Introduction
The sub-prime consumer credit market is complex. A wide range of lenders exist serving those unable to access the mainstream credit market, typically due to low incomes and/or a lack of, or no, credit history (Burton et al., Reference Burton, Knights, Leyshon, Alferoff and Signoretta2004; Leyshon, Reference Leyshon2009; Appleyard et al., Reference Appleyard, Rowlingson and Gardner2016). Marginalised from the mainstream, individuals operating in this market have complex financial lives and utilise sophisticated money management, and coping, strategies (Biosca et al., Reference Biosca, McHugh, Ibrahim, Baker, Laxton and Donaldson2020; Appleyard et al., Reference Appleyard, Packman, Lazell and Aslam2023). Even seemingly exploitative forms of consumer credit, such as payday lending, are used successfully by some borrowers to meet their basic needs and smooth gaps in their income (Marston and Shevellar, Reference Marston and Shevellar2014; Rowlingson et al., Reference Rowlingson, Appleyard and Gardner2016). Yet effectively navigating the world of high-cost lenders places the responsibility on the individual (Langley, Reference Langley2008). Examples abound of individuals becoming indebted by borrowing from high-cost providers that have unfavourable or coercive repayment mechanisms with negative consequences for their health and wellbeing (Rowlingson et al., Reference Rowlingson, Appleyard and Gardner2016; Sweet et al., Reference Sweet, DuBois and Stanley2018a, Reference Sweet, Kuzawa and McDade2018b, Reference Sweet, Nandi, Adam and McDade2013). Such individuals require accessible, appropriate, and affordable lenders (Sinclair, Reference Sinclair2013; Salignac et al., Reference Salignac, Muir and Wong2016). In the UK, such lenders are termed Community Development Finance Institutions (CDFIs).
CFDIs provide small, short-term personal loans to individuals with low incomes who lack collateral and savings. They are recognised as a more responsible and affordable alternative to other forms of sub-prime lending (Lenton and Mosley, Reference Lenton and Mosley2012; FCA, 2019; Appleyard et al., Reference Appleyard, Packman, Lazell and Aslam2023). While credit unions are another important form of not-for-profit sub-prime lender, they generally target relatively more-affluent households than CDFIs, require membership and some form of savings or collateral (Roy et al., Reference Roy, McHugh, Huckfield, Kay and Donaldson2015; Carnegie, 2020; Dayson et al., Reference Dayson, Vik and Curtis2020; FCA, 2023).Footnote 1 CDFIs play an important role not only in the sub-prime market but also in society through their role in tackling, and helping prevent, the social consequences of financial exclusion, such as poverty and adverse health consequences, that can ensue from struggling to manage day-to-day financial needs and loss of earned income, meeting one-off expenses and avoiding, or reducing, problem debt (Kempson and Collard, Reference Kempson and Collard2012; Biosca et al., Reference Biosca, Bellazzecca, Donaldson, Bala, Mojarrieta, White, McHugh, Baker and Morduch2024, Reference Biosca, McHugh, Ibrahim, Baker, Laxton and Donaldson2020; Ibrahim et al., Reference Ibrahim, McHugh, Biosca, Baker, Laxton and Donaldson2021). Yet in social policy terms, personal-lending CDFIs are relatively overlooked with previous analysis focusing on business-lending CDFIs (Affleck and Mellor, Reference Affleck and Mellor2006). The need to address this is amplified by the recent closure of two of the UK’s most well-known and long-standing personal lending CDFIs – Scotcash and StreetUK – for a mixture of economic, funding, and regulatory reasons (McArthur, Reference McArthur2023; StreetUK, 2023). Their closures exemplify the difficulties of CDFIs serving creditworthy financially vulnerable individuals, where the current unmet commercially viable credit need is estimated at 2,000,000,000 pounds (LEK Consulting, 2023) and are clear examples of market failure. Arguably, government intervention is required to ensure this group of borrowers can access not-for-profit provided affordable credit.
In this paper, we argue that market failure in the UK sub-prime consumer credit market is more extensive than previously acknowledged. Market failure, around credit provision, typically centres on adverse selection and moral hazard. We utilise a Diverse Economies Framework to distinguish between different types of lender (mainstream, alternative. and non-market) and neoclassical economic theory as an analytic framework to introduce three additional forms of market failure – diseconomies of small scale, externalities, and excess demand and oversupply. This suggests market failure in the UK sub-prime consumer credit market is more comprehensive than previously recognised, increases the argument for government intervention, and points to four policy responses – public subsidies, patient capital, regulation, and taxation – to complement and supplement market responses.
