Building a Digital Masterpiece on Top of the Core

Digital banking has become a must-have feature. The coronavirus pandemic forced consumers to accelerate their adoption of digital banking tools; now they love the convenience and flexibility these products provide.

But what is troubling for banks is that many consumers do not care if these services are met by a traditional financial institution or a fintech challenger bank. U.S. consumers are increasingly comfortable transacting with an increasing number of financial service providers to get the specific products and features that are most important to them.

According to a recent survey conducted by Cornerstone Advisors, 35% of consumers now have more than one checking account, led by the 42% of millennials who have two or more accounts. The report found that challenger banks hold a growing number of these accounts by offering specific features that consumers can’t get from their existing financial institution.

This pressure is particularly high on community and regional banks, which lack the budgets and IT resources of the global banks. However, the technology powering challenger banks has also created an emerging option that enables banks to accelerate product innovation and effectively compete with larger financial institutions and challenger banks: modular banking.

Challenger Bank Tech, One Block at a Time

Community and regional banks in pursuit of innovation are often left to choose between two equally unappealing options: wait on a core that may not innovate at the speed they want or take on the risk of a massive core conversion.

Modular banking, on the other hand, applies the challenger bank approach of building hyper-focused services to the realities of a bank’s existing core and IT landscape. Modular banking platforms typically offer the same functionality as a modern core banking system. However, instead of building the entire platform at once, modular banking approaches service much like a set of building blocks. Banks only need to select the products and services that complement their existing systems’ functionality or build new digital products on top of it.

Put simply, modular banking looks at each piece of a bank’s functionality — such as Know Your Customer, card issuance, P2P or rewards — as a collection of loosely coupled microservices and application programming interfaces (APIs) that can be combined and deployed in a cloud environment to facilitate specific use cases.

Modular banking enables institutions to build specific products to meet the specific needs of their customers and quickly adjust as market conditions change. For example, a regional bank could solve an immediate need for banking products to offer contract workers with a pre-built module, before shifting to bring innovative features for families that make up most of the service area with teen and children accounts. A modular approach to digital transformation benefits small and mid-size community banks in two keys ways.

Quickly Develop New Products
By decoupling critical infrastructure, like the systems and processes that need to work reliably but don’t confer competitive differentiation, from the people, processes and technology focused on product innovation, modular banking provides a potential solution to execution challenges that banks face.

Productive Fintech Partnerships
Creating productive, long-term partnerships requires financial institutions to build mutually beneficial relationships with fintech companies. Innovating through fintech partnerships also requires banks to move fast, which is where modular banking comes in.

The open architecture of a modular banking platform can facilitate the rapid integration of third-party partners, by giving potential partners a modern API to connect to and build on top of. Bank leaders can take a much more proactive approach to pursuing and operationalizing new partnerships.

By building these strategic partnerships, they can create a competitive differentiator to fuel growth for the coming years.

Three Steps to Building a Commercial Card Business In-House

As the economy recovers from the impact of the Covid-19 pandemic, community banks will need to evaluate how to best serve their small and medium business (SMB) customers.

These companies will be seeking to ramp up hiring, restart operations or return to pre-pandemic levels of service. Many SMBs will turn to credit cards to help fund necessary changes — but too many community banks may miss out on this spending because they do not have a strong in-house commercial card business.

According to call reports from the Federal Deposit Insurance Corp., community banks make up half of all term loans to small businesses, yet four out of five have no credit card loans. At the same time, Accenture reports that commercial payments made via credit card are expected to grow 12% each year from 2019 to 2024. This is a significant strategic opportunity for community bankers to capitalize on the increased growth of cards and payments. Community bankers can use commercial cards to quickly capitalize on this growth and strengthen the relationships with existing SMB customers while boosting their local communities. Commercial credit cards can also be a sticky product banks can use to retain new Paycheck Protection Program loan customers.

Comparing Credit Card Program
Many community banks offer a branded business credit card program through the increasingly-outdated agent bank model. The agent bank model divorces the bank from their customer relationship, as well as any ability to provide local decisioning and servicing to their customers. Additionally, the community banks carry the risk of the credit lines they have guaranteed. In comparison, banks can launch an in-house credit card program within 90 days with modern technology and a partnership with the right provider. These programs require little to no upfront investment and don’t need additional human resources on the bank’s payroll.

