FORTUNE — It’s tough being a regulator. Regulate “too much” and confront a chorus of critics who say you are constraining the public’s ability to borrow money. Regulate “too little” and you face attacks for letting irresponsible lenders make abusive loans to vulnerable borrowers.
No issue illustrates this conundrum better than the market for so-called payday lending, where consumers borrow small amounts of cash on a short-term basis to cover unexpected emergencies or, more frequently, just to tide themselves over until their next paychecks.
As real wages for middle and low income working families have steadily declined over the past several years, cash shortfalls for this group are an increasing reality. If you are making around $25,000 to $50,000 a year and find yourself struggling to make ends meet, your options are limited. Payday lenders will give you a loan, but you must repay it in full out of your next paycheck. And they will typically charge you $15 for every $100 you borrow. Assuming a two-week repayment period, that works out to an annualized percentage rate (APR) of nearly 400%. What’s more, because the loan must be repaid in one lump sum, you will probably have to take out a new payday loan just to pay off the old one.
I have long thought that what this market really needs is more price competition. The storefront, payday-lending operation is highly inefficient. The cost of the stores and staff needed to offer these loans is significant. So are the losses when borrowers default. Banks, on the other hand, already have physical locations and staff, a preexisting customer base, and tools like direct deposit and automatic debit that can dramatically reduce their risk of a borrower defaulting. According to ongoing research by the Consumer Financial Protection Bureau (CFPB), it costs banks about $1 to make a $100 dollar loan of this kind, compared to $9 to $12 for payday lenders.
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In recent years, more and more banks have woken up to this potential market opportunity and have started offering their own version of a payday loan, called “deposit advance.” These loans are provided to a bank’s existing checking account customers who use direct deposit for their paychecks. As with a payday loan, the borrowers must repay the advance in full when they receive their next paycheck. The banks use automatic debit to make first claim on those paycheck proceeds, meaning there is very little risk that the deposit advance won’t be repaid.
So what kind of APR do you think banks charge for this nearly risk-free loan? 20%? 30%? Nope. Most charge $10 per $100, which is certainly better than the typical payday lender, but still works out to a stratospheric 261% APR. Moreover, because users of deposit advance, like users of payday loans, must repay the loan in full on their next payday, they frequently find it necessary to borrow again to pay the advance off. According to the CFPB, chronic re-borrowing drives profitability for banks’ deposit advance loans. Borrowers who use these loans 10 or more times a year account for at least 68% of all deposit advance transactions and at least 76% of all revenue.
Two bank regulators, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation (FDIC), recently instructed the banks they regulate to essentially get out of the deposit advance business. They concluded that a loan that a borrower typically cannot repay without borrowing again is not the kind of safe and sound banking practice expected of FDIC-insured institutions.
Now that banks have been duly chastised by their regulators, I hope they will go back to the drawing board and develop a payday loan that while profitable to them, is also affordable to borrowers without having to engage in serial re-borrowings. Indeed, both regulators have strongly encouraged banks to make affordable small dollar loans to their customers. The FDIC has suggested keeping the APR below 36%, still a quite healthy return in this interest rate environment. Two of the largest banks offering deposit advance — Wells Fargo (WFC) and US Bancorp (USB) — are banks with good reputations that lost their way in offering this product. They should lead industry efforts to find a responsible alternative.
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Of course, if bank regulators crack down on deposit advance, without similar restrictions on payday lenders, the result will be to force some bank customers back into the arms of that industry, which charges even more. This is why it is essential for the CFPB to promulgate standards across the board for all payday loan products, to give consumers uniform protections.
A recent report by the Pew Charitable Trusts (disclosure: I am a Pew Senior Advisor) identifies a promising approach in Colorado, where the state has effectively limited payday loan payments to 5% of a borrower’s paycheck. This has forced payday lenders to spread out repayments into affordable installments, significantly reducing the need for repeat borrowings. The result has been a 71% drop in the average number of payday loans per borrower, and a 42% reduction in average borrower costs.
As income inequality worsens and real wages continue to decline for most working families, we can expect increased demand for these kinds of loans. The best solution would be to get our economy producing good jobs again, through corporate tax reform, infrastructure spending, and better targeting of our education dollars to retrain our workforce. Until that happens (which could be a long time, given Washington dysfunction) we need more responsible avenues for cash-strapped families to borrow.
Banks should jump into this market with both feet, but in a way that keeps faith with the public trust and confidence that goes hand-in-hand with their FDIC-backed status.