‘Diverse economy’ framework
Gibson-Graham articulates the conceptualisation of the ‘diverse economy’ (Gibson-Graham, Reference Gibson-Graham2014, Reference Gibson-Graham2006). This draws attention to the diverse economic practices sustaining the economy that are often overlooked due to the hegemony of capitalism. Gibson-Graham identifies different domains of economic practice that exist in relation to different sectors of the economy. For the finance sector different financial institutions and transactions are distinguished based on how financial return is negotiated and under what social relations people borrow and lend, save, and invest (Gibson-Graham and Dombroski, Reference Gibson-Graham and Dombroski2020). The three domains, and examples of corresponding providers, are: mainstream market (e.g. commercial banks); alternative market (e.g. community based financial institutions, microcredit, credit unions); and non-market (e.g. family lending, rotating credit funds).
Within the mainstream market, the overriding principle is one of profit maximisation. In the alternative market, different alterities exist, ranging from providing additional choice to consumers through to different values underpinning operating practices (Fuller and Jonas, Reference Fuller and Jonas2003). Non-market providers sit outwith the market and are unregulated. For this paper, we focus on four forms of UK financial providers that sit within the three domains of the diverse economy framework (see Table 1).
Providers within a diverse economy
Within the UK, commercial banks dominate the retail banking market. While digital challengers have entered the market in recent years they primarily focus on wealthier creditworthy individuals and four banks – Lloyds Banking Group, Barclays, HSBC, and NatWest – continue to have the majority market share (FCA, 2022). As outlined in Table 1, these commercial banks constitute the mainstream market and have a primary aim of profit maximisation.
For the alternative market, providers are categorised as not-for-profit or for-profit. As outlined above, we focus on CDFIs as an example of a not-for-profit sub-prime lender. A social purpose rather than profit maximisation underpins their operating practices. In 2023, nine CDFIs lent 66,000,000 pounds in short-term, small personal loans (the average loan size was 726 pounds) to low-income households struggling to access other forms of regulated credit (Responsible Finance, 2024). For-profit sub-prime lenders include payday loan companies, home-collected credit, buy-now-pay-later (BNPL) companies, and unlicensed lenders (Aitken, Reference Aitken2010; Appleyard et al., Reference Appleyard, Rowlingson and Gardner2016; Rowlingson et al., Reference Rowlingson, Appleyard and Gardner2016). These lenders operate differently to the mainstream, in terms of their lending and repayment mechanisms. However, they still aim to maximise profit. Importantly, they do so by, in general, charging high default fees and usurious interest rates and selling credit that does not account for whether it will be beneficial to the borrower. There are a lack of affordability checks and inconsistent treatment of customers in financial difficulty. While payday loan companies and home-collected credit are subjected to differing degrees of regulation by the Financial Conduct Authority (FCA) in the UK, BNPL companies are not yet regulated and unlicensed lenders are neither regulated nor authorised by the FCA. This area of the consumer credit market has changed dramatically in recent years. Regulatory reform (as discussed later) has seen a shrinking of payday and home-collected lending. Loans values in the high-cost short-term credit market, which includes payday lending, have declined from 2,500,000,000 pounds in 2013 to 244,000,000 pounds in 2022 and there has been a similar decline in home collected credit from 1,200,000,000 pounds to 200,000,000 pounds (fair4all finance, 2024a). Alternatively, the use of unregulated lenders has grown rapidly. In 2023, 27 per cent of UK adults (or 14,000,000 people) used BNPL, up from 17 per cent in 2022, and over 3,000,000 people are estimated users of illegal moneylenders (fair4all finance, 2024a).
Lastly, we utilise one form of non-market lender: family and friends. For some people, turning to family and friends is a last resort (fair4all finance, 2024a). This source of lending is similar to unlicensed lenders in some respects, being unregulated and offering informal loans without paperwork, but differ in other important ways. Financially vulnerable individuals tend to seek loans from family and friends who are frequently in a similarly vulnerable position (Biosca et al., Reference Biosca, Bellazzecca, Donaldson, Bala, Mojarrieta, White, McHugh, Baker and Morduch2024, Reference Biosca, McHugh, Ibrahim, Baker, Laxton and Donaldson2020). While unlicensed lenders generally operate with market forces, providing high-interest loans with coercive practices to extract repayment.
Perfect competition
In a perfect market, equilibrium, in terms of supply and demand, is met using price and quantity signals. In this state, no producers and consumers are left unsatisfied by the market exchange so societal welfare (or utility) is maximised. According to neoclassical economic theory, a free, unregulated market solution is the most efficient way to maximise societal welfare. Government intervention comes with a cost. Consequently, government should intervene only when market failure leads to an imperfect market with lower utility than could otherwise be the case. However, a perfect market only occurs under certain conditions. In what follows, we relate the four main conditions necessary for a perfect market to the market for small, unsecured personal loans (see Table 2 for a definition of these four conditions).
