What Online Banking Really Means

This is a chapter in a book I helped boutique investment banker Cohen Bros. & Company create. The Cohen family has a notable heritage in banking and financial services, and with this work they wanted to formalize some of their thinking and observations on banking gleaned over the years.

David R. Evanson

Present Value: Essays on Community Banking, Winter, 2005

The late 1990s were a scary time. It seemed like the so-called new economy was going to eclipse the so-called old economy. If you were in some sort of traditional business, like retailing or manufacturing, you thought that your e-commerce counterparts would ultimately put you out of business.

Many things were overlooked in the bubble economy, but perhaps one of the most important was the subtle distinction between force and persuasion. It’s true that in almost every application, Internet technology and electronic communications could enhance efficiency and productivity and increase the speed with which commerce took place. But the true winners of the era, or the candidates to become winners, were those who could force their constituents to do things in new ways compared with those who had to persuade their constituents to do things differently.

Therefore, when a mortgage company told its 1,000 sales agents to use an integrated mortgage application, underwriting and disbursement system, there was no argument. The marketing to “sell” the idea could be as simple and inexpensive as a memo distributed through e-mail. When an accounts-receivable department switched to a platform that integrated sales and service and guided collections personnel with screen-based prompts, the largest costs and risks were installation and training, not divining the true path to consumer acceptance.

By contrast, it required a great deal of persuasion to lure pet owners to a specific Internet site to do business in a new way, to convince readers to forsake their morning newspaper for digital news delivery, and to tempt natural-foods enthusiasts to shop online for homeopathic medicines without sales assistance. In most cases, this persuasion was so expensive that it undermined the entire premise of the business model.

As a case in point, consider Pets.com, which was formed in February 1999. The company quickly gained attention as a result of its television ads featuring a smart-aleck sock puppet. By December 1999, Pets.com had filed a registration statement for an $82 million initial public offering with white-shoe investment bankers Merrill Lynch, Bear Stearns, Thomas Weisel, and Warburg Dillon Read.

The excitement of the era obscured the reality of what Pets.com was trying to accomplish: nothing less than the wholesale persuasion of millions of customers to make a fundamental change in the care and feeding of their beloved pets. A cold, hard, objective look at the financial statements could — or perhaps should — have made it obvious that there was simply not enough equity capital in the world to do this.

In the 10 months leading up to the offering, total marketing expenditures of $42.5 million netted sales of $5.8 million. Pets.com had a negative gross margin of $7.6 million and a net loss of $61.8 million. Despite this, the company went public on February 10, 2000, with a valuation of $290 million (or $325 million if unvested stock options were included in the share count). Net proceeds were $76 million. Given that $42.5 million produced less than $6 million in sales, in hindsight it’s difficult to see how the next $42 million and then some was going to make a big difference.

At the time, none of this seemed to matter, not because no one cared, but because everyone believed that the world was going to go digital and that the companies with “first-mover” status, in the jargon of the era, would reap the rewards and gain primacy as a result of the “brand identity” they had established.

Banking and financial services were not immune to this kind of thinking. It’s little wonder why. All of the leading thinking, or thinking that was supposed to lead the way, reported that a new world order was at hand. Consider the following assertions from researchers Asish Ramchandran and Viijay Gurbaxani at the University of California’s (Irvine) Center for Research on Information Technology and Organization. Their comments appeared in a November 1999 analysis of E Trade Group versus Charles Schwab:

“Late entrants are likely to encounter significant hurdles in their attempts to build online businesses. With the large number of companies in all industries rushing to get on the Web, the costs of developing brand recognition are escalating rapidly. Industry sources say American Express spent millions of dollars last year and got only a small number of customers with its launch campaign for their online brokerage offering called American Express Direct. First-mover advantage is providing a larger and perhaps more sustainable benefit to the innovators than many observers initially anticipated.”

This kind of thinking had a significant impact on the capital markets. For instance, at the end of 1999, E Trade had a market capitalization of $16.9 billion while venerable Lehman Brothers had a market value of just $4.9 billion. This disparity was all the more perplexing in light of their relative size and financial performance. For 1999 (December fiscal year), Lehman, with total assets and shareholder equity of $139.2 and $3.1 billion respectively, delivered net revenues of $3.4 billion and net income of $696 million. At the end of fiscal 1999 (September fiscal year), E Trade, with total assets and shareholder equity of $7.9 billion and $1.4 billion respectively, had net revenues of $657 million and a net loss of about $52 million. Lehman made more in net income than E Trade generated in revenues, yet the latter was valued more than three times higher. Obviously, investors were expecting great things to happen in the not-too-distant future.

Revisiting the force versus persuasion theme, it’s worth noting that of E Trade’s $507 million in operating expenses, fully 63 percent were devoted to selling and marketing expenses. Over at Lehman, selling and marketing expenses didn’t even make it as a line item on the income statement. Instead, the firm posted understated “business development” costs of $83 million, even though its revenues were more than 4.5 times those of E Trade.

