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The Opportunity (and Peril) in High-Yield Online Savings Accounts
BY BILL STONEMAN
High-yield online savings accounts work for some, but may not be a panacea for all banks.
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SYNOPSIS | Internet banks offering high-yield savings accounts, such as ING Direct, have attracted a great deal of attention for their ability to raise deposits at a time when deposit growth is sluggish for the rest of the industry. Some traditional banks with large branch networks have begun offering the product as well. But for them, the risk of cannibalizing existing accounts looms large. Experts suggest the use of ?product fences? to separate online and offline accounts at such institutions.
High-yield online accounts clearly help some financial institutions attract deposits; the question is whether they will work for everyone, particularly banks with large branch networks.
The temptation to offer such accounts is strong. At a point in time when most banks are struggling to gather deposits, ING Direct is practically swimming in them. Just seven years after its launch, the U.S. unit of Dutch ING Groep N.V. has become one of the largest banks in the United States, with $74 billion in assets and $54 billion in deposits as of June 30, 2007, according to the Federal Deposit Insurance Corp. Moreover, ING Direct and its followers are capturing a big chunk of the overall growth in the savings and money market business.
A recent analysis by New York-based bank consulting firm Novantas LLC notes that while high-yield online savings still represent only about 6% of total high-yield and money market deposit account balances in the United States, they captured 145% of total growth in the first six months of 2007 (see chart, “High-Yield Online Savings Propels Deposit Growth”).
ING Direct’s basic approach is to attract deposits with generous rates, but provide service mainly online. The lower cost of serving customers online helps offset some of the cost in yields needed to attract those customers. This causes a problem, however, for traditional banks that attempt to offer their own version of high-yield online savings. “At some point in time, the branch customer will come in and say, ‘Why am I not getting this higher rate?’” says Frank O. Trotter, executive vice president and head of the direct banking unit at EverBank in Jacksonville, Fla.
If branch customers shift their balances to higher-yield accounts, banks take on greater interest expense without reaping any savings in the cost of operating branches. That’s why some experts say traditional banks that offer high-yield online savings must find ways to wall off those accounts from branch customers. “The difference between a wild success and a disaster is going to be around ‘product fences’ to limit cannibalization,” says Sherief Meleis, a managing director with Novantas.
Such product fences carry their own set of problems; customers might resent the additional layers of complexity, for example. But the success of ING Direct in raising deposits has proven a strong enough stimulus for traditional banks such as Emigrant Savings Bank, HSBC, Citigroup Inc. and Provident Bankshares Corp. to get into the game and wrestle with these issues.
Internet Banks Redux
One of the oddities of the debate over high-yield online savings is that the industry, in a sense, has been here before. The mid- to late-1990s saw the emergence of both “pure play” and hybrid (combining online and offline) Internet banks, most of which quickly flamed out. Just this past summer, the granddaddy of Internet pure plays, Atlanta-based NetBank Inc., failed and was liquidated by federal regulators.
But Internet banking, as opposed to Internet banks, has clearly caught on. Some 53 million households did some form of online banking in 2007, up from 46 million just a year earlier, according to estimates from Forrester Research Inc. Moreover, ING Direct illustrates the Internet’s continuing ability to rearrange banking’s existing order as it opens as many as 100,000 accounts a month.
Without a branch network, the Delaware-based ING Direct has vastly lower operating costs than traditional banks, allowing it to pay 4.2% on money market deposits last November, compared with the industry average of 3.53%, according to bankrate.com. “Our business is built on high volumes and low margins,” says Todd Sandler, the company’s head of deposit services. “Think Wal-Mart. Think Southwest Airlines.”
It’s too early to say whether ING Direct or any of its emulators will emerge as a “category killer” on the scale of Wal-Mart or Southwest. But the business model does appear to have staying power. ING Direct deposits rose by nearly $8 billion from June 2006 to June 2007. And although ING Direct is obviously targeted at rate-sensitive savers, it doesn’t have to pay the highest rate to attract customers— and it hasn’t over the past year. Continued growth without rate leadership, observers say, suggests that savers are as pleased with the simplicity of ING Direct’s offer, such as its promise of no hidden or surprise fees, as they are with its rates.
ING Direct offered only a savings account when it started up in September 2000. It initially encouraged savers to maintain checking accounts with their local banks. It has now added a checking account to its menu and it is beginning to ramp up efforts on the asset side of the business by offering mortgages. Although ING Direct’s profitability remains low due to its reliance on securities rather than loans for assets— 0.33% return on assets in the first six months of 2007 with a 4.13% return on equity—its success in raising deposits has inspired others.
Perhaps most visible among the financial institutions offering similar high-yield online accounts, at least in terms of online advertising, is Emigrant Savings Bank in New York, which launched Emigrant Direct, in February 2005, and BancoFortuna.com, aimed at Hispanic savers, in May 2007. Other new players include Provident; EverBank; AmTrust Bank in Cleveland, which was known as Ohio Savings Bank until last April; Wilmington Trust Corp. in Delaware; and Flushing Savings Bank fsb in New York. Several banking units of non-bank financial companies also offer high-yield accounts, including Countrywide Financial Corp., the mortgage giant; Capital One Financial Corp., which owns two banks but is better known as a credit card company; Discover Financial Services; E*Trade Group Inc.; E-Loan Inc. and Allstate Insurance Co.
