Looking beyond overdraft, the general direction of product development for small dollar liquidity will center on new forms of unsecured credit. Are banks ready?
Within U.S. consumer financial services there is a large, under-served need for small dollar liquidity — short-term credit for purchases or bill payment that is not fulfilled by conventional financing products such as credit cards and installment loans. Examples of current liquidity products that help to bridge contingencies and monthly cash flows include checking account overdraft, traditional payday loans and the like, and recently a host of innovative and largely non-bank offerings.
Banks have relied almost exclusively on checking account overdraft for this segment, which is centered on people who either do not qualify for conventional credit products or do not ordinarily use them. Overdraft usage has slumped under the weight of opt-in and other regulation, suffering a 45% revenue decline since the peak year of 2008, with the potential for renewed slippage as Washington considers additional prescriptive controls. Yet overdraft still constitutes an $18 billion annual business for banks and is valued by remaining users, so industry executives are right to focus on preserving what remains — but only partially.
At many banks, fixation with the checking overdraft product — which serves only a portion of segment need in a limited fashion — is diverting attention from a pressing innovation challenge in small dollar liquidity. Looking ahead, the question is how to expand consumer relevance and also meet the competition in an increasingly electronic financial services market where niche players have an edge. Research-based innovation, unfamiliar though it may be for this market segment, must be on the agenda for banks committed to moving ahead.
Beyond overdraft, the general direction of product development for small dollar liquidity will center on new forms of unsecured credit. This presents numerous questions regarding product design, marketing and distribution, underwriting and credit risk management, and reputational risk. Yet banks have enormous advantages arising out of the checking relationship, such as ease of customer access, an abundance of data, and the ability to attach products to the checking account as “features” or as part of a package. Also there are possibilities with merchant alliances; bringing new small-dollar financing options to the point of sale; mobile/online offerings; and teaming up with a niche player in online unsecured lending.
In exploring the possibilities, there are four development factors for new products, including: 1) consumer awareness and timely ease of access within purchase and payment transactions; 2) friction-free application and a balanced approval process that engages customers in effective but diplomatic ways; 3) flexible repayment options that will broaden the customer base and help responsible users to build their credit scores; and 4) cost and usage controls that protect consumer interests while preserving maximum product utility (Figure 1: Critical Product Attributes).
It is a complicated challenge to be sure, yet increasingly unavoidable. With even more regulation under active discussion, banks cannot afford to freeze and simply watch their overdraft franchise dwindle away. In the face of likely innovation and potential regulation, the erosion of overdraft volume and profitability could easily accelerate. By working on new alternatives now, banks can expand the reach of their offerings today and also avoid getting caught flat-footed in a future worst-case scenario where overdraft service loses all viability.
Customer Demand and Disruptive Innovators
Customer demand for alternative credit is strong and will remain so, reflective of financial circumstances that leave many households living from paycheck to paycheck. According to a survey by Bankrate Inc., 38% of Americans do not have sufficient funds to withstand a $500 emergency. The fallback is subprime unsecured credit, a broad category that includes overdraft, some types of credit cards, payday loans and even pawn services. According to the Center for Financial Services Innovation and Novantas analysis, this market supplies more than $100 billion of contingency/cash flow financing to consumers annually, generating more than $30 billion of fees and interest charges.
From the consumer perspective, checking overdraft remains a preferred solution. A Novantas national consumer survey found that even when fully informed of liquidity alternatives and their comparative costs, overdraft users still assign top preference to that service to meet cash contingencies. And fee levels for overdraft placed a distant seventh in a shopper ranking of checking features. Clearly there is consumer segment in need of short-term liquidity, and overdraft satisfies a significant portion of that segment.
But from a regulatory perspective, overdraft falls into a category of “single-payment” credit products — including bank deposit advance services and non-bank payday lending (both in person and online) — that have been targeted for constraint. Federal and state regulatory pressure is so intense that all of these credit options have lost momentum. As summarized by the Center for Financial Services Innovation, “The downward trend for single-payment credit is due in large part to regulatory actions that have: 1) curtailed online payday through the Justice Department’s Operation Choke Point; 2) largely eliminated storefront payday in states with strict regulations; 3) slowed the uptake of overdraft services through opt-in requirements in Regulation E; and 4) led to the discontinuation of deposit advance services following FDIC and OCC guidance.”
In their place, various flavors of short-term credit with expanded repayment options and low balance ceilings are on the rise. These include subprime credit cards, various kinds of micro installment loans offered online or at the point of sale, and rent-to-own arrangements.
The electronic marketplace is the locus of innovation, attracting both balance sheet lenders and marketplace lenders that concentrate on origination and sell their loans to banks and hedge funds directly or via wholesale platforms. Non-bank players see particular advantages in the online/mobile space because there is no branch network overhead and less of a regulatory burden (although that could change).
