When we come out the other side of this difficult macroeconomic environment, it is important to think about what kind of world we want for consumers, for the financial industry and for government policy.
Access to credit for consumers is one important component.
Last week my organization, the Center for Financial Services Innovation, with the Pew Charitable Trusts and the New America Foundation, hosted an event highlighting the need for new, safe and affordable credit options for consumers and the important roles both the federal government and the financial services industry can and must play to ensure consumers have such options.
For the 100 million underbanked consumers, access to these financial products and services at an affordable price has always been challenging. We found that more than 28% of underbanked consumers borrowed money. A significant amount of that borrowing was for emergencies or living expenses. For example, the car breaks down or there's an unexpected medical expense and there just isn't any money in the bank.
Many of these underserved consumers lack credit scores, so they do not have access to credit cards or other mainstream lending products.
With no reasonably priced alternatives, costly payday loans or overdraft fees may be the only option. Others choose to go this route, preferring alternative providers to banks.
The need for short-term, small-value credit will continue to grow at the same time that consumers have fewer affordable credit options. Well-intended consumer protections are complicating things further. More states are introducing interest rate caps, often at 36%, to curb high-cost lending products. An unintended result is that online payday lending is a booming business.
What's needed?
Consumers need access to high-quality credit products that help them when necessary bridge one paycheck to the next and handle emergencies, while also helping them save money, so they are in a better financial position and can, ultimately, achieve financial prosperity.
While the definition of high-quality credit products will continue to be debated, at the end of the day quality, responsible products will share some common features. They will:
- Meet consumer needs.
- Be transparent and easy for consumers to understand.
- Be fairly priced and offered according to an affordability test.
- Help consumers build credit and learn more about how to use financial products successfully.
- Have solid underwriting.
Banks and other financial institutions will need incentives to offer these products. Currently the reputational risk is too high for many institutions to offer quality small-value loan products at prices that cover their operational costs and reasonably compensate their risk.
One potential incentive would be for the federal government to create a loan guarantee program to support the extension of credit directly to underserved families. Banks, credit unions and responsible small-dollar lenders following certain loan standards would have access to these funds. For banks, this fund should be a portfolio guarantee, not a guarantee for the entity.
The lending institution should be required to bear the first dollar losses on the loan; if we've learned anything from the subprime crisis it must be lenders need to have some skin in the game. Their loss exposure would be limited to a certain percentage of the principal balance due to the guarantee.
The guarantee fund should be a short-term program, not a long-term solution. We need to jump-start innovation to meet consumer needs. Smaller nonbank innovators need help to turn a corner and get to scale.
New market entrants, including banks, need reputational cover for product offerings.
A fundamental question is why financial institutions should receive special funds to do something that arguably they should already be doing. Why isn't the answer just to mandate high standards for small-value loan products?
The business model for small value consumer credit is already incredibly challenging. That's partly why we don't see an abundance of products in the marketplace. With the Credit CARD Act, the industry is already raising the concern that credit is being more restricted, and we've seen costs of credit going up. Without solid options, consumers' lack of access to quality products will be further exacerbated or some lenders will find ways around the regulations. More people will be forced to choose high-cost credit.
If banks do not choose to lend directly, they should be offered carrots to lend indirectly, including but not limited to CRA credit. Banks can lend money to innovative, reasonably priced nonbank lenders, providing necessary lending capital to bring these models to scale.
Consumer credit is only part of the answer. Consumers also need adequate income and savings and access to relationship-based financial products and services. Efforts to encourage credit access should also take into account how financial institutions are responsibly meeting the other parts of customers' financial lives. This requires that consumers, the financial services industry and government are all working toward this common vision.
