What happens to pawnbrokers when you ban payday loans?

Many people believe that payday loans are exploitative. They come with high fees and high effective interest rates (some can exceed 500% on an annualised basis). They tend to be targeted at low income people, who are excluded from traditional lending due to being perceived as high risk and/or lacking the collateral and credit history or rating necessary to obtain a loan from a more traditional lender.

A common policy solution to the perceived exploitation of low income borrowers is to restrict lending practices, such as setting a maximum effective interest rate (annual percentage rate, or APR). If the maximum rate is set too low though, it makes it uneconomic for any payday lender to lend to low income borrowers, effectively closing the market for payday loans, and further excluding low income borrowers from credit markets. However, that doesn't mean that these low income borrowers aren't going to look elsewhere for short-term loans.

If the government bans payday loans, or makes them uneconomic to offer, these borrowers might turn to other sources of loans, such as informal and unregulated loan sharks, or pawnshops. This increases the demand for those services, and makes them more profitable. If the barriers to entry into the loan shark or pawnshop market are low, then new firms may enter these markets to take advantage of the new profit opportunities.

That is the hypothesis that was tested in this article by Stefanie Ramirez (University of Idaho), published in the journal Empirical Economics (sorry, I don't see an ungated version). Ramirez looked at how the number of financial institutions (of various types) changed when Ohio set a maximum APR of 28% on payday loans in 2008, effectively making the industry uneconomic. Using monthly data at the county level from 2006 to 2010, she found that:

...the payday lending industry was demonstrably populated and active within the state prior to the ban with an average of 123.85 county-level operating branches per million. The effects of the ban can most definitely be seen as the average number of operating branches decreases to 10.14 branches per million in periods with the ban enacted.

Ok, so the ban was effective. Turning to other financial institutions, she finds that:

Pawnbrokers and precious-metals dealers are similarly concentrated to one another pre-ban, with an average of 16.65 branches per million and 18.51 branches per million, respectively. However, while there was an increase in concentration in both industries after the ban, growth in the pawnbroker industry was more pronounced than with previous-metal dealers, with the pawnbroker industry nearly doubling in size...

Small-loan lenders are the least populated industry but also show slight growth between pre- and post-ban periods. The average number of operating branches per million increased by approximately 21% between regulatory periods...

Finally, the average operating second-mortgage licensees per million shows no growth, however shows no decline between pre- and post-ban periods.

After controlling for other variables (like the price of gold, and the real estate index, population and other demographic variables) in a regression analysis, she found that pawnbrokers, small-loan lenders and second-mortgage licensees all showed statistically significant increases in numbers after the law change came into effect.

Low income people want access to credit. If policymakers ban one source of credit, they simply shift those borrowers into other markets, and those markets become more active. As Ramirez concludes:

In an effort to eliminate payday lending and protect consumers, policymakers may have simply shifted operating firms from one industry to another, having no real effect on market conduct.

The sad thing is that these other markets (e.g. pawnbrokers) may be even more difficult to regulate than the payday loan industry was.

[HT: Marginal Revolution, last year]