E-Profitability: A Mirage?

By Bill Stoneman

Banks increasingly cite customer relationships to justify online operations, but the search for fee income needs to continue.

Banks increasingly assert that their Internet services are either approaching profitability or have even attained it. But what exactly do they mean by that? It may well be true that Internet offerings are a major factor in the profitability of certain customers and certain lines of business. However, with scant revenue directly attributable to Net services and scant information regarding their contribution visible in company financial reports, outsiders can't reach an independent conclusion.

This goes to a deeper question: Can Internet services be held to standard profit-and-loss measurement on a stand-alone basis? Or more fundamentally: Are there online services for which customers will actually pay? The answers to these questions will go a long way in determining whether companies can sustain their online development efforts.

Consider the basic online banking package offered to retail customers, which provides access to account information and the ability to transfer funds among accounts: It is free at most institutions. E-billing? Many banks charge about $6 a month for the service, which typically only covers the fee charged by the outsourced providers of the service. And the tide is running against charging at all, as several influential banks, such as Bank of America Corp., have decided that the fee impedes customer adoption.

The picture is somewhat brighter in the small business and commercial banking areas. Banks typically charge specific fees for cash management activities such as online origination of automated clearinghouse drafts and receipt of wire transfers. But even this revenue may simply replace fees banks received for essentially the same service provided over a phone or dial-up connection.

"The question that's not yet answered is whether this revenue is substitutional or incremental," says Yawar Shah, executive vice president for e-business in the retail and middle market financial services group at J.P. Morgan Chase & Co. in New York.

Therein lies the dilemma. If retail online services are a net drain and the scarce revenue banks receive from commercial offerings is mostly substitutional, then "profitability" in the online channel is a mirage, at least on a stand-alone basis. Said another way, unless the Internet truly helps to solidify relationships, reduce turnover and cut other costs, building an elaborate online infrastructure may do nothing more than hike up the cost of serving established customers.

To be sure, in explaining the benefits of online services, bankers typically cite genuine improvements in "soft" measurements — such as improved customer retention, a bigger share of their online customers' business and reduced transaction costs. They argue that online banking must be viewed within the context of the overall customer relationship, which is the real linchpin of institutional profitability. "You can't necessarily disaggregate one service and look at it in a vacuum," says Parrish Arturi, senior vice president for e-strategy with Charlotte-based Wachovia Corp.

It remains to be seen, however, whether an indirect business case for online banking can sustain itself over the long term. A prolonged period of economic weakness nationally would put more pressure on banks to cut costs. Internet services could be vulnerable under such a scenario if they can't make some claim to direct profitability. It only seems prudent to continue the search for incremental fee income.

Search for Fees

Although some financial institutions charged a fee for online banking via a dial-up connection before the emergence of the Internet, banks have generally been unable to make fees stick for consumer services on the Net. The current standard package features free access to account balances and free movement of funds between accounts.

For a few years, banks tried to charge for electronic bill presentment and payment services. But with consumer adoption lagging, many are now throwing in the towel on that as well. Charlotte-based Bank of America, for example, dropped the monthly fee last May. And even banks that maintain fee schedules for e-billing services charge them less often. Wachovia, for example, waives the fee for accounts that exceed minimum balance requirements, an exception that ropes in about 70% of its online customers.

Trying another tack, Morgan Chase is pitching e-billing to consumers whose checking account bank does not offer it, in effect competing with non-banking companies such as Yahoo! Inc. and Intuit Inc.'s Quicken.com. The bank, however, declines to discuss the product's profitability.

The basic challenge facing banks is the same that confronts other industries that offer their services online. "Consumers universally reject any direct fees for online access," says James Van Dyke, the founder of Javelin Strategy and Research in Pleasanton, Calif., "because they generally feel like they're being charged for something that costs the provider less money."

Facing lackluster retail results, most banks have focused their efforts on generating incremental fee income on the commercial side of the house, where customers are more receptive to paying for service. But even here, results have been disappointing.

