Is The Internet-Only Bank A Viable Model?

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In an editorial in American Banker titled NetBank Failure Kills One Web Bank Model (pw req’d), Christopher Whalen wrote:

[NetBank] was dying — but it wasn’t dying from bad loans. An irrational growth strategy, supported by $1.2 billion in FHLB advances at the end of 2005, as actually killing it. Assets grew [from 2001 to 2005] to peak at just more than 5 billion, when its ROA was 0.07% and ROE was 0.91%. By then the bank’s efficiency ratio was 148%, meaning it was spending $1.48 to get $1 in new revenue.

The FDIC noted that “the failed bank was an Internet bank and did not have any physical branches.” This fact, however, only partly explains the failure of NetBank and, with t, the independent online banking model. Branches and people remain an important part of the business model at US banks. The fact that many online banks have a hard time achieving adequate profitability suggests that this business model may not be viable except as a loss-leader within a larger organization.”

My take: NetBank: 1) Didn’t need branches; 2) Suffered from a poor product strategy; and 3) Wouldn’t have succeeded as a loss-leader subsidiary.

1) NetBank didn’t need branches. Mr. Phalen makes a common mistake: Confusing branches with people. It isn’t the physicalness (physicality?) of a branch that consumers want — it’s the people in them. And increasingly, it doesn’t matter if those people are in a branch, on the phone, or online. Even more importantly, it’s mattering less and less that those people are actually employees of the financial institution. (Dell’s user-supported support network is a great example of this).

The failure of NetBank wasn’t due to lack of branches. It had people who were available on the phone — just not in branches. But the people it had couldn’t overcome the real reason for the failure:

2) NetBank failed because of a poor product strategy. Mr. Whalen is spot on when he says that NetBank suffered from more than just bad loans. Spending $1.48 to get a dollar of revenue can only be sustained for so long. Having branches wouldn’t have fixed that problem however.

ING Direct’s initial success was due to its focus on selling high-yield savings accounts, and not trying to wrest checking accounts away from its customers’ incumbent banks. NetBank’s strategy, on the other hand, was more akin to a traditional bank’s: Trying to become consumers’ primary FI by providing a range of financial products.

It tried to sell a range of financial services, from checking accounts, to savings accounts, to loans. The loans it sold proved to be bad ones. The rates it offered on savings accounts weren’t competitive enough. And not enough people wanted a new checking account.

3) NetBank wouldn’t have succeeded as a loss-leader subsidiary. Could it (or another Net-only firm) have made it as a loss-leader subsidiary of a larger firm? Not a chance (remember Wingspan?). This approach makes no sense. Why create a loss-leader business unit to support a line of business (the retail bank) that may not be making big profits in the first place?

In fact, the opposite (i.e., profitable subsidiary) is happening. Citibank and Emigrant Bank have achieved some success with their online-only units, which aren’t loss-leaders. What makes them successful is their product focus, and the recognition that they’re not cross-selling platforms into other product lines.

And that’s at the heart of why the online-only model wouldn’t work as a loss-leader: It won’t help cross-selling efforts. Hell, most banks’ existing retail LOBs aren’t producing leads and cross-sale opportunities for one another.

Bottom line: NetBank was at a disadvantage from the start. The US adult population, still dominated by boomers and seniors, didn’t want a branchless bank as their primary financial institution.

Does that mean an Internet-only model isn’t a viable one? No way. What NetBank proved is that a poor product strategy will fail regardless of the channels a firm operates in. The jury is still out on whether or not an Internet-only strategy can succeed.

Gen Yers and the generation that follows may turn out to be very different from today’s boomers and seniors. I’m not sure that it’ll even be a traditional FI that they consider to be their primary provider. They may be just as likely to consider a Wesabe or Geezeo their “primary firm” because of the financial advice and guidance they receive from those….sites? firms? networks?

Mr. Whalen may remember NetBank as proof of the failure of the Internet-only bank model. It should be remembered as a pioneer who did a lot of smart things with the online channel, particularly with site design and account alerts.

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