Price Regulation in Credit Markets

From Cuesta and Sepulveda’s Price Regulation in Credit Markets: A Trade-off between Consumer Protection and Credit Access.

Interest rate caps are widespread in consumer credit markets, yet there is limited evidence on its effects on market outcomes and welfare. Conceptually, the effects of
interest rate caps are ambiguous and depend on a trade-off between consumer protection from banks’ market power and reductions in credit access. We exploit a policy in Chile that lowered interest rate caps by 20 percentage points to understand its impacts. Using comprehensive individual-level administrative data, we document that the policy decreased transacted interest rates by 9%, but also reduced the number of loans by 19%. To estimate the welfare effects of this policy, we develop and estimate a model of loan applications, pricing, and repayment of loans. Consumer surplus decreases by an equivalent of 3.5% of average income, with larger losses for risky borrowers. Survey evidence suggests these welfare effects may be driven by decreased consumption smoothing and increased financial distress. Interest rate caps provide greater consumer protection in more concentrated markets, but welfare effects are negative even under a monopoly. Risk-based regulation reduces the adverse effects of interest rate caps, but does not eliminate them.

Hat tip: Matt Notowidigdo.

Comments

How does this affect bankruptcy?

Payday loans are the favored approach to predatory lending in America. Although some states limit the interest rate charged or even prohibit payday loans, they are the exception - and various schemes (such as lender/Native American joint ventures for payday loans made via the internet) avoid regulation. In some states, interest rates sometimes exceed 3,000%. Yes, 3,000%. Mercifully (?), 1,000% is more common. Collection practices for payday loans often copy the mafia model. On the flip side, the absence of effective regulation has resulted in a flourishing market in payday loans. One might ask if that's a market success or a market failure.

3,000%? Literally, 3,000% interest rate? I think you mean annual percentage rate.

Coincidence? There were no rate caps or limits on access to consumer mortgage credit in the run-up to the 2008 financial catastrophe.

Speaking of predatory lending, yesterday TV interviewed Angelo Mozilo (of Countrywide/the face of America's mortgage nightmare notoriety) seems he's on a grand tour of self-rehabilitation, was yacking before a gathering of mortgage brokers (honor among thieves?) and still lying after all these years - advocating again writing 2006 style mortgages, and hoping the World forgets his/Countrywide's role in the catastrophe. [none of it mentioned by FOX Business]

@D the B - some academic papers--TC has cited some--suggest what Mozilo did with Alt-A subprime liar loans and the like were not responsible for the panic and credit crunch of the Great Recession (they were a tiny percentage of the problem), which, in retrospect, indeed was a liquidity event not a solvency event. The Big One has yet to hit... When it does, possibly in response to a supply shock like oil exhausting suddenly (many fields run dry quickly, not unlike drained batteries that suddenly shut off), I think then and only then will depression become a solvency event. According to one math economist, Didier Sornette, an earthquake (patented!) equation he has predicts this will happen around 2050, which (coincidentally?) is the time of peak world population. Is today's late modern capitalism only succeeding with extensive growth not intensive growth, as TC has argued in his Great Stagnation book? In dumb or 'extensive' growth, only population growth matters, since technology has stagnated.

Dick the Butcher, time to become a prepper!

What caused the Great Depression? Falling asset prices. What averted another Great Depression in 2007-08 when asset prices were falling? The Fed, when it intervened and stopped asset prices from falling and reinflated asset prices. What causes asset prices to fall to begin with, smarty pants? The herd stampede. But what causes the herd to stampede? Most anything, that's the nature of the herd. Anything from a bankruptcy of a large company like Boeing to an ignorant and angry president with a twitter account. But what about all those detailed and impressive studies by economists that attribute depressions to, I don't know, the money supply? What about them?

What is the asset price on the food you bought on credit last week?

I grew up when consumption goods could not be bought on credit, unless gthe store selling the food offered the credit, or the loan was illegal aka loan shark.

Bank regulations required assets as collateral plus income to repay the debt and interest. Most "personal" loans required cosigners who had assets.

GDP growth was higher when credit was hard to get in the 50s and 60s. Transactions were done then with cash and checks, which today are replaced with EFT in Europe, but not credit.

The Bible was the law among bankers. No usury. No locking people into debt.

I find it interesting the Bible Belt Bible thumpers are the ones today defending high usury rates and zero Jubilee discharge of all debt. The Bible called for debt forgiveness every seven years, and the Bible contribution of bankruptcy to Congress and Federal courts trumping the States generally limited escaping debt to only once every seven years back in those days.

I grew up in Indiana with politicians using the Bible to oppose leftist efforts to allow more credit to socialist workers. Lots of quoting the Bible when bank laws and regulations were debated. As a PK, I heard the arguments, but my parents were adverse to debt and credit from growing up in the depression, as had most of my peers parents, so getting out of debt to eliminate the threat of repo man taking car and house and boat and RV was a high priority.

Of course, no one at the fed or economics academy saw the crash coming. Why should they know what caused it?

