Today millions of Americans are stuck living paycheck to paycheck, relying on small-dollar loans to get through tough times when they are short on cash. The small-dollar credit market has attracted significant regulatory scrutiny from the Consumer Financial Protection Bureau and bank regulators, who are concerned about fees and charges that are significantly higher than traditional bank products.

The policy debate about how best to regulate payday lenders, pawnshops, auto title lenders and other small-dollar credit providers thus far has largely centered on what these products should cost. This focus results in a well-trod argument between what it truly costs to provide this type of lending and what costs are socially or morally acceptable. The debate about usury interest goes back to biblical times and has yet to be resolved. It is highly unlikely that this venue will solve it.

Instead, we should refocus the discussion back on the consumer.  Specifically, consumer groups, lenders and regulators should look at how to better distinguish between illiquid consumers who are short on cash but have sufficient means to pay these loans back and insolvent consumers who are headed toward bankruptcy and are unlikely to repay their loans.  Moving the debate in this direction could lower costs to quality borrowers while simultaneously lowering costs to the industry. Profitable and socially responsible lending would be far more likely to occur if consumers can be accurately be categorized at a reasonable cost.

Borrowers for small-dollar loans can be divided into two categories: illiquid and insolvent. Illiquid borrowershave run into a short-term problem – an unexpected emergency cost or a bad month of earnings, for example – and have a temporary need to access future funds to meet current expenses. This is a growing market, as research by Jacob Hacker at the Economic Policy Institute has shown that income volatility has doubled over the last 30 years. Illiquid borrowers are good bets to pay back a well-structured loan. However, they are willing to pay much more than their credit risk would indicate because the costs of failing to address their liquidity crises are high.

Insolvent borrowers are highly unlikely to be able to pay back their loans. Their income will be insufficient to meet their obligations. Instead, they search for sources of credit to delay the inevitable reckoning of bankruptcy, eviction, and foreclosure, among other problems. As the number of bankruptcies, repossessions, loan workouts and foreclosures indicate, insolvent borrowers make up a significant share of the market as well. Insolvent borrowers also are not very price sensitive, since they see continued borrowing as better than facing short-term consequences.

Based on this analysis, four problems stand out in setting policy for serving this market. First, it is difficult and expensive for lenders to distinguish between insolvent and illiquid borrowers. Every time a loan is provided to an insolvent borrower, it drives up the total cost of serving the market, raising the price for creditworthy but illiquid borrowers.

Second, both types of borrowers are relatively price insensitive. Illiquid borrowers are willing to pay high fees and interest rates to avoid the even higher costs of not paying their bills on time, while insolvent borrowers are willing to roll the dice at almost any price. As a result, market competition is unlikely to drive down prices as much as in other markets. 

A third problem is that since many of these borrowers already have little margin for financial error, the cost of a short-term, small-dollar loan may itself push someone over the line from illiquid to insolvent. Hence, the focus on the product’s cost is necessary to prevent consumers from going under because of the expenses associated with many small-dollar credit products. But a focus solely on cost is insufficient because it misses the key point that changes in the marginal cost of the loan are unlikely to change consumer behavior.

Fourth, reputational risk can drive respectable lenders away from this market, as well as lenders who are not seeking exceptional returns—that is, lower-cost providers. This reduces supply and competition for these services and raises consumer costs.

One clear way to improve this market would be to make it cheaper and easier for lenders to distinguish between illiquid and insolvent borrowers. Better separating consumers who are likely to repay from those who are postponing the inevitable will drive down costs for providers and increase competitive forces to lend to borrowers who need the funds and can pay back a reasonably priced product. This could potentially be achieved through the use of big data, nonconventional credit scoring or advanced computing algorithms.

Under this approach, profitable lending will be possible at lower cost to illiquid consumers, benefiting both lenders and many consumers. Insolvent borrowers may appear to be worse off, as their access to credit will be reduced. However, if these borrowers were already highly unlikely to repay and were simply exhausting all avenues before collapse, then hastening the moment at which restructuring is necessary can be a good thing. Put simply, does anyone believe that it is in a person’s best interest to be given a loan that they are highly unlikely to repay?

Shifting the debate away from product cost toward a discussion about how to better identify and serve creditworthy short-term borrowers would benefit all stakeholders. This approach should attract bipartisan support.

Aaron Klein is director of the Bipartisan Policy Center’s Financial Regulatory Reform Initiative. He served as a deputy assistant secretary for economic policy at the Treasury Department from 2009-2012.