Community banks can leverage new technology platforms that are substantially cheaper than previous programs, enabling issuers to launch products faster. The technology allows bank leaders to effortlessly update and modify products that cater to their customer’s changing needs. Technology can also lower customer acquisition and service costs through digital channels, especially when it comes to onboarding and self-service resources.

More importantly in agent bank models, the community bank does not underwrite, fund or keep the credit card balances on its books. It has little or no say in the issuing bank’s decisions to cancel a card; if it guarantees the loan, it takes all the risk but receives no incremental reward or revenue. The bank earns a small referral fee, but that is a fraction of the total return on assets it can earn by owning the loans and capturing the lucrative issuer interchange.

Bringing credit card business in-house allows for an enhanced user experience and improved customer retention. Community banks can use their unique insight to their SMB customers to craft personalized and tailored products, such as fleet cards, physical cards, ghost cards for preferred vendors or virtual cards for AP invoices. An in-house corporate credit card program gives banks complete access to customer data and total control over the user experience. They can also set their own update and product development timelines to better serve the changing needs of their customers.

Three Steps to Start an In-House Program
The first step to starting an in-house credit card program to build out the program’s strategy, including goals and parameters for credit underwriting. The underwriting strategy will establish score cutoffs, debt-to-income ratios, relationship values and other criteria so automated decisions reflect the policies and priorities of the bank. It is important to consider the relationship value of a customer, as it provides an edge in decision making for improved risk, better engagement and higher return. If a bank selects a seasoned technology partner, that partner may be able to provide a champion strategy and best practices from their experience.

Next, community banks should establish a long-term financial plan designed to meet its strategic objectives while addressing risk management criteria, including credit, collection and fraud exposures. It is important that bank leaders evaluate potential partners to ensure proper fraud protections and security. Some card platform providers will even share in the responsibility for fraud-related financial losses to help mitigate the risk for the bank.

The third step is to understand and establish support needs. These days, a strong account issuer program limits the bank’s need for dedicated personnel to operate or manage the portfolio. Many providers also offer resources to handle accounting and settlement, risk management, technology infrastructure, product development, compliance and customer service functions. The bank can work with partners to build the right mix of in-house and provided support, and align its compensation systems to provide the best balance of profitability and support.

Building an in-house corporate credit card program is an important strategic priority for every community bank, increasing its franchise value and ensuring its business is ready for the future.

Tailor Innovation With Fintech, Bank Collaborations

The Covid-19 pandemic reshaped the way that community banks think about their digital products and the expectations that consumers have for them. Digital transformation is no longer an option – it is a necessity.

In fact, 52% of consumers have used their financial institution’s digital banking services more since the start of the pandemic, according to BAI Banking Outlook. However, the research also found that only 61% of consumers feel their community bank understands their digital needs, compared to that 89% of direct bank consumers and 77% of large bank consumers.

As customers’ ever-growing expectations are not being met, banking teams are also concerned that their digital tools may be missing the mark. For many, the investments into digital solutions and tools are not having as wide as an impact as expected; on occasion, they do not hold any true benefit to their current and prospective account holders.

In addition, many community banks find themselves innovating for the sake of innovating, rather than solving real problems that exist within their target market. The communities that these banks serve are distinctive and can present unique challenges and opportunities, unlike those as little as a state away. Community banks must consider practical, powerful digital tools that benefit their one-of-a-kind customer base.

Rather than a product-driven approach to development, community banks must look to the niche needs within the market to discover areas to innovate. Identifying obstacles in the financial lives of existing customers and prospects ensures that community banks are working to solve a problem that will alleviate pain points for accountholders. But, with limited time and resources, how can this be accomplished?

Fintech-Bank Partnerships
Community banks can attract new customers, expand existing relationships and improve customer experience within the specific communities that they serve by implementing fintech solutions that are  specialized to the individual market or demographic.

It makes sense. Fintech-bank partnerships can pair a bank’s distinct market opportunities with technology that can effectively unlock niche verticals. We collaborated with five community banks who were searching for a responsive web app for digital commercial escrow and subaccounting that would eliminate the manual processes that limited their ability to handle commercial escrow and subaccounting accounts. Engaging with a fintech and leveraging extensive resources that are dedicated to developing and improving upon innovative technology gave these institutions a solution built with their companies in mind.

