FDIC Banking Review Limited-Purpose Banks: Their Specialties, Performance, and Prospects Chiwon Yom*
Limited-purpose banks are institutions
that specialize in relatively narrow business lines. Some limited-purpose banks concentrate on
making a certain type of loan, some serve a subset of consumers, and some offer
an innovative product. As niche players focusing
on a limited set of activities, these institutions can quickly develop
expertise in their particular business lines and can become efficient
producers. Specialization may have been
promoted by technological innovations, which generally lead to gains in
productivity and economies of scale.
This study examines credit card banks,
subprime lenders, and Internet primary banks. Although numerically these institutions make up a small share of the
financial services industry, their unique products and technologies have
attracted considerable attention. Insured institutions such as MBNA, Providian, and ETrade Bank are
examples of limited-purpose banks specializing, respectively, in credit card
services, subprime lending, and Internet banking.
Credit card banks offer their
customers both convenience and liquidity by providing a financial product that
can be used as a means of payment and a source of instant credit. These banks are very profitable, earning
higher income than the industry. Their
use of technology and the benefits of economies of scale have probably
contributed to their superior financial performance.
Subprime lenders are insured
institutions that specialize in lending to people with poor credit
histories. By focusing on a customer
base that was formerly shunned by the banking industry, these banks can boost
their profit margins. Although some
subprime lenders have outperformed the industry, others have either failed,
experienced large losses, or remained in business but exited the subprime market
Internet primary banks use the
Internet as their sole means of delivering banking services. It was once widely believed that Internet
banks could earn higher profits by eliminating physical branches and reducing
overhead expenses. However, cost
reductions and higher profitability have not been realized, and Internet banks
continue to underperform relative to the industry. Their underperformance may reflect limited
consumer demand for Internet banking services. And relative to branching banks, Internet banks are at a competitive
disadvantage in lending to small businesses because they lack the means of
building long-term relationships with borrowers.
The next section reviews some of the
important technological innovations that promoted the growth of limited-purpose
banks. The subsequent section describes
the data used in this study. Then come
three sections analyzing, respectively, credit card banks, subprime lenders,
and Internet banks. Each of those three
sections describes the unique characteristics of the particular type of
limited-purpose bank, along with the distinctive business model used; compares
that type of limited-purpose bank with the rest of the industry in terms of
financial performance and risk characteristics; and assesses those banks’
viability and prospects. A final section
Technological Innovations in the
Financial Services Industry
Technological improvements have played
an important role in the growth of limited-purpose banks as well as in the
broader financial services industry. Some people even argue that improvements in technology led financial
institutions to specialize. Jim Marks, a
director at Credit Suisse First Boston, states, “The lessons over the past 20
to 30 years have taught us that technological improvements lead to
specialization.”1 Technologically intensive production processes
generally exhibit large economies of scale which means that larger operations
have lower costs. By producing a large
quantity of a single product, these banks can benefit from scale
economies. In addition, specialization
may reduce the risky investments in technology that banks need to make.
A number of innovations were vital to
implementing the business models adopted by limited-purpose banks. Among these innovations are data-mining
techniques, electronic payment systems, securitization, and the Internet.
Data-mining techniques are
increasingly used for various purposes in the financial services industry. The most significant example of their use is
in credit scoring. Credit scoring uses
historical data and statistical techniques to produce a score that summarizes a
loan applicant’s credit risk. Credit
scoring is used to speed up credit decisions, to price loans, to constitute
input in automated underwriting processes, to screen prospective customers, to
price the default risk of asset-backed securities in secondary markets, and to
Data-mining techniques are also used
by financial institutions to target potential customers for solicitations and
to manage existing accounts. To attract
new customers, institutions use data-mining techniques to identify potential
customers. Institutions can target
potential customers of a certain credit quality or can identify the potential
customers most likely to respond to specific offers (such as free airline miles
or low-cost balance transfers). Once the
institutions obtain new customers, they can use the data to manage the accounts
on an ongoing basis. They may use
customer-specific information to assess which accounts are most profitable for
them or to predict which customers are likely to defect to a competitor. The limited-purpose banks examined in this
study, especially credit card banks and Internet banks, rely heavily on
data-mining techniques. These banks
operate in a national market and have little direct contact with borrowers, so
data mining is the only feasible way for them to solicit potential customers,
underwrite loans, and manage customers’ accounts.
Electronic payment systems, which are
methods of transferring funds electronically, are another important innovation
in the financial services industry. Studies have found results that are consistent with electronic payments
technologies displaying economies of scale (Berger ). Moreover, improvements in technology have
dramatically reduced the costs of processing electronic payments and increased
the availability of such processing. Such improvements benefited credit card banks as lower cost and increased
availability of electronic payments technology has led more retail businesses
to accept payments by credit card. Internet banks, too, rely heavily on electronic payments technology. Lacking physical branches, they rely both on
ATMs to give their customers access to cash and on the Automated Clearing House
(ACH) for fund transfers.
