Why do the poorest pay the most for banking?

In an era of austerity – characterised by stagnant wages, widespread public spending cuts, and increased fuel, food and transport costs – the need to provide people with an alternative to rent-to-own companies, door-to-door moneylenders, and the payday industry has never been greater.

But despite several government-funded initiatives in recent years, the scale of credit unions and community development finance institutions (CDFIs) remains woefully inadequate to provide any real brake on the inexorable growth of the legal loan sharks.  The question arises as to what ambition policymakers really have to develop affordable financial services for people on low to middle incomes?  There is certainly no cohesive strategy in place at the moment.

In my view, a fundamental issue needs to be addressed. The question is why do we have two models for delivery – credit unions and CDFIs?

Credit unions – deposit-taking institutions – have traditionally been cautious lenders due to the very tight maximum cap on lending rates.  As institutions which intermediate between small scale depositors and small scale borrowers, the margins are extremely thin and, when serving higher risk groups, often disappear altogether.  Combine that problem with tight common bonds, which limit the possible market they can serve, and restrictions on the extent to which they can co-operate with each other (for example, by preventing them from investing their members’ money in other credit unions or in joint ventures) and you have a recipe for slow growth and, in some cases, failure.

In contrast, CDFIs do not have restrictions on the rates that they can charge, which means they have been viewed as a means to provide loans to higher risk (for which read ‘poor’) households.  However, the cost of capital for these organisations (which cannot take deposits) is often high even when borrowed from sources of ‘social’ finance.  This cost, together with their relatively high operating costs that arise from their lack of scale, has to be borne by the borrower.

Fair Finance, a CDFI based in Tower Hamlets in London, charges £169 in interest and fees on a £500 loan over 52 weeks, with a quoted APR of 75%.  This is certainly cheaper than the largest door-to-door moneylender, Provident Financial, which charges a whopping £410 on the same amount of loan over the same period.  However, the CDFI rates are by no means ‘cheap’ when compared to credit unions, which, even following the recent increase in the maximum amount they can charge, are limited to loans carrying no more than 42.6% APR.  In addition, CDFIs do not offer the other financial services – including savings and current accounts – that are provided through credit unions.

Low income households need a much more joined-up, and scaled-up, solution.  In some areas this recognition has led to the development of partnerships between credit unions and CDFIs.  But this still carries the burden of two sets of governance arrangements and infrastructure, plus the added transaction costs (notably staff time) in terms of establishing effective partnership arrangements and implementing these.  If we were starting with a blank sheet of paper, this isn’t the system we would construct.

We need to consider an alternative to the current patchwork quilt of credit unions and CDFIs, and raise the banner for the creation of a coherent national network of new mutually-owned financial institutions, providing a consistent offer in every area of the country.  A starting point would be the removal of the maximum limit on existing, larger, credit unions altogether, and the granting of permission for these to raise capital from social finance intermediaries as well as from depositors.   These organisations should also be allowed to develop jointly-funded vehicles to support the delivery of national initiatives of mutual benefit, including, for example, the delivery of national marketing campaigns to attract new members and to take forward the work to develop and improve back office functions that has thus far been taken forwards within the credit union expansion project.

However, the poorest should not be expected to meet the full costs of their risk and pay for the building of this infrastructure in its entirety. High interest rates can disguise poor practices and a lack of operational efficiency.  They also contribute to the legitimisation of the predatory lending sector.  What we need is the development of a progressive financial system which cross-subsidises the cost of making financial services available to people on low incomes.  Achieving that will require long-term investment to reduce the cost of capital for the sector and a sustained drive to achieve a much more sustainable membership base.

As a starting point, a conference of credit unions, CDFIs, government and the Bank of England should be organised to develop a strategy (owned by the Cabinet Office) for the creation of a national system of affordable financial services provision.  The Bank of England should commit to diverting some of its quantitative easing programme – which has pumped cheap money into banks to preserve the existing dysfunctional system – into developing affordable financial services of real benefit for the majority of British households instead.