Online banks outgrowing brick and mortar banking model

Online Banks Outgrowing Brick-andMortar Banking Model

Sutherland Banking Insights

December 2013

Overview Banks are moving to smart banking with implementation of the multi-channel distribution strategy.

Earlier, customers were required to show up at their bank to conduct any banking-related business, which made bank branches the only channel of communication for the customers. But as the digital revolution swept the world, the banking industry redefined the way it does business. Now, customers hold banks in their hands, banking at a click of a button.

Traditional branch and ATM-based approach is making way for new-age channels of online and mobile banking. Online banking is changing the banking industry. Banking is no longer limited to branches, where one has to approach a branch in person to withdraw cash or deposit a check or request a statement of accounts. In online banking, any inquiry or transaction is processed online without any reference to the branch. Increasing demand for internet banking – ‘anywhere, anytime’ banking – is shifting customers’ preference from “nice to have” service to "need to have” service.

The financial meltdown in 2007-08 battered the US banking industry, and US banks have still not recovered from the losses. Amid the need to improve their ROI, increasing pressure to cut costs and more customers embracing online and mobile banking; the banks are closing thousands of branches across the US. Digitization has led to the emergence of a new segment of direct banks – a no branch bank. Direct banks have no branches; they provide services through online, mail and mobile channel. No branch policy saves these banks from high operations cost of branch infrastructure, and thus allow them to provide attractive interest rates and charge lower fees compared to traditional banks. The traditional banking space also faces competition from Alternative Financial Services (AFS) providers, which are majorly targeting small institutions and unbanked populations in the US. This whitepaper outlines how banking is shifting gears from brick-and-mortar to online.

“Over a five-year period ending in 2010, neither loan nor deposit levels were increasing. The rise of Internet banking, contributed to our decision to close the branch.”

– John Castle, Chief Executive of Southern Michigan

Changing Dynamics of the US Banking Industry Preferred Channel for Banking in the US (2007-15) Customers’ preference for speed and convenience has increased the demand for internet and mobile as a preferred channel for banking, which is expected to grow further in future. A joint study of American Banker Association (ABA) and Nielsen estimates that since 2009, online banking is considered as the most preferred channel; currently, more than 60% of customers prefer doing transactions through

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online mode. Mobile banking, which accounted for only c.2% in 2009, increased to 6% in 2012 and is expected to grow further in future due to increase in penetration of smartphones.

Most preferred banking channels in the US 70%

Web

60% 50%

40% 30% 20%

ATM

10%

0% 2007

2008

2009

2010

2011

2012

2013

2014

2015

Source: ABA/Nielsen

The rise in digitization and declining ROI are forcing banks to close their branches. Banks are also discouraging their customers from visiting branches by levying charges on transactions such as cash deposits. Thus, branches, being inconvenient for customers and costlier for banks, are becoming the least-preferred channel and are expected to decline further.

Customers’ preferred channels for various banking transactions Loan Application

50%

Mortgage Application Credit card application

47%

28%

Research on loan Research a mortgage Research a credit card Bank Branches

3% 3%

4%

32%

30%

51% 4%

28% 21%

29%

49%

5%

51%

2%

Telephone Banking

63% Internet

Mobiles/Smartphone

2%

16%

2%

19%

2%

16%

1% 1%

14% 15%

1%

13%

Other

Branches remain the most popular channel for mortgage applications and product sales where face-toface interaction is important. Internet banking is widely used for services to research loans, mortgages, and credit cards.

Decrease in Branches in the US Banks are in the midst of a major effort to save costs by closing branches, with particular focus on eliminating locations outside the major metropolitan areas, and especially in smaller, more remote and

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less populated towns. This latest trend in branch banking is also accelerated due to the emergence of online and mobile banking in the US. Bank customers are increasingly preferring online and mobile banking, as advancing technology enables them to make remote deposits, shop for loans and manage accounts more efficiently from their desktops or smartphones. This has resulted in a steady decrease of foot traffic in many branches, a valid reason for banks to close them.

Branches in the US opened and closed during 2005-12 Total Branches

92,043

94,752

97,274

99,163

99,550

98,519

98,193

97,340

2005

2006

2007

2008

2009

2010

2011

2012

5,500 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0

Total Opens

Total Closes

Source: American Banker Association (ABA)

Banks across the US are closing branches faster than opening new branches. According to statistics from ABA, since 2010, net branch growth (Total Opens – Total Closes) has plunged, as the pace of opening a branch has declined dramatically. Many banks are funding branch openings only to the extent that they can be offset by closures.

