Bankruptcy

Credit Cards to Payday Substitution?

By Adam Levitin

Over at Volokh Conspiracy, Todd Zywicki spent Christmas Eve crowing about a Wall Street Journal article about the boom in payday lending. Todd sees the article as vindication for his insistence that regulation of consumer credit will inevitably result in a substitution of another type of credit. For Todd, the substitution hypothesis makes regulation not just pointless, but actually harmful because it will eventually push consumers into the arms of loan sharks.  

There are a whole bunch of problems with the substitution hypothesis, as well as for Todd's interpretation of the WSJ article. Todd writes that: 

Maybe instead we ought to acknowledge that there will be unintended consequences, such as by making credit cards less available regulation will drive many consumers to substitute to more expensive types of credit, such as payday loans? And just wait until the well-intentioned bureaucrats at the CFPB really start protecting those poor folks, then they are really going to get it.

For starters, Todd doesn't accurately summarize the WSJ article. He implies that it was referring to credit cards in general. It wasn't.  It was referring to subprime credit cards. The WSJ article quotes a payday lender as stating, "We believe that we're starting to see a benefit of a general reduction in consumer credit, particularly ... subprime credit cards."  

It turns out that subprime credit cards are often as or more expensive than payday loans. The Credit CARD Act severely curtailed a type of subprime card called "fee harvester" cards. A 2007 NCLC study shows that the costs of fee harvester cards rival or exceed payday loans. So if there's substitution here, it might actually be a good thing. The article is certainly not evidence for middle class consumers getting driven into the arms of payday lenders. Instead, at best, it shows some substitution of fringe financial products and it isn't clear that it is harmful substitution. 

As a general matter, there's very little empirical evidence on the substitution hypothesis one way or another. The most recent work I'm aware of is by Credit Slips' Own Angie Littwin, who has shown that there isn't necessarily dollar for dollar substitution--sometimes consumers simply borrow less rather than turn to less savory sources of credit. Put differently, Angie's work shows that demand for credit is elastic, at least in some situations.  

But even if we were to accept the substitution hypothesis and posit inelastic demand for credit, it doesn't follow that all sources of credit are created equal. Some credit products are more competitive than others. So if regulation forces business to shift to more competitive markets, substitution results in a net consumer welfare gain. Todd argues that the payday lending market "is highly competitive." If it is more competitive than the subprime card market, then it shouldn't be surprising if costs are lower.  

Similarly, even with a product class, regulation of one type of fee can cause fees to shift to other types of fees. Thus, Todd predicts that the regulation of debit card interchange fees will result in an increase in consumer debit card fees. That's quite possible, but again, I don't see why that's such a bad thing. Consumers end up paying for most of those costs one way or another as merchants pass through interchange to consumers. All else being equal, a substitution from a less transparent/salient fee to a more transparent/salient fee will result in stronger price competition and therefore something less than a 1:1 fee shift. Consumers win. Conversely, if the shift is to a less transparaent fee, consumers lose. Presumably, any profit-maximizing firm would already have engaged in the optimal shift to less transparent fees, so there's no further ability to engage in this.  

I think this spells out an important task for the Consumer Financial Protection Bureau:  identifying which types of fees are more or less transparent and salient and then adopting policies to shift pricing toward the most salient and transparent fees. This will have the result of increasing price competition (not pricing competition) in consumer financial services. That will mean smaller profits for the financial services industry, but will also produce a greater incentive to come up with product innoviations, rather than pricing scheme innovations.

Full post as published by Credit Slips on December 30, 2010 (boomark / email).