Paydaynomics

The magic (money) roundabout

In our second post we thought it would be constructive to put up a very simplified description of the economics of a payday lender explaining how this has altered through the new FCA regime to help build a base to discuss industry issues and misconceptions.

FCA reforms haven’t worked

The FCA is a more effective regulator than the old OFT and has made meaningful changes — reduced loan rollovers, stopping abuse of continuous payment authorities (CPAs) and suppressing the use of ‘ping-trees’ — that have had a positive impact in stopping the most abusive practices. We wholeheartedly agree with the FCA treating customers fairly agenda in spirit but we think it is quite confused in implementation in this sector and, as a result, it is more a cause of problems for the customer than a solution.

Perversely, the average remaining customer has probably seen the cost of credit increase not decrease. This customer will have been assessed to be less at risk than customers no longer using payday so how can this higher quality remaining group be paying more for short term cash? Answer: High cost instalment loans where the APR is much lower than old payday but the cash cost can be much higher.

The price cap doesn’t work and the affordability paradigm has been twisted into a way of making loans more ‘affordable’ short-term but significantly higher total cash cost longer term. Coupled with continued volatile income this can lead to higher chances of debt overlap and possible debt entrapment. It seems to us that onlookers have been ‘bought-off’ with the lower APRs that come with instalment loans.

Affordability is a real issue and we don’t dismiss it, but nothing good comes from just spouting the term repeatedly like a mantra. To be honest, we’d be just as well talking about making payday loans more ‘cuddly’ than banging on about affordability the way we all do. Both terms give a warm glow but are equally vacuous in reality. And, whilst we were all distracted by the warm glow, the hard reality that is money making payday businesses just took your cuddly/affordability and warped it into a higher cash price.

The rest of this post goes into the financial dynamics to build the case to understand our controversial criticism. We will return to price caps and affordability in more specific detail in later posts as these issues create problems much more than they solve them.

Payday business is rental company first, loan company second

You should think of traditional payday companies as a type of rental company — like car rental, except with money. The great thing for money renters when compared to those that hire out physical goods is that they suffer very little ‘wear and tear’ on their asset (money), particularly with base rates so low. Conceptually, whether defaults should be included as wear and tear in the money rental model is tricky. A small amount probably should count as depreciation — every loan business is going to have some problem loans — however, a high level of defaults should not. High default rates, particularly in payday, are an active choice of the business in terms of the customers it targets and the methods used to acquire them and should therefore be regarded more accurately as a customer acquisition or marketing cost than depreciation.

We don’t think the money rental perspective is well understood, at least in a clear sighted enough way, and that has probably contributed to a bunch of ineffective FCA reforms. These reforms have been in response to often partially informed ‘drive-by’ criticisms of the industry. Once the rental model is appreciated these reforms can start to look quite perverse. Perhaps the FCA confused payday for a sort of specialist bank rather than a ‘money rental’ business [1].

In many ways payday reforms to date appear to legitimise and reinforce its very high potential profit model in a way that was not intended and has generally not been beneficial to the consumer that remains. This is one of those deliciously paradoxical outcomes that can result when a lot of non-specific outrage meets a situation that “must be changed”.

Simplified models of payday

The actual real financial returns to short term credit providers are complex to model and the details would be rather arcane for our purposes here and beyond the interest of all but the very geekiest of you. However, the very simplified models below provide you with an informative and relevant base from which to understand the profit dynamic for payday and other high cost short term credit (HCSTC) businesses.

We will use a couple of diagrams and a table to illustrate how money flows (or circulates) in a typical payday business and how it has changed pre and post FCA price cap. Instinctively, most readers will probably think of the earnings potential of payday as similar to other loan providers such as a bank providing mortgages. Although money is paid out and then received back in with interest added just like for a mortgage, the speed of repayment of the loan and the level of interest over that short time frame set payday and general HCSTC a world apart from the instinctive bank-like picture you have in your head. It’s why we say payday is really a rental business first, loan business second.

The original magic money rental roundabout (pre FCA price cap)

The diagram shows that £300 rented out every 15 days is equivalent to a one year loan of £7,200. Now that is what you call leverage! And it’s not that dangerous sort of financial leverage that you hear about in financial markets but it’s much healthier (for sustained profitability that is) cousin called operating leverage — old payday could really sweat its little bit of capital and generate a lot of business from it. The interest is 1% per day, if the length of loan went down by 5 days the interest earned in the example above would be 10%, but that could be rented our 36x a year rather than just 24x, so even more operating leverage meaning that annualised returns remains the same.

