doorstep robbery

8/8/2019 Doorstep Robbery

1/40

Doorstep Robbery:

why the UK needs a air lending law


2/40

nef is an independent think-and-dotank that inspires and demonstratesreal economic well-being.

We aim to improve quality o lie bypromoting innovative solutions thatchallenge mainstream thinking oneconomic, environmental and social

issues. We work in partnership andput people and the planet frst.

nef (the new economics oundation) is a registered charity ounded in 1986 by the leaders o The Other Economic Summit (TOES),which orced issues such as international debt onto the agenda o the G8 summit meetings. It has taken a lead in helping establish newcoalitions and organisations such as the Jubilee 2000 debt campaign; the Ethical Trading Initiative; the UK Social Investment Forum;and new ways to measure social and economic well-being.


3/40

Executive summary 2

Introduction 4

Of risk and knowledge: a short overview of consumer credit 6

The effects of interest rate caps a comparison 12

Escaping the debt trap: increasing affordable lending and

decreasing credit dependency 23

Conclusions and recommendations 29

Appendix 1 31

Endnotes 35

Contents


4/40Doorstep Robbery 2

Because income and benefts levels in the UK are too low to allow people tosave, make ends meet, cope with an unoreseen emergency, or just aord risingliving costs, people at the bottom o the income ladder are driven to use high

cost credit.

Nine million people in the UK dont have access to credit rom banks, so haveno choice but to use rip-o lenders: The cost o a loan o 100 with a companysuch as Provident Financial can be 49.50 nearly 50 per cent o the amountborrowed, or an APR o 545.2 per cent. A loan rom a payday lender costs evenmore; to borrow 100, lenders charge 25 or one month an annual percentagerate o nearly 1300 per cent. These lenders charge whatever they want the skyis the limit.

The Ofce o Fair Trading estimates that high cost lending in the UK is worth 35bna year. A huge amount squeezed rom the budgets o the poorest in society.

Unlike many European countries, the UK guarantees its citizens no legal accessto aordable credit, or caps the cost o it; lenders can reuse to lend to anyone orany reason, and they can charge any price be it 500 per cent or 5000 per cent.In other words, there is no air lending ethos in this country.

Legislation that would stop these practices has been rejected by Governmentbased on awed evidence.

The Government argues that poor people in Germany and France where theprice o credit is capped are worse o than poor people in the UK. But theevidence or this claim is awed and ignores the ollowing key acts:

P Poor people in Germany and France have much greater access to

mainstream credit than in the UK. Here, an estimated nine million peoplecannot access credit rom banks. In Germany and France, this fgure is arlower, both in numbers and in relation to their populations (2.5m and 3.5mrespectively).

P There are ar ewer adults without a bank account in Germany and France approximately 500,000 (in Germany) and one million (in France), comparedto 1.75m in the UK. Not having a bank account means paying much moreor bill payments and other services, urther increasing the need or credit. Itis the UK in which the poor are excluded.

Our solution

We call or an independent and wide-ranging review o the UK consumer creditmarket. We recommend to Government the ollowing:

The introduction o a community reinvestment actthat promotes transparencyin the fnancial system, that applies to all lenders. Banks that do not invest

Executive summary

The UK has a major debt problem one unnoticed by mainstreammedia and society. It aects the very poorest in our society. At leastthree million UK households pay hundreds o thousands o pounds

to legal loan sharks who charge them over the odds or somethingthat most o us can easily access rom banks: credit.



sufciently in local communities should be orced to sponsor a local aordablelender. High-cost lenders (e.g., doorstep lenders) should be compelled to alertpeople to alternative, cheaper lenders operating in their area and co-operate withthem.

The introduction o a cap on the total cost of credit.The exact level needs to beinvestigated as there is a need to establish the real risk o deault and the cap tobe set accordingly. In addition, there needs to be a discussion o where the cut-opoint should be: i people have more than a 50 per cent risk o deaulting on theirloans, is it wise or them to take out loans in the frst place?

Abolishment o credit dependency. Independent research should establish theshortalls in income and boost levels where necessary to maintain an acceptedstandard o living. Also, it should seek to promote savings programmes andsupport credit unions and CDFIs across the country to help them break the marketdominance o payday and doorstep lenders.

The evidence of the impact of interest rate caps on poor households needs tobe revisited. Current research seriously overstates the risk o credit exclusion andis conusing cause and eect. This does not allow or a balanced assessment oeects o price caps on poor households.



The Government was accused o acting like a loan shark by exploiting the plighto the poor. The Government quickly backed down and decided not to charge whatTheMail on Sundaycalled punishingly high interest rates on vital loans to thepoor.1

The outcry was, o course, justifed. It seems like a no-brainer that people alreadyon low incomes and in need o fnancial support should not be charged an interestrate that many o us would fnd obscenely high.

This logic, however, does not apply to the commercial sub-prime credit industry.Companies operating in this sector provide small consumer loans to people on lowincomes who cannot or do not want to use banks. Their prices exceed by ar the27 per cent APR suggested by the Government annual percentage rates startat around 180 per cent, but are more oten than not 600 per cent. In the case opayday lending, interest rates o several 1000 per cent are common. The public

outcry over these charges is notably absent.

This is despite the act that at least three million people2 use sub-prime lenders,oten to pay bills or or emergency expenditure. Payday lenders, home creditinstitutions and pawnshops make a tidy proft rom the need o poor people to takeout credit when their money doesnt stretch ar enough. Companies operating inthe sector claim to provide an essential social service by making small amountso credit available to people in emergencies, thereby avoiding destitution or anincrease in the number o illegal loan sharks.

Unlike in many other countries in the world, there are no price controls on

the cost of credit in the UK. Under the pretext of free market rhetoric and

purported negative outcomes for people on low incomes should credit be

restricted, there is no legislation in the UK that limits the price of credit.

This means that lenders can set the level o interest rate as high as they want. Theonly constraint is the price that potential borrowers are willing to pay; otherwisethe sky is the limit. The outcome is that many sub-prime clients are trapped in acontinuous cycle o indebtedness as they pay disproportionate sums to borrowsmall amounts o money, with the interest payments oten exceeding the originalcredit.

The underlying argument or this ree market approach is that access to any orm ocredit at any time by everyone is a good thing and that restricting access to creditis detrimental to the poor. This belie is frmly entrenched in the minds o politicians,

the industry, and many third sector organisations. This thinking is underpinned bystructural changes that resulted in the increase o unsecured consumer credit aswages and incomes have not kept step with ination rates; savings rates havedropped, and the use o credit to und everyday expenses has increased. Credituse has become the norm rather than the exception. Instead o closing the gap

Introduction

Late in 2008, there was an outcry over plans by the UK Governmentto introduce an interest charge on emergency loans available topeople on benefts. The proposal would have meant that recipients

would pay an annual interest rate o 27 per cent on the loans theytake out to replace essential goods, such as a rerigerator.



between income and basic expenditure, the Government has avoured a market-ledsolution to the problem, which in essence means that credit dependency has risen,and those who can least aord it pay the highest price. The sub-prime industryargues that it provides an essential service to people on low incomes to fnanceonce-o expenditures. However, most o their clients are now continuously in debt,which is partially caused by the business models o sub-prime credit, and partiallybecause o the decline in real incomes that creates a continuous need or credit tomake ends meet.

The consequences are obvious, continuous debt means continuous repayment

o capital and interest. Interest payments reduce disposable incomes, potentiallyincreasing the need or credit and limiting the ability to save. People are quicklylocked into a debt trap that can potentially lead to personal bankruptcy. High levelso debt create anxiety and health problems.3

Despite these clear problems, existing research on interest rate caps and creditexclusion does not question credit dependency. Based on a rather thin evidencebase, it is argued that restricting access to credit to low-income households willincrease credit exclusion and over-indebtedness, and drive people to illegal loansharks. This view has taken hold in Government and to some extent in the thirdsector as well. The pervasiveness o this view is dangerous, as it cements themarket dominance o high-cost lenders, and endemic poverty.

We thereore seek to revisit the evidence used to demonstrate the negative eectso interest rate caps. Are caps really bad or the poor? Is credit the only way out orpeople on low incomes? What other solutions are there?

First, we address pricing structures and risk models to explain the emergence osub-prime lending and why dierent people pay dierent interest rates.

Next, we examine existing evidence on interest rate caps and analyse theimplications o these fndings

Finally, we propose potential alternatives to the current high-cost credit model.


8/40



lender. The question that any lender will ask beore providing credit is: how likely is itthat the borrower will be able to repay the credit in ull and on time? Depending onthe answer the lender will decide whether or not to provide credit to the applicant. Asecond consideration is the cost o credit: lenders prices will also be inuenced byhow much clients are willing to pay.

