Superstars or Shooting Stars?

By Kenneth Cline

Cyber-banks are growing explosively, although their ability to sustain this progress is by no means assured. How should conventional banks respond?

The future of banking may possibly be found at Net.B@nk Inc., where there's nary a teller or vault in sight, just bare rooms and modular furniture in a nondescript suburban Atlanta office park. Speaking above the constant hum of telephone chatter, chief executive D.R. Grimes strides past a room crowded with clerical employees and remarks, "This used to be a nice boardroom, but we had to take over the space."

Appearances don't matter since the public never comes to visit. As one of the nation's first true virtual banks, Net.B@nk operates entirely via computer and telephone wires. It is also growing explosively. Net.B@nk has gained 30,000 customers since its PC screens first flickered to life in 1996 and is now pulling in thousands of accounts per month with the allure of above-market interest rates. "What we've done is unheard of in the last 20 years of banking," Grimes contends. "While the vast majority of banks in America grow deposits by single digits, we grow by hundreds of percents."

The fact that similar results are being reported by other cyber-banks seems to suggest that a powerful new force has arrived on the American banking scene. This force may even represent a new business model for the industry, some experts reckon, one that could jeopardize the heavy investment traditional banks have made in brick and mortar. The fact that some of these startups are combining banking and brokerage products only intensifies the threat.

The implications pose serious questions for banking's titans. Should they meet this competitive threat head-on, possibly by forming their own Internet bank subsidiaries that mimic the aggressive tactics of the Web banks? Or should they blend Web site capabilities with their robust array of conventional offerings and delivery channels, and hope to outlast the pesky upstarts? The manner in which industry leaders answer this question, coupled with the public's response, will help determine the shape of banking in the next century.

With such momentous issues at stake, it is important to analyze all of the ramifications of the Internet bank challenge. Do Web banks constitute a viable long-term business model? Do they have the customer acquisition capabilities and the profitability dynamics to sustain themselves beyond the startup phase? The questions are difficult to answer, since not one of these fledglings is more than four years old. But some insights are emerging.

First, while the Web banks certainly operate with a lower cost structure than traditional branch banks, they are not as efficient as many seem to think. True, transaction costs are low, but marketing, technological and funding costs can be quite high. Secondly, while the startup banks do a good job of generating deposits, they have been less successful originating loans, and therefore typically purchase assets that provide lower spreads than would be available to a traditional bank. It is also unclear whether these banks can ever truly reach mainstream customers, since they cannot take deposits and provide cash at convenient physical locations.

The upshot is that big-bank CEOs should not stampede into Internet-only banking without first considering all of the alternatives. If major players are content to view online banking as a defensive tactic to keep existing customers, they can simply make sure that their own sites have sufficient functionality to either meet or beat the startups, and refrain from risky rate competition to attract new customers. Since many of them own brokerage subsidiaries, they could also consider integrating banking and brokerage services on their sites, which would help blunt challenges from that quarter.

In any case, bankers need to brace themselves for a change in the economics of their business. "Whether big banks should embrace the Internet as a low-cost mechanism to acquire customers is up in the air right now," says analyst Thomas F. Theurkauf, with Keefe, Bruyette & Woods Inc. "The direction, however, seems clear: more commoditization of products, more margin pressure, and more of a need for efficiency and scale."

Profitability Dynamics

The Internet bank phenomenon has already made its mark on the industry. During the first five months of 1999, Net.B@nk's stock rocketed by 365%, while Telebanc Financial Corp. surged by 96%. That compares with a 0.2% gain for the Standard & Poor's 500 index and a 5.9% gain for the SNL bank index. In early June, Telebanc sold itself to E*Trade Group Inc. for $1.8 billion, or 350% of book value.

Meanwhile, the CEOs of Bank One Corp. and First Union Corp. are musing publicly about the growing power of the Internet and voicing doubt about the value of traditional bank acquisitions. Bank One has launched a separately chartered Web bank of its own under its First USA subsidiary.

But that doesn't mean strategists should hit the panic button. All of the cyber-banks are quite young, and their long-term potential for profitability and widespread customer acceptance remains a question mark. "Managers are projecting their hot startup growth rates into the future, but people might want to peer beneath that 'dot com' hood and see what's really driving this thing," says analyst Jeff Runnfeldt, with First Security Van Kasper.

For one thing, it's not clear that Web banks can reach beyond the "early adopter" category of computer-literate customers to achieve true mainstream acceptance. Their inability to take deposits and provide cash at physical points of distribution remains a major barrier, although shared ATM networks and computer-reloadable smart cards may constitute an acceptable "work-around" for some customers.

There's also the issue of profitability dynamics. In the early going, Web banks have found it easier to attract deposits than to sell loans. They can offer high rates and bring in floods of cash, but they cannot turn around and electronically redeploy those resources into high-yielding assets. This translates into a very thin net interest margin, which partially offsets the low overhead advantage.

Most Web banks do not actually underwrite loans online, but simply refer customers to behind-the-scenes processors, such as E-Loan for mortgages and First USA for credit cards. USAccess Bank and First Internet Bank of Indiana, however, are experimenting with online origination: USAccess through a network of small loan production offices in major metropolitan areas; First of Indiana via automated credit scoring.

It boils down to a revenue challenge. Typically, the Web banks invest their high-cost deposits in mortgage-backed securities, Fed funds, bonds and other conservative assets, virtually ensuring a thin net interest margin. Fee income is also hard to come by, since these banks offer most transaction services -- such as account transfers and electronic bill pay -- for free. A recent report from San Francisco-based First Security Van Kasper estimates that branchless bank net interest margins track at one-third to one-half the industry average, and that fee income is "modest at best." Analyst Runnfeldt goes so far as to argue that "branchless banks don't have core revenue-generating capabilities."

