Payday lending: fixing a broken market - ACCA

76 Pages·2014·0.75 MB·English

Payday lending: fixing a broken market
About ACCA
This report analyses online payday
lending business models and
outlines a proposed framework to
be used to determine the level for
the cap on the cost of credit, which
both allows lenders to cover their
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M2 ay 2014
Payday lending: fixing a broken market
Sarah Beddows,
Independent Consultant
and
Mick McAteer,
Financial Inclusion Centre.
ACKNOWLEDGEMENTS
Thanks to Robin Jarvis, Special Adviser, ACCA and Professor of Accounting at Brunel University.
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Contents
1. Introduction 7
2. The structure of the UK payday lending market 10
3. Literature review 12
4. Data sources 13
5. Customer Acquisition Cost 15
6. Default 25
7. Rollovers and refinancing 40
8. Intensity of use 46
9. Market failure 54
10. Framework for setting the Rate Cap 60
11. Conclusion 65
12. Technical appendix 66
References 69
PAYDAY LENDING: FIXING A BROKEN MARKET 5
6
1. Introduction
In 2012 over 12m short-term cash Figure 1.1: Total UK originations (billions)
advance or ‘payday’ loans1 were
arranged in the UK. A total of £3.7bn-
worth of credit was extended in this way
and UK borrowers paid over £900m in 4 £3.709
interest and charges.2 The lack of
appropriate regulation, post-crisis £3.016
3
constrictions in traditional forms of
unsecured lending and a large
population struggling with falling real 2 £1.902
incomes have combined to create an
£1.200
attractive market for payday loans in the
1
UK. As we can see in Figure 1.1, growth £0.780
£0.508
since 2006 has been explosive. £0.330
0
A payday loan is a small, short-term 2006 2007 2008 2009 2010 2011 2012
unsecured loan with both principal and
interest scheduled to be repaid on a Source: 2006 and 2009 figures from Burton 2010; 2011 and 2012 estimates based on lenders’ financial
single date. The average payday loan is statements. All other years are interpolated.4
currently around £270 for 30 days
(Office of Fair Trading 2013b). Payday
loans represent one of the highest-cost
forms of credit available, interest
charges range from £15 to £35 per £100
borrowed for 30 days, equivalent to
between 448% and 3,752% Annual
Percentage Rate (APR). Late payment
and transmission fees further increase
the Total Cost of Credit (TCC)
associated with these small loans.
Payday loans are the fastest way to
obtain credit: first-time, store-based
loans take about an hour to process
(BBC One 2012), first-time online loans
can take as little as 15 minutes,3 and
repeat loans are even faster to obtain.
Online lenders are open 24 hours a day
seven days a week.
1. The generic term ‘payday loan’ is used
throughout to refer both to traditional payday
loans and short-term cash advance loans.
2. Estimates based on lenders’ financial
statements and Office of Fair Trading (2011a)
estimates of market shares.
4. In their Payday Lending Compliance Review Final Report, The Office of Fair Trading (2013b) appear to
3. Online lenders’ own estimates from their have based their estimate of the size of the UK payday lending market of £2.0bn to £2.2bn on ‘initial loans’
websites. only. We include all loans in order to allow comparison between years.
PAYDAY LENDING: FIXING A BROKEN MARKET 7
Those in favour of payday loans typically Credit Act and other legislation’ (Office SMALL LOANS – HIGH CHARGES
advance one of four main arguments in of Fair Trading 2013b: 2) and that
support of the product. First, the high ‘Payday lenders are also not meeting The payday lending industry’s principal
interest rates charged simply reflect the the standards set out in our defence of the high interest rates
high costs involved in providing small ‘Irresponsible Lending Guidance, charged is that they simply reflect the
sum, short term loans. Second, the low (Office of Fair Trading 2013b: 2) The high costs involved in providing small
absolute cost of each loan means they entire industry has now been referred to sum, short-term loans (see, for example,
are often cheaper than alternative the Competition Commission and the Booth 2012). This implies that their
sources of short term credit such as Banking Reform Bill will confer a ‘duty pricing policy is based on a cost plus
unauthorised overdrafts. Third, the to cap interest rates’ (HM Treasury 2013) pricing methodology.
