The Consumer Financial Protection Bureau (CFPB) published its final rule addressing so-called payday loans as well as certain other extensions of credit to consumers on Thursday. These loans are usually small, very short-term (often just a few weeks) and carry a very high effective interest rate after all fees are taken into account.
Troubles can arise for those borrowers who pay off a payday loan and the related interest and fees by taking out a subsequent loan for an even larger amount, trapping the borrower in a debt cycle they often can escape only through a personal bankruptcy.
{mosads}The stated purpose of the CFPB rule, quite simply, is to protect consumers against falling into these debt traps. Whether the rule will be effective, though, is an open question.
The rule applies to three types of “covered short-term loans:”
- Short-term loans maturing in 45 days or less
- Longer-term (more than 45 days) balloon-payment loans; that is, the loan is paid in full when it comes due or the loan agreement requires at least one substantial down payment of the loan.
- Longer-term loans with a cost of credit exceeding 36 percent that either have a balloon-payment feature or the lender is authorized to obtain repayment by initiating a transfer of funds from the borrower’s bank account.
An essential feature of the new rule is a complex “ability-to-repay” requirement. That is, it will be “an unfair and abusive practice” for banks and other types of lenders to make a covered short-term loan without the lender first making a reasonable determination that the borrower has the ability to repay the loan. The rule sets out the steps the lender must follow to make this determination.
Portions of the rule will become effective 60 days after it is published in the Federal Register; other provisions will take effect 21 months after publication. Given its complexity, full implementation of the rule is likely to be delayed and subject to numerous interpretations.
The marketplace for short-term consumer lending almost certainly will begin to change before these effective dates in anticipation of the rule’s likely effects, intended or not.
In a related move, the Office of the Comptroller of the Currency (OCC), which regulates national banks, has removed guidance it issued in 2013, which effectively barred national banks from offering deposit advances; these advances are short-term loans repaid from an upcoming electronic deposit, such as the borrower’s next paycheck or Social Security deposit.
Removing the guidance may lead to increased deposit-advance lending by banks. The OCC has listed three broad principles that banks should follow in offering deposit-advance products: soundness, risk management and reasonable underwriting.
While not cheap, in terms of the effective interest rate the borrower pays, deposit-advance loans are an alternative to borrowing from non-bank lenders subject to the new CFPB rule.
The great unknown is what will the short-term, small-dollar-amount consumer lending marketplace look like once the CFPB rule takes full effect. In particular, what distortions will emerge that are harmful to borrowers, and how will lenders lawfully try to sidestep or game the rule, to their advantage?
Almost certainly, the costs imposed on lenders by the new rule, which must be passed through to borrowers, will reduce the amount of small-dollar loans taken out by consumers.
Those effects will not be known, though, for several years. Undoubtedly, the CFPB will be forced to tweak the rule to try to deal with the perceived negative effects of these unintended consequences, which could trigger other unintended consequences.
What the rule cannot address is what will occur outside the regulated marketplace for short-term consumer loans. One perverse and undesirable effect of the rule may be to stimulate the growth of unofficial and unregulated small-dollar lending where effective interest rates are much higher, but where the borrower faces less hassle in obtaining a loan.
Carried to an extreme, the CFPB rule may spark an increase in outright loan sharking, with extraordinarily high interest rates and questionable loan collection techniques.
In various meetings over the years where rules regarding small-dollar consumer lending have been discussed, I have expressed concern about the potential that the CFPB rules may lead to increased loan sharking. I have even joked that perhaps among the advocates for these rules is the (non-existent) National Association of Loan Sharks.
My concerns about the potential for increased loan-sharking as the CFPB rule takes effect were quickly dismissed. Time will tell if that was wise.
Bert Ely is the principal of Ely & Company, Inc., where he monitors conditions in the banking and thrift industries, monetary policy, the payments system and the growing federalization of credit risk.