A recent story in American Banker reported that at least three banks are planning to launch new small-dollar loans products after the Consumer Financial Protection Bureau's payday lending rule becomes effective. The article states that banks are drawn to a possible CFPB exemption from underwriting requirements for loans meeting certain characteristics. Here's why I'm dubious about this development.
The re-entry of banks into the small-dollar, short-term credit market would be a win for consumers' choice. Additional competition spurs innovation, which improves products and services and drives down costs. Payday lenders represented by the Community Financial Services Association of America have always welcomed more competition, as we have noted in these pages previously.
I am, however, quite skeptical of the notion that the CFPB rule will change banks' resistance to these products. Up to now, major banks have been uninterested in serving this market, and the products they have tried to offer have not been successful. If banks could be serving this market profitably, why aren't they already doing it?
A recent study commissioned by the American Bankers Association found that only 1% of banks surveyed currently offer loans of $500 or less. Banks largely find loans of a few hundred dollars unprofitable and unsustainable due to the high cost and risk of offering these products. In fact, in 2009, the FDIC's Small-Dollar Loan Pilot Program allowed banks to offer payday loan-type products with a 36% interest rate cap. But those products proved unprofitable in the short term.
Even if more banks would offer small-dollar loans under the CFPB's rule, the recent American Banker article states that banks would only net $70 on a $500 loan, only about twice the cost of an average overdraft fee. This is simply not enough revenue to offset the increased costs associated with offering small-dollar products. Personnel and real estate expenses — the principal drivers of the cost of a payday loan — are much higher on a per-unit basis for banks.
The article said loan products drawing banks' interest would have monthly payments limited to 5% of a borrowers' income, since that is the threshold exempting the loans from CFPB underwriting requirements. The 5% threshold superficially seems like a good idea; it would certainly ensure that such loans are affordable to the most creditworthy of current borrowers. However, the 5% limit will serve to exclude the vast majority of current borrowers because they could not qualify for the amount of credit they require under this test. The Pew Charitable Trusts developed the 5% test from anecdotes of focus-group participants, and there is no empirical support for the notion that the imposition of such a standard — at 5% or any other level — would improve the welfare of borrowers.
The CFPB's proposal, which in its current form would drive nonbank lenders out of the market, creates a convenient entry for traditional banks, but at the same time leaves millions of customers without access to short-term credit. Many consumers who use payday loans are unable to borrow from banks. Some choose to visit nonbank lenders because they are uncomfortable with banks or find them unaccommodating, while others live in areas that are not served by banks.
If banks truly could serve these customers profitably, they would remain in these neighborhoods. Instead, they have written off these areas as poor prospects where consumers tend to keep small account balances and are unlikely to gravitate towards more profitable bank products.
An executive quoted in the article attempts to justify the lower profit margin of short-term credit products as a gateway to future transactions. However, what will happen if these transactions do not materialize at the levels banks want? The check-cashing, money-transfer, remittance and other “high-touch” services these customers demand are inconsistent with current models of retail banking that depend on streamlined self-service and electronic transactions. The numbers simply will not add up for banks.
If Pew and other critics get their way, the CFPB's proposals will lead to an estimated 82% reduction in payday loan revenues for small lenders. I have estimated that 60% or more of storefront payday lenders could shut down. Some of these lenders' customers will turn to banks, if they are able to do so. However, it is far more likely that banks will acquire a very small number of the best-qualified borrowers and leave less creditworthy applicants without options — forcing many to turn to illegal online lenders and loan sharks.
Regulators and advocacy groups should keep these thoughts in mind before crafting a rule that would favor the needs of banks over the needs of the consumers whom the advocates claim to represent.
Dennis Shaul is the chief executive of the Community Financial Services Association of America, which represents nonbank lenders. He previously served as a senior adviser to former Rep. Barney Frank and as a professional staff member of the House Financial Services Committee.