Conditions for a perfect market
Perfect knowledge and certainty
Regarding financial decisions, this condition assumes consumers can perfectly plan every financial decision and use of credit, without making a wrong decision, and are not susceptible to sudden and unexpected financial shocks. Similarly, potential solutions would not be unavailable, expensive, or unaffordable. Consequently, there would be no need for a knowledgeable expert advising on the best product. Evidence suggests that financially excluded individuals with low-incomes in the UK use complex and sophisticated financial management strategies to manage their financial lives (Biosca et al., Reference Biosca, Bellazzecca, Donaldson, Bala, Mojarrieta, White, McHugh, Baker and Morduch2024, Reference Biosca, McHugh, Ibrahim, Baker, Laxton and Donaldson2020; Appleyard et al., Reference Appleyard, Packman, Lazell and Aslam2023). However, it also highlights these individuals are making financial-related decisions every other day, which is a significant cognitive burden, and that they are vulnerable to financial shocks that can be sudden and unexpected. Evidence also abounds of individuals with problem debt (McKay et al., Reference McKay, Rowlingson and Atkinson2022). For example, in the 12 months to January 2024, 7,400,000 (14 per cent of UK adults) struggled to pay domestic bills and credit repayments, and 2,700,000 people (5 per cent UK adults) sought financial support due to financial difficulty (FCA, 2024). Therefore, while it is possible to plan some financial decisions and select the most appropriate financial product, this is not always the case. This implies that for some financial decisions there is a need for a knowledgeable expert advising on the best product. Typically, for credit transactions, this would be a loan officer. However, loan officers, generally, act in the suppliers’ self-interest. As consumers lack perfect knowledge, suppliers are in a situation to both provide advice about credit products and influence demand to maximise profit.
No externalities
If no externalities exist in the market for small, unsecured personal loans then family or friends of (non-)creditworthy individuals or others in society would not be (positively or negatively) affected by their use of debt, or exclusion, from certain credit providers. However, evidence suggests the existence of ‘selfish’ (Biosca et al., Reference Biosca, Bellazzecca, Donaldson, Bala, Mojarrieta, White, McHugh, Baker and Morduch2024, Reference Biosca, McHugh, Ibrahim, Baker, Laxton and Donaldson2020; Ibrahim et al., Reference Ibrahim, McHugh, Biosca, Baker, Laxton and Donaldson2021) and ‘caring’ externalities (UK Parliament, 2018; Labour, 2024) in relation to the provision of appropriately provided credit to creditworthy individuals (these concepts are explained in more detail in the ‘Market failure’ sub-section below).
Large number of sellers and free entry of firms
For lenders of credit, this condition assumes there would be no restrictions preventing different producers from competing purely on price. As previously outlined, in the UK four commercial banks have the majority market share, indicating that this market concentration allows them to influence price. While there are a number of other lenders in the mainstream market, such as mid-tier banks and digital challengers, these banks do not compete for financially vulnerable creditworthy individuals who require access to small, unsecured loans. This is a risky segment and it has been traditionally excluded from commercial bank clientele as a credit risk mitigation measure, which has been aggravated by market uncertainty and the cost of living crisis (Jenkins, Reference Jenkins2023). CDFIs are set up to serve this market but only nine exist in the UK serving 86,000 individuals, typically within a narrow geographic area (Responsible Finance, 2024). Arguably, restricting the number and reach of CDFIs is unsuitable regulation and operational costs. Regulation is required to maintain standards. But in the UK, while CDFIs receive some special status for being not-for-profit, they must comply with FCA regulation aimed at bigger, more profit oriented lenders (European Microfinance Network, 2022). Lenders are also geographically targeted and offer operationally intensive, and relatively expensive, products and services. The costs of regulation and operations, as an ‘overhead’, are more easily spread across the activities of bigger banks (and people seeking larger amounts of credit). This further increases the relatively high transaction costs associated with this form of lending, making it more difficult for providers to make economic profits from providing small, unsecured personal loans (FCA, 2021). This acts as a disincentive to market entry and is a factor in the reduction of CDFIs operating in this market.
Identical goods
This condition implies that all lenders would implement the same lending (e.g. interest rate, collateral, credit scoring) and repayment (e.g. frequency of repayment schedule, form of collecting repayment) mechanisms. Consequently, producers offering an ‘inferior’ product would be forced to alter it or go out of business as consumers would utilise a competitor. However, this is not the case (Appleyard et al., Reference Appleyard, Rowlingson and Gardner2016). For example, prior to the FCA introducing new rules around price caps (FCA, 2014), it was not untypical for for-profit sub-prime lenders, such as payday lenders, to offer loans with an APR over 1,000 per cent (Rowlingson et al., Reference Rowlingson, Appleyard and Gardner2016). Rather than go out of business, these lenders flourished. There are two ways to interpret this. One, as different lenders offer credit in different ways (Sweet et al., Reference Sweet, Kuzawa and McDade2018b; Ibrahim et al., Reference Ibrahim, McHugh, Biosca, Baker, Laxton and Donaldson2021), other characteristics of the product, such as the ability to access to credit quickly, more than compensate for the higher charges. Second, due to limited competition, borrowers lack consumer sovereignty over their choice of provider. Either way it is clear that small, unsecured personal loans are not offered identically by providers.
