Payday lending in the UK: a review of the debate and policy options

Transcription

1 : a review of the debate and policy options Damon Gibbons, Neha Malhotra, and Richard Bulmore October 2010 Centre for Responsible Credit, 3rd Floor, Inclusion, 89 Albert Embankment, London SE1 7TP Tel: + 44 (0) Fax: + 44 (0) admin@responsible-credit.org.uk

2 Acknowledgements The authors would like to thank Veronika Thiel at the Centre for Responsible Credit for her helpful comments on an earlier draft of this report. However, the responsibility for any omissions or errors remains our own.

3 Contents Acknowledgements Executive summary Chapter One: Introduction Chapter Two: Background to the payday lending industry Chapter Three: The payday debate Chapter Four: Policy responses in the United States and Canada Chapter Five: Conclusions and recommendations Appendix A: Comparison of a payday loan to various unauthorised bank overdrafts Appendix B: US state level payday lending regulation Bibliography

4 Executive summary Payday loans are small loans provided for short term periods, usually until the borrower s next pay date. Loans are sold both in high street premises and online. Typical costs range from per 100 for those borrowed on the high-street to per 100 for loans taken out online. Loans sold in high street premises usually involve the customer receiving physical cash in the premises, and repaying using a post-dated cheque that they leave behind at the time the loan is taken out. Where loans are sold online the money is transferred electronically to the customer s bank account at the time of application approval, and repayment is also taken electronically, either by debit card or direct debit at the agreed later date. Both online and high street loans therefore require the customer to have the use of a bank account for repayment purposes. Due to the short term nature of the loans, the APRs are extremely high ranging from 334% to 4,400%. However, the use of the APR calculation for very short term loans has been criticised for exaggerating the cost of borrowing relative to other forms of credit, particularly unauthorised bank overdrafts where the costs are not required to be expressed as an APR percentage. The cost of payday loans is nevertheless high relative to authorised overdraft credit and to small sum credit card borrowing, where this is cleared within three months. Further to this, the costs of borrowing from payday lenders can increase rapidly if borrowers elect to defer loan repayments beyond the original repayment date. Many payday lenders allow loans to be deferred or rolled over beyond the original repayment date provided the borrower pays another month s fees and charges. The way that these roll over loans are handled varies between payday loan providers, with the best current practice operators limiting the number of roll overs allowed. However, some lenders place no limits on the number of times a loan can be rolled over, significantly lengthening the repayment period and dramatically increasing the overall cost of the credit. Having originated in the US, the industry subsequently expanded into the UK in the late 1990 s and has grown rapidly. Five of the seven largest payday lenders in the UK are owned or controlled by US companies, and it is currently estimated by the Office of Fair Trading that the industry makes over 900 million of loans in the UK per year. Payday loan customers are typically single, without children, and have incomes of over 1,000 per month. The average size of an initial loan is between 230 and 300, but repeat customers are offered higher amounts of up to This suggests that payday loans are provided to a higher income demographic than customers served by other forms of high-cost credit, for example, by home credit or door to door moneylenders. Despite this, there are concerns that some payday customers could become trapped in a cycle of repeat borrowing because: The costs of the credit are high, particularly when loans are rolled over Some borrowers do have low incomes, with lenders making loans available to people with net incomes of just 750 per month (equivalent to a gross yearly income of approximately 10,300). Payday lenders advertise their products by comparing their charges to unauthorised overdraft fees, indicating that some borrowers are likely to have exhausted this line of credit and that they could already be in financial difficulties. These concerns have recently been reinforced by qualitative research undertaken by Consumer Focus. This found that lower income consumers were particularly at risk of getting into financial difficulties and could become caught up in a cycle of increasing indebtedness. However, the research also found that for some, mainly higher income, borrowers the use of payday loans did not cause problems. 1

5 In addition, the recent Office of Fair Trading High Cost Credit review highlights that payday loans meet a demand for easy access to credit, and fill a gap not currently met by mainstream lenders. The Office of Fair Trading also reports evidence that some lenders exercise forbearance when customers experience payment problems and that the level of consumer complaints is low. Further to this, payday lenders themselves argue that their costs are reasonable when compared with unauthorised overdraft charges, bank fees for returned direct debits, and with interest charges on revolving credit card balances, and that their pricing structure is more transparent than these other forms of borrowing, with no hidden costs to the consumer. Indeed, consumers relying on their bank to provide an unauthorised overdraft face considerable uncertainty. Whether or not pending payments, such as direct debits, will be met remains at the discretion of the bank and there may be situations where payments are returned unpaid, which incur additional bank charges. The level of charges that will be applied by the bank are often difficult to calculate and will vary significantly depending on individual circumstances such as the number of direct debits returned or the amount and duration of the unauthorised overdraft, if this is granted. In order to progress the debate and inform possible regulatory and self regulatory action in the UK, this report examines the two central issues: Whether payday loans are expensive relative to other forms of borrowing, particularly in relation to the cost of unauthorised overdrafts and banks charges, and Whether there is evidence of consumers becoming trapped in a cycle of repeat borrowing. We also review the regulatory and self regulatory actions being taken in the US and Canada and highlight variations in existing practice in the UK market. ARE PAYDAY LOANS EXPENSIVE? We compare the cost of payday loans to unauthorised overdraft charges from five high street lenders and find that whilst very small sum payday loans will often be cheaper than an unauthorised overdraft, this is not generally the case once loan sizes begin to exceed 250 to 300. We find that whether or not a payday loan will be cheaper than an unauthorised overdraft depends on: The charging policies of the bank concerned The amount of loan being sought, and The level of the specific payday lender s charges. Likewise, where an unauthorised overdraft is not granted by the bank, and the alternative to a payday loan is having direct debits returned unpaid, then the fee charging policies of individual banks are important as are the number of likely returned transaction costs that will be incurred. As a result, we find that those payday lenders who state, without equivocation, that their loans are a cheaper alternative to unauthorised overdrafts and bank charges could be misleading some of their customers. However, in some cases payday loans are a cheaper alternative to these forms of borrowing, and taking out a payday loan also offers the borrower greater certainty than relying on a bank using its discretion to allow the use of an unauthorised overdraft. We also compare payday loans to small sum credit card borrowing and find that payday loan charges are significantly more expensive. This position is only reversed where relatively high credit card balances have accrued (in excess of 1,000) and are unlikely to be cleared within a short period, or where an account has gone into arrears. 2

