The concept of payday lending is too deep for a layman to understand. In simple words, it is transaction of money outside the primary market, without securities. It is a loan that can be acquired very quickly because of the procedural simplicity, which at the same time contributes to the heavy risk involved. However, the concept is much deeper with a broader scope.
First, it is necessary to understand the term – subprime lending – it is a type of lending that relies on risk-based pricing to serve borrowers who cannot obtain credit in the prime market, where higher degrees of risk for borrowers carry higher costs for loans. Subprime loans are often called "A- through D" credits.
A payday lending is a specific type of subprime lending. In the past few years, a number of lenders have broadened their risk selection limits to attract subprime loans.
Of the different kinds of subprime loans, "payday loans" are provided by a growing number of insured depository institutions.
Payday loans (also called deferred deposit advances) are small-dollar, short-term, unsecured loans. Borrowers generally promise to repay the loan from their immediate paycheck or regular income payment (for example social security check). The deferred deposit advances are usually priced at a fixed dollar charge, representing the finance cost to the borrower. In these kinds of lending, the cost of borrowing, which is expressed as an annual percentage rate, is generally very high, owing to the short term maturities of the loan.
As a security, the borrowers generally provide a check or debit authorization for the amount of the loan, including the fee. The check is usually post-dated to the next payday. In other cases, the lender agrees to suspend presenting the check for payment until a future date, usually two weeks or may be lesser. Once the loan is due, the lender collects the loan by either depositing the check or by debiting the borrower's account or requests the borrower to redeem the Payday loans.
However, if the borrower does not have sufficient funds to repay the loan, a refinance
facility is made available, which however involves payment of an additional fee. If the borrower neither redeems the check in cash nor if the loan is refinanced, the lender automatically puts the check or debit authorization through the payment system. If the borrower's deposit account has is short of funds, the borrower naturally incurs a NSF charge on his account.
Furthermore, when the check or the debit is returned unpaid, the lender charges a returned fee in addition to collection charges.
Money always carries risk, along with interest (and not to forget – greed). But in the case of payday lending, the risk factor is higher due to the following reasons:
1. The major risk involved in this nature of lending is that is does not involve security against loan.
2. Payday lending fail to collect and analyze the borrower's credit standing. Neither do they collect other details from the major national credit bureaus (Equifax, Experian, TransUnion) nor do they conduct a substantive review of the borrower's credit history.
Steps to control risk
Federal law authorizes federal and state-chartered insured depository institutions that provide loans to out of state borrowers to "export" favorable interest rates, which are provided under the laws of the state where the bank is located.
To say, a state-chartered bank is permitted to charge interest on loans to out of state borrowers at the rates authorized by the state where the bank is located, regardless of usury limitations imposed by the state laws of the borrower's residence. However, institutions are faced with reputation risks each time they enter into certain deals with payday lenders.
Examiners of the loans need to apply the 2001 Subprime Guidance to banks with payday lending programs that the banks administer directly or via a third party contractor. The guidance excludes banks that occasionally occasionally provides its customers with low-denomination, short-term loan.
As per 2001 Subprime Guidance, “a program involves the regular origination of loans, using tailored marketing, underwriting standards and risk selection.” The 2001 Subprime Guidance specifically caters to institutions with programs where the aggregate credit exposure is equal to or greater than 25% or more of tier 1 capital. However, the magnifound credit and reputation risks inherent in payday lending makes it necessary that the guidance is applied irrespective of whether a payday loan program meets that credit exposure threshold or not.
It is always recommended that all examiners use the procedures outlined in the Subprime Lending Examination Procedures, along with the above guidelines. While the rules stress on safety issues, segments of the Subprime Lending Examination Procedures also apply to compliance examinations. They will be required to be supplemented with existing procedures relating to specific consumer protection laws and regulations.
As a result of the increased safety and compliance risks invloved in payday lending, concurrent risk management and consumer protection examinations should be compulsorily conducted. In all cases, the pre-examination planning process should include a review of each discipline's examinations, along with work papers. Relevant state examinations also need to be verified.
Rules regarding third party
Examiners are also required to conduct targeted examinations of the third party wherever required. the examiners are given teh authority to conduct examinations of third parties under several circumstances, for example, through the bank's written agreement with the third party, section 7 of the Bank Service Company Act, or through powers granted under section 10 of the Federal Deposit Insurance Act.
Third party examination activities would typically include, though not limited to, a review of compensation and staffing practices; marketing and pricing policies; management information systems; and compliance with bank policy,respective law and related regulations. – as per guidelines. Third party reviews should also contain testing of individual loans for obedience with underwriting and loan administration procedure and proper treatment of loans under delinquency.
Payday loans are a form of specialized lending, typically found in state non-member institutions, and are most often originated in specialized non-bank firms, subject to state regulation. Payday loans are always subject to high levels of transaction risk - given the large volume of loans, the handling of documents, and the movement of loan funds between the institution and any third party originators. Further, since the payday loans have the option to be underwritten off-site, there is an additional threat that agents or employees may misrepresent information about the loans or otherwise increase credit risk by failing to adhere to established underwriting guidelines.
Robert Benchley had once said, “I don't trust a bank that would lend money to such a poor risk.”