American Rejects: Subprime/Shadow Banking in Canada

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It seems that all of those predatory lenders that were outlawed in the U.S. circa 2008 have made their way north, into Canada. The biggest offender? Citibank. While Canadian banks are some of the most heavily regulated in the world (Canada has never had a bank crash in its history as a result), it seems that Canadian law can’t keep up with the American rejects in banking & lending. So consumers are on their own for the most part.

There are two main problems with shadow lending from a neoclassical economic perspective, which specifically makes it “predatory”: 1) its interest rates defy the supply & demand schedule, and 2) this interest rate distorts the risk premium mechanism

First, interest paid on money is supposed to represent the cost of money. How is that cost determined? Theory says the supply and demand for money determines the price, but in the real world, price is usually set and adjusted until the demand falls.

Suppose that the supply of money is constant (or infinite). A demand schedule for money that is reflected in interest rates looks something like this:

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So as more people demand more loans, then the interest rates go up. When the demand for loans goes down, then the interest rate falls to entice more people to take out more loans. However, here’s where the supply & demand catch is with predator lenders: it doesn’t matter whether a people are lined up around the corner at their local payday loan shop, interest rates never change; they’re always high no matter what.

Here’s where banking regulation comes in. In Canada, it is federal law that lenders cannot charge more than 60% interest. Looking back at the demand schedule figure, suppose that “i2” is the constraint – the 60% point where no more interest can be charged by law. Even though predator lenders aren’t all that concerned about demand, they want more (and more, and more). How do they get around that upper limit? Service Fees.

So there is the interest rate, and then there is the “effective” interest rate; that interest rate calculated when all the service fees are factored into the nominal interest rate.

Suppose a person takes out a $1000 payday loan at 22% interest, with $100 in service fees. Their “nominal” interest is 22%, owing $1,220. However, they really owe $1,300 when service fees are factored, making the “effective” interest rate 30%.

Second is risk premium. Defenders of predatory lending cite that they are taking larger risks, and should charge a premium for this. The problem with this logic is that while risk premiums are standard in all lending, people are put into risk “pools” based on their credit history. In order to be classified as “high risk,” a person has to be compared to “low risk” clients. Predatory lenders classify all of their clients as “high risk,” regardless of whether or not they are actually high risk. With no comparison to “low risk” pools, this distorts the risk premium mechanism.

Canada is in the middle of a housing bubble, and a credit boom. Just like in the U.S., predator lenders have found a niche for people who are struggling either because they are over leveraged, or just don’t have enough income. What we’re learning from American rejects in Canada is that as long as there are over leveraged people with stagnant incomes, the sharks will attack regardless of borders. We’ve already seen the carnage in the U.S. Hopefully Canadian law can out swim the sharks.

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