Market failure: an imperfect market for small, unsecured loans?
If the above assumptions held true for the market of small, unsecured personal loans in the UK there would be no case for government intervention. Due to consumer sovereignty, consumers would be the best judge of products on offer and the level of supply would shift to meet demand. However, as our initial discussion highlights this market does not satisfy these conditions. Indeed, there is already government intervention in the market through, for example, regulation. Consequently, the key, related, questions become twofold. How comprehensive is market failure? Does the market, without further government intervention, result in the best societal outcomes?
The two most commonly articulated forms of market failure around credit provision are adverse selection and moral hazard (see, for example, Arnott and Stiglitz (Reference Arnott and Stiglitz1991) and Stiglitz and Weiss (Reference Stiglitz and Weiss1981) for a more in-depth discussion). Both market failures result from informational asymmetries between consumers and producers. Adverse selection results in creditworthy borrowers being inadvertently rejected as lenders are unable to differentiate them from non-creditworthy individuals using traditional lending mechanisms – interest rates, credit scores, and collateral. Moral hazard stems from lenders facing problems ensuring repayments after loan issuance. If lenders believe they cannot incentivise borrowers to make repayments, they may choose not to issue a loan which again can result in the unnecessary exclusion of creditworthy individuals. In what follows, we introduce three additional forms of market failure – diseconomies of small scale, externalities, and excess demand and oversupply – that suggests market failure in the market for small, unsecured personal loans is more comprehensive than previously recognised, and increases the argument for government intervention.
Diseconomies of small scale
Alongside adverse selection and moral hazard a third source of market failure exists that also relates to the risk and uncertainty of providing small, unsecured personal loans – diseconomies of small scale. This concept is more easily understood in the relation to its more commonly encountered antithesis, economies of scale. Larger organisations are generally able to spread the fixed cost of its commodities, taking advantage of economies of scale to reduce the cost per unit. Unit costs are generally portrayed with a U shaped graph; if an organisation becomes too large its unit costs can begin to rise again. Similarly, if the organisation is too small. In the context of small, unsecured personal loans, diseconomies of small-scale relate to the unit cost of offering these loans (i.e. transaction costs) and the size of the market available. This market failure is only relevant to lenders operating in the regulated credit market.
For commercial banks operating in the mainstream market diseconomies of small scale are not an issue (FCA, 2021). Small, unsecured personal loans to financially vulnerable individuals is one potential product among many products and services they could offer. However, this market is generally deemed too risky, in terms of defaults, by mainstream lenders and transaction costs too high (FCA, 2021). This implies that the price (or marginal revenue) is less than the average total cost at the quantity of loans demanded. However, these lenders should be able to cross-subsidise the provision of this loan type to this market by spreading the cost over their other products and services. Banks already do something similar with free bank accounts that are paid for via other profitable components of their business. This acts as a loss leading strategy, enabling banks to sell products or services to those individuals attracted to this product. Arguably, small, unsecured personal loans are not treated the same way as the target customers are not deemed commercially viable; thus, banks lack a profit motive. However, with TSB recently becoming the first major UK bank to advertise and offer small loans (<1,000 pounds) (fair4all finance, 2024a) this demonstrates that commercial banks can lend in this market.
The same market failure exists for sub-prime (for-profit and not-for-profit) lenders. However, it is more pronounced for not-for-profit lenders for five main reasons. First, these lenders are more likely to use relationship banking than credit scoring practices, which is more resource intensive (McHugh et al., Reference McHugh, Baker and Donaldson2019; Magli et al., Reference Magli, Mazzei, Biosca and McHugh2024). Second, as not-for-profit lenders have a social mission alongside, or instead of, a profit motive, while interest rates are high (i.e. potentially up to 100 per cent APR), in general, they are recognised as affordable lenders as there are self-imposed limits to the rates offered (FCA, 2021, 2019). Third, unlike for-profit lenders, not-for-profit lenders are more likely to discriminate between creditworthy and non-creditworthy individuals by not lending to the latter and, in general, aim to achieve a balance between making people aware of their existence but without incentivising people to borrow if they do not need the product or if the product is unlikely to improve their situation (Magli et al., Reference Magli, Mazzei, Biosca and McHugh2024). This reduces the size of their available market. While for-profit lenders are not as concerned with affordability because revenue can still be generated through, for example, high default charges or rolling-over loans (Biosca et al., Reference Biosca, Bellazzecca, Donaldson, Bala, Mojarrieta, White, McHugh, Baker and Morduch2024; Deville, Reference Deville2015). Fourth, not-for-profit lenders, such as CDFIs, typically operate within a narrow geographic area, which further restricts the size of the market available (FCA, 2021). Lastly, CDFIs offer a narrow range of products. For example, regulation restricts CDFIs from offering savings products (Ruesta and Benaglio, Reference Ruesta and Benaglio2020; FCA, 2021, 2019). This further constrains the number of customers available to them and reduces the opportunity for cross-subsidisation.
