Innovation does not guarantee financial success. Some innovations never pay off; others pay off for facile adapters rather than the first movers.
In the banking industry, where it is relatively easy to copy competitors, the financial advantage to being first is frequently inconsequential. But the most powerful ideas are measured not by the income statement but by the market - in the way customers use banks and how they regard them.
So it is with Internet banking or, more accurately, the second coming of Internet banking. Its first go-round in early 1999, when banks tested the span of their wings and found they could not fly, was not very impressive. But a survivor of that era - ING Bank FSB - is proving the potential of the channel, and Arkadi Kuhlmann, its chairman and chief executive officer, is American Banker's Innovator for 2006.
ING Bank, which uses the marketing name ING Direct, is trying to make saving popular in a country with a deplorable savings rate. As elusive as that goal seems, its success at gathering deposits on the Internet alone has commanded the attention of brick-and-mortar bankers. Its branchless, fee-less model, unusual branding, and technological simplicity have unleashed a flood of "direct" imitators, which threaten to change how banking companies fund themselves and how Americans think about their money.
Seven years ago ING Bank opened with relatively little fanfare. Some bankers still regard it as a start-up, despite the fact that it is among the 20 largest banks in the United States by deposits and among the 25 largest by assets. Bankers also regard it with a combination of suspicion and admiration - and occasionally as a source of inspiration.
In a late October sampling of 30 banks offering high-yield savings accounts, eight prominently featured "direct" in their brand, from AmTrust Direct in Cleveland to ufbdirect in Irvine, Calif. Other "direct" aspirants included Citi Direct, HSBC Direct, and Emigrant Direct.
Mr. Kuhlmann is surprised that it took so long for his competitors to try the direct model.
"People have ripped off most of my ads, copied my color, copied my logo, but that's OK - I don't care about that stuff," he said in an interview in which he estimated the consumer deposit market at $1.6 trillion and offered his competitors some advice.
"Plow into it all you want. I'm not going to be able to take the whole $1.6 trillion myself; I'm just looking for a couple hundred billion," Mr. Kuhlmann said.
"DEAD RIGHT"
ING Direct is trying to reject banking orthodoxy without quite setting it on fire. It dissociated itself from other banks as a key strategic element - right down to picking the ING Direct brand and leaving "bank" out of its trade name.
"I think consumers in general have an attitude about banks in this country - and credit unions, and trust companies, and 16,000 financial service companies - and we are trying to change the way people think," he said.
At the same time, this is banking, where "evolutionary, not revolutionary" is about as radical as it gets.
"I'm not exactly a total gadfly, because I'm in a regulated industry," Mr. Kuhlmann said. "I'm not running a radio show here. I'm running a bank. I do have rules and a framework that I operate under, but I do try to have some different views."
That's one of his rare understatements. Like most of his banking counterparts, he doesn't accept at face value Wal-Mart Stores Inc.'s contention that it wants a banking charter just so it can do its own processing. Though his counterparts feed their trade associations to do battle with the giant retailer, he doesn't see any reason why it should be disqualified from taking a crack at retail banking.
He also may be the only banker to have lobbied against a bankruptcy law that went into effect in October 2005, writing in an opinion piece that the law would be "harmful to our civil society: It limits the rights of individuals to start over after financial difficulty overwhelms them."
And Mr. Kuhlmann would be inclined to laugh at the industry's privacy standards if he didn't find them so harmful. ING Direct customers must opt in to receive third-party marketing, inverting the opt-out policy that virtually all banks use.
"You know in your heart that it goes against human behavior," he said. "You know that most people won't opt out. Why as a banker would you stand on that principle? Why do that? That is saying that you are in competition - you are at war - with your customer."
He said customers should be able to freeze access to their credit reports, and he feels passionate enough about it that, before answering why, he asserts that he is "dead right on this" - and seconds later says he is "the only guy in the industry" voicing the opinion.
"I subscribe to a paper. I go on holidays. I call the newspaper and say, 'Stop my delivery.' I come back from holiday and say, 'Redeliver my newspaper.' You think I can do that with a credit report? They want to charge me $20. They are out of their minds," he said. "You want to collect my data and hold it, you have an obligation to keep it private, and you are not going to charge me for it."
Though most banks tout fee income as evidence of liberation from interest rate cycles, ING Direct does not charge fees.
In the quarter that ended June 30, the most recent for which detailed financial information is available, ING Bank FSB reported net interest income of $164 million and a marginal loss in noninterest income. In the call-report category "Service Charges on Deposit Accounts," the company responds with an "N/A."
These policies are in keeping with more broadly articulated principles that Mr. Kuhlmann said guides ING Direct. He said passing legal muster is too low a bar for new products and services; propriety must be considered.
