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.
Type
Master's projectDepartment
The Sanford School of Public PolicyPermalink
https://hdl.handle.net/10161/5176Citation
Bansal, Megha (2012). Incentivizing Responsible Small-Dollar Lending in Low-Income Communities. Master's project, Duke University. Retrieved from https://hdl.handle.net/10161/5176.More Info
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