Disruptors are re-imagining convenience in small dollar liquidity. Operating without geographic constraints, they are able to target customers with the best risk/return characteristics — without fear of cannibalizing established products.
While not all players strictly target the sub-prime market segment, the variety of competition underscores the innovation intensity in the marketplace. Domestically:
- Paypal no longer confines itself to pass-through billing for purchases, but instead has launched its own lending service, PayPal Credit, “the simple, flexible credit line built into your account.”
- LendingTree, an online service that allows loan applicants to seek offers from multiple participating lenders, is seeing a surge in nonbank personal loans to subprime borrowers.
- Goldman Sachs is building a consumer online lending business that will “offer loans of a few thousand dollars to ordinary Americans and compete with main street banks and other lenders.”
Along with domestic competitors, dozens of international players reportedly are working to bring new small-dollar credit and payment services to market, often targeting consumers who have only loose ties with the banking system. As a single example, Hamburg-based Kreditech Group specializes in micro-finance for online and mobile users, relying on big data and device-usage screening algorithms to underwrite customers — even without bank accounts or credit scores. Underscoring the substance of this effort, Kreditech has raised more than $300 million of debt and equity financing since its founding in 2012.
While competition from niche players is real, banks have a continuing advantage in building and leveraging fuller customer relationships. But product innovation in this space presents many new questions.
The simplicity and product advantage of overdraft coverage is that it requires no further thought from consumers once they have opted in to the service. In the small dollar loan market, by contrast, consumers have many ongoing options. Competing products are often handicapped by limited consumer awareness, moreover, and they often pose substantial requirements for signing up. New offerings will not succeed unless they win customer attention and usage — not just from former regular overdraft users, but from a broader mix of consumers in need of small dollar liquidity.
The situation calls for a blended developmental effort that considers a host of factors: borrower purpose, the channel and point of sale circumstances, the need for highly streamlined application and approval, curbs on borrower over-extension, and the potential for relationship expansion over time. One immediate implication is that while the erosion of checking overdraft may have provided the impetus for action, new alternatives will require a team effort that extends well beyond the checking product group and into consumer lending and merchant payments.
Awareness and Access. Before consumers can request a solution they need to be made aware of it, either before or at the time of need. In some cases this will mean marketing pre-approved micro-credit, linked either to a bank account or a card. In other cases it will mean bringing a bank-supplied financing option to the attention of the customer midstream in a transaction. In still other cases it will mean providing credit availability among consumer-selectable groups of merchants.
Micro-credit options must also be easily accessible within the context of transactions. Some depository institutions are already taking tangible steps to widen micro-credit access, with many more likely to follow. For example, Synchrony Bank (formerly GE Capital Retail Bank) invites website visitors to click on a particular needs category, such as auto parts, electronics or sporting goods, and then “apply now” for a card that will be accepted by all of the merchants enrolled the category.
Application and Approval. Inside the bank, a companion effort is needed to come up with a fluid application and approval process for small dollar credit. The goal is to expedite the transfer/capture of salient information, provide a rapid-yet-analytically-sound response, and do so in a way that addresses customer and regulatory sensitivities.
Small dollar loans require a different application dynamic for customers seeking instant approval and funds access. Consumers pressed for liquidity are not shopping for a loan, but trying to solve an immediate cash flow need.
On this score banks are uniquely positioned to respond to current customers. Unlike niche players, banks have customer profiles and financial histories to draw upon in assessing creditworthiness. In this vein, with “just six taps on the mobile app,” members of the Washington State Employees Credit Union can get a 60-day loan of $50 to $700, or a nine- to 36-month loan of up to $4,000, with the funds linked to WSEC customer accounts upon application approval.
We continue to believe that banks could make much greater use of customer information in credit origination. In a small dollar online/mobile offer, for example, an application could be pre-populated and also pre-scored, ready for customer review and completion via electronic signature. Applicants simply have to validate information that the bank already has on file.
At the point of sale, it is the merchant providers who have an advantage in gathering information for credit applications with purchasing customers. By contrast, new online entrants are disadvantaged in the quest for rapid responsiveness with new credit applicants because they have less customer information to go on. Banks also have a harder time when serving consumers they have not previously done business with.
In terms of approval, our research in checking overdraft service and among consumer finance companies reveals that fear of embarrassment over a potential rejected application prevents some consumers from applying in the first place. The situation could worsen under proposed regulations that would require a formal credit bureau review even for small-dollar applications. In a fail situation, not only are embarrassed applicants denied credit, but rejection incidents could also further impact their credit scores.
One response is to limit the visibility and usability of contingency liquidity options to only those consumers who have been pre-qualified. Disruptors have other workarounds, such as facilitating personal loans among family members and friends, as seen at ZimpleMoney (although applicants still may be uncomfortable asking for help).
