What Financial Service Providers
Can Learn from Payday Lenders

Joe Coleman summed up these differences to Servon by pointing out the basic difference in business models between banks and check cashing stores. Banks make money by collecting as much in deposits as they can and investing that money. That makes them most interested in serving customers who can deposit large amounts of money. Their business model makes it too expensive for them to serve people with low balance accounts and lots of transactions. Forced by regulators to provide accounts for all, they find ways to ding these people with multiple fees to generate more income. (In her research Servon found that, up until it was outlawed by regulators, many banks deployed software that would time the order in which they processed checks so that they could maximize the amount they earned in overdraft fees.). In contrast, check cashing stores build their business model on multiple small interactions with the same people. Repeat business is important to their bottom line, so they treat their customers well. They earn small amounts on every transaction, so they want to process as many transactions as possible.

And What About Payday Lenders?

Since New York does not allow payday lending, Servon went to Oakland, California to work in the Check Center chain of stores. There she saw the value and the dangers of this type of lending. The customers who came to the payday lenders either had very low credit scores or no credit score at all. Living paycheck to paycheck, they had no other alternatives when hit with an unexpected bill, like a car repair or a child's hospital fees. On the other hand, the payday lending model often trapped their clients in a debt cycle. They provided emergency cash when needed, charging a large fee for the service. The loan terms require the full amount to be repaid within a month, but few clients can earn enough in a month to pay their own ongoing expenses and the full amount of the loan. They roll over the loan, paying the fee again for each month they extend the loan. This works out to an average APR of 300 to 600 percent. Just paying the interest becomes a burden for many clients.



As Servon talked with the people who took out these loans, she learned why someone would be willing to pay that amount. When your car breaks down and you need it to get to work, do you take out a high-priced loan to get it fixed, or do you risk losing your job? People living paycheck to paycheck have few other options for dealing with an unexpected cost. In some circumstances, when a loan helps a person keep their job or restore their health, the benefits of the loan can outweigh the costs. However, Servon cites a study that 69 percent of payday loan borrowers use their loans to pay regular expenses like food, rent or a utility bill. In these cases, the high costs of the loans can lead to a debt spiral that leaves the borrowers much worse off than before.

The payday lender that Servon worked for ran a reputable business, looking out for its clients as much as possible, while still charging enough to make a profit. Servon wanted to learn more about the disreputable part of the business, so she worked on the Predatory Loan Hotline for the Virginia Poverty Law Center. She received calls from clients complaining about being hassled by companies that they had never heard of, telling them that they owed large amounts of money. Many of these companies had direct access to their bank accounts, and would take money out whenever they could, often leading to overdraft charges for the client. The clients felt like they had paid off their loans long ago, but they still saw regular withdrawals from their account.

Servon learned some of the shady tricks of the online lending business. Lenders would sell their loans to collectors, with contracts that said they were not liable for any misinformation in the lists that they provided. Collectors would sell their list to other collection agencies, while sometimes continuing to attempt to make collections themselves. A person could end up with several different debt collection companies pursuing them for the same loan. Servon would explain to the callers what they could do to stop the money coming out of their account (which basically required closing that account and opening one in another bank).

Changing for the Better

Next Servon met with some of the disrupters in the financial services industry, app developers and alternative finance providers that target the market that does not get good service from banks. These included those that offer new loan products to replace the need for payday loans (Opportún and Fenway Summer), a credit scoring model that works for those with low and irregular incomes (L2C), a system that moves money immediately in real time and thereby eliminates waits on check clearing (Ripple), and a program that formalizes the rotating credit and savings system in a way that provides a credit history for participants (Mission Asset Fund). Servon noticed two key differences between these innovators and other financial institutions. First, solving a social problem served as their primary motivation, rather than making lots of money. Second, many of their leaders had spent a part of their lives living with financial uncertainty. They viscerally understood the predicaments of the people they sought to serve.



Servon sums up what she learned about providing financial services for the marginalized and the financially insecure like this:


As I read the book, I thought about how Servon’s observations were true for those that live with insecure financial means in other countries as well. Banks have long operated with business models that do not serve those whose incomes are small, irregular and unpredictable (as Rutherford et. al. describe in Portfolios of the Poor). Which begs the question, why are we measuring how many of these people are unbanked? Why does the World Bank measure its Universal Financial Inclusion Goal by the percentage of adults who have accounts in a regulated financial institution? As Servon says "The problem is not that people are unbanked, but that they lack high-quality, affordable financial services and the resources to attain the stability that once defined what it meant to be middle class." Our goal should be that all people have access to financial services appropriate to them, not that they all have accounts in banks that have no interest in serving them.

Servon comes up with some recommendations for how the US could make its financial system more useful to those with low, irregular and unpredictable incomes.

• Change the relationship between banking and government – If banks do not find it profitable to serve low income customers, the federal government could either:
  
  
  1. subsidize banks for the cost of providing accounts to these clients;
  2. provide regulatory and financial help to banks that focus on this client segment as part of their mission; and/or
  3. allow post offices to also provide financial services, as they did for fifty years in the early 20th century.
• Enable better financial decision making – Create clear standards for disclosing fees and charges for financial products, rate banks on how safe and affordable they and require banks to put their rating in their windows and online, create a system where each person has control over their own, unique financial identity, provide financial coaching for those who need help to access financial services.


• Create a sandbox for innovators – The high cost of complying with government regulations prevents many innovators from turning their ideas into new companies. The US could follow the example of the UK Financial Conduct Authority, which has created a “regulatory sandbox” where businesses can test new products without being subject to all the financial regulations that might apply. This allows reduces the time and costs of developing and testing a new product, giving innovations space to prove their value and attract the funding they need to expand.

Those with small incomes need financial services even more than wealthier people do. They often live on the margin, and need safe places to save and loans to help them when they experience financial emergencies. They need to have financial services that let them build relationships of trust as they transact in small amounts. Banks want customers that transact in large amounts and leave large sums on deposit. Businesses can be profitable serving those with small and irregular incomes, but they need to focus on a long-term relationship with customers who transact several times a week, earning small amounts on each transaction.

Because financial services make such a difference to those with low incomes, and because few businesses compete for this business, those who do hold great power over their customers. As Servon shows, many times the payday loan providers use this power to extort their customers. This part of the market needs a regulatory framework that provides flexibility for new types of businesses to serves these customers, increasing the level of competition between providers. At the same time, this market also needs regulations that prevent common abuses, preventing businesses from trapping their customers in debt or abusing them in the collection process. Financial services targeted for those with small incomes is a market ripe for social entrepreneurs who want to help solve a social problem – the huge cost of financial services to those living in poverty.

Your Thoughts

What do you think?

• Do you think check cashing stores and payday lenders exploit people in poverty or provide them with a needed service?
• What should financial regulators do to encourage businesses to serve this segment of the market, while also preventing exploitation?
• What businesses do you know that do a good job of serving clients with low and irregular income?

Give your answers in the comments section below.