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The Future of Money in the Information Age

Chapter 19: Payment Technologies, Financial Innovation, and Laissez-Faire Banking: A Further Discussion of the Issues

F. X. Browne and David Cronin

Laissez-faire banking literature is based on the premises that the market is better at allocating resources than government and that there is nothing fundamentally different about the provision of money and banking services relative to the provision of other goods and services that should invite "special" government intervention in the banking industry. That literature has tended to focus on private banks issuing traditional notes and coin. We have sought to complement that body of research by giving greater attention to the potential implications of electronic payment instruments that are currently being developed by private-sector firms. Those implications are discussed in our recent article in the Cato Journal (Browne and Cronin 1995). The underlying theme of that paper is that advances in electronic payments, in conjunction with innovations in financial products, would appear capable of delivering a laissez-faire banking system that would be both inherently stable and beneficial to macroeconomic performance.

In this paper, we summarize the arguments made in our Cato Journal paper and discuss further some of the key issues in this area. In particular, we look more closely at how technology might affect the future shape of banking and what role government regulation might play in banking in the future. We conclude that laissez-faire banking could emerge endogenously over time in response to technological improvements in information and financial products; that regulation of this "new" banking industry could prove extremely costly for government to undertake; and that, irrespective of whether government is inclined or not to do so, any attempts to regulate would be unjustified because of the system's likely inherent stability and efficiency.

Electronic Payments and the Demise of Outside Currency

Our view that laissez-faire banking could emerge endogenously in the future is grounded in the pecuniary and nonpecuniary advantages that new electronic payments technologies are likely to have over government-issued currency. Those advantages will extend to all parties who use currency for transactions purposes. For banks, electronic payments promise to be very cost efficient in comparison to prevailing paper-based payments systems. A switch from paper to electronic media is likely to cut deep inroads into bank costs, particularly labor costs, of routine processing of currency and paper-based payment instruments. Retailers would benefit from a switch to electronic payments by not having to carry or handle large physical sums of currency, which would also reduce their costs and susceptibility to theft. Electronic payments are likely to prove attractive to consumers as well. In particular, there is the potential pecuniary advantage of earning interest on unspent electronic purchasing power. In the case of smart cards with embedded value, the logistics of the issuer paying interest on the unspent balances are simple. (As Lawrence H. White [1995] has pointed out, this could be achieved by programming the card's microchip to augment the unspent card balance automatically over time.) Where electronic payments are effected on-line to an interest-bearing bank account, the payment of interest would be obviously very straightforward.

For all the aforementioned parties, the technology would also have the benefit of allowing instant verification of a payer's creditworthiness, unlike pay-later payment media such as credit cards. Thus, the hitherto distinct advantage of government currency over privately issued paper-based payment instruments in allowing immediate verification of the creditworthiness of the payer could be mitigated with the arrival of new privately issued electronic payment instruments.

Given these advantages, it is not unreasonable to argue that electronic payments could substitute strongly for currency and other paper-based instruments. It is difficult to see how those paper media could undergo any improvements that would allow them to compete with electronic media. Networking effects are also likely to play an important part in the spread of new electronic payments technologies. The usefulness of any particular payments product to an individual is an increasing function of the number of individuals who already use and accept it in executing transactions. If that number is small the benefit to the marginal individual of choosing the new instrument is also going to be small given the low number of other agents utilizing the instrument.[1Caskey and Sellon (1994) identify difficulties of this nature (along with the pricing of payment methods) as an impediment to debit card growth.] If the number of users is large, or growing rapidly, then the incentive to start utilizing and accepting the instrument in payments will correspondingly increase. This type of networking effect could give rise to important nonlinearities in the rate at which new payments products spread throughout the economy. There could be large inertial effects initially preventing the demand for a new payments product taking off, but once it does take off it could experience exponential growth. If demand does not reach a critical mass, the instrument may never succeed. But once this critical mass has been reached the use of the payments product will be diffused very rapidly and should quickly displace other existing, but inferior, products. Predictions of the rate at which new electronic payments products will grow and replace currency that do not take account of such networking effects may be quite misleading.[2Stix (1993) makes the point that the diffusion of a technology often accelerates as costs drop. In particular, he shows how products such as the telephone, the personal computer, and the videocassette recorder penetrated the U.S. consumer market as their costs fell exponentially. A similar situation might be expected to develop with regard to the new payment technologies.]

