For 35 years the Chicago Fed has brought together practitioners and researchers to successfully address some of the toughest problems facing the financial services industry-- through its annual Bank Structure Conference. The key to the conference's success has been the Chicago Fed's strategy of creating venues for business practitioners, policymakers, and academics to interact. The conference's success stems from the value unlocked when representatives from these groups come together to focus on issues concerning the banking industry.
Now the Chicago Fed is taking that strategy to the Internet, making possible year-round initiatives to address the most pressing concerns of the industry. In September 2000, the Chicago Fed, with cooperation from the U.S. Department of the Treasury, launched a new website, www.chicagofed.org/unbanked/. The site aims to provide a forum for research on issues relating to the unbanked segment of the LT.S. population, i.e., those who do not use mainstream financial services. The Fed's experience with the Bank Structure Conference shows that publicizing research promotes research. Drawing on this experience, the Bank intends the new website to provide one place where bankers can obtain the information they need to develop banking services for this nontraditional customer base. The site is also intended to encourage academic research in this area. Researchers at the Chicago Fed have learned that the focus of academic research can benefit from close interaction between academics and members of the banking industry.
In this Chicago Fed Letter, I outline the Chicago Fed's strategy for addressing issues relating to the unbanked via the Internet.1 Below, I provide some background on the unbanked population. I then describe what has been done to date and how the Bank's new website contributes to the effort.
The Unbanked?
Simply put, the unbanked are those who are not using the financial services that are used by the majority of the population. Estimates of the size of the unbanked population range from the five million recipients of federal benefits who do not have bank accounts (which would translate to 1.5% of the U.S. population) to 10% of the population. Why should we be concerned that individuals choose, for various reasons, not to use formal financial services? There are two main consequences from nonuse that are of concern to policymakers and industry observers. First, it is costly to deliver government benefits to recipients outside of mainstream payments channels. It simply costs more to deliver social security, veteran, and other benefits when the payment must be delivered via a check rather than an electronic transfer. The added cost is not trivial. Rates paid by the U.S. Treasury per individual transaction are 42 cents for payments by check and 2 cents for electronically delivered payments. Treasury estimates it can save $100 million per year by delivering federal benefits electronically.2 The second consequence of obtaining financial services outside of mainstream channels is higher costs for households. These costs include: higher fees for completing transactions, a loss of personal security, and less effective participation in the economy.
The first of the costs for unbanked households is transaction fees. Most participants in the economy accomplish their payments via transfers between deposit accounts. Households receive income in the form of electronic transfers to their accounts or paper checks that can be deposited to accounts. These households then pay monthly bills from these accounts using similar payment mechanisms. By and large, the accounts used by households are provided by banks and other depository institutions. The costs institutions incur to provide these services are generally higher than the charges they levy on account holders. What makes the arrangement work is the income banks derive from the use of funds that households leave on account. Bank costs are also reduced because the scale of operation for their payment services is so large.
It is important to understand that participants in the mainstream of the financial system derive considerable benefit from their use of excess balances and from scale economies. Absent the ability to use funds left on account, the operating costs incurred by check cashers providing payment services must be covered by service fees for individual transactions. In addition, because the customers of a check cashing operation are far fewer, the operating scale is not present. These two factors imply that the payment services offered by check cashing operations are considerably more expensive than similar services offered by banks.
Transaction fees are higher for other reasons as well. The very large customer base seeking banking services attracts numerous entrants to the payment services business. Competition among these participants ensures that households shopping for payment service providers can expect to obtain good value for money spent. Absent this large market share, financial access is limited to a few providers and, therefore, is much more susceptible to less competitive pricing. In addition, the check cashing industry points out that it incurs higher costs of fraudulent presentations than do mainstream depository institutions. As the costs of fraud are much more easily understood than some of the other costs outlined above, it is not surprising that most explanations for the high cost of check cashing operations emphasize fraud. Although anecdotes may suggest otherwise, it is entirely possible that the other costs cited above may be more significant for check cashing operations than the costs associated with fraud.
When combined, Treasury notes these factors result in significant costs. The average 3% fee charged by check cashers for payroll checks produces a per month cost of $15 to $30. The average charge applied to social security checks ranges from $9 to $16 per month. Treasury estimates the average lifetime impact of all such charges for low- and moderate-income individuals at $15,000.3
The second cost unbanked households face is a loss of security. There is only one term of exchange for transactions outside the mainstream financial services arena: cash. With no place to store balances, individuals necessarily keep and carry large portions of their wealth in cash. This implies that these households cannot benefit from protections such as the $50 limit of liability from fraudulent use of a person's credit card or from daily limits on ATM withdrawals. Because of the availability of such protections, the majority of the population can protect a much larger fraction of its wealth by simply using protected payments mechanisms rather than cash. Treasury estimates that U.S. households can reduce their annual losses from crime bv $100 million by switching from a paper-based to an electronic payment mechanism.4 The third cost incurred by unbanked households is one of mindset. To succeed in today's business world, one needs to be familiar with fundamental concepts such as credits and debits and to be able to critically review invoices and billings. Households limited to cash transactions have fewer opportunities to gain experience in these matters and, as a result, are less likely to develop the mindset needed to succeed in the work place. Such practices deter individuals from extracting the full value of their labor, discourage efforts that will develop their skills, and, consequently, make those skills less available to the rest of the economy.
What is being done?
A number of efforts are underway to bring the unbanked into the mainstream of financial services. In June 1999, the U.S. Treasury introduced its ETA(SM) product (electronic transfer account). This effort gives the recipients of payments from federal benefits programs a banking account, enabling beneficiaries to receive payments via electronic transfer rather than postal delivery of paper checks. Given an estimated five million recipients of federal benefits in the U.S., the complete success of the ETA program would result in a significant decline in the cost that Treasurv incurs in delivering benefits-the cost savings would be more than enough to cover the operating costs of the ETA program. Working with Treasury are over 600 financial institutions at 9,500 branch locations that have agreed to provide ETA accounts in their communities. The Federal Reserve Bank of Dallas plays a key role in the development and operation of the ETA system.
