« Welcome to New York; the Bankruptcy Court is Below the Museum | Main | Explaining the Housing Bubble »

Fringe Lending and Consumer Welfare

posted by Alan White
Like Katie Porter, I found Professor Jim Hawkins' paper on fringe lending valuable for challenging some of the premises underlying calls for stricter regulation of fringe lending products like payday loans.  In my view, there are empirically testable criteria for regulation of fringe credit, which I hope to elaborate in a forthcoming paper.  Unfortunately, Professor Hawkins ultimately does not offer either a normative consumer welfare framework for credit regulation, or a truly empirical examination of the welfare impacts of fringe lending.  Instead, he relies on product descriptions that reflect industry marketing more than the experienced reality of working class borrowers who use them, and uses a very limited implicit definition of consumer harm to restrict the possible justifications for market intervention.

Studies of fringe lending differ radically in their conclusions in part because they differ in their understanding of consumer welfare and harm.  At one end of the spectrum are those who rely principally on revealed preferences as their yardstick.  If consumers voluntarily contract for a loan, it by definition increases their utility, based on their expressed preferences including their rational assumption regarding repayment risks.  If revealed preferences is the standard, then perhaps the only justification for regulation might involve information problems that would distort a consumer's ability to understand price and terms in order to choose a credit product.  While information problems are not absent from the fringe credit market, they are not the principal source of trouble, from the standpoint of regulation advocates.  At the other extreme are those who object to high-interest-rate loans purely on equity grounds, regardless of whether an income-constrained borrower might gain more than they lose with a short-term, 200% APR loan.  If the objectives of market regulation are egalitarian rather than utilitarian, abhorrence of redistribution from borrowers to lenders justifies regulation, regardless of any aggregate consumer welfare function.

A third approach remains utilitarian, but suggests that expressed preferences are not the best measure of consumer welfare and harm.  Consider two payday loan borrowers.  One needs $500 to repair an automobile in order to retain a $35,000-a-year job in a market where job loss will mean at least 12 months of unemployment, with a loss of at least half of that income.  If, and it is a big if, the worker can repay the $550 with her next paycheck, the $50 loan cost is fully justified by the avoidance of a much larger loss.  On the other hand, consider the same borrower who, in order to avoid a $35 penalty, borrows $500 to pay a delinquent credit card bill, but finds herself unable to repay the loan on payday, and simply pays $50 interest every two weeks for the next nine months until finally deciding to close the pledged bank account and default on the payday loan.  These and similar miscalculations and overoptimistic assumptions are, according to the evidence, a common experience of payday loan borrowers, and it is hard to say that their preference to obtain these loans reflects any increase in their welfare, even measured only in dollars by consumption and net worth over time, and setting aside psychological and other indirect harms.

Any coherent fact-based approach to regulating fringe credit needs to begin with a coherent account of consumer welfare and harm.  Certainly some objective measures of extreme debt distress could be arrived at, based on not only the percentage of income devoted to debt repayment, but also the relation of debt service to minimum expenditures needed to buy basic necessities.  The IRS, for example, establishes standards for basic expenditures that the Bankruptcy Code borrows for the means test.  One could investigate the degree to which fringe credit borrowers are driven below those levels by debt service.  Likewise, the personal costs of credit defaults are still not well described or understood.  We don't really know, for example, the true cost to a family of losing a home to foreclosure, or the cost of losing a car to repossession, which is surely greater than the market value equity in the car.  In addition to overindebtedness, regulators could and should gather data on default costs and default risks connected to various credit products.

Empirical sources are not lacking, and several studies have relied on available data or original survey research.  A number of states maintain credit databases on payday borrowers.  The 2007 Survey of Consumer Finances includes a number of data elements regarding fringe banking usage, as well as bankruptcy filings.  It reveals, for example, that about one-third of payday loans are used to meet emergencies, while two-thirds are used to pay other debts, ordinary living expenses, or help friends and family.  The 2010 SCF should be available some time next year.  The new Consumer Financial Protection Bureau will have both the resources and the mandate to investigate these questions and make their assumptions, their data and their conclusions public. 


Anyone with enough resources to make a plausible example for justified use of a triple-digit-interest loan -- for example, a $35,000/year job -- is very likely to have more prudent resources, such as even a high-interest credit card. Can anyone argue with a straight face that these operations could survive with a clientele NOT making "miscalculations and overoptimistic assumptions"?

My question exactly, Ken. If the majority of borrowers dealt with their loan in the manner the payday loan companies say is intended, I really don't believe the industry would exist.

A couple of other problems bring customers into PDL companies, however. One is that, at least around here (central Canada), normal bank services have become much scarcer in poor neighbourhoods. For many people, it's the PDLs or else a half a day on the bus going somewhere else.

Too, many banks will not create an account for a person with no fixed address or other problems related to poverty. These people become willy nilly customers of the PDL companies, because many banks (even the ones issuing the cheque) will not cash a checque unless the person has an account with them.

And finally, PDL companies can be very useful in cashing cheques for people one hop ahead of eviction or bankruptcy, keeping the cash out of reach of garnishment.

Of course, if you're that poor, you pay a big fat premium for that maneuverability.

i liked the contents & material of the website. displaying such banking facts is beneficial to the common man.

The comments to this entry are closed.


Current Guests

Follow Us On Twitter

Like Us on Facebook

  • Like Us on Facebook

    By "Liking" us on Facebook, you will receive excerpts of our posts in your Facebook news feed. (If you change your mind, you can undo it later.) Note that this is different than "Liking" our Facebook page, although a "Like" in either place will get you Credit Slips post on your Facebook news feed.



  • As a public service, the University of Illinois College of Law operates Bankr-L, an e-mail list on which bankruptcy professionals can exchange information. Bankr-L is administered by one of the Credit Slips bloggers, Professor Robert M. Lawless of the University of Illinois. Although Bankr-L is a free service, membership is limited only to persons with a professional connection to the bankruptcy field (e.g., lawyer, accountant, academic, judge). To request a subscription on Bankr-L, click here to visit the page for the list and then click on the link for "Subscribe." After completing the information there, please also send an e-mail to Professor Lawless ([email protected]) with a short description of your professional connection to bankruptcy. A link to a URL with a professional bio or other identifying information would be great.