Payday Lending: Still on the Front Burner

In recent years, we have coined a variety of terms for high-cost, short term loans. The names can vary from late payment fees through overdraft protection to payday lending. Whatever the name and whatever the mechanism used to trigger the transaction, these high-cost, short-term transactions generate a high level of concern among regulators.

Payday lending, like other forms of short-term, high-cost loans raises issues under several umbrellas, including unfair or deceptive trade practices, consumer protection, and safety and soundness.

The Loans
Payday lending is a term used to refer to small-dollar, short-term loans or advances made against the borrower's next paycheck or regular income payment such as social security or retirement. Other names include deferred deposit advances, check advances and similar inventions.

Payday loans have several basic characteristics. First, they are usually provided at a fixed dollar fee. This fee may be related to the amount borrowed but is not calculated as interest would be. For example, the lender might charge a fixed fee per $100 and a larger fee for amounts between $100 and $200.

Because the fee is based on the transaction more than on the amount borrowed and because the loans are short term, the APRs on payday loans can be a figure much higher than bankers are used to seeing. For example, charging a fee of $17.50 on a loan of $100 results in an APR close to 350% or even 400%.

The APR figure alone makes these loans seem predatory. However, the reasons for borrowing add significantly to the picture.

The Borrowers
The typical payday loan borrower is not destitute. Instead, the borrower has many indicia of responsible money management. The borrower has a checking account and usually has one or more credit cards. And this may be the problem. The most common reason for taking a payday loan is to avoid a late payment fee on the borrower's credit card account. Borrowers are willing to pay $17.50 to a payday lender rather than incur a late payment fee of $39 on their credit card account and also risk negative information reported on their credit history.

The checking account is typically a requirement for the payday lender who takes and holds a check from the borrower for payment. The credit card may be the genesis of the need to borrow.

Subprime and Payday
Payday loans are not necessarily subprime loans. In fact, the borrower may be using the payday loans to keep the credit history and credit score favorable. However, practices by the lender may result in the regulatory agency classifying short-term, high-cost loans as subprime.

Essentially, a payday borrower is one who faces cash flow difficulties. The borrowing to manage cash flow may indicate careful budgeting and cash management or it may indicate a struggle to stay afloat. The former borrowing style is a credit need that can be met with positive results for both borrower and lender. However, the risk in payday lending is that too many of the borrowers are turning to payday loans because they are losing the struggle to stay afloat. And, probably worse, the payday lending itself may be the factor that drives the borrower into unmanageable debt.

Exam Procedures
Because of concerns about payday lending and other lending practices that may put the institution at risk, the FDIC has issued additional guidance on payday lending in FIL-14-2005. In its 2001 guidance on subprime lending, the FDIC laid out guidelines for determining when a bank was a subprime lender. This constituted the regular origination of such loans using a tailored marketing, underwriting and risk program. For purposes of payday lending, FDIC concerns are sufficiently strong that examiners are advised to apply the payday lending guidance whether or not the bank meets the earlier definition of a subprime lender.

The procedures vary based on whether the bank is a direct payday lender or makes these loans through a relationship with a third party. If the bank is using a third party, the examiners will look for effective risk controls. The bank should have a contract with the third party which specifies duties and responsibilities of each party and calls for compliance on the part of the third party. As with most third party contracts, the agreement should authorize the bank to monitor the activities of the third party and to have access to its records.

The contract should provide that the third party will comply with all applicable laws and regulations, including consumer compliance disclosures and non-discrimination. Even with such contract provisions, liability for violations may attach to the bank, but the contract provides the bank with the standing to hold the third party liable.

Finally, the agreement should include a provision for how customer complaints will be addressed. There should be specific provisions for communications between the parties upon receiving a complaint and for developing a satisfactory response to complaints.

Safety and Soundness
FDIC concerns about payday lending span almost all regulatory areas, but the leaders are compliance and safety and soundness. It is interesting to note that the safety and soundness issues tie closely to the compliance issues. Payday lending, like other forms of high-risk lending, operates under the shadow of CRA, unfair or deceptive trade practices, and consumer protection regulations. In payday lending, these concerns become integrated with safety and soundness. The guidelines direct examiners to look for practices that pose a risk to safety and soundness and that also raise compliance concerns.

First, examiners should look for underwriting standards. Weak underwriting standards present credit risk. They also present risk for violations and for patterns of lending that may have a disparate impact on minority groups in the market.

Second, examiners will look for lending patterns with each customer. The policy guidance advises that renewals or extensions to a customer should be limited as repeated payday borrowing can be abusively costly to the customer and raise the risk for the lender. The institution should have and strictly follow clear procedures on late payments, non-payments, and repeated requests for renewal.

Third, examiners will review the practices for accruing fees and finance charges to ensure that they are consistent with safe and sound practices.

Finally, examiners will review the lender's practices in reporting collections. Continuing to treat delinquent payday loans as collectable presents a misleading balance sheet. Examiners will look to be sure that the institution is properly reporting its charge-off experience with the loans.

Unfair or Deceptive
Although presented in the context of safety and soundness, the FIL lays out expectations for renewals and rewrites of payday loans. Certain policies, backed up by consistent practices, are essential. These include:

limiting the number and frequency of renewals or extensions;
prohibiting advances to finance fees and interest;
maintaining customer cooling-off periods between payday loans;
setting a maximum number of payday loans a customer may have per year;
limiting each borrower to one payday loan at a time; and
limiting payday loans if borrowers have similar loans with other lenders within the past year.

Each of these practices are designed to minimize harm to consumers and prevent predatory lending practices.

To support the anti-predatory practices, the FIL also advises institutions to ensure that payday loans are in compliance with consumer protection laws and to consider the impact of such a program on the bank's CRA program. Payday lending is one way to meet credit needs in a community. But before jumping on the payday lending bandwagon, the lender should thoroughly investigate other methods that may meet the same credit needs at less cost to the consumer.

Any payday lending should have a timely and accurate Truth in Lending disclosure and advertisements should be in compliance with Regulation Z's advertising rules. The nature of payday lending - short term with limited underwriting - may enable discrimination. The lender should have tight controls on rate structures, information gathering, decision-making and notifications.

If credit reports are used (this includes deposit-oriented reports) the lender must provide FCRA notices as appropriate. Marketing and privacy are also high concerns. Marketing must not only comply with Regulation Z but should also avoid any form of deception. Finally, payday lending is also subject to privacy requirements and information security. These may be particular challenges if the lending is done through a third party.

The bottom line is that while payday lending may be profitable, it brings risks and compliance challenges. Both must be managed actively and effectively.

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