‘bullet’ structure (principal and interest on the Financial Conduct Authority
repaid on a single date) of payday loans (FCA). The Consumer Finance Association
makes the product simple to (CFA) currently has this Industry Briefing
understand and means prolonged The level and form of this new interest regarding APRs on its website: ‘the
indebtedness is less likely. And fourth, rate cap is yet to be determined. There costs of lending this way are high. The
lenders have a clear incentive to lend are questions, however, as to whether a cost of lending someone a small
responsibly: they want to get their cap on APR alone will be sufficient to amount, eg £200, is the same as lending
money back. For its supporters, a make the payday lending market a larger amount, eg £5000. It entails the
payday loan is a useful income- function well for borrowers. In same credit checks, bank verification
smoothing tool with clearly stated particular, the potential for lenders to checks, fraud prevention checks and
terms. derive revenue from interest charges regulatory requirements including
and from default fees and interest anti-money laundering, mental capacity
On the other hand, critics assert that accrued post-default means a cap on and responsible lending checks.
the very high interest rates charged are the TCC may well be more appropriate. Underwriting 25 × £200 loans (£5,000
predatory by definition (see, for total) clearly increases the cost to the
example, Mendick 2012). They argue The purpose of this report is to develop lender 25 fold.’ (Consumer Finance
that the bullet style of repayment makes a detailed understanding of the Association 2013b)
payday loans very hard to repay and business models driving UK payday
means borrowers are often sucked into lending in order to inform the debate Similarly, Wonga.com’s founder and
a ‘debt spiral’: unable to pay back their about the level and structure of the new former CEO Errol Damelin commented
first loan they take another loan (called interest rate cap and to examine which that ‘We do small, short-term things,
‘rolling over’, ‘extending’, ‘refinancing’ other regulatory interventions may be and the cost of delivering that service is
or ‘renewing’), incurring more and more necessary to create a small-sum lending high’ (Shaw 2011). The CFA further
charges. And they are concerned that market which allows lenders to innovate argues ‘Set the rate (cap) too low and
the increasing numbers of borrowers and also delivers good outcomes for payday lenders will no longer be able to
reporting problems repaying such borrowers. This report is designed to afford the high operational costs ...
loans5 constitutes clear evidence of support the ongoing work of the thereby putting them out of business’
irresponsible lending. Competition Commission (CC) and the (Consumer Finance Association 2013b).
FCA, but it may also be of interest to
The industry’s own regulator, the Office consumer groups and, ultimately, to Determining how much ‘headroom’ – in
of Fair Trading (OFT), has found that investors. the form of profit and costs which could
‘The payday loans market is not working be reduced while still providing loans –
well for many consumers. Our review exists in prevailing business models is
has found evidence of widespread therefore now critically important in the
non-compliance with the Consumer determination of a cap that is fair both
to borrowers and lenders.
5. For example, the number of people contacting
the Consumer Credit Counselling Service (CCCS;
now called ‘StepChange’) about payday debt
more than doubled between 2010 and 2011 (Hall
2012).
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This report will examine in detail the We explore the potential for adverse Could a new framework be devised to
following areas. selection and product design to determine the level of the new rate
contribute to high levels of defaults. cap?
Do charges faced by borrowers really We outline a proposed framework for
correlate to the operating costs How profitable are rollovers? determining the level of the new rate
incurred by lenders? What are the We extend the simple model using a cap. We argue that the low elasticity of
costs involved in providing online theoretical distribution of rollovers demand exhibited by existing payday
payday loans? based on that found in the OFT’s borrowers makes a ‘cost plus’ approach
To answer these questions we construct Payday Lending Compliance Review to pricing inappropriate for this market.
a simple model using cost information Final Report (Office of Fair Trading Building on the work of the National
taken from Cash America’s financial 2013b) and find that rollovers are Consumer Law Center in the US we
statements. We argue that the level and disproportionately profitable – argue that affordability should be of
structure of advertising and marketing accounting for 200% of our model primary importance in setting the new
costs exceed income on first-time loans. business’s profits. (Rollovers are loan rate cap and that the patterns of
If this is the case then online business extensions. They are fully defined and repayment and default experienced by
models are reliant on repeat lending for discussed at the beginning of Chapter 7.) existing payday borrowers can help
their profitability. inform our thinking about affordability.
Has innovation in the form of
What proportion of lenders’ revenues charging interest on a daily basis
is absorbed by losses due to default? actually resulted in shorter, cheaper
We examine the relative riskiness of loans for borrowers?
online and retail payday lending in We construct another simple model
the UK. using revenues earned, average loan
sizes and average loan lengths taken
We develop a simple methodology to from Wonga.com’s 2011 financial
estimate the numbers of loans statements in order to examine the
borrowers have difficulty repaying, possible distributions of loan sizes and
using the percentage of revenues lengths.
lenders are willing to lose to defaults. It
is not surprising that these estimates Why is competition not working for
are broadly consistent with the OFT’s consumers and which policy options
finding that ‘...around a third of loans could improve the functioning of the
are repaid late or not at all.’ (Office of payday lending market?
