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Bankruptcy is a form of consumer protection, providing individuals with the opportunity to write down debt and receive a fresh start. Given the difficulties lower income consumers may face in asserting their rights through individual consumer redress mechanisms, bankruptcy may also be viewed as a substitute for the limitations of these mechanisms. While bankruptcy may be an overinclusive remedy, permitting an individual to write down all unsecured debt, it can provide a type of aggregate rough justice which balances out the interests of creditor and debtor.
Insufficient attention has been paid to bankruptcy as a site of consumer protection. Since the 2008 financial crash, many jurisdictions have introduced responsible lending provisions and indeed it may be described as a nascent international principle of consumer credit law. Bankruptcy could be one site for raising issues of responsible lending. This is not a novel suggestion since s343 of the Insolvency Act 1986 permits a trustee to apply to court to have a credit transaction entered into by the debtor set aside if it is extortionate. This provision is similar to the original extortionate bargain provision in the Consumer Credit Act 1974. Earlier Bankruptcy Acts had also contained limits on interest chargeable on creditors claims to prevent rapacious moneylenders taking the bulk of an estate, an issue highlighted by the Select Committee on Moneylending in 1890. It concluded that claims of other creditors, other than moneylenders were often swamped by the claims of the moneylender (see here at ix). The Cork Committee in 1982 proposed that the court should continue to have the power to set aside an extortionate credit transaction in bankruptcy but the provision, like the similar provision in the Consumer Credit Act 1974, seems to have had little effect in practice given its vagueness and high burden of proof. Thus the unfair credit relationship provision replaced the extortionate credit bargain provision in the 2006 reforms to the Consumer Credit Act 1974.
Under current practice the Insolvency Service may investigate the conduct of the debtor and there is always the possibility of a Bankruptcy Restriction Order or Undertaking if an individual has for example run up debts irresponsibly in the period preceding bankruptcy. A balancing provision could be introduced requiring the Insolvency Service to check for irresponsible lending and any contraventions of consumer protection and debt collection regulation. This would not require the Service to engage in fishing expeditions, but provided some sanctions (such as disallowance of a claim in contravention of consumer protection rules) existed this might be a modest contribution to achieving the goals of responsible lending, one of the objectives of personal insolvency identified by the World Bank (see here at 31). In this context the most recent US proposal for bankruptcy reform include provisions which would disallow the claims of creditors who violate Federal Financial consumer protection rules and permit the Consumer Financial Protection Bureau to appear in any bankruptcy case to enforce unfair and deceptive practices law as well as acting a Consumer Ombuds (see here and here) .
The Insolvency Service would be unlikely to willingly adopt such a role, but it could clearly be justified in terms of its role as an impartial actor who has an interest in ensuring that irresponsible lending or contraventions of credit rules do not occur. In fact the Service is unlikely to have the resources or competence to undertake such a role. Katharina Möser has shown how the interests of the Policy Unit in London, striving to be a key player in high level policy debates, was content to pursue a strategy which dismantled much of its front line functions during the austerity following the financial crash in 2008 (see here). The Service is unlikely to support any new regulatory functions, which suggests that the implementation of responsible lending in bankruptcy administration should be a significant topic in any review.
What can we learn from the history of regulation of small sum high-cost lending? Anne Fleming, in a thoughtful, carefully researched, and stimulating book, City of Debtors examines the history of regulation of ‘fringe finance’ in the US since the early twentieth century. Fleming argues that Americans are torn between concerns to protect working class and poor debtors from exploitation by high-cost credit, while still permitting access to credit, and allowing individuals to control their own financial lives. She highlights a number of continuing themes in the history of credit regulation, including regulatory arbitrage and reforms as often representing a coalition of reformer and lender groups.
Her narrative begins with progressives’ concerns at the beginning of the 20th century with salary lenders (modern payday lenders) who provided short term loans to urban workers usually in contravention of the usury laws. In response to public concern, reformers collaborated with ‘high-road’ lenders to develop the model Uniform Small Loan Law with generous price caps, as a legitimate method for providing small loans to the working class. The price caps reflected the views of reformers (The Russell Sage Foundation) that it was inherently costly to offer small loans to poor consumers and that this would attract capital to the industry. Licensing of a limited number of lenders gave stability to the industry, reducing incentives for excessive competition.
This reform represented a confluence of lender and reform interests, with lenders interested in stability and legitimacy and indeed viewing the law as constituting the industry. In order to deter unlicensed loan sharks from undercutting the law, severe sanctions were introduced for failure to comply with the requirements of the Act, including the unenforceability of any credit contracts. The need for such strong sanctions was based on the theory that low income individuals would be unlikely to challenge loan sharks through the courts.
