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New architectures for financial services

Success and Failure in Web-Based Financial Services

The exponential growth of the Internet during the past decade has essentially altered the landscape of the financial services industry with the initiation of continuously available banking services and the adoption of e-transactions. This year, the number of households in the U.S. that will use online banking is expected to exceed approximately 24 million (50 million worldwide)—nearly double the number of households at the end of 2000.1 Yet the number of virtual banks and Web-based start-ups has shrunk more than 97% [4]. In 1990, there were no Internet banks in the world. In 1995, there was one financial institution with banking capabilities on the Internet. By the late 1990s, hundreds of virtual banks had been initiated. However, at the end of 2003 only a handful of virtual banks had survived. Increasingly, these institutions envision a "click-and-brick" strategy for survival and strategic positioning. In contrast, more than 3,000 brick-and-mortar banks in the U.S. have incorporated interactive Internet banking channels.2

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Internet Banking Business Models

The driving force for Internet banking, in addition to convenience, is the low cost efficiency. The Internet is the least expensive retail delivery channel available for financial services. An Internet banking transaction typically costs a bank just one cent, as compared to 27 cents for an ATM transaction and $1.07 for a teller-window transaction.3 The cost of designing a non-interactive, static site ranges from $5,000 to $50,000, and a dynamic, interactive channel ranges from $300,000 to $500,000 for community banks. A virtual bank costs $2 million, with continued recurring investments to upgrade and maintain the integrity of the architecture. (These figures are based on research from various sources, including [1]; deliberations with financial architecture firms, such as Crowe Chizek, and Digital Insight; and discussions with banks initiating online banking.) Banks generally spend up to 1% of their non-interest expenses on the infrastructure [3]. Nevertheless, an elaborate infrastructure does not guarantee profitability, as revenue generation through the Internet has to exceed the cost of maintaining an Internet presence.

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Online Banking Financial Model

The popular Du Pont model for financial institutions disaggregates profitability for effective analysis and managerial control. The equation shown in the figure here delineates the financial underpinnings of the business model for a bank and provides insights regarding the financial value proposition for an online bank. The net income of a bank is dependent on several factors. Two crucial ones are the net interest income generated by the deployment of assets and liabilities and burden, the excess of non-interest expenses (administrative and operational expenses) over non-interest revenue. The interrelationships among the variables are discussed in standard textbooks (see [2]).

Compared to a brick-and-mortar bank, the comparative advantage for a virtual bank is significantly lower operating costs, and hence lower burden. The cost of operation for a virtual operation was expected at 10% of revenue, as compared with 60% for brick-and-mortar banks, due to lack of investment in physical infrastructure. This was to be the driving force in ensuring profitability, and if all factors remain unaltered, represents a value proposition for investors. This value proposition never materialized. Initially, less than 15% of the pure play, new-entrant banks were profitable, which was expected to change as the Internet became the prevalent mode of banking. However, intense competition necessitated changes in the business model. Lack of name recognition forced virtual banks to pay significantly higher interest rates on deposits, substantially increasing their funding costs. This interest rate differential averaged 1% higher for Internet customers, limiting profitability. Additionally, the lack of established lending relationships forced virtual banks to invest in lower-yielding secondary markets, further eroding their return. On average, the net interest margin for virtual operations has been at 1% of assets, as compared with 4% for brick-and-mortar operations. The concomitant increases in funding costs, and lower yields, were not offset by the lower burden. Hence, many Web-based banks were unprofitable and subsequently folded.

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Predatory Competition

One major problem for virtual operations was market penetration and overall market share. By 2000, Internet customers never exceeded 7% of the potential banking customer base.4 Hence, the virtual operations could not achieve economies of scale and scope. The limited amount of user participation was unpredicted since banks had developed superior technology architecture. Additionally, channel creep was a major problem: banking customers wanted multichannel access, such as branches, ATMs, and kiosks, in addition to Internet banking. This necessitated Web-based operations to enter into expensive strategic partnerships. Furthermore, competition from other virtual banks created enormous downward pricing pressure. Internal rivalry and lack of structural entry barriers lead to numerous banks entering the market, which resulted in surplus capacity. This competition in turn morphed to limited and predatory pricing in the hope the survivors could recoup infrastructure investment through economies of scale and structural alliances, as Internet banking flourished. Unanticipated marketing costs of business eroded profitability. Established brick-and-mortar banks thus had a comparative cost advantage, given these circumstances.

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Future Challenges

Historically, banks subsidize unprofitable segments, products, or activities in the overall interest of customer relationship management. The challenge Web-based financial intermediaries face is the transformation to profitability by expanding their banking relationship through the cross-selling of products and services. The requisite technology and infrastructure for banking on the Web are already in place. In the future, as the Internet banking customer base expands, Web-based financial intermediaries will succeed by offering seamless integration of banking and business processes—a compelling value proposition.

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1. Alex Sheshunoff Management Services, L.P. Pricing of Financial Services. 1998.

2. Gardner, M.J., Mills, D., and Cooperman, E. Managing Financial Institutions: An Asset Liability Approach. The Dryden Press, 2000.

3. Morgan Stanley Dean Witter. Internet and Financial Services (May 3, 2000), 26.

4. Ward, L. The new face of B2B e-commerce. E-Commerce Times (May 22, 2003).

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Krishnan Dandapani ( is a professor of Finance and Banking in the College of Business Adminstration at Florida International University in Miami.

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This article is based on research of e-business firms conducted from 2000–2002 by the Knight-Ridder E-business Center at the Chapman Graduate School of Business at Florida International University, Miami.

1See the study by Jupiter Research, as reported in Wall Street Journal Reports: E-Commerce (Oct. 21, 2002), R-5.

2 See the study, Online Banking Report, as detailed at, Business section, June 2000.

3See the study by Booz, Allen, and Hamilton, as reported in Wall Street Journal Reports: E-Commerce (Oct. 21, 2002), R-5.

4See, for example, "Breaking the Virtual Bank," Red Herring;; "Study Finds Web Banks at a Disadvantage"; (June 13, 2000).

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UF1Figure. Value proposition for an Internet bank.

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