Risk and credit scoring

The relationship between a potential borrower and a potential lender is marked bystrong inormation asymmetries. This means that potential borrowers know ar moreabout their fnancial situation and their ability and willingness to repay the loan in

ull and on time than the lender. Lenders can only rely on the inormation givenby the applicant, such as payslips, proo o permanent employment, and proo oassets, or example a house or savings i.e., collateral. The ultimate risk o a clientdeaulting or paying back late can never be ully excluded and thus needs to beestimated. The cost o credit, usually expressed as interest rate payable on theoutstanding loan amount (the principal), thus always includes a certain componentthat reects the probability o the lender losing part or all o the money lent.

In the last couple o decades, lenders have tried to change this inormationimbalance by building databases containing inormation about borrowers beyondtheir repayment punctuality. This method is called credit scoring.

Lenders or credit rating agencies, such as Experian, collect demographicinormation to build risk profles o their clients, calculating the likelihood o deaultbased on statistical ormulae. These profles are made up o payment records (e.g.,the regularity o repayments made on previous loans, use o credit cards, etc.),but also o socio-demographic data, such as age, gender, occupation, post code,marital status, number o dependants, home ownership, and stability o lie situation(e.g., requency o job changes, house moves, etc.). The more detailed the credithistory, the more a lender can fnd out about the borrower. Depending on the score,lenders decide i they will provide a loan, and at what price. Living in an auentarea (identifed by the post code), with a stable well-paying job and an impeccablerepayment record on previous loans, or example, results in a good credit score,indicating a high probability o repayment and hence a low risk. This low level o riskis typically reected in a persons ability to easily access credit and at a low price.

On the other hand, i the credit history shows a bad repayment record (i.e., missedpayments on previous loans, or repossession o goods bought on credit), and i theapplicant lives in a poor area, and requently changes jobs, this will lead to a poorcredit score. Depending on the lenders policy, and on the severity o the repaymentproblems, credit may be denied completely, or a higher interest rate charged tocover the increased risk o deault. The higher the risk, the higher the interest rate,and usually the lower the amount o credit an applicant can borrow.

At frst sight, this appears to be a good system to streamline the credit applicationprocess and even out the inormation imbalance. However, these profles are nota perect predictor o risk, and they can be too schematic and omit alternative

inormation, such as regularity o bill payments or savings.4 By and large,applications or consumer credit are solely based on credit scoring. While thismakes the process quick and efcient or most, those rejected because o someperceived or real aw in their credit history will fnd themselves unable to access thecheap mainstream option, as appeals against rejection decisions are rarely granted.

An additional systemic problem with credit scoring is that a lack o credit history isinterpreted as having a bad credit rating. This leads to the situation where someonewho is prudent with money, manages on an existing budget and has had noprevious need or credit can be denied a loan or credit card application (the latteris now oten essential or paying or goods on the internet, or example). This is acatch 22 situation without using credit, people cannot build a credit history andhence will be seen as high-risk clients, either reused credit or charged higher rates.This aects mostly poor households, as they tend to budget in cash rather thanthrough bank accounts.5

In short, credit scoring relies too much on existing inormation and puts too strongan emphasis on statistical probability, marginalising people on low incomes.



The next question is: why do banks not simply increase the price or the high-riskgroups to reect the risk that they seemingly present to their lending operations?Why outsource this group to the sub-prime market? Ater all, there is no price capon the level o interest in the UK; hence they could charge what ever they deemft to cover the high risk, making up or some o the lost capital should a borrowerdeault beore completely repaying the loan. Also, the return on a risky loan, i repaidcompletely, would be high, thus compensating or the risk o deault. Following thislogic, there appears to be no reason or the apparently systematic credit exclusiono people on low incomes.6

The reasons or banks behaviour lies in cost/proft considerations and reputationalrisk.

First, the loans poor people require are requently small, a ew hundred pounds atthe most. Banks make more proft rom larger loans than rom smaller ones. Thereis a fxed cost o processing a credit application that is independent o the loansize (the unit cost). Hence, the proportion o money that can be earned rom small,short-term loan is lower than rom a large loan that is paid o over several years.Banks thus have little incentive to provide small consumer loans when there is moremoney to be earned rom higher value loans. The combination o this disincentivecombined with the (perceived or real) higher risk means that banks oten do notbother with loan applications or small amounts. I one o the credit-scoring markers

indicates that the risk is high (e.g., the post code or occupation) and the amountapplied or is low, then the bank might well reject an application because the proftmargin would be insufcient.

Secondly, most mainstream banks (such as Barclays, HSBC, or First Direct) wouldrecoil rom charging high interest rates, as they ear repercussions rom bothcustomers and shareholders alike:

P Customers may fnd their practices distasteul as the interest rates appearextortionate.

P Shareholders may ear that customers will desert the bank because o theirdistaste, and may believe that despite the higher prices, lending to poor

households is still too risky.7

The combination o the lower proft margins and the reputational risk o charginginterest rates that would compensate or these lower profts thus create exclusionrom mainstream credit.

Enter the sub-prime industry. Sub-prime lenders provide products that meet theneeds o people on low incomes. Flexibility and aordability o instalments arethe main criteria here. First, low-income households requently budget in cash,as it suits their payment cycle better (benefts and low wages are oten paid outweekly or ortnightly rather than monthly). Also, poor households have little leewayin their budget to pay or unoreseen expenses. Predictable, fxed-value instalments

to repay credit are thus important, as is the exibility to occasionally pay late ormiss one repayment. Banks typically charge ees or late or only partial repaymento instalments, thereby increasing the cost o credit drastically and, above all,burdening already-stretched households with a urther expense that usually needsto be paid immediately. There is hence little exibility in repayment schedules. Sub-prime lenders provide the necessary requirements o predictability and exibility thatbanks cannot or do not want to provide.

What are sub-prime lenders?

Sub-prime lenders include a wide array o institutions that provide credit to thosecustomers that mainstream lenders (such as the high street banks) would reject.Their lending criteria are more relaxed than those o mainstream lenders, but theirprices mostly exceed those o the standard lenders.

As a rough guideline, sub-prime lenders and products can be separated into twogroups. In the frst group, we have those who cater to people with a bank accountand jobs, oering interest rates o around 50 per cent APR, and give people theopportunity to build a credit history or improve an existing credit rating. Examples o



this include the now inamous Northern Rock mortgage lender. The second groupo sub-prime lenders concentrates on those people without access to mainstreamcredit. Roughly speaking, these include people with basic bank accounts (these donot oer any credit acilities), the unbanked, and people with a strongly impairedcredit history that do not qualiy as average clients. Our report concentrates on thisgroup o people. For the remainder o this report, we will use the term sub-prime toindicate both clients and companies in this market segment.8

As pointed out in the introduction, sub-prime lenders charge APRs o usually morethan 180 per cent, with the highest to be ound in the payday lending industry, with

APRs o up to 1700 per cent.9 This pricing structure can be partially explained bythe high risk o deault, but there are other reasons why lending to people on verylow incomes costs more than to more mainstream clients. More auent peoplecan reduce consumption, or sell smaller assets to ensure continuing repayment.The poor oten have ew ways o managing debt when presented with an incomeshortage. This adds another layer o risk to the lender, hence increasing the pricecharged to compensate or the potential deault or late payment.

In addition, sub-prime lenders, particularly those operating in cash (home creditproviders and the payday lending industry) use the exibility they provide as anargument or very high interest rates as part o their service. Their business modelsall into two categories: home credit and payday loans.

Home credit

Home credit companies have a network o local agents that visit people in theirhomes to oer credit and collect weekly instalments. Credit amounts are typicallyaround 200, but can be as low as 50 and as high as 500. Typical annualinterest rates are upwards o 150 per cent or loans repaid over 30 or 50 weeks.Clients are oten unemployed and many do not have a bank account, precludingcollection by direct debit. According to the Competition Commission, 2.3 millionpeople use this orm o credit.10 Home credit provides the exibility in repaymentthat low-income households need. Instalments can be missed without incurring anextra ee or other orm o penalty (i.e. restriction o credit availability). Home-creditproviders use this exibility to justiy their high prices the risk o late payment isbuilt into the price. Whilst this exibility is greatly appreciated by clients, it imposes ahigh cost on them there are no rebates or changes in credit conditions when theclient always repays on time. To a certain extent, good clients subsidise those whopay late or miss payments.

