As recently as a year ago, ceos of banks, brokerage firms, and insurance companies worried mostly about competition within their own industries. Today, however, personal financial services providers see themselves pitted against a whole set of new players: information, software, electronic payment, transaction processing, and multimedia companies. Microsoft, First Data Corporation, ADP, and AT&T are poised to become major financial institutions. Dozens of alliances have been struck between credit card companies, banks, software houses, and other information businesses. A slew of entrepreneurial startups—including Mondex, First Virtual, DigiCash, and CyberCash—have emerged to provide financial services and electronic payments.

Bill Gates, Microsoft’s CEO, is now talking about the future of electronic banking in his industry speeches, and recently followed up his words by attempting to buy Intuit for $2 billion. With 7 million users, this 12-year-old software firm has more customers than all but a handful of US financial institutions.

Traditional financial institutions are beginning to sense the threat. Many have struggled to adapt delivery systems that are difficult for both themselves and customers to access; to transform costly and cumbersome business processes; and to increase their limited resources and reach more customers through alliances. Many industry leaders are now wondering, however, whether their efforts have gone far enough, and are asking:

• How will multimedia play out for us?
• What pace of change is appropriate?
• Is it better to attack or defend?
• Who are the likely winners?
• Where will the money be made?
• How should we reshape our company culture?

These are tough questions. As in all multimedia, how quickly things will change and how they will end up are impossible to predict. Yet despite the uncertainty, key factors—current technology, evolving consumer preferences, and the cost advantages of interactive and electronic transactions—indicate that the new multimedia competitors will transform the way in which financial services are delivered to consumers. And they will do so soon.

The new financial institutions will be especially attractive to younger, more affluent customers

The new financial institutions that are evolving will have delivery economics far superior to those of existing retail banks, as well as offering consumers much greater convenience. They will be especially attractive to younger and more affluent customers. With strengths like these, they pose a real threat to traditional financial institutions. In response, banks and other established providers will have to transform their branch-based delivery systems and at the same time make investments and build skills in order to compete against these powerful new entrants.

What is a multimedia bank?

A multimedia bank looks nothing like a traditional financial institution. It need have neither branches nor tellers (although it might choose to set up low-cost "microbranches" in busy locations to handle customers who want personal service or advice). It gives consumers easy access to a wide variety of financial services—credit cards, bill payment, insurance, investments, and brokerage—in a single integrated account. It offers products from many different providers: a bond fund from Fidelity, a credit card from Visa, a mortgage from Countrywide.

Customers communicate with the multimedia bank through a range of devices including phones, PCs, faxes, and ATMs. All the information in their accounts is automatically downloaded and updated in real time as transactions take place.

The advantages over conventional banking are numerous. Clearly, multimedia banking offers customers real convenience. It also gives financial institutions the opportunity to use information residing in the new integrated accounts to carry out highly tailored marketing. But the most compelling—and least understood—advantage derives from cost.

Traditional banks and financial institutions suffer from burdensome delivery systems based on brick and mortar branches and paper. With these systems, many customers—those who carry out many transactions, but keep low balances—are unprofitable. Old-fashioned banks also stick to mass-market approaches that allow little differentiation in service or pricing.

The multimedia bank, on the other hand, will avoid both the expense of physical branches and, in the long run, the processing costs associated with paper transactions. By carefully targeting its customers and service offerings, a phone-based direct bank can secure a 30 to 40 percent cost advantage over traditional banks, thus redefining cost-effectiveness for the entire industry (see Exhibit 1). The savings come from three sources:

A smaller, leaner staff with a greater focus on marketing. To serve a customer base of one million, a multimedia bank will have a total headcount of 2,000, compared with approximately 3,000 to 3,500 for a traditional bank. Despite paying higher wages to its more skilled employees, the multimedia bank will have a total salary bill less than half that of its conventional rival.

