Payday loan rule can attract hidden loan sharks
The Consumer Financial Protection Bureau (CFPB) on Thursday released its final rule regarding payday loans as well as certain other consumer credit extensions. These loans are generally small, very short term (often only a few weeks) and carry a very high effective interest rate after taking into account all costs.
Problems can arise for borrowers who pay off a payday loan and the associated interest and fees by taking out a subsequent loan for an even larger amount, trapping the borrower in a cycle of indebtedness from which they can often only escape through a personal bankruptcy.
The stated purpose of the CFPB rule, quite simply, is to protect consumers from falling into these debt traps. However, the question of whether the rule will be effective is an open question.
The rule applies to three types of “short-term covered loans”:
- Short-term loans maturing in 45 days or less
- Longer term loans (over 45 days) with lump sum repayment; that is, the loan is repaid in full when it falls due or the loan agreement requires at least a substantial down payment of the loan.
- Longer-term loans where the cost of credit exceeds 36% and which either have a lump sum payment function or the lender is authorized to obtain repayment by making a transfer of funds from the bank account of the borrower.
An essential feature of the new rule is a complex “repayment capacity” requirement. That is, it will be “an unfair and abusive practice” for banks and other types of lenders to provide a short-term covered loan without the lender having first reasonably determined that the borrower has the ability to repay the loan. The rule sets out the steps the lender must take to make that decision.
Parts of the rule will come into effect 60 days after its publication in the Federal Register; the other provisions will take effect 21 months after their publication. Given its complexity, full implementation of the rule is likely to be delayed and subject to many interpretations.
The market for short-term consumer loans will almost certainly start to change before these effective dates in anticipation of the rule’s likely effects, intended or not.
In a related move, the Office of the Comptroller of the Currency (OCC), which regulates domestic banks, removed guidelines it issued in 2013, which effectively prohibited domestic banks from offering deposit advances; these advances are short-term loans repaid from an upcoming electronic deposit, such as the borrower’s next paycheck or social security deposit.
Removal of guidance may result in an increase in anti-deposit lending by banks. The OCC has listed three main principles that banks should follow when offering early deposit products: soundness, risk management and reasonable underwriting.
While not cheap, in terms of the effective interest rate paid by the borrower, deposit advance loans are an alternative to borrowing from non-bank lenders subject to the new CFPB rule.
The big unknown is what the market for short-term, low-value consumer loans will look like once the CFPB rule takes full effect. In particular, what distortions will emerge that are detrimental to borrowers, and how will lenders legally try to circumvent or play the rule, to their advantage?
It is almost certain that the costs imposed on lenders by the new rule, which must be passed on to borrowers, will reduce the amount of small loans taken by consumers.
These effects will not be known, however, for several years. There is no doubt that the CFPB will be forced to change the rule in an attempt to manage the perceived negative effects of these unintended consequences, which could trigger other unintended consequences.
What the rule cannot fix is what will happen outside the regulated market for short-term consumer loans. One of the perverse and undesirable effects of the rule may be to stimulate the development of unofficial activities and unregulated small loans where the effective interest rates are much higher, but where the borrower has less difficulty in obtaining a loan.
Taken to the extreme, the CFPB rule can trigger an increase in outright usurious lending, with extraordinarily high interest rates and questionable loan collection techniques.
In various meetings over the years that the rules regarding small dollar consumer loans have been discussed, I have expressed my concern that the CFPB rules may lead to an increase in usurious lending. I even joked that maybe among the defenders of these rules is the (non-existent) National Association of Loan Sharks.
My concerns about the possibility of an increase in usurious loans with the entry into force of the CFPB rule were quickly dismissed. Time will tell if it was wise.
Bert Ely is the Director of Ely & Company, Inc., where he oversees conditions in the banking and savings industries, monetary policy, the payments system and the growing federalization of credit risk.