Research and debate on price controls
Academics, government and independent experts have carried out a number of studies into the feasibility of price controls. These studies have aimed to find out if price controls would reduce the cost of borrowing for lower income customers. Price controls would limit the APR or Total Cost of Credit (TCC) a lender could apply to a home credit loan1. Advocates of price controls argue they can reduce the cost of borrowing for consumers without impacting on the supply of credit to those low income borrowers who need it. However, research has found that price controls restrict the diversity and volume of credit supplied and reduce choice and access for non-standard borrowers2.
Users of home credit can have limited credit options. Those who favour price controls say such a lack of choice makes borrowers more reliant on higher cost providers3 and suggest that a cap on interest rates would prevent such reliance. The lack of choice in the small-sum credit market is, they argue, a market failure which would be corrected by price controls. But research for the Treasury4 has suggested that such price controls would have many unintended consequences. In a price-capped regime, a home credit supplier would still need to recoup the cost of lending. The supplier would be most likely to do this by introducing a structure of fees (for example for set-up or administration costs) and penalties (for missed, late or bounced) payments. Charging of this kind is less transparent than all-in pricing and penalties for missed payments would penalise borrowers when they are least able to afford it. Under such 'behavioural charging' regimes high-risk borrowers can easily find themselves trapped in a long-term cycle of debt. This can happen because the addition of fees and charges to the amount an individual originally borrowed causes the total amount repayable to increase rather than decrease over time5.
Lenders providing small-sum credit to higher risk customers who prefer to avoid charging additional penalties and fees would struggle to serve as wide a market as they currently do under a price-capped regime6. As price controls restrict lenders' capacity to cover their costs of supply, it is likely that lenders would raise access hurdles for the highest risk borrowers or cease supplying the market altogether7. This would do nothing to reduce the demand for credit – which research has shown is inelastic and permanent8 – but would mean many of the most vulnerable customers would lose access to the legal and regulated credit they need. An absence of legal lenders would increase the opportunity for illegal lenders to fill the gap in the market. At present illegal lending in the UK is not widespread relative to comparable European countries but this is in part because a variety of legal higher cost credit options are available to borrowers9. Areas with relatively higher levels of deprivation in the UK where home credit is less available tend to see higher incidences of illegal lending10. This view is supported by the Office for Fair Trading11 which found that if people are unable to access credit they are more likely to borrow from illegal lenders.
Mainstream lenders such as high-street banks which tend to charge lower APRs are often reluctant to lend to higher risk borrowers or don't provide the small-sum loans lower income borrowers want and could afford to repay. Where they do lend, the loans tend to be of higher value and fees and penalties are often imposed. The potential risks to lower income borrowers of using mainstream credit have been highlighted in research for the Financial Inclusion TaskForce12. Lower income borrowers tend to have more volatile incomes and are less likely to have a buffer of savings. This means there is higher chance that at some point during the course of a loan they will be unable to make a payment. When fees or charges are added to a low APR product the cost to the borrower can quickly match or exceed that of a loans with a much higher APR13. The all-in, fixed cost pricing of home credit providers avoids the spiral of debt which can arise where penalties, fees or additional interest charges are applied to missed or late payments14.
Credit is also available to lower income borrowers from not-for-profit providers, such as credit unions or community development finance institutions. Those who favour rate caps sometimes suggest that these are the sorts of organisations lower income borrowers should use, not least because credit unions have statutory limits on the interest they can charge. Not-for-profit lenders are certainly a useful option for lower income borrowers but their model is quite different. What is more, despite significant support from successive Governments, not-for-profit lenders still have limited geographic coverage and have found it challenging to become financially sustainable. Research has shown that these lenders do not yet have the 'reach' or financial health to replace private sector lenders15. Operating in a price-constrained regime can have significant consequences for not-for-profit lenders too. Lenders either have to rely on subsidies to cover their costs or find themselves able to lend only to a more limited or less risky subset of borrowers. A report by the Joseph Rowntree Foundation16 found that – even on a not-for-profit basis – a subsided not-for-profit lender would have to charge an APR of 123% to begin to replicate the service of home credit providers and cover costs.
