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Can the Payday Loan Be Reinvented?

There's been some speculation that payday lending is set to have a big year. And with good reason. 

As mentioned in American Banker's "8 Nonbanks to Watch in 2013," several tech startups have made short-term credit the sole focus of their business model. The slideshow mentions ThinkFinance, an online business that uses data collected via social media to drive down the cost of a short-term loan, and Wonga, a short-term lender based in the U.K. that is considering a trip to this side of the pond.

Other companies are targeting the space. ZestFinance, a Hollywood, Calif., company, is marketing an underwriting model to lenders that it claims has a default rate 50% better than industry average. BillFloat, a San Francisco startup that offers a short-term lending platform, just announced it had raised $21 million to expand its loan offerings.  Also based in San Francisco, LendUp advertises transparent loans to select borrowers.   

While these companies' business models vary, their ultimate goal appears to be the same: use some form of big data to drive down the cost of a loan so underserved customers can get credit without paying an exorbitant price. (According to the Consumer Federation of America, payday loans typically cost 400% on an annual percentage rate basis or more, with finance charges ranging from $15 to $30 on a $100 loan.) Price transparency is usually part of the pitch as well.  

There's certainly a demand for this type of product. According to a report from the Center for Financial Services Innovation, an estimated 15 million Americans turned to small-dollar credit products in 2011, with fees paid to access these loans amounting to $17 billion. Other analysts have pegged the industry's annual profits much higher, at about $30 billion a year, and results of a recent FDIC survey led the agency to urge banks to expand services to the underbanked in December.

But there are reasons why most traditional financial institutions may be hesitant to partner, or alternately compete, with these startups. Just this month, five Senate Democrats urged regulators to stop the few banks that are already offering high-interest, short-term loans of their own, typically referred to as deposit advance products.

These Senators were the latest group to voice opposition to the practice. Consumer advocacy organizations, such as the Center for Responsible Lending, have long campaigned for Wells Fargo, US Bank, Regions Financial, Fifth Third and Guaranty Bank to remove these products from their arsenal.

"Ultimately, payday loans erode the assets of bank customers and, rather than promote savings, make checking accounts unsafe for many customers," advocacy groups wrote in a petition to regulators early last year.

And startups have tried – and failed – to improve on the payday lending industry in the past. TandemMoney, a South Dakota-based company hoping to wean the underserved off high-cost credit, went out of business at the end of 2012, citing regulatory scrutiny as the reason for its demise. The main complaint among its opponents: the concept – a prepaid debit card that let customers borrow short-term money so long as they set aside $20 in savings every month – all too closely resembled a payday loan.

Stigma isn't the only reason short-term credit remains a risky business. Financial institutions – small banks, especially – have long had a hard time profiting off of small-dollar loans. Tech companies, particularly those looking to underwrite for banks and not make loans themselves, may be able to drive APRs down to a level considered acceptable by consumer advocacy groups and other payday opponents, but there's no guarantee that number will be equally attractive to their potential clients (i.e., financial institutions).    

Additionally, as a Wired article points out, better data and more sophisticated risk management tools could just as easily work against underserved borrowers. 

"A lender might decide to play the spread," the article notes. "Charge the least risky customers a lot less and the most risky customers a lot more, all in the name of getting as many customers as possible," rather than just lending to the ones revealed to be good risks.

Can the payday loan ever be reinvented? If so, what terms and conditions would have to be associated with it? Let us know in the comments below.

Jeanine Skowronski is the deputy editor of BankThink. You can contact her at or follow her at Twitter @JeanineSko.





(14) Comments



Comments (14)
@frankarauscher - I'm not against payday lending totally. I am against the way it is currently being used. I think traditional banks are losing a huge opportunity to pull in enormous per product profit and serve a much needed financial services niche. Banks could easily under cut the bulk of the internet payday firms and still make substantial return per investment. The reason why the default rate is so high is because of the outrageous fees charged by these firms. Let the borrower breathe and more of the loans will be repaid.