Some observers might argue that, irrespective of the technological and economic superiority of electronic payment media, consumers will continue to utilize paper-based instruments with which they are familiar and which they trust. Certainly, such inertia might be expected in the short- to medium-term. It might be particularly strong among older generations. Younger generations, however, are likely to trust and use new technology so that this source of inertia might disappear within a few decades. Yet, the initial strength of the inertia might be in itself exaggerated because, as Tom Kokkola and Raul Pauli (1994: 7) argue,

In principle, the introduction of electronic cash constitutes a far less dramatic change than the introduction of paper money [as a replacement for metallic money] since it really only involves a change in the form of the "instrument" representing purchasing power. What paper money and electronic money share in common then is that the monetary status of both is based on the holder's confidence that the issuer will meet his obligations under all circumstances.

Growing familiarity over time with new payments products should tend to reduce gradually people's natural reluctance to trust payments products that they may not fully understand. The mere demonstration of their durability and viability by some agents should be enough to encourage others to use and accept the new payments products. This is not a networking effect as such but would nevertheless tend to operate in the same highly nonlinear way in its impact on the usage of electronic payments.

For these reasons, we believe that government-issued currency may experience a substantial decline or even disappear as a transactions medium in the long run with seigniorage passing to the private sector in the form of a cheaper and more efficient payments system, unless these competitive advantages were somehow countered by central banks. That would appear unlikely since, as already noted, it is difficult to envisage currency undergoing any technological improvement that would allow it to counter the attractions of electronic money. Should central banks seek to engage in the supply of electronic money they are likely to be frustrated in their attempts to do so, because electronic payments technology is already well-disbursed among private institutions and central banks have little expertise in retail banking. In our view, therefore, central banks are unlikely to become direct issuers of electronic money.

Regulation of Electronic Payments

An outright prohibition by central banks on electronic money issue by private banks to sustain demand for its own (paper) currency is not likely to arise. For one thing, such a prohibition might prove politically sensitive, particularly if electronic money has garnered a significant popularity among the public. Second, many central banks appear willing to accept that consumers should be free to choose their own preferred payment medium.[3The Working Group on EU Payment Systems (1994: 7), for instance, states that "EU central banks are of the opinion that the market should decide which payment instruments best serve customer needs."]

Furthermore, any attempt to regulate the electronic money industry might prove to be futile for central banks. Electronic purse schemes, now being operated on either a pilot or fully operational basis in many countries, might be easily regulated because they are mainly being operated by resident banks with a large physical presence in a country. Payments services that are being provided via the Internet are, however, likely to prove far more difficult to regulate. The Internet is an information network that has no physical presence and recognizes no national barriers. Even if a government succeeded in regulating the activities of Internet payment service providers in its jurisdiction, it is likely that consumers could turn to other service providers based abroad in order to avail of, for example, superior interest-earning opportunities being offered by those foreign operators. Any attempt by regulatory authorities to exercise influence on the domestic nonbank public could also prove futile since cryptographic procedures and the multiplicity of transmission paths available on the Internet would make the cost of any effective attempts to regulate those agents' behavior excessively costly.[4The nature of the Internet could make it difficult for central banks to quantify the amount of effective transactions balances within the economy. With imperfect information on the amount of money in circulation in the country, or on the velocity of such money, the ability of the central bank to pursue a monetary policy strategy of intermediate monetary targeting would be compromised.]

An attempt by regulatory authorities to prevent its supervisees from providing electronic payment facilities to their customers could threaten to reduce the supervisees' customer base as less-regulated institutions would be free to provide such payment facilities. Indeed, in order to preserve the systemic health of their constituencies (and the public perception of the success of their own regulatory activity), regulatory authorities would most likely be forced to rescind their own regulation that restricted their "clients" from competing effectively with other firms in this area.[5This argument is somewhat similar to the viewpoint of Edward Kane (1983) on the nature of regulatory activity.]

Accounting System of Exchange and the Unit of Account

There is, we would argue, considerable potential for on-line electronic payments technology to impact on how exchange in the economy takes place. Specifically, it seems capable of making an accounting system of exchange (ASE) a viable challenger and alternative to the current ubiquitous monetary exchange system.[6Prepaid cards, because purchasing power is embedded in the card and can only be transferred by possession and physical utilization of that instrument, are bearer instruments. Those instruments, by definition, do not embrace book entry in the settlement of transactions and are, therefore, monetary rather than ASE payment instruments. Payments made on the Internet involve settlement of transactions by book entry. Similarly, debit cards are used to initiate account-to-account transfers and, thus, are compatible with an ASE.