Externalities
Two externalities are the ‘selfish’ and the ‘caring’ externality. The ‘selfish’ externality occurs when people benefit directly through others’ consumption of a commodity. Family and friends of a financially excluded individual can benefit directly, through less strained relationships, from that individual consuming a not-for-profit loan as opposed to relying on them for credit (Ibrahim et al., Reference Ibrahim, McHugh, Biosca, Baker, Laxton and Donaldson2021; Biosca et al., Reference Biosca, Bellazzecca, Donaldson, Bala, Mojarrieta, White, McHugh, Baker and Morduch2024, Reference Biosca, McHugh, Ibrahim, Baker, Laxton and Donaldson2020). Additionally, problem debt, which is less likely via not-for-profit lenders who do not focus on maximising profit, also impacts negatively on relationships with family and friends (Magli et al., Reference Magli, Mazzei, Biosca and McHugh2024; Step Change, 2024).
The ‘caring’ externality was first articulated in relation to the provision of health care in the UK through the National Health Service (NHS) (Culyer, Reference Culyer1976). The reason why the NHS, funded directly through taxation, is accepted is that ‘individuals are affected by others’ health status for the simple reason that most of them care’ (Culyer, Reference Culyer1976:89). A similar argument is possible for the provision of financial products to financially excluded individuals. A market failure exists because other members of society care about these individuals gaining access to beneficial financial products and services and the associated positive social consequences, including health and wellbeing benefits. This is evidenced through social campaigns, such as the End High Cost Credit Alliance, which promotes not-for-profit lenders, such as CDFIs (UK Parliament, 2018), and the new UK Government’s commitment to create a National Financial Inclusion Strategy (Labour, 2024).
Excess demand and oversupply
Asymmetric information between consumers and producers leads to market failure in the form of excess demand and oversupply. Contrary to consumer sovereignty, in relation to financial decisions consumers are not necessarily always the best judges of their own welfare. Financially vulnerable individuals use sophisticated and complex financial management strategies (Biosca et al., Reference Biosca, Bellazzecca, Donaldson, Bala, Mojarrieta, White, McHugh, Baker and Morduch2024, Reference Biosca, McHugh, Ibrahim, Baker, Laxton and Donaldson2020; Appleyard et al., Reference Appleyard, Packman, Lazell and Aslam2023). However, they also face considerable pressures from a high volume and frequency of financial decisions and the need to cope with sudden and unexpected financial shocks. Consumers seek ways to improve their financial situation but the market does not necessarily provide this information. For example, financially vulnerable individuals may be eligible for unclaimed welfare benefits (Butler, Reference Butler2023; fair4all finance, 2024a). As for-profit sub-prime lenders are incentivised to maximise profit, the welfare of financially vulnerable individuals is not their primary concern. This could result in oversupplying loans; for example, to non-creditworthy individuals where the potential to generate money outweighs the potential impact of borrowing on the individual, while not-for-profit lenders are more likely to prioritise the welfare of the individual, only providing a loan if it is in the borrowers’ interest (McHugh et al., Reference McHugh, Baker and Donaldson2019; Ibrahim et al., Reference Ibrahim, McHugh, Biosca, Baker, Laxton and Donaldson2021; Magli et al., Reference Magli, Mazzei, Biosca and McHugh2024). Thus, it is necessary to distinguish between creditworthy and non-credit-worthy individuals. As noted earlier, the unmet demand in the UK among the former group is estimated at 2,000,000,000 pounds, however, it is also estimated that there is 5,000,000,000 pounds of unmet need among a group where further borrowing would likely have a negative impact on recipients and would not be commercially viable for lenders (LEK Consulting, 2023). While creditworthy individuals would potentially benefit from access to not-for-profit lenders, other non-credit based solutions are required for non-credit-worthy individuals. Worryingly both groups seem to be turning to unregulated, exploitative lenders (fair4all finance, 2024a).
Discussion
As outlined, the market for credit is not operating in a socially desirable way. Market failures are leading to a situation where there is an undersupply of loans to creditworthy individuals and an oversupply of loans to uncreditworthy individuals. From a neoclassical economic perspective, the ideal scenario is that self-generated market mechanisms ‘correct’ these market failures. This has occurred to some degree. However, the comprehensiveness of market failure requires policy responses to complement and supplement these mechanisms.
Market responses to market failures
The two forms of alternative market providers – not-for-profit and for-profit sub-prime lenders – are able to lend to a market vacated by mainstream providers due to innovative lending and repayment practices. These practices, to varying degrees, aim to repair aspects of market failure.