The turmoil in brokerage reached its frenzied peak in June 1999, as Merrill Lynch, the market leader in full-service brokerage, made a formal announcement of its online product offering. The announcement was preceded by intense speculation that threatened to spill into open revolt by the firm’s 14,000 retail brokers. Would an online offering cannibalize the full-service operation? Was Merrill, which had spent nearly 100 years trying to bring Wall Street to Main Street, about to make an abrupt about-face?

In the end, Merrill struck a delicate balance with its so-called Integrated Choice product, allowing clients to choose the level of advice they wanted and the way they would transact their business. This was explained in one of the advertisements at the time, which read, “By mouse, by phone, by human being.” Merrill’s carefully considered approach may have saved the firm from a costly, life-threatening blunder. Many other firms, not as lucky, lost their entire market as trading from retail investors dried up in the wake of a brutal bear market that took hold in the spring of 2000.

All of this shaped the thinking of bankers. In the conventional wisdom of the time, online banking was viewed as a threat. While the titans of the brokerage business were rebuilding themselves, the banking industry was changing, too. Unlike brokerage, the world of banking was not turned upside down, but based on the market’s enthusiastic reception to Internet banks, its universe was clearly tilted on a new axis. For instance, NetBank, with total assets of $1.2 billion, interest income of $54 million, and net income of $3 million, achieved a peak valuation of $2.3 billion during 1999. Meanwhile, Commerce Bancorp, headquartered in southern New Jersey with $6.6 billion in assets, $386 million in interest income, and $66 million in net income, was worth just $513 million. Like the Lehman/E Trade example, Commerce’s net income was greater than NetBank’s net revenue, yet the former was valued at a fraction of the latter.

Like those in the brokerage business, investors were clearly expecting great things to happen because of Internet banks and Internet banking. This belief was not just idle speculation. Investors were putting their money where their mouths were. This sentiment, fortified by daily reporting of the promise of the new economy and the optimism of the leading business thinkers of the day, frightened many bankers. The prevailing fear was this: Internet banks are going to replace traditional banks.

Ironically, the banking industry’s historical resistance to change may have been what ultimately saved it from the threat of Internet banking. As it turned out, the real danger was not being too slow to adopt an online banking strategy, but rather succumbing to the mood of the era and adopting the technology too fast.

Ample proof of this is provided by those who did move rapidly to achieve “first-mover” advantage, most notably Bank One’s Wingspan Bank, followed by Juniper Bank. A chronology of these two institutions, which are related, is useful in sorting out what community and regional banks would come to learn at the expense of the behemoths.

Bank One’s Wingspan was formed in June 1999 with much fanfare and a purported promotional budget of $150 million. Wingspan positioned itself with a snappy tagline that said, “If a bank could start over, this is what it would be.” It’s worth noting that Bank One already had an online banking product with several hundred thousand customers. However, in forming Wingspan as a stand-alone effort, Bank One hoped to go one step further and create something with no physical presence that would appeal to heavy online users.

The launch of Wingspan was accompanied by all of the rhetoric typical of the era, which at the time terrified the rest of the industry. In August 1999, Jim Stewart, president and chief executive officer of Wingspan, said, “We developed a culture that allowed executives to think quickly and execute immediately.” This was anathema to many bankers who were, and still are, often chided for their stodginess. These same bankers were thinking, “Is our ingrained culture of prudence a liability that will cause us to miss one of the greatest transformations of banking in history?”

In November 1999, Bill Wallace, chief information officer of Wingspan, explained that “The first-mover advantage will allow us to learn more quickly than our competitors what those things are that customers value.” More prophetic words could have hardly been spoken. Unfortunately, what Wingspan and its executives would soon learn is that banking customers really didn’t want banking services that were completely devoid of a physical presence.

By 2000, the bloom was off the rose. After spending a purported $35 million in marketing and advertising, Wingspan had fewer than 100,000 customers. CEO Stewart indicated that the company was not as large as originally anticipated because planned marketing expenditures were slashed due to Bank One’s earnings shortfall.

While Bank One was showing signs that it had had enough, Stewart wasn’t through yet. Neither was Richard Vague, former head of Bank One’s First USA unit. At the time it looked like the inability to attract enough new customers was a cultural issue — not the American culture at large, but Bank One’s, as Stewart announced, “Companies that are part of larger companies have different sets of issues than stand-alone companies.” As a result, the pair teamed up, and in May 2000 launched Juniper Bank.

Unlike Wingspan, which had utilized costly television advertising, Vague planned to capitalize on his expertise in direct marketing to promote the new bank. In addition, Vague said that Juniper would make its online-banking product easier to use and more customer-friendly than its competition.

With the benefit of hindsight, it’s now obvious that the collaboration with Mail Boxes Etc., announced about three months after the launch of Juniper, was a sign that Internet banking had a very narrow market and would never succeed on a grand scale. According to a press release announcing the partnership, Juniper and MBE teamed up so that “Juniper customers will be able to walk into most of MBEzzs 3,400 U.S. locations and overnight their deposits to Juniper free of charge.” In the same release, Juniper’s Vague said, “Up to this point, online banking has struggled in part because it has been difficult to make a deposit, which is a basic step in the banking life process. We want to make banking as simple as possible for our customers, so we are looking for creative solutions to fit our customerszz needs.”

