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Information Asymmetry, Moral Hazard, and Payday Loans

Dobbie’s and Skiba’s paper: “Information Asymmetries in Consumer Credit Markets: Evidence from Payday Lending” uses the following information to describe payday loans. A payday loan is a consumer loan given to people who need money and cannot afford to wait for their next paycheck, and a personal check is used as collateral. They are usually for small amounts to meet immediate obligations and have extremely high interest rates (sometimes as a high 400%-500% annual rate). Many men and women who take out payday loans need to do so again and again in subsequent months due to the interest rates they are charged. Studies have also found a correlation between taking out payday loans and running into credit card delinquency and bankruptcy. Finally, different payday loans are given in $50 increments depending on one’s income bracket, so they use fine lines to draw distinctions between people of similar creditworthiness leaving those who barely do not qualify for certain payments in difficult situations.

It is intuitive to think the unjust payday loan system originally grew from problems of information asymmetry and moral hazard. Moral hazard often arises in consumer lending when banks do not have critical information about potential borrowers that would lead them to reconsider the borrowing terms, or not lend to a person at all. Many banks lose money because only the borrower truly knows how risky an endeavor they might take on with the loan they receive from a bank. In order to flip the script, lending institutions charge unreasonably high interest rates, even considering the below average credit ratings of the borrowers.

It is a problem much like the market for lemons. Used car purchasers have little idea of the quality of cars they are viewing, whereas lending institutions have little idea whether or not they are dealing with a person who will pay back his or her loan. For that reason, in order to make sure that they profit, lenders will want to charge a rate that balances risk and reward as if their pool of borrowers consists of some combination of reliable and unreliable borrowers.   However, unlike the market for lemons in which sellers of good cars will drop out of the market in a pooling situation, the more reliable payday borrowers are still desperate for immediate cash, and thus are forced to take out a loan at an unfair interest rate. It is a combination of information asymmetry and the banks tendencies to take advantage of a person’s desperate financial situation that brings about the predatory lending practices.

Some suggestions on how to combat the problem of such predatory lending (other than mandating lower interest rates) are applications of ideas from Networks, Crowds, and Markets. The first would be incorporating types of reputation systems into the process. If, for example, potential borrowers can show proof of adequate, steady income and have a history of paying off their payday loans, they should be rewarded with lower interest rates. Currently, instead of requiring background checks, many lending institutions are known to skip them altogether. If gathering information for background checks proves to be very difficult, another possibility (similar to what is suggested in predicting a worker’s productivity in the labor market), is to use proxies such as education or number of children that are indicative of one’s creditworthiness. But obviously the reliability of the characteristics used as proxies must be proven before applied.

Overall, combatting information asymmetry in predatory lending can be a means to create fairer lending agreements on payday loans. It can also be a method to stop institutions from taking additional money from what are already low-income households.


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