The 'Network Effect' Persists Even in the Age of Electronic Banking

The 'Network Effect' Persists Even in the Age of Electronic Banking

In the world of banking, the concept of the network effect is still relevant and impactful, even in the age of electronic banking. The network effect refers to the phenomenon where large branch networks capture a disproportionate share of market deposits. This means that as a financial institution adds more branches to its network, the average deposit size per branch increases. Each new branch provides a lift to all the preexisting branches in the market, creating a mutually beneficial relationship.

Historically, financial institutions have pursued concentrated deployment strategies to leverage the network effect. Instead of spreading their branches across multiple markets, they concentrate their efforts in one market with a larger number of branches. This strategy has been proven effective, as studies in 2004 and 2010 found significant positive correlations between network size and average branch size. In fact, the more recent study found a strong correlation in 25 out of the top 50 metros.

However, there are exceptions to this trend. Some community banks in the middle tier have maintained lending levels and deposit funding needs, even as larger banks reduced leverage ratios and focused on resolving problem loans. These community banks have managed to mitigate the impact of the network effect by prioritizing fiscal responsibility over location convenience.

Additionally, the financial crisis had a significant impact on the industry's reputation. Large banks bore the brunt of the reputational damage, leading some consumers to migrate to smaller banks. This shift rewarded fiscal responsibility and allowed smaller banks to boost their ranking on the deposits-per-branch measure. While the network effect still holds true, this demonstrates that consumer behavior can influence the balance of power in the banking industry.

For smaller banks operating in a single market, it is essential to understand that the network effect applies not only at the metropolitan area level but also at the corridor level. Instead of scattering branches across an entire metro area, it is more beneficial to build a cohesive network in one or two corridors while ceding others entirely. This strategic approach will yield increased per-branch deposits and maximize the benefits of the network effect.

It is important to note that the strength of the network effect varies across different markets. Markets with strong legacies of thrifts and mutual savings banks tend to show lower correlations. Institutions in this sector of the industry lean towards rate-based, branch-light operating models. Understanding the nuances of each market is crucial for financial institutions to make informed decisions about branch network expansion and deployment strategies.

In conclusion, the network effect continues to play a significant role in the banking industry, even in the age of electronic banking. While larger branch networks are generally more efficient from a balances-per-branch standpoint, there are exceptions and ways for smaller banks to compete. By focusing on cohesive networks in strategic corridors and prioritizing fiscal responsibility, smaller banks can leverage their strengths and thrive in an industry dominated by larger institutions.

Actionable Advice:

1. Conduct market research: Before expanding or deploying branches, conduct thorough market research to understand the dynamics of each market. This will help identify the strength of the network effect and tailor deployment strategies accordingly.
2. Prioritize fiscal responsibility: In an industry where reputation matters, prioritize fiscal responsibility over location convenience. This will not only attract customers but also improve rankings on measures such as deposits-per-branch.
3. Embrace technology: While the network effect is traditionally associated with physical branches, embracing technology can enhance the overall banking experience. Invest in digital platforms and services to complement branch networks and cater to the evolving needs of customers.

In summary, the network effect remains a relevant and influential factor in the banking industry. Understanding its dynamics and leveraging its benefits can help financial institutions thrive in a rapidly evolving landscape. By adopting strategic deployment strategies, prioritizing fiscal responsibility, and embracing technology, banks can navigate the network effect and stay competitive in the age of electronic banking.