This was tantamount to an admission that online banking could not succeed without a physical presence. Based on this, one could argue that it was over for Juniper before it ever started. Note: Juniper has since morphed into a full-service credit card issuer.

Perhaps the threat that Internet banking posed to traditional banking was officially rescinded in September 2000, when Jamie Dimon, Bank One chairman and chief executive officer, delivered a speech to the National Association for Business Economics in Chicago: “The Internet basically stinks. It’s slow, it’s tedious, it doesn’t work all the time. It’s like walking into the library where all the books are thrown on the floor.”

In 2001, Bank One brought Wingspan into an internal organization known as the Consumer Internet Group, and it ceased to be an independent entity. In a flash, a high-flying era rife with intense speculation about its ultimate impact came to an end.

There were several lessons learned that have and will continue to have an impact on banking. Perhaps most important is that branches mean a lot in the banking business. After due consideration, this should not be a surprise. Throughout modern history, the physical edifice of a bank was always considered an important part of its image and was one of the key sales propositions. Through their buildings, banks have always tried to convey the notion: This institution is rock solid.

It seems that almost out of a sense of embarrassment over the Internet banking fad, banks now are focusing intently on their branches as if to verify that managing a deposit franchise –- and all that it entails -– is very much their core business. Actually, the real story about the commitment of banks to their branch operations is told by the numbers.

Fig XXX shows the growth in branches from 1980 to 2003 and, for context and perspective, the trend in commercial banking institutions. The data forcefully demonstrates that no matter what bankers were thinking about the Internet in the middle of the night, they never gave up on branches. Also noteworthy is the trend in commercial banking institutions relative to branches.

Source: FDIC
On left: Number of Banking Institutions
On right: Number of Branches

In many ways, the fact that fewer institutions operate far more branches is a triumph of technology. Thus, no one can ever say that banks and bankers got it wrong with technology. While most took a wait and see regarding online banking, many more invested in the kind of enterprise-wide systems that would allow them to achieve scale with little additional cost.

Branches, once dead, are now celebrated. Here’s a description of the fanfare over the opening of a Fleet branch in New York City as it was reported in the June 2004 issue of Bank Systems & Technology Magazine.

“Adorned with balloons, a FleetBoston branch across from New Yorkzzs Grand Central Terminal celebrated its grand opening one recent evening as commuters dashed to catch trains to the New York and Connecticut suburbs. Fleet intends this branch to be the latest in multimedia, ergonomics and environmental design. Prominent signs bearing the Fleet logo will be replaced soon by ones bearing the logo of Bank of America, which merged with Fleet this year.
“The interior includes wall-mounted TV monitors displaying business and news headlines, an LCD stock ticker above the teller cages, and online banking and investment stations where customers check balances, transfer funds, pay bills, and even trade stocks via Fleetzzs Quick & Reilly brokerage unit. Weight sensors in the floor tell the machine to automatically log off customers when they step away.”
The revival of the branch leads to another lesson that was learned: Banking is truly a multichannel business consisting of branches, ATMS, call centers, mail and the Internet. No single channel -– particularly the Internet –- is going to drive other banks out of business purely by its existence.

The reason for this rests with two elements of consumer banking behavior. First, despite the fact that for most readers of this book banking is extremely interesting, for most consumers, banking is considerably less exciting. Most often, it’s a habituated activity. Based on this, the way in which consumers do their banking today is an accurate predictor of how they will do business tomorrow. If this were the single prevailing behavior of bank customers, the Internet may have never even got a toehold in banking. Parenthetically, one could argue that the existence of a single and uniform consumer behavior was what ultimately undermined Pets.com, which was discussed at the beginning of this chapter.

In banking, habituated behavior is modified by consumers’ purposeful channel choice. Specifically, consumers will pick the banking channel that most rapidly and most effectively solves the problem or delivers the service. Deposits can be easily made by mail. Resolving an NSF notification usually requires a branch visit. Getting cash from remote locales is easy through an ATM. Making transfers and paying bills can be done efficiently online.

As a result, Internet banking, once considered a threat to banking, has quietly and humbly assumed its role within the hierarchy of distribution channels. According to Financial Insights, a Framingham, Mass.-based financial services research firm, Internet banking ranks third as a distribution channel. When consumers were asked about their primary channel, branches led with about 60 percent, ATMs were second with about 29 percent, and online access was a distant third at about 5 percent.

Presently, utilization rates for online banking are about 22 percent to 28 percent. But these numbers, estimated by Financial Insights and based on log-ons to the secure portion of a bank’s online site, are tricky because it’s hard to measure utilization, and online utilization should not be confused with usage of the primary channel.

While banking appears to have reached a state of equilibrium with respect to online banking, complacency appears ill-advised. Specifically, the estimated cost of an online transaction ranges between $0.02 and $0.06. The cost per transaction at a branch ranges between $3.50 and $10. Therefore, the question becomes: How much service can be reasonably and effectively delivered through the online channel? The answer is a lot more than 5 percent.

Banks successfully survived the threat of online banking, but moving forward, the real question becomes: Can they capitalize on the true opportunities of online banking?

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