These partnerships between fintechs and banks are also more financially feasible — many community banks are unable to develop similar solutions in-house due to understaffing or lack of resources. With the help of a fintech, the institution can implement solutions faster and reach profitable clients sooner.

Fintech and bank collaborations are changing the way that community banks innovate. Together, they can expand the potential of a solution, both in its specialization and its capability, to better meet customer needs. Banking teams can provide the digital tools that their clients need and attract desirable clients that they hope to serve.

How Fintechs Can Help Advance Financial Inclusion

Last year, the coronavirus pandemic swiftly shut down the U.S. economy. Demand for manufactured goods stagnated while restaurant activity fell to zero. The number of unbanked and underbanked persons looked likely to increase, after years of decline. However, federal legislation has created incentives for community banks to help those struggling financially. Fintechs can also play an important role.

The Covid-19 pandemic has affected everyone — but not all equally. Although the number of American households with bank accounts grew to a record 95% in 2019 according to the Federal Deposit Insurance Corp.’s “How America Banks” survey, the crisis is still likely to contribute to an increase in unbanked as unemployment remains high. Why should banks take action now?

Financial inclusion is critical — not just for those individuals involved, but for the wider economy. The Financial Health Network estimates that 167 million America adults are not “financially healthy,” while the FDIC reports that 85 million Americans are either unbanked or “underbanked” and aren’t able to access the traditional services of a financial institution.

It can be expensive to be outside of the financial services space: up to 10% of the income of the unbanked and underbanked is spent on interest and fees. This makes it difficult to set aside money for future spending or an unforeseen contingency. Having an emergency fund is a cornerstone of financial health, and a way for individuals to avoid high fees and interest rates of payday loans.

Promoting financial inclusion allows a bank to cultivate a market that might ultimately need more advanced financial products, enhance its Community Reinvestment Act standing and stimulate the community. Financial inclusion is a worthy goal for all banks, one that the government is also incentivizing.

Recent Government Action Creates Opportunity
Recent federal legislation has created opportunities for banks to help individuals and small businesses in economically challenged areas. The Consolidated Appropriations Act includes $3 billion in funding directed to Community Development Financial Institutions. CDFIs are financial institutions that share a common goal of expanding economic access to financial products and services for resident and businesses.

Approximately $200 million of this funding is available to all financial institutions — institutions do need not to be currently designated as a CDFI to obtain this portion of the funding. These funds offer a way to promoting financial inclusion, with government backing of your institution’s assistance efforts.

Charting a Path Toward Inclusion
The path to building a financially inclusive world involves a concerted effort to address many historic and systemic issues. There’s no simple guidebook, but having the right technology is a good first step.

Banks and fintechs should revisit their product roadmaps and reassess their innovation strategies to ensure they use technologies that can empower all Americans with access to financial services. For example, providing financial advice and education can extend a bank’s role as a trusted advisor, while helping the underbanked improve their banking aptitude and proficiency.

At FIS, we plan to continue supporting standards that advance financial inclusion, provide relevant inclusion research and help educate our partners on inclusion opportunities. FIS actively supports the Bank On effort to ensure Americans have access to safe, affordable bank or credit union accounts. The Bank On program, Cities for Financial Empowerment Fund, certifies public-private partnership accounts that drive financial inclusion. Banks and fintechs should continue joining these efforts and help identify new features and capabilities that can provide affordable access to financial services.

Understanding the Needs of the Underbanked
Recent research we’ve conducted highlights the extent of the financial inclusion challenge. The key findings suggest that the underbanked population require a nuanced approach to address specific concerns:

  • Time: Customers would like to decrease time spent on, or increase efficiency of, engaging with their personal finances.
  • Trust: Consumers trust banks to secure their money, but are less inclined to trust them with their financial health.
  • Literacy: Respondents often use their institution’s digital tools and rarely use third-party finance apps, such as Intuit’s Mint and Acorns.
  • Guidance: The underbanked desire financial guidance to help them reach their goals.

Financial institutions must address both the transactional and emotional needs of the underbanked to accommodate the distinct characteristics of these consumers. Other potential banking product categories that can help to serve the underbanked include: financial services education programs, financial wellness services and apps and digital-only banking offerings.

FIS is committed to promoting financial inclusion. We will continue evaluating the role of technology in promoting financial inclusion and track government initiatives that drive financial inclusion to keep clients informed on any new developments.

