The Unbanked and Underbanked: Why Many Opt Out of the Banking System

March 17, 2015

While many people depend on their bank for everything from everyday money management tasks to big money pursuits like car loans and mortgages, a significant portion of the population doesn't take part in the system at all. The reasons vary -- sometimes people with limited means find alternative ways to engage in financial transactions outside of the established banking system, while others find banks hard to deal with and decide to avoid them altogether. The financial regulators have studied these facts and made recommendations designed to make banking more inclusive.

First let’s define the terms. Unbanked individuals have no savings or checking accounts with any financial institution. Underbanked individuals have a bank account of some form but utilize alternative financial firms for some transactions. These individuals use retail institutions for check cashing, money order firms for transfer payments, and pawn shops and payday loan companies for short term loans.

How big is the problem?

Currently across America, 9.6 million household representing 16.7 million adults and 8.7 million children are unbanked. Broadening the scope to include underbanked families adds another 24.8 households. Taken together, this represents 28% of American households. Colorado is a little better off, but 22% of Colorado households find themselves in this group. I was not aware of how broad this issue was until I talked to a primary school teacher from an inner city school who tried to explain the challenges that these families face. Without access to banks, many families rely on cash for all transactions and pay usury rates for any form of credit. Their ability to finance a large purchase or accumulate savings is very limited.

Money worries and aspirations

The research shows those in this group have the same worries and aspirations as the rest of us. They want to own a home, drive a nice car, manage their budgets, and be able to provide for their families and children’s education. They worry about losing their jobs, not having enough money, and not being able to pay their bills. Concerns of the unbanked focus on bankruptcy, healthcare and medical issues, and on budgeting their money from paycheck to paycheck. Among the underbanked, worries included sinking further into debt, unexpected large expenses, a lack of retirement savings, and their ability to send their children to college. They long for the assurance of living within a budget, having an emergency fund, and being able to plan for their future. Both groups aspire toward financial security to improve their lives.

Why does this happen?

The Fed’s research showed several reasons why people were unbanked or underbanked. First, and probably the most obvious, was a limited or unstable income. Many  lack the steady income needed to utilize a bank and rely on cash wages or retail check cashing services for their limited earnings. Secondly, some had negative prior experiences with banks -- including bad practices or poor communication with banks who were often seen as charging predatory fees and charges against customers with limited funds and limited ability to manage their funds.

The lack of transparency on fees led to the perception that the banks were discriminating against their low incomes or lack of language skills and were ripping them off. These customers then make the economically efficient decision to avoid the banks. Lack of education played a role with some not being familiar with how banks work. Finally, convenience played a large role. The retail institutions that are attracting these customers are easier to use based upon location and access to their communities.

What can be done?

Several recommendations fell out of the Fed’s study. First, the services provided by banks should be simple to use and have transparent fees. The accounts should be simple to open, requiring minimal identification requirements and the banks should provide better client education on their services and charges. The banks should help their clients to get the benefits without the penalties of misuse and customers should have easy access to their money. Better locations and hours would help, but recently technology has led many of these customers preferring online banking. It may be counterintuitive, but many of these customers have access to smart phones and are very adept to utilizing online services. Finally, better customer service and better accuracy and fairness were seen as essential.

The research showed two principle factors led to stronger ties between the banking system and unbanked or underbanked customers. First, direct deposit of payrolls was the strongest motivator of initiating and building banking services. The recent prevalence of having earnings directly deposited led many  into the system and helped familiarize them with the benefits.  Secondly, the influence of family, coworkers and friends was the next strongest influence. Financial advice is most highly regarded and followed if it comes from trusted sources. The discussion you have with the people around you has a profound influence upon their actions. Sharing your good council, offering recommendations, and explaining financial management with your friends and families will help them secure a better financial future.