How FinTech Can Help Bend the Curve for the Underbanked (Part 1)
This is the first in a series of articles that we will publish on FinTech for the Underbanked. In this article, we focus on the US, where legacy banking infrastructure and traditional industry practices continue to limit access to mainstream financial services for millions of households, most notably minorities and low-income individuals.
It is expensive to be poor. This is true for the nearly 2 billion unbanked individuals in the world. But in the U.S. this masks a deeper truth. Black and Hispanic communities are overrepresented in the underbanked and financially vulnerable populations, which spend ~$200 billion in interest and fees to access financial services.
In America, it is expensive to be Black and Brown.
We expect the underbanked and financially vulnerable populations to rise as the COVID-19 driven economic shock disproportionately hurts minorities and young individuals. These are unfortunately the same populations that were already overrepresented in the underbanked population and among those most vulnerable to an economic shock. As in the decade following the 2007–2008 Financial Crisis, we believe FinTech startups could help bend the curve for the underbanked post the pandemic.
Sizing the Underbanked In the US
The Financial Crisis of 2007–2008 ushered in a big decade for FinTech companies serving the underbanked. Companies such as Green Dot (NYSE: GDOT), NetSpend (a Total Systems company), Lending Club (NYSE: LC), and XOOM (a PayPal company) all went public with a vision to provide financial services to a vastly underserved segment of the market. The services they offered varied from debit accounts to credit to remittances. Some of these models have proven to be more successful than others and all of them have shifted parts of their business model/strategy post IPO.
But their legacy in FinTech is cemented. These companies proved that you could leverage technology to offer better services to underbanked consumers. And you could make money doing it. FinTech founders saw that they could do well by doing good. VCs saw the potential for “billion-dollar IPOs” (NetSpend and Xoom were slightly below $1 billion at IPO but would eventually get acquired at/or above the $1 Billion mark).
These IPOs ushered in a wave of socially-focused entrepreneurs wanting to offer sound financial services to the underbanked population. Some of these efforts — along with the longest US economic expansion in history — seemed to pay off over the last decade. According to the 2019 FDIC National Survey of Unbanked and Underbanked Households:
- The unbanked population — households that do not have any formal bank account — shrank from 7.7% in 2013 to 6.5% in 2017.
- The underbanked population — households that have at least one bank account but use alternative financial services outside of the formal banking system — decreased from 28% in 2013 to 25% in 2013–2017.
As of 2017, 25.2% of US households were not fully incorporated into the formal financial services system. That represents 32.5 million households, a net decrease from 34.3M underbanked households in 2013. But despite the progress of the last decade, the size of this group remains alarmingly high. And the fees they pay to access alternative financial services has actually increased over the last few years.
Figure 1: Banking Status of US Households, 2013–2017
Who Are the US Underbanked: Black, Brown, and Young
In the US, there were key demographics more prone to be underbanked: minorities and young individuals.
(1) Black and Hispanics: There was also some incremental progress in the underbanked and unbanked status for Black and Brown populations, but they continued to be overrepresented.
- The unbanked rate for Black and Hispanics decreased by approximately 4 percentage points each. However, the gap between these groups and white households improved only gradually. In 2017, the gap between Black and White households was 14% points and the gap between Hispanic and White Households was 11% points. That gap only decreased by 3% for each group since 2013.
Figure 2: Unbanked Rates by Households Race and Ethnicity
- The underbanked rate for Black and Hispanics was approximately 30% in 2017. This was a gap of 16% points compared to Whites (which had an underbanked rate of 14%). Black and Brown communities were 2X more likely to be underbanked than White households.
Figure 3: Underbanked Rates by Households Race and Ethnicity
(2) Young households.
- Young individuals are more likely to be unbanked than older generations. However, that gap improved significantly over the last decade. For example, when comparing the two youngest cohorts (15–24 and 25–34) to the two oldest cohorts (55–64 and 65 and older), the gap in unbanked rate for young individuals improved from 19 percentage points in 2013 to 8.7 percentage points in 2017.
- The underbanked rate for these young individuals in 2017 was 52.4% for younger households. This was a 13% point gap to the underbanked rate for older generations (29.4%). The gap in the underbanked rate for younger individuals in 2015 was 22%. This was almost a 10% improvement in just two years.
Figure 4: Unbanked Rates by Household Age and Year
US Underbanked Revenue Opportunity: $200BN
While the global underbanked opportunity represents a $1 Trillion revenue opportunity, we believe the US market alone offers a sizable market for FinTechs. According to the Financial Health Network, underbanked consumers spent $189 billion in fees and interest on financial products in 2018. That number was projected to grow to $196B in 2019.