The Community Bank Advantage to Helping Small Businesses Recover

While the Covid-19 vaccination rollout is progressing steadily and several portions of the country are making steps toward reopening and establishing a new normal, it is still too early to gauge how many small businesses will survive the pandemic’s impacts.

In a 2020 study of small firms by McKinsey & Co., it was initially estimated between 1.4 million to 2.1 million of the country’s 31 million small businesses could fail because of the events experienced in 2020 and 2021. However, a more recent report from the Federal Reserve revealed that bankruptcies during 2020 were not as bad as originally feared — with around 200,000 more business failures than average. Simply put, the true impact of the pandemic’s interruptions cannot be known until later this year or even next.

A PwC study on bankruptcy activity across the broader business sectors reveals which industries were impacted the most. Of the bankruptcies in 2020 where total obligations exceeded $10 million, retail and consumer sectors led the way, followed by energy and real estate. Together, these three sectors accounted for 63% of all bankruptcies.

Reimagining Small Business Success
While a lack of revenue has been the most critical issue for small business owners, they are also suffering from other challenges like a lack of time and guidance. Business owners have faced tremendous pressure to meet local and national guidelines and restrictions around interacting with the public, many even having to transform their business models to reach customers remotely. Such burdens often leave business owners meeting operational needs during nights and weekends.

This creates a timely opportunity for community banks to better support business customers’ recovery from this period of economic stress. Financial instituions can provide anytime, anywhere access to their accounts and financial tools, more-effective cash flow management capabilities and personalized digital advisory services to meet evolving needs. These tailored services can be supported with personal digital support to revitalize the service and relationships that have always been a competitive advantage of community institutions.

Putting Humans at the Center
A 2021 study by Deloitte’s Doblin revealed five ways financial services firms can support their business customers post-pandemic, including demonstrate that they know the customer, help them save time, guide them with expertise, prepare them for the unexpected and share the same values. These findings provide insight into how business owners prefer to bank and what they look for in a bank partner. In fact, 62% of small businesses were most interested in receiving financial advice from their financial institutions.

The Doblin study goes on to explore the activities that institutions can engage in to better serve the small business marketplace. Top findings included enabling an easier lending journey, investing in innovative, digital-led initiatives and offering personalized, context-rich engagement. These areas have been priorities for community banks, and the pandemic has accelerated the timeline for adopting a strong digital strategy. Compared to competitors including national banks, digital banks and nontraditional players, community banks are uniquely positioned to help local businesses recover by combining digital solutions with services that center the human connections within the banking relationship.

As business owners look to finance their road to recovery, it’s been repeatedly shown that they prefer a relationship lender who understands their holistic financial picture and can connect them to the right products, rather than shopping around. Business owners want a trusted partner who uses technology to make things easy and convenient and is available to talk in their moments of need. The best financial technologies strengthen human connections during the process of fulfilling transactions. These technologies automate redundant tasks and streamline workflows to reduce the mundane and maximize the meaningful interactions. When done right, this strategy creates an enhanced borrower experience as well as happier, more productive bank employees.

There’s a clear sense that the events of 2020 and 2021 will permanently shape the delivery of financial services, as well as the expectations of small business owners. The year has been a crisis-induced stress test for how technology is used; more importantly, how that technology can be improved in the months and years ahead. The pandemic, as challenging and destructive at it has been, generated a significant opportunity to reimagine the future, including the ways bankers and small businesses interact. Those community institutions that take the lessons learned and find ways to build and maintain human relationships within digital channels will be well positioned to serve their communities and succeed.

Highlights From CECL Adoption

On Jan. 1, 2020, approximately 100 SEC financial institutions with less than $50 billion in assets across the country adopted Accounting Standards Update 2016-13, Financial Instruments—Credit Losses (Topic 326) Measurement of Credit Losses on Financial Statements.

More commonly referred to as “CECL,” the standard requires banks to estimate the credit losses for the estimated life of its loans — essentially estimating lifetime losses for loans at origination. Not all banks adopted the standard, however. While calendar-year SEC filers that are not considered to be smaller reporting companies or emerging growth companies were set to implement the standard at the start of 2020, the Coronavirus Aid, Relief, and Economic Security Act and subsequent Consolidated Appropriations Act, 2021, allowed them to delay CECL implementation through the first day of the fiscal year following the termination of the Covid-19 national emergency or Jan. 1, 2022. Of the publicly traded institutions below $50 billion in assets that were previously required to adopt the standard, approximately 25% elected to delay.

