Internet Banking: Changing Expectations and Regulations

CRS Report for Congress
Internet Banking:
Changing Expectations
and Regulations
March 12, 2002
Walter W. Eubanks
Specialist in Economic Policy
Government and Finance Division

Congressional Research Service ˜ The Library of Congress

Internet Banking:
Changing Expectations and Regulations
Summary
Despite the surge in customers singing up for Internet banking in the aftermath
of the 911 attacks on New York and Washington and the anthrax scare that followed,
Internet banking is not growing as fast as expected before or after the attacks. A
main reason is consumer confidence in and familiarity with the paper-based payment
methods of cash and checks. Many smaller banking institutions viewed the prospect
of Internet banking as providing opportunities to expand their services beyond their
brick and mortar establishments and compete with larger banks. But the fixed cost
of establishing transaction Internet sites is having a greater impact on the bottom lines
of smaller banks. To overcome this problem, Internet bankers might be waiting until
they have a critical mass of users before imposing or raising the user fees on this
channel to banking services, as they did with automated teller machines (ATMs).
Congress and regulators have been moving rapidly to set up regulations and
oversight to protect consumers from the new risks Internet banking has introduced.
The Gramm-Leach-Bliley Act of 1999 (P.L. 106-102) and the Electronic Signatures
in Global and National Commerce Act of 2000 (P.L. 106-229) both address
regulatory issues pertaining to electronic banking. Since the 911 attacks Congress
passed the USA PATRIOT Act (107-56) that makes it easier for law enforcement to
monitor Internet activities, including banking. Regarding innovations in Internet
banking technology, banking regulators have taken the stance not to interfere with the
innovation process for fear of stifling them. Despite the stance, regulatory agencies
have implemented rules which tend to make Internet banking more costly.
This report will be updated as legislative and economic developments warrant.

Contents
Internet Banking............................................1
Bankers Lower Their Growth Expectations........................2
Bank Costs................................................2
Consumer Adoption Is Slower Than Expected..........................3
The Paper-based are still preferred...............................4
Internet Banking Profitability Is Below Expectations.....................4
Internet-Only Banks Are in Difficulty.............................5
Large Banks’ Internet Banking Profitability is Unclear................6
The “Critical Mass” Problem...................................6
Regulatory Policy...............................................7
Congress and Federal Regulatory Agencies........................7
The Regulatory Agencies’ Stance............................7
Risk Management...........................................8
Regulatory Examination of Internet Banking Operations..............9

Internet Banking:
Changing Expectations and Regulations
Internet Banking
The term Internet banking refers to conducting banking business over the
Internet. Depository institutions use this channel to offer their customers a range of
services that very widely among institutions. The services offered include examining
balances, transferring funds between accounts, applying for credit, making electronic
bill payments, and bill presentations (where payees send their bills via the Internet to
a payer’s bank, which pays them). Some also offer insurance and brokerage services.
In addition, business Internet banking enables businesses to apply for loans, initiate
wire transfers, and use cash management and payroll services over the Internet.
Most depository institutions conducting Internet banking are depository
institutions with physical offices, but some Internet bankers are Web-based, Internet-
only banks.¹ Internet-only banks are also called “virtual banks.” At the heart of these
virtual banks are computer servers that may or may not be located at the legal address
of the virtual bank. Virtual banks take deposits and make payments primarily through
automatic teller machines and through the mail.
In the mid-1990s, Internet banking supplanted but did not eliminate personal
computer (PC) banking, where the bank’s proprietary software resides on each
customer’s PC and business is conducted over private networks. PC banking
provides basic banking and billpaying services but relies heavily on the U.S. Postal
Service for the delivery of many payment checks. In contrast, Internet banking relies
heavily on “e-pay,” which electronically transfers money directly into the accounts of
the payees in other depository institutions through electronic networks. Internet
banking, however, also uses the mail to deliver payments when an institution uses
checks instead of paying electronically.
PC banking is more costly than Internet banking for the depository institutions
and their customers because it requires maintaining a costly, proprietary network
infrastructure of hardware and software. By contrast, some of the Internet banking
infrastructure is in the freely accessible public domain, which accounts for its lower
costs relative to PC banking.

