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Fringe Banking and Financial Distress

posted by Jim Hawkins

The answers to the question about the definition of financial distress track with my thinking too.  On the one hand, we could define financial distress loosely and almost everything counts (like forgetting your wallet and needing to pay for parking).  Stephen Ware once wrote that financial distress could mean having wants that exceed your ability to pay.  For me, such a loose conception of the term causes it to lose any meaning.  Wants exceeding needs could be the owner of the Yankees wanting to own a NBA team but not having enough money.  This expansive of a definition misses the heart of distress which seems to relate to not meeting basic needs or getting collection calls, etc.  

On the other hand, some definitions are so restrictive that they miss a large group of people we’d commonly think of as in distress.  If we define distress as declaring bankruptcy or even getting sued or called for collection, we miss all the people who are going without basic medications to pay their credit card bills or skipping meals to service other debt.  And, we miss all the people who do not declare bankruptcy but for whom it would be efficient to do so.

The two most common definitions that came up in law review articles were (1) having unmanageable debt; and (2) not being able to have your financial ends meet.  I think the first is a better definition because most measures of financial distress relate to debt (debt to income ratio; negative net worth; debt service ratio, etc).  But, because the concept is indeterminate and people accept both, I use both.

Using these two definitions, I started to think about whether fringe banking products cause financial distress.  Academics and policymakers often assert that they do.  And, the argument makes a lot of sense: Fringe borrowers are on the financial fringe already, and fringe banking products cost ridiculous amounts of money.  It seems likely that using fringe credit would cause distress.  But I don’t think so.

There are two key characteristics of fringe banking products that limit the likelihood borrowers will experience distress when using them.  First, the amounts of the loans are small.  At most, you can get a payday loans for a total of 1/26th of your annual salary.  The average payday loan is for $300.  The average pawn loan is around $70.  But, a single credit card company will give you a credit limit of 1/5th of your annual income.  With such a small amount of money owed, it is unlikely you’ll be taking on unmanageable debt.

Second, most fringe credit is structured to guarantee repayment regardless of whether the borrower can repay the loan.  Pawn loans and auto title loans are both self-liquidating.  If you don’t pay the loan, you don’t owe anything because the lender just keeps your property (and usually isn't entitled to any deficiency).  Similarly, if someone doesn’t make a rent-to-own payment, the person doesn’t owe any money, they just lose possession of the goods.

Anyway, the full argument is here.  This is a rough draft, so I’m very interested in any comments.  If you want to email me directly, my email is jrhawkins [at] uh.edu .


This is a great reminder that regulation that simply sounds good is not always good. We have been going through this process of deciding how to regulate payday lenders here in Virginia. I have been reminding our legislators that people in this market are already under severe financial distress and cracking down on this type of lending will not get them out of that distress. Indeed, drying up the supply of this type of credit (through interest rate caps or outstanding loan caps) may actually do more to perpetuate their current distress level and leave them no options for short-term credit access.

Off the bat, did you put the year you intended to on your draft date?

The idea that loans at 300% interest are useful to someone in financial distress is so absurd it's hard to know how to respond. But what is much worse is the fact that these "loans" are designed not for short-term use (as they are advertised) but as a way to keep someone paying and paying and paying....

“You’ve got to get that customer in, work to turn him into a
repetitive customer, long-term customer, because that’s really where the profitability is,” Dan Feehan, CEO of Cash America, a major payday lender, remarks made at the
Jefferies Financial Services
Conference (June 20, 2007)

I should clarify that the paper does not argue that payday loans or other loans should be unregulated. It just says regulating them because they cause financial distress is a mistake. If we really want to protect people using these loans, it is better to focus on real problems.

(Thanks for the correction Hillary. I've updated the date.)

We'll see what the new generation products shall be... won't we?

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