Welcome to the world of the unbanked, and their first cousins, the underbanked. These so-called no-hit or thin-file consumers fall into that shadowy area of credit risk between prime and subprime. Their problems are not that they have bad credit histories. It's that they often have no credit histories at all. Yet they offer opportunities for new revenue streams to a credit card industry that has pretty much exhausted other market segments.
"The (credit card) market is saturated," says Josh Kessler, manager of research at Purchase Street Research, the Purchase, N.Y.-based subsidiary of MasterCard International. "Now they're looking for new areas-whether it be new products or new customers-to try to expand their portfolios."
The unbanked comprise more than 13% of the 105 million households in the U.S., according to the 2000 census. And they are a diverse lot, ranging from immigrants with no checking accounts to recent widows without credit histories in their own names.
One of the fastest growing thin-file segments is Hispanics, who are expected to make up 25% of the U.S. population by 2050, Kessler says.
The group also includes people who filed for bankruptcy but have since demonstrated responsible payment behavior. "There's probably not one common theme," he says.
As such, the unbanked and underbanked present challenges to an industry structured to accommodate mainstream, creditworthy consumers. Typical credit-scoring models simply don't work.
What's more, standard card products won't do because most of these consumers have had little or no experience dealing with credit. To tap into the market, issuers must offer non-traditional products, such as prepaid cards or money transfers, that teach fiscal responsibility and can help ease users into the credit culture.
Needless to say, the unbanked and underbanked must be approached with care. If underwriting criteria are flawed, a card issuer could be left with major losses. Witness the financial collapse of the subprime programs of high-profile issuers such as Providian Financial Corp. and Metris Companies Inc.
And an issuer's reputation also is at stake. Many products for the unbanked, such as secured cards and payday loans, have histories of victimizing credit-hungry consumers. Abuses in those areas have been so flagrant that banking regulators felt the need to issue guidelines for financial institutions operating such programs. Missteps in this area could cause major image problems for even the most reputable issuers.
But many issuers are willing to take those risks. And they are clamoring for new scoring models that will help them separate the creditworthy from the credit-challenged.
Fair Isaac Corp. estimates that while about 160 million Americans have documented credit histories adequate for calculating its traditional credit scores, an estimated 50 million do not. Minneapolis-based Fair Isaac's scoring models-so-called FICO scores-are considered industry standards.
"We've heard from our clients that there's a huge population out there that doesn't (show up when using standard scoring models), so they don't have a way to reach that population," says Karlene Bowen, client relationship director at Fair Isaac.
In response to that need, Fair Isaac in July introduced the FICO Expansion score designed to cover consumers with little or no credit history. The Expansion score uses non-traditional data, such as checking and savings accounts, payday loans, book or record clubs, furniture lay-away plans, and rent-to-own programs.
"We were looking for non-traditional data that would allow us to assess the risk of this population, and we've been able to accomplish that," Bowen says.
Fair Isaac also looks at account application data, such as "how long have they been on the job, how long have they been at their residence," she says. Fair Isaac estimates that by using the new model, it can generate scores for 25 million consumers that the traditional FICO scores would miss.
But the Expansion score isn't Fair Isaac's first attempt to target the unbanked and underbanked. Its so-called NextGen scores, updates on its classic scores, enable issuers to "reach a little bit further into" the unbanked population. NextGen scoring models have been available at the three major credit-reporting agencies for about two years. Although not as powerful as the Expansion score, the most recent version, NextGen 2.0, "will actually score two percent more of the national population than the classic score does today," Bowen says.
Fair Isaac's classic scores range from 300 to 850, compared to 150 through 950 for NextGen and FICO Expansion. Consumers whose scores fall below 600 generally are considered subprime.
New approaches for determining the credit risk of the unbanked and underbanked are coming from other quarters as well. One new entrant, Pay Rent, Build Credit Inc., an Annapolis, Md.-based credit bureau, in December launched a Web-based, self-help service that enables consumers and small-business owners to build credit scores based on rent, mortgage and other recurring bill payments.
Consumers enroll in the system by submitting up to three years of payment records that can be manually verified by independent sources, such as banks, Realtors, accountants and credit counselors. They access the PRBC site using a user name and password.
"It takes a little work on the part of consumers, but we think it can save thousands of dollars" because they will qualify for lower interest rates, says Michael Nathans, founder and chief executive.
The PRBC method is "almost like manual underwriting," in which a creditor looks at cancelled rent checks, utility bills, bank statements, money orders, or other proof of an applicant's payment record, he says.
In addition, PRBC will accept electronic uploads of data on rental and other bill-payment information from landlords, mortgage lenders and other creditors.
At least one major player, Citigroup Inc.'s CitiMortgage, has a subscriber agreement with PRBC and serves on its technical steering committee.
Using a weighted approach, PRBC's Bill Payment Score assigns numerical points based on the timeliness of recurring payments made over the previous 36 months. More points are allocated to larger payments such as leases and mortgages, and fewer points to smaller payments such as utilities and phone and cable services.
