The True Costs of Joining the Formal Financial System

What products are “right” for people who are outside of the formal financial system and/or poor? It’s a question as relevant in developed economies as in developing ones. During the housing bubble in the US, financial inclusion was often a justification for what in retrospect looks more like predatory behavior. It’s difficult to tell in the moment, though, the difference between a product priced appropriately (for cost of delivery, value to the consumer, and risk among other factors) and one that is predatory when those customers are almost entirely outside the existing formal system. 

The financial crisis extended the debate in the US from payday loans to mortgages and now to checking accounts, debit cards and credit cards via regulatory changes that have changed how providers charge for these services. These changes, in general, have made it much more explicit that the cost of basic financial services for the poor or those who do not manage their money carefully are much higher than for others. 

Along with driving some people away from some products—fewer people can get a credit card for instance—there is some innovation happening, particularly around alternatives to checking accounts. Felix Salmon has been writing about the new products, pre-paid debit cards in particular, and which of them make sense for people on the edges of the formal financial system. In a recent post he discusses the “true” costs of pre-paid debit cards and finds that checking accounts are almost always cheaper, calling into question whether these products are good value. 

While Felix is right that checking accounts are almost certainly the best option in terms of explicit costs, he, like many others looking at financial inclusion in the US and in developing countries, ignores the equally true psychological costs of checking accounts and other formal services as we know them.

Looking at the financial services that the poor actually use the world over, from savings clubs to prepaid cards to microcredit to payday loans, there are a few common themes. Perhaps most important is that the poor are willing to pay relatively high explicit costs to offset implicit psychological and behavioral costs: shame, convenience, and temptation. 

Many among the poor avoid formal financial services because they feel, or are, treated badly, looked down on, or simply don’t fit in with the clientele of traditional banks. While this may seem ridiculous, think about the choices that you make all the time in terms of what businesses and restaurants to patronize. Even though you can afford it you probably don’t go into a fancy restaurant when you are wearing jeans with holes in the knee and sporting a baseball cap. It’s uncomfortable to not fit in. It’s even more uncomfortable to be looked down on or ignored (see this recent paper for instance). The additional transaction costs for a debit card may be small compared to the benefit of never having to go into a bank branch.

Pre-paid debit cards may also seem, if not in actuality be, more convenient than taking the time to go to a bank and open a checking account. Similarly, the higher transaction fees of a debit card may serve as a guard against the temptation to spend in unwise ways while not making emergency use of funds hopelessly inconvenient or impossible. Finally, you have to take into account decision fatigue—pre-paid cards perceived simplicity may be a significant benefit to people who are faced with dozens of high-stakes financial decisions each month. 

All of these implicit costs make it very hard to determine what the best option is for someone on the edges of the formal financial system. Explicit costs may seem high but may in fact be cheap if they reduce higher implicit costs. 

Unfortunately we have practically no solid data on the financial lives of the poor in developed countries to help product designers and advocates for financial inclusion better understand the tradeoffs and design optimal products. That’s why I’m so excited about the US Financial Diaries project.

In the meantime, we would all do well to remember that the explicit costs of financial services are only one piece of the puzzle. 

Timothy Ogden is an executive partner at Sona Partners, the editor in chief of Philanthropy Action, and co-author of Toyota Under Fire.