Making hay from payday loans

The "payday" loans industry has shifted from the fringe of consumer finance in Australia to the mainstream despite recent regulatory setbacks and a challenged image. The country’s short-term lending market is thought to be worth around $800 million a year. But developments overseas mean there could be more movement in the sector ahead.

"One particularly interesting development since the legislative change has been the emergence of a dual market."

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The Federal Government set new laws for Australian payday loans in 2013, forcing changes to existing operations in the sector. Following the introduction of this more restrictive legislation the industry has recovered through innovation in product design, marketing and delivery.

Payday loans are referred to in the Australian legislation as "small amount credit contracts". The Australian market has lenders who deal only in SACC loans products and others who offer a wider range of loan options.

One particularly interesting development since the legislative change has been the emergence of a dual market. On one side are low-income, high-street lenders like Cash Converters which has around 140 shop-front outlets in Australia.

On the other is the online sector which targets the higher income earners, like Nimble, which has made around 550,000 loans since its formation in 2005 with revenues of around $30 million. In response to Nimble’s success, Cash Converters now also lends online, with $14.6 million lent in the three months to the end of 2013.

Outside Australia, the payday loans industry has also grown to become a significant component of consumer finance markets. The total revenue of the US payday loan industry is currently around $US11 billion, while the UK market was worth about $US5 billion at the end of 2014.

Trap for young players

What we can learn from the growth of the industry elsewhere in the world will be particularly useful when the Australian government conducts an extensive review of the market in July 2015.

The debate between the industry and consumer/welfare advocates centres on the cost of payday loans and the risk of repeat borrowing which can trap the unwary.

These ongoing issues provoked a national credit licensing scheme overseen by the Australian Securities Investment Commission (ASIC).

The federal government’s intervention in 2013 capped interest rates on payday loans at 4 per cent per month, restricted ‘establishment fees’ to 20 per cent of the principle and prohibited concurrent loans and the refinancing of any existing loans.

The arrival and growth of online lenders has been facilitated by the innovative use of data sources to assess the risk of lending to a particular borrower. This has allowed a reduction in processing times for risk assessment and approval as well as electronic funds transfers to customers.

As an example Nimble accepts applications online for short-term loans of between $100 and $1,200. Such applications are assessed as they are received and a decision is made (it is claimed) on average in 5 minutes and 44 seconds from the completion of the online application form.

The loan can then be immediately transferred to the customer via a Nimble VISA prepaid card and a repayment schedule can be agreed where the repayments come out of the borrower’s bank account by direct debit.

This product design and delivery system is already advanced in other countries, with the UK Competition Commission suggesting in 2014 that seven out of 10 customers will take out a payday loan online.

The vicious cycle

In the UK the Office of Fair Trading (OFT) produced a compliance review of payday lending in 2013 which detailed evidence of some of the problems borrowers can face.

The OFT review found evidence of widespread non-compliance with the existing UK legislation with particular concern about the existence of irresponsible lending.

Such lending is where too many consumers are being given loans they cannot afford and when they cannot repay are then encouraged to extend the loan, thereby exacerbating their financial difficulties.

The OFT research found around one-third of loans in the UK were repaid late or not repayed at all. Twenty eight per cent of those loans were rolled over or refinanced at least once, providing around 50 per cent of lenders' revenues.

Moreover, around 20 per cent of lenders revenues came from 5 per cent of loans which were rolled over or refinanced four or more times. Of the 50 websites that were examined, 30 emphasised the speed and simplicity of the payday loan process over the cost of the loans.

The OFT said the lending practices observed had its roots in the way competition worked in the market and that consumers were in a weak bargaining position as providers competed on speed of approval rather than on price.

In addition the providers described and marketed their products as one-off, short-term loans but in practice around half of their revenues were derived from loans that lasted longer than intended.

The OFT said lenders did not have to compete hard for this income stream as they had a captive market and borrowers were not getting a balanced picture of the costs and risks of taking out a payday loan.

The review and subsequent evidence that some payday loan lenders had fallen short of the expected standards of business behaviour provoked the UK’s Financial Conduct Authority (FCA) to intervene to set new limits on payday lending.

In November 2014 the FCA declared from January 2015 daily charges for interest and fees will be limited to 0.8 per cent and that there will be a cap equal to the size of the original loan on the total cost that can accumulate to the borrower.

All about the timing

There is a role for short-term, high-cost loans in the modern economy as unexpected bills and sudden emergencies can create an urgent need for cash.

Customers however do not shop around and they appear to care less about cost than the immediacy of rapid access to cash.

In future new entrants to banking, credit union and peer-to-peer sectors may emerge to fill this demand but they will find it hard to compete against payday lenders whose key competitive advantage is they can reach a decision about a loan in minutes.

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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