Figure 5: Underserved Market Revenue, 2015–2019
There are several key drivers of revenue and growth in the underserved market. We highlight a few of the key drivers of this revenue, including:
- Subprime Credit Cards. Credit cards represented the lion’s share of fees paid by the underbanked for financial services. Subprime credit cards generated $36.3BN or 19% of fees paid by underserved consumers. This grew by a modest 2.8% YoY in 2018 and is expected to remain in the low single digits for 2019.
- Subprime Auto Loans. Underbanked consumers paid $29.8BN in fees to access subprime auto loans. This accounted for 15% of the total fees paid by underbanked consumers. This product continued to capture a larger share of underbanked total spend grew at 9.7% in 2018.
- Installment Loans. These installment loans continued to grow at a rapid clip of $9.8BN in 2018. This represented 5% of the total revenue generated by underbanked consumers. From 2015–2018, installment loans posted a CAGR of 13% and are expected to continue posting double-digit growth.
- Private Student Loans. Underbanked consumers paid $9.5BN in fees for private student loans. This made up 5% of the total fees paid by underbanked for financial services.
- Payment and Deposit Accounts. Finally, while payment and deposit accounts generate a relatively smaller percentage of total fees for the industry ($16.7BN or 9% of total) compared to credit products, it is worth mentioning some of the key drivers in this bucket as they remain important products in the underbanked market. These include (1) Checking and Deposit Accounts, which generated $4.2BN, (2) Remittances, which generated $3.7BN, and (3) GPR Prepaid Card, which generated $2.8BN worth of fees.
Credit remains the largest driver of fees in the underbanked market, but payment/deposit accounts continue to drive more engagement. We see this as a key factor in the “rebundling” trend we are seeing in fintech today. FinTech Startups/NeoBanks that started with deposit or payment solutions are seeking to add a credit product to drive additional monetization. Companies who had existing credit customers are adding payment and deposit account products to enhance everyday use and stickiness.
Figure 6: Share of Underserved Market Revenue
COVID-19 Will Lead to An Uptick in the Underbanked Population
In an April 23, 2020 blog post — The Federal Reserve of St. Louis simulated how COVID-19 will disproportionately impact families in Financial Distress (defined as a family that is delinquent on credit/debt). Their model split households by “quintiles of financial distress”, where Q1 are households who live in the 20% of zip codes that exhibit the lowest levels of financial distress and Q5 are those in the 20% of zip codes with the highest levels of financial distress.
According to the Federal Reserve simulation, a demand plunge of 75% in the accommodation sector, food services sector and related sectors (such as leisure and hospitality) would reduce the income of the most financially distressed households by over 9%. This impact is 1.5X higher than the estimated impact on families in the least financially distressed households.
Figure 7: Simulated Impact of COVID-19 on Household Income
Such a shock to income for the most financially vulnerable could have a significant impact on their ability to access mainstream financial services for two key reasons:
(1) Income is still the main reason cited for Unbanked Status.
According to a 2017 FDIC Survey, 52% of US unbanked households cited not having enough money to keep in an account as a reason for not having a bank account. This was the main reason cited for 34% of the unbanked households. This had a 20% point lead over the second most cited reason for not having a bank account, which was a distrust of banks (a topic we address below).
Figure 8: Reasons for Not Having a Bank Account
(2) Financially Vulnerable Households Can Be Pushed Further into Underbanked Status.
According to a Financial Health Network report, 71% of the US Population struggled with at least one aspect of their financial lives. In total, this represented almost 180m people that were either classified as “financially coping” (defined as individuals struggling with some aspects of their financial lives) or “financially vulnerable” (individuals struggling with all or nearly all aspects of their financial lives).
Figure 9: Financial Health in America
US households cannot weather an economic shock of more than 5 months.
The Financial Health Network found that household balance sheets in general recovered from the Great Recession of 2007–2008. But despite the fact that more people felt comfortable with paying their bills and managing their debt, most of the population were financially susceptible to an unexpected shock as of 2019. In fact, 65% of the population had 5 months or less of liquid savings in 2019. Nearly 50% of the population had 2 months or less.
Figure 10: Months of Savings for US Households
Who are the Most Financially Vulnerable? Black, Brown, and Poor
In addition to being overrepresented in the underbanked population, Black and Hispanic communities were significantly more financially vulnerable than their White or Asian peers. The Financial Health Network measures financial health through a proprietary FinHealth score, which measures 8 indicators on a household’s ability to manage to spend, save, borrow, and plan for the future. Black and Hispanic households scored 56 points on this measure, a full 10 percentage points lower than their White peers (and about 15 percentage points lower than Asian households).