Lending practices
Not-for-profit sub-prime lenders, such as CDFIs, traditionally use relationship-banking practices to circumvent adverse selection. This person-centred, resource intensive approach to lending aims to holistically consider an individual’s situation and aligns with CDFIs’ social mission (McHugh et al., Reference McHugh, Baker and Donaldson2019; Lenton and Mosley, Reference Lenton and Mosley2012; Ibrahim et al., Reference Ibrahim, McHugh, Biosca, Baker, Laxton and Donaldson2021; Magli et al., Reference Magli, Mazzei, Biosca and McHugh2024). As well as placing the interests of the borrower ahead of maximising profit, this provides an in-depth insight into the borrowers’ ability to repay and their creditworthiness. This approach to lending also helps internalise externalities into the transaction and avoid excess demand and oversupply. More recently, CDFIs are exploring ways to offer similar services via digital technology and to make use of innovations, such as Open Banking, to inform their lending practices (Hadjimichael, Reference Hadjimichael2021). This transition aims to maintain their person-centric lending model while reducing the cost of lending.
Repayment practices
To differing degrees, innovative repayment practices, such as frequent repayments, flexible repayments, and alternative collection approaches, are embedded in the contracts of not-for-profit and for-profit sub-prime lenders to overcome moral hazard (Lenton and Mosley, Reference Lenton and Mosley2012; McHugh et al., Reference McHugh, Baker and Donaldson2019; Ibrahim et al., Reference Ibrahim, McHugh, Biosca, Baker, Laxton and Donaldson2021; fair4all finance, 2024a, 2023a; Magli et al., Reference Magli, Mazzei, Biosca and McHugh2024). Both forms of lender generally utilise frequent (i.e. weekly or bi-weekly repayments) and regular repayment schedules, starting almost immediately after loan issuance. There are three main advantages to this approach. First, early and frequent contact with borrowers provides lenders with an early warning system to detect, and intervene to help, struggling borrowers. Second, it can instil repayment discipline in borrowers. Third, as making small regular repayments resembles savings, learning this skill could benefit borrowers in the future. Not-for-profit lenders are more likely to offer flexible repayments, including repayment holidays or reduced instalments paid over a longer period without penalties for late payment or default (Ibrahim et al., Reference Ibrahim, McHugh, Biosca, Baker, Laxton and Donaldson2021; Magli et al., Reference Magli, Mazzei, Biosca and McHugh2024). Such an approach can help ease the stress and anxiety associated with borrowers’ experiencing repayment difficulties. Lastly, for-profit lenders, particularly home-credit providers and unlicensed lenders, collect repayments in-person from borrowers’ homes (fair4all finance, 2024a, 2023a). This is convenient for borrowers without bank accounts who cannot use direct debits for repayments. However, it also involves enforcement techniques designed to pressurise borrowers into making repayments.
Policy responses to market failure
Market mechanisms mean that an alternative market exists for financially vulnerable individuals, excluded from the mainstream market, seeking small, unsecured personal loans. However, not all such lenders offer a socially desirable solution and not all these individuals are able to access this market; instead turning to non-market lenders, such family and friends, or not borrowing at all and going without essential items (Biosca et al., Reference Biosca, McHugh, Ibrahim, Baker, Laxton and Donaldson2020; Appleyard et al., Reference Appleyard, Packman, Lazell and Aslam2023). For-profit sub-prime lenders, generally, do not internalise externalities into their decisions and can supply credit to non-creditworthy individuals due to their profit incentive. While lending from family and friends risks pressurising key social relationships and/or and transforming them into financial ones. Instead, and as demonstrated, not-for-profit sub-prime lenders present the best opportunity to reduce an already vulnerable group’s exposure to the consequences of market failure. However, due to the extensiveness of market failures in this area, these lenders require non-market support to do so.
Diseconomies of small scale and lenders resource intensive lending and repayment practices make it very difficult to operate sustainably in this market, which COVID-19 amplified (Dayson et al., Reference Dayson, Vik and Curtis2020; FCA, 2021). Responsible lenders are increasingly pressured to adopt new strategies to generate income, such as introducing online lending to expand market size (Carnegie, 2020; Dayson et al., Reference Dayson, Vik and Curtis2020). Such changes are aimed at making not-for-profit finance providers more competitive, by reducing costs, but can lead to them targeting marginally better-off individuals (McHugh et al., Reference McHugh, Baker and Donaldson2019; Dayson et al., Reference Dayson, Vik and Curtis2020; Magli et al., Reference Magli, Mazzei, Biosca and McHugh2024), threatening the uniqueness of their relationship-lending model. For such alternative financial institutions to not only survive, but also develop and continue to support the most vulnerable in society from even greater debt and associated worse health and wellbeing, government support is needed. We outline four policy responses to identified market failures: public subsidies; patient capital; regulation; and taxation.