This truly is a magic roundabout for any business that implemented the model successfully. It is also important to realise that most payday companies charged similar or higher prices to the very successful operators such as Wonga but did not succeed in making nearly as much money, with many actually exiting the field before price caps were even introduced as they were already losing money [2]. The struggle to make profit was primarily due the extremely high unit cost of customer acquisition but partially informed outsiders tend to think it was due to very high defaults (a myth that is convenient for successful incumbents as it facilitates the ‘free-market’ orientated belief by most onlookers that high loan costs are a function of high risk customers).

As mentioned above the diagram is a simplification. A real business would probably not recycle a fixed amount of loan capital around — paying out all the profit made from each loan cycle as a dividend to capital providers and/or business owners — as the simplified model implies. They would most likely reinvest as much of the profit from each turn as possible to organically grow the size of their loan book to take on increasing market share so as they could very quickly achieve the even higher returns that a bigger loan book delivers.

Each turn of the payday roundabout is not for free and requires some elbow grease too. Beyond regular business overheads the c.15% gross interest [3] per loan cycle (assuming 15 day loan) must pay for credit checking through credit reference agencies and other data, loan payment processing fees, customer acquisition and cover both the average default rate and the cost of capital [4].

It’s helpful to think in cash terms too and 15% on a £300 loan is £45 gross interest earned in 15 days, and repeated 24 times a year earns a tidy £1080 from ‘renting out’ the £300 loan capital (and getting the £300 capital back too). Wow! Obviously, due to fixed costs, higher value and/or longer duration loans are more profitable (assuming that there was not a significantly worse default rate than on lower value/shorter duration loans). Our £300 15 day loan example is probably below the average combination of loan value and duration the industry achieved so they didn’t rotate round the roundabout as often as our diagram depicts but this would have been advantageous to profit due to an improved cost-return trade-off.

What this simple model illustrates is that there is a helluva lot of scope to make money in the old payday model. Remember it’s money rental more than classic loan business.

The new slightly less magic money rental roundabout (post FCA price cap)

This is the same model as the pre FCA price cap model above. The only difference is that the permissible daily interest rate that can be charged has been capped at 0.8% and that reduces the gross returns that can be earned. Most payday companies now charge the daily maximum that the FCA decree (no price competition there then!).

Although not quite as giddy-making it’s still a pretty exhilarating roundabout from a money making perspective. The profitable post FCA price cap businesses will make a bit less money assuming the business model isn’t changed up to seek to hold on to profits (hint: see the next section as most did change) and the struggling and marginal businesses will fold.

We can only assume that after all the papers had been written and industry consultations had finished the FCA decided that the best thing to do was just to slice a bit off of the margin of profitable companies and push less able companies to the wall. This simple move has been effective at pushing firms with the most abusive approach out of business and of course it makes it easier for the FCA to monitor what remains. As an immediate fix to political pressure and bad press coverage of the sector it was a nice easy solution that minimally taxed the already stretched resources of the FCA. The FCA initially expected the industry to shrink from approximately 400 to 4 when they introduced the price cap and tightened other rules [5] (in fact, many more than 4 survived the FCA cut).

Instalments. Or a bigger more affordable debt trap?

Mr Payday says: “Boom! Take that! You can’t suppress our profit innovation.”

With instalments the magic money roundabout is still working underneath as effectively as ever before but it’s harder to depict in a diagram. Instead, we have focused on the repayment cash-flows from a customer perspective. The one month ‘instalment’ is the same as a classic payday loan operating under the FCA 0.8% per day interest cap. 0.8% per day on a £300 loan leads to a £372 repayment 1 month (30 days) later. Using this figure as a base you can use the tables above to easily see how much more in cash terms the customer is paying for the “greater affordability” of instalments. Supposedly, this will make them less financially vulnerable too…but enough sniping for now, more of that some other time.

