Center for Financial Innovation and Stability

Notes from the Vault
Larry D. Wall
August 2017

The cost of obtaining financial services from nonbank providers can be rather high for those with low and/or volatile incomes. For instance, a payday lender typically charges about $15 to borrow $100 for two weeks. This works out to an annual interest rate of 391 percent.¹ The price for cashing a check at a check-cashing service depends in part on state regulations but will cost at least 1 percent of the value of the check or $1, whichever is larger.² Yet the nonbank firms or alternative financial services providers engaged in these activities tend to have high costs and are not necessarily highly profitable.³ This Notes from the Vault post first considers why the cost of some nonbank providers is so high. It then discusses some ways that financial technology firms are working to lower the cost of financial services as well as some of the issues faced by these firms and their customers.

Alternative financial services providers
Most U.S. citizens rely primarily on a federally insured commercial or savings bank, or on a credit union, to obtain financial services. However, some people rely on nonbank alternative service providers for some or all of their financial services.⁴ The focus of this post is on a subset of these services: check-cashing, payday lending, and related services. Check-cashing services convert checks into immediate cash for a fee and often provide related fee-based services, including money orders and electronic bill payment. Payday lenders provide an immediate loan in return for the borrower providing a check or debt authorization that is postdated to the borrower's next payday. Alternatively, individuals may borrow at a lower but still relatively high interest rate from pawnshops and auto title lenders by providing the lender with collateral. These lenders typically offer loans for only a fraction of the item's likely resale value and will sell the collateral to a third party if the loan is not repaid.

The potential for technology to reduce costs
Although checking-cashing services and payday lending seem relatively expensive, the fact that some consumers nevertheless use them suggests that the package of services they provide is perceived to be more valuable than more conventional alternatives. University of Pennsylvania Professor Lisa Servon worked for both a check-cashing firm and a payday lender to gain a better understanding of what motivated their customers to use these services.⁵ In an interview, Servon gave three reasons why individuals use check-cashing services: cost, transparency, and service. She gave an example of someone looking to cash a check on Friday to obtain money needed that weekend. A bank would charge a lower fee, but it may not provide access to the funds until the following week. In this case, the benefit of having the funds before the weekend may significantly outweigh the higher fee charged by a check-cashing firm.

The cost and transparency reasons also work together in important ways. Servon observed that the fee structure in a cash-checking firm was prominently displayed as in a fast-food restaurant. Given that these check-cashing and bill-paying services are cash based, an individual knows exactly how much money he or she has in hand at any moment and exactly what the fees are to obtain a particular service.

In contrast, reported bank balances are generally not reliable indicators of how much money is available to an individual, and the fees at a bank can rapidly add up if the customer unintentionally overdraws the account. The funds available to a consumer often differ from bank balances both because check deposits may not always be available for immediate withdrawal and check payments generally not immediately deducted from the payer's bank account. In terms of the importance of service, Servon observed in an article that the "glue" at the check-cashing firm she worked at was "the customer/teller relationship." Indeed, she noted that the tellers often received tips from their customers for providing good service.

Still, these services come at a cost that translates into an especially high percentage of the value of these transactions. Comprehensive data on the costs of check-cashing, payday lending, and similar services are not available. However, University of Florida Professor Mark Flannery and Federal Deposit Insurance Corporation economist Katherine Samolyk were able to obtain data from a sample of payday lenders in 2002, 2003, and 2004. Their paper found that the average loan at a mature store (which they define as open for at least four years) was $230, had an average maturity of 14 to 15 days, and was associated with average store operating expenses (wages, occupancy, advertising, other) per loan of $19.08. The arithmetic of such high operating costs to provide such small low-dollar value, short-term loans is brutal. Given these operating costs and loan terms, a lender needs an annualized interest rate of over 200 percent just to cover the store's operating expenses. A much lower spread would be needed to cover operating costs for a larger dollar amount spread over a longer period. For example, the added interest needed to cover those same operating costs on a $1,000 loan with a one-year term would be less than 2 percent.