Regulatory arbitrage and regulatory circumvention existed throughout the twentieth century. The time-price doctrine in US law (the price depending on whether the purchaser paid cash up front or over time) historically exempted sales finance from the usury law resulting in irrational distinctions between different forms of financing purchases, and offering incentives for the creation of fake instalment sales to get around usury laws. Although small loan interest rates were regulated from the 1920s , sales finance was relatively unregulated, and often did not disclose the costs of lending. Certain parts of the sales finance business became associated with practices similar to those which stimulated the English Hire Purchase Act 1938. Known as ‘chain repossession’ in the US and the ‘snatch back’ in the UK, sellers repossessed goods when individuals fell behind on a repayment notwithstanding that borrowers had repaid most of the debt, with the seller subsequently reselling the goods at a profit. The seller in the US might also take a wage assignment against the borrower which if enforced could result in loss of employment. Regulation of these practices was often justified as protecting individuals from becoming a public charge on the state.
In later eras, rent-to-own and leasing companies would attempt to circumvent the protections in retail instalment sales law. The Federal structure of the US offered further opportunities for arbitrage. Thus some early salary lenders in New York structured their loans to be governed by the law of the state of Maine which did not have usury ceilings. And in the 1970s, a bank successfully convinced the Supreme Court in Marquette National Bank of Minneapolis v. First of Omaha Service Corp. that banks, by chartering in a state without usury ceilings, could export that rate throughout the country.
The book provides a rich analysis of the subsequent decline of the Small Loan law and the development of credit law as part of the ‘law of the poor’ in the 1960s, when credit exploitation of black and minority consumers, often through door-to-door selling, was attacked under the unconscionability doctrine (see here )and the Supreme Court used the due process clause to establish minimum standards in credit enforcement. But the book also demonstrates the limits of litigation and the need for legislation, as well as the difficulties of policing the ‘fly-by-night’ operator. The book concludes by discussing the rise of the check cashers and modern payday lenders which have, according to one payday lender cited in the book, become “an adjunct of the welfare system”.
Credit has historically functioned as an informal safety net in the US (see here) with a reluctance in the US to provide state subsidised lending for the poor (although the US tax system was used to provide generous tax subsidies for middle class borrowers). Fleming highlights a belief among some groups that state provision might undermine an individual’s dignity, and result in the ‘stigma’ of welfare. Fleming concludes that the contemporary challenge for policy makers is how to regulate small sum lending in ‘a world in which welfare and small sum credit are the two sturdiest life rafts available to those drowning in the choppy waters at the edge of the economy’.
The book is a valuable contribution to debates on high cost lending even if it does not provide any solutions. It might have benefited from further engagement with theories of the role of consumer credit in contemporary capitalism. For example how would this history of high-cost credit fit with Soederberg’s description of the US as a “debtfare state” with credit as a form of secondary exploitation of the surplus population?
What relevance does this US history have for the UK?
Many of the themes identified also can be identified in UK credit history such as regulatory arbitrage and legislation representing a confluence of industry and consumer groups. In the 1950s some finance companies attempted to avoid the bite of regulation by constructing their hire-purchase agreements as hires. The recent rise of auto log-book loans exploits a loophole in protections for consumers against seizure of their goods. Reforms which represented a congruence of industry and consumer interests include the 1938 Hire Purchase Act, the outcome of a Bill promoted by Toynbee Hall (see here) an organisation working with poor debtors and the Hire Purchase Trade Association. The Consumer Credit Act 1974 was supported by both finance groups and consumer groups. In both cases these Act gave legitimacy to the credit industry as well as providing consumer reforms.
The UK never developed a Small Loans Law, although social reformers such as Dorothy Keeling urged Parliament in the 1920s to follow the US model as a solution to problems of illegal moneylending in large industrial towns such as Liverpool.
The UK also faces the contemporary challenge of regulating high-cost credit in a shrinking safety net where the poor continue to pay more (see the recent Office of National Statistics study here). The Financial Conduct Authority has capped the cost of payday loans, promises to cap the cost of logbook loans, but is not certain whether to regulate the price of home credit and overdrafts. Even with price caps, credit remains costly for individuals in these markets. The recent Treasury committee report did not identify any ‘silver bullets’ for addressing this question, although more secure employment and reasonable housing costs might be a start. It is not obvious what is the solution. The suggestion that Housing Associations might provide lower cost appliances to compete with the rent-to-own companies merits further study. The welfare state in the UK did historically attempt to protect low income individuals through social grants, and subsidies, but increasingly individuals are being left to the credit market to make ends meet.
