NetBank vice chairman D.R. Grimes, the oft-quoted Internet banker, expressed disappointment during a recent interview with The Internet Analyst about the scarcity of Internet-only banks. NetBank, growing rapidly and profitable since its inception, proves the viability of the business model, he said. Why aren't more people following NetBank's lead?

Mr. Grimes' musings suggest that the industry and its investors could benefit by emulating NetBank. It attracts customers rapidly by offering high interest rates on deposits and low rates on loans, coupled with low or nonexistent fees. Eliminating facility expenses and smartly incorporating technology to reduce personnel costs offset the negative impact of NetBank's otherwise highly flammable pricing strategy.

So why aren't more investor groups jumping on the bandwagon to start Internet-only banks?

Well, you can fool some of the people all of the time and all of the people some of the time, but you can't fool all of the people all of the time. A look beyond NetBank's hyperbolic public relations efforts and its tortured interpretation of its financial results reveals glaring deficiencies.

Consider the following comparisons, courtesy of the FDIC, of NetBank with 112 peer institutions. (These are thrifts - not commercial banks - with assets of $1 billion to $5 billion). As of March 31, the peer group's return on equity is 11.76%, versus NetBank's 00.10%. As for return on assets, NetBank's peers generate a return of 0.98% versus its 0.02%. As for efficiency ratio, peers spend $57.24 for every $100 in income; NetBank spends $97.11 for the same $100.

How can this be? NetBank claims to have great employee productivity, averaging more than $17 million in assets per employee compared to the industry's $4 million. This may be true, but the question is, what is this group's value-added contribution to NetBank's book of mortgage loans and certificates of deposit?

In the first quarter, NetBank produced just $988 in pretax net income per employee versus the industry peer average of $9,909 per employee. In fact, NetBank has exceptionally poor productivity. Its operating expenses (at 2.78% of assets) are higher, not lower, than its peers' expenses (at 2.44% of assets).

In fairness, not all investors find this performance as dismal as I do. NetBank's stock has been hovering around $11 and change for the past couple of months, trading at an eye-popping 40 or so times its earnings of the last 12 months. Is there an alternative view of NetBank's valuation?

It seems to me there is an old-economy explanation for investors' assessment of NetBank's worth.

It turns out the average thrift stock - hardly a high-flying group - trades at 2.55 times its tangible book value. NetBank's price-to-book value is an uninspiring 1.31 times its tangible book, according to the investment research firm Multex.

The truth is, NetBank's investors aren't paying any kind of meaningful premium over the equity of the corporation.

Alas, like so much of the rest of the Internet banking story, the hard facts continue to illustrate that too much money is being spent for a woefully inadequate return. There is nothing sustainable about NetBank, or Internet-only banks in general, as an ongoing operating model.

Does this mean that no one has profited from NetBank? Hardly. The original investors, who provided pre-IPO funding, made a killing at the time of the IPO and in the short-lived run-up of NetBank in the aftermarket.

Unfortunately for those hoping to replicate that formula, NetBank has demonstrated that as an investment it produces inferior earnings, surely dampening the market's appetite for more Internet-only institutions.

So I am more than happy to respond to Mr. Grimes' musings about why there are not more Internet-only banks like NetBank. It's because NetBank is no model for success.

I am not suggesting that the Internet has no place in banking. My argument is not with applying new technologies. The industry is obligated to explore all avenues to improve service and efficiency in search of improved performance.

My gripe is with the suspect research, supported by disingenuous claims of success and shameless self-promotion, that is pushing too many bankers into investments to support unpopular or unwanted products with little or no economic value to shareholders and of marginal usefulness to customers.

The hard truth is that the Internet is not the be-all and end-all of banking. The Internet is but a small part of any financial institution's current and future success - one delivery channel of many needed to serve customers' complex financial needs.

Still, the industry needs to be reminded that every dollar invested in what should by now be recognized as a highly suspect Internet project is a dollar unavailable for other technology projects.


Mr. McGrath is a managing partner of Bank Earnings International LLP, a consulting firm in Orange, Va.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.