For Consumers, One Product = One Service
I learned from my days in the Consumer Electronics industry that most hybrid or combination products don’t make sense. For example, while well over 90% of people who have a TV also have a DVD or Blu-Ray player, nobody would buy a combination TV set + DVD/BR. Even when TVs used to be big and fat and had room for a built-in VCR, TVs with built-in VCRs stayed unsold on store shelves.
This is because consumers associate one device with one function: watching TV is not the same as watching movies, even if the same screen is being used technically.
Granted, today’s smartphones look like the Swiss-army knives of consumer electronics, but they are really a whole new category of personal companions built around a new type of interaction not inherited from prior devices: the touch screen.
Consumer confusion is a terrible thing in more than one way: it can even hurt people. This is exactly the point that the Consumer Financial Protection Bureau is making when writing up 100’s of pages of proposed rule making about credit being extended out of prepaid cards through overdraft facilities. A credit card looks exactly the same as a prepaid card: a very standardized rectangle of plastic. The only difference between the two is that the prepaid card has the word “debit” printed on its front. And just to increase the confusion, why “debit” when it should really say “prepaid”? And why offer prepaid cardholders the option to run a transaction through the credit rails anyways??
On the one hand, a prepaid card with no overdraft capabilities is a very safe product: nothing wrong can happen to the cardholder except the embarrassment of being declined for insufficient funds. On the other hand, a credit card can drive cardholders into more debt than they can afford and can damage their credit score. Unfortunately, everything about prepaid versus credit cards, from the physical device to the choice of credit versus debit network is prone to creating confusion in the mind of cardholders.
Prepaid Cards and Credit Complement Each Other
Remarkably, prepaid cards and credit can be made to work together in a very powerful way and without confusing consumers: by either using prepaid cards as a precursor to credit or by using prepaid cards as a channel for credit disbursement and loan management.
Prepaid cards can be a stepping stone towards short term credit, in particular for people with no or thin credit files.
Under-banked people as well a Millenials and recent immigrants use prepaid cards as substitutes for checking accounts. A paper checkbook being the only thing missing from the best prepaid card accounts, when compared with regular checking accounts, people can deposit their salaries and tax refunds, pay bills, pay in shops and even set money aside in the built-in saving purses of prepaid cards.
For such users, prepaid card usage history can be leveraged in much the same way as checking account usage history to evaluate how much money people have access to, and how responsible they are in its management. Prepaid card usage can either be used in the underwriting process of granting a loan, or can be used to pre-qualify people with the best chances of success with certain types of loans.
For example, prepaid cardholders who have been able to set aside $300 in the savings purse of their prepaid card, and have organized the regular direct deposit of their salary in the card have significant chances of being approved for a secured credit card, if they agree to turn the $300 they had saved into the required security deposit for the credit card. Prepaid cardholders with recurrent direct deposits but without a savings “pocket” may be eligible for an unsecured loan of the kind provided by LendUp.
The loan product that prepaid cardholders may qualify for is completely separate from the prepaid card and does not need to be issued by the same financial institution.
The US Treasury is devoting a part of its recent Financial Innovations fund to researching how prepaid cardholders and safely by offered access to secured credit cards and what type of financial guidance will help them be more successful once they have been approved for a secured credit card. The project participants are Banking Up, the Consumer Federation of America, Payments Law and the Marketing and Consumer Policy Office of the George Washington University School of Business.
In the opposite direction, someone having been granted a short term loan could choose to receive the proceeds of the loan into either an existing or a new prepaid card, mostly for the purpose of separating the loan money from the rest of their finances and facilitate the management of the loan for its intended purpose.
People who open a savings account at the same time as a checking account are provably more responsible with their money than bank customers who don’t.
Oportun has disbursed $1.3B to more than 485,000 customers and is offering a prepaid card to their repeat customers as a way to help them better manage their loan money.
Even borrowers who are already banked benefit from being offered the option of receiving their loan into a separate prepaid card as it helps them keep their resolutions to use the money for specific goals.
Credit with Upstream or Downstream Prepaid
The industry has attempted so far to build prepaid with credit products by adding overdraft or other very short term lending options to prepaid cards. This has all the trappings of a two-in-one product that will confuse many customers.
