Towards a more sophisticated debate on payday loans

24^th October 2014

The debate around payday lending in the UK can often seem very black and white. For a long time, when covered in the mainstream press, much focus was put on APR. Over time, however, most have accepted that APR figures are all but meaningless when applied to short-term loans.

There has been a richer debate on the issue lately, which is all to the good. Sam Bowman at the Adam Smith Institute, for example, has challenged the received wisdom and raised some very difficult questions about the existence of companies like Wonga from a free-market perspective.

Also, Richard Speight at the Fabian Society recently argued that people will put up with the higher charges of a Wonga or QuickQuid loan because of the convenience and, as such, any alternative will have to match other lenders on that.

In my own work researching alternative finance I have tried to move past the scripts and ask slightly more challenging questions about payday lending – I will attempt to do so here.

Can payday lending ever be relational?

For finance to be truly relational, lenders must restore local trust by showing that it seeks to appropriately and responsibly invest in an area. It also means that all lenders, including payday lenders, must apply diligence to whether their lending contributes to the responsible investment of households in a local area.

Two studies from the US are interesting in this regard. Ronald Mann, the Professor of Law at the Columbia Law School, recorded in a 2013 survey of 1,374 payday loans borrowers (for which the response rate was 96.5%) that around 60% accurately predicted how long it would take for them to pay it back. On the other hand Pew, a US think tank, in their research on payday loans borrowers found evidence to suggest that even when some borrowers fully comprehend the terms and conditions of payday loans and know they will be difficult to repay, they will still take them (some 37% of borrowers would borrow on whatever terms offered).

In a credit transaction, the onus of responsibility is on both borrower and lender. Accepting a loan of any terms offered is potentially irresponsible, but a lender, also, has a duty to tally up whether going ahead with this transaction warrants good investment. Though speed of service is more profitable, for a payday lender to ever be considered relational finance they must forego this profit – and in this regard, since speed is the primary mode of competition between short-term lenders, there is a long way to go.

Can payday lending ever repair household finances?

Recently there has been an effort, particularly by trade bodies such as the Consumer Finance Association, to demonstrate the part that could be played by payday loans to repair a person’s creditworthiness, and use such loans as a stepping-stone to a better credit record. Though taking a payday loan could add reputational damage to a credit file, could it improve household finances more broadly in the future? Put another way, could a payday loan ever be a sensible investment by a consumer towards greater future prosperity?

In a very interesting study by Paige Marta Skiba and Jeremy Tobacman in the US in 2007, they looked at the loan contracts of 51,636 bi-weekly paid borrowers who among them collectively took out 335,376 loans over four year period from 2000-2004. They found that with the first three loans there is a very elevated probability of default at around the 12% level, with subsequent loans being less risky to the point where default probability levels even out at around 6%. This perhaps shows that even with a riskier customer (bi-weekly pay has similar connotations to that in the UK) payday loans can become less risky the more they are used.

This study, however, doesn’t explain everything. What we are often left without in these debates is the extent to which borrowers are struggling elsewhere. When I look at this study I ask myself: if a borrower paid bi-weekly takes at least three loans out and over time reduces the probability of default, to what extent are they falling behind on other commitments? This question, in a UK context, still needs addressing.

Is regulation paternalistic?

It’s been noted that the FCA, the regulator of all consumer credit in the UK, has moved toward a more paternalistic approach. In a recent speech at The Lord Mayor’s residence Martin Wheatley, the Director of the FCA, made the intention of his organisation quite clear:

“Unlike the liberalisation of the 80s, and all the cynicism that went hand-in-hand with it, we want to ensure that a competitive financial services market works for the interests of consumers, with adequate protections in place.”

It is very interesting rhetoric for a regulator, and it is very enthusiastically pro-consumer. The concern some will have, however, is that the FCA is removing choice. The problem, however, whether we like it or not, is that by allowing consumers greater autonomy over their credit choices has allowed unruly lenders to take advantage of them. That, or competition based on speed has removed the incentive to carry out rigorous credit checking.

Away from the ‘back’n fourth’ arguments about APR or whether payday loan companies should be banned, we are starting to move on and have more sophisticated debates about what lenders contribute to household finances, and the regulatory architecture that befits it. This is all to the good for both payday loan advocates and critics alike.