THE non-stop tide of new regulation from the government continues. It now appears to be preparing to accept an amendment to the Financial Services Bill, which will allow the Financial Conduct Authority to cap interest rates on payday loans. A recent intervention by the incoming archbishop of Canterbury (who is strongly in favour of the amendment) probably proved decisive.
Even if you have no sympathy with the argument that people may rationally use payday loans to tide them over difficult times, banning an undesirable action isn’t necessarily the right way of solving the problem itself. As we know from other prohibitions, the effect of banning something is often to make a risky situation even more risky.
But first, some context. The incredible interest rates often quoted on payday loans are not really interest rates at all. Of course, part of the interest rate is designed to compensate the lender for risk – and this is a very risky business. But, more importantly, the administration costs of these tiny loans are included in the quoted interest rate. For example, a £100 loan for two weeks. with a set-up cost of £5, would have a quoted annual percentage rate of interest (APR) of 256 per cent, even if the interest charge were zero.
Yet such a set-up cost is not interest at all. If only 5 per cent of loans default (or require additional collection costs because of late payment), you can easily see how the quoted interest costs rise, even though those costs bear little relation to the concept of interest as it is normally understood. Arguably APR should not be used at all when looking at the cost of payday loans. It is a totally misleading concept.
Proponents of a cap on interest rates often cite credit unions as providing much cheaper finance. And it’s true that they are much less expensive. But their costs are lower because they are able to use volunteers to administer the organisation, and financial regulation is much less intrusive.
Putting these points aside, the capping of interest rates on payday loans also has great risks. The Office of Fair Trading has always been reluctant to recommend this step, and with good reason.
The Department for Business, Innovation and Skills (BIS) undertook comprehensive research on interest rate caps back in 2004. Some of that research has been criticised for being incomplete. However, the critics never really provided any evidence that BIS’s conclusions were actually wrong. And those conclusions were particularly interesting.
France and Germany, which both have interest rate caps, had around five times the level of complete financial breakdown – such as bankruptcy – among people who had trouble with their debts. While the figure stood at only 4 per cent in the UK, in France and Germany it was between 20 and 25 per cent. This is a shocking statistic. Financial breakdown of this kind is often accompanied by difficulties in obtaining housing, employment and the purchase of essentials such as food.
Furthermore, the proportion of those who are credit impaired who use illegal loans was reported to be tiny in the UK – around 3 per cent. However, the use of illegal loans was much greater in France and Germany, at nearly three times the British figure. Debt collection agencies are bad enough but, when it comes to calling in loans, illegal loan sharks have very unpleasant methods indeed.
The problems do not end there. Those who cannot get credit, in markets where there are interest rate caps, tend to turn to even more expensive or less desirable sources of finance. This will include forms of finance with much higher explicit charges or the use of mail order to purchase essentials at much higher prices.
None of this should imply any lack of sympathy for those who are caught in the payday loan trap. But our experience over a wide range of issues is that banning something that people – for good reasons or ill – desperately feel they need can be very counterproductive. The most vulnerable often suffer most. Trying to simply legislate away a problem does not make it disappear.
Philip Booth is professor of insurance and risk management at Cass Business School and editorial and programmes director at the Institute of Economic Affairs.