¹ Robert DeYoung, “The Internet’s Place in the Banking Industry,” Chicago Fed News Letter,
The Federal Reserve Bank of Chicago, vol. 163, March 2001, p. 2.

Bankers Lower Their Growth Expectations
Almost 20% of the customers of a few major depository institutions are
banking online over the Internet. However, Internet banking has made some
depository institutions (especially smaller ones) less profitable, and half of the Internet
banking-only banks have gone out of business.² A September 2000 study conducted
by the Office of Comptroller of the Currency (OCC) concluded that five banks
account for about 36% of Internet bank users. Most banks that offer Internet
banking are currently serving a relatively small share of their customer base. In late
1999, about 5 million households used online banking. These customers had been
expected to grow to about 32 million by the end of 2002, one-third of the 93 million
households with a banking relationship.
These predictions have been revised downward. In 2000, just 6% of banking
transactions were done online. Bankers now expect the same rate for 2001, having
earlier projected 9% for 2001.³ In the aftermath of the 911 attacks it is estimated and
the anthrax scare, it was estimated that there were about 7.5 million Internet banking
customers. “Whether people are anxious about cross contaminated mail or about
delays that could result in late mortgage and credit-card payments, more customers
are turning to online banks.”⁴ However, most banking transactions continue to be
conducted at branches, through the mail, by telephone, or over the automated teller
machine (ATM) networks.
Bank Costs
Banking via World Wide Web sites offers depository institutions and their
customers advantages over traditional banking. To customers, the convenience of
accessing their financial information 24 hours a day has a strong appeal. The
institutions benefit from cost savings that occur when customers perform the
transactions without tellers or telephone representatives. Driven on by the reported
low variable cost, many smaller banking institutions saw Internet banking as an
opportunity to expand services beyond brick and mortar establishments to compete
with larger banks. According to one variable cost estimate, branch banking cost
about $1.07 per transactions, telephone cost about $0.55 per transaction, ATM
banking cost about $0.27 per transaction, and Internet banking cost about $.01 per
transaction.⁵
However, there are also disadvantages. For the depository institutions, there
are the fixed costs of building infrastructures of hardware, software, and personnel.
Designing an Internet banking Web site costs on average around $25,000, but the

² Jeremy Quittner, “Internet-Only Banking: A Game of Survivor,”in The American Banker
Special Report: Retail Delivery Innovation in Marketing and Technology, Sept. 11, 2001,
p. 8A.
³ Lauren Weber, “Reality Check: Less Expected of Web Banking,” Ibid., p. 17A.
⁴ “Should you Bank online?” Consumer Reports, Feb. 2002. p. 28.
⁵DeYoung, p. 2.

costs of a transaction distribution and customer service web site for a medium size
bank could be as high a $150 million.⁶
Consumer Adoption Is Slower Than Expected
For the customers, Internet banking offers fewer opportunities for personal
interaction with banking personnel and places more responsibilities on the customer,
which some customers clearly do not want. Customers are responsible for the
physical security of computers, personal identification numbers, and the accuracy of
a transaction entry.⁷ Consumers are increasingly concerned about identity theft and
depository institutions’ privacy policy.⁸ Most consumers are concerned that hackers
may break into computers servers and get their personal information and account
numbers, according to Consumer Reports. “ Once hackers have your Social Security
number and date of birth, both of which may be attached to your bank account, they
can open credit cards in your name, run up bills and wreak havoc with your financial
life. Fortunately, security breaches have been rare.”⁹ Even so, the concern has
prevented bank customers from banking online.
Internet banking costs may discourage potential customers. The monthly fees
for basic Internet banking services run from free to $10.00 in the Consumer Reports
sample of 15 Internet banking providers.¹⁰ Basic service enables the customer to
check account balances and transfer funds between accounts. In addition, minimum
required account balances vary from none to $3,000, and the monthly costs can be
higher for additional services such as billpaying services. In the case of Bank of
America, there is a monthly fee of $5.00 for the basic service and an additional $5.95
fee for billpaying services. For other Internet bank customers, the price of some
services are on a per transaction basis.
There are other reasons for consumer resistance to using Internet banking.
The number one reason for customers who signed up for online banking but stop
using it is that it was “too complicated”(27%). The second reason was that they were
“dissatisfied with services”(25%). Of those discontinued users in the surveyed 52%
gave these two reasons for having stopped using online banking. Other reasons given
were “no need/not interested” (21%), “security concerns” (11%), “cost too much”
(11%), and “privacy concern”(5%).¹¹ An explanation for the small percentage with