Consumer credit law is complex partly because of regulatory arbitrage and historical attempts at circumvention. Given the incentives to circumvent regulation and the assumption that individuals would be unlikely to bring actions for contraventions of rules, legislators often inserted strong sanctions in laws such as the Moneylenders Acts, similar to the Uniform Small Loans Law. Undoubtedly this had value but it also provided opportunities for individuals to reject agreements on technicalities. Given the seeming individual injustice in these cases, judges were reluctant to apply the letter of the law resulting in tortuous interpretations. Successive generations have attempted simplification. This was the objective of the Crowther Committee which deplored the technical morass of interpretation under the earlier Moneylenders Acts. But the Consumer Credit Act 1974 carried forward significant complexity which resulted in litigation often focused on technicalities rather than substantive fairness. The FCA developed its high level principles such as treating customers fairly as a response to the technicalities of detailed rules, inviting firms to embed these in their products and treatment of consumers. The Payment Protection Insurance scandal indicated the limitations of this strategy with the finding that managers in many cases received substantial commissions for selling insurance policies to consumers.
Finally there is the role of competition. Contemporary reformers generally assume that vigorous competition in credit markets is good for consumers. Measures such as the Uniform Small Loan Law restricted competition and were criticised subsequently for doing so. In the UK the finance houses in the 1950s ran a cartel which limited competition. The Crowther Committee believed that vigorous competition would benefit consumers and reduce the price of credit. This had some truth. However, historical evidence does suggest that increased aggressive competition in credit markets often leads to a lowering of credit standards and a search for methods of increasing profits through exploitation of consumer biases. The PPI scandal in the UK occurred in a highly competitive market where competition on price, among other factors, created incentives for firms to find other methods of maximising profits for shareholders through the highly profitable sale of credit insurance.
The Treasury Select Committee published today its report Household Finances: Income, Saving and Debt and in this blog I focus on its consideration of household debt and overindebtedness. The Committee notes the debt driven model of the UK economy, the low savings ratio, and the fact that “substantial numbers of households are over-indebted or at risk of it and are vulnerable to aggressive debt collection”. The increasing significance of debt arrears to the central and local state have raised concerns about the heavy handed approach to debt collection by some of these state agencies.
On high cost credit it concludes that the apparent success of the FCAs payday loan price cap suggests that ‘there is not always a trade-off between regulating harmful credit products and denying access to credit to those who need it’. It encourages the FCA to move forward with its proposals on other forms of high-cost credit, but also observes that Parliament could move faster, given the relatively drawn out rulemaking process of the FCA and the potential for judicial review. This might be appropriate if the objective is to establish appropriate across the board norms, rather than the discrete market focus of the FCA.
On the protection of the overindebted it endorses the ‘breathing space’ promoted by debt advice agencies. But it has nothing to say about how this will fit into the existing complex of debt remedies for the overindebted.
The Committee considers the seemingly intractable problem of providing reasonably priced credit for lower income consumers–the FCA recognises that even with price controls individuals using payday loans remain lower income, with 68% struggling to repay their bills from time to time–the main reason for taking out a payday loan being to pay for living expenses. The Committee repeats previous Committee’s proposals for further development of credit unions (see here) which remain a very small part of the lending landscape, but is ambivalent about including rental payments in credit rating assessments as a means of extending access.
The Committee’s recommendations break little new ground. However, the Committee does suggest that the Treasury take greater responsibility for monitoring, reporting and discussing issues of household debt and savings including in its Budget statements, something that the Treasury is unlikely to embrace enthusiastically. In addition, the Committee’s conclusions confirm the possible sea change in thinking about interest rate ceilings in the UK, at one time shunned by regulators, (see here) but now accepted more as a useful regulatory tool.
The Committee failed to consider the role of personal insolvency and the rules on writing down debt. It seems unaware that these rules are important parts of the ground rules of the credit market. It regrets the insufficient nature of free debt advice but makes no connections between existing rules on debt relief and the need for extensive advice. Straightforward access to debt relief reduces the need for extensive assistance by debt advice agencies and can provide significant economic and social benefits. The English system is unnecessarily complex, increasing the need for objective advice. Preliminary findings from my research on Debt Relief Orders suggests that the complexity of the means testing and liability limits substantially increase the costs of advice agencies, so that bankruptcy is in fact a simpler remedy for individuals– a clearly unintended consequence of the legislation.
While the Committee clearly wishes to give an up-to-date snapshot of issues, this has the effect of obscuring the fact that the issues considered have a history, with previous reports at the national and international level. Thus it focuses on definitions of over-indebtedness as if these have not been considered before, and fails to refer to the fairly exhaustive consideration of this question by the EU in 2013 (see here). It argues for greater co-ordination between government departments but does not remember the failed attempt at an overindebtedness strategy in the 2000s (see National Audit Office).
