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Payday Lending's Final Payday?

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While the financial reform law that was signed by President Obama yesterday signaled a renewed interest in Washington to regulate go-go bankers, it may have an even greater impact on "fringe banking" -- the high-cost, dead-end alternative banking industry that includes payday lenders and check cashers. Regulators across the country and new competition from banks are squeezing their ability to survive.

Every year, this $250 billion market serves about 20 million U.S. households (about one-fifth of the population), most of whom are middle- and low-income. Fringe banks charge skyscraping prices for a handful of basic services that are available at banks for much less. The average payday loan, for instance, carries an APR of about 390 percent, compared to an average credit card APR of around 14 percent. Regular check-cashing customers pay almost $1,000 a year. Considering that the average customer earns about $20,000, that's a dire amount of money to be paying for a service that's free at most banks.

Conventional banks have traditionally stayed away from the 20 million households in the fringe bank market, fearing low revenue opportunities and high credit risks. But the financial reform bill is the latest in a series of recent market changes that have started to fundamentally change that equation.

Here's why: new regulations are choking off fringe banks' ability to survive. From the dozens of states that have been tightening regulations in recent years to the new federal Consumer Financial Protection Agency that promises to reign in misleading consumer finance policies and practices, the high-fee model is drawing an increasing amount of criticism and pushback from regulators.

Just as important, bank shareholders will demand that banks start competing with their newly hobbled fringe counterparts for those 20 million households. The fact is, banks' current business model is forcing them to serve an ever-shrinking share of the market that has money to burn and does not pose a significant credit risk. The reform bill reinforces banks' conservative standard through strict lending requirements and other mandates.

These credit-constraining provisions have plenty of consumer finance experts predicting a windfall for the fringe bankers who are standing at the ready to serve those turned away from banks. Yes, a payday may be coming, but it won't last.

If banks want to grow in the future, they will have to adapt their business models to serve the credit-challenged population. They will also acquire start-up companies that are already striving to serve that market through models that will pass muster with watchful regulators (see, for example, Progreso Financiero). Just last week FICO reported that, for the first time, one-third of the population has a high-risk credit rating and that share is forecasted to continue expanding over the next few years. That means one out of three Americans already looks unattractive to banks, and that millions more will be soon be joining them.

A final strike against fringe banking is that one of their major competitive advantages -- transparent pricing -- is due to expire. I've found in my research that about half of fringe banking customers choose to use these services because they fear "hidden" bank fees (such as overdrafts), even though most would actually save money by using banks. When banks are forced to advertise their fee structures as clearly as a McDonald's menu rather than burying them in fine print, the "hidden fee" deterrent will disappear. Already, the first wave of financial reform last year has forced banks to move away from "hidden" fees (like overdrafts) and toward "transparent" ones (like monthly fees). The impact of this shift will lessen as banks attempt to recoup lost revenue elsewhere, but check cashing costs an average of $1,000 each year -- even if upfront (transparent) fees increase, it's unlikely that banks will ever drain customers' finances at the same level.

Add it all up, and fringe banking appears to be headed for the exit ramp -- but not before one last raid on millions of people's wallets. Banks have traditionally been sluggish in adopting strategic rethinking related to their retail businesses, and reform will move slowly before it has a meaningful impact on the industry. Still, competition from banks for fringe banking customers will grow rapidly in the years to come, and eventually regulators will squeeze out the remaining viability of these dead-end, high-cost businesses. For the millions of fringe banking customers, that day can't come too soon.