Payday Lending and the Regulation of Consumer Finance II

Criticism of the payday loan industry ranges from the moderate to the more radical. Moderate critics of the industry point to undeniable abuses by particular lending operations and advocate strict enforcement of disclosure requirements to ensure that consumers know what they are paying relative to mainstream alternatives and anti-fraud regulations that protect consumers against the use of deceptive terms.[1] More radical critics insist that the fault lay in the nature of the product itself. Payday loans, they claim—because of ultra-high interest rates, short repayment terms, and aggressive marketing—are inherently predatory and inevitably cause financial distress among borrowers. Hence, among radical critics, reform proposals tend to focus on outright bans or restructuring this credit product through rate restrictions on lenders and borrowing limits on consumers. Restructuring proposals fundamentally alter the nature of the credit transaction, conforming this “fringe” market to the model of its mainstream counterpart.[2]

Policing instances of outright fraud or material misrepresentation is uncontroversial in the regulation of consumer credit markets and American law more generally. However, more severe limitations on contractual relations in a free market system require fairly strong evidence that such measures are welfare-enhancing. For present purposes, I refer to all legal measures that would ban, effectively ban, or substantially alter the terms of the transaction as restrictive regulation, and distinguish such measures from those aimed at increased transparency or educating credit consumers on the relative merits of alternative credit instruments. See my first post in this series for an explanation of what payday loans are and how they work. In this post, I outline each of the more radical criticisms and reform proposals before evaluating them in light of the empirical literature in a following post.

Predation

Many consumer advocates believe that payday loans are inherently predatory. According to Alabama Appleseed Center for Law and Justice, whose mission is to “identify the root causes of injustice and inequality and to develop and advocate for solutions”[3] the terms “payday loan” and “predatory lending” are a straightforward identity. The organization offered the following definitions in a report it issued in 2010:

Payday loan: short-term credit offered at high interest in exchange for proof of income and a post-dated check or debit authorization.

Predatory lending: credit services exploiting low-income people by offering short-term, high interest loans with high fees and penalties for late payment.[4]

By this definition, a payday loan, by its very design features, is exploitative and, hence, predatory.

A scan of the literature critical of payday lending reveals that a predatory loan is one in which the interest rate is unjustifiably high—either reflecting lenders’ voracious appetite for profits at the expense of consumer financial health,[5] or set by the vagaries of the market without regard for consumer welfare,[6] or a deliberate attempt by lenders to trap vulnerable consumers into a cycle of debt that allows for the prolonged extraction of rents by lenders.[7] The bottom line for these critics, however, is that the price is simply too high and borne by individuals and families least equipped to handle it. Journalist Gary Rivlin, author of Broke USA, described payday lenders thusly: “You’re making 3 or 4 times the profit margin off the single mom with two kids making twenty grand a year as you are off the white collar (more prosperous) banking customer.”[8]

Broke-USA

Financial Distress

Radical critics of the industry also argue that payday lending inevitably leads to financial distress for the typical borrower. Harvard law professor, consumer advocate, and now-U.S. Senator Elizabeth Warren has famously drawn an analogy to consumer products safety and argues that this form of consumer credit is inherently unsafe for consumers.[9] Just as most consumers do not understand the inner workings of their consumer appliances, the argument goes, consumers cannot be expected to understand the intricacies of financial products such as payday loans. This understandable ignorance leaves consumers vulnerable to design defects that could spell disaster if not tightly regulated. Again, what distinguishes the radical critic from the general universe of consumer advocacy is the insistence that, quite apart from any particular abuses, payday lending inevitably produces financial distress. Consumers, critics argue, are made worse off from the availability of this product.  High interest rates “spring the debt trap,” which, combined with a short repayment period, results in a product “designed to fail.” [10] Some critics have drawn causal links between payday loans and reduction in overall credit health and increased risk of bankruptcy.

Policymakers at the state level rely heavily on financial distress as a basis for regulatory intervention in the payday loan industry.[11] According to Wisconsin State Senator Tim Cullen, “an interest rate cap is necessary to prevent consumers from being trapped in a cycle of debt.”[12] One Illinois state senator put it this way: “During tough economic times…predatory lenders are taking advantage of desperate borrowers by strapping them with long-term loans at triple-digit interest rates.”[13] These policymakers believe that payday loans are such a bad deal that only desperation would drive consumers into the arms of payday lenders. The lenders then take advantage of that desperation and send consumers into an inevitable “cycle of debt.”

