When Payday Loans Die, Something Else Is Going to Replace Them

For years, the word most closely associated with payday loans has been predatory. These loans have been derided not just for how expensive they are, or how they tend to push borrowers into a series of recurring loans, but also because of who they target: poor and minority consumers who have few other banking options. New regulations released by the Consumer Financial Protection Bureau this month will seriously curb the supply of the most dangerous and well-known versions of payday loans: small in amount, high in fees, with repayment periods of only a few weeks.

But the regulations will do little to address the other side of the problem: consumers’ demand for small, fast, easy-to-obtain loans. Solving that problem, while ensuring that new predatory loans options don’t pop up, will fall to the financial industry and state legislators—who’ve struggled in the past to protect financially vulnerable Americans.

The new CFPB payday rules focus on payday and auto-title loans that require repayment in less 45 days or less. Among the stipulations, the regulations require lenders making such loans to assess a borrower’s ability to repay (based on factors such as income and housing costs), set limits on how many times a borrower can rollover a loan, and prevent lenders from continually trying to automatically debit from a borrower’s account. Together, the rules will help curb some of the most abusive and dangerous practices when it comes to small, very short-term loans. But what they don’t do is create new or safer products to take their place—nor do they force financial institutions to do so. And that means that the millions of Americans who use traditional payday loans will now have to turn to other, potentially dubious sources.

Some of those options are already out there, and won’t be covered by the CFPB’s new rule, says Nick Bourke, the director of the consumer-finance program at Pew Charitable Trusts. According to Bourke, many of the same payday and auto-title lenders that will be shelving shorter-term loans ahead of the CFPB’s onerous new rules already have other loan options available. And they’re available in about half of all states. “The market has already shifted greatly toward longer loans, and there’s a lot of danger ahead because that market is essentially unregulated,” says Bourke. “In some states, like Ohio, lenders can easily shift to high-cost, harmful installment loans. We’re just going to see a lot more of that unless the state lawmakers fix it.”

To prevent that, Bourke says, states could mandate that small and installment loan options include affordable repayment structures, reasonable repayment times, and lower fees. That’s an option that has already been implemented in some states such as Colorado, and one that might work elsewhere.

Dennis Shaul, the CEO of the Community Financial Services Association of America, which lobbies on behalf of small-dollar, payday lenders, is, unsurprisingly, critical of the new rules, which he calls “arbitrary” and “inconsistent.” For example, he argues with the metrics used to determine ability to pay, saying that traditional measures are inappropriate for customers who don’t have many of the traditional requirements for credit. And he says that limits placed on number of loans per year won’t actually protect consumers, but instead place arbitrary limits on their ability to get money when they most need it. Shaul says that while he’s theoretically not opposed to a regulation of some kind, he finds this particular rule bad and unnecessarily punitive—for both borrowers and lenders. “One of the things that CFPB doesn't seem to get is how many people in this country are served by no institution,” Shaul told me. “They’re simply out there with a need for credit, and nothing they can rely on.”

Shaul’s not a neutral party, of course. The industry he represents benefits from protecting payday lenders, whose profit model would be seriously hurt by a new regulation. But he’s not the only one with concerns about how short-term payday loan borrowers will cope once the market tightens.There are few places for poor, underbanked Americans to turn when they’re in need of a couple hundred dollars in a pinch. In the past, many traditional banks have said that the risk and cost of underwriting small-dollar loans simply isn’t worth it: Small loans, coupled with borrowers with low incomes and spotty or nonexistent credit history, don’t really appeal to large, profit-seeking banks.

Payday lenders were able to fill that gap and turn a profit by charging high fees within truncated repayment periods. The fact that borrowers were typically those least able to repay under either of those conditions created insidious cycles of debt, in which a delinquent loan would lead to high fees and more loans, which would in turn lead to more debt. But in exchange for the exorbitant costs, borrowers got small amounts of money immediately—with few requirements. For many poor Americans, who have few resources in an emergency, the loans were often crucial.

