Payday lending is a financial technology that has affected the society since estimated 2mln people have taken out payday loans in UK. In this post I will explore what characteristics of payday lending make it controversial, and what are the issues of governing this emerging technology.
Payday lenders provide small cash amounts to advance customer’s salary. Payday lending is innovative in claim assessment. It uses automated algorithms that assign weights different from regular lending institutions to the information on the borrower. It results in their lending to those ranked not-so-favourably by the traditional credit agencies. But an official definition demonstrates the intricacies of payday lending: “the provision of small-sum cash loans marketed on a short-term basis, not secured against collateral, including (but not limited to) loans repayable on the customer’s next payday or at the end of the month, and specifically excluding home credit loan agreements, credit cards, credit unions and overdrafts”. The need for such a detailed definition provides insight into the issues of governance: payday lending is not a simple financial product, it is fluid to slip through the cracks in legislation and to reach the customers at any cost.
Payday lending is different from mainstream finance in the following ways:
- Traditional lenders can be reluctant to lend small amount for short-term as it would be too risky and/or unprofitable, while payday lenders cover these costs by charging a premium (i.e. making lending more expensive).
- Payday loans are available to the customers who are unbanked (i.e. do not hold a bank account or a credit card) and are not necessarily creditworthy (e.g. unemployed).
- The speed of access to funds is very high, with many payday lenders advertising that one can get their loan in 5min.
Sounds great, doesn’t it? It appears to serve a social purpose: one gets a loan bypassing the bank. However, this promise has not been delivered in a socially-directed manner, and I believe these are unintended consequences, negative features not designed but emergent from the technology. Payday lenders rely on economies of scale, i.e. their profits rise as they lend more. This undermines the principles of social responsibility and can qualify as exploitation when loans are issued to people who shouldn’t qualify as they cannot afford them and can get into deeper financial problems.
Payday lending can be beneficial to the unbanked customer who are left with no other choice when in urgent need of funds. But for most customers cheaper, hence theoretically more desirable, alternatives (e.g. pawnshop, credit union loan, and credit card overdraft) exist. It means too many people used a means of financing that they didn’t actually need to choose. Why did they do that? Because payday loans are well-marketed, easy to access, simple to understand at a surface-level, and require little paperwork. This leads to payday loans being predominantly used by certain social groups more than the others: low-income families, immigrants, cultural minorities. Any technology that deals with particularly fragile social groups should be scrutinised for potential risks they bring to these people’s lives.
The education gap in the aforementioned groups is also an issue. Research shows that customers cannot calculate the actual amount they’ll need to repay. They are also too optimistic about their ability to repay. Generally speaking, cognitive biases, lack of education in statistics and personal finance management translates into regrettable decisions to out the payday loan, or not repay it straight away.
Payday lending became a successful business because there are people who choose this service. However, this raises questions about whether our society itself is a good mechanism of regulating technology. Numerous media reports show many customers are incapable of making sound financial decisions. Perhaps then governance is needed?
In UK one of the forms of governance of payday lending industry is customer protection. UK’s Financial Conduct Authority recently passed regulations that will limit the cost of borrowing for the customers. The market met it with backlash: although most agree that it will solve some of the existent problems (deepening debt in case the customer cannot repay), the regulation may raise new issues. Such unintended consequences are potentially harmful for the customers they try to protect. It’s because FCA is reactive to existent issues and not proactive in identifying where the industry is going; it’s the failure to grasp the scope of the technology. On balance, markets react negatively to almost all regulation. This is a classic Collingridge’s dilemma of control as discussed earlier in my blog.
In the light of inability to control the technology efficiently, I believe educating more than regulating is the answer. This relies on regulators communicating the risks to the society. A more customer-centric approach is needed. It means not (only) regulating the lenders, but taming the demand, by better informing. One way to overcome challenges of educating the lenders who are generally not well-educates is nudging them towards sounder financial decisions.
Dovilė & The Emerging Technologies 