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From Banking and Finance Law Daily, October 19, 2015

The debate on payday lending should be reframed, says blog post

By Stephanie K. Mann, J.D.

Payday lenders have received unfair criticism from consumer advocates and policymakers, says a new Federal Reserve Bank of New York Liberty Street Economics blog post. The post was authored by Robert DeYoung, Capitol Federal Distinguished Professor in Finance at the University of Kansas School of Business; Ronald J. Mann, the Albert E. Cinelli Enterprise Professor of Law at Columbia University; Donald P. Morgan, Assistant Vice President in the New York Fed’s Research and Statistics Group; and Michael R. Strain, Deputy Director of Economic Policy Studies and a resident scholar at the American Enterprise Institute.

According to the authors, except for the 10 to 12 million people who use them every year, just about everybody hates payday loans. The blog post attempts to demonstrate that many elements of the payday lending critique—their “unconscionable” and “spiraling” fees and their “targeting” of minorities, for example—do not hold up under scrutiny and the weight of evidence. Instead, the authors offer “a possible right reason: the tendency for some borrowers to roll over loans repeatedly.” The authors conclude that more research on the causes and consequences of rollovers should come before any wholesale reforms of payday credit.

The following questions guided the authors in their quest to reframe the debate about payday lending:

Justified prices? The first complaint against payday lenders is often their high prices: a typical payday lender charges $15 per $100 borrowed per two weeks, implying an annual interest rate of 391 percent. While this may be expensive, said the authors, it may not be unfair. Payday credit markets are seemingly highly competitive, with payday lenders outnumbering Starbucks. This healthy price competition allows for fees to be driven down to the point where they just cover costs, including loan losses and overhead. In a study conducted by the authors, it is estimated that each additional payday firm per 1,000 residents in a given zip code was associated with a $4 decline in fees (compared with a mean finance charge of about $55). In the later years of the study, the authors found that prices tended to gravitate upward toward price caps, but that seems like a problem with price caps, not competition, they said.

Is a 36 percent interest cap in order? Even though payday loan fees seem competitive, says the blog post, many reformers have advocated price caps. The Center for Responsible Lending has recommended capping annual rates at 36 percent “to spring the (debt) trap.” The CRL is technically correct, but only because a 36 percent cap eliminates payday loans altogether, said the authors. Payday lenders would earn the equivalent of $1.38 per $100, essentially forcing them out of business, argued the lenders.

Do payday lenders target minorities? Evidence suggests that payday lenders are locating in lower-income, minority communities because of their financial composition. Using zip code-level data, the study found that racial composition of a zip code area had little influence on payday lender locations, given financial and demographic conditions. Similarly, this blog post showed that blacks and Hispanics were no more likely to use payday loans than whites who were experiencing the same financial problems (such as having missed a loan payment or having been rejected for credit elsewhere).

It’s all about rollovers. Payday lenders often pitch their two-week loans as the solution to short-term financial problems, and about half of initial loans (those not taken out within 14 days of a prior loan) are repaid within a month, said the blog post. However, 20 percent of new payday loans are rolled over six times (three months), so the borrower winds up paying more in fees than the original principal. Critics see these chronic rollovers as proving the need for reform, and in the end they may. A crucial first question, however, is whether the 20 percent of borrowers who roll over repeatedly are being fooled, either by lenders or by themselves, about how quickly they will repay their loans. Unfortunately, researchers have only begun to investigate the cause of rollovers, and the evidence thus far is mixed.

Reform or more research? Given the mixed evidence on the “big question” and the smaller, but crucial, question of whether rollovers reflect overoptimism, the authors conclude that more research should precede wholesale reforms. A handful of states already limit rollovers, so they constitute a useful laboratory: how have borrowers fared there compared with their counterparts in “unreformed” states?

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