By Daniel Kreps

Why would one pay a large fee to cash a government check or pay a bill?  What induces some people to pay an effective annual interest rate of 400% for a short-term secured loan?  Two studies, one by the Center for Financial Services Innovation (CFSI) and another by the Pew Charitable Trust (PCT) provide some answers to these questions and were the basis for the session concerning “Understanding the Underbanked Consumer and the Future of Financial Services.”

Rachel Schneider outlined the findings in the CFSI study which found an ethnically mixed population of 21 million American households with little or no bank relationships.  According to the CFSI study these low-income consumers spend $29 billion per annum on financial services. While the study determined there was significant overlap between the unbanked and subprime borrowers, some 25 percent would be considered prime borrowers and 42% simply had too thin a credit profile to qualify for prime credit products.

The study also found that the banked and the unbanked borrow and save for essentially the same reasons.  Roughly 40% of both populations borrow because they have trouble covering living costs from current income.  And, the major reasons for savings for both groups are also similar—emergency fund, retirement, college savings, buying a home purchase and purchasing a car.

However, the un-banked must rely on so-called “alternative financial service providers” (AFS) who tailor their product offerings to be more appealing to the unbanked while those with access to banking services address their needs at lower costs and often with government subsidies.  As a consequence, while both banked and under banked low-income consumers were hard hit by the economic downturn, those with access to standard banking products fared much better.

The PCT study, presented by Eleni Constantine, documented the interesting phenomenon that as many low-income consumers seem to be exiting banking relationships as opening accounts.  This suggests that as individuals circumstances change for better or worse, they gain or lose options in the financial services arena.

So why might rational consumers opt for products and services that are significantly more expensive? Both studies pointed to the greater simplicity of the AFS products and how AFS providers made greater efforts to make low-income consumers comfortable.  The studies quoted participants as saying they felt more appreciated and respected by the AFS providers and that their products, such as pre-paid cards, kept them from bouncing checks and running up large credit card balances.

The PCT study forecasted a growing need for low-income financial products and services—especially for credit—and noted the growing participation of retailers, such as Wal-Mart in catering to the needs of the underbanked.  It recommended that credit products be integrated with savings products and credit repair services, and warned that the growth in financial services provided by non-banks risked the creation of a two-tier system for the banked and the unbanked.

Ms. Constantine concluded that recent regulatory efforts designed to protect consumers from high banking fees could actually push more low-income consumers out of the banking system and into the high cost environment of largely unregulated alternative financial service providers.