⁶ Weber, p. 15A.
⁷CRS Report 98-67 STM, Internet: An Overview of Key Technology Policy Issues affecting
its Use and Growth, by Marcia S. Smith, et al.
⁸See CRS Report RS20185, Privacy Protection for Customer Financial Information, M.
Maureen Murphy; and CRS Report RS20035, Internet Privacy: Overview and Pending
Legislation, by Marcia S. Smith.
⁹Consumer Report, p. 29.
¹⁰Ibid., p. 31.
¹¹Doug Johnson, “Trend in Technology: Internet Banking,
(continued...)

privacy concerns is that concerns about privacy would be greater for customers
actually using Internet banking than those who have stopped using this channel of
banking services.
The Paper-based are still preferred
A dominant reason for the slow growth of Internet banking is the satisfaction
of the public with the paper-based methods of payments. In 2000, approximately
70% of total consumer transactions used paper-based methods of payments of cash
and checks. Payments by check are first in terms of value and second only to cash in
terms of the number of transactions, and almost half of all consumer expenditure
payments were made by checks in 2000.¹² According to a Federal Reserve Study,
nearly 50 billion transactions in 2000 involved checks, with a value totaling $47¹³
trillion. Some analysts argue that banking customers prefer checks because the float
enables the payer to earn interest income while the check is being cleared and settled.
But there are other important reasons for the popularity of checks. Checks offer the
users greater flexibility and control of payment initiation, legal standing, user
familiarity, and an automatic receipt in the form of a canceled check. Together these
characteristics probably explain the dominance of checks over more efficient methods
of payment like credit cards and Internet banking. Cash is preferred and more efficient
particularly for small purchases. For small payments cash is the only method that
requires no promises to pay, or confirmation of payment. Internet payments involve
costs of confirming payments; even though they are small in most cases, sometimes
they are quite high in terms of time and bank fees. For these reasons Internet
banking is not expected to replace a significant part of paper-based payments system
in the near future.
Internet Banking Profitability Is Below Expectations
Bankers are discovering that developing and maintaining a transaction Internet
Web site is more costly than expected in light of slower than expected customer
acceptance.¹⁴ These costs have had a severe impact on some smaller banks offering
Internet banking. Smaller brick and mortar banks offering online banking have had high
expenses and large losses. An OCC study concluded that “Internet banking may be a

¹¹ (...continued)
[http://www.aba.com/aba/PDF/TrendinTechnolgy.pdf] , visited March 6, 2002.
¹²See “Consumer Payment System,” The Nilson Report, issue 753, Dec. 2001, p. 3.
¹³ Financial Services Policy Committee, Fed Announce Results of Study of the Payments
System First Authoritative Study in 20 Years, Federal Reserve of Boston,
[http://www.frsbservices.org], last visited December 1, 2001. 3p.
¹⁴Alan Kline, “Pro-online Despite Bad Bottom-Line Data,” American Banker, March 5,

2002. [http://www.americanbanker.com], last visited March 6, 2002. p. 2.

