Can pure play internet banking survive the credit crisis?

https://doi.org/10.1016/j.jbankfin.2010.10.010Get rights and content

Abstract

This paper positions the pure-play internet banking model (PPI) as a hybrid business model that combines features of both relationship and transaction banking. Although in terms of customer orientation PPI banks may partly resemble relationship banks, they lack their comparative advantage in generating borrower-specific information. Instead, the characteristic features of PPI banks are low costs and easy scalability. While the latter may enable PPI banks to quickly capture market share, it may also generate overexposure in risky markets. We present a case study on ING Direct, one of the leading global PPI banks and address the sustainability of the PPI business model by comparing the ING Direct foreign operations. The findings for ING Direct are validated using data for E-Trade Bank. We conclude that managing growth appears to be the prime challenge to PPI banks.

Introduction

The unavoidable time gap in most financial transactions, whereby an initial transfer of funds raises the expectation of a future payback, leads to potential problems of asymmetric information. Lenders need to screen and monitor borrowers to tackle adverse selection and moral hazard problems. This makes the financial sector an information-intensive industry, which is strongly affected by developments in information and communication technology (ICT). ICT has enabled financial institutions to generate, process and disseminate information “better-faster-cheaper” (White, 2003), allowing financial institutions to expand their reach and consumers to increase their indebtedness. For example securitization, the process of converting bundles of non-tradable loans into tradable securities, requires large amounts of information to be collected, transmitted and analyzed. Although the credit crisis has raised questions regarding the quality of the information being generated – and, more specifically, about the disincentive to invest in information gathering when financial risk can easily be passed on (Buiter, 2008) – the ICT improvements are here to stay.

The credit crisis has also exposed flaws in the business models of some banks. The literature on financial intermediation traditionally distinguishes between a relationship-oriented banking model (ROM) and a transaction-oriented one (TOM). Boot (2000) defines relationship banking as financial intermediation that invests in obtaining proprietary information about its clients, evaluating the profitability of its investments by engaging into multiple transactions with one client, either across product ranges, or over time. In contrast, transaction-oriented banking focuses on independent, often impersonal transactions, whereby financial services are commoditized and marketed (Buiter, 2008). The credit crisis has drawn attention to the perceived weaknesses of the transaction-oriented model, such as the quality of information being generated and the vulnerability to liquidity shocks. As a consequence, some banks have renewed their focus on relationship banking.

The black-and-white distinction between relationship and transaction banking is not always easy to maintain. In the decade prior to the credit crisis, an ICT-enabled pure-play (i.e. branchless) internet banking model (PPI) has emerged. On the surface, this model combines features of both relationship and transaction banking. The strategic value of PPI banking is said to stem from significantly lower overhead costs. This enables banks to offer high deposit rates and low service fees, and allows them to quickly capture market share. The model has often been cited in the literature as highly innovative (Dermine, 2005, Güttler and Hackethal, 2005, Verweire and De Grande, 2008). Recently, however, some doubts regarding the sustainability of this new form of financial intermediation have come to the fore. These pertain to the stability and profitability of individual PPI institutions and to their impact on the savings market. The very advantage of the PPI model, easy scalability, may also be its main weakness. While the deposit base of a PPI bank can be expanded quickly by offering competitive rates, the selection of the most interest-sensitive clients may weaken the stability of its funding base. Further, lacking the infrastructure to screen and monitor loan applicants, a PPI bank may be challenged to quickly invest its funds in ways that cover their high cost of funding but do not entail excessive risks. From a micro-prudential perspective, both effects may reduce the stability of individual PPI banks.

On a macro-level, one concern is that internet banks tap savings from traditional relationship banks. This may reduce the pool of savings available to small and medium sized enterprises that have no access to capital market funding. An additional complication in the European context is that cross-border branches of internet banks can easily tap the European savings market. In the event of failure, this may expose the home country to financial obligations which surpass its tax-bearing capacity.

