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Evolution of the Payday Lending War

Money bullet in holder
History books record and remind consumers about the wars waged across the world. Without a solid record, what happens to the details for sub-level wars for financial and political issues?

One such war is the battle between consumer advocacy groups and lenders over payday loans.

Very few payday lenders existed two decades ago. In that time frame, the whole concept of consumer credit has altered the lending industry.

Payday lending is now a multi-billion dollar business. According to a 2012 report by the Pew Charitable Trusts, payday loan borrowers spent $7.4 billion in one year at approximately 20,000 storefronts, websites, and banks.

Similar to other heated political topics, payday lending has become a black and white topic. Most consumers and groups either support or oppose the practice. Although it is extreme, a quasi-war has erupted between the two sides that strengthen each day. Across the United States, state legislators try to limit interest rate caps in order to make payday lending unprofitable in their areas. The other side of the spectrum is the payday lending businesses that need to charge higher interest rates due to the short-term nature of the loans.

But when and where did this conflict come from, and how did it erupt into the battle that it is today?

History of the Payday Loan Industry

Despite its recent exponential growth, payday lending has roots that stretch back nearly a century.

The act of extending credit against a postdated check has roots back to the Great Depression, according to the Consumer Federation of America. The term “loan shark” was created to describe lenders who purchased wages or salaries and used them to charge high interest rates.

Carl Packman, author of “Loan Sharks: the Rise and Rise of Payday Lending” told loans.org that loansharking was frowned upon and banned in certain areas, even during the Depression.

Following the Depression, both the successful and unsuccessful endeavors to regulate the industry, struggled with usury charges because the government did not spend enough time modernizing and clarifying what reasonable interest actually meant, Packman said.

“It is in nobody’s interest to ban payday lending if the demand is still there,” said Packman. “What there should be is an analysis of how that demand can be better served by responsible lenders lending at reasonable prices, and what constitutes reasonable interest. Until then, governments remain confused and consumers fall in hock to expensive credit sellers.”

Little changes occurred to the industry after the Great Depression. Although clarification and regulation was needed, the opposite happened three to four decades later. Lenders were given more and more freedom without enough thought into the outcome.

Federal banking laws passed in the 1970s and 1980s gave more freedom to financial companies such as credit card companies, mortgage lenders, and federally insured depositories, according to a Pew Charitable Trusts report.

This added freedom set the arena for the industry to expand.

Payday lending on a large scale was partially implemented due to the Depository Institutions Deregulation and Monetary Control Act in 1980. This Act forced all banks to abide by the Federal Reserve’s rules, raised the deposit insurance at banks and credit unions, and most importantly, allowed banking institutions to charge any loan interest rates they desired.

The federal government instated this Act to react to the rise of inflation. It eliminated interest rate limits set by each state because federal laws always override state laws.

High interest rates are the livelihood of payday lenders, and now they had a legal way to make a profit.

After the 1980 Act, the payday lending industry was able to truly grow. Deferred presentment transactions, such as payday loans, began to take off in the early 1990s and throughout the 21st century.

One online payday lender, CashAdvance.com, did not experience as much regulation when it started in 1997. Matt Becker, spokesperson for CashAdvance.com, said the industry was more open because fewer states banned payday loans.

“The environment was very new, there weren’t a lot of people in the industry online so things were not regulated like they are today,” he said. “There was no OLA (Online Lenders Alliance), so it was kind of the Wild West in those days.”

That decade was a logical time to enter the industry.

“Consumer credit was big and the lending industry was strong. The 90s were a great time to lend as there was more trust because the economy was better,” Becker said.

When payday loans took off in the early 1990s, they were offered at storefront businesses. Slowly online stores caught on, offering a national option for borrowers.

But a newer business model adopted by banks created even murkier waters for regulators. Several large banks including Wells Fargo and U.S. Bank began offering “deposit advance” loans which carry similar rates and rules as storefront payday lenders.

