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OCC Payday Lending Bulletin

posted by Adam Levitin

The Office of Comptroller of the Currency put out a Bulletin this week encouraging banks to make short-term small-dollar installment loans to their customers—basically bank payday loans.  The OCC seems to envision 2-12 month amortizing, level-payment loans, but they're meant to be a payday substitute.  

I suspect many readers of this blog will react with indignation and possibly shock (well, maybe nothing's shocking these days), but I think the issue is more complicated.  Depending on what one sees as being the policy problem posed by payday lending, bank payday lending might make a lot of sense.  Specifically, if one sees the policy issue with payday lending as being its high costs, then bank payday lending (like postal banking) holds out the promise of lower-cost loans. If, however, one sees the policy issue as being about payday borrower’s inability to repay even the principal on their loans, then bank payday lending (or postal payday lending) isn’t a solution at all, but a whitewash. Yet, as we'll see, there's surprising convergence between these positions on the ground in regulatory-land.

More Competition Isn’t Necessarily a Good Thing in Payday Lending

Mick Mulvaney, who claims to be the Acting Director of the CFPB, praised the OCC’s Bulletin, stating that “In any market, robust competition is a win for consumers.” Mick has learned his free market dogma 101, but while it’s generically true, it does not always hold “in any market," and happens to be totally wrong in the payday context. (Shouldn't someone who claims to be the CFPB Director know a little more about the product markets the CFPB regulates?)

Normally we think of competition as good for consumers because competition pushes down prices and pushes out bad practices.  But that outcome depends on a number of assumptions that do not always hold true.  Three are applicable here.   

First, greater competition will help consumer welfare only if consumers are sensitive to price and practice differences among competitors.  If consumer demand is not price elastic, then competition doesn’t improve consumer welfare. 

Second, greater competition will help consumer welfare only if there is non-monopolistic competition—that is the products offered by competitors need to be reasonably good substitutes for each other.  To the extent that a loan from lender A is not really a substitute for a loan from lenders or C, then the presence of additional competitors in the market may not matter for consumer welfare.

And third, greater competition will help consumer welfare only if there is competitive equilibrium in which lenders have the ability to lower prices while remaining profitable enough to attract capital. All are questionable for payday lending. 

Let's drill down on these three points.  

Price Elasticity of Payday Borrowers

Payday borrowers do not exhibit price elasticity in their demand, at least below usury caps.  Part of this is because payday borrowers are generally in financial distress.  Their concern is dealing with an immediate problem—fixing a car or fridge or avoiding a power disconnect or funeral expenses—and the marginal dollar cost variation between lenders is of little concern relative to whether they can get approved for a loan and how quickly and how conveniently.  The cost of the loan is a worry for another time.  There’s considerable price variation in payday loans across state lines, and the pricing does not seem to affect demand. Indeed, in the seven states that do not have usury caps for payday lending, lenders pricing varies considerably, suggesting that there is not price competition (see Figure 1 here)—if there were, one would expect prices to coalesce on the lowest market-clearing price. 

Monopolistic Competition Among Payday Lenders

Competition among payday lenders also often seems like monopolistic competition—that is the products are not true substitutes for each other.  At first glimpse this would seem preposterous—the product is a loan—money—the must fungible product in the world.  But a payday borrower doesn’t see a loan from the payday lender 1 mile away as interchangeable with one from a lender 15 miles away.  Geographic proximity—convenience—is an important factor for payday borrowers.  Transportation (and possibly child care) costs figure into borrowing decisions, particularly when the price differences between loans are small, say $10.  A payday loan in East St. Louis, Illinois is going to be cheaper than one in St. Louis, Missouri, but for a low-income borrower, the added time and cost of traveling to East St. Louis may rationally not be worthwhile.  Thus, payday products are distinguished in part on geographic location, and that adds an element of monopolistic competition to the industry, which means that more competitors do not necessarily translate into improved consumer welfare. 

(Yes, there’s on-line lending, but it suffers from an adverse selection problem, and the lead generation system means that competition is for obtaining the lead, not for the borrower’s business, and it’s not clear that on-line lending really substitutes for store-front.)

