CESPRI Centro di Ricerca sui Processi di Innovazione e Internazionalizzazione Universit Commerciale "Luigi Bocconi" via R.

Sarfatti 25 - 20136 Milano tel. 02 5836.3395/7 - fax 02 5836.3399 http://www.cespri.uni-bocconi.it/

Nicoletta Corrocher

Does Internet banking substitute traditional banking? Empirical evidence from Italy

WP n. 134

Novembre 2002

ABSTRACT The paper aims at examining the drivers of the adoption of the Internet banking, in order to understand its role with respect to the traditional banking activity and to offer a comprehensive picture of the diffusion of such a technology within the sector. In doing so, it analyses the role of firm-specific and non firm-specific (technology, market, environment) characteristics in influencing the decision to adopt the new technological platforms to perform on-line banking transactions within the retail segment of the financial sector in Italy. The main purpose of this paper is to investigate the relationship between the Internet banking and the traditional banking activity, in order to understand if these two systems of financial services delivery are perceived as substitutes or complements by the banks. JEL Classification: O3; L0; L86 Keywords: Technology Diffusion; Internet; Banking Sector

1. Introduction
The paper aims at examining the drivers of the adoption of the Internet banking, in order to understand its role with respect to the traditional banking activity and to offer a comprehensive picture of the diffusion of such a technology within the sector. In doing so, it analyses the role of firm-specific and non firm-specific (technology, market, environment) characteristics in influencing the decision to adopt the new technological platforms to perform on-line banking transactions within the retail segment of the financial sector in Italy. The main purpose of this paper is to investigate the relationship between the Internet banking and the traditional banking activity, in order to understand if these two systems of financial services delivery are perceived as substitutes or complements by the banks. The interest towards this issue has been stimulated simultaneously by the recognition of the revolutionary characterisation of the Internet within the existing technological trajectory of ICT and by the growing importance of the service industries - especially informationintensive sectors - in the process of development of innovations. Adoption-based models of diffusion of innovation have a long history both of theoretical developments and of empirical studies (for a review see Karshenas and Stoneman, 1995; Baptista, 1999). Applications to the banking sector, however, are only a few ones and most of them deal with the diffusion of ATMs in the financial sector (Hannan and McDowell, 1984; Escuer et al., 1991; Pennings and Harianto, 1992; Ingham and Thompson, 1993; Hester et al., 2000), and only a few authors have concentrated on more recent innovations (Buzzacchi et al., 1995; Daniel, 1999; Mahler and Rogers, 1999). Very few studies have so far been published on the diffusion of Internet-based technological platforms for banking and just two of them have dealt with the diffusion of any technological innovations in the Italian banking system, which is the third banking system in the European Union by market capitalisation (after UK, France and Sweden). The paper is structured as follows. First, some general remarks on Internet banking as an innovation and on the relationship between this new technological platform and the existing banking activity are presented. Second, an overview of the most important contributions on the adoption of new technologies in the banking sector is provided. The aim of this section is to identify the main factors that have been taken into account in order to explain the diffusion of innovations in this industry. In the third part, a description of the available data sets concerning the characteristics of Italian banks and the pattern of adoption of the new technology is offered. In this context, an empirical model for the examination of the adoption of the Internet banking technology is developed, on the basis of the 2

available data. Finally, the results of the empirical analysis are illustrated and interpreted and conclusions are drawn on the relationship between Internet banking and the traditional banking system.

2. Internet banking as a radical innovation

Internet banking identifies a particular set of technological solutions for the development and the distribution of financial services, which rely upon the open architecture of the Internet. The users can conduct financial transactions anywhere - at home, at the office or at school - as long as they have a computer and a modem. With the implementation of an Internet banking system, the banks maintain a direct relationship with the end users via the web and are able to provide a personal characterisation to the interface, by offering additional customised services (Cronin, 1998). A common view of Internet banking is that it represents a process innovation, because the technological developments behind this innovation seem to improve exclusively the operational procedures. Following this perception, in OECD (2000), it is stated that the new ICT affect the relationship between producers and consumers, in that the personal contact becomes less essential, because in many cases the services can be provided much more efficiently via the Internet or through other communications modes. This is a somewhat misleading perception concerning the impact of Internet-based technologies on the provision of services and in particular on the distribution of information-intensive services such as the financial ones, whose content can be easily transformed into an electronic format and delivered over the web. However, the concept of an evolutionary process within the banks output from products to services1 and the characteristics of the Internet lead us to adopt a different view of the Internet banking. This technological innovation represents a process innovation, since it strengthens the interaction between the bank and its customers and enhances the distribution function. However, it can be conceived also as a product innovation, since it embodies the creation of new products as such and the development of innovative combinations of the existing products. This second aspect
At a very general level, it is possible to state that the output of the back office operations are the financial products that are successively made part of the distribution process and delivered to the end users through the front office operations. In this second phase, additional value and functionality are given to the financial products, so that they assume the identity of financial services. In particular, the value added stems from the interactivity with the final users and the consequent customisation of the product, so that what is actually distributed on the market is a financial service. There is therefore a process of evolution of the output of the banking firm from the simple form of financial product to the more sophisticated form of financial service and it could be argued that the more value is added to the end users via the intermediation of the bank, the more the output of financial institutions can be considered a service. A high level of customisation and a direct relationship between the bank and its users is what differentiates a standardised financial product from a financial service, which appears to be more customised and personalised.
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is made possible by the potentialities of the Internet, which encourages and facilitates a move from hierarchical single-supplier relationships, to market-based multiple-suppliers scenarios (Daniel, 1999). Bracchi et al. (2000) stress that Internet banking allows customers to interact more with the front office operations and, at the same time, it allows the bank to concentrate the back office operations by increasing their efficiency. According to such perspective, Internet banking constitutes an innovation both in the processes of production and in the distribution of financial services. On the customer side, the Internet gives more information on the types of financial services of different banks and allows comparisons between the available offerings. On the bank side, the new technologies offer greater information on the users needs and requirements and therefore they permit to develop customised services. Moreover, the Internet represents a valuable instrument to monitor the activity of the competitors. This may drive networking and interaction between the different banks, but may also strengthen the competition and make the selection process severe. The Internet banking constitutes a complex innovation that does not fall into the simple categorisation of product/process innovations, but encompasses both, as a part of a continuum. In other words, in the case of Internet banking, as in the case of other ICT-based innovations, it is not possible to talk about a temporal sequence of product and process innovations. The pervasiveness of such technological developments in the sector allows for the simultaneous presence and, even more, for the strong interdependence of the two types of innovations. In this respect, the notion of service innovations becomes quite helpful in identifying the characteristics of the Internet banking. It is possible to conceptualise innovation in services as a complex entity, in which elements of product and process innovation closely interact with each other. It is reasonable to argue that Internet banking entails all the peculiarities of service innovation, which combines some forms of product innovation and some forms of process innovation. It is particularly the interactivity and the information intensity of the new service that matters for the characterisation of the Internet banking and for the fact that both process and product innovations emerge in such a context. The discussion on the nature of the Internet banking as a service innovation receives some more insights if one considers the relationship between the traditional banking activity and the Internet banking. On the one hand, it is possible to perceive Internet banking (and in general electronic banking) and the traditional banking as two substitute forms of managing financial transactions. An 4

