Nothing wrong with payday loans!

The credit crunch has brought into sharp relief some questionable activities of the banks in the UK. But it is not only the high street banks that are in the spotlight. As people struggle to get credit from the main UK banks, people with poor credit history increasingly turn to loan sharks or payday loans. While loan sharks often operate in the murky zone of informal non-contractual credit agreements, payday loans are technically regulated contracts. Their agreements with customers are based on clear terms and conditions. Wonga is probably one of the best known in the UK.

Yet, pay day loan companies serve a difficult segment of the market. Their customers are mainly people who have been turned away by the highstreet banks and payday loans are temporary credit agreements which can only serve as a stopgap, not as a source of long term credit. Given their exorbitant interest rates (sometimes up to 4,000% p.a.) payday loan companies have come under fire from various campaigners. Most recently, the Labour MP Stella Creasy has argued that payday loan companies should be brought under the financial regulation as any highstreet bank (not that the regulation by the FSA made any difference to banking behaviour before the banking crash in 2008) and their interest rates should be capped by a fixed cash amount. 

At first glance, this seems one of those worthy campaigns that is driven by righteous indignation at poor people being exploited by ruthless companies. However, the first impression does not last once the reasons why many people use payday loans become clear. 

First, people who use payday loans do so because they fail to get credit from the main UK banks, often because of their poor credit history or previous default on credit agreements. Stella Creasy mentions the case of a young woman who has lost her home because of the demands of payday loans. This is difficult to understand for two reasons. 

First, payday loans provide cash to people who would otherwise get no credit at all. So, in a way they serve a community that is being failed by the main banks. 

Second, payday loans are unsecured loans which is one reason why the interest rates are so high. This means that if somebody cannot pay back the loan at the end of the month, the only consequence is that the company wont lend her money in future. Payday loan companies can employ agencies to recover their loan but they have no power over any assets people have, including property. So, in effect, if you default on a payday loan you cannot lose the home you own, no matter what happens. 

Remains the prickly issue of the high interest rates. In the wake of the financial crisis and the bailout some banks received from the tax payer, bashing a banker has been a popular sport in the UK. Yet payday loan companies are not banks, nor have they been bailed out. The reason they levy high interests rates is exactly because of the nature of their clientele, people who disproportionately fail to meet the repayment requirements. 

Payday loan companies calculate the interest rates by spreading the risks of their customers across their customer base. In a sense, they operate along the lines of insurance companies, socialising risk, rather than individualising it. So they use a risk spreading mechanism that should be close to the heart of any social democrat. The better off amongst their customers (who tend to pay back their loan) finance the loans of those who fail to repay. 

Seen this way, Stella Creasy’s campaign to cap the cash amount in interest to be paid on pay day loans reveals itself as a cynical ploy to hit the poorest hardest. If legislation was brought in to cap interest payments, loan companies would have to screen out those who are least likely to repay their loans. Which in effect means to close off the last chance to receive cash in difficult times for many of the poorest people. 

So is there no worthy cause Stella Creasy could turn to? Of course there is. Payday loan companies are here for a reason: the high street banks who refuse to lend at acceptable interest rates to ordinary people. It is the tightening of credit from the main banks that drives the demand for payday loans. 

Not that the likes of Barclays and HSBC differ much from payday loan companies. Using NatWest's unauthorised  overdraft facility can cost anyone up to 2,190% APR. Not a rate to be scoffed at. But presumably Stella Creasy doesn’t want to take the fight to the high street banks. That would involve a lot of protracted work with her parliamentary colleagues. Rather make some cheap shots at the bottom rung of financial services, it pays off with the Guardian readers.