The Borrowers: Don’t Be Too Hasty Condemning So-called Loan Sharks.

Listener 16 November, 2002.

Keywords: Business & Finance; Macroeconomics & Money; Regulation & Taxation;

Tamaloa wants to go back to Samoa for an aiga maliu (family funeral). With no spare cash he needs to borrow. He has no record with any core financial institution, no assets to secure a loan, only the prospect of repaying out of future earnings, which sadly are not as secure as those of the Palangi. No bank will advance him a loan, so he goes to a fringe financial institution, and ends up paying a much higher interest rate.

Because they have high interest and fees, the public tends to disapprove fringe institutions, abusing them with terms like ‘loan sharks’. But they are providing a social service to people like Tamaloa. Indeed some of their financings may be more worthy than some middle class borrowings from a bank – such as financing a holiday in Samoa.

Economists start off with the assumption that in a competitive market with freedom of entry and exit, the typical return on investment (adjusted for risk) will be broadly the same across various businesses. The higher interest of ‘loan sharks’ reflects their higher costs. It can be immensely more expensive to assess the credit risk of customers without track records. (Fringe lenders are often from the same ethnic group as the borrowers, because they can better judge the customer.) It is harder and more expensive to collect the repayments; and their debtors are more likely to default which is directly costly, and also costly to administer. In contrast, a bank can make an advance cheaply (in a matter of hours based on the customer’s record of financial dealings), securing the repayments against some financial asset (usually a house), and recover their advance as cheaply. Of course all borrowers from fringe institutions are not as honest as Tamaloa. To stay in business, the fringe lenders have to charge the losses from the dishonest to other lenders.

Making it easier to recover debt may reduce interest rates, and make credit more widely available. The Bangladeshi middle class had no access to consumer credit – no hire purchase nor credit cards. Their law is perfectly adequate, but the courts are so chock-a-block it takes ten years to recover any defaulted credit. No one is willing to advance credit, because if anything goes wrong there is no simple way of recovering the advance. So Bangladeshis can only borrow from relatives, or friends – or from informal lenders charging very high interest, and using dubious extra-legal enforcement techniques.

Of course things go wrong. Even if Tamaloa is of the highest integrity he may struggle to repay when his employer lays him off. Some people get into debt when they shouldnt, miscalculating their ability to repay. It is hard to prevent foolish borrowing. The difference is banks sell up the assets. Fringe financial institutions frontend load the potential costs. Sometimes the lenders behave badly too, misrepresenting the cost and terms of the credit, or introducing oppressive measures to secure the repayments (like confiscating the beneficiary’s ATM card, taking their repayment from the account on benefit day, and giving the residual to the debtor).

Like many industries fringe lending is messy. But it provides a social service – like most businesses. Better not to call those who supply finance to the most difficult groups ‘loan sharks’, because that discourages honest providers. Instead, let us provide a good legal framework, with clear information for the consumer, and penalties and remedies to deal with the dishonest lender. But there will always be faulty transactions. Trying to prohibit them will damage the honest part of the market – even core financial institutions such as the banks – making it harder for everyone to borrow.

That is the philosophy behind the Consumer Credit Bill recently introduced into parliament. (I was involved in its early development.) First promised 14 years ago when its sponsor, the Ministry of Consumer Affairs was established, and following widespread consultation, it reflects the best in the liberalisation of the 1980s, trying to leave as much of the regulation as possible to the market, based on individual judgement and free contract, but providing alternative procedures where that does not work out. (The old regime had debtors with grievances suing the lender, a useless provision when debtors cannot afford lawyers’ fees. The new Bill allows the Commerce Commission to take cases.)

The Bill will have little impact on the vast majority of credit transactions, for most consumers can rely on simple and fair access to credit. Banks depend on their reputation, in a highly competitive environment. Occasionally they make mistakes, which is why they have set up a banking ombudsman. Ordinary law, such as the Fair Trading Act is sufficient to regulate them. However the fringe institutions require specific law. Tamaloa and his friends deserve the opportunity to borrow fairly and as cheaply as possible, just like the rest of us.