Payday and subprime lending – A new regulatory paradigm is needed

A theme we keep returning to at the Centre is the worrying growth in payday and other forms of subprime lenders and the impact this has on vulnerable households and communities. We like to see successful businesses but, unfortunately, this is one consumer sector where the more successful it is, the worse it can be for certain communities.

It would now seem that the Office of Fair Trading (OFT) is taking a more intrusive approach to investigating payday lending firms (see http://www.independent.co.uk/money/loans-credit/payday-loans-firms-raided-by-watchdog-8201373.html).  This is to be welcomed but it must lead to urgent action and controls placed on some of the more predatory activities in this sector.

As with any policy response, the robustness of a regulatory intervention must be proportionate to the detriment caused by an activity. But it is very worrying that so far the debate around subprime lending seems to focus on shallow, narrow consumer protection issues. Consumer protection is of course important but this narrow regulatory paradigm is far too limited to understand the wider socio-economic impacts of subprime lending on vulnerable households and communities.

The growth in subprime and payday lending not only leaves many vulnerable households overindebted and exposed to unfair and aggressive practices, it undermines households’ efforts to build financial resilience and create secure financial futures, it extracts resources from disadvantaged communities and undermines the ability of community lenders such as credit unions to provide access to fair and affordable credit to more consumers.

It follows that, if policymakers, regulators, and consumer activists fail to understand the wider public policy impacts on households and communities, then the policy and regulatory response will be far too tame to deal with the problems.

What’s at stake?

The regulation of subprime lending is a difficult, contentious issue – it can be as much a philosophical and moral issue as a regulatory, economic issue.

Some people argue that: subprime lenders give consumers what they want and sometimes need; consumers are able to handle these loans; and clamping down too much would be ‘nanny-statist’ and risk driving some consumers into the hands of illegal lenders.  Others think that this is an ‘extractive’ industry that: exploits consumers’ vulnerabilities and adverse behaviours; is contaminated by toxic, predatory practices on the part of many lenders; strips money out of local communities; and creates more problems than it solves for vulnerable consumers and communities. It is probably not too hard to guess which camp I’m in.

Let’s understand what is at stake here. The obvious detriment is that growing numbers of vulnerable households are targeted and missold toxic credit by poorly regulated lenders. Many of these households will end up in dire financial straits, persuaded to take out debt they cannot afford, ending up seriously overindebted, and/ or hit by heavy penalty charges.

An insight into the effects of payday lending on vulnerable consumers can be seen in data provided by CCCS, the UK’s largest debt advice charity. In 2011, CCCS was contacted by 370,000 people seeking debt advice. Worryingly, in 2011, contacts about payday loans made up 13% of the total – up from 5.5% in 2010 and 2.6% in 2009[1]. These payday loans appear to have been taken out on top of existing credit commitments – clients with payday loan debts will on average have three more unsecured debts than a client without. CCCS suggests that consumers are taking out payday loans in an attempt to keep on top of their other contractual debt repayments which is clearly unsustainable. The amount owed by CCCS clients to payday lenders is much larger than what might be expected. The total average amount owed in payday loans is £1,267 – four and a half times the average size of a loan (around £275). This suggests clients with payday loans are often struggling to keep control of the spiralling costs of this type of credit or taking out multiple payday loans. Three-quarters of payday borrowers who come to CCCS earn less than £20,000 a year; their disposable income is £100 less per month than that of all clients.

There has been much debate recently about how to regulate this type of lending to protect consumers. The approach so far has been to follow a fairly permissive licensing and standards regime and provide consumers with information to: i) change their behaviour (and in turn change the behaviour of lenders) and ii) promote ‘competition’. This information approach is not very effective in financial markets generally. But it offers very little protection in markets such as subprime lending where consumers are inherently vulnerable and certain firms adopt very aggressive business models to acquire market share and grow and churn their business.  There is a clear need for a more robust consumer protection measures to stamp out irresponsible lending and protect consumers from aggressive practices.

But on top of this, targeting by subprime lenders undermines the ability of households and communities to build up financial resilience and create secure financial futures. It is just far too easy to borrow money; it is just wrong that someone on a very low income can be sold significant amounts of potentially toxic debt in a matter of minutes – yet they may be trapped by the long term consequences of this instant decision. The balance between debt and savings in the UK seems to have got completely out of kilter. We saw the consequences of a too liberal approach to lending in the ‘mainstream’ lending market. This is now being repeated in the subprime market. Economically disadvantaged households and communities cannot keep their heads above water never mind build up savings if they are repeatedly targeted by aggressive marketing or selling practices to take out high levels of debt. If someone is in trouble it is not a good idea to allow subprime lenders to push more expensive debt at them. The default position should be to try to promote financial resilience and encourage savings, and discourage this form of borrowing.

