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Regulators Should Rescind 'Small-Dollar' Loan Rule

This post is the first in a 10-part series on reform proposals for the Consumer Financial Protection Bureau. 

The Consumer Financial Protection Bureau is one of the most controversial regulators in Washington, D.C. Since its founding in 2010 under the Dodd-Frank Wall Street Reform and Consumer Protection Act, the bureau has faced relentless scrutiny for its unconstitutional structure, reckless spending, aggressive enforcement activity, and flawed rulemakings, to name a few.

Critics have pointed out time and again the dire need for wholesale reform at the bureau. Fortunately, there is no better time than now. In late 2018, the Senate confirmed Kathleen Kraninger to head the bureau for a five-year term. With a new, permanent director installed, Kraninger has a unique opportunity to champion wide-ranging reforms, including everything from rulemakings to hiring practices.

In her confirmation hearing, Ms. Kraninger assured the Senate Banking Committee that she would implement a free-market agenda at the bureau, focusing on greater competition and the rule of law. In this regard, Director Kraninger and her staff are off to a great start, implementing new initiatives to encourage innovation and competition. However, there is much more work that needs to be done.

This post is the first in a 10-part series that will look at reform ideas for the Bureau’s new leadership to pursue. While all ten reforms may be out of reach for one administration, each particular recommendation is an important step towards creating a more fair and competitive consumer financial marketplace.

Perhaps the most pressing issue for the Bureau’s new leadership is what to do about the controversial Payday, Vehicle Title, and Certain High-Cost Installment Loans rule. Finalized by former Democratic Director Richard Cordray in 2017, the main provisions of the rule include imposing an onerous “ability-to-repay” (ATR) underwriting standard on small-dollar loans as well as stringent provisions relating to a lender’s ability to collect payment from a customer.

The 2017 payday loan rule would have imposed an enormous burden on the industry and its customers. For example, payday loan volume and revenues were predicted to decline between 60 and 82 percent under the rule, meaning that billions of dollars of consumer credit would be wiped out. But eliminating the supply of credit does not eliminate its demand.  Instead, the 12 million Americans who take out a payday loan each year may lose access to legitimate credit altogether, perhaps even forcing them into the hands of black market loan sharks.

Fortunately, Director Kraninger announced in February 2019 a new proposal to rescind the ATR portion of the payday loan rule. As I recently argued in comments to the bureau, this is well justified, as the original ATR requirements were imposed utterly without evidence.

To start with, the ATR standard is inappropriate for small-dollar loans. If borrowers had an immediate ability to repay—including meeting basic living expenses without needing to re-borrow over the ensuing month—they would have no need to patronize payday lenders in the first place. Instead, they would access traditional sources of credit, such as their own savings or credit cards. As Thomas W. Miller, Jr. a professor of finance at Mississippi State University, has written, “Though [the ATR requirement] may sound sensible, basic living expenses are exactly what many payday loan borrowers seek to cover—meaning the rule denies them the option until their financial situation improves.”

Second, the research the bureau conducted to promulgate the rule was deeply flawed. For example, the bureau did not base its rulemaking on the consumer complaints portal or any empirical survey data concerning consumer sentiment. It also failed to design an appropriate and representative study of the small-dollar loan market, while the background research the bureau did complete failed to study whether protracted payday loan borrowing actually reduced consumer welfare. Further, the final rule refused to consider the wealth of research that refuted its empirical claims.

The greatest problem with the 2017 rule, however, was its failure to demonstrate the behavioral economics claims made in favor of regulation. Notably, the ATR requirements were based off a faulty behavioral economics premise that claimed that consumers could not accurately predict how long it will take to pay off a single loan, which leads them to roll over their loans more than they otherwise would. In the economic literature, this is known as an “optimism bias.”

The bureau largely relied on this theory to justify the payday loan rule, but provided scant empirical evidence to support it. In fact, it relied almost exclusively upon one 2011 study by Columbia Law Professor Ronald Mann. The problem, however, is that the Mann study itself contradicts the claims of the bureau. The Mann study had to two relevant findings. First, it found that consumers expected and understood before taking out a loan that they were likely to borrow again. Second, the study found that around 60 percent of borrowers accurately predicted before taking out a loan the date when they would be free from debt.

The study, therefore, concluded that a majority of consumers do appreciate the risks of short-term, small-dollar loans, and rationally decide to take them out anyway. Yet the bureau interpreted these results to argue just the opposite. In response to the bureau’s use of his study, Prof. Mann criticized the regulator in a public comment letter, stating that it was “frustrating” that the CFPB’s summary of his work was “so inaccurate and misleading,” torturing the analysis to the extent that it was “unrecognizable.” It is hard to fathom why the bureau felt that this one study justified a regulation that would all but eliminate the small-dollar loan industry.

In short, the current leadership of the bureau is well justified in rescinding the ATR provisions of the payday loan rule. The original rule emphatically failed to demonstrate a case for regulation. However, while most of the attention has been focused on the rescission of ATR, the bureau decided to leave in place the stringent provisions relating to how lenders can collect payment from a customer’s account, which industry must comply with by August 19, 2019.

The rule prevents lenders from automatically charging a customer’s account after two failed attempts at collection to prevent insufficient funds fees. The requirement is perplexing, as there is no other product or service that requires re-authorization after a failed attempt at obtaining payment. Indeed, consumers typically consider automatic payments a convenience, not a burden, and pay for numerous different products in this manner.

The payments provisions have important implications for creditors, as lenders have few avenues to collect on small, unsecured lines of credit. For example, storefront lenders take a postdated check from a consumer to ensure a relatively low-cost method of collection: they can deposit the check to obtain payment. It is precisely this risk of an insufficient funds charge that provides a strong incentive for the customer not to default, and by reducing the probability of default and the expected collection costs, an incentive for lenders to provide credit in the first place. This helps to reduce the bad debt costs for a lender and keeps prices lower than they otherwise would be.

Further, the payments provision particularly threatens the business model of online lenders. Online lenders do not obtain a postdated check like a storefront lender. Instead, they rely on having access to a customer’s bank account. Without any collateral and a limited ability to service their debts, online lenders are at a much greater risk of fraud, default, or bad-faith borrowing. When lenders cannot collect on their debts, they will respond by charging more, lending less, restricting access to credit altogether, or engaging in more aggressive collection tactics, such as litigation, more quickly. Indeed, the industry has noted that because lenders are not required to seek reauthorization, some may simply place the loan in collection after two failed attempts. Given that the bureau recently proposed regulations to address the consumer protection concerns surrounding debt collection, this would seem unwise to promote.

The bureau should also consider how the payments provision conflicts with certain state laws. For example, both Oklahoma and Washington prohibit lenders from communicating with borrowers for the purposes of reminding borrowers about their loan obligations or collecting on debts. Lenders are therefore stuck between a rock and a hard place—either violating state or federal law. 

While the bureau is to be applauded for rescinding the ATR requirements of the payday loan rule, it should go much further and rescind the entire rule, including the “payments” provision.