‘People don’t want just another card’: Q2’s Ahon Sarkar on how banking as a service changes the economics of serving the underbanked

The following was produced by Tearsheet Studios. We worked with Q2, a digital banking software company, to create a four part podcast series on how embedded finance and banking as a service is changing the definition of who is a bank, where customers turn for banking products and services, and how this new technology is helping some of the weakest players in the economy get access to the modern financial industry. 

There is still almost 20% of the U.S. population that are underbanked. That’s tens of millions of people who may have access to basic banking but are falling between the cracks. And this is in spite of the fintech bull market we’ve had over the past few years.

Tearsheet interviews Q2's Ahon Sarkar about the impact banking as a service has the economics of banking. The result is more products and services available for the underbanked. We discuss how this changes the banking industry and the customers it serves.

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The following excerpts were edited for clarity.

Ahon Sarkar, Q2: My name is Ahon Sarkar. I'm the VP of product and strategy for Q2's Banking as a Service Group. So that basically means I focus on how our platform is evolving over time, how we're working with different kinds of customers to build differentiated products, and how we're taking that and messaging that into the market to grow the industry.

You have to look at what drives the way that consumers feel about banks and what the root cause of that is. So if you look at it, at the most basic level, there's 16% to 20% of the population, depending on who you ask, that is what's called underbanked. That means that they have a social security number and they could get banking services, but either they're not really served by the banks, or they might have lost trust over the years and choose not to use banks today. 

Part of the reason many people aren’t served by banks is that the economics are messed up. It simply costs a financial institution more money than it’s worth to service people without a lot of money in their accounts. It comes down to the business model.

Ahon Sarkar, Q2: Now, if you trace that back as to why, a lot of people look at that, and say it's because banks are evil. And that's not really the case, right? Banks aren't evil. They're trying to make a business that works for them and that works for their communities. And if you look at how the business model of banking works, you can uncover why some of these underbanked folks might feel underserved by those banks.

As an example, one of the biggest costs for a bank is the technology. Banks have to run on what's called core. And within the country, there are tons of cores, but most banks use one of four traditional cores. And the core is basically your ledgering activity for a customer, how you're opening accounts, all that kind of stuff.

But let's just do a simple math equation. On average, for those kinds of core processors, banks pay somewhere between $3 and $12 per month, per account, to go and service these customers. If we take a very conservative look, and we say, let's look at that $3 per month, and let's pretend that there are no costs for branches or for marketing. Let's just pretend my only costs are technology costs and the cost of capital. In fact, let's say you have $1,000, which is more than most Americans have today, and you come into this bank, and say, hey, I want to open an account.

Well, let's first look at the cost side: the bank's going to have to pay about $10 in cost of capital, and then they're going have to pay $3 times 12, or $36, for technology cost. And again, we're not paying employees, we're not paying branches, we're not paying marketing. But so far, we've spent about $46,to power banking services for you.

Now, on the flip side, in the U.S. today, that interest margin for a bank on loans is something like 3%. So you take that $1,000, you get 3% against it, and you're making about $30. So, pulled together, the two sides, you're making $30, and you're losing $46 -- even though you have more money than the average American, the bank is losing $16 on you. So the bank has a problem: the bank wants to serve you and give you some kind of financial services, but if they're losing $16 on you and every consumer like you over time, that's going to drive them out of business. 

This deficit -- that it costs banks more money than they make with smaller accounts -- has led to a reliance on fees that ultimately hurts consumers.

Ahon Sarkar, Q2: So then you got this cycle: as banks were trying to push over into free checking, as Discover sort of started with the free checking account and other banks followed suit, they had to find a way to become profitable. So they solved this $-16 problem with things like NSF fees and overdraft fees. While that solved the financial problem, this created a cycle where the poorest Americans were being charged the most in monthly fees. I mean, imagine you make $30,000 a year, and you pay something like the US average of $300 plus in bank fees. That means more than 1% of your post tax income just disappears, right? Just goes towards these kinds of fees to use those services.

And so it's natural that that universe of customers doesn't feel like they're being served, doesn't feel like there are solutions out there for them. And so they remain underbanked in the United States.