Instead, the market should deploy credit with prepaid products, where a prepaid card is used either as a precursor to credit or as a vehicle for receiving the loan money. This will increase both the number of people who are eligible for good and safe short term credit, and the odds that they will be successful with the resulting loan.
While there may be 25M people in the US whose contracts are up for renewal and who will jump at (or rather wait in line for) the opportunity to buy a new iPhone, there is a larger number of people for whom a smartphone means a lot more than a 25% gain in screen size or processing power.
They are the economically and financially under-served, or even the excluded.
- The FDIC published earlier this year a study assessing the potential impact on economic inclusion of financial services delivered by mobile phone
- The Federal Bank of Boston just published an article by Elisa Tavilla about expanding financial access an inclusion with mobile financial services.
Download the documents by clicking on the cover pictures.
Both documents point to a promising and positive influence of mobile phones on fostering economic and financial inclusion. The anticipated “Haves versus Have Nots” problem with access to technology does not actually come into play here because under-served people use more smartphones than the average US population.
It is now up to the banking industry to leverage the unexpected penetration of smartphones and the expected positive influence they will have on helping people climb the financial inclusion ladder.
I think the prepaid card industry has reached a maturity plateau in terms of features, access, and acceptance. Products like H&R Block’s Emerald, American Express Bluebird, T-Mobile’s Mobile Money and our own UPside card are pretty good alternatives to checking accounts.
While you don’t get a paper checkbook with those cards, you can pay your bills electronically, and at least the Bluebird and the UPside cards offer paper checks on demand.
Don’t get me wrong: prepaid cards still have a lot of growth potential. A majority of people who could benefit from them still don’t use them, mostly because they are not aware of their availability, or because they confuse them with one-time use gift cards. So, the industry has some work to do marketing the cards to the right people through the right channels. For example, under-banked employees who work for small and medium businesses generally do not have access to dedicated payroll cards; so the new generation of “prepaid as checking” has an important market to address among the 110M Americans who work for the 2M businesses of less than 1,000 employees.
Prepaid cards have the ability to upgrade most consumers out of the “cash only” economy by offering them a way to manage their deposits and payments electronically (and with paper checks for as long as paper checks will survive). So far so good.
What should the industry do now to bring consumers one or several more levels up in the world of banking?
- Savings: the ability to set money aside for later
- Credit: the ability to borrow some money
Neither of those two services are easy to deploy, in particular among those who need them most: low to moderate income (LMI) consumers.
Allowing people to set money aside for later is in fact technically easy: several prepaid cards already provide savings “purses” or sub-accounts. Others offer a separate but easy to open savings account.
What is difficult is to motivate people to save, especially when they live paycheck to paycheck and don’t have much to save at all. Current interest rates are so low that the interest accumulated at the end of the year is just a few dollars or even less for most people.
Research is being conducted by the likes of Doorways to Dreams to “gamify” savings: this consists of combining the act of savings with some fun, challenging and rewarding activities other than just accrued interest. Financial fitness games, sweepstakes, contests… are all options being explored. SaveUp is a good example of savings gamification.
Credit is even more difficult: prepaid cards cannot help build up credit files and credit scores because they are just a deposit instrument.
Very short term loans from payday lenders and pawn shops are easily accessible to prepaid cardholders with no credit history, but they are costly and don’t usually build credit scores.
Alternative (to FICO) credit scoring services that rely on “Big Data” tend to have a market ignition problem, because they are of little use to creditors if few borrowers use them, and of little use to borrowers if few creditors consult them. While the law requires creditors to consider all available credit scores, the market reality is that the FICO score is still indispensable for the vast majority of consumers, while the recent interest in Big Data based scoring has not yielded practical scalable products yet.
Un(der)banked people eagerly seek credit cards because they do build up mainstream credit files and scores by reporting to the top 3 Credit Bureaus. However, the standard qualification criteria for mainstream credit cards are ill-suited because they rely on the very same credit scoring system they contribute to.
Here is how we think access to credit can be provided to prepaid cardholders:
- use the savings that users of certain prepaid cards have been able to set aside as the security deposit for a secured credit card
- use the history of prepaid card transactions as input data for the underwriting decision, to evaluate the creditworthiness of the cardholder
Secured credit cards are not very widespread but they require little of no prior credit history and they do report to the 3 main credit bureaus.
