© 2006 Thomson Business and Professional Publishing. All rights reserved. T H I R D E D I T I O N PowerPoint Presentation by Charlie Cook The University of West Alabama Banking in the Digital Age Chapter 2 Unit 1 Introduction

© 2006 Thomson Business and Professional Publishing. All rights reserved.2–2 Fundamental Issues 1.What is the difference between stored-value cards and smart cards? 2.Is digital cash less secure than physical cash? 3.What are the rationales for regulating cyberbanking? 4.Does e-money matter for monetary policy?

© 2006 Thomson Business and Professional Publishing. All rights reserved.2–3 Banking in the digital age Federal reserves processing of checks has dropped nearly 20% since Why are people writing fewer checks? Even McDonald’s takes cards now! Why? See management focus, page23.

© 2006 Thomson Business and Professional Publishing. All rights reserved.2–4 Stored-Value and Debit-Card Systems Closed stored-value system:  An e-money system in which consumers use cards containing prestored funds to buy specific goods and services offered by a single issuer of the cards. Open stored-value system:  An e-money system in which consumers buy goods and services using cards containing prestored funds that are offered by multiple card issuers and accepted by multiple retailers.

© 2006 Thomson Business and Professional Publishing. All rights reserved.2–5 Card Systems (cont’d) Debit card:  A plastic card that allows the bearer to transfer funds to a merchant’s account, provided that the bearer authorizes the transfer by providing personal identification. In essence, debit cards amount to electronic checking.

© 2006 Thomson Business and Professional Publishing. All rights reserved.2–6 A Debit-Card System Figure 2–1

© 2006 Thomson Business and Professional Publishing. All rights reserved.2–7 Card Systems (cont’d) Debit card:  Do debit card transactions happen immediately? Often the answer is no. Many are done later in the day. See the box on page 25.

© 2006 Thomson Business and Professional Publishing. All rights reserved.2–8 Total U.S.Debit-Card Transactions Figure 2–2 SOURCE: Bank for International Settlements and authors’ estimates.

© 2006 Thomson Business and Professional Publishing. All rights reserved.2–9 Smart Cards and Digital Cash Smart card:  A card containing a microprocessor that permits storage of funds via security programming, that can communicate with other computers, and that does not require online authorization for funds transfer to occur. Open smart-card system:  An e-money system in which consumers use smart cards with embedded microprocessors, which may be issued by a number of institutions, to purchase goods and services offered by multiple retailers.

© 2006 Thomson Business and Professional Publishing. All rights reserved.2–10 Digital Encryption and Electronic Payment Security Figure 2–3

© 2006 Thomson Business and Professional Publishing. All rights reserved.2–11 Digital Cash Digital cash:  Funds contained on computer software, in the form of secure algorithms, that is stored on microchips and other computer devices. Payment intermediary:  An institution that facilitates the transfer of funds between buyer and seller during the course of any purchase of goods, services, or financial assets.

© 2006 Thomson Business and Professional Publishing. All rights reserved.2–12 The Distribution of the World’s Smart Cards. Figure 2–4 The bulk of the world’s smart cards are currently held in Europe. FOR CRITICAL ANALYSIS: Why do you suppose that U.S. banks’ successes in protecting U.S. consumers from payment fraud have contributed to the relatively slow rate of smart-card adoption in the United States? SOURCE: Bank for International Settlements

© 2006 Thomson Business and Professional Publishing. All rights reserved.2–13 Smart Cards

© 2006 Thomson Business and Professional Publishing. All rights reserved.2–14 Online Banking Opportunities for banks  More deposits available to lend out at higher interest rates  Lower transaction costs  More fees from retailers who accept smart cards  Unused “spare change” remaining on cards Types of online banking services  Bill consolidation and payment  Transfer of funds among accounts (ATMs)  Initial application for loans Banks are lowering fees for online services to get more people to bank online.

© 2006 Thomson Business and Professional Publishing. All rights reserved.2–15 The Percentage of Households That Bank Online. Figure 2–5 SOURCE: Office of the Comptroller of the Currency.