"I don't believe the way to operate is to go as far as the market will bear," he said. "I am very well aware of individual freedoms and individual rights, but I believe that in this 21st century, not be too dramatic about it, but we do tell people to wear their seat belt, we tell minors not to smoke cigarettes, and we do tell people to wear helmets."
He acknowledges that he sounds like a combination of an evangelist and Ralph Nader when he advances a higher standard: "Would I sell this product to my daughter, son, or mother?"
Mr. Kuhlmann speaks of a happy intersection of sincere advocacy and sound branding - and those who doubt the financial power of advocacy as a branding strategy are not paying attention to the rates ING is paying.
"I'm 80 basis points on my savings behind the leaders, and I'm still opening 105,000 [accounts] a month," he said. "How is that possible? Am I really just buying the market? That's not the numbers on the scoreboard. Watch the baseball game."
Not all observers embrace Mr. Kuhlmann's sermons. They note that the financial services giant ING Group NV, which owns ING Direct, is a public company with shareholders to satisfy. Public companies do not do altruism. There are plenty of things in the banking industry that are dear, but skepticism comes cheap.
SUCCEEDING WHERE OTHERS FAILED
The industry has earned its skepticism of online banking.
A small bank in Atlanta limped into 1999 with its shares trading under $9 (on a split-adjusted basis). Its performance had been weak enough that it had recently repriced stock options to placate executives. But during the previous year, the bank's deposits jumped almost fourfold, to $283.6 million; customer accounts more than tripled, to over 17,000.
"We believe our growth is attributable to increasing consumer use of the Internet and our ability to offer a broad array of convenient, cost-effective, secure banking services to this growing customer base," NetBank Inc. wrote in its 10-K form filed March 31, 1999. "Our low-cost, branchless business model has allowed us to attain profitability within a year of acquiring our bank charter while continuing to pass along our operating cost savings to customers in the form of attractive interest rates and low fees."
Internet banking caught fire in early April of that year. In the eight trading days following NetBank's 10-K filing, its stock jumped from under $20 a share to over $70. The denouement is well known to every investor who bought the premise of Internet banking: NetBank was trading under $6 a share in late October of this year.
It wasn't just NetBank.
IndyMac Mortgage Holdings shares jumped 30% when it announced it would originate mortgages on the Internet.
Sovereign Bancorp announced an Internet initiative and enjoyed a 50% increase in its stock price, to over $15 a share, during the eight trading days in which NetBank's stock jumped. Jay Sidhu, then Sovereign's CEO, said the market reaction was "crazy," and he promised that his company did not make its announcement "just for the sake of a hike in the stock price." Good thing, because by the end of 1999, its stock was back under $6 a share. The Internet bubble was bursting, and investors saw no evidence of the channel's potential.
That was about the time that ING Direct was launched in the United States. Mr. Kuhlmann, who is German by way of Canada, was working in Toronto in 1996 when he got together with ING Group executives looking for a strategy to plant a stake in North America. They launched ING Direct in Canada in 1997.
By the fourth quarter of 1999, they were ready for the U.S. market.
"You do the summer program in upstate New York, and if it works, you take it down to Broadway. That's kind of how ING Direct worked," he said. "It worked in Canada, and we brought it down to the United States.
"My view was that if it was going to be successful in Canada, it would be in black and white; if we brought it down to the U.S., it would be in Technicolor," he said.
Its deposit growth was - and is - eye-popping. Deposits grew to $9.3 billion in 2002; to $16.2 billion in 2003; to $28.8 billion in 2004; and to $40 billion in 2005. In the first six months of this year, deposits increased 16%, to $46.4 billion.
When Bank One Corp. chartered its now notorious Wingspan Bank as a separate unit in 1999, it put forth an ambitious model: "If your bank could start over, this is what it would be."
Two years later, however, Bank One started over, scrapped Wingspan, and folded its customers into its existing brick-and-mortar bank. Customers refused to accept that an Internet-only bank could serve all their banking needs; traditional banks that set up online subsidiaries found that the modest accounts they drew cannibalized existing checking relationships.
ING Direct's strategy "was different than that of … [its predecessors] whose concept was to do battle with your primary relationship," said Chris Musto, an analyst with Keynote Systems Inc. in San Mateo, Calif. "ING took a different tack: 'Don't leave your primary bank, because we don't want to be your primary bank. Keep your checking account, but take all your extra money and send it to us.' And ING Direct set itself up from the get-go to work very seamlessly with other banks."
