The government yesterday announced major plans to clamp down on the practices of payday loan companies like Wonga. Although sensibly deciding against a cap on interest rates, restrictions on advertising will be introduced, and firms will be asked to draw up a code of practice. In a separate announcement, the Office of Fair Trading threatened to take away the licenses of payday lenders if they fail to change the way they operate.
But even if you don’t agree that consenting adults may rationally enter a voluntary transaction to tide them over hard times, tightly regulating an undesirable action isn’t necessarily the best way of solving it. In fact, it could make the situation for vulnerable people much worse.
Restricting payday lending will likely harm the very people it intends to help – the poor. Most attacks on payday loans, for instance, cite truly eye-watering rates of interest. But these figures are misleading. They are annualised percentage rates (APR), which are only useful means of comparison if a loan is repaid over a longer period.
Indeed, payday loan rates aren’t really interest rates at all. The administration costs of these tiny loans are included in the quoted rate. A £100 loan for two weeks, for example, with a set-up cost of £5, would have a quoted APR of 256 per cent, even if the interest charge were zero. In any case, loans from payday lenders are almost always paid off over a short period (typically one to two weeks), so the actual amount of interest paid is in most cases nothing like that suggested.
Crucially, loans of this kind are intended to provide cash over the very short term – they are a mechanism for letting people without access to other finance get liquidity. And this is done on the basis of the only kind of security many poor people have – future income from employment or personal possessions.
And restricting access has been found to have devastating effects. The Department for Business, Innovation and Skills undertook research of restrictions to payday lending back in 2004. It found that Germany and France, which both have interest rate caps, had around five times the level of complete financial breakdown (like bankruptcy) among people who had trouble with debts.
The same study showed that an absence of high interest payday lenders would make short-term cash flow problems more serious and harmful than they otherwise needed to be. The use of illegal loans was found to be much greater in France and Germany, at nearly three times the UK figure. If cash is needed in the short term to meet a utility bill, for example, it’s far better that liquidity is provided by a payday lender than by a truly unsavoury loan shark.
All the evidence suggests that, by restricting legitimate payday lenders like Wonga and its competitors, you are not helping the poor and vulnerable. You are creating troubles that could make the poor’s difficult financial position even worse.
This article originally appeared in City AM.