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ESSAYS ON ISSUES THE FEDERAL RESERVE BANK OF CHICAGO MARCH 2001 NUMBER 163 Chicago Fed Letter The Internet’s place in the banking industry How the Internet will affect banking is one of the most intriguing questions in the ongoing evolution of the U.S. banking industry. Internet banking gives customers the ability to access virtually any type of banking service (the main exception for now being cash) in any place and at any time. If customers adopt this new way of banking in large numbers, banks may be able to shed much of their investment in expensive brick and mortar branches. But Internet banking remains a work in progress, and for many U.S. banks the initial Internet experience has been disappointing. In this Chicago Fed Letter, I argue that the Internet is chiefly a new delivery channel—not a new product—and based on this argument, I propose a simple framework for analyzing the strategic interactions between physical branches, automated teller machines (ATMs), the Internet, and other bank delivery channels. For most banks, the future of the Internet lies in how well it can be integrated with more traditional delivery channels. But in the end, profitability will depend primarily on the quality of the products and services banks deliver to their customers, and not necessarily on how those products and services are delivered. Changing delivery channels The way that U.S. commercial banks deliver products and services to their customers has changed substantially over the past decade (figure 1). Bank mergers—many of which combined two banks from different geographic markets—reduced the total number of banks by about one-third during the 1990s. But despite having fewer banks, the U.S. now has more banking “points of sale” than a decade ago. The number of branch locations has increased from about 60,000 to about 70,000, and the number of ATMs has skyrocketed. The typical bank now has a greater geographic reach, and covers those markets with a denser network of branches and ATMs. 1. Bank delivery channels, 1991–99 number 250,000 number 12,500 Banks (right scale) 10,000 200,000 7,500 150,000 ATMs (left scale) 100,000 5,000 Branches (left scale) 50,000 Transactional websites 2,500 (right scale) 0 1991 0 ’93 ’95 ’97 Sources: Data on ATMs from American Bankers Association, Bank Network News, Ernst & Young, and Dove Associates; ’99 More recently, banks banks and branches from FDIC; transactional websites from OCC. have augmented their distribution networks with transactional websites, which allow customers to open New product or new package? accounts, apply for loans, check balWhen a retailer like Eddie Bauer sells ances, transfer funds, and make and a pair of jeans, the point of sale might receive payments over the Internet. be a physical store, a telephone order, The number of banks with transacor an Internet purchase. Regardless, tional websites is increasing rapidly— the customer’s choice of a delivery from near zero just a few years ago, channel does not affect the nature to 1,100 at year-end 1999, to an estiof the product. This analysis can be mated 2,000 plus by the end of 2001. applied to most banking services, reAnd the recent introduction of wiregardless of whether the point of sale less Internet banking promises to is a physical branch, an ATM or ABM, further increase the convenience of or the Web. With a few exceptions, a 1 Web-based banking. transactional Internet website is not The Internet is also transforming a new financial product—rather, it is traditional bank distribution channels. a new delivery channel for existing For example, the recent increase in financial products. ATMs includes the introduction of In some ways, the introduction of the automated banking machines (ABMs). Internet banking channel parallels Often deployed at banking “kiosks,” the introduction of ATMs several deABMs combine at a single location an ATM for getting cash and deposit- cades ago. ATMs did not introduce any new financial services, but they ing checks, an Internet connection offered customers more convenient to the bank’s website, and often a telephone for accessing customer service. access to a limited array of existing financial services, primarily the safeSimilarly, the increase in bank branchkeeping of deposits, liquidity services, es over the past decade includes the and information on account balances. introduction of “mini-branches,” in Like ATMs, Internet banking (supportwhich Internet kiosks are placed sideed by other developments like credit by-side with teller windows. scoring technology, check imaging, Choosing a distribution strategy Not all banking products, and not all banking customers, adapt well to the Internet channel. Transferring funds, paying bills, and applying for a credit card do not require personal contact or a large physical space, and are therefore well suited for Internet delivery. But applying for a business loan, closing on a home mortgage, and estate planning are complex transactions, which typically require a secure physical space and/or personto-person communication. And getting cash is impossible over the Internet, requiring either branches or ATMs. Because of such limitations, most banks that offer Internet delivery do not rely on it entirely. The mix of delivery channels a bank chooses has consequences for its expenses, the convenience of its customers, and the quality of the products and services it delivers. Figure 2 categorizes bank delivery channels according to the distance that customers typically must travel to use them Farther 2. Bank delivery channels: A set of choices Unit bank Branch bank Distance to customer As a bank’s mix of dev Drive-through livery channels shifts vertically from the top of the figure toward the bottom, there are benATM efits for both the customer and the bank: convenience increases Internet Telephone because customers don’t have to travel as Wireless far to perform transactions, and bank expensLess Person-to person contact More es tend to fall because less physical overhead is necessary to facilitate the transacbetween customer convenience and tion. According to some recent estiin-person quality by allowing custommates, branch banking costs about ers to choose the mix of delivery chan$1.07 per