Failures of Basic Financial Services

The Federal Reserve held a conference in April on research in community development. There were several papers on payday lending, tax refund anticipation loans, prepaid cards and other forms of credit. These non-traditional sources of loans may at first blush seem illogical: Why would someone borrow next week's paycheck for a $30 fee when that amounts to a 360% APR on an annual basis? Or borrow their tax refund in October at a cost of nearly $100 for $1500 in 5 months. Why opt out of checking accounts and use higher cost prepaid cards?

The answer it seems, at least in part, is that people are not well served by financial services and using what is available to as best they can. Jennifer Romich and colleagues followed a small group users of prepaid cards using details interviews. It turns out these consumers liked the limits on prepaid cards and generally eschewed conventional checking accounts because they had been burned in the past. Checking accounts have fees on low balance accounts, charges for check printing and from the perspective of these consumers, banks just seem to be out to get them. For people with just enough income to get by several checks may go out that come close to overdrawing the account. Banks generally will cash the largest check first, bouncing several smaller checks. Consumers see this as capricious and vindictive. So they opt out of the system entirely.

Angela Littwin used similar methods to look at high cost credit cards used by low-income women in Boston. In part because Boston has few short term payday loan options (regulations largely ban these loans), credit cards are a key source of credit. Low income families use credit cards as a form of an emergency fund. But they report being frustrated as the card issuer periodically 'gives' them more credit; they feel they would be better off without the option to borrow more. The author suggests new forms of credit cards with simple fees and low balances that the consumer affirmatively selects--and they can set limits on their own use.

Jeremy Tobacman and colleagues look at pay day loans and credit card use. The authors note many payday loan users actually have credit available on their credit cards, yet still use high cost payday loans. They also find that the use of a payday loan is a precursor to credit card default. Thus consumers may be using payday loans because they know they are in financial trouble. The costs of over charging a credit card and/or late fees or even carrying debt over time on a card are such that consumers are allocating their credit across all available options.

One other paper from the conference that is relevant to this discussion is by Peter Tufano and colleagues. They look at income tax filings and clients using advance refund loans. They then track how clients use their refunds among those who took their refund on a stored value card. The #1 item for which the funds were used? Groceries. For many the purchase happened immediately--within a few days. Less than 10% appeared to buy big items or consumer durables (the stereotype of buying a flat screen TV).

These are all insightful papers and deserve more attention than the few sentences offered here. The overall picture these papers paint is that consumers do make mistakes and suffer from mis-information. But they also are doing the best they can with the tools they have available. And it seems many see mainstream banking-- checking accounts and credit cards-- as more trouble than they are worth. Non-traditional users of these accounts are slapped with fees and charges on a regular basis making even a high-cost payday loan a cheaper alternative. It is also clear these products all interact, as consumer trade off one form for another--probably not something regulators pay attention to. Moreover as financial services consolidates and firms look to raise more revenue from basic transactional and small credit services, it seems likely more consumers on the fringe will opt out of mainstream services.

New products and markets are developing to better serve this population. So long as they offer transparent pricing, consumers are likely to be better off for it. A better understanding of the landscape of consumer services in this segment is clearly needed.