Analysis: The government move that threatens to keep Americans trapped in debt

In November 2017, the Consumer Financial Protection Bureau (CFPB) issued a rule requiring payday lenders to assess a borrower's ability to repay before making a loan. Then, in February, the agency reversed course and announced a plan to rescind the core features of the rule.

The hundreds of pages of evidence supporting the 2017 rule, amassed over five years, did not change in the interim. The CFPB's leadership did, and its new proposal threatens to continue a regime of ineffectual regulation, led by states, that has left many Americans trapped in a cycle of debt.

For more than a century, the states have regulated small-dollar, high-cost loans primarily through controls on the price of credit and limits on other loan terms. In the early 20th century, state usury laws capped how much lenders could charge for credit, and most set fees too low for small-sum lenders to operate profitably. Raising rate ceilings was the first step to creating a functioning and legal market for small-sum credit.

Many states adopted a model lending law, known as the Uniform Small Loan Law, that allowed licensed lenders to make loans up to $300, repayable in regular installments, with fees capped at 3.5 percent per month. Where enacted, the Uniform Law succeeded in spurring the entry of legitimate companies offering reasonably priced loans into the lending industry during the 1920s and '30s.

But over time, as market conditions changed, the Uniform Law fell out of step with the needs of many lenders and borrowers. Its loan limits and maximum rates of charge did not reflect the commercial realities of post-World War II America. Many states failed to update their laws to keep pace. This made it harder for lenders to make these small sum loans profitably. With the deregulation of various financial service markets in the 1970s and 1980s, some licensed small-sum lenders moved into other, more profitable lines of business.

As a result, while traditional installment lenders licensed under state small-loan laws still operate today, they generally do not serve consumers who need loans of only a few hundred dollars. The legal limitations make it too unprofitable.

Enter payday lenders. Beginning in the early 1990s, some check-cashing stores began offering “deferred presentment” transactions, which are better known as payday loans. The check casher would give the customer immediate cash and, in exchange, would accept a postdated check to be cashed after the customer's next payday.

Although the stores initially argued these transactions were not loans, their claims ran into legal challenges. So the industry launched a state-by-state campaign for new laws to legalize payday lending. This approach has led to a patchwork of regulations, under which some states allow payday lending with few restrictions, some regulate it closely and others ban it entirely.

This is a throwback to the situation in the early 20th century. Then, as now, state-by-state variations created opportunities for lenders to evade restrictive state laws by lending across state lines.

In the past, lenders congregated in states that either failed to regulate lending or that adopted rules which were easily evaded. In the early 20th century, for example, “salary” lenders based their operations in Maine and Rhode Island, two states without strong usury laws. The salary lenders then extended credit through the mail to borrowers in states with more protective laws, such as New York and Pennsylvania, in an attempt to evade state-level restrictions.

More recently, payday lenders have partnered with Indian tribes to evade state lending laws, claiming sovereign immunity from enforcement of state consumer protection rules. Several states have challenged the validity of these arrangements in ongoing litigation.

That's why the CFPB regulations are so important. The CFPB was created in 2010 to enforce federal consumer financial laws and to protect consumers against unfair, deceptive or abusive acts and practices.

Federal law already requires credit card issuers and mortgage lenders to assess a borrower's ability to repay. The proposed CFPB rule extends this requirement to lenders offering high-cost loans that must be repaid in a short time period (45 days or less) or that require a final “balloon” payment, meaning a lump-sum payment that is more than twice the size of the other required installment payments.

The proposed CFPB rule innovates in several ways: First, compared to state-level lending laws, the CFPB's proposed rule adopts an entirely new regulatory approach for small-dollar loans. Rather than control the price of credit, the CFPB rule would require lenders to assess the borrower's ability to repay the debt. Regardless of the cost of credit, the rule would require payments to be affordable so that the borrower would not end up in a long-term cycle of taking out new debt to pay off the old one.

In explaining the agency's rationale for attempting to rescind the 2017 rule, the CFPB emphasized the importance of access to credit. But access to unaffordable credit does not benefit consumers. As the CFPB concedes, many borrowers are already “in financial distress” when they take out a payday loan.

An affordable small loan can offer these borrowers a lifeline. But a loan that the borrower cannot repay just makes the struggle to stay above water longer and harder. The CFPB's 2017 rule would eliminate loans that drag struggling families deeper into distress, while keeping affordable small-dollar loans available.

Second, the CFPB's 2017 rule would create national minimum standards for payday loans, thereby shifting some of the burden of regulating them from the states to the federal government. It would provide a floor applicable everywhere — and therefore harder to evade — without setting a ceiling on state-level consumer protections.

In the past, federal law has imposed ceilings on state efforts to protect consumers, with poor results. Before the mortgage crisis of 2008, federal regulators preempted the application of state anti-predatory lending laws to federally charted banks, allowing those lenders to make risky loans that were more likely to default. Likewise, since 1978, federal law has preempted state interest rate laws from being applied to out-of-state national banks, opening the door to high-rate lending even in states with strong rules on the books.

In the early 2000s, payday lenders seized on the opportunity to evade state laws by partnering with national banks — until federal regulators clamped down on the practice, demonstrating the need for federal action.

In contrast, the CFPB proposed rule does something different. The CFPB rule would leave states free to adopt additional consumer protections, such as caps on interest rates or limits on other loan terms. Ohio, for example, amended its lending laws in 2018 to close existing loopholes and to allow lenders to offer affordable products with total fees and interest not exceeding 60 percent of the amount borrowed. The CFPB rule complements Ohio's regulations instead of preempting them.

If the CFPB rolls back its payday lending rule, however, it will shift the full burden of regulation back to the states. The federal floor will fall away, leaving state law as the only safeguard against unfair and deceptive business practices. States such as Ohio will need to rely solely on their own laws and already stretched state enforcement budgets to protect small-dollar borrowers.

For more than a century, the states have carried this burden, with mixed results for consumers. By retaining the ability-to-repay rule, the CFPB can finally ease the burden on the states and build a solid foundation for advancing consumer protection nationwide.

The demand for small loans is real and driven by forces outside the CFPB's control. The agency cannot reduce the need for small-dollar credit or the number of financially fragile Americans. It can, however, try to prevent struggling families from being dragged down by unaffordable debts that exacerbate their economic suffering.

— — — Fleming, an associate professor of law at Georgetown University, is the author of “City of Debtors: A Century of Fringe Finance.”