Ease of use is a central point in the model. ING Direct's Web site remains the industry's paradigm for simplicity. Its site map - the X-ray of the bank's online body - contains none of the cross-selling bells and whistles that confuse customers who use other banks' sites. Opening an Orange Savings account takes only a few clicks, the online application is simple, and real-time customer service is available for those who need to be ushered through the process. Within minutes, the account leeches the liquidity in the customer's primary checking account.
"Everybody is jumping in with the direct-bank, cloned approach to ING, and I still think that nobody gets some of what makes ING Direct so effective, which is taking a nonbanker mindset," said Cathy Graeber, an analyst at Forrester Research in Cambridge, Mass. "It's all about product simplicity and pricing simplicity. We don't need 89 versions of the savings account or 29 different tiers of pricing."
ING made it easy for customers to earn real returns on dumb money. And its timing was impeccable. Other banks' online experiments were imploding, and ING stood ready to accept a wave of dollars flowing from disenchanted investors suffering through the first bear market in a decade.
"They had good market timing in a dismal rate environment," said Alenka Grealish, manager of the banking group at Celent LLC in Boston. "They could stand out as stars offering high yields where other banks couldn't because they had a big physical infrastructure to support. They came in when bank deposits were safe havens as people exited the market. They established a brand and built that trust and became a safe haven for savvy consumers who shopped for rates."
DEPOSITS, YES; PROFITS, NOT SO MUCH
There's little denying that ING's efforts to develop an online bank in the United States are momentous. But so far, they have not proved very profitable. For the first half of 2006, its net interest margin was just north of 1%. Its return on equity lurked beneath 6%, according to Federal Deposit Insurance Corp. data.
Mr. Kuhlmann does not apologize for his bank's weak returns. In fact, he touts them as evidence of its commitment to customers.
"I'm probably one of the best bankers around - I can show you more ways to make money than God has angels," he said. "If I need to make 25% or 30% on equity, I can do that. But I have actually found people to work with to put up capital to create a franchise in the United States where maximizing return on equity is not the primary focus."
He offered socially conscious and green mutual funds as a reasonable point of comparison: Advocacy and business acumen can intersect not only for banking consumers, but also for investors. He chalks up ING Group's willingness to accept a lower return to its cultural heritage in the Netherlands.
"I think it is a trend in the United States that is actually increasing," he said. "We are holding the corporate world much more accountable than we ever have before in many different ways, whether it's through the Patriot Act or Sarbanes-Oxley. At the end of the day, there is a balance that is going to come with profit and growth."
Critics contend that an executive scraping along with a 6% ROE has no other argument left to fall back on. And ING Direct is struggling with the same problem that has long dogged online banks: asset generation. As of June 30, about 75% of its assets - $45.5 billion - were securities, mostly domestic debt securities and Treasury notes. An additional $14.2 billion was in mortgage assets - about 99.4% in first mortgages.
"The question of whether ING becomes a full-service retail bank" depends upon "getting the asset side of the equation - and that's always the challenge for direct-only banks," Ms. Grealish said.
Evidence of ING Direct's innovation is in its competitors' reaction. Nationwide banking companies are reluctant to comment on ING Direct's influence. Representatives of Citigroup Inc. and Washington Mutual Inc., for instance, would not say whether ING Direct influenced them, but analysts generally say drawing a connection is as simple as a straight line between two dots.
Some competitors are willing to acknowledge the ING effect.
"We saw ING's success and decided that it was an opportunity for our bank," said Howard P. Milstein, the president and CEO of New York Private Bank and Trust Corp., the parent of Emigrant Direct. "We felt we could substantially improve on their record, and we have taken a substantial market share at much lower cost."
He said there's a lesson for all banks in the success of the direct banks.
"Retail banks have to take seriously the impact of Internet banking," Mr. Milstein said. "We have gotten this type of share with only 7% of people banking on the Internet. Ten years from now, that will be 80% of people."
Ms. Graeber says quite simply, "Everybody is at risk."
George Tubin, a senior analyst at MasterCard Inc.'s TowerGroup, said large banks may ultimately prove better suited for the direct model.
With its current product set, ING "can't make up relationship profitability anywhere else, whereas Citi can offer that 5% rate, which may be marginally profitable or unprofitable, but they will sell other products," he said. "The supermarket is selling milk for a buck a gallon in the back of the store because you are going to buy a lot more stuff on the way out. If you are the milkman, you can't give it away for a buck, because it's your only product."
Mr. Kuhlmann knows that convincing skeptics is an impossible task. Banks mind their bottom lines above all else, and ING Direct is, regardless of its branding attempts, a bank.
"I'm not trying to win you over. This is the platform that I'm working," but "it is in the industry's interest that someone like me espouses a different view," he said. "I'm tolerant of other views. Should you not be tolerant of mine?"