6 DO PAYDAY LOANS TRAP PEOPLE IN A CYCLE OF REPEAT BORROWING? Payday lenders require borrowers to be in employment and have access to a bank account. As a result, loans are not offered to the very poorest consumers. Nevertheless, loans are available to people with net incomes of just 750 per month. This, combined with the fact that payday loans are advertised as an alternative to exceeding overdraft limits and incurring bank charges, suggests that some loans are offered to low income consumers who are likely to have, or are already, experiencing financial difficulties. This concern is reinforced by some cases reported by Citizens Advice, and by recent qualitative research conducted by Consumer Focus, but there is little quantitative information available concerning how big a problem this may be and Citizens Advice has itself noted that payday lending accounts for a very small proportion of their overall debt work. We therefore find that there is a danger that some customers could be using payday loans inappropriately but that further work is required to accurately determine the scale of this problem. In the US and Canada there has also been an active debate about the impact of payday lending on default rates and bankruptcies. The evidence here appears to be finely balanced with some studies indicating that payday loans help people to manage occasional financial crises and to avoid defaulting on bill payments, whilst others appear to link payday loan use with increased bankruptcy filings. It is clear that much greater access to payday customer data has been made available to researchers in the US than in the UK. We consider that it would help ensure confidence in the industry if a similar level of data transparency was provided here also, and that further research in this area needs to: Accurately establish the income distribution of payday borrowers in the UK Track users of payday loans and report on the overall impact of payday borrowing on their finances over time, relative to non payday loan users with similar characteristics Examine how much credit card and authorised overdraft borrowing has already taken place prior to the use of payday loans Consider in further detail the relationship between payday lending, credit defaults and insolvencies. In the interim, we consider that the most responsible payday lenders would want to take steps to ensure that they reduce the risk of people with ongoing financial problems using their products inappropriately. They will also want to take full account of the recent Office of Fair Trading guidance with regard to irresponsible lending. Indeed, some lenders have already put in place one or more of the following measures: Restrictions on the number of roll over loans that they will grant to a customer, Limits on the amount of loan relative to the borrower s available income, Limited or eliminated default charges and put in place policies to freeze interest at an early stage. Unfortunately, these best practices are not shared across the entire industry, and, there are some lenders who continue to engage in practices which appear to contradict the Office of Fair Trading guidance, for example by failing to limit the number of times that a loan can be rolled over. We also find a lack of transparency concerning default charges on some online payday lending websites. 3

7 WHAT ARE THE REGULATORY OPTIONS? Reviewing the regulatory approaches in the U.S and Canada, as well as industry codes of practice in these countries, we find that: Fifteen states in the US have prohibited payday lending altogether either by introducing a ban on this form of lending or by introducing a cap on the maximum charge for credit which can be made and setting this at a low level, making the payday lending model unviable. Thirty five states in the US and eight provinces in Canada have introduced legislation which allows payday lending to take place. However, these laws frequently include a cap on the maximum charge for credit. Caps have been set at a sufficiently high rate to allow payday lenders to operate, for example at $21 - $23 per $100 lent in a number of Canadian provinces. Payday lending laws in the US and Canada also incorporate measures to ensure responsible lending, notably placing restrictions on: the amount of loan relative to the borrower s income the absolute maximum level of loans. the number of loans that can be provided in any given period the number of times a loan can be rolled over the level of fees that can be charged for overdue loans It is also notable that members of the Canadian Payday Lending Association have signed up to a complete prohibition on roll over lending. Although we recognise that the UK payday customer base may be broader than that in the US, where there has been a particular concern about payday stores concentrating on very low income communities, we consider that many of the measures adopted in the US and Canada could usefully be adopted by regulators, and the industry itself, here. In the UK, the recent Office of Fair Trading high-cost credit review has noted that there may be a lack of effective price competition, but has rejected the use of caps on the cost of credit and has not referred the market to the Competition Commission. It has, however, noted that it will continue to monitor prices moving forwards. We welcome this but urge the Office of Fair Trading to make this information publicly available on a regular basis. The Office of Fair Trading has also made a number of other suggestions, including that: Payday lenders could provide better information to credit reference agencies about the payment performance of their customers which would allow those with good repayment records to more easily access mainstream credit in the future, and Payday lending associations could establish codes of practice which: include clear standards for dealing with complaints, limit the number of roll over loans, provide rules of thumb to guide typical loan amounts include guidance to ensure misleading advertising is avoided, and make sure that people know who owns each payday lending brand. We agree with these suggestions, but consider it to be important that any industry led code of practice should be 4

