This is the second article in a two-part series adapted from a keynote speech delivered recently at the annual meeting of the Financial Services Centers of America, a trade group representing nonbank financial services companies.
In any line of business, there are some good operators and some who refuse to play by the rules. The same holds true among payday lenders, check cashers and other alternative financial service providers. It's clear that we must protect consumers from those who seek to take unfair advantage. Regulators and law enforcement agencies need to be aggressive with companies that are ethically challenged or lax in observing the law.
Where regulators and law enforcement agencies lose me is when they cast a net so wide that they fail to distinguish good operators from the not so good. The Department of Justice's Operation Choke Point program, apparently run in conjunction with the Federal Trade Commission and some bank regulators, casts a net so indiscriminately that one can only conclude that it is intended to drive all providers of alternative financial services out of business by denying them access to the banking system and harassing them with regulatory enforcement actions. This type of action drives banks to "derisk" (i.e.,dump) alternative financial service providers to avoid unwarranted scrutiny and greatly increased costs for risk controls.
This represents a serious abuse of government power. It is causing significant harm to the economy generally and to tens of millions of working-class Americans for whom alternative financial services provide a lifeline.
To put the market need in perspective, let's take a look at some key findings from the Federal Deposit Insurance Corp.'s latest survey of unbanked and underbanked households. In 2013, roughly 34 million households, representing 68 million adults, had limited or no participation in the banking system. According to an earlier survey in 2009, two-thirds of unbanked households use alternative financial service providers to cash checks, provide payday and title loans, issue money orders, and issue pre-paid cards.The FDIC survey indicates that most underbanked households that use alternative financial services do so primarily for convenience, speed of service, and ease in qualifying for a loan.
Critics call payday loans "predatory," due to their short term and relatively high cost, but it is very difficult for me to understand how a small, unsecured loan to a high-risk borrower can be predatory. If the borrower defaults, the lender has no collateral to go after, and the loan is too small to justify legal action to collect. The only recourse the lender has is to refuse to make additional loans to that borrower.
Short-term, unsecured consumer loans to borrowers with weak or limited credit histories are priced to cover the risks and operating costs of providing the service. The loans are short-term to limit the default risk. The typical payday loan is priced at a flat $15 per $100 two-week loan. Critics point out that the annual percentage rate on this loan exceeds 350% and call for short-term lenders to limit the APR to 36%.
But to achieve a 36% APR, the lender would need to limit the fee on a two-week $100 loan to $1.38. While I believe that a more competitive marketplace will likely bring the price meaningfully below $15 per $100 loan, I can't conceive of any business being willing or able to make $100 two-week unsecured loans to borrowers with poor or nonexistent credit histories for anything close to a $1.38 fee.
The millions of people who use short-term, fixed-fee loans almost certainly know what's in their own best interest better than anyone else. Payday loans are usually less expensive than overdraft fees. They are less painful than the consequences of defaulting on an auto loan or a mortgage. And they are a better deal than having the electricity turned off only later to pay fees for having it turned back on.
Critics also attack check cashing services, questioning why people should be charged $7 or $8 to cash a payroll check, particularly when the check can be deposited in a bank account without a fee. But many people take their payroll check to a non-bank check-cashing firm because they need the funds immediately, and their bank will not release the funds until three or four days after the check is deposited. These customers make the entirely reasonable judgment that having the cash in hand on Friday afternoon rather than the following Wednesday is worth seven dollars. Who are we to tell these people they are not capable of making that call?
There is no doubt that alternative financial services companies should be regulated and indeed they are by both the states and the Consumer Financial Protection Bureau. But eliminating these businesses will not do consumers any favors. States that eliminate payday loans immediately experience a substantial rise in costly outcomes to consumers, according to research at the Federal Reserve Bank of New York and Kansas City Fed. These studies also find that more households file for bankruptcy when payday loans are no longer available.
Until U.S. authorities can demonstrate that they have a better idea as to how to deliver necessary financial services to this large segment of our population at attractive prices that allow a fair margin for profit, they should stop trying to drive from business the lawful companies that are working night and day to serve this clear market need.
It is my fervent hope that Congress will act to curtail Operation Choke Point immediately after the elections in November. I urge the House of Representatives to promptly pass the bill introduced by Rep. Blaine Luetkemeyer, R-Mo., the End Operation Choke Point Act of 2014.
The legislation would correct the most serious abuses under Operation Choke Point by offering safe harbor to financial institutions that do business with legal payday lenders and other businesses as long as they meet certain conditions. It is my hope that banks that have cut ties with the alternative financial services industry will restore their years-long profitable relationships with legal, licensed businesses.
William M. Isaac, a former chairman of the Federal Deposit Insurance Corp., is senior managing director and global head of financial institutions at FTI Consulting, which represents many clients throughout the world, some of which have interests in the issues considered in this article. The views expressed are his own.