Short term lending – A pink Slip

“WHAT rate of interest…can naturally be more proper than another?” asked Jeremy Bentham in “Defence of Usury” in 1787. Anything less than 36%, answer American activists who want to curtail payday lending—pricey, short-term credit typically used as an advance on a pay cheque. When the Consumer Financial Protection Bureau (CFPB) unveils its proposals for regulating the industry on June 2nd, it will not set such an interest-rate cap (the Dodd-Frank act, which established the agency, forbids it from doing so). But the regulator will probably impose tough new requirements that could wipe out much of the supply of high-cost, short-term credit.Around 12m Americans turn to payday lenders in any given year. The typical loan is about $350 and costs about $15 every two weeks for each $100 borrowed. At that interest rate, a $100 loan, with both principal and interest rolled over for a year, would explode into a debt of almost $3,800.

The CFPB’s studies of the market make for uncomfortable reading. Nearly half of customers borrow or roll over debt at least ten times per year. About half of those who borrow online incur bank fees averaging $185, on top of the cost of the payday loan, when automated repayments from their bank accounts leave them overdrawn or fail entirely. Richard Cordray, the agency’s director, alleges that many loans “ensnare” borrowers in debt traps.

Last year the agency floated some ideas to improve the market, such as mandatory affordability checks and limits on rollovers. Critics say such rules will force lenders to cut off credit to needy borrowers, or to shut down entirely. Thomas Miller, a professor of finance at Mississippi State University, estimates that preventing anyone from using payday loans more than six times a year—another possibility—would cause 60% of the industry to disappear.

That might harm those who need short-term credit to cover unexpected outlays, such as replacing a broken boiler. People typically need emergency credit because they have few savings; this means they probably have low credit scores, too. That leaves them with few other options.

A recent episode illustrates this point. Many states already have usury laws which, in theory, cap interest rates. In New York, for instance, charging a rate of more than 25% is a criminal offence. But most banks can avoid the caps by lending across state lines. New Yorkers can still borrow at 30% interest on credit cards issued by banks in, say, Utah. Last year, however, a federal court ruled that banks that sell on their loans cannot always make use of the loophole. One effect of the ruling was that all of a sudden, interest-rate caps applied to online, peer-to-peer lenders, who had previously channelled their loans through banks to avoid usury laws.

A recent paper finds that this crimped lending to those with low credit scores. In the seven months following the ruling, online peer-to-peer loan volumes for those with the lowest credit scores grew by 124% in states not yet affected by the decision. In states where the ruling applied, they shrank by 48% (see chart).

That suggests sky-high interest rates on payday loans do reflect underlying risks, not simply an attempt to exploit borrowers. In 2005 a study by researchers at the Federal Deposit Insurance Corporation, another regulator, found that payday lenders were not unusually profitable. Bob DeYoung, a professor of finance at the University of Kansas, compares payday loans to short-term car rentals, arguing that if you divide the fee charged by the value of the car, you get a similarly high “interest rate”.

Elizabeth Warren, the senator whose efforts led to the founding of the CFPB, has long argued that financial products should be regulated like toasters: those that often cause fires should be banned. It seems certain that people who regularly turn to payday loans to cover recurring expenses are doing themselves no good. The trick, though, is to protect them without burning the entire industry to the ground.

First appeared at the Economist