Occupancy costs that are 80 percent lower than for a traditional institution. The multimedia bank will have centralized customer servicing and processing centers located in low-rent areas, in direct contrast to the geographically dispersed retail bank operating a high-cost branch network largely in urban areas.

Lower transaction processing costs, due to the lower volume of cash, checks, and personal transactions. As technology continues to develop, the economic advantage of the multimedia bank will grow. With the introduction of electronic cash, processing costs should decline even further. Through its emphasis on electronic payment, the multimedia bank will also acquire many opportunities to capitalize on information. While checks offer few details about a purchase beyond amount and payee, newer electronic forms of payment such as smart cards will provide details like payer ID, paying institution, itemized transaction information for expense reporting, and other information not related to the payment.

The ability to capture, integrate, and disseminate information at extremely low cost will enable highly customized marketing approaches and a flurry of new product innovation. Smart cards, for example, may be used to search out the best lending rate from among a number of providers at the time of sale. Integrated cards could allow several payment methods—debit, credit, store account—to be accessed from the same card.

Finally, the multimedia bank will reduce transaction times and expand the number of customer access options available 24 hours a day. With electronic cash, the need to visit a branch—or even an ATM—vanishes. By simply picking up a phone, users have access to transactions at any time of day, without leaving their home. Not only does the transaction itself take less time, but travel to and from a branch or ATM is eliminated.

No "wait and see"

Traditional financial services providers have typically opted to make only incremental improvements to their operations when faced with threatening trends. But this "wait and see" response can be dangerous. Banks typically take mar-ginal costs out of the branch system while focusing the bulk of marketing and other activities on supporting the branches. They make ad hoc investments in new distribution systems like phones or PCs, and participate sporadically in industry alliances and consortia without taking a clear leadership role.

Incremental improvements layer on extra costs as channels multiply and complexity rises

At first sight conservative, this approach is far more costly than it seems. It actually layers on additional costs as channels multiply and the cost of complexity rises.

Newer electronic and remote channels are certainly cheaper than physical channels; a simple transaction by a teller, for instance, costs over $1.00, compared to 25 cents for an ATM withdrawal or point-of-sale debit. Nevertheless, when electronic channels are added without any corresponding reduction in existing branches, the result is higher network costs. While ATMs in the US have proliferated from 103 in 1970 to 109,000 in 1994, branch employment has risen too—from 987,000 in 1970 to 1.76 million today.

"Wait and see" also overlooks the cost-reduction and skill-building programs required in the new environment

The "wait and see" response that prevails among traditional institutions also overlooks the cost-reduction and skill-building programs that are required to compete in the new environment. It also fails to position banks to avoid lockout as key alliances are formed and the industry consolidates.

Instead, traditional financial institutions should respond to multimedia by redesigning their entire delivery system, locking in attractive customers with remote channels while aggressively shrinking their branch infrastructure. They must build new skills and capabilities in teleservicing, interactive technologies, and database marketing, perhaps through a series of alliances. They must realign their organizations to support multimedia applications. And all these actions must be informed by a practical understanding of how multimedia will evolve in personal financial services.

Riding the waves

The transition to multimedia banking is likely to occur in three waves, each representing the point where technological capability meets consumer acceptance (Exhibit 2). From today’s vantage point, there appears to be a number of emerging themes:

• Most of the technology required to drive each wave has already been developed.
• Each wave moves from a period of immaturity, with rudimentary or limited technology at high cost, through a period of rapid acceleration of capabilities and acceptance into a mature phase, with stable technology at relatively low cost and broad consumer acceptance.
• Each wave builds on the consumer acceptance and technology trends of previous waves.
• Waves of change in the delivery of financial services are building and reinforcing changes in the delivery of all products and services.

Wave 1: ATMs and telephones

This wave is well established, so much so that many CEOs may not recognize it for the technological revolution it has actually been. Wave 1 centers around the telephone, an invention over a century old, and the ATM, about 25 years old. These technologies have created the shift to remote distribution that is just now beginning to peak.