alternative perspective is to consider these two systems as complementary solutions for the provision of financial services. The first approach naturally leads to view the Internet banking as a second-best system compared to the traditional banking: the personal contacts between the banks and the final users are eliminated and the non-verbal dimension of the communication cannot be perfectly reproduced over the Web. However, it is worth considering that there is not a substitution between the technological systems and the human resources involved in the banking activity, and that the implementation of new Internet-based solutions require both the development of new knowledge and competencies, in order to increase the functionality and the value of the financial services for the end users, and the reinforcement of the existing routines and skills, in order to adapt them to the new paradigm. Therefore it is more appropriate to adopt a perspective that emphasises the complementarity between the traditional banking activity and the new Internet banking solutions and considers them two separate, but not incompatible systems of providing financial services. The pattern of evolution of the banking activity does not prevent us to regard the different forms as sequential, but not mutually excluding technological and business models for the provision of financial services. In the initial phase of the development of electronic banking, the new system was conceived as a substitute for the existing model and the tendency of the banks was to replicate the traditional banking activity, by adding new features and functionality made available by the emergence of the new technologies. However, it soon became clear that the two forms of banking were not incompatible and could coexist within the same environment. Furthermore, banks realised that the potential of each these models would have been strengthened, if both systems had been put in place. This means that the capability of the new technological systems could not be exploited exclusively by applying the new ICT to the existing systems, but required the creation of different technological and business models2. It is true that the Internet banking cannot provide customers with the same range of financial services of the traditional bank, especially as far as the type and degree of interaction is concerned. However, it is also true that it allows the emergence of new typologies of services and the possibility of making use of them on a continuous basis. It is not possible to establish a once-for-all best solution for the implementation of the banking activity, but it is reasonable to argue that the combination of connectivity, continuity of the service, user

In this respect, Filotto (2000) makes an interesting comparison between the transition from the traditional banking to the Internet banking and the evolution of the flight systems. For ages, the human beings tried to replicate the flight of the birds and built a variety of flying machines based upon a mechanism of flexible wings that never worked properly. The history of the flight with heavy machines started with the introduction of fixed wings, which allowed a much higher carrying capacity compared to the flexible wings, suitable to carry only very light weights. This example shows how the best results are often achieved not by reproducing the existing models with the new technologies, but by identifying new trajectories that can fully exploit the potential of such new technologies.

interface and low costs makes the electronic bank a model that complements and strengthens the functionality of the existing one. The above considerations have a significant impact on the identification of the determinants of Internet banking adoption by banks. It is often argued that a process innovation offers lower costs and provides benefits more to the existing customers of a firm, while a product innovation is directed to capture new users and to enlarge the market share. The analysis allows us to investigate the relationship between the Internet banking and the traditional banking in terms of substitution/complementarity and to understand which bank-specific characteristics are most conducive to the adoption of Internet banking.

3. Empirical contributions on the adoption of innovations in the banking sector

It is quite significant that the appearance of the initial contributions on this topic followed the introduction of the ATMs in the banking industry, which was perceived as an important example of ICT-based service innovation and therefore attracted the interest of many researchers. As a consequence of this, a process of data collection started in the industry, which allowed the development of empirical analysis on the pattern of adoption of this innovation by banks, although the literature has also investigated the adoption of other types of new technologies. In the examination of the main features of the different studies, we will pay particular attention to the determinants of adoption of the new technologies identified by the relevant contributions. This is because such an analysis constitutes a useful starting point for the development of the empirical model regarding the adoption of Internet banking in Italy, particularly as far as the choice of explanatory variables is concerned. Hannan and McDowell (1984) investigate the determinants of adoption of ATMs in the US financial sector. The results of the analysis largely confirm the assumptions made by the authors. Market concentration and firms size both have a significant and positive impact on the probability of adoption of ATMs. Concentration allows a faster introduction of new technologies and produces dynamic efficiency benefits (despite lowering static efficiency gains). With reference to firm size, on the other hand, large firms have a more positive attitude towards the introduction of new technologies than small firms benefit from relevant economies of scale in the use of ATMs. As far as other market characteristics are concerned, market growth does not have a significant impact on the adoption, while the wage rate shows positive and significant coefficients. This means that 6

reducing the operating costs represents one of the most important drivers of the adoption of ATMs. A very interesting result concerns the role of firm profitability: the impact of profits on the conditional probability of adoption is negative but statistically insignificant, and this means that there is no evidence of the role of financial constraints in the technological strategies of banks. On the contrary, the specific product mix of a bank greatly affects to a great extent the adoption of ATMs: the positive coefficient of this variable is consistent with the idea that, since cash withdrawals from demand deposits are the most common type of transactions performed with the ATMs, a high proportion of demand deposits over total deposits acts as a driver of the adoption. As far as the dummy variables are concerned, the findings show a positive and significant effect of the existence of branching restrictions on the probability of adoption, suggesting that banks are more likely to adopt ATMs when alternative methods of providing value-added services to customers are limited. This is further supported by the fact that banks seem to be more likely to introduce the new technological systems, if the regulations allow the setting up of off-premise ATMs. Other important results relate to the fact that banks that are owned by a holding company are more likely to adopt the innovation, as well as banks that operate in an urban environment although the coefficient for this variable is marginally significant. Along this line of research, Ingham and Thompson (1993) aim at investigate the determinants of the adoption of ATMs in the UK financial sector. The results of this analysis are largely consistent with the findings of Hannan and McDowell (1984). Firm size has the expected positive effect on the adoption of new technologies, as well as labour costs. The most interesting result relates to the effect of branching, which is negative, although marginally significant: according to the authors, this means that the sunk costs of building a structure of branches have an important role in determining the probability of adopting the ATMs, as compared to the alternative effect of cost reduction deriving from the introduction of the new technology. However, we believe that the negative relationship between branching intensity and the probability of adoption could also be determined by the fact that banks with a high number of branches have a very close contact with the customers and do not feel the need for implementing other systems for financial services delivery. The proportion of non-retail deposits shows a negative but not significant effect, as well as the variable identifying the strategy of the building societies (more or less close to the one of commercial banks). Finally, advertising seems to affect positively the adoption of ATMs and this again accounts for a relevant scale effect.

