A Bridge to Somewhere

For most Americans, the banking system is a tool to manage our money and build security. Through an array of competitively priced financial products, we can cheaply and easily convert income into assets, make payments, store and invest money, and borrow for consumer purchases, homes, and businesses. To the extent that we flourish, so too do the institutions within this system.

Unfortunately, lower-income consumers operate within a separate and decidedly unequal system. Mainstream providers have little interest in competing for this high frequency/low-balance business, forcing lower-income families to rely on check cashers, payday lenders, pawn shops, automobile-title lenders, high-priced credit cards, tax refund advance lenders, and predatory mortgage lenders.

Given the premise that low-income people are a meager source of business, the scale of the sector is mind-boggling. Today, check-cashing and payday-lending outlets in America outnumber all the McDonald's, Burger Kings, Targets, Sears, JCPenneys, and Wal-Marts combined (33,000 versus less than 29,000, respectively, in 2004). Add in all the other alternative service providers, and you have a vast and often rapacious network offering easy access to the financially strapped.

Excess fees and interest charged by these fringe services drain resources from vulnerable communities. They erode the value of modest paychecks and of federal programs seeking to lift people out of poverty. For example: $2 billion is stripped off the Earned Income Tax Credit benefits for the working poor annually by tax providers and their refund-advance products. Check-cashing fees can cost two weeks' salary over the course of a year. Payday loans extract more than $4 billion a year in fees. With the lure of small weekly payments, rent-to-own businesses (RTO) offer appliances, furniture, and electronics at prices many times retail. For example, a computer retailing for $851 can be obtained at an RTO shop for only $49 a week; after 91 payments (that's 21 months) it will be all yours for just $4,449; miss a payment and you risk forfeiting the item and all payments made.

At their best, these services address basic needs at exorbitant fees, but without features that help build financial security. Use of fringe financial services doesn't build credit histories or money-management tools, and savings vehicles are almost unheard of.

In their worst forms, alternative financial services compound low-income families' economic hardships. The standard payday loan has a 400 percent annual interest rate. A typical sub-prime credit card with a $300 limit arrives with $250 in fees already charged against it. Or consider the mainstream banking alternative?courtesy overdrafts. This benevolent-sounding service earns banks more in fees ($17.5 billion a year) than the amount of funds actually covered ($15.8 billion). In 2006, it accounted for 74 percent of banks' total consumer-fee income, subsidizing the cost of serving other consumers.

Defenders of such practices assert that these products help lower-income people meet urgent needs and that, when used correctly, they make sense. They further extol the virtues of consumer choice. But the profits made in the predatory economy are disproportionately derived from people who don't use the products "correctly" and don't have any choice. Who, given a full range of options, would choose usurious interest rates and late charges?

Debtors are at the mercy of creditors. A typical payday-loan customer has no more money at the next payday and must pay to renew. Card holders' fees and punitive interest rates pile on, cross-subsidizing those who use credit cards for free. Nearly half of all overdraft, or "NSF," fees are incurred on small debit-card and ATM transactions; thus the typical NSF debit-card purchase of $20 results in an NSF charge of $34. The vast majority of banks simply let these go through without warning?even at the ATM machine. And when you check your balance at some ATMs, the figure includes the overdraft cushion. In the mortgage market, low- and moderate-income borrowers given sub-prime loans were several times more likely to default than like borrowers under similar conditions who took out prime mortgages.

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What possesses lower-income people to take on such high-cost debt? Commonly cited suspects are lack of impulse control, financial illiteracy, and naiveté. While a small percentage of households might use fringe services because of ignorance or profligacy, the majority of households resort to parasitic lenders for one reason: They don't have enough money to make ends meet.

Between 2001 and 2007, the median income of the bottom 40 percent of earners rose only $300 in the face of rapidly rising costs for housing and health care. Today, in Charlotte, North Carolina, home of Bank of America and Wachovia, a single parent with two children must make $3,479 a month to pay for necessities; some three times minimum wage. The social safety net has frayed and economic risk is increasingly weathered at the individual household level. The high-cost debt industry is thriving because people can't afford to meet basic needs and because institutions refuse to extend them credit under the more reasonable terms that the better-off enjoy.

