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Risks Associated with Payday Lending

While the payday lending business presents banks with new growth opportunities, it also presents significant risks. To be sure, higher pricing on payday loans promises higher revenues and wider margins for lenders. However, there also are greater risks associated with payday lending. The credit risk associated with payday lending is significant, even when compared to other types of unsecured subprime lending such as credit card lending.

There are key differences between the underwriting methods used for subprime credit card lending and payday lending that renders payday lending among the highest risk subsets of subprime lending. Payday underwriting requirements are substantially less than those required by subprime credit card lenders who often supplement a prospective borrower’s credit bureau report with such additional information as income, employment history, and the nature of prior credit problems. The prevailing underwriting criteria of most payday lenders require that consumers need proof only of a documented regular income stream, a personal checking account, and valid personal identification to receive a payday loan.

Credit quality data for specialty payday lending entities is lacking since most payday lenders are small, non-publicly traded firms. Review of publicly traded company reports indicates that some specialty payday lenders have recently recorded quarterly annualized net charge-off ratios as high as 83 percent,3 far higher than the typical annualized net charge-off ratio for subprime credit card lenders. Recent charge-off ratios for subprime lending institutions’ credit card portfolios, while still high, typically do not exceed 20 percent. Higher default rates for payday loan portfolios indicate that loan loss reserves and capital levels that may be adequate for some other forms of subprime lending may not properly cover the greater risks associated with payday loans.

Depository institutions involved in payday lending also may enter arrangements with third parties to originate payday loans. These loans often involve fees and charges in excess of those the third party could otherwise charge under state law. Although federal banking statutes authorize insured depository institutions to “export” interest rates from states where the lender is located on loans made to borrowers residing outside the state, litigation involving the use of this authority by third-party payday lenders has recently increased. In addition, some suits also have alleged lender violations of various state and federal consumer protection laws in connection with these loans. Thus, participation in these arrangements may expose insured depository institutions to substantial legal and reputational risks. In addition, third-party arrangements may also pose additional operational risks, such as a heightened risk of transactional error or fraud.

source: fdic.gov

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