Another interesting contribution in this context is the one by Escuer et al. (1991) on the determinants of adoption of the teleprocess terminals by Spanish commercial and savings banks. The main object of investigation is the diffusion of a new process technology developed in an outside industry within a population of homogeneous firms operating in different geographical markets. The theoretical model used to guide the empirical analysis is the probit model of adoption of process innovations by business firms (Davies, 1979). The results show that adoption time is minimised for a medium level of size, which identifies banks with deposits of approximately 400.000 million pesetas. Capital intensity is positively associated with the time of adoption, which indicates that labour intensive banks adopt the new labour saving technology earlier than capital intensive ones. Finally, the time of adoption is negatively related to the profitability, but the level of statistical significance of this variable is quite low, which is a common result in the literature. The authors apply the model also to savings banks, but extend it in order to account for the impact of the market structure on the adoption of new technologies. In particular, they introduce two additional determinants - market concentration and market growth - to explain adoption time. The empirical analysis demonstrates that both these variables are significantly related to the decision to invest in the innovation. In particular, the results indicate that the diffusion of the new technologies is faster with intermediate levels of concentration in the market, i.e. with intermediate level of competition. An interesting paper is the one by Pennings and Harianto (1992) that deals with the adoption of video banking services within a sample of 152 of the largest 300 commercial banks in the US between 1980 and 1987. The authors argue that the likelihood that banks invest in this technology is positively associated with the accumulation of experience in the ICT area, with the capital investments in systems and equipment, with the development of inter-firm linkages with firms in the ICT, stock brokerage and insurance sectors and with other transactional providers. The study takes into account four groups of determinants, related to technological experience, networking, firm attributes and industry characteristics. The results of the model partially confirm the three hypotheses made by the authors with reference to the determinants of adoption of video banking services. Cumulative experience in technology and in inter-firm linkages are highly correlated, meaning that they compete in explaining the probability of introducing the new technological systems. Both these factors are conducive to innovation, although when they are introduced together in the model, the most significant one is the existence of inter-firm linkages. Within this category, it seems that the agreements involving inter-firm conduct stimulate technological innovations, while inter-organisational relationships contribute to the diffusion of innovations. This is not very surprising, since many technological activities entail some form of networking and 8

hence technologically active firms are prominent also in inter-organisational strategies. However, it is worth underlining that the exclusion of either variable from the model makes the other highly significant. On the contrary, the productivity index and the investments in systems and equipment have no significant effects. As far as firm and market attributes are concerned, firm size is the only characteristic that has a significant impact on the adoption of video banking services. Buzzacchi et al. (1995) develop a theoretical model to analyse the determinants of ICT-based innovations in the banking sector and test it for the use of electronic payment systems of a sample of 77 Italian commercial banks. The authors analyse four groups of factors that can drive the diffusion of such services and refer to the structure and conduct of banks, the characteristics of their market, and the driving forces of the technology. The empirical findings show that the level of IT literacy accumulated during the mass automation regime is very important in explaining the adoption of electronic banking services. On the contrary, the coefficients of technology-push variables are not significant, meaning that technological leadership in the automation of back-office operations does not provide banks with additional advantages. The demand-pull variables appear to play a crucial role in affecting the innovation in the baking industry: however, this holds just for banks that have a high level of IT-related skills, while technological laggards have reduced capabilities to take advantage of favourable demand conditions. Market structure fails to prove any effect on the introduction of innovations in electronic banking, while size exerts a positive but decreasing effect. Furthermore, a banks market share does not evidence any effect upon the adoption of innovations and the same holds for the profitability of a bank, meaning that banks do not face liquidity constraints in the development of innovations. Another study (Daniel, 1999) examines the provision of electronic banking in the UK and in the Republic of Ireland and is based upon data from a questionnaire. The aim of the research is to investigate the importance of a series of factors for the provision of electronic banking services: the organisational culture of innovation, the market share or strength of the organisation, organisational restrictions and limitations, the prediction of customer acceptance and the vision of the future. Most respondents agree that providing electronic banking is crucial to meet the expectations of the existing customers in terms of the range of products and services offered, and to capture new users. With reference to the organisational limitations, the empirical findings suggest that financial constraints and the scarce availability of human resources are the most important problems related to the possible implementation of electronic banking. However, beyond these restrictions there are also some cultural barriers, such as the lack of senior management support and commitment. 9

Turning to the market variables, it is interesting to observe that most respondents forecast a low usage of electronic banking by their customers, despite recognising that the uncertainty of customer acceptance does not affect the adoption of these technologies and that the main reason for providing such services can be identified in their value-added for the customers. Finally, the respondents believe that the provision of electronic banking is fundamental for the future strategy of the bank, since it reduces costs and offers a strong competitive advantage. In general, the vision of the future is considered to be the most important factor stimulating the adoption of electronic banking services, followed by customer acceptance, while organisational restrictions and limitations are perceived as the least important variables that explain the provision of electronic banking: this means that market drivers play a more significant role than organisational drivers. Finally, Mahler and Rogers (1999) focus on the role of the critical mass in explaining the diffusion of interactive communication innovations (of which Internet banking could be thought as the most complex one). The starting point is the recognition that the adoption of this type of innovations depends on the perceived number of other competitors that have already adopted them: therefore the diffusion path does not follow the common S-shaped curve until a critical mass of users is reached. The object of the analysis is the diffusion of twelve communication services in the German banking industry, a sector which is a pioneer in the adoption of new telecommunications technologies. After having collected the information from banks with respect to the relevance of these determinants for not adopting the innovations, the authors conduct a factor analysis and extract three factors. The first one is related to the poor service from the supplier and is explained by variables such as bad service, resistance from employees, long waiting period, bad information from the supplier, bad price/value ratio. The second factor identifies an ensemble of socio-technical determinants and includes variables such as bad data security, lack of sufficient standards and organisational problems. The third factor contains just one variable, i.e. the low rate of diffusion of the innovations. The study then examines the relationship between these three obstacles to adoption and the degree of innovativeness of German banks - that are divided into innovators, early adopters, early majority, late majority and laggards (following Rogers, 1995). The low rate of diffusion is the most important obstacle to the adoption for all the categories but for the innovators, that consider the socio-technical reasons as being more important. Furthermore, for all the categories except for the innovators, the poor service from the supplier is considered as more relevant than the sociotechnical reasons. The analysis shows that, whether or not the diffusion process of a specific innovation has reached a critical mass, the obstacle to adoption represented by the low rate of diffusion is of significant relevance for all the innovations, regardless of the presence of network 10

externalities. Furthermore, these results are quite interesting because they put emphasis one the role of suppliers in affecting the decisions of the banks to adopt the innovative services.

4. A model for the analysis of the adoption of Internet banking in Italy

The starting point for the analysis is the development of a model of duration to examine the conditional probability of adoption of Internet banking. We provide the theoretical background related to the specification of the model, explaining the approach used in the present research to estimate the model. The second part concerns the description of the variables chosen as explanatory factors of the adoption of Internet banking technology. The object of investigation is the probability that a bank adopts in time t, given that it has not yet adopted by that time: this conditional probability constitutes the dependent variable in the model. In order to analyse the effect of covariates on the hazard rate, one of the most common model is given by Coxs approach to the proportional hazard (Kiefer, 1988; Greene, 1997). The present study takes this technique as the point of reference for the estimation of the model. This method is a semiparametric approach to survival analysis. It does not require the probability distribution F(t) to be specified and utilises regression parameters in the same way as generalised linear models. The model specifies that h(ti ) = h0 (ti ) exp( ' xi ) so that the hazard functions of any two individuals are assumed to be constant multiples of each other, the multiple being exp( ' ( xi x j )) , the hazard ratio or incidence ratio. The function h0 is the baseline hazard and represents the individual heterogeneity, while the set of parameters ho(t) can be considered as nuisance parameters that merely control the parameters of interest for any change in the hazard over time. In principle these parameters should be estimated for each observation: however the Coxs partial likelihood estimator provides a method of estimating without requiring the estimation of ho(t). Having described the theoretical framework, the next step of the analysis will consist in the choice of the covariates X that explain the conditional probability of failure (adoption).