The UK Crowther Report in 1971 was a key document in the development of consumer credit in the UK. Chaired by the mercurial Geoffrey Crowther it examined both the macro- and micro- economic aspects of consumer credit and its regulation. It legitimated the idea of consumer credit by distancing it from its seedy associations with moneylending or paying on the ‘never-never’ and provided a battery of economic arguments for the generally beneficial role of consumer credit in the economy. It provided the blueprint for the model of regulation which was carried over into the Consumer Credit Act 1974.
The report assumed that credit would function against the backdrop of a well-functioning welfare state and that the welfare state would meet the needs of poor individuals with limited resources. In a telling comment on interest rate ceilings it concluded that individuals should not have to borrow for necessities at a high rate, but that their needs should be met by social services. It recognised that the ‘poor pay more’ for credit, arguing that education, counselling and self-help through credit unions might contribute to solve the problem.
Fast forward to 2017. The poor continue to pay more for credit. Credit is used to meet welfare needs and as a substitute for welfare. The FCA finds that credit card companies adopt a sweatbox model (here) of lending to consumers. Select Committee Chairs demand a public inquiry into Britain’s ‘debt mountain’ (here ). The IMF documents the dangers of high levels of household credit in leading to recessions with long periods needed for recovery (here). The Bank for International Settlements notes that consumer credit may promote short term growth but act as a drag on long term growth (here). The extent of the latter effect may depend on the extent to which individuals are able to write down debt quickly. So that long debt repayment programmes, an increasing feature in the UK, may hamper economic recovery.
The FCA has undertaken significant initiatives since it took over consumer credit regulation in 2014. Price controls have been introduced on some high cost products, an approach traditionally shunned by UK regulators, and affordability rules on mortgages have had some effects. However it has also indicated that it does not have easy credit solutions for generally lower income individuals and those on unstable incomes or social support.
Given all these findings a new Crowther report is desperately needed in the UK along with the search for the appropriate macro- and micro- policies for consumer credit and defining its relationship to social welfare policy.
The ‘sweatbox’ model of credit card lending was set out in a well-known article by Ronald Mann in 2007 (here) . Credit card companies through the use of sophisticated data could make substantial profits from individuals who had difficulties in repaying or were financially distressed. Although certain of these accounts would be written off, the overall profits from the various fees and costs levied on individuals who are locked in to an existing lender and struggling to repay were substantial. This sweatbox model benefited from the 2005 reforms to US bankruptcy law which delayed the ability of individuals to file for bankruptcy, extending the time an individual was in the sweatbox of increased financial distress.
Recent studies by the Financial Conduct Authority suggests that the sweatbox model is alive and well in the UK (here and here). The Authority highlighted two issues. First a significant group of borrowers carry potentially problematic debt for a number of years with some making repeated minimum payments. Second, they identified a higher risk group who move swiftly from acquiring a credit card into potentially problematic personal debt. A quarter of cards opened in 2013 in this market segment were in serious or severe arrears a year later. Over 20 percent with serious arrears did not have an active card in 2012 suggesting a ‘rapid descent into arrears’. The FCA noted in an understatement that these data raise problems about the affordability assessments which companies are required to undertake of potential customers. A product which results in a failure rate of 25 percent would normally not be permitted on the market.
These findings on the use of credit cards must be set in the economic context of the UK with relatively stagnant real wages for many, insecure employment and currently the lowest savings level (3.3 percent) since 1963. Many writers have underlined how loans may substitute for stagnant wages but that this cannot be a long term fix for the economy.
The FCA propose several behavioural remedies for consumers and earlier intervention by creditors to address persistent arrears. However the ability to write-off debt swiftly would provide a way out for debtors and complement other techniques such as responsible lending. Unfortunately the complexity of current debt write down procedures (IVAs, debt management programmes, bankruptcy, Debt Relief Orders) in England and Wales make this more difficult. A damning report by the FCA on the debt advice industry (here) indicates that advisors often did not give balanced information about insolvency alternatives.
Credit card use raise wider questions about the contemporary role of credit in the UK. The governor of the Bank of England introduced a recent financial stability report with a concern about existing vulnerabilities from high and rising UK household indebtedness. On April 4 the Bank of England Financial Policy Committee noted the continuing rapid growth in consumer credit (here). At the same time the respected Institute for Fiscal Studies reports that based on the Autumn 2016 budget statement real wages will, remarkably, still be below their 2008 levels in 2021. One cannot stress enough how dreadful that is – more than a decade without real earnings growth. We have certainly not seen a period remotely like it in the last 70 years’
The Institute of Fiscal Studies concluded also that middle income families with children are no longer so different from the poor: almost half middle income families are now renters (home ownership in the UK has reduced from 72 % in 2007 to 64% in 2016 ) and middle income families with children get 30% of their income from benefits and tax credits. This means that credit use is likely to increase as middle to lower income earners use it as a defensive strategy to maintain living standards . Austerity also means individuals having difficulties with current commitments such as utilities and council tax, described by the Institute of Fiscal Studies as a tax ‘deliberately regressive in design’.
