Strike the right balance in regulating small-dollar lending

As the Biden administration ushers its cabinet nominees through the Senate confirmation process, pundits of all stripes are offering predictions concerning how bank regulation might proceed under a president who promises greater protections for vulnerable Americans.

One frequently discussed area is small-dollar lending, which includes — but is not limited to — payday lending.

Heightened regulation for the small-dollar space is necessary and overdue. But it is critical to first understand that the space is not monolithic.

Instead, small-dollar lending is a spectrum that spans from mainstream banks to peripheral actors, including pawnshops and storefront payday lenders. At its best, small-dollar lending is a vital bridge for more than 60 million consumers, who lack access to credit and who live without any essential savings — the majority of the country. And at its worst, there are well-documented instances of bad situations deepened further by cycles of unaffordable debt.

Given the disparity of players that exist within the small-dollar lending space, and because its borrowers are among the more vulnerable, it makes perfect sense for the Biden administration to focus on the space. The goal of any regulation, however, should be to ensure that even those consumers who may have poor credit have access when appropriate, and bring more consumers closer to mainstream financial services.

The alternative — pushing struggling consumers further into the less regulated periphery, making them more prone to predatory debt traps — is the wrong solution. Getting the balance right from a public policy perspective will require precision, but it’s still quite feasible.

A logical first order of business would be to reinstate the Consumer Financial Protection Bureau’s small-dollar lending rule that required lenders to first make sure borrowers have the ability to repay before issuing loans. Lenders that do not do this for small-dollar loans typically rely on fees and rollovers to make a profit, which often leads to more hardship consumers trying to pay back their debts.

It’s also important for any potential regulation to address the rampant problem of borrowers needing to take out additional loans to pay back an initial loan. All too often, interest-only partial payments lead to cycles of crushing debt that fail to chip away at the principal balance. Mortgages, on the other hand, pay off principal with every single payment. That same concept, in that every payments should pay off part of the principal, should apply for all small-dollar loans.

Additionally, banning late fees, nonsufficient-funds fees, origination fees and prepayment penalties could help chip away at costs to prevent consumers from having to roll over their debts. Policymakers should also take a harder look at debt collections policies.

A few of the largest federally regulated banks that have direct visibility into key underwriting data such as cash flow have created small-dollar products aimed at greater inclusion to those left behind by mainstream financial services. This should help these consumers gain enhanced access across traditional products, including mortgages.

However, the number of banks that offer these products, and the restrictions they have in place, do little to solve the problem of credit access.

Where well-intended regulation could backfire and hurt consumers is by taking too scattershot of an approach, or applying ideas that have outlived their useful shelf life. Capping interest rates at a 36% annual percentage rate, as some states have done, is a prominent example, although federal- and state-chartered banks have interest rate preemption.

Proponents proudly trumpet tradition of rate cap dating back to the early 20^th century with little recent study of its impact. But there are virtually no public policy discussions today that should be guided by metrics devised so long ago that only men could vote at the time.

In fact, just before the pandemic, California implemented a 36% APR rate cap on loans of $10,000 or less, pushing traffic to sovereign lenders and payday loans, according to a 2021 report by TransUnion. This created the opposite effect the legislation tried to put in place.

More important than the age of an idea, though, are its practical implications.The Federal Reserve recently showed that loans must be $2,530 or greater for lenders to simply break even on costs when charging a rate of 36%. A $594 loan, for example, would require a triple-digit rate.

It’s difficult to call breaking even “predatory.” It’s also important to understand that if a business can’t justify offering a loan product from a dollars-and-cents perspective, the product won’t exist.

When it comes to helping consumers gain access to traditional forms of credit, small-dollar loans provide the lowest-stakes on-ramp for banks to offer wider access to the U.S. financial system. It’s important to recognize that if done right, there is an opportunity to serve the greater good more broadly.

Small-dollar loans are necessary. They are viable, and they can improve financial outcomes for people the traditional system might overlook.

While regulation should remove the ability for bad actors to operate within the space, new regulation should also be careful not to hinder emergency credit flows to millions who desperately need it.