Payday loans

Users o this type o credit must be employed and have a bank account into whichtheir wages are paid. There are no credit checks and little to no investigation intothe ability o a client to service the loan. The lender accepts a post-dated chequemade out or the next payday, and pays out the sum on the cheque minus a ee orthe service. The incoming salary serves as security that the lender will receive themoney back. On the day that the client receives his or her salary, the payday lenderthen cashes the cheque. For a cheque o 100, payday lenders will typically keep

between 15 and 20. APRs on these arrangements typically exceed 1000 percent.11 For this type o lending, it can be argued that the risk to the lender is actuallyvery low. The lender holds the cheque as a security against the next incomingwage, and hence the risk is only that o an employee being made redundant beorethe next payday, or the company going into administration. Whilst it is a risk, this issomething that all lenders have to deal with, so the excessive charge cannot bejustifed.

The real problems with payday lending start with the practice o rolling the loanover: i clients do not have sufcient unds in their account, they can pay a urtheree to deer the cashing o the cheque. I this is done over several months, the eescan quickly surpass the actual amount owed (the principal). Most crucially, theoriginal loan is not repaid through this rolling over. An example can illustrate thiscost structure:

A customer gives the payday lender a cheque o 100, and receives 80. The eeo 20 goes directly to the lender. The client cannot cover the amount at the next



payday, and rolls the credit over against another ee o 15. I this is done over sixmonths, the client has paid 95 in ees to obtain 80 as a cash advance and has yetto repay the original 80. Whilst some payday lenders restrict the number o timesa loan can be rolled over, and require a partial repayment o the principal, there isno regulation that standardises this behaviour. According to Debt on our Doorstep(DOOD), a leading organisation in the campaign or responsible lending practices inthe UK, there is no comprehensive overview o the payday lending market, and hencelittle inormation on the size o the problem. However, according to the research byDOOD, the number o payday outlets has grown substantially since 2007.12

Sub-prime credit providers oten claim that they provide a socially benefcial service,as they oer short-term credit in times o emergency to a population group thatcannot access fnance rom elsewhere. However, it appears that many sub-primeclients are perpetually in debt and never pay o the principal as they require thecredit to make ends meet. This prompts the question what is credit or?

The uses of credit

To shed some light on this question, it is important to revisit the original purpose ocredit, namely the extension o cash or an investment that will prove proftable inthe long run, i.e., where returns exceed the cost o repaying the loan with interest.Lenders and borrowers expect a return on investment. In recent years, however,credit has not necessarily been tied to fnancing a specifc investment but used

to fnance consumption. In the case o much o sub-prime lending, credit hasbeen extended to cover basic living expenses. For the purpose o this paper, wedistinguish our types o situations where credit may be required:

1 Emergencies

Households who manage reasonably well on their budget, but cannot makesubstantial savings, are suddenly hit by an unexpected expenditure that cannotbe deerred. This can be the cost o a uneral, a broken rerigerator, or carrepairs. All emergency expenditure has a one-o character, i.e., credit or it hasa limited time period and is paid o in ull.

2 Investment

This category reects expenditure made to improve a living situation. This can

include, or example, the purchase o a car that enables someone to obtain ajob, or ees or a training or university course. It can also include replacing amattress to improve sleep, or redecorating a room. Again, these are requentlyone-o expenditures and credit taken out to pay or these is clearly delineatedin volume and length.

3 Consumption

Credit usage to pay or holidays or clothes has increased drastically. Manyauent households see their credit cards as a means to increase theirdisposable income. Similar to the ourth credit type, the principal is rarely paido and debts can build up quickly.

4 Daily expenditure

Households on very low income oten cannot make ends meet. There is littleto no scope or making urther savings in expenditure, and hence credit needsto be taken out to pay or ood, clothes, utility bills, and other expendituresin everyday lie. This need to take out high-cost credit puts an unnecessarypressure on low household budgets, and it also means that households areperpetually in debt. The situation is exacerbated when households need toborrow additional sums to service existing debt.

With the increase in consumer credit, products that provided fnance or dailyexpenditure have increased dramatically. Increases in the cost o living were notmatched by increases in wages and benefts, thus creating credit dependencyamong poorer households. This credit dependency can quickly lead to high levelso debt, and eventual over-indebtedness. Revolving credit and roll-over credit have

greatly contributed to this development.

P Revolving creditdescribes the practice most associated with credit cards.Customers are given a monthly limit that they can use on their credit card. Thislimit is renewed monthly, giving the customer resh access to credit. I this limit



is or example 1,000, this means that the client has access to 12,000 o

unsecured credit a year. O course, clients need to make regular repaymentsthat are agreed with the credit card company. There are usually mandatoryminimum repayments to pay o the outstanding debt, on which interestis charged. I the client uses credit constantly, and makes only minimumrepayments, the outstanding balance and the interest due can quickly rise torepresent a substantial sum o annual income, resulting in over-indebtedness.As this product is not typically oered by doorstep and payday lenders, we willnot concentrate on this type o credit.

P Roll overcredit is the practice o deerring payment o an outstanding loan bycontinuing to pay interest, but leaving the capital unpaid. This is common inpayday lending, and also reported in the home credit industry.

P Renegotiated loans are those loans where lender and borrower have agreedto change the terms o repayment. Repayment instalments are decreased tobetter suit the borrowers budget, which increases the length o the loan. Whilstit provides relie on the budget, it increases the total cost o credit (Box 1).

P Credit reshufingis used when existing credit lines are ully exhausted.Borrowers obtain a new credit card with a higher limit or take out a new loan.The new credit is then used to pay o existing debt and the higher limit is usedto continue to increase spending power. This tactic is oten used by peoplestruggling with repayment to appease lenders and maintain a clean credit history.In some cases, this type o credit consolidation can help to better deal with debt,but can also increase the risk o over-indebtedness, especially when the terms

o the consolidation loan are worse than those o the existing loans. As peoplescramble or new lenders, these terms are not always ully read and understood.In the home credit industry, borrowers oten take out a new and larger loan romthe same lender to pay o the outstanding debt, with the terms o the new loanthen leading to higher costs o credit, similar to credit renegotiation.

Box 1: Total cost of credit vs annual percentage rates (APRs)

There is justifed criticism o the use o APR as a price measure o credit. We agree with these criticisms and explain inthis box the shortcomings o APR and why using the total cost o credit to provide price comparisons would be better.

Discussions around interest rate caps oten ocus on the APR that is charged on the borrowed amount. Unortunately,with the ocus on APRs, the true cost o credit is obscured.

In the home credit industry, all ees associated with the loan are part o the cost o credit and included in the APR. At

frst sight, the APR would thus seem to adequately reect the price o credit. However, APRs only reect the annualcost, not the total cost over the length o the loan. In addition, the APR does change quite dramatically with the lengtho the loan: the longer it takes to repay the loan, the lower the APR becomes. At the same time, the total cost o creditrises with the length o the repayment period. The reason lies in the way repayment is adjusted or a shorter/longerrepayment period: the shorter the repayment period, the higher the weekly instalment, and vice versa.

In other words: the longer it takes to repay a loan, the higher the total cost o credit, and the lower the APR an exampleusing the loan calculator on the website o Provident Financial, one o the largest home credit lenders, illustrates this.

For a loan o 200 over 31 weeks, the weekly instalment is 10, and the total amount payable 310. This is an APR o365.1 per cent. The total cost o credit is 110 (310200).

To repay the same 200 over 52 weeks results in a weekly instalment o 7, and an APR o 272.2 per cent. The total

amount repayable is then 364, and the cost o credit is 164 (364-200). So, in spite o the lower APR, the secondoption is actually more expensive.13

The total cost o credit (TCC), in contrast, expresses the price o credit as a percentage o the amount borrowed. Thisgives a good indication o the proportions between amount borrowed and the price paid or it. Using the examplesabove, the frst loan would result in a TCC percentage o 55 per cent (110/200*100). In the second example, it is 82per cent (164/200*100). There is no conusion about which o the two is lower, and thus represents the better deal. Italso underlines the high prices paid in both instances the cost o credit is over hal o the amount borrowed.



This is based on a set o arguments derived rom research carried out in theUK, Germany and France. Germany and France have price controls and morerestrictive consumer credit regulation and practice than the UK. The researchargues that the situation or poor people in Germany and France is worse, asthey are excluded rom credit.

Research supporting these claims is driven by the assumption that access tocredit is a necessity o modern lie and does not question the act that peopleon low incomes need credit to und essentials, and that they have to pay thehighest price or it. Following this line o argument, sub-prime lenders (such asdoorstep lenders) are seen as a orce or good, as they provide an essentialservice to a market that the mainstream does not, or cannot, serve. From thisperspective, a price cap in consumer credit markets would mean that sub-primelenders could not cover their costs anymore, and hence they would withdrawrom this market segment, leaving the poor exposed to hardship and illegality.