Highlights from the banks that adopted the standard could prove very useful to other community banks, as many work toward their January 2023 effective date. A few of the relevant highlights include:

  • Unfunded commitments had significant effects. It is important that your institution understands the potential effect of unfunded commitments when it adopts CECL. The new standard has caused significant increases in reserves recorded for these commitments. At institutions that have already adopted the standard, approximately 20% had a more significant effect from unfunded commitments than they did from funded loans.
  • Certain loan types were correlated with higher reserves. When comparing the reserves to loan concentrations at CECL adopters with less than $50 billion in assets, institutions with high levels of commercial and commercial real estate/multifamily loans experienced larger increases in reserves as a percentage of total loans for the period ended March 31, 2020.
  • Certain models were more prevalent in banks with less than $50 billion in assets. Approximately 60% of the banks with less than $50 billion in assets indicated they used the probability of default/loss given default model in some way. Other commonly used models were the discounted cash flow model and loss rate models. Less than 10% of adopters so far have disclosed using the weighted-average remaining maturity (WARM) model.
  • One to 2 years were the most commonly used forecast periods. The new standard requires banks to use a reasonable and supportable economic forecast to guage loss potential, which demands a significant amount of judgment and estimation from management. Of the banks that adopted, more than half used 1 year, and approximately a quarter used 2 years.
  • Acquisitions impacted the additional reserves recorded at adoption. Of the 10 CECL adopters with the most significant increases in reserves as a percentage of loans, nine had completed an acquisition in the previous year. This is due to the significant changes in the accounting around acquisitions as a part of the CECL standard. The new standard requires reserves to be recorded on purchased loans at acquisition; the old standard largely did not.
  • Reserves increased. Focusing on banks that adopted CECL in the first quarter that have less than $5 billion in assets (21 institutions), all but one experienced an increase in reserves as a percentage of loans. Approximately 70% of those institutions had an increase of between 30% and 100%.

The CECL standard allows management teams to customize the calculation method they use, even among different types of loans within the portfolio. Because of that and because each bank’s asset pool will look a little different, there will be variations in the CECL effects at each institution. However, the general themes seen in these first adopters can provide useful insight to help community banks make strides toward implementation.

This article is for general information purposes only and is not to be considered as legal advice. This information was written by qualified, experienced BKD professionals, but applying this information to your particular situation requires careful consideration of your specific facts and circumstances. Consult your BKD advisor or legal counsel before acting on any matter covered in this update.

Why Community Banks Are Investing in Startups

Reliant Bancorp is a community bank by almost any definition of the word. It has $3 billion in assets and focuses on its Middle Tennessee community around its headquarters in Brentwood, Tennessee. It funds what community banks commonly fund: loans mostly tied to real estate, commercial and industrial loans and a small amount of consumer loans. And now, it’s funding something less common for a community bank: startups.

Reliant Bancorp is joining a group of 66 institutions, mostly community banks, who recently helped close a new $150 million fund for financial technology companies called JAM FINTOP Banktech. JAM Special Opportunity Ventures, an affiliate of New York based-bank investor Jacobs Asset Management, and Nashville-based technology investor FINTOP Capital announced the joint raise last month, which will plow Series A funding into startups that cater to community banks.

I got a chance recently to speak to Reliant’s chairman and CEO, DeVan Ard Jr., a longtime Middle Tennessee banker. He explains the logic of community banks putting their hard-earned dollars into one of the riskiest investment categories there is.

“I don’t view it as risky as much as I do giving us a window into new financial technology opportunities,” he says. Ard declines to disclose Reliant’s investment amount, but says it was small. Currently, no institution owns more than 4.4% of the fund, says John Philpott, general partner at FINTOP Capital.

The sizeable list of community banks joining the funding round shows that even fairly small institutions are investing as a way to get in on the ground floor of technological development. Ard thinks JAM FINTOP Banktech will help the bank get early access to opportunities in the tech space.

“All banks today know they can be nimble,” Ard says. “That’s the lesson we learned throughout the pandemic. You have to do business with your customers wherever and whenever they want to do business with you.”

But the fund wasn’t exclusive to community banks. A few mid-sized and large institutions joined in on the raise, including $57 billion East West Bancorp, based in Pasadena, California, and the St. Louis-based investment bank Stifel Financial Corp., according to JAM FINTOP’s website.