Securitization, which is a process of
pooling financial assets into commodity-like securities, has also played a
vital role in the growth of limited-purpose banks. Securitized financial assets typically
include credit card balances, automobile receivable paper, commercial and
residential first mortgages, commercial loans, home equity loans, and student
loans.2 The pool of assets is
transferred to a special-purpose entity, which issues securities that are
rated, underwritten, and then sold to investors. During the period 1984–2001, asset-backed
securities grew at an average annual rate of 13.7 percent (Berger ). According to Furletti (2002), $6.6 trillion
of tradable securities made up the asset-backed securities market as of June
Since its introduction in 1987, credit
card securitization has become a primary source of funding (Furletti )
and is integral to the growth of the credit card industry (Calomiris and Mason
). More generally, securitization
helped the consumer finance sector reach double-digit growth in the early 1990s
(Calomiris and Mason ). As of June
2002, credit card asset-backed securities amounted to $400 billion (Furletti ).
Securitization also contributed to the
growth in subprime lending (Laderman ). Mahalik and Robinson (1998) note that the production of subprime
mortgage securities more than tripled between 1995 and 1997, going from $18
billion to $66 billion. In addition, the
percentage of subprime mortgages being financed by securitizations is rising:
approximately 53 percent of all subprime mortgage loans originated in 1997 were
sold in the securities market, compared with 28 percent in 1995.
The Internet and Internet security and
protection technologies are important for on-line banking. As part of information technology, the
Internet brings together different parties and allows them to share
information. Because banking is an
exchange of information between a bank and its customers, the Internet has
become an important innovation for financial institutions. Using the Internet distribution channel,
banks can offer increased convenience to customers by allowing them to perform
their banking activities on-line at any time and in any place. Moreover, improvements in Internet security
and protection technologies help prevent hackers from breaking into the
computer systems. These technologies
provide consumers with some confidence that their Internet bank accounts will
The sample of limited-purpose banks
used in this study is taken from various sources. Credit card banks are those defined as such
by the FDIC’s Research Information System (RIS). The list of subprime lenders is from the FDIC’s
Quarterly Lending Alert (QLA). The
sample of Internet banks is from the FDIC’s informal database of Internet
Credit card banks are institutions (1)
the sum of whose total loans, asset-backed securities on credit card
receivables, and bank securitization activities of credit card loans sold and
securitized (with servicing retained or with recourse or other seller-provided
credit enhancements) is greater than 50 percent of the sum of total assets and
bank securitization activities of credit card loans sold and securitized, and
(2) the sum of whose credit card loans, asset-backed securities on credit card
receivables, and bank securitization activities of credit card loans sold and
securitized is greater than 50 percent of the sum of total loans, asset-backed
securities on credit card receivables, and bank securitization activities of
credit card loans sold and securitized.
The FDIC’s QLA is a database of
insured institutions that engage in risky lending activities such as high
loan-to-value loans, subprime lending, and payday lending. Insured banks with an aggregate credit
exposure related to subprime loans that are equal to or greater than 25 percent
of Tier 1 capital are referred to as subprime lenders. According to this FDIC definition, aggregate
exposure includes principal outstanding and committed, accrued and unpaid
interest, and any retained residual assets relating to securitized subprime
loans. The QLA database includes
information on types of subprime loans (e.g., automobile, credit card,
mortgage, and other).
As of October 22, 2002, there were 18
banks that used the Internet as their primary method of contacting
customers. One institution has been
removed from the sample because it has 17 full-service brick-and-mortar branches,
and it is hard to argue that an institution with 17 branches is an Internet
bank. In addition, two institutions were
involved in voluntary liquidation and closing prior to December 2003. As a result, 15 Internet primary banks remain
in the sample.
All balance-sheet and income-statement
variables are from the quarterly Report of Income and Condition (Call
Report). The Federal Reserve System’s
Surveys of Consumer Finances data are also used.
Credit Card Banks
Credit cards date from the Diners
Club, the first “universal” card, which was introduced in 1949 and used for
purchases at restaurants and in department stores. Recognizing the potential profitability of
providing open-end financing to consumers who were willing to pay high rates of
interest to obtain unsecured credit, commercial banks began offering
general-purpose credit cards to individual consumers; the cards came into broad
use in the middle-to-late 1960s (Canner and Luckett ). Bank-type credit cards offer both convenience
and liquidity to their customers: they can be used as a payment device or as
open-end revolving credit. Today, the
bank-type card is the most widely held among different types of credit cards.