The system can work even for people with damaged credit histories. "If you can't show a history of paying your credit card or some other loan on time, it's very hard to get credit," Nathans says. Documentation of prompt payment of rent or utility bills could convince a lender to give the consumer a second chance, he adds.
PRBC's scores are not statistically predictive and are not designed to replace FICO scores or other predictive models, Nathans says. "It's one more piece of information a lender can use to make more intelligent lending decisions by getting a more complete picture of the borrower," he says.
Other vendors offering scoring for thin-file applicants include LexisNexis and processor eFunds Corp.
Because most thin-file consumers by definition have little or no experience with credit, they are not candidates for standard credit card products. But the card industry is trying to tap into that market by developing products such as payroll cards and other prepaid cards that give the unbanked and underbanked limited access to the system.
'Big Focus'
"The unbanked and underbanked is a big focus for Visa," says Nizam Antoo, director of prepaid products for Visa USA. He estimates that there are about 20 million to 25 million unbanked employees in the U.S., and about 25 million underbanked employees.
About $1 trillion in payments, such as payroll, child support, unemployment and Social Security, are disbursed to the unbanked and underbanked via checks on an annual basis, Antoo says.
Visa is attempting to reach those segments with reloadable prepaid cards that can be used at merchants that accept Visa-branded debit cards as well as at Visa Plus automated teller machines, he says.
MasterCard International, too, sees prepaid cards as a way to reach unbanked consumers.
"Prepaid cards ... provide financial institutions the opportunity to build 'sticky' relationships with the unbanked," Bill Mathis, senior vice president of North American member relations, said in a prepared statement. The unbanked are prospective customers who "may one day require other, more traditional banking and financial services, including checking and savings accounts, credit and debit cards, mortgages and other consumer and business loans," he said.
Card issuers are trying to reach thin-file consumers with a variety of new products in addition to older ones being spiffed up in the new marketing effort to reach the underserved. They include secured cards, payday loans and money transfers.
Citigroup's Citi Cards offers a number of programs to reach the unbanked, primarily recent immigrants, Ellen Barbara, senior director, said in a written statement. In addition to a secured card offered through its branches and other face-to-face channels, Citi holds credit-education seminars and also has a Spanish-language Web site, she said.
South Jordan, Utah-based Merrick Bank offers a "full spectrum" of MasterCard- and Visa-branded products, says David B. Watson, chairman. Merrick's lead card product is an unsecured card, but the bank also offers secured and stored-value cards, he says.
Merrick's customers include near-prime consumers "with more history and better history down to subprime people with thinner history or not as good of credit history," he says.
Merrick has built its card program on a "hierarchy of risk," with near-prime consumers qualifying for unsecured cards, Watson says. Secured cards are given to consumers with a higher level of risk but who have cash. Immigrants usually fall into that category, he says.
The stored-value card is "kind of a pay-as-you-go card," Watson says. "You just load money on the card rather than putting money up as a security against a credit card loan."
Prepaid cards "really require a minimum of underwriting," because they have a minimum of risk associated with them, he says. That "broadly opens up the population you can offer the product to." Merrick distributes prepaid cards through partnerships with retailers and other entities.
Secured cards, however, are best for consumers looking to establish a credit history, since they are reported to the credit bureaus as collateralized loans.
Merrick uses a proprietary scoring model, combined with credit-bureau information, to decide which type of card will be offered to a consumer. Because its proprietary score is based on a specific population, it is more powerful than the pooled data score found at credit bureaus, Watson says.
CompuCredit Corp., an Atlanta-based subprime card marketer, is taking a similar approach to the unbanked. It is adding both stored-value cards and micro-loans, also known as payday loans, to its product mix.
"CompuCredit is transforming itself from a credit card company focused on a discrete market to a provider of a full suite of financial services that appeal to the 90 million or so people in the U.S. who comprise the underserved and unbanked population," CEO David Hanna told analysts during a conference call in August.
CompuCredit plans a national rollout of its stored-value debit card product before year's end, partnering with grocery stores and check cashers to market the product at the point of sale, Hanna said.
Another new financial product for CompuCredit is the payday loan-generally defined as a loan of less than $500 for less than a 30-day period. To that end, CompuCredit acquired the 300-store First American Cash Advance chain during the second quarter, and will complete the acquisition of a 450-store chain this quarter.
CompuCredit considers both new products complementary and expects them to be "meaningful contributors" to earnings over the next several years, Hanna said.
"A lot of our strategy for having the storefront (payday lenders) is we want to get to the people ... that direct marketing and telemarketing doesn't always work with," he said. "So while we have bought these companies that are in the micro-lending business, we think that the same storefront can be used for our stored-value or debit products."
There's no doubt that fee-laden products such as secured cards and payday loans can generate significant revenue. But they also bring with them a history of abuse that has drawn fire from consumer groups and close scrutiny from regulators and law enforcement. And in some cases, such programs have taken a financial toll on the banks that operated them.