The investment managers billed the fund as a way for community banks to learn about the technology space, given the sheer number of financial technology companies competing for their business. “The banks [are] being shown thousands of demos,” says Adam Aspes, a general partner at Jam Special Opportunity Ventures. “It’s overwhelming. If you make the wrong decision, it can really set you back.”

How Community Banks Compete on Digital Account Openings

In 2019, over half of all checking accounts were opened via digital channels. In 2020, this number rose to two-thirds.

In 2019, megabanks and digital banks were responsible for 55% all checking applications. In the first three months of 2020, this figure reached 63% — and climbed to 69% in the next three months.

Meanwhile, community banks and credit unions accounted for 15% of applications in 2019, and even fewer than that in the six months of 2020. What’s happening here?

It’s a trend: More accounts are being opened online. But digital account openings are only one piece of a steady shift in the financial services industry, one where consumers do more over online and mobile channels. Megabanks and digital banks are riding this wave, using powerful online offerings to draw consumers away from smaller institutions.

Moneycenter banks have strong digital operations that allow them to expand into communities where they may not have a single branch. Digital offerings have also opened the door for new players like online-only challenger banks, big tech companies and fintechs that are successfully luring in younger customers with payments, investing and even cryptocurrency services. Make no mistake: if community banks aren’t already in direct competition with these digital players now, it’s only a matter of time before they are.

Who Are The New Players?

In the past, community banks’ primary competitors were primarily each another or a nearby regional bank. Today, technology is redefining what it means to be a financial institution, and thereby reshaping the competitive landscape.

Big tech heavyweights like Facebook, Alphabet’s Google, Apple, and Amazon.com have become increasingly involved in financial services in recent years. Their efforts are growing in scope: Google, for example, launching Google Plex, which includes a checking account. Most likely, these firms believe that over time, their expertise in the areas of data and software development will yield a natural advantage over incumbent financial institutions.

Online-only startup banks (also known as challenger banks or neobanks) like Chime and Varo Money are also proving to be a legitimate concern. While Varo’s strategy included obtaining a full-fledged banking charter, which it received in July 2020, Chime relies on partner banks to manage their deposits. And just because they’re startups, doesn’t mean they’re small; Chime boasted 12 million users as of the end of 2020 — 4.3 million of whom identified it as their primary bank.

How Community Banks Compete

As the marketplace evolves, so do consumer expectations. With Amazon and other on-demand services at their fingertips, consumers have become accustomed to digital experiences that are fast, seamless, and personalized.

To compete with megabanks, tech companies and challenger banks for digitally-savvy customers, it’s essential that community banks consider the following strategies:

Invest in speed and reliability
Digital banking solutions need to be fast and reliable to satisfy the high standards that consumers have come to expect. This means efficient processes, minimal to no downtime and speedy customer service. Technology that integrates with your core in real time is key to accelerating customer onboarding and boosting overall user experience.

Play to key strengths
Community banks should lean into the areas where they shine by catering to customers’ personalized needs. Banks should also position their products according to market demand and digital best practices, and configure them for strong customer experience and institutional outcomes.

Seek out the right technology partners
The difference between a good and bad technology partnership is significant; banks often end up disappointed with the performance of a digital solution. To avoid this, it’s important to extensively reference-check technology providers and inquire about the actual delivered (and not theoretical) return on investment of a solution.

Building a Digital Transformation Strategy

As digital banking becomes the norm, it has prompted a massive shift in the competitive landscape. Yet with the daunting task of digital transformation ahead of them, what’s the best place for community banks to start?

One impactful area to focus on is digital account opening. In fact, 42% of banks and 35% of credit unions say they are very interested in fintech partnerships that prioritize digital account opening solutions. Partnering with an account opening provider can help small and mid-size financial institutions position themselves favorably as consumers continue to adopt digital banking.

Best Practices to Achieve True Financial Inclusivity

According to the Federal Reserve’s report on the economic well-being of U.S. households in 2019, 6% of American adults were “unbanked” and 16% of U.S. adults make up the “underbanked” segment.

Source: Federal Reserve

With evolving technological advancements and broader access to digital innovations, financial institutions are better equipped to close the gap on financial inclusivity and reach the underserved consumers. But to do so successfully, banks first need to address a few dimensions.