8 based on best practice both from the UK and abroad. We therefore make the following recommendations for such a code: Advertising of payday loans should make clear that loans are an expensive form of borrowing and blanket statements that loans are cheaper than bank charges or going over-limit on an overdraft should not be used A clear multiple of maximum loan value to income, such as the 25% rule used in some of the US states, should be introduced to restrict loan sizes A limit on the number of roll over loans should reflect existing best practice. The Canadian Payday Lending Association demonstrates that responsible lenders are capable of accepting a complete prohibition on roll over lending The code should also incorporate clear rules regarding the treatment of overdue amounts and should restrict default charges and freeze interest at an early stage when accounts are in default Efforts should also be made to prevent people from obtaining multiple loans from different payday lenders, for example by increasing data sharing amongst payday lenders. However, not all lenders are members of the trade associations and there is a need for the Office of Fair Trading to immediately review the lending policies of some lenders in this market against their irresponsible lending guidance issued in March of this year. In particular, it is difficult to see how those lenders who roll over loans as the default option or who allow an unlimited number of roll over loans are following the Office of Fair Trading guidance. The level of some payday loan charges may also indicate that lenders are providing loans to people with an unacceptably high level of default risk, and therefore calls into question whether or not they are lending responsibly. One means of preventing the taking of excessive risks would be to limit the cost of credit that can be charged by lenders. This approach has been adopted with industry support in a number of Canadian provinces, where some payday lenders have welcomed the introduction of caps at around the $23 per $100 level, and caps are also used by many US states. In the UK, the Coalition Government has indicated that it intends to introduce a power for regulators to define and ban excessive prices in the credit and store card markets and we consider it would be appropriate for them to widen the scope of that commitment to include the payday lending market. However, we accept that clear criteria would need to be provided by Government for regulators to consider whether and how to use such a power. A possible set of considerations would comprise: Whether other measures, for example remedies designed to increase price competition, could address the problem within twelve months. Regulators should be required to review progress and use their power to cap prices in the event that no improvement in price has been achieved through the use of other remedies within a year The level of any price cap, with regulators required to balance: The desirability of maintaining access to affordable and responsible credit and the likely impact of the cap on its supply Levels of consumer detriment caused by a lack of price competition and the amount of the reduction in price that could be achieved by the imposition of a cap for the majority of borrowers in the market The estimated enforcement costs of the proposed cap The desirability of eliminating clearly excessive risk taking by lenders in the market. The form of the cap. Regulators should be tasked with constructing caps in such a way as to prevent lender avoidance and pricing distortions 5

9 We note that the Office of Fair Trading itself has not been supportive of price capping, and accept that a possible, albeit a likely more expensive and complex alternative to enforce, would be to use its irresponsible lending guidance as a means of eliminating excessive risk taking. We would therefore welcome further details from the Office of Fair Trading as to how it will ensure that its guidance will be enforced in the payday lending market to achieve this, for example by indicating a level of charge which could be taken as prima facie evidence of irresponsible lending practice and used as the basis for targeting its enforcement action. We also consider that greater competitive pressure could be be brought to bear on prices by requiring banks to reduce charges for returned direct debits and to be pro-active in identifying people in financial difficulties, including by offering access to mainstream small sum credit provision to people on low to middle incomes. We identify the Small Dollar Loan Pilot, organised by the Federal Deposit Insurance Corporation in the US, as a model of good practice in this respect. The pilot has demonstrated that banks can offer commercially viable alternatives to payday loans, and that these are especially effective when customers are also provided with access to simple savings products and financial education. We therefore recommend that regulators pursue the creation of a similar pilot in the UK. This could also be used to test out whether direct bank provision of small sum loans, combined with financial education and access to simple savings products, would be better placed to meet the needs of payday borrowers than other affordable credit options, for example Credit Unions and Community Development Finance Institutions. A summary of our final recommendations is provided in the box below. Summary of Recommendations Responsible payday lenders should ensure that their advertising of the costs of payday loans relative to bank overdrafts and charges is balanced and warns consumers that whether or not it is cheaper to take out a payday loan will depend on who they bank with and their individual circumstances. The Office of Fair Trading and Advertising Standards Authority should review all current payday loan advertising and take action as appropriate on this point. The Office of Fair Trading should launch an immediate review of the practices of the highest cost payday lenders against the responsible lending guidance and also take enforcement action against firms which fail to limit roll over lending. Further research is required to examine whether the majority of payday borrowers have already exhausted their overdraft limits or have accrued significant credit card balances and should look into the relationship between payday lending use, credit defaults, and insolvencies in more detail. The Financial Services Authority and Office of Fair Trading should encourage British banks and credit card companies to establish a small sum credit pilot targeted at customers who have exhausted their overdraft limits and are struggling to pay down credit card debts, which provides loans to help reschedule commitments together with financial education and access to simple savings products Approved codes of practice should be developed, in consultation with consumer groups, which include the following commitments from the industry: That maximum loan values will not exceed one quarter of monthly income as is the case in some US states. That multiple, repeat, and roll over lending will be avoided That borrowers in financial difficulties are provided with assistance to reduce their level of debt without incurring additional charges. The industry should increase levels of data sharing in order to facilitate price competition for good customers and to avoid problems of multiple borrowing Government should commit to expanding the scope of its proposed price capping powers for regulators to all areas of the credit market. It should consult on the criteria to be considered by regulators when deciding whether or not to use this power. 6