primary reason why small particularly de novo institutions are unprofitable.”¹⁵ However,
some smaller banks offering Internet banking have been able to generate sufficient
revenues from fee income on other banking business lines to overcome their high
expenses.
The lower than expected profitability is the direct result of greater than expected
expenses to install online banking applications. In addition, Internet banking customers
are not as self-sufficient as anticipated. The result is that while the infrastructure
expenses are higher than expected, the variable costs exceed expectations as well.
Internet banking customers still want contact with human beings while conducting
banking over the Internet. Installing Internet banking was expected to cut back bank
operating personnel hours and to produce significant savings. Instead, Internet banking
has extended banking hours around the clock, “always on,” and increased expenses such
as hiring e-banking specialists whose duties include visiting customers who might need
instructions in paying bills online.¹⁶
Internet-Only Banks Are in Difficulty
Virtual or Internet-only banks have been racking up losses for so many years that
some owners have had to close their doors. “Many industry analysts and observers
predict a continuation of the consolidation wave and do not expect the bulk of the
estimated 50 Internet-only banks in the United States to survive the next three to five
years.”¹⁷
Analysts believe that Internet bank customers need branches where customers
can speak to representatives about complicated transactions such as mortgages. Without
offices, Internet-only banks, for example, have to pay for the use of other banks’ ATMs.
Similarly, on the other side of the balance sheet, because Internet-only banks offer better
interest rates on deposits than the competition, they attract less reliable and less
profitable customers, who are shopping only for the best rates, and are uninterested in
a long-term banking relationship.
Under strangling costs, many Internet-only banks have consolidated with brick
and mortar banks that offer online services. For example, Wingspan.com was folded into
Bank One after tremendous losses and Citigroup ultimately terminated Citi f/i as an
Internet-only bank because of losses. The surviving Internet-only banks, like E-Trade
bank, have found a niche for themselves. E-Trade bank offers brokerage customers
financial products that complement its parent company, E-Trade Groups (an Internet
equities brokerage firm).

¹⁵ Richard J. Sullivan, “How Has the Adoption of Internet Banking Affected Performance and
Risk in Banks?” Federal Reserve Bank of Kansas City, Financial Industry Perspectives
2000, December 2000, pp. 1-3., and Karen Furst et al., “Internet Banking: Developments and
Prospects,” Office of the Comptroller of the Currency, Economic and Policy Working Paper

2000-9, Sept. 2000, 57 pp.

¹⁶ Kline, p.2.
¹⁷ Quittner, p. 8A.

Large Banks’ Internet Banking Profitability is Unclear
For the larger banks, the correlation between profitability and Internet banking
is not clear. The unprofitability of new, smaller, Internet-only banks is linked to the cost
of providing Internet banking. Large banking institutions have not released information
on their different banking activities, nor can the information be easily derived from the
consolidated data they release. Some analysts believe that Internet banking has also had
a negative impact on some large commercial banks’ profits; however, revenues from
other profit centers overwhelm their losses on Internet banking.
The “Critical Mass” Problem
Both the benefits and the costs of using Internet banking depend on the number
of users. Because Internet banking is conducted over the World Wide Web network, it
is subject to network externalities. Network externalities arise when the benefit a
consumer expects to receive from a good or service depends on the number of
consumers using the good or service. The fax machine is the classic example: If only one
business owned a fax, the machine would have no practical value. The existence of a
second machine would increase the benefits to the first machine’s owner by activating
the potential for sending and receiving faxes. Each additional fax installation in a
different location would increase the benefits to existing users. The benefits to a new fax
machine purchaser would depend on the number of machines already installed. This
interdependency of demand means that the market for network goods such as Internet
banking services must meet a minimum size before the network can break even or
achieve a sustainable equilibrium. This minimum size of the network is called “critical¹⁸
mass.”
The problem this concept poses for Internet banking providers and all networks
is that it is not very helpful in determining the size of the market. After the beforehand
unknown critical mass is reached, market dynamics usually change considerably. The
market for Internet banking might grow slowly until reaching critical mass and then
suddenly begin expanding at a very rapid rate. An example to illustrate this market
behavior is the credit card market in the 1960s and 1970s. The growth rate of the credit
card market was slow, but began growing very rapidly in the 1980s and 1990s. Another
example is electronic funds transfer at point-of-sale terminals, which are currently at
almost every major supermarket checkout counter. This method of payment grew very
slowly up to the 1990s, when it took off. Without knowing the size of the market
Internet banking providers are unable to determine their share of the market and thus
unable to determine the optimal Internet banking capacity needed.
Bankers don’t believe Internet banking has reached its critical mass with only
roughly 6% of bank customers using Internet banking. However, they are not able to
forecast the size of the Internet banking market at critical mass or after critical mass is
reached. Banking analysts believe that once critical mass is reached, the up-front fixed