This is only true, however, i pricing does accurately reect risk. Pricing in thesub-prime industry is not transparent, and there is some evidence to suggest

that prices in the sector are overinated. When the Competition Commissioninvestigated the home credit industry in 2003/2004, it ound that one sub-primelender operating in both the UK and in Ireland was cheaper in Ireland thanin the UK. Overall, it concluded that the doorstep lending industry in the UKovercharges its clients by around 7 per 100 lent, a cautious estimate by theCompetition Commissions own admission.14

In spite o these acts, the Government did not compel the industry to lowerprices or to become more transparent. The discussion then and now isdominated by the assumption that prices accurately reect risk, and that thesub-prime sector provides a vital service to those on low incomes. The questionas to why those who can least aord it need to take out high-cost credit to aord

basic everyday items was never asked. The narrow ocus o the discussiondetracts rom the wider issue o credit dependency o the poor.

Instead, opponents o interest rate caps pointed to the research mentionedabove.

This research demonstrated seemingly greater levels o credit exclusionin Germany and France, higher levels o over-indebtedness, and a greaterincidence o illegal loan sharking. The price cap is seen as the singularexplanatory actor or these circumstances. This is despite the act that inter-country comparisons o consumer credit markets are very difcult to make,and that dierences will have more complex roots than only interest rate caps.Research that provides arguments against interest rate caps overlooks this

wider picture. A more nuanced analysis o credit regulation, income levels, socialwelare provisions, and cultural attitudes to credit is missing rom the discussion.

In the ollowing section, we seek to introduce a more detailed picture and opena discussion on credit dependency in the UK.

The effects of interest rate caps a comparison

Despite the evident burden on poor households rom having to takeout high-cost credit, the Government is opposed to the introductiono an interest rate cap. It argues that interest rate caps would reduce

the availability o sub-prime credit, causing destitution and drivingpeople into the arms o illegal loan sharks.



In particular, we reassess the validity o the claims made by opponents ointerest rate caps:

P Countries with interest rate caps have higher levels o credit exclusion.

P Countries with interest rate caps have higher levels o over-indebtedness.

P Countries with interest rate caps have higher incidence o illegal lending.

P Demand or credit among poor households is the same in countries withand without interest rate caps.

But frst, lets briey review the sources o these claims.

The sources of evidence

The research that orms the basis o much o the UKs stance on price capsstems rom reports prepared by the consultancy Policis on behal o theDepartment or Trade and Industry (DTI), now the Department or Business, Skillsand Innovation (BIS). When asked about their opinion on interest rate caps,policy-makers and practitioners in the feld o debt advice requently cite thisresearch as the reason or their opposition. In our opinion, however, there aresome question marks over this research; it does not appear to adhere to basicstandards o social science research. We set out our concerns regarding thequality o the research in Appendix 1 while in the body o this report we ocus onthe arguments made. We concentrate on two reports prepared or the DTI (now

BIS) and one presentation, all o which are in the public realm:

P The effect of interest rate controls in other countries.15

P Illegal lending in the UK(together with the Personal Finance ResearchCentre, November 2006)16

P Interest rate ceilings and responsible lending an international perspective, apresentation given at the Transact National Conerence 21 November 200817

There appear to be no other UK reports that empirically investigate the impact ointerest rate ceilings on consumers.18

All three o these reports/presentations rely strongly on a survey among low-income households conducted in Germany, France and the UK in 2004. Hence,

Box 2: The empirical data: a survey without basis?

The evidence base o the DTI report relies heavily on a market survey undertaken by TNS on behal o Policis (theconsultancy that carried out the report) in 2003. Against common practice, however, next to no inormation is availableon how and with whom the survey was undertaken. Only in one report is mention made o the number o people whoresponded to the survey, and that these 2,717 respondents were chosen rom among the 20 per cent o the pooresthouseholds in each country.19 Beyond this statement, no inormation is available on:

P Selection methods: who was asked and how were they chosen?

P Number o respondents in each country: how many replied and rom where?

P The questions asked: why was the questionnaire not included in the reports?

P Type o questioning techniques: how was inormation collected? Did people tick boxes, were answers prompted,or were they coded retrospectively?

Contrary to convention,20 none o this inormation is provided; hence there is no way to assess the quality o the data,the wording o the questions and to establish whether or not keywords were defned. These are important issues insocial science research as respondents tend to interpret questions in dierent ways and without a uniying defnition,

results are difcult to compare (see Appendix 1 or a detailed explanation). Similarly, the analysis does not providesufcient inormation to allow or an inormed assessment o the research no actual response fgures are given oreach question. Responses are requently expressed in percentages, but without knowing how many people answered,the inormation is useless. Hence, the validity o answers or the whole o the database needs to be questioned.



by and large, they use the same database. Germany and France were chosenas comparison countries as they both have interest rate ceilings in place.

There are some serious question marks over the survey which orms the basiso the evidence and the conclusions drawn. We discuss the methodologicalshortcomings o this report in detail in Appendix 1, and limit our concernsregarding the customer survey to a ew short points presented in Box 2 beorewe concentrate on the analysis o the data.

Leaving these methodological concerns aside or the moment, we now turn to

assess the claims made by opponents o price caps on their eects on the poor.

Credit exclusion: causes and extent

One argument against price caps is that they exclude poor people rom credit:they present a higher risk, which lenders cannot cover adequately becausethe price o credit is capped. The evidence gathered by Policis on behal o theDTI (now the BIS) is used to underline this point.21The report, The effects ofinterest rate controls in other countries, states that credit exclusion in Germanyand France is higher than in the UK. Credit exclusion here is defned as notbeing able to access credit at all, be it rom a sub-prime or rom a mainstreamlender. The price cap in both countries is given as explanation or this apparentwidespread exclusion: because o the limits on prices, there would be no sub-

prime lenders providing credit to the high-risk segment o the population.

From data on consumer credit market volumes, it becomes immediately clearthat supply o credit in Germany and France is not as abundant as in the UK.

However, is the price cap the only reason or this situation? And does this meanthat credit exclusion is widespread? Or do other actors play a role?

Regulatory differences

The regulatory regimes or consumer credit vary greatly between Franceand Germany on the one hand, and the UK on the other. Broadly speaking,regulation in the UK is not very onerous on lenders, while rules and laws aremuch tighter in the other two countries.

Price capping

As mentioned above, there are no price caps on the cost o credit in the UK.Both Germany and France, on the other hand, have price caps in place. InGermany, usury is defned as the interest rate being more than twice the market

0

50

100

150

200

250

2007

bn

2006200520042003

Germany

France

United Kingdom

Source: ECB 2008,22 modifed. Note that the comparisons are approximate as data collection varies between the three territories.

Figure 2: Consumer credit lending (ebn)



rate. Lending above this limit is considered predatory lending and constitutes acriminal oence. Credit agreements where this ceiling is exceeded are void andthe client does not have to repay the interest. The level o the ceiling can oat upand down. In practice, maximum APRs are usually around 2830 per cent.23

In France, the cap is prescribed by law and is adjusted quarterly by the Banquede France. There are two ceilings: one or credit belowe1500 at around 2025per cent and one or credit above e1500, at around 78 per cent APR.24 TheFrench Government is currently reviewing its consumer credit legislation, so thismay change in the near uture.

From our explanations o the dierences in risk and pricing structures betweenthe mainstream and the sub-prime market, it reasonable to deduce that theprice cap is responsible or the absence o a sub-prime market.

However, this is not the sole actor that restricts the development o a sub-primemarket and the availability o consumer credit in general.

Current legislation in Germany, or example, allows only banks to provide credit.As a consequence, home credit companies and payday lenders cannot exist inGermany. In addition, credit card balances have to be paid o in ull each month,unlike in the UK, where credit card debt can be paid o over several months.

These actors already limit the availability o credit but this has nothing to dowith the usury ceiling.25

In France, there are fnancial institutions (some o which are at least part-owned by a bank) specialising on the provision o consumer credit o varyingtypes. Credit can either be tied to the purchase o a good, or can be unsecuredcredit, such as revolving credit. Interest rates or credit are limited by the ceilingdescribed earlier. However, this does apparently not restrain accessibility ocredit or most people. Real credit cards are common, as is revolving credit ingeneral (we will return to this later in more detail). Regulation o operations,however, is stricter than in the UK: all types o credit institutions are regulatedby the Bank o France (or the Committee or Credit Institutions and InvestmentInstitutions (CECEI) to be more precise) and have to ulfl certain licensing

criteria, such as minimum capital requirements.26 As a consequence o theseregulatory requirements, certain sub-prime models such as cheque cashingservices, payday loans or home credit companies do not exist. Again, the interestrate ceiling cannot be seen as the sole determining actor or the absence o asub-prime market in France.