Table 1, which reports the percentage
of households with bank-type cards, shows the rise in ownership of bank-type
cards over the past three decades. In
1970, 16 percent of households surveyed had bank-type credit cards. In 2001, the comparable figure was 72
percent. Moreover, the increase in the
shares of households with credit cards over time is evident at all income
levels (Durkin ). Clearly, credit
cards have become a consumer financial product important to households
regardless of income.
Credit card banks are affiliated with
national credit systems, such as VISA and MasterCard, to be part of a
network. The national credit systems
allow the cardholder to use a credit card for purchasing goods and services in
areas served by other banks. Thus, sales
drafts can be transferred from the merchant’s bank to the cardholder’s bank for
collection. The national systems
effectively transform local cards into national cards.
Business decisions, however, are made
at the level of the card-issuing bank. Individual banks own their cardholders’ accounts and determine the
interest rate, annual fee, grace period, credit limit, and other terms of the
accounts. Thus, this study examines the
credit card business at the individual-bank level.
Figure 1 shows that in recent years,
trends in the size and number of credit card banks have gone in opposing
directions. Since 1995, the average
asset size of credit card banks has been growing at the rate of roughly 20.5
percent annually. In contrast, the number
of credit card banks has been declining at an annual rate of 6.8 percent. Similarly, figure 2 shows that trends for the
number of credit card banks and for the mean value of credit card loans have
moved in opposing directions in recent years. The average credit card loan has been steadily increasing.
Consolidation in the bank credit card
industry can be attributed to a number of factors (Mandell ). First, consolidation may be necessary to
exploit economies of scale. There is
some evidence that credit card bank operations exhibit increasing returns to
scale. Pavel and Binkley (1987) find
evidence of increasing returns to scale at small-to medium-size card
banks. Canner and Luckett (1992) find
that operating expenses account for a smaller portion of the total cost for the
large issuers; thus, large card issuers would enjoy some benefits of economies
of scale in their operations.
Second, by consolidating, banks can
achieve the size necessary to conduct certain activities. For instance, the marketing tools used by
credit card banks, such as television commercials, Internet advertisements, and
mail solicitations, are expensive and can be used only by a few large
institutions. Through consolidation,
credit card banks may reach the size that will enable them to allocate funds
for such costly marketing activities.
Third, because most cardholders lack a
sense of identification with the banks that issued their credit cards, their
loyalty to specific card banks is likely to be low; accordingly, little (in
terms of customer loyalty) is lost through consolidation.
Credit card banks enjoy consistently
higher earnings than the banking industry as a whole. Table 2 presents interest and noninterest
income for the three kinds of limited-purpose banks we are studying and for all
banks. As of December 2003, the average
return on assets (ROA) of credit card banks was 4.6 percent—more than four
times the 1.0 percent of the industry average. Possibly the card banks’ ROAs are being inflated by their securitization
A closer examination of credit card
bank operations will help us understand the revenue and cost structures of
these banks. As mentioned above,
consumers use credit cards mainly as a means of payment and a source of
open-end revolving credit. In transactions where consumers use credit
cards as a payment device and pay back the loans within the grace period, banks
forgo interest income, although they still earn noninterest income from fees. Only when the card is used as a source of
credit do banks earn interest income as well as noninterest income.
Column 1 of table 2 shows that credit card banks earn high
interest income. On average, the card
banks’ interest income is 10.8 percent of assets—more than twice the 5.3
percent earned by the industry during the year ending December 31, 2003. Historically, credit card rates have been
higher than competitive rates and more stable than the cost of funds. Moreover, credit card loan rates are more
stable than the rates of other types of loans, such as mortgage and auto loans
(Canner and Luckett ).
Some economists argue that cardholders are insensitive to
interest rates because the cardholders persistently underestimate the extent to
which they will carry over unpaid balances and thereby incur interest costs
(Ausubel ). Moreover,
high-and-sticky card rates are attributed to the high search-and-switching
costs. Cargill and Wendel (1996) claim
that compared with small average balances, the cost of cardholders searching
for lower rates is too high. Calem and
Mester (1995) maintain that the inconvenience of switching accounts is another
reason for cardholders to be insensitive to interest rates.
While credit card banks’ interest income is substantially
higher, their interest expense is similar to the industry average: during the
year ending December 31, 2003, interest expense on average amounted to 1.6
percent of total assets at credit card banks, same as for the industry. By earning substantially higher interest
income without having to incur higher interest expense, credit card banks earn
a high net interest income. During the
year ending December 31, 2003, the mean value of net interest income to total
assets ratio for credit card banks was more than double the industry average.