"Mozilo . . . did with Alt-A subprime liar loans and the like were not responsible for the panic and credit crunch of the Great Recession"

That's what Angelo told FOX Bus., yesterday. It's a lie. Not factual. There were a hundred contributors (all adding $trillions in excess cash which needed to be loaned on residential RE collateral ): low-to-moderate income loans, subprime loans, NINJA loans, low-no doc loans, ownership nation, FNM/FRE/HUD, clueless rating agencies, broken appraisal profession, the carry trade, securitization/CDO/CDS, . . . . a real clown show that was massively run in the US between 1995 and 2006. The bubble collapsed when too many of the poorly underwritten, social justice, fraudulent loans stopped paying - who'd a thunk! Note it was not thus in Canada - go look up why.

Try to find "Highlights of HUD accomplishments 1997 - 1999." The document chronicles the "accomplishments under the leadership of Secretary Andrew Cuomo, who took over in January 1997." It provides the unintentional blueprints for the housing bubble, the subprime mortgage crisis, the financial catastrophe of 2008, and the Great Recession. Cuomo set affordable housing goals for FNM/FRE - the two, huge GSE's involved in home finance - to buy $2.4 trillion in mortgages over ten years. He raised from 42% to 50% the requirements for FMN/FRE home loans purchases to be with low-to-moderate (CRA) borrowers. Low-to-moderate home buyers accounted for 49% of the 12.5 million rise in home ownership in the ten-year period from 1995 to 2005."

In addition, Howard Husock of City Journal presciently warned at the start of Bill Clinton’s last year in office: Here is another $1 trillion adding to the price bubbles.

"The Clinton administration turned the Community Reinvestment Act, a once-obscure and lightly enforced banking regulation law, into one of the most powerful mandates shaping American cities—and, as Senate Banking Committee chairman Phil Gramm memorably put it, a vast extortion scheme against the nation’s banks. Under its provisions, U.S. banks have committed nearly $1 trillion for inner-city and low-income mortgages and real estate development projects, most of it funneled through a nationwide network of left-wing community groups, intent, in some cases, on teaching their low-income clients that the financial system is their enemy and, implicitly, that government, rather than their own striving, is the key to their well-being."

Post-modern academics slay me. Do mean the BS that some new financial instrument allowed greedy people to short MBS? Bull shit: short sales contracts have been around FOREVER. And, just because a bunch were sold short, didn't crash the overall MV -that was massive defaults of sub-quality and fraudulent mortgages underlying the pass-throughs. Find out who paid for the study and it'll reveal the bias.

Rayward, There are as many theories on the causes of the Great Depression and Great Recession as there are writers on the subjects.

Here is one theory on depressions/business cycles which for 106 years the Fed has been unable to mitigate/regulate. Boom/Bust - based on speculation, get-rich-quick (FOMO) schemes, and (the most common theme) huge over-supplies of money from easy underwriting/low-cost credit. 1873 - RR's. 1929 - stocks overleveraged margin loans. 2006 - overleveraged/liberally underwritten Residential RE and mortgage derivatives (the defaults of the loans not the derivatives - really not derivatives themselves and really a symptom not the cause). All made worse from resultant bank failures, chaos, asset price falls, stocks crash, panic. Government reaction - add liquidity. Before Fed as in the 1873 panic that meant purchase T bonds from national banks and reissue greenbacks.

Re: banks lending on real estate. It was forbidden (too speculative and risky) for national banks prior to 1913, bank authority for RE lending was a sweetener to get the Federal Reserve Act passed Congress. This garnered support of rural banks and politicians, most of whom had been silver and inflated currency advocates.

"Collection practices for payday loans often copy the mafia model."

I call BS. Evidence?

The question is, what happens to the people paying over 15% interest today?

1. Maybe the market is such that they are still adequately serviced at 15% interest. Or,
2. Maybe they are shut out from the market.

How could #1 be? Aren't they rational actors? I think so, but I could be persuaded that they aren't, or that the demand curve bends such that it's easy for lenders to quickly move them up in rates when they don't need to.

For #2, I could also be persuaded that these people are better off being cut off from the market, and that, whatever else bad is going on in their lives, when they get to the point of needing to pay more than 15% interest, it's time to Just Stop and they should fix whatever the underlying problem is.

The problem is that persuading on either of those two things requires significant work, not just "well here is how in theory we aren't totally destroying the lives of the people we are claiming to be trying to save." I sure don't trust Sanders or Cortez to have done this in-depth analysis, but to be more motivated by mood affiliation against the banks.

“Risk-based regulation reduces the adverse effects of interest rate caps, but does not eliminate them.”

How does it reduce the adverse effects of interest rate caps?

On the margin interest rate caps affects solely the access to credit of the risky.

And since “risk-based regulation” already affects negatively the access to credit of the risky, “the risky’s” difficulties to access credit has then only been put on steroids.

AOC and Bernie! have the solution: the USPS will make subprime loans to people that can't repay.

Brilliant! USPS already loses $3 billion a year.

