Banks sometimes fail. This is an unfortunate fact of life. During the Great Depression, closing a bank often led to panic, with depositors desperately trying to withdraw their funds. Anyone who has seen the movie, It's a Wonderful Life, knows what a bank filled with panicked customers looks like.
Bank runs do not happen anymore -- at least not in the United States. That is because of insurance provided by the Federal Deposit Insurance Corporation (FDIC). When a bank fails today, its insured depositors never lose a dime. By design, the failing bank is usually taken over by another bank. The transition is swift, precise and creates few ripples for consumers, because it is handled by highly trained professionals at the FDIC. Families can keep paying bills and businesses can make payroll. In fact, nearly 500 banks failed during the financial crisis and its aftermath, and every single depositor had access to their insured money within one business day.
But this seamless protection for insured depositors can be avoided by companies that offer "reloadable" prepaid cards, a rapidly growing product that many Americans use instead of conventional checking accounts.
Like a checking account, these products allow consumers to direct deposit their paychecks and pay bills online. But unlike checking accounts, which carry up to $250,000 in mandatory FDIC backing for every customer, prepaid cards are not required to carry deposit insurance. Rather, these companies can choose how their products are covered -- either through a patchwork of state laws or via tried and true FDIC insurance.
This is a critical consumer protection issue. The prepaid card industry is experiencing explosive growth, primarily because the cards function like a checking account but have lower fees. According to Mercator Advisory Group, a financial consulting firm, the use of these cards has grown 600% since 2010. Americans are expected to load over $200 billion on them this year.
Many banks and financial services companies offer these products. Major retailers are getting in on the action, too, partnering with financial companies to create their own prepaid cards that customers use to purchase everyday items. Most have voluntarily chosen to cover them with FDIC insurance.
However, others have opted to forgo the cost of providing FDIC insurance coverage. For example, the American Express for Target Card is covered by state money transmitter licenses rather than FDIC insurance. Doing business this way may be cheaper for the prepaid card company, but these licenses are a poor substitute. And, unfortunately, this sets a precedent, allowing others entering the marketplace to do the same.
These state laws typically require issuers of prepaid cards to post a surety bond, which covers far less than the total amount customers have loaded on their cards. What's more, prepaid card companies can take customers' money and invest it in any investment-grade securities, which may or may not be readily convertible to cash. In the event that the company offering the card lacks FDIC insurance and goes under, its customers might not be fully reimbursed. The amount of compensation will depend on the state in which they live. Some states offer no protection at all.
If the prepaid card company has invested its customers' funds in securities, which have lost their value, the only protection those customers will have is the surety bond. In Alabama, for example, customers are collectively protected up to $50,000. In Florida, they are collectively protected up to $2 million. These amounts do not represent the compensation given to each customer. They represent the upper limit for the entire class no matter how many prepaid cards have been issued or how much money has been loaded on them. Three states -- Montana, New Mexico, and South Carolina -- do not guarantee any repayment.
Inadequate reimbursement is not the only problem. When an account is insured by the FDIC, consumers can access their money quickly and easily without going to court. But if the issuer of a prepaid card loses a customer's money, the customer will likely have to take legal action to get their money back. This could be costly for the consumer and involve lengthy delays. Even then, there is no guarantee that the full amount on the card will be returned. In some cases, the cardholder might walk away with nothing.
This problem does have a solution. Policymakers can -- and should -- require prepaid card issuers to acquire FDIC insurance. At a time when consumer confidence is making a fragile recovery, prepaid card customers deserve the same peace of mind as more traditional bank account holders: that their money is safe and will be readily accessible when they need it.
Sheila Bair is the former chairwoman of the FDIC and a senior adviser at The Pew Charitable Trusts.