The other day, I had coffee with a few of my students, and one asked me what motivated me to go into academia. Although I blathered on the intellectual freedom to pursue what interested me, it was difficult to convey in a concrete way how much fun I have being an academic, but yesterday afternoon provided a perfect example. It was an early spring day, and I got a sandwich and headed toward our Quad. Once there, I sat in the sun next to a tree reading some articles in the latest issue of Journal of Economic Perspectives that interested me. This all qualified, in some loose way, as "work." It really is a privilege to have such a job, although it is certainly not everyone’s ideal.
Michael Stegman, the Director of Housing and Policy at the John D. and Catherine T. MacArthur Foundation and the Duncan MacRae ’09 and Rebecca Kyle MacRae Professor of Public Policy, Planning, and Business, emeritus, at the University of North Carolina, has an article entitled simply "Payday Lending." Because it is an article that many Credit Slips readers might not otherwise see, I thought I would occupy a few lines of text discussing it. You can find it at volume 21, p. 169 in the Winter 2007 issue of the Journal of Economic Perspectives.
If you are familiar with the research on payday lending, there will not be much new in Stegman’s article other than his prescription at the end of the article. The mission of the Journal of Economic Perspectives is to synthesize information from "active lines of economic research." Hence, Stegman collects in one place the many payday lending studies done by academia, nonprofits, and the industry. These studies can be hard to find because they appear in wide variety of places such as traditional academic journals, the Internet, or simply in a report released by a trade or nonprofit group. If one is wanting to do research on the payday lending industry, Stegman’s article is an excellent research tool. He also lists some of the data available on payday lending. As I read the article, I wondered whether the article’s discussion of phenomena of annualized interest rate charges of between 400 and 1,000 percent or concentration in minority neighborhoods would be new to the Journal‘s audience of economists? Sometimes, when I talk to persons who advocate letting market forces solve payday lending abuses, the opposition to government regulation melts away when they learn we are talking about triple or even quadruple-digit interest rates.
Stegman asks why mainstream banking has not stepped into offer short-term loans that mimic payday loan terms only at lower rates of interest. (This is a question that Credit Slips commenters sometimes ask as well.) His answer is the growth in fee-based revenues at traditional lending institutions. Stegman writes, "As banks have become fee-based businesses, their bottom lines are better served by levying bounced check and overdraft fees on the payday loan customer base than they would be by undercutting payday lenders with lower cost, short-term unsecured loan products." That doesn’t sound right. Shouldn’t the question be at the margin, i.e., whether banks can generate more revenues by engaging in "lower cost, short-term unsecured loan products" than by not doing so. Rephrasing Stegman’s observation from a matter of economics to a matter of sociology might make it stronger: it is more advantageous to the individuals who make decisions in banks to stick to traditional fee-based revenue streams that are booming rather than staking their career on an untested product. That explanation strikes me as a stronger one for why traditional financial institutions have not moved toward competing with the payday lenders.
At the end of his article, Stegman discusses that some smaller financial institutions have begun to compete with payday lenders. He explores the example of the North Carolina State Employee’s Credit Union, which has begun to offer one month advance of up to $500 at a current annual percentage rate of 12%. This is a small fraction of the rate charged by payday lenders. In the first four and a half years of the program, the credit union’s chargeoff rate was 0.27%. A number of credit unions have begun experimenting with these sorts of products. Here in central Illinois, some credit unions offer short-term loans that function much like a payday loan except at a fraction of the price.
Comments
3 responses to “Stegman on Payday Lending”
Cool! I guess sometimes it just takes time. I suppose that suggests that there is significant profit growth in other areas for banks.
I’m curious why people don’t analyze Wells Fargo’s payday loan product.
https://www.wellsfargo.com/checking/dda/index
A Discussion of the Economic Viability of the Small Loan Service Provider
A finance charge of 36% per annum sounds like a lot of percentage, and it is in certain cases. For example, a finance charge of 36% per annum on a $100,000 loan is a lot of money, but 36% on a $100 loan does not produce enough revenue to service the transaction. That person who believes 36% per annum is enough across the board regardless of the size of the loan is, perhaps unknowingly, advocating effective prohibition of those loans that do not produce enough revenue to be economically viable. The result will be a lack of financial resource for those consumers who deem a regulated small loan service to be of value in pursuit of their personal best interests.
