During the late 1990s, productivity trends in retail banking1 stood in contrast to those in much of the rest of the economy: the industry’s information technology investments accelerated substantially, but its labor productivity growth rates, though higher than the economy-wide average, actually declined (Exhibit 1), from 5.5 percent (1987–95) to 4.1 percent (after 1995). Research into this paradox reveals that the relationship between IT and labor productivity is more complicated than merely adding the former to lift the latter.

The nature of IT investments

Throughout the 1990s, the focus of many retail banks on revenue growth resulted in major new IT investments, the largest involving services and marketing tools for customer information management and support (Exhibit 2). Financial institutions have traditionally been organized around product lines, such as deposit accounts, loans, and credit cards. Coordination among departments was loose, and customer information did not flow easily across the organization.

To remedy this problem, banks attempted to create a single customer interface, which forced them to integrate their databases and IT systems. Once this was accomplished, banks adopted applications—or, more precisely, customer-relationship-management tools—to improve their customer retention and to facilitate up-selling and cross-selling. All of this required significant investments...