California Federal Bank in San Francisco, for example, hooked up with Web marketplace eScout.com to offer e-procurement services to its commercial customers. "We projected that it would become a great revenue generator for us," says Lelah Jenkins, senior vice president for technology strategies with CalFed, a unit of Golden State Bancorp Inc. "But the revenue never materialized."

The bank, which expects to be acquired by Citigroup Inc. in the fourth quarter, signed up about 1,000 customers to use the marketplace, where they could buy office supplies and other commonly used products. Most, however, experimented a few times with small orders and then never returned to the site.

Stand-alone Profitability

Executives at Wells Fargo & Co., an Internet banking pioneer, have been quoted as asserting their online banking operation attained profitability in 2000. And the San Francisco-based bank does indeed offer an array of fee-generating services.

Most important is the "Commercial Electronic Office," through which corporate financial officers can initiate ACH and wire transactions, authorize payment of individual checks after viewing an online image of them, send and receive payments in dozens of currencies and apply for letters of credit.

But even Wells Fargo doesn't attempt to attribute revenue from such services to a discrete online business unit, as would be necessary to measure stand-alone profitability. Rather, executives say, the company profits as it wins more business from established customers after they migrate online.

Companies that formerly obtained wire transfers from multiple banks, for example, have consolidated their business with Wells Fargo, according to Steve Ellis, executive ice president for wholesale Internet services. Moreover, the fees for wire transfers and other corporate treasury services are based on the customer's overall relationship and are built into a package price for the relationship. That would make it nearly impossible to credit revenue directly to an Internet P&L even if the company wanted to.

Pittsburgh-based PNC Financial Services Group offers its small business clients tools created by Gateway Inc. to build their own online stores. The personal computer maker sells the same capability directly, but PNC pitches it in conjunction with its credit card merchant services offered to online merchants. Rico Iacchetti, vice president and e-commerce product manager, says PNC's customers do pay for the service but declines to reveal how much. As is true of most facets of online banking, he says the main benefit is indirect — it comes not from the fee but rather from helping build up the bank's merchant services business.

Elsewhere, Citigroup and FleetBoston Financial Group are selling a business-to-business electronic invoice presentment and payment system provided by Bottomline Technologies in Portsmouth, N.H.

Brian Hinton, Bottomline's vice president and product executive for e-billing services, says corporate customers are responding cautiously to this offer, but he asserts the potential for the banks remains substantial. Hinton estimates that businesses send 1.2 billion invoices to other businesses each year. A bank could bring in $120 million annually, he says, by capturing 1% of the total volume and charging $1 for each invoice presented through its infrastructure.

"We clearly think the revenue opportunity is significant," agrees Kevin Tissot, vice president in the wholesale e-business unit of Citigroup. While declining to comment on the pricing of this service, Tissot says electronic invoice presentment and payment will generate higher margins for Citi than traditional lockbox services, which it will eventually replace, because the bank will take a more active role in matters such as dispute resolution. Customers so far include UK-based Air BP Ltd., a division of BP PLC; Cargo Network Services, Garden City, N.Y., which performs billing and collection services for much of the international air cargo business in the U.S.; and Cargo Lux, a Luxembourg-based company.

Wells Fargo, meanwhile, is introducing several other services it regards as experimental. In the fall of 2001, for example, it launched an electronic marketplace similar to the one operated by eScout. Some two dozen suppliers have since posted their catalogs on the site, providing Wells Fargo with a fee for each transaction, says Ellis.

In addition, Wells introduced an online credit management tool last summer for which it hopes to charge commercial customers a fee. After the bank loads all available information about outstanding loans into a database, customers can pay down lines of credit or take new advances and negotiate terms and interest rates online.

Monetizing the Channel

While some of these activities may have potential, none are believed to be significant money-makers today. Still, vendors say there's more development occurring behind the scenes. Alex Hart, president of Corillian Corp., a maker of Internet banking systems based in Hillsboro, Ore., says large banks are experimenting with a number of different ideas for saleable services, though they're generally not ready to discuss them. "Financial institutions need to monetize the online channel and create new sources of revenue to sustain the level of investment they think is necessary to be competitive," Hart says.