In 2012, the top 5 banks of the US that closed branches accounted for around 17% of the branch closures. These top five banks include Bank of America (193 branches), PNC Financial Services Group (54 branches), RBS Citizens (53 branches), US Bank (44 branches) and Wells Fargo (43 branches).

Many of the closings have taken place in the states that were hardest hit by the mortgage meltdown and the following bank failures. The state of Nevada has lost 10.3% of its branches since 2009, whereas Georgia has seen a decline of 7.7%.

Bank of America Bank of America is an American multinational banking and financial services corporation headquartered in Charlotte, North Carolina. It is also the second largest bank in the US by asset size. In 2011, the bank

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announced Project New BAC, an initiative to streamline operations and cut expenses. As part of this initiative, the bank announced to cut 10% or 600 branches nationwide.

The progress towards this target over the last two years is evident from the table below, which shows the number of branches Bank of America operated in the US at the end of each of the last nine quarters.

Bank of America Branches during 2011-13 5,805

5,742

5,715

5,702

5,651

5,594

5,540

5,478

5,389

Q1

Q2

Q3 2011

Q4

Q1

Q2

Q3 2012

Q4

Q1 2013

Source: Bank of America Quarterly Reports

From Q1 2011 to Q1 2013, the number of branches of Bank of America has reduced by 416 to 5,389, a decline of 7.2%. The bank further wants to reduce its branch footprint to 5,000 by the end of 2014.

Moreover, the bank is constantly modifying its branch network to meet customers’ changing needs and habits. The bank is consolidating branches where there is overlap or investing in new or modifying branches where there is a need.

Apart from reducing its branch footprint, the bank is also reducing its ATM network nationwide. Many of the ATMs that the bank has closed were doing “cash-only” transactions – where customers were not able to use them to make deposits. The bank is planning to open more ATMs, which will provide fullservice features.

“…Customers just aren't coming to the branch as often as they used to. There are “tens of thousands" of customers each week who bank on mobile devices ...”

– Rob Aulebach, SVP, Consumer unit, Bank of America

Associated Banc-Corp Founded in 1964, Associated Banc-Corp offers banking and non-banking financial services to individuals and businesses, primarily in Wisconsin, Illinois, and Minnesota.

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Associated Bank is closing its branches because they are too expensive to maintain. On each closure, the bank saves USD300,000. A unit of Associated Banc-Corp closed 21 branches in 2012, and is in the process of shutting more in the future. The bank conducts analysis of branch locations, transaction trends and checks whether they are strategically fit for the bank. It also regularly evaluates its retail footprint to ensure its network is ideally positioned to provide consistent value to its customers and shareholders.

Emergence of Direct Banks Top banks in the US are losing market share due to poor customer service, high fees, and lower interest rates. Large regional banks are struggling to grow in consumer banking on an organic basis. Even smaller banks and credit unions, which are majorly favored by customers, are losing market share due to lower online and mobile banking offerings. Among the above-mentioned competitors, only direct banks are winning the market share.

Direct banks are online banks. Unlike traditional banks, they do not have any branches and they operate through phone and internet and provide attractive interest rate. The direct banking landscape is primarily dominated by players including Ally Bank, Discover Bank, Capital One 360 (earlier known as ING Direct) and United Services Automobile Association (USAA). Deposits of these direct banks have more than doubled over the past five years, at a growth rate more than three times the industry average.

Direct banking market has experienced significant growth over the last 10 years. It grew to 10% of the total retail deposit market in 2012 vs. 3% in 2002. From 2002-12, direct banks grew at a CAGR of 22% while traditional banks grew at 6%.

Online banks have cost advantage over traditional banks as they do not have to bear with the high cost of branch infrastructure. They provide higher interest rates and lower fees as the cost per transaction is relatively low compared to traditional banks.

Ally Bank Ally Bank, a subsidiary of Ally Financial, is one of the largest direct banks in the US offering banking with no minimum deposit required to open an account, no monthly maintenance fees and 24/7 live customer service. The bank offers online savings, interest checking, money market accounts, and certificates of deposit with terms ranging from three months to five years, and IRA Plans and products.

Since the launch of the Ally Bank brand in 2009, the bank’s deposits have grown at a CAGR of 27.5% during 2009-12. The growth was mainly due to the bank’s attractive products and services, higher interest rates and 24/7 customer service. The bank’s online platform allows customers to easily manage their accounts online.