In light of these observations, we believe that the credit crisis calls for a reassessment of the viability of the PPI model. Pure-play internet banking is a relatively new research area. The existing literature is small and focuses on a single issue, i.e. the presumed cost advantage of PPI banks (DeYoung, 2001, DeYoung, 2005, Delgado et al., 2007). The contribution of this paper is to position the PPI model in the spectrum from relationship-oriented to transaction-oriented banking and to deduce what this implies for the sustainability and stability of the business model.

The paucity of high-quality data, due to the fact that most PPI banks are small and have been in business for only a short period, hampers empirical research. The current paper therefore uses a case study approach by presenting the case of ING Direct, the largest, global internet bank. We will argue that ING Direct represents a critical case due to its fast growth, size and interest-rate sensitive clients. For purposes of validation, we include an analysis of a second pure-play internet bank: E-Trade Bank.

Prior to the crisis, ING Direct has been the subject matter of case studies emphasizing the success of its business model (Dermine, 2005, Heskett, 2005, Sequeira et al., 2007, Verweire and Van den Berghe, 2007). Recently, however, the bank has experienced serious problems, most notably in the US. We use the ING Direct case to find an answer to several questions. Can the PPI model be considered as a hybrid business model, combining features of both ROM and TOM, or does it primarily lean towards one of these models? How does ING Direct cope with scalability? Is the funding base of ING Direct sufficiently stable? Does the interest rate sensitivity of ING Direct clients differ from those of non-PPI banks?

Our paper is structured as follows: The next section discusses the literature on the traditional business models in banking. Section 3 introduces the PPI model and positions it vis-à-vis ROM and TOM. In Section 4 we justify our case study approach and introduce both ING Direct and E-Trade Bank. In Section 5, we explore whether the ING Direct case fits our positioning of the PPI model and examine ING Direct in terms of scalability and funding stability. Section 6 concludes and summarizes.

Section snippets

Traditional banking models

The existence of financial intermediaries is usually explained by emphasizing their role in mitigating problems of information asymmetry and reducing agency costs (Diamond, 1984). Financial intermediaries do this by specializing in screening and monitoring services. While Diamond (1984) focuses on the benefits of diversification (multiple clients), Greenbaum and Thakor (1995) introduce the inter-temporal reusability of information (multiple transactions with one client). In the traditional

Pure-play internet banking

For banks, as for other firms, the internet has opened up a new distribution channel and a new business model. The internet increases competition by enabling new entrants to compete with established banks in local markets, which can no longer be dominated simply by a bank’s physical presence. In practice, a bank can choose between two internet strategies. Most banks maintain their traditional network of branch offices while establishing a website that customers can use to complete transactions

Case study approach

Following earlier studies by DeYoung, 2001, Delgado et al., 2007, we have started gathering data for a sample of US- and Europe-based PPI banks. Unfortunately, for most banks the data are scarred by short time spans, gaps and structural breaks, often due to mergers, takeovers or other strategic changes. The exceptions are ING-Direct and E-Trade, which have followed a consistent PPI strategy for a lengthy period of time.

Considering the poor quality of most of the data available, we have chosen

Positioning the PPI business model

We first look at balance sheet data of ING Direct to position its various foreign operations along the dimensions customer orientation/client specific information (cf. Fig. 1) and thus compare it to the traditional banking business models (ROM and TOM). In the second and third subsections we discuss the issues of scalability and funding stability.

We benchmark INGs foreign internet banking divisions against the group’s domestic retail bank. Where possible, we include data on both foreign

Conclusion

Prior to the credit crisis, the literature on PPI banks focused on their financial performance compared to traditional banks. While some authors have stressed PPI’s positive prospects, the evidence that their low-cost business model enabled them to reap superior profits was mixed at best. During the credit crisis, doubts regarding the stability of this new form of financial intermediation have come to light. This paper discusses a number of stability issues with regard to the PPI model.

PPI

Acknowledgements

We thank the editor, the guest editors, an anonymous referee and seminar participants at the 14th Conference in Macroeconomic Analysis and International Finance 2010 in Rethymno, Greece, for helpful suggestions and discussion.

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