The Tension Begins

Packman said the merger of payday lenders and national banks, an outcome of deregulation in the 1980s, created a growing tension in the industry.

Tension increased even further after payday lending companies expanded and began to find loopholes in state and federal laws. One such occurrence is the South Carolina Deferred Presentment Services Act (SCDPSA) which passed in 2009. Packman said the Act had the unanticipated loophole which allowed lenders to become licensed as supervised lenders and to be governed by another set of rules.

“There was some cat and mouse with the regulations which bolstered an intensified relationship,” he said.

As the loopholes surfaced, the battles became stronger. Packman said federal agencies that regulated financial institutions would side with big banking institutions.

“Historically, there [has] been backdoor support from banks to payday lenders,” he said. “The regulatory bodies have no idea how to even begin with small payday lending firms let alone firms online.”

Federal Government Takes A Stand

As the number of payday lenders increased at a staggering rate, more regulators began to take notice. In 2010, Congress finally took action to limit the power of short-term lenders.

State regulation does impact each individual state, but when the federal government steps in, the impact is greater than any state can ever hope to accomplish alone.

In 2010, the Consumer Financial Protection Bureau (CFPB) was created by Congress to do just that. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 created the CFPB which regulates the payday lending industry, among many other financial sectors.

Packman said that positive regulation, as performed by the CFPB, can inform consumers about the dangers of “bad debt.”

The regulation and oversight by a federal organization could not have arrived at a more important time. According to the 2012 report by the Pew Charitable Trusts, 12 million American adults took out a payday loan in 2010.  

Becker said this type of regulation was simply not present 10 to 15 years ago.

“In the 90s, the internet was still in its infancy for online lending so you didn’t hear many stories about it. It wasn’t the huge industry that it is today,” he said.

Like most businesses facing an altered environment, the decision was either to change or fail.

For CashAdvance.com, the solution was to completely direct business online. In the early stages, the majority of their short-term loans were completed through a store front but as the years progressed the business migrated entirely to the internet.  

Nowadays, online and storefront lenders are more regulated and are forced to be transparent.

“We must follow the advertising rule set by the online lenders alliance and have our terms and conditions clearly displayed,” Becker said.

Packman agrees that increased external regulation is key. He said there is a need for short-term credit, but that the payday loan industry should be regulated “effectively, not overregulated.”

“Self-regulation is a bad idea in theory and in practice,” Packman said.

Economic Benefits

Despite the strong opposition, there are businesses and consumer groups across the country that go against the regulatory grain. Payday loans can harm consumers, but the benefit of increasing consumer credit can be positive for some.

Packman said the U.S. Recession put a strain on the cost of living, decreased wages, and created a large inequality gap.

“All of these things compounded make the need for credit … all the more necessary,” he said.

Packman did acknowledge the fact that the full outcome of the Recession is still unknown. The impact of payday loans could be viewed in a more negative light as more research is compiled about the economic decline.

Beyond the positive impact on a singular consumer, payday loans contribute to larger economic forces such as to local and state revenues. For example, California’s state economy is strengthened by $1,155,150,000 due to payday loan companies alone, representing 0.064 percent of the state’s total domestic production.

The Murky Future of the Industry

Despite the monetary strength of the payday loan industry, its future is not as clear.

Currently, 12 states have laws that make payday lending illegal or unprofitable. Several other states have legislation waiting on approval to eliminate the consumer lending from their state.

Becker predicts the future of payday lending will be dominated by a few select companies that mostly handle business online.

“Online businesses will do better in the future. There will always be a need for storefronts, but nothing compared to online,” he said.

Packman agrees that online lenders are stronger than storefront lenders because state laws are harder to enforce when the jurisdiction is online.

In the end and despite their efforts, the federal government will struggle to regulate the industry on a national level.

“I think there will be a cat and mouse chase for 10 years which ends in nothing being sorted,” Packman said.