Industry Research

"Defining and Detecting Predatory Lending"

By Donald P. Morgan and Samuel G. Hanson
Federal Reserve Bank of New York

Summary

A recently published working paper, “Defining and Detecting Predatory Lending,” by Donald P. Morgan, an economist and research officer with the Federal Reserve Bank of New York, examines empirical data to assess whether payday advances constitute a form of predatory lending. In conducting his analysis, the author broadly defines the term “predatory lending” as a welfare reducing provision of credit to encompass specific practices which are attacked by reformers who are critical of the payday lending industry. The Federal Reserve study author analyzes the impact payday advances have on the “welfare” of consumers and concludes this form of credit provides consumers with a critical choice for managing short-term financial challenges.

Written from the perspective of an economist, the Federal Reserve study utilizes empirical data in states where payday lending is legally permissible as compared to states where they are not to examine whether consumers are worse off financially if they voluntarily enter into a payday advance transaction. To test whether payday advances satisfy his definition of predatory, the author conducts a comparative analysis of the welfare debt and delinquency rates, such as household non-mortgage debt levels delinquent bill payments of households, between the “payday states” and “non-payday states.”

The author concludes, “[o]ur findings seem mostly inconsistent with the hypothesis that payday lenders prey on, i.e., lower the welfare of households with uncertain income or households with less education. Rather, the study suggests that payday loans may actually have a positive effect on the welfare of consumers. The study states, “our results seem consistent with the hypothesis that payday lending represents a legitimate increase in the supply of credit, not a contrived increase in credit demand,” thereby, disproving the commonly held opinion that payday lenders "prey" on consumers. As evidence of this increased credit supply, the study shows that consumers with access to payday advances are less likely to have missed a debt payment over the previous year.

In addition, the Federal Reserve study demonstrates that the amount of the fee charged to a consumer obtaining a payday advance is considerably less as the number of short-term credit options increase. As such, the author concludes that competition among payday lenders effectively causes the cost of a payday advance to decrease, thus, ultimately benefiting the consumer.

The Federal Reserve study is a valuable and enlightening contribution to the ongoing debate over the usage of payday advances and the effect this form of short-term credit has on consumers.

Importantly, this study supports the hypothesis that consumers should have financial freedom in choosing what credit alternative best serves their financial needs, as it demonstrates that payday  lenders enhance the welfare of consumer households by increasing their supply of credit.

Click here for the report (PDF).