Information asymmetry
Lack of credit bureau information on the so-called “credit invisible” or “thin file” portions of unbanked/underbanked credit application has been a key challenge to accurately assessing credit risk. Banks can successfully address this information asymmetry with Fair Credit Reporting Act compliant augmented data sources, such as telecom, utility or alternative financing data. Moreover, leveraging the deposits and spend behavior can help institutions understand the needs of the underbanked and unbanked better.

Pairing augmented data with artificial intelligence and machine learning algorithms can further enhance a bank’s ability to identify low risk, underserved consumers. Algorithms powered by machine learning can identify non-linear patterns, otherwise invisible to decision makers, and enhance their ability to screen applications for creditworthiness. Banks could increase loan approvals easily by 15% to 40% without taking on more risk, enhancing lives and reinforcing their commitment towards the financial inclusion.

Financial Inclusion Scope and Regulation
Like the Community Reinvestment Act, acts of law encourage banks to “help meet the credit needs of the communities in which they operate, including low- and moderate-income (LMI) neighborhoods, consistent with safe and sound banking operations.” While legislations like the CRA provide adequate guidance and framework on providing access to credit to the underserved communities, there is still much to be covered in mandating practices around deposit products.

Banks themselves have a role to play in redefining and broadening the lens through which the customer relationship is viewed. A comprehensive approach to financial inclusion cannot rest alone on the credit or lending relationships. Banks must both assess the overall banking, checking and savings needs of the underbanked and unbanked and provide for simple products catering to those needs.

Simplified Products/Processes
“Keep it simple” has generally been a mantra for success in promoting financial inclusion. A simple checking or savings account with effective check cashing facilities and a clear overdraft fee structure would attract “unbanked” who may have avoided formal banking systems due to their complexities and product configurations. Similarly, customized lending solutions with simplified term/loan requirements for customers promotes the formal credit environment.

Technology advancements in processing speed and availability of digital platforms have paved the way for banks to offer these products at a cost structure and speed that benefits everybody.

The benefits of offering more financially inclusive products cannot be overstated. Surveys indicate that consumers who have banking accounts are more likely to save money and are more financially disciplined.

From a bank’s perspective, a commitment to supporting financial inclusivity supports the entire banking ecosystem. It supports future growth through account acquisition — both from the addition of new customers into the banking system and also among millennial and Gen Z consumers with a demonstrated preference for providers that share their commitment to social responsibility initiatives.

When it comes to successfully executing financial inclusion outreach, community banks are ideally positioned to meet the need — much more so than their larger competitors. While large institutions may take a broader strategy to address financial inclusion, community banks can personalize their offerings to be more relevant to underserved consumers within their own local markets.

The concept of financial inclusion has evolved in recent years. With the technological advancements in the use of alternative data and machine learning algorithms, banks are now positioned to market to and acquire new customers in a way that supports long-term profitability without adding undue risk.

Low Interest Rates Threaten Banks — But Not the Way You Think

The coronavirus pandemic laid bare the struggles of average Americans — middle class and lower-income individuals and families. But these struggles are an ongoing trend that Karen Petrou, managing partner of the consulting firm Federal Financial Analytics, tracks back to monetary policy set by the Federal Reserve since the financial crisis of 2008-09.

In short, she says, the Fed bears some of the blame for the widening wealth gap, which sees the rich getting richer, the poor getting poorer and the middle class slowly disappearing. And that’s an existential threat to most financial institutions.

“The bread and butter of community banks — urban, rural, suburban — is the middle class and the upper-middle class, as well as the health of the communities [banks] serve,” Petrou explains to me in a recent interview. Even for banks focused on more affluent populations, the health of their communities derives from everyone living and working in it. “When you have a customer base that is really living hand to mouth,” she says, “that’s not a growth scenario for stable communities, or of course, [a bank’s] customer base.”

A lot of digital ink has been spilled on inequality, but Petrou’s analysis — which you’ll find in her book, “Engine of Inequality: The Fed and the Future of Wealth in America,” is unique. She explores how misguided Fed policy fuels inequality, why it matters, and how she’d recraft monetary policy and regulation. And she believes the future is bleak for banks and their communities if changes don’t occur.

Her ideas have the attention of industry leaders like Richard Hunt, CEO of the Consumer Bankers Association. “She’s not what I’d consider an activist or someone who has an agenda,” he says. “She is purely facts-driven.”