Figure 11: Black, Brown and Poor Communities Had the Lowest FinHealth Score
COVID-19 Is Disproportionately Hurting Financially Vulnerable Populations
According to a study conducted by Gusto — a leading provider of HR, payroll and benefits solutions for US small and medium-sized businesses — these most vulnerable populations were far more likely to be impacted by COVID-19 related shutdowns.
Below is a summary of their findings, which includes data from over 100,000 US SMBs:
- Lower-income employees were more likely to be laid off. For example, Gusto data showed that workers earning less than $20 per hour had a 115% higher rate of layoffs compared to workers making $30 or more.
- Younger workers were also disproportionately impacted by COVID-19 related layoffs. Workers aged 25 or younger experienced a 93% higher rate than workers aged 35 or older.
- Finally, employees who worked in low-Income areas were most at-risk. Employees who worked in lower-income areas were 25% more likely to have been laid off compared with employees who work in higher-income areas.
In Hindsight: FinTech’s impact on the Underbanked since the Great Recession.
It is perhaps a little difficult to gauge the positive impact that FinTech has had on the lives of the underbanked over the last decade. After all, the number of underserved households is still in the millions and they are paying ~$200 million dollars in fees per year. However, we offer up the following data points as an indication of positive impact:
- Payday Lending has been on a secular decline since the Great Recession.
Payday Lending is perhaps the most notorious alternative financial services product in the market. High fees (with APRs that can be well over 400%), high rollover rates, and overall subpar customer experience are general hallmarks of payday lending.
Payday lending has decreased to $4.3Bn in fees, with storefront payday lending shrinking -16% for storefront payday lending since 2015 and online payday lending revenue decreasing by 10% over the same time period.
Figure 12: Payday Lending Is On a Secular Decline
2. Prepaid cards continue their steady, but uninterrupted growth.
The general-purpose reloadable prepaid cards made popular by the likes of Green Dot and NetSpend represented a simple, yet creative solution to one of the greatest challenges faced by the unbanked population: how to participate in digital banking/commerce. By enabling unbanked and underbanked individuals to digitize cash (through either direct deposits or cash-based deposits in retail stores), prepaid debit cards enabled millions of unbanked individuals to shop online, pay their bills digitally or send electronic transfers to other people in the network.
Currently, millions of users are loading over $300 billion annually on general-purpose reloadable prepaid cards. GRP debit card providers are generating $2.8Bn in fees in 2018, according to the Financial Health Network.
Figure 13: Annual Load Volume in US GPR Prepaid Cards
3. P2P Models Led to A Wave of Digital Lenders.
Peer-to-peer models presented an innovative and disruptive approach to lending. By connecting individual borrowers to lenders (individual and/or institutional lenders), the platforms were able to cut out traditional banks from the lending process. By handling the entire lending process digitally, these online credit marketplaces did not have the high fixed costs associated with branches, agent, and back-office costs; and had relatively lower regulatory requirements than deposit-taking institutions.
These US P2P lending platforms have had varying degrees of success, but as a group generated $1BN in revenues and have grown at a CAGR of 19% from 2015 -2018.
Figure 14: Personal Marketplace Loans Continue to Post Solid Growth
But perhaps the most significant contribution from models like Prosper Marketplace and LendingClub is that they paved the way for the digital lending platform to challenge traditional lending models across several markets, including SME lending, student loans, and more recently, mortgage lending. Additionally, these models encouraged other founders to defy traditional underwriting models with more robust credit decisioning algorithms, leading to models such as Upstart and Sofi in the student/alumni space; and OnDeck and Kabbage in the SME space; Oportun and Aura (in the underbanked/immigrant space).
According to a recent Experian study, personal loan originations have increased 97% over the past four years, with fintech share rapidly increasing from 22.4% of total loans originated to 49.4%.
How FinTech Can Rise Up to the COVID-19 Challenge
Once again, we believe that the global economic shock has created a window of opportunity for some FinTech companies to fill a growing void in the underbanked market. However, the industry is better equipped to rise up to the challenge as the technological infrastructure (and accessibility) has evolved significantly in the last decade. Companies can now integrate APIs to solve for critical parts of the financial services value chain — from KYC to account verification to communication — with their customers. As a result, fintech solution providers can more cost-effectively serve their underbanked customers.
