Philip Krinks was formerly a partner in a global management consulting firm and is now training for ministry in the Church of England. An extended version of this essay is available in God and the Moneylenders: faith and the battle against exploitative lending.
Conservatives might well feel unsure how to react to the Chancellor’s cap on payday loan charges. On the one hand, it seems a departure from a belief in market solutions to market failures. On the other, (as Charlie Elphicke MP has explained on this site), international evidence suggests that a cap is an effective way to protect borrowers.
I want to suggest a way to square this circle: to see the proposed cap as one part of the response to payday lending, but one which needs supplementing by new more ethical supply of credit. Back in July, Francis Davis wrote on this site applauding the intervention of the Archbishop of Canterbury, but suggesting that credit unions could not be the only ethical source of supply. Credit Unions play an important role providing services and financial education for difficult to reach adults, and offer a unique kind of inclusion through their mutual structures. It is welcome that the Archbishop of Canterbury’s intervention is spurring local churches to add much-needed help to their expansion programme. But this will not be sufficient on its own.
To halt the rise of for-profit lenders will also require services which match them for speed and convenience, yet are offered with a different intention, and without the desire to make large profits. In this post, I will sketch out the economic challenge – and how such an social enterprise could meet it.
Problems with the supply of credit
The supply-side problems in the short-term credit market result from the underlying economics of payday lending, and the effects this has on the way credit is supplied.
When we speak of payday loans, we typically mean loans which have five characteristics: they are
- For relatively small amounts (e.g. £100-500);
- To fairly high risk borrowers (e.g. young adults on below average incomes);
- Over a short term (e.g. 3-28 days);
- Requested at short notice (e.g. on the day)
- Offered to all comers (i.e. little or no need for past relationship to lender).
Most such payday loans are offered by a small number of for-profit groups working through branches and the internet, and it is their activity which is the primary focus of current public discussion and concern. Similar products are also offered by doorstep lenders, who continue to work house-to-house via agents, and of course by unlicensed informal lenders of varying levels of salubriousness.
This definition of payday loans clarifies the basic supply-side economics: the lender’s balance of revenue and costs. Compared with other lending activities, loans of this type have the potential to be unprofitable for the lender at a typical interest rate. This is because the sum of interest chargeable on each loan at any normal interest rate is very small: the loan being a small amount, and borrowed for a very short time.
The operating costs in a lending business, on the other hand, are largely fixed. Furthermore, the loan default rate is high, with attendant follow-up costs, and write-offs are often in double digit percentage points. This is a basic reason that the costs to the payday borrower are so high: since the lender’s balance of revenue and costs is unprofitable at any usual interest rate, the rate charged needs to be relatively high compared to other credit products. The proposed cap recognises, however, that the rate does not need to be as high as currently charged by for-profit lenders.
This initial problem snowballs through a series of effects it has on the structure of supply of credit. An immediate effect of the high rates is that no-one will borrow in this way if they have an alternative source of credit. Those on middle or higher incomes typically do have an alternative: to draw on savings, or borrow larger amounts, over a longer term, or secured on some asset. These are the types of finance familiar to people on middle and upper incomes, and commonly offered by banks and other mainstream finance companies: credit cards, personal loans, secured loans (for example to buy vehicles) and mortgages. All of those offer preferable economics to the lender, so draw in more credit supply, and for both those reasons offer better rates for the borrower.
Since middle income borrowers do not borrow on a payday basis, and lower income borrowers do not have the alternatives, a gulf opens up between the two products. That is reinforced by a gulf between two groups of lenders. Mainstream lenders are faced with the reputational and other issues of charging the high APRs required to make profits and following up on the relatively high number of defaulting loans. Thus, they have generally chosen to have little involvement in short-term credit products. This means that payday loans are offered by specialist lenders, which have the understanding, business model, culture and mind-set required to provide lower income borrowers with short-term credit profitably. It is aspects of this model, culture and mind-set which are currently, and rightly, being criticised.
Roles which a new social enterprise might play
This makes it essential for ethical suppliers of credit to enter the market. However, it has proved difficult for ethical suppliers to offer short-term credit in a financially sustainable way to lower income borrowers. Credit unions offer other valuable services, and the most innovative have begun to offer payday-style loans, yet historically they have been limited in their ability to make short-term loans by their low interest rate cap. Other providers also exist, generally offering a combination of financial advice, debt restructuring and medium-term cash loans. Examples of providers playing a valuable role include Moneyline expanding from East Lancashire, Fair Finance in East London and Scotcash in Glasgow.
The supply structure also provides a reason why the provision of financial coaching, counselling and education is crucial. Those considering such short-term borrowing, from any lender, but especially from the for-profit lenders, must be offered this type of advice and support. They need to understand their situation, the reasons for it, the choices they have and the consequences of making these choices, as clearly as possible. Charities – many of them Christian – are doing important work in this area.
A new national social enterprise could set itself the mission of going further than existing alternatives, whilst still respecting and reinforcing them. It could offer an integrated set of services, which need to include at least two. Firstly, a national not-for-profit short and medium term lending service. Secondly, signposting for lower income adults to long-term solutions to credit dependency: especially to active membership in the credit union sector and to financial coaching, counselling and education.
The logic for the social enterprise style of engagement suggested here is two-fold. It is partly that this engagement would be effective, with a direct impact on payday borrowing, by reducing its cost and extent. And it is also that, by creating structures which are distinct from but connected to the credit union movement, it would expand the coalition of those working against exploitative lending. By offering these services on a not-for-profit basis, it could open up new options for low income adults, protect them from exploitative lenders and point them onwards to other beneficial services and habits.
The logic for integrating this set of activities in a single enterprise is similar to the rationale for supporting credit union expansion: that there is a need for supply-side interventions, to expand access to lower cost sources of credit, but this supply needs to be linked to demand-side working on saving and money management.
Establishing such an enterprise
Some work has begun to define what would be needed to realise this vision of establishing a new social enterprise. There are at least three requirements. The most important requirement is passionate people: those committed to serve the needs of lower income adults and to work with them and their contexts – and not only as one might ideally wish those contexts to be, but as they are and as what they can feasibly become. The second is financial resources, in the forms both of philanthropic support and social investment and finance. The third is partnerships: with organisations which already provide ethical and innovative loans, payments and banking services, including banks and credit unions; with technology, e-commerce and enterprise development companies; and with organisations which already provide financial coaching, counselling and education.
For those who commit to it, realising this vision will be a large undertaking. Not unrelatedly, the scale of the opportunity to free lower income adults in the UK from exploitative lending and engage them in relationships of genuine mutuality is also large.
Such a transformation, and the liberation and empowerment it promises, might appear limited to the financial sphere of people’s lives. In reality, it would unlock energy and potential much more broadly. Setting up a new social enterprise to offer these services in an integrated way could be a vital contribution to the common good, and an appropriate addition to ongoing work on regulating payday lending.