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communication technology and electronic commerce. This chapter chooses the perspec-
tive of New Institutional Economics, more precisely the Transaction Cost Approach,
which has been developed since the 1950s because of certain deficits in the Neoclassical
Theory. The criticism leveled is that the use of a market or of the legal system is neither
free nor without frictions (Williamson, 1990). On the contrary, institutions have to be
taken into account and transaction costs arise.
Ostrom (1990, p.51) states as follows:


“Institutions” can be defined as the sets of working rules that are used to
determine who is eligible to make decisions in some area, what actions are
allowed or constrained, what aggregation rules will be used, what procedures
must be followed, what information must or must not be provided, and what
payoffs will be assigned to individuals dependent on their actions.



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Reduction of Transaction Costs by Using E-Commerce in Financial Services 65


Transactions

The basis of the Transaction Cost Approach was established by Coase in 1937, who
questioned the reason for the existence of firms. He concludes that, “there is a cost of
using the price mechanism” during the transactional process between individuals. The
term “transaction” was introduced into the economic context by Commons (1990, p.58),
who reasoned:


Transactions [...] are not the “exchange of commodities,” in the physical sense
of “delivery,” they are the alienation and acquisition, between individuals,
of the rights of future ownership of physical things, as determined by collective
working rules of society.


Other authors do not limit the relevance to property rights. Williamson (1985, p.1) claims
that a transaction “occurs when a good or a service is transferred across a technologically
separable interface.” This definition will be the basis for all further discussion in this
context. Many differing points of view can be found, but there is at least agreement that
transactions are not free.


Transaction Costs

Arrow (1969, p.48) defines these specific costs in a very general way and found that
transaction costs are “costs of running the economic system,” whereas Williamson
(1989, p.142) considers them as the costs of “planning, adapting, and monitoring task
completion under alternative governance structures.” This latter explanation is the basis
for the development of the cost model and will be referred to later on when two
transactions are compared which are accomplished in various ways.
Transaction costs may occur in markets, within firms and corporations or in the political
framework (Richter/Furubotn, 1996). They may be fixed costs or variable costs. During
the transactional process, transaction costs are generated before, during and after the
actual transaction takes place (Coase, 1937). For example, costs of gathering information,
costs of preparing the transaction, costs of monitoring or contracting costs can be
distinguished in the different phases of a transaction. The specific amount of the
transaction costs accruing varies, and depends for example on the specificity of a
necessary investment in this transaction, on the frequency of occurrence or the
uncertainty in respect to environmental factors or the contractual partner. In the context
of all further investigations, uncertainty and opportunism can be excluded because the
analysis considers the contractual relationship between a financial institution and its
customers.




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66 Pfahler & Grebe


Quantification of Transaction Costs

After transaction costs have been identified and introduced as a new cost category, the
question is how to measure these costs and how to use them for economic analysis.
Different approaches can be found, for example from a macroeconomic or microeconomic
perspective. In addition, many case studies focus on certain markets or specific aspects
in or between corporations.
One of the most famous studies is the analysis of the development and importance of
transaction costs for the United States over a period of 100 years by North and Wallis
(1986, p.97). For them, transaction costs “are the costs associated with making ex-
changes, the costs of performing the transaction function.” All economic activities are
divided into activities which mainly transform input into output and those which are
basically involved in coordination and transaction processes. North and Wallis (1986)
demonstrate an increase of transaction costs of the whole transaction sector from 26.1%
to 54.7% of GDP between 1870 and 1970 and conclude that transaction costs are as
important as production costs in highly industrialised nations.
Demsetz (1968, p.35) focuses on the New York Stock Exchange (NYSE) and defines
transaction costs as “the cost of exchanging ownership titles.” He points out that these
costs decrease with an increasing trade volume and thus explains the concentration
processes at the NYSE.


Criticism

The most serious problem of the Transaction Cost Approach is the lack of a consistent
terminology. Even for a basic term like transaction costs there is disagreement about its
components, determinants and applicability for certain issues. Moreover, Niehans (1987)
points out that transaction costs “become difficult, perhaps impossible, to quantify.”
This lack of transparency is evident and basically the criticism is justified. But as the
Theory of New Institutional Economics and the Transaction Cost Approach are compara-
tively young disciplines in economic science, a fairly standardised terminology will
probably be developed in the future. Undoubtedly, transaction costs are relevant in
industrial nations and make up an increasing part of all costs caused by economic
activity. Last but not least, it is important to note that there is no imperative to measure
transaction costs absolutely or in a direct way. The approach developed in the next
section will link the Transaction Cost Theory to a specific subarea of Electronic
Commerce in Financial Services.