Of course, the problem is the business model wherein creditors and equity investors require income and return (minimally preservation) of principal on their investments, which in turn requires lenders to collect principal and interest on the loans they advance. Unless, like credit cards or payday, lenders charge high interest rates, loan losses over 2% or 3% cause deep financial difficulties, whether or not the lender relies on leverage.

On the other hand, 81% of customers pay now 9% less of interest.

Interesting moral question, Who do you support? The 81% that pays lower interest rates or the 19% excluded from cash loans? I have no idea.

A second interesting moral question is: are cash loans a human right?.........Sorry, I digressed and started thinking about human rights because the author says people is being harmed and excluded by interest rate caps:

"welfare implications of stronger interest rate regulation are potentially heterogeneous along borrower risk, as it benefits protected borrowers and harms excluded ones."

Social justice - I keep hearing about the GOP, Trump, the 1%, . . stealing from the poor. How does one steal something someone doesn't have?

In addition to socialist justice implications, interest rate caps and floors are conducive to arbitrage and hedging.

Twin mass superstitions - owning a home is a God-endowed, inalienable right and real estate market values ALWAYS rise - were among a hundred causes of the 2008 global catastrophe.

Poor people absolutely need payday loans in unjust jurisdictions that prohibit using food stamps for booze, Chick-fil-A, chips and dips, and lotto tickets.

Could slave owners possibly have stolen from slaves?

81% of customers now pay 9% lower interest rates?! I missed that part of the study. Oh, because you made that up.

Banks did lowering interest rates... by 3.8% on small loans (under $2000) and 1.7% on larger loans (page 18). But more dramatically, they responded by not offering credit to people whose risk doesn't justify a lower interest rate. Read the study.

"Average transacted interest rates decreased by 9% (2.6 p.p) in response to the policy change. The quantity of credit in the market also decreased, as the number of loan contracts went down by 19%".

p.p stands for percentage points. In the article the of interest rate is given in p.p while changes in the interest rate are expressed in %. I think you got confused between absolute values and percentage changes.

The number of contracts went down by 19%, so the remaining fraction of contracts (81%)enjoyed lower rates because "...the borrower pool became safer and default rates decreased by 18% (1.15 p.p)."

I failed to see the harm and I think I'm also missing the drama =/

Ahh. Your switch from "9% less interest" in the first paragraph to "lower interest rates" in the second paragraph threw me off. I apologize for accusing you of making figures up.

'yet there is limited evidence on its effects on market outcomes and welfare'

Loan sharking, an apparently neglected area of study.

Would you prefer to be able buy eggs at $2./dozen that are actually available, or would you prefer egg prices capped at $1./dozen even if no one will actually sell them to you at that price?

Of course, the difference is that we're talking about loans, not eggs, and some people have appalling financial judgement. Then again, some people have appalling judgement when it comes to what they eat. So perhaps the larger question is, "To what extent should government protect adults (for their own good) from making bad decisions?"

And to those who say "never," would you want adults to be able to sell themselves into slavery? Or to sell their organs, or other body parts? Is paternalism never, ever justified? Or, perhaps, justified but only in extreme cases (and, given the availability of bankruptcy, debt is not an extreme case)?

One thing to consider is that there are so legal ways around usury laws. For example, there are slum stores (and certain mail-order catalogs) in which prices are perhaps double what you'd expect, but, that price includes a (poorly hidden) subsidy for the high-risk, unsecured credit that is offered to poor credit risks with the purchase. Short of having a government office to determine price caps for practically everything, how would you prevent this?

Or, ye old Rent-To-Own, wherein by the time you own (and most never do) you'll have paid perhaps three times the usual market price for the TV or furniture or whatever.

BTW, may credit unions offer alternatives to Payday loans. But, these loans still carry very high APRs, as they must to cover the high transaction costs for small loans plus the high risks of the loans themselves.

"we develop and estimate a model of loan applications, pricing, and repayment of loans."
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No kidding? What did these authors do for a living before they had this model?

Hard to imagine that borrowing money at 15%+ on a credit card increases people's welfare.

It was a period of abstinence in America, Vietnam had ended, steel was unprofitable, the year we lost, Apple introduced the Macintosh. Two years later, in 1984 the Raiders beat the Redskins. The evolution of the musical device and streaming video, for example, the Sony Walkman, the Apple Macintosh, the TV/VCR and along with it, cable news, the Nintendo Entertainment System, confabulated the national conscious into self-awareness, jerking the medical field inside the brain so that Eli Lilly began marketing Prozac in 1988. Ronald Reagan, in the years the dawn of the Revolutionary Guard, in the years that preceded a leveling of third world currency, issued a giant balloon of bank deregulation that stabilized a soaring unemployment rate, a savings rate that never really recovered, ushering in an era of innovation, where by 1989, eight years after the Columbia shuttle, eight years after Muhammed Ali retired from boxing, the total amount of US patents hit the 100,000 mark for the first time, And more to my view, in 1981 the first music video inspired the a generation of martyrs, who both fought against republican political correctness and the crushing weight of drug addiction, and found punk rock to fountain the tree of liberty.

That was a fun read, I like that style.

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