Robert DeYoung

English

Research Papers in Economics

ESSAYS ON ISSUES THE FEDERAL RESERVE BANK MARCH 2001
OF CHICAGO 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 bank-
ing in large numbers, banks may be
able to shed much of their investment
in expensive brick and mortar branch-
es. 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 de-
pend 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 num-
ber of branch locations
has increased from
about 60,000 to about
70,000, and the num-
ber of ATMs has sky-
rocketed. The typical
bank now has a greater
geographic reach, and
covers those markets
with a denser network
of branches and ATMs.
More recently, banks
have augmented their
distribution networks
with transactional web-
sites, which allow customers to open
accounts, apply for loans, check bal-
ances, transfer funds, and make and
receive payments over the Internet.
The number of banks with transac-
tional websites is increasing rapidly—
from near zero just a few years ago,
to 1,100 at year-end 1999, to an esti-
mated 2,000 plus by the end of 2001.
And the recent introduction of wire-
less Internet banking promises to
further increase the convenience of
Web-based banking.1
The Internet is also transforming
traditional bank distribution channels.
For example, the recent increase in
ATMs includes the introduction of
automated banking machines (ABMs).
Often deployed at banking “kiosks,”
ABMs combine at a single location
an ATM for getting cash and deposit-
ing checks, an Internet connection
to the bank’s website, and often a tele-
phone for accessing customer service.
Similarly, the increase in bank branch-
es over the past decade includes the
introduction of “mini-branches,” in
which Internet kiosks are placed side-
by-side with teller windows.
New product or new package?
When a retailer like Eddie Bauer sells
a pair of jeans, the point of sale might
be a physical store, a telephone order,
or an Internet purchase. Regardless,
the customer’s choice of a delivery
channel does not affect the nature
of the product. This analysis can be
applied to most banking services, re-
gardless of whether the point of sale
is a physical branch, an ATM or ABM,
or the Web. With a few exceptions, a
transactional Internet website is not
a new financial product—rather, it is
a new delivery channel for existing
financial products.
In some ways, the introduction of the
Internet banking channel parallels
the introduction of ATMs several de-
cades ago. ATMs did not introduce
any new financial services, but they
offered customers more convenient
access to a limited array of existing
financial services, primarily the safe-
keeping of deposits, liquidity services,
and information on account balances.
Like ATMs, Internet banking (support-
ed by other developments like credit
scoring technology, check imaging,
number
1. Bank delivery channels, 1991–99
Banks
(right scale)
1991 ’93 ’95 ’97 ’99
0
50,000
100,000
150,000
200,000
250,000
0
2,500
5,000
7,500
10,000
12,500
number
Transactional websites
(right scale)
ATMs
(left scale)
Branches
(left scale)
Sources: Data on ATMs from American Bankers Association,
Bank Network News, Ernst & Young, and Dove Associates;
banks and branches from FDIC; transactional websites from OCC.and check truncation) has increased
the convenience of accessing an even
wider array of existing banking services.
However, some of the financial servic-
es 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, in-
surance companies, and brokerage
firms. (Prior to financial deregulation,
customers tended to have relationships
with fewer financial institutions, so ac-
count aggregation was less necessary.
And prior to the Internet, the logistics
of collecting data and mailing it to
customers made this a less cost-effec-
tive service.) Another example is the
business-to-business marketplace, where
banks use the Internet to bring togeth-
er 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 financ-
ing for the deals that result.
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 con-
tact 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 person-
to-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 ex-
penses, the convenience of its custom-
ers, and the quality of the products
and services it delivers. Figure 2 cate-
gorizes bank delivery channels accord-
ing to the distance that customers
typically must travel to use them
(vertical axis) and the
amount of in-person
service that customers
receive (horizontal axis).
As a bank’s mix of de-
livery channels shifts
vertically from the top
of the figure toward the
bottom, there are ben-
efits for both the cus-
tomer and the bank:
convenience increases
because customers
don’t have to travel as
far to perform transac-
tions, and bank expens-
es tend to fall because
less physical overhead
is necessary to facilitate the transac-
tion. According to some recent esti-
mates, branch banking costs about
$1.07 per transaction, telephone
banking costs about $0.55 per transac-
tion, ATM banking costs about $0.27
per transaction, and Internet banking
costs about $0.01 per transaction.2
But there is a tradeoff: Shifting to a
more convenient, lower cost mix of
delivery channels also tends to reduce
person-to-person contact with the cus-
tomer. As a bank’s mix of delivery
channels shifts horizontally from right
to left in figure 2, some customers
will experience a reduction in (either
actual or perceived) service quality.
Note that the data displayed in figure 1
indicate that the mix of bank delivery
channels has been shifting from the
top right corner of figure 2 toward
the bottom left corner of figure 2.
Does the resulting increase in cus-
tomer convenience offset the decline
in service quality? This shift may or
may not be a profitable move for any
given bank, depending on the nature
of the financial services it sells, the
preferences of its customers, and the
amount of cost savings from the new
distribution strategy.
One potentially successful distribu-
tion strategy is to occupy the entire
space in figure 2. A click and mortar
bank augments its existing brick and