On a related point, David Everett (1996) has pointed out that electronic purses such as Mondex are as fungible as cash insofar as payment flows can take place in a bi-directional flow between (initial) payer and payee. In contrast, book-entry type exchange must involve immediate exchange of assets between the payer's bank and the payee's bank so that all payment flows operate unidirectionally.] In the future it could be possible to settle transactions by means of signals to an electronic accounting network resulting in appropriate credits and debits to agents' bank accounts. Ownership of security claims could be transferred to settle transactions. Such an exchange system would correspond to an ASE. In monetary exchange systems, the basic medium of exchange (be that commodity money or fiat money) invariably has served as the unit of account. In a situation where there is no tangible medium of exchange, the choice of the unit of account becomes less obvious. New monetary economics theorists, who have considered how an exchange system based on (intrinsic) book-entry transfers of wealth to settle transactions might function, have argued that a unit of account based on some quantity of a commodity or bundle of commodities would be required in an ASE. In considering the possible demise of currency as a transaction medium in the context of a movement toward a cashless economy, based on the technologies described above, we believe that currency's unit of account function need not necessarily be undermined. So long as a demand for currency prevails, it will continue to have a positive and determinate value relative to other goods and consequently will continue to be capable of serving as a viable unit of account. Even if the demand for currency as a medium of exchange were to disappear, it is likely that an alternative demand for that currency as a store of value would remain, such as a demand among numismatists to hold particular fiat note and coin issues and among agents in other, less developed countries in search of "hard" currency to hold as a store of value.

The Future of Banking

We have argued that technological developments may, in the long run, lead to payments services being fully provided by an unregulated private sector utilizing electronic technology. Providing payment facilities to its customers has been one of the two key functions that banks have undertaken within the economy; the other is intermediating funds between savers and investors. Both functions are no longer the sole preserve of banks, however. Mutual funds and brokerage firms now compete with banks in financial intermediation. The number of nonbanks seeking to enter the market for providing payment facilities by exploiting the opportunities that the new information technologies present is also growing.

Does this threaten banking and banks? On the one hand, banks seem certain to face greater competition with the advent of sophisticated information and financial products. On the other hand, it is difficult to see the business of banking being undermined, if one takes banking's central quality to be its ability to help solve information asymmetries in the intermediation process. We would expect that banks will continue to earn fee income in reducing the cost and risk of intermediation, irrespective of who originates the funds to make a loan or what liability remains with the bank. Banks' credit assessing skills might be expected, for example, to be in demand from nonbank electronic payment service providers choosing to enter the area of intermediation of funds. Given that those "digital banks" would have little or no prior knowledge of banking and that banking may be "special" insofar as banks have unique access to information about their clients' activities, the model of share banking might prove the only feasible option for those new banks to follow in engaging in intermediation. This is because their inexperience of the banking business would not prove costly to them if those agents saving with them, rather than themselves, bore the default risk associated with loans. This could be achieved through securitization, which involves financial intermediaries extending loans to borrowers as per traditional (par-value) intermediation but, unlike that form of intermediation, pooling those loans and selling claims on this pool to savers. In addition, they would not be required to engage in risk assessment of ultimate issuers (in which they have no experience), because that function is already being done by underwriters (for example, merchant banks) in the case of new issues and by the market in the case of outstanding issues.

Competition in this new banking environment might be expected to be strong. If data and payment transmission could be made at negligible marginal cost, geography would be irrelevant in the provision of banking services so that a strong horizontal dimension to competition in banking would exist. Also, almost by definition, the Internet removes the need for intermediaries in the transmission of information. It is difficult to believe how this should not also apply to banking on the Internet, particularly if it is securitized claims that are exchanged therein. With securitized claims, there would seem to be no need for clearinghouses (which formed an integral element in the institutional development of monetary payment systems) in an ASE. That is because there would be no need to hold quantities of a noninterest-bearing asset (final money) as the ultimate settlement medium, and because all transactions would be settled in real time on a bilateral, rather than a multilateral, basis. The absence of an institution such as a clearinghouse, with a unique function in the payment system, would remove any focal point for government regulation. Indeed, recognition of that fact should remove any inclination on private institutions' part to form a central organization for clearing payments. The impact of the new technologies, therefore, may be to weaken, and perhaps, fully remove government regulation of financial intermediation and payments; the cost of direct monitoring of intermediary activity and implementation of supervisory rules could end up being excessively large and could put regulatees at a distinct disadvantage to their competitors.

