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Usury and the Loan Shark Myth

posted by Lauren Willis

Consumer financial education, disclosure, and defaults all dispensed with in my prior posts, shall we move on to “substantive” regulation, dare I even say “usury”? Before we do that, I need to clear up another myth that, like the belief in the efficacy of consumer financial education, is deeply ingrained: the loan shark myth.

Forthcoming in the Washington & Lee Law Review is a historical expose of the relationship – or lack thereof – between credit price regulation in the small loan market and loan sharking. The author, political scientist Robert Mayer, finds that what the popular culture has called loan sharking consists of two different types: violent and nonviolent. Both have been characterized by: (1) high prices, in excess of usury restrictions where such restrictions have applied, and (2) short-term, nonamortizing loans made to people who have a decent likelihood of being able to pay the interest amount due at maturity but a low likelihood of being able to pay off the principal balance, resulting in a steady stream of interest income to the lender as the loans roll over and over. It is this second feature that in the 19th Century first earned even nonviolent loan sharks their “shark” moniker – a single loan, even if it is expensive, looks harmless enough, but stealthily traps the borrower in a cycle of debt.

To summarize Mayer’s findings, violent loan sharking (meaning that the threat of violence ensures repayment) has been relatively rare and limited to a few big cities with large crime families, and rose and fell with their organized crime operations more generally. The prevalence of violent loan sharking has borne no relationship to state interest rate caps, and largely disappeared before the interest rate deregulation of the late 1970s. Although when violent loan sharking began, some of these loans were made to working laborers, high default rates and servicing costs forced these lenders to shift their clientele to wealthier borrowers who could afford to make larger, regular interest payments on larger loans, such as small businessmen and serious gamblers.

Nonviolent loan sharking, which ensures repayment through the threat of cutting off all future credit from borrowers who usually have few if any other credit sources, has tracked the rise of industrialization and the existence of a labor force earning low but regular wages. This type of lending has thrived in environments of both low price caps and high or no price regulation, although in the latter environments it is called “payday lending” instead of “loan sharking.” Recent work by PEW confirms that payday loans conform to the loan shark model of trapping the borrower in a cycle of debt -- most borrowers can afford to pay off the interest each pay period, but not the principal, leading to repeated rollovers.  Mayer finds that the only legal environment in which the nonviolent loan sharking business model of continual rollover of small, short-term, non-amortizing high-priced loans is not successful appears to be where Small Loan Acts have allowed a moderate price to be charged and have required some form of amortization such that principal can be paid back in installments over several pay periods.  

Whether the Small Loan Acts are truly the panacea Mayer claims, and which combination of repayment schedules and prices are most likely to lead to repayment instead of rollover, require further study. But what is plain is that the claim that price caps will drive high-priced lending to the violent criminal netherworld is false.  

When we consider consumer psychology and the economics of small loan lending, repayment over several pay periods and price caps both make sense. Paying down principal in installments is a self-control device for all of us who would have trouble saving up the principal to pay a loan off all at once. Although the scale of a small loan and a mortgage are different, a lender that wants to be repaid (rather than rolling over the loan or foreclosing on the house) will put both loans on an amortizing repayment schedule. 

The economic and psychological dynamics that affect pricing, on the other hand, are importantly different for small loans than mortgages. From the lender’s perspective, the extensive underwriting that would be necessary to engage in risk-based pricing of small loans is not worth the bother (and could be a psychological deterrent to borrowing by customers who experience extensive underwriting as a humiliating financial strip search). Thus only the most obviously uncreditworthy applicants are turned down for payday loans, and all others are offered a single rate, as Ron Mann and Jim Hawkins have explained. 

Further, the psychology and economics of shopping for a small loan are such that consumers do not perceive value in shopping for the best rate. The implication of the payday loan disclosure experiments performed by Marianne Bertrand and Adiar Morse (which I discussed in an earlier post) implies that payday loan borrowers optimistically believe they will pay the loan off sooner than they actually do, and while $50 for a $300 loan sounds steep, shopping around for a lower-priced loan – assuming the borrower will only pay the lender $50 once – is not worth the time and effort. Without consumer price shopping, the single rate a lender charges can exceed the average cost to the lender of the loans made, without losing many customers. These high prices endogenously create more risk that borrowers will be unable to make payments. Assuming that the goal is to reduce rollovers, reducing the price substantially would further that goal. Moreover, given that price competition is not working, ideally a price cap would be set to what price competition would have produced – something close to an efficient lender’s average cost. 

Setting price caps is a delicate business, perhaps even impossible (although the FDIC's Small Dollar Loan Program claims to have found 36% or less to be the sweet spot), but it is this business, as well as determining the right repayment schedules to require, rather than the bugaboo of the violent loan shark, to which we should attend.    


I don't disagree with anything that Lauren Willis says, although the Singaporean experience might be different than ours. They seem to have a stable illegal loan shark business.

But the case for price caps is good even if the price caps drive some business to the illegal lending sector. The illegal lending sector cannot use mass advertising, and has a difficult time projecting a warm-and-fuzzy image. In other words, it cannot induce demand. ("You deserve a vacation now!")

Lauren touches on what is one of the most important topics relative to small dollar lending and that is an appropriate repayment structure. As most know, the Small Dollar Loan Acts were created almost 100 years ago, the result of addressing both small dollar lending needs in a safe and regulated model and the necessity of having commercially sustainable rates.

The problem with today's conversations on small dollar lending is that too often the APR number becomes the issue versus the dollar cost to the consumer.

The fact remains that even at a 36%, which is strictly an arbitrary rate and has no basis in economic modeling, not enough interest dollars are earned to cover the operational costs of underwriting and managing a structured installment repayment on smaller dollar loans. It is the structured installment repayment (fully amortized) that is the only proven option for an affordable and disciplined small dollar loan.

This economic reality was proven with the FDIC's small dollar lending experiment which sought to demonstrate that banks could profitably make such loans at a 36% cap. At the end the FDIC dropped its profitability objective. Simply declaring the program a "success" because loans were being made was a false narrative. The participating banks said they could not offer the loan as a commercially sustainable product. It was a square peg in the round hole strategy with respect to a commercially sustainable rate and it failed.

Took me a few days before I could get to this, but
I was bothered by the law review article you link to claiming that the term "loan shark" didn't refer to violent lending. I was sure I'd seen the term in earlier works, and my wife thinks she's seen it used in the 1880s (but her research on that time period was about 10 years ago, so we can't get a reference easily).

t took me 10 minutes to find a 1935 New York Times article ("27 ARRESTED AS USURERS IN SUDDEN MOVE BY DEWEY TO BREAK UP VAST RACKET", New York Times, Oct 29, 1935) using the term "Loan Shark" for lenders who used violence to collect.

This leads me to wonder about the information in the rest of the paper.

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