A Better Way to Regulate Payday Lending

I’m of two minds about news reports that the Consumer Financial Protection Board is considering strict limitations on payday lending. On the one hand, the practice of loaning money for a short term at high interest is odious; on the other, the libertarian who slumbers uneasily within me worries about paternalism.

The payday industry lends around $90 billion a year, mainly in small-dollar amounts, typically to borrowers with poor credit who can’t get bank loans or credit cards. In general, no collateral is demanded. Instead, the borrower pledges a part of future income. The loans are short term, and, when the borrower can’t pay, are generally rolled over, a practice that can lead to compound interest amounting to several hundred percent.

Hardly anybody thinks payday loans are a good idea; on the other hand, they also offer cash to borrowers who otherwise might not be able to get any, even in an emergency. Too much regulation might price those borrowers out of the loan market completely.

A pair of intriguing new papers shed useful light on the dilemma. One delivers a wealth of information on the effect of regulating payday loans; the second offers a solution so unexpected and innovative that it just might work.

The first paper, by the economists Jialan Wang and Kathleen Burke, looks at the experience of Texas, which in 2011 and 2012 adopted a number of rules governing the issuance of payday loans. The results are striking.

A key requirement of the Texas regulations was that potential borrowers be made aware, in simple terms, of the overall cost of the payday loan compared to overall cost of other forms of credit. Using data collected by the Consumer Financial Protection Board, Wang and Burke calculate that the regulatory change led to a 13% decrease in total payday loan dollar volume in the state, as well as an 11% decrease in the number of payday loans extended, compared to other states that adopted no new rules. The loans themselves aren’t smaller, but fewer people are using them.

But to opponents of payday loans, the size of the loan matters too. Thus, although Texas’s statewide regulations dealt mostly with disclosure, the cities of Dallas and Austin went further by adopting what amount to underwriting rules. Both cities passed ordinances limiting payday loans to 20% of the borrower’s gross monthly income. The rules also restrict the ability of the borrower to roll the loan over without repaying at least 25% of the principal.

Rules this draconian would be expected to put a far more serious dent in payday loans. Dallas data are incomplete, but Wang and Burke find that once Austin began enforcing the new rules, the number of loans fell by 41% and the total dollar value by an astonishing 62%.

This is where I begin to worry. If we reduce the number of payday loans, we make it harder for the poor-in-credit to borrow. As I’ve noted before in this space, they might go to the underground market, or to family and friends, who have no way of pricing or spreading the risk.

True, we might believe that the poor-in-credit are better off not borrowing at all, particularly if they’re funding present consumption (that is, living beyond their means). But paternalism, even with the best of intentions, remains an offense against dignity. On the other hand, payday lending does indeed involve all the abuses that have people worried. The question we should be asking, then, is whether there’s a way to regulate the market for short-term loans to those who can’t get cash elsewhere without unreasonably restricting the ability of the poor-in-credit to borrow.

Which brings us to the second paper, this one by my Yale Law School colleague Jonathan Macey. Like other critics, Macey favors more regulation of payday lenders.  But unlike most who clamor for a crackdown, he also recognizes that people with bad credit often face a genuine cash crunch.  His innovative solution is that the Federal Reserve — yes, you heard that right — the Fed should make its emergency lending facilities available to low- and moderate-income households forced to borrow in short-term markets for medical care and other essentials.

At first blush this might sound like a stretch. But it isn’t. For one thing, as Macey notes, we use the Fed for plenty of things these days besides stabilizing the banking system. During the pandemic, for example, the Fed has loaned to small and medium-sized businesses, along with large employers. Moreover, as Macey reminds us, there’s reason to believe that as originally conceived, the Fed’s lending facilities were to be available to individuals in exceptional cases. It’s true that the plan was to lend only to collateralized borrowers, but Macey suggests that the Fed solve that problem the same way payday lenders do: by treating the borrower’s future income as collateral.

Macey’s proposal is attractive. He’d limit the loans to emergencies, such as child care or repairs to a motor vehicle — the sorts of things that bring many a potential borrower to the payday lender. The obvious risk is that over time, political pressure might expand the definition of emergency.  But unless we take the paternalistic view that the poor-in-credit shouldn’t be able to borrow at all, maybe we should consider that risk more a feature than a bug.

In particular, Macey would apply analogues to the anti-churning and suitability rules that guard individual investors against predatory brokers.

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

Stephen L. Carter is a Bloomberg Opinion 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 his latest nonfiction book is “Invisible: The Forgotten Story of the Black Woman Lawyer Who Took Down America's Most Powerful Mobster.”

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