Banking on the Underbanked: Exploring the Incentives for Banks to Reconsider Inclusive Lending (Part 1 of 2)

Introduction

A June 2023 publication by a UK-Based financial inclusion organisation identified that approximately 17.5 million UK adults are financially vulnerableⁱ. UK consumers face a strained economic environment, marked by stagnant wage growth and a widening productivity gap with countries such as France, Germany, and the US. Indeed, the gap between the UK and these nations, on average, has effectively doubled since 2008, reaching 18%ⁱⁱ. Household incomes are also not forecasted to recover to their pre-pandemic levels until at least 2027ⁱⁱⁱ.

This significant population of financially vulnerable adults is characterised by a diverse range of demographics and circumstances^iv. This includes young adults who are often relying on short term credit to make ends meet, families juggling daily expenses without the benefit of a financial safety net, and older adults facing uncertainty over their financial future in retirement. Many will share the issue of having limited access to credit, a challenge that further marginalises and excludes them from financial opportunities available to others.

Inspired by the innovative spirit of Jeremy Clarkson's "Farming the Unfarmed" initiative from the Amazon TV series Clarkson's Farm, where the host explores the untapped potential of previously disused farmland, this first blog in a two-part series seeks to address similarly underserved territories within the UK financial sector. And, much like Mr Clarkson’s venture into making profitable use of underutilised land, we believe similar opportunities may exist in serving the unbanked and underbanked populations of the UK.

The situation

There are a number of barriers to financial inclusion present in the UK financial services sector, especially in the area of personal lending. For example:

• Approximately 1.2 million people in the UK do not have access to a bank account^v, driving a high degree of financial exclusion for those affected.
• Recent data from the Office for National Statistics (Feb 2023) also shows that 22% of UK adults – approximately 11.5 million people – increasingly depend on credit to cover their living expenses as a result of rising living costs in key areas like food, rent, and utilities^vi.

This gap in credit availability also comes just as demand for personal lending solutions is rising. Between the complex needs of more vulnerable borrowers and the rising appetite for consumer credit, we believe an opportunity may exist for financial institutions to adapt their lending strategies and products to better meet the changing needs of society. In this way, banks can ensure their practices align not only with their risk appetite but also with the wider principles of responsible lending.

Incentives for Banks

While much social good can be derived from addressing financial exclusions, just as Mr Clarkson found new income streams by reclaiming and rejuvenating previously unused land on his farm, banks may also discover potentially profitable opportunities by extending financial services to the unbanked. Real-world success stories reinforce the potential. For example, there have been some well-publicised cases of credit card issuers partnering with fintechs to leverage credit data in order to unlock new customer bases at lower risk. In this spirit, key incentives for banks to consider include:

1. Segment-Specific Value Creation and Long-term Customer Relationships

Banks can harness potentially significant value by carefully targeting specific higher-risk segments in personal lending. This could include young professionals with limited credit histories, emerging sectors and the small business owners operating within them. Borrowers recovering from financial distress, as well as immigrants new to the UK seeking access to financial services, could also be well served. Customising lending solutions for these groups, in the context of careful, data-driven risk management, could open fresh avenues of long-term profitability for banks. And, for those that stabilise financially, there is a good chance they will become loyal customers over the longer-term, more willing to concentrate their financial services activity with the lenders who supported them as they become candidates for more complex, riskier offerings. 

2. Diversification Benefits

Banks can benefit from diversifying their customer base beyond prime markets to improve portfolio resilience. While prime customers are generally considered lower risk, over-reliance on these segments can limit flexibility and growth opportunities^vii. However, the impact of economic downturns on prime and subprime portfolios varies. While some, like Northern Rock's subprime book, suffered substantial losses^viii during the financial crisis of 2008, others experienced minimal movements. Hence, diversification is not solely about moving away from prime or subprime markets but about leveraging tailored strategies and data-driven risk assessments to engage with diverse segments. 