Internet bankers downplay the margin drawbacks, contending that their lower cost structures provide a powerful offset. Net.B@nk, for example, handles all customer contact via PC and telephone, and it outsources most back office functions. Net operating expenses equaled 1.66% of average earning assets during the first quarter, according to SNL Securities LP, compared with roughly 4% at most traditional banks. But when you factor in the lower net yield on those expensively funded assets, the picture is less rosy. For example, Net.B@nk's 66.2% ratio of operating expenses to operating revenues is actually at the high end of industry norms.

Even Web banks' core competitive advantage -- low non-interest expenses -- fades somewhat when elaborate technological capabilities and marketing campaigns are introduced. Take the case of Security First Network Bank, the oldest and most sophisticated Internet startup.

The Atlanta-based institution kicked off in October 1995, a full three years before most of the others. The technologists who ran the bank used it primarily as a platform for their experimental online banking systems. They split the company in 1998, keeping the technology division, which became Security First Technologies, and selling the bank for $20 million to Royal Bank of Canada.

Security First's account base had reached 10,000 by the time of the Royal Bank purchase but was showing signs of stagnation. Instead of immediately re-starting the growth engine, Royal Bank executives reexamined the online business model and the investments required to exploit its full potential. They decided they needed to capture detailed customer information to effectively cross-sell other products and services. For that reason, Security First invested in "fat server" technology that enables both the bank and customer to retrieve and view instantly all current and historical account data. This approach, however, costs more than the simpler "thin server" technology used at other Internet banks.

To jumpstart account growth, Security First sharply raised its customer acquisition costs, paying four times the national average, 6%, on an interest-bearing checking account. In a little over a month, the introductory program attracted 6,500 account applications, boosting the bank's account base by a third. "That's not something we intend to do forever, but it grabs people's attention and gets them to try us," says president and CEO David Noble. On top of all that, Security First opened a branch in Clearwater, Fla. to serve "snow bird" customers of the parent company.

While some of Security First's Internet-only peers expect to be profitable within their first year of operation, the Canadian-owned bank remains in the red after four years. And Noble indicates profitability is still several years away. "We do believe Internet banking is a lower-cost form of delivery than traditional banking, but it's not low cost," he says.

Bullish on Synergy

While Web banks share the industry's cross-selling aspirations, the options are fewer, again demonstrating the limits of the Internet-only business model. Cyber-banks, by definition, offer fewer products and services than traditional branch banks. Lacking physical locations, they can't provide cash management services for small business or safety deposit boxes for consumers, for example. This raises the strategic question as to whether even well-endowed Web banks can capture customers' primary banking relationships, or whether they are destined to become specialty players.

David Becker, chairman of First Internet Bank of Indiana, believes Web banks must aspire to a "full service" configuration to attract and retain customers, which is why his bank offers consumer credit products online. He even plans to introduce a small business loan product by September. "To attract the consumer or small businessman, you've got to offer everything that a traditional bank offers," he says. "People want control over their entire financial environment, not just half of it."

At the opposite end of the strategic spectrum is Houston's CompuBank, which offers deposit products only. CompuBank executives see the Internet as a place where customers ferret out value wherever they can find it. The bank's role, in their view, is to focus on a few core competencies and let customers take other business elsewhere. "Anyone who thinks they can draw a big fence around themselves on the Internet is misjudging the average Internet consumer, who wants choices and options," says Jonathan H. Lack, CompuBank's executive vice president of marketing and planning.

In fact, the Internet business model itself could very well be inimical to one-stop shopping in financial services. Electronic "portals" -- such as those operated by Intuit Inc., Microsoft Corp. and Yahoo! Inc. -- already allow customers to choose among dozens of different providers for various types of products, including mortgages, insurance and credit cards.

Looming on the horizon, however, is a powerful financial services package that could elicit a lot of customer response and loyalty. This is the banking/brokerage combination, heralded by E*Trade's purchase of Telebanc. Given the high customer acquisition costs in Internet banking, analysts expect Telebanc to grow faster and cheaper by cross-selling its services to E*Trade's one million online brokerage customers. "Telebanc's officers realized that the E*Trades of the world are driving consumer interest in online financial services," says Ian Rubin, senior analyst with the Tower Group. "They wanted to align themselves with somebody who could sustain that interest."

In October, Security First plans to launch a fully integrated banking/brokerage account in alliance with Bull & Bear Securities Inc., a Royal Bank-owned New York securities firm. "Brokerage offers a compelling value proposition to online customers," says CEO Noble, citing the success of companies such as E*Trade and Charles Schwab & Co.

Perhaps more than the Internet-only banks themselves, this is a combination that traditional banks need to watch closely. But even here, the megabanks enjoy formidable competitive strength since most of them own their own brokerage firms. Conceivably, it's already within the power of many institutions to introduce affiliate brokerage capabilities into their Web sites. They also could purchase an Internet-only startup and then merge it with their existing securities firm. That is, after all, what Royal Bank did with Security First. "The big players have many options here," says Chuck Hieronymi, director of the financial services group at Dove Associates.

One way or the other, major institutions must make sure they leverage their competitive strengths in this new arena, using a product-rich, multi-channel framework to offer a customer value proposition that does not rely on high rates. This entails at least matching the functional capabilities of the startup Web banks. "Having an array of different channels is a huge competitive advantage," says analyst Rubin. "Once the full-service banks understand what they must do, and make the necessary investments, it will be hard for Internet-only banks to sustain their advantage."

Mr. Cline is senior editor of Banking Strategies.

Copyright © 2003 by Banking Strategies, published by BAI.

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