The Future of On-Line Banking

What will be the effect of on-line banking on our banking industry? What strategies should commercial bankers adopt to fend off competition from on-line banks and increase their market share of financial services? The most recent issue of Economic Intuition, published by the National Bureau of Economic Research, addresses this important issue. More detailed discussions may be found in The McKinsey Quarterly, 2000, No. 3.

Many pundits have predicted that the growth of on-line banking heralds the end of small banks and bank branches. After all, many consumers have learned how to use the Internet. Those who are fairly affluent and short on time make ideal customers for on-line banking. Further, virtual banks have lower operating expenses than banks with brick and mortar branches and human tellers.

In spite of all the hype, the data indicate that on-line banks are not making much of a dent in the banking market. Recent data show that the two leading e-banks, Telebank and NetBank, had a total of 100,000 customers. In contrast, Bank of America had 1,200,000 customers; Wells Fargo, 980,000; and Citibank, 675,000.

The outlook for growth of e-banks

The current position of e-banks should not lead traditional bankers to be complacent. On-line bankers are signing up brokers to provide their customers with on-line banking services. The McKinsey research shows that 75 percent of on-line bank customers are willing to transfer their funds to on-line brokers that also offer basic banking services. Furthermore, on-line banks are competing directly with traditional branches by offering retailers and insurance companies bank-in-a-box facilities. These e-bank branches enable a grocery store, for example, to attract customers by offering them virtual banking services. Since the service is designed to bring in customers, the retailers can afford to offer the banking service at a nominal cost.

In a recent article in the Wall Street Journal, Tamsin Carlisle recounts how the Dutch bank, ING Group, launched its ING Direct Interbank in Canada in late 1998. It now has more than 300,000 accounts with the equivalent of US$2 billion in deposits. How did it break into the market so successfully? First, it attracts depositors by making it easy for them to access their accounts and by paying higher interest rates than brick-and-mortar competitors. For example, it pays 6.5 percent on U.S. savings accounts. Second, it makes e-banking "user friendly" to ordinary consumers, not just computer "nerds." To reach this goal, ING operates several cafes where expresso and biscotti are available at reasonable prices. Along with these servings, management provides a helping of information about bank accounts. A chalkboard back of the counter shows the current rates paid on various accounts, and a bank representative provides information about e-banking. A sofa, easy chair and popular music sooth customers who might otherwise worry about trusting their savings to cyberspace banks. ING reports that its cafes in two cities generated about a fourth of its customers in those locals.

ING plans to enter the U.S. Whereas 31 percent of Internet users in Canada and 42 percent in Germany do their banking on-line, only 22 percent of American Internet users do so. ING will find out whether the difference reflects a lack of demand or lack of user-friendly supply. It has plans for cafes in New York, Philadelphia and Wilmington, DE. ING also plans a mass-marketing campaign in the northeast.

E-banks vs. traditional banks

Traditional banks can retain their market share by (1) emphasizing their advantages relative to e-banks, and (2) reducing their expense-to-income ratios. First of all, the researchers note the increasing importance of branches to consumers. The number of in-branch transactions per U.S. household rose from 54 in 1993 to 62 in 1998. Furthermore, branches are an important source of new customers. The McKinsey research shows that branches generate 80 percent to 90 percent of new deposits, loans and investments.

Nor do e-banks have an easy path to profits. Many customers of e-banks are evidently unwilling to place all of their financial affairs with virtual banks. In particular, they cannot make deposits in the banks except by ATMs. Also, many consumers miss face-to-face contact with human beings and do not completely trust the Internet and may be concerned about their privacy. However, e-banks do offer many convenient services. Consequently, a traditional bank with branches that also offer e-banking may have an advantage over both "regular" banks as well as e-banks.

Reducing the expense-to-income ratio

While branches generate a high proportion of new deposits and loans, they also generate 50 percent of costs. Basically, the McKinsey researchers argue that managers of brick-and-mortar banks need to identify customer segments and then design different systems to deliver services in a cost-effective manner without sacrificing significant income. "Prune the branches, not the customers." (Easier said than done!) To accomplish this result, banks must "determine the functional and strategic roles that each distribution channel should play." For example, it may be desirable to retain a branch that serves a number of small businesses and to help it to expand those services. In contrast, a bank may replace a full-service branch with more ATMs or rent space in retail stores. For example, Wells Fargo has rented space in coffee shops and drug stores. In England, Lloyds TSB Bank has arranged with post offices to cash checks and take deposits of its rural customers. Such innovative strategies have enabled some banks to reduce their expense-to-income ratios by as much as 200 basis points.