Central to the inequality challenge is the ongoing low-rate environment. We often talk about the Fed’s dual mandates — promoting maximum employment and price stability — but Petrou points out in her book that setting moderate rates also falls under its purview.

Low rates have pressured banks’ net interest margins for over a decade, but they’ve squeezed the average American household, too. Petrou writes that these ultra-low rates have failed to stimulate growth. They’ve also “made most Americans even worse off because trillions of dollars in savings were sacrificed in favor of ever higher stock markets.”

The Fed’s preoccupation with markets over households, she says, benefits the most affluent.

Low interest rates, as we all know, lower the returns one earns on safer investments, like money market accounts or certificates of deposit. That drives investors to the stock market, driving up valuations. Excepting a brief blip early in the pandemic, the S&P 500, Dow Jones Industrial Average and Nasdaq have all performed well over the past year, despite high unemployment and economic closures.

However, stock ownership is concentrated in the hands of a few. As of the fourth quarter 2020, the top 1% hold 53% of corporate equity and mutual fund shares, according to the Federal Reserve; the bottom 90% own 11% of those shares. Most of us would be better off, Petrou concludes, earning a safe, living return off the money we manage to sock away.

More than 60% of middle-class wealth is tied up in their homes; pension funds account for another 17%. Those have been underfunded, “but even underfunded pensions have a hope of paying claims when interest rates are enough above the rate of inflation to ensure a meaningful return on investment,” she writes.

And while homes account for a huge portion of middle-class wealth, home ownership has actually declined over the past two decades among adults below the age of 65, according to a Harvard University study. The supply of lower-cost homes has dwindled, and banks are reticent to make small mortgage loans, which are costly to underwrite. And for those who already own a home, prices still haven’t reached the levels seen before the financial crisis — in real dollars, they’re not worth what they once were.

And homes aren’t a liquid asset. Middle class Americans used to hold more than 20% of their assets in deposit accounts, but that’s declined dramatically. All told, low interest rates severely punish savers, who actually lose money when one adjusts for inflation.

Average real wages haven’t budged in decades — but the costs for everything else have risen, from medical expenses to childcare to education and housing. So, what’s paying for all that if savings yield little and incomes are stagnant? Debt. And a lot of it, at least for the middle class, whose debt-to-income ratio has grown to a whopping 120% — almost double what it was in 1983. For the top 1%, it’s more than halved, to 35% of income.

Middle class households were in survival mode before the pandemic hit, explains Petrou.

“All of the Fed’s monetary-policy thinking is premised on the view that ultra-low rates spur economic growth, but most low-cost debt isn’t available to lower-income households, and most middle-income households are already over their head in debt,” she writes. “Monetary policy has failed in part because the Fed failed to understand America as it bought, saved and borrowed.”

Debt can be wonderful; it can build businesses and make buying a home possible for many. But that dream is disappearing. Coupled with the regulatory regime, low interest rates have changed traditional banking, explains Petrou. Financial institutions are forced to chase fee income, found in wealth management and similar products and services. And lending to more affluent customers makes better business sense.

Petrou wants the Fed to gradually raise rates to “ensure a positive real return.” Combined with other factors, rising rates would “make saving for the future not just virtuous, but successful,” she writes, “giving families with growing wages in a more productive economy a better chance for wealth accumulation, intergenerational mobility, and a secure retirement.”

It won’t fix everything, but it will help middle and lower-income families save for their homes, save for college and even pay down some of that debt.

Petrou is clear — in her book and in my interview with her — that the Fed isn’t ill-intentioned. But the agency is ill informed, she believes, relying on aggregate data that doesn’t reflect a full picture of the economy.

“The economy we’re in is not the one in which most of us grew up,” she says, referring to the baby boomers who form the majority of bank boards and C-suites. The top 10% hold a much greater share of wealth, and that share is growing. The things that many boomers took for granted, she says, are increasingly unattainable, or require an unsustainable debt burden.

College tuition offers a measurable example of how much things have changed. Adjusted for 2018-19 dollars, baby boomers paid an average $7,719 a year to attend a four-year public college, according to the U.S. Department of Education. Generation Z is now entering college paying roughly 2.5 times that amount — contributing to the growing volume of student loans.

“Assuming that [the economy] works equitably because there’s a large middle class means that banks will make strategic errors, misunderstanding their customers and communities,” Petrou tells me. “And that the Fed will make terrific financial policy mistakes.”