Report 2. Does State Regulation of Small-Dollar Lending Displace Demand to Internet Lenders?

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1 Report 2 Does State Regulation of Small-Dollar Lending Displace Demand to Internet Lenders?

2 Does State Regulation of Small-Dollar Lending Displace Demand to Internet Lenders? By: Small-Dollar Markets Research Team 1 January 6, 2015 Introduction State price regulation of small-dollar lending ranges from relatively strict restrictions, limiting all small-dollar lending to rates in the range of 18% 2 to 30% 3 per annum, to more permissive approaches permitting biweekly charges that translate into annual rates near 350%. 4 Leading consumer advocates have urged state adoption of a 36% rate cap to protect consumers from serial use of small-dollar loans. 5 When state (and even local) legislatures are presented with proposals for such restrictions, lenders who operate retail storefronts will often argue that consumers want their products and will simply get them on the Internet, if local supply is constrained by lower usury caps. Because many Internet lenders choose regulatory models that allegedly immunize them from state and local regulation, and because the Internet is inherently more difficult to police than a lender s storefront, it is important to understand the extent to which consumer demand 6 is displaced to Internet lenders when state regulation inhibits local supply. 1. This Report was prepared by Rick Hackett, special policy consultant to Clarity Services, and Amir Fekrazad, Research Assistant to Clarity Services. Rick is the former assistant director of the CFPB for Installment and Liquidity Lending Markets. Amir is a PhD candidate in economics at the University of Texas at Austin. The matters addressed in this report reflect the research and opinions of the authors. Clarity Services did not participate in, and had no influence or control over, the preparation of this report. 2. See, e.g., 9-A M.R.S.A. Section 2-401, which limits loans of more than $4000 to 18%, and permits rates up to 30% for loans less than $ See, e.g., Massachusetts General Laws chapter 140, section A and its implementing Regulation 209 CMR 20.00, limiting loans under $6000 to 23%. 4. For example, Florida allows a charge of $10 per $100 for a loan of not less than 7 nor more than 31 days. Fla. Stat Ann. Section California allows a fee of $15 per $100 for loans of up to 31 days. Calif. Civil Code section , et. seq. Alabama allows a charge of up to 17.5% for a loan of 10 to 31 days. Alabama Code section 5-18A-1 et. seq This paper does not address a potentially relevant issue when referring to displacement of demand. When consumers take up financial products, their behavior reflects a combination of inherent demand (need) and targeted communication of supply (advertising). It is quite possible that lenders choose to direct advertising in geographic ways, even on the Internet, focusing supply on geographic areas (IP addresses) where storefront retail supply is absent. Thus, our discussion of demand subsumes a larger question of how much of that demand is influenced by lender behavior.. 1

3 This paper finds that: (a) Internet lenders do not appear to be constrained in serving consumer demand by the existence of state restrictions, and (b) market penetration (percentage uptake by the potential borrower base) by Internet lenders who do not conform to state regulation is in fact slightly greater in states that prohibit high-cost lending than it is in more permissive states. Because permissive states tend to have larger non-prime populations, however, the actual volume of lending by non-statelicensed lenders is greater in permissive states. In addition, there appears to be a correlation between the vigor of law enforcement by states that prohibit high-cost lending and reduced market penetration of Internet delivery of small-dollar products. This critical role of enforcement also suggests that new rules constraining high-cost small-dollar lending promised by federal authorities must be coupled with significant investment in enforcement in the Internet market, lest displacement to non-compliant lenders unfairly tilt the market field. This paper examines the question of market behavior by segmenting each of the fifty states into three groups by regulatory treatment of small-dollar lending: restrictive, permissive and hybrid (permitting high-rate small-dollar loans, but subject to significant restriction). It then examines the penetration of the non-prime population of each group of states by a group of lenders who eschew state licensing and regulation of their loan terms. That penetration rate is compared over time and also viewed in terms of change of market penetration as a year-over-year growth rate. The growth rates and market penetration are significantly affected after June 2013, likely as a result of federal regulatory interventions that are referred to in the media as Operation Choke Point, 7 making the conclusions reached in this paper difficult to extrapolate in terms of future market behavior. A separate paper by this research team will examine the effects of Operation Choke Point on different lender types in the near future. 7. See, e.g., content/uploads/2014/05/staff-report- Operation-Choke-Point1.pdf. Many of the cited sources are openly partisan and should be taken with several grams of salt. Nevertheless, they suggest that a significant regulatory intervention was ongoing in the second half of