¹⁸ See Nicholas Economides and Charles Himmelberg, “The Economics of Networks,”
International Journal of Industrial Organization, Vol. 14, Oct. 1996, pp. 673 –99.

costs, including infrastructure, security, and regulatory compliance costs will be
distributed over a larger number of customers, and the variable costs per Internet
banking transaction will be negligible. These analysts argue that banks are planning to
recoup their losses in the long term when they are expected to raise the price of
providing Internet banking services. This strategy is the same as what the industry used
with their automated teller machines. Depository institutions first offered ATM services
free, or below cost, to build customer use to a critical level and then imposed fees.¹⁹
Customers accustomed to using ATMs continued to use them despite the greater cost.
The same strategy is expected eventually to make Internet banking a major profit center.
Regulatory Policy
Congress and Federal Regulatory Agencies
Congress has left it to the federal regulatory agencies to make sure that
electronic financial transactions are in compliance with regulations governing traditional
paper-based transactions. However, as illustrated by a number of congressional hearings
concerning the Internet and Internet banking, Congress has relied on its oversight
responsibilities to monitor developments. Congress has passed only two laws that are
significantly related to Internet banking. The Gramm-Leach-Bliley Act of 1999 (P.L.
106-102) requires federal regulators to issue guidelines to ensure that electronic banking
activities are conducted in keeping with safety and soundness regulations. The
regulatory agencies were able to issue these guidelines by January 2001. The Electronic
Signatures in Global and National Commerce Act of 2000 (P.L. 106-229) provides that
no contract, signature, or record may be denied legally binding status only because it is
in electronic form. It also placed similar disclosure requirements on electronic banking
as there are on paper-based payments. Congress is expected to continue to monitor
regulatory developments under its oversight responsibilities.
The Regulatory Agencies’ Stance. In certain respects, the federal
regulatory stance toward electronic financial transactions meets the expectations of
neither consumers nor the banking industry. On one hand, the regulatory stance is not
to interfere with the introduction of new technologies because electronic banking
regulations could stifle such innovations by locking the banking industry into fewer
beneficial technologies. On the other hand, federal and state regulatory agencies have
developed procedures and examinations for Internet banking that are costly for Internet
bankers to comply with. As Fed Chairman Alan Greenspan stated, “If we wish to foster
financial innovation, we must be careful not impose rules that inhibit it. I am especially
concerned that we not attempt to impede unduly our newest innovation, electronic
money, or more generally, our increasingly broad electronic payments system.... To

¹⁹ When ATMs were first introduced, there were no fees for using other banks’ ATMs to
encourage widespread usage. It was in the mid-1990s when ATMs became very popular that
banks began imposing fees for using “foreign ATMs” – other banks’ ATMS. Consumer
advocates accused the banking industry of exploiting consumers with these fees.