Eligible people would end up with two cards in their wallet:
- The prepaid card available as a ‘safe to spend’ instrument for everyday purchases.
- The secured credit card to be used very carefully as its bill will come at the end of every month. When handled within the intended rules, the card starts contributing to the user’s FICO score.
In summary, the prepaid card industry has the opportunity to “graduate” its customers into savings and credit services, by using prepaid cards as a foundation. This is a bright and promising future.
The most beautiful meeting room I have ever been to is in the Treasury building near the White House. It is called the Cash Room, because it used to contain actual piles of cash when the Treasury was the bankers’ bank. The general public could also go there to cash government-issued checks, or change gold and silver.
Now compare this with the den of Satoshi Nakamoto, where the first Bitcoins were minted and stored. OK, I made that one up, because Satoshi Nakamoto is a pseudonym: we don’t really know who created this cryptographic currency and its associated transfer protocols. It might actually be a group of developers rather than a single person.
But you get the idea: digital representation of money and mathematical protocols take a lot less space than physical cash and require no brick-and-mortar security.
When combining the exponential benefits of Moore’s law (where every 18 months the same amount of silicon chips can double in power), the multiplying effects of networks (where useful connections increase proportionally to the square of the number of nodes, as first highlighted by Bob Metcalfe’s law), and the algorithmic smarts of 20-somethings out of Stanford University, you get a Google.
While planetary growth has made it difficult for Google to stay true to its core value of “doing no evil”, one has to wonder if a Google-equivalent of banking could not be built with the same mix of computer, Internet and algorithmic wizardry and have a main goal of being an “ethical bank” that does no evil.
After many years of unconscionable risk taking, rate manipulations, customer abuses and self-awarded fat bonuses, banking is in dire need of an ethical offering available to everybody. While there are plenty of well-run, customer-friendly credit unions and community banks, their scale is limited by their own charter to serving a small number of qualifying customers in a restricted geography.
So, is digital banking the foundation for scalable ethical banking? I think digital banking is necessary, but not sufficient.
Back to Bitcoins: the technology was initially deployed with no business rules (and pretty much no business model), resulting in sites like Silk Road using Bitcoins for drug sales, before it was shut down by the Federal Government last week. While the Bitcoin Foundation is putting a brave face on this (see the Washington Post article ) there are countless Bitcoin “exchanges” being run by entrepreneurs without a clue about money laundering risks.
Digital payment processing is not the exclusive domain of new new things like Bitcoin: in fact all large banks and the dominant payment networks (Visa. MasterCard, American Express, Discover) are pretty much 100% digital, even if their protocols and algorithms are far from being as smart Bitcoin. These incumbent banking services have plenty of rules and regulations to protect consumers (and themselves), with more to come from the Consumer Financial Protection Bureau. This does not make them ethical, by any stretch of the imagination.
In his book “Jimmy Stewart is Dead” Professor Laurence Kotlikoff suggest “Limited Purpose Banking” as a cure to what he calls the ongoing financial plague. While large established players would have a hard time limiting themselves as suggested by Kotlikoff or dividing themselves up into the required independent pieces, new initiatives, or “neobanks” can easily just focus on retail or consumer banking.
While I am not expecting neobanking initiatives to use the words “ethical” or “sustainable” explicitly in their marketing pitches, nor include “do no evil” in their mission statement, the opportunity is there for entrepreneurs to achieve ethical banking by combining:
- The digital efficiency and scalability of computers and networks.
- The rules and regulations already in place for consumer protection
- Their own additional rules of conduct, mission statement and operational procedures
Two initiatives came to my attention last week, which looks like they are being built in exactly that way: the Occupy Cooperative, born out of the Occupy Wall Street movement, which plans to launch a prepaid card, and Sustain Green, which plans to launch credit, payroll and prepaid cards with rewards in the form of carbon offsets.
I suppose they will also keep an eye on Bitcoins and other new ways to make electronic payments more efficient in the future, like the recently announced protocol by Visa, MasterCard and American Express to make online and mobile payments simpler and safer.
These are exciting times.