Going under

TowerGroup’s Bobbi Britting discusses how financial institutes need to serve the underbanked market during the credit crisis.

“Underbanked and credit underserved consumers form a large portion of the US population”
-Bobbi Britting, TowerGroup

More than 100 million individuals in the United States today are considered unbanked, underbanked, or credit underserved. These people have no bank accounts or far fewer accounts than the average American. While the US economy is caught up in the current worldwide credit crisis and recession, some important questions arise: Are bankers even thinking about the underbanked? And why should they?

Underbanked consumers have traditionally relied heavily on a cash-based economy or alternative, nonbank providers of financial services to conduct their financial transactions, which are profiting nicely from these relationships. Traditional financial services institutions (FSIs) could be on the profit side of the equation, but to emerge from the current credit crisis, they will need to create the right products and tools for financially underserved consumers. For the most part, existing bank products, including loan underwriting processes, do not meet the needs of underbanked consumers and were not built with them in mind.

This population typically falls into one of three categories related to credit:

• No hits. These individuals have no record at traditional credit reporting agencies such as Equifax, Experian, and TransUnion. Approximately 20 million people in the US are in this group. Without a record at a credit reporting agency, they will nearly always be declined credit by a bank, thrift, or credit union and often will be unable to open a demand deposit account (DDA) or savings account.
• Unscorable. The unscorable population includes people with ‘thin’ credit files containing little or no credit history or payment data. Again, lenders won’t have enough data to score their credit worthiness and or make a lending decision. Consumers with thin credit files include young people who have not had time to build a credit history, recent immigrants who have been in the US only a short time, and others who are undergoing a life change, such as losing a spouse whose credit history was tied to theirs.
• Subprime. For each type of loan product, the exact definition of subprime will vary. In general, the subprime category includes consumers with unfavorable credit history based on credit bureau reports. More Americans are falling into this category because of their delinquent or unpaid credit balances, overextension of credit, and extreme factors such as defaulted loan accounts and loan foreclosures and because bankruptcy is becoming more prevalent.

The regulators and the underbanked
In 1977, the US Congress enacted the Community Reinvestment Act (CRA) to ensure that banks serve a greater portion of the population. The intent of the act is to encourage depository institutions to help meet the credit needs of the communities in which they operate, including low- and moderate-income neighborhoods. CRA does not require institutions to make high-risk loans that will jeopardize their safety.

Today, some would argue that subprime borrowers who benefited by receiving mortgages from lenders struggling to meet CRA objectives contributed to the mortgage crisis. However, a study released by the University of North Carolina at Chapel Hill’s Center for Community Capital on default rates among low-income and minority homebuyers notes, “Risky mortgage products, not risky borrowers, are the root cause of the mortgage default crisis." The study shows that mortgage borrowers with similar risk characteristics defaulted at much higher rates if they took subprime mortgages than if they took loans made under the auspices of CRA. Although not all consumers can afford a home, the actual mortgage product, features and underwriting guidelines are more the cause of the default than is the risk profile of borrower.

Banks may be missing an opportunity to serve and profit from the underbanked markets, but consumers are not going completely without financial services. Nonbank financial service centers (FSCs) and community financial centers (CFCs) operate nationwide in 13,000 - 20,000 physical locations today. Financial Service Centers of America (FiSCA), a trade association of nonbank FSCs, estimates that 30 million customers are being served annually through 350 million transactions representing more than $106 billion in various products and services.

According to a 2007 FiSCA key member survey, some notable volume estimates for products and services purchased at the association's member organizations included 137 million checks cashed, for $56 billion; 86 million money orders sold, with a value of $17.6 billion; 2.8 million prepaid value cards sold and $5.4 billion transferred to the cards; 32 million payday advances for a total of $13.2 billion; and 21 million wire remittances, with a value of $8.3 billion.

Check-cashing services and payday loans for small dollar amounts may represent the most abusive services to the unbanked and are the ones banking institutions have the greatest opportunity to disrupt. Numerous sources estimate total payday lending loans at approximately $40 billion annually. Although loan amounts range from $100 to $1,500, the average is just over $400 for the 100 million loans made annually.

How banks can compete for the underserved market
Traditional FSIs need to rethink strategies for attracting underbanked and credit underserved populations to compete with these other organizations. Accessing current practices and realigning their offerings with the needs and desires of the underbanked and credit underserved markets will be critical to garnering profitable market share.

To aid in reaching the underbanked, traditional credit reporting agencies are now providing a variety of risk models using nontraditional data to score no hits and previously unscorable files. New products typically try to emulate the efforts of traditional scoring models by rank ordering risk of an applicant, thus offering the ability to evaluate additional credit applications and increase the lendable population as well as support lenders' CRA initiatives and efforts to serve underbanked consumers.

In addition, a number of nontraditional providers have entered the market with new scoring products using nontraditional credit data to bring new risk management insights to FSIs.

To compete with nonbanks, traditional FSIs will need to expand their products' features and offer attractive intangible benefits to underbanked consumers. This population needs products and services tailored to their unique needs, preferences, and economic circumstances rather than "stripped-down" versions of those designed for more affluent consumers.

The volume of services being provided to underbanked consumers proves the market need, but some important features are typically missing from traditional FSI product offerings. Underbanked consumers need product features at no or low costs that help them avoid heavy expenses involved with financial transactions. These include access to small-dollar, short-term, unsecured credit; ability to build or rehabilitate credit histories; ability to transact in the internet (noncash) economy; immediate liquidity for paper checks, including shortening or eliminating hold periods; ability to pay bills at the last minute to avoid late fees and overdraft fees; wire transfer services; and low-balance checking and savings accounts with no or very low fees. Another feature not offered by or thought about at most mainstream FSIs is the ability to accept alternate forms of identification that are compliant with the USA PATRIOT Act, such as the Mexican Matricula Consular Card or the Guatemalan Consular ID card.

As important as responding to unique product needs of the vast array of underbanked consumers is, understanding other intangible characteristics of the market and meeting those needs as well. Factors include trust, which requires banks to show respect for the customer while offering acceptance and understanding customs and culture. Many underbanked consumers consider confidentiality extremely important, possibly because of a previous negative experience with a bank. Easy access to FSIs' locations in neighborhoods where consumers live and work and offices that are open at times allowing for nontraditional work schedules are also vital. To succeed in reaching underbanked consumers, FSIs need to provide services in the languages they speak as well as in English.

Conclusion
Underbanked and credit underserved consumers form a large portion of the US population, and although the world focuses on FSIs struggling through the credit crisis, innovative institutions will likely be positioning themselves to create new products and serve a greater portion of the population. They will make a full-scale evaluation of the market and address its unique needs where they operate. For lending transactions, a number of risk tools using alternative data elements not previously available for credit evaluation purposes can help FSIs ascertain the credit worthiness of credit underserved consumers. They also will be able to consider other aspects to attract this population, including office locations and hours, language barriers, marketing, account documentation and cultural traditions.

This article is based on research by the consumer lending service at TowerGroup, a leading research and advisory services firm focused exclusively on the global financial services industry. To learn more please contact service-info@towergroup.com.