Credit card banks earn noninterest income by charging annual
fees, finance charges, late-payment fees, over-limit fees, and other servicing
fees. Feldman and Schmidt (2000) find
that noninterest income makes up a greater share of net revenue at credit card
banks than at noncredit card banks. Moreover, credit card banks earn noninterest income by servicing
accounts that are taken off their balance sheets through securitization. By providing services to securitized asset
trusts—for example, by mailing monthly statements to customers, answering phone
calls, and collecting past-due balances—credit card banks earn servicing fees
from the trusts (Furletti ). Earning servicing fees from securitized assets has the effect of
inflating the credit card banks’ROAs: in most cases, credit card securitization
is structured as a sale, and by earning noninterest income on securitized
assets that are taken off their balance sheets, the credit card banks have an
ROA that is elevated compared with the ROAs of institutions that keep their
receivables in their asset portfolios. This situation suggests that simply examining the financial ratios, such
as ROA, can be misleading, since these ratios mask the risks that banks are exposed
to if they have recourse interest on their securitized assets.
At the same time, credit card banks incur high noninterest
expenses. On December 31, 2003, for
instance, the average noninterest expense of credit card banks amounted to
roughly 17 percent of total assets. Processing credit card transactions is a
costly operation. Pavel and Binkley
(1987) detail the mechanics of bank card transactions. When a cardholder uses his or her credit
card, a sales slip is created and sent to a merchant’s bank for
processing. The merchant’s bank credits
the merchant’s account for the amount of the sale and sends the sales
information to the interchange facilities (such as MasterCard or Visa). The interchange facilities transfer the sales
information to the issuing bank and send the amount of the transaction less an
interchange fee and a per-item fee to the merchant’s bank. Then the issuing bank bills the
cardholder. Having to process a large
volume of transactions and service a large number of accounts, credit card
banks incur large processing expenses. Although advances in technology have substantially improved operating
efficiency at credit card banks, operating expenses remain high. Other noninterest expenses include
advertising and marketing expenses, fraud losses, and network access fees.
Like other limited-purpose banks, credit card banks are likely to
suffer from high income volatility because of a lack of diversification in
their loan portfolios. There are,
however, a number of factors that can dampen these income fluctuations. First, credit card banks’ greater dependence
on noninterest income can partially offset and reduce the income
volatility. Second, credit card banks’ cost
of funds tends to go down when charge-off costs are high, and the lower cost of
funds can offset the adverse effects of high default rates on the banks’
Empirical evidence however, shows that these factors fail to
offset the credit card banks’ income volatility; these banks suffer from higher
income fluctuations. At the same time,
their earnings are consistently higher than those of a typical bank. Even during periods of low profitability,
credit card banks continue to outperform other banks.
Credit card banks are highly profitable and are an example of
institutions that successfully implemented the business model of
specialization. The successful use of
technology and the benefits of scale economies are likely to have contributed
to their superior financial performance. Given their profitability, it is reasonable to expect that these banks
will continue to supply credit card services.
On the demand side, the share of households with bank-type cards
has been steadily rising, and these households maintain positive attitudes
toward credit cards. According to the
Survey of Consumer Finances in 2001, the holders of bank-type credit cards
consider the cards useful and believe that they are better off with them. It is reasonable to expect that the demand
for credit card services will remain high and that credit card banks will
continue to provide the service. It
remains to be seen whether these banks have exhausted the benefits of scale
economies or will continue to consolidate.
Subprime borrowers are those with weakened-or-poor credit histories,
and traditionally banks have stayed away from extending credit to them.4 Banks’ practices have locked subprime
borrowers out of the mainstream credit system.
In the early-1900s, the credit market neglected lower-income
households. At the time, usury laws set
a maximum rate that could be charged on loans. Such laws reflected a sentiment shared by many at the time that regarded
debt for the purposes of personal consumption with great disfavor. Because of high transaction costs per
account, such usury laws effectively made small loans infeasible. In contrast, businessmen were easily able to
obtain bank loans for both business and personal needs. Hence, usury laws had the effect of locking
lower-income households out of the credit market. Consequently, many of these households had to
rely on loan sharks for credit and had to pay high (illegal) rates.
Similarly today, subprime borrowers who cannot obtain credit
from banks or other financial institutions are left to rely on pawnshops,
payday lenders, and rent-to-own stores to meet their credit needs. Carr and Shuetz (2001) note that as many as
12 million households either have no relationship with traditional financial
institutions or depend on fringe lenders for financial services. The fringe lenders remain largely
unregulated, and they frequently charge excessively high fees. Relying heavily on such lenders for credit
needs can marginalize borrowers and expose them to predatory practices. Carr and Kolluri (2001) note that predatory
lending thrives in an environment where competition for financial services is
limited or nonexistent.