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4.1 The explanatory variables

The first variable we take into account is the size of the potential adopters (banks), in line with the existing studies related to the adoption of new technologies in the financial sector and in general to the diffusion of innovations among firms (Karshenas and Stoneman, 1995). The most common proxy for firm size is the number of employees; nonetheless, when analysing the financial sector, the literature measures firm size with total assets3. In our investigation, we propose two different specifications of the model, which alternatively include, as a proxy of firm size, the total assets and the number of branches. As we will see later on, the main reason behind the use of two alternative measures of firm size relies in the relation between these variables and other explanatory factors in the model (e.g profits). In general it is assumed that the size variable captures the scale effect, although some authors (Rose and Joskow, 1990; Hannan and McDowell, 1994) argue that differences in firm size may also reveal differences in managerial attitudes and in the risk aversion to experiment new technologies. In the present study, we expect a positive relation between size and the conditional probability of adoption, therefore believing that there exist significant economies of scale associated with the implementation of Internet banking. This could be partly explained by the fact that a big bank reduces its transaction costs much more than a small bank, if it offers its customers on-line banking services, since it deals with a high number of customers and it manages a relevant amount of financial operations. Beyond this, Internet banking platforms provide a way to facilitate the coordination between the branches of a bank, which represents a strategic issue more for big institutions than for small ones. However, some authors (Pennings and Harianto, 1992; Buzzacchi et al., 1995) have underlined that in the smart automation regime, the importance of external sources of technology should reduce the role of size as a determinant of adoption of innovations. If we look at the pattern of adoption of Internet banking in Italy, we can see that the first adopters of Internet banking technological systems were not the largest banks, but the medium size institutions. Accordingly, although we believe in a positive relationship between size and the conditional probability of adoption, we perform a non linearity test, introducing a term that represents size squared (assets2 and branch2) to allow for more flexibility in the relationship and to investigate the existence of a size most conducive to technological adoption. Based upon the results obtained in the

Other authors (e.g. Escuer et al., 1991, Buzzacchi et al., 1995) measure the size as the volume of bank deposits.

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descriptive statistics, we expect that the probability of adoption is positively affected by size up to a certain point, but as banks become larger and larger, this relationship is inverted. The second variable that is included in the range of independent variables is the profitability of the bank, measured as total profits: the issue here is to test the importance of liquidity constraints in funding the adoption of a new technology. The relationship between the profitability of a bank and the conditional probability of adoption of a new technology does not appear to be significant in the literature, and even when the profitability is measured with the return on equity - an indicator that should help avoiding problems of correlations between profitability and size - the results do not improve (Escuer et al., 1991; Pennings and Harianto, 1992; Buzzacchi et al., 1995). Despite this evidence, we allow for the possibility of profits affecting the adoption and therefore do not make any a-priori assumption on this relationship. The third factor we consider is the share of interest margin over gross income, which illustrates the characteristics of the activity of a bank. The introduction of a variable that identifies the product mix of the bank is quite common in the literature on the diffusion of ATMs and usually the research investigates the share of retail accounts over total deposits, because it is assumed that ATM services are utilised mostly by retail accounts holders (see, for example, Ingham and Thompson, 1993). In the present analysis, the variable into question indicates what is the magnitude of interest-based transactions (e.g. loans) as compared to the total gross income. A bank with a high interest margin/gross income ratio performs an activity that generates a high share of interest-based income and could be considered less innovative than a bank with a high proportion of income deriving from other value-added activities, such as brokerage. This factor is quite relevant when taking into account the pattern of adoption of Internet banking. On the one hand, banks need to find new ways of generating income other than interest-based transactions, since these are less and less profitable due to the sharp decrease in the interest rates: therefore going on-line could help the development of new value-added products and services and this means that a high interest margin/gross income ratio could drive the adoption. On the other hand, banks with a low interest margin/gross income ratio are already oriented towards more valueadded activities. It follows that the adoption of Internet banking, especially in a country like Italy where the stock trading business has boomed dramatically in the last two or three years, would prove to be particularly useful and efficient for such institutions. Furthermore, it is worth remembering that non interest-based transactions involve a higher cost than interest-based ones: this 13

means that the advantages of on-line banking stemming from the reduction of costs per transaction4 would be higher, the lower is the interest margin/gross income ratio. Despite the ambiguous effect of the banking activity on the probability of adoption, we are more inclined to think that there exists a negative relationship between the interest margin/gross income ratio and the adoption of Internet banking. It is quite common to assume that the adoption of innovations - particularly ICT-based innovations presents a high degree of persistence, so that a firm that has proven to be a heavy adopter in the past, will continue to do so also in the future. In some cases of ICT-based innovations, there is also an important effect of complementarity between different technologies, so that the adoption of a specific innovation depends upon the previous adoption of a complementary technology (Pennings and Harianto, 1992; Stoneman and Kwon, 1994; Buzzacchi et al., 1995; Colombo and Mosconi, 1995; Shapiro and Varian, 1999). The cumulative experience in information technology as a driver of adoption of innovations is quite visible in the case of Internet banking, which involves both telecommunications and computer technology and could not be adopted without the benefits of commensurate learning curves. The capacity of banks to innovate around ICT depends very much upon whether they have engaged in the acquisition of cumulated computer skills, developing an absorptive capacity in the field. Unfortunately the data we have on the banking sector in Italy do not allow us to identify a proper measure of innovativeness, since we do not have data on IT systems expenditures or, more in general, on R&D expenditures. Therefore, we measure the innovativeness of a bank as the intensity of ATM adoption, i.e. as the share of ATMs over total branches. Since the first ATM appeared a long time ago and most banks have an ATM in each branch (which means an intensity of ATM adoption equal to 1), we generate a dummy variable. This dummy is equal to 0, if the ratio between the number of ATM and the number of branches is 1, and is equal to 1, if the ratio is greater than 1 - meaning that the bank is actually more innovative than the average. Accepting this indicator as a measure of the propensity to innovate, we expect a positive effect of this variable on the probability of adoption.

The comparison between banking transaction costs by channel shows that Internet banking costs less than 1% of traditional branch banking, with telephone banking being less than 50% as expensive as branch transactions and ATM transactions costing 50% of telephone banking (Shroeder Salomon Smith Barney, 1999).

