Payday Loans: Can Borrowers Have Speed, Convenience And Affordability?

Source: OFT

Problems with payday lending are not new. As with payment protection insurance, campaigners in the US were attempting to address poor practices in this area long before they rose to prominence in the UK - and still are. Regulatory solutions don't seem to make much difference. However, recent research shows that 46% of the UK's online borrowers shop around, versus 28% of those on the high street. This suggests technology may also help ensure compliance with affordability requirements, if only creditors would provide transaction and fees data in machine-readable format.

In its consultation on Payday Lending in the UK, the OFT estimates that the volume of payday loans has grown from £900m to £2.2bn since 2008. It says the top 3 providers account for 57% of all payday loans, but concedes the number of lenders has grown from 96 in 2009 to 190 in 2012. This growth, and the efforts of UK campaigners, sparked the OFT's payday lending compliance review in February 2012. As a result of that review, the OFT is now considering a referral of the industry to the Competition Commission, though it believes the transfer of its own regulatory role to the Financial Conduct Authority in 2014 "is likely to increase regulatory costs and make entry to the payday lending market more difficult."

True, the FCA will have more powers, e.g. to limit the number of roll-overs, cap interest rates and control advertising (see the Treasury and FCA consultation papers on the transfer of consumer credit). But the past decade here and in the US has shown that regulation itself is no panacea. Technology appears to have had a bigger impact, both in terms of access and the ability to shop around, and this suggests that technology represents the best avenue for addressing affordability issues.

It's important to start with the borrower. You can't ignore the fact that 90% of online customers who responded to the OFT survey find it "quick and convenient" to get a short term loan and 81% say it makes it easier to manage when money is tight. Customers expressed their satisfaction in terms of decision speed (36%), convenience (35%) and customer service (27%). While affordability therefore appears to be a secondary consideration for all concerned, that's a bit misleading. Research shows that customers ignore the annualised interest rate and look at the absolute charges. These may make loan cost comparison harder, but makes more sense to someone who believes he's only borrowing for a month - which is the case for 72% of payday loans (see graphic). Assessing affordability is also hard - especially for the borrower, on whom the lender is largely relying to provide the relevant figures.

It is therefore no suprise that the industry advertising generally emphasises 'time to cash'.  But the OFT also found that some lenders seem to skimp on credit and affordability checks in order to deliver that speed. You would think that's a dangerous game for lenders to play when their own money is at risk. But the OFT found that about half lenders' revenue come from the 28% of loans that 'roll-over' at least once before being repaid (see graphic). Instinctively, that looks bad. But if those loans are so valuable to lenders, it seems odd that the OFT found little evidence of competition for them loans that are about to roll-over. Perhaps borrowers think they have no alternative at that point, or perhaps they don't care about the cost. But it's also consistent with the fact that these borrowers - and lenders - find it really hard to assess affordability.

While the OFT will decide in June whether to refer the payday lending 'market' to the Competition Commission, you can see from Annex A to its report that it's struggling to define that market. There's a long list of potentially competing finance products. But there are at least 4 unmentioned 'gorillas in the room'. The 'silverback' is the overall debt scenario facing any borrower considering a payday loan. Another gorilla in this troop is the charge for unapproved overdrafts, about which the OFT is understandably gun-shy after its long-running court battle with the banks. Yet another is the fact that when you use a credit card you have no ready means of knowing what the outstanding balance is, as some transactions may not yet be recorded, and interest and charges may only be added to the bill at the end of the month. That's a common reason that the so-called 'financial excluded' give for not trusting financial services, including cheque books and debit cards. The final gorilla in the troop is the borrower's overall financial situation, including the non-financial implications of failing to pay existing or potential creditors, like kids having no school shoes...

However, like a credit reference search itself, these gorillas are all really data problems that are capable of a technological solution, as I've explained previously. Rather than skimp on affordability checks, lenders should figure out how to enable them to be carried out quickly and conveniently. Small lenders might share the cost of a common underwriting platform, for example. But, more importantly, borrowers need to be armed with an application that very simply presents an option that is affordable, based on the analysis of their own transaction data (including fees) from their existing creditors, and the competing costs of different financing options (including charges for missing a payment). 