10 Chapter One: Introduction Payday loans are small cash advances provided for short term periods, usually until the borrower s next pay date. Loans are sold both in high street premises and online, and typical costs (expressed as the total charge for credit) range from per 100 borrowed on the high-street to as high as per 100 borrowed online (Office of Fair Trading, 2010, Annex E, para 3.2). Due to the short term nature of the loans, the APRs are extremely high and range from 334% to over 4,400% (Office of Fair Trading, 2010, Annex E, para 8.27). At the time of the loan application the borrower either provides a post-dated cheque or authorizes a subsequent electronic transfer of funds from their bank account in order to allow the lender to withdraw the full sum due from the account on the agreed repayment date. Borrowers are often also able to elect to pay another month s interest and fees in order to defer or roll over the repayment of the principal for a further period. This can make the cost of payday borrowing very expensive as charges quickly accumulate and can even exceed the amount borrowed within five or six months. The way that roll over loans are handled varies between payday loan providers, with the best practice operators limiting the number of roll overs allowed, whilst some other lenders make rolling over the loan the default option. There has been considerable growth in the payday lending market in the UK in recent years and the market is currently estimated to turn over more than 900 million of loans per annum (Office of Fair Trading, 2010, Annex E, para 2.3). In its recent high-cost credit review, the Office of Fair Trading recognises (Office of Fair Trading 2010, p.5) that payday loans, alongside other forms of high-cost lending, do meet a demand for credit, and fill a gap not currently met by mainstream lenders. The Office of Fair Trading also reports evidence that some lenders exercise forbearance when customers experience payment problems and that the level of consumer complaints is low. However, there are concerns (Citizens Advice, 2009, p. 5) that payday lending is contributing to over-indebtedness amongst lower income consumers. Qualitative research with 20 payday loan customers conducted by Consumer Focus research earlier this year (Burton 2010, pp 23-24) reports that low income users had a long term negative experience, and that payday borrowing has substantial knock-on effects, causing people to struggle with other commitments such as paying minimum monthly repayments on credit cards or overdrafts, and resulting in additional charges. As well as causing financial problems, some of the respondents also said the experience of trying to pay back payday loans, particularly after having let them roll over or taken out multiple loans, had caused them emotional stress and anxiety. The industry also attracts criticism because of the high APR rates associated with its loans. In March 2008, these concerns were raised in Parliament with 51 MPs signing a motion calling for an inquiry into the industry, 1 and media reaction to the high APR figures charged by payday lenders has included calls (Collinson, 29th May 2010) for the introduction of interest rate caps. Most recently, the End Legal Loan Sharking campaign, which is being coordinated by Compass, has led to an Early Day Motion signed by over 100 MPs calling for caps to be introduced. 2 In contrast, payday lenders argue (see for example, British Cheque & Credit Association 2010) that the APR measurement inflates the price of small sum, short term lending and provides a distorted picture of the true cost of their loans. They further argue that their product provides a necessary and cheaper alternative to high bank charges and penalty fees, and that they act responsibly by ensuring that people can afford to repay prior to making any advance (for example, the Payday UK website contains a clear statement committing it to responsible lending). Nevertheless, regulators are taking a keen interest in payday lending both here in the UK and abroad. In the US, where the payday lending model originated, the federal Government has imposed a cap of 36% on rates for payday advances to military personnel and a number of states have introduced payday specific legislation involving combinations of caps 1 See 2 See 7

11 on interest rates, restrictions on the amount of loan relative to income, and limitations on the number of times a loan can be refinanced. These approaches have also been taken in a number of Canadian provinces. Here in the UK, the Office of Fair Trading has recently completed a study of high-cost credit markets, which included payday lending. Its final report, published on 15th June 2010, rejected the use of interest rate ceilings but retains some concerns that the payday lending market, particularly the online market, may not be subject to effective price competition, because: Suppliers primarily attract customers with the convenience and speed of the application process rather than by competing on price terms Payday loan suppliers own a number of different brands where the ultimate parent company is not always clear, and this can inhibit the ability of consumers to shop around For online payday loans there are a number of lead generator websites which, together with the proliferation of brand names, may make the market appear more competitive than it actually is and which make it difficult for consumers to compare prices as details of the cost are only provided once an application has been received. The Office of Fair Trading also indicated that a lack of effective price competition may arise because of relatively low levels of financial literacy amongst borrowers and a lack of other, more affordable, options including difficulties in obtaining mainstream credit, for example authorised bank overdrafts. It notes that addressing these deep seated problems would require a long term programme of activity and commitment from Government. However, some shorter term measures are also recommended, including: Working with industry groups to provide greater information on price comparison websites, and considering whether legislation is required to create a single website allowing consumers to compare the features of home credit, payday, and pawnbroking loans alongside credit unions and other lenders in their local area Considering whether there is scope under the European Consumer Credit Directive for a requirement that high-cost credit suppliers must include 'wealth warning' statements on advertisements for high-cost credit Working with credit reference agencies to explore ways in which payday lenders and could provide suitable information to credit reference agencies about the payment performance of their customers, in turn allowing those with good payment records to use mainstream lenders more easily in the future Supporting payday lender trade associations to establish a code or codes of practice covering best practice policy in a number of areas. Such a code could include: complaints processes and advice to customers policies on rolling over of loans rules of thumb on typical limits for amounts to lend to consumers guidance on avoiding misleading consumers through advertisements, and steps to ensure that consumers are aware of the ultimate owners of brand names. The Office of Fair Trading has also indicated that it intends to continue to monitor loan volumes and prices in the high-cost credit sector to inform future policy making (Office of Fair Trading, 2010, p.7). Although the High Cost Credit Review rejected the use of price caps on the grounds that these would be expensive to administer, the Coalition Government has made a commitment to providing a power for regulators to define and ban excessive prices in the credit card and store card markets. Expanding the scope of this power to other areas of the credit market which have been identified as lacking effective price competition may therefore make sense, and is the subject of a wider campaign to End Legal Loan Sharking being led by Compass. 8