In recent years, however, insured institutions have begun to
participate in the subprime market. Their entry has been motivated by high prospective profits and the possibility
of using existing capacity. Banks
generally participate in the subprime market by, “Lending directly to subprime
borrowers, purchasing subprime dealer paper or loans acquired through brokers,
lending directly to financing companies involved in subprime lending,
participating in loan syndications providing credit to such financing
companies, and acquiring asset-backed securities issued by these financing
Table 3 summarizes the subprime loan portfolio of subprime
lenders over time. The FDIC’s QLA
database includes banks identified as subprime lenders starting with September
1999. For each quarter, one column
reports the total amount of subprime loans in these lenders’ asset portfolios
and a second column reports the ratio (as a percentage) of total subprime loans
to total assets.
Table 3 also breaks down subprime loans into different
types, such as automobile, credit card, mortgage, and other. For September 1999 and September 2000,
automobile, credit card, mortgage, and other subprime loan information are
missing because these loans are not documented in the QLA database. For all periods, mortgage and credit card
loans make up the largest volume of subprime loans.
On average, subprime lenders are larger than a typical
bank. As of December 31, 2003, the
average total assets of subprime lenders were $4.0 billion, compared with $1.0
billion for the industry. It may well be
that subprime lending requires a certain set of skills or resources that are
more likely to be available to larger banks. These lenders may need staff with expertise in subprime lending
activities, or larger staff to handle the collection efforts on delinquent
loans. Moreover, accessing capital
markets to fund these loans may be easier for large banks.
In September 1999, subprime loans totaled $23 billion, which
made up 7.2 percent of these institutions’ assets. For the next two years the volume of lending
by insured institutions to subprime borrowers steadily rose (except for June
2000), reaching $81 billion in September 2001. Since September 2001, however, the volume of subprime loans has been
gradually decreasing. By December 2003,
total subprime loans had fallen to $52 billion, making up 11.21 percent of
assets at these institutions.
The number of institutions actively participating in the
subprime market shows a similar trend. The number increased to 156 institutions in December 2000 and fell
thereafter, dropping to 116 by December 2003.
At the same time, the ratio of subprime loans to total assets at these institutions has been increasing. Figure 3 shows that the ratio of total subprime loans to total assets at subprime lenders rose sharply from December 2001. Although the concentration in subprime loans has fallen in recent periods, the ratio of subprime loans to total assets at subprime lenders remains above those prior to December 2001. This rise suggests that the insured institutions that continue to participate in the subprime market are the ones whose loan portfolios have higher concentrations of subprime loans. It may well be that the insured institutions that are successful in lending to the subprime market are staying in the market and increasing their concentrations in these loans.
On average, subprime lenders earn higher net interest income compared with the industry. Figure 4 graphs the ratio of interest income, interest expense, and net interest income to total assets across time for subprime lenders and for all banks.
Subprime lenders earn higher interest income. During the period September 1999 to December 2003, the ratio of subprime lenders' annual average interest income to assets was 9.3 percent. In comparison, the industry earned 6.8 percent on average. Subprime lenders charge higher interest rates to compensate for the greater risk posed by subprime borrowers. Some people argue that the higher interest rates charged also reflect a lack of standardization in underwriting that makes it more costly to originate and service loans to borrowers with blemished credit histories and limited income.
The high interest income earned by subprime lenders more than offsets their higher interest expense and allows them to earn higher net interest income than the industry average. For instance, during the period September 1999 to December 2003, subprime lenders had the average annual net interest income-to-assets ratio of 5.8 percent, compared with 3.9 percent for the industry.
In many cases, the loan rate is not the entire source of
income for subprime lenders. Subprime
lenders generally charge up-front fees and prepayment penalties, both of which
increase their noninterest income. At
the same time, loans to subprime borrowers usually require intensive levels of
servicing and collection efforts to ensure timely payment, with the result that
noninterest expense is higher. Thus,
subprime lenders earn lower net noninterest income (see figure 5). During the same period (September 1999 to
December 2003), subprime lenders earned net noninterest income of –2.4 percent,
compared with –2.1 percent for the industry. Moreover, high charge-offs and loan-loss provisions deplete the earnings
of these institutions.
Net of these factors, subprime lenders’ profitability is
comparable to that of other insured institutions. During the period September 1999 to December
2003, subprime lenders earned an average ROA of 1.2 percent, compared with 1.1
percent for the industry average. Similarly, the average return on equity (ROE) of subprime lenders was
10.9 percent, compared with 10.8 percent for the industry.