The API economy in financial services could result in more options for consumers. However, for FinTech and — the VCs investing in the space — this also means a lot more competition. One of the by-products of Open Banking is that many FinTechs are reversing a decades-long trend of “unbundling” financial products. Instead, FinTechs are increasingly “bundling” financial services, offering multiple products from debit to credit to investment products under one platform. Some of these “NeoBanks” launched a multi-product offering from the beginning. Others waited until they scaled a core product first before attempting to cross-sell additional products to their customers.
Whether one strategy is better than the other misses the bigger point in the race to serve the underbanked. As in any financial services relationship, the key to winning in the underbanked market over the long-term will be based on customer trust. This is particularly the case with underbanked consumers, which as we saw pay an egregious amount of fees for financial services and have a healthy degree of skepticism for financial services products. In the near-term, consumers might be swayed by an additional 10 basis points APY on a deposit account or a 10-basis reduction on the APR charged on a personal loan. But pricing alone won’t cut it over the long run.
Here are some lessons from the first wave of FinTechs that were successful in acquiring underbanked sectors following the financial crisis. Current and future FinTechs that want to help “Bend the Curve for the Underbanked” should keep these in mind:
- Understanding the target demographics is critical. When targeting the underbanked, it is important to understand who these customers are. As noted above, race is still an important driver in the underbanked population, Black and Hispanics are more likely to have issues accessing mainstream financial services than other demographics. In addition, younger, lower-income, and unmarried female-headed households are more likely to be underbanked, according to the FDIC.
Understanding the key characteristics of these demographics are important because they will inform product, distribution, and marketing strategy. If you are focused on solving issues for the underbanked. Companies that have designed their business strategy around their customers well include Oportun (which went public in 2019), Aura and Finhabits, all of which have done a good job targeting the Hispanic/low-income populations); SOFI/Upstart which has targeted the student/alumni population; and NOVA Credit, which is focusing on the immigration population. All of these companies have created successful strategies to target their demographics through product/distribution/marketing strategies.
2. Security and Transparency are paramount. Companies need to make the proper investments in data security, fraud prevention, and compliance that are critical foundations to build trust. These are the important “back-office” operations that digital financial services consumers are demanding more of.
But the external strategies around pricing and communication are equally important. Product fees, interests and other costs need to be transparent and clearly communicated. Many of the early breakthrough companies in fintech for the underbanked were not necessarily “low-cost”. But they were transparent about the pricing and about ways to avoid certain costs.
Think about the early days of GPR Prepaid Debit Cards, where customers paid for every load, reload, and other items. These fees were transparent on the packaging, along with options on how to avoid those fees (from direct deposit to minimum load amounts to the number of monthly transactions). This concept did not just apply to consumer-focused fintech companies, by the way. On the merchant side, payment processors like Square/Braintree/Stripe took a novel approach of presenting a transparent fee structure in an industry long accustomed to complex, opaque pricing schemes.
3. Be creative with distribution and retention strategies. The underbanked market is large but also complex. Social media and other digital channels can help, but companies and VCs should be willing to think “outside the box” when it comes to distribution strategies in the underbanked market. Traditional Silicon Valley scale-up strategies may not entirely work for this segment of the market or might need to be tweaked. The same goes for strategies focused on customer retention.
One interesting case study is that of the prepaid industry, where some of the early leaders in the market scaled through the “J-hook” distribution model. Companies like Green Dot and NetSpend partnered with retailers or convenience were underbanked consumers went shopping (i.e. Walmart, 7/11) or alternative financial services providers where these consumers went for certain financial products (i.e. check cashers, payday lenders). Depending on physical retail stores for distribution was not a traditional model necessarily applauded by VCs. But it proved effective to acquire underbanked consumers.
In addition, these early prepaid card managers realized that despite given access to digital accounts/debit cards, many of their bank customers still relied heavily on cash. This distribution network thus also proved critical to customer retention in the early days (hence the Green Dot @ the Register reload network). Over time, more and more of the strategy for these prepaid card managers shifted to digital — ranging from online account transfers to payroll direct deposit.
These methods might not work for all products, particularly in a post-COVID-19 world. But they exemplify how founders that think creatively about their distribution strategy can build sustainable companies, and the VCs that back them could be rewarded.
4. Use data to “super-serve” existing customers. This might sound very intuitive, but we have spoken to a number of companies that want to offer the next checking account or savings account without necessarily justifying it through the data. To be clear, at a certain scale and with a certain cost structure, it might make economic sense to launch multiple additional financial services products. But unless existing customers are demanding these products, FinTechs may not see the type of conversion rate they need to move the needle on their business or to drive further customer retention.