12 The publication of Office of Fair Trading guidance on responsible lending practice earlier this year (Office of Fair Trading 2010a) is also important. The guidance covers the entire process of lending from the advertising of products, through to assessment of affordability, and debt recovery, and includes specific information concerning acceptable practice relevant to the payday lending industry in these areas. The remainder of this report further examines the central issues in the payday lending debate in respect of the cost of loans and whether people become trapped in a cycle of repeat borrowing. In order to provide possible options for further action in the UK we also undertake a review the regulatory and self regulatory approaches being taken in the US and Canada. It is structured as follows: Chapter two provides a brief background to the development of the payday lending industry in the UK and the regulation of its provision. Chapter three sets out further detail of consumer criticisms and lender arguments in defence of payday loans, including a comparison of the costs of a typical payday loan with unauthorised overdrafts, and bounced direct debit fees, and with the cost of borrowing on credit cards. Chapter four reviews the regulatory options being pursued in the United States and Canada, including initiatives to expand mainstream credit alternatives to payday lending, and compares this to current lending practice in the UK. Finally, chapter five sets out our conclusions and provides a number of recommendations. We believe that a number of these could be progressed on a voluntary basis by the industry and could form the basis of approved Codes of Practice. However, we also indicate where we consider further regulatory action and research is now required. 3 The End Legal Loan Sharking campaign particularly focuses on the Home Credit market, which was subject to a Competition Commission inquiry in This confirmed that there was a lack of effective price competition but its remedies have been ineffective and the cost of credit per 100 borrowed has increased significantly in the past four years (see Gibbons & McCartney, 2008). 9

13 Chapter Two: Background to the payday lending industry The payday lending model originated in the US where it is generally considered to be a form of sub-prime lending, as payday customers often have cash flow difficulties and few, if any, lower cost borrowing alternatives (Flannery & Samolyk, 2005, p. 1). For example, Stegman (2001, p.17-19) raises concerns that payday lending stores are concentrated in low income neighbourhoods and that levels of repeat borrowing demonstrate that some families with fragile finances can become addicted to payday loans. In the 1990 s, the payday lending model was exported to the UK, and its expansion here has in large part been generated by US lenders establishing a direct presence. A clear example demonstrating the success of this model is The Money Shop, which is owned by Dollar Financial, a US based lender. The Money Shop has expanded from one store in 1992 dealing primarily with cheque cashing to 273 stores and 64 franchises across the UK in 2009 and payday loans have become a major source of its revenue (Dollar Financial Corp, 2009, p. 8). In addition, whilst reporting record financial results in May of this year the company also indicated that it sees the UK market as an opportunity for additional rapid store expansion. 4 US based companies have also established online payday lending operations in the UK. Indeed, as we show in the box below, the majority of the main payday lending operations in the UK are either owned by US companies or have received considerable investment from the US and are answerable to US shareholders. Of the seven companies highlighted by Consumer Focus (Burton 2010, p. 12) as the largest market operators, only two are not ultimately owned by American companies: the pawnbrokers H&T Pawnbrokers and Albemarle & Bond. However, even Albemarle and Bond s largest shareholder is EZCorp, the second largest pawnbroker in the US. Ownership of UK Payday Lending Operations The Money Shop and Express Finance (Bromley) Ltd, which trades as PayDay Express, are owned by Dollar Financial Corp, incorporated in the US. According to Consumer Focus, Dollar Financial supplied 25% of all payday loans originated in MEM Consumer Finance (which owns the Month End Money, PayDay Now, PayDay UK, PayDay store, Quicksilver and PayDay Loans brands) is ultimately owned by Compucredit Holdings, a company incorporated in the US. Compucredit Holdings is a sub-prime lender that lends to Americans underserved by mainstream banks. Quick Quid, the second largest online lender, is owned by CashEuroNet UK LLC, a Delaware company. Lending Stream Ltd, an online payday lender, is owned by Global Analytics Holdings, another Delaware company. Cash Centres, the second largest high street lender, is owned by Check n Go, a company incorporated in the US. National Cash Advance, with 21 high street branches across the UK, is owned by Advance America Cash Advance Centers, incorporated in the US. High profile lender Wonga.com Ltd s holding company, Quickbridge (UK) Limited, has various shareholders, including several investment funds, notably Accel Investments, a Silicon Valley venture capital provider, and Balderton Capital, the European arm of Silicon Valley venture capitalists, Benchmark Capital. Wonga also obtained start-up capital from Silicon Valley bank. Of the seven companies highlighted by Consumer Focus (Burton 2010, p. 12) as the largest market operators, only two are not ultimately owned by American companies: the pawnbrokers H&T Pawnbrokers and Albemarle & Bond. However, even Albemarle and Bond s largest shareholder is EZCorp, the second largest pawnbroker in the US See

