Are we ignoring the wider problem with pay day loans?

5th July 2013

Consumer and financial journalist Tony Levene suggests we may be in danger missing the point when it comes to pay day loans.

Payday loans – so-called because borrowers are supposed to repay with their next salary cheque – are under attack. But in the clash between the firms offering the high cost credit and those who want to rein them in, wider aspects have been ignored.

It is in many ways akin to the debate on drugs.

For as with almost all attempts to curb cannabis and cocaine, the discussion focuses on the supply. There is virtually no consideration of the demand side of the equation. Why do people take out this credit when they know (or should know) of the financial harm it can do? Are they driven by financial desperation or do they calculate that the harm is less than what they derive from spending the money?

The assault on payday lenders is not without reason. They are accused of a model which charges interest rates running well into four figures when they can finance their activities for a tiny fraction of that.

They are accused of making credit too easy for those who will have the most difficulty in repaying – their advertising on television, online and elsewhere is arguably aimed at the least creditworthy and most vulnerable. That is the point of their existence. Those with good ratings who can pay back loans borrow at much cheaper rates via standard credit cards and overdrafts.

And they are accused of having a greater interest in customers remaining on their books by taking out new loans rather than repaying – a process known as “rollover” – and of charging excessive fees when borrowers fail to comply with repayment terms. Around half of all lending is “rolled over”.

All of this is true. Even the leaders of the £2bn industry find it tough denying these accusations – instead blaming the usual “few rotten apples.”

Now the Office of Fair Trading is looking at the terms and conditions of the 50 larger participants – there are some 5,000 in all. The government in the shape of consumer affairs minister Jo Swinson held a “summit” meeting at the start of July with payday lenders, debt charities and regulators to show it was “doing something” even though it ruled out cost-capping, a device used in many other countries. This is the mechanism preferred by Walthamstow Labour MP Stella Creasy, at the forefront of campaigns to control payday lenders. She believes a limit on a loan’s total cost is the right route to protect vulnerable people.

But while payday lending and the technology that powers it is relatively recent, none of this is new.

A decade ago, two decades ago, and further back, there was equal indignation against “door to door lending” where agents for firms such as the stockmarket quoted Provident Financial and S & U Stores, or Shopacheck (once part of now defunct Cattle’s Holdings) would call on customers at their homes and offer short term loans at what then appeared to be high interest rates – around 200% measured on an annual percentage rate basis.

This rate has more or less doubled – thanks to the “competition” from online lenders as this example from the Shopacheck website makes clear. “A £300 loan repayable over 32 weeks at £15 per week, Rate of interest 60% fixed; Representative 399.7%APR, Total Amount Payable is £480. No Deposit.”

Door to door lenders were also accused of “rolling over” – as a customer approached the end of a loan, they would typically entice them to a new line of credit via desirable pictures of consumer goods in expensive shopping catalogues. This was hardly surprising. As with online lenders, agents and their employers would hardly prosper if borrowers just took out one loan and repaid it. All firms, in whatever field they may be, rely on repeat business.

Then too, people were calling for a cap on loan costs. And then too, the short term loan industry’s cheerleaders argued against it, claiming it would constrain their lending, sending the desperate into the arms of illegal loan sharks.

Anecdotal evidence on illegal loan sharks – the nature of their business makes verified statistics hard if not impossible to come by – from areas as different as Chicago and Leicester suggests that, while their collection methods from delinquent borrowers are more physical, they may often charge less. Japan, which operates a costs cap and which has a thriving gangster culture, found that limiting charges did not encourage illegal loans.

Damon Gibbons for the Centre for Responsible Credit, in a report on Japan and interest rate caps, suggests a ceiling on loan costs will make borrowing less expensive.

Market forces work in a perverse way as far as consumers are concerned. Traditional door to door lenders have increased their rates to approach those of online firms because they can get away with it. If a competitor has a thriving business at 1,000% and you are only charging 200%, then why not up your own fees? This is a captive market which has no choice other than to go without.

A second, but reverse, perversity concerns “illegal loan sharks”. Because the legal companies will lend all the way down to the sub-sub-sub-prime level and below, the illegals have been deprived of a large slice of their market (assuming it ever existed to any great extent – anecdotal evidence suggests that much “illegal” lending is simply by those in an area with a bit of cash lending to neighbours on an informal basis). So if they see their customer base eroded, then they have to reduce their fees to below that of the legal lenders.

All regulated participants in the loans market from top of the market credit cards with concierge services to payday lenders have an interest in talking up the threat from illegals.

There are two real difficulties with total costs ceilings. One is where to set the cap. Make it too high and the effect is diluted. But pushing it too low invites other participants in the loans market such as sub-prime credit cards to complain that they can no longer contain their costs The other problem is to make a cap watertight so firms don’t work around it – some might try a pawn-broking-plus model where you have to pledge an item to get cash or a super sub-prime plastic card.

The issue is uncomfortable for the government. It instinctively opposes caps and other controls. And it knows the problem is decades old – and will not be improved by welfare cuts. It does not appear to countenance a cigarette-style health warning and advertising campaign which could reduce the demand for payday loans.

Cutting demand would rein back the lenders but no one knows how removing or reducing this line of credit would play. In that respect, payday lending is a microcosm of much that goes in the wider economy.

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