Argument and market failure – Payday loan rule

PAYDAY LOAN RULE
Name
Instructor
Course
Date
Payday Loan Rule
Market failure is a term used to refer to a situation where there is a breakdown in an organization production or efficient allocation of desired goods (Cunningham, 2011). The imperfection of the price system or frail institutional arrangements could be the main cause of his phenomenon. A payday loan is an unsecured financial product targeting the retail segment that allows customers to borrow small amounts of money averaging $300 in the short-term by pledging as collateral a check bearing the date of the subsequent payday. There is thus quick access to cash attracting millions of clients who end up repaying the loans in a lump sum and practicing continuous borrowing. A scenario necessitated by the conditional availability of a third of the average clients pay to facilitate full loan repayment hence creating a gap in financing of everyday life (PEW Charitable Trusts, 2013). It is significant to note that both the principal amount in addition to interest is due on the same date. Plugging this gap necessitates additional borrowing. Consequently, those who have taken to this product end up struggling financially, making it a failed product.
Economists who view the payday loan rule as a market failure term as ‘predatory’ the increased interest rates charged since they take advantage of the borrower’s behavior. They point out that the bit-by-bit repayment mode renders their repayment difficult as a result plunging the customers into a ‘debt spiral’ and ultimately personal bankruptcy (Beddows and McAteer, 2014).

The incurred cost is a derivative of cost added to pricing methodology. Inability to pay an initial loan results in the acquisition of another loan resulting in the accumulation of additional charges. They argue that the witnessed high numbers of bad debts are an indicator of irresponsible lending. Regulators of fair trading including OFT are in concurrence on the lack of viability of payday loan rule from a client’s perspective. Their review uncovers evidence of lack of the products rule conformance to the Consumer Credit Act and the regulator’s Irresponsible Lending Guidance necessitating the introduction of caps on interest rates.
On the other hand, proponents of this form of loan credit the high-interest rates involved in the increased input costs involved in the provision of small amounts of short-term loans. Penalties associated with defaulting are high due to lack of attachment of fixed assets as collateral while each loan has a low absolute cost compared with alternative forms similar credit facilities like overdrafts they tend to be cheaper. Simplicity in the understanding of the product due to the structure of the repayment mode is another fact they allude to act in eliminating the prospect of prolonged indebtedness. Finally, they conclude that the motivation of a lender to plow back their money is enough incentive towards responsible lending. They equate the payday loan principle to a tool for income smoothing that processes stated terms (Beddows and McAteer, 2014). Researchers point to the facility providing a well-needed source of funds in the wake of access to limited alternatives like regular bank loans and thus encompass a conventional market response. Compared to other borrowers the payday loan clients also undergo the scrutiny of credit scores, amount of collateral and income against the size of debts they owe. Accordingly, the borrowers benefit by quenching their financial pressures and avoidance of costly liabilities while the lenders are involved in a competitive industry with minimal barriers to entry. Additionally, fixed operating expenses incurred by the lender do not vary when indexed against the small size of the loan and maturity (Shapiro, 2011). Shapiro based this on a study conducted at the Federal Deposit Insurance Corporation (2009) that concluded that the profits accrued by the lenders are dependent on the volume of the product they push. This group lists pawnshop loans, high available liquidity, credit card loans and overdrafts as some of the alternatives available.
Contrarily, documentation of the ease of entry, lack of security and checks limited to the clients’ loan history has gained currency as catalysts towards embracing the culture of successive borrowing resulting in an accumulation of charges thus increasing the fees. There is an increase in the potential of exacerbating financial trauma. Behavioral theories have also fueled the conception that the designing of the product takes advantage of the borrowers who harbor the intuition to settle their loans on time only to end up struggling. Economic researchers opine on the overconfidence and unrealistic nature of payday users as hindrances influencing the determination of their ability to make quick payment and misjudgment of prospective future incomes and expected expenses. Two-thirds of those who use payday loans lack access to credit cards while most of those constituting the other third have hit their credit limits. Credit card loans are thus not only inaccessible but also expensive due to the charges of interests being 129-155% per annum (Shapiro, 2011). Overdrafts when repeated and the issuance of bouncing checks pose the threat of damaging credit ratings and possible criminal prosecution. As an alternative pawnshop, credit facility has as a demerit the requirement of collateral and the relatively small amount of cash on offer in comparison to payday loans.
Payday loans have emerged as a center of attention in the recent past with some states like Georgia advocating for its abolishment while others like Indiana offering reforms that regulate the fees. Vouching for federal regulation by bodies like, Consumer Financial Protection Bureau that clarifies the modulation should not tinker with other lending arrangements has come to the fore. It is worth noting that the legislators in conjunction with regulators cannot tell whether proposed legislation will lead to the attainment of financial benefits or harm. Since the payday loan facilities target a vulnerable segment of the society, the implications of further regulation need tremendous weighing. Lack of evidence and analysis of data that would lend credence to the effectiveness of financial caps also serve as a drawback. Use of more research should thus precede deployment of regulation in addressing the concerns about payday loan rule.
References
Beddows, S. & McAteer, M. (2014). Payday lending: fixing a broken market. The Association of Chartered Certified Accountants, 1, 1-69.
Cunningham, S. (2011). Understanding Market Failure in an Economic Development Context. Mesopartner Monograph, 4(1), 1-59.
Federal Deposit Insurance Corporation. (2009) “FDIC National Survey of Unbanked and Underbanked Households,” http://www.fdic.gov/householdsurvey/full_report.pdfShapiro, R. (2011). The Consumer and Social Welfare Benefits and Costs of Payday Loans: A Review of the Evidence. Sonecon, 1, 1-23.
The PEW Charitable Trusts. (2013). Payday Lending in America: Policy Solutions, http://www.pewtrusts.org/~/media/legacy/uploadedfiles/pcs_assets/2013/pewpaydayoverviewandrecommendationspdf.pdf