WILLIAMS: The dynamics of market credit for low-end consumers

ANALYSIS/OPINION:

A recent Wall Street Journal article examined how the Federal Reserve’s use of low interest rate policies has failed to reach those most in need. Aptly calling it the “credit divide,” the article said that “Fed officials have been so frustrated in the past year that low interest rate policies haven’t reached enough Americans to spur stronger growth, the way economics textbooks say low rates should.”

That conclusion is of no surprise to many, especially the 73 million unbanked and underbanked Americans who don’t even figure into the Fed’s equation. Extending credit to these individuals has never been seen as a meaningful contributing factor to the overall health of the economy. Sure, there have been special initiatives like the FDIC’s small-dollar loan program a few years back, which by all measurable accounts failed not because banks weren’t willing to participate in the pilot program, but because without FDIC incentives, banks simply couldn’t make money on the program.

Yet we have 73 million men and women who live with constant fear that a financial hiccup will trigger a need for money they don’t have and most likely can’t get. While the Fed is pushing easy money policies, it’s going to those with near-perfect credit scores, leaving many of these 73 million Americans scrambling for other options. In other words, while interest rates are at or near all-time lows, money still isn’t available to those who need it the most.

In a recent study, “Serving Consumers’ Needs for Loans in the 21st Century,” author Michael Flores finds that neither banks nor alternative financial services providers are extending loans in the $750- to -$5,000 range. Despite benefiting from the Fed’s loose monetary stance, banks are finding that loans of less than $5,000 simply aren’t profitable. Even if such loans were available, many borrowers wouldn’t qualify. Alternative financial services providers can’t fill the space because of the burdensome costs of complying with 50 distinct sets of state regulations.

Still, Mr. Flores suggests it is alternative financial services providers who are in better positions to extend credit to low- to moderate-income consumers because they have built a more efficient and technology-driven model — but only if regulators can come up with a new banking model. The alternative financial services market is limited mostly to payday lenders, pawnshops or title loans. With the right regulatory framework, however, alternative financial service providers are capable of expanding into longer-term credit options that are better-suited for many consumers’ needs.

It all comes down to a commitment in Washington to focus some of that monetary policy on closing the ever-widening gap between the “haves and the have-nots.” However, it will take looking beyond banks as the answer to delivering credit to the 73 million Americans who are on the wrong side of the credit divide.

Allocating credit to those who need it is a complex subject. It’s a mistake to think all commercial banks have the expertise to undertake the credit analysis to make and service all kinds of loans. A bank analyst who understands the credit issues of an oil and gas exploration company is unlikely to have the expertise to analyze a consumer auto loan. Like other industries, the financial industry tends to specialize in various market segments.

The challenge of making consumer loans to people on the wrong side of the credit divide raises other issues that make lending to this group very expensive.

Despite a mid-July report by Standard & Poor’s that found that consumer credit default rates have decreased for the sixth consecutive month, the default rates among different demographics show sharp divides.

First, default rates among the poor are much higher than among the rich. Therefore, everything else being equal, loans to the poor will reflect premium pricing to cover the higher default risks. Second, because these loans are riskier, the banks will be forced to have higher capital requirements to support these loans, leading to higher capital costs. Third, because these loans are smaller than similar loans to the wealthy, the expense of issuing and servicing the loans must be amortized over a smaller loan principal. This also makes a loan relatively more expensive to the poor.

Also, loans to consumers tend to be subject to much more government regulation than commercial loans. This, too, adds to the costs of low-income consumer lending.

Given that high cost, it is no surprise that payday loan companies and pawnshops have arisen to serve these low-end markets. It also should not be a surprise that the large commercial banks shun these markets.

The Fed is principally tied into the regulation of the financial system through the commercial banks. When the Fed introduces stimulus into the banking system, it’s the commercial banks’ lending to the upper tier of the economy that first gets the lower rates and the stimulus. The low-end financial institutions such as the payday loan companies and the pawnshops are the last in the financial food chain to the feel the stimulative impact of the looser monetary policy.

Furthermore, high-end borrowers pay interest rates closer to the risk-free market interest rate. So if the Fed reduces the risk-free rate by 1 percent, interest rates to the high-end borrowers would decline from, say, 5 percent to 4 percent. That is a meaningful 20 percent decline in borrowing costs. Low-end borrowers, by contrast, usually pay high credit and servicing costs discussed above, so a 1 percent decline in interest rates might take one of these loans down from 20 percent to 19 percent — a negligible 5 percent decline in total borrowing costs.

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