Finance On The Net

Banks are scrambling to offer Web-wise ways to do business

Net.B@nk. TeleBanc. E*Offering. They're not names that grab much attention on Wall Street. Part of a wave of new commercial and investment banks designed for the Internet, they're small, they don't have much money, and they're easy to ignore. But they may not be in the future.


On paper, Mark L. Walsh should be first in line to take his company public over the Internet. After all, he's CEO of VerticalNet Inc., publisher of sites such as that compete with printed trade journals. VerticalNet's Feb. 10 initial public offering drew investors like trash draws seagulls. But the stock opened at $41 a share a day after being priced at only $16, which means old-style investment banking delivered millions of bucks to stock flippers, not VerticalNet. So why would Walsh rebuff online investment banks and pick Lehman Brothers Inc.?

Reputation is part of it. "I wanted guys with good suits and real brains to say: `I'll put my brand on this,"' Walsh says. Another part was the peace of mind promised by a firm big enough to step in if something went wrong. "If the night before, Saddam had bombed Mae East and Mae West, I still would have gotten my $16."

New entrants are flocking to online investment banking, promising a long battle over one of Wall Street's highest-profile businesses. A handful of new Internet investment banks, including W.R. Hambrecht, Wit Capital Group, and E*Offering, an affiliate of E*Trade Group, have hung out shingles and vowed to make E-banking as big as Web trading. They say the Net will modernize the archaic process of IPOs. "Within five years, 80% of [IPOs] will be done through the Internet," says E*Offering co-founder Walter Cruttenden.

But Walsh's stance shows why investment banking will be a tougher business for E-commerce to overhaul than books, auctions, or even trading stocks. With quality IPO investments scarce, issuers such as Walsh hold more power than either old-line banks such as Lehman or new firms and their retail-investor clients. To win, Hambrecht founder William R. Hambrecht et al. must convince people like Walsh and venture capitalist Peter J. Barris, a director of 11 startups. "I'm personally in a wait-and-see mode," Barris says. "Hopefully, someone else will step up and be the guinea pig."

So far, the guinea pigs have been relatively few. Hambrecht's three-month-old firm has led the way in only one deal, for Ravenswood Winery Inc. Wit has been a part of 41 IPOs but has co-managed just four. E*Offering has yet to lead a deal.

Insurgents say both retail investors and issuers will do better as the Internet substitutes a more open market for the cloistered, clubby IPO world. Today, banks such as Lehman line up issuers and take them on "road shows," visiting institutional investors to get "indications of interest." Under that system, individuals often get shut out, and deals are often underpriced: 90 IPOs since early 1997 have risen more than 50% in the first trading day. And underwriting fees have stayed around 7%.

The insurgents' plan is simple: Cut costs first, then expand the market by making it easier for customers to find and buy the product. Finally, create a business model that changes the industry's profit structure.

But it's not clear this will work with IPOs. Even if E-commerce does cut some costs, it might not make a big dent in overall fees. Hambrecht says his firm can charge 3% to 5%. Kathy Levinson, president of E-Trade Securities Inc., says her firm can automate almost everything that happens before the deal. The road show can be on the Web, investor orders processed via E-mail, and collection costs sliced by requiring clients to have funds in their accounts before the deal. "With that alone, it easily knocks out 1%," she says. But that's not nearly all the 7% covers. Old-line banks spend much more on research and trading to support stocks after the IPO, says BT Alex. Brown Inc. co-CEO Mayo A. Shattuck III.

Signs are that Internet firms will spend heavily on research and trading, too--limiting the short-term cost savings that E-commerce can deliver. Wit has hired high-profile analysts such as former Merrill, Lynch & Co. Internet-stock maven Jonathan H. Cohen, and it's building a trading desk. Rivals such as Shattuck insist that the new firms' costs will be much higher than they expect. "It's not clear what the business model is," he says.

A tougher problem: Issuers may not want the broad audience E-commerce delivers. There are plenty of buyers for tech IPOs--that's why their prices spike. Issuers can pick their shareholders, and most want institutions, which have a reputation for flipping stocks less often than individuals (which Cruttenden insists isn't true), and they're usually management allies. Says Walsh: "I want Janus owning 500,000 shares and loving my company and asking about the quarter, not E-mail from Ralph in Detroit asking why the stock is up today."

If issuers share their leverage with institutions, pension and mutual funds will fight to preserve a system they know. Money managers will be slow to let new issuers abandon road shows, where buyers assess company execs. "I never invest in a company unless I or one of our analysts has met management face-to-face," says T. Rowe Price Associates Inc. fund manager Jack Laporte.

Of all the newcomers, Hambrecht has the best chance because it offers the most radical change. Unlike Wit or E*Offering, Hambrecht wants to revamp the whole price-setting system. Instead of closed negotiations, Hambrecht uses an auction. Large and small investors will place orders and bids on a Hambrecht Web page. Every winning bidder pays the lowest winning price. The benefit: In theory, if retail interest pushes the price up, it will happen before the offering. That way, the company gets the money.

The system has won Hambrecht lots of attention and its first lead role in a technology company IPO: the upcoming offering of online magazine Scouting the deal is Andrew J. Hajducky, chief financial officer of E-commerce venture-investing firm CMGI Inc. His take could be crucial: Up to 15 CMGI-backed outfits plan IPOs within two years. Hajducky wonders if the new model can give more to CMGI: "The thing I like about electronic IPOs is that any increase in valuation goes to the company."

E-commerce will have an impact on the IPO business right away. If new firms can cut costs by automating processes, pressure on old-line firms to match those moves will be intense. Last month, Goldman Sachs & Co. bought 22% of Wit Capital--demonstrating the interest old-line firms have in the new tools. This week, software maker Novell Inc. invested in Hambrecht. But E-IPOs won't cause a revolution until more issuers agree with Hajducky than Walsh.