We would argue that a banking system of the type described above, based on electronic payments and share banking, would be inherently stable. Laissez-faire in electronic payments could compare favorably with free-banking note and coin issue. The stability of bank liability issue could be strengthened by the mechanism of adverse clearing operating even more promptly in a payment system based on electronic funds transfer than on circulating physical currency.[7The use of securitized claims for payments might also ease credit risks that payees might have with regard to both payers and their banks. Those claims would be marked-to-market on an ongoing basis and would be transferable instantaneously at the time of contract. Thus, electronic technology would ensure that there would be no delay in a payment obligation being made good with underlying real wealth. The creditworthiness of any counterparty to a transaction can be verified, the required funds transferred and the transaction settled with finality virtually instantaneously.] Share banking can support stability in laissez-faire banking. In particular, as has been pointed out by David Glasner (1989) and George Selgin and Lawrence H. White (1994), runs are unlikely to be made on share banks.[8The arguments supporting this view are more fully outlined in our Cato Journal article.]

Selgin and White (1994: 1729), while acknowledging that runs cannot occur on share banks, argue that par-value banking would survive under laissez-faire because "it beneficially constrains banks to act in the interest of claimholders, precisely because claimholders have the option of forcing liquidation." We would argue that a similar constraint would operate on share banks. Savers in share banks do not have fixed nominal claims on those banks. This should lead them to monitor more closely the investment performance of those banks. Should a bank be making inferior investment choices, savers would most likely become more fully and more quickly informed of those poor choices in a share-banking environment than they would in a par-value system and would seek to divert existing (and new) savings to other banks; this could be achieved rapidly since all claims in share banks are liquid and are not subject to either term or period-of-notice constraints. Par-value deposits are, with the exception of sight deposits, subject to such constraints. This impedes the ability of depositors to force liquidation on those banks.[9Stephen Ross (1989) characterizes par-value intermediaries, such as savings and loan organizations, as opaque. Those are institutions for which "monitoring, bonding and control costs, i.e., agency problems, are most severe . . . .[A] depositor in an S&L has almost no knowledge of the particular loans the institution is making" (ibid.:542). In contrast, he holds that participants in an open-ended mutual fund "at any moment of time. . . . can be fully informed about the assets of the fund. There is no substantial equity investment in the fund by those who manage it, and their principal compensation is a percentage of the assets under management . . . . there is less room for a divergence in interests between management and the participants."]

The new electronic payments media, particularly on-line technology, could help to promote share banking. Using paper-based media to settle transactions with shares in a bank is excessively costly (hence the existing demand for par-value notes and coin and sight deposits as settlement media). Electronic transfer of marked-to-market shares could prove, however, to be a cost-competitive alternative to payment by par-value notes and coin and sight deposits. This in itself could help promote share banking. Also, what is likely to be attractive to retail transactors about share banking is that all account holdings would be liquid and divisible. This contrasts with par-value banking deposits which tend (with the exception of sight deposits) to come with maturity bands or periods of notice. Since they are not negotiable, they cannot be mobilized for payments short of maturity except at a penalty. Transferring them to an alternative ownership may be impossible if deposits cannot be converted to notes and coin or a sight deposit or can only be converted to liquidity at a cost that is too large relative to the value of the transactions in question. This is not a problem with share banking since account holdings are all liquid and divisible. If banks wish to maximize their services to clients who have installed the required network infrastructure to support, say, a debit card system, banks would have a strong incentive to supply tradable marked-to-market financial instruments rather than medium-to-long maturity deposits.

Macroeconomic Behavior in an ASE

Legal restrictions imposed by government could be either circumvented or rescinded in the new banking environment. The end of the endogenous developments now being observed in their infancy could give substance to the central paradigm of the new monetary economics literature: "If legal restrictions explain the special role of money and banking [in economic activity], a world without such restrictions should be one in which money and banking are devoid of such special significance" (Harper and Coleman 1992: 29). Contributors to that literature (in particular, Fama [1980]) have argued that by maintaining bank liabilities at par, regulators give special significance to bank liability issue, insofar as the incentive for its continued issue is unlimited and that issue gives rise to ongoing inflation unless a quantity restriction is imposed by further regulation. If the initial restriction had not been imposed, then bank liability issue would have an impact on its own price. With a falling marginal profit from liability issue, any incentive for overissue would be eliminated. In this way there would be nothing "special" about bank liability issue; its equilibrium quantity would be determined by the orthodox demand and supply forces that operate in most goods markets.