These conditions fuel the growth of sweatbox lending and the resulting household misery for some. Solutions may require action at micro- and macro- level. But there is no doubt that action is necessary.
Damning report on debt management advice by Financial Conduct Authority–need for comprehensive review of insolvency alternatives
The FCA published on Thursday 25th June a damning thematic review on the quality of debt management advice, concluding that the quality of advice was of an ‘unacceptably low standard’. Advisors often did not make an adequate assessment of individuals’ revenues and expenditures or give balanced information about insolvency alternatives. For example, they often reinforced customers’ initial reluctance to consider bankruptcy and played on misconceptions about bankruptcy to deter them from this alternative. The FCA reported ‘many instances where customers were recommended very long-term debt management plans (often many decades…) when debt relief solutions are likely to have been more appropriate but adequate information and advice was not provided”(para 4.55). In one case a debt advisor failed to correct a debtor’s misconception about the effects of bankruptcy and recommended a debt management plan lasting 125 years! Firms often had incentive structures for selling debt solutions.
The study was primarily of the fee-charging debt management industry but it was also critical of those firms providing free debt advice to consumers, indicating that there was ‘scope for material improvement’.
These findings are perhaps not surprising given the continuing concerns expressed about practices by some debt management companies by Parliamentary Committees and the Office of Fair Trading. Studies in other countries have raised similar concerns. In a recent article Stephanie Ben-Ishai and Saul Schwartz studied how not-for-profit Credit Counselling Agencies in Canada gave advice to individuals with debt problems. Using carefully scripted mystery calls to credit counselling agencies Ben-Ishai and Schwartz found that the agencies surveyed did not present the options for dealing with a debtor’s financial in a complete and impartial manner and did not present bankruptcy as a viable option. The focus was on ‘fitting the caller into the requirements’ of a debt management plan. They concluded that although the agencies portray themselves as debtor-friendly they operate rather as collection agents.
A fundamental concern in England and Wales raised by the FCA report is whether these practices by debt management companies are undermining public policy on debt relief by steering individuals to debt management plans rather than permitting individuals to make a ‘fresh start’ through bankruptcy or a debt relief order and becoming productive again. Joseph Spooner and myself have commented elsewhere on whether England and Wales has struck the right balance between the wide variety of repayment plans, sometimes lasting many years, and the straight discharge of most debts. Almost one-third of Individual Voluntary Arrangements fail to complete. Many individuals may choose a repayment plan because they assume it will be better for their credit rating (and they may be able to retain their home) but credit reference agencies make little distinction between bankrupts and those who have been on repayment plans. The complexity of the English system with its many alternatives also creates difficulties for individuals choosing the best option, and increases the power of private and public intermediaries in the system, whose financial incentives may not align with public interest concerns.
A ‘very intrusive proposition’ . That was the verdict of the Financial Conduct Authority in early October 2013 on price controls for payday loans (see para 6.71 of Detailed Proposals for the FCA regime for consumer credit ). The FCA was forced almost immediately to change course and implement this proposition when George Osborne directed the agency to introduce price controls on payday loans (see for details the Financial Services (Banking Reform) Act 2013 s131). This requires the regulator to determine how to establish a price ceiling and to conduct a systematic analysis of the consequences of such a ceiling. The response by the FCA is a watershed in policymaking. It is the first time that a UK ‘expert’ agency (such as OFT, FSA, Competition and Markets Authority) recommends interest rate ceilings for credit and makes the case for them based on an evidence based, cost-benefit analysis.
Why have UK technocrats and policy makers historically been reluctant to recommend interest rate controls on credit?
It is not simply a story of the political influence of interest groups, but reflects ideas about credit regulation with a long historical pedigree. Usury laws were repealed in the UK in the mid 19th century under the influence of the ideas of Jeremy Bentham. In the late 19th century the UK government rejected the re-introduction of price controls on moneylending–in response to public outrage about the practices of moneylenders. The Moneylenders Committee rejected ceilings in 1898 because ‘interest rates may not be the best measure of the cost of small loans, different conditions are applicable to different types of loans and ceilings would be circumvented’. Instead of price controls extremely broad powers were conferred on judges to hold a bargain to be unconscionable. This measure had little impact on working class moneylending after the First World War in many industrial cities and in 1927 a presumption was introduced that a loan was unconscionable if it exceeded 48%. But the courts did not use this as a price ceiling and upheld higher charge unless there was evidence of advantage taking. In any event the main working class credit was hire-purchase which because it was not technically a loan, was not subject to the Moneylenders Acts.
