2.2.1.

Contemporary Banking Theory

This theory was postulated by (Bhattacharya & Thakor, 1993). Contemporary banking
theory suggests that commercial banks and other financial intermediaries are
necessary in order to efficiently allocate capital resources in the economy. This
implies that a well-functioning banking industry through ICT has a great potential to
enhance bank performance and ultimately broad based development. Moreover it
reduces the occurrence of asymmetric information that causes adverse selection and
moral hazard complications. This theory contributes immensely to the independent
variable electronic banking and the dependent variable financial performance of
commercial banks. Electronic banking has enabled clients to have easy access to
information on the banking products and services without going through the
traditional bank branches which was the primary point of contact between the bank
and the bank clients in the past. Easy access to information on bank products through
modern e-banking channels has helped in improving financial inclusion and
consequently financial performance.

2.2.2 Bank-Focused Theory

Under the bank-focused theory, a conventional bank uses non-traditional inexpensive
delivery channels to provide banking services to its existing customers. Those
inexpensive delivery channels includes use of automatic teller machines and mobile
banking to provide certain limited banking services to bank customers. This theory
was developed by (Kapoor, 2010). Use of ATMs is complementary in nature and may
be seen as a modest extension of conventional branch-based banking. This offers
advantages such as more control and branding visibility to the concerned financial
institutions. However there are concerns with the experience, protection of identity
and transactions, consistency and accessibility of service and extent of personalization
allowed. Financial institutions address these issues and concerns by providing
electronic banking service with a simple and easy to use interface. The security is
further strengthened with the help of multi-factor authentication and other technology,
capable of running continuously and uninterrupted 365 days a year (Kapoor, 2010).
Bank focused theory is relevant to this study as it is concerned with the use of non-
traditional low-cost delivery channels like ATMs, internet banking or mobile banking
solutions to provide banking services to its existing customers. This theory contributes
to the independent variables electronic banking since it explains how commercial
banks use non-traditional inexpensive delivery channels in providing banking services
to improve their performance.

2.2.3 Transactions Cost Innovative Theory

This theory was initiated by (Niehans, 2006).The theory stated that the dominant
factor of financial innovation is the reduction of transaction cost, and actually
financial innovation is the reaction of the development in technology which caused
the transaction cost to reduce. The reduction of transaction cost can accelerate
financial innovation and improvement of financial service. Further, it states that
financial innovation reduces transaction costs. This theory is also relevant in this
context: since it states clearly the relationship between independent variable of
electronic banking and dependent variable of cost efficiency. Consequently, reduction
of operation costs through ATM, POS, internet banking, mobile banking and other
electronic banking product may contribute to improvement in financial performance
of the bank.

2.2.4 Innovation Diffusion Theory

This theory was officially introduced by Bradley and Stewart in the year 2002 and it
confirms that firms engage in the diffusion of innovation in order to gain competitive
advantage, reduce costs and protect their strategic positions. Rogers (1995) postulated
that diffusion of innovation theory attempts to explain and describe the mechanisms
of how new inventions, in this case electronic banking, are adopted and become
successful. Not all innovations are adopted and even if they are good, it may take a
long time for an innovation to be adopted. He further states that resistance to change
may be a hindrance to diffusion of innovation and although it might not stop the
innovation, it will slow it down. Moreover, Rogers (1995) identified five critical
attributes that greatly influences the rate of adoption. These include relative
advantage, compatibility, complexity, attainability and serviceability. This theory was
used as basis in this study to investigate how various electronic banking products
affect financial performance of commercial banks.
2.2.5 Conceptualizing Electronic Banking
The term e-banking were explained in different way from different perspectives.
However, researchers across the world have made extensive efforts to provide a
precise and all-inclusive concept of e-banking. This section presents e-banking
concepts provided by different researchers over the world.

A common definition for electronic banking comes from the Basel committee on
banking supervision: e-banking includes the provision of modern and traditional
banking products and services through electronic channels (Basel committee banking
supervision [BCBS], 2003). Ebanking is a system in which financial service
providers, customers, individuals and businesses are able to access their accounts, do
transactions and obtain latest information on financial products and services from
public or private networks (Daniel, 1999). As of Driga and Isac(2014), e-banking, is a
term used for new age banking system, represents an automated delivery of new and
traditional banking services directly to customers through electronic, interactive
communication channels. It is a service that provides customers the opportunity to
gain access to their accounts, execute transactions, and obtain information on
financial products and services through a public or private network, including the
internet.