There are also wider economic effects on economically disadvantaged communities. Subprime lending is an extractive industry unlike borrowing from a credit union where the savings and loans are circulated in the local community. On that point, we certainly want to ensure that communities do have access to ‘productive’ credit. But it is difficult to see how community lenders such as credit unions can really stand a chance of thriving while subprime lenders can crowd them out of their own communities due to the lack of restrictions on their expansion.

The economic doldrums that continues to beset vulnerable communities provides a perfect climate for these lenders to thrive. A fascinating article in the FT, ‘Payday lenders growth on high streets’ highlights the growth in payday lenders and decline of bank and building societies particularly in deprived areas[2].

So, there are compelling consumer protection, socio-economic, and wider public policy reasons for controlling the supply of subprime lending.

But the narrative developing around subprime lending may hinder any robust interventions. The subprime sector is brazenly trying to recast itself as being on the side of vulnerable consumers and argues that to constrain its activities denies consumers their ‘rights’ of access to credit. Next we’ll be hearing that they are providing a social service.

Moreover, the consumer movement has to be careful to avoid ‘bleeding heart’ syndrome – that is, unwilling to campaign for tougher controls for fear of appearing patronising or nanny statist. I’m not afraid to say that, given how vulnerable existing and potential borrowers are to the predatory practices of some lenders, it is right to intervene to protect the interests of people and their communities.

The case is even more compelling given that the regulatory regime covering subprime products used by vulnerable consumers is weaker than that covering ‘mainstream’ products regulated by the Financial Services Authority (FSA). Indeed, the Government is quite rightly encouraging the new Financial Conduct Authority (FCA) to become even more robust and intervene early to protect consumers when it takes over the regulating of financial services from the FSA next year. Surely, on the basis that regulation should be proportionate to the vulnerability of consumers involved, subprime borrowers deserve at the least the same, if not higher, levels of consumer protection.

What can be done?

Overall, we argue that we need a much more precautionary, interventionist approach to regulating this sector to replace the current rather permissive approach. The priority must be to find ways of intervening to control the supply and form of this type of credit.

The question is: what is the best way to achieve this? OFT guidance on responsible lending doesn’t go far enough in this market and, of course, information/ disclosure doesn’t work. So the focus needs to be on the business models and marketing practices. So, here is a ten point plan that can be tailored according to different forms of lending – payday lending, doorstep lending, high street/ internet based:

  1. Business models that exploit adverse price selection/ price gouging/ cross subsidies between different groups of borrowers should be prohibited.
  2. ‘Competition’ works against consumers in this market. Depending on the form of credit involved, subprime lenders rely on aggressive advertising and promotional activity, or agents working on commission/aggressive targets or leads generated by introducers – the same root causes that hurt consumers in other financial markets. Incentive schemes that force low paid agents to ‘sell’ more loans or volume related incentives should be prohibited. Advertising and promotional activities should be pre-approved using tougher standards and allowed only under controlled conditions. This should also apply to internet based promotions.
  3. To prevent borrowers being exploited by high interest rates and charges, the total repayable on any loan should be capped – for example, twice the value of the original loan.
  4. The ratio of the total value of loans /disposable monthly income should be capped along with a cap on the number of loans per household/ address.
  5. There should be an obligation on lenders to check if borrowers have other loans – we urgently need a proper centralised, independently managed register of loans which lenders should be legally required to consult.
  6. Lenders should not be able to enforce loans classified as subprime if they cannot prove that due diligence on affordability has been done – regardless of who has sold the loan.
  7. Lenders should be required to refer borrowers in financial difficulty to debt advice charities.
  8. The licensing process needs to be toughened up considerably with robust pre-approval measures before firms are allowed to offer loans.
  9. Moreover, local communities should be given a greater say in approving the siting of subprime lenders in local communities and given the right to hit doorstep lenders with a financial ASBO if there is evidence of predatory practices.
  10. More robust enforcement of existing legislation is needed along with tougher sanctions to control excessive behaviours.

Of course, there are other measures needed to control the behaviours of commercial debt management companies, buyers of distressed debt, and to boost capacity amongst the community lending sector. Details of these measures can be found in our Financial Inclusion Manifesto

It is expected that the regulation of unsecured credit will be transferred from the OFT to the new FCA. This should provide an opportunity for more robust regulation of this sector. But this may take some time to implement – time which vulnerable households and communities do not have. The measures listed above need to be implemented as a matter of urgency.

Mick McAteer

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