Comment: A Virtual-Banking Future Requires Policymakers to Go Back to

Some time back, when I went to register my Mazda RX7 with the New York State Department of Motor Vehicles, I was reminded of what is in store for the financial services industry and regulators as they go about sorting through the realities of virtual banking.

"How many cylinders does your car have?" the man behind the counter inquired matter-of-factly.

"None," I responded. "The RX7 has a rotor. It has a rotary engine. There are no cylinders."

Right before my eyes, the regulatory machinery of the great Empire State appeared to come to a grinding halt for just a few seconds, as this bureaucrat assessed the implications of a car without cylinders in a world where taxes are assessed based on those very numbers.

"That's O.K.," he observed without skipping a beat. "It's technically a three-cylinder car."

On a different scale perhaps, and certainly with much different potential consequences, I believe the public and private sectors are facing an identical scenario as they grapple with the advent of virtual banking.

Two contrasting perspectives on this score have emerged in the marketplace.

Some maintain that virtual banking is "just a new form of bank." They hold that the same rules and regulations should apply, and that all we need to do is figure out some new tactical means to enforce them.

A second group sees a virtual bank as much more than just another kind of bank. They view it as an entirely new means of conducting all financial transactions - without branches, automated teller machines, or any other physical boundaries. They believe that regulations should be built around definitions of what specifically has to be regulated, and that virtual banks promise to fundamentally change everything in banking that has not changed already.

Though many institutions debate whether customers will remain branch- dependent, and others draw criticism for levying fees on teller transactions, I share that second view.

There is a cachet to talking about virtual banking. We are fast moving toward a marketplace of virtual financial services that are provided not only by banks, but by a host of companies outside the industry.

In the process, it seems clear that the regulatory framework that created banks - and subsequently insurers, securities firms, and mutual fund companies - is rapidly becoming irrelevant.

The emergence of virtual banking appears to be a perfect opportunity to rethink the regulation of all financial institutions in the United States.

After all, banks and insurance, securities, and mutual fund companies were created separately for different policy purposes and objectives, many of which have changed along the way. Even our present form of currency is constructed to have a regulatory purpose.

Some of our policy goals will no doubt remain the same, but most delivery vehicles do not apply anymore. How they have been structured and operate has fundamentally changed.

Bankers as well as state banking departments, the Office of Thrift Supervision, and the Securities and Exchange Commission do not need to look very far to see where virtual banking is likely to take the financial services sector.

The telecommunications bill recently approved by the Senate removes any barriers that still exist between local telephone companies, long-distance carriers, and cable television providers. In this and the imminent deregulation of electric utilities we are witnessing the convergence of what less than a decade ago were four separate industries.

When industries and governments are faced by tremendous marketplace changes, many executives and regulators unwittingly focus more on the entrance to the cave they are approaching, and not on what might be lurking back deep inside. That seems to be the case with virtual banking.

Much of our recent attention around this topic has been on security, fraud, and privacy concerns. We are hearing a lot about unscrupulous folks who may be tempted to take deposits on the Internet and into numbered Swiss bank accounts, bypassing the Internal Revenue Service altogether.

There has been a frenzy of debate on the security of E-cash and the confidentiality of all future financial transactions. Misconceptions about what distinguishes virtual banking from on-line, telephone, and home banking abound.

But by speculating so intensely about the entrance of this particular cave, we run the risk of failing to see and plan for what is really in store for us - and to understand what is at stake. Indeed, bankers and regulators would be well advised to start at the back of the cave and work their way to the front.

The fact is that it is becoming increasingly difficult to distinguish a bank from any other financial intermediary.

The one thing that used to differentiate banks was their ability to take deposits.

Not that long ago, savings banks took deposits, used funds to invest in mortgages and gave their customers a rate of return.

Today, mutual fund firms do much the same when they invest shareholder assets in securities representing home mortgages - but without the constraints of the Community Reinvestment Act.

Until quite recently, other financial institutions also had to acquire a bank to offer those services. No longer. Now firms like Merrill Lynch process drafts on their cash management accounts, in this instance through Banc One. Indeed, Merrill Lynch's Ready Asset Trust (the money market fund for their cash management account) is one of the largest mutual funds in the nation.

Yet money market assets are currently not included in M1 or any other definition of money in this country, even though consumers can pay their Federal income taxes with drafts on such accounts.

Virtual banking, which dispenses with physical presence, geographic boundaries, and paper money, makes these distinctions even more complex.

Many think the old rules governing what used to be banking will work just fine in this new virtual territory, with just a modification here and there.

To these people I say: Think again - you are making the mistaken assumption that past regulatory purposes have remained unchanged or simply disappeared.

A case in point: Federally chartered banks at present cannot be closed for more than three consecutive days. The original intent was to instill added confidence in the safety and soundness of banking institutions.

Needless to say, this and countless other banking regulations have had little or no relevance to banking over the last few decades - let alone to banking in the virtual environment of the 1990s.

For many of us who have stood in frustration at an ATM that was not functioning or had run out of cash, the basic array of comparable virtual scenarios is daunting, to the say the least.

Where do you begin when a line is down and you cannot re-charge your smart card? Your money is somewhere in cyberspace, but you can't get at it. You also cannot visit a physical place like a branch. The worst part is that you do not even know for sure if the funds are still there. Everything you have come to rely on in traditional banking - qualities like safety and soundness - is up in the air.

When it comes to virtual banking, we need to envision a world no more than five or 10 years away in which all of us will carry around an encoded card instead of specie. This card will be the key to paying bills, taxes, mortgages, and other purchases, as well as to putting aside college funds for our children, buying life and every other kind of insurance, and making a full range of investments - from home or any other place we might chose.

Unless industry and government join forces and are prepared to approach this world soon with a clean sheet of paper for new regulatory goals and purposes, the best virtual institutions for the future are not likely to rise to the top.

Instead of survival of the fittest, we are likely to see only the savviest companies survive - the ones most adept at operating under the existing antiquated rules, but not necessarily the best-equipped beyond tomorrow.

I believe a Commission on Virtual Financial Services, with representatives from both the public and private sectors, should be established. This group could start by posing a lot of questions, such as:

*What policy objectives should we try to achieve in tomorrow's regulatory environment?

*Whom are we trying to protect, and what is the best way to go about protecting them?

*How do we audit these institutions, and what new series of controls should we come to rely on?

A commission like this could also establish means of ascertaining whether the objectives set were being met.

A good model might be the commission that was set up in the wake of the Three Mile Island accident. This group went beyond that facility and that incident, making recommendations for nuclear energy policy and safety in the future.

Mr. Saubert is director in charge of the financial industries practice of Arthur D. Little Inc., Cambridge, Mass.

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