May 11 2010
Tough on Wall Street? This Bill Is Tough on the Little Guy
Carrie L. Lukas
Washington politicians have been talking tough about cracking down on big business. Press Secretary Gibbs said that the White House would "keep a boot on the throat" of British Petroleum, the company at the center of the oil spill. There have also been strong words for the top whipping boy du jour, big Wall Street banks. The President proclaimed that he didn't run for office to help "a bunch of fat cat bankers on Wall Street," and Harry Reid accused "un-American" Republicans who want to change the current version of financial regulatory reform as being "more concerned about taking care of the fat cats on Wall Street."
Not surprisingly, this rhetoric has little to do with the legislation's actual effects. And in fact, it's the little guys-both small lenders and those with modest incomes seeking loans-who will be subject to some of the biggest restrictions under the proposed legislation.
The proposed Consumer Financial Protection Agency, for example, is supposed to defend unwitting consumers from unfair lending practices, but this "protection" comes with some high costs. Instead of just ensuring that borrowers understand the full-terms of proposed lending contracts and preventing fraud, this agency will limit the types of loans that are available to individuals, which will ultimately restrict their access to credit.
One amendment, offered by Senator Kay Hagan (D-NC) would go further, limiting access to credit based on an individual's borrowing profile. Americans would be allowed no more than six small (under $3,000), short term (less than 90 day), high interest (in excess of 36 percent on an annualized basis) loans per year. To enforce this provision, the Hagan amendment charges the government with creating a national database that would contain information about the credit and borrowing habits of small loan recipients-a considerable expansion of government power and an unprecedented intervention into the personal finances of individual Americans.
Who would bear the brunt of these new restrictions on small loans? Low-income Americans who are most likely to seek these types of loans and have less access to other forms of credit. Proponents of restricting or even eliminating the availability of these types of short-term loans focus criticism on the loan's high interest rates. However there's a reason that these interest rates are high: given the short-time horizon and the high risk of non-payment, high interest rates are the only way these loans will be profitable for lenders. Absent high interest rates, these lenders wouldn't offer credit to high-risk borrowers.
And if high interest rates are the primary concern, then policymakers are missing their target by excluding other high interest, short-term loans. Overdraft protection, for example, acts as a short-term loan: when the account holder withdraws too much, the bank covers the shortfall for a price. Typically, banks charge an immediate penalty for activating overdraft protection and then charge additional interest on the loan. So someone who takes out a short-term loan of $100 through overdraft protection may end up paying a $50 fine immediately, and then interest and sometimes additional penalties until that loan is paid off. The implicit interest rates of these transactions can make payday loans a far more sensible option.
More broadly, Americans should ask themselves why the federal government should be trying to protect us from ourselves by restricting our access to credit. After all, it wasn't payday loan services that created the financial crisis or that pose a systemic risk to our financial system. This is pure paternalism, and it's inappropriate in a free society.
Those concerned about the welfare of borrowers who would resort to high interest short-term loans should consider what will happen if these credit options are driven out of existence. Eliminating sources of credit won't cure the underlying need for short term loans. Rather than helping people, it is far more likely that desperate individuals will instead look to the black market for loans, where terms will be far worse.
Instead of attempting to limit the ability of Americans to borrow money, policymakers should refocus on reforms that ensure transparency and create an environment in which the risks of lending, whether it is done by a big Wall Street bank or a small short-term loan provider, are born by the lender and the borrower. Washington-awash in trillions of dollars of debt and growing-should save lectures about prudent financial planning for themselves.