Banking as a service changes some of these dynamics. Technologies powered by cloud and API make it viable for any brand -- it could be a payroll processor or accounting software -- to offer banking services. Being able to offer a banking or payment product gives their customers a better ultimate experience. Banking as a Service changes things, starting with the economics.

Ahon Sarkar, Q2: I think it really comes down to two things. One is capabilities. And two is business model. We'll start with the second one, because we just talked about what the existing business model would look like. Go back to that simple equation. Zack has $1,000, you don't have marketing costs, you don't have employee -- guys, we're just looking at cost of capital, technology cost and lending margin. If you're able to do what new innovations in the space have done, like cloud based cores, you can decrease the cost to serve that user dramatically. Because those legacy cores have been around 40 to 60 years, they are built in COBOL and require pretty heavy costs when it comes to maintenance and upkeep.

If you use something like a cloud based core, the cost to serve that user goes down from something like $3 to $12 per month per account down to something like $0.50 per user per month. Let's pretend that's the only change, the only thing that changes is the technology. Well, if you look at that same equation, you spend $10 in cost of capital, but now you're only spending $6 to go and service that user, and you're still making the $30 in net interest margin. So you're now you're making $30 and you're spending $16. Now, you're making $14.

So what happened was we changed the technology foundation of the product. And we took for the exact same user for the same value prop, we took it from negative $16 to positive $14. That's pretty amazing, right? What that does is it changes the incentive structure. Because in the United States, folks go after ways to make profit. And so finally, this population of approximately 16% of the US population, which used to be fundamentally unprofitable due to the cost of legacy solutions, is now an open market. Now you have a business model that allows you to serve the majority of Americans, even those that are low balance users, with a pretty compelling value proposition. So that's the business model side. 

In addition to making it profitable to offer bank accounts to more customers, banking as a service also opens up new opportunities. In particular, it ties financial transactions tighter to other activities. Banking becomes something you do -- as opposed to somewhere you go.

Ahon Sarkar, Q2: On the other side of the fence, you have capabilities. For the longest time, cores, by and large, stayed the same. You could open an account, you could KYC an underlying user, and the last 15 to 20 years, you could access it on your computer and eventually your phone. But what's happened with the advent of banking as a service platforms is those capabilities to build those underlying products have been exposed as tools.

So it's not just open an account, create a transfer. Now you can sort of think about, hey, if I could really change the way that we store money, or change the way that we move money, how can I plug that into my existing ecosystem to make something different? What fintechs are able to do is use those capabilities and combine it with that business model to build something that's truly differentiated -- and that allows them to go after that specific customer base, and say, hey, what are your problems? And how can I solve them for you? If you look out into the market, you'll see products like CreditKarma, allowing folks to access stimulus checks, early access tax refunds, earn Instant Karma on everyday transactions that would normally be reserved for only those served by the credit market. Suddenly, if those two days are going make a big difference for you credit, Credit Karma is giving you an option to get that access as soon as possible.

You can look at folks like Gusto, which allows folks to get a free cash advance on their paycheck, leveraging their capabilities as a payroll provider, which allows folks to avoid payday lenders who might take anywhere from 10 to 20% of every single paycheck.

Or you can even see folks like Acorns, who've embedded banking inside of the ecosystem with investing to help folks save, invest and plan for their future, all in one tight package. So you zoom out and you see two things: the business model has changed to allow folks to profitably serve underbanked users creating an incentive for companies to build highly targeted products that actually solve underbanked users needs. Also, the capabilities have become modular and are being delivered through the cloud, allowing these companies to build them in a way that's tailored, bespoke, and not sort of a one size fits all.

Banking as a Service is being used by brands like CreditKarma and Gusto to offer integrated banking solutions with new capabilities to their users. Now, they’re not banks. They’re not financial institutions. I asked Ahon how they make money by offering a free debit card.

Ahon Sarkar, Q2: Yeah, that's a great question. The nice thing about the business model of banking as a service is it's intrinsically tied to the behavior that you're trying to catalyze. So all of these companies, whether it be the ones that you mentioned, or folks like Chime or the other challenger banks that you're seeing, by and large make money off of interchange -- the ability to earn some money when that debit card is swiped.

