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Cheaper (but scarcer) credit cards and the end of payday loans.
Sen. Bernie Sanders (I-VT) and Rep. Alexandria Ocasio-Cortez (D-NY) have a deceptively simple proposal to make banking better — cap interest rates on consumer loans at 15 percent per year.
The Stop Loan Sharks Act is a sweeping policy proposal that would not just affect the credit card industry — one of the main targets of immediate coverage of the bill — but also other sectors of the financial services industry. The plan would virtually eliminate so-called “payday loans” and a range of other high-interest products that are used mostly by low-income borrowers without good credit histories.
This is an idea that polls extremely well. When it was last pending in Congress in 1991, it passed the Senate by an overwhelming 71-14 margin. At the time, however, the near-universal understanding on Capitol Hill was that the bill was just an opportunity for cheap position-taking with no chance of actually becoming law. David Rosenbaum reported back then for the New York Times that “many lawmakers, insisting on anonymity, said they would vote against it if they thought it stood a chance of becoming law” and were just trying to stay on the right side of public opinion. Since then, the bank lobby has managed to keep interest rate regulation off the political agenda, and the industry is doubtless unhappy to see it back.
Economics 101, however, would argue that these kinds of regulations will have perverse effects — by capping the price of credit, you’ll fatally reduce its supply. And while theory-driven forecasts don’t always come true, the empirical evidence on interest rate regulation does seem to suggest that cheaper credit cards would also be scarcer. On the payday lending side, the 15 percent rate is so out of line with current industry practices which feature interest rates that are invariably in the three digits, it’s absolutely clear that the supply of loans will go down.
The larger question, then, is whether the broad trend toward financial deregulation and the democratization of credit was a mistake.
Credit cards, explained
The ubiquitous pieces of plastic that Americans use to pay for things are actually a deceptively complicated bundle of revenue streams and consumer benefits.
Credit card companies collect swipe fees from merchants, who pay a percentage of every credit card transaction to the credit card company. This is expensive, which is why some merchants won’t accept credit cards. Consumers, however, generally enjoy the convenience of credit cards, and most stores and restaurants fear losing business if they don’t accept them. To collect these lucrative swipe fees, credit card companies these days normally split some of the proceeds with the customer via various “points,” “miles,” or cash back schemes.
But credit cards are also a form of credit. You buy something now, the merchant gets paid now, and then you repay the credit card company when the bill comes due at the end of the month. But if you have some kind of big expense and are strapped for cash, you don’t have to fully pay the bill off — you can instead roll credit over into the next month. But if you do that, the credit card company will charge you interest — typically a much higher interest rate than you’d be charged for a mortgage or an auto loan because the credit isn’t “backed” by an underlying asset like a house or a car. This is the core credit function of the credit card that Sanders and Ocasio-Cortez are targeting for regulation.
Last, but by no means least, some credit cards charge an annual fee in exchange for your right to use the card. Once upon a time, this was a major part of the credit card business model. Modern-day competition has ensured that no-fee cards are plentiful, but cards with fees remain a significant niche of the industry — typically the way it works is that an annual fee credit card will give you various perks outside the core transaction function of a credit card. In a more tightly regulated industry, these fees would likely become a bigger deal.
Interest rate caps would transform the credit card industry
A 15 percent cap on interest rates would mark a significant transformation of the credit card industry.
Right now according to WalletHub, the average interest rate available to people with excellent credit is 14.41 percent. For people with good credit, it’s 20.31 percent, and for those whose credit is only fair, 22.57 percent.
The credit card industry is only modestly competitive — according to the Federal Reserve, Visa and MasterCard together control 85 percent of the market — and it enjoys reasonably high profit margins. So under regulatory pressure to reduce interest rates, many customers would end up getting a better deal.
Cards for people with good credit might charge rates right up at the 15 percent cap, and competition to capture the excellent credit crowd might push their rates two or three points below that. But people with merely “fair” credit might be left out in the cold. These customers get charged high interest rates because they are relatively likely to default and because, being less affluent on average, they are also less valuable as generators of swipe fees. In a world of capped interest rates, it’s in many cases not going to be worth banks’ while to offer loans to marginal credit prospects.