4 Data Set and Approach As in the past, the research team used quantitative data provided by Clarity Services, Inc. We also relied upon qualitative data provided by Clarity, who reviewed the documentation that was submitted by their twenty-five largest lenders when they contracted with Clarity for credit reporting services. Lenders were required to demonstrate permissible purpose 8 for obtaining credit reports. That information included an explanation of the lenders choice of regulatory relationship to state law. While the legal review was limited to 25 out of more than 100 lenders, the lenders we selected represented approximately 60% 9 of loans by volume. We then used the quantitative data to sample only the activity of lenders who chose not to obtain state licenses (and presumably not to comply with other state law restrictions on loan terms). The data set of loans made by non-state-licensed lenders spans the period January 1, 2012 through June 30, It totals 2,839,223 loans and 1,774,057 unique borrowers. 10 The loans include both those reported by the lenders as payday and those reported as payday installment. The latter make up about 6% of the total data set we used. We chose to include the latter form of lending because the data shows non-state-licensed lenders have increasingly offered multi-payment loan options at prices that equal or exceed prices on small-dollar loans, in states that have usury caps of one-tenth or less of the rates being offered. The multi-payment small-dollar loans serve as a substitute product for traditional single-payment loans in the Internet market. A subsequent report by this research team will examine the product mix and product terms of recent Internet small-dollar lending, as well as the evolution of product mix over time. In order to sort the state regulatory treatment of small-dollar lending, we utilized a study of state regulation by Pew Research, which characterizes state laws as either permissive, restrictive, or hybrid (as described above). 11 We have independently checked for recent amendments to laws referenced in the Pew categories to confirm that there have not been major changes to the restrictive and permissive states since the date of that study (2012). The Pew study is primarily focused on small-dollar loans that span one week to one month, and does not comprehensively address longerterm small-dollar installment loans at similarly high rates. 12 However, as noted above, states which prohibit high-rate short-term loans are unlikely to permit equally high rate longer-term loans. 13 In short, we believe that the Pew categories of state regulatory treatment remain a directionally accurate characterization of state law treatment, two years after the publication of their study, and a fair way to assess state treatment of a set of loans that includes a small number of longer-term loans. 8. See section 604 of the federal Fair Credit Reporting Act (15 USC section 1681b). 9. We analyzed 2,839,223 loans observed out of a total 4,983,630 observations 10. The restrictions we applied to the data are set forth in the Technical Appendix. 11. The full study is at Regulation%20and%20Usage%20Rates/Report/State_Payday_Loan_Regulation_and_Usage_Rates.pdf 12. Pew does address some states, like Colorado, which have used regulation to force payday lending into longer term loans. 13. Our report on rates of interest for short-term loans in this data set can be found at https://www.nonprime101.com/wp-content/uploads/2013/10/clarity-services-profiling- Internet-Small-Dollar-Lending.pdf 3

5 In order to establish rates of market penetration in the relevant market, we obtained counts of consumers having Vantage scores less than 600 by state, as of January A sub-600 Vantage score is a common characteristic of non-prime consumer. We then computed the percentage penetration of the non-prime consumer market in each state, each quarter, by the non-state-licensed lenders. We then combined those computations, sorting the states as described above. Several caveats apply to this approach. Vantage scores can change over time, as can the total non-prime population of a state. Similarly, our determination of state law compliance profiles of various lenders only spanned the one year period prior to July Lenders change regulatory profile from time to time, although it is a fair statement that few or none migrate from state-licensed to non-state-licensed. Indeed, the distribution of loans geographically, as well as industry reporting, suggests a substantial trend toward obtaining state licenses by larger lenders. These limitations on the data and approach of this study indicate that it should not be viewed as providing precise measurements, but rather is directional in terms of answering the underlying question whether demand is displaced to non-state-compliant lenders where state law constricts supply locally. 4