14 However, the UK payday customer base may be broader than that of the US. One of the UK payday lending trade bodies, the Consumer Finance Association, 5 estimates that the average value of a payday loan is 230 and that payday loan customers have annual gross incomes of between 12,500 and 30,000, with 18,000 the approximate average. The Office of Fair Trading (2010, Annex E, pp ) estimates a slightly higher average loan of 300 but also reports a typical user to be a young single man in rented accommodation earning in excess of 1,000 per month. It is certainly true that payday loan customers are unlikely to be the poorest consumers. The payday product requires that borrowers have a bank account from which repayments can be withdrawn automatically on the due date, and that borrowers provide evidence that they are in employment. Repayment dates are also set to coincide with the clearance of wages into the bank account as a means of reducing default risk. Consumers who are unemployed or otherwise without work are therefore not eligible for the loans. Nevertheless, it is also clear that the payday customer base in the UK does include low to moderate earners. Research conducted by Policis for the Friends Provident Foundation, and cited in the Office of Fair Trading s High- Cost Credit Review (Annex C, p. 36), finds that 10.4% of payday customers have incomes of less than 11,100 per annum, and that 49.1% of all customers have incomes of less than 19,200 per year. There are also concerns that some borrowers may already have exhausted other lines of credit and may not be able to afford further borrowing. The Office of Fair Trading (2010, Annex E, p.16) cites findings from research conducted by Policis for the Friends Provident Foundation which indicates that lower income payday loan customers use the product because they are cash constrained, need to cope with an emergency or pay an urgent bill, or are struggling to keep up with mortgage, rent, or utility payments. Indeed, the Office of Fair Trading goes on to indicate (2010, Annex E, p.17) that payday lenders appear to appeal directly to potential borrowers who have already exhausted their bank overdraft limits by using their advertising to compare their charges to those that would otherwise be incurred through unauthorised overdraft borrowing. Online Payday Lending The Office of Fair Trading (Office of Fair Trading, 2010, Annex E, p. 22) reports that online lenders serve a different type of customer compared to borrowers through high-street stores, as these are more likely: to make multiple online applications, because the number of declined applications is high, and to prefer the anonymity and convenience offered by online lenders. Online lenders have also been found by the Office of Fair Trading to charge higher prices than their counterparts on the high street, partly as a consequence of their higher exposure to potential fraud. Demand for payday lending may also be set to increase further as banks and credit card companies become more selective as a consequence of the financial crisis and tighten their lending criteria. Indeed, there are some early signs that non bank, and non credit card, lenders are becoming more important as sources of consumer credit. Data from the Bank of England (2010, table c, p.2) indicates that the overall amount of consumer credit debt held by banks fell by 5.5 billion between May and December 2009 whilst the outstanding amounts held by other consumer credit lenders remained stable over this period at 96.5 billion. This had the effect of increasing the overall share of consumer credit balances for these non bank or building society lenders from 41 to 42.5 per cent. It is also notable that, as at December 2009, credit card balances represented just 24% of all outstanding consumer credit debt compared to 29% in December See 11

15 REGULATION OF PAYDAY LENDING IN THE UK Whilst there is no payday specific regulation in the UK, payday lending is regulated by our general consumer credit legislation. The Consumer Credit Act 1974 requires lenders to obtain a consumer credit licence from the Office of Fair Trading. Operating without a licence can result in a fine and/or imprisonment. Before a lender is issued with a licence, the Office of Fair Trading determines whether the lender is a fit person. To determine this, the Office of Fair Trading considers a range of factors including the lender s business practices, any previous consumer complaints and any offence or conviction of violence or dishonesty. If, after issuing a licence, the Office of Fair Trading determines that a lender is no longer fit, it has the power to revoke the lender s consumer credit licence. Further to this, the Consumer Credit Act 2006 (S. 25 (2B)) introduced an explicit requirement for the Office of Fair Trading to consider irresponsible lending as a factor in determining the overall fitness of a lender to hold a consumer credit licence, and guidance on this was issued to the credit industry in March Key aspects of the guidance include requirements to: Clearly state the total cost associated with obtaining a loan and include the APR in any advertisement Lend responsibly and ensure that they assess the borrower s capacity to repay a loan in a sustainable manner, this includes the ability of the borrower to repay the loan without having to take out an additional loan; Provide borrowers with a sufficient explanation of the credit product, this should allow the borrower to understand whether he can afford the credit and also any risks associated with the credit product; Advise whether a product is better suited for the short term rather than for long term borrowing; Clearly explain to consumers the effects of rolling over a loan and lenders should not roll over a borrower s existing credit commitment for a short term credit product in a way that is unsustainable or harmful; and In an online environment, a borrower should not be allowed to enter into a credit agreement until they have been provided with an adequate explanation about the features of the credit agreement and been provided with an opportunity to question the lender. Finally, there have also been a small number of adjudications by the Advertising Standards Authority (ASA) with regard to payday lending: In April 2008 the ASA upheld a complaint against the payday lender, the Money Shop for using advertising which suggested that the use of high rate, short-term credit was suitable to fund aspirational, non-essential purchases such as a party, a shopping trip or a holiday. The ASA ruled that this was likely to be seen as encouraging carefree, impulsive and frivolous spending on credit and concluded that the advertisement could encourage consumers to spend borrowed money irresponsibly In October 2009, the ASA upheld a complaint against the online payday lender Quickquid, for failing to include the APR of 2,000% in its TV advert. The ASA ruled that the APR had to be disclosed as the advert emphasised the speed of the loan process and that this constituted an incentive for people to take up their offer In July 2010, the ASA upheld a complaint against online payday lender Wonga.com Ltd for portraying the act of taking out a loan in an overly whimsical fashion, including using laughter when the suggestion was made that a bank may offer a better alternative. The failure to give greater prominence to the APR than other information presented in the ad concerning the cost of borrowing also caused it to breach the Consumer Credit (Advertisements) Regulations