mortar branches, ATM locations, and
other delivery channels with a trans-
actional Internet website. This ap-
proach arguably avoids the tradeoff
between customer convenience and
in-person quality by allowing custom-
ers to choose the mix of delivery chan-
nels that works best for them. The
click and mortar strategy has been
adopted by all of the largest U.S.
banks. An increasing number of full
service community banks are also im-
plementing this strategy, chiefly as a
defensive move aimed at retaining
high-value customers who want to use
the Internet for some of their bank-
ing transactions.
Another potentially successful strategy
is to occupy only the bottom left cor-
ner of figure 2. An Internet-only or pure
play Internet bank operates no brick
and mortar branches. With the excep-
tion of arrangements for customers to
get cash and deposit checks at ATM
machines, banks using this distribution
strategy deliver all of their products
and services over the Internet. The
very nature of this delivery channel
precludes person-to-person customer
service, and although this can limit
the ability of a pure play Internet bank
to charge premium prices, reduced
spending on physical overhead may
potentially offset these revenue limita-
tions. Internet-only banking is often re-
garded as a niche strategy that focuses
only on the most Internet-savvy bank-
ing customers and/or delivers only a
limited array of financial services.
A final strategy is to occupy only the
top right corner of figure 2. A brick
and mortar bank does not operate a
transactional website, but may operate
2. Bank delivery channels: A set of choices
Unit bank
Branch bank
Drive-through
ATM
Telephone Internet
Wireless
Person-to person contact More Less
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rMichael 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
a non-transactional website where cus-
tomers 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 profit-
able strategy for some community
banks into the near future, any strat-
egy that completely excludes Internet
banking options is unlikely to be prof-
itable in the long run. As time passes
and a greater percentage of the pop-
ulation want to do at least some of
their banking on the Web, these banks
are likely to lose an increasing num-
ber of their high-value loan and de-
posit 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 stud-
ies 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 finan-
cial 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 num-
ber of similar results. Most important-
ly, they find that profitability at the
Internet banks tends to be higher
than, or is at least comparable to, prof-
itability at the more traditional banks.
While the direction of causation in
these studies is not completely clear—
for example, it may be that well-man-
aged, 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 fee-
based revenues, and difficulty gener-
ating deposit funding. However,
rather than concluding that Internet-
only banks are necessarily unprofit-
able, the study stresses that it may
simply be too soon to judge this busi-
ness 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, evi-
dence is mounting that banks using
this business model are unlikely to
capture a dominant share of the
full-service banking market. A grow-
ing number of Internet-only banks
are specializing in niche product
markets or customer groups. For ex-
ample, iVantage Bancorp focuses on
college students and their parents;
UmbrellaBank.com attempts to build
long-term relationships with tradi-
tionally “unbanked” consumers;
AeroBank.com concentrates on sell-
ing loan and cash management ser-
vices 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 num-
ber 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 Chicago-
based 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 with-
out ATMs. In the near future, it may
be just as difficult to imagine a suc-
cessful bank that operates without a
transactional website.
These developments suggest that the
majority of Internet banking custom-
ers will be served by click and mortar
banks, not by Internet-only banks. Fig-
ure 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 busi-
ness that any given click and mortar
bank delivers over the Internet chan-
nel is likely to be determined by themix of products it offers and the pref-
erences 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 prod-
ucts and services. Banks that success-
fully integrate this new channel with
their preexisting branch and ATM
networks, choosing the mix of chan-
nels that best complements their prod-
uct mixes and customer bases, will
gain a strategic advantage. But the
business of banking remains the pro-
vision of credit, safekeeping, transac-
tions, insurance, and investment
services—banks that are unable to pro-
vide these services efficiently in an in-
creasingly competitive environment
will not flourish, regardless of the
delivery channels they use.
—Robert DeYoung
Senior economist and economic advisor
n
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a
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k
s
3. Hypothetical distribution of banks
percent of business over Internet
1Currently, 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.
2See Luxman Nathan, 1999, “Community banks
are going online,” Communities and Banking, Fed-
eral 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.
3For example, see Dow Jones & Company, 2001,
“Online banks fail to realize cyber-goals,” Wall
Street Journal, January 10, p. C18.
4The 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 affect-
ed performance and risk in banks?,” Financial
Industry Perspectives, Federal Reserve Bank of
Kansas City, December, pp. 1–16.
5Robert DeYoung, 2001, “The financial perfor-
mance 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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The Internet's place in the banking industry

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The Internet's place in the banking industry

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