The accumulated experience in sub-prime markets can be particularly valuable in the event of a future downturn, where signals around financial distress may be easier to spot by systems trained to do so, and processes to manage turnaround as more customers fall into debt distress become better-tuned and optimised.

3. Systemic Stability

By expanding financial access, banks can prevent underserved customers from turning to predatory lenders, who may charge very high interest rates and fees that contribute to higher default rates. Widespread reliance on unregulated credit can lead to higher aggregate default rates and encourage predatory lending practices that undermine overall financial stability. Supporting these customers within the regulated banking ecosystem ensures greater transparency, reduces the likelihood of systemic financial shocks, and strengthens the overall stability of the financial sector.

4. ESG and Reputation Enhancement

Engaging in responsible lending practices, particularly in underserved communities, can also play a crucial role in banks’ ESG strategies. The 'social' aspect of ESG is particularly relevant here, as banks that contribute to financial inclusion are regarded as not merely profit-driven, but also as valuable institutions contributing to social welfare. This broader focus can enhance the bank's reputation, strengthen customer loyalty, and potentially attract socially conscious investors. And over the long term, these ESG-focused strategies can also lead to indirect financial benefits too, especially as customers and investors increasingly favour institutions that demonstrate a commitment to societal well-being alongside financial success.

Combining these incentives highlights the business and societal value of expanding lending to underserved segments, strengthening trust, diversifying portfolios, and enhancing resilience. By capitalising on these opportunities, banks can drive sustainable growth and broaden their customer reach.

Conclusion

Much like Jeremy Clarkson’s transformation of unfarmed land, some banks have already evaluated underserved lending segments and concluded there’s limited opportunity while others may have not visited this space at all.  However, in today’s environment, competitive pressures from fintech companies and alternative lenders, combined with changing macro conditions, emerging customer needs, and advances in data analytics are beginning to shift the balance. 

Now is an opportune time for banks to reexamine their products, portfolios, and lending approaches, identifying where recent developments might tip the scales in favour of serving this segment.

In our next blog, we will explore the barriers to serving these underserved borrowers and examine how banks can adapt their operational models and processes to overcome challenges while seizing these potential opportunities.

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References

i. A plan for the whole sector - Fair4All Finance. Available at: https://fair4allfinance.org.uk/resources/financial-inclusion-plan/ [Accessed: 10 November 2023].

ii. The Resolution Foundation, 2023. Ending Stagnation. [online]: The Resolution Foundation. Available at: https://economy2030.resolutionfoundation.org/reports/ending-stagnation/ [Accessed: 22 May 2024].

iii. The Resolution Foundation, 2023. Ending Stagnation. [online]: The Resolution Foundation. Available at: https://economy2030.resolutionfoundation.org/reports/ending-stagnation/ [Accessed: 22 May 2024].

iv. A plan for the whole sector - Fair4All Finance. Available at: https://fair4allfinance.org.uk/resources/financial-inclusion-plan/ [Accessed: 10 November 2023].

v. A plan for the whole sector - Fair4All Finance. Available at: https://fair4allfinance.org.uk/resources/financial-inclusion-plan/ [Accessed: 10 November 2023].

vi. How are financial pressures affecting people in Great Britain? - Office for National Statistics (ons.gov.uk) (2023) https://www.ons.gov.uk/peoplepopulationandcommunity/wellbeing/articles/howarefinancialpressuresaffectingpeopleingreatbritain/2023-02-22#:~:text=More%20than%20a%20fifth%20of,January%20and%205%20February%202023. [Accessed: 22 May 2024].

vii. How Diversification Helps Banks Lend More, Cut Risk, and Boost the Economy: Knowledge at Wharton (2023). Available at: https://knowledge.wharton.upenn.edu/article/how-diversification-helps-banks-lend-more-cut-risk-and-boost-the-economy/ [Accessed: 22 August 2024].

viii. Treasury slated over Rock Lending (2009) BBC News. Available at: http://news.bbc.co.uk/1/hi/business/7952923.stm [Accessed: 02 June 2024].