The reverse o this situation is also true: the absence o a price cap in the UKis not the sole reason why sub-prime lending is thriving here. O all the threecountries, consumer credit regulation is most relaxed in the UK. Companiesproviding consumer loans, but not taking consumer deposits, only need toobtain a license rom the Ofce o Fair Trading. The conditions o obtaining thislicense concern themselves mostly with character ftness and proessional

competence o the applicant,27but do not require minimum capital holdingsor other pre-conditions. Consumer credit companies are not regulated orsupervised by the Financial Services Authority, the Treasury, or the Bank oEngland. O course, the ability to charge very high prices will be conducive tothe existence o a large sub-prime market. However, the relative simplicity withwhich lending operations can be established is also an important actor.

These dierences in regulation make it difcult to compare countries based onthe existence or absence o interest rate caps alone. Because o the tighter ruleson suppliers o credit (stricter licensing and supervision regimes), there will beewer organisations willing to enter the market in Germany and France in thefrst place. The lower barriers to entry into the personal consumer credit marketin the UK result in a higher availability o credit in the UK compared to the othercountries. Does this mean, however, that credit exclusion is more widespread inGermany and France? Given that there is no sub-prime lending industry in thesetwo countries, we need to concentrate on the exclusion rom mainstream banking.Not being banked in either France or Germany makes obtaining credit nigh onimpossible, as opposed to the UK where doorstep lenders provide credit or the



unbanked. For credit exclusion to be per se higher in Germany and France, morepeople in these countries would have to be unbanked than in the UK.

Financial exclusion levels

Looking at the numbers o unbanked people in all three countries, it quicklybecomes clear that this number is ar higher in the UK than the other countries.As a consequence, the levels o exclusion rom the mainstream credit marketare ar higher: a conservatively estimated 1.75m adults in the UK do not have atransactional bank account.28 In contrast, in Germany, there are only an estimated500,000 adults.29 The estimates o the number o unbanked people in France vary

between 500,000 and 1 million adults.30

O course, having a bank account is not the same as having access to credit. In allthree countries, banks oer basic bank accounts (BBAs) without overdrat acilitiesor credit cards to certain client groups.

In the UK, there are 7.7 million accounts without credit acilities,31 nearly 4 times thenumber o Germany (two million at the end o 200632) and France (2.1 million in200833).

This puts the number o people excluded rom mainstream credit in the UK wellahead o the other two countries: in total, at least 9 million people cannot access

credit rom mainstream banks here, as opposed to ca 2.5 million in Germany andbetween 2.5 million and 4.1 million in France.

These fgures indicate that the banking systems in Germany and France are moreinclusive than in the UK, reducing the potential market or sub-prime credit throughspecialised high-cost lenders. Again, dierent regulatory regimes contribute to thesedierences.

In the UK, there is no universal service obligation, i.e., banks are not compelled toopen bank accounts or clients they do not approve o. The Government and thebanks started a voluntary initiative in 2003 to halve the 2.8 million people that werethen unbanked, with varying degrees o success.34 The basic bank account (BBA)is recommended as a frst account or people on benefts, and or people on low

incomes. British banks may reuse people a BBA i they have an undischargedbankruptcy (i.e., they are in the process o insolvency procedures) or have a badcredit history.

In contrast, banks in France are obliged to open a bank account or everyone, andhave to oer an overdrat o 50 per cent o a clients income on current accounts.This regulation was created to curb the penalty payments that clients incur whengoing accidentally overdrawn.35 Accounts without credit acilities are specifcallyor those who have entered bankruptcy procedures and hence by law have losttheir right to access credit or a certain period. Rather than being a specifc bankaccount, current accounts have their credit acilities withdrawn (i.e., overdrats arecancelled and credit and debit cards voided).

Similar to the UK, German banks have undersigned a voluntary commitment toopen bank accounts or everyone. There is a legal quasi-obligation or savingsbanks to open bank accounts that is taken very seriously (the exact status o thisobligation appears to be disputed and varies rom state to state). BBAs are oeredto those who have been declared bankrupt or are seen as over-indebted. Reasons

Table 1: levels of credit exclusion in the UK, Germany and France

UK Germany France

Number o unbanked (in m) 1.75 0.5 0.52.0

People with basic bank accounts (in m) 7.70 2.0* 2.1

Total excluded rom mainstream credit 9.45 2.5 2.64.1

Souce: nef research; *end o 2006



to reuse the opening o a BBA in Germany, or example, are limited to raudulentbehaviour or repeated breach o agreements.36

While there is no compulsion or banks to oer an overdrat, banks are lessrestrictive in their practices than in the UK. According to the German Federation oSavings Banks, the source and level o income does not automatically precludethe extension o an overdrat to a client. There is no precise data on the volumeo overdrat lending to people on low incomes or benefts as there are no bindingrules, and each o the ca 1500 banking institutions in Germany can decide onlending practices.

It is noteworthy that in the UK, bankruptcy and over-indebtedness are reasons toreuse the opening o a BBA, while in the other two countries they are specifcallydesigned or this segment o the population.

As a consequence o UK banking policies, credit exclusion rom the mainstream isar more pronounced here than in Germany and France so even though there isno dedicated sub-prime market in the latter two countries, there is also much lessneed or it. Not only does this challenge the validity o claims that credit exclusionis worse in countries with interest rate caps, it is also a clear demonstration o theimportance o an inclusive banking sector that provides bank accounts and,where reasonable, credit to people on low incomes.

Over-indebtedness

Research into interest rate caps also claims that levels o over-indebtedness arehigher in France and Germany than in the UK. Again, the existence o an interestrate cap is used to explain this phenomenon. As interest rate caps would suppressthe development o a sub-prime credit market (and as we have explained earlier,this explanation is insufcient), people would have to take out loans that are notcommensurate with their needs. The very small loans usually oered by sub-prime lenders in the UK (rom 50 upwards) would not be available. Instead, thepoor would have to borrow amounts that exceed their needs (and budgets) rommainstream lenders, thereby unnecessarily burdening them with a high debt loadthat causes over-indebtedness.

There are two problems with this argument. First, opponents to interest rate capsclaim that these cause credit exclusion. At the same time, they claim that caps causeover-indebtedness. This appears to be a contradiction: i interest rate caps causeexclusion rom credit, how can people become over-indebted in the frst place?

Secondly, comparing data on over-indebtedness between countries is difcult asthere is no single defnition o over-indebtedness in Europe. As a consequence,over-indebtedness is not a good indicator to compare levels o problem debt. Inter-country comparisons based on this indicator should thus be treated with caution.

Furthermore, research seeking to demonstrate that levels o over-indebtednessare higher in Germany than in the UK37 compares two dierent indicators: namely

estimated levels o over-indebted households in Germany with the number opersonal insolvency proceedings in the UK (Appendix 1). These two indicators donot allow or a direct comparison as over-indebtedness is a process that doesnot necessarily lead to personal insolvency. Interventions by debt advisors andnegotiations with creditors can achieve a sustainable repayment plan and helpavoid bankruptcy. Personal insolvency, on the other hand, is an administrativeprocedure regulated by law, and once proceedings have started, they cannot behalted. In order to obtain a good comparison o problem debt between countries,personal insolvency fgures are a ar more suitable indictor.

As Figure 3 shows, personal insolvency fgures in the UK have increased dramaticallysince 2006. This is despite the act that this predates the credit crunch, i.e., in timeswhere credit was reely available. Since 1999, UK fgures have been consistently

higher than in Germany, where the numbers have actually dropped in 2008. This iscounter-evidence to the argument that interest rate caps cause over-indebtedness.

The sharp increase in the UK is all the more startling as it occurred during the goodtimes. A way to avoid insolvency (i.e., the inability to service debt) is to take out



a new loan to pay o previous debt. The amounts that need to be paid are thus

shued rom credit card to credit card, without ever paying o the outstandingamount. In a situation where consumer credit is reely available (i.e., checks onability to repay are based mostly on an applicants credit score and annual income),this can be done several times beore the credit burden becomes too high tomanage. The increase in personal insolvencies in 2006 indicates that even withoutthe credit crunch and subsequent reduction o availability o consumer credit,people ound themselves unable to cope with their debt load.

However, as Figure 3 also reveals, personal insolvencies are much higher in Francethan in both Germany and the UK. Again, can this be attributed to the interest ratecap, or are other actors at play?

