The dynamics of market credit for low-end consumers

Armstrong Williams | 7/2/2013, 9:48 a.m. | Updated on 7/2/2013, 9:48 a.m.

The issue of making consumer loans to people on the wrong side of the credit divide raises other issues that make lending to this group very expensive.

Despite a mid-July report by the S&P that says consumer credit default rates have decreased for the sixth consecutive month, the default rates among different demographics show a sharp divide. First, default rates among the poor are much higher than among the rich. Therefore, everything else being equal, loans to the poor will reflect premium pricing to cover the higher default risks. Second, because these are riskier loans, the banks will be forced to have higher capital requirements to support these loans, leading to higher capital costs. Third, because these loans are smaller than similar loans to the wealthy, the expense of issuing and servicing the loans must be amortized over a smaller loan principal. This also makes a loan relatively more expensive to the poor. Fourth, loans to consumers tend to be subject to much more government consumer and banking regulations than loans to businesses. This too adds to the costs of low-income consumer loans.

Given the high cost of low-end consumer lending, it is no surprise that high-cost payday loan companies and pawn shops have arisen to serve these low-end markets. It also should not be a surprise that the large commercial banks shun these markets.

The Fed is principally tied into the regulation of the financial system through the commercial banks. When the Fed introduces stimulus into the banking system, it’s the commercial banks lending to the upper tier of the economy that first gets the lower rates and the stimulus. The low-end financial institutions like the payday loan companies and the pawn shops are the last in the financial food chain to the feel the stimulus impact of the Fed’s easy money policy.

Furthermore, high-end borrowers pay interest rates closer to the risk-free market interest rate. So if the Fed reduces the risk-free rate by 1 percent, interest rates to the high-end borrowers would decline from say 5 percent to 4 percent. That is a meaningful 20 percent decline in borrowing costs. On the other hand, low-end borrowers usually pay high credit and servicing costs, as discussed above, so a 1 percent decline in interest rates might take one of these loans down from 20 percent to 19 percent. That is a negligible 5 percent decline in borrowing costs.

Given the dynamics of the market for credit, there is very little the Fed can do to make additional credit and lower rates available to the lower end of the market. If the Fed wants to go around the market and introduce rationing, it can force commercial banks to make loans available to the lower end of the market they do not normally serve. However, rationing would have unintended consequences, like high losses on low-end consumer loans for commercial banks, which will impair their capital and thereby reduce their ability to lend additional capital to other segments of the market. Smaller loans have higher transactional costs relative to the loan amount.

While government regulations designed to “protect consumers” may be well intended, if the result is to prevent lenders from recovering those costs, then the unintended result will be denial of credit to otherwise creditworthy consumers.

Armstrong Williams is the author of the brand-new book “Reawakening Virtues.” More content can be found on RightSideWire.com. Come join the discussion live 4-5, 6-8 p.m. EST at www.livestream.com/armstrongwilliams or tune in 4-5 p.m. EST on S.C. WGCV, Sirius/XM Power 128, 6-7 p.m. and 4-5 a.m. EST. Become a fan on Facebook and follow him on Twitter.