M-RCBG Associate Working Paper No. 75
FinTech Alternatives to Short-Term Small-Dollar Credit: Helping Low-Income Working Families Escape the High-Cost Lending Trap
Todd H. Baker
The focus of this paper is the most promising alternative to the current short-term, small-dollar credit (“STSDC”) system serving low-income working families --the rapidly growing U.S. financial technology software –or “FinTech”--industry.
The paper begins by reviewing previous research on the underlying causes of demand for STSDC--payday loans, auto title loans, bank overdraft protection and similar financial products--by low-income working families. The author discusses evidence that rising levels of monthly income volatility are creating a new set of liquidity management problems for families, and documents the adverse impact that reliance on STSDC for liquidity support has on working families, their communities, their employers and the economy as a whole.
The paper then describes regulatory interventions in this area and concludes that, despite considerable effort and some local success, none have materially curbed the expansion—or the adverse effects-- of STSDC products nationally. The author discusses why banks are not likely to play a significant role in the STSDC market and argues that, in the anti-regulatory political environment following the 2016 election, private sector FinTech alternatives now offer the best opportunity to help low-income working Americans manage their day-to-day finances without resorting to STSDC.
The next section of the paper is an assessment of the potential for FinTech companies and products to provide a superior alternative to the current STSDC system. Using a variety of methods, the author identified relevant FinTech companies and classified them into six distinct categories. Then author contacted 50 identified companies and conducted interviews with senior management of 30 of these companies (several others were included in the study without interviews based on the prior knowledge of the author.) Based on these interviews and additional research, the author assessed individual FinTech companies and the identified categories of companies for “Utility” (defined as the ability of the products offered by a company to either provide a superior substitute for current STSDC products or an effective mechanism for consumers to avoid the use of credit products) and “Scalability” (defined as the potential for a company’s business model to support rapid penetration of the low-income working family market to serve a significant portion of low-income working families.) Using the assessments, the author distilled a detailed set of key observations about the strengths, weaknesses and challenges facing each of the FinTech categories, including the likely evolution of these categories over time.
The assessments show that FinTech companies in all of the categories, with one possibly temporary exception, are today providing products that have greater Utility than STSDC for low-income working families, and thus represent a meaningful improvement over the current STSDC system. One category—Digital Income/Expense Variability Management Solutions--- was assessed as both the most Scalable and the highest Utility category measured in the study. A second category--Digital Credit Access/Cost Improvement Lenders—was also assessed positively in terms of both Utility and Scalability and should be able to provide significant amounts of alternative credit to low-income working families, subject to a number of important caveats. The other four categories of companies all had strengths in either Utility or Scalability, but would need to evolve further before becoming significant alternatives to STSDC for low-income working families.
The paper concludes that private sector adoption of a set of FinTech-centered alternatives to STSDC has the potential to shift a significant fraction of low-income working families away from reliance on the current STSDC system over time and to materially improve their financial resiliency and health, without the need for government financial support or new laws or regulations. The paper further argues that the employer channel is the best vehicle for disseminating FinTech products to low-income working families because of its potential to reach very large numbers of workers quickly with effective—and sometimes subsidized--liquidity and financial management solutions which also provide financial benefits to employers through reduced employee financial stress, improved employee engagement and satisfaction, lower turnover and lower absenteeism.
Based upon the author’s calculations, the use of FinTech products from the studied categories, alone or in combination, would be sufficient to manage a $700 to $980 maximum monthly negative variance (combining below average income and above average expense) in consumer income/expense, an amount sufficient in most instances to eliminate the need for a low-income working family to use STSDC. The author’s calculations further show that if these FinTech products were to become widely available, they would be able to address the Utility needs of a minimum of 4.7 million and a maximum of 15.6 million full-time workers in low-income working families. Collectively, the author believes that these FinTech products could benefit virtually all of the 10.4 million low-income working families and, indirectly, the 47 million individual members of those families, by reducing or eliminating reliance on STSDC.
The paper proposes a number of concrete steps that private sector and government employers, employee benefit providers, FinTech companies, other financial companies and non-profits can take to accelerate the adoption of superior FinTech alternatives to STSDC by low-income working Americans:
- Employers (private and public) should adopt and subsidize employee financial health benefit plans that include the highest Utility products from FinTech companies.
- Employee benefits intermediaries should support adoption of financial health benefit plans.
- FinTech companies should broaden their offerings to incorporate the product capabilities of other FinTech companies into their own product offering for low-income working Americans.
- Non FinTech financial companies should adopt FinTech products to help improve their own customers’ financial health.
- FinTechs and financial sector should resolve data governance Issues
- The non-profit sector should advocate for FinTech benefits and data governance and consider subsidizing test cases.
The paper also sets forth public sector legislative/regulatory actions that could help accelerate adoption of FinTech alternatives to STSDC:
- Congress should make employer contributions/subsidization with respect to Employee Financial Health Benefit Plans tax deductible.
- State regulators should work collaboratively to reduce the burden of 50-state licensing and compliance on FinTech companies.
- Federal and state banking regulators, with assistance from Congress as necessary, should make insured banking charters (national and state) available to FinTech companies with business models involving innovative digital deposit taking and other digital banking/lending activities that are (i) consistent with the purposes of banks generally but are (ii) inconsistent with the community banking format of locally-based customers and physical distribution coupled with a traditional mix of bank balance sheet and revenue components.
- Regulatory and statutory uncertainty about permitted uses of “alternative data” should be resolved to avoid unnecessarily restricting the provision of high Utility FinTech products to low-income working families.