Q2’s Ahon Sarkar appeared on a podcast with Tearsheet on the topic of how banking as a service is changing the economics of banking to give the underbanked access to banking services. Here’s a recap of that conversation.
The Problem: Legacy technology costs exclude low-deposit account holders.
Depending on whom you ask, 16 to 20 percent of the US population is underbanked. That means they have a social security number and are eligible for banking services, but they either aren’t well served by financial institutions (FIs) or have lost trust in the banking system and choose not to participate.
What does it mean to be “not well served” by banks? It’s a question of economics. Unfortunately, it often costs FIs more money to serve low-balance account holders than they make from them, which disincentivizes FIs from creating services that cater to this demographic.
One of the biggest costs for an FI is technology costs — roughly 3 to 12 dollars per account per month. Let’s look at an example of how this plays out for Jim, a low-balance account holder. Jim walks into a bank and asks to open an account. If you exclude costs for marketing and branches and just look at the cost of technology (let’s be conservative and say 3 dollars per account per month) and cost of capital (around 10 dollars), you see that it will cost the FI 46 dollars per year to serve Jim. Now let’s say Jim puts 1,000 dollars in his account, which is more than most Americans have today. The typical net interest margin on loans for an FI is 3 percent, which means the FI will make 30 dollars on Jim’s 1,000 dollars. So the FI is paying 46 dollars and making only 30 dollars, a loss of 16 dollars.
Because FIs are losing money on low-balance account holders like Jim, it’s forced them to institute fees to make up for it. This ultimately hurts the consumer. Imagine if Jim makes 30,000 dollars per year and pays the average of 300 dollars in fees. He’s seeing 1 percent of his post-tax income just disappear.
“It’s natural that this universe of customers doesn’t feel like they’re being served, doesn’t feel like there are solutions out there for them. And so they remain underbanked in the United States,” says Sarkar.
The Solution: New core technology reduces the cost of serving account holders, making it profitable to create innovative solutions for the low-balance demographic.
The reason technology costs are so high for FIs is they’re using legacy core technologies, which have been around for 40 to 60 years. These cores simply have high upkeep costs because they have to handle an expansive set of use cases and the existing technology requires maintenance.
But now a new generation of cores — lightweight and based in the cloud — have come on the market. Instead of costing 3 to 12 dollars per account per month, these new cores cost roughly 50 cents per user per month. If you spend the same 10 dollars on cost of capital, but only 6 dollars to service that user for the year, you’re spending 16 dollars instead of 46. For the same 1,000-dollar deposit, of which the FI earns 30 dollars in net interest margin, you’re now making 14 dollars instead of losing 16. That’s a huge change.
“What that does is it changes the incentive structure. Because in the United States, folks go after ways to make profit. And so finally, this population of approximately 16% of the US population, which used to be fundamentally unprofitable due to the cost of legacy solutions, is now an open market,” says Sarkar.
In addition to a radical change in economics, these new cores have introduced new capabilities and incentives to take advantage of them. Instead of just opening an account and creating a transfer, fintechs can think about fundamentally changing the way we store and move money and then plug those changes into their existing product ecosystem to create something new and differentiated.
For example, Gusto leverages their capabilities as a payroll provider to allow users to get a free cash advance on their next paycheck. Or look at Credit Karma, who gives early access to tax refunds and stimulus checks and allows you to earn Instant Karma on everyday transactions that are normally reserved for those served by the credit market.
The financial incentive created by these new cores allows fintechs and other financial services providers to investigate the problems of this underbanked demographic and create new solutions.
How do companies make money offering a free debit card?
Most companies leveraging banking as a service technology make money off of interchange revenue, which is money earned when a customer swipes a debit card. And by the way, banking as a service refers to an arrangement where fintechs and other companies offload the financial backend of banking to financial institutions and just focus on frontend development and customer experience.
According to Sarkar, the business model of banking as a service is “intrinsically tied to the behavior that you’re trying to catalyze.” This means that these companies are trying to build products that are useful, consumers use those products, and the use of those products drives revenue. This is in contrast to products that are ostensibly free, such as Facebook, where the consumer becomes the product. They’re using the sale of data to power their underlying service, which can be at odds with what the consumer wants.
Banking as a service models have the potential to change consumer expectations.
Because fintechs and other companies can finally serve the underbanked demographic with low-cost, targeted products that solve their specific problems, that will become the new expectation. In order to be competitive, traditional financial institutions will need to figure out how to meet that expectation, whether that’s by revitalizing their technology or defeaturing products.
“The net result is whether you’re partnering with a banking as a service-powered fintech or you’re going to one of the larger banks, pretty soon, a lot of these underbanked folks will have options. And will have options that are not fee-ing them to death, that are not ludicrously expensive, and that allow them to actually start building their wealth and getting out of the economic paradigm that they’ve been in historically,” says Sarkar.
Ultimately, as this shift in expectations continues to play out in the market, we’re going to see a lot of the underbanked population cease to be underbanked.
Of course, some people distrust all FIs, and that distrust will carry over to these new providers of banking services. It’ll take time to fix. But as examples of trustworthiness accumulate — transparency, communication, and showing that the company is out for the consumer’s best interest — you’ll see these relationships begin to mend.
Improving the low-income economic situation will have powerful ripples through the economy.
Velocity of money is key to understanding this concept. If you give 1,000 dollars to someone who has a high income, the chances are that they’ll put this money in savings. That’s low velocity. If you give it to someone low income, that money will change hands many more times in the coming year. High velocity. “Higher velocity of money means more money is getting spent in the economy and that means a healthier and faster growing economy and also means that we’re sort of all lifting each other up,” says Sarkar.
Systemic problems — such as the 300 dollars in bank fees or payday lender interest paid by the lowest income Americans — are keeping these people from building wealth and improving their economic situation. If you can do away with these systemic problems and allow these Americans to put the money back into the economy in a more productive way, you create an economy that’s better for all people.
How is Q2 contributing to this shift?
Q2 offers a proprietary cloud-based core like the kind described above, called CorePro. We’ve taken the functionality of a traditional core, focused on the white label components, and built it in a way that allows for better collaboration between banks and fintechs. Because we have our own core, we don’t operate with middleware and aren’t encumbered by legacy core limitations.
If you want to learn more about how Q2 Banking as a Service makes it easy for fintechs to grow their product ecosystems, check out our eBook: The Age of Abundant Banking: How to stay innovative when every company offers a debit card.