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September 24, 2012

Alternative Financial Services Grow, and So Do the Unbanked and Underbanked

The just-released 2011 FDIC national survey on unbanked and underbanked households reports that this demographic segment has shown modest growth since the 2009 survey. Despite improvements in the general economy, 20.1 percent of U.S. households are underbanked and 8.2 percent are unbanked completely. According to the FDIC's definition, underbanked consumers may have a traditional bank account, but they rely heavily on alternative providers for financial services (shortened to AFS in the FDIC report). As we described in a previous post on nonbanks, the landscape for AFS today is a highly dynamic free-market environment that fosters creativity and innovation. Will the confluence of a growing underserved market and the ever-expanding role of nonbanks in our U.S. payments system fuel the fire for increased reliance upon AFS in general?

Growing use of alternative financial services
The growing reliance on AFS became more widespread between 2009 and 2011. According to the 2011 FDIC report, about 25 percent of all households, including the unbanked and underbanked, reported using AFS in the last year. These AFS users report finding nonbank financial services more convenient, faster, and less expensive than traditional banks.

Figure 6.1: Timing of AFS Use ofr All Households

Every day, many new types of nonbanks, including telecom firms, are entering the payments space, as we noted in this 2009 post on mobile money transfers. More recently, social networks like Facebook and PayPal-like payment business models such as Dwolla are entering the fray. Regulators of money transfer operators are working diligently to ensure that the myriad of new firms in the business are appropriately licensed and regulated. The fast pace of nonbank entry is creating a confusing regulatory environment and potential vulnerabilities that bad actors may find opportunities to exploit.

The growing appeal of prepaid
The 2011 FDIC report also notes that the unbanked and underbanked households rely on prepaid cards more than do fully banked households. One in 10 households overall reported the use of a prepaid card. The proportion of unbanked household that have used a prepaid card climbed from 12.2 percent in 2009 to 17.8 percent in the last survey.

The fact is, prepaid card adoption has been on the rise for some time. The Fed's last triennial payment study reported it to be the fastest growing retail payment method. The expanded functionality for prepaid payments today make them practical for many uses, including payroll, travel, and the provision of benefits. Consumers can purchase prepaid cards from merchants and other nonbank locales where they might be more comfortable than they would be in a traditional financial institution.

This is all good news in the context of financial inclusion and expanded opportunity for the unbanked to participate in the electronic economy and shift from more informal transfer methods. However, payments experts still have concerns. In particular, there is the risk that violators of money laundering laws may go undetected as stored-value payments move from the plastic card to other access devices such as mobile handsets. FinCEN and other regulators will need to keep these issues front of mind as adoption grows and more nonbanks participate in the prepaid industry.

Implications for policymakers and financial institutions
The report concludes that one particularly noteworthy lesson for banks to consider is the need to make traditional financial products more convenient, faster, and less expensive in order to compete with AFS. They should try harder to appeal to the under- and unbanked by providing expedited availability for deposited funds to compete with check cashers. The report even goes on to say that banks might find it useful to promote mobile technology to increase convenience, the most commonly reported reason that households use nonbank check cashiers. With the growing use of prepaid cards for both federal and state government benefits, astute financial institutions may recognize other opportunities to provide prepaid services that may eventually shift the unbanked and underbanked to more a formal banking economy.

However, one clear trend is that technology is driving entrepreneurship in payments delivery methods in unexpected ways, with new AFS services announced all the time. In the long run, AFS may not be considered alternative any more, shedding the negative reputation that label traditionally implies. If new payments are cheaper and faster, perhaps they deserve a less jaundiced eye.

Cynthia MerrittBy Cynthia Merritt, assistant director of the Retail Payments Risk Forum

September 24, 2012 in banks and banking, transmitters | Permalink

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