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Restrictions on Payday Loans Hurt the Poor

Stephen L. Carter is a Bloomberg View columnist. He is a professor of law at Yale University and was a clerk to U.S. Supreme Court Justice Thurgood Marshall. His novels include “The Emperor of Ocean Park” and “Back Channel,” and his nonfiction includes “Civility” and “Integrity.”
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Everybody hates payday loans. Interest rates are high. Borrowers can lose property they pledge as collateral, or wind up in a debt spiral as they roll the loans over. 

Yet those sometimes called the “less numerate” have trouble calculating these and other risks. Google recently set off a debate by banning ads for payday loan firms from its site. Prosecutors are on the hunt for indictments.

So last week’s announcement by the Consumer Financial Protection Bureau of proposed rules to protect low-income borrowers from the horrors of payday loans has been widely cheered. But the applause overlooks an important issue: the possibility that we will hurt the very people we are trying to help.

The CFPB isn’t proposing to ban the loans. Its principal idea is to require underwriting -- that is, to force lenders to be sure that the borrowers can pay.  What’s not to like?

First, some practicalities. The unpopularity of payday loans doesn't mean they serve no function. In the words of an October post on the blog of the New York Fed, the loans are hated by everyone except “the ten to twelve million people who use them every year.” That number may soon be growing.

We tend to envision the population seeking payday loans as those less numerate borrowers who have little access to credit markets. But as the traditional weekly or semiweekly paycheck increasingly falls out of sync with the growing diversity of our lifestyles, innovative investors are searching for ways to bring payday-loan-like services to everyone who works.

Uber, for instance, recently announced plans to allow its drivers to draw advances of up to $1,000. Other new lending ventures, working through employers, will allow employees to receive loans against their paychecks the day the pay is earned

In other words, it’s possible that the consumer protection bureau, in the grand tradition of government, is trying to regulate an industry already on the verge of transformation. More to the point, the rules will likely limit access for the poor to payday loans just as they become widely available to the middle classes.

And limit access they will. According to the CFPB, the proposed guidelines, by raising the lender’s cost, would shrink the dollar volume of the loans by more than half. What then happens to the money that would otherwise have been loaned to high-risk borrowers? The answer may well be that it winds up in the hands of low-risk borrowers.

The argument is fairly straightforward. When we regulate any aspect of lending, the rational lender responds by repricing some other part  of the loan contract to reflect the increased risk. For example, if we limit interest rates, lenders may boost annual fees. When we make it difficult for the lender to price the risk into the contract, the rational lender will change its lending practices.

In particular, if the cost to lenders of dealing with high-risk borrowers becomes too high, the pool of money available for loans will gravitate to low-risk borrowers. This in turn increases the amount of loan money chasing low-risk borrowers, thus driving down rates for more desirable customers. In other words, rules intended to protect the poor wind up subsidizing the rich.

We have known for some time that usury laws, for example, are of little benefit to the poor but tend to be good for the well-to-do. There’s no reason to think that raising the cost of payday lending will have a different effect. So the distributional effect of the consumer protection guidelines might be the opposite of what advocates believe.

Moreover, although it is undeniable that there are large groups of less numerate payday borrowers who have only the haziest idea of what they're getting into, there likely remains another significant subset who do know what they're getting into and are willing to take the chance. The proposed rules punish the second group for the benefit of the first group. To be sure, there might exist an adequate justification for the decision. But what’s missing in the consumer protection bureau's analysis is any weighing of the costs to one group against the benefits to the other. Without this information, it’s difficult to assess the rationality of the rule.

For example, the CFPB cites a study showing that among payday borrowers who pledge an automobile as collateral, one in five winds up losing the car. That’s a terrible thing, particularly if the borrowers did not fully understand the risks. The unexamined question is whether there is a way other than restricting access to capital to protect the interests of the 80 percent of payday borrowers who didn’t lose their cars.

It’s important to remember that reducing the supply of credit to high-risk borrowers doesn’t necessarily reduce the demand for credit by high-risk borrowers. Sure, it’s possible that by making it hard for them to get loans we will force them to live within their limited means, and thus impose upon them an admirable ethic (albeit one within which the government imposing the rule can’t seem to live). But it’s also possible that potential borrowers will seek loans in the informal economy (read: loan sharks) or from family and friends, who have no way of spreading the risk and therefore, if the borrower defaults, are made worse off.

In other words, the uncalculated costs of the rules to the poor are likely to be substantial.

I'm not arguing on behalf of the payday loan industry, which in practice is often predatory and deceitful. My concern, rather, is that government should always be crystal clear about what it is up to. If we reduce the pool of loan money available to the poor while putting nothing in its place, the principal beneficiaries are likely to be the rest of us.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Stephen L Carter at scarter01@bloomberg.net

To contact the editor responsible for this story:
Susan Warren at susanwarren@bloomberg.net