This isn’t just a theoretical concern. In January, Jose Ignacio Cuesta and Alberto Sepulveda released a study of a policy in Chile that capped consumer interest rates.
They found that many consumers did get a better deal as interest rates fell. But there was also a significant reduction in the availability of credit, including a 19 percent drop in the total number of loans.
Because the credit card industry is multifaceted, the precise consequences of the shakeout are likely to be complex. Some people who can currently get a credit card wouldn’t be able to. Others would still be able to get a card but would face lower credit limits. A larger swath of the population might be pushed into the niche of “secured” credit cards (where you pay a refundable deposit in advance to your credit card company) that is currently only used by people with poor credit.
Annual fees would likely become higher and more widespread to offset the lower margins in the credit side of the businesses. With fewer people holding cards, more merchants might be willing to refuse to accept credit cards, which in turn could push credit card companies to accept lower swipe fees — and offer more modest rewards to consumers in exchange.
The exact details are hard to predict from first principles, but the basic shape of the change is clear — we’d be looking at a smaller, less profitable credit card industry that offers a better deal to some customers and no deal at all to some others.
The less mainstream payday loan industry, meanwhile, would basically just go away.
The plan would ban payday loans
“Payday” loans are essentially short-term loans (the idea is you are being fronted a little bit of money for a week or two until your next paycheck clears) which carry interest rates that sound reasonable in the short-term context — 10 percent over two weeks, say, plus some fees. But in annualized terms, these loans carry an average rate of 391 percent, and in some cases soar far higher than that.
While the credit card industry would be significantly altered by a 15 percent rate cap, the payday lending industry might be entirely destroyed.
This industry has a poor reputation among avid consumers of progressive media — Mother Jones’s Hannah Levintova characterized the Stop Loan Sharks Act as a crackdown on “predatory interest rates,” while Sarah Jones at New York magazine said Sanders and Ocasio-Cortez were teaming up “against companies that prey on the poor.”
It is clearly true that some people get in badly over their heads with these high-interest loans. And some of this is reasonably attributable to companies taking advantage of people’s lack of comprehension of compound interest over time. A 2012 study by Annamaria Lusardi and Carlo de Bassa Scheresberg, for example, finds that “most high-cost borrowers display very low levels of financial literacy … and do not possess knowledge of basic financial concepts” while “those who are more financially literature are much less likely to have engaged in high-cost borrowing.”
At the same time, sometimes people with low incomes and weak credit really do face transient financial distress, and access to a short-term high-interest loan can be vital.
Since payday loans are regulated primarily at the state level, there is considerable variation in their availability and thus plenty of research on the impact of constraining or banning payday lending. Unfortunately, the studies lack a really clear takeaway. Harold Cuffe and Christopher Gibbs, for example, found that restricting payday loans reduces liquor store sales, with the biggest impact at stores that are located near payday lenders, suggesting that high-interest loans are often used for short-sighted reasons.
But Neil Bhutta, Paige Marta Skiba, and Jeremy Tobacman found that using payday loans has no impact on borrowers’ credit scores, suggesting that in most cases, people are not ending up in unsustainable debt cycles. Gregory Elliehausen finds that “nearly all payday loan customers said that they were satisfied or somewhat satisfied with their most recent new payday loan” and that the typical borrower uses payday loans infrequently and to cope with an unexpected expense.
Christine Dobridge’s 2016 study of payday lending uses unusually detailed information to reach the conclusion that, basically, it depends.
She finds that in periods of unusual financial distress — after blizzards, hurricanes, or other events that disrupt work arrangements and induce unusual spending needs — widespread availability of payday loans helps minimize the declines in spending on food, mortgage payments, and home repairs, suggesting that they are filling a very useful niche. But in an average period, she finds that “access to payday credit reduces well-being” and that areas with laxer regulation of payday loans lead families to make imprudent spending decisions that ultimately leave them with less money to spend on food and housing.
