          1.40        56.46

Source: Federal Deposit Insurance Corporation,

(1) American Bankers Association, Retrieved on April 11, 2005 from
http://aba.com/NR/rdonlyres/80468400-4225-11D4-AAE6-00508B95258D/
34469/ATMfacts.pdf

(2) Authors' calculation based on the data from Federal Deposit
Insurance Corporation