The Growing Might of Online Banks

Online banks fueled both consternation and copycatting when they first came onto the scene more than a dozen years ago. Only a handful survived the dot-com bust, however, and conventional wisdom holds that the remaining few are harmless havens for inveterate rate seekers-hardly a threat to traditional banks.

But now some online banks are talking tough, and given a variety of changes in the market, they just might have the chops to back it up. Evolving consumer attitudes, new technologies and a shift in the basic how-to’s for attracting online customers are likely to give virtual banks a stronger foothold in the banking landscape over the next few years. “We really see that now is our time,” says Gregory Garrabrants, president and chief executive officer at Bank of Internet USA, which at 11 years old, calls itself America’s oldest and most trusted Internet bank.

Online banks have always had the advantage of not having to support physical branches. Dan O’Malley, chief executive officer of PerkStreet Financial, did the math on branch infrastructure costs after founding his Boston-based online bank two years ago, and says he was shocked to realize the industry spends $800 per household on branches. “That is a phenomenal amount of money and it is a waste,” he says. “I’ve never met anyone who gets $800 worth of value from a bank branch.”

The difference today is that the market is more receptive than ever to the goodies branchless banks can bestow through their savings. Before, just about every bank offered free checking accounts. But with new laws on overdraft protection cutting off lucrative checking account fees, fewer are now able to. Bankrate’s 2011 Checking Account Survey, released in September, found that only 45 percent of no-interest checking accounts in the United States are fee-free, down from 65 percent in 2010 and 76 percent in 2009.

Not only are traditional banks taking away free checking, they are also angling for new fees. Bank of America and other large banks may have backed off a plan to charge $5 a month for debit cards, but they piqued the ire of their customers in the process. The debacle, which frothed to the point that a nationwide Bank Transfer Day last November became headline news, gave online banks a golden opportunity to play up their more attractive offerings.

“Switch today and get $60 bonus cash,” said EverBank Direct, a 12-year-old unit of EverBank Financial Corp. based in Jacksonville, Florida, in a promotion that lasted through November and directly referenced the $60 that BofA’s debit fee would have cost customers annually. Even without making any special offers, Bank of Internet has experienced a 200 percent to 300 percent increase in checking account applications since traditional banks began eliminating free checking, Garrabrants says. Similarly, PerkStreet Financial says it doubled its best day ever in account acquisition on the Friday after BofA announced its fee. “Customers are shifting away from their existing banks to find more value,” O’Malley says.

But there’s more to it. If the 85,000 people who have signed up to become customers of Simple (formerly BankSimple) are any indication, fees are just one of the complaints customers have about their current banks. Another is that effectively managing one’s money has just become too complicated. Joshua Reich, CEO and founder of Simple, which began adding customers at the end of 2011, describes his target market of well-educated, tech-savvy individuals earning about $80,000 a year as “financially guilty” because they know what to do with their money, but find it difficult to execute. Instead of a small pile of money in savings at the end of the month, they somehow wind up with two overdrafts.

Reich speaks from experience. As an investment banker on Wall Street, Reich says he could easily track billions of dollars of other people’s money, but found his own monthly bank statement to be cryptic and confusing. Compared to his native Australia, banking in the United States took much more time and energy. “If I was not on top of it, I got hit with fees and charges,” he says.

Particularly revealing was an episode in which his bank’s web site crashed during an online bill pay session, resulting in overdrafts from payments being executed twice, as well as the funding of a low-rate automated debt payment with a high-rate credit card. The fiasco, which took weeks to correct, highlighted with stunning clarity that his bank was acting against his own financial interests, Reich says.

Through a sophisticated technology platform that offers a variety of personal financial products through various bank partners that hold deposits and make loans, Simple’s main goal is to create an interface that makes it easier for customers to interact with their banks. The interface will tell customers things like how much money they can safely spend and how close they are to particular savings goals. Simple will automatically route deposits and payments in ways that most benefit the customer. “We’re not making money from fees,” Reich says. “We don’t have to depend on customer confusion as a revenue source.”

Simple’s strategy-to improve the customer experience-highlights one of the big differences facing online banks today versus when the category debuted. In the early days, online banks competed strictly by offering higher interest rates. Now, thanks to burgeoning dissatisfaction with traditional banks, they don’t even have to do that. Simple, for example, has no plans to offer high-rate checking or savings accounts. “I want to win those customers with service,” Reich says.

PerkStreet Financial also sees an opportunity to resonate with customers without having to offer high rates. The way O’Malley sees it, “online banks have only been for rich people. Interest rates only matter if you have a lot of money.” Particularly in today’s low-rate environment, the average person does not have enough wealth for a slightly higher rate to make a difference, he says.

Accordingly, PerkStreet is offering something it believes is more appealing. Its rewards checking account gives customers cash back when they make non-PIN debit card purchases. It figures the average American family can earn about $600 annually through purchases they already make with a debit card. “We think a bank can be an institution that saves everyone money, regardless of how much wealth you have,” O’Malley says.

PerkStreet’s strategy is to motivate customers to perform actions-like paying bills electronically, or making direct deposits and debit card transactions-that drive value for the bank. Soon, PerkStreet will also introduce a way for customers to receive rewards when they hit a savings goal. The rewards-focused approach marks a step away from the traditional bank role of accepting deposits in exchange for an interest-rate bump. “It’s a fundamental rethinking of what banks can do for their customers,” O’Malley says.

