NEW YORK (TheStreet) -- Why should banks be allowed to lend to consumers at annual interest rates as high as 300%?
Because the alternative is far worse, according to Rafferty Capital Markets analyst Richard Bove.
The Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency late last year issued new rules to govern "deposit advance products," which everyone else calls payday loans. These loans are made to checking account customers in anticipation of direct deposits of salary payments or other regular direct deposits.
In its final guidance to banks in November, the FDIC said, "The cost of the deposit advance is typically based on a fee structure, rather than an interest rate. Generally advances are made in fixed dollar increments and a flat fee is assessed for each advance. For example, a customer may obtain advances in increments of $20 with a fee of $10 per every $100 advanced. The cost of the deposit advance can be more expensive than other forms of credit, such as a credit card or a traditional line of credit."
This means the cost of a payday loan made by a bank would be very high, if expressed as an annual percentage rate.
Unlike non-bank payday lenders, the banks have some certainty in knowing a customer's deposit advance loan will be repaid when the next direct deposit comes in, thus simplifying a bank's underwriting process. But that will no longer be the case.
"Deposit advance products share a number of characteristics seen in traditional payday loans, including high fees; short, lump-sum repayment terms; and inadequate attention to the consumer's ability to repay. As such, banks need to be aware that deposit advance products can pose a variety of credit, reputational, operational, compliance and other risks," the FDIC said when announcing its new rules in November.
Under the FDIC's new rules, a bank must assess a deposit advance loan customer's eligibilty for the loans every six months, including a detailed analysis of checking-account inflows and outflows, factoring in overdrafts and drafts from savings account. The FDIC also requires a "cooling off period," meaning the bank can only make one payday loan to a customer per month.
"Additionally, a bank should monitor for repeated customer usage, which may indicate a need for alternative credit arrangements or other services, and inform customers of these available options when appropriate."
The OCC in December issued similar rules in December.
The upshot of all this is that the big banks are now shying away from making deposit advance loans. Wells Fargo (WFC) on Friday said deposit advance loans would not be available for accounts opened after Feb. 1., and that current payday loan customers "will be able to access the service until mid-year."
U.S. Bancorp (USB) of Minneapolis on Friday said it would begin "to wind down its short-term, small-dollar deposit advance product, Checking Account Advance, to align with final regulatory guidance issued by the Office of Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC)." USB will no longer offer the service to new checking accounts after Jan. 31, and will completely discontinue making payday loans on May 30.
Fifth Third Bancorp (FITB) is also discontinuing its deposit advance lending, as is Regions Financial (RF).
"On the surface, the new regulation seems to make sense. Tell the banks that they can no longer make these loans and the consumers will no longer borrow money at high rates," Bove wrote in a note to clients on Tuesday. "The problem with this simplistic view is that no mechanism has been provided by the Agencies to replace bank lending to troubled households."
Bove argues that the regulators should have conducted a study " to determine why low income households borrow money at these rates."
It certainly is an interesting phenomenon. A deposit advance loan customer presumably can't use a credit card to tie himself or herself over until the next pay period. The customer may have a low credit score, may not have any access to traditional consumer credit, or may simply be going through a "bad period," for which a short-term loan is an excellent solution, despite the high fees. But what really concerns regulators, and Bove, are the consumers who form a "habit" of taking repeat payday loans in an endless cycle. These consumers have fallen into a very expensive trap.
I have witnessed something similar with mortgage loan customers who make payments late every month, incurring late fees for years and years. It's possible that some of these customers could "tighten their belts," in some way, long enough to escape the cycle, but it certainly isn't easy. Otherwise they would do so.
"If one makes the assumption that the households who are using these programs are borrowing because they actually need the money (a point that could be clarified if the Agencies actually studied the issue) then the next study that has not been made would be focused on where the troubled household will get the funds if they cannot borrow from the banks," Bove wrote. He identified the other possible lenders as "payday loan organizations, pawn shops, the mafia, and other sources, all of whom charge rates well above the 300% at the banks."
The FDIC previously issued plenty of guidance on how banks can make "small dollar" loans at reasonable rates to consumers, while factoring-in the risks associated with these loans. But the big banks have been sufficiently dismayed by the new deposit advance rules to simply exit the payday loan business, rather than setting up extensive underwriting and monitoring programs, while simultaneously seeing their deposit advance lending businesses curtailed by the "cooling off period."
Bove went so far as to take the "well-paid bureaucrats living on government salaries" to task for having a "vendetta to eliminate low income households access to funds."
The regulators are effectively telling "poor people that they should go to the grey and black markets to get money because the funds will not be forthcoming from the banks," Bove added.