In a market economy that is based on private property and the rule of law, the efficient and effective enforcement of contracts is indispensable. Without the ability to enforce the promises made between individuals and businesses, any form of transaction, especially credit products, would be harder and more expensive, if not impossible.
Services and mechanisms to settle debts, therefore, are a vital (if underappreciated) aspect of a market economy. They are a part of the “plumbing”—the underlying architecture—that makes our modern credit markets possible. Whether it is a bank, a local gym, or a medical facility, a creditor’s ability to offer services is dependent upon enforcement mechanisms that allow them to pursue a defaulting borrower’s income and assets. Considering that businesses have a vested interest in customer retention, it is useful that they can outsource this process to a third-party collector, where necessary.
While the vast majority of consumer credit contracts are fulfilled without issue, a minority do end up in collection. After all, debt collection in the United States is a large and competitive industry, with around $12 billion in total revenue across nearly 8,000 collection agencies. These agencies recover tens of millions of dollars that would otherwise go uncollected, which in turn lowers bad debt costs for businesses, reducing the price of credit for all consumers.
Given the relationship between the willingness of a lender to offer unsecured credit and the ability to collect on debt, it would make sense that consequences of regulating the collection of debt are similar to the regulation of debt itself.
Credit is priced according to risk. If the restrictions on collections are too great, the risk of loss is higher, as creditors will recover less from borrowers, and borrowers will have an incentive to default more often. In this case, a lender will respond in a number of predictable ways: charging more, lending less, requiring higher collateral, restricting access to credit altogether, or engaging in more aggressive collection tacts, such as litigation, more quickly. The end result is that consumers are left with higher prices and lower quality products.
Indeed, the economic literature on debt collection largely reflects this theory. For example, going as far back as the 1970s, a summary of the National Commission on Consumer Finance report described debt collection restrictions in the following way.
When an important sanction is prohibited or significantly restricted, creditors compensate for the increased risk burden they consequently carry by introducing more stringent standards of applicant acceptability and/or raising rates of charge. In connection with sales credit this also means that larger down payments will be required and perhaps shorter maturities as well. Although virtually all consumers would be thus affected by such market changes, the most greatly affected would be the relatively poor and least credit worthy, so if such restrictions or prohibitions are imposed for the sake of these latter people, it is not self-evident that they will gain a net benefit by such action. It follows that the credit problems of the poor and those subject to cyclical unemployment are not necessarily solved by the curtailment of collections sanctions…
More recently, the Federal Reserve Bank of Philadelphia published a study in 2015 that found that “Stricter debt collection regulations appear to reduce the number of third-party debt collectors and to lower recovery rates on delinquent credit card loans. This, in turn, leads to fewer openings of credit cards.” Even further, the paper found that “one additional restriction on debt collection activity reduces the number of debt collectors per capita by 15.9% of the sample mean and lowers the number of new revolving lines of credit by 2.2% of the sample mean.”
Furthermore, a 2017 study from the Federal Reserve Bank of New York that looked at the effect of state-level debt collection restrictions concluded that “restricting collection activities leads to a decrease in access to credit and to a deterioration in indicators of financial health,” particularly for those with the worst credit scores.
To take another recent example, the necessity of debt collection to a functioning credit market was made plain by a Second Circuit Court of Appeals case, Madden v. Midland Funding. In Madden, the Second Circuit held that the National Bank Act (NBA) preempts state usury limits for nationally chartered banks, but does not preempt state usury limits for the sale of a debt to a nonbank debt buyer. As a Columbia Law Review article argues, constraining the the ability of national banks to sell debt to third-party buyers will lead to the cost of credit rising and secondary debt markets freezing up.
This wealth of evidence with regards to the value of debt collection services should give pause to calls for more regulation. Indeed, it appears that the harder it is to collect on debts, the less credit will be made available, and the more borrowers will be unable to smooth their income or invest in household capital goods.
Undoubtedly, there were draconian debt collection practices that have been rightly prohibited for centuries, such as imprisonment for debt. Other conduct such as certain forms of harassment and intimidation have more recently been prohibited. But virtually all of the “low-hanging fruit” has been picked—further regulation will represent a much more acute discernment between the marginal costs and benefits of new regulation. Adding new regulations on top of an already heavily regulated industry will likely be a net loss for consumer welfare, as any gains by debtors will be offset by higher prices and less choice for consumers in general.
In the next post, I will look at specific proposals from federal regulators, including the Consumer Financial Protection Bureau, for regulating the debt collection industry, and what this may mean for business and consumers.
Competitive Enterprise Institute Research Associate Gabriel Greenspan contributed to this post.