Payday Lending and Bank Overdrafts
Dean Karlan (Yale University) and
Jonathan Zinman (Dartmouth College)
Why Consider Payday Loans and Bank
Overdrafts Together?
Product similarities:
• Key sources of short-term, small dollar liquidity for
(vulnerable) households
• Very expensive in annualized terms
– Interest rate in triple digits
• Not necessarily expensive in dollar terms
– Typical total outlays: $15-$45 per loan
• Some evidence that consumers don’t use these products
wisely, and that lenders exploit this
There is significant interest in regulating/restricting both markets
2
Why Consider Payday Loans and
Bank Overdrafts Together?
Differences in federal policy approach instructive:
• Overdrafts: laissez faire →
decision architecture
– Proposed Fed rules would begin
changing “decision architecture”
to “nudge” consumers toward
better decisions
• Payday loans: wrecking ball
– “Protect” consumers by shutting
down market
– But behavioral economics can
work here too
– If anything product structure
more amenable to nudge
approach than overdrafts
3
Payday Loans:
Market Background
• Short-term, expensive credit
– “$15 per $100” for 2 week loan » 390% APR
• Common
– More payday loan outlets than McDonalds + Starbucks
combined
– 5-10% of U.S. households use annually
– Higher prevalence in key segments (military, working poor)
4
Payday Loans:
Policy Background
?
• About a dozen states effectively outlaw, with
licensing and/or pricing restrictions
• 36% federal ceiling on loans to military personnel
effective October 2007
– President Obama wants to extend this to everyone
• Congress considering 4 bills in current session that
could effectively shut down market
5
Payday Loans:
Pressing Policy Questions
• How would shutdown affect consumers?
– We don’t know: evidence is mixed
– Some studies: expensive short-term credit finances productive
“investments” (in job retention, health, consumption smoothing)
– Other studies: expensive credit exacerbates financial distress
Given this uncertainty, why shut off a key source
of liquidity when we’re pouring $trillions to get/keep credit flowing?
6
Regulating Payday Loans:
A Behavioral Approach
• Mothball the wrecking ball
• Improve architecture to help consumers make
better decisions
– To design effective policy it helps to think a bit
more deeply about what we’re trying to fix….
7
Regulating Payday Loans: Behavioral
Diagnostics
• Exactly how are consumers going awry?
• How and why might consumers do themselves harm
when handling expensive short-term credit?
– Note: focus is not on mistakes per se
• underborrowing rarely a concern; overborrowing is
– So what cognitive biases might lead consumers to “get in
over their heads”
8
Behavioral Diagnostics and Treatments
• Cognitive bias and problem #1: consumers are
impulsive and lack self-control.
• Solutions to improve decisions
– Delay: build it into the borrowing process
– Commitment: help consumers formulate and stick
to a sensible plan, in their less-impulsive moments
9
Treatments for Impulse Control:
Delay
Customer
applies &
gets approved
Customer
returns with I.D.
in N days
Customer
gets cash
• Dampen impulsivity by reducing instant gratification
• Require consumers to obtain a license: extra step (prior to application)
• Waiting period: delay and extra step
– Example rule: days delay in getting cash equals
number of payday loans previously taken out that year
10
Treatments for Impulse Control:
Self-Regulation
Allow consumers to sign contract(s) that
voluntarily restrict their own borrowing
11
Behavioral Diagnostics
and Treatments
• Cognitive bias and problem #2: consumers do not anticipate
the doo doo they’re getting into
– Debt appears deceptively cheap: underestimate costs
– Future appears overly bright: overestimate prospects
• Solutions to improve decisions at point-of-borrowing:
– Bundle loan products with financial counseling
– Change disclosures to better highlight true costs, realistic prospects
12
Treatments for Poorly Informed Consumers:
Financial Advice
• Make completion of financial counseling a
precondition for (repeat) borrowing
– Medicine, not education: advise people, and help
them come up with a healthy plan
– Would need to subsidize advice
• Nonprofits & trade associations key players here
13
Treatments for Poorly Informed Consumers:
New Disclosures
Customer
borrows $300 at $15
per $100 for 2 weeks
Customer
rolls loan over
twice
Customer
pays $156 in
total interest
• Highlight true costs of borrowing in terms that
consumers can actually understand
– Expected total dollar cost
• Over multiple loans, compounded
14
Treatments for Poorly Informed Consumers:
New Disclosures
• Show typical
borrowing experiences
(reality check for the
overly optimistic)
• “Borrowers like you
typically take N loans,
pay $X in interest, and
default Y% of the time”
15
Bank Overdrafts: Supply-Side Background
• Big source of revenue for banks
– 74% of explicit revenue on deposit accounts
– 6% of net operating income
• Current regulation: malevolent neglect
– Inadequate disclosures
• Elephant in room: (already struggling) banks making
unsustainable profits off poor consumer decisions?...
16
Bank Overdrafts: Consumer-Side Background
• Preliminary evidence says “yes”, banks profiting off
consumer inattention
– Consumers could avoid nearly all overdrafts with simple
changes in behavior
• Big cost for many consumers
• Can be even pricier than payday loans
– Median fee in $20-$30 range, regardless of size of the loan
(i.e., of the amount of overdraft)
17
Bank Overdrafts:
Regulatory Environment
• Problem: upfront disclosure lacking
• Solution: mandate upfront disclosure
– A la Federal Reserve Board proposed rule!
• Model disclosure presentation is quite dry though
• Simple product so disclosure should be effective
– But for how long?
– Upfront disclosure probably insufficient given nature of the product
• Probably also need….
18
Bank Overdrafts:
Regulatory Environment
“Warning: if you complete
this transaction you will
overdraft by __$ and incur
an NSF fee of $35”
• Problem: no disclosure at point-of-overdraft
• Unlike a payday loan, customer may not even know
they’re entering into a separate, borrowing
transaction!
19
Bank Overdrafts:
Regulatory Environment
• Problem: most programs opt consumers in
• Solution: change default to opt-out, require
“active decision” by consumer to opt-in
Federal Reserve Board proposed rule would make this change!
20
Treatments Beyond the
Point-of-Borrowing
• Many households need to reduce debt before they
start saving
– I.e., their highest investment return comes from paying
down expensive debt
• So offer new products and programs for debt
reduction: “Borrow Less Tomorrow”
– Automatic payroll withdrawals
– Other SMaRT-like features
21
Summary of Behavioral Approach to Regulating
Payday Loans and Bank Overdrafts
• Decision architecture, not wrecking ball
• Tools
–
–
–
–
–
Delay (waiting periods and consumer licensing)
Self-regulation (commitment contracts)
Financial advice
New disclosures (true costs, typical experiences)
New products (“Borrow Less Tomorrow”)
22