Divide and Conquer

By Brian O'Connell

When launching Internet-only units, banks must carefully partition physical and online operations. Will customers go along?

A pivotal banking experiment commenced this year as several major U.S. institutions unveiled Internet-only units. Unrestricted by geography and physical sites, the lean cyber-banks can lure customers with better rates while still making profits, it is hoped, and clients can be acquired nationwide.

"It's the invasion of the customer snatchers," says James Deupree, a Charlotte, N.C.-based Internet consultant. "Halting conventional mergers and emphasizing Internet banking for expansion is a huge shift."

As they set foot on this path, however, banks face the critical challenge of partitioning their delivery systems. In order to offer attractive rates online, they cannot offer unrestricted branch access to Internet subsidiary customers, even those cannibalized from their own branches. Conversely, if they are to afford their costly physical systems, they cannot offer branch clients the attractive rates to be found online. Can both customer segments be kept happy?

There's certain to be lots of customer confusion as bankers run parallel business models, one based on physical systems and economics, another based on electronic systems and economics. "If you're offering 5% on Web-based checking accounts and 1% on paper-based accounts, the latter customers will not be happy," contends George Barto, senior analyst with Dataquest in Stamford, Conn. Physical and virtual customers of a bank will tend to take the view that "all the money ultimately ends up in one place," Barto says, rationalizing that they therefore deserve the best aspects of both delivery systems. "You'll have a lot of explaining to do."

This delicate balancing act has already unraveled once in Canada. The separately chartered Internet subsidiary of Bank of Montreal, mbanx, wound up deriving 80% of its accounts from parent company customers, who wanted to retain their branch privileges while capturing attractive online rates. The unit has been decommissioned, with its accounts merged into Bank of Montreal's Web site. "We launched mbanx as a stand-alone entity, touted it as a virtual bank, and found out very quickly that it really wasn't what customers want at this juncture," says spokeswoman Denny Allen. "Customers were falling back on branches more than we would have thought."

To succeed where mbanx fell short, aspiring U.S. players will have to handle some sensitive implementation issues. One is managing customer expectations. Especially when the parent bank lends its brand name and automated teller machine system to the Internet subsidiary, it will need a clear yet diplomatic way of conveying where parent linkages stop. A second issue is handling customer inquiries and reactions. Representatives can't just recite account features and restrictions. They must be able to articulate the value propositions for both physical and online accounts, and help clients understand the tradeoffs.

Longer term, banks will have to flesh out service and transaction options for online customers. Bank One Corp. has a vast network of 7,000 ATMs in 15 states, for example, but alternatives will be needed for the other 35 states in which it hopes to acquire online clients. And through it all, banks must closely monitor market dynamics. Customer decisions ultimately will shape the market, and keen attention must be paid to traffic and transaction patterns in both physical and electronic systems.

Rate Competition

U.S. banking's latest online experiment got into gear this summer. Chicago-based Bank One unveiled WingspanBank.com, and New York's Citigroup launched Citi f/i. They are joined by regional banks, such as Synovus Financial Corp., Columbus, Ga., and North Fork Bancorp, Melville, N.Y., and by thrifts, such as the $25 billion-asset Sovereign Bancorp, Wyomissing, Penn.

Such ventures are the industry's rejoinder to startup cyber-depositories such as Net.B@nk, Telebank and CompuBank, new competitors that conduct their business only on the Internet. Low expense ratios permit these branch-free players to offer deposit rates and loan rates that are among the most attractive in the nation.

Blended banking programs, which combine branch and Web site services, can't match those rates because they are tied to more expensive physical delivery systems. Bankone.com, for example, cannot afford to match Net.B@nk's CD rates. But WingspanBank can, since it also exists mostly in the virtual realm and has a slender expense base. The result: 12-month CD rates that beat Bank One by 75 to 80 basis points. "That's the biggest reason to launch an Internet bank — to lure customers with higher rates," says Lisa White, president of the newly created Synovusbank.com, which is scheduled to begin operations in the second quarter of next year.

