Price Cap introduced for the UK Payday Loans Market

The UK Financial Conduct Authority has announced direct interventions in the market for payday loans - the high cost short term loans market which has expanded rapidly in recent years led by businesses such as Wonga. The decision is the result of a detailed assessment of the industry which had flagged up a number of market failures.

Three main market failures are flagged up in the FCA analysis of the payday loans market:

1. Behavioural biases - not least people’s desire for instant gratification which leads them to take out loans
2. Information asymmetries - most lenders know more about the risk of default than the people they sell credit to
3. Limited price competition between the major providers in the market

The cap

In January 2015, the FCA will introduce a cap (ceiling) on the total amount that high-cost short-term credit lenders can charge. According to the FCA announcement, a person taking out a typical loan over 30 days and repaying on time will not pay more than £24 per £100 borrowed. A £15 cap on default charges (paid by those who fail to repay their debt on time) will also be applied.

Payday loans market in the UK

In 2013 the UK payday loans market provided a total of over 10 million loans for 1.6 million people worth £2.5 billion. The average loan per consumer was £260. The FCA argues that found that excessive charges for high-cost short-term credit are harming significant numbers of consumers. Many borrowers pay a high price for a loan that is of limited net benefit, or makes their already difficult financial situation worse.

Likely exit of unprofitable lenders

Price capping for payday loans will reduce total revenue and overall profitability for lenders and there are forecasts that this intervention will cut the availability of loans for around 11% of individuals. However the FCA argues that "for most of these people, a payday loan or other form of high-cost short-term credit is not the best outcome for them due to the high cost, particularly if they are unable to pay back on time.”

Alternatives to payday loans

The FCA wants to see more people in financial difficult seek debt advice rather than approach payday lenders. In recent months there has also been increased interest in the potential of locally-run credit unions to supply alternative short term finance at lower interest rates than charged by the payday lenders.

The likelihood is that the payday loans price cap will bring about a sizeable reduction in the number of lenders in the market. The FCA report finds that only the largest lenders currently make significant profits – most are only marginally profitable, and some make no profit at all. The exit of many lenders from the market due to subnormal profits may impact on the degree of competition in the market.

Unintended consequences?

Critics of the price cap intervention argue that individuals denied credit will then seek inferior alternative means of borrowing, such as ‘bouncing’ cheques, exceeding authorised overdraft limits of borrowing from a pawnbroker (otherwise known as loan sharks).

The well established commercial banks such as Lloyds Banking Group and Royal Bank of Scotland might decide to enter the market for short term loans and offer viable competition to the payday lenders.

Interventions in other countries

Price caps for short term high cost credit have been applied in a number of countries notably Canada and the United States. In the USA, 15 states eliminated payday lending by either introducing a ban or capping the maximum charge for credit at a low level, driving lenders out of business. 35 states in the US have introduced higher caps on the price of payday loans which protect consumers from high charges but keep the market viable.

Background on the UK payday loan market

(HCSTC: High cost short term credit)

• Total payday loan revenue in 2012/13 was £1.1 billion, with 10.2 million loans issued, worth £2.8 billion
• The average loan was £260 (£290 online and £180 on the high street)
• The three largest lenders, operating under five brand names, have a combined market share of 72% by revenue
• Most firms’ revenue is generated through interest charges
• HCSTC users are younger than the UK population as a whole (33 versus 40 years)
• HCSTC users have lower income levels (the majority under £18,000 versus £26,500 per year)
• Around 65% of HCSTC users have no savings compared to 32% of the UK population; most of those who do save have less than £500 (compared to a median of £1,500-£3,000 for the UK population
• 64% have outstanding debt from other types of lender, mainly credit cards (20%) and overdrafts (28%) and on household bills or mobiles (28%)
• Non-price competition in this market includes speed of access to funds and quality of access to information on loan costs provided to consumers

More reading

BBC - Payday loan firms not competitive, says CMA (June 2014) http://www.bbc.co.uk/news/business-27790924

Guardian: Articles on payday loans: http://www.theguardian.com/money/payday-loans

Channel 4 (November 2013): http://blogs.channel4.com/faisal-islam-on-economic...