Terms and Usage. Beyond the hurdle of getting consumers interested and successfully enrolled in new products, developers face a series of questions about terms and usage. One consideration is credit enhancement and repair: establishing workable repayment arrangements that will assist consumers in managing their finances and help to strengthen credit standing over time. A second consideration is the type of credit facility best offered in various situations: installment versus revolving. Third, a balance must be struck between ease of application and approval and the prevention of over-borrowing.
1) Credit standing — Many of the consumers who have participated in our research in this space say they are eager for solutions that will help them either build or repair their credit rating. Checking overdraft has a drawback in this particular aspect. Though meeting emergency funding needs for a wide swath of consumers, overdraft service does not fall into the category of products tracked by credit bureaus, which in turn do not impound successful overdraft repayment into credit scores.
Non-bank players have come up with a variety of forms of manageable alternative credit that helps consumers build a record of responsible repayment:
Verizon Wireless offers installment credit for items such as smartphones and tablets (usually under $750), allowing customers to upgrade their devices while stretching out repayment terms over the life of a service contract. By virtue of its control over customer access to telecommunications, it has an added measure of security in extending credit down-market.
Lending circles, such as Harlem Congregations for Community Improvement Inc., provide joint savings and lending programs that allow participants to sequentially access small dollar loans drawn from a pool that is funded by monthly payments from all group members. Both SmartPayLease and ZimpleMoney supply reports on payment timeliness to credit bureaus with appropriate formality, benefiting responsible users.
2) Credit terms — While revolving and single-payment credit facilities likely will continue to anchor the market for small dollar credit, banks in particular may find traction with small-dollar installment loans (roughly $500 to $1,500), currently an overlooked and under-served portion of the market. By providing qualified current customers (a key requirement is skilled screening) with quick access plus a longer and more manageable repayment timeline, installment credit has the potential for broad appeal. Some portion of this business could take the form of secured loans, with monthly payments debited to the active checking account to ensure regular repayment.
3) Credit controls — Regulators and commentators in this space have focused on reputational issues associated with small dollar lending programs, pushing providers to make a stronger effort to contain the cycle of consumer dependency on emergency funding and exposure to fees and interest expense.
The audience for easy access small dollar credit is limited to begin with, as not all applicants qualify, and regulatory pressure likely will further restrict eligibility. And while innovative niche alternatives (co-sponsored credit, lending circles) do help more consumers to qualify for credit, they have their own constraints.
To promote convenient access and rapid approval while maintaining careful boundaries, one workaround is to tightly restrict the initial credit facility, with possibilities for higher balance limits and longer repayment terms as consumers demonstrate responsible usage. Some subprime card offers and online niche players limit the initial facility to $500, for example, accompanied by text alerts and other information tools to help customers stay mindful of account status and usage patterns.
U.S. banks are facing challenging conditions in serving the market for small dollar liquidity. On top of the regulatory crunch on checking overdraft, the market itself is shifting as nonbank entrants focus on the online/mobile space. U.S. banks cannot afford to sit still. Difficult though it may be, product innovation is a growing necessity in the market for small dollar liquidity (Figure 2: Key Considerations in Product Innovation).
The journey begins with a detailed examination of customer needs, profiles and usage cases, backing into general value propositions. Three major examples include: 1) bill payment deferral, to provide payment flexibility for qualified bill pay transactions; 2) purposeful installments, to provide funding access without the slippery slope of revolving credit; and 3) leveraging assets for liquidity, including loans against bank account balances without depleting them.
In mocking up specific offerings, development teams must consider key questions such as product positioning, credit structure, transaction proximity, repayment terms and pricing. Then there are go-to-market questions such as delivery channels and the terms of credit availability. Interwoven throughout are questions about product economics and risk management, competitive distinctiveness, reputational risk, regulatory compliance (both in the current and emerging environment), and potential spillover effects on other established products.
The good news is that banks bring distinctive strengths to this effort, in particular customer engagement through checking and distribution channels (online, mobile, etc.), not to mention capital, which remains challenge for many of the disruptors in this space. The problem is that many institutions are stuck in a mindset of revenue replacement rather than market development.
Most start the small dollar lending exercise by examining how to appeal to existing users of overdraft — rather than the market opportunity to satisfy these needs more broadly and at a competitive price for the risk. Success lies in appealing to a broad spectrum of customers for whom price is not the only consideration.
At least a few major regional banks have gotten off the starting line, mocking up a series of product hypotheses and pilot-testing some of the stronger candidates. Many others are either hanging back or focusing too narrowly.
The opportunity to serve will not go away, given the ample evidence of continuing customer need. Players can either get in the game with product innovation or lose share to progressive competitors and non-bank entrants.
Hank Israel, Brett Friedman and David Shimko are Directors in the New York office of Novantas Inc. They can be reached at email@example.com, firstname.lastname@example.org, and email@example.com, respectively.