RegulationNov 20 2014

FCA backs payday loan customers

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Last week, the Financial Conduct Authority announced the final version of its plans to cap the cost of payday loans in the UK.

The introduction of a price cap marks the latest intervention in an extensive programme of regulatory measures pursued by the FCA. These have included limitations on ‘rollovers’ and continuous access to client bank accounts, plus new rules designed to ensure firms conduct proper affordability assessments of their clients’ ability to repay. In addition, the Advertising Standards Agency has taken action against firms for irresponsible advertising.

These measures are much needed. The payday lending market has been plagued with a litany of lender misconduct towards customers. Lenders have exploited a lack of financial sophistication by trivialising the cost of their loans through hidden charges and fees, illegal attempts to enforce debts and failure to evaluate the consumer’s ability to repay. Such conduct was allowed to continue for too long under a weak regulatory regime. The FCA now has stronger powers and more resources to use those powers. It has not been afraid to act.

Introduced next year, the price cap establishes clear boundaries for the products firms can offer in the market. From 2 January lenders will be limited in what they can charge. Interest and charges on loans will be capped at a maximum 0.8 per cent of the loan principal per day – a loan of £100 over 30 days will have a maximum price of £24. If a customer does not repay on time firms will be limited to charging £15 in default fees. Additionally, all interest and charges, including default charges, cannot exceed 100 per cent of the loan principal. This final component – the 100 per cent total cost of credit cap – will prevent the horror stories of small loans transforming into large debts.

How should firms react to the introduction of this cap? The FCA expects many lenders, especially the smaller lenders, to exit this less profitable market. High street lending, with its higher operating costs, may disappear altogether. Remaining lenders will be forced to fit their product offerings within the price cap constraint. Short-term loan products may cease – the cap does not allow an upfront fixed fee to cover the cost of making a loan – and the convention of allowing customers to repay early for free may end. Despite this, the FCA expects the majority of consumers to continue to be served in this market. It sees the alternative – a cap so low that the whole market becomes unprofitable – as worse for consumers, given their often limited alternatives.

But if the payday lending market is to become genuinely enhancing for consumers, the market must change beyond simply realigning prices to the cap. In my recent report with the think-tank ResPublica, Climbing the Credit Ladder: Short-Term Loans as a Path to Long-Term Credit, I argue the payday lending market must become the first rung on a ladder to better forms of credit instead of the last step on a descent into financial ruin. Firms must take account of the differing and changing risk profiles of their clients when pricing loans. The credit industry must remove the barriers to consumers searching for the best products available. And all lenders – payday and mainstream – must move to a model wherein clients who face problems repaying their debts are automatically referred to free, independent advice.

First, firms must move away from one-price-for-all models towards lending practices based upon risk-based pricing. Most customers of payday lenders regularly use their services, borrowing an average of six loans a year. But in the current market, repeat borrowing occurs at the same price as the initial loan. Repeat customers, who repay on time and therefore show themselves as good risks receive no reward in terms of lower prices. Hence firms earn a surplus from these customers by not re-pricing subsequent loans. In nearly all cases where firms offer trust-based ratings and reward schemes, trusted customers are offered larger loans, but not cheaper loans. This only serves to increase the surplus to firms. A basic feature of an efficient credit market is that firms price loans based on risk. Payday lenders must move to this model. The FCA has identified repeat borrowing as a topic for potential further policy interventions, and should consider creating rules for the re-pricing of loans.

Second, consumers must be given better tools and more power for shopping around in the credit market. A fundamental inefficiency in the UK consumer credit market is the convention that credit reference agencies record credit application histories and customers who make multiple applications – and are seen as credit-hungry – are more likely to be denied loans. Lenders claim they check recent application histories, as these predict creditworthiness. But this convention is inherently anti-competitive: it actively discourages consumers from making multiple applications in search of the best deal.

The ability to search a market without penalty is a basic requirement of market efficiency. But the status quo in the credit market is to effectively prohibit this behaviour. Hence the price comparison websites, ubiquitous in many areas of consumer shopping, are grossly ineffective in the consumer credit card market. They allow consumers to compare only headline interest rates and not personal credit offers. This can only be resolved by credit reference agencies no longer having the power to record credit applications and allowing widespread use of low-cost quotation searches which allow a lender to offer agreements in principle at low cost. Only then will the benefits of effective price comparison technology be brought to fruition in this market.

Third, payday lenders must move to a model whereby clients who face problems repaying their debts are automatically referred to free, independent advice. Conduct of lenders in this market has been worst in dealing with customers unable to repay their debts – we have seen the imposition of prohibitive fees and charges, intimidation of customers through fail [veiled?] threats of debt enforcement, and relentless harassment by technology.

Fundamental change must occur in how lenders treat customers who cannot repay their debts. It should no longer be the role of the lender to dictate terms of charges and repayment. Customers with problem debt need advice from a source they can trust to act for them, and balance their rights with those of the lender. The UK has a developed free-to-client debt advice sector comprising trusted charities including Stepchange and Citizens Advice Bureaux. Customers unable to meet their debt payments should be automatically referred to these advice providers by the lender.

The payday lending market can only move forward with a radical re-thinking of its offering to consumers. The current regulatory intervention package may be close to completion, but the political appetite for further action against payday lenders will remain. They have been the villains of recession Britain. The FCA has offered payday lenders a chance to reform within the new market context of the price cap. They must take this, and show they can provide products and services for the good of the consumer, or risk annihilation.

Professor John Gathergood is Professor of Economics at the University of Nottingham

Key Points

The FCA is to cap the prices on payday loans.

Firms must move away from one-price-for-all models towards lending practices based upon risk-based pricing.

Lenders must fundamentally improve the way they treat customers who cannot repay their debts.