6 Results In Figure 1 we show the percentage penetration of the state non-prime consumer populations, averaging the percentages for each of the three categories of states. For example, in Q4 of 2012,.5347% of the non-prime population of restrictive states took out high-rate small-dollar loans from non-state-licensed lenders (the red bar). In the same period,.4686% of non-prime consumers took out loans from the same lenders in permissive states (the green bar). The results show the non-state-licensed lenders Figure 1 Percent of Non-Prime Population Using Small-Dollar Loans from Non-state-licensed Lenders (Vantage sub 600) by Quarter by State Regulatory Treatment Groups (Permissive, Banned, Hybrid) Q Hybrid Permissive Restrictive Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q not only do business in restricted states, they actually do more business (as a percentage of the relevant market) than they do where some form of competing product is available from state-compliant lenders. The overall market penetration for this group of lenders is small (on the order of.5%) and the quantity of the difference is not large, but it is measurable. In the 2012 Q4 example above, market penetration in restrictive states is 14% higher than in permissive states. We note also that relative penetration changes after regulatory intervention in the banking and payments system occurred at both the federal and state (notably New York) level See note 7, above. In the fall of 2013, the New York Department of Financial Services began a jaw bone campaign addressed to banks doing business in New York, objecting to the provision of payment services to non-state-licensed lenders. The allegations in a resulting lawsuit by tribal lenders doing business in New York explain the effect. See OTOE MISSOURIA TRIBE OF INDIANS LLC LLC v. NEW YORK STATE DEPARTMENT OF FINANCIAL SERVICES - 2nd-circuit/ html 35

7 The data in Figure 1 may not be the clearest view of the relative penetration, as it treats each state percentage equally: Vermont counts the same as California. Figure 2 presents the same results on a population-weighted basis. Looking again at the market in 2012 Q4, population-weighted market penetration in permissive states was.4449%; in restrictive states it was.5985%, or 35% higher Figure 2 Percent of Non-Prime Population Using Small-Dollar Loans from Non-state-licensed Lenders Weighted by Population (Vantage sub 600) by Quarter by State Regulatory Treatment Groups (Permissive, Banned, Hybrid) Q Hybrid Permissive Restrictive Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q Thus, in terms of consumer head count, the percentage penetration of non-prime markets was considerably greater in restrictive markets, prior to regulatory intervention. Greater relative market penetration does not mean, however, that loan volume by nonstate-licensed lenders was predominantly concentrated in restrictive states, prior to regulatory intervention. The states that permit high-rate small-dollar lending tend to have larger borrower populations, as is seen in a raw count of loans made by non-state-licensed lenders, again sorted by state regulatory treatment. This information is presented in Figure 3. Looking again at 2012 Q4, roughly 165,000 loans were made in permissive states and only 40,000 loans were made in restrictive states by this lender group. 6

8 Figure 3 Total Loans by State Regulatory Treatment: Loans from Non-state-licensed Lenders Groups (Permissive, Banned, Hybrid) 300, ,000 Hybrid Permissive Restricted 200, , ,000 50,000 0 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q As shown in Figure 3, the lion s share of business by non-state-licensed lenders is in states that permit high-cost short-term lending. Because we have data on market penetration spanning several years, we can also look at rates of change in market penetration by regulatory treatment, asking the question: is business growing more in states where competing products are not available, or is business growing (or shrinking) at relatively the same rate? Figure 4 shows that growth rates for non-state-compliant lenders were greater in permissive and hybrid states than in restrictive states, prior to regulatory intervention. After that intervention, market penetration in restrictive states shrank faster than market penetration in hybrid and permissive states. Looking at year-over year growth in the last quarter before regulatory intervention (Q Q2 2013), growth was 29.7% in permissive states and only 21.3% in restrictive states. Similarly, after regulatory intervention, the year-over year rate of contraction of market share in permissive states was 63.1% versus 71.2% in restrictive states, for the period Q to Q In short, while non-state-licensed lenders have historically taken up a greater market share of non-prime consumers in restrictive states than elsewhere, the trend over time is for growth of market share to be greater in less restrictive states. After regulatory intervention, market share shrank more rapidly in the restrictive states than it did in the permissive states. 7

9 Figure 4 Annual Annual Growth Growth Rate: Rate: Fraction of of Online Borrowers Borrowers, by Quarterly by Quarter and and State State Regulatory Regulatory Treatment, Treatment. Non-state-licensed Lenders s Hybrid Permissive Restricted Growth Rate Q1 Q2 Q3 Q4 The trend in Figure 4 is even more pronounced when viewed on a population-weighted basis, in Figure 5. Figure 5 Q Q Annual Growth Rate: Weighted by non-prime Population Fraction of Online Borrowers, by Quarter and State Regulatory Treatment. Non-state-licensed Lenders Growth Rate Hybrid Permissive Restricted Q1 Q2 Q3 Q4 Q Q