Payday Lenders' Cost Structure Means that More Competition Results in Higher Prices

Competition in the payday market is also marked by quasi-cannibalistic competition.  There are some 20,000 payday lenders in the US, concentrated in 36 states.  Barriers to entry are minimal, in contrast to banking.  There is a limited borrower base, however, and the result is that the typical payday lending storefront has less than 500 unique customers per year.  That’s determinative of the economics of payday lending because the lenders have high fixed costs—rent, utilities, labor—that have to be amortized over a very small borrower base.  The result is that lenders have to keep prices relatively high in order to cover their costs and attract capital.  Payday is not an industry with outsized profit margins (and why would it be given the low barriers to entry?). 

This means that more competition is actually a bad thing in payday lending.  To the extent there are more lenders competing for the same limited customer base, it will force prices up in order for lenders to cover their fixed costs with smaller borrower bases.

The best evidence of this is what happened in Colorado after it undertook payday reforms in 2010.  Colorado’s reforms resulted in roughly half of payday lenders going out of business.  But consumer demand did not slacken.  That meant that the surviving payday lenders had twice the business as before, and because of larger per store customer bases, they were able to amortize their costs over a larger population, which had the result of lowering costs.  This suggests that encouraging more competition in payday lending might be exactly the wrong idea. 

But there’s a catch. The Colorado reforms didn’t change the institutional landscape of lenders.  All of the Colorado lenders were still dealing with the same cost structure of storefront payday lending.  If banks start making small dollar installment loans per the OCC Bulletin, the new entrants to the market would have a different (and lower) cost structure.  Instead of just increasing the number of storefront payday lenders, all with the same high fixed costs, bank payday lending would bring a new type of competitor into the market, and the marginal additional costs for a bank to do payday lending are relatively small, particularly if it is lending to its own depositors.  There’s no additional overhead involved, the cost of funds is minimal (the loans are very small), which basically leaves the credit losses, but bank payday credit losses are likely to be lower (and to the extent payday is substituting for overdraft, no different).  In this regard, bank payday lending is a LOT more promising than postal banking.  The Post Office would have much greater additional operational costs than banks, not to mention the problematic politics. 

What this means is that bank payday lending will likely result in more competition, but competition with a lower cost structure.  If so, that would seem to really squeeze storefront lenders. (An alternative possibility is that banks skim the lowest risk payday customers, but that would leave the customers most likely to rollover their loans--the most profitable ones--in the storefront payday system.). 

And yet there remains the first two issues:  payday borrowers aren’t particularly focused on cost, but on the ease (including geography) and speed of obtaining funds, which results in monopolistic competition.  Bank payday loans aren’t going to be a competitive product unless they can match storefront payday loans on those dimensions.  They might be able to with on-line approval and immediate funding to deposit accounts.  (If the borrower wants to get cash, however, it’s a different matter).

What this all means is that bank payday might result in lower costs for payday loans. I don’t know that it’s going to result in 36% APR payday loans, but even if it’s 100% APR that’s a lot cheaper than prevailing rates.  And if the competition from banks means that some storefront payday lenders go out of business, it will mean that the surviving storefront lenders will have larger customer bases and then more room for price competition.  More price competition is a good thing, but I’m skeptical about the magnitude of the consumer welfare benefit, both in terms of number of consumers and savings per consumer.  Yet this sort of marginal improvement in consumer welfare might be missing the point, depending on how one sees the policy issues involved with payday lending. 

Is the Problem with Payday Loans Their Cost or Borrowers’ Lack of Ability to Repay Principal?

If the policy issue with payday lending is the cost of the loans, then any proposals that would bring down cost make sense in broad terms—more competition via bank payday loans, post banking, limiting entry into the market, or capping fees at much lower levels. But if the policy issue is that borrowers can’t afford to repay the loans irrespective of the fees, then cost-reduction proposals look like Titanic deck-chair reshuffles.  In other words, depending on the diagnosis, there’s a marginalist approach and a maximalist approach, and the OCC bulletin is definitely in the marginalist camp. 

Curiously, the CPFB’s Payday Rule is of two minds on this.  On the one hand it is structured as an ability-to-repay rule.  But then there are safeharbors from the Rule’s ability-to-repay requirement that are keyed to price or longer repayment term, among other things.  I think the way to understand this is that the CFPB recognized that the problem with payday loans is not the cost, but the lack of borrower repayment capacity, but at the same time recognized that there is a level of demand for small-dollar credit because people often have emergencies and can't make ends meet.  So the CFPB's position seems to be an attempt to compromise and say, "no loans without ability to repay...unless the loan isn't on terms that are too onerous or too likely to result in a cascade of debt." That seems like a result that isn't so different from the OCC Bulletin. 

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