The modern story begins with the Crowther committee which reported in 1971 and which provided the ideological and practical foundations for the Consumer Credit Act 1974. My research in the archives of the Committee show that the initial draft of the relevant section of the report was written by legal academic Roy Goode who proposed the abolition of price ceilings. Ultimately, however the issue was controversial within the Committee and it maintained the presumption that 48% was unconscionable. However when the Conservative government introduced the Consumer Credit Act 1974 ceilings were abolished and in its place an ‘extortionate credit bargain’ provision substituted. This vague standard which imposed a very high standard of proof on a consumer proved to be a useless form of market regulation. Given its uncertainty and dependence on private action it had little regulatory bite.
The Labour government of 1997 had contained an electoral pledge to address problems of loan sharking as part of a review of the Consumer Credit Act 1974. Debt on our Doorstep mounted a sustained campaign to introduce ceilings on high cost credit. An attempt was made to introduce amendments during the Parliamentary process leading up to the 2006 amendments but failed to gain acceptance. The government based its resistance partly on a comparative study by Policis which had been commissioned by the relevant department. This study argued that ceilings in France and Germany had resulted in significant exclusion of debtors from credit and higher levels of illegal lending, as well as channelling individuals to use inappropriate credit products designed for mainstream consumers. This study remains controversial and has been critiqued. Resistance to a price ceiling also found support in a coalition of mainstream consumer groups, advisory agencies and academics who wrote a collective letter of opposition to price ceilings to the House of Lords Committee considering the Bill. Gerry Sutcliffe, then Undersecretary at the DTI claimed in Parliament that a new ‘unfair credit relationships’ test which permitted a court to look at all the circumstances of the contract would substitute for price controls. In his words ‘I am very confident that the unfairness test …will work and that there will be no need for interest rate caps’. The new ‘unfair relationships’ test has in fact had little, if any, impact on controlling the price of credit.
The continued growth of payday lending after the Great Recession of 2008 with jaw-dropping APRs in the thousands, and the public campaign of Stella Creasy MP for Walthamstow and Damon Gibbons of Debt on our Doorstep continued pressure for the introduction of ceilings. The Select Committee on Business Innovation and Skills in 2012 suggested that the government should consider a cap on interest rates. The government attempted to defuse the situation by commissioning another study of the impact of price ceilings, conducted by the Bristol Personal Finance Research Centre. This report was unable to provide definitive advice on the impact of ceilings although it did conclude that individuals denied access to payday loans would be unlikely to use illegal lenders. Meanwhile the OFT, having found substantial non-compliance with statutory obligations in the payday loan industry, referred it to the Competition Commission which produced very useful information on the industry but a set of unimaginative proposals which had not worked with the home lending industry. I commented on this here.
Many ‘experts’ in the UK including civil servants in DBIS, the OFT and the FSA have been unenthusiastic about price controls as an effective method of regulation of high cost credit. And mainstream consumer groups have also been reluctant to support ceilings. Which? (then the Consumers’Association) was lukewarm in support of them as long ago as its submission in the late 1960s to the Crowther committee. This stance may partly reflect an ideological aversion to limiting consumer choice, even if that choice is to purchase high-risk credit, or the influence of neoclassical economic models. In addition the spectre of the loan shark has haunted UK discussions on high cost credit with the argument that those denied access to the legitimate high cost credit market would be forced to enter the unpleasant world of the illegal loan shark. A heavy burden has existed therefore over the past 25 years on anyone proposing price controls (see discussion here). It might be said that there was a dominant coalition of regulators, mainstream consumer groups and ‘experts’ who weaved an influential narrative about the dangers of interest rate ceilings. It was not surprising therefore that the FCA, which inherited the conduct of business jurisdiction of the FSA, would initially set its face against price controls using the time-worn mantra that ‘more research’ was needed before price controls could be contemplated.
The recent FCA consultation paper is therefore a watershed. It may herald a change in regulatory thinking.
The FCA proposes a limit of 0.8 percent per day with a total cost of credit limit of 100% of the amount borrowed. A loan of £100 for 30 days would thus cost £24. Default charges will be capped at £15. The FCA estimates the impact on consumers to be lower prices for those eligible for loans under the new system but 11% of individuals who would currently qualify will be excluded from the payday loan market. The FCA argues that for most of this group payday loans are not beneficial. Based on existing studies (Bristol PFRC and Competition and Markets Authority) and their own analysis they do not think that those unable to obtain payday loans will turn to illegal moneylenders. Fewer than 5 percent of people turned down for high cost credit had considered using an illegal moneylender. The impact on the payday loan industry of the ceiling would be a consolidation with only three or four firms operating successfully.
