Ebook Learning-by-Doing, Scale Efficiencies, and Financial Performance at Internet-Only Banks
The Internet has become a major distribution channel for U.S. banks and thrifts. Nearly two thousand banks and thrifts have established transactional websites since 1997. Most of these websites are deployed by banks and thrifts alongside traditional brick and mortar branches in a “click and mortar” banking model. The core of this distribution strategy is to route repetitive, low-value-added transactions through the inexpensive, low-touch Internet channel, while routing low-volume, high-value-added transactions through expensive, high-touch brick and mortar branches. In contrast, only a handful of these websites are used as the sole delivery channel in a stand-alone, “Internet-only” banking model. The core of this distribution strategy is to leverage the savings from eliminating physical overhead into better prices and faster growth.
To date, most Internet-only banks and thrifts have struggled for profitability. Some independent Internet-only banks have responded to low profits by abandoning the pure Internet business model and adding physical branches, and some large banks have responded to poor performance at their “trade name” Internet-only units by integrating them back into the main bank. At mid-year 2001, only about two dozen U.S. banks and thrifts are operating as separately chartered virtual banks without any full service branches. (For convenience, the generic term “banks” will often be used in place of “banks and thrifts” for the remainder of the paper.)
The difficulties experienced by Internet-only banks belies relatively recent predictions that Internet-only banks would dominate traditional branching banks. According to the standard Internet-only business model, low overhead expenses and access to larger geographic markets should allow Internet-only banks to offer better prices (higher deposit rates, lower loan rates) than branching banks, grow faster than branching banks, and still earn normal profits. Although the logic of this model appears sound in theory, in practice physical branch locations continue to be important features in banking. The number of U.S. commercial bank branches increased by about 10,000 during the 1990s, even as the number of U.S. commercial banks declined by about 4,000. A new conventional wisdom is emerging that the Internet-only banking model is not viable.
But this emerging conventional wisdom may be premature. As Internet-only banks age, they accumulate experience with this new business model which may allow them to run it more efficiently in the future. Moreover, as Internet-only banks grow larger, they may generate scale economies in excess of those available to traditional banks that use less capital-intensive production and distribution technologies. If these effects are substantial, Internet-only banks may be able to close the performance gap with traditional banks.
In this paper, I propose three separate and simultaneous processes that may be operating at new Internet-only banks: a maturity experience effect that transforms accumulated general banking experience into improved financial performance; a technology experience effect that transforms accumulated experience using the Internet-only technology into improved financial performance; and a technology-specific scale effect that transforms increased Internet-only bank size into scale efficiencies that will improve financial performance. Based on maturity experience effects alone, financial performance at new Internet-only banks will improve at the same rate as traditional start-up banks over time, preserving the current performance gap. But if technology experience effects or technology-specific scale effects exist, financial performance at new Internet-only banks could improve faster than at traditional start-up banks, narrowing or perhaps closing the performance gap.
This study investigates whether the financial performance data for Internet-only banks and thrifts are consistent with the experience effects and scale effects proposed here. I compare the financial performance of Internet-only banks and thrifts that started up between 1997 and 2000 to the financial performance of traditional banks and thrifts that started up at the same time. These financial performance comparisons take two forms. A static analysis tests for cross-sectional differences in the performance of Internet-only banks and traditional banks over the entire 1997-2000 time period, after controlling for bank age, bank size, and other conditions that can influence financial performance (e.g., economic conditions, the identity of the chartering/supervisory authority, product mix, organizational form). A dynamic analysis tests for differences in the intertemporal performance of Internet-only banks and traditional banks as these new banks grow older and larger, after controlling for conditions other than bank age and bank size that can influence financial performance.
The results of the static analysis are largely consistent with results of earlier studies. On average, newly chartered Internet-only banks perform poorly relative to newly chartered traditional banks. Profitability is low, due primarily to high noninterest expenditures and low business volumes. By themselves, the results of the static analysis support the emerging conventional wisdom that the Internet-only banking model is not viable however, the dynamic analysis finds evidence of potentially offsetting intertemporal effects at the Internet-only banks. Profitability ratios and noninterest expense ratios improve more quickly over time at the Internet only start-ups than at the traditional start-ups, propelled by both technology experience effects and technology-specific scale effects. While these findings are preliminary – after two full years of existence, the data suggest that the Internet-only banks have still not fully caught up – they suggest that it may be too early to write-off Internet-only banking as a failed business model, despite its generally poor financial performance to date.
Download
PDF Ebook Learning-by-Doing, Scale Efficiencies, and Financial Performance at Internet-Only Banks
Posted in :
