Having recently retired from a long banking career, I take pride in how our industry has improved the lives of most Americans. Seeing a customer start with a checking account, add a savings account, qualify for a credit card, auto loan, mortgage, and then benefit from asset management services are signs that things are going as planned. A bank's success and a customer's financial well-being are closely linked.
But on the lower end of the income and credit spectrum I fear that this happy tale is not unfolding. Banks, weighing factors that include cost-efficient underwriting, keeping credit losses under control, and regulators' caution on products such as deposit advance, struggle to create workable credit products that meet the short-term borrowing needs of low- and moderate-income customers. This prevents those customers from climbing the traditional bank credit ladder, and drives them to seek other options. Consequently, the landscape is saturated with more than 50,000 alternative financial services storefronts and websites that include check cashers, auto title lenders, pawnshops and the like. These alternative lenders are often labeled "fringe," but one in four households use them regularly.
While it is tempting to dismiss these households as unbankable or undesirable, two of the requirements needed to obtain a payday loan – income and a checking account – challenge that assumption. The fact that so many bank customers go outside the financial mainstream and pay exorbitant prices to fill a borrowing need suggests banks are missing an opportunity to play a meaningful role in improving those customers financial well-being.
Finding a solution to this challenge will require collaboration between key stakeholders: banks, consumer groups, and both consumer and prudential regulators. The goal needs to be workable rules and the creation of small-dollar credit products that are easily accessed, fairly priced and allow banks to make good credit decisions and a reasonable return on their investment.
The Consumer Financial Protection Bureau has been an important catalyst in this dialogue and vocal about the importance of banks offering small-dollar loans to customers. The bureau's encouragement is well-founded as banks have many potential advantages over payday lenders. Banks are able to prescreen and automate much of the lending process, send loan proceeds to customers' checking accounts and schedule payments that coincide with customers' cash flow. These advantages have the potential to allow banks to price these loans significantly lower than payday lenders. But to leverage these advantages, banks need clear guidelines that will enable prescreening and automation, and minimize costly staff time and compliance burdens.
The CFPB's proposed rules published in June do offer an ability to better understand a borrower's current financial condition, but they add little predictive value to a bank's underwriting capability while adding cost, regulatory risk and time to the origination process. Compliance could undermine the business case for making such loans.
But there is an alternative approach for regulators and bankers to consider more seriously.
The CFPB proposal solicited comment on a simpler lending approach with some consumer protections that might open the door to banks offering lower-cost small-dollar loans. That proposal would allow monthly installment payments of up to 5% of monthly income with a maximum term to prevent loans from being excessively costly. The bureau left this alternative model out of the proposed regulation, despite bankers' hopes that it would be included, but the agency's decision to obtain feedback about this strategy still offers hope.
Under this alternative plan, if an applicant had an average monthly income of $2,500, the loan's installment payment (including principal) would be up to $125. In addition to simplifying the application process for the consumer, this alternative plan would also open the door to banks using customer account information and alternative data in underwriting, which would enable banks to more efficiently address the safety and soundness concerns of the prudential regulators. Similar small-dollar loan programs for banks and credit unions have had loss rates of 4% to 6%. Should chargeoffs exceed that, banks would likely alter underwriting standards to mitigate higher capital costs and prudential regulator scrutiny (contrasted with payday lenders who pass higher credit losses on to paying customers in the form of higher finance charges).
Banks could also work with customers on payment schedules to minimize instances where payments trigger overdraft fees. And the reporting of timely payment history to credit bureaus would enable improved credit scores and the pathway to graduate to other bank product offerings.
Chances are that these products would not make banks big profits, but if they contributed modestly to the bottom line, banks might be eager to make the investment as a way to capture a part of the customer market that is closed to them today. The result could be products that create a credit ladder for more consumers that is less costly, mitigates debt traps and improves their financial well-being.
Neil F. Hall is the former head of retail banking at PNC Financial Services and currently serves on the CFPB's Consumer Advisory Board. The views expressed are his own, and do not reflect the views of either PNC or the CFPB Consumer Advisory Board.