transaction, telephone nels that works best for them. The banking costs about $0.55 per transac- click and mortar strategy has been tion, ATM banking costs about $0.27 adopted by all of the largest U.S. per transaction, and Internet banking banks. An increasing number of full costs about $0.01 per transaction.2 service community banks are also imBut there is a tradeoff: Shifting to a plementing this strategy, chiefly as a more convenient, lower cost mix of defensive move aimed at retaining delivery channels also tends to reduce high-value customers who want to use person-to-person contact with the custhe Internet for some of their banktomer. As a bank’s mix of delivery ing transactions. channels shifts horizontally from right Another potentially successful strategy to left in figure 2, some customers is to occupy only the bottom left corwill experience a reduction in (either ner of figure 2. An Internet-only or pure actual or perceived) service quality. play Internet bank operates no brick Note that the data displayed in figure 1 and mortar branches. With the excepindicate that the mix of bank delivery tion of arrangements for customers to channels has been shifting from the get cash and deposit checks at ATM top right corner of figure 2 toward machines, banks using this distribution the bottom left corner of figure 2. strategy deliver all of their products Does the resulting increase in cusand services over the Internet. The tomer convenience offset the decline very nature of this delivery channel in service quality? This shift may or precludes person-to-person customer may not be a profitable move for any service, and although this can limit given bank, depending on the nature the ability of a pure play Internet bank of the financial services it sells, the to charge premium prices, reduced preferences of its customers, and the spending on physical overhead may amount of cost savings from the new potentially offset these revenue limitadistribution strategy. tions. Internet-only banking is often regarded as a niche strategy that focuses One potentially successful distribuonly on the most Internet-savvy banktion strategy is to occupy the entire ing customers and/or delivers only a space in figure 2. A click and mortar limited array of financial services. bank augments its existing brick and mortar branches, ATM locations, and A final strategy is to occupy only the other delivery channels with a transtop right corner of figure 2. A brick actional Internet website. This apand mortar bank does not operate a proach arguably avoids the tradeoff transactional website, but may operate v Closer v However, some of the financial services that banks offer over the Internet are new. For example, some banks are using the Internet to offer account aggregation, which organizes in one place all the data from a customer’s multiple relationships with banks, insurance companies, and brokerage firms. (Prior to financial deregulation, customers tended to have relationships with fewer financial institutions, so account aggregation was less necessary. And prior to the Internet, the logistics of collecting data and mailing it to customers made this a less cost-effective service.) Another example is the business-to-business marketplace, where banks use the Internet to bring together prospective buyers and sellers of standardized business inputs (e.g., chemicals or paper products). If these markets are constructed efficiently, buyers and sellers benefit from better prices and more timely delivery, and banks can benefit by providing financing for the deals that result. (vertical axis) and the amount of in-person service that customers receive (horizontal axis). v and check truncation) has increased the convenience of accessing an even wider array of existing banking services. a non-transactional website where customers can check account balances and get information on products and prices. Banks that use this distribution strategy deliver all of their products and services through traditional full service branches, augmented by ATM machines. Although this traditional approach is likely to remain a profitable strategy for some community banks into the near future, any strategy that completely excludes Internet banking options is unlikely to be profitable in the long run. As time passes and a greater percentage of the population want to do at least some of their banking on the Web, these banks are likely to lose an increasing number of their high-value loan and deposit customers. Is Internet banking profitable so far? Just a few years ago, pundits were predicting that the Internet channel would soon eclipse brick and mortar branches, and that Internet-only banks would quickly capture a large share of the banking market. More recently, these predictions have swung like a pendulum. Indeed, some analysts now argue that pure play Internet banking is a flawed business model.3 The reality probably lies somewhere between these two extreme positions. To date, only a handful of serious studies have examined the performance of the Internet banking channel. Not surprisingly, the assessments of these studies tend to be less extreme than conclusions drawn in the financial press. Two of these studies—one performed at the Office of the Comptroller of the Currency, the other at the Federal Reserve Bank of Kansas City—compare the performance of click and mortar banks with that of brick and mortar banks.4 These two studies find a number of similar results. Most importantly, they find that profitability at the Internet banks tends to be higher than, or is at least comparable to, profitability at the more traditional banks. While the direction of causation in these studies is not completely clear— for example, it may be that well-managed, profitable banks are more likely to start up transactional websites— these studies suggest that the Internet delivery channel can be part of a profitable banking strategy. A third study, performed at the Federal Reserve Bank of Chicago, compares the performance of Internet-only banks and thrifts with that of banks and thrifts that operate branches (after controlling for a number of outside factors).5 The study finds relatively low profits at the Internet-only institutions, caused in part by high labor costs, low feebased revenues, and