PAPER’S WE’RE READING: “The Effects on Consumers from Two State-Level Regulations of the Payday Loan Market”

The payday loan market is highly competitive and heavily state-regulated. Payday loans are often the last legal source of consumer credit. Critics of this market charge that payday loans are debt traps, because borrowers who cannot repay the loan must default or take out a new loan to repay their debt. Some critics define payday lenders as “predatory.” When payday loan fees are annualized, critics charge that the resulting interest rate is outrageous. These and other claims fuel strong federal regulatory interest in the market for payday loans.

In “The Effects on Consumers from Two State-Level Regulations of the Payday Loan Market,” Thomas W. Miller, Professor of Finance at Mississippi State University and Senior Research Fellow at Consumers’ Research, and Todd J. Zywicki, Professor of Law at Antonin Scalia Law School and Senior Fellow at the Cato Institute, examine the claim that there is minimal price competition or a “market failure” in the payday loan market.

The authors test whether payday loan customers take out loans at “almost any price,” the driving consensus behind the Consumer Financial Protection Bureau’s (CFPB) 2017 attempt to place a cap on the number of payday loans issued to any given borrower. Related to this claim is whether payday borrowers are routinely paying the maximum legal dollar fee limit, another argument the authors dissect. In addition, the authors examine whether payday lenders routinely lend the maximum allowable amount permitted.

Contrary to popular opinion and the CFPB’s claims, the authors find that the payday loan market is competitive. They find that payday loan customers  do not, in general, borrow loan amounts or pay loan prices at the state-mandated maximum levels.

“The tendency in some states for most loans to be made at the legal maximum might result, at least in part, from an unusually low permissible maximum loan amount cap instead of a failure of competition in the market,” the authors explain.

Similarly, concerning the issue of predatory lending and the notion that lenders take advantage of borrowers’ financial distress, one would expect most loans to be issued at an amount close to or equal to the maximum legal limit (i.e., within $50 of the cap). Instead, the data reveals that just over half of all loans in the data set are made for an amount within $50 of the cap. The figure is significantly smaller when excluding California (an outlier given the state’s exceptionally low fee and amount caps).

“Overall, in our study, in states with a statutory loan amount cap, about 52.3 percent of the loans were made for an amount within $50 of the cap. Excluding California, this percentage was 36.8,” the authors write.

Not only do the authors dispel the popular idea that the payday loan market fees are inherently abusive, but they also rebuke the claim that in the absence of regulation, fees and loan sizes would rise to exorbitantly high levels (what we would expect to see in states with minimal or no regulations). The authors find that in states with no mandatory fee cap, 87 percent of the loans were issued at rates of 21 percent or less per $100 loaned.

Regarding loan size, in states with no mandatory amount cap, two-thirds of the loans were for less than $500. In the states with a $1,000 amount cap, 81 percent of the loans were less than $500. For the entire 30-state sample, 89 percent of the payday loans are for amounts less than $500–the most common loan amount cap in the sample.

These results are consistent with the notion that competitive, free-market forces constrain prices even in the absence of regulation. The authors state: “We do not find that loan fees and amounts rise inexorably in the absence of regulation…We find that in states that impose no fee caps on payday loan fees, payday loan fees are like the fees in states that limit fees.”

The authors also point out a perhaps unintended consequence of regulation in the payday loan market: “Borrowers in states with lower caps on permissible loan amounts take out a greater number of loans per year, on average, than borrowers in states with higher loan amount caps or no caps.”

Regulations meant to protect consumers from financial exploitation, therefore, make them worse off because borrowers’ demand for credit is likely inelastic, according to the authors. That is, borrowers will exhibit a demand for a certain amount of credit regardless of whether the state they live in limits them from borrowing their desired amount. So, in states where regulations limit the loan size available to borrowers, borrowers will simply obtain more loans to compensate for the smaller loan amount cap.

“Consumers use alternative lending products because they have an urgent need for cash credit,” said Zywicki. “Arbitrarily limiting the number of loans they can take does not relieve them of this financial necessity and results in them taking more loans and borrowing the same amount of money overall.”

Despite their intended benefits, these laws harm consumer well-being. By forcing borrowers to go through the trouble of obtaining multiple smaller loans, they typically increase consumers’ out-of-pocket costs as well, making consumers worse off in states where the federal payday loan market is heavily regulated, like in California.

The authors state: “We reach two general conclusions from our sample. First, we find that the fundamental terms of these payday loans are influenced by market forces of supply and demand, including the price of the loan and the average amount of the loans. We do not find that, absent regulation, payday lenders set the price of payday loans at extortionate levels. We find that in states that impose no fee caps on payday loan fees, payday loan fees are like the fees in states that limit fees. We also find that, contrary to previous research, many payday loans are made at fee levels below the maximum permitted by state law. In fact, we find that 31.5 percent of the loans are made at a fee level at least one percent less than the permitted fee. Excluding California, we find that 48.6 percent of the loans are made at a fee level at least one percent less than the permitted fee. Second, we  find that binding regulatory constraints, especially limits on the permissible size of a loan, are associated with a higher usage rate by consumers in terms of number of loans obtained during a year.”

“Our research shows how valuable careful, replicable research can be to Federal regulators and state legislatures,” said Miller. “Examining market data can uncover facts that dispel misconceptions that exist in payday loan markets.”


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