Now, when I say that it's intrinsically tied to the activity that you're trying to catalyze, what I mean is, what are these companies trying to solve? They're trying to help you with your money management, they're trying to help you manage your cash flow. And most importantly, they're trying to help you meet your goals. And so why would you use that product? Well, you'd use it to the extent that it helps you meet your goals, right? Whether that be investing for the first time or saving towards your daughter's education, whatever that might be. And so you are trying to use their product and get some value out of it, and they are trying to create a product that's useful. If they can get you to use their card and drive transactions, that drives interchange revenue for them.

And so it creates this sort of virtuous cycle, where they build products that are useful for you, you use those products, and the usage of those products drives revenue. Compare that to 'free products' like Facebook where they're selling you. You become the product. They're selling your data. And they're using that data to power this underlying service, which can sometimes be at odds with what you want: privacy is important and that data is important. And so that model can sometimes become tough for people to stomach.

On this side, you see a model that's driven by action, in which users are making those transactions, creating revenue and getting benefit from it. A lot of these companies, whether they be the ones that you mentioned or others, are taking some of that interchange revenue and passing it back to the user. Take that simple math equation that we were just talking about. If I'm able to make something like $14, just by working with you, I could pull $7 in revenue, and I can give that $7 back to you in the form of things like accessing ATMs for free, or getting cash back on a debit card. And so long story short, companies are making money off of interchange, interchange is driven by usage that causes companies to build usage focused products, which are tailored to the underlying demographic.

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As new industries and brands begin offering financial products and services, there’s a changing dynamic in the industry. When you start to look at it, it actually could have a positive spillover effect to the economy at large.

Ahon Sarkar, Q2: Yeah, that's a really interesting question, because I think folks tend to focus on the banking as a service, specifically how these platforms are changing. But I think your questions are really interesting: one, how do the changes that are happening within banking as a service affect the economy? I think what you start to see is a change in expectations. In the same way that when Discover launched the first checking account, the expectation suddenly became that checking would become free. And then banks had to adjust and bring in the fees that I mentioned prior.

As fintechs, technology companies and other companies are able to finally serve these underbanked users with targeted products that are low cost and solve their specific problems, that becomes the expectation. Consumers start to expect that when they go into a bank, be at a small bank, a large bank or fintech, that they're getting solutions built for them at a low cost basis, that allows them to live their life. And so what you're seeing is even the largest institutions trying to figure out a way to become competitive with that new set of consumer expectations.

So what used to be, hey, consumers are just the cost of deposits, I really, ultimately make my money through loans is becoming consumers are a key part of our overall philosophy and we're trying to find ways to serve them at low cost, whether that is by doing a technology revitalization, or by de-featuring our products and going after them. But the net result is whether you're partnering with a banking as a service powered fintech or you're going to one of the larger banks, pretty soon, a lot of these underbanked folks will have options. And will have options that are not fee-ing them to death, that are not ludicrously expensive, and that allow them to actually start building their wealth and getting out of the economic paradigm that they've been in historically.

If Ahon’s vision continues to play out, we get a lot closer to reaching those 40 to 70 million people in the underbanked category. The underbanked may not do their banking with a traditional bank in the future -- they’ll access financial services from other software and apps they commonly use.

Ahon Sarkar, Q2: It's pretty interesting to be sitting in the middle of these changing times because to some extent, we're all sort of watching that future become a reality. I think you can start to pick some of the breadcrumbs today. I mean, look at the population -- like I said, depending on who you ask, that underbanked population is somewhere between 40 and 70 million people within the United States. But if you look at some of the existing platforms, like Square Cash, Credit Karma, Venmo, Chime, the collective user bases of those products are already larger than that underbanked population is today.

So that begs the question I think that you're asking, which is, as you play that story out, as more companies into this space with the capabilities of serving this underlying demographic and an incentive structure to do that, as more and more consumers start to trust a lot of these solutions, which have trust underwritten inside of the very UI, and as business models become more and more refined to allow folks to offer more targeted products or products with underlying better hooks, I think what you'll start to see is that a large population within that sort of underbanked population will cease to be underbanked.

If you go back to that initial question -- who are the underbanked -- the folks that aren't served by the banks or that have lost trust over the years. Those paradigms are changing, right? The banks are serving them, because there's an incentive because the technology itself has changed. And so over this upcoming decade, I think what you'll see is a greater and greater adoption within that population of these kinds of products. Now, if you go out and you talk to the consultants in the space, you might get stats like 10% of users would change their checking account over into a new neobank. And people extrapolate from that, that neobanks are doomed or that they won't find a solution for these underbanked folks. And what you tend to find is that sometimes you're not asking the right question. Not every person is going to go to a neobank. But every person is going to need some kind of banking services and may end up choosing it from an area that you might not find the most intuitive.