Wowsers. This is the new and improved payday? All you concerned onlookers must be heavily medicated to have missed this. Payday reforms seem to be legitimising a path to even higher profitability for payday companies. Of course, current profitability is suppressed as conforming with new FCA rules is near-term expensive. Plus, the enforced changes in customer engagement processes mean that loan volumes have fallen at the same time that the costs of conforming with FCA have arrived. But the reduction in volume and the increase in costs are temporary and magnified at the moment and they will reverse. With the new ‘innovative’ instalment loans a company can do less customer loan volume and yet still make significantly more money. Particularly, the larger companies that have the ability to bury compliance costs and other fixed costs within their scale. Batten down the hatches and ride out the storm to the other side!

The paradoxical situation revealed by the table above is that whilst the price of the daily payday rent has gone down, the total cost to the customer has gone up as they now pay that rent for longer. Not every payday business charges exactly as we depict in the table but it is broadly representative of how the industry has responded to the FCA price cap and its concerns about affordability and vulnerability [6]. It should be noted that the industry poster-child Wonga has, to their great credit in our opinion, so far stuck with the short duration loan framework [7]. If daily interest rates are kept near the 0.8% FCA rate cap then customers are surely better served by a shorter duration classic payday loan rather than the new instalment loans (charging payday-like daily rates).

Have we all been sidetracked by sentiment?

Affordability in payday is a mess because the term is used without robust enough thought and analysis by concerned onlookers and APR is so misunderstood [8]. The current affordability focus seems to us to be more a mood and feeling thing than a genuine attempt to assess how to define, assess and manage affordability in a context relevant way for people who have volatile and, often, marginal net income. By that we mean its an overlay of middle class anxieties looking at payday rather than a real appraisal of what a payday customer wants and needs to fit with their financially stretched and unpredictable lives.

The term ‘affordability’ and the associated term ‘vulnerability’ are used (unintentionally) in a deeply counterproductive way by concerned onlookers and the FCA. As a result, the affordability and vulnerability paradigm that has arisen has become part of what entraps people in the high cost credit debt trap rather than being something that prevents them from falling in. We know that sounds hard to believe as that is not what the words and sentiment means — but the devil is in the detail.

The focus on affordability and vulnerability chafes against the reality of the consumer in this sector — they are taking a loan as they are in a financially insecure and, often, in an unpredictable position which means cash-flow predictability is very hard. Only better product design that is sympathetic to real-life circumstances can solve this and that is likely to be delivered by innovative industry outsiders (hint hint), though the barriers to entry are very high. Systemic change is the solution not cuddly words, and regulation’s role is holding the coats better and not seeking to lead the charge.

The reality in short term emergency credit is that most customers are going to have an affordability issue — by definition as it’s what it says on the tin. It is impossibly paradoxical to seek to prevent affordability and vulnerability issues from arising. People want to believe in the silver bullet of better or new data or processes that can be prescient on affordability and vulnerability. This is just wishful magical thinking. Affordability and vulnerability are issues the industry needs to manage much better but the solution for the customer does not lie in increasingly expensive rules that effectively ghettoise them and push up the price of their loans.

Conclusion: Are we there yet?

No.

The payday industry has changed a lot in response to the FCA taking oversight responsibility from the OFT, but probably for the worse from the perspective of the customer.

Some concerned onlookers may assume that the customer will react “rationally” to this cost increase and choose other sources of credit. We think that is probably wishful thinking by those fortunate enough to be far removed from the issue. A payday customer tends to have limited sources of credit and find themselves in a position whereby the payday route is the easiest and most viable option for them to pursue, particularly when the pressures of tight short-term cash-flows bite hard and fast. A following post (working title ‘Scarce-o-nomics’) will delve into the issues here a bit further and explain why the customer needs a payday-like product, but one that is more sympathetic to the context and the vulnerabilities in choice and action this consumer experiences.

In future, we will also delve into why the risk that many payday customers present as borrowers is systematically misrepresented. Obviously, the higher the risk label that can be attached to a cohort of people then the more you can justify charging them a higher price of credit. Pretty neat trick from a profit potential perspective and great that concerned onlookers and the FCA are lending a helping hand with a lot of fluff on affordability and vulnerability.

