H.R. 1909 Brings Competitive Regulation to Small Loan Market

The Summer of 2011 will likely be remembered as a season that overregulation came to a boiling point — at all levels of the U.S. government.

At the federal level, businesses big and small were spending countless hours and resources dealing with the first mandates from from Dodd-Frank and Obamacare and planning for the next ones to be issued.

A visible moment of regulatory overkill was the armed raid on August 24 of the Gibson Guitar factory in Memphis, because of an alleged technical violation in importing non-endangered Indian wood. As September opened, the Obama administration relented on a costly new rule further restricting emissions of ground-level ozone — just four years after a previous limit had been issued — but promised the regulation would be back in 2013.

The laboratories of democracy at the state and local level didn’t fare much better in their treatment of entrepreneurs, especially of those who are literally the smallest business people. All over the country, overzealous authorities shut down children who had the temerity to practice the time-honored tradition of setting up a lemonade stand.

CEI has long recognized that no level of government is a citadel of wisdom when it comes to weighing the costs and risks of regulation. So our president and founder Fred Smith and our chairman Michael Greve have called for a “competitive federalism” that breeds “competitive regulation.”

As Greve, who is also the John G. Searle Scholar at the American Enterprise Institute, has written in his book Real Federalism, “The federalism I have in mind — real federalism — aims to provide citizens with choices among different sovereigns [and] regulatory regimes.” Competitive federalism, he wrote, “serves not so much to empower the states but to discipline them,” as well as to discipline an overweening federal government.

Under competitive regulation, entrepreneurs, consumers and investors can choose the regime they believe best balances the need for innovation with the need to manage risk.

In state chartering of corporations, for example, an entrepreneur might choose to incorporate in Nevada because for what he would believe would be the greatest flexibility. But a large investor might choose to only buy shares in Delaware, because she believes that state offers greater protection of shareholders in takeovers and proxy fights. (This is not necessarily an opinion on the adequacy of the incorporation process in either state.)

In the process, a balance is struck that results in the improvement of the overall regulatory regime for everyone. As CEI President Smith wrote in his essay “Cowboys and Cattle Thieves,” competitive regulation “encourages prudence … by allowing the parties to better attain that level of risk they prefer, and by remaining open to further refinements over time.”

As part of furthering competitive regulation, CEI has long advocated in areas of legitimate interstate commerce that states and the federal government compete with each other. That is, having firms choose whether to be regulated by the states or the feds.

An example of this working well is the National Bank Act, which as interpreted by the Supreme Court in the 1978 case Marquette National Bank of Minneapolis v. First of Omaha Service Corp, allows federally chartered banks to charge credit card interest rates according to the laws of the states in which they are incorporated.

Because this decision allowed risk-based pricing to a national market, the result was increased competition among credit card issuers that eliminated annual fees and boosted services such as reward programs for most American card holders. (Although unfortunately, annual fees and reduced rewards are on the upswing now due to the limits on interest rate hikes in the CARD Act of 2009 and the price controls on interchange fees for debit card transactions enacted last year in Dodd-Frank.)

CEI has urged this approach to optional federal chartering in other areas of financial services as an alternative to burdensome overlapping state and federal regulation. In the insurance area, for instance, we have called for two mutually exclusive state and federal regimes that insurers and their customers can choose from.

As a CEI Web Memo by Jennifer Smith-Bozek put it in 2008, “Optional federal chartering can offer two clear benefits. First, participating insurers may operate in any state without having to file separate state applications. Second, having the federal and state governments compete for licensing revenues should encourage both to create more efficient regulations.”

Recently, a bipartisan bill was introduced that introduces the competitive forces of optional federal chartering to one of the most important areas of financial services: the small loan market. H.R. 1909, the FFSCC Charter Act of 2011, would create an optional charter from the Comptroller of the Currency for nonbank lenders who choose to be designated as “Federal Financial Services and Credit Companies.” It is sponsored by Joe Baca (D-Calif.), with cosponsors Jean Schmidt (R-Ohio), Gregory Meeks (D-N.Y.), and Albio Sires (D-N.J.).

