Incentivizing Responsible Small-Dollar Lending in Low-Income Communities

Abstract

POLICY QUESTION: “Based on results of pilot programs and policies implemented in other parts of the country, how can New York City/State best support and incentivize responsible small-dollar lending in low-income communities?” RECOMMENDATION: Design a borrower’s card system to collect information about consumers’ borrowing and repayment behaviors, to encourage lenders to extend loans to low-income individuals in need, and to incentivize consumers to take ownership of their own financial behavior. PROBLEM STATEMENT: In many states, the payday lending market has operated to meet the strong consumer demand for short-term small-dollar loans. In the realm of small-dollar lending, the payday lending market provides access for low-income individuals who might be classified as higher risk consumers, likely due to blemished credit histories. Lenders compensate for this higher risk by charging a higher interest rate, which would allow for the possibility that the borrower does not repay the loan. However, though the payday lending market is competitive, significant information asymmetries exist for both the lender and the borrower, which leave lenders unable to discern between high-risk and low-risk consumers, and leave borrowers with an unclear understanding of the terms of the loans and often, with increased amounts of debt. The reliance on payday loans poses significant problems for borrowers, however. Research has shown that consumers often are unable to repay within a single pay period and thus have to roll over their loan for another borrowing period, and accrue another fee. Therefore, for many borrowers, what starts off as a short-term loan turns into long-term payments because of rollover and chronic borrowing patterns. Furthermore, within the industry, only a few states seem to have a standardized database housing information on borrowing and repayment history for payday loan consumers. The lack of a centralized system makes it difficult to keep track of where consumers are originating their loans, how often they are taking out payday loans, and their true ability to repay. More responsible loan programs are characterized by a variety of criteria to ensure access to credit without trapping borrowers in additional debt. These characteristics include annual percentage rate caps, extended loan terms, multiple installment payment plans, proper underwriting of loans based on a borrower’s ability to repay, and financial counseling or a savings component. The tension in designing an alternative program is in balancing consumer need and incentive, market failures in information asymmetries, and business profitability concerns in order to meet the demand for these loans while not encouraging or incentivizing unscrupulous or predatory behavior. CRITERIA: 1) Minimize risk associated with consumers’ ability to repay loans: This criterion aims to reduce the risk associated with a consumer’s ability to repay by either better assessing consumer riskiness or ensuring that whatever consumer risk does exist does not prohibit or limit the potential for the loan to be repaid. 2) Provide incentive for lenders to make loans with a positive expected value: A viable alternative will provide the incentive for lenders to rationally extend a loan by reducing consumer risk, allowing lenders to better examine consumer risk, or by guaranteeing that they will be compensated for the risk associated with the population they are serving. 3) Provide incentive for consumers to improve behavior: A viable alternative should provide a mechanism by which consumers choose to improve their own repayment behavior, in order to ensure lenders receive the return on the loans that they make and continue to provide access to the small-dollar loans. 4) Maximize sustainability of program implementation: Any recommended program design should consider factors of sustainability, such as cost considerations, simplicity of implementation, political pushback, or scalability concerns. ALTERNATIVES: The following alternatives provide plausible program designs for a responsible small-dollar lending program. Each alternative is weighted against the specific criteria identified above. 1) Use a referral process to provide loans to approved low-income and/or high-risk consumers. 2) Design a borrower’s card system to collect information about consumers’ borrowing and repayment behaviors. 3) Fund a loan loss reserve pool to back loans made to low-income and/or high-risk consumers.