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The introduction of Internet-based technological systems is often seen as part of a strategy of cost reduction, notwithstanding the need for substantial technological and marketing investments, for the recruitment of new technological experts and for the creation of new job functions. As far as human capital is concerned, the issue is quite straightforward, since the adoption of Internet banking tends to reduce the cost of personnel, at least in the short term. If a bank sees the possibility of cost reduction, it will be more inclined to adopt the new technology. In order to account for this variable, we use a relative measure, i.e. the share of personnel expenditures over total assets. As far as the costs of the infrastructure are concerned, the question is how the Internet banking is perceived in relation to the existing banking structure. In line with Ingham and Thompson (1993), we measure the intensity of branching as the adjusted number of branches over total assets. If banks considered the sunk costs of having built up a branch network, this could retard the adoption of Internet banking. Furthermore, banks with a significant number of branches are deeply rooted in the geographical area where they operate: this means that they have well-established contacts with customers and therefore do not feel the need to implement technological systems for the provision of on-line financial services. According to this view, the Internet banking is considered as a substitute for the branch activity: banks do not see many benefits stemming from the provision of financial services over the Internet and may even perceive the existence of an opportunity cost to switch to the on-line business. Alternatively, more intensively branched banks can see great potentials for costs savings and the possibility of increasing the efficiency of their existing operations, if Internet banking is perceived as a means of rationalising the existing network of services distribution, without necessarily substituting it. Given this ambiguity, it is not possible to make any a-priori assumption on the effect of branching intensity on the adoption. Another variable included in the model is the age of a bank, that indicates how long the bank has been operating. On the one hand, the age affects the structure and dynamics of the loss and profits of the institution and the stability of the financial statements. A new bank usually faces losses due to start up costs and this would lead to assume that older banks are more stable and can more easily invest in Internet banking systems, relying upon their existing revenues. However, it is also true that new banks are more flexible, do not have a legacy system to deal with, and face smaller managerial obstacles to the adoption of the new technology. Furthermore, since the provision of on-line banking services represents also a means to attract customers, it could constitute a strong incentive for relatively new institutions. In view of these considerations, we do not make any a-priori assumption on the effect of age on the adoption. 15

The corporate governance of a bank is quite relevant in explaining the speed and intensity of adoption of Internet banking5. The empirical evidence on Internet banking shows that most savings banks have been fast adopters, while co-operative tend to be laggards. The model therefore includes a dummy variable indicating the specific category of a bank. The group of commercial banks is very heterogeneous and it is not possible to make any a-priori assumption on the effect of the dummy variable on the probability of adoption of Internet banking with respect to this group of institutions. Savings banks are generally more flexible than commercial banks and have a particular attention towards customer needs and towards the development of new technologies that enhance service functionality: therefore we expect these institutions to be particularly proactive in the adoption of Internet banking. On the contrary, rural and trade banks have the statute of a cooperative firm, are generally quite small and tend to be non-profit oriented organisations that operate in a geographically limited context: in line with the descriptive analysis made before, we expect these banks to be quite slow in the adoption. The last explanatory variable take into account concerns the demand side of the market. In the service sectors the introduction of innovations often occurs in response to users needs. The possibility of accessing banking services 24 hours a day, without having to go to the branch, constitutes a value-added function for the customers of a bank. However, the exploitation of Internet banking services requires that the potential users are familiar with the Internet: therefore the banks may consider the diffusion of the Internet within the population as a necessary pre-condition for the success of Internet banking. Furthermore, although in principle the Internet could allow banks to acquire new customers without the need to build a brick and mortar structure, Italian banks - beyond few exceptions - operate in a well-defined geographical area and their customer base is located in that region. For this reason, we consider the percentage of Internet users (home, work and school users) over total population within a certain region (macro-region) as the potential market for Internet banking services for a bank that operates in that area. According to the official statistics, the distribution of Internet users over total populations in Italy is the following: 26.3% in the North West, 26.1% in the North East, 28.3% in the Centre and 20.1% in the South. The most advanced
5

Beyond commercial banks, the Italian banking system includes also saving banks and cooperative banks. Saving banks are retail banks and other similar financial institutions that generally have a significant share in their national domestic banking markets, maintain broad national distribution channels and enjoy a common customer oriented and regionally rooted banking tradition, acting in a socially responsible manner. Their market focus includes amongst others individuals, households, SMEs and local authorities. Their distinguishing feature is that they wish to cooperate with essentially similar types of bank internationally on cross border projects and issues that are of mutual benefit to the retail banking industry, enable them to take advantage of combined strength and/or economies of scale in making a contribution to their respective profits. Cooperative banks are banking institutions that serve the cooperative business community, both agriculture and consumer. These institutions were created in part to meet the financial needs of the cooperative community that were not being met by the traditional financial community.

16

area in terms of Internet diffusion is the Centre, with the North West and the North East being quite close, and the South being far behind. We introduce a dummy variable that indicates the potential demand for Internet banking, assuming that the existence of a high percentage of Internet users acts as an incentive for banks to adopt the technology. Therefore we expect that banks operating in the Centre are stimulated to adopt quickly, while banks located in the South are slow to introduce Internet banking services. Table 6.1 summarises the explanatory variables. Table 6.1 Explanatory variables
Branch Assets Profit Age Intmarg Branching Costhk Duminnov DumstatCOMM DumstatCOOP DumstatSAV DumregNW DumregNE DumregCEN DumregS Number of branches 1999 Assets 1999 - ITL million Profits 1999 - ITL million Year of foundation Interest margin/Gross income Branches/Assets*1000 Cost of personnel/Assets =1 if ATM/Branches >1 =0 otherwise =1 if commercial bank =0 otherwise =1 if co-operative bank =0 otherwise =1 if savings bank =0 otherwise =1 if NorthWest bank =0 otherwise =1 if North East bank =0 otherwise =1 if Centre bank =0 otherwise =1 if South bank =0 otherwise

5. The sample of analysis and the specifications of the model

The Web site of Nuova Banca di Credito di Trieste (http://www.nbctkb.it) lists all the adopters per month since September 1995 together with the type of services they provide (informative Web pages, home banking, trading on line, electronic commerce). It would have been interesting to carry out an analysis of adoption for each different technological solution, but due to the scarcity of adopters in some of these categories, we decided to put all the services (informative and transactional Internet banking) together under the label of Internet banking for the econometric analysis. With the information on the exact number and names of adopters by month, we chose to investigate the probability of adoption by semester. Data on the explanatory variables were obtained from three different and complementary sources: BANKSCOPE - a database which includes 17

balance sheets data and ratings on about 10,500 world banks; the annual report on Italian banks published by Milano Finanza (2000), a newspaper specialised in financial issues; the annual report of the Italian Banking Association (2000). The sample of analysis includes 698 banks, out of which 96 commercial banks, 60 savings banks and 542 co-operative banks. We do not have any financial group in the sample. If we look at the location of the banks, 117 banks operate in the North West, 277 in the North East, 130 in the Centre and 157 in the South. It is important to notice that we could not categorise geographically 17 banks, whose activity is nation-wide. The failure event is the adoption of Internet banking: out of 698 total banks, 21 adopt the technology on enter time (second semester of 1995); of the remaining 677, 309 experience a failure (i.e. adopt) and 25% of them have a survival time of 6 semesters (3 years). If the incidence rate (i.e. the hazard function) could be assumed to be constant, it would be estimated as .0567702 per semester, which corresponds to 0.1135404 per year. This means that in each year, there would be a probability of 11% that adoption occurs, given that it has not yet occurred in the previous year. All the data on the explanatory variables refer to 19996. Table 6.2 illustrates summary statistics. Table 6.2 Summary statistics for the explanatory variables
Variable Obs. Branch Assets Profit Age Intmarg Branching Costhk 698 648 697 695 697 648 610 Mean 4046.275 4265.702 14044.12 69.35827 .7664665 2.449344 1.782668 Std. Dev. 13000.48 20108.1 72155.02 89.62882 .2848755 1.557126 .6004572 Min 100 15.877 -93476.5 1 .0599877 .0063061 .3078829 Max 129200 242409 1022303 2000 7.187097 20.67291 8.520941

In order to estimate duration models of diffusion, one would need a data base on the life history of the population of potential adopters, together with detailed data about a new technology over a long period of time, beginning with the emergence of the innovation in the market. However it is quite difficult to find such data bases and it is common practice to sample a population of potential adopters at one point in time. This procedure may lead to sample attrition, since some firms may have closed down by the time of the sampling precisely because of the adoption of the new technology. However, Karshenas and Stoneman (1993) demonstrate that the sample design is insignificant for

18

Before performing the econometric analysis and testing the survival model of technology adoption, it is useful to study the matrix of correlation of the explanatory variables.

estimation purposes, building a probability model of the exit times to account for the possibility of selection bias in the sampling distribution of the model and rejecting the hypothesis of state dependence of exit time,.