The FCA is to be complimented for engaging in comprehensive data analysis as part of its cost/benefit analysis. They claim to have undertaken ‘the most extensive analysis undertaken by a public body when setting a price cap for credit’ obtaining substantial data from firms, Credit Reference Data on successful and unsuccessful applications, and a consumer survey of individuals who applied for a loan. With these data they were able to model the effects of a cap on profits and access as well as evidence of harm. In particular they compared the experience of those who just qualified for a loan with those who marginally failed to obtain a loan. For the former group there was a greater than 40% chance that an initial loan would not be repaid, 41% of borrowers surveyed regretted taking out a payday loan and analysis of Credit Reference Agency data indicated that using payday loans increases the likelihood of missing payments on other debt. Although the loan seemed to solve problems with an overdraft in the short term, this group were more likely to exceed their limit after three months.
Several issues arise from the proposals.
First, the proposals are restricted to short-term loans(under 12 months) where the APR is over 100 percent. Unauthorised overdrafts, doorstep lending (home credit) are excluded from the proposals although their costs may be similar to or higher than the cost of a payday loan. The question is how far to extend the regulatory role of interest rates. Apart from technical issues of regulation here there are political challenges. It is one thing to take on the payday loan industry which hardly has a positive public image or strong political influence. It is quite another to take on the British Bankers Association or UK Cards Association with their ability to finance extensive expert reports in their defence, seek judicial review of any proposed change, and wield their substantial lobbying influence.
Second, the consolidation of the industry with price controls may lend greater legitimacy to the high-cost credit market. However few believe that high-cost credit is a desirable method to borrow. Supporters of ceilings argue that a rejuvenated credit union movement should fill the the need being met by payday loans but credit unions have had a difficult time taking off in the UK. I discussed this problem here. The real challenge is the development of a credit system which is not regressive or reducing the extent to which individuals must use credit for meeting basic needs.
Third, experience in other countries has demonstrated the influence of the industry in establishing ceilings. In Australia and some Canadian provinces this resulted in legislation which has had little effect on the industry (see here). Hopefully the careful work of the FCA will not be undermined in this way in the UK.
Fourth, lenders have incentives to circumvent the ceiling by restructuring the loans perhaps over a longer period, or go offshore. The FCA indicates an awareness of these issues which will require continuing monitoring.
Finally, one question is whether the Authority would have countenanced price controls in the absence of the political intervention by George Osborne. It seems unlikely given their initial consultation paper. This raises questions about the deep assumptions or ‘world views’ which guide the thinking of ‘expert’ agencies. It also raises the relationship of technical expertise to political decision-making. Much policy making is supposed to be ‘evidence driven’. This is indeed a good idea. But powerful interest groups are able to buy much more expertise from management consultants than diffuse groups such as consumers.
Two recent interesting events occurred in the regulation of payday lending in the UK. First, the provisional findings of the Competition and Markets Authority (formerly Competition Commission) investigation into payday lending. The Authority’s research provides a wealth of carefully documented data on the industry and users of payday loans; that they are more likely to be male, in full-time work, younger than the general population, often using the loans for living expenses and as a response to an unexpected change in income. They are not the poorest consumers with median incomes of £16,500. The average consumer takes out 6 loans a year with repeat business accounting for 80 percent of new loans. The industry is dominated by three large lenders, Cash Euronet and Dollar Financial (both US owned) and Wonga.
A central conclusion of the Authority is that because of competition failures lenders have been making supranormal returns : the average return on capital of the major lenders being ‘high and in some cases exceptional’. The provisional remedies proposed include : a trusted comparison website, improving consumer awareness of additional charges, helping consumers to assess their own creditworthiness, periodic statements of the cost of borrowing, and measures to increase the transparency of lead generators. The Competition Authority has been here before. After its investigation of home lending it proposed a not dissimilar set of remedies to make the market work better. These remedies had a very modest impact on the market. The report is therefore disappointing in its response.
The second is the revelation that the payday lender Wonga between 2008 and 2010 was sending debt collection letters from fictitious law firms threatening further legal action if the overdue loan was not repaid. As the Financial Conduct Authority (which succeeded to the investigation initiated the OFT) notes ‘this practice was adopted with a view to maximizing Wonga’s collections by unfairly increasing pressure on customers. Charges were added to customer accounts before and/or after these letters were sent out’. This practice appears to be a breach of the Consumer Protection from Unfair Trading Regulations in relation to consumers, licensing rules for credit companies, and more generally section 40 of the Administration of Justice Act 1970. The Financial Conduct Authority (FCA ) required Wonga to establish a consumer redress scheme overseen by an independent entity under section 166 of the Financial Services and Markets Act 2000.The expected compensation is over £2million to approximately 45,000 customers.
