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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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