Payday lenders and the unintended consequences of regulation

In the autumn of 2015 the FCA, the UK’s financial regulator, were hard at work on a new set of regulations. In their sights were payday lenders, who had been resurgent as the first recession since the early 1990ies put a squeeze on the UK’s finances. Accused by politicians of exploiting the misfortunes of people who had encountered financial difficulties, these fintech innovators would lend small amounts for short periods of time, typically up to £500 for up to a month, at much higher interest rates than traditional banks. But regulators were concerned about the cost of payday loans which politicians deemed tantamount to exploitation (a word which, by the way, has become increasingly popular when describing transactions between voluntary parties). So, effective from 2 January 2015 the FCA clamped down on the payday lenders, mandating a cap on interest at 0.08% per day, along with rules on default fees and maximum total costs.

The lenders had argued that they served a niche of the market which traditional banking could not provide for, and that payday lending was distinctly different from longer term loans such as consumer finance. Much like the cost of a cab is much higher per travelled distance than a bus, payday lenders were positioned to provide a convenient service to a short-term need which justified the higher cost. But the FCA saw things differently and proceeded with the tough regulation which were going to change the market and provide “substantial protections” for borrowers.

Now, three years later the market has indeed changed dramatically. But maybe not quite as the FCA had hoped. Of course payday lending is a much smaller market today than it was at the end of 2014. Wonga, once the market leader, saw revenues plunge a whopping 64% last year as it continued to change its business model and move “up market”. Dollar Financial, another large player, has put its payday loans unit Money Shop up for sale after closing hundreds of stores. And it was the same story with every other provider: they closed or changed their business model.

So, it was easy to regulate away supply of “exploitative” lending options. But the alternative to payday lending was not cheaper payday lending, as maybe somehow the proponents of the new regulation had anticipated. It was no lending. The FCA predicted that 7 % of then-current borrowers – some 70,000 people – would lose access to loans after 2 January 2015, but in reality, a much higher number were shut out of the market. The Consumer Finance Association today estimates around 600,000 people may struggle to get short-term credit as the payday lenders continue to pull back from the market. Debt charity StepChange, which works with people in financial distress, estimates that 40% of its clients end up missing a bill payment if they are turned down for a payday loan. 34% take out other forms of short-term credit, typically at rates not much different from the “exploitative” rates once charged by payday lenders. Because, with a gap in the market, other types of lenders moved in to capitalise on the opportunity. So-called rent-to-own loans offered by white goods suppliers such as BrightHouse, PerfectHome and Buy as you View, have been buoyant, but charge high interest rates just as the payday lenders. And undoubtedly, a large number of people have been pushed into the arms of criminal gangs, taking advantage of a welcome business opportunity courtesy of the FCA.

So, there is a sorry lesson here, one that believers in free markets didn’t need to learn, but which politicians and regulators seem to have to be taught again and again: price fixing doesn’t work. When you interfere with the market and force supplier to sell below the clearing price, they offer less product. In the case of payday lending, they closed shop or moved up market, providing loans to customers whose credit risk was commensurate with the interest rate the regulators allowed them to charge. And they left their traditional borrowers without financing or drove them into the arms of lenders who were allowed to charge a price for the product which compensated for the risk.

It’s a lesson which should not have to be taught, but even after all this, it still seems some have learned nothing from the fiasco. Quite astonishingly, the Financial Services Consumer Panel, an advisor to the FCA, have recently called for regulation to cover all forms of consumer borrowing. We already know the result: rent-to-own lenders and others will scale back, just as the payday lenders did. And StepChange can expect more calls from desperate people who have been denied access to the market by misguided politicians and over-zealous regulators.

  1. I’ve no doubt that a large percentage of payday loan customers don’t have too much complaint – people aren’t stupid, and the costs of payday lending are common knowledge….

  2. For one thing, they endure much higher rates of default than banks do. Just as hospitals must charge paying customers more to cover charity care, payday lenders must charge more to cover the welshers.

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