Among the new products Hart cites are wealth management services. Such offerings enable customers to provide their various financial advisers with different levels of access to their online accounts. A private banker might be able to pay routine bills, for example, while an investment adviser would aggregate data for the purposes of presenting options.

Banks are also working on person-to-person payment services that offer foreign nationals lacking bank accounts a better way to repatriate earnings, Hart says. Another possibility is to charge customers for alerting them about important issues, such as bills coming due or balances falling below a specified level. Although such services probably would not bring in more than $1 or $2 at a time, he says automated teller machines have previously demonstrated how small fees can add up to a big business.

Katherine Jansen, director of strategic analysis and research for Calabasas, Calif.-based Digital Insight Corp., also an Internet banking system vendor, views cash management services as a key area for growth in fee-income businesses. As evidence that commercial customers are willing to pay for such services as online stop-payment orders, ACH service and incoming and outgoing wire transfers, she cites a listing of prices for online services in the 2001-2002 Blue Book of Bank Prices, published by Durham, N.C.-based Phoenix-Hecht. According to the listing, banks charge, on average, $9.10 for automated stop-payment orders and $8.30 for an incoming wire transfer. The book, however, says nothing about actual customer demand for these services.

Though many bankers will point out that businesses were already paying for such services before the Internet arrived, Jansen says the low-cost nature of the Net is widening the market for cash management to include multitudes of smaller businesses, thus generating new income for banks.

Lowered Expectations

The difficulty in determining whether online fees represent incremental or substitutional revenues points to the challenge of measuring the financial contribution of an Internet offering. The metrics themselves are unsatisfactory and bankers have competing priorities, as emerged from a survey earlier this year by Forrester Research Inc.

When asked by the Cambridge, Mass., technology research company to list the biggest shortcoming of their online metrics, the 30 bank e-commerce executives in the survey ranked "understanding profitability" at the very top (52%). They also placed "increase profitability" near the bottom of their list of top objectives (17%), preferring instead to focus on customer service, customer retention and cost reduction.

If senior executives are disappointed that their Internet platforms have not generated significant fee revenue, it may be that expectations were unreasonable to begin with. "Everybody, even those who were cautious, got caught up in the enthusiasm of a couple of years ago," says Hal R. Tovin, executive vice president for the emerging channels group with Citizens Financial Group in Providence, R.I. Citizens Financial is a subsidiary of Royal Bank of Scotland Group PLC.

Bankers have since lowered their expectations to the point where few expect direct revenue to add up to much at all. Instead, they argue that the payoff from Internet banking will come indirectly, mostly from helping the institution retain valued relationships. "I don't view us as having an online fee strategy in and of itself," says Wachovia's Arturi.

Even Corillian's Hart acknowledges that the talk about getting bank customers to pay directly for Internet-related services is mostly theoretical today. "We don't have a lot of real-life experience," he says.

Tovin, in fact, is relatively rare among online banking executives in expressing confidence that banks will be able to develop direct revenue. Those opportunities will likely involve services readily available in an offline world but made more economical by the Internet, he says. For example, the commercial side of banking companies might provide payroll services online at a lower cost than existing payroll service providers can, by virtue of more efficient transmission of information. The same logic should apply in the retail business, he says, though he hasn't yet worked out the options.

It's possible that some of the electronic marketplace and online credit management tools will eventually develop into something akin to stand-alone businesses. Technology analyst Aaron McPherson, with IDC in Framingham, Mass., contends banks could succeed with e-marketplaces, where so many others have failed in the last couple of years, because they can tie procurement to payments processing.

But until something like that develops, online profitability will involve inferences that go well beyond traditional accounting, such as crediting the Internet organization for the lower cost of acquiring new customers or cross-selling existing customers in another part of the company. Investors and cost-conscious senior executives may eventually lose patience with that.

Banks aren't going to pull the plug on their Internet platforms. But the well of money for developing ever-fancier services could dry up if online banking managers don't put fee revenue generation back on their agenda.

Mr. Stoneman is a freelance writer based in Albany, N.Y.

Copyright © 2003 by Banking Strategies, published by BAI.

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