16 INDUSTRY ASSOCIATIONS In addition to the activities of regulators there are two industry bodies representing payday lenders in the UK, the British Cheque & Credit Association and the Consumer Finance Association, both of which impose rules on their members. However, the extent of these rules is currently limited. The British Cheque & Credit Association (BCCA) acts as an industry body for unsecured loan products where the intended repayment period is 6 months or less 6 (but excluding pawnbroking and home credit). The BCCA has issued guidance on best practices for payday lenders and these include a requirement that its members should not issue more than six consecutive loans to a borrower (Office of Fair Trading, 2009, p. 24). However, it should be noted that details of this membership requirement is not available from the BCCA website, and the BCCA has not obtained approved status from the Office of Fair Trading under its scheme for quality assuring codes of practice. The Consumer Finance Association (CFA) which has members of both high street payday lenders and lenders who operate predominantly online. The CFA does not currently have a code of conduct. It does, however, state that it encourages high standards from its members in terms of transparency, customer service and responsible lending. 7 6 BCCA website ( accessed on 17th July CFA website ( accessed on 17th July

17 Chapter Three: The payday debate.concerns about payday lending centre on two main issues (i) the cost of loans, and (ii) whether payday lending traps consumers in a cycle of increasing indebtedness. Payday lenders have defended themselves against both of these criticisms, for example by arguing that their pricing structure is justified by high operational costs and that they are responsible lenders. This chapter provides an assessment of the evidence on both sides of these arguments. ARE PAYDAY LOANS EXPENSIVE? The APR rates associated with payday loans are extremely high. For example, a typical loan of 230, 8 taken out for 30 days, with a loan fee of has an equivalent APR of 1355 percent. Indeed, the Office of Fair Trading reports that APRs can reach over 4,400%. However, there appears to be some agreement (Office of Fair Trading 2010, p.23) between consumer agencies and the industry that APRs are a poor measure of the actual price of a payday loan, as the APR is an annualised compounded rate and hence becomes higher as the loan period becomes shorter. Whilst APR may not be a helpful measurement of price, there nevertheless remain concerns that the cost is still high when compared to other forms of lending, notably overdraft and sub-prime credit cards to which the payday lending customer base is likely to have at least some level of access. For example, table 2, below, sets out the costs of borrowing 100 on sub-prime credit cards available from Capital One, Vanquis Bank, and with Barclaycard Initial. Table 2: Selected sub-prime credit card products cost of credit over 90 days Capital One Vanquis Bank Barclaycard Initial Purchase amount ( ) Loan period 90 days 90 days 90 days Interest free period^ 56 days 56 days 56 days Maximum credit limit^ ( ) Annual purchase rate^ % 34.94% 39.94% 29.90% Monthly purchase rate^ % 2.53% 2.84% 2.21% Minimum repayments^ ( ) Fees^ Annual or monthly fee/s Other fee/s Total cost of credit over 90 days ( ) ^ Interest rates and fees as at 28 April Interest rates may differ for cash advances. Interest rates are typical, and may differ depending on individual circumstances - can be up to 59.9% for the Vanquis Visa Card. Minimum repayments can be affected by credit balance, maximum credit limit, and individual circumstances. Interest free periods may vary between credit card providers. 8 This is the typical loan size cited by the Consumer Finance Association on their website. 14

18 As with other credit cards, borrowing which is cleared in full within the initial 56 day period does not attract any interest. But even where the borrower fails to clear the outstanding amount within this time-frame the costs are significantly lower than borrowing on a payday product for low amounts. It should also be noted that these cards also have relatively small credit limits attached to them. For example, the Capital One Classic card provides a starting credit limit from as little as 100, and is available to people with poor credit scores and a pre-existing history of County Court judgments. It is therefore reasonable to assume that many payday customers would have access to these products. Further to this, although the use of these credit cards for cash advances is more expensive than for purchases, the costs are still significantly lower than payday borrowing over a 90 day period (see table 3, below). Table 3: Cost of 100 cash advance over 90 days on selected sub-prime credit cards Capital One Vanquis Bank Barclaycard Initial Cash advance amount ( ) Loan period 90 days 90 days 90 days Interest free period 0 days 0 days 0 days Maximum credit limit ( ) Annual cash advance rate^ % 34.94% 54.57% 29.90% Monthly cash advance rate % 2.53% 3.43% 2.21% Minimum repayments^ ( ) Fees^ Annual or monthly fee/s Other fee/s 3% of advance - 2.5% of advance Total cost of credit over 90 days ( ) ^ Interest rates and fees as at 28 April Interest rates may differ from purchase rates. Interest rates are typical, and may differ depending on individual circumstances - can be up to 59.9% for the Vanquis Visa Card. Minimum repayments can be affected by credit balance, maximum credit limit, and individual circumstances. Given the large difference in price, we therefore consider it unlikely that consumers would rationally choose to use a payday loan in preference to credit cards for small sum, one-off borrowing, where they are confident that they will be able to repay in full within a 90 day period. However, the relative cost of credit cards and payday loans can be reversed where large credit card balances in excess of 1000 have already accrued and where there is no prospect of the borrower paying these off within a relatively short period. In these cases, the debtor using cards for purchases has an ongoing liability in interest payments of between and per month and additional use of the credit card may no longer be an attractive option. In these cases, we find that payday loans could present a competitively priced product. Indeed, where a credit card borrower goes into arrears, or has been using their card to run up significant balances by taking out cash advances, then it is also possible that payday loans could be a cheaper form of borrowing. This analysis would suggest that payday borrowers are likely to consider payday loans an attractive alternative where they have significant outstanding credit card debt. However, this raises concern that further borrowing is also likely to be unsustainable. Unfortunately, there is little information available concerning the credit card use of payday customers in the UK on which we can currently draw and this presents an area where further research is required. Some evidence is available from the US where a recent study (Agarwal et al, 2009), which matched payday borrowers with their credit card records, finds that the amount of liquidity remaining on US borrowers credit cards had 15

