Do Banks Have a Future in Small-Dollar Credit?

Consumer advocates derided it as a "bank payday loan," while its sellers preferred the more neutral-sounding term "deposit advance." Whatever name goes on its tombstone, the product's funeral was unceremonious.

Over a weeklong stretch last month, all six institutions that offered the controversial credit product — they range in size from megabank to community bank — quietly announced plans to pull the plug. Pressure from federal banking regulators made the business untenable.

Yet four of the banks — U.S. Bancorp (USB), Regions Financial (RF), Fifth Third Bancorp (FITB) and BOK Financial (BOKF) — pledged to develop new small-dollar loan options for customers who previously used the deposit advance.

The coming months will demonstrate just how hard those banks, and others that have been watching from the sidelines, are willing to fight for borrowers with low incomes and poor credit profiles.

Will banks put substantial resources behind their loan offerings in an effort to compete with payday lenders, auto title lenders and other high-priced sources of small-dollar credit? Or will they unenthusiastically introduce new products simply to assuage their regulators?

"We're never going to give up trying to serve all of our customers," says Richard Hunt, president of the Consumer Bankers Association, a trade group that has been sharply critical of the regulations that killed the deposit advance. "We're trying every day to come up with another product."

Some bankers sound skeptical, though, that there's an attractive business opportunity.

At one point, before regulatory scrutiny clouded the future of the deposit advance, Bank of the West in San Francisco considered getting into the business.

Today, while the company is hoping to reach underserved consumers by offering a prepaid debit card, it is not exploring potential new credit offers to those borrowers, according to Senior Executive Vice President Andy Harmening.

"It's not obvious to me what the replacement product" for the deposit advance is, says Harmening, who also serves as chair of the Consumer Bankers Association's board of directors.

For those banks that take the plunge on small-dollar consumer lending, there are numerous hurdles to overcome. Here are four early thoughts for banks to consider about the road ahead.

Whatever banks offer will likely be less profitable than the deposit advance was.

While no comprehensive data exists on the economics of the deposit-advance loan, there's little doubt that it was highly profitable. (U.S. Bancorp's chief financial officer, Andy Cecere, told analysts last month that his company's version of the product "earns approximately $50 million a quarter.")

It's little wonder why. Borrowers paid triple-digit annual percentage rates, and the banks could deduct whatever was owed as soon as the borrower's next paycheck arrived. High annualized interest rates and low risk generally equal large profits.

That enticing combination will be impossible under the new guidance from the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. The guidance requires banks to underwrite the borrower's ability to repay the loan, rather than relying on a cycle of repeated borrowing. In order to fit within the guidance, unsecured loans will likely feature longer terms and carry lower annual percentage rates.

Since 2011 KeyCorp (KEY) has been offering an unsecured line of credit that passes muster with regulators. The product provides borrowers $250-$1,500, with annual percentage rates ranging from 14%-19%, and repayment periods of up to five years.

The "Key Basic" line of credit frequently gets cited as an example of a product that other banks may seek to emulate under the new regulations.

Keycorp Senior Vice President Cynthia Balser contends that the Cleveland company is pleased with the line of credit's financial performance. But she also says: "So while this product is profitable for us, it would not be as profitable as some of our other products."

Paul Leonard, who as West Coast director at the Center for Responsible Lending has been a vocal critic of deposit-advance loans, argues that banks should focus on more than the profitability of the loan itself. He argues that if banks can build long-term relationships with their customers, they'll build brand loyalty that will pay off over time.

"It's not necessarily just about one single transaction," he says.

But that may be a tough sell inside some banks, where small-dollar lending will be competing with other potential investment decisions.

The market for small-dollar credit will likely become more fragmented.

When Regions announced its plans to exit the deposit-advance market, the Birmingham, Ala., company also unveiled a new secured installment loan product. Customers can borrow as little as $250, but the loan amount has to be secured by funds in a savings account.

This approach to small-dollar lending is nothing new — secured credit cards are a longstanding way for consumers to rebuild bad credit profiles — but it may offer a way to fill some of the supply void left by the deposit advance's demise.

The problem with secured lending is that many borrowers lack the savings necessary to qualify. A recent report by the Center for Financial Services Innovation found that 30% of the demand for short-term credit is from people who are living beyond their means, while another 32% is from people who get hit with an unexpected expense.

So there's good reason to think that lots of the customers who used deposit advances won't qualify for secured loans.

Regions' new secured loan is not intended to replace the deposit advance, a bank spokeswoman says. But she adds that many of the bank's deposit-advance customers have Regions savings accounts and may qualify for a secured loan.

It may make sense to consider a partnership with a nonbank.

Building a small-dollar loan program from scratch can consume a lot of time and resources inside a bank.

"Long before we began to design and build, we did a lot of research," recalls KeyCorp's Balser, looking back on the early development of the Key Basic. "So we did take a lot of time."

The easier path may be to partner with a nonbank that already has expertise in small-dollar lending. This month a team that includes several alumni of Capital One's (COF) credit card business announced plans to partner with an unnamed bank on a new subprime card.

LendUp, a startup in San Francisco, is also preparing to announce partnerships with banks on small-dollar credit products.

LendUp currently offers short-term loans direct to consumers through its website. The company advertises that it can get funds into a customer's bank account in as little as 15 minutes.

Sasha Orloff, LendUp's chief executive officer, is touting his company's speed as an advantage as he looks to sign up banks. Consumers often turn to payday lenders because they know they'll receive the cash they need right away, he argues.

"Banks can take 7-30 days to get you a credit card in the mail. They're not set up for instant deployment of cash," Orloff says.

It's going to take a while for all of the relevant regulations to shake out.

Banks want greater certainty about the regulatory landscape, but that may not happen for some time.

At the moment, there's a three-way split between federal regulators: the FDIC and OCC issued the guidance last fall that killed the deposit advance, while the Federal Reserve Board declined to sign on, and the Consumer Financial Protection Bureau is preparing to issue its own regulations on small-dollar credit.

"Four agencies with three answers," gripes the Consumer Bankers Association's Hunt. "Until I see it, I don't expect regulatory coordination."

The picture should become somewhat clearer later this year, because any new CFPB regulations are expected to apply both to banks and payday lenders.

"A broad rule is important to create a level playing field for banks," says Alex Horowitz, a research manager at the Pew Charitable Trusts.

Still, observers do not expect the CFPB to act as quickly on the related issue of overdraft fees, which often function as a form of small-dollar consumer credit. That means banks will likely have to wait until at least 2015 before all of the relevant regulations are in place.