This may sound futuristic, but it only requires a commitment on the part of all the typical creditors and financial services providers to make this data available to their customers (or their nominated service provider) in machine-readable format. The analysis can be done by either the customer's or a supplier's computer, with the results accessible either online or physically, via a print-out. 

There are plenty of examples of individual customers' transaction data being made available to them or their nominees in this way already, and the immediate focus of the government's voluntary 'Midata' programme is to persuade the banks, telcos and energy companies to do this for all their customers (rather than only those with internet banking accounts, for example). 

Problems like the affordability issues in the £2.2bn payday lending sector represent a good argument for getting on with it.

Should The CBI Chief Resign?

Really?

Despite purporting to represent 240,000 businesses of all sizes, the Confederation of British Industry (CBI) has long been an apologist for the UK's banks (who account for a substantial proportion of its funding). But in one hilariously poorly judged article in the Times, its director-general has finally eroded all credibility by calling for both a time-bar on PPI compensation claims and protection for UK banks against any successful court proceedings arising from their Libor fixing activities. 

Now you might think it particularly poor judgement to choose the current bank-driven economic scenario as a golden opportunity to demand yet more public assistance for the authors of our doom.  

And you might well believe it to be spectacularly naive, irresponsible and even downright absurd to demand protection for the beneficiaries of what is now the largest case of financial mis-selling in British history, at the expense of victims, from the very regulator who is bound to protect them.

But surely then you'd have to consider it to be successfully suicidal to invoke retrospective sovereign immunity for fixing a global interest rate benchmark while domestic criminal investigations are in progress, not to mention civil suits of the kind one or more of your own members might bring.

I can't imagine that even the banks would have the barefaced cheek to ask for any of this privately, let alone in an article in the Times. Still, you never can tell with Britain's institutions.

Finally, however, let's not ignore the CBI chief's bold and cunning suggestion that the banks' £12bn in provisions for PPI compensation might somehow represent spare funds that could, or would otherwise be lent to people and businesses (in other words, not to the low income earners who would have received it in compensation). 

Conflating the accounting for civil penalties with the privilege bestowed on banks by the state to create credit is not just silly in its own right. It also invites attention to the fact emphasised by Richard Werner, that only 10% of the credit created by UK banks in the exercise of that great public privilege is actually directed toward the people and businesses who need it to grow the economy, while the other 90% goes to fuel speculative deals in non-GDP financial assets. So, whatever you might think of opportunistic, ambulance-chasing PPI claims management firms, you might find it utterly contemptuous for anyone to suggest that consumers should forego compensation for being sold phoney insurance when it would barely amount to a rounding-error on such rampant, unchecked public exploitation. 

But maybe this is what the CBI means by "asking for immediate action to smooth the transition to a "new normal" in banking lending [sic]."

Yes, Mr Crudland, I reckon you should get your coat.

FSA Note On Crowd Investing

In response to various comments and queries, I've reviewed the FSA's recent note to consumers on 'crowdfunding'. The FSA's note is actually quite a positive sign, although it's worth clarifying a few aspects discussed below. These relate to terminology and the policy context, the wider audience, opportunities for everyone to diversify, the potential for secondary markets and another means of protecting customer funds.

Here one has to sympathise with the FSA. Alternative finance platforms are springing up all over the country and the FSA no doubt feels obliged to say something helpful about those closest to its remit. Yet it is only empowered to supervise the current regulatory framework, which is ill-suited to the sort of innovation that crowd investing represents. The Treasury, which is responsible for producing the regulation that governs the FSA's remit, has been dragging its heels somewhat on this front. Even the US has beaten us to the punch by cutting a swathe through its byzantine securities legislation to provide a more proportionate regime to support crowd investing.

