Earlier this month, the Office of Thrift Supervision ordered MetaBank to shut down its iAdvance loan product. According to Meta, the OTS said it had engaged in unfair or deceptive acts or practices in offering the product, which provided prepaid card users with small amounts of credit advanced against their incoming direct deposits.
In the wake of this action, it is worth reflecting on the state of the small-dollar credit market and the credit needs of underserved consumers. Despite some innovation and a handful of new products over the last few years, the gap between supply and demand is greater than ever.
Demand for small amounts of credit is high among certain segments of the underbanked. Our organization's 2008 Underbanked Consumer Study found that 28% of the underbanked had borrowed money within the last 12 months. Almost 40% of those borrowing do so to pay bills or to cover basic living expenses.
Borrowers used a wide array of debt products, including personal loans (30%), lines of credit (24%), cash advances on credit cards (16%) and payday loans (8%); a sizable group (43%) borrows from family and friends.
Two distinct behavioral patterns emerge among these borrowers. One group borrowed once a year for $1,000 or more, most often to purchase a vehicle.
The other group of borrowers generally borrowed two to four times a year at amounts between $100 and $1,000.
They borrow to pay for utilities (32%), home repairs (31%), basic living expenses (22%), repayment of other debt (21%) or medical bills (17%).
The need to borrow to make ends meet has almost certainly been exacerbated in the last two years by the recession, job loss, the tightening of credit and other financial stress.
Underbanked consumers were already at a disadvantage before the financial crisis.
Our survey showed that one-third of underbanked consumers had subprime credit scores, while over 40% had limited or no credit information on file, making them unscorable.
Some may interpret these statistics to mean that underserved consumers are income-challenged rather than credit-challenged, and that the solution is better income supports or budgeting help. Others may read the numbers and believe the answer is encouraging savings in order to build a cushion to weather crises.
However, income supports, budgeting guidance and additional savings will not entirely fill the need that credit satisfies. Well-structured credit can help build a credit history; facilitate an investment or purchase that provides the foundation for other wealth-building activities; and support a household's ability to save.
To meet these goals, small-dollar credit must be high-quality. It must be marketed transparently. It must be affordable and structured to support repayment, with amortization periods that extend beyond a single pay period, and repayment must be reported to the credit bureaus.
Ideally, it may also be accompanied by other features, such as savings accounts or budgeting advice that can prepare the borrower for greater financial prosperity over time. However, the additional complexity created by such features must be balanced against the convenience, speed and privacy that consumers demand and the additional costs they create for the lender.
The trade-offs are real, and complex. Smaller banks and credit unions that have begun offering alternatives to payday loans typically price their products at cost in order to build deeper customer relationships, but the limits of branch distribution make the model impossible to scale.
Larger banks offering salary-advance products have the benefits of efficiency and scale, but they achieve it by doing little to no underwriting or risk-based pricing. Virtually anyone with direct deposit qualifies, driving up risk and ultimately price.
A handful of web-based startups are focused on improving the customer experience through increased convenience and transparency. In addition, a few startups and traditional financial institutions alike are beginning to experiment with longer repayment periods to break the cycle of debt that payday loans, which typically require payment in full by next payday, are infamous for causing. And a few are exploring savings products, defaults and other incentives to reduce reliance on loans.
The greatest threat to this latest wave of innovation is regulatory uncertainty.
Few formal guidelines for small-dollar loans exist. Given this vacuum, the debate over what is "fair" gets played out in the media without the subtlety that such a complex subject demands.
Lenders would benefit from a set of generally accepted criteria that define high-quality small-dollar loans. The criteria should be specific enough to provide meaningful direction, yet broad enough to promote innovation and competition, recognizing there are a variety of loan types that customers use.
We need to increase access to responsible, scalable and ultimately profitable forms of credit for households that need it and can benefit from it.