10 Effects of Regulatory Enforcement We were also curious as to the possible effect of regulatory enforcement on market penetration in restrictive states. To examine this question, we computed the mean penetration of the non-prime consumer market, by quarter, for all states. We then examined the states that were consistently at least one standard deviation above or below the mean. As expected from the general trend reported above, many restrictive states were consistently above the mean in most quarters, but some were consistently below the mean by more than one standard deviation. Examples of the former are Connecticut and North Carolina. West Virginia stands out as being consistently more than one standard deviation below the mean in Internet small-dollar lending throughout the study period. Most interesting, market penetration in Georgia was more than one standard deviation above the mean throughout 2012, but by Q3 of 2013 had dropped by 83% to more than a full standard deviation below the mean. Figure 6 plots the mean market penetration and one standard deviation above and below the mean quarterly across the study period. Figure 6 also shows the market penetration by quarter for West Virginia, Connecticut and Georgia. A review of the literature provides suggested correlations between the inconsistent outcomes in these three states and the vigor of state regulatory enforcement. Between 2005 and 2010, West Virginia reached settlements with 107 Internet and tribal small-dollar lenders and their collection agencies, resulting in $2.5 million in refunds and cancelled debts for over 8,000 West Virginians % 0.60% 0.50% 0.40% Figure 6 Effect of Regulatory Enforcement on Market Penetration in Restrictive States Average 1SDAbove 1SDBelow West Virginia Georgia Connecticut 0.30% 0.20% 0.10% 0.00% Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q Press Release, Georgia Department of Law, Attorney General Olens Files Suit to Protect Georgia Consumers from Illegal Payday Lenders, July 29, 2013, gov/1apbpse; See complaint filed by the Georgia Department of Law, 9

11 Additional enforcement by West Virginia took place in This appears to correlate with consistently low market penetration in West Virginia by lenders who generally argue they are immune from state laws. In Georgia, the steep decline in market penetration correlates with a 2013 action by that state s attorney general. 16 In contrast, we are not able to locate high-profile enforcement actions by the State of Connecticut against Internet lenders during the study period. The data would appear to suggest that market displacement to the Internet can be significantly affected by the vigor of state enforcement. A state with a history of rigorous enforcement history (West Virginia, in purple) is consistently below the mean minus a full SD. A state with less reported history of enforcement (Connecticut, in orange) stays consistently above the mean plus one SD. Georgia (in yellow) significantly shifted the scope of market penetration concurrent with regulatory enforcement. This finding may also be relevant to the promised rule making by the Consumer Financial Protection Bureau (CFPB) that will set new federal limits on small-dollar lending. 17 Storefront outlets have been the subject of CFPB supervision since early The Bureau knows where to find them to enforce its new rules. One conclusion suggested by our data is that enforcing restrictions against Internet lenders may require much more regulatory effort, and the protection afforded by the rule of law will extend only as far as vigorous regulatory enforcement may take it in the Internet. If CFPB rules curtail supply in storefronts where it is currently permitted under state law, our data suggests that demand will displace to the Internet unless and until CFPB, and possibly state attorneys general 18, devote significant enforcement resources to that market We note that section 1042(a) (1) of the Dodd-Frank Act permits state attorneys general to bring an action to enforce CFPB Rules issued under the Consumer Financial Protection Act. The payday rules will, in large part, be based on that Act. 19. The CFPB could make its enforcement process much simpler by utilizing its as-yet-un-deployed power to require Internet providers of small dollar loans to register with the Bureau by Rule. Section 1024(b)(7) of the Dodd Frank Act empowers the Bureau to require any sort of non-bank provider of consumer financial services to register with the Bureau and provide information necessary to facilitate supervision and detect risks to consumers. A simple rule requiring key contact information and registration of all trade names and web domains would go a long way to identifying those who choose to play by the rules and those who do not. Those who do not register would violate federal law simply by doing business, and hoist red flags inviting investigation. 10

12 Technical Appendix Sampling Restrictions and Variable Coding: Net Monthly Income >10000 Highest Credit > or <100 State Misreported The effect of these restrictions was to remove 1.31% of the observations. We believed that monthly income or credit over $10,000 were data entry errors. None of the lenders in the data set generally offered credit less than $100, and we also treated credit under $100 as a data entry error. State mis-coding (no such state) was also an entry error. Sample Size Figures 1-5: Date Range: January 1, 2012 June 30, 2014 Loans Observed: 2,839,223 Borrowers Observed: 1,792,827 Sample Size Figure 6: Date Range: January 1, 2012 June 30, 2014 Loans Observed: Connecticut: 35,632 Georgia: 94,635 West Virginia: 138 NonPrime101.com Does State Regulation of Small NonPrime101.com Dollar Lending Displace Profiling Demand Internet to Small-Dollar Internet Lenders? Lending 10 11

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