So in these respects the FSA's note is also helpful in illustrating the need for proportionate regulation that the alternative finance industry has been calling for to enable the responsible growth of non-bank retail financial services. The note is also perhaps a sign that the FSA acknowledges the need to look beyond the regulated markets when considering whether there is adequate innovation and competition within them.

Terminology and The Policy Context
 
I've previously discussed the various meanings of the term 'crowdfunding' and the policy context here. The FSA's note initially states that "crowdfunding involves a large group of people contributing money to support a business, individual or campaign." But that would encompass a wide array of situations that surely aren't in scope, including ordinary donations to charities, buying shares on a stock exchange and perhaps even retail sales. Accordingly, later in its note the FSA qualifies the statement by adding that crowdfunding investors will usually receive shares in the business or project they contribute to..." pre-purchase goods to be produced or "...receive a reward like a t-shirt or mug". I read this to mean that the FSA is referring to both 'crowd-investing' as well as the original form of 'rewards-based' crowdfunding that I've discussed previously. But that's not to say these activities are necessarily regulated by the FSA - indeed the FSA later points out that "almost all crowdfunds are not authorsed by [it]" - though it can be a complex undertaking to determine what is in or out of scope.
 
What is perhaps missing, however, is the primary point of distinction between crowd investing and traditional forms of investment. Crowd investing involves a marketplace comprising a crowd of consumers and/or small businesses on both sides, whose direct interaction is faciliated by a neutral platform operator. In other words, members of the crowd are engaging with each other on the same platform, rather than a single financial institution offering its own products to its customers. This phenomenon partly reflects the 'Web 2.0' or 'social media' trend that has also 'democratised' the retail, entertainment and other consumer-facing industries. In the investment context, it most often involves contributing relatively small sums of money you would be prepared to lose, in order to finance the activities of people and businesses whose success might benefit you, your community or society generally, but on terms that could also give you a financial return in that success. Other key differences between various types of crowdfunding models (in the broader sense) and traditional financial services are explained in Annex 1 to this note on regulatory reform.
 
Wider Audience
 
The FSA's note is primarily an explanation for consumers acting as investors, rather than an explanatory note to the people or businesses who see crowd investing as a way to raise funds, or to the platform operators who facilitate the interaction between the two. Again, this perhaps misses the point that crowd investing comprises a marketplace with a crowd of consumers and/or small businesses on both the investing side and the receiving side.

But the note does helpfully point out that "for businesses, crowdfunding can be a useful way to gain direct access to investors and finance that more traditional investors, venture capitalist or lenders are not prepared to offer."

That's putting it politely, as you might expect. Aside from the Web 2.0 trend, another reason for the growth in peer-to-peer finance models is that banks, pension funds and other traditional investors whom the FSA does regulate are continuing to conserve capital or offer finance on terms that are unduly onerous, while charging savers and investors high fees and/or failing to offer a decent return. This intransigence suggests that it's down to entrepreneurs and private investors to connect the dots between low returns on savings and the opportunity to fill the SME funding gap of £26bn - £52bn over the next 5 years, or the annual social sector finance gap of £0.9bn - £1.7bn.

Opportunities To Diversify

The FSA says that "crowdfunding could make up part of a diversified portfolio, especially for sophisticated investors." I do not read this to necessarily mean "sophisticated investors" in a regulatory sense (e.g. under the Financial Promotions Order). Even so, this begs the question why only 'sophisticated investors' should enjoy the benefits of the reduced investment risk that goes with maintaining a diversified portfolio beyond "mainstream investment products". People seen as 'ordinary' investors are proportionately suffering much more from a lack of opportunities to diversify than those who are more wealthy or finance professionals (if that's any proxy for 'sophisticated'). ISA and pension rules incentivise the concentration of funds into assets that are providing little return and generate high fees for institutions. Ironically, in rejecting calls by the Breedon Taskforce for broadening the ISA scheme the government highlighted the problem by confirming that 45% of the adult population is herding into the same narrow range of asset classes.