develop new forms of payment, the private sector will need the flexibility to experiment,
without broad interference by government.”²⁰
However, some analysts interpret this stance as a wait-and-see policy, allowing
the industry to do what it wants. Regulators, they argue, should be more proactive in
helping consumers make choices among new technologies through which banking
services are being offered. Neither individual consumers nor consumer advocacy
organizations have the resources to participate in all the standard-setting projects now
underway.²¹ Without input on behalf of consumers in standard-setting projects, genuine
consumer preferences may not be taken into account. Consumers look to the regulators
to intervene on their behalf before new forms of electronic banking are introduced.
Some argue that regulators’ sensitivity to consumers could lessen consumer resistance
to changes in the U.S. electronic payments infrastructure.
Risk Management
Regulators are concerned about the new risks that accompany Internet banking.
The Bank for International Settlements (BIS) has published special risk management
guidelines for banks and the regulators who supervise providers of Internet banking.²²
The overarching concern for banks offering Internet banking is security control, which
begins with authentication and access to privileged financial data. A security breach can
lead to significant losses in a short period of time because of the dynamic environment
in which Internet banking activities take place.
Internet banking providers have greater risk exposure than traditional banking
because Internet banking providers are more reliant on third party services. For many
banks, third parties supply the expertise and technologies that run the day-to-day Internet
banking operations. Operational risks of fraud exist, and technical problems can lead to
costly bottlenecks and result in significant losses and inconvenience for customers.
Consequently, the central theme of the BIS guidelines is that the boards and senior
management of depository institutions should not permit an institution to engage in
electronic banking activities unless it has the necessary expertise to provide competent
risk management oversight.

²⁰ Remarks at the U.S. Treasury Conference on Electronic Money and Banking: the Role of
Government, Washington, D.C., Sept.19, 1996.
[http://www.federalreserve.gov/boarddocs/speeches/1996/19960919.htm], last visited Oct.

31, 2001.

²¹ Standard-setting projects refers to establishing uniform requirements, procedures, and
capabilities when introducing new technologies. For Internet banking, an example of a
standard would be the number and type of identifications required to enter an Internet banking
account and the kinds of transactions that a customer is allowed conduct within that account.
²² Paul Allan Schott, “The New Basle Risk Principles for Electronic Banking,” Electronic
Banking Law and Commerce Report, July/ Aug. 2001, p. 9.

Regulatory Examination of Internet Banking Operations
Federal and state regulatory agencies have developed examination procedures to
protect Internet banking consumers against these risks but these procedures tend to
increase compliance costs. The aim of these examination procedures is to determine
whether the depository institutions have taken steps to control risk in Internet banking
and whether the institutions are in compliance with relevant laws and regulations.
Because higher-skilled employees are necessary to keep an institution in regulatory
compliance, regulatory compliance in Internet banking is often more financially
burdensome than traditional banking.
Internet banking examinations are conducted by bank examiners and information
technology specialists, who evaluate institutions’ safety and soundness within a risk
assessment framework. This framework includes a determination whether the
compliance management program in the depository institutions has been updated to
control the compliance risks of Internet banking. To illustrate, Internet banking, if newly
implemented or significantly changed since the last examination, is reviewed in the
following subject areas:²³
!Broad oversight and strategic planning;
!Appropriate policies and procedures;
!Adequate internal controls, including internal and external audits;
!Attention to the unique security issues on electronic banking;
!Due diligence and oversight of vendors and outsourcing arrangements;
!Reporting systems that allow monitoring of electronic banking activity; and
!Personnel with acceptable knowledge and technical skills.
In addition, consumer compliance specialists examine a depository institution’s Web site
for compliance with regulations. For example, the advertisement terminology must be
consistent with Truth in Savings and Truth in Lending requirements.
While the costs of regulatory compliance are not the major costs driving
depository institutions’ losses from their Internet banking activities, they are a factor.
Moreover, the expense to institutions is not enough to prevent regulators from making
sure that Internet banking providers are in compliance with appropriate laws and
regulations. In the past, the banking industry has asked Congress for regulatory relief
for traditional banking activities because the cost of compliance is high. According to
some bankers, the cost of compliance for Internet banking is several times higher than
traditional banking. Despite the regulatory compliance and other costs, analysts believe
that the Internet bankers’ strategy is focused on increasing Internet banking customers
to develop a critical mass. According to that interpretation, the full costs of Internet
banking would then be capitalized after this critical mass was reached, even if it required
charging those customers additional fees.

²³ Sullivan, p. 12.