It is important to note that the above-average rate of
return masks the large fluctuations in earnings experienced by subprime
lenders. Figure 6, which graphs the rate
of return over time, shows these fluctuations. In some periods, subprime lenders performed worse than the
industry. For instance, in December 2001
subprime lenders had an average ROA and ROE of 0.77 percent and 7.23 percent,
respectively. In comparison, the
industry average ROA and ROE for the same period were 0.94 percent and 9.58
percent, respectively. In more recent
periods, however, the subprime lenders have been outperforming the
industry. Possibly there is a survivorship
bias in the sample: only the successful participants are left, while poorly
performing lenders have exited the subprime market.
As stated above, the number of insured institutions
participating in the subprime market and the dollar amount of subprime loans
have fallen in recent quarters. Several
factors may have led to this decreasing trend. First, some participants may have exited the market because they were
performing poorly. This hypothesis is
consistent with the result discussed above—that while some lenders were exiting
the subprime market, the ones remaining have been outperforming the industry in
recent periods. It may be that success
in subprime lending requires an institution to have certain expertise and
Second, increased capital requirements may have effectively
eliminated the advantage that insured banks enjoyed by participating in the
subprime market. Typically, insured
banks hold lower capital than their nonbank counterparts (consumer finance
companies and mortgage lenders). Thus,
insured banks enjoyed an advantage in competing against the nonbank financial
institutions in the subprime market. By
holding lower capital, the insured institutions incurred a lower cost than
their nonbank counterparts in making subprime loans. However, recent regulatory and supervisory
changes may have effectively eliminated this advantage.
Greater supervisory scrutiny of subprime lenders’ capital adequacy
is well justified. Concern has been
rising that subprime lending activities are accompanied by significant
risks. A number of institutions have
failed, while others have experienced large losses in recent years as a result
of their participation in the subprime market. Among the failed subprime lenders have been Superior Bank of Chicago,
First National Bank of Keystone, NextBank, and Pacific Thrift and Loan Company. Alexander, Grimshaw, McQueen, and Slade
(2002) give examples of banking institutions that have experienced large losses
in recent years. First Union National
Bank closed its acquired subprime lender, The Money Store, and took a $2.8
billion restructuring charge in 2000. In
2001, Bank of America announced its exit from the subprime lending market and
sold its $22 billion subprime loan portfolio and took a large restructuring
In general, subprime lenders have poor asset quality. As Table 4 shows, non-performing and
non-accrual loans are substantially higher at subprime lenders than at a
typical bank. Similarly, the average
gross charge-offs were nine times those of a typical bank. In response, the bank regulators have begun
to require more capital for subprime loans. This is both to ensure that banks’ capital matches the risks they carry
and to help ensure the survival of these institutions.
The bank regulators note that minimum capital requirements
apply to loan portfolios that are less risky than the subprime loans. Therefore, the subprime lenders are expected
to hold higher capital ratios and to quantify the additional capital needed for
subprime lending activities. In 2001,
the banking regulators noted that “…[g]iven the higher risk inherent in
subprime lending programs, examiners should reasonably expect, as a starting
point, that an institution would hold capital against such portfolios in an
amount that is one and one half to three times greater than what is appropriate
for non-subprime assets of a similar type.”6
Moreover, because subprime lenders are active participants
in securitizations, the recently established risk-based capital requirements on
recourse obligations, residual interests, and direct credit substitutes for
banks indirectly affect subprime lenders.
There is some evidence that these supervisory and regulatory
measures have led to an increase in the amount of capital held by subprime
lenders. For instance, these lenders’
average capital-to-assets ratio was 11.8 percent in December 2003, compared
with 9.3 percent in September 1999.
The measures undertaken by bank regulatory agencies may have
effectively leveled the playing field for different lenders in the subprime
market. Consequently, the advantage
banking institutions used to enjoy in the subprime market may have largely disappeared. The fall in the number of subprime lenders
and in the dollar amount of subprime loans held by these lenders may reflect
their response to the new regulatory regime.
Both market forces and regulatory changes appear to be
reducing insured institutions’ participation in the subprime market. Institutions that can effectively manage the
elevated risks associated with subprime lending and also be profitable will
continue extending credit to the subprime market. It is not clear whether insured banks’
participation in this market has already begun to stabilize or will decrease
As a public-policy goal, the active participation of insured
institutions in the subprime market may be important for promoting the
availability of credit to all households. At the same time, it is important for these institutions to recognize
the risks associated with subprime lending and to enhance risk-management
A small number of banks deliver banking services primarily
on-line. In theory, Internet banking
offers attractive features. By
eliminating the physical branches and employing fewer workers, Internet banks
can reduce overhead expenses (DeYoung [2001, 2002]) and salary expenses. Orr (2001) refers to a study by Booz, Allen
& Hamilton that reports that a typical transaction over the Internet costs
about a penny, compared with $1.07 at a full-service teller window and $0.27 at
an ATM. Furthermore, with an
Internet-based distribution channel, Internet banks can easily enter new
geographic markets without starting new branches. Thus, Internet banks can grow more rapidly.