Take something like Gusto, for example. I might be using Gusto today to get my paycheck. And tomorrow, my tire might pop and stressed, I might be looking at things like payday lenders and trying to figure out how I'm going to cover that while still putting food on the table for my family. And when I go to check my payroll for Gusto to see when's that money coming in, I might see a button that says access to your pay day early. And as I learned more about that, I see, hey, it's free, and because I already use Gusto, I can earn more from the underlying account that I create that might cause me to say, let me give this a shot. Let me see how it works. And when I have a good experience, when I'm able to access my money, when I'm able to go and buy that tire and put food on the table, I remember that feeling.

So while 10% of people might be the ones that are willing to move over to a new neobank, I think what you'll see is folks that are willing to try better targeted and lower cost financial services are a much bigger population than just that 10%.

Don't get me wrong. Some of those folks don't trust financial institutions holistically. And trust doesn't get fixed overnight. The way trust gets fixed is effectively proving that relationship over time. The more data points you have that I'm out in your best interest, that I'm being transparent, that I'm communicating with you, the more likely we are to have a trusting relationship. And so I think that over the coming decades, there will still be a segment of folks that don't trust financial institutions that are still looking out for that. But I think the majority of that population over the course of the next 10 years are probably going to migrate out of being the underbanked and become served by one of these flavors of banking solutions across the markets.

It’s expensive to be poor in America. The poorest people in America pay really high relative fees just to get a bank account. Getting access to cheaper and broader financial services can help the underbanked move up the economic ladder. 

Ahon Sarkar, Q2: If you think about this population, these are typically folks who are in lower income demographics. But the thing about folks in those demographics is they tend to have a much higher velocity of money. So if you give $1,000 to someone who is in this demographic, versus giving it to someone who is a high net worth individual, the high net worth individual is much more likely to store that money somewhere and hold on to it, which basically has a relatively low velocity. So they're not spending it on something.

Whereas if you give those $1,000 to someone in this demographic, that dollar might change hands seven times over the coming year. And so that higher velocity of money means more money is getting spent in the economy and that means a healthier and faster growing economy and also means that we're sort of all lifting each other up.

If you look at where the economy is today, for folks who are underbanked, there's this great book called Nickeled and Dimed, which takes you through the decisions that folks in this population have to make. So a really simple example, is something like, you know, if you're a construction worker and you have to buy a pair of boots, rather than buying a nice pair of boots that will last years, because of how much money it will take, in the short term, you'll buy a pair of boots, the cheapest one you can find. But the problem is, over only half a season, you will need to buy another pair of boots. And you'll have to do that over and over and over again. And it becomes this pseudo tax, where you have to go put a percentage of your income to that, that will need to be re-upped soon. And that keeps you from building wealth and getting yourself out of this paradigm.

The same thing is true in banking. The poorest folks in America are the ones that are being charged $300 plus per year in these kinds of banking fees. And so as you start to get rid of some of those systemic problems, you get rid of the $300 in banking fees. You get rid of the 10% to 15% you're paying to payday lenders. You get rid of the amount that you're paying to go pay your bills, and you get rid of the pain that comes from credit cards and extremely high interest. You start to put a lot more money back in the pockets of those individuals, drive the health of the economy, and create an economy that's better for all people.

The net net of it is by helping these folks, we're helping everyone because those folks catalyze economic activity, catalyze economic growth, and I think will usher in a new era of financial understanding and growth for the average American.

We’re in the early stages of banking as a service. As it technology matures, it’s helping to power new use cases. Q2’s Banking as a Service platform, for example, is being used by payroll companies and personal finance tools to help their customers track and now manage and move their money.

Ahon Sarkar, Q2: It's been really interesting to see that evolution over the last four or five years. You have to start with one of the problems that most underbanked folks feel today. They have problems around accessing their money, whether it is the paychecks that they get or the stimulus checks that are coming in from the government. And they have problems when it comes to becoming a part of the investing ecosystem, starting to build their wealth, and have their money work for them. They have problems when it comes to transferring money to each other, to saving for their upcoming goals. And so different fintechs have gone about those issues differently with highly targeted solutions.