The cumulative effects of this shift have recently become apparent. A large number of consumers are now using the telephone, ATM, and mail for the bulk of their financial affairs. In the United States, for example, over 40 percent of mutual funds are distributed via the phone and mail. Fifty-seven percent of all banking transactions take place outside the branch, 24 percent by phone and 31 percent by ATM. Nearly 20 percent of consumers visit a branch less than once a month.

The key consumer benefit in the first wave of technology is convenience of access

The key consumer benefit in this wave is convenience of access. The 24-hour availability of phone and ATM meets the needs of consumers with busy lives. In many cases, price is also a factor. Mutual funds sold direct carry no load, for instance, while those purchased through brokers have a 5 percent load. The shift to remote delivery parallels similar trends in retail merchandising, where catalog and home shopping, for example, now account for 8 to 10 percent of all US apparel sales.

A number of European banks have exploited ATM and telephone channels to launch direct banks offering a variety of remote services. These new ventures have adopted one of two models:

Standalone direct banks, which seek to build a separate brand identity independent of the parent institution. These banks now serve over a million customers in Europe. Leading players include Corta, Quelle, Banco Directe, Directbanken, and Banco 7. The most successful is in the United Kingdom, Midland Bank’s First Direct, which has half a million customers after less than six years of operation and continues to grow rapidly.

Complementary direct banking, offering extended telephone service and ATM access, and mimicking many of the attributes of direct banks, but positioning itself under the core brand of the parent bank as a supplement to its branch system. Complementary services are offered by dozens of European banks. Often, though, they are priced at a premium to branch-based transactions, creating incentives curiously at odds with the underlying economics.

In the United States, mutual fund companies are moving toward a "virtual bank" concept

In the United States, mutual fund companies have already taken advantage of remote delivery channels and seem to be moving toward a "virtual bank" concept. Fidelity and Schwab offer 24-hour telephone and PC access, transaction accounts, bill payment services, and checking, linked to a wide range of investment products. Fidelity is defining consumer expectations for levels of service, while Schwab, with several dozen independent mutual fund companies selling through it, is setting the standard for broad access and low-cost service. Both offer a cost-efficient network of "microbranches" to satisfy customers who seek physical communication to supplement remote service.

US banks, however, have not so far competed as standalone remote banks. Many have chosen the complementary approach, layering remote access options over the traditional branch system. Most continue to price electronic access at a premium to conventional delivery, no doubt in the belief that the branch system needs to be protected from cannibalization. Several leading banks have announced plans to create virtual banks outside their home markets, again seeking to protect their branch system from cannibalization.

The goal of financial institutions must be to add remote delivery capabilities while slashing costs

In many respects, banks have yet to take full advantage of the possibilities created by the comparatively straightforward technology of wave 1. The goal of financial institutions at this stage in the industry’s evolution must be to add remote delivery capabilities while slashing costs—and to avoid the trap of adding costs at the same time as new channels. They must protect customer segments at risk of being lured away by new providers by building exit barriers and enhancing remote service offerings. They must also attract selected segments over to remote channels with prices that reflect the true underlying costs.

Finally, they must raise prices for unprofitable customers and branch transactions, and fund investment in new channels with significant—30 to 40 percent—cost takeout in the branches. Every financial institution will need to craft its own response to wave 1, taking into account local competition, the composition of its customer base, and its current branch cost base.

Wave 2: PCs and online services

The second wave of technological change focuses on the personal computer as a financial management tool, combined with information reporting through online network services like Prodigy and America Online. This wave is now reaching an inflection point of accelerated growth, although its full impact is still several years off. Its eventual effect on financial services delivery channels, at least with respect to a broad segment of techno-savvy users, is likely to be profound.

Most senior executives in financial services hugely underestimate the current penetration of PCs and financial management software into more affluent households. Already, over 30 million US households own PCs, which includes more than 60 percent of the top income quintile. Over 20 percent of owners use their PCs to help manage their financial affairs. Quicken has a 70 percent share of this market, with over 7 million customers, at least 5 million of whom, to judge by their purchases of upgrades, are active users.