The Cost Model
The preceding sections have developed the conceptual framework for the target analysis
by defining the most important terms and by explaining the basic ideas. Now our own


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Reduction of Transaction Costs by Using E-Commerce in Financial Services 67


proposal to measure transaction costs will be introduced. We refrain from attempting to
quantify these costs in absolute terms but concentrate deliberately on relative consid-
erations. As the focus in this context is on the relevant interface between a bank and its
customers, internal and inter-bank transactions will be left out of consideration. Our
approach describes and illustrates a new way to combine the business perspective of a
financial institution and the personal perspective of a customer. As business modularity
can hardly be used to extend internal processes and to bridge the contrast between both
perspectives, the given theoretical framework used in Banking and Finance is insufficient
for the very specific investigation in this chapter: Only monetary factors have been
considered so far. This new approach includes monetary as well as non-monetary factors,
which are both covered by the underlying notion of transaction costs. The latter can
actually be more important and they may represent the major proportion of all the costs
that arise. Therefore, a relatively new framework to measure transaction costs has to be
developed.


Phases of a Transaction

In a first step, the transaction will be subdivided and classified into different phases
according to their evolution over the period under observation (Picot, 1982). Seven steps
can be well-defined:


Before a transaction can take place, certain preparations have to be made. To
initiate a bank transfer or a stock purchase, all necessary information has to
be collected. This phase is called “information seeking.” Afterwards, the form
has to be completed (“preparation”) by the customer. All details have to be
checked (“review”) before the instructions are forwarded (“transmission”)
from the customer to the financial institution. The latter has to verify the given
data (“inspection”) and starts processing the task. Subsequently, an order
confirmation is generated and transmitted back to the customer (“confirma-
tion”). The transaction is terminated when the customer has received this
piece of information and checked all of the particulars (“final checkup”)
(p.270).


Modes of Coordination

The model differentiates between seven modes of coordination. Each transaction can be
arranged in a traditional way by visiting a bank. Another possibility offered by most
European commercial banks is to send in a request by mail. Using a telephone to transmit
the required information, utilizing facsimile communication or interactive video-text
services are additional options. As a result of extensive technological progress, online
processing and mobile processing of transactions via the Internet is commonly used
nowadays.




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68 Pfahler & Grebe


Traditionally, a customer visits his bank during its office hours from time to time. He has
to leave his home to get there, and typing errors may occur while completing the form
manually. If he has to queue at the counter before it is his turn, the transaction may be
very time-consuming. The confirmation of the order completion will be received at the
next visit to the bank. A second alternative would be to post the order form by mail. Even
though there is still no device to protect a customer from typos, informal language and
errors, there is no need for him to go to his bank (which may be located far away) at a
certain time: The next postbox will do. A confirmation of the order completion will also
be received by mail several days later. By accomplishing a transaction via telephone it
is not necessary for a bank customer to leave his home anymore. Although it may be more
difficult to collect all information and to prepare the order, the transmission itself and the
generation of the order confirmation is partially automated and comparatively fast.
Telephone circuits can be used to transmit facsimiles and to receive information via
faxback, too. Most European banks offer or have offered this option for certain groups
of customers. No matter whether the order form is drawn up manually or by using a
computer, the bank has to review all instructions and enter them into the system.
BTX is the German version of interactive video-text. With regard to the stock market, it
is possible to receive and realize up-to-date market prices and to interact spontaneously.
Other information can be acquired easily and fast in comparison to the media mentioned
above, and error messages will occur in the case of typos in the electronic order form.
By using a computer with a connection to the Internet, a customer can initiate transac-
tions at home and is not restricted to office hours any longer. Typos and other errors will
usually be reported before the order form is transmitted electronically. The exchange of
information takes place instantly, the confirmation of the order completion will be
generated and received directly after the acknowledgement on the part of the bank. Most
services mentioned in the context of an online transaction are available for mobile
devices, too. The crucial advantage is the stand-alone aspect: No other equipment is
needed to seek information and to interact rapidly with markets from almost any location
at any time.
The verbal description of these reflections can be transformed into a qualitative ranking
on an ordinal scale. The matrix (Table 1) summarizes the potential relative reduction of
transaction costs and illustrates which technology has the largest impact on the process
described.




Table 1. Simple matrix for the phases in the transaction process and the mode of
accomplishment

No. Phase Manual Mail Phone Fax BTX Online Mobile

1. Information Seeking 0 0 0 0 +++ ++++ +++++
2. Preparation 0 0 - - 0 +++++ ++++
3. Review 0 0 + 0 +++ ++++ +++++
4. Transmission 0 + +++ ++ ++++ ++++ +++++
5. Inspection 0 0 + 0 +++++ +++++ +++++
6. Confirmation 0 + +++ ++ ++++ ++++ +++++
7. Final Checkup 0 0 0 0 0 0 0




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Reduction of Transaction Costs by Using E-Commerce in Financial Services 69


Enhancements of the Model

Although this table already reveals potential benefits and disadvantages of certain
technologies, its explanatory power is limited to ordinal statements. Assuming that the
chosen type of transaction costs can be measured on a relational scale, the values above
can be transformed into numerical values. Thus it is possible to introduce a simple scoring
model and to deduce more tangible conclusions than those derived from these first
ordinal assessments.
The aggregated value (AV) of a mode will be defined as the sum of all allocated part values
(PV) multiplied by their weightings (w). Each part value ranges from 0 to 1 and all part
values together sum up to 1. Below the formal description of the basic model is given:
m

‘ PV
(II) AV j = — wi
ij
i =1


(II) 0 ¤ wi ¤ 1


m
pi = 1
(II) i =1




The assumption is made that there are equal occurrences of transaction costs for bank
transfers and stock exchanges. No matter which of the two transactions is investigated
in the model, the same amount of costs (or reduction of transaction costs) is measured
for each combination of mode of coordination and phase of the transaction. In more
precise terms, the difference between a bank transfer and a stock purchase is the
importance of the specific phase in the evolution of the transaction as a whole. This is
taken into account by weighting the different steps according to their relevance in the
transactional process. Thus it is crucial for an order to be transmitted to the stock market
immediately, whereas a bank transfer may even take one more day without serious
consequences. Table 2 gives an overview of all assigned weightings.




