Market Structure and the Diffusion of Electronic Banking∗

This paper studies the role that market structure plays in affecting the diffusion of electronic banking. Electronic banking represents a process innovation since it reduces the cost of performing many types of transactions for banks. However, electronic banking (and electronic commerce more generally) is particular since the full benefits for firms from adoption only accrue once consumers begin to perform a significant share of their transactions online. Since it is costly for consumers to switch to the new technology (they must learn how to use it) banks may try to encourage consumers to go online by affecting the relative quality of the online and offline options. Their ability to do so is a function of market structure since in more competitive markets, reducing the relative attractiveness of the offline option involves the risk of losing customers (or potential customers) to competitors, whereas, this is less of a concern for a more dominant bank. Based on the Beggs and Klemperer (1992) model of price competition, we develop a model of branch-service quality choice with switching costs meant to characterize the trade-off banks face when rationalizing their network between technology penetration and business stealing. The model is solved numerically and we show that the incentive to lower branch-service quality and drive consumers into electronic banking is greater in more concentrated markets and for more dominant banks. We find support for the predictions of the model using a panel of household survey data on electronic payment usage as well as branch location data, which we use to construct a measure of branch quality (namely branch density). PRELIMINARY. PLEASE DO NOT CITE JEL classification: D14, D4, G21, L1 ∗Correspondence to Jean-François Houde: University of Wisconsin-Madison, Madison, Wisconsin; Phone: (608) 262-3805; Email: [email protected], Robert Clark: HEC Montréal, CIRANO and CIRPÉE, Montreal, Quebec; Phone: (514) 340-7034; Email: [email protected], and Jason Allen: Bank of Canada, Ottawa, Ontario; Phone (613) 782-8712; Email: [email protected]. Robert Clark thanks the FQRSC and HEC Montréal for funding. We thank Micromedia Proquest as well as Peter Kascor at Credit Union Central of Canada for information on credit unions. We thank the Big 6 Canadian banks for giving us access to IT executives who patiently answered many of our questions. We thank Gautam Gowrisankaram and Randy Wright for comments and suggestions as well as seminar participants at the Bank of Canada, the Competition Bureau, and HEC Montréal. The views in this paper do not necessarily reflect those of the Bank of Canada. All errors are our own.