The term “e-banking” refers to a method of banking through which customers are able
to carry out their banking transactions electronically without visiting a bank branch
(Simpson, 2002). Among other benefits, e-banking saves time, customers need not to
visit the bank branch and banks have the opportunity to enhance their customer base
thereby experience improved profits (Okibo & Wario 2014). According to Sokolov
(2007), financial institutions, in addition to provide traditional banking services, can
also facilitates a wider array of banking products and services that have been designed
or tailored to shore up e-commerce.

In the last decades, e-banking has attracted increased attention from bankers and bank
customers. This popularity can be attributed to all the advantages that e-banking is
offering to both banks and customers. For instance, customers can have access to their
accounts around the clock, from all over the world. In addition, they have access to up
to date information on their accounts.
Banks on the other hand can employ fewer personnel, as e-banking encourages
customers to perform banking transactions electronically at a lower cost. Automated
e-banking services, offer banks a perfect opportunity for maximizing profits. The
main economic benefit of e-banking is the positive impact of communication
technologies on the entire economic growth of banking institutions. Banks are able to
offer their services at lower costs, with fewer staff. Banks which offer e-banking
services are perceived as leaders in technology implementation and they would have a
better brand image (Lustsik & Sorg, 2003). Moreover, there is easy publicity for
banks, which can pass the information they want over the internet, so there is
significant reduction in banks’ operation costs.

In more recent years, modern e-banking services such as internet and mobile banking
has revolutionized banking services. The advancement of the e-banking can be traced
to the early 1970s when banks began to look at these types of services as an alternate
to some of their traditional bank functions. Foremost, such a choice was considered
appropriate since it ensures reduced costs as branches were very expensive to set up
and maintain. Additionally, e-banking products and services like ATMs and electronic
fund transfer were an important qualitative element of differentiation for banks that
used them (Mobarek, 2007). Given that banks operate in an aggressively competitive
industry, their ability to differentiate themselves on the basis of price is limited. Thus,
in order to remain on the market it is imperative for banks to adjust their strategies in
response to changing customers’ needs and developments in technology.

Operating cost minimization and revenue maximization are the major drivers that
boost e banking services (Reibstein, 2002). Because e-banking service is essentially a
self-service by customers, these in turn enable banks, to use fewer resources and to
make lower transaction and production costs (Southard & Siau, 2004). A study about
the e-banking over 1999–2006 in the context of Kenya shows that the application of
e-banking can improve banks’ performance in terms of the growth in assets, reduction
in operating expenses and portfolio enhancement (dandapani et al., 2008).

E-banking allow banks to offer new products and services, to expand their markets for
traditional activities and to consolidate their competitive position in offering available
payment services, while ensuring operating costs cut for banks (BCBS, 2003).
Consequently, e-banking has become popular because of its convenience and
flexibility, and also transaction related benefits like speed, efficiency, accessibility
and so on.

2.2.6. Role of E-Banking Service

The implementation of e-banking can bring about many competitive advantages for
banks in today’s highly competitive banking market. E-banking transactions are much
cheaper than branch. Some of major advantages of e-banking are:

 Cost reduction

The major economic rational of e-banking so far has been reduction of overhead costs
in providing banking service, that are expensive while using other channel. It also
looks that the cost per transaction of e-banking often falls more rapidly than that of
traditional banks once a critical mass of customers is achieved (Shah & Clarke, 2009).

 Choice and convenience for customers

This is the most important benefits that outweigh any shortcoming of e- banking.
Conducting transactions right from the comfort of home at the click of a button
without even having to action out is a facility none would like to skip. Having a path
of accounts through the internet is much faster and convenient as compared to going
to the bank for the same. Even non transaction facilities like ordering check books
online, updating accounts, enquiring about interest rates o f various financial products
become much simpler on the internet (Sannes, 2001).

 Load reduction on other channels

E-banking products are largely automatic and most of the customary activity such as
account checking is carried out using these channels. This typically results in load
reduction on other delivery channels, such as branches. This tendency is likely to
continue as more high-level services such as mortgages or asset finance are offered
using e-banking channels. In some countries, routine branch transactions such as cash
deposit related activities are also being automated, further reducing the workload of
branch staff, and enabling the time to be used for providing better quality customer
services (Shah & Clarke, 2009).

 Easier expansion
Conventionally, when a bank wanted to expand geographically it had to expand new
branches, thus incurring high startup and maintenance costs. E-channels, such as the
ATM, POS, mobile banking and other has made this comparatively unnecessary in
many circumstances. Now banks with a traditional customer base in one part of the
country or world can attract customers from other parts, as most of the financial
transactions do not require a physical presence near a customer’s working place (Shah
& Clarke, 2009).