Likewise, Internet banking benefits customers by offering
services at a low cost. The banks’
savings in overhead and salary expenses can be transferred to their
customers. The banks can offer higher
rates to depositors while charging lower rates to borrowers. According to one Internet banker, savings in
fixed capital can make a difference of 50–70 basis points of interest on
savings accounts.7 Moreover,
Internet banking offers convenience to customers, for they can perform many
types of banking transactions—for example, checking their account balances,
paying bills, and applying for loans—on-line at any time without having to
To reap such benefits, some people have started Internet
primary banks while some existing banks have entered the Internet banking
business. Table 5 lists the Internet
primary banks included in this study. The first column reports the dates these banks were chartered: the dates
range from 1933 to 2001, although most were chartered in or after 1998. The chartered date is not necessarily the
date these institutions entered the Internet banking business—some institutions
switched from offering banking services via branches, telephone, fax, and mail
to Internet banking services. The second
column describes the service facilities of these institutions. It is noteworthy that only three banks have
exclusively cyber offices. Others
maintain one or two full-service brick-and-mortar offices. It may well be that physical branches are
made available for types of transactions that are impossible to perform via the
Internet, such as withdrawing cash or depositing checks.
Internet banks are bigger than the industry average. For instance, in December 2003, average total
assets of Internet banks were $3.5 billion, compared with $1 billion for all
banks and thrifts. To achieve such size,
Internet banks have been growing rapidly. Table 4 shows that their average asset growth is 20.3 percent, and loan
growth is 30.5 percent. To achieve such
rapid growth, Internet banks are relying on expensive and volatile funds
(average noncore funds amount to 44.5 percent of their assets).
The large size and rapid growth of Internet banks may be
associated with these institutions’ heavy reliance on technology. They may have to pass a certain size
threshold in order to earn enough revenues to cover the high fixed costs
associated with technology-intensive production processes. Earlier studies found that technology-intensive
production processes exhibit economies of scale. Thus, these institutions are growing rapidly
to take advantage of the benefits of scale economies associated with
technologically intensive production processes.
Contrary to prediction, Internet banks have not proven to be
very profitable. In fact, their
performance is inferior to that of the industry. As of December 2003, for instance, Internet
banks had an average ROA of 0.7 percent, compared with 1.0 percent for the
industry. Moreover, the average ROE of
Internet banks was 8.8 percent, compared with the industry average of 10.0
These banks’ low profitability is attributed to both low net
interest and low noninterest income. Internet banks earn lower interest income than the industry. Some Internet banks buy loans on the
wholesale market instead of originating them, and thus earn lower interest
income. Internet banks also incur higher
interest expense by offering higher rates on deposits and relying more heavily
on expensive sources of funds. As table
4 shows, in December 2003 noncore funds amounted to 44.5 percent of total
assets at Internet banks, compared with 19.5 percent at a typical bank. Such heavy reliance on “hot” money may have
resulted from the failure to attract a core client base (Hine and Phillips
) and from the attempt to achieve a certain size through rapid growth.
Compared with the industry, Internet banks also earn lower
net noninterest income. The reason is
that although they earn higher noninterest income, they also incur higher
noninterest expense; the technology-intensive production process used by
Internet banks is likely to have high fixed costs. (Banks must generate a large enough volume to
offset the high fixed costs.) Moreover,
Internet banks spend more on salary expenses. It may well be that Internet delivery systems require fewer but
better-skilled employees resulting in higher salary expenses (DeYoung ).
Internet banks are also likely to spend more on marketing
and advertising to attract customers to their Web sites. Unlike a branching bank, an Internet bank
does not benefit from free advertising whenever a potential customer walks or
drives past it. Instead, Internet banks
have to purchase advertising to attract new customers to their Web sites. DeYoung (2001) refers to a study by Rosen and
Howard (2000) that finds that compared with the average brick-and-mortar
retailer, the average on-line retailer spends more than ten times as much per
purchase on marketing and advertising. Other expenses include contracts with vendors to service and maintain
the Web site, and payments to ATM networks.
