Payday lending is big business. Nonbank financial services companies, such as stand-alone payday stores, financial service centers and online payday lenders, generate nearly $50 billion in payday loans annually, according to Financial Service Centers of America, or FiSCA, a trade association that represents more than half of the nation's financial service centers. The banking industry would like a piece of that pie.
Payday lending has had a less-than-stellar reputation. The industry routinely gets pounded by consumer groups that criticize the loans as an extraordinarily expensive form of credit. It would not be unusual for a customer to pay a $50 finance charge on a two-week, $300 loan, according to a paper published by the Federal Reserve Bank of Kansas City. That amounts to an annual percentage rate of 435 percent. Too often, the customer can't repay the loan on time and rolls it over, incurring even steeper charges.
FDIC's pilot program
The Federal Deposit Insurance Corp., or FDIC, is in the midst of a two-year pilot program to see if banks can provide an alternative -- not only to payday loans but to fee-based overdraft protection, a bank product that's also scorched by consumer activists. The idea is to reduce the cost of the loans, make them cost-effective for the bank and encourage borrowers to become regular customers of the bank. Ironically, payday loan customers generally need a checking account to complete their transactions at a payday lender. If banks can provide those customers with the loans they need, they may, eventually, be able to sell them other products.
The FDIC's Small-Dollar Loan Pilot Program began with 31 banks in February 2008. The institutions are primarily community banks, often near military bases or in low- to middle-income neighborhoods. To be sure, there are many banks across the country that make small-dollar loans and are not part of the pilot program. But by and large, banks have shied away from small loans as it can be difficult to make them profitable.
The pilot program sets parameters for the terms of the loans. The FDIC's latest statistics show that more than 11,700 loans have been originated with a principal balance of $13.5 million.
"The amounts are generally larger than $500; terms are longer (than at a payday lender), nobody in our pilot is doing two-week loans; and interest rates are much less," says Rae-Ann Miller, a special advisor with the FDIC.
Building a relationship
"In general, what (the banks) are looking for is a relationship. Most payday lenders aren't looking to sell other products to these consumers. They're looking to make fees on these immediately, and that's the primary goal. The primary goal here is a relationship-building aspect," says Miller.
The FDIC's guidelines for the pilot program include the following:
- Loan amounts up to $1,000.
- Payment periods extending beyond a single paycheck cycle.
- Annual percentage rates below 36 percent.
- Low or no origination fees.
- No prepayment penalties.
- Encourage principal reduction.
- Automatic savings component.
- Access to financial education.
Streamlining the underwriting process enables banks to save money and get the loan into the customer's hands quickly. At Mitchell Bank in Milwaukee, customer service representatives are authorized to pull the borrower's credit report, verify income and make the loan. You might think that could lead to a high percentage of bad loans, but bank Chairman James Maloney says that hasn't been the case.
"We've had only one loan that was charged off, and that was a mistake in the underwriting. Other than that, all of the loans that we've made have paid as agreed. We look at the credit score to determine the interest rate we're going to charge -- starting at 15 percent for decent credit, going to 22 percent for very poor credit, a credit score below 570. We verify the receipt of at least $1,000 of monthly income from some source. It could be Social Security, unemployment compensation -- it doesn't have to be employment," says Maloney.
If an applicant's credit score is below 570, the bank refers the person to a one-time, one-hour session with a credit counselor who prepares a budget for the borrower.
Maloney says the bank currently has about 45 loans outstanding and that at least 80 percent of them are for $1,000. Borrowers have the option to take six or 12 months to repay. Seventy percent of the borrowers opt for 12 months, which significantly lowers the monthly payment.
"We require that borrowers put 10 percent of the amount of the loan into a dedicated savings account," Maloney says. "We pay an interest rate that's 1 percent above our normal rate on that account. They can't take the 10 percent until they pay off the loan but they can use it to make the last payment. What we really want them to do is keep adding to the account so they don't have to come back for a payday loan, and they're doing that. By and large, about 80 percent to 90 percent of the accounts remain open."
To further help break the cycle of borrowers rolling from one loan to the next, the bank limits the number of loans to two in a 12-month period.
Re-creating the wheel
Representatives of the traditional payday-lending industry say the FDIC appears to be trying to re-create the wheel when it comes to serving the needs of low- and moderate-income consumers.
"If I were to guess, I would tell you that they can't do it more cheaply because I think their cost structure is different," says Edward D'Alessio, deputy general counsel for Financial Service Centers of America. "They're not going to be able to make as many loans because they're not set up to handle the volumes that the industry is set up to handle.
"If they can come up with a better mousetrap, then they should; competition is a good thing. But there's no reason why alternative financial service providers need to be looked at in a negative way just because they're not a bank. We believe that the issue is not a matter of whether everybody needs to get their financial services through a bank; it's that everybody needs financial services, whether they get them through a bank or an alternative provider. The more important thing is that people get the products they need."
Maloney is cautiously optimistic that the FDIC's program will succeed.
"We're kind of surprised about how it has performed. We weren't anticipating it performing this well. We went into it skeptically. The FDIC was encouraging banks to participate. It's cost-effective as long as we continue to not have losses. A loss of $1,000 could put the whole thing 'underwater' because we're not making a lot of money on it."
Maloney says he doubts that banks that participate in fee-based overdraft protection, sometimes called bounce protection, would switch to these loans because there's just too much money being made from the fee income.