"Consumer Credit and the American Economy," Part 5: Government Regulation of Consumer Credit

This essay continues a short review of some ideas discussed at greater length in Consumer Credit and the American Economy, a new book by Thomas A. Durkin, Gregory Elliehausen, Michael E. Staten, and Todd J. Zywicki (Oxford University Press, August, 2014). The first essay examined economic reasons why consumer credit use is widespread, the second at the question whether consumer credit use is excessive, the third at evidence of psychological influences on the economics of consumer credit use, and the fourth on why consumers may sometimes use small amounts of high cost credit. This essay discusses governmental regulation of consumer credit and particularly at regulation of credit pricing (usury laws). This area has been controversial for centuries and are the locus of many misunderstandings and related unintended consequences.

Government Regulation of Consumer Credit

Credit for individuals is as old as recorded human history, and so is the ongoing interest of governments in controlling it. Ancient laws of Babylon, Greece, and Rome all contained regulation of lending and borrowing by individuals, and some historians have conjectured that centralized tribal control of credit extends even deeper into antiquity. Much later, in the Middle Ages, the Christian church contended that charging interest on loans was a moral evil (usury) and therefore prohibited, ultimately based on restrictions found in its own antiquity, the ancient books of the Old Testament. Overlaps between religious and civil authority during the Middle Ages guaranteed that development of lending and borrowing relationships in western Europe remained complicated for centuries, producing legal difficulties extending even into modern times.

As notions of morality based on religious principles have faded over time as a foundation for commercial restrictions, concern has developed in some quarters that individuals still need government protection in their credit relationships for two further reasons: to shield them from inability to understand fully the implications of the credit transactions they enter into and to help them avoid possible inappropriate behavior by questionable credit vendors in the marketplace. In this view, the term consumer protection in credit matters refers to various governmental means of altering prevailing conditions and practices in the credit marketplace rather than absolute prohibition of credit relationships. Today, many observers of consumer credit markets believe that they are neither perfectly competitive nor perfectly uncompetitive, and, consequently, they recommend regulatory roles for both competition and government.

Whatever the influences, reasoning, and circumstances leading to current conditions, it is apparent that few areas of the American economy are as closely regulated as consumer credit. Until the late 1960s, governmental consumer protection in credit markets was mostly the province of state agencies, but today both federal and state authorities are involved. Consumer credit regulation evolved during a time when the federal system of governing left most aspects of local commerce as the province of state governments, and so early forms of regulation were at the state level. Federal activities for consumer protection began in 1968, with enactment of the federal Consumer Credit Protection Act on May 29 that year, and with its most important provision, the Truth in Lending Act, effective July 1, 1969. The Equal Credit Opportunity Act and other federal legislation followed in the 1970s. By 2010, the growth of federal regulation led to establishment of a new federal Consumer Financial Protection Bureau (CFPB), with official opening date July 21, 2011. Historically, regulation of pricing terms on consumer credit has been the province of state regulation but with federal regulators today waiting in the wings. It is possible, even likely, that federal activity in this area could increase substantially in the future. This essay examines this aspect of government regulation of consumer credit.

Usury laws in Britain served as the model for the American colonies in the eighteenth century. The colonies (and later the fledgling states) adopted a usury ceiling of 6 percent as a carryover of the prevailing 5 percent ceiling in Britain at the time, with an extra percentage point added to help raise capital. For the next century, ceilings on loan interest rates were the rule throughout the states, although with wide variance in levels. The western states, where capital was in great demand and scarce supply, generally adopted higher rate ceilings and weaker penalties for violation of the law than the eastern states, where capital was more plentiful. A lack of hard (coin) money in the west also necessitated a greater reliance on credit, making the inevitable shortages that accompanied interest rate and other lending restrictions more painful.

Legal limits in the colonial period and the early republic sometimes exceeded prevailing market rates and thus were not binding. In some cases states raised or abolished rate ceilings so that they no longer placed constraints on the market. Ceilings also were commonly evaded and were difficult to enforce, although during the colonial period and the 19th century there was not much consumer credit under modern definition available anyway.

But during the early modern industrial period, high rates of interest, abusive collection practices in some cases, and a perception that small loan cash lenders preyed on the poor gave rise in the 1880s to calls for stricter laws and more vigorous reform. Most of the states that had earlier repealed usury laws reinstated them over the next two decades. Generally, these reform efforts were ineffective and counterproductive. Lenders often changed the details of the transaction to place it outside the purview of the revised law; and borrowers, unwilling to risk losing access to credit, were often reluctant to complain to enforcement authorities.