2.2.7 Types of Electronic Banking Service

The common types of e-banking components include the following: Automated teller
machines: An automated teller machine (ATM), also known as automated banking
machine (ABM) or cash machine is a computerized telecommunications device that
provides the clients of a bank with access to banking transactions in a public space
without the need for a cashier, human clerk or bank teller. While using modern
ATMs, the customer is recognized by inserting a plastic ATM card with a magnetic
chip that contains a unique card number and some security information such as an
expiration date (Thompson, 1997). According to Thompson (1997), authentication is
provided by the customer entering a personal identification number (PIN).

ATM banking enable customers to access their bank accounts in order to make cash
withdrawals, check their account balances, furthermore, as the ATMs continue when
human tellers stop, therefore, there is continual productivity for the banks even after
banking hours (Yosef, 2017).

The primary advantages of ATMs are they save the customer’s time in service
delivery and it is cost efficient way of yielding higher productivity per period than
human tellers. Electronic funds transfer system: Electronic funds transfer or EFT is
the electronic exchange or transfer of money from one account to another, either
within a single financial institution or across multiple institutions, through computer-
based systems (Bahia, 2007). Bahia (2007) further stated that EFT is also a way of
transferring money from one bank account directly to another without any paper
money changing hands.

One of the most widely-used EFT programs in our country is direct deposit, in which
payroll is deposited straight into an employee's bank account, although EFT refers to
any transfer of funds initiated through an electronic terminal, including credit card,
ATM, and POS transactions. Mobile banking: Mobile banking is a system that
allows bank customers to conduct different financial transactions through a mobile
device, being the newest service in electronic banking; mobile banking relies on WAP
(wireless application protocol) technologies since a mobile device requires a WAP
browser installed in order to allow access to information (Driga & Isac, 2014). In
developing countries where modern telecommunication infrastructure is not well
advanced, mobile technologies is transforming accessibility to the internet based
services (Driga & Isac, 2014).

Currently almost all commercial banks in Ethiopia are making significant investments
in mobile banking systems to deliver a wide range of banking service, to reach on
increased efficiency, cost reduction, improved operational effectiveness and improved
customer service and to achieve the aim of financial inclusion (NBE, 2015).

Mobile banking may be described as the newest channel in our country electronic
banking channel to provide a convenient way of performing banking transaction using
mobile devices(Tigist, 2018).

The mobile banking development in Ethiopia is not full-fledged in terms of

exhaustively utilizing all the mobile services one can get. Currently, of all the types of
mobile banking services, mostly customers of the bank use notification or alarm
inquiry (NBE, 2015).

Internet banking: Internet banking refers to systems that enable bank customers to
get access to their accounts and general information on bank products and services
through the use of bank’s website, without the intervention or inconvenience of
sending letters, faxes, original signatures and telephone confirmations (Witman &
poust, 2008).

According to Simpson (2002), banks offer internet banking in two main ways. First,
an existing bank with physical offices can establish a web site and offer its customers
internet banking in addition to its traditional delivery channels. Second, a bank may
be established as a “virtual,” “branchless,” or “internet only” bank, with a computer
server at its heart that is housed in an office that serves as the bank’s official address.
Simpson, further explained internet only banks may offer customers the ability to
make deposits and withdraw funds at automated teller machines or other remote
delivery channels owned by other institutions

POS banking: It is a system that uses a computer terminal located at the point of
sales transaction so that the data can be captured immediately by the computer
system. It is also a retail payment system that substitutes an electronic transfer of
funds for cash, cheques or drafts in the purchase of retail goods and services (Gerlach,
2000). As of Gerlach (2000), in a POS banking system, sales and payment
information are saved electronically, including the amount of the sale, the date and
place of the transaction, and the consumer's account number. If the transaction is done
on a bank credit or debit card, the payment information is passed on to the financial
institution or payment processor, and the sales data is sent to the seller's management
information system for updating of sales records.

2.2.8. Electronic Banking System in Ethiopian Banking Sector

When we come to our financial sector, it is in its infancy in terms of providing
technology-based products and services to its consumers. The emergence of electronic
banking in Ethiopia goes back to the late 2001, when the largest state possessed,
commercial bank of Ethiopia (CBE) pioneered ATM to deliver service to the local
users. Besides eight ATM located in Addis Ababa, CBE has had visa membership
since November 14, 2005. Then, due to lack of appropriate arrangement it failed to
reap the fruit of its membership. Irrespective of being, the pioneer in introducing
automatic teller machine based payment system and attained visa membership, CBE
covered behind Dashen bank, which operated aggressively to continue its’ leading in
e-payment system (Gardachew, 2010).

