In defence of payday loans: Regulation is not the answer
If the government seeks to interfere more with payday lenders the market will be further hampered and innovation to serve the needs of borrowers will be disrupted
In this week’s newest batch of state regulation the government has promised to crack down on the menace of payday lenders. Payday lenders have the kind of reputation that heroin dealers would baulk at. These businesses provide short term loans to people whom major banks and financial institutions refuse to lend to, regarding them as too risky. The catch in lending from such people are the astronomically high rates of interest charged, some of these go as high as an annual rate of 4000 percent.
Payday lenders stand accused of preying on the vulnerable who end up in inescapable cycles of debt. Whilst this may be partially true in some cases we should question whether government regulation is needed or will indeed succeed in mitigating this risk and helping those trapped in such dire circumstances.
The situation has been made more difficult thanks to a level of moral panic that has been introduced into this debate with the incoming Archbishop of Canterbury describing the industry as being guilty of usury.
The government’s solution to this ‘problem’ will be to put a cap on the cost of payday loans. But when we look at the evidence the case for government interference in this market, which may have a major impact on access, is remarkably weak.
Consider a working single mother struggling to pay her bills and living close to the edge. This is the kind of person the government wishes to protect from unscrupulous lenders. However if she has an electricity bill to pay but will not have the money on hand for another couple of weeks the sermons of the Archbishop of Canterbury are not going to keep her lights on. If she cannot obtain an ordinary loan from a bank then the alternative left to her is to borrow a small amount of money from a payday lender to tide her over until her next pay check.
The fact that this temporary loan comes at cost, which many will find distressing, does not change the fact that the single parent in our example needs the money. Which is the better situation: one in which this loan is available, albeit at a high cost, or one in which no loan is available as no lender will either take the risk of lending to this person or there is no financial incentive to do so and she and her child go without electricity?
If large numbers of poor people in need of short term liquidity find they will no longer be able to access it, the likelihood is that we will see an increase in the poorest people being unable to meet their bills and pay for services they need.
This not an entirely theoretical example; a 2007 federal reserve study showed that when the state of Georgia regulated pay day loan industries out of the state, consumers “bounced more checks” and “filed for bankruptcy at a higher rate”. An official study in 2010 concluded that pay day lenders provided a useful service covering gaps in the market.
Many have moral objections to the fact that pay day lenders are making more money from the poorest people in society than they would if they were in the business of lending to middle or higher income earners. But this is largely a myth; when factoring in the transaction costs, as well as having to write off a large number of loans, a 2007 study found that companies in the pay day loan industry see returns of around 10 percent which is similar to profits generated by many other financial services companies.
There are other benefits of payday lenders. Payday lenders give the chance for borrowers to establish a positive credit history. In this discussion we must remember that credit, as described by the economist Henry Hazlitt, is not "something a banker gives to a man. Credit, on the contrary is something a man already has."
It is easy to understand why legislators see that there is a problem, or some kind of exploitation, and that something must be done. The Labour MP Stella Creasy has campaigned on this issue describing the many payday loan services as “legal loan sharks”.
But the important word there is legal. Despite all the objections to payday lenders, if people are desperate for short term cash it is more preferable for them to seek it from a legal payday lender than a criminal loan shark.
Pete Hoskin at Conservative Home has also welcomed the new regulation as part of an agenda to wean Britain off cheap and easy credit, to move away from an economy over reliant on debt financed consumption.
Whilst I share the view that Britain needs a sea change in economic issues, regulation of pay day lenders is unlikely to achieve any part of this. Indeed the problem with regulators is that they are always fighting the last recession. Regulators are often backward looking and unwilling to accept many of the unintended consequences that will come as result of their regulation. We do not know for certain when or how the next financial crisis will come, whether through artificial credit expansion or external shocks.
What we do know is that government attempts to interfere in prices and credit markets often have disastrous results as the financial crisis has shown.
Financial services are already highly regulated, distorting the market. If the government seeks to interfere more with payday lenders, setting regulations on how much interest they can charge or how many loans can be made to a client over a certain period of time, the market will be further hampered and innovation to serve the needs of borrowers will be disrupted.
When presented with moral challenges about the vulnerability of the poor the easiest and most satisfying response is to call for a new government rule or regulation to solve the problem. However the government should be humble enough to recognise the limits of its knowledge – that it cannot make regulations to solve the credit challenges of thousands of different people in different circumstances all over the country.
Indeed the unintended consequences of its actions could create a situation far worse than one they wished to solve.
Guy Bentley is a Libertarian blogger. Follow him on Twitter @gbentley1
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