That's not to say that any old asset should necessarily qualify for ISAs and pensions, and I agree that the risks in such investments should be clearly explained to investors, along with the benefits. As I've said repeatedly, simplicity and transparency as to both the benefits and the extent to which you risk losing money are critical to the process of making financial services more consumable, but we need a more facilitative approach to that process. Policy-makers must recognise that crowd investing has its genesis in the trend towards greater transparency and consumer control, not less. Operators are trying to simplify financial services and make them more transparent and accessible to all. Legacy financial regulation is one of very few hurdles in the way of that trend, yet entrepreneurs are responsibly calling for more proportionate regulation rather than some kind of unregulated free-for-all.

Secondary Markets?

Interestingly, the FSA points to the inability to sell many crowd investments as a risk associated with crowd investing (which perhaps misses the point of crowd investing in the first place, as discussed above). Yet, ironically, current regulation renders the development of such secondary markets impracticable. So the fact that the FSA has called this out as a risk suggests that efficient means of secondary trading on crowd investing platforms may be permitted as a benefit to consumers in future.

Protection of Customer Funds

The FSA says you should "find out how your money is protected if the business, project or even the crowdfunding platform collapses - in particular check whether the business has appropriate cash reserves or even insurance supporting if it fails." This is true. While the very nature of 'investment' is that you may lose your money if a company or project you invest in does not succeed, it should also be made clear to you from the outset. But when considering what happens to your uninvested funds if an unregulated crowd investment platform collapses, it's worth mentioning that the platform operator might legitimately choose to hold funds received from customers in trust in a separate bank account, designated as holding customers' funds with the bank's acknowledgement, so that those funds do not form part of the operator's assets and would not be available to the operator's creditors if the operator were to fail. The operator may also make arrangements for the ongoing administration of investments in the event that it ceases to operate.

At the end of its note the FSA adds that "We are also concerned that some firms involved in crowdfunding may be handling client money without our permission or authorisation, and therefore may not have adequate protection in place for investors." However, its important to clarify that 'handling client money' is not a regulated activity in its own right. The FSA's client money rules only apply where the provider is both authorised by the FSA and subject to the FSA's own client money rules. So this does not mean that firms who are legitimately operating outside the FSA's remit (or who are FSA-regulated but not subject to the FSA's client money rules), cannot choose the other ways of protecting their customers' funds described above.

Finally, it's worth clarifying that even FSA-authorised firms may fail to follow the right procedures to protect customer funds, thereby potentially undermine the protective effect of the arrangements (as alleged in the case of Lehman Brothers and MF Global). In January 2011, the FSA also fined Barclays Capital £1.12 million for "failing to protect and segregate on an intra-day basis client money held in sterling money market deposits" over an eight year period.

The point is that even the most intense regulation will not remove investment risk entirely.

Image from Lattice Capital.

Unpacking The Term "Crowdfunding"

The term "crowdfunding" is being used a lot in legal circles these days, but it can mean a number of different things to different people - from many people buying shares in a single company to any form of peer-to-peer financing or donations. So for the sake of clarity I thought I'd explain my own understanding of the different types, as well as the overall policy context.  

Terminology

In its broadest sense, 'crowdfunding' describes a key impact of Web 2.0 on financial services (as discussed over on Pragmatist, and in print here). It's one aspect of the same trend towards greater consumer control that has swept through retailing, entertainment and so on. The critical point of distinction between the various forms of crowdfunding and 'traditional' forms of finance is that crowdfunding involves a finance marketplace comprising consumers and/or small businesses on both sides, whose direct interaction is facilitated by a neutral platform operator, rather than a single financial institution offering its products to its customers. Other key characteristics are set out in Annex 1 to this note. But when the term 'crowdfunding' is used in this broad sense, one should bear in mind that it actually encompasses a range of very different models, involving very different legal instruments, with very different legal and regulatory outcomes, as discussed below.