The ineffectiveness of restrictive laws in curbing illegal lending gradually led to an acceptance of the view that laws should regulate but not prohibit cash loans, either explicitly or through restrictions that make small, relatively short-term unsecured loans economically infeasible. Around the turn of the century and especially after 1910, states began passing specific legislation to create a regulated lending industry. Early efforts typically were viewed as consumer protection. Efforts of entrepreneurs and joint efforts with social reformers during this period led to the beginnings of philanthropic lending, Morris Plan industrial banks for working people, credit unions, and the regulated small loan industry. By the end of the first half of the twentieth century, consumer credit reforms had created the institutional structure for modern consumer credit markets, excluding three-party credit cards which also depend on more modern data processing and communications. Nonetheless, evidence shows that rate ceilings continued to influence development of the institutions and markets.

Economists have demonstrated convincingly the complicated nature of the theory of setting appropriate rates to produce favored social outcomes outside of the market context. Various government attempts over the years have demonstrated the practical difficulties, especially if one of the goals involves providing for credit availability at reasonable rates to all risk classes of borrowers. Theoretical work shows that interest rate ceilings can affect the distribution of credit across risk classes of borrowers in ways that are difficult to predict. Depending upon competitive conditions, some risk classes of borrowers may sometimes benefit and others may be harmed.

For this reason, economists have been skeptical that authorities possess the analytical capabilities to assess the supply and demand conditions, price elasticities, and cost conditions in credit markets in order to set ceiling rates in a way that would reduce monopolistic power and produce competitive outcomes for all market participants. They have noted also that even a lender's experience with customers provides information for assessing risk that may not be available to the authorities. Furthermore, they pointed out that in many situations, credit is provided in conjunction with the sale of goods, making evasion of rate ceilings relatively easy. And so interest rate ceilings may not be very effective for controlling such sources of market power.

In addition to the obvious direct impacts on borrowers and lenders of these attempts to manipulate marketplace rates, the differential ceilings according to institutional class of lender found in many states have had the more subtle effect of actually reducing marketplace competition. Fragmented markets for consumer credit and the reduced competition they entailed encouraged higher, less competitive prices in each fragment. For unsecured personal loans, rate ceilings for finance companies typically were higher than those for banks, particularly for small loan sizes. Rate ceilings for credit unions were usually closer to rate ceilings for banks, although most credit unions enjoyed cost advantages over the other institutions. As a result, banks tended to make larger, lower-cost loans per loan dollar, and credit unions and especially finance companies tended to make smaller, higher-cost loans. In 1971-1972, the National Commission on Consumer Finance (NCCF), a federal government study commission authorized by the federal Consumer Credit Protection Act, verified important facts about consumer lending markets at the time:

1) Market rates did not always rise to ceilings as broadly believed.

2) Differential rate ceilings by institutional class segmented markets and reduced competition.

3) The degree of competition influenced both rate and credit availability.

4) Rate ceilings promoted credit rationing.

Summarizing the empirical evidence, the National Commission and other researchers have found empirical evidence of a variety of problems with rate ceilings. None of the findings is encouraging about the overall usefulness of rate ceilings as a consumer protection.

First, differential rate ceilings by institutional class of lenders have segmented consumer credit markets, thereby reducing the ability of different lender types to compete with one another. Thus, interest rate regulation has tended to foster market power of lenders, one of the alleged problems that rate ceilings were intended to remedy.

Second, evidence suggests that low rate ceilings reduce the quantity of consumer credit. This result argues against rate ceilings producing more competitive outcomes than markets in which rates are not restricted. Evidence further suggests that competitive influences have always existed in consumer credit markets, both within lender type and across lender types, despite the adverse effects of market segmentation arising from rate ceilings in the past.

Third, interest rate ceilings have not affected all consumers equally. Higher-risk consumers are more likely to experience a reduction in credit availability than lower-risk consumers, with lower rate ceilings affecting greater percentages of the risk distribution of consumers than higher rate ceilings. Lenders may offer potentially rationed borrowers less risky loan contracts, such as contracts requiring larger down payments or with shorter maturities.

Fourth, high-risk consumers also have obtained credit from sellers who reallocated part of the cost of credit to product prices. The presence of substantial numbers of cash customers (or lower-risk credit customers who can obtain credit elsewhere) limits mainstream sellers' ability to reallocate credit costs in this way. This has given rise to specialized retailers in certain areas without substantial numbers of cash customers or others with access to outside credit sources. Those sellers willing to specialize in credit sales to high-risk consumers face little competition from mainstream sellers and sometimes have been able to charge very high prices for the goods purchased.

Finally, high-risk consumers may obtain credit from friends or family, high-APR lenders, and illegal lenders. Limited financial resources and high-interest or noninterest prices for these sources suggest that high-risk borrowers will not obtain as much funds at a lower price from these sources as from forgone institutional installment credit. This outcome may prevent some perhaps excessive consumption, as some proponents of interest rate ceilings have argued, but it is likely that much investment in higher-quality household durable goods is also forgone. Since household investment can have high rates of return and be wealth-increasing, such rationing likely harms many rationed consumers.