The problem with banks


TL;DR: Banks perform several vital roles in our lives but are exclusionary, expensive, and often inadequate. Unfortunately, high barriers to entry (regulation, card networks) prevent direct challenger models from emerging.


Banks figure deeply in our lives

When I ask people (as one does) what their bank does for them, the most common response is: “protects my money”. Some add that their bank “pays me interest”. Congratulations, I’ve created a strawman view of banking, but when we talk about banks it’s safe to say that the general perception of what a bank does is very, very limited compared to what banks actually do. Banks are absolutely central to our day-to-day lives.

Let me count the ways:

  1. Keeps my money safe
  2. Lets me send money electronically
  3. Lets me write and deposit cheques
  4. Provides me with cashier’s cheques
  5. Lets me pay for things using a plastic card
  6. Lets me pay for things using my phone
  7. Lets me take out physical money at branches and ATMs
  8. Lends to me
  9. Invests my money in loans and treasuries and provides me with some interest income
  10. Lets me manage my money online

I’m probably forgetting a few, and it’s worthwhile pointing out that these are just the consumer services most banks offer — the bigger banks also support large portions of the merchant processing infrastructure which allows me to pay businesses with a card, or as a business make payroll, etc. Bottom line? Banks do a LOT for us.

Banks are central to our economic lives

So, what’s the problem here? Well, quite frankly, banks do all of this but they don’t do it all particularly well.

A confused and overcharged customer is not a happy customer

Are customers happy with their banks? Despite an upward trend in satisfaction (upward from 2008/9, it’s worth noting, when there was a little thing called the financial crisis that some people would put squarely on banks’ threshold) at the end of last year customer satisfaction dipped. Now, American Consumer Satisfaction Index reports probably shouldn’t be compared this way, but banks today are less popular than cigarette manufacturers were in 2012.

Why? Well, bank fees confuse their customers. In 2012, Pew reported that 1/3rd of customers didn’t know they had “overdraft protection” until they incurred a penalty. Overdraft protection, by the way, is where your bank lets you withdraw more money than you have and then charges you extremely high interest on the extra money you’ve just borrowed. Extremely high interest on short term borrowing? If that sounds a lot like a payday loan, that’s because the difference is negligible. Lending Club threw together some representative numbers to show that this “overdraft protection” actually cost more than just taking a payday loan directly. And remember, 1/3rd of consumers didn’t realize they had this wonderful “protection” until they were being charged for an overdraft. An updated Pew report from mid-2014 confirms that despite changes to the way banks describe these programs, consumers are still confused.

What’s worse is that the fees for a checking account — that’s the kind of account that lets you deposit money, take only that money out (unless you have overdraft protection), and earn a little (very little) interest — are actually going up. Fees charged to all account holders include ATM fees and overdraft fees (called Non Sufficient Fund, or NSF, fees), and they continue to rise according to this survey from Bankrate.

Courtesy of Bankrate.com, Fall 2014
Courtesy of Bankrate.com, Fall 2014

Monthly service fees for the poor and unemployed, 17 million unbanked Americans

Account holders who can’t maintain a certain minimum balance in their account or sign up for direct deposit also have to deal with monthly “account maintenance fees” which have risen steeply since the financial crisis. That’s right, if you’ve lost your job and don’t have a pay check to direct deposit, or don’t earn much money in the first place, you will need to pay your bank a fee for the privilege of depositing money. This is, in effect, a regressive fee for those people who are unemployed or too poor to keep their money at a bank.

Courtesy of Bankrate.com, Fall 2013

As a consequence of these fees, confusing terms, and general dissatisfaction, there are 16.7 million U.S. adults who are unbanked, according to this 2013 FDIC survey published last year. That’s one in thirteen households. Unbanked, by the way, means exactly what it sounds like — these households don’t have an account with an insured financial institution. They rely instead on alternatives such as cash, prepaid debit cards, loan sharks, alternative lenders, and, according to an excellent ethnographic study by Alice Goffman, bail bonds as deposits. Why are they unbanked? Because they didn’t have enough money to use a bank (36%), didn’t trust banks (15%), found the fees high/ confusing (13%), or had ID difficulties (7%). The study doesn’t even touch on the roughly 2.3 million online applicants who are denied access to accounts for credit issues, despite the accounts in question not having credit/borrowing features. That’s like not letting me ride a bike because I can’t get car insurance.

Keep in mind that no less than Bill Gates recently said that not having access to bank services was a major impediment to alleviating global poverty. He was talking about Kenya, but sadly the same hallmarks of life without stable financial services (difficulty storing, saving or sending money) are present today in the U.S.