Between 1992 and 1993, the number of users of personal financial management software rose by 30 percent. Over the next few years, growth should continue as software is increasingly linked to transaction and portfolio information and to execution via online networks.

Once home-based financial software is fully connected, it should be possible to download current data to PCs

Currently, software users have to enter volumes of data manually into their programs. But once home-based financial management software is fully connected through secure online networks to payment mechanisms and investment providers, it should be possible to download data automatically to PCs and to execute transactions. Fidelity, Schwab, and Intuit have already moved in this direction; Intuit, for example, offers online bill payment and the downloading of Visa charges from the Quicken program.

Although thwarted by the Justice Department, Microsoft continues to position itself as the leading gateway for financial services and electronic commerce. This strategy is illustrated by the now squelched purchase of Intuit and its 7 million customer relationships for $2 billion. If the deal had been consummated, it would have ranked among the highest value financial institutions acquisitions in US history.

In wave 2, financial institutions face a real threat of losing relationships as gateways intervene between the consumer and the product supplier. The battle between content, transport, and gateway providers for control of customer relationships could produce a series of variations on multimedia banking, all with very different strategic implications for industry participants. Banks should prepare to compete under at least four different scenarios for the future:

Gateway domination. Electronic gateways backward-integrate into financial services, with consumers consolidating their financial relationships around the gateway to obtain seamless integration of financial and nonfinancial information. Personal financial services providers are forced to compete for back-end commodity manufacturing roles.

Financial supermarket. A few mega-institutions emerge as the dominant providers of a wide range of integrated financial services, serving a large segment of consumers who consolidate their relationships. Financial service providers that do not form alliances or sell out to winners risk lockout.

Mix and match. Consumers use simple household management programs to run their financial affairs. Gateways and intelligent search agents allow easy comparison-shopping among multiple providers and products. While personal financial services providers are somewhat commoditized, opportunities will remain to compete nationally on the basis of product price and features.

Branch or agent into the home. Card associations allow existing banks to offer ubiquitous interactive services at low cost. Consumers regard these services as enhancing their traditional banking relationships—much as many people regard ATMs today. This is the preferred scenario for most banks and insurance companies, as it does little to disrupt the current industry structure.

Financial institutions need to develop clear strategies to control and exploit information in order to enhance relationships

Financial institutions in wave 2 need to develop and execute clear strategies to control and exploit information in order to enhance relationships. These strategies must be resilient to all of the likely scenarios. Key elements will include capturing and using expense information, adopting the PC as a distribution channel, and expanding online services. While widespread switching to wave 2 is at least five years in the future, attractive segments of affluent customers are progressing much more rapidly, making it imperative that institutions take action in the next year or two to position themselves for this coming stage in the industry’s evolution.

Wave 3: E-cash and interactive video

The third—and perhaps most fundamental—wave will involve electronic cash. In the United States, cash and checks still account for over three-quarters of all retail payment transactions. While many European and Asian countries have higher electronic payment penetration, in no major country do check- and paper-based transfers account for less than 20 percent of noncash transactions. All this paper in the system perpetuates the need for geographic presence to collect and disperse payments.

Electronic cash will allow secure online cash transfer over the Internet and widespread use of "electronic wallets"

Electronic cash will evolve in two ways. First, in the further development of existing attempts to allow secure online cash transfer over the Internet. Second, in the development and widespread use of "electronic wallets" that allow convenient transport of small amounts of cash for typical purchases. Combining purchase convenience with information in truly unique ways, this wave is likely to have profound effects not only on the financial services industry but also on many other industries.

The development and widespread use of electronic cash will render geographic presence obsolete. Customers wanting to make deposits or withdrawals will no longer need to visit a branch. Small businesses will not have to drop off notes and checks at nearby branches. ATMs need not be stocked with cash at considerable expense. Instead, consumers will be able to obtain electronic cash in the safety and comfort of their own homes, via phone, PC, or dedicated terminal.