Dot com banks also offer the advantages of technological simplicity and organizational clarity. By starting from scratch, the Web units escape the cumbersome legacy systems of their parent companies. Each account is a new account and can be formatted according to the model used by the Web bank. WingspanBank customer accounts, for example, are not linked to Bank One at all.

Carving out a separate organization under the control of one executive can provide more focused management, moreover, and execution likely will benefit by dedicating certain employees entirely to the online operation. "Every bank is questioning whether the Internet bank is a channel or a new business," says consultant Deupree. "If it's operated as a channel, then you have battles about who's in charge and questions on whether it's a profit center. But if you form a separate unit, at least some of those problems go away."

Customers, in turn, are presented with two distinct ways to interact with the institution. Synovus, for example, will retain an online banking channel for customers of its traditional bank; those customers can go online or walk into a Synovus branch as they choose, and the blended offering will be priced accordingly. Customers of Synovusbank.com, on the other hand, can capture better rates but will be strictly confined to cyberspace. "In that regard, they're not really customers of the brick-and-mortar portion of Synovus Bank," White says. "Synovusbank.com is geared to those customers who are willing to forego the brick-and-mortar channel and get better rates by interacting strictly online."

Love Those Branches

The implications of this shift are potentially profound. The industry's enormous investment in brick-and-mortar infrastructure could be devalued if the Web banks significantly penetrate the mass market. Traditional institutions would then face increased pressure to shed branches and employees, likely spurring accelerated levels of acquisition activity.

But Internet-only subsidiaries first must overcome many hurdles. Having a fling with fickle, rate-conscious CD customers is one thing; establishing "core" online relationships is quite another. Cyber Dialogue, an Internet database marketing company, estimates that almost a third of the 9.4 million people who have signed up for online banking have discontinued the service and says only 35% of the defectors are inclined to try it again. The problem: overly complicated technology and inadequate levels of customer service.

For good reason, mass-market customers have a continuing propensity to fall back on branches for their service needs. Web affiliates can't permit such access and still preserve their economics, however, and they are trying to plug the gap by offering free access to parent company ATMs.

As with any compromise, there is the risk of not entirely satisfying everybody. Certificate of deposit rates at WingspanBank, Bank One's Web unit, are above the national average. But they are slightly lower than those offered by "pure" Internet-only banks such as Net.B@nk and Telebank. Meanwhile, customers of bankone.com, the Internet "channel" operated by the parent company, are allowed to conduct transactions in Bank One branches. But they don't receive the more attractive CD and loan rates offered by Wingspan.

Sound confusing? It certainly must be for Bank One customers. Segregating a virtual and physical bank within one holding company raises all sorts of prickly operational issues. How do you explain to customers of the physical bank why they have to settle for lower rates on their CDs? How do you keep virtual bank customers from trying to get service in a branch when they have been allowed access to ATMs? Mainspring Inc. consultant Daniel W. Latimore notes that many ATMs are located in branch lobbies. "What's to prevent Internet customers from walking in the front door?"

Cost is another issue. While a Web bank operates much more economically than a physical bank, marketing expenses can be quite high. To distinguish themselves amid all the cyber clutter, top Internet companies such as Yahoo, Amazon.com and E*Trade devote 45% to 60% of their operating outlays to brand promotion, according to PricewaterhouseCoopers. Bank One says it expects to spend about $150 million on WingspanBank during the next year, two-thirds of that on a nationwide advertising blitz. That's a lot of resources lavished on a business model that hasn't yet proven itself.

"The problem for Internet-only banks — and the parent banks that subsidize them — is that you have to attract new customers," says Diogo Teixeira, president of the TowerGroup in Needham, Mass. "But every dollar you save in overhead costs you're giving back in higher rates and marketing expenses. Where's the profit in that?"

All that trouble could prove worthwhile if the new Internet-only units can get beyond the startup phase and acquire massive numbers of new customers. Banks have spent untold fortunes acquiring customer relationships via mergers; any institution that could bypass M&A and get the job done electronically would gain a formidable competitive advantage, at least temporarily. And as many online players point out, electronic systems have exceedingly low variable costs. Once a Web unit gets past breakeven, profits begin rising quickly with additional business.

