Has Wonga gone out of its mind? Yesterday it effectively wrote off £220m owed to the payday lend by 330,000 borrowers who were more than 30 days in arrears in paying back their debt. It might seem like a drop in the bucket in the financial sector, but £220m is a huge amount for Wonga. To put it in perspective, it is five-and-a-half times the firm’s annual profits and more than 11 times the amount it was recently fined by the Financial Conduct Agency (FCA) for sending faked letters to debtors.
As if this was not enough, 45,000 customers in arrears will not have to pay interest. All this followed an announcement yesterday that its profits had more than halved, and in the future the firm would be a smaller and less profitable business.
From afar this seems like a crazy business decisions. Why would a payday lender send out such a grand Mea Culpa? It seems to be similar to a mob boss forgetting all the “favours” which he had done for members of the local community. But Wonga’s plan to write off the debt is not irrational decision making. Nor is it a company suddenly finding its soul. It is simply shrewd business strategy.
By writing off these debts, Wonga clearly hopes to reset the company’s image. No longer will it seem like a rapacious company preying on the poor. It now hopes to be seen as a new-age capitalist with a conscience. But – perhaps more importantly – the company will get the regulator off its back. We must also remember that much of the debt which Wonga wrote off would have been sold on to debt collection companies at a huge discount.
Loan sharks would blush
In the past Wonga has been in the firing line for running what looked like a lending racket. It charged interests rates which would make a loan shark blush. This was dressed up in the garb of advertising featuring slightly batty puppets, presumably designed to appeal to company’s target market. It also portrayed itself as an online high-tech company located at the heart of London’s Tech City. Despite this nice facade, many commentators noted that the company had perfected a rogue business model which was legal, but many members of the public considered it to be illegitimate and unethical. Even the Archbishop of Canterbury weighed into the debate.
Clearly Wonga has tried to defend itself against criticism. It found customers willing to speak positively of its services. Despite this PR campaign, public suspicions persisted. These criticisms are not unfounded. There is a substantial academic literature showing many of the problems associated with payday lending. US research found the average payday loan is $375, but the average amount of interest paid on that loan is $520. Payday lenders clearly target the poor, and often those people of ethnic minorities.
This is partially because because mainstream banks have abandoned many poorer communities as they have closed branches and centralised services. This has been largely driven by the ongoing consolidation of financial institutions from a series of smaller institutions serving particular audiences into a small number of larger organisations catering to large numbers of average customers.
Poorer communities have been particularly hard hit by the retrenchment of non-profit financial institutions such as credit unions which traditionally lent to the poor. In poorer communities, payday loans are often used instead of social security payments. They often leave poor people trapped in cycles of debt, causing personal misery and dampening economic activity in these communities.
These concerns have resulted in an international crack-down on payday lenders. In the US, 14 states have banned payday lenders. The Australian states of New South Wales and Queensland have set a maximum annual percentage rate (APR) of 48%. In the United Kingdom, there is no maximum APR and little legislation to curtail the industry. Traditionally, payday lenders has been subjected to “light-touch” regulation. It is only during the past year that the Financial Conduct Authority has started to get tough with the industry. The result of this have been a £11m fine and today’s voluntary agreement with Wonga.
Wonga’s management clearly hopes that its debt cancellation might help to reset the company’s image. Other payday lenders may remain in the cross-hairs of the regulators. But it is far from certain whether the structural issues which underlie the growth of the payday lending market have actually disappeared.
Banks continue to close branches, tighten up lending and move out of poorer areas. At the same time, non-profit financial institutions such as credit unions remain a shadow of their formal selves. The result is that many poorer communities only have access to fringe institutions such as payday lenders. At the same time, consumers continue to be called upon to “prime the pump of” the economy through personal borrowing. Now people take out loans for everything from housing to education to day-to-day consumption. This leads to a strange kind of privatised Keynesianism, whereby individuals take on the debt which the state once bore.
The upshot is a continually high levels of individual indebtedness across the population. The difference of course is that corporations and high net-worth individuals pay practically nothing for their lending. The middle classes currently pay unprecedentedly low levels for their borrowing to pay off their homes. In contrast, the working class are forced to turn to payday lenders continue to pay thousands of percent to pay off a weekly food shop.
A recent study of payday lenders in the US state of Wisconsin offers some ways forward. The authors of this study suggest that if any regulator is serious about halting the spread of payday lending, then they should try to create incentives for the growth of non-profit financial institutions such as credit unions which typically cater to the poor. They also point out that banning payday lending does not necessarily help the problem. In states where payday lending is banned, mainstream banks began to offer overdraft services which were very much like payday lending. The way products are labelled matters.
Clearly flagging up not just the APR but also the total cost of borrowing to customers may force customers to think twice before taking on a high interest loan. But dutiful monitoring by regulators can also make a difference. For instance, South Carolina, which carefully monitors the databases of payday lenders, has been able to significantly reduce the practice of rolling over loans.
Forgiving 330,000 borrowers of theirs debts may help to ease the burdens of many individuals. It also could help to start shifting the image of Wonga from being what looked very like a rogue lender to a responsible citizen. But sorting out the problems of payday lending is likely to require much more far reaching structural measures.