Why Starting A Digital Bank is Probably a Bad Idea

Mobile Phone Banking App Picture
Mobile Strategy

There is an idea that has been going around for the past couple years that community banks should start a digital-only bank under a separate brand similar to what Goldman Sachs has done with Marcus or Chase has done with Finn. In fact, we are at the Financial Brands Forum this week and the topic is still garnering a deep buzz. Since Marcus, several community banks have done this as well and many others are thinking about following suit. In this article, we look into this strategy to see if the idea holds merit and break down when to consider the strategy.


Why Consider A Digital-Only Bank


The argument in support of this idea of starting a digital bank goes that by creating a separate digital brand you can offer limited banking services across a wider geography without interrupting your current customer base. Tactically, this strategy usually includes one or more of the following key objectives:


Limited Products: Most digital-only banks focus on just offering credit/debit cards, a checking, savings and maybe a money market account. By using this approach, a bank is free to not have the pressure of offering a wide array of other products such as wires, loans, and other functionality. This aspect further comes into play when you are switching over platforms and don’t want to go backward in terms of functionality while you build the mobile bank out.  


Meet Finn Advertisement


Rate: A derivation of the product objective is to be able to offer a higher-than-average rate to attract deposits that you don’t want to cannibalize their current customer base. This is the most common reason community banks cite wanting to start a separate bank so they can keep their pricing channels separate. Banks get attracted to the average 15% growth rate at many of these digital-only banks compared to 3% for traditional banks. The argument for generating this type of top-line growth is strong. 


Customer Segmentation: Here, creating a separate channel helps segment the customer base for more effective marketing. In an interesting twist, Axos Bank ($9.8B, CA), which is the old Bank of the Internet, was always known as a higher rate payer and collected deposits across the nation. However, as the brand matured, and rates moderated, they rolled out UFB Direct in order to offer even higher premium rates. 


UFB Direct Advertisement


Customer Segment: Finally, there are banks such as Customers Bank ($9.8B, PA) that created a separate bank and platform to address the growing gap between low and middle-income Americans by offering low-cost financial services via digital-only. In this case, Customers wanted to keep their main brand identity separate while rolling out new technology.


In each of these cases, having a separate digital-only bank may absolutely be the right strategic move. However, it comes at a cost, and the strategy begs the question – when should a bank consider a separate digital bank. Is it just wanted to go after a separate customer segment? Does asset size play a part? Is pricing strategy part of it?


When Not To Use A Digital-Only Bank


The problem with starting another channel is that it takes resources. Almost every bank, no matter what their size, is resource constrained. Banking has, and is, changing so rapidly that banks could spend more money on technology in almost every area. Profit margins and capital charges are not so advantageous in our industry to make investing in another channel an easy decision.


In addition to taking extra resources, banks that start digital-only banks now have the extra burden of deciding where to place resources within the SAME product area. Thus, if you want to build up non-maturity deposits, you now have to decide under which brand to do it in. 


The answer must be to allocate resources to the areas that give you the highest risk-adjusted return over a long-run time horizon. This is the rub. With triple-digit return potential in digitizing treasury management, commercial core deposits or online commercial lending, how can a bank justify to their shareholders investing in a lower returning digital channel?


Using this standard, going after rate-sensitive customers ranks as one of the worst ideas. While some bank has been successful in good times, few banks have ever executed this strategy with success during a downturn. ING Bank, one of the most successful banks at this strategy, ended up being forced to sell at close to book value.


If you are Ally Bank or Capital One and you have assets that can support this strategy, then going after rate-sensitive customers might make sense. However, if you are a community bank and you have the burden of a branch network, average risk-adjusted net interest margins and you go after a rate-sensitive customer base, then starting a digital-only bank will likely increase capital pressure and thus, the probability of failure.

Further, the whole stated objective was to not cannibalize your customer base. However, the more successful you are, the more your customer base increases its rate sensitivity while at the same time the higher the probability your current customer base finds out about your other online offerings. If you want to take your bank to a different geography that is what mobile banking is for in general. You don’t need a separate bank to do it, just a separate product. It is much more additive to the brand and your efficiency ratio if you channelize by product as opposed to bank brand.


The same goes for going after a lower returning customer base, such as the underbanked. If shareholders have the admirable desire to forgo return in order to help society, starting a separate brand and banking platform is absolutely the right move. However, management must be transparent to what this burden is on capital, particularly in an environment of higher rates and deteriorating credit.  


The Strategic and Execution Pitfalls


Starting a digital bank forces your core bank to compete with your digital-only bank for resources. It is far better, to do one thing well and build on that success than to diverge your resources and risk the higher probability of doing nothing well. If you put all your resources into digital innovation for your core bank and fail, you will likely still have a pretty good platform to survive. However, if your digital bank runs into problems, you have likely put both efforts in jeopardy.


There are also a host of issues that come into play when you have a digital-only bank that further tax the board and management in new ways. For example, at what point do you get rid of your community bank if your digital bank is successful? Conversely, what do you do with those rate sensitive or underbanked customers if during a downturn, you become resources constrained and you can’t support the digital-only effort?


There is also the added regulatory, legal and compliance risk that further puts pressure on your bank. What happens if regulators treat higher rate, digital bank deposits as non-core?


It is hard enough to build brand equity in banking. We think it makes sense to put all your resources into improving your core bank and then use your core bank to expand as you strategically see fit by branding certain products.  In this manner, you reduce the burden of maintaining two platforms, security systems, regulatory support, etc.  


If your bank wants to transition to a new core and a new digital platform while it wants to change its brand over several years, that is probably the best reason to start a digital-only bank and then morph the current bank into the new entity. Getting the products and services right on digital, with the potential higher margins, and then supporting the effort with brick and mortar makes some sense and is similar to how Amazon and Apple are executing. Unfortunately, very few banks have these strategic plans. Other than that path, it seems like starting a digital-only bank has more downside than upside.