Fringe Banking: Going the Way of the Dinosaurs?

In last week’s Huffington Post entry, Matt argues that the fringe banking industry is slowly on its way to extinction, largely due to tighter state and federal regulations and increased competition from conventional banks. There are three arguments in particular that strengthen this claim, but first—a primer.

What is fringe banking?

Many Americans borrow from institutions that aren’t banks. We’ve all seen the flashing “Payday Loans” and “E-Z Cash… NOW!” signs along the side of the road. Inside these establishments, pictures of overjoyed families, wads of cash in their hands, adorn the walls selling the promise of stress-free borrowing and better living. Services offered include:

  • Payday loans
  • Auto title loans
  • Advances on tax refunds
  • “Rent-to-own” agreements
  • Pawnshop loans

The majority of these non-bank loans are short-term and come at an exorbitantly high cost. The average payday loan, for example, carries an APR of 390% and usually has to be paid back within a couple of weeks. According to a recent FINRA report that we wrote about here, 23% of Americans have engaged in a form of high-cost borrowing in the last five years. Once a consumer borrows from a fringe banking institution, it becomes highly likely that she will go back and borrow again (9 times per year on average, according to the Center for Responsible Lending). Over time, many consumers end up paying much more in fees than the amount they initially borrowed. The Consumerist estimates that payday borrowers spend an average of $793 trying to repay a $325 loan.

Photo: The Consumerist

The fringe banking industry is a $250 billion market serving 20 million US households. Fringe bankers often target consumers with poor credit history and a lack of access to conventional credit, which is why banks have steered clear of these consumers in the past.

So why is it reasonable to think that fringe banking is on its way out?

Three forces are slowly pushing the fringe banking industry over the edge:

  1. Caps on interest rates: New rules are growing increasingly critical of fringe banking’s high-fee business model. Backers of the Consumer Financial Protection Agency (CFPA), created under last week’s federal financial reform bill, have already vowed to place a cap on interest rates for short-term loans. In recent years, several states have implemented similar interest rates caps and are witnessing direct effects on payday lenders. Two weeks ago for example, Advance Advance (one of the largest payday lenders in the US) announced plans to close all 47 of its locations in Arizona after state law capped interest rates at 36%.
  2. More Americans with credit risk: In the wake of the recent crisis, the number of consumers with squeaky-clean credit ratings has diminished. Banks’ desirable market of consumers has shrunk considerably: one in three consumers now have unattractive credit profiles. Banks will need to adapt their business model and the market of consumers they serve to survive.
  3. Transparent pricing: One of the main reasons consumers turn to fringe banking is because they’re afraid of “hidden” fees at regular banks. Overdraft fees are the most common culprits, but consumers can incur upwards of 24 other fees on checking accounts—many of which are buried in the fine print. New regulation is forcing banks to become more transparent with their pricing and do away with “hidden” fees. This may, over time, win the trust of fringe banking customers.

Still, fringe banking is not going away overnight. The financial reform bill that was signed into law by President Obama last week imposes strict lending requirements on conventional banks. Payday and other non-bank lenders will most likely get one last windfall, since many consumers will continue to be turned down by banks in the short term. With the three forces above at play though, Matt makes the call that fringe banking will go the way of the dinosaurs within the next 5-10 years, as they are slowly squeezed out by regulation and increased competition from banks.

What do you think? Do you foresee banks adjusting their business model to cater to the fringe banking market?

Check out the full article here and join the conversation in the comments.