Opinion

Felix Salmon

Everyone into the next shadow banking system

September 19, 2011

By Barbara Kiviat

Consumer advocates have been worrying for a while now that the rapid rise of reloadable prepaid cards will lead to a two-tier financial system. There will be folks with bank accounts, and then there will be folks with prepaid cards.

Prepaid cards, which consumers (or their employers) load with money for debit-card-like spending, may  seem like the perfect solution for the 17 million American adults without a bank account—no carrying around wads of cash, no pesky check-cashing fees—but prepaid cards are hardly little angels. They often come with significant fees, including ones to use ATMs, to put more money on the card, and to close out the account. Plus, they tend not to have handy devices, like account statements, that people with bank accounts rely on.

This has led to calls to more closely regulate the industry.

One of the biggest issues is that, unlike bank accounts, prepaid cards don’t necessarily come with FDIC insurance or the protections of the Electronic Funds Transfer Act. To be clear: many prepaid cards do carry “pass-through” FDIC insurance, and some prepaid cards do fall under Reg E, thus carrying consumer protections like limited liability for lost or stolen cards. But the regulation of prepaid cards is patchwork, much of the compliance is voluntary, and consumers are almost certainly not shopping around based on which cards are covered. In many cases, consumers wouldn’t get to pick which card they use anyway, since their employer or government is the one putting money on the thing.

Typically, when people talk about these facts, the conversation is framed as being about the “unbanked,” the low-income, or those out of the “financial mainstream.”

But maybe it’s time we think a little more broadly about prepaid cards.

Since signing up to guest blog while Felix is on vacation, I’ve started doing things like reading wire stories about what MasterCard executives have to say to investors. This Dow Jones piece provides the following nugget:

MasterCard also is pushing its prepaid card business to spur growth.

Prepaid cards, which traditionally have been offered to low-income or “underbanked” consumers, are also a focus.

Increasingly, interest in prepaid cards “will be driven by banked consumers looking” to divide up and budget their spending, Murphy said.

In other words, prepaid cards are on their way into the financial mainstream.

The MasterCard execs point out a demand-side reason for the expansion: using a series of prepaid cards can be a useful way to set aside different pots of money for different uses. It’s mental accounting come to life. I’ve heard about people doing this—even buying prepaid cards specifically to store them away as savings—but I’m guessing what will have much more of an impact on the size and reach of the prepaid industry is the insane marketing muscle of firms like MasterCard.

Anyway, none of that is necessarily bad. Fifty years ago credit cards were the new kid on the block, and 30 years ago hardly anyone was using an ATM. New financial products can be useful, even life-changing.

But there are real reasons why current mainstream products typically come with substantial consumer protections. If the future is one in which we’re all using prepaid cards, perhaps more than those looking out for the “unbanked” should be paying attention.

Comments
7 comments so far | RSS Comments RSS

Barbara! It’s great to read you again. You’re somewhere in my LinkedIn; I should catch up with what you’re doing there.

I think the real tragedy here is that people lack either the knowledge or the discipline to manage their finances without such an explicit vehicle. Is it a generational thing, or a cultural one? I grew up with no understanding of personal finances, and my reaction as a young adult was to teach myself the subject, and to be conservative in my spending behavior. Clearly others learned other lessons.

Posted by Curmudgeon | Report as abusive
 

Most people most definitely lack the knowledge to manage their own finances, and one of the reasons is that they are never taught how to. Financial literacy is not part of any school curriculum, and most parents lack the knowledge themselves, and therefore cannot effectively teach the topic to their own children.

Posted by mfw13 | Report as abusive
 

Maryland’ Comptroller has been trying for several years to require financial literacy in schools. Latest shot is a petition to present to the next legislative session.
http://www.comp.state.md.us/comptroller/ initiatives/literacy/default.asp

And I second curmudgeon’s welcome back!

Posted by Lunasea | Report as abusive
 

Hey, Curmudgeon! Hey, Lunasea! Thanks for the warm welcome. RE financial literacy education, here are two of my favorite papers:
http://www.aspeninstitute.org/publicatio ns/two-cheer-school-based-financial-educ ation
http://www.law.uiowa.edu/documents/ilr/w illis.pdf

Perhaps I should write a blog post…

Posted by BarbaraKiviat | Report as abusive
 

Barbara: good article, I just wanted to point out that shadow banking usually refers to major creditors that are outside of the traditional banking system. Private non-bank financial institutions buying home loans from mortgage brokers, auto loans turned into ABS and sold to private investors (and ABS of all sorts), etc. All not showing up on the balance sheets of the banking system.

If the consumer asset balances on these cards are ultimately held on bank balance sheets, then this is not really shadow banking.

The real “next shadow banking system” question is what do we do after Frannie starts slowing down – it currently is the ultimate financier of 80+% of U.S.home mortgages. The structured ABS market is dead or on life support, and one the reasons that overall credit growth has stalled. Traditional bank leverage should be coming down.

On whose balance sheet is future credit creation going to be booked?

Posted by SteveHamlin | Report as abusive
 

Hi Barbara, interesting read. I’ve considered using the pre-paid cards for one time transactions in business. I can see where they could be abused as a means of paying “cash” for services and avoiding the issues associated with tax reporting. Creating a shadow economy outside the fingers of Federal, State and City.

SteveHamlin, where there is a viabile market (i.e. reasonable regualtion and opportunity) entrepreneurs will step in to fill the void. That’s if we have any left after D.C. gets done with us….

Posted by GeorgeChaney | Report as abusive
 

Prepaid cards are issued by banks, not by some alternative financial services providers. “Prepaid” is actually a pretty bad adjective. Even checking accounts are “prepaid”: try spending money out of a checking account without having deposited some money in it first!

One of the reasons prepaid cards are gaining ground is that the corresponding accounts held by the issuing banks are usually “co-mingled” into a single very large account, making them somewhat cheaper for the banks to operate (than individual checking accounts)
The vast majority of banks hosting prepaid card accounts provide “pass through” FDIC insurance, providing the same protection as individual checking accounts.
And now, for prepaid cards to receive deposits from federal or state sources (tax refunds, benefits…), they must comply with Regulation E for the protection of consumers. This makes prepaid card accounts very similar to checking accounts.
Expect the Center for Financial Services Innovations (“CFSI”) to push de-facto rules and principles for prepaid cards demanding FDIC and Reg E protection, to ensure that the whole industry is homogeneous.

These are hardly the premises for a “shadow” banking system: banks are at the heart of prepaid, and consumer protections will be de rigueur for any serious competitor in this space.

Full disclosure: my own company, Plastyc, manages prepaid card programs and has received funding from Core Innovation Capital, the investment partner of CFSI.

Posted by PPeyret | Report as abusive
 

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