In addition, Internet banks incur unanticipated costs by
offering physical delivery channels. As
noted above, the majority of Internet banks have one or two physical branches,
probably because customers need to perform certain transactions at physical
Internet banks underperform brick-and-mortar banks, with
little evidence of improvement over time. This situation may be attributed to a number of factors. For one thing, Internet banks suffer from low
consumer demand. The low volume of
business is partly explained by the fact that most Internet banks were
established only recently. Like
branching de novo banks, newly established Internet banks need time to attract
depositors, find borrowers who are good credit risks, and find other profitable
opportunities. Low business volume is
also attributed to limited consumer demand for Internet services (Orr ). For many consumers, a technology-driven
Internet delivery channel can be both intimidating and frustrating. In addition, transactions such as making
deposits or withdrawing cash are impossible to perform via the Internet. Moreover, automated banking services lack
person-to-person contact and do not create customer loyalty.
Relative to branching banks, Internet banks are also at a
competitive disadvantage in lending to small businesses because they lack the
means of building long-term relationships with borrowers. Small businesses tend to be informationally
opaque, with little public information available. Banks can alleviate information asymmetries
and agency costs by building a relationship with the borrower. Through repeated interactions, banks can gain
private information on borrowers and can better monitor the borrower to prevent
unanticipated risk-taking activities.
In contrast, Internet banks use automated underwriting
procedures for generating loans and manage risk by diversifying large pools of
these loans. Through such
transaction-lending practices, Internet banks fail to build relationships with
borrowers. Consequently, Internet banks
are less likely to gain proprietary information about their borrowers and less
likely to monitor them effectively. Hence, Internet banks are at a disadvantage compared with branching
For these reasons, Internet banks can be expected to have
only a modest chance of success.
Limited-purpose banks challenge the traditional notion of banking. Although relatively few in number, they have
unique business models and product mixes that have attracted considerable
attention. This study has described
their business models, evaluated their performance and risk characteristics,
and discussed their prospects.
Some business strategies adopted by limited-purpose banks
lead to superior financial performance. For instance, credit card banks are highly profitable compared with both
other limited-purpose banks and the industry benchmark. Because of the inherent riskiness of
unsecured credit, credit card banks have poor asset quality and high default
rates. However, their interest and
noninterest income is sufficiently high, leading to high profits. Given their volatile yet robust
profitability, credit card banks are likely to have found a permanent place in
the banking sector. Moreover, the
increasing trend of consolidation suggests that a few large institutions will
remain and dominate the sector.
In contrast, other business models show lackluster performance. Subprime lenders earn higher interest income
than the industry average, yet poor asset quality diminishes those
earnings. Moreover, recent initiatives
by the banking regulators impose higher capital requirements on subprime loans
and may have eliminated the advantage the insured banks enjoyed in the subprime
market. Consequently, the number of
subprime lenders has been falling in recent years. It is reasonable to expect that bank
participation in subprime lending will remain at reduced levels, if it does not
Similarly, Internet banks have not proven to be
profitable. They incur high costs in
acquiring and keeping customers and in using technology-intensive production
processes. Moreover, Internet banks fail
to build relationships with borrowers and thus forgo an informational advantage
with respect to their borrowers. The
evidence to date appears to suggest that Internet banks have only a modest
chance of success.
The evidence presented in this paper suggests that some limited-purpose
banks may have little success in the long run. But although some of these business lines may be less successful as
free-standing operations, they may be suitable as part of a larger bank. Citibank, for example, offers all such
Integrating such disparate business lines and offering
various financial products and services may lead to economies of both scope and
scale; and institutions with diversified asset portfolios may then achieve more
stable streams of income. Moreover,
institutions offer convenience to their customers by providing different
financial products and services in one place.
The trend of institutions offering multiple services and
products is already evident. For
instance, increasing numbers of banks are using the “click-and-mortar” strategy
of adding an Internet site to their physical branches. Through the Internet site, customers can
perform banking transactions such as accessing accounts and transferring funds
on-line. In addition, customers can make
deposits, apply for a loan, or withdraw cash from their accounts in physical
branches or at ATM networks. Gup (2003)
refers to studies that document the preference by customers of large banks
(such as Morgan Online and Bank of America) for a combination of Internet-based
tools and a close relationship with a personal banker. Thus, diversified banks offering multiple
services may well be the wave of the future.
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*The author is a senior
financial economist in the Division of Insurance and Research at the Federal
Deposit Insurance Corporation. The
author would like to thank George Hanc, Dan Nuxoll, Jack Reidhill, Tim Curry,
and Gary Fissel for valuable comments and suggestions, and Sarah Junker for research
3This is an informal database and may not be comprehensive.
4The bank regulatory agencies have recently suggested that any of
the following may indicate a subprime borrower: (1) a FICO credit score of 660
or below; (2) two or more 30-day delinquencies during the past year; (3)
bankruptcy within the last five years; (4) judgement, foreclosure,
repossession, or charge-offs in the prior 24 months; or (5) debt
service-to-income ratio of 50 percent or greater (OCC et al. ).