Labels are important. A wrap dress from Diane von Furstenberg may cost you $400. A knockoff may cost $25. But with the DVF label, you get quality — a dress that will last for decades. With the knockoff, you get a dress that maybe makes it through three washings. The labels tell you what you’re getting. No surprises.
Financial products are a different animal. They are often named one thing when they are something quite different. In the late 1990s, banks and credit unions started marketing “free” checking accounts to consumers when in fact those accounts were subject to hefty fees. Overdraw your account? Thirty dollars a pop. Fall below your minimum account balance? Ante up another $10. Tens of billions in profits have been made on fees from these supposedly free accounts, paid mostly by lower- and middle-income depositors who can ill afford them.
Deceptive labeling reaped short-term profits for banks but ended up backfiring with many customers. According to a 2011 FDIC survey (the most recent available), the percentage of American households using alternative providers (i.e., check cashers, money transmitters) instead of banks for some or all of their financial needs is rising and stands at 42.9%. Many of these “under-banked” households once actually had traditional banking accounts but felt burned by high, unexpected fees.
Now banks have a chance to get it right with a popular product called the general purpose reloadable card, or GPR , more commonly known as a prepaid debit card. These cards are offered by both banks and nonbanks. The market for these cards has grown from almost zero a decade ago to $65 billion today. Prepaid cards have the virtue of simplicity. Load money on to the card, use it, reload. No need for a minimum balance. No ability usually to inadvertently overdraft and be whacked with multiple fees.
Surveys by the Pew Charitable Trusts (where I serve as a senior adviser) suggest that GPR cards are attractive to lower- and middle-income households. The average cardholder makes $30,000 a year. These surveys also show that consumers are attracted to the card because they feel it gives them control over their money. The vast majority do not want overdraft protection, linked loans, or lines of credit. Shocking, yes, but they do not want to borrow money. They want to spend only what they have.
That’s the good news. But Pew found that as the prepaid market has grown, so have the number and kinds of fees. Providers now have fees for acquiring the card, loading the card, maintaining the card, and even calling the provider to ask a question about the card. And disclosure of these fees is uneven across the industry. Fortunately, the Consumer Financial Protection Bureau (CFPB ) is moving forward with proposals for clear and uniform GPR fee disclosures. It should also limit the number of fees. (I mean really, don’t they already charge enough?) This will not only protect consumers but also promote price competition.
But better fee disclosure is not enough. The rapid growth of prepaid cards without fee-reaping features like overdraft protection shows that they can be profitable without having to gouge cash-strapped customers who overspend. A prepaid card should remain what its label suggests: a way to spend the money loaded onto the card and nothing more. Fortunately, most banks do not allow overdraft coverage on prepaid cards. The CFPB should ratify this best practice by banning overdraft protection on all prepaid cards.
Most consumers believe their money is safe when loaded on prepaid cards. Not all providers offer FDIC insurance, as it is not required. Without it, cardholders are vulnerable to losses should the card provider go bankrupt. Regulators should mandate it. If done right, prepaid cards can provide a cost-effective way for banks to responsibly and profitably serve lower-income customers and atone for their “free checking” mislabeling past.
Fortune contributor Sheila Bair is former chair of the FDIC and sits on the board of Spain’s Santander Group. The views expressed here are her own.
This story is from the April 28, 2014 issue of Fortune.