All of which raises the question of whether there might be some way to replicate the constructive elements of payday lending without the more destructive ones.
The postal banking solution
Sanders and Ocasio-Cortez propose that the government fill the gap left by payday lenders by letting the United States Postal Service offer banking services.
The Post Office currently offers some very limited forms of financial services, and it offered more full-featured banking services in the past. Several foreign countries continue to offer postal banking today, and there’s been a broad revival of interest in the concept in recent years. That’s in part a result of the financial crisis but also because USPS needs a new line of business in the face of declining mail volumes. Probably the most thoroughly conceptualized version of this idea is a proposal by Morgan Ricks, John Crawford, and Lev Menand to actually have the Federal Reserve rather than the Postal Service offer the public banking option and then contract with the Postal Service to use its retail locations.
These technical implementation details aside, the real question is whether a public banking option could meaningfully fill the payday lending gap.
A universal public bank’s primary benefit is that it would spare currently unbanked Americans from the inconvenience of needing to go through life without a checking account. Secondarily, it would spare another tranche of Americans the costs and difficulty of dealing with checking account fees and minimum balance requirements. Having done that, the public banking option would in turn ameliorate a bunch of big-picture problems around payment processing, debit card fees, and the Fed’s ability to stabilize the economy during times of recession.
But would a public bank be able to offer people short-term credit to smooth over transient financial distress? Sen. Kirsten Gillibrand’s (D-NY) postal banking bill purports to address this by authorizing the Postal Service to make “low-cost, small-dollar loans” of up to $1,000.
That sounds nice. But if there were actually money to be paid in offering cheap loans to outcompete payday lenders, you’d expect to see some of the existing players in the financial industry to try it. At a minimum, you might expect to see such business models observer in the states that have already banned payday lending. In practice, a postal bank would likely have to itself become a “predatory” payday lender to make this business work — something that would be illegal under the rate cap proposal anyway.
What you’d really need to replace payday lending is not so much an alternative loan product but a much more robust overall system of social insurance — free health care, more generous unemployment insurance, more housing assistance, and a larger welfare state in general. This is, of course, what Bernie Sanders is all about. As is fairly typical for a Sanders proposal, the loan cap makes a lot more sense as a broad thematic illustration of his vision of the good society than as a specific, detailed policy remedy.
Taking on banks is very popular
Last but by no means least, a key reason Sanders and Ocasio-Cortez are talking about this is that it’s popular.
A poll by Business Insider found that 73 percent of Democratic Party primary voters think it’s a good idea, and 70 percent of Republican Party primary voters think it’s a good idea. Those numbers would certainly fall in the context of an extended political struggle, but Fox News’s Tucker Carlson likes the idea, so there’s clearly some crossover appeal.
Tucker Carlson blasting usury last night: “There is a reason why the world’s great religions condemn usury & why societies have restricted it for thousands of years. High interest rates exploit the weak. Credit card debt destroys people…what the banks are doing is disgusting.” pic.twitter.com/7TRFpdDhSg
— The Columbia Bugle (@ColumbiaBugle) May 11, 2019
On some level, after all, restrictions on high-interest loans tap into both a progressive sense that we should get tough on business and a conservative sense that low-income people are prone to making irresponsible decisions. It’s also an example of what’s generally the political sweet spot for Democrats — proposals to take on big business that don’t involve introducing any new taxes or hassles that would fall on typical middle-class people.
But beyond crass political calculations, this proposal also speaks to a big important question that’s been essentially deferred ever since the great financial crisis of 2007-2008. Over the course of the generation before the crisis, the United States experienced a broad and multi-faceted expansion of consumer credit availability. This “democratization of credit” was widely celebrated in the 1990s and 2000s, but in the wake of the financial crisis, it looked more like an unsustainable Band-Aid that had been placed on the gaping wound of wage stagnation and rising inequality.
The establishment of the Consumer Financial Protection Bureau was meant to address this turn of events, but even as Republicans fought tooth-and-nail against its creation, the idea of a new expert regulatory agency never really captured the public imagination.
Cruder proposals that make things more difficult for banks — an interest rate cap — might.
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