As was pointed out in another post, the existence of the payday loan is indicative of a bigger problem in that wages and buying power have been shrinking for 30 years, especially in the past dozen. More people are living pay check to pay check so that the slightest change can snowball into an insurmountable problem. The small, short-term loan is a much needed product/service which can and should be provided by traditional financial services.
Posted by RSE Journal | Monday, February 11 2013 at 12:03PM ET
Twelve comments and all are against payday lending. Yet Wells Fargo, US Bank, Regions Bank, and Fifth-third Bank believe that preying upon their customers is good!It is good - but only for the banks which can earn over 1000% ROE after taxes on this product, As long as they hold to their outrageous position, the whole banking industry will suffer.
And the Consumer Bankers Association chooses to be silent even though I have been after them for a year to take a stand on the product.
Posted by frankarauscher | Monday, February 11 2013 at 10:05AM ET
The payday loan should not be "reinvented" because it's structurally flawed. Any short-term, high-cost, lump sum payment loan is predatory by design and intended to keep consumers in long term debt. There is an incredible need for small dollar credit and banks clearly aren't meeting that need with a responsible product. Their solution is a sanitized version of a payday loan. Loans and credit aren't always the solution; peoples' cash flow shortfalls are part of a much bigger problem and we need to broaden and expand the way we think about "alternatives" to payday loans and "financial stability."
Posted by California Reinvestment Coalition | Monday, February 04 2013 at 1:37PM ET
Probably payday loan is one of the most expensive kinds of loans but it's easy to explain why. We always pay for urgency and in case we want to borrow money urgently we should be ready to pay high interest rate. If payday loan lenders will lower interest rates then probably they will change conditions and taking out payday loans online will not be so easy. There are lenders who charge hidden fees and really get consumers in a debt circle. I think that short-term loan market needs a reinvention, there should be only those who are fair with their clients and charge reasonable rates. Also consumers should learn more about the services they are going to use. It's not worth to believe that you simply can borrow money quickly with minimum requirements and this service doesn't have any lacks.
Posted by Christina8 | Monday, February 04 2013 at 4:57AM ET
Thanks Adam for your nice comment about Float. Let me just point out though that our VCs can keep their Bugatis. Pro-consumer is pro-business; loyalty is gold.
Posted by Shane Hadden | Sunday, February 03 2013 at 2:00PM ET
I'm always concerned when innovation means finding a new method to do the same thing, without adding value for customers. The author has a really good point - these new entrants are just using big data to lower supplier costs while essentially offering the same product to consumers. If you really look at the fine print, though, you will see that the interest rates are actually higher for ZestCash and Wonga then for retail payday, mainly because they have to pay for lead generation.