Public subsidies
Extending the provision of financial products in a responsible way could ensure the capture of social benefits (i.e. positive externalities) and minimisation of social costs (i.e. negative externalities). The existence of positive externalities would indicate that the public are willing to sacrifice some of their own resources to this end; most efficiently achieved through the taxation framework (Culyer, Reference Culyer1976). Issued as ‘smart subsidies’ – designed to limit market distortions and miss-targeting of borrowers while maximising social benefits (Morduch, Reference Morduch2007) – this could allow the not-for-profit lending sector to scale-up and meet demand. The increased volume of transactions would also reduce operational costs, allowing these lenders to take advantage of economies of scale. Such subsidies should be seen as complementary rather than as an alternative approach to other existing initiatives, such as the No Interest Loan Scheme (NILS). Currently, operating as a pilot project in England, 10,000,000 pounds in additional credit has been provided to financially vulnerable individuals since 2022 through the NILS (fair4all finance, 2024b). While this project provides a needed loan product to a segment of society it does not protect the long-term sustainability of the not-for-profit sector. Subsidies could help responsible lenders with the cost of restructuring loans and improve consumer awareness. Unlike doorstep and payday lenders that charge financial penalties, responsible lenders currently absorb these costs. Additionally, compared to many for-profit providers, consumer awareness of CDFIs is low (FCA, 2019; Appleyard et al., Reference Appleyard, Packman, Lazell and Aslam2023). Government could support the promotion of not-for-profit lenders to the same level they have with FinTechs or commercial banks. For example, by subsiding advertising which is another fixed cost. Promotion could also occur through local government with incentives introduced to encourage, for example, housing associations to promote not-for-profit lenders. This would enable not-for-profit lenders to better connect with local markets. Finally, subsidies would enable not-for-profit lenders to provide in-person financial advice or an alternative, such as a digital benefits checker, to potential borrowers to check their eligibility for welfare benefits. This approach would help reduce the oversupply of credit through the availability of a more objective knowledgeable expert. Subsidies are needed for this service as financial advice, in particular, is difficult to provide as it generates no financial return for the lender. Subsidising this sector is not a new idea. From 2006 to 2011 the Growth Fund, issued by the Department of Work and Pensions, supported personal lending CDFIs. This funding increased their competitiveness and helped them expand the geographic scope of their operations while maintaining a focus on the poor (Lenton and Mosley, Reference Lenton and Mosley2014). The funding only stopped because of the UK Government’s, at that time, focus on austerity.
Patient capital
In addition to subsidies, government can act as a source of patient capital (Mazzucato, Reference Mazzucato2013). The private sector is increasingly fixated on generating short-term returns and unwilling to take on projects perceived as risky. Consequently, CDFIs struggle to attract investment to increase their lending capacity (FCA, 2021). There is a need for low-cost, patient capital that is more willing to bear risk and accept long-run returns. Patient capital could be used in two main ways. First, as a source of finance to on-lend to borrowers at a higher interest rate. Second, to invest in their operating practices, such as the development of new products and services, technology, or premises.
In the UK, fair4all finance has recently emerged as a potential source of patient capital for CDFIs. Set up in 2019 by the UK Government through the Dormant Assets Scheme, fair4all finance aims to increase ‘the availability of fair and accessible financial products and services’ (fair4all finance, 2023b). An explicit aim of fair4all is the expanded provision of credit provided by community lenders, such as CDFIs, with grant, debt, or long-term equity-life funding potentially available. While fair4all finance is a welcome addition it does not provide all the financial support needed for two main reasons. First, funding is only available to providers in England. Thus, CDFIs operating in other countries in the UK, such as Scotcash in Scotland, are ineligible for funding. Second, there is a focus on scaling-up affordable credit provision (fair4all finance, 2020). While such support is much needed and scaling-up could help increase not-for-profit providers economies of scale, it is important to consider how scaling-up is undertaken (if at all). Focusing solely on scaling-up risks excluding those lenders offering a valuable product or service in their community where financial assistance is required to continue operating but there is a lack of scope or motivation to scale-up. Relatedly, scaling-up is not risk neutral. Mission drift is a well-known unintended consequence of meeting growth targets. For example, when lenders target marginally better-off individuals who have less risk and demand relatively larger loans for similar transaction costs or by shifting fully to online lending, these actions could compromise relationship banking practices, to reach a larger market. A diverse range of patient capital is needed to support responsible lenders of different shapes and sizes.
