High cost credit is part of the problem not the solution

5 November 2014

Damon Gibbons of Centre for Responsible Credit, responds to ResPublica report on payday lending

This Monday saw the publication of a new report from ResPublica: ‘Climbing the credit ladder: short term loans as a path to long term credit’. The report was financed by the main payday lending trade association, the Consumer Finance Association (‘CFA’), and is co-authored by ResPublica staff and Professor John Gathergood from the University of Nottingham. It marks another stage in the CFA-led strategy to defend the payday lending industry by raising fears of a growth in illegal lending arising from supposed over-regulation.

Just two weeks ago the CFA published results from a YouGov survey of people who had been declined payday loans, which reported that four per cent of declined applicants had gone on to use an illegal lender. This figure is likely to be subject to a significant degree of sampling error but that was not mentioned in the CFA press release and the survey questions and raw data have not been published. There also appears to be some confusion as to the precise type of illegal lending that is being used, with the CFA also using the term ‘unlicensed’ lender, which may distinguish them in some way from the traditional image of ‘loan sharks’, operating with violence. Interestingly, some 76 per cent of respondents did not know whether the lender they subsequently used was licensed or not, which may also raise questions about respondents reporting on their experience accurately.

Nevertheless, Monday’s report uses the four per cent figure (alongside lender estimates that the FCA’s proposed cap and increased regulation could result in as many as 50 per cent of current customers losing access to credit) as the basis of an argument in favour of retaining high cost short term lending. ResPublica and the CFA argue that although this sector must be ‘shorn of its negative aspects’, it should also be preserved to ‘provide a bulwark against illegal lending’. One of the main recommendations is for the Financial Conduct Authority (‘FCA’) to commission research to understand what happens to people when they are refused access to payday loans, including whether or not payday loans are ‘welfare enhancing’ because, it is argued, they prevent people from incurring higher charges (for example, by entering into an unauthorised overdraft) or resorting to illegal lenders.

ResPublica is of course coming rather late to this issue, and it is perhaps worth reminding them of the ‘negative aspects’ of payday lending which some of us have long played a part in highlighting and which we are only now beginning to get tackled. Despite a long campaign of denial by lenders and the CFA, and the initial reluctance of regulators to investigate, these are now all too apparent. We now know, without any equivocation, that lenders systematically fail to assess the affordability of loans; that business models are based on trapping people in ongoing ‘credit dependent’ relationships, requiring them to roll over borrowing or increase the level of their borrowing on a frequent basis; that the use of Continuous Payment Authority and a scandalous lack of care for the borrower leaves people in financial difficulties, without sufficient money for food or other basics; that default charges are excessive and punitive; and that lenders are guilty of intimidating collection practices and fail to provide effective assistance to people in debt.

Self regulation in every one of these respects has been an abject failure and regulators are only now putting in place the measures required to force the sector to clean up its act. Chief amongst these is the price cap, which offers the potential (if set at a low enough level) to ensure much greater responsibility in lending practice; end the exploitation of households in desperate financial positions and prevent lenders from profiteering from driving borrowers into default. A cap on the total cost of credit, combined with restrictions on rollover lending and repeat borrowing introduced in July 2014, are undoubtedly the correct tools for the job although the FCA has not been convincing about the level of the cap and why two rollovers remain permissible for a loan product which is marketed on the basis of meeting the need arising from small sum cash flow problems. The current rules appear to accept that many loans are simply unaffordable from the outset and allow the lenders to profit on this basis. The FCA has also failed to put forward effective measures to prevent repeated borrowing and the simultaneous use of multiple lenders.

The fear of reduced access to legal high cost lending and the supposed potential for this to result in greater illegal lending has been apparent as one of the the main reasons for theFCA’s over-cautious approach and the ResPublica/ CFA report plays to this. Yet, there is no evidence that illegal lending has increased during the period since the restrictions on rollover lending have been brought into effect and since the regulator has upped its game in scrutinising lending decisions. According to the ResPublica/ CFA report the number of payday loans made by CFA members peaked at around 1.2 million in the final quarter of 2012. This was prior to the introduction of restrictions on rollover lending, and it was not until October 2013 that the FCA set out its proposals in this respect and in relation to affordability assessments. Despite this, the number of payday loans issued by CFA members fell over the course of 2013 to around 800,000 per quarter as the industry responded to greater scrutiny and was put on notice by the FCA of forthcoming regulation. Despite this reduction in payday lending there is no evidence of an increase in illegal lending. In a recent response to a Parliamentary Question concerning the work of the Illegal Moneylending Team in England, the Department for Business, Innovation and Skills revealed[1][1] that in 2012/13 the team conducted 522 investigations but this dropped dramatically to 399 last year – a fall of 23.5 per cent. This pattern appears to be similar to that experienced in Japan where the expansion of illegal money lending grew alongside the growth of legal high cost credit. Following the implementation of regulatory measures, including a tightening of its price cap, in 2010 the use of both legal and illegal money lenders has reduced[2][2].