If you look at Square Cash, they solve the problem of transferring money to each other. So now it's easier to split bills, it's easier to earn rewards on everyday transactions that would normally be reserved only if you have a credit card. Or you see folks like Acorns who are helping people invest for the first time, even if they don't know too much about picking stocks, but enabling them to plan for their future, save on everyday purchases and put that towards growing their income, growing their wealth, so that they can continue to do more and more in their lives.

Or you can look at Credit Karma, who allow folks to access their stimulus checks and tax refunds, and direct deposits early, which is a huge thing for most people. A tax refund is sometimes the biggest lump sum payment they get all year. And so by providing access to those things early, enabling them to spend them and allowing them to earn Instant Karma on those everyday transactions, they're creating healthier habits, better transparency, and easier access to cash for individuals right now.

The last one that I'll mention is actually one that I mentioned earlier in this call, but I think it's fantastic, Gusto. One of the biggest problems for the underbanked is that ability to get an advance on their paycheck, and that's why payday lenders exist. That's why certain lenders exist, because that underlying cash flow problem is still there. But by combining their position as a payroll provider with their position as a partner to a banking as a service platform, Gusto is able to offer its customers free cash advances on their paychecks and solve a real problem that cannot be easily replicated by its competition or easily replicated by banks, because of how it's uniquely using the components of its business to solve a specific customer problem.

All of these little things add up. Individually, they seem like small items. But when you're saving that 15% of your paycheck by not going to a payday lender, and when you're getting your paycheck early enabled to put it towards some of your short term cash flow needs and when you're able to take the savings that you've made and grow your wealth with them, you find yourself 5, 10 years later with a compounding effect where those savings over the last 10 years -- plus the growth of the market that you've invested them puts you in a much better financial position for your financial future.

I still think we're in the early innings. I think you'll start to see folks in insurance, telecommunications, marketplaces start asking the same question of how can I reimagine my ecosystem and build something that uniquely solves my customers problems while driving value for us? And that will create a whole new generation of products that we haven't even seen yet. But even based on what we've seen so far, I think it's reason to be excited.

When Q2 began offering banking as a service, people didn’t quite understand it. One of the things it does differently than some of the other options out there is that it’s built around Q2’s own core banking software.

Ahon Sarkar, Q2: If you fast forward four to five years from when this industry started, there are lots of banking as a service players. But one of the things that can get lost is the idea of middleware versus core systems. Unlike others, we don't operate in the middleware structure. So we're not working with one of those legacy cores and we aren't encumbered by them. We have our own cloud based, lightweight core. And that does a few things. The two biggest things that have changed with banking as a service are the business model and the capabilities. And at the core of that are platforms like Q2's, where by bringing in a proprietary, lightweight cloud based core, we're able to decrease the cost to service these users dramatically and make it profitable to serve underbanked, low balance users.

And by taking the functionality of a traditional core, and focusing on the white label components and building it in a way that allows for better collaboration between banks and fintechs, we're able to expose that functionality via API in a way that allows these companies to embed them into their existing ecosystems. People don't want another account or card -- they want something that's useful, something that actually solves an existing problem. And so by allowing folks to take those modular components and embed them inside their existing ecosystems, and combine the synergies, like we were talking about with the payroll powered free cash advance, for example, that enables these companies to differentiate. It enables them to serve this population at a lower cost.

If allows them to decide down the line if they want to become the bank and start serving these users through a litany of financial products. Core Pro, our core, can become the core at the center of their offering. They're able to migrate from partnering with a bank to becoming the bank without disrupting their services, without changing their business model, and allowing them to continue growing rapidly and actually scale.

It's been an interesting last five years. We've focused primarily on that thesis of driving differentiation across verticals. So, we've gone from payments to savings to lending to PFM to payroll. We're just going market by market and working with our partners to build a new financial ecosystem.

That was Q2’s Ahon Sarkar on how banking as a service is helping to open up financial services to millions of new people. It’s part of a 4 part series Tearsheet Studios is running with Q2. Go to the Tearsheet website to listen and read the other parts of the series.

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