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How Banks & Regulators Can Better Serve the Underbanked

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by Rick Buczynski, Robert Kennedy
May 16 2013

As seen in the RMA Journal

Evidence is growing that an increasing number of American households are joining the ranks of the underbanked, shifting away from traditional banking and relying more on alternative financial services (AFS).

The “underbanked” are the 24 million households that use a traditional bank for checking or other services, but that also use one or more AFS products from a lightly regulated nonbank. Adding this number to the millions who lack any form of deposit account—the “unbanked”—reveals a poten­tially disturbing shift away from fully banked households to underbanked and unbanked households over the 2009-11 period (Table 1). This development has implications for policymakers and bankers alike, presenting business op­portunities as well as challenges.

Cyclical factors related to the Great Recession explain much of this shift. Unemployment soared, household in­comes were compromised, and, perhaps most critically, net worth eroded. This negative wealth effect is especially worrisome for lower-income families that typically seek out AFS (Figure 1).

A recent FDIC survey suggests that other structural factors need to be taken into account—in particular, household demographics (Table 2).

Minorities, foreign-born noncitizens, the unemployed, low-income families, and the young lead the list of the un­derbanked and unbanked. Many other key findings reported by the FDIC are jaw-dropping:

  • Almost 10 million households (8.2% of total households) are unbanked. Roughly 17 million adults live in unbanked households.
  • Underbanked households increased by 2.5 million during 2009-11; unbanked households increased by 821,000 in the same period.
  • 20.1% of households are underbanked, representing 24 million households with 51 million adults.
  • 29.3% of households do not have a savings account and nearly one out of 10 do not have a checking account.
  • One-quarter of households have accessed an AFS product in the past year, and almost one in 10 have used two or more types of AFS products.

Serving the Underbanked: Increased Competition from Unregulated Nonbanks

Traditionally regulated commercial banks have had an in­creasingly difficult time serving the underbanked, including many checking account customers. Lightly regulated non­banks such as payday lenders, check cashers, title lenders, pawn shops, and rent-to-own retailers have benefited as traditional banks have become wary of low-income customers since the financial crisis.

Nonetheless, AFS custom­ers often are crushed by a vi­cious, snowballing avalanche of rising fees and interest charges that also damage their credit reputations. This debt burden is nefariously calcu­lated in the business models of the most notorious of the lot: payday lenders, auto-title lenders, and pawn shops. The model is often a serious debt trap for the underbanked. Moreover, AFS firms stealth­ily shift the risk burden of the underbanked on to regulated banks, which eat the overdraft losses of abandoned checking accounts.

Ironically, heightened regulatory scrutiny of commercial banks and the many new rules designed to protect consum­ers from banks’ predatory practices have helped drive strong growth in nonbank activity and AFS. Increased regulation of overdrafts and credit/debit cards by Congress and the Federal Reserve has led banks to innovate far less. Higher costs associated with increased regulatory pressures and gen­erally compressed net interest margins3 have not helped. The regulatory bill for commercial banks to serve underbanked demographics has turned into a boom for AFS providers.

Table 3 lists the main industry players in the AFS game. Many of these nonbanks advertise heavily, offering conve­nience and “easy” money. However, these firms are notorious for charging high fees and interest rates and for employing business practices long shunned by regulated mainstream banks. Several reports authored by IBISWorld4 and a joint study compiled by the Consumer Federation of America and the Center for Responsible Lending5summarize the key products and issues:

  • Check-cashing and payday loan services. A dominant player in the AFS space, this group generates two-thirds of its revenue from loan services. In 2011, the FDIC found that 5.5 million underbanked households—those with traditional bank checking accounts or other services— used nonbank check-cashing firms, while 1.9 million underbanked households used payday lenders. The in­dustries’ “fast cash” tune has resonated with the swelling number of underbanked individuals. According to recent studies,6,7 payday loans have annual percentage rates that range between 225% to 300%; only 14% of borrowers can afford to repay an average monthly payday loan; and payday loans do not mitigate overdraft risk. In fact, for 27% of borrowers, payday loans actually led to checking account overdrafts. Abusive practices have drawn the ire of federal and state governments, and regulatory measures are being ramped up. The majority of states require AFS firms to file for an operating license and to adhere to strict laws regarding the principal amount of loans and loan interest rates.
  • Pawn shops. This serious AFS player thrives on the eco­nomic hardships of the underbanked and revels in the TV show Pawn Stars. The pawn shop industry provides short-term loans, taking tangible personal property as collateral. In 2011, the FDIC found that 2.5 million of underbanked households used pawn shops. When bor­rowers repay the loan, their personal property is returned. If the borrower “defaults,” the shop owns the “collateral.” Approximately 40% of this industry’s revenue is garnered through pawn-secured loan interest and fees. This fig­ure probably underestimates the true revenue stream since shops can sell goods abandoned by their “clients.” Regulated by the states and municipalities where they are located, pawn shops generally need a state license. States typically regulate service charges, interest rates, and maximum allowable loan amounts.
  • Prepaid credit and debit card providers. This group, the fastest growing in the AFS industry, has had 40% annual growth over the past five years. Unlike payday lenders and pawn shops, the prepaid-card-provider industry is much more concentrated, dominated by major players like Green Dot Corporation (20% market share) and NetSpend (11% share). Prestigious American Express has joined the fray, issuing prepaid reloadable cards at Wal-Mart and Target. Recently, American Express an­nounced that some of its prepaid cards will be insured by the FDIC, an interesting twist to this rapidly evolv­ing market. Young individuals, even those who don’t fit the typical underbanked profile, are regular users of this convenient product for online purchases. Consumers with poor credit histories also are finding this payment system increasingly attractive. Although this product typi­cally entails high user fees and up-front cash, there is no need for credit-risk verification, nor are there delays or declinations. After years of benign neglect by the federal regulators, the Consumer Financial Protection Bureau announced in May 2012 that it will study prepaid debit cards and consider regulations to protect consumers from high and often hidden fees.
  • Rent-to-own stores. The bulk of operators are in two broad categories: home furniturerent-to-own stores and consumer electronics/appliance rentals. Many firms oper­ate in this space, but two dominant enterprises—Rent- A-Center and Aaron’s—together command more than 50% of the market. Rent-to-own stores cater to poorer households and the under-30 population. Furniture rent-to-own stores face little government intrusion and have not been addressed by the Dodd-Frank Act or the Consumer Financial Protection Bureau (CFPB). However, the consumer electronic/appliance industry faces far more regulation, as 47 states require contractual and advertising disclosures as well as consumer protection.
  • Car-title lenders. Critics claim this business line literally drives borrowers to financial ruin. As the moniker makes clear, car-title loans are secured by a borrower’s vehicle title that is owned outright. Nearly 8,000 firms work in this industry, where the underbanked and unbanked are ripe pickings. A study by the Center for Responsible Lending suggests that an average car-title borrower renews his loan eight times, paying $2,142 in interest for a scant $951 in credit. One in six borrowers is estimated to have suffered repossession of her vehicle. Regulation of this industry is light and spotty, depending primarily on state laws and enforcement. Given all the negative press, this industry, like payday lenders, will likely face hard-line regulator resistance down the road.

Interestingly, emerging nonbank players in the highly profitable prepaid-card business have sought to complement their retail businesses with financial services designed to facilitate point-of-sale transactions, effectively choking off the position of the regulated banks in the processing of these transactions and accounts. In this way, these retailers en­sure that sales generate fee income from transactions, while reducing the processing fees paid to the banking industry. For example, PayPal, operating without a U.S. bank charter, provides a wide range of “banking” services, of­fering deposit accounts insured by the FDIC, loans, and international payment services. As discussed above, large retailers like Target and Wal-Mart offer their own decoupled “debit card,” providing the stores with direct access to the customer’s checking account in return for a discounted price on purchases. It’s likely that the prepaid-card business will morph into a secured-credit-card model for these nonbanks, with an individual’s “savings account” serving as collateral. This debit card-to-loan evolution would further undermine traditional banks’ value proposition to the underbanked.

The AFS industry appears to be moving out of the shad­ows. Although shadier operators are attempting to sidestep the law by moving online, and in some cases offshore, it will be difficult for them to stay one step ahead of government supervision. Credit card companies will continue to team up with big-name retailers, both brick-and-mortar and online (think Amazon and PayPal). Banks need an action plan to take advantage of this rapidly evolving marketplace.

The Role of the CFPB

The CFPB is more of an enforcement agency compared to the traditional federal bank regulators, which focus on in­stitutional and systemic safety and soundness. Nonetheless, the CFPB will conduct examinations of banks with assets in excess of $10 billion, not unlike the examination program of the traditional federal bank regulators. To fulfill its mandate, the CFPB needs to ensure that nonbanks—including old-fashioned ones like payday lenders and mortgage brokers, and new ones such as Wal-Mart and PayPal—play by the same rules as traditional banks. The CFPB will apply its standards consistently across banks and nonbanks.

The banking industry needs to insist on consistent treat­ment and a level playing field. The consistent regulatory treatment should include on-site examinations for non­banks, since they are currently required for regulated banks. Only with on-site examinations will the CFPB be able to de­termine that the nonbanks have the appropriate compliance culture and compliance management program. Consumers then would be assured of equal protection regardless of the entity’s charter, including consistent error resolution processes. Banks and nonbanks would bear similar cost structures for regulatory compliance.

Business Opportunities for Commercial Banks

Realistically, banks need to compete with nonbanks in “smart” segments of the underbanked space. Banks should focus pri­marily on customers who already maintain banking relation­ships. In contrast are the pay­day-hungry borrowers, who rely on AFS facilities mostly for convenience in small-dollar transactions. These are typi­cally bank checking-account customers who drift into the nonbank loan-shark universe when they have credit troubles. Banks must be careful to design a product that helps those cus­tomers take care of occasional financial problems without encouraging overuse of credit.

The most difficult market will be the unbanked—those who have never had a bank­ing relationship or who have a spotty employment or student record. This group presents many underwriting and regulatory challenges to a commercial bank, especially in terms of the stringent “know your customer” expectations of a BSA/AML compliance pro­gram. Consequently, designing products for the unbanked market will not be easy.

Meanwhile, banks need to develop new products to compete for consumer busi­ness, particularly in the areas of transaction processing and payments. With the likes of Wal-Mart, Target, PayPal, and major credit card companies nibbling away at this mar­ket, banks need to develop payment mechanisms with enough bite to keep them at the center of the transaction as the processor for either the consumer or the merchant— ideally, both.

Banks’ undeniable advantages can be leveraged to com­pete with nonbank challengers:

  • The vast majority of the underbanked have bank checking accounts, but they are often used as “parking lots” for funds secured via nonbanking alternative sources.
  • Banks have transaction-processing capacity and network access, all at extraordinarily low costs compared with nonbanks.
  • Despite bad press on cyber attacks, banks and their customers have suffered few losses. Unlike nonbanks, they have a solid record of regulatory compliance, particularly on dispute resolution.
  • Banks retain strong relationships with merchants of all sizes.
  • Banks have significant customer transaction data that can be used to develop competitive deposit account and loan products to profitably serve customers.

Before designing a business plan to serve the underbanked, banks should consider these insights from the FDIC survey:

  • Understanding the characteristics of different segments of the unbanked and underbanked populations might increase the efficacy of economic inclusion strategies. The FDIC survey shows that within the broad groups of unbanked and underbanked households, there are distinct demographic segments requiring different bank­ing services to meet their varying financial challenges.
  • Having a bank account does not guarantee long-term participation in the banking system.
  • Households with banking experience appear to have more positive perceptions of maintaining a bank account and rely less on AFS.
  • Financial institutions might need to demonstrate the value of a bank account to AFS users who perceive nonbank financial services as more convenient, faster, less expen­sive, or with lower barriers to qualification.

Figure 2 provides a simple blueprint for developing an effective product to assist customers at risk from alternative lenders. Banks should also consider these simple suggestions:

  • Assemble a team of bank professionals from various de­partments to evaluate your underbanked market. Include business development/ marketing, credit, IT, and compliance. Each will need to use the bank’s customer data to identify customers who maintain low check­ing account balances, incur overdrafts, and use pay­day lenders. Establishing a focus group of existing customers drawn from the target market should be part of this exercise and will help define the salable features for a new product.
  • Assess your bank’s capabilities to deliver and service the product. Include a review of existing bank services and infrastructure, as well as regulatory compliance is­sues, principally in how they relate to credit policies and underwriting.
  • Be patient before fully launching the product. A pilot program will enable you to embrace client feedback and evaluate established metrics.

Conclusion: A Win-Win-Win Situation

For commercial banks of all sizes, the underbanked represent a lending opportunity to compete with lightly regulated nonbanks. Bank customers living paycheck to paycheck and young people just starting out will ben­efit. By becoming bank customers, these groups will be able to build a much needed credit history. They’ll also avoid the pitfalls of doing business with lightly regulated nonbanks, whose business model keeps these customers mired in debt.

Meanwhile, the banks will be able to grow market share with a segment that appears to be eroding, while also sat­isfying regulatory requirements and new CFPB mandates.

And let’s not forget the underbanked businesses,8 the “other underbanked.” Small businesses often mimic the con­sumer behavior of their owners, but have unique needs that should also offer possibilities for product development.

Rick Buczynski, Ph.D., is senior vice president and chief economist at IBISWorld, Santa Monica, California. He can be reached at rickb@ibisworld.com. Robert Kennedy recently retired from the Federal Reserve Bank of Atlanta after 28 years of service. He can be reached at arrowheadstar@gmail.com. The authors thank Dev Strischek of SunTrust Banks for comments on an earlier draft of this article.


1. “2011 FDIC National Survey of Unbanked and Underbanked House­holds,” Federal Deposit Insurance Corporation, September 2012.

2. “Changes in U.S. Family Finances from 2007 to 2010: Evidence from the Survey of Consumer Finances,” Jesse Bricker, Arthur B. Kennickell, Kevin B. Moore, and John Sabelhaus, Federal Reserve Bulletin 98, no. 23, June 2012. Note that the net worth data is highly skewed: The median lies substantially below the mean.

3. See “The Fed’s Quantitative Easing and C&I Lending Opportunities,” Rick Buczynski, The RMA Journal, May 2013.

4. Consult the following reports from IBISWorld: “Check Cashing and Payday Loan Services,” Eben Jose, May 2012; “Pawn Shops,” Janet Shim, September 2011; “Prepaid Credit and Debit Card Providers,” Nima Samadi, June 2012; “Home Furniture Rental,” Agata Kacza­nowska, February 2012; and “Consumer Electronics and Appliances Rental,” Justin Waterman, July 2012.

5. “Driven to Disaster: Car-Title Lending and Its Impact on Consumers,” Jean Ann Fox and Tom Feltner, Consumer Federation of America, and Delvin Davis and Uriah King, Center for Responsible Lending, February 28, 2013.

6. “Triple-Digit Danger: Bank Payday Lending Persists,” Rebecca Borné and Peter Smith, Center for Responsible Lending, March 2013.

7. “How Borrowers Choose and Repay Payday Loans,” Pew Charitable Trusts, February 2013.

8. “The Other Underbanked,” American Banker, January 2010.

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