Payday lending: a thin line between love and hate.

• Author: Shih, Jopei

The post-2008 recession and frozen credit markets have constrained the borrowing options of working-class Americans, prompting many to seek payday loans for their emergency credit needs. Consumer advocates have cried "foul" and have launched all-out warfare against the industry. They claim that payday lending abuses and exploits working-class consumers, and they appear to be winning the battle. Many states have strongly limited or even banned payday lending. In deciding to legislate, however, lawmakers rarely rely on objective research into the net welfare effects of payday lending; instead, legislators seem to simply pick a side on instinct and legislate accordingly.

Unfortunately, banning or severely restricting payday lending may hurt the very consumers that legislators are trying to protect. This article comprehensively surveys and incorporates recent econometric research on high-cost credit that has been critically lacking within the legal academy. For instance, this article includes a study that features the gold standard of scientific research, a randomized controlled trial. Although no absolute consensus has been reached, meticulous studies appear to suggest that, on average, payday lending might help more people than it hurts. For instance, many consumers use payday loans to bridge financial emergencies.

Accordingly, this article sets out a timely suite of legislative proposals that should be adopted by state and federal governments. The recommendations reflect results from cutting-edge empirical payday-lending studies and caution against direct bans or strict usury caps that aim to quash the industry. The principles underlying these legislative proposals seek many changes: increase competition in order to drive down prices; lessen regulatory risk to reduce lenders' costs, which would be passed down to consumers; force consumer segmentation to mitigate the harm to the population hurt by the "debt treadmill"; improve consumers' contracting powers to further reduce the payday-loan rollover trap; improve transparency and disclosures; and manage consumer demand for high-cost credit. These proposals represent a balanced and informed approach to regulation that aims to increase net social welfare.

TABLE OF CONTENTS INTRODUCTION OVERVIEW OF PAYDAY LENDING What is Payday Lending? Typical Borrower Typical Lender Development of Payday Lending and Current Market Size Prehistory Recent Reincarnation Substitutes for Payday Lending Bounced Check and Overdraft Protection Fees Illegal Loansharking Pawnbroking Subprime Credit Cards Product Economics: Pricing and Profitability REGULATION SURVEY Overview of Federal Regulations Overview of State Regulations Legal and Regulated Prohibited IS PAYDAY LENDING PREDATORY? Is Choosing 391% APR Credit Rational? NO Yes What Does "Predatory" Mean? Empirical Literature Review Payday Lending Studies: Net Social Cost Payday Lending Studies: Net Social Benefit Gold Standard of Empirical Studies: A Randomized Controlled Trial Lessons from the Literature: A Partial Answer FIRST PRINCIPLES: TOWARD OPTIMAL PAYDAY LENDING REGULATIONS Increasing Competition Zoning Restrictions Interest Rate Cap Moderation or Removal Supply-Side Incentives: Promoting Alternatives Signaling Certainty: Governmental Commitment to Allowing Payday Lending Forcing Consumer Segmentation Improving Consumers' Contractual Terms Transparency and Disclosure Demand-Side Management CONCLUSION INTRODUCTION

Articles about payday lending usually commence with a heart-wrenching story about an endearing protagonist, typically a young, single mother who visits a payday lender, desperate to get a cash advance. Knowing that her paycheck is two long weeks away, she hands over a $345 post-dated check, opting to pay the $45 one-time fee, in order to get $300 cash today, which is a 391% effective annual percentage rate ("APR"). (1) Unfortunately, she loses her job and is unable to pay off the loan at the end of two weeks. The lender offers to "rollover" her loan for another two weeks with another $45 fee. She does this, repeatedly, because she cannot find a good job and ends up paying over $800 in fees, none of which reduce the $300 principal, even after many months. Some borrowers clearly become trapped by this nefarious "debt treadmill," but this is not the be-all and end-all of payday-lending stories.