France, like many other countries, has seen a stark increase in consumer creditover the past 15 years. Revolving credit plays an important role in this market. Thisorm o credit makes up 20 per cent o total consumer credit, the third-highest levelin Western Europe. In terms o volume, France (e28.8m) ranks second behind theUK (e90m), (by contrast, the share o revolving credit o total consumer credit inGermany is only 7 per cent, and a volume o e15.7m38). This relatively new ormo credit, and the selling practices associated with it, is seen by some as the mainculprit or over-indebtedness.

Just as in the UK, the credit crunch has put an end to a way o budgeting which isentirely dependent on the continuous availability o resh sources o credit. Short-term credit in general (e.g., renewable, unsecured credit without a repaymentplan) now accounts or 70 per cent o debt o insolvency submissions,39 a strong

indicator o the problems associated with this orm o credit.

Apparently, the regulation on sales and marketing practices has ailed: a study by aconsumer protection agency, UFC Que Choisir, (the French equivalent o Which?)suggests the credit is oten pushed on to clients. Customers are sold revolving creditalthough they sought fnance or a specifc product, like an electronic good. Accordingto the UFC Que Choisir, the revolving credit market in France would be characterisedby absence o choice, systematic and hidden provision o credit (via store cards),granting o credit without in-depth investigation o the consumers circumstances).40Credit tied to the purchase o a certain good (with a payment plan) was replaced byrevolving credit provided through store cards. While it seems that there is regulatoryailure, the level o the interest rate does not appear to play a role here.

Again, by solely ocusing on interest rate caps as the explanation or a certainsocietal phenomenon, the wider picture is missed. Over-indebtedness is a problemin both France and Germany, but the interest rate cap appears to be unrelated tothis problem.

0

20000

40000

6000080000

100000

120000

140000

160000

180000

1999

N

umber

Germany

France

England and Wales

UK

2007200520032001

Figure 3: Insolvencies in the UK, France and Germany

Sources: UK fgures: The Insolvency Service; or Germany: Statistisches Bundesamt; France: Banque de France.



Credit dependency and illegal lending

We have already shown that levels o credit exclusion are not necessarily higherin countries with interest rate caps provided they have banking regulation thatpromotes fnancial inclusion. Interest rate caps are also not responsible or over-indebtedness as the experience in Germany and France demonstrates. Thediscussion shows clearly that the ocus on interest rate caps does not serve wellas an explanation o the dierences in consumer credit markets.

This also applies to a urther claim made by opponents o interest rate caps,namely that demand or credit among poor households is similar across

countries. Again, the consumer survey carried out by Policis41 is cited asevidence to back up this argument. This suggests that there would be equalcredit dependency o low-income households, i.e., the absolute need to take outa loan when an emergency arises. As we investigate in closer detail in Appendix1, we have doubts about the conclusions drawn by the reports authors basedon the survey. In addition, we are questioning the statement that credit demandis not specifc to a countrys regulatory and cultural environment.

There are two reasons why we doubt the validity o this statement:

1 Poverty and inequality levels are higher in the UK.

2 Disposable incomes are lower and prices higher in the UK.

Equality of poverty?

The statement that the demand or credit is equal in all three countriescompared can be interpreted in two ways:

1 The spread o poverty is similar, i.e., that there is a similar proportion o poorpeople in all three countries.

2 The depth o poverty is similar, i.e., that the gap between the householdsearning the least money and the national average is the same.

To assess the frst possible interpretation o demand equality, it is necessary toestablish i similar proportions o households in all three countries are poor. Ocourse, being poor does not mean that credit is absolutely necessary, i.e., that

people are dependent on credit to make ends meet. However, the proportiono households in poverty is a good indictor to assess the potential size o themarket.

As we have already demonstrated, exclusion rom mainstream credit is armore widespread in the UK than in Germany and France; this casts doubt onthe assertion that demand will be equal in all three countries. Secondly, theproportion o households at risk o poverty is also higher in the UK. Table 2depicts the percentage o total households at risk o poverty ater transer obenefts in Germany, France and the UK. The defnition or poverty used is that ahousehold is poor i its income is less than 60 per cent o the median income ina given country.

As can be seen rom Table 2, the percentage is highest in the UK. This suggeststhat the potential need or credit to make ends meet is more pronounced. Isocial transers and income rom work are not sufcient to make ends meet,credit may be considered as a way to increase disposable income.

This indicator is also a measure o inequality: the more people below thethreshold o 60 per cent, the more unequal the society as the dierences inincome are starker. Data on income inequality confrms this.

Figure 4 shows the ratio between the income o the top 20 per cent earners ineach country compared to the bottom 20 per cent (a so-called quintile) . Forexample, in 2007, the ratio in the UK was 5.5:1, meaning that the income o

earnings in the highest quintile is 5.5 times more than that o the earnings in thelowest quintile. The ratios in France (3.8) and Germany (5 in 2007, 4.8 in 2008)are lower.



This indicates that relative poverty levels are higher in the UK than in the other

two countries. Whilst this is not a clear indicator o credit dependency, it stronglysuggests that there is greater demand or credit in the UK hence, levels varyand are not equal as the Policis research suggests. However, it appears thatGermany is approaching UK levels o inequality, so this may have to be revisitedin the uture.

Coping mechanisms credit is the only way out?

The second interpretation o equality o demand suggests that people belowa certain income will need credit to make ends meet. Although there may beewer households in need o credit individually, all aected households wouldneed the same amount o money to cover unexpected expenditure and/or payor everyday goods and services. This money can only be obtained throughcredit, and not through other coping mechanisms. So the argument goes on:

excluding people rom credit will drive them into the arms o illegal loan sharks.Commonly, illegal lending in this context is defned as the provision o loans byindividuals who charge extortionate ees and interest rates, and use threats tolie and limb i repayments cannot be made.

Table 2. Percentage of households at risk of poverty

Country/Year 2005 2006 2007

United Kingdom 19 19 19

France 13 13 13

Germany 12 13 15

The increase in percentage in Germany can be attributed to the reorm o unemployment transers that

saw a steep decline in the provision o secondary unemployment money (see section below or urtherexplanation). Data or 2008 was only available or Germany where the rate remained constant at 15 percent.

The poverty defnition used to produce this data is not fxed, i.e. the income level below which ahousehold is considered to be poor can go up as well as down: i the majority o households earn20,000 a year, the poverty threshold is 12,000 (60 per cent o 20,000). I the majority o householdshave an annual income o 17,000 a year, then the threshold sinks to 10,200 (60 per cent o 17,000).

Source: EUROSTAT42

2007

Ratio

20062005

GermanyFrance

United Kingdom

1

2

3

4

5

6

7

0

Figure 4: Income ratios in the UK, Germany and France in 2007.

Source: Eurostat.43

NB Data or 2008 was only available or Germany, where the ratio has gone down to 4.8.



Again, this argument overlooks the more varied reality o people on low incomes.The poor use a variety o coping strategies to overcome crises none o them areideal; the use o credit is only one o them, and one that does not seem to be usedequally across all countries.

For example, the high levels o illegal lending that Policis suggests exist in Germanyand France may be overstated by the survey.

Speaking to several experts in France and Germany to investigate the extent towhich illegal lending is a problem, most respondents agreed that this phenomenon

is much less pronounced in France, and is unlikely to exist at all in Germany.44 TheInstitut r Finanzdienstleistungen (IFF, Institute or fnancial services) recently, in asubmission to the Ofce o Fair Trading, highlighted the lack o evidence on loansharks in Germany.45 In addition, extensive internet and literature research did notreveal evidence o illegal lending in Germany and France.

Germany does have a problem with raudulent credit brokers, who promiseprovision o money to applicants without any credit checks. As a research reportwith mystery shoppers carried out by SCHUFA (Germanys main credit ratingagency) has demonstrated, credit is hardly ever orthcoming. Instead, applicants arepersuaded or cajoled into paying upront ees or budget checks and compulsoryhome visits, oten resulting in the payment o several 100 euros beore a decision

on the credit is made. In the study, none o the attempts to secure credit in this waywas successul.46

These raudsters cause considerable damage to applicants and their amilies, notonly fnancially but also psychologically. There is no question that this practiceneeds to be curbed. However, the existence o such raudulent activity has nothingto do with the usury rate, and does not prove the existence o loan sharks as theyare defned in the UK. According to the SCHUFA report, people turning to thesecredit brokers are already classed as over-indebted i.e., a responsible lenderwould not extend any urther credit to them, interest rate ceiling or not. Furthermore,it appears unlikely that the raudsters target the poorest o households. The sumsthat need to be paid up ront are quite considerable, and it is questionable i low-income households would have this kind o money to spare.