Saying that the payday customer should have planned ahead better or saved more for a rainy day totally misses the reality of managing a persistently tight financial budget. If you are short of money and in a real tunnel of worry working out how to pay the bills then paying a £150 instalment at the end of the month rather than £372 total repayment can look very attractive. Of course, you still have two more £150 instalments to pay-off but, heh, that’s a budget battle for another time. It may even encourage you to take a bit more money to make the immediate future nicer as, in the tunnel of money worry, three/four/five/six months seems a long way off. It is truly perverse that this situation passes the ‘affordability’ and ‘vulnerability’ test better than a traditional payday loan.

And no, just in case you are casually thinking it, credit unions or not-for-profit sector are not the answer. There’s nothing wrong with either of those things but they are not the commercial answer to re-enfranchising a significant subset of the UK population in a credit and financial services sense. People need a solution that can be commercial and mainstream — that’s how financial inclusion is built.

We hope we have prompted some thought and welcome questions, debate or disagreement — get in touch in the comments below or directly to me on ceo@leanonafriend.com.

Paul

Footnotes:

[1] The FCA is truly caught between a rock and a hard place with payday. Their mandate is very new having just taken this over from the OFT in 2015 and it is simultaneously to support and police the industry. It’s not their job to shut the whole sector down (that would require legislative support, and would not be most beneficial to the consumer either!). So, they are left with a sector that has come into being not under their watch, that is malformed through previous practices (in our opinion) but which the FCA knows it must not entirely smother. It will have gone through a consultation process where the big firms would have all made very similar pleads about what they could and couldn’t bare as regulatory intervention and the FCA had to work from that information. However, now that caveat has been made, we will make critical statements of the FCA in this blog as it is the organisation holding the bag of responsibility. Looking forward the FCA can only play a role in fixing the sector by making it much much (much) easier for outsider competition to come in (we got through authorisation but it was a near death experience and much harder than it needed to be for a start-up).

[2] This is a highly interesting point but alas, in the interest of brevity, we will not go into detail in this post. Before the FCA took over the oversight role from the OFT the industry was tiered into big fish, some middling size operators and small business without scale — altogether something in the region of 400–500 firms and a mixture of online and high street. The big guys generally had the pick of the risks due to combination of brand awareness and marketing, better underwriting and the fact they could place themselves at the top of pathways that fed the industry (premium marketing, paid for clicks and ‘ping-trees’). Simplistically, smaller online players fed off of scraps that the big players didn’t want and there was a very profitable market in selling these scraps. Smaller players would often charge even more than big players but they could be taking on very high risk customers (i.e. economically very marginal) and fraud. If you are charging 2% per day in interest (plus other charges) then you can potentially accommodate a lot of fraud and still earn profits!

[3] The well known names tended to charge about 1% per day in interest. Some lesser names charged significantly more and we are aware of interest of up to and over 2% per day pre FCA clean-up. In all cases there could be other charges on top of the interest but they cannot be universally modelled in the same way as interest can. For example, payment process charges and some lenders (high street rather than online) had deliberately complex extra charges and rewards that revolved around meeting exact instalment payment schedules. Of course, if you have stretched finances it is quite likely you may struggle with a repayment here and there…and that then triggered charges.

[4] The costs are mix of fixed and variable and it is necessary to understand them more granularly to develop a deeper understanding of profit dynamics of the industry. In particular, default costs are complex as payday businesses have historically targeted higher risk customers causing higher default rates but seeking to have that more than compensated by earning higher income through additional fees and interest. There’s some good stuff on costs in this ACCA paper — Payday Lending: Fixing a Broken Market.

[5] See “Wonga slides to first annual loss as regulatory crackdown bites”, Financial Times 21 April 2015. Note, we were one of the first firms to be fully authorised on 8 January 2016 so you now know 1 of the 4 (of course, there will be many more than 4!).

[6] Payday companies will say they have done much more than this on affordability and vulnerability and they likely have tacit support in that from the FCA <head scratch>. Call us simple, but we can’t see how that carries much weight given the extra cost to the consumer.

[7] Wonga are currently testing out an instalment product. We don’t know the details of the product at time of publication.

[8] The instalment loans above have a much lower APR at around 1,200% than the old +/-5,000% we saw pre FCA price cap. Confused? Well APR doesn’t necessarily measure how much cash you payback and is very sensitive to timeframe of repayments, particularly over short durations. By extending the payback time by a month or two the APR falls precipitously even if the actual cash repayment goes up. The arithmetic of compounding can be confusing. Most people don’t understand it as it is non-intuitive.