Can an interest-free credit facility be more efficient than a usurious payday loan?

https://doi.org/10.1016/j.jebo.2013.05.014Get rights and content

Highlights

  • This paper illustrates the viability of interest-free endogenous leveraged circuit.

  • We contrast the interest-free facility with usurious payday loans.

  • We demonstrate the former's efficiency using a net present value (NPV) analysis.

Abstract

Inefficiencies in mainstream credit markets have pushed selected households to frequent high cost payday loans for their liquidity needs. Ironically, despite the prohibitive cost there is still persistent demand for the product. This paper rides on the public policy objective of expanding affordable credit to rationed households. Here, we expound a simple model that integrates inexpensive interest-free liquidity facility within an endogenous leverage circuit. This builds on the technology of ROSCA/ASCRA/mutual/financial cooperative and cultural beliefs indoctrinated in Islam. Our results indicate the potential Pareto-efficiency of this interest-free circuit in contrast to the competing interest-bearing schemes of payday lenders and mainstream financiers.

Introduction

“Many people, particularly low-to-moderate income households, do not have access to mainstream financial products such as bank accounts and low-cost loans. Other households have access to a bank account, but nevertheless rely on more costly financial service providers for a variety of reasons. In addition to paying more for basic transaction and credit financial services, these households may be more vulnerable to loss or theft and often struggle to build credit histories and achieve financial security”. FDIC (2009, p. 10)

A survey by the Federal Deposit Insurance Corporation (FDIC) in 2009 carries concerns on the extent of financial rationing faced by American households.1 According to the FDIC (2009), approximately 17.9% or 21 million households who do have banking accounts subscribe to the services of alternative financial service providers. With respect to their credit needs, these households have had to frequent these service providers, including payday lenders. In a separate study, Lawrence and Elliehausen (2008) find 73% of the surveyed payday loan borrowers suffered rejection or limitation on their credit application (i.e., rationed or completely rationed out) by mainstream financiers, which is three times above the United States general population. The use of payday loans are largely for unplanned events that highlights the liquidity constrained status of this cohort.

Payday loans or cash advances, are structured to function as a short-term liquidity facility to smooth inter-temporal income shocks. This involves issuance of single, small, short-term and unsecured consumer loan, ranging from $100 to $500. An average payday loan is for less than $300, with repayment period of 7–30 days (Lawrence and Elliehausen, 2008). The industry has been severely criticised for its high credit cost, in combination with wider issues of predatory practices and expropriation of wealth (OFT, 2013).2 Undergirding these criticisms is the interest servicing burden (Melzer, 2011) faced by these households who are in the moderate to low income bracket, and lack financial sophistication (Lawrence and Elliehausen, 2008). The fees reflect the industry's severe default rates (DeYoung and Phillips, 2009).3 Interestingly, despite heavy criticisms, there is still persistent demand for the products. Thus, this highlights a pressing need to explore inexpensive financial alternatives to assuage the liquidity needs of this market segment.4 The fact that these households have had to exhaust other credit avenues alludes to the rationed out effect and potentially non-Pareto efficient solution. To date, studies on payday loans have either focused on (i) credit behaviours; or (ii) welfare effect of the borrowers, without delving on Pareto optimal substitutes.

Recognising this shortcoming, the primary motivation of this paper is to expound an institutional design for the provision of inexpensive, short-term liquidity facility, which satisfies the latent demand of these households to smooth their inter-temporal exogenous income shocks. Specifically, our study aims to explore the following question: Can an endogenous interest-free payday loan circuit provide a more efficient credit solution in contrast to current payday lenders and mainstream financiers? This is achieved through integrating the two strands of literature on: (i) institutional structures related to endogenous circuits; with (ii) cultural beliefs (i.e., Islamic tenets) in particular, interest-free loans.5,6 Our research motivation is consistent with that of Coase (1937) and Alchian (1950), who in their seminal papers rationalise efficient institutions as those that evolve and adapt to the environment to deliver services in a cost effective manner. Moreover, the approach taken in this paper to intertwine institutional design with culture is reflective of Acemoglu et al. (2005, p. 424), who reiterate “belief differences clearly do play a role in shaping policies and institutions”.