In France, experts agree that there may be some incidence o illegal lendingsimilar to the UK (extortionate credit rates, threat and use o violence in case onon-payment) however, as Mr Kiehl rom Crsus states: the French Governmentdoes not investigate this problem and there are no ofcial statistics that attempt toestimate the scale o the problem.

To assume that people on low incomes will inevitably turn to unlicensed extortionistlenders when reused mainstream credit is very restrictive. People devise a series ocoping strategies to cope with emergencies. These include strategic deault on billpayments, pawnbroking,47 appeals to social services or a grant or a loan, charitabledonations, borrowing rom riends and amily, or simply going without the latter

o course oten under considerable distress. We do not argue that these strategiesare without problems or should be seen as an ideal. As a simple calculationdemonstrates, however, the link between credit exclusion and illegal lending is notas clear-cut as opponents o interest rate caps suggest. This can be demonstratedusing fgures rom the UK.

In the UK, a substantial proportion o people excluded rom mainstream credit donot use sub-prime credit. According to the Competition Commission, the homecredit industry has 2.3 million clients.48 Many o these have access to mainstreamor other orms o sub-prime credit. The Competition Commission, or example,states that in 2004, 49 per cent o all customers o Provident Financial (the largesto all home credit providers with 1.5 million customers) had access to other ormso credit, all o which require a bank account.49 I we assume that hal o all homecredit clients (1.15 million) have access to mainstream credit, this leaves 1.15 millionpeople or whom sub-prime credit is their sole option.

However, there are ca 9 million adults without access to mainstream credit (1.75million without a bank account and 7.7 million with an account that oers credit



acilities) or which sub-prime credit remains the sole legal option.50 I we generouslyassume that o these 9 million, 1.15 million are home credit clients, and around700,000 people use payday lenders (there is no data on the size o this market), thisleaves 7.15 million adults without recourse to legal credit. Are these all going to illegallenders, or do they use other coping strategies? Even Policis does not suggest theincidence o illegal lending to be this high.51 Hence, the assumption that interest ratecaps will inevitably drive people to illegal lenders cannot be upheld.

Without dedicated research into this, we simply cannot know how low-incomehouseholds cope. To assume, however, that credit is the only option considered

is to overlook other coping strategies and to detract again rom the wider issue oinsufcient incomes or people on low incomes.

Box 3: Interest rate caps in the USA uncompetitive and reducing diversity?

Research into interest rate caps also looks to the USA to assess the experience o dierent states there. Again, weseek to challenge the main points made in regards to the US sub-prime credit market. For reasons o space, we willonly draw out the salient points.

The arguments against caps reer to payday lending, one o the main orm o sub-prime lending. They can be

summarised as ollows:

P States without interest rate caps have a more competitive and diversifed market.52,53

P Payday lending is short-term in nature, aimed at providing cash or emergencies, and hence serves a socialpurpose.

Based on these arguments, payday lending was requently exempt rom interest rate regulation. Some states allowedpayday lenders to charge 10 times the ofcial limit. In recent years, however, this perception seems to shit, as moreand more states are introducing stricter regulation.

Claim 1: Payday lending is competitive and diverse in states without caps

In a study carried out by the Centre or Responsible Lending, prices and ees in payday lending in states without an

interest rate cap do not uctuate between dierent markets.54

Rather than reecting cost, ees are charged at thehighest permissible levels because they are the primary source o revenue or the lenders. In Colorado, or example,where the Government imposes a maximum ee on payday lending, payday lenders charge this maximum in 93 percent o cases. Advance America, a company operating across several states in the USA was ound to charge a atee o 16 per cent o the amount lent in all states, regardless o the level o competition. Similarly, QC Holdings heldits ee constant at 15 per cent in all states between 2003 and 2005. 55 This evidence clearly indicates that paydaylenders do not compete in price, but charge what the market will bear or what is legally permissible.

Claim 2: Payday loans are short-term and for emergencies only

There is strong evidence to suggest that a large percentage o customers roll their loans over, or take out loans inquick succession, thereby landing requently in a debt trap. According to regulatory flings, over 90 per cent o paydayloans are oered to borrowers with fve or more loans per year. Over 60 per cent o loans go to borrowers taking out12 or more loans per year, which is a rate o at least once a month or loans that last typically two weeks. Researchers

also argue that lenders are relying heavily on this roll-over debt to und their operations,56 thereby exploiting the debttrap and fnancial illiteracy o clients unable to access credit rom mainstream banks.

The experience o North Carolina, where payday lenders ceased to operate ater the introduction o strict paydaylegislation, serves as a good example to demonstrate that caps can actually increase competitiveness and diversityin the market. Ater the introduction o a cap:

P small consumer loans (less than $600) increased by 37 per cent;

P aordable lenders could expand their market share as awareness o aordable lending increased andaggressive marketing by payday lenders disappeared; and

P there was an increase in savings brought about by switching to low-cost credit.57

In addition to challenging the arguments o opponents o price caps, the example o North Carolina also demonstratesthe importance o building a strong aordable lending sector, which in the USA is nurtured by the CommunityReinvestment Act (Box 4).



The scope o the reorms needed to create a transparent and just lendingenvironment in the UK is large, but this should not deter policy-makers romembarking on this task. The current situation in which high-cost lenders can chargeextortionate interest rates under the pretence o providing a social service is

untenable. By having to pay the highest price or credit, the poor are unable to buildany assets and are trapped in the cycle o low income and high-cost credit. Thereis thereore an urgent need or reorm and bolster existing eorts to increase theincome o the poor.

In the ollowing section we outline the reorms we propose, ocusing strongly on theintroduction o price controls and universal banking services.

What price credit? Ensuring equity of access

As a frst step to developing our proposal or a airer lending environment in the UK,we model the impact o a law that would set a price cap on the total cost o credit(Box 1) and impose a universal service obligation or credit on credit providers.

We aim to provide an alternative vision to the view that there is no alternativeto the situation at hand (as witnessed in a recent research report on aordablehome credit provision58). We propose a model in which a cap on the TCC is to besupported by additional regulatory and social measures to increase transparency,airness and aordability, while decreasing the credit dependency o households onlow income in the UK.

Modelling the impact of usury rates59

As explained in the introduction, there are marked dierences between sub-primeand mainstream credit markets. In the mainstream market, the price o credit isdependent on the risk that the borrower presents to the lender. In the sub-primemarket, all borrowers are categorised as high-risk and charged the same uniorm

price. These dierences in pricing structures are to some extent a reection odierences in demand. The demand curves or both markets are depicted in Figure 1.

In the mainstream market, demand reacts heavily to price: the higher the price,the lower the demand. As this group is not highly dependent on credit, and has alow risk profle, it reacts strongly to price changes. Seeing as they are good clients(i.e., high likelihood that they will repay the credit), this group has a bargaining chip lenders want to lend to them. Hence, there is competition, and many dierentcompanies rom which members o this group can choose.

For the second group, demand is less sensitive to price and hence more inexibleor several reasons:

P Sub-prime clients credit ratings usually prevent them rom accessing creditrom mainstream banks, meaning they have no or very little choice in lenders.As lending to this group is associated with higher risk, not many lenders wantto enter this market. This is not only because o the increased risk o deaulting

Escaping the debt trap: increasing affordable

lending and decreasing credit dependency

As we have shown, interest rate caps do not need to have anegative impact on poor households. They cannot be seen inisolation, but have to be part o a wider set o measures that willenable poor households to escape the debt trap and reduce creditdependency.



(the high charge or credit would compensate or this to a certain extent), butalso because o reputational risks.60 In the classical market model, a limitednumber o competitors means limits on price competition, adding to the otheractors that drive up the cost o credit (such as high risk, home collection,inclusion o penalty ees upront in the price, etc).61

P Certain eatures o sub-prime credit, especially the home credit market,are indispensable or clients on low incomes: ast availability, exibility inrepayment, and low instalments. Clients are prepared to pay a higher price orthese eatures, reducing their sensitivity to price levels. The strong relationship

developed by home credit providers, such as Provident Financial, with theirclients also creates barriers to entry or would-be competitors. This, too, keepsprices higher than would otherwise be the case.62

P In an emergency, or i credit is used to pay or basic expenditure, creditdependency is high and so is the willingness to pay high prices or it.

Hence, the price does not inuence demand as much as it does or the other set oclients. Figure 5 schematically depicts these dierent demand levels.

As a consequence o the dierences in demand (so-called dierences in priceelasticity between dierent market segments), pricing policies also vary between

the two credit markets.