Once overwhelmed by this debt, they are judged to be irresponsible. Thus debt has the pernicious effect of masking class inequality by increasing the short-term purchasing power of the poor, while at the same time reinforcing it by decreasing their long-term economic prospects.

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Solving these complex problems requires that we acknowledge the massive power advantage wielded by the financiers. It necessitates that we put more financial power in the hands of consumers and put an end to the most abusive (and lucrative) lending practices and that we expand mainstream credit services into low-income communities. With ethical behavior on the part of lenders, and a modicum of financial education, low-income people can be responsible users of credit, and financial institutions can earn reasonable returns serving them.

Provide true financial knowledge. Financial education and better disclosures are oft-cited solutions, but these must go beyond dressing broken windows. A full financial curriculum must take its rightful place in the K-12 system. Economist Robert Shiller calls for the government to subsidize a network of independent financial advisers. The federally subsidized Neighborhood Housing Services/NeighborWorks America network, for example, combines counseling with mortgage finance. Its 230 organizations helped over 240,000 families in 2007, but it would have to be greatly expanded to fill the national need.

Offer control, transparency, and no surprises. Better products can safely enable users to direct, track, and manage money while avoiding high-cost traps. There is no shortage of promising approaches in various stages of commercialization: Basic accounts that are no frills, low-cost, bounce-free, or rely less on branches and more on technologies such as lifeline, second chance, and express checking accounts; specially tailored bank branches; banking kiosks; mobile and online banking; employer-based banking; and even bank-less bank accounts in the form of stored value and payroll cards. The Center for Financial Services Innovation is dedicated to this effort.

Make savings pay. Many Americans are richly rewarded for saving through deferred taxes, tax credits, and employer matches on retirement savings, but low-income households have less access to these mechanisms and benefits. Numerous experiments have demonstrated that the poor want to save, and, if given mechanisms and inducements, will do so. But low yields on basic savings accounts may not even cover fees, and public-assistance benefits are cut for those who save too much. This backward incentive structure can be rectified by matching savings by the poor or extending savings-related tax benefits to lower-wage workers.

Make debt repayable. People should be sold loans that they can repay. The more institutions charge on debt and the longer they can reap these returns, the less they worry about repayment of initial principal. The opportunity to thrive on consumer indebtedness diverts institutions from making "an honest living." In addition to current movements to clamp down on abusive mortgage practices, Congress is considering an across-the-board 36 percent rate cap on consumer loans. But let's not kid ourselves that implementation of these reforms will go smoothly: the recent failure in Congress to extend bankruptcy protection to home mortgages warns us that lending reform faces a steep uphill battle.

Institutions Matter. This is especially true in poorer communities. Community-development financial institutions and community-development credit unions (CDFIs and CDCUs), which serve the banking needs of low-income communities, are enjoying more than a doubling in federal support in the stimulus bill and the new budget. But the CDFI scale remains relatively small, as can be seen by comparing CDFI funding?$400 million over two years?to the hundreds of billions invested to stabilize the nation's banks.

For some, credit unions hold a solution. Since the 1700s, people have set up lending cooperatives in times when fairly priced credit was unavailable and abusive lending, rampant. Modern credit unions are nonprofits serving 85 million members with such advantages as low credit-card interest-rate caps for federal credit unions, and pioneering affordable alternatives to payday lending. Yet, their total assets are one-seventeenth those of banks, while the size of any individual institution is limited by the available pool of member resources. Moreover, limited geographic coverage and membership eligibility constraints mean that not everyone can access these institutions. While expanding and invigorating the credit-union movement could build on the promise this industry holds, major impact on the financial-services landscape would be a long way off and would require firm political resolve to overcome the objections of the powerful banking industry.

Clearly, then, we must look to our mainstream banking sector, whose reliance on taxpayer backing is now painfully evident and whose duty to serve the credit needs of its communities was confirmed in the Community Reinvestment Act of 1977 (CRA).