A more fundamental question is whether price controls have any impact at all on the persistent underlying difficulty facing low income borrowers. That is, when living permanently on a low income, without access to small - sum credit, how would they alleviate financial pressure and bridge gaps in household expenditure?17
A number of studies have examined what impact price controls have in those countries where they are in place. Studies of how such controls function in states such as the US, France and Germany have concluded that price controls do not generate better outcomes for lower income borrowers18. Both reports agreed that the negative outcomes of caps include reduced transparency and increased financial exclusion (fewer legal, regulated options are available to borrowers). The OFT also concluded that caps tend to be difficult to enforce, even more so when the internet offers access to credit from providers based outside the regulator's and borrower's home country19.
The growth of payday lending in the UK in recent years has prompted a fresh focus on price controls. (Payday lending is quite different to home credit in many ways: the most important distinction is that the cost of home credit is all-in and fixed, whereas the cost of payday is variable. Moreover the evidence suggests payday customers vary quite significantly from those who use home credit.)20 The impetus for interventions in the payday sector has arisen from concerns that borrowers are suffering detriment. Such concerns led to a Government announcement in November 2013 that it would legislate to introduce a cap on the total cost of credit for payday loans.21 An amendment to the Financial Services (Banking Reform) Act created a duty on the consumer credit regulator, the Financial Conduct Authority, to introduce a cap by January 2015. In the interim the FCA was tasked to determine the nature and level of the proposed cap. This process is to encompass economic analysis; consideration of the international experience of introducing equivalent measures; and statutory consultation with parties likely to be affected.
- Frequently asked question relating to APR
- OFT 2010 Review of high-cost credit, Final Report, Annexe B – Price Controls, Evidence and arguments surrounding price control and interest rate caps for high cost credit (PDF 0.48Mb) OFT 1232b, pp8-11
- Financial Inclusion Task Force. 2010, Mainstreaming Financial Inclusion, Planning for the future and coping with financial pressure: access to affordable credit (PDF 0.23Mb), pp13-14 & Annex F, p35
- Anna Ellison, Rob Forster, Paul Jones, Claire Whyley, 2011, Briefing note on the potential impact of price caps on low income customers, Friends Provident Foundation, Policis, Liverpool John Moores University. Also see Policis 2004 The effect of interest rate capping in other countries (PDF 0.41Mb) DTI, pp25-35
- OFT 2009 (PDF 0.77Mb) OFT 1150b, p11
- Policis 2004 The effect of interest rate controls in other countries (PDF 0.41Mb) op cit pp17-19, and FITF 2010 (PDF 0.23Mb) op cit pp13-14
- See Friends Provident Foundation briefing 2011 op cit, and FITF 2010 (PDF 0.23Mb) op cit pp15-18
- Anna Ellison, Sharron Collard and Rob Foster, 2006, Illegal lending in the UK (PDF 0.88Mb), Personal Finance Centre and Policis, DTI, p89. Also see FITF 2010 (PDF 0.23Mb) op cit p14
- Ellison, Collard & Forster 2006 (PDF 0.88) op cit pp25-32
- OFT 2009 (PDF 0.77Mb) OFT 1150b op cit pp12-13
- FITF 2010 (PDF 0.23Mb) op cit p18
- Friends Provident Foundation briefing 2011 op cit
- Malcolm Hurlston, August 2010, Capping interest rates on high-cost loans may do more harm than good, Guardian Money Blog, August 2010
- FITF 2010 (PDF 0.23Mb) op cit pp7-13. See also Elaine Kempson, Anna Ellison, Claire Whyley and Paul Jones, 2009, Is a not-for-profit home credit business feasible? JRF p42
- ibid p47, www.jrf.org.uk/publications/not-for-profit-home-credit
- Policis 2004 The effect of interest rate controls in other countries (PDF 0.41Mb) ibid pp10-21, and OFT, 2010, Review of high-cost credit, Final Report (PDF 0.44Mb), OFT1232, pp6-8
- OFT 2009 (PDF 0.77Mb) OFT1150b op cit, and Policis 2004 (PDF 0.41Mb)
- OFT 2010 Review of high-cost credit, Final Report, Annexe B – Price Controls, Evidence and arguments surrounding price control and interest rate caps for high cost credit (PDF 0.48Mb) OFT 1232b, pp31-17
- Competition between payday lenders and other credit providers working paper (PDF, 311 Kb)