A top priority of the FDIC is to explore ways to help consumers enter the mainstream financial system. The growth of nonbank financial institutions, such as payday lending, demonstrates that consumers are not utilizing banks for their credit needs. The unbanked or underbanked consumer represents a significant opportunity for banks. The FDIC’s Small-Dollar Loan Pilot Program, which began in February 2008, is a two-year case study designed to help the FDIC identify best practices for structuring and marketing small-dollar loans to consumers that can be replicated by other banks as an alternative to higher cost financial products, such as payday loans and fee-based overdraft protection. Recently released results of the first four quarters of the pilot program are varied based on the goals of each particular bank.
The FDIC selected 31 banks to take part in the pilot program. The banks, with a total of 446 banking offices in 26 states, have total assets ranging from $26 million to $10 billion. Banks utilized in the pilot program had to meet the following requirements:
The FDIC provided only general guidelines for those banks participating in the pilot program. The guidelines are consistent with the Affordable Small-Dollar Loan Guidelines issued June 19, 2007, by the FDIC. Key features in the guidelines include:
Although the underwriting process differs to some extent between the pilot banks, the criteria used is streamlined. All pilot banks require proof of identity, address and income, as well as a credit report to determine loan amounts and repayment ability. Some banks require customers to open a savings account linked to the small-dollar loan, while others only encourage customers to open a savings account. The banks indicated loans can be underwritten within 48 hours, while many indicated loans can be processed in less than an hour if the borrower has the appropriate documentation. The size of the bank and business model employed determines whether the bank uses a centralized approval process or grants lending authority to branch managers or similar personnel.
Year one financial results
A small-dollar loan threshold of $1,000 was selected for uniformity with the Affordable Small-Dollar Loan Guidelines and to determine whether $1,000 can be viewed as a “bright line” for a small-dollar loan program that can be duplicated by others. A number of banks in the pilot program also generate loans between $1,000 and $2,500 (referred to as nearly small-dollar loans) depending on consumer demand and their particular business plan. All banks in the pilot program only offer closed-end installment loans. The average size of the small-dollar loans has been $675, the interest rate has been around 15 percent and loan terms have ranged from 10 to12 months. The average size of nearly small-dollar loans has been approximately $1,700, the interest rate has been between 14 and 15 percent and the term has ranged from 14 to 16 months.
During the first four quarters of the pilot, participating banks have originated 8,346 small-dollar loans with a balance of $5.5 million and 7,681 nearly small-dollar loans totaling $13 million. The total amount of small-dollar loans delinquent at the end of the fourth quarter was $184,636 or 7.3 percent of loans outstanding. To date, the total amount of small-dollar loans charged off is $187,378 or 3.4 percent of loans originated in the pilot program. Charge-offs and delinquency data has not been tracked for nearly small-dollar loans for purposes of the pilot. Banks have indicated job losses and the economy in their market areas have recently led to increases in delinquencies and a general reduction in the pool of acceptable borrowers.
The degree of success of banks participating in the pilot program differs based on the business model implemented and the goals of each bank. Most pilot banks are primarily using the small-dollar loan product to build a foundation for long-term relationships, some are seeking short-term profitability, while others are focused solely on creating goodwill in the community. Regardless of the business model, all of the banks indicated that participating in small-dollar lending is important in serving their communities. Many banks indicated the key to reaching out to the unbanked and underbanked is to establish solid relationships with community organizations. The support of these and other important stakeholders inside and outside the bank is essential to a successful small-dollar loan program. The following discusses the different types of business models employed by banks in the pilot program.
Long-term relationship building business model
While some banks have overlapping goals, most have designed their programs to develop long-term relationships with individuals in their community. Nine banks in the program were already operating small-dollar loan programs, some for 20 years or more, prior to the start of the pilot. Banks with existing programs were the most likely to report that overall relationships with small-dollar loan customers are profitable, while those with new programs were more likely to not yet be profitable. Due to the small size of the loans, interest income and fees generated does not generally translate into profit initially for a new program. However, banks with existing programs have generated long-term profitability by developing relationships with customers and increasing volume over time.
One effective way banks have strengthened relationships with customers is through financial education efforts. Examples of effective education efforts include formal classroom education, community outreach and participation with third-party organizations. Banks have successfully partnered with third-party organizations, such as employers, schools, nonprofit organizations and assistance agencies to provide education to unbanked populations in settings they frequent and consider most comfortable. More importantly, these third-party organizations often serve as a referral source for potential borrowers. Developing relationships in the community has not only allowed banks to identify potential borrowers but also the ability to cross-sell other products. The most commonly cross-sold products include checking accounts, savings accounts and other loan products.
Short-term profitability business model
While most banks with new small-dollar loan programs have interest in pursuing the long-term relationship business model, several banks have focused more on attaining short-term profitability. Banks pursuing short-term profitability are located in census tracts with high concentrations of low- to moderate-income households and immigrant households. Banks utilizing this model are in markets where a higher demand exists for the small-dollar loan product. Consumers in these markets have previously relied heavily on payday loan and check cashing providers. In general, these banks have leveraged this demand to impose interest rates and fees closer to the recommended 36 percent APR limit and have generated higher transaction volumes.
Community goodwill and CRA business model
The difference between the community goodwill and CRA business model and the long-term relationship building model is that ultimately the goal is to not make a profit. The principal objective of banks employing this model is to enhance the accessibility of reasonably priced credit to low- to moderate-income consumers in the community. Several banks in the pilot, both with new and existing programs, offer small-dollar programs exclusively for the goodwill and positive CRA consideration. Such banks are located in suburban areas with few low- to moderate-income households and low numbers of immigrant households. These banks primarily work with consumer and community groups that refer clients. For banks employing this model it is equally important to provide customers with a full range of social services to enhance their ability to remain current on loan payments.
Many banks are trying to reach out to the unbanked and underbanked populations. Most banks in the pilot program have determined the small-dollar loan is an integral part of establishing long-term profitable relationships with the unbanked and underbanked. The small-dollar loan pilot program after one year has proved that banks can provide reasonably priced alternatives to higher-cost, short-term credit.
Brian J. Mischel is a certified public accountant with BKD, LLP. Contact the author at bmischel(at)bkd.com.
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