As finance professors, we have studied payday loans, banking, and small credit generally for years. We offer these thoughts on the FDIC’s request for information on small-dollar lending:
Our work has covered the geographic relationship between banks and payday lenders, how which political party is in office in states affects payday lending regulation, the relationship between access to small credit and crime rates, and how payday lending regulation affects the density of payday loan stores and the availability of credit.
Our research suggests that access to credit is helpful for consumers during difficult times. The regulatory barriers to banks and credit unions offering small loans profitably are a primary driver of the high-cost credit market. Because every payday loan borrower has an income and checking account, clear, simple, affirmative guidelines from regulators that enable banks and credit unions to offer small loans at scale would be likely to disrupt this market. The bulk of evidence suggests that people use payday loans because they do not have better options. Enabling banks to offer their customers lower-cost alternatives is likely to enhance their welfare.
We recommend that the FDIC encourage banks to offer small-dollar loans in a safe and sound way to their customers. Doing so has the potential to bolster financial inclusion and provide high-cost lenders with much-needed competition. The four largest banks in the US have more branches than all the payday lenders in the US combined.
When it comes to small-dollar loans with terms of just a few months, a 36 percent rate cap is too low for payday lenders to operate profitably, as it is for banks. But banks have such large competitive advantages over payday lenders that they offer small installment loans profitably at a fraction of the price. Because of the slim revenue available on a small loan, interest rates in the mid-to-high double digits are likely to be necessary for banks to scale products with adequate volume and provide competition to the nonbank high-cost lenders.
As we noted in a 2016 article, competition in the payday loan market doesn’t bring prices down; the states with the highest prices often have the most firms and store locations. That is in part because payday lenders spend so much of their revenue on overhead, and most of their costs are fixed, not variable. But banks are more diversified and amortize these fixed costs over more products and more customers. Their customer acquisition costs for small-dollar loans are negligible because they lend to their existing checking account holders.
As we also noted in that article, it makes little sense to allow a depository institution to charge $75-90 for three small overdrafts but not to allow them to charge the same amount for a few months of safe small installment credit. As evidenced by U.S. Bank’s launch of a new 3-month installment loan this past September, banks can indeed offer small credit profitably, and the 71-88 percent APRs on these loans are within the range our research suggests makes sense for banks and customers.
The FDIC can harmonize policies with other federal regulators to ensure that credit is widely available at the lowest sustainable prices without being overly burdensome to lenders or putting consumers at risk. When the CFPB initially proposed an ability-to-repay test with heavy documentation, staff time, external data requirements, and compliance, we were concerned that it may lead to adverse selection, where lenders such as banks that have a comparative advantage elect not to compete in the market because of these regulatory requirements.
This concern was addressed when the CFPB ultimately scaled back the rule, creating a pathway for installment loans of longer than 45 days from banks. The Office of the Comptroller of the Currency deserves credit for taking complementary steps in May 2018 to make it easier for nationally chartered banks to offer small-dollar loans. That move probably helped the U.S. Bank product reach market.
We encourage the FDIC to follow suit with similarly straightforward guidelines so that supervised banks can make small loans sustainably to the benefit of consumers who need a safe alternative to payday and other high-cost credit.
James R. Barth
Lowder Eminent Scholar in Finance
Associate Professor of Finance