But it's not yet clear whether progressive institutions will be able to do more than lure their own established customers from one type of delivery system to another. Mainspring's Latimore says companies like Bank One and Synovus probably won't have tremendous success attracting new customers through their Web-only subsidiaries, simply because it's so hard to come up with something lastingly distinctive. Innovation has a short shelf life on the Internet, he says, and any new product or service is quickly replicated by competitors.

Mending the Fences

Then there's the mbanx precedent. Established in October 1996 as a separate subsidiary within Bank of Montreal, mbanx gained 170,000 customers. Unfortunately, 80% of them came from Bank of Montreal rather than the market at large. Meanwhile, Netbanxing, the "mainstream" online access channel that offered a blend of Web site and branch services, grew to nearly one million customers. In August, the two electronic offerings were folded into one, called MbanxDirect.

Unlike its U.S. counterparts, mbanx never explicitly prohibited customers from using its branches. Instead, it offered financial incentives to entice people to consolidate their accounts at the online subsidiary. For most routine transactions, such as paying bills and transferring funds between accounts, the Internet proved sufficient. The trouble, according to Allen, came with more complex transactions: customers would initiate mortgage purchases online, for example, but then insist on coming into the branch to close.

It is possible that WingspanBank and Citi f/i will have more success in partitioning respective virtual and physical facilities. No allusions to branch service are being made. And in WingspanBank's case, it would be technologically impossible for Bank One branch reps to service an Internet account. Spokesman Jeff Unkle says WingspanBank customers "would gain nothing" from entering a Bank One branch, since the two affiliates run on entirely different systems and can't exchange account information.

Clever compromises may help bridge the service gap, moreover. Bank One, for example, is hoping that its network of 7,000 ATMs in 15 states will provide enough physical infrastructure to satisfy WingspanBank customers who need to withdraw cash and don't want to mail their deposits to a post office box in Philadelphia. For customers beyond the reach of a Bank One ATM, WingspanBank will reimburse up to $5 a month for withdrawals from "foreign" ATMs. It's too early to tell how this will work out, however. Other arrangements may be required.

There's also the question of how big the online banking market really is. While personal computer usage continues to soar in the U.S., online banking activity has lagged. A recent Gallup/American Banker survey found that 63% of U.S. households now own personal computers, but only 12% use them for banking transactions. "If not for the fact that PC ownership is expanding, there would be no growth in online banking customers," American Banker concluded.

And among those who do sign up with Internet-only affiliates, how many will be drawn from the parent company's established base of branch customers? No one knows just how many will simply switch their business from one type of arrangement to another. Latimore says account cannibalization is inevitable in today's financial services industry, whether it involves online access or the flow of deposits from savings accounts to mutual funds. Strategists may simply have to accept it as a fact of life.

Under that scenario, Web affiliates ultimately would wind up more as a tool for customer retention, rather than customer acquisition. "An increasing proportion of your customer base is going to migrate across channels, and they're either going to migrate with you or from you. If you don't cannibalize, then somebody else is going to eat your lunch for you," Latimore says. WingspanBank spokesman Unkle says "There's probably going to be some cannibalization, but it's not that big a deal — at least for Bank One — because we're still maintaining the banking relationship."

But if that's the case, why go to all the trouble of creating a Web bank? Some institutions seem to be doing splendidly by offering a blend of branch and Web site services. Significantly, online banking leader Wells Fargo & Co., with one million Internet customers, has so far refrained from establishing a Net-only subsidiary on the grounds that it already offers a compelling package for online customers. "Our competitive advantage is that customers have access to all of the channels they want to use," said CEO Richard M. Kovacevich in a media conference call reported in American Banker.

Even so, the fact that some big banking companies are proceeding with Web-only affiliates suggests that a larger factor than current customer preference is at work — namely, the need for competitive options. With all the uncertainties, the best argument for pursuing the Internet-only strategy may simply be the need to be ready if and when online banking becomes a mass-market phenomenon. "It makes sense for banks to hedge their bets," Latimore says. The institutions jumping in now "want an entry in every race so at least one of their horses will end up finishing."

Mr. O'Connell is a freelance writer based in Framingham, Mass.

Copyright © 2003 by Banking Strategies, published by BAI.

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