In an ASE, signaling between economic agents could improve due to all wealth being liquid and perfectly divisible. Since all wealth, when combined with a secure electronic messaging transmission process, would be capable of acting as transactions media, there would be no need to hoard transaction balances in order to build up liquid savings to finance future expenditure plans, as is the case in monetary economies where only money (which represents a small proportion of total wealth) constitutes readily expendable balances. Thus, with no need to hoard in an ASE, current expenditure patterns would not need to be disrupted to build up a stock of transactions balances. Such hoarding activity has been identified as a means by which business cycles can arise since firms may mistakenly view the decline in consumer expenditures as permanent (rather than as an intertemporal readjustment of expenditures) so that they will tend to produce less output than will actually be demanded in the future. Such a coordination failure between producers and consumers would not arise in an ASE because its source, the need to build up liquid balances, would be mitigated.

Furthermore, as Cronin (1994: 55) notes, resource allocation would also be improved insofar as when agents observe price changes occurring they would be aware that those are specifically relative price changes (since changes in the aggregate price level do not arise in an ASE) and, consequently, agents would channel resources to more efficient uses in response to these signals.

Conclusion

In this paper, we have argued that new electronic payments media, being developed by private firms, could replace government-issued notes and coins and that laissez-faire banking could emerge endogenously from that technology. We believe that a banking industry based on the model of share banking and electronic payments would be both efficient and stable and would prove conducive to improved economic performance. While technological developments might be expected to expose existing banks to strong competition in payments and intermediation, those banks are likely to continue to have both perceived and actual superior risk-assessing skills to new entrants in the intermediation business. This comparative advantage should ensure that they will continue to earn income by way of fee for their credit-rating skills, irrespective of whether all their other business activities prosper or fail in the new technological environment.

References

Browne, F.X., and Cronin, D. (1995) "Payment Technologies, Financial Innovation, and Laissez-Faire Banking." Cato Journal 15 (1): 101-16.

Caskey, J.P, and Sellon, G.H. Jr. (1994) "Is the Debit Card Revolution Finally Here?" Federal Reserve Bank of Kansas City Economic Review (fourth quarter): 79-95.

Cronin, D. (1994) "Patterns in Money Demand: Indicators and Predictions." Central Bank of Ireland Technical Paper 8/RT/94. Dublin, Ireland.

Everett, D. (1996) "A Security Comparison of Modern Electronic Payment Instruments." Paper presented at a conference on "The Cashless Economy" 28 March, Dublin, Ireland.

Fama, E. (1980) "Banking in the Theory of Finance." Journal of Monetary Economics 6: 39-57.

Glasner, D. (1989) Free Banking and Monetary Reform. Cambridge: Cambridge University Press.

Harper, I., and Coleman, A. (1992) "New Monetary Economics." In P. Newman, M. Milgate, and J. Eatwell (eds.) New Palgrave Dictionary of Money and Finance, Vol. 3: 28-31. New York: Stockton Press.

Kane, E.J. (1983) "Policy Implications of Structural Changes in Financial Markets." American Economic Review 73: 96-100.

Kokkola, T., and Pauli, R. (1994) "Electronic Cash." Bank of Finland Bulletin 12: 2-7. Helsinki, Finland.

Ross, S. (1989) "Institutional Markets, Financial Marketing, and Financial Innovation." Journal of Finance 44: 541-56.

Selgin, G., and White, L.H. (1994) "How Would the Invisible Hand Handle Money?" Journal of Economic Literature 32: 1718-49.

Stix, G. (1993) "Domesticating Cyberspace." Scientific American (August): 85-92.

White, L.H. (1995) "Thoughts on the Economics of Digital Currency." Extropy 15 (7)(2): 16-18.

Working Group on EU Payment Systems (1994) Report to the Council of the European Monetary Institute on Prepaid Cards. European Monetary Institute, Frankfurt-am-Main, Germany.

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