Additional products and services can help drive more customer engagement even if they don’t necessarily result in near-term monetization. Think about how long it took banks to fully roll-out their mobile banking channel. Mobile banking might not generate significant revenue for large financial institutions, but they are now the key driver of customer engagement for banks. Going back to our prepaid industry analogy — early prepaid debit card pioneer Green Dot rolled out a large, accessible cash-out network — including its retail stores and ATM Network. These were both important for customer engagement beyond the initial customer load.
Our Investment in LISTO Financial
We have learned a great deal about the underbanked market through our investment in Listo Financial. Listo (Spanish for “smart, ready”), is co-founded by Samuel Ulloa (a previous executive at Oportun) and James Gutierrez (former CEO of Oportun and current CEO of Aura), both with in-depth experience navigating the complexities of serving the underbanked. Listo financial has the vision to build a trusted source for financial services for the underbanked population.
The company’s core offerings center around three key aspirational and foundational financial services namely: access to fair, transparent, credit building loans; affordable protection with insurance products; and wealth building through investment products, such as Roth IRA and 529 plans.
Listo crafted its go-to-market strategy and customer experience with its target demographic in mind. Listo went to market with a few carefully selected physical, tech-enabled stores. This decision was backed by data indicating that underbanked Hispanics highly valued live interaction with their financial services provider. These physical stores were important to building initial trust and engagement with their target market.
Everything within the store is carefully designed to cater to this demographic as well. The staff is bilingual — as US Hispanics are increasingly bilingual. The stores have a section for kids with mini iPads, which keep the children entertained while the parents engage with a Listo agent, nurturing the beginning of a trusted advisor-type of relationship vs. a typical transactional relationship.
A typical customer engagement experience usually involves the customer approaching the “Listo bar” (“akin to Apple Genius bar”) where the customer interacts with thoughtfully designed, highly intuitive and educational content on an Ipad. This content provides the customer with information and transparency to make well informed, smart financial decisions (a.k.a. to be “Listo”). Through this process, customers learn how to use their mobile device to access these financial services. The customer walks away having initiated a trusting relationship with the listo brand and with the listo experience in their “pocket”.
Listo’s technology marketplace distills the complexity of financial products for its target customers. Its loan product, as an example does not require an SSN, accepts foreign IDs and uses alternative data and creative methods for address verification. As an example, Listo mails a unique notification to a customer’s address on file and the customer has the option to present that unique notification in a Listo store to complete address verification.
Listo’s store agents help customers create and access their online profile in store and assure them that they can receive the same service online. Despite these efforts, thousands of customers visit a Listo store in a given month. Even throughout the COVID-19 pandemic, (Listo stores remained opened as they were deemed an essential service for its underbanked customers) thousands of customers have chosen to enter a Listo store to speak directly with an agent.
Listo’s financial products are competitive and fully transparent. The company presents its financial services offerings in kayak-like experience. Customers clearly see pricing — both one-time and recurring fees to compare across different options. The company acts as a marketplace for loan and insurance products, which means it charges its lending and insurance partners — not consumers. Still, customers rely on Listo as a trusted financial advisor and as a result, Listo does not partner with insurance carriers or lenders that have opaque pricing schemes.
Listo employs a hybrid offline/online distribution model. The company’s physical retail distribution goes against the status quo for venture backed companies. But it is a critical driver of customer engagement, the company’s 90%+ retention and online organic growth through referrals. In addition, the stores provided Listo with the ability to “be there” even in the darkest of times (i.e. during the COVID-19 shut down).
That said, the company recognizes that its online presence is important to grow its customer base beyond the stores. Thus, while the offline presence are important pillars for trust and retention, their online distribution model will be important for overall market share.
Data is informing Listo on future products. Listo Financial launched with credit, as over half of the US Hispanic underbanked population are “credit invisible”, having little to no credit history. While the company’s mission was to offer multiple financial services under one trusted brand from the start, Listo has prioritized new product launches based on the demand from its customers. This is why auto insurance, its second launched product, quickly grew to drive more revenue than loans. The company is now adding more partners to its life insurance offering, given increased demand by customers in light of the current pandemic.
FinTech Can Seize the Moment
COVID-19 will push more US households into underbanked/financially vulnerable status. As in the 2007–2008 downturn, this will present an opportunity for nimble fintechs. And this time around, FinTechs will be equipped with more tools to launch financial service products as well as more flexible digital distribution models. That said, newcomers should learn from the accomplishments (and mistakes) from the first wave of FinTech companies focused on the underbanked. By fully understanding their demographics, offering transparent solutions, leveraging data to inform their roadmap and being flexible on distribution, FinTechs can help bend the curve for the underbanked.