Institutions like PerkStreet and Simple represent a new wave of online entities that are seeking out innovative ways to attract banking customers. (Like Simple, PerkStreet is not a bank, but is partnering with financial institutions that will hold the deposits and make loans.) The senior citizens of the online bank category-those that survived the dot-com bust and now are 10 to 12 years old-continue to rely mostly on a strategy that emphasizes high rates. This proven strategy (at least for a certain segment of the population), combined with the insight these banks have gained over the years on how to run a successful online enterprise, are fostering an optimistic outlook for their future.

First Internet Bank of Indiana, for example, does not have a flashy web site. In fact, the site is downright staid. But after 12 years, the $560-million asset bank has become an expert at wringing efficiencies out of processes. About four years ago, the Indianapolis, Indiana-based bank saw an opportunity to add web-based consumer mortgages to its product lineup, and jumped in by purchasing a local mortgage lender with two branches.

David Becker, president and CEO, reasoned that online financing was a natural fit with today’s home purchasing process, which almost always includes an online component. After taking the intellectual capital of its acquisition (and closing the two branches), First Internet Bank began extending mortgages online. Last September, it originated more mortgages online than the acquired institution had done in a year, with about one-third the staff, Becker says.

Online banks are also taking advantage of new technology of all stripes to put them on par with more traditional banks. In 2011, $2-billion asset Bank of Internet, based in San Diego, beefed up its customer-facing technology, adding the ability for customers to deposit checks remotely, an online personal financial management program, person-to-person payments and enhanced mobile banking. “We can compete with the big boys technologically, and now people are really receptive to that message,” Garrabrants says. “This is what we’ve been waiting for.”

Customer service, particularly the inability to go into a branch to buy a new product or resolve an issue, has always been a rap against online banks. But now they are breaking down that barrier, too. For the newest online banks, interacting with customers through social media such as Facebook and Twitter is de rigueur. Perkstreet has an extremely active Facebook page-nearly 10,000 people have “liked” it-where it responds to customer posts and questions all day long. “Our ability to reach out to customers is huge,” O’Malley says. “And it’s more personal than going to a branch and waiting in line.” Further, if someone posts a question about PerkStreet on another web site-say, where an article about the company has appeared-PerkStreet will go and answer that question as well. “We have a level of commitment that other institutions do not have,” O’Malley says.

First Internet Bank of Indiana credits interactive chat, available since the bank opened, as one reason customer service has never been an issue. Over the years the bank has become “phenomenally responsive” to the e-mails and chat requests it receives, says Becker. It has added staffers to ensure quick turnaround times, and from the beginning has maintained an internal database of frequently asked questions. The database supports the bank’s FAQ section, which dynamically changes based on the types of questions being received. The bank also recently introduced an enhancement that takes advantage of the fact that online banking customers develop relationships with bankers over the phone. It shows brightened images of particular customer service reps when they are available, and darkened images when they are not.

Despite their current momentum, online banks still will never have the full suite of delivery channels that today’s most desirable customers covet. Javelin Strategy & Research calls these highly attractive customers “moneyhawks,” and notes they represent the most profitable customer segment because they have more accounts and transact more frequently. Moneyhawks also like to have all the delivery channels at their disposal, says Mark Schwanhausser, senior analyst of multichannel financial services at Pleasanton, California-based Javelin. The combination of branch, online, ATM and mobile channels is “extremely appealing,” Schwanhausser says, and explains why moneyhawks are “flocking to big banks.” He added, “The big banks are still in the driver’s seat.”

The big-bank way of doing business, however, is losing momentum. Big banks are more likely to be closing branches than building them, a trend confirmed by data from the Federal Deposit Insurance Corp. and the Census Bureau, which showed a decrease of 78 branches per million households between the second quarters of 2008 and 2011. This trend is not lost on McLean, Virginia-based Capital One Financial Corp., which over the summer agreed to pay $9 billion in cash and stock for ING Direct and its 7 million branchless-banking aficionados. Notes Garrabrants of Bank of Internet, “Branches are not necessary and they’re going to become much less necessary. We definitely do not want to ever have branches.”

Today’s online banks see numerous ways to expand without branches. First Internet Bank of Indiana is hoping to fuel growth by building on a recent expansion into commercial real estate lending. And it plans to take advantage of the repeal of Reg Q to do what comes naturally-offer high-interest-rate checking accounts, in this case to business customers. “With our low overhead, I think that can be very attractive,” Becker says. Over the next three years, the bank, which started with 16 employees and now has 32, expects to about double its size to $1 billion in assets. “We really do get leverage of scale and size that a traditional bank can’t,” Becker says. “That will always be our competitive advantage.”

PerkStreet Financial does not say how big it is, only that its customers are spending hundreds of millions of dollars a year on their debit cards, and receiving more than $1 million a year back. PerkStreet aspires to add savings and investment products to its line-up and expand its reward program to things like investing for the long term. “Two years from now, we’ll be able to save the average family $1,000 annually,” O’Malley says. In his view, online banking is going to shift from being an activity of very wealthy interest-rate seekers, to one of the mass market. “All of the fee pressures are going to drive people to better options,” he says. In 10 years, the majority of people will be banking with a direct bank, he predicts. “It’s going to happen fast and it’s going to catch a lot of people by surprise.”