It’s not always dangerous swimming with sharks

Just after I started my first job as a new graduate I applied to my bank for a personal loan to buy a second-hand car.  It wasn't flash car –  an 8-year-old Toyota Corona.  The bank refused my application.  Although had good income prospects my credit card was at its limit, I'd missed the odd monthly payment, and I owned few assets.  The loan officer rigidly followed the banks’ lending guidelines and I didn't make the grade.  In the end my employer kindly lent me the money I needed so I was able to buy the car.  The predicament I faced is one experienced by many low income people seeking credit, but without a beneficent employer to turn to. A low income person with a weak credit record today would need to either give up on their purchase or consider applying for a loan from an alternative credit provider, such as a consumer finance company.

Consumer finance companies, or loan sharks as they are often derogatorily known, provide credit to parts of the market that are not generally touched by mainstream banks. Banks, especially large ones, choose not to put resources into detailed investigations of credit records, income prospects, loan uses, general trustworthiness, and other factors relevant tithe ability and willingness of borrowers to repay their loans.  Their general practice is to charge a set rate of interest for a certain class of lending (say, unsecured personal loans) and then ration the amount they lend through criteria such as previous credit record, current income, and personal assets.

The result of the blanket approach of banks to their lending is that there are people who would like to borrow at the existing lending rates and who have the ability and willingness to repay, but who are denied access to bank credit.  This is where consumer finance companies can help.  Such institutions specialise in lending small to moderate amounts to people on low incomes who have few assets and often sketchy credit records.  Obtaining credit from them is costly.  Higher rates of interest are charged to compensate them for the greater risk that loans will not be repaid and for the more intensive efforts required to monitor and collect repayments.  Nevertheless, if a person's need is high enough they will be willing to pay the higher cost.

There have been reports of some consumer finance companies taking advantage of vulnerable low income borrowers.  Some have deliberately misrepresented their lending terms or signed contracts with people who clearly do not understand them.  As a result of trying to keep up with repayments some borrowers have experienced severe financial hardship.  There have also been reports of thuggish behaviour by loan companies in cases of defaults.  There has been much gnashing of teeth by politicians and welfare groups about such instances.

There is no doubt there are shysters out there white-shoe crooks who prey on ignorance and desperation among those who have nowhere else to turn for a financial quick-fix.  Physically threatening behaviour, even if it is to collect money legally owed, is unacceptable in a civil country.  However, the calls for bans of consumer finance companies, severe limitations on their activities, or interest rate caps because of the bad behaviour of a few have been over-the-top.  Such actions would wipe out a valid part of the credit market disadvantaging those that cannot legitimately borrow from other sources. They would also risk creating a black market in credit whereby desperate borrowers seek even more unsavoury sources of funds.

The best solution to disreputable lenders is to force them to disclose lending terms in simple prescribed ways.  The Credit Contracts and Consumer Finance Act already requires a reasonably high level of disclosure blenders.  Nevertheless, it would be worth assessing whether there are improvements that could make loan terms more understandable to those with relatively low degrees of financial awareness.  No doubt this is something that will be discussed by the Financial Summit to be convened by the Consumer Affairs Minister Simon Power in August.

Another leg to addressing the loan shark problem is efforts to improve financial literacy.  It is apparent that for some the consequences of compounding interest are unfathomable.  This is a difficult area, admittedly.  However, improving basic financial literacy education in schools and assisting those in need with basic financial training as part of budgetary advice will likely pay dividends.

At some point, however, we need to trust that people take responsibility for their own borrowing decisions and accept the consequences of poor judgements.  It is important that people enter into agreements with adequate information and their eyes wide open.  Policy should be targeted to this area, rather than paternalistic measures that seek to wipe out fringe lending and disadvantage deserving borrowers.

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