Table 2. Phases in the transaction process and weightings for bank transfers and stock
purchases

No. Phase Weighting (Bank Transfer) Weighting (Stock Purchase)

1. Information Seeking 10% 20%
2. Preparation 15% 5%
3. Review 15% 5%
4. Transmission 20% 30%
5. Inspection 10% 5%
6. Confirmation 20% 30%
7. Final Checkup 10% 5%




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70 Pfahler & Grebe


Table 3. Enhanced matrix concerning stock purchases for the phases in the transaction
process and the mode of accomplishment
No. Phase Manual Mail Phone Fax BTX Online Mobile Weighting

1. Information Seeking 0 0 0 0 3 4 5 10%
2. Preparation 0 0 -1 -1 0 5 4 15%
3. Review 0 0 1 0 3 4 5 15%
4. Transmission 0 1 3 2 4 4 5 20%
5. Inspection 0 0 1 0 5 5 5 10%
6. Confirmation 0 1 3 2 4 4 5 20%
7. Final Checkup 0 0 0 0 0 0 0 10%


I. Sum (AV) 0.00 0.40 1.30 0.65 2.85 3.85 4.35

Potential Relative
II. 0% 9% 30% 15% 66% 89% 100%
Reduction of TAC




Table 4. Enhanced matrix concerning stock purchases for the phases in the transaction
process and the mode of accomplishment

No. Phase Manual Mail Phone Fax BTX Online Mobile Weighting

1. Information Seeking 0 0 0 0 3 4 5 20%
2. Preparation 0 0 -1 -1 0 5 4 5%
3. Review 0 0 1 0 3 4 5 5%
4. Transmission 0 1 3 2 4 4 5 30%
5. Inspection 0 0 1 0 5 5 5 5%
6. Confirmation 0 1 3 2 4 4 5 30%
7. Final Checkup 0 0 0 0 0 0 0 5%


I. Sum (AV) 0.00 0.60 1.85 1.15 3.40 3.90 4.70

Potential Relative
II. 0% 13% 39% 24% 72% 83% 100%
Reduction of TAC




For instance, information seeking and a rapid transmission to the financial institution
involved as well as a quick confirmation of a completed transaction is much more
important for stock purchases than for bank transfers. The latter may even take several
days before the final completion without serious consequences for any party.
Now that all necessary steps have been taken, the scoring model can be applied using
all assigned values and weightings. Advantages, restrictions and required technological
devices are summarized in one new enhanced matrix for each transaction (Tables 3 and
4), and each combination of a transactional phase and a mode of coordination has been
assessed and evaluated.
The total number of points acquired in the scoring model will finally be the basis for
additional conclusions on the relative percentages of potential reductions of transaction
costs.



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Reduction of Transaction Costs by Using E-Commerce in Financial Services 71


Session costs and insurance costs will always be limiting factors in mobile banking
deployment. Similar restrictions could be found for any other mode of coordination
mentioned in the chapter. Therefore, all reasoning is done on a relative basis. At this
point, the assumption is made that there is no relative reduction of transaction costs if
a transaction is accomplished in the traditional way without the use of technology (i.e.,
a manual transaction). Using the most sophisticated medium at a given point of time (i.e.,
mobile devices), a potential relative reduction of 100% can be achieved in comparison
to the remaining media. Specific potential relative reductions of transaction costs can
now be derived for all other modes in between.


Premises and Hypotheses

As models are created to simplify and to explain real coherences or circumstances,
premises may not be neglected. In this case, several simplifications have to be made:
• There are only the seven ways mentioned above to accomplish the transaction
• There is an absence of progress or new trends at the chosen point of time
• The same medium is used during the whole transaction process
• There are only two parties engaged, the bank and its customer
• The technical infrastructure has already been acquired and established
• The final result of each process is the same


In addition, several hypotheses are introduced, some of which will be referred to and
tested later on:
• There has been an enormous increase in the use of information and communication
technology in the last decade
• For this reason business processes have changed to a great extent
• For a national economy, the requirement for electronic commerce is the diffusion
of information and communication technology
• Customers act in a rational way and prefer those modes of coordination which help
to decrease the amount of accruing transaction costs
• Financial institutions are aware of these changes and the potential reduction of
transaction costs, and they offer new modes of interaction for their customers
• Relative reductions of transaction costs are decisive for the development and the
use of a new mode of transaction as well as the diffusion rates of the underlying
technologies




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