Ally Bank’s ‘Ally eCheck Deposit’ offers an easy way to deposit checks via a smartphone camera, computer scanner, or free paid-postage envelopes. The bank also provides easy fund transfer between

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Ally accounts or between Ally and non-Ally accounts for free. It has no physical branches, and therefore offers free ATM fee reimbursements for all of its accounts.

Ally Bank Total Retail Deposits

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

2009

2010

2011

2012

Q4

41.7

Q4

39.9

Q3

38.8

24.6

Q2

35.0

23.5

32.1

21.8

30.4

18.6

20.5

29.3

17.6

27.7

16.9

26.3

15.8

Q1

14.4

6.8

Deposits Growth During 2010-13 (USD Bn)

Q1

Q2

Q3

2013

Source: Ally Bank Annual Report

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Discover Bank Discover Bank is a direct banking segment of Discover Financial Services, a direct banking and payment services company. Its direct banking products include credit cards, home loans, student loans, personal loans, CDs, money market accounts and savings accounts. Discover has one physical branch, located in Delaware, the US. The bank handles its mortgage business entirely online, except for the closing.

Discover Bank’s Deposits and Direct Banking Loans

Direct Banking Loans (USD Bn)

Consumer Deposits (USD Bn) 26.2

27.9

20.6

57.7 2.6 8.1

61.0 3.3 8.1

51.1 0.4

50.9 1.8

49.2 3.0 1.0

49.7

47.5

45.2

47.0

49.6

2008

2009

2010

2011

2012

12.6 6.1

2008

2009

2010

2011

2012

Credit Card**

Student/Other*

Personal

Source: Discover Bank Annual Report

"We believe that the direct banking model is very viable, and that it will prevail; Physical branches will become irrelevant," "I think you'll continue to see a role for small branches on the business banking side, but we're a totally consumer banking company, so we don't see any need for that� – Carlos Minetti, President Consumer Banking, Discover Bank

Emerging Alternative Financial Services Alternative Financial Services (AFS) are financial services offered by providers, outside the traditional banking space. Many times, the AFS are actually not alternative to bank services, rather they are services delivered outside brick-and-mortar bank branches. The alternative financial industry is made up of non-bank check-cashing outlets, payday lenders, pawnshops, rent-to-own stores, etc.

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AFS Segments The alternative financial services are divided into two segments: •

•

Transaction Products and Services: These services are primarily used for financial transactions. For example, prepaid cards are used for point-of-sales (POS) transactions while remittance could be one transaction by an unbanked individual.

Credit Products and Services: This covers credit services provided by any non-bank. Interest rates charged by alternative financial service providers are generally higher than the banks.

AFS is seen as a viable alternative to banks for the 26% of the US households that are either underbanked or unbanked. The transaction value of AFS is expected to grow 9% per annum to reach USD520 Bn in 2015 from USD338 Bn in 2010. AFS transaction products are considerably more widely used than AFS credit products. In 2011, 23.3% of US households used transaction AFS while 6% used AFS credit products.

US Prepaid Cards Prepaid cards work like debit cards wherein the user can only spend the amount of money they have deposited into their accounts. Unlike traditional banks, prepaid card users do not have to open a checking or savings account. They can simply load the cards with money and use them to make purchases and pay bills. Customers also do not need a credit history to get the cards.

Since the mid-2000s, prepaid debit cards have been the faster growing segment of non-cash payments, exceeding the growth of traditional bank debit cards and credit cards. The US prepaid card landscape is dominated by Green Dot, NetSpend, H&R Block, American Express, Western Union, RushCard and AccountNow.

NetSpend Founded in 1999, NetSpend is a provider of general-purpose reloadable prepaid debit cards and related financial services to under-banked consumers in the United States. NetSpend is the second largest prepaid provider by active accounts, with a market share of 15-20%. Since 2006-12, the company has grown its account base at a CAGR of 17.7% through a distribution network comprising primarily check cashers (notably ACE Cash Express), alternative financial solutions outlets, and some retail locations.

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NetSpend Active GPR Cards during 2006-12 (In Mn)

2.4 2.1

2.1

2010

2011

1.9

1.6 1.2 0.9

2006

2007

2008

2009

2012

Source: NetSpend Annual Report

Conclusion The biggest risk for traditional banks is the distribution and cultural bias towards physical branches.

Traditional banks are facing difficulty in unwinding the investment due to vast scale of branch networks. To grow in the future and increase its market share, traditional banks need to transition from physical structure to banking Anytime, Anywhere and Anyhow.

The banks to remain competitive in the industry should follow a hybrid strategy between brick-andmortar and online banking. They should utilize branches for complex transactions like mortgages and promote online channel for other transactions.

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