The application of finance technology provides a clear opportunity to reduce the operating costs of providing these services for low-dollar amounts. Providing these services electronically allows for increased convenience with services available at all times from any location where the consumer can access the Internet. Moreover, the shift to electronic access can potentially allow for a large reduction in operating expenses. A recent speech by J. Michael Evans, president of Alibaba Group, the Chinese e-commerce company, gives an extreme example of the potential for cost reduction. He noted that Ant Financial, an online financial services provider in China, requires only a minimum deposit of $0.125 in its interest-bearing money market account and that the fund's average account size is $8.⁶ Evans explains that one of the main reasons Ant Financial can profitably provide such low-balance accounts is, "If there are no people required…you have almost zero costs."

The application of technology also provides for the potential of faster payments settlement and clearing, which would help make reported bank balances more accurate measures of a consumer's financial position. The Federal Reserve's Fed Payments Improvement project is working with industry to encourage the use of technology that would speed up the U.S. payments system.

Unfortunately, the problem of reducing the costs of obtaining financial services goes beyond the mere application of technology to reduce operating costs and payments speed. Payday lending has expanded from relying on high-operating-cost storefronts to providing credit online. However, the move online has not necessarily improved the terms, according to a report by Nick Bourke, Alex Horowitz, Walter Lake, and Tara Roche of Pew Charitable Trusts. The problem is that many consumers who turn to alternative financial services providers do so because they are perceived as high-risk customers for bank deposit accounts and loans. Thus, reducing the perception and reality of that risk is an important element in reducing the prices these consumers pay for financial services.

Some fintech solutions
A variety of fintech firms have developed innovative ideas that show what can be done with technology to help people dealing with financial problems better manage their money and become less risky. This section highlights some of those services, drawing on recent discussions of selected products by Wall Street Journal reporter David Wessel, the venture capital firm Life SREDA, and a more in-depth analysis of some product categories by Todd H. Baker, managing principal at Broadmoor Consulting LLC. As an important caveat to the discussion in this section, the following references to individual products and companies are intended merely to highlight what is possible with fintech and do not serve as endorsements of individual firms or products.⁷

One problem that some individuals have with bank accounts is simply understanding their current position well enough to avoid both bank overdraft fees and late charges from other service providers. The app Prism from Prism Money seeks to solve these problems by collecting information on bank accounts and monthly bills in one place to help users track their positions. Additionally, the app lets users know when a proposed payment will trigger an overdraft fee or failure to pay will trigger a late fee.

A step beyond helping consumers identify their current position is to help them understand how their finances are likely to evolve. The app Digit from Hello Digit Inc. not only analyzes income and spending patterns to forecast an individual's financial condition but also uses that information to determine how much money can be safely moved from a transactions account to a savings account.

For many low-income individuals, a major problem is the volatility of their income, such as may arise from changes in their weekly work schedule at a job that pays an hourly rate. The firm Even offers a pay protection feature that smooths out income, advancing money during the bad weeks and repaying the advance from the good weeks. Individuals may purchase this service but most users receive it as a benefit from their employer.

The above services help individuals manage their assets and smooth their income, but they do not provide loans other than as needed for income smoothing. One approach to helping consumers obtain credit is to develop alternative credit ratings that rely on measures of financial responsibility that are not incorporated into traditional credit scores such as Fair Isaac Corporation's FICO score. An article by Let's Talk Payments writer Elena Mesropyan provides a brief overview of a number of alternative credit scoring firms, including Atlanta-based Factor Trust.

Some firms not only use alternative data to develop their own credit risk measures but also provide short-term credit to consumers with impaired or no credit rating. These firms often take account of information not used in traditional credit scores. For example, Ashley Dull of badcredit.org reports that Lenny Credit takes account of a person's background and earnings potential. Additionally, these firms typically help consumers improve their traditional credit rating and provide for reduced rates as their ratings improve.