The information element of the multimedia delivery revolution is already entering maturity for all markets and products. On the Internet, it is now possible to track a Federal Express package minute by minute, from pickup through delivery truck to airport, flight number, and so on. On the entertainment front, individuals can now dial into a small record company in Canada and listen to various tracks from the compact discs it sells. Although service selection, service quality, and security are still obstacles to the development of a robust market in "electronic commerce," it is already possible to make purchases directly over the Internet.

Electronic cash standards are being developed to enable secure electronic commerce without cash, checks, or credit cards

Although this third wave is still in its infancy, initiatives are under way to develop electronic cash standards to enable secure electronic commerce and face-to-face transactions without cash, checks, or credit cards. Several of these approaches will harness new electronic channels without disintermediating traditional payments providers. They include encrypted credit card payments over the Internet (for instance, CyberCash and Microsoft/Visa), digital checks, and smart cards or prepaid debit cards.

Even more radical are various experiments in creating true electronic cash: anonymous digital currency in an electronic wallet, which can be safely transferred in person or over data networks. While full-scale electronic cash is some years off, a number of promising pilots are emerging.

Mondex, for example, is close to launching a test in Swindon, a city of 170,000 people in the United Kingdom. It will offer a smart card with an electronic wallet to 40,000 customers. Accessible via ATMs and telephones, this card will be valid at a thousand retailers and for personal payments. Users will enjoy convenient cash access from home, shorter transaction times, security, and automatic transaction recording. Banks will benefit from eliminating paper, automating transactions, and earning float on funds stored in cards.

Two-way interactive video can provide the face-to-face service traditionally provided only by personal sales channels

Later on, we are also likely to see personal financial services sold through interactive TV, a vehicle that avoids the tradeoffs usual with remote channels. Through two-way interactive video, consumers can receive the face-to-face service traditionally provided only by personal sales channels, while enjoying the convenience afforded by remote delivery.

Huntington Bankshares in Ohio has pioneered the use of video kiosks for personal banking. The bank plans to close as many as 40 percent of its branches to make way for 24-hour kiosks with ATMs and interactive video. Customers who use the video kiosks still feel as though they are talking to a person, but total transaction times are much shorter. Though current kiosk technology is cumbersome and costly, future developments—especially in broadband cable TV and domestic telephone networks—will permit interactive video capability to be extended to the office or home.

Banks need to begin to define how their institutions might fit into the electronic cash future

In wave 3, financial institutions must replace paper-based payments and cash access mechanisms and make large-scale cost reductions throughout the system. In particular, branch and back-office resources must be sharply cut back as electronic cash gains wider acceptance. Finally, banks need to develop and provide access to two-way interactive video. While wave 3 is still several years away, banks need to begin to define how their institutions might fit into the electronic cash future and use pilots and alliances to acquire experience and understanding.

Accelerated timing

Since the three waves reinforce one another as they sweep along, multimedia banking may be here sooner than we think. The growth of telephones and ATMs (wave 1), for example, has created a large segment of affluent consumers comfortable with remote delivery. These consumers have adopted PC technology and are beginning to apply it in financial management (wave 2).

A large group of PC users will create the impetus to move to electronic cash. They will be able to obtain funds without leaving home and achieve easy downloading of expense data into their financial management software (wave 3). This will force old-fashioned checks and cash out of the banking system, making branches even less economical than they are today. Branches will close, forcing more people to use ATMs and phones (wave 1 again), and accelerating the evolution of the industry.

No one knows exactly how multimedia banking will play out. With each successive wave, consumers will be able to derive greater value and convenience from the electronic delivery of financial services. The most attractive offerings will draw in still more consumers, allowing costs to be spread over a wider base and spurring product and service innovation. All players, whether traditional banks or multimedia outsiders like Microsoft, will have the opportunity to experiment in the market, learn what works, and apply it in this rapidly changing industry.