[A lack of] Innovation in banking

Bill Gates has hope for the developing world because services like MPesa allow Kenyans and a growing number of customers in other countries to send money via their mobile phones and exchange it for cash at local agents. While MPesa was created by a mobile network (Vodaphone/Safaricom), the money that flows through it is fully backed by accounts held at commercial banks. Without the permission, flexibility, and foresight of those commercial banking systems, MPesa would not be possible.

Contrast that with the systems used to send money here in the U.S. Despite driving the development of the modern ATM, credit and debit card systems, banks have recently been notoriously slow adopting technological advances. Although the legislation to allow banks to accept digital images of checks vs. paper was cleared in 2004, the first bank to do so was USAA in 2009. [Update: a more knowledgeable friend pointed out that USAA introduced online check scanning in 2007, albeit via your home scanner] By 2011, just 3 of the 10 largest banks in the U.S. offered the service, or only ~10% of all US banks in 2013. This isn’t an issue of banks having trouble developing the technology: there are white label providers of this service. This is banks deciding not to offer a new service that would make customer’s lives easier. And in case you think I’m missing something, ApplePay may co-brand with many banks, but the enabling technology behind it was developed solely by the payment card companies.

“Look, I don’t want to make the consumer feel more awkward…”

The best example of the slowdown in innovation has to be the time it takes for money to move in the banking system. The US ACH system takes more than 3 days to fully settle payments due to bizarre legacy reasons. In the UK it takes a day or less, and in Mexico it takes minutes. Foreign banks like BBVA Compass have instituted real-time transaction settlement so that there’s no lag between your swiping a card at a retailer and the retailer receiving money in their bank account. Despite appeals from consumers, retailers and the government, bank groups have avoided investing in the system to get payments settled more quickly. The same banks have been reluctant to adopt EMV (“chip & PIN”) card security because “look, I don’t want to make the consumer feel more awkward than they do with having to use a chip card, dipping it into a terminal, letting it sit there and then pulling it back out.” Because afterall, that’s not what we do at many ATMs. It’s fair to point out that most card fraud doesn’t directly harm consumers as banks cover fraud costs. It does hurt, however, in transactions which aren’t consummated by fraud false positives.

Similarly, the lack of investment in transfer technology costs consumers by slowing down the flow of money. Every time that a check deposit takes a day to clear, or a payment is held for three days, that’s money that could be put to use in a business’ or individual’s bank account. The lack of investment also creates fragility. Because it takes around 3 days for a money transfer to move between banks, Venmo and other transfer companies offer to hold onto your funds so that you can move money instantaneously. You are, in essence, lending money to Venmo. What happens if Venmo fails? Well, whatever money you had in their system isn’t insured, so, good luck.

Consequences and lack of alternatives

I’ve described how banks are vital to our economic lives and how they regularly underperform when it comes to the services they offer. Their services are increasingly costly and confusing, exclude a sizable portion of the adult population, and aren’t keeping pace with innovation or best practices. Worse, because many internet services rely on the combination of a bank account/card and email address as identification, banks create a two-speed system whereby those that have a bank account and credit card have access to all the benefits (services, savings, convenience) the “new economy” has to offer. You know that income inequality issue everyone keeps talking about? This probably doesn’t help.

But if we’re customers of banks, why would we tolerate this situation? Logically, if we’re unhappy with the services offered, we would take our business elsewhere. But that’s the catch: there isn’t really an “elsewhere” to go. And that’s because of three things:

  1. Banking (for the most part) is free. Banks take your money, invest it in loans and bonds, and give you a small part of what they make back. They then present the cost of ATM access and other expected services as orthogonal to their core business, which is protecting your money, which they do for free. Free is pretty hard to compete with if you can’t also invest the money you’re protecting. How can you protect money and invest it? Become a regulated depository institution.
  2. Regulations. If you take a consumer’s deposit, you are a depository institution and will be regulated as such. Regulation costs money. Yes, banks have had to spend that money as well, but they have created and adjusted their business model over time to support the costs of regulation. Your new hypothetical bank-like competitor? Not so much. These regulations act as a barrier to entry.
  3. Card companies. So let’s say that you’ve created a company that, I don’t know, sells consumer transaction data in exchange for keeping their money safe. This won’t get you around the core fact that card companies work exclusively with banks. So you may be able to protect your consumers’ money, but they can’t use it for anything, in any store, anywhere.

As a result, there’s no “elsewhere” to go. So banks may not be great at what they do, but they’re not going anywhere soon.

Check out part two, where I discuss why these issues have arisen, and part three, where I talk about where this all may be headed.

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