Impact of Computers in Banking

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The Impact of Information Technology on the
Banking Industry: Theory and Empirics
Shirley J. Ho
National Chengchi University, Taiwan
Sushanta K. Mallick
Queen Mary, University of London, UK
November 7, 2006
This paper develops and tests a model to examine the effects of information technology (IT) in the US banking industry. It is believed that IT can improve bank’s performance in two ways: IT can reduce operational cost (cost effect), and facilitate transactions among customers within the same network (network effect). The empirical studies, however, have shown inconsistency on this hypothesis; some agree with the Solow Paradox, some are against. Since most empirical studies have adopted the production function approach, it is difficult to identify which effect has dominated, hence the reasons attributed have been the difference in econometric methodology and measurement. This paper attempts to explain the inconsistency by stressing the heterogeneity in banking services; in a differentiated model with network effects, we characterize the conditions to identify these two effects and the conditions for the two seemingly positive effects to turn negative in the equilibrium. The results are tested on a panel of 68 US banks over 20 years, and we find that the bank profits decline due to adoption and diffusion of IT investment, reflecting negative network effects in this industry.

1 Introduction
The usage of information technology (IT), broadly referring to computers and peripheral equipment, has seen tremendous growth in service industries in the recent past. The most obvious example is perhaps the banking industry, where through the introduction of IT related products in internet banking, electronic payments, security investments, information exchanges (Berger, 2003), banks now can provide more diverse services to customers with less manpower. Seeing this pattern of growth, it seems obvious that IT can bring about equivalent contribution to profits.

In general, existing studies have concluded two positive effects regarding the relation between IT and banks’ performance. First, IT can reduce banks’ operational costs (the cost advantage). For example, internet helps banks to conduct standardized, low value-added transactions (e.g. bill payments, balance inquiries, account transfer) through the online channel, while focusing their resources into specialized, high-value added transactions (e.g. small business lending, personal trust services, investment banking) through branches. Second, IT can facilitate transactions among customers within the same network (the network effect) (see Farrell and Saloner, 1985; Katz and Shapiro, 1985; Economides and Salop, 1992). Let us consider the case of automated teller machines (ATMs) by banks. If ATMs are largely available over geographically dispersed areas, the benefit from using an ATM will increase since customers will be able to access their bank accounts from any geographic location they want. This would imply that the value of an ATM network increases with the number of available ATMlocations, and the value of a bank’s network to a customer will be determined in part by the final network size of the bank. Indeed, Saloner and Shepard (1995), using data for United States commercial banks for the period 1971-1979, showed that the concern of network effect is important in the ATM adoption of United States commercial banks (see also Milne, 2006).

In view of these two effects above, it should be surprising to know that the evidence, however, shows some inconsistency in concluding the contribution of IT to banks’ profit. 2
Some studies echo the so called Solow Paradox in concluding that IT will actually decrease productivity. As stated by Solow (1987), "you can see the computer age everywhere these days, except in the productivity statistics". Shu and Strassmann (2005) studied 12 banks operating in the US for the period of 1989-1997 and found that although IT has been...
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