Regulation
Regulation could take two main forms. First, providing additional funding for responsible lenders. For example, legislating for mainstream lenders to support local communities would foster collaboration across financial markets. Such legalisation exists in the USA – the Community Reinvestment Act – compelling commercial banks to provide funds to alternative, responsible finance providers (Appleyard, Reference Appleyard2013, Reference Appleyard2011). Alternatively, a small levy could be introduced on, for example, all bank accounts, that is directly used to subsidise the cost of providing small, unsecured loans. The existence of positive externalities would indicate public support for this policy. Second, more appropriate regulatory frameworks. The power of regulation is illustrated by the case of high-cost payday loan companies in the UK. In 2014, the FCA assumed the regulation for the consumer credit market in the UK. The FCA introduced various new rules around, for example, price caps, affordability tests, limits on roll-over loans to help protect consumers from escalating debts (FCA, 2014). The impact of this regulation was that payday firms, such as Wonga, that previously issued loans with an APR over 1,000 per cent could no longer afford to operate in the market, ceasing to exist. While these organisations were generally perceived as extractive and not socially desirable, they served a need and this demand still exists (Appleyard et al., Reference Appleyard, Packman, Lazell and Aslam2023; fair4all finance, 2024a, 2023a). More appropriate regulation is needed to support better existing alternatives, such as not-for-profit lenders. Current regulation prohibits CDFIs from collecting and holding deposits and CDFIs have to comply with regulation aimed at bigger, more profit-orientated lenders that is a resource intensive exercise. Regulation that is more specific would focus on recognising CDFIs different business models and enable them to expand their product range without succumbing to mission drift. This would help remove some of the diseconomies of scale preventing not-for-profit lenders from reaching a wider market, support alternative providers that internalise externalities and reduce problems caused by excess demand and oversupply.
Taxation
In the UK, the Community Investment Tax Relief (CITR) scheme exists to stimulate private investment from individuals and companies in disadvantaged communities. Accredited retail and wholesale CDFIs offering finance to small and medium enterprises, social enterprises, and charities can raise up to 25,000,000 pounds or 100,000,000 pounds, respectively (Responsible Finance, 2023). However, personal lending CDFIs are unable to access this scheme. Currently, no taxation option exists to improve the supply or cost of capital to this form of CDFI. Extending the CITR to personal lending CDFIs is recognised as an easy win for both CDFIs and investors (Dayson et al., Reference Dayson, Vik and Curtis2020).
Due to the existence of externalities, Pigovian taxation policies could also be an option. For example, rather than introducing regulation that, for example, places a cap on interest rates, government could levy a tax to those lenders with non-responsible lending and repayment practices. While the fine details of such a scheme would require much discussion, in principle this approach would force lenders to internalise negative externalities. Such a scheme would also need to go hand-in-hand with one that internalises positive externalities, such as public subsidies outlined previously, to meet continuing demand.
Conclusion
The consumer credit market has ‘not been widely explored by social policy academics’ (Rowlingson et al., Reference Rowlingson, Appleyard and Gardner2016: 540). This is despite the well-known social consequences of financial exclusion (Kempson and Collard, Reference Kempson and Collard2012; Biosca et al., Reference Biosca, McHugh, Ibrahim, Baker, Laxton and Donaldson2020; Ibrahim et al., Reference Ibrahim, McHugh, Biosca, Baker, Laxton and Donaldson2021). We extend the social policy analysis of this market from its focus on payday lending (Marston and Shevellar, Reference Marston and Shevellar2014; Rowlingson et al., Reference Rowlingson, Appleyard and Gardner2016) to the personal-lending sector. By outlining the pervasiveness and consequences of market failure in the UK sub-prime and the challenges for policy, this work complements, and extends, recent work exploring how financially marginalised individuals manage their finances and the positive impact that community finance initiatives such as those promoted by CDFIs can have on their lives (Ibrahim et al., Reference Ibrahim, McHugh, Biosca, Baker, Laxton and Donaldson2021; Appleyard et al., Reference Appleyard, Packman, Lazell and Aslam2023; Biosca et al., Reference Biosca, Bellazzecca, Donaldson, Bala, Mojarrieta, White, McHugh, Baker and Morduch2024, Reference Biosca, McHugh, Ibrahim, Baker, Laxton and Donaldson2020; Magli et al., Reference Magli, Mazzei, Biosca and McHugh2024; McHugh et al., Reference McHugh, Biosca and Donaldson2024). In combination with a diverse economics framework, our analysis of market failure utilises the current dominant economic discourse of neoclassical economics. It is not necessary to subscribe to this discourse. Indeed, for critics of it, the power of our analysis comes from showing that the sub-prime consumer credit market in the UK is imperfect according to the assumptions underpinning perfect competition. While market mechanisms provide some means of ‘correcting’ these market failures, the extensiveness of market failure strengthens the case for government intervention and points to four possible policy responses: public subsidies; patient capital; regulation; and taxation. Implementing these responses will enable this imperfect market to operate in a more socially desirable way. Otherwise, not-for-profit sub-prime lenders, such as CDFIs, will struggle to survive, further exposing an already-vulnerable group of borrowers to even greater debt and associated worse health and wellbeing.
Open access