Though it’s difficult for outsiders to judge just how well most of these direct bank subsidiaries are performing financially, executives express satisfaction with the results so far. “It’s a way to grow deposits without a huge investment in infrastructure,” says Rebecca DePorte, a senior vice president in personal financial services division of Wilmington Trust, which does business online as WT Direct. Most of WT Direct’s deposit balances are new to the bank, DePorte adds.
Although high rates— which ranged from about 4% to 5.5% on savings or money market accounts in November— are obviously a big part of the draw, the money is quite stable, bankers say. “I don’t think anyone knows the exact elasticity of these accounts,” says Matt Lehman, vice president and Internet marketing manager at AmTrust. “But customers seem to be saying that if you offer a good rate and a good customer experience, they’re not going to move it every week for five or 10 basis points.”
Non-bank lenders with prominent brands appear especially eager to gather deposits online. Countrywide Bank, for example, has emerged as a bulwark in its parent’s plans to stabilize the funding side of its mortgage business. “Consumers are willing to disaggregate their funds because it’s so simple with the click of a button,” says Pierre Habis, managing director of retail banking.
Yet for banks with extensive branch networks, the picture is less clear. The biggest can’t help but reach many of their existing customers with national marketing campaigns, thus raising the risk of simply moving many customers into higher-yielding accounts.
Given the risk of losing deposits if they do nothing, all of the biggest retail banks are considering direct offerings, Meleis says. Still, it’s not surprising, he says, that only Citigroup and HSBC among the largest banks have launched a high-yield online account and stuck with it. He notes that neither institution possesses a U.S. branch system that is as large or geographically dispersed as that of the other mega-banks.
Even so, Citigroup, whose executives declined to be interviewed for this story, suggests in its shareholder communications that cannibalization is a problem. Just after launching Citi Direct in early 2006, the company said, “The results from our newly launched Citibank e-savings business have been exceptional, with $4.2 billion of deposits since its launch three months ago— approximately two-thirds representing new money to Citibank.” But in the third quarter of 2007, in referring to its U.S. deposits overall, it said, “Volume growth was partially offset by lower net interest margins, reflecting a shift in customer deposits to higher-cost direct bank and time deposit balances.”
Fencing In High-Yield
Novantas estimates that about 30% of all deposits are rate-sensitive, meaning they could easily shift to a better-paying alternative. And that percentage could grow as rate-related marketing catches the attention of more consumers who understand how easy it is to transfer balances to the online banks.
The result could be continual pressure across the banking industry to pay more on savings deposits, according to Gordon Goetzmann, a managing vice president with New York-based First Manhattan Consulting Group. That could put a big dent in profitability and then hit equity valuations hard, he adds. “If direct banking really gets some traction, we might be looking at an impact of 20% of stock price,” Goetzmann says, explaining that retail banking produces 60% or more of profitability at most regional banks and that high-margin savings and money market businesses represent a big share of that.
Banks that compete mainly on the basis of price are the most vulnerable to losing deposits to direct banks while banks with value-based offerings ought to have an easier time holding onto customers, Goetzmann adds. Nonetheless, the cumulative effect of direct bank marketing could be to nudge deposit competition from a series of local marketplaces to the national stage, he says.
And there’s not much to bar additional players from entering the high-yield online game. Bankers at Wilmington Trust and AmTrust say that the costs of setting up and operating a direct bank are relatively low. Rather than handling checks or cash, most deposits are taken via automated clearing house (ACH) transfers from other banks. Relatively modest Internet advertising expenditures, especially at rate-listing sites, can get the word out. Executives say the main challenge is to bring in new money without cannibalization.
Novantas, in fact, estimates that most banks need 80% of their deposits in online high-yield accounts to be new money just to break even on the business. So the success of traditional banks entering the business will depend on how well they discourage existing depositors from shifting balances, according to Meleis. He says the best prospects for avoiding such cannibalization are product fences, or product structure and promotion tactics that keep existing depositors and new high-yield accounts apart.
Banks might, for example, restrict or completely preclude branch or phone access to accounts that are meant to be managed online, Meleis suggests. They might go further by making withdrawals more difficult, thus signaling that there is a downside to an online relationship. And they might promote the account through local media in markets where they do not have a branch presence to reach people who are not existing customers, he says.
One recent entrant into the high-yield business is giving aspects of the fencing strategy a try. Baltimore-based Provident launched provident-direct.com last October. Rather than cast its marketing net widely, Provident will target slices of the marketplace with tailored pitches, says Lillian Kilroy, the bank’s managing director of emerging businesses. Recognizing that some of its own customers will be tempted by ING Direct and other high-rate players, Provident will market its direct offering to them, as opposed to nationally, he says.
Isn’t that a recipe for cannibalization? Kilroy says no, pointing out that Provident will pitch its highest rates, via Web marketing, only to customers who strongly prefer to bank online and thus would be most likely to move their balances anyway. It will pitch account bundles to people who use both the branch and the online channel, seeking to bolster relationships. But those bundles will only be available at the bank’s main Web site, Kilroy says.
Provident will also e-mail pitches to non-customers locally and advertise on national rate-comparison Web sites, such as bankrate.com, Kilroy adds, but mainly when it has a particular need to raise deposit balances quickly.
Though the bank won’t pitch the best rates to customers who are less likely to decamp for ING Direct, it will allow those who use the direct channel to access the branches. “We’re saying we want people to bank with Provident when they want, where they want, how they want and as much as they want,” Kilroy says.
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