I really like the idea behind Float.
Here, the lender extracts profit from credit, but such costs are borne not by borrowers but by partner retail firms. The rate of return is not going to keep a VC in Bugatis, but it will work.
Posted by Adam Rust | Friday, February 01 2013 at 4:24PM ET
Non-bank lenders lack the leverage of capital (they may be 4:1) that an FDIC insured bank has (10:1). It would be very easy for a large commercial bank to make a very fine return on payday loans; but, they choose to earn an outrageous return. I have personally provided US Bank and Regions Bank with proforma profitability analysis that shows their return on equity exceeds 1000% after a 31% tax rate! They do not dispute any of the calculations of which most are taken from their SEC filings.
When judging them you can listen to their words or look at their actions. This is not CRA lending. This is pure greed.
What would an acceptable payday loan from a bank (checking direct deposit advance) look like?
To start with, the banks need to provide a definition of PREDATORY CONSUMER LENDING to use as a base case. Then the banks need to involve their financial professions such as Registered Investment Advisers, CFP's, CFA's, and other that follow the prudent man requirements of financial management. Then they look at the fact that the FDIC and the Congress have pretty much accepted that a 36% interest rate would be OK. This would include all fees, charges, etc. (Remember that these banks use 29.99% as the max interest on their worst credit card accounts wherein they expect very high loss rates that would be greater than they are experiencing on this direct deposit advance currently).An option to repay the loan over a short period of time such as 4 months if the direct deposit did not appear. The ability to use the product maybe twice a year for unplanned emergencies and for laziness to fail to budget. And subsequent usage would require completion of an financial counseling program.
Posted by frankarauscher | Friday, February 01 2013 at 10:08AM ET
Take a look at Cash America's latest quarterly earnings; they are the largest regulated online payday lender. Loan losses are over 40% of loan fees. Net income margin for the whole company (payday and pawn lending) is less than 5%. Hardly an enormous margin. If you are saying that the unregulated lenders are more profitable than the regulated companies, you are probably correct, otherwise why go to the trouble of sidestepping the laws.
Posted by PTO | Friday, February 01 2013 at 8:19AM ET
We're not talking about firms that are making a semblance of adhering to some sort of regulatory practices. These payday lenders are making enormous profits. A $300 loan taken to full term can bring a company $1,200 in six months. Even if the borrower is able to make a single payment pay back, some charge as much as $150 in "fees." They don't have to go through the regulatory wringer and much of their business is return lending. The only reason why net income may be down is because they can't lend to military personnel anymore and many states are outlawing their predatory lending practices.
Posted by RSE Journal | Thursday, January 31 2013 at 10:26PM ET
Payday lending can definitely be reinvented. But I am not sure if these companies are the right ones to do it. I disagree with RSE, most of them are not making obscene profits, and at least the public companies have lower margins than banks. I agree with T S
Posted by PTO | Thursday, January 31 2013 at 5:58PM ET
Before one goes to market with a product, there must be demand for the service or it doesn't work. In recent meetings with regulators, there seems to be recognition that people living pay check to pay checks do not have money each month to put aside money for emergencies., therefore short term loans are in demand. The current problems exist from tying repayment to the next paycheck, which in most cases is unrealistic. Consumer advocates should encourage banks to move vigorously into this market. They have a much lower cost of funds and therefore a price advantage. The is plenty of room between what the payday and title lenders charge and what the banks need to charge to compensate for he risk and still make a profit. Wouldn't these products be more consumer friendly if regulated by bank regulators,, but there has to be enough profit to cover the losses and the expensive learning curve. Besides, banks already have a short term loan product, they just call it free checking.
Posted by T Stephen Johnson | Thursday, January 31 2013 at 12:03PM ET
There is a very big need for small, short-term lending. The reason for the exorbitant rates really has nothing to do with an inability to "be profitable following the law." Rather, by staying under the radar, current payday loan firms reap obscene profits because they can. They have no competition and are preying on people in a desperate situation. They have no brick and mortar facilities and virtually no overhead. After just two or three minimum payments from their victims, the payday loan firm has recovered the initial loan and everything after that is just gravy. Real financial services companies could easily undercut the exorbitant rates of the payday loan firm thereby making it more likely that the loan will be repaid. Finally, payday loan users tend to access the system again. Making it possible to repay the loan without gutting the user gives them incentive to stay within the regulated system. Emergence of the payday loan scam is more indicative of eroding wage scales and buying power and is only a symptom of growing cancer.
Posted by RSE Journal | Thursday, January 31 2013 at 10:48AM ET
To PTO: You state that the companies partner with banks to avoid existing laws re: short-term credit? How does that work? Do banks not have to comply with laws?

Companies partner with banks and others to respond to state laws which make it impossible to lend small amounts of money for a short period of time. This has nothing to do with transparency or safety - federal laws and bank regulations still apply - this has to do with state licensing requirements, state usury caps, and idiosyncratic state restrictions on loan amounts and terms.
Posted by XYZ1 | Thursday, January 31 2013 at 10:45AM ET
Most of these companies either partner with banks (in the case of Billfloat) or tribal nations (in the case of Thinkfinance and ZestCash) to avoid the existing laws regulating short-term credit. I do not think they they would go to so much trouble if they could be profitable following the law.

If they are purposely avoiding regulation, I find it hard to believe that their products are more transparent and somehow safer for consumers. Using social media or "big data" are simply ways to attract customers and enhance profitability.
Posted by PTO | Thursday, January 31 2013 at 8:05AM ET
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