© 2006 Thomson Business and Professional Publishing. All rights reserved.2–16 Online banking Possible “chicken or egg problem.” Bank customers may be waiting for more retailers to accept smart cards before using home banking, and banks are waiting for more customers to choose online banking before making huge investments in smart card technology. However, competitive pressures are forcing more banks and other firms to go online. Applying for mortgages and refinancing online is beginning to grow rapidly.

© 2006 Thomson Business and Professional Publishing. All rights reserved.2–17 Could e-money “catch a cold”? Malfunctioning money Swiping digital cash offline and online Digital counterfeiting The Security of Digital Cash

© 2006 Thomson Business and Professional Publishing. All rights reserved.2–18 Regulatory issues of Electronic Money Some people concerned with the security of e-money payments. Digital counterfeiting: could computer geeks produce their own smart cards? Could e-money be subject to various forms of online theft? Could a terrorist hacker infect smart card microprocessors with a virus? Malfunctions: E-money transactions affected by power failures and equipment problems, unlike cash.

© 2006 Thomson Business and Professional Publishing. All rights reserved.2–19 Bank Fraud: An Old Problem with a New Face “Wildcat” banks  Banknotes: privately issued paper currency.  Free-banking laws:  State laws in force between 1837 and 1861 that allowed anyone to obtain a charter authorizing banking operations. Pros and cons of cyberbanking  Web-facilitated risk taking  Innovation and regulatory enforcement limitations  See examples on pages 34-35

© 2006 Thomson Business and Professional Publishing. All rights reserved.2–20 States with Free-Banking Laws, 1837–1860 Table 2–1 SOURCE: Reprinted from A.J.Rolnick and W.E.Weber, “Inherent Instability in Banking: The Free Banking Experience,” Cato Journal 5 (Winter 1986). Their source was Hugh Rockoff, The Free Banking Era: A Re-Examination (New York: Arno Press,1975). a Michigan prohibited free banking in 1840 and allowed it again in b According to Rockoff, very little free banking was done under the laws in these states.

© 2006 Thomson Business and Professional Publishing. All rights reserved.2–21 Cyberbanking: Bank Regulation Goals 1. Maintaining depository institution liquidity.  Illiquidity: A situation in which a banking institution lacks the cash assets required to meet requests for depositor withdrawals. 2. Assuring bank solvency by limiting failures.  Insolvency: A situation in which the value of a bank’s assets falls below the value of its liabilities. 3. Promoting an efficient financial system. 4. Protecting consumers.

© 2006 Thomson Business and Professional Publishing. All rights reserved.2–22 Cyberbanking: Bank Regulation Goals Problem with these goals: there is often a tradeoff between them. Helping achieve one goal may come at the expense of achieving another. Example: high bank profits reduces the chance of bank failure, so regulators may be tempted to reduce competition to keep profits high: but this reduces the efficiency of banks and may not be seen as good to consumers. Also over-regulation of electronic technology may slow the pace of innovation and reduce efficiency of banks. However, under-regulation may encourage banks to engage in riskier practices, thus endangering consumers and their savings.

© 2006 Thomson Business and Professional Publishing. All rights reserved.2–23 Electronic Money and Monetary Policy What form?  Real money versus virtual money—does it matter?  Coins, paper, or deposits: form does not really matter, so long as people accept it and there is no change in its purchasing power. Who will issue digital cash?  Control of the total quantity of money in circulation  Traditional banking institutions  Nonbanking institutions  The Federal Reserve’s control over privately issued money in the national banking system  Digital-cash (e-money) accounts

© 2006 Thomson Business and Professional Publishing. All rights reserved.2–24 The Composition of the Quantity of Money in 1861 Figure 2–6 SOURCE: Richard H.Timberlake, Monetary Policy in the United States: An Intellectual and Institutional History (Chicago:University of Chicago Press,1993). Figure 2–7 The Composition of the Quantity of Money in 1866

© 2006 Thomson Business and Professional Publishing. All rights reserved.2–25 Notes and Deposits at State and National Banks, 1860–1868 Figure 2–8 SOURCE: Richard H.Timberlake, Monetary Policy in the United States: An Intellectual and Institutional History (Chicago:University of Chicago Press,1993). 1863