August 02, 2011

Ed. Note: This article is based on research by Corporate Executive Board and TowerGroup, a Corporate Executive Board company.

Although the acquisition of a direct bank by a traditional bank may signal the death of direct banking, Capital One's acquisition of ING Direct tells a different story. The combined organization will give Capital One the opportunity to develop a new model for nationwide banking by building a growth strategy for the present based on a traditional presence with branches and ATMs as well as a future growth strategy with an established direct banking brand.

As the acquiring institution, Capital One's most immediate challenge will be introducing ING Direct customers to its products and channels, while focusing on retaining and growing relationships with existing ING Direct customers -- and with good reason: According to the information presented by Capital One at the acquisition announcement, ING Direct's customers are slightly more affluent than those of a traditional top-tier U.S. retail bank, and almost 70 percent are under the age of 47. With many FSIs currently working on a strategy to appeal to younger consumers, Capital One has adopted the strategy of buying them. However, there may be retention challenges. Self-selection bias, combined with the nature of the products offered, suggests that ING Direct customers are less focused on a relationship than on finding a good rate. It is therefore likely that Capital One's new customers may not easily accept any cross-sell initiatives or be open to the company's overtures to convert the bank's low-cost loans to higher-cost credit card balances. Capital One's analytics and marketing prowess will surely be tested as it tries to cross-sell additional products to generate better margins from these customers.

Beyond the relatively straightforward tasks associated with any large-scale banking merger, this acquisition suggests the emergence of a third way to run a nationwide banking franchise. Capital One recognized six years ago that it needed a branch footprint to drive acquisition of low-cost deposits (funding for its national credit card business). The company's acquisitions since 2005 have enabled it to grow to 985 branches. In the short term, the company still views branches as a desirable commodity. On the same day that the ING Direct acquisition was announced, Capital One was listed as the only public bidder for 175 HSBC branches in upstate New York. Continuing to build out the branch network allows Capital One to reach the majority of clients who still prefer to open new accounts in a branch.

In the longer run, however, this selective branch focus will be supplanted by a more broad-based national bank product marketing organization, driven through self-service channels such as the web and mobile devices. Although today direct banks' 2.6 percent share of U.S. deposits seems quite small, it's important to note that the percentage of direct bank deposits was close to zero just 10 years ago. To date, ING Direct's inability to gather true demand deposit account (DDA) balances is reflective of a legacy preference on the part of consumers to open and support these higher-activity accounts in branches.

As recent research from the Corporate Executive Board shows, the direct banking model in the United States still faces an uphill battle against a strong, national branch network. Analysis of customer channel preferences shows that customers build their own channel strategies based on their personal evaluations of channel quality for different banking activities. Channel usage is based on the quality of supply, not customer demand -- and right now, customers still see the branch as the highest-quality channel for sales.

Put simply: Direct banking is not being held back because of lack of trust or knowledge around the Internet, but rather simply because the branch still performs sales activities best.

By contrast, the success of online sales in some non-U.S. markets is driven by the relative quality of sales through websites compared to the branch. The key lesson for banks is that direct banking will not truly take off until a platform emerges that offers a better sales experience than the branch. Yet direct banking platforms will inevitably improve, meaning a decline in branch importance. Capital One's dual-strategy has positioned the bank for just that moment.

Some unknowns should keep Capital One executives up at night. Will ING Direct customers be amenable to cross-sales offers from Capital One? Will the traditional Capital One credit card be attractive enough to ING Direct customers as is, or will Capital One need to make changes to gain interest from them? Can Capital One integrate the online and mobile applications such that ING Direct customers will not get frustrated?

Those issues aside, it's undeniable that Capital One has now garnered a customer demographic that must make many FSIs envious. Capital One's prowess in segmenting customers, managing their profitability, and designing new products that will appeal to them will provide Capital One a leg up on traditional banks, which still struggle in this area.