For the purpose of this paper, the target population are economically active households. This is consistent with the underwriting criteria of payday lenders that require borrowers to be in employment and bank account holders, as well as with the findings of the FDIC (2009) survey. Additionally, our model is based on risk neutral economic agents.7 We illustrate the above through an institutional structure of an endogenous leverage circuit formed from member based contributions.8 This is followed by two stepped extensions that assimilate real world elements of having fraction of borrowers within a finite life circuit, and subsequently extending the circuit as a going concern with random repetitive borrowing. The objective of the basic framework and the extensions is to solve for Pareto-efficiency by simultaneously (i) ensuring availability of affordable credit (where credit is due); and (ii) moderating their commitment issues that promotes long-term financial security. This is showcased by mathematically modelling a short-term interest-free liquidity facility circuit that moderates adverse selection and moral hazard. The beauty of the model lies in the structuring of the circuit, where members help one another to alleviate inter-temporal liquidity shocks such that the benefits of borrowing outweigh the cost of it. This draws from the ‘barn raising’ practices in the United States frontiers discussed in Besley et al. (1993) and captures Commons's viewpoint (1931, p. 651), where he states “…collective action is more than control and liberation of individual action-it is expansion of the will of the individual far beyond what he can do by his own puny acts”.9

This paper contributes to existing literature from four perspectives. First, it averts expropriation of wealth of these households through establishing an alternative recourse for liquidity funding. This is in contrast with liquidity stripping from onerous interest charges of current payday loans. It conjointly satisfies public policy call for expansion of affordable credit. Second, our framework allows for satisfaction of liquidity needs of households as solution to rationing by mainstream financiers. Third, we integrate interest-free loans in our liquidity facility. This is drawn from charitable teachings, specifically from Islamic religious tenets that are proffered as a remedy to the prohibited ribā an-nasi’ah. Thus, it unveils the economic potential of this antiquated financing, conceived from cultural ideals, as a financial development device. Fourth, by binding eligibility to the liquidity facility with a member's fulfilment of the periodical contributions ruling, it harnesses the commitment technology sacrosanct with endogenous leveraged circuit-based institutions.10 This effectively moderates the issue of time-inconsistent preferences closely associated with payday loan borrowers as well as shelters them from liquidity gaps arising from exogenous shocks.

The remaining of this paper is structured as follows. Section 2 details the landscape of the payday lending industry and related literature. Section 3 discusses the rationale for the prohibition of ribā and its contrast against charitable modes in Islamic tenets. In Section 4, we develop a simple model to illustrate the Pareto-efficiency of endogenous interest-free payday loan circuit in addressing financial constraints of these households and its results. Finally, we conclude in Section 5.

Section snippets

Landscape of payday loan industry and related literature

Payday lending emerged in early 1990s in response to increased demand for short-term credit following the spatial void created by withdrawal of mainstream banks from small loans, low profit margin business segment (OFT, 2010). The convenience of fast disbursement, minimal or non-existent credit checks further adds to its attractiveness (FDIC, 2009). An indicator of its growth pace is the extensiveness of payday loan network across the United States. Payday lenders have more branch presence then

Islamic prohibition of ribā and the contrast against charity

Salleh et al. (2012) demonstrate that Islamic prohibition of ribā an-nasi’ah credit transactions is attributed to the inclination for expropriation of wealth. Using a capital structure approach, they observe inequity in pure interest-bearing debt structures that leads to two equilibrium cases. First, in the case of financial repression, where the real interest rate is negative the lender's assets are expropriated. Second, in case of negative leverage, where the real interest rate is greater

Model development

This section details the mathematical design of an efficient interest-free short-term payday loan facility (using endogenous leverage) to address the inter-temporal liquidity needs of payday loan borrowers. Our endogenous leveraged circuit is founded in the works of institutional economics (Commons, 1931), and builds from the technology of ROSCA (Besley et al., 1993, Dagnelie and LeMay-Boucher, 2012), its associated hybrids; namely, ASCRA (Bouman, 1995), and the more contemporary mutual and

Discussion and conclusion

Payday borrowers are categorically those who suffer from poor credit history, exhibit time-inconsistent preferences and are often precluded by mainstream financiers. The prohibitive payday loan rates may potentially lead into a debt cycle if the borrower fails to observe the repayment term. Despite the unfavourable publicity against payday loans, financially constrained households still succumb to its services. This underlines a latent need for inexpensive short-term liquidity facility to

Disclaimer

The views expressed in this paper are those of the authors and do not necessarily reflect the official position of Bank Negara Malaysia.

Glossary of Arabic terms

Arabic term
Closest English meaning
fiqh
Islamic jurisprudence
hiba
voluntary gift
ijtihād
literally ‘exertion’. It implies independent deduction of laws not self-evident from the primary sources, namely the Qur’ān and Sunnah
qard
the act of extending interest-free loan from one's property without expectations of gains. It is also known as qard hasan or qardah-yi hasanah
Qur’ān
the holy book of Islam
ribā
an injunction protecting property rights. This is generally misinterpreted as usury or interest
ribā

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