The bill addresses a vital need for access to credit for both lower and middle-income Americans. “Microfinance” is a hot topic in the academic and policy world. Muhammad Yunus of Bangladesh won a well-deserved Nobel Prize a few years back with his innovative approach to non-bank neighborhood lending in Bangladesh.

Yet providers of microcredit in America — payday lenders, pawn shops, etc. — are looked on by many policy elites with scorn. And even when these lenders are subject to legitimate criticism, frequently no one details how to remove barriers to creating an alternative in the lending market.

And the need for quick access to small amounts of credit couldn’t be more pressing in an economy with 9 percent unemployment. Unexpected circumstances can like a car breaking down or the need for emergency travel can hit responsible individuals who could pay back the loan in a few months, or even a few weeks.

If they find themselves in these circumstances, however, their options are limited. A bank typically won’t process a consumer loan of a few hundred dollars. Sometimes folks in a pinch can borrow money from relatives, but even when they can, for many this is a blow to their pride.

These individuals can also be late in paying their bills and credit card debt, bounce a check, or overdraw on their debit card. But these options not only result in lowering their credit scores, which affect their ability to better their lives through a new job or starting a business, they are often more costly than a payday loan would be.

This is where the typical charge that payday lenders charge 400 percent annual percentage rate, which has served as the basis for several state interest caps enacted in the past few years, is so misleading. If common “fees” for overdrafts, bounced checks and late payments were counted as interest, they would well exceed the APR for payday loans.

Kelly Edmonston, senior economist at the Federal Reserve Bank of Kansas City, points out in his study published in that Fed branch’s Economic Review , that the “median interest rate” for bounced check fees — if they were measured as interest payments — would be  “well in excess of 4,000 percent, or up to 20 times that of payday loans”

In short, annual percentage rate is an inappropriate measure for loans that have a duration of weeks and months. This is something that H.R. 1909 recognizes in directing the federal regulator to measure “the true cost of the loan in terms of actual finance charge per dollar of credit extended to such person instead of the annual percentage rate.”

Under competitive regulation, alternatives to payday lending could also flourish. A somewhat legitimate criticism of a payday loan is that it must be folded into another loan if it can’t be paid in the two-week duration, rather than modified.

But much of the reason for the way this works is that many states severely restrict nonbank lenders from making installment loans. However, installment loans would be explicitly allowed under H.R. 1909’s federal charter.

One clue as to an innovative product in a competitive market that would better serve borrowers comes from the book License to Pawn by Rick Harrison, star of the History Channel’s highly rated reality series “Pawn Stars.” What comes through on the show is the fair dealing Harrison and his relatives at Las Vegas’ Gold & Silver Pawn Shop are known for when they buy unique collector’s item such as a horseshoe worn by champion Secretariat. They typically don’t agree with the customer’s asking price, but they are transparent in their explanations on how the price they offer reflects the storage costs and the risk that the product won’t sell.

Harrison describes his brief venture into the alternative loan business: “I would loan you a hundred bucks with a $25 service fee, and put you on a four-month payment plan. … I would actually work with people and enable them to get out from under the debt load.” He admits, however, that interest rates were “roughly 60 percent, but that’s just because it’s an incredibly high-risk business.” Harrison says he got out of the business because of lawsuits from competitors.

The product Harrison created might be more affordable and stable than many payday loans. Yet it would still be illegal under the interest rate caps of many state, including the 28 percent APR limit of Ohio, which was championed by Richard Cordray, who is now President Obama’s nominee to head the Consumer Financial Protection Bureau created by Dodd-Frank

H.R. 1909 should be amended to not only shield innovative nonbank lenders from overzealous state regulators but from the unbridled power of the federal CFPB. It should also be stripped of some vague criminal penalties for nonbank lenders that have caused the bill to be flagged by the Heritage Foundation’s Overcriminalization Project.

The bill is not atypical in this regard, as criminal penalties for regulatory violations of environmental, financial and health care laws are almost routine in statutes these days. But that should not serve as an excuse for putting these flawed provisions in an otherwise sound bill.

For the most part, however, H.R. 1909 is a welcome step toward competitive federalism and competitive regulation that will benefit entrepreneurs and consumers by stimulating much-needed innovation in the market for small loans.