By Jacob Spiegel
Do you remember the moment you opened your first bank account? Did you go over to your local bank and make your first deposit of a few dollars with perhaps your proud parent standing behind you? Or, did you download the “bank app” on your smartphone, enter your personal information, and deposit funds into your account via PayPal or other virtual money-transfer service? While a visit to the local bank may have been the experience of new bankers for centuries, current and future generations may more often taking their visit virtually. Many new banks are online-only—they have no tellers or branches—just a website, app, and perhaps customer service reps. While banking at these institutions involves no face-to-face interactions, they offer many attractive features for younger customers, and are forcing the brick-and-mortar banks to adapt to the digital age.
Take the example of online bank, Ally. The bank has no branches or tellers; business is done completely online, yet consumers may open and manage a savings, money market, interest-checking, or investing account. The bank also offers home and auto loans, where borrowers go through the application process with a loan advisor over the phone. There are now dozens of these types of banks, who, due to their significantly lower overhead costs, are able to offer many competitive features such as higher interest rates. Ally offers a 1.8% annual percentage yield (APY), compared to 0.03% for a standard savings account at Bank of America. Online bank Wealthfront offers a rate of 2.07%, or over 20 times the national average of 0.1%. Because of these attractive interest rates, as well as their sleek, simple interfaces that appeal to tech-savvy segments of the population, a market research firm projects the online banking market size to register a compound annual growth rate of 22.6% from 2017 to 2023. These banks currently have about 10% of the US deposit market, or roughly $1.26.
While many online banks offer retail services, many also offer investment portfolios and robo-advisory services on their platform. For example, Robinhood is an app offering commission-free investing. Robinhood, which launched in 2013, is now practically a household name with over 6 million user accounts. Through their app, consumers can buy stock with the tap of a screen, never once interacting with a broker. So if there is no commission, how does the company make money? One way is through Robinhood Gold, a premium version of their investment portfolio that offers margin investing and research reports for a monthly fee. It also earns rebates from trading venues, and by sweeping customers’ uninvested cash into a network of program banks. However, this is one of the reasons the US is trailing Europe in financial startups—while Europe is encouraging online bank growth through lax regulation, American financial startups must set up partnerships with traditional banks to hold deposits. Robinhood has still managed to grow, though; since launching in 2013 with $3 million in venture capital, a recent funding round valued the company at $7.6 billion. Robinhood is the largest app of its kind; however, competitors such as Acorns, Betterment and Wealthfront are all quickly approaching the billion-dollar valuation range. These are just a few of the many apps offering similar mobile investing services that have launched in the last few years.
These online banks have 10% of the market, but who exactly uses them? The target market consists of Gen-Z, millennials, and other younger, more technologically adept segments of the population. According to data from a US Financial Health Pulse Report, 65% of millenials have used online banking. When Robinhood was launched, the appeal to millenials was the simple, friendly trading interface as well as no minimum balance and lack of fees— addressing the misperception among many younger people that investing requires significant upfront capital. This shows how online trading and banking platforms can cater to populations who may have been alienated by traditional platforms.
The success of these services has not gone unnoticed by big banks, who are now forced to offer digital services with high interest rates to compete with this younger market segment. Goldman Sachs is trying to change its business strategy after the 2008 financial crisis led to the imposition of regulations on its bond and investment segments, shifting its strategy to enter retail banking for low and middle-income individuals. In addition, Goldman is hoping to repair its image after attracting blame during the crisis. In 2016, Goldman launched Marcus, a simple, online retail bank that offers small fixed-rate loans and a high-yield savings account. This trendy offering tailored to small borrowers is a significant change in Goldman’s traditional image of serving only large institutions and high-net-worth individuals. While established investment banks such as Goldman Sachs are entering retail banking for the small borrower, they still do not operate as commercial banks with branches and high overhead costs, competing with online-only banks. Other established banks, such as Citizens and HSBC, have started competing with online banks by offering far higher interest rates and stylish online platforms. In essence, the impact of online banks on competition in the banking industry has been substantial.
While Goldman is entering the retail banking industry, other investment banks are trying to compete with apps like Robinhood who offer investment portfolios with zero-commission trades. In 2010, Merrill Lynch launched Merrill Edge, a web-based investment platform allowing investors to make trades and monitor their portfolio independently, and with a $0 minimum investment. Established names in the financial advisory industry such as Charles Schwab, Vanguard, and Fidelity are now offering commission-free stock or ETF trading, too, while others are charging flat monthly fees, and many now offer online, self-guided platforms. The trends in banking being brought about by online banks is making it easier for young people with little capital to get into investing.
Established banks are adapting, but according to many analysts, not fast enough. According to an analysis from McKinsey and Company, the brands that many banks have built to convey trust and security are now restricting their progress. The analysts at McKinsey believe that this is for four reasons. First, the correlation between branch scale and deposit growth has shrunk for US retail banks. For the top 25 US banks, there has been a 210% increase in deposits since 2008, but a 15% decline in branches, suggesting banks need to cut branches at a faster rate to keep pace with online-only competitors. Second, customer satisfaction with their experience is hampered at big banks due to their legacy IT infrastructures. Third, with the shift from physical to digital channels for customer acquisition, large banks are no longer the most efficient market players. Finally, a decline in customer loyalty has reduced the customer-bank relationship of getting all financial products at one place. Tunde Olanrewaju, a senior partner at McKinsey, said in 2014 that brick-and-mortar banks have been slow to adapt to these trends because they view technological adaptations too narrowly—as an app or online comparison charts. With more and more people switching to online banks, established institutions need to do more to adapt and compete.
Online retail and investment banking services are providing younger, tech-savvy generations with an opportunity to invest with limited capital and open savings accounts with interest rates 20 times what you could get at your local branch. The introduction of online banks is a major trend in the history of banking as digital tools create a vastly different banking experience. Big banks are adapting slowly by cutting branches and raising APYs, but are facing the consequences of missing out on a huge market share that online banks are reaping. However, this competition in the banking industry both allows many younger generations to become involved in banking and investing, and is great for depositors in general. When Goldman launched their retail bank in April 2016 (then called GS Bank), it was the first time in the investment bank’s 147-year history that they entered the retail banking sphere. This is as indicative as it can get that this is a significant period of promise and change in the banking industry.