Returning Morality to Small Dollar Lending

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Scholar argues that policymakers should reexamine usury laws and introduce public banking to combat payday lending.

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How can regulators make capitalism more moral?

In a recent article, Mehrsa Baradaran recommends that regulators return moral considerations to capitalism by creating a public option for banking that would offer small-dollar loans at lower interest rates.

Baradaran claims that, because regulators have emphasized the importance of markets over morality since the 1980s, the regulation of small-dollar loans has shifted away from a focus on usury laws—or laws capping interest rates on loans—to a consumer protection framework. The current regulatory regime, Baradaran claims, imposes challenges on modern regulators who oppose predatory small-dollar loans.

Small-dollar loans, Baradaran emphasizes, inherently sit “at the tense intersection of capitalism and morality.”

Payday loans are an example of small-dollar loans. These loans offer financing to predominately low-income communities. Borrowers must prove that they have regular paychecks and give lenders access to their bank accounts for direct withdrawals. Although these are short-term loans, lenders will “roll over” the loans for a fee if the borrower struggles with repayment. These fees typically exceed the cost of the original loan.

A borrower with a $300 loan could, for example, pay $50 every two weeks to roll over the loan and avoid default. After a year, the borrower could ultimately owe $1,300 of interest on a $300 dollar loan.

Baradaran argues that the modern regulation of payday lending focuses on the consumer protection framework rather than usury laws because policymakers have prioritized market efficiency over morality. As a result, policymakers have been reluctant to implement regulations—such as interest rate caps—that interfere with loan agreements, Baradaran claims.

Historically, religious leaders claimed that it was immoral to charge interest on loans. Since the rise of laissez-faire capitalism, however, policy discussions focus on market pricing and efficiency rather than morality as a primary concern, Baradaran claims. Usury limits increased from 6 to 12 percent to over 700 percent in the 1980s in the United States. Furthermore, lenders can base their businesses in states with the highest interest rates and apply those rates to all their loans.

Weakened usury laws hinder regulators who want to combat predatory loans. Only states can regulate usury. But states that want to enforce maximum interest rates, Baradaran emphasizes, lose the “race to the bottom” because lenders will relocate to states that do not regulate payday loans. Baradaran notes that lenders that do not relocate thwart some regulations through lobbying and circumvent other regulations by creating new products or fee structures, “forcing lawmakers to play a frustrating game of whack-a-mole.”

Baradaran blames weakened usury laws for the increase in high-cost, small-dollar lenders.

Under the current consumer protection regime, some regulators suggest that consumer education is the appropriate response to predatory loans. Baradaran contends, however, that payday loan borrowers search “extensively for preferred credit before deciding on a payday loan” and that they seek payday loans typically as a last resort. Furthermore, Baradaran emphasizes that low-income borrowers manage the repayment of multiple loans and calculate the costs associated with simple financial transactions, showing “a level of financial literacy that many in the middle class don’t have, and frankly don’t need.”

The demand for payday loans, Baradaran notes, increased alongside poverty rates over the last several decades in the United States. Baradaran argues that until poverty is addressed or fair credit becomes more accessible, consumers will continue to seek high-interest loans.

“Educating the poor to choose better options,” Baradaran quips, “must mean that there are better options to choose from.”

Rather than relying on financial education to combat payday lending, Baradaran recommends creating a public banking option—a service or product offered by the government to compete with private companies. A public option would allow the government to enter the small-dollar loan market to compete with payday lenders.

Banks can borrow funds at a discounted rate of 2 percent from the Board of Governors of the Federal Reserve System in times of financial constraint. But individuals who face financial hardship must turn to emergency small-dollar loans with interest rates as high as 2000 percent, Baradaran notes. She argues that government support of the banking sector means that “the government and by extension ‘the people’ must be entitled to demand a banking sector that serves all of us,” justifying a public option for banking.

The U.S. Postal Service, Baradaran suggests, could offer financial services at a lower price than payday lenders while remaining financially self-sufficient and accessible to all households. Baradaran recommends that the Postal Service offer the public option because, as a non-profit entity, it can charge the cost of the loan to borrowers, without significant additional interest. In addition, the Postal Service can lend more efficiently than other institutions because it has an “existing and large network of branches to sell new products without much additional startup, overhead, or marketing costs.” Because the Postal Service accepts and transports cash as part of its operations, it can offer financial services more easily.

Furthermore, the Postal Service has branches in every part of the country, including in communities that banks have abandoned. Individuals who do use a bank purchase money orders from the Postal Service, so the Postal Service’s customer base already includes economically vulnerable households.

As interest rates on payday loans reach “unprecedented heights,” elected officials in the United States are reconsidering the regulation of usury laws. Baradaran argues that the renewed focus on usury represents “a broader backlash against market rules and assumptions.” A public banking option offered by the Postal Service, of the kind that Baradaran recommends, could offer a path to economic inclusion for vulnerable communities and return moral considerations to small-dollar lending.