'Crowdfunding' first gained currency to describe 'rewards-based' peer-to-peer platforms like ArtistShare and Kickstarter.com, which were designed to raise money from many people to fund many small budget projects via the internet without infringing US laws that control the offer of 'securities' to the public. On those web sites, eligible people are enabled to post 'pitches' seeking funding for a project (e.g. to start a monthly magazine) in return for a 'reward' of some kind (e.g. a monthly copy of the magazine for a period). There is a range of similar platforms in the UK (e.g. Peoplefund.it, Crowdfunder and those mentioned here).

Independently of rewards-based crowdfunding, peer-to-peer platforms have also emerged in the markets for personal loans and small business loans. This activity was first called 'social lending', then 'person-to-person lending', 'peer-to-peer lending', 'P2P lending' and more recently 'crowd lending'. Examples include Zopa, Ratesetter and Funding Circle in the UK and, say, Comunitae in Spain. The peer-to-peer lending model has also been adapted to enable many people to fund numerous small businesses in developing countries, which is referred to as 'micro-finance' (e.g. Kiva, MyC4). When applied in the domestic not-for-profit or charity sector, the peer-to-peer lending model tends to be referred to as 'social finance' (e.g. Buzzbnk).

However, the term 'crowdfunding' has acquired a more formal regulatory meaning over the past year or so, as a result of the successful campaign in the US to introduce the JOBS Act to allow the crowdfunding model to be used in situations where 'securities' are the reward (Title III of  the JOBS Act is called the Crowdfund Act). This is apt to cause confusion outside the US, because the US Securities Exchange Commission has a broader interpretation of what constitutes a 'security', and narrower exemptions from the scope of its securities laws, than the UK and many other jurisdictions.

Prior to the JOBS Act, the SEC required an individual or small business borrower to comply with the same formal registration requirements for entering into a simple loan contract via a public web site that a major corporation must follow when offering its shares, bonds or debentures to the public. So US-based peer-to-peer lending programmes have had to be registered with the SEC at great expense and require a financial institution to act as an intermediary (e.g. Lending Club, Prosper).

But in the UK and many other jurisdictions such heavyweight requirements are applied to more complex debt instruments (bonds and debentures) and shares ('equities'). As a result, peer-to-peer lending (or 'crowd lending') using simple loan contracts has been established outside the scope of securities or investment regulation in the UK since Zopa launched in 2005 (later joined by Ratesetter and Funding Circle).

However, peer-to-peer models that involve shares and debentures ('crowd investing') have proved a lot more awkward to implement, given that traditional financial regulation is more intense in connection with those instruments. Exemptions have been more liberal than in the US (at least pre-JOBS Act), although fiendishly complex and expensive in time and money to interpret. As a result, there is a growing political consensus that the UK would also benefit from a US-style regulatory overhaul in this area. And it is in the context of this policy debate that use of the term 'crowdfunding' is most at risk of generating confusion between 'crowd investing' and other forms of  'crowdfunding' in the broader sense.

Policy Context

While 'crowd investing' is perhaps most under the regulatory spotlight currently, there are some common issues and operational risks across all types of 'crowdfunding' in the broadest sense (though less so with rewards-based crowdfunding). All types of plaforms involve a similar technological and operational 'architecture of participation'. And they all meet some difficulty under traditional regulation - and the more intense that regulation is, the more complex it is to innovate, launch, operate and grow. Small changes can trigger significant regulatory requirements, increase costs and inhibit marketing. Tax incentives favour products offered by traditional institutions and inhibit the ability of ordinary savers and investors to diversify.

As a result, the operators of both peer-to-peer lending and crowd investing platforms have been calling for proportionate regulation at the platform-level to enable rapid, responsible development, regardless of the type of instrument available on the platform. This process began when the leading UK peer-to-peer lenders launched the Peer-to-Peer Finance Association in July 2011, proposing a set of Operating Principles to address typical operational risks. They and several crowd investment operators have also participated in various government and private sector forums. The social finance sector has since added its support, with leading charity lawyers Bates Wells & Braithwaite citing the development of these types of platform as a necessary step in the development of social investment (which was also endorsed by the government-funded Community Shares Unit). And a meeting of wide variety of European industry participants took place in June 2012 to discuss the need for EU regulation. 

