The nearly $50 billion small dollar lending market continues to experience significant changes as increased regulatory scrutiny and business model innovation impact the nature of competition. As consumer demand for short-term credit has rebounded since the downturn, the traditional storefront, “payday” operation has given way to inventive online, installment lending models. Since 2007, loans originated through storefront lenders have dropped by over 30% to less than $30 billion while volume at online lenders has increased steadily at a 25% CAGR.
Earlier this year, the Consumer Financial Protection Bureau (CFPB) announced regulatory guidelines for both short and long-term small dollar loans. Proposals under consideration include:
- Debt trap prevention requirements – requiring lenders to determine at the outset that the consumer can repay the loan when due (including verification of income and loan obligations)
- Debt trap protection requirements – requiring lenders to provide affordable repayment options and limiting the number of loans a borrower could take out in a row and over the course of a year
- Harmful payment collection practice restrictions – requiring borrower notification before accessing deposit accounts and limiting unsuccessful withdrawal attempts that lead to excessive deposit account fees
While the impact of these changes will not be completely realized unless fully implemented, increased uncertainty has the potential to cause further shakeup in the industry.
Business Model Innovation
An ever-changing regulatory landscape as well as growing consumer appetite for small dollar credit is encouraging both traditional and non-traditional lenders to explore market opportunities. Key industry players include:
- Storefronts: Although storefront and payday lenders are expected to continue making up a smaller percentage of loan originations, they currently control the vast majority of the market and have the most experience serving consumers of short-term loans.
- Online Lenders:The online small-dollar lending market is predicted to continue its rapid rise over the next five to ten years. While online platforms benefit from operational and analytical efficiencies, they must contend with a crowded marketplace and high customer acquisition costs. The success of peer-to-peer models (including Lending Club’s recent IPO) demonstrate online lenders can succeed through sustained innovation.
- Credit Unions / Banks: According to a recent study by the Pew Charitable Trusts, almost 80% of consumers favor allowing credit unions and banks to provide small-dollar installment loans at favorable terms to borrowers. In 2010, the National Credit Union Administration (NCUA) established a regulatory framework for payday-alternative loans. Today, more than 500 federal credit unions offer these loans – often with successful results. While banks have traditionally favored higher value personal loans, the market may become attractive enough to warrant increased investment and product development.
- Non-traditional Alternatives: A number of new entrants may also find success in the market. Dodd-Frank legislation enables Community Development Financial Institutions (CDFIs) to compete with payday lenders. The United States Postal Service (USPS) has also explored the small dollar market, suggesting the agency could provide services at a significantly lower cost than private businesses. Earlier this year, the investment bank Goldman Sachs announced its interest in offering unsecured consumer loans.
Summary and Impact
In order to excel in a dynamic and volatile environment, small dollar lenders will need to (1) Strengthen their product and processes to stay ahead of regulatory and compliance challenges (2) Leverage data and analytics to improve risk selection and differentiate products (3) Better understand customer needs and behaviors – particularly as it relates to channel preferences (4) Drive efficiencies in customer acquisition and marketing.
Regulation and innovation will continue to influence the direction of small dollar lending. Companies who improve and advance their business models and can withstand regulatory pressures will be best positioned to survive and prosper in this environment.