According to Wondwossen and Tsegai (2005), in 2005 commercial bank of Ethiopia

(CBE) were offered ATM service with eight ATMs in Addis Ababa. These ATMs
enabled customers to withdraw limited amount of money from their account on per
day basis. The ATMs were also enabled customers to check their account balance.
However, depositing money through ATM is impossible until now, due to the
outdated nature of ATM available in our country’s banking industry. In order to get
ATM services, customers need ATM cards and secrete PIN codes. The ATM card is a
smart card used for security purpose only. The ATM card coupled with a PIN code
provides state-of-the-art authentication scheme called two-factor authentication.
Controlling its leadership with advanced banking technology, Dashen bank started to
use ATM

machine to deliver service to its customers in 2006, and the bank adopts mobile
banking (Modbirr) in the year 2009 (Ayana, 2012). Dashen bank signed an agreement
with iVery, a South African e-payment technology company, for the introduction of
mobile commerce in April 21, 2009. According to the agreement, ivery payment
technologies have licensed its gateway and micard e-payment processing solution to
Dashen bank. While Dashen bank is pioneer in channeling new technology, the
younger United bank was the first to introduce mobile and internet banking systems
by the end of 2008 (Ayana, 2012). United bank received the approval to go on
delivering agent banking on March 31, 2015. In its agent banking services, united
bank is providing branchless banking services specifically for the unbanked society. .

The other big event in advancement of e-banking in Ethiopian banking industry is the
agreement signed between Wegagen bank with technology associates, a Kenyan
information technology (IT) firm, for the development of the solutions for the
payment system and installation of a network of ATMs on December 30, 2008. In the
other hand in February 2009 three private commercial banks - Awash international
bank S.C., Nib international bank S.C. and United Bank S.C signed to launch ATM
and POS terminal network (Ayana, 2012).

The long expected national switch system, ET switch S.C, has gone operational on
April 20, 2016. According to addisbiz report, now depositors in Ethiopia can cash
their account from any ATM even if it is not operated by the bank where they have
deposited their savings. ET switch was started in 2011 by the member of 16 banks,
with 80.5 million birr registered capital. This event has great advantage to the
development of e-banking service in Ethiopia by increasing the accessibility of ATM
machine for bank customers all over the country.

As we know that, in modern economy a strong financial system is a pillar of

economic growth and development. The availability of banking facilities and growing
banking service outreach are the major facilitators of developmental and expansionary
activities. The Ethiopian commercial banking system is composed of one state owned
commercial banks and 16 private banks. It is true that traditional banking has grown
steadily over the years, in terms of technological based financial service/ product; in
this regard information technology plays a key role in promoting inclusive financial
system as it is the only way to reduce the cost significantly and reach the masses.

Technology contributes towards efficient financial system (NBE, 2015). Additionally,

quarterly magazine of national bank of Ethiopia, (2015) clearly states that it is not
only possible, but necessary to take advantage of new developments and innovation in
technology, infrastructure and distribution networks to deliver financial services cost-
effectively and easily accessible to the public.

2.2.9. Indicators of Commercial Banks Financial Performance

Performance is considered to be the fulfillment of an obligation. Bank performance, is
a combination of various aspects which cannot be observed directly but economically
important. However, stockholders are view performance in terms of the profits made
on their behalf, whether or not adjusted for risks taken. There is also contribution
banking institutions make to the common wealth of its customers. However, financial
performance is mostly used standards by many researchers to evaluate the
performance of banking institutions.

Financial performance is measured in a number of ways. Profitability is one of the

most commonly used financial performance measures. Some of the key performance
indicators of bank’s profitability include; return on Assets (ROA) calculated as net
profit per total assets. ROA shows the ability of the management to acquire deposits
at a reasonable cost and invest them in profitable investments (Ahmed, 2009). This
ratio indicates how much net income is generated per each unit of assets. A higher
ROA value indicates higher profitability. Return on Equity (ROE) is another
profitability indicator. This is net profit per total equity. ROE is the most important
indicator of a bank’s profitability and growth potential from the shareholders or
investors perspective. It is the rate of return to shareholders or investors or the
percentage return on each unit of equity invested in the bank (Ahmed, 2009). Another
performance indicator is the cost to income ratio (C/I). This is calculated as total cost
per total income. It measures the income generated per unit cost. That is how costly it
is for the bank to produce a unit of output. A lower the cost to income ratio indicates
more cost efficiency and a higher cost to income ratio indicates low cost efficiency.
Higher C/I ratio implies that the operations are cost - inefficient (Ahmed, 2009).
For this study ROA and cost efficiency was used as a measure of financial
performance of commercial banks since it is justifiable to investigate cost efficiency
and profitability of commercial banks in Ethiopia to assess whether the leading
driving purposes (reducing operating cost and increasing profitability of the banks by
having large customer base through electronic banking) of adopting electronic
banking service has realized.