19

Table 6.3 Correlation matrix

Assets Branch Profit Intmarg Age Branching Costhk INNOV NW NE CEN S COMM COOP SAV Assets 1.0000 0.8901 0.9063 -0.0765 0.0884 -0.1714 -0.0734 0.1658 0.1592 -0.0749 -0.0131 -0.0443 0.2122 -0.2485 0.1124 branch 1.0000 0.8358 -0.1094 0.0634 -0.1079 -0.0383 0.2001 0.1449 -0.0612 -0.0173 -0.0438 0.2985 -0.3331 0.1355 profit intmarg age branching costhk INNOV NW NE CEN S COMM COOP SAV

1.0000 -0.0803 0.0883 -0.1598 -0.0624 0.1603 0.1476 -0.0365 -0.0177 -0.0776 0.2268 -0.2346 0.0773

1.0000 -0.0070 0.2070 -0.1126 -0.1145 -0.1328 0.0857 -0.0261 0.0454 -0.1389 0.1523 -0.0592

1.0000 -0.1008 -0.0503 -0.0143 -0.0028 0.0209 0.0020 -0.0261 0.0850 -0.1104 0.0600

1.0000 0.0004 -0.2264 -0.1215 0.0943 -0.0970 0.0965 -0.1444 0.2164 -0.1419

1.0000 0.0014 0.0651 -0.1601 0.1078 0.0311 0.1387 -0.2323 0.1702

1.0000 0.1192 0.0015 0.0556 -0.1745 0.0663 -0.1658 0.1569

1.0000 -0.4055 -0.2254 -0.2146 0.1735 -0.1566 0.0276

1.0000 -0.4488 -0.4273 -0.1821 0.1989 -0.0767

1.0000 -0.2375 -0.0074 -0.1160 0.1685

1.0000 0.0734 1.0000 0.0160 -0.6966 1.0000 -0.1021 -0.1262 -0.6238 1.0000

20

Table 6.3 confirms that there is a high correlation between the size variables - assets and branch and between these variables and profit: branch and profit are slightly less correlated than assets and profits, although the correlation becomes higher if we consider the size squared term. For this reason, using the Coxs exponential survival model previously described, we decide to test two different specifications of the model: in the first one we measure size as the total assets, in the second one we measure size as the number of branches. SP1: Pr (adoption in t | non adoption in t-1) = f (assets, profit, age, intmarg, branching, costhk) SP2: Pr (adoption in t | non adoption in t-1) = f (branch, profit, age, intmarg, branching, costhk) Both the specifications are tested with and without the size squared term. The dummy variables concerning the degree of innovativeness, the region of operation and the corporate governance of the bank are not included in the initial specifications, but are introduced in a second stage.

6. The results of the econometric analysis

The analysis is performed using maximum likelihood estimations, with a number of observations equal to 586 in all the regressions, but in the ones including the dummy variables for the region of operation, where we have 573 observations (for the reason previously mentioned). Table 6.4 illustrates the results of the test. Specifications 1 and 3 include measure size as total assets, while specifications 2 and 4 use number of branches. Specifications 1 and 2 include the dummy variables of the demand, specifications 3 and 4 include the variables of corporate governance. The hazard ratio identifies the coefficient under the proportional hazards assumption that characterises the present model and represents also the differences between the banks due to individual characteristics. The coefficient can be interpreted as the increase (if >1) or the decrease (if <1) in the hazard ratio by (Hazard Ratio -1)% or (1-Hazard Ratio)% if the variable under observation increase by one unit. For example, if we look at the coefficient of the branching variable in the second column, it is possible to say that for every increase in branching by one unit, the hazard is multiplied by 0.8641198. A hazard ratio close to one derives from the fact that one unit of a specific variable may not be a large quantity; therefore, in order to find how much a unit of a certain variable is, we calculate the sample standard deviation. If the unit is not much, in that banks differ from each other by units higher than one, we rescale the hazard ratio of two

21

subjects differing by one standard deviation by raising the hazard ratio to the power on one standard deviation. Table 6.4 The determinants of Internet banking adoption
Assets Assets2 Branch Branch2 Profit Age 0,9999979 -1,23 (0,859396) 1,00082 1,46 (1,076231) 0,1886067* -3,58 0,8641198** -2,52 1,381094* 3,48 1,731355* 4,16 1,245348 0,96 1,115722 0,55 1,454971*** 1,76 SP1 Haz, Ratio z 1,000055 4,53 (3,021989)* 0,999998 -3,43 (0,474664)* SP2 Haz, Ratio z SP3 Haz. Ratio 1,000058* (3,20989) 0,999998* (0,40894) Z 5,11 -4,36 1,000062* (2,23895) 0,999996** (0,63275) 0,999999 (0,98567) 1,00057 (1,05240) 0,187653* 0,863608** 1,279599** 1,573884* 5,69 -2,28 -0,15 0,91 -3,57 -2,49 2,25 3,57 SP4 Haz. Ratio z

Intmarg -3,06 Branching -2,44 Costhk 3,22 Duminnov 3,91 DumregNW 1,06 DumregNE 0,71 DumregCEN 1,97 DumstatCOOP 0,317237* DumstatCOMM 0,3603538* Note: the figures in brackets represent the rescaled coefficients. *Significant at 99% ; ** Significant at 95%

1,000067* (2,389306) 0,999995** (0,576050) 0,9999997 (0,978586) 1,000884 (1,082417) 0,227109* 0,867371** 1,374485* 1,674559* 1,274981 1,152695 1,520739**

5,69 -2,43 -0,15 1,61 0,999998 (0,90392) 1,000511 (1,04685) 0,182343* 0,877971** 1,292288** 1,603387* -1,07 0,82 -3,72 -2,23 2,47 3,71