Some challenges for fintech firms and their customers
Although fintech has substantial potential to lower the cost of financial services to many lower-income and credit-constrained consumers, there are various challenges to both the providers and consumers of these services. Baker (page 53) discusses some of the barriers faced by fintech firms that seek to serve low- and moderate-income consumers. For example, a fundamental problem with fintech firms that help consumers manage their financial affairs is the challenge of "accessing sustainable sources of revenue," given that they typically do not charge consumers for using their service. He suggests that this problem is likely to lead these companies to combine with other financial services providers. Another problem Baker identified for firms that directly lend money is that most of them have not been in operation through a full business cycle. Will these firms be able to obtain funding during a period of high default rates and loan losses?

Similarly, potential consumers of these services face a variety of challenges. The first is that most fintechs' reliance on online rather than physical connections is a critical element of holding down costs. But such reliance on the Internet implies that their customers have access to the Internet and in most cases to a mobile device. Although access to the Internet and mobile phones is not universal, the Federal Reserve Board's report "Consumers and Mobile Financial Services 2016" finds that a large fraction of unbanked and underbanked consumers have access to a smart phone or at least to a mobile phone.

A second challenge is these services are generally designed to help consumers manage their financial affairs in a way that leads them to a more secure financial position. However, these products are likely to be of less help to consumers who are hit by major adverse shocks such as job loss or large medical expenses, especially in the period where these consumers are still building toward a more secure position.

Beyond that, the potential consumers of these financial services face the same problems as any individual seeking to use a new financial service provider. Is this provider trustworthy? Is this provider dependable in the sense that it will remain in operation? Is the product reliable, or is it prone to crashing at inconvenient times?

One final consideration is that these products are unlikely to work for everyone and those left behind may end up in even worse condition. For example, the rates charged for credit products, such as payday loans, depend in part on the average loss experience of such borrowers. To the extent that the lower-risk borrowers use fintech products to obtain a more secure financial position, these borrowers should qualify for lower-rate loans. However, the average credit losses from the remaining pool of borrowers is likely to go up and with it the average loan rate that lenders will need to remain profitable.

Conclusion
Individuals with low and variable income, and with low credit ratings, often obtain essential financial services at prices far above those paid by more financially secure individuals. A variety of fintech firms are offering products that help these individuals better manage their financial affairs and help them improve their credit ratings. These products offer the potential for reducing the prices paid by many individuals to obtain financial services. However, both these fintech firms and their customers face some challenges in reaching the full potential of this technology.

Larry D. Wall is executive director of the Center for Financial Innovation and Stability at the Atlanta Fed. The author thanks Scott Frame for helpful comments. The view expressed here are the author's and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. If you wish to comment on this post, please email atl.nftv.mailbox@atl.frb.org.

_______________________________________

¹ The figures are from a Liberty Street Economics blog post by Robert DeYoung, Ronald J. Mann, Donald P. Morgan, and Michael R. Strain.

² An article by Deborah M. Figart and Thomas Barr discusses the maximum rates allowed by state regulations.

³ For example, a study by University of Florida Professor Mark Flannery and FDIC economist Katherine Samolyk and a study by Aaron Huckstep of Moss Adams LLP document the high cost of providing payday loans. The evidence on profitability is not as strong. Former Yale law Professor Peggy Delinois Hamilton asserts that check cashing is "highly profitable" based on a return on equity of 9.06 percent on average for 2005 and 2006 for two firms that were publicly traded at this time, but the average commercial bank return on equity exceeded 10 percent during this time period. Additionally, both of the cost studies provide evidence on overall profitability. However, all three of these studies date to the early 2000s and rely on relatively small samples, in part because many of the firms offering these services are privately owned.

⁴ A primer from the Federal Deposit Insurance Corporation (FDIC) in 2009 discusses a variety of these services.

⁵ See Sevron (2017) and an interview by Dave Davies.

⁶ The discussion of Ant Financial money market accounts starts at about 23:10 and ends at about 27:10 of Evans's speech to FinTech@Princeton 2017.

⁷ I have not tested any of these products nor evaluated them relative to comparable products offered by other firms. Moreover, some of the firms and products discussed may no longer be in operation, while others may have expanded the functionality of their products.