Consider another young, single mother. She earns a $30,000 salary as a secretary and responsibly pays her monthly rent, gas, electric, water, and phone bills on time. She manages to eke out a living for her two children, but unfortunately disaster strikes: her Chevy Nova refuses to move. She will lose her job if the car is not fixed because she cannot commute to work. Short on funds, she ponders making late payments on her utilities until the next payday. However, she quickly realizes that each company levies a multitude of late fees, which cost nearly $50 each. (2) Bank loans are not an option because she has a low credit score and is a poor credit risk. So, she turns to a payday lender, and she pays $45 for a $300 loan. She is able to fix her car, keep her job, and pay her bills on time. When her paycheck comes, she repays the $300 and breathes a sigh of relief as her life returns to normal.

Which story is true? The question is critically important because payday lending has attracted the eyes of legislators to the "fringe banking" market. (3) Consumer-advocacy organizations and payday lenders have both responded with games of hyperbole by twisting evidence in their favor. (4) On one hand, payday lenders extol the virtues of providing credit to those in need, reasoning that consumers would be worse off if they were forced into the arms of loan sharks. (5) On the other hand, consumer advocates call for the government to play a paternalistic role in order to prevent alleged abuses of consumers who are purportedly fooled into credit arrangements that they cannot understand. (6)

Consumer advocates appear to be winning the battle. (7) In response to critics, many states have strongly limited or even banned payday lending. (8) In 2006, the federal government effectively banned payday lending to military personnel by setting a 36% APR cap ($1.38 per $100 loan), which is too low for payday lending to be profitable. (9) In deciding to legislate, however, lawmakers rarely rely on objective research into the net welfare effects of payday lending; instead, legislators seem to simply pick a side on instinct and legislate accordingly. Given the post-2008 economic recession, legislators have again trained their eyes on payday lenders since the credit crunch has constrained the borrowing options of many. (10) Unfortunately, banning or severely restricting payday lending may hurt the very consumers that legislators are trying to protect. (11)

Both stories are simultaneously true: some people are indubitably better off with payday lending and some are worse off, but the jury is still out on which group dominates and what effect payday lending has on net social welfare. Thus, the debate should be reframed away from the morally tinged accusations of usury toward a more dispassionate endeavor of how to better regulate payday lending. This article surveys and incorporates recent econometric research on high-cost credit that has been critically lacking within the legal academy, including a study that features the gold standard of scientific research, a randomized controlled trial. (12) Although no concrete consensus has been reached, meticulous studies appear to suggest that, on average, payday lending might help more people than it hurts.

This article sets out a suite of legislative proposals that should be adopted by state and federal governments. The recommendations reflect results from cutting-edge empirical payday-lending studies and caution against direct bans or strict usury caps that aim to quash the industry. The principles underlying these legislative proposals seek to make the following changes: increase competition in order to drive down prices; lessen regulatory risk to reduce lenders' costs, which would be passed down to consumers; force consumer segmentation to mitigate the harm to the population hurt by the "debt treadmill"; improve consumers' contracting powers to further reduce the rollover trap; improve transparency and disclosures; and manage consumer demand for high-cost credit.

Part I traces the payday-lending market by describing the product's characteristics, historical development, competitors, and its economics with a specific focus on pricing and profitability. Part II details the state and federal efforts to regulate payday lending and categorizes the regulations. Part III explores the delicate question of whether payday lending is in fact "predatory" by first explaining the rationales for and against regulation and creating a common definition for how to judge whether the practice is "predatory." It then uses this definition as a framework for conducting the literature review. Finally, it concludes that payday lending is in fact not predatory. Part IV describes this Article's suite of regulatory proposals.

OVERVIEW OF PAYDAY LENDING

This part provides a background of the payday-lending business. It describes the typical transaction, the players involved, the history of the payday loan, the competitive landscape, and the economics of the business.

What is Payday Lending?

The typical payday-loan transaction involves a two-week loan for less than $500, financed at a fee of $15 per $100 borrowed (391% APR). (13) The consumer gives the lender a check that is postdated to his payday that covers the principal and the lender's fee. (14) In exchange, the consumer leaves with cash amounting to the principal. (15) On payday, the consumer has the option to pay back the principal and the fee to redeem the check or to simply allow the lender to cash it. (16) If the consumer has insufficient funds, the lender will offer to...