Payday loans, as widely practiced, rarely end with the borrower simply paying the lender back.
Instead, the product typically creates a downward spiral of debt, long past the receipt of the borrower's next paycheck. Therefore, the Consumer Financial Protection Bureau has taken an admirable step to eliminate many of the worst practices in the small-dollar credit market with the proposed rule it released last week.
The agency's proposal protects borrowers from unaffordable loans, cycles of reborrowing, and exorbitant fees—all positive steps in reducing consumer harm. But if the final rule doesn't create a clear lane for good lenders to step in with a variety of new loan product designs, the CFPB risks leaving important consumer needs unfulfilled. Not everyone who can get a payday loan today should be getting credit, but the proposed rule may ultimately leave too many people behind.
The needs that drive consumers toward payday lenders, after all, will remain. A Center for Financial Services Innovation study found that more than a third of all households say they frequently or occasionally run out of money before the end of the month. Further, more than four in 10 households struggle to keep up with their bills and credit payments.
U.S. consumers often have small-dollar credit needs from a variety of causes: spikes and dips in income that lead to cash-flow problems, unexpected expenses and timing mismatches between the arrival of income and bill due dates.
Granted, it is no easy feat to craft a rule that targets the worst practices, can withstand legal challenges and yet can still support the creation of high-quality, profitable products to fill the resulting gap.
Optimally, the bureau's rulemaking – which is in response to the current state of payday lending – is a unique opportunity to point the way to what a better small-dollar lending market could look like in the future.
What if the CFPB took a blank page and made room for some blue-sky thinking? The CFPB has significant authority to reimagine what high-quality small-dollar credit looks like, which it could promote in its final rule along with consumer protections. To get there, the CFPB could look at CFSI's compass guide to small-dollar credit, to help define lanes and pathways for well-intentioned providers.
That guide defines standards that could be used for principle-based regulation to support small-dollar credit products that: are made with a high confidence in the borrower's ability to repay; are structured to support repayment; are priced to align profitability for the provider with success for the borrower; create opportunities for upward mobility and greater financial health; have transparent marketing, communications and disclosures; are accessible and convenient; and provide support and rights for borrowers.
The CFPB could find ways to help lenders offer small-dollar credit products that align with the rule efficiently and sustainably, with less emphasis on exemptions from hard thresholds. Where requirements are narrowly proscribed, sanctioned timeframes and methods to road-test the best ways to comply should be explicitly stated. Better yet, the CFPB could take a sandbox approach to pilot the most promising new product designs. This tactic would allow regulators and providers to test a broad range of possible solutions that may otherwise be constrained by the new rules. CFSI's recent small-dollar credit test and learn project illustrates the kinds of insights regulators could gain by creating an environment that supports responsible experimentation.
For instance, the proposed rule addresses the fundamental problem of loan rollovers trapping borrowers in a cycle of debt. However, exemptions based on annual percentage rates – as proposed by the CFPB – might exclude the most promising solutions. Some new products on the market that enable people to build credit, demonstrate they are good risks and get reduced rates over time start with initial loans that are higher than 36%.
Likewise, the proposal's underwriting requirements could use more flexibility. While the proposed rule is very specific about how to calculate a borrower's ability to repay, data companies and lenders have been experimenting with new underwriting systems that rely on a broader array of data to accurately and efficiently measure a borrower's likelihood of success.
A sandbox approach would create a safe place for lenders to develop and test new models while ensuring they are harmonized with the final rule.
The CFPB deserves praise for tackling a complex issue. The ongoing conversations, research and innovation in small-dollar credit can help the agency design a framework that will end the worst practices, meet consumer needs and define clearer pathways for improving consumer financial health.
Jeanne Hogarth is a vice president at the Center for Financial Services Innovation and leads the organization's policy work.