Last month, there was chatter that federal regulators could revisit policies and regulations that touch on small-dollar lending. Jelena McWilliams, chairman of the Federal Deposit Insurance Corp., said draft changes to the Community Reinvestment Act, a key piece of legislation governing small-dollar loans, will be released over the coming months, symbolizing a larger resolve by policy makers to restructure the small-dollar lending industry.
Legislators and others in the political arena have also become increasingly vocal on alternative lending. Congress recently held a hearing to try find ways to curb the spike in predatory lending by small-dollar loan providers, a trend that has been on the rise in recent years. This also comes in the face of a proposal by Sen. Bernie Sanders and Rep. Alexandria Ocasio-Cortez to cap consumer interest rates at 15 percent, which is almost half of the 36 percent cap for military personnel that was instituted by the Obama administration.
And it’s not that there’s aren’t enough restrictive laws and policies within the country. According to alternative loan data available online, title loans, for instance, are only allowed in 20 states across the US, with tight laws and policies governing this subset of small-dollar lending.
The small-dollar lending industry plays a vital role in financial ecosystems around the globe. Shunned by banks and other traditional lenders who often abide by strict, often limiting lending rules, consumers have become reliant on the nonprime market for many of their financial needs. 40 percent of Americans, for instance, wouldn’t be able to cover a $400 emergency out of pocket. And with credit cards unavailable to many in the country and banks turning down these small loans, small-dollar lending becomes the only option for individuals and small businesses that need access to credit.
Evidently, the importance of the small-dollar lending industry can never be understated. This is why the spirit and nature of any new legislations or amendments to existing policies should take into account the potential for negative disruption that would accompany any restrictive cap laws or policies.
One of the main reasons why capping interest rates for small-dollar lenders would be detrimental for consumers and the industry in general has to do with the high cost of making these loans available. At the center of small-dollar lending is a consumer base that typically seeks short-term loans of small amounts. So, for a three month $200 loan with an interest cap of 6 percent, for example, the lender would only make about $3 in accrued interest over this period, which would make it impossible for the lender to sustain their business.
Additionally, there’s the element of risk, something that bears heavily on interest rates applied by small-dollar lenders. Consumers who seek small-dollar loans often lack a proven credit history, making them risky borrowers for traditional lenders. Small-dollar lenders use fintech to go beyond traditional credit scores to assess a borrower’s creditworthiness, going beyond what traditional lenders like banks would be willing to use.
And because of their riskier credit profile, interest rates must be high if small-dollar loan providers are to take on this risk, something that speaks against efforts to cap interest rates for this segment.
To that end, policy makers, advocates, and legislators should push for a healthy, balanced regulatory environment that does enough to ensure consumers get access to the funds they need while promoting the growth of small-dollar lenders that work within the boundaries of the law. That conversation should also not be determined by how high these interest rates can go, but by the willingness of consumers to pay. This is because proponents for cap laws have always suggested that behavioral economics makes consumers susceptible to high interest loans, which apparently reduces consumer welfare, thus the need for regulation. But studies, including the famous Mann study back in 2011, continue to show that borrowers are aware and rationally appreciate the risks associated with small-dollar loans.
So, differentiating between prohibition and protection should be the main goal of any piece of legislation within the small-dollar lending industry. Otherwise, regulators and policymakers risk promoting the growth of predatory loan sharks who will be the only lenders willing to take the risk to cater for the high consumer demand for small-sum loans.