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All of these measures must be complemented by systemic financial regulation, for as long as profiteering is sanctioned, it will be pursued at the expense of innovation and sustainability. True, even a well-regulated financial system wouldn't replace the frayed social safety net or make the poor rich. But there are tools available to enable low-income people to control their finances, keep more of the money they earn, and use that money to build financial capacity. Beyond its benefits to consumers, such a system could provide profits to banks. Here are some key principles:

Make basic financial services available to low-income consumers. Given the millions paid to check cashers, it is clear that consumers can tolerate fee-based accounts, though such products should be structured to minimize costs and therefore the need for fees. How? Electronic banking can lower banks' costs, while simultaneously giving customers easy access to account information. For customers with past credit problems, carefully managed "second chance" checking accounts could be made more available. For those not ready for or interested in bank accounts, prepaid cards that act as virtual bank accounts might be the perfect option. The inability to overdraw prepaid cards is particularly appealing to those consumers with past overdraft problems, and early innovators are now exploring ways to add such features as a savings mechanism.

Promote savings for low-income people. Many lower-income customers report preferring automatic, regular, small deductions from their wages. Built-in "stickiness" (limited withdrawals or small matches to leave savings alone, for example) serves competing preferences for resisting temptation yet maintaining access to one's limited resources. Another variant, which builds on the target market's penchant for lotteries, is prize-based savings, like those being developed by the D2D Foundation, a fund that emerged from the research of Harvard Business School's Peter Tufano; here, the more you save and the longer you save it, the better shot you have at a windfall.

A comprehensive savings policy requires a more concerted public-sector commitment. Imagine, for example, workers automatically enrolled in employer-based, payroll-deduction savings plans and tax benefits extended to lower-wage earners. (The Obama administration proposes a 50 percent match of the first $1,000 saved with a goal of bringing 80 percent of low- and middle-earning workers into retirement savings.) Similar benefits would apply to savings in enhanced 529 college-savings accounts, savings bonds, and certificates of deposit. Tax filers could also direct portions of their refunds to this range of savings options. Early savings habits would be forged through tax preferenced youth savings accounts or publicly subsidized universal child-savings accounts, as in the U.K.

Make available affordable and responsible credit. Low-income consumers do need access to small, occasional loans. How might these be provided? Consumers indicate strong preferences for loans that are repayable in installments. Surely banks and other depositories can serve many customers with alternatives priced well under the price umbrella of current services, and even within the proposed 36 percent -- rate caps. Several credit unions currently offer low-cost payday-loan alternatives, some of which wrap in a savings device; for example, the North Carolina State Employees' Credit Union (SECU) profitably offers its 1.5 million members a 12 percent annual percentage rate salary advance loan, where borrowers must deposit 5 percent into savings at each renewal. By early 2008, SECU customers had avoided $145 million in payday loan fees and instead put $13.2 million into savings accounts. Another important part of the solution is safer, more responsible credit cards that consumers can manage to repay. One concept proposed by Angela Littwin, assistant professor at the University of Texas School of Law, is a "self-directed credit card," with built-in discipline?firm credit limits, low transaction limits, and/or fixed monthly payments.

Assure that housing and education loans are safe and affordable. Homeownership and education remain indispensable levers for long-term economic advancement, and system-wide reform of both of these industries is critical. Some have proposed that every borrower get a safe, standard-issue mortgage product, unless the customer explicitly chooses a riskier product, with full knowledge of the risks (which would carry greater liability for the lender as well).

Approaches like these illustrate what a viable and productive financing system for low-income households and communities could look like. It's not that hard to envision, because it looks a lot like what many of us already have and, until recently, have taken for granted. The change called for in this article won't come from within the industry. CRA, NeigborWorks, CDFIs, and credit unions all have their roots in community action and empowerment. Today, victims of the system may be silenced by the stigma that surrounds financial problems, but those who are speaking out are compelling lawmakers to act to protect us all. Meanwhile, complacent beneficiaries of this system need look no further than the far-reaching effects of the sub-prime mortgage crisis to realize that our separate financial systems really aren't that distinct after all. Each of us has reason to fight for the necessary marketplace and policy changes that will ultimately serve us all.

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