Tuesday, 30 July 2013

Pay day loans

Hello. My name is Kostas Economides and I am a lecturer in the Department of Economics at the University of the South of England (USE for short). Well, actually that is not true really as the names of individuals and institutions in this blog have been changed to protect the innocent - and the guilty!

There has been quite a lot of the discussion in the cafe these last few days about pay day loans. As has been widely reported in the media the Archbishop of Canterbury, Justin Welby, has proposed that, rather than being outlawed, pay day loan companies such as Wonga should face competition from credit unions. He has promised that up to 15,000 churches could be used by credit unions as locations from which to operate.

Unfortunately for him the Archbishop then discovered that the Church of England Commissioners, who look after the church's pension fund and investments, has been indirectly putting money into Wonga through a US venture capital firm called Accel. In a way this doesn't matter as the extra publicity has keep the story going, and it is virtually impossible for any investment, however ethical, to be completely without indirect complications of this sort.

The discussion has several strands. First there is the question of whether pay day loan companies should be more tightly regulated, or even banned. Should the interest rate, which on an annualized rate is 5853% at Wonga,be capped?

In the cafe we all agreed that banning these companies would not be a good idea as they would likely just be replaced by less visible and more obnoxious loan sharks.

The question of an interest rate cap was more contentious. Mike Rowe and some others argued that any attempt to impose a cap would just distort the market. They went along with the Archbishop's view which is that the best way to approach the problem is to offer a viable competitive alternative. A few others though argued that the real problem was the automatic rollover of debts each month so that they became impossible to pay back. So their answer was not so much a cap on the interest rate as a limit on the number of months over which a debt could be accumulated. Mike said that unfortunately this would introduce an element of moral hazard. If a debtor knew that the debt would be frozen after a certain number of months then this would reduce, or maybe even remove completely, the incentive to pay it back before then.

This point led us on to discuss ethical rather than straight economic aspects of the situation. In some religions the idea of interest itself is considered unacceptable. As Giles Fraser in his Loose Canon column in the Guardian said, at one point Christians had declined to become money lenders themselves, leaving it to the Jews who they then persecuted for it.

As economists we recognise the need for interest payments on opportunity cost grounds. If a lender makes funds available for someone else to use then they are unable to use the money themselves. But why should interest rates reach such ridiculously high levels? "Normal" rates of 5% or even 10% seem to be acceptable but of course certain groups are more likely to default on the loan which means the lender will want an additional premium to cover this risk.

Is the real problem that the ordinary high street banks have just not been willing to make loans available to low income families? Decision processes have become too automatic and less personal. In the old days the local bank manager would know his customers and would help them to arrange a suitable pay back plan.

It will be interesting to know how this will develop. Will the government feel that it has to do something and intervene in some way? Or will credit unions operating from churches provide a competitive alternative to companies like Wonga?

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