Whilst we support the call for further research concerning what happens to people who arerefused payday and other high cost credit we need to ensure this is balanced by also looking at the long term outcomes for people who have been regular users. Far from protecting people from illegal lenders the expansion of high cost short term credit makes a bad situation worse for many borrowers; is likely to increase borrower desperation and could drive some to turn to illegal loan sharks. Prior research, focused on the door to door lending market, has indicated that over 50 per cent of people using illegal loan sharks have also got outstanding loans with high cost door to door money lending companies[3][3]. It is therefore nonsense to suggest that illegal moneylending arises in response to a high cost legal lending ‘vacuum’ as some of the contributors to ResPublica’s report have previously suggested[4][4]. If this were the case, then there would have been a collapse in illegal lending activity in recent years as a result of the payday sector’s expansion, but this has not been the case. During the years of payday lending’s expansion the number of investigations by the Illegal Moneylending Teams increased.

Whilst accepting that the number of investigations conducted by formal teams is also influenced by their own capacity and the level of resources dedicated to detection, the reality is that the dynamic underpinning the use of illegal moneylenders is much more complex than the defendants of legal loan sharking are prepared to admit, and in most working class communities it is heavily associated with wider social problems, including drug and alcohol abuse. Despite all the claims made by the defendants of high cost credit providers of their desire to prevent illegal loan sharking not one of them has considered it sufficiently important to research an alternative to the pro-market ‘credit vacuum’ theory and the ResPublica/ CFA report does not even consider this to be a possibility.

Similarly, the claim put forward by Respublica and the CFA that payday loans are ‘welfare enhancing’ needs to be treated with considerable scepticism. Although it is true that a payday loan can appear to be a better option in some circumstances than an unauthorised overdraft (see our earlier report from 2010[5][5]), whether this is actually the case or not depends on the specific financial situation of the borrower; the particular charging policies of the bank; whether the loan is rolled over; and what happens in terms of other, often severely, welfare limiting decisions that have to be made in order to repay the payday loan and its accrued interest and other charges later. A similar set of factors needs to be considered when assessing whether or not taking out a high cost loan is ‘better’ than going into arrears with a household bill or other credit agreement. We need to develop a consistent approach for measuring the relative welfare impacts for households of using, or not using, payday loans. On developing this methodology, the ResPublica/ CFA report is completely silent. We argue that looking at only the immediate short term implications of whether a bill was paid or an unauthorised overdraft fee is incurred is misleading: the longer term consequences of using payday loans need to be factored in. And the costs of those are likely to be borne by more than just payday borrowers themselves. The widespread social costs associated with long term use include physical and mental health problems arising from cold homes, poor diets and increasingly hungry mouths as well as missed rent, Council tax and utility bill payments. A complete analysis of these social costs of high cost credit (not just payday lending) is urgently needed but ResPublica and the CFA are silent about any of them.

More fundamentally still, the Respublica/ CFA report falls into the trap of accepting the wider consumer credit market as it is. This is highly regressive in its pricing structure, with the poorest borrowers segmented into a group which must meet the full costs of its own risk, and with banks and credit card providers also guilty of many of the same predatory practices as payday firms. Creating a ‘ladder’ to these other forms of lending, through increased data sharing as is proposed in the Respublica/ CFA report, is not a real solution to the problems faced by low income consumers: who are systematically ripped off by the entire system. Indeed, many will already have considerable outstanding credit card and overdraft debts. Why is a ‘ladder’ back to these desired when they have in fact contributed to people having to turn to higher cost lenders in the first place?

It is time to recognise that data sharing is the bedrock on which the segmentation of the market and continued targeting of the poorest consumers with more ‘innovative’ high cost and exploitative products takes place. Payday loans are simply the latest in a long line of products designed to rip off those who are already in financial difficulties and who are unable to make ends meet due to inadequate incomes and rising cost of living. Regulating payday is needed, but unless a fundamental shift in the way the financial services system operates takes place there will be other products to perform the same role along shortly.

A new approach is needed: one which limits the extent of risk based pricing and recognises the fundamental need (and possible ‘right’) of all sections of society to access small sum credit at an affordable price. To start to achieve that the regulator should begin by extending the proposed total cost cap to all sections of the consumer credit market. That would begin to counter the constant churning of credit agreements and long term charging of interest on interest which serves little real economic purpose and creates major hardship for households. The FCA also needs to put an end to banks profiteering from default and overdraft charges, which payday lenders are so keen to compare themselves with.

Ultimately, we need to recognise that there is no ‘market based solution’ capable of delivering a fair credit deal for lower income households. Offering credit to people whose disposable incomes are too low or who are already over-indebted but who nevertheless have ongoing cash flow or investment needs will need to be subsidised in some way – either by the taxpayer; by better off consumers of financial services; or by employers paying decent wages and offering more secure employment. Politicians and regulators should ignore the arguments of the legal loan shark firms and their apologists and focus instead on how to create a genuinely progressive financial services system as part of a wider strategy for national renewal in response to our ongoing personal debt crisis.

Damon Gibbons, 5th November 2014