The practice of using misleading letterheads to unfairly threaten debtors is not new. Section 40 of the Administration of Justice Act 1970 was enacted because of extensive evidence presented to the Payne Committee on the Enforcement of Judgment Debts of the use of misleading techniques at that time such as the ‘blue frightener’—debt collection letters written to resemble court documents. The Wonga case demonstrates that we cannot assume that companies learn from the past or will comply with widely known legislation unless strong regulation exists to ensure that the ground rules of a fair marketplace exists.
With the growth of inequality payday lending is an example of the extent to which individuals trying hard to make ends meet–some of whom may be part of the new precariat –borrow money at high cost from high income investors or savers. Borrowing can help to smooth consumption needs but this form of lending is problematic if it is compensating on a continuing basis for insecure and stagnating incomes. Payday loans are a symptom of broader economic problems associated with an economy of unequals driven by private debt. Effective regulation of the industry should therefore be only one part of both analysis of the role of consumer credit institutions in contemporary society and measures to reduce inequality.
The Guardian notes that it is the fiftieth anniversary of the establishment of the first credit union in England. Developed primarily in West Indian communities as a response to discrimination by the mainstream financial sector they drew on the ‘partner’ model of saving which existed in Jamaica and other Caribbean countries. It was not until 1979 that a proper legal framework was introduced. Although the Credit Unions Act 1979 was described by the Observer as ‘an acorn from which a veritable grove of credit union trees will grow’ credit unions remained a tiny part of the lending landscape in England and Wales. The Griffiths Commission in 2006 indicated that most credit unions have less than 200 members, lacked modern management skills and suffered from the image of being the ‘poor man’s bank’. Legal restrictions on the scope of membership (the requirement of a common bond) limited their growth and in 2012 there were only about 400 credit unions in the UK serving under 1 million individuals.
Legislative reforms have made it easier for credit unions to grow and the Coalition government is committed to promoting the growth of the mutual credit sector hoping that it might provide an alternative to the high-cost loan market. Credit Unions however continue to represent a very small part of the UK credit market. There is also the paradox that if credit unions grow to become more ‘modern’ they may lose their community and social orientation and become more like mainstream financial institutions.
A good question is why mutual credit institutions did not take root in England when they did in countries such as Germany, Ireland and Canada. The Crowther Committee on Consumer Credit reported in 1970 that ‘the principle of mutual aid has never taken such strong roots in the credit field in Britain as it has in other countries’.
The new Financial Conduct Authority has published a report on factors contributing to debt problems. Change in individual circumstances and high levels of existing debt are central factors. Others include lack of savings, and lack of confidence in managing financial products. Low income individuals are more vulnerable to these risk factors and have higher debt-to-income ratios than other groups. The FCA therefore conducted qualitative research on attitudes and uses of credit among individuals with low incomes (bottom 10-15 percent of household income). The research identified three groups: “survival borrowers”; “lifestyle borrowers” and “reluctant borrowers”. The first two groups used primarily low-income credit such as home credit, rent-to-own, and catalogues. The last group who had faced income setbacks and were struggling to manage credit, would ‘reluctantly’ access mainstream credit such as overdrafts and credit cards.
The research is part of FCA work on high cost short-term credit, problems with credit cards, overdrafts and log book lending, and debt management. The paper represents an ongoing discussion on the concept of “vulnerability” in credit relationships–a concept which the report admits is hard to define. They define a vulnerable consumer as ‘someone who, due to their personal circumstances, is especially susceptible to detriment”. This does not take one much further since it might include personal characteristics (impulsiveness, lack of confidence) particular circumstances or structural factors (low income).
A number of previous policy studies exist on the vulnerable consumer by for example the Office of Fair Trading and Consumer Focus and modern concern about the high cost credit for low-income consumers goes back to the famous books by David Caplovitz, The Poor Pay More (1963)and Consumers in Trouble: Debtors in Default (1974). The continuing problem is that credit is generally a regressive product i.e. the more income and assets you have the less you pay.
The FCA might find some assistance in the recent book Scarcity by Sendhil Mullainathan and Eldar Shafir. They suggest that lower-income consumers have similar behavioural biases to other consumers but that the pressures of poverty make it difficult to focus, resulting in a ‘tunnelling’ of vision. The poor are often as well-informed as affluent individuals but they have much smaller room for errors in decision-making and therefore must make better quality decisions. The many pressures on their time mean that they are more likely to be myopic in decision-making and not attentive to long-term costs. Mullainathan and Shafir refer to the problem as an absence of ‘bandwidth’ –represented by scarcity of money, unpredictability of income, and lack of buffers. Policy solutions might change the institutional context of lending along with measures which radically reduce the costs of decision making. Mullainathan and Shafir’s focus on the context of decision making provides a better explanation of vulnerability than individualistic explanations which ‘assume that the problem lies with the person’ and imply policies to change the consumer rather than the institutional framework.