In the mainstream market, price is adjusted according to the risk profle: the lowerthe risk, the lower the price. In the sub-prime market, this risked-based pricingdoes not exist. All clients are charged a uniorm rate. A good repayment historydoes not lead to price reduction. Not only does this uniormly high price createthe operational profts or sub-prime lenders, it also means that good repayerssubsidise losses or the company incurred by bad repayers. This is an unjustsituation, where equally poor people have to pay high prices and cross-subsidiselosses, whilst in the mainstream market, the richer section o the population canenjoy the benefts o price competition and good repayment behaviour.

As explained earlier, there is a large gap between maximum prices in the

mainstream and the sub-prime market. The mainstream maximum price is, ocourse, much lower than or the high-risk group. This is evidenced in the UK where,in the absence o any restrictions on interest rate levels, the mainstream creditrates are between 5 per cent and 30 per cent (this is including some o the more

Price

Demand

Sub-prime market

Mainstream market

Figure 5: Differences in demand levels: sub-prime and mainstream market



expensive credit cards oered, or example, by Barclays to people with an impairedcredit history), but the sub-prime interest rates can go up to over 1000 per cent APRor cash loans (e.g., Chase Finance Limited), and even higher or payday lenders. Ithas to be recalled at this stage that sub-prime lenders argue that lending to high-risk groups is costly and hence the prices are justifed.

The argument against a cap is that the introduction o a price cap will reduce theavailability o credit, as some sub-prime models may not be viable any more: i theprice o the high risk cannot be covered, i.e., the likelihood o a client deaultingon repayment, then companies will stop lending to the high-risk segment o the

population. For example, i the probability o a client deaulting is 60 per cent, andthe cap is set at 50 per cent, then companies will not lend to this client anymore.

In our model, we propose to overcome this problem by removing the distinctionbetween sub-prime and prime markets and introducing a universal serviceobligation. The introduction o a price cap could then lead to a reduction in pricewhilst credit supply will remain by and large stable.

I a price cap is set at a level that is higher than the maximum price currentlycharged in the mainstream sector (this will be called price P1), the supply o creditto the low-risk group remains unaected. For example, i the maximum price paid bylow-risk customers is 30 per cent APR, then a price cap o 50 per cent TCC will not

reduce credit availability or this group.

However, as pointed out above, in the high-risk market, this could, theoretically, leadto a decline in supply i price caps do not reect the risk o a client deaulting. I weintroduce the price cap at 50 per cent, but the probability o deault is 60 per cent,then these clients may be unable to obtain credit in the uture. On the other hand,we have to ask i people whose probability o deault is at such a high level shouldtake out a loan in the frst place? They may be better served by a grant or advice onhow to increase their income.

For those where the probability is not exceedingly high, the introduction o a universalservice obligation would overcome this problem. All lenders would be obliged to lendto all customers, regardless o their credit risk (o course, within limits o responsibility,

e.g., i a customer is already over-indebted, no urther debt should be added). Thiswould orce lenders to adjust their models the cost o credit would have to bebrought down to match or undercut the maximum price allowed.

Risk

New price curve

Old price level sub-prime market

Price

Max price charged in old mainstream market

Old price curve mainstream market

TCC cap

Figure 6: Theoretical changes to the credit market



This change in credit markets would have a variety o impacts. Cross-subsidisingrom the good sub-prime group to the bad sub-prime group would in essencecease, as the good clients would beneft rom price reductions due to their bettercredit history. This would mean that losses through deaults would increase, andprofts would be reduced. To compensate or that, the price o credit or goodcustomers would be increased to reinstate this cross-subsidy.

Figure 6 depicts the current situation and how it could be seen rom a lendersperspective (we will consider the demand side, i.e., the customers in the nextparagraph). The dashed line is the mainstream market beore the price cap is

introduced: people with a good credit history (low risk) pay low interest rates, but astheir risk profle increases, so does the price. There is a cut-o point beyond whichmainstream lenders are not prepared to go (marked by the black dot), both in termso risk and price. The thin line at the top represents the current price levels in asub-prime market. Here, lenders will extend credit to those groups the mainstreamdoes not want to lend to; however, within that market, there is no risk-based pricedierentiation. The thick black line represents the situation ater the introduction oa universal service obligation and an interest rate cap (marked by the dotted line).Prices or lower-risk clients will rise as lenders encounter higher deault rates romthe high-risk customers, but prices will drop or the higher-risk clients.

It is likely that when customers all into a certain high-risk credit category, they will

be charged the maximum allowable rate. However, through improving their creditscore, they may be able to obtain cheaper interest rates in the uture.

So, how are these changes going to impact on demand? Theoretically, the increasein prices or the low-risk group may reduce demand, as they are not as dependenton credit, hence lenders would have to rely more on the higher-risk group. However,the reduced price would lead to an increase in demand as credit would be moreaordable, allowing people to fnance purchases more requently on credit butcrucially, contrary to the old system, they would be in a better position to pay o theoutstanding amount as the price is vastly reduced. The changes may also attract asecond group, namely those people on low incomes currently put o by the highprices charged in the sub-prime industry. The experience o North Carolina (Box 3)indicates that an increase in demand is realistic.

There are, o course, several obstacles in this model. The frst set o obstaclesrelates to company strategies, and existing market conditions.

First, given the current market inrastructure in the UK, it would be unlikely that thismodel would be implemented even with great political will. A mainstream customeris unlikely to take out a loan rom Provident Financial or another sub-prime lender orear o being branded a poor customer. Likewise, mainstream banks would be veryreluctant to accept high-risk clients, not only because o the high prices they wouldhave to charge, but also or ear to be branded a bank or the poor.

To circumvent this, we thus propose the additional (and long overdue) introduction

o a community reinvestment act that is adapted to the UK. This act should ensurethat banks invest a share o their profts in those communities rom which theygenerate profts, thereby contributing to the economic regeneration o areas romwhich banks have largely withdrawn in the UK.63,64 Whilst a detailed descriptiono what such an act should look like in the UK would go beyond the remit o thisreport, and is or Government to determine, we outline the basic tenets such an actwould have to ulfl.

Similar to the USA, a community reinvestment act in the UK would require banksand other fnancial institutions licensed under the Financial Services Authority (FSA)to disclose how much, where and who they lend to. At the same time, they wouldbe required to disclose the sums they earn rom these locations, or example,rom deposits made by individuals and small businesses. As part o their licenserequirements, these institutions would be compelled to reinvest a certain proportiono the money into the communities they lend to. I they ail to comply, they shouldbe subject to fnancial sanctions. The investment by banks does not need to beundertaken by the banks directly. They could invest in aordable providers o credit,such as credit unions and CDFIs that are already undercutting the existing high-



cost lenders by a large margin. However, they are woeully underunded and hencecannot compete at sufcient scale with the commercial lenders. A reinvestment act,combined with a price cap on the cost o credit, would thus present this sector withthe opportunity to grow to scale and get the opportunity o breaking the dominanceo home credit and payday lenders in the UK.

The second set o obstacles relates again to market theory.

In our model, we assume an increase in lending to high-risk customers and adecrease in lending to low-risk consumers. Theoretically, this would mean thatcredit prices would be pushed up to the cap that is set on the total cost o credit something that in economic theory is oten reerred to as a market or lemons.65The inormation asymmetries mentioned earlier come into play here again. Iborrowers who know that they have a higher risk o deault are in urgent need ocredit (e.g., because o irregular income patterns), they are prepared to pay higherprices. This then drives lenders to assume that someone who is prepared to payhigh prices will inevitably deault, reducing their incentive to lend to this client in thefrst place. Where they are orced to do so (as our model proposes), lenders willthus be tempted to lend to all clients, at the same high price, independent o creditrisks to even out losses incurred rom deaults. Hence, there is the likelihood o adrit towards the maximum ceiling. As a consequence, people less dependent oncredit will take out less and less credit, leaving lenders with only high-risk clients resulting in higher losses and decreased proftability that could eventually lead to

the demise o the lender.

However, theory is contradicted here by empirical evidence and the adaptability obusiness models.

First, despite interest rate caps, there is still a large supply o consumer credit inFrance and Germany, as well as the USA. Banks compete or the business o low-risk clients on price, not only because it is a less risky business, but also becausethey tend to take out larger loans, increasing profts even i interest rates are lower.

Secondly, by channelling unds to not-or-proft lenders, these can then developproducts that suit the needs o low-income households, especially low instalmentsand high exibility (Box 3). In the UK, CDFIs and credit unions oer such products,but because o the lack o political and fnancial support have yet to realise th

doorstep robbery

Documents