-6,54 -4,83

0,348471* 0,359590*

-5,95 -4,92

The probability of adoption of Internet banking is positively affected by the size variable, meaning that large banks tend to adopt the technology more quickly than small banks, which confirms our initial hypothesis. However, the coefficient of the size squared term is lower than one and statistically significant. This result confirms our expectations on the role of medium banks as the quickest adopters of the technology: indeed the positive relationship between size and the conditional probability of adoption holds up to a certain size and then it becomes negative. The fact that medium size banks tend to adopt Internet banking faster than large banks is partially explained by the greater flexibility and smaller constraints of these institutions that are innovative and can rely upon relevant financial resources, but do not invest heavily in physical infrastructure and do not have to deal with a myopic and constraining legacy system. The profitability of the bank has a negative effect on the adoption, but it is statistically insignificant, which is in line with the literature (see Hannan and McDowell, 1984; Escuer et al., 1991; Buzzacchi et al., 1995). Similarly, there is not a statistically significant relationship between the age of the bank and the probability of adoption. 22

A very interesting result is related to the characteristics of the activity of the bank: the interest margin/gross income ratio seems to have quite a negative effect on the conditional probability of adoption of Internet banking (the corresponding hazard ratio decreases significantly when intmarg increases by one unit). We have already mentioned that a high ratio indicates a strong propensity towards basic, interest income transactions. From the above results it seems that banks with a high share of interest margin adopt the technology more slowly than banks that are engaged in different types of financial transactions - e.g. brokerage - and this finding can be interpreted according to two explanations. On the one hand, it is usually believed that banks with a high proportion of income deriving from non-interest activities are more innovative than the others. This is because they have aligned their business strategy with their technology strategy, so that core financial competencies are strongly linked to the governance of technological assets. These banks tend to quickly adopt a new technology, since they envisage the value-added of Internet banking for their overall business and not just in terms of enhancement of the ICT functions. On the other hand, the average cost of a financial transaction for the bank is quite different according to the specific transaction taken into consideration. As mentioned before, an interest income activity is less expensive for the bank than a transaction that generates non interest income. This means that the cost reduction deriving from the adoption of Internet banking is much higher for banks whose activity is biased towards non interest income transactions than for banks with a high interest margin/gross income ratio. Therefore these banks have more incentives to adopt these technological systems. Another remarkable finding concerns the role of branching intensity in affecting the conditional probability of adoption. The coefficient indicates that banks with a high branching intensity adopt more slowly than banks with a more flexible and leaner branch structure. This relationship supports the idea that having built a branch structure is perceived by banks as a sunk cost and this investment tends to retard the adoption of Internet banking. Furthermore, an intense branch structure indicates also the existence of a well-established relationship with the customers and this means that banks do not see the need for investing in new technologies in order to provide enhanced services. According to this line of reasoning, it is possible to say that this technology is considered by the financial institutions more as a substitute than as a complement to the existing system of service delivery. However, Internet banking should not be conceived as an alternative technology to the existing one, but as a complementary technological and organisational system, which helps banks find new ways of delivering their existing services and of developing innovative services.

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The evidence of a positive relationship between the cost of human capital and the adoption of Internet banking is also quite strong. Table 6.4 shows that the hazard ratio of the variable costhk is greater than one and significant, meaning that if a bank bears considerable personnel costs, it will be more induced to adopt Internet banking than a bank that does not incur in such expenditures. Our initial hypothesis, based on the consideration that, at least in the short term, the adoption of Internet banking causes a reduction of the costs of human capital, finds confirmations. However, it is important to remember that this technology has appeared quite recently in the market and therefore banks still perceive its short term advantages. In the long run, it is quite likely that there will be the need for new professional figures and new experts both in the ICT and in the financial area: therefore, the diffusion of Internet banking is probably going to raise the cost of human capital within the banking industry. Among the dummy variables, the first factor we consider is the attitude of the bank towards innovation. The test of the specifications shows clearly that there is a positive relationship between the propensity to innovate and the conditional probability of Internet banking adoption, as we had previously assumed. This is in line with the idea that the development and adoption of ICT-based technologies require a set of competencies that can be accumulated only through an incremental learning process, from the most simple forms of automation, to the more complex Internet-based systems. Although the relative number of ATM is not the most appropriate indicator of technological intensity, it nonetheless represents an important factor in identifying the diffusion of ICT in a bank7. The second factor we examine through the introduction of a dummy variable is the relevance of the demand context in which banks operate. In particular, we want to investigate if the existence of a potential demand for Internet banking services is conducive to the adoption of this technology and in doing so, we consider the number of Internet users in the region of operation of the bank as the potential demand, assuming that these users will be more inclined to utilise Internet-based financial services. In order to avoid problems of multicollinearity, we test the two specifications 1 and 2 by introducing three regional dummy variables. If we consider the three regional dummy variables (dumregNW, dumregNE, dumregCEN ), we find that the coefficients of dumregNW and of dumregNE are statistically insignificant, while the coefficient of dumregCEN is greater than one and statistically significant (although in specification

24

1 the level of significance is quite low), meaning that if a bank operates in the Centre, its conditional probability of adoption increases with respect to banks operating in the South. We have already mentioned in the first part of the chapter that the Centre is the geographical area in Italy with the highest percentage of Internet users over total population, while the South is at the bottom of the ranking. The econometric analysis indicates that the potential demand has a role in determining the adoption of Internet banking by financial institutions, although the results are not very robust. The relationship we find with respect to this specific innovation confirms the importance of the demand context as a driver of adoption of new technologies in the service sectors. However, the scarce significance of this dummy variable for the other two regions suggests also that, in the case of Internet banking, the supply-push forces are much stronger than market pull factors, at least in the initial phases. In other words, it is reasonable to argue that the adoption of these technological systems, at least in the initial phase, has been determined more by banks strategies to face the competition of rivals than by the need to meet existing users requirements. The last issue concerns the relevance of the statute of the bank in determining the probability of adoption of Internet banking. The relationship between the type of corporate governance and the adoption of Internet banking is negative and statistically significant for commercial banks and for co-operative banks. This means that the conditional probability of adoption of Internet banking is lower for these two types of institutions as compared to savings banks. We had already mentioned that savings banks have been the fastest adopters of Internet banking, followed by commercial banks and by co-operative banks. The econometric analysis confirms this evidence, by showing not only that the hazard ratio is lower than one for these two groups of banks, but also that the conditional probability of adoption is lower for co-operative banks than for commercial banks. This finding verifies our initial hypothesis that co-operative banks are not very inclined to adopt Internet banking, because their activity is very much concentrated on basic financial transactions - loans and deposits - and because they usually have a small and local customer base. As far as savings banks are concerned, they are more likely to adopt Internet banking technological systems than other institutions, because they generally aim at offering innovative services to their customers and are less inertial than big commercial institutions towards the adoption of new technologies. However, the scarce propensity to adopt the innovation shown by commercial banks as compared to savings banks should be taken into consideration with some caution, since this group of institutions is quite heterogeneous and includes many different banks, some of which have had a leading role in the process of diffusion of technological systems in the sector.
7

Indeed, most of the studies related to the diffusion of new technologies in the banking industry have investigated the adoption of ATM as the most significant ICT-based innovation.