Fair Trading 2013b: 2) We examine market failure and argue
that there is a risk that multiple loans
We develop an understanding of the allow lenders to finance each others’
distribution of defaults and argue that activities – more payday loans may lead
if, as the evidence suggests, elevated to more payday loans.
losses are associated with new
borrowers, this increases prevailing We also argue that existing regulation
business models’ reliance on repeat may allow ‘bad’ behaviours to be more
lending for their profitability. profitable than ‘good’ ones and that
this can lead to the crowding out of
We examine the extent to which responsible lenders.
defaults are a function of the
creditworthiness of the pool of
borrowers and the extent to which they
are the function of underwriting
standards.
PAYDAY LENDING: FIXING A BROKEN MARKET 9
2. The structure of the UK payday lending market
There are two markets for payday THE IMPORTANCE OF THE ONLINE Similarly, the OFT, consumer advocacy
lending in the UK, the retail market and BUSINESS MODEL groups, and lenders all report little
the online market. These markets have overlap between the online and retail
distinct characteristics and customer Online payday lending is a distinct customer bases in the UK. Online
bases. business from traditional retail payday lenders have reached different
lending. Online lending businesses demographic groups, attracted by the
THE RETAIL MARKET face: anonymity and speed of online loans
(and, no doubt, encouraged by high-
Payday lending first started in the UK in • lower operating costs profile advertising campaigns).
pawnbroking and cheque-cashing shops.
There are currently estimated to be • higher marketing costs – in The focus of this report is the online
around 1,800 stores providing payday particular the use of third party ‘lead market for a number of reasons:
loans as part of their product offering. generators’ – companies that
For some alternative financial providers specialise in sourcing the personal • The online market is significantly
payday lending provides a significant details of prospective borrowers larger than the store based market
revenue stream, while for others it is a with around two thirds of loans now
small part of their overall business. • higher loss rates due to greater originated online.8
difficulties in assessing
The retail market is dominated by two creditworthiness and preventing • The online market is growing faster
US companies: Dollar Financial and fraud. than the store-based market and is
Axcess Financial (both of which operate of increasing importance.9
under multiple brand names on the The online and retail business models
high street). Other retail lenders are significantly different; this is • Online loans carry higher charges
include: Cash Converters, Albemarle evidenced by the fact that successful, than store-based loans, so
and Bond/Herbert Brown (which experienced retail lenders have not prolonged use carries a greater risk
recently acquired a small online lender). always been able to make the online of consumer detriment.
Ramsdens and, until recently, H&T business model work. In the US the
(Farrell 2013), all of their operations are largest retail lender does not underwrite • Default rates among online
dwarfed by those of the big two. online loans, choosing instead to act as borrowers are significantly higher
an online broker for a competitor.6 In than among store-based
It is difficult to comment in detail on the the UK few retail lenders underwrite borrowers.10
business model driving retail payday online loans and those that do have
lending for two reasons: typically grown via the acquisition of
established online businesses.7
Most of the retail providers are privately
owned (rather than listed on a stock
exchange) making it difficult to obtain
detailed information about their 8. Evidence from lenders’ financial statements
combined with the OFT’s analysis of overall market
operations.
size and 2010 online market shares (Office of Fair
Trading 2011a).
The ‘multiline’ nature of the business.
9. Evidence from lenders’ financial statements
Retail payday loans are always offered
combined with OFT estimates of 2010 online
as part of a broader product offering, market shares. The rapid growth of online lending
there are no standalone payday lending 6. Cash America’s subsidiary, CashNetUSA.com is best illustrated by considering Cash America
shops in the UK. This means that while (formerly Enova), offers online loans marketed and Wonga.com, both of which operate exclusively
through Advance America’s website www. online and entered the UK market in 2008. In 2012
revenue streams can be categorised by
advanceamerica.net they accounted for over £1.75bn of the total £3.7bn
product, even lenders themselves find it
of credit extended – that Is over 47% of the
difficult to accurately attribute costs to 7. Dollar Financial has expanded into the UK combined retail and online markets.
online lending via the acquisition of various online
different products offered in the same
lending businesses, including Month End Money 10. A detailed discussion of levels of default in
shop. (MEM). Cash America expanded into global online both retail and internet businesses is presented in
lending via the acquisition of CashNetUSA/Enova. Chapter 6, ‘Loss rates’.
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