May 31, 2018
The Borrower Still Loses If U.S. Mandates Post Office Banking
By Ariel Zetlin-Jones, Assistant Professor of Economics at Carnegie Mellon University’s Tepper School of Business
Without access to banks or credit unions, people who depend on loans from payday lenders when facing unexpected expenses or financial emergencies often find themselves in a miserable cycle of endless debt. Senator Kirsten Gillibrand has recently proposed legislation for the United States Post Office to offer low cost, basic financial services to millions of “unbanked” Americans, particularly low-income Americans.
Gillibrand’s goal is to “effectively wipe out predatory payday lending industry practices... that cost the average underserved household 10 percent, or $2,412, of their gross income in fees and interest.” Her idea is to create a publicly subsidized low-cost competitor to private lenders in an effort to reduce prices and increase access to credit. However, this solution doesn’t take into account the fundamental economic principles of high risk lending.
The high fees and interest rates associated with payday loans reflect two “frictions” at work in short-term consumer lending markets. The first is simply a lack of competition. The second is that would-be borrowers know more about their risk of default than do lenders. This gives rise to what economists call “adverse selection”– the tendency for those with adverse characteristics to become over-represented in a pool of market participants. Adverse selection has long been recognized as an important stumbling block in the effective design of many different kinds of markets, ranging from health insurance, to financial securities, to used cars.
In consumer lending markets, if lenders cannot distinguish between high and low default-risk borrowers, they attempt to protect themselves from the former through some combination of high interest rates and credit rationing applied to all borrowers. These loan terms reflect the credit quality of the average borrower. Borrowers whose credit quality is above average may view such terms as being unfair and, as a result, choose not to borrow at all. This then lowers the average credit quality of those who do borrow, leading lenders to further increase rates and/or ration credit. This process may ultimately cause the market to unravel and lead to outcomes similar to what we observe today: only the riskiest borrowers participate, and they get charged high rates on small loans.
The adverse selection problem has garnered far less attention from policymakers than has the competition problem. Senator Gillibrand’s post office banking proposal focuses exclusively on competition and, as a result, is subject to serious, unintended policy risks. In a recent study, my co-authors and I show that policies that create additional competitive pressure in markets with adverse selection can harm borrowers. While additional competitive pressure lowers average interest rates charged by lenders, it also raises lenders’ concerns of extending credit to high risk borrowers. Lenders deal with these concerns by rationing credit. Those who get rationed are likely to be the higher quality borrowers. The costs of credit rationing caused by additional competitive pressure can outweigh the benefits of reduced average interest rates making borrowers worse off. These costs are largest in markets with relatively competitive markets for payday loans.
Our results imply that a post office banking policy where loan rates are implemented uniformly throughout the United States is particularly likely to induce adverse consequences for credit access in cities and states where competition among payday lenders to attract borrowers is already relatively high.
A well-designed policy to increase competition to underserved Americans, then, requires a careful consideration of how much competition is needed in each city or state where the post office operates. This should not be surprising; when designing Obamacare, publicly-sponsored insurance premiums were also dependent on features of the local marketplace.
While it is tempting to conclude that “Literally the only person who is going to be against this is somebody who wants to protect payday lender profits,” as Senator Gillibrand recently asserted, our research shows that among the underserved population, those borrowers with the lowest default risk may suffer the most from this policy.