In the meantime, economic reality has also increased the pressure for clear and proportionate regulation to enable alternative finance. Banks and other traditional investors continue to conserve capital or offer finance on terms that are unduly onerous, while charging savers and investors high fees and/or failing to offer a decent return. There is a dawning recognition that it's down to entrepreneurs and private investors to connect the dots between low returns on savings and the fact that SMEs face a funding gap of £26bn - £52bn over the next 5 years, or that social sector organisations face an annual finance gap of £0.9bn  - £1.7bn. 

Against this backdrop, there have been numerous UK government reports and recommendations on the need to encourage the creation and development of both peer-to-peer lending and crowd-investing, with the weight of emphasis depending on the focus of the relevant initiative. These include the Cabinet Office's Red Tape Challenge on disruptive business models; NESTA's "Beyond the Banks" report; the Breedon Taskforce report (which the government largely accepted); Andrew Haldane's speech on forging a common financial language; and Lord Young's report to the Prime Minister on the start-up and development of small business. 

However, there has been little concrete action from the UK Treasury, prompting the debate of various amendments to the Financial Services Bill in the House of Lords. In essence, these amendments seek both greater engagement by the authorities in encouraging innovation generally, as well as specific regulation to encourage the growth of peer-to-peer models for a range of different instruments.

By way of comparison, it's interesting to note that the JOBS Act was the product of a US Presidential initiative in January 2011 which received bi-partisan support in the US Congress, and the new law was signed by the President on 5 April 2012.

Image from Lattice Capital.

Week One: Build A Decent Framework

The first week in any new in-house role or project has many defining moments. Are you friendly and approachable, or nervous and shy? Do you listen respectfully before suggesting improvements, or arrogantly impose your own experience and expertise from the outset? Do you have a plan for how you'll approach your new role, or will you simply react to demands on your time?

One advantage to having worked in nearly a dozen businesses over the past twenty years or so is having the opportunity to experience many 'fresh starts'. Here are three steps I've learned to take each time:

1. Research the business and its products: You should've done this at interview stage (along with understanding the overall market context), but you probably didn't get the whole picture from company filings, web sites and other publicly available material. Depending on seniority, you may not get much more. Play the 'newbie' card while you can. Try to meet the lead business people and ask plenty of questions about their successes and key challenges. Ask each product manager to explain how his or her product works. Make a note of anything that surprises you - good or bad. Understand the business problem-solving methodology (if any), project planning framework (if any) and the end-to-end business processes that comprise or support the products - how customers are signed up, complaints are handled, how distribution works, the supply chains, how contractual rights are enforced. Due diligence reports, regulatory filings, major contracts, sales presentations and process maps all make great source material.

2. Figure out the top ten challenges for the business: This can be a hair-raising experience, especially in a young business or one that's poorly run. Try to be discreet, patient and under-react until you've figured out the list and considered how to align yourself with each challenge. A well-managed business will identify and prioritise its most significant challenges annually. In that case, figuring these out will involve a fairly easy discussion with the boss about the business planning cycle, the current plan and where you fit in. In other cases, there may be no clarity at all, and no process for achieving it - great opportunities for anyone with an analytical mind and a positive attitude. Clearly the annual revenue target, major product launches, acquisitions and any substantial new regulation will be likely to feature in the top ten. Addressing the organisation's substantial strengths, weaknesses, opportunities and threats should round out the list.

3. Figure out the top ten legal challenges: What the lawyers need to do should have become pretty clear by now. Of course you have to factor in your own major initiatives, like getting a handle on significant contracts, contested litigation, training and competence, ensuring appropriate records retention and so on. But some of that will be business as usual. The major challenges should involve cross-functional co-operation - including public affairs and PR.

I'm interested in your thoughts.


Image from De Madera Constructions.