A recent American Banker article requested ideas for reinventing payday loans.
As the founder of a nonbank lender that specializes in small-dollar credit, I would like to suggest that banks, credit unions and nonbank lenders can and should replace these loans with low-rate, pro-consumer loans. To start this process, we must agree on the following four basic principles:
First, high-rate consumer loans are dangerous and should not be made. Until we agree on this, nothing is going to change.
Second, there is no such thing as a short-term (e.g., two week) loan. From the borrower's perspective all loans are longer term in cases of default or refinancing. Let's only make longer term loans that are pre-payable by the borrower. This will end the counterproductive conversation about how to recover costs over a two-week loan.
Third, we need to target a maximum, sustainable all-in interest rate (with fees). This rate may be 36%, for example. Many people, including myself, would say that 36% is still an unsustainably high rate. However, since loans to the U.S. military are legally capped at this rate, this seems to be a reasonable target for the general population. Developing new online platforms to lower annual percentage rates to 365% is a waste of resources and makes the problem worse.
And fourth, no loan should be made without an expectation of repayment. Let's not lend unless there is an expected cumulative default rate over the term of the loan of less than, say, 25%, and let's define this level as "creditworthy." The term "creditworthy" cannot remain abstract if this industry is going to thrive in a responsible way.
Once we agree on these basic principles, we can create profitable, pro-consumer loans. The question is not whether we can make profitable low-rate loans with a reasonable charge-off expectation. The question is how we maximize profitability within these constraints. There are three places to look for increased profitability:
Ancillary revenue (loyalty): The old banking concept of "relationship lending" can be applied to subprime lending in new ways. The interest or fees on a loan are not the only revenue that is earned by making the loan. Revenue is also earned on future loans and the sale of other products, including, for nonbank lenders, nonfinancial products. For example, an unprofitable three-month loan by a bank can become profitable if it is used four times over two years. Similarly, an unprofitable one-year loan by a nonbank can become profitable if the borrower returns to buy consumer products from the lender. The best approach to reducing rates is to make loans that are safe and responsible, so that borrowers stay financially secure and come back to the lender to generate this additional revenue.
Partnerships: Depository institutions can expand their customer base by partnering with nonbank lenders. Banks and credit unions have low funding costs and efficient marketing and lending platforms that the nonbank lender could benefit from, but are hampered by regulatory capital requirements and operational restrictions that limit their ability to meet the credit needs of subprime borrowers. Nonbank lenders can innovate to meet these needs in the near term, while promoting the borrower as a saver and loyal bank customer in the long term.
Underwriting and product design: To be profitable and socially responsible, we need to improve credit scoring techniques and the charge-off experience for subprime borrowers. We should develop objective underwriting standards and an information sharing infrastructure that facilitates accurate measurement. We also need to develop best practices around product design and education to reduce actual defaults. Only by doing this will the industry as a whole be able to maximize profitability from creditworthy borrowers and minimize loan offerings to non-creditworthy borrowers.