This summer the FDIC issued a report documenting the first year of loan activity under its Small Dollar Loan Pilot Program. Despite the FDIC's public relations posturing within the report, the actual data demonstrates a program that is destined for failure.
Further, the report highlights the extreme challenges that banks are bound to encounter as part of any effort to service a market segment that desires access to small-dollar, short-term loans; a segment that financial service centers, traditionally recognized as check cashers, are already successfully and satisfactorily serving by offering payday loans and other financial services.
The FDIC attempted to lure banks into the SDL Pilot Program by offering Community Reinvestment Act-based incentives. While it appears that this "carrot" enticed some banks to enroll in the program, it did not significantly affect participation.
In fact, most banks participating in the SDL Pilot Program have erected barriers to borrowing, which resulted in an extremely low loan volume during the first year of the program. Participating banks, representing 446 locations in 26 states, originated only 8,346 SDLs, or roughly one loan every 20 days per branch. Putting this further in perspective is a 2005 study published by the FDIC Center for Financial Research: "Payday Lending: Do the Costs Justify the Price?" It said that on average a single mature payday loan store makes 8,743 loans a year.
As with all financial services, consumers decide which product or service is best for them. The volume of payday loans compared with SDLs made by banks under the pilot program makes it clear that financial service centers are consumers' preferred provider of these types of products.
Much of the success of the financial service center industry is tied to the historic unwillingness of mainstream financial institutions to serve the needs of the low-to-moderate-income consumer. Too often, this consumer hears the word "no" from banks — an unfamiliar word at financial service centers. The FDIC's case study of Citizens Trust Bank, as noted in the report, is a perfect illustration of this bank philosophy. In the first two months that the bank offered its small-dollar loan product to the general public, it received 574 applications, but only 81 (14%) of those became loan originations. In other words, nearly nine out of every 10 applications were denied, withdrawn or not approved for one reason or another. The FDIC inexplicably deemed the Citizens Trust Bank's program a success.
Why has the FDIC's program not achieved greater success? One of the primary reasons is that the FDIC imposed an unrealistic 36% annual percentage rate cap, which, as the report confirmed, serves as a deterrent for banks. Yet, the FDIC seems to be encouraging banks, during a period in which the number of failed banks continues to grow weekly (including some banks participating in the pilot program), to treat their SDL programs as a loss leader that will ultimately result in long-term profitably through volume and by using SDL programs to cross-sell additional products. The FDIC's advocacy of its SDL model is problematic for several reasons.
First, while loss leaders certainly have a place in business models, it is confounding that this message is coming from the federal government regulator that is most acutely aware of the difficulties banks have faced in recent years in making bad loans, albeit much larger ones. Moreover, this model does not promote transparency, since those banks that are seeking to make profitable small-dollar loans tack on inconspicuously disclosed additional fees, such as "documentation" and "processing" fees.
Second, the FDIC fails to recognize that banks are unwilling to replace highly profitable overdraft protection with unprofitable SDLs. As the FDIC itself reports in its "Study of Bank Overdraft Programs," published last year, banks are generating huge sums of revenue on fees from their checking account overdraft protection programs.
Why would they offer a competing, less profitable product than what they already have?
Third, banks are not set up to handle a sufficient volume of SDLs. While undoubtedly the bank model serves an important purpose in our society, the financial service center model is better suited to serve the financial needs of many consumers.
With a year's worth of data in hand, the SDL Pilot Program is proving to be a glaring example of a misguided and failing attempt by the FDIC to push a struggling and reluctant banking industry into unprofitably offering consumers financial services that already are provided successfully by another business sector.
Rather than continuing to promote a program that seems destined to fail, the FDIC should use its experience from the pilot program to illustrate to members of Congress and the Obama administration that an arbitrary cap on small-dollar loans, such as a 36% APR ceiling, is unrealistic and would merely harm the industry segment that is already ably serving this market need. That, in turn, would cause considerable harm to consumers who choose small-dollar loans, such as payday advances, to address their credit needs when unexpected or emergency financial shortfalls occur. No one stands to gain if a void is created in the small-dollar-loan marketplace.