difficulty generating deposit funding. However, rather than concluding that Internetonly banks are necessarily unprofitable, the study stresses that it may simply be too soon to judge this business model—both Internet-only banks and their customers are still learning how to efficiently use this delivery channel, and overall demand for Internet-only banking is likely to grow. The Internet’s (eventual) place in banking Although Internet-only banks may eventually become profitable, evidence is mounting that banks using this business model are unlikely to capture a dominant share of the full-service banking market. A growing number of Internet-only banks are specializing in niche product markets or customer groups. For example, iVantage Bancorp focuses on college students and their parents; UmbrellaBank.com attempts to build long-term relationships with traditionally “unbanked” consumers; AeroBank.com concentrates on selling loan and cash management services to small business owners; BMW Bank cultivates an upscale customer base at BMW auto dealerships; and State Farm Bank markets online banking services through State Farm insurance agents. Meanwhile, a number of large banking companies that launched high-profile Internet-only ventures—including Wingspan (Bank One), mbanx (Bank of Montreal), and Citi f/i (Citigroup)—have been integrating these ventures back into the main bank, giving their Internet customers full access to their branch distribution networks. Similarly, Royal Bank of Canada purchased a Chicagobased mortgage company with 150 branch offices so that customers of its U.S. Internet-only bank, Security First Network Bank, could access banking services at brick and mortar locations. At the other extreme, it seems even less likely that traditional brick and mortar banks will retain a large market share in the long run without offering their customers an Internet banking option. Today, it is difficult to imagine a successful bank that operates without ATMs. In the near future, it may be just as difficult to imagine a successful bank that operates without a transactional website. These developments suggest that the majority of Internet banking customers will be served by click and mortar banks, not by Internet-only banks. Figure 3 maps out a hypothetical future distribution of bank delivery channels: a handful of pure play Internet banks at one extreme, virtually no brick and mortar banks at the other extreme, and a continuum of click and mortar banks in the middle. The percentage of business that any given click and mortar bank delivers over the Internet channel is likely to be determined by the Michael H. Moskow, President; William C. Hunter, Senior Vice President and Director of Research; Douglas Evanoff, Vice President, financial studies; Charles Evans, Vice President, macroeconomic policy research; Daniel Sullivan, Vice President, microeconomic policy research; William Testa, Vice President, regional programs and Economics Editor; Helen O’D. Koshy, Editor; Kathryn Moran, Associate Editor. Chicago Fed Letter is published monthly by the Research Department of the Federal Reserve Bank of Chicago. The views expressed are the authors’ and are not necessarily those of the Federal Reserve Bank of Chicago or the Federal Reserve System. Articles may be reprinted if the source is credited and the Research Department is provided with copies of the reprints. Chicago Fed Letter is available without charge from the Public Information Center, Federal Reserve Bank of Chicago, P.O. Box 834, Chicago, Illinois 60690-0834, tel. 312-322-5111 or fax 312-322-5515. Chicago Fed Letter and other Bank publications are available on the World Wide Web at http:// www.frbchi.org. ISSN 0895-0164 number of banks 3. Hypothetical distribution of banks 0 20 40 60 80 percent of business over Internet 100 mix of products it offers and the preferences of the customers it serves. Conclusion For most banks, and for most of their customers, banking over the Internet is still a relatively new phenomenon. Because the pace of technological change is so fast, it can be difficult to evaluate the strategic importance and the financial impact of Internet banking. This Fed Letter argues that the Internet, much like the ATM that came before it, is fundamentally a new distribution channel over which banks can deliver traditional banking products and services. Banks that successfully integrate this new channel with their preexisting branch and ATM networks, choosing the mix of channels that best complements their product mixes and customer bases, will gain a strategic advantage. But the business of banking remains the provision of credit, safekeeping, transactions, insurance, and investment services—banks that are unable to provide these services efficiently in an increasingly competitive environment will not flourish, regardless of the delivery channels they use. —Robert DeYoung Senior economist and economic advisor 1 Currently, wireless devices are used most often for a limited array of brokerage (e.g., monitoring financial markets, executing trades) and banking (e.g., transferring funds, checking account balances) transactions. 2 See Luxman Nathan, 1999, “Community banks are going online,” Communities and Banking, Federal Reserve Bank of Boston, Fall, No. 27, pp. 2–8. Also see The Economist Newspaper Limited, 2000, “Branching out,” The Economist: A Survey of Online Finance, May 20, pp. 19–23. 3 For example, see Dow Jones & Company, 2001, “Online banks fail to realize cyber-goals,” Wall Street Journal, January 10, p. C18. 4 The first of these studies looks at national banks. See Karen Furst, William W. Lang, and Daniel E. Nolle, 2000, “Who offers Internet banking,” Quarterly Journal, Office of the Comptroller of the Currency, Vol. 19, No. 1, June, pp. 1–21. The second looks at banks in the Tenth Federal Reserve District. See Richard J. Sullivan, 2000, “How has the adoption of Internet banking affected performance and risk in banks?,” Financial Industry Perspectives, Federal Reserve Bank of Kansas City, December, pp. 1–16. 5 Robert DeYoung, 2001, “The financial performance of pure play Internet banks,” Economic Perspectives, Federal Reserve Bank of Chicago, Vol. 25, No. 1, First Quarter, pp. 60–76. 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