By Timothy J. Mullaney in New York and Joseph Weber in Toronto, with Paul C. Judge in Boston


Don't call Mitchell H. Caplan a banker. Sure, he's president and chief executive of $2.3 billion TeleBanc Financial Corp. of Arlington, Va., a leading Internet bank. But Caplan sees more to his future than taking deposits and making loans. "We are first and foremost a direct-marketing company," he says. "It just so happens that the products we sell are FDIC-insured banking products." TeleBanc's goal for now, Caplan says, is to attract as many customers as it can. The company's ultimate reward, he says, will come later, when it hopes to sell insurance and other fee-generating products. "I want to dominate our space," Caplan says. "Just like"

Caplan's ambitions reflect the intriguing possibilities--and risks--of Internet banking. Companies such as TeleBanc and Atlanta-based Net.B@nk Inc. have accumulated small profits and lofty stock market valuations by setting up online. Traditional banks--the leaders include Wells Fargo & Co. and Citigroup--are beefing up their Net capabilities to retain and attract customers.

LOW COSTS. But whether the Net will make banks more profitable or less, bigger or smaller, is unclear. "The Net is an opportunity for banks," says Michael L. Mayo, bank analyst at Credit Suisse First Boston, "and it is a threat."

There's no question the Net will enable banks to process transactions far more cheaply than they do today at branches. It will help them gather deposits and better track customers' tastes. The Internet could even position banks to take an expanded role as cyberspace centers for all bill payments.

But the Internet could also increase costs for traditional banks if customers demand service on the Web and in the branch. If Internet banks get too aggressive in raising deposit rates, that could erode profit margins or lead to unwise lending. Nonbanking companies could even replace bank checks with electronic payment systems.

To be sure, there is no such thing as a pure Internet bank. What's now called Internet banking only means customers can check account information, make transfers, and pay bills. Deposits must be sent by mail or wire, and withdrawals usually require automatic teller machines--often owned by other banks, which charge fees. TeleBanc, as its name indicates, conducts business by phone as well as online. Net.B@nk, which casts itself as a purer Internet company, takes customer phone calls.

Still, however defined, Net banking is promising. CSFB estimates that banks' transaction costs on the Net are less than 1% of those at a branch. A year ago, 17 of the top 100 consumer banks offered full Internet banking, says Christopher E. Musto, senior analyst at Gomez Advisors Inc., which tracks the industry. Now, he says, 39 do.

The problem is the payoff. Cost-saving technology is an old story at banks. ATMs are cheaper than tellers, and so are telephone centers. But customers want it all. So as cheaper technology has been employed, banks have wound up with higher costs. "I have never told my clients that by getting on the Internet, they will get rid of costs," says Jeffrey S. Irby, partner with KMPG LLP's financial-services practice. "Customer retention is the big issue."

Encouraging customers to switch from tellers to the Net requires a retailing touch most banks have yet to demonstrate. When First Chicago Corp. tacked on a $3 fee in 1995 for visiting a teller, it became a national laughingstock--Tonight Show host Jay Leno joked that for $3.95, the teller would "talk dirty" to you. Even now, many banks discourage customers from using Net services by charging fees.

S&Ls REVISITED? Branchless banks, by contrast, have taken advantage of lower Net costs by offering higher deposit rates. But again, there is a catch. Internet banks have yet to show they can find highly profitable uses for this money. Caplan's bank, which admittedly is spending heavily on advertising, managed a return on equity of only 2% last year.

To longtime banking observers, this combination of high deposit rates and low returns spells trouble. Bert Ely, president of consultants Ely & Co., fears Net banks could take too many risks. "This is what happened to the savings and loans in the 1980s," he says. "They were paying up to get what they could in deposits, and they took on high-risk assets." Attracting customers with high rates, he adds, means loyalty lasts "as long as rates are good."

Net operators say that just isn't so. Telebanc's customers "are rate-aware but not rate-sensitive," argues Caplan. And TeleBanc's low returns, he says, are all part of the plan: investing only in "plain, generic, and clean" assets, mostly single-family mortgages. The idea is to produce a return while building a customer base that can be sold other fee-generating products. "What I'm trying to do is get to scale," he says. With more than 50,000 accounts, he adds: "We're just touching on scale."

Net bankers believe their customers will only be rate-conscious in the short term. On Apr. 27, for instance, Security First Network Bank began offering a no-fee checking account paying 6% interest through the end of 1999--more than quadruple the average rate nationwide. Eric W. Hartz, president and chief operating officer, says the bank will decide later whether the rates are sustainable. But he adds that it's worth the risk. "If we can get folks to come in here," he says, "they are going to stay."

WEB WARS. Underlying this confidence is a belief that the convenience of Net banking will produce customer loyalty. One key is the role of Web sites in bill payments. Eventually, the thinking goes, most bills will be sent to consumers via the Net. Banks' sites would be a logical place to send the bills because consumers could check their finances while paying. Banks could charge fees from utilities, merchants, and others for providing this service. And bank Web sites would be required stops for consumers.

But it's uncertain whether banks or others--utilities or Web portals, say--will play this role. "It's the banks' race to lose," says Linda A. Weber, E-customer director at technology consultants American Management Systems Inc. "They have huge opportunities here, but so do lots of other folks."

Investors, though, should be prepared for the fallout. The bank Web wars have begun. And the result, says Jeffrey M. Lynn, financial-services consultant at IBM, "will be huge winners and a ton of losers." Soon, just appending dot com to your name won't be enough.

By Gary Silverman in New York

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