One of the main alternatives provided by credit unions is the Payday Alternative Loan—which allows federally backed credit unions to provide their members with small loans in amounts ranging from $200 to $1,000, with repayment terms of one to six months. But when you compare the accessibility of PAL loans to the demand for payday products, it’s clear that they can’t meet the need. In 2016, only about 20 percent of the country’s fewer than 4,000 federal credit unions offered the loans. And to get one, a borrower must be a member of a credit union for at least a month, and sometimes complete a financial-education requirement in order to fulfill a loan application. That’s an imperfect swap for many of the 12 million Americans who use payday loans each year to receive an instant cash infusion.

One possibility when it comes to curbing dangerous loans is having traditional institutions such as banks and credit unions provide more and better alternatives. As Bourke and many others have noted, these operations are often flush enough to offer small-dollar loans at much cheaper prices than payday lenders—which often operated on very thin margins. But in order to do that, these institutions would need to have an incentive, or at least clear rules about how to structure small-dollar loans without getting in trouble with regulators. “These aren’t moneymakers for credit unions,” Dan Berger, the CEO of the National Association of Federally-Insured Credit Unions (NAFCU), says about small-dollar loans. “It’s not that attractive.”

In order to get banks and credit unions on board, they will need to be able to process the loans quickly and cheaply—by automating their underwriting, for example. And to do that, they need clear rules about how federal regulators want the financial sector to deal with small-dollar loans. The CFPB kept their regulations very specific, so that they would target payday lenders but not prevent more-traditional entities from making smaller loans. But the actual work of outlining how those loans might work falls to regulators outside of the CFPB such as the Federal Insurance Deposit Corporation (FDIC), the Office of the Comptroller of the Currency (OCC), and the National Credit Union Administration (NCUA) (the agencies declined to comment about any forthcoming plans for small-dollar loan guidance).

Ryan Donovan, the chief advocacy officer at Credit Union National Association, says that he’s hopeful that with some help from NCUA, credit unions will be better prepared to fulfill the need for small-dollar loans—a practice that’s central to their mission. “Credit unions were created about 100 years ago to provide this type of credit. They were the original small-dollar, short-term lender.” In order to do that, Berger, of NAFCU, says that their regulator might consider offering more flexibility in the rates charged on small-loans (including risk-based pricing) and the minimum requirements potential borrowers must meet. And the NCUA could also weigh in on whether or not they will consider adopting the widely discussed 5 percent suggestion—that a loan shouldn’t exceed 5 percent of a borrower’s income—when it comes to determining whether or not a loan is affordable.

For banks, the calculations might be tricker. While credit unions are not-for-profit entities with a mandate to serve their communities, banks are profit-seeking businesses owned by shareholders. In 2008, the FDIC embarked upon a two-year pilot program with nearly 30 community banks to see if small-dollar lending could be profitable. The program was relatively small, with only around 450 offices in 27 states participating. The results were encouraging, but not definitive. Only some of the banks were able to profit from the loans, though many banks claimed that they remained interested in offering small loans for the purposes of building client relationships. It’s not clear if bigger banks with fewer ties to specific communities might feel similarly.

It’s likely that creating a larger market for small-dollar loans that would produce profit, without running afoul of CFPB rules, would require some new guidance, and perhaps regulation from bank regulators. In addition to the FDIC, experts say that the OCC could play a critical role in fostering a safe and flexible framework for small loans. Whether or not that happens might have a lot to do with the comptroller of the currency, says Paul Bland, the executive director of the advocacy group Public Justice.

Right now, the agency is in the midst of a leadership change. The interim head, Keith Noreika, has held his position for longer than the allotted 130 days, spurring criticism from some Democrats. And in that time he has sought to roll back regulations, not introduce new ones, and has maintained a contentious relationship with the CFPB. In the meantime, it’s unclear how Trump’s pick to take on the role full time, Joseph Otting, might handle the administration’s mandate to decrease regulation.

Though it’s possible that Republicans will attempt to use the Congressional Review Act to quash the payday rules before they go into effect, it’s unlikely that the attempt to squash the regulation will gain much traction. Since the CFPB reworked their proposal in a way that left the loans of credit unions and traditional financial institutions untouched, the dissenters to the final rules have dwindled. That gives regulators on both the state and federal level nearly two years to figure out how to bridge the gap between the need for small-dollar loans and the lackluster options. That’s enough time to come up with some potential strategies to usher former payday devotees into newer and safer products, but only if there’s the political will to do so.