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7. Summary and conclusions

This paper has aimed at throwing light on a recent and not well-investigated phenomenon, i.e. the adoption of Internet banking. In particular, the objective has been to investigate the relationship between Internet banking and the traditional banking activity, in order to examine the degree of substitution/complementarity between these systems as perceived by banks. The focus of the study has been the Italian retail financial service sector and the research has concentrated on the determinants of adoption. We propose here a summary of the most significant results we have obtained from the econometric analysis. In doing so, we provide at the same time some conclusive remarks on the pattern of adoption of Internet banking technology within the Italian banking sector and we elaborate a possible future scenario for the diffusion of the on-line financial services. 7.1 Summary of the results: the determinants of Internet banking adoption The present analysis represents one of the first attempts to investigate the determinants of the adoption of Internet technology for the provision of banking services in the Italian context and it is an innovative piece of work in that it examines the entire population of Italian banks. Relying upon a well-established econometric technique (duration/failure time models) for testing models of adoption-based diffusion of innovations, the study introduces a relevant number of explanatory variables, in order to understand their role in determining the adoption of new technologies by banks. The research generates important results concerning the determinants of adoption. In some cases, the results reinforce or contradict the findings of the previous literature on the diffusion of new technologies in the banking sector, in other cases they offer new evidence on the impact of specific variables on the probability of adoption. First, we find that the conditional probability of adoption of Internet banking is positively affected by size; however, while the coefficient of the size term is positive, the coefficient of the size squared term is negative, meaning that medium banks tend to adopt more quickly than large banks, mostly because they have a more flexible structure and lesser constraints than big financial institutions. This result is quite new, since the literature does not find a significant non-linear relationship between the adoption of a new technology and firm size. One of the most important results concerns the role of the investments in physical infrastructure and human capital in explaining the pattern of adoption of Internet banking. The intensity of branching 26

negatively affects the probability of adoption of this technology, meaning that the existence of a branch structure is perceived as a sunk cost by the banks and that the brick-and-mortar infrastructure is still seen as the best way to maintain the contact with the customers. This finding is crucial, since it implies that banks perceive this technological system as a substitute more than as a complement to their existing branching structure. As we have mentioned before, other works have found a similar result with reference to the adoption of ATM, but the finding appears to be quite relevant in this specific case. With respect to the costs of personnel, we find that they are positively related to the probability of adoption, and this indicates that if a bank faces considerable expenditures in human resources, it will be more inclined to adopt the technology (in order to reduce these costs). Once again, this result seems to support the idea that there exists a relationship of substitution instead of complementarity between Internet banking and the traditional banking system, since it implies that banks see the new technological platforms as a means to reduce the need for human capital, without considering that the implementation of the new system requires the employment of new professional figures (especially Internet experts) and the re-training of the existing ones. Another important result concerns the role of the activity of the bank: we show that a high interest margin/gross income ratio negatively affects the adoption of Internet banking. Banks with a high proportion of income deriving from non-interest activities provide more complex and value-added (innovative) services and tend to adopt new technologies more quickly than other banks. This is because they are forward-looking institutions that have aligned their financial competencies with their technology strategy and consider Internet banking as a crucial component of their overall business. Furthermore, the average cost of a financial transaction for the bank is lower for an interest-based transactions than for a transaction that generates commission income. This means that the cost reduction deriving from the adoption of Internet banking is higher for banks whose activity is biased towards non-interest income transactions and therefore these banks have more incentives to adopt the new technological systems. There is a positive relationship between the propensity to innovate and the conditional probability of adoption and this is in line with the idea that the development and adoption of ICT-based technologies require a set of competencies that can be accumulated only through an incremental learning process. This is in line with other similar findings in the literature: here we chose a new

27

indicator for the propensity to innovate of banks (ATM/Branches), but future research should concentrate on the development of more appropriate indicators to account for this characteristic. The demand context appears to be a significant variable in shaping the process of diffusion of Internet banking, although the level of significance is not very high and the result is not very robust. The fact that banks operating in the Centre have a higher probability of adopting Internet banking systems than banks in the South partially confirms that the existence of a potential customer base may constitute an incentive for banks to offer value-added Internet services, considering that this area has the highest percentage of Internet users over total population. This is the first attempt to include a variable which accounts for the potential demand in works related to the adoption of new technologies in service sectors and the results suggest that the issue is quite relevant. We believe that there is the need for future investigation on the topic and particularly on the co-evolution between the dynamics of the demand context and the development and diffusion of innovations in the service sectors, especially with reference to ICT-based innovations. Finally, the statute of the bank is quite important in affecting the conditional probability of adoption of Internet banking. In particular, we find that savings banks tend to adopt quicker than commercial banks and co-operative banks, the latter being the slowest adopters of Internet banking. This is a very important result, which we suspect does not apply exclusively to the Italian case, and is also quite new, at least in the context of research on the banking sector. Previous empirical studies based upon the applications of duration techniques have generally investigated the role of corporate governance in terms of public vs. private ownership, but the differences between banks have not been analysed before. 7.2 Conclusions and prospects for future research Internet banking constitutes a radical service innovation in the financial sector: the radical characteristic of such an innovation lies in its potential for changing the technological, organisational and market context in which banks operate. They face the opportunity to enormously increase the value of the services they offer to the end users, while, at the same time, gaining longterm efficiency in terms of economies of scale and scope. The main issue for banks is to understand the real value of the innovation, which is not a substitute of the existing structure, but represents a means of increasing its flexibility and, at the same time, a way of widening and customising the range of services provided on the market. 28

From the results of the empirical analysis, banks seem to perceive Internet banking as a substitute for the existing branching structure, although there is also some evidence that banks providing innovative financial services are more inclined to adopt the innovation than traditional banks. Due to the fragmentation of the banking system in Italy, with more than two thirds of financial institutions being constituted as co-operative banks, the adoption of Internet banking has so far concerned slightly more than half of the total population and the low intensity of adoption, in terms of the complexity of the services offered, suggests that there is still a great opportunity for the future diffusion of these technological systems. The relatively recent appearance of the innovation in Italy can partially justify the scarce demand for new Internet-based services (around 10% of the existing customers) and the scepticism of some banks towards the adoption of Internet platforms. So far the introduction of Internet banking has been driven more by the willingness of the banks to be competitive on the market with respect to new entrants and innovative institutions than by the emergence of specific needs from the demand side. In this context, the fact that early adopters have been savings banks, that are traditionally oriented to satisfy customers requirements, might suggest that a certain interest from the end users towards these applications is emerging. In the future, it is likely that banks will be more active in the provision of Internet-based financial services, while, at the same time, they will renovate their organisational structures in order to harness the potential of new technologies to increase their competitiveness. However, the success of Internet banking will impinge upon the interplay between technology and marketing strategies of financial institutions and market requirements, and it is reasonable to argue that banks will need to develop an incentive structure for the end users, in order to stimulate the diffusion of new services. Further research is needed in order to identify more specific issues regarding the adoption of Internet banking in the financial sector in general and the pattern of diffusion of such innovation among banks in Italy. One of the most important issues is the analysis of the intensity of adoption, in terms of the complexity of the services provided by different categories of banks. In this respect, it would be useful to carry out an econometric analysis which takes into account different types of Internet based services and applications and the pattern of adoption across different categories of banks. Furthermore, once data on the demand side of the market will be available, the investigation of the role of customers on the adoption of such innovation would add valuable information about the phenomenon.

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