19 substantially reduced in the five months immediately prior to the use of payday loans, indicating (p.5) that borrowers were starting to experience financial difficulties with credit card repayments. Importantly these problems do not appear to be caused by a single income or expenditure shock but are more persistent. The study finds that taking out a payday loan does not appear to help address this problem but predicts nearly a doubling in the probability of serious credit card delinquency over the twelve months following the use of a payday loan. Regardless of the presence of alternative credit options such as sub-prime credit cards, payday lenders have defended their charges on the basis of the high costs associated with operating in the industry and argue that their customers understand the cost of taking out a payday loan and are making an intelligent and informed choice. Payday lenders argue that their products are provided more quickly, anonymously, and conveniently, all of which are valued by their customers. Further, the presence of available credit on a credit card may not help the customer if they need to make a payment for which they need cleared funds in their bank current account. Lenders also argue that limiting their ability to charge high prices would make it unviable to continue operating in the market. For example, Kitching & Starky (2006, p.9) cite an Ernst & Young (2004, p.39) report commissioned by the Canadian Payday Loan Association which reports that the cost of providing a payday loan is in the range of CA$15.35 to CA$21.22 per CA$100 loan, depending on the size of the business. The chief contributors to this overall cost are reported as operating costs (75 percent of the overall cost) and bad debts (20 percent of the overall cost). The cost of capital has a very small impact on the overall cost. The Ernst & Young report further argues that the operational costs are high due to the small capital base and the short maturity period within which the lender must recover all its fixed costs, including the costs associated with providing and writing the loan. Further support for the argument that prices reflect high operating costs can be found in Flannery and Samolyk s 2005 research for the US Federal Deposit Insurance Corporation. This examined data from two large store based payday lenders to determine store operating costs and profitability levels and found that fixed operating costs and loan loss rates accounted for a large part of the price of the loans. In this sense, the prices of loans could be considered to be fair in that they reflect the genuine costs to originate and recover loans from borrowers with a high risk of default. Information regarding this issue is limited in the UK, where the only study that has been conducted forms part of the recent Office of Fair Trading s review of high-cost credit. This study concluded that firms operating in the UK market were able to generate a return on capital employed (ROCE) in excess of the weighted average cost of capital (WACC) which may indicate that excess profits are being made. However, the Office of Fair Trading has not considered this finding to be sufficient to have warranted further regulatory action, for example by referring the industry to the Competition Commission for a full inquiry. The Office of Fair Trading review also rejected the potential use of price capping measures for this and other high cost credit markets. However, the Coalition Government has subsequently indicated that it is committed to introducing a power for regulators to define and ban excessive prices in the credit and store card sectors of the market, and the End Legal Loan Sharking Campaign being led by Compass has attracted considerable support from MPs for the scope of this power to be extended to all areas of the unsecured market. 16

20 The rate cap debate The debate concerning rate caps in the UK is long standing (see for example, Gibbons, 2003; Policis 2004; McCartney & Gibbons 2008) and further research concerning the use and impacts of rate caps in other European countries is also due to be published in the new year by the European Commission (Institut fur finanzdienstleistungen, forthcoming). The European research indicates that generalisations concerning the impact of caps unhelpful, with the precise level of the cap, degree of competition in the market, form of cap, and policy intent for example to eliminate excessive risk taking all important. A power for regulators to cap prices will therefore need to be accompanied by a clear set of criteria to which regulators must have regard when using it. Reviewing prior debates on the issue in the UK, and the findings of the Competition Commission inquiry into home credit (Competition Commission 2006), we suggest that these criteria would need to include: Whether other measures, for example remedies designed to increase price competition, could address the problem within twelve months. Regulators should be required to review progress and use their power to cap prices in the event that no improvement in price has been achieved through the use of other remedies within a year The level of any price cap, with regulators required to balance: The desirability of maintaining access to affordable and responsible credit and the likely impact of the cap on its supply Levels of consumer detriment caused by a lack of price competition and the amount of the reduction in price that could be achieved by the imposition of a cap for the majority of borrowers in the market The estimated enforcement costs of the proposed cap The desirability of eliminating clearly excessive risk taking by lenders in the market. The form of the cap. Regulators should be tasked with constructing caps in such a way as to prevent lender avoidance and pricing distortions It should be noted that the Office of Fair Trading does not report on whether or not those lenders charging the highest prices ( 30 per 100 lent and above) are targeting people for whom there is less competition, which may be the case, or whether these extremely high charges are justified on the basis of higher default risks, in which case the high cost of loans may indicate irresponsible lending practices (i.e. loans being given to people who cannot really afford to take out any further borrowing). In any event, for consumers the issue of whether or not the payday loan product represents good value in comparison to possible alternative sources of credit is more pertinent to them than the level of profitability being made by lenders. In this respect, payday lenders argue that obtaining a payday loan is cheaper than being forced into unauthorised overdraft borrowing. We find evidence in support of this argument, and the table below sets out a comparison of a payday loan of 100 charging a fee of 25 with unauthorised overdraft charges currently levied by five high street mainstream credit lenders. As can be seen from the table, the total monthly charge incurred from an unauthorised overdraft is higher than that incurred from the payday loan in four of the five cases; and in the case of Lloyds TSB it is more than six times higher. However, there are limitations to this analysis. In particular, as we go to explain, the comparison becomes less clear cut as the overdrawn amount increases and on some occasions the cost of a payday loan may actually be more expensive than an unauthorised overdraft. 17