Guidelines
In April, the U.S. Office of the Comptroller of the Currency distributed an advisory letter outlining what it considered illegal, deceptive, and unsafe practices of some secured card programs. It also laid down guidelines on the steps national banks must take to ensure that secured card programs are run in "a safe and sound manner that treats customers fairly" and promotes responsible credit access.
The OCC singled out for criticism programs that charged security deposits and other fees to the card, leaving little or no credit available to the cardholder. "... This type of secured credit card product is not appropriate for national banks, and should not be offered by them," the OCC said.
Watson says Merrick Bank tries to differentiate its cards from the questionable products "that offer a $300 credit line, then it's immediately used up with $278 worth of fees. We're not in that business. We think that's wrong."
Merrick's cards "give you a real loan. They're expensive but fairly priced to the risk," he says. Secured cards account for less than 15% of Merrick's $500 million portfolio.
Like secured cards, payday loans have caught a lot of flack from consumer groups and regulators. Drawing the most fire are what consumer groups consider excessive interest rates-between 300% to 450% on an annualized basis by some estimates. Consumer groups also have decried the "rent-a-bank" strategy, in which payday lenders form partnerships with banks. A 2001 survey conducted by the U.S. Public Interest Research Group found that lenders with partner banks usually charged higher rates, made larger loans and made repeated loans in violation of state laws.
The OCC, too, expressed concerns about payday lenders' excessively high interest rates and other abusive practices, issuing an advisory letter setting down guidelines for banks. The OCC also was concerned that banks weren't setting aside enough capital for to cover any losses, says a spokesperson.
Under the guidelines, the OCC capped payday lending at 25% of a bank's capital. It also limited the period of time a loan could be extended before it had to be written off. The OCC also set down some consumer-protection requirements, including full disclosure of fees.
The OCC has issued cease-and-desist orders to three banks involved in payday lending. But some argue that payday lenders are getting a bad rap.
The payday loan business "came into being because people wanted short-term access to small-dollar credit, and there really wasn't any other way of getting that," says Jerry Robinson, a board member of the Community Financial Services Association of America, an Alexandria, Va.-based trade group for payday lenders.
The typical payday-loan customer has a household income of between $25,000 and $50,000, has a job and has a checking account, according to the CFSA (chart). Robinson estimates that between 10 million and 15 million households have used payday loans over the past few years.
In a payday loan operation, the lender generally markets and collects the loans through storefronts while the bank underwrites the credit, he says.
Robinson challenges criticisms that payday loan rates are excessively high. Payday loan operators typically charge a flat fee of 15% of the loan, the CFSA says. "We're certainly cheaper than the overdraft protection product used by banks," he says, claiming that banks "make in excess of $15 billion a year on bounced-check fees."
While card issuers have been most active in the unbanked and underbanked arena, they are not the only ones looking to tap into that segment. Several large card processors, including First Data Corp. and Global Payments Inc., have acquired money-transfer businesses. Such services are used heavily by the unbanked, including immigrants sending money abroad.
When First Data acquired industry giant Western Union Financial Services Inc. 10 years ago, "we saw it as a value-the brand value that it brought and the trust that it had with consumers," a spokesperson says. "We saw it had great potential for international growth."
Western Union completed more than 81 million consumer-to-consumer transfers last year, the spokesperson says. Of that amount, international money transfers accounted for 56% of volume and domestic (including Canada), 19%. Mexico accounted for 7% of volume.
The average amount of a money transfer was $300 for the U.S. and $500 outside the U.S., the spokesperson says. Western Union has 195,000 agent locations worldwide.
Processors are moving into the business because "the (money-transfer) industry is much less mature than the credit card industry and is growing a little bit faster," says Jim Leroux, a principal at Linthicum, Md.-based First Annapolis Consulting Inc. He estimates that volume will increase from 10% to 15% annually ("The Allure of Money Transfers," June). In 2003, there were an estimated $150 billion in transfers worldwide.
What's more, money-transfer services have higher margins than the processing industry. Money-transfer services operate in a similar fashion to transaction processing, Leroux says. "It's like merchant acquiring-you establish relationships with retail merchants and then you process transactions for them."
And because sales people call on merchant locations, there are cross-selling opportunities as well, he says.
Indeed, some companies, including Bank of America and Citigroup, have developed card-based money-transfer models. "The logic behind that is to leverage (automated teller machine) networks, particularly in the countries where the money is being received and paid out," Leroux says.
Under the card-based model, the banks enable consumers to load funds into stored-value accounts. The companies then issue stored-value cards to the money-transfer recipients overseas. The cards can be used to make purchases or withdraw funds from automated teller machines.
"It's just a much easier way to build a distribution network ... and much more cost-effective," Leroux says.
It's too early to tell how successful the card industry will be in its quest for the unbanked consumer. It is clear that the road ahead will be challenging, but the rewards at the end could be great.
