Payday loans from banks pose huge problems for poor consumers – and
the banks themselves. The federal government has finally stepped in
with new guidelines for payday loans.
By Sanjay Sanghoee
In an effort to curb abusive lending practices, the U.S. government
has finally issued guidelines – long overdue – on short-term bank
loans tied to consumers’ income. The new federal limits will help to
protect consumers and, surprisingly, the banks who make such loans.
The benefit for consumers is obvious. These deposit advance loans
(which are really just payday loans offered by legitimate banks rather
than shady neighborhood dealers or online outlets) hit consumers with
a myriad of expensive fees and charge up to 120 percent in interest.
The new guidelines, issued last month by the Office of the Comptroller
of the Currency and the Federal Deposit Insurance Corp., rein in the
interest rates that banks can charge and the balloon payments they
Here is how the loans work: A bank advances money to existing
customers against their paycheck, Social Security, or other benefit
that is due to be deposited into their accounts. When the expected
deposit hits, the bank withdraws its principal plus interest directly
from the account.
So far, such an advance could be construed as a valuable service for
cash-strapped consumers. Deposit advance lending exists because some
people cannot meet their near-term financial obligations and need a
little extra time to round up the necessary funds.
The problems start, however, when the deposit cannot cover the full
amount of what the customer has borrowed. The bank takes its money
anyway, and socks the borrower with overdraft fees and additional
interest. Since people who need these advances are invariably low
income and struggling to pay their bills in the first place, these
fees and interest charges quickly build up and can create a growing
and never-ending cycle of debt.
But the practice is problematic for the banks, too. They do not
typically do a credit check for deposit advance loans, which means
they cannot assess the real risk of lending to such borrowers. Plus,
high interest loans can easily push borrowers with bad credit further
into the red and render them unable to pay back the bank. Free
enterprise is not a license for irresponsibility and there are few
business practices worse than lending to unqualified borrowers at high
rates. The outcome is predictable and ultimately runs to the detriment
of both the borrower and the lender.
To see evidence of this, look no further than the subprime mortgage
crisis of 2008, which began with mortgage loans to unqualified
borrowers and ended in mass foreclosures and the widespread
destruction of wealth. While in that case banks and mortgage
originators were able to offload most of their risk onto
quasi-governmental agencies like Fannie Mae and Freddie Mac, there is
no such safety net for deposit advance loans.
It is also worth noting that the investment banks that bought the bad
mortgages in order to securitize them and sell them to outside
investors profited at first but eventually took massive losses when
the loans went bad and the insurers who had backstopped them could not
pay up. The moral of the story is that whenever lenders fail to assess
true risk or actually compound that risk through onerous terms, the
results are bound to be bad.
That’s why the new federal guidelines should help banks. They require
banks to moderate the fees and interest on their loans to avoid
increasing the chances of default and, equally importantly, refrain
from lending when consumers show patterns of delinquency. It’s sad
that in a free enterprise system the federal government has to step in
to save the banks from themselves, but when lending bubbles can cause
the type of havoc we witnessed in 2008, and when respected banks like
Wells Fargo (Ticker: WFC) and U.S. Bancorp (Ticker: USB) choose to
ignore the risk of offering dubious products like deposit advance
loans, what choice is there?
Political and business commentator Sanjay Sanghoee has worked at
leading investment banks Lazard Freres and Dresdner, as well as at
multibillion-dollar hedge fund Ramius. His opinion pieces have
appeared in Time, Bloomberg Businessweek, Fortune, and Huffington
Post, and he has appeared on CNBC’s ‘Closing Bell’, TheStreet.com, and