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Credit Cards to Payday Substitution?

posted by Adam Levitin

Over at Volokh Conspiracy, Todd Zywicki spent Christmas Eve crowing about a Wall Street Journal article about the boom in payday lending. Todd sees the article as vindication for his insistence that regulation of consumer credit will inevitably result in a substitution of another type of credit. For Todd, the substitution hypothesis makes regulation not just pointless, but actually harmful because it will eventually push consumers into the arms of loan sharks.  

There are a whole bunch of problems with the substitution hypothesis, as well as for Todd's interpretation of the WSJ article. Todd writes that: 

Maybe instead we ought to acknowledge that there will be unintended consequences, such as by making credit cards less available regulation will drive many consumers to substitute to more expensive types of credit, such as payday loans? And just wait until the well-intentioned bureaucrats at the CFPB really start protecting those poor folks, then they are really going to get it.

For starters, Todd doesn't accurately summarize the WSJ article. He implies that it was referring to credit cards in general. It wasn't.  It was referring to subprime credit cards. The WSJ article quotes a payday lender as stating, "We believe that we're starting to see a benefit of a general reduction in consumer credit, particularly ... subprime credit cards."  

It turns out that subprime credit cards are often as or more expensive than payday loans. The Credit CARD Act severely curtailed a type of subprime card called "fee harvester" cards. A 2007 NCLC study shows that the costs of fee harvester cards rival or exceed payday loans. So if there's substitution here, it might actually be a good thing. The article is certainly not evidence for middle class consumers getting driven into the arms of payday lenders. Instead, at best, it shows some substitution of fringe financial products and it isn't clear that it is harmful substitution. 

As a general matter, there's very little empirical evidence on the substitution hypothesis one way or another. The most recent work I'm aware of is by Credit Slips' Own Angie Littwin, who has shown that there isn't necessarily dollar for dollar substitution--sometimes consumers simply borrow less rather than turn to less savory sources of credit. Put differently, Angie's work shows that demand for credit is elastic, at least in some situations.  

But even if we were to accept the substitution hypothesis and posit inelastic demand for credit, it doesn't follow that all sources of credit are created equal. Some credit products are more competitive than others. So if regulation forces business to shift to more competitive markets, substitution results in a net consumer welfare gain. Todd argues that the payday lending market "is highly competitive." If it is more competitive than the subprime card market, then it shouldn't be surprising if costs are lower.  

Similarly, even with a product class, regulation of one type of fee can cause fees to shift to other types of fees. Thus, Todd predicts that the regulation of debit card interchange fees will result in an increase in consumer debit card fees. That's quite possible, but again, I don't see why that's such a bad thing. Consumers end up paying for most of those costs one way or another as merchants pass through interchange to consumers. All else being equal, a substitution from a less transparent/salient fee to a more transparent/salient fee will result in stronger price competition and therefore something less than a 1:1 fee shift. Consumers win. Conversely, if the shift is to a less transparaent fee, consumers lose. Presumably, any profit-maximizing firm would already have engaged in the optimal shift to less transparent fees, so there's no further ability to engage in this.  

I think this spells out an important task for the Consumer Financial Protection Bureau:  identifying which types of fees are more or less transparent and salient and then adopting policies to shift pricing toward the most salient and transparent fees. This will have the result of increasing price competition (not pricing competition) in consumer financial services. That will mean smaller profits for the financial services industry, but will also produce a greater incentive to come up with product innoviations, rather than pricing scheme innovations.


Apologies, Professor...

No idea where to throw this so it lands here. Obviously, feel free to remove/relocate/delete as y'all like...

From Today's WSJ:

Dead Soul Is a Debt Collector

Deceased Woman's Name Was Robo-Signed on Thousands of Affidavits

She died in 1995. Yet her signature later appeared on thousands of affidavits submitted by one of the nation's largest debt collectors, Portfolio Recovery Associates Inc., in lawsuits filed against borrowers.

I don't know much about the validity of the substitution hypothesis. However, I do read the Singapore Straits Times. You can only tell so much by looking at newspaper stories, but they sure seem to have a lot of loansharking there--in a country that is regulated to a fare-thee-well.

That being said, even a proponent of the substitution hypothesis must agree that it has its limits. Illegal products are bought; legal products can be sold. You don't see the Mafia taking out ads depicting the smiling families who have used their product to take a well-earned vacation.

Micro finance in the third world is having similar problems. In India in particular (see recent issues of The Economist), politicians are attempting to put caps on micro finance lenders, who charge in the 35% range. The concern is that people will be driven back to village money lenders charging over 50%. As described by the Economist, it appears to be politicians trying to look good, but I'm only seeing the one side of the issue.

Payday lenders are also under fire for high interest rates and fees, with attempts to cap them. Again the concern is that people will have to resort to loan sharks.

Even so, while lending demand may be inelastic in the short term (it being hard to cut spending and budget), in will change in the long run (after all, there's a lot more lending today than in the pre-credit card days of the 1950s).

A question occurs to me relating to economic theory. Is the concept of an asymmetric elasticity used? I'd imagine that demand for debt is elastic with increased supply (lower interest rates and lending standards) but relatively inelastic with decreased supply (higher rates and tighter lending criteria). It's much easier to borrow and spend more than it is to spend less. Just ask any government.

Mr. Wicklund makes a point and it is reflective of the debate that was waged at the turn of the last century. In the early 1900's usury caps were lifted with the express purpose to combat illegal loan sharks and salary advance lenders.

Thanks to the work of Arthur Ham and the Russell Sage foundation, the framework for legal, regulated small loan lending was created. It was recognized that existing usury caps were hurting the very people they were meant to protect.

Now we are seeing the same arguments all over again and it is clear that many people in this debate have forgotten history. Or is some cases they are making up their own history.

I would suggest a reading of FINANCING THE AMERICAN DREAM (Calder). In particular, Chapter 3.

The main reason that we have witnessed the explosion of Payday Lending is that the small loan installment product, which is the most responsible and disciplined product for the people who are in the most need for small loans, has been thwarted in its use due to existing price caps that fall well below the cost to provide the product.

Payday lending did not create a new level of debt, it satisfied an existing credit need that was becoming more difficult to meet with the existing lenders.

In the last six weeks, there were 200 filed in Northern Virginia–and 120 were dismissed. That works out to a failure rate of 60%.

I disagree, because many credit cards while sub-prime do not necessarily make up the main component of credit cards, many credit card such as high interest unsecured ones at 25% interest if you do not pay in full or secured credit cards with low or no interest exist.

Surcharging those cards, while make the actual interest rate go higher, since many merchants as in Australia will surcharge beyond the cost of the transaction, those with monopoly power, however to support adam card companies like any company can keep profits to themselves and many poor or those with bad credit, many not be able to get credit easily. It is not just the poor inner city folks, bankrupt folks also turn to check cashing services.

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