Policymakers at the national level have also taken note of payday loans.[14] The Dodd-Frank Wall Street Reform Bill was initially intended to deal with the causes of the global financial crisis. The bill was expanded to establish the Bureau of Consumer Financial Protection “in the Federal Reserve System…[to] regulate the offering and provision of consumer financial products or services under the federal consumer financial laws.”[15] This Bureau has broad power under the law to regulate “any transaction with a consumer for a consumer financial product or service,” reaching activities previously left to general state authority.[16] Elizabeth Warren, known as the intellectual architect of the agency, also employed financial distress as a justification for regulating payday loans at the national level:

Consumer credit products also pose safety risks for customers. Credit cards, subprime mortagages, and payday loans can lead to financial distress, bankruptcy, and foreclosure. Economic losses can be imposed on third parties, including neighbors of foreclosed property, and widespread economic instability may affect economic growth and job prospects for millions of families that never took on a risky financial instrument.[17]

Bar-Gill and Warren’s statement has several important features. First of all, three very different credit products—credit cards, subprime mortgages, and payday loans—are lumped together in one category. Second, all three products are linked to financial distress for individual borrowers. Finally, this distress is deemed to have significant and widespread negative externalities. These points are addressed in Part IV of this series.

But how is it that some consumers are so taken in by payday lenders to the consumers’ own detriment. Bar-Gill and Warren argue that the availability of lower cost credit alternatives and the availability of liquid assets among the majority of payday borrowers demonstrates the irrationality of these borrowers: “While paying a 400% interest rate may be rational, absent other options, under conditions of extreme financial distress, it is very difficult to rationalize when the borrower can draw on substantial liquid assets.”[18] For radical critics, the payday lending market, which continued to grow even after substantial efforts to educate consumers and require greater transparency among lenders, is a case-study in rapacious lenders and irrational borrowers.

Reform Proposals

Payday loan reform proposals abound, but basically collapse into restrictions on the lender and restrictions on borrowing behavior to reduce the volume of such loan transactions or eliminate them altogether. On the more moderate end of the spectrum, critics seek limits on the amount which can be borrowed per transaction, a limit to the number of loans a borrower can receive from different lenders at the same time, a limit to the number of transactions per year, and a mandatory cool-off period to prevent roll-over borrowing. Most states which permit payday lending do so subject to such restrictions, though to varying degrees.

Toward the more radical end of the reform spectrum, critics seek price caps and restructuring that would effectively transform these products into more conventional credit products. The most common of such proposals come from organizations such as the Center for Responsible Lending (CRL). CRL has advocated legislation that would cap the annualized percentage rate on payday loans at 36% and extend the repayment term to a minimum of 90 days. Rate caps would dramatically reduce the cost of these loans to consumers as well as the return to lenders. In its advocacy for extending the repayment period on borrowers, CRL has insisted that “Consumers largely do not need access to short-term credit” and that “the very short-term nature of a payday loan…is a large part of the debt trap problem.”[19] Consumers who seek a loan because they lack $200 today are unlikely to have $236 two weeks from today, these critics argue. Requiring immediate repayment causes consumers to fall deeper into financial distress, perhaps necessitating another costly loan or inching the borrower closer to bankruptcy.[20]

Though the more radical proposals described above would essentially destroy the payday lending model,[21] if the case of the radical critics bears out, such a move would be welfare-enhancing.[22] In the next post, I evaluate these claims in light of the most recent empirical research.


[1] The new Consumer Financial Protection Bureau has recently engaged in joint efforts with several state attorneys general to stop illegal advance fees by one payday loan operation: http://www.consumerfinance.gov/blog/a-joint-enforcement-action-with-states-to-stop-illegal-advance-fees/.

[2] Hawkins, J. (2011). Regulating on the Fringe: Reexamining the Link Between Fringe banking and Financial Distress. Indiana Law Journal, Vol. 86:1361-1408.

[3] Alabama Appleseed Center for Law and Justice. (2011, April 29). Our Mission. http://www.alabamaappleseed.org/index.php?view=article&id=55:our-mission&format=pdf.

[4] Stetson, S., & Farley, S. (2010, October 7). Hard Cash: Predatory Lending in Alabama. http://alabamaappleseed.org/publications/Arise%20FS%20-%20updated%20-%20final.pdf.

[5] As one critic put it “[P]ayday loans produce exorbitant profit margins for lenders” and “acquire huge gains by targeting low-income populations…” Secrest, S. Past Due (2013, 4), http://idahocan.org/wp-content/uploads/2013/02/Past-Due.pdf.

[6] Mews,C.J. & Abraham, I. (2007) define a loan as predatory when the interest rate is set according to “the impersonal vagaries of the market or even the predatory instincts of the lender.” Journal of Business Ethics, Vol. 72, No. 1 (Apr., 2007), p. 11.

[7] CRL Issue Brief (2009) refers to “the predatory practice of charging 400 percent annual interest [which] effectively springs the debt trap that payday lenders have set for their customers.” Stetson & Farley (2010) describe payday loans as “promising easy money” but really “designed to trap consumers in financial quicksand” so that the lender may generate additional revenue.

[8] Quotation transcribed from Reason Magazine interview with the author, available at http://reason.com/blog/2010/11/10/reasontv-in-defense-of-payday.

[9] Bar-Gill, O., Warren, E. “Making Credit Safer” (2008) University of Pennsylvania Law Review, Vol. 157, Number 1

[10]Parrish & King (2009) argued that the apparently high demand for payday loans really amounts to a relatively small number of borrowers trapped in a cycle of repeat borrowing. Consumers are “compelled” to enter this cycle because “if a borrower cannot repay their regular bills and living expenses with no interest charged, it stands to reason that they cannot pay them at 400 percent APR.”

[11] Hawkins (2011).

[12] Cullen, T. (2011, May 12). Senator Cullen Supports Interest Rate Cap on Payday Loans. Wisconsin Legislature Website: http://legis.wisconsin.gov/senate/cullen/PressReleases/Pages/Senator-Cullen-Supports-Interest-Rate-Cap-on-Payday-Loans.aspx.

[13] Sen. Lightford’s Staff. (2010, May 7). Sweeping Payday Loan Reform Bill Passes Illinois Senate. Illinois Senate Democrats: http://www.senatedem.ilga.gov/index.php/sen-lightford-home/1056-sweeping-payday-loan-reform-bill-passes-illinois-senate.

[14] Congress passed Military Personnel Financial Services Protection Act of 2006 which bans payday loans for members of the U.S. military.

[15] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111- 203, § 1011(a), 124 Stat. 1376, 1964 (2010).

[16] Id.

[17] Bar-Gill, O., Warren, E. (2008), p. 1.

[18] Id. at 45.

[19] Parrish & King (2009).

[20] Parrish & King argued that the apparently high demand for payday loans really amounts to a relatively small number of borrowers trapped in a cycle of repeat borrowing. Consumers are “compelled” to enter this cycle because “if a borrower cannot repay their regular bills and living expenses with no interest charged, it stands to reason that they cannot pay them at 400 percent APR”, id.

[21] One researcher notes, for example, that “Oregon restricted payday lenders to charging 36% interest rate in 2007. Within a year, 75% of the lenders left Oregon. After Ohio imposed a 28% interest rate cap on payday lending, hundreds of payday lenders left the state completely, and the lenders who stayed created new fees to obviate the cap. While these statutes take the form of price regulations, they function really as bans on fringe credit.”  Hawkins, J. (2011).

[22] Indeed, the Appleseed Network of nonprofit public interest centers has stated plainly its goal to “either eliminate payday loans altogether or institute a cap for interest rates on the loans.” See, http://www.appleseednetwork.org/bAccomplishments/tabid/109/Default.aspx

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6 thoughts on “Payday Lending and the Regulation of Consumer Finance II

  1. Pingback: Texas Payday Lending Headlines for February 11, 2014 - Texas PayDay Lending
  2. Pingback: Payday Lending and the Regulation of Consumer Finance IV | Economics & Institutions
  3. Pingback: Uncategorized - Texas Payday Lending News: Consumer Finance Regulation
  4. Pingback: Payday Lending and the Regulation of Consumer Finance I | Economics & Institutions
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