This prohibition will apply equally to banks, credit unions and other small loan service providers. No business can or will provide a service below its cost except for a relatively short time as an advertisement loss leader. Any person who naively believes that a bank or credit union should or will permanently provide this service below its cost in the volume demonstrated and demanded by the general public will be disappointed. To permanently provide a service below cost of production will require subsidy from another source such as government.
One loan of $100,000 times 36% per annum results in annual revenue of $36,000, divided by 12 months equal $3,000 revenue per month. In a simplistic view, if the lender borrows funds at 6% per annum, that leaves $2,500 per month to pay other costs of providing the loan service. That would indeed be a lot of money. Just a few loans would provide a hugely profitable revenue stream to the lender with a typical store front expense structure. But, no company would loan $100,000 at any percent per annum without substantial collateralization. The reasonable qualified consumer with collateral would reject a $100,000 loan at 36% per annum as inappropriate. Alternatives already exist for this consumer.
$100 times 36% per annum results in annual revenue of $36, divided by 12 months equals $3 per month. Is this enough revenue to make a $300 uncollateralized signature loan economically viable? Let’s do some math.
First, let’s assume that $20,000 per month is a reasonable expense structure to provide a single place of business, utilities, employ two staff persons, depreciation of essential furniture and equipment, governmental taxes, licenses and fees, legal and accounting services, advertising, cost of supervision, interest on funds invested in the business, and a reasonable bad debt experience. Let’s ignore profit or other corporate overhead for this exercise.
$300 times 36% per annum equals $9 per month revenue from the loan. A monthly expense structure of $20,000 divided by $9 equals 2,222 active loan customers required just to cover expenses. Any reasonable person will recognize that a staff of two persons cannot service the volume of the multiple transactions required by 2,222 active customers. The staff must number four, five or six persons depending on their level of experience and capability. But now, the monthly cost may be approaching $30,000 to provide for the additional staff, larger quarters to service the increased number of customers, the additional bad debt experience and other costs that escalate with volume. A monthly expense of $30,000 divided by $9 equals 3,333 active customers, which requires more staff and etc. It soon becomes impossible to service the sheer volume of transactions necessary to produce the revenue to overcome cost, plus provide a profit when restricted to revenues produced by monthly limitation of 3%. Many communities will not support the large number of 3,333 (or more) active customers required to cover the cost of a single service provider. The obvious conclusion of this exercise is that a revenue limitation of 3% per month on a $300 loan will result in the absence of such service by any lender unless the product is subsidized in some manner.
What is the minimum size loan required to produce the revenue to cover the costs of a two person office at 3% per month revenue limitation? Let’s assume that a well trained and competent staff member can service 350 customers, times two persons equals 700 active customers. This means that a $20,000 monthly cost divided by 700 customers will require revenue of $28 per loan (or more). $28 divided by $3 means that the minimum size loan under these assumptions must be $900. Realistically, the minimum size loan must produce enough revenue to cover other corporate overhead and to allow a profit to the service provider. A good assumption would be that any service provider, including a bank or credit union (without subsidy), will by necessity limit their service to loans well over $1,500. The minimum loan amount will increase as inflation drives cost upward while the percentage revenue formula remains the same. Most banks will not make a consumer loan now under $2,000 because a smaller loan is not profitable. That consumer who cannot qualify for a signature loan of $1,500 will be without a loan service resource. The reader may disagree with some detail in the above assumptions but by and large they are representative of the current circumstances for providing a specialized small loan service.
A rate structure limited to 36% per annum will today effectively prohibit loans less than $1,500. And then, only the qualified consumer will have access to a lender. What measurement tool should be used to determine if the public will be allowed the convenient availability of small loans of $200, $300, $500? Is it an irrelevant annual percentage rate? Or is it the personal preference of the general public as demonstrated in the huge demand for this service at some cost? Who shall make this decision? Shall it be the consumer that wants to use the service or will it be the politician or media editorialist who has no need to use the service? Whose wishes should prevail? Whose wishes shall prevail?
The politician or activist who advocates denying the general public access to regulated small loans is an elitist and is out of touch with the real world of human economic activity in 21st century America. Without a doubt, that leader can legislatively force the small loan industry out of existence. But he cannot legislatively force the public demand for small loans out of existence. What will be the end result? Will the consumer demand be serviced via government subsidy? Or possibly by unregulated lending activity outside the pale? Or should the public demand be met through a regulated lending industry under laws that allow sufficient incentive to encourage legitimate businesses to provide service to the consumer with the desired convenience, quality and quantity?