15 Points about the Underbanked

Originally published on blog.andera.com. Follow us on twitter @AnderaInc

What: Definitions

The term underbanked has become a bit of a buzz word in the past few months, so it’s good to start by clarifying its meaning. Different definers offer different definitions, but the authoritative definition is probably that of the FDIC who, in its National Survey of Unbanked and Underbanked Households, classifies households as “Underbanked” and “Unbanked” based on responses to survey questions:

1. Unbanked:  Households that do not have a checking and/or savings account.

2. Underbanked: Households that have a checking and/or a savings account and had used non-bank money orders, non-bank check cashing services, non-bank remittances, payday loans, rent-to-own services, pawn shops, or refund anticipation loans (RALs) in the past 12 months.

In casual language, however, the term “underbanked,” usually refers to the “underserved” individuals or households who for some reason don’t fit neatly into the conventional financial services landscape:

3. Underserved: The unbanked, the underbanked, and all consumers who can’t access credit because of poor, thin, or no credit files, or face some other barrier to complete financial markets.

Who: Demographics

Charts tell this story better than I can:

4. Scope: 1 in 4 US Consumers are Unbanked or Underbanked. From the FDIC National Survey of Unbanked and Underbanked Households

5. Race and Ethnicity: The unbanked are disproportionately minorities. From the FDIC National Survey of Unbanked and Underbanked Household

6.  Score: This graph needs a little explanation:  it shows credit scores with and without the use of Alternative Data, mainly utility and telecom payments. Loan applicants with no score are usually denied credit. From Give Credit Where Credit is Due: Increasing Access to Affordable Mainstream Credit Using Alternative Data” Political Economic Research Council and The Brookings Institution Urban Markets Initiative (2006)

Why: Reasons

7. Distrust: On Friday I ran into an old acquaintance on the train to Boston and, when I pulled out my debit card to pay for my ticket, he remarked that “he doesn’t do that anymore.” Out of anger at the big banks, and possibly in solidarity with the Occupy Wall Street movement, he had pulled his money entirely out of the system. While statistically he is in a small minority, dislike and distrust is an important reason for the high percentage of underbanked; consumers who have managed for years without a checking account aren’t about to go sign up for one now.  Distrust goes both ways; risk aversion and fear of default has led some institutions to tighten their lending rules.

8. Low Rates, High Fees: Both the public perception and the value proposition of financial institutions right now are near rock bottom. The Fed’s quantitative easing measures drove down lending rates, the primary source of revenue for banks and credit unions, which in turn led to lower deposit rates and higher fees. Consumers have to search nowadays for a deposit account that will earn them money instead of costing them money.

9. Regulation: I saved the most interesting reason for last; regulation is never designed to hurt the underbanked, and some regulation, such as the Community Reinvestment Act of 1977, is specifically designed to help. Regulation is, however, designed to catch money-launderers and identity thieves, and reduce systematic risk. Identity verification and red flag rules strengthened under the PATRIOT Act of 2001 can prevent applicants with no or thin credit files from opening even a basic checking account. Basel III liquidity requirements may induce some banks to lend more conservatively, and CFPB oversight may cause banks to up fees to cover compliance costs. Talk about unintended consequences.

How: Solutions

10. Alternative Financial Services: The “traditional” way to serve the underbanked is through Alternative Financial Services (AFS), including check cashing services, payday and tax-refund loans, rent-to-own agreements, subprime mortgage and auto loans, and also person-to-person lending. Although not exploitative by rule, most AFS have a bad reputation because informal operations, local monopolies, and asymmetrical information allow AFS providers to charge high fees or lock the underbanked into burdensome debt agreements.

• Read More: FDIC : Alternative Financial Services, A Primer

11. Prepaid Cards: Prepaid cards evolved from the gift cards that first appeared in the 1970s andElectronic Benefit Transfer (EBT) cards debuted by the government as an alternative way to pay unbanked employees in the 1990s. Various independent and private label prepaid card providers, including Playstc, our partner for a free webinar next week, emerged in the early 2000s. Prepaid cards have generated much speculation recently with the launch of Bluebird by American Express and Wal Mart, and the launch of GoBank by mega prepaid provider Green Dot.

12. Mobile Banking: Several different organizations and publications have touted mobile banking as a pathway to serving the underbanked.  A significant proportion of underbanked consumers have mobile phones, more than have a personal laptop or a home internet connection among some demographics. Mobile allows low-income consumers to access key financial services at a low cost both to them and the bank, and also integrates will with personal finance management tools to encourage smart spending and“financial capability,” not to mention opportunites for peer-to-peer lending.

• Read More Reaching Underbanked Consumers Through Mobile Services From Celent and the Center For Financial Services Innovation

So What?

Definitions, Demographics, Reasons and Solutions are of little use without a reason to care. With public feeling against financial institutions at an all-time low, many consumers may simply say good riddance. For banks and credit unions, the demographics of the underbanked overlap heavily with the demographics of their least profitable and highest risk customers, and directors may not view efforts to lure the underbanked back in as cost-effective.  So why, apart from an ethical appeal to equality of opportunity, should you care about the underbanked?

13. Lifetime Value Fortune at the bottom of the pyramid aside, the underbanked have long-term potential greater than their short-term appeal. And remember, we’re not talking about a few customers who slip through the cracks; we’re talking about a full quarter of the population. Financial institutions from all stripes today are eager for loans, and offering credit to an underbanked but responsible consumer who would have otherwise sought credit from an AFS provider benefits both parties.

14. IT Catalyst: Cost-effectively serving the underbanked requires out-of-the-box thinking to lower the cost and increase accessibility of transaction services. Luckily, this is exactly the kind of out-of-the-box thinking that banks should be doing anyway. It’s no coincidence that the services required to serve the underbanked are growing fast; prepaid cards and mobile banking have been constantly in the headlines these last few months.

15. The Macroeconomy: Standard economic theory says that entrepreneurs need access to financial services to obtain funds to innovate. Exclusion from financial services prevents the would-be small business owners from breaking out, and may stunt growth, and likewise may prevent the underbanked from pursuing higher education. Similarly, the burdensome interest rate payments and high transaction costs keep the underbanked in poverty, hurting the economy at large.

Want to Learn more? Register for Andera’s free webinar, “Serving the Underbanked: Prepaid Cards and